Tuesday, June 23, 2009

Whose Fault is It?

It is tempting to blame the government of the day for the current economic problems. But, economic problems are often cumulative; some caused by government policy, some caused by absence of government policy and some caused by market forces. Also problems may hit the public consciousness at a particular time. But, the root cause of crisis can stem from the past decade or even longer.

Away from political name calling, there is usually no simplistic answer, and it is unfortunate that debate often seeks simplistic solutions.

When did Our Current Problems Start?

Structural Deficits from mid 1990s.

The US achieved a budget surplus during the latter years of the Clinton administration. This was a combination of fiscal restraint and a booming economy. The US went into deficit after the mild recession of 2001 gave an excuse for large fiscal stimulus.

However, the tax cut during the recession was not reversed during the boom years of 2002-06. The opposite occurred and it was accompanied by spending increases (in particular) on health and defence.

There was a similar situation in the UK. a low public sector debt of 29% in 2003, was turned into a structural deficit as the government decided to increase real spending on health care and education significantly.

The decision to run structural deficits during a boom has made the current deficits more damaging and reduced scope for safe fiscal expansion.

But, a structural budget deficit is hardly the cause of the crisis. The real culprits of the current crisis are the banks and mortgage company who grossly miscalculated what constitutes responsible lending.

A key issue in the UK was the financial deregulation of the 80s and 90s. It is no coincidence that former building societies who became banks pursued the most aggressive and unsustainable lending practices.

There was no particular turning point you can put your finger on. It was a cumulative failure amongst bankers, regulators, analysts and government policy. It was the banks who provided a growing driving force for the expansion of financial instruments. Governments generally went along with the vision of the city. Many were sucked into the ideology of the infallibility of markets. It was an easy philosophy to follow, much easier than trying to fight against.

By 2007-08, the structural weakness was embedded deeply into the system. There was little that could prevent the Tsunami of financial / economic crisis. If the government can be blamed for causing the crisis, they deserve at least some credit for not letting it get out of hand. Mistakes were made, not least the dithering over Northern Rock and bankruptcy of Lehman Brothers. But, it could have been alot worse if different policies had been followed. (see: Crisis Averted)

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