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How the UK economy weathered the financial storm Andrew Sentance, Mark P. Taylor, Tomasz Wieladek

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S0261-5606(11)00160-4 10.1016/j.jimonfin.2011.11.007 JIMF 1101 Journal of International Money and Finance

Please cite this article as: Sentance, A., Taylor, M.P., Wieladek, T., How the UK economy weathered the financial storm, Journal of International Money and Finance (2011), doi: 10.1016/j.jimonfin.2011.11.007 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

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How the UK economy weathered the financial storm
Andrew Sentance, Mark P. Taylor and Tomasz Wieladek*1

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Abstract

most observers expected.

JEL classification: F3, E5, G01

Keywords:International Finance, Monetary Economics, Financial crisis ___________________________________________________________________________________

* Corresponding author: Email: twieladek@london.edu ;Tel.: +44 (0) 20 7000 8433; fax: +44 (0) 20 7000 7001. 1 Andrew Sentance is a former member of the Bank of England Monetary Policy Committee and a part-time professor at Warwick Business School (andrew.sentance@wbs.ac.uk). Mark Taylor is Dean of Warwick Business School (mark.taylor@wbs.ac.uk). Tomasz Wieladek is a researcher in the Economics Department at London Business School, Sussex Place, London, UK.

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Prior to the global financial crisis of 2008, the UK had the largest banking sector asset to GDP ratio among large countries, and had experienced rapid real property price increases as well as a persistent current account deficit in the preceding decade. These factors, together with its role as an international financial centre, made the UK economy particularly vulnerable to the onset of the global financial crisis. Although the initial drop in real GDP was steep, we provide evidence that that the economy has weathered the financial storm better than many feared, and has fared no worse than its peer group of major economies. In this paper we assess the reasons underlying this outcome, including the possibility of exaggerated vulnerabilities, global economic recovery, the flexible supply side of the UK economy, as well as fiscal, financial and monetary policy interventions. Our analysis suggests that all of these factors played a role in cushioning the impact on the UK real economy, leading to a more benign outcome than

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1 Introduction

At the onset of the global financial crisis, in the second half of 2007, the UK looked to be more heavily exposed to the emerging problems in the banking sector than its peer group of large

much larger in relation to the size of its economy than any other G7 economy (Figure 1).

Second, there were worries that the UK housing market might share some of the vulnerabilities that had afflicted the US housing market through the rapid expansion of sub-prime lending, adding to the weaknesses in the UKs financial system (Figure 2). Third, a British Bank – Northern Rock – was one of the early major casualties of the financial crisis. And fourth, the UK was running a current account deficit of around 3% of GDP and was potentially vulnerable to a cessation of capital flows to finance the deficit (Figure 3).

[Insert Figure 1-3 here]

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

much lower than earlier downturns. Though there are still some uncertainties surrounding the

level of over 3 million which was being widely forecast in early 2009.3 The main issues concerning the performance of the UK economy are therefore why it has survived the crisis so well, rather than why it has done so badly.

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In the first year of recovery from the trough in output (2009Q3 to 2010Q3), UK GDP rose by 2.5% and excluding the volatile oil and gas component, the rise was 2.8%. Subsequent growth figures have been less positive, though adverse weather and other special factors have played a part Moreover, initial estimates of UK real GDP data are subject to substantial revisions, as for example the initial estimate of real GDP growth in Q4 2009 has already been revised from 0.1% to 0.5% . 3 For example, the Confederation of British Industry forecast in February 2009 that unemployment would exceed 3 million by mid-2010 whereas the jobless total has levelled off at around 2.5 million.

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outlook for growth and inflation has been surprisingly high, unemployment did not reach the

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of other peer group economies.2 Employment has been more resilient and company failure rates

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industrialised countries. There were a number of reasons for this. First, its financial sector was

fiscal and monetary policy interventions. The second section considers the four broad areas of explanation highlighted above. there has also been a relatively strong rebound in real GDP and employment has been surprisingly resilient. And the third section of the paper considers the economic outlook for the UK and current policy dilemmas in the aftermath of the financial crisis. and the impact of the recovery of the global economy. The paper is divided into three main sections.ACCEPTED MANUSCRIPT In this paper we assess why the worst case scenario did not materialise and investigate four possible explanations: the possibility that UK vulnerabilities to the crisis were exaggerated. AC C EP TE D M AN U SC RI PT played a role in cushioning the UK economy from the shocks associated with the onset of the . The first section considers the performance of the UK economy through the crisis and into the early phase of the recovery. the effectiveness of banking. the role of the supply side. While the current vintage of output data shows a relatively deep recession. Our analysis suggests that all four factors global financial crisis.

