Introduction: What will be covered in this report?
Accusations have been put forward that the UK government, led by controversial figure Gordon Brown did not act quickly enough to fluctuations in economic growth, supply and demand, unemployment figures and consumption levels. Warning signs from across the Atlantic Ocean started as early as 2007, however could the government have planned action early to avoid inevitable recession? Was it possible for the Labour government and the Bank of England to modify macroeconomic policy to aid consumers when the credit crunch arrived in late 2007? In this report I will break down the recent events of the UK economy, and look in depth as to how the government should have acted, as well as applying my own knowledge of possible economical and financial policies.
The Credit Crunch and its Origin
The credit crunch first made the news headlines in the US when financial trouble spouted from a lack of confidence in lending from major banks to one another. A sharp rise in US interest rates of over 4% in the years 2004-2006 meant homeowners with subprime mortgages defaulted their payments. Banks had become lenient with customers they were lending to; some of the blame has been placed on bankers who saw commission based payment as an incentive to sell mortgages to any customer, with little thought of the risk involved with repayments. Many of these defaulted mortgages had subsequently been passed on to other banks and private investors and suddenly the US financial market was in trouble. As smaller, subprime focused banks started to realise bankruptcy was inevitable - jobs were lost and the market as a whole lost confidence. To realise the extent of the problem America faced, we only need to look at the facts; 100 banks have folded in the US in the last financial year. This means unemployment was set to rise, triggering a knock on effect in the economy, through a fall in consumer spending. Looking at simple economics, this would lead to a fall in supply as the demand for luxury goods collapsed. Businesses with profit as their main incentive would make thousands redundant in a desperate attempt to lower their costs. The snowball effect would bring GDP and economic growth down in the service sector. The US recession followed, disposable income falling to an all time low for consumers. The circular flow of income slowed, confidence in the finance market was lost and loans from the remaining operating banks were now offered with a high rate of interest, to cover the risk factor. Consumers thus saved their earnings - avoiding lavish spending on luxury goods.
UK policy to postpone or even avoid the recession
Although UK banks were not offering mortgages as easily as their US counterparts were, the Bank of England was still worried of the knock on effects to the UK's economy. To put the US and UK relationship in perspective we need only look towards statistics based on the balance of payments and trade; £33bn was exported to the US in 2006, compared to £27.5bn imported. The UK and US economies work in unison, and any change in either could majorly affect the other. The Bank of England subsequently drops the base rate in Britain from 5.25% to 5%, attempting to stimulate spending and growth in the economy. The UK economy in fact, from quarter 3 of 2008 through to quarter 3 of 2009, saw a shrinking economy, of almost 7%.
Problems with Monetary Policy as a method of stimulating economic growth
Lag time is unavoidable when implementing monetary policy in the economy - by changing the base rate level - it will take time to filter through to consumers and have any effect. Cutting interest rates by one quarter of a percent may hypothetically influence consumers to spend more; however in practice it can take weeks to see a noticeable difference in consumption and savings made. Many other factors must also be accounted for, for example confidence in the UK housing market will affect a first time buyer's decision on whether to rent or purchase a property. Will their bank agree to offer a mortgage, no matter the amount of risk involved? High loan-to-value mortgages (these are mortgages where the bank is willing to put forward more of the total mortgage against the property) have drastically fallen in recent months. Property investors are required to seek lower loan-to-value mortgages, which are more common in the current economic climate. This change in affairs is due to banks assessing risk much more thoroughly, to avoid facing defaulting mortgage payments as the US saw in 2007. Offering low loan-to-value mortgages will give bankers clarification of collateral, which reduces the risk, but also their business.
We must look at monetary policy from a Keynesian perspective as the government and bank of England have control over base rates, in order to guide the economy, rather than leaving it to find an equilibrium value (a classical economics approach). Lowering the base rate should hypothetically stimulate consumer and banks spending, borrowing and so forth. Due to the lack of confidence occurring in the recent market, banks are unwilling to lend their capital, as they are taking into account the risk of getting any back. Even with a minimal base rate offered by the Bank of England; banks will now be more cautious of their own interest rate they offer to customers. At present there is seen to be a very high risk, thus banks will want a high return on investment when lending.
Monetary policy made little difference to the UK economy. Calculating the correct change in base rates would be near impossible, and economists have little clue as to whether these rates would kick-start UK consumption, without affecting other major economic targets. An example of this being inflationary pressures - the governments target just 2% inflation year on year. Adapting monetary policy to the economic climate can be a useful stimulus for consumption; however in this case, confidence in the market was not enough for banks to trust consumers and their rival banks when it came to lending. Therefore, economic growth slowed, as did inflation. I would describe the current economic climate as a stagnating, showing little growth or inflation (Nelson, E and Khalin, N. 2004; Pg 294-295).
A Last resort: Quantitative Easing
The Bank of England has subsequently resorted to quantitative easing as a method to restore steady economic growth. Quantitative easing, to put it simply, is the government printing more money into the circular flow of income, in order to stimulate growth. The Bank of England has attempted to ease pressure on UK banks by buying bad assets, purchasing government bonds and even lending money to banks and building societies which require funds to continue in business. In light of this £175bn was injected into the UK economy.
The problem with this method is the inevitable risk involved. Buying banks bad assets or simply injecting money into the economy could lead to high inflation in the short term. Quantitative easing is seen as a last resort for the Bank of England. It is used when monetary measures such as cutting interest rates has little effect, or when base rates are already close to 0% (which is not uncommon in many countries to date, for example the European Central Bank reduced its base rate to 2.5% in 2008, this is the largest fall in 10 years) (Dennis, N and Johnson, M; 2008, Sterling recovers after UK rate cut).
