Alistair Darling/Addendum

The financial crisis

When Alistair Darling took office as Chancellor of the Exchequer in June 2007, the international financial system had just entered the first stage of the financial crisis. A sharp and unexpected fall in United States house prices had created the subprime mortgage crisis by causing large falls in the prices of internationally-held securities whose value depended upon mortgages secured on those houses. British banks were known to be affected, and it was realised that their losses could be expected to have an adverse effect on other sectors of the economy. The crisis entered its second stage in August 2007, when the French BNP Paribas bank announced that it could not determine the value of those of its bonds that were backed by US house mortgages. A mood of uncertainty developed in which every financial institution experienced doubts, not only about its own holdings, but also about the securlties held by its trading partners. That uncertainty deprived some banks of their accustomed sources of loans, and placed some of them in danger of insolvency. (One such was Northern Rock). That was the situation faced by Alistair Darling at the time of his first budget in March 2008. By October, however, the situation had changed. The catastrophic third stage of the crisis had been triggered by the insolvency of one of the world's largest investment banks, Lehman Brothers and the writeoff of $785bn worth of its issued funds. Uncertainty had changed to panic, with banks and others refusing to lend to each other, or to commercial borrowers; and the financial system seemed to be in imminent danger of total collapse.

Support for the banks

(The reasons why banks fail and the arguments for rescuing them are summarised in the article on Bank failures and rescues.)

Northern Rock

Until the summer of 2007, Northern Rock had been considered to be one of the most successful of Britain's companies. Over the previous ten years it had been converted from a run-of-the-mill provincial building society into a major bank that became one of the country's 100 largest companies. On 13 September 2007, BBC's Robert Peston reported that it was seeking help from the Bank of England. That report triggered the first run on a British bank since the Overend-Gurney failure of 1860 . A House of Commons committee was to report that the directors of the bank had pursued a reckless business model which was excessively reliant on wholesale funding, and that Financial Services Authority had systematically failed in its regulatory duty to ensure that Northern Rock would not pose a systemic risk. The committee considered that The Chancellor of the Exchequer was right to ... authorise the Bank of England’s support facility., but that the Tripartite authorities did not prepare adequately for that support operation (referring to joint action by the Bank of England, the Treasury and the Financial Services Authority). The run was brought to an end on 17 September by a Government guarantee on savings and deposits. For the next five months the bank was kept afloat using taxpayers' money and there were protracted negotiations with possible private sector buyers. On February 17 2008 the Chancellor announced that Northern Rock was to be taken into temporary public ownership, having been advised that the private sector bids would be poor value for taxpayers' money, a decision that was strongly criticised by the Shadow Chancellor.

The next five

The panic that followed the collapse of the Lehman Brothers bank in September 2008 was followed by massive writedowns of the assets of the world's banks. There were major support operations by their governments and a total collapse was averted, but there were many casualties. Of the top nine UK banks that had been trading in April 2007, five (Bradford & Bingley, HBOS, Lloyds TSB, Northern Rock and RBS) had been taken partly or wholly into public ownership by April 2009, with the intention of returning them to the private sector in due course. The banks concerned were generally required to grant preference shares to the government that were to pay a 12 per cent dividend.

The bubget deficit

The effect of the financial crisis was to deprive firms of the ability to finance their activities by borrowing or by the roll-over of debt due for repayment, and so bring about a reduction in economic activity and an increase in unemployment. A rise in the government's budget deficit follows because lower activity leads to lower tax revenues and more unemployment leads to increased benefit payments. Because it destroyed some of the country's production capacity, the following Great Recession added to the pre-existing or "structural" deficit as well as creating a "cyclical" deficit which will disappear when the utilisation of the surviving capacity returns to normal.

According to estimates by the Institute of Fiscal Studies, the United Kingdom entered the recession in 2007-8 with a relatively small structural deficit of around 2 per cent of GDP, which the recession had extended to 6 per cent during the financial year 2009-10, and to which was added a cyclical deficit of about 4 per cent of GDP and a discretionary fiscal stimulus of nearly 2 per cent, to make a total approaching 12 per cent of GDP However, as the Institute's authors add, "borrowing as high as 6% of national income permanently would have left debt on an unsustainable upward path".