Savvy spending

Economics: You are what you earn. Material lifestyles are determined principally by real disposable incomes. Rising real incomes prompt increasing levels of consumer spending which, in turn, allow the enjoyment of higher material standards of living, writes Paul Tansey.

But one other factor usually exerts a significant influence on household spending: wealth. Additions to household wealth - both in the form of growing financial assets and rising house prices - have usually been found to induce additional consumer spending by households.

The recent international evidence indicates that this "wealth effect" on consumer spending may range between 0.01 and 0.11, with an average level of about 0.04.

This implies that for every €1 million addition to its wealth, perhaps caused by a sustained rise in house prices, a household would spend an extra €40,000 on current goods and services.

Property is the principal form of household wealth in the Republic. Central Bank statistics show that, in 2005, the gross assets of Irish households were €819 billion. Of this, household financial assets - cash, shares, pensions - were worth €273 billion while the property assets owned by households were then valued at €546 billion.

However, households have debts as well as assets. In 2005, Irish households were indebted to the tune of €145 billion - €100 billion of which represented mortgage debt. Subtracting debt from gross assets left Irish households with net assets of €674 billion in 2006, a tidy sum.

Moreover, the wealth of Irish households increased rapidly in the early years of this decade. Between 2001 and 2005, household net worth increased from €411 billion to €674 billion, an increase of 64 per cent*.

This sizeable addition to household net worth was mostly powered by rising house prices.

It might be expected that the massive windfall wealth gains conferred by rising house prices would have spurred consumer spending to a significant degree.

Not so, says a recent piece of research by Vincent Hogan and Pat O'Sullivan**. The recent consumer spending boom owes nothing at all to enhanced household wealth, they argue. Instead, the surge in consumer spending is wholly explained by increases in real personal disposable income. Thus they conclude that in the Republic, "the marginal propensity to consume out of housing wealth is essentially zero".

This is a remarkable finding in view of the wall of wealth that has enveloped Irish households over the past decade. It is also at odds with the behaviour of households in other developed countries.

So why have Irish households not flaunted their new-found wealth in a wave of conspicuous consumption? The authors reach two tentative conclusions, based on anecdotal rather than empirical evidence. First, they suggest that until recently in the Republic, it was difficult for homeowners to release the increasing equity they held in their homes in the form of cash.

Second, where home equity was released, they speculate, it was not spent on consumer goods and services; rather, it was invested - in more housing.

It may also be the case that households are economical with the truth when negotiating equity releases from financial institutions. Funds ostensibly freed for home improvements may finance foreign holidays.

Nonetheless, the implications of this research are important.

On the available evidence, the sustained rise in Irish house prices, while enhancing greatly the scale of household wealth, played no part in supporting the current consumer boom. Households have not, to any appreciable extent, attempted to cash in their housing chips to finance their current spending.

House prices are now falling. The recent Permanent tsb/ESRI house price index shows that in the first nine months of the year, house prices in the Republic fell by 3.6 per cent.

The decline was more marked in Dublin, where average prices were down by 5.1 per cent.

However, since the wealth effects generated by rising house prices contributed little or nothing to the strength of consumer spending in recent years, it follows that declining house prices should not materially affect consumer spending volumes.

The direct economic impact of the forecast downturn in construction will be substantial. Residential construction is projected by the Department of Finance to fall from its peak of 88,000 units in 2006 to an average level of 60,000 units in the three years 2008-2010. At best, this will cause gross fixed investment to mark time in 2008 before recovering moderately thereafter.

On the employment front, the latest Quarterly Labour Market Commentary from Fás is projecting a net national employment increase of just 21,000 in 2008, with the total dragged down by an anticipated loss of 17,000 jobs in construction.

However, while the direct economic effects of stalling fixed investment and falling construction employment are undoubtedly large, at least they are unlikely to be accentuated by an induced indirect contraction of consumer spending.

Indeed, given the pay rises in the pipeline for next year, the likely deceleration in inflation in the absence of a further series of interest rate increases and the unwillingness of consumers to be parted from their SSIA payouts this year, real consumer spending growth could easily outperform current expectations during 2008.

*The Net Worth of Irish Households by John Kelly, Mary Cussen and Gillian Phelan, Central Bank Quarterly Bulletin No 3, 2007.

**Consumption and House Prices in Ireland by V Hogan and P. O'Sullivan, ESRI Quarterly Economic Commentary, Autumn 2007