What, then, has thwarted our hopes of recovery? A factor distinguishing this recession from previous ones is the strong downturn in consumer spending. Given the preponderance of consumption in the total GDP (more than two-thirds), this is bound to have had significant implications for the economy as a whole.
Total consumer spending has now fallen for seven consecutive quarters, and in the first quarter of 1992 it was 3.5 per cent below its peak of early 1990. Overestimating the desire of households to return to higher spending is probably the main reason the recession has lingered much longer than most forecasters expected.
Low consumption in the early Nineties is largely the aftermath of a frenzy of consumer activity at the end of the Eighties. Financial deregulation combined with a lax monetary policy to produce a housing boom, intertwining with a sharp build-up in personal debt. These developments boosted consumer spending, since there were more household purchases because of the higher number of transactions in the market and people were able to borrow on the back of rapid growth in property equity. Such an environment perpetuated a mood of confidence. The resulting flurry of consumption was broken only by a protracted period of high interest rates.
The legacy of the consumer boom has been high levels of household debt. It is now widely argued that households have responded by reducing consumption in order to pay off their debts. However, there appears to be little evidence for this assertion. Indeed, total debt in the personal sector has grown by more than 19 per cent since 1989. Households have increased repayments of expensive consumer credit debts (from credit cards and the like), but overall these repayments remain insignificant and total debt levels have continued to rise.
The income that households have chosen to save rather than spend has not been used to repay liabilities but to build up financial assets. In particular, savers have channelled money into life assurance, pension funds and building society deposit accounts. Although some of this flow has undoubtedly been non-discretionary (due, for example, to the end of pension fund holidays), it would indicate that consumers are less concerned about their debt levels than their overall balance sheet.
There are a number of possible explanations for such behaviour. It may simply be that individuals prefer to hold liquid assets instead of reducing debt, since this gives more financial flexibility at little extra cost. This may be of particular relevance at a time when many workers fear redundancy. Alternatively, it may simply be that the savers and the debtors are different people. The savers are saving while the debtors hang on.
Whatever the reason, it may go a long way to explaining recent consumer behaviour. It seems likely that consumers are adjusting to a desired ratio of wealth-to-income somewhat higher than implied by most forecasts of consumer spending.
To achieve this, households have increased to relatively high levels their ratio of savings to personal disposable income. In the first quarter of 1992, the savings ratio was 11.5 per cent, compared with levels of less than 6 per cent in the late Eighties.
Where does consumer spending go from here? We have decided to adopt a more cautious approach in our latest forecast and have assumed that the savings ratio stays high for the next few years at least. This is consistent with the long-term average for the Sixties and Seventies.
The non-discretionary nature of at least a proportion of the increase in personal sector savings over the last two years provides a further reason why the savings ratio, according to its current definition, is likely to stay high. Such an outcome for saving implies a relatively bleak outlook for the economy this year and next. We expect GDP to decline by 1.1 per cent this year and grow by just 1.8 per cent in 1993.
Our view is that sterling will not (and should not) be devalued within the ERM and that UK interest rates will come down only slowly during the course of 1993, closely following the monetary stance of the Bundesbank. Tight monetary policy is likely to be matched by only modest growth in public spending in the next fiscal year.
Although headline inflation should continue to fall, averaging less than 3 per cent in 1993, unemployment will increase to almost three million by the end of 1993.
While the recovery after 1993 is not expected to be particularly strong, unemployment should start to come down thereafter, mainly because of a sharp decline in the number of school-leavers.
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