Author: By Sean O’Grady, Economics Editor
Why are we asking this now?
Because the Government is borrowing even more than anyone thought possible.
Yesterday’s official release on the public finances shows that the Treasury
ran an £8bn deficit in July, rather than the usual surplus as people pay tax
bills on account in this month. Other economic indicators, such as figures
on bank lending and retail sales seem to be printing in different
directions. Meanwhile, major economies, such as France, Germany and Japan,
which started their descent sooner, are now emerging from recession earlier
than the UK.
So what went wrong with the public finances?
They are unusually dire, even by recent standards. In July last year, when the
economy was already contracting, they showed a £5bn surplus; that has
reversed by £13bn to a £8bn deficit, partly due to lower tax receipts and
partly down to higher public spending. Central government receipts have
fallen by around 12 per cent on a year earlier; central Government current
spending is up by around 6 per cent on July 2008, and net public sector
investment is up by 39 per cent on this time last year.
This always tends to happen during a recession, these effects being what
economists call “natural stabilisers”, as tax revenues fall with
falling economic activity, and public spending is forced upwards by more
people being unemployed and claiming benefits. In this downturn, however,
there are additional effects. First, the Government is in the midst of
implementing its additional “discretionary” fiscal stimulus of
around £20bn announced in the pre-Budget report last year and confirmed in
the Budget. Thus the big rise in investment spending, and measures such as
the car scrappage scheme will also push the deficit higher at the present.
The Government also cut VAT from 17.5 to 15 per cent and made some
concessions on income tax and stamp duty to help stimulate the economy.
Second, the UK’s tax base had become unhealthily dependent on income from the
booming property market (eg stamp duty and inheritance tax) and from income
tax on those huge City bonuses. As both of these have fallen faster even
than the economy as a whole, so the public finances have suffered
What are the other danger signals?
The banks still aren’t lending, according to all the evidence, including
yesterday’s “Trends in Lending” report form the Bank of England.
Mortgage approvals are up by 26 per cent, but that is from a very low level
and they are down 38 per cent on last year, which was hardly a bonanza in
any case. The good news is that larger companies are now able to go to the
bond and share markets to issue debt securities and shares and raise capital
that way, though this tends only to be an option for the more secure and
creditworthy firms. That should leave more money for the banks to lend to
smaller and less creditworthy companies, but the banks are still worried
about getting their money back from the dodgier credit risks, so they are
still wary of them.
Much the same goes for the mortgage market, where those with lots of equity in
their existing property, or first-time buyers with very large deposits can
obtain finance, albeit at a cost; those who need close to 100 per cent
mortgages or very high loan-to-value advances find the situation as bad as
it has been during the height of the credit crunch. The old adage that the
banks only lend to those who don’t need the money is truer than ever.
Why aren’t the banks lending?
The banks say it’s not a supply issue but a demand one. That’s because there’s
less demand for credit now that firms and households, fearful of their
economic futures, want to pay off their debts rather than take on new ones.
The banks also want to improve their profitability, so they can pay back the
support the Government has given them and get the politicians out of their
hair, so they want to lend less but with better returns.
What about all the money the Bank of England is pumping in?
Indeed. The real mystery is why the money the Bank of England has been pumping
into the economy hasn’t yet fed through to lending in any spectacular way.
On the other hand, by buying gilts the Bank has pushed their price higher,
reduced their yields and made equities and corporate bonds more attractive
to investors, which has helped firms raise money on those capital markets.
The Bank argues that the situation is much better than it would be if it had
never launched the policy in March, which has seen more than £125bn injected
into the economy. Even so, critics say that the banks are “sitting”
on the money, effectively leaving it on deposit with the Bank of England ?
so the impact has been much less than hoped. That may well be why the Bank
decided earlier this week to expand the programme to £200bn and why the
Governor, Mervyn King, and two of his colleagues wanted to do even more,
although they were outvoted. The Bank worries that inflation will sink so
low over the next few months that it may not be possible to boost the
economy sufficiently to see inflation come back up to the official 2 per
Surely something is going right?
Plenty. The fact that France, Germany and Japan are growing again isn’t bad
news for us, but good. Major markets such as theirs can take more of our
exports and will have more money to invest in the UK. So that is one good
thing. Surveys of business and consumer confidence are also on the rise, and
they’re a good predictor, or “leading indicator” in
economist-speak, of changes in the real economy six or nine months down the
line. “Destocking” is almost over, which means shops will stop
selling from stock and start making new orders. The housing market is
starting to stabilise, though a simple shortage of supply could be keeping
prices steady, rather than some sudden increase in demand, which still seems
very weak thanks to the shortage of mortgage finance. Retail sales, so it
was said yesterday, are holding up remarkably well; but some areas have been
doing much worse, such as hotels and restaurants and the motor trade. The
car industry has been helped by the scrappage scheme, and all have been
encouraged by the cut in VAT, but both those measures are essentially
temporary. The concern is what happens when those measures are reversed next
year, and the Bank of England eventually raises interest rates and leaves
mortgage holders with even less money to spend.
This is if the revival in economies such as China’s (which never went into
recession anyway) pushes the price of oil and other commodities higher
again, and panic over government borrowing prompts a serious run on the
pound, already badly devalued. That would mean that inflation starts spiking
upwards again before the UK’s recovery is scarcely underway. In that
circumstance the Bank of England might feel obliged to raise interest rates
to control the surge in inflation, even when the economy is still trying to
get up off its knees. It would be a nasty combination of inflation and
stagnation ? or “stagflation” as it was labelled the last
time it happened, in the early 1980s. Unemployment would still be rising,
and the Government may not be able to borrow more on international markets,
leaving it powerless. Such a crisis could coincide with the general
election. Whoever wins that will face formidable challenges.
Is the economy really recovering?
* The Bank of England is pumping huge amounts of money into the economy
* The rest of the world is already coming out of recession and will drag us
* Consumer and business confidence is returning, according to surveys
* Paying off our £1.4trillion consumer debt overhang and another £800m of
government debt will hamper spending
* The recovery depends too much on artificial stimulus by the Government and
the central banks
* The banks are still broken
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