No 218: The way ahead?

By Galeeva Dariya

"Give me a one-handed economist! All my economists say, On the one hand ____, on the other ____,." 

Harry S. Truman

2011 was definitely a hard time in economic terms. However, 2012 has already brought some positive signs such as forecasts of a higher GDP growth of 0.6% than the previous year. The unemployment rate is increasing slower as well (According to “UK unemployment rises by 28000 to 2.67m, ONS reports” article BBC News 14 March 2011) .

The government is trying to return the country on the way of stable economic growth and to breath life and confidence back into both consumers and suppliers, still having serious doubts concerning the economy's stability. Some of the government actions have been in use since the crisis of 2008, nevertheless, the UK recently faced a danger of having a double dip recession. (“The UK will avoid a double-dip recession but growth this year will be slower than previously forecast, the British Chambers of Commerce has said.” BBC News stated 5^th March 2012)

So what are possible ways of regulating economy nowadays and why the situation is so controversial to decide on the best regulation?

First, one of the possible measures is reducing the rate of interest. In theory, this measure if taken by the Bank of England, will lead to other banks to reduce their interest rates. Therefore, the savings are going to decrease, whereas the increase in spending is going to occur. As the result, the aggregate demand will increase causing the GDP to increase. The decrease in savings will also increase the money actually used in the economy, so it’s going to be an additional injection into the economy, which will certainly boost the latter. One of the drawbacks is inflation, however, in such need of an actual growth a European countries are, this seems to be a fair price to pay.

But this is only theory. In practice, lower refinancing rate does not force banks to lower their rates significantly. Considering the losses of banks after the financial crisis, they are not going to do so in the nearest time as it is much more profitable to gain benefits from both – 0.5% of refinancing rate and their own high interest rates.

It is doubtful that the government can change the situation. There is not much possibility of decreasing the base rate even more significantly with current figure at 0.5%. Intervention of the government into the market can discourage the banks of having their main assets in the UK and possibly will lead to banks switching to other countries.

Second, one of the measures that can be taken is increasing government spending and/or decreasing taxation. Decreased income taxation will increase consumers’ purchasing power, so encouraging buying more; decreased taxation for firms will possibly lead to increase investment (which affects actual and potential growth) and/or the output itself. The government spending is an important part of AD, so its increase will boost the economy as well. Therefore, both measures will certainly increase aggregate demand, which will lead to increase in GDP and inflation (the possibility of which we have already discussed).

Nonetheless, it is hard to rely on increased purchasing power, as people may tend to save more, which will be a certain drawback for the economy.

Furthermore, both will also cause an increase in the budget deficit. This is important, if we believe that the government should stick to its Deficit Reduction Programme, so it is hard to expect significant increase in the government spending for another 5-6 years.

Third measure, which is widely discussed nowadays, is rebalancing the economy, i.e. changing the share of the service industry that comprises 27% of the whole economy and developing  manufacturing industry. This measure is thought to make the economy more stable since the manufacturing industry is less liable to fluctuations and shocks compared with services and banking. One of the strongest arguments for it is that Germany and France - the strongest economies in Europe nowadays – have strong manufacturing sectors which helps them to avoid a steep decrease in GDP and makes them less dependent on the banking and services sector.

This makes some people believe that if the same is done with the UK economy, the latter will see prosperity in a few years. But is that really so?

If we think of comparative advantage, that is vitally important in the modern globalized economy, the UK in the last several decades had one in the service sector. That has happened for the reason that developing countries with lower wages and lower costs for raw materials compared with Europe and the USA have gained their comparative advantage in the manufacturing industry. Therefore, in case of the UK developing its manufacturing sector, the companies will be faced with strong competition with foreign countries’ firms even in domestic markets. This actually means that in this way the time needed to see the real development in manufacturing will be rather long.

The government is also carrying out quantitative easing policy which has already injected 325 bn pounds in the economy. This has increased the money supply, which, according to the Fisher’s equation M^.V=P^.T, will increase the value of transactions, therefore GDP. By this measure, the Bank of England is buying UK Government bonds from the banks, providing banks with more loanable funds and less incentive to buy bonds themselves. However, the drawbacks of this measure are almost the same as with interest rates as banks are not likely to inject this money into the circular flow of income. And this will certainly lead to a significant increase in inflation.

An important fact is the term “political economy” that was replaced by Alfred Marshall in 1890 with just “economy” seems to have more sense nowadays. Because of the globalization process and stronger political, economic and cultural connections between countries, some of the measures cannot be taken. For example, a decrease in exchange rate can in theory increase exports and decrease costs on imports, thus increasing aggregate demand and, consequently, GDP. However, this will worsen the international position of the UK, which is rather undesirable in the situation of a fragile economy after the crisis. Also, the very large size of the market for pounds means that the UK government has to let the exchange rate "float", thereby giving up the option of controlling it themselves.

As we can see from above all the measures have their drawbacks even if advantages are strong enough. This actually does make it difficult for the government to decide on the measure to be taken. However, by the latest information on improvements of the economic situation the advantages are overwhelming the drawbacks.