Why is Oxfam lying to us about the Financial Transactions Tax?

It's a sad thing to have to say but, sadly, every single word in that video above is a lie. And this is not just to say that of course all acting is a lie: it is to say that the entire basis upon which Oxfam is operating here is incorrect and also that they know that they are incorrect.

Here is their briefing paper which accompanies that video.

A tiny tax could raise as much as €37bn and would be a heroic victory for people and planet above the special interests of the financial sector.

The lie is in there, in that one single sentence.

The Financial Transactions Tax, as proposed, will raise no revenue at all. Indeed, it will lead to a reduction in revenue collected.

Leave aside all the wittering about the evils of HFT (that did not, in any manner, cause the financial crisis). Leave aside their seeming hatred of derivatives trading (none of which had anything at all to do with the financial crisis). Leave aside their ignorance of the fact that it was mortgages which did cause the crisis: and mortgages tend, even when packaged into bonds, not to get traded very much so a transactions tax is going to have no effect on this market. We can even leave aside the views of this year's Nobel Laureate, Robert Shiller, who insists that it was the absence of trade in derivatives on mortgages that aided the bubble in expanding to the point of collapse. And we can even leave aside the views of Diamond and Mirrlees, Laureates both for their studies of taxation, who point out that transactions taxes are a very bad form of taxation indeed.

We can, instead, simply turn to the European Union itself and its own study of the effects of such a financial transactions tax. As I've pointed out before:

No net revenue will be raised by the specific proposals that have been put forward. This will sound strange to those who can see that there will indeed be revenue coming from the tax, but that is because while there will indeed be revenue from the tax itself there will also be falls in revenue from other taxes. The net effect of this is that there will be less revenue in total as a result of an FTT. But of course, do not just take our word for it. That of the European Commission should be sufficient1:

‘With a tax rate of 0.1% the model shows drops in GDP (-1.76%) in the long-run. It should be noted that these strong results are related to the fact that the tax is cumulative and cascading which leads to rather strong economic reactions in the model.’ (Vol. 1 (Summary), p. 50)

Revenue estimates are as follows: ‘[A] stylised transaction tax on securities (STT), where it is assumed that all investment in the economy are financed with the help of securities (shares and bonds) at 0.1% is simulated to cause output losses (i.e. deviation of GDP from its long-run baseline level) of up to 1.76% in the long run, while yielding annual revenues of less than 0.1% of GDP.’ (Vol. 1 (Summary), p. 33)

A reasonable estimate of the marginal rate of taxation for EU countries is 40-50% of any increase in GDP. That is, that from all of the various taxes levied, 40-50% of any increase in GDP ends up as tax revenues to the respective governments. Thus if we have a fall of 1.76% in GDP we have a fall in tax revenues of 0.7-0.9% of GDP. The proposed FTT is a tax which collects 0.1% of GDP while other tax collections fall by 0.7-0.9% of GDP. It is very difficult indeed to describe this as an increase in tax revenue.

There are, however, bureaucratic reasons why the European Commission might still suggest such a tax move. The revenues from the FTT would be designated as the EU’s ‘own resources’, that is, money which comes to the centre to be spent as of right; not, as with the current system, money begrudgingly handed over by national governments. The EU bureaucracy therefore has a strong interest in promoting such a change. What’s in it for the rest of society is harder to spot.

This result is not unexpected. When the Institute for Fiscal Studies looked at the impacts of the UK’s own FTT, Stamp Duty upon shares2, they found much the same result – from the same cause too. Such a transactions tax upon securities lowers securities prices. This then makes the issuance of new securities more expensive for those wishing to raise capital. More expensive capital leads, inexorably, to less of it being used and thus less growth in the economy.

