David Coates and Kara Dickstein
Paper prepared for the British Politics Group conference
“The UK and US in 2010”
George Washington University, Washington DC
September 1, 2010
Please do not cite without permission
David Coates & Kara Dickstein
Departments of Politics and Economics
Wake Forest University
1834 Wake Forest Road
Winston-Salem NC 27109
The effects of the credit crisis which broke in September 2008 were particularly marked in the two economies whose financial networks and housing markets were critical to its origin – namely the United States and United Kingdom. The paper charts the development of the crisis in each, and traces the policy responses of governments in Washington and London. It then moves to a comparison of the crisis and its consequences on either side of the Atlantic, before exploring the forces generating the Atlantic divide evident in that comparison. The paper closes with a set of remarks on likely developments in each “city”.
A Tale of Two Cities:1 Financial Meltdown and the Atlantic Divide “…the stimulating effects of either fiscal or monetary expansion may be disappointingly small. The truth is that there
is no easy way of digging yourself out of a hole. It is far more important to take precautions against falling into one.”2
The 2008 financial meltdown was a genuinely global affair. By the time it was through, the global banking system had lost maybe $4.1 trillion of its value, the world fiscal deficit had risen from 2% to over 10%, and economies world-wide had seen a spike in unemployment that totaled at least 50 million.3 These enormous numbers stand in comparison to those generated by the depression of the 1930s, and like that depression, the one which began in 2008 threw a long global shadow. But the shadow is not the same everywhere. It is deepest where the crisis originated and the meltdown first occurred – in the United States (US) and the United Kingdom (UK) – and even where it is deepest, there we can still see significant variations of gray. The purpose of this paper is to chart and explain both the shadow and the variation. The paper begins with a schematic story-telling, which documents the key events that shaped the crisis in both economies, and records the major policy responses. It then moves to a comparison of the crisis and its consequences on either side of the Atlantic, before exploring the forces generating the Atlantic divide evident in that comparison. The paper closes with a set of remarks on likely developments in each “city”.
THE SCHEMATIC STORY
THE US STORY
The credit-crisis began in the US housing market in 2006 and 2007. After a decade in which house prices had effectively doubled and in which many home-owners had remortgaged their houses to sustain high levels of immediate consumption, two Bear Stearns hedge funds heavily engaged with subprime loans unexpectedly collapsed at the end of July 2007. Concern then spread rapidly through the entire US financial system about the widespread sale of such loans to house buyers on low incomes, and about the associated danger of a foreclosure tsunami; and with good reason. In 2001 new subprime and home equity loans had totaled $330 billion, just 15% of all new residential mortgages. Five years later the equivalent figures were $1.4 trillionand 48% of all new residential mortgages. This would not have mattered – outside the housing sector at least – had not these mortgages also been securitized.But they had. Securities collateralized by mortgages increased in the US financial system from $18.5 billion in 1995 to $507.9 billion in 2005. The two dates were divided by what the Federal Reserve Board called “a dramatic weakening of underwriting standards for US subprime mortgages.”4 That weakening was so dramatic that by November 2007 Merrill Lynch was obliged to write off $8 billion in losses on mortgage-backed securities, and by the end of 2008 one house in ten in the United States was either in or on the edge of foreclosure.
This deepening foreclosure crisis spread rapidly through the entire US banking and insurance system, leaving key players unsure about their own viability and the viability of others, and bringing down a number of leading US financial institutions. 2008 witnessed first the January sale to Bank of America of Countrywide Financial (the main private provider of subprime loans) followed in September by the seizure by federal regulators of Washington Mutual, the nation’s largest savings and loan institution. 2008 also saw the complete collapse of Bear Stearns in March 2008 (sold to JPMorgan Chase at $2 a share) and then, in a single terrifying week in September, the swallowing up of Merrill Lynch by Bank of America, the first of many Treasury bailouts of insurance giant AIG, and the allowed collapse of Lehman Brothers. The spreading financial crisis broke the confidence of banks in each other, and dried up the supply of credit from bank to bank, and from bank to consumer. What had begun as a financial problem in the housing market then rapidly became a credit-shortage problem for firms and households alike. The US GDP fell at an annualized rate of 6.2% in the last quarter of 2008, a year in which 2.6 million Americans lost their jobs. 2009 was worse – 6 million more jobs gone, including 1.2 million lost in the US manufacturing sector. The Federal Reserve cut interest rates in a vain attempt to blunt the recession – the bench-mark discount rate was down from 6.25% in August 2007 to 1% by November 2008 and effectively to zero in 2009 – yet the US economy still moved into recession in December 2007 and stayed there throughout 2008 and the first half of 2009.
The initial Bush administration response to difficulties in the US housing market was simply to allow market forces to play themselves out. To householders facing negative equity as house prices fell in 2007, or foreclosure as subprime “teaser” rates gave way to real ones, the Republican administration’s initial argument was that “a federal bailout of lenders would only encourage a recurrence of the problem. It is not the government’s job,” President Bush said in September 2007, “to bail out speculators or those who made the decision to buy a home they knew they could never afford.” 5 As mortgage lenders themselves then began to default, the Bush administration, seeing the wider problem, initially restricted itself to quietly orchestrating private-sector rescues designed to contain the spreading fire. Only at the eleventh hour did the Bush administration see the need for unprecedented public intervention, and when it did, it went in for bailouts on the grandest of scales. The two main Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, were already in federal hands by the time Lehman Brothers fell, taken into full “conservatorship” (that is, effectively nationalized) by the hitherto entirely free-market Republican administration. The subsequent Paulson response to the September 2008 credit-crisis was a $700 billion rescue package (contained in a three page document giving the Treasury unprecedented powers and freedom from Congressional oversight) aimed at locating and absorbing mortgage-backed securities whose value was in freefall. It was this Treasury power grab that the Republican-dominated House then rejected, obliging the administration to change course. (The TARP bill that passed early in October 2008 included a Congressionally-imposed $150 billion of tax breaks, limits on executive pay in bailed out companies, and powers to ease mortgage terms to prevent foreclosure). Paulson then used the resulting TARP money in the last months of the Bush administration not to buy toxic assets (quickly finding and valuing them proved too difficult) but to recapitalize commercial and investment banks, and the largest of the insurance companies and hedge funds, hoping in that way to restore inter-bank confidence and the large-scale flow of credit again.
