On average consumer spending in an economy makes up more than 50% of national income. (Deaton 2008) Therefore changes in consumption will affect much of the economy; from employment to economic growth and the business cycle. The consumption function is defined as; C=a+bYD, in which a is considered a constant known as 'autonomous spending', that is, a level of spending which is not affected by income, such as spending on food and general living costs, and b is the marginal propensity to consume; the proportion of disposable income that is spent on consumption. We define YD as: YD=(1-t)Y, t is the rate of tax and YD is disposable income.
If we consider the 27 states of the EU combined, Household final consumption expenditure since the year 2000 has fluctuated as shown here in Figure 1.
(Based on figures from Eurostat)
As you can see, consumer expenditure grew steadily in the period 2000-2007, peaking at over 6,500,000m Euros, before suffering sharp drop off in line with the financial crisis which occurred at the beginning of 2008. Consumer expenditure then began to pick up again at the end of the period graphed.
In order to analyse the changes in consumer expenditure, there are a number of contributing factors which must be considered. According to the consumption function, changes in consumer expenditure are brought about by changes in any one or combination of: autonomous spending, marginal propensity to consume, and disposable income. As mentioned earlier, we assume autonomous spending to be a constant and therefore, one must consider what factors would affect the latter two of these figures in order to find the reasons behind the trends in consumption.
Firstly, consider the effect of monetary policy, specifically the level of interest rates, on marginal propensity to consume. Figure 2 shows the interest rate, set by the European Central Bank, with inflation taken into account.
(Based on figures from Eurostat)
From 2002 to 2005, real interest rates were negative. That is to say, inflation exceeded nominal interest rates. This essentially created an environment where it was costly to save, and borrowing was prosperous as inflation devalued savings at a higher rate than interest would add to them. This causes the marginal propensity to consume to increase because there was incentive for consumers to borrow money.
(Based on figures from Eurostat)
Figure 3 shows how debt has risen consistently in relation to income for households since the start of the period in the Euro area. Barrell et al.(2011) infer that debt to income ratios of newer member states of the EU such as Slovenia and Romania have recently been beginning to converge with the higher levels of the older states.
However, although low real interest rates incentivise borrowing and thus spending, it could be argued that, because the rate of inflation is uncertain, consumer spending could be linked to a combination of nominal interest rates and the expected rate of inflation; for the majority of consumers this is likely to be simply the inflation rate of the previous period. Therefore real interest may not be completely aligned with consumption at any single point in time, but consumption may still follow the trend of interest rates with some time lag. For example if we compare Figures 1 and 2, we can see that the real interest rate increased roughly one year before consumption began to decrease, as the low rate of inflation and therefore higher real interest rate was not anticipated by the majority of consumers.
Another factor affecting the marginal propensity to consume is consumer confidence; Ludvigson (2004) suggests that a positive wealth effect will cause consumer spending to rise proportionately as wealth, based on income, increases. During the NICE (Non-Inflationary Consistent Expansion) period at the beginning of the century, while growth was consistent, consumer expenditure was increasing at a similarly consistent rate.
Consumer confidence is also the most obvious explanation for the fall in consumer spending that we see between 2008-09 in Figure 1. The financial crisis, caused by the collapse of the sub-prime mortgage market created large amounts of uncertainty throughout the Euro area and the world. The idea of precautionary saving (Carroll and Kimball 2006) proposes that individuals will save in the current period due to uncertainty of future periods. This is seen in Figure 4 below, as the percentage of household savings increases in 2009. This is because households attempt to stockpile wealth in case they may need it in the future.
(Based on figures from Eurostat)
Further factors affecting consumer expenditure are those which have impact on disposable income; firstly taxation. Clearly if taxation is increased disposable income will fall and vice versa. Income tax is the most prominent form of taxation in most of the member states of the EU. According to data from Eurostat, income tax fell in the EU27 countries from 44.7% to 37.6% (Europa 2011) in the first decade on the century; this is in line with the growth of consumer expenditure over the same timeframe. However, the tax rate continued to fall to 37.1% on 2011, yet consumer spending fell. This could be down to a number of factors, the first of which could be that these data are for income tax only, whereas other taxes may have risen, VAT for example in the UK. It is also argued that individuals will not adjust their consumption based on changes in taxes, because they expect the original tax rate to be restored in the long run, and that the current rate is only temporary, as consumers will tend to internalize the government's budget constraint.(Barro 1974) It should also be considered that income tax is regressive and therefore those with higher incomes will be affected more by a rise or fall in the rates, yet these higher earners are less likely to be affected by the changes in income tax, as their incomes are so high, the effects are felt less.
Unemployment should also be considered when examining changes in disposable income in the EU. Figure 5 shows the level of unemployment in the EU27 from 2000-2010.
Figure 5:
(Eurostat 2010)
Comparing Figures 1 and 5, it is clear that unemployment is at its lowest as consumer spending is at one of its highest points. This suggests a link between the two factors, which is theoretically backed up, in that as unemployment is higher, less people are earning and therefore the mean disposable income in the economy is lower. However, at the beginning of the period, unemployment is relatively high, yet consumer spending is continuing to grow. One explanation of this is that, the majority of the workforce who are unemployed are those lower skilled workers, and therefore the difference between their incomes in employment and out of it, which is the difference between wages and benefit payments, is fairly small. This means that unemployment will hardly affect the disposable income of these individuals.
The discussed points undoubtedly all impact on consumer spending and in terms of weighting it would seem that interest rates and economic performance have the biggest role to play in determining the level of spending in the economy. Both empirically and theoretically, the theory of wealth effect and idea of consumer confidence affect the value for the marginal propensity to consume. However, it can be argued that the increase in the consumption is also down to a change in culture and attitude towards debt and spending. Is debt increasing because real interest rates are low or because it is now seen as acceptable for individuals to borrow large percentages of their income, because banks and other lenders are doing their job well in convincing people that debt is a long term issue, not a short term one?
In terms of forecast, it would seem that, in the period to 2016, growth in consumption is likely to be positive, but at a modest level. In fact Barrell et al. (2009) predict average consumption growth of 1.8% until 2015. Looking forward, inflationary pressures brought about by quantitive easing will erode real interest rates and as such create more incentive to borrow and spend, therefore increasing spending. Reasons for the low prediction however include the uncertainty in the EU and in the Euro itself, especially with Greece unlikely to be able to keep its place among the other member states for much longer. High government debt levels are still an issue, in fact the Bank of International Settlements predicts that US government debt will hit over 400% by 2040 (Durden 2010), and the Euro area is unlikely to be far behind. These figures will definitely affect economic growth in the long run, and again this will impact on consumer confidence, yet this is longer term than the period we consider and the likelihood of economies being able to adapt to these levels by the time it would become an issue is high enough that there has been no short-term panic, yet.
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