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The Effects of Unsustainable Borrowing: A Credit Crunch Recession


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The policy response rolled out during the pandemic is characterised by the lessons learnt from the Financial Crisis. Fiscal policies such as Furlough, Stamp Duty Holiday, and the Help to Buy Scheme, have all shown that the UK government attempted to avoid the same problems that the 2008 Crash brought. For example, Furlough supported labour market stability, preventing unemployment rates from skyrocketing. (Figure 1) With the introduction of the Help to Buy Scheme and Stamp Duty Holiday, house prices remained stable. (Figure 2) As such, this was instrumental in preventing a repeat of the Financial Crisis with a negative wealth effect avoided. This meant the UK government attempted to rectify its past mistakes. For the Bank of England however, such an expression is not applicable. By introducing similar monetary measures during the pandemic to the Financial Crisis the Bank of England’s Monetary response has had widely detrimental effects as policymakers took a ‘one size fits all’ approach. As such, the following essay will assess the impacts of the UK government's successful fiscal policies as well as the poor policymaking by central bankers on money growth, inflation, and spending.


To appreciate the success and effects of the UK government's fiscal approach the differences between the Financial Crash and pandemic must be examined. Concerning the Financial Crisis, the economic collapse originates from financial circulation. With the US subprime mortgage crisis spreading contagion to the UK a severe fall in confidence followed within the financial circulation. As such, this led to the devaluation of assets such as housing as well as equities. (Banks et al., 2012) This trend, whilst originating within the financial circulation, spread to the industrial circulation, or, the ‘real economy.’ The impacts of this were a negative wealth effect for consumers, reducing consumption, and, for businesses, reduced valuations. This all contributed to a reduction in aggregate, yielding a fall in GDP (ONS, 2018a) with economic uncertainty being high. Consequently, during the crisis, UK unemployment rates spiked to record highs (ONS, 2018b) as the derived demand for labour collapsed due to reduced economic activity. Within this climate, traditional economic theory would suggest the UK government should have introduced large-scale expansionary fiscal measures to counteract the fall in aggregate demand. However, the fiscal response during the crisis was limited as a large portion of the government's budget was allocated towards bailouts. (Grice, 2009) As such, the opportunity cost associated with this decision meant that fewer resources were directed toward the industrial circulation. With this lack of support, UK GDP took five years to recover, with unemployment rates staying above target for years post-financial crisis. (ONS, 2018c)


Looking at the fallout from the Financial Crisis, once the pandemic arose, the UK government adapted its strategy to balance the support of both the financial and industrial circulation. During the pandemic, the financial circulation saw government support via schemes such as Help to Buy and the Stamp Duty Holiday. By nature, this intervention kept the UK property market moving. This contributed to higher house price growth (Figure 2) which helped to prevent a repeat of the Financial Crisis as stability in the housing market prevented a negative wealth effect. Yet, with the pandemic originating within the industrial circulation as a supply and demand shock, fiscal measures that stimulated the financial circulation did not address the root of the crisis. However, with aggregate supply levels being difficult to stimulate due to the opportunity cost of prioritising public health, (Brinca, Duarte and Castro, 2020) the UK government focused on the demand shock. This fiscal policy direction, designed to mitigate the extent to which aggregate demand levels, or short-run economic growth, would fall during the pandemic, was characterised by one main intervention. The Furlough Scheme. Factors such as high uncertainty during the pandemic as well as lockdowns all contributed to a reduction in economic activity. As such, with lower aggregate demand levels, the derived demand for labour fell. However, this reduction was cushioned via the Furlough Scheme as the intervention effectively provided a replacement for the lost income, and, marginal revenue product, that would have occurred for workers, and, the latter, borne by the firms. With 11.7 million employee jobs being Furloughed through the scheme, at a cost of £70 billion, (Powell, Francis-Devine and Clark, 2021) the fiscal response maintained job security and consumer liquidity. Consequently, once lockdown restrictions were lifted and vaccination rates rose, rising confidence followed, (Romei, 2021) which led to a demand-side recovery as consumer spending backed by a stable labour market increased. By looking at core economic indicators, it is found that compared to the Financial Crisis, the UK recovered faster, and stronger, from the pandemic. GDP is above pre-pandemic levels (Figure 3) and labour markets are tight with unemployment rates nearing record lows, (Figure 1) all of which show the successes of the UK government's fiscal response during the pandemic.


