Insecurity About Future Income Breeds Cautious Consumers

Uncertainty about the future earnings of an average household in the 1990s is almost twice as high as it was in the late 1960s. And households that face greater uncertainty tend to save considerably more of their incomes, perhaps even doubling the proportion they save.

What's more, rising house prices seem to have little impact in encouraging consumer spending. These are some of the conclusions of David Miles of Imperial College, London and Merrill Lynch, in a major study of the determinants of household incomes and expenditure, published in the latest issue of the Economic Journal.

The policy implications of his work are important:

  • First, if rising house prices do not drive consumer expenditure, policy-makers need ;to be wary of trying to choke them off to avoid overheating in the wider economy.
  • Second, changes in social security rules and benefits – by altering the degree of uncertainty about future incomes – can have a powerful impact on consumption. If the insurance role played by the state through its payment of income support, unemployment and sickness benefits were to fall, the rate of private sector saving may increase significantly.

Miles notes that there is a great deal of speculation about the impact of uncertainty about future incomes on people's saving and spending patterns. There is also a widespread belief that such uncertainty has increased over the past decade. At the same time, it is widely thought that movements in house prices have had a significant impact upon consumption. But in all these areas, there is surprisingly little hard evidence.

Miles uses information on savings, incomes and other household characteristics (such as education, home ownership and number of children) from very large samples of households that have responded to surveys undertaken at regular intervals over the past 30 years.

He aims first to uncover some of the key factors that determine household income and then to measure income uncertainty. He assesses how anticipated and unanticipated movements in income affect spending and saving. And he analyses the role played by movements in housing wealth in households'' spending decisions.

The empirical results reveal that the variability in incomes around the levels that households might expect based on their qualifications, age, regional location, etc. has tended to rise over the past 30 years. Households'' earnings uncertainty was, on average, almost twice as high in 1990 as in the late 1960s. It also seems that households facing greater uncertainty tend to save more. The scale of the effects is substantial: a household facing little earnings uncertainty would, if subject to a shock that exposed it to average income risk, reduce its consumption by about 5%. This could represent a doubling of its saving rate.

While Miles'' research finds a powerful effect of income risk on saving, there is not much evidence of house price rises influencing consumption. This might appear surprising in view of the widely held belief that the consumer boom of the 1980s was largely a reaction to the capital gains experienced by most home-owners.

But house price rises only generate real gains for households that are willing to move to smaller and cheaper houses or to regions of the country where houses are much less valuable. Otherwise, price increases just raise the cost of buying your next house in line with the value you get on your house sale. It is not surprising in such circumstances that most households would not feel they could spend much of their housing capital gains. One implication of this is that the consumption boom of the late 1980s may have had much more to do with expectations of rising after-tax incomes in the future, and greater ease of borrowing on the back of that, than with house price rises. Indeed greater optimism about the economy and more credit were probably the cause of both the consumption boom and the rapid rises in house prices.

''A Household Level Study of the Determinants of Incomes and Consumption'' by David Miles is published in the January 1997 issue of the Economic Journal. Miles is Professor of Economics at Imperial College, University of London and an economic adviser to Merrill Lynch.