Our article on the United Kingdom in the last Global Economic Outlook noted a sharp rise in UK business confidence and a generally more positive tone for the economy. We concluded, however, that macro risks and sentiment could change swiftly, and that the United Kingdom was “not out of the woods.” That has proved to be something of an understatement.
It has since emerged that the United Kingdom fell back into a “double dip” recession in the fourth quarter of 2011 and the first quarter of 2012. The economy has scarcely grown in the last 18 months. The level of UK output today is 4.3 percent lower than it was on the eve of the recession in late 2007. In the United States and Germany, output has risen over this period. The contraction in UK GDP since 2008 has been greater than the shrinkage in the Spanish economy.
Many of the factors used to explain the weakness of UK growth—from high commodity prices, indebted consumers, and a fragile financial system—afflict other countries. So why has UK growth been so slow? Part of the explanation may lie in tighter fiscal policy. According to IMF data, the squeeze on public spending, aggravated by tax rises, has been on par with that seen in Ireland and Spain.
But a possibly more significant factor is the weakness of UK consumer spending. Household spending is 5.2 percent lower today than in late 2007. In the United States, which has witnessed a housing market crash and sharply higher unemployment, household spending rose 2.1 percent over this period. Indeed, no industrialized country outside the euro area periphery has suffered such a fierce contraction in consumer spending as in the United Kingdom. In part, the squeeze on UK consumers reflects the very high rates of inflation being generated in the United Kingdom in recent years.
Despite suffering a deep downturn, UK consumer prices are today almost 16 percent higher than they were in late 2007, more than twice as large an increase as in the United States or Germany. But this period of inflation seems to be drawing to an end. From a peak of over 5 percent last autumn, UK inflation could drop to as low as 1 percent by the end of 2013. Further declines in inflation should offer some respite to consumers over coming quarters. But just as the pressure of high inflation on the UK economy has started to ease, a major new source of risk—the mounting crisis in the euro area—has emerged.
The crisis has severely affected the outlook for growth in the United Kingdom, as well as in other northern European economies such as Sweden, Germany, and the Netherlands. The effect of economic and financial shocks in the euro area is being transmitted to the rest of Europe through trade flows, financial conditions, and business confidence. Prolonged weakness in the euro area, the United Kingdom’s largest export market, poses a potent threat to hopes of export-led recovery.
UK business sentiment has zigzagged over the last year, driven by events in Europe. According to Deloitte’s 2012 CFO Survey, confidence among UK chief financial officers plummeted on the gathering euro crisis in the second half of 2011, rose in March 2012 as the European Central Bank injected liquidity into the banks, and in June registered its sharpest decline since the survey started in 2007. CFOs now see an average probability of 36 percent that one or more countries leave the single currency by the end of this year, up from 26 percent in March.
UK policymakers responded to these challenges by announcing a further £50 billion of quantitative easing (QE) on July 5, taking the total program of money creation to £375 billion. With UK government bond yields already at historic lows, the effects of this further round of QE are likely to be limited. We do not see significant scope for a relaxation of fiscal policy. The government has been adamant on its program of fiscal consolidation, and a major change here would represent a political defeat on a core element of coalition policy. The government does, however, seem likely to use its low cost of borrowing to subsidize lending to the private sector, although the scale and effectiveness of such policies can only be guessed at. The heavy lifting of macro policy seems likely to come from further rounds of QE, coupled with attempts to improve the availability and price of credit. Such measures will not be able to fully offset the dampening effect of the euro crisis. Even outside the euro area, the outlook for UK growth over coming quarters will hinge critically on events in Europe.
Indeed, no industrialized country outside the euro area periphery has suffered such a fierce contraction in consumer spending as in the United Kingdom.