How the UK economy weathered the financial storm

Journal of International Money and Finance 31 (2012) 102–123

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Journal of International Moneyand Finance

journal homepage: www.elsevier .com/locate/ j imf

How the UK economy weathered the financial storm

Andrew Sentance a, Mark P. Taylor a, Tomasz Wieladek b,*

aWarwick Business School, UKb Economics Department, London Business School, Sussex Place, London, UK

JEL classification:F3E5G01

Keywords:International financeMonetary economicsFinancial crisis

* Corresponding author. Tel.: þ44 (0) 20 7000 8E-mail addresses: [email protected]

(T. Wieladek).

0261-5606/$ – see front matter Crown Copyright �doi:10.1016/j.jimonfin.2011.11.007

a b s t r a c t

Prior to the global financial crisis of 2008, the UK had the largestbanking sector asset to GDP ratio among large countries, and hadexperienced rapid real property price increases as well asa persistent current account deficit in the preceding decade. Thesefactors, together with its role as an international financial centre,made the UK economy particularly vulnerable to the onset of theglobal financial crisis. Although the initial drop in real GDP wassteep, we provide evidence that the economy has weathered thefinancial storm better than many feared, and has fared no worsethan its peer group of major economies. In this paper we assessthe reasons underlying this outcome, including the possibility ofexaggerated vulnerabilities, global economic recovery, the flexiblesupply side of the UK economy, as well as fiscal, financial andmonetary policy interventions. Our analysis suggests that all ofthese factors played a role in cushioning the impact on the UK realeconomy, leading to a more benign outcome than most observersexpected.

Crown Copyright � 2011 Published by Elsevier Ltd. All rightsreserved.

1. Introduction

At the onset of the global financial crisis, in the second half of 2007, the UK looked to be moreheavily exposed to the emerging problems in the banking sector than its peer group of largeindustrialised countries. There were a number of reasons for this. First, its financial sector was

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Fig. 1. Banking sector size across OECD economies. Banking sector assets as percentage of GDP. Source: OECD.

A. Sentance et al. / Journal of International Money and Finance 31 (2012) 102–123 103

much larger in relation to the size of its economy than any other G7 economy (Fig. 1). Second,there were worries that the UK housing market might share some of the vulnerabilities that hadafflicted the US housing market through the rapid expansion of sub-prime lending, adding to theweaknesses in the UK’s financial system (Fig. 2). Third, a British Bank – Northern Rock – was one ofthe early major casualties of the financial crisis. And fourth, the UK was running a current accountdeficit of around 3% of GDP and was potentially vulnerable to a cessation of capital flows to financethe deficit (Fig. 3).

But more recent trends point to a more optimistic outcome for the UK real economy. The initialrebound in output in the UK was stronger than previous recoveries, and also outpaced a number of

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Fig. 2. Real house price growth in OECD countries. Percentage change in real house prices between Q1 1999 and Q4 2006. Source:Bank for International Settlements.

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Fig. 3. Current account balances in OECD countries. Average current account to GDP balance, 1999–2006. Source: OECD.

A. Sentance et al. / Journal of International Money and Finance 31 (2012) 102–123104

other peer group economies.1 Employment has been more resilient and company failure rates muchlower than earlier downturns. Though there are still some uncertainties surrounding the outlook forgrowth and inflation has been surprisingly high, unemployment did not reach the level of over3 millionwhich was being widely forecast in early 2009.2 The main issues concerning the performanceof the UK economy are therefore why it has survived the crisis so well, rather than why it has doneso badly.

In this paper we assess why theworst case scenario did notmaterialise and investigate four possibleexplanations: the possibility that UK vulnerabilities to the crisis were exaggerated; the effectiveness ofbanking, fiscal and monetary policy interventions; the role of the supply side; and the impact of therecovery of the global economy. Our analysis suggests that all four factors played a role in cushioningthe UK economy from the shocks associated with the onset of the global financial crisis. The paper isdivided into three main sections. The first section considers the performance of the UK economythrough the crisis and into the early phase of the recovery. While the current vintage of output datashows a relatively deep recession, there has also been a relatively strong rebound in real GDP andemployment has been surprisingly resilient. The second section considers the four broad areas ofexplanation highlighted above. And the third section of the paper considers the economic outlook forthe UK and current policy dilemmas in the aftermath of the financial crisis.

