Terra Firma

In the last two decades of the twentieth century, a political revolution took place. Led by Thatcher in the UK and Reagan in the US, the economic borders of the State were rolled back. Functions which had implicitly or explicitly been taken on by governments of both left and right were handed over to the private sector. Gone was the creed of nationalisation, national champions and monopolies and in its place the new conventional wisdom became privatisation, competition and liberalisation.

A raft of policies followed this revolution. In addition to selling off state assets and abolishing statutory monopolies, financial liberalisation, the sale of publicly owned housing and sharp reductions in income taxes characterised a period of a rekindling of faith in markets, and a corresponding pessimism about the capacities of government.

The new conventional wisdom survived the demise of its architects. In the UK, after Thatcher, Labour did not dare to challenge the all-encompassing powers of the market. Indeed, Labour under Blair carried on where the Conservatives left off, selling off more assets and sharpening up competition policy. In financial markets, Labour’s faith knew few bounds, and after 1997, the Brown-led Treasury significantly weakened the few remaining constraints. Indeed, Brown took every opportunity to lambast his European counterparts on their sloth in liberalisation and the implementation of the Lisbon agenda. In the US, Clinton similarly adhered to his Reagan inheritance. Indeed, so much so that Clinton was a role model for Blair.

The new market-based conventional wisdom delivered much. Few would argue that there were not very considerable gains in efficiency in the old public sector domains and that freedom for entrepreneurial spirit did not benefit the economy generally. The 1980s and 1990s brought us the internet and the information revolution—a transformation in the nature of economic organisation on a par with the coming of the railways in the 1840s, and electricity and cars after the First World War. It would be hard to envisage that the State could have delivered this technology and the scale of investment that went with it, as witnessed by the statist performance of the Soviet Union and pre-market China.

But the new conventional wisdom—like all economic faiths—led its supporters to overstate what the market could deliver. With privatisation and liberalisation came the belief that unregulated markets were bound to meet the public interest and even that greed was a sufficient condition for wealth creation. So the believers brought us not only an economic transformation, but a massive bubble too. Banks, companies and consumers bought into the story: since tomorrow was bound to be better than today, not only was it irrational to save, but all parties should gear up into that inevitable growth. Even governments joined in: if the economic miracle was boundless, then tax revenues would be higher tomorrow and therefore deficits today did not matter since they would be financed by the proceeds of growth.

Politicians—too often with little knowledge of economics—basked in the reflective glory of all this economic growth. Few were as hubristic as Brown: there would be ‘no more boom and bust’. He had, after all, abolished the business cycle. His spending boom after 2000 would be financed from his successes. House prices could rise rapidly, justified by increased wealth, and the correct response was to build more houses to meet the higher expected demand. The Bank of England would no longer need to regulate the financial institutions—this could be left to an independent FSA. In the Brown world, there was no prospect of banks going bust or the enormous piles of securities and debt instruments going belly up.

What happens when the bubble bursts?

In 2007, the bubble burst. The credit crunch first engulfed the US sub-prime market, revealing that the combined wisdom of regulators, rating agencies and banks had somehow failed to notice that the securitisation process had not abolished risk, but rather concentrated it. A financial tragedy gradually unfolded, eventually engulfing the global economy into a severe recession, a process which has many acts left to run.

The first move was a global reduction in interest rates, led by the US. That did not work and a full credit crunch ensued. Lending between banks dried up. Northern Rock collapsed despite the FSA saying it was solvent, for the very good reason that, whatever the accounts say, once confidence is gone and people want their money back, few financial institutions can survive. Worse, Lehman Brothers went bust too and even Goldman Sachs was forced to dash for the protection of the formal status of a mainstream bank.

As a result, the interbank market failed and a gradual process of central banks taking over the functions of the financial markets ensued. Retail deposits were guaranteed, Northern Rock, AIG, Fannie Mae and Freddie Mac were all nationalised, followed by the partial nationalisation of many of the mainstream banks as governments recapitalised them. As the capital base of the banks contracted, then governments began the process of guarantees and direct lending to industry—a process which is likely to run on for perhaps years to come.

Where does it end?

By the time the credit crunch and recession have run their course, the economic landscape will be almost unrecognisable to the politicians, bankers and industrialists of the late 1990s. At a minimum, the State will have nationalised much of the risk of the market economies, from houses to pensions to corporate borrowing through to retail deposits and the banks themselves. State ownership of assets—and especially liabilities—will have rapidly expanded. Not since the immediate post-Second World War years of 1945–50 will the State have owned so much of the economy and held so much equity risk.

The State will also be deeply in debt. It is hard to imagine any major developed country with a debt to GDP ratio of less than 100% and Japan as well as the US and the UK may eventually end up closer to 200%. These debts, and continued deficits, will haunt financial markets. For every borrower, there needs to be a lender. It is not clear who these might be and whether they have the capacity to deliver the money required. Most likely governments will resort to the printing press—deficits will not only be unfunded, but also unfinanced. Inflation may follow.

The end result is almost inevitably a crisis and this indeed is what provides the glimmer of hope. For a crisis enables the decks to be cleared—to renege on the debts. In some cases this will be straightforward defaults (like the Russian one in 1998). In others, it may be implicit through inflation.

Where will that leave the State?

However the end game plays out, the question then is what is the longer-term role of the State. Can the borders by rolled back again—as in the 1980s, after the crises of the 1970s? Or will a different kind of State emerge?

Some sort of roll-back is probably inevitable. The State will simply not be able to levy the taxes necessary to finance its bloated functions. It will have to retreat and thereby expand the role of the private sector again. We can expect the gradual re-privatisation of the financial institutions, the return to market disciplines for the bailed-out industries, and gradually a re-pricing of labour from unemployment back into the labour force.

But other aspects of the State will not revert so easily back to the old model. The regulatory functions of the State will remain and there is likely to be a generational scepticism amongst not only politicians but also the general public towards unbridled capital markets. Reform of regulation, a return to the low-risk utility model for banks and the clear supervision of debt markets are most likely. Public confidence in capitalism has been severely dented and it will take time for the new confidence in government to wane with the experience of its consequences.

To make this work—rather than provide a deadening hand on enterprise and innovation—will require conceptual and practical skills. The trick with designing regulation is not to make it light-handed—that, after all, is what we have had, and what has failed so lamentably. It is not even that it should be proportionate. It is that it should provide clear, predictable and targeted rules within which markets can function with confidence. It is a constitutionalism towards markets. So, just as we need monetary rules, and rules to constrain fiscal irresponsibility, we also need market rules. That is the challenge—whether the current crop of politicians and officials understand it is another matter.


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.

© Dieter Helm