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The Economic Crisis of 2008 and the UK Government Response

Introduction The current economic crisis which had its roots in the US sub-primes market produced a profound shift in UK economic policy, Hodson et al (2009). The latter suggests that prior to this crisis UK economic policy centred on three principles which included fiscal prudence, low inflation and inadequate regulation and supervision of the UK banking sector. However, the result of the crisis was so severe that the government refocused economic policy such that large public sector borrowing was necessary. This was due to the fact that a number of large UK banks were in trouble having had exposure to the troubled sub-primes market with subsequent bad debts on their balance sheets, Hodson et al (2009). Therefore, in order improve the health of the banks the UK government became effective shareholders using tax payer’s money. The banks which were assisted include Northern Rock, HBOS and Lloyds TSB as well as the Royal Bank of Scotland. However, the principle reason for government intervention was to provide liquidity to the interbank loans market and facilitate banks to lend to firms and consumers, Hodson et al (2009). It was envisaged that once sufficient liquidity had been provided to the interbank market, then the banks would be willing to lend to each other and then the banks would be able to lend to the wider economy. The total cost of government action to avert a collapse in the financial markets amounted to 28% of GDP, Furceri et al (2009).
The Economic Crisis of 2008 The roots of the financial crisis which surfaced in July 2007, and which became worldwide after the collpase of Lehman Brothers on 14th September 2008, Guillen (2009), lay in the sub-prime mortgage market in the United States, Lapavitsas(2009). It was between 2001 to 2003 that mortgage lending in the US rose significantly until 2006. At the heart of the financial crisis lay the fact that loans for homes were being made to those who would not be able to continue to make repayments on the mortgages either because they lost their jobs or interest rates increased. The latter may be a result of the government trying to stem a short term increase in inflation.
Thus, the global economic crisis of 2008 had its roots in 2007. In the US, financial institutions were lending money to borrowers whose income was insufficient for them to comfortably keep up the payments on mortgages, Hodson et al (2009). However, as house prices were going up more and more bad loans for mortgages were being made. It was due to the fact that these mortgages were valuable because the prices of houses were increasing that US investment banks took the mortgages and securitised them to form CDO’s. Nevertheless, the problem started when US house prices began to fall, Hodson et al (2009). In this case, as the price of US houses began to decline the securitised debt also began to lose value.
However, by this time the securitised debt had been cut up into smaller chunks and siphoned off to banks around the world, ending up as liabilities on their balance sheets, Hodson et al (2009). Some banks had larger chunks of securitised debt on their balance sheets than other banks while some banks had no exposure to securitised debt at all. In the period 2004-2006, US$ 1.4 trillion worth of mortgages had been securitised.This represented 79.3% of all sub-prime mortgages, Lapavitsas(2009). Moreover, according to the latter securitisation was the process whereby morgages were parcelled into small amounts placing them into other financial structures and selling the lots as new securities. These new securities or CDOs’ were to be held by financial institutions around the world. However, as interest rates began to rise after 2004, mortgage foreclosures increased.The result of the increased foreclosures was that the securities became worthless and banks were unable to sell or trade them and increase their cash assets, Lapavitsas(2009). The fact that banks had worthless, untradeable liabilities on their balance sheets put into doubt the solvency of UK as well as other global banks. These financial institutions preferred to collect liquid assets instead of ensuring that liquidity to other banks was maintained through the interbank market. The resulting liquidity shortage was characterised by the movement between the interbank lending rate and the 3 month Overnight Indexed Swap rate. The Overnight Indexed Swap rate was exceeded by the interbanklending rate after August 2007 with the difference reaching a peak in the last quarter of 2008, Lapavitsas (2009). Thus, liquidity dried up with banks unwilling to lend to each other;and consequently to firms and consumers.
It is now clear that the problems in the US housing market started when interest rates rose and house prices began to fall. At the same time the cost of borrowing to firms began to increase, making it more expensive for them to be able make productive investments which maintained current employment and generated further employment. In this case people began to be laid off and unemployment in the UK began to increase, Hodson et al (2009). Furthermore, in the UK people began to lose their jobs demand for goods and services fell and in the US as the number of housing foreclosures began to increase significantly as people were laid off. Once people began to get laid off they lost their capacity to pay for the mortgages which they had taken out, Hodson et al (2009). As the number of foreclosures soared and house prices to sink even deeper, the values of the securitised debt which was sitting on the balance sheets of banks around the world also began to fall in value. A consequence of this was that the liabilities side of the bank’s balance sheet began to increase. As rumours began to spread in the market that some banks were more exposed than others to bad securitised debt, banks became fearful of lending to each other through the interbank market. The impact of this was reduced consumption, increasing unemployment and overall contraction of the economies of developed countries, including in the UK.
