British Economy. Threat of Recession Still Looming

By mid-2013, the British economy could not completely overcome the aftermath of the financial and economic crisis. Under these circumstances, the government, while continuing to pursue a policy of financial stabilization, has applied extra efforts to stimulate economic growth. However, more and more people are recognizing that the country cannot solve its problems without innovation and a modernization of its economic structure and institutions.

By mid-2013, the British economy could not completely overcome the aftermath of the financial and economic crisis. Under these circumstances, the government, while continuing to pursue a policy of financial stabilization, has applied extra efforts to stimulate economic growth. However, more and more people are recognizing that the country cannot solve its problems without innovation and a modernization of its economic structure and institutions.

Barriers to Growth

Currently, the British economy is facing several complex and confusing processes. Overcoming the deepest in the post-war period crisis (in 2008-2009, GDP fell by 6.3 percent) has proven to be protracted. Now Britain is experiencing the slowest rate of post-crisis recovery in the past one hundred years, and is unlikely to recover its maximum GDP until 2015.

In 2010, Britain's GDP grew by 1.8 percent, while in 2011 – by only 0.9 percent. At the end of 2011 growth was followed by recession again – for three consecutive quarters (the fourth in 2011, and the first two in 2012) the economy shrunk. The country is facing this recurring decline for the first time since 1975. In the third quarter of 2012, GDP growth of 1.0 percent occurred due to such temporary factors as the celebration of the Jubilee of Queen Elizabeth II and the Olympic Games. In the fourth quarter, GDP fell again by 0.3 percent. Although GDP grew by the same 0.3 percent in the first quarter of 2013, now it is still about 2.6 percent below its pre-crisis peak, recorded in January 2008. The independent Office for Budget Responsibility, established in May 2010, forecasts that the production volume of the British economy in 2016-2017 would be 18 percent less than it would have been had the economy developed at the rate noted from 1997-2007. As a result, according to estimates by the British Institute for Fiscal Studies, in 2015 British living standards (GDP per capita, measured in constant prices) will be lower than in 2002 [1].

Why is the British economy recovering so slowly? We can single out several reasons:

1. A special position in the world economy. British business is more integrated into international production than the leading states of the Eurozone and Japan [2]. Business decline in the global economy which we are currently facing immediately affects the state of the UK economy, causing its slowdown.

Photo: creditwritedowns.com
GDP growth by quarter

2. The susceptibility of the economy to the credit crises in other countries and regions of the world due to the outstanding role of the City of London in the global financial system. Loans of British banks to Ireland, Spain, Italy and Greece in 2012 amounted to 250 billion pounds, which make up 14.7 percent of the UK GDP [3].

3. The peculiarities of the British version of the Anglo-Saxon development model with its loan nature of the economy, in the first place. Since 2001, the volume of loans issued by the UK has increased rapidly, especially due to consumer credits. The point is that consumption in the country exceeds production; household and state spending, as a rule, go beyond income, while investments surpass savings. Imports exceed exports, and the UK economy is suffering from a current account deficit. According to Oxford University professor D. Helm, in the 2000s the country lived beyond its means. In 2012, savings amounted to 12.1 percent of the GDP, investment – 14.7 percent, the deficit in the balance of payments – 4.0 percent, and the budget deficit – 6.9 percent. The government increased borrowing to finance augmented spending. The ratio of net public debt to GDP grew from 37 percent in 2007 to almost 70 percent in 2012. According to forecasts from the Office for Budget Responsibility, this figure will continue to rise until 2015. Gross debt, including the arrears of the population, exceeds 500% of GDP. and is largely financed by foreign borrowing [4].

The regulatory role of the state in the UK is less than in continental countries. Moreover, in recent decades British economic policy has been characterized by further deregulation of the national economy. This process has gone too far in the field of finance. As a result, huge risks have been disregarded. Regulators cannot adequately assess the scope of risks in financial institutions and corporations. The stability of financial institutions, providing investment of savings, have suffered a shock. Inadequate risk and financial flows management have resulted in a general crisis of confidence, which, in the end, provoked a financial crisis, followed by the curtailment of production.

