Chris Watling: Debt was at the heart of this crisis – and we must never let it happen again

Economic view

The UK was the last of the G20 economies to emerge from recession. Even so, its recovery now appears to be under way.

In particular, while still heavily indebted, household cashflows have retrenched aggressively, such that the savings ratio has risen from minus 1 per cent (at the start of this recession) to 9 per cent on the latest data (see chart). History suggests that after such a big move upwards, the near-term imperative to save even more, especially given that the pace of job losses has slowed and confidence risen, is likely to diminish. A stable, as opposed to rising, saving ratio equates, via simple mathematics, to faster spending growth. As such this is one reason, among many others, why the economy has probably begun to grow again.

However, policy makers have yet to seriously begin the process of ensuring that such a crisis is not repeated in this country.

Sitting at the heart of the crisis, in Britain and globally, was an unprecedented build-up in financial and household indebtedness. Total UK debt to GDP rose from 173 per cent at the start of Labour's term in power to around 270 per cent today. Household savings rates, meanwhile, fell from 10 per cent to under zero – the product of poor financial regulation (aka financial liberalisation) and too-loose monetary policy.

All of the above was aided and abetted by a Labour government that under Chancellor, then Prime Minister, Brown, borrowed year in, year out – since 2000 – and built up Britain's worst peacetime fiscal deficit at a time when other, more prudent, countries were running surpluses.

The implications of this credit bubble were severalfold: Overinflated house prices; households suffocated by debt repayments; rising income inequality and social inequality; the deepest British recession on record; the worst public finances in Europe; and a 30 per cent drop in the UK's purchasing power in the world economy as a result of one of the sharpest falls on record of the pound. Over and above that, Britain has monetised its entire fiscal deficit from 2009. That is, it has created new money at the Bank of England which has, indirectly, been lent or given to the Government. If history is any guide, there is a high risk that we will see a re-run, in some form, of the inflation issues that plagued the country in the 1970s.

While this may seem like a gloomy list, economies have an inbuilt ability to recreate themselves and emerge stronger from crises, if the right policy choices are taken. Policy to encourage that recreation, though, must be designed around first principles: (i) That long-term sustainable economic growth is about wealth creation (ie productivity); (ii) governments do not create wealth, they just redistribute money and provide common goods such as street lighting and defence; and, (iii) governments are large, unwieldy, and almost always wasteful compared with the private sector. So, in general, the smaller the government the better.

With that backdrop, therefore, several plausible policy suggestions make sense.

First, reduce ease of access to credit. Increase minimum monthly credit-card payments – or phase out the cards altogether; increase, and legislate on, the minimum deposit required to buy a house, which would instantly provide banks with a buffer on losses from house price falls, thereby reducing the impact on the taxpayer (this would also result in houses being cheaper, in the long run, for, most importantly, first-time buyers); and ban firms which charge extortionate interest rates – over 250 per cent, in some cases.

Second, serious consideration needs to be given to moving away from the current international dollar-based monetary system. Globally there has been a clear relationship between the depth and duration of recession and the levels of economy-wide, and especially household, leverage (indebtedness) coming into this crisis. Just compare the heavily indebted UK's record recession with lightly indebted South Korea's short one-quarter downturn. Equally, there is a clear relationship between financial crises across the globe, the build-up of indebtedness and the underlying international monetary order.

Under the current, dollar-based international monetary system, where the creation of credit and money has been increasingly liberalised, we have had more than 140 financial crises in the world economy. Under the prior, more restrictive system (Bretton Woods, from 1947 to the early 1970s), there was only one.

And third, shrink the size of government, dramatically. One rule of thumb in economics is that the larger the government share of GDP, the slower trend economic growth. The reason, as highlighted above, is simply that governments don't create wealth, they redistribute it. A higher share of government in an economy therefore equals higher taxation, and, so, higher disincentives to entrepreneurs which, in turn, leads to lower productivity and wealth creation. Furthermore, most major fiscal consolidations fail when they emphasise increasing taxes to pay down deficits.

The key rule for consolidating public finances is to hold government spending flat in real terms. Beyond that, though, the role of government needs to be radically rethought. Since the start of the Labour government, spending has risen by about 10 percentage points of GDP, from 38 per cent or so to around 48 per cent today. Much of that has been driven by an approximate tripling of spending on education (from £14bn in 1997-98 to an expected £49bn in 2009-10) and health (from £35bn to an expected £100bn this fiscal year), while the numbers claiming benefits have also increased dramatically, most notably on incapacity benefit, despite such high spending on health.

Finally, the systemic threat to the economy from our banking system needs to be addressed. At the start of the Labour government the balance sheets of the five biggest banks equated to approximately one times GDP. By the start of the crisis, that total had risen to almost four times GDP, while, during the crisis, it rose again to more than five times GDP. With governments clearly backstopping these too-large-to-fail banks, moral hazard, and ultimately income inequality, are enhanced. In order to force the current beneficiaries of the Government's backstop to take on board the full risk, commercial and investment banks should be separated.

While this list is far from comprehensive, a reduction in the size of government, and the level of economy-wide leverage, and a removal of many of the best-paid from the arms of, in effect, an explicit government guarantee would serve our economy well.

Stand by, we're heading into the second phase of a cyclical bull market

Cyclical equity bull markets typically have three phases. Phase I is the initial rally out of the bear market anticipating the end of the recession, taking most by surprise. It is typically strong, persistent and can last from six months up to two years. Phase II begins as investors start to discount future interest rate hikes from the Federal Reserve, thereby anticipating the beginning of the withdrawal of excess liquidity. At that stage, global equity markets consolidate their gains from the initial rally, and, on average, fall by between 6 and 7 per cent over the following six to nine months (or by an average of 5 per cent in the UK). Phase III is then a resumption of the uptrend, which can last from one to seven years (before the next bear market). Annual gains, however, are considerably more muted than in the initial rally; on average, 40 per cent of the cyclical bull market is completed in the first phase. Phase III's length is dictated by the economic cycle – as equity markets begin to anticipate another recession, another bear market should then commence.

Currently, though, there is a strong case to suggest that global equity markets are moving into phase II of a stylised cyclical bull market, the phase of consolidation of gains from the initial rally. That case rests on the US economy and our view that it is moving towards a self-sustaining economic recovery led by the private sector. The key for that transfer of economic growth leadership (ie from government-led "life-support" growth to private-sector led growth) is an improving jobs market, an end to household deleveraging and a resumption of business investment spending (and, with that, hiring). Economic indicators suggest that all three factors are close to occurring.

If correct, then US one and two-year bond yields should start to move meaningfully higher, anticipating future interest rate hikes. Historically, that change in trend has marked the move of a cyclical bull market from phase I into phase II. If we're right, markets are likely to remain volatile over the next six to nine months.