The UK government was thus facing an economic crisis which was not unique to this country but part of a far wider global contagion whose spread was facilitated by the mechanics and linkages of globalisation, Lapavitsas (2009). However, the government in its response to the crisis had to ensure that the banks did not collapse, continued to lend to each other and to consumers and firms in the wider economy. The next section will look at the UK government policy response in more detail.
The UK Government Response The UK was one of the European countries to be hit the hardest by the global economic crisis which began with the US sub-primes crisis. The crisis led to the first run on a UK bank since the latter part of the 19th century with the whole banking sector facing near meltdown 12 months later with the collapse of Lehman Brothers on the 18th September 2008, Hodson et al (2009). Furthermore, the latter suggest that the resulting credit crunch and the bursting of the UK housing bubble have had a profound impact on the UK economy which has required a UK government policy response which has had to be not only substantial but also has had to set aside rules such as those associated with competition policy which would not normally have been done, Hodson et al (2009). It has also been suggested in the literature that the UK economy will contract by about 4% in 2009 with inflation falling by 1.7% and unemployment reaching 3 million before a sustained recovery kicks sets in, NIESR (2009). Furthermore, the economic crisis has led to unprecedented economic policy co-ordination at an international level with policy formulation at the national and international level constantly evolving, Pauly (2009).
Hodson et al (2009) suggests that the policy paradigm which was followed by the UK Labour Party following its 1997 election victory was essentially the New Keynesian consensus on macroeconomic policy, the composite of policies which changed after the crisis. Specifically, the UK government relied on fiscal policy and monetary policy although undoubtedly, the latter was dominant. With regards to fiscal policy, the main drivers included the reduction in the VAT rate from 17.5% to 15%; and an increase in government borrowing. Indeed the government’s borrowing requirements increased 5 fold from its level in 2007-2008 to its level in 2008-2009 with the borrowing requirement moving from2.3% of its GDP in 2007-2008 to 11.3% in 2008-2009. The increase in government borrowing was not due to the work of automatic stabilisers and was in fact outside the work of the automatic stabilisers which caused the government to suspend its normal fiscal rules for borrowing. On the other hand with the use of monetary policy the government was able to do far more extensive surgery to the UK economy. Firstly, the Bank of England dropped bank base rates from 5.75% in November 2007 to 0.5% in April 2009. This procedure was meant to make borrowing cheaper in the interbank market and facilitate general bank lending to the wider economy allowing firms to borrow to invest, while the reduction in VAT was meant to cut the costs of firms so that they would not lay off staff, Hodson et al (2009). In terms of an IS-LM analysis the increased lending by the banks due to lower bank base rates would be reflected by the LM curve shifting downwards with national outcome theoretically increasing. However, the lowering of bank base rates did not work in the manner dictated by theory, Hodson et al (2009). The latter characterise the neutral impact of the lowering of bank base rates on interbank lending by observing that neither did the volumes of interbank lending increase or interbank rates fall. Moreover, because inflation also fell, the Bank of England was unable to manipulate the real interest rate. For example, if inflation is high and the nominal rate of interest is low, then it is possible to have negative levels of the real interest rate, Hodson et al (2009). However, this may not be possible when the level of inflation is falling or very low. This is indicative of the fact that perhaps the pre-crisis policy of targeting inflation was set at too lower rate and a higher rate of perhaps 5% should have been operational to give more flexibility to the Bank of England when using monetary policy. The failure of the use of interest rates to resolve the crisis led to the Bank of England bringing into action new policy instruments such as quantitative easing and the Asset Purchasing Facility (APF), Hodson et al (2009). The former policy instrument allowed the Bank to lend against securities using its discount window in order to increase liquidity. Furthermore, the APF allowed the bank not just to lend against securities but to purchase them from other financial institutions.
Conclusion This paper has evaluated the causes of the global economic crisis of 2008 and the subsequent policy response of the UK government. It has been shown that the crisis began the US sub-primes market and spread globally due to the securitisation of sub-primes mortgages which thus entered the circulation of the global financial system. The subsequent busting of the US housing bubble made the securitised debt worthless and as a consequence lending in the interbank lending market dried up with banks waiting to fail with disastrous consequences. The government’s policy response to the crisis was at first to use both monetary and fiscal policy with fiscal policy focusing on an increase in government borrowing and a reduction the rate of VAT. Monetary policy at first relied on the use of lowering bank base rates to stimulate interbank lending. However, this did not work because inflation was at a low and so the government resorted to using unorthodox techniques such as quantitative easing and the Asset Purchasing Facility to increase liquidity in the market. The government still faces the problems associated with the need for co-ordinated action amongst nation states to deal with the crisis as well as the prospect that there may be a second credit crisis which involves not banks or firms but consumers and sovereign states.

The process of budgeting and its uses

“Budgeting is an important control system in almost all organizations (Armstrong et al., 1996; Ekholm and Wallin, 2000; Merchant and Van der Stede, 2003 cited in Hansen and Van der Stede)”. In an organisation all the activities are coordinated together by preparing plans for the future. These plans are called as Budgets. “A budget can be defined as the quantitative expression of a plan action and an aid to coordination and implementation of the plan” (Kennedy A and Dugdale D(1999). Long term planning is taken into consideration while preparing the budget. According to Colin Drury, budgets are the clear indicators of what a company will expect in the coming year. Budgeting is very useful tool for the companies to protect their future as it provides a system of authorisation and acts as a mean to forecast and planning. In a globalised civilization, Innovation is a key to success (Marginson D and Ogden S (2005). The question arises is that does budgeting and innovation go hand in hand? Budgeting harms trust and authorisation which in turn affects innovation according to many critics. All the leading companies in this age want their products to be new and innovative. Does that mean they do not use budgeting? These are some of the question which instantly arises in the minds of a consumer or a student who is doing an academic research on budgeting. In this essay we will discuss the uses of budgeting and make an attempt to discuss the validity of the criticism levelled at the traditional budget in the modern organisations.
A company prepare budget in order to get a clear picture of the future. It is carried in the context of long term strategic planning. This planning is then converted into budgeting process. Budgeting process is the process of preparing long term plan or strategic plan for the organisation. According to Kennedy A and Dugdale D (1999), while preparing budgets we should follow a series of steps. Following are the steps of preparation of budget:
Establish the mission and objectives
Determining the limiting factor example sales
Setting up the budget restricted by limited factor
Set different budgets in accordance with objectives
Mix all the budgets to form a master budget
Accept the master budget
Monitor the actual results with the budgeted plan.
The budgeting process is simple to understand and easy to implement. But still budgeting has been the area of criticism (Hope and Fraser (1999); Ekholm and Wallin (2000)). According to Hope and Fraser (1999a), in this information age traditional budgeting has not been able to meet the demands of the competitive environment. Many critics of the budgeting are management consultants themselves with an interest of changing the models of their management. Marginson and Ogden believed the opposite of Hope and Fraser. They performed a case study on a company called Astoria which is a leading player in global technological area. The main conclusion of this study was Innovation and budgeting go hand in hand. The company used an innovative management control system (aggregated variance analysis) and this allowed innovation to be accounted with the budgetary process.
Kennedy A and Dugdale D (1999) believe in getting most from the budgeting but also believe that the problem in the budgeting arises because of the purpose it serves. Budget serves a number of useful purposes such as a means of forecasting and planning, a system of authorisation, a source of decision making, motivational device and evaluating the performance of managers.
Annual budgeting process leads to betterment of the long term plans set by an organisation. Managers sometimes make hasty decision which can hamper the growth of plans set. Budgeting process encourages managers to anticipate the problems in the future. According to Kennedy and Dugdale two budgeting models should be made, one for planning and forecasting and the other for motivational reason. Planning a budget process takes a lot of time and becomes a costly affair (Mike B, Andy N and Herman H (2002)). This has been one of the most frequent criticisms about the budgeting.
