A look back at the past decade – The Economics of the Naughties

- A decade which brought us everything from NINJA mortgages to Quantitative easing and a new meaning of the phrase ‘economic stability’

The UK economy has suffered the most because of its reliance on the financial markets and an asset (housing) boom. The government and monetary authorities must be pretty dissapointed at the sluggish response of the economy. They have done as much as they can with fiscal and conventional monetary policy. Even the scope of quantitative easing is one of the most radical amongst Western nations. (though some commentators say by just buying gilts and not corporate bonds, the impact of UK QE has been diminished.)

Whilst other countries are considering raising interest rates, that looks a long way off for the UK. Any tightening of the economy will need to come from tax rises to deal with the burgeoning debt. (see: prospects for UK Interest rates)

Furthermore, despite a 20% depreciation in sterling, the UK retains a persistent trade deficit suggesting an underlying imbalance in the economy. Since the credit crunch there are less capital flows to finance a current account deficit. Therefore there we may need to have to be a further depreciation to boost exports relative to imports.

Another factor in the equation is the scale of government debt and the purchase of government gilts. This has potential to worry markets and raise future inflationary pressures.

Given these factors the prospects for Pound Sterling looks pretty grim. Low interest rates and quantitative easing will weaken sterling and the government’s fiscal position will not help. The trade deficit just adds to the gloom behind sterling.

The saving grace for Sterling may be the relative weakness of our competitors. The Euro is starting to look prohibitively expensive, at least for south European economies like Spain and Ireland. Though the Eurozone is emerging from recession, it still looks pretty weak. The ECB takes a fundamentalist approach to keeping inflation low, but, even the ECB will be hard pressed to justify rate increases with the Euro economy so weak.

The good news for sterling is that the worst may (hopefully) be over. Forward looking surveys on confidence show improvements. The recent rise in manufacturing output and car sales give hope a real recovery could materialise next year.

It is hard to make predictions because the current situation is exceptional with no real precedent. Alot will depend on the nature of recovery. If the UK’s growth continues to be weaker than our competitors sterling will continue its downward slide. But, if the UK grows quicker than expected and confidence is restored in the UK people may switch back to Pounds. But, overall, I think the most likely scenario is that the Pound will remain weak. Alot of us could be spending our summer holidays in old Blighty rather than paying to goto Euroland.

Led by the German economy, the Eurozone experienced a sharp contraction in the first quarter of this year. Eurozone GDP fell by 2.5% and the most optimistic forecasts show a decline of 4% of GDP.

It will come as no comfort to the Germany economy that they avoided a housing boom and bust and avoiding a similar credit bubble. It has shown the global recession has affected all countries – whether or not they were involved in the credit boom and bust.

So far the ECB have been the most cautious out of the Central Banks, ECB interest rates have fallen slower than in the UK and US. There is the possibility of ECB cutting rates even lower close to 0% interest rates. This would definitely weaken the value of the Euro.

Also, some analysts feel that the Pound’s weakness has been overdone and on purchasing power parity, the pound looks undervalued by 10 or 15%.

The UK still has many significant economic problems which could keep the pound undervalued

• Very high government borrowing (12% of GDP in 2009)
• Policy of Quantitative Easing to increase money supply increasing threat of future inflation.
• Deep recession.

Yet, these weaknesses of high borrowing and deep recession are now faced by Eurozone members as well. Also, although the UK may experience some inflation, it will mean UK interest rates have the prospect of rising and this would lead to a higher value of sterling.

The weaker value of Sterling and hopes the UK market may be bottoming out have caused foreign interest in buying UK houses. Neil Turner a Germany-based executive in charge of a 300 million-euro ($403 million) property fund says:

“Weaker sterling makes U.K. property more attractive,”

Barclays Plc predicts it will rise as much as 18 percent against the dollar and 11 percent versus the euro in the coming year.
Goldman Sachs Group Inc. sees a 23 percent gain versus the dollar and 15 percent advance against the euro.

Impact of not Being in the Euro on UK economy
Forecasts for Euro to fall
(bloomberg)

See: Causes of Credit Crunch

Many UK Banks bought bundles of the bad mortgage debt from US mortgage companies (either directly or indirectly). Therefore, when the US mortgage defaults rose, many UK banks lost money. They had to write off bad debts and this caused a deterioration in their balance sheets. Because of the large write offs they have been trying to improve their balance sheets by lending less and encouraging saving deposits.

This caused interbank lending to freeze up. – Because everyone lost money nobody wanted to lend each other money. This increased the cost of interbank lending causing a fall in general lending.

This problem was exacerbated because many banks especially the former building societies like Bradford and Bingley and Northern Rock had lent a high ratio of their deposits. Northern Rock lent many mortgages by raising money on the money markets. Therefore, when the money markets froze up, Northern Rock ran out of funding. They couldn’t call in their long term loans (mortgages) and they were short of cash. This is when they had to ask Bank of England for funding.

