Lehman's trillion-dollar bankruptcy shook the foundations of the global economy. Larry Elliott retraces the reverberations
Threadneedle Street August 2013Green shoots of recovery were bursting out all over as Mark Carney, the new governor of the Bank of England, presented his first health check on the UK economy. Napoleon hungered for "lucky generals" and George Osborne appeared to have followed the Bonapartist doctrine to the letter when he poached Carney from the Bank of Canada.
After two years of moving sideways, economic growth has accelerated in the second quarter; there are solid reports from the manufacturing, construction and services sector; even the news from the battered eurozone is better.
The housing market is humming, courtesy of ultra-low interest rates and Treasury subsidies for new buyers. Just three months earlier economists had been agonising about the risks of an unprecedented triple dip recession. Now, the talk was of boom-boom Britain.
Not so fast, Carney said. A broad-based recovery may be under way but it is weak by historical standards. Interest rates – pegged at 0.5% for more than four years – will need to stay unchanged at least until unemployment comes down to 7%. Whereas the US and Germany have more than made up the ground lost during the recession, Britain has not. Output is still below its pre-Lehman level and the recovery is slower even than during the 1930s.
Lurking in the shadows as Carney made his debut were the other big economic themes since the collapse of Lehman Brothers in September 2008: the magnitude and scope of the crisis; the fact that only a handful of politicians and central bankers saw it coming; the rise and fall of global co-operation; the unprecedented policy response with its as yet unknown side-effects; the transformation of a private debt crisis into a sovereign debt crisis; the squeeze on living standards; and the shift in the global economy away from the developed west towards emerging markets.
Early on, there had been much talk about rebalancing the economy. Osborne talked of the "march of the makers" as he said the new economy would be built on investment and exports, not public or private debt. But while there has been some pick-up in industrial output, the driving force behind UK growth in 2013 is again the housing market, just as it had been in the years before the crash.
Memories have proved short. Households are taking on more debt in order to get on the property ladder. The economist Ann Pettifor struck a chord when she dubbed Britain the Alice in Wongaland economy.
It is an uneasy situation. Osborne last week said the UK had turned the corner. Others are unsure, but what is certain is it has been a tumultuous ride.
Threadneedle Street August 2008Same venue, same occasion, different governor. Mervyn King's message – six weeks before the sky fell in on the financial sector – was sombre but not, as it turned out, nearly sombre enough.
Noting that growth was slowing and inflation rising, the governor said: "The adjustment of the UK economy to higher commodity prices and a more realistic pricing of credit will be painful.
"The next year will be a difficult one," he predicted, "with inflation high and output broadly flat. But with monetary policy focused on its task of bringing inflation back to the target, we will come through the adjustment."
King was both right and wrong. Right that the next year would be difficult; completely wrong in the judgment that the UK would get away with a soft landing followed by a rapid bounce back.
Revisions to official data since then show that the UK was already in recession by August 2008 and much worse was to come. The economy would shrink by more than 5% in 2009, the biggest annual decline in almost 90 years. Of the nine members of the Bank's monetary policy committee – made up of Threadneedle Street insiders and independent experts – only David Blanchflower thought a cut in interest rates from the then 5% was warranted. One MPC member even voted for rates to rise.
Blanchflower had outlined his reasoning in the spring of 2008, when he said the UK was following the US through four stages of descent into recession. "First the housing market weakens, then consumer confidence collapses, then the labour market falls, then output drops. In the UK by the spring of 2008 we had gone through three of the four steps. Mervyn was sure the UK had de-coupled from the US and was more worried by the risk of exploding wage pressure. The high quality US economists I was speaking to were telling me that the world was coming to and end.
"It was a complete disaster and even by the beginning of September 2008 the MPC had no idea what was coming. It was the shock of a lifetime."
To King's fury, Blanchflower went public with his views. "I got a message from the governor's private secretary asking me to go and see Mervyn." Blanchflower refused to apologise for what King saw as uncollegiate behaviour. "I told him to go fuck himself," Blanchflower recalls, adding: "I was furious. I said you guys are out of your minds and you had better start doing something".
By this stage house prices in some parts of the US had plunged by 50% and millions of housebuyers faced foreclosure.
