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Greece is the word
30 June 2015
Greece is dominating headlines after the Syriza government's shock announcement that it intends
to hold a referendum on July 5 on the bail-out extension proposed by creditors last week. Initially,
the government insisted that the country’s banks would remain open. But in the wake of the ECB's
decision to cap the Emergency Liquidity Assistance (ELA) keeping the Greek banking system
afloat, as well as the continued deposit flight over the weekend, a week-long bank holiday has
been announced. The current programme is due to expire on June 30 and while there is time
for a last minute agreement, this is fast running out. Barring a U-turn Sunday's vote will be a defacto referendum on Greece's membership of the Eurozone, although how the creditor message is
relayed in Greece will be crucial. A yes vote would lend popular support to a compromise agreement
with creditors, most likely under a new government, although Tsiparas could try to cling to power.
A no vote means capital controls will inexorably give way to a parallel currency and probably a
formal exit. Either way, Greece's long-suffering citizens have more painful adjustment ahead. The
bank holiday will deepen the country's recession. Any new bail-out will bring further austerity with
it. EMU exit would result in an even larger shock, though it might make adjustment easier in the
long-run. Unsurprisingly, global risk assets sold off when markets opened on Monday, although
we take comfort from the fact that the early rout in European equities, peripheral bonds and the
currency was mostly reversed. That may be partly due to investors betting that the polls are right
and a yes vote is much more likely. However, it is probably also due to the credibility of the ECB's
backstop. If contagion were to worsen, the central bank has the tools, as well as the flexibility, within
its current QE programme and broader policy mandate to limit any market dislocations. Whatever
it takes is still in force.
If we are right that a Greek crisis is unlikely to derail the nascent Eurozone recovery, it makes
sense to look through the short-term market volatility and focus on the underlying trajectory of the
global economy. In that spirit, the rest of this week's WEB examines household wealth effects on
consumption and whether they have changed in the wake of the crisis.
Contributors
Authors:
Jeremy Lawson
James McCann
Govinda Finn
Alex Wolf
Editors:
Jeremy Lawson
Stephanie Kelly
Chart Editor:
Craig Hoyda
Contact:
Jeremy Lawson,
Chief Economist
jeremy_lawson@standardlife.com
Fading wealth effects
The lacklustre American recovery has challenged many of the economic community's pre-crisis assumptions about how the
economy works. Among the most important are that central banks can easily generate higher inflation if they want to, that fiscal
policy has only a minor role to play in managing the business cycle, that increasing income inequality does not have negative growth
implications and that the supply-side of the economy is in good shape. It looks increasingly like another will have to be added to
the list; that rising household wealth has a meaningful positive effect on personal consumption growth. The theory underpinning
wealth effects is straightforward. According to the permanent income hypothesis, household consumption decisions depend not
only on current income but also expected future income, of which financial and housing wealth is an important component. Thus,
when wealth rises, permanent income does too, allowing households to consume more today by saving less out of their current
income. Prior to 2010, the empirical evidence strongly supported the existence of wealth effects. Periods in which wealth
was rising (falling) coincided with periods in which the personal saving rate declined (increased). Although housing wealth
effects were found to be particularly large, financial wealth effects were also positive. Since 2010, however, these relationships
appear to have broken down. In the first quarter of 2010, personal saving as a proportion of household disposable income was
5% and the ratio of household net worth (wealth minus debt) to disposable income was 537%. By the first quarter of this year, net
worth had risen to 639%, only a little below its pre-crisis peak, yet the personal saving rate was modestly above its level five years
ago (see Chart 2). The upshot is that consumption growth has not been as strong over that period as models based on pre-crisis
empirical relationships have expected.
