Economic Policy of the United Kingdom in the crisis of 2008-2010

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Economic Policy of the United Kingdom in the crisis of 2008-2010

Scientific Paper

Abstract

The global financial and economic crisis of 2008-2010 affected all countries around the world plunging the UK into one of its deepest recession since World War II. The purpose of this paper is to analyze monetary and fiscal policies undertaken by the UK during the crisis. The central argument is that the British government implemented the combination of aggressive expansionary monetary policy and decretive fiscal stimulus to mitigate the crisis. The research was undertaken based on the Internet date of international, European and British institutions as well as research papers of renowned think tanks and scholars in this field. The scientific and deductive methods were used. Key findings demonstrated that the government targeted its efforts at addressing system wide instability, tackling problems in individual institutions and getting credit flowing through the economy. In international comparisons, the United Kingdom has spent the greatest amount on banking sector stabilization. Bail out measures included bank recapitalization, credit guarantees, state ownership of endangered banks, deposit guarantees and swaps of illiquid assets with the Bank of England. In addition to drastically cutting interest rates the Central Bank had to utilize quantitative easing to stimulate the economy. The seriousness of the situation and ineffectiveness of automatic stabilizers prompted the government also to use discretionary fiscal tools that included support for household consumption, private investment, labour market adjustment and public investment. The research indicated the shift towards a more Keynesian paradigm of fiscal policy as more than half of fiscal stimulus went on supporting household consumption.

Introduction

global financial economic crisis

The financial crisis that started in 2007 and turned into an economic recession in 2008 was considered to be the worst since the Great Depression of the 1930s. Globally reduced access to credit, higher lending rates, falling asset prices and a weakening of economic growth rates have all been linked to the so called `credit crunch'. Growing losses on portfolios linked to the troubled US sub-prime mortgages market have triggered a series of investment write-offs, general loss of confidence and increased uncertainty in the financial services sector.

It was no surprise, that the United Kingdom - a home to some of the most sophisticated financial markets in the world - was particularly hard hit by the crisis. A great amount of articles has already been written on this topic, but the central argument of this scientific paper is to provide a concise explanation of the magnitude of the crisis in the United Kingdom with a focus and in-depth analysis and assessment of various monetary and fiscal policy instruments undertaken during the recession. It also highlights the transmission mechanisms from financial instability to weaker economic growth and provides with some degree of forecast regarding the direction in which the UK economy is headed.

Between 2008 and 2010, which are the years of this study, the UK government and the Bank of England used a combination of expansionary monetary policy and discretionary fiscal stimulus to respond to the crisis. In terms of the monetary policy and bail out for banks, the authors of this paper aimed at responding in the Discussion Part of the study to the following questions:

· How important is the financial sector for the UK economy and what steps did the government take in order to save financial institutions from collapse?

· What was the role of the Bank of England and how the change of interest rates has helped businesses and households to survive the recession?

· How did the change of the interest rates and Quantitive Easing impact the inflation and employment levels?

The paper highlights the importance of coordination of the government and the Bank of England. Therefore, after having reviewed the monetary policy instruments, the authors also analyzed the fiscal policy undertaken by the government and evaluate its effectiveness in dealing with the consequences of the crisis. With regards to the fiscal policy, the paper answers the following questions:

· Why did the automatic stabilizers not work during this crisis?

· Which particular discretionary fiscal tools did the government use?

· How did the government help to increase aggregated demand and who benefited from the fiscal stimulus package?

· Were there any shifts in fiscal policy paradigm in response to the crisis?

Materials and Methods

The research was done on the basis of the Internet data from various economic resources. Statistical and quantative data was elicited from such organizations as Eurostat, European Commission, IMF, International Labor Organization, the UK Office for the National Statistics and Bank of England. Research papers on financial and economic crisis of prominent think tanks and scholars were analyzed as a means to identify correlations, similarities and differences between current and previous studies in this field. The scientific method was mainly used in this research. The data was gathered, analyzed and transformed as for validating the central argument and answering the stated questions. The qualitative and quantitative methods of gathering data were used in order to analyze tools of monetary and fiscal policies. The observations and statistic information helped to evaluate a number of the consequences and to identify major patterns. Due to deductive methods the general conclusions were drawn down in the research paper.

Results

The financial crisis resulted from bursting of a property bubble boosted by issuing of “sub-prime” mortgages to less credit worthy customers. Then, many of these mortgages were securitised and sold internationally to financial institutions spreading the risk around the world. However, when the houses prices went down, the defaults on “sub-prime” mortgages grew up and the whole system collapsed.

Consequently, the supply of credit from banks and capital markets dried up causing liquidity problem. `The UK's household debt increased significantly since the year 1973 as rising house prices (Fischer 2008) enhanced consumption (Figure 1).' In 2008 the financial crisis turned quickly into economic recession as credits ceased, confidence decreased, the value of savings and pensions fell, and demand declined when firms and households cut down expenses and raised saving levels.

As a result, market stress increased rapidly and fears of further failures rose, leading to the announcement by the UK government of a package of measures to tackle the existing crisis. The government's responses were targeted at three areas: addressing system wide instability, tackling problems in individual institutions and getting credit flowing through the economy. Given the importance of the financial sector for the UK economy, saving the banks from collapse was a prime objective for the government to deal with and the competences were divided between: the Bank of England, the FSA (Financial Services Authority) and the Treasury. `In order to stabilize the banking system, the UK government launched a program worth more than ?500 billion. It consisted of bank recapitalization, credit guarantees, (partial) state ownership of endangered banks such as RBS and Lloyds, deposit guarantees and swaps of illiquid assets with the Bank of England (Andreas Busch, 2008).

The following support measures were aimed at enhancing the liquidity, solvency and funding of financial institutions:

· a governmental intervention was aimed at enabling banks to continue to lend to the economy during the recession and to restore financial stability;

· explicit guarantees covering liabilities were aimed at helping banks maintain access to wholesale funding;

· purchases or guarantees of impaired legacy assets were aimed at helping reduce banks' exposure to large losses'.

In international comparison, the United Kingdom has spent the greatest amount on banking sector stabilization (only Iceland spent relatively more), amounting to more than 50% of its 2008 GDP (Bank for International Settlements, 2009). According to the International Monetary Fund (IMF, 2009), in 2008 the United Kingdom spent about 81.8% of GDP to support the financial sector as it is shown on Table 1.

Table 1: Support for the financial sector as a % of GDP.

Source: IMF, Update on Fiscal Stimulus and Financial Sector Measures, April 26 (2009)

Specifically, the government established a ?50 billion Bank Recapitalization Fund to make capital available to eligible banks and building societies to strengthen their capital ratios, as well as a Credit Guarantee Scheme (up to ?250 billion) aimed at unblocking the interbank money market, and thus providing banks with a guaranteed source of funding and improving the flow of credit to the economy. The government also made ?200 billion available under the Bank of England's Special Liquidity Scheme, which allowed institutions to swap preexisting illiquid assets for Treasury bills over a three-year period, thus providing financial institutions with short-term liquidity' (Andreas Busch, 2008). Lastly, the Asset Protection Scheme was offered. This plan offered banks protection against future losses on certain assets in exchange for a fee, with the intention of allowing the institutions to continue making loans to creditworthy businesses and households.

Simultaneously, the Bank of England pursued a highly aggressive expansionary monetary policy. In particular, the bank cut its interest rate from 5% in October 2008 to 0.5 % in March 2009 (Figure 2). According to Marcel Burkard research, (Burkard, 2010) initially, the Bank of England seemed reluctant to cut interest rates, because the inflation rate was more than 5% (beginning of 2008), well above the target of 2%.

The decision to cut interest rates was yet made, when it became evident that the high inflation rate reflected the impact of higher energy and food prices earlier in 2008; soon (as expected) inflation for the medium term had fallen back significantly (Figure 3). With the economy slipping further into recession, the Bank of England kept on cutting the interest rate every month in the first quarter 2009, taking the official rate to only 0.5%, the lowest rate in the history of the Bank of England.