Although this analysis illustrates the effects of fiscal policy, it does little to forecast the future impacts on economic indicators. This is for two reasons. First, it is difficult to forecast the consequences of fiscal measures such as Furlough as the scheme was not additional income, or, for firms, additional MRP. Instead, Furlough was a substitute for lost economic activity. Not even a complete substitute. The scheme covered 80% of workers' wages. (GOV.UK, 2021) Hence, those Furloughed are 20% worse off, meaning a reduction in aggregate demand. From a Keynesian perspective, this means the injection of government spending into the circular flow via fiscal policy did not fully replace or increase the exchange of income between households and firms. In other words, the view that the Furlough Scheme has been directly inflationary is incorrect. This analysis lays the groundwork for the second argument. The ‘ketchup-bottle economy,’ was a term coined by Economists (Sandbu, 2021) to show the potential short-term surge in spending that would occur once confidence rose. And, to an extent, the ketchup-bottle economy did manifest in the UK. Once vaccine rates rose to 80 per 100, UK inflation rates spiked (Figure 4) as UK households spent their lockdown savings. (Elliott, 2021a) This is why Economists have argued that fiscal measures have been inflationary. Yet, if the income spent from Furlough were to have been spent gradually throughout the pandemic, the likelihood is that the scheme would have been hardly inflationary. Hence, spikes in the rate of inflation were not a direct byproduct of fiscal policies such as Furlough. Rather, initial higher inflation rates were a consequence of lockdowns that warped consumer saving habits, yielding unnatural levels of savings and household liquidity. (Partington, 2021) Therefore, lifted lockdown restrictions rectified the distortion as a correction arose in the form of a spending spree. (Elliot, 2021b) Consequently, in the case of fiscal policy, rising inflation and spending in the short run were a symptom of halted economic activity. Moreover, with these policies being a substitute for lost economic activity, it is difficult to argue that they have directly contributed to past, present and future deviations away from trend growth in indicators such as money growth, inflation and spending in the long term. The only certain consequences of these policies however will be an increase in austerity measures to balance the UK’s record levels of national debt, (ONS, 2022) which, according to Keynesian Economic thought, will reduce spending and inflation in future.


However, this analysis does not explain the current record-high rates of inflation that the UK (Bruce and Milliken, 2022a) is experiencing and the forecasted peak in inflation rates. (Bank of England, 2022a) This is because the Keynesian model of the circular flow of income is limited in describing the relationship between Industrial and financial circulation. The previous analysis, which this examination will continue to refer to, concludes fiscal policy conducted during the pandemic will not cause any expansionary deviations in money growth, inflation, and spending. As such, to explain why forecasts indicate trends such as higher inflation in future, one must examine other ways to how the financial circulation of an economy is stimulated. From a policy perspective, the use of Monetary Policy is how the Bank of England stimulates the financial circulation of an economy to meet the inflation rate target of 2.0% CPI as such stimulation feeds into the industrial circulation. During the pandemic, the halting of economic activity due to lockdowns depreciated aggregate demand levels as money leaked out of the circular flow due to higher savings. This led to a reduction in CPI inflation rates to below target, (Figure 5) prompting a response from the Bank of England to reduce interest rates to record lows and a QE programme of £895bn. (Bank of England, 2021) (Bank Of England, 2020) Such a Monetary response is akin to the one implemented during the Financial Crisis, (Deleidi and Mazzucato, 2018) yet, the effects have been drastically different. With the Financial Crisis first originating in the financial circulation meant the Bank of England's Monetary Policy response was not inflationary. (IIMR, 2021) Despite increased liquidity due to QE, the lack of confidence in the financial sector meant that banks which were illiquid were unwilling to create credit even at cheaper rates. Additionally, with little fiscal support during the crisis, the high rates of unemployment (Figure 1) and uncertain economic climate meant consumers and businesses were unwilling to demand credit, opting for more risk-averse behaviour. This combination of an unwillingness to create new money (credit) paired with a lack of demand for money meant Central Bank measures during the Financial Crisis did not yield higher rates of inflation.


