New data released on 25/7/12 by the Office for National Statistics showed that the UK economy shrank by a further 0.7% in the second quarter of 2012. This makes it the third quarter in a row in which GDP has fallen – and it is the steepest fall of the three. Faced with this, should the government simply maintain the status quo, or does it need to take new action?
The construction sector declined the most steeply, with construction output 5.2% down on the previous quarter, which in turn was 4.9% down on the quarter previous to that. The output of the production industries as a whole fell by 1.3% and the service sector fell by 0.1%. (For a PowerPoint of the following chart, click here.)
The immediate cause of the decline in GDP has been a decline in real aggregate demand, but the reasons for this are several. Consumer demand has fallen because of the squeeze on real wages, partly the result of low nominal pre-tax wage increases and partly the result of inflation and tax rises; the government’s austerity programme is holding back a growth in government expenditure; export growth has been constrained by a slowing down in the global economy and especially in the eurozone, the UK’s major trading partner; and investment is being held back by the pessimism of investors about recovery in the economy and difficulties in raising finance.
So what can be done about it?
Monetary policy is already being used to stimulate demand, but to little effect (see Pushing on a string. Despite record low interest rates and a large increase in narrow money through quantitative easing, broad money is falling as bank lending remains low. This is caused partly by a reluctance of banks to lend as they seek to increase their capital and liquidity ratios, and partly by a reluctance of people to borrow as individuals seek to reduce their debts and as firms are pessimistic about investing. But perhaps even more quantitative easing might go some way to stimulating lending.
Fiscal policy might seem the obvious alternative. The problem here is that the government is committed to reducing the public-sector deficit and is worried that if it eases up on this commitment, this would play badly with credit rating agencies. Indeed, on 27/7/12, Standard & Poor’s, one of the three global credit rating agencies, confirmed the UK’s triple A rating, but stated that “We could lower the ratings in particular if the pace and extent of fiscal consolidation slows beyond what we currently expect.” Nevertheless, critics of the government maintain that this is a risk worth taking.
The following articles look at the causes of the current double-dip recession, the deepest and most prolonged for over 100 years. They also look at what options are open to the government to get the economy growing again.
Articles
Britain shrinks again The Economist (25/7/12)
Shock 0.7% fall in UK GDP deepens double-dip recession Guardian, Larry Elliott (25/7/12)
UK GDP figures: expert panel verdict Guardian, Frances O’Grady, Will Hutton, Sheila Lawlor, Vicky Pryce and John Cridland (25/7/12)
GDP shock fall: UK growth in 2012 ‘inconceivable’, warn economists The Telegraph, Angela Monaghan (25/7/12)
UK recession deepens after 0.7% fall in GDP BBC News (25/7/12)
UK economy: Why is it shrinking? BBC News (25/7/12)
UK GDP: A nasty surprise and a puzzle BBC News, Stephanie Flanders (25/7/12)
Tough choices for Mr Osborne BBC News, Stephanie Flanders (26/7/12)
David Cameron in pledge to control UK’s debt Independent, Andrew Woodcock and James Tapsfield (26/7/12)
David Cameron defends economic policies BBC News (26/7/12)
The GDP number is awful – and it’s the product of the Government’s amateur policies, not the euro crisis The Telegraph, Thomas Pascoe (25/7/12)
UK recession: have we heard it all before? Guardian, Duncan Weldon (25/7/12)
US economic growth slows in second quarter BBC News (27/7/12)
GDP data trigger debate on economy Financial Times, Norma Cohen and Sarah O’Connor (25/7/12)
Does weak UK growth warrant more QE? Financial Times (25/7/12)
The recession: Osborne’s mess Guardian editorial (25/7/12)
Data
Gross Domestic Product, Preliminary Estimate, Q2 2012 ONS (25/7/12)
Preliminary Estimate of GDP – Time Series Dataset 2012 Q2 ONS (25/7/12)
Questions
- What are the causes of the deepening of the current recession in the UK?
