The economic fall-out from the windfall factor

In the mid-1980s, a serious shock hit the consumer sector of the economy in the form of deregulation of the financial system, which enabled individuals to borrow much more freely than before against the security of their homes and other assets. If economists at the time had fully understood the extraordinary impact of this development, much of the sorry story of the late Thatcher years could have been avoided. But we did not, so monetary policy stayed too loose for too long, and the boom/bust cycle was reborn.

It is possible that a similar shock is about to hit the system, with similarly unpredictable results. Just as before, most economists believe that this shock will have relatively small effects. And just as before, the monetary authorities are aware of the potential for adverse surprises, yet are still choosing to leave base rates at relatively low levels. We could all be wrong again.

The shock I am referring to is the series of consumer "windfalls" due to hit the system in the next couple of years. These are outlined in Table 1, and they aggregate to pounds 45bn over 1996 and 1997 - equivalent to more than 4 per cent of personal disposable income over that period. This is such a huge number that it could clearly have an impact on consumer psychology, and potentially even determine the result of the next general election. Yet, in the main, the economics profession has concluded that the impact of these "windfalls" on consumer spending will be extremely small. Why is this?

It is basically because the dominant economic model of consumer behaviour nowadays assumes that households will not adjust their spending in a knee- jerk fashion to one-off gains in income or wealth. Only to the extent that they consider that their permanent flow of income over the rest of their lifetimes has been "shocked" upwards will households increase spending today. Furthermore, several of the items in Table 1 are not shocks at all, but should have been fully anticipated by rational consumers.

Before looking at the main items one by one, it is important to understand the permanent income hypothesis (PIH) in common-sense terms. Simple observation suggests that households tend to resort to borrowing in order to consume more than they are earning when they are young, then build up assets in middle age, and finally run down assets in retirement. Provided that they can borrow freely against future earning power, they can therefore smooth their consumption throughout their lifetimes as income varies up and down.

Consumption is determined not by today's income but by permanent or lifetime income - defined as the expected value of future earnings from employment, plus the sum that can be generated each year from any investments they may hold. When the value of these investments increases, rational consumers increase their spending not by the full value of this rise, but only by the amount of extra income (in interest, rent or dividends) that can be generated each year from their additional investments.

One crucial assumption for this hypothesis to be valid is that consumers can borrow without hindrance against future income. If they cannot, they are said to be "liquidity constrained", and an increase in wealth can generate a much larger rise in spending than suggested by the PIH. A second crucial assumption is that households look beyond the end of their own lifetimes, and care just as much about the future welfare of their heirs as they do about their own welfare. If this is not valid, then households will seek to end their lives with no net wealth - and any increase in wealth today will be slowly run down over the rest of their lives. This will also lead to bigger effects than the PIH suggests. Both effects probably apply to some extent in the real world.

Armed with this thinking, David Walton of Goldman Sachs has recently released a detailed special study of the windfall effect, from which the accompanying tables are taken. To start with the most straightforward, the tax cuts of pounds 3.5bn this year will be worth 0.6 per cent to disposable income. This will probably be regarded as a permanent addition to household income, so will also add 0.6 per cent to consumer spending. By contrast, the one-off electricity rebate, which will give pounds 50 to each household in the current quarter (worth pounds 1.1bn in aggregate), will have almost no impact on permanent income, and may therefore have only a negligible effect on spending.

The effect of the release of pounds 18bn of Tessas this year is more problematic. In principle, since these accounts have been part of people's savings for several years, there was no sudden increase in wealth when many of them were "unfrozen" in January. So far, the evidence is that most of the principal amounts in these Tessas is flowing back into new savings instruments, but that still leaves around pounds 4.5bn of accrued interest which is not allowed to go back into Tessas, and which could therefore be spent. It seems likely that at least some consumers have been waiting for this money to become available to relax "liquidity constraints" upon them, and that they will spend part of it. David Walton assumes that about 40 per cent of the interest (and none of the principal) leaks into spending, boosting consumption by around 0.4 per cent this year. But this is highly uncertain.

Finally, the largest factor of all, the wave of building society flotations and takeovers. This will add around pounds 19bn to consumer net wealth in the next two years. It can be argued, as Patrick Minford has done, that all of this wealth was already recognised by the account-holders, since it lay dormant in the reserves of the society, and was owned by the society's investors. Furthermore, he argues that when the societies become public companies, they will charge more for their mortgage lending, or reduce deposit rates, either of which will reduce consumer spending. He therefore concludes that the overall effect on consumption will be negligible.

I find this hard to accept. People simply are not, I would contend, sufficiently informed to have realised in advance that the hidden reserves of the building societies were really part of their wealth. Instead, they are going to adjust their estimates of wealth upwards when the flotations occur. On past evidence, about 40 per cent of the new shares will be sold within a year, but some of this may go into other investments rather than directly into spending. The table assumes that in fact half is spent, which would boost overall consumption by 0.8 per cent next year.

