Union Jack: Be Nimble, Be Quick

By Ajai Chopra

The U.K. government should be nimble in its policy response if it looks as though the economy is headed for a prolonged period of weak growth, high unemployment, and subdued inflation. Currently, we don’t expect this scenario to happen. But if such a scenario appears to be in prospect, we recommend responding quickly with some combination of further quantitative easing by the Bank of England and temporary tax cuts.

The most likely scenario for the U.K. economy is that it will gradually recover, although it will face continued headwinds from a soft housing market, household and financial sector deleveraging, and ongoing consolidation of the budget. Against this, the economy should get a push from private investment and an increase in exports driven by the global recovery. Labor productivity may also rebound and improve competitiveness.

Led by these forces, the IMF is expecting a bumpy and uneven recovery in the U.K. and our updated growth forecast for the near term, taking into account the recent GDP release for the second quarter, will be published with the September World Economic Outlook. Over the medium term, we expect growth to accelerate gradually to about 2½ percent.

But volatile commodity prices, the uncertain magnitude of fiscal headwinds, and problems in the eurozone have added a lot of uncertainty to this outlook. It’s not easy to steer a clear course in such circumstances.

Three scenarios

In our recent discussions with policymakers, we outlined different scenarios for the U.K. economy. The precise nature of the policy response will, of course, depend on which way the wind blows.

Stronger growth and higher inflation. If growth and inflationary pressures are stronger than expected, monetary tightening will need to accelerate, and all fiscal windfalls should be saved.

Prolonged slump and subdued inflation. If there are signs the economy is entering a prolonged period of weak growth, high unemployment, and subdued inflation, rapid action may be needed to kick-start growth to avoid the slump becoming entrenched. If this happens, the risk is that productive capacity could be permanently lost, as temporary job losses morph into long-term unemployment due to job-seekers losing skills and dropping out of the labor market. Such measures to kick-start growth could include a combination of expanded asset purchases by the Bank of England and temporary tax cuts, combined with further reforms of pension and other entitlement programs to safeguard fiscal sustainability and market confidence.

• Weak growth and high inflation. If a slump weren’t bad enough, add to that high inflation. If that scenario unfolds, the appropriate response will depend on what is the root cause. If volatile commodity prices are the main driver of price increases, policies need not respond as long as there remains little evidence that commodity price spikes are producing more persistent price pressures. But if weak growth and high inflation are the result of labor and skills shortages, as evidenced by rapid wage growth, policymakers would have little choice but to tighten monetary policy. A narrower output gap would also imply a higher structural deficit and would therefore require more fiscal adjustment over the medium term.

The most important thing for the government is to stay nimble, and be ready to alter course, should any of these scenarios manifest themselves. For now, staying the course and implementing the wide-ranging policy program that was agreed last year seems the right thing to do.

8 Responses

  1. [...] quantitative easing should the recovery go awry, as recently recommend by one Vince Cable. In a blog post to accompany today’s report, the IMF’s mission chief to the UK writes that, "The [...]

  2. … Yes, but yes, but no, but yes (as they say)…however, the ‘cuts’ have not yet kicked in. A very recent academic paper – a study by economists Hans-Joachim Voth and Jacopo Ponticelli shows that from 1919 to 2009, a policy of austerity has coincided with violence and instability. In their summary the authors concluded:

    Does fiscal consolidation lead to social unrest? From the end of the Weimar Republic in Germany in the 1930s to anti-government demonstrations in Greece in 2010-11, austerity has tended to go hand in hand with politically motivated violence and social instability. In this paper, we assemble cross-country evidence for the period 1919 to the present, and examine the extent to which societies become unstable after budget cuts. The results show a clear positive correlation between fiscal retrenchment and instability. We test if the relationship simply reflects economic downturns, and conclude that this is not the key factor.

    Therefore Javed – you are correct in principle – it’s just that these riots kicked in before the said policies have done. It’s like anthropogenic global warming – expect a higher frequency of extreme weather events – but no one extreme event can be said to have been caused by it. In this UK case the tinder has been dry for some little while…

  3. I sincerely thank Mr DMO for correcting my information about the recent riots across the United Kingdom, triggered by shooting of an inner city black man, which were later exacerbated by helpless and hopeless members of the society.

    However, this eruption in a historically conservative society like that of United Kingdom is quite unexpected.