- Search for data on other G7 countries and compare the UK’s performance with that of the other six countries (see, for example, the OECD’s StatExtracts.
- Compare the approach of George Osborne with that of Neville Chamberlain in 1932, during the Great Depression.
- Does weak UK growth warrant more quantitative easing by the Bank of England?
- To what extent can fiscal policy be used to stimulate the economy without deepening the public-sector deficit in the short term?
- What is meant by ‘crowding out’? If fiscal policy were used to stimulate demand, to what extent would this cause crowding out?
The 2012 London Olympics opened on 27 July. This has been the result of years of planning and investment in infrastructure since London won the bid in 2005.
It is estimated that hosting the Games will have cost over £9bn. It is therefore interesting to consider the long-run impact on a host city years after the last medal has been won. We might expect host cities to achieve increased growth due to the benefits from the improved infrastructure and the impact of increased publicity and exposure on trade, capital and population.
This has recently been investigated in a paper published in the Economic Inquiry by Stephen Billings and James Holladay which looks at the impact hosting the Games has on GDP and trade (working paper available here). One difficulty with trying to identify the impact of hosting the Games, is that only certain cities will have a chance of being chosen as hosts and these may be cities that are more likely to experience future growth. If this is the case, it would appear that the future growth was due to hosting the Games when it would in fact have been likely to occur anyway. In order to control for this, the above paper compares the winners with losing finalists in the selection process for host cities. For example under this approach London would be compared with Singapore, Moscow, New York and Madrid. In addition, subsequent matching processes are also used to select appropriate cities for comparison.
They find that larger cities in wealthier countries are more likely to be chosen to host the Games. However, once comparisons with other appropriate cities are made, overall, they find that hosting the Games has no effect on a cities population, growth or trade. One explanation provided is that the intense competition to host the Games means the potential gains are competed away via escalated promises in order to increase a cities chances of being selected. In addition, they note that there may well still be considerable specific benefits from the investments made to host the Games.
It is also clear that there are both positive and negative externalities from hosting the Games that, whilst difficult to measure, ideally should be taken into account. On the negative side, these include the extra hassle anybody travelling to work in London during the Games will face. On the other hand, on the positive side, it is hoped that part of the long-run legacy of the Games will be increased interest and participation in sport which would result in substantial health benefits.
David Cameron claims London 2012 will bring £13bn ‘gold for Britain’ The Guardian, Hélène Mulholland (05/07/12)
Olympic legacy: how the six Olympic boroughs compare for children The Guardian, Simon Rodgers (19/07/12)
London 2012: Olympics legacy hard to define BBC News, David Bond (13/07/12)
Questions
- Explain how intense competition to host the Games might result in benefits being competed away.
- Can you think of any other externalities resulting from the Olympic Games?
- Why are the impact of externalities difficult to measure?
- What other factors should be taken into account when assessing the costs and benefits of hosting the Games?
- Do you think the decision to bid to host the Games should be purely based on a cost-benefit analysis?
With the deepening euro crisis, the slide back into recession in many developed countries and the slowing down of fast-growing developing countries, such as China and India, confidence is waning.
But just as pessimism increases, so too does uncertainty. The global economy is getting more and more difficult to forecast. So should economists give up trying to forecast? Should we rely on guesswork and hunch, or looking into crystal balls?
Bank of England representatives have been appearing before the Treasury Select Committee. And they have reiterated the consensus that things are getting more difficult to forecast. As Mervyn King said in his evidence:
There is just enormous uncertainty out there. I have no idea what is going to happen in the euro area.
And this uncertainty is making people cautious, which, in turn, damages recovery. As Dr King went on to say:
There is no doubt that with the additional uncertainty this year there’s evidence of people behaving in a very defensive way, being unwilling to invest and of course the most extreme example of that would be if we were to get to a liquidity trap where essentially the main assets people wanted to hold were claims on the central bank.
