The recent global economic crisis exposed most of the world economies to recessionary pressures, stemming from the collapse of the subprime mortgage markets in the US in 2007, which reverberated across the world owing to the international reach and interdependence of financial markets. The UK’s economic suffered the pressures with the near collapse of Northern Rock, coupled with the faltering profitability of some its businesses. The UK grew by 0.5% in 2010 far below the country’s historical average of over 5%. The modest growth is however, a remarkable increase over the performance in 2010, which posted a 1.2% fall in the Kingdom’s GDP. The global GDP faltered with the European Union and EU27 GDP declining by 0.1% and 0.3% respectively, by the close of 2009. The initial quarter of the year saw an even bigger decline the Euro zone economy, with a 2.5% decline, as compared to the year 2008, which took much of the recessionary pressure, posting a 4.6% fall in the bloc’s GDP. During the same year (2009), The United States GDP fell by 0.3% which did however, represent an increase over the previous year that saw larger declines.
The declining economic activity and GDP in the UK, the United States as w ell as Europe, resulted in reduced consumer and investment demand not only in Britain, but also in the country’s leading markets in the Euro zone, and across the world. Falling consumption and investment demand do in turn result into a decline in investments in the local UK economy, resulting in a reduction in the output of the economy. Reduced output implies the existence of excess production capacity in the economy and inefficiencies. The slowing economy inevitably breeds growing unemployment rates, which was witnessed across the major economies, amidst the rising effects of the global economic crisis. With unemployment reaching 8.3% in 2011, representing a modest fall in a largely stabilizing trend, the UK has largely averted the disastrous increases in unemployment that rocked the United States, reaching in excess of 9.4 and 9.1% in 2007 and 2011 respectively. The Euro Zone equally suffered equally rising rates of unemployment. See the figure below
In order to help fight off the global economic slowdown, coupled with the recessionary pressures in the economy, The Bank of England as well as the government resorted to expansionary monetary and fiscal policies in order to boost economic activity and growth. These included UK nationalization of Northern Rock on a limited scale and on larger scale, the Bank of England (BoE)’s slashing of the benchmark interest rate to 0.5% more than thirty months ago, in common with the major central banks across the world’s leading economies. In the United States, the Fed cut the bench mark interest rate to 0% to 0.25%; which was in emulation of Japan’s recession bursting monetary policies. Cutting the overnight borrowing rates effectively increase the money supply to the major financial institutions in the country, which consequently leads to the reduction in other interests that ultimately boost the availability of credit in the country.
Inevitably, increasing money supply results in the inflation and the increase in the country’s commodity’s prices that would make the country’s exports unattractive abroad. However, the BoF, which envisaged the inflationary effect of the increase in monetary policy to be about 2%, banked on the UK’s floating foreign exchange market, coupled with similar expansionary monetary policies both in the United States, Japan and the across Europe to offset the possible inflationary effect on the country’s exports. As a consequence, the pound registered a mild depreciation against the major trading currencies in 2007 and 2008. However, the slight depreciation in the pound has not been sufficient to absorb the effects of the expansionary monetary policy, hence the increase in the country’s inflation, to more than 100% of the BoE projected level of 2%. With equity market’s 17% forecast of a possible recession in the UK during the last quarter of the year, the BoE assessment of the inflation risks, which faces the rest of Europe and the economic growth objectives have resulted in it overlooking the inflationary pressures of its policies.
The reduced interest rates, especially with similar interest rate cuts across the major economies results in increased investment and consumer borrowing in the economy. This result in not only new investments, but an increase in the demand; which further boosts the increase in the economy’s output. Increasing output facilitates an increase in the demand for capital equipment and equally crucially (given the huge service industry in the UK) a rise in the demand for human capital and labor. These demands boost economic out and employment, which are responsible for the UK’s modest, but expanding GDP, even as the rest of its peers in the European Union and the rest of the world struggle with the slowing economies. A further reason as to why the BoE has maintained low interest rates in defiance of the inflationary pressures on the economy is the impact that increased money supply and availability of credit has on real GDP, which will ultimately absorb the increase in the money supply (The Telegraph, 2011). This stems from the fact that an increase in the volume and value of the economic activities, money supply would ultimately have to be increased, in order to avoid slowing down the economy. Thus with the growth in GDP, the Bank of England hopes the excess money supply would be absorbed, allowing for a possible increase in the bench mark rate of interest.
There are however, negative impacts of the expansionary monetary policy by the UK. To begin with, the soaring debt crisis in Europe, with its major economies struggling, have threatened to bring trigger a further banking crisis across the Union. The expectations of a possible depreciation of the Euro by the public, coupled with widespread expectations of a possible slump in the Euro Zone economy, will deter external investments and thus not foreign currency (Euro) inflows into the United Kingdom. The public’s confidence in the Euro has plummeted and thus despite the increasing supply of the pound, it is unlikely that it will depreciate against the continent’s leading currency, the Euro. As such, the effect of the expansionary monetary policy on the UK will be negative. This is not least because increasing the money stock without the immediate or modest expansion of the economy is only bound to lead to increased rates of inflation, which have devastating effects on the prices, investment returns and the incentives available for people to invest.
Effects of Low Benchmark Interest Rates on Real Estate
The real estate industry forms an important part of the UK economy, which makes the industry particularly sensitive to the changes in the economic and business environment, just as the economy is equally sensitive to the changes in the real estate industry (Brickley, Brickely, Smith & Zimmerman, 2008). The supply of property and the demand for real estate, both for residential and commercial purposes is influenced by a multiplicity of factors. These include government regulations, market imperfections and the condition in the financial markets. The effect of the financial markets on the real estate industry in the UK, the European Union and the United States is dependent on interest rates, which are majorly influenced by the respective nation’s central bank. This is not least because the supply of housing, land and commercial properties is subject to availability of funding for the suppliers. Given the fact that upwards of 74% of home owners in the United Kingdom are reliant on mortgage financing, coupled with a variety multiple credit facilities, the fluctuations in the cost of credit and the terms of these services is bound to have a bearing on the industry.
Short run Effects on the Market
A reduction in the bench mark interest rate results in a reduction in the interest rates of the intermediary financial institutions, which provide credit and financing for the real estate industry. A reduction in the costs of borrowing increases the incentives for consumers to borrow from the financial institutions, which boosts their spending and investment in the economy, including in housing. Increased lending and reduced costs of borrowing translates to reduced mortgage rates, long term loans, coupled with a reduced premium on savings, which reduces the economy’s marginal propensity to save, instead boosting consumer spending. These increased demand for housing, creates demand for residential housing as well as commercial properties. Increased demand raises the prices for properties, not least because the stock of properties in the market is a function of long term incomes and demand, as against short term increases in the same variables. Increasing prices of housing in the industry renders new investments profitable, enough to induce new investments to increase the stock of housing and properties in the market.
Long term Effects
However, the decisions to invest are subject to further environmental conditions in the financial markets. This stems from the fact that the largest proportion of real estate investments are usually mortgage backed, which effectively derive from other investments made by independent pension fund, independent investors, insurance companies, foreign governments and hedge funds among others. These investments are solely driven by the returns and safety of their mortgage securities as well fixed investments (Brickley, Brickely, Smith & Zimmerman, 2008). The returns and safety of investments do in turn derive from the prevailing inflation rates and perhaps most crucially, the prevailing benchmark interest rates. Inflation rates reduce the returns on long term investments, and thus reduce the incentives to invest, while the reduced bench mark interest rates reduce the cost of borrowing, which facilitates borrowing and further investments to make profit. As such, low bench mark interest rates will increase investments in the new stock of housing.
Increased output in the industry leads to increased demand for raw materials that include equipment, human capital and labor, which boost the incomes that in turn fuel a new wave of demand for housing as well as other commodities. As such, increasing the base interest rate would result into a rise in the market interest rates, which reduce the availability of credit, while at once discouraging borrowing. Consumers will resort to saving, while financial markets will equally reduce the availability of credit. The demand for housing will plummet, and with it, the fall in rents and prices. These will in turn lead to a recession in the real estate industry.
Conclusion
The recessionary pressures that hit the world in the wake of the global economic crisis bore testimony to the importance of the real estate industry to any economy. This is not least because the crisis stemmed from the real estate industry in the United States, but also because the industry comprises a considerable proportion of many countries’ economies. It is crucial that the measures taken by the UK government and Bank of England, in common with other governments across the world, to militate against the effects of the global financial crisis, are maintained until when the recessionary pressures are completely subdued. This will protect the UK’s real estate industry, as well as the rest of the economy from a relapse into a crisis.
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