Bank bail-ins: needed, or misguided?

Like other businesses, banks get money from shareholders. When a business fails, the shareholders are first to take the hit. And banks also raise money from bondholders – investors who give them cash in return for an IOU.  But in the recent financial crash, innocent taxpayers bailed out the banks – the bondholders were largely unscathed. So now there are moves towards a ‘bail-in’ system – where bondholders forfeit before taxpayers do.

It’s good politics, but is it good finance? I’m really not sure. If bondholders face higher risk, they will demand higher interest. Banks will have to pay more to raise money, and will pass on the higher interest charges to customers. Right now, that could tip a number of businesses and families over the edge.

There are established legal rules about who loses what when a firm gets into trouble; but the ‘bail-in’ proposals would see regulators deciding who pays what. That’s a recipe for injustice: one can easily envisage regulators discriminating in favour of domestic bondholders, for example, and against foreign ones – after all, the foreigners have no votes. And among domestic investors too, those with political clout are likely to be favoured over others.

When things are booming, of course, bail-in bonds will look safe as houses, and their value will rise. But the slightest doubts about the security of a bank will see them plummet. Like the Basel II capital rules, people will find themselves selling off other assets to raise cash – depressing the price of what they are trying to sell and forcing them to sell even more in a market spiralling downwards. Bail-in bonds might well worsen the panic and losses that go with financial crises.

When banks run out of credit and investors run out of cash, the only agency left standing is the central bank. And traditionally, central banks have been the lender of last resort to a struggling banking system. Which means taxpayers’ cash is called on. Some people argue that this is in fact far less messy than forcing bondholders and others to try to raise cash fast on a falling market – which inevitably brings real losses.

Equally, I do not see why taxpayers should be called on to save any business that has got itself into a mess. Is banking any different? Perhaps it is. But only because of the fractional reserve system, the government guarantee of depositors’ funds, and the fact that the huge burden of bank regulation stifles competition in the sector. A better solution is, like Switzerland, to have much higher capital requirements on larger banks – so encouraging the banks to split themselves up, and encouraging new banks to start up. Competition is the best regulator.

Why Britain should embrace entrepreneurship

Guy Myles, managing director at Octopus Investments, welcomes The Entrepreneurs Network, a new think tank set up by the Adam Smith Institute.

It’s hard being an entrepreneur. You work every hour God sends. You have people depending on you for their livelihoods. And you’re taking levels of risk most people couldn’t even contemplate.

On top of all that, you probably feel you’re on your own. Within your company, it may be you’re the only one shouldering real responsibility, while the wider world can feel like hostile territory, where you go into battle all by yourself – fighting for finance, for customers, for less red tape, and most of all for recognition.

It’s crazy that we as a country should let entrepreneurs feel unloved or isolated in this way. After all, we’re relying on them to create the jobs and sales that are helping to get the UK economy back on its feet. And they deserve to have their voice heard.

Making a difference in communities

Part of the problem is that smaller businesses don’t attract the attention that commercial giants get, even though their contribution to the economy may be just as important. If one of the big supermarkets unveils plans for a new distribution centre, or a car manufacturer decides to build its latest model in the UK, you’re bound to see it in the news. But if a local furniture factory gradually doubles its staff from, say, 20 to 40, few people will find out. Yet the impact of those extra jobs on shops, tradesmen and support services in the area could be enormous.

That’s why Octopus Investments is so pleased to be sponsoring The Entrepreneurs Network (TEN).  We work with entrepreneurs all the time. They’re great fun, but we see at first hand exactly how much support they need. The ones we back tend to have businesses that are already established. They’re looking to take things up to the next level, and they’re invariably hungry, not just for money, but for ideas, contacts and encouragement.

Why continued support is so vital

We make a point of helping out in any we can. Completing an investment is just the start of the story. Whenever we invest in an unquoted company, someone from Octopus will sit on the board. One CEO has told us this helped him keep his eye on the big picture, without micro-managing. Another said the Octopus director offered a strategy for breaking into the US market.

We came up with the idea of hosting regular forums, such as breakfast seminars, for CEOs from our portfolio companies. These events give them a chance to swap stories and hear how other businesses are coping with challenges and capitalising on opportunities. We may focus a session on a specific sector – such as media, technology or telecoms – but it’s great if we can also create cross-fertilisation of ideas between businesses in completely different fields.

Keeping up the pressure for change

So, we’re hoping The Entrepreneurs Network will provide a bigger arena where entrepreneurs can support each other. But it’s in the area of public policy that I hope TEN can make a real difference. We desperately need a body that can lobby government and policy-makers on the many issues that affect smaller businesses. To take just one example, a major area of complaint in recent years has been the length of time it can take to get work visas for staff coming in from abroad. This is the sort of problem where we need to keep pressuring the government to take action.

