Recession and Recovery in the United Kingdom in the 1990s: Identifying the Shocks
Catao, Luis, Ramaswamy, Ramana, National Institute Economic Review
After a sustained expansion of output which began in the second half of 1981, the UK economy experienced a decline in real GDP starting in the second quarter of 1990, which continued into the first quarter of 1992. The cumulative fall in output over the two years amounted to more than 3 1/2 per cent, in contrast to the 1979-81 recession, when output declined by about 4 1/2 per cent over a period of 6 quarters [ILLUSTRATION FOR CHART 1 OMITTED]. This article seeks to identify the shocks which were instrumental in causing the recession in 1990, and how they have impinged on the nature of the subsequent recovery.
The obvious contenders that could qualify as possible proximate causes of the recession in 1990 are: (1) changes in the stance of fiscal policy; (2) shocks arising from the external sector; (3) the stance of monetary policy preceding the recession; and (4) shocks to individual demand components. This article starts by providing an intuitive discussion of the various possible factors that could have induced the recession, and then proceeds to offer a more rigorous analysis of the proximate causes using a vector autoregression (VAR) approach.
A cursory examination of the data fails to provide support for the hypothesis that fiscal and external shocks were instrumental in precipitating the recession. As can be seen from Chart 2, the fiscal impulse measure for the United Kingdom was expansionary when the economy went into recession and, except for a brief contractionary interlude in mid-1991, remained strongly positive well into 1993. This stands out in marked contrast to the 1979-81 recession, when the fiscal impulse was strongly contractionary. (The fiscal impulse measure, defined as the change in the structural budget balance, provides one particular indicator of the impact of fiscal policy on activity. A positive value for the fiscal impulse indicates an expansionary fiscal stance, and a negative value a contractionary one(1)). The external sector's contribution to output growth was also positive when the economy went into recession. However, as Chart 3 shows, the external sector's contribution to growth started to decline as the recession got underway, and this may have possibly contributed to prolonging the recession. This again stands in contrast with the experience in 1979-81, when the external sector's contribution to growth was negative at the start of the recession.
As regards the role of monetary policy, the policy stance was tightened sharply beginning in mid-1988. Base rates were increased from a low of 7 1/2 per cent in May 1988 to 13 per cent by the end of that year and further to a high of 15 per cent by the fourth quarter of 1989. Real interest rates were relatively high in this period and, in fact, averaged over 7 per cent in the second half of 1989. Base rates continued to remain at high levels until January 1991, when they were 14 per cent, before tapering off through a series of reductions to 10 1/2 per cent by the last quarter of 1991. An index of monetary conditions (a weighted average of the real interest rate and the real exchange rate), which provides a broader measure of the monetary stance, indicates that monetary policy was even more restrictive around 8 quarters preceding the recession than would appear from just looking at the nominal interest rates (Chart 2).(2) That is, the data on interest rates and monetary conditions suggest a plausible role for the monetary transmission mechanism in bringing about the recession in 1990.
There is, however, much controversy over the precise channels through which monetary policy impinges on activity and on the magnitude of the monetary impact on the distinct expenditure components.(3) In the case of consumption, this is not only on account of the potentially offsetting income and substitution effects, but is also related to the changing nature of the interaction between interest rates and wealth-effects following the financial liberalisation in the 1980s. …