Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 21 April 2015

Mediamacro myth 1: 2010 Britain faced a financial crisis

The idea that the Coalition rescued Britain from a crisis is routinely put forward as fact by both the Conservatives and Nick Clegg. Every time the media let such statements pass (as they invariably do), the language seems to get more florid: Clegg’s latest is that the coalition was born in the “midst of an economic firestorm”. [1]

The facts say this is pure nonsense. The economy had begun to recover from the recession, and this recovery might have continued if it had not been hit on the head by domestic and Eurozone austerity. As Larry Elliott makes clear (see also here), there was no sign of any market panic, either in the markets for Sterling or government debt. 

But the government’s budget deficit was very large, and debt as a proportion of GDP was therefore growing. If, through a separate myth, you have created the idea that the major (perhaps only) goal of aggregate fiscal policy is to reduce deficits, this seems like a serious problem. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

Any economist would cringe at the idea that policy should try and eliminate deficits and surpluses created by the economic cycle, because that would mean destabilising the economy. This is sufficiently well known (cyclical deficits and surplus are called ‘the automatic stabiliser’) that it could undermine the idea that the high deficit was an immediate problem. This is one reason why it is important to push another mediamacro myth - the idea of Labour profligacy, which we debunk tomorrow. [2]

So where is the half-truth that gives the ‘firestorm’ myth some credence? It is of course the Eurozone crisis, and the idea that the UK could suffer a similar fate to the Eurozone periphery. But academic macroeconomists understand that the situation of a country with its own central bank, like the UK, is quite different from a country without, because the central bank can (and in the UK will) act as a lender of last resort, so the government will never ‘run out of money’. That simple fact is sufficient to prevent any crisis happening for an economy like the UK. Greece was profligate, and had to default, but the crisis in the rest of the Eurozone ended the moment the European Central Bank agreed to act as a lender of last resort in 2012.

Why is it so important to keep up the pretence that in 2010 the UK economy was ‘on the brink’ of a financial crisis? Because only then can the pain of the subsequent few years be excused. The truth is that the failure to recover until 2013 was not the inevitable cost of rescuing the economy from crisis, but an avoidable choice by the Coalition government. The delayed recovery, and the damage that did to living standards, was at least in part a direct consequence of attempts to reduce the deficit far too early, and there was no impending crisis that forced the government's hand. [3]

Previous posts in this series

[1] There is something about Clegg that wants me to see him in the best possible light. So I imagine that, when confronted just after the 2010 election by briefings from the Treasury and the Bank about the dire economic situation, he really believed what he was reading. He did not realise that, from the Treasury at least, it is standard practice to say this to any incoming government. (One of the interesting untold stories of austerity is the extent to which it was encouraged by senior Treasury civil servants.) But I suspect my imagine of 'Clegg the naive' is, well, imaginary.

[2] If the financial crisis had permanently lowered UK GDP, or the tax potential of GDP, then that would also imply the need to reduce government spending at some point. But, as most economists agree, you do that when monetary policy can offset the impact of these cuts on demand. You do not choose to undertake austerity when short term interest rates cannot fall any further.

[3] The clear majority of macroeconomists agree that austerity when short term interest rates cannot fall any further will reduce output. The OBR calculate that austerity cut growth in financial years 2010-11 and 2011-12 by 1%, but there are good reasons for thinking this may be an underestimate. 


  1. The other factor you need to bear in mind when assessing the situation in 2010 is the near-death experience the financial system went through in 2009. Given the very recent memory of that event, extreme caution was an understandable position.

    Oliver Kamm has written this in the Times this morning:

    "In fact, budgetary responsibility is being overemphasised in this election campaign. Yes, Britain has a problem: a debt-to-GDP ratio of 80 per cent is not sustainable in the long term. It's sustainable now, though, with funding costs so low and a respectable pace of recovery.

    I favour tighter fiscal policy, but the issue doesn't have the urgency or saliency that it did when the coalition took office."

    I nearly fell off my chair.

    1. Understandable yes - I did think of adding that as a half-truth. But reasonable no - you just needed to ask what could happen, as I did in my New Statesman piece. (Markets panic and do not buy gov debt. Central bank does so instead. Markets think sterling overvalued: depreciation helps UK recovery at the expense of the rest of the world.)

      Too many people who should know better thought (and still think) markets could panic at any time with terrible consequences, so we must do what those clever people who are 'close to the markets' say. The fact that those close to the markets got things horribly wrong in 2007/8 seems not to register.

    2. Forgive a stupid question, but why didn't the UK just do this in 1976?

    3. A very good question. I have some thoughts, but I was only the most junior of economists in the Treasury at the time. Does anyone have any good references for what happened over this period?

    4. "close to the markets"

      By definition, people close to the markets hold government bonds. Yes, some people may short them, but on average they must be long bonds. The government is, by definition, short on bonds. Therefore everyone else, on average, is holding bonds. This means they want low inflation, low default risk, and they want the asset price to go up (i.e. low yields).

      Bondholders do not represent "the market", they represent "people who have recently made purchases in the market". They are therefore very biased, and have no interest in the broader state of the economy and have no interest in protecting the government's ability to make new borrowing at a reasonable rate, and therefore they shouldn't be allowed to influence policy so corruptly.