2. The performance of the UK economy since the crisis

In the UK economy of the mid-2000s, there were few indications from the key macroeconomicindicators of the economic turmoil which was to unfold in 2008 and 2009. Unemployment was around5% of the labour force, and was being sustained at the lowest rate since the 1970s. Growth during themid-2000s was broadly in line with historical averages, and inflation had been sustained in line withthe 2% target. To some extent policy-makers were lulled into a sense of false security by these

1 In the first year of recovery from the trough in output (Q3 2009–Q3 2010), UK GDP rose by 2.5% and excluding the volatileoil and gas component, the rise was 2.8%. Subsequent growth figures have been less positive, though adverse weather and otherspecial factors have played a part. Moreover, initial estimates of UK real GDP data are subject to substantial revisions, as forexample the initial estimate of real GDP growth in Q4 2009 has already been revised from .1% to .5%.

2 For example, the Confederation of British Industry forecast in February 2009 that unemployment would exceed 3 million bymid-2010 whereas the jobless total has levelled off at around 2.5 million.

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Fig. 4. International employment outcomes. Source: OECD.


developments.3 While the warning signals of a conventional inflationary boom–bust cycle –which theUK had experienced on a number of occasions since the 1970s –were not present, therewere signs thatthe expansion of the financial sector during the 1990s and 2000s was a potential source of instability.4

These concerns featured in the macroeconomic debate in the UK in the form of worries about risinghouse prices and rapid growth of measures of money and credit, which reflected the expansion of thefinancial sector. What was less apparent at the time was the increasing global interdependence of thefinancial system in the UK and elsewhere, which was to be highly instrumental in transmittingproblems which emerged in the US housing market to other major economies around the world.

The evolution of the financial crisis has been analysed in great detail elsewhere and it is not thepurpose of this paper to go over this ground again. However, at an early stage of the crisis concernsbegan to be expressed that the UK could be particularly vulnerable to shocks emanating from the UShousing market. These concerns reflected the very international focus of the UK banking system andthe dependence of some banks on short-term capital flows and whole-sale financial markets whichwere disrupted by the crisis.

To what extent were these fears borne out by the macroeconomic outcomes?Figs. 4 and 5 compare the level of GDP and employment in the UK with the US and a weighted

average of other major European economies over the period 2006–2010. In terms of employment, theperformance of the UK seems to be clearly more in line with a weighted average of the largest fourEuropean countries (Germany, France, Italy and Spain) than the US, which experienced a much largerdrop in employment, despite sharing a similar set of vulnerabilities, such as a exuberant housingmarket and a persistent current account deficit.

The UK real GDP figures are slightly weaker (Fig. 5), but these must be seen against evidence thatinitial estimates of GDP in the UK have been revised upwards following past recessions. In particular,Faust et al. (2005) documented that the UK has the largest real GDP data revisions in the G7. Fig. 6compares the evolution of real GDP during past recessions in real-time, i.e. data available at thetime, and final revised data. In both the 1980s and 1990s recession, real GDP revisions appear to bequite large. As a result of methodological changes, it is unfortunately not possible to compare real-time and final data employment outturns during the 1980s recession. But evidence from the 1990srecession suggests that revisions to UK employment outturns are very small. Industrial production

3 Indeed, the Bank of England hosted a conference on ‘The Great Stability’, on the day that the British Bank Northern Rockdeclared that it needed liquidity support from the government.

4 Furthermore, although there was some evidence that the ‘Great Stability’ in the UK was more due to the absence of adverseshocks, rather than good monetary policy (see Benati, 2007), insufficient weight was placed on it.

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Fig. 6. Real-time versus final real GDP data in past UK recessions. Source: ONS ‘Economic trends’ Publication.


does not appear to be subject to large revisions either. Since these two important indicators ofeconomic activity are only revised slightly, they can be used to infer a final data, revised, estimate ofreal GDP. We therefore regress year-on-year final data employment and industrial production growthon year-on-year final data real GDP growth. Our model predicts a substantial upwards revision,suggesting that the most recent recession could look very similar to the 1980s recession in final data.5

In a similar spirit to the analysis above, Chiu and Wieladek (forthcoming-a) assess revisions tothe total output loss during recessions in 54 past recessions across 21 OECD countries. They find that

5 The regression was estimated over the horizon Q1 1991 until Q4 2005, since real GDP data is typically not considered‘mature’ until 5 years have passed, suggesting that data past 2005 could be revised. Both coefficients are highly statisticallysignificant and this simple regression appears to fit final year-on-year real GDP growth data reasonably well, as suggested by anR2 of .89. Furthermore our model seems to fit recession periods particularly well (Fig. 7). We use this regression to predict finalreal GDP growth during the most recent UK recession.

