Last time we touched on the lack of confidence in the financial markets. This has now spread to the whole economy. The country is forecast to go from a very low savings ratio to a high one in the space of a few months. The National Institute of Economic and Social Research is forecasting an increase from 1.7% to 7.1%. This means that the individuals who have money aren’t spending it causing a large drop in consumer spending, especially on ‘big ticket’ items e.g. cars, causing a depression. This is Keynes’ paradox of thrift. 

The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The UK government is clearly concerned about the possibility of depression even if Gordon Brown retreated from his use of the word in Parliament.

Meanwhile others are concerned about future hyper-inflation brought about by excessive monetary stimulation now. It is believed that interest rate changes take around 18 months to take full effect. Rates have been cut aggressively from 5% on 8th October to 1% on 5th February – that’s only 120 days!

When weighing up the possible future scenarios (recession, depression, hyper inflation) one must bear in mind the de-leveraging of the financial sector, which is still taking place. Mervyn King estimated that two thirds of the increase in lending since the early 90s was to the financial sector. These institutions will carry on re-building their balance sheets by increasing margins and reducing risk. These financial constraints will prevent the economy from ‘exploding’ into hyper inflation. All we can do is wait and see.