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Deregulation, debt and downturn in the UK economy.

The Review is pleased to give hospitality to the deliberations of the CLARE Group but is not necessarily in agreement with the views expressed. Members of the CLARE Group are M.J.Artis,A.J.C. Britton, WA. Brown, C.H. Feinstein, C.A.E Goodhart, D.A. Hay, J.A. Kay, R.C.O. Matthews, M.H. Miller, P.M. Oppenheimer, M. V Posner, WB. Reddaway, J.R. Sargent, M.F-G. Scott, ZA. Silberston, J.H.B. Tew, S. Wadhwani.

The boom of the later 1980s was not due solely to financial institutions greater freedom to lend to the private sector. This was activated by over-optimism about the economy's performance. These two influences combined to cause the over-heating' for which the current recession is seen as the cure. Although the removal of restraints on financial institutions contributed, it was a once-for-all process which is now virtually complete. The case for returning to a regulated financial system is weaker than the case for living with an unregulated one, despite the higher debt ratios and other conditions which have resulted from the transition to it.

Are recessions getting worse in the UK? When the current recession can be calibrated against its predecessors of 1974/5 and 1980/1, could there be a degenerative pattern describable as recession, depression, slump? Whatever time will tell, the downturn which began in the second half of last year has certainly generated a heavy volume of gloom and despondency, and fears that the answer 'yes' might eventually have to be given to the questions posed. A cynical view, on the other hand, would be that complaints about the current recession have become particularly audible because its effects have been felt to a relatively greater extent in the South of England and in the financial sector than on previous occasions. Certainly in the last recession, of 1980/1, the problems were less obvious from the Waterloo and City Line than they were f rom the Tyne and Wear Metro; but this is not so now. A recession's claim to attention, it might be said, like the claim to be a cockney, increases the nearer it is to being born within the sound of Bow Bells.

The most comprehensive indicator is the movement of GDP measured at constant prices. Chart 1 takes in the latest recorded figures for the output measure of GDP (at 1985 prices), including the first quarter of this year, and projects them forward using the most recent forecast of the OECD published at the beginning of July. On this reckoning, the current recession should turn out to be slightly less severe than either of its two predecessors, of 1974/5 and 1980/1, although worse than any in the 1950s and 1960s. But even if this is the outcome of the present downturn, it needs to be placed in its comparative context. in the first place, in 1974/5 and 1980/1, the recessionary movements derived impetus from the world outside the UK to a greater extent than now; both were affected by substantial increases in the price of oil. Secondly, the domestic inflation which preceded these earlier recessions was considerably more severe. As measured by the index of Retail Prices, compared with a year before, inflation in the UK peaked at 25.6 per cent in the fourth quarter of 1975, and at 21.6 per cent in the second quarter of 1980, but at only 10.4 per cent in the fourth quarter of 1990. If recession is to be seen as the price paid to reduce inflation, a lower price should be called for this time. Thirdly, the current recession began from a higher level of unemployment than either of its predecessors. Fourthly, it has to be seen against the background of a relatively long period of fairly steady economic growth. Between 1982 and 1989, there were seven consecutive years of GDP(O) growth exceeding 2 per cent per annum, and between 1983 and 1989 six consecutive years exceeding 2.5 per cent per annum, an experience not to be found before that in the post-war period from 1948. Although this experience partly reflected the low level from which the recovery began, it suggested a welcome degree of stability in the growth process, which some claimed to be due to the abandonment of Keynesian attempts to manage aggregate demand and the end of 'stop-go' movements attributed to these. Such claims have been jolted by the downturn currently in course. Commenting on the economy's behaviour as tracked by a wider range of indicators than GDP alone, the January 1991 issue of Economic Trends, published by the Government Statistical Service, observes:

the cyclical movements in the economy following the 1981 trough and prior to the 1988 peak are significantly smaller than those in the 1970s and a little smaller than those in the 1960s, reflecting the fact that during this period GDP growth was exceptionally steady by historical standards. The 1988 peak and subsequent movements of the indices suggest a return towards a more marked cyclical pattern.

Even this wider range of indicators, however, does not include what now seems set to be the particularly notable feature of the current recession: the failure of debtors to meet their obligations, and its consequences in the form of insolvencies, bankruptcies and repossessions of mortgaged properties. Annual insolvencies among companies, as a proportion of the number of companies on the active register at the end of the previous year, reached a peak of 11 per cent in 1976 following the 1974/5 recession, and of 1.7 per cent following that of 1980/1. In 1990, although the year's total of company insolvencies (15,051) was higher than for any year since 1970, so was the number of companies, and the percentage of insolvencies, at almost 1.6, was still below the previous peak. But the experience of the last two recessions is that the insolvency percentage reaches its peak a year or two after the recession has reached its trough. From this one could expect that, if a trough is reached this year, the insolvency percentage has two years or so to go on rising from 1.6 before it reaches its cyclical peak. Indeed, the number of insolvencies in the first quarter of 1991, seasonally adjusted and turned into an annual rate, already amounts to 2.2 per cent of the number of companies on the active register at the end of 1990.(" The number of insolvencies among individuals has been increasing even more rapidly than among companies in the last few years; after fluctuating around a-third of the total in 1980-6, it has climbed steadily since then to over one half. But the number of non-corporate enterprises has probably been increasing rapidly too. We lack a reliable base for establishing the incidence of individual insolvency. Individual and company insolvencies together, however, can be related to the number of businesses registered for VAT. (2) This produces an insolvency percentage which peaks at 1.5 in 1984, and declines to a low point of 1.2 in 1988, but rises sharply to 1.9 in 1990, when the downturn was only beginning. While all of these figures count numbers of businesses without reference to their size, they justify a fairly strong presumption that the current recession is or will be characterised by the collapse of businesses on a relatively larger scale than the two which preceded it.

We should bear in mind, of course, that a higher incidence of business insolvency is not in itself an index of the depth of recession; it could also reflect an increasingly competitive environment, in which the normal mortality rate of businesses would be expected to rise even in a given state of trade. A similar point applies to difficulties which households have making payments on mortgages, which have become more easily obtainable in the last decade for a greater multiple of the borrower's income. The annual number of properties repossessed by building societies which had lent against them, expressed as a percentage of the number of loans outstanding at the end of the period, moved steadily upwards from .05 per cent in 1979 to 0.32 per cent in 1987, showing little trace of the 1980/1 recession. The percentage then fell to 0.17 in 1989, but in 1990 jumped to .47 per cent, well above the 1987 peak. The percentage of loans in arrears has behaved in a similar way.(3) It might be argued that what we are observing is, strictly speaking, a lagged response to a prolonged period of high interest rates rather than an effect of the recession as such; but for most people this is a distinction without a difference.

How did it come to this?

Although the recessionary movement in the UK is now receiving some impetus from a slowdown in the world outside, it originated from the perceived need, and the government's determination, to curb a resurgence of inflation which was generated by essentially domestic influences. There is a strong consensus that these influences had three components:

(1) inflation began to accelerate from 1988 on because the demand for consumption and investment goods was enabled to grow rather rapidly, and to exceed the growth of productive capacity, by an increase in the extent to which borrowing from financial institutions became accessible to households and to businesses.

(2) Financial institutions were enabled to expand their lending in this way because various restraints on their activities had previously been removed. It is convenient to refer to this process as financial deregulation', but the blanket term covers a number of separate actions, which are set out in a box on the following page.

The authorities failed both to foresee the extent to which 'financial deregulation' would affect the domestic demand for consumption and investment goods, and to identify correctly the point, in early 1988, at which it was beginning to cause inflation to accelerate.

Tables 1 and 2 set out the elements which contributed to the build-up of borrowing mentioned in (1). The figures refer to annual flows relative to disposable income for the personal sector and to trading profits and other income for industrial and commercial companies. The personal sector includes not only households but also unincorporated enterprises, and so table 2 contains an element of business transactions which the available statistics do not always allow to be separately identified. The tables call for some comments. The first is that in both there is a substantial discrepancy between the amount identifiable as having been borrowed by each sector and the amount that each appeared to need to borrow in order to acquire physical and financial assets beyond what its own saving or undistributed profits would meet. This large balancing item' warns us of the uncertain quality of the figures, which are subject to sizeable revisions from time to time; and this item is particularly marked for industrial and commercial companies in the last two years. Nevertheless, for both sectors identified borrowing and the apparent borrowing requirement both move up sharply in the second half of the 1980s, reaching a peak in 1987 for the personal sector and in 1989 for industrial and commercial companies. The latter peak is likely to include an element attributable to the involuntary accumulation of stocks of finished goods as the economy began to slow down, and so may exaggerate the underlying trend. Moreover, it should be noted that some of the heavy borrowing by these companies would not in itself have contributed to excess demand for goods and services in the UK. In 1987-9 the companies borrowed large amounts to finance investment abroad, and in 1988-9 to finance takeovers; the latter no doubt occasioned the jump in their bank borrowing then. But there was also a substantial increase in their purchases of investment goods (line 2 of table 1) in the second half of the 1980s, which clearly played a part in the growing strain on productive capacity. During that period, the rise in borrowing went together with a rise in dividend payments, which might suggest that at any rate a modest pinch of salt could be applied to company complaints about high interest rates. However, this movement could also be seen as an aspect of easier access to borrowing and a less imperfect capital market, in which the balance of advantage was shifting for firms away from retaining profits in order to avoid borrowing and towards distributing them in order to facilitate it.

Turning to the personal sector, in table 2, it is evident that the shift in the second half of the 1980s to a higher level of borrowing made possible a higher expenditure on physical assets, relative to income, although part of this was for land and houses already in existence, and apparently none for the other fixed assets' which include the buildings and equipment of unincorporated enterprises. The borrowing shift was reflected more perceptibly in the decline in the savings ratio, which gave an additional stimulus to consumption at a time when real incomes were rising rapidly. Compared with an average of 2.1 per cent from 1980 to 1985, the annual rise in the volume of consumers' expenditure jumped to 6.3 per cent in 1986, 5.2 per cent in 1987 and no less than 6.9 per cent in 1988. In the latter year, the personal sector's capital as well as consumption spending reached the highest proportion of income, but borrowing was past its peak and sales of securities provided the alternative source of finance, which became even more substantial in 1989. (5)

