The myth of the irrational consumer

We’ve seen house prices and shares plummet, unemployment rise and, according to the MPC (if not the data), the worst banking crisis since World War I. And how have consumers reacted?
By increasing spending. Today’s figures show that, despite the troubles of (quoted) retailers, retail sales volumes have risen 2% in the last 12 months.
How can consumers have been so resilient in the face of so much terrible news?
My chart shows part of the answer. It shows that before the crisis struck last year, consumers were, in effect,  behaving as if bad news were on the way. The ratios of retail sales to house prices and share prices reached low points in 2007. This meant that consumers, in aggregate, did not much increase spending in response to rising wealth. They behaved as if the rises in house prices and shares in 2003-07 were largely temporary. In effect, they were bracing themselves for bad times. The result has been that, as house and share prices fell, spending has held up, causing the ratios of sales to wealth to rise.
In other words, consumers - on average - are rational and forward-looking. They see trouble coming.  A now-classic paper expressed it thus:

Consumers tend to smooth out anticipated, transitory movements in tomorrow’s returns by factoring them into consumption today. When wealth is temporarily higher than its long-term trend with consumption and labour income, investors must be expecting returns on the market portfolio to fall and are holding consumption temporarily below its trend relationship with assets and income in anticipation of lower returns.

Although that paper used US data, Bank of England research has found a similar thing true for the UK.
This raises a devastating problem for managerialist ideology. It suggests that consumers - on average and in terms of behaviour rather than words - are much more rational than “experts” or government. Whilst the banking system has been driven to the brink of collapse, and government finances are in a mess, consumers have weathered the storm quite well in part because they - more than government or “experts” - saw it coming.
Now, I am not saying here that spending will continue to hold up.  Maybe rising unemployment will hit it. But the data suffices to disprove one theory that was popular a few months ago - that reckless consumers would cause a recession. The truth is that consumers have not been a cause of our troubles - though some (many?) will be victims of it.
Instead, the fact is that the crowd of ordinary people has been much more resilient than top-down organizations such as banks or government.
There’s a lesson here that won’t be learnt.

Comments

[JimH]

Not sure about your analysis here. Stats show that a large amount of equity was withdrawn from the rising house prices, and that presumably was not saved but spent. This is not possible anymore, so will spending not have to fall to compensate? My thinking is that an incraeasing amount of spending (much of it non-discretionary) is being piled onto credit/store cards, in the hope of being able to ride out the recession without massive changes in lifestyle. I suspect once unemployment begins to rise steeply (as it will into 2009) credit card companies will withdraw cards for new spending, or drastically reduce credit limits. Then we will see the true level of consumer demand in the economy.

Also I suspect that the CPI figure used is too low, thereby boosting the growth of consumption artificially. My feeling is that CPI understates inflation by a good 1-2%. Factor that into the sales figures and we are already seeing large falls.

[Bob B]

To balance the analysis here, this Google lecture says consumers are not rational in their purchasing decisions:
The paradox of choice, by Prof Barry Schwartz (a psychologist):
http://video.google.com/videoplay?docid=6127548813950043200

[Bob B]

"My feeling is that CPI understates inflation by a good 1-2%."

Compare these plots by the ONS of the inflation rates as measured by the (Harmonized) CPI and the RPI:
http://www.statistics.gov.uk/cci/nugget.asp?ID=19

The RPI index includes house prices while the CPI index doesn't and the RPI index is more broadly based.

In December 2003, GB as Chancellor, switched the BoE's official inflation target from 2.5%, as measured by the RPI minus mortage interest (RPIX), to 2%, as measured by the CPI effective from February 2004. Thereafter, as the plots show, the two measures of inflation diverged until very recently.
http://news.bbc.co.uk/1/hi/business/3188470.stm

By reports, the BoE advised against the switch.

[chris]

JimH - Bank of England figures show that between end-03 and end-07, households withdrew £179.4bn of housing equity. This is only 15% of the rise in households' housing wealth in this period.
In the last 12 months, credit card debt has risen by £5.8bn. This is only just over 2% of total retail sales during this time (though all the growth!). In the same time, households' bank deposits have risen by £62.8bn.
You point about CPI is irrelevant. If inflation is higher than reported, it means the falls in real wealth are larger than reported, as well as spending growth weaker. So the point that spending has help up despite falling real wealth remains unaffected.

[JimH]

I have to say I don't think consumers are acting rationally. Or rather a significant proportion of consumers are not acting rationally. This entirely from anecdotal personal experience, but I think a good number of people have become addicted to the lifestyles that they managed to achieve in the good times, and are attempting to maintain those spending patterns despite the changing circumstances. Hence the rise in credit card debt being the entire growth in spending.

I think it is neccessary also to remember that the nation is split fundamentally on the issue of debt. I believe around 30% of households have no mortgage debt (ie own outright). And presumably of the remainder significant numbers have nominal or very low mortgages as well. I suspect the numbers for unsecured debt are similarly weighted to the extreme. So we have probably half the nation either debt free, or very low levels of debt. And we have the other half who have either through purchasing more and more expensive property, or by spending more and more on a walletful of credit cards, racked up phenomenal amounts of debt. I would say the debt free section have acted rationally - spent within their means, paid down debt incurred when neccessary. The other half have just closed their eyes to the future, stuck their fingers in their ears and pretended that having shed loads of debt was fine and made no provisions to ever pay it back. Which is not rational.

[Anewman]

I am a small business owner of a company called www.GorgeousGarage.com I saw this housing mess coming just because in the history of our company i have never seen so many homes being built and sold so fast and prices climb so fast. At that same time spending on our products started to become steady but we did not see a huge climb. In the last 7 months we have grown like crazy, and until October we were having a record year. Now the news has gotten so scared that no one is buying. So I agree that people are not rational when it comes to spending. It just doesn't make sense.

[Glenn Carver]

Has anybody read Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely?

I understand its worthy.

[Glenn Carver]

Has anybody read Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely?

I understand its worthy.