UK Economy in 1990s

The 1990s began with a severe recession, and a humiliating exit from the ERM, leading to higher unemployment.

The mirage of the 1980s bubble had exploded. Inflation, once thought to be defeated once again had reared its ugly head. All the hard won gains of the 1980s seemed to be lost.

Belatedly, the government sought to tackle the bubble inflation indirectly through the Exchange Rate Mechanism - a semi fixed exchange rate. This required exceptionally high interest rates which made a mild recession into a much deeper recession, - unemployment soared. More detail - ERM Crisis 1992

The worst hit area of the economy was the housing market. After enjoying the heady days of the late 80s with 30% annual growth in house prices, the housing market slumped as people simply couldn't afford the record mortgage interest payments. House prices began falling in 1990, and were still falling in 1995. Adjusted for inflation, the real house price fall was even more dramatic.



As the economy recovered, the primary objective of economic policy was geared towards avoiding future booms and busts, which the UK economy seemed particularly prone to.

Rather than target indirectly through money supply or exchange rate, the Bank of England were given a specific inflation target of RPI 2.5% +/-1

By, 1997, the Bank of England were made independent, giving them control of setting interest rates. It was hoped, an independent Bank would not be vulnerable to the political cycle of creating a convenient economic boom before an election. It was felt the Bank of England would have the willingness to make unpopular decision in keeping inflation under check and avoid the boom and bust which had weighed down the UK economy. Importantly, it was hoped, that people would have confidence in the Bank of England and this would help permanently reduce inflation expectations.

On a narrow judgement, this has been remarkably successful. Inflation, remained low throughout the 1990s and into the 2000s, since the end of the Lawson boom, UK inflation has been close to the government's target of 2%, apart from the odd temporary deviations. It is certainly nothing like the inflation problems of the 1970s and 1980s.

By, the end of the 1990s, the economy seemed to be doing well, and quietly there was growing optimism. Already people were talking of the end of boom and bust, the new buzzword was the period of great stability.

It seemed that this new policy of inflation targeting had solved all the major economic problems at a stroke. This new found optimism was perhaps summed up by a quote by Paul Krugman in 1997. Quote

“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.”

After the 1992 recession, a flexible labour market helped unemployment fall quickly (much more quickly than after the 1980s recession)

Economic growth was positive, unemployment falling rapidly and towards the end of the decade, the government even recorded a budget surplus.... Surely nothing could go wrong now?

Related

• UK economy in 1980s - The Thatcher Revolution
• Modern Economic History of UK
• Economics of the Naughties
  

The Thatcher Revolution - 1980s

If the 1970s, ended with a feeling of powerlessness, who else could have taken power but Margaret Thatcher? Before her election, few would have realised her conviction and rigid adherence to a new market based ideology. Few, if any could have predicted how she took the economy and reshaped it in her own image.

Whatever, you might say about Thatcher, the period is certainly interesting for economic historians.

The late 70s left two major economic problems - high inflation and industrial unrest. With her chancellor, Geoffrey Howe, she took to tackling inflation with a gusto and intensity rarely matched. The government pursued a new set of Monetarist policies - jettisoning the post-war Keynesian consensus. Tax were raised, spending cut, interest rates increased, the pound appreciated, the money supply was controlled. All this reduced inflation.

Money Supply targets (an intrinsic part of Monetarism) proved to be more or less useless. But, the deflationary fiscal and deflationary monetary policy did succeed in achieving a reduction in inflation. Thatcher had achieved her first goal, but, unfortunately, that was only part of the story. The unprecedented reduction in aggregate demand led to one of the deepest recessions since the 1930s. Manufacturing output plummeted and unemployment shot up to 3 million. (see: 1981 Recession)

In inner cities, youth unemployment reached over 50% leading to a wave of inner city violence from Brixton to Toxteth. It seemed the great Thatcher revolution was ushering in a new social revolution. At the height of the recession, 365 economists wrote to the Times saying Mrs Thatcher must change her economic policies. Yet, if the country didn't know by now - this Lady was not for turning. She persisted with her policies and unemployment remained at 3 million until the mid 1980s. If Britain had been the first industrial nation, it was also becoming the first nation to 'de-industrialise'

There was certainly a need to tackle inflation in the late 70s. It would have been hard to do that without some fall in output. But, the extent of the recession was far greater than necessary. - I can only give the analogy of solving a painful toe, by cutting off a leg. The recession of 1981 really didn't need to be so severe. - Ideology did triumph over common sense.