4 While the warning signals of a conventional inflationary boom-bust cycle – which the UK had experienced on a number of occasions since the 1970s . .5 These concerns featured in the macroeconomic debate in the UK in the form of worries about rising house prices and rapid growth of measures of money and credit. there were few indications from the key macroeconomic indicators of the economic turmoil which was to unfold in 2008 and 2009. However. the Bank of England hosted a conference on ‘The Great Stability’. at an early stage of the crisis emanating from the US housing market. 5 Furthermore. on the day that the British Bank Northern Rock declared that it needed liquidity support from the government. and was being sustained at the lowest rate since the 1970s. and inflation had been sustained in line with the 2% target. which reflected the expansion of the financial sector. AC C concerns began to be expressed that the UK could be particularly vulnerable to shocks EP The evolution of the financial crisis has been analysed in great detail elsewhere and it is not the TE D system in the UK and elsewhere. These concerns reflected the very international focus of the UK banking system and the dependence of some banks on short-term capital flows and wholesale financial markets which were disrupted by the crisis.were not present. To what extent were these fears borne out by the macroeconomic outcomes? 4 Indeed. 2007 ).ACCEPTED MANUSCRIPT 2 The performance of the UK economy since the crisis In the UK economy of the mid-2000s. purpose of this paper to go over this ground again. What was less apparent at the time was the increasing global interdependence of the financial which emerged in the US housing market to other major economies around the world. although there was some evidence that the ‘Great Stability’ in the UK was more due to the absence of adverse shocks. rather than good monetary policy (see Benati. there were signs that the expansion of the financial sector during the 1990s and 2000s was a potential source of instability. which was to be highly instrumental in transmitting problems M AN U SC RI PT around 5% of the labour force. Unemployment was Growth during the mid-2000s was broadly in line with historical averages.To some extent policymakers were lulled into a sense of false security by these developments. insufficient weight was placed on it.

Rogers and Wright (2005) document that the UK has the largest real GDP data revisions in the G7. data available at the time.6 6 The regression was estimated over the horizon 1991Q1 until 2005Q4. i. . Italy and Spain) than the US. As a result of methodological changes. In terms of employment. they can be used to infer a final data. suggesting that data past 2005 could be revised. Our model predicts a substantial upwards revision. Figure 6 compares the evolution of real GDP during past and 1990s recession. such as a the exuberant housing market and a persistent current account deficit. We therefore regress year-on-year final data employment and industrial production growth on yearon-year final data real GDP growth.ACCEPTED MANUSCRIPT Figures 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 2006-10. [Insert Figure 4-5 here] The UK real GDP figures are slightly weaker (Figure 5). and final revised data. Industrial production does not appear to be only revised slightly. But evidence from the 1990s recession suggests that TE D recessions in real-time.e. real GDP revisions appear to be quite large. it is unfortunately not possible to compare real-time and final data employment revisions to UK employment outturns are very small. Both coefficients are highly statistically significant and AC C subject to large revisions either. France. the performance of the UK seems to be clearly more in line with a weighted which experienced a much larger drop in employment. despite sharing a similar set of vulnerabilities. suggesting that the most recent recession could look very similar to the 1980s recession in final data. but these must be seen against evidence that initial estimates of GDP in the UK have been revised upwards following past recessions. In both the 1980s M AN U SC RI PT average of the largest four European countries (Germany. Faust. Since these two important indicators of economic activity are EP outturns during the 1980s recession. In particular. revised. estimate of real GDP. since real GDP data is typically not considered ‘mature’ until 5 years have passed.

Nevertheless. which may have eased the competitive pressure on UK producers to shed jobs. A key issue facing policy-makers going forward is to ensure that this rise in inflation does not become a more persistent feature of the UK economic landscape. Furthermore our model seems to fit recession periods particularly well (Chart 7). Figure 8 shows the peak to trough change in harmonised (internationally comparable) unemployment rates across OECD countries and it shows that the UK ranked around the middle of its peer group of economies and experienced a significantly smaller rise in unemployment than the worst affected nations .the United States and peripheral European economies. as suggested by an R2 of . . this simple regression appears to fit final year-on-year real GDP growth data reasonably well. Furthermore. the UK’s better performance during the crisis seems to have come at the expense forecasts have been subject to persistent upside errors also suggests that the high rate of inflation 10). The fact that UK inflation TE D [Insert Figure 8 here] M AN U SC RI PT total expected revision increases with the initial estimate of the total output loss. AC C is due to persistent changes in the inflation process rather than one-off price level shocks (Figure EP of higher inflation than its international peer group (Figure 9).This partly reflects the very significant depreciation of the sterling exchange rate relative to the US Dollar and Euro. Based on these two stylised facts about data revisions we therefore argue that unemployment rate outturns are more informative about real economic conditions in real-time than real GDP. They find that the Chiu and Wieladek (2011b) show that the change in the unemployment rate across the G-7 economies on the other hand is virtually never revised.ACCEPTED MANUSCRIPT [Insert Figure 6-7 here] In a similar spirit to the analysis above. Chiu and Wieladek (2011a) assess revisions to the total output loss during recessions in 54 past recessions across 21 OECD countries.89. We use this regression to predict final real GDP growth during the most recent UK recession.

policy actions. The bank’s inability to roll over its liabilities ultimately led to a lack of liquidity becoming an insolvency problem.1 Exaggerated Vulnerabilities observers to believe that the UK might be more vulnerable to the global financial crisis than other economies: the size and vulnerability of UK financial institutions. the UK’s role as an international financial centre. the supply side of the economy. and the recovery in the global economy.ACCEPTED MANUSCRIPT [Insert Figure 9-10 here] In summary. and the role of the financial sector in The failure of Northern Rock in September 2007 was an early warning of the problems affecting the UK’s banking system. EP decline in house prices on the real economy and associated repercussions for the banking TE D In the introduction to this paper. the evidence suggests that the UK’s economic performance has not been substantially different from other large industrialised countries. 3. we highlighted a number of reasons that may have led M AN U SC RI PT large GDP revisions is taken into account. especially once the potential for 3 What lies behind the resilience In this section we explore four possible explanations for the resilience of the UK economy to the global financial crisis: exaggerated vulnerabilities. Shin (2009) documents extensively that the failure of Northern Rock was a result of a run on the banks liabilities in whole-sale funding markets. rather than the withdrawal of deposits by individual customers. the effect of a rapid system. Among observers there AC C the UK economy. .