In this process, key financial institutions received huge sums of public money. By the time the Obama administration came to power, the US Treasury had made available $125 billion in aid to nine major banks, an additional $125 billion to smaller banks and an extra $40 billion to AIG. Alongside the moves to stabilize individual institutions, monetary policy too quietly eased, with Federal Reserve-financed injections of yet more credit-guarantees and central bank-orchestrated expansion programs for the financial industry world-wide. $900 billion in loans to banks were made available by the Federal Reserve as early as December 2007, followed by a further $250 billion in March 2008 to encourage mortgage lending, $29 billion to smooth the sale of Bear Stearns to JPMorgan Chase in March 2008, eventually $123.8 billion to bail out AIG, $620 billion in October to help foreign central banks trade foreign currency for dollars, $1.8 trillion to buy commercial paper, and $540 billion to buy assets from money market mutual funds short of cash – these last two again in October 2008. In the last 15 months of the Bush presidency, breath-taking amounts of money were poured into the financial system on a regular basis to keep institutions viable and credit-creation intact.
The Obama administration then enthusiastically followed up, unhampered as it was by the anti-statist ideological baggage around which Paulson had had to navigate. The incoming administration moved quickly on all four fronts of the crisis: housing, banking, unemployment and global recovery.
On the housing front, and sharply reversing the Paulson policy of not using TARP money to directly help struggling mortgage holders, within a month of being in office the Obama administration put aside $75 billion of the bank bailout fund to help up to four million homeowners renegotiate their primary mortgages. That same month, the administration put an extra $200 billion into Fannie Mae and Freddie Mac, and then later (Christmas Eve, 2009) quietly announced that the Treasury would provide unlimited financial assistance to both the main GSEs. By that point too, the Federal Reserve (with administration support) had purchased from Fannie and Freddie hundreds of millions of dollars of mortgage-backed securities, with the aim of ultimately owning $1.25 trillion of such securities.6 The banking story was more complicated: a matter of initial support and long-term regulation. The administration continued the Bush policy of giving TARP loans to major institutions: in March taking up to a 36% stake in Citigroup and making a fourth injection of capital into AIG; and in May putting TARP money into six major insurance companies. TARP money was still being distributed, to GMAC among others, as late as December 2009, although by then other temporary support measures – including the temporary Treasury underwriting of the money market mutual fund industry – were being allowed to expire on schedule. Individual bank bailouts were supplemented during the early months of the Obama administration by a three month-long stress test to establish the financial viability of 19 major US banks; and by the launch of a toxic assets plan that had the Treasury partially financing a series of public-private investment funds to buy up unwanted mortgage-backed securities.7 New legislation to tighten federal and state regulation of US financial institutions took much longer to implement: first proposed by the Obama administration in May 2009, financial reform was finally enacted in July 2010. (The details of that legislation are given in the Appendix.)
What the Obama administration brought new to the table, when compared to its Republican predecessor, was a stimulus package aimed at alleviating the general recessionary impact of the credit-crisis. The first Obama budget, announced in February 2009, reversed Bush tax policy by increasing tax rates for wealthier Americans, and laid out an ambitious ten-year spending program on health, education and energy. The associated stimulus package, the American Recovery and Reinvestment Act, came in with an initial price tag of $787 billion: $276 billion in tax cuts for low and middle income Americans and for small businesses, and over $500 billion in a series of spending programs. Unlike the Bush administration, the Obama White House rendered specific assistance to the US auto industry, even taking partial temporary ownership of GM. Like the Bush administration in its brief post-crisis moment, the Obama team continued to press other major industrial economies to adopt similarly loose fiscal and monetary policy. It was a US pressure for fiscal largesse that met increasing resistance over time, particularly from the German government of Angela Merkel. In 2008, every major government had briefly been fiscally liberal.8 Not all of them were by 2010. 9 THE UK STORY
As in the US, the financial problems experienced in the UK in 2008-9 had their domestic origins in the local housing market where – just as in America – subprime mortgage loans had become increasingly common and mortgage-backed securitization had been accompanied by declining underwriting standards.10 In the UK as in the US, as more people received loans to finance home purchases, the demand for homes had increased and house prices had soared. By 2007, the total value of housing assets in the UK was 3.5 times as large as the total value of housing debt.11 In London as in New York, housing and finance markets had also become intertwined as consumers borrowed more based on their home equity, and lending secured on dwellings had drastically increased.12 The warning bells of an impending financial crash began to sound in the UK just after they were heard in the US. In September 2007, Northern Rock, a mortgage lender, was forced to turn to the Bank of England for cash. When banks increased the cost of inter-bank lending in response to concerns about bad loans in the US, the inter-bank money markets on which Northern Rock depended for funding dried up. Concerns about Northern Rock’s liquidity led to a run on the bank, the country’s first in more than a century.13 Initially Northern Rock seemed to be a localized and isolated problem caused by a reckless business model, but over time, as US-exported uncertainty hit the inter-bank lending markets in London, lending by UK-based banks and building societies occurred more slowly and at higher interest rates for both banks and consumers. Demand for houses decreased and the price of homes fell, cutting into the equity on which consumers had heavily borrowed. Climbing interest rates for consumers increased the pain of homeowners and debtors who had to pay off their various loans. Repossessions (i.e. foreclosures) began to rise, and increasing numbers of borrowers began to default on their loans. As in the US, securitization then spread the pain to even more institutions. September 2008 was a traumatic month in London no less than in New York. Amid the blows to their finances and the growing uncertainty, London-based banks also began to shut their doors to new mortgage customers and to decrease their loan availability.14 The frozen banking system and resulting lending slump led to a credit crunch in the UK which affected not only the ability of consumers to borrow and spend but the ability of firms to obtain the funding necessary for their growth. So, as in America, unemployment rapidly rose in the UK, with the percentage of the working-age population unemployed rising from 5.3% in 2007 to 7.6% in 2009. The UK GDP declined as well, decreasing at an annualized rate of 2.8% in the last quarter of 2008 and falling 3.7% in 2009. The Bank of England cut its interest rates in an attempt to stimulate the economy; however, it did so more slowly than the Federal Reserve. While the Bank incrementally decreased its rates from 5.75% in December 2007 to 0.5% in March 2009, the rates were still as high as 3% in November 2008, and the economic contraction, despite rate cuts, lasted through 2009.