From the history in tables 1 and 2, let us return to the causes of the boom of the late 1980s and the consensus which exists concerning them. As stated at the beginning of this section (in (1) to (3) on pages 76-7), it leaves out an important question. While there is little doubt that the process of financial deregulation' permitted banks and building societies to increase the supply of finance offered to households and businesses in the private sector, was this sufficient in itself to cause the private sector to take it up in the way that it did? Given the restraints on financial institutions which had previously existed, and their tendency to lead to rationing' of loans, there was no doubt some unsatisfied desire to borrow on the part of households and businesses-at given levels of income and interest rates-which the removal of the restraints allowed to be met. As a natural consequence of this, an increase in the ratio of debt to income was only to be expected as it adjusted to the new equilibrium appropriate to the liberated state of financial markets. But the scale of the increase in borrowing in the 1980s is larger than it seems plausible to attribute to this alone. It suggests that there must have been another contributory factor which induced borrowers in the private sector not merely to lift the actual ratio of debt to income towards a previously unattainable equilibrium, but also to raise the equilibrium level itself. The presence of such an increase in the underlying demand for finance in the private sector helps to explain why the increase in the supply did not lead to downward pressure on real rates of interest. The fact that this failed to appear in the 1980s supports the belief that there was also an increase in the extent to which the private sector was willing to incur debt at given levels of income and interest rates. 63 This increase, we argue, was the direct result of the climate of over-optimistic expectations which developed in the 1980s about the economy's performance. (7)

Sources of exaggerated expectations

This hypothesis is consistent with the fact that the boom of the second half of the 1980s was characterised, to a much greater extent than most previous booms, by inflation of asset prices as distinct from producer prices, wages or retail prices. it is also borne out by the difficulties which debtors are experiencing to a greater degree in the current than in earlier recessions. But if it is correct to see the growth of exaggerated expectations as a crucial element which activated the increased supply of finance available because of financial deregulation', we need to explain how such a growth came to develop. It appears to have originated in the following way. In the postwar period, the UK economy suffered from three distinct basic problems:

a slow rate of growth of productivity (at normal levels of capacity utilisation);

a tendency for output to respond inadequately if aggregate demand for goods and services grew faster than normal, with a consequent proneness to inflation or balance of payments deficits when this occurred;

a labour market which was chronically subject (even when not aggravated by (b)) to the exogenously-generated, and often union-initiated, pressure for higher wages generally known as 'wage-push'.

After the 1980/1 recession, a welcome increase in the rate of growth of labour productivity was observed, and encouraged the belief that problem (a) was on the way to being solved. But the increase was widely misinterpreted in two ways. The first was that insufficient allowance was made for the extent to which the improvement in labour productivity was a once-for-all effect of a deep recession in which, since Keynesian stimulants were no longer to be applied, pruning of the labour force became unavoidable. The second was that optimism about problem (a) led too easily to optimism about problem (b). In point of fact, the closure of capacity which contributed to the improvement under (a) implied that a given increase in the aggregate demand for goods and services would be less easily met from domestic sources and would also generate more demand for investment goods than in the past, so that (at any rate for a while) the proneness to inflation and balance of payments deficits might actually be aggravated. While the pick-up in the growth of labour productivity, which was particularly marked in manufacturing, thus came to be projected over-optimistically into expectations about the UK economy's future performance, euphoria was amplified by comparisons with the UK's European competitors, whose productivity growth in the first half of the 1980s appeared, by contrast with the UK's, to be slowing down.(8) Although the equalising of the score suggested that the other Europeans might be prone for relegation to Division II, it was often mistakenly interpreted as heralding the UK's promotion to Division 1; and the mistake was the basis for much talk of the 'renaissance' or 'transformation' of the UK economy.(9) All of this was accompanied by a certain monetaristically-inspired indifference to the rise in money wages due to problem (c), and a somewhat simplistic view of the extent to which the government's anti-union legislation would ameliorate it.

It is not at all surprising that the government should have enjoyed the 'rosy scenario'. But it may now be regretting that it allowed it to become so widely believed, with the result that exaggerated expectations of future growth of real incomes came to be built into the calculations made by households and businesses of the scale on which it would be wise to borrow and into the prices they were prepared to pay for physical and financial assets. If penitence is compatible with politics, it is here that it should be concentrated rather than on the lapses of judgement concerning the precise state of the economy and the imminence of inflationary pressures which have been referred to above.110) For these it is not difficult to assemble a case in mitigation. In the first place, the process of financial deregulation' involved a major structural change in financial markets, and it would have been remarkable if the magnitude of its adverse effects (on personal savings, the financial surplus of the private sector and the money supply) had been foreseen with any precision. As it happened, the public sector's finances did move in the correct compensating direction, from deficit to surplus. Secondly, when the government is accused of having failed to appreciate the seriousness of worsening inflationary pressures, three instances are usually cited: its overassessment of the adverse effects on aggregate demand of the October 1987 decline in the stock market, the decision to keep the pound pegged to the D-Mark at the beginning of 1988, and the tax cuts in the 1988 Budget. Of these instances, everyone was in the dark about the first. The second was associated with a genuine policy dilemma' when heavy capital inflows to the UK at the time meant either lower interest rates or official purchases of foreign currency, both of which might lead to increased growth in the money supply.[11] As to the third instance, L2.lbn of the L5.7bn of income tax cuts were attributable to the abolition of the higher rates, with a presumably small direct impact on consumer demand, and took place within an unchanged budget surplus. if there were indirect effects on wage settlements, these are difficult to trace in the figures. Finally, the government's ability to judge the degree of inflationary pressure correctly was undermined by GDP figures which underestimated the rate at which the economy is now known to have been growing at the time.

