The Ukraine Crisis: Weekly analysis
Please join me, my colleagues James Dillon and Peter Gooch this Thursday for a 30-minute discussion on the economic effects of the war in Ukraine, financial sanctions and cyber risk
Timing: Thursday, 31 March, 13:00 GMT.
Growth in Europe and North America faces serious challenges this year – soaring inflation, rising interest rates, a major squeeze on spending power and a host of risks created by the war in Ukraine and by the pandemic.
Forecasts for growth in Europe and North America have fallen since January but remain consistent with a continued recovery. In the UK the official forecaster, the Office for Budget Responsibility (OBR), last week cut its forecast for UK GDP growth this year from 6.0% to a still respectable 3.8%.
Given the risks, above all the near certainty that inflation will run higher than earnings or wage growth across the West this year, why do forecasters think there’ll be any growth at all this year? With consumer spending accounting for half to two-thirds of all economic activity, surely declines in real household incomes spell declining consumer spending and contracting GDP growth?
With inflation likely to hit around 7.0%–8.0% in Europe and North America in the next few months tough times lie ahead. On average forecasters expect incomes, or earnings, after inflation, in the US, the euro area, the UK and Canada to contract by around 2.0% this year. In the UK the OBR estimates that the fall in real household income this year will be the most severe in more than 60 years.
Despite the looming squeeze, forecasters expect consumer spending, the main engine of GDP growth, to grow. The scale of the apparent disconnect between real earnings and spending is arresting. In the euro area, for instance, where economists see real average wages falling by over 2.0% this year, they are forecasting growth in consumer spending of over 4.0%.
A number of factors help explain why consumer spending is likely to keep growing in the face of falling real incomes.
First, rising numbers of people in work should support spending. Labour markets have staged a strong recovery from the pandemic, but unemployment and economic inactivity have yet to return to pre-pandemic levels. The carrot of plentiful job opportunities and the stick of high inflation are likely to bring more people into the labour market. Even as inflation reduces the spending power of the average consumer this year rising employment should bolster overall consumer spending power.
Second, consumers are not totally reliant on earned income to finance spending. They can also draw on savings built up during the downturn. On average – and the money is spread unevenly across the population – UK households are sitting on about £6,500 in extra bank deposits and cash than would have been expected had the pandemic not happened. The UK savings rate, at 8.3%, is well above the levels seen in the years before the pandemic, giving consumers space to redirect income from savings to spending. A similar story holds in the rest of Europe and North America.
Third, rising equity and house prices are supportive of spending. Euro area equity prices have risen by over 40% in the last two years and US equities are up by 80%. Higher equity prices boost consumer balance sheets and give more affluent consumers the firepower to keep spending when incomes are under pressure. With property prices growing at double digit rates in the last couple of years in the US and Europe, owner-occupiers have more scope to withdraw equity from the market by remortgaging.
Fourth, consumers can fund spending by borrowing. Having paid down credit card and other consumer debt over the last two years, and with interest rates at low levels, they are well placed to do so.
The notion that spending can, and does, deviate from income growth is embodied in economic theory in the work of US economists, Franco Modigliani and Milton Friedman, who posited that
consumers smooth spending through their lifetimes using saving and borrowing as stabilisers.
The recent past provides an example of such behaviour. Disposable incomes suffered a prolonged squeeze in the UK in the wake of the financial crisis. Between 2010 and 2019 real average earnings grew by a total of just 1.2%. But over the same period employment grew almost 13%, adding to the number of consumers, while households borrowed more and saved less. The result was that even though real earnings rose by just 1.2% between 2010 and 2019, total household spending rose by 21%.
Just because total spending is rising doesn’t mean that everyone’s spending is. Lower-income households spend more of their income on necessities, including food and fuel, where inflation is being driven by surging commodity prices. Those on benefits saw a £20 a week reduction in their income last September as the pandemic uplift to Universal Credit ended.
Savings, assets and borrowing power give higher-income households a cushion against inflation that low earners do not have. Higher-income households account for a disproportionate share of spending. In the UK the top 50% account for almost 70% of all spending. Data on total consumer spending do not reflect the true pressure felt by the lower half of the income distribution because so much spending is accounted for by higher earners.
Many low-income households are likely to see a decline in their real incomes this year. The Resolution Foundation estimates that an unemployed single person renting a shared room, faces a £1,336, or 15%, reduction in real income this year, mainly because of higher inflation and the ending of the pandemic uplift to Universal Credit.
Overall spending is likely to keep rising this year, and, with it, GDP growth. That will be of little consolation to lower-income households who don’t have the savings, the assets or the access to credit to enable them to maintain their spending.