Part of the reason for the uncertainty about global growth prospects is uncertainty about what European leaders will decide about the future of the eurozone. Another is uncertainty about how people will respond to the uncertainty of others. But predicting how others will predict is very difficult as they will themselves be predicting what others will predict. This dilemma was observed by Keynes when observing how investors on the stock market behaved, all trying to predict what others will do, and is known as the Keynesian Beauty Contest dilemma (see also).
So are governments and central banks powerless to counteract the uncertainty and pessimism? Can they restore confidence and growth? Members of the Bank of England’s Monetary Policy Committee believe that further action can be taken to stimulate aggregate demand. Further quantitative easing and cuts in interest rates could help as, according to Dr King, we are not yet in a liquidity trap.
UK Economic Outlook Uncertain Amid Euro Zone Crisis – BOE NASDAQ, Ilona Billington (26/6/12)
BOE King: UK Not In Liquidity Trap; No Limit On QE Market News International (26/6/12)
BOE King: Unity On Loose Policy; Not Half Way Through Crisis Market News International (26/6/12)
Full Text Of BOE MPC Dale At Treasury Select Committee Market News International (26/6/12)
Recovery still five years away, Mervyn King warns The Telegraph, Philip Aldrick (26/6/12)
Governor pessimistic on recovery ShareCast, Michael Millar (26/6/12)
Bank’s King says ‘pessimistic’ about worsening economy BBC News (26/6/12)
UK economic outlook getting worse, warns Bank of England Guardian, Phillip Inman (26/6/12)
Questions
- Why is it worth economists forecasting, even if those forecasts rarely turn out to be totally accurate?
- Why is it particularly difficult in current circumstances to forecast the state of the macroeconomy 12 months hence – let alone in two or three years?
- In what ways is the global macroeconomic situation deteriorating? What can national governments do about it?
- What limits the effectiveness of government action to deal with the current situation?
- What is meant by the liquidity trap? Are we close to being in such a situation today?
- Explain what is meant by the Keynesian Beauty Contest? How is this relevant today in explaining economic uncertainty and the difficulty of forecasting the economy?
Oil prices have been falling in recent months. By early June they had reached a 17-month low. The benchmark US crude price (the West Texas Intermediate price) fell to $83.2 at the beginning of the month, and Brent Crude (the North Sea reference price for refining into petrol) fell to $97.7 (see chart). (For a PowerPoint of the chart below, click here.)
At the same time various commodity prices have also been falling. The IMF all commodities price index has fallen by 7.2% over the past 12 months and by 6.2% in May alone. Some commodities have fallen much faster. In the 12 months to May 2012, natural gas fell by 44%, wheat by 25%, lamb by 37%, Arabica coffee by 36%, coconut oil by 45%, cotton by 47%, iron ore by 23% and tin by 29%.
Although part of the reason for the fall in the price of some commodities is increased supply, the main reason is weak world demand. And with continuing problems in the eurozone and a slowdown in China and the USA, commodity price weakness is likely to continue.
So is this good news? To the extent that commodity prices feed through into consumer prices and impact on the rate of inflation, then this is good news. As inflation falls, so central banks will be encouraged to make further cuts in interest rates (in the cases where they are not already at a minimum). For example, the Reserve Bank of Australia cut its cash rate last week from 3.75% to 3.5%. This follows on from a cut from 4.25% on 1 May. In cases where there is no further scope for interest rate cuts (e.g. the US Federal Reserve Bank, whose interest rate is between 0% and 0.25%), then the fall in inflation may encourage a further round of quantitative easing.
But falling commodity prices are also a reflection of bad news, namely the low economic growth of the world economy and fears of turmoil from a possible Greek exit from the euro.
