Hamish McRae: Higher interest won't stop us splashing out yet. But spend, spend, spend will come to an end

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Yes, higher rates may put a ceiling on the housing boom but will they check the growth of consumption?

Yes, higher rates may put a ceiling on the housing boom but will they check the growth of consumption?

One of the oddities of the British and the Americans is that we consume a much higher percentage of national output than do the continentals or the Japanese. UK consumers account for over 65 per cent of GDP, whereas French consumers account for only 55 per cent. I had thought that this was something to do with the insouciance of the English-speaking world as opposed to the earnestness of our European neighbours. But, as the left-hand graph shows, Canada and Australia are among the continental pack. The British and the Americans are the odd ones out.

We were not always so profligate. In the early 1980s, UK consumption was nearly 10 percentage points lower, about where the Continent is now (right-hand graph). As you can see, the twin booms of the late 1980s and the last decade have ratcheted up our consumption, while the recession of 1991-92 only knocked it back a bit.

Between 1996 and 2003, real consumer spending rose by an average of 3.7 per cent a year, a full percentage point higher than the growth of output at 2.7 per cent, itself a fair clip by historical standards. How have we managed it? By increasing our imports relative to exports. Net exports as a percentage of GDP are some 4 per cent lower now in volume terms than they were eight years ago.

So that has lead to a surge in the current account deficit? Well, not really. It has risen a bit and now stands at about 2 per cent of GDP. But that is half the level of the US current account deficit; sterling is strong and stable. A recent study by Lombard Street Research shows two things have helped us. One is a big rise in investment income from abroad. The other is a 10 per cent improvement in our real terms of trade.

The terms of trade are a little-noticed feature of our international accounts but a tremendously important one. If the relative price of our exports rises and the relative price of our imports falls, that is an improvement in our terms of trade. So this is the result of cheap imports? Well, no. The improvement has been mostly in services rather than goods. We seem to be able to charge a huge amount more for our service exports. I have not seen a breakdown of this but I suspect it is partly to do with the success of financial services, not an industry known for under-pricing.

This leads to an obvious question. Can we carry on increasing the proportion of GDP we consume without running into the sort of current account deficits of the US? I should have thought the answer was "not for too long". Investment income seems to be holding up through the financial markets' downswing, which is good, and the City shows no sign yet of losing market share; if anything, the reverse. So there is no red light. But there is an amber one.

The Bank of England has an economic model that seeks to predict what will happen to consumer spending after various shocks. In the long term, the thing that matters most is people's real incomes. Changes in the amount we earn are by far the most important feature determining how much we spend. Other features, such as the value of our homes or our financial savings, matter a bit but their effect is dwarfed by changes in our earnings.

However, in the short run, say the next three months, while earnings are still the most important factor, changes in house prices are quite important too. And the long run is a series of short runs. So the housing boom, carrying on for a couple of years longer than most of us expected, will surely have been a big force behind recent consumption increases. But ultimately, what will matter is earnings and that depends largely on demand for labour. Will employment remain high and rising?

There are reasons to suspect that the present pressure in the labour market will ease quite soon. The public sector will not be able to maintain its present rate of new hiring, even if you take with a pinch of salt the Chancellor's plans to cut civil service jobs. If you dig down into the public spending plans, most departments are having their spending cut as a proportion of national income and some are having it cut in absolute terms. Tax revenues have remained weak (though helped a bit by the oil price) and the Treasury is bouncing up against the 3 per cent of GDP Maastricht deficit ceiling. (We are not in the eurozone but we still go through the motions of following its recommendations.)

Meanwhile, the private sector has not increased its hiring - manufacturing is still shedding labour and services have been hiring more slowly - and the obvious danger is that modest net hiring will shift to modest net reductions. A great surge in unemployment, such as occurred in the early 1990s, is unlikely. But if the economy were to slow seriously, you can bet that the Bank would swiftly cut interest rates to pump things up again. It has considerable leeway to do so.

Nevertheless, the world economy seems likely to slow again next year, especially if oil prices remain at their present levels or rise further. If it does, the UK will feel something of the cooler climate and it seems reasonable to expect the first small rises in unemployment to start coming through next year.

House prices do not have to fall to change the climate for consumption. All they have to do is stop rising. Some homeowners, and probably quite a few buy-to-let owners, have built the prospect of capital gains into their calculations. If prices stick for, say, four years, some people would be disappointed. House prices under-performing expectations would cool the climate for consumption in much the same way as prices over-performing have heated it over the past couple of years.

So the answer to the question posed at the beginning? It depends on the timescale. In the next six months, interest rates will not have much impact. The UK economy has a huge amount of momentum: it is growing at the fastest rate for four years and well above its long-term trend. That momentum will not come off quickly. Nor would you want it to, given the potential hit that higher oil prices are giving the world economy.

But on, say, a two-year view, it is clear that consumption cannot carry on rising as fast as it has in the recent past. We have had an eight-year consumption boom and it could run on a little longer. But not, I suspect, much longer than the next election.

We're not going on a summer holiday

What is happening to summer tourism? Already a few themes seem to be emerging - ones that may well loom larger in the next year or so.

Theme one is the trend for people not to take a midsummer holiday at all. One reason is the growing number of self-employed people who can choose to take holidays out of season. Another is the growing ranks of the semi-retired and the older baby-boomers who are approaching retirement age. A third is the growth of exotic winter holidays; after three weeks in Sri Lanka in February, you may be content with a few long weekends off in the summer.

Theme two is the growing numbers who take their main holidays in their home country. Americans are now travelling abroad less than ever. The low dollar and fears of terrorism don't help. So New York is having a great year for domestic tourists while seeing a fall in the number of foreign ones. In the UK, the good summers of recent years have shifted the balance slightly towards a holiday here. Certainly, the holiday homes market in France and Italy has gone soft as fewer Britons seem to be renting them this summer, though this may also be the result of over-supply.

Theme three may be related to this. Taking the car to France for a holiday - as opposed to filling up the boot in Calais - has become much less popular. Instead, people are making short trips on cheap airlines and renting cars at the other end, which leads to the next theme.

The budget airline phenomenon has transformed the holiday industry in several ways. It is as important as the package tour boom that started in the 1960s. People are encouraged to experiment by travelling to a new destination - say in Eastern Europe - that they would never have thought of going to. But they don't want to risk investing the time of a conventional holiday. So they take a short break, affordable because the fare is so cheap, and make a more conventional choice for their main holiday.

Finally, the growing wealth of British travellers vis-à-vis continental Europeans and the strong pound against the dollar is encouraging more upmarket choices. But greater pressure on working people is encouraging shorter breaks. The next big breakthrough for the holiday industry will be to put those two together: luxury experiences that don't take too long to enjoy.

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