Fig. 7. UK real GDP year-on-year growth rates actual versus predicted. Source: Authors’ calculation.


the total expected revision increases with the initial estimate of the total output loss. Furthermore,Chiu and Wieladek (forthcoming-b) show that the change in the unemployment rate across theG7 economies on the other hand is virtually never revised. Based on these two stylised facts aboutdata revisions we therefore argue that unemployment rate outturns are more informative aboutreal economic conditions in real-time than real GDP. Fig. 8 shows the peak to trough change inharmonised (internationally comparable) unemployment rates across OECD countries and it showsthat the UK ranked around the middle of its peer group of economies and experienced a significantlysmaller rise in unemployment than the worst affected nations – the United States and peripheralEuropean economies.

Nevertheless, the UK’s better performance during the crisis seems to have come at the expense ofhigher inflation than its international peer group (Fig. 9). The fact that UK inflation forecasts have beensubject to persistent upside errors also suggests that the high rate of inflation is due to persistentchanges in the inflation process rather than one-off price level shocks (Fig. 10). This partly reflects thevery significant depreciation of the sterling exchange rate relative to the US Dollar and Euro, whichmayhave eased the competitive pressure on UK producers to shed jobs. A key issue facing policy-makers

Fig. 8. Peak to trough change in the harmonised unemployment rate. Source: OECD main Economic indicators.

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Fig. 10. Bank of England inflation forecasts against outcomes. Source: Bank of England.


going forward is to ensure that this rise in inflation does not become a more persistent feature of theUK economic landscape.

In summary, the evidence suggests that the UK’s economic performance has not been substantiallydifferent from other large industrialised countries, especially once the potential for large GDP revisionsis taken into account.

3. What lies behind the resilience

In this section we explore four possible explanations for the resilience of the UK economy to theglobal financial crisis: exaggerated vulnerabilities; policy actions; the supply side of the economy; andthe recovery in the global economy.


3.1. Exaggerated vulnerabilities

In the introduction to this paper, we highlighted a number of reasons thatmay have led observers tobelieve that the UK might be more vulnerable to the global financial crisis than other economies: thesize and vulnerability of UK financial institutions; the effect of a rapid decline in house prices on thereal economy and associated repercussions for the banking system; the UK’s role as an internationalfinancial centre; and the role of the financial sector in the UK economy.

The failure of Northern Rock in September 2007 was an early warning of the problems affecting theUK’s banking system. Shin (2009) documents extensively that the failure of Northern Rock was a resultof a run on the banks liabilities in whole-sale funding markets, rather than the withdrawal of depositsby individual customers. The bank’s inability to roll over its liabilities ultimately led to a lack of liquiditybecoming an insolvency problem. Among observers there was a substantial fear that much of the restof the UK banking systemwas strickenwith similar problems. This is not surprising, as on the eve of thefinancial crisis, roughly 70% of UK banks funding was at a less than one-year maturity. This exposuremade the UK banking system particularly vulnerable to the freeze in money markets that followed thefailure of the American investment bank Lehman Brothers.

On the asset side of bank’s balance sheets, growth in lending to the real estate sector substantiallyoutstripped lending to other sectors in the run-up to the crisis –which suggested that the asset side ofbanks’ balance sheets was very vulnerable to a decline in real property prices. The simultaneousrealisation of both vulnerabilities could have had a significant impact on the ability of banks to lendto other sectors of the economy. UK financial intermediation is dominated by banks, as privatenon-financial companies rely on banks for 77% of their funding, while 60% of bank lending goes tohouseholds. A disruption in lending could therefore have serious consequences for the non-financialsectors of the economy.

In addition, the UK’s role as hub for global financial activity made it particularly susceptible toshocks affecting the global financial system. Kubelec and Sa (2010) have collected bilateral data onfinancial linkages for 18 countries. Their description of the data suggests that the UKwas at the heart ofthe international financial network in 1985. The UKmaintained this position over the next 20 years butthe global financial system became a lot more interconnected and much larger during this time. Anydisruption to global financial activity would therefore probably have a disproportionately large effecton the UK. Last but not least, financial and business services contribute a substantial 30% of GDP in theUK economy (Fig. 11). The financial intermediation sector in particular was a strong engine of growth

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before the crisis, contributing disproportionately to GDP growth in the decade before the crisis.Financial services also made a substantial contribution to services and total exports (Fig. 12).

In summary, on the eve of the crisis, there were several reasons to believe that the UK was veryvulnerable to an external financial shock. The UK had the largest banking sector with respect to its GDPamong large countries. Despite low public debt, the government had therefore large implicit bankingsector liabilities like Iceland, Ireland and Switzerland. Domestic lenders were also overly exposed to theproperty market which had experienced a boom in the run-up to the crisis, funded by whole-salemarkets at short maturity. Finally, the contribution of the financial sector to GDP and exports, aswell as the UK’s role as a major hub in the international financial system, made the country seemparticularly vulnerable to an external financial shock. All of these fears were reflected in a significantdepreciation of sterling, starting in the summer of 2007 (Fig. 13).

