It looks like being a busy time for economic commentators for many, many months as they keep an eye on how the economy is progressing in light of the squeeze in public spending and impending tax increases. Inevitably these commentators – including us here on the Sloman News Site – will be watching to see how the private sector responds and whether or not, as is hoped, private sector activity will begin filling the void left by the public sector.
Of course, the largest group of purchasers in the economy is the household sector. So, in the short term at least, they will be crucial in supporting the total level of aggregate demand. The effects of any rebalancing of aggregate demand as the public sector’s role is reduced will be more painful should the real growth in household spending slow or even go into reverse. As consumers we are well aware that our spending depends on more than just our current income. For instance, it is affected by our expectations of our future incomes and by our general financial position. In essence the latter reflects our holdings of financial assets and liabilities (debt) and any wealth we may be lucky enough to hold in valuables such as housing.
So, do we have any clues as to how the financial position of households might be impacting on our spending? Well, the latest numbers from the Bank of England on Housing Equity Withdrawal (HEW) offer us an important insight in to the extent of the fragility felt by households as to their financial position. These numbers show that households increased their stake in housing by some £6.2 billion in the second quarter of 2010. At least two questions probably spring to mind at this point! Firstly, what is HEW and, secondly, what has this got to do with spending?
Let’s begin by defining Housing equity withdrawal (HEW). HEW occurs when new lending secured on dwellings (net lending) increases by more than the investment in the housing stock. Housing investment relates largely to the purchase of brand new homes and to major home improvements, but also includes house moving costs, such as legal fees. When HEW is negative, new secured lending is less than the level of housing investment. In other words, given the level of investment in housing, we would have expected new mortgage debt to have been greater. This means that households are increasing their housing equity.
This brings us to answering our second question – the ‘so what question’. As with all the choices we make, there is an opportunity cost – a sacrifice. By increasing our equity in property and using housing as a vehicle for saving we are using money that cannot be used to fund current consumption or to purchase financial assets.
As we have already noted, the Housing Equity Withdrawal (HEW) figures for Q2 2010 show that households increased their stake in housing by some £6.2 billion. This is equivalent to a little over 2½% of disposable income in the period and income that, as we have also said, could have helped to boost aggregate demand through spending. And, there is another concern for those hoping that households will help support aggregate demand in the short term: negative HEW is not new. In fact, HEW has been negative since the second quarter of 2008, the exact same quarter that the UK entered recession. The magnitude of negative HEW over these past 9 quarters is equivalent to £44.2 billion or 2.1% of disposable income.
Of course, these latest HEW figures are figures from the past. What we are ultimately interested in, of course, is future behaviour. But, it might be that the prolonged period over which British households have been consolidating their own financial position – just as the public sector is looking to do – suggests that households are in cautious mood. So the question for you to debate is how cautious you think the household sector will remain and, therefore, how much households will help support aggregate demand in the months ahead.
Articles
Mortgage equity still increasing, Bank of England says BBC News (1/10/10)
Homeowners pay down loans Independent (2/10/10)
Paying off mortgages is a priority Telegraph, Philip Aldrick (3/10/10)
Homeowners pay off £6.2 billion in mortgage debt Guardian, Phillip Inman (1/10/10)
Families pay off £6bn mortgages Express, Sarah O’Grady (2/10/10)
Data
Housing equity withdrawal (HEW) statistical releases Bank of England
Questions
- What do you understand by aggregate demand? And what do you think a ‘rebalancing’ of aggregate demand might refer to?
- What do you understand by the term housing equity withdrawal?
- What is the opportunity cost of positive housing equity withdrawal (HEW)? What about the opportunity cost of negative HEW?
- What factors might help to explain the nine consecutive quarters of negative HEW?
- List those items that you might included under: (i) household financial assets; (ii) household financial liabilities; and (iii) household physical assets. Using this information, how would you calculate the net worth of a household?
- Let’s think about the spending of households. Draw up a list of factors that you think would affect a household’s current spending plans. Given your list, what conclusion would you draw about the strength of household spending in the months ahead?
In the run-up to the Comprehensive Spending Review a battle is raging. On one side are those who argue that cuts are necessary to secure long-term growth and to maintain confidence on the UK economy. These people include leaders of 35 major companies in the UK who wrote a letter to the Telegraph (see below) suppporting George Osborne’s policy of cuts.
