Wednesday, March 4, 2009

Economic Stability

The period 1993-2007 is (was) often referred to as the period of Great Stability. This seems rather paradoxical after the financial turmoil that has gripped the world since everything started to unravel in late 2006, 2007. Yet, on the surface there was a great stability (apart from short lived panic from the dot com bubble in 2001)

Why was this period Known as The Great Stability?

In recent history the UK had experienced 3 painful periods of boom and bust economic growth. Periods of high inflation were followed by painful recessions:

Previous UK Recessions

1974: 1.4% fall in GDP
1975: 0.6% fall
1980: 2.1% fall
1981: 1.5% fall
1991: 1.4% fall

Annual GDP figures by market prices (Source: Official for National Statistics)

The UK developed a reputation for the 'boom and bust cycle'

It seemed that high inflation was the cause of macro economic instability. If we allowed inflation to increase it caused a boom and bust. Therefore the idea was that if we could prevent inflation we could prevent recessions.

After trying Bretton Woods (upto 1970s), Monetarism (1979-1984), ERM (1990-92), we finally moved to inflation targeting and gave independence of setting interest rates to the Bank of England.

Everything seemed to work well. The UK experienced the longest period of economic expansion on record. (1992-2007) and inflation stayed close to the government target.

The government even brought public sector borrowing down from a peak 73% of GDP in the 1970s to 29% in 2003. The government lost no opportunity to pat themselves on the back and share the very impressive economic statistics with anyone who cared to listen (and even those who didn't particularly want to.) It appeared we had broken the 'inflationary boom and bust cycle'

So Why Was this Great Stability so Instable?

Using statistics of inflation, unemployment, growth and government borrowing, the economy was doing well. In the past this had been sufficient to maintain a stable growth. However, the macro economic stability hid a growing financial instability.
  • Asset prices rises well above inflation - primarily house prices. This rise in house prices exacerbated a boom in lending.
  • Bank Lending becoming based on riskier models. e.g. Northern Rock, RBS e.t.c
  • Growth of financial derivatives which helped hedge risk. But, actually caused a build up of more risk
  • Decline in bank reserves as banks borrowed on money markets to lend new mortgages.
  • In short there was a credit bubble. Credit was made cheaply available to a new range of customers. This encouraged high levels of debt, low levels of personal saving and an unbalanced economy.
  • Inflationary boom and bust cycles had been replaced with a credit boom and bust.
  • Also, it should be said, the economic statistics were impressive. 17 years of economic growth is not based on a complete illusion. The causes of this very deep recession are global and we would be in recession even if the UK credit bubble had been less.
Problems in Economy
  • Policy makers underestimated how much asset bubbles could effect the economy
  • Very few realised how the new bank lending practises and balance sheets could be so destabilising for the economy.
  • Economic growth was unbalanced - dependent on rising house prices, low saving rates and high personal debts.
Faced with these developments in the finance sector. The old measures of economic stability have proved to be insufficient. Policy makers paid too much attention to headline figures like inflation and growth and ignored seemingly less significant statistics.

Future for Macro economic policy
  1. Greater weighting to credit and asset prices in macro economic models
  2. A greater flexibility in macro policy making. The models which worked in the past and even at present moment (e.g. inflation targeting) can become insufficient in the future.
  3. More policy instruments. Interest rates alone are insufficient to deal with growth, inflation and asset bubbles. Increasingly policy makers see the need to force banks to ration credit in a boom building up reserves for a recession.

1 comment:

Unknown said...

I would add a 4th possibility to the Future for Macro economic policy.

I believe that apologies from top executives from banks or gently asking executives to retire without loss is entirely inadequate.The stick must be more potent if it is to curb irresponsible lending.

There could be an international financial court of law dedicated to investigating managers of financial institutions if illegal/irresponsible practice is suspected after a crisis is discovered.
If found guilty, the manager should be jailed and fined and the banks (i.e. the staff not the investor) should be financially punished with a greater priority than the shareholders (call this 'preference punishment').

That would enhance incentives for a more critical
self-regulation in the finance industry.