But despite all of these a priori vulnerabilities, the UK housing market, overall banking system andthe economy were able to withstand the shocks emanating from the global financial crisis better thanmost observers expected.

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Activity in the UK housing market and prices both fell sharply as the financial crisis took hold in2007/2008. But the decline in housing wealth was much more muted than expected in the early phasesof the crisis.6 Fig. 14 shows that despite greater rises in real house prices in the run-up to the crisis, thesubsequent decline in real house prices was about 15% smaller than at an equivalent stage in the 1990sUK house price bust. This was a very different development to the US, reflecting three main factors – thedifference in mortgage market structure, repossession laws and the planning permission regime.

As pointed out in Miles (2004), the vast majority of UKmortgages are floating rate mortgages, manyof which are directly linked to the Bank of England base rate. In the US, on the other hand, the majorityof mortgages are linked to 30-year fixed rate. Monetary policy in the UK therefore has a much moredirect impact on household’s mortgage payments and hence on house prices than is the case in the US.Mortgage costs declined substantially following the large cuts in the Bank of England base ratebetween Autumn 2008 and Spring 2009, which helped to reduce forced sales and foreclosures andhence eased the downward pressure on property prices. Whereas US default legislation generallyallows homeowners to default on their mortgagewithout any repercussions for their remaining assets,the consequences of default are much more severe in the UK – where lenders can repossess all of theborrowers’ assets once the default occurs. Borrowers, whose future mortgage payments exceeded theirequity, are therefore incentivised to wait until the housing market recovers to avoid the financialliabilities associated with default.

Another important contrast between UK and US housing market experience reflects differences inthe planning system. The UK has a very restrictive planning system reducing new housing supply,while this only applies to certain areas of the US. For example, areas with limited land, such asNew York City, experienced very different house price dynamics than, for example, Las Vegas, whereland supply is abundant and prices fell rapidly. This restriction of new housing supply, together withthe large net immigration from EU accession countries the UK witnessed during the run-up to thecrisis, probably contributed to persistent excess demand for housing and the associated upwardpressure on national real house prices in the UK. The financial crisis helped to remove this excessdemand, but because supply had not been able to keep up with strong demand in the boom, there wasa less pronounced overhang of excess supply in the UK when the housing bust came.

At the onset of the crisis, many observers feared that the dependence of the UK banking system onwhole-sale funding would turn illiquidity into insolvency problems. A widely used measure of the

6 In 2008, most forecasts predicted a house price fall between 20 and 30%.

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ability of the banking system to fund its activities is the LIBOR-policy rate spread. This spread rosesharply in the Autumn of 2007 when Northern Rock failed and even further when Lehman Brotherscollapsed in Autumn 2008 (Fig. 15). However, the recent indications are that this risk spread hasreturned to levels very close to the position before the financial crisis. This provides some indication ofconfidence in the UK banking system – though clearly underpinned by public sector guarantees.

This suggests that the UK banking system was stabilised, albeit at a potential cost to the taxpayerthrough public sector guarantees. An uncontrolled failure of the banking system was avoided, whichwas aworry at the height of the financial crisis. The UK banking system is not immune to future shocks,but the balance sheets of the key financial institutions are likely to become more resilient as recoveryproceeds.

Similarly, the UK was potentially vulnerable to a sharp current account reversal at the onset of thecrisis. But the combination of subdued demand growth in the recession and the impact of a weakerexchange rate subsequently have produced a more gradual adjustment than during the early 1990srecession (Fig. 16). There is also evidence that the UK economy is rebalancing – with manufacturing

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growing faster than services and double digit growth of export volumes (Figs. 17 and 18). As in the1990s recovery, this is likely to help close the current account deficit.

Finally, there were also some concerns about the size of the financial sector in the UK economyand the growth impact from the financial crisis going forward. Since 2008, financial and businessservices have showed different profiles – the output of financial services (technically “financialintermediation”) fell sharply and has not bounced back reflecting low levels of lending in theaftermath of the crisis. But business services have bounced back more significantly, with UK businessconfidence bouncing back in line with its international peer group (Fig. 19). While difficulties in thefinancial sector can have a much broader impact on economic activity if firms cannot access financeto support their activities, survey evidence shows that the most severe constraints on access tofinance were short-lived. Surveys by the CBI and other business organisations show that the numberof companies citing external finance as a constraint on production has now fallen back close to thevalues seen before the crisis (Fig. 20). This evidence suggests that the strong dependence of the UK onfinancial and business services did not seem to greatly intensify the recession or delay the recovery.