Thatcher may have been an ideologue, but, she did have luck.

• The Falklands war was perfectly timed to give her an unexpected landslide in the 1983 election. The public finances also received a huge boost from:
• Oil revenues - 10% of Tax revenues were coming from oil in early 1980s. Something kept strangely quiet.
• Sale of Council houses
• Proceeds from privatisation.

This enabled a wave of tax cuts - mostly on income tax for high earners.

The Miners Strike

1984, was Thatcher's next war, and this time it was 'the enemy within'. - She wasn't talking about members of her cabinet - that would be later. This time the enemy was the high priest of the Union movement - Marxist and firebrand Arthur Scargill. If the miners had won in 1973, Thatcher was not going to share the same weakness as Heath. Thatcher prepared for war and after a bitter, bloody and damaging strike, the miners finally trudged back to work, outmanoeuvred and defeated after 12 months of strike action. It was perhaps a 'pyrrhic victory. A fight where the victor emerged with little credit. But, it did break the back of the militant union movement. Combined with strict anti-union legislation. The threat of a 3 day weak would never be repeated.

Lawson Boom

 

As the economy recovered, the government were keen to promote the idea of a 'supply side miracle'. After all the government had all but defeated the unions, it had implemented new supply side policies like privatisation. Britain no longer appeared the 'sick man of Europe' but, it appeared Britain was leading the world with its groundbreaking policies of privatisation and market deregulation.

In particular, the finance sector boomed as layers of regulation were removed at a stroke. The good times were back - especially for the young professionals in the south. It was the age of the Yuppie. A wave of consumerism and materialism gripped part of the nations. House prices and share prices rocketed. Even the likes of 'Sid' could benefit from this new share owning, property owning democracy. By the late 1980s, memories of the Winter of Discontent were like a bad dream as the UK economy raced away - outstripping the growth even of Germany and Japan.

It seemed there was nothing could stop the economies momentum - Mrs Thatcher may have made political enemies with the poll tax, but, the economy looked rosy. It seemed too good to be true - but, unfortunately - 'too good to be true' characterised the Lawson boom perfectly. There had been no supply-side miracle. Growth of 5% was simply unsustainable. Inflation reared its ugly head. By the time, it reached 10% it was too late. Belatedly the government sought to control inflation - through entry into ERM and higher interest rates. Thatcher may have disliked the political impact of ERM, but, it was the economic costs of ERM which was the biggest problem. Reminiscent of the 1968 devaluation crisis. The government was committed to maintaining a rate of the pound the markets though ridiculous. The government almost comically raised interest rates to 15% - in the middle of a recession - in the hope they could maintain the value of the Pound. The Markets ignored the desperate move and continued selling the Pound. After ignoring the inevitable for so long, the chancellor (now Norman Lamont) finally on Black Wednesday, left the ERM and devalued the pound. Finally, interest rates could fall and the UK could start to recover from another needlessly severe recession. See: (ERM Crisis)

- It was a classic boom and bust - but surely we would learn our mistake of the 1980s boom and bust - we wouldn't allow that to happen again.... (to be Continued...)

• Modern Economic History of Britain

Post War Economic Britain

Pre War - It is worth remembering how bad the economic situation was before the war. Mass unemployment started in the 1920s. There was deflation, and falling wages which precipitated the great national strike of 1926. The Great Depression only exacerbated the problem of unemployment and poverty. As writers such as George Orwell memorably depicted in The Road To Wigan Pier - The 1930s was also a bad time to be unemployed - unemployment insurance was meagre, means tested and inadequate. Basically, in the 1930s, there was no welfare state, no universal health care - just mass unemployment, especially in the north.