roughly 70% of UK banks funding was at a less than one-year maturity. while 60% of bank lending goes to households.which suggested that the asset side of banks’ balance sheets was very vulnerable to a decline in real property prices.ACCEPTED MANUSCRIPT was a substantial fear that much of the rest of the UK banking system was stricken with similar problems. The financial intermediation sector in particular was a strong engine of growth before the crisis. contributing disproportionately to GDP growth in the decade before the crisis. UK financial intermediation is dominated by banks. Any disruption to global financial activity would therefore probably have a disproportionately large effect on the UK. The UK maintained this position over the during this time. AC C next 20 years but the global financial system became a lot more interconnected and much larger EP financial linkages for 18 countries. A disruption in lending could therefore have serious consequences for the non-financial sectors of the economy. In addition. The simultaneous realisation of both vulnerabilities could have had a significant impact on the ability of banks to lend to other sectors of the economy. Last but not least. as on the eve of the financial crisis. financial and business services contribute a substantial 30% of GDP in the UK economy (Figure 11). Their description of the data suggests that the UK was at the TE D M AN U SC RI PT investment bank Lehman Brothers. This is not surprising. growth in lending to the real estate sector substantially outstripped lending to other sectors in the run-up to the crisis . This exposure made the UK banking system particularly vulnerable to the freeze in money markets that followed the failure of the American On the asset side of bank’s balance sheets. Kubelec and Sa (2010) collect bilateral data on heart of the international financial network in 1985. as private non-financial companies rely on Banks for 77% of their funding. . the UK’s role as hub for global financial activity made it particularly susceptible to shocks affecting the global financial system. Financial services also made a substantial contribution to services and total exports (Figure 12).

overall banking system better than most observers expected. on the eve of the crisis. This was a very different development to the 7 In 2008. But the decline in housing wealth was much more muted than expected in the early phases of the crisis. the contribution of the financial sector to GDP and exports. the government had therefore large implicit banking sector liabilities like Iceland. AC C EP and the economy were able to withstand the shocks emanating from the global financial crisis TE D [Insert Figure 13 here] M AN U SC RI PT vulnerable to an external financial shock. starting in the summer of 2007 (Figure 13) But despite all of these a priori vulnerabilities.7 Figure 14 shows that despite greater rises in real house prices in the run-up to the crisis. the subsequent decline in real house prices was about 15% smaller than at an equivalent stage in the 1990s UK house price bust. The UK had the largest banking sector with respect to . funded by whole-sale markets at short maturity. made the country seem particularly vulnerable to an external financial shock. as well as the UK’s role as a major hub in the international financial system. there were several reasons to believe that the UK was very its GDP among large countries. Despite low public debt. All of these fears were reflected in a significant depreciation of sterling. Domestic lenders were also overly exposed to the property market which had experienced a boom in the run-up to the crisis.ACCEPTED MANUSCRIPT [Insert Figure 11-12 here] In summary. Ireland and Switzerland. most forecasts predicted a house price fall between 20 and 30%. Activity in the UK housing market and prices both fell sharply as the financial crisis took hold in 2007/8. Finally. the UK housing market.

whose future mortgage payments exceeded their equity. For example. repossession laws and the planning permission regime. such as New York City. where land supply is abundant and prices fell rapidly. are therefore incentivised to wait until the housing market recovers to avoid the financial liabilities associated in the planning system. which helped to reduce forced sales and foreclosures and hence eased the downward pressure on property prices. the vast majority of UK mortgages are floating rate mortgages. reflecting three main factors . probably contributed to persistent excess demand for housing and AC C Another important contrast between UK and US housing market experience reflects differences EP with default. Monetary policy in the UK therefore has a much more direct impact on household’s mortgage payments and hence on house prices than is the case in the US. the majority of mortgages are linked to 30-year fixed rate. This restriction of new housing supply. many of which are directly linked to the Bank of England base rate. The UK has a very restrictive planning system reducing new housing supply. Mortgage costs declined substantially following the large cuts in the Bank of England base rate between autumn 2008 and spring 2009. Whereas US default legislation generally allows homeowners to default on their mortgage without any repercussions for their remaining assets. experienced very different house price dynamics than. together with the large net immigration from EU accession countries the UK witnessed during the run-up to the crisis.the difference in mortgage market structure. for example. the consequences of default are much more occurs. [Insert Figure 14 here] As pointed out in Miles (2004). Borrowers. on the other hand.ACCEPTED MANUSCRIPT US. areas with limited land. TE D severe in the UK . In the US.where lenders can repossess all of the borrowers’ assets once the default M AN U SC RI PT . while this only applies to certain areas of the US. Las Vegas.

