UK Economy: The Crisis in Perspective

Gabriele Giudice, Robert Kuenzel, Thomas Springbett, Tom Springbett

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9789279197062
• eBook ISBN: 9781136312106

The global financial crisis, which began in 2007, was probably the biggest shock to hit the UK economy in living memory. Since the beginning of this crisis, much has happened that might previously have been thought impossible: the virtual nationalization of two of the UK's largest banks, a government deficit in double digits, a negative watch on the UK's AAA credit rating, a Bank of England base rate 150 basis points below its previous all-time low, and a £200,000m. programme of quantitative easing. These momentous events have demanded a fundamental reworking of the traditional analysis of the UK economy. The publication of UK Economy: The Crisis in Perspective meets this need for a radical new analysis of the UK economic system. The book is an edited collection of papers presented to a European Commission seminar held in June 2010 to discuss prospects for the UK economy, the book includes chapters by some of the most prominent and respected commentators on the UK economy, including Christopher Pissarides, winner of the 2010 Nobel Prize for economics sciences, Martin Weale, recently appointed to the Bank of England's Monetary Policy Committee and Dave Ramsden, Chief Economic Adviser to the Treasury. The chapters cover:

fiscal policy and its impact on growth and wealth distribution monetary policy and the Bank of England's unprecedented stimulus programme a detailed decomposition of the sources of UK growth between 1973 and 2009 the structural excess of consumption that fuelled the UK's long boom the UK's labour market performance.

The highly distinguished group of authors, coverage and analysis of issues central to recent UK economic history, along with the European Commission's assessment of UK economic prospects make this essential reading for economists, business and financial people, academics and students, as well for all those interested in the historical background of, and prospects for, the UK economy. Information in the chapters will be supplemented by a number of charts and tables offering information in graphic form. The contributors are: Gabriele Giudice, Head of the Unit responsible for the UK, Estonia and Latvia in the Directorate General for Economic and Financial Affairs (DG ECFIN) at the European Commission; Robert Kuenzel, an Economist in DG ECFIN; Thomas Springbett, UK country desk officer in DG ECFIN, responsible for forecasting and surveillance; Christopher Pissarides, professor of economics at the London School of Economics and holder of the Norman Sosnow Chair in Economics; Ray Barrell, professor at Brunel University; Philip Davis, senior fellow at the National Institute for Economic and Social Research; Martin Weale, an independent member of the Bank of England's Monetary Policy Committee; Xavier Ramos, associate professor at the Universitat Autonoma de Barcelona;Dave Ramsden, Managing Director of Macroeconomic and Fiscal Policy at HM Treasury and joint Head of the UK Government Economic Service.

1 Introduction and overview

Gabriele Giudice, Robert Kuenzel and Tom Springbett

In the decade between 1997 and 2007, the UK enjoyed strong and stable growth. Gross domestic product (GDP) grew by an average of 3.2% per year, peaking at 4.5% in 2000. Unemployment fell from its peak of 10.4% in 1993 to 5.3% in 2007. The same year, government debt was 44.5% of GDP and the deficit was 2.7% of GDP. However, this strong growth performance masked emerging imbalances, in particular: (i) greater-than-average reliance on household consumption growth to propel GDP, leading to an increasing current account deficit;¹ (ii) a large increase in household debt linked to the housing boom and falling saving rate; and (iii) a fiscal position which, although within the limits for deficit and debt set in the Stability and Growth Pact, failed to take into account the large cyclical revenues which were flattering the overall balance.

After many years of persistent and exuberant growth in the so-called Noughties, the correction that arrived was much tougher than expected. UK GDP first contracted by 1.1% in 2008 and then by 4.4% in 2009. The trigger was the international financial crisis to which the UK was particularly exposed because of its large, globally integrated and highly leveraged financial sector and high levels of household debt, particularly in the form of mortgages.

A prominent feature of the pre-crisis decade was the rapid expansion and globalization of the UK financial sector. The seeds of this success had been sown in 1986 with the Big Bang reform of regulation of the City of London. In the following 20 years the City vied consistently with New York for the position of the world’s leading financial centre. UK banks also became much more leveraged than in the past. Between December 2000 and December 2007 median leverage² of British banks rose from 21 to 35. Between 1960 and 1999 it had averaged 19, peaking at 25 in 1984.³ This high leverage, coupled with their reliance on short-term funding and exposure to risky repackaged loans, left the banks vulnerable to financial market disturbances.

