How economic policy played its part in the Crash and how it can shape our ability to deal with or avoid the next crash.
What went wrong?
This is a highly disputed issue. There are two main versions that have been debated since the Crash on the role UK government’s economic policy played or didn’t play in acerbating the effects of the Crash.
One says the public debt rose – as a consequence of the implosion of the British banking system which is at the heart of the global financial system: that it was the private financial and debt crisis that caused the rise in the public deficit, and not the public sector. The other stresses that the Labour Government’s policies of running deficits from 2002 to 2007 left the UK economy particularly vulnerable and so are to blame for the levels of debt inherited by the Coalition Government.
The latter version has tended to be dominant as the Coalition Government has in general successfully argued that the previous Labour Government was responsible for the impacts of the Crash. However other commentators such as Mervyn King the Governor of the Bank of England at the time have been less willing to point the finger of blame suggesting it is more collective.
So what is the answer? As can be seen from the chart below, public debt under Labour was not particularly significant until after the Crash, suggesting that the debt was an effect rather than a cause. Furthermore what can be seen is that private debt was growing at a very fast rate prior to the Crash. This is seen by many as the key factor that causes crashes. In particular Richard Vague, a successful US banker, has analysed data from all crashes and found this to be the common factor – see here for further information.
However in the context of major countries in Europe, the UK may have been in the weakest position with respect to its finances at the beginning of the crisis, both because of the size and impact of the collapse of the banking system in relation to UK GDP, but also because public spending had risen under the Labour government.
It is generally agreed that a key issue was a policy of light regulation of financial transactions, which was supported by both the Labour and Coalition governments and their opposition. Others actually go even further, suggesting that the so-called ‘Finance Curse‘: the huge relative size of the finance sector, which is particular to the UK, actually distorts economic policy overall.
What happened next?
A short period of expansionary fiscal policy was followed by unprecedented austerity.
Once the recession hit in 2008/9, Gross Domestic Product (the key measure of economic health) fell by 6.3%, leading government revenues to decline steeply and the costs of supporting those who were vulnerable to rise. This reflected a pattern around the world leading the G20 leaders to meet in London in April 2009 to agree a global stimulus package worth $5trillion (see report) to ‘save the world’. This was a classic Keynesian fiscal measure that had been out of favour since the 70s.
However, once in power in 2010, the Coalition government changed direction, with talk of ‘rebalancing’ the economy. The then Chancellor of the Exchequer George Osborne said:
The economics profession is in broad agreement that the recovery will only be sustainable if it is accompanied by an internal and external rebalancing of our economy.
This was portrayed as part of a wider need for economic reform away from an oversized public sector. As the newly-elected Prime Minister David Cameron stated:
“The economy has become over-reliant on welfare, with mass worklessness accepted as a fact of life and around five million people now on ‘out of work’ benefits. It has become increasingly hostile to enterprise and far too dependent on the public sector”. Read more here
This started a period of unprecedented austerity with reductions in corporate and personal taxation, and cuts to public expenditure such as on benefits, which has been highly controversial. Some, like the Coalition Government, saw it as essential to maintain economic credibility, read more here. However, many economists, some claim a majority, see it as making no sense economically (e.g. Professor Simon Wren Lewis) as it stokes debt by suppressing economic activity and reducing tax receipts. In fact debt has continued to increase and targets to reduce it set by successive governments have been missed and abandoned with debt levels now reaching 90% of GDP.
There was a very active monetary policy with very low interest rates and huge injections of liquidity into banks
During this period, the UK and other countries had a very active monetary policy keeping interest rates very low and also putting substantial funds into Quantitative Easing, which increased the available short-term money supply. The idea behind this was that as a result banks would lend more to drive growth in the economy. In fact, many argue (e.g. see Ann Pettifor) that it fuelled asset value inflation including the housing market, as the money was used to speculate on an increase in asset values rather than being lent to the productive economy.
Meanwhile productivity has gone backwards in the UK
During the period 2006-16, world productivity growth has been very low and UK productivity growth worst of all. This is seen as a fundamental economic policy problem. As Andy Haldane, Chief Economist at the Bank of England stated in March 2017, see relevant speech:
For the past decade, average productivity growth has been negative. This is unusual, if not unique, historically. You would have to go right back to the 18th century to see a similarly lengthy period of stagnant productivity.
One might have expected a one-off hit due to the Crash but ongoing slow growth has become known as the ‘productivity puzzle’ sparking ongoing debate on what is going on. In the UK, a key issue is the wide disparity of productivity claimed to affect inequality. In December 2016 the CBI published a major report by McKinsey’s Unlocking Regional Growth (read more here). This was based on detailed local data and showed wide disparity in productivity across the UK which they put down (in order of importance) to i) educational & skills, ii) transport infrastructure, iii) management and iv) lack of export orientation.
As a result the balance of payments has deteriorated significantly, sucking resources out of the UK
The current account has been consistently negative for some time, but since the Crash has deteriorated significantly as a percentage of GDP.
What is the outlook?
Currently, future policy on fiscal policy, and tax and spend, in the UK is highly disputed. However it is clear that the Government see tackling productivity as the key way forward, as evidenced by Phillip Hammond’s Mansion House speech on 26 June 2017:
Productivity is the elixir that raises incomes and living standards, and it must be a national priority to make every learner more skilled; every worker more productive; every business more competitive; and every public service more efficient.
That is the route to higher wages, higher quality public services, and a brighter future.
A key element of this was the Coalition Government’s rediscovery of industrial strategy, which the current Conservative Government is building on, as Vince Cable explained in The Mint. The Industrial Strategy Commission have just published an interim report (PDF) suggesting there is a need for radical institutional reform to support an effective industrial strategy. The Government has yet to respond.
The Labour opposition has focussed more on the need for public spending and it is clear following the 2017 General Election that there is increasing support amongst the electorate for taxes and spending to increase:
Monetary policy remains the same but there are questions as to how long such extremely low interest rates and high levels of quantitative easing can go on. There are also concerns as to how quantitative easing can be ‘switched off’ without a shock to an economy which has become ‘used’ to it.
The most important issue may be how Brexit affects the economy as recently discussed by Frances Coppola, Angus Armstrong and Steve Keen. Again Government policy on this is still developing with different views across the political spectrum.