Let’s not muddy the waters over the big society benefits
A LOT of people, both on the Left and the Right, are suspicious of David Cameron’s plans for the “big society”. The Left think it’s a way of making cuts sound cuddly, while the Right fears it will turn into just another way for Government to boss us around. I think both sides have got it wrong.
At the core of the the big society agenda is a great idea: that voluntary co-operation should, as far as possible, replace coercive state action. It means groups of parents setting up their own schools, neighbourhoods coming up with their own development plans, or charities and social enterprises getting the unemployed back to work. This, really, is what Cameron is on about when he talks about “rolling forward society”, rather than just rolling back the state.
But why is local voluntary co-operation better than Government provision? There are two big reasons. The first is that voluntary co-operation will provide better services and achieve better outcomes. This is partly because the services will be more responsive to the needs of the people using them, and the providers more directly accountable. But it is also because radical decentralisation of this sort allows for innovation and experimentation. Lots of different things can be tried; some will succeed, some will fail, but overall we learn and improve. Top-down provision can never hope to emulate this discovery process.
The second reason is that empowering people to do things themselves, rather than always relying on bureaucrats, will allow them to lead richer, more fulfilling lives.
American political scientist Charles Murray has written persuasively about this: people get a great deal of real, lasting satisfaction from community, from voluntarily working with their neighbours to overcome local problems and meet local needs. Letting Government take over doesn’t just disempower people; it also leaves them feeling rootless.
Indeed, one of the most pernicious myths about leaving people free to make their own choices is that it leads to atomisation. Nothing could be further from the truth. In fact, big government undermines the complex fabric of voluntary relationships that exist in a free society, and replaces it with nothing more than distant, top-down authority. Instead of combining with their families, colleagues and neighbours to help themselves, people are infantilised, told that they are too weak to be independent, and that they must become clients of a patronising state.
Yet the ethos of the big, activist society is deeply rooted in Britain’s history. You can see it in the great charitable hospitals of the 19th century. You can see it in the mutual aid organisations that provided millions of manual workers with healthcare and unemployment benefits before Lloyd George’s National Insurance Act. And you can see it in the extraordinary levels of charitable giving and civic activism that characterised Victorian Britain.
That these things happened in the past, when we were so much poorer than we are today, should be a source of inspiration. Just imagine what could be achieved if we combined the big society spirit of the 19th century with the wealth we acquired in the 20th. And, of course, the big society is not just a thing of the past. Far from it. Just look at the New Model School Company, which provides low-cost, private education to disadvantaged children. Or even the trades unions that provide millions of their members with access to affordable, private healthcare.
But big government’s greatest trick has been to convince everyone that they can’t live without it. And this, ultimately, is the political point of the big society agenda: people have become so reliant on government doing things for them that we can’t just roll back the state and hope for the best.
Maybe the private and voluntary sector would fill the gaps, but the adjustment process would be painful and the politics of the situation impossible. Instead, we should use the power of the state to remake society, to stimulate the renaissance of voluntary co-operation, and make room for the bureaucratic state to gradually, not suddenly, withdraw.
That all sounds appealing, but there are dangers. Government is unlikely to be any better at planning society than it has been at planning the economy. Indeed, the fact that teams of civil servants have been assigned to oversee big society pilot projects does not bode well. Nor does the idea of a state-sponsored Big Society Bank, or a “neighbourhood army” of Government-trained activists, fill me with optimism.
It would be all-too-easy for us to end up nationalising and bureaucratising existing social enterprises, getting them hooked on taxpayer subsidies and subjecting them to countless rules and regulations, rather than inspiring a generation of new ones. The Government’s influence could, in other words, be malign rather than constructive. Only time and experience will tell.
But whatever the outcome, it is good to see that at least some on the Right are abandoning their belief that “society” is an inherently Leftist concept, which stands opposed to free markets and individual freedom.
This notion – perhaps rooted in a woeful misunderstanding of Margaret Thatcher’s “no such thing as society speech” – does them no favours at all. For, in fact, the market and society are two sides of the same coin. One means voluntary co-operation in the economic sphere, the other means voluntary co-operation in the social sphere. And we need both if we are going to make Britain a better and more prosperous place to live.
Published in the Yorkshire Post.
Crime: The false dilemma of Right versus Left still reigns
Libertarians believe that the real political issue is not whether a government is Left or Right but rather whether it is large or small. Freedom is indivisible; it is silly to want free speech without freedom of (peaceful) action. (If A and B meet in the street and agree under free speech that it would be good to swap A’s apples for B’s oranges in a certain ratio, it is silly to forbid them to go ahead with the swap).
So the last 100 years have not been happy for libertarians; under governments of every hue, taxes and other forms of intervention have expanded exponentially with hardly any respite. All three of the main parties remain incorrigibly statist, and at this rate, almost any action will soon be classed as either banned or compulsory.
It is true that under the present coalition there have been some significant crumbs of comfort; for example if the coalition is to be believed, we will soon see the abolition or reduction in the scope of several Labour-induced intrusions, including the identity card scheme, biometric passports, the National Identity Register, CCTV expansion, storage of internet and email records, the weakening of both trial by jury and the DNA database, and various others.
But let’s get real; big government is not going to disappear in a hurry, not even in genuinely downsizing its role. A good example is the issue of crime and imprisonment, where over the past week or two, MPs David Davis and Kenneth Clarke, the press, and think-tanks have argued over one variety of big government for another. In essence the “prison works” camp advocates locking up the perpetrators at swish hotel rates (about £40,000 a year) paid by the taxpayer, whilst the other camp advocates, instead of prison, various types of rehabilitation and/or community services, also paid by the taxpayer. In other words they argue over the fate of the perpetrators, the taxpayers, and the rest of the citizenry, with the “prison works” camp assuming rather blithely that lock-ups will save loads-a-money or its equivalent in crime-reduction – not only whilst criminals are locked up but also after their release as reformed citizens. Yeah, right; exactly how would, or did, such a result come about in the cases of Lester Piggott and Jeffrey Archer? They were no doubt rare cases, but does anybody really believe that most fraudsters and thieves undergo a Damascene conversion whilst spending years amongst their new chums? To me, the idea of locking up non-violent criminals must be counter-productive on almost any count.
“OK, but where is the big government?” you may ask. Two issues stand out here. The first is the proliferation of actions which become “crimes” at the stroke of a pen, and the second is that, as far as I have seen, not one of the matters in the current debate mentions the victims of crime. The word “crime” was introduced a thousand or more years ago to cover offences against the reigning monarch, and even now it is primarily reserved for offences against “the State”. That says it all. Increasingly, new stroke-of-the-pen “crimes” don’t have “victims” apart from the politicians and their anger that somebody should transgress their made-up rules. Two big examples are drug-taking (the banning of which causes true crimes as drug barons take advantage of the resulting high prices) and white collar “crimes” which are increasing as Gung ho regulators like the Financial Services Authority talk openly of “getting a result” almost irrespectively of guilt. (Again, “guilt” is often the breaking of a highly dubious law where victims are hard to find yet punishment consists of both prison and fines). (The USA SEC is even worse; for example the only “crimes” of Kenneth Lay and Martha Stewart were to lie to the authorities.) Contract law is all that is necessary to deal with the “crimes” of insider dealing and “market abuse”.
In most cases, surely the test of criminal behaviour is whether there are specific and identifiable victims? It is outrageous that people go to jail when there are no victims, and when there are victims they are ignored! The victims of true crime, or their families, are the primary sufferers. Yet my only recollection of anything concerning the victim from our politicians was a few years ago when someone had the idea that the victim or his/her representatives should be allowed to have their day in court. Great! Here’s a chance to say your piece. Then go home, lick your wounds and get used to it.
One word seems to be taboo in all of this – compensation. Damages, if you like. Isn’t it rather odd that you can sue for damages except for really serious crimes? Whatever the crime, why not levy fines payable directly to the victims? Granted, not all criminals are well off or even comfortable but surely it is not beyond the wit of lawyers to devise an equivalent to Bankruptcy under which the perpetrator’s capital and income are available as a first call to pay the victim(s) – for as long as it takes to pay it all off at double (say) the assessed loss.
The important principle should be that the perpetrator is recognised as a debtor of the victim rather than of the State. This does not mean that the debt must be paid by either the perpetrator or nobody at all. Where this is not possible, at least not in full, there’s always the £40,000 a year to fall back on!
