My Economics Homework (sorry it's late – and sorry it's so long)

[I wrote this about a year ago, in an attempt to get my brain round the various claims being made about the banking crisis, the deficit and the national debt. I’m publishing it in the hope that it may be useful to someone …]

Debts, deficits and denials

I’m not an economist. I have found the financial turmoil of the last two years quite baffling, and I’m not sure how to assess the severity of the financial difficulties we apparently find ourselves in – some of the numbers bandied about are so huge that they mean very little to me, and some of the jargon used by the experts serves only to obscure things further. Nonetheless, I’ve been trying to disentangle some of the issues, and my conclusions so far are here. Please note: all this is rather tentative, and subject to revision. But I believe I am not alone in my uncertainty. There are nine experts on the Monetary Policy Committee which decides what the Bank of England’s base rate should be; last month (February 2011) they managed four opinions between them!

I’ve been trying to find the answers to three major questions – one to do with the role of the banks, another to do with the performance of the UK economy in general, and the third to do with the scope and timing of the cuts being introduced by the coalition government.

Quite a lot of people blame the banks for everything; some go further, and seem to imply that if only we taxed the bankers a bit more, all our problems would be over. How near to the truth is that? And was it all the banks’ fault?

That’s one issue. The next is: how healthy was the economy when the crisis hit? Were we on a sustainable path, with manageable national debt and deficit? The Tory mantra before the election was that we had been spending £4 for every £3 that we earned; Labour insisted that everything was OK, and that if it hadn’t been for the banks we could have carried on as we were. And Ed Balls has repeated much the same recently.

The final question: given where we are now, what’s the best course of action? Again, there’s a difference of opinion here; the coalition partners say that significant cuts are necessary and urgent – Labour say there’s no need to be hasty – we can wait a bit, until we’re out of the recession before we tackle the deficit. Who’s right?

The role of the banks

So, to the banks. We know that there was a crisis in the banking world which threatened the rest of the UK economy, and that the government was compelled to intervene to prevent the collapse of the banking system. We also know that the banking crisis was brought about by banks selling each other risky loans. (The root cause seems to be US banks giving mortgages to people who were never going to be able to pay them back.) It’s actually quite difficult to establish with any certainty how much money the UK government actually gave to the banks. The latest figure I can find is £65.8 billion – that’s real tax-payers’ money the government gave Royal Bank of Scotland and the Lloyds Banking Group in 2008 to stop them going under[i]. The result of this is that the tax-payer now owns 83% of RBS and 41% of Lloyds. We also own Northern Rock, having provided £27 billion[ii] to keep it afloat over the winter of 2007-8. A total then, of £92.8 billion.

However, these are not the only figures people refer to. In December 2009, a report from the National Audit Office suggested that ‘Government support for Britain’s banks has reached a staggering £850bn and the eventual cost to taxpayers will not be known for years’[iii]. Earlier that year, Will Hutton wrote: ‘Now the British government has had to put an astounding £1.3 trillion in various guarantees and investments behind the banking system in order to avoid the consequence of its fall’[iv]. £1.3 trillion? Yes, that really is astounding! [I wrote to Will Hutton some weeks ago, asking him to explain his figures. I will let you know if he replies.]

So where do these figures come from? As far as I can make out, the £92.8 billion I referred to earlier is actual cash, given to the banks or used by the government to buy bank shares. The other much bigger figures seem to refer to potential cash – they are guarantees or indemnities which may never be called on. Hutton hints at that – but his Observer article was (misleadingly) headlined ‘You give bankers £1.3 trillion and do they thank you? Do they hell’. Similarly, we should note the distinction in the NAO report between ‘government support’ and ‘eventual cost’ – not the same thing at all.

I don’t think it’s reasonable to ask the banks for £1.3 trillion back – as we haven’t actually given it to them. But it seems perfectly reasonable to ask for the £92.8 billion that we gave Northern Rock, RBS and Lloyds Banking Group.

