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A lot from the Lehman Brothers: Artwork and Ephemera" sale at Christie's of London in September 2010
A lot from Lehman Brothers: sale of artwork and ephemera from the failed investment bank at Christie's of London in September 2010, on the second anniversary of the bankruptcy. Photograph: Linda Nylind for the Guardian
A lot from Lehman Brothers: sale of artwork and ephemera from the failed investment bank at Christie's of London in September 2010, on the second anniversary of the bankruptcy. Photograph: Linda Nylind for the Guardian

Three myths that sustain the economic crisis

This article is more than 11 years old
Five years ago the banks stopped lending to each other. Larry Elliott on why the temporary, technical problem is still with us

The summer of 2007 was a run-of-the-mill affair. Tony Blair had stepped down as prime minister in late June and his successor, Gordon Brown, was enjoying a honeymoon period. It was a year without a football World Cup or an Olympics.

Then, on 9 August, came reports that central banks had been active in the markets. The Guardian said the action involved pumping billions of pounds into the financial system to calm nerves amid fears of a credit crunch. The trigger for the panic was the decision by BNP Paribas to block withdrawals from three hedge funds because of what it called a complete evaporation of liquidity. A spokesman for the bank described the move as a temporary technical issue.

Technical? Temporary? Within six weeks, it was clear the meltdown of August 2007 was no short-term blip when investors queued outside branches of Northern Rock for three days in the first run on a leading UK bank since the mid-19th century. Five years on, the global economy has yet to recover from the deep trauma caused by the hubris of the bankers.

Back then, though, there were few who imagined that 9 August 2007 would prove to be such a milestone in financial history. The Guardian carried the story on page 29 because there seemed no reason to believe this was different from previous bouts of jitters in the markets. It took a few days to work out what the bankers had been up to, because the "masters of the universe" had their own esoteric language. Talk of mortgage-backed securities, credit default swaps and over-the-counter derivatives was the equivalent of 12th century monks writing bibles in medieval Latin for peasants who only spoke English.

Stripped of the jargon, it is now quite easy to see what happened. Banks were taking large gambles with precious little capital in reserve if the bets went wrong. Individuals were borrowing at levels that were only sustainable if the value of their share portfolios and homes continued to rise year after year. Governments assumed booming tax receipts were permanent and increased public spending.

In August 2007, the air started to escape from this gigantic bubble. It happened in three stages. The financial sector was the first to feel the impact, because while it was evident that almost every bank had been up to its eyeballs in investments linked to the American housing market, no one knew just how much money each institution stood to lose. The financial system grinds to a halt if banks refuse to lend to each other, as they did in August 2007.

It took more than a year for the second stage of the crisis to unfold. During that period there were a number of developments: the finance crisis deepened, house and share prices fell, and inflationary pressures increased after a sharp jump in the cost of fuel. When Lehman Brothers went bankrupt in September 2008, the global economy was ready to blow and the next six months saw the biggest slump since the Great Depression.

Governments arrested the slide into a 1930s-style slump by co-ordinated action, but wrecked their own finances in the process. Bailing out the banks was expensive, particularly since much lower levels of output reduced tax revenues. Banks felt they had too much debt. Consumers felt they had too much debt. By mid-2009, most governments also felt they had too much debt. It was not a comfortable place to be.Central banks tried to help out by making credit cheap and plentiful. They cut interest rates and used unconventional methods – such as buying bonds in exchange for cash – to boost the money supply. The hope was this would stimulate a private sector recovery and so provide a breathing space in which governments could repair their finances.

The attempt to solve a crisis caused by credit with even more credit has, predictably enough, proved a failure. It has been a bit like the motorist desperately pumping air into a tyre with a slow puncture: it works for a while, but eventually the tyre goes flat again.

Some countries have fared better than others. Australia was one of the few nations to escape recession, because it had well regulated banks and is a supplier of raw materials to China.

Britain, by contrast, was more exposed than most. Lax regulation cultivated an "anything goes" culture in the City; equity withdrawal from rising house prices underpinned consumer spending; inflationary pressures were stronger than elsewhere. The level of activity in the economy is close to 15% below where it would have been had growth continued at just over 2% a year since output peaked in early 2008.

For the global economy, things may get worse before they get better. The summer of 2012 has seen signs of a general slowdown, with knock-on effects from Europe's sovereign debt problems felt in North America and Asia. The eurozone is heading for a double-dip recession, the US is growing far more slowly than has been the norm after previous downturns, while China's economy is feeling the impact of policy tightening deemed necessary to curb the inflationary effects of the stimulus injected in 2008-09.

There is no real comparison between the past five years and the half-decade after the Wall Street Crash in October 1929. In the 1930s, a quarter of the American workforce was out of work and industrial production fell by 50%. A better historical parallel may be the Great Depression of the 19th century, a slowdown in growth and deflationary pressure that lasted from 1873 to 1896.

The reason the crisis has been so long comes down to three myths. The Anglo-Saxon myth is that big finance is a force for good, rather than rent-seeking and corrupt. The German myth is you can solve a problem of demand deficiency with belt tightening and export growth. The right policy involves tough curbs on the banks, international co-operation so creditor countries increase domestic demand to help debtor countries, and a measured pace of deficit reduction governed by the pace of growth rather than arbitrary targets.

The chances of this happening are slim. Because there is a third myth – that there was not much wrong with the global economy in 2007. But the old model was financially flawed as it operated with high levels of debt, socially flawed in that the spoils of growth were captured by a small elite, and environmentally flawed in that all that mattered was ever-higher levels of growth. It is possible to move on, but only when it is recognised that the genie will not go back into the bottle.

More on this story

More on this story

  • Financial crisis, five years on: trust in banking hits new low

  • Financial crisis, five years on: Q&A

  • Northern Rock shareholders reflect on compensation claim loss

  • Financial crisis, five years on: readers' stories

  • Roll up for the financial crisis tour

  • The financial crisis five years on: share your stories

  • Credit crunch: elusive ghosts of the financial feast lurk in the shadows

  • The financial crisis, five years on: 25 people at the heart of the meltdown

  • Five years ago, the credit crunch began; today it's worse. How long will it last?

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