Academic journal article National Institute Economic Review

Consumption in the Euro Area

Academic journal article National Institute Economic Review

Consumption in the Euro Area

Article excerpt

Consumption has been weak in the Euro Area, and in order to evaluate longer-term prospects it is useful to analyse why this might have been the case. If consumption and real personal disposable income are growing at about the same rate there would be little to explain. If consumption has been growing relatively more slowly than income in the recent past, then we might need to look for an explanation. This might depend upon consumer confidence about the management of the economy. It might also come from developments in personal sector financial wealth. A change in consumer behaviour could, in addition, be driven by pension reforms that have led to higher levels of saving, as in Italy. It could also result from deep structural factors, such as the impact on consumption of prospective labour market reforms as in Germany. Different housing market developments could also have been influencing differences in consumption growth.

A first glance at the data in figure 1 suggests that consumption growth in France has been as robust as the growth in incomes, while in Germany consumption growth has been even weaker than income. Consumption growth in the Netherlands and in Italy has exceeded income growth on average in the past three years. Consumption growth has been relatively robust in Spain even given the strong growth in incomes.

[FIGURE 1 OMITTED]

Income growth is not the only determinant of consumption, and it is important to evaluate both the role of other factors, such as housing markets and financial wealth, and the speed at which changes in these others factors have an impact. Simple Keynesian theories suggested that income and consumption should grow together, but developments in economic theory, such as the life cycle hypothesis, have led us to look for other factors explaining consumption. (1) In particular researchers have looked for a role for financial wealth and for total wealth, which includes the value of tangible assets such as housing. It is now generally agreed that consumption does in the long run depend upon income and (total) wealth, but that the speed of response to these factors depends on institutions. In liberalised financial markets consumers can smooth their spending when income fluctuates, and they can realise the value of changes in their housing equity relatively easily. Housing wealth is much more immediately obvious to consumers than is their financial wealth (at least in the countries we are considering) as financial wealth is largely held by life assurance and pension funds, and changes in its value do not impinge quickly on consumers. Hence we expect consumption to respond more quickly to changes in house prices than to changes in net financial wealth. (2)

Explaining consumption in Europe

Our examination of the determinants of aggregate consumption uses a 'workhorse' equilibrium-correction model (ECM). We include a change term in house prices to help pick up the impact of housing wealth on consumption, although this is not always significant. In the long run consumption is determined by income and real net financial wealth. We tested to see if total wealth might be a better argument for the long run in France and Germany, where data are good, and we found that we could use either the level of tangible wealth or the change in house prices in Germany with similar results. In France neither the level of housing wealth nor the change in house prices was significant. Dynamic terms are included in income and real net financial wealth, and they are reported where they are significant. Our specification is given in equation (1).

(1)

[DELTA] ln [C.sub.t] = [[alpha].sub.0] + [[alpha].sub.1] ln [C.sub.t-1] + [[beta].sub.1] ln RPD[I.sub.t-1]

+ (1 - [[beta].sub.1])lnRN[W.sub.t-1] + [[gamma].sub.i][DELTA]ln RN[W.sub.t-1]

+ [[gamma].sub.2][DELTA] ln RPD[I.sub.t] + [[gamma].sub.3][DELTA] ln RP[H.sub.t]

where C is total real consumption, RPDI is real personal disposable income, RNW is real net financial wealth, RPH is the real price of housing, and static homogeneity is imposed on the long-run income and wealth terms. …

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