Update
A day after this was written (9/6/12), a deal was agreed between eurozone ministers to provide support of up to €100 billion for Spanish banks. This helped to reduce pessimism about the world economy, at least temporarily. Stock markets rose and so too did oil prices, by around 1%. But if pessimism increases again, then the fall is likely to resume.
Articles
Oil prices hit a 17-month low on China slowdown fears BBC News (8/6/12)
Oil gives up gains without signs of Fed move BloombergBusinessweek, Sandy Shore (7/6/12)
Oil Heads for Longest Run of Weekly Losses in More Than 13 Years BloombergBusinessweek, (8/6/12)
Gold plunges as Bernanke gives no hint of stimulus Live5News(7/6/12)
Oil Price Tumbles Below $83 on Weak Economy Money News(8/6/12)
World food price index expected to fall for May Reuters(6/6/12)
Oil price losing streak continues Guardian, Julia Kollewe (8/6/12)
Data
Spot fuel prices US Energy Information Administration
Commodity Prices Index Mundi
Crude Oil Price Index Index Mundi
Questions
- Why have crude oil prices fallen to their lowest level for 17 months?
- How can the concepts of income elasticity of demand, price elasticity of supply and price elasticity of demand help to explain the magnitude of the fall in crude oil prices?
- Would a fall in inflation linked to a fall in commodity prices be a fall in cost-push or demand-pull inflation? Explain.
- What are the macroeconomic implications of the fall in crude oil prices?
- What factors are likely to have significant impact on crude oil prices in the coming months
- Why is it difficult to predict crude oil prices over the coming months?
With tight incomes, the first things that families tend to cut back on are the more luxury items. Extensions to houses are delayed, interior refurbishments are put off and the old car that was going to be traded in becomes something you can live with for another few years.
Car sales have been adversely affected during the recession, but data for May 2012 show a positive turn. Manufacturers have said that car sales are up by 7.9% compared with May last year. According to the Society of Motor Manufacturers and Traders (SMTT), much of the increased demand has come from private sales, where the increase has been over 14%.
This data may not be the answer to the economic troubles, but it is perhaps an indication that confidence is beginning to return. However, should things go from bad to worse in the eurozone, it isn’t hard to see data for the coming months showing the opposite trend. One other key piece of information to take from this data is the growth in the sales of lower-emissions vehicles. Sales of these were up 31.8% in May 2012 compared to the same time last year. Jonathan Visscher from SMMT said:
‘The green sector is growing fast…Every car manufacturer is going to have a hybrid model on its lists by the end of this year, even Ferrari.’
The continuing upward trend in car sales is by no means guaranteed to continue, especially with things like the expected rise in fuel duty later this year and the ongoing crisis in the eurozone, with Spanish banks potentially looking for help via a bail-out in the not too distant future. The following articles consider the acceleration in car sales.
UK sees biggest annual rise in car sales for nearly 2 years Reuters (8/6/12)
New car sales accelerate ahead Press Association (8/6/12)
UK new car sales accelerated in May, say manufacturers BBC News (8/6/12)
New car sales accelerate ahead Independent, Peter Woodman (8/6/12)
Car registrations accelerate in May Financial Times, John Reed (8/6/12)
Questions
- How would you define a luxury good? What is the relationship with income?
- How could an increase in car sales benefit the economy? How could the multiplier effect have an impact?
- Which factors have contributed towards the growth in low-emissions cars?
- Sales of low-emissions cars have significantly increased. However, why is this increase
- What are some of the key things that can help to bring a recession to an end? Into which general category would you place this increase in car sales?
- Fuel duty is expected to rise later this year. How might this affect the number of new car registrations? What does your answer tell you about the cross elasticity of demand?
New data released on 25/7/12 by the Office for National Statistics showed that the UK economy shrank by a further 0.7% in the second quarter of 2012. This makes it the third quarter in a row in which GDP has fallen – and it is the steepest fall of the three. Faced with this, should the government simply maintain the status quo, or does it need to take new action?
