In Gloomy prospects for UK consumer spending in 2012? we talked about how consumer spending can be affected by the financial position of households. Figures from United Kingdom National Accounts – Blue Book 2011 (see Tables 6.1.9 and 10.10) give the latest complete set of balance sheets for the UK household sector. The figures are for 2010 and in this blog we provide a brief overview of what these figures reveal.
In effect, there are two main balance sheets of interest for households (and non-profit institutions serving households (NPISHs), i.e. charities and voluntary organisations). The first details their net financial wealth and the second their physical wealth, also known as their non-financial wealth. We begin with net financial wealth. This is found by subtracting financial liabilities (debt) from financial assets. The household sector in 2010 had financial liabilities of £1.54 trillion equivalent to 1.6 times its disposable income for the year or 1.1 times the nation’s Gross Domestic Product. Of these liabilities, £1.2 trillion was mortgage debt, i.e. loans secured against property. On the other hand, the sector had financial assets of £4.3 trillion equivalent to 4.4 times its disposable income in 2010 or 3 times GDP. Of these financial assets, the value in pension funds and life assurance was £2.27 trillion.
The net financial wealth of households and NPISHs in 2010 was £2.8 trillion, 2.9 times the sector’s disposable income for the year or 1.9 times GDP. To this we need to add physical wealth of £4.9 trillion, a massive 5 times the sector’s disposable income or 3.3 times the nation’s GDP. The majority of this is residential buildings the value of which were put at £4 billion for 2010. This demonstrates the significance of housing to the UK household sector balance sheet.
If we now add physical wealth to net financial wealth, we find that in 2010 the household and NPISH sector had a net worth of £7.7 trillion. To put this in context, it is equivalent to 7.8 times the disposable income it earned in 2010 and 5.3 times the UK’s Gross Domestic Product. While these are enormous figures it is worth noting that in 2007 the sector’s net worth was £7.4 trillion, equivalent to 8.5 times annual disposable income.
A trawl through the figures clearly shows the impact of the financial crisis on the sector’s net worth. From £7.4 trillion in 2007, net worth fell in 2008 to £6.6 trillion or 7.2 times annual disposable income. However, 2009 and 2010 did see the households’ net worth increase again – including relative to its disposable income. This has been the result of its net financial wealth increasing. Net financial wealth in 2010 was 9.8 per cent higher than in 2007. However, the depressed housing market has continued to adversely impact on the sector’s net worth. Physical wealth in 2010 was 0.7 per cent lower than in 2007.
Of course, while these empirical observations are undoubtedly interesting, the key question for debate is how these patterns affect household behaviour. Of particular importance, is how changes in both the household sector’s total net worth and the components making up the total will translate into changes in consumer spending. Economists are increasingly recognising that in understanding consumer spending patterns we need to gain a deeper understanding of the impact of the balance sheets on consumer spending. It is quite likely that many retailers when forming their plans for the year ahead will be analysing the potential impact of household finances on spending behaviour. Developing strategies to respond to the state of the household balance sheets may be crucial to their success.
In the context of the household balance sheets, explain the difference between the concepts of stocks and flows.
Illustrate with examples your understanding of what is meant by secured and unsecured debt. What factors are likely to affect the growth from one period to another in the stocks of secured and unsecured debt outstanding?
Draw up a list of possible factors that could affect the value of the household sector’s net financial wealth. Now repeat the exercise for non-financial wealth.
Draw up a list of ways in which you think changes to the values of items on the household balance sheets could affect consumer spending. After drawing up this list consider their significance in 2012.
What sort of items would be included in the balance sheets of firms and of government?
A key determinant of our economy’s rate of growth over the year ahead is likely to be the behaviour of households and, in particular, the rate of growth in consumer (or household) spending. In other words, your appetite for spending will help to determine how quickly the economy grows. The importance of household spending for the economy is straightforward to understand given that it accounts for roughly two-thirds of the total demand for firms’ goods and services, i.e. two-thirds of aggregate demand. In its November 2011 Economic and Fiscal Outlook the Office for Budget Responsibility presents it forecasts for economic growth and household spending. The following table summarises these forecasts.
