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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of the United Kingdom published on 29 June 2009.
The world economy was hit by a succession of shocks during 2007 and 2008. The United Kingdom, like most OECD economies, is experiencing a severe economic downturn, and there is enormous uncertainty about the macroeconomic outlook. Since the peak, GDP has contracted by 4.2% in real terms and is projected to contract further, with a decline of 4.3% expected in 2009. Falling house prices and the slump in equity prices will depress household consumption, together with rising unemployment and weak consumer confidence. Business investment will decline owing to the challenging prospects and tight financial conditions. While sterling has depreciated by around 20% in effective terms since 2007, exports will decline due to the sharp fall in external demand. However, imports are expected to fall faster meaning that net exports will contribute positively to growth. The unemployment rate is rising sharply and could be close to 10% by 2010. Monetary and fiscal stimulus, the weaker exchange rate and some recovery in foreign demand should promote a recovery during 2010. But, this will depend critically on whether measures to stabilise the financial system are effective. Even if they succeed, growth is expected to remain well below trend as households and firms rebuild their balance sheets. The pass-through of higher import prices will slow the decline in inflation in the early part of 2009 but the weakness of demand will create substantial spare capacity in the economy, which will lead to inflation well below the official target for some time. The extent of the global downturn on activity is unclear. A slower than anticipated return to normal financial conditions would have a negative impact on the economy. Greater than anticipated declines in house prices could weigh further on consumption and increase the feedback by exerting further pressures on banks' and households' balance sheets. Significant monetary and fiscal policy stimulus is in place, and although it may not prove as effective as hoped, it is possible that the policies will have a faster and stronger positive effect than anticipated.
Figure 1. Recent economic performance
1. Excludes MTIC fraud.
2. Unemployment in per cent of labour force; employment in per cent of working-age population. Includes OECD estimates for working-age population for 2007.
Source: OECD (2009); OECD Economic Outlook 85 database and ONS.
The downturn follows prolonged growth in credit and asset prices, driven by a combination of financial innovation and regulation characterised by some as ‘light’. Growth was strong and macroeconomic volatility unusually low. Although the credit cycle touched many assets and countries, the UK housing cycle was particularly intense: nominal house prices more than doubled in the ten years to their peak. The asset-price and credit boom was self-perpetuating for a time, as easy availability of credit stoked demand and raised asset prices, which in turn increased the value of collateral and engendered further borrowing. In the end, this proved unsustainable. Starting in August 2007, financial market turmoil led to illiquidity in the interbank lending market. As in some other OECD countries, some UK banks were particularly exposed due to their heavy reliance on market finance rather than deposits and their extensive use of securitisation. The Bank of England has increased the availability of funds but liquidity conditions remain considerably worse than before the turmoil began. Since September 2008, the financial crisis has intensified with sharp falls in asset prices; higher interest spreads on lending and a tightening of bank lending conditions. Even with cuts in official interest rates and the exchange rate depreciation, financial conditions continue to have a substantial negative impact on activity. However, since the beginning of 2009, credit conditions have shown some signs of easing.
In response to the severe downturn, the Bank of England has lowered the official interest rate very rapidly to 0.5% in March 2009, an unprecedentedly low level. However, this overstates the degree of monetary easing because the transmission mechanism is impaired by the financial crisis and reductions in the Bank rate have not been passed on fully to the rates facing borrowers. The depreciation of sterling provides additional support but overall financial conditions are likely to restrain activity for some time. With the Bank rate now effectively at the zero bound and given that the downward pressure of the large amount of spare capacity on prices is intense, the Bank of England has begun a policy of quantitative easing. In addition to purchasing some non-financial corporate sector securities, the Bank has embarked on large-scale purchases of government debt in the secondary market using central bank money. This will raise the money supply, helping to boost nominal demand, and stabilise output and inflation. There is significant uncertainty as to what scale of quantitative easing is required to boost nominal demand sufficiently. A policy of quantitative easing is more likely to be effective if the scope of future central bank actions is clearly signalled.
Economic recovery requires that the financial system and the supply of credit are restored. Beyond measures to supply liquidity, the authorities have undertaken a wide range of system-wide policy measures to restore the banking system’s ability to supply credit, including a guarantee of certain securities issued by banks. A fund to recapitalise banks was set up and a scheme to insure banks against losses on certain bad assets introduced. Three banks accepted recapitalisation funds from the government and two of them subsequently merged. Other financial institutions have raised capital from private sources. The same two large banks, one of which is now largely under public ownership, have expressed their intentions to participate in the insurance scheme. These banks have given some undertakings to increase the supply of credit. Moreover, one smaller bank has been fully nationalised, with another split into two with the retail deposits sold to a private sector purchaser and the remainder being wound down in public ownership. The government has also put in place schemes to help small and medium-sized businesses, although these measures are small relative to the stock of credit. These measures have helped to stabilise the financial system, but credit conditions remain very tight.
Restoring the supply of credit requires addressing the ability and the willingness of institutions to lend in a very unfavourable economic environment. Although each financial crisis is different and raises specific issues, international evidence indicates that government support that allows fundamentally weakened institutions to remain in business tends to increase the fiscal and economic costs of crises. It is essential that the supply of new lending is not held back any longer by banks with insufficient capital to meet losses associated with past lending. Recapitalisation and asset protection measures remain appropriate where a bank can function normally with some public assistance. Where institutions are unlikely to be viable, even with substantial assistance, other measures might be required to restore the health and stability of the financial system without undue cost to the taxpayer. The new Special Resolution Regime provides several options for such banks including transferring ownership, a special administration procedure for banks and temporary public ownership. The impact of existing policy measures on the public finances is already very large, both in terms of actual costs and the increase in implicit liabilities.
Although the financial crisis may strengthen the case for additional fiscal stimulus, there is limited room for manoeuvre at the present time. In the November Pre-Budget Report, the government announced a moderate fiscal stimulus package amounting to around 1.4% of GDP in 2009, which included a temporary valued-added tax (VAT) cut to the end of 2009 and an acceleration of already planned capital spending. The 2009 Budget announced further targeted support including for employment and investment. A further deterioration in economic circumstances could require limited additional fiscal stimulus but this must be well-targeted to have a strong effect on demand and to ensure that the long-run impact of the crisis, for example on unemployment, is contained. Any stimulus package must be accompanied by credible consolidation plans. Industry-specific support should be used cautiously, if at all, and reversed quickly to avoid misallocation of resources and damage to long-term productivity.
How to obtain this publication
The complete edition of the Economic Survey of the United Kingdom is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the United Kingdom Desk at the OECD Economics Department at firstname.lastname@example.org.
The OECD Secretariat’s report was prepared by Petar Vujanovic, Sebastian Barnes, Philip Davis and Peter Smith under the supervision of Peter Hoeller. Statistical assistance was provided by Joseph Chien.