The other area of big government here is its role in rehabilitation via probation officers and a galaxy of other government employees. It would be far better to allow private charities (with no links whatsoever to government) to take over these functions and also to deal with the welfare of victims, including any shortfalls in restitution. Such charities were (until the State took over) the primary sources of welfare provision. Their biggest advantage is that whilst they would naturally provide succour when needed, in direct contrast to the state welfare industry (which wants to retain its “clients” on the books) their major aim would be that of the great Victorian charities, namely to get their clientsoff their books via reform. Such twin aims are essential, whether for criminals or victims.
The hidden debt is the real monster
Yes, the government is deep in debt. But how deep? The Treasury says about £893 billion, equivalent to 62% of GDP, the amount we earn each year. Even with the promised cuts it will reach 75% of GDP in five years’ time.
That isn’t the half of it; not even a quarter of it. The government owes five or six times more than it lets on. Like the iceberg, its IOUs to lenders are just the part you can see. Far bigger are all those IOUs it has given us on our future pensions and medical bills — promises that keep growing as the population ages.
George Osborne, the chancellor, and Danny Alexander, chief secretary to the Treasury, are simply trying to steer the ship of state round the visible iceberg, unaware of the hidden costs that could still sink it. They should hear the first sonar bleep this summer when the National Institute of Economic and Social Research reports to them on the subject.
The visible bit of the national debt iceberg is the £893 billion of bonds and savings certificates that the government has issued to raise cash. The financial crisis and the bank bailouts have driven that up to a peacetime record. The coalition has no plans to pay it off — its promise to “reduce the deficit” simply means adding to it less fast.
This debt is just half the cost of what we have promised ourselves in free healthcare, according to public debt expert Christian Hagist of Freiburg University. With the baby-boom generation now showing up more in the surgeries, those costs will soar — but nobody in government seems to know how much.
Even larger is the mountain of money we are promised in pensions. It depends on how long we live but, again, the costs are going to escalate as the baby-boomers reach retirement. I estimate the Treasury has promised us £2,200 billion of pension benefits — more than twice the official national debt.
And don’t forget those index-linked pensions promised to civil servants — far more generous than anything available in the private sector. By the time the last of today’s civil servants dies, that will cost another £1,100 billion or so, again eclipsing the official debt.
Nor does the red ink stop there. Just as big are the commitments made to schools and universities, including all the future payouts to private contractors for building and maintaining schools under the private finance initiative (PFI).
I used to be proud of PFI. At the Adam Smith Institute we developed the idea of pulling private development and financial expertise into public infrastructure projects, which civil servants were poor at. But Gordon Brown perverted it into a way of getting new schools and hospitals on tick — winning kudos today and leaving future generations to pay the tab. That’s why he fought so hard to keep the £148 billion potential cost of PFI off the Treasury’s books.
The £28 billion of guarantees on Network Rail’s borrowing looks a tiddler by comparison, as does the £73 billion cost of decommissioning nuclear power stations. Somewhat greater is the £142 billion of commitments to the banks. Nobody knows how much of the £3,000 billion of their business that the government underwrites is bad debt. We should be told.
The coalition needs to get to the bottom of these figures. It has no idea how much is hidden — often deliberately — below the surface and whether government promises are affordable. Overlarge commitments are one reason why the rating agencies downgraded Greece. We can’t expect to escape scrutiny either.
Every promise that government makes today — on pensions, healthcare or welfare — puts a future cost on all of us. Starting with this summer’s report, the coalition needs to get a clear grip on those commitments and whether they are affordable. That is what government demands of private companies, which have to make provision for the future cost of their pension plans. New Zealand put its own government under such rigorous accounting standards 25 years ago. It’s time we followed suit.
Only then will we know if we need to raise taxes to provide for these future costs — or if we need to scale back the generous promises we have made ourselves. Just as Osborne and Alexander are asking us which bits of today’s spending we could live without, they should ask us which of tomorrow’s promises can be ditched. It may well be that things like free higher education or elderly care can’t be afforded.
After that the key is transparency. Any government decision that implies contractual or moral commitments for the future must be fully costed. When politicians promise new schools or more generous pensions, they should state the full future price tag. And our generation, not our children’s generation, should provide for those costs. That’s not just better economics, its better ethics, too.
Published in the Sunday Times here
A scalpel is needed on health costs we can no longer afford
Cutting public spending is the most pressing challenge the Government faces. Right now, we have the biggest budget deficit in the developed world and are accumulating debt fast. Put simply, the British government is borrowing about £18m per hour, every hour, all year long. But we can’t go on like this indefinitely. And the slower the political response to our fiscal crisis is, the more likely a Greek-style meltdown becomes.
Our latest research puts the task facing the Government in stark contrast. To balance the budget by 2015, they need to find more than £90bn in cuts over the course of this Parliament.
That works out at three per cent cuts every year.
And perhaps three per cent doesn’t sound like much. After all, many households and businesses have had to make much bigger savings during the downturn. But politics is a tricky business, and we should be under no illusions about how difficult these spending cuts will be to achieve.
Fortunately, there are international examples they can look to. Canada and Sweden have both successfully turned big deficits into surpluses in a short period of time. But one of the main lessons from these countries is that no area of public spending can be sacrosanct: as soon as you start making exceptions and putting up ring-fences, you undermine the whole process.
In Britain, this applies especially to healthcare. After social security, the NHS is our biggest expense, consuming more than £100bn of taxpayers’ money each year. As such, any attempt to dramatically reduce expenditure without looking at the health service is doomed to fail.
It’s not just that the NHS costs a lot, it’s that its costs have skyrocketed in the last decade, doubling in real terms between 1999 and 2009. Yet over that period, productivity has fallen – in other words, we are getting less for our money.
It was Derek Wanless’s 2002 review of the health system that paved the way for these spending increases. But when the King’s Fund asked him to review the results several years later, he found that 43 per cent of the extra money had been absorbed by higher wages and price inflation.
This is hardly surprising when you consider that NHS pay increases have outstripped those in the wider economy by 15 per cent in recent years, or contemplate the fact that the number of managers in the NHS has risen by 84 per cent since 1999. We now have over 44,600 of them, earning an average £60,000 each.
So the place to start is payroll costs and bureaucracy. Reform, a think-tank, has calculated that a 10 per cent pay cut for the highest paid NHS workers – bringing their salaries back into line with private sector trends – would save £1.3bn a year.
Freezing salary levels across the NHS until the deficit is dealt with would deliver significant additional savings.
As for the bureaucrats, returning to the number of NHS managers we had in 1999 – a reasonable objective if the coalition Government makes good on its promise to free hospitals from red tape – would cut annual costs by more than £1bn.
Abolishing Strategic Health Authorities would save a few hundred million more.
But this kind of tinkering only takes you so far. Because one of the other lessons we need to learn from Canada and Sweden is that making spending cuts sustainable in the long run means completely re-thinking the role of government, what it does, and how it does it.
When it comes to health, the key question we need to ask is this: can we still afford to provide everyone with comprehensive healthcare, free at the point of use? Or should we focus scarce resources on those most in need, using government as a safety net and guarantor of minimum standards, rather than a provider of universal services?
Our answer will become increasingly important in the years ahead, as baby boomers age and technological advances drive a spiralling burden on taxpayers. And yet, in a way, the question is misleading.
The NHS has not been truly comprehensive and free at the point of use since 1951, when charges were introduced for prescriptions, dental care, and spectacles.
For now, we should take that precedent and run with it, gradually introducing user charges throughout the NHS. Britain is virtually unique in the world for not charging people to visit their GP, for instance, and even a modest fee of £10 would save the NHS around £1.5bn a year.
Direct payment would have a powerful effect on the way people see the NHS. Realising that healthcare is never really “free” would make them use services more judiciously; knowing they would bear some of the cost of their lifestyle choices might also encourage people to take greater responsibility for their own health.
Eventually, most medical services could be paid for directly by patients, with various exemptions and spending caps in place to ensure that the disadvantaged do not suffer unfairly. The NHS would become a “people’s insurance policy”, covering Britons against unpredictable, big-ticket health expenses, and ensuring no one went without, but no longer providing comprehensive services itself.
Of course, there’s no question that these are radical suggestions. But the Government has promised us a “once-in-a-generation” re-think of government. Will it be brave enough to think the unthinkable?
Published in the Yorkshire Post here
When Will the Eurozone Collapse?
As a long-standing critic of the concept of a single European currency, I have not rejoiced at the current problems in the eurozone that threaten the very survival of the euro. Before discussing the events surrounding the Greek debt crisis further, I must provide at least a working definition of what the word “collapse” means. In the context of the euro, there are at least two interpretations that come to mind. The first one suggests that the eurozone project or the project establishing a common European currency has collapsed already by failing to bring about positive effects that had been expected of it.
