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British Economy Not Looking Great

Bhuwan Thapaliya - 1/8/2008

Some economists have questioned whether British economy is heading the American way as the British economy has historically tended to move in line with America's.In America, these days, energy inflation, interest rate cut, banking crunch, and speculations of recession are in fashion. Britain’s economic shine has been losing its shine lately though only nominally, but the worries about the economy abounded after The Bank of England on December 6th brought down the interest rate by a quarter- point, from 5.75% to 5.5% much earlier than expected.

The question now, however, is whether it will prove to be the last. The answer is almost certainly no as most economists are predicting a slow down in growth next year. Various British Statistical reports suggested that growth in Britain would slow from 3.1% in 2007 to 2.0% in 2008. And these are worrying indicators for the British policy makers and most importantly to its central bank, “The Bank of England.”

There have been significant variations in the money supply and interest rates in Britain’s recent history but the latest decision of the Central Bank reflected the two main economic worries of Britain: slowing GDP growth and rising inflation as highlighted by The Economist. Like most nations, Britain too has suffered from the worldwide financial turmoil of the past few months. Credit crunch, rising oil and food prices, deteriorating conditions in the global financial markets had a profound and continuing economic and financial effect on the global economy, and that has led to turmoil in Britain too.

When economists all agree that the financial markets are deteriorating, alarm bells should start ringing. The markets can indeed, of course, deteriorate, and often it deteriorates. However, it is worth asking whether economists may be systematically underestimating the reviving power of the British economy given the strong bouncing back capacity of the British economy.

In the midst of this all British Prime Minister Gordon Brown is confident of the British economy and he went on to declare that UK economy would weather the global financial storms. Mr. Brown insisted inflation was lower in Britain than in the US or Europe, showing that measures this year had been effective. “We stand able to weather the global financial storms and to respond where necessary, as the Bank of England has already done, with a cut in interest rates," he was quoted as saying by the media reports.

But no matter how Mr. Brown tries to hide the British economic disgust. The fact is this. UK’s current account deficit is widening at an accelerating pace and the U.K.'s current-account deficit widened to a record in the third quarter.

The current-account gap was 20 billion pounds ($40 billion), the most since records started in 1948. “There was a current account deficit of £20.0 billion in the third quarter, equivalent to -5.7 per cent of Gross Domestic Product (GDP), compared with £13.7 billion, equivalent to -4.0 per cent of GDP, in the previous quarter,” according to the Office for National Statistics in London.

The Office for National Statistics in London further revealed that the higher deficit was due to an increase in the deficits on trade in goods and on investment income. Its report stated that, the deficit on trade in goods increased by £3.1billion to £22.6 billion.

Balance of Payments
2007 Q3: UK deficit widens


Annual current account balance

Source: Office for National Statistics

Furthermore, in the currency front, the pound has already dropped 6 percent since rising to a 26-year high against the dollar and against the euro, the pound has declined 7 percent since July. And though there are no plausible explanations of the pound’s temporary sickness, most economists continue to expect it to revive. But that expectation unfortunately ignores a growing gap between the pound’s importance in the world economy and Britain’s economic weight.

And to add to the economic misery, Income inequality has risen all over the world and Britain is no exception when it comes to income inequality. Income inequality in 2005/06 increased compared to the previous year. And according to the experts, this increase is due to greater inequality of earnings and self-employment income, rather than the tax and benefit system. Furthermore, there has been an increase in wage inequality, and particularly an increase in the gap between wages for skilled and unskilled workers, according to the reports.

And how has the widening income gap hampered the British economy? Widening income gap has hampered further consumption expansion and that will worsen the imbalance between investment and consumption. The Institute for Fiscal Studies (IFS) has investigated some of the possible explanations for the higher level of inequality that has persisted since the late 1980s. The IFS found that the income tax cuts of the late 1980s worked to increase income inequality while direct tax rises in the early 1990s - together with the increases in means-tested benefits in the late 1990s - produced the opposite effect.

Meanwhile, in reality what does the interest rate cut means and what causes the interest rates to fall?

Opportunity cost of holding money is its interest rate. It is: other things being equal, the lower the expected inflation rate, the lower are interest rates and the lower, therefore, is the opportunity cost of holding money. An increase in the quantity of money causes interest rates to fall.

With lower interest rates, people increase their expenditure and firms increase their planned investment. Aggregate planned expenditure increases and, at every price level, aggregate demand increases and as aggregate demand changes, the equilibrium level of real GDP and the price level change. And this is what the Bank of England; Britain’s Central Bank is trying to do by cutting its interest rate. It is hoping to raise the aggregate consumer demand and revive its economy.

Does housing prices often rise after Interest Rate reduction? Often it does, but not always. Interest rate reductions lower mortgage payments and thus give potential buyers a confidence and ability to fund a larger amount of borrowing and so offer a higher price for their new home. And this time around by cutting the interest rate, the Bank of England hopes to re-gather the economic momentum it has lost as it knows the role of housing market and its direct impact on the economy. For instance, in 2005, when house prices stalled for a few months, consumption growth slowed to 1.5% and the economy grew by only 1.8%, according to the report published by The Economist.

Meanwhile, everything doesn’t look murky for England. The unemployment rate is falling and there has been a further fall in the number of people claiming Jobseeker's Allowance benefit. The number of job vacancies has increased.


“The employment rate for people of working age was 74.5 per cent for the three months to October 2007, up 0.1 from the previous quarter but unchanged over the year. The number of people in employment for the three months to October 2007 was 29.29 million, up 114,000 over the quarter and up 226,000 over the year. Total hours worked per week were 940.0 million, up 5.1 million over the quarter and up 11.7 million over the year. These figures for people in employment and hours worked are the highest since comparable records began in 1971,” according to the Office for National Statistics

Employment
Rate increases to 74.5%

Source: Office for National Statistics

However, the bad news is that England may be facing new economic vulnerabilities. And surprisingly, new crisis are never like the old ones. New crisis needs new solutions and new solutions take time as well as lengthy deliberation to be properly implemented. For England, that remains the biggest challenge of all. Particularly worrisome in that regard, is the credit squeeze, as most Banks are now lending with caution both to individuals and to firms. And they are charging more for their loans, especially to riskier customers as a backup. In particular, new entrepreneurs, new business firms and small businesses will find it harder to get loans. What that means, of course, is that Britain is highly vulnerable to a growth shortfall.

Should the demands of the British consumer’s shrink- a distinct possibility in the event of a current account deficit, oilflation, and non availability of cheap loans from the bank – Britain would be in serious trouble. Needless to say, this is a troubling message for England but if you are a believer in the coming U.K current account adjustment as the only conceivable way to rebalance its economy, then for Britain it could be the toughest challenge of all.

Even so, at this critical juncture, it seems that the British Policy makers may still be underestimating the possible economic downturn, and the Bank of England too is not expecting a downturn in the housing market to the level of U.S.A. But the Royal Institution of Chartered Surveyors has a harsher story to share.

A report from the Royal Institution of Chartered Surveyors revealed a picture of falling house prices and lower inquiries from new buyers. And if the housing market does turn down decisively, consumer-spending growth is likely to be a lot weaker than the central bank expects. And furthermore, if America slips into recession, and if world’s financial markets deteriorate further, as seems increasingly likely then England would sink further.

However, the economy has proved its resilience in recent years and based on my assessment of Britain’s economy, and upon my simulative analysis using World Bank’s Macroeconomic Model for Britain; I expect the British economy to achieve its targeted soft landing though some harsh economic realities hangs above its head like the sword of Damocles.