The UK economy is suffering from deep-seated psychological scarring caused by a sequence of crises, which necessitates a strategic re-imagining of the state’s role in generating growth, says Andy Haldane

We are fast approaching the ten-year anniversary of Brexit – an event that is sure to leave a large and lasting scar on our economy, society and polity. But it has hardly been the only surprise the UK has faced. This century has been pockmarked by a sequence of large, adverse global events – from the Global Financial Crisis (GFC) to Covid, from the cost of living to the ongoing geopolitical crises. 

Each of these once-in-a-generation events has left a deep scar. These scars are both financial and psychological. The financial scars are still evident, most obviously in the elevated public debt levels of the major economies. On average across the G7 economies, public debt now exceeds annual national income. Prior to the GFC, it was less than six months’ national income. In the UK, public debt relative to national income has trebled in less than a generation. 

Spiralling public debt is the result of government extending public support on a scale never before witnessed in peacetime. The GFC cost the average G7 government around seven–eight per cent of GDP. Covid cost more than three times that amount. Brexit is estimated to cost the UK perhaps four per cent of GDP. The recent cost of living crisis cost the UK two–three per cent of GDP. The ongoing geopolitical crisis, if countries step up to the 5per cent of GDP target for defence spending suggested by NATO, could cost an extra two per cent of GDP per year. Its cumulative cost could well dwarf Covid. Each has caused a ratchet in public debt. 

The good news is that this extension of the public safety net has given businesses and households time and resources to repair their damaged balance sheets. In the UK, both businesses and households are now running financial surpluses – that is to say, they are saving more than they are spending. Their levels of debt are now modest by recent historical comparison. With financial scars healed, they should in principle be primed for lift-off, fuelling investment, productivity improvements and, ultimately, higher growth. 

In practice, there are few signs of this having happened in the UK. Private investment has remained subdued. Productivity has flatlined since the GFC, rising at around a quarter of its pre-crisis rate. In consequence, economic growth has been anaemic. Real median pay for workers is still lower today than at the time of the GFC. Despite their repaired balance sheets, households and businesses are continuing to exercise extreme caution, saving not spending. Why so? 

The answer lies in the second, and more damaging, of the scars left by the sequence of crises – psychological scarring. A driver witnessing a car crash slows down, initially because of traffic congestion (the transport equivalent of financial scarring), but for many miles afterwards even when the road is clear. The reason is psychological scarring: a fearfulness of history repeat ing itself, even when the chances of that are minuscule.

This behavioural trait, part of our psychological make-up since at least hunter–gatherer times, is particularly potent when it comes to financial decision-making. The Great Crash of 1929 scarred investor appetite for at least a couple of generations. This led investors to demand an extra return for holdings stocks – the equity premium – whose size and persistence for many years baffled financial economists. 

As it spread from investors to businesses and consumers, it was the same psychological scarring that turned the trauma of the Great Crash into the tragedy of the Great Depression in the 1930s. John Maynard Keynes diagnosed this, astutely, as the “paradox of thrift”. The paradox was that an individually virtuous act – saving in the face of uncertainty – could be collectively calamitous. If everyone is saving, and no one is spending, the result is depression. If all cars are on a go-slow, the result is a ten-mile tail-back. 

Having faced not one financial car crash but several in less than a generation, it is little wonder today’s risk-takers, investors, households and corporates alike, are sticking rather than twisting, saving not spending, braking not accelerating, their animal spirits anaesthetised. Although it is collectively damaging, this is the individually prudent thing to do. We are facing a twenty-first-century ‘paradox of thrift’, whose psychological scars might easily persist as long as those of its twentieth-century counterpart did. 

The upstream effects of this reduced risk-taking can be clearly seen in the damped dynamism and caged animal spirits both of businesses and of households. In the words of Austrian economist Joseph Schumpeter, the forces of ‘creative destruction’ have been significantly and persistently diminished by the sequence of crises, stunting innovation, enterprise and hence the dynamism of our economies. 

