Government Response to the Financial Crisis

Written for the school newsletter:

The international response to the financial crisis of 2008 was nothing short of extraordinary. From direct injections of government capital into financial institutions to coordinated central bank interventions (quantitative easing) and overall massive fiscal stimuli, this unprecedented response has been analyzed ever since. Years later, we can now see which actions led the quickest recoveries and which unfortunately did not. I will be talking about the American & British response to the crisis.

US Government Response

With panic spreading across the world and capital markets drying up, the initial actions of the Federal Reserve included a broad-based guarantee of bank accounts, money market funds and liquidity. However, with the situation rapidly plummeting, policy makers realized that this would not be enough and with bipartisan approval signed the Troubled Asset Relief Program (TARP). This program allocated $700 billion (later lowered to $475 billion by the Dodd-Frank Act) to purchase assets from financial institutions, “the purchase of which is necessary to promote financial stability”. From the program’s inception, $245 billion went to stabilize banks, $68 billion went to stabilize AIG, $27 billion went to programs to increase credit availability, $80 billion went to the U.S. auto industry (specifically GM and Chrysler), and $46 billion went to foreclosure-prevention programs, such as Making Home Affordable. It is important to note that ARP recovered funds totalling $441.7 billion when the program ended in 2014 from $426.4 billion finally invested, earning a $15.3 billion profit or an annualized rate of return of 0.6% and a small loss when adjusted for inflation.

An important goal of the program was to encourage banks to resume lending again at levels seen before the crisis, both to each other in the central bank and to consumers and businesses. If the program can stabilize bank capital ratios, it should in theory allow them to increase lending instead of hoarding cash to cushion against future unforeseen losses from troubled assets. Increased lending equates to “loosening” of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets.

Other than addressing the financial industry, several other acts significantly increased the government fiscal injections into the economy along with the automatic stabilisers including the the Economic Stimulus Act of 2008, a $152 billion stimulus designed to help stave off a recession and the American Recovery and Reinvestment Act of 2009, a $787 billion bill covering a variety of expenditures from rebates on taxes to business investment.

But putting out the fires wasn’t enough. The incentives for the high-risk loans that had led to the creation of the financial bubble had to be stopped and this lead to the Dodd-Frank Wall Street Reform and Consumer Protection Act​, a law that enforced greater transparency, created a new governing office called the Financial Stability Oversight Council (FSOC) and other significant regulation measures.

The US government continued to invest into the economy through the stimulus programs, with large funds allocated to do so. With the rapid fiscal response to the financial crisis as well as continuation of these programs, the economy had recovered to pre-crisis levels in 2010 and has not contracted in the last decade. Although both sides of the economic debate argue on the final impact of the response, the economy has done well since.

Expansionary Austerity

We have to a small break here to talk about a concept called expansionary austerity (formally known as the Expansionary Fiscal Contraction Hypothesis). The theoretical idea was that a reduction in debt levels of the government would reduce the “crowding-out” effects caused by the borrowing of the government and would lead to higher private investment. This reduction in the debt would also hypothetically increase the confidence of the markets and would lead to higher consumption & investment. It’s important to mention this here, because even though it was brought up in economic discussions in the United States, it did not take over the discussion and became the main response as it did in Europe.

UK Government Response

In 2008, the British government was one of the major economies calling for fiscal injections to stimulate the aggregate demand and economic growth. Along with a variety of public investment projects such a £20 billion Small Enterprise Loan Guarantee Scheme, several tax cuts, and significant automatic stabilisers, the UK government had a similar plan to the UK government’s TARP plan to stabilise the financial system. Totalling some £500 billion, the plan aimed to restore market confidence and help stabilise the British banking system, and provided for a range of what was claimed to be short-term “loans” from the taxpayer and guarantees of interbank lending. The mechanism through which they injected funds into the system was by buying ordinary and preferential shares from the bank, the amount negotiated with each bank. The long-term government plan was to offset the large costs of this injection by receiving dividends from these shares, and later, to sell the shares after a market recovery.

The extent to which different banks participated varied according to their needs. HSBC Group announced it was injecting £750 m of capital into the UK bank and therefore has no plans to utilise the UK government’s recapitalisation initiative. Standard Chartered declared its support for the scheme but its intention not to participate in the capital injection element. Barclays raised its own new capital from private investors.

The plan was open to all UK incorporated banks and all building societies, however, Abbey, Barclays, Clydesdale, HSBC, Nationwide, and Standard Chartered chose not to receive any government money, leaving Lloyds (Lloyds took over HBOS) and RBS as the only major recipients. The RBS (Royal Bank of Scotland Group) raised £20 billion from the Bank Recapitalisation Fund, with £5 billion in preferential shares and a further £15 billion being issued as ordinary shares. HBOS and Lloyds TSB together raised £17 billion.

However, after the bailouts of 2008, with significant debt levels of around 80% of GDP, the UK was limited in its ability to take large fiscal actions such as the US. In 2010 the UK began a fiscal consolidation program after the government’s fiscal stimulus package was withdrawn and the new coalition government implemented spending cuts and increases in indirect taxation. With the expansionary austerity message taking over the conversation in mainland europe and the UK, additional fiscal consolidation measures continued under the government elected in 2015. However, statistical analysis shows that the austerity implemented in UK has hit GDP per person by £1500 a year according to new analysis from the New Economics Foundation (NEF) – just over £3600 per household – . The analysis shows that the isolated effects of government policy have been to reduce GDP growth every single year since 2010. This has suppressed the level of GDP by just under £100bn (£99.4bn) in 2018/​19.

Too big too fail

Some commentators noted that, although under the capitalist model inefficient private commercial enterprises should be allowed to go bust, the banks were “too big to fail”. This idea centers around the thought that certain businesses, such as the biggest banks, are so vital to an economy that it would be disastrous if they went bankrupt. To avoid a crisis, the government can provide bailout funds which support failing business operations, protecting companies from their creditors and also protecting creditors against losses. Those financial institutions which fall into the “too big” category include banks, insurance, and other finance organization. This corporate socialism has been the topic of great controversy and anger especially with the fact that not a single bank chief or chairman went to prison in the UK or in the US after the crisis.

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