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The Great Recession – Professor Sir Donald MacKay

This blog examines the nature of “The Great Recession” which was determined largely by failures in UK macroeconomic policy and financial regulation in the “noughties.” It must be said, however, that the subsequent recovery has confounded those who argue that macoeconomic management has suffered from undue “austerity.”  The recovery has been driven by supply side forces, particularly in the labour market, and this has been a feature in Scotland as much as it has been in the UK as a whole. This section concentrates on “The Great Recession”, while the next blog looks at the changes in the labour market in Scotland and the UK through the period of boom bust and subsequent recovery.

The “Great Recession,” which began in 2008, was unusual in a number of important respects. The squeeze on real incomes ran on until 2011 but the accompanying rise in unemployment was much less than in the “Great Depression” of 1929-32. Indeed, before real incomes began to recover employment was rising and unemployment was falling.[1]  Among the most noteable changes in the labour market were a marked and continuing rise in private sector employment; a continuing, smaller fall in public sector employment; increased activity rates amongst females and those past the previous default retirement age; and falling unemployment. The recovery was essentially supply side driven and had to be if we were ever going to escape from the historically high levels of both public and private debt incurred in the first decade of this century.

Gordon Brown’s “Golden Rule” for fiscal policy was that the government should borrow only to invest, while current expenditure should be financed through taxation over the economic cycle. Over the cycle the budget should balance or be in surplus.  This was a perfectly sensible rule, but the devil was in the detail and the detail was horrendous!  The framework was supposed to provide a stable supply of public resources over the trade cycle and a fiscal policy which was counter-cyclical.  It failed on both counts.

The charts below, taken from ukpublicspening.co.uk[2] show the total UK national debt and that debt as a % of GDP over 2005-15. In the early and mid “noughties” fiscal policy was clearly counter-cyclical, as total public debt and debt as a % of GDP were rising, while the economy was growing quite strongly. The extent of the subsequent bust from 2008 has no parallel in our peacetime history.

The immediate trigger was the collapse of Lehman Brothers. The cause was a vastly over-leveraged balance sheet, especially in the sub-prime US housing market. Unfortunately, over-leveraged balance sheets were  a feature across many economies and financial institutions – RBS being the outstanding  Scottish example. And, as we have learned to our cost, there was, particularly in some major international banks, widespread trading on own account, often including collusion in fixing market prices to benefit the trader rather than the personal and business clients of the bank.

In the UK there was a serious failure in the regulatory regime, particularly for the banks which, as any economic student knows, are “manufacturers of money!” The old regime, where a quiet word from the Governor of the Bank of England was sufficient to make the clearing banks behave more sensibly, was replaced by a complex and badly functioning tripartite system involving the Financial Services Authority, the Bank of England and HM Treasury. Everyone blamed everyone else in the post-2008 crisis. The fundamental problem remains in a toxic mix of commercial, retail and investment banking within institutions which have great difficulty in policing the ring fences within their own institutions.

The Labour Government determined that the major financial institutions were “too big to fail”.  A strong case can be made that this concept has no place in a market economy, but it is certainly arguable that the shock waves of such a policy  would have created an even bigger bust than that we experienced. When the Coalition Government came to power in 2010, Liam Byrne’s parting note as the departing Chief Secretary to the Treasury – “I’m afraid there is no money” – said it all!

The Coalition Government, like all governments, found it difficult to reign in the rate of growth of public expenditure quickly, while tax receipts grew more slowly than anticipated. As the figures illustrate, total national debt continued to grow after 2010 until it began to level out just below 80 % of GDP toward the end of the period. The classic sign that the public debt should be reduced is when the cost of servicing that debt approaches   the cost of defence, historically regarded “as the first duty of the sovereign.” We are there already and it is now necessary to set some clear and sensible rules for public finance.

The central objective should be that the national debt should be in the range of 35-40% of GDP, aiming at the bottom of that range in periods of reasonable growth and moving up the range in periods of slow growth or recession. To get there from here to there seems a big ask but it is important to emphasize that the longer the period of forecast the greater the danger of being seriously wrong. Hence, while the recovery seems well established and might continue for some time, this is no time to abandon the attempt to bring the national debt under control. The sun is shining, so we must now fix the roof!

To do this will require pushing forward the programme of welfare reform, the structure of which is so confused and confusing that it emulates a dog’s breakfast! The next essential is to reduce current rather than capital government expenditure. As to reducing private debt, we should bear in mind Adam Smith’s dictum: “It is the highest impertinence and presumption, therefore, in kings and ministers, to pretend to watch over the economy of private people…..They are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look well after their own expence, (sic) and they may safely trust private people with theirs.” Our present sovereign is an exception to this rule, but given either independence or Home Rule it is Ministers, both in Scotland and elsewhere in the UK, whose behavior will need to be closely monitored.

In place of the often absent “Prudence,” we need to make the Governor of the Bank of England responsible for regulating our financial institutions. This is an unfortunate title and the geographical range should be regarded more widely, but we have a Canadian Governor whose background and attitude appear suited to the task in hand. He certainly understands the scale of the task as witness his recent remarks that financial markets can be “prone to excess and abuse” and “Individuals need to be held more to account…(and) regulators need to take a tough line on market abuse.” My only advice would be that we don’t need a host of regulators from the same stables as fathered our recent “Great Recession.”  The regulator must be the Bank of England and the Governor must have the direct responsibility for its performance.

picture for Sir Donald's 3rd blog piece

(Please click on the charts to view a larger version)

[1] ONS Average Weekly Earnings and Real wages data, http://www.ons.gov.uk/ons/dcp171778_414231.pdf Figure 1.2

[2] http://www.ukpublicspending.co.uk/uk_national_debt_chart.html