THE FINANCIAL CRISIS: UNITED KINGDOM – POLICY RESPONSES FROM THE GOVERNMENT

By | May 25, 2013

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Introduction

 

Economic and financial crisis are no longer a strange phenomenon in modern day world. Since the Great depression of the 1930s, the global financial system has witnessed ups and downs frequently nearly every decade or two. While some of the crises are region focused with contagion affects spreading across neighbouring countries (for e.g. Asian Financial Crises affected mainly Asian countries while the Latin American currency crises affected countries in that region, etc.), the recent financial crises were a crises of developed countries which eventually had world-wide contagion affects. The triggering country had been the United States and following the world economy had a negative impact. Below is a graph which is prepared using data from IMF (2009) which illustrates the fall in GDP growth rates following 2007 in the economies across the world.

 

In this report, a critical analysis is presented of the macroeconomic consequences on the British economy as a result of the financial crises and what were the British government’s policy responses in order to mitigate the impact of the crises. It is also analyzed and discussed how effective were these policies adopted by the British government and suggestions for improving the situation is also provided.

The report is structured in a chronological sequence in order to facilitate reader understanding and provide clarity. Following this introduction, a summary and explanation is given regarding the fundamentals of the recent financial crises and the alleged reasons for contagion across the world. Next, a detailed overview is presented over the impact and damage faced by the British economy as a result of the financial crises. The British economy is further pondered upon and the policy responses implemented by the government are considered. These responses are then analyzed and judged for effectiveness. In order to understand the consequences better, a macroeconomic analyses of the British economy is conducted for a period of 10 years prior to the current state of affairs. In the end, a critical analysis is done to evaluate the effectiveness of the policy responses by the British government and recommendations concerning optimal macroeconomic decisions to bring the economy back on track to pre-crises levels are given.

 

The Financial Crisis of 2007 till date

 

From several explanations and arguments regarding the fundamental causes of this crisis, the key blame is put on lax lending practices which created a housing bubble that peaked in the US in 2006 and triggered the crisis. Blumberg and Dawson researched and produced a television documentary in May 2008 covering the events which occurred in this housing fiasco. In Alex Blumberg’s words, “From 2003 to 2006, the housing market was in a classic speculative bubble. Home loans were easy to get, so more and more people were buying houses. The increased demand for houses caused the price to increase. The rising prices created even more demand, as people started to look at homes as investments — investments that never went down in value. In 2003 and 2004, 2005, they didn’t. You could buy a house with no money down, turn around and sell it a year later for in some areas double what you paid. People who’d never invested in real estate before started buying multiple properties as investments.”

Elliot and Baily (2009) suggest that the US government bears prime responsibility for the housing bubble because it strongly pushed a substantial increase in home ownership rates. This effect was significantly magnified because Fannie Mae and Freddie Mac (US House Mortgage providers) were effectively encouraged by the government to take on $5 trillion of housing exposure with minimal capital to cover the risk. The end result was millions of Americans owning houses which they couldn’t possibly afford and the massive demand deeply inflating the house prices. Such a risky credit market is called the sub-prime mortgage market. Those loans, with lower standards and higher risks (and consequently higher interest rates) and where an asset was used as a security became known as subprime mortgage loans.

Magnusson et al (2009) state in their report that in 1994 about 5 % of the mortgages in the U.S were subprime loans whereas until 2006, 21% of the total mortgage originations where subprime and they were accounting for a total sum of about $600 billion.

Magnusson et al (2009) explain the burst of the bubble and eruption of crisis. The subprime crisis became a reality late 2006, as increase in average house prices in the U.S came to a standstill and the market interest rate at the same time rose. This resulted in tightened conditions for mortgage loans on the market and several subprime borrowers found themselves defaulting on paying interest rates and amortization. Moreover, the subprime borrowers lost the choice of refinancing their loans, since new negotiations for loans were under tighter policies, and falling house prices meant lower value of it as an asset for loan security, which was the basis for subprime loans. With borrowers ending up in defaults and delinquencies, banks faced foreclosures. The banks started repossessing the houses, but many were now worth less than the mortgage loans causing huge losses in their balance sheets. There was also a domino-effect because of the number of foreclosures, as more houses were placed on the market the house prices fell further. An additional contributing factor to the falling house prices was the fact that lenders, as previously mentioned, tightened the conditions for loans, which contributed to fewer buyers capable to bid for houses.