Unlike the Bush administration, the Brown Government never left the resolution of the UK’s growing financial and economic problems simply to market forces. Instead, the members of the tripartite arrangement15 took immediate action on several fronts even before the crisis of September 2008. They addressed the looming failures of important lending institutions, prevented further bank runs by protecting depositors’ funds, and worked to restore liquidity and encourage lending. Only days after the run on Northern Rock, the Treasury guaranteed all of the bank’s deposits. After several failed attempts to find a private buyer for the bank, Northern Rock was officially taken under temporary public ownership in February 2008. The Government also orchestrated a rescue takeover of HBOS by Lloyds Banking Group in September 2008, and took Bradford & Bingley into partial public ownership later in the same month. In November 2008, the Government took a majority share in RBS: that stake was later increased to 68% in return for the bank’s pledge to extend more loans. The Bank of England began its Special Liquidity Scheme (SLS) in April 2008, lending banks £50 billion in government bonds in return for collateral in the form of the banks’ high-quality mortgage-backed and other securities.16 In October 2008, the Treasury began a recapitalization scheme, initially purchasing £25 billion of Tier 1 capital from eligible institutions and spending a further £25 billion on preference shares. Through this scheme, the Government invested £37 billion into RBS and HBOS/Lloyds. Also at this time, the Government put forth a £200 billion extension of the SLS and created a £250 billion credit guarantee scheme.17 Additionally, Darling cut fees to banks in December 2008 in an effort to stimulate their lending.
As in the US, addressing the banks’ toxic assets became an important policy measure in the UK. In February 2009, the Government proposed an Asset Protection Scheme (APS) through which the Treasury would underwrite a bank’s toxic assets in return for an agreement to lend more to homeowners and businesses. In addition to pouring public funds into the bailout and assistance of banks, the Government moved to protect depositors’ funds. In October 2007, depositor protection was extended to guarantee the first £35,000 of a depositor’s savings. A year later, this guarantee was increased to cover the first £50,000 of savings. As in the US, monetary policy was also eased in the UK to restore liquidity and encourage credit-creation. As mentioned earlier, the Bank of England decreased the official bank rate by over 5% from December 2007 to March 2010. In September 2007, the Bank of England announced that it would inject £10 billion into the money market to bring down the cost of inter-bank lending, and in December 2007, it participated in a coordinated international move by five major central banks to inject £50 billion into world money markets. In March 2009, the Bank of England began its Asset Purchase Program (APP), or quantitative easing policy. The APP began at £75 billion. In August 2009, it was expanded to £175 billion, and it became £200 billion by 2010.18
Additionally, the Brown Government took medium- to long-term measures on the same four fronts on which the Obama administration also moved: housing, banking, the global recovery and the role of government stimulus. Far less was done in the UK than in the US directly to assist housing. In one of his few measures to help the housing market, Darling raised the value of residential property to which stamp duty land tax would apply, first to £175,000 in 2008 and then to £250,000 in 2010.19 In 2008, New Labour pressed major mortgage providers to extend the minimum period before commencing repossession and provided help to the unemployed with interest payments on their mortgages. In April 2009, New Labour also introduced a modest Homeowners Mortgage Support Scheme which, though directly helping only 34 households in its first year, was widely credited with “a positive impact on mortgage arrears management, encouraging greater patience from lenders when borrowers missed payments.”20In contrast, Cameron’s Government, elected late in the crisis (May 2010), put housing benefit caps into place, scrapped regional house building targets and reduced the housing budget. On the banking front, both governments (Labour and later Conservative) took several measures. In August 2009, the FSA mandated that bankers’ pay deals be linked more closely to their banks’ long-term profitability. In November 2009, Darling required banks such as RBS and Lloyds to create and eventually sell new banks from their existing branch networks. In December 2009, the Treasury implemented a one-off punitive super-tax of over 50% of bankers’ bonuses. Both Darling and later Osborne examined the efficacy of the tripartite regime. While Darling did not plan to change its fundamental structure, Osborne quickly transferred many of the FSA’s powers to the Bank of England, essentially stripping the FSA of its responsibility and ending the tripartite system.21 Liquidity and credit creation were still sluggish when the coalition took office, and as a result the new Government began to work on establishing new lending targets for bailed-out banks. In June 2010, Osborne announced a 0.04% tax of bank balance sheets, which would begin in 2011 and increase to 0.07% in 2012. He also presided over the participation of four UK banks in the European stress tests.22 Finally, in July, the Government announced plans eventually to sell its state-controlled banking assets and to allow several of New Labour’s liquidity schemes to be withdrawn in 2012 as planned.23
The approach of Cameron’s Government to the question of global recovery differed from those of its New Labour predecessor and the Obama administration. While Darling had often spoken of the danger of ending fiscal stimulus programs prematurely, Osborne quickly joined the overarching voice of the EU in promoting a turn to fiscal moderation. These views are illustrated by a divergence in the measures taken by the two parties to stimulate the UK economy. Darling had, in November 2008, launched a significant economic stimulus package in the form of £20 billion of tax cuts and government spending. This followed a call by Brown for governments around the world to adopt similar measures. In contrast, Cameron and Osborne emphasized the importance of reducing the UK’s budget deficit. The new Government quickly created the Office for Budgetary Responsibility (OBR) to independently assess the nation’s finances and spending patterns; following a report by the OBR of slow growth and yawning deficits, Osborne stressed the need for an austerity budget.24 That £40 billion budget (primarily spending cuts and some tax increases) included a trimming of the welfare bill, a rise in the UK’s VAT, and a £2 billion levy to be imposed on banks and building societies.25 Thus fiscal restraint became the new means by which to achieve economic stimulus in the UK, the kind of fiscal restraint favored in the US by the Republican Party.
