Britains Recent Credit Crisis - Case Study Example

How useful is the circular flow diagram in explaining Britain’s recent credit crisis? The September 6, 2008 edition of business week ran a story d “Britains Coming Credit Crisis” that predicted that Britain is about to undergo a credit crisis much like the way American economy has experienced years ago. The writer drew parallels between the US and UK economy, in their ever-increasing dependence on business and financial services for overall growth, the higher rate of consumer spending, the higher percentage of unsecured loans given away by the banks, the over-valuation of real-estate and topping of housing prices. (Capell). One of the country’s top five banks The Northern Rock Bank announced severe bad debts and a depleting bottom line due to poor repayment of unsecured loans. Northern Rock was one of the main mortgage lenders in UK who had jumped onto the home loan bandwagon headfirst and declared unprecedented growth in their operations. The credit crisis in UK happened mainly due to the following reasons, 1. Dependence on Financial Services to sustain the economy. 2. Over selling of unsecured personal loans by the banks. 3. Excessive consumer spending. 4. Over-valuation/appreciation of real estate assets. 5. Low borrowing interest rates making them increasingly attractive for consumers. 6. Non-or-low timely intervention by the regulatory authorities. Many of these factors are so inter-dependent to each other in such a way that when one occurs the others are bound to flow as a chain of events. The circular flow diagram is a good tool to depict the inter-dependence of these factors and to show how a change in one factor will change the other. The circular flow diagram: It is a simple illustration how money flows in an economy. In the diagram money flows in the clock-wise direction while goods/service flow in the opposite direction. This shows how money circulates from the producers to the consumers and back to producers and then back to the consumers in a continuous circular operation. The circular flow diagram bifurcates the economy of a country into two distinct parts. The first part is concerned with producing goods and services while the other deals the consumption of these goods and services. Businesses /firms convert the resources into goods and services, and, these in turn travel back to consumers when they pay money to purchase these goods and services. (Circular Flow). The circular flow diagram can be used to explain the credit crisis in UK by showing how consumer spending affects the other factors of economy. The consumers had an almost unlimited access to cheap credit that accelerated fueled a decade of unprecedented growth in financial services, with real estate prices growing by over three times over the past decade, Consumer spending skyrocketed, now making up roughly two-thirds of the countrys total outlays. Financial and business services had increasingly dominated economy with almost half of the national income coming from these sectors from accounting and legal advice to real estate. Such over dependence meant that if there was a fall-off in financial services it would put the brakes on the economy to such an extend that thousands of jobs could be lost, especially those employed with banks, brokerages, and other financial outfits. Like the US, consumers had become the key driver of the economy in UK. Easy access to cheap credit had made them among the most indebted in the world. “British consumers owe $2.7 trillion on credit cards, mortgages, and other consumer loans—or more than the countrys entire economic output. Household debt as a percentage of gross disposable income is 166%, compared with 127% in the U.S. So its hardly surprising that in the past year, British banks have had to write off $18 billion in bad debts, mostly consumer borrowing.” (Capell). (Theories). In the above diagram, the circular flow diagram has been expanded to include the real world economic forces such as Governmental intervention, taxes, financial institutions etc. In Britain’s case, it all started with the financial institution offering cheap credit to the consumers making them borrow more and more on mortgage or other unsecured loans far above their income levels. Apparently, the more the consumer borrowed the more he spent. This increased levels of consumer spending created a spurt in the product markets resulting more consumption of products and services, which in turn increased the income levels of the firms that produced these products and services. The firms then spend their income on resources such as labour; land and capital further their output of products and services. In the case of Britain, there was injection of money into the system by the financial institution to the consumers. Instead of spending what they were earning from their livelihoods, they were spending from borrowed money. However, the product markets in Britain were booming due to the increased consumer spending. This increased the income of the firms to such a level that after spending for their resources they had enough surpluses to invest in the money market. This worked fine initially while the economy was booming. But the fact that the consumers were spending on borrowed money ultimately caught up with them as the valuation of their mortgages get saturated and loans had to stop. When the economy began to collapse under the pressure of peaking real