On the other side are those who maintain that the cuts will drive the economy back into recession or, at least, will hamper economic recovery. The Federation of Small Businesses warns that “Some small firms rely on public-sector contracts for 50 or 60 per cent of their turnover. If the cuts are swingeing and overnight, these companies will be lost to the UK economy forever.”
Read the following articles to get a clear understanding of the arguments on both sides. Hopefully this will then put you in a better position to assess the cuts and their impact.
Articles
Osborne’s cuts will strengthen Britain’s economy by allowing the private sector to generate more jobs Telegraph, letter from 35 business leaders (18/10/10)
Spending Review 2010: cut now or pay later, say business leaders Telegraph, Andrew Porter, and Robert Winnett (17/10/10)
35 business leaders back Osborne’s cuts BBC News blogs: Peston’s Picks, Robert Peston (17/10/10)
Prominent Tory donors among business leaders who backed Osborne’s cuts Independent, Andrew Grice (19/10/10)
On the tight side The Economist (30/9/10)
History will see these cuts as one of the great acts of political folly Observer, Will Hutton (17/10/10)
Osborne has taken the coward’s route Guardian, David Blanchflower (18/10/10)
Osborne reading Christian Andersen, claims economist The Herald, Ian McConnell (19/10/10)
Time to broaden the debate on spending cuts Guardian, Ha-Joon Chang (19/10/10)
Slugging it out over spending cuts Independent, Sean O’Grady (19/10/10)
Spending Review 2010: We should all fear the darkness, David Cameron included Telegraph, Mary Riddell (18/10/10)
Spending cuts: Molehill and mountain BBC News blogs: Stephanomics, Stephanie Flanders (19/10/10)
Does fiscal austerity boost short-term growth? A new IMF paper thinks not The Economist (30/9/10)
Spending Review: Forecasts rely on ‘heroic assumptions’ BBC News (20/10/10)
Spending cuts: City divided on whether cuts are good for recovery Yorkshire Evening Post (20/10/10)
Spending Review 2010: Spending cuts will hit small businesses hardest Telegraph, James Hurley (20/10/10)
Speech
Rebalancing the Economy Speech by Mervyn King, Bank of England Governor (30/9/10)
Mervyn King warns of 1930s-style collapse (Extract from above speech) BBC News, Mervyn King (19/10/10)
Questions
- What are the main arguments for making large-scale cuts to government spending at the present time?
- What are the main arguments against making large-scale cuts to government spending at the present time?
- To what extent should the government’s poplicy on the size and timing of the cuts be influenced by international economic relations?
- What role might the ‘inventory cycle’ play in the economic recovery?
- Why may the government “pay heavily unless it learns to temper its bloody cuts with humanity”?
- How will large-scale spending cuts impact on (a) consumer confidence; (b) business confidence; (c) the confidence of international financiers?
- Will monetary policy allow fiscal policy to be tightened without causing a recession? Explain the effectiveness of monetary policy in these circumstances.
National debt has increased rapidly over the past few years. In 2006/7 general government debt was £577.8bn or 42.9% of GDP. In 2009/10 it was £1000.4bn or 71.3% of GDP. It is set to go higher, with government debt forecast to be around 87% of GDP in 2011. This compares with forecasts of 82% for Germany, 87% for France, 103% for the USA, 134% for Greece and 195% for Japan.
Getting the deficit and debt down has, not surprisingly, become an issue in many countries. In the UK it has become the major current pre-occupation of the Coalition government and on 20 October it is set to announce major public spending cuts as a means of achieving this.