The case in mitigation can, of course, be challenged at various points. The decline in the quality of official statistics was not unconnected with economies in government spending. The move from deficit to surplus in the public finances was helped by transitory receipts from asset sales, by oil revenues which could not be counted on to last, and by the favourable effect on tax revenues of the boom itself. It was also motivated more by politico-ideological objectives than by a calculated need to counterbalance the private sector's lapse into financial deficit. The effect of the 1988 tax cuts may have been quite small relative to the growth rate of GDP', to quote the National institute, but were 'a cost rather than a benefit' when concern was being expressed about 'overheating'. (12) Of greater importance than their immediate impact was the fact that they confirmed the expectations, which the government had encouraged, of repeated tax cuts in years to come; and this must have aggravated the climate of generally exaggerated expectations which, as argued above, had loosed the avalanche of debt. But the conjunctural misjudgements of 1987-8 which aggravated the boom were unfortunate rather than unforgivable. The economy after the deluge We may hope that experience will improve the ability of governments to judge correctly what is happening in the economy and to avoid the mistakes of 1987-8, of which the price is now being paid. The immediate question is how soon the economy will have recovered from the recession; but we leave that to the forecasters, and fix our attention on the kind of economy we shall then have to live with. It will be one whose financial structure has undergone a significant change. The central issue now is whether it will be possible to maintain a stable rate of economic growth in the UK, avoiding bouts of resurgent inflation (like that of 1987-9) which are suppressed by spells of recession (like that of 1990-1), with unregulated financial markets. (13) Latent in this issue is the further question whether some revived or revised form of regulation will not have to be considered.

Two arguments for living with the status quo run as follows. The first is that 'financial deregulation' can be seen as a once-for-all process, which is now complete. It has not been solely responsible for the problems which have arisen; these were also created, as we have argued, by the climate of exaggerated expectations in which it was allowed to take place. But the part that it did play in creating these problems is attributable essentially to the transition from a regulated to an unregulated financial system. The transition may have been too rapid, its effects inaccurately identified, and corrective action taken too late, but a recurrence of the problems need not be anticipated in an unregulated financial system in a 'steady state'. The second argument is that the positive benefits of such a system are bound to take time to make themselves felt. These are the benefits of improved allocative efficiency. Regulatory restraints on financial institutions are liable to distort and conceal the true costs of providing finance, so that it comes to be allocated among potential borrowers in a way which fails to reflect the uses of it most likely to be profitable, and in the economy as a whole the returns from investment are less than they might be. So in principle there should be 'welfare gains' following the removal of these restraints, which ought to be allowed the chance to validate themselves.

The second of these arguments is a theoretical one which is a good deal easier to state than it ever will be to test against evidence. It is the familiar argument of unripe time', which has often served to prevent change by postponing it. But it has some weight against any early move to reintroduce regulation into the financial system, and this is added to by the consideration that, although the process of removing previous regulations may be complete, the financial environment may not yet have fully adapted to it. The first argument makes a more radical claim; but it begs the question of what the new environment will be like when it has fully adapted. Will it exhibit a permanently higher incidence of insolvencies, bankruptcies and repossessions, after allowing for their cyclical fluctuations? The latest figures quoted at the beginning of this article suggest as much, although the welfare costs of such an increase have to be set against the putative gains from a more competitive economy, to which freer access to finance has made one but not the only contribution The other new feature of the financial environment which is likely to endure is the higher ratio of debt to income in the private sector. This ratio is now being adjusted downwards, both in the personal sector and among industrial and commercial companies, and will presumably settle at some time at levels acceptable to those concerned. If these equilibrium levels turn out to be significantly lower than now, the present recession will be prolonged by the adjustment to them. But if this is avoided because the equilibrium levels of the debt-to-income ratios turn out to be not much lower than the levels prevailing now, the ratios will still remain significantly higher than in the previously regulated system. This could leave the private sector, even when it has fully adapted to the new financial environment, permanently more vulnerable to recessionary shocks.

Industrial and commercial companies

The situation left behind by the growth of debt in the 1980s is somewhat different in the two parts of the private sector. For industrial and commercial companies, the consequences of the annual borrowings set out in table 1 have been to raise not only the ratio of debt and debt servicing costs to trading profits and other income, but also the ratio of net debt to the current (replacement) value of their stock of physical assets. This capital gearing is illustrated in chart 2, which shows that it more than doubled in the 1980s to reach 20 per cent. The chart suggests that industrial and commercial companies are no strangers to a capital gearing ratio of this size, which was reached in 1970; but that reflected a low level of real interest rates, and interest payments then absorbed a very small proportion of industrial and commercial companies' income compared with now. The return to higher gearing in the 1980s has come about mainly through increased indebtedness to financial institutions, not to bondholders. (14) This could mean that for a limited degree of gearing there is less risk for the companies involved. In the first place, both banks and building societies are open to public pressure to deal flexibly with borrowers in difficulty in a general recession, and have often done so. But the indications lately are that the limits of flexibility can be reached. Moreover, the banks' readiness to exercise it has been sapped by the decline in 'relationship banking'-itself an aspect of more competitive financial markets. If their customers have felt freer to 'shop around' for better terms, the banks have felt less obliged to be sympathetic when a borrower's gives way to a lender's market. A second characteristic of indebtedness to financial institutions is that it generally carries a variable rate of interest, which ought theoretically to fall in a recession and rise in a boom, causing payments of interest to be correlated positively with cash flow. But this can certainly not be counted on; and when money market rates and base rates do yield to a recession, the rates charged to borrowers will not necessarily follow them if the recession also lowers the borrowers' bargaining power.

