The Legacy of the Crash

by Terrence Casey

  TARP wound down in October 2010 with the government having dispersed $388 billion of the $700 billion available. By that time $204 billion has been repaid, including 78 percent of the capital injected into financial institutions (US Department of the Treasury, 2010, p. i). Citigroup and Bank of America are no longer under the TARP, although AIG has only repaid about one-fifth of the capital advanced. By early 2011 the government’s share of GM was down to one-third with the automaker looking to buy back additional shares, and Fiat was set to purchase the remaining shares of Chrysler. In both word and deed the Obama administration has established that it intends to liquidate government holdings in these companies as soon as possible. When combined with revenues raised from stock sales, the Treasury estimates that the total cost of TARP to be around $50 billion, as well as an additional $30 billion loss on AIG (US Department of the Treasury, 2010, p. 3). At about 0.5 percent of GDP, this is well below both the $350 billion initial estimates for the TARP and comparably much lower than the savings and loan bailouts of the 1980s, which cost the taxpayers the equivalent of 2–3 percent of GDP.

  The Brown government moved with similar speed to shore up the banks. Following Lehman’s collapse, and with direct intervention from the prime minister, Lloyds TSB purchased HBOS, the UK’s largest mortgage lender, in a £12 billion shares swap. Two weeks later the government nationalized Bradford & Bingley, taking over its £50 billion mortgage unit. Following America’s lead, Brown and Darling announced a rescue package of their own, including £50 billion of cash for equity swaps, £100 billion in short-term loans from the Bank of England, and another £250 billion in loan guarantees (Guardian (online edition), 8 October 2008). Five days later it was announced that the Royal Bank of Scotland, Lloyds TSB and HBOS were to receive £37 billion between them in exchange for equity stakes of roughly 60 percent for RBS and 40 percent for the merged Lloyds TSB and HBOS (BBC News Online, 13 October 2008). Whitehall would also now have a say in how the banks were run, including questions of executive compensation.

  Having blocked financial collapse, attention turned to reviving growth. The ‘era of big government’ came roaring back to life as both nations implemented massive stimulus packages. American stimulus began before the crisis broke in earnest, with a $168 billion package in February 2008. Bush’s lame-duck status precluded additional stimulus before 2009. Just after being sworn in President Obama signed the $787 billion American Recovery and Reinvestment Act, including immediate aid to states and localities, extended unemployment benefits, and tax cuts. Longer-term commitments included an array of infrastructure and transportation projects, R&D grants, and nearly $90 billion for clean energy development (Grunwald, 2010). Chancellor Darling sought to jump-start the British economy with a £21 billion stimulus package in November 2008. The bulk of the stimulus came through a 2.5 percent VAT reduction applicable through 2009, necessitating a vast increase in public borrowing, up to £175 billion in 2009.

  Monetary policy was also unleashed with full force. The Fed began aggressively cutting rates at the end of 2007, with the Bank taking a more conservative approach. Once the crisis hit full force, both central banks quickly slashed rates to near zero. With nowhere else to go on interest rates, Mervyn King and Ben Bernanke moved to boost the money supply through ‘quantitative easing’. This involved purchasing assets and then transferring credits to institutions reserve accounts – a more subtle and sophisticated equivalent to printing money. In March 2009 the Bank, with the Chancellor’s approval, purchased £75 billion of government securities (gilts) and some high-quality private assets. Three additional rounds raised the total amount of assets purchased to £200 billion. The MPC decided in February 2010 to hold at that level, reviewing the need for further purchases at each meeting (Bank of England website). The Fed was even quicker on quantitative easing, buying up $1.4 trillion in assets (GSE securities, private MBS’s, and commercial paper) between the fall of 2008 and August 2010 (Federal Reserve website). With the economy still struggling and core inflation flat, the Fed initiated a second $600 billion round of quantitative easing (quickly dubbed ‘QE2’) in the fall of 2010. Purchases of new assets under QE2 came to an end with the second quarter of 2011, with the Fed continuing to buy new bonds as existing investments mature, thus not withdrawing any money from the economy. In the first ever press conference by a Federal Reserve Chairman in April 2011, Bernanke gave no indication as to when that policy would change.