To get a flavour of the government’s thinking and the message that ministers are putting out to the electorate, the following are quotes from the Prime Minister’s and then the Chancellor’s speeches to the Conservative Party Conference:
This year, we’re going to spend £43 billion pounds on debt interest payments alone. £43 billion – not to pay off the debt – just to stand still. Do you know what we could do with that sort of money? We could take eleven million people out of paying income tax altogether. We could take every business in the country out of corporation tax. That’s why we have acted decisively – to stop pouring so much of your hard-earned money down the drain. We are already paying £120m of interest every single day thanks to the last Labour government. (David Cameron)
It’s the borrowing that doesn’t go away as the economy grows, and we have £109bn of it. It’s like with a credit card. The longer you leave it, the worse it gets. You pay more interest. You pay interest on the interest. You pay interest on the interest on the interest. We are already paying £120m of interest every single day thanks to the last Labour government. Millions of pounds every day that goes to the foreign governments we owe so they can build the schools and hospitals for their own citizens that we aren’t able to afford for ours. How dare Labour call that protecting the poor? (George Osborne)
Let’s unpick this a bit. Who earns the interest? The answer is that it is paid to holders of government debt in the form of government bonds (gilts), national savings certificates, premium bonds, etc. In other words it is paid to savers, whether individuals or pension funds or companies.
Does it all go abroad? In fact 29% of gilts are held abroad. The rest are held by British residents. Thus some 70% of the interest rate paid on government debt goes to British residents and supports pensions and savers. It can thus be seen as a transfer from taxpayers to savers.
Because of the record low interest rates many pensioners who rely on savings interest have seen their incomes fall dramatically. Others draw income from a ‘self-invested personal pension’. The amount that can be drawn each year is based on tables according to a person’s age and the current 15-year Treasury gilt yield (currently 3.45%). Thus the lower the rate of interest, and the less the yield, the less that can be drawn.
So who are the gainers and losers from high general government debt and attempts to get it down? Read the following articles and look at the data and then try answering the questions.
Articles
Britons have donated £7m to help pay off the national debt (but that’s a drop in the ocean) Mail Online, Daniel Martin (9/10/10)
A trillion and rising: Britain’s £1,000,000,000,000 debt means it is now paying as much in interest as it does for defence Mail Online, Hugo Duncan (1/10/10)
Spending cuts “not enough”, say small firms Telegraph, James Hurley (8/10/10)
UK public finances post record August deficit Guardian, Julia Kollewe (21/9/10)
Another paradox of thrift The Economist, Buttonwood (16/9/10)
Data
The gilt market UK Debt Management Office
Gilt market data UK Debt Management Office
Overseas gilt holdings UK Debt Management Office
Public sector: current position ONS (30/9/10)
Public sector finances ONS Statistical Bulletin (21/9/10)
Government deficit and debt under the Maastricht Treaty ONS Statistical Bulletin (30/9/10)
Contributions to the government deficit and debt ONS Statistical Bulletin (31/3/10)
Questions
- Explain the difference between central government, general government and public-sector deficits and debt.
- Who loses from a rising public-sector debt? Who gains?
- Conduct an international comparison of (a) the level of the government deficit and debt and (b) their rate of growth over the past few years.
- What is meant by the ‘yield’ on a particular gilt?
- If gilt yields fall, does this mean that the government pays less on existing gilts? Is it likely to pay less on new gilt issues? Explain.
- How do cuts affect the distribution between savers and borrowers?
Towards the end of each month the European Commission for Economic and Financial Affairs publishes its economic sentiment index for each EU country, including the UK, along with average scores for the EU and for the countries using the euro. September’s release showed sentiment in the UK amongst consumers and businesses to have weakened more than in any other EU country. The index fell from a score of 102.3 to 100.2, where 100 represents an equal number of optimistic and pessimistic responses.
In itself the score seems to suggest that there remains some degree of economic confidence here in the UK. So should we be concerned? Well, the direction of the sentiment index is very likely to be of some concern and something that policy-makers will be keeping a keen eye on. Furthemore, the direction of sentiment in the UK is contrary, perhaps surprisingly so you might think, to that in most EU countries. The EU-average score, for instance, rose from 103.1 to 103.4, its highest since March 2008. From this we can infer not only that more people in the survey are optimistic than pessimistic but also that sentiment is becoming more positive (slightly). In Germany the economic sentiment index rose between August and September from 111.2 to 113.2, its highest since February 1991, with sentiment rising across consumers and all sectors of business.
If we delve a little deeper into the UK sentiment figures we see that the weakening of economic confidence is greatest amongst retailers. To a large extent this reflects an erosion of the significant increase in sentiment reported by retailers in the summer months. It also appears to reflect something of a lagged response to the waning sentiment amongst consumers. The figures for consumer confidence showed a ‘bounce’ in confidence during the spring, but September’s consumer confidence level was the lowest since June 2009 when the economy was still in recession.
