Britains Recent Credit Crisis - Report Example

A Report on Britain’s recent credit crisis a) How useful is the circular flow diagram in explaining Britain’s recent credit crisis? Circular Flow Diagram Before moving further it is important to know what is a circular flow diagram .Circular flow is a term in economics which basically is a model which describes a circulation of money between producers and consumers In the circular flow model,i producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income and are interdependent on each other The circle of money flowing through the economy is as follows: total income is spent with the exception of savings which are termed leakages while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth can add to total spending. There is another term called injections which equals borrowing for purchasing or investment. If injections are greater than the leakages, in other words there is more borrowing than savings, the circular flow grows and there is economic prosperity. If it is opposite there is recession. “The circular flow diagram divides the economyii into two sectors: one concerned with producing goods and services, and the other with consuming them. Resources are converted into goods and services by business, and in this transformed state travel back to consumers. Money flows in the opposite direction. These flows involve two markets in which exchange take place: the resource or factor market in which business buys resources, and the goods and services market in which business sells goods.” Credit Crisis in Britain “Access to cheap credit in Britain has fuelled a decade of unprecedented growth, with home prices tripling over the past decade, a faster rise than in the US. Consumer spending has skyrocketed, now making up roughly two-thirds of the country’s total outlays. And the overall economy in Britain is more dependent on financial services than it is in the States. As in the US, consumers are another key driver of the economy and today they’re 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 country’s entire economic output. Household debt as a percentage of gross disposable income is 166%, compared with 127% in the US. So it’s hardly surprising that in the past year, British banks have had to write off $18 billion in bad debts, mostly consumer borrowing. With the average home now costing $370,000 roughly 11 times the average salary housing is less affordable than at any time in the past 15 years. The latest data show house price inflation running at about 9.5% annually for August, but the rate is starting to slow. Although most believe that the Bank of England is unlikely to raise rates further anytime soon, the cost of servicing mortgages is expected to climb. That’s because the crisis in the financial markets has raised the cost of borrowing for lenders, who will in turn pass on those costs to consumers, many of whom have adjustable rates.”iii Explanation of Current Credit Crisis in Great Britain using the circular flow diagram. The diagram below shows the U.S. Circular flow including credit flows. It is a lot more involved than the previous circular flow diagram but it would explain the current credit crisis in Great Britain. Since the financial system in Great Britain and the U.S. are very similar, they have similar traits but face similar problems. The only thing is Great Britain’s credit problems are a lot worse than the U.S. Let us analyze the British situation using the circular flow diagram below. 1. British Consumers have borrowed over $ 2.7 trillion which is even higher than the total Annual GDP number. Now obviously this debt has been acquired over a period of few years, so how does this reflect as an injection into the circular diagram. 2. Let us look at the simple circular flow diagram on the first page. If one British person earns a hundred pounds, he buys a hundred pounds worth of goods and services, assuming no savings. 3. Using the circular flow diagram below, one can see that the same British person is able to inject more than the amount of his earnings into the Economy. So a person earning 100 pounds has bought 266 pounds of goods and services , bringing in a certain amount of prosperity 4. The industry has built up capacity now to produce 266 pounds of goods and services. But this prosperity is not sustainable as the ability of the person to borrow now diminishes and not only that, he has to return the amount of money he has borrowed. This will result in reduced circular flow and trigger a recession. Conclusion: The freely available credit over the last few years to the Great Britain has resulted in a strong growth in GDP and a drastic inflation of asset prices like houses. The Britons have used this injection of money into the economic system and have become heavily indebted. Since the debt amount is so much larger than the income in the circular flow, increasing debt defaults and reduction in credit will seriously reduce the circular flow having serious repercussions for the British Credit market in particular and economy in general.iv (b) How does Britain’s consumer debt compare with German consumer debt? There is a fundamental cultural difference which can be seen herev. The way an average Briton looks at debt as compared to an average German. “As in the United States, a decade-long housing boom and strong economic growth bolstered consumer confidence, creating a perception of wealth almost unknown in countries like Germany. Germans remain reluctant to borrow and banks are often state-owned, pushing less for profits from lending, according to Alistair Milne, a professor at Cass Business School in London. The average British adult has 2.8 credit or debit cards, more than any other country in Europe. A growing number are borrowing to pay for vacations, furniture, even plastic surgery. As a result, Britons are spending more than they earn, racking up a household debt-to-income ratio of 1.62 compared with 1.42 in the United States and 1.09 in Germany. While Britain’s financial regulators watched the explosion of retail lending from the sidelines, their counterparts in Germany were more restrictive. As a result, the British market became the largest and most sophisticated in Europe. The growth was also fueled by soaring demand for debt on the back of rising real estate prices and relatively low interest rates in the late 1990s and early 2000s. Those who did not own a house rushed to join the homeowners watching their property triple in value. The trend on the Continent was the opposite. Home prices in Germany barely moved, mainly because markets were more regulated, there was more housing stock and renting was more popular.”vi The Germans are a lot more equipped than the Britons for handling any economic slow down as their average debt just equals their annual income. There also is no danger of any housing collapse in Germany as it is the U.K where the prices have gone up almost three times. Apart from the cultural difference, the Britons and Germans have viewed the economy very differently. While the Britons have pretty much assumed that the bad times will never come, the Germans have been very pessimistic. The result has been that “German consumer credit market has seen slow growth in recent years. A number of factors have contributed to this including poor economic performance, persistent unemployment, and low consumer confidence, a culture that is adverse to debt and promotes work, discipline and saving and poor credit card penetration”vii Skip to next paragraph Reference: Read More