SECTION 1: GOVERNMENT ECONOMIC POLICY

Will the UK avoid catching a cold?

SUSAN GRANT

Lecturer in Economics at West Oxfordshire College, Witney

1 Introduction

It has traditionally been said that when America sneezes the rest of the world catches a cold. With recent fears that the US may be slipping into a recession, concerns have been raised that the UK may also experience a period of falling output.

Whether these concerns will be proved to be justified or not will be determined by what actually happens to US economic activity, the state of the UK economy and the policy measures taken in the US, the UK and the rest of the EU.

2 Reasons for concern over the US economy

After a decade of rapid growth, fuelled by advances in information technology and rising productivity, US economic growth slowed significantly in the second half of 2000. It fell from an annualised growth rate of 5.6 per cent in the second quarter to 2.2 per cent in the third quarter and 1.4 per cent in the final quarter.

A number of indicators suggest that US economic growth may fall further and may even become negative. One indicator is the reduction in private sector investment, the first decline in eight years. Firms are becoming reluctant to buy more capital goods because of reduced confidence about future demand, rising inventories (stocks), falling profits and rising debts. For example, profit levels have been squeezed by higher energy prices and a slowdown in the growth of consumer spending. In addition, firms’ debts have been rising and share prices falling, making it more difficult for firms to raise finance for expansion.

Consumer spending has also been hit by rising levels of debt, lack of confidence in the future, rising energy prices, and the fall in share prices. The upward trend in unemployment, which reached 4.2 per cent in January 2001, its highest level for sixteen months, is one factor behind the fall in consumer confidence. The higher level of unemployment combined with higher energy prices and falling wealth (resulting from lower share prices) have also reduced consumer spending power. For example, the serious drop in US share prices in March 2001 left the US with its first fall in household wealth in 55 years.

At the same time, the US economy has also been experiencing a large and rising current account deficit. In 1999 it had to attract $450bn (£308bn) of foreign capital to finance its deficit. Therefore, from the indicators noted above it is clear that the US is experiencing downward pressure on all three components of its aggregate demand function: investment, consumption and net exports.

3 Reasons why the US economy may not move into recession

Alan Greenspan, Chairman of the American Federal Reserve, Sir Edward George, Governor of the Bank of England, and many economists and commentators believe that, whilst US economic growth will fall to a low level for a short period, it will avoid sinking into a recession and its economic growth rate will soon return to a higher level. To support this view they refer to a variety of evidence and advance a range of arguments.

Among the evidence they point to are the healthy state of the US housing market, changes in the value of the dollar, and oil prices. New house sales soared by 13 per cent in January 2001, the fastest rise since April 1993. This rise is making homeowners wealthier and so may stimulate consumption. The recent fall in the value of the dollar is likely to raise net exports while falling oil prices will cut firms’ costs. Supporters of the view that the US will avoid a recession also argue that US economic policy will help to return US economic growth back to its trend rate. The Federal Reserve has already taken action, cutting interest rates by half a percentage point on 3 January and by another half a percentage point on 31 January, bringing the rate down to 5.5 per cent. This was the largest reduction in interest rates for 16 years. With inflationary pressure low, the Federal Reserve is prepared to cut interest rates further, if necessary, to stimulate economic growth. The new Bush administration is also planning substantial tax cuts and higher spending on defence, education and expanded prescription day coverage for senior citizens. It has been estimated that this expansionary fiscal policy may increase GDP by 1.5 per cent per annum.

The supporters also claim that the US economy is essentially in good shape. Part of the slowdown, they suggest, is accounted for by the country readjusting to more sustainable levels of consumer spending and investment, after a period of very rapid rises in consumption and investment.

4 Ways in which a US slowdown may affect the UK economy

The US economy is the strongest economy in the world. It produces approximately a third of world output so that a slowdown in US economic activity has the potential to reduce economic growth throughout the world including, of course, in the UK. There are a number of channels through which a US slowdown may have an adverse impact on the UK economy.

