Who is to blame for the UK’s economic mess?

As time passes it is clear that the UK’s economic crisis is amongst the worst of the major developed economies, though Japan may beat it on some measures.  It’s not in the league of some smaller economies, like Ireland or Greece, although a comparison with Portugal may be more nuanced.  Some people (notably Labour politicians) struggle to accept just how bad things are; others don’t get much beyond railing deficits and the National Debt.  It’s worth pausing to consider what went wrong, and to try and attribute responsibility.

What happened?  Until 2007, the UK had an astonishingly consistent record of economic growth.  This started with the departure from the European Exchange Rate Mechanism under John Major in 1992, and continued until early 2008.  Economists had taken an average annual growth rate of 2.5% for granted.  Unemployment fell, and most people felt better off, though the very wealthy did much better than the rest.  Public expenditure rocketed, with massive investment in the NHS in particular.  A recent study by the Institute for Fiscal Studies (IFS) shows that poverty was reduced, largely because of increased benefits and tax credits.

And then bang!  GDP shrank by 6% in a year, stayed flat for the year after that, before struggling to a bit under 2% growth in the year after that (taking the year to the 1st quarter from the ONS).  Forecasts are for consistently anaemic growth. This is striking.  When economies hit a recession due to a temporary shock, they bounce back quite sharply, as temporarily unused capacity comes back on stream; this is what has happened in Germany this time.  Not for us; a good 7% of the economy has vanished never to return.  What makes this particularly bad is that this 7% produced an awful lot of taxes, while public expenditure carried on regardless (with benefits increasing due to the extra unemployment and hardship).  This has left the country with a “structural deficit” of about 8%.  This is the excess of public expenditure over taxes after you strip out temporary factors; the actual deficit was much larger (it reached 11% and has now dropped to 10% per annum).  Now I’m not sure how we ended up with an 8% structural deficit after losing just 7% of GDP, of which presumably no more than half would will have been taxed.  The government was already running a bit of a deficit when disaster struck; I think that capital taxes must account for the difference, now that the property boom has disappeared.

What this comes down to is that a lot of the pre-crisis growth was not for real, and government finances were built on unsustainable foundations.  What was happening?  This phantom growth seems to have been related to a boom in personal borrowing to finance property purchases and good old fashioned consumption.  Symptoms included an over-sized finance industry (in earnings if not jobs) and unsustainable levels of consumption.

Who was to blame?  The three commonly cited answers are everybody-and-nobody/events-beyond-our-control, bankers, or the Labour Government.  Some Labour politicians still seem to subscribe to the first idea.  It was an international storm (I never want to hear the phrase “perfect storm” again) and we were caught in it; nobody was seriously criticising government policy before the crisis.  As the economy has failed to bounce back, this has become unsustainable; why are we having so much difficulty when other countries caught by the crisis are having an easier time?  Of course some try to say this is because of Coalition policies over the last year.  But almost all of the many critics of the Coalition policies accept that we were in a terrible mess in the first place.

So the critics shift to another target: Britain’s bankers.  These are an easy target, paying themselves handsomely while their organisations required government bailouts.  There is also a widespread conception that the bailouts cost a lot of money, and that this is one of the reasons that government debt is a problem.  Actually the government has largely got away with it, for which Gordon Brown and Alistair Darling deserve some credit (contrast the terrible hash that the Irish government has made).  A lot of government money was put at risk, yes, but the banks were charged for it, and the money lent will largely be repaid, and the guarantees not called on.  Where the bankers were culpable was in rampant lending, supporting excessive consumption and a property bubble.  But the lending was nothing like as reckless as in the US (or Ireland for that matter).  If the government had awakened to the idea that consumer lending needed restraint, something could have been done.  Let me be clear; the banks were reckless; we need to regulate them much better – but they were not the fundamental cause of the crisis.  We had a narrow escape.

Could the government have seen the vulnerability of the British economy?  There were not many prominent critics at the time, though Vince Cable was clear enough, for exactly the right reasons.  But it was a matter of undergraduate economics to see that economic policy was on an unsustainable path.  Literally.  As a second year economics undergraduate at UCL in early 2007 my macroeconomics lecturer, Professor Wendy Carlin, used the UK economy as a case study to illustrate her model for an open economy.  It was also used as an exam question.  Was the UK’s strong economic performance due to increasing economic efficiency or excess aggregate demand, she asked.  It was clearly the latter: the giveaways being the appreciating real exchange rate, and a large current account deficit (the economy as a whole consuming more than it was spending).

What should the government have done?  The first thing should have been to raise interest rates and tighten monetary policy much earlier.  Unfortunately this was genuinely difficult, because this was the Bank of England’s main target was inflation, and not the general standing of the monetary system. And the inflation rate seemed benign (thanks in large part to the overvalued pound).  The second thing would have been to regulate the banks harder, to restrain lending.  This was the FSA’s job, although the degree of independence of this agency is less strong.  Finally the government could have tightened fiscal policy to reduce the level of demand in the economy, through expenditure cuts or tax increases.  Nominally the government’s policy was to run a zero structural deficit, but it chose to fiddle with the statistics on the economic cycle so as to argue that it did not have to do anything.  The government was not egregiously profligate, as Coalition politicians like to suggest, but it was pushing the wrong way.

What comes over, above all, is a failure of leadership, especially from Gordon Brown, as a formidably powerful Chancellor of the Exchequer.  The tripartite arrangement for managing the financial system (between Treasury, Bank of England, and FSA) did not help, but it is very clear that if in doubt it was the Treasury’s job to lead.  They didn’t.  They could have leant on the FSA and Bank of England, as well as tightening fiscal policy directly.  But Mr Brown either refused to recognise the gravity of the situation, or his political courage failed him.  Given his constant level of denial about the seriousness of the crisis, I suspect it was mainly the former.  He could not face admitting that so much of economic achievement was unsustainable.  It is invidious to blame one man, when the hands of many were involved.  But Gordon Brown had the authority; there was enough evidence for him to act on; and he made things worse not better.  A career in the Treasury that had started so brilliantly ended catastrophically.

My next topic on the economy: is the Coalition economic policy making matters worse or better?