I was blown away by BBC’s article on the top economic graphs of 2011 for the UK: http://www.bbc.co.uk/news/in-pictures-16090055

Not only do they paint a very interesting picture, I think they do a good job of summarising the headaches (and also some excitement through curiosity) that economists have been experiencing in the last couple of years.

There were two graphs that caught my eye in particular. The first one, looks at debt in the UK from private institutions and households, and compares this to public debt.

There are 3 obvious facts we can get from this graph at first glance. Since the global financial crisis:

  1. Companies and households in the UK have massively increased savings (and most of this seems to have come from households).
  2. The government has massively increased debt, almost to an equal magnitude as the private savings increase.
  3. The underlying trend of a small financial surplus seems to have remained stationary for the rest of the world.

The second graph is a little simpler. It shows that real income in the UK has dipped a little since the crisis, but the overall trend, whilst flattening slightly, doesn’t appear to have been affected hugely. The big message here though, is that consumption has plunged since 2008, and has remained low since 2009. It is now well below real income, where it was previously roughly in line with it.

Why is this significant?

Well, the other bit of information missing here is the Bank of England’s interest rate. Interest rates have been at an historic low of 0.5% since March 2009 (see graph below). According to standard consumer theory, a lower interest rate reduces the yield we get on our savings, whilst simultaneously decreasing the cost of borrowing. So, one would expect that following such a dramatic reduction in interest rates, consumption would have risen (or at least not fallen as much). Indeed, there was a small recovery during 2009, but that seems to have worn off.

Okay, well, suppose we argue that interest rates had their effect and they aren’t much use in increasing consumption. The second key thing that consumer theory teaches us is that an increase in government spending is likely to increase consumption. But the first graph shows the complete contradiction to this conjecture – namely government debt has increased, but consumption has fallen and saving has increased instead.

So what’s going on? There are obviously a lot of forces involved in consumption so it would be impossible to identify and go through every possible reason for these events. However, I have a strong belief that the best way to explain things is by looking at the individual level to see how people’s behaviour shapes what happens in an economy. In light of this, I want to identify 3 factors in particular that I think have a big part to play in explaining this seemingly strange consumption scenario.

Lots of interest rates

This is an important argument from the monetary economist’s point of view. After all, what is  the Bank of England’s interest rate actually for? When you go to the bank to check out a loan or savings account, interest rates can and do fluctuate when the central bank (CB) changes their rate. But how much do the rates the banks give out correspond to the base rate? Take a look next time. The answer is ‘not necessarily that much’.

Loosely speaking, the Bank of England’s rates are the rates at which commercial banks borrow. But banks need to make a profit, so when they lend you money, the interest rate will be higher than what they borrowed at. Similarly, when you save with them, you may not always get a rate which is as high as the CB rate. The difference is largely dependent on competitiveness and the profits the banks are looking to make.

For example, suppose the CB rate is 3% and so your local bank is charging 4% on a loan. If the CB rate was cut to 0.5% (like it is now), your bank might ordinarily cut interest rates to 1.5% on your loan if it wants to maintain a constant differential. However, if the banks think ‘screw it, we need to make more money’, which is likely given the fact that the banking system has been in tatters the past few years, they may well keep lending rates at 4% and absorb the extra profit.

What this means overall is that the CB’s interest rate might not have as large an impact on the interest rates seen by the average consumer when they go to get a loan or open a savings account. This is especially likely to be the case at a time when bank behaviour is not following a regular pattern. This might be one possible reason for consumption falling and remaining low despite historically low interest rates.

Uncertainty

Whilst the previous reason is an important one, the issue of uncertainty provides, to me, a much more powerful explanation. This is because it delves into the psyche a little more.

Most people are risk averse. This means that wherever possible, you’d like to take away as much risk and uncertainty from your life as possible. Think about it. It’s pretty unlikely that you will spontaneously combust whilst on holiday, or that your house will be blown away by a hurricane (thought this depends on where you live), but most people would rather insure against these events just in case. If I were to offer you a job for a year that had 2 salary options:

  1. You get £30,000
  2. I flip a coin and you get £0 if it comes up heads, but you get £100,000 if it comes up tails

then I’m pretty sure you’re unlikely to pick the second one because although it is the better option mathematically, the prospect of you earning nothing for an entire year’s work is probably too risky (unless you’re particularly sadistic) for you to even consider.

In light of this, the one thing that the crisis has done for the average person more than anything else is spread FUD (fear, uncertainty and doubt) about everything from their job to their house. I would argue that the media has blown things out of proportion and scared people more than they ought to be to an extent, but the fear is there regardless. Certainly, high unemployment levels of late should be a cause for concern if nothing else.

Economists such as Chris Carroll have argued that people hold a ‘Buffer Stock’ of savings in light of this uncertainty. It has been shown that farmers and others who work in jobs with an uncertain level of income tend to have higher than average savings rates. Now that fear over income has become more widespread, a lot of people think that their long term (permanent) income might fall. This means that people are likely to increase their savings and cut consumption, fearing that ever-looming ‘rainy day’. This behaviour is likely to be much more deep rooted than the transitory effect of an interest rate change, and so might explain the unresponsiveness of consumption to CB rates.