For businesses, those caged animal spirits have manifested themselves in reduced numbers of firms entering and, just as importantly, exiting the market. Entry and exit rates for UK firms are around a third lower today than at the time of the GFC. Entrepreneurs are more fearful of starting new businesses, despite them being the wellspring of innovation and jobs; and owners and government have been more wary of seeing businesses fail, leaving resources trapped in inefficient businesses. 

What is true of companies is true too of households. It is by moving job that people raise their levels of skill and pay. Since the GFC, fearfulness has led to rates of job churn, entry and exit, falling by around a third in the UK. Reduced dyna 

mism in the market for jobs has mirrored reduced dynamism in the market for products – and for the same reasons. As dur ing the Great Depression, innovation and growth have been the casualties. 

This leaves the UK, and much of the rest of the Western world, in a strangely topsy-turvy dilemma. The world is unquestionably a highly uncertain place. It is both understandable and reasonable that people would want to insure themselves against future downsides. It is understandable that there is a desire to slow down the pace of change to reduce one additional source of uncertainty.

Yet, as Keynes recognised almost a century ago, rational decisions at the individual or micro-level do not always aggregate up into rational ones at the collective or macro-level. This is one of those moments. At the very time people crave greater stability, we need to rekindle the flames of creative disruption to stir us from our macroeconomic slumber. The question is how this is best achieved. 

21st century solutions

Keynes’s solution to the paradox of thrift in the 1930s was outlined in the most important economics book of the twen tieth century, the General Theory. Government needed to step in where the private sector feared to tread. Only government, Keynes argued, could bear the burden of increased risk-taking and spending. Where government led, the private sector would then follow with its own risk-taking and spending to beat back the paradox of thrift. 

This is the essence of what became known as Keynesian economics, with the state as spender-cum-risk-taker of last resort. In the 1930s it worked, as a programme of public works in the UK and United States uncaged the animal spirits of households and businesses, leading those economies out of the Great Depression. A century on, can we rely on the same Keynesian recipe to revivify animal spirits, creative destruction and growth? 

In one sense, the Keynesian playbook has already been followed, perhaps too slavishly. Each of the sequence of crises this century has rekindled fears of another Great Depression. That has led to governments stepping in with muscular and increasingly open-ended support packages. What began as support to stricken financial institutions at the time of the GFC migrated to support for non-financial institutions during Covid and the cost-of-living crisis. The social safety net has bulged not only in scale but also in scope. 

We do not know how differently the world would have looked without this public insurance. What we can say is that the scarring effect of it on the government balance sheet has been profound. Viewed through the lens of twentieth-century history, debt ratios in excess of national income are nothing special: the average over that century is roughly where the UK stands today. So too are Government borrowing costs, at around five per cent. 

But future headwinds to the public finances are far stronger now than then – from the climate and nature crises, from increased defence spending, from an ageing population. Crucially, the great redeemer of debt problems of the past – economic growth – is subdued. Even levying the inflation tax – another great debt redeemer of the past – is far harder in a world of independent central banks with statutory inflation mandates. 

The UK has not run a fiscal surplus this century. As the Office for Budget Responsibility (OBR) has pointed out, given current debt and interest rate levels, without a material rise in growth or far greater restraint in public spending, UK debt ratios will continue to ratchet upwards in the decades ahead to levels unmatched in peacetime. 

As well as the costs of servicing this debt, there is also an incentives problem that arises from offering public insurance on this scale – a moral hazard problem. Is there now an expec tation that future, rather than current, taxpayers will bear the risk of the next big shock? Has reliance on public support gone too far? In today’s uncertain world, it is only a matter of time before another nasty generates public calls for a further extension of the safety net. Can we afford another ratchet in public debt? 

While today’s world of damped dynamism and acute risk aversion has strong similarities with a century ago, I think the Keynesian policy solution is far less likely to work now than then. Indeed, turning on the fiscal taps might even make a bad situation worse if it began increasing fears about future tax rises – what economists call Ricardian equivalence. If so, what else might be done to encourage animal spirits? Let me discuss three options: private insurance; tax and regulation; and education and learning.

Private Insurance 

In the early part of this century, the concept of the ‘Greenspan put’ emerged – the expectation that central banks would ride to the rescue of financial markets. During the later part of the century, this has morphed into a ‘Greenspan plus government put’, with governments and central banks now joining hands in extending the safety net. Is there another way of providing that insurance, credibly, in the face of future shock – another epidemic, a cyber attack, a natural disaster? 

One means of credibly hedging these risks in advance is by making greater use of private markets to hedge these tail risks. This is hardly new. The catalyst for the creation of the London insurance market was the Great Fire of London in 1666. Today, most fire insurance is private. More recently, catastrophe insurance has emerged to hedge threats from terrorism and flooding. And governments have issued index linked bonds to hedge against inflation risk. 

It is time to think afresh about what new insurance and bond market instruments might be needed to hedge the most pressing twenty-first-century risks. For example, I would say there is a compelling case for developing a deep and liquid private market in cyber and pandemic insurance. There is an equally compelling case for governments issuing bonds indexed to GDP to insure against big future shocks to national income. 

These instruments and markets are not hypothetical – they already exist, but at far too small a scale to meaningfully hedge rising global existential threats. Nor are the incentives or regulations in place for households and businesses to take out this insurance, either because of a lack of awareness of the threat or because they believe government will protect them in the event of the risk being realised – the moral hazard. 

A recent and topical example is the cyber threat facing UK businesses. As recent experience at the British Library, Marks & Spencer, the Co-operative and Jaguar Land Rover (JLR) illustrate, cyber threats can disable a company for months. The last example was particularly revealing. Because of the failure to put in place adequate cyber protections or insurance, the government was obliged to provide a £1.5bn support package for JLR. Without change, this moral hazard seems certain to grow. As with the terrorism risk in the UK in the early 1990s, miss ing markets need a catalyst for change. Then it was cooperation between the public and private sectors, in a co-insurance model, that led to a private market emerging. A similar co-insurance approach to designing and delivering these new private insur ance markets is needed now. Work is also needed on alerting businesses and consumers to these risks and providing incen tives for them to take out insurance against them. Financial innovation of this sort is plainly both socially useful and commercially viable. As in seventeenth-century England, the cradle of modern insurance markets, this is finan cial innovation whose time has come, given the new and rising risks we face. As then, with its deep expertise, where better to develop those new markets than London? Here is a way of both enhancing safety and security among the public and also gener ating innovation and opportunity within businesses. 

Tax and Regulation 

The UK does not have the largest economy in the world, but does have the longest tax code. The UK also does not have the largest financial sector in the world, but does have one of the most extensive and intrusive regulatory regimes. Why? The  answer is history-dependence – the QWERTY-keyboard theory of why we have otherwise inexplicable degrees of com plexity in our systems, complexity that serves as a barrier to innovation, enterprise and dynamism. 

The evolution of financial regulation has been almost entirely crisis-driven. The greatest regulatory leap forward came after the bank collapses of the 1930s. Central banks, deposit insurance and securities and banking regulation came of age after that financial crisis. Ever since these institutional pillars were erected, dismantling or even re-architecting them has been a near-impossible political task. 

Instead, we have seen a regulatory ratchet in response to each financial crisis, as the regulatory Tower of Babel has continued to grow. The last ratchet occurred at the time of the GFC. Reform, plainly, was needed. But, as with past crises, this regulatory reform took the form of additions to the regulatory rulebook and the numbers of regulators. There was no attempt to rethink the regulatory infrastructure itself or the culture of regulation. 

What is true of financial regulation has been true of regulation generally, in the UK and more broadly. Remarkably, the UK now has in excess of 100 regulatory bodies. Each is individually well-intentioned. The catalyst for each was a risk unjustly borne by society. And each regulatory tower, once erected, has proved to be remarkably resistant to change, despite the rising tide of rhetoric around deregulation. 

There is now a growing sense of the regulatory pendulum having swung too far. This critique of regulatory overreach typically has two strands. One contends that the infrastructure is too complex – too much regulation, too many regulators. Stripping away this deadweight cost would deliver a significant societal saving in red-tape, helping to boost growth and encour age enterprise. 

The second is that regulation itself is too monocular, focusing on curbing risk rather than encouraging commerce. This critique has become louder as evidence has grown of risk aversion among both the suppliers and the demanders of finance. For example, it is remarkable that UK banks have not extended a single pound of net new lending to UK small and medium-sized enterprises (SMEs) since the GFC. 

Both of these critiques of the UK’s regulatory infrastructure have merit. What was needed when this infrastructure was put in place in 2008, when risk-taking was rapacious and animal spirits excessive, is not what is needed today, when risk-taking is insufficient and animal spirits quiescent. The question is how this regulatory reboot is best achieved. 

What is clear from past experience is that a brick-by-brick dismantling of this regulatory tower is doomed, because it would, as in the past, quickly be overwhelmed by regulatory regrowth. It would also be doomed because, like a giant Jenga puzzle, many of these bricks are mutually self-supporting. What is needed is a new regulatory edifice built, structurally and cul turally, from the bottom up. 

That structure needs to have the agility to flex with the risk environment in a symmetric fashion – constraining risk-taking when excessive but, just as importantly, encouraging it when deficient. It needs to focus on shaping risk incentives at the top of institutions, not man-marking risks from the bottom up. It needs to have regulatory mandates that give primacy to return – that is, growth – as well as risk. And it needs culturally to restore the principle of caveat emptor for consumers and investors. 

These self-same principles apply across the entire regulatory spectrum. And they apply with equal force too to the UK’s tax code. Complexity is a tax on enterprise. It is also precisely the wrong response to a world that itself is beset by greater complexity and uncertainty. This calls for a regime-shift in regulatory philosophy and culture as much as in regulation itself. 

Education and Learning 

Animal spirits are rooted in a sense of the possible. We can not equalise societal outcomes, but we can and should level the playing field of opportunities for people to thrive. This means creating a ladder that is both longer and stronger for everyone. This is essential not only for personal wealth, but for personal health and happiness too. 

Yet that ladder of opportunity is, for many, broken, its lowermost rungs removed. We see that in the 9.5m across the UK – almost a third of the workforce – who are econom ically inactive. That is, they are neither learning nor earning. Appallingly, around 1 million of them are aged between six teen and twenty-four. This risks young people being lost to work and learning on a lifelong basis. 

These inactivity problems are not confined to the young. A quarter of workers over the age of fifty-five are inactive, as are half of those over the age of sixty. These are people with the experience and skills to make a significant contribution in the workforce, which is being lost. And the cost is large. If employment rates among the over-fifties could be increased by five percentage points, this would bring a boost to annual UK growth of over 1.5 per cent. 

If economic inactivity imposes a large and growing dead weight burden on growth or our economy, how is it to be reduced? The key is keeping everyone on the learning and employment pathway, from early to senior years. For the young, this means instilling work as a habit – for example by hard-wiring work experience into all schools from ages fourteen to eighteen. It also means guaranteeing every young person at age eighteen a pathway into learning, work or both – a degree, degree-apprenticeship or apprenticeship. 

But learning should not end in our twenties. We need to make a reality of lifelong learning so that longevity becomes an asset for our economies rather than a liability. This means looking afresh at the Lifelong Learning Entitlement (LLE) pro 

grammes recently put in place, making them both less restrictive and more generous for workers and businesses alike to harvest the large and growing longevity dividend. 

Conclusion

The American social psychologist Jonathan Haidt has called the twenty-first century the ‘anxious generation’. There are good grounds for that anxiety given the nasty sequence of surprises the first quarter of this century has served up – and the fears many more such nasties might lie ahead. That anxiety is calcifying our economies, dividing our societies and toxifying our politics. The UK is experiencing this anxiety attack as badly as any Western nation, with Brexit both symptom and cause. 

Breaking free from this era of anxiety, and ushering in an era of opportunity, will require a mass re-imagining. That includes the appropriate role and scope of the state in insuring against future risks, the role of taxation and regulation in constraining animal spirits and the role of education and learning in rekin 

dling them. That re-imagining will require, above all else, leader ship. Perhaps the greatest anxiety of them all is whether the UK has the leadership capable of rising to this challenge.

This is an extract from The Brexit Effect 2016 – 2026 edited by Anthony Seldon is published by Cambridge University Press, price £16.99.