Similarly. This provides some indication of confidence in the UK banking system – though clearly underpinned by public sector guarantees. This suggests that the UK banking system was stabilised. This spread rose sharply in the Autumn of 2007 when Northern Rock failed and even further when Lehman Brothers collapsed in Autumn 2008 (Figure 15).ACCEPTED MANUSCRIPT the associated upward pressure on national real house prices in the UK.There is also evidence is that the UK economy is rebalancing AC C immune to future shocks. but because supply had not been able to keep up with strong demand in the boom. many observers feared that the dependence of the UK banking system on wholesale funding would turn illiquidity into insolvency problems. but the balance sheets of the key financial institutions are likely to EP taxpayer through public sector guarantees. A widely used measure of the ability of the banking system to fund its activities is the LIBOR-policy rate spread. But the combination of subdued demand growth in the recession and the impact of a weaker exchange rate subsequently have produced a more gradual adjustment than during the early 1990s recession (Figure 16). The UK banking system is not become more resilient as recovery proceeds. which was a worry at the height of the financial crisis. the UK was potentially vulnerable to a sharp current account reversal at the onset of the crisis. At the onset of the crisis. albeit at a potential cost to the avoided. An uncontrolled failure of the banking system was TE D [Insert Figure 15-16 here] M AN U SC RI PT . there was a less pronounced overhang of excess supply in the UK when the housing bust came. The financial crisis helped to remove this excess demand. the recent indications are that this risk spread has returned to levels very close to the position before the financial crisis. However.

survey evidence and other business organisations show that the number of companies citing external finance as a constraint on production has now fallen back close to the values seen before the crisis (Figure services did not seem to greatly intensify the recession or delay the recovery. Since 2008. This evidence suggests that the strong dependence of the UK on financial and business TE D shows that the most severe constraints on access to finance were short-lived. with UK business confidence bouncing back in line with its international peer group (Figure 19). [Insert Figure 19-20 here] 3. this is likely to help close the current account deficit. Surveys by the CBI M AN U SC RI PT [Insert Figure 17-18 here] . Finally. While difficulties in the financial sector can have a much broader impact on economic activity if firms cannot access finance to support their activities. As in the 1990s recovery. there were also some concerns about the size of the financial sector in the UK economy and the growth impact from the financial crisis going forward. financial and business services have showed different profiles – the output of financial services (technically “financial intermediation”) fell sharply and has not bounced back reflecting low levels of lending in the aftermath of the crisis. There were three main elements AC C Policy Actions EP 20).2 But one very important factor helping to ease the stresses and strains created by the financial crisis on the UK economy was the impact of policy measures. But business services have bounced back more significantly.ACCEPTED MANUSCRIPT – with manufacturing growing faster than services and double digit growth of export volumes (Figure 17 and 18).

It was unusual for the government to intervene directly in the sector (in this case the financial sector) which was at the epicentre of the recession. and fiscal policies which supported demand. In the downturns of the early 1980s . the UK had the 4th largest capital injection. it EP largest up-front government financing package and the second largest banking debt guarantees TE D 3. unlike other countries. the UK tried a variety of policies to protect the real economy from the banking sector fall-out. whose problems were contributing to that downturn.2. it was very unusual to have such a concerted policy and early 1990s. and in the early 1990s there was relatively little intervention to support the housing market and consumer-facing businesses. which ultimately probably lead to a more benign outcome. In terms of its GDP. which was at the epicentre of that recession. the in terms of GDP among industrial countries. monetary stimulus.in turn. We consider the three areas of policy response financial interventions. the UK authorities did not intervene to support manufacturing industry. Compared to previous UK experience. The UK government took a very broad-brush approach to financial sector intervention. On the other hand. In the early 1980s. monetary policy and fiscal policy . To a certain extent this reflects the initial severity was a lot less clear which policies would be most effective in ameliorating the UK’s banking system problems. [Insert Figure 21 here] AC C of the banking crisis in the UK. the 2nd largest liquidity support. the policy response was delayed because of the need to deal with the inflationary aftermath of the previous upswing.ACCEPTED MANUSCRIPT to this policy response: direct interventions into the banking system.1 Financial interventions M AN U SC RI PT response which was implemented so early in the recession. unlike with monetary policy and inflation. The evidence in Figure 21 suggests that.

like the UK. Stevens and Tong (2010) estimate that the effect of the Bank of England’s asset purchase programme was to depress gilt yields by about 100 basis points. Nevertheless. too. the decline in the pound sterling after the 2007/8 financial crisis appears to be the biggest depreciation that the UK had experienced since To highlight the scale of the monetary stimulus. and assess their performance relative to past monetary policy expansions. the exchange rate plays a key part in the monetary transmissions mechanism. AC C Traditionally. Joyce.5% and embarked on an asset purchase programme of £200 bn. Here. Prior to this episode. The Bank of England quickly lowered the official interest called Quantitative Easing. Measured in terms of a trade-weighted exchange rate basket. a trade-weighted exchange rate to account for the transmission channels associated with these variables. TE D departing the Gold Standard in 1931 (Sentance. The monetary stimulus was not simply reflected in these interest rate movements. .ACCEPTED MANUSCRIPT 3. These were the most stimulatory policies pursued in the Bank’s history.2. to provide further monetary stimulus even though interest rates were very close to the zero-lower bound. M AN U SC RI PT rate to the present level of 0. there were very significant movements . they did not take the effect of asset purchases into account. As a small open economy.as we have already noticed. we use two different monetary conditions Batini and Turnbull (2000) provide a useful survey of monetary conditions indices for the UK. contained both the interest rate and EP indices (MCIs). MCIs for small open economies.2 Monetary Policy To cushion the real economy from the fall-out of the banking crisis. the Bank of England and provided substantial policy stimulus. Lasaosa. the Bank Rate had not been reduced below 2%. 2011).

