Bank regulation, not austerity, explains why Britain is poorer than America
When it comes to Britain’s stagnant growth, we must first diagnose the root cause. That starts in the City, writes Daniel Freeman
Britain has never really recovered from the Great Financial Crisis, and we will soon be entering our third lost decade of economic growth. Before 2008, the UK and US economies grew at an almost identical rate. Per capita trend growth was 2.3 per cent in the UK, slightly higher than the 2.1 per cent in the US. When the financial crash hit, both countries, along with many others, took a significant economic hit. But then the US returned to trend, and the UK didn’t.
This is divergence crystallises the UK’s poor economic performance over recent years, and goes some way to explaining why today economic growth is such a hot-button issue. Everyone, from the City to Carlisle, can feel the effects of stagnation in lower wage growth, job opportunities and living standards. Politicians, who in the last five years have finally noticed the problem, claim to put growth at the top of their priority lists, and yet little changes. But, like a doctor approaching an ailing patient, if we are to have any hope of treating an illness, we must first diagnose it. So what went wrong?
There are a number of explanations, but many fall at the first hurdle. The first and perhaps laziest assumption is just that financial crises inevitably leave long shadows, and a big crisis was always going to leave a big shadow. But this doesn’t explain the gap between us and America. What’s more, the economist Tyler Goodspeed has looked at the evidence from 300 years of recessions on both sides of the Atlantic and found the opposite is true, deeper economic contractions are typically followed by steeper rebounds.
The common explanation that many on the left will reach for is that we have austerity to thank. But this doesn’t explain the divergence with our Atlantic cousins either; America ran a very similar programme of fiscal retrenchment and spending cuts. US government spending peaked at 40 per cent of GDP after the Global Financial Crisis but had been cut back to 34 per cent by 2015. In the UK, government expenditure was still 42 per cent of GDP in 2015 and has since jumped back up to 45 per cent.
What about the favoured explanations of many on the right – in particular a restrictive planning regime and a tax system that is overly burdensome both in size and style? Both are definitely a break on growth, and should absolutely be a priority for the government to fix to get us out of the stagnant waters we find ourselves in. But neither are particularly strong explainers for the specific divergence from America after the GFC. Mainly, because both predate the crash.
So how then, can we best explain why we are today 40 per cent poorer than America, when in 2008 we were catching up to them? How is it that, thanks to the last sixteen years, we would be the poorest US state measured by GDP per capita? In a new briefing for the Institute of Economic Affairs by Tyler Goodspeed examining Britain’s Great Stagnation, he argues that the key difference between the two economies, is the impact of banking regulation.
In response to the crash there was a serious tightening of bank capital, leverage and liquidity rules. After 2009, successive Basel Accords required banks above certain size thresholds to hold more capital and pass tougher stress testing. Sovereign debt carries a zero-risk weight; lending to a small manufacturer in Sheffield does not. Liquidity coverage rules obliged banks to hold government bonds against thirty days of outflows. From 2010, Britain made the situation even worse with a bank levy that taxed bank lending but exempted liabilities backed by gilts. The cumulative effect was to make lending to the state cheap and lending to business expensive and more difficult. And while similar changes were made on both sides of the pond, they had a much greater impact on Britain’s much more bank-dependent economy.
In the UK businesses rely on banks for over 60 per cent of their external financing. In the US that number is below 40 per cent, with the majority of external funding coming from non-bank lending including venture capital and private equity. Additionally, many smaller US banks escaped the worst impacts of the Basel Accords, by not meeting the size thresholds at which financial institutions became subject to new regulation.
The lines charting the UK and US growth trends in this period show a remarkably similar pattern to the ones charting the amount of credit going to the private business sectors. In the US, that credit returned to its pre-GFC level by mid-2013. In the UK, it remains 15 per cent below pre-GFC levels.
When politicians responded to the GFC they did so first and foremost through financial regulation That regulation effectively mandated that their economies produce with less of a critical input for which there are limited substitutes for – bank credit. Before the crisis, small and medium-sized British firms saw 80 to 90 per cent of loan applications approved. By 2024, the approval rate had fallen below half. Without access credit many small and medium businesses struggle to scale, depriving the UK economy of a vital driver of economic growth.
Today, the average family is around £10,000 a year worse off than they otherwise would have been if we hadn’t made these choices. Fortunately, with a better understanding of the problems that caused our great stagnation, we can find the right solutions.
Daniel Freeman is managing editor and deputy editorial director at the Institute of Economic Affairs