The near-collapse of the western banking system in 2008 pulled the global economy into the bitterest recession since the 1930s. Policymakers responded, hesitantly at first, by applying the lessons learned since the days of J M Keynes. They slashed interest rates, rescued stricken banks and (mainly in consequence) ran up huge budget deficits. A catastrophe comparable to the Great Depression was averted. But it is not yet clear whether the medicine worked as intended. Recovery has not been consistent. The UK was the only one of the G7 advanced industrial economies not to emerge from recession in the third quarter.
Gordon Brown has continually depicted the recession as an external shock, brought about by problems in the US housing market. That is not true. The collapse of the market for US sub-prime mortgage market was only a symptom of the financial crisis. The cause was an explosion of credit. That was the handiwork of the banks. They assumed that a combination of easy monetary conditions, low inflation and the development of new financial instruments had reduced the risks of lending. Moreover, they reasoned, the inexorable rise of house prices would increase the value of the collateral for mortgage loans.
That assessment was terribly wrong. The UK economy became skewed by the stress on investment in property rather than in financial assets, the dominance of the financial services sector in the economy of the south east, and the dominance of London’s regional economy for the rest of the country. Those characteristics have prolonged the UK recession. The economy will recover, but the shape of that recovery is unclear.
Economists like to talk in images. The best case for the economy is that it will trace a V-shape, that is a sharp recovery after a deep trough. The cautionary tale for policymakers is that instead of a ‘V’, the economy might instead follow an L-shape, with prolonged stagnation, as happened in Japan for a decade after the deflation of a huge asset price bubble in the early 1990s. Those letters do not exhaust the alphabetical metaphors. There is also the possibility of a W-shaped recession, in which central bankers and the Treasury tighten policy too quickly and thereby cause another bout of economic contraction.
The economy will recover, but the shape of that recovery is unclear
The most likely course for the economy is in my view none of these, but something like a U-shaped recovery. Growth will have resumed by the time you read this, but the credit crisis of 2007-08 will have caused lasting damage to the economy. The after-effects will act as a constraint on medium-term growth. The biggest constraint is the huge expansion in government borrowing. On the Treasury’s own projection, the budget deficit will amount to £178 billion, or 13 per cent of GDP, in the current financial year. In the pit of the last recession, in 1992-93, the equivalent figure was 7 per cent. Even in the sterling crisis of 1975-76, the figure was just 8 per cent.
There was an impeccable theoretical case for the government to expand borrowing in a deep recession, and the shock of the banking crisis has no post-war precedent. But the peculiar weakness of the British economy is that the country went into this recession with a wide structural deficit. The central insight of Keynes was that capitalism is cyclically unstable: governments need to use monetary and fiscal measures to stabilise the economy. The corollary is that governments should build up budget surpluses during an economic expansion. When it came to office in 1997, that is what new Labour did. In its first two years, the government accepted the spending plans of its Conservative predecessor. Total managed expenditure in 1999-2000, at 37.7 per cent of GDP, was at its lowest level since the early 1960s. After the 2001 election, that fiscal discipline was abandoned.
Whichever party wins the general election of 2010, fiscal contraction will be a fact of economic life. Given the high levels of household debt, the burden of deficit reduction will need to be borne by cuts in public spending rather than tax rises, lest personal consumption be squeezed once more. Expansion will have to be supported by monetary policy.
The biggest risk to the UK economy in these circumstances is that consumer and business confidence might not pick up enough to sustain growth. In a new version of Keynes’s ’liquidity trap’, consumers will constrain their spending and businesses will not invest, even with interest rates that are close to zero. The first effects of the Bank of England’s policy of quantitative easing – expanding the money supply by buying government and corporate debt – would be higher inflation rather than a pick-up in economic activity. Welcome to the age of austerity.
Oliver Kamm is a leader writer and columnist for The Times