The UK’s model of growth is often seen as intrinsically different from the ‘continental’ one and more similar to that of the US. This model is characterized by comparatively sharp fluctuations in household demand that are driven by the credit cycle, with subsequent waves of leveraging and deleveraging (or ‘boom’ and ‘bust’). It can only be sustained if labour markets are sufficiently flexible, as this strengthens incentives for employers to hire staff quickly and for workers to seek jobs instead of claiming unemployment benefits.
The ‘continental’ model in some ways would be its opposite, with consumption driven more by income than by credit conditions, as saving rates are high and stable. As a result, individuals attach more importance to stability of employment and income (as opposed to the level of income). Comparatively rigid labour market regulations, in turn, tend to discourage job creation and limit employment growth, so resulting in higher ‘non-frictional’ unemployment rates (defined as excluding people in transition between jobs).
The extent to which these perceived differences between the British and continental growth models have enabled or impeded economic recovery is somewhat of an open question for us, which we will examine below. However, as will become clear, this is but one of several factors that explain the growth gap between the UK and eurozone, differences in macroeconomic policy stances being particularly prominent among them.
Indeed, monetary and fiscal policies were more accommodative in the initial stages of the recovery in the UK than in the eurozone. As well, the UK tackled the resolution of insolvent financial institutions up front whereas the eurozone left this largely unaddressed, contributing to a credit crunch and exposing sovereign risk. Could this have made it harder for the latter to attain ‘escape velocity’ and keep growing strongly once policy support is withdrawn?12
Monetary policy
As shown in Figure 3, the initial cuts in official interest rates in 2008 and 2009 were larger in the UK than in the eurozone. What is more, the response of the European Central Bank (ECB) was impeded by having to reverse policy tightening, as the bank had initially hiked rates at the start of the crisis in 2008 and then did so again twice in 2011. With hindsight these rate hikes were premature. They probably damaged the ECB’s credibility and may have rendered subsequent action less effective than it would otherwise have been. The ECB also started unorthodox asset purchases much later than the Bank of England did, and its ‘quantitative easing’ (QE) still has a long way to go before matching that of the UK in relative terms. QE is generally thought to stimulate economic activity through a range of channels, for example by encouraging investors to rebalance their portfolios towards alternative assets (stocks, corporate bonds, foreign assets). It was developed as a means of easing financial conditions when official interest rates are at or near zero – when the scope for conventional monetary policy easing is therefore constrained by what economists call the ‘zero lower bound’. Figure 3 suggests that the ECB has only now reached the same scale of asset purchases that the Bank of England achieved in 2011. At its current pace of asset purchases, €80 billion per month, the ECB would have to continue QE for at least another year in order to match the scale of balance sheet expansion in the UK.
The reasons why the ECB has been slow to respond are manifold and largely political. By design the ECB is a central bank without a single sovereign. As asset purchases potentially have far-reaching cross-country distributional effects, national politicians – and arguably some central bankers – are understandably wary of their use in the eurozone. Without dwelling too much on these political economy aspects, the conclusion is clear: monetary policy in the UK was more responsive at an early stage, which facilitated quick and smooth deleveraging while avoiding a debt crisis (as the cost of capital fell more quickly and asset prices held up better). This then set the scene for a quicker recovery.
Figure 3: Monetary policy indicators
Figure 3: Monetary policy indicators
The impact of the UK’s faster monetary policy response is also reflected in the movement of exchange rates. On all measures, sterling declined steeply in the aftermath of the financial crisis (see Figure 4) – which would be consistent with the Bank of England’s earlier and larger policy easing measures. Depending on how the exchange rate is measured, the euro depreciated more modestly than sterling or continued to appreciate in the early stages of the crisis. It was only when the ECB launched QE in early 2015 that the depreciation in the euro, in trade-weighted terms, equalled the decline in sterling. But even this closing of the gap was temporary, as the UK saw another sharp depreciation in sterling after the June 2016 referendum on EU membership. Taking the period since the financial crisis as a whole, sterling’s real effective exchange rate (REER) has fallen by about the same amount as that of the euro. However, in terms of the nominal effective exchange rate (NEER), sterling has fallen much further than the euro since the crisis. This has surely helped the Bank of England to push up inflation, which in turn has facilitated deleveraging in the UK as the real value of debt – fixed in nominal terms – has fallen as a result.
Figure 4: Exchange rates
Figure 4: Exchange rates
Fiscal policy
Fiscal policy was also much more accommodative in the UK than in the eurozone in the early years after the crisis. The UK’s fiscal stimulus in 2009 was much larger than that in the eurozone (see Figure 5). And while the UK started fiscal consolidation earlier than the eurozone (in 2010, as opposed to 2011), the effects of austerity proved much more brutal in the eurozone, where governments adopted a contractionary policy stance in the midst of the recession in 2012–13. Moreover, the UK’s fiscal consolidation was driven more by expenditure restraint than by tax increases. This mitigated the immediate impact on disposable income and consumption, whereas the tax hikes that predominated in euro member states – from levels that were already comparatively high – likely helped to subdue domestic demand.
