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.

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