Statutory Regulations and Controls in the UK - Essay Example

Credit crunch in 2007: Rescue and stimulation packages by the UK Government Introduction Prima facie the financial crisis leading to credit crunch is related to the banks, when the news and its analysis blissfully ignored the fundamental issues which culminated into a catastrophe, and limited to the survival of banks. Statutory regulations and controls have earlier been hated, citing that it would stifle the private entrepreneurship. The government intervention is sought when the situation has gone out of control, and there is a call for protection from the government using public money. The ideological conflicts which had been detrimental to the welfare of people entrenched into the system have been justified in the name of ‘free enterprise’. It is in this backdrop, we analyze the factors leading to the crisis and the efficacy of the rescue and stimulation packages introduced by the UK government to improve the situation. According to the Banking Guide it has been an episode of financial instability that was, arguably, the most serious since the 1930s. It states “The risks of negative equity (where mortgages are greater than the value of the property) became a reality and mortgage defaults hit record highs. Banks have lost the trust which is a pre-requisite to the efficient functioning of credit markets”. The table as given in Appendix I shows the fall in the world’s major equity markets since June 2007, and the cumulative change from 30-6-2007 to 10-10-2008 in the case of ‘FTSE All-share Index’ of the UK is negative by 40.9%. Subprime crisis and Debt culture The habit of borrowing by the individuals and corporate bodies ingrained predominantly in the US culture at a staggering level which over the period of time made the financial structure in the country vulnerable. As a lighted match to a train of gunpowder, the subprime crisis acted as a trigger for the collapse of the leading banks. The cases of isolated bad debt in the banking system could be a normal phenomenon. However, when it has become impossible to quantify the bad debts in the nation as a whole, the system became victim to the crisis. This unprecedented phenomenon has arrested the flow of capital and liquidity, fundamental to the banking system. It is a vicious circle and the banking system has been clogged up completely due to growing suspicion among the market players. The bank finance locked up in subprime mortgages and housing development projects has paralyzed the system as a whole. The bailout plan was formulated under the Treasury Secretary, Henry Paulson, who had been the Chairman and Chief Executive Officer of Goldman Sachs earlier. Pittman, M. (2008) states that “Without the government money, Goldman, Merrill Lynch & Co., Morgan Stanley, Deutsche Bank AG and other firms could have become some of the biggest creditors in a bankruptcy filing by AIG, the worlds largest insurer, because of its billions in losses on subprime bonds and corporate debt.” The crisis thus started has resulted into credit crunch and transformed into a global financial and economic crisis Theories Discussion about the theoretical background in this connection would be helpful in understanding the issues in proper perspective. In a study by Verma & Wilson (2005, p. 16-17) it was found that the per worker household and private corporate savings affecting GDP support the Solow growth model, whereby domestic private sector savings promote long run economic growth. The principles governing the well established theories have been ignored and not adopted by the society and the government on the back of consumerism founded on consumption beyond the means through borrowing. Toba (148) states “Both the classics, and also J. M. Keynes, considered the individual saving as a primordial source of investments. The sacrificing of the present consumption was considered as the basis of the first stage of the investment process, respectively the savings stage. Nowadays, the main productive investments are constituted based on the credits which have been gotten from the banks”. The banking system played an important role by extending credit to the people giving principles of a good banking a go by. When the relationship between earning-consumption-savings in the society has deteriorated beyond redemption, the system collapsed and brought down the accumulated benefits of privatization, liberalization and globalization along with it. According to the various theories of consumption and saving behavior, the people make efforts to maximize their personal well-being by balancing the stream of earnings in their lifetime with the pattern of consumption. Pintus and Wen (2009, p. 26) states “The history of economic thought has long suggested that boom-bust business cycles may be driven by over-investment fueled by credit expansion. … However, in general equilibrium, income stimulates consumption, consumption reduces savings, yet investment requires savings to finance”. Evidences The financial crisis faced by the world is historically the deepest one