The Excel Centre in London's docklands April 2009In the previous six months industrial output and global trade had shrunk at rates last seen in the early stages of the Great Depression, but Gordon Brown was in upbeat mood as he outlined the results of a summit of the crucial G20 group of rich and developing nations.
"This is the day that the world came together, to fight back against the global recession", the PM said. "Not with words, but a plan for global recovery and for reform and with a clear timetable."
There was a six point plan including reform of the global financial system and a common approach to dealing with toxic assets, together with a $1tn stimulus package to supplement $5tn from individual countries.
Few knew it at the time, but the London G20 marked the nadir of the downturn following the bankruptcy of Lehman Brothers in September 2008. It also marked the pinnacle of global co-operation in which countries were thrown together by the scale of the crisis.
Policymakers abandoned the nostrums that they had held dear for the past three decades. Copies of John Maynard Keynes's General Theory were dusted down to find a cure for a slump that the high priests of free-market economics said would never happen. Blanchflower won his battle on the MPC. Interest rates were slashed to the bone; central banks started to print large quantities of electronic money to compensate for the credit crunch; taxes were cut and public spending increased. Governments rediscovered the urge to intervene. Germany provided subsidies to keep workers in jobs. America bailed out the automobile industry. The UK put pressure on mortgage lenders to show forbearance to struggling home-buyers.
On the left, the assumption was that the financial and economic crisis of 2007-09 would bring an end to three decades of free-market hegemony, in just the same way that the oil price spike of the mid-1970s called time on the golden era of post-war social democracy.
It didn't work out that way. Within a year Keynes was back on the shelf. Austerity replaced interventionism. Instead of seeking global solutions to a global problem, countries went their own way. The London G20 had three big objectives: to prevent a second Great Depression, to agree a joint plan for financial supervision, and to come up with a global growth plan. Only the first was achieved, because although the global economy contracted in 2009 for the first time since 1945, by the second half of the year output was increasing, most markedly in the big beasts of the emerging world, India and China.
But the other two legs of the grand plan fell by the wayside. Nobody was really interested in a global growth pact, while the attempt at a joint approach to regulating the banks was scuppered In Europe and the US. Ever since, governments have been seeking national solutions to a global problem.
Alistair Darling sensed the changing mood at his last IMF meeting as chancellor, in April 2010. "One school of thought was that we were through it so we could take our foot off the accelerator. Then there was the rightwing aversion to doing things together," he recalled.
HM Treasury May 2010After Britain's inconclusive general election, the country had a new coalition government and Osborne wasted no time in making clear that there would be a change of strategy. "Last year our budget deficit was the largest it has ever been in our peacetime history. This year it is set to be among the largest in the world. This is the legacy of 13 years of fiscal irresponsibility. And it poses a very real threat to the recovery."
Growth had returned to Britain by polling day. As Europe's financial centre, the UK had been particularly vulnerable to a crisis detonated deep in the banking industry. Consumers had taken on more and more debt in the years leading up to the crash; now they had lost the appetite to borrow. With companies hoarding their cash, the burden for supporting the economy through the recession fell on the government, but at a cost. Public borrowing, which stood at £34bn in 2006-07, had more than quadrupled three years later.
Osborne's fear was that the markets would take fright and push up market interest rates in the way they had in Greece, which received its first bailout on the weekend after the election. Unemployment across the eurozone was rising. In Greece it was 12% – and on its way to the current 28%.
The young were to take the greatest hit. In Greece today 59% of those aged 15-24 are out of work and across the eurozone one in four of those aged under 25 are unemployed.
The new chancellor's strategy involved keeping fiscal policy (taxes and spending) tight and monetary policy (interest rates, quantitative easing, the exchange rate) loose. King provided crucial political cover for the chancellor by stating publicly that it was right "to put in place a serious plan to tackle the fiscal deficit".
Public spending was cut and VAT raised to 20% that summer in pursuit of what the government hoped would be "contractionary fiscal expansion".
Osborne thought that the markets would be impressed by his promise to reduce the structural deficit – the part that would not disappear even when the economy was fully back to health – within four years. The expectation was that lower interest rates would result, providing incentives for the private sector to invest.
It hasn't happened yet. The chancellor said the UK was blown off course by the sovereign debt crisis in Europe and by higher global commodity markets. Darling says his successor at the Treasury only has himself to blame.