Meanwhile, at the other end, investors from across the world were also being drawn into this fiasco indirectly. An unusual new bond called the Collateralized Debt Obligations was being offered to investors and banks all over the world. These CDOs were a combination of high risk uncertain subprime loans which were packaged with some other better secured loans and backed by ‘mortgaged assets’ (houses). The irony was that all ratings agencies such as S&P, Moody’s placed high AAA secured ratings on such bonds. What they all seem to be ignoring was what if the housing bubble bursts and the ‘mortgaged assets’ plummet and lose value. More importantly, on the danger end, these ratings made these CDOs appear to foreign investors as low risk assets when it was otherwise. Promised with high returns, these CDOs were heavily purchased by banks and investors alike, across the world and the virus of the subprime loans spread into the global financial economy. And once the housing bubble burst in the US and defaults spread, the CDOs issuing institutions collapsed spreading panic and bank-runs across the world. The figure below created from data obtained from Securities Industry and Financial Markets Association (SIFMA, 2009) shows the total number of CDOs issued over the period of 2004-2008.

 

 

Source: Data Obtained from Securities Industry and Financial Markets Association (2009)

To understand the concept of CDOs better, let’s look at a chart which I obtained from Gary & Shilling Economic Consultants which explains the CDOs creation.

 

Using explanations from Mauldin (2007), Collateralized Debt Obligation (CDO) was an attempt by investments banks to make it easier to sell lower-rated tranches of Mortgage-Backed Securities (MBS). The CDOs were composed of the BBB-rated tranches and then these investment banks like Lehmann Brothers got the rating agencies to give 75% of such tranches an AAA rating! It is suggested by Mauldin (2007) that foreign investors owned as much as 16% of the total mortgage securities. Mutual funds have about 16%.

Once default rates in the US rose and the Portfolio of Subprime Residential Mortgages lost value and suffered bad loans, the entire chain suffered as the CDOs became worthless and there was panic everywhere. The worst effected countries were the most developed ones. This was owing to the fact that such countries were more credit based economies where mortgages and buying on credit is a common practice. As banks were dried up of liquidity, all credit transactions froze and there were massive defaults. Governments and Central Banks had to provide huge amounts of stimulus money as well as had to nationalize banks to save the global financial system.

With money from all over the world invested in these CDOs and other MBS, the foreclosures in the US banks & financial institutions caused losses across the world for anyone who had an exposure here. Several countries in Europe, particularly in Britain, had large amounts of exposure and banks such as HSBC had to write of billions of US dollars in investments in subprime-related holdings (Coleman, 2008).

United Kingdom – Consequences from the crisis

 

Initially, several European countries including Britain considered the financial turmoil to be a purely American affair. However, this assumption changed quickly as the European economies started suffering (Jackson, 2009).

Uneasiness amongst depositors had led to bank-runs. Northern Rock, a retail bank in UK was the first major causality from the financial crisis. On 13th September 2007, it had announced that it had taken emergency funding from the Bank of England. And then onwards, the UK economy faced several adverse macroeconomic consequences.

There was an impending credit crunch as liquidity dried up and this was evidenced by the fact that the LIBOR rates in UK went as high as 6.7% in the second quarter of 2008. This was considerably higher than the Bank of England’s base rate of 5.7% (Oxlade, 2010). The LIBOR rates were increasing as bank feared their own needs of liquidity and doubted repayment ability of other banks as uneasiness about banks runs prevailed.

Meanwhile, as Hickman (2008) reported that there were growing concerns regarding insolvencies and soaring debt levels amongst the British public. Grant Thornton, the accounting firm estimated that the number of individual bankruptcies reached 120,000 in 2008. More than nine million were estimated to be struggling with mortgage and credit card bills in 2008.

In macroeconomic terms, the British economy suffered its worst recession in 30 years. Subsequent macroeconomic figures are now reported from the British Government’s National Statistics Database (2010) available online. In terms of GDP, the British economy started declining from the Q3 of 2008 and suffered a 6.2% fall in output during the year 2009, which is the worst since 1921 according to Oxlade (2010). It has recovered to a certain extent currently in the year 2010 but still there is pessimism expressed by financial experts regarding consistent recovery.

