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Tuesday, 30 August 2011

Debt Crisis: Is The Great Reckoning Upon Us?

Gordon Brown: one of the chief architects.

In response to the crisis of 2008, UK policy-makers did five key things:

1. They bailed out a number of banks that had inadequate capital.
2. They insisted that banks that were not bailed out had to raise additional capital privately.
3. They raised spending, by around £110 billion (mainly by continuing with previously-scheduled large. spending rises even though the situation had changed).
4. They enacted a temporary tax cut (around £12.5 billion).
5. They printed money (around £200 billion).

Of these policies, the first three were serious errors. The last (money-printing) was done well, and was the key reason for the growth from mid-2009 to mid-2010. The temporary tax cut was in principle a good idea, though it would have been better to have cut income tax than VAT. And if we had not done the ill-conceived spending rises, we could have made the temporary tax cut at least three times (perhaps six times) as big. Extensive academic studies have demonstrated that temporary tax cuts provide much more effective stimulus than spending rises (indeed, since spending rises may be believed to be permanent – as they often are – they can make households and businesses believe that the medium-term growth outlook is worse (as it would be if the public spending stayed up) and thus actually damage growth even in the short term.

However, although raising spending was an error, much the worst error was bailing out the banks. As of 2008, the situations in the UK, Spain and Ireland were all fairly similar: each had had a serious housing bubble; each had banking sectors of above 400 per cent of GDP; none of them had particular high government debt; all had government deficits headed towards 10 per cent of GDP. There was no intrinsic way for us to know that Ireland would be very rapidly ruined by its decision to bail out the banks, whilst in Britain it would be more drawn out, and in Spain matters would be somewhere in between. Irish nominal GDP shrank by around 20 per cent in 2008/9. (The worst recession of the past century in Britain was that of the early 1920s, when nominal GDP shrank by around 28 per cent.)

Bailing out the banks meant that the governments of Britain, Ireland, Spain and elsewhere took onto the public balance sheet the liabilities of the banking sector. (I occasionally read articles suggesting that this is true in a metaphorical sense, because of the large deficits run. No. It is true in a literal sense. According to National Statistics, the liabilities of RBS and Lloyds are UK government liabilities.) This overstretch in the government balance sheet is a key reason the government needs to cut the deficit as quickly as it does – without the commitments to the banks, we would have been able to run larger deficits for longer (especially if those deficits were the result of temporary tax cuts).

I would have opposed bailing out the banks even if I had been certain it would “work” in its own terms. It is immoral to tax poor people to keep rich people rich, despite their bad investment choices, and it destroys the functioning of capitalism. But there was always the danger that – as in Ireland – they wouldn’t work in any sense, but would simply bankrupt the governments involved. The crisis of 2008/9 was not simply a liquidity crisis. It was not the result of market irrationality. It was not even simply a matter of insolvency arising from past losses. In a number of cases the business models of financial institutions were no longer going concerns – they were value-destroying enterprises, not value-creating ones. This was not simply a matter of gambles with fancy financial derivatives. Even before the bonds market madness of 2005-7, around 30 per cent of the gross income of European retail banking came from mortgages. But mortgage volumes remain way down on their mid-2000s levels, and even when they come back the value of transactions will be much lower. The only way a number of these business could continue without significant restructuring of the sort that would occur under administration is for governments to provide an ongoing stream of subsidies.

Recent developments in financial markets suggest that we may soon face a Great Reckoning for the policy errors of 2008/9. Some bank shares are now worth less than before nationalisation; the cost of insuring the debts of some banks has recently been higher than the 2008 peaks. Governments have been arrogant in assuming themselves capable of bailing out some of these monster banks, when they had made such bad losses. They have been deluded in assuming that significant structural change was not required in the banking sector. There is now a significant risk that, around Europe in particular, many state-owned banks will go bust, despite government backing. If it happens, this is likely to bring down governments – indeed, may even lead to constitutional overthrows in two or three countries. The consequence could be another recession as bad to twice as bad as that of 2008/9.

In countries such as Britain and Ireland and Spain, that ought to have been OK. Public debt – setting aside banking sector liabilities – is not at critical levels even now. We ought to be able to cut taxes temporarily, increase deficits, and see ourselves through in the normal way. Unfortunately, because of government over-commitments in the banking sector, we will struggle to maintain solvency even by cutting spending as aggressively as is politically deliverable.

A further phase of recession (indeed, even simply tepid growth) will necessitate further spending cuts. The UK political debate is still stuck in an absurd situation in which a supposedly-serious political party, egged on by quite a section of the press, still wants to pretend that the alternative to the Coalition’s programme would be to cut spending less and cut slower. The truth is that we are likely to have to cut spending more and faster. Indeed, there is a chance that we shall yet be forced to cut spending much faster – including on sacred cows like health – because a further phase of recession could well lead financial markets to lose confidence in our government’s bonds, as they have lost confidence in the bonds of other governments.

Much of this was avoidable. We did not need to bail out the banks, bankrupting multiple governments in the process. There were alternatives, such as imposing debt-equity swaps. We did not need to whack up spending, undermining long-term growth rates. We could have kept spending under control and instead cut taxes.

Four years after the financial crisis began, in the summer of 2007, we still send tens of billions more, every few months, to bail out the banks – though these days we have rebranded our banking sector bailouts “sovereign debt bailouts”. The patience of taxpayers with such nonsense is an affront to democracy – No. More than that: democracy has failed, and in a number of European states political upheaval may (justly) be part of a Great Reckoning.

Perhaps we shall muddle through, for a little while yet, with policy errors simply leading to hidden damage and injustice – as usual. But if, despite the trillions poured into them, large government-backed banks now go bust, dragging down their states’ solvency in the process, the bailouts of 2008/9 will go down as the greatest economic folly in history. And I shall be bitter and ungracious enough to say: I told you so.

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