Saturday, June 20, 2009

Cutting question - Consumer Boom?

By Andrew Bounds and Chris Giles

Published: June 16 2009 03:00 Financial Times p 7

As Britain's recession bit over the winter, the country became obsessed with finding someone or something to blame. Greedy bankers, addicted to taking risks and paying themselves lavish sums, took much of the flak, as did hapless financial regulators who failed to react to the danger signs.

But fingers were also pointed at ordinary households: Britons had become hooked on material consumption, fuelled by debt and rising house prices. People flocked to the "Together" range of mortgages from Northern Rock, which offered loans of up to 125 per cent of a property's value until the lender ignominiously failed. London's house prices and luxury shopping boomed on the back of big City bonuses. It was unsustainable and, as economists like to say, things that are unsustainable do not last.

But as Britain starts to enjoy its new sport of spotting the green shoots of economic growth sprout up (and seeing whether they will wither), was it all the standard story of consumer boom followed by inevitable comeuppance? Once you get past the anecdotes, the evidence is against that.

One good place to start is a comparison with the 1980s, when no one doubts Britain's consumers went shopping crazy. As a share of gross domestic product, household consumption rose by almost 2 percentage points, with the big boom between 1985 and 1988, when it reached 60.5 per cent of GDP. In comparison, for all the talk of shop-till-you-drop consumers bashing their credit cards, consumption this decade has fallen as a share of GDP by 1.3 points, with declines even during the supposed consumer boom years of 2006-07.

In this decade, the price of imports, particularly from China, has gone down - so people can feel happier about falling consumption. But this underscores the data findings that households did not go on some dreadful borrowing and spending binge. Based on this and other evidence, economists such as Ben Broadbent of Goldman Sachs become agitated, saying: "I just don't understand why people persist in saying there was a consumption boom - there just wasn't."

But the popular belief, also stoked by many economists and officials, remains that consumption has boomed and that is the prime cause of unsustainability in the economy. The rise in household debt to 160 per cent of disposable income, from 100 per cent in 2000, has to unwind, says Andrew Bridgden of Fathom Financial Consulting, and if that happened gradually, "then growth in consumption would be subdued, perhaps close to zero, for the next 10 years".

The International Monetary Fund last month sang from the same hymn sheet in its annual survey of the British economy. "The high level of household indebtedness constrains the pace of economic recovery," it concluded, at the same time fretting about weaknesses in banks.

Mervyn King, the Bank of England governor, came close to the same interpretation of the feebleness of household finances and the resulting sluggish outlook when presenting the central bank's latest inflation report. "In the light of the state of balance sheets, especially in the financial sector, the [Monetary Policy] Committee judges that the risks are weighted towards a relatively slow and protracted recovery," he said.

The dispute about the fragility of household finances stems from a legitimate fear, underscored by a plunging household savings rate in 2006-07, that households were living well beyond their means. The savings rate even briefly turned negative at the start of 2008, fuelling concerns about overconsumption among households and the inevitable retrenchment to come.

But a closer look shows the main reason for the savings drop appears to be that as inflation rose over that period, so did households' bills and spending. Consumers did not cut other items much, sensing the rise in prices was temporary - which turned out to be the case. Subsequently, incomes rose faster than expenditure, bringing the savings ratio back to 4.8 per cent, a level no different from a decade earlier. Though households could decide to retrench, the evidence that they will is so far rather thin.

But as so often with aggregate data, the real behavioural response of households is difficult to infer from the figures because so many things are going on. This is where microeconomic evidence can help - and this year, evidence has accumulated to suggest that there was indeed no housing-fuelled consumption boom.

John Gathergood and Richard Disney of Nottingham University compared the spending and saving behaviour of the same households over time and found, first, that those renting properties were just as likely to reduce their saving when house prices were booming as home owners were. This result has been seen repeatedly in large-scale economic studies of the UK and is a real challenge to the consumption boom protagonists. Why would renters spend more and save less when house prices rise, since their chances of getting on to the housing ladder had just grown worse?

The two researchers went further and added household expectations of their future incomes to their equations. This they found to be the most important determinant of active decisions to save. Renters, it transpired, saved less alongside homeowners because both groups were optimistic about their future incomes.

Looking at similar data across the Atlantic, the two could also spot a difference between British households, whose upbeat income expectations made them shun saving, and US households, who did respond aggressively to higher house prices.

If there is almost no evidence that consumption boomed this decade in Britain as a result of house price appreciation, why did household debt rise so explosively?

There is no disagreement that high house prices are related to this increase in debt, but a fierce disagreement persists between those who think loose lending criteria forced house prices higher and those who believe, as Mr King does, that high house prices led to higher debt because those buying a home needed a bigger mortgage than the people selling - as the vendors enjoyed capital gains from previous house price rises. While both arguments have merit, the important point is that debt and house prices went together, not debt and consumption.

Then, if consumption is not the obviously unsustainable element, where should the spotlight fall? Government spending on goods and services is the short answer. Health, education, defence and law and order spending (including capital expenditure) grew extremely rapidly from 2000, when all this accounted for 20 per cent of GDP, to the 24.4 per cent it reached in 2008. Although financed by borrowing, this rise appeared under control until the recession hit, because tax revenues were strong, particularly corporation tax paid by the risk-taking financial sector. Again, this was the reverse of the 1980s.