Please note that this is not some strange application of the Laffer Curve argument. It is not to say that lowering all taxes, or any tax, leads to such extra growth that revenues increase. Rather, it is derived from Diamond and Mirrlees (1971)3 that transactions taxes multiply then cascade through the economy. They are therefore best avoided if another method of achieving the same end is available. Indeed, they point out that taxation of intermediate inputs is to be avoided if possible – better by far to tax final consumption or some other final result of the economy. This very point is acknowledged in the way VAT is structured. Rather than a series of sales taxes which accumulate as one company sells to another along the production chain, there is a value added tax which amounts to one single rate at the point of final consumption. That this point is recognised in a major part of our taxation system suggests that it might be wise to recognise it with regard to the FTT.

1 http://ec.europa.eu/taxation_customs/resources/documents/taxation/other_taxes/financial_sector/impact_assessment.zip

2 http://www.ifs.org.uk/wps/wp0411.pdf

3 Diamond, P. A. and J. A. Mirrlees (1971) ‘Optimal Taxation and Public Production II: Tax Rules’, American Economic Review, 61, 3, 261-78.

And yes, I do know that Oxfam are aware of this paper and of the basic truth contained within it. For I have discussed it with them. And their response is, well, umm........*crickets*.

An FTT would raise no net revenue: therefore all tales about how lovely things have been done with the revenue it will not raise are, well, what do you want to call it? Untruths? Misleading? Something stronger?

I would point out that that paper of mine above has been peer reviewed: something I doubt has happened to Oxfam's press release or video. Perhaps that's why the House of Lords Sub-Committee that looked at this proposal believed me not them.

Just as an interesting little update to this story I posted from this same paper in the comments section of The Guardian. On a Bill Nighy piece commending the FTT. Indeed, I used exactly the same quote. And of course the moderators deleted it near immediately.

Comment is free indeed.

The annuities market

The Financial Confusion Authority (FCA) has just spent a year, and a massive amount of our money, discovering that some annuities are better value for money than others. Fancy that!  Some brands of corn flakes are better value than others too.  Some brands of corn flakes are more trustworthy than others and the same applies to annuity providers.  Consumers consider it good use of their money to pay a premium for security.  And who is the FCA to tell them that they shouldn’t?  According to the FCA, differing annuity payments means the market is “disorderly”.

They now intend to spend a further year considering what to do about it, i.e. interfere further in the market and thereby raise the total costs for all buyers of annuities.  Yes, of course financial markets need regulation, as do all markets, but the excessively detailed interventions we have witnessed since Gordon Brown gave us the Financial Standards Authority have eroded the very value for money these regulators were set up to achieve.

Regulators were created to bring about fair, competitive markets and then step away leaving choice to consumers.  Of course this means that the necessary information should be provided, be it the weight of a packet of potatoes or the amount of the annual annuity. The consumer is not helped by information being excessive or over-complex.  The regulator should be able to specify the key facts to be provided by annuity sellers in two days, not 12 months.

The primary mission of any organisation is to survive and, better, to grow.  The FCA is no exception.  The reality, as has been shown before (“I dreamed a dream of the FCA” 29 April 2013 and other ASI blogs and publications) is that the FCA is unnecessary.  The little it achieves could be handled by the Financial Ombudsman Service and Office of Fair Trading.

They key lesson from these two years of FCA self-promotion is that it is struggling to justify its existence.

How Scotland could flourish by unilaterally keeping the pound

Between 1716 and 1844, Scotland had one of the world’s most stable and robust banking systems. It had no central bank, no lender of last resort, and no bank bailouts. When banks did fail, it was shareholders who were liable for paying back depositors, not taxpayers. Scottish GDP per capita was less than half of England’s in 1750; by the end of the era in 1845 it was nearly the same. Now that George Osborne has ruled out a currency union if Scotland votes for independence, the Scots have an opportunity to return to this system more seamlessly than any other place in the world could.

As I said to the press this week, there’s nothing really stopping Scotland from continuing to use the pound unilaterally. (Unless the remaining UK introduced strict foreign exchange controls, which would be absolutely crazy.)

