In the latest issue of the Deloitte Economic Review, our Economic Adviser, Roger Bootle, considers just how bad the economic fallout from the credit crunch will be. His main points are as follows:

• Recently announced measures by the UK Government and other world policymakers have avoided the unthinkable scenario of a full-scale meltdown in the UK and global banking and financial systems. Nonetheless, the bulk of the economic fallout has yet to be felt. The UK is heading for a recession broadly similar in depth to that of the early 1990s.
• Despite the Government’s best efforts, the recapitalisation of the banking system is unlikely to prevent a major slowdown in the growth of bank lending to households and companies. Moreover, even if the supply is there, in the current environment it is unlikely that the demand will be.
• The triple whammy of plummeting house prices, sluggish income growth and soaring inflation is already weighing down on consumer spending growth and will continue to do so for some time yet. This will contribute to a further fall in company profits, which in turn will compound the recent slump in business investment.
• The result will be a major rise in unemployment. I expect that on its widest measure, the number of unemployed workers will rise by 1.5 million over the next two years, adding to the downward pressure on house prices and consumer spending. This would push the unemployment rate up to 9%, the likes of which haven’t been seen since the years after the early 1990s recession.
• Against this background, concerns over inflation will continue to fade rapidly. Having peaked at a little over 5%, consumer price inflation will plummet to around 1% by the autumn of 2009. And if oil and food prices fall much further, the UK could drop into deflation.
• Faced with such a prospect, the MPC will slash interest rates very aggressively. I now expect interest rates to fall to 2.5% next year, their lowest level since 1951. And they may have to fall beneath their previous all-time low of 2%.
• But even such a sharp drop in rates won’t stop the economy from contracting sharply over the next two years. It is too late to stop this now. All the policymakers can do is to try to limit the depth and duration of the recession. I now expect GDP to fall by a full 1% in 2009 and by another 0.5% in 2010. This would put the current downturn in the same league as that of the early 1990s, when output fell by 2.5%.
• Things could be even worse if a more vicious circle between events in the real economy and the financial markets develops. In perhaps the very worst case scenario, this could prompt a fall in the price level and a bout of Japanese style “debt-deflation”.
• Looking a bit further ahead, the economy is unlikely to recover very quickly either. History shows that the economic fallout from previous financial crises has often lasted for a number of years.
• What’s more, the need for a major fiscal consolidation – as the Government moves to plug the huge hole blown in the public finances by the nationalisation of some banks and the recapitalisation of others – will limit the extent of the recovery. This underlines the need for interest rates to remain low for a prolonged period.
• That all said, I think there are three reasons to be less than apocalyptic. First, the sharp fall in commodity prices – which I expect to continue – will allow households’ real incomes to start growing again. Second, low interest rates will eventually bolster demand. Third, once the world economy recovers, the significant fall in the pound seen over the last year will increase the competitiveness of UK exporters in overseas markets and boost net exports.
• Although it might not feel like it now, a few years down the line we might be thanking the credit crisis for shaking up the financial system and making its institutions healthier – and better able to contribute to the future progress of society at large.

For further information, download the full publication Economic Review Staring into the abyss. (PDF, 1311KB)

Notes
This press release has been prepared by Roger Bootle, Economic Adviser to Deloitte.  If you have any questions regarding the views in it, please contact Roger Bootle directly on 07887 955 875 or 020 7823 5000 or via email on business@capitaleconomics.com.

This press release contains general information only and is not intended to be comprehensive nor to provide professional advice.  It is not a substitute for such professional advice and should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business.  Deloitte & Touche LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from acting as a result of any material in this publication.

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