Sterling devaluation best hope for UK economy

By Neil Behrmann

 

December 2008 :- The UK Treasury and Bank of England are pursuing a multi pronged attack to counter a deepening downturn in the British economy. In the end, however, the sharp depreciation of sterling, monetary expansion and belated interest rate cuts will be far better than Government measures to get the economy moving.

The UK economy shrank for the first time in 16 years between July and September, confirming that the UK had begun a recession that is deepening swiftly. Output fell by 0.5 percent in the third quarter, according to the Office for National Statistics, a bigger-than-expected drop following zero growth in the second quarter. The unemployment rate has surged to around 6 percent, the fastest rise in seventeen years and is climbing rapidly.

The Bank of England has already slashed interest rates to 2 percent from 4 percent in October. The Bank has purchased toxic debt from weak banks to ease the money market to encourage banks to lend. The Government has also bailed out several leading banks by partially nationalising them.

Bank of England Governor Mervyn King has issued gloomy warnings about a deep recession. The combination of lower interest rates and fears about the economy have caused sterling to tumble by around 25 percent against the euro and 30 percent against the US and Asian currencies. This devaluation from exceedingly overvalued levels, will help UK exporters and will hopefully boost depressed parts of the economy. The slump in imported energy, food, raw materials and shipping rates are expected to counter higher import costs and inflation that normally result from devaluation. Indeed inflation is expected to decline from anAugust 2008 peak annual level of around 5 percent to around 2 percent or lower in 2009. Growing numbers are forecasting zero inflation or deflation.

British Pound slump against US dollar

 

Keynesian economics for a stricken economy

Chancellor of the Exchequer Alistair Darling describes himself as a Keynesian. He says that the government intends pursuing the policies of John Maynard Keynes who in the deflationary Great Depression in the 1930s advised governments to increase public spending. The aim is to create jobs, which in turn will encourage consumer spending thus improving the profitability of businesses. This in turn generates a multiplier effect of increased investment and employment of businesses in the private sector that raises employment, consumer spending and so on.

So much for the theory.  The big question is whether the policies will work. Critics of the Government and Bank of England say that they were in denial for far too long. The Bank of England feared inflation, which was mainly caused by commodity speculation, a bubble that was bound to burst. Critics contend that the Bank has been far too slow in slashing rates to counter the deflationary consequences of a housing price crash and a sharp decline in consumer and business spending. David Blanchflower, an external member of the bank of England monetary policy committee and professor of economics at Dartmouth College in the US, went against the majority and voted for a an interest rate cut on every occasion since October 2007. He expects the numbers of jobless to reach two million by Christmas.

"The UK is especially exposed to the financial turmoil because of our dependency on the financial sector, and because the run-up in house prices and debt levels was even greater here than in the United States,” he says. "Interest rates need to come down significantly – and quickly.” Recent events in financial markets are likely to reduce lending further to both households and firms in the near term, adds Blanchflower. A start has been made, but if rates are not cut further, the UK faces the prospect of a relatively deep and long-lasting recession.

Brown one of Britain's worst Chancellors

The Conservative and Liberal Democrat opposition complain that when he was Chancellor of the Exchequer, Premier Gordon Brown went on a borrowing and spending spree. Brown, who is likely to go down in history as one of Britain's worst finance ministers overborrowed during good economic times.  In the March budget, his successor, Darling forecast that public borrowing would amount to £43 billion in the 2008-09 fiscal year. It is now forecast to to double this year to around £80 billion. Next year Government borrowing could reach £118 billion and government debt will represent something like 60 percent of British gross domestic product.


A far better fiscal route is to follow US policies and cut direct taxes. But Darling has cut VAT, or sales tax, by a pitiful 2.5 percent, which has caused businesses considerable administrative time and expense. Heavy borrowing will lead to big tax rises in years to come. The economy is thus dependent on exports, but the manufacturing sector has been decimated and the financial sector is contracting. Recovery will be exceedingly difficult. Despite the problems, the stock market is slavishly following Wall Street even though profits are likely to be poor in the fourth quarter.

 

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