Is pain aversion a good basis for the country’s economic policy?
We all know the UK and its citizens have lived beyond its means for far too long, with consumption and government expenditures allowed to range well ahead of the ability to repay the debt that was being run up – UK government debt is approaching 100% of GDP, and is perhaps twice that if you add in public pensions, PFI and bank support. (See Miles Saltiel’s On Borrowed Time for a detailed look into some of these commitments.)
We reached a position last year where the Government was spending £4 for every £3 it raised in taxes. Only a couple of nations – Ireland and Iceland – managed to increase their debt relative to GDP faster than the UK in the last 3 years.
We are, however, far from alone – the Western world is generally overspending and overindebted – and has poor demographic prospects too. The USA will spend $1.40 for every dollar the government raises this year. Ireland, Greece, Portugal, Spain, Italy are all ropey in considerable measure. Events outside our borders are a risk for our economy. Global financial stability seems unlikely.
The debt binge has been going on for a long time – 20 years ago, total private debt in the UK ran at 150% of GDP, which doubled to 300% eight years ago and has now increased to 450%. Consumers and industrial companies roughly doubled their leverage in those 20 years whilst financials went up by a factor of around 5 times – though almost no-one can now really disentangle or define the debts of the financial sector as they trade in increasingly impenetrable derivatives and structured finance products.
Only 20 years ago the Government was briefly spending less than its income. State spending’s share of GDP has risen steadily towards 50% of the economy. Experience of history suggests that 40% is about the limit – above this growth tends to slow and stop.
In 2008, failures in the structured finance and investment banking industries precipitated a major global financial collapse – Lehman, RBOS, AIG, Bear Sterns, Northern Rock, and even the seemingly-secure Alliance and Leicester failed. Britain’s GDP fell by around 6% in a year. Unemployment went up painfully, but actually, surprisingly little – from 5% to 8%. This was much less than the rise from 4.5% to 10% in the USA.
And we have suffered much less pain and failure than might have been expected in our economic system – company failures are at near 30-year lows and housing repossessions are remarkably low, given the financial shambles. House prices have suffered little – indeed, people with large mortgages on variable rates have seen a huge rise in their disposable incomes, as Lord Young pointed out (perhaps unadvisedly) last month.
The recession hasn’t been anything like as bad as we might have feared – or perhaps deserved. Or has it? The remarkably mild short-term consequences of the last decades of debt orgy have mostly been the result of policies designed to lower interest rates to levels not seen in 30 years in the UK. You can manage a lot of debt if you pay next to no interest. The government has printed money (lightly disguised and much obscured by the new name “quantitative easing”) and increased borrowing to avoid cutting government spending and to maintain low interest rates. This may have reduced unemployment and mitigated some financial distress in the short-term. Put simply, we’ve tried to solve the difficulties of having too much debt by using more debt and making that debt tolerable – at least for a short time. Quite a few people have compared the process to treating a hangover by drinking more alcohol, and it’s a good analogy. You feel better temporarily, but actually the problem grows. The debt is still there, and bigger, the day after.
These policies punished individual savers who saw the value of their savings slashed, whilst those with reckless levels of personal lending were given a sharp rise in disposable income. The massive increase in Government borrowing enabled the current generation to live comfortably whilst leaving the burden of paying off the deficit to our children.
The inflationary policies meant that savers and people buying annuities have been hurt, while borrowers have been rewarded and protected. Parents might be fine for now, but their children will struggle paying for their irresponsibility. It is pretty likely that by avoiding pain now we ensure that the future economy will be weaker and riskier. It does not feel a very noble policy, and the continuation of these policies seems increasingly likely as we try to protect our current excessive consumption.
In the corporate world, the very low failure rate of large companies is the consequence of very low interest rates, massive Government support of businesses with uncollected taxes of some £30bn-plus propping up a number of enterprises, and a banking sector generally unwilling or unable to recognise losses. Industrial debt runs at twice the level of the early 1990s recession. That recession was only one third as deep as our recent one. So, if interest rates rise, we should expect more failures than then – and corporate insolvencies then ran at 6 times today.
This lack of corporate casualties is not necessarily good news. Though in the short term it reduces job losses and the (very real) pain that involves, many enterprises that would normally have perished continue to trade. Assets and people that are tied up in those hopeless businesses would do more good for the economy deployed elsewhere.
It is unlikely you will hear our politicians say it but actually we live in a time with an unhealthily low rate of corporate failure – an infeasible line for any political party. The policies of low interest rates have protected the weak, inefficient and, in some cases, blameworthy parts of the economic world and prolonged a misallocation of resources in areas that could not survive by themselves.
Consider what has happened in the world of banking, especially investment banking. A combination of state guarantees, abundant state subsidies and a capricious approach to regulation has enabled flawed banking models to survive in spite of their mistakes. Why did this happen? In part, simply because of an unwillingness to take the pain of more bank failures during the crisis. Now I fear an unwillingness to tackle the remaining threats to the financial sector caused by the immediate pain of restricting and dividing banks into the essential bits and the gambling pieces – or allowing the riskily-structured ones to fail outright.
In general, society is pretty short-term in its views – sadly this often leads to trading off integrity against short-term profits. This obviously generates a bias against integrity and stability, which is allowed free rein when the moral hazard of bailouts are present. This creates a vicious cycle of irresponsibility, the consequences of which are paid for by the taxpayer.
