Thursday, April 30, 2009

Is UK Overly Optimistic About Economic Recovery?

Not long after delivering Budget 2009 speech, the Chancellor was mocked by many as ‘Alistair in Wonderland’ when he quoted that British economy will be back on track end of this year. The Labour projected growth of 1.25% next year & 3.2% in 2011, something deemed as overly-optimistic

Perhaps he shouldn’t even have brought up this retarded statistics in the first place, instead comparing the extent of recession UK is experiencing now with other major European economies. For instance, Germany the largest European economy is expected to contract 5.4% this year, Ireland a drop of 9%, Latvia will shrink by 13.1% etc. That will at least ‘distract’ the Conservative & public away from government weaknesses in running the state. Having said so, these figures indicate that British economy is the star-performer, but only among a bunch of sour grapes

Nevertheless, his pure intention was well understood. First, he is trying to preserve the consumer confidence which seems to have made a comeback in March. Secondly, to gather public support given that there will be election next year

Why the growth figure is not-achievable?

(1) ‘Policy-proof’ recession. UK is said to have entered into a period of unprecedented economic downfall. Many leading economists regard this as probably the worst ever recession haunting the British economy after the post-war era. Given the nature of huge & fast contraction, it gained the name of ‘Great Recession’. In the recent Budget 2009, Chancellor Alistair Darling revealed that the government have to downgrade the forecast growth from -1% to -3.5%, also the biggest downgrade ever. All these prove that the recession is so deep that any ‘ordinary’ policy may not work

For instance, Bank of England had cut interest rate for six consecutive times since October last year. Since then, the interest rate is maintained at 0.5% (from April onward), the lowest ever in 315 years since the Bank was founded. Even at such low level, there is no pick-up in economic activities. People are increasingly cautious in their spending. Even with quantitative easing, house prices still fall by 0.4% in April. Fiscal stance is rather blunt as increase in government spending last year does not put a brake to the current recession

(2) Consensus. The National Institute of Economic & Social Research (NIESR), a leading economic think-tank said that British economy could contract by 4.3% this year. If this materialise, that means government’s statistic although have been downgraded a lot from the pre-budget, still proven to be overly-optimistic. Even the IMF boss dismissed Alistair’s claim saying that the figure was brought up with certain intention. In short, the whole world thinks that UK has not seen the worst & there is still space for further contraction. Therefore the forecasted growth will not be met

(3) Limit in future spending. The UK’s national debt as a percentage of GDP had increased dramatically from 2002 to 2007. This was despite the period of long economic expansion. The Labour government is very ambitious in their spending onto healthcare & education to increase productive capacity of British economy. However, it seems to be the gravest fault they have ever committed. They contradicted the common practice of slashing public spending & rise in tax rate in period of boom. Now it’s rather difficult to make a u-turn

David Cameron slammed the Labour administration by using an interesting quote of ‘not fixing the room when the sun was shining’. Nonetheless, national debt have increased at an exponential rate due to reasons like shrinking tax receipts, financial bailout of Northern Rock & RBS, nationalisation of Bradford & Bingley, purchase of shares in HBOS, pension obligations etc. Given such huge current fiscal deficit the future administration will have no alternative but to slash public spending, a painful but necessary decision. As such, the first sign of recovery in near future may be muted due to this

(4) Future tax rise. As expected, there will be several tax rises. The Chancellor tore up the New Labour election pledge by unveiling a new 50% tax rate onto those earning more than £150, 000 from April 2010 onwards. Also he added 2p on fuel, 1p on a pint of beer & 7p on cigarettes which have regressive effect since lower income people spend larger proportion of their income onto these. It will kick in as early as in September this year. Therefore, most average Britons will have lesser income to spend elsewhere like on leisure, food & clothing

(5) House prices. Despite various measures to ease tension in financial system, clearly there is no quick return to easy lending. Banks are still traumatised by the subprime crisis & as such increasingly cautious in approving mortgages. In fact to some extent, they are ‘discouraging’ borrowing activities. Two-thirds of the mortgage deals are only available to those who can put down a deposit worth at least 25% of the property’s value

With such condition, house prices will continue to fall & the negative wealth effect will spread wider into the economy. Base on past trends, house prices could fall for 4 years

(6) Escalating unemployment. Unemployment figure makes the biggest jump in nearly two decades to reach at 6.7%. The jobless total at the day of Budget was 2.1 million, the highest since Labour came to power in 1997. Rising number of jobless people could have a rippling effect onto whole economic system. It feeds through the negative multiplier effect. When the unemployed spend lesser, other businesses around will either make lesser profits, losses or worst went under administration. More unemployment will result. Leading economists claim that the rippling effect is just half way & as such it will break through the psychological barrier of 3 million by the end of this year

(7) Return of deflation. Deflation is defined as a period of falling price level. Arguably it presents more problems itself than inflation. When prices are falling, people will defer their spending say, on property & other consumer goods in expectation that future prices will be lower. So, aggregate demand (AD) will fall. As such in the following months, prices will be lower as predicted & there is a tendency to again adopt wait-and-see attitude. The cycle repeats itself. It is more like a self-fulfilling prophecy. Although rationally people want to make best decisions for themselves, but they didn’t realise that postponing spending will be ultimately disastrous since contraction in real GDP will lead to higher unemployment

The Japanese economy had tasted this under the so called long lost decade. A great recession, when prolonged turned itself into Great Depression. There might be a chance for the British economy to slip into that although the possibility is remote

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