With the official interest rate near the zero, further stimulus could not be provided through setting the interest rate any lower. Such a situation is also known as a `liquidity trap' (Wikipedia), considering that nominal interest rates cannot fall below zero. The main point of the concept of a liquidity trap is that monetary policy becomes ineffective, because no further interest rate cut is possible. In this situation, the Bank and the Treasury agreed in March 2009 on the need for quantitative easing. The aim of quantitative easing is to boost the supply of money, push up a wide range of asset prices and facilitate finance through the capital markets, thus raising nominal demand in the economy. `Quantitative easing is often considered as a "last resort" to stimulate the economy and it means that the central bank buys up government bonds and private sector bonds, thus literally injecting fresh money into the economy. This is a highly unusual policy for a central bank to pursue and its use is a measure of the seriousness of the situation' (Hadson and Mabbett, 2009). Overall, the Bank has bought ?200 billion of assets financed by the issuance of central bank reserves.

Turning now to fiscal policy, `one of the most striking symptoms (Hadson and Mabbett 2009) of the financial crisis has been a massive increase in borrowing, with the government's net cash requirement soaring from 2.3% of GDP in 2007-08 to 11.5% in 2008-09.' Only Iceland and Greece had higher deficits than the UK in 2009. This change is not the result of the workings of the automatic stabilizers, something that would have been compatible with the government's fiscal framework under “normal” policy-making. Quarterly GDP began contracting in the second quarter of 2008 and subsequently declined more sharply, reaching its lowest point in the first quarter of 2009, -2.6 percent. `As a result of financial bailout (European Commission 2009) of Northern Rock, RBS and other banks as well as recession the national debt of the UK has increased sharply from 43.3 percent in 2005-2007 to 68.4 percent in 2009.' `Increases in general government deficits (IMF 2009) have led the European Commission to institute Excessive Deficit Procedures in relation the UK in June of 2008.'

Taking into account the severity of the situation, the government undertook discretionary fiscal measures in response to the crisis including support for household consumption, private investment, labour market adjustment and public investment.

`Tax cuts account (Crossley, Low and Wakefield 2009) for an estimated 73 percent of the ? 20 billion fiscal stimulus package, with the principal mechanism a temporary cut in the rate of Value Added Tax (VAT), from 17.5 percent to 15 percent, for a 13-month period from 1 December 2008 until 31 December 2009. In order to further support household consumption the government has announced a reduction in the personal income tax allowance for people with incomes over ?100,000 from April 2010.' `Additional support for private households (Busch 2010) included:

· a ?600 increase in the income tax personal allowance, originally announced in May 2008, was made permanent with a further increase of ?130;

· the April 2009 increase in child benefit payments was brought for-ward to January;

· child tax credits were increased;

· all pensioners gained a payment of ?60 that was equivalent to bring-ing forward the April 2009 increase in the basic state pension to January; and

· help for eligible homeowners in difficulty through mortgage rescue and support for mortgage interest schemes.

Unemployment (G20 2010), measured under the International Labor Office definition, rose 2.6 percent points between the first quarter of 2008 and the second quarter of 2009, reaching 7.8 percent (Figure 5). Unemployment rose from 5? percent to 8 percent as a result of the crisis. In order to mitigate this situation and to enhance active labour market policies, the government prepared the white paper on employment, “Building Britain's Recovery: Achieving Full Employment.” In 2009 an estimated ?5 billion was spent on employment-related measures.' It included extended support for short-time working staff, training schemes for unemployed people, support for young people, those with low skills, people with disabilities or health conditions and lone parents and others with caring responsibilities.

`In order to support businesses (Davies, Kah and Woods 2010) the government focused on the provision of loans or loan guarantees to small and medium enterprises (SMEs) as well as venture capital. An important focus was support for exporting, such as enhanced guarantees for existing export credit guarantee schemes. In addition to the above mentioned cuts in VAT a reduction in the taxation of foreign profits as well as more generous tax relief for loss-making businesses were introduced.' Some measures focused on particular sectors including R&D aid and loan guarantees to support investment renewable energies and low-carbon business activities.