To include the effect of QE. AC C challenge now facing the UK and many other major economies is how they should rein in these EP estimates of the recently formed Office of Budget Responsibility. we thus rely on these two MCIs.ACCEPTED MANUSCRIPT The survey in Batini and Turnbull (2000) suggests that two previous MCIs. Although they are derived from different models.2. they place similar weights on the individual components. .35 on the long rate and .18 on the exchange rate.8 It is therefore not surprising that they both indicate that the size of the recent monetary policy expansion has been unusually large. 8 The Kennedy and Van Riet (1995) MCI places a weight of . they suggest that the exchange rate had the largest contribution to the most recent monetary policy expansion. with a similar weight as on the short rate. one by Kennedy and Van Riet (1995) and the other one by Walton and Massone (1999).43 on the long and short rate and . [Insert Figure 22-23 here] Alongside a substantial relaxation of monetary policy.47 on the short rate. fiscal policy also played a part in supporting the growth of the UK economy following the financial crisis. the MCI weights are derived from the National Institute of Economic and Social are derived from an unrestricted vector autoregression in four endogenous (GDP. More interestingly. there was a substantial TE D 3. the 10-year gilt yield and sterling ERI) and one exogenous variable (oil prices). include the impact of the long rate in their MCI. In the case of Kennedy and Van Riet. while the MCI weights in Walton and Massone (1999) .3 Fiscal Policy M AN U SC RI PT Research’s NIGEM multinational model. A major large structural budget deficits as the recovery progresses. According to the relaxation in the structural budget deficit as the financial crisis took hold (Figure 24). The Walton and Massone (1999) MCI places a weight of . the short-term interest rate.13 on the exchange rate.

Kim and Taylor (2011) use a factoraugmented VAR framework to show that. contract enforcement. The latest ‘Doing Business’ survey by the World Bank suggests that the UK has the most flexible business environment among large countries. tax payment. and Reichlin (2010) examine 2008-09 GDP growth assessing the impact of 9 It is important to point that a methodological change led to fall in this ratio in the mid-2000s. following the labour market reforms of the 1980s and 1990s. In particular. The index measures the impact of a range of regulations dealing with starting a business. various supply-side rigidities have held back the adjustment of the real labour market rigidities resulted in continuing rises in unemployment which continued for around five years into the recovery. There has been relatively little evidence of that process in this recession. Indeed. as the number of insolvencies has been substantially lower during this than previous M AN U SC RI PT economy and a return to growth. .3 Supply side flexibility In past UK recessions. These legal reforms are also reflected in real economic recessions (Figure 25). In particular. the number of insolvencies is still smaller than in the past. in the aftermath of the early 1980s recession. aggregate supply and demand shocks affect output and unemployment to a smaller extent. property and construction transactions. even adjusting for this change in the denominator. This view is also verified by more comprehensive cross-country studies. Giannone. For example.9 economic from adverse economic shocks. Lenza. etc. various structural measures show the UK supply-side to be relatively flexible compared to other countries. AC C Previous academic studies suggest that increased supply side flexibility may shield the domestic EP [Insert Figure 25-26 here] TE D outcomes.ACCEPTED MANUSCRIPT 3. since the definition of firms changed. However.

the UK is the third most open economy in the G-7 behind Germany and Canada. and Weber (2010) find that countries with high severance packages and unemployment benefits experienced larger declines market reforms in the late 19809s and 1990s. Similarly.4 Global Recovery in term of GDP. Figure 26 suggests that real wages in the private sector adjusted to a much a greater extent that in the 1990s recession. 3. Gamberoni. suggesting substantial labour market flexibility. when measured as a sum of imports and exports M AN U SC RI PT in employment growth during past global employment crisis. Although this spread increased during the crisis. As a result of several labour . Similarly. In particular. As the both the UK specific and cross-country academic evidence suggests that labour market flexibility weakens the effect of adverse macroeconomic shocks. IMF and consensus forecasts suggests a large revision to world real GDP growth forecasts (Figure 28). von Uexkull. On the real side of the economy. Eichengreen and O’Rourke TE D The UK is a small open economy.ACCEPTED MANUSCRIPT labour market regulation and business sector regulation quality and find that while labour market flexibility dampened the effects of the crisis on real GDP growth. the UK now has the second lowest level of employment protection among OECD countries. the same is not true of the business environment. Following the failure of Lehman Brothers. Indeed. one widely used measure of global risk aversion if the difference between the yields of BAA and AAA corporate bonds in the US. the size of the shock was substantially smaller than the increase during the great depression and also a lot less AC C production and international trade was in many ways similar to the path of these variables EP economic developments. Developments in the world economy have therefore a substantial impact on domestic (2009) documented that the behaviour of macroeconomic aggregates such as world industrial during the great recession. it should therefore not be too surprising that UK employment outturns have been much stronger than expected.

[Insert Figure 27-28 here] in the UK were probably exaggerated. but also the second largest depreciation since 1841. This was not only one of the largest depreciations in the G20. As the UK is a relatively open economy. AC C quicker than most observers expected. there is some evidence that the macro-financial vulnerabilities on the real economy M AN U SC RI PT affect domestic economic development positively. most likely contributing to the recovery in a small open UK economic outlook and policy issues EP cushioned the effect of the impact of the shock associated with the global financial crisis on the TE D In summary. partially as a result of the perceived vulnerability to the crisis. in trade-weighted terms.10 The openness of the UK economy. . conditions in the global financial and real economy recovered a lot economies like the UK. This suggests that the world economy showed a more a robust reaction to the global financial crisis than initially feared. the swift and comprehensive reaction of public policy. Finally. 4 10 The Pound experienced the largest two-year depreciation in its history. therefore meant that the strong recovery in world GDP had a larger effect on the recovery in the UK than is most other countries. Our analysis thus suggests that all four factors played a role in the relatively benign outcome for the UK real economy thus far in the cycle. the strong recovery in world GDP would naturally sterling fell by about 22% in two years. in conjunction with the UKs flexible supply side of the economy. the Euro Area. together with the unusually large depreciation in the pound.ACCEPTED MANUSCRIPT persistent (Figure 29). But in addition. but also as a result of the relative large size of monetary stimulus relative to its largest trading partner. At the same time. probably UK real economy. when the UK left the Gold standard in 1932.