SIMILARITIES AND DIFFERENCES
Although the housing markets in the US and UK contain important differences (to which we will come), there are also striking similarities in the ways in which they are organized and linked to the wider financial system. In the work of Schwartz and Seabrooke on varieties of residential capitalism, it is striking that they place both the US and UK in what they term the “liberal market” quadrant of their comparative typology. “Liberal market” housing systems share certain characteristics: relatively high levels of private ownership, relatively high levels of mortgage debt in relation to GDP, easy and relatively cheap refinancing of mortgages, and a significant degree of securitization of mortgage loans.26 In such housing systems, “people are likely to see housing as a form of investment to a greater degree than in systems dominated by socially provided rentals,”27 of the sort common elsewhere in much of Western Europe. Three shared features of the two housing markets stand out as particularly significant here. (a) Policy/regulatory changes prior to the bubble. In the years leading up to the housing bubble, both countries experienced a shift from more regulated mortgage providers (such as building societies in the UK and Savings & Loans in the US) to private mortgage providers which were not bound by the same regulatory standards.28 (b) The growing securitization of mortgages, including subprime mortgages. In the US, “at its peak in 2005, more than $1.1 trillion in residential mortgage-backed securities were issued and sold to investors,”29 40% of which were subprime and near prime loans.30 In the UK a third of all new mortgages contracted between the second quarter of 2005 and the third quarter of 2007 were similarly subprime or near prime.31 (c) The formation of a housing price bubble. In the US, house prices which had been virtually flat for four decades prior to 1995 then effectively doubled in a decade. In the UK, the pattern of house prices was more volatile over time, but similarly exploded in the years following financial deregulation. (See Appendix 2)
There are striking similarities too between New York and London as financial centers, and indeed very strong linkages between the two. US-owned and headquartered financial institutions have a real presence in the City of London; British banks are minor but real players in New York. In both economies, the financial sector is a key contributor to GDP, a key conduit of foreign (and bountiful) investment flows, and a key contributor to the trade balance. Both financial centers experienced systematic deregulation in the years after 1980. Both came to be dominated by a handful of major institutions (commercial banks, investment banks, hedge funds and insurance companies) committed to organizational growth and enhanced profits. These were institutions that were increasingly involved in (and actively hungry for) the buying and selling of mortgage-backed securities, and ever more linked together in a shadow banking network of new financial instruments that operated below the regulatory radar. In both financial centers, cultures developed of banking superiority, high and expanded bonus payments, and increasingly breathless speculation. At the start of the crisis, each financial center contained rogue institutions that had allowed themselves to become excessively leveraged. At the start of the crisis too, each financial center contained institutions that were considered both too big to fail and yet too insolvent to continue without government assistance. At the end of the crisis – and in large measure because of that assistance – each financial center, to differing degrees, contained institutions that were even bigger (and so even less able safely to be allowed to fail), that were once more extremely profitable, were paying out generous bonuses to senior staff and were resisting calls for tighter financial regulation.
Crisis and Responses
In both the US and UK, the period of rising house prices and thriving financial institutions came to a definite end during a shared September 2008 shock. At this time, house prices fell, inter-bank lending rates rose, repossessions and defaults on loans increased, and a credit-crunch ensued as lending slowed. These conditions led to a serious destabilization of the banking system, and triggered a common set of policy responses that were simultaneously institutional, fiscal and monetary. On the institutional front, policymakers in both countries exhibited a shared willingness to save the banking system from collapse by guaranteeing bank deposits, buying out toxic assets, recapitalizing banks and subjecting them to stress tests. On the fiscal front, policymakers put forth big initial spending programs – quickly in the UK, slightly later in the US. On the monetary front, both countries cut interest rates and utilized internal and globally-coordinated quantitative easing. In addition to these common political responses, which were initially geared toward the national and global stabilization of the banking system, the countries experienced a common popular response. Both saw growing antagonism to bankers, increased calls for tighter regulation, and an acceptance of the key role of public policy in lifting the economies out of recession. These popular responses propelled further reforms, as policymakers worked to create new regulatory structures, to rekindle economic growth and job creation, and to deal with soaring levels of public debt.
In both economies, it was predominantly the small business sector that bore the immediate brunt of the credit dearth: a dearth that quickly brought in its wake layoffs, falling consumer demand and diminishing business confidence. In both countries, a crisis that had begun in one part of the economy rapidly became a crisis of the whole economy. As it did so, the value of financial assets dropped dramatically – hitting small savers as well as large ones, triggering (among other things) an entirely unexpected crisis of private pension provision for baby boomers on both sides of the Atlantic. The parallel collapse of consumer demand hit the labor market equally potently: and as jobs were lost in both the US and UK, a housing crisis which had originally been rooted in subprime lending morphed into one rooted in large-scale involuntary unemployment. The generalized recession that each economy acquired so quickly and so unexpectedly then became one that neither economy could easily shed.32 Indeed and instead, the recession incrementally spread from the private sector into the public sector, as the capacity of local and state government to finance basic welfare services was systematically undermined by the falling tax revenues generated by private sector layoffs. In that way, in each economy, a crisis initially characterized by private debt became, ironically, a crisis characterized by public debt – one in which the public spending made necessary by bank collapse and its ramifications reached a volume that the revitalized banking system was increasingly unwilling or unable to finance! Outcomes do not come more quixotic than that.
