Current Economic Scenario in the UK - Essay Example

Research –Academia 14th April 2008 Business Economics 2 . For last decade or so consumers in Britain are so much accustomed to spending spree financed by debt that made them the most indebted nation in the world more than the Americans are. They have record debt of £1.4 trillion that is more than their GDP. The economic boom bolstered by a decade –long housing boom in UK in particular created consumer confidence and perception of wealth that is not experienced by anyone else. At the onset of prosperity in real estate market in UK very few opportunity for investment was present in this segment. People and financial institutions both took advantage of the opportunity of borrowing and lending in this segment even by ignoring the basic rules and laws. 70% of bank funds were diverted to real estate mortgage. The income of families and household was diverted from buying goods and services to buying properties- houses and buildings. A large chunk of money was used in payment of debt service to banks and financial companies. The payment of debt service by the economy’s non-financial sectors interrupts the circular flow of income supposed to exist between produces and consumers. The problem of financing network became more complex. Britain faced acute credit crisis in the recent periods caused by slack lending practice by banks, financial turmoil caused by dearth of liquidity, extending risky loans to unpredictable parties and passing on to other institutions, excessive dependency on credit rating companies, over dependence on in financial markets or inadequate liquidity risk management. This has put many sectors of the economy at risk such as · UK commercial property sector, Stock markets, First-time buyers, Buy-to-let investors, UKs sub-prime borrowers and many others. There was exponential growth of savings and debt in UK market. They were used mainly for financing the purchase of real estate, stocks and bonds. Net savings don’t increase in the economy because it is used in re lending for or refinancing assets. This process does not necessarily promote new investment in tangible assets or new factories that add to new employment. No more output is added, no more factors of production is paid. Thus there is a blockade in the circular flow of income. UK faced this very type of economic scenario recently. Consumption from household, which accounts for about 70% of GDP, is the basis of production. Exports add to the consumption share because it takes off consumption of other country’s consumption also. Consumption of UK in recent years had been 90% that was financed out of the real income of the country and not debt. Consumption by household should flow directly from income received from producing goods and services in the country and not financed by debts. In 2007 Gross consumption in UK has been increasing as per the data furnished by bank of England in its report from the Expenditure components of Demand Table 2A 2006 2007 Q1 Q2 Q3 Percentage of Household consumption: 0.7 0.7 0.7 1.1 Govt. Consumption 0.4 0.6 0.5 0.3 Investment 2.4 1.0 -0.8 2.4 Final Domestic Demand 0.9 0.8 0.5 1.1 Higher mortgage rate however will have the biggest impact on consumption. Banks who are themselves borrowing from inter-bank markets at higher rates of 6.5 % or more will charge more to the clients to be profitable. According to Lombard Street Research, household debt is 165% of disposable income in the UK but only 130% in the US. With UK interest rates 20%-25% higher than in the US, UK borrowers are at least 50% more vulnerable. In the first half of 2007, the household sector had a financial deficit of £27.8bn, greater than the £27.4bn for the whole of last year. Richard Jeffrey, economist at Ingenious Securities, estimates a total of £50bn for the year, equivalent to 3.6% of GDP. Household expenditure rose by 0.1% down from 0.8% in the previous quarter. Final consumption expenditure of government fell by 0.5% in this quarter. Gross fixed capital formation rose by 1.8% over 4th quarter of 2006. There was fall in export growth by 0.5%. Import growth rate also fell by1.0%. Trade deficit in real terms decreased from £12.2 in the 3rd quarter to £11.6 billion in the 3rd quarter of 2007 In UK the economy and its prime assets was loaded with debt and interest charges. The growth in credit that is channelled towards asset buying extracts interest payment. With the increase in asset prices the interest charges go on increasing. This takes away again the consumers income away from buying goods and services to further debt servicing. This is another blow to circular flow if income. Physical flow of goods and services from business to household and of resource services from household to the business sector is the basic foundation of circular flow. Besides two sectors there are two markets that include products and