The creation of the eurozone was presented as an unambiguous economic benefit to all the countries willing to give up their own currencies that had been in existence for decades or centuries. Extensive, yet tendentious and, therefore, quasiscientific studies were published prior to the launch of the single currency. Those studies promised that the euro would help accelerate economic growth and reduce inflation and stressed, in particular, the expectation that the member states of the eurozone would be protected against all kinds of unfavorable economic disruptions or exogenous shocks.
The Euro Has Not Led to Higher Growth in the Eurozone
It is absolutely clear that nothing of that sort has happened. After the establishment of the eurozone, the economic growth of its member states slowed down compared to the previous decades, thus increasing the gap between the speed of economic growth in the eurozone countries and that in major economies such as the United States and China, smaller economies in Southeast Asia and parts of the developing world, as well as Central and Eastern European countries that are not members of the eurozone. Since the 1960s, economic growth in the eurozone countries has been slowing down and the existence of the euro has not reversed that trend. According to European Central Bank data, average annual economic growth in the eurozone countries was 3.4 percent in the 1970s, 2.4 percent in the 1980s, 2.2 percent in the 1990s and only 1.1 percent from 2001 to 2009 (the decade of the euro) (see Figure 1).1 A similar slowdown has not occurred anywhere else in the world.
The Eurozone Economies Have Not Converged
Not even the expected convergence of the inflation rates of the eurozone countries has taken place. Two distinct groups of countries have formed within the eurozone — one with a low inflation rate and one (Greece, Spain, Portugal, Ireland and some other countries) with a higher inflation rate. We have also seen an increase in long-term trade imbalances. On the one hand, there are countries with a balance of trade where exports exceed imports and, on the other hand, those countries that import more than they export. It is no coincidence that the latter countries also have higher inflation rates. The establishment of the eurozone has not led to any homogenization of the member states’ economies.
The global financial and economic crisis only escalated and exposed all economic problems in the eurozone — it did not cause them. That did not come as a surprise to me. The eurozone, which comprises 16 European countries, is not an “optimum currency area” as the elementary economic theorems tell us it should be. The former member of the Executive Board and chief economist of the European Central Bank Otmar Issing has repeatedly pointed out (most recently in a speech in Prague in December 2009) that the establishment of the eurozone was primarily a political decision.2 That decision did not take into account the suitability of this whole group of countries for the single currency project. However, if the existing monetary area is not the optimum currency area, it is inevitable that the costs of establishing and maintaining it exceed the benefits.
My choice of the words “establishing” and “maintaining” is not accidental. Most economic commentators (not to speak of the non-economic commentators) were satisfied by the ease and apparent inexpensiveness of the first step (i.e., the establishment of the common monetary area). This has helped to form the mistaken impression that everything was fine with the European single currency project. That was a mistake that at least some of us have been pointing out since the very birth of the euro. Unfortunately, nobody has listened to us.
I have never questioned the fact that the exchange rates of the countries joining the eurozone more or less reflected the economic reality in Europe at the time when the euro was born. However, over the last decade, the economic performance of individual eurozone members diverged and the negative effects of the “straight-jacket” of a single currency over the individual member states have become visible. When “good weather” (in the economic sense) prevailed, no visible problems arose. Once the crisis or “bad weather” arrived, however, the lack of homogeneity among the eurozone members manifested itself very clearly. In that sense, I dare say that — as a project that promised to be of considerable economic benefit to its members — the eurozone has failed.
The Hidden Costs of the Euro
Of greater interest to non-experts and politicians (rather than economists) is the question of the collapse of the eurozone as an institution. To that question, my answer is no, it will not collapse. So much political capital had been invested in the existence of the euro and its role as a “cement” that binds the EU on its way to supra-nationality that in the foreseeable future the eurozone will surely not be abandoned. It will continue, but at an extremely high price that will be paid by the citizens of the eurozone countries (and, indirectly by those Europeans who have kept their own currencies).
The price of maintaining the euro will be low economic growth in the eurozone. Sluggish eurozone growth will result in economic losses in other European countries, like the Czech Republic, and in the rest of the world. The high price of the euro will be most visible in the volume of financial transfers that will have to be sent to eurozone countries suffering from the biggest economic and financial problems. The idea that such transfers would not be easy without the existence of a political union was known to German Chancellor Helmut Kohl back in 1991 when he said that “recent history, and not just that of Germany, teaches us that the idea of sustaining an economic and monetary union over time without political union is a fallacy.”3 He seems to have forgotten it, unfortunately, as time went by.
The amount of money that Greece will receive in the foreseeable future can be divided by the number of the eurozone inhabitants and each person can easily calculate his or her own contribution. However, the “opportunity” cost arising from the loss of a potentially higher growth rate, which is much more difficult for a non-economist to contemplate, will be far more painful. Yet, I do not doubt that for political reasons this high price of the euro will be paid and that the eurozone inhabitants will never find out just how much the euro truly cost them.
To summarize, the European monetary union is not at risk of being abolished. The price of maintaining it will, however, continue to grow.
The Czech Republic has not made a mistake by avoiding membership in the eurozone so far. And we are not the only country taking that view. On April 13, 2010, the Financial Times published an article by the late Governor of the Polish Central Bank Slawomir Skrzypek — a man whom I had the honor of knowing very well. Skrzypek wrote that article shortly before his tragic death in the airplane crash that carried a number of Polish dignitaries near Smolensk, Russia. In that article, Skrzypek wrote, “As a non-member of the euro, Poland has been able to profit from flexibility of the zloty exchange rate in a way that has helped growth and lowered the current account deficit without importing inflation.” He added that “the decade-long story of peripheral euro members drastically losing competitiveness has been a salutary lesson.”4 There is no need to add anything more.
Notes The original Czech version of this article was published in Ekonom, a Czech weekly magazine, on April 22, 2010.
This English version was first published by the Cato Institute on April 26,2010, (it can be accessed here).
1. The European Central Bank, “Statistics Pocket Book,” March 2010, http://www.ecb.int/pub/pdf/stapobo/spb201003en.pdf. 2. Otmar Issing, The Birth of the Euro (Cambridge, U.K.: Cambridge University Press, 2008). 3. Quoted in Otmar Issing, “The Euro: Does a Currency Need a State?” International Finance 11, no. 3 (2008): 303. 4. Slawomir Skrzypek, “Poland Should Not Rush to Sign Up to The Euro,” Financial Times, April 13, 2010.
Václav Klaus is the President of the Czech Republic and a fellow of the Adam Smith Institute.
A law to stop the splurge
Our new prime minister and his deputy agree: our government has been spending and borrowing too much. Good, as Alcoholics Anonymous might say — admitting your problem is the first step towards dealing with it.
The new Treasury team might actually manage to re-cork the bottle. George Osborne, the chancellor, is blunt about wanting to balance the budget and David Laws, his Liberal Democrat deputy, is also known to be a hawk on economic matters. It bodes well, too, that Iain Duncan Smith, who knows how to get people off welfare and into work, is now installed at work and pensions.
The message they are all receiving is clear: we must spend less and work more. Intentions, however, are not enough because fiscal alcoholics have a habit of telling themselves that just one more little splurge can’t hurt.
Remember Gordon Brown’s “golden rules”, which stipulated that the government should borrow only to invest and it should keep its debts “prudently” down to about two-fifths of what the nation earns? Unfortunately, he fudged the first rule, showering us with treats on tick, and abandoned the second when the going got tough.
The world’s central bankers have warned us that if Britain carries on in this fashion, our debts will rocket to five times our earnings by 2040. Even with firm action they are expected to soar to three times earnings.
So we need new rules on the public finances that politicians can’t wriggle out of — if not constitutional restraints, then at least limits that cannot be brushed aside for the sake of political convenience.
That’s why I want to propose a new economic responsibility act, which would set in stone the spending and borrowing targets to be hit by the end of the coalition’s five-year term.
Here are my suggestions:
— Cap the budget at one-third of gross domestic product, so the government can’t spend more than £1 for every £3 that the nation earns. The experience of other countries tells us this is as much as the public can bear before it starts concealing income or voting out governments. This cap should be set on the basis of what we’ve actually earned, not on the jam-tomorrow budget forecasts of over-optimistic chancellors. And if the economy nosedives, it’s not just private sector workers who should suffer pay and job cuts — government programmes would have to share the pain, too.
— Cap the deficit at 3% of GDP — the limit that “prudent” Brown commendably foisted on his government and the European Union. Three per cent gives a bit of flexibility but keeps the total debt under control.