in the past eight decades according to the banking guide, rather than the reports or the analysis of the outside agencies. O’Connell, J. (2010, p. 148) states “An international redistribution of purchasing power associated with rising oil prices, and high household indebtedness in some developed countries, were also relevant influences”. The Impact of this crisis on UK particularly has been hard due to the reasons ranging from the disorientation of the policies of the government which has been influenced largely by global factors to the delay in initiating response measures by the government at the earlier stages. Secondly, the developments in the financial sector, especially in the US had serious implications in the UK due to its close economic relationships with the US and the nexus between the UK and the US financial institutions in terms of their operations. According to Bayne, N. (2008, p. 7) the collapse in September 2007 of Northern Rock in the UK was a bad shock for the Bank of England and blames FSA’s weak supervision and lack of effective deposit protection scheme for the disaster. Savings & consumption The complacency prevailed in the country, and the lack of alertness on the part of the government to channelize the pattern of spending behavior of the society has undermined the strength of the economy. Whatever money saved is eventually meant for consumption and also, savings is the foundation for investment. However, the importance of savings in life and its effects on economy has been ignored in the society. Savings ensure uniformity in consumption, keeping in mind the need for resources during unemployment or recession. In the absence of savings, the impact of recession would be severe in the people’s life, and the sudden disruption in consumption affect the business and industry which in turn increase the unemployment level resulting into a vicious circle. Unemployment and Inflation The impact of credit crunch on employment and inflation needs to be analyzed critically. PricewaterhouseCoopers UK (2008, p. 17) is of the view that although the crisis in the US sub-prime market is regarded as the trigger of the current financial climate, the roots of the credit crunch lie in the aftermath of the last global financial crisis in 2001, which was precipitated by the dot-com stock market crash of 2000. This highlights the absence of timely intervention to rectify the situation in the intervening period on the part of the government. According to their assessment, “The potential for job losses largely depends on the duration of the current level of instability and expectations of things getting much worse before they get any better”. (p. 21) In his report to the Treasury Select Committee, Barker (2008) stated that inflation pressures were proving stronger than expected, justifying the additional 0.25 point rise in Bank Rate. It is pertinent to note that there are limitations for the central bank in combating the issue through monetary policy by tinkering with the interest rates and regulating money supply because, increase in lending interest rates will reduce consumer spending which will in turn will affect the growth. Similarly, any move to reduce the interest may stoke up the demand, but will affect the pensioners. Non plan expenditure The fiscal measures of the government through its revenue and spending policies adopted judiciously is very essential in overcoming the recessionary pressures in the economy. The proportion of plan expenditure in the national budget has been steadily decreasing over a period of time. The role of government as the major consumer of construction and infrastructure materials as well as provider of employment has been progressively diminished over the period of time. The major reason is attributed to the ever increasing proportion of the non-plan expenditure in the budget. However, the government should strike a balance between plan and non plan expenditure, and can’t afford to expand the outlay for non-plan expenditure and other populist measures with an eye on votes in the democratic process of elections at the cost of Plan Expenditure. Discussion Stimulus packages by the government In October 2008, the British government announced a 500 billion pound stimulus package to shore up the nations financial system. Like the U.S., banks did not use the capital to lend as they were expected to. (Silver, T., 2009) Apart from the fiscal stimulus, monetary measures were taken to restore market confidence. O’Connell, J. (2010, 155) states that the Bank of England and the European Central Bank as a policy measure reduced their key interest rates to 0.5 and 1 per cent, respectively, and resorted to less orthodox monetary policy actions. Monetary policy initiatives were accompanied by expansionary fiscal policies in order to stimulate output and employment. The benefits of stimulus package have not been useful in the revival of the sagging economy. Rather, the objective of the package was to bailout the tottering financial institutions and banks, and amply reflected in the rally of these shares in the