By Dennis John, April 2020
The worldwide financial crisis, which began in summer 2007, proceeded to wreak havoc, destroy and dismantle all the markets and economies across the world. Arguably, some countries across the world are still struggling from the effects of it today: namely, the UK, which has seen productivity growth stagnate for the last ten years. And, like many others, the UK government’s response to the crisis has come under fire from all corners. Therefore, I am going to offer my opinion on whether the UK government responded correctly to the 2008 financial crisis.
One of my sources was by George Walker, who is the Professor in International Financial Law for Commercial Law Studies at Queen Mary, University of London. He was a Legal Consultant with the International Monetary Fund. I think that this source, which was a journal article written by him on the UK’s Policy and Regulatory Response to the 2008 financial crisis is very reliable for a few reasons. He has already authored or co-authored multiple books, articles and other papers in the banking and financial law areas including the co-editing of two major encyclopaedias. He also has doctoral degrees from London and Oxford universities. Despite having initial doubts since he was only a lawyer, I was positively reaffirmed finding out that he was the Professor of Financial Regulation and Policy, alongside Law. I certainly believe that a person like him with so much expertise and knowledge in this field is very capable of producing a suitable and helpful piece on this topic. I also believe that the reputation of the journal article I read written by him was very high, as it went into considerable detail about why the crisis happened, and what the UK government did in response to it. I believe that the journal article was of a very high standard. I believe that he was not limited to a lot of information whatsoever when writing his article, as there were not necessarily any secrets being kept when talking about this kind of thing. All economic policies must be announced by the Chancellor of the Exchequer at the Budget, so there is almost no secrecy. So Mr. Walker’s journal article is based on most of the information available at the time. I don’t believe George Walker has any personal vested interest on this topic, as he is not publicly affiliated with any sort of political party. As a result, he would not be biased towards saying that the UK’s government’s actions were more or less suitable than what he genuinely thinks, as he has nothing to gain. George Walker’s main arguments were on the basis that there were a multitude of causes for the 2008 financial crisis. I do agree with that to a small extent. I personally believe that he has understated the importance of the liquidity crisis which started in 2001, as being the precursor to the financial crisis in 2008.
Another source I looked at was by Ray Barrell, Tatiana Fic and Dawn Holland, who evaluated the policy reactions to the financial crisis. They wrote a journal article in the National Institute Economic Review, which seemed pretty supportive of the UK government’s measures. They seemed to believe that the UK government did enough to combat the financial crisis on the monetary policy front, but not enough on the fiscal policy front. This source is from a reliable group of people, as they regularly write in this column for this journal. I do not think there is any bias or vested interest, since all three authors have nothing to gain by not sharing their true beliefs on the matter.
Firstly, for every problem, we need to know what caused it. So, we need to fully understand why the financial crisis happened. In 2001, the United States of America experienced a mild, short-lived recession. To encourage economic growth, the Federal Reserve repeatedly cut the interest rate, slashing it from 6.5% in May 2000 to 1.75% in December 2001. This resulted in a sudden surge of liquidity into the U.S. economy. As a result, restless consumers, many of whom who had been hit very hard by the 2001 recession, were very eager to borrow. Banks were very willing to offer consumers high levels of credit as it allowed them to generate high levels of profit. What ensued was an environment of easy credit, continuing the excessive borrowing by consumers, and excessive lending and risk-taking by banks with money they just did not have. This led to many banks filing for bankruptcy, reducing consumer confidence in the financial sector. But the big hit was when Lehman Brothers, one of the biggest banks in the world, filed for bankruptcy and went defunct in 2008. Supporting the “Too Big to Let Fail” doctrine, the collapse of the bank sent shockwaves rippling through the global economy. An initial liquidity problem was converted into a global solvency problem at that point in time. As a result, growth and investment dropped severely, most predominantly in members of the G20.
Henceforth, that was what the UK government needed to target. Economic growth and business investment. To do that, the UK government used deflationary fiscal policy, where they increased taxes and decreased government spending. This policy has been given the name “austerity”. This meant there was more revenue than expenditure by the government, resulting in government budget surpluses. According to Chancellor of the Exchequer, George Osborne, in his June 2010 budget he had two aims. He aimed to eliminate the structural current budget deficit, which would assist him in attaining his second goal: decreasing national debt as a percentage of GDP. As a result, there would be increased confidence that the UK government will be able to pay back their borrowed funds. There would be increased business and consumer confidence of the stability and safety of the UK economy, leading to an increase in consumption and investment. Hence, there would be an increase in aggregate demand, leading to an increase in the growth of the UK’s GDP, leading to an increase in economic growth. Sounds fine, right? This policy would appease economists, who had been complaining for many years before the recession that the persistent budget deficit was dangerous for the UK economy, as well as those who were determined to increase economic growth in order to take the UK out of recession.
Unfortunately, this is not exactly what happened. Since that announcement, all the budgets made by the government have led to an increase in the size of the UK’s national debt. Furthermore, the UK’s national debt-to-GDP ratio has risen from 74.6% in 2010 to 86.6% in 2019. In my opinion, the main reason for this is probably policy myopia. In other words, policy myopia is the belief that politicians act in the short-term, for their own vested interests. For example, politicians may act in ways which allow them to be perceived as helpful and useful by the general public, which would increase their chances of getting re-elected at the next local election. In my opinion, that is exactly what happened. Increasing taxes is never likely to be favourable for the general public, and neither is decreasing government spending. As a result, they decided to increase taxes by a small amount and decrease government spending by a small amount. This resulted in there still being constant budget deficits, which meant that there was a constant increase in the size of the UK’s national debt.
The alternative approach the UK government could have taken would have been to use inflationary fiscal policy. This would have involved the UK government decreasing taxes and increasing government spending. Despite the fact that this would have definitely led to a further substantial worsening of the UK’s national debt, it would have led to a decrease in withdrawals from the circular flow of income (due to decreased taxation) and an increase in injections into the circular flow of income (through increased government spending). As a result, there would have been an increased multiplier effect on demand, output and employment within the economy. Increased employment would mean an increase in household incomes, leading to an increase in disposable incomes. This would lead to an increase in consumption in the economy. Increased demand would also lead to increased consumption. Furthermore, firms would be attracted to the UK through low corporation tax rates, increasing business investment. This would lead to a substantial increase in aggregate demand, which would lead to an increase in gross domestic product, leading to economic growth.
So why might have the UK not chosen to go on this route? Firstly, as mentioned before, the UK’s national debt, which is already high at the moment, would have been even higher. But there is arguably an even more important economic reason. The UK has a high marginal propensity to import, meaning, per extra unit of income that UK consumers earn, they are very likely to spend that on imported goods and services. This leads to the UK having a current account deficit of $106.7 billion, as of 2017, which is the second largest current account deficit in the world. If the UK government decided to follow through with inflationary fiscal policy, the current account deficit would have been even greater. A persistently current account deficit brings a lot of problems with it. Firstly, a deficit means that the current account is financed through borrowing, since countries are burdened with interest payments, meaning that this economic growth is unsustainable in the long run. Furthermore, if you are running a deficit on the current account, this means that you are running a surplus on the financial/capital account. This means that in the UK, foreigners will have increasing control over UK assets. This means that profits generated as a result of ownership of these assets may be transferred back to their country of origin, which would be a withdrawal from the UK’s circular flow of income. Another problem is the risk of capital flight associated with a large current account deficit. A very high current account on the balance of payments deficit is likely to lead to a loss of confidence by foreign investors in the UK economy. Henceforth, there is quite a likely possibility that investors will remove their investments, causing a big fall in the value of the currency (devaluation).
One thing must be said for sure: almost all governments across the world used demand-side policies. Most Western governments looked at aspects of Keynesian aggregate demand policy, which is what I have mostly told you about so far. However, there is an alternative policy which I have not mentioned yet, and in fact was mentioned by almost no one following the crash. That is supply-side policies. Supply-side policies are the attempts of governments to increase productivity and efficiency in the economy. These tend to work by increasing long run aggregate supply, which increases the productive potential capacity of the economy. There are many examples of these, one of which is education and training. If the government increases investment into education, and specific training for workers, the population will become more skilled. As a result, they can complete higher-skilled jobs in the economy, meaning that they can demand greater wages from their employers. Also, being more skilled is likely to increase their productivity, meaning that the firm they work in will produce more output. As a result, the firms generate more revenue, and hence profit. The firms can respond to requests for higher wages, as the increase in the costs of production is less significant. This also means that workers will get higher wages. Household incomes are composed of four types of payments – wages, interest, rent and profits. Therefore, an increase in wages across the country will lead to an increase in household incomes across the economy. As a result, the disposable incomes (money available for consumers to spend on goods and services) will increase as well. They now have a greater ability to choose what goods and services they demand for, since they can now afford more expensive goods and services. Henceforth, people are more likely to consume more goods and services, increasing aggregate demand in the economy. This will lead to an increase in gross domestic product in the economy. This means that there will be increased economic growth in the economy.
But there are a few problems with supply-side policies which make it completely ineffective as a responsive measure to the 2008 financial crisis. The primary issue is the time lag between the implementation of a supply-side policy and then its impact on the UK economy. For example, investment into education, which is a supply-side policy, does increase the long run productive potential of the UK economy. This means that it increases potential economic growth in an economy. But it doesn’t increase actual economic growth in an economy. As a result, supply-side policies were ineffective, since the UK government were hoping to increase economic growth rapidly in order to kickstart the economy and take it out of recession as soon as possible. Another issue is the fundamental problem causing any recession: a lack of aggregate demand. This was also the case in the 2008 financial crisis, so as a result, a supply-side policy would be pretty ineffective in terms of increasing economic growth.
So, did the UK make the right decision by committing to austerity? According to the Office for National Statistics, the real average wages of people in the country today is at the same level as it was in 2005. 2005 was 15 years ago. The reason for this is that austerity is a slower, more long-term solution than the other option suggested. Therein lies the issue: do we prefer short-term, unsustainable economic growth, that increases national debt, or do we recover slowly, but in a more efficient manner? In my opinion, the UK government made the right decision sticking with deflationary fiscal policy/austerity, as if the national debt got any higher, it would have discouraged future foreign direct investment. However, I do believe that policy myopia did hinder the effectiveness of the policy, as I do think that the governments did not increase taxes enough, in order to appeal to the general public.
References (using MLA citations):
Barrell, Ray, et al. “EVALUATING POLICY REACTIONS TO THE FINANCIAL CRISIS.” National Institute Economic Review, no. 207, 2009, pp. 39–42. JSTOR, www.jstor.org/stable/23880624. Accessed 08 Apr. 2020.
Walker, George A. “Financial Crisis-U.K. Policy and Regulatory Response.” The International Lawyer, vol. 44, no. 2, 2010, pp. 751–789. JSTOR, www.jstor.org/stable/41757385. Accessed 09 Apr. 2020.
“THE FINANCIAL CRISIS OF 2007–08.” The Future of Money: From Financial Crisis to Public Resource, by MARY MELLOR, Pluto Press, London, 2010, pp. 109–130. JSTOR, www.jstor.org/stable/j.ctt183h0cz.9. Accessed 09 Apr. 2020.