Hamish McRae: Consumption set to improve after upcoming blip

If our economy is to keep growing, the next government will need to support consumptionto offset the decline that will take place in government spending

A final splurge before the austerity just around the corner in the new year? A sign that confidence is returning among consumers? A rational response to the fact that VAT is about to go up again? Or some mix of all of the above?

It would be silly to try to read too much into the apparent strength of the sales, but the past year has been so dispiriting that it is undoubtedly encouraging when there seems to be some further sign of a return to normality.

Those of us who spend our time trying to understand the twists and turns of the world economy have been suitably humbled by the collapse in economic activity that occurred during the course of the past 18 months.

Even those of us who were relatively pessimistic have been proved not pessimistic enough. To take the UK, while we obviously don't yet have final figures (and these strong sales will help a bit), the fall in GDP this year will be close to 4.5 per cent.

I cannot find a single economic forecast made before the start of the year that foresaw that the economy might contract by as much as even 4 per cent – not one. We got the scale of the recession in the rest of the developed world equally wrong. Indeed the only thing we did get pretty much right was that the emerging economies would come through in good shape: it seems the two largest, India and China, have been largely unscathed. It has, to put it mildly, been a most abnormal year.

You can react two ways to that. One is to say that if economists got this year so wrong, why should anyone take seriously what they might have to say about the coming one?

You have to have some sympathy with that. But the other is to wonder whether the more abnormal the circumstances one year, the greater is the possibility that there will be a swift return to some sort of normality during the next.

There are two broad views among the economic fraternity at the moment. The majority one is that there is still great uncertainty, that the policies that seem to have turned western economies around are not sustainable, and that accordingly the recovery will be slow and painful.

This outlook notes the fact that unemployment is likely to continue rising, that house prices in most developed countries remain historically high, that government debts will take a decade to bring under control, that banks will unable to finance a rapid recovery, and so on.

There is however a minority view that is somewhat more optimistic. It is that the savage nature of the recession has forced a lot of adjustment to take place very quickly, and that as a result the capacity of the main economies to resume decent growth is much enhanced. Companies have been swift and innovative in their response to the crisis, business confidence has recovered and is actually higher than it has been for several years, and while fiscal deficits do have to be tackled, low interest rates can remain in place for some time yet.

We don't know who will be proved right – we can't. What we can do, though, is observe what seems to be happening and see what clues there are that point towards the more or less positive outcomes.

Consumer confidence is extremely important. Consumption makes up about two-thirds of economic demand, so provided it is sustainable – we will come to that in a moment – it is the key thing that determines how rapidly an economy grows.

In the US, and to a lesser extent the UK and many other countries, recent increases in demand were not sustainable. We all know that people borrowed, either on credit cards or against the value of their homes, to maintain their lifestyles. And we know how that ended.

However look at what happened next. The first chart shows the UK savings ratio, which as you can see went negative at the end of 2007. Households, instead of their normal pattern of saving between 5 and 10 per cent of their income, actually spent more than their income. That was unprecedented.

Even at the top of the 1980s boom savings were still positive. But look how savings have bounced back. Savings are now back to 8.6 per cent of income, a level that is pretty healthy by past standards. Indeed the way a downward trend of more than 15 years has snapped back is pretty astounding. Suddenly Britons have re-learnt the virtue of thrift.

The flip side of this recovery has been weak consumption, as you can see from the other graph. If people are saving more, they are spending less. What seems to have happened is that a lot of the benefit of low interest has gone into cutting debts. Near-zero rates have not been as a effective as expected in boosting demand, which is one of the reasons why the Bank of England introduced its so-called "quantitative easing" programme.

But if this programme has enabled people to correct their personal financial positions, then it is getting people to a position where they should be able to resume spending.

That is just starting to happen. On a quarterly basis, consumption has just gone positive again. So the question is whether this has been principally the result of policies to boost demand, in particular the car scrapping scheme and the cut in VAT, or whether there has also been a spontaneous recovery in confidence. That is why these seasonal sales are interesting. Are they a last hurrah or the start of something, if not big, at least sustainable?

My own view is that consumers, that is to say all of us, are as a group pretty sensible. It is reasonable enough to borrow more if the value of your principal asset, your home, is rising in value and your income is secure. By contrast, it is madness to do so if house prices are falling and you might lose your job.

House prices have now steadied, even risen a bit, but clearly will remain a long way off their peak for some time to come. And while employment seems to be nudging up a little, that is mostly the result of the rise in part-time jobs exceeding the decline in full-time ones. Against this background people will be very cautious for some time yet.

These are not the circumstances for any new consumer boom. In addition we have political uncertainty for some months yet – the only absolute certainty being that after the election the new government will have to tackle the deficit. That, as we can see from the Irish experience, will not be pleasant.

But – and this is important – if our economy is to keep growing, the next government will need to support consumption to offset the decline that will take place in government spending.

Or, to put the point another way, one of the things that cuts in public spending will do is to increase the scope for private spending. Not a splurge, to be sure, but reasonable and responsible spending on things that we all need.

So I think that after a difficult few months, and after a shock in reaction to whatever budget will be imposed after the election, consumption can start to climb once more.