— Cap the national debt at 40% of GDP. Without strict limits, as recent times have shown, government debts spin quickly out of control. In 1997 the debt was £350 billion. Now it has more than doubled to £770 billion. It is expected to double again to £1,406 billion in five years’ time. Now I would love to be able to double my own borrowings whenever I liked — but that would just encourage me to live beyond my means; pretty soon, lenders would get nervous and want their money back. The same applies to governments. The international agencies that rate our creditworthiness think that a debt of 40% of GDP is sustainable. It’s a good target.
— No off-the-books fiddling. Brown claimed that his borrowings were scarcely more than those of other European countries. But many other commitments that he made, a dozen times larger, are conveniently unrecorded in the Treasury’s books. Why? The government requires companies to state their future commitments, such as staff pensions. But its own civil service pensions, not to mention future state pensions and contractual payments to school and hospital builders and countless other items are never accounted for. That must change.
— Borrow only to invest. It makes perfect sense, but Brown kept labelling his spending as “investments” for the future. In fact, most of his vast budget increases went on hiring more public workers and raising their wages.
— Limit tax rises. High taxes choke off investment and growth, which are our only way out of this slump. I suggest we hold public referendums before any tax rises and before any local government budget is approved. And the office of budget responsibility should be given full power to block counterproductive rises — such as the 50% envy tax that will drive high earners abroad.
Am I being too hard on a new and well intentioned government? Alas, even the most “prudent” politicians cannot always be trusted. So we need these strict rules to protect our personal and public finances. Only from that solid, restrained foundation can we build Britain’s future economic growth.
Published in the Sunday Times here
Reflections on the coalition agreement
An emergency budget will be held within 50 days, and will announce £6bn of cuts in the current financial year, and outline a deliverable long-term plan for “significantly accelerated reduction in the structural deficit”, mainly through spending cuts. A full spending review will be initiated, and will report in the autumn. Full strategic and defence reviews will be held at the same time. However, NHS spending will increase in real terms every year, the target to spend 0.7% of GDP on overseas aid will remain in place, and a significant ‘pupil premium’ for disadvantaged pupils will be introduced.
This is good, but is it enough? I appreciate that cutting public spending in-year is tricky (like a big ship, government takes a while to change direction) but I am sure that bigger year-1 savings are both possible and desirable, given the state of the UK’s public finances and the disaster unfolding elsewhere in Europe. Moreover, saying you will significantly accelerate deficit reduction is not the same as pledging to eliminate the budget deficit over the course of the parliament, which is the promise I hoped the new government would make. And it is disappointing to see that NHS and international development spending is still ring-fenced – there should not be any sacred cows. Nevertheless, this is a step in the right direction and it is the job of organizations like the Adam Smith Institute to drag the government towards real fiscal responsibility.
Reductions will be made to the Child Trust Fund and tax credits for higher earners.
Good – the Child Trust Fund is a pointless gimmick, and when money is tight it makes sense to target resources on the most needy.
There will be a substantial increase in the personal allowance from April 2011, with stated longer-term objective of raising it to £10,000.
Excellent – the ASI has been pushing for this for ages, and it is great to see steps being taken in this direction.
That means no increase in the thresholds for employee NI (as Tories originally pledged), but the increase in the thresholds for employer NI will go ahead as planned.
Well, that’s a bit of a disappointment, but the rise in the income tax personal allowance more than makes up for it. Stopping the rise in employers’ contributions is the really important bit, so it’s good that didn’t fall by the wayside in negotiations.
Non-business capital gains will be taxed at or near to the same rates as ordinary income, with generous exemptions for entrepreneurial business activities.
It isn’t entirely clear what this means but regardless, raising taxes on capital and investment when you are trying to encourage economic growth isn’t terribly sensible. The fact that this measure will only apply to non-business assets and will be subject to major exemptions may stop this tax hike being too damaging, but the devil is in the detail. Generally though, raising capital taxes is counter-productive – CGT is the tax that tends to exhibit the strongest laffer curve effects, and I’ve seen research suggesting that c.15% is the revenue maximising rate – more than that and you just change people’s behaviour.
Inheritance tax cut kicked into the long grass. Lib Dems allowed to abstain on transferable tax allowances for married couples. Air Passenger Duty will be charged on a per-plane, rather than per-passenger basis.
All this was expected. The transferable allowance is small beer, and the changes to Air Passenger Duty are, in themselves, unobjectionable. It is still my view that inheritance tax is unjust and ought to be abolished, but it is understandable that this is not seen as a priority.
An independent commission to review public sector pensions will be set up (accrued rights will be protected). The basic state pension will rise in line with earnings, prices or by 3.5% from April 2011 – whichever is highest.
Good that public sector pensions are being reviewed, but that may just be used as an opportunity to bury a potentially very unpopular issue. As for the state pension, I’m all in favour of dignity for the elderly and agree that the current state pension is rather pitiful. But the question is, are spending commitments like this affordable? And will the government introduce measures to shift the UK to a funded pension system, rather than a PAYGO one? We desperately need to address our long-term age-related liabilities, but I don’t see much sign of that happening at the moment.
A levy on the banks will be introduced.
One can see the argument here – without a levy, banks won’t have to pay any tax on their profits for a few years, because they have such gigantic accumulated losses to bring forward. But this isn’t a sensible way for taxpayers to ‘get their money back’ – what we want is for the government to be able to sell off their bank shares as soon as possible, hopefully at a profit. Bank bashing measures just make this more difficult. ASI fellow Miles Saltiel has a more detailed reaction to plans for a bank levy here.
Robust action to tackle unacceptable bonuses in the financial services sector will be undertaken.
This is ill-advised. The proposals the FSA made on financial sector services last year go far enough. Any additional measures amount to little more than economic populism, and are potentially quite damaging to Britain’s standing as an internationally competitive, major financial centre. It is also worth pointing out – again – that bonuses played no significant role in the financial crisis.
Detailed proposals to make the banking sector more competitive will be brought forward.
This is good news: the obvious place to start is to reduce barriers of entry into the banking sector, so that trusted consumer brands like Tesco can get involved, while also splitting up the nationalized mega-banks as they are returned to the private sector.
An independent commission will examine the case for separating retail and investment banking. It will report in a year.
This idea is worth looking at properly. Opinion among free market economists remains divided.
Responsibility for macro and micro-prudential financial regulation will be transferred to the Bank of England.
This is a good thing, and is something the ASI has called for in a series of reports and briefings on financial regulation. The point though is not just to change the name above the door, but to change the way financial regulation is done. The key is to focus on the big picture instead of box-ticking compliance. Ultimately, sensible monetary reform would be a far better guarantor of financial stability than improved regulation, but that’s a subject for another day.
The government will attempt to ensure the flow of credit to viable small and medium sized enterprises, possibly through a major loan guarantee scheme and net lending targets for the nationalizing banks.
Yes, viable SMEs need access to finance, but government involvement is troubling. Like it or not, the UK economy is hugely indebted and massively overleveraged. We won’t have a sustainable economic recovery until these imbalances have been addressed, and government intervention that has the effect of delaying necessary adjustments may end up causing more pain down the line.
There will be an annual limit on the number of non-EU economic migrants allowed to live and work in the UK.
Not sure about this – if people want to work and contribute, I say let them. The free movement of labour is really just an extension of free trade. Of course, there are legitimate social concerns about immigration, and security worries too – but is this the way to address them?
Consideration will be given to bringing forward the rise in the state pension age to 66, but it won’t happen before 2016 for men and 2020 for women. Rules requiring compulsory annuitization at 75 will be scrapped.
OK, but if we’re going to deal with our fiscal problems it would be better to raise the retirement age higher and sooner. Of course that may be a non-starter politically. Getting rid of compulsory annuitization makes sense – it may be the right option for some people, but it isn’t right for everyone. People ought to be free to act in their own best interests.
The Tory welfare-to-work plans will be implemented in full. The receipt of benefits will be made conditional on the willingness to work, and welfare-to-work providers will be paid according to how successful they are in getting back into work.
Excellent – the Wisconsin reforms finally make it to Britain!
The Tory school choice reforms will be implemented. Parents, teachers, charities, churches, companies, etc will be able to set up new schools, and they will receive taxpayer funding on a per-pupil basis. All schools will be given greater freedom over their curriculum.
This was by far the best and most developed policy the Conservatives had in their general election manifesto, so thank goodness it survived the coalition horse-trading. Michael Gove’s ‘supply side revolution’ has the potential to transform British schooling for the better. The only lingering concerns are will new schools be exempt from local authority approval, and will operators be allowed to make a profit (both of which are essential if the necessary numbers of new schools are going to be established)?