Irrationality, Behavioural Economics and un-classical motives

And so we move on to my favourite area – behaviour. I think a lot of the classical theory that has defined and been embedded in economics, whilst useful, falls flat on its face when we consider that people are not exemplars of rationality in general. (This is a sensitive issue in academic economics and my view will probably earn me the wrath of old-school economists, but at least you can’t say that academia is boring now…)

It’s important to note that by irrational, I don’t mean ‘stupid’. I mean that people tend to do things like take revenge on other people even when it harms themselves because it gives them satisfaction to do so. I mean that people reward fairness and sharing in experiments rather than selfishly take all the money even when they have the opportunity to do so. I mean that people consistently disprove the fact that we are all out to maximise income by taking jobs that pay much less than they are able to get elsewhere in favour of ‘job satisfaction’, among other psychological factors.

Certainly, uncertainty and fear play into behaviour, and the two are intrinsically linked. However, consider everything that has been made out of the importance of reducing debt in the last year or so. Before the crisis, consumption had been historically pretty high. It is likely that a lot of people had borrowed to finance that consumption. Now, with the added uncertainty, the psychological effect on the individual is likely to be that they should focus on eliminating debt and saving more, even when it might not be financially optimal to do so. In this way, I think that on an individual level, people pay much less attention to interest rates in making consumption decisions than might be suggested by classical theory (although it is true that changes in interest rates are known to have only temporary macroeconomic effects).

The uncertainty is also likely to make people more patient. Although there is a desire for people to smooth their consumption over time as classical theory predicts, they tend to respond to temporary shocks in income with immediate changes in consumption. Suppose you got a one-off £500 bonus for Christmas. It’s a temporary change to your income. It doesn’t make you significantly richer in the long run. The theory suggests that you shouldn’t really change your spending habit over Christmas at all. But I’m sure that you would splash out on something with the bonus. The data also suggests that this is what most people would do. This is partly linked to the idea of ‘present bias’. People generally like to have things sooner rather than later, although the degree of bias depends on the individual. Hence, if patience has increased as a result of the crisis, then people would be more conservative with small increases in income and not spend it all at once.

If income falls a little, then more patient people would also not change their spending behaviour much. But the data suggests that people reduced their consumption whether incomes temporarily increased or decreased. What this suggests to me is that there might be an aspect of ‘loss aversion’ embedded in here. Because of the uncertainty in income, you’d expect more saving and less consumption. If patience increased, it might mean that people didn’t change their behaviour much… but because people are intrinsically pretty scared of losing money, even temporarily, the ‘safe’ option is just to keep consumption low and save more (bringing us back to the Buffer Stock idea) rather than keep it constant even in the face of temporary losses.

There are plenty of other theories we could concoct using behaviour as a basis. There’s the ‘people are sheep’ idea, where people copy their friends and family in terms of making financial decisions. Some people saving might make others save too. I think this is always a factor in behaviour, but considering everyone is in a slightly different situation, I’m not sure that high saving is quite akin to lemmings following each other off a cliff.

How about stress? People’s lives are under a lot of strain when they’re worrying about their job and the value of their house. It is possible that people have realised that the added worry that results from our consumer-oriented lifestyle is not worth the added stress it brings in terms of commitments and obligations. There has been a lot of emphasis on happiness over GDP in recent years. People may be coming to terms with the fact that there are things which make them happy that don’t require money: being with someone special or family, taking a long walk in nice surroundings, visiting the library to catch up on some reading, and so on.

A recent related idea, put forward in Dan Ariely’s book ‘The Upside of Irrationality’, is how ‘breaking up’ good experiences seems to increase average happiness, whereas indulging in a lot of good things at once means that we adapt to them after a while, such that they no longer become novel and stop bringing us the buzz that we first experienced. Maybe people are just cottoning on to the fact that there is more to life than extravagant consumption, and that consumption levels aren’t just low for the short haul. This, I accept, is a little idealistic, but I think the fact remains that there is more to be said about the motives of humans than simple material gain.

Conclusion

I’ve just touched on some ideas here to get you thinking more deeply about what is going on beneath the surface of the superficial news stories that you are likely to come across.

From a policy perspective, it’s pretty difficult to gauge what to do given that the issues are so complex. I think the main points to take from this are that:

  • It’s important to people to know what will happen in the future, and whatever we can do to ensure stability, we should do. This is something that economists and governments are all too aware of, but it’s something that should nevertheless be stressed.
  • We, as a society, should devote more time and energy to find out what really makes people tick. This means lots of hard thinking, but also the potential for lots of fun discoveries and experiments.
  • We also then need to figure out how best to target individual behaviour. Large scale decisions like cutting interest rates by a little are unlikely to get John Smith to do much above and beyond what he was already planning to do in line with his own motives.