Consumption must be reined in

The weak retail sales figures for February published last week have set off another bout of pessimism in some quarters about the prospects for continuing economic recovery.

This has been a repeating pattern in the past two years, despite the fact that during the whole of that period the economy has been growing serenely at an annual rate of around 2 per cent.

(Actually, the steadiness of the growth rate from one quarter to the next has been remarkable, both before and after sterling's exit from the ERM in the autumn of 1992, but we cannot expect everyone to notice such niceties.)

Previous experience suggests that, once a recovery really takes hold in this fashion, it generally becomes self- sustaining and can only be derailed by an extraordinary upheaval on the policy front.

In the past such upheavals have been triggered either by oil price shocks - 1974 and 1979 - or by a significant increase in inflation pressure as in 1990. Neither of these is remotely on the horizon at present, so the default assumption should be that the recovery will continue. However, there is admittedly a large fiscal shock just around the corner, and this is what has triggered concern.

SPENDING

Keynesians such as myself are supposed to believe in the power of fiscal policy, so it is rather embarrassing to admit that I have never been able to find much of a role for the budgetary stance in equations that directly explain the growth of GDP.

Certainly, in such equations, monetary policy - essentially, the level of interest rates - invariably proves more powerful than tax or government spending in explaining future changes in economic activity. This is not true of large macro models, which generally incorporate sizeable fiscal effects, but these effects are included as much by assumption as by empirical estimation.

Classical economists have no trouble in explaining this difficulty in finding fiscal effects, since they start from a belief that anything done by the Government to influence real economic activity will be offset by the actions of the private sector.

For example, tax increases are expected to be financed entirely out of private saving, with no decline in spending. This proposition - the so-called Ricardian Equivalence proposition - stems from a belief that consumers' spending depends not on current income, but on permanent income, which is the expected average income flow over a lifetime.

Add to this an assumption that consumers correctly know that governments must balance their budgets in the long run, so that neither tax cuts nor tax increases can last forever, and it is safe to conclude that the tax changes this year will have been fully anticipated by consumers, so that their spending behaviour will not be affected when the tax demands actually arrive.

Anyone who applies commonsense to economics will have trouble swallowing this Ricardian doctrine in its strict form. However, the tax increases which will soon take effect have been unusually well telegraphed in advance, and it would be surprising if consumers are taken entirely by surprise in April.

In fact, if there is any surprise, it could even be a pleasant one for many people. Labour's Gordon Brown has run such an effective publicity campaign about the Tory tax increases that the size of the actual increases due this year may have been exaggerated in many people's minds.

David Walton of Goldman Sachs estimates that consumers will be hit by pounds 4.8bn of extra tax in 1994/95, with the main items being the increase in employees' national insurance contributions ( pounds 1.8bn), the restriction of key income tax allowances to the 20p tax rate ( pounds 1.7bn), and the VAT on fuel ( pounds 1.0 bn). This works out at pounds 4.20 per week for each household. This is not a sum to be sneezed at, especially with more to come next year, but it pales by comparison with the increase in disposable income which many families have enjoyed since the mortgage rate started to decline three years ago.

The graph shows that real income for those in work has risen by about 6 per cent, or pounds 25.70 a week since early 1991. Add to this a drop in average mortgage payments of pounds 16.80 a week, and the disposable income of those in work has risen in real terms by pounds 65.20 a week. For these households, a tax increase of pounds 4.20 per week should not pose a major threat to living standards.

We should of course be aware of the caveats to these calculations. Not all households have mortgages, or have been fortunate enough to retain their jobs since 1991.

Many other households, which have always relied on pensions and other social security for their income, will not have enjoyed these large gains in living standards.

Yet for the bulk of the working population, a sizeable financial cushion will be left even after the Chancellor conducts his raid in April.

It is entirely conceivable that households will have fully adjusted their spending levels well before then.

The Gallup Survey of consumer confidence shows that the balance of respondents expecting their own financial situation to improve in the next 12 months has already declined to about minus 12 per cent, down from a peak of plus 3 per cent at the time of the 1992 general election.

People are now a good deal more pessimistic about their own financial situation than they are about general economic prospects, which is the exact reverse of the usual relativity on these questions.

In fact, consumers have barely ever been more pessimistic about their own financial prospects since 1979, which surely implies that they have already taken into account the full impact of this year's tax increases. This would explain why retail sales volume has weakened slightly in the past couple of months. For much of last year, the annual growth rate in sales volume was about 4 per cent, but this has now slipped to about 2.5 per cent.

Instead of generating a chorus of complaints from some thoughtless echelons of the press, it should be a great relief to everyone concerned with the medium-term welfare of the economy that this slowdown in consumption is taking place.

One of the bizarre and dangerous features of the 1980s was that consumers' expenditure grew about 1 per cent per annum more rapidly than GDP for the entire decade. This was made possible only by the flattering effects of North Sea oil prouction on the balance of payments, and any attempt to replicate the feat in the rest of the 1990s will very quickly end in disaster.

RECOVERY

Those who are bemoaning the return to reality in consumer behaviour since Christmas should bear this fact in mind. Far from seeking additional ways of stimulating consumption in the next couple of years, the Chancellor should be increasingly concerned that the British may be embarking on the early stages of one of their spending and borrowing binges. The housing market has in the past few months moved out of the recuperation phase into full recovery, and car sales (especially to individuals paying with their own money, as distinct from fleet purchasers) are strong.

As consumers adjust to the tax increases, it would not be surprising to find that retail spending remains generally too strong for the health of the economy, especially in view of the recent worrying (and predictable) deterioration in the trade figures.

Before the year is out, the Chancellor might well need to follow the US federal reserve and contemplate base rate increases on top of tax rises to keep things under control.

(Graph omitted)