In addition, ?3 billion of capital spending was brought forward, involving public investment to support infrastructure. This focus was partly due to the short-to-medium term multiplier effects in terms of demand and employment that were created by infrastructure projectsas well as compensating for the downturn in the housing market which has reduced employment demand in the construction industry. `In connection with this (G20 2010), the government required that successful contractors had apprentices as an identified proportion of their workforce, which could lead to an extra 7,000 apprenticeships in construction alone. National investment funding was focused primarily on schools, social housing, motorways and energy efficiency.'

`To finance the stimulus program (Busch 2010), and in order to offset the effects of the temporary VAT reduction, alcohol and tobacco duties were increased. In addition, fuel duties increased about 2 pence per liter beginning December 1, 2008. In April 2011, national insurance contribution rates for employees, employers and the self-employed will be increased by 0.5 percent. Moreover, from April 2011 onward, a new additional higher income tax rate of 45 percent for those with incomes above ?150,000 will be introduced.'

According to the size (Davies, Kah and Woods 2010) of the discretionary fiscal stimulus package UK was on the seventh place comparing to other countries in the EU zone (Table 2).'

Table 2: Discretionary fiscal stimulus packages, as a percentage of GDP

Source: European Policies Research Centre. Regional Dimensions of the Financial and Economic Crisis. (2010)

This demonstrates that the major stimulus given to the economy was achieved by monetary tools, particularly reviving the supply of credit. `The scale of the discretionary fiscal policy (IMF 2009) response also reflects differences in the impact of the crisis on individual countries, as well as their capacity to loosen fiscal policy given existing levels of public indebtedness.'

Discussion

Based on the collected data we saw that as financial markets collapsed and the global crisis unravelled, the UK was plunged into one of its deepest recessions in the post World War II era. The magnitude of the crisis called for combination of the expansionary monetary policy and discretionary fiscal stimulus. In the existing situation the automatic stabilizers were not effective enough to rebuild business and consumer confidence and to stimulate consumption and investment in order to prevent recession from turning into depression.

The ability of the Bank of England to reduce interest rates so quickly and significantly as the economy moved into recession, reflects the fact, that it was not needed to hold back monetary easing because of concerns about inflation. While there were concerns in 2009 about whether borrowers would indeed benefit from lower interest rates (Sentence 2009), there is now much more evidence that firms and households are seeing lower borrowing costs. In order to check it we compared levels of LIBOR, mortgage and bank rate. LIBOR - which underpins the pricing of a large part of bank lending to business has fallen significantly, mortgage rates have also come down for many borrowers, as can be seen on Figure 6. Lower cost of borrowing has been feeding through to consumers and firms since late 2008 until now.

`Under normal circumstances, imposing such an aggressive monetary policy as cutting interest rates at a historical level of 0,5% alone would have been sufficient to provide a massive stimulus. However, in this case it became clear that interest rate cuts were insufficient for reviving the economy' (Hadson and Mabbett 2009). Quantitative easing seemed to be a radical but a rational move for a given situation. How well was the quantitative easing working? According to Deputy Governor for Monetary Policy at the Bank of England Charles Bean (Bean 2010), there could be seen positive aspects of quantitative easing. `Since it began, investment-grade corporate bond yields have fallen by almost 4 percentage points, equity prices have regained half their losses and capital market issuance has been unusually strong. Finally, nominal demand growth recovered to an annualised rate of around 4%. He said that `we cannot be sure what would have happened without asset purchases, however these movements go in the expected direction'. Some other commentators pointed to the weakness in bank lending and argued that this shows that quantitative easing did not worked. While the substantial increase in bank deposits and bank reserves as a result of the asset purchase programme could indeed encourage banks to extend more credit, such an effect was always likely to be quite weak, as the banks in times of financial difficulties tend to seek to repair their balance sheets and to deleverage.

In fact, some businesses, especially small and medium-sized enterprises (SMEs), could not find it possible to access funds through the capital markets. And that's why, the right response was to get the banks back into a position to lend normally as soon as possible. The array of measures introduced by the Government to support the banking system - described in details in previous section - have all been aimed at that objective and although extremely costly, effectively solved the difficulties with obtaining loans and put the financial institutions back on track.