Although the housing markets in both countries have many common characteristics, there are significant differences on both the demand and supply sides of each. The supply-side differences are the more visible. The UK is a small island with a large population, extensive planning controls and limited building land; by contrast, except in its urban centers, the US is not. The supply of housing in the latter in the last decade has been far more buoyant than it has in the former. “Between 2001 and 2006, the United States built more new homes than would have been required by the growth in its population. In contrast, countries such as…the United Kingdom…barely managed to build enough homes to keep up with growth in the number of households.”33 On the demand-side, the manner in which house purchases are financed in the two economies also differs. There is no tradition in the UK of the US fixed-rate 30-year amortized mortgage of the kind generalized by Fannie Mae. Indeed there is no secondary mortgage market in the UK; the purchase of most UK houses is still financed through bank/building society-provided adjustable-rate mortgages of variable length.34 In addition, the tax regimes in the two systems are very different. The UK phased out tax relief on mortgage interest payments in the 1980s, just at the time that the US was extending tax relief to take in not simply first mortgages but also second ones. The UK levies a substantial stamp duty on house purchases; in the US, such taxation occurs only at the state level and is generally lighter. There was no UK equivalent to the US Savings & Loans crisis of the late 1980s; rather, there was a slow and incremental demutualization of UK building societies, made possible by the 1986 Building Societies Act. In the run-up to the crisis, the UK housing market had a lower level of subprime lending than did the US housing market; and after the crisis (and in spite of its more onerous tax regime) the UK saw a more rapid return to stable or rising house prices.
Though the relationship between New York and London as financial centers is a close one, it is in no sense an equal one. Nor are the regulatory structures and philosophies operative in each exactly the same. In a very real sense the US exported the financial crisis of 2008, and the UK imported it. It is true that many UK financial institutions were enthusiastic importers of US-generated financial instruments; but it remains the case that the instruments they imported were US-made. It was subprime mortgage securitization from the US housing market, not from the UK housing market, that infected the global (including the London) financial networks with toxic assets in the years up to 2008. It was US-based credit-rating agencies that gave those assets Triple-A ratings they did not warrant. It was major US financial institutions that drove the subprime frenzy;35 and it was US-based companies (especially Lehman Brothers and AIG) who were key players in the escalation of leverage rates to unsustainable heights in London no less than in New York. UK banks were not innocent in the process.36 Most followed suit. Some, like Northern Rock, followed suit with internally-generated enthusiasm. The Northern Rock business model was voluntarily adopted though still Lehman-backed. But the space within which to develop and generalize that business model, and in which to enshrine a culture of speculation and high-risk profit taking, was far greater in the US than in the UK. It was far greater partly because, in the US, the regulatory structure was so complex relative to the single UK oversight exercised by the FSA. It was also far greater because – though light regulation was the norm in both cities – the people heading the US regulatory agencies were so committed to regulating with only the lightest of touches. In the US, as the FSA was being empowered in London, Congress was dismantling Glass-Steagall and the Clinton administration was declining to regulate the new financial products then emerging: this even before Greenspan and Bush II combined to make a religion of leaving things entirely to the market.
Crisis and Responses
Because the underlying dynamic of the crisis was so fundamentally different in the two economies, the policy response that it generated differed too: differed in width, differed in sequence and differed in trajectory. In the UK, as we have just seen, much of the financialcrisis was imported into the banking system via the purchase of US financial products. The housing problems in the UK made the crisis worse, certainly, but the housing market did not create the financial crisis to the same extent that it did in the US. Policy was therefore narrower in the UK; since housing was not as central to the crisis, the resulting policy was less focused on the foreclosure dimension in this country than in the US. The sequence of immediate policy responses also varied in the two countries: the UK went from bank guarantees to recapitalization, to nationalization, to toxic asset isolation, to stress tests, to bank surcharges, to belated minor regulatory change. While the US also began with bank guarantees, policy there focused on absorption of toxic assets before turning to, in sequence, recapitalization, stress tests, bank surcharges, and eventually, extensive re-regulation. The US saved its banking system without nationalization.37 The UK did not.38 Finally, the trajectory of policy differed between the two. While both countries were initially committed to fiscal stimuli, only the US has continued on this path; the UK is no longer committed.
The economic recoveries of the US and UK as the bulk of the financial crisis has subsided have had several significant differences. As Figures 1 and 2 in Appendix 2 make clear, the UK housing market revived while the US housing market did not. While banking ultimately bounced back in both economies, the recovery of this industry was initially stronger in the US than in the UK. On the broader economic stage, the UK carried a greater scale/burden of public ownership than did the US. Furthermore, the former economy has not recovered its growth as fast as the latter, although unemployment remains high in both. Finally, the UK may be more at risk of a double-dip recession than the US, although this remains to be seen.
Similarities In many ways the most striking aspect of this tale of two cities is the difference in the economies’ experience of the financial crisis and its aftermath. But as we have seen, the differences were not absolute. Both economies shared a level of exposure to the impact of the credit crisis which set them apart from other major economies. All were affected, but none so deeply as the US and UK. All were (through their banking systems) to some degree culpable, but none were as responsible as the US (and the UK) for the origins and dissemination of the crisis. So there is something special and different about the modern US and UK economies that set them apart: and the question is what.
