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As bank shares tumble, the scale of the financial shock becomes clear

Osborne's mettle will be tested when Greece defaults, as it surely will.

The Tories, after 13 years in opposition, have now been in government for 17 months and still they have no plan for growth. The Chancellor, George Osborne, made this clear in his rather flat and uninspiring speech at the Conservative party conference in Manchester on 3 October. He insists that he is not for turning – but a previously announced freeze in council tax, some money to pay binmen and a few extra pounds for developing graphene won't cut the mustard in a crisis.

It is unclear what impact the new right-to-buy and housebuilding plans will have. They certainly won't create jobs or new homes any time soon, because there are long lags between announcement and delivery. This looks like another of the coalition government's half-baked ideas that are all announcement and no substance and probably won't work.

Osborne offered some insightful economic analysis when he suggested, "Our economic problems were not visited on this country by some cruel act of God or blind force of nature. They were created by the mistakes of human beings." Amazing. I had always thought they were the fault of Martians but I stand corrected.

Falling down

The Chancellor argued that there were three main problems. "First," he said, "the last government borrowed too much money." The second mistake was apparently made by the banks, which "ran up staggering debts of their own, buying financial instruments even they couldn't understand". Third, "Our European neighbours plunged headlong into the euro without thinking through the consequences."

He repeated his claim that both he and David Cameron are fiscal conservatives but monetary activists, hinting heavily that the Bank of England can take the strain of the crisis by doing more quantitative easing. His plan to introduce a "credit-easing" scheme to help small businesses is welcome.

This idea was first proposed by me in a recent New Statesman column and backed in a speech by Adam Posen, member of the Bank of England's Monetary Policy Committee. It would involve the Treasury buying bonds issued by companies, thereby boosting the supply of credit and cutting the cost. The need for such a scheme suggests that Project Merlin, a deal made between the coalition and banks earlier this year in an attempt to increase lending to small firms, has failed.

Given these announcements, it was sur­prising to hear Osborne, once again, drawing comparisons between Britain's economy, with its own currency and independent bank, and those of Greece, Portugal, Italy and Spain. Stuck in a monetary union and without their own central bank, these countries cannot devalue their currency, engage in quantitative easing or, presumably, introduce a credit-easing programme for small firms.

Worryingly, things are likely to get much worse - and fast - in the eurozone and the wider banking system. In recent weeks, the Franco-Belgian bank Dexia SA has sunk deeper into trouble. With a portfolio of loans and bonds reaching €651bn (£562bn) - many times its relatively small retail-deposit base, centred in Belgium and Turkey - the bank is a major holder of sovereign debt from the eurozone's fragile periphery.

Following the collapse of Lehman Brothers in 2008, the authorities in France, Luxembourg and Belgium injected €6.4bn (£5.5bn) into Dexia but the bank may now need rescuing again. At the time of writing, on 4 October, Dexia's shares had fallen sharply (by more than 20 per cent) for a second consecutive day and the finance ministers of France and Belgium made a statement that they would support the troubled bank, amid signs that it
could be broken up.

Over the past year, the share prices of French and German banks have been hit by fears of their exposure to Greece and the other peripheral countries in the European Union. The four main banks involved are down from their 52-week highs as follows: Société Générale by 66 per cent, Crédit Agricole by 63 per cent, BNP Paribas by 54 per cent and Deutsche Bank by 50 per cent.

Less well known is that there has been a collapse in the share prices of UK and US banks, as the table (below) shows. At the close of the London Stock Exchange on 4 October, Lloyds had fallen by 10.6 per cent, the Royal Bank of Scotland (RBS) by 8.4 per cent, Barclays by 10.5 per cent and HSBC by 4.7 per cent. On the year, the share prices of three of the four major British banks are down and they don't look so different from Dexia. Only HSBC looks significantly less exposed.

blanchflower table

House of cards

The huge drop in the share prices of these banks over the past five years (compare their five-year highs in the second column of the table with the last trade figures in the first) indicates the scale of the financial shock that we have been exposed to.

One other point of note is that the value of the UK's investment in Lloyds and RBS has halved since the day that the coalition government took over - on 12 May 2010, share prices were £59.51 and £48.40, respectively, on the market opening. As I write, they are £31.80 and £21.52. I have not heard much from Osborne about the decline in the value of the UK's assets on his watch.

Osborne's mettle will be tested when Greece defaults, as it surely will. I recall how he and Cameron opposed the rescue of the banks in 2008 without telling us what they would have done instead. The former chancellor Alistair Darling made clear recently that, on 7 October 2008, the then chairman of RBS, Tom McKillop, called him to say that the bank would run out of money in two hours and wouldn't last the day if the government didn't step in with a rescue plan. I hope we won't have to find out how Osborne would respond to a comparable crisis but the markets appear to be expecting just that. One down, all down.

David Blanchflower is the New Statesman's economics editor and a professor at Dartmouth College, New Hampshire, and the University of Stirling

David Blanchflower is economics editor of the New Statesman and professor of economics at Dartmouth College, New Hampshire

This article first appeared in the 10 October 2011 issue of the New Statesman, The next great depression

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.