estate prices and mortgages consumers started defaulting on repayment of loans making the financial institutions vulnerable. Foreclosures and personal bankruptcies increased. The government tried to intervene by increasing the interest rates but this also made the financial institutions borrowings from other institutions difficult. In the diagram, one can see the part played by the government in collecting taxes and spending towards infrastructure and other developmental costs. As also the part of financial institutions in lending funds to the consumers and firms. While the money flows in one way, the products/services flow the other way as it is an exchange that takes place. Today’s real world economies there are a significant amount of leakages and injections into this circular system. This is fine for any economy as long as they are balanced i.e., when the injections and leakages even out. What happened in Britain was an unbalanced injection of funds into the market because of excessive borrowing of consumers riding on an artificial appreciation of real-estate prices. The system became unstable as the real estate prices hit the roof and threatened to collapse. The circular flow diagram given clearly depicts the roles played by each of the factors in the system. The diagram is effective while explaining the credit crisis of Britain. Britain’s consumer debt vis-à-vis German Consumer Debt: When one compares the British and German economy, there are number of substantial similarities. Even though the general image of Britain as service oriented economy and Germany as a manufacturing economy, the development of both these countries has been very similar to each other. There is also a significant amount cross border investment between the two countries. The consumer debt crisis in the UK affected a number of German Banks as they had invested heavily in the debt instruments in UK. The main constituent in the consumer debt has been in the form of borrowing for housing. For example, such borrowing currently accounts for around 75% of total household debt in the United States and the United Kingdom and around 60% in France and Germany, while in Australia it accounts for 85%. Like the graph above shows most of the developed countries has followed a similar pattern as far progress in consumer debt is concerned. UK shows the highest levels of consumer debt by the year 2005. “According to the most recent data from Paris-based Organization for Economic Cooperation and Development, total consumer debt in the U.K. stood at 164% of annual disposable income at the end of 2006, by far the highest level of any developed country. In the U.S., that number was 138%.” (MacDonald and Whitehouse). This statement alone is sufficient to explain the state of affairs in Britain as far as consumer credit is concerned. The history of Consumer debt in UK: The increasing consumer debt phenomenon started in the mid 1990s when the housing boom began. As prices of personal real estate assets rose, so did the level of debt carried by individuals. Banks and financial institutions significantly loosened their lending terms to such an easy level because of the value of mortaged assets were on the rise. Rising real estate prices made lenders believe that they could recover their money in case of repayment problems. To add to the consumer debt, US credit card firms such as MBNA started their operations in UK and introduced interest-free credit deals, which started a trend followed by most of the competitors. The access of such cheap credit made the people spend heavily on home improvements, new cars and holidays to expensive locations. All on credit - as lenders soaring profits encouraged them to downgrade the risk of defaults. The lending became further developed as sophisticated credit score were given to consumers giving them instant loans with minimal information. Other factors were the mis-selling of financial products, which critics argue increased personal debts, and student loans, loading a generation with years of debt. (Inman). When the UK consumer debt scenario is compared with that of Germany, it is seen that the though the pattern has been similar, Germany has handled it a much better fashion than UK. The graph shows how the number of households with severe debt crisis have increased over the years comparing the east and west regions. It shows a steady increase over the years and much like the UK credit crisis has resulted in several banks being victims of repayment issues and forced to write off hefty amounts of debt. (Haas). The consumer debt of UK has recently been excess of 1000bn pounds, which is above its total national economic output whereas in Germany the figure has not reached such alarming levels. Works Cited Capell, Kerry. Britains Coming Credit Crisis, Steep housing prices and a dependence on financial services make its economy vulnerable. Business Week. 2007. 18 Apr. 2008. . Circular Flow. 18 Apr. 2008. . Haas, Oliver J. Overindebtedness in Germany: Working Paper N° 44. International Labour Office: Geneva. 2006. 18 Apr. 2008. . Inman, Phillip. Debt worries become the chief reason citizens seek advice. Guardian.co.uk. 2007. 18 Apr. 2008. . MacDonald, Alistair., and Whitehouse, Mark. Credit Crunch Pounds U.K. Economy. The Wall Street Journal. 2008. 18 Apr. 2008. . Theories: The National Income Accounts: Measuring the Circular Flow of Income. Zambia: Virtual. 2008. 18 Apr. 2008. . Read More