Thursday, November 27, 2008

Irresponsible Borrowing

"It was borrowing that got us into this mess, so why is the government borrowing to get us out?"

It was not government borrowing that got us into the mess. It was irresponsible bank lending.
  • The roots of the current crisis lie in US Subprime mortgage markets where banks loaned mortgages to people who had little chance of repaying them back.
  • For more on the roots of the subprime mortgage crisis see - Who is to Blame for credit crunch?
  • The mortgage defaults led to banks losing money. The subprime mortgage crisis spread to the UK mainly because British banks relied on raising money through money markets. As the mortgage companies lost money, it was difficult to raise money on the money markets so banks like the Northern Rock had liquidity shortages.
  • Because the banks had a shortage of liquidity, they cut back on mortgage lending making it very difficult for homeowners to get a mortgage. This precipitated the slide in house prices which caused a fall in consumer spending and lower economic growth.
Personal borrowing in the UK increased on the back of rising house prices. This willingness to borrow and take out large mortgages helped fuel a boom in house prices. This means that the consequent fall in house prices is larger.

But mainly the recession was caused by the financial crisis which led to a decline in normal business and consumer lending. This shock to the economic system has led to a decline in growth.

Because growth is falling, the government is trying to stimulate the economy through tax cuts and higher borrowing. The last thing the government wants to do in a recession is to balance the budget. This would just make the current downturn worse.

It is true that Government borrowing has been rising in previous years, even before the recession. from 29% of GDP in 2001 to 37% of GDP in 2007. This now looks irresponsible in the sense the government doesn't have a war chest to stimulate the economy. However, this increased borrowing did not cause the current recession.

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