SPECIAL FEATURE: NIESR: doubts over double-dip

Robyn Hall

May 4, 2012

The UK economy contracted in the first quarter of this year by 0.2 per cent, returning the economy to recession.

Of course, revisions may change this.

However, small quarter to quarter movements of this sort are largely irrelevant to the broader picture of an economy that remains very weak.

Our monthly estimate of GDP suggests the level of economic activity in the economy in March 2012 was the same as in September 2010.

This clearly does not constitute a sustained recovery, so the question of whether or not the economy is technically in a double-dip recession is moot.

Such weakness is likely to persist over the next couple of quarters, and means that growth this year will be close to zero.

But from the start of next year we expect more robust growth, with a sustained period of above-potential growth from 2014, which is necessary to reduce the output and unemployment gaps.

The unemployment rate will rise to about 9% this year and remain high throughout the forecast period. Elevated unemployment for such a long period is likely to do permanent damage to the supply side of the economy, with large long-run economic costs. Our central forecast is that inflation will fall below the 2 per cent target at the end of this year.

It remains our view that fiscal policy could be used to raise aggregate demand in the economy with little to no loss of fiscal credibility.

We have never and do not now advocate scaling back the government’s medium- to longer-term policy of fiscal consolidation.

However, the UK also suffers from a lack of demand in the short term.

As we noted in our January Review, a 1% of GDP increase in government investment this year would boost GDP by around 0.7%, assuming no reaction by the MPC.

A temporary boost to net investment, which has been cut extremely sharply, would have no direct effect on the government’s primary fiscal target of balancing the cyclically-adjusted current budget in 2016–17.

UK Household Rebalancing

In the latest National Institute Economic Review, published today, Dr. Angus Armstrong, director of macroeconomic research at NIESR, examines the process of household rebalancing.

There is broad agreement that prior to the crisis households increased borrowing and house prices rose sharply.

Yet there are important differences in the interpretation of these trends.

The OBR points out that the rise in household borrowing has been matched by a rise in financial assets and so they play-down the need for rebalancing and forecast the ratio of household debt to income will rise each year over the forecast period.

The decline in global real interest rates clearly provided a favourable backdrop for borrowing.

Angus Armstrong suggests that the rise in households’ income inequality may have been an additional cause for the emergence of imbalances.

In the years prior to the crisis income inequality widened which does not appear to have been matched by wider consumption inequality.

For total consumption to even rise in line with income this requires more saving to be intermediated from the high to low income households.

High income households must save more and low income households must borrow more.

This insight offers four benefits in terms of explaining the Great Recession over the standard decline in real interest rates argument: (a) it explains the observed differences in saving behaviour across income groups, (b) it explains why the volume of financial flows was well in excess of output growth, (c) it is consistent with the innovations in mortgage market finance which connected lower income borrowers with higher income savers, and (d) it explains why this process would eventually lead to greater financial risk taking.

The official (OBR) assessment is entirely consistent when looking at aggregate level data.

Our concern is that this masks important distributional consequences between households.

When the solvency condition of borrowers is questioned the absolute size of credits and debits is of first order significance and not just the net position.

Just as in Japan the aggregate net asset figures can be very misleading. The link between inequality and debt deflation has lead to parallels being drawn in the US between the Great Depression and this Great Recession.

Prospects for the household sector are very different depending on which segment of the sector one considers.

The Bank of England’s mortgage repayment data show no sign of any increase in repayment behaviour.

According to the FSA between 5-8% of mortgages could be subject to forbearance.

This has a familiar ring of the zombie firms in Japan which were insolvent but the banks would not close to avoid crystallising a loss.

If this gamble-for-recovery does not pay-off the result may be a very low activity equilibrium in the housing market in certain parts of the country.

NIESR’s global economic forecast

Economic prospects deteriorated sharply towards the end of 2011, as the Euro Area sovereign debt crisis threatened to ignite a second global banking crisis.

Policy actions by the European Central Bank appear to have averted the immediate danger, by pumping €530 billion in 3-year longer-term refinancing operations (LTROs) into the European banking system in February.

Tensions in European financial markets have eased since February.

However, fiscal austerity is depressing growth in those countries most affected by the crisis; this in turn reduces tax revenues, making the restoration of fiscal sustainability and hence market confidence even more difficult.

This risks a negative feedback loop; downside risks, both economic and political, therefore remain high.

Elsewhere, while short-term global prospects have improved marginally since January, a rise in the oil price has largely offset the gains from the decline in short-term uncertainty.

We continue to expect a recession in the Euro Area and the UK in the first half of 2012.

We forecast relatively slow growth (about 2 percent) in other developed economies.

In the US, this assumes that fiscal policy is not tightened abruptly; were this to be the case, growth would be significantly slower.

Fast, although slightly slowing, growth in China and India, continues to drive global growth, for the year as a whole.

In 2013, we see some rebalancing of global growth, as the Euro Area recovers somewhat, growth picks up further in the US, and China continues to slow. Global current account imbalances, however, remain elevated, although not at pre-crisis levels.

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