What the Chancellor's announcement actually means is that the Bank of England (BoE) would no longer consider Scottish interests when it determines monetary policy and that illiquid Scottish banks would no longer be able to use the BoE as a Lender of Last Resort.

I’m not sure that the first point really matters at all. Scotland’s five million people can’t have much of an influence over the BoE’s policy for the UK’s 63 million people as it is. And, frankly, I’m not sure the BoE knows what it’s doing well enough for it to matter whether it cares about you or not.

The second point is the interesting bit. George Selgin has pointed to research by the Federal Reserve Bank of Atlanta about the Latin American countries that unilaterally use the dollar. Because these countries – Panama, Ecuador and El Salvador – lack a Lender of Last Resort, their banking systems have had to be far more prudent and cautious than most of their neighbours.

Panama, which has used the US Dollar for one hundred years, is the most useful example because it is a relatively rich and stable country. A recent IMF report said that:

By not having a central bank, Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages. The authorities emphasized that these features had contributed to the strength and resilience of the system, which relies on banks holding high levels of liquidity beyond the prudential requirement of 30 percent of short-term deposits.

Panama also lacks any bank reserve requirement rules or deposit insurance. Despite or, more likely, because of these factors, the World Economic Forum’s Global Competitiveness Report ranks Panama seventh in the world for the soundness of its banks.

I suspect that there would also be another upside. Following Walter Bagehot, central banks are only supposed to lend to illiquid banks, not insolvent ones. Yet since the start of the Eurozone crisis the ECB has clearly made significant bond purchases to prop up both insolvent banks and insolvent governments. This may have been a lesser evil than letting them collapse altogether, but it’s hard to say that this kind of moral hazard is not present.

So, given that some countries do survive and even flourish without a central bank, how would Scotland do it?

The basic mechanics, I think, would be this: in a hangover from the old free banking period, Scottish banks currently issue their own banknotes. After independence, they could continue issuing their own notes that entitle the bearer to GBP on demand. BoE pounds, in other words, would be the 'base money' that Scottish banks use to back their own private currencies, in the same way gold was used during the last Scottish free banking era.

A banknote from a Scottish bank would be, in effect, a promissory note redeemable on demand in BoE-issued pound sterling. (Scottish notes are already promissory notes, but issuance is closely regulated by the BoE.) Of course, there should be nothing stopping banks from issuing notes redeemable in something else, like US Dollars, gold, Bitcoins, or Tesco Clubcard points. Scottish banks would have to arrange private clearing houses, as they did in the last free banking era, to provide loans to illiquid banks, or they could follow Panama in simply maintaining very high reserves.

No bank would have monopoly privileges: any ‘bank’ could issue notes and it would be up to the market to decide whether to accept them as money or not. As Selgin explains here, banks free to issue their own notes will set their reserve ratios according to people's demand for money, stabilising nominal spending.

With respect to other regulations, I quote Selgin again:

It is, in any event, desirable that there be no Scottish public authority capable of bailing out insolvent banks and of thereby introducing a moral hazard. Deposit insurance should be resisted for the same reason. Foreign banks should be admitted, by way of branches rather than subsidiaries, and should enjoy the same rights as Scottish banks. (Of course the major "Scottish" banks are themselves no longer really Scottish anyway.) Finally, re-establishing some form of extended liability (though not necessarily unlimited liability) wouldn't be a bad idea.

We take no position on Scottish independence — it is up to Scottish voters to decide. And while a return to free banking in Scotland may seem fanciful, this week’s announcement makes it much more likely. Keeping the pound and treating it as the ‘specie’ on which banks can base their notes would make the transition virtually seamless for the average Scot, while giving them a banking system that is unrivalled anywhere in the world for being stable, open, and free.

