The Brexit slowdown begins (probably)

When the Bank of England after the Brexit vote forecast 0.8% GDP growth in 2017, they expected consumption growth to decline to just 1%, with only a small fall in the savings ratio. But consumption growth proved much stronger in the second half of 2016 than the Bank had expected. As this chart from the Resolution Foundation shows, pretty well all the GDP growth through 2016 was down to consumption growth, something they rightly describe as unsustainable. (If consumption is growing but the other components of GDP are not, that implies consumers are eating into their savings. That cannot go on forever)

This strong growth in consumption in 2016 led the Bank to change its forecast. By February

their forecast for 2017 involved 2% growth in consumption and GDP, and a substantial fall in the savings ratio.

What was going on here? In August, the Bank reasoned that consumers would recognise that Brexit would lead to a significant fall in future income growth, and that they would quickly start reducing their consumption as a result. When that didn’t happen the Bank appeared to adopt something close to the opposite assumption, which is that consumers would assume that Brexit would have little impact on expected income growth. As a result, in the Bank’s February forecast, the savings ratio was expected to decline further in 2018 and 2019, as I noted here. Consumers, in this new forecast, would continually be surprised that income growth was less than they had expected.

The first estimate for 2017 Q1 GDP that came out yesterday showed growth of only 0.3%, about half what the Bank had expected in February. This low growth figure appeared to be mainly down to weakness in sectors associated with consumption (although we will not get the consumption growth figure until the second GDP estimate comes out). So what is going on?

There are three possible explanations. The first, which is the least likely, is that 2017 Q1 is just a blip. The second is that many more consumers are starting to realise that Brexit will indeed mean they are worse off (I noted some polling evidence suggesting that here.), and are now adjusting their spending accordingly The third is that consumption was strong at the end of 2016 because people were buying overseas goods before prices went up as a result of the Brexit deprecation.

If you have followed me so far, you can get an idea of how difficult this kind of forecasting is, and why the huge fuss the Brexiteers made about the August to February revision to the Bank’s forecast was both completely overblown and also probably premature. All Philip Hammond could manage to say about the latest disappointing growth data was how it showed that we needed ‘strong and stable’ government! I suspect, however, that we might be hearing a little less about our strong economy in the next few weeks.

Of course growth could easily pick up in subsequent quarters, particularly if firms take advantage of the temporary ‘sweet spot’ created by the depreciation preceding us actually leaving the EU. Forecasts are almost always wrong. But even if this happens, what I do not think most journalists have realised yet is just how inappropriate it is to use GDP as a measure of economic health after a large depreciation. Because that depreciation makes overseas goods more expensive to buy, people in the UK can see a deterioration in their real income and therefore well being even if GDP growth is reasonable. As I pointed out here, that is why real earnings have fallen since 2010 even though we have had positive (although low) growth in real GDP per head, and as I pointed out here that is why Brexit will make the average UK citizen worse off even if GDP growth does not decline. If it does decline, that just makes things worse.  

The Eurozone Recovery and Household Savings

A follow-up to my last post. The US growth recovery began in 2010 and has been sustained, albeit at a modest pace. The UK recovery did not really begin until 2013, but growth may be quite rapid in 2014. So will it be the Eurozone’s turn in 2014? Furthermore, just as UK growth this year can be quite strong because we have a lot of catching up to do from the lost years of 2010-12, will Eurozone growth also be rapid as it has two recessions (2012 as well as 2009) to recover from?

The chart below suggests perhaps not. It shows household savings rates in these three areas, and also Spain. 

Household Savings Rates. Sources: OECD Economic Outlook and Eurostat

Focus on the changes. During the 2008/9 recession we saw increases in savings everywhere, as we might expect after a financial crisis. In the US and UK savings stayed high until 2013. The 2013 recovery in the UK is all about the subsequent decline in the savings ratio. Once again, this is what you might expect after a financial crisis: a prolonged period of high savings as borrowing is gradually reduced and wealth positions restored, followed by a boost to demand as savings rates are normalised.

So can we expect the same dynamic in the Eurozone in 2014 and beyond? The answer is probably not, because the decline in the savings ratio has already happened. In fact it seems to have happened earlier than in the UK or US. There is one obvious explanation for this, again straight out of the Keynesian playbook. Unlike the financial crisis, the 2012 Eurozone recession was a recession caused in large part by fiscal tightening. And as basic macroeconomics tells you, if the public sector decides to save more, the private sector has to save less.