If higher debt ratios involve greater cyclical risks for industrial and commercial firms, they also reflect the revealed preferences of firms for increasing the extent to which they find their finance from banks compared with other sources; and this implies that firms see some longer-term advantages in it. Two reasons may be advanced for this shift of preferences. The first is that the banks have greatly extended the range of the facilities that they offer; for example, variable-rate loans at medium-term, leasing arrangements, greater possibilities of equity participation, and loans denominated in foreign currency. The transformation from deposit banks into general providers of financial services has increased the banks' capacity to offer their customers financial packages' and thus the incentive to go to them rather than directly to the financial markets. Secondly, industrial and commercial firms have always been suspicious, whether justifiably or not, of 'short-termism' in the equity markets, and thus have been ready to respond with some alacrity to improvements in the alternative sources of finance offered by the banks. It may be said, of course, that there is nothing shorter term than the traditional bank overdraft, which in principle can be called in at any time; but the banks have for some time been moving away from reliance on this form of lending and increasing their willingness to lend for fixed terms, often with some initial deferment of interest payments. In present circumstances, the attractions offered by the banks may seem to have been oversold, and a retreat from them is taking place. But they were bought by industrial and commercial firms in earlier years in what can hardly have been a fit of absence of mind rather than the exercise of a rational preference. Although the Bank of England has expressed the view that for industrial and commercial companies the recent substantial increase in gearing was well above the long-term trend, it also thought that the long-term trend would be upwards.(15) 1n so far as this reflects the increased competitiveness of the banks as lenders, and financial deregulation' has been an important stimulus to this, the case against re-regulation is strengthened. When deregulation has helped to push the banks (and perhaps especially the London Clearing banks) into doing what public opinion has long been urging them to do-namely, to be more forward in meeting the needs of industry-it would be somewhat perverse to want them locked up again for having done it.

The personal sector

When we turn to the personal sector, the experience of the 1980s differs from that of industrial and commercial companies in one respect. Although the ratio of debt to disposable income doubled, the ratio of debt to assets rose much less markedly than in the case of companies. In other words, while financial liabilities increased faster than income, so did the value of assets, and also the amount by which they exceeded liabilities or net worth. This is illustrated in table 3. It was thus possible for the personal sector to raise its debt-to-income ratio quite substantially while still enjoying an increased ratio of net worth to income. A consequence of the increase in personal sector debt which thus seemed sustainable was the decline in the savings ratio which has been a feature of the transition to an unregulated financial system. As table 2 shows, the ratio fell from an average of about 11.5 per cent in 1979-84 to less than half that in 1988, before beginning to rise again. Some such recovery is to be expected as the transition comes to an end. But when it is complete, and we have an unregulated financial system in a 'steady state', will the savings ratio revert to what it was before (for a given rate of inflation, rates of interest etc), or will it remain lower than before the transition began? The answer is relevant to fiscal policy. If the latter is the correct forecast, it implies that in the financially deregulated economy the avoidance of inflation will require lower savings in the personal sector to be offset by higher savings elsewhere. Against the putative benefits of deregulation, there may need to be set the costs to society of the higher taxes or lower public expenditure needed to raise saving or lower dissaving in the public sector.

The savings ratio may be expressed as:

[EXPRESSION HAS BEEN OMMITED]

where S stands for the year's flow of personal savings, and [Yp.sub.y] for the year's disposable income represented as having a 'real' and a 'price' component. [A.sub.T] and [A.sup.F], signify the nominal value of tangible and financial assets respectively which were held at the beginning of the year, while the As signify the net amounts spent adding to these holdings during it; and similarly for D, which signifies the nominal total of outstanding indebtedness at the beginning of the year. Taken by itself, a higher debt-to-income ratio implies a lower savings ratio. if the rate of growth in the nominal value of debt is constrained, for example, by the rate of growth of disposable income, the absolute amount by which debt can be increased in a year itself increases with the level outstanding, and the absolute amount that needs to be saved is correspondingly reduced. But that is only part of the e story, since the need to save depends not only (negatively) on the capacity to sustain debt but also (positively) on the desire to accumulate tangible and financial assets.

