The UK macro-economic environment between 2008 and 2011

The UK macro-economic environment between 2008 and 2011

  1. Discuss the macro-economic environment in the UK between 2008-2011 referencing variables such as inflation, unemployment, fiscal policy...

  2. Discuss also the impact of cuts in government public sector spending on employment levels for businesses within the UK

 

Introduction

The essay will identify the concepts relating to macroeconomic variables such inflation, fiscal policy, unemployment and how they relate to each other. It will then discuss these in relationship to the global financial crisis of 2007 and its impact on above variables and UK government spending and the effect on unemployment levels in the UK.

 

Literature Review

In this section, the essay will look at what economic literature says about macro-economic policy in general before looking at it in detail and applying it to the UK economy and reality during the last 3 years.

Macro-economic policy is the study of the behaviour of broad economic aggregates and averages, such as total national output, income, employment and unemployment as well as the average level of all prices (Lipsey & Harbury 1988 p241). In general, there are six issues that fall under macro-economic policy. These are 1) Inflation 2) trade cycle 3) stagflation 4) economic growth and 5) exchange rates and the balance of payments. Government policy is there to manage all these issues though the method may vary from government to government. For example, if there is a recession in the UK (as we will see in subsequent chapters following the global financial crisis), the UK government can increase the level of expenditure, cut taxation to encourage spending and cut interest rates to discourage saving and encourage spending. Alternatively, if there is a boom, the UK government can reduce its expenditure, increase taxation to discourage spending and increase interest rates to encourage saving while discouraging spending. This type of method of controlling the economy would be termed as the Keynesian model, an alternative model to the Monetarist policy which uses the control of inflation as the main priority to control an economy (Lipsey & Harbury 1988).

In subsequent chapters, the essay will look at the global financial crisis of 2007-2008 and how it changed the economic policy of the UK government, looking at what policies were used and their impact on other macro-economic variables such as unemployment as mentioned before.

 

The financial crisis

The global ļ¬nancial crisis (GFC) was originally caused by the systemic failure of the US subprime mortgage market and by September 2008, many of the large ļ¬nancial institutions and banks in the US and the Europe were incurring massive losses. The collapse in the banking system in many nations rapidly led to recession in many economies, resulting in deļ¬‚ation, a sharp decrease in trade, industrial production, share and commodities prices and employment. The financial crisis was also regarded as the most serious in financial history since the Great Depression. As a result of the crisis, many governments intervened through quick and massive rescue efforts aimed at reducing interest rates, following quantitative easing and stimulus investments (Yao and Zhang 2011 p764)

The UK economy was among the hardest hit in Europe when the global financial crisis struck from 2007 as a result of problems with sub-prime mortgages in the US and a bursting of the UK house price burble. It was so catastrophic that it led to the first bank closure in the UK since 1866 and a near collapse of the UK banking sector to a point where most big banks had to be either part or wholly nationalised. The crisis also led the first recession in the UK for more than two decades and the worst in more than 60 years causing heavy unemployment as well as forcing the government to implement policies to try and combat the recession (Hodson & Mabbett 2009).

Over time, variables such as income, employment and investment tend to fluctuate over time. Economies go through 4 economic cycles; 1) Boom 2) Recession 3) Slump 4) Recovery. During all these periods, governments use different policies and methods to manage economies. But the financial crisis of 2007 brought about a paradigm shift away from traditional policies the UK government had normally used in the past. For example, the Thatcher years were characterised by a prioritizing of fighting inflation as a key cornerstone of economic policy for UK growth and prosperity, which is a movement away from monetarism. The New Labour government also continued the move away from monetarism adopting a New Keynesian policy which prioritised the control of inflation at its heart. It even went further though by handing over operational control of monetary policy to the Monetary Policy Committee (MPC) of the Bank of England, a move the markets welcomed in recession (Hodson & Mabbett 2009 p1045).

The financial crisis also led to changes in UK government fiscal and monetary policy. This change in fiscal policy will now be examined below;

 

Fiscal policy

Up until the 1930’s, it was more or less accepted that a prudent government should always follow its budget based on the argument that its prudent behaviour as any household should do. It’s only a foolish household that would spend more than its current revenue even going into debt (Lipsey & Harbury 1988 p314). But this is exactly what the UK government has done for some time now.