A ‘Freedom Bill’ or ‘Great Repeal Bill’ will be enacted. The ID card scheme, the national identity register, the next generation of biometric passports, and the Contact Point Database will be scrapped. Traditional civil liberties will be restored.
Music to my ears!
Fixed term parliaments will be established. This means that the next general election will be on the first Thursday of May in 2015, unless 55% of both Houses of Parliament vote to dissolve before then.
This is a probably a political requirement of coalition government – it prevents the Conservatives from trying to stitch up the Liberal Democrats by calling an election whenever it looks like they could get an overall majority. The downside of fixed election dates is that they tend to lengthen the campaign phase of the political cycle – something most of us could do without!
Legislation will introduce fewer and more equal sized parliamentary constituencies, and ensure a referendum on the Alternative Vote.
A fairer distribution of seats is an essential reform, and I’m relaxed about a referendum on the Alternative Vote. I still think the most important quality of an electoral system is that it allows you to change governments, rather than that it ‘accurately reflects the views of voters’ (which, as any public choice economist will tell you, would never happen anyway). Moreover, I suspect that the Alternative Vote would force politicians to cluster even more around the centre ground, and may drive politics to become even more shallow and personality-driven. So sticking with first-past-the-post would be my preference, but I’m open to persuasion. After all, the Alternative Vote doesn’t seem to have thrown up too many problems in Australia.
A committee will be set up to bring forward proposals on introducing a mainly or wholly PR-elected House of Lords, with members serving a single long term. This committee will report by December this year.
As it stands, the unelected House of Lords does a far better job of protecting our liberties than the elected House of Commons. Might that quality of the Lords be lost in the introduction of elections, especially if those elections are based on a party list system, leading to the Lords being stuffed full of party apparatchiks? Most likely, yes. On the other hand, there are clearly inadequacies with the current system and the impetus for change is strong. What matters is that any changes deliver a House of Lords that is more willing to stand up to government, better able to scrutinize legislation, and more effective at protecting liberty than the current one, and not less. How they might be done is a subject for another time, but this is clearly the test that any changes to our constitutional arrangements should be judged.
Voters will get the right of recall: a petition signed by ten percent of an MP’s constituents will trigger a by-election (assuming the MP was found to have engaged in serious wrongdoing).
Good, although this does seem a case of closing the gate after the horse has bolted. I can’t see the right of recall be used all that much in future (even if it would have been very useful during the expenses scandal). And of course, who judges whether an MP has been engaged in serious wrongdoing or not?
A House Business Committee will be put in charge of Parliament’s timetable, to ensure that the legislature is properly able to hold the executive to account.
This is an excellent idea. Over the past couple of decades the executive has come to utterly dominate the legislature. Any measures to reverse this trend are welcome.
A commission will be established to consider the ‘West Lothian question’.
Fine, as long as the issue doesn’t get kicked into the long grass. I think the time has come for England to have its own Parliament.
The Calman Commission’s proposals will be implemented, and the Welsh will be offered a referendum on further devolution.
As I’ve written before, the Calman Commission’s proposals are a complete dog’s breakfast that would do very little to increase Scotland’s fiscal autonomy or to encourage more prudent expenditure. A much better idea would be to keep National Insurance and VAT as UK taxes, and devolve everything else to Holyrood. As for greater devolution in Wales: no objections here.
An agreement on limiting donations and reforming party funding will be pursued, with the aim of removing ‘big money’ from politics.
When they say big money, I have a funny feeling the mean trade union money – i.e. Labour money. But party politics aside, I’m not convinced the further regulation of political donations is either necessary or desirable. And under no circumstances would I be willing to contemplate state funding of political parties (which would further insulate our political class from the real world). Unfortunately this is likely to be the direction in which banning ‘big money’ would take us.
Power will be radically devolved to local government, which will be given greater financial autonomy. There will be a full review of local government finance.
This is good stuff, but I’ll believe it when I see it. Now that they have finally got their hands on a bit of central power, the Liberal Democrats may cool about giving that power away to local authorities. And I suspect the Tories will be very wary about making any changes to local government finance – the words ‘poll tax’ don’t provoke happy memories. If decentralization does go ahead, the government should start abolishing the regional tier of government and redistributing its powers to the local level. The next step is to give local authorities real policy freedom in the areas they are responsible for. Then they should be made as fully self-financing as possible.
A high-speed rail network will be established, the third runway at Heathrow will be cancelled, and no new runways at Gatwick or Stansted will be allowed. We won’t get any new nuclear power stations, but we will get lots of new environmental legislation.
It’s a shame to finish on a negative, but this has the main area of concern in the coalition agreement – a great multitude of sins are being proposed under the cover of ‘making Britain a low carbon economy’. Most of them are likely to increase prices for consumers, encourage more businesses to rent-seek rather than engage in entrepreneurial activity, and significantly decrease our energy security. High-speed rail is likely to cost a lot and fail to deliver corresponding benefits, while not allowing new runways is likely to make life even more difficult for British travellers.
US financial reform: two key mistakes
Introduction
Two financial reform bills, one passed by the House of Representatives in December, the other currently making its way through the Senate, are touted as representative of the largest overhaul of the financial services industry in recent years. Many economists, politicians and commentators agree that a key problem in the US government’s reaction to the financial crisis was a fundamental incentive problem, where large financial institutions such as AIG and Citigroup where effectively marked as ‘Too Big to Fail’, impliying the possibility of bailouts and thus distorting the market behaviour of such behemoths. It is not clear, however, that the legislation does anywhere near enough to remedy this crucial economic issue at the heart of the recent crisis. In fact, it has been argued that the Senate bill is likely to make this issue worse.
The increased regulation of alternative investments, such as hedge funds and private equity dealers, is another element of the proposed reforms that has provoked controversy. It has been argued that the dynamic nature of the trading strategies and mobility of hedge funds, as well as the increased market efficiency and liquidity promoted by hedge funds and private equity dealers makes increased regulation both futile and potentially harmful.
The actual bills are each over a thousand pages long, the House bill can be found here, and the Senate bill here. Alternatively, read the summary of the Senate bill here and an even briefer summary of both bills here.
A Bailout Bill?
The authors of both bills claim to have ended the era of ‘Too Big to Fail’ (1,2) banks, thus precluding the possibility of taxpayer-funded bailouts. However, the actual mechanisms of reform may have far less effect than is supposed in the summary. The House bill establishes two main ways to deal with the problem, neither of which is adequate. First, a Financial Services Oversight Council is proposed (3), an inter-agency body that aims to enhance the oversight of large financial firms posing a systemic risk to the wider economy. Second, a Dissolution Authority (4) will be established, finding ways to dismantle failing firms safely, apparently without cost to the taxpayer.
Both agencies are reactions to the development of large, systemically risky firms, but when an institution gets to the size of AIG or Citigroup, it is already too late. What is needed is not more bureaucracy, ‘acting after the fact’ of the development of such systemic risk, but real market competitiveness to limit the growth of systemically risky firms. The Senate bill proposes a similarly flimsy solution. Recommendations are to be made to the Federal Reserve for “for increasingly strict rules for capital, leverage, liquidity and risk management”(5). However, the Fed’s judgment on such matters is highly suspect given the enormous leveraged positions built up by some banks previously. Also, it could be argued that it is not any specific type of risk that is the issue here, but the sheer market share and size of some banks. Such requirements also, are notoriously subject to manipulation and trickery.
Such recommendations aim to discourage the growth of some financial institutions, arguably ineffectively so, but fail to address the problem of the large ‘Too Big to Fail’ firms in existence. It has been argued that the bill’s provisions to deal with the failure of such firms actually enshrine the possibility of taxpayer-funded bailouts (6). The Senate bill creates a ‘liquidation fund’ of $50 billion, the cost of which is funded by a loosely defined tax on the ‘largest firms’ (7). This fund goes towards any future liquidity injections needed if a systemically risky firm fails. Leaving aside the perverse incentives for now, it is highly doubtful that the funds raised by contributions from the largest firms would actually be enough to prevent general taxpayer money from becoming involved.
The amount given to Citigroup alone in liquidity injections was $20 billion, while upwards of $40 billion were lent to AIG, with similar amounts going to other firms. Owing to the interlocking nature of the financial industry, the likelihood is that when one fails, many such large firms will fail, leaving $50 billion clearly inadequate.