 

Source: National Statistics Online (2010)

In terms of unemployment, the figures have reached record highs as the government struggled to combat rising unemployment and unemployment benefits (Job Seekers Allowance) costs (National Statistics, 2010). Jobs were lost across a range of sectors with the hardest hit being the finance, construction and property consulting sectors (UK Economy, 2009). The unemployment rates had stabilized since mid 2009 but have not returned to pre-crisis levels.

 

Source: National Statistics Online (2010)

The UK government’s borrowing and public expenditures deficit is at an alarmingly high level. The British government had engaged in bailing out troubled financial institutions (will be discussed later in policy responses) and this had surged the level of public debt. This policy had widely led to public dissatisfaction with the way the government had handled tax payer money. The then opposition leader of British Parliament, David Cameron, had claimed this to be the highest level of national debt since the formation of Bank of England three centuries ago (Global Economic Crisis, 2009).

 

Source: National Statistics Online (2010)

The UK’s balance of trade account also slipped deeper into deficit even though the sterling had lost a lot of value since its pre-crisis levels. However, this depreciation in currency had not helped to improve the position of the account. In fact, the deficit put greater pressure on the exchange rate. This had gone against earlier predictions that a fall in sterling’s value shall help improve the position on the balance of trade account in the year 2009 (UK Economy, 2009).

UK Balance of Trade deficit percentage

Source: National Statistics Online (2010)

As far as inflation is concerned, the British economy experienced deflation in much of 2009 before turning positive again in 2010 and currently is at stable levels.

 

Source: National Statistics Online (2010)

 

The interest rates by the Bank of England are kept at record low levels in order to encourage consumption and so hope for revival of the economy. Using data from the Bank of England, the bank rate graph is drawn below. Since March 2009, the rate has continually been kept at 0.5%.

 

Percentage change in bank discount rate source: Bank of England

 

The exchange rate has lost considerable value and experienced depreciation as high as 26% since pre-crisis levels. The graph below is again drawn using data from the Bank of England’s website and shows the percentage movement of the British Sterling Pound since Jan 2007 till date.

 

Source: Bank of England Online (2010)

The house prices in UK also suffered a severe downturn falling throughout 2008. They had reached peak levels during 2007. Falling house values further put pressure on house owners who had taken mortgages with the aim of quickly profiting and selling off their mortgage properties as soon as prices doubled or increased significantly. However, with falling house prices, such individuals were on verge of insolvencies. The falling graph is constructed using data from Nationwide (2009). It shows comparisons between data values from Halifax and Nationwide.

 

 

Along with all these economic catastrophes experienced during the financial crisis, London, the capital of UK also experienced several angry protests against the government and its handling of the economic crisis. One of the major protests was during 1st and 2nd April 2009 G-20 leaders meeting held in London. Protests had also begun to get violent as police clamped down on the protesters and ugly scenes were witnessed. Following is a picture showing a protest crowd in London during the G-20 meeting (Wikipedia, 2009).

 

 

Nearly 180 people formally lodged complaints against being inflicted with bodily injury by authorities during protests (New York Times, 2009)

United Kingdom – Policy responses from the government

 

This section will analyze the government’s macroeconomic policies initiated to counter and mitigate the effects of the impending financial crisis. The three major policies which any capitalist government makes use of to control the economy are the fiscal, monetary and supply side policies. Fiscal policies are policies where tools of the government to influence the economy are taxation and its own public spending. Monetary policies consist of tools of the interest rates and money supply as well as exchange rate valuation to a certain extent. Supply side policies are tools which encourage expanding output and production in an economy with the overall objective of achieving different macroeconomic targets. As the financial crisis loomed ahead, the British government also introduced several policies with the aim of mitigating the effects. This section will list and analyze the policies.