One possibility is that in a 'steady state savers will want the value of their net assets to increase in line with their disposable income, so as to maintain a constant ratio of net worth of disposable income. This objective may be partially satisfied by increases in the market prices of some of their existing assets; and the extent to which it is not satisfied will then determine the amount that must be set aside from disposable income to be spent on adding to existing assets. An approach along these lines is illustrated in table 4 which takes a 5 per cent per annum rate of general inflation, and a 3 per cent rate of growth of real disposable income, as representative for the long term, and assumes that savers' best estimate for the prices of existing tangible assets, and of financial assets in the form of company shares, is that they will increase at the same rate as prices in general i.e. 5 per cent per annum. On these assumptions, the objective of maintaining the ratio of net worth to income at its end-1989 value of 5.22 would call for personal savings of over 171/2per cent of disposable income, which is higher than has been experienced in the UK in the post-war period. However, savers in the personal sector may well regard the latest ratio of net worth to income as abnormally high, since it resulted from an unsustainable boom. At the end of 1989 the ratio stood above the top end of the range of 3.5 to 4.5 within which it fluctuated between 1957 and 1978, without showing any obvious trend.(16) Rather than save at the higher rate needed to maintain the end-1989 ratio of net worth to disposable income, the personal sector may prefer to save less and allow the ratio to fall back towards what it regards as an equilibrium level. If this equilibrium were to be slightly below the bottom end of the 1957-78 range, at the value which actually obtained at the end of 1980, line 6 of table 4 shows that, on the assumptions made, some 12 1/2 per cent of disposable income would have to be saved to maintain the ratio of net worth to disposable income at that level. This is still a relatively high figure. All of this is somewhat speculative; but it may suggest a reason for thinking that, after the transition to the unregulated financial system, the personal sector will not necessarily be found to be saving a smaller proportion of its disposable income than before. ('interest rates and monetary policy A more lasting consequence of the removal of regulatory restraints on financial institutions is that the authorities have come to rely almost entirely on interest rates to control monetary conditions and the demand for goods and services. In itself this is a neutral statement, but it can imply approval or disapproval. Approval usually stems from a belief in the superior allocative efficiency of a freely-operating market for credit, which we have already referred to and which can only be tested by experience over a number of years. Disapproval, on the other hand, has tended to focus mainly on the deficiencies of interest rates as a means of controlling shorter-term fluctuations in the pressure of demand. There are two main sources of these deficiencies. The first is a result of the private sector's increased dependence on borrowing from the banks, which has also increased the relative importance of variable-rate borrowing (at medium- as well as short-term, and for more businesses at rates which move with money market rates rather than bank base rates). It has been argued that the effect of this has been to reduce the interest-elasticity of the demand for loans, since a rise in interest rates does not increase the future risks of variable-rate borrowing to the same extent as if the borrowing were to be at a fixed rate for the term of the loan. (18) This argument does not necessarily imply that increases in interest rates as such are an ineffective means of reducing demand; but it does mean that, with the greater dependence there now is on variable-rate borrowing, they need to be moved by more to have the same effect, and this may inhibit their appropriate use when there is a need to combat inflationary pressures. A second deficiency arises from the fact that the private sector (and particularly the personal sector) is a substantial holder of financial assets as well as of financial liabilities carrying a variable rate. Consequently an increase in interest rates has a redistributive effect: It raises purchasing power in some parts of the private sector at the same time as it deters expenditure in other parts. Why should the latter prevail? When interest rates first move upwards, it may not. But as they move still higher, presumably the marginal propensity to consume of the gainers falls, and allows the negative effect on demand to prevail. This is why it takes time for rising interest rates to bite. In the end, however, any given rise will be liable to put more pressure on the sufferers to spend less than on the gainers to spend more; and the sufferers will include existing borrowers on a variable rate. Thus in present circumstances rising interest rates are a deterrent which it is difficult to control appropriately since the effect may change unpredictably from under-kill to over-kill. Like the mills of God, interest rates grind slowly; yet they can grind exceeding small.

Although the authorities have come to rely on interest rates, they need not have done so. The Bank of England has retained the power to call for Special Deposits, although it has never used it since the reforms of August 1981 which abolished the Reserve Asset Ratio. This power could be reactivated and made use of without formally back-tracking on' financial deregulation'. No doubt it would involve some disintermediation, whereby lending transactions take place outside the balance sheets of the financial institutions subjected to a call for Special Deposits, but this would not necessarily be large enough to prevent the call from having a significant effect. It may be that, compared with the 'signals' now transmitted through money-market rates when the Bank of England sets out to tighten credit, discrete changes in instruments of control such as Special Deposits, or others such as a variable Reserve Asset Ratio, are sharper and clearer, and are therefore better conveyors of information to the private sector about changes in the direction of monetary policy. However, this raises the question whether the use of Special Deposits, or resort to other controls on financial institutions, can have significant effects (on the money supply, the demand for loans, and the demand for goods and services) apart from those which follow from the influence they exert on interest rates. Such controls operate by raising the marginal costs for financial institutions of making loans, and it is not clear that they offer a given amount of restraint on credit for lower interest rates than the 'interestrates-only' policy which prevails at present. An alternative approach which avoids a return to regulatory instruments is control of the monetary base; but its advocates have not yet succeeded in convincing the sceptics that it offers an improvement in this sense, or that it amounts to any more than another way of engineering the requisite movement in interest rates.('9)

Whatever the deficiencies of an 'interest-ratesonly' policy may be, however, any return towards a regulated financial system will be faced with the problem of evasion of such controls as may be applied. It is true that in the past an important reason why controls have proved ineffective has been that they were less than comprehensive; for example, they were applied to only a part of the banking system, such as the London Clearing banks, or to banks but not to building societies. An all-embracing system of controls applied to all financial institutions might be more effective, although costlier to monitor and to enforce. But in present-day conditions it is not easy to define what a financial institution' is. Many industrial and commercial companies operate financially, borrowing and lending between each other and making use of the wholesale money markets. Large retail stores have their own credit cards. The substantial pool of wholesale deposits means that credit can be mobilised, and perhaps on-lent, by finance directors of firms whose main business is non-financial. If controls on credit are to be applied, the appropriate target must be financial operations rather than financial institutions. A perimeter around the latter would either be a poor proxy for what would be required, or would need to be very widely drawn with consequent problems of policing it. Drawn less widely, it would stimulate further growth of the inter-company market in wholesale deposits and the market in commercial paper. These arguments reinforce the general conclusion that the only universal policeman of financial operations which may add to the supply of credit is the rate of interest.

