26th August 2015 by Simon Ward
UK household spending is as extended relative to income as in the late 1980s and mid 2000s, ahead of the 1990-91 and 2008-09 recessions. Those earlier episodes were associated with rapid and unsustainable credit growth; current spending excess, by contrast, is the mirror of record-low accumulation of financial assets. A normalisation of financial investment behaviour threatens MPC and OBR central forecasts that GDP growth will be sustained at about 2.5% per annum over the next three to five years.
The suggestion that household finances are weak runs counter to recent commentary noting stronger nominal and real wage growth and a significant decline in the debt / income ratio from its 2009 peak. Spending, however, has accelerated along with income, while lower gearing has been achieved mainly by paring asset accumulation.
The difference between income and spending is equal to “net lending” in the capital account of the national accounts. Household sector net lending was negative by £5.4 billion, or 1.7% of available income (resources), in the first quarter of 2015. In data extending back to 1987, deficits were previously recorded only in 1988, 1999 and over 2004-08 – see first chart.
The weakness of household finances in the late 1980s and mid 2000s was transmitted to spending as interest rates subsequently rose. Rates, by contrast, fell in 1999, while the trend in net lending – as measured by a four-quarter moving sum – did not fall as far as in the other episodes. Growth slowed in the early 2000s but remained respectable. With interest rates likely to rise soon, and net lending in persistent deficit, current conditions bear a closer resemblance to the late 1980s and mid 2000s.
Household net lending should be distinguished from “saving”, which is the difference between income and consumption. Saving, in other words, includes household spending on investment goods – mainly housing. The saving ratio – saving as percentage of income – was 4.9% in the first quarter of 2015. Subtracting investment net of capital transfers of 6.6% of income generates the net lending deficit of 1.7% of income. The saving ratio is low by historical standards – it was below the current level in only three quarters in data extending back to 1963.
While net lending is similar now to the late 1980s and mid 2000s, borrowing / saving behaviour is very different. The net lending position in the capital account is mirrored in the financial account by the difference between gross lending or financial investment (“net acquisition of financial assets”) and borrowing (“net acquisition of financial liabilities”). This alternative financial account measure is not exactly equal to net lending in the capital account because of a statistical discrepancy, which is usually positive – second chart. Assuming that the capital account is more accurate, this implies that the financial account either overstates financial investment or understates borrowing.
The weakness of net lending in the late 1980s and mid 2000s, and to a lesser extent 1999, reflected strong borrowing, which peaked at 16.1% and 17.1% of income respectively in the former two cases (four-quarter moving sum) – third chart. Despite a recent recovery, borrowing currently remains historically very subdued, at 3.4% of income.
Weak net lending today is explained, instead, by low financial asset accumulation – currently only 4.0% of income versus a pre-crisis average (1987-2007) of 16.1%.
Households have slashed their asset accumulation probably for two main reasons, both related to monetary policy. First, low interest rates have reduced the demand for bank deposits and other money-like assets. This has been reflected in monetary data showing a persistent withdrawal of funds from household time deposits – the outflow totalled £23 billion in the 12 months to June.
Secondly, super-loose monetary policy has inflated the valuations of existing equity and bond holdings, allowing households to scale back their acquisition of new assets while maintaining a rise in wealth – fourth chart. Asset price inflation, in other words, has temporarily reduced the need for financial saving.
Household spending turned down in the late 1980s and mid 2000s as rising interest rates and other developments triggered a normalisation of borrowing behaviour. The risk now is that households will reduce spending to return asset accumulation to a more normal historical level.
Such a scenario would probably involve a rise in interest rates but could occur simply as a result of asset price inflation slowing. With smaller price gains, households would need to raise their acquisition of assets to maintain growth in financial wealth. (This is analogous to the “credit impulse” idea that spending is related to the rate of change of borrowing rather than its level.)
To summarise, it is likely that households will wish to return their financial asset accumulation / net lending to a more normal historical level at some point over the next few years. Barring a substantial rise in income, this would require spending restraint, with negative implications for economic growth.
Could the adjustment be achieved solely via income expansion? This would require a rise in spending relative to income in other sectors of the economy. The equality of aggregate spending and income implies the following identity for the net lending positions of the various sectors:
Household + corporate + government + rest of world = 0
Since the net lending position of the rest of the world is, to a close approximation, the mirror-image of the current account balance, this is equivalent to:
Household + corporate + government = current account
A rise in household net lending would require the corporate / government positions to deteriorate and / or the current account to improve. The Chancellor’s plans, of course, involve eliminating the government deficit. An income-driven recovery in household net lending, therefore, would depend on big rise in corporate spending relative to income and / or a surge in net overseas earnings.
Corporate net lending has moved from a large surplus after the 2008-09 recession to a modest deficit – fifth chart. Scarred by the crisis, and uncertain about the financial / economic impact of monetary policy normalisation, firms may be reluctant to allow a significantly larger shortfall.
The current account position may improve as the recent puzzling weakness of net investment earnings reverses but there is little reason to expect significantly stronger export performance, with the most dynamic sector – financial services – now hobbled by overregulation.
The prospective combined change in the corporate and rest of world positions, in other words, is unlikely to be sufficient to accommodate both government deficit reduction and a pain-free recovery in household net lending.