Another problem is house prices. As banks stopped normal lending. Demand for housing dried up. This caused house prices to fall. As house prices fell, it caused even greater reluctance to lend as many homeowners were facing negative equity.

Why is Recession in UK so Deep?

• Influence of the Housing Market. The housing market plays a key role in determining confidence and consumer spending. Now that house prices are falling so sharply, confidence has evaporated and people with negative equity are spending much less. It appears these factors have a great weight than the cuts in interest rates. Rising house prices played a key role in maintaining high levels of consumer spending in the 2000-2007 period now that is unwinding. Other countries like Germany have not had the same sharp rise and fall in house prices (though the UK is not alone to have a boom and bust in house prices e.g. Spain and Ireland
• Financial Shocks. UK growth was based on high spending levels and low saving rates (saving rate fell to under 1% this year). This was fine when confidence in the finance sector was high. But, now people are worried about the safety of banks and the credit crunch. There is a change in attitudes, people no longer wish to borrow to the  hilt, a new frugality is coming – this is causing sharp falls in spending, only mitigated by shops aggressively cutting prices.
• Cuts in interest rates not effective. Usually cutting interest rates would boost spending, but, in the current turmoil people are proving resistant to the idea of spending more.
• Reliance on consumer spending and Finance Sector. The pound has depreciated significantly in past few months; many economies would expect to see a boost in exports. However, the industrial sector only accounts for 18% of GDP these days. Therefore, exports are unable to pull the economy out of recession (like they might in Japan or Germany). A large share of GDP is the finance sector – the City of London. It is this area of the economy that has been hit the hardest, therefore, we are seeing a sharp fall in GDP from this sector (unfortunately, we will also see a sharp fall in income tax revenues – the top 1% of income earners pay 16% of total income tax revenues)

How long will recession last?

There is a strong negative momentum at moment. The monetary and fiscal expansions will have a time lag of about 6 months before they have any real effect. Yet, house prices will keep falling in 2009 making a recovery difficult. Unemployment will also rise sharply throughout 2009.

• Worst recession since war?

• 1. Low inflation of CPI 2% +/-1
• 2. Consider wider macro economic objectives such as growth and unemployment.

Therefore, the MPC’s primary target is low inflation, but the second objective enables them to give less importance to inflation if there is an unexpected shock to the economy.
Many argue the MPC have done a good job. Between 1997 and 2007, they kept inflation low whilst maintaining strong but sustainable growth. Unemployment fell and the UK enjoyed the longest period of growth on record (16 years). It appeared the MPC had avoided the old boom and bust cycle.

However, the MPC have been criticised

1. For allowing a boom in house prices which was unsustainable. Now house prices are falling the economy has suffered lower growth
2. Ignoring the impending recession and giving too much importance to temporary cost push inflation. e.g. David Blanchflower criticised MPC for keeping interest rates too high for too long. The dramatic cuts in rates, show how the MPC perhaps admit they were too high for too long.

However, in defence of the MPC

1. The MPC were not asked to target house prices with interest rates. Arguably this was a micro economic problem. If they had increased interest rates in 2004-05 to reduce house prices it would have caused lower growth even when inflation was on target. Rising house prices reflected shortage of supply and excess lending. The boom in house prices was undesirable, but, it needed to be tackled by measures other than interest rates.2. The recession was mainly caused by the global credit crunch outside their control. The UK government could have done more to regulate the financial system.
2. Many were surprised at how quickly the UK Economy slid into recession
3. Also the cost push inflation presented a difficult dilemma. The MPC feared that if they cut rates as inflation was increasing it could lead to permanently higher inflation expectations. The MPC were not confident oil prices would fall.

In hindsight, interest rates could have been cut earlier in 2008. The concerns over inflation have been outweighed by the much more serious decline in growth and rise in unemployment. This may have caused a sharper downturn. But, it was not the main cause of the recession – far from it. The main cause of this recession was the combination of a global credit crunch, falling house prices and decline in consumer confidence.

Overview of MPC at Bank of England

The Dollar’s weakness has been well documented, but unfortunately many of the reasons for the Dollar’s weakness are shared by the Pound.