The Eurozone appears to have already had its growth boost from declines in the savings ratio: it helped moderate the size of the 2012 recession. This also means we do not know to what extent consumers’ financial balances in the Eurozone have been restored: savings may have fallen in 2010/11 not because any correction was complete (as we hope is the case in the UK and US by 2013), but simply because incomes fell. So for 2014 and beyond, the impetus for recovery may have to come from elsewhere. The pace of fiscal tightening may ease, but it is still a drag on growth. Growth in the UK and US will help, but this may be offset by a decline in the rate of growth in emerging markets. Is there anything else that could provide the basis for a strong recovery?  

Some notes on the UK recovery

The latest national accounts data we have is for 2013 Q3. Between 2012Q4 and 2013Q3 real GDP increased by 2.1% (actual, not annual rate). Not a great number, but it represented three continuous quarters of solid growth, which we had not seen since 2007. So where did this growth come from? The good news is that investment over that same period rose by 4%. (This and all subsequent figures are the actual 2013Q3/2012Q4 percentage growth rate.) Business investment increased (2.7%), public investment did not (0.5%), but dwellings investment rose by 8%. The bad news is that exports rose by only 0.1%. Government consumption increased by 1.0%.

Over half of the increase in GDP was down to a 1.8% rise in consumption. Not huge, but significant because it represented a large fall in the savings ratio, as this chart shows.

The large increase in saving since 2009 is a major factor behind the recession. The recovery this year is in large part because the savings ratio has begun to fall. We should be cautious here, because data on the savings ratio is notoriously subject to revision. However if we look at the main component of income, compensation of employees, this rose by 3.4%, while nominal consumption rose by 4.4%, again indicating a reduction in savings.  

So the recovery so far is essentially down to less saving/more borrowing, with a minor contribution from investment in dwellings (house building). As Duncan Weldon suggests, the Funding for Lending scheme may be an important factor here. However it may also just be the coming to an end of a balance sheet adjustment, with consumers getting their debts and savings nearer a place they want them to be following the financial crash.

I cannot help but repeat an observation that I have made before at this point. Macro gets blamed for not foreseeing the financial crisis, although I suspect if most macroeconomists had seen this data before the crash they would have become pretty worried. But what macro can certainly be blamed for is not having much clue about the proportion of consumers who are subject to credit constraints, and for those who are not, what determines their precautionary savings: see this post for more. This is why no one really knew when the savings ratio would start coming down, and no one really knows when this will stop.

Some people have argued that we should be suspicious about this recovery, because it involves consumers saving less and borrowing more. Some of the fears behind this are real. One fear is that, encouraged by Help to Buy, the housing market will see a new bubble, and many people will get burned as a result. Another is that some households will erroneously believe that ultra low interest rates are here forever, and will not be able to cope when they rise. But although these are legitimate concerns, which macroprudential policy should try and tackle, the truth is that one of the key ways that monetary policy expands the economy is by getting people to spend more and save less. So if we want a recovery, and the government does not allow itself fiscal stimulus, and Europe remains depressed because of austerity, this was always going to be how it happens. [1]

However there is a legitimate point about a recovery that comes from a falling savings ratio which is that the savings ratio cannot go on falling forever. The moment it stops falling, consumption growth will match income growth. The hope must be that it will continue for long enough to get business investment rising more rapidly, and for the Eurozone to start growing again so that exports can start increasing. But the big unknown remains productivity. So far, the upturn in growth does not seem to have been accompanied by an upturn in productivity. In the short term that is good because it reduces unemployment, but if it continues it will mean real wages will not increase by much, which in turn will mean at some point consumption growth will slow.

There is a great set of graphs in this post at Flip Chart Fairy Tales which illustrate the scale of the productivity problem. (Rick - apologies for not discovering your blog earlier.) For example the OBR, in November 2010, were expecting real wages in 2015 to be 10% higher than in their recent Autumn Statement forecast. We will not recover the ground lost as a result of the recession until productivity growth starts exceeding pre-recession averages. As Martin Wolf and I suggest, the Chancellor should be focusing on the reasons for the UK’s productivity slowdown rather than obsessing about the government’s budget deficit.

[1] In theory it could have happened through a large increase in investment. However the experience of the recession itself, and more general evidence, suggests that investment is strongly influenced by output growth. That is why investment has not forged ahead as a result of low interest rates, and why firms continue to say that a shortage of finance is not holding them back. Having said that, I would have prefered the government to try fiscal incentives to bring forward investment rather than implement measures aimed at raising house prices. 

Savings Equals Investment?

This post is for first year undergraduate students (and the occasional blogger) who appear confused.

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A:  It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.