The OBR are forecasting that household spending will fall in real terms in 2011 by 1.1 per cent and grow by only 0.2 per cent in 2012. This is not good news for retailers nor, of course, for the economy. The drag on consumer spending growth is largely attributed to expected falls in real disposable (after-tax) incomes in both 2011 and 2012. In 2011, the household sector’s real income is forecast to decline by 2.3 per cent and then by a further 0.3 per cent in 2012.
The OBR’s figures on spending growth critically depend on the ability of households to absorb the negative shock to their real income. Empirical evidence tends to show that household spending growth is less variable than that in income and that households try and smooth, if they can, their spending. This means that the marginal propensity of households to consume out of changes to their income is below 1 in the short-run. In fact, the shorter the period of time over which we analyse income and consumption changes the smaller the consumption responses become. This is consistent with the idea that households are consumption-smoothers disliking excessively volatile spending patterns. In other words, the size of our monthly shop will usually vary less than any changes in our real income.
Of course, consumption-smoothing cannot be taken for granted. Households need the means to be able to smooth their spending given volatile and, in the current context, declining real incomes. Some economic theorists point to the importance of the financial system in enabling households to smooth their spending. In effect, households move their resources across time so that their current spending is not constrained solely by the income available to them in the current time period. This could mean in the face of falling real income perhaps borrowing against future incomes (moving forward in time expected incomes) or drawing down past savings.
The ability of households to move future incomes forward to the present has probably been impaired by the financial crisis. Banks are inevitably less cautious in their lending and therefore households are unable to borrow as much and so consume large amounts of future income today. In other words, households are credit-constrained. Furthermore, it is likely that households are somewhat uneasy about borrowing in the current climate, certainly any substantial amounts. Uncertainty tends to increase the stock of net worth a household would like to hold. A household’s net worth is the value of its stock of physical assets (largely housing wealth) and financial assets (savings) less its financial liabilities (debt). If households feel the need for a larger buffer stock of wealth to act as a sort of security blanket, they will not rush to acquire more debt (even if they could) or to draw down their savings.
The impairment of the financial system and the need for a buffer stock are two impediments to households smoothing their spending. They tend to make consumption more sensitive to income changes and so with falling incomes make it more likely that consumption will fall too. There are other related concerns too about the ability and willingness of consumers to smooth spending. Uncertainty arising from the volatility of the financial markets imposes liquidity constraints because households become less sure about the value of those savings products linked to the performance of equity markets. Consequently, they become less certain about the money (liquidity) that could be raised by cashing-in such products and so are more cautious about spending. Similarly, the falls in house prices have reduced the ability of households to extract housing equity to support spending. Indeed, with fewer transactions in the housing market the household sector is extracting less housing equity because it has been quite common, at least in the past, for households to over-borrow when moving and use the excess money borrowed to fund spending.
In short, there are many reasons to be cautious about the prospects for household spending. The expected decline in real income again in 2012 will ‘hit’ consumer spending. The question is how big this ‘hit’ will be and crucially on the extent to which households will be able to absorb it and keep spending.
What do you understand by a consumption function? What variables would you include in such a function?
Using the figures in the table in the text above, calculate ‘rough’ estimates of the income elasticity of consumption for each year. Why are these estimates only ‘rough’ approximations of the income elasticity of consumer spending?
Draw up a list of factors that are likely to affect the strength of consumer spending in 2012. Explain how similar or different these factors are likely to have been to those that may affect spending during periods of strong economic growth.
Explain what you understand by the term consumption-smoothing. Explore how households can smooth their spending and the factors that are likely to both help and prevent them from doing so.
What do you understand by the net worth of housholds? Try drawing up a list of factors that could affect the net worth of households and then analyse how they might affect consumer spending.
