Facing Upto Our Economic Reality
July 10, 2009
Too few of my parliamentary colleagues have woken up to the enormity of the debt crisis that follows hot on the heels from the economic downturn. Yet the seriousness of what will follow cannot be long denied.
For sure, technically the worst of the economic recession may now be behind us although it would be premature to conclude that a ‘double-dip’ recession is not on the cards as the effect of the stimulus dies off in the New Year. Amidst some of the glib green-shoots commentary, we should also understand that the banking crisis represented nothing unusual. Indeed it signalled the end of another in a long line of boom/bust cycles (positively commonplace in the second half of the last century) caused by speculative euphoria and an excess of credit.
The crisis is being presented to serve narrow interests as being an entirely unprecedented type of downturn caused by modern financial alchemy gone wrong, failure by regulators or rank unforeseeable misfortune. This is not so. It is true that the global nature of the economic crisis has made things worse. But there are also clear lessons we can learn from the past. One of the grand old names of British banking, Barings, collapsed owing £780 million only fourteen years ago; today RBS survives courtesy of a £26 billion bailout. But it is only the extent of the economic downturn, not its cause that is so very different.
The UK economic downturn began when household debt and housing bubbles simultaneously burst. Our house prices rose 88.5% in the decade to 2007 – even in the sub-prime enhanced US this index rose by only 64.5%. Our average household debt leapt from 105% in 1997 to 177% of disposable income a decade later – in Europe and the US both the overall levels and increases during this period were significantly lower. The toleration and promotion of these debt bubbles alongside the growth in financial services and property industries was an integral part of the government’s narrative of creating an economic miracle. It had long since given up on encouraging old-school manufacturing and needed to find favour amongst middle income Britain’s to secure electoral support.
The past decade seemed for so long like the best of times. However, in our complacency we planted the seeds of catastrophe. Consumer consumption in the US and Europe was maintained by unsustainable levels of public and private debt. The dotcom revolution was heralded as a ‘new paradigm’, so whilst almost imperceptibly the wages of middle income earners stagnated, consumption in a low inflation, low interest rate economy remained apparently robust. In truth – as we have seen – the ‘new’ economy was sustained by an old-fashioned private debt bubble. Cheap mortgages remained eminently affordable by virtue of the deflationary effects of China and India’s emergence on the global economic scene. The Clinton administration’s deregulatory policies promoted a love affair with home ownership in the US previously seen only in the UK. Millions of families – including latterly many of the sub-prime borrowers – were able to clamber for the first time onto the property ladder. For so long as the housing bubble inflated, this new breed of property owner was able to borrow yet more on the back of rising house prices. Naturally this also happened with a vengeance on these shores as became startlingly apparent with the demise of Northern Rock.
As the level of private debt reached dizzy heights the financial risk to the general taxpayer of widespread default suddenly got a whole lot more serious. As we now know there was good cause for retaining the distinction between retail and investment banking, which in the US at least existed for over six decades until the repeal of Glass-Steagall in 1999. Little did we know that the inherent risk of investment banking was to be transferred not to retail banking depositors but to global government balance sheets. Instinctively bankers understood this and once their institutions became too big to be allowed to fail, they had precisely zero incentive to minimise danger. On the contrary investment banking’s short-termist bonus culture positively encouraged reckless risk taking.
The abiding lesson of the global banking bailouts is that in future no institution should be allowed to become so large that it cannot be allowed to fail. That way lies the madness of ever more public exposure to financial calamity. An effective regulatory regime requires the eradication of, rather than reward for, risk taking. It must avoid the creation of barriers to entry that favour large established corporations over entrepreneurial start-ups. Hence the Conservatives’ support for a future banking industry made up of smaller, more competitive institutions.
However, there is an uneasy feeling that banking is fast returning to ‘business as usual’. Public anger at the proposed £10 million bonus package for the new top team at RBS would perhaps be better directed towards ensuring that risk-taking in future is better managed. Indeed the crisis of the past nine months has seen those banks that have not collapsed, disappeared or been nationalised suddenly become markedly more profitable as competition has fallen away. Yet whilst money flows again into the hands of bankers the essential structure of the industry remains intact – in short, the taxpayer will be the lender of last resort if all goes wrong. Small wonder that even some Conservative commentators support the notion that banking as a sector whose failure threatens the entire economy must have some added costs and regulatory restraints imposed upon it. After all, the debt now facing future generations of taxpayers courtesy of this banking-led credit catastrophe is more than was ever racked up to fight two world wars. Let’s not even speculate at the inflationary prospects ahead if Quantitative Easing proves overly effective.
I have written before about the colossal trade imbalances between the West and China which have spawned a fatal interdependency. This has been made worse by the ending over recent decades of both the gold standard and capital controls, the mechanisms by which trade imbalances were traditionally kept in check. Consequently since the late 1970s the UK and US have borrowed incrementally more and exported ever less whilst China, especially over the past decade and a half, has built up a huge current account surplus.
Arguably it is these imbalances rather than inadequate regulation that have been the cause of the economic calamity that has beset the global monetary system. A new international framework to secure stability in the management of global trade and the flow of money within the world economy is now overdue.
This economic downturn has been unique in its dramatic global effect. But the core causes are not so very different from what we have seen before. As a result the solutions do not require a bewildering racking-up of unimaginable levels of debt for future generations of taxpayers. Indeed nothing will more certainly hinder our prospects of rapid economic recovery and a sustainable return to improved living standards.
The biggest threat in the years ahead is that the indiscriminate pumping of money by the Bank of England into the economy will bring with it an unsustainable mini-boom. Thereafter a combination of inflation, rising unemployment, weak growth and diminished competitiveness will produce a toxic mix of stagflation – truly a ‘back to the 1970s’ phenomenon. The worst case scenario here is that a future government may regard a sustained dose of inflation as the quickest and most politically convenient way of helping bring down the level of public debt.
In truth, any UK government that is regarded as popular in 2011 and 2012 is probably not administering effective economic medicine. To do the right thing on tax and expenditure in the years to come will not be seen as a politically easy option.
This year, if we follow the government’s almost certainly optimistic predictions, we shall be borrowing – I repeat, borrowing, not spending – £450 million each and every day. As such for every £3 raised in taxes in 2009, the government is spending £4. None of this can remotely be regarded as investment – this is consumption plain and simple. The billions being borrowed now to ease the impact of the downturn for today’s electors will be repaid by future generations in the form of higher spending, higher inflation and reduced living standards. Yet the true cost of all this will not become apparent in the months ahead. The government is desperately hoping these sands of time nor the patience and goodwill of an increasingly alarmed gilt and bonds market do not run out before it has to face the voters. Which makes talk of economic recovery now so very dangerous. This is not a simple, binary choice of ‘cuts’ set against ‘investment’. There is a hard slog ahead for any administration.
If political leaders are unwilling to face up to the stark facts of this long march back to fiscal balance and economic recovery it may even be necessary to bring in the IMF. What better way to encapsulate the power of the quangocracy we have built up for a political class unwilling to take responsibility or court unpopularity than to bring in a neutral umpire to make the really tough decisions on public spending?