There are a number of potential explanations for why wealth effects have faded in recent years. One is that households are
maintaining a higher level of precautionary savings while they recover from the shock of the crisis. A complementary explanation is
that more households recognise that paper gains in wealth can be transitory and that it is prudent to wait until gains are fully realised
before spending the proceeds. Changes in the lending market are probably also playing a role. Before the crisis it was easy to obtain
lines of credit that enabled borrowers to draw down on the increased equity in their homes without having to sell. This type of credit
is now much more difficult to obtain (see Chart 3). Finally, changes in the distribution of wealth may be influencing consumption
behaviour. There is some evidence that QE may have had a larger impact on the wealth of households in the upper reaches
of the wealth distribution, while an increasing share of the recovery in house prices is being captured by investors that snapped
up foreclosed homes and other distressed sales. If these barriers to positive wealth effects persist, it will have important
macroeconomic consequences. Not only will consumption growth be tied more closely to current income growth, but business
investment spending is also likely to suffer as firms anticipate weaker demand. The only bright side is that a lower or non-existent
wealth effect should also help to elongate and dampen the business cycle because imbalances are less likely to build up in the
household sector.
Author: Jeremy Lawson
Weekly Economic Briefing
2
30 June 2015
www.standardlifeinvestments.com
Feeling flush
The good times were rolling for UK households in the decade before the crisis. With the economy growing steadily, we saw
sustained and pronounced rises in household net worth - defined here as total wealth (including financial assets, such as equities,
and nonfinancial assets, like property) less debt. Indeed, between 1998 and 2007 household total net worth grew from 658% of
gross disposable income to 772% (see Chart 4). The housing market boom was largely responsible for this rise. Residential property
assets increased by 12.2% year-on-year (y/y) on average over this period and by 2007, this asset class accounted for half of total
asset holdings. This was only partly counterbalanced by a rise in debt, with loans to the household sector increasing by 10% y/y
over the decade. Financial asset growth was stable over the period, although currency and deposits increased (118%) as a share
of disposable income, while equities decreased (70%). There is a large literature on the relationship between household wealth and
consumption. In the UK, a number of studies suggest that historically the long-run marginal propensity to consume out of wealth
is around 0.04-0.06. This suggests that consumption will increase between 4-6 pence for every £1 rise in wealth. Does this
tally with what we saw before the crisis? Consumption was certainly strong over this period, averaging 3.7% y/y annually. In part,
this was boosted by strong income growth, but wealth effects do look to have played a role. Indeed, the household saving rate
dropped steadily in the lead up to the crisis, from 11% in 1998 to 7.1% in 2007. This suggests that the sustained improvements in
net worth encouraged households to spend rather than save over this period.
Households have had a rockier time since the financial crisis. Net worth for the sector declined to 683% of gross disposable income
in 2008, driven predominately by falling property and equity prices. Thereafter, we have seen net worth rise as a proportion of
disposable income, albeit slowly, to reach 748% in 2013. Interestingly, the crisis and associated decline in wealth triggered a
larger and more lasting rise in savings behaviour than historical relationships might have predicted (see Chart 5). There are
a number of explanations why this might be the case. The size of the shock meant that precautionary saving has been particularly
high and only recently started to fade. This is likely to be partly related to the build-up in debt experienced during the housing
market boom. While net worth has been increasing, an uneven distribution of debt and assets has meant that more indebted
households have needed to make larger adjustments than the aggregate data might suggest. Moreover, there are other distributional
effects. Growth in financial assets, which tend to be held by wealthier households with a lower propensity to consume, has clearly
outpaced the more broadly held nonfinancial assets, like property. On a positive note, some of these effects may be starting to
fade. Consumption growth has accelerated, driven by a combination of rising income, as the labour market tightens, and a drop
in the savings rate back to pre-crisis lows. Net wealth has also started to grow more rapidly, with financial assets up 13% y/y in
2014. While we don't yet have official data on non-financial assets, we have seen house price indicators pointing to robust growth
in the sector. A combination of rising incomes, broader improvements in wealth and less precautionary saving should set
decent foundations for a sustained rise in UK consumption.
