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THE FINANCIAL CRISIS AND ECONOMIC
STAGNATION IN BRITAIN
September 2012
Professor Michael C. Howard
(Principal Economist – CEI)
Prior to the onset of the financial crisis in the autumn of 2008, the British economy appeared to
be performing satisfactorily. GDP had grown at an annual rate of between 2% and 4% since the
beginning of 2000. Over the same period, inflation had been moderate (less than 3% per year),
unemployment quite low (usually around 5%), and although the annual budget and current
account deficits were persistent, they were not large (less than 3% of GDP). The ratio of public
debt to GDP stood at less than 45% for the whole period, which was modest when measured by
historical standards. Moreover, the British economy was widely regarded as ‘very modern’ owing
to the extensive program of neoliberalisation implemented by successive governments since the
1970s: the promotion of markets through privatization, deregulation, public sector
commercialization and outsourcing, and the reorientation of macroeconomic policy toward the
strict control of inflation by an ‘independent’ Bank of England. The “jewel in the crown” was
seen to be the financial centre located in the City of London, and rivaled only by that of New
York. Although concentrated in space, the City was widely advertised as benefiting the nation as
a whole through its provision of sophisticated financial services, the creation of many thousands
of highly paid occupations, and the generation of billions of pounds in tax revenue and foreign
exchange.
Gordon Brown, Chancellor of the Exchequer from 1997, and later Prime Minister, prided
himself on the success being generated by “light touch” regulation and the prudent
macroeconomic management that he had institutionalized, which ensured Britain would “not
return to boom and bust”. In stating this, Brown was enunciating his own version of what became
known globally as “the great moderation”. From the 1990s on, it was popular among economists
and finance specialists to claim that the latest general purpose technology centred on the
computer, married to neoliberal reforms and the novel management techniques of information
processing, along with new financial instruments providing more comprehensive insurance
against risks, including those involved in globalization, had made advanced capitalist economies
much more stable as well as efficient. The main threat was generally regarded to be inflation, but
the independence granted to central banks, with their sophisticated models of inflation targeting,
was believed to ensure that the threat would not materialize.
Naturally, the crisis came as a huge shock to conventional opinion, and especially because it
had originated in finance. So much so in fact that there have been repeated attempts to deflect
blame elsewhere by highlighting other problematic phenomena. The most persuasive arguments
are those that point to the record of large current account surpluses in the East causing the current
account deficits in the West during the preceding decade, which facilitated excessive credit
expansion and fueled asset price bubbles. However, even if it is accepted that other factors may
shed light on the crisis, there is a clear and categorical sense in which it is appropriate to declare
‘finance’ to be the cause of the crisis.
The financial sector has two intertwined functions in any capitalist economy. First, to provide
financial intermediation between borrowers and lenders, so facilitating the funding of investments
and the distribution of consumption through time. Second, to ensure that the associated assets and
liabilities are valued to reflect the risks entailed, and that they are allocated efficiently to
correspond to the risk preferences of lenders and borrowers. Joseph Schumpeter expressed all this
by characterizing finance as “the headquarters of the capitalist system, from which orders go out
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to its individual divisions”. However, perhaps a more appropriate metaphor is to say that finance
is the gatekeeper of intertemporal transactions, each of which receives a marker of relative
reliability. Thus, if finance is performing appropriately, dangerous transactions would either be
blocked or immediately assigned a suspect grade for all to see, and not result in a crisis like that
of 2008.
The crisis first emerged in American finance. The securitizations of trillions of dollars of
loans, principally mortgages, were based on wildly unreasonable risk assessments, and when the
mistakes became evident after the housing boom ended the securities were rapidly devalued,
causing serious problems for the balance sheets of many US financial companies. The effects
were not limited to the United States, and Britain was especially affected because of the large size
of its own financial sector and its intimate integration with American finance. Many British
financial institutions had portfolios which included large amounts of toxic American assets.
Moreover, domestic loans became suspect owing to the very large expansion of credit in Britain
over many years, and the use of similar risk models to those employed by American financiers.
