I wrote this article for Positive Money. It was first published on the Positive Money Website on September 14, 2011. You can also read it on http://www.positivemoney.org.uk/2011/09/consumption-saving-trend-uk-households/. I am publishing this on my blog so that people who access to my blog read this as well.
Households saving is the proportion of disposable income that is not spent on consumption, or alternatively the difference between current income and current consumption. Households’ decisions to save or spend plays a key role in the determination of aggregate demand and their willingness to spend on final goods and services. It has a key effect on economic outlook of the UK because 60 percent of contribution in the consumption of the UK is by consumer sector. The saving ratio of the UK fell steadily from 1995 – 2007 but increased by the end of 2008 and 2009. The output of the UK also fell over 5 ½ percent in 2007.
Berry and Williams in their paper “Household Saving” explained that either saving or debt can be used to accumulate assets by households. They used the following equation to explain this:
S+D = A+H
A=Financial Assets (deposits and shares)
H= Housing Assets
This means that households can acquire financial assets or housing assets by saving or by obtaining debt. In practice some of the households will be obtaining debt to increase the amount of funds for consumption and some of the households will be saving. But during the last decade saving ratio of the UK households has decreased and household debts have increased markedly.
Saving ratio in the UK has declined since 1992 as the household sector increased its consumption expenditure. The increase in rate of consumption was greater than the increase in disposable income which means that households acquired huge debt to finance their consumption expenditure. Following figure shows the decline in consumption of households in 2007.
The households saving ratio declined from around 10 percent in the mid – 1990 to around 2 percent in mid 2007 and then -0.7 percent in 2008. It then increased to 4 percent in 2009. The following figure shows the actual saving ratio and inflation adjusted saving ratio.
The households saving ratio declined over last decade due to low interest rates, low inflation, excessive lending by banks to households sector, loose credit conditions, high asset prices and an economic boom (naturally fuelled by debt).
According to the modern consumption theory, which is based on Friedman’s “life-cycle permanent income” model, households decide on their current spending on their expected future income. If they expect the income to be higher today than in future than they will save today and if they expect the income to be lower now than expected future income than households will ‘dis-save’ (by borrowing or using ‘saving’ assets for consumption). [Of course, this theory is very much open to dispute – ed.]
The ‘risk-free real interest rate’ is also one of the key determinants of the households consumption and saving. In economic conditions with low interest rates, the saving ratio is also low because the households are able to borrow easily to fund their consumption (because increase in house prices provide more collateral against which they can borrow more). A higher real interest rate encourages consumers to spend less at the moment to maintain their real value of money by saving higher interest receipts.
Over a last decade long term interest rate of the UK was at historically low levels making possible for households to obtain credit easily. The spread between bank rate and mortgage rates narrowed to around 50 basis point from 100 basis points at the end of 2006. This encouraged the households to increase their consumption and reduce savings.
The increase in consumption and decrease in saving of households was not a result of their expectation of high future income but due to easy availability of credit. Banks played a crucial role in influencing consumption and saving pattern of the households. The excessive lending by banks in the form of secured (mortgage) and unsecured (credit cards, overdrafts etc) encouraged the borrowers to increase their consumption and decrease saving over last ten years period. The consumption and saving trend reversed during economic slowdown.
Households decisions to save or spend are dependent on their expectation of future economic growth and easy availability of credit. Households increased their saving during the financial turmoil because they were uncertain about future positive growth prospects, non-availability of credit in the economy, increased job uncertainty, decrease in net financial wealth, and lower expected future income.
Increase in unemployment and low future expected income was major causes that encouraged households to increase their savings and cut consumption. Unemployment in the UK increased sharply during the financial crisis. Unemployment rate rose over 2 ½ percentage points over the past two years. Households expected increase in unemployment and prolonged period of economic slowdown so they cut their spending. Following figure shows the households expectation of unemployment.
GDP growth of 0.2 percent in the second quarter caused households to revise their expected future income. Following figure shows that households are expecting to have low future income.
Due to financial turmoil and uncertain future economic conditions consumers responded by cutting back their consumption / spending. Households are now trying to save for debt repayment and to maintain their real value of money. This adjustment in saving will have important consequences on the economic outlook keeping in mind the role of households spending in the aggregate demand.
Reduction in consumption by households will push down economic outlook and eventually households income because businesses will cut their capital spending that leads to low job creation in the economy. The drag on households income will make it harder for them to increase their saving which mean that we don’t see increase in consumption by households in near future.
If banks continue to invest in mortgages and speculative investments we will soon be witnessing another economic boom and bust. Banks should invest in productive sector of the economy particularly to Small and Medium Businesses that contribute to the economic development, create employment opportunities, increase saving of households, lead to stable consumption and spending in the economy and reduce vulnerability of output in the economy and for businesses.