Bank lending at root of UK’s economic ‘puzzles’

By Kevin Daly

Funding for Lending Scheme helped spark recovery 

The performance of the UK economy from the start of the financial crisis until early 2013 was unusual in a number of respects. Its recovery since then has been more remarkable still.

Four “puzzles” were particularly notable, some of which were common to other advanced economies but the combination of which was unique to the UK.

First, relative to past cycles, the recovery in output was exceptionally weak: in the first quarter of 2013, five years after output began to fall, it remained 3.5 per cent below its pre-crisis peak and 11 percentage points lower than it had been at an equivalent stage of the three previous post-recession recoveries (early 1990s, early 1980s and mid-1970s). The UK’s output performance was also significantly weaker than the OECD average in this cycle. 

Second, the performance of UK labour productivity was especially poor: GDP per hour in the first quarter of 2013 stood 5 per cent lower than it had in the first quarter of 2008 and 18 percentage points lower than at an equivalent stage of the three previous post-recession recoveries.

Third, the UK’s trade deficit remained stubbornly large, despite an exceptionally weak exchange rate: sterling’s real trade-weighted exchange rate fell 25 per cent during the crisis, close to double the decline that followed Britain’s exit from the exchange rate mechanism in 1992. Yet, despite this, the trade deficit in goods and services averaged 2 per cent of GDP in the year to the first quarter of 2013, not far from where it had been before sterling’s collapse. 

Bank system cause 

Fourth, despite the weakness of the economy, UK inflation remained high: annual CPI inflation averaged 3.3 per cent between the first quarters of 2008 and 2013.

Each of these economic puzzles had at their root a common cause: the impairment of the UK’s banking system in the aftermath of the crisis. 

It has been widely documented that the loss of output during recessions associated with financial crises tends to be relatively large and that recoveries from such recessions tend to be relatively slow.

But, in slowing a reallocation of resources towards companies with the strongest growth prospects, the problems with credit provision can also account for the weakness of productivity, the failure of trade to respond to sterling’s weakness and the high levels of inflation. 

Two developments in the second half of 2012 started the process of resolving these problems: the euro-area crisis abated and the Bank of England launched the Funding for Lending Scheme. Both had the effect of lowering the funding costs of UK banks, which as a result became more willing to lend. 

Consistent with the view that problems with credit provision were the main reason for the UK economy’s poor performance between the first quarters of 2008 and 2013, the easing in credit availability since then has coincided with a turnround in the economy. 

Output has risen 3.1 per cent in the past year, according to the Office for National Statistics, faster than in any other major advanced economy. 

Impressive as this has been, it is likely to understate the true strength of the recovery: the official data are prone to significant revision, and business surveys and other activity indicators suggest growth in the past year has been closer to 4 per cent.

Productivity growth 

Productivity (output per employee) growth has risen from -0.8 per cent year-on-year in 2012 to 0.6 per cent in the first quarter of 2014. This is still less than half the long-term average but, if output growth over the past year is under-recorded in the official data by 1 percentage point, then productivity growth has been under-recorded by the same amount. 

The trade deficit in goods and services has fallen to 1.3 per cent of GDP in the first quarter of 2014 , despite sterling’s trade-weighted exchange rate having risen by close to 10 per cent in the past year. 

While UK output data have surprised on the upside in the past 15 months, inflation data have more often surprised on the downside. Annual CPI inflation rose from 1.5 per cent to 1.9 per cent in June but we expect it to fall back again in the coming months. 

If the improvement in credit provision is maintained – particularly to small and medium enterprises – the progress in the past year may be just the start of a reversal of all four puzzles.

While the UK’s economic performance in the five years after the crisis began was characterised by slow growth, weak productivity, persistent imbalances and high inflation, it is plausible that its performance in the coming years will be characterised by fast growth, strong productivity, reduced imbalances and low inflation.

Copyright The Financial Times Limited 2014.