`One might expect that, after such a sharp downturn, inflation would have dropped back. Indeed, inflation had fallen as low as 1% September 2009. Since then, it has moved up sharply, reaching 3.5% in January 2010'. Deputy Governor for Monetary Policy clarified (Bean 2010) `that volatility in inflation can be explained in terms of a variety of factors impacting on the price level: the restoration of the standard rate of VAT to 17.5%; recent movements in the oil price and a year earlier; and the pass through into consumer prices of the higher import prices associated with the depreciation in sterling.' Despite recent volatility in actual inflation, inflation expectations, according to a variety of measures, have remained stable and reasonably well anchored at levels consistent with the target

Though the monetary policy played the key role in mitigating the crisis, the average size of 2.6 percent of GDP in 2009-2010 of the UK discretionary fiscal measures (Davies, Kah and Woods 2010) was higher than the average equivalent in the EU (1.1 percent of GDP in 2009 and 0.7 percent in 2010) and in the United States (2.1 percent of GDP in 2009 and 2.4 percent in 2010). This finding differs from the assumption of the research conducted by Dermot Hodson and Deborah Mabbett who `stated (Hodson and Mabbett 2009) that discretionary decisions to reduce taxes or increase spending did not account for much of the ballooning fiscal deficit in the UK.'

Moreover, the finding that more than half of fiscal stimulus went on supporting household consumption demonstrates that government was forced to suspend its fiscal rules. The government adopted a Fiscal Code of Conduct in 1998 which committed it to two rules, the so-called Golden Rule and the sustainable investment rule. `The Golden Rule (Carlin and Soskice 2006) states that only investment and not consumption should be financed by borrowing over the course of the economic cycle. Under the sustainable investment rule, public-sector net debt should be stable as a percentage of GDP; the government set this at 40 percent.' The sharp increase in government borrowing and the suspension of the fiscal rules is an indicator of the shift towards a more Keynesian paradigm based on raising expenditure on goods and services or increasing transfer payments. This is well supported by research of S. Lee. `Both Brown and his chancellor (Lee 2009), Alistair Darling, have rediscovered the political economy of [. . .] Keynes.'

The results of the research proved that government measures of temporary cut of the VAT, loans to SMEs and sectorial support of industries were effective and allowed to boost business confidence. This is well supported by the data provided by the UK Office for the National Statistics (Figure 7).

Though the government undertook the multifaceted strategy to support labor face, it has only allowed to slowdown but not to decrease the unemployment rate during the crisis. The recent data of the UK Office for the National Statistics supports this statement (Figure 8).

This should be taken into account because further job losses are expected in the public sector as the government starts implementing its planned budget cuts. The new jobs will have to be created mainly in the private sector and further support of SMEs is indispensible. However, job cuts would worsen the economic situation by reducing demand in the economy and providing less tax revenue.

Results demonstrated that with growing deficit the UK's government was under increasing pressure to lower financing requirements. In the existing situation, support for public investment had the least priority in the discretionary package. The core focus was the energy saving and low-carbon industry. This finding is supported by the research of Jim Brumby and Marijn Verhoeven. `In such a situation (Brumby and Verhoeven 2010), there is a real temptation to cut spending on investment as a first resort, since this is seen as being easier than raising taxes or cutting social expenditure or public service wages and salaries. If pressure on public finances were to become particularly acute, there is a risk that governments might be induced not only to postpone investment in new infrastructure, but also to reduce spending on maintaining existing infrastructure and facilities and to cut down on core social spending.'

Conclusions

The past two and a half years have certainly been interesting for both the UK economy and for policy makers. The consequences of the market crisis demanded swift and decisive government reactions and these can clearly be said to have been forthcoming. If the financial crisis has taught us one thing, it is a lesson that the world economic system is a potentially unstable place and while long periods of relative stability can be achieved, they cannot be sustained indefinitely.