Markets do set rates: A reply to Julien Noizet

Financial analyst and blogger Julien Noizet has replied to my article on mortgage rates on his blog. It is a good piece, worth reading, but I still think I am right. It is perhaps true that Noizet is right too, because my claim was really very modest: in total, mortgage interest rates do not mechanically vary with the Bank of England's base rate; we can show this because the spread between them and the base rate varies extremely widely; and since we have very strong independent reasons to expect that market forces largely drive rate moves, that should be our back-up explanation. The implication of this I was interested in was that this meant a hike in Bank Rate wouldn't necessarily drive effective rates up to a point that would substantially increase the cost of servicing a mortgage and hence compress the demand for (London) housing.

Even if the first graph in Noizet's blog post did appear to support his narrative that effective market rates follow Bank Rate moves, I'm not sure why these disaggregated numbers matter given that the spread between overall effective rates on both new and existing mortgages varied so widely. If it turns out that specific mortgage types varied closely with Bank Rate but the overall picture did not, then markets still control effective rates, they just do it via a changing composition of mortgages, not by changing the rates on particular products. The effect is the same—and it is the effect we see in the Bank's main series for effective rates secured on dwellings. But the graph, to me, looks a lot like mine, despite the effect of new reporting standards: mortgage rates are about a percentage point from the base rate until 2008, then they don't fall nearly as far as the base rate in 2008 and they stay that way until today. If other Bank schemes, like Funding for Lending or quantitative easing were overwhelming the market then we'd expect the spread to be lower than usual, not much higher.

His second big point, that the spread between the Bank Rate and the rates banks charged on markets couldn't narrow any further 2009 onwards perplexes me. On the one hand, it is effectively an illustration of my general principle that markets set rates—rates are being determined by banks' considerations about their bottom line, not Bank Rate moves. On the other hand, it seems internally inconsistent. If banks make money (i.e. the money they need to cover the fixed costs Julien mentions) on the spread between Bank Rate and mortgage rates (i.e. if Bank Rate is important in determining rates, rather than market moves) then the absolute levels of the numbers is irrelevant. It's the spread that counts. But the whole point of my post is demonstrating that the spread changes very widely, and none of Julien's evidence seems to me to contradict that claim. Indeed, Noizet's very very good posts on MMT, which stress how deposit rates are much more important as a funding cost than discount rates for private banks, seem at odds with what he's written in this post. And supporting this story is the fact that the spread between rates on deposits (both time and sight) and mortgages changes much less widely. If we roughly and readily average time and sight on the one side and average existing and new mortgages on the other, the spread goes no higher than 2.3 percentage points and no lower than 1.48.

In general with the post I don't feel I understand the mechanisms Noizet is relying on, perhaps I'm misunderstanding him, but the implications of his claims regularly seem to contradict our basic models of markets. For example, he says that a rate rise would lead banks to try and rebuild their margins and profitability. But I can't see any reason why banks wouldn't always be doing that. The mortgage market is fairly competitive, at least measured by the numbers of packages on offer and the relatively small differences between their prices. I don't think Julien has presented any mechanism to suggest why banks would suddenly want to maximise profit after a rate rise but wouldn't beforehand—or why they'd suddenly be able to ignore their competitors but couldn't beforehand. It's possible there is one, but I can't see that he's explained it. Overall I suspect I've missed something crucial, so I welcome any more comments Julien has on the issue.

Why financial regulation fails

The supposed prime objective of banking rules and regulation is to protect and reduce risk. As the credit crisis has clearly demonstrated regulation has failed to do so. Despite this the proposed solution is more regulation.

Rules and regulations are focused on mechanically risk weighting loans and allocating capital against that perception of risk in a prescribed formula that sounds complicated and is complicated. The capital charade and secrecy with government backing for large banks and almost all deposits means market scrutiny is all but removed from the banks. Detailed P&L and balance sheet data only goes to a few regulators opposed to the many that deposit, invest and research the banks thus limiting market review, risk assessment and analysis.