      It's like saying that the price of bread should skyrocket because people "close to the market" (i.e. bakers) want that to happen. Customers are also "close to the market", but their interests should be reflected too.

    5. "by definition, people close to the markets hold government bonds"

      This is not true. A market participant might be short government bonds, or want the price to fall in order to buy government bonds next week.

      The issue with 'market participants' is one of perspective. They live in a world where tiny changes to the expected rate of inflation create market movements that appear huge to them, so this is what they focus on, and they develop an exaggerated sense of its importance to the wider economy.

      A baker will naturally be very focussed on the price of bread: the rest of us are just as worried about clean water.

    6. Simon,

      Generally you had ministers brought up on Bretton Woods Keynesianism struggling to adapt to a floating exchange rate world.

      The UK made the mistake of the state borrowing US dollars to maintain an exchange rate.

      They were then persuaded to get that from the IMF, which turned out to be unnecessary. The UK only drew down half the IMF loan and paid it all back before Labour left office. But the political damage had been done and the Monetarists made hay.

      I've done a small write up here which links to the original Treasury documents.


    7. What I do remember corresponds exactly with your point about being stuck with a Bretton Woods view (although in this case applying to senior officials). They had a view about the exchange rate that once it started moving, it would fall off a cliff. The more junior members kept talking about UIP, but it didn't seem to sink in.

    8. Thank you Neil, that question has been bugging me. A combination of dollar denominated debt and exchange rate targeting... like Argentina joining the ERM!

  2. The deception was made clear from the start:
    “There is no choice between going for growth today and dealing with our debts tomorrow.
    Indeed we will not have any meaningful growth unless we show we can deal with our debts.
    For it is the lack of a credible plan to deal with the deficit that is already pushing up market interest rates, undermining the monetary stimulus that is supporting the economy, and sapping the confidence of investors and consumers.

    It is the lack of a credible plan that has the credit rating agencies threatening to downgrade us unless action is taken urgently.

    This is the reality of the situation we are facing. Those who say we should simply ignore the markets are siren voices, luring us onto the rocks.”
    George Osborne, Mais Lecture 2010.

    Check out the yields on UK 10yr gilts on this graph at the time he said “the lack of a credible plan to deal with the deficit that is already pushing up market interest rates“:
    Did anyone think to pick him up on this lie?

  3. Forgive my macroeconomic illiteracy, but if a sovereign state with an independent central bank can always print money to pay their debts, why do such states ever default? Why has Argentina defaulted twice?

    1. Because they borrow in a currency other than their own.

    2. Argentina borrowed in dollars which their central bank can't print.

      In theory they could have bought dollars with printed money, which would have decreased the value of the Argentinian peso against the dollar and maybe caused inflation.

      They chose not to do that, perhaps due to worries about hyperinflation.

  4. >Simon

    The UK has a central bank and you treat it in your analysis as a lender to the government. However, the Lisbon treaty prohibits the central bank lending to the government directly , and the UK is a signatory to the Lisbon treaty.

    1. And yet ... QE.

    2. Plus where's the enforcement mechanism?

      There is no law without enforcement.

      And whatever the case the primary dealers provide the 'private' loop by which the Bank of England buys bonds from it's owners.

      The primary dealers take a cut and order a new yacht every now and again. What a fabulous control mechanism.

  5. With all this in mind? What are your views on whether or not we should even be in the EU?

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  7. I think you're desire to resist some Clegg iconoclasm is identical to the problem Susan Pedersen found in her article at the LRB, in which she assessed the hope that many had that Shirley Williams could somehow replace Margaret Thatcher as Prime Minister.

    I think it also explains why so many academics have and still do vote Liberal in the post-war period, and only when their MPs (infrequently) come to have some power the utter duffers many of them prove to be.

  8. But isn't the whole point that almost everyone agreed a large chunk of the deficit was structural, and no cyclical?

  9. Interesting your article focuses on Clegg when he is almost powerless as a junior partner in a system of Cabinet Government. I think democracy would be a whole lot healthier if coalition partners could say when they disagreed with something - especially now when we are looking at the prospect of either a right led coalition of the Centre and right, or a left led coalition of the Centre and left. We may even see a coalition of more than two parties. In such cases, Cabinet unanimity in public looks more and more out of date.

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  12. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

    But the point is that the chart shows the deficit running at about 3% in the years 2001-2007, ie, during the boom years, before the recession.

    So surely during those years the deficit should have fallen, not risen?

    If it hadn't even fallen, but had simply remained at its pre-boom level of -1.something% (in 2000) for the boom period (ie, running a budget surplus for nearly a decade of boom), then presumably two things would have happened:

    (a) Britain would have had a smaller debt, both in absolute terms and as a percentage of GDP, in 2007

    (b) when the deficit jumped up, then instead of jumping from about 3% to about 10%, it would have jumped form about -1% to, well, maybe 7% or 8%?

    Therefore the problem was that in a boom, when the government ought (according to Keynesian economics) to have been running a surplus, it was instead running a consistent deficit of around 3% of GDP.

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