experienced rapid real house prices increases (like the US and Spain). 11 The CPB Netherlands Bureau for Economic policy Analysis. Unlike the 1930s. the swift and comprehensive policy response. repossession law and housing supply constraints. which monitors world trade data. reported on 23 rd February 2011 that in December 2010 world trade volumes had passed the previous peak in April 2008. the . Though real GDP fell by about 6%. allowing world trade to recover the losses suffered in the recession11. as prior to the crisis it had the largest banking sector with respect to GDP (similar to Iceland and Ireland). as in past UK recessions. despite these vulnerabilities the performance of the UK real economy in terms of employment is in line with its international subject to substantial upward revision. The UK is a case in point. Growth has been supported by a large relaxation of policy. many observers feared that the world faced a repeat of the Great Depression of the 1930s. this could be M AN U SC RI PT system in many countries and a recovery in private sector confidence. direct interventions to stabilise the financial world economy has not lapsed into protectionism. Similarly. the flexible supply side of the UK economy and the stronger than expected recovery in the world economy all contributed to the resilience of the UK economy and its return to growth after the recession. Our analysis suggests differences in the mortgage market structure. had a persistent current account deficit and a banking system funded by flighty whole-sale markets at short maturity. However. it seems as if the world economy has bounced back strongly after very weak demand conditions in late 2008 and early 2009.ACCEPTED MANUSCRIPT At the onset of the global financial crisis. economy has been so benign despite all of these apriori vulnerabilities. To some extent this is a function of EP The question we tried to answer in this paper is therefore why the impact on the UK real TE D peer group and better than past UK recessions. Thus far at least. But some economies were still thought to be more vulnerable to global financial disruption than others. AC C that some of the vulnerabilities may have been exaggerated. all which probably contributed to a much smaller decline in real house prices than experienced in the US.

households and banks continue to deleverage. however. differing views on the outlook for the UK economy and the appropriate policy response reflect different weights attached to two different scenarios for the growth and inflation outlook.12 Going forward. AC C spending and confidence are supportive of this view (see Figure 30). The inhibiting impact of these negative influences on private sector demand limit the ability of households and consolidation (see Figure 29). particularly when the impact of strong world growth on energy and commodity prices is factored in. it does suggest that the deflationary number of members of the Bank of England’s Monetary Policy Committee.ACCEPTED MANUSCRIPT In terms of inflation. EP this scenario. Recent evidence of weakness in consumer [Insert Figure 29-30 here] In the second scenario. According to this view. however. the weakness of domestic demand is the key policy concern. And in the view of a . TE D firms to maintain consumer spending and private investment in the face of a substantial fiscal M AN U SC RI PT risks identified during the early phases of the recession have receded. In keeping it close to the Bank of England’s 2% target. This could arise because the combined impact of strong world 12 Add references to my Selling England by the Pound speech and latest speeches by Spencer and Martin. In the first scenario. high inflation – rather than weak economic growth is the predominant policy concern. the balance of risks on inflation has probably shifted to the upside. while credit constraint from banks’ reluctance to lend lead to a weak demand environment. weak growth is then expected to push down on inflation over the medium term. the UK has experienced a worse performance relative to its peer group of advanced economies. Even if this is regarded as a temporary phase (as suggested by the Bank of England’s quarterly Inflation Report forecasts). which could be reinforced if the global economic recovery were to falter.

In the the economy recover from recession turns out to be a prolonged period of above-target inflation. which scenario might dominate. Bank of England Inflation Report. there might be reasons to temper the relatively positive conclusions of this paper.ACCEPTED MANUSCRIPT growth and the resilience of private sector demand sustain the economic recovery in the face of a significant consolidation of public finances. UK monetary policy-makers are in danger of making errors which could add to the volatility of output and inflation in the future. That would also cast the resilience of the UK economy in recent years in a less favourable light. there is an active debate among policy-makers and in the media as to M AN U SC RI PT investment and steady growth of consumer spending. This could occur if inflation expectations had drifted upwards (see Dale (2011) and Weale (2011)) or if supply side constraints – such as the weakness of the UK manufacturing base – prevented the UK taking full benefit of the competitive advantage from the depreciation of sterling since 2007. as well as a recovery in business scenario would be a situation where growth was relatively disappointing but inflation still remained high. this was the experience of the UK economy in the mid-1990s when UK growth was also supported by a competitive exchange rate and healthy export demand. In the first scenario. February 2011 AC C second scenario. Sentance (2011) has also argued that by putting too much weight on the impact of the domestic “output gap” on inflation and not enough on external influences on growth and inflation.13 But on both scenarios. As Sentance (2010) and others have argued. there is a danger that the legacy of the large policy stimulus provided to help EP real economy in the early phase of the recovery may look less impressive if the economy suffers TE D At the time of writing. A less encouraging version of this . as the coming years could be dominated by a prolonged struggle to return inflation to target and to re-anchor inflation expectations at a level consistent with medium term price stability. the positive performance of the a prolonged period of weak growth as the planned fiscal consolidation takes effect. 13 See for example.

The UK has weathered the global financial storm relatively well so far and we have sought to identify the factors underpinning this relatively good performance. .ACCEPTED MANUSCRIPT Our conclusions at this stage of the economic recovery should therefore be regarded as provisional. But a proper verdict cannot be reached until we can see how the current conflicting pressures on the growth AC C EP TE D M AN U SC RI PT and inflation outlook resolve themselves over the next few years.

Credit. Rogers... Chiu. and the economic consequences of Mrs Thatcher.. 2007... Wieladek.. Von Uexhull. and Banking. Stevens.Is the ‘Great Recession’ really so different from the past?External RI PT ... 1-5. T. The ‘great moderation’ in the United Kingdom. A. 1995. forthcoming. M AN U Dale. 59(1). Speech by Spencer Dale at the National Asset-Liability SC Chiu. Joyce. 403-417. 2010. D.. M. E. 2005... Kennedy.A monetary conditions index for the major EU AC C EP TE D Eichengreen.. M. O’Rourke.External MPC Unit Discussion paper. Van Riet. E..... 2011a.. 2010. N. I. Gamberoni. S. London on 24 March 2011 Giannone.Monetary conditions indices for the UK: A survey. J. Taylor. K. 393. Large datasets.External MPC Unit Discussion Paper No. J. M.. Kim.ACCEPTED MANUSCRIPT References Batini. News and noise in G-7 GDP announcements. 121-147. L. A tale of two depressions. 2011. T. forthcoming.Bank of England Working Paper N. B. Wright.. Management conference. H. J. 2000. Credit.2011b. 2011. L. Turnbull. K. A. MPC Unit Discussion paper. IMF Economic Review. Reichlin. 39(1).1.Lasaosa. A. and Banking.. factor-augmented and factor-only vector autoregressive models.. forthcoming. 111-135.. The financial market impact of quantitative easing.. 29.Lenza. 2009. A. 2011.. 37 (3).P. N. Faust. H. Bank of England Benati.In progress.On the stylised facts about real GDP revisions during recessions.H.. Tong. Weber. Economica.Journal of Money. S. Journal of Money.Market freedom and the global recession. M...The roles of openness and labor market institutions for employment dynamics during economic crises.World Bank premise. Wieladek.MPC in the dock.

Journal of Economic Perspectives. A. 2009.Getting back to business..Speech at the CBI/Bank of England lunch in Belfast on 24 November 2010 Sentance.. Speech to Institute of Actuaries 17 February 2011 AC C EP TE D M AN U SC RI PT Miles..Government spending multipliers: An international comparison. Pappa. 2010. 2010..ACCEPTED MANUSCRIPT Countries: A preliminary investigation... C.Reflections on Northern Rock: The Bank Run that heralded the global financial crisis. H.. M. A.Sterling and the conduct of UK monetary policy. ..European Monetary Institute – MESD Mimeo. 101-119.. 2011.Barcelona Graduate School of Economics Working Paper. E. Walton. Sa. The miles report on the UK mortgage market.The UK Economics Analyst. Kubelec.Freshfields Bruckhaus Deringer. 384. Sentance.. 23-1. D.The UK’s inflation problem: Selling England by the pound? Speech at the IEA State of the Economy Conference on 17 February 2011 Shin. Massone. M. D. 2010. 2004. . F.Uncertain Uncertainty. 2011. 1999. Weale.‘The geographical composition of national external balance sheets: 1980-2005’. Bank of England Working Paper N.

ACCEPTED MANUSCRIPT FIGURES Figure 1: Banking sector size across OECD economies Banking Sector Assets as Percentage of GDP Portugal Germany Netherlands Belgium Switzerland Sweden New Zealand United Kingdom Source: OECD Figure 2: Real house price growth in OECD countries Percentage change in real house prices between Q1 1999 and Q4 2006 Percent 100 80 60 40 20 0 -20 USA Denmark Australia Norway Canada Italy UK Netherlands Belgium Sweden France Ireland New Zealand Spain Korea Germany Source: Bank for International Settlements Switzerland Finland Japan AC C EP TE D M AN U SC Iceland Ireland Greece Norway Italy Canada Finland Austria France Japan Spain RI PT 1000 900 800 700 600 500 400 300 200 100 0 .

4 United States Q1 2002 Q1 2004 Q1 2006 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Source: OECD Source: OECD RI PT 5 0 -5 -10 85 Euro-4 80 Q1 2008 Q1 2010 10 . 1999 – 2006 Percent of GDP 15 Source: OECD Figure 4: International employment outcomes TE D M AN U 102 100 98 96 94 92 90 Japan Figure 5: UK real GDP outcomes New Zealand SC Australia USA Spain 105 100 95 90 United Kingdom Denmark Korea Italy Germany Canada Norway Finland Netherlands Belgium Sweden France Japan Switzerland AC C EP UK US Ireland UK Euro .ACCEPTED MANUSCRIPT Figure 3: Current account balances in OECD countries Average current account to GDP balance.

0 100.ACCEPTED MANUSCRIPT Figure 6: Real-time versus final real GDP data in past UK recessions Figure 7: UK Real GDP year-on-year growth rates actual versus predicted 102.89 Source: Authors calculation SC .0 98.73*EMP R2 = .0 1980s real time 1990s real time Current 1980s final 1990s final Real GDP growth Predicted real GDP gorwth RI PT 12 10 8 6 4 2 0 -2 -4 -6 -8 92.0 94.0 96.0 90.0 1972 1977 1982 1987 1992 1997 2002 2007 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 Source: ONS ‘Economic Trends’ Publication Figure 8: Peak to through change in the harmonised unemployment rate Source: OECD Main Economic Indicators.32*IP +. AC C EP TE D M AN U y= 1.9 + .0 88.

ACCEPTED MANUSCRIPT Figure 9: International inflation outcomes Figure 10: Bank of England inflation forecasts against outcomes 6 5 4 3 2 UK US 6 RI PT 2009 2010 May 2009 forecast August 2009 forecast 5 4 3 2 1 0 November 2009 forecast Actual CPI inflation 1 0 -1 OECD -2 2005 2006 2007 2008 2009 2010 Source: OECD TE D Figure 11: Financial intermediation and business services Percent of Gross Value added M AN U Source: Bank of England 2007 Figure 12: Financial services exports SC 2008 25 20 15 10 35 Financial services exports as % of UK services exports Financial services as % of total exports EP 30 25 20 15 10 AC C Financial intermediation Business services 5 5 0 1990 1993 1996 1999 2002 2005 2008 1990 1993 1996 1999 2002 2005 2008 0 Source: ONS Source: ONS .

ACCEPTED MANUSCRIPT Figure 13: Sterling trade weighted exchange rate over time 110 105 100 95 90 2000 2002 2003 2005 2006 Figure 14: Real house price level EP 1980/90s 2000s AC C t-8 t-6 t-4 t-2 t-0 t+2 t+4 t+6 t+8 t+10 Source: Consensus Economics TE D M AN U 105 100 95 90 85 80 75 70 65 60 Source: Bank of England SC 2008 2009 RI PT 85 80 75 70 65 60 .

ACCEPTED MANUSCRIPT Figure 15: Libor-OIS spread Figure 16: Current account adjustment 350 300 250 200 150 100 50 0 2007 2008 2008 2009 2009 2010 2010 1 1987 .1993 2004-2009 0 -1 -2 -3 -4 -5 -6 6 7 8 2 Source: Thomson DataStream Figure 17: UK Manufacturing and services growth Manufacturing Services TE D 10 M AN U Source: ONS Figure 18: UK exports volume growth SC 3 4 5 5 0 EP -5 -10 -20 AC C -15 2009 2003 2004 2005 2006 2007 2008 2009 2010 2003 2005 2007 Note: Growth rates are expressed in year-on-year terms Source: ONS Note: Growth rates are expressed in year-on-year terms Source: IMF IFS RI PT 0 40 30 20 10 -10 -30 .

ACCEPTED MANUSCRIPT Figure 19: Business confidence level across countries Figure 20: Survey percentage of firms citing external finance as a constraint to production Deviation from long-run average since 1990 30 20 10 0 -10 -20 18 16 14 Germany France -30 -40 -50 SC 1992 1998 Italy UK 1995 1997 1999 2001 2003 2005 2007 2009 1980 1986 Source: Eurostat Figure 21: Various financial system interventions in terms of GDP Source: IMF AC C EP TE D M AN U Source: CBI RI PT 12 10 8 6 4 2 0 2004 2010 .

ACCEPTED MANUSCRIPT Figure 22: Kennedy and Van Riet MCI over time Figure 23: Walton and Massone MCI over time 106 102 MCI MCI 94 SC 1991 1999 2007 98 MCI .Bank rate only MCI .Long rate only M AN U MCI-FX only 90 1983 1991 1999 2007 1983 Source: Auhors calculation Source: Authors calculation Figure 24: Headline versus structural budget deficit.Bank rate only MCI .Long rate only MCI-FX only MCI . in percent of GDP 12 10 8 6 4 2 0 -2 -4 1987 1991 1995 1999 2003 2007 2011 2015 Headline budget deficit Structural budget deficit Note: Values for 2011and onwards are forecasts Source: UK Office of Budget Responsibility (OBR) AC C 1975 1979 EP 1983 TE D RI PT 106 104 102 100 98 96 94 92 90 .

Louis RI PT 0 1983 1999 3 2000s 99 98 97 96 95 600 500 400 300 200 100 .AAA spread April 2009 EP October 2010 AC C IMF WEO 1919 1935 Source: Consensus Economics Source: Federal Reserve Bank of St. as a percentage of all firms 3 Figure 26: UK private sector real wages during recent and previous recessions 104 1990s 103 102 101 100 2 2 1 SC 1951 1967 1 0 1975 1980 1985 1990 1995 2000 2005 2010 t-2 t-1 t-0 t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 Source: UK insolvency service TE D Figure 27: World real GDP growth forecasts at different points in time 6 5 4 3 2 1 0 Consensus M AN U Source: ONS Figure 28: BAA.ACCEPTED MANUSCRIPT Figure 25: Corporate bankruptcies.

as deviation from long-run average since 1990 8 6 4 1990s 2000s RI PT SC Germany Italy France Deviation from long-run average since 1990 UK 1995 1997 1999 2001 2003 2005 2007 2009 10 30 20 10 0 -10 -20 -30 2 0 -2 0 3 6 9 12 15 18 21 24 27 30 33 36 Note: Quarters from fiscal deficit low point. Data past the 12 quarter for the 2000s consolidation reflect a projection. Note that a positive th number of the axis implies a budget deficit.ACCEPTED MANUSCRIPT Figure 29: Change in headline government budget deficit Figure 30: International Consumer confidence. Source: OBR AC C EP TE D M AN U Source: EuroStat .