Thus the true values of huge amounts of financial securities were put in question and interbank
lending and money market loans became scarcer and more costly. In effect, this was a modern
form of an old fashioned ‘bank run’, where depositors in banks demanded repayment en masse.
The banks typically found it impossible to honour their commitments because of the very nature
of banking - which necessarily involves lending ‘long’ and borrowing ‘short’. In 2008, depositors
were less important and more passive because of the insurance provided by states after the
experience of the Great Depression in the 1930s. But now financial institutions faced the problem
of meeting their obligations when short term loans from the wholesale markets became
significantly more expensive, or dried up altogether.
Without government intervention, significant numbers of financial institutions in most
advanced countries would have been bankrupted in short order. The principle of responsibility
was expressed by Mervyn King, Governor of the Bank of England, when he commented that
while banks may be “global in life” they become “national in death”. Therefore, Britain had to
take care of its own financial sector, which relative to the size of the national economy (and tax
base) was one of the largest in the world. Consequently, it was very expensive, but the
government did act decisively. Lender of last resort facilities were provided on a massive scale
and widened to include new institutions. Interbank lending and money market loans received a
state guarantee against default. Some financial companies obtained injections of equity and
became wholly of partially nationalized. The cost were enormous but they are impossible to
calculate with any precision because many of the measures cannot be accurately valued,
accounting conventions still allow the overvaluation of bank assets and undervaluation of their
liabilities, and the exact extent of government support has sometimes been hidden.
Clearly, ‘market rules of the game’ were suspended, and they had to be. Contemporary
capitalism in advanced countries is very different from its early modern predecessors, and the
financial system of a country like Britain is now infrastructural. If it seizes up, it can take the rest
of the economy with it. Nonetheless, the rules were suspended in a particularly disgraceful way.
Financial institutions were not only protected from bankruptcy, their shareholders and
bondholders were also shielded from losses, and bank executives were allowed to keep the
substantial bonuses they had received in the past on the basis of mistaken risk assessments.
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Furthermore, prosecutions for fraudulent behaviour were hardly ever initiated. In short, after a
long period in which profits were privatized, the losses were socialized, and those responsible
escaped punishment.
Even so, the British bail out proved insufficient to ‘normalize’ the financial sector, and there
was also a negative impact on overall economic activity. From the autumn of 2008 through 2009,
GDP declined by 6% - a faster rate of decline than that of the corresponding period of the Great
Depression in the 1930s. Measured unemployment stood at 8% at the end of 2009, nearly double
the pre-crisis rate. There were many forces of contraction at work. Bank lending to the private
sector dropped significantly, complemented by deleveraging by non-financial companies and
consumers who cut back on investments and raised their rates of saving
The contraction in economic activity was clearly the result of a fall in aggregate demand, not
the consequence of an adverse supply shock which impaired productive capacity. It would have
been far worse had not the public authorities acted to compensate with both fiscal and monetary
measures. The Bank of England cut the interest rates under its direct control almost to zero,
allowing the value of the pound to drop by a quarter, and seemingly ignored its inflation target.
The automatic stabilizers inherent in income support policies and taxation were unconstrained by
policy changes, and indeed discretionary fiscal policy supplemented their contribution in
maintaining aggregate demand. As a consequence the budget deficit doubled in 2008 from its
level a year earlier, and more than doubled again in 2009. The national debt as a percentage of
GDP had risen over 20% by the beginning of 2010.
This deterioration in the public finances caused much concern among members of the political
class in all parties. And, by the end of 2009, when it appeared that the contraction in GDP was
ending, there were tentative steps taken to move into fiscal reverse. However, this was taken
much further by the new Coalition government (of conservatives and liberal democrats) which
replaced the government of New Labour in May 2010. It moved quickly to implement fiscal
austerity on the assumption that the contraction and recovery were analogous to those of postwar
recessions. Thus it was assumed that loose monetary policy alone could close the gap between
actual and potential GDP, so returning the economy to the trend growth path. But this assumption
was erroneous. Britain, along with many other advanced economies, had not experienced a
normal recession. It was more accurate to describe the situation as one of depression which meant
(to quote Keynes) there was “a chronic condition of subnormal activity without marked tendency
towards recovery or towards complete collapse”. In such circumstances, many ‘normal’ economic
relationships change fundamentally and government policy ideally should remain unconventional,
at least until deleveraging in the private sector is close to completion.
