Business News

The Economy - How Bad is it Going to Get?

As we head into the summer holiday period, the question that arises, as we see huge problems occurring in certain sectors of the economy, is will economic and industrial activity reduce so far that a significant number of people will lose their jobs. If so, house prices could drop very rapidly, leading to much greater problems in the financial markets and consequently a further drop in the economy.

Stable Economy

In the late 1960s and early 1970s, the government thought they could stabilise the economy by treating it rather like a balloon and reflating or deflating this as the need arises through making credit available and easing controls, or prices and incomes policies restricting price increases and wages. The question for them then was at what level should the economy increase in order to remain stable. Other foreign economies, particularly Japan and Germany, had much higher growth rates and the government thought that they could provide more credit and reflate the economy in order to obtain the higher growth rates. The result, as we know, was that asset prices increased, particularly property, oil prices shot up, inflation increased and, through the union power, wages increased rapidly. The consequence was that the economy overheated, interest rates went up and the result was the recession in the mid 1970s.

Since the early 1990s western governments have put in place interest rate mechanisms to control inflation and in the UK the Monetary Policy Committee decides on interest rates with the main aim of controlling inflation, but with an eye to other economic factors. The US have particularly taken this further by using interest rates to try to stabilise the economy, reducing interest rates hugely in order to protect the economy when it starts to slow down. For a time this has been relatively successful, but it has been partly responsible for higher inflation and also asset price increases and excessively risky lending.

Western economies have benefited from cheap Far East labour in a global economy, but the effect of this has been to lead to a huge increase in demand for commodities, including oil, and prices have risen leading to high inflation globally.

Is Slowdown/Recession inevitable every 6-8 years?

There is a view that mature economies should not grow more than 2%-2.5% per annum. If they do, they will be vulnerable to slowdown or recession.

There is also concern that, if an economy is protected through interest rates (such as in the US), or by other means, this could lead to the following:

1. Inefficiencies - through protecting the economy, the inefficient businesses do not go to the wall.
   
2. Productivity - without the competition for business and jobs, productivity falls.
   
3. Gearing and risk - businesses take higher risks and increase their gearing, and financial institutions make risky lending decisions.

We have particularly seen no. 3 above come out in terms of the IT/Technology bubble of 2001, and the problems in the financial markets and property lending in 2007.

UK Economy

There is no doubt that the UK economy has weakened significantly, and there have been some suggestions that we might even be in recession now. It is certainly clear that there are huge problems in certain sectors, particularly housing and construction and allied industries, financial institutions, retail and perhaps motor. Houses are not selling, mortgage rates are going up and consumer expenditure is down.

UK personal debt is still very high, with the figure at the end of May 2008 being £1,443 billion, with a growth rate for the year to that date of 8%. The total consumer credit lending to individuals in May 2008 was £233 billion. Individuals are under pressure from higher mortgage interest rates, higher food prices and the increases in petrol and energy prices. This is having its effect on keeping inflation high and consequently interest rates are not dropping. It remains to be seen whether the UK economy will go into an accelerating downspin, with the problems in the sectors mentioned above feeding through to the wider economy.

How can the Economy pull back up?

There are a number of ways in which the economy could improve, but in view of the above, an increase in consumer spending seems the least likely. Other possibilities are as follows:

1. The slowing of the UK and world economies reducing inflation, which leads to lower interest rates, providing a stimulus to the economy.
   
2. Liquidity problems ease. Inter-bank lending increases. However, if property prices drop too far, the problems with the financial institutions would only increase.
   
3. The US economy starts to pull out of recession/slowdown with a knock-on effect in the UK.
   
4. The lower exchange rates help to stimulate the economy through increasing exports.

With the news that there are huge problems with certain sectors in the economy and job losses likely to increase significantly in the autumn, perhaps now is the time for the MPC to reduce interest rates. They can probably afford to do so because petrol and energy prices are holding back consumer spending and mortgage interest rates are likely to remain high even if base rates reduce. Also, inflation tends to lag the economy and is likely to fall over the next 6-9 months, particularly with job losses starting to feed through.

Stock Markets

The FTSE 100 Index is back to around the level of March 2005, and reflects the problems in the economy with certain sectors falling very sharply. The financial sector is down 37%, whereas the mining sector is up 24%. The oil and gas sector is only up 5%, but was quite high a year ago.

Although the average price earnings ratio for the FTSE 100 companies is very low at 10.8, this, of course, compares the current price with historic earnings and it clearly indicates that the market thinks earnings are going to drop significantly. The average dividend yield at 4.3% is high, but the uncertainty is whether dividends will be cut, as seems likely, particularly in the banking sector.