Talking about Northern Rock, Wikipedia says: ‘As of 3 March 2009 the bank was repaying the loan well ahead of target, owing a net balance of only £8.9 billion of the loan which stood at £26.9 billion at the end of 2007’ (I suspect this refers to the ‘bad bank’, Northern Rock Asset Management (NRAM), which took over £50bn of the bank’s older mortgages; the ‘good bank’, known simply as Northern Rock, still owes us £1.4 billion.) Robert Peston reckons that in the end ‘the rescue of the Rock will be seen to be have had negligible fiscal consequences’ – i.e. the taxpayer will probably just about break even.

It is not clear how the money we loaned to the other two banks can be recouped. Lib Dem MP Stephen Williams is backing a scheme to distribute most of the nationalised shares in Royal Bank of Scotland and Lloyds to those of us on the electoral register. The City establishment is a bit sniffy about this – but given their recent record, I don’t really care what they think. One of the main benefits of this scheme is that it will get round the ‘overhang’ problem faced by UK Financial Investments (UKFI), who will be selling the shares on behalf of the Treasury – the market knows that whenever a tranche of these shares becomes available, there will be another tranche along soon, and consequently discounts the price they’re prepared to pay. Another benefit is that such a sharing out may do something to reduce the anger we feel about the way the banks have behaved, and their astonishing lack of remorse (I do not share Mervyn King’s view that people aren’t angry about this).

Let’s turn to the suggestion that the bankers ought to do more to pay back the money we have loaned them – in particular the notion that their bonuses should be slashed. In 2010 bankers were expected to share a bonus pot of around £7.3 billion- not quite as eye-watering as the £11 billion they had in 2007, but I expect they’ll manage.

You can see why some people argue that these bonuses should be scrapped. I’m thinking of this sort of statement from Unison (Fact Sheet #29): ‘The pay and bonuses of the 10 highest paid Lloyds employees would pay for 6,124 hip operations’[v]. Unfortunately, the punitive approach this suggestion hints at fails some basic tests. For a start, bankers’ bonuses are taxed – so out of the £7.3 billion, it is estimated that the bankers took home around £3.8 billion, with the Treasury taking £4.1 billion[vi]. I calculate that that tax would pay for 800,000 hip operations. Logically, we might argue for increased bonuses – every time a bonus doubles, the Treasury’s tax take will double as well. We should certainly take note of the fact that if we scrap bankers’ bonuses, we also lose the tax they pay. I also wonder if it’s sensible to make lots of bankers unemployed – would you be prepared for your taxes to go up to pay their benefits?

In Mervyn King’s interview in the Daily Telegraph (4th March 2011) he says that in the past 25 years, banks have increasingly ‘taken bets with other people’s money’[vii]. Not only that – ‘the rules of the game are that they get bailed out if it all goes wrong … We allowed a [banking] system to build up which contained the seeds of its own destruction … We’ve not yet solved … the ‘too important to fail’ problem. The concept of being too important to fail should have no place in a market economy.’ In the Lib Dem Manifesto we said “We will break up the banks, to ensure taxpayers are never again expected to underwrite high-risk banking. We will introduce a Banking Levy, so that banks pay for their tax-payer guarantee, until the break-up is complete.”[viii] We have set up an independent commission on separating investment and retail banking, reporting by September 2011, and introduced a banking levy that will raise £2.5bn a year. A good start, I’d say.

One final point on the banks. Labour insists that our problems are all due to the global crisis in the banking industry. But does the government have no responsibility for how the banks behave? Here’s Ed Balls, talking five years ago: ‘Nothing should be done to put at risk a light-touch, risk-based regulatory regime.’[ix] And here he is again, in January this year: ‘We should have ignored Tory and City claims that we were being too tough on financial regulation and been much tougher still.’[x] This looks to me like wanting to have your cake and eat it. As long as the banking bubble was merrily inflating itself, and pouring taxes into Labour’s public spending spree, Labour were happy to be hands-off. As soon as the bubble collapsed,  Balls thinks they should have been more hands on. Well, I think he’s right there – the government should certainly have taken more of an interest in how the banking system was working (or not, as it turned out).

