By late Sunday evening, 12 October 2008, we had the deals we needed. HSBC showed a united front by putting a small amount of extra capital into their British subsidiary despite the fact they did not need it. Barclays, which did need more money, was determined not to take anything from the taxpayer. The board could see all too clearly that the political spotlight would turn on their arrangements for pay – or ‘compensation’, as bankers prefer to call it – and on their lending. They were, I think, philosophically opposed to any government shareholding. Paul spent some hours persuading them to let us announce that they were making their own arrangements, lest complete silence might signal that they were not out of trouble.
Lloyds and HBOS, now on the way to becoming one bank, needed £17 billion, which meant that the UK taxpayer acquired about 43 per cent of their shareholding. This was difficult. Lloyds on its own would probably not have needed so much capital. It was a conservative, well-run bank. HBOS, on the other hand, was neither of those things. It was apparent, after its desperate attempt to raise money in the summer, that it would need a substantial injection of capital.
Gordon had been invited by President Sarkozy of France to explain our thinking to eurozone leaders on the Sunday evening. It was the first time a British prime minister had ever attended this group. This was one of the occasions on which Gordon’s force of personality and determination helped make things happen immediately.
There were no late-night dramas this time. I was in the Treasury before 6 a.m. on the Monday morning. As I sat in my room, waiting for the market press notices to be finalized, as yet again the lawyers demonstrated their uncanny ability to discover problems previously unthought of, I sat down to sign the documentation that effectively transferred the world’s largest bank into public ownership. There was page after page of it, which Gordon and I signed, as Her Majesty’s Lords of the Treasury. This was a dramatic moment.
Sitting there, in the silence of my room, looking out over St James’s Park before dawn broke, I reflected on how much some of my Labour predecessors would have loved to have done this. The last thing I wanted was to nationalize this bank, bringing with it all the problems that it entailed. As it was, we were bringing to an end a conflagration that threatened to bring down the world’s banking system. The media round, a couple of hours later, was largely successful; there seemed now to be a grudging acceptance that we had pulled it off. There should have been a sense of achievement and relief, but there wasn’t. The economy was in jeopardy. I knew it. And the rest of the world was about to wake up to how bad things were.
8 Knocking at the White House Door
The world’s banking crisis was taking its toll on economies around the world. In America, in Europe, in Japan, no one was spared. As a result, government revenues fell and as they all maintained – and in many cases increased – their spending, deficits rose inexorably. Why did governments carry on spending when their incomes started to fall? Margaret Thatcher cleverly but deceptively made the comparison between government and household debt. The analogy took hold, but it is disingenuous. A household experiencing a fall in income that’s likely to last will cut back on what it spends in order to remain solvent. Stay in rather than eat out, shop at Lidl rather than Sainsbury’s, cancel a holiday, sell things on eBay. The impact of that family’s savings on the economy is negligible. But magnify the actions of that household by tens of millions and the knock-on effects are enormous. Shops and businesses start to lose customers and income. They cut back, make people redundant, the people they trade with find their incomes falling and have less to spend, they lay off people, and so it goes on. If, on top of that, the government starts to reduce what it spends, it propels the downward spiral. If the government cuts back the number of people employed in public services, it has to spend more on unemployment benefit and receives nothing back in tax from those who’ve lost their jobs. In turn, those who have lost their jobs spend less because their income has been cut. That hits shops and businesses. Fewer people have jobs, and there is less tax coming into the coffers. Cutting spending in one area leads to increased spending in another: more people out of work means more money spent on benefits. A major rise in unemployment cascades job losses down the line and more businesses fail, throwing even more people out of work.
You are unlikely to solve a crisis in the household budget by throwing your granny out on the street in order to make a quick saving on the food bill. So why would a government throw millions of people out of work to cut a deficit that could be managed down at a steady pace over time? Demand for goods and services generates jobs. Lower demand brings in lower tax revenues. The choices a government makes have a massive and profound impact on the economy, most crucially in times of crisis. When households and companies spend less, and governments cut public spending, recession risks turning into depression. Now we were facing the deepest recession in living history. Granny was going nowhere.
The argument for maintaining public spending is therefore quite straightforward: it takes the strain as business activity reduces and people spend less. In many countries, particularly in Europe, public spending automatically increases during an economic downturn. This is because when someone loses their job they are usually entitled to unemployment benefit. Benefit spending goes up and that has the effect of maintaining spending power in the economy, because people on benefits invariably spend rather than save. In economic terms, this is known as an ‘automatic stabilizer’. The effect is less pronounced in the US, where the payment of unemployment benefit is more limited. Here in the UK, despite everything that was said after the election in 2010, both the Conservatives and Liberal Democrats supported the operation of this automatic stabilizer. Certainly, to start cutting public spending midway through 2008 would have jeopardized millions of jobs.
