Tag Archives | investment

Importance of Bank Lending to UK Economy

Readers Question: What is the importance of bank lending to the UK economy?

Bank lending plays an important role in influencing levels of consumer spending, investment and economic growth.

When bank lending reduced at the start of the credit crunch in 2008 – this decline in bank lending was a significant factor in causing the 2008 recession.


Source: News Release – Quarterly Bulletin 2012 Q4

This graph shows that lending to UK households and business was growing rapidly during the period 2000-2008. However, the credit crunch caused a precipitous fall in the growth of bank lending. Bank lending fell from growth of +10% to negative growth during 2010 and 2011.

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Gross Fixed Capital Formation

Gross fixed capital formation is essentially net investment. It is a component of the Expenditure method of calculating GDP.

To be more precise Gross fixed capital formation measures the net increase in fixed capital.

Gross fixed capital formation includes spending on land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; the construction of roads, railways, private residential dwellings, and commercial and industrial buildings. Disposal of fixed assets is taken away from the total.


Gross fixed capital formation – UK

The fall in Gross Fixed capital formation has been a significant contributor to the recent UK recession.  (contributions to UK growth)

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Investment in UK – Business and Public Sector


Total UK Business investment, slow recovery from 2009. (seasonally adjusted, Current Prices)

business investment growth

Source: ONS Q3 2012

An unconvincing recovery in business investment.

But still, business investment increased by £1.3 billion (4.5 per cent) when compared with the third quarter of 2011.

The outlook for business investment remains muted:

  • Despite low interest rates, banks are maintaining strict lending criteria and rationing finance. Many small and medium sized firms still state finance is difficult to come by.
  • Prospects for economic recovery are poor. The Bank of England’s latest inflation report painted a gloomy picture of an economy struggling to post positive economic growth.
  • With more austerity to come, business and consumer confidence is low.
  • Some reduction in producer price inflation has increased the profitability of business investment. However, commodity prices are volatile and there is no guarantee this low input inflation will continued.
  • Euro-zone debt crisis and EU recession also weigh heavily on UK investment decisions.

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Impact of a Fall in Public Sector Investment

Source ONS | NTV

A possible unit 4 A Level question this summer could be:

Discuss the Impact of a fall in public sector investment on the UK economy?

The graph shows a fall in public sector investment from 3.5% of GDP in 2008  to 1.5% in 2011. This means cuts of approximately £30bn a year.

It means the government is spending less on capital investment projects such as new schools, new roads and other infrastructure investment.

That is quite a significant fall. With a fall in government investment, the first impact will be to reduce aggregate demand, lower economic growth and lead to higher unemployment.

Investment spending in the construction sector also tends to have a high multiplier effect (1.7 – 2.0). This study by RICS claims a multiplier of 2.84 . If there are less investment projects, construction workers will be more likely to be unemployed, and therefore, they will spend less causing a further fall in demand in the economy. Therefore, a fall in investment spending could cause a bigger fall in AD, than the initial cut in government spending.

Furthermore, given the weakness of other areas of the economy, this fall in government spending will lead to a significant fall in AD. If the economy was in robust shape with growing private sector demand and a strong export sector, this fall in public sector spending would not be so serious. But, the UK economy remains in a double dip recession with the uncertainty of the Euro crisis discouraging private sector investment.

One benefit of cutting public sector investment is that it will help reduce government borrowing. In the UK borrowing is forecast to be £123bn in 2011-12. Therefore, without a plan to reduce government spending and deficit, we may see a rise in bond yields as markets are concerned about the rise in government debt. An increase in interest rates would be very damaging for the UK economy given the levels of household debt and fragile nature of spending.

Another argument is that cutting government spending should enable ‘more efficient’ private sector spending and investment. It is argued, government spending can ‘crowd out’ the private sector spending. Reducing government spending helps reduce government borrowing, keeps interest rates low and encourages the private sector to spend and invest.


However, it is debatable whether interest rates would actually rise if the government invested an extra £30bn. Interest rates have fallen since 2008 because there has been a rise in private sector saving and demand for buying secure bonds. The interest rate on long term index linked yields is low at 0.5%. This suggests public sector investment could be finances for a very low annual interest payment.

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