It was this grim period of the 1930s, that raised so much hopes that after the war things would really be better. A key element for this new hope was The Beveridge report which laid the foundation for the modern welfare state and the abolishment of poverty. Beveridge was not a socialist, but, a liberal. Yet, his vision of a universal welfare state laid the foundation of post war Britain and defined the post war Labour government.

Britain in 1945.

In 1945, Britain was triumphant in defeating the axis powers. At conferences like Yalta, we appeared to be one of the Big Three powers. But, the reality was - we were completely broke. The war had exhausted our financial reserves. It is fashionable to worry about the UK national debt (currently 60% of GDP). But, in the 1940s, this had reached over 200% of GDP.

This scale of debt, was the over-riding feature of our post war economy which hung like a shadow over the UK economy and UK politics.

In 1946, towards the end of his life, we sent the great economist - Lord Keynes to Washington to help argue for an £8bn loan. People say that despite his ailing health, this was one of Keynes' greatest hours - passionately and brilliantly explaining why Britain needed a loan. The American's politely listened - only to refuse. It was only the heightening of cold war tensions that America became motivated to bailout Britain and the rest of Europe. But, whatever the motive, it is certain the America loans were vital to keep the UK economy afloat - especially in that awful winter of Britain in 1947, where secret government records show they drew up contingency plans for mass starvation.

Against a backdrop of record debt, and a reluctant profession of private doctors, any government may have been forgiven for dropping an ambitious plan to introduce a universal national health care service. But, somehow, Nye Bevan succeeded in introducing a universal health care service free at the point of use. True, the number of treatments were more limited in the 1940s, but, the basics of the health service have remained in place ever since. It was a great achievement given the fiscal state of the country. But, it certainly couldn't have been done without a loan from the US.

The 1940s and 1950s, were an age of austerity (rationing only ended in 1954). But, it was an era of full employment. And after the horrors of the Great Depression, this was no small thing. With the end of rationing, and the booming of global trade, living standards rose rapidly. We entered a new era of consumption - labour saving devices like vacuums and washing machines became the norm rather than the exception. In 1957, Harold Macmillan proclaimed in a speech that 'people have never had it so good' - A sentiment that seemed to express the improvement in living standards of the 50s and early 60s. Yet, despite the improvements in living standards. Britain was quietly slipping behind our competitors. And this period of prosperity would soon be challenged.

• Next - the 1960s economy

Related

• More detail on Post-war Britain

An Economic History of Modern Britain

I've been enjoying watching Andrew Marr's BBC programme- A History of Modern Britain - from rationing to punk rock - from Enoch Powell to Arthur Scargill - modern Britain had everything (and at times, surprisingly violent into the bargain). You also realise how much economics influenced, life, living standards, politics and society. Looking back over the turbulent past few decades also puts the current economic crisis into perspective.

This week I will be writing a brief and potted Economic history of Modern Britain.

• Economics of the 1920s - a legacy of war debt, deflation and life under the gold standard
  
• Economics of the Great Depression 1930s - the economics of mass unemployment.

This week:

• Economics of the 1940s and 1950s - Austerity, rationing, war debt, but full employment, new welfare state and rising living standards.
• 1960s - The 'You've never had it so good era' starts to unwind.
• 1970s - The Era of Discontent. Strikes, 3 day weeks, inflation, boom and bust. The 70s had everything except stability
• 1980s - The Thatcher era gave us two deep recessions, an experiment with monetarism mass unemployment, broke the power of trades and one of the most memorable booms of post war Britain.
• 1990s - Recession and then the great stability
• The economics of the 2000s
  

Steps to Avoid Future Financial Crisis.

The current financial / economic crisis should be focusing the minds on economists of how to avoid a similar repeat. It will be difficult - human nature is unlikely to be changing in the near future. For example, we always have potential of more irrational behaviour and false exuberance
Also, it is not a new situation, housing boom and busts seem to be, unfortunately, quite common - Why Boom and bust in Housing markets are common.

