By Professor Andy Mullineux
Lloyds Banking Group Centre for Responsible Business, Emeritus Professor of Financial Economics
Much of the analysis following the Autumn Statement (AS) on 17th November focused on the impact of the rising cost of living and the stealth tax effects of inflation on household discretionary incomes (i.e. income after tax).
With wage increases also failing to keep up with inflation, particularly in the public sector, real disposable incomes are falling (allowing for inflation) and will continue to do so for the foreseeable future. The more this leads to consumption expenditure being curbed, the worse the resulting recession – which can be expected, in turn, to lead to a rise in unemployment, adding to the growing number of people discouraged from seeking work due to ill-health and other, not-fully-understood reasons. This will put further pressure on household financial wellbeing.
The extent to which consumption is reigned in depends on the extent to which households can draw on accumulated savings or have access to credit. Many households, particularly the middle to higher income ones, were ‘forced’ to save when consumption opportunities were restricted during Covid-19 lockdowns. Some may choose to maintain consumption levels by drawing down their accumulated savings, the purchasing power of which continues to be eroded as inflation accelerates much faster than the interest paid on deposits is rising. The extent to which they do so depends on the extent of their savings balances, the length of the recession and how elevated energy and food prices remain – and for how long.
Broadly-speaking, the higher a household’s earnings, the smaller the proportion of non-discretionary (‘essential’) consumption expenditure. Households with lower incomes will thus suffer most, especially if members of their households lose jobs and despite the decision a raise in universal benefits and state pensions in line with September’s already lagging inflation rate. With little or no savings to fall back on, they may be forced to take on more and more expensive debt given rising interest rates – if indeed they have access to credit through regulated channels.
Middle income groups have been encouraged to save through ISAs (Individual Savings Accounts), the returns on which are exempt from tax. An increasing concern of the Financial Conduct Authority (FCA) has been the very high proportion choosing ‘Cash ISAs’, which are deposits with banks and building societies, over ‘Investment ISAs’, which are invested in financial assets and generally pay a higher return. The accumulated wealth in Cash ISAs has been slowly eroded for years as inflation exceeded the interest paid. But now their purchasing power are also being eroded rapidly as inflation soars above 10% and interest rate rises lag ever further behind.
However, recent political and economic turmoil has resulted in a widespread fall in the value of financial assets, and traded stock and shares in particular, both in the UK and overseas. Hence the value of Investment ISAs and other investments held by the more wealthy have also declined.
The post-AS analysis has tended to ignore these impacts on wealth, except speculation about the extent to which households dipping into their savings might ameliorate the recession. However, savings depletion and the negative impact of inflation on the real value of wealth are likely to extend the recessionary tendency. As well as precautionary saving for unforeseen events, such as repair or replacement of durable goods like washing machines and cars, households also save for retirement and to put down deposits on house purchases, among other things. The real value of defined contribution pensions has also been falling with stock market prices and due to inflation. The other major component of household wealth is ‘equity’ in housing, for those fortunate enough have got on to the property ladder. With mortgage rates rising this year, and probably not yet peaked, there is an expectation that house prices may also fall and housing wealth with it. In addition, rising mortgage rates are pushing ‘buy to let’ landlords to push up rents, adding to the cost of living crisis.
In this respect, the more wealthy will take a hit too and can only restore their wealth, particularly pensions, to target levels in the short to medium term by consuming less and saving more – thereby extending the recessionary impact into the future. Some of the ‘squeezed middle’, whose real earnings have now been stagnant or falling for over 5 years, are being tempted by their ‘pension freedoms’ to cash in more than their 25% tax-free allowance and hence depleting their future income and consumption options. The deferral in the AS of a decision to act on the recommendation of the Dilnot Report, to cap the amount of household wealth that must be used to fund social care, leaves households with members who are ageing and infirm facing continuing uncertainty about their future financial commitments.
Another factor accentuating the impact of the recession is the growth of national debt, pumped up by Covid-19 and energy price relief expenditures and tax shortfalls. The AS focussed initially on reducing the fiscal deficit (between government expenditure and tax revenue) to contain the accumulation of public debt, postponing the debt-reduction programme until after the next election, due by the end of January 2024. This effectively postponed fiscal consolidation (‘austerity’), relying primarily on the ‘fiscal drag’ effects of inflation to increase income tax and other revenue. This leaves the younger generations burdened with national debt approaching 100% of national income (GDP), which has become increasingly costly to service; though that cost should subside as inflation is brought under control and interest rates are reduced.
By extending the analysis to take into account the impact of the AS and the spike in inflation on real wealth, as well as real income, we get a much richer picture of the potential scenarios and their distributional and intergenerational impacts. The effects of real income decline and debt accumulation will hit lower income households most severely. While real wealth decline impacts richer households more, particularly those with more diversified assets and proportionately lower cash holdings. Those able to hold onto their investments in stocks and shares, property etc can expect their values to eventually rebound. But cash savers must save more to replace depleted real savings since positive real interest rates cannot be expected in the foreseeable future, or indeed wished for by those holding debt, especially mortgages.
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The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the University of Birmingham.