 

Fiscal Policies

 

From the fiscal side, in order to curb falling demand and contraction in economy, as well as to protect the major banks from being bankrupt, the British government took several expansionary fiscal steps. The government had decided to introduce several schemes which provided guarantees to depositors in order to ease panic and eliminate bank-runs. Starting from 17th September 2007 when Northern Rock faced bank-runs, the government guaranteed 100% deposits return for depositors’ in Northern Rock up to 35,000 pounds. This guarantee was eventually extended for all banks on 1st October 2007. The guarantee limit was then increased up to 50,000 GBP by October 2008 (Thain, 2009).

However, the crisis was fast developing. Bowdler (2009) explains that the UK mortgage market resembled closely to that of the US and there was a brewing subprime crisis in the British financial market. Meanwhile, the economic and financial linkages between US and Britain were much stronger than that compared to other European countries. As a result, the British financial institutions faced growing pressures and liquidity crisis was inevitable.

The British government massively swelled its public spending by deciding to nationalise major financial institutions suffering heavy losses on their financial statements. Meanwhile, in order to ease pressure on society, tax cuts were also introduced. Therefore, there was a combination of increased public spending and reduced taxation. Nanto (2009) lists that on 8th October 2008, the British government unveiled a nearly 850 billion USD programme to save its banking sector. This was introduced a day after the British banks lost 17 billion GBP equity value on the London Stock Exchange with the Royal Bank of Scotland facing worst downfall of 39% in a day. Meanwhile, Bank of England also injected 10 billion pounds in the money markets in order to push the LIBOR rates lower and ease credit crunch. This was essential as lenders became risk-averse causing LIBOR rates to increase at a time when liquidity was scarce and badly needed.

This expansionary fiscal policy and the swelling of public deficit would turn out to be a major factor in the British elections which would eventually lead to the demise of the Labour Party and the victory for James Cameron in 2010 British general elections. On November 24, 2008, Gordon Brown’s government tabled a programme in Parliament which intended to stimulate the country’s slowing economy by providing a range of tax cuts and government spending projects totalling 20 billion pounds (about $30 billion) (Mark, 2008). The stimulus package included a 2.5% cut in the value added tax (VAT), or sales tax, for a period of 13 months; also highlighted was a postponement of corporate tax increases, and introduction of government guarantees for loans to small and midsize businesses. The plan also included government plans to spend 4.5 billion pounds on public works, such as public housing and energy efficiency. Werdigier (2008) suggested that this additional spending required by the plan will push Britain’s government budget deficit in 2009 to an amount equivalent to 8% of GDP.

Several other tax cuts were introduced such as 120 GBP tax cut to all basic rate tax payers in UK on 13th May 2009 as well as stamp duty and land tax was abolished on properties valued at 175,000 GBP and lower. Corporation tax rates were also reduced in 2009 from 30% to 28% and there was increased expenditure on accounts of Job Seekers Allowances as people lost jobs amid the contracting economy (Nanto, 2009). The overall impact from liquidity injection to save the financial institutions, increased expenditure on social and unemployment benefits and also tax cuts meant ballooning public deficit. The government spending increased and its revenue from taxation decreased and much of this spending was done through borrowing.

 

Monetary Policies

 

The United Kingdom has relatively enjoyed freedom to engage in monetary policies as it remained independent from the European Central Bank and Euro. The British government pursued expansionary and conventional monetary policy aimed at increasing the aggregate demand to counter falling GDP levels. In order to ease LIBOR and other interest rates in the economy to attempt to limit credit crunch and make funds available, the Bank of England slashed the discount rates by nearly 4.5 basis points within a period of 6months. From approximately 5% base rate in October 2008, the rate was slashed to 0.5% by March 2009. And this rate has continued so since then (Battelino, 2009). This is a conventional method in order to revive investment and spending in an economy and an attempt to discourage saving. This is an expansionary monetary policy aimed to cause an increase in aggregate demand as well as facilitate cheap liquidity availability to corporations and individuals alike.

By excessive borrowing, spending and injections into the financial system, the government was also increasing the money supply in the economy. The borrowing was mainly done from the Bank of England and so crowding out affects were tried to be avoided (Swain, 2009). The Bank of England also engaged in what is referred to as ‘quantitative easing’. This is a method of increasing money supply by actively engaging in asset purchases, insurance schemes, guarantees, etc which increases the asset and liabilities holdings on the balance sheet of the Bank of England (Bowdler, 2009). Thain (2009) gives an example that the assets and liabilities of the Bank of England in early 2007 were £75billion which eventually rose to over £250 billion in late 2008. Measures were also taken to increase the reserve balances on the balance sheet of the Bank of England.