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3.2. Policy actions

But one very important factor helping to ease the stresses and strains created by the financial crisison the UK economy was the impact of policy measures. There were three main elements to this policyresponse: direct interventions into the banking system; monetary stimulus; and fiscal policies whichsupported demand.

Compared to previous UK experience, it was very unusual to have such a concerted policy responsewhich was implemented so early in the recession. In the downturns of the early 1980s and early 1990s,the policy response was delayed because of the need to deal with the inflationary aftermath of the

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previous upswing. It was unusual for the government to intervene directly in the sector (in this case thefinancial sector) which was at the epicentre of the recession. In the early 1980s, the UK authorities didnot intervene to support manufacturing industry, which was at the epicentre of that recession, and inthe early 1990s there was relatively little intervention to support the housing market and consumer-facing businesses, whose problems were contributing to that downturn. We consider the three areas ofpolicy response – financial interventions, monetary policy and fiscal policy – in turn.

3.2.1. Financial interventionsThe UK government took a very broad-brush approach to financial sector intervention. In terms of

its GDP, the UK had the 4th largest capital injection, the 2nd largest liquidity support, the largestup-front government financing package and the second largest banking debt guarantees in terms ofGDP among industrial countries. To a certain extent this reflects the initial severity of the banking crisisin the UK. On the other hand, unlike with monetary policy and inflation, it was a lot less clear whichpolicies would be most effective in ameliorating the UK’s banking system problems. The evidence inFig. 21 suggests that, unlike other countries, the UK tried a variety of policies to protect the realeconomy from the banking sector fall-out, which ultimately probably lead to a more benign outcome.

3.2.2. Monetary policyTo cushion the real economy from the fall-out of the banking crisis, the Bank of England had

provided substantial policy stimulus. The Bank of England quickly lowered the official interest rate tothe present level of .5% and embarked on an asset purchase programme of £200 bn, called QuantitativeEasing, to provide further monetary stimulus even though interest rates were very close to thezero-lower bound. These were the most stimulatory policies pursued in the Bank’s history. Prior to thisepisode, the Bank Rate had not been reduced below 2%.

The monetary stimulus was not simply reflected in these interest rate movements. As a smallopen economy, the exchange rate plays a key part in the monetary transmissions mechanism. Here,too, there were very significant movements – as we have already noticed. Measured in terms ofa trade-weighted exchange rate basket, the decline in the pound sterling after the 2007/2008financial crisis appears to be the biggest depreciation that the UK had experienced since departingthe Gold Standard in 1931 (Sentance, 2011).

To highlight the scale of the monetary stimulus, we use two different monetary conditions indices(MCIs), and assess their performance relative to past monetary policy expansions. Batini and Turnbull(2000) provide a useful survey of monetary conditions indices for the UK. Traditionally, MCIs for smallopen economies, like the UK, contained both the interest rate and a trade-weighted exchange rate to

Fig. 21. Various financial system interventions in terms of GDP. Source: IMF.

Fig. 22. Kennedy and Van Riet MCI over time. Source: Authors’ calculation.


account for the transmission channels associated with these variables. Nevertheless, they did not takethe effect of asset purchases into account. Joyce et al. (2010) estimate that the effect of the Bank ofEngland’s asset purchase programme was to depress gilt yields by about 100 basis points.

The survey in Batini and Turnbull (2000) suggests that two previous MCIs, one by Kennedy andVan Riet (1995) and the other one by Massone and Walton (1999), include the impact of the longrate in their MCI, with a similar weight as on the short rate. In the case of Kennedy and Van Riet, theMCI weights are derived from the National Institute of Economic and Social Research’s NIGEMmultinational model, while the MCI weights in Massone and Walton (1999) are derived from anunrestricted vector autoregression in four endogenous (GDP, the short-term interest rate, the10-year gilt yield and sterling ERI) and one exogenous variable (oil prices). To include the effect ofQE, we thus rely on these two MCIs. Although they are derived from different models, they placesimilar weights on the individual components.7 It is therefore not surprising that they both indicatethat the size of the recent monetary policy expansion has been unusually large. More interestingly,they suggest that the exchange rate had the largest contribution to the most recent monetary policyexpansion (Figs. 22 and 23).

3.2.3. Fiscal policyAlongside a substantial relaxation of monetary policy, fiscal policy also played a part in supporting

the growth of the UK economy following the financial crisis. According to the estimates of the recentlyformedOffice of Budget Responsibility, therewas a substantial relaxation in the structural budget deficitas the financial crisis took hold (Fig. 24). A major challenge now facing the UK and many other majoreconomies is how they should rein in these large structural budget deficits as the recovery progresses.

3.3. Supply side flexibility

In past UK recessions, various supply-side rigidities have held back the adjustment of the realeconomy and a return to growth. For example, in the aftermath of the early 1980s recession, labourmarket rigidities resulted in continuing rises in unemployment which continued for around five yearsinto the recovery. There has been relatively little evidence of that process in this recession. Indeed,

7 The Kennedy and Van Riet (1995) MCI places a weight of .43 on the long and short rate and .13 on the exchange rate. TheMassone and Walton (1999) MCI places a weight of .47 on the short rate, .35 on the long rate and .18 on the exchange rate.

Fig. 23. Massone and Walton MCI over time. Source: Authors’ calculation.

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Fig. 24. Headline versus structural budget deficit, in percent of GDP. Note: Values for 2011 and onwards are forecasts. Source: UKOffice of Budget Responsibility (OBR).


various structural measures show the UK supply side to be relatively flexible compared to othercountries.

The latest ‘Doing Business’ survey by the World Bank suggests that the UK has the mostflexible business environment among large countries. The index measures the impact of a rangeof regulations dealing with starting a business, property and construction transactions,contract enforcement, tax payment, etc. These legal reforms are also reflected in real economicoutcomes, as the number of insolvencies has been substantially lower during this than previousrecessions (Fig. 25).8

8 It is important to point that a methodological change led to fall in this ratio in the mid-2000s, since the definition of firmschanged. However, even adjusting for this change in the denominator, the number of insolvencies is still smaller than in thepast.

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Fig. 25. Corporate bankruptcies, as a percentage of all firms. Source: UK insolvency service.


Previous academic studies suggest that increased supply side flexibility may shield the domesticeconomy from adverse economic shocks. In particular, Kim and Taylor (forthcoming) use a factor-augmented VAR framework to show that, following the labour market reforms of the 1980s and1990s, aggregate supply and demand shocks affect output and unemployment to a smaller extent.This view is also verified by more comprehensive cross-country studies. In particular, Giannoneet al. (2011) examine 2008–2009 GDP growth assessing the impact of labour market regulationand business sector regulation quality and find that while labour market flexibility dampened theeffects of the crisis on real GDP growth, the same is not true of the business environment. Similarly,Gamberoni et al. (2010) find that countries with high severance packages and unemploymentbenefits experienced larger declines in employment growth during past global employment crisis.As a result of several labour market reforms in the late 1980s and 1990s, the UK now has the secondlowest level of employment protection among OECD countries, suggesting substantial labourmarket flexibility. Indeed, Fig. 26 suggests that real wages in the private sector adjusted to a much

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Fig. 27. World real GDP growth forecasts at different points in time. Source: Consensus Economics.


greater extent than that in the 1990s recession. As both the UK specific and cross-country academicevidence suggest that labour market flexibility weakens the effect of adverse macroeconomicshocks, it should therefore not be too surprising that UK employment outturns have been muchstronger than expected.

3.4. Global recovery

The UK is a small open economy. In particular, when measured as a sum of imports and exports interms of GDP, the UK is the third most open economy in the G7 behind Germany and Canada.Developments in the world economy have therefore a substantial impact on domestic economicdevelopments. Following the failure of Lehman Brothers, Eichengreen and O’Rourke (2010)documented that the behaviour of macroeconomic aggregates such as world industrial productionand international trade was in many ways similar to the path of these variables during the greatrecession. On the real side of the economy, IMF and consensus forecasts suggest a large revision toworld real GDP growth forecasts (Figs. 27 and 28). Similarly, one widely used measure of global riskaversion is the difference between the yields of BAA and AAA corporate bonds in the US. Although thisspread increased during the crisis, the size of the shock was substantially smaller than the increaseduring the great depression and also a lot less persistent (Fig. 29). This suggests that the worldeconomy showed a more robust reaction to the global financial crisis than initially feared.

As the UK is a relatively open economy, the strong recovery in world GDP would naturally affectdomestic economic development positively. But in addition, in trade-weighted terms, sterling fell byabout 22% in two years, partially as a result of the perceived vulnerability to the crisis, but also asa result of the relative large size of monetary stimulus relative to its largest trading partner, the EuroArea. This was not only one of the largest depreciations in the G20, but also the second largestdepreciation since 1841.9 The openness of the UK economy, together with the unusually largedepreciation in the pound, therefore meant that the strong recovery inworld GDP had a larger effect onthe recovery in the UK than in most other countries.

