Consumer expenditure Mini Case John Hookworms “Opinion: Economic Trends – Saved by the consumer? “, Accountancy, London, Mar 2002 (with minor editing) How long can the I-J economy buck the global trend Just because our consumers keep spending money? Have we avoided the recession that has gripped the US, Japan and Germany over the past six to 12 months or are we Just postponing the day of reckoning? And are we storing up worse problems for the future as a result of rising household debt levels and a widening trade deficit?

Driving force A good starting point is to consider what drives consumer spending. In the long run, economic research indicates a stable relationship between household spending, disposable income and wealth (all defined in real, inflation-adjusted terms). In the short term, consumer spending can move above or below this long-run ‘equilibrium’ as a result of temporary variations in factors such as interest rates and confidence levels, but the fundamentals tend to reassert themselves in the long run.

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As regards the first of these fundamentals, real disposable income has been boosted gently by average earnings growth of around 4%-4. 5% combined with low inflation and, since last April, a somewhat lower tax burden. At the same time, the latest Labor Force Survey shows a rise in total employment of around 75,000 in the three months to November. Average earnings have moderated slightly but should still rise by an average of at least 4% in 2002, boosted by higher public sector wages. Inflation is expected to remain below the 2. % target level this year and next. Taxes may need to rise from 2004 onwards to fund increased government spending, but probably not before then. Taking all these factors together, real disposable income growth may moderate from around 4% in 2001 to around 2. 5-3% in 2002, but this still suggests reasonable consumer spending growth unless the savings ratio rises sharply. This ratio will be influenced by interrelated factors such as wealth, interest rates and general confidence levels.

If people feel wealthier because of asset price rises, they may feel less need to save. They may also feel more confident about borrowing against the value of these assets to finance big-ticket purchases of cars and household goods. However, we need to distinguish between different types of assets and their implications for consumer spending. In general, changes in the value of liquid assets, such as cash in the bank, are likely to have more impact on spending than changes in the value of illiquid assets, such as pension funds, at least in the short to medium term.

Direct household ownership of shares in the I-J is still relatively low compared dampened the impact of share-price falls over the past year or two on UK consumer spending, at least relative to the US. But house prices are likely to be more important for UK consumer spending than the tock market. This is partly because higher house prices seem to be closely related to the ‘feel-good factor’, even if this is not entirely rational given that you can only realize these potential capital gains by trading down.

On the other hand, the possibility of borrowing against housing equity through re-mortgaging means that property is not nearly as illiquid an asset as it used to be 20 or 30 years ago, creating an important direct linkage between house prices and consumer spending. As noted above, Bank of England estimates put mortgage equity withdrawal in the second half f 2001 at the highest levels since the Lawson boom of the late asses (see Figure 2). Furthermore, the very large interest rate rises (from 7. % to 1 5%) that punctured the late asses boom now look less of a risk, even if there is some upward drift in UK rates later in 2002 and into 2003. Having said that, consumers may have been taking on too much debt because they failed to distinguish between real and nominal interest rates. Headline mortgage and consumer credit rates have fallen significantly with lower inflation, allowing debt-to-income ratios to rise to record highs in 2001 while peeping debt service burdens at affordable levels.

According to economic theory, however, real interest rates should drive decisions on borrowing and investment, not nominal rates. If inflation stays low, the real burden of servicing a given level of mortgage debt will not decline over time as fast as in a high- inflation environment. There is therefore a real danger that consumers will be unpleasantly surprised by the ongoing burden of servicing the debts they have taken on in recent years, resulting in a moderation of consumer spending growth.

This is keel to be a long-run phenomenon (ii, with impacts over 10 years or more) rather than a factor that, in itself, would precipitate a I-J recession over the next year or two in the absence of sharp interest-rate rises. Fly in the ointment However, the fly in the ointment may be the rising gap between our imports, boosted by high levels of consumer spending, and our exports, which have been hit by the global downturn and the persistent strength of the pound over the last five years. When consumers borrow to spend, they are indirectly borrowing from abroad to fund he resulting trade gap.

With the government also now starting to borrow more to fund extra spending, the Treasury predicts that the current account deficit will widen to almost Gibbon by 2003, just under 3% of GAP. With the exchange rate floating freely, this can no longer lead to an old- fashioned sterling crisis of the type seen in 1967 or 1992, when speculators moved in and reserves ran out, but this does not mean that the UK can ‘live beyond its means’ exchange markets being what they are, this will probably happen suddenly and unexpectedly. No-one knows exactly when, or how far, sterling will decline, but it must happen sooner or later.

At that point, import prices will increase, interest rates will probably rise to compensate and the consumer boom will come to an abrupt end. So the short-term outlook for consumer spending remains reasonably healthy and, taking increased government spending into account too, the I-J should avoid recession and achieve growth close to its trend rate of 2. 5% over the next 12-18 months. But in the medium-to-long term there will be a price to pay for the consumer mom and the consequent build up of household debt and external deficits.

John Hookworms is head of the Macroeconomics Unit at PricewaterhouseCoopers Copyright Financial Times Information Limited Mar 2002 Questions: Identify the factors affecting consumers’ expenditure in the I-J that the author refers to and distinguish between long term and short term effects. Based on relevant theories and the more recent developments in the UK economy (including the recession of 2008-9 and later), outline the favorable and unfavorable contributions of consumers’ expenditure to the performance of the I-J economy.