What we have learnt from the financial crisis?

JONATHAN BOTIZ and SAHIR PATEL

We had the lucky opportunity to go and see Vince Cable, the leader of the Liberal Democrats and the MP of Twickenham, at a lecture at the LSE. He has been recognised as an expert on the financial crisis and is an author of ‘The Storm’ and ‘After the Storm’ both books about the 2008 world economic crisis.

We wanted to share some of the amazing knowledge Vince Cable shared with us about the Financial Crisis.

The financial crisis

The 2008 financial crisis has been the worst economic shock since the 1929 Depression, which was caused by deregulation in the financial industry, which led to banks to engage in hedge fund trading. Hedge funds are pools of capital, used by hedge fund traders to help generate profits in financial markets. Also, banks demanded more mortgages to be able to support profitable sales. This created interest-only loans that became affordable to subprime borrowers. This led to a bubble which had formed within the housing market as house prices rocketed. But like all bubbles, the housing bubble popped as investors started to sell the homes and house prices soon plummeted which led to a whole host of problems. 

PAST

In the past, the country tried to recover from the financial crisis by using austerity, this is the difficult economic conditions created by government measures to reduce public expenditure and increase tax revenue.

Vince Cable labelled the financial crisis as “complete nonsense” as it was aided by mismanagement of our economic situation by the government. An example of this was our high government debt created by Gordon Brown’s reckless spending. We had an enormous budget deficit. Moreover, that austerity was a choice.

Before the financial crisis, there was an economist called Hyman Minsky, who was ignored. He said market economies operate in cycles driven by a sentiment which you get an upsurge, exuberance, inflated asset market.

The exuberance becomes too great


Markets crash,


There’s panic,



Banks stop lending which drives the economy into a recession,



Correction is made and you have another cycle upwards.



This is essentially what we now call the economics cycle.



Another cause of the financial crisis as said by Cable was debt deflation. This is when debt becomes too large, (household/ corporate/ government debt) this will drag down the economic activity. As when people have debt, they become more cautious and do not spend as much. Corporations will cut on investment so they do not become bankrupt and the government will stop spending to retain growth and sustainability. All of this will lead to an economic contraction. The combination of Minsky’s bubble and the debt deflation were contributors to the financial crisis of 2008.

The UK was at the epicentre of the financial crisis. It had one of the largest financial sectors in the world. As it had banks such as RBS (biggest bank at the time) and Barclays which all took hard hits.

PRESENT

After the financial crisis, there has been more in place to help prevent another devastating crisis.

The first is that banks are required to hold much more capital, so if there is a crash, they have the capital to help prevent illiquidity, which can lead to insolvency.


Secondly, the more speculative aspects of banking (such as investment banking) have been separated out. This was through the vicar’s reform, where the large British banks have to ringfence their speculative banking activities. Also, there is a more regulatory framework with this banking sector.



Thirdly, we have something new called macroprudential regulation, which means if banks or other financial institutions are lending excessively into a market, they are required to set aside more capital in order to safeguard the sector in the event of a crash.



Even after these measures we still have a risk of having another financial crisis. At the moment property markets are looking dangerous, as house prices now are similar to how they were before the financial crisis.

Another risk is that the UK has a very enormous financial sector, and here we are very dependent on it. So, if anything is to happen to the sector it can have a major impact on the economy. And little has been done to try and balance the UK economy.

What could go wrong?

One thing we need to worry about is the abnormal monetary conditions we are still under with an interest rate of 0.74%...VERY LOW.  If something were to happen to the economy and we have another crisis we wouldn’t be able to rely on expansionary monetary policy as we did back in 2008/09 when our Interest Rate was lowered from 5% to 0.5%. At the moment we would have to rely on Quantitative Easing.

Overseas there have been worries in the US because the debt levels have increased dramatically especially with corporations and the government. The housing market in the US is currently on the rise and the economy overall is in the boom phase of Minsky’s cycle.  If this boom suddenly turned into recession it could have drastic impacts on the UK economy as we have strong ties to the US Economy.

After the financial crisis, the Chinese fought their way out of danger by embarking a massive Keynesian investment program. they borrowed very heavily and experience a massive boom in the country. However, the consequence is that China has accumulated a very large level of debt, it is estimated that corporate debt is 160% of the GDP of China.

A combination of all of these factors can lead to a similar, if not worse financial crisis than we have experienced just over 10 years ago.

By Jonathan Botiz and Sahir Patel