Sustainable recovery after a financial crisis is a long haul
March 6, 2016
The UK economy was critically exposed when the global financial crisis of liquidity and solvency hit in 2007-08. Yet it is impossible to see how this fate might have been avoided given the importance and size of the City of London with its financial services expertise.
Nevertheless it became clear as the crisis unfolded that these inherent vulnerabilities had been compounded by profound policy failures and complacency under the Brown chancellorship. From the turn of the century onwards expectations of welfare and healthcare entitlements had been systematically ramped up with the commensurate structural uplift in public expenditure that has proved difficult to tame ever since. However, this spending splurge was funded by a windfall in receipts from the financial services industry and a property boom, which Brown & Co regarded as a permanent feature of the economic landscape.
The last Labour administration spent up to and, as we now know, well beyond this illusory expansion in the UK’s tax base. When the money ran out, widespread expectations about entitlement sadly did not. We are still living with the consequences: a persistent, dangerously high deficit with its affordability apparently sustained only by the maintenance of an emergency interest rates regime now in its eighth year.
Perhaps even more cause for concern has been the continued difficulty even in the past half-decade of addressing poor UK labour productivity. Regrettably in his Autumn Statement, political pressure saw Chancellor George Osborne back down from his attempts to deal with the distorting impact of in-work benefits (working tax credits). First introduced in 1997 by then-chancellor Gordon Brown, who had faithfully assured his Downing Street neighbour that their annual cost would never exceed £600 million, on average the Treasury has spent almost £10 billion per annum on working tax credits since 2010.
While part of the Osborne’s laudable strategy to create a low tax, high wage economy, a corresponding hike in the minimum wage while benefits are pared back could serve to compound the problem. The stark truth is that for too long, millions of our fellow Britons have lacked the skills or consistent record of employment to justify their level of workplace earnings in what is a highly competitive global economy. Incidentally this is one of the key reasons why many employers prefer to take on migrant labour in relatively low-skilled occupations.
The government is addressing this issue aggressively through infrastructure investment, increases in public service efficiency, projects such as the Northern Powerhouse and the radical education reforms started by Michael Gove. But these policies will take time to bear fruit. The risk in the meantime is that the relatively unskilled will find employers who will regard the enhanced statutory minimum wage as a maximum to be paid. If employers continue to believe that any shortfall between a statutory minimum wages entitlement and the wage level required to be ‘better off in work’ will continue to be covered by the state, the incentive to pay more or to ensure a properly skilled workforce is substantially reduced.
Once again, current policy designed to promote social cohesion kicks into the longer grass the need to make tough decisions. All of this harms the future competitiveness of the UK economy in the global race. Yet unless the underlying weaknesses and problems are properly tackled the near collapse brought about as a consequence of a global financial crisis simply persists. In Saving the City – The Great Financial Crisis of 1914, Professor Richard Roberts of King’s College London narrates the feverish activity that followed the seizing up of global financial markets and eventually culminated in the declaration of the Great War. London’s Stock Exchange closed for five months as free, open markets, as understood at the time, were fundamentally distorted by central bank intervention.
The disorientation takes time – as we have witnessed since 2008 – to work its way through the economic system. A vast injection of liquidity designed to stave off imminent insolvency within the financial markets inevitably can only be reversed carefully. Even now there is no sign that the £375bn of quantitative easing will any time soon be pared down by the Bank of England, and this March will represent the seventh anniversary of the imposition of a record low 0.5% interest rate. Worryingly, if understandably, this artificially low cost of borrowing is now regarded by millions of Britons as the new norm as they juggle household debts and contemplate taking on mortgage commitments. Moreover, the prolonged intervention distorts the lending policies of banks and their approach to foreclosure, not least when – in the aftermath of 1914, as today – indirect pressure is imposed from Whitehall to carry out political priorities.
So the real question is: what happens now? The Chancellor rightly warned of a ‘dangerous cocktail of new economic threats’ as 2016 dawned. Until recent weeks the conventional wisdom has been that slowly but surely the world economy is on the road to recovery – the financial system has been rescued, the Eurozone crisis contained and the overall debt burden steadily dealt with. The parallels with the world of nine decades ago are stark – then the end of wartime hostilities lulled policymakers of the time into believing that all would now return to ‘business as usual’. Is that not, in our hearts, where we are today? For all the talk of creating a culture of investment and export-led growth, of a radical makeover for the UK economy moving away from reliance on borrowing, arguably a large chunk of the growth our economy has seen comes courtesy of debt-fuelled consumption and a renewed housing and property boom.
This matters because the reputational importance of the City to the UK economy as a whole means that the successful management out of any financial crisis is of key strategic importance to the nation. It is also often assumed that banks have become more risk averse since in the aftermath of a major crisis the regulatory framework tightens and capital requirements become more stringent. However, as memories fade, future generations convince themselves that ‘next time will be different’ and as recovery takes hold and markets pick up, the easiest way to maximise returns is to take more risks. And so it goes on…
The seeds of the 1930s Depression were sowed in part by poor policymaking outcomes, a series of missed opportunities and political complacency in the aftermath of the financial crunch brought about by the headlong rush to war in 1914.
In the modern era the Treasury has discovered that it has not been so easy to adapt the UK economy towards a versatile future on the global stage following the financial crisis of 2007-08, not least as a consequence of the pronounced sense of entitlement and expectation that hinders plans to reduce public expenditure. George Osborne has repeated the mantra – an echo of Angela Merkel’s strictures to the EU – that the UK has one per cent of the world’s population, four per cent of global GDP, but seven per cent of global welfare spending, and in highlighting global risks he knows that there is no room for complacency in fixing our structural difficulties. The Chancellor knows too that time is now running out before the next bank of dark economic clouds begins to descend. Despite the best of intentions it is clear that converting the UK to the ideal of a low tax, high wage, low welfare economy remains very much a long-term plan.