ChainWhat it assumes · how to break it
Start
Banks suffer large losses on mortgage-related loans and securities as house prices fall, as in the 2007–08 global financial crisis, and begin to doubt each other's solvency.
1
As a result, the government may have to rescue failing banks by buying shares or guaranteeing their debts, which adds to public sector borrowing.
bailout · too big to fail
bailout · too big to fail
Assumes: The failing banks are too big to be allowed to collapse.
But: Smaller banks can be wound down, and deposit insurance protects savers without a full rescue.
2
At the same time, the recession that follows reduces tax receipts from income, profits and spending, because incomes, profits and spending all fall.
automatic stabilisers · tax revenue
automatic stabilisers · tax revenue
Best link to attack
Assumes: Tax receipts stay low.
Assumes: Tax receipts stay low.
But: Tax receipts recover as the economy recovers, so much of the extra deficit is cyclical and closes on its own.
3
In addition, spending on unemployment benefits rises as more people lose their jobs.
automatic stabilisers · welfare spending
automatic stabilisers · welfare spending
Assumes: Unemployment rises sharply.
But: If firms hoard labour, as many UK firms did after 2008, benefit spending rises less than the fall in output suggests.
4
Therefore, the budget deficit widens sharply, and the debt-to-GDP ratio rises because debt grows while GDP falls.
budget deficit · debt-to-GDP ratio
budget deficit · debt-to-GDP ratio
Assumes: The government lets the deficit widen.
But: A government facing high borrowing costs may cut spending during the downturn, although that deepens the recession.
5
Consequently, the government may need fiscal consolidation later, raising taxes or cutting spending to bring borrowing down.
fiscal consolidation (austerity)
fiscal consolidation (austerity)
Assumes: The government aims to reduce the deficit quickly.
But: If borrowing costs stay low, the government can reduce the deficit gradually as growth returns.
End
The budget deficit widens sharply through rescue costs, lower tax receipts and higher benefit spending, and the national debt rises.
Evaluation chain
- E1However, how long the deficit stays high depends on whether the fall in tax receipts is cyclical or structural.
- E2If the crisis only causes a temporary negative output gap, tax receipts and benefit spending return to normal as the economy recovers.
- E3As a result, the cyclical part of the deficit closes without tax rises or spending cuts.
- E4So the lasting damage to the fiscal balance is smaller, unless the crisis permanently lowers potential output, as the UK's slower productivity growth after 2008 suggests, which leaves a structural deficit.
Another way to attack it: Rescue costs can be partly recovered when shares in rescued banks are later sold, so the lasting fiscal cost depends more on how much the crisis damages output than on the bailout itself.
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Questions this answers
- Assess the impact of a financial crisis on the government's budget deficit.
- Evaluate the reasons why government debt rose sharply in the UK after 2008.
- Discuss whether fiscal consolidation was necessary after the financial crisis.
Diagram
No standard diagram. Evidence of public sector net borrowing and debt as a share of GDP before and after 2008 works well.
Reverse and related
Stable, growing banking system → tax receipts rise and benefit spending falls, so the deficit narrows.