Issues and Prospects for the UK Economy in 2010

Here are some notes from a presentation on some current issues affecting the UK economy - suitable I hope for AS and A2 macroeconomics courses and students preparing for their June 2010 papers.

We will make the full presentation available late and this blog post links to many of our other recent blogs on UK and global macroeconomic issues.

The collapse of Lehman Bros was a game changing moment for the world financial system - perhaps the pivotal moment in finance in over 60 years. The run on the bank at Northern Rock and the subsequent bail outs of others such as RBS and Bradford and Bingley was part of a steep descent into recession in the aftermath of the credit crunch. The NICE decade (Non-inflationary continuous expansion) came to an abrupt end!

There has been a slump in the UK economy of more than 6% of GDP from peak to trough. Economic growth is back (just!) but the sustainability and resilience of the recovery is in major doubt.

At the trough of the economic cycle, UK GDP is well below potential leading to a large negative output gap but keep in mind that potential GDP (sustainable output in the long term) is an estimate. There is much uncertainty about the impact of the downturn on the UK’s productive capacity.

A steep rise in cyclical unemployment was unavoidable and businesses shed workers rapidly once the cycle had turned. But overall, the rate of unemloyment in the UK remains below the peaks experienced in the previous two recessions and below the three million level that was expected by many when the recession began in full. Why has unemployment not risen as high as many forecast?

1/ Flexibility (1): Hours have been cut
2/ Flexibility (2): Many have taken pay cuts or accepted pay freezes (leading to a reduction in real wages)
3/ Don’t forget the stimulus policies! We have seen perhaps the biggest macroeconomic stimulus in our post war history.

Despite the better news on total unemployment, long-term UK unemployment is rising and will be a major drag on the economy in the years ahead unless active supply-side policies in the labour market prove to be effective.

Young people nearly always suffer worst during downturns - they are at greater risk because of their relative inexperience and susceptibility to being made redundant when jobs are being shed. One young worker in five in the UK are out of work. Long-term unemployment among younger workers is rising quickly and the NEET problem is a key policy issue (Not in Employment, Education or Training)

There are now less than 3 million people working in manufacturing after the worst industrial slump for decades

Other countries have seen similar effects - notably the export-heavy and capital-goods dependent German economy who have felt the brunt of the downturn. But there are signs of a stronger rebound in manufacturing production not least because of strong import demand from fast- growing emerging market countries.

Stimulating times

We have seen an unprecedented macro policy response to the crisis and there has been a greater sense of coordination between the major economies. There are so many moving parts at the moment that no one country can fix the problems - this demands a coordinated response and we have seen it not least in cuts in policy interest rates by most of the major central banks.

UK policy rates were cut below 1 per cent to avoid a depression - this was a remarkable change in domestic monetary policy and these are historic lows for nominal interest rates - the main aim of lower rates has been to avoid a depression and reduce the risk of a period of sustained price deflation. The 2% inflation target seems to have been conveniently ignored in the last sixteen months - there is too much uncertainty in the economy to be wedded to rigid adherence to a narrow inflation target. There is an ongoing debate about whether the inflation target might be changed once the economy has emerged from the recession.

But many people and businesses are paying more for their loans and overdrafts - the average interest rate on overdrafts is nearly forty times the base rate of interest.

While cheaper mortgages have provided a boost to the effective disposable incomes of home-owners, many people with a mortgage have chosen to pay back some of their debt.

The household savings ratio has risen (from low levels) even though the returns have collapsed - indeed the real rate of interest is negative for millions of savers, many of whom are heavily dependent on savings income to maintain their standard of living.

(Quantitative) Easing the Pain

The Bank of England introduced quantitative easing in March 2009. The vast majority of the debt purchases have been government gilts rather than corporate bonds.

LIBOR is now back to ‘normal’ indicating a return to confidence among the major lenders but lending to businesses and consumers appears to have stalled – are banks hoarding cash and continuing to rebuild their balance sheets before starting to lend out again? The supply of credit remains constrained and this may hamper the recovery. Many new businesses are finding it tough to get finance and exporters may struggle to get trade finance.

The lower value of sterling has undoubtedly boosted competitiveness for UK businesses. Sterling has flirted with parity v the Euro and the pound is weaker against the US dollar. The depreciation has offered an additional stimulus to demand, output and corporate profits at an important time.

But UK exports were hit by global trade slump in 2009 and, this far, the lower £ has had only a small impact on the trade deficit. The recession more than the weaker pound has been the key reason behind the improvement in the balance of trade. A key question for 2010 is whether the UK export sector can successfully take advantage of having a competitive exchange rate now that the global economy is forecast to grow strongly (close to 4%) in 2010.

Several supply-side indicators are causes for concern. Very Weak business capital investment spending threatens a sustainable upturn and labour productivity has dipped in the slump reversing some of the gains in relative productivity achieved in recent years. The result of lower investment, slower productivity, debt-constrained spending and higher unemployment is that UK trend growth will be weaker. Some economists call this the “new normal”.

And slower economic growth will reduce the chances of getting unemployment down and bringing the government’s budget deficit under control.

A fiscal crisis?

We have seen a deliberate Keynesian stimulus - with government spending as a share of GDP rising to new heights and tax revenues falling. The national debt has climbed to the highest level in peacetime.

Incentives such as the car scrappage scheme have boosted demand in vehicle manufacturing - the scheme has ended for the time being. But we are coming out of the recession with a huge structural fiscal deficit of approximately 10% of GDP. Our budget deficit in 2009-10 was over £162bn and is on a par with the crisi-hit Greek economy.

The government has a plan to halve the structural deficit within four years but a 12% budget deficit carries enormous economic risks. None of the political parties are being transparent in accepting the scale of reductions in public spending that will be needed to cut the deficit. There are important issues of timing in terms of when to take away some of the fiscal stimulus, but fiscal policy in the near term may be influenced by the reactions of the financial markets (especially the bond and currency markets) to the policy decisions of a new government.

Risks and uncertainties

We are at a turning point in the economic cycle but there are big risks and uncertainties ahead and this makes macroeconomics especially interesting at the moment. We live in a multi-polar world where most new (marginal) demand is from the fast-growing emerging economies. The global power of the BRIC countries is rising even though the USA remains an important trade partner for the UK and Europe accounts for over 55% of our trade.

Big Risks in 2010 – External Headwinds

Further external shocks
Stalled recoveries in major trading partners
Contagion effects from the debt crisis in some Euro Zone countries
Financial instability in the booming Chinese economy - the bubble may burst
Fresh surge in commodity prices e.g. Oil, gas, metals, foodstuffs that will drive up inflation
Sudden depreciation of the US dollar (drives sterling up)

Fragility of the UK economy
*The return of inflation and higher interest rates?
*Eye watering fiscal deficit will require a squeeze on G&T
*Worries that UK government will lose AAA credit rating
*Worries of capital flight / sterling weakness
*Counter-risk – rising £ might choke export recovery
*Huge level of household debt left to be repaid

But there are some optimistic signs and reasons to be cheerful

Prospect of an UK export surge in 2010 and 2011
Manufacturing industry may rebound quite well
Many businesses have done well in the recession (e.g. cinemas, pizza companies, discount stores)
Company profits are high
Can the business sector drive the recovery?
There are big opportunities for green-industries – a recovery built on investment in the environment
Signs of an improving balance of payments

Geoff Riley