Conventional wisdom says that the deficit is all the fault of dodgy lending by the banks. But is it? If there had been no financial crisis, just a correction at the end of a credit bubble, would the deficit have disappeared?
The recession has certainly caused a temporary deficit. We’ve seen a reduction in GDP of about six per cent, and unemployment up to two and a half million. The temporary effects of the recession, a higher spending on benefits and reduced tax revenue, account for around £50bn of the deficit. But this will disappear as the economy recovers.
In response to the financial crisis, the government spent large sums bailing out the banks, and rightly so. But these bailouts were one-offs, and were mostly loans or the purchase of assets. They’ve affected the debt to some extent, but they haven’t affected the deficit.
What really gives central bankers sleepless nights is the rest of the deficit, the part which won’t disappear as the economy recovers.
This £100bn per year of “structural” deficit is not caused by the recession. But where did it come from?
Part of it is easy to explain. During the latter part of the recent boom, between 2003 and 2007, the government significantly increased spending commitments, but didn’t raise enough taxes to pay for them. As a result, they ran deficits of between £30bn and £40bn per year.
But what of the remaining £60bn to £70bn of structural deficit that appeared as soon as the recession hit?
For a decade, the government let a bubble build up in the housing and financial sectors. This gave a huge temporary boost in tax revenue. When the bubble burst, this temporary revenue disappeared. The OBR believe this revenue will not return, and so they dramatically increased their estimates for what the deficit will still be when the economy recovers.
The bubble was caused by deliberate government action. Back in 2001, in order to prevent a recession following the dot com crash, Gordon Brown loosened policy, deliberately stoking up a bubble. Gordon Brown’s success in keeping the economy out of recession was seen as a vindication of his claim that Labour’s policies would see “an end to Tory boom and bust”.
Eddie George, as Governor of the Bank of England, agreed with the policy, but has said how this left his successors with the challenge of sorting out the problems it would cause. Unfortunately, they weren’t sorted out.
The ideal time to rein back the bubble would have been from around 2003, but rather than act, for years, Labour continued to massively increase spending. In 2006, they marginally slowed the increase, which meant the budget deficit fell back a little, but it still remained at £30bn, and they did nothing to rein back the credit bubble.
Then, at the end of 2007, the global financial crisis hit and the bubble burst.
The main reasons the government didn’t act must surely have been political: partly the 2005 election, and then Brown’s plans to become Prime Minister, perhaps thinking of a further election when he did.
But those weren’t the only reasons. He was also encouraged in these policies by experts from around the world.
The rest of the political class must also share some of the blame.
Until 2008, the Conservatives under Cameron committed themselves to match Labour’s spending plans. Although Vince Cable warned about the debt bubble, he didn’t advocate a reduction in spending.
I think there are hard lessons for all of us.
Political parties will, naturally, be tempted to put off hard decisions, especially in the run-up to an election, but we should resist the temptation. If the government had not run deficits of £30bn to £40bn per year, if it had restrained the growth in private debt from 2003, our present deficit would have been substantially smaller, and we would not be facing £83bn cuts.
In the booming economy of 2003, when anyone following Keynesian theory should have exercised restraint, the government chose the opposite course. It continued doing this until the end of 2007, when the consequences finally caught up with us.
Those same temptations are with us today. There are voices calling for delay, saying it is too soon to tackle the deficit. But aren’t those voices making the mistakes of 2004, 2005 and 2006? If they argue we should wait a year, then another, before long we will be in the run-up to another election, when tough action becomes politically impossible.
Just as failure to act in 2003 has left us with a far worse problem today, might not delay today leave us with even more serious problems when we hit the next crisis, perhaps in a few years time?