The banks did cause the deficit

The banks gave the economy a heart attack

My good colleague John Rentoul has posted an admirably clear blog on the causes of the fiscal deficit.

Answering the question “How much of the budget deficit was caused by (1) having to bail out the banks, and (2) Labour over-spending?” John’s response is  ”(1) None of it, and (2) About a third”.

He’s right that the Treasury might end up making a profit on the disposal of its RBS and Lloyds shares (although no one can be sure about that). And he’s right that the 3 per cent deficit Gordon Brown was running as Britain entered this crisis means that the deficit now is higher than it otherwise would have been. His estimate of about a third seems reasonable.

But my problem with John’s blog is that it  gives the misleading impression that the crisis in the public finances is nothing really to do with the behaviour of the banks.

What John doesn’t mention is that the banking crisis gave the UK economy a heart attack and that this had a disastrous impact on the public finances. Between 2007-08 and 2009-10, nominal GDP fell by 1.4 per cent (£20.6bn). And tax receipts dropped by 5 per cent  (£27.3bn). It’s this sudden collapse in economic activity, brought on by the bursting of the bank-inflated credit bubble, which is responsible for the bulk of the deficit. Yes, the previous Government could have cut its spending as revenues fell, but that would have made the slump deeper and the deficit still greater.

Here’s what Adair Turner, the head of the Financial Services Authority, had to say in a recent speech about the costs of rescuing banks in the US and the UK:

“Direct support costs are swamped by the macroeconomic harm produced by the financial crisis.  US public debt to GDP will increase by at least 50% in this recession, even if the direct cost of support ends up as zero.  UK public debt similarly will increase by at least 50% of GDP, even though the direct costs may not exceed 5%.”

When analysing the damage inflicted by the banking sector on the public finances, it’s vital to look not just at the direct public cost of bank recapitalisations, but also the wider macroeconomic impact of their reckless behaviour.

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• Guest

  Banks. Hedge funds were not a problem, some went bust and that is OK. Lehman Bros should not have been a problem – it only had to be bailed out because banks were overexposed to counterparty risk.

  As to how to spot a bubble, every one is different. In the recent case it was a return on capital invested of over 40% which should have set the red light flashing. As I said in my original post, most banking industry leaders knew there was a problem – so should the FSA and US equivalent.

• Richard_SM

  “In the recent case it was a return on capital invested of over 40% which should have set the red light flashing.”

  Pre-tax return on equity for the major UK banks appears pretty consistent over the ten years 1997-2007, at around 24% and in the range 20% to 28%.

  But, why do you think a 40% ROC lead to the banking crisis?

  And, what about banks posting losses?

• steverooney

  What’s depressing is that I suspect Rentoul’s original piece was less to do with his views on the deficit (he clearly lacks even an elementary grasp of the arguments if he thinks financial sector culpability equates to the cost of the bail out) and more with the frustration Blairites feel with the (exceedingly modest) language of social democracy now being articulated by Labour. Much of what the Coalition is doing – de-regulating the labour market, privatising the NHS, blaming the unemployed for their own situation – is straight out of the New Labour play-book, and is entirely consistent with the neoliberal creed they adhered to in government. Their problem with the current govt. is not one of philosophy, values or direction of travel, but rather that they feel it should be their clique of careerist hacks who should be managing this process.

  What’s more alarming is that the Blairites are clearly being driven by dogma, and not their famed powers of political calculation. Most recent polls suggest that the majority of the public are actually closer to the social democratic/Keynsian analysis over the cuts and the need to create and defend jobs, than they are to the government’s line. This is hardly surprising given the threats to living standards and public services the overwhelming majority of us face, currently.

  It’s a shame people like Rentoul, Mandelson et al, can’t just transport themselves back to the heady days of 1997 – the last time their analysis carried any (arguable) empirical weight whatever

• steverooney

  What’s depressing is that I suspect Rentoul’s original piece was less to do with his views on the deficit (he clearly lacks even an elementary grasp of the arguments if he thinks financial sector culpability equates to the cost of the bail out) and more with the frustration Blairites feel with the (exceedingly modest) language of social democracy now being articulated by Labour. Much of what the Coalition is doing – de-regulating the labour market, privatising the NHS, blaming the unemployed for their own situation – is straight out of the New Labour play-book, and is entirely consistent with the neoliberal creed they adhered to in government. Their problem with the current govt. is not one of philosophy, values or direction of travel, but rather that they feel it should be their clique of careerist hacks who should be managing this process.

  What’s more alarming is that the Blairites are clearly being driven by dogma, and not their famed powers of political calculation. Most recent polls suggest that the majority of the public are actually closer to the social democratic/Keynsian analysis over the cuts and the need to create and defend jobs, than they are to the government’s line. This is hardly surprising given the threats to living standards and public services the overwhelming majority of us face, currently.

  It’s a shame people like Rentoul, Mandelson et al, can’t just transport themselves back to the heady days of 1997 – the last time their analysis carried any (arguable) empirical weight whatever

• rms3

  I’m not following you, I’m afraid.

  Your argument seems to apply equally to government/central banks raising interest rates in anticipation of inflationary pressure when they consider growth exceeds long term sustainable rates of GDP increase for the economy in question, which of course forms the centrepiece of monetary policy in most leading Western countries …..? Granted it’s not perfect by any stretch as predicting the future is not a science, no one credible is arguing for ditching it wholesale so far as I am aware…..

  Presumably the same judgments re the future that might justify raising interest rates in such cases might also inform other measures to damp down the supply of credit e.g. mandatory loan to value ratios for domestic mortgages….?

• Richard_SM

  “Your argument seems to apply …”

  What argument?