4. Strengthening macroeconomic disproportions, growing imbalances in the industrial structure of the economy, and the continuation of uneven regional development. Over the past two decades, the UK has been characterized by two different processes: the advanced development of distribution and services (especially the financial sector) in relation to material production, and accelerated de-industrialization of the economy.

The most important feature of the UK economy is that the distribution and services sectors are making a bigger contribution to GDP and employment than in most European countries [5]. In 2011, the share of these sectors in the British GDP was 77.1 percent, while in the EU as a whole – 70.5 percent. It should also be noted that in recent years, the UK has rapidly financialized its economy, i.e. excessively expanded the financial and credit sectors. The securities market is more developed than its equivalents in Europe and has created an artificial reality of its own [6]. Increasingly sophisticated financial instruments have appeared, especially derivatives, namely, instruments of the financial market, the price of which is determined by the price of the underlying asset (futures and forward contracts, options, swaps, hybrid instruments and securities). The credit superstructure has swollen and become more and more complicated. The financial depth of the economy has increased too – in 2010, the value of financial assets in relation to GDP has exceeded 540 percent [4]. The growth of bank retail operations and credit expansion “blew” the balance sheets of British banks out of proportion. Financial operations have become more and more isolated from both commodity production and trade, and developed autonomously all by themselves.

It should also be noted that the positive impact of energy factor on the country’s economy and foreign trade has been fading with the depletion of oil and gas fields on the North Sea shelf and production cutbacks, turning the UK into a net importer of energy resources.

These are the main obstacles along Great Britain’s way out of recession and impeding accelerated economic growth.

Economic Policy Guidelines

Photo: accountancyage.com
Elizaveta Gromoglasova:
Britain's Search for a New European Policy

To overcome these obstacles, the UK coalition government has worked out a development strategy, providing for:

1. Measures to recover macroeconomic stability, which combine tight fiscal and loose monetary policies, proposed by the Cabinet after coming to power in 2010.
2. Focusing on structural and institutional changes in the economy.

These two areas are closely linked. Financial stabilization is a necessary condition for changing the pattern of the country’s economic growth. In turn, modernization of the economy and reorganization of its institutions help to address the problems of financial stabilization.

Great Britain pursues tight fiscal policies, aimed at reducing the budget deficit and public debt, more actively than other Western countries. The main emphasis is being made on reducing government spending. It is expected that by 2016-2017, the budget deficit will be reduced by 81 percent due to spending cuts and by 19 percent due to increased income [7]. According to the estimates of the Office for Budget Responsibility, 710 thousand civil servants will be laid off before 2017. The budgets of the ministries and departments will be cut down by 19 percent. Salaries of the majority of public employees will be frozen for two years [7]. It is not accidental that London so vigorously opposes increasing the EU budget expenditures.

The budget savings plan provides for freezing the preferential minimum tax threshold for the elderly at the current level of 10.5 thousand pounds a year and calls it off for those, who turn 65 after April 5, 2013. This means that in 2013-2014, the financial position of 4.4 million British citizens will deteriorate in real terms on average by about 83 pounds. In addition, “child benefits” will be waived for those families in which at least one parent pays tax at the higher rate of 40 percent (in other words, earns more than 43 thousand pounds a year). As a result, 750 thousand families will no longer receive allowances for children [8]. As the Leader of the Labor Party Ed Miliband noted, history has shown that every time the Tories reduced taxes, it cost the people more. He also warned, that when families looked at the budget and saw a drop in their living standards and a rise in unemployment, they would know that the policy of the coalition hurt, but did not work.

In the long term, the budget savings plan provides for large-scale pension reform, including inccreasing the retirement age to 67 years. Deductions from salaries for civil servants’ pensions are to rise too while payments for years of service will be reduced [8].

All these measures, aimed at re-balancing the country’s financial system, are holding back expansion of the internal market and lead to a slowdown of economic growth, necessitating putting into effect expansionary monetary policy (the policy of “cheap money”). Since Britain is not part of the Eurozone and pursues an independent monetary policy, it is easier for the country to cope with its budget deficit than for the Eurozone states.

