UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.

Dips or a Pancake – the UK economy

The UK does not have an official definition of a recession, so the media use the US definition of two consecutive quarters of negative growth in the size of the economy. Measuring the size of the economy is a hugely complex task that takes three to six months to do properly. However the markets and media are only interested in the first estimate that is produced about three weeks after the end of each quarter. Then they only look at the change of that result from the previous quarter – if the answer is less than zero then recessionary conditions are proclaimed, if between zero and one half of one per cent then it is sluggish growth and if above three-quarters of one per cent then Britain is booming. The margin between deep gloom and euphoria is amazingly small – when one adds to this the fact that the average size of error between the first estimate and the final figure is about 0.3%, then it is easy to see why instant newspaper headlines following quarterly GDP data can often turn out to be very misleading.

The first estimate recently published for Q1 2012 UK growth was -0.2%, this followed -0.3% for Q4 2011 and so satisfies the working definition of a recession; worse still because there had been such a poor recovery since the last recession, it can also be called a “double-dip” recession, adding further hyperbole to the headlines. There are at least 11 other EU nations who are also in recession with a few more still to report. For those who follow the detail, the surprise in the data came from construction spending, which had it been in line with expectations would have  brought growth up to +0.1% and prevented the headlines about recession. The National Statistics Office has for some time now had problems in accurately calculating construction spending and keeps changing how they measure it, and when one adds to that the fact that there is normally relatively little construction work done in winter and so substantial seasonal adjustments have to be  made to the data, but that this winter the weather was surprisingly good, then quite frankly nobody will know for some time what the correct numbers might be.

The last 6 quarterly reports have been -0.5%, +0.2%, -0.1%, +0.6%, -0.3%, -0.2% – the most sound conclusion that can be drawn from this is that for eighteen months the economy has been flat and growth has been zero. Within that the public sector has seen slightly negative growth (but only slightly, see here), the private sector has seen slightly positive growth (but not enough to stop unemployment rising) as at home consumers fear for their jobs and in the Eurozone, our largest export market, significant and painful austerity is being imposed. Additionally, loan growth is negative as consumers, companies and banks all seek to reduce their debts and hold more cash, rather than invest for the future.

This “flat as a pancake” picture is likely to continue, but the risks are much more skewed to a worse outcome than they are to a better one. At a zero rate of growth, the economy is very vulnerable to any external shock quickly sending it into recession, and western policymakers have very limited policy options available to mitigate any such shock. Fiscal deficits and debts are already too large and need to be brought lower and so provide no scope for fiscal stimulus, whilst monetary policy has rates close to zero and only further Quantitative Easing as a policy tool which is showing a clear pattern of diminishing returns, each time it gets deployed.

This UK government has only ever had a Plan A, and so is sticking firmly to it, mostly because there are no decent Plan Bs anyway, and has always relied on the rest of the global economy being in a reasonable state. However the pancake is better than the dips.