The crisis triggered serious liquidity and solvency problems for several UK banks. The UK government intervened decisively to support the sector, nationalizing Northern Rock, taking large equity stakes in Royal Bank of Scotland and Lloyds Banking Group, breaking up Bradford and Bingley and providing extraordinary additional liquidity to the whole sector, mainly through the Bank of England. The Bank also implemented unprecedentedly loose monetary policy, reducing the main policy rate to 0.5% and engaging in a £275bn (19% of GDP) programme of quantitative easing. After the nadir of the crisis, banking solvency ratios recovered sharply, assisted significantly by government support.

Private-sector debt in the UK was also very high, especially by European standards, reflecting in particular the indebtedness of the household sector, at 107% of GDP vs. 70% in Europe in 2008. By contrast, UK non-financial corporation debt was, at 132% of GDP, close to the European Union (EU) average of 126%. High household indebtedness was mainly due to a high stock of mortgage debt: in 2009 household loans secured on dwellings were 78% of total loans to households. This high level of indebtedness made households vulnerable to unexpected falls in income and in the value of their collateral. When the crisis hit, the rapid growth in household consumption, which had done so much to drive pre-crisis growth, went into reverse.

Both the financial and the household sector were very exposed to the housing market, a factor that exacerbated the UK’s crisis experience. Average nominal house prices doubled between 2000 and 2007. While the UK’s strict planning laws prevented this price increase from causing a construction boom it did help drive a large increase in household debt as first time buyers were forced to take on more debt to buy houses and some existing owners borrowed more against their increased housing equity.

There was a clear link between rising house prices and rising household debt since the majority of the increase in debt was in the form of mortgages. The link between house prices and the UK’s domestic consumption boom is less certain. It could be that both were caused mainly by strong consumer confidence and access to cheap credit, as consumers found themselves more able to borrow for house purchases or current consumption and less worried about a job loss or other negative financial event making them unable to service their debt. The Bank of England (2001) provided a useful examination of the theory and early empirical evidence from the early days of the house price boom. It pointed out that UK households cannot, in aggregate, realize an increase in housing wealth by selling housing assets because, unlike financial assets, UK houses are not widely traded on international markets. However, households can take advantage of increased housing equity to increase their secured borrowing, which is typically cheaper than unsecured borrowing. A model can be defined under which this phenomenon allows rising house prices to feed into increased housing investment and household consumption. As such, it seems likely that rising house prices did at least reinforce the UK’s pre-crisis consumption boom.

The interaction between the financial and household sectors through the housing market also had significant implications for the public sector. After years of strong revenues from property transaction taxes and corporate taxes on the financial sector, the near-collapse of the banking sector and the sudden drop-off in property transactions had a dramatic impact on the public finances. The government deficit rose by 8.5 percentage points in two years to 11.2% of GDP in 2009.

In the external sector, UK net exports deteriorated steadily throughout the pre-crisis decade, with a surplus in (mainly financial) services more than offset by a large and growing deficit in goods. This decline appears to have been due partly to the strength of domestic consumption and partly to the persistent strength of sterling, with demand for the pound kept high by the UK’s relatively high interest rates. Over the course of 2008 and 2009 sterling depreciated 25% on a nominal effective basis as the interest rate differentials with the rest of the world evaporated and investments in the UK banking sector became less attractive. However, this did not deliver an immediate improvement in UK net exports. Nevertheless, the impact of the depreciation was felt through high imported inflation, which helped push inflation well above the official target of 2% for a long period.

Quarterly growth returned in the final quarter of 2009, though with some volatility, to an average annualised rate of around 1.6%. However, the level of GDP looks likely to remain well below its pre-crisis trend for the foreseeable future. For the UK economy to adapt sustainably to the post-crisis world implies a number of challenges both for the public and private sector.

Consolidation of the public finances is the most pressing. While the UK entered the crisis with low government debt, the high deficit will soon take debt above the EU average. The crisis revealed the unsustainable nature of some pre-crisis tax revenues. The government must now meet the challenge of returning the public finances to balance with output significantly lower than pre-crisis expectations and a particular weakness in previously tax-rich parts of the economy.

The crisis also clearly exposed the weakness in the fiscal framework, which had been considered during the golden decade by many UK politicians and commentators as superior to the European Stability and Growth Pact. While decisive steps have been taken to define a new fiscal mandate and set up the Office for Budget Responsibility to provide the official forecast independent of political influence, the effectiveness of the new UK fiscal framework remains to be tested over a full economic cycle.

In addition, as part of the fiscal consolidation, public investment will suffer cuts in real terms of around 28% by 2014–15 compared to its 2010–11 level. UK public investment has been significantly below the EU average throughout recent history. This has been reflected in relatively poor UK infrastructure, particularly as regards transport. The investment gap closed significantly during the last decade. While it was not realistic to avoid cutting investment given the need for such significant cuts in overall spending, persistently low government investment could constitute an obstacle to growth in the future. Thus, there appears a good case for attaching high priority to public investment, research and development (R&D) and other forms of growth-enhancing expenditure in future spending rounds.

A second challenge for the UK is to ensure financial stability and avoid the formation of new bubbles. While the triggers of the crisis were global, two factors that exacerbated the situation in the UK were the large, globally integrated and highly leveraged financial sector and the overheating housing market. In the financial sector a particular problem, not unique to the UK, was a failure to identify and mitigate risks that were common to the business models of most or all banks, as opposed to idiosyncratic risks associated with any one given institution. Key examples were UK banks’ reliance on short-term funding and implicit underwriting of off-balance sheet vehicles, which were excluded from regulatory capital calculations in spite of banks de facto standing behind them. There were also failures in individual firm supervision. Reducing the risk of such failures in the financial sector in the future and strengthening the economy’s ability to cope if they do happen are thus key challenges for the UK.

Concerning the housing market, a number of issues stand out. First, house price swings have a big impact on household balance sheets. Second, banks providing mortgages are vulnerable to swings in the housing cycle, increasing its economic impact. Third, public finances are vulnerable to swings in housing tax revenues. Fourth, high house prices help explain the large share (around 25%) of the population living in state-subsidized accommodation and the high expenditure (around 1.5% of GDP) of housing benefit for poor households. Reducing the UK economy’s vulnerability to the housing cycle is thus another important challenge.

The UK has already announced reforms in this area. On the supply side, central control of local planning decisions will be largely abolished and replaced with a system of financial incentives to local authorities to allow new house building. On the demand side, the rules governing sales of new mortgages will be tightened to try to do more to prevent lenders from granting mortgages that borrowers cannot afford. This could potentially rein in demand peaks driven by easy credit availability. The new Financial Policy Committee of the Bank of England could also use tools such as increased capital charges on mortgage lending for banks to lean against the building-up of new housing bubbles. An area of housing policy that remains largely unreformed is taxation. Problems with the UK housing tax system, including its regressivity, the volatility of its revenues and its discouragement of transactions have been highlighted by a number of commentators, including the Organisation for Economic Co-operation and Development (OECD 2011) and the Joseph Rowntree Foundation (2011). Reflecting the importance of housing issues to all sectors of the UK economy, there is a case to build on these measures to develop a more comprehensive package of reforms including in the mortgage market and property taxation.

In the labour market, overall post-crisis performance has been much better than might have been expected given the severity of the recession. Unemployment rose from 5.3% in 2007 to 7.8% in 2010. By mid-2011, two years after the most serious UK recession in recent history, unemployment had still not risen above its 1990s average. A number of factors contributed to this apparent paradox, including wage flexibility, which allowed average real wages to fall, labour hoarding by firms, a concentration of job losses in sectors with the highest output per worker, and the success of labour market reforms in the 1990s and early 2000s which reduced structural unemployment.

However, some groups were hit harder than others. Youth unemployment increased disproportionately. Between Q4 2009 and Q4 2010, unemployment of more than two years duration among the 18–24 age category increased by 43.4% compared to 37.2% for the working-age population as a whole. The 16–24 year old age group accounted for 56% of the total decline in employment between the peak in Q2 2008 and trough in Q1 2010, despite representing only 15% of total employees in 2008. A further challenge comes from the approximately 400,000 public-sector job cuts required to implement the government’s challenging fiscal consolidation. While private-sector job creation in aggregate is likely to generate sufficient vacancies to accommodate those losing their jobs in the public sector, their skills may not be appropriate to the areas of the economy growing most quickly, notably manufacturing.

Some longer-standing problems in the labour market also remain to be resolved. Weak work incentives have been a long-running problem for the UK, with high marginal withdrawal rates for those moving off benefits into low-paid jobs and a complex benefits system which makes it hard for benefit recipients to assess how much benefit they would lose if they took a job. These issues can be particularly acute for single parents and second earners. This contributes to the high rate of jobless households with children, which is the highest in Europe at 17.5% compared to 10.2% for the EU as a whole. Combating poverty and promoting social inclusion represents hence a key concern. People in the UK also face a higher risk of poverty than the EU average (17.3% against an EU average of 16.3% in 2009).

Another long-standing issue in the UK that was brought out by the crisis is the low rate of business investment. In the decade to 2007 private-sector fixed capital formation averaged 15.6% of GDP in the UK compared to 17.8% in the EU. During the crisis an unprecedented drop-off in investment brought the ratio down to 11.9% in 2009 compared to 16.2% in the EU. While the UK’s relatively large services sector partly explains its low historical investment record, the differences do not appear big enough to explain the entire gap. A period of strong investment growth could therefore offer a significant boost to the UK economy, both in the short-to-medium term as a support to weak domestic demand and, over the longer term, to help drive productivity gains.

One key driver of this investment weakness during the crisis has been tight credit supply, as banks demanded higher spreads reflecting their desire to deleverage and reduced risk appetite. Whilst it is impossible to split out the effects of lower credit demand and reduced availability reliably, as the Bank of England (2010) points out, the fact that spreads increased⁴ and that some borrowers substituted corporate bond finance for bank credit suggests that tighter supply was the main explanatory factor. Improving credit availability could therefore help significantly in fostering an investment rebound.

Another critical support to final demand in the post-crisis period could be net exports. The external sector subtracted around one percentage point from GDP growth in 2010 as imports rebounded faster than exports. This was surprising given sterling’s significant depreciation in 2008 and 2009. As the majority of UK exports go to the USA and the euro area, it did not benefit from the much more dynamic developments in emerging markets, pointing to the need to rebalance the composition of its destination markets. Restricted credit availability could also have played a role here as banks reduced their provision of trade finance. The government has since decided to broaden the range of products offered by the Export Credits Guarantee Department, which should alleviate this problem. Firms may also have been waiting to see whether sterling would remain at its lower level before deciding whether to increase capacity or to invest time in building an overseas client base. As such, the weakness in net exports since the depreciation is not in itself evidence that a net export rebound will not come eventually, although its timing remains uncertain.

In sum, the UK’s recent economic experience has raised a number of questions, some of them short-term, others more fundamental. Interpretation of this vast boom and bust has focused the minds of the UK’s leading economists, sometimes with the aim of finding a culprit in policy decisions. The extent to which UK policy and institutions were direct causes of its crisis should not be exaggerated. As an open economy and leading participant in financial globalization, the UK could never have come through the crisis unscathed. However, there are aspects of the UK’s crisis experience, and of its strong pre-crisis performance, which yield valuable insights for those who seek to understand the UK economy and to define optimal policies for the future.

A good place to start this assessment is with a detailed analysis of the components of UK growth in the pre-crisis decade. Examining a breakdown of the UK’s main growth drivers in Chapter 2 of this book, Ray Barrell, Dawn Holland and Iana Liadze find that it was productivity gains, rather than growing labour and capital input, that were the most important contributor to UK growth in the decade to 2007, resulting from more integrated and competitive markets. While financial services did play a part in this, their contribution was only around one-eighth of total productivity growth for the period, implying that while the UK benefited more than most from the rapid expansion of the financial sector, it was not utterly reliant upon it. Policy does seem to have played a significant part in driving the UK’s golden decade, with European integration and strengthened competition policy prevalent. This points clearly to key priorities looking forward to secure sustained growth supported by the remaining scope for further integration at European level.

Another important pillar of UK growth was steadily falling unemployment. In Chapter 3, Christopher Pissarides points out that this strong performance was all the ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Contents
• List of illustrations
• Acknowledgements
• Disclaimer
• About the authors
• Preface
• Abbreviations
• 1 Introduction and overview
• 2 Accounting for UK economic performance 1973–2009
• 3 British labour market performance before the crisis, 1993–2007
• 4 Unsustainable consumption: The structural flaw behind the UK’s long boom
• 5 The UK’s external position
• 6 Long-term effects of fiscal policy on the size and distribution of the pie in the UK
• 7 The changing relationship between the UK economy and its banking sector
• 8 Policy efficacy in the crisis, exit strategies and the return of growth
• 9 Disease and cure in the UK: The fiscal impact of the crisis and the policy response
• 10 The government’s strategy for sustainable growth
• Index