A constant feature of the UK economy (and of many other Western economies) has been record low interest rates. Since March 2009, Bank Rate has stood at 0.5%. Interest rates have traditionally been used to keep inflation on target, but more recently their objective has been to stimulate growth. However, have these low interest rates had a negative effect on the business environment?
Interest rates are a powerful tool of monetary policy and by affecting many of the components of aggregate demand, economic growth can be stimulated. This low-interest rate environment is an effective tool to stimulate consumer spending, as it keeps borrowing costs low and in particular can keep mortgage repayments down. However, this policy has been criticised for the harm it has been doing to savers – after all, money in the bank will not earn an individual any money with interest rates at 0.5%! Furthermore, there is now a concern that such low interest rates have led to ‘zombie companies’ and they are restricting the growth potential and recovery of the economy.
A report by the Adam Smith Institute suggests that these ‘zombie companies’ have emerged in part by the low-interest environment and are continuing to absorb resources, which could otherwise be re-allocated to companies with more potential, productivity and a greater contribution to the economic recovery. During a recession, there will undoubtedly be many business closures, as aggregate demand falls, sales and profits decline until eventually the business becomes unviable and loans cannot be repaid. Given the depth and duration of the recent recessionary period, the number of business closures should have been very large. However, the total number appears to be relatively low – around 2% or 100,000 and the report suggests that the low interest rates have helped to ‘protect’ them.
Low interest rates have enabled businesses to meet their debt repayments more easily and with some banks being unwilling to admit to ‘bad loans’, businesses have benefited from loans being extended or ‘rolled over’. This has enabled them to survive for longer and as the report suggests, may be preventing a full recovery. The report’s author, Tom Papworth said:
Low interest rates and bank forbearance represent a vast and badly targeted attempt to avoid dealing with the recession. Rather than solving our current crisis, they risk dooming the UK to a decade of stagnation … We tend to see zombies as slow-moving and faintly laughable works of fiction. Economically, zombies are quite real and hugely damaging, and governments and entrepreneurs cannot simply walk away.
The problem they create is that resources are invested into these companies – labour, capital, innovation. This creates an opportunity cost – the resources may be more productive if invested into new companies, with greater productive potential. The criticism is that the competitiveness of the economy is being undermined by the continued presence of such companies and that this in turn is holding the UK economy back. Perhaps the interest rate rise that may happen this time next year may be what is needed to encourage the re-allocation of capital. However, a 0.5 percentage point rise in interest rates would hardly be the end of the world for some of these companies. Perhaps a more focused approach looking at restructuring is the key to their survival and the allocation of resources to their most productive use. The following articles and the report itself consider the case of the trading dead.
Report
The Trading Dead The Adam Smith Institute, Tom Papworth November 2013
Articles
Zombie firms threaten UK’s economic recovery, says thinktank The Guardian, Gyyn Topam (18/11/13)
Zombie companies ‘probably have no long term future’ BBC News (18/11/13)
Rate rise set to put stake through heart of zombie companies Financial Times, Brian Groom (14/11/13)
Why we can still save the zombie firms hindering the UK economic rival City A.M., Henry Jackson (18/11/13)
Breathing new life into zombies The Telegraph, Rachel Bridge (9/11/13)
Questions
- Which components of aggregate demand are affected (and how) by low interest rates?
- Why do low interest rates offer ‘protection’ to vulnerable businesses?
- How is the reallocation of resources relevant in the case of zombie companies?
- If interest rates were to increase, how would this affect the debts of vulnerable businesses? Would a small rate irse be sufficient and effective?
- What suggestions does the report give for zombie companies to survive and become more productive?
- Is there evidence of zombie companies in other parts of the world?
The Consumer Prices index (CPI) measures the rate of inflation and in October, this rate fell to 2.2%, bringing inflation to its lowest level since September 2012. For many, this drop in inflation came as a surprise, but it brings the rate much closer to the Bank of England’s target and thus reduces the pressure on changing interest rates.
