Economics made simple


Economics often seems impossibly complicated. Professor John Van Reenen, Director of the ESRC Centre for Economic Performance, gives some simple answers to commonly asked questions about the causes of the recession, the euro crisis, financial regulation, taxes and growth


What really caused the recession? Was it failure of the global financial system or too much national debt – or a combination of both?


JVR It was certainly not to do with too much national debt. The underlying cause was a huge global imbalance between some regions of the world like China, Germany and Japan consuming too little (given the size of their economies) and others like the US, UK and Spain spending too much. The excess savings of the low spending countries were recycled by a dysfunctional financial system. This meant a relatively local problem – the US sub-prime crisis – sparked off a cascade of problems throughout the global economic system.


“ Psychologically, bankers seem to


believe that good fortune is due to skill and bad outcomes to luck


Is national debt necessarily a bad thing?


JVR No, it is a good thing to have some national debt, especially when a country needs to keep demand up during a deep recession. The world learned an important lesson from the Great Depression – cutting to balance the books in a recession is a recipe for prolonging it.


”


What exactly is a double dip recession? Has Britain experienced one before?


JVR This is when the economy seems to be recovering, but then falls back into negative growth. The main example of this was in the 1930-34 Great Depression, although arguably a milder form was seen in 1973-76 (see Figure 1 in blogs.lse.ac.uk/ politicsandpolicy/2011/08/02/slow-growth-not- new-normal).


Why does the crisis in the eurozone affect the UK?


JVR First, the eurozone is the main trading partner of the UK, so if it suffers a downturn our exports will take a major hit. Second, many UK banks hold debt in eurozone countries, so if there is a restructuring of debt, this will hurt UK banks.


What does it mean for Greece to leave the euro? What currency would it use instead?


JVR There is no precedent for a country doing this, but at the moment it is a distinct possibility as I can see no way that Greece can service its debt


26 SOCIETY NOW AUTUMN 2011


and there must be a restructuring. Greece could re-introduce its own currency which would devalue rapidly and cushion the economy to some degree, but it would generate turmoil in the Greek banking system as savers rushed to withdraw funds.


Banks have spent years trying to reduce risk in the financial system. What went wrong in 2008?


JVR The risk management systems in banks were clearly not working. They massively underestimated the chances of many assets falling in value at the same time (such as house prices falling in all regions of the US). The structure of incentives in banking encourages everyone from the trading floor to the board room to take excessive risk. For the trader, the annual bonus can be huge and the worst that can happen on the downside is to lose one’s job. For the top bosses of large institutions that are ‘too big to fail’, they know that there is a good chance of being bailed out by the taxpayer.


Do you think a tax such as the Tobin tax could succeed in raising revenue for the government or would it, as critics claim, discourage financial institutions from operating in the UK?


JVR The arguments for the Tobin tax are completely confused. The aim of the tax should not be to raise revenue but rather to reduce the volatility of financial markets (especially in foreign exchange and shares). In principle it should do this as it is a tax on transactions, but of course there may be costs (reduced liquidity of markets) and lower stock prices (this happened when Sweden introduced one in 1989). It would do nothing to reduce the risks of financial crises which had entirely different routes (especially the ‘too big to fail’ problem). It is also not particularly good as a revenue raising idea. First, volumes of transactions fall. Second, other tax revenue falls (like capital gains – this happened in Sweden).


Are investment bankers very smart or just lucky gamblers?


JVR Generally it is a mixture of both ability and luck. The increase in the scale of funds managed meant that small differences in ability (or luck) could lead to tremendous rewards. Psychologically, bankers seem to believe that good fortune is due to skill and bad outcomes to luck. In retrospect, the luck component seems to have been underestimated!


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