According to the self congratulatory speeches of Gordon Brown and the New Chancellor, Alistair Darling, the UK Economy is one of the best performing economies in the world.
However, is their cheerful optimism matched by economic reality?

Reasons to Be Optimistic about UK Economy

• Economic Growth: Current Economic growth for 2007 is forecast to be 3.1%. This may be revised slightly downwards, but, it does make the UK one of the fastest growing OECD countries.
• Inflation: CPI inflation is on target. It is currently very close to the government's target of 2%. It is just under at 1.9%
• Economic Cycle: The end of the Economic Cycle? The UK economy has been experiencing its longest uninterrupted economic expansion on record. Since the end of the last recession in 1992, economic growth has been positive. There is even evidence the Long run trend rate of growth (basically the average growth) has slightly increased. With an independent monetary policy the UK seems to have brought an end to the boom and bust economic cycle which destabilised the economy so much in the post war period.

Why Prospects may be Worse than Government Predict

Many experts predict that the government's growth forecasts are over-optimistic. The government itself has reduced growth forecasts to 2.25% for 2007. However, they predict growth will spring back to 3% in 2009 and 2010. Economists argue the government has failed to take into account potential adverse effects on the economy

Potential Problems for UK economy

• House Price Collapse. - If not a collapse, house price growth could fall significantly, this would take a lot of the energy out of consumer spending. - Are House prices set to fall?
  
• Global credit Crunch - The impact of the US mortgage crisis has yet to be fully felt in the UK, despite the recent Northern Rock crisis.
• Recession Possible: It is unlikely we have seen the end of the economic cycle. There is a good chance we will see a much more marked slowdown in growth than the government predict.
• Current Account Deficit. At the moment the current account deficit is 3% of GDP. This is not as serious as the US deficit (at around 6%) but, in the long term it may require a readjustment and lower consumer spending to reduce the deficit.
• Government Borrowing. Despite being at the peak of the economic cycle, government borrowing is already close to breaching the 3% ceiling (imposed by the government themselves.) Any slowdown in growth next year will cause tax revenues to be less than predicted. Therefore, the chancellor may find himself in the unwelcome position of having to increase taxes or limit public sector spending. Something he would hardly like to do before an election. (the government may yet regret not having an election this autumn.
• High Level of Debt. The UK savings ratio is at an all time low. The level of consumer debt is very high (partly caused by rising house prices) This level of debt makes the economy more vulnerable to any interest rate changes. It may mean that consumer spending could fall, when confidence reduces. - Record debt levels threaten UK economy
  
• RPI inflation is 4.1% For those who feel inflation is under control, it is easy to forget that the old measure of inflation, RPI is actually above the government's target. Arguably this gives a more convincing account of inflation because it includes more items than the new CPI measure. Therefore, the persistence of underlying inflation means that the scope for interest rate cuts is much less than many hope for.
  

Conclusion

The UK economy is doing well. However, the budget deficit will be an increasing problem because I feel that the government is being overoptimistic in projected tax revenues. At the moment the chance of a recession is pretty remote, but, with a global slowdown and a decline in house price growth. It is is quite likely growth could be much lower than forecast in 2008 and 2009


Prospects for UK Economy

• The Economy: In this uncertainty a recession is a possibility - at Independent

Labels: UK economy

The Fed recently cut interest rates from 5.25% to 4.75% (sept 18th) The half percent cut took the markets by surprise because they had not been expecting such a large cut.

This also changes many predictions about the future of US interest rates. It suggests the Fed are now concerned about the state of the US economy, and in particular, the US housing market. This suggests they may be willing to cut interest rates further before the end of 2007 and 2008 could see a return to periods of low interest rates.

See: Why the Fed cut interest rates?

A lot will depend on how much this half percent cut in interest rate boosts confidence spending and prevents further falls in US housing prices. My feeling is that it will be insufficient. There will certainly be a time delay before the US housing market returns to steady house price growth.

Also see: problems in cutting interest rates further

Labels: UK economy

factors affecting the international competitiveness and government policies to enhance the UK relative position. and how successive uk gov measures have been

Factors effecting International Competitiveness

1. Inflation

UK inflation has been close to governments target since government made MPC independent in 1997. Therefore, this low inflation has helped increase UK competitivness.
HOwever, low inflation is due to other factors as well as Government

• See reasons for low inflation in UK

2. Increased Productivity

Government has used supply side policies to increase productivity. E.g. education and training.
However, there is a limit to what the government can do to increase productivity. Increased productivity can be due to other factors.

3. Value of Exchange Rate

A devaluation improves competitiveness. HOwever, in recent years the £ has been strong. This suggests it is other factors which have increased competitiveness rather than the exchange rate.

• Government policies to increase competitiveness
• International Competitiveness
  

Labels: UK economy

A current account deficit means the value of imports of goods and services is greater than the value of exports.

The UK has a growing current account deficit. It is currently stands at 3.5% of GDP.

Reasons for this deficit include:

1. Growth in Consumer Spending.

Due to 14 consecutive years of economic growth, a falling savings ratio, rising house prices, and low interest rates, consumer spending in the UK has been increasing. A significant percentage of this consumer spending is on imports (often on luxury manufactured goods). Part of the deficit is called cyclical.

2. Strong Exchange Rate.

Sterling has appreciated against other countries, especially the dollar. The strength of the £ makes exports less competitive and imports cheaper. Demand for exports is less elastic than it used to be, nevertheless a higher value of the exchange rate still reduces the total value of exports.

3. Structural Weaknesses in manufacturing.

Our export manufacturing sector has struggled to compete with low wage countries like China. The process of globalisation has hastened the relative demise of the UK's exporting sector. The deficit on the goods component of the current account is bigger than the overall current account deficit.

4. Deficit is Being Financed

the UK has been able to attract capital flows from abroad. This has financed the current account deficit.

Related

• What Causes US Current Account Deficit?
• Balance of Payments Revision Notes
  

Labels: UK economy

Q. Discuss Reasons for Low Inflation in the UK? (30)

Despite recent increases in inflation, by historical standards, inflation in the UK is very low (3% as opposed to 10% in 1990). Since independence of the B of England, in 1997, inflation has remained close to the governments target of 2% Many feel the MPC has played a pivotal role in keeping inflation low. However, there are also other reasons to consider such as; globalisation, commodity prices and supply side reforms.

Factors explaining Low Inflation in UK

1. Independent Bank of England - MPC

The MPC has sought to maintain low inflation and sustainable economic growth. It has managed interest rates to avoid inflationary growth. If the economy was expanding too quickly interest rates were increased to prevent future inflation. This is known as pre-emptive monetary policy, interest rates increased BEFORE inflation becomes a problem. As a consequence of this policy, growth has been close to the long run trend rate, and this has been a significant factor in maintaining low inflation.
(AD increasing at same rate as AS)

2. Lower Inflation Expectations

Related to the independence of the MPC, is the fall in inflation expectations. Because people expect low inflation it is easier to create low inflation. For example, workers do not bargain for high wage increases. Firms don't expect to be able to pass price increases on. It is a virtuous circle.

3. International Price trends.

It is not just in the UK that inflation has fallen. Other OECD countries have seen low inflation. For example, the process of globalisation has seen falling prices of manufactured goods, often produced in China. Several commodity prices have also been increasing at low rates, although recently they have started to increased.

4. New Technology.

New technology has helped to reduce the costs of firms. Therefore, the AS curve will shift to the right. For example, the internet and improvements in microchip computers have helped to reduce costs for firms.

5. Supply side reforms in the UK.

Supply side policies implemented since the 1980s have helped to reduce cost push inflation. For example, privatisation has seen public companies become more efficient, leading to lower prices. Privatisation was often accompanied by deregulation, which seeks to increase competition and therefore reduce prices. It is hard to quantify the contribution of supply side reforms to reducing inflation, but, they have had a benefit.


Related Posts

• An Evaluation of MPC in controlling inflation
• Forecasts for Inflation in UK during 2007
• Causes of Inflation
• Bank of England - home to MPC
  
• UK inflation - recent trends at tutor 2U
  

Labels: inflation, UK economy

The UK housing market has a significant impact on the UK economy because:

1. 78% of households are privately owned. Home ownership rates are amongst the highest in Europe
2. Housing is the biggest form of wealth in the UK.
3. Mortgage debt accounts for the largest section of UK debt. Average mortgage debt is £21,000 per person.
4. House Prices have a significant effect on consumer confidence and expectations. (house prices and house price predictions are often front page news)

Effect of Rising House Prices.

Those who own houses will see an increase in their wealth. This is likely to increase their confidence, thereby causing higher levels of consumer spending.

In addition, if house prices rise, consumers can increase spending by remortgaging. This means they take out a bigger loan, against the value of their house. This means that the difference between, the current price and their buying price, is available for spend. Mortgage equity withdrawal has been a significant determinant of consumer spending in the UK

Higher levels of consumer spending lead to rising Aggregate Demand and therefore higher economic growth. Consumer spending accounts for 66% of AD, therefore, the effect of rising house prices can be quite significant in determining economic growth.

Higher house prices may cause inflation. This is because, if AD increases then the economy may get close to full capacity, and grow faster than the long run trend rate.

