Monetary and fiscal policies in the UK

EXECUTIVE SUMMARY:

The UK’s monetary and fiscal policies came in the form of three main thrusts. The first was a significant reduction in interest rates, the second was the provision of £200 billion of quantitative easing; and the third was a process of fiscal stimulation to the economy (Bank of England, 2009, p. 1). Although the aim of the monetary stimulus package was to raise nominal demand, the monetary aspect largely failed to boost the economy, due to high elasticity of money demand and the low money multiplier (OECD, 2009b, p. 36).

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The fiscal policy stimulus on the other hand, had a more direct impact on the economy.. However, the UK government was unable to provide a substantial stimulus to the economy, due to the weak fiscal position that the UK was in when the crisis broke out (Sawyer, 2007, p. 885). In addition to this, stimulation through government expenditure forced the government to borrow, and run a very high budget deficit. As a result of this, even when the UK began to emerge from the crisis towards the end of 2009, the UK was burdened by a high level of public sector debt. This caused some concern, and led to the value of the UK pound falling as investors were concerned about how secure the currency would be (OECD, 2009b, p. 32). As a result, the cost of UK government debt rose, further burdening the UK economy and making it harder for the government to bring the debt under control. As a result of this, as the UK began to emerge from the financial crisis, the government was forced to cut back on spending, which slowed the pace of the economic recovery (Institute of Fiscal Studies, 2009, p. 3).

The main industry that these policies affected was the financial services industry, and particularly banking businesses within this industry. As Banks were unable to trade in mortgage backed securities during the credit crunch and the subsequent recession, the market value of their assets dropped sharply, forcing many firms into insolvency. UK policies rapidly reduced the risk of a potential major failure in the UK banking industry; banks were able to borrow money much cheaper, and lend it at higher margins (OECD, 2009b, p. 35).

In the UK, HSBC has largely managed to avoid being forced to look for significant financial support from the UK government, and has actually turned the challenges of these policies into opportunities. , In particular, following poor results in 2008, the company cut its dividend, and announced the biggest ever sterling rights issue in order to raise £12.5 billion of new capital from shareholders (Lee, 2009, p. 57). The bank also took advantage of the low cost of finance in the UK to raise more capital for its balance sheet. Whilst this may have seemed like another attempt to board cash and minimise risks, the company actually used this new capital to grow its customer base and business, both organically and through acquisitions.

1-MONETARY AND FISCAL POLICIES:

Frank (1990) defined monetary policies as that part of the government’s policy designed to affect the level of economic activity by influencing the supply and cost of money. On the other hand, fiscal policies can be described as that part of government policy concerned with raising revenue, primarily through taxation, and using revenues to fund public expenditure. (Ian et al., 2001). The UK government have tried, through a mix of monetary and fiscal policies, to curtail the impacts of the financial crisis which started in 2008.

The UK’s monetary and fiscal policies came in the form of three main thrusts. The first was a significant reduction in interest rates, which begun in October 2008 and finished in March 2009; the second was the provision of £200 billion of quantitative easing; and the third was a process of fiscal stimulation to the economy (Bank of England, 2009, p. 1). Of these, the monetary policy was arguably the swiftest response to the crisis. Following the collapse of Lehman Brothers in September 2008, and the subsequent freezing up of credit markets, the Bank of England decided that there was a strong chance of deflation in the UK economy. As a result, the headline policy rate “was cut from 5% before the October 2008 meeting to 0.5% in March 2009, the lowest rate on record. In terms of the real interest rate, the current policy rate implies ex ante real interest rates that are mildly negative in the short run” (OECD, 2009b, p. 36). In other words, the UK cut interest rates so sharply that there was no real cost of borrowing money, as the inflation rate was higher than the interest rate.

However, when this monetary policy failed to have a significant impact on the crisis, and failed to stimulate the economy, the Bank of England tried a new approach. They undertook to provide £200 billion of direct funding to the economy in the form of “quantitative easing”. The Bank of England provided this money by purchasing a large volume of gilts, or UK government bonds, as well as a significant volume of commercial paper. This had the effective of increasing the money supply, whilst also improving conditions in corporate debt markets, effectively allowing banks and other investors to trade their bonds for cash and thus generate more capital (OECD, 2009b, p. 37). Finally, the government also undertook a significant fiscal stimulus, in the form of a temporary cut in VAT; a temporary increase in capital allowances; and bringing forward planned capital expenditure. This has the effect of directly pumping money into the economy, by reducing tax rates for consumers and businesses, and providing more revenue to businesses dependent on the government for work. In addition, the VAT cut was phased out in December 2009, hence helping stimulate short term consumption by indicating to consumers that prices would soon rise again (OECD, 2009b, p. 42).

2-POLICIES AND OUTCOME:

The main aim of the monetary aspect of the stimulus package was to raise nominal demand, by providing a greater level of capital to the economy, and also boosting the money supply. However, the OECD (2009b, p. 36) noted that the monetary aspect largely failed to boost the economy, due to high elasticity of money demand and the low money multiplier (OECD, 2009b, p. 36). In other words, rather than lend the money to their customers, thus helping them spend and invest, banks took advantage of the low cost of the credit to hoard cash in order to protect themselves against any future bad debts or economic issues, and in the knowledge that the negative real cost of the credit meant that they could effectively hoard the cash for free. However, according to the Bank of England the monetary policy stimulus did have some beneficial impacts, including shortening the duration of the crisis, and encouraging more lending in the latter part of 2009 (Bank of England, 2009, p. 6).

The fiscal policy stimulus had a more direct impact on the economy, as it directly boosted GDP by boosting levels of government spending, which is a component on economic value. However, the UK government was unable to provide a substantial stimulus to the economy, due to the weak fiscal position that the UK was in when the crisis broke out (Sawyer, 2007, p. 885). In addition to this, rather than spending all the stimulus money on expenditure, the government was also forced to intervene in the banking crisis, and provide capital to many of the banks, with the banks then proceeding to hoard this capital instead of using it to boost their lending activities. As a result of this, the fiscal stimulus was not particularly effective, and the UK ultimately experienced a recession that was deeper than in many other countries with similar programs (Chamberlin, 2009, p. 6).

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In addition to this, even the direct government spending was not particular effective at stimulating the economy, as the UK has very low multipliers from government spending, with each £1 of government expenditure only providing around a 40 boost to GDP, due to the government crowding out other sectors OECD (2009a, p. 1). As a result, the fiscal stimulus may actually have harmed part of the private sector. Further to this, the decision of the UK government to spend so much money attempting to stimulate the economy meant that the government was forced to take on a significant level of debt, and run a very high budget deficit. As a result of this, even when the UK began to emerge from the crisis towards the end of 2009, the UK was burdened by a high level of public sector debt. This level of debt was so high that some analysts were concerned about the ability of the UK government to pay the interest and repay the debt. This caused some concern, and led to the value of the UK pound falling as investors were concerned about how secure the currency would be (OECD, 2009b, p. 32). As a result, the cost of UK government debt rose, further burdening the UK economy and making it harder for the government to bring the debt under control. As a result of this, as the UK began to emerge from the financial crisis, the government was forced to cut back on spending, which slowed the pace of the economic recovery (Institute of Fiscal Studies, 2009, p. 3).

Another significant issue which occurred was that, as Keynesian economics predicts, the UK experienced a “paradox of thrift” (Corden, 2010, p. 38. This paradox occurs during a recession, when the falling economy causes people to save more and spend less, thus driving the economy ever lower and forcing more savings. Corden’s (2010, p. 38) study shows that, in such a case, monetary policy cannot solve the paradox, as it becomes a market failure and thus needs direct government action to solve it. In the case of the UK, the lack of effective direct government action meant that the paradox of thrift remained, although it was the banks saving money rather than individuals. However, in spite of this the action of the government was somewhat successful at addressing the issues in the UK. In particular, the recession caused an output gap in the UK of around 3 to 5 per cent of potential GDP. The impact of monetary policy acted to reduce this output gap by half a per cent in 2009, effectively reducing the severity of the recession by around 10-20%, and fiscal policy was roughly equally as effective (Barrell and Holland, 2010, p. R51). As a result, in spite of the unintended consequences of the policies, the UK economy would have been worse off without them.

3-IMPACT OF POLICIES ON FINANCIAL SERVICE INDUSTRY:

The main industry that these policies affected was the financial services industry, and particularly banking businesses within this industry. In particular, the credit crunch and the subsequent recession meant that many banks were unable to trade in the mortgage backed securities and other derivative financial assets that they held on their balance sheets. As a result of this, the market value of these assets dropped sharply. This meant that banks were forced to mark the value of these assets down on their balance sheets, to reflect their lower market value. As a result, many of the banks became dangerously insolvent, and were potentially unable to repay some of their obligations and debts as they came due for repayment. This could potentially have caused some banks to collapse, thus reducing the confidence in the financial services industry and causing a major economic crisis in the UK.

However, the impact of these policies rapidly reduced the risk of a potential major failure in the UK banking industry; even if they did not significant improve the situation in the economy as a whole. Specifically, the decision of the Bank of England to reduce the interest rate meant that banks were able to borrow money much cheaper, and lend it at higher margins (OECD, 2009b, p. 35). This made it easier for banks to make profits, and thus make up for the losses that they had made during the credit crunch. Secondly, the use of qualitative easing made it much easier for banks to convert illiquid assets such as commercial paper and government bonds into cash. This gave them more cash to cover their short term obligations, and improve their balance sheets. Finally, the fiscal stimulus directly helped some banks who were dangerously short of capital; by giving them large injections of capital and helping them remain solvent and also meet banking regulations on capital adequacy. Whilst this did not initially have a significant impact on the availability of new finance for businesses in the UK, it did lead to a general increase in credit availability over the course of 2009 (OECD, 2009b, p. 31).

4-POLICIES AND HSBC:

All of the banks in the UK have suffered from the crisis, and been force to cope with the new challenges created by the crisis and by the UK government’s policies aimed at averting them. However, HSBC has largely managed to avoid being forced to look for significant financial support from the UK government, and has actually turned the challenges of these policies into opportunities. In particular, following poor results in 2008, the company cut its dividend, and announced the biggest ever sterling rights issue in order to raise £12.5 billion of new capital from shareholders (Lee, 2009, p. 57). The bank also took advantage of the low cost of finance in the UK to raise more capital for its balance sheet. Whilst this may have seemed like another attempt to board cash and minimise risks, the company actually used this new capital to grow its customer base and business, both organically and through acquisitions. The company thus used the cheap capital and its strong fundamentals to support a policy of offering reasonable prices and a high availability of financial products, thus gaining more customers for itself in the UK whilst other banks were reducing their lending activities.

The company also effectively created its own form of the carry trade, and dealing with the lack of UK demand by using cheap funding from the UK to fund acquisitions and organic growth in the strongly growing market of Asia. HSBC was able to grow its customer base by 10% year on year across Asia, taking advantage of the continuing strong economic growth in countries like China and India (Lee, 2009, p. 59). The company was also able to take advantage of the fact that many western banks were forced to withdraw from Asia as their domestic troubles prevented them from investing in the developing Asian economies. As such, HSBC positioned itself to grab the customers that were left by the withdrawal of western banks, and thus used aggressive promoting activities to expand its customer base whilst it faced a lack of major competitors (Euro money, 2009, p. 15). This example shows that HSBC has manage to turn some of the most significant challenges generated by the financial crisis and the UK government’s policies to its advantage and used them to exploit opportunities both in the UK and abroad.