With much attention focused on the UK’s rapidly rising public-sector debt, fiscal policy will have to be tightened once the economy is recovering. This will entail substantial cuts in government expenditure and possibly tax rises too, whoever wins the election next year. The danger, of course, is that if aggregate demand is cut, or its growth is severely curtailed, the economy could lurch back into recession. For this reason, it is likely that monetary policy will have to remain expansionary for some time to come. Interest rates will stay low and further quantitative easing could take place.
This was the conclusion of a report by the Centre for Economics and Business Research (see link below). The CEBR argued that Bank Rate will remain at 0.5% at least until 2011 and not reach 2% until 2014. “The forecasts show that the fiscal consolidation is likely to be matched with an unprecedented monetary relaxation. … Douglas McWilliams, one of the report’s authors and Chief Executive at CEBR, commented: ‘We are likely to see an exciting policy mix, with the fiscal policy lever pulled right back while the monetary lever is fast forward. Our analysis says that this ought to work. If it does so, we are likely to see a major rerating of equities and property which in turn should stimulate economic growth after a lag.’
The following articles look at the report and the implications of its predictions for economic growth and exchange rates.
Bank rate to ‘stay frozen’ for five years Times Online (11/10/09)
Mortgage rates to stay low until 2014 Telegraph (12/10/09)
Tax and spending squeeze to keep bank rate low David Smith’s EconomicsUK.com (11/10/09)
UK rates ‘to stay low for years’ BBC News (12/10/09)
Pound plunges as UK markets rally to year high Telegraph (11/10/09)
Tough times ahead as traders poised to offload their sterling Sunday Herald (11/10/09)
CEBR News Release (12/10/09)
Questions
- Under what conditions would a combination of a contractionary fiscal policy and an expansionary monetary policy be most effective in delivering economic growth?
- What would be the long-term effect on private-sector debt?
- How would such a policy mix affect the rate of exchange? Would this help to stimulate economic growth or dampen it?
- How will the size of these effects depend on the mobility of international financial capital?
- Explain the following: ‘Our analysis says that this ought to work. If it does so, we are likely to see a major rerating of equities and property which in turn should stimulate economic growth after a lag’.
The pound is regarded as an international currency. However, the financial crisis has caused the value of the pound to fall, reaching a four-month low against the euro in September. This recent weakening of sterling is partly the result of worries that the Lloyds Banking Group will find it difficult to meet the ‘strict criteria to leave the government’s insurance scheme for toxic banking assets’ set for it by the Financial Services Authority.
However, one of the main reasons relates to recently published figures showing UK debt (see for data). The UK’s public-sector net borrowing has now reached £16.1bn and the government’s overall debt now stands at £804.8bn: 57.5% of GDP. This represents an increase of £172bn in the past year. Over the longer term, this is unsustainable. The government could find it increasingly difficult to service this debt. This would mean that higher interest rates would have to be offered to attract people to lend to the government (e.g. through bonds and bills), but this, in turn, would further increase the cost of servicing the debt. Worries about the potential unsustainability of UK govenrment debt have weakened the pound.
But isn’t a lower exchange rate a good thing in times of recession as it gives UK-based companies a competitive advantage over companies abroad? The following articles consider UK debt and the exchange rate.
Pound plumbs five-month euro low BBC News (21/9/09)
Market data Telegraph (22/9/09)
Pound slides back against dollar and euro Guardian (21/9/09)
Pound drops as UK stocks fall for first time in seven days Bloomberg (21/9/09)
Public sector borrowing soaring BBC News (18/9/09)
Govt spending cuts ‘could help pound’ Just the Flight (21/9/09)
Pound dips to four month euro low BBC News (18/9/09)
Weak pound hits eurozone holidaymakers Compare and save (21/9/09)
Questions
- What is the relationship between public debt and the value of the pound? How do interest rates play a part?
- What is quantitative easing and has it been effective? How does it affect the exchange rate?
- What are the advantages and disadvantages of a freely floating exchange rate relative to a fixed exchange rate?
- If the UK had joined the euro, do you think the country would have fared better during the recession? Consider public debt levels: would they have been restricted? What would have happened to interest rates? What would have happened to the rate of recovery
On the eve of the September 5/6 G20 meeting of Finance Ministers in London, the OECD published an interim forecast of the macroeconomic and financial performance of the G7 economies. According to the OECD, “Recovery from the global recession is likely to arrive earlier than had been expected a few months ago but the pace of activity will remain weak well into next year.” So is it time to start reversing the various fiscal and monetary stimuli adopted around the world? Or should governments and central banks continue to stimulate aggregate demand in order to maintain the fragile recovery? The following news releases, speeches and articles look at answers given to these questions by various countries and international institutions.
Recovery arriving quicker than expected but activity will remain weak, says OECD OECD News release (3/9/09)
What is the economic outlook for OECD countries? An interim assessment OECD Economic Outlook, Interim Assessment (3/9/09)
IMF Managing Director Dominique Strauss-Kahn sees Renewed Stability but remains cautious about Global Economic Recovery, notes need for Continued Policy Actions IMF press release (4/9/09)
Beyond the Crisis: Sustainable Growth and a Stable International Monetary System Speech by Dominique Strauss-Kahn, Managing Director of the International Monetary Fund (4/9/09)
Brown urges further G20 spending (video) Gordon Brown on BBC News (5/9/09)
America’s Timothy Geithner says it’s ‘too early’ to withdraw economic stimulus Telegraph (3/9/09)
Finance chiefs warn against early end to state support for eurozone economies Guardian (3/9/09)
Keep spending – Darling warns G20 against complacency Independent (3/9/09)
Brown’s agenda deserves a hearing Financial Times (1/9/09)
Tories join Germany and France in call for exit strategy from G20 bailout Times Online (3/9/09)
UK recession: Why are we lagging our neighbours? Telegraph (3/9/09)
Reflections after the conference:
After the shock, challenges remain BBC News (7/9/09)
The G20 has saved us, but it’s failing to rein in those who caused the crisis Observer (6/9/09)
The world is as one on not endangering recovery Times Online (t/9/09)
Questions
- Why is the pace of recovery in the G7 countries likely to be modest for some time?