  Fiscal and monetary stimulus did not produce recovery, however. Following a sharp downturn in 2009, both economies saw the return of modest growth in 2010 (see Table 3.1). The OECD’s May 2011 Economic Outlook makes similar projections for the next two years. Even these numbers may prove optimistic as the US housing market again declined and the May jobless rate tipped above 9 percent. The UK economy saw a 0.5 percent contraction in the last quarter of 2010 followed by an equivalent uptick in the first quarter of 2011. The refrain from the Labour government (when they were still in power) and the Obama administration was that without aggressive intervention the economy would be vastly worse, a politically and economically difficult counterfactual. Whatever gains were made, they came at a terrible cost to public finances. Deficits skyrocketed to 11.3 percent of GDP in the UK and 11 percent in the US in 2009. CBO projections do not see the US deficit dipping below $500 billion for the rest of the decade. National debts have concurrently ballooned (Figure 3.2), doubling in the US and increasing over 150 percent in Britain.

  Table 3.1 GDP growth and unemployment rates in the US and UK

  * Projections (from May 2011).

  Source: OECD (2011).

  Figure 3.2 Public debt levels

  Source: OECD (2011).

  Faced with this abysmal fiscal situation, Chancellor George Osborne’s 2011 budget aimed to eliminate the structural deficit within the term of this Parliament. Given the Tory’s manifesto commitments on the NHS, other departments will see 19 percent cuts on average. Up to half a million public sector jobs may be shed by 2015 and additional contributions (£3.5 billion total) required by public employees for their pension schemes. Cost control in general state pensions would be achieved by hastening the increase in the retirement age to 66 and indexing pensions to the consumer price index (CPI) rather than the (generally higher) retail price index (RPI). An additional £7 billion in savings will come from reductions in welfare budgets through changes to incapacity, housing benefit and tax credits (BBC News Online, 20 October 2010). New revenue would be generated through a VAT increase from 17.5 percent to 20 percent, purported to raise an additional £13 billion per year. The overall corporate tax rate was cut while new levies will be imposed on North Sea oil producers and banks. Even with this the deficit will remain at 9.5 percent of GDP for the 2010/11 fiscal year (ONS, 2011). Whether this increases market confidence and private investment is a point of speculation. What is certain is that the pain will be felt in the near term. With flat wages, declining public benefits, and rising inflation, the Office of Budget Responsibility (OBR) forecasts that the real standard of living for most British families will fall through 2013 (Daily Telegraph (online edition), 24 March 2011). The coalition is betting that strong growth will return by then.

  The fiscal quandary is equally severe in the US, driven by the big entitlement programs: Social Security, Medicare, and Medicaid, accounting for 43 percent of federal outlays between them. Other mandatory spending and interest on the debt account for an additional 17 percent; defense spending and non-defense discretionary spending account for about 20 percent each. With rising healthcare costs and aging baby-boomers, the fiscal burden of all three entitlement programs will increase exponentially without reform. The steep rise in the debt combined with the lack of a credible reduction plan was sufficient to draw an admonition from the International Monetary Fund (IMF) (IMF Fiscal Monitor, April 2011).

  America’s separation of powers and divided government complicates matters. Following big Republican gains in the 2010 midterm congressional elections,
the two ends of Pennsylvania Avenue are at loggerheads. The Republican position is built on House Budget Committee Chairman Paul Ryan’s proposals (Ryan, 2011), calling for $6.2 trillion in spending cuts over the next decade and bringing overall federal spending below 20 percent of GDP, having risen to 24 percent in 2010. Domestic spending would be cut to 2008 levels and frozen for five years, Medicare transformed into a voucher program, and Medicaid shifted to block grants to the states. Having staked a forward position on Medicare and Medicaid – and remembering George W. Bush’s failures – the plan offers no reforms of Social Security. The Republican plan also would reform the tax code, reducing the top rates for individual and corporations, and closing various tax breaks and loopholes. The balance of adjustments fall on the spending side and, adopting supply side arguments, is premised on tax cuts increasing revenue by stimulating growth.