None of this was new. After the Wall Street Crash of 1929, as a result of falling government revenues, conventional wisdom meant that the US government cut its spending. Money dried up, unemployment soared, businesses crashed and recession turned into the misery of the Great Depression. Exactly the same wisdom, or lack of it, led the Labour Chancellor, Philip Snowden, in 1931 to propose cutting benefits, which led to the fall of the government. It would take the advent of the Second World War and its associated spending on rearmament to bring about a full economic recovery.
Fortunately, wiser voices, and most notably that of the British economist John Maynard Keynes, one of the most influential thinkers of the twentieth century, were there to point out that it is better for governments to employ people to work, thus providing them with an income which they will then spend. This will, in turn, boost the income of the people they spend money with, who will spend in turn, and so on. Although Keynes’s seminal work, The General Theory of Employment, Interest and Money, did not appear until 1936, his thinking was hugely influential on governments struggling to find a way out of recession and the terrible human and economic costs of the Great Depression.
It was the backlash against Keynes’s ideas that drove government economic policy in the recession of the 1980s. We were still paying the social costs of this policy a generation later. In late 2008, I was influenced hugely by Keynes’s thinking – as, indeed, were most other governments dealing with the fallout from the crisis. I could see that if we did not maintain our spending levels, we ran the severe risk of an inevitable recession turning into a deep depression which might last for years. More than that, I felt the government would have to do something extra to stimulate economic growth. Nor was this just our thinking; it was replicated in most countries. In the US, the Republican president, George W. Bush, increased spending. At the same time Communist China was pumping money into its economy.
Here in the UK, though for completely different reasons, the Conservatives and Liberal Democrats both supported the current level of government spending. There was a consensus that public services lacked the necessary level of investment, and certainly in the case of the Liberal Democrats, they sought not to be outdone
by calling for more spending rather than less. On many occasions, so too did the Tories. The Conservatives changed their minds at the end of 2008, sensing, no doubt, where the political advantage would lie at the time of an election two years later. They counted, successfully as it turned out, on a two-year lag which might allow people to forget how close to the brink we were. Curiously, they changed their tune at precisely the wrong time. At the end of 2008 there were very few people in the world who thought that was a good time to cut back public spending. Having supported our public spending levels for years, in October 2008 George Osborne went into fast reverse: ‘Even a modest dose of Keynsian spending is a cruise missile aimed at the heart of recovery,’ he said.
He might count himself fortunate that he wasn’t Chancellor at the time. Much of the growth seen in the UK economy during the summer and autumn of 2010 was due to the measures we took two years earlier, which he fiercely opposed. At that stage, the Liberal Democrats were supportive. Even as late as April 2010, a month before going into coalition with the Conservatives, their leader, Nick Clegg, said: ‘Do I think that these big cuts are merited or justified at a time when the economy is struggling to get to its feet? Clearly not.’ A month later he was singing a different song.
The situation we faced in the summer and autumn of 2008 was a classic case where the government could make a genuine difference. Millions of people, and tens of thousands of businesses, were facing the possibility of a deep economic slump. It is precisely at this time that they look to government to take action in a way that they cannot do as individuals. That, for me, is one of the core purposes of government. Although the general strategy I wanted to pursue was straightforward, the politics and the economics were more complicated. If spending is to be maintained, borrowing needs to rise, and borrowing adds to the national debt, which is the accumulation of each year’s borrowing. A balance must be achieved: how much can safely be spent to support the economy, and how much can be borrowed before the country’s ability to repay it is called into question? That is a matter of judgement. But it is a judgement I believe we got right. If we had not stopped the banking system from collapse, there would have been immediate economic meltdown.
In late October 2008, immediately following the announcement on the bank rescue, I sat down to work out what we needed to include in the pre-Budget report. This would be no ordinary report. It would be, in effect if not in name, a Budget. It would need a lot of thought and a lot of work. The first part of the preparation was to confirm what most commentators already suspected, that there was no hope whatsoever of us complying with our fiscal rules. The rules said two things: one, that we should only borrow to invest and not to fund day-to-day spending; and two, that debt must be kept at a sustainable level, which was set at 40 per cent of our national income. That might seem a lot, but most countries maintain debt levels considerably higher than that. In Japan, for example, it is approaching 200 per cent. No British government has ever defaulted on its obligations; indeed, unlike most governments, which borrow over a short period of about seven years, most of our debt is borrowed over a longer period, on average over thirteen years. That is one of the reasons why we were never at any time at risk of being unable to raise the money we needed. The political scare stories that we might default and go the way of Greece were just that, a ludicrous exaggeration.
I had, however, to prepare the way for breaking these rules. As I had planned to do earlier, I used my postponed Mais Lecture in late October to argue the case that our fiscal rules were there to fit the prevailing current economic circumstances. My argument was that, in the extraordinary times we faced in the autumn of 2008, we had to change our approach to meet them. This was a fairly refined argument, which, although widely covered in the greatly respected Financial Times, was not explored much elsewhere.