Twice a year, directly after the government’s Spring Budget and Autumn Statement, the Institute for Fiscal Studies gives its verdict on the performance of the economy and the government’s economic policies – past and planned. This year is no exception. After the Chancellor had delivered his Autumn Statement, the next day the IFS published its analysis. And what grim reading it makes.
• Real average (mean) incomes in 2011 will have fallen by 3%. • Between 2009/10 and 2012/13, real median household incomes will have fallen by 7.4% • Over the same period, real mean household income will have fallen by 4.7% – easily the biggest 3-year drop since records began in the mid 1950s. • Real mean household incomes will be no higher in 2015/16 than in 2002/03. • The poorest will be hardest hit by the measures announced in the Autumn Statement. • Infrastructure spending of £4bn to £5bn will only go some way offsetting the effects of £17bn capital spending cuts over the Parliament. • The economy will be 3.5% smaller in 2016 than thought in March. • The structural budget deficit is 1.6% higher than thought in March. • That will extend to 6 years the period over which total spending will have been cut year on year.
Referring to this last point, Paul Johnson, director of the IFS, said in his Opening Remarks, “One begins to run out of superlatives for describing quite how unprecedented that is. Certainly there has been no period like it in the UK in the last 60 years.” Referring to the fall in real incomes, he said, “Again we are running out of superlatives to describe just how extraordinary are some of these changes.”
Commentators have referred to the “lost decade” where the average Briton will not have seen an increase in real income.
Why is it likely that the median real income will have fallen by more than the mean real income?
Why is the structural deficit now estimated to be some 1.6 percentage points higher than was estimated by the OBR back in March 2011?
How could the structural deficit be affected by a prolonged recession? Is this a case of hysteresis?
What are the government’s fiscal rules?
Is the IFS predicting that the rules will be met? What might adversely affect this prediction?
If technological progress is allowing a continuous increase in potential real GDP, why will median real incomes have fallen over the 13 years between 2002/03 and 2015/16? What might have affected long-term aggregate supply adversely?
With Christmas approaching, many high street stores will be hoping for a big increase in sales, but that seems unlikely to be enough for Arcadia, whose brands include Top Shop, BHS and Dorothy Perkins. Arcadia’s profits have decreased to £133m, which is a fall of 38% and, based on this data, it is planning on closing many stores across the country over the next few years. With leases expiring on many of their stores within about 3 years, the current plan, according to Sir Phillip Green, is to close about 250 stores. Speaking to the BBC, he commented:
‘Now, there may be other opportunities that turn up that we might want to open. But certainly, in terms of our existing portfolio, currently that’s our thinking.’
The economic climate has obviously played a key role, but so has the weather. With the hottest October and November for decades, people have been delaying their shopping and purchases of winter clothing and this has put increased strain on many high street traders (see the news item Dreaming of a white Christmas).
What is perhaps of more concern than one company’s profits being significantly lower is the impact this may have on unemployment. With over 2500 stores, Arcadia is one of the largest private employers in the UK and if 250 stores are closed, there may be severe consequences for the labour market and this may have further adverse effects on aggregate demand. A key factor that may partly determine the future of firms such as Arcadia is how much consumers spend this Christmas. Perhaps for these stores, they really may be hoping for a white Christmas – at least that may encourage people to stock up on winter clothes – if they can get to the shops!
Explain why the current economic situation has caused a slowdown in retail sales.
Illustrate the way in which a firm will maximise profits. If profits are declining, is it because sales revenue has fallen or that costs have risen? Adapt your diagram to show a fall in profits based on your answer.
According to the article by the Press Association, margins were ‘squeezed by 1.8% as it took a £53 million hit to absorb price increases’. What does this mean?
How might the unseasonably warm weather be an explanation for a weaker trading environment?
If 260 stores are closed, what impact might this have on unemployment?
If more workers lose their jobs, how might this have a subsequent adverse effect on sales? Think about the multiplier effect here.
