You might enjoy predicting the future (https://canarywharfian.co.uk/threads/my-economic-predictions-for-2023.705/), but I also wanted to take a look back at past developments in economics. Initially, I considered reviewing the past decade, but going as far back as 2007/08 makes more sense—the year of the Global Financial Crisis. It seems fairly distant now, but the reactions to contain the crisis laid the groundwork for the economic developments in the past ten years.

Roots of the Global Financial Crisis

Books (“Too Big to Fail”) and movies (“The Big Short,” “Margin Call”) have been written and produced, but let’s have a quick look back at the roots of the crisis. The political will to increase the rate of home ownership met low interest rates, which made houses more affordable, fueling a boom in mortgage finance. To increase market shares, some market players went after low-income homebuyers and other applicants who were not previously offered mortgages (“subprime”). To counter this excessive risk-taking, mortgage-backed securities (MBS) (https://www.investopedia.com/terms/m/mbs.asp), mostly tied to American real estate, were introduced. These securities were based on mortgages—essentially the value of the homes that were financed. Not a problem in times of an economic boom with rising house prices, but you can imagine what would happen if prices were to fall (more on this later).

The Housing Bubble and Financial Exposure

The increased demand for mortgages and houses led to an asset bubble in the housing market (demand was higher than supply, so prices went up). As all large financial institutions were exposed to this market, the downfall of one (Bear Stearns) led to severe risks of taking down other financial institutions—a potential run on banks and a meltdown of the whole financial system were worst-case (but somewhat realistic) scenarios. Central banks and governments had to intervene—and they intervened in a big way. The U.S. Troubled Asset Relief Program (TARP) (https://home.treasury.gov/data/troubled-assets-relief-program) alone was a USD 700 billion package to purchase toxic assets and equity from financial institutions in trouble. To put things into perspective: this was equal to the annual GDP of Turkey at that time, the 17th biggest economy in the world. This helped to clear up balance sheets from risks. The value of the underlying assets for the MBS was reduced, so these securities were valued below their initial value.

Monetary and Fiscal Responses

The reactions to this crisis were mainly monetary, including quantitative easing (i.e., printing of money by central banks (https://www.bankofengland.co.uk/monetary-policy/quantitative-easing)) and deep cuts in interest rates. Fiscal policy by governments saw large stimulus packages (i.e., subsidies and cash injections). Some financial institutions were nationalised and/or bailed out (the state taking over parts of companies or buying some of their assets). With more money meeting the same supply (after all, it takes time to build houses), asset prices rebounded—another housing boom followed in a number of countries, similarly for commodities. Artificially low interest rates also provided little incentive for households to reduce debt.The big packages mentioned above also caused government debt to increase significantly—the cause of the European Sovereign Debt Crisis, when mostly Southern European countries were unable to repay or refinance their government debt or bail out over-indebted banks. When this information was discovered, capital inflows into these countries stopped, exacerbating the crisis even further. Having entered the euro, these states were also unable to devalue their currency (actively or passively) to regain competitiveness, so eventually bailouts were arranged against the promise of reforms and austerity (a reduction in public spending). The ECB also introduced substantial asset purchase programs (https://www.ecb.europa.eu/mopo/implement/app/html/index.en.html). While the adjustment process was painful, these measures were eventually successful.

An Era of Low Interest Rates

What followed was an era of relative calm, with interest rates kept very low or even at zero, leading to an economic recovery or even a boom. Low interest rates mean that the price of money is low, so borrowing for investments is cheap. This also has profound effects on finance—with an interest rate of zero, calculated net present values do not have a discount (the price of money is zero), leading to asset price bubbles in some areas. We have seen this, e.g., in cryptocurrency, venture capital, in some housing markets, and some argue even in the stock markets.

The Impact of COVID

This period of relative calm changed with the outbreak of COVID. Lockdowns led to a significant reduction in economic activity. The reaction was (again) a mixture of subsidies, asset purchases, and an increase in money supply. Furlough schemes helped at the household level while interest rates were kept low.This increase of the monetary supply led to higher rates of inflation to levels not seen since the 1970s. Central banks had to raise interest rates to tame inflation, leading us to where we are now. The current danger is that this will lead to stagflation, a period of high inflation without any (or only very limited) economic growth, which will mean that households will get poorer in real terms. There are signs that inflation will be reduced (https://www.ft.com/content/b28eacca-87cb-41ba-9055-12fbe6a12358) (note that a falling rate of inflation still means an increase in prices), especially with energy prices falling, so this high level of inflation might be a passing episode rather than a persistent trend like in the 1920s.

Divergent Economic Developments

It is interesting to note the different developments in the US, Europe, and China—it is also worth noting the abysmal performance of the UK over the past decade (https://www.ft.com/content/2f835691-2824-4f79-8ba0-7969674cdcbd), without any economic growth at all. Partly as a result of that, disposable household income (adjusted for inflation) has stayed flat over the past 15 years (https://www.ft.com/content/ef830f78-75ee-4b91-a48e-04defa0f96d4); i.e., inhabitants of the UK have not seen their disposable income increase for the past 15 years, whereas other European countries have seen double-digit increases. On an individual level, this might look different, especially if you are at the start of your career, earning pay raises and getting promoted.

Causes of the UK's Productivity Slowdown

One reason for this is the lack of productivity growth over the past decade, which is unprecedented in economic history (https://www.cambridge.org/core/journals/national-institute-economic-review/article/abs/is-the-uk-productivity-slowdown-unprecedented/287949348D9BBA0223B3EA7E532C4B22). COVID and Brexit did not help, but there are a number of other factors causing this: lower human capital, including education and employee skills; insufficient investment in research and development (roughly half of Germany's as a proportion of GDP); and low internal demand due to the financial crisis, austerity policies, or Brexit, among others (https://cepr.org/voxeu/columns/explaining-uks-productivity-slowdown-views-leading-economists).

Looking Ahead

Let’s see what the next decade brings—I am mildly optimistic that things will get better relatively soon.