In fact, one of the defining features of this financial crisis is the way the UK government turned to borrowing heavily to meet the shortfall for cash which grew from 2.3 percent of GDP in 2007. This change was not a by-product of the workings of the automatic stabilizers, a move that would have suited government’s ļ¬scal framework under ‘normal’ policy-making. To get an idea of the effect of the scale and effect of the stabilizers, one can look at and compare the actual budget deļ¬cit with its cyclically adjusted value. The resulting value suggests that the automatic stabilizers brought about a decrease of about 0.3 per cent of GDP in the ļ¬scal position in 2007–08 and 0.5 per cent in 2008–09-2008 to 11.3 percent in 2008-2009 (Hodson & Mabbett 2009 p1052). To some, this change to heavy reliance on borrowing was a change from normal fiscal policy to almost a radical Keynesian policy based on the political economy of Keynes. But this doesn’t hold water because more than half of the fiscal expenditure occurred not to raise household income or boost demand for goods but to plug the shortfall in credit that had occurred from the crunch. In other words, the financial crisis led the “fiscalization” of monetary policy which in itself was a break from traditional fiscal policy.

This also ushered in the era of cuts in welfare service provision and austerity in general.

 

Inflation

Its important to note that inflation is the rise of general prices. Anything that drives up the prices can be referred to as an inflationary shock while a deflationary shock drives down the price. These shifts can also be down to the demand side or aggregate supply side (Valdez and Molineux 2010).

It’s important to note that the UK recession was underpinned not only by debt but by inflation too. Essentially, the easy access to credit, much of it secured against a housing bubble, was what led to the recession. But central to this was the simultaneous availability of low interest rates and low inflation, more precisely “inflationary pressures that could be ameliorated without posing any threat to historically low interest rate settings. For as long as this persisted, credit was easily accessible on favourable terms. This served to broaden access to – and to improve affordability within – the housing market, driving up prices and leading to both a developing house price bubble and, on the back of that, a consumer boom. Once inflated this was sustained and, increasingly, nurtured by interest rates which remained historically low throughout the boom” (Hay 2010 p393).

Ofcourse this was fine as long as it continued that way without any hiccup, but there was one. The low interest rate-low inflation equilibrium could not be sustained forever and when it collapsed, it brought down with it the whole UK economy and the collapse of the financial sector as banks found themselves at the heart of it (Hay 2010; Valdez 2010).

 

Unemployment and government spending

The unprecedented cuts that the government had to implement to combat the financial crisis especially in public sectors had a profound impact on the UK economy as expected. They affected around a quarter of the public sector and were to be implemented over a five year period. The cuts in public sector spending have already resulted in public sector job redundancies and unemployment. This combined with cuts in the purchasing power of the public sector such as schools, hospitals and local authorities inevitably led to the slowing down further of the UK economy causing a further reduction in aggregate demand. It essentially became a vicious circle because cuts led to unemployment and less spending which reduced demand. The low demand meant businesses couldn't employ more people as they had less consumers thus causing more unemployment (Hay 2010). So the relationship between the high unemployment rates in the UK during the recession can be traced back to the macro-economic policies that the UK government implemented in order to combat the financial crisis, for example, the austerity measures and cuts in public sector spending which led to further unemployment.

 

Conclusion

In summary, the macro-economic environment in the UK has been in turmoil due in small part to the global financial crisis which heralded in the age of austerity. This was rather a necessity, as some argue on the part of the government, in order to “live within its means”. The implications of this were adverse especially the impact on unemployment which rose to some of its highest levels in more than 20 years. The shift between monetarism and Keynesian models of managing the economy were also blurred as the government moved between the two in order to arrive at a satisfactory way of stabilising the UK economy.

 

References

Dermot Hodson and Deborah Mabbett (2009) “UK Economic Policy and the Global Financial Crisis: Paradigm Lost?” Journal of Common Market Studies, Volume 47, Issue 5, p1041 -1061.

Colin Hay (2010) 'Things can only get worse ...': The political and economic significance of 2010” British Politics, Volume 5, Issue 4, p391-401 

Valdez. S & Molyneux. P (2010) “An introduction to global financial markets” 6th Edition. Palgrave Macmillan.

Richard G. Lipsey & Colin Harbury (1988) “First Principles of Economics” Second Edition

Shujie Yao & Jing Zhang (2011) “On Economic Theory and Recovery of the Financial Crisis” The World Economy, Blackwell Publishing

Mark Billings & Forrest Capie (2011) “Financial crisis, contagion, and the British banking system between the world wars” Business History, Volume 53, issue 2, p193 -215 

Financial Times (2007) “Bank warns UK financial sector still 'vulnerable' 25 Oct 2007

Mankiw, G & Tylor, M.P (2010) “Economics” 2nd Edition. South-Western

 

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