In 2008 bank failures around the world sparked difficult trading conditions and a global economic slowdown. This reduced the amount of money available in the economy; governments started spending less on public services (e.g. schools, hospitals, police) and unemployment increased as firms attempted to reduce costs through redundancies. As there is less money for businesses and consumers to spend firms have to change their marketing activities during economic downturns. We felt that it may be useful to provide you with an article defining some of the terms and phrases you may hear in the news about the economic climate.
Definition of Recession
Difficult trading conditions have sent many countries around the world into recession. Recession is where the amount of goods produced by a country falls in two consecutive quarters of the year. For example if the amount of goods produced by a country were less in the second quarter of the year (April, May, June) than the first quarter of the year (January, February, March) and then after that if there was another fall so that the amount of goods produced by that country in the third quarter of the year (July, August, September) is less than the second quarter of the year. Economic activity in the UK is measured by the Office for National Statistics and is reported as a figure known as the Gross Domestic Product . The Gross Domestic Product is the total value of goods and services produced by a country over a set period.
Definition Of The Phrase "Double Dip Recession"
A double dip recession is when a country that managed to climb out of recession, falls back into recession. As the UK was last in recession in 2009, its current recession means that the UK is now experiencing a double dip recession. It is known as a double dip because if you drew a line showing how the economy was growing or shrinking, the line would go down (for the first recession), back up again for the period of growth and then back down again during the second recession.
Inflation and Deflation
Rising prices are known as inflation. Inflation is measured by countries because price rises affect how much money people and businesses have to spend. Countries measure inflation by looking how the price of a defined number of goods and services has changed over a set period. For example in the United Kingdom (UK) the Consumer Price Index and the Retail Price Index review the change in prices of things people spend their money on such as food, fuel, clothing and furniture. One of the differences between them is that RPI includes housing costs like mortgages and council tax but CPI does not.
Recession can lead to deflation; the reverse of inflation. Deflation is where prices drop as opposed to remaining constant or increasing. Deflation can adversely affect businesses, if it leads to reduced demand from buyers expecting future price decreases. It can also lead to reduced profits because businesses are forced to charge less for their goods or services.
Definition Of The Phrase "Austerity Measures"
Any action taken to reduce public spending is known as an austerity measure. Some countries have borrowed a lot of money and want to pay it back relatively quickly because the interest on the loans is expensive. Austerity measures are a way to raise money to pay back loans.
Definition Of The Phrase " The Credit Crunch"
Bank failures in 2008 made banks very cautious about lending money to each other and this reduced the amount of loan money available for consumers and businesses. When lenders decided to tighten their lending criteria for loans and mortgages, this became known as the "Credit Crunch" as many people and small businesses found it difficult to obtain credit (loans, mortgages etc).
Background To The Credit Crunch
Some banks decided to invest heavily in the US sub prime mortgage market. The sub prime market is very risky because it involves investing in stock market securities linked to mortgages given to people with poor credit ratings or low income. Many of the people with sub prime mortgages did not have the ability to pay back the money they had borrowed. This resulted in heavy losses and bank failures such as the collapse of US investment bank Lehman brothers in September 2008 and UK bank Northern Rock being taken into public ownership in February 2008; both banks had heavily invested in securities linked to the US sub prime mortgage market.
Why Did The Amount of Lending Reduce?
Banks and building societies lend money with the aim of making profit from the interest charged to the applicants taking out the loan. During the latter part of 2007 it started to become apparent that many individuals could not afford to pay back their mortgages and would make lenders a loss not profit. Investigations revealed that financial institutions had engaged in “risky” lending through:
Big lending multiples so that individuals were lent five to ten times their annual income
Lending to individuals with poor credit history e.g. missed loan repayments, defaults and court judgments against them
Lending to individuals on very low or no income other than state benefits
Not checking the information provided by the loan applicant e.g. wage slips to confirm income
Providing individuals with mortgages greater than the value of their property
100% mortgages so that the borrower did not need to contribute towards the purchase price of the property.
High street lenders borrow money from other financial institutions (via the money markets) and then lend the money they have borrowed to individuals and businesses. High street lenders make a profit by lending money at a high interest rate than the one they have paid to borrow the money.
After the news regarding risky lending practices broke, financial institutions became apprehensive about lending to each other. This apprehension reduced the amount of money available to high street lenders and led to an increase in the interest rates. The lack of credit available to high street lenders reduced the amount of credit offered by high street lenders to individuals and businesses. High street lenders also tightened their lending criteria through things like reducing lending multiples, only accepting individuals with excellent credit records and increasing the amount of money (deposit) people had to put towards the purchase price of their property.
When people take out a mortgage to buy their home, the loan money is said to be secured against their property. This means that if they are unable to make their mortgage payments each month, the lender will sell their property; the money from the sale of the property is used to pay back the mortgage. You may hear that during recessions the number of repossessions increase. This is because during a recession some people have less money for example if they have lost their job or through austerity measures leading to a reduction in state benefits. If people experience a reduction in income (have less money) they will often find it difficult to make mortgage payments.
In 2008 financial institutions wrote off (cancelled) loans that they felt would never be repaid by the individuals and organisations who borrowed the money. Loans that are unlikely to be repaid are known as toxic debt.
Credit Ratings for Countries
Countries often need to borrow money and just like people are assigned credit ratings based on how likely they are to pay back the money. A low credit rating will make borrowing money on the money markets expensive and a good credit rating will make it cheaper. Credit reference agencies such as Moodys, Fitch and Standard and Poor will regularly assess the economic outlook for a country and then assign it a rating with a letter from the alphabet. As the 3 agencies usually slightly different ratings a country may have more than one rating; AAA is the highest rating.