If, in the aftermath of the financial crisis, private debt fell more rapidly in the UK than in the eurozone, albeit from higher starting levels (see below), it was counteracted by rapid leveraging of the public sector. Expansionary fiscal policy was therefore a major driver of the UK recovery in the years immediately after the crisis. In the eurozone, fiscal expansion in response to the crisis was more limited, which again explains in part the more muted recovery there compared with in the UK. While the subsequent reversal of fiscal easing has been brutal in both economies, the UK proved much more resilient to it than the eurozone.
Figure 5: Cyclically adjusted fiscal indicators
Source: OECD.
Figure 5: Cyclically adjusted fiscal indicators
Source: OECD.
Crisis resolution
The initial shock stemming from the financial crisis was much larger, relative to GDP, in the UK than in the eurozone. However, it took the latter much longer to restore the balance sheets of its banks – again reflecting opposing views and conflicts of interest among the debtor and creditor nations inside the single currency area. These different approaches are reflected in the evolution in debt and bank lending, which in turn helps to explain the divergent growth performances of the UK and eurozone economies.
The strong growth of consumption in the UK before the crisis was financed in large part through access to credit. This can be seen in the fact that households’ net lending – in effect, the difference between savings and (debt-financed) investment – turned negative in the five years leading up to the crisis (see Figure 6). Gross household debt, already high in comparison with the eurozone, had also soared as a percentage of GDP over the preceding decade (see Table 2).
By contrast, households in the eurozone remained net lenders and the increases in their gross debt were much less pronounced than in the UK. This was reflected in the different current-account positions of the UK and the eurozone respectively: in the run-up to the crisis of 2008–09 the UK ran a deficit in the range of 2–4 per cent of GDP, while the eurozone’s current account was broadly in balance (see Figure 6). Domestic household net lending in the eurozone was sufficient to finance government deficits even as the corporate sector maintained a net lending position close enough to balance.
The fact that gross debt-to-GDP ratios in the eurozone nonetheless rose during this period is a reflection of the core/periphery divide, with companies and households in periphery countries assuming more debt, ultimately financed by net saving in Germany. This imbalance subsequently contributed to the 2010–12 debt crisis, as did the ‘one-size-fits-all’ monetary policy of the ECB, market rigidities in the periphery countries, and the idiosyncratic problems of Greece and Cyprus.
If these were broadly the dynamics leading up to 2009, the situation changed after the financial crisis as UK households initially reversed their behaviour – deleveraging to become large net lenders (see Figure 6). As a result, household debt began to fall sharply. The belt-tightening didn’t last, however, as UK households soon began to borrow and spend more freely again, reducing their net savings. By 2015 they had reverted to net dissaving – the same pattern observed in 2004–08 in the run-up to the financial crisis – and this was reflected in a small increase in the household debt ratio from a low of 85.7 per cent of GDP in mid-2015 to 87.4 per cent of GDP in the first quarter of this year.13
Eurozone households have continued to be net savers even if the ratio of household net lending to GDP has not quite recovered from the drop in 2010 – this despite consumption spending and housing purchases having fallen in countries hit by the debt crisis. There is a similar contrast between Britain and Europe in the corporate sector. Corporates in the UK, after an initial surge in net lending post-financial crisis, reverted to net dissaving in 2015, whereas eurozone corporates have remained net savers since 2009. However, this has not reduced gross corporate indebtedness in the eurozone (see Table 2), as massive retained profits in Germany are no longer recycled in the eurozone and as corporates in the rest of Europe continue to struggle to pay back their bank loans. The latter situation is reflected in the large number of non-performing loans held by banks in Europe, which helps to explain the weak recovery of both bank credit and investment.
Figure 6: Sector net lending balances
Figure 6: Sector net lending balances
Table 2: Gross debt as a percentage of GDP
|
United Kingdom |
Eurozone |
|||||
|---|---|---|---|---|---|---|
|
Q4 1999 |
Q4 2008 |
Q1 2016 |
Q4 1999 |
Q4 2008 |
Q1 2016 |
|
|
Gross debt* |
|
|
|
|
|
|
|
Non-financial corporate |
65.7 |
93.9 |
70.8 |
76.0 |
98.5 |
105.0 |
|
Households |
63.0 |
94.4 |
87.4 |
46.8 |
60.0 |
59.0 |
|
Central government |
42.9 |
54.9 |
107.9 |
73.8 |
71.8 |
106.7 |
* Debt securities and loans, non-consolidated.
Source: Bank for International Settlements (2016), ‘Credit to the non-financial sector’, http://www.bis.org/statistics/totcredit.htm?m=6%7C326 (accessed 5 Oct. 2016).
12 This is even aside from the effects of the 2010–12 debt crisis in the eurozone, which entailed a comparatively large fiscal contraction that has also been counterproductive to prospects for cyclical recovery.
13 Bank for International Settlements (2016), ‘Credit to the non-financial sector’, http://www.bis.org/statistics/totcredit.htm?m=6%7C326 (accessed 5 Oct. 2016).