Superficially, the similarity seems rooted in a shared growth model, one anchored in debt. The US, for its part, has known two sustained periods of economic growth in the post-war era. The first, from 1948 to 1973, rested on a capital-labor accord that regularly raised the wages of blue-collar unionized northern male workers. It was a growth model based on rising labor productivity and strong internal sources of consumer demand. The second, from 1992 to 2008, was similarly based on rising labor productivity, but this time growing income inequality (and weak labor unions) left internal consumer demand dependent on rising levels of personal debt.39 The slightly more sustained UK growth experience from 1992 to 2008 contained a stronger internal wage dynamic, but it too ultimately depended for its capacity to raise living standards on the willingness and ability of people to deploy (via credit) wages they had not yet earned. By 2009, the volume of consumer credit outstanding in the US had reached $2.48 trillion. By June 2010, total UK personal debt stood at £1.46 trillion – the consumer credit part being £218 billion.40 In such a context of debt, it is hardly surprising that any substantial expansion of home ownership should require subprime lending, or that the growing wealth of the financial sector should have become such a source of popular resentment.
The ability of people to borrow on this scale tells us that the financial institutions in each economy had grown to play a critical intermediating role between producers and consumers. The growing weight of finance relative to manufacturing was similarly marked in both economies: outsourcing and the decline of home-based manufacturing was a feature of both. But banks cannot lend what they do not first borrow: and the other common feature of the financial institutions in both economies was their enhanced capacity to do this. That capacity was itself partly the result of growing income inequality – the accumulation of surpluses by the super-rich had to be put somewhere. But mainly the capacity of Washington/New York and London to attract capital was the product of the global role played now by the US and previously by the UK as imperial powers. Foreign capital flowed into the US in vast volume in the years after 9/11. It flowed into London in smaller amounts, but still far more plentifully than into Frankfurt or Tokyo. It was when it stopped flowing – when confidence broke down in September 2008 – that the crisis began; and because it was into the US and UK that foreign investment funds had flowed so easily, the impact there was disproportionately great.
Money flows of this volume made the creation and proliferation of ever more complex financial instruments both possible and profitable. The flows also kept interest rates disproportionately low, helping to fuel the housing boom and the purchase of houses by people further and further down the increasingly unequal income ladder. The flows were a response to a new global pattern of surplus and deficit through which the US and UK became major debtor economies. The US quite simply followed a path which the UK had trodden long before. It stopped being the manufacturing center of the global system. Instead, the US became the world’s consumer of last resort and the system’s dominant borrower.41 In 2006, the US’s current account deficit was $857 billion. The UK’s was $68 billion – far smaller than that of the US but still qualitatively inferior to the current account surpluses of established economies like Germany and Japan and of the new emerging giants (China in particular). Oil economies and export-led growth economies drew revenues to themselves. Those revenues flowed back as foreign investment to the US and UK.42 The US and UK became debt-soaked, functioning at their existing levels of output and consumption only so long as the flows continued. In September 2008, briefly, those flows stopped.43
Differences Despite the above similarities between the US and UK, their different experiences during and after the financial crisis were shaped by undeniable variations between the two countries. These variations come on several levels: political, economic, and global.
Some accidental political differences arose as the crisis unfolded: the source of these differences was the timing of the crisis in relation to the electoral cycles in the two countries. In the US, a presidential election took place just as the crisis was hitting its stride; this election placed a moderate center-left government into power in Washington, replacing a more conservative party. In the UK, in contrast, such a moderate center-left government was replaced late in the crisis by a center-right one. Thus at different stages, the trajectory of policy changed course, leading the US to go slightly “left” during the crisis, and the UK slightly “right.” These changes indicate the popular dissatisfaction in both countries with the governments that were perceived to have steered the country into crisis in the first place.
The political differences between the two countries also have deeper institutional and historical roots which affected the speed and focus of the policy measures enacted. The US and UK have completely different political systems: one is federal, the other is non-federal; one is presidential, the other is parliamentary. The non-federal, parliamentary system in the UK was bound to generate a greater coherence and speed of policy implementation than any of which the US was capable. Furthermore, the political debates and veins of thought vary either side of the Atlantic. While the legitimacy of a statist response to a crisis is a common dimension of UK conservative thought, it is not heavily present in American conservatism. The US political debate contains a libertarian strand of argument which does not appear in the UK (again, allowing state intervention to be more acceptable in the latter country), while the UK must consider the voice and policy measures of the EU as the US need not. Finally, the actions of the political leaders in the two countries may have been influenced by dissimilar historical experiences. In the ongoing debate on the benefits of fiscal austerity as opposed to fiscal stimulus, Obama has looked toward the example of the Great Depression, when the quick withdrawal of government programs led to greater hardship and recession. In contrast, leaders in the UK must, along with other EU leaders, bear in mind the 1920s hyperinflation which occurred in their collective history and, more recently, the effects of the Greek debt crisis.
Both economies are post-industrial, in the sense that service employment and output have long replaced manufacturing as the key source of GDP growth and labor utilization. UK manufacturing employment peaked at 8.6 million in 1966, and is now in the region of 4 million. The US peaked later – at 19.6 million in 1979 – but is also now down: to 11.7 million.44 But finance still makes a significantly smaller contribution to US GDP than to UK GDP – 8% in one, 30% in the other – it is the UK and not the US that has acquired what Vince Cable called “the Icelandic disease”: an over-reliance on finance that makes City success so critical to overall government performance.45 Certainly City concerns were evident in the UK’s maintenance of higher interest rates than those ruling in Frankfurt and New York prior to the onset of the crisis.46 Investment funds have to be attracted to London. There is nothing self-evident about why they should flow there; whereas New York has still the automatic cache of being the financial hub of the dominant global power (still commanding the main reserve currency) and the system’s largest economy. How else are we to make sense of the bizarre clash between Alistair Darling and Mervyn King in the dog-days of the New Labour Government – the strange phenomenon of a Governor of the Bank of England campaigning to break up London-based banks to prevent them from becoming “too big to fail,” falling foul of a Labour Chancellor too concerned with the long-term viability of London as a financial center to be willing to contemplate anything so radical!