- Why have unemployment rates risen much more rapidly in some countries than in others (see page 19 of the OECD report)?
- Referring to the OECD report, how would you summarise changes in the global financial situation over the past few months?
- Assess the arguments put forward by France and Germany for reining in their expansionary fiscal and monetary policies.
- Why is the UK economy, according to the OECD, likely to be the last of the G7 countries to pull out of recession?
In the light of the continuing recession that, according to the Bank of England, “appears to have been deeper than previously thought”, the Monetary Policy Committee has decided to increase narrow money through an additional £50 billion of ‘quantitative easing’. This will involve extending “its programme of purchases of government and corporate debt to a total of £175 billion, financed by the issuance of central bank reserves. The Committee expects the announced programme to take another three months to complete. The scale of the programme will be kept under review.”
This decision took markets by surprise. Does this mean that the outlook for the economy is bleaker than most people expect? Why does the MPC feel that the original £125 billion of quantitative easing is insufficient? What will determine the effectiveness of the additional £50 billion increase in narrow money? The articles below look at the issues.
Bank of England Maintains Bank Rate at 0.5% and Increases Size of Asset Purchase Programme by £50 Billion to £175 Billion Bank of England News Release (6/8/09)
Bank pumps in another £50bn to aid green shoots of recovery Guardian (6/8/09)
Quantitative easing: questions and answers Guardian (6/8/09)
How much money has been pumped into the British economy? Guardian (6/8/09)
Bank of England pumps another £50 billion into economy ITN News (YouTube) (6/8/09)
Bank pumps £50bn into economy BBC News (video) (6/8/09)
Bank policy ‘not fully effective’ BBC Today Programme (audio) (6/8/09)
Are the banks lending enough? BBC News (video) (4/8/09)
Is quantitative easing working? BBC News (6/8/09)
QE: More to do? Stephanomics: BBC blog (6/8/09)
What RBS’s results say about QE Peston’s picks: BBC blog (7/8/09)
Bank wants extra £50bn for ‘fragile’ economy Independent (7/8/09)
David Prosser: Have MPC members lost their nerve? Independent (7/8/09)
The Bank of England thinks the credit crunch is far from over: Edmund Conway Telegraph (6/8/09)
Bank split over money injection BBC News (19/8/09)
Questions
- Why did the Bank of England’s Monetary Policy Committee feel that it was necessary to increase the money supply further through the purchase of an additional £50 billion of assets?
- With the use of a diagram, explain how the effect of the increase in money supply will depend on the nature of the demand for money?
- What will determine the size of the money multiplier effect resulting from the increased asset purchases?
Preliminary figures for Quarter 2 UK GDP suggest that the UK economy has been declining faster than many had expected. Does this mean that the recession in the UK will be more prolonged, or can we expect a return to growth by the end of the year? How much does the outcome depend on policy decisions taken now and what should be done in terms of quantitative easing and other policy measures?
The answers to these questions depend to some extent on the reliability of the figures, which, after all, are only preliminary estimates. Past estimates have tended to understate the level of output and growth, but could the latest estimates understate the depth of the recession? The following articles look at the figures and their implications for policy. The two articles from The Economist look at the global context.
UK economy continues to contract BBC News (24/7/09)
Recession Britain Guardian (24/7/09)
‘Shocking’ GDP figures raise fears of long road to recovery Herald (25/7/09)
Hopes of early end to recession dashed Independent (25/7/09)
Treasury defiant on growth despite gloom over GDP Times Online (26/7/09)
UK GDP: What the economists say Guardian (24/7/09)
Hamish McRae: The GDP figures were profoundly gloomy … but they were wrong Independent (26/7/09)
The shrinking economy BBC News, Stephanomics (24/7/09)
Here comes August, the cruellest month of all Observer (26/7/09)
Rebalancing global growth: a long way to go Economist (23/7/09)
Unpredictable tides Economist (23/7/09)
Gross domestic product, Preliminary estimate, 2nd quarter 2009 Office for National Statistics, Statistical Bulletin (24/7/09)
Gross domestic product, Preliminary estimate, 4th quarter 2008 Office for National Statistics, Statistical Bulletin (24/7/09)
Questions
- What factors will determine whether the UK economy starts to growth again by the end of 2009?
- Plot the quarterly growth rate of GDP from 2007 Q1. Plot two lines on the same graph: one from the 2008 Q4 estimates and one from the 2009 Q2 estimates (see last two links above). How would you explain the discrepancies between the figures?
- What policy measures would you recommend to the Bank of England and the government in the light of the GDP estimates?
- ’The deeper and longer the recession, the more will potential (as well as actual) output fall.’ Do you agree with this statement? Explain your answer.
- Referring to the two Economist articles, what conditions are necessary for sustained long-term economic growth?