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The Office of National Statistics has revised the final quarter of 2011 growth figure down from -0.5% to -0.6%.
This provides a significant reminder of how important it is to ensure that economic conditions are conducive to growth. The revision also means that even if the effects of the bad weather are remove the economy still contacted by 0.1%, rather than remaining static. Such a revision will put pressure on the government to include a definitive plan for growth in the upcoming budget. However, despite a general consensus on the need for a “growth plan” to be put in place there is little consensus on the nature of that plan or the mechanisms most likely to deliver results.
Looking forward it is important that such plans are based on the experiences and lessons learned over the last few years. We need to ponder the market conditions that resulted in our present position, and what their continuing effects on our rate of growth are.
The financial crisis
The financial crisis shook investors, consumers and governments. It resulted in the first truly global effort to implement economic policies to mitigate against a system on the verge of collapse.
The effect of this ‘near miss’ should not be understated and its effects are still being felt today. Lending conditions remain significantly constrained and the cost of financing is higher than it should theoretically be given the present level of the base rate.
Constrained and more expensive lending impacts on economic growth in a number of ways. Firstly, as lending conditions tighten, the cash flow positions of companies become tighter, with SMEs in particular having difficulty smoothing income and expenditure. Given constrained lending, companies are more likely to hold significant reserves to mitigate against the risk of being caught out as illiquid. The cost of holding such reserves is lower investment and spending which reduces economic output.
Another aspect is the cost of lending. With costs rising companies not only hold greater reserves, but also re-evaluate the cost and benefit of investments. An investment that was considered feasible before the financial crisis may no longer be undertaken, which once again reduces the consumption of goods and labour reducing economic output.
Finally, the crisis changed attitudes. Companies were no longer prepared to hold significant amounts of debt on their balance sheet as the cost of repayments increased. This meant that a number of companies issued shares to recapitalise their companies and reduce their liabilities.
It is worth noting that SMEs rarely have the luxury of such financing mechanisms. Injecting capital into these smaller businesses is generally undertaken by their owners, sacrificing the consumption of other goods and services in order to recapitalise their company.
The examples above show that the financial sector is a key facilitator of growth, and unfortunately the system can still not be considered to be in good health. The system has to adapt and learn from the mistakes it made. A co-ordinated effort by both the financial sector and government to commit to policies that ensure financial responsibility, long term stability and growth would aid this.
The recession
Following the financial crisis, the economy entered recession as demand conditions and confidence plummeted. Unfortunately, such conditions lead to further uncertainty and so further spending restraint. This created a downward multiplier effect. as a result, companies began to reduce staff numbers as output fell, which in turn resulted in individuals further constraining spending.
One method of mitigating this spiral is for governments to increase spending and thus improve output. Such policies can be seen across a variety of countries with the emphasis being placed on capital expenditure. This capital spending should not only provide a much needed boost in terms of jobs and consumption but also improve the long run output and efficiency of the economy.
For an example of this, look to the regeneration of east London for the Olympics. This has provided stability for the companies involved, regenerated significant brown field sites to improve the area for residents, significantly improved transportation links in the area, and increased not only the current but future potential for commercial activity.
However, given the cost of the financial crisis, the degree to which such policies can be pursued is limited. This has meant that there is greater reliance on the private sector to lead the recovery, though to date the pace of this recovery seems very uncertain.
The tough market conditions have increased competitiveness, and there have been a significant number of companies making efficiency improvements. Over time these efficiencies should enable companies to pursue new opportunities at a lower unit cost, enhancing profit. This in turn encourages a further expansion in activity, driving recruitment, improving confidence and increasing output.
Although this process will occur, the timeline over which this process will take place is very debatable. Expanding activities requires confidence in the market and cost effective finance availability to encourage investment, both of which are lacking given the financial crisis and concerns over sovereign debt.
The sovereign debt crisis
The swift action of governments during the financial crisis may have stabilised the banking sector, but the liabilities of their actions remain. These liabilities now lie in the public sector and despite the initial global consensus that stimuli packages were required to mitigate the effects of the crisis and recession, the willingness of investors to watch public debt soar has ended.
Investors are now looking for credible exit strategies from the liabilities that the public sector undertook. It is for this reason that the UK government has implemented a significant public cuts programme, to ensure continued confidence. However, whilst the UK’s cuts are aimed at reducing the deficit, there is also a willingness to rebalance the economy with a shift away from publically-funded activities.
This shift not only effectively ends the support the market has had from the government, placing a downward pressure on growth, but also potentially limits the growth prospects from this sector in the future. As mentioned previously, if the private sector is able to react accordingly and address issues surrounding financing there is significant potential for profits to be made and growth to occur. The speed of this reaction will be key.
Alternatively, the government could scale back the size of the proposed cuts. However, the cost of public debt is increasing and investor confidence might result in the removal of investors’ funds from the country. This would increase in the cost of borrowing.
Such actions have been seen in both Greece and Ireland, as these countries edged towards bankruptcy. The response to their economic troubles has been nothing short of historic. International institutions consisting of, and funded by, multiple national governments have stepped in to ensure the continued stability of the financial system.
One must ask how long it will be before investors have concerns about the stability of such institutions. A loss of confidence at this level could be catastrophic, and so it is vital that policies are put in place to ensure continuing confidence amongst investors.
The start of this process can already be seen with proposals for the European Union to have far greater monitoring controls over governments’ fiscal positions. Unlocking this confidence is key to getting international capital flowing, which will in turn release significant opportunities for growth.
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