The public spending bonanza, financed by erratic financial sector profits, was clearly unsustainable. With tax revenues slashed by the recession and borrowing set to rise to £175bn ($286bn, €207bn) or 12.5 per cent of GDP, this level of government consumption will not be able to continue. The big story of the next decade will be government retrenchment and deficit reduction.

So what does that mean for the UK economy? As ever in economics, there is good news and bad news. The good news is that the absence of a boom over the past decade implies that a consumer retrenchment is far from a certainty, even with falling house prices. As in the past, incomes - and expectations of income growth - are more likely to determine household consumption than household finances and debt are.

Sterling's 20 per cent fall since November 2007 raises the competitiveness of the UK and should allow net exports and business investment to contribute significantly to growth, replacing government spending. Monetary policy is likely to remain very loose, to encourage demand as the government consolidates the budget. This is a reasonable expectation, says Malcolm Barr of JPMorgan, though it is impossible to know in advance "where is growth coming from".

But the bad news is that the recession has destroyed some of Britain's productive capacity forever - 5 per cent is the Treasury's estimate. Charlie Bean, the Bank of England's deputy governor, adds that the fragility of banks will hit working capital, corporate investment and research and development, so limiting potential growth, while unemployment reduces the skills of many employees.

Moreover, continued household consumption at today's level cannot be taken for granted. Households may find their income growth in the years ahead disappointing, especially as taxes and unemployment rise.

There is also the big unknown global element, which is whether the Asian countries that run big surpluses will put more effort into consuming at home rather than saving abroad. Such a shift would raise global real interest rates and make consumer debt feel more onerous.

Although what is not known outweighs the certainties, the outlook is not as bleak, at least for households, as the simple story of excess followed by penitence. Britain is often a miniversion of the US - but its unsustainable expansion of the past decade was very different.

Do not adjust your data set

One of the problems in determining the degree of any surge in household consumption is that the answer depends on which bit of the national accounts you use.

Gross domestic product - the value of goods and services produced in the economy each year - can be broken down into contributions from household consumption, investment, government spending, and the balance between exports and imports. This decomposition can also be adjusted for the inflation of each component part.

If no inflation adjustment is used, there was no consumer boom this decade. Household consumption fell from 63.5 per cent of GDP at the start of 2000 to 61.4 per cent in the second quarter of 2008, just as the recession began.

But after standardising everything at 2003 prices, the official figures show consumption rising from 61.1 per cent to 62.5 per cent of GDP over the same period.

Over long periods the nominal, or unadjusted, figures are preferable because they are easier to measure and they quantify what households actually spent, not the rather more nebulous concept of what their spending would have been had they bought the same goods and services but at 2003 prices.


From mills to tills: an industrial centre turned shopping mecca

Few institutions epitomised the boom and bust of Britain's economic "miracle" more than Leeds United.

The Yorkshire soccer club, whose rugged style won league titles in 1969, 1974 and 1992, transformed itself into a leisure brand listed on the stock market and boasting a team full of young talent. By 2001 it had reached the semi-finals of the European Champions League. Then its debt caught up with it.

Owing £79m, it began a fire sale of players. Peter Ridsdale, chairman, left in 2003 but the shake-up could not stave off bankruptcy - or relegation. "We lived the dream," he said. The nightmare of a third season in the third tier of English soccer continues.

Could the city, which has undergone a similarly stellar transformation, suffer the same fate?

Regenerated after the collapse of the clothing industry in the 1970s, its centre is almost unrecognisable from the days when Montague Burton ran the largest clothing factory in Europe there. With engineering and textiles in decline, Leeds fell back on its other strength: finance. Yorkshire was the home of the building society movement and had a big legal sector. The city rediscovered a taste for shopping evident in the graceful but neglected Victorian arcades. Nothing did more to change its image than the opening of the first branch outside London of Harvey Nichols, the upmarket department store,in 1996.

In a decade from 1991 the number of bars and cafés doubled, with nightclubs and restaurants not far behind, as the leisure economy came to life. Up to £4bn has been ploughed into shops, apartments and offices in a centre once dominated by warehouses and mills.

That may reflect an unsustainable consumer binge, or it may just mark Britain's conversion to continental- style café culture. Since 1999 Leeds, with a population of 750,000, has added 31,600 net new jobs, a rise of almost 10 per cent. Yet a large amount have been in public services, and almost all the rest in finance and business services, which each account for one-quarter of the working population. The council believes it will be 2015 before employment returns to 2007 levels and is reducing its own staff by 450.

Civic leaders believe the financial goose will lay golden eggs again. There is still plenty of untapped wealth around: SG Hambros, the private bank, opened an office in the city only in March.

Howard Kew, chief executive of the Leeds Financial Services Initiative, points to the diversity of the sector, which includes asset management, call centres and retail banking. He also notes a tradition of innovation. First Direct, the first telephone bank, set up there in 1989. The recession could even help, as costs in Leeds are one-third lower than London, he adds.

Martin Allison, dean of Leeds Metropolitan University Business School, accepts the city has "suffered a systemic shock". But, he says, "it has had them before. Thirty years ago we were wondering what would come after textiles".

Andrew Bounds


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