Apart from the difficulties of regulating financial operations by regulating financial institutions, there are those of preventing evasion by borrowing abroad, unless a radical move reintroducing exchange control could be contemplated. Short of that, these difficulties are probably insuperable as far as businesses are concerned. However, the extent to which credit is still regulated abroad, at any rate in continental Europe, is greater than in the UK. If the effect of this is to set the marginal cost of obtaining finance abroad above what it is in the UK, it could be argued that some degree of control could be reintroduced into the UK (eg a Reserve Asset Ratio) without necessarily raising the cost of finance in the UK to an extent which would drive business borrowers to sources of finance abroad on a significant scale. As to mortgages and other personal borrowing, the argument that controls can be evaded by borrowing abroad must surely have less force, and their looseness may be within acceptable tolerances. However, like much else in the financial system, the inertia may not be what it was. As the Bank of England points out: (20)

Foreign currency mortgages are freely available, and

entry into the ERM and the approach of the single

European market have increased the awareness of

overseas sources of finance, including mortgages.

The Bank might have added that entry to the ERM also reduces the exchange risk, unless the parity is non-credible, and that this would disappear under EMU. It goes on to say:

It is difficult to imagine that informal controls or guidance would provide an effective cap on mortgages financed from overseas. A more formal requirement involving sanctions for non-compliance would be needed if such control were to be effective. This might require, for instance, that lenders would lose the right to sue for recovery of that part of any loan in excess of a stipulated loan-to-value ratio.

The idea of a limit on the proportion of the value of a house which may be advanced as a loan is one which particularly deserves exploration if some reintroduction of financial regulation seems desirable. It would be consistent with the principle that regulation should be applied to financial operations rather than financial institutions, and might be particularly effective against resort to sources abroad. The sanction proposed by the Bank would not prevent borrowing in excess of the stipulated ratio, but this would have to be through an unsecured loan which would be risky for the lender and difficult, or expensive, for the borrower to find. For borrowers who always opt for the maximum proportion when the loan is taken out, the limit should remove the scope for 'equity extraction' as house prices rise, although not for those who advance to the maximum from below.

After deregulation

Although a restraint on mortgage lending along the lines above might be useful, and resort to the weapon of Special Deposits, which is still available to the Bank of England, should not be ruled out, the case for returning towards a regulated financial system is weaker than the case for living with it as it now is, at any rate for the time being. Does this mean that the experience of the last decade is no more than a piece of past history from which no lessons can be learned? It has been argued above that the growth of credit which fuelled the boom of the 1980s was not due only to an unsatisfied desire to borrow assuaged by financial deregulation', but was also over-activated by exaggerated expectations of the growth the economy had become capable of delivering in the future. To take the optimistic view, the first of these causes stemmed from a process which is now complete, and the second was a product of its time. It is hardly surprising that a government which came to power with an avowedly radical programme for the 1980s, challenging the postwar consensus' and seeking to transform the economy and its management, should have been eager for signs of success. Nor is it surprising that business leaders, after many years in which a number of measures of the UK's economic performance stamped it as inferior to its major competitors, should have been ready to abandon pessimism for optimism. Nevertheless, a price is now being paid because the public generally became converted rather prematurely and precipitately in the 1980s to a belief in economic miracles, and literally took the credit before it was clearly due.

In forming the climate of expectations, government ministers play an important part, since they speak with authority and are well furnished with economic advice. But they are also under pressure to claim victory for the policies to which they are committed, and can hardly be expected to be impervious to it. If the climate of expectations is to be formed more objectively and realistically, some antidote is required. This is now provided by an army of independent commentators; but it might be more effective if there were also an important public input from authoritative and officially-recognised sources outside the government itself. Such a source might be a body similar to the Council of Economic Advisers which reports regularly to the President of the United States and publishes its conclusions. A body of this kind in the UK would more appropriately report to Parliament. its conclusions might help to introduce greater realism into wage-bargaining, but the main reason for creating it would be to add an independent but officially-recognised voice to the formation of expectations about the economy's performance and its capacity to meet the demands laid upon it. But the appointment of such a body would present problems; there would be a temptation for the government to pack it with sympathisers, and the Treasury would dislike having to pay for it. Moreover, there could be no guarantee that it would provide a sounder basis for expectations than the pronouncements of government ministers drawing on the economic advice available to them, or that when it did, it would exert the same claim on the public's attention.

in any case, it is uncertain how long it is to remain within the power of the UK government either to provoke or to correct disturbances to a stable rate of economic growth in the UK. The commitment to ERM already means that the leverage the authorities have over domestic interest rates is constrained by whatever pressures there may be on the exchange rate. If there is monetary union in Europe, the power to influence interest rates in the UK will be ceded to a European central bank. Stabilisation of domestic demand would then logically require a greater reliance on domestic fiscal policy; but the power of national governments to set their own fiscal policy may also be restricted by Euro-determined limits on the size of the budget deficits they can run and on the rates they may set for VAT. There is certainly a case for holding onto some independence in the fiscal area. But it is in danger of going by default, since the cogency of the arguments for retaining national independence in economic policy has been undermined by the experience of the boom with which the 1980s ended and the recession with which the 1990s have begun.

