Discuss whether providing substantial government financial support to banks is the best policy response during a financial crisis

Edexcel A-Level Economics Paper 2 June 2019 Extract

Discuss whether providing substantial government financial support to banks is the best policy response during a financial crisis. (15 marks)

Paragraph 1

1. One reason why it is best that the government provide financial support to banks during a financial crisis is to reduce the damage from a recession.
2. During a financial crisis, customers lose confidence in the financial system. 
3. This causes them to withdraw money from banks, which is known as a bank run. 
4. When this happens, banks lose liquidity, and this liquidity crisis can quickly spread across the financial system as financial markets are strongly interconnected.
5. As banks lose liquidity, some may have to shut down, or cut jobs.
6. Additionally, as consumers have low confidence, spending and aggregate demand can fall in the economy. This can lead to a decrease in aggregate demand and possibly a negative multiplier effect. 
7. This causes unemployment and causes economic growth to fall and the price level to fall. 
8. This effect can also cause a deflationary spiral, which is why it's so important that the government acts early to prevent the financial market failure spreading from one bank to another 

Evaluation 1

1. However, one problem with providing financial support to banks is an increase in national debt. 
2. National debt is the accumulation of budget deficits over the years, and this can be expensive, especially in terms of repayment of interest. 
3. Last year, the government spent £100 billion roughly on interest alone. 
4. The opportunity cost of this is that the government has less money to spend on health care or education, which means that living standards are worse off than they could be if the country was debt-free. 

Paragraph 2

1. Another reason why it is important that the government supports banks during a financial crisis is to reduce the size of externalities.
2. A failure of the entire financial system would lead to a recession which means that the government would have to increase spending on welfare payments caused by an increase in unemployment. 
3. Additionally, due to lower business profits, and less output, the government would collect less revenue from income taxes and corporation taxes.
4. this would lead to an increase in the budget deficit and therefore an increase in national debt levels. 
5. This means that the government would have to increase taxes or decrease spending in the future to pay off national debt, which is known as austerity. 
6. A decrease in spending on increasing taxes, as we are seeing in the economy now, affects people's living standards. For example, an income tax freeze currently means that people have less disposable income, which means that living standards fall. 
7. Therefore, it makes more sense for the government to prevent one bank from failing than to allow the economy to suffer a recession, which causes even more harm to society. 
8. The extract mentions that the government ‘recovered every penny of its investment in Lloyds’ as the economy grew.

Evaluation 2

1. However, the problem with the government financially supporting banks is that it causes moral hazard.
2. In the future, financial institutions may expect the government or the central bank to bail them out if there is a risk of financial market failure.
3. If firms expect this, they may act in a more risky way, making the failure more likely.
4. Additionally, there is a huge cost of supporting financial institutions.
5. For example, the extract mentions the £65bn bailout of RBS and LBG.
6. This would lead to an increase in the budget deficit and also national debt levels, which means higher taxes and lower government spending for future generations.

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