The new coalition government made one other erroneous assumption, centred on the belief
that the economy could be protected from another serious financial crisis without fundamentally
changing the structure of finance and without regulating with a much ‘heavier touch’. It is in the
very nature of finance to generate instability unless it is contained in a way that inhibits the
operation of market forces. Finance is not like other economic activities, where markets can
usually be relied on to work reasonable well even with minimal regulation. Finance deals with
‘promises’, and very often complex promises, whose costs of production are considerably less
that the values promised. In a world where there are major informational imperfections, any
financial structure resembling that of free markets will not perform well. At the microeconomic
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level there will be many opportunities for fraud, and at the macroeconomic level there will be a
tendency to instability. In the boom, finance will supply too much credit, create bubbles and,
subsequently, they will burst. In the ensuing downturn, finance will supply too little credit and
worsen the deficiency in aggregate demand. This instability happens because the financial sector
as a whole creates economic effects that feedback to itself and signal reinforcement of the
expansionary or contractionary credit policy it is implementing. When credit is expanding and
boom occurs, the increase in economic activity signals that further credit expansion is a sound
policy. When credit contracts and downturn occurs, the decrease in economic activity signals that
credit contraction is a prudent policy.
The Coalition government’s economic program from its beginning has been composed of four
strands. First, there is fiscal austerity focused on large expenditure reductions rather than tax
increases. When first announced in 2010, the plan was to substantially reduce the budget deficit
and stabilize the public debt ratio in five years. Since then actual growth has been much slower
than forecast so the time frame has been extended, but there has been no overt change in policy.
Second, monetary policy was to remain loose in order to promote recovery, and this has been
implemented. The Bank of England has continued to maintain very low short term interest rates
and has engaged in periodic bouts of quantitative easing designed to reduce longer rates.
Moreover, the Bank has resolutely opposed modifying its policies in the face of headline inflation
rates exceeding its target for core inflation. Third, the government continued implementing
neoliberal policies, including plans to privatize various police functions and reduce income
support benefits to improve the incentives to take gainful employment. The rationale is the same
as it has always been, to promote efficiency, although the government seems to recognize that
any success will take many years to materialize. Fourth, the principal exceptions to further
neoliberalisation are the proposed reforms to the financial sector. The internal structure of large
banks will be altered so that deposit taking and retail lending are “ring-fenced” from other riskier
activities, and there are to be higher capital ratios imposed.
As already intimated, the major problems with this four-fold program concern the first and
fourth components: the fiscal austerity and the minimalist reform of the financial sector. Both are
wholly inappropriate in the face of depression conditions and the financial circumstances which
caused them, and the government’s justifications have been extraordinarily weak. On the fiscal
front, the usual nonsense of presenting the prudent household to be the model for government
expenditure and debt has figured repeatedly. A moments thought should have been sufficient to
reveal that it is no model at all because a household is so small relative to the size of the overall
economy that any decisions to reduce its expenditure and debt will not feedback to reduce its own
income to any discernable degree and, thereby, undermine its own savings and debt plans. The
British government is in a very different position because it is large relative to the size of the
economy. Thus, in present circumstances, decisions to reduce its own expenditure and Debt/GDP
ratio will encounter “the paradox of thrift” and the “paradox of deleveraging” because these
decisions will reduce GDP, and hence undermine success in achieving the targets for the deficit
and debt ratio. Nor does a household resemble the British government in being monetarily
sovereign, or sovereign in any other dimension either. These characteristics make states very
different types of entity from those which they rule, even if some members of the political class
are deluded into thinking otherwise.
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In a similar vein, the British government has claimed that any relaxation of fiscal austerity
would prompt the Bank of England to tighten monetary policy in order to offset its inflationary
effects. This ignores two brute facts: there remains considerable slack in the economy so an
acceleration of core inflation is not an immediate threat to relaxing austerity. Moreover, it is the
British government that sets the policy objectives of the Bank of England, whose ‘independence’
does not extend to choosing its own goals.
Only slightly less absurd is the government’s argument that the austerity program is actually
expansionary because it boosts confidence in the viability of public finances, so encouraging
companies and consumers to increase their own expenditures. Since ‘confidence’ is a nebulous
concept, the argument is difficult to falsify (or confirm). So far as the conventional measures are
concerned though, neither consumer confidence nor business confidence appears to have risen
because of government austerity. This is not surprising. Companies and consumers act in terms of
their own finances, not those of the state, and in the current circumstances fiscal austerity actually
reduces their incomes.
Of more substance is the fear that financial markets would raise interest rates on new issues of
British government debt if austerity is reversed, or even relaxed. However, these interest rates
have been historically low since 2008 and, even though public debt has risen substantially since
then, have continued on a downward path. Ten year government bonds currently yield 1.5%,
which may turn out to be a negative real rate (that is, after taking account of inflation). This really
does indicate that financial markets are unconcerned about public debt levels in Britain. And why
should they be? With inflation subdued and stagnation evident, the risk of loss through
unanticipated erosion of purchasing power is predictably low. Britain is also a monetarily
sovereign country that can borrow in its own currency, so it would never have to default on public
debt. Other advanced countries in a similar situation to Britain also have very low interest rates
even if they too have substantial deficits and debt. The situation in the Euro area is a very
different matter because no country which has adopted the Euro is monetarily sovereign and
defaults are a real possibility.
There is no disguising the fact that the governments own arguments in favour of fiscal
austerity are feeble, and underpinning them all is a misdiagnosis of the shortfall in aggregate
demand. Britain is not in a normal recession, double dip or otherwise. It is suffering from a
balance-sheet depression in which the private sector seeks to reduce debt by increasing savings
and thus reduces aggregate demand. This implies that the contractionary effects of fiscal austerity
cannot be offset by monetary policy. With interest rates along the yield curve already close to
zero, monetary expansion by the Bank of England is (in the words of Keynes) analogous to
“pushing on a string”. The effect at best will be marginal because nominal interest rates cannot be
reduced below zero. Thus purchasing government debt of any maturity, and thereby increasing
the monetary base, may reduce interest rates very slightly but the bulk of the money will be
hoarded by banks, companies and households for their own precautionary reasons.
The proposal of the government to end systemic risk by restructuring financial companies
through ring-fencing retail banking is minimalist and mistaken. In a world of imperfect
information, there will always be skepticism since ‘Chinese walls’ are known to be permeable,
and regulators are at a huge informational disadvantage in detecting the holes. Even if the walls
held, this would not allow the government to passively await the bankruptcy of any financial
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company because this could still be systemically threatening. After all, it was the insolvency of
Lehman Brothers in the autumn of 2008 which unleashed the financial crisis with full force, and
Lehman’s was an investment bank. Moreover, a major component of the crisis was the seizing up
of the interbank loan market, which arose because lenders had no way of knowing the current
values of the assets and liabilities of those financial companies requiring loans, and for obvious
reasons had become very cautious. Even aside from these problems, which would not be solved
by ring-fencing and higher capital ratios, there are many others? For example, assume ringfencing was successful, and everyone knew for certain that it was successful. Also assume that
there was a pure hedge fund, or a pure investment bank, experiencing difficulties. Could this be
considered to be systemically irrelevant and thus of little concern to the government? Hardly. The
executives of a company in financial distress might reasonable be expected to liquidate large parts
of the asset portfolio very rapidly as commitments came due. This could adversely affect a wide
spectrum of asset values and in so doing spread financial distress to other companies. Moreover,
this example is not purely hypothetical, but is constructed from what happened to an actual
hedge-fund, ‘Long Term Capital Management’, in 1998, and which prompted rapid intervention
by the Federal Reserve. Given the present potentialities for leverage in finance, a company with
quite a small capital base can be ‘too big to fail’. And even if we were to imagine companies each
of which were systemically irrelevant, in the aggregate they may not be. After all their asset
portfolios could well mirror each other, and the mistakes of one could then be the mistakes of all,
because they tend to use the same type of risk models in picking their assets and liabilities.
It is perhaps appropriate to interject at this point and repeat that the present British government
played no part in causing the financial crisis of 2008. Any governmental responsibility lies most
obviously with the previous governments of New Labour under Tony Blair and Gordon Brown,
whose conceit in having found ‘Third Way’ formulas for perfecting the world knew few bounds.
Their projects have collapsed like a house of cards and the present Coalition government
inherited the ruins. However, for all their criticisms of their predecessors, the new government in
2010 failed to properly diagnose what went wrong and the character of the effects it would have.
In consequence they adopted inappropriate policies to preclude a repeat performance or improve
on the present reality.
There are alternatives and none is more pressing than putting fiscal austerity into reverse.
Given the huge size of modern governments, this could be done in many ways, but the most
prudent would be to invest in new infrastructure on a grand scale. The London Tube, the
railways, the road network and airports are often thought of as national embarrassments and are
certainly in dire need of modernization and expansion. All such expenditures would increase
aggregate demand, while hastening the deleveraging in the private sector by making possible
more savings via a higher GDP. And, in the long run, the expenditures would prove to be hugely
beneficial in raising the productive capacity of the British economy.
Recently there have been signs that the government is ‘rethinking’ and moving in this
direction as criticism builds among its own supporters. Nonetheless, the reorientation appears to
be pathetic in ambition. Apparently, planned debt levels in the public sector are to remain
unaffected and financing is to be provided by raising prices for services in advance of any
improvements (which will negate the stimulus effects of the expenditures), and by outsourcing
projects to the private sector, which will be wasteful. Any private sector financing will come with
private ownership rights, yet will be contingent on government guarantees for the borrowings
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made and for the customer demands that will materialize when the projects are complete. In other
words the taxpayers bear a lot of the downside risks while the private owners will receive all of
the profits. That could prove very expensive for taxpayers in the future, as well as for future debt
levels, even if it does not impact the present level of the public debt (which seems to be the
government’s main fixation).
In effect, the coalition government is following in the steps of its New Labour predecessors
and interpreting neoliberalism as forming ‘public-private partnerships’. So far as infrastructure
projects are concerned the result will be indirect forms of state subsidy creating quasi-monopoly
positions for private companies - in short, a form of crony capitalism which compromises both
government and private businesses. And the efficiency gains are likely to be seriously reduced
compared to a more direct approach of employing consultants and private companies to design
and create publicly owned facilities.
Unfortunately, the government’s plans for the reorganization of finance are seriously deficient
in much the same way. The truth, unfortunate or otherwise, is that protecting the real economy
against the destabilizing potentialities of the financial sector requires a full-spectrum containment
of its activities, similar to that which prevailed during the postwar years prior to the neoliberal
deregulation. However, a simple reversal would not be appropriate because circumstances have
changed. The world is more globalized, there is a greater variety of potentially useful financial
instruments, and both companies and households require more financial services because they are
richer. But the basic principles of sound financial reorganization remain clear, and go far beyond
ring-fencing and higher capital ratios.
Certainly there needs to be more capital and less leverage throughout the financial sector. But
this needs to be coupled with limits on the size of individual companies and the organizational
separation of different types of financial activity. The forms of interaction of companies and
activities should be monitored and managed to inhibit threats to systemic stability. This means
inter alia that customized derivatives need special scrutiny and standardized derivatives should be
traded on exchanges where market risk assessments are made public. Accounting practices
require a thorough cleansing, while the legal definition of fraud needs to be made more sensible
and prosecutions undertaken on its basis. Equally obviously, any bonus payments made to
executives should be geared to very long-run performance.