NOTES

The figures are compiled by the Department of Trade and Industry (Companies House Executive Agency), and refer to England and Wales. They include both compulsory and creditors' voluntary liquidations. Comparisons with the previous recession are complicated by the 1986 Insolvency Act, which enables businesses in difficulty to continue to trade, through the appointment of an administrator, for longer than they would have been permitted to do by the earlier legislation. in principle, this should have reduced the number of insolvencies, so that the 1990 percentage of 16 should be enlarged to make it comparable with the pre-1 986 figures. In practice, the Act is not thought to have made much difference to them.

These figures refer to the UK.

The figures are compiled and published by the Council of Mortgage Lenders: see Housing Finance, May 1991. For the personal sector (table 2) identified borrowing in all the years shown is less than the apparent borrowing requirement, and the balancing item may well reflect changes in trade credit received by unincorporated enterprises which remains unidentified because the statistical information about them, and it, is thin. Some of this credit would be extended by industrial and commercial companies, leading to an underestimate of the outlay under 'Other (net)' in table 1 and a negative balancing item there. This has generally been the case in the 1980s, although with marked exceptions in 1989 and 1990. In the latter-two years, a withdrawal of trade credit from unincorporated enterprises and other sectors (including the public sector and overseas) is a plausible explanation of the fact that industrial and commercial companies identified borrowing drops well below their apparent borrowing requirement. There is little sign, however, of a corresponding movement in the balancing item for the personal sector. It is generally recognised that some part of the heavy borrowing in 1986-8 and possibly in other years, which in line 7 of table 2 is identified as for house purchase, in effect financed higher consumption as house owners cashed in some of the equity in their properties. It is also interesting to note that the personal sector has been a net seller of company securities in every year from 1979 to 1990. This maintains a long-standing tradition which appears to have survived Mrs Thatcher's ambition to make everyone into a shareholder. What has Sid been up to? An alternative explanation of why real interest rates did not fall is that in a relatively small open economy they would not be expected to. if sterling carries a given exchange-rate risk linked to a given relation between inflation rates expected in the UK and overseas, an initial reduction in nominal interest rates in the UK should be eliminated by international arbitrage. We doubt this alternative explanation because the process of arbitrage envisaged would imply an increase in net outflows of capital from the UK, which is contrary to what was observed in the 1980s. While this climate encouraged the borrowers, the lenders were not immune from it, although they were driven to a greater extent by the competitive forces which financial deregulation' released. See the Clare Group article by Posner and Sargent in the final issue of the Midland Bank Review(Winter 1987):'A Case of Euro-sclerosis?' (table 1).

The plain fact is that the British economy has been transformed': the Chancellor of the Exchequer (Mr Nigel Lawson) in the Budget speech, March 15th 1988. In 1986 Sir Alan Walters had published a book entitled: Britain's Economic Renaissance'. In November 1990 Sir Geoffrey Howe wrote to the Prime Minister in his letter of resignation: 'It has been a great privilege to serve under your leadership at a time when we have been able to change Britain's future so much for the better'.

See page 77 above, item (3) or what has been stated as the 'consensus view' of the 1980s boom. C. Goodhart, The Conduct of Monetary Policy', Economic Journal, June 1989. Memorandum submitted by Mr Andrew Britton to the Treasury and Civil Service Committee of the House of Commons; see the Committee's second report, Session 1988/9, The 1989 Budget', p.1 14. Professor Tew points out that, while the regulatory measures in the box on page 77 have disappeared, financial institutions are now to be required to maintain an 8 per cent ratio of capital (of which half must be equity capital) to the risk-weighted sum of their assets. This was originally agreed among the members of the Bank for international Settlements, and is the subject of an EC directive which comes into force in 1993. Since financial institutions are currently moving towards compliance, it has become in present circumstances an effective constraint on lending. Its ostensible purpose, however, is to protect depositors rather than to influence the flow of spending and economic activity, for which it is not well-designed. The revival of the corporate bond market has provided funds mainly to the financial institutions themselves rather than to industry and commerce directly.

Quarterly Bulletin, August 1990.

See C.G.E. Bryant, Economic Trends, May 1987, National and Sector Balance Sheets, 1957-85'. Using Bryant's series, the ratio fluctuates between 4.07 and 5.07 over this period. But his figures include intangible non-financial assets, such as tenancy rights, whereas these are not included in table 4. Comparisons with later estimates for overlapping years suggests that the exclusion of these intangible assets lowers the ratio by about .5. See however, Ermisch and Westaway, (National Institute Discussion Paper 190' The dynamics of aggregate consumption in an open economy life cycle model'. Simulations with their model suggest that the relaxation of borrowing constraints may reduce the aggregate savings ratio by 1 1/2 to 2 1/2 percentage points in the 'steady state'. C. Goodhart, Financial innovation and Monetary Control', Oxford Economic Policy Review, Winter 1986. See G. Pepper, Money, Credit and Inflation, IEA Research Monograph 44, p.62. Evidence to the Treasury and Civil Service Committee of the House of Commons, April 8th 1991.
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Author:Sargent, J.R.
Publication:National Institute Economic Review
Date:Aug 1, 1991
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