Yet, though we cannot prevent any boom and bust, the magnitude, length and duration can be limited by a thoughtful range of policies.

Better Mortgage Products

In the boom years, banks (especially in US) were offering teaser mortgages. - A great introductory rate for first year or two. Then the interest rate shot up. These teaser rates encouraged people into a false sense of hope they could afford mortgages. When teaser rates expired - then the problems began (see: subprime crisis). Legislation against teaser rates would avoid this.
See also: Paul Krugman (NYT) on relative success of Canadian regulation to avoid financial meltdown)

Counter Cyclical Mortgage Products

When House prices rises, this encourages housing equity withdrawal and people to take on bigger mortgages. This effect is known as a financial accelerator because one rising economic indicator encourages more risky lending and spending. Similarly - When house prices fall there is a rise in negative equity. A counter cyclical mortgage product would make homeowners pay more capital back during rising house prices leaving them less to pay when the housing market turns.

Greater Use of Fixed Rate mortgages.

UK homeowners are generally reluctant to take out fixed rate mortgages, and if they do, they tend to be short term fixed rates of 2 years. Greater encouragement for longer term fixed rate mortgages would help avoid volatility of changing interest rates - not so much an issue in 2008, but definitely a factor in 1991-92

Capital Ratios.

A prominent feature of the boom years was falling capital ratios of banks. Typified by the likes of Northern Rock and Royal Bank of Scotland increasing lending and reducing their capital ratios. This made them vulnerable during credit crunch. Forcing banks to keep more capital during good years would help work against the sentiment of irrational exuberance. A fund paid to the government could then be paid back during difficult times.

Limiting Dividends and Pay.

A startling statistic - In 2008, global banks made losses totalling $60 billion, but on average still made dividend payouts of over $60 billion (1). Banks listed on the stockmarkets are under pressure to pay out dividends and keep less in reserve. The German model of banks may be preferential - less emphasis on equity and stock market listing.

The ideal mortgage product which makes people pay more mortgage payments during a boom in house prices and pay less during a fall in house prices.

According to the Bank of England Financial Stability Report (). Between 2000 and 2007, UK banks could have saved £85 billion in capital through:

• Trimming payouts to staff by 10%
• Reducing dividend payouts by a third
• Stopped paying dividends in the event of an annual loss.

That kind of capital would have been an insurance against the credit crisis.

Monetary Policy

Generally, I don't blame monetary policy for the Boom and bust (see: should we blame Bank of England for recession). But, it still had an effect. Even using a standard Taylor rule, the Federal Reserve kept interest rates too low for too long. But, also by focusing excessively on inflation, Central Banks paid too little attention to an asset bubble. Certainly Central Banks need to have wider targets than just inflation.

References

(1) Debt Hangover B of E Andrew Haldane

• Are recessions avoidable?
• Top Financial Mistakes

Problems With Spanish Economy

There are many similarities with the problems of fellow Euro member - Greece. But, there are differences.

Uncompetitiveness

source: Spain's problem P.Krugman

The Spanish economy has become increasingly uncompetitive. Wages have risen faster than other countries leading to a decline in relative productivity. This has led to a decline in demand and rising unemployment. Again, like Greece, Spain has no ability to devalue to regain competitiveness.

Boom and Bust

Spain had a spectacular boom - focused on housing and construction. This led to a rise in house prices and a rise in house building. Though Spain avoided the irresponsible subprime mortgage markets (in fact Spanish bank - Santander has made great strides in capturing market share in the UK), the rise in Spanish house prices was punctured, leading to a large fall in prices. Unlike the UK, Spain has now a large stock of surplus houses that nobody wants. This excess supply will depress house prices for much longer than in the UK.

The fall in house prices and decline in construction industry has had a big impact on GDP and jobs. The construction industry was a key factor in the Spanish economy but is now struggling, leading to a high number of job losses. Some 900,000 of the new unemployed are largely unskilled construction workers.(2)

Unemployment.