The Bank of England is stimulating real economy and consumption growth by cheap credit and new money emission. To create incentives for the economy, it has cut the base rate dramatically to its lowest level ever of 0.5 percent [7,9] in March 2009. But keeping the rate at an unprecedentedly low level has made this instrument of monetary policy ineffective and practically useless for reducing the exchange rate of the national currency and for money supply increase.

Under these conditions, the quantitative easing program has come to the foreground – an unconventional method of regulating government cash injections into the economy by purchasing assets, mainly government bonds – gilts – from the private sector to create a lot of new money. Quantitative easing program was first introduced in the UK in March 2009 and over the past three years the Bank of England purchased £375 billion of assets which makes about a quarter of the UK's GDP [9]. Incidentally, the statement made in this respect by former Governor of the Bank of England Sir Mervyn King in his speech in Cardiff is quite noteworthy: “Printing money is not, however, simply manna from heaven… When the factors leading to a downturn are long-lasting, only continual injections of stimulus will suffice to sustain the level of real activity. Obviously, this cannot continue

indefinitely.”

The Course to Modernize Economy

Photo: tothetick.com
Bank of England

Recently, the economic policy of the UK has been gradually shifting its focus from crisis response to the long-term strategic objectives of modernization nature. The introduced Plan for Growth includes a package of measures designed to inject dynamism into the economy. Priority is being given to the creation of a balanced economy, which should rely on savings, private investment and exports, as well as on the real economy and production diversification, and should be less dependent on government and consumer spending and the service sector, particularly the financial one. The Plan pays special attention to high value manufacturing.

The point at issue, in the first place, is the re-industrialization of the economy on the basis on new technology. In this regard, the so-called British dilemma, implying shifting the balance in favor of the real sector, is widely debated in the country.

But how to do it, if it is the financial sector that shapes the image of the British economy and makes a great contribution to the GDP? The financial services industry is more important for the UK than for other European countries, since its share of the British GDP is as high as 8.5 percent while in the eurozone states it is only 5 percent. For its size, it is second only to the United States and Japan. Another 3 percent of GDP is created by financial intermediation services, i.e. auditing, accounting, law, consulting, etc. [10] The financial services industry accounts for a quarter of the corporate tax in the budget. Restrictive practices detrimental to the industry may cause significant damage to the economy and undermine the UK's position in the world.

Under these circumstances, the Government and the Bank of England are finding it hard to adopt a balanced approach to the City of London, which is one of the main sources of tax revenue. On the one hand, the authorities are seeking to protect the financial services industry by opposing Brussels’ initiatives to impose a tax on transactions and create a single European banking union. On the other hand, London is being forced to tighten regulation of this industry, making it less competitive. The City of London is already facing tough competition from New York, Singapore and Hong Kong.

To reconcile this contradiction, it is necessary to increase the efficiency of the banking system. The inefficient coordination of activities among the Treasury, the Financial Services Authority, and the Bank of England has led to the collapse of the megaregulating institute and contributed to the exacerbation of the financial crisis. This explains the need to improve the system of financial regulation and create new architecture. For this purpose the government abolished the system of regulation, formed by the Labor Party in 1997, and created a new supervisory body – the Prudential Regulation Authority (PRA), whose functions are to prevent undesired events and take preventive (prudential) measures to maintain stability in the financial sector. This agency is responsible for regulating and supervising organizations, accepting cash deposits, providing insurance and investment services. The PRA will work with the Financial Policy Committee which is another new regulating body of the Bank of England. One of the major claims advanced by London in the EU is preserving the national system of banking regulation.

Restructuring of large banks is intended to increase the stability of the banking sector. Separating retail operations (taking deposits, crediting individuals and small businesses) from other financial services, primarily from investment banking, will allow authorities to meet its commitments concerning deposit insurance and dispose of the need to support risky investment banking operations in case of a crisis. The issue of downscaling the biggest banks is currently under discussion too. The crisis has shown that the failure of one of them can lead to a crisis in the whole banking system. It is assumed that previously nationalized banks will be divided into parts and privatized.