The CPI is calculated by calculating the weighted average price of a basket of goods and comparing how this price level changes from one month to the next. Between September and October prices across a range of markets fell, thus bringing inflation to its lowest level in many months. Transport prices fell by their largest amount since mid-2009, in part driven by fuel price cuts at the big supermarkets and this was also accompanied by falls in education costs and food. The Mail Online article linked below gives a breakdown of the sectors where the largest price falls have taken place. One thing that has not yet been included in the data is the impact of the price rises by the energy companies. The impact of his will obviously be to raise energy costs and hence we can expect to see an impact on the CPI in the coming months, once the price rises take effect.
With inflation coming back on target, pressures on the Bank of England to raise interest rates have been reduced. When inflation was above the target rate, there were concerns that the Bank of England would need to raise interest rates to cut aggregate demand and thus bring inflation down.
However, the adverse effect of this would be a potential decline in growth. With inflation falling to 2.2%, this pressure has been removed and hence interest rates can continue to remain at the record low, with the objective of stimulating the economy. Chris Williamson from Markit said:
The easing in the rate of inflation and underlying price pressures will provide greater scope for monetary policy to be kept looser for longer and thereby helping ensure a sustainable upturn in the economy … Lower inflation reduces the risk of the Bank of England having to hike rates earlier than it may otherwise prefer to, allowing policy to focus on stimulating growth rather than warding off rising inflationary pressures.
The lower rate of inflation also has good news for consumers and businesses. Wages remain flat and thus the reduction in the CPI is crucial for consumers, as it improves their purchasing power. As for businesses, a low inflation environment creates more certainty, as inflation tends to be more stable. Businesses are more able to invest with confidence, again benefiting the economy. Any further falls in the CPI would bring inflation back to its target level of 2% and then undoubtedly concerns will turn back to the spectre of deflation, though with the recent announcements in energy price rises, perhaps we’re getting a little ahead of ourselves! Though we only need to look to countries such as Spain and Sweden where prices are falling to realise that it is certainly a possibility. The following articles consider the data and the impact.
UK inflation falls in October: what the economists say The Guardian, Katie Allen (12/11/13)
British inflation hits 13-month low, easing pressure on central bank Reuters, David Milliken and William Schomberg (12/11/13)
UK inflation falls to 2.2% in October BBC News (1211/13)
UK inflation falls to 13-month low: reaction The Telegraph (12/11/13)
Fall in inflation to 2.2% welcome by government The Guardian, Katie Allen (12/11/13)
Inflation falls to lowest level for a year as supermarket petrol price war helps ease the squeeze on family finances Mail Online, Matt Chorley (12/11/13)
Inflation falls to its lowest level for more than a year as consumers benefit from petrol pump price war Independent, John-Paul Ford Rojas (12/11/13)
UK inflation slows to 2.2%, lowest level in a year Bloomberg, Scott Hamilton and Jennifer Ryan (12/11/13)
Are we facing deflation? Let’s not get carried away The Telegraph, Jeremy Warner (12/11/13)
Questions
- How is the CPI calculated?
- Use an AD/AS diagram to illustrate how prices have been brought back down. Is the reduction in inflation due to demand-side or supply-side factors?
- What are the benefits of low inflation?
- The Telegraph article mentions the possibility of deflation. What is deflation and why does it cause such concern?
- Explain why a fall in the rate of inflation eases pressure on the Bank of England.
- How does the rate of inflation affect the cost of living?
- Is a target rate of inflation a good idea?
Nearly two years ago, France lost its triple A credit-rating and the news has only got worse. Unemployment has risen and economic growth in France has remained low and this is one of the reasons why France’s credit rating has been downgraded further from AA+ to AA. A high credit rating doesn’t guarantee market confidence, but it does help to keep the cost of borrowing for the government low. Thus, this downgrading could spell trouble for French borrowing costs.
Standard and Poor’s (S&P), who downgraded the French credit rating, is expecting government debt to rise to 86% of gross domestic product and believes that unemployment will remain above 10% until 2016. While the French government has put various reforms in place to boost the struggling economy, S&P don’t believe they are sufficient and have been very public in criticising the government’s effort. They were quoted as saying:
We believe the French government’s reforms to taxation, as well as to product, services and labour markets, will not substantially raise France’s medium-term growth prospects and that on-going high unemployment is weakening support for further significant fiscal and structural policy measures.