It was not easy to believe from their words that any of the parties in the last election actually were aware of the scale of public spending cuts that had to come. Pain aversion was at the core of the politics. Politicians danced throughout the election campaign between the awful reality that they faced and their desire for election.
Margaret Thatcher never actually cut public spending overall, and older souls may remember the pain during her reign. Simply to stop the national debt from rising even higher, the current government needs to get the gap between spending and revenue down by £150bn – which would mean a 28% cut in spending. All history says that tax rises can only play a very small part in bridging the gap – spending has to take the strain. Indeed, tax cuts to stimulate growth can be sensibly argued for.
And given that the Coalition has said they will protect the spending of the NHS and international aid actually the rest would have to drop by around 35%. The Coalition will need extraordinary courage and cohesion to get anywhere near this. As it is a willingness to avoid short term pain whilst harming future prospects is clearly in the Government plans to cut net investment by two thirds over the next five years rather than deal with the further grief of more cuts in revenue spending.
Even relatively mild cuts will be very difficult. Trident, social workers, cancer drugs, school milk, nursing care, pensions, and the list goes on. Choosing where the pain is to be felt is a very difficult task with a great deal of pain to be distributed.
What price a good short-term economic recovery?
Is the FT’s Martin Wolf right to say “Any recovery is better than none”? This simply cannot be true – the costs have to be measured. Short-term growth is not worth having if we mortgage our futures to get it.
Should we carry on with a policy designed to simply reduce the rate of increase of the national debt in order to get a rapid recovery? Current Government plans see some £400bn added to the Government debt before it is planned to stop that debt increasing.
It is generally the experience that highly indebted economies grow more slowly than less indebted ones. Less wealth is likely to be available in the future if there is more debt.
It is very likely that the economy will grow slower with the state at half the economy rather than the 40% or so which has generally proved just about sustainable. It is certain that every pound of debt put onto the national balance sheet either has to be serviced, defaulted or inflated away.
It is certain that the levels of debt and deficits in the developed Western economies are in historically high and largely uncharted territory. Whilst there have been times of very high debt – say post WWII – things were very different. When creditors get to fear default or inflation, interest rates will certainly rise, and that would really hammer the highly leveraged UK economy. Only the timing of this event is uncertain.
The government is currently talking quite toughly but its plans still mean continuing to load debt onto the next generation over the coming years and relying on low interest rates persisting, decent economic growth and stable international financial conditions to get close to equality in spending and income in 5 years – a very uncertain prospect. Even if all the winds blow in the right direction, achieving this equality is not in itself a victory – there will be a very considerable debt mountain to be lived with.
It must be right to be concerned that the Coalition may lack the necessary stomach and cohesion to grasp the nettle firmly. Union opposition seems increasingly likely to be resolute.
With all this in mind, it’s pretty clear that it would be better for the country to take the pain now and get the deficit down more quickly. Yes, it would probably mean more unemployment and business failure in the short run, but it could provide a much better base for future growth. Resources would move from the public sector to the private sector quicker and, with a more sensibly balanced and less levered national economy, growth would return. It would be less risky and definitely a great deal more morally honest to cut the state quicker. Our kids do not deserve our debts.
The Adam Smith Institute assesses when Britain might go bust
We are in a much bigger debt hole than any government is prepared to own up to. On top of the trillion or so they admit, you have to add another three trillion or so for the future costs of public and state pensions. Then what about the cost of all those healthcare and other benefits? Our problem is not just that the last government spent billions trying to borrow its way out of economic incompetence – and indeed trying to borrow its way out of debt. Our real, long-term problem is that we have promised ourselves more and more generous benefits on the assumption that we can pass the bill to our kids.
If we had the decency to kill ourselves with booze and fags, there wouldn’t be so much of a problem. But now we are all goody-goodies and living well beyond our allotted span, all those promised pensions, health benefits, free TV licences and bus passes, winter fuel payments and the rest add up to an unpayable bill.
Saltiel looks at three scenarios. The first is where the current Government’s ‘cuts’ – well, you know what I mean: reductions in the rate of increase – work through until 2015, and then the proceeds of any economic growth after that go to fund yet more government spending. That is not as outlandish as it sounds, because governments these days are pretty good at swallowing up the greater part of our economic growth. But if they do, Saltiel figures Britain will be bust by 2019.
The second scenario is where future governments show uncharacteristic restraint and split the proceeds of growth 50:50 between increasing public spending and reducing public debt. We still go bust, but not until 2031.
The third possibility is where all post-2015 growth goes into paying off our debts. The cheery conclusion is that in time, we could actually pay off the national debt. The chilling conclusion is that even with restraint on that scale, it wouldn’t be paid off until 2041, so there’s only an evens chance that I would live to see it.
We can’t keep voting ourselves gold-plated social benefits. We need to make politicians fess up to the real scale of the obligations we have shifted onto future generations, so we can see just how deep a hole we are in. Then we need to make them reveal the future cost of new policies they propose today. And we need to put limits on how much cost we can push onto our children. Otherwise, both generations have had it.
Airport regulation in the United Kingdom
The aviation industry in the United Kingdom has undergone a drastic transformation since 1980. Privatisation and partial deregulation have created a robust and competitive private market for air travel in the place of the old, government planned system. Britons have enjoyed substantial decreases in the cost of air travel, while the number of routes and the range of destinations available to them expanded. These domestