Risk!

With only a couple of weeks to go before I undertake my BSc Economics degree at the London School of Economics (LSE,) I thought it was about time that I posted something on my rather neglected blog! Here is an article I wrote recently for a school magazine about risk and uncertainty in the UK economy. I hope it provides some insight into a topic that I spent a long time researching last year (more to follow in a later post.) 

"Aside from Mervyn King and George Osborne, risk and uncertainty are the biggest players in the UK economy as they impact the stock market, investment and consumption among many other factors. When markets are buoyant, uncertainty is low, so households and firms are more confident and are likely to hold stocks and shares, refinance property to increase consumption and borrow from banks for investment purposes.

However, following the 2008 credit crunch, uncertainty over the economy’s growth prospects has been high, so domestic absorption has been weak. Therefore, the encouragement of risk taking has become a crucial factor in stimulating the UK recovery. With banks, firms and consumers deleveraging (paying down debt) rather than spending, and reducing the risk on their balance sheets, growth prospects in the UK remain weak. Historically, a period of private sector debt reduction has been coupled with an expansion of government debt, but with the chancellor extending fiscal austerity until 2018, the UK economy is being held back from returning to growth, as the public and private sectors are being cut back at the same time.

It has therefore been left to Mervyn King and from July, Mark Carney, the George Clooney of economics (google him, it will be worthwhile) at the Bank of England to manage this uncertainty by stimulating the UK’s economic recovery and reducing perceived risk using monetary policy, taking some focus away from their primary mandate of maintaining inflation at its 2% target. One of the policies implemented by the Bank is Quantitative Easing (the asset purchase programme), which aims to reduce the cost of borrowing for firms in order to increase investment. Although QE has had the desired effect on government borrowing costs, with gilt yields falling quite significantly, it has not had the same impact on the borrowing costs for firms as banks are unwilling to take the risk of investing in private bonds.

In order to improve the effectiveness of QE and encourage banks to take the necessary risk of lending to businesses in order to fuel the UK’s economic recovery, one policy that the Bank could enforce is a negative operational standing deposit facility rate. This means that banks are charged to hold excess reserves at the Bank of England, rather than receiving an interest rate of 0.5%, encouraging them to invest in private assets, which although may be higher risk, generate higher yields. This should mean that QE actually has its desired impact.

The Bank of England has also implemented the Funding for Lending Scheme, which enables banks to borrow at a lower cost if they maintain or increase new net lending to any household or corporation. Banks can also refinance up to 5% of their existing loans, which should translate into lower mortgage costs for consumers and lower borrowing costs for firms. Although mortgage costs have fallen following the implementation of the scheme, funding has not increased to small and medium sized enterprises, which make up 99% of all businesses in the UK, and therefore a large proportion of total employment.

A potential policy measure to address this concern could be a reduction in the cost for banks if they take the risk of increasing new net lending to small and medium sized firms, which make up a large proportion of UK employment. Additionally, if firms could refinance up to 10% rather than 5% of their existing loans, mortgage costs for existing customers could be reduced, which would free up money, resulting in higher consumer expenditure.

It may seem counter-intuitive to encourage greater risk taking at a time when this is being touted as a fundamental cause for creating our current economic mess. However, in order to set the economy back on track, it seems necessary to pursue bold policy measures which may increase confidence in the prospects for the UK economy and raise the level of risk everyone is willing to take, helping to aid the recovery. Risk taking needs to be managed throughout an economic cycle, and should be reined in at a time when everyone is prospering, and encouraged when the economy has flat-lined and is struggling to pick up."

I think my next blog post shall be explaining the policies I mentioned above in greater detail, which hopefully will come before the turn of the next century!