"The mistake Osborne made was to trash confidence. His message was 'we are Greece. It's panic stations. It's terrible.'" People said if that's the case we are going to stop spending. The idea of eliminating the structural deficit in a four-year period was foolish and we are paying a heavy price for that – 2.5 million people unemployed, and the economy smaller than it was in 2008, young people struggling to find jobs."
Cannes November 2011There was little of the film festival glitter when the G20 met two and a half years after its successful London summit. It sheeted down with rain all day, matching the mood inside. A deal to provide more funds so that the IMF could help poor countries came to nothing. The German chancellor, Angela Merkel, resisted pressure from the French president, Nicolas Sarkozy, to allow the European Central Bank to be the lender of last resort for the euro.
The US president, Barack Obama, and prime minister David Cameron vocally expressed their frustration at the inability of the Europeans to end the sovereign debt crisis that by this stage had resulted in three countries requiring international bailouts – Greece, Ireland and Portugal.
"Every day that the eurozone crisis continues and every day it is not resolved is a day that it has a chilling effect on the rest of the world economy, including the British economy," Cameron said. "I am not going to pretend all the problems in the eurozone have been fixed. They have not."
It was now more than three years since the Lehman Brothers collapse and still there was no sign of the crisis ending.
The summit communique noted that recovery was slowing down and unemployment unacceptably high. Tensions in the financial markets were high and higher commodity prices were putting growth at risk. Even the emerging markets were losing their lustre.
London July 2012Europe's single currency was fighting for its life when the president of the ECB, Mario Draghi, arrived in London to address a global investment conference. Bond yields on Spanish and Italian debt were heading for the 7% levels that had made life financially intolerable for the governments in Athens, Dublin and Lisbon and resulted in them going cap in hand to the IMF and EU for bailouts.
But these were small countries on Europe's periphery: Spain was the fourth biggest economy in the eurozone; Italy, a founder member of the Common Market, the third biggest. Markets doubted whether the combined firepower of Europe and the IMF would be enough to bail out Rome and Madrid; speculation was rife that the single currency was on the point of disintegration.
In just 20 words, Draghi turned the market tide. "The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."
There had been periods of uneasy calm throughout the eurozone crisis, but Draghi's intervention brought Europe's leaders a genuine breathing space to sort out the mess. Faced with the threat that the ECB would wade into the markets and buy Spanish and Italian bonds, the speculators backed off. Bond yields moved rapidly out of the danger zone.
There was a heavy price to pay for the sovereign debt crisis: an 18-month double dip recession and an unemployment rate of 12.1%. Politicians paid with their jobs. By October 2012 every major European country had replaced its government apart from Germany.
TodayIn Britain, by the time of Carney's arrival at the Bank, growth prospects appeared the rosiest in more than half a decade. Confidence was rising and forward-looking surveys were positive. City economists were revising up their growth forecasts for the first time since the coalition came to power.
But after all the false dawns and the many setbacks, few – apart from George Osborne – are confident enough to say the crisis is over.
Nicola Smith, chief economist at the TUC, says one persistent problem since Lehman has been that prices have tended to rise more quickly than wages, leading to falling living standards. "That may be appropriate for a period of recession in order to keep people in jobs but not when the economy is growing. It doesn't give you a sustainable model for the future."
Bill Martin, an economist who has looked closely at Britain's recent growth record, says the recovery will be unsustainable if it involves the household sector moving into financial deficit, and that rising house prices would materially add to that risk. Although it is early days, that does seem to be happening.
Finally, there's the question of how and when policymakers unwind the colossal stimulus they have provided. Stephen King, the chief economist at HSBC, says stimulus was originally needed to prevent a Second Great Depression. "But it has morphed from an anti-biotic to an addictive painkiller. The acid test for a sustainable recovery is whether interest rates can return to normal levels. If they can't there is something wrong. But in the near term it is difficult to imagine how they can."
Lehman BrothersBankingEconomicsEurozone crisisEuropean UnionEuropean monetary unionEuropean banksFinancial crisisFinancial sectorEuroEuropeEconomic policyUnited StatesLarry Elliotttheguardian.com © 2013 Guardian News and Media Limited or its affiliated companies. All rights reserved. | Use of this content is subject to our Terms & Conditions | More Feeds |
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