In summary, there is some evidence that the macro-financial vulnerabilities on the real economy inthe UK were probably exaggerated. At the same time, the swift and comprehensive reaction of public

9 The Pound experienced the largest two-year depreciation in its history, when the UK left the Gold standard in 1932.

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Fig. 29. Change in headline government budget deficit. Note: Quarters from fiscal deficit low point. Note that a positive number ofthe axis implies a budget deficit. Data past the 12th quarter for the 2000s consolidation reflect a projection. Source: OBR.


policy, in conjunction with the UKs flexible supply side of the economy, probably cushioned the effectof the impact of the shock associated with the global financial crisis on the UK real economy. Finally,conditions in the global financial and real economy recovered a lot quicker than most observersexpected, most likely contributing to the recovery in small open economies like the UK. Our analysisthus suggests that all four factors played a role in the relatively benign outcome for the UK realeconomy thus far in the cycle.

4. UK economic outlook and policy issues

At the onset of the global financial crisis, many observers feared that the world faced a repeat of theGreat Depression of the 1930s. Thus far at least, it seems as if the world economy has bounced back


strongly after very weak demand conditions in late 2008 and early 2009. Growth has been supportedby a large relaxation of policy, direct interventions to stabilise the financial system in many countriesand a recovery in private sector confidence. Unlike the 1930s, the world economy has not lapsed intoprotectionism, allowing world trade to recover the losses suffered in the recession.10

But some economies were still thought to be more vulnerable to global financial disruption thanothers. The UK is a case in point, as prior to the crisis it had the largest banking sector with respect toGDP (similar to Iceland and Ireland), experienced rapid real house price increases (like the US andSpain), had a persistent current account deficit and a banking system funded by flighty whole-salemarkets at short maturity. However, despite these vulnerabilities the performance of the UK realeconomy in terms of employment is in line with its international peer group and better than past UKrecessions. Though real GDP fell by about 6%, this could be subject to substantial upward revision, as inpast UK recessions.

The question we tried to answer in this paper is therefore why the impact on the UK real economyhas been so benign despite all of these a priori vulnerabilities. Our analysis suggests that some of thevulnerabilities may have been exaggerated. To some extent this is a function of differences in themortgage market structure, repossession law and housing supply constraints, all of which probablycontributed to a much smaller decline in real house prices than experienced in the US. Similarly, theswift and comprehensive policy response, the flexible supply side of the UK economy and the strongerthan expected recovery in the world economy all contributed to the resilience of the UK economy andits return to growth after the recession.

In terms of inflation, however, the UK has experienced a worse performance relative to its peergroup of advanced economies. Even if this is regarded as a temporary phase (as suggested by the Bankof England’s quarterly Inflation Report forecasts), it does suggest that the deflationary risks identifiedduring the early phases of the recession have receded. And in the view of a number of members of theBank of England’s Monetary Policy Committee, the balance of risks on inflation has probably shifted tothe upside, particularly when the impact of strong world growth on energy and commodity prices isfactored in (Sentance, 2011; Dale, 2011; Weale, 2011).

Going forward, differing views on the outlook for the UK economy and the appropriate policyresponse reflect different weights attached to two different scenarios for the growth and inflationoutlook. In the first scenario, households and banks continue to deleverage, while credit constraintfrom banks’ reluctance to lend led to a weak demand environment. The inhibiting impact of thesenegative influences on private sector demand limit the ability of households and firms to maintainconsumer spending and private investment in the face of a substantial fiscal consolidation (see Fig. 29).According to this view, the weakness of domestic demand is the key policy concern, which could bereinforced if the global economic recovery was to falter. In this scenario, weak growth is then expectedto push down on inflation over the medium term, keeping it close to the Bank of England’s 2% target.Recent evidence of weakness in consumer spending and confidence is supportive of this view(see Fig. 30).

In the second scenario, however, high inflation – rather than weak economic growth is thepredominant policy concern. This could arise because the combined impact of strong world growthand the resilience of private sector demand sustain the economic recovery in the face of a significantconsolidation of public finances. As Sentance (2010) and others have argued, this was the experience ofthe UK economy in the mid-1990s when UK growth was also supported by a competitive exchangerate and healthy export demand, as well as a recovery in business investment and steady growth ofconsumer spending. A less encouraging version of this scenariowould be a situationwhere growthwasrelatively disappointing but inflation still remained high. This could occur if inflation expectations haddrifted upwards (see Dale, 2011 andWeale, 2011) or if supply side constraints – such as theweakness ofthe UK manufacturing base – prevented the UK taking full benefit of the competitive advantage fromthe depreciation of sterling since 2007. Sentance (2011) has also argued that by putting too muchweight on the impact of the domestic “output gap” on inflation and not enough on external influences

10 The CPB Netherlands Bureau for Economic Policy Analysis, which monitors world trade data, reported on 23rd February2011 that in December 2010 world trade volumes had passed the previous peak in April 2008.

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Fig. 30. International consumer confidence, as deviation from long-run average since 1990. Source: EuroStat.


on growth and inflation, UKmonetary policy-makers are in danger of making errors which could add tothe volatility of output and inflation in the future.

At the time of writing, there is an active debate among policy-makers and in the media as to whichscenario might dominate.11 But on both scenarios, there might be reasons to temper the relativelypositive conclusions of this paper. In the first scenario, the positive performance of the real economy inthe early phase of the recovery may look less impressive if the economy suffers a prolonged period ofweak growth as the planned fiscal consolidation takes effect. In the second scenario, there is a dangerthat the legacy of the large policy stimulus provided to help the economy recover from recession turnsout to be a prolonged period of above-target inflation. That would also cast the resilience of the UKeconomy in recent years in a less favourable light, as the coming years could be dominated bya prolonged struggle to return inflation to target and to re-anchor inflation expectations at a levelconsistent with medium term price stability.

Our conclusions at this stage of the economic recovery should therefore be regarded as provisional.The UK has weathered the global financial storm relatively well so far and we have sought to identifythe factors underpinning this relatively good performance. But a proper verdict cannot be reacheduntil we can see how the current conflicting pressures on the growth and inflation outlook resolvethemselves over the next few years.

References

Batini, N., Turnbull, K., 2000. Monetary conditions indices for the UK: a survey. External MPC Unit Discussion Paper No. 1, Bankof England.

Benati, L., 2007. The ‘great moderation’ in the United Kingdom. Journal of Money, Credit, and Banking 39 (1), 121–147.Chiu, A., Wieladek, T. On the stylised facts about real GDP revisions during recessions. External MPC Unit Discussion Paper,

forthcoming-a.Chiu, A., Wieladek, T. Is the ‘Great Recession’ really so different from the past? External MPC Unit Discussion Paper,

forthcoming-b.Dale, S., 2011. MPC in the dock. Speech by Spencer Dale at the National Asset-liability Management Conference, London on

24 March 2011.Eichengreen, B., O’Rourke, K.H., 2010. A Tale of Two Depressions. Voxeu.org (8 March 2010).Faust, J., Rogers, J.H., Wright, J., 2005. News and noise in G-7 GDP announcements. Journal of Money, Credit, and Banking 37 (3),

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11 See for example, Bank of England Inflation Report, February 2011.

http://Voxeu.org


Gamberoni, E., Von Uexhull, E., Weber, S., 2010. The roles of openness and labor market institutions for employment dynamicsduring economic crises. World Bank Premise 29, 1–5.

Giannone, D., Lenza, M., Reichlin, L., 2011. Market freedom and the global recession. IMF Economic Review 59 (1), 111–135.Joyce, M., Lasaosa, A., Stevens, I., Tong, M., 2010. The financial market impact of quantitative easing. Bank of England Working

Paper 393.Kennedy, N., Van Riet, A., 1995. A Monetary Conditions Index for the Major EU Countries: a Preliminary Investigation. European

Monetary Institute – MESD Mimeo.Kim, H., Taylor, M.P. Large datasets, factor-augmented and factor-only vector autoregressive models, and the economic

consequences of Mrs Thatcher. Economica, forthcoming.Kubelec, C., Sa, F., 2010. The geographical composition of national external balance sheets: 1980–2005. Bank of England

Working Paper 384.Massone, M., Walton, D., 1999. Sterling and the Conduct of UK Monetary Policy. The UK Economics Analyst.Miles, D., 2004. The Miles Report on the UK Mortgage Market. Freshfields Bruckhaus Deringer.Sentance, A., 2010. Getting back to business. Speech at the CBI/Bank of England Lunch in Belfast on 24 November 2010.Sentance, A., 2011. The UK’s inflation problem: selling England by the pound? Speech at the IEA State of the Economy

Conference on 17 February 2011.Shin, H., 2009. Reflections on Northern Rock: the bank run that heralded the global financial crisis. Journal of Economic

Perspectives 23 (1), 101–119.Weale, M., 2011. Uncertain uncertainty. Speech to Institute of Actuaries 17 February 2011.

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How the UK economy weathered the financial storm