The fiscal background
According to the Institute for Fiscal Studies:
- Labour inherited, by international standards, a big budget deficit and an average public sector debt burden. More than a decade later, the structural budget deficit and the debt burden have both been reduced...Since taking office, Labour has announced net tax increases that will raise 1.3% of national income (£18.8 billion in today’s terms) this year. This has contributed to a total increase in the tax burden of 2.1% of national income (£29.5 billion). This is being used to increase public sector investment and cut government borrowing..
Table 2.2 of the Institute's report shows a reduction, between 1996/7 and 2007/8, in the current budget deficit from 2.7 per cent to 0.3 per cent of national income; an increase in public sector net investment from 0.7 per cent to 2.1 per cent; and a reduction in public sector net borrowing from 3.4 per cent to 2.4 per cent. As a result there had been a reduction in the accumulated national debt from 43.3 per cent to 37.6 per cent of national income between 1996/7 and 2007/8.
The financial crisis
When Alistair Darling took office as Chancellor of the Exchequer in June 2007, the international financial system had just entered the first stage of the financial crisis. A sharp and unexpected fall in United States house prices had created the subprime mortgage crisis by causing large falls in the prices of internationally-held securities whose value depended upon mortgages secured on those houses. British banks were known to be affected, and it was realised that their losses could be expected to have an adverse effect on other sectors of the economy. The crisis entered its second stage in August 2007, when the French BNP Paribas bank announced that it could not determine the value of those of its bonds that were backed by US house mortgages. A mood of uncertainty developed in which every financial institution experienced doubts, not only about its own holdings, but also about the securlties held by its trading partners. That uncertainty deprived some banks of their accustomed sources of loans, and placed some of them in danger of insolvency. (One such was Northern Rock). That was the situation faced by Alistair Darling at the time of his first budget in March 2008. By October, however, the situation had changed. The catastrophic third stage of the crisis had been triggered by the insolvency of one of the world's largest investment banks, Lehman Brothers and the writeoff of $785bn worth of its issued funds. Uncertainty had changed to panic, with banks and others refusing to lend to each other, or to commercial borrowers; and the financial system seemed to be in imminent danger of total collapse.
Support for the banks
(The reasons why banks fail and the arguments for rescuing them are summarised in the article on Bank failures and rescues.)
Until the summer of 2007, Northern Rock had been considered to be one of the most successful of Britain's companies. Over the previous ten years it had been converted from a run-of-the-mill provincial building society into a major bank that became one of the country's 100 largest companies. On 13 September 2007, BBC's Robert Peston reported that it was seeking help from the Bank of England. That report triggered the first run on a British bank since the Overend-Gurney failure of 1860 . A House of Commons committee was to report that the directors of the bank had pursued a reckless business model which was excessively reliant on wholesale funding, and that Financial Services Authority had systematically failed in its regulatory duty to ensure that Northern Rock would not pose a systemic risk. The committee considered that The Chancellor of the Exchequer was right to ... authorise the Bank of England’s support facility., but that the Tripartite authorities did not prepare adequately for that support operation (referring to joint action by the Bank of England, the Treasury and the Financial Services Authority). The run was brought to an end on 17 September by a Government guarantee on savings and deposits. For the next five months the bank was kept afloat using taxpayers' money and there were protracted negotiations with possible private sector buyers. On February 17 2008 the Chancellor announced that Northern Rock was to be taken into temporary public ownership, having been advised that the private sector bids would be poor value for taxpayers' money, a decision that was strongly criticised by the Shadow Chancellor.
The next five casualties
The panic that followed the collapse of the Lehman Brothers bank in September 2008 was followed by massive writedowns of the assets of the world's banks. There were major support operations by their governments and a total collapse was averted, but there were many casualties. Of the top nine UK banks that had been trading in April 2007, five (Bradford & Bingley, HBOS, Lloyds TSB, Northern Rock and RBS) had been taken partly or wholly into public ownership by April 2009, with the intention of returning them to the private sector in due course. The banks concerned were generally required to grant preference shares to the government that were to pay a 12 per cent dividend. 
The budget deficit
The effect of the financial crisis was to deprive firms of the ability to finance their activities by borrowing or by the roll-over of debt due for repayment, and so bring about a reduction in economic activity and an increase in unemployment. A rise in the government's budget deficit follows because lower activity leads to lower tax revenues and more unemployment leads to increased benefit payments. The Great Recession is expected to have added to the pre-existing or "structural" deficit as well as creating a "cyclical" deficit which will disappear when the utilisation of the surviving capacity returns to normal.
According to estimates by the Institute of Fiscal Studies, the United Kingdom entered the recession in 2007-8 with a structural deficit of 2.7 per cent of GDP, which the recession had extended to about 6 per cent during the financial year 2009-10, and to which was added a cyclical deficit of about 4 per cent of GDP and a discretionary fiscal stimulus of nearly 2 per cent, to make a total approaching 12 per cent of GDP. The recession-induced increase in the structural deficit is attributed by the Institute to an assessment that "financial crisis and recession has both permanently damaged the productive potential of the UK economy and permanently reduced long-run price levels." However, as the Institute's authors add, "borrowing as high as 6% of national income permanently would have left debt on an unsustainable upward path".
- Robert Chote, Carl Emmerson and Gemma Tetlow: Green Budget 2008, Institute for Fiscal Studies, March 2008
- Rush on Northern Rock continues BBC News, 15 September 2007
- The run on the Rock, Fifth Report of Session 2007–08, Volume I, House of Commons Treasury Committee, 24 January 2008
- David Smith: The Age of Instability, Chapter 7, Profile Books, 2010
- Darling called 'dead man walking' , BBC News, 18 February 2008
- Banking Crisis: dealing with the failure of the UK banks, Seventh Report of Session 2008–09, House of Commons Treasury Committee, 21 April 2009
- For a note on the uncertainties surrounding the concept of the structural deficit, see the article on fiscal policy
- Robert Chote, Rowena Crawford, Carl Emmerson and Gemma Tetlow: The public finances: 1997 to 2010, Fig 3.1 page 13, Institute for Fiscal Studies, March 2010
- For an explanation of fiscal sustainability, see the article on fiscal policy.