The finances of poorer and younger UK households are being hit harder by the Covid-19 recession. The policy response to provide immediate support for fragile household finances has been radical, but there are big questions about longer-term outcomes.
The Covid-19 crisis is causing a deep recession in the UK, and it is generating a sudden and sharp shock to household finances. This is hitting some households much more than others, with poorer and younger households being hit harder. The policy response in support of household finances has been radical, both in using extensive fiscal support to insure household incomes, and swift regulatory changes to amend the terms and conditions of financial contracts between lenders and households. It remains unclear what the long-run effects will be.
What does evidence from economic research tell us?
- Among the working age population, it is likely that those who are experiencing a reduction in income are also likely to be in increased financial distress, such as delinquency in payments, at the household level. Households at highest risk of reduced income due to the crisis are also those with the most fragile finances.
- The government furlough scheme provides extensive income insurance for salaried workers, but it is less likely to support consumer spending (at least in the short term) as households keep cash due to concerns about the risk of future job losses.
- Policy actions that have been taken so far to mitigate financial distress in the mortgage and consumer credit markets in the form of payment holidays crucially rely on the idea that recovery from the recession will happen reasonably quickly – that it will be more V-shaped than U- or L-shaped. If households face a persistent reduction in their income, this is unlikely to be effective, in which case debt ‘forgiveness’ (write-downs) or bankruptcy programmes may be necessary.
- In the longer term, reductions in asset prices, particularly housing, are likely to generate a debt overhang problem (‘negative equity’) for some households, increasing the prevalence of ‘mortgage prisoners’ who are unable to refinance mortgage deals at the end of teaser-rate periods.
How reliable is the evidence?
It is well established that the most financially fragile households (that is, those with least liquid savings and those most reliant on consumer credit) are typically lower income and experience higher income risk. Studies using representative survey data covering the US population and UK population show that, in normal times, approximately a quarter of households are unable to come up with approximately one month’s income in order to meet an unexpected financial need (Lusardi et al, 2011; Gathergood and Wylie, 2018).
While older households tend to hold significant financial savings and experience lower income risk (due to pension guarantees), younger and lower-skilled households hold less liquid wealth and tend to meet short-term financial needs through borrowing.
Consistent with this, emerging evidence using real-time data shows that in the initial weeks of lockdown, households at the bottom of the consumption and income distributions experienced the largest proportional declines in spending, suggesting that these households are being hit hardest by the crisis (Surico et al, 2020).
This is in part because the current recession has seen the retail, hospitality and international travel sectors hit the hardest. These sectors employ a large share of young, lower-skilled workers who are more financial fragile. Further emerging evidence suggests that increases in unemployment are larger among this group compared with others in the economy.
The furlough scheme has acted to provide partial insurance of the incomes of many salaried workers in the economy. Furloughed workers are likely to respond by hoarding liquidity, given the risk of future lay-offs when government support is withdrawn. This is suggested by the increase in the household saving rate during the 2008/09 global financial crisis (Alan et al, 2012).
Uncertainty and the shape of the recession
Recent research shows that heightened macroeconomic uncertainty depresses household spending because households react by building-up liquidity (Bayer et al, 2019). Households reduce their illiquid investments (such as housing renovations and pension contributions) and instead build up cash holdings.
Unsurprisingly, households facing uncertainty over the continuation of their employment when the furlough scheme is wound down are unlikely to judge that now is the time to make large investments, or increase spending. It is likely, therefore, that households will continue to build-up cash balances until the macroeconomic uncertainty, which focuses on the likelihood of future waves of infections and resulting lockdowns, passes.
A key issue for the effectiveness of government support in maintaining consumer spending, therefore, will be the shape of the recession. To understand these issues, a study of US data predicts the effects of the 2020 US CARES act on consumption (Carroll et al, 2020).
The authors estimate that if the lockdown is short-lived, the combination of expanded unemployment insurance benefits and stimulus payments in the United States should be sufficient to allow a swift recovery in consumer spending to its pre-crisis levels. If the lockdown lasts longer, an extension of enhanced unemployment benefits will likely be necessary if consumer spending is to recover.
But recent evidence also suggests that there are differences in household responses, with some over-optimistic households increasing their borrowing, raising the likelihood of future distress (Cocco et al, 2019). It is possible that the effects of the crisis on household saving behaviour may persist into the longer term. A body of evidence also suggests that experience of extreme macroeconomic experiences can affect long-term individual financial behaviour (Malmendier and Nagel, 2011).