The bill hints at this possibility, stating that the FDIC (the body responsible for allocating the liquidity injections) can acquire working capital from the Treasury department (8). Since it seems that the $50 billion will not be enough, this amounts to an implicit government guarantee of the large firms. The Senate Bill effectively enshrines the principle of taxpayer bailouts, explicitly outlining the possibility of Treasury funds being deployed as capital for FDIC liquidity injections. It is indeed a ‘bailout bill.’
It is stated that in the event of Treasury funds being deployed as liquidity, the taxpayer will be “first in line for repayment” (9). This does not guarantee repayment in the short term, nor does it change the fact that government debt may have to rise in order to keep the financial system afloat, with all the associated problems. Perhaps even more worrying, however, is that by effectively guaranteeing a bailout for large firms, an incentive problem remains. Such firms will keep all profits from high performance, but face potentially softer losses as a result of poor performance. This is neither ethically justifiable nor economically efficient. it is certainly not free-market capitalism.
No Commitment to Competitive Markets
In explicitly outlining the possibility of Treasury-funded bailouts of large financial firms, the Senate bill hinders competition, in effect conferring a competitive advantage on the ‘Too Big to Fail’ institutions.
From the perspective of such firms, the prospect of a $50 billion liquidity injection, the cost of which is shared between various firms, and that of a FDIC bailout, effectively funded by the taxpayer, is favourable to the bare bankruptcy laws faced by smaller financial institutions. This creates what may be called a ‘soft budget constraint’ for the largest financial firms, in comparison to the ‘hard budget constraints’ faced by the smallest.
Not only does this actually encourage the growth of behemoths such as Citigroup, posing a systemic risk to the wider economy, but it drastically reduces the competitiveness of smaller firms. Lacking competitiveness in the financial industry, encouraged by such government guarantees, is bad for everyone except workers and shareholders of the largest firms in the short run, and bad for us all in the long run.
The perverse incentives outlined discourage competitive financial markets. Systemic risk is increased when large, ‘Too Big to Fail’ firms have highly correlated trading positions. It is almost futile to regulate such activities, given the number of transactions such firms take part in; the possibility of a bailout reduces the incentive for firms to behave prudently and encourages the growth of highly correlated positions amongst the largest firms. The best way to prohibit the development of such risk is to allow mistakes to be punished; the self-regulating aspect of financial markets can then kick in.
By breaking up the largest institutions, competition in the industry could be immediately increased. This is outlined as a possibility in the Senate bill, but it is advocated “only as a last resort” (10). Reducing the size of some quasi-monopolistic behemoths in the financial sector should actually be the first step taken, reducing overall systemic risk and restoring the sector to something like a functioning market is of crucial importance.
Poorly Aimed Regulation
Both the Senate and House bills are insufficiently sensitive to the dangers of softening the budget constraints of large financial institutions and the resulting decreased market competitiveness. In contrast, the legislators seem over-sensitive to the risk posed by the area of ‘alternative’ investments, specifically hedge funds and private equity. In the Senate bill, plans are laid out to bring hedge fund managers under the title of ‘Investment Advisors’, and to raise the threshold of regulation in order to increase the amount of ‘advisors’ under state supervision by 28% (11).
The danger posed by hedge funds is not as serious as is often claimed, and the benefits of increased liquidity and efficiency in financial markets must not be underestimated. Hedge funds take up so many different positions and, as the name would suggest, often hedge against the possibility of large losses, so that failures are more likely cancel each other out than with the large investment banks, whose positions are often highly correlated. There is also the possibility that hedge funds may actually diminish in importance as markets become more efficient and there is less opportunity to take advantage of pricing anomalies.
In fact, hedge funds fail all the time (12), and have been doing so for over a decade with limited systemic impact. There are exceptions to this rule, for example LTCM in 1999, but the large losses of one hedge fund were actually absorbed fairly well by the banks, among others. It is not clear that increased regulation would have made much difference in this case, since not many – fund managers, investors and regulators included – seem to have comprehended the risks taken on by LTCM. It is difficult to see how regulators would do a better job at assessing the risk taken on by hedge funds than the funds themselves.
It is even more difficult to imagine private equity dealers and hedge funds actually staying put in regions with increased regulation; both are notoriously mobile and could potentially relocate to a more hospitable environment. Increased regulation of this more nimble and adaptive area of the industry is likely to be futile.
In short, no one argues that hedge funds and private equity dealers played an important role in this crisis, and even less so that increased regulation of such institutions would have reduced the risk to the financial sector; tighter regulation would not therefore be a worthwhile investment of time or taxpayer money.
Conclusion
On two key points of reform, both congressional finance bills have got it wrong. The potential for a taxpayer funded bailout remains, as does the associated incentive issues for large ‘Too Big to Fail’ institutions. The Senate bill recognises that taking steps to increase market competition by breaking up the largest firms is the solution, but poses it merely as a last resort. By failing to take such steps immediately, and by enshrining the possibility of future emergency liquidity injections for the ‘Too Big to Fail’ institutions, the bill confers an advantage to the largest financial firms and thus shows no commitment to competitive financial markets.
While the proposed reforms are lacking and too inactive in ensuring competitive markets and breaking up the largest firms, the issue of the regulation of hedge funds and private equity dealers seems to have provoked hyperactivity. Increased regulation of these ‘alternative’ investments is both misguided and largely futile.
Based on the proposed reforms in the two congressional bills, US financial reform is likely to do little in terms of encouraging competition, and risks over-reacting and over-regulating ‘alternative’ investments.
References
- Wall Street Reform and Consumer Protection Act, 2009: page 325, Sec 1601, lines 7-14.
- Restoring American Financial Stability Act, 2010: “ends ‘Too Big to Fail” is part of the long title on the cover page.
- Wall Street Reform and Consumer Protection Act, 2009: page 25, Sec 1001, line 10-12.
- Wall Street Reform and Consumer Protection Act, 2009: page 325, Sec1601, line 5.
- Financial Reform Summary as Filed: page 4, ‘Discouraging Excessive Growth and Complexity:’
- ‘Yes, It’s a Bailout Bill’, Phillip Swagel, The Journal of the American Enterprise Institute, 24/04/10.
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 3, ‘Break Up Large, Complex Companies:’
- Financial Reform Summary as Filed: page 7, ‘Greater State Supervision:’
- According to HFR (Hedge Fund Research), 1400 failed in 2008 alone with limited market impact.
Gordon Brown’s Economic Record
Gordon Brown has claimed his management of the economy is the main reason why his Government should be re-elected. In view of his responsibility for the recession and the wreckage of the public finances, this is a breathtaking claim. For Mr Brown to claim credit for managing the economy during the recession is rather like a driver responsible for a major road crash claiming credit for taking the survivors to hospital.
The Brown storyline is that the recession was a one-off unforeseeable event, global in origin. It was created by greedy bankers who had to be rescued from their own folly. The truth is rather different.
The present recession was neither unique nor unforeseeable. A cycle of boom and bust has always been a feature of market economies: there were recessions in the UK as recently as 1975, 1981 and 1992 and a major stock market crash in 2001. As with earlier recessions, the bust of 2008-2009 was the result of a preceding credit-fuelled boomwhich artificially inflated the prices of houses, shares and other assets and securities. And although the consequences of the present recession were global, its origins were not. These origins are to be found in the lax way from 2000 onwards that the authorities in the UK and the US controlled the money supply and public expenditure, and regulated banking.
Just as the only way to escape a hangover is not to drink too much, so the only way to avoid a recession is to moderate the preceding boom. To do this, governments have at their disposal three instruments of policy, monetary – control of the money supply, fiscal – the power to vary taxes and government spending, and regulatory – the power to supervise the conduct of banks. Between 2000 and 2007, the Labour Government made major policy mistakes in all of these areas.
Monetary policy was kept too loose for too long. The Bank of England averted its eyes from the rapid expansion of the balance sheets of the banks. It ignored the bubble in house prices that its policies built up, targeting only increases in the prices of goods and services, and not the prices of assets like houses.
While he was Chancellor, Mr Brown made inadequate budgetary provision for the occurrence of a recession. Why did he fail to act? Perhaps he believed the siren voices of those American economists who told him that they had solved the problem of preventing recessions. Whatever the reason, as late as March 2007 he was still repeating his claim that “we will never return to the old boom and bust”. Martin Weale, Director of the National Institute of Economic and Social Research, has estimated that Brown’s rule of delivering a current budget balance over the cycle was too slack by about 3% of GDP.
The result of that error was revealed in the Budget of 2009. Large budget deficits will persist for almost a decade, long after the recession is over and the growth of the economy has resumed. This means that for years to come the country is condemned bothto an effective standstill in the provision of public services and to increases in taxation that will affect all families, not just the rich.
