Saturday, July 30, 2011

Putting away dollars makes sense once again

Our top econocrats make a lot more speeches these days, but sometimes they say things that represent a clear advance in our understanding of what's happening with that mysterious animal we call the economy. Glenn Stevens, governor of the Reserve Bank, gave such a speech this week.

One device economists use to get a handle on economic developments is to distinguish between those that are ''cyclical'' and those that are ''structural''. Cyclical developments are a product of the economy's present position in its eternal movement through the business cycle of boom and bust. That is, they may be important now, but they won't last.

Structural developments, by contrast, come from deeper, underlying and long-running economic and social forces. They usually move more slowly, but they're more permanent.

The main message the econocrats have been trying to get to us is that the present resources boom isn't just another short-lived commodity boom but is bringing about a long-lasting change in the structure of our economy.

But this week Stevens identified a quite different structural change occurring at the same time as the mining construction boom. We're in the middle of a profound shift in the attitudes of Australian households towards how much of their income they spend on consumption and how much they save.

For many years households used to save a high proportion of their disposable incomes: 10, 12 even 15 per cent. Taking all households together, their mortgage and other debt stood at less than 50 per cent of annual household disposable income. Everyone's ambition was to pay off their mortgage as early as possible.

But, as Stevens points out, all that started to change in the mid-1990s. Over the 10 years to 2005, the trend rate of growth in real household disposable income (here, meaning income after tax and net interest payments) was 2 per cent a year per person. That's a very healthy rate of income growth - more than double the rate seen in the previous two decades.

Even so, household consumption spending grew over the same period at the even faster real, per-person rate of 2.8 per cent a year. How can our spending grow at a faster rate than our income? By us steadily cutting the rate of our saving.

We even got to the point where our consumption spending exceeded our income. How is that possible? By ''dissaving'' - running down past savings or by borrowing.

But from about 2005, before the global financial crisis in late 2008, all that began changing.

Over the five years to the end of 2010, real household disposable income per person grew at the even faster rate of 2.9 per cent. Why? Because of the flow through the economy of the very much higher export prices we've been getting.

But here's the thing: as our rate of income growth has accelerated, our rate of consumer spending has slowed down. In per-person terms, real consumption today is no higher than it was three years ago.

So what's changed? We've stopped saving less and started saving more. Why? Well, it's obviously not primarily because we're worried about higher interest rates, the risk of problems in Europe and America causing another global financial crisis or we're all afraid the world will end when the carbon tax starts next July.

Those worries are clearly part of the present, short-term, cyclical explanation for our caution as consumers, but they can't explain a structural trend that began about six years ago.

For that you have to look deeper. As we've seen, it's possible for your spending to grow faster than your income for a protracted period as you run down past savings and borrow. But you can't keep doing it forever. Eventually, your debts get so great that you (or your bankers) call a halt.

You realise having so much debt is dangerous, so you hold back your spending and increase your saving - often by paying off some of the debt. The ratio of household debt to annual disposable income shot up to about 150 per cent, but in the past few years it's levelled off.

The point to realise is that this new trend represents a return to normal behaviour after a protracted period of abnormal behaviour. We used to save 10 or 12 per cent of our incomes, and now we've got back to saving that much. We used to want to pay off our mortgage ASAP, and now we're back to wanting that to.

What happened in the middle was households making a protracted but essentially once-only adjustment to two major developments: financial deregulation, which made banks much keener to lend to households using newer, more flexible deals, and the return to low inflation and low nominal interest rates, which allowed people to borrow a lot more for the same monthly payments.

With hindsight it's clear we'd long wanted to spend more on better housing so, when the opportunity arose, we did. In the process of everyone wanting to move to a better house at pretty much the same time, however, we greatly bid up the price of houses and acquired a lot of debt.

But now we've adjusted to the new world of lower interest rates and higher levels of debt. We're not getting in any deeper, so have moved back to more normal levels of saving.

While we were watching the value of our homes going up and up we felt richer and so didn't feel we needed to save from our incomes. We stepped up our consumption. But now house prices have levelled off and so we've held back our consumption and returned to saving for the future the normal way.

Point is, the period of consumption spending growing faster than income has ended and is unlikely to return. At present, our efforts to increase our rate of saving mean consumption is growing a lot more slowly than our income is growing.

But as soon as we get our rate of saving back to where we want it to be, we can maintain that rate while consumer spending returns to growing at the same speed as income. With the saving rate already back to 11 per cent, you'd think we must be pretty close to reaching that point. If so, consumer spending could resume a reasonable rate of growth once our present short-term worries lift.

Message for retailers: the party times will never return, but the present tough times won't last.