15 January 2019

Vox EU: Brexit: Blame it on the banking crisis

Author argues that the austerity policies embarked on in response to the fiscal damage resulting from the banking crisis in 2007 to 2009 triggered the protest votes of left-behind voters, which at the margin allowed Leave to win the referendum vote.

The banking crisis was damaging in many ways, most obviously through the output and fiscal costs of the recessionary shock that it imposed on the economy. The key point for the argument of this column is that it reduced the level of potential output in the economy and accordingly raised the structural budget deficit. This effect comes through decreases in capital, human capital and total factor productivity. A conventional estimate might be that the crisis of ten years ago probably reduced the level of potential output in the UK by somewhere between 3.8% and 7.5%.

Plans for fiscal tightening were formulated in the context of contemporary estimates of the increase in the structural budget deficit since before the crisis (Table 2). Both the outgoing Labour government and the incoming Coalition government accepted the case for significant fiscal consolidation to restore fiscal sustainability, although the parties differed somewhat on its composition, size and timing. Austerity was a bi-partisan policy response to the fiscal implications of the banking crisis without which it would not have been instigated by either party.  

In the event, the austerity programme relied very heavily on cuts to public expenditure which comprised 89% of the fiscal consolidation. In turn, a substantial part of these cuts were implemented through reductions in grants to local authorities which fell by 36.3% on average between 2009/10 and 2015/16. Across local authorities the reductions in public spending per person ranged from 46.3% to 6.2% with the most deprived areas experiencing relatively large cuts (Innes and Tetlow 2015).

After 2010 support for UKIP in local elections surged to the extent that they became a serious electoral threat to the Conservatives who therefore promised a referendum on EU membership. In a difference-in-differences analysis, Fetzer (2018) shows that rising support for UKIP at the local level was strongly correlated over time with the impact of austerity in areas with weak socioeconomic fundamentals. The effects are sizeable: for a district experiencing the average austerity shock UKIP’s vote share would rise by 3.58 percentage points based on the pooled estimate for the post-2010 period and 11.51 percentage points based on the estimate for 2015. Given the tight relationship between the vote shares of UKIP in elections and Leave in the referendum, these results suggest that Remain would very probably have won in the absence of austerity.

 

Clearly, in principle, fiscal consolidation could have been designed differently; for example, increased taxation could have played a much bigger part. Also, the Conservatives winning a majority in 2015 and having to implement their referendum promise was something of a surprise especially as fiscal consolidation was still ongoing. As it turned out, however, the sequence of events seems clear – the financial crisis led to an austerity programme which boosted support for UKIP enough to make the Conservatives promise a referendum and antagonised left-behind voters whose protest votes were enough to tip the balance for Leave.   [...]

The banking crisis and Brexit are usually seen as two unrelated setbacks. In fact, there is a close connection between them which runs through the fiscal consolidation that had to be undertaken in the wake of the financial crisis. The pain of austerity promoted the rise of UKIP, a referendum on EU membership, and a win for Leave. None of these outcomes was by any means certain ex ante but they were the realised results of the policy response to the banking crisis. If Brexit is seen as an outcome of the banking crisis, then the total loss of potential output from that debacle is approximately doubled and lies in the range 7.7% to 16.2% of GDP.

The implication is that, if the risks of unfortunate policy responses following a crisis are taken into account, there are even stronger reasons to regulate the banking system strictly, in particular to ensure that it has adequate levels of loss absorbing equity capital. Miles et al. (2013) show that the social benefit-cost ratio of reducing leverage substantially is high in any case. The events of the last ten years indicate that it is even higher than they thought.

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