In the last Perspective we discussed how the eurozone economies were diverging. Specifically we discussed the divergence between the peripheral “Club Med” countries – Greece, Spain, Portugal, and possibly Ireland and Italy – and the core economies centring on Germany, France and the Benelux countries. We concluded that the peripheral countries were currently in a policy trap and the consequences would be painful however they tried to release themselves from this trap.

The current debate on Greece’s fiscal difficulties, possible bailout or default or, even, possible withdrawal from the eurozone is but one aspect of the seemingly intractable economic problems facing certain members of the eurozone. Back in the mid-1990s there was a hotly-contested debate about the potential eurozone as a possible optimal currency area in which all members could not just live with, but economically thrive, with the same currency and the same short-term interest rates as set by a European Central Bank. It clearly is not.

The Bank of England’s Monetary Policy Committee will meet this week and the usual announcement will be made on Thursday, 7 January, on their decisions. It is almost universally expected that the Bank Rate will remain at 0.5% and there will be no announcement concerning any further Quantitative Easing. The current plan is to achieve £200bn of QE by the end of January.^1,2  But the MPC could well discuss the merits and demerits of a further tranche of QE with the distinct possibility that, if there is to be one, this will be announced at the February meeting.

In last week’s Perspective we posed the question whether the Pre-Budget Report would primarily be a political exercise.¹ So it proved to be. And, as with the April Budget, the Chancellor procrastinated over the necessary medicine, the required repairs, for Britain’s damaged public sector finances.²

This week’s Pre-Budget Report (PBR) could have more political than fiscal or economic significance. Whilst there is room in the electoral timetable for a March (or even April) 2010 Budget, such an event would be before a rapidly approaching a general election (assuming this occurs in May or June 2010 and not before) which implies that the Government is likely to use the PBR for setting the economic battle-lines for the next election rather than wait until the Budget. 

Last week Eurostat, the Statistical Office of the European Communities, released the third quarter flash estimates for the EU27’s GDP. It showed a 0.2% increase in the quarter. For the euro area (EA16) in general, and for Germany in particular, they made more satisfactory reading. GDP for the EA16 rose 0.4% in the quarter, with Germany experiencing 0.7% growth.¹

There was much consternation when the third quarter GDP data for the UK were released recently.¹ They showed a quarterly fall of 0.4%. This was well short of City expectations of a rise of 0.1%, or even 0.2%, and the "end of recession". Within the total, the production industries and construction showed falls though services, especially distribution, were also weak and made a major contribution to the quarterly decrease.  

Several recent Perspectives have been devoted to the unfolding fiscal crisis.¹ But an issue we have been barely touched on is the implications for the public finances of the ageing population over the next 40-50 years.

The relative shift in economic power from the developed economies to the emerging economies is indisputable. The rise of China and India and the relative decline of European countries have been commented on many times.¹ It is difficult to see how these trends would reverse, especially given Europe’s ageing demographics, and it is reasonable to assume that they will not be reversed.

There is little doubt that one of the greatest economic problems facing the country, if not the greatest, is the state of the public finances. Last week the August figures for public sector borrowing were released and showed a shortfall of some £16bn, compared with borrowing of less than £10bn the year before.¹ Tax receipts have fallen, even after allowing for the reduction in the VAT take because of the cut in the standard rate from 17.5% to 15% last December. Income tax receipts have fallen and the corporation tax take has plummeted. Spending, not least of all social security payments, has increased as unemployment has picked up.

The coverage of last week’s G20 meeting of finance ministers in London was dominated by the debate on restricting bankers’ bonuses and the potential clash between France and Germany on one side and the US and possibly the UK on the other. (There seemed to be some ambiguity on the British part.) By the end of the meeting there was, however, some agreement on matters including disclosure and structuring bonuses to relate to the long-term fortunes of the business. The Financial Stability Board¹ was tasked with the job of devising detailed rules over bonus structures in time for the next G20 meeting of heads of state later this month (24-25 September) in Pittsburgh.

The MPC surprised the markets with their decisions at their last two meetings. At their July meeting they appeared to call a halt to further Quantitative Easing (QE), when the markets were expecting them to announce they would proceed with the further, permitted, £25bn of asset purchases through the Asset Purchase Facility (APF).¹ And at their August meeting they announced not just the extra £25bn - but an extra £25bn on top, making total planned asset purchases of £175bn.²

Britain’s four biggest banks will release their results for the first 6 months of 2009 this week and it is expected that some will declare profits.¹ But this news should not be interpreted as a “business as usual all-clear” for the banking sector and a return to pre-credit crunch “normality”. This clearly is not the situation as any inspection of the latest bank lending data and the, very significant, ongoing problems in the banking sector show.