And another final point: it wasn’t just the banks that had problems – and not all banks were affected equally. AIG, the US insurance giant, nearly collapsed due to their dealings in the sub-prime market. As Ben Bernanke put it: ‘AIG exploited a huge gap in the regulatory system,’ and ‘… to nobody’s surprise, made irresponsible bets and took huge losses’. Meanwhile, this side of the Atlantic, Barclays survived without needing to take advantage of the 2008 UK government investment that saved RBS and Lloyds.

And a final final point: there’s more to the role of the banks than the actual cash the government invested. We (UK taxpayers) may make a profit of up to £19bn by the time the government has sold all its RBS and Lloyds shares – but the cost to the country of the recession triggered by the banking collapse (currently estimated to be about 6% of GDP) is huge.

How was the UK economy doing before the banking crisis?

There’s no doubt that the banking crisis in the UK clobbered our economy. The issue I want to address now is the underlying health of the economy. To put it another way, would everything be hunky dory if the banks hadn’t been so reckless?

In his foreword to the Labour Party Manifesto of 2010, Gordon Brown said: ‘At the same time the world has been rocked by the first great crisis of the new global economic age.’ This theme – that our difficulties are the result of a global crisis – was repeated ad nauseam during the last two years of the Labour government, and through the election campaign. The implication, of course, is that it wasn’t Labour’s fault, and in particular that Gordon Brown himself bore no responsibility for the mess we find ourselves in. At the same time, David Cameron’s mantra during the election was ‘We are spending £4 for every £3 in revenue, and we can’t go on like that.’

I said earlier that I’m not an economist; however, I know enough to understand that if government spending consistently exceeds government income, then there is what is known as a structural deficit. I’m also aware that governments sometimes spend more than they’re collecting in tax to smooth hiccups in the public finances, this spending in the bad times being balanced by increased income in the good. This kind of deficit is called a cyclical deficit. So – was there a deficit? If so, what kind of deficit was it?

Ed Balls on the Andrew Marr show on January 30th 2011 said ‘I don’t think we had a structural deficit at all in that period [i.e. leading up to the financial crisis]…’ A few weeks earlier, he had written in The Times: ‘My concern is that a great deceit designed to damage Labour has led to profoundly misguided and dangerous economic decisions that I fear will cause deep damage to Britain’s future. What is this deceit? It is that the deficit was caused by chronic overspending …’ Instead, Ed blames the financial crisis, the subsequent recession, and the consequent collapse in tax revenues that resulted.

The Institute for Fiscal Studies (page 6 of their Briefing Note No. 79, published in 2008), have a different view:

‘On the OECD measure, the UK had a structural budget deficit of 3.1% of national income in 2007. This is the 2nd biggest structural budget deficit among the G7 large economies (after the US) and the 4th highest of the 26 industrial countries for which the OECD has data.’[xi]

Let’s look at a graph:

governmentborrowingforecastFigure 1: UK income and spending 1997-2015

The most eye-catching feature is the sudden huge leap in spending in the two years after the start of the banking crisis in 2007, leading to a massive increase in borrowing. But look carefully at the years leading up to 2007. From 2002 to 2007, we were clearly spending more than we were earning. If you prefer the numbers, try this:


Fiscal Year

Public Spending (£bn)

Tax Revenue (£bn)

Balance (£bn)













































Figure 2: UK income and spending 2000-2011

Whichever way you look at it, that’s chronic overspending, isn’t it? Most economists seem to agree that it’s OK to run a cyclical deficit when the economy is threatened by recession, but surely remaining in deficit during the years through to 2007, when the UK economy was performing reasonably well, was reckless?

Remember that Northern Rock was not nationalized until February 2008, and that RBS and HBOS were not bailed out until October 2008. So while it is true that the financial crisis made the deficit much worse, you plainly cannot deny that chronic overspending played a major role too – an assertion borne out by the fact that the OECD puts the UK’s 2007 structural deficit at 3.9% of GDP.

Consider two other things. First, between 2000-01 and 2006-07, spending rose by 51%, while tax revenues only rose by 36%. Secondly, from 2006-07 to 2009-10 (which encompasses the crisis years), spending rose by 22%, while tax revenues rose and then fell back to where they’d started.

Let’s put it another way. Between 2002 and 2008 we spent £200 billion pounds we didn’t have – i.e. money we had to borrow. If we hadn’t spent that money, wouldn’t we have been in a better position to tackle the bank fiasco?

The cuts

The first thing to be said about the cuts is that we’re talking about choosing between bad options and worse options. The key is deciding which option is which. It seems to me that the risk of cutting is recession, while the risk of not cutting is national insolvency. Needless to say, it’s all a bit more complicated than that …

The cuts (invariably described as ‘savage’) are not actually cuts in public spending, believe it or not – rather they are cuts in the rate at which public spending is increasing. They will reduce the amount by which our debt is rising – but it will still keep rising for five years, just not quite as fast as it has been for the last ten. In 2015-16, public spending (at £647bn, expressed at 2009-2010 values) will be higher than it was in 2008-09 (£640bn).

When the unions or the defence chiefs protest about the severity of the cuts, it’s worth taking a step back for a longer view. In 1999-2000, Labour shrugged free of their self-imposed commitment to stick to Tory spending plans; fast forward to the end of this parliament and we find that welfare spending will be 34 per cent higher, in real terms, in 2014-15 than it was in 1999-2000, and defence spending will be 36 per cent higher.

In five years time we will still be increasing our national debt at a rate of £20 billion pa. This chart shows the continuing rise in our spending:

 public spending 2000-2015Figure 3: UK spending 2000-2015 [estimates in red]

What the government is actually doing is eliminating the structural part of the deficit. That should leave us in the desirable position of being able to borrow when we need to, and saving when times are better. A position one might reasonably describe as prudent.

The IMF gave thumbs up to coalition spending plans in September 2010. They reckoned that the benefits of Osborne’s tougher deficit plan ‘outweigh the expected costs in terms of adverse effects on near-term growth. Indeed, market reaction to the adjustment plan has been positive.’ In other words, the coalition have taken an economic risk with their approach, but the IMF thinks it’s a risk worth taking.

Is there an alternative? Not really; during the election campaign, all parties seemed to be agreed that cuts would have to be implemented. Alistair Darling promised ‘tougher and deeper’ cuts than those implemented by Margaret Thatcher.[xii] The only difference between the two biggest parties was the timetable, with Labour wanting to halve the deficit in four years and the Conservatives wanting to eliminate it entirely within their first term of government. The Lib Dems accepted Labour’s plan to halve the structural deficit in four years, but our manifesto also sets out numerous extra cuts that would have been made on top of Labour’s (rather vague) plans.

It’s worth looking at these figures in some detail. The proposals that Labour fought the election on would have seen the structural deficit halved in four years – i.e. between £30-40bn over that time, equivalent to between £7.5-10bn a year. The proportions in terms of increased taxation and reduced spending would have been similar to the proportions pursued by the current government. This would have equated to roughly 20% cuts in unprotected departments over four years, or 5% a year.

The coalition government has pledged to eliminate the structural deficit within five years – i.e. £12-16bn per year. This equates to roughly 30% cuts in unprotected departments over a five year period, or 6% a year.

So the difference between Labour’s plans and the current government’s plans equates to about one percentage point a year in most departments.

One has to assume, therefore, that people who argue that the coalition’s plans go too far, too fast, are also saying that Labour’s plans went too far, too fast. They are invariably reluctant to suggest alternatives.

So – what difference might timing make? I suggested earlier that our choice was between recession (if we cut too quickly) and national bankruptcy (if we cut too slowly). Unfortunately, we cannot try both approaches to see which works better; hindsight will tell us if we made the right choice, but foresight cannot really help. One thing we know already: our national debt is going to keep increasing for the next five years, along with the interest we have to pay on it. We also know that if we don’t cut, our debt will get bigger more quickly than if we do. Here’s another graph, illustrating the scale of the problem:

 uk interest on public debtFigure 4: UK interest on government debt 2000-2015 [estimates in red]

To give some perspective, it may be worth noting that the interest for this year (£43bn) is slightly more than we will spend this year on defence.