There is also a major skill set asymmetry with the many PhD brains of the banks easily able to outwit a few £60,000 a year PRA and BoE staff. Consequently the SIV CDO3, inverse IO and many other regulatory compliant but circumventing structures and strategies are created. The fixed formula driven official capital ratios all look to be unchanged at a level we are told is strong. The risk weighting of a loan to a business that is 1000% geared with no sales is the same as a loan to a 1% geared business that has a 50% operating margin from 50 year government contracts. The market would never be so simplistic and will always look forwards opposed to regulators that tend to look backwards. The market would allow much more leverage for genuinely low risk lenders and require much less for high risk lenders.

Today all banks essentially work to a very similar core capital ratio. The regulation based system allows banks to disclose as little as possible to as few as possible, complicating obscuring and circumventing. A market based system would encourage transparency, simplicity and full disclosure to as many as possible. Without regulation there would be little restriction on new banks being created and consequently there would be more specialists and more competition.

The abolition of regulation would make banks less risky. With banks that are too big to fail and deposit protection all banks can borrow cheaply regardless of the risks they take. Removing this will require banks who want cheap deposits to prove they are worthy of them. A market based pricing structure will be created with each bank having to fight for its funding. With very low real deposit returns the demand for disclosure, balance sheet transparency, simplicity and capital strength will be high. Where this is not the case real returns for depositors will be high.

With depositors now determining how much capital is required for any given deposit cost the subordinated debt now, now not ranking in line with the depositors will be priced based on the preference and equity capital structure. Today return on equity is maximised by reducing equity as much as the rules will allow with there being no correlation between capital strength and funding cost. In a market driven world the key funding cost will fall as equity increases. The correlation analysis below shows not only that pre-crisis capital and risk were inversely correlated, but also that risk and return were even more strongly inversely correlated. The strongest inverse correlation is, however, between Growth and Risk.

With rules based regulation that evolves slowly and usually only changes after a major problem banks can easily manipulate their balance sheets to comply with the letter if often not the spirit of the regulation. With the market/depositors setting a bank’s funding cost, the risk perception and analysis of anything new, complicated, or unclear should immediately impact the bank. Consequently the banks focus will shift to genuine economic profit based risk and reward analysis opposed to regulatory arbitrage.

Over time better banks will secure more funding at better terms rewarding appropriate risk assessment with those who operate inappropriately way failing. Evolution will be returned to the banking sector by the removal or regulation. Largely unregulated sectors such as retail have evolved rapidly providing customers with the Amazon service they desire replacing the Woolworths service they do not.

The positive money idea refuses to die

This idea is being given another run around in The G today.

But the 1844 law was never updated to apply to electronic money and still only applies to paper notes. Metal coins and paper notes now make up just 3% of all the money in the UK. The remaining 97% of money consists of essentially numbers in high street banks' computer systems. Banks create this electronic money through a simple accounting process whenever someone takes out a loan.

Yup, same ol' same ol'.

If the Bank of England created all that electronic money instead of the private banking system creating it then we'd be in the clover. And as ever, the idea just doesn't work. Consider just this one point:

Government finances would receive a boost, as the Treasury would earn the profit on creating electronic money, instead of only on the creation of bank notes. The profit on the creation of bank notes has raised £16.7bn for the Treasury over the past decade. But by allowing banks to create electronic money, it has lost hundreds of billions of potential revenue – and taxpayers have ended up making up the difference.

OK, that number for seigniorage is roughly correct on the physical money. But what's wrong with the number for electronic money? Hundreds of billions? Well, the contention is that this value has been created by those private banks: that's how, if the BoE creates it instead then the BoE gets that hundreds of billions in revenue. Excellent: so, if the private banks have been creating all this money then those private banks must have been making those hundreds of billions. Or someone, somewhere, has been.

And the thing is, there just isn't anyone out there who has that hundreds of billions. There just ain't. Therefore, somehow, the creation of that credit (to give it its proper name, not money) doesn't carry a seigniorage profit of hundreds of billions. And thus the BoE cannot appropriate that non-existent seigniorage by doing the credit creation directly.

