Consumer behaviour and the GFC

Understandably, as we reflect on our escape from the global financial crisis, most media and policy attention has been concerned with the financial institutions themselves. It is informative, however, to consider how individuals – you, I, and 22 million other Australians – have interacted with the finance sector, and whether we have made the best adjustments to our behaviour. After all, we should remember that this crisis stems largely from imprudent borrowing by households. The banks needed the help of American households to bring on the GFC.

In the USA housing interest rates have been on a roller coaster ride since the turn of the century. In response to the "tech wreck" of 2000 official interest rates were lowered to absurdly low levels over the following three years. Households responded to the availability of cheap loans, and, as the cliché goes, the rest is history.

We may say it was irrational for people to have become so overcommitted, but such over-commitment is normal in housing markets. When we take a mortgage, the decision rule governing the amount we borrow is usually related to immediate affordability – such as a repayment commitment of no more than 25 percent of income. (Even these decision rules were bypassed by many of America's sub-prime spruikers.)

When interest rates are abnormally low such rules can lead to over-commitment. But even in more normal times we tend to become over-committed, because we are over-confident about our ability to repay a loan. Research in behavioural economics reveals what is known as the "Lake Woebegone" effect: almost all of us consider ourselves to be above average in our abilities as cooks, drivers, lovers and financial managers, and we ignore risks such as unemployment, illness, or a fall in house values.

In times past this bias was offset by inflation – in the days when five to ten percent inflation prevailed. We may have been over-committed in the first year or two of our mortgage, but over time our nominal income rose as a result of inflation, while the amount outstanding on our mortgage, denominated in pre-inflation dollars, fell in real terms. Modest inflation saved us from our own folly.

In a low inflation environment, however, that offsetting mechanism no longer operates – which is one reason why American authorities are so anxious to see some restoration of inflation; a period of deflation would make the matter so much worse, as has been the experience of Japan over the last twenty years.

Australia has been far more fortunate in that we have had a sustained shortage of housing, supported by immigration, and much more stable interest rates. (Our misfortune has been unaffordable housing.) Politicians like to raise the heat about interest rates, but, rhetoric aside, our Reserve Bank has kept our real housing interest rates – the interest rate after inflation – within a tight band around 4.5 percent ever since the Howard Government, early in its term of office, granted a large degree of independence to the Reserve Bank. Although this has been one of our nation's most significant economic reforms, the Liberal Party tends not to celebrate it, presumably because stressing the Bank's independence would distract from political claims about interest rates "always being higher under Labor".

Our households therefore have largely avoided becoming overcommitted in debt. In fact, one development which has taken policymakers by surprise has been an outbreak of financial conservatism among households. We have started saving again. A generation ago, in the early 1970s, saving was the norm; we were putting aside up to twenty percent of our income in savings. Over the following decades credit cards, car loans, and mortgage re-draw facilities became more widely available, and by early this century we were actually spending more than we were earning.

But saving is once more fashionable, and this seems to have been a response to the GFC. The official data is in the Reserve Bank's statistics, but anyone who has been to the shops in the Christmas-New Year period, seeing their extraordinary promotions, would be well aware that people are not spending freely.

In all, a retreat to financial conservatism is a wise move economically. In countries like the USA or in economically integrated regions such as Europe, consumer conservatism creates a dangerous feedback cycle of low demand on domestic industries. In our case, however, because we are so reliant on imports, that is not such a significant problem. In fact, it may help redress our fairly serious imbalance in our current account with the rest of the world.

Another benefit is that if we have become more financially conservative we are less likely to be sucked in by "too good to be true" offers, such as those which were promoted by the now bankrupt Storm Financial Services, and are less likely to have to pay for very expensive credit, such as credit card interest.

Yet, conservatism can have its own costs. While financial recklessness can lead to quick ruin, hyper-conservatism can lead to slow poverty. Behavioural research shows that we are much more concerned about potential losses than about missed opportunities for gain. (In economists' terms, we tend to discount or ignore opportunity costs.)