What happens when national debt gets out of control? At its simplest, money becomes more expensive to borrow. We have evidence from our European neighbours to help us here: the so-called PIGS countries (Portugal, Italy, Greece and Spain – sometimes extended to include Ireland) are all suffering to different degrees from having national debts so large that the markets are increasingly reluctant to lend them money (i.e. to buy government bonds for redemption at some time in the future). Benchmark borrowing costs, as measured by 10-year bond yields, hit 5.51% for Spain earlier this month [9th March 2011], 7.63% for Portugal, 9.58% for Ireland and 12.90% for Greece. The UK, meanwhile can borrow at 3.73% – the markets think we’re a fairly safe bet.

Making your mind up

In September last year Stephanie Flanders offered three helpful summaries on her blog – the case for austerity[xiii], the case against[xiv], and how to decide where you stand[xv]. In brief, she suggests:

You will worry most about the coalition’s policies if you think that this is a once-in-a -lifetime crisis; that government spending can help avert disaster; that the short-term risk to the recovery trumps everything else; and that policy makers can be trusted to cut borrowing as soon as the danger is past.

You’ll be most supportive of Mr Osborne if you think that this economic cycle will be similar to the past; that more borrowing can’t do much to support growth; that it’s the long-term risk of inflation and a loss of market confidence that we should be focused on; and that politicians have a hard time keeping their promises.

Either way, the choices you might make will depend on your political outlook.

Even Ed Balls accepts that the deficit will have to be addressed eventually; he just doesn’t like the way the coalition is doing it. He portrays the argument as one between austerity and growth, without explaining convincingly how higher public spending will promote growth. And given that we won’t be able to borrow on the scale of the last ten years, at some point he will have to stop decrying coalition tax rises and start talking about how much higher he’d like to see our taxes go.

It isn’t always helpful to ask ‘Well, what would you do?’ (especially if you’re talking to Ed Balls). The Labour party says the government needs a growth strategy, yet the Labour party’s growth strategy seems to be: don’t cut public spending as fast. That is not a growth strategy.

At this point, my essay officially comes to an end, with a few notes left that I have not used. I have certainly found it very useful to do the research and try to organise the relevant data into some kind of coherent overall picture. No doubt there are errors, but I’ve teased out a few strands to my own satisfaction … But be warned: there is more to come!


[Odd notes, may be used later:

Manifesto 2001

Public spending not to outstrip the growth of the economy

Labour have said that, if they were re-elected, they would increase spending each year faster than the growth of our national income. That inevitably means even higher taxes. Higher taxes come naturally to Labour, because they don’t trust people to spend their own money.

Manifesto 2005

Today, government is spending too much, wasting too much and taxing too much. Britain cannot continue indefinitely to spend more than she is earning without higher taxes or higher interest rates – either of which will harm our economic prospects. If we are to secure our future prosperity, government must once again start to live within its means. The consequences of Labour’s profligacy are now plain to see. Last

year, average living standards fell for the first time in over a decade – and the poorest 10 per cent of Britons became poorer.

Fraser Nelson in the Spectator (23rd March 2011): The “total cuts” figure is, oddly, not printed in the Budget. Perhaps because it’s so embarrassingly small. After the Autumn Statement, it was 5 per cent over four years. Now it’s back to 3.7 per cent over four years: that is to say, total cuts of just 0.9 per cent a year.

BUT – he’s talking about total govt spending; so as soc security payments increase (unemployment), tax falls (ditto), inflation – departmental spending must fall to compensate. And where some depts are protected (though that looks increasingly thin, to me), other depts will have to lose even more.]




[To be continued … you have been warned!]



