The TPA, Household Debt and Inflation

My good friend’s at the TPA have responded to my False Economy post on household debt. Leaving aside the sniping (I’m a ‘hack’ apparently), their key argument is that the higher household debt forecasts are due to higher inflation (’the colossal elephant in the room’).

Fair enough, although the basic problem with this argument is that the OBR haven’t really revised their inflation forecasts by all that much.

Since their June pre-Budget forecast they have revised up the 2011 CPI forecast from 1.6% to 4.2% and the 2012 forecast from 2.0% to 2.5%. They have made no changes to their forecasts for inflation in 2013, 2014 or 2015. The ‘elephant in the room’ isn’t really so large.

It seems unlikely, to say the least, that a relatively minor (and temporary) increase could cause such a large increase in the household debt forecast.

But then ‘inflation’ is the right’s new best friend – household debt rising? Blame inflation. Government borrowing an additional £45 billion? Must be inflation.

As Chris Dillow wrote two weeks ago this excuse, in relation to higher government borrowing,  is ‘drivel’.

For what it’s worth I’ve emailed the OBR asking for more detail on their household debt forecasts and the reason for the increase. But let’s remind ourselves – back in June they forecast that household debt/income would fall every year until 2015, now they expect it to rise every year. It seems unlikely that two years of higher inflation could cause such a large effect.

The Household Savings Ratio is now key

This past week has seen a lot of comment on the likely path of UK household debt growth following blog posts from myself (both at False Economy and here) Richard Murphy and Sturdyblog, Parliamentary questioning by Chuka Umunna, an intervention by Paul Krugman and a big splash in the Observer.

What has become clear is that the OBR is expecting a big increase in household indebtedness over the next few years.

As the Observer put it:

The Office for Budget Responsibility has raised its prediction of total household debt in 2015 by a staggering £303bn since late last year, in the belief that families and individuals will respond to straitened times by extra borrowing. Average household debt based on the OBR figures is forecast to rise to £77,309 by 2015, rather than the £66,291 under previous projections.

Krugman explained the reasoning:

Why? Because the only way the economy can avoid taking a hit from government cuts is if private spending rises to fill the gap — and although you rarely hear the austerians admitting this, the only way that can happen is if people take on more debt. So we have the spectacle of a government that inveighs against the evils of debt pinning all its hopes on an assumption that over-indebted households will dig their hole even deeper.

An important point was raised last week by Richard Excell, who asked if this forecast for strong household debt growth was realistic.  He noted a half dozen recent data points suggesting that a large increase in debt was unlikely.

Adam Posen, of the MPC, appears to agree telling the Guardian last week that:

“Household consumption is going to be pretty darn weak. It may even contract a little”.

Consumers, he said, were unlikely to run down their savings in an attempt to maintain spending patterns, while the weakness of trade unions meant it would be hard for wage bargainers to push up pay settlements in response to higher inflation.

Posen then is taking the contray line to the OBR which belives that:

This subdued consumption outlook requires households to dip into their savings again in 2011, so the saving ratio continues to fall back from its post recession peak. Thereafter, the saving ratio stabilises at around 3½ per cent in our forecast (much the same as forecast in November), which is around half its average over the last 50 years.

This is the key divide between Posen and the OBR – the OBR believe that the household savings ratio (the amount of post tax income households save) will fall in the coming years providing a boost to consumption and hence GDP growth (at the cost of increased personal debt), whilst Posen thinks it won’t fall and hence squeezed incomes will lead to lower spending and lower growth.

The household savings ratio will be a key economic indicator to watch over the coming year.

It is currently 4.9%, the ONR expect it to fall to 3.4% – as they say, half of its average of the past 50 years. (Clearly the OBR aren’t big fans of mean reversion!)

To get a sense of how key it will be, it’s worth looking in more detail at the OBR forecasts. Despite Osborne’s talk of investment, exports and rebalancing – consumption will still be key to the UK economy according to the OBR – as the table below shows.

Overall household consumption (on the OBR forecasts) will provide around 38.3% of all UK growth by 2015.

How crucial is a falling savings ratio to this forecast?

Very, as the table below demonstrates.

 

As can be seen, in 4 of the next 5 years the OBR expects consumption to grow by more than household income – obviously this can only happen if the savings ratio falls.

If consumer confidence took a bigger hit and nervous households started to save more (or if banks were unwilling to lend), then consumption growth could actually be slower than income growth. (The ratio would rise, and remember its half it’s long-run average at the moment)

Weaker consumption growth (or in Posen’s case possibly an outright fall), would clearly have a major impact on the OBR’s growth forecasts – and hence its government borrowing forecast.

The household savings ratio (along side business investment) is now a key factor to watch. Either it falls and we get consumption growth at the cost of a huge increase in household debt or it doesn;t and we get much weaker growth.