I agree entirely that it is indeed the banking system (but not an individual bank) that creates credit. But there isn't some hundreds of billions of profit to be made out of doing so: for no one is in fact making that hundreds of billions. Thus it's not possible to the Bank of England to appropriate that hundreds of billions.

It's interesting to note that this idea is backed by Andrew Simms of Not Economics Frankly fame. Sigh.

Interest rates are set in the market place

The London housing market is booming. According to Nationwide, prices rose 14.9% over 2013. According to Halifax, they climbed 9.4%. According to the Land Registry they were up 11.2%. The Office for National Statistics hasn't quite got data for the whole year yet, but their numbers show prices up 11.6% in London in the 12 months to November 2013. No doubt Rightmove, LSL, Hometrack and all of the many other indices echo this finding. While we at the ASI have pointed out how the government has jacked up demand with the Help to Buy scheme (some have quipped it might more accurately be termed "Help to Sell") the Bank of England and Treasury have dialled down the housing element of the Funding for Lending Scheme in response to worries about a bubble and unaffordability.

But however much these schemes are artificially adding to demand, it is certainly clear that London houses—a desirable place for natives and people across the world to live—face a huge demand and are in limited supply. Since this is clear, I have been loath to call the situation a "bubble"—a bubble seems bound to pop, but tight supply and ample demand suggests a situation where prices will remain high (see an excellent post from my colleague Sam for more detail). However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England's base rate, a jump in rates, something we'd expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn't chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England's data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically. For example, it was almost one percentage point in January 2004, fell to 0.5pp by July, rose to around 0.6pp where it stayed until July 2006 when it crashed to nearly zero in a year, before rising to 1pp in October 2008 and then almost 3.5pp in April 2009. Since then it has steadily trended down to around 2.5pp. There are lots of interesting and obvious stories to tell here, hearkening back to my piece about the confusion between interest rates as a stance of monetary policy and interest rates as the actual cost of borrowing firms and consumers face, but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

What this means is that the fact the Bank's base rate will almost certainly be hiked in the next couple of years if economic growth continues at its current healthy pace is not a reason to worry that London's housing bubble will pop. Indeed, the only way London house prices are likely to drop from their current stratospheric levels is if we get a good honest bit of planning deregulation. Moving the green belt out just one mile would allow us to build one million houses, after all. And it could add percentage points of pure supply-side driven growth to GDP and living standards.

Deregulate banks for more competition

Sometimes politicians don't know how powerful they are. The UK Labour leader Ed Miliband, for instance, seems able to cause the London Stock Exchange to plummet just by speaking. First he promised price caps on energy companies, and their shares reeled. Then last week he promised to break up the banks, whereupon billions were wiped off their value.

As Jeremy Warner tellingly observes in Saturday's Daily Telegraph, Miliband is not the first in his party to want to get tough on bankers. When Gordon Brown became Chancellor in 1997, he instructed the OFT's John Bridgeman to investigate their supposed lack of competitiveness. Bridgeman refused on the grounds that he could find no sign of anti-competitive behaviour. So Brown set up his own inquiry under former telecoms regulator Don Cruickshank. As intended, he reported that the banks must be uncompetitive because they were making so much money on their capital. But "It didn't seem to occur to Cruickshank that the more plausible explanation for high returns was that the banks were operating on dangerously small levels of capital," writes Warner.

Anyway, by the time Cruickshank reported, the banks were making so much money, and contributing so much in tax to the Exchequer, that Brown no longer wanted to break them up. Indeed, he went the other way, suspending competition rules to allow Lloyds buying the near-insolvent HBOS, a "final act of folly" which taxpayers got the bill for.

There is indeed far too little competition in UK banking. America has 7,000 banks. In Britain, four banks control about 4/5 of the banking market, and five control 2/3 of the mortgage market. That is because of too much regulation, not too little. Regulation is a fixed cost. Big firms can bear it, small ones cannot. That is why the newcomer MetroBank is the first high-street bank to be created since Georgian times.