A recent Perspective discussed the prospects for manufacturing industry. The paper concluded that "it may seem perverse to be discussing a brighter future for manufacturing when it is disproportionately suffering from the current recession. But, reflecting the need for the economy to be rebalanced and the continuing difficulties in the financial sector, manufacturing exports in particular and the sector more generally should play a bigger role in the economy in the future." ¹

Several Perspectives have dealt with the issue of public sector indebtedness and public sector spending in recent months. But as the political debate on the public finances intensifies, it is timely to return to the subject. 

Two months ago I wrote a Perspective on the “green shoots” of economic recovery and how they should be kept in “perspective”. Nevertheless I concluded on the basis of survey data of the services and manufacturing industries, better housing market data and modest improvements in credit availability that, at the very least, the rate of decline was decelerating after the much, much worse than expected falls in GDP in the final quarter of 2008 and the first quarter of 2009.¹

Even though the evidence of “green shoots” is patchy, on balance it does seem that the decline in British economic activity continues to ease.¹ But this should not deceive anyone into believing that Britain’s economic problems are behind us. They are not. As we have discussed before the public finances are truly horrendous, the Budget was a wasted opportunity to start tackling the public sector deficit and there is no sense of urgency in Government about what needs to be done.² Given the fact that a general election has to be called within a year, it is unlikely that any significant decisions will be taken until a new Government is in office.³

 It may seem perverse to speculate about a brighter future for manufacturing industry when the evidence shows that the sector is suffering disproportionately during this recession. In the first quarter of 2009, whilst GDP tumbled 1.9% in the quarter to be 4.1% lower than a year earlier, manufacturing output had fallen 5.5% to be 13.1% down on the previous year. Moreover, the economies that are especially sensitive to the growth in world trade manufactures are experiencing some of the worst declines during this recession.¹ Germany’s GDP fell a worse-than-expected 3.8% in the first quarter of 2009, to give a quite staggering 6.7% year-on-year drop.   

The latest Economic Perspective by Ruth Lea, Economic Adviser to Arbuthnot Banking Group, provides an analysis of last week’s Budget. The Chancellor painted a picture of the public finances for both borrowing and indebtedness that was breathtakingly, shockingly bad.

The economic background to the Budget remains dire, despite the tentative signs that the rate of decline of economic growth may actually now be easing.¹ And it is expected that the Chancellor will radically revise his GDP forecasts compared with those he made less than 6 months ago in his 2008 Pre-Budget Report (PBR). These were widely criticised at the time for being overly-sanguine. The table below compares the PBR forecasts with expectations for 2009 Budget. 

Last week saw some signs that, even though the economic outlook generally remains bleak, there were some tentative “green shoots” sprouting in the British economy. The apparently positive outcome of the G20 meeting probably contributed to the general mood of rising economic confidence – though the direct impact on the world economy, in general, and on the British economy, in particular, is likely to be very modest.¹

Last weekend’s meeting of G20¹ finance ministers and central bank governors, ahead of the G20 meeting of heads of state on 2 April, was widely reported as a conflict between the US, on the one hand, and Continental Europe, on the other, with Britain playing the role of honest broker. The US, goes this scenario, was pushing for Europe to do more by way of a fiscal boost, whereas Europe’s priority centred on reforms to the regulation of the financial system. Europe’s reaction to exhortations to more fiscal activism, especially from Germany and France, was to see how the fiscal stimuli already implemented would play out before considering further moves.  

As the economy deteriorates, there is increasing speculation that the British economy may be facing a Japanese-style period of falling prices or deflation.^1,2 Before taking the debate any further it is essential to be clear about the economic implications of different types of deflation.

During last Wednesday’s press conference on the Bank’s February Inflation Report, Governor Mervyn King hinted strongly that the Monetary Policy Committee would be discussing “unconventional” monetary policy instruments at its next meeting in March (4-5 March). Moreover, there was a good chance that the discussion would lead to their implementation.

The global economic outlook continues to deteriorate. The IMF recently downgraded its forecasts, yet again, and significantly. The sheer scale of the revisions indicates that in the current circumstances economic forecasters and their models, which tend to assume a normally functioning financial system, are flying blind. Despite the press headlines emphasising that the UK will have the worst growth performance of all the major economies this year, caution should be exercised in interpreting the figures.

There are several ways of defining recession. But taking the most usual definition of two consecutive quarters of falling GDP, then Friday, 23 January 2009, should be the day when the British economy is officially proclaimed as being in recession.

On Friday the 4^th quarter GDP preliminary estimate will be released by the Office of National Statistics. It is expected that it will show a substantial fall compared with the third quarter. The National Institute of Economic and Social Research (NIESR) has already published its estimate for the quarter, which shows a drop in GDP of 1.5%, after a revised estimate of a 1.1% fall for 3 months to November (compared with the previous three months). Since 1955 when quarterly figures were first produced there have been only 5 quarters in which output has fallen more sharply.¹

Credit conditions are still tightening

The credit statistics released last week made for difficult reading. Despite the aggressive cuts in official rates and the Government’s support for the banking sector, the Bank of England’s latest Credit Conditions Survey for the 2008Q4 showed a further deterioration in credit availability.¹ 

The year 2008 will go down in history. It is difficult to recall that in the first half of September there were actually some modest and tentative signs that the credit crunch may be easing. LIBOR rates were, for example, modestly ticking down. Such optimism was blown away on 15 September with the collapse of Lehman Brothers and the following financial crisis, which profoundly undermined consumer and business confidence.¹

shocking public finances

The public finance projections in the Pre-Budget Report (PBR) were as bad as expected – if not worse. Even allowing for the fiscal stimulus, which amounted to £9.3bn in FY2008 and £16.3bn for FY2009 (compared with the budget and including the announcements already made since the budget on, for example, the compensation for the losers of the abolition of the 10p tax band), the deterioration since the March Budget was dramatic.

Next Monday’s Pre-Budget Report will an unusually significant one – both politically and economically – reflecting the severity of Britain’s economic problems. The main economic ingredients of the Report will be the economic forecast, the public finances forecast and the “fiscal stimulus measures”.

The third quarter GDP data were dire
The economic news over the last fortnight has been dire. The fall in the third quarter GDP figure, of 0.5%, was significantly worse than the expected 0.2% decline.¹ Most sectors of the economy contracted – with the exception of agriculture (despite the wet summer) and “Government and other services”. The biggest fallers were “distribution, hotels and catering” (down 1.7%) and the production industries including manufacturing (down 1%).  But declines were also recorded in the construction industry, hard hit by the difficulties in the housing market, “transport and communication” and “business services and finances”. They all declined by around ½% in the quarter.

The current crisis in the financial markets, and the banking rescue, has understandably taken centre stage in the recent media coverage of finance and the economy. But as the Chancellor prepares for the Pre-Budget Report, expected next month, the real economy and the public finances will come to the fore. Central to the Pre-Budget Report are the revised forecasts for GDP, other key economic variables and the public finances. This note concentrates on the rapidly deteriorating public finances, which are, of course, partly dependent on our economic fortunes.

Although there are still some details yet to be fleshed out, the overall shape, and size, of the Treasury’s rescue plan is a very considerable step forward in addressing the current problems in the banking system. The collapse in confidence and the freezing-up of the credit markets call for radical policy responses. The current difficulties in the financial markets and the drying up of credit have major recessionary implications for the real economy, at a time when the economy is probably already tipping into recession. It is vital, therefore, that the British authorities, the Treasury and the Bank of England, act to unfreeze the credit market and normalise lending to businesses and households.

To date, the authorities’ policy to combat the worst aspects of the financial crisis had focused on nationalising failed banks, injecting liquidity of increasing magnitudes into the credit markets and raising the level of state guaranteed deposits from £35,000 to £50,000. But the large infusions of funds have clearly failed to stabilize the banking system. Concomitantly, it has become increasingly clear that the current liquidity crisis has had a more fundamental cause than mere shortages of liquidity and funding. And that has been the lending institutions’ fear of insolvency of their counter-parties. Re-capitalisation of the banking system is, therefore, a priority. The Treasury’s rescue plan has, rightly, grasped this issue square on.

The Treasury will make available at least £50bn of new capital in order to re-capitalise banks which have a substantial business in the UK and building societies. Such injections of capital are expected to be in the form of preference shares or Permanent Interest Bearing Shares (PIBS). £50bn is a very substantial sum and should be sufficient to keep the banking system functioning in these challenging times. £25bn is to be made available to the eight major banks that have confirmed their participation in this Government-supported re-capitalisation scheme¹ and at least another £25bn is to be made available for other eligible financial institutions.

There are two other, helpful, parts to the rescue plan. Firstly, the Bank of England will take all actions necessary to ensure the banking system has access to sufficient liquidity. This includes at least £200bn, a doubling, being made available under the Special Liquidity Scheme (which allows banks to swap their mortgage-backed securities and other illiquid assets for Treasury bills). And, secondly, the Government will guarantee new short and medium-term debt issuance to help eligible institutions refinance maturing, wholesale funding issues as they fall due. The Government expects the take-up of the guarantee to be of the order of £250bn.

But the authorities have clearly decided that they must also act to lower lending costs. Today’s announcement of the 0.5% cut, a day ahead of expectation, is another decision that should help confidence and the ailing economy. It is a most welcome move. 

The Government’s rescue plan, by providing much-needed capital as well as unlimited liquidity, should underpin confidence in the solvency of the banks. It is a very big, and comprehensive, step towards the normalisation of the banking system and the unfreezing of the credit markets.

Note

1.      Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland, Standard Chartered. 

The economic prospects and perceptions for Britain have deteriorated significantly over the past month as a new and vicious twist has developed in the credit crunch. It can be said, with little fear of exaggerating, that the current global financial situation is the most severe since the late 1920s and early 1930s

In my last Perspective, I wrote about the changing perceptions of the economic prospects for the US, on the one hand, and of  the Euro Area, on the other.¹ The broad conclusion was that the US, despite the ongoing problems with its financial sector and housing market, had, if anything, performed slightly better than expected a few months ago, whilst the Euro Area had performed worse. The IMF, for example, had recently downgraded its GDP forecasts for the EA15 for both 2008 and 2009 whilst barely altering its forecast for the US. The implication for the dollar (which arguably has been undervalued) and the euro (which arguably has been overvalued) is that the dollar should continue, financial crises apart, to strengthen against the euro.  

Over the last month there has been a marked change in the overall assessment of the Euro Area’s economic prospects and, related to this, the fortunes of the euro against the dollar. Until recently the “consensus view” was that the Euro Area would perform better this year than the US partly because it would be less vulnerable to fall-out from the “credit crunch” (perceived primarily as an Anglo-Saxon problem). It was, of course, accepted that growth prospects in the Euro Area would be damaged by slowdown in the key export markets of the US and the UK and this would be exacerbated by the strength of the euro against the dollar and the pound. But, nevertheless, the Euro Area countries could partly de-couple and perform reasonably well.

The current difficulties of the global financial industry, as it struggles with the “credit crunch”, are still frequently reported in the press. This is of great significance to the people closely involved with the financial sector, obviously, but it also has significance for the rest of the British economy – not least of all because of the knock-on effects on the real economy. But it is also worth noting just how much the City of London’s activities contribute to the economy.¹ If the City fails to prosper, London’s economy and by extension the British economy will be adversely affected.

The British economy: growth is stalling

The recently released second quarter GDP data confirmed a still weakening economy.¹ GDP rose by only 0.2% in the quarter, following the marginally stronger increase of just 0.3% in the first quarter. Construction output, reflecting the contracting house-building sector, fell by 0.7% whilst manufacturing was down 0.4%. “Business services and finance” rose by a paltry 0.1%, compared with a marginally stronger 0.2% in the first quarter. The ONS’s press release contained the explanation that “activities auxiliary to financial intermediation drove the deceleration, which was partly offset by increased growth in computer services and other business services”. In other words, the output of financial services almost certainly fell.

As the British economy slows and inflation rises, hit by the twin problems of the credit crunch and the rapid rise in oil prices, speculation increases that we will experience a nasty bout of “stagflation” or even fall into a true recession. Concerning “stagflation” comparisons are increasingly being made with the horrors of the 1970s. Turning to the possibility of a “recession”, comparisons are increasingly being made with the early 1990s or the 1980s.

Prices inflation is rising

There is no doubt that the economy is caught between the twin toxic affects of the credit crunch, on the one hand, and rapidly rising commodity prices which are feeding into higher consumer prices, on the other. Chart 1 shows just how significantly prices inflation has ticked up over the last 12 months. 

The huge expansion of state spending and the general mismanagement of the public finances have been discussed in previous Perspectives.^{1, 2}

But it is worth recapping the main developments over the past decade as background to this Perspective. The state spending taps were turned on in FY2000 (financial year 2000, 2000/2001) after a couple of years of politically-imposed restraint. Over the decade FY1997 to FY2007, state spending rose in total by over 80% - an annual average increase of over 6% in current prices. This was well above the rate of growth in the whole economy and, as a consequence, the share of total spending to GDP has risen from less than 39% in FY1997 to around 42% currently.³ Even allowing for inflation, the annual average increase over this period was 3½ to 4%, again well above the average growth rate of real GDP. ⁴

The recent increase in crude oil prices has been extraordinary. Between 1999 and 2006 oil prices, in nominal terms, rose from an unsustainable “low” of $10pb to $60pb. Since then they have more than doubled again and recently touched $135pb.

As the chart below shows, even if allowance is made for inflation, current prices are around the levels recorded in the late 1970s and the early 1980s, when supply was disrupted by the Iran/Iraq war. The current developments in the oil market can indeed be designated an “oil shock” – the “2008 oil shock”.

The housing market is now slowing significantly, partly reflecting the persistence of abnormally tight credit conditions. Forecasts for house prices worsen with each revision. And it is no longer unusual to speculate that nominal house prices could fall by as much as 10% over 2008 and a further 5% in 2009.1, 2 In other words, prices in December 2009 could be some 15% lower in nominal terms than in December 2007. This is a substantial drop by any standards. But should this be regarded as a “correction”, after the near tripling of house prices over the past 10 years, or should it be regarded as a “crash”? The terminology used is not unambiguous but the Oxford Shorter English Dictionary defines the terms as follows: • Correction: the action of putting right…errors. • Crash (figurative): a sudden ruin, failure or collapse, especially of a financial undertaking.

EMBARGOED UNTIL 0001 HOURS, MONDAY 5 MAY 2008 

In this latest Economic Perspective Ruth Lea, Economic Adviser to Arbuthnot Banking Group, discusses the feasibility of Britain’s targets for using renewable energy sources.

Britain currently has a diverse mix of energy sources for electricity generation. But the Department for Business, Enterprise and Regulatory Reform (BERR) expects this to change over the next 10-15 years as ageing nuclear power stations are decommissioned and a number of coal-fired power stations are retired in response to the EU’s 1988 Large Combustion Plant Directive (LCPD) that mandates the reduction in acid gas emissions, primarily SO₂ and NO_x, from large combustion units. The gap is expected to be filled by a combination of renewable energy sources and gas-fired generating capacity, with an increasing share of the required natural gas being imported with serious implications for energy security.

The UK is committed, through the EU’s “burden sharing” agreement, to a 15% target for renewable energy in final energy consumption (including transport) by 2020. In 2005 the share was a mere 1.3%. The electricity sector is expected to assume much of the burden of meeting the target because it presents an easy regulatory target. BERR has already estimated that at least 30%, and as high as 45%, of electricity should come from renewables, mainly wind-power, by 2020. The current share is 5%. Britain faces an insuperable task in hitting the 2020 target.

EMBARGOED UNTIL 0001 HOURS, MONDAY 21 APRIL 2008  

In this latest Economic Perspective Ruth Lea, Economic Adviser to Arbuthnot Banking Group, discusses the impact of the current credit crunch, which is intensifying, on the UK housing market.  

There is little doubt that the housing market is weakening and prices are slipping but comparisons with the recent experience in the US are misleading, not least of all because there has been a glut of properties in the US, unlike the UK, and the lending practices in the US were even looser than in Britain. Similarly, comparison with the housing market in the early 1990s can be misleading. In the late 1980s and early 1990s, Britain experienced double digit interest rates, prolonged by membership of the ERM, which undermined both the housing market and the economy. The economy slipped into recession and the housing market crashed. This should not be the situation now.

Ruth Lea said “The impact of the credit crunch on the real economy, in general, and on the housing market, in particular, is intensifying. The housing market is looking very vulnerable. But there is a good chance that an early 1990s-style crash will be avoided. If need be, the Bank can continue to loosen monetary policy this time, inflationary-pressures permitting. In the early 1990s, when the UK was locked inside the ERM, interest rates could not be cut appropriately. Only when the pound was ejected from the ERM in September 1992 could rates be reduced as the economy required.”

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