The third failed area of economic policy is in the regulation of financial markets. During the boom, neither the Bank of England nor the FSA exercised their powers to oblige the banks to keep more liquidity or to build up more capital. This was in large part because in 1997 Brown unwisely split responsibility for supervising the banking system between them.
The current British framework for financial regulation was created by Brown himself with some help from Alastair Darling: it is embodied in The Financial Services and Markets Act of 2000. Unlike, for example, Canadian banking regulation which restrained reckless lending by that country’s banks, so that none collapsed during the financial crisis, bank lending in Britain to people who couldn’t afford to repay their loans was not just tolerated but actively encouraged by the Government in the name of ‘social inclusiveness’.
The other major omission of Brown’s banking legislation is that it made no provision for the orderly liquidation of a bank in the event of its insolvency. This meant that the Government was forced into an emergency £50 billion bail-out of the banks in the autumn of 2008. Had that money been available for spending on infrastructure, it could have provided a more productive use of taxpayers’ money.
People may also remember Brown’s ill-judged decision to sell off half the nation’s stock of gold in 2002, when the price of gold stood at one quarter of its present level. It is said that when your neighbour loses his job that is a recession, whereas when you lose your own job, it’s a depression. Many people might think that when Gordon Brown loses his job, it will signal the beginning of a recovery.
David Simpson is a former Economic Adviser to Standard Life. He is also the author ofThe Recession: Causes and cures (PDF), which was published by the Adam Smith Institute in June 2009.
Wealth inequality and the Hills Report: a critical assessment
Synopsis
The National Equality Panel recently released its inaugural report. Called the Hills Report after the panel’s chairman, it manages to specifically and directly ignore strictures offered by the Office of National Statistics (ONS) on how to measure the gender pay gap, overstates income inequality and wildly and grossly overstates wealth inequality. They have also ignored all of the things that we already do to try and narrow the wealth gap.
The major claim picked up by the newspapers – probably because it was emphasized in the National Equality Panel’s own publicity about the report – is that “household wealth of the top 10% of the population stands at £853,000 and more – over 100 times higher than the wealth of the poorest 10%, which is £8,800 or below”(1). A more accurate estimate of that wealth gap would be somewhere between five and ten times higher. The error comes from the report’s authors ignoring the major source of both income and wealth for the poor in our society: the welfare state.
Minor matters
It has long been a favourite trick of those who talk about the gender pay gap to conflate various extant pay gaps and attribute them all to gender. This is political prestidigitation with statistics to make the problem seem larger and more important than is actually the case. Greater problems are more likely to have political attention paid to them. And so with the gender pay statistics, a running theme has been to add together two quite different things.
The first is the real gender pay gap. It is true that women in general are paid less than men in general. While the methods used to calculate this are still somewhat suspect – taking no account of different levels of human capital, choices about jobs done and so on – the Annual Survey of Hours and Earnings (ASHE) from the ONS suggests that a gap does exist. On the basis of hourly wages without overtime it is certainly the case that women get paid less than men on both median and mean average measures.
The second is the part-time pay gap. Those who work part-time tend to receive less compensation per hour of labour than those who work full-time. We can see this from the ASHE statistics. As with the gender pay gap, the reason this is the case is a complex matter. But it is indeed the case that men who work part-time get paid less than men who work full-time.
There is a third fact we must recognize: more women than men work part-time. This is almost certainly a result of the way in which women in our society do most of the childcare (and indeed, caring for other family members as well). Whether this is how one would wish the world to be is less important than the recognition that for now, this is the way it is.
Putting these three things together we can see that if we compared the wages of all men with those of all women then we would not be describing the gender pay gap. We would be describing both the gender pay gap and the part -time pay gap. If were to call this the gender pay gap we would be misleading those to whom we were presenting our statistics, whether deliberately or through ignorance.
After some years of various people doing exactly this, the UK Statistics Authority, in the form of Sir Michael Scholar (2), wrote to the Equalities Minister, Harriet Harman, to point out that this technique “risks giving a misleading quantification of the gender pay gap”. If we look at the statistics one can see his point. The average Ms. Harman was using suggests a 23% gender pay gap while the ONS puts it at 12.8%. The ONS statistics use only full-time workers (and thus measure the pure gender pay gap) while the former figure conflates both gender and part- and full- time. It is thus inaccurate for the government and pressure groups to use the 23% figure, but this does not stop them doing so.
Sir Michael’s actions were a serious injuction and as close as we get to a mandarin slapping wrists – which is why it is a surprise to see the Hills Report doing the same thing just six months after this public admonition. In the report’s discussions of hourly gender pay, figures for all men and women working are used, both full- and part-time. This gives us a 21% pay gap (we have a new set of ASHE statistics to calculate it from). And that, as Sir Michael pointed out, is a “misleading quantification of the gender pay gap”. The report does go on to look at only full-time workers, but it does so in the context of weekly wages, not hourly ones. The authors note that women tend not to work as many hours a week as men but then sail on happily to ignore their own point and point to the gender pay gap again without adjusting for differences in such working hours.
To put it mildly, this does not engender confidence in how they have presented other information in the report. Why would a report to Harriet Harman depend upon a statistical method which she herself has been expressly told not to use?
A digression
It is extremely important that when we look at a problem we make sure that the information we have about it is accurate. It is not enough just to look at what the current situation is; we must also look at the effects of what we are already doing about it, or attempting to do about it. After all, there is the possibility that our current actions are making the problem worse. For example, with the gender pay gap there is at least some evidence that longer maternity leaves increase the size of the gap.
In our discussion of income and wealth gaps, however, the story of John Edwards is instructive. No, not the more tawdry tales of recent months, but his Vice Presidential campaign in 2004 and his more recent attempt to gain the Democratic nomination for President. In both, his stump speeches would point to the US poverty rate (at that time 12 and 13%) and insist that a wealthy nation could do better. Obviously, it is possible that it could, and whether it ought to is certainly a valid political question. Edwards would then go on to propose the following three policies.
- Firstly, a substantial rise in the Earned Income Tax Credit (EITC). This is very similar to our own Working Tax Credit system, which is not that surprising as our system is based on the US one.
- Secondly, a further one million Section 8 housing vouchers. This is similar in intent to our Housing Benefit. As with our own experience with council estates, the Americans realized that dispersing the poor through the wider society avoided creating pockets of deprivation like the vertical slums put up by the US Department of Housing and Development and now referred to as “the projects”.
- Thirdly, a large expansion of Medicaid, the US programme that provides health insurance to the poor.
However, these policies would not change the number defined as being in poverty by one single person. If spending on these programs was doubled, or even tripled, there would still be that 12-13% of the US population ‘in poverty’. This is because there is something very strange about the way that poverty is defined in the US.
The poverty line in the US is an absolute number: three times the food budget for a family in the early 1960s up-rated for inflation. It is not, like the poverty line in all other OECD states, a relative measure – we use less than 60% of equivalized median household income as our measure, for example. More importantly, the US poverty number includes in the income that qualifies you as poor only market income and direct cash grants. It does not include any poverty alleviation that comes through the tax system and does not include any aid that comes in kind.
The EITC is paid through the tax system, while health care and housing are both benefits in kind. Therefore they are not included. It is possible to raise the provision of these things, which do indeed reduce poverty, without changing the number under the poverty line by one iota. Indeed, this is largely what the US has been doing since the 1970s. The EITC, for example, was introduced 1975. Before this the major poverty alleviation program was what we now call “welfare” – simple cash payments to those who didn’t have enough money. A bipartisan change came in around the time of the EITC determining that we should provide benefits to the poor not in cash, but either through the tax system or as benefits in kind.
All of these programmes have been expanded in the decades since then, and the US poverty rate has barely changed. This is not a surprise when the system doesn’t actually take account, when measuring poverty alleviation, of the things that are done to alleviate poverty. One estimate is that the $40 billion a year spent through the EITC lifts 5 million families above the poverty line. Yet in the official statistics they’re still under it.
It is possible to look at the US poverty figures and conclude that something went drastically wrong in the mid 1970s. The number under the poverty line had been falling sharply since World War II and then essentially flat-lined. Indeed many do look at those numbers and then leap to the conclusion that it was Reagan, or the neo-liberals, or some other hated figure or group, that caused poverty levels to stop falling. A more accurate analysis is that before this date we included all the effects of what was spent upon poverty alleviation before calculating how much poverty there was. Now we include only a minor portion of it. It is therefore of little surprise that spending on poverty alleviation has continued to rise without there being much change in the poverty rate.