Miliband's prescription is typically statist. He wants to break up the big banks and "create two 'challenger' banks." Why two? Why not six, eight or fifteen? How does a politician – or anyone else – know how many banks (or energy companies, or carmakers, or supermarkets, or dog groomers and cafes, for that matter) we should have?

Obviously, the best thing is to leave such decisions to the market. But at present, the market is rigged, through regulation, in favour of big firms. It is right that there should be strong capital controls on large banks: if RBS or Lloyds skate on dangerously thin capital, they could bring down the entire financial system. If some tiny bank goes down, that is unfortunate, but not catastrophic, and we can deal with it just as we deal with any other small business failure.

So the solution seems obvious: have stringent enough capital regulation on large banks, and less stringent rules on small ones. That would encourage newcomers and innovators to enter the markets – not just two "challenger" banks but potentially dozens, even hundreds. And it would encourage the larger banks to break themselves up. Which they would probably do in a way that made much more business sense than any break-up engineered by clod-hopping officials employed by Business Secretary Vince Cable or would-be Prime Minister Ed Miliband.

Bank bonuses and bogus arguments

Here I go again, defending bankers. It's a dirty job, but someone has to do it. Well, it's more than a hobby than a job because the banks don't even pay me to do it.

It's bonus time once more, that time of year when the unpleasant politics of envy erupts after the peace and goodwill of the holiday season. This time, RBS wants to pay bonuses more than 200% of staff salaries. That of course requires the permission of its shareholders – principally, the UK Government in the form of Chancellor George Osborne. Such bonuses are "inappropriate" say many political critics, particularly when "ordinary families are struggling with the cost of living."

But bonuses are a very sensible way to pay people in a volatile sector. In an economy that is growing, as the UK's is now, banking business is great. There are company mergers and acquisitions to do, investments to be placed, and all the rest. In a stuttering economy, business is disastrous. So banks have a system that rewards key people on the basis of results. That is a lot better than scrapping bonuses, raising salaries instead (which is what would happen), and then having to lay people off (and lose their expertise) where you hit a rough patch. With a bonus system, you just pay them less and they hang on, in the hope and expectation that things will improve.

It should not be up to MPs – and MEPs in Brussels, Strasbourg, or wherever they have decanted to this week – to decide how much bankers should be paid. They are hardly icons of virtue on the pay and expenses front themselves. Most of them don't even understand the sector. If bonus caps are to "reduce risk taking", then why did MEPs cap fund managers, who don't take anything like the risks that bankers do.

Bank bonuses are already heavily restricted. Rules introduced in 2010 cut the amount that could be paid in cash, and spread the pay-out time over 3-5 years. So people today get more of their bonus in shares - which means that the long-term health of their company is dearer to their hearts than any one-off "quick profit."

Let us not forget that after New York, London is the world's leading services centre. The sector brings in about £60bn in tax every year, more than 10% of the government's entire budget. We need it to succeed, and retain talent – which means paying them world market rates. That's what we do with footballers – John Terry is paid £6.7m a year, Wayne Rooney is on £15.1m and Steven Gerrard picks up £7.2m and got an MBE too. But football clubs are very small businesses compared to banks. Though a world footballing brand, Manchester United's capitalization is just £2.47bn; the market capitalization of RBS is seventeen times bigger, at £41.8bn. Should we be surprised if star performers in RBS are paid seventeen times what Rooney earns? But in fact we baulk when they are paid fifteen times less.

There is a problem with banking, but it is not bonuses. It is the lack of competition. The main UK banks can literally be counted on one hand: HSBC, Lloyds (which includes Bank of Scotland), RBS (which inlcudes NatWest), Barclays and Standard Chartered - though the latter operates mainly overseas. Lack of competition means customers get a worse service at a higher price, and providers can indeed overpay themselves. In a competitive market, anyone over-rewarding their staff would go out of business. So let's not try to guess what the "right" remuneration is for bankers. Let's open the sector to competition – which means scaling back the regulation on new entrants – and let the market do the job for us.