Economic growth in developed countries, like the UK, exhibits two important characteristics. First, growth is positive over the long run such that the volume of output increases over time. Second, growth in the short-term is highly variable with patterns in the volume of output creating business cycles. With increased global interdependence through trade and integrated financial systems, domestic business cycles often resemble a global or international business cycle. This was certainly the case during the late 2000s. Recent releases from the Office for National Statistics provide an opportunity to look again at the characteristics of UK economic growth. In particular, they show the importance of differentiating between nominal and real values. Furthermore, revisions to the data have somewhat revised our view of economic growth before and after the economic crisis of the late 2000s.
The value of goods and services produced in the UK in 2010, as measured by GDP, is estimated at £1.46 trillion. This is the nominal GDP estimate because it measures the economy’s output for 2010 using the prices of 2010. Back in 1948, GDP measured at 1948 prices was £11.97 billion. Based on these nominal estimates the size of the UK economy would appear to have grown some 122 times which is the equivalent of growing by 8.1 per cent each year. However, some of this increase relates not to the volume of output but to the prices of the goods and services produced. It is for this reason that when analysing economic growth we ordinarily look at constant-price or real estimates of GDP. Such estimates effectively show what GDP would have been if prices had remained at the levels of a chosen year known as the base year. The base year now being used in the UK is 2008.
GDP at constant 2008 prices in 2010 is estimated at £1.40 trillion as compared with £314.5 billion in 1948. The real GDP figures reveal that the volume of UK output increased not by a factor of 122 but by a factor of 4.44; this is the equivalent to growth of 2.4 per cent each year.
The nominal GDP estimates for each year from 1948 up to 2010 rise with only one exception: 2009. In 2009, nominal GDP fell by 2.8 per cent. However, over the same period, real GDP fell during seven of the years. What this tells us, is that in six of the seven years, price increases were enough to offset falls in the volume of output such that nominal GDP increased. However, in 2009, the average price of the economy’s output, which is measured by the GDP deflator, rose by a just a little under 1.7 per cent, while the volume of output and, hence, real GDP, fell by almost 4.4 per cent.
The real annual GDP numbers estimate that the volume of UK output declined both in 2008 and 2009. In 2008 output is thought to have fallen by 1.1 per cent, while in 2009, as we have just seen, it fell by 4.4 per cent. The last time the UK experienced two consecutive annual (yearly) falls in output was in 1980 and 1981 when output fell by 2.1 per cent and 1.3 per cent respectively.
If we want to identify recessions then yearly GDP numbers will not do, rather, we need to use quarterly GDP numbers. This is because we are looking for two consecutive quarters where real GDP (output) declined. The revised GDP data show that the UK experienced five consecutive quarterly falls in real GDP in the late 2000s. We went into recession in Q2 of 2008 and came out in Q3 of 2009. As a result, real GDP was 7 per cent lower than before the UK economy entered recession. The previous recession, from Q3 of 1990 to Q3 of 1991 (5 quarters), saw UK output fall by 2.5 per cent. Between these two recessions the UK experienced 66 consecutive quarters of economic growth during which time the revised estimates show that the average annual rate of growth was 3 per cent. Compared with the recession of 2008/09, the next deepest recession in recent times occurred between Q1 of 1980 and Q1 of 1981 (5 quarters) when output fell by 4.7 per cent. In other words, these figures help to illustrate the extraordinary depth of the 2008/9 recession.
Quarterly National Accounts, Q2 2011Office for National Statistics (5/10/11) For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see: AMECO onlineEuropean Commission
Questions
Explain what you understand by the terms nominal GDP and real GDP. Can you think of other examples of where economists might distinguish between nominal and real variables?
Explain under what circumstances nominal GDP could rise despite the output of the economy falling.
The average annual change in nominal GDP since 1948 is 8.2% while that for real GDP is 2.4%. What do you think we can learn from each of these figures about long-term economic growth in the UK?
What do you understand to be the difference between short-term and long-run economic growth?
What is meant by the concept of a business cycle? In what ways can the characteristics of business cycles differ across time? What about across countries?
How might the position within the business cycle impact on an economy’s potential output?
What factors might influence a country’s long-term rate of economic growth?