The UK economy, at current, faces an account deficit. One of the essential targets for the chancellor is to force a surplus - by exporting more than we import in the financial year. With supply in the UK falling, proven by unemployment levels increasing and economic growth slowing rapidly, the exports in the UK have fallen. In the short run, the account deficit is likely to force the Labour government to increase tax revenues in order to fund this relative deficit. Tax rises are not desirable for the UK population, especially where disposable income and consumer confidence is at an all time low. From a political perspective, the Labour Government face a general election by mid next year - a tax increase would be problematic in the run up to the electoral campaign. Also, if inflation were to rise in the short run - this may be due to government expenditure, which we know through quantitative easing figures has happened in recent months, or costs of production for firms could rise - with profit maximising aspirations, firms with high market share can afford to rise prices in order to increase revenues to combat their rising overhead costs. An example of this could be oil prices rising due to shortening supply in the East. This can lead to the CPI rising substantially, as oil is such a valuable commodity to so many organisations in Britain today. Furthermore, strike action proposed by unionised organisations demanding relative price increases, forces firms to review their pricing strategy - increasing their product price - leading to cost push inflation.
An Alternative method to pulling the economy out of recession
Firstly, we can identify major current problems which hold back the economy from steady growth in the near future. The value of the pound sterling has declined somewhat in recent years, and if this trend continues Britain could soon see the value of one pound equalling that of the euro. The fall in demand for the pound is affecting the UK market in terms of global trade and the pound must be supported.
UK unemployment is at an all time high. This has led to a rise in welfare bills for government, and a fall in net tax profit. This is an unsustainable situation for the UK government, as the debt level is so high already. Taxes must rise to create revenue in order to level out the budget deficit, yet this could also lead to a fall in government spending in critical areas, for example schools and the NHS.
How to stimulate growth and recover from the recession
I believe the government and bank of England would benefit the UK economy by modifying fiscal policy rather than monetary. There is too little confidence in the UK market to use base rate decreases as a method of stimulating spending, where banks are seeking such low risk investments. Fiscal policy is the use of tax and government spending to stimulate economic growth. Essentially the government need foreign investors to have an interest in setting up business in the UK - this would aid the balance of payments through exportation of goods, however the UK infrastructure would need to be outstanding for any major global firm to invest. The main rate of Corporation tax in Britain is, and has been up to, around 30% in recent years. Compare this rate to countries within the EU; Switzerland on average at 19% and Ireland at 12.5%, we can see this figure is much higher than rival nations. Investors view this figure as a barrier to entry, when seeking low cost employment and business rates - deferring these large firms from investing. The UK already has an issue with unionised employment, the minimum wage and supply side policies for example mean generally high costing labour, deterring global investors seeking cheap running costs (Eaglesham, J. 2009. Osborne proposes corporation tax cut).
The reality is that any economic theory designed to pull the UK economy out of a recession has problems, and any government action has repercussions and downsides. People need more disposable income to fund their spending of luxury goods; they also need confidence in their currency in the long term. The Government should focus their attention to the supply side, rather than attempting to force consumers to spend. This means diverting injections towards small firms and exporters. Subsidising industry may be a practical method of encouraging higher wage levels and better services in the economy. Encouraging new firms to set up in Britain where industry has declined over the years can lead to better employment statistics and Labour government can begin to level out the balance of payments.
There are very few journals available which offer ideas as to why the credit crunch happened and the economic situation, due to the contemporary nature of the topic. Through choosing and analysing this question I feel I have used some good, helpful sources online to aid my research, I also used journals and books from recent years to look back at the recession in the early 1990's, for example, which helped when looking at causes and factors affecting the recession. I have attempted to give my own ideas towards the topic in question, how I think government should have reacted etc, although I realise it is difficult for any one solution to be implemented, especially when looking at an overview of the UK's current economic situation.
- Nelson, E. Khalin, N. 2004. Monetary Policy and Stagflation in the UK. Journal of Money, Credit and Banking, Vol. 36, No. 3, Part 1, Pg 293-318.
- Alesina, A. Ardagna, S. Perotti, R. Schiantarelli, F; 2002. Fiscal policy, Profits and Investment. The American Economic Review, Vol. 92, No. 3, Pg 571-589.
- Mizen, P; 2008. The Credit Crunch of 2007-2008: A discussion of the background, market reactions and policy responses. Federal Reserve of St. Louis Review. Pg 531-568, http://w4.stern.nyu.edu/salomon/docs/crisis/FRBStLouisMizen.pdf (09/11/09).
- Bernanke, B, S. Lown, C,S. Friedman, B, M. 1991. The Credit Crunch. Brookings Papers on Economic Activity, Vol . 1991, No. 2, Pg 205-247 http://www.jstor.org/stable/2534592 (10/11/09).
- Turner, G; 2008. The Credit Crunch: Housing Bubble, Globalisation and the Worldwide Economic Crisis. Pluto Press, 2008.
- Drury, C; 2007. Part 5 Cost Management and Strategic Management Accounting. In Management and Cost Accounting 7th Edition, Pg 534-568.
- Dennis, N. Johnson, M; 2008. Sterling recovers after UK rate cut, Financial Times. http://www.ft.com/cms/s/0/b0c61624-c1e9-11dd-a350-000077b07658.html. (11/11/09)
- Eaglesham, J. 2009. Osborne proposes corporation tax cut, Financial Times. http://www.ft.com/cms/s/0/a4142636-0a60-11de-95ed-0000779fd2ac.html (17/11/09)