Yet, paradoxically, the greater contribution of UK-based financial institutions to UK economic performance does not make the London government as subservient to City interests as Washington can be to the interests of Wall Street. This is partly because UK financial institutions are long used to government-led oversight through the Bank of England.47 It is also partly because the structures of financial regulation are so different in the two countries: the single-focused FSA automatically generates a more coherent code of behavior than any that can possibly be expected from the myriad of regulatory agencies that exist in the US at both the federal and state levels.48 The greater subservience of Washington to Wall Street is also partly the product of the porous nature of the US political system. Washington is so much more easily penetrated (and dominated) by well-placed lobby pressure.49 Finally, the revolving door that carries major financial figures into and out of the US administration has no easy parallel in a UK world of career politicians, an independent civil service, and tight ethic rules.
Many of the differences between the US and UK are the products of domestic political and economic variations, as we have seen. However, the policies and characteristics of both countries are also shaped by global forces reflective of their relative positions in the international community. US administrations, regardless of political color, are critically concerned with the US role as the global hegemon. US leadership on the world stage has had several effects: as we have mentioned, this leadership brings capital flows to the US by default. It also maintains foreign confidence in the US dollar in the face of fiscal deficit, confidence which would be denied to the currency of a lesser power. The UK, in contrast to the US, possesses only the memory of its former global dominance. As such, its government’s focus – again regardless of political color – is invariably one of maintaining the UK’s relevance among global economic leaders. Throughout the crisis, and in the face of US and German competition, the UK government was determined to maintain London’s supremacy as a financial center, a determination which contributed to New Labour’s light-touch regulatory policies and to its emphasis prior to the crisis on strengthening the financial service sector above all others. As indicated above, the UK must find ways to draw speculative capital to the City of London through its financial policy, while the US simply attracts such monetary flows by virtue of its dominant global role.
The positions of the two countries on the world stage differ as well. While the US stands alone in its globally hegemonic role, the UK is critically concerned with its position on the edge of Europe. Despite its decision to remain out of the eurozone, the UK, as a member of the EU, is constantly obliged to filter global policy concerns through this European lens. Unlike the US, the UK cannot act entirely alone. Thus we can see that certain UK policies have been influenced by European concerns: the Greek debt crisis spurred calls for fiscal austerity and deficit reduction on the Continent, calls which the UK has also latterly adopted. Also European concerns about moral hazard and barriers to competition were reflected in the Bank of England’s emphasis on the breaking up of big banks.
In conclusion, a set of final thoughts, triggered by the realization that economic crises of the scale released by the credit-crunch of 2008 inevitably leave deep scars and teach stern lessons. The 2008 crisis certainly has. The scars run deep, though the learning process remains dangerously incomplete.
Housing and Mortgages Subprime lending in US and UK housing markets will presumably never return on its previous scale. That much at least will be a blessing. Understandably, given the scale of distress in contemporary housing markets, a limited number of negative equity mortgages are now available to those worst affected by the collapse in their property values; but in general underwriting standards have tightened significantly. To differing degrees, the housing market on both sides of the Atlantic is accordingly constrained and likely to remain so – constrained both by the unemployment that loose underwriting standards helped to trigger and by the rise in the standards themselves.50
Wall Street and the City The worst excesses of the banking system that fueled the growth of subprime mortgages are now under tighter regulation; major banks in the UK at least face annual levies;51 and major financial institutions have faced fines (and the occasional UK banker, even ejection from the industry).52 But the banks are back, the growth of the biggest of them actually enhanced by the rescue packages in which they participated.53 Bonuses remain huge54 while capital and liquidity ratios remain terrifyingly low:55 so the issue of whether any major financial institution is still “too big to fail” remains on the agenda of both Treasuries.56 In fact, Wall Street and the City have survived remarkably unaltered, given the scale of the crisis in which they were immersed less than two years ago.
Main Street and the Economy But the smaller banks in each financial sector remain vulnerable, and the small businesses they service remain credit-starved and insolvency-threatened. Unemployment is in consequence stuck at levels not seen in either economy since the deep recession of the early 1980s; and both economies – but particularly that of the UK– continue to teeter on the edge of a double-dip recession.
What we are seeing on both sides of the Atlantic is the return of sharp disagreements about how best to rescue Main Street. Governments in both the US and UK are being advised either to pull away from financial regulation altogether (and to let market forces operate unchecked) or to test to the full the limits of state power in relation to finance. What is already clear, however, are the dangers of a half-way house between light and tight financial regulation. In the UK, the Treasury reportedly “whines” that bank lending is low,57 and in the US the Congressional Oversight Panel pushes the US Treasury to do more.58 But they do not. Ignoring Rahm Emanuel’s dictum never to waste a good crisis, both governments seem – for different reasons – determined to do so. If they do continue to waste it, the rest of us will undoubtedly lose. Indeed, as unemployment spreads and welfare programs are curtailed, the rest of us are already beginning to do so.
Wake Forest University, August 2010
Appendix 1: Key Events
United States 2007 July 17: Bear Stearns admits two of its hedge funds wiped out because of losses on mortgage- backed securities.
August 17: Federal Reserve cuts discount rate by 50 basis points (bps)- (dropping the rate from 6.25% to 5.75%).
August 19: Countrywide Financial borrows the entire $11.5 billion available in bank credit lines after
being unable to access short-term financing.
September 18: Federal Reserve cuts Federal funds rate by 50 bps.
November 9: Bernanke plans to revive secondary market for jumbo mortgages by supporting a
temporary increase in the size of individual loans eligible for securitization by Fannie &
Freddie from $417k to $1 million.FDIC chair calls on mortgage lenders to voluntarily
adjust mortgage terms before Congress mandates them.
January 11: Bank of America buys Countrywide Financial.