Low rates doesn't mean low rates

I got called up last Wednesday to ask if anyone at the Adam Smith Institute would go on the Daily Politics to explain why the Bank of England should raise its base rate (not exactly in those words). The producer was familiar with common free market ideas that argue that artificially low interest rates are blowing up a housing bubble which will later burst. I had to try to explain to the producer why I both agree and disagree with these sentiments: low interest rates do underlie economic limbo, but raising the base rate is not a solution and may produce yet lower real interest rates where it matters—throughout the economy.

The problem comes from the dual use, in the popular economic press, and even by top economists, of the term "interest rates" to mean both the stance of monetary policy and the cost of borrowing. This is understandable because during the Great Moderation of 1992-2008 all the world's most important macroeconomic authorities attempted to control the overall economy through adjusting one or a small number of key interest rates to achieve a consumer price inflation (CPI) target. At the same time, we are familiar with interest rates through our normal life: on loans, mortgages, savings, credit cards and so on. But acting as though the Bank of England directly controls these rates when it adjusts policy seriously obfuscates how the macroeconomy works and contributes to a lot of sloppy thinking.

Whereas the Federal Reserve has always used a form of quantitative easing (QE) to adjust a market interest rate—the Federal Funds Rate—the Bank of England has typically adjusted its base rate, which it calls Bank Rate, instead (updated). Bank Rate is the flat (nominal) interest rate it charges commercial banks for short term funding, and pays on their excess reserves. This sets a lower bound on overnight commercial lending, since it is always an option to lend or borrow money at Bank Rate, and therefore it is included in some market contracts, like tracker variable rate mortgages. The current UK base rate is 0.5%, a nominal number which translates to a negative real rate, but secured loans charge more like 3% in nominal terms, unsecured loans 8%, and credit cards 10%.

So we've established that the Bank of England sets a lower bound on interest rates with its Bank Rate. And we've also established that Bank Rate affects some other rates directly, principally tracker mortgages. We might also expect it to affect other rates in the economy—for example a cut will "ripple out" through the economy, because all other things being equal, it is now cheaper for banks to borrow from the BoE and they will thus be more willing to do so. Economists call this the liquidity effect. They will thus be more willing to lend cheaply and less willing to borrow from savers. So one effect of lowering the Bank Rate is to directly lower some rates, put a lower lower bound on others, and make others cheaper.

However there is an opposed reaction. Lowering Bank Rate doesn't just make loans cheaper, but it increases demand. It does so by injecting extra money into the economy (from the extra loans), but more importantly by signalling to markets that it intends demand to grow faster and that it is willing to take measures (such as further lowering Bank Rate or boosting the money supply through a QE programme) to make sure this happens. This is why stock markets react so strongly to a (policy) interest rate cut—all businesses are worth a bit more because they expect higher total revenues over their future.

But if firms expect higher demand in the future they will in turn demand more investment funds to put into projects to service that demand. This means that cutting the BoE's base rate puts pressure on effective market interest rates in both directions. It is an empirical question which direction the overall effect goes in—but this means that the simple coincidence of low real effective interest rates out in the economy and a low, by historical terms, Bank Rate, shows nothing. It could be that the best way to raise interest rates out there in the economy is to cut the Bank's base rate, or, since it can't go much further now, print money to raise inflation (which would ceteris paribus cut the rate in real terms). Look at the graph above for an illustration of how the Fed's changes in their QE programme (the red line) and their Federal Funds rate (the dark blue line) don't produce big shifts in (real) market interest rates like corporate bond returns and 30-year mortgages.

So my view on low interest rates is complicated. I think the Bank should get out of the business of setting rates altogether, and vary the size of the monetary base to control nominal income in the economy. But if the Bank is going to use rates as its key policy tool, it shouldn't raise them when a recovery hasn't quite taken hold—it's uncertain whether it'll raise market interest rates, but it will certainly choke off the demand we need for solid growth.