Bank regulation, not austerity, explains why Britain is 40% poorer than America

Britain’s weak recovery from the 2008-09 financial crisis was caused by post-crisis banking regulation, not fiscal austerity or an inevitable feature of deep recessions, according to a new briefing from the Institute of Economic Affairs.

Before 2008, the UK and US economies grew at almost identical rates. UK per capita trend growth was 2.3% compared to 2.1% in the US. Since the crisis, that pattern has broken down entirely. The US suffered a one-off drop in output before returning to its pre-crisis growth rate. The UK suffered both a deeper drop and a permanently slower rate of growth thereafter.

The new briefing by Tyler Goodspeed, formerly Chairman of the White House Council of Economic Advisers, sets out the case that Britain’s slow recovery was a policy choice rather than a historical inevitability. Examining 132 recessions in the UK and US over four centuries, Goodspeed finds that neither the depth nor the duration of a recession predicts a slow recovery: on average, deeper downturns are followed by higher rebounds, and financial crises are no more likely to produce sluggish recoveries than ordinary ones.

Ruling out austerity, planning and tax

The paper also tests the leading rival explanations for the UK’s stagnation. Austerity is ruled out because the US tightened fiscal policy by a similar amount over the same period. Restrictive planning laws and high taxes on labour do damage growth but don’t fully explain the downward shift after 2008, because both predate the crisis by decades.

Why the regulatory squeeze hit Britain hardest

Instead, Goodspeed points to the tightening of bank capital, leverage and liquidity rules introduced after 2009 on both sides of the Atlantic. UK businesses, and small and medium-sized firms in particular, rely far more heavily on bank lending than their US counterparts (over 60% of external financing, against under 40% in the US). Britain also has fewer, larger banks, fewer than 300 serving around 29 million households, compared with roughly 5,000 serving 134 million households in the US, making them more likely to be caught by the new size thresholds.

The credit crunch in numbers

Lending to business. Real credit to the private business sector recovered to its early 2008 level in the US by mid-2013. In the UK it remains 15% below that level today.

Loan approvals. Approval rates for small business loan applications, which ran at around 80-90% before 2008, had fallen to under half by 2024.

Public substitution. Goodspeed’s calculations suggest that 30-50% of the entire decline in lending to UK businesses can be explained by banks substituting safer government lending for lending to private firms.

What’s next. The incoming Basel 3.1 rules are likely to make the environment for UK business borrowing harder still.

This briefing is the first in a series published by the IEA on Britain’s ‘Great Stagnation’, diagnosing Britain’s growth problem. The next briefings in the series will be published in the coming weeks and will be compiled into a full book published in September.

Tyler Goodspeed, economist and author of the briefing said:

“For fifteen years, British policymakers have told themselves that a slow recovery was simply the price of a deep recession. It isn’t. History shows deep recessions are usually followed by strong rebounds. Britain’s experience after 2009 departed from this pattern because regulators, with the best of intentions, made it structurally harder for banks to lend to British businesses. That was a choice, and it is still being made today.”

Lord Hannan, Director General of the Institute of Economic Affairs said:

“Britain has a growth gap, and it isn’t because it spent too little. Britain has underlying structural problems of its own creation that undermines its ability to grow and create wealth and prosperity, including banking regulation. We made it too hard for banks to lend to businesses. Every recession in our history teaches the same lesson: the deeper the fall, the stronger the bounce. Ours didn’t bounce, because regulators — with entirely good intentions — built a system that starves small firms of credit while rewarding banks for buying gilts instead. If we want the growth we were on course for in 2007, we need to think again about capital regulation.”