January 16: Citigroup & Merrill Lynch announce $21 billion foreign bail-out to help them deal with
losses on sub-prime loans. Citigroup announce a $9.83 billion fourth quarter loss.
January 22: Federal Reserve cuts Federal funds rate by 75 bps in emergency move (to 3.5%) On 31st , the Federal Reserve makes a further 50 bps cut – the most abrupt sequence of cutting since the 1980s.
March 13: Paulson recommends tougher disclosure requirements, nationwide licensing system for
mortgage brokers, and tighter state & federal oversight of mortgage provision.
March 14: Federal Reserve announces emergency lending facility for Bear Stearns through JPMorgan Chase.
March 17: Bear Stearns sold to JPMorgan Chase.
March 20: Federal Reserve makes $436 billion emergency funds available to US financial institutions, including all the big investment banks.
March 27: Federal Reserve starts program to ease frozen markets in MBS by allowing them to be swapped for Treasury bonds.
July 13: Treasury and Federal Reserve give Fannie and Freddie a special government credit line & access to the Fed’s emergency funds.
September 7: Fannie Mae & Freddie Mac are taken into ‘conservatorship’ by the US Treasury and the
FHFA: send regulators in, and agree to inject up to $100 billion in to each GSE.
September 15: Lehman Brothers files for bankruptcy. Merrill Lynch is bought by Bank of America for
September 18: Bernanke & Paulson seek Congressional support for $700 billion bail-out fund.
September 21: Federal Reserve establishes a temporary guarantee program for the US mutual fund industry.
September 25: Washington Mutual fails: sold to JPMorgan Chase.
September 29: House of Representatives rejects bail-out 228-205.
October 3: House and Senate approve revised $700 billion financial rescue package.
October 7: Federal Reserve announces willingness to buy commercial paper. US Treasury begins to ponder shift from buying toxic assets to recapitalizing US financial institutions by buying non-voting preference shares.
October 15: Paulson announces $250 billion (TARP money) recapitalization plan for US banks.
October 21: Federal Reserve announces $540 billion to purchase debt held by money market funds.
October 29: Federal Reserve cuts interest rates to 1% , their lowest since 2003-4.
November 12: Paulson drops plan to buy toxic assets.
November 23:` Treasury, FIDC & Federal Reserve combine to rescue Citigroup.
November 25: Federal Reserve creates Term Asset-backed Securities Lending Facility (TALF): commits an extra $800 billion for loans to homebuyers, consumers, students and small business.
December 16: Federal funds rate cut to zero.
December 19: Treasury approves loans of $13.4 for GM & $4.0 for Chrysler, from TARP.
January 16: Treasury, Federal Reserve & FIDC rescue Bank of America. Treasury invests another $20 billion from TARP.
February 10: New Treasury Secretary Geitner announces $2.5 trillion injection of funds into US
financial institutions, to kick start student, auto and credit-card lending, and mortgage
provision. Promises plan on toxic asset acquisition based on public-private investment
February 18: Obama announces $75 billion HAMP scheme to head off foreclosures, and doubles
emergency aid to the GSEs to $400 billion.
March 18: Federal Reserve decides to buy Treasury securities, up to $300 billion over next 6 months.
March 23: Geitner toxic asset plan announced: Treasury to partially finance a series of public-
private investment funds to buy up unwanted MBS, with federal authorities lending as
much as 85% of the purchase price, plus a matching dollar-for-dollar contribution to
cover the remaining 15%.
May 7: Federal Reserve announces results of stress tests on 19 largest US bank holding companies.
May 15: Treasury announces plan to regulate over-the-counter derivatives through a central
clearing house. President signs legislation to limit credit card industry’s ability to raise
rates, penalize late payers and issue cards to people under 21.
June 1: US government takes 60% stake in GM, which files for bankruptcy reorganization.
June 17: The President issues a plan on the oversight of financial institutions. The plan gives the
Federal Reserve greater supervisory authority, expands the powers of the FIDC, creates a council of regulators under the Treasury Secretary and a consumer financial protection agency.
July 1: Federal offer to refinance mortgages extended to those whose mortgages are up to 25% greater than the value of their property.
September 13: Federal Reserve to phase out of buying MBS more slowly, extending year-end deadline to March.
September 18: Treasury ends money market guarantee.
October 28: Federal Reserve ends program of purchasing Treasury securities.
November 3: Fannie Mae to allow owners facing foreclosure to rent their homes for up to a year.
December 9: Bank of America repays TARP money.
December 14: Citigroup & Wells Fargo agree to pay back TARP money.
December 24: Treasury announces unlimited backing for the 2 GSEs, removing the $400 billion cap on
January 15: President condemns excessive bank bonuses and announces a $90 billion 10-year levy on the top 50 financial institutions.
January 21: President calls for implementation of the Volker rule banning banks from trading on their
own account and from owning/investing in hedge funds & private equity groups.
February 10: Bernanke signals that the Federal Reserve has no intention of tightening credit in the short term, but does have long-term plans to unwind the unprecedented level of support it has provided to the financial system since September 2008. US banks post their sharpest decline in lending in 2009 since 1924!
March 15: Senate Democrats issue 1,336 page bill to overhaul financial regulation.
March 16: Federal Reserve affirms intention to stop buying MBS after spending $1.25 trillion this way up to the end of March 2010.
March 23: Finance regulation bill clears Senate Banking Committee.
April 16: SEC charges Goldman Sachs with fraud over marketing of a particular CDO.
April 30: Tax credit on new house purchases expires. House sales drop sharply in May.
May 20: Mortgage defaults still at 14% (7.3 million households). Up from 12% in May 2009.
Fannie Mae loses $13.1 billion in first quarter 2010, down from a #23.2 billion lost for
the same quarter in 2009.
June 29: Agreed financial regulation bill (Dodd-Frank Bill) passes the House, on a 237-192 vote. 19 Democrats vote against. 3 Republicans vote for.