However, not everything requires the heavy hand of government diktat. Much enhanced
performance in finance at the microeconomic level and the macroeconomic could be expected if
those who controlled financial companies had more ‘skin in the game’. If what they stood to lose
from high-risk actions were raised substantially they would behave more judiciously. So some
modification of limited liability status could be in order, along with the requirement that
executives be shareholders of substance. When the limited liability privilege was granted jointstock companies in the nineteenth century, critics pointed to obvious moral hazard concerns and
these seem to have been totally forgotten in the neoliberal age.
It might be objected that implementing such extensive financial repression would come at a
high cost in terms of lost efficiency. But as we have already argued, anything approximating ‘free
enterprise’ cannot be expected to be a productive system when the trade is in ‘promises’, which is
essentially what financial assets and liabilities are. Moreover, as Adair Turner, Chairman of the
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Financial Services Authority since September 2008 has argued, much of contemporary finance is
actually “extractive” rather than “productive”. It sucks value out of productive activities without
contributing very much in return. Because of this, such financial activity is not only “socially
useless” it is malignant. The really productive functions capable of being performed by finance
are the old fashioned sort centered on the allocation of capital, facilitating the smoothing of
consumption through time, and the assessment of risks. The financial innovations of the
neoliberal age were once described by Paul Volker, Chairman of the Federal Reserve in the
Reagan Administration, as unproductive except for ATMs. This is an exaggeration, but the
underlying sentiment is a wise one.
It might also be objected that financial reform will be costly to the banks and thus further
reduce their credit creation, making economic performance even worse than in the present
circumstances. Moreover, the more radical is the reform, the greater will be the contraction of
credit and deterioration in economic activity. Stated in this way, the argument has some force,
and it seems to have affected the government’s policy because even its own minimalist reforms of
finance are to be delayed for many years. But no government need be intimidated in this way.
They have the authority to set up state banks, charter new private banks and provide incentives to
existing banks to expand credit to the domestic economy. Financial reform does not have to stop
at restructuring and re-regulating the existing institutions.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The current state of the British economy is dire. GDP is about 5% below the pre-crisis peak
and approximately 15% below pre-crisis trend, while economic growth is negative. Measured
unemployment is above 8%, and certainly an underestimate of the true rate. Moreover, the
medium term outlook is dark. The austerity plan of the government has barely begun, and the
Euro zone - Britain’s principal export market and an area to which the British banking system is
strongly linked - is in the process of disintegration. Nowhere else of any significance in the world
is experiencing robust expansion. Furthermore, the longer stagnation (or worse) persists, the more
there are adverse effects on long term productive capacity and human misery. Companies will
have cut back more on their investments and the technical progress embodied in them, while the
skills of the unemployed will have eroded even further. Simultaneously, the longer depression
conditions continue, the more they induce pessimism in assessments of saving needs, so
stagnation gets ‘locked-in’. At the same time the British financial sector remains essentially
unreformed and hence poses the ever-present danger of hatching a new financial crisis. There is
really nothing to be optimistic about.
M.C. Howard, CEI International and University of Waterloo, Canada.
L.E. Azarova, Innovative University of Eurasia, Kazakhstan.
July 2012.
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References
J. Cassidy, How Markets Fail: The Logic of Economic Calamities (Toronto: Penguin, 2009).
P. Coggan, Paper Promises: Money, Debt and the New World Order (London: Allen Lane, 2011).
P. Krugman, End This Depression Now! (New York: Norton, 2012).
J. Quiggin, Zombie Economics: How Dead Ideas Still Walk Among Us (Princeton: Princeton
University Press, 2010).
D. Romer, “What Have We Learned about Fiscal Policy from the Crisis?”, IMF Conference on
Macro and Growth Policies in the Wake of the Crisis, March 7th and 8th, 2011, Washington, DC.
www.imf.org
N. N. Taleb, The Black Swan: the Impact of the Highly Improbable (New York: Random House,
2007).
A. Turner, Economics after the Crisis: Objectives and Means (Cambridge, Mass: MIT Press,
2012).
M. Wolf, Fixing Global Finance (Baltimore: John Hopkins University Press, 2010).
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