financial crisis

Economic Nonsense: 49. Government was wrong to use austerity to deal with the 2008 financial crisis


Gordon Brown as Chancellor and Prime Minister spent money profusely, believing that he could spend the British people's money more appropriately than they could spend it themselves, and by a political desire to have a large section of the populace on state largesse and thus supportive of a party that promised big spending.  The result was to make the UK hugely indebted, with an annual deficit that required borrowing to sustain that spending and increase the debt year by year.

The coalition government that followed him took action to reduce the deficit by a reduction in government spending.  This was the so-called 'austerity' package, although some critics claimed it was more talk than substance, with reductions in the increase in the debt, rather than in the debt itself.

Crucially, though, the policy was not only one of austerity.  It was accompanied by quantitative easing (QE), or increasing the money supply to reduce the more baneful effects of austerity.  Latterday Keynesians claim that government should have increased its spending to stimulate demand instead of decreasing it to tackle the deficit.  Their critics in turn suggest that it is not demand by government that sustains real economic growth, but investment by businesses in anticipation of future private demand.

The United States followed a similar policy of reduced spending combined with QE, whereas the eurozone countries led by a cautious Germany did not.  They imposed austerity on the over-extended countries of Southern Europe, but without the QE used in the UK and the US.

Britain and America experienced significant economic growth after a few flat years, whereas the eurozone countries did not.  Anti-austerity campaigners have suggested that the recovery is weak, perhaps "not even real," but the evidence does not support this.  The empirical result suggests that the combination of austerity and quantitative easing has worked, but that the eurozone policy did not.  Significantly, the QE countries did not suffer the big rise in inflation which some critics predicted.  In 2015, the eurozone countries announced their own quantitative easing, some 7 years after the UK and US did so.

The conclusion has to be that government was right to use austerity and quantitative easing to deal with the crisis.  They did not repeat the mistakes that turned a recession into the Great Depression of the 1930s.

Economic Nonsense: 28. Capitalism brought about the financial crisis and should be replaced


Opinions differ on the causes of the financial crisis; some economists suggest it happened because of a combination of several causes. In the US sub-prime mortgages were involved, in that mortgages had been given to some who were poor repayment risks. When these were bundled into other securities, an unknown risk was being marketed, with some institutions heavily over-extended with potentially bad debts. It should be pointed out that it was US government policy to extend home ownership to low income people. The two agencies Freddie Mac and Fannie Mae were both encouraged to do this. The process of 'red-lining,' drawing lines around city zones inside which no mortgages would be given, was outlawed. It might also be noted that most of those who received mortgages, including low income people, continued to pay their mortgages payments and successfully became home owners. Only a tiny proportion were defaulters. It was the unquantifiable nature of the risk that caused problems.

Others have pointed out that the Federal Reserve Bank made a policy of cheap credit. They did this to weather crises and prevent economic downturns. The Bank of England did some of the same. When money was cheap, so was risk, and the message encouraged financial institutions to undertake riskier ventures. It was as if all the traffic lights were stuck on green, and everyone pressed ahead at speed.

The lesson is that governments and central banks were at fault, as were reckless traders taking huge risks to bring greater returns. It was not capitalism itself that brought about the crisis, but rather the inappropriate behaviour of some of the parties involved, including government. Neither was it regulation. With the possible exception of the pharmaceutical industry, the financial sector was among the most tightly regulated in the world. It was unsuitable regulation that sent the wrong messages and brought about wrong behaviour.

Capitalism has not been replaced and almost certainly will not be replaced, in that no-one has found a better way of generating wealth or of improving living standards over the long term. It experiences shocks and crises from time to time, and it is partly a learning process. After each crisis it is modified to prevent the same happening again. But there may well be new and different crises in the future, and new ways will have to be found to deal with them.

Putting bankers in jail cannot prevent mistakes

The Parliamentary Commission on Banking Standards has published its report on how to make bankers act less irresponsibly. Among other things, it recommends making bankers criminally liable for reckless professional conduct. “Too many bankers”, it says, “especially at the most senior levels, have operated in an environment with insufficient personal responsibility”.

The assumption here is that bankers acted recklessly because they were insulated from the negative consequences of their actions. I don’t know if that’s true. During the 2008 crisis, plenty of executives at failing financial institutions made the same mistakes that their firms made. AIG’s former CEO kept much of his net worth in AIG stock, most of which he lost. The CEO of Lehman Bros lost $1bn. Citigroup’s Sanford Weill lost $500m. Between them, Bear Stearns’ executives lost billions.

There are many other examples like these. If bankers had known that they were acting recklessly in business, they would not have done the same thing with their personal holdings. That so many executives' personal losses were so great suggests that they did not realise what they were doing. Their bad business moves were errors, not calculatedly reckless decisions.

Indeed, Jeffrey Friedman has shown that the real error was on the part of regulators. Financial regulations such as the Basel capital accords that were designed to make banks act more prudentially in fact did the opposite, incentivizing banks to load up on government-backed mortgage debt and, particularly in Europe, government bonds. And, unlike mistakes made by individual firms, these mistakes were compounded across the entire global financial system.

Making the punishment for failure harsher will only improve behaviour if the people affected already know that they’re doing wrong. If they’re simply mistaken – as I would imagine you’d have to be to lose billions of dollars of your own net worth – regulations like this will not have the effect we want them to.

But what about the ones who really did know what they’re doing? We used to have a mechanism for punishing reckless business practices — it was called bankruptcy. In banking, at least, this seems to have been abandoned in favour of unlimited bailouts. If we had let bad banks go bankrupt, as Iceland did, we might not be in such a bad situation today.

Throwing a few scapegoats in jail to satisfy an anti-banker mob ignores that the crisis was largely about regulators' and bankers' error. It is no replacement for letting bad firms go bust and punishing them the old-fashioned way.