[iii] Independent, 4 December 2009 –

[iv] Observer, 19 April 2009 –




[viii] You can download a list of Lib Dem achievements here:

[ix] Bloomberg Speech, 14 June 2006

[x] Independent, 24 January 2011

[xi] you can download the whole IFS report here – full of interesting graphs and explanations:






Ten Years After …

It’s not often that I can read something I wrote ten years ago and still agree with every last word. So here’s a rare example – the article I wrote after marching against the Iraq war ten years ago today:

“Peace Hath Her Victories, No Less Renowned Than War.” (John Milton)

anti-war march february 2003

I was there, with my wife and daughter. So were many other good folk we saw getting on the train at Rayleigh, and more than a million from all over the UK. We walked with the Lib Dem march from the Royal Festival Hall, across Westminster Bridge, round Parliament Square, up Whitehall, and eventually arrived, some hours later, at Hyde Park. We missed Charles Kennedy, but we caught Jesse Jackson and Ms Dynamite.

The effect was stunning. We are told that people are not interested in politics, that the young are ‘switched off’, that the apathy party wins. But there we were, one chilly Saturday in February, making our views known – ‘the mother of all focus groups’, as one commentator described us.

There were all sorts there. Pacifists, who reject war under all circumstances. Kurds and other Iraqis, who think that war may be the only way to free their country – but don’t believe the time is right. People of profound faith, and people with no particular belief, who just don’t trust our Prime Minister.

Charles Kennedy, the Lib Dem leader, showed remarkable courage appearing on the platform in Hyde Park. It could so easily go wrong. The US is hell-bent on a war, come what may; and if everything goes well for the Americans and whatever allies they can muster, it might all be over in a week, and the world would soon forget the tortuous path we are currently treading.

But Kennedy and the Liberal Democrats won’t be swayed by such pragmatic thoughts. The case for war has not been made, and we have the self-belief to stand up to Blair’s “Trust me, I know what I’m doing” approach.

It is not clear that Iraq possesses weapons of mass destruction. It is not clear that they intend to use them. It is not clear that the inspection process is useless. There is room for doubt in all these cases – unless you are Mr Blair. Even the most aggressive hawks in the US administration have toned down their assertion that Iraq has links with Al Qaida – there is just no convincing evidence.

The UN inspector, Hans Blix, asks why there is such a hurry. Eight years with inspectors in Iraq. Four years without. Now twelve weeks with them back in again – and Blair and Bush can see no alternative to war.

There is no doubt that Saddam Hussein is a nasty piece of work, and that Iraq (and the rest of the world) would be better off without him.

Blair has done his case no good by switching his argument from the need to control Iraq’s armoury to the moral case for getting rid of Saddam. This has highlighted the weakness of the first argument – for if Iraq poses a real threat to our security then we have no alternative but to act robustly in our own defence. It has also underlined the shakiness of the moral approach, as religious leaders in this country and abroad have made clear their doubts about the current Anglo-American war fever.

One of the things the Lib Dems are concerned about, but which does not appear to feature strongly in the Prime Minister’s views, is what happens after a war. American plans are sketchy, to say the least, but seem to be based on leaving the current ruling Ba’ath party in charge in Iraq, under the control of a US Army General.

Here again, the weakness of Mr Blair’s arguments become apparent. If Saddam’s regime really is so intolerable that we have no option but to intervene militarily, then the last thing we should do is remove the head and leave the body. We must be prepared to replace the whole corrupt system of government. This means creating a whole new framework of international law, since regime change for its own sake is quite illegal under current international law.

We should also ask ourselves whether military intervention in the middle east will make the world a better place. My view is that an attack on Iraq, led by two Christian leaders from the western world, will sow seeds of resentment which will bear unwelcome fruit for centuries to come. Will bombing Baghdad make a repeat of September 11th more or less likely?

As I write, our Prime Minister has reportedly been stunned by the extent of opposition to his pro-war stance in the House of Commons. 52 Lib Dem MPs, with rebels from Blair’s own party and others, have inflicted a historic humiliation on the government. He should listen to them. He should listen to us.

So – what the hell have the Lib Dems done?

Well, they haven’t achieved miracles … but in the first half of the coalition government they have certainly managed more than many people are aware of (or are prepared to give them credit for). For example, the scrapping of Michael Gove’s batty exam reforms is due to pressure from all sides – including Lib Dems in government.

For a list of some of our achievements, try Mark Pack’s site – click on the image below: