Why UK Recession is Deep

It is a mute point whether the UK or US is facing the worst recession. So far there has been a close correlation between the US economy and the UK economy. The UK housing market bubble ended later than the US, but since then the UK economy has fallen into recession in a similar way to the US. With the US cutting interest rates to 0%, it suggests this could be the UK’s fate within a few months.

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?