    Despite the above credible information, I still feel that underneath ‘THIS IS ECONOMY, SIR’.

    Mr Matthias Matthijs of the School of International Services of American University (on the website of CFR) has confirmed my thinking in the following words:-

    UNLIKE MARGARET THATCHER IN 1981, BRITISH PRIME MINISTER DAVID CAMERON HAS APPEARED TOTALLY UNPREPARED FOR THE SOCIAL UNREST THAT HIS SPENDING CUTS INEVITABLY LEASHED; THE RESULT: UGLY CLASS POLITICS ARE BACK IN BRITAIN.

    THE RIOTS ARE SET AGAINST THE BACKDROP OF BRITAIN’S ONGOING FISCAL AND SOVEREIGN DEBT CRISIS AND THE COALITION’S POLITICS OF AUSTERITY.

    Kind regards

    Javed Ahmed Mir.

  4. “The British Government’s recent proposed slashing of welfare payments and cutting of public sector jobs have caused a wave of violence and looting across London and other major British cities”

    Javed – you have completely misrepresented the causes of the rioting in the UK. They were nothing like the Greek and Spanish demonstrations in origin – as you should have been aware if you had read the British press reports and analysis (both left and right wing).

    This is not to say that the austerity measures the government is adopting are correct for the circumstances of the UK – they almost certainly are not – and they almost certainly will exacerbate any tendency to civil unrest in the future, as well as being damaging to growth. We currently have, here, over 20% youth unemployment – worse in the inner cities, plus a highly consumerist ‘bling’ oriented society at large. The riots were triggered by the shooting of an inner city ‘black’ man by police, which then spread and developed into what might be described as ‘gucci’ riots, vandalism and theft; where the initial group of hopeless, helpless, undereducated, low self-esteem, violence-prone members of inner-city youth gangs were joined by professional criminal gangs and ‘chancers’ of all ages and strata of society.

  5. The UK has been hit badly by the global financial crisis due to her close interconnectedness with the financial institutions, markets and activities in other parts of the world. The UK is both a home and a host country to the banks of all the important economies of the world. She is a member of the EU. It appears that the overall financial situation is not going to be viable in the near future. Treasury Bills outstanding (Jan 2009) amounted to GBP 185 billion against illiquid collateral.

    Domestic imbalances have also resulted mainly due to:

    + a highly leveraged real estate sector,
    + lack of an effective and adequate legal framework to tackle external interventions since ad hoc measures became more disruptive and expensive
    + lack of needed role for macro prudential oversight
    + excessively high aging and health care costs
    + unemployment

    The British Government’s recent proposed slashing of welfare payments and cutting of public sector jobs have caused a wave of violence and looting across London and other major British cities.

    In order to overcome the growing economic unrest, the British policymakers have to develop and maintain close cooperation between their financial regulators such as the Bank of England, the Financial Services Authority (FSA), HMT (Her Majesty’s Treasury) and FSCS (the Financial Services Compensation Scheme) under deposit insurance. This understanding and interaction will result in rigorous prudential bank supervision. The weak banks will be assisted in increasing their loss absorbency and their vulnerability will be measured before breaching the threshold conditions. Since vulnerability is now a global issue, the UK market is more heavily affected and needs global agreements and hormonization.

    UK policymakers have to assess their pull and push factors affecting their economy. They should devise their policies in such a manner that they can develop the so-called ‘Dutch Vigor’ instead of falling prey to the ‘Dutch Contagion’.

  6. [...] Three scenarios for the UK economy – The IMF Blog [...]

  7. “Against this, the (UK) economy should get a push from private investment and an increase in exports driven by the global recovery”.

    It beggars belief that there will — in the short term, and probably the medium term — be any push from private investment, when companies — large and small — are sitting on whatever profits they have because they do not perceive the demand for their new products or services. That is the situation now, so what will produce a change in this situation in the face of government cuts? Interest rates are currently unprecedentedly low — and there is no such private investment to be discerned. It also beggars belief that exports will drive a recovery when the main export markets are all also implementing austerity policies. This is just whistling in the dark and our Chancellor should not be encouraged by it.

  8. [...] More : Union Jack: Be Nimble, Be Quick « iMFdirect – The IMF Blog Destiny Image Films endeavors to tell inspirational stories that will touch and change lives. We [...]

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