stock markets. Devereux, M. & Fuest, C. (2008) state that according to some commentators, the government´s recent capital injections to UK banks may be a threat to fiscal sustainability. Tax payers’ money was used to clear up the mess caused by the banks. Apart from the survival of these banks, the crisis has several other dimensions which the country has blissfully ignored, because the stakeholders, mainly the common men in the other issues, are not as influential as the bankers. Impact of government action Hannon, P. (2009) writes “The fiscal-stimulus package might not help reduce the severity of the recession, the committee [Treasury Select Committee] said in a report…” However, the positive consequence of the impact is that the bailout package has to a greater extent, ensured stability in the financial sector. The public confidence in the financial sector of a country is important for the growth and development of the economy. The government is now in a position to regulate the functioning of the financial sector which had otherwise been resented by the industry when the going was good for them. Time is ripe for the introduction of reforms in respect of public ownership in the backdrop of the paradigm shift in the role of the regulatory frame work. The effectiveness of the reforms should be viewed in the backdrop of the credit crunch caused by the unprecedented collapse of the system. Perhaps, limiting the damages had been the priority objective of the government though the name ‘stimulation package’ connotes different objective, because failure of timely action by the government could have precipitated a situation, where the entire economic order would have collapsed. The experience gained in this crisis calls for restructuring of the financial sector in terms of capital adequacy, managerial remuneration, risk management, management controls to identify the inconsistencies at the earliest stage, expansion of the capital base for stability, accountability of the board and so on. Analysis There are controversies surrounding the effects of the policy interventions from shorter and longer term points of view. However, unless the fundamental issues are addressed over a period of time on a systematic basis, the financial crises could become a recurring feature affecting the growth of the economy, especially when the country is committed to the difficult task of environmental obligations post Kyoto Protocol. There are debates on the medium- to long-run effects of policy intervention between the Keynesians/NKS on the one side and the Classical/Monetarist/NCS on the other side – the essence of the debate hinges on one critical issue: whether or not government intervention will help with the recovery and growth of the real economy. It is in this background the following policy measures are suggested with a view to make the foundations of the economy stronger in the long run. Budget deficits The burden of bailout package and decrease in tax revenues in the backdrop of slowdown in economy increases the budget deficit and financing this deficit with minimal impact on interest rates and inflation is a challenge to the government. But, the government should develop a long term plan to reduce the deficit to the desired level in a phased manner for sustainability. Tax Reforms It is time for the government to revisit the taxation policy for giving more thrust to savings in the society. The violent fluctuations in the consumption level which is related to employment could be reduced if there is buffer by way of savings to avoid harsh landing of the economy. Banking reforms Stable interest and exchange rates are important for the growth and development of the economy. The inflation caused by increase in interest rates results into decline of real income, and the food inflation affects the poor. Lin, J., Vinals, J. & Dadush, U., (2010) states that, “Financial institutions should pay for their costs to society through a financial levy and by adopting remuneration schemes that discourage excessive risk-taking. The absence of regulations with regard to rating of complex financial products has aggravated the crisis, and the reforms should aim at proper risk management by the banks. Wage reforms Under the inflationary situation and changes in the interest rates, wage reforms are necessary to maintain the purchasing power of the workers and reduce the disparity in the income levels of the people, and a national policy linking wages to the economic indicators should be evolved. Education Reforms The people of the country are exposed to global competition under liberalization and globalization due to various international agreements. Therefore, the educational standard need to be improved to meet the global challenges. Nation’s growth strategy & public spending In an economy where consumption is driven by debt, reversal of the trend in the short term is fraught with so many imbalances. Keeping inflation under control is a daunting task. Increasing the rate of interest to overcome any monetary imbalances may affect growth at a time when recession is