In terms of the exchange rate, the Bank of England refrained from interference and let market forces adjust. The sterling pound saw a nearly 25% depreciation in its value. From exchange rates of 1.5 Euro to a GBP in early 2007, it fell to nearly 1.15 Euro to a GBP by early 2009 (Goddard et al, 2009). Such change is usually welcomed since it makes exports more attractive and cheaper to foreigner buyers while imports appear dearer in the home country. Such depreciation should help improve balance of trade account with a ceteris paribus assumption that exports will increase while imports decrease allowing initially for a J-curve worse off effect.

Supply Side, Trade and Economic Policies

 

The option of supply side policies is usually insufficiently used by governments as the affects of them usually take place over a long term horizon. Najeeb (2010) explains that the economy responds faster to fiscal and monetary changes initiated by governments and the supply side policies are more effective over a long term cycle. However, Najeeb is of opinion that supply side policies are more effective and should be greatly implemented by economies worldwide.

During this crisis, greater reliance by almost all countries had been on fiscal and monetary policies and there is hardly any evidence of real consideration given to supply side policies. In the case of Britain, there are reports of British government introducing more support and training programmes for people who lost their jobs. One example narrated by a colleague in UK states that many bankers who lost their jobs in the financial crisis are now being trained by the government for other professions such as teaching.

From a trading perspective, UK has been engaged in negotiations and collective decision making with European Union, G7 and G20 and other international bodies worldwide. There is also growing concerns about currency wars and artificial currency values maintained by China which negatively affect the trade balances of the western countries. However, in spite, apart from small scale support and talks, there is no major reliance on supply side policies from British government.

 

United Kingdom – A macroeconomic analyses from 2000 till date

 

United Kingdom lists among the developed nations and demonstrates economic characteristics which are equivalent to its peers classified as developed economies. Below is a graph illustrating the GDP levels of United Kingdom from 2000 till 2010.

 

Source: Trading Economics (2010)

The real GDP rates had fallen significantly during 2008 to 2009, however since mid 2010, the GDP rates seem to be normalizing and returning to pre-crisis levels. However, things are not returned to normal levels for the unemployment rates. The unemployment rates continue to be highest in the decade as shown by the graph below. This trend is worrisome as unproductive labour leads to several other problems including rising unemployment benefits costs, lost productivity, social costs and crimes, etc.

 

Source: Trading Economics (2010)

The inflation rate seems to be standard and normal; the government has been able to successfully avoid deflationary concerns. The inflation did reach higher levels during the peak of the bubble before the crisis erupted and then the levels went down nearly to pre-crisis levels 2009 onwards.

 

Source: Rate Inflation (2010)

 

As far as the balance of trade account is concerned, Britain has experienced trade deficits throughout the decade. There have been ups and downs at the deficit levels. The deficit is mainly due to a deficit in the trade of goods while the services trade has always been in surplus. Interesting to note here is the fact that a devalued sterling pound has failed to improve the balance of trade account as in 2010, the levels are actually getting worse off.

 

Source: Trading Economics (2010)

Finally, the UK public debt has continually been on the rise and it has reached record levels at current state. This had been a focal point of argument between Gordon Brown and James Cameron during the recent British elections. The bar graph below shows this case and also gives estimates until 2015.

 

Source: UK Public Spending (2010)

United Kingdom – Critical analyses and discussion on the government’s policy responses

 

Before I discuss the decision making of the government, it is useful to mention the different economic viewpoints of Keynesians and Monetarists. Keynes was a British economist who advocated more government intervention to correct for failures in the market. Taking a simplified version from Pettinger (2008), the situation can be presented as below:

 

Keynes was of the view that during recession there are high levels of demand deficient unemployment and he advocated more government spending to stimulate depressed economies.

The monetarists on the other hand are of the view that the market forces should be left to clear on their own and any attempts by government to influence Real GDP is ineffective and only causes inflation. Below is another simplified diagram taken from Pettinger (2008).

