Back to Reality

"Britain's growth will continue into its 59th quarter and then into its 60th and 61st quarter and beyond ... Inflation has fallen from 3% to 2.8%, and will fall further this year to 2% ... Looking ahead to 2008 and 2009, inflation will also be on target. And we will never return to the old boom and bust." Thus Gordon Brown, as Britain's Chancellor of the Exchequer, in his Budget statement only last year. No Chancellor since the war has quite so disastrously misread the economic situation, or so fundamentally misunderstood the inescapable nature of market economies — namely, that the greater the binge, the greater the hangover. Today, Britain is on the brink of recession, inflation has jumped to 4.7%, the housing bubble has burst, and mortgage lender Bradford & Bingley has just been nationalized.

But Brown was by no means alone in his folly. Banks and financial institutions throughout the Western world acted as if the economic cycle was a thing of the past. Instead of understanding that the longer the debt-fueled boom lasted and the greater the debt burden became, the greater would be the carnage when the inevitable day of reckoning arrived, they acted as if the longer the good times lasted the more they could be regarded as a permanent fixture.

This basic error, born of folly, ignorance and greed, is the biggest cause of the mess we are now in. It was compounded by other factors. A system of remunerating bankers with fat bonuses based on the volume of business done, irrespective of the quality and future profitability of that business, did not help. A variation of Gresham's Law was also at play, with imprudent lending driving out prudent lending. This tends to occur as responsible institutions see their market share fall while those of irresponsible institutions rise, and decide to emulate the reckless practices they previously eschewed. The phenomenon was particularly prevalent in the mortgage market. Central bankers cannot escape censure, either. In his memoirs Alan Greenspan, former chairman of the U.S. Federal Reserve, writes: "I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidized home-ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk."

The current crisis reminds us that, in a free economy, the price of the greatly improved long-term performance that only free economies can provide is an ineradicable economic cycle. As John Maynard Keynes pointed out in the 1930s, the cause of the cycle is alternating moods of optimism and pessimism, and its motor is credit, which enables optimism to determine economic activity. However, when Keynes discussed it, the only significant form of credit was business credit, financing capital investment decisions. There has since been a massive growth of consumer credit, which amplified the business cycle and prolonged the recent upswing. In the U.S., consumer indebtedness is a massive 139% of disposable income, while in the U.K. it is even higher at 173%.

The unsurprising consequence of such excess is that individuals and financial institutions must now retrench to rebuild their balance sheets. That is why this is not merely a financial crisis, but an economic crisis. A more prolonged recession than is currently expected is almost inevitable.

What, then, needs to be done? Government and central bank action, around the world, must have two objectives. The first is speedy intervention to prevent a self-perpetuating downward spiral, which means protecting depositors at minimal long-term cost to the taxpayer. The second is to ensure so far as possible that future booms are less exaggerated. This has implications for the form of any rescue package, and for the system of financial oversight that is put in place.

So far as rescue packages are concerned, the presumption must be that, for institutions that avail themselves of a government or central bank rescue operation, the managements concerned lose their jobs, and the shareholders lose their money. This is not vindictiveness: it is needed to prevent moral hazard and to ensure more prudence in future, and of course to protect the taxpayer. As for oversight, banks and other financial institutions clearly need to be far better capitalized than the existing rules require.

And, above all, everyone — banks, borrowers, regulators, central bankers and politicians — must be ever mindful that there is no such thing as an end to boom and bust.

Lord Lawson was Britain's Chancellor of the Exchequer under Margaret Thatcher