However rising house prices no not necessarily cause inflation. Firstly, it depends upon other factors affecting consumers. For example, if real wages are growing very slowly, or taxes have been increased, then consumer spending will be moderated. Since 2001, House prices in the UK have doubled, however, this has not caused inflation; the reason is that other inflationary pressures have low. For example:

• Independent MPC target low inflation, they have raised interest rates to moderate demand where appropriate
• Real wage growth has been low, (especially in public sector.)
• Low global inflation - helped by cheap manufacturing imports from China, and low commodity prices.
• Improved supply side policies increasing competitiveness of the UK economy.
• UK manufacturing sector in recession.
• UK economic growth close to long run trend rate.

Note: in the 1980s, rising house prices did contribute to inflation (inflation reached over 10% in 1990), because it was combined with loose monetary policy, and buoyant levels of consumer confidence.


Rising house prices are likely to cause a current account deficit. This is because rising house prices increase consumption and therefore consumers will spend more on imports from abroad. Equity withdrawal tends to be spent on luxury imported goods. The UK has a marginal propensity to import. The UK current account deficit recently increased to 3.5% of GDP.

Slump in Housing Market effect on Circular Flow

A fall in house prices will have the opposite effect. Falling house prices will reduce consumer wealth, creating a negative effect on consumer spending and consumer confidence. Therefore, there will be a fall in AD and a reduction in injections into the circular flow. This will lead to lower economic growth, unless other factors override this.

1. Why House prices may continue to rise?
2. How do House Prices effect Consumption
   

Labels: UK economy, UK housing Market

This is an interesting question asked by a reader, (thanks Bhavin.)

With regard to the recession of 1981 I think that the cause of the recession cannot be entirely attributed to Monetary policy.

Reasons for Recession in 1981

1. Structural problems in economy late 1970s.

In 1979 inflation was a significant problem in the UK economy. The inflation was primarily cost push inflation. This was a combination of wage push inflation, caused by powerful trades unions and rising oil prices. To reduce this inflation was arguably necessary for the long term benefit of the economy; to reduce inflation of 20% inevitably leads to some slow down in economic growth.

2. Strength of Sterling.

Normally the increased production of oil would be beneficial for an economy. However in the case of the UK it came at an unfortunate time. The discovery of oil combined with high interest rates caused a significant appreciation in the £. This caused real problems for exporters. It was in the manufacturing export sector where the recession was felt most keenly.

3. Monetary Policy

However, despite the above 2 being contributing factors, monetary policy played an important role in the recession of 1981. The government had a Monetarist zeal to try and control the money supply. Arguably this caused real interest rates to be higher than necessary. Therefore monetary policy caused the recession to be deeper and more lasting than necessary. This is a good example of the limitation of using monetary targets, rather than targeting inflation directly.



Causes of Recession 1991.

In my view the recession of 1991 can be attributed almost entirely to a failure of government macro economy policy. By 1987 the economy was in a good position. Supply side policies were beginning to increase competitiveness and structural inflation had been brought under control. The essential problem was that the government allowed itself to get carried away by the perceived success of its supply side policies. Therefore it allowed the economy to grow much faster than the long term trend rate of economic growth. Therefore inflation was almost inevitable. In response to inflation of 10% the government then overreacted by increasing interest rates to 15%. The failure of macro economic policy was highlighted by using the ERM as a tool for reducing inflation, rather than direct inflation targeting. Again the recession was deeper than necessary because they tried to maintain a value of the exchange rate that was higher than necessary.

In short the government made 2 elementary mistakes.

1. Allowed the economy to grow too fast - Boom and Bust

2. By targeting a high value of the exchange rate, they caused interest rates to be much higher than necessary to reduce the inflationary pressures they had created.


related posts

• Causes of Recession
• UK economy under Mrs Thatcher

Labels: recession, UK economy

When Mrs Thatcher came to power in 1979, the economy was generally considered to be facing severe structural problems including:

• Inflation of 27%
• Powerful Trades unions causing wage inflation and time lost to strikes.
• Unemployment increasing to a post war record of 700,000
• High levels of government debt that required politically sensitive borrowing from the IMF.

On coming to power in 1979, Mrs Thatcher lost no time in seeking to make a clean break with the past. Mrs Thatcher was heavily influenced by the idea of Monetarism and free market economics. In addition, she wished to “destroy” the power of the “Socialist / Communist” trades unions. On coming to power, the first policies of the Conservative administration were to tackle both inflation and the budget deficit.

The belief of Monetarism was that to control inflation you needed to control the money supply. To control the money supply, it was necessary to reduce any government deficit. Therefore, extreme deflationary policies were implemented. Firstly taxes were raised and government spending cut. Interest rates were also increased, as the government sought to reduce inflation. These deflationary fiscal and monetary policies did have the effect of reducing inflation; however it was at a cost of falling Aggregate Demand and lower economic growth. In the middle of 1980 the economy had been plunged into full scale recession, but the government still pursued its deflationary policies. As unemployment reached the unprecedented level of 3 million (1) There was widespread criticism of the government. During 1981, in a famous letter to the Times, 365 economists signed a letter calling on the government to alter its economic policy and put an end to the recession. (3)

With criticism mounting, even from her own party, Mrs Thatcher was under pressure to change course (a little like Edward Heath had in the early 1970s) However, in a now famous speech at the 1980 Conservative party conference, Mrs Thatcher stood up and defiantly said.

”You turn if you want to, but this lady is not for turning.”(2) It encapsulated her stubbornness and resolve. Fiscal policy and monetary policy remained tight, and unemployment remained close to 3 million until 1986.

The deflationary fiscal and monetary policy’s were exacerbated by 2 factors.

Firstly in the early 1980s sterling became an important petro currency; with the production of oil in the north sea. The £ rose rapidly. Combined with rising interest rates, sterling appreciated from £1 to $1.5 to $2.5. This appreciation in the pound adversely affected Britain’s exports and manufacturing sector. It was here, that the UK suffered the worst effects of the 1981 recession.

Secondly, controlling the money supply proved to be much more difficult than theory predicted. Despite rising interest rates and falling AD, growth in the money supply remained stubbornly high. This encouraged the government to maintain a tight fiscal and monetary policy. Inflation fell but the money supply didn’t; the link between money supply and inflation proved to be very tenuous, but by trying to reduce the money supply they reduced AD by more than was necessary.

On the one hand, inflation was reduced, but arguably it could have been done with much less pain. In seeking to meet spurious money supply targets they caused an unprecedented level of unemployment. This unemployment caused not only personal loss but widespread social problems. The mass unemployment, associated with inner cities, was very closely responsible for the riots which sparked across Britain in 1981.

Public anger at the Conservative economic record was to a large extent mollified by the patriotic success of the Falklands War. Riding on the back of a successful military victory, and a Labour party hopelessly divided, Mrs Thatcher was returned to power in 1983; ready for her next challenge - to take on the miners.

References

(1) Highest since Great Depression

(2) BBC 1980 - Mrs Thatcher

(3) Economist letter to Times

• Thatcherite Economics
• Economics, Mrs Thatcher and the British voter at Amazon.com
• Recession of 1991-92
• Causes of Recessions - Economic Theory
  

Labels: Mrs Thatcher, UK economy

After 11 consecutive years of being Chancellor of the Exchequer Gordon Brown is the longest serving chancellor since 1820 overtaking David Lloyd George (2). As Gordon Brown wrly noted as chancellor Lloyd George successfully combined both being chancellor and being PM. In fact his last budget speech sounded in parts like a pre – election budget. – If not a general election at least a leadership election.

Quick Summary of the 2007 Budget

1. Income tax cut from 22p to 20p. This is largely financed by abolishing the 10p starting rate and removing allowances in N.I contributions. – “The tax man giveth and the tax man taketh away.”
2. Corporation tax cut from 30% to 28%. This will largely be financed by raising the tax rate on small business from 20% to 22%. The justification was that it was to avoid people using small companies as a way to reduce income tax burden. However it is strange to increase corporation tax to 22% when income tax falls to 20%. Tax relief on capital investment was also reduced from 25% to 20% this will particularly cost manufacturing firms.
3. Environmental taxes. Road tax on gas guzzlers will double. Tax on petrol will rise above the rate of inflation in the future. This will have quite a limited impact. Evidence suggests raising road tax does little to reduce the demand for SUVs which cost in the range of £20,000 - £30,000. Overall on the environment Gordon Brown can be accused of just tinkering at the edges. It will do little to make the target of cutting CO2 emissions by 70% a reality.
4. Increase in Child Benefit. The reduction in tax credits means many on low incomes have an effective marginal tax rate of 70% (with income tax, NI and reduction of benefits and tax credits)
5. Increase in Pension credits, but the means tested nature of this benefit discourages savings in the long term. E.g. when a single person pension passes £6,100 they have a 40% deduction in tax credit.
6. Economic Record. The economic performance of the UK continues to remain impressive with economic growth edging upto 3% and inflation still on target for 2%. However an interesting question is how much credit will the voters give to Gordon Brown? Polls suggest the Conservatives are ahead in both economic management and perspectives on the environment

To summarise the overall impact of the budget one could use this choice expression of David Smith, economist at the Times.

“This chancellor is like one of those people you shake hands with only to discover a couple of days later you are missing a couple of fingers.” (1)

Labels: Gordon Brown, UK Budget, UK economy

Since becoming Chancellor in 1997 Gordon Brown has presided over the longest period of economic expansion in the UK since records began. He is widely credited for having been a model of fiscal prudence which has allowed the UK to go from the laughing stock of Europe to one of the best performers in the OECD.

Is Gordon Brown Britain’s best chancellor ever? Or is it more a case of being lucky to inherit a promising economic situation? Or is it as some people suggest an opportunity wasted, storing up economic problems for the future?

This is a short economic evaluation of Gordon Browns’ record as Chancellor.

Achievements of Gordon Brown as Chancellor of Exchequer.

1. Independence of Bank of England.

4 days into his job he handed over control of Monetary policy from no.11 to the Bank of England Monetary Policy Committee. This is widely regarded as being a key factor in creating economic stability and a low inflationary environment for the long period of economic expansion. (Note the Conservatives had made moves towards independence, making the step easier to make)

2. Longest Period of Economic Expansion on record.

Economic Growth has averaged 2.8% between 1997 – 2006 also the growth has been remarkably stable, the boom and bust cycles which characterised the 80s and early 90s have been completely avoided. The success of high growth and low inflation has earned generous praise from the IMF and World Bank. The chief economist of OECD, Jean-Philippe Cotis, described Britain as a "goldilocks" economy – This means they had the perfect balance of strong growth and low inflation. "It is in fact surprising how stable the UK economy has been. It is doing very well." (i)

3. Unemployment has fallen to the lowest level since the early 1970s.

In May 1997 the number unemployed was 1.7 million, this has now fallen to 925,000. (However it is worth noting the ILO measure, which doesn’t rely on govt statistics shows a higher figure.)

4. Fiscal Prudence.

On coming to power Gordon Brown imposed a rule of fiscal prudence saying government borrowing should never exceed more than 3% of GDP over the course of the economic cycle. This justified some tough public spending decisions in the early years. However in recent times he has been close to breaking his own fiscal rule due to more extravagant spending on health and education.

5. Avoided potentially difficult economic situations.

Although certain global factors have helped the UK economic performance Gordon Brown would point to potentially destabilizing influences which could have made things worse. For example; the dot com Boom and bust; the housing boom which threatened inflation; and the mild recession in Europe our main trading partner. None of these knocked the economy of target.

6. Inflation on Target.

Inflation has remained within the government’s target of CPI 2% +/-1. This is a remarkable record considering the recent inflation history of the UK. True much of the credit can be given to other sources. But unlike the previous Conservative governments, Gordon Brown never allowed himself to get carried away into thinking there had been an economic miracle. The Conservatives belief the economy could grow at 4%+ in the 1980s caused the boom and bust of the 1991.

7. Avoided Joining the EURO as the Eurozone went into recession.

His 5 economic tests were designed to prevent premature entry. There seems little interest in reviving such as idea. The UK has not been burdened with an interest rate unsuitable for the UK economy.


See also:

• Criticisms of Gordon Brown's Economic Record as Chancellor

References


i) Gordon Brown's Record

Labels: Economic News, Gordon Brown, UK economy

Gordon Brown has been Chancelor since 1997, despite impressive growth figures some argue he was lucky to inherit a strong economic foundation and actually the last 10 years represented a wasted opportunity to secure the long term future of the UK economy

1. He inherited the benefits of Supply side reforms.

It is argued by the Conservatives that when he took power the economic fundamentals were already in place for a strong economy. Unemployment was already sharply falling from 3 million to 1.6 million. Over the past 20 years policies such as Privatisation and labour market reforms had helped increase the UK’s competitiveness and placed the framework for low inflationary growth. Gordon Brown was merely lucky to inherit these.

2. A Tax Meddler.

Gordon Brown has introduced over 66 new types of tax. Although he has kept his promise of not raising income tax he has compensated by introducing new types of taxes like Airport tax, such taxes have been labelled “stealth taxes”. Depsite tax rises the government is close to breaking its own public sector borrowing rules. Despite 12 years of economic growth government borrowing stands at £38bn or 3% of GDP.

3. Public Sector spending has been inefficient.

Gordon Brown has increased spending on public services like health and education however these have failed to deliver good results in terms of improved services. It has been argued that much of this spending has been on “non jobs” e.g. extra layers of management in health care. A report by Centre for Policy Studies argues that productivity in the public sector has fallen by 1.3% in 2003 + 2004. However Private sector productivity has increased. (Source 1) Thus the tax raises have been inefficiently spent and will result in lost growth in the future.

4. Complicated tax and Benefit system.

Making tax credits means tested has meant that most recipients are unaware of their eligibility. For example a significant proportion of child tax credit goes uncollected.

5. Unbalanced Growth.

The strong economic growth masks the unbalanced nature of the growth. The main contributor towards economic growth has been consumers spending. The increase in consumer spending has been financed by rising house prices and record levels of borrowing. The unbalanced nature of the UK’s growth is reflected in the record current account deficit of 2.9% of GDP (3)

6. Housing Bubble could bust.

With much of the economies strength being based on rising house prices, if a housing boom was to turn into a bust it could have a disastrous effect on the economy. It is worth noting the US housing market is experiencing problems of high levels of mortgage defaults and falling prices. This could also happen in the UK.

7. Unreformed Pensions.

The UK faces a demographic time bomb with the % of retired workers due to rise in the next 20 years. Industry experts have criticised his pension reforms as being too timid.

• See also: Success of Gordon Brown during his time as Chancellor

References


(1) Brown Blows it - Money Week

(2) Brown's Record

(3) Balance of Payments statistics

(4) Economic Problems of EU

Labels: Economic News, Gordon Brown, UK economy

As Gordon Brown approaches his last budget as chancellor many are reviewing his tenure as Chancellor and evaluating his success or failure. One important contribution he made was to steer the UK away from joining the Euro on the ground that "it would not be in Britain's economic interest". The justification for this was based on his 5 economics tests.

Before deciding whether the UK should join the Euro the Chancellor, Gordon Brown drew up 5 economic tests which the UK must pass for the UK to join. The main principle behind these 5 economic tests was whether the UK would cope with a common monetary policy. The 5 tests are in some ways superfluous. The main test being is really whether the UK has a degree of economic harmonisation with the rest of Europe.

5 Economic Tests for Joining the Euro

1. Economic Harmonisation.
   
   The UK economy must be harmonised with the Euro zone. If the UK economy was growing much faster than EU then UK interest rates would need to be higher. For example, at the moment if the UK joined interest rates would fall and this may cause inflation. Therefore it is essential that the UK has a similar economic cycle to Europe. Even if there is temporary harmonisation there is no guarantee it will continue on a permanent basis.
   
   
2. Is there sufficient Flexibility?
   
   If the UK went into recession could it be able to cope? It would have no influence over Monetary policy but also Fiscal policy is limited by the growth and stability pact. This limits the amount of government borrowing and therefore limits the scope for expansionary fiscal policy.
   
   
3. Effect on Investment.
   
   Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? UK inward Investment has not suffered since the UK decided not to join
   
   
4. Effect on Financial services.
   
   What impact would entry into the euro have on the UK's financial services industry? London as a financial centre has boomed in recent years.
   
   
5. Effect on Growth and Jobs
   
   Would joining the euro promote higher growth, stability and a lasting increase in jobs? There is no clear evidence that it would. UK economy has done better outside the Euro than in the Euro.

At the moment the weight of economic opinion is that the UK is better off not joining the Euro. One important factor is that the UK housing market is very sensitive to interest rates. Many UK householders are homeowners and also many mortgages are variable. Therefore the cost of mortgages fluctuates with changes in the base rate. Thus a small change in European interest rates could potentially have a damaging effect on UK economy. For example, if the UK was to join now, interest rates would fall causing a potentially harmful inflationary boom.

See also:

• Why the UK will never join the Euro.
• Benefits of Joining Euro
• Costs of Joining Euro

Labels: Euro, Gordon Brown, UK economy

Admist the turbulence of the financial markets the IMF produced a report generally positive on the state of the UK economy. They revised growth figure of the UK economy to 2.9%, this is in line with the Chancellors last budget forecast.

However the IMF did note a cautionary note.

1. They said inflationary pressures may pick up throughout the year. This will be particularly a problem if wage settlements generate high wage increases. Higher interest rates are a distinct possibility.

2. Although the Chancellor is at last on course to meet the golden rule the IMF warned the government it needed to make "disciplined" choices in the forthcoming spending review. - Government spending has increased sharply making the government's fiscal position less promising.

more at independent

Labels: UK economy

The aim of monetary policy is to achieve the governments inflation target of CPI= 2% +/-1. They will also consider impact on economic growth and unemployment. But control of inflation is their primary objective.

Factors which determine success of Monetary Policy

1. Accuracy of inflation forecasts. Monetary policy is pre emptive which means they try to reduce inflationary pressures before they occur. If inflation is higher than predicted, then interest rates will be too low to control inflation. Inflation predictions could be wrong if there is an unexpected rise in cost push inflation, for example an increase in the price of oil. In the past 15 years the MPC have benefited from generally low global inflation, However some economists feel that this “golden era” of price stability may not continue indefinitely. E.g. economic shocks associated with rising commodity prices.
   

2. Time lags. It is estimated interest rate changes can take upto 18 months to have their full effects. For example if interest rates rise then people who are currently spending on investment will not stop straight away. They will continue with their project. However higher interest rates may deter future projects from starting. By the time interest rates have had their desired effect it may be too late to reduce inflation. (This is why the MPC is always trying to predict future inflation trends)
   

3. Interest Elasticity of Demand. This measures how responsive demand is to a change in interest rates. For example if consumer confidence is very high then higher interest rates may not deter consumer spending. This is because people expect to make more money in the future so are willing to borrow at higher levels of interest.
   

4. Effects of interest rates not equally shared. The effect of rising interest rates effects some much more than others. For example in the UK many have high levels of debt through mortgages. Thus first time buyers with large mortgages will be effected by interest rate changes much more than older people who have paid off most of their mortgages. To reduce inflation may cause financial hardship for a small % of the population who have very high levels of mortgage debt.

5. Other Variables. Interest rates effect other variables in the economy. Higher interest rates increase the value of the £ (through hot money flows). This causes problems for exporters and may worsen current account. Higher interest rates also have a disproportionate effect on the volatile UK housing market.

6. Inflation expectations. The success of monetary policy depends upon credibility of the Monetary authorities. If people have low inflation expectations then it is much easier to keep inflation low. Since independence the MPC have benefited from a reduction in inflation expectations. This is partly due to the credence people give to an independent body rather than politicians with a poor track record of keeping inflation low.

7. Levels of Government debt. High levels of government debt generally put upward pressure on interest rates. This is because to attract enough people to buy government bonds interest rates on these securities need to rise. This puts upward pressure on interest rates throughout the economy.

Note in Japan Monetary policy became ineffective because they experience deflation. Because interest rates cannot fall below 0% this meant the Japanese real interest rates were too high for the state of the economy. Monetary policy could not be used to reflate the economy. However deflation is unlikely to be a real problem in UK for the foreseeable future.

See also: Should primary objective of the UK be low inflation of 2%?

Labels: UK economy, UK Monetary Policy

From a political perspective the UK has always been reluctant to submerge itself in a European identity. The EU, with its prescriptions on the shape and size of bananas,(1) remains an easy target for UK tabloids and satirists. The idea of giving up the £ for a nondescript EURO would hardly make for a populist political agenda. However, political arguments aside, there is increasingly little if any support for the EURO, even from a purely economic point of view.

Firstly the supposed benefits of joining the EURO are becoming increasingly marginal.

1. Exchange Rate Stability. A main advantage of joining the Euro is that it reduces exchange rate volatility with our main EU trading partners. However since 2003 the £ has displayed very little exchange rate volatility. In this article. Stephen King, Chief Economist at HSBC claims that in effect the UK has already in effect joined the Euro. Anyway it is also relatively easy to insure against exchange rate movements through the purchase of currency on the open markets. Therefore at the moment there is little risk associated with exchange rate fluctuations.

2. Inward Investment. Inward Investment has continued to soar even outside the EURO. It was thought joining the EURO was necessary to attract sufficient inward investment. However it appears that a separate currency has not been a deterrent to further inward investment. See: Inward investment in UK

3. Low inflation. There was a time when the UK was known as the “sick man of Europe” its economy characterised by, boom and bust cycles and high inflation. It was thought that joining the EURO would give the UK a strong anti inflation framework. However since the MPC was given independence in 1997 inflation has remained close to the government’s target of 2%. Furthermore this low inflation has been consistent with an enviably high growth rate. When your economy is outperforming the Euro Zone there seems little reason to join.

Joining the Euro would give the UK a small gain in terms of lower transaction costs and greater exchange rate stability. However it must be emphasised for many businesses, both domestic and foreign, these costs are a small % of total costs. However many economists fear that joining the Euro could lead to some significant economic problems.

Disadvantages of Joining Euro

1. Loss of Independent Monetary Policy. On joining the EURO interest rates would no longer be set by the MPC. They would be set by the European Central Bank. The ECB look at the whole EURO economy and not what is best for the UK. Thus if the UK joined now interest rates would fall from 5.25% to the ECB rate of 2.25%. This fall in interest rates could cause and further boost the buoyant Housing Market and cause future inflationary pressures.

2. Difficulty in getting out of a recession. On the other hand if the UK suffered a recession they would be unable to cut interest rates. It would be difficult to boost demand and get out of the recession. To an extent this occurred in 1992; the UK was in a recession but because they were in the ERM (2) they were trying to maintain a high value of the £. Thus interest rates were far too high (15%) these high interest rates exacerbated the UK’s recession.

3. Sensitivity to interest Rates. The nature of the UK housing market means the UK economy is sensitive to changes in interest rates. Unlike European countries most UK householders own their own house, their variable mortgage is a high % of their income. Thus even a 0.25% change in interest rate can significantly affect disposable income. If the UK were to join now and interest rates were to fall by 2% it would very likely cause a further boom in the housing market which would feed through into higher inflation.

4. Loss of independence of Fiscal Policy. The growth and stability pact limits the levels of government borrowing to 3% of GDP. This is another difficulty in getting the economy out of a recession. However it would not affect the UK at the moment. Also France and Germany have conveniently been able to sidestep this rule when necessity demanded.

The UK economy is doing relatively well, by historical standards the UK economic performance is quite remarkable. Thus there seems little incentive for a British politician to take on the entrenched Euro scepticism prevalent in British media and society. There is little to be gained by joining and there are many potential problems, the Queen’s head is safe for the foreseeable future.


By: R.Pettinger

See also:

Benefits of Joining EURO

Costs of Joining Euro

(1) This is actually a myth. The EU never had a regulation about the shape of bananas, but the point is it has entered British folklore.

Labels: Euro, UK economy

How Effective have the MPC been in meeting the Governments inflation target?

The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Currently (Feb 2007) inflation in 2.7%

Advantages of MPC in setting interest rates.

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to keep interest rates low before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the govts target then they can increase interest rates to reduce consumer spending and keep inflation on track.

3. MPC have reduced inflation expectations. People have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low.

4. By targeting inflation directly they get the best overall picture of the economy rather than focusing on small aspects like the money supply.

5. Since 1997 UK inflation has remained close to the government’s target of 2%. This is much lower than UK inflation in the 1980s which reached 10%

6. Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.


Limitations of the MPC’s Effectiveness

1. Inflation is low but this is partly due to global pressures keeping inflation low. E.g. globalisation, low prices of raw materials and better technology. If these factors were to increase it would be much more difficult for the MPC to keep inflation low.

2. Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect. Therefore it becomes difficult to control inflation solely through interest rates.

3. Some sections of the economy do not respond to higher interest rates. For example the recent rises in interest rates have not stopped house prices rising. Many older people have a small mortgage therefore changes in interest rates have little effect. However interest rates have a disproportionate effect on people who have just joined the housing market ladder.

4. It depends upon other components of AD. E.g. if consumer confidence is high then raising interest rates may have little effect on reducing consumer spending.

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Labels: UK economy, UK Monetary Policy

Since the Bank of England was given independence in 1997 UK inflation has been close to the government’s target of 2% +/-1. This is a remarkable improvement for the UK economy. Previously the UK economy suffered from consistently high inflation. Eg in 1979 inflation reached 25%. In 1992 inflation reached 11%. Reasons for low inflation are a matter of debate. The chancellor Gordon Brown likes to take credit for giving the Bank of England independence in 1992. However although this partly explains low inflation, it is only a small % of the reason.

Reasons for Low Inflation in the UK

1. Economic growth has been more stable and predictable. The MPC have avoided a boom and Bust economic cycle. At the first sign of inflationary pressures increasing they have increased interest rates to reduce inflation before it occurs (policy is known as pre emptive monetary policy.) This has avoided a repeat of the late 80s inflationary boom.

2. Inflation expectations are lower. Partly as a result of the MPC’s greater credibility. People expect inflation to be low, therefore wage demands have been correspondingly lower. This has made it easier to keep inflation low.

3. The process of globalisation has helped to reduce costs and increase competitiveness in global markets. The UK has benefited from falling prices of manufactured goods that have been made in countries like China and Korea.

4. Improvements in technology. The internet and micro chip computers have helped to increase efficiency and lower costs.

5. Increase in the labour supply. Increased immigration has created a new supply of cheap labour which has helped keep wage pressures low.

6. Appreciation of £. This has helped reduce inflation, because imports are cheaper and quantity of exports lower

However inflation may increase in the future. The Governor of the Bank of England recently said there is no reason why the past period of stability and low real interest rates will continue. Several reasons may cause inflation to rise in the future including:

Why Inflation May Rise

1. Economic growth in China and India is causing high demand for commodities and therefore prices are rising. This will feed through into cost push inflation.

2. The UK has a large current account deficit. To reduce this deficit it will be necessary to have a devaluation in the value of £, at some point.

3. The supply of labour is unlikely to increase by too much in the future. Therefore wage inflation may become a problem as the labour market nears full employment.

4. UK House prices continue to rise. This creates additional consumer wealth and therefore increases consumer spending.

The effect of this is that in the future interest rates may have to rise in order to keep inflation low. This will have the effect of keeping mortgage payments high.

Labels: inflation, UK economy

Hi and welcome to a blog about Economics and in particular UK economics.

This blog is updated by Tejvan R. Pettinger. Tejvan studied Politics, Philosophy and Economics at LMH, Oxford University. He now works as an Economics teacher in Oxford. He also works as a senior examiner for Edexcel.

Contact Tejvan

Labels: UK economy