Following the downgrading, the return for those investors purchasing French debt did begin to rise, echoing the theory that the cost of borrowing would rise. 
The yield on French government 10-year bonds increased from 2.158% to 2.389%. The outlook given to France by S&P was ‘stable’, implying that there is a relatively low chance that S&P would change France’s credit-rating again in the next two years.
Many were surprised at the downgrading of France’s credit rating, but this may be the nudge that President Hollande needs to push through extensive labour market reforms with the aim of reducing unemployment and generating growth in the economy. Despite this latest move by S&P, the other credit rating agencies have yet to take similar action. Perhaps they are more convinced by the Finance Minister, Pierre Moscovici who claims that France’s debt is ‘one of the safest and most liquid in the world.’ He commented that:
They are underestimating France’s ability to reform, to pull itself up … During the last 18 months the government has implemented major reforms aimed at improving the French economic situation, restoring its public finances and its competitiveness.
It will take some time for the full impact of this development in France’s economy to become apparent. The cost of borrowing has already risen only time will tell what will happen to market confidence over the coming weeks. However, what is certain is that pressure is already mounting on Francois Hollande. The following articles consider the French economy.
France told to reform labour market after second credit rating downgrade The Guardian, Phillip Inman (8/13/13)
France’s credit rating cut by S&P to AA BBC News (8/11/13)
S&P lowers France rating on reform doubts, markets unfazed Reuters, Nicholas Vinocur (8/11/13)
Hollande approval rating slumps as France downgraded The Telegraph, James Titcomb (8/11/13)
S&P cuts France’s credit rating by one notch to double-A Wall Street Journal, William Horobin (8/11/13)
Five charts that show the state of the French economy The Telegraph (8/11/13)
France rating downgrade heaps pressure on Francois Hollande Financial Times, Michael Stothard (8/11/13)
Questions
- What does a double A rating mean for the French economy?
- Which factors will be considered when a ratings agency decides to change a country’s credit rating?
- France’s unemployment rate is one of the key factors that S&P has considered. Why is France’s unemployment rate so high? Which type(s) of unemployment are increasing?
- Use a diagram to illustrate the unemployment that France is facing.
- If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
- Markets have been ‘unfazed’ by the downgrade. How do you think markets will react to over the coming weeks? Explain your answer.
- What action could the French government take to ensure that S&P is the only ratings agency that downgrades their credit rating?
UK house prices are incredibly volatile. This helps to explain the fascination that many of us have with the British housing market. According to the latest ONS house Price Index, the average UK house price in August 2013 was 3.8 per cent higher than 12 months earlier. The rates varied across the home nations: 4.1 per cent in England, 1.1 per cent in Northern Ireland, 1 per cent in Wales and -0.7 per cent in Scotland. Here we take a look at international house price inflation rates. Is the British housing market as unique as we think it is?
Let’s begin at home (excuse the pun). If we take the period from 1970 Q1 to 2013 Q2, the average annual rate of house price inflation across the UK is 9.7 per cent. The average rate in England is 9.8 per cent, as it is in Wales too, while in Scotland it is 9.0 per cent and in Northern Ireland it is 8.8 per cent. While the long-term averages of the UK nations are rather more similar than perhaps we might expect, what is quite interesting is the differences that emerge in more recent times. If we take the period from July 2008 to August 2013, the average annual rate of house price inflation in the UK is -0.2 per cent, in England it is 0.1 per cent, in both Wales and Scotland it is -1.0 per cent, while in Northern Ireland it is -11 per cent.
The recent English average is heavily distorted by London and to a lesser extent the rest of the South East. In London and the South East the average annual house price inflation rates since July 2008 have been 2.6 per cent and 0.2 per cent respectively. In all the other English regions the average rate has been negative. In my own region of the East Midlands the average rate has been -1.2 per cent – this is exactly the UK average if both London and the South East are removed from the figures.