resources. Payment flow, that is payment of money from household to business sector in exchange of goods and services and from business to household in exchange for services of resources is opposite to physical flow of goods, services and resources. Circular Flow of Income Revenue Spending Markets Goods & Services Goods & services sold Bought Firms Household Production inputs Land, Labour, Capital Market for factors for production Wages ,rents, profits Income GDP of an economy is the revenue received by the business sector from the household sector for the production of goods and services sold to them Factor payments are wages rent, interest and profits made by the business sector to household sector for hiring resources such as labor, capital, land and entrepreneurship National Income is the income earned by the household sector against supplying labor, land, capital and entrepreneurship to the business sector. Consumption Expenditure is the payments made by the household sector to buy products and services or GDP from the business sector. There is a continuous movement of production, income and resources between producers and consumers and government, between household, business, government and foreign sectors. This circular flow is shown in the diagram. When this income circular flow is disrupted there is economic turmoil. This happened in UK leading to credit crisis. UK economy suffered on account of this. Current economic scenario in UK is discouraging: Saving ratio is all time low. Credit door is cut off. Borrowers have no scope to maintain consumption at previous levels. Real wages are falling though there are increments in wages. Economic growth is slowing. The last quarter growth rate in UK’s GDP is 0.6%. Taxes are rising. Government spending is under pressure. There is threat of rising unemployment. The fiscal deficit is heading for £36bn,which is 3% of GDP. If there is higher welfare spending or lower growth in tax revenue in the wake of slowing growth in the economy this is likely to put strain on government finances. Money market investors are not ready to roll over the old short-term loans as they fall due on account of Northern Rock. The burden has been rising steadily. The will need to finance those loans or force the actual borrower to repay it to Northern Rock. This will amount to raising rates. Output of production rose by 0.2% in the latest quarter but manufacturing, as a whole was flat. Service industries grew at 0.7% in the 4th quarter down from 0.9% in the previous quarter. Monetary Policy committee has been trying to check reckless growth in borrowing for real estate by raising the base rate of interest but ignored by the creditors. The present borrowing rates fixed by the banks and institutions is 6.5%. The basic difference between the Britain Consumer debt and that with German’s is the size of debt in Britain. . UK bears a record debt of £1.4 trillion that is more than their GDP. The economic boom bolstered by a decade –long housing boom in UK created consumer confidence and perception of wealth that is not seen in Germany at all. People in Germany are reluctant to borrow more from banks for any damn purchase as Britons do. State-owned banks also don’t push for bank loans to earn profits. In Britain the basic mantra is to spend now and think later as American do. The credit environment is easy to promote credit card and loans than to promote saving cards. That is why there are about in average 2.8 credits cars with every youth of Britain more than any German or European has. As a result a common Briton spends quite more than an average German on any common things such as pay for vacation or buying furniture or on medical bills. Surprisingly the household debt –to – income ratio in Britain is 1.62-compared to1.09 in Germany. This is bigger than even that of USA, which is 1.42 only The financial regulators in Britain are almost supportive and control from surface only but in Germany they are very restrictive. This led to proliferation of this market to more sophisticated and large. The real estate soaring prices in Great Britain fuelled the soaring demand for debts. The lower interest rates in early 2000s supported it. The real estate prices in Germany and in the rest of Europe did move much because the market was very much regulated. References Circular Flow, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2008. [Accessed: April 5, 2008]. Larry Eliott economics editor The Guardian, Thursday October 25 2007 www.guardian.co.uk Max King, guest columnist, This is Money 3 October 2007, 3:36pm Mankiw,Gregory(2006). Principles of Economics. Thomson Europe. ISBN 1844801330.  pp23 Sam Fleming, Daily Mail1 November 2007, 8:21am www.thisismoney.co.uk Sloman, John (1999). Economics, 3rd edition, Prentice Economics. Europe: Prentice-Hall. ISBN 0273655744.  pp12 www.economicsuk.com www.bankof england.co.uk Read More