Chancellor George Osborne, ritually holding the Budget box for the cameras outside 11 Downing Street, before delivering his first « austerity » budget to the Commons on June 22, 2010.

Ten years on from the financial crash, we need to get ready for another one

Op-Ed by Robert Skidelsky, The Guardian, 12 September 2018

The collapse of Lehman Brothers on 15 September 2008 unleashed the worst global downturn since the Great Depression. Ten years on is a good time to ask what governments, and economists might learn from this catastrophe – how to prevent future ones, and how to overcome them if they happen. By prevention, I do not chiefly mean trying to stop the semi-regular fluctuations of the business cycle. The authorities already possess the tools to dampen, if not altogether prevent, these fluctuations. Central banks can use interest rates to restrict or expand credit or they can vary the reserve requirements of member banks counter-cyclically. Governments can keep a buffer stock of public works which can be quickly expanded and contracted as unemployment rises and falls.

No, the job of preventing economic collapses requires far more ambitious thinking. If the economy is allowed to fail, the “cure”, as the events of the past 10 years have shown, is very difficult. A severe recession is bound to increase the government’s deficit. A continually rising deficit, financed by public bond issues, rapidly raises the national debt to astronomical heights. So a politically irresistible demand arises to “cut” the deficit. This is what happened over most of the industrial world from 2010 onwards.

In 2010, as the British economy was just beginning its long recovery, David Cameron came to power attacking the economic mismanagement and « reckless spending » of the Labour government. George Osborne, his Chancellor of the Exchequer, announced a variety of spending cuts and tax rises which he claimed would reduce the budget deficit from 11% to 1% by 2015 and significantly reduce the debt. Yet the economy grew far less than he had predicted, and the deficit and debt did not reduce at anything like he had predicted. He had overlooked the effect of austerity on the size of the economy. Indeed, one of the falsest arguments about cutting public spending is that it promotes recovery by increasing the confidence of the business community. This doctrine of “fiscal consolidation” was much in vogue in 2010. It is false, because businesses invest when they see a market, and the market expands when consumers have more money to spend. If government, in an attempt to “balance the books”, reduces people’s spending power, economic recovery stalls. And this is what Osborne’s did in 2010, condemning Britain to at least two further years of stagnation.

A final mistake was the belief that monetary policy could undo the effects of fiscal contraction. The idea was that if the central bank pumped enough money into the economy, people would start spending again. Certainly, what is called quantitative easing undid some of the bad effects of fiscal austerity. The error was to believe that printing money is the same as spending it. Much of the extra money “printed” by the central bank swelled the cash reserves of banks and businesses, rather than being spent to revive activity. Because it went to the holders of existing assets, it increased inequality; and because the rich save more than the poor, it reduced the consumption base of the economy.

Three essential lessons should be learnt now. The most important is to prevent financial collapses at all. Banks have to be stopped from putting the economy in jeopardy by risky lending. This is a big reform agenda that has barely been scratched by telling banks to hold more capital or reserves. It requires breaking up banks into smaller units and instituting controls over the type and destination of loans they make.

The second step is the revival of proper macroeconomic policy. Monetary policy on its own is too weak to prevent economic collapse or bring about economic recovery. Fiscal policy needs to become again a tool for economic management, by maintaining a steady stream of public investment amounting to at least 20% of total investment, to offset the volatility of the private economy.

The third preventive step is to reverse the rise in equality. If too much wealth is concentrated in too few hands, the consumption base of the economy becomes too weak to support full employment, high or low. The effects of failing to take precautions against a big collapse of economic activity and the botched and inegalitarian recovery measures implemented by the government from 2010 onwards have left a damaging legacy of political resentment. The electoral support for populist movements, of which the vote for Brexit is an example, has deeper roots than mere economic distress. But the correlation between the collapse of 2008 and the growth in support for populism is too striking to be ignored. Adequate policies of prevention would, by reducing the likelihood of large-scale economic collapses in the future, staunch the flight of voters toward political extremism.

Robert Skidelsky is professor of political economy at Warwick University and the author of Money and Government: A Challenge to Mainstream Economics.