Why Pound is Falling

1. Current Account Deficit approaching 5% of GDP. A current account deficit means the value of imports is greater than exports, basically it means money is leaving the economy. If the UK, struggle to gain an equivalent surplus on the financial account it will lead to a devaluation.
2. Recession. The UK is in its steepest recession since the war. [link]
3. Interest Rates falling. Interest rates have a big impact on the value of a currency. Lower interest rates mean that it is less attractive to deposit money in sterling accounts and buy sterling bonds. The relatively high UK interest rates have been one of the main reasons for Central Banks and international investors being so willing to buy sterling. However, as interest rates fall this is no longer be the case.
4. Housing Market With house prices considered to be overvalued falling  house prices in 2008 and 2009 are causing a recession and necessitating interest rate cuts to avoid recession.
5. Debt. UK government debt is approximately 43% of GDP (£516.7bn) However, this ignores Government promises regarding pensions. As the baby boomers retire the government will be faced with a large increase in demand for pensions, boosting government debt. Consumer debt is also at a record high. Boosted by a booming housing market, consumer debt levels have increased. High levels of debt mean that the economy has long term weaknesses and therefore it is hard to understand the Pound’s strength. UK debt levels have increased significantly in 2008, government borrowing could reach £100bn in 2009 alone, as the government struggles with credit crisis and housing downturn.
6. International Currency Reserve. The Pound accounts for 12% of all international currency reserves. It has been the choice for many Central Bankers after they have diversified out of the dollar. However, the reason for buying pounds has not been so much as a positive reason, but that it wasn’t the dollar or the Yen. It is likely Central bankers will no longer want to increase their exposure to Pound Sterling given so much weakness in the Dollar.

The strength of the Pound was mainly due to the weakness of other curencies and investment opportunities.

Predictions for Pound vs Dollar

• Lehman Brothers say Sterling will drop to $1.68.
• Goldman Sachs forecast a 13% drop or more versus the Dollar.
• Morgan Stanley in summer of 2008 set “fair value” at $1.63.
• Predictions of £1 to 1 Euro to provide a benchmark for Pound in 2009.

Related

• Forecast for Pound Sterling 2008
• Pound Sterling Predictions

Anyway, the economic outlook is pretty grim at the moment.
Confidence amongst manufactures has fallen to -60
Unemployment is rising sharply.
Gordon Brown and Mervyn King have both admitted the economy is entering a full blown recession.
Housing market continues to freeze up, causing few house sales and falling house prices.
Banks still reluctant to lend despite injection of cash into the banking system by government.

Although inflation is still way above target, the collapse in oil prices means inflation will definitely be coming down next year. With inflation forecast to come down, the Bank of England may feel free to aggressively cut rates to try and avoid a lengthy recession.
In addition to a loosening of monetary policy, the government is also proposing higher spending to boost Aggregate demand through expansionary fiscal policy. (despite the increase in government borrowing and National Debt)

I think interest rates of 3% are a possibility for the end of 2009. It depends how deep the recession becomes and whether the economy responds to the lower rates and higher spending.

2009 will not be a good year for people living off savings, but, it will be a good year for people like me with large debts. If interest rates do fall to 3% buying a house will become very attractive – as long as people can actually get a mortgages.

There are few things that financial authorities and governments fear more than a rush to withdraw savings from banks. It evokes memories of the Great Depression, and in Germany the hyper inflation which made money worthless, facilitating the rise of the Nazis.

In the UK, the government explicitly guarantee the first £50,000 of savings in a bank account (having recently increased it from £35,000. In practise, the government would not want to let any bank go bankrupt for the negative impact on confidence. However, there is a reluctance to explicitly guarantee all savings because this encourages banks to  engage in risky behaviour, because the government will always secured savings should banks go bankrupt.

The problem is that now Ireland and Germany have abolished an upper ceiling on bank deposits, it creates an incentive for savers to move their savings to Germany and Ireland where they can have 100% security. If there was a widespread withdrawal from British banks, it would be very damaging. At the moment, banks are desperate for more savings to improve their battered balance sheets.

Therefore, to prevent a flow of savings from the UK to Ireland and / or Germany, Gordon Brown is under pressure to abolish the limit on savings. This would mean the UK government promising to honour upto £2 trillion worth of deposits. It’s a difficult choice, and no wonder they are not happy with the Germans and Irish for raising the stakes of securing bank deposits.

Bad News on Economy

• Falling House prices reducing consumer confidence and consumer spending
• Problems of Bradford & Bingley and HBOS will lead to less mortgages on market and likelihood of further house price falls.
• Manufacturing output, and employment decreased at the fastest rate since the severe recession of 1982. Manufacturing output has now fallen for 5 consecutive months, and illustrates how the ‘real economy’ is being affected by the slowdown – not just stock markets.
• Burdgeoning National debt leaves the chancellor with little room for manoeuvre. Expansionary fiscal policy requires more government borrowing, but, this would be difficult.
• Rising Unemployment. After a decade of low unemployment, unemployment is now rising very quick. Rising unemployment will increase mortgage defaults and cause more problem for the beleaguered banking sector.
• Credit Crunch – More still to come. A recession and continued fall in house prices will only cause further problems for banks who have holes in their balance sheets. There will be further difficulties on the stock market and borrowing will become more difficult, reducing investment.

Good News

The ray of hope is that at least cost push inflation appears to be coming down, the producer price index dropped last month, indicating lower retail inflation in the future. With oil prices also coming down as well, it enables the MPC to be able to cut interest rates which will hopefully lessen the impact of the slowdown.