Actually, there never was any real likelihood that large UK banks would close their doors. This is not because of any deposit guarantees but because our banks run the payments system. If a large bank ceased honouring demands to withdraw deposits, people and businesses would be unable to pay their bills and the whole economy would abruptly come to a halt. Our large banks are “too large to fail” and, whatever the cost, the government will always ensure that they stay in business in one form or another – so long as the government itself can borrow enough money to do so.
So our banks are still with us, but they have lost their appetite for lending. After years of aggressive lending at smaller and smaller margins, the famous collapse in 2007 of the sub-prime market in the United States sparked the realisation that over the long years of uninterrupted global growth, risk had become more and more underpriced. The crazy mortgage loans of 120% loan-to-value had to come to an end. Unfortunately, in their desire to hang on to “liquidity”, banks are now also much more hesitant about lending generally, not just to individuals but also to each other and to businesses, particularly small ones.
This means our small businesses are hit from both ends. Their overdrafts are costing more – even if they can still get them – and they are selling less because personal borrowing is drying up and people are saving what they can rather than spending. With small businesses as the source of two-thirds of UK jobs, unemployment will rise further, house prices – already down15% – will go down some more, and the government budget, already looking dreadful, is going to get worse. The credit crunch has brought on the recession and we are in for a hard time.
So what do we do about it? What does the government do about it? Having rescued the banks, the assumption is that the government must fix the economy: it must get economic growth moving again.
The Bank of England has now realised that interest rates were unnecessarily high. There is no near-term threat of inflation and it has dramatically reduced its base rate by 1.5% to 3% with hopefully more reduction to come. But with people bothered about their future incomes and jobs, this is not going to have much effect on spending even if banks fully “pass on” the reduction to their retail customers.
Meantime, the government is leaning on the banks to return to 2007 lending levels. Let’s be thankful that the banks, even those that now have a government shareholding, are resisting this call. They are probably being over-cautious, but a return to previous lending habits would be a return to the very behaviour that started the credit crunch in the first place.
So we fall back on fiscal policy, with renewed reverence paid to the “Keynesian” recipe of curing the recession by more government spending and/or less taxation. If people won’t spend, then the government must do it for them, otherwise it must give them some more spending money by letting them off some taxation. And we now have the unsightly spectacle of our main political parties competing with each other to see who can be the best tax-cutter.
Yet, beyond the received wisdom that lower taxes ought to help there is no consensus about which specific cuts should be made, how big they should be, or how they might be funded from a government budget that is already heavily in deficit.
Amongst the ragbag of gimmicky ideas, one better suggestion is to cut employers’ national insurance. This might be a good candidate as it is a direct tax on jobs. Another is to reintroduce MIRAS (Mortgage Interest Relief at Source) which up until 2000 used to allow tax relief on mortgage payments. Since one the roots of the crisis is the fall in housing prices, a reduction in the cost of mortgage finance would at least address this.
But the fact that we are in a recession implies that even sensible cuts will not help much as sensible people will use them to pay off debt and to save. Add to this our government’s reputation for changing its mind and the certainty that taxes will rise again as soon as growth resumes, and we have to conclude that temporary tax breaks are only going to bring a temporary interruption to the slide. Even if the proposed fiscal stimulus packages are co-ordinated across developed countries they will, at best, provide a cushion during the readjustment.
Some commentators are recalling the Great Depression of the 1930s, arguing that it was the fiscal stimulus of the 1933 New Deal that brought recovery in the United States. However, the big difference between then and now is that by 1933 many workers had been unemployed for three years and, with no welfare net, were in serious straits and prepared to work for any wage. A bit of extra spending by the US government had a large result.
Which leads to the key point. The root cause of the current recession is that we have increasingly been living above our means, on borrowed money. Credit has been too cheap, its price driven down during the good times by competition between the banks, following relaxation of regulation in the 1980s and 1990s – in particular the “de-mutualisation” of building societies in 1997 which permitted Northern Rock and Bradford and Bingley, for instance, to adopt their suicidal “business models”.
Now, as re-pricing of doubtful assets leads to “de-leveraging” by investment banks and the drying up of credit all round, the result in the real economy is that we must get used to a reduced standard of living. But, unlike the United States of the 1930s, this adjustment is made more difficult in today’s Britain by our elaborate structure of employment law that holds up wages, provides for generous benefits, makes severance difficult and generally makes labour markets inflexible. Given all the costs and red tape involved in employing labour, it will be a long time before any small businessman with a brain considers taking on more staff again.
It is a measure of the extreme detachment of the European Union that at this time when all member states are facing severe economic difficulties, they continue to insist on rules that make life even harder for business, for instance, statutory employment rights for temporary workers and the removal of opt-outs from the working time directive. And, in their unrelenting zeal to regulate everything, there is no regard for the effect of this on the international competiveness of EU economies, Britain included.
But whilst adjustment in the private sector will be painful, it is the public sector that most needs to adjust. For while people have been living above their means, the government has excelled in wasting resources on creating new jobs – 700,000 during the last decade – all of which are paid for by the treasury, i.e. out of the taxes paid by those in productive private sector jobs.
There is now so much flab in the government that it will take years of painful dieting to remove it. But the government will not diet voluntarily. The only way that the flab might be reduced is if it is starved away by a lack of funds at the treasury as the recession deepens. Sadly, it will be softer areas of government spending, such as defence, that are cut first. The last to go will be the Diversity Outreach Officers and the Social Network Co-ordinators employed by our councils.
Don’t expect our politicians to admit it, but the recession will be painful, there are no quick fixes, and a lasting solution to our economic ills depends on a significant reduction of the public sector.
As with every gloomy story, there is always a positive side. One welcome casualty will likely be the misguided climate change agenda being quietly abandoned as it is simply no longer affordable in today’s economic conditions.
The shake-out may also bring an end to the euro as a multinational currency. For as demands on government budgets grow – to prop up banks, provide fiscal stimulus and simply because tax revenue falls in recessions as welfare expenditure rises – some EU government debts are beginning to look unsustainable. The Irish government has sold bonds to borrow €4 billion for three years, and has had to pay 1.2% more interest than the German government would for a similar loan.
It also looks bad for Italy, whose government has huge debts (109% of GDP) and for Greece, where the going rate on government debt is around 1.5% above German rates. Even our own Debt Management Office, which looks after British government borrowing, is anxious whether financial markets will comfortably digest the £100 billion or so of bonds that it will have to sell in this financial year.
This can only mean that the markets are viewing these sovereign debts as a poor risk. If, as the slump deepens, some euro zone government finds itself no longer able to borrow on any reasonable terms, its only recourse is to go begging to other governments. The EU might be able to help the Irish as theirs is a small economy (perhaps in return for ratifying the Lisbon treaty). But if a large country such as Italy is facing default, there is no way that other EU countries could realistically provide support or guarantees. The only avenue left for Italy would be to re-issue its own currency and devalue, effectively reneging on its debts.
If one or more EU countries should ditch the euro and be forced to go their own way we may hopefully begin to see a wider realisation that, while trade and co-operation between independent countries benefits all, political union is ultimately unworkable.
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