However, the same strategy the Bank of England used during the Financial Crisis does not apply to the pandemic as Monetary Policy has been inflationary. The reasoning behind this error is due to the pandemic originating in the industrial circulation rather than the Financial one. With the Financial Crisis occurring due to an inherent distrust and lack of confidence in the financial sector, the COVID pandemic was a supply and demand shock of the ‘real economy.’ Granted, such a shock would spill into the financial circulation as investors would look to liquidate returns due to a lack of confidence. Yet, in the case of the pandemic, the lack of confidence was only temporary. The large fiscal response from the UK government meant that investors seized opportunities in markets such as housing with the Stamp Duty Removal, increasing housing prices. (Figure 2) Moreover, with markets being forward-looking, the rollout of schemes such as Furlough meant investors believed a strong recovery was a possibility, thus aiding the recovery of asset prices. (Wearden, 2021) Additionally, this recovery in asset prices was accelerated by Monetary Policy with the QE programme as OMOs make other assets more attractive as rising government bond prices reduce yields. This paired with increased liquidity for investors means more cash is diverted towards the said assets. Consequently, this yields an increased wealth effect for agents operating in the Financial Sector. Appreciating prices means firms wish to liquidate their assets, opting to spend returns in the industrial circulation, or, for banks, an increase in the willingness to lend. As such, with financial markets having comparatively higher confidence, banks were willing to expand the supply of money by creating credit. At the same time, once lockdown restrictions were lifted, strong demand for credit ensued as households who had their job security protected through Furlough were willing to engage in more risky behaviour. In this sense, the strong fiscal response from the UK government has created a climate for Monetary Policy to be more inflationary in the medium to long term. Hence, the expansion in the supply of money broadly defined (Figure 6) due to private money creation has led to the real balance effect. This has led to record high inflation rates (Bruce and Milliken, 2022b) manifesting to rectify the disproportionate increase in the supply of money caused by the bank of England.


Consequently, this analysis highlights how the Bank of England has severely underestimated the inflationary effect of QE. By focusing too much on the Keynesian flow model, the Bank of England prioritises interest rate changes as its focus for policy direction. (IIMR, 2022a) Unfortunately for the Bank of England, interest rates and inflation rates have little correlation, (IIMR, 2022b) and, by failing to understand the differences between the 2008 Financial Crisis and the pandemic, the Bank of England’s Monetary Policy response may yield severely detrimental effects in the next two to three years if one of two scenarios manifests. The scenario the Bank of England is hoping for is the one illustrated within its forecasts. (Bank of England, 2022b) That being a mild yet long and disinflationary recession. The structure of this recession is an increase in aggregate supply levels as cost-push pressures rectify paired with a reduction in aggregate demand levels. The Bank of England forecasts that increasing interest rates in a climate of reduced costs will decrease economic activity as individuals, firms, and other agents will repay accumulated debts from the cost of living crisis. If this scenario occurs, then in the next two to three years spending, inflation, and money growth will slow down in a stable manner. Yet, this forecast is based on interest rates being a key policy tool, rather than restricting money supply growth. As such, the second scenario is much more dismal and takes the form of a credit crunch. A climate of cost-push pressures (Giles, 2022) paired with decreasing real wages (Inman, 2022) (Figure 7) will yield a continued rise in UK consumer credit as individuals borrow to retain living standards. (Luttig, 2022) Since the pandemics recovery, approximately two years, the difference between UK outstanding consumer credit and repayments has widened to the same difference that took ten years to manifest post-financial crash. (Figure 8) This indicates either that the UK economy has recovered quickly and strongly, or, a credit bubble. Hence, this large increase in outstanding consumer credit under more turbulent economic conditions poises the UK economy at a higher risk of a credit crunch. As such, in this scenario, rather than a slow reduction in the rate of money growth, inflation, and spending, a collapse would occur, which, will disproportionally hit those on the lowest incomes.

 
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