  President Obama countered in April 2011 with a plan for $4 trillion in cuts over the next 12 years – despite having submitted a budget in December that increased spending and foresaw a $1.65 trillion deficit. Obama’s proposed savings come mainly through cuts in discretionary domestic and defense spending, as well as raising revenue through repealing tax benefits aimed at upper income Americans. Republican Speaker John Boehner immediately declared tax increases a ‘non-starter’ (Washington Post (online edition), 14 April 2011). Also included is a proposed ‘debt failsafe’, a triggering mechanism that would automatically cut spending across the board if deficits are not stabilized by 2014 – but excluding Social Security, Medicare, and other programs for low-income Americans (Bloomberg (Online edition), 13 April 2011). Indeed, Obama’s proposal offers no significant changes to the major entitlement programs other than some general proposals to seek greater efficiencies within Medicare.

  The first skirmish in this war ended with an eleventh hour compromise in April 2011 to cut $38 billion from the fiscal year (FY) 2011 budget. The battle shifted in the summer to the need to raise the debt ceiling, which will be reached by August 2011. Conservative Republicans vowed to vote against this unless matched by serious deficit reductions. As of this writing, negotiations were ongoing.5

  The final major element of recovery was the re-regulation of the financial system. With health care dominating the legislative agenda in Obama’s first year, the Dodd-Frank Wall Street Reform and Consumer Protection Act was not passed until July 2010. Under this legislation the Federal Deposit Insurance Corporation (FDIC) is granted powers to unwind failing firms deemed a threat to financial stability. The Act also implemented a watered down version of the ‘Volcker Rule’ (named for former Fed Chairman Paul Volcker), intended to stop banks from proprietary trading (playing the market with their own money) and investing in hedge funds and private equity. Banks are also required to spin some riskier derivative swaps (commodity, equity, and non-investment grade credit contracts) off to separate affiliates (with higher capital margins) while retaining interest rate, exchange rate, and higher-quality credit swaps (The Economist, 2010, 3 July, p. 66). It also requires standardized derivatives to be traded through clearing houses. Customized derivatives are not so restricted. To better spot the onset of systemic risk, the bill creates a Financial Stability Oversight Council, headed up by the Treasury Secretary and the Chairman of the Federal Reserve. For consumers the Act also created a broadly empowered Consumer Financial Protection Bureau (CFPB) housed inside the Federal Reserve.6

  The final bill was an unwieldy 2,319 pages, criticized for being both too restrictive and too permissive. If the problem was giant firms taking giant risks in unregulated markets, the law provides only a partial cure, putting limited constraints on reckless behavior and providing a loose structure for liquidation when things go bad. In reality, many of those ‘too big to fail’ firms are even bigger than before the crisis. For those who see government as the problem, the legislation has a massive omission: it does nothing with Fannie Mae and Freddie Mac. A February 2011 Treasury White Paper presented three options for the government’s role in the mortgage market: limit it only to Federal Housing Authority loans (for poorer borrowers only); providing guarantees for mortgages, but only at market-competitive standards (for example, higher down-payments); or serve as an insurer of mortgages only for ‘catastrophic downturns’ in the market. But the final choice was kicked to Congress and any transition would take five to seven years at least (US Department of the Treasury, 2011). All three proposals foresee a substantial withdraw of the government from the mortgage market over the long term. Overall, the biggest issue with the Dodd-Frank Act is that nobody really knows how it will work. The legislation requires hundreds of rules to be written by dozens of agencies. How agencies will translate the legislation and what ability lobbyists have to blunt the process remains to be seen. Beyond this, a more Republican Congress will be less inclined to authorize funding for increased government regulation of financial markets, which may gut the rules regardless of how they are written.

  In the UK, within the pre-crisis tripartite system, the Bank of England focused on macro-economic stability, the Treasury on the budget, and the FSA on individual financial institutions. Systemic risk fell between the cracks (HM Treasury, 2010a, p. 4). In the wake of the meltdown, the Labour government passed the Banking Act of 2009, giving the Bank a statutory obligation to maintain stability, managed by a new Financial Stability Committee and creating a Special Resolution Regime to allow authorities to manage distressed institutions (Bank of England website). For the Coalition government, these reforms did not go far enough (Hoban, 2010). In June 2010 they appointed an Independent Banking Commission headed by Sir John Vickers. The main issue for the Vickers’s Commission is whether to separate retail and investment banking along the lines of the old US Glass-Steagall Act. Their final report is not due until September 2011, but an interim report in April suggested only putting a firewall between retail banking operations and riskier trading operations (Independent Commission on Banking, 2011), rather than formally breaking up universal banks.

