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What impact are government schemes having on the economy?

POSTED: 26th November 2013
IN: Business news
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2013 has seen the UK economy grow throughout the year and it looks as if the economy is finally emerging from the recession and the stagnation that has characterised the last five years since the financial crisis of 2008.

undefinedThe UK struggled to come out of the deep recession caused by the 2008 financial crisis and subsequent credit crunch as consumers, businesses and financial institutions went through a period of retrenchment and focused on repairing their own balance sheets and paying back debt rather than borrowing and spending.

According to the Office for National Statistics (ONS), the UK economy contracted by 4.7 per cent in 2008, by 0.9 per cent in 2009 and then grew by 1.5 per cent in 2010.

However, this momentum did not continue into 2011, with growth falling back to 1.1 per cent. In 2012, the UK technically avoided a double-dip recession, but only just, despite the boost to the economy from the London 2012 Olympics, as overall there was no movement up or down in economic output.

By the end of 2012 the UK economy was still almost five per cent smaller than at its peak in the first quarter of 2008.

The outlook has brightened in 2013 with growth of 0.3 per cent in the first quarter, 0.7 per cent in Q2 and the ONS reported GDP growth of 0.8 per cent in its first estimate for the third quarter.

However, it should be noted that the UK economy is still 2.5 per cent smaller than it was at the end of the first quarter of 2008.

So, what has contributed to the recovery and is helping produce the longest period of sustained growth since the start of the financial crisis mid-way through 2008?

Between the government and the Bank of England there are three main policies and schemes that have had a big impact on the economy. They are the government’s policy of deficit reduction, the Funding for Lending Scheme and the Help to Buy scheme.

Austerity and deficit reduction

The coalition came to power in April 2010 and six months later the chancellor George Osborne laid out plans to try and cut the UK’s huge deficit - which the ONS predicted would cost the UK £48.6 billion in interest payments in 2011-12 - in his emergency budget of October 2010.

At that point UK government borrowing was £760 billion or around 50 per cent of GDP and the government hoped to eliminate the structural deficit by balancing the cyclically-adjusted current budget over five years, by 2015-16. The coalition set a target of national debt falling as a proportion of national income by that same year.

However, the economy did not grow as quickly as hoped in the next two years which caused Mr Osborne to revise his predictions as tax receipts did not grow and benefit payments did not fall as hoped. Austerity is set to last until at least 2017-18.

The Labour party argued that the spending cuts imposed by the coalition cut off growth undermining consumer confidence, which in turn harmed and delayed the recovery.

In 2010-11 government borrowing was £143.1 billion, falling to £118.5 billion in 2011-12 and in 2012-13 it increased slightly to £118.8 billion.

At the end of September 2013, the deficit was £1,211.8 billion, equivalent to 75.9 per cent of GDP.

Although government borrowing has stabilised, the overall total is still going up, so it is clear that this is still a major problem for the UK.

Whether the policy postponed growth or not is up for debate but another important cause of problems in the economy following the credit crunch was how difficult businesses and households found it to borrow money and this led to the introduction of a succession of schemes to try and get banks lending again.

Funding for Lending Scheme (FLS)

Initially the government tried to get the bank’s lending again through Project Merlin, a scheme that set lending levels that banks had to adhere to, but it didn’t seem to work.

The FLS has made a strong contribution in unlocking mortgage lending but its impact on lending to business has been limited.

The scheme works by allowing banks and building societies to access wholesale funds at below market rates on condition that they pass on the borrowing to homes and businesses.

In combination with low interest rates, FLS has helped to increase the range and number of mortgages available.

Initially, the scheme led to reductions in mortgage rates for homeowners with lots of equity in their property, but from January 2013, the number of mortgages available to first-time buyers and homeowners with low levels of equity also went up and competition meant that rates fell too.

Just weeks after the scheme was launched in August 2008, a number of lenders started to offer five-year fixed rate deals at below three per cent.

At the time, Ray Boulger of mortgage adviser John Charcol said: “With the launch of these new rates it is already clear that, in stark contrast to Project Merlin, the Funding for Lending Scheme is very quickly proving effective as far as the mortgage market is concerned.”

The housing market has been a big contributor to the strong growth the UK has seen so far in 2013.

However, lending to business remains a problem and the latter part of the FLS has been redesigned to provide further incentives for banks’ to lend to businesses.

When the governor of the Bank of England, Mark Carney, presented the latest Bank of England Quarterly Inflation Report in November he said that a lack of business investment was still key to the recovery maintaining momentum.

Help to Buy

The timing of the next initiative to help the property market appears to have been very good, helping to build on the momentum in the property market caused by FLS.

Help to Buy is designed to allow first-time buyers to access the property market without the help of the “Bank of mum and dad”.

It has been launched in two stages. Firstly, potential homeowners with a five per cent deposit can apply for an equity loan from the government of up to 20 per cent of the value of a newly built property up to the limit of £600,000.

The second part of the Help to Buy scheme which was launched three months earlier than scheduled in October provides a mortgage guarantee of up to 15 per cent of the value of a property and is not limited to new builds.

The combination of the two policies and the bank of England’s announcement that interest rates will not rise for an extended period has encouraged people to try and get on the property ladder. It has also led to an increase in existing homeowners moving up the property ladder, which in turn has helped to meet demand for new smaller properties for first-time buyers.

The latest data from the Bank of England shows that mortgage approvals reached a 66-month high of 66,226, still only about two-thirds of the level seen in the decade up to the time of the credit crunch, but a sign that the policies are leading to increased activity in the property market.

This leads onto one of the potential problems with the scheme.

Critics say that without a policy launched in tandem that increases the supply of new homes, Help to Buy could contribute to a house price bubble that prices out the people the scheme is designed to help.

However, the data shows that only in London is house price growth running at close to 10 per cent and part of the reason for that is foreign investors buying up new housing stock as they see London property as a safe haven.

The rest of the country is seeing prices rise by between one and three per cent with market commentators predicting annual house price growth of around five per cent for the next four years.

The Bank of England has been asked by the government to review the scheme annually to ensure this risk is assessed.

Conclusion

Overall, the UK is finally emerging from the stagnation that characterised 2011 and 2012 after the economy emerged from such a deep and damaging recession in 2008 and 2009.

Growth is being driven by the housing market which has gained strength helped by low mortgage rates, FLS and Help to Buy.

However, the UK’s trade deficit is still getting wider. This is partly because demand from many of our key markets is still low as the eurozone has only just come out of recession so export growth is not helping the UK economy.

This, coupled with more business investment, is an area the government sees as key in order for the economy to rebalance itself away from reliance on consumer spending and the housing market, but as yet this aspect of the economy is still not functioning as the policymakers would like.

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