Thursday, 7 March 2013

Recessions, Ice creams, and the UK economy

The UK economy is set for a triple dip recession but it may not be the last.

Children love ice cream cones but a chocolate coating makes it even better.  Ice cream can be covered in chocolate not once but twice and a double-dip ice cream cone was a real treat.  It is a pity that recessions don’t work the same way.  This is particularly true in the case of the UK which may be in the midst of a triple-dip recession after real GDP fell in the last three months of 2012.  Even worse than this is that the fear that a weak UK economy may dip into negative growth a few more times this decade. 

A double-dip recession is a relatively common flavour of recession.  It occurs when an economy rebounds after a recession but the ensuing growth is not strong enough to be sustained and the economy weakens again before an upward trajectory is finally achieved.  The reasoning behind such a growth path is that businesses and households will hold back on spending during a recession due to heightened cautiousness and uncertainty about the future but spending will pick up again once the economy seems to be improving.  If the delayed burst of spending is premature or small in size, the boost to the economy is only temporary and growth stalls until the economy has worked through the issues that caused the first recession.

Investments by companies in new factories or equipment are essential for an economy to return to sustainable growth.  But such investments fluctuate considerably depending on the business mood and companies will delay or terminate investment plans if the economy is not strong enough for the companies to earn a suitable return.  So growth will remain feeble with short periods of weak recovery followed by similarly short and shallow recessions.  Such is the background behind the triple-dip recession and why the third consecutive recession in the UK may not be the last.  This weak business cycle with minimal investment in the UK will continue until business confidence is revived.
What makes the state of the economy after a deep recession in the UK different from the plain vanilla type is the hard-to-digest problem of a banking crisis and the bitter tonic of austerity measures.  In the build-up to the global financial crisis, the UK economy was more reliant on its banking sector than most other countries.  High wages earned by employees in the finance sector helped boost spending and a willingness by banks to lend fuelled a real estate boom.  The excesses of the finance sector in the good times amplify the problems that need to be sorted when times turn bad.  The result in this case is that the UK economy is currently suffering from weak consumer spending and a decline in lending by banks.  Reregulation of banking activities has added further complication to sorting out the finance sector. 

The effect of the banks adding to the swings in the economy is further heightened through the government.  The buoyant finance sector provided extra income for the government when the economy was booming.  Not only did this boost of funds to the government quickly dry up after the global financial crisis but the government also had to use up valuable resources to step in to rescue the banking sector.  Having already spent the cash bonus, the government is now having to take money out of the economy in a manner which is the opposite of a fiscal stimulus through its austerity measures.  This is also not a problem that will be easy to sort out and government cut backs are expected to continue through to 2018.

Considering that a “triple-dip recession” is relatively new term, what comes next?  A quadruple-dip recession?  Even if the UK economy manages to survive without slumping to two consecutive quarters with negative growth (the common definition of a recession), years of slow growth are ahead.  The worst case scenario is Japan.  The extent of the economic stagnation in Japan is not measured in the number of recessions but in the number of decades for which there has been no substantial growth.  Japan also suffered a property bubble which triggered a banking crisis but on a larger scale.  Yet, like Japan, the UK still has a lot to do, such as finding the right balance between regulations and increasing lending at banks along with government measures to boost the economy.  Until this happens, hopes for recovery are likely to melt away like an ice cream cone on a hot day.

Friday, 1 March 2013

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest.