After the pandemic hit the UK economy in March 2020, it was quickly apparent that animal spirits were low in the economy, and that the economy was entering a recession far more severe than that of the 2008-09 financial crisis. As a result, it was vital that the government appropriately reacted by using a combination of fiscal and monetary policy to make sure the impact of the recession on the UK economy wasn’t as pronounced as it was looking to be.
Firstly, the Chancellor of the Exchequer, Rishi Sunak, introduced a furlough scheme to counteract the avalanche of job losses across the country. This was an example of fiscal policy, where current government expenditure was used to boost the economy to attempt to take it out of the recession. All those who were unemployed in the pandemic and were part of the workforce were eligible to claim transfer payments (through their employer) to help millions across the country have an income. This has cost the Treasury over £100 billion so far. This has been very expensive for the government as they are running a budget deficit, meaning that they are having to fund all their government expenditure via borrowing. This also inhibits future economic growth, as in the future some money will have to be spent on interest payments on this loan. As a result, this loan will lead to an opportunity cost, as this money, which could have been spent on improving the standard of living in the economy, now has to be used to pay-off something which the future generation are not even responsible for.
Another example of fiscal policy which was introduced in the summer of 2020 was a government scheme titled Eat Out to Help Out. The hospitality industry was one of the most heavily effected industries in the UK, with 1.4 million people working in this industry being furloughed. Therefore, this scheme was used to stimulate the economy by boosting the food and beverage sector of the hospitality industry. In this scheme, Rishi Sunak announced the Treasury would be funding 50% off the total cost of meals up to £10 from Monday to Wednesday throughout August. As a result, this was a real boost to the hospitality industry, as there was an incentive for consumers to go to restaurants and eat out, with the cost of eating out being half of what it normally was. The increased consumption resulted in a rise in aggregate demand and also significantly helped with increasing consumer confidence in the economy in the hospitality industry. However, some people say that the scheme led to nothing but exuberant spending by the public from Monday to Wednesday in August.
Secondly, the Bank of England implemented some changes in monetary policy. Interest rates, which are the reward for saving and the cost of borrowing, were dropped from 0.75% to 0.25% on 11th March 2020, then dropped again to 0.1% just 8 days later, which is the interest rate as of 17th June 2021. A fall in the reward for saving disincentivises people from saving, meaning the marginal propensity to save (MPS) will fall, and so will saving. In conjunction with this, a fall in the cost of borrowing incentivises people to borrow, meaning they are more likely to take loans and consume more, resulting in increased aggregate demand and hence, increased economic growth. However, there are a few problems with lowering interest rates in response to a recession. Firstly, very low interest rates can result in healthy firms undertaking unproductive projects, as they are more likely to be open to ideas which they wouldn’t have initially considered had the cost of borrowing been higher. Furthermore, lower interest rates incentivise the existence of “zombie firms” - a term used to refer to those firms who are inefficient and significantly underperforming, but are able to stagger on as a result of low interest rates funding their unsustainable spending. A report by KPMG in May 2019 stated that almost one in seven firms in the UK at the time were in this category, and after interest rates have dropped even further, the proportion of zombie firms in the UK will only be higher. After the interest rates are raised, these firms will not be able to grow, but rather only just manage to survive by paying off their debts, with no supernormal profits available to be re-invested into the firm. Furthermore, there will be a misallocation of capital and labour, as the factors of production at a less productive firm would be more useful in a more productive firm.
Another tool central banks can use to stimulate the economy is known as quantitative easing. Here, the government makes large-scale purchases of government bonds, which help to lower the yields (interest rates) on these bonds. In turn, this pushes down the interest rates offered on loans as rates on government bonds tend to affect other interest rates in the economy. Again, this means it is cheaper for households and businesses to borrow money, increasing the marginal propensity to consume (MPC), which encourages spending. Another way quantitative easing can stimulate the economy is by boosting financial asset prices. For example, if the Bank of England buys £2 million of government bonds from a pension fund, the pension fund now has £2 million in money. They might decide to invest this money into financial assets, like shares. As a result, there is now a greater demand for these shares, which in turn drives up the price of these financial assets. As wealth is defined as the stock of assets, the increase in value of these assets results in the increased wealth for those who own these assets. This results in the wealth effect, which is the notion that individuals increase their consumption when they feel wealthier. Increased consumption results in an increase in aggregate demand, and hence more economic growth. In fact, the Bank of England used quantitative easing initially in November 2009 in response to the financial crisis, with £200 billion being spent on bonds. After March 2020, the BofE has spent £450 billion on bonds in an attempt to stimulate the economy after the pandemic, taking the total spending on quantitative easing up to £895 billion. This has been the case as of July 2021, when I have written this article.
However, quantitative easing can result in a few problems for the UK economy. Quantitative easing can result in an increase in the money supply, which causes inflation. This leads to a depreciating exchange rate, leading to a fall in the purchasing power of the Great British Pound (GBP). The UK has been a net importer for a long time, and so while the depreciation will help to make exports more price competitive on the global scale, exports will become more expensive for UK inhabitants, which would result in a fall in the standard of living of UK residents.
Another policy used by the Bank of England was the re-activation of a liquidity facility which was created after the 2008 financial crisis, named the Contingent Term Repo Facility (CTRF). This was introduced with the aim of alleviating friction in money markets as a result of the economic shock caused by the COVID-19 pandemic. Financial institutions could borrow cash from the Bank of England for a 3-month term in exchange for less liquid assets (collateral). In turn, this has supported financial market functioning by providing market participants with a reliable source of liquidity, which would allow businesses to increase investment, which is a component of aggregate demand. The increase in aggregate demand would also result in an increase in economic growth.
Finally, the government also introduced the Stamp Duty Holiday in June 2020. This had the intention of boosting the housing market by making it cheaper to buy houses. Stamp Duty is a type of tax paid when you purchase a house. Normally, the Stamp Duty free threshold is £125,000, meaning you don’t have to pay Stamp Duty on the first £125,000 on your house. Recently, this tax free threshold was increased to £500,000, meaning buyers would have to pay far less Stamp Duty tax than in a normal case. The Stamp Duty Holiday achieved its aim, as there was a marked increase in consumer confidence in the economy, and a higher willingness for people to buy houses. Property prices across the UK have risen 13.4% on the previous year, resulting in the greatest increase in house prices since 2004. However, some people have seemed to suggest that all the holiday has done is inflated a big bubble, and created a massive increase in prices and lending which will all eventually fall away again.
In conclusion, recent analysis seems to suggest that the UK is slowly returning to pre-COVID levels. While the actions of the government and the Bank of England have been vital for the UK economy’s recovery, in truth we will only be able to judge the impact of the borrowing on the economy in the future.
References:
1.How much is COVID-19 costing the UK and how will we pay? - BBC News
2.Eat Out to Help Out hailed a success by majority of hospitality businesses - The Guardian
3.Bank of England website
4.Head 2 Head: Has the stamp duty holiday been a success? - Financial Times
Comments