  In July 2010 the Treasury released a White Paper (HM Treasury, 2010a) outlining its other proposed reforms. The tripartite system, it argued, failed to identify problems as they were developing, did not mitigate them before dangerous instabilities built up, and had difficulty dealing with the crisis once it broke. To better identify and counter systemic threats – ‘macro-prudential regulation’ – the White Paper proposes creating a new Financial Policy Committee (FPC) chaired by the Governor of the Bank and made up mainly of Bank representatives. Operational responsibility for regulating individual banks was transferred from the FSA to a new Prudential Regulation Authority (PRA), also under the Bank. As the FSA was said to rely too heavily on ‘tick-box’ regulation rather than risk analysis, the PRA is intended to follow rules less and judgment more (HM Treasury, 2010a, p. 23). This structure combines macro- and micro-prudential regulation in the Bank, closing the gaps in responsibilities and giving regulators tools to ensure systemic stability, such as countercyclical capital requirements, capital buffers during upturns, leverage limits, and variable risk weights (HM Treasury, 2010a, pp. 15-16). Centering these controls in the Bank will additionally allow monetary policy and financial regulation to work together. As in the US, the Cameron government proposes creating a Consumer Protections and Markets Authority (CPMA) to take over the business regulation responsibilities of the FSA (itself being dissolved into the new PRA and CPMA). Following consultations, the new regulatory framework is not expected to be in place until the end of 2012, however.

  Concurrent with national reforms are a new set of international rules, the so-called Basel III rules, which increase and tighten the definition of banks’ capital requirements. This renders finance more solvent, but may reduce profitability and national growth. A 2011 OECD study estimated that the new requirements might reduce aggregate output by –0.05 per cent to –0.15 percent per annum (Slovnik and Cournède, 2011). Of greater concern is that banks moved into mortgage-backed securities because their lower risk-weight allow
ed them to reduce capital minima. The new rules leave risk-weights unchanged. As these rules are being phased through 2019, moreover, the details of implementation may substantially affect their actual impact.

  Our current economic woes grew out of the financial sector. One would expect major reforms in response to the crisis. Nevertheless, neither Britain nor America attempted a major structural reform of finance. While there will be new limitations and controls, they do not look to be especially onerous. More importantly, given delays in rule-making and implementation, we will not know how any of this will really work until at least 2013.

  The stability of Anglo-Saxon capitalism

  In the homelands of neoliberalism, the financial crisis of 2008 produced the unthinkable: nationalization, market intervention, and a revival of Keynesianism. Given the scope and rapidity of this volte-face, it seemed an era had ended. Surveying the scene three years later, however, what is most striking is how little the political economies of the US and UK have changed. The retreat of the free market model appears to have been temporary.

  This is quite a contrast from previous crises. The Great Depression saw the New Deal in the US, initiating a multi-decade rise in the scale and scope of the federal government. The Attlee Government went even farther, nationalizing major industries, undertaking demand management, and implementing cradle-to-grave welfare. The crisis of the 1930s thus moved the state to the center of economic management in both countries. As the postwar boom collapsed in the 1970s, the Thatcher and Reagan governments reversed course, arguing that the state was the problem and inaugurating three decades of neoliberal economic governance. However, if we look at the major policies in response to the 2008 crisis – bailing out the banks, fiscal and monetary stimulus, and financial market regulation – these are better described as ad hoc reactions in a moment of crisis rather than a coherent rejection of neoliberalism. The policies of Gordon Brown, George W. Bush, Barack Obama, and David Cameron have all in their own way sought to address the specific excesses of the recent past, not fundamentally restructure the political economy. The Obama administration may have run on ‘change you can believe in’, but they have not been able to deliver any structural change in American economic management. Even the health care plan has an uncertain fate. So far there is minimal indication that political elites in Britain and America are ready to abandon the core elements of a liberal market economy.