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Thursday
Sep012016

The lethargic recovery

I was talking today about why I thought the UK's recovery was lethargic, back when we thought that it was (we now think it was signficently better). There's obviously  a number of factors, and I wouldn't paint government policy as the sole determinant. We can split them into 6 main categories:

  • Falling real incomes: Household consumption has been squeezed via low wage increases and high inflation. CPI has been above the 2% target since December 2009 reaching 5.2% in September 2011. As already mentioned huge open ended tax liabilities and tax uncertainty has dampened spending with signs that consumers are factoring future debt burdens into their present consumption choices, “indebted consumers seem more interested in paying down what they owe than splashing out on flat-screen televisions” 
  • Low business confidence: not just because of low demand, but also due to Robert Higg’s concept of “regime uncertainty”. This results from the erosion of investor’s confidence in private property rights, and there is evidence that this occurred in the UK following the crisis.
  • Distressed export markets: since the financial crisis the trade-weighted value of the pound has fallen by about 20%, however 45% of exports go to countries within the Eurozone meaning that the UK is highly dependent on Eurozone growth.
  • Breakdown in financial intermediation: Bank lending has been weak, in large part due to new Basel rules that intend to encourage banks to hold more reserves. Evidence suggests that any gains from quantitative easing were almost totally offset by stricter capital requirements imposed by regulators.  In addition the recession directly followed a banking crisis that resulted in the government nationalising the four largest lenders in the country.  According to Reinhart and Rogoff, “the aftermath of banking crises is associated with profound declines in output and employment” , and the conventional view is that balance sheet repair takes time.  This may especially hold if accompanied by a housing bust – and the UK had one of the largest housing bubbles.
  • Regulatory problems: not only had much of the productive capacity of the economy been hollowed out prior to the financial crisis, there has been little supply side reforms as part of the recovery. The list of regulatory reforms in recent Budgets is underwhelming, treating government investment in infrastructure as being synonymous with supply side growth. Meanwhile airports are constrained by planning laws, housing developers can’t build new housing and small businesses are stifled by red tape.  In addition high marginal tax rates across the tax schedule dampens incentives and hinders growth.
  • Monetary policy mistakes: Similar to the US, interest rates in the UK were kept artificially low in the period building up to the financial crisis creating distortions in the economy. This “malinvestment” sowed the seeds of an inevitable correction, but these problems were compounded by additional monetary policy failures. In terms of the crisis period itself, nominal GDP began to collapse in early 2008 and didn’t reach its pre crisis growth rate of around 5% until late 2010. Some argue that the Bank of England was slow to respond to this – interest rates were 5% in February 2008 and they only began cutting in October (to 4.5%). Quantitative easing didn’t begin until 6 months after the collapse of Lehman Brothers, in March 2009.

In short, there has been a combination of reasons why the UK economy recovered thw way it did. It was vulnerable to a recession and monetary mismanagement compounded fiscal folly. 2008 wasn’t a temporary, irrational pause in spending but a permanent wealth shock.

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