Spain has had a persistent long term unemployment problem. This has only been exacerbated by the recession and boom and bust. In Dec 2009, Unemployment was just below 19%. This places a huge strain on government finances, but, more importantly is a real social and personal loss for those (mostly young people) who find themselves unemployed.

The problem is there seems little immediate hope of a change in fortunes. Whilst the economy is uncompetitive, there is no obvious source of growth and development.

Prospect of Deflation

CPI inflation in Dec 2009 was 0.9%. But, the deflationary forces in Spain - the prospect of wage cuts, fiscal tightening and a continued fall in house prices could create deflation (a fall in prices). Deflation would further depress the economy and make the economy struggle to recover from this bust.

Rise in Government Borrowing

Spain has a reasonably good set of public finances - public sector debt is currently 59.5% of GDP (2009 est.) - though this is a sharp deterioration on 2008 when gross debt was 40.7% of GDP (1). Spain has gone from budget surplus in 2007 to a deficit of over 10% of GDP last year (2). The recession has caused a large rise in government borrowing. Total debt is not too high, but, the rapid deterioration causes an additional headache. The fiscal tightening will at best do nothing to help the economy recover.

Related

• Spanish Economy

References

• (1) Spain at CIA factbook
• (2) Spain's Economic Troubles at Economist
  

Debt Hangover

Definition of Debt Hangover - A situation where agents (firms, governments, individuals) hold too much debt holding back normal economic activity.

Definition of Debt Overhang - a similar situation. Debt overhang occurs when the interest burden of existing debt is greater than the profit the firm can generate from its core business. Debt overhang was a situation faced by many banks during credit crisis.

Debt imposes the cost of debt interest repayments. A high level of debt increases the cost of servicing debt. If this cost of paying debt interest payments is too high then firms may be reluctant to invest and individuals reluctant to spend - governments may have to increase tax. Thus debt can be a constraint to economic recovery.

A further problem is when debt interest payments are so high, firms or individuals lose hope of ever getting on top of their debts so are encouraged to default on debt.

At the moment the cost of our debt hangover has been diminished by the record low interest rates. However, as interest rates rise back to normal levels the cost of servicing debt will come as an unwelcome shock.

The Culture of Debt in UK

Among households, debt-to-income ratios have risen significantly over the past twenty
years. In the UK, household debt-to-income ratios rose from around 100% in 1988 to
a peak of around 170% in 2008. (1) see also: Personal debt in UK

The Great recession has also led to a significant rise in public sector (government debt). The UK's rise in public sector debt is well documented. The IMF forecast that the public sector debt ratios of the G7 will rise from 80% (2007) to 125% in 2014 (1)

Gross Debt.

Gross Debt it the total debt of the economy - combining government, private and corporation debt. Th is is important because it shows the combined debt of an economy. For example, one justification for deficit spending in Keynesian economics is that the government needs to borrow to offset a rise in private sector saving during a recession. However, if the government is borrowing more - but also, the private sector still have high debts, this is more of a problem.

According to the McKinsey Global Institute gross debt has risen 60% by $40 trillion in ten leading developed economies. This is roughly split between the three main sectors.

References
(1) The Debt Hangover at B of E Andrew Haldane

(2) McKinsey’s Global Institute (2010), “Debt and Deleveraging: the Global Credit Bubble and its
Economic Consequences”. http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp

Problem With Greece Economy

As I mentioned last week, the Eurozone is far from being an optimal currency area. The current recession has made the difficulties of the Euro become more prominent - especially for the peripheral areas of the Eurozone - Portugal Ireland, Italy Greece and Spain.

The Problems Facing Greece are:

Rising Government Debt to over 100% of GDP. A budget deficit of 12% for this year. This level of debt has started to make markets wonder whether the government might default. This fear has led to people selling Greek bonds and pushing up the interest rate. Greek debt is now much more expensive than German Debt.

Uncompetitive Economy. The Greek economy is uncompetitive. Rising wages have not been matched by rising productivity. THe lack of competitiveness has led to a fall in demand for Greek goods and a very large current account deficit (imports greater than exports)

No Ability to Devalue. If Greece had their own currency, the currency would devalue to help restore competitiveness. But, being in the Euro, they are not able to devalue and regain competitiveness.

Recession. Greece GDP fell last year by 1.2%. This increases the budget deficit and leads to higher unemployment.

So Called Solutions will Only Make Things Worse. Greece is being told it needs to tackle its fiscal deficit with immediate effect. This involves - higher taxes, cuts in public sector wages and lower government spending. But, when the economy is facing - a fall in output, rising unemployment and the very real threat of deflation a deflationary fiscal policy without a corresponding loosening of monetary policy could make things worse. - The budget deficit does need to be tackled, but, the economy needs some monetary stimulus (Quantitative easing and to prevent a collapse in demand

Needless to say, the triple whammy of higher taxes, lower wages and cuts in government spending are about as politically popular as suggesting Greece bailout the Turkish economy. - Greek farmers are already protesting

Some think the main EURO members (i.e. Germany ) will bailout profligate Greek taxpayers and inefficient governments. It's the same kind of mindless optimism that certain British politicians had in 1992, when they fully expected Germany to bailout the Pound and keep it in the ERM. (Britain soon was forced out and devalued 20% - much to the relief of the economy it has to be said.) But, I really can't see the German taxpayer bailing out not just Greece, but, Italy and other members.

The Greek economy is in a real mess - and it's not just the high government debt that is the issue. In fact solutions, to reducing debt could cause a deep recession (which will reduce tax revenues even further.) They need to tackle the deficit, whilst boosting the economy in other ways. At the moment, they are being asked to do all the painful things without any anaesthetic.

Related

• Arguments against joining the Euro
• Greece Economy

Comparison of Recessions

Graph showing comparisons of Recessions.

www.economicshelp.org - A graph showing scale of different recessions in UK

Note in the Great Depression output in UK fell 10% (In US GDP fell by 30% - but UK did not have boom in 20s or 30s - UK unemployment was already high by 1929.)

In terms of GDP fall, the UK recession is the worst since the Great Depression. It is also the longest (6 consecutive quarters). Last quarters growth of 0.1% is so feeble it means it could have easily have been 7 quarters.

Another feature of this great recession was the rapid fall in asset prices in 2008. A fall in asset prices is often an indication of a depression - rather than just recession. This is one reason why so many economists were worried in 2008

Yet, other factors suggest it could have been worse.
Comparing Unemployment, the rise has been relatively modest given output decline.

source: B of E (pdf)
See also: Why is UK unemployment not higher

Also, a positive sign for this recession, is the relative recovery in business and consumer confidence.


source: B of E (pdf)

This upturn in confidence may explain why firms have been keen to retain workers - rather than make redundancies - it may suggest a positive expectation about the medium term.

Housing Recovery

In the 1990s, house prices fell for four years, real house prices (adjusted for inflation) remain below the boom peak for several years until after 1997. So far the housing market has recovered far quicker. Whilst some may state that this is only a temporary recovery, one difference in this recession is that there wasn't the same increase in housing supply. Thus, we do not have to deal with excess housing supply depressing prices (this excess housing supply is a big problem for US, Spain and Ireland)


source: B of E (pdf)
see also: Impact of house prices on consumer spending

Other factors in this recovery is the sharp devaluation of sterling in past two years. As the global economy recovers, the UK should be in a good position to benefit from growth in trade.

This paints a rather rosy picture. But, there is unfortunately more. In particular the hangover of debt - both government, corporate and household. Currently cushioned by low interest rates, as the economy and interest rates recover to normal rates, the record levels of debt will be a factor holding back growth - banks will be reluctant to lend, households will be looking to pay back debt and governments will have to improve fiscal position.

Related

• essays on recessions
  
• Recession Tracker at BBC