1. Demand for UK exports may fall. If US incomes fall, US consumers will buy fewer UK products and US firms will order fewer raw materials from UK suppliers. In 1999 the UK exported £37bn worth of goods to the US. Other countries’ demand for UK products may also fall if their own incomes decline because they cannot sell as much to the US. Similarly, demand for UK exports will fall if US products become more price competitive in third markets, relative to UK products, because of the lower value of the US dollar. Such a decrease in net exports would, other things being equal, reduce UK aggregate demand from AD to AD₁ and lower GDP from Q to Q₁ , as shown in Figure 1.
2. US foreign direct investment in the UK may be reduced and existing US multinational companies (MNCs) based in the UK may cut back their output and employment. Some US MNCs may even close some of their plants in the UK, thereby raising UK unemployment (see Section 11).
3. UK MNCs based in the US may experience a decline in their sales and profits. In 1999 the UK accounted for 18.6 per cent of total foreign direct investment in the US.
4. A decline in US share prices may depress UK share prices, making it more difficult for UK firms to raise investment finance and reducing household wealth.
5. Concern over the performance of the US economy may reduce business and consumer confidence in the UK. Expectations about the future are an important determinant of consumer spending and investment.

 Figure 1.  UK: aggregate demand and supply

5 Why the UK may avoid a recession

Even if the US does slip into a recession, the UK may not experience a significant downturn in its economic growth. This is because the UK is becoming increasingly linked to the EU, which is predicted to grow more rapidly than the US. Also, the economic conditions prevailing in the UK differ from those in the US and UK monetary and fiscal policy is likely to be used in order to stimulate economic growth.

In 1999, UK exports to the EU amounted to £103bn ($150bn), 56 per cent of its total exports, and the proportion is expected to rise. In contrast, exports to the US accounted for less than 15 per cent of UK total exports and for less than 5 per cent of its GDP. The EU experienced a 3.1 per cent growth in 2000 and it is anticipated that, whilst its growth rate may fall slightly in 2001, to 2.9 per cent, it will achieve a more rapid rise in output than the US and a rate above its trend growth rate of 2–2.5 per cent.

Demand in the EU is predicted to rise further in the future as tax cuts in a number of member countries, including Germany and France, begin to take effect. As a result UK exports are likely to rise.

The UK economy is currently performing well. Its economic growth rate is relatively high and it is enjoying its lowest inflation and unemployment rates for 25 years. The UK also does not have the high levels of consumer and business debt of the US. In addition, in the UK technology shares, which have experienced the sharpest fall in price in the US, are less important and the FTSE 100 index fell by only 3 per cent in 2000. Households in the UK hold less of their personal wealth in shares (its wealth effect is more heavily influenced by house prices) so that the effect of technology shares is less.

Table 1  A comparison of growth rates

UK monetary and fiscal policy is likely to increase aggregate demand and long-run aggregate supply over the next few years. On 8 February the Bank of England cut the rate of interest by a quarter of a percentage point to 5.75 per cent. With inflation so low and with the possibility that a structural change has occurred in the economy (meaning that unemployment can fall without generating inflation) the Bank of England has considerable flexibility to cut interest rates further. Lower interest rates are likely to stimulate consumption, investment and, via a reduction in the value of the pound, net exports.

The UK government is also planning to cut tax rates and to raise government spending. Some of this extra spending will be on public sector investment, including infrastructure investment. This is forecasted to double over the next three years. Such investment tends to have a low import content and so has a relatively strong multiplier effect. Infrastructure investment is also likely to increase the productive potential of the economy and so increase both aggregate demand (from AD to AD₁) and long-run aggregate supply (from LRAS to LRAS₁) as shown in Figure 2. The result is likely to be an increase in real GDP from Q to Q₁ .

Figure 2.  UK: aggregate demand and long-run aggregate supply

Conclusion

Due to its inherent economic strength, and action by the Federal Reserve, the US may well avoid moving into recession. Even if it does, the UK is likely to miss being dragged into a recession because of its closer links with the EU, its differences from the US economy and its expansionary monetary and fiscal policy. As Jean-Claude Tricket, Governor of the Bank of France – in line to be the European Central Bank’s new president – said in January 2001: ‘It used to be the case when the US caught a cold, Europe got pneumonia. But those times are over.’ Given the recent serious falls in the New York and London markets, only time will tell whether his prediction will be realised!

Questions

1  Explain what is meant by trend growth.

2  Discuss what factors economists take into account when forecasting future economic growth.