Following the pre-budget speech it appears that further economic gloom is on the horizon. During the speech Alistair Darling, the UK Chancellor, outlined government forecasts indicating:
- Four quarters of negative economic growth over 2009 with a significant impact upon the real economy, which is perhaps a tad optimistic.
- National debt is likely to increase to around £15,000 per person over the coming year.
A concerted effort will be necessary to resolve these problems from both the Bank of England and the government. Here we consider what the problems and the potential impacts are of rate cuts and the governments latest legislative proposals.
Problems with the UK national debt
The status of national debt is now so bad that, according to the Credit Default Swap (CDS) market - complex instruments which effectively allow investors to insure debt - UK debt is now more 'risky' than McDonalds debt.
The huge amounts of new debt that are to be issued to stimulate the economy has resulted in the pricing on these instruments increasing a whopping 63% in the month. In comparison, the US is up 25%, Japanese debt is up 18% and even German debt, considered the safest debt in the world, is up 10%.
Some commentators believe that the UK, whose ability to pay their IOU's is ultimately a function of GDP now that the gold standard has been abandoned, is playing a dangerous game considering their dependence upon the financial sector. The fears are that generations to come will suffer as a result of the burgeoning debt burden that will come from increased government expenditure and falling tax receipts.
The Debt Management Office (DMO) has now estimated that national debt is to increase to some £1 trillion, or 57% of GDP, by 2013. The banking bailout will result in the DMO issuing a further £70 billion worth of gilts (government debt).
The actual impact upon the economy
The impact of recent events are being fully felt in the real economy now. Numerous companies are looking at large-scale layoffs and redundancies to reduce costs. The following statistics testify to the poor health of the economy:
- Industrial production fell 1.1% during the third quarter of 2008.
- New construction fell by 11% over the same period.
- Liquidations were up 10% over the quarter and 30.4% on the year.
- Halifax believes that house prices have fallen 14.9% over the year to November 2008, with an average house price in the UK now estimated at £208,583.
- The number of unemployed rose from 140,000 to 1,825,000 in September.
- Mortgage possession claims were 9% higher over the year and mortgage possession orders were 24% higher than the previous year.
- A number of high-profile companies have also struggled or filed for bankruptcy including Woolworths, MFI (for the second time this year) and Mk One (also for the second time this year). Yahoo found that neither Google nor Microsoft wanted to buy it anymore. US car sales sank to their lowest level for 25 years as Chrysler, GM and Ford begged congress for money. BMW also considered being bailed out by the German government. Even the indefatigable assault of Starbucks on the high street was reduced as the coffee chain announced that net profits fell 97%.
- It wasn't just companies that were in trouble, however: whole countries found themselves in dire straits with the IMF agreeing to a $16.4bn loan to the Ukraine and $10bn to Iceland.
One solution: rate cuts
Central Banks around the world have cut interest rates to unprecedented levels to stimulate aggregate demand. The cut to 2% in the UK is only the second time in modern history that the Bank of England Rate has been so low. The last time was for the duration of the Second World War and the recovery afterwards (prior to that the rate had been 2% for seventeen different periods in the 19th century).
The recent rate cut has been welcomed by many economists who, given comparisons to the Great Depression, believe that such drastic measures are necessary.
The full minutes of the latest MPC meeting are not available until 18 December 2008. However, in November the MPC stated that it did not want to reduce rates by more than 1.5% because the members were awaiting the measures to be announced in the Pre-Budget Report (PBR) of 24 November 2008.
The fact that the MPC have decided to rescind their original position is an indication that they do not believe the government’s actions will provide enough of a stimulus to the economy.
Whether the actions of the MPC will be impotent or not will largely depend upon whether banks will maintain their reticence to pass rate cuts onto consumers. The recent rate cut will be passed on by Nationwide, Lloyds TSB, the Woolwich and Bristol & West, but the UK's biggest lender, Halifax Bank of Scotland (HBOS), has stated that it will only make a cut on it’s Standard Variable Rate (SVR) of 0.25%.
Furthermore, while three-month LIBOR (the rate that Banks lend to each other) has fallen away from highs of 6.3% in October, it is still artificially high at 1.3% above the base rate (traditionally the gap between LIBOR and the repo rate is about 0.15%).
Pre-Budget Speech
Unsurprisingly, the economy has become the main source of political debate during recent months with David Cameron urging the prime minister to call an election so that “the people can decide”. During such fragile times, this bi-partisan behaviour should perhaps be frowned upon, for solidarity and debate could provide the most appropriate solution.
In his speech of 24 November 2008 the chancellor was presented with an opportunity to show what the current government plans to do through legislature to abate the current decline.
We have considered here the main provisions of the speech relevant to individuals to see whether consumers are likely to benefit and be able to stimulate economic growth.
- VAT will be reduced from 17.5% to 15% for thirteen months from 1 December 2008.
- National Insurance contributions for both employees and employers will increase by 0.5%.
- Those still lucky enough to be earning over £100,000 will start to lose their personal allowance.
- A new tax level of 45% will be applied to those earning above £150,000. There will also be a commensurate new tax rate on dividend income. This increases from the current 32.5% to 37.5%.
- Pensioners' basic state pension is to rise from £90.70 to £95.25 after April 2009.
- The Savings Gateway – a provision whereby from 2010 the government will contribute 50p for every £1 saved by low-income savers.
- £3 billion of capital spending to be brought forward on motorways, schools and energy efficiency.
- To allow for the removal of the 10% tax rate, the £120 adjustment to personal allowance will be increased to £145 and be made permanent.
The changes to NI and tax are due to take effect from April 2011. However, in the event of a general election and change of government before then, the legislation could change.
Will these changes help consumers stimulate the economy?
VAT
The VAT is likely to be largely ineffective as the great stimulus package needed. This is because VAT is an indirect purchase-based tax, rather than a direct (eg. income) tax, and subsequently depends upon spending. Huge discounting by retailers has had little impact, so a miserly 2.5% rate cut is unlikely to change consumer habits.
Furthermore, as the consumption of luxury goods is likely to fall as consumers spend more of their disposable income on essentials, VAT gained from these will also go down.
Finally, the huge amount of hassle for businesses in the pre-Christmas rush is also likely to be a significant drag on the impact of this change.
National Insurance
The increase in NI contributions by 0.5% will be permanent (as opposed to the temporary nature of the VAT arrangements). This cumulative 1% increase will offset the burden on the government's pocket from the VAT cut due to the higher nature of salaries.
Income Taxes
The tapering of the personal allowance at a level of £1 for every £2 earned leads to a 60% effective tax rate for those earning between £100 and £140k p.a. (around 650,000 people).
Savings
Approximately 50% of the working population is not saving enough for retirement (a rough guide is 'your age divided by two' as a % of your salary, so a 30 year old starting a pension should be paying in 15% of their salary).
The assistance to those on the lowest incomes is obviously a positive. However, this is the area of society that is least inclined to save and subsequently this is unlikely to have a significant impact or stimulate growth. The consequences of people failing to save enough are going to be huge in years to come given increasing life expectancy.
Increased Capital Spending
The extra £3 billion is unlikely to be effective because of the effects of fiscal crowding out and the drag resulting from the capital budgeting process.