Innovative development has been attached primary importance. The Chancellor of the Exchequer George Osborne wants to see Britain the technology centre of Europe. The Secretary of State for Business, Innovation and Skills Vince Cable made a remarkable statement in October 2011: “Economists disagree on many things. But there is clear consensus that, in mature economies, all long-term economic growth processes depend on innovation: that is, applying new technologies in an economically productive way… The main policy question is what governments should do to promote innovation.” [11]

Priorities for scientific and technological development of the country are being defined. Currently they comprise new materials, medical technology and healthcare, the creative and “digital” economy, promising energy resources, electronics and nanoelectronics, transport, information and communication technology, protection of communications infrastructure, biotechnology, smart control systems, and environmental management.

In 2011, the government allocated over £200 million to create a network of technology and innovation centers for the development of high-tech sectors of the economy [11]. In his speech to the Confederation of British Industry David Cameron said that the measure was intended to strengthen the links between universities and businesses, to promote the commercialization of research and development, to facilitate business access to new equipment and expertise, financial resources, and to help business to carry out its own R&D. The first Technology and Innovation Centre was opened for business in October 2011, bringing together seven university research institutions to support a number of different industries in high value manufacturing [11].

Photo: independent.co.uk
The Wylfa Nuclear Power Station, North Wales.
Wylfa houses two 490 MW Magnox nuclear
reactors, "Reactor 1" and "Reactor 2". Reactor 2
was retired in 2012; Reactor 1 may operate
until 2014.
David Cameron spoke about the need to build
a new generation of nuclear power stations to
replace nine obsolete ones.

The national plan for the development of infrastructure is under way, providing, inter alia, the allocation of £200 billion over the next five years to develop transport, energy, telecommunications, water supply and waste treatment. Investment in “the green economy” is on the rise too. Measures to rationalize environmental regulation will allow businesses to save one billion pounds over the next five years. The Green Investment Bank is capitalized with £3 billion [12]. As to energy resources, power plants using coal are to be replaced, investments will be made in modern natural gas power plants (which will become the foundation of British power industry) and energy from renewable sources, especially wind energy. David Cameron also spoke about the need to build a new generation of nuclear power stations to replace nine obsolete ones.

In March 2012, British Prime Minister proposed employing resources of private investors, including pension funds and sovereign wealth funds to manage the roads. The number of toll roads is expected to increase. David Cameron has emphasized the need for improving communication services and housing development, and meeting modern environmental and municipal standards.

Measures have been introduced to increase employment in the private sector in regions with a rate of development below the national average (excluding London and the south-east). The government has established 21 new Enterprise Zones with high-speed internet, reduced taxation rates, and simplified systems of regulation and planning.

The changes have affected the tax system. Further reduction of the tax burden on businesses, which in recent years was significantly higher than in other major developed countries, and the simplification of tax administration have been recognized as priority goals. In April 2011, the rate of corporate income tax was reduced from 28 percent to 26 percent, and in April 2012 – to 24 percent. The Road Map for reforming the corporate income tax provides for reducing this rate to 22 percent in 2014, making it lower than in other major developed countries [13]. To make up for the budget losses, the government has focused on improving tax collection. It is no secret that corporations often abuse transfer pricing, trying to move profits to the low-tax jurisdictions.

Much attention is being paid to promoting small business. The tax rate on their income has been reduced from 21 to 20 percent for companies with annual revenues of less than 300 thousand pounds. The system of levying the tax is being simplified too. Since April 2011 a tax credit to small and medium-sized companies (those employing less than 500 people) is allowing them to deduct from income the amount equal to 100 percent of the costs for research and development and another 100 percent in the form of tax credit. The rate of additional deduction has been increased, making the total deduction for qualifying R&D expenditure incurred on or after April 1, 2012 225 percent [14]. The government explains the lessening of the tax burden for small and medium-sized businesses by the necessity of making the economy more competitive, accelerating GDP growth and attracting foreign investment.

An ambitious goal was set for doubling the volume of exports by 2020 and making it £1 trillion [15]. To solve this problem, the expansion has suggested of the financial capacity and the work of the Export Credits Guarantee Department (ECGD). Small and medium-sized firms are being offered assistance to enter foreign markets. The economic climate for direct foreign investment is becoming more favorable. Considerable attention is being paid to attracting the financial resources of sovereign funds from developing countries, China in particular.

The worsening of economic situation in the UK and the world at large has resulted, among other things, in changing the structure of Britain’s foreign economic relations in favor of larger developing countries. A significant drop in business activity in the European Union and especially the debt crisis in the Eurozone has caused a decline in British trade with its EU partners, and also provoked an evolution of their relationship. Arrangements to strengthen the supranational mechanism of association and deepen integration in the fiscal sphere, recently made by the EU leadership, are causing resistance in London, which fears, not without reason, that these measures may undermine the monetary and credit independence of the United Kingdom and the position of the City of London as the world's leading financial center. This explains efforts by the British government to prevent the transfer of powers of the national parliament, government, and the Bank of England to the central structures of the community. Moreover, the Conservatives, given the lack of popularity in the UK of British membership in the EU, decided to conduct a referendum on the country's withdrawal from the European Union before the end of 2017, if they win the next general election. It should be noted that UK involvement in EU activities is already conditioned by numerous reservations. For example, having formally joined the Schengen agreement, Britain has reserved the right to maintain passport controls at their external borders and pursue an independent visa policy.

It should be emphasized that, despite the existing economic problems and, until recently, tensions in political relations, trade and economic ties between the UK and Russia have been strengthening. The common challenges faced by both countries against the background of increased economic interdependence are playing an important role in developing bilateral trade and investment cooperation. During a meeting with David Cameron in London in June 2013, Russian President Vladimir Putin rated high the prospects of trade and economic relations between the two countries. Space, nuclear energy (not just in the United Kingdom and Russia, but in third countries too), hydrocarbons, metals and mining industry were identified as the main areas of cooperation. According to Vladimir Putin, Russia is interested “in adopting the experience of the British capital as one of the world's financial centers, and in working in the field of small and medium-sized businesses”.

* * *

How can we assess the economic policy of the coalition government of Great Britain?

On the one hand, the consequences of the crisis have yet to be overcome completely. On the other hand, there are certain positive accomplishments. During the government of the Conservative-Liberal Democrat Coalition, 1.2 million new jobs have been created. Perhaps, that explains the absence of mass protest movements. The level of inflation fell from 4.5 percent in 2011 to 2.8 percent at the end of 2012; the budget deficit decreased from 11.2 percent of the GDP in 2010 to 6.9 percent in 2012; state borrowing declined. In recent months the pace of economic growth has accelerated. According to forecasts, GDP growth in 2013 is expected to be 1.2 percent [16]. It is not much, but is more than in Germany or France.

In other words, against the background of recession, the British economy is displaying signs of recovery. This recovery could turn into a rebound, provided the global economic environment improves and the debt crisis in the Eurozone mitigates [17].

1. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2011. Moscow p. 298–299; Economic Review, June 2013, July 2013.

2. IMF World Economic Outlook. April 2013. P. 2.

3. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2012. Moscow p. 293.

4. World Economic Forum. The Financial Development Report 2012. P. 291.

5. Europe in Figures. Eurostat Yearbook 2012.

6. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2011. Moscow p. 300.

7. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2012. Moscow p. 295.

8. Britanija v krizise: takticheskie mery i strategicheskie tseli. Moscow, Institute of Europe RAS, 2012. p. 15.

9. Bank of England News, July 2013.

10. UK International Financial Services – The Future. A Report from UK Based Services Leaders to the Government. L., 2009. P. 3–6; UK 2004. The Official Yearbook of the United Kingdom and Northern Ireland. L., 2003. Р. 454–464; UK 2005. P. 469; Globalization and the Changing UK Economy. BERR. February 2008. P. 16.

11. BIS. Department for Business, Innovation & Skills. October 11, 2011.

12. BIS. News. October 14, 2011.

13. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2011. Moscow p. 302.

14. BIS. About R&D Tax Credits. September 2011.

15. God planety. Ekonomika, politika, bezopasnost. IMEMO RAS Yearbook. 2012. Moscow p. 299.

16. Britanija v krizise: takticheskie mery i strategicheskie tseli. Moscow, Institute of Europe RAS, 2012. p. 21.

17. The Guardian, January 15, 2013; The Daily Telegraph, January 14, 2013.