Within the Treasury there was, and will always be, a theological debate about fiscal rules, what they should be and what they do. It was clear that the original rules we had adopted were now irrelevant. The argument was whether we should impose new ceilings on spending and borrowing, or whether they should instead reflect a more general aspiration. I did not want to be placed in a straitjacket, especially one that I would have to discard if things got much worse. This is not an academic discussion. If we set rules, especially in a time of crisis, and then broke them, the markets would turn against us, which would mean that the cost of our borrowing would rocket. Rules would require us to do such things as cut public spending or increase taxes, so they do have a direct impact on people.
The only time I lost my temper at a Treasury meeting was during one such discussion with senior officials, which reached such a theoretical, pointy-headed level, so divorced from life out there on the street, that I suggested to officials that Pol Pot had been right: they needed to go back to the countryside and rediscover their roots. I am normally fairly easy-going and they were, I think, taken aback when I sent them packing. A few minutes later I went out to find them huddled in groups, asking each other what had gone wrong.
We came up with a temporary set of rules, which was provided for in the small print of the rules established in 1997. However, even devising temporary rules inevitably caused problems with the author of the original rules, who was now the Prime Minister. There was no question that the original rules were effectively redundant, but Gordon was concerned about anything that might box us in. I agreed, but felt that we needed something to show that, notwithstanding the times, there was some discipline in our approach. We had to maintain the confidence of the markets.
I thought our approach at Dorneywood in July was right. We had sketched out our approach as to how we should deal with the looming recession. First, it would be necessary to maintain public spending momentum in the economy. Secondly, we would also need to provide an additional stimulus. But the third leg was equally important. We would have to show a plan to cut borrowing and reduce debt as we moved out of recession. We thought this would be in 2009 or 2010. I was in a relatively confident mood as I prepared for the pre-Budget report. The bank rescue had worked. The Mais Lecture was written over three months and it was, I thought, logical and coherent. The press remained bad, unremittingly so, but I suppose it might have been worse.
Firstly, I had to pay for the cost of restoring the damage caused by the abolition of the 10p tax rate. I had also promised to do more to try to reduce the number of losers who had not been compensated in the summer. This was a constantly moving target, as people’s circumstances keep changing, and it was to prove impossible to ensure that not a single person lost out. When I announced the measure in May, we were sure the extra spending power, when the money got into people’s pockets in September, would help the economy. I wanted to keep the measure as one part of my plan to boost the economy. Measures on tax would also be part of the stimulus. On top of that, I wanted to do more to encourage spending and help shops and businesses.
That is where cutting the rate of VAT came in, an idea we had first discussed at Dorneywood back in July, as the storm clouds gathered. The idea behind a temporary cut in VAT is that it not only increases spending, but also brings spending forward, as people seek to take advantage of the temporary reduction. For this to work, it has to be announced that VAT will go back up on a specified date. What to do with VAT was to dominate the tensions between me and my next-door neighbour right up until the general election. He was initially sceptical about a reduction and was worried what the reaction would be when the rate went back up a year later.
I wanted to put extra money into the hands of consumers as quickly as possible, in the hope that they would go out and spend it and so support businesses. There are two ways in which this can be done. The first, which would have been my preference, was to increase everyone’s personal tax allowance, as I had done earlier in the year to compensate for the abolition of the 10p tax rate. This had cost £3.5 billion and it put another £120 per year into the pocket of every basic rate taxpayer. The problem was that, because of HMRC’s
creaking computer systems, it would take nearly six months from the time of the announcement for the benefit to be felt. It would be early summer of 2009 before anyone would see any money, which was far too late.
That left me with the second option, of cutting VAT by as much as was permitted under European Union rules, to 15 per cent. A VAT cut could come in immediately, certainly in time for Christmas. I settled on the VAT cut. The question then was how to pay for it. I judged that the markets would accept increased spending so long as they could see that we were also putting in place longer-term plans to get the money back once the crisis was over. It was also necessary, in my view, to begin to signal measures that would bring down our borrowing once we thought the recovery was established, which we knew would not be until 2010 or 2011. I therefore proposed that after the temporary cut in VAT we would gradually increase VAT in stages. It would return to the 17.5 per cent rate in January 2010 and would then rise each year by 1 per cent until it reached 20 per cent. This gradual rise was important. I didn’t want to put up VAT in one go because I thought that would be a shock to the economy and to consumers, and, because it would increase prices, it would push up inflation.
Because a tax on the cost of goods and services has a greater impact on people on lower incomes, I would also need to do something to help them elsewhere in the tax system. In the jargon, VAT is mildly regressive – that is, it has a greater effect on people on lower incomes, unless you do something to counter it. However, it is not as regressive as some people believe. It is not levied on food and children’s clothes, for example.
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