 

The monetarists tend to have the view that the Long Run Aggregate Supply is inelastic and so any attempts to expand the output through government intervention only leads to inflation with no Real GDP expansion.

It is worthwhile to note that during recessions, Keynesian economics are widely in effect and all the stimulus packages and expansionary fiscal and monetary policies represent Keynesian school of economics. The British government has also made use of Keynesian policy of government introducing stimulus to revive the depressed economy. Now it will be analyzed and discussed how well the government has achieved success in mitigating and recovering from the global financial crisis.

 The British government introduced expansionary fiscal and monetary policies to counter the financial crisis. Efforts involved tax cuts, increased government spending, slashing of interest rates and expanding money supply and also allowing of the sterling’s exchange rate to lose value.

From the analyses from the previous section about the British economy, it can be seen that these efforts initially were not enough to prevent the economy from tumbling into recession. The British economy contracted throughout 2009, but however has now stabilized and returned to pre-crisis levels. Also in control are inflation rates and the Bank of England has been successful in avoiding a deflationary situation in the economy.

So does this mean Keynesian school of thought proved valid? The answer is still not clear, since some deep negative marks have also been created in the British economy following these expansionary government interventions. Worrying trends are the unemployment levels and the ballooning public deficit. The unemployment levels continue to remain high causing public and social expenditure to increase and so does the balance of trade account remains in deficit. Keynesian model suggested increased government spending will eliminate demand deficient unemployment; however, the results have not yet been witnessed in the form of lowering of unemployment. Meanwhile, a devalued sterling has also failed to improve the balance of trade position. And the government is already in massive deficit and the new Tory government in Britain aim’s to check on this public deficit which means further government spending is not an option. Thus while the policies have helped recover economic growth levels to pre-crisis levels and also stabilize inflation levels, the unemployment, public debt and balance of trade account deficit remain high.

Another notable critic as presented by Goddard et al (2009) is the huge bank bailouts conducted by British government as well as other governments using tax payer money is morally wrong as the tax payers are made to bear the mistakes made by opportunistic bank executives. This is one of the major reasons of the swelling public deficit of Britain.

United Kingdom – Evaluations and recommendations for future

 

As concluded in the previous section, the British government’s Keynesian motivated expansionary policies have achieved success in reviving growth in economy as well as stabilizing inflation. But they have failed to correct for three major deficiencies; high unemployment, huge public debt and balance of trade account deficit. In this section, recommendations are to be given in order to solve for these issues in the near future.

Following Najeeb’s (2010) advice, it is highly recommended to start focusing on supply side policies on a greater extent for Britain to solve its problems. The British government should provide conditions which encourage retraining and employment opportunities in diverse industries for workers who lost their jobs. They also need to induce more entrepreneurial spirit amongst the British public as it’s commonly established in economics literature that the small and medium enterprises are the more valuable employers in any economy. The fiscal and monetary policies currently in place appropriately support this objective. With lower taxation rates and cheaper availability of credit from government, it is a good time to induce upcoming entrepreneurs to start up ventures and create more employment and economic activity in the economy. Through this, lower levels of unemployment can be achieved and so can output be expanded more. Following this, more consumption and income in an economy means more taxation revenues for the government and lower unemployment claims which can help reduce the public debt.

As far as the balance of trade account is concerned, UK has always enjoyed better export of services and this is an ideal time for UK to capitalize on it taking advantage of the devalued sterling. UK should improve its foreign relations and also smooth its visa procedures with countries across the world. These would encourage more foreign students to take up tertiary education in UK as well as attract more tourists. These two services are very strong selling points and can help inflow of much needed foreign exchange which will help improve the balance of trade account. Meanwhile, encouraging entrepreneurial activity at home shall help expand output with option of exporting products or switching reliance on imports which may also help improve the balance of trade account.

In summary, the reliance on expansionary fiscal and monetary policies has failed to completely revive the British economy and pressing issues remain. The government is advised to make use of supply side policies effectively which are more long lasting and permanent and the fiscal and monetary policies should be supporting the implementation of supply side policies. By effectively tackling and expanding aggregate supply, issues such as inflation, unemployment, public debt, trade deficit, etc can all be addressed. 

 

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