Terra Firma

The credit crunch – and the recession – have provided a sharp reminder that, contrary to Gordon Brown’s assertion, ‘boom-and-bust’ has not been abolished. The business cycle is back with a vengeance. It has also reminded us that the easy assumption that the Reagan- Thatcher era of liberalisation and privatisation does not represent the ‘end of history’, but rather represents but one episode in economic history. We can now see that the assumptions that pervaded the great capitalist expansion at the end of the last century are just that – assumptions.

Of these, the assumption about the diminished role – and inferiority – of the State in the economy now looks very hollow. The credit crunch has demonstrated that only the State can rescue financial markets; that the State can take unlimited liability in the way that no bank can. It has also exposed the limitations of unregulated markets: suddenly regulation is not a universal evil, but in some circumstances necessary to maintain the very fabric of the financial system – and, at its heart, confidence.

What began in the housing market, in summer 2007, has gradually infected the global financial system giving, in historical terms, a whole new meaning to the concept of ‘systemic risk’. It has now engulfed banks, hedge funds and stock markets and triggered a global recession.

The State and Financial Markets

As the credit crunch gathered momentum, it assumed a remorseless logic. At each stage, the State has been dragged in to pick up the pieces – and so far, in three main ways. First, early on in Northern Rock’s case, it was seen that no financial institution is safe from bankruptcy if the depositors all want their money back. Banking is based upon a confidence trick: we believe we can always have our money back, but in fact this is only possible if everyone else does not. So the State has to stand behind the banks if their bluff is called: in effect, retail deposits have been nationalised.

Second, the State is also the provider of liquidity of the last resort. If banks will not lend to each other, the State becomes the inter-bank market until a point is reached when confidence returns. For no modern economy can function without credit – hence, the State has to provide what the private banks are unwilling to.

Third, when the banks cannot withstand their losses, the State has to assume these too – hence, the effective nationalisation of banks and key financial institutions and their recapitalisation by the State. The fall in share prices and the attempts to inject more private capital demonstrate that banks have limited liability. Indeed, recent events have demonstrated just how limited it is, compared with the enormous quantum of leveraged debt they have, in effect, underwritten. Northern Rock is now but one example – even the mighty RBS has succumbed. In the US, the role call is awesome, carried through by a right-wing Republican administration.

The financial markets will, as a result, never be quite the same again. The dependency on the State has been made explicit: as a result, there is unlikely to be a return to laissez-faire financial capitalism any time soon. No democracy can withstand the demands of its taxpayers on government to take steps to limit their own future exposure to the sorts of excesses witnessed in this boom.

The State and the Real Economy

What has happened in financial markets may in the end turn out to have one significant benefit – it may just reduce the chances of another credit crunch on anything like this scale, and as a result induce a key element of longer-term stability. But it may not – there may be a ‘dash-to-regulate’ everything from executive pay through to the details of mortgage and other credit provision.

More worrying, perhaps, is the return to the idea that the State can spend its way out of recession, and that both the public finances and the share of government in the economy no longer matter. The simplistic perversion of Keynes’ careful arguments – packaged up in the idea that all that matters is aggregate demand, and that if the private sector stops spending, the State can step in to plug the gap – was discredited in the 1970s. Yet the current UK Brown-Darling policy amounts to little more than this simplistic approach.

What was learnt in the experience of the 1970s was that it matters what the composition of demand is – in particular, the balance between consumption and investment. The tragedy of the 1980s and 1990s – and perpetuated since then – has been to fail to learn that lesson. Private consumption drove demand and the consumer boom went on and on. It was fed by asset inflation – particularly housing – and it fed that asset inflation too. The result is an economy with poor infrastructure and a low level of investment. Pull away the plug of consumption, and the worrying reality has been revealed. The idea that making up the gap by public consumption will do the trick is at best naive.

The State and Infrastructure

If the State has been lax in respect of monetary matters, and is making a serious mistake in respect of fiscal matters, there is a third positive area for it to contribute – and where it has been, and remains, largely absent. This is infrastructure: the core networks that provide the framework for industry to compete.

The infrastructure networks – transport, water, telecoms and energy – are in poor shape. The transport system is widely agreed to be deplorable: trains are full, stations congested, performance is weak; the roads are congested; and some airports are at times described as a national disgrace. The energy sector is no longer fit-for-purpose, and whereas telecoms once led, it now follows its European peers. Water systems creak in droughts. Add to these the twenty years it took to get a railway joined up properly to the Channel Tunnel, the sad tale of the Crossrail delays, and the state of the London Underground, and it is hardly surprising that productivity in the UK lags far behind that of France, even with the latter’s sclerotic labour markets.

Rebalancing the Economic Borders of the State

What these three areas demonstrate is that the economic borders of the State need to be recalibrated to the needs of the twenty-first century. There are some things that only the State can do; there are some things that the State is better at than the market; and there are lots of things that the State is worse at than the market.

In monetary policy, the State’s core and necessary role has been reinforced. In fiscal policy and public finances, the rules are in tatters, and we are now embarking on a splurge of public expenditure on a scale not seen since the Battle of Britain in 1940. This will turn out to be a very costly move – crowding out the private sector for years to come. In infrastructure, the State has been reluctant to shoulder responsibilities that the private sector cannot manage. The lesson from the 1980s and 1990s is that it is not the job of the State to provide. The State is not a good producer: markets are typically much better. But, contrary to the assumptions of those decades, it is the job of the State to decide what sort of infrastructure will be provided – and to make sure it gets paid for.

If the current government wants to use the State to help find a way out of the recession, then it should look to infrastructure – to ways in which investment (rather than consumption) can be increased, which at the same time improves the competitiveness of the economy. The pity is that whilst the government talks about such spending, the reality is that much more will go on social security, transfers and public consumption – buying perhaps some temporary relief, but at a long-term price.


Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

© D.R. Helm, 2007