The Financial Crisis and Beyond

Modern economies run on credit and so the collapse in confidence and lending within the international financial system in 2007-09 was bound to bring about a series of after-shocks to global demand, trade and jobs. In this sense, the economic and political crisis in Greece represents a stark example of the ripple effects of the credit crunch as we edge our way forward in an age of instability.

This to me was the key theme running through David Smith’s talk at the Keynes Society on Thursday night. Followers of David’s columns in the Sunday Times will appreciate his unerring ability to capture the essence of what really matters in the economics and business domain. In his presentation David’s narrative provided a tremendously clear overview of the background to the crisis, the shape of the inevitable recession that followed. And, more pertinently, prospects for the UK economy in 2011 and beyond.

The credit crunch was the consequence of what David Smith terms a “self-feeding cycle” - a world economy emboldened by rising trend growth, low inflation and falling interest rates. He argued that the underlying causes of the boom in credit (and crucially off-balance sheet lending) could be traced back to a long-term surge in banking, finance, property and commodities triggered in the late 1980s. The search for higher yields in a world of falling long term interest rates led to excessive risk-taking supported by a whole series of regulatory failures, not least the AAA ratings given to sub-prime mortgages by the much maligned ratings agencies.

Northern Rock provided the clearest signal of a UK economy that had become dangerously unbalanced. The collapse of Lehman Bros a year later (reasserting the principle of moral hazard) sent the panic into madness. And we saw in 2008-09 an almost instantaneous transition from distress in the financial markets to a collapse in confidence, spending and production in the real economy. World GDP fell last year for the first time since the 1930s. And global trade dropped by 12 per cent - partly as a result of a return to protectionism, but largely on account of the fall in supply of trade credit and the breaking down of global vertically integrated supply chains. 2009 was a reminder of just how inter-connected our multi polar world economy has become.

The recession in Britain has been deep - from peak to trough a fall in real national output of 6 per cent - and you always lose something permanently as a result of the crisis. Treasury estimates put the long-term cost of the financial crisis and ensuing recession at 5 per cent of GDP.

One bright spot has been the performance of the labour market during the downturn. Here is an interesting contrast:

*In the UK GDP has fallen by 6% and employment has contracted by just 2%
*In the US output is down 4% but employment has fallen by 7%

We are starting to see some of the benefits of having labour market flexibility in its various guises - businesses were very quick off the mark to make redundancies when the crunch happened, but the rate of new job losses slowed down remarkably quickly in the late spring and summer of 2009.

What matters now is the resilience and shape of the recovery. David Smith drew on a revealing chart from the IMF showing the contraction in bank lending in the EU, USA and UK - borrowing to businesses, home-owners and governments. The shrinking capacity of the banking system - as lenders continue to de-leverage and repair their balance sheets - may lead us to experience a “credit-less recovery” and this will inevitably curb the ability of new businesses to emerge and exporters to take advantage of a competitive exchange rate.

And nobody can ignore the dominant issue of our time - the staggering levels of government debt that a new administration will inherit. Gordon Brown’s “fiscal rules” much loved and heavily flaunted during the earlier years of his Chancellorship have been totally blown away by recent events. There is no avoiding the post-election fiscal pain. And, even on plausible assumptions, it may take the best part of a generation for government debt to head back towards 40% of GDP (Brown’s sustainable investment rule). The UK’s fiscal position is helped (for now) by the fact that much of our government debt is made up of long-dated gilts (in contrast the debt issued by Greece). But perhaps Mervyn King’s apparent comments over the breakfast table to a US journalist will become apparent to all very soon? There are at least two Parliaments of pain in front of taxpayers and beneficiaries of government spending.

One of David’s arguments that really struck home for me was that the economic crisis has fast-forwarded the re-shaping and re-balancing of the world economy by perhaps five to ten years. The relative success of the emerging market economies in avoiding the worst of the collateral damage from downturns in advanced nations has propelled their rise up the rankings of the world’s leading economies. The UK economy must tap in to where marginal demand growth is coming - and the Euro Zone doesn’t look like being engine of growth for some time ahead.

Ending on an optimistic note, David highlighted some green shoots for the UK economy.

*There are signs of a bounce back in industrial production
*The stock market has rallied well in the last 16 months
*House prices are rising strongly (is this a green shoot or a more worrying sign?)

Recessions have huge and wide ranging effects - we often do not see the true impact for several years not least because new enterprises, products and business models take some time to emerge from the smoke. Downturns can be hugely damaging; they change our expectations and inflict damaging consequences on those who played little or no role in causing the slump. There are grounds for optimism that the British economy will enjoy a better year in 2011. It would be difficult not to given the size of the policy stimulus and the opportunity of a competitive exchange rate.

But debt is the defining constraint on the next stage of the cycle. And Britain is leaving the recession with an eye-watering level of borrowing, heavily exposed to uncertain international investor confidence and the risk of higher interest rates as the policy stimulus is taken away.

David Smith’s new book is available from Amazon. And teachers and students are directed to David’s excellent web site containing many of his articles and supplementary pieces.

The Age of Instability: The Global Financial Crisis and What Comes Next