One of the tasks facing policy-makers and economists is to try to predict what these economic sentiment figures might mean for economic activity. In particular, to what extent do these figures have significance for the future decisions made by households and businesses? Surprisingly, relatively little column space is given to measures of confidence and to the EU’s Economic Sentiment Index in particular.
It’s probably fair to say too that, as economists, we are a long way from fully understanding the role that confidence plays in affecting individual behaviour or indeed the variables that impact on confidence. It was once suggested to me (Dean), for instance, that changes in UK consumer confidence might be closely related to changes in housing wealth. Further, we economists struggle to understand what these survey measures of economic confidence are actually capturing, since the surveys comprise a multitude of questions, which, in the case of consumers for instance, ask them to compare their current financial situation with that in the past as well as to predict how it will evolve over the coming months.
Despite our imperfect understanding of the role played by confidence and how we can measure it, there is considerable interest amongst policy-makers, economic think-tanks and economic forecasters. For example, earlier this week a statement following an IMF Mission to the UK indentified ‘sizeable’ downside risks to the UK economy’s recovery, including what it termed ‘the continued fragility of confidence’. Could the release just a few days later from the EU reporting a decline in economic sentiment in the UK be timely?
Articles
Eurozone optimism nears three-year high Financial Times, Ralph Atkins and David Oakley (29/9/10)
EU economic, business indicators improve again The Sofia Echo (29/9/10)
Eurozone Sept. economic sentiment strongest since 2008 RTT News (29/9/10)
EU September economic morale unexpectedly improves MarketNews.com (29/9/10)
Data
Business and Consumer Surveys The Directorate General for Economics and Financial Affairs, European Commission
Consumer Confidence Nationwide Building Society
Questions
- Do you think economic sentiment or economic confidence is a worthwhile concept for economists and policy-makers to analyse?
- Draw up a series of factors that you think might affect the economic sentiment amongst consumers. Are there any factors that might be peculiar to the UK? Then repeat the exercise for businesses.
- Why do you think there is a ‘fragility of confidence’ in the UK? What might explain the stronger confidence levels in other EU countries, such as Germany?
One of the structural problems facing the UK economy is that people have been borrowing too much and saving too little. As a result, vast numbers of people have been living on credit and accumulating large debts, and many people have little in the way of savings when they retire.
So should the government or Bank of England be encouraging people to save? Not according to Charles Bean, Deputy Governor of the Bank of England – at least not in the short term. While acknowledging that people should be saving more over the long term, he argues that the main purpose of the historically low Bank Rate since the beginning of 2009 has been to encourage people to spend, thereby boosting the economy. In other words, if the purpose of a loose monetary policy is to increase aggregate demand and stimulate the economy, then what is needed is increased consumption and reduced saving, not increased saving.
In the following webcast, Charles Bean gives his views about interest rates and counters the criticism that savers are being pid too little interest. He argues that for many the solution is to start drawing on some of their capital – not a solution that most savers find very appealing!
Webcast
Bank of England: savers should eat into cash Channel 4 News, Faisal Islam (27/9/10)
Articles
Savers told to stop moaning and start spending Telegraph, Robert Winnett and Myra Butterworth (28/9/10)
Bean Says Bank of England Trying to Get Reasonable Economic Activity Level Bloomberg, Scott Hamilton and Gonzalo Vina (27/9/10)
Spend, spend, spend, demands Bank of England deputy governor Investment & Business News , Tom Harris (28/9/10)
Data
International saving data (see Table 23) Economic Outlook, OECD
AMECO on line (see tables in section 15.3) AMECO, Economic and Financial Affairs (European Commission)
Economic and Labour Market Review (see Table 1.07) National Statistics
Questions
- What is meant by the ‘paradox of thrift’?
- Reconcile the argument that it is in the long-term interests of the UK economy for people to save more with the Bank of England’s current intention that people should save less?
- Is there a parallel argument about fiscal policy and government spending (see the news item The ‘paradox of cuts’?)
- What are the determinants of saving?
- Look at the data links above and compare the UK’s saving rate with that of other countries.
- What has happened to the UK saving rate over the past four years? Attempt an explanation of this.