One of the uses of budgeting is Motivation. A budget is a device used for influencing managerial behaviour and motivating the managers to perform the objectives of the organisation. It acts as a motivational device by providing a challenge to the managers. Colin Drury believes that budget helps managers to coordinate the activities of the organisation and achieve organisational goals. Budgeting helps organisation to run smoothly and effectively. This is because of the proper lines of communication which will allow managers and other staff understand what part they need to carry out or perform (Colin Drury (2009); Hansen s and Van der Stede w (2004)). A research shows that budgeting encourages ‘gaming’ situation between superiors and the subordinates during the target setting (Mike B, Andy N and Herman H (2002)).
Budgeting allows a manager to control and manage the activities of the organisation. When the actual results are compared with planned results there is a chance that some of the costs don not conform to the original plan which makes necessary for the manager to give an attention. This system is called Management by exception.
A Budget provides a means of evaluation of the performance of the managers. The performance of the managers is evaluated by measuring the success he has achieved in achieving the targets set by the manager (Colin Drury, 2009). This use of budgets helps influencing the behaviour of humans. There are many other useful purposes of budgeting but I laid an emphasis on only a few of them which would be helpful for a debate on budgeting in contemporary organisations.
Budgeting has been a very important subject of academic researchers. But not many academic researchers have been able to address criticism publicly made by the practitioners and the management consultants. (Ekholm and Wallin,2000). According to Hope and Fraser (2000) the most useful management accounting model is functional based model which focuses on command and control. But in this information these types of models have become inefficient and are not effective as they were. They claimed a different technique called process based management model should be used instead which will help in coping to new environment by developing empowerment and not the budgets. Marginson and Ogden completely disagree with the statements of Hope and Fraser about not using the budgets. A research shows that most of the leading business use budgeting in various different forms.
When we have a closer look at the system of annual budgets these are time consuming (Mike B, Andy N and Herman H (2002)), reduces the performance of managers (Mike B, Andy N and Herman H (2002); Hansen s and Van der Stede w (2004)), encourages rigid planning and incremental thinking and are focused on cost rather than value creation. A research shows 80 per cent of the businesses are not satisfied with their budgeting techniques (Mike B, Andy N and Herman H, 2002). Most of the financial directors rank budgeting as their first reform for coming years. A budget is prepared on an annual basis which has been criticised as these ties a company into 12 month commitment with the budget which can be a risk for the business as budgets are based on unsure forecasts. Hope and Fraser (1999c) argue that the budget cannot cope with environmental uncertainty. Rolling forecast methods have been suggested as the main alternative to annual budget method as it is produced monthly or quarterly (Arterian, 1998; Hope and Fraser, 1999a).
In a research many companies were surveyed who still are using planning and budgeting processes but many of the companies no longer used the word budget. New approaches are being used instead. Many companies including Electrolux have started using rolling forecast method. Nowadays, most organizations have recognized that the traditional budgeting is the greatest barrier to achieve the goal. The traditional budgeting is described as “Bane of corporate America” and “tool of repression”. Svenska Handelsbanken has stopped using the annual budget method (Mike B, Andy N and Herman H, 2002).
Many accountants believe that Activity-based Budgeting (ABB) and 4P-based Budgeting (PBB) are the most widely approaches used by the modern organizations all over the world. In contrast, Dugdale and Lyne (2006) surveyed 40 different UK companies. His survey included survey on financial and non financial managers. The main conclusion was that traditional budgeting is still alive and not dead. The companies he surveyed were all using budgets and the managers of all the companies agreed that budgeting and its process is still necessary along with other techniques of performance evaluation, communication and coordination. This survey led because of the beyond budgeting movement by Hope and Fraser. The study by Ekholm and Wallin shows that traditional budgeting is still a very important and integral part of an organisation. Their study also shows that practitioners are willing to accept the criticism but they are not ready to forgo the traditional budget.
Thus, the situation of traditional budgeting working in modern organisation is still a debatable issue. But one could argue that, traditional budgeting is required for maintaining organisation’s internal effectiveness. On the other hand, traditional budgeting does not seem to aid in value creation based on external effectiveness of organisation External effectiveness can be achieved by strategic means, but an organisation cannot achieve its objectives unless internal effectiveness is low. Therefore the annual budget, along with other methods, still has strong and important role to play.