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This could be worse than what followed the fall of Lehman Brothers

The UK is far from being a "safe harbour from the storm", as Osborne ludicrously claimed.

I have had the strange feeling over the past month or so that economic developments were beginning to mirror those of the late spring of 2008, when the world was heading into a once-in-a-century financial crisis and nobody seemed to notice. All the talk at that time was about rising oil prices and the need to tighten monetary policy, because of misplaced fears of inflation. In the UK, consumer confidence had collapsed and house prices had started their steady decline; unemployment had begun to increase and, all the while, the Bank of England's Monetary Policy Committee (MPC) continued to fiddle while Rome burned. Some members were voting for rate increases when the right policy was to lower them. Sound familiar?

Eventually, the collapse of Lehman Brothers in September 2008 made macro policymakers take note and act but, by then, it was too late
to prevent the terrible slump that is not over by a long way. Central banks set interest rates as close to the zero nominal bound as was feasible and governments across the globe injected huge amounts of fiscal stimulus into their economies. Together, these actions saved the world from going into a second Great Depression.

The public sector stepped in and rescued large parts of the private sector, including banks, car manufacturers and insurance companies that would have failed without public funds. Without these interventions, unemployment could well have hit 20 per cent or even higher in both the US and the UK. George Osborne and David Cameron opposed the rescue package in the UK but have never told us what they would have done instead.
The rise in unemployment and fall in living standards that resulted generated a predictable response from right-wingers, who saw the situation as an excuse to push forward an agenda of smaller government. The public wanted it all to be over and has still not understood that there is going to be a downward pressure on living standards for a long time, as economies adjust to a permanent increase in the price of risk. Hence the focus on the immediate removal of stimulus, which some wrongly claim didn't work, but did.

So here we are on the edge of the economic precipice again - as I have warned could occur so many times in this column over the past year - driven by the hopeless economic policies that western governments have pursued. The decision by Standard & Poor's to downgrade the US AAA credit rating does seem rather precipitate, especially given that Fitch and Moody's have reaffirmed it. The US is perfectly able to fund its debt and make its payments and can borrow money at historically low levels. The problem is that the Republicans in the US Congress are unwilling to do so, pushing the world towards financial cataclysm. That members of the Tea Party can bring a nation to its knees has put in question the credibility of US macroeconomic policy. It is hard for eco­nomists to model behaviour when people act against their own best interests. It is the Tea Party's downgrade.

Fortunately, the Federal Reserve acted on 9 August to reassure the markets by promising to keep rates at rock bottom for the next two years. As I have been saying for months, there is a good chance that the Fed will start a further round of quantitative easing, probably by November.
At the same time, the eurozone crisis took off again. The inability to prevent the crisis in Greece from spreading to Ireland and Portugal should have set alarm bells ringing.

The actions taken were too little, too late, primarily because European leaders failed to deal with the underlying structural problems. Austerity measures compromised growth and the countries on the periphery were unable to depreciate their currencies. As I expected, the crisis in the bond markets has now moved on to Spain and Italy, with France next on the list. It didn't help that the European Central Bank raised rates twice this year, even though inflation is falling and there is no evidence of wage pressure.

Sadly, the UK is far from being a "safe harbour from the storm", as Osborne ludicrously claimed. There is a growing prospect of a downgrade for the UK, as all of the most recent economic data points downwards. So it was rather surprising to find Tory spin merchants arguing that Osborne had been "vindicated". Oh, dear. Laugh out loud. Growth has ground to a halt and, judging by the PMIs in services, construction and manufacturing, unemployment is likely to rise. Consumer confidence has fallen and retail spending is soft. The recent data on manufacturing has been dis­appointing, showing a 0.4 per cent fall in June against market expectations of a rise of 0.4 per cent.

The net trade data was also weak. The FTSE has fallen sharply and, worst of all, shares in UK banks have collapsed. RBS has fallen by a quarter over the past few weeks and is now around half the price at which we would get all our money back. Lloyds and Barclays share prices are markedly down. On 10 August, the MPC cut its forecast for growth and inflation. It still seems overly optimistic, and there is every prospect that its forecasts will have to be revised down a lot in the future. The MPC's credibility is now an issue, as it does not seem to have learned from its past mistakes of assuming all will be well, when it won't.

All of this incompetence has brought us to the brink of disaster once more. What we are witnessing could be worse even than what followed the fall of Lehman Brothers. These are extremely worrying days.

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

This article first appeared in the 15 August 2011 issue of the New Statesman, The coming anarchy