The monetary policy - which was done through the dramatic reduction in interest rates in late 2008 and early 2009 and through the policy of Quantitative Easing - has played a significant role in mitigating the effects on unemployment and living standards. Although, the monetary policy framework worked reasonably well, there are still important policy lessons that can be drawn from the financial crisis and the recession which unfolded from it.

Firstly, the UK monetary policy needs to be reinforced with much closer supervision and analysis of the financial sector and its impact on the activities of households and businesses. In retrospection, more attention should have been paid to the behaviour of the financial sector. There are very important lessons to be learned by banks themselves about their own attitudes to risk and about mechanisms for managing complex financial instruments. It has been now acknowledged that banks need to hold stronger reserves of capital to protect themselves against difficult times, which should reduce or even eliminate the need for the dramatic government interventions in the future. In addition, the crisis has caused banks to become much more cautious about lending, limiting the access of smaller firms and some households to finance and making the terms and conditions attached to new borrowing much less favourable

Secondly, the increasing integration of the global economy should be recognised, with the consequence that an economy very open to international trade like the UK itself is much more vulnerable to global economic shocks. The obvious conclusion which might be drawn especially about global instabilities is the need for more effective international co-operation to address potential problems and UK had some success in the crisis in developing the G20 as a forum for international policy co-ordination, including both developed and developing economies.

The third lesson should be connected to revising the point of view that monetary policy - the setting of interest rates and the control of the money supply - could always successfully stabilise economies in the face of a wide range of shocks. This view led to a false belief in the world of steady growth and price stability. There are limits to the effectiveness of monetary policy and not all economic shocks can be smoothed out successfully with interest rate changes or other tools of monetary policy and this should be always taken into consideration.

By the end of 2008 it became clear that aggressive monetary policy was not sufficient to prevent a sharp contraction of the real economy in the UK. The scale of the crisis as well as preexisting economic vulnerabilities including budget deficit maintained even in times of continuous economic growth, a high level of debt, particularly among private households and the dependence of private consumption on an ever-rising housing market hindered the effectiveness of automatic stabilizers.

Therefore, the government had to respond by introducing a sizeable fiscal stimulus to support aggregate demand. More than half of the entire package was aimed at the support of private households. The key measures included changes in tax rates, including temporary cut in the VAT rate, introduction of additional allowances focusing on children and pensioners, support for mortgage payments in the case of job loss as well as subsidies on the purchase of more energy efficient cars. The bail-out of the labor market was achieved by enhancement of active labour market policies with the aim of assisting unemployed people or workers at risk of losing their jobs to find new work as well as supporting youth and people with disabilities. The government also reduced social security contributions in order to decrease the costs to businesses of maintaining staff in employment, despite the fall in aggregate demand.

The private investment was implemented through a Small Business Finance Scheme, aimed at supporting bank lending to small and medium-sized businesses as well as tax relief for businesses making losses. Public investment funding was mainly focused on development of social infrastructure, renewable energy and energy efficiency. Duties on alcohol and tobacco and fuel were increased to finance the discretionary stimulus package. Moreover, starting from 2011 the income tax personal allowance for those with high incomes, national insurance contribution rates for employees, employers and the self-employed were also increased to further assist in fiscal consolidation.

The monetary policy played the key role in mitigating the crisis, however the average size of the UK discretionary fiscal measures in 2009-2010 was higher than the average equivalent in the EU and in the United States. During this crisis the government fiscal rules were suspended as more than half of fiscal stimulus went on supporting household consumption and public-sector net debt increased far beyond the set limit. This could be an evidence of the shift towards a more Keynesian paradigm of fiscal policy.

The combination of the expansionary monetary policy and discretionary fiscal stimulus allowed to overcome a deep recession, recover major equity markets and return to economic growth in the UK. At the same time such macroeconomic indicators as the rate of unemployment or the size of the budget deficit developed in a rather negative manner during 2008-2010. However, if the UK continues to ensure a sustainable fiscal path, decrease of public debt, implement wide-ranging reforms in the regulation and supervision of the financial system, the economy would return to its steady growth.

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