Now let’s go international. Chart 1 shows annual house price inflation rates for the UK and six other countries since 1997. Interestingly, it shows that house price volatility is a common feature of housing markets. It is not a uniquely British thing. It also shows that the USA is notable for its relatively robust house price inflation rates of late. In the first half of 2013 annual house price inflation has been running at 7 per cent in America, compared with 2 to 3 per cent here in the UK. In contrast, the Netherlands has seen near-double digit rates of house price deflation over the past year, albeit with a rebound in the third quarter of this year. (Click here to download a PowerPoint of the chart.)
The chart captures very nicely the effect of the financial crisis and subsequent economic downturn on global house prices. Ireland saw annual rates of house price deflation touch 23 per cent in 2009 compared with rates of deflation of 12 per cent in the UK. Denmark too suffered significant house price deflation with prices falling at an annual rate of 15 per cent in 2009.
House price volatility appears to be an inherent characteristic of housing markets worldwide. Let’s now consider the extent to which house prices rise over the longer term. In doing so, we consider real house price growth after having stripped out the effect of consumer price inflation. Real house price growth measures the growth of house prices relative to consumer prices.
Chart 2 shows real house prices since 1996 Q1. (Click here to download a PowerPoint of the chart.) It shows that up to 2013 Q2, real house prices in the UK have risen by a factor of 2.24, i.e. they are two and a quarter times higher. This is a little less than in Sweden where prices are 2.5 times higher.
Chart 2 shows that the increase in real house prices in the UK and Sweden is significantly higher than in the other countries in the sample. In particular, in the USA real house prices in 2013 Q2 are only 1.16 times higher than in 1996 Q1. In the US actual house prices, when viewed over the past 17 years or so, have grown only a little more quickly than consumer prices.
The latest data on house prices suggest that house price volatility is not unique to the UK. However the rate of growth over the longer term relative to consumer prices is markedly quicker than in many other countries. It is this which helps to explain the amount of attention paid to the UK housing market – and not least by policy-makers.
Data
House Price Indices: Data Tables Office for National Statistics
Articles
First time buyers in race to beat house price rises Telegraph, Nicole Blackmore (8/11/13)
House prices soar by £13,000: Values rise at fastest rate for 3 years Express, Sarah O’Grady (7/11/13)
House prices: ‘south-east set to outpace London’ for first time in a decade Guardian, Jennifer Rankin (6/11/13)
UK house prices hit record level, says ONS BBC News, (15/10/13)
UK house prices rise at fastest pace in three years in October – Nationwide Reuter (31/11/13)
Jonathan Portes: UK house prices a ‘force of evil’ BBC News, (5/11/13)
Questions
- What is meant by the annual rate of house price inflation? What about the annual rate of house price deflation?
- What factors are likely to affect housing demand?
- What factors are likely to affect housing supply?
- Explain the difference between nominal and real house prices. What does a real increase in house prices mean?
- How might we explain the recent differences between house price inflation rates in London and the South East relative to the rest of the UK?
- What might explain the very different long-term growth rates in real house prices in the USA and the UK?
- Why were house prices so affected by the financial crisis?
- What factors help explain the volatility in house prices?
The latest preliminary GDP estimates for 2013 Q3 suggest that the economy’s output (real GDP) expanded by 0.8 per cent following on the back of a 0.7 per cent increase in Q2. Growth was observed across the main industrial sectors with the important service sector growing by 0.7 per cent. While the output of the service sector is now 0.5 per cent higher than its 2008 Q1 peak, the total output of the economy remains 2.6 per cent below its 2008 Q1 peak.
The volatility of growth underpins the idea of business cycles and on occasions results in recessions. Today’s release needs to be set in the context of this volatility and in the context of 2008/9 recession which saw output fall by 7.2 per cent. UK output peaked in 2008 Q1 (£392.786 billion at 2010 prices). There then followed 6 quarters during which output declined.
Output declined again in 2010 Q4 (–0.2% growth) and again in 2011 Q4 (–0.1% growth). The estimates of real GDP for 2011 Q4 and 2012 Q1 are identical at £376.462 billion (at 2010 prices). Previous revisions have seen the 2012 Q1 growth number revised up so that a further recession resulting in a double-dip recession no longer appears in the figures.
While output is now portrayed as (very) flat in 2012 Q1, it did fall again in 2012 Q2 (–0.5 per cent growth) and in 2012 Q4 (–0.3 per cent growth). Moving forward in time, the latest ONS numbers show an economy that grew by 0.4 per cent in 2013 Q1 (to £377.301 billion at 2010 prices), by 0.7 per cent in 2013 Q2 (to £379.780 billion at 2010 prices) and by 0.8 per cent in 2013 Q3 billion (to £382.818 billion at 2010 prices). Compared with 2012 Q3, the output of the UK economy in 2013 Q2 is 1.5 per cent higher.
Chart 1 helps to put the recent growth numbers into an historical context. It shows the quarterly change in real GDP since the 1980s. From it, we can see the 5-quarter recession that commenced in 1980 Q1 when output shrunk by 4.6 per cent, the 5-quarter recession that commenced in 1990 Q3 when output shrank by 2.4 per cent and the 6-quarter recession that commenced in 2008 Q2 when output shrank by 7.2 per cent. (Click here to download a PowerPoint of the chart.)
Chart 2 scratches a little below the surface by looking at output by the four principal industrial types. The interesting finding is that the output of the service sector has now risen above its 2008 Q1 peak. In 2013 Q3 output is 0.5 per cent larger. By contrast, the other three sectors remain smaller than in 2008 Q1. Agriculture, forestry and fisheries is 5.9 per cent smaller, construction 14.3 per cent smaller and production (including manufacturing) is 14.6 per cent smaller. (Click here to download a PowerPoint of the chart.)
With today’s release, quarterly growth now averages –0.11 per cent since 2008 Q2. If we take the series back to the mid 1950s when it began, the average quarterly rate of growth is 0.64 per cent which is equivalent to an annual rate of increase of 2.57 per cent. While today’s news is encouraging it remains important to keep it in perspective and to ensure that growth is sustainable and built on firm foundations.
Data
Preliminary Estimate of GDP – Time Series Dataset Q3 2013 Office for National StatisticsGross Domestic Product Preliminary Estimate, Q3 2013 Office for National Statistics
New Articles
UK economy grows by 0.8% – the fastest pace in three years Guardian, Larry Elliott (25/10/13)
UK economy grew by 0.8% in third quarter Independent, Nick Renaud-Komiya (25/10/13)
UK GDP: fastest growth for three years BBC News (25/10/13)
UK economy grows by 0.8pc in third quarter Telegraph, Szu Ping Chu (25/10/13)
UK Economy: GDP Growth Accelerates To 0.8% Sky News (25/10/13)
Previous Articles
GDP grows 0.7% as UK economy shows steady recovery Guardian, Phillip Inman (26/9/13)
Hopes of economic recovery take double blow as GDP remains at 0.7% Independent, Russell Lynch (26/9/13)
UK economic growth confirmed at 0.7% BBC News (26/9/13)
IMF cuts global growth outlook but raises UK forecast BBC News (9/10/13)
Good news as IMF upgrades UK’s growth forecast Independent, Ben Chu (8/10/13)
Economy: IMF Makes UK Growth Forecast U-Turn Sky News (8/10/13)
Questions
- What is the difference between nominal and real GDP? Which of these helps to track changes in economic output?
- Looking at Chart 1 above, summarise the key patterns in real GDP since the 1980s.
- What is a recession? What is a double-dip recession?
- What are some of the problems with the traditional definition of a recession?
- Explain the arguments for and against the proposition that the UK has recently experienced a double-dip recession.
- Can a recession occur if nominal GDP is actually rising? Explain your answer.
- What factors might result in economic growth being so variable?
- What factors might explain the very different patterns seen since the late 2000s in the volume of output of the 4 main industrial sectors?
- Produce a short briefing paper exploring the prospects for economic growth in the UK over the next 12 to 18 months.
