UK Fiscal and Monetary Policy: Ensuring a Quick Economic Recovery

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UK Fiscal and Monetary Policy: Ensuring a Quick Economic Recovery

Fiscal policy has had to adapt to the unique implications of the coronavirus. Spending is currently at an all time high of 16.3% of GDP to support crippled industries and a population without income. Policymakers are approaching a crucial moment where they need to avoid austerity while managing national debt; development of contemporary ideas will be key.

Monetary policy has taken inspiration from the introduction of quantitative easing and the drastically low interest rates brought about after the financial crisis of 2008 just being used in a more drastic manner. Monetary policy in the future will depend upon the Bank of Englandâ€™s forecasts for economic growth and any other economic shocks.

After a 9.9% GDP fall in 2020 the United Kingdom is at a crossroads of utmost significance. Much like the Keynesian post-war approach and the stretch of austerity after the economic collapse of 2008, an economic crisis is often used as a catalyst for change. Thus, the decisions made by the policymakers of today will become a focal point for the country’s direction over the next decade. In this report I will analyse both the fiscal and monetary policy used as a reaction to COVID-19, and then conclude upon what stance the UK should take to ensure a bright recovery.

The impact of COVID-19 has left the current Conservative government in a truly unique position. Whilst most businesses were forced to adapt towards a working-from-home environment, other industries, such as hospitality, airlines and leisure were left completely paralysed. With the alternative being the implosion of many successful UK companies and a complete loss of income to a large proportion of the population; Rishi Sunak was left with no other option but to implement expansionary fiscal policy (increasing government expenditure andor reducing taxes). As shown by the figure below, this led to a discretionary fiscal expansion of 16.3% (proportion of GDP) – a much higher figure in comparison to other developed countries.

However, it must be noted that the most likely reason for such aggressive use of fiscal policy is because other than Spain and Peru, no countryâ€™s GDP fell more than the UK’s during 2020.

Milton Friedman once said, Only a crisis – actual or perceived – produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around.

This proves true for the Bank of England’s innovative approach to monetary policy after the Lehman collapse of 2008, particularly due to the introduction of quantitative easing and the severe manipulation of interest rates. Both transmission mechanisms continue to be utilised in this current post pandemic climate, arguably to a more drastic extent.

As you can see on Figure 2, the Bank of England set the interest rate to a previously unseen level of 0.1% in 2020.

This increases AD and inflation in two key ways:

Decreasing the rate of interest leads to a lower rate of return from savings for both consumers and businesses. As a result, agents are encouraged to either invest or consume in the economy inducing a surge of spending in the economy, in turn leading to demand-pull inflation.

A fall in the interest rate also brings about a fall in the cost of borrowing. A low cost of borrowing should incentivise both consumers and businesses to take out more loans, which should then prompt an increase in AD and a slight rise in inflation.

However, both scenarios assume that consumers are willing to spend. In an economic climate filled with uncertainty, agents may instead opt to save as much as possible, even when it may seem rational to consume or invest.

Figure 3 depicts how quantitative easing, a once temporary measure, has steadily increased since 2009 to complement a low interest rate and boost the amount of money flowing round the economy. This occurs when central banks purchase assets, such as government bonds, from private banks to inject cash into the economy, and consequently increase economic activity.

A low interest rate and a sharp increase in quantitative easing across many major global banks (Fed, BoE and ECB) has caused a fall in bond yields and increased the money supply of economies all over the world. As a result, both real estate and the equity market are seeing a huge surge in investment, which is in turn giving economic agents more confidence, and then leading to a rise in consumption (the wealth effect). Whilst this is currently promoting economic growth, policymakers must be aware that continuing in this manner will bring about an unsustainable level of demand-pull inflation and an unmanageable national debt; yet on the other hand implementing contractionary monetary policy will inevitably cause a fall in asset prices, potentially inducing another recession.

Policy Recommendations

I believe policymakers should opt for a more innovative fiscal approach, which can be accomplished by focussing on two key aspects:

Increased Bailout Scrutiny

Why?

As previously stated in the report, the Â£70 billion used to reduce insolvencies in 2020 led to a 27% decrease when compared to the previous year. Whilst at first glance this may come across as a positive statistic, this reveals that policymakers have financed several unsuccessful firms. The COVID pandemic has brought about a situation whereupon profitable companies in need of support have been put together with businesses which would have most likely become insolvent in 2020.

How?

I believe the CMA should take a more strict and measured approach when dealing with bailouts over the next ten years, as there are much better uses for fiscal expenditure. Through using the capital saved from a reduction of bailouts, the government could instead spend more on infrastructure, which will in turn lead to a rise in GDP (depending on the size of the multiplier) and an increase in living standards. The temporary rise in our already low level of unemployment will eventually be offset by new firms filling the place of the bankrupt companies.

Imposing Bailout Conditions

Why?

A recession gives the government a rare opportunity to align corporate behaviour with long-term societal needs. This was where western economies fell short in 2008, as condition-less bailouts allowed policymakers to flood the world with liquidity without directing it towards any fundamental change. This could have been an opportunity to reform the economy, yet instead most of the money went back into the financial sector. In response to COVID, nations such as France have begun adding conditions onto bailouts by imposing carbon reduction commitments onto corporations (e.g., Airfrance, Renault) and Denmark have denied state aid to any business domiciled in an EU designated tax-haven.

How?

I would advise policymakers to set the objective of reducing carbon emissions, and to then establish a fitting condition when bailing out large corporations over the next decade. Whilst the productivity of firms may be affected in the short term, businesses will eventually innovate and adapt to stay profitable, and a large reduction in negative externalities will ensue.

Conclusion

Whilst many of the measures taken by the government throughout 2020 were devised to combat the unique implications of the COVID pandemic, the general fiscal and monetary policy used was influenced by the blueprint set from the reaction to the financial crisis. Up until 2008, interest rates had never been set so low and quantitative easing was merely a concept in the UK. Since then, interest rates have stayed below 1% and quantitative easing has grown over the past 12 years. With a combination of monetary policy and a new and improved fiscal policy, the UK will be able to grow higher than pre-COVID levels, while also meeting its target to reduce UK emissions at least 68% by 2030 (GOV, 2020).

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