looming large. Also, if inflation is not kept under control, the benefits of growth on revival would be offset by inflation. The government should embark upon massive developmental programs to bring the economy back on the rail. Spending cuts per se is not the solution to any economic crisis. Rather the quality of spending matters more, because the economic situation calls for rationalization of non-plan expenditure. However, plan expenditure is needed to overcome the recessionary trends in the economy, as employment, spending, savings and investment hinges on spending by the government as it acts as a catalyst for the private sector to catch up with the revival strategies of the government during this critical juncture. Any letup in the efforts could lead the economy deeper into the troubles. It could be observed from the following chart that the public debt has been increasing over the period of time. Therefore any increase in non-plan expenditure through public debt or printing money to finance the budget deficit can only increase the financial woes. UK Total Government Debt for end FY 2011: £0.932 trillion Source: ukpublicspending.co.uk (2011) Budgeted UK Total Government Debt: Current – Historical – As Percent GDP. Summary The theoretical background of the crisis and the evidences has been considered as a basis for further discussions and analysis. The stimulation package announced by the government and the impact of the government actions has been discussed. After analysing the factors involved in the government policy for its success, the paper outlines the future growth strategy and public spending in brief for making the foundations of the economy stronger in the long run. Conclusion The consumption driven world economy is closely linked to debt. The unemployment scenario coupled with financial crisis leads to slowdown in spending by the public and the corporations, and the reduction in demand results in production cuts. This cyclical phenomenon in the economy takes time to bottom out, and already there are signs of revival in the global economy. Monetary policy is a double edged sword and increasing the interest rates to combat inflation would be counterproductive as it affects growth at the times of depression. As a consequence, the interest rate yield on government bonds is therefore unfavorable to the government in the sphere of public debt and will affects the government’s ability to service debt and to raise funds in the future. Reduction in interest rates will affect the pensioners and the proportion of pensioners in the population has increased over a period of time. Therefore, stability in the interest rate is important for all people in different sections of the society. References Banking Guide, Background to Recent Market Events, viewed 9 April 2011, Barker, K. (2008) Report to Treasury Select Committee, June 2008, viewed 10 April 2011, Bayne, N. (2008) ‘FINANCIAL DIPLOMACY AND THE CREDIT CRUNCH: THE RISE OF CENTRAL BANKS’, Journal of International Affairs, Fall 2008, Volume 62, Issue 1. Devereux, M. & Fuest, C. (2008) ‘A Fiscal Stimulus Package for the UK?’, Oxford University Centre for Business Taxation, 18 November 2008, viewed 11 April 2011, Hannon, P. (2009) U.K. Budget Plan Comes Under Fire, The Wall Street Journal, 28 January 2009, viewed 10 April 2011, Lin, J., Vinals, J. & Dadush, U. (2010), ‘Lessons from the Global Financial Crisis’, 17 June 2010, Carnegie Endowment for International Peace, viewed 11April 2011, O’Connell, J. (2010) ‘The 2007 crisis and countercyclical policy’, Studies in Economics and Finance, Volume 27, Issue 2, pp. 148-160. Pintus, P. A. & Wen, Y. (2009), Leveraged Financing, Over Investment, and Boom-Bust Cycles, Research Division, Federal Reserve Bank of St. Louis, viewed 9April 2011, PricewaterhouseCoopers (2008) III – Assessing the economic impact of the credit crunch, UK Economic Outlook March 2008. Silver, T., (2009) Global Bailout: Did The U.K. Do Enough? Financial Edge, viewed 11April 2011, Toba, D. (2008), ‘PEOPLE’S CONSUMPTION AND SAVINGS IN CORRELATION WITH THE INVESTMENTS FROM THE ECONOMY’, The Young Economists Journal, Volume 1, Issue 10, pp. 148-153. ukpublicspending.co.uk (2011) Budgeted UK Total Government Debt: Current – Historical – As Percent GDP, viewed 10 April 2011, Verma, R & Wilson, E. J. (2005), ‘A Multivariate Analysis of Savings, Investment and Growth in India’, p. 1-20. School of Economics, University of Wollongong, Australia, viewed 9 April 2011, http://www.uow.edu.au/content/groups/public/@web/@commerce/@econ/documents/doc/uow012207.pdf Appendix I Investment Markets Change in Value of Markets (Local Currency) Equity Market Year to 30/6/2008 (%) 3rd Quarter 2008 (%) 1 to 10 October 2008 (%) Cumulative Change 30/6/2007 to 10/10/2008 (%) UK (FTSE All-Share Index) -16.1 -13.0 -19.0 -40.9 US (S&P 500) -14.9 -8.9 -22.9 -40.2 Europe (MSCI Europe ex-UK) -25.2 -11.3 -19.9 -46.9 Japan (Nikkei 225) -25.7 -16.5 -26.5 -54.4 Emerging Markets (MSCI Emerging Markets) -0.6 -21.6 -19.7 -37.4 Source: Datastream, http://www.banking-guide.org.uk/credit-crunch.html Read More