Consumer protection actions, such as the introduction of mortgage and credit card payment holidays, introduce radical changes in the short-term obligations of households to creditors. The evidence for the effectiveness of such payment ‘holidays’ is less clear.
A recent study involved a field experiment with a US debt management plan provider, in which two treatments were tested: first, immediate minimum payment reductions meant to address short-run liquidity constraints; and second, delayed interest write-downs meant to address longer-run debt overhang (Dobbie and Song, 2020).
The authors find positive effects of interest write-downs on medium-term financial and labour market outcomes, with in contrast no positive effects of immediate minimum payment reductions. This result may arise because in their sample most individuals faced persistent payment problems (a problem of insolvency) and not short-term distress (a problem of liquidity).
This implies that, for the current crisis, the effectiveness of payment holidays is dependent on the persistence of income reductions arising from the weakened labour market. For households experiencing persistent declines in income, payment holidays will be ineffective in addressing the longer-term unsustainability of their debt commitments.
Payment holidays result in higher future payments or extended maturities. Households may be unable to service these in light of persistent reductions in income, for examples servicing extended mortgage maturity dates may be infeasible for households forced into involuntary retirement, as is more common in recessions (Disney et al, 2015). Persistent periods of unemployment lead to increases in bankruptcy filings (Keys, 2018).
When households face persistent income reductions, insolvency (bankruptcy) may be a better outcome. Also, the scarring effects of insolvency on future labour market outcomes appear to be small (Dobbie et al, 2016), and there is evidence to suggest that widespread waves of bankruptcies have a less severe effect on physical and mental health due to the reduced social stigma of being unable to pay debt when it becomes a common shared experience (Gathergood, 2010).
If the crisis turns into a persistent economic downturn, we are likely to see an increase in household debt overhangs in the mortgage market (commonly referred to as ‘negative equity’ in the UK), creating difficulties for households seeking to refinance their mortgages at the end of teaser-rate periods (so-called ‘mortgage prisoners’). Debt overhangs drag on households’ finances as they have to services mortgages at reset rates for longer than intended, or try to build up equity through additional savings to allow them to refinance (Dynan, 2012).
US evidence suggests that widespread mortgage modification programmes, such as the Home Affordable Modification Program (HAMP) can lead to a lower rate of repossessions, consumer debt delinquencies, house price declines and an increase in durable spending (Agarwal et al, 2017).
In the longer term, the challenges presented to household finances by the crisis may be fiscal, as the government addresses the enormous increase in the government deficit and large increase in government debt.
What further research is going on?
John Gathergood and Neil Stewart are starting a UKRI Rapid Response grant-funded project ‘Real-time evaluation of the effects of Covid-19 and policy responses on consumer and small business finances’ in conjunction with the UK Financial Conduct Authority and retail banks.
Paolo Surico and co-authors have developed a real-time indicator of consumer spending, income and household finance in the UK based on anonymised transasaction-level data from a large fintech company, focusing on the impact of the Covid-19 crisis on consumption and income inequality.
What more can I read?
Consumption in the time of Covid-19: evidence from UK transaction data: Paolo Surico discusses how can we quickly and accurately measure the macroeconomic shock brought about by COVID-19.
Covid-19: Paolo Surico’s website of popular writing on the crisis.
Real-time consumer spending responses to the Covid-19 crisis and government lockdown: Dimitris Chronopoulos and colleagues analyse a large anonymised transaction-level dataset covering Great Britain to examine real-time consumer spending responses to the COVID-19 pandemic and related public policy measures.
The economy after COVID-19: John Gathergood explains how the crisis will alter the complexion of the UK’s public finances for decades to come.
Incomes before, during and after the pandemic: This episode of the Institute for Fiscal Studies' podcast looks at how household incomes were looking before the crisis, how they've been impacted during the lockdown and what they could look like in future.
Who are UK experts on this question?
- John Gathergood, Professor at University of Nottingham
- Paulo Surico, Professor at London Business School
- Sule Alan, Professor at European University Institute
- Thomas Crossley, Professor at European University Institute
- Joao Cocco, Professor at London Business School
- Hamish Low, Professor at University of Oxford
- Tarun Ramadorai, Professor at Imperial College London
- Robert Joyce, Institute for Fiscal Studies