Overall, then, the windfalls are calculated to boost spending by about 1.2 per cent this year, half of which comes from the tax cuts. Next year, the windfalls are worth 1.7 per cent to spending, with any further tax cuts coming on top of this. These figures are not large enough to fundamentally change the course of the economy, but neither are they negligible. They will boost the economy. And remember that additional wealth, even when not immediately turned into spending, will make people feel better off - and therefore a lot more forgiving of the Government's past misdemeanours.

Suggested Topics
News
peoplePerformer had recently been diagnosed with prostate cancer
News
The surrealist comedian at the Q Awards in 2010
people
News
i100
Arts and Entertainment
Media baron Rupert Murdoch owns News Corps and 20th Century Fox
theatrePlaywright David Williamson is struggling to find a big name to star as the media mogul
PROMOTED VIDEO
News
ebooksAn unforgettable anthology of contemporary reportage
News
Russell Brand arriving for the book launch in East London
peopleRussell Brand cancels his book launch debate due to concerns about the make-up of the panel
Arts and Entertainment
JK Rowling will not be releasing a 'romance' novel anytime soon
books
Life and Style
tech

Of all the computers Apple has ever made there’s only one that Steve Jobs had to sell his car to finance

Arts and Entertainment
Sarah Dales attempts to sell British Breeze in the luxury scent task
tvReview: 'Apprentice' candidates on the verge of tears as they were ejected from the boardroom
News
One of the 'princesses' in the video
videoYouTube reinstates sweary video after takedown for 'violating terms'
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SQL Developer with T-SQL, Watford, Hertfordshire - £350 - £360

£350 - £360 per day: Ashdown Group: SQL Developer with T-SQL, Watford, Hertfor...

IT Systems Business Analyst - Watford - £28k + bonus + benefits

£24000 - £28000 per annum + bonus & benefits: Ashdown Group: IT Business Syste...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: The SThree group is a world le...

Trainee Recruitment Consultant Birmingham

£18000 - £23000 per annum + Comission: SThree: The SThree group is a world lea...

Day In a Page

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?

A crime that reveals London's dark heart

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?
Meet 'Porridge' and 'Vampire': Chinese state TV is offering advice for citizens picking a Western moniker

Lost in translation: Western monikers

Chinese state TV is offering advice for citizens picking a Western moniker. Simon Usborne, who met a 'Porridge' and a 'Vampire' while in China, can see the problem
Handy hacks that make life easier: New book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone

Handy hacks that make life easier

New book reveals how to rid your email inbox of spam, protect your passwords and amplify your iPhone with a loo-roll
KidZania lets children try their hands at being a firefighter, doctor or factory worker for the day

KidZania: It's a small world

The new 'educational entertainment experience' in London's Shepherd's Bush will allow children to try out the jobs that are usually undertaken by adults, including firefighter, doctor or factory worker
Renée Zellweger's real crime has been to age in an industry that prizes women's youth over humanity

'Renée Zellweger's real crime was to age'

The actress's altered appearance raised eyebrows at Elle's Women in Hollywood awards on Monday
From Cinderella to The Jungle Book, Disney plans live-action remakes of animated classics

Disney plans live-action remakes of animated classics

From Cinderella to The Jungle Book, Patrick Grafton-Green wonders if they can ever recapture the old magic
Thousands of teenagers to visit battlefields of the First World War in new Government scheme

Pupils to visit First World War battlefields

A new Government scheme aims to bring the the horrors of the conflict to life over the next five years
The 10 best smartphone accessories

Make the most of your mobile: 10 best smartphone accessories

Try these add-ons for everything from secret charging to making sure you never lose your keys again
Mario Balotelli substituted at half-time against Real Madrid: Was this shirt swapping the real reason?

Liverpool v Real Madrid

Mario Balotelli substituted at half-time. Was shirt swapping the real reason?
West Indies tour of India: Hurricane set to sweep Windies into the shadows

Hurricane set to sweep Windies into the shadows

Decision to pull out of India tour leaves the WICB fighting for its existence with an off-field storm building
Indiana serial killer? Man arrested for murdering teenage prostitute confesses to six other murders - and police fear there could be many more

A new American serial killer?

Police fear man arrested for murder of teen prostitute could be responsible for killing spree dating back 20 years
Sweetie, the fake 10-year-old girl designed to catch online predators, claims her first scalp

Sting to trap paedophiles may not carry weight in UK courts

Computer image of ‘Sweetie’ represented entrapment, experts say
Fukushima nuclear crisis: Evacuees still stuck in cramped emergency housing three years on - and may never return home

Return to Fukushima – a land they will never call home again

Evacuees still stuck in cramped emergency housing three years on from nuclear disaster
Wildlife Photographer of the Year: Intimate image of resting lions claims top prize

Wildlife Photographer of the Year

Intimate image of resting lions claims top prize
Online petitions: Sign here to change the world

Want to change the world? Just sign here

The proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?