Can we just go back to 2006?

The Duncan Weldon Economics Matters Column

An awful lot has happened in economic sphere over the past 4 years – the ‘subprime crisis’ of 2007 became the ‘credit crunch’ of 2008 which morphed into the ‘Great Recession’ of 2008-09, economic questions dominated the general election of 2010 and now Britain faces a sluggish recovery, huge cuts to public services and the not entirely implausible threat of a double dip recession.

The central political issue (at least according to the media) is the question of how best to reduce the deficit. But today I want to step back from the immediate battles over economic policy (to cut VAT or not, the pace of spending cuts, the balance of tax and spending) and ask a bigger question – one that, I believe, gets to the core of Labour’s thoughts on the whole question of political economy.

“If we could just ‘go back to 2006’ would we be happy with that?”

Remember the campaign posters in 2005? How the issue of the economy was dealt with? A near endless repetition of macroeconomic statistics – the longest period of unbroken economic growth in 200 years, the lowest interest rates and inflation since the 1960s, low unemployment.

Much of this though was underpinned by an enormous credit bubble. Between 1997 and 2007 banks advanced £1.3 trillion of loans to UK residents – 46% of this went to financial companies, 12% to commercial real estate and another 23% on residential mortgages. Mortgage equity withdrawal in 2004 was around 8% of household post-tax income.

2006 was the last year that the old New Labour model of political economy worked – credit continued to flow propping up both asset prices and consumption and boosting the Treasury’s coffers to the extent that financial services firms alone contributed around a quarter of corporation tax receipts in 2006/07 (and 14% of total revenues).

If one adds on stamp duty, income tax from those involved in the financial services and real estate industries and the VAT collected on goods bought on credit, the total contribution of the credit boom to the tax take was much higher.

This higher tax take from finance and property allowed Labour to fund higher spending on core public services without recourse to raising income tax or VAT, the credit boom kept house prices high ensuring a feel good factor (especially in ‘middle England’) and the easy availability of loans made up for poor wage growth.

Of course it also made both the economy, and crucially the public finances, especially vulnerable to a financial crash. The central reason that the UK’s deficit rose by much more than other advanced economies in 2008 was not because the UK government spent more (our stimulus was actually on the low side) but because tax revenues collapsed.

We mistook the financial services boom for a miracle when it was actually a mirage driven by increased risk taking, as the Bank of England’s Andy Haldane has put it (pdf).

Labour achieved a great deal in office from 1997 until 2010 – increased (and much needed) investment in public services, huge progress on eliminating child poverty, the minimum wage, to name but three – but much of it was built on weak foundations.

Looking back, with the benefit of hindsight, the party leadership is more than happy to admit that Labour got its regulatory approach to the banks wrong. Of course the Tories were worse – calling for even further deregulation, but this almost beside the point.

Imagine for a moment that Labour had been tougher on the banks – had called for less risk taking, required higher capital ratios, put an end to much of the more speculative activities – where would that have left the Brownite model of political economy?

Without the credit boom – where would the revenues to pay for increased investment in public services have come from? Without easy lending how would households have maintained their consumption (and remember that in the 5 years before the crash household income was falling in much of the UK)? How would the feel good factor have been maintained without seemingly ever rising house prices? Where would the growth (and jobs) have come from given the UK’s low level of investment in productive businesses?

Just saying ‘we would have regulated the banks better’ isn’t enough. It raises far more interesting, and difficult, questions.