This is not just some recondite point about statistics. If you were a politican, like John Edwards, you could advocate massively increased spending on poverty alleviation while knowing that this increase would have absolutely no effect upon the metric you were using to measure the problem. Which politician would not like to have an issue which calls for ever greater effort but which can never be solved?
Ending the digression
Of course, we in the UK don’t do anything quite so silly in our measurements of poverty and what we spend upon its alleviation. We use total income as our measurement: income after all taxes and benefits have been included. Don’t we?
Well, actually, no, we don’t. In the UK have universal healthcare, the NHS. Everyone is entitled to the treatment they need – as long as it’s not too expensive – as of right. This matters little when we try to look at static levels of inequality or poverty here since everyone has access to the same services. However, if we want to compare either income or wealth inequality over time, then it needs to be taken into the calculations.
Furthermore, we need to look very carefully at the Hills Report’s method of looking at income and wealth inequality. For in fact, in their look at wealth inequality, they manage to entirely ignore not just the effect of the NHS but the entire apparatus of what we call the welfare state. When we include these effects, far from the wealth gap being 100:1 a more accurate estimate would be 5:1 or 10:1.
Apologies
In the following sections I am not going to try and explain the intricacies of each and every aspect of the welfare state. Who is eligible for what under which precise circumstances is not part of the remit of this paper. I intend to take just a few examples to show the point. I am also not aiming to state an authoritative set of figures. The aim is simply to explain the basic idea, and thus the flaw in the Hills Report’s estimates.
There is also one conceptual point that needs to be understood: a stream of payments that you are entitled to is indeed wealth. You may not be able to sell it, you may not be able to transfer it, but we can and do calculate what the capital value of that stream of payment is.
Consider, for example, a private pension plan. At some point, by law, you must convert this into an annuity. An annuity is a stream of payments and in this case one that will last for the rest of your life. As a rough example, these days, a payment of £100,000 will secure, for a 65 year old man, a stream of payments of £6,000 per year until his death. It is thus entirely logical to turn around and run the calculation the other way: a stream of payments of £6,000 a year until death for a 65-year old man has a capital value of £100,000. It is, in short, wealth of £100,000.
Thus, if the State old age pension were £6,000 a year, then each and every person eligible for that pension would have wealth of £100,000. And it is this point which the Hills Report has failed to include in its calculations of the wealth gap. The welfare state provides almost all of us with some such wealth. It provides some of us with very much more than others. The wealth gap is thus closed by the fact that we have this welfare state. By ignoring it, we make the John Edwards mistake, failing to account for what we are already doing to reduce the perceived problem.
Examples
As Polly Toynbee says in one of her recent columns (3):
The excellent plan in the green paper suggests a long-term solution, fair and sensible. On retirement anyone with the money would pay a lump sum – around £20,000 – to cover all future care, at home or nursing home. They would never need to pay another penny. If they own a home but have no money, the sum can be taken from their estate after death. Those with neither savings nor property would be paid for by the state.
At present the system is that the poor get such services free (as they would in the future), while those with either high incomes or high levels of wealth have to pay for such services. There are many stories of people running down their savings to pay for care homes, with the local council picking up the bill once the money runs out. Or of people selling houses to meet such care bills. What the green paper proposal gives us is an estimate of the capital value of that option that the poor have and the rich do not. It is only an option of course, since not everyone moves into a care home: even now many of us die in our own beds. But the value of that option is clearly £20,000. Those who have that sum must pay it, those who do not have it do not: but both get the same services. Not having to pay thus equates to wealth of £20,000.
Old age pension
Puzzlingly, the Hills Report considers only private pension plans to be wealth that should be counted. They look at “personal marketable wealth” and refer to Wealth and Assets Survey (4), in which we find the following two points being made:
The wealth from pensions in receipt is calculated as the present value of the future income stream that the individual will receive.
This is the same method that I am using to provide an estimate of the Net Present Value (NPV) of other state derived income streams.
We are also told that:
The figures in this chapter relate to private pension wealth only. Since wealth from state pensions is more evenly distributed than wealth from private pensions (as a result of the contribution and benefit formulae), the distribution of total pension wealth (i.e. state plus private) will be more even than that described in the figures below.
How interesting that everyone decides not to use the state pension in the calculation of assets or wealth then, isn’t it? As a rough idea of what the state pension is worth at a net present value, assume that life expectancy at 65 is 15 years. This isn’t too far off the truth. Also assume that the pension itself is £5,000 a year. It isn’t, it’s less than this, but the minimum pension guarantee (which is going to be received by those with no other wealth) is higher, so to a certain extent it all comes out in the wash. The other thing we need to know to get an NPV is the discount rate. Currently the long gilt yields are just over 4%, which would give us an NPV of £60,000. However, the state pension (in contrast to the usual annuities bought with private pension plans) is inflation upgraded each year. So the more appropriate interest rate would be that on inflation indexed gilts, around 1% at present. This gives us an NPV for the state pension of £75,000.
The NHS
As a round number it costs £2,000 a year to provide the NHS to each adult in Britain. There are indeed countries where health care must be purchased out of disposable income: thus not having to pay this insurance bill for the NHS is a source of wealth. Assuming only a 25 year receipt of this free at the point of use health care (these are all simply examples, remember, not attempts to provide strictly accurate numbers) this has an NPV of £46,000, again at that 1% interest rate. As the poor in income are net receivers of benefits from the tax and benefit system it seems logical to state that they thus have an asset of £46,000 or more.
There are many more such benefits available as part of the welfare state, but rather than try to provide an exhaustive list (education free at the point of use, etc, etc, all things which in other countries or at other times have had to be paid for), here is just one more example…
According to the Hills Report a household in the bottom 10% of the income distribution has an average market income of £4,700 a year. After benefits (but not including the education, pension or health care benefits above) the income rises to £14,300. Call that £10,000 a year as a round number and at our 1% discount rate for 25 years that income stream has an NPV of £228,000.
Marketable and non-marketable wealth
It is true that the Hills Report tries to, or at least says it tries to, look at marketable wealth. But private pension plans are not marketable: you’re not allowed to sell them. So they are at least slightly in breach of this idea. But much more important than this is that marketable wealth isn’t the important determinant.
For example, owning a house which you can sell is to have marketable wealth. Living in social housing or being in receipt of housing benefit is not marketable. But both are wealth: both lead to you living in better housing than you would without that asset. And if you sell your house and bank the money you will not get social housing or housing benefit. Only those who do not have marketable wealth receive either. And the wealth that comes from subsidized social housing or, indeed, housing benefit itself can be calculated.
There is one other point to make about this “wealth” that comes from the welfare state. All of these things, the state pension, the NHS, help with housing, benefits such as jobseekers’ allowance, tax credits and the rest of the system: all of them are supported precisely because they make the poor wealthier. That is their purpose. To suggest that while we spend a couple of hundred billion pounds a year on the entire system, we cannot count, and should not include the increase in wealth which it provides seems remarkable, if not unsupportable. It is to make the John Edwards mistake again.
Conclusion
The Hills Report states that the wealth gap between the 10th and 90th percentile is of the order of 1:100. It says that the average 10th percentile household has assets of £8,800 and the 90th £853,000. But it is only possible to reach this conclusion by ignoring all of the things that we already do to redistribute wealth.
Just as we do with income inequality, we should measure wealth inequality after the influence of the tax and benefit systems. The benefit system provides a number of income streams to the poor and we can calculate their net present value by treating them as an annuity.
Combining the value of just the NHS and the state old age pension every individual has wealth of over £100,000. This must of course be added to the wealth of both poor and rich but it brings the 90:10 wealth ratio down to 10:1.
Looking purely at the income support available to an average 10th percentile household the value of their annual receipts from the welfare state is some quarter of a million pounds when capitalized. This lowers that 90:10 wealth gap to somewhere under 5:1.
It much be stressed that all of the calculations and examples here are only indicative. No attempt has been made to develop authoritative statistics on wealth inequality. But my examples nevertheless clearly illustrate the argument presented here.
Overall then, and in conclusion, if we are to attempt to measure the wealth gap in the UK, we must measure it after the influence of the tax and benefit system on the wealth gap, just as we do with income inequality.
It might be righteous and just that we should do more to close this wealth gap. It might be that what we already do could or should be done better. But before we attempt to answer those questions we have to analyze what it is that we are already doing and the effects this has on the wealth gap.
The Hills Report neglects entirely to do this and is therefore an unhelpful contribution to the debate.