Author: James McCann
Weekly Economic Briefing
3
30 June 2015
www.standardlifeinvestments.com
Fighting contagion
The Greek crisis has reached a new crescendo. While the deterioration in the political situation has been rapid, we expect the
economic and market impacts (outside of Greece) to be contained. Greece accounts for just 1.8% of Eurozone aggregate GDP
and private sector financial linkages have been slashed. The initial market reaction to events over the weekend was painful, but not
catastrophic (see chart 6). In part this reflects the powerful backstop provided by the European Central Bank (ECB). The ECB has
a host of tools at its disposal to limit contagion. In the first instance this might come through a more aggressive implementation of
QE, with the central bank having been careful thus far to minimise market distortions from its buying. If more forceful options were
needed, the ECB could announce an increase in the scale or pattern of purchases. Alternatively the recent ruling by the European
Court of Justice on the OMT programme gave the ECB clear discretion over policy. This opens the door to other bond buying
operations aimed at fighting these types of financial risks.
Eurozone households must look back fondly at the pre-crisis days. The ratio of net wealth to disposable income increased steadily
from 550% in 1999 to 703% in 2007. This was driven by a rise in residential property assets which increased from 300% of income to
472% (hinting at problems to come). There is an active debate in academic circles over the existence of wealth effects on Eurozone
consumption. OECD analysis finds that these are significant, but less pronounced than in other developed economies. The ECB
meanwhile argues that wealth effects are present, but only for financial assets. A casual look at headline developments seems
to support the OECD's arguments. Household saving rates declined alongside a property fuelled rise in wealth before the crisis
(see chart 7). However, the decline in saving was far less pronounced than that seen in the US and UK over the same
period. Moreover, the relationship since the crisis has been loose, with wealth effects seemingly even less pronounced. This is
likely to reflect a large precautionary element to saving, given the bumpy ride in the domestic economy. Additionally, banking sector
blockages have probably dampened the relationship further through housing credit constraints.
As always there are interesting cross country comparisons in Europe. German household wealth has increased very slowly over
the last 15 years, although this has seemingly had little impact on saving behaviour. Italy meanwhile has seen its high levels of
household wealth (compared to income) fall since the crisis. However, this has yet to trigger a rise in saving with Italians seemingly
willing to draw down these resources to support consumption. Spain meanwhile has seen large swings in housing wealth although
both savings rates and house prices have stabilised recently. These differences are not surprising given the vast differences
in wealth and its composition between countries. Home ownership rates vary between 44% in Germany and 83% in Spain. The
split between financial assets is also pronounced, but overall ownership rates are generally low. For example only 10% of Eurozone
residents are invested in the stock market, compare to 55% of Americans. This makes it less surprising that wealth effects are
less important in this region.
Author: James McCann
Weekly Economic Briefing
4
30 June 2015
www.standardlifeinvestments.com
Leftfield policy
In recent quarters, the Bank of Japan has been unusually strident in its demands for corporates to increase employee wages,
with Governor Kuroda invoking the spectre of a 'visible hand' to facilitate such change. The rationale is straight forward; higher
incomes should boost domestic consumption, improve the output gap and drive prices higher. However, while the Bank's aims
may be noble, the approach is somewhat unconventional. In other countries, monetary policy efforts to boost consumption are also
viewed through the prism of a 'wealth effect', whereby lower real interest rates inflate asset prices and feed household wealth.
Unfortunately, in Japan this mechanism has proved remarkably ineffective in recent decades, forcing the Bank to take
a more hands on approach.
The weakness of Japan's wealth effect stems from two key factors. Firstly, households continue to have a relatively high proportion
of their wealth in low risk assets, with cash and bank deposits accounting for 53.1% of total household assets while stock
holdings account for just 9.4% (see Chart 8). Not surprisingly then, the causality between stock price movements and national
consumption is weak. Secondly, Japanese households access to credit has remained remarkably constrained, with little evidence
of the liberalisation of household credit markets witnessed elsewhere. With poor access to credit for first time buyers and only
limited access to home equity loans for homeowners, the ability of house price rises to feed through to higher consumption has
been severely constrained. If anything, empirical studies suggest that the house price mechanism has been working in reverse,
with periods of rising real land prices having a negative effect on consumption, as a pick-up in saving rates among younger
households and renters has outweighed higher spending from home owners.
The question is whether these factors continue to constrain the wealth effect as Japan's economy migrates away from its long
term deflationary equilibrium. In terms of household portfolio, the weight of equities to total assets has been rising (see Chart 9).
This should increase the impact of higher stock prices on households' wealth, but will it result in higher consumption? Work from
the OECD suggests that, over the longer term, the marginal propensity of Japanese households to consume financial wealth is
relatively similar to the US and Eurozone – so the potency of the financial wealth effect should be improving. However, in the short
term the relationship is less clear, with the stock price surge we have seen on the back of the Bank's QQE programme likely to
prove less potent if it is deemed to be temporary. The fact that household savings rates have ticked up during the recent stock
market rally suggests that households remain cautious about future wealth. To counter this, the government has thrown the
considerable weight of the nation's state-run pension funds behind the equity market, while also initiating a tax free investment
scheme. As for the housing effect, we can discount any meaningful impact of lower real interest rates on household wealth, as
land prices are still falling nationwide. However, we suspect that even if Japan's housing market was to finally turn around, credit
considerations would severely limit the efficacy of the housing wealth effect.
Author: Govinda Finn
Weekly Economic Briefing
5
30 June 2015
www.standardlifeinvestments.com
Combusting consumption
Aggregate consumption across the emerging world has been weakening since the global financial crisis, driven primarily by slowing
private consumption growth (see Chart 10). Regionally, consumption has been somewhat resilient in China, although it's
unclear how it will hold up as investment continues to slow and the stock market corrects. Consumption is weakening the
most in Russia and Brazil. In Russia, lower oil prices and sanctions led to currency weakness, which resulted in higher inflation and
collapsing real wages. In Brazil, pro-cyclical tightening of fiscal, monetary, and credit conditions are beginning to impact the labour
market and consumer spending. Risks of further weakness in consumer spending are evident as Brazil's adjustment process is
facing its most problematic phase as the Fed is about to begin tightening.
There are many reasons consumption growth has slowed across emerging markets, but primary among them has been a sharp
slowdown in investment across most countries. Consumption was supported by high rates of investment, which drove corporate
profits higher and labour markets tighter. Additionally, consumption growth was supported by policy measures, including fiscal and
quasi-fiscal support to labour markets. Now, as investment slows and policy support is constrained, consumption across
most countries is set to slow further. The investment slowdown has been stark; since the financial crisis investment growth has
collapsed from 11% down to 1% in EM ex-China (see Chart 11). The reasons behind the slowdown include weak external demand,
declining terms of trade, falling productivity and political uncertainty. Any revival in consumption will likely be led by a pick-up in
investment. However, other headwinds are emerging which will prevent an investment upturn. High real rates, Fed normalisation
and sluggish domestic demand in China are all preventing a return to higher investment growth and thus restraining consumption.
Wealth effects from increased equity prices were expected to support private consumption in many emerging markets, including
India, Turkey, and China. However, in China the consumption impact of elevated equity prices is unclear and may now be a moot
point as the market appears to be correcting. In fact, according to ECB researchers, consumption in emerging markets reacts
more strongly to negative shocks than positive wealth shocks, suggesting that the recent fall, if sustained, will have
a larger impact than the rapid rise. Research also suggests that the wealth effect of rising equity prices may be statistically
insignificant in China. The participation rate is still low, with households holding only around 5% of their total assets in the stock
market. A strong stock market may also 'crowd-out' the positive wealth effect. Anecdotal reports suggest rising equity prices
encourage residents to substitute away from consumption and towards investment. Additionally, the decade-long upswing in housing
prices did not result in any wealth effect on consumption; most research has shown the wealth effect from China's housing market
is non-positive. Of course, there are some EM bright spots; commodity importers have fared well over the past few months and
improving labour market conditions in Poland, Mexico and India are beginning to improve the consumption outlook.
Author: Alex Wolf
Weekly Economic Briefing
6
30 June 2015
www.standardlifeinvestments.com
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