As it happens, the UK isn’t such a bad place to set up a business. A report from the World Bank’s Doing Business project put us seventh out of 185 countries on the ‘ease of doing business index’ for 2013. The survey looks at everything from getting building permits and electricity connections to enforcing contracts and trading across borders.

The worrying point is that the UK has slipped a couple of places down the rankings in the past few years. And there are countries like South Korea, Georgia and Malaysia coming up fast behind us. We have to keep working to make the regulatory environment as supportive as possible for small businesses, and that’s the challenge we’re all hoping TEN can rise to.

Guy is co-founder and Managing Director at Octopus Investments.

The ideological drift of Nobel laureates in economics

The new issue of Econ Journal Watch is online. It is a bit different from most issues, being devoted to a survey of the ideological stances of 71 Nobel economists – with profile of all of them.The aim is to assess how their opinion changes, and whether Nobel economists tend to become more or less classical liberal throughout their lives.

George Mason economist Daniel Klein led the project, a very substantial piece of work. Twelve of the laureates replied to a questionnaire seeking to identify their ideological outlooks at different times in their lives. Klein discusses the results in an audio podcast. The bottom line? Most of the Nobel economists (51 of them) did not noticeably change their views. Of those that did, a larger number grew more classical liberal over their lives than grew less classical liberal.

On Russell Brand's misunderstanding of profit

The former Mr. Katy Perry took to Newsnight this week to display to all of us his ignorance of economics.

And after a few textbook political dodging of the question, Brand, 38, finally laid down his revolutionary manifesto which would create: 'a socialist egalitarian system based on the massive redistribution of wealth, heavy taxation of corporations and massive responsibilities for energy companies exploiting the environment.'

Hmm. I wonder whether we can manage it without starving 8 million Ukrainians this time. The fallacy at the heart of his prejudices though is this:

'David Cameron says profit isn't a dirty word, well I say profit is a filthy word,' the comedian passionately declared. 'I think the very concept of profit should be very much reduced because wherever there is profit there is also deficit. This system currently doesn't address these ideas.'

Ah, no. Entirely misunderstanding what is going on here.

Profit is simply the proof that value is being created. Leave aside for a moment who is getting that profit and consider what it actually is. We have the costs of our doing something: whatever those costs might be in labour, wages (no, not the same thing), raw materials, other inputs and for purists, the opportunity costs of doing something else with all of these things. We also have the income from having done this thing, whatever it is. All profit is is the acknowledgement that the income is higher than hte costs of having done it. Thus value has been created.

And we like people creating value: it's really rather the point of having an economy at all, creating value. For if no value was being created then there wouldn't be any value for us human beings to consume.

Indeed, we can go further. The opposite of profits is losses: they being an acknowledgement that  value is being destroyed. What is being produced from our process is less valuable than the things we are using to do the production. There is therefore less wealth to share around: people are all poorer therefore.

Losses are the destruction of economic wealth, profits the creation of that wealth.

Now, we can indeed mumble to ourselves over who gets these profits. We can even note that the consumer surplus (which is the profit accruing to consumers from that production with profit normally being defined as the value created flowing to the producers) is usually vastly higher than those "profits".  But even as we shout about the distribution of profits we must all recall the most important point here. Which is that we very much desire that profits be made. For they are, by definition, the proof that economic value is being created, that the value of output is higher than the value of inputs.

And that really is what we want in an economy, an increase in value creation.

Is economics a science?

There should be no Nobel Prize in Economic Science, says economist Liam Halligan, because economics is not a science. It was, of course, only added (by the Swedish central bank) some 75 years after Alfred Nobel's death; but recipients get the same grand medal and scroll, get to shake hands with the King, and give a lecture.

Halligan cites this year's award to Eugene Fama and Lars Hansen of Chicago University, and Robert Shiller of Yale, jointly honoured for "laying the foundations for the current understanding of asset prices". Understanding? As Halligan says, "You may be forgiven for thinking that no one truly understands asset prices. The global stock market turmoil of recent years is surely testament to that."

The sad thing is that economists are so keen that their subject should be thought of as a science that they have infused it with many of the tools and approaches of the physical sciences – making it look more like applied mathematics than the study of (decidedly non-mathematical) human beings that it really is. I often say that, through their intense application of mathematics, the mainstream economists of today pride themselves on a more and more precise understanding of things that the rest of us know are complete tosh.

Under all the equations and algorithms, Fama's 'rational markets' idea is quite simple: markets quickly price in all new information. And since information itself can change quickly, the short-term movement of markets can be hard to predict.

That is plainly true: people in markets would soon find themselves losing money if they did not take account of the facts. However, there is more to human life (and therefore to markets) than mere facts – as both Hayek and Keynes knew. Halligan sums up this point with a phrase that should be engraved onto the computer screen of every supposed economist:

"...it obviously makes sense that share prices reflect all available information.... But they also clearly reflect rumours, supposition, herd-instinct, prejudice, hubris, pessimism and a myriad of other immeasurable qualitative factors, including occasional madness...." That's humanity for you. Good luck trying to model that.

The rediscovery of classical economics

It is appropriate that David Simpson should preface his new book The Rediscovery of Classical Economics with the famous 'road less traveled by' poem by Robert Frost. For his purpose is to put forward an alternative to the equilibrium economics that has dominated the subject for nearly a century. His alternative is classical economics, in the tradition of Adam Smith, Marshall and the Austrians. In their view, economic growth is the thing to study; they see markets as a dynamic process rather than as static; and they focus very much on human nature rather than seeing economics as a series of detached, static, mechanical models.

The reliance on equilibrium economics leads to some systematically bad policy mistakes. The mainstream economists tend to assume knowledge, such as the lowest-cost mix for production, that the classical economists point out must be, sometimes painfully, discovered. Knowledge, and how dispersed pieces of partial information are used and co-ordinated by market players, is critical, but the mainstream economists and their policymaker counterparts again assume that they can do better themselves, from the centre – a fatal conceit. And the mainstream economists again assume that people are rational in their economic behaviour – which, says Simpson, does not reflect the reality of the world that we are trying to understand.

The book shows how classical approaches provide a much better understanding of how market economies work than does equilibrium theory. All economics is about human behaviour – something often forgotten by the mathematical modellers – so Simpson starts with looking at human being, the limited information they have and their hopes and expectations, and adaptive nature. Adaptation of course means constant change, and the book looks at how markets adapt to change in an incremental, voluntary and self-organising way, another useful lesson for policymakers.

Simpson sees the process of policy formulation as another evolutionary, adaptive process, though of course the motivating factors are different. And they are much more complicated than the simple business objective of turning a profit, which is why government policy is so often confused and contradictory. Simpson concludes by extracting some key principles from the Austrian economics including some insights on the severe limitations of mathematical analysis in economics.

Readers who have that uncomfortable feeling that economic policymakers and the economists who advise them have a less than complete understanding of what they are doing will find out, from this book, why they are right to think like that. I hope both economics and policymakers read the book, as it will make them far more aware of their own limitations when it comes to managing the economy – which is not a sort of machine you can easily tinker with, but a complex, dynamic network of economic processes that is quite good at organising itself.

If you don't pay for someone else's university course then you're violating their human rights apparently

A rather worrying document crosses my desk. This one, in which we are told the following:

The Task Force’s human rights analysis begins by making a link between human rights and extreme poverty. For instance, the UN Human Rights Council has recently adopted Guiding Principles on Extreme Poverty and Human Rights that describe how poverty is connected as a cause or consequence of violations of 14 different human rights and all the key human rights principles − ranging from the right to food, the right to health, the right to education and the right to social security, to the principle of transparency.

Considering the negative impact that tax abuses have on poverty and human rights, the state has a number of obligations to counter tax abuses. These flow from states’ obligation to use the maximum available resources to progressively realise human rights − including the obligation to confront tax abuses as part of an overall plan to strengthen financial and tax governance.

This is the International Bar Association talking here: and it's an interesting perversion of human rights that has led us to this pretty pass.

That perversion is of course the idea that positive rights are human rights. It's pretty simple with negative rights: freedoms of speech, or association and so on. These cost nothing to provide, you just don't do things that would stop people having such rights. Positive rights, those rights to food, education, health care, they do indeed cost money to provide. In the UK at present something like 30 t0 40% of everything the entire country produces in a year in fact. We must therefore violate someone's right to property to be able to provide those things to all. We thus have a conflict of rights and one or other of them has to give.

Now I'm not an advocate of our not having a state financed welfare, health care, education or social security system. Even the most minarchist state that I can imagine happening is going to have some role for government in those fields. Which inevitably leads to taxation of course. But I am arguing that we cannot include these positive rights in our definitions of human rights. For they directly conflict with others, with negative rights that we have already decided are indeed human rights.

Clearly and obviously the UN and the International Bar Association disagree with me on this point but I wave a very English two fingers in their general direction. We're going to have government come what may and that inevitably means taxation to pay for it. But it's taking matters much too far to claim that my paying Johnny No VAT cash for cleaning my windows is a violation of Jimmy's human rights as he doesn't get a plaster for his cut finger.

Bad bank

Let us join with the evangelist’s celebration of heaven’s joy at the sinner who repenteth. Even since the financial crisis kicked in, we’ve been banging on about the government’s approach to banking regulation, variously irrelevant as the bonkers Vickers proposals, self-contradictory as schemes simultaneously to recapitalise and to promote lending (help to buy, anyone?), and generally panic-stricken throughout.

Four years ago we argued for “the formation of a bad bank and subsequent work-out, which often proves profitable”. Well at last George Osborne has got the email, a few days ago telling reporters in China that he’s asked Rothschilds to make proposals. This would pave the way for RBS to be floated, with a sale of Lloyds signalled for the off following Royal Mail and the Government’s belated rediscovery of the feel-good properties of privatisations.

The most successful example of bad banking came after the Swedish banking bubble of the early nineties. Duff assets were transferred to a couple of asset management companies which in due course sold them off, often at a profit. The Swiss took a similar approach in 2009, as did the NY Fed which created “Maiden Lane” to take over assets from Lehmans and AIG. Indeed we already have something of a bad bank in “UK Asset Resolution”, which recently sold its portfolio of Northern Rock’s dodgy loans to an American consortium including debt recovery specialists.

So why so long to apply this tried and tested approach to RBS? Maybe it’s scale: the egregious Fred Goodwin was celebrated for his commitment to buying the worst business at the top of the market. Maybe it’s politics: the rediscovered merits of privatisations mentioned above, or the prospect of the Scottish independence referendum next September. In which case, why did Osborne rule out selling a stake in RBS this side of the UK’s general election in 2015? We couldn’t say, other than to note that once sinners take up this repenting habit, it becomes far easier for them to change their minds about other errors.

Chart of the week: US monthly cash balance

Summary: A shutdown is easiest in Q2

What the chart shows: The chart shows the US Federal Government monthly cash balance over the past ten years

Why is the chart important: One (of many) problems relating to the discussion about the US Federal Government debt ceiling is the monthly pattern of revenue and expenditure. The first three months of the fiscal year – October to December – tend to be deficit months. Only in January ist here usually a cash surplus. But by that time, the cumulative balance is already so deep into the red that it is impossible to catch up. It also means that government spending is quickly hit by the need to restrict expenditures to revenues. With the recent agreement on the debt ceiling, the US government is functioning until February next year. At that stage, there may be a further cliff-hanger of shutdowns and debt ceiling threats – or there may not. But from a government perspective, calendar Q2 is easier to deal with than calendar Q4 or Q1, since revenues tend to exceed expenditures for a brief period.

Markets are solving the food waste problem

Tesco, one of Britain's largest supermarkets, has revealed that it threw out 30,000 tonnes of food in the last six months. Customers throw out yet more. Appalling waste caused by the 'pile it high, sell it cheap' capitalist ethic?

Nobody likes waste, particularly those of us in the baby boom generation whose parents had lived through wartime rationing – or those who are old enough to remember it personally. We were brought up with the mantra 'waste not, want not'. Supermarket bosses are no different from the rest of us in that respect, but they have another powerful motive to avoid waste too: it is very bad for the bottom line. Why pay producers for food that goes unsold?

That is why Tesco has actually done a survey of what customers actually ditch, going through 10,000 dustbins in their research (ugh!). It seems that 65% of bagged salad is discarded, for example. The result of that? Probably, smaller bags being put on sale from now on. And clearer instructions on food packaging about how to keep it fresh.

There are many other reasons why so much food is wasted, though. In most cases it cannot be put into pig swill any more, because of the risk of animal diseases that might affect humans, though a bit goes to local zoos. Then there is the absurd 'best by' and 'sell by' labelling – you can blame government for that, of course.

Actually, we waste a lot less food than our wartime and postwar parents did. My mother's dustbin used to be full of potato peelings and the outer garbage of cabbages and other vegetables. Now, these are used and recycled and only the best bits reach our homes. Packaging too helps keep food fresh by protecting it from bruising and from the air.

The counterintuitive fact is that, thanks to capitalism, we actually have a system that produces food so efficiently that we don't actually mind throwing it out if it looks and tastes a bit elderly. If only we could spread this production system to other places in the world where food is scarce and expensive because it is not produced efficiently at all. Again, you can blame governments in those countries for resisting the market economy, and out own EU authorities for trying to protect their own famers behind trade walls, for that crime – not a crime against food, but against humanity.