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Economics Weekly

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Will this UK recession be as bad as last time?

Tue, Nov 4 2008, 07:29 GMT
by Trevor Williams

Lloyds TSB Financial Markets

UK economy contracts for the first time since 1992
The first decline in UK gdp since 1992 means that the economy is heading for recession. Growth contracted by 0.5% in Q3, after being flat in Q2. On balance, it is likely that growth will fall again in Q4 though not by as much as in Q3, which saw a bigger fall than expected as manufacturing output dropped across the board. The global and UK economic backdrop has worsened significantly in the last 3 months, with the capital injections, government guarantees and cuts in official interest rates doing little to calm financial markets, though some of the panic in equity markets seems to have abated. Such has been the loss of confidence in financial markets that all global leveraged positions are suspect, for countries, firms or industrial sectors. UK growth in Q3 was especially hit hard by the sharp rise in price inflation, weakening in wage inflation and the increases in petrol, gas and electricity charges that cut real household incomes quite sharply.

Last three months have seen worsening economic and financial market data...
In the last three months, manufacturing output has fallen ever more sharply and retail sales growth slowed further, see chart a. Consequently, business and consumer confidence have fallen steeply. It is not therefore surprising that consumer spending and investment spending growth have turned negative, see chart b. Once the detailed figures by expenditure are revealed (due end November), it is likely that consumer and investment spending fell in Q3 as well as in Q2. Falls in house prices, measured by the Halifax and Nationwide indices, are of the order of 12-16% year on year, and home repossessions are starting to rise strongly. Car sales are down and the fall in house prices and in house sales have hit durable consumer spending particularly hard.

Moreover, unemployment is rising and wage inflation is stagnant in the face of rising price inflation, leading to further falls in real, or inflation adjusted, income growth. The credit crisis has also led to tighter lending standards and to a wider spread, meaning that libor rates remain high even though base rates have been cut. It is surely no coincidence that the recent wave of financial market turmoil intensified in the weeks following the collapse of Lehman Brothers, as it highlighted the counterparty risk that financial institutions face. The subsequent falls in equity markets and rise in volatility seems to have badly impacted consumer and business confidence around the world.

A key question therefore is whether this current UK economic downturn will be as sharp as in the 1990s. Then, output fell about 2.5% peak to trough. However, this imminent recession is likely to be shallower. Why is this? After all, in the last recession the world economy was not in the grip of the worst financial markets crisis in decades and was perhaps not as interconnected as it is now. But table 1 gives some of the reasons why this slowdown may not be as steep. For a start, as chart c shows, the UK gdp decline of 0.5% compares favourably with the 1.2% fall in 1990, and this is over a year into the credit crisis that was predicted to have led to recession much sooner and deeper than seen so far. Short term interest UK rates, including libor rates, are a lot lower than they were in 1990. Base rates are much lower and so are long term interest rates. The reason is that price inflation is also much lower. In turn, this is helped by wage inflation, which is also much weaker, giving scope for price inflation to ease and so for interest rates to be cut below the current level of 4.5%. The pound is lower in trade weighted terms, making the UK economy more competitive, even though growth in overseas markets is slowing as well.

Table 1 also shows that unemployment is much lower now than in 1990 on the claimant count basis, and would have to be 750,000 higher than it is currently, just to match the starting level of the early 1990's recession. All in all, these are not the sort of starting level, at least from these figures, that suggest an economy about to plunge into its deepest recession since the 1990s or the 1980s. However, this does partly assume an aggressive policy response. But one does seem to be underway, with government spending commitments of the order of £500bn so far and both tax cuts and further spending increases are likely to be announced in the Autumn Statement later this year. Official interest rates have been cut by 0.5% in one coordinated global move in the past month, and a further fall of 1 percentage point is likely by end-year taking UK base rate to 3.5%. Where price inflation may eventually end up, with a loose fiscal and monetary policy and a weakening currency is uncertain, though it may be that policy will be tightened pretty sharply once recovery gets solidly underway.

...and the jury is still out on whether this downturn will be shallow or steep
In any event, the focus of fiscal and monetary policy is now targeted at mitigating the economic slowdown, and solving the credit crisis. Of course, the eventual outcome of the current downturn is very uncertain, more so than even in 1990. With falling real wealth (equity and housing markets) and bank and financial institutions shrinking their balance sheets, it is possible that the current economic downturn will be as bad or worse than in earlier episodes. Although we would give this scenario a much lower probability than a shallow recession, the jury is still out. However, all recessions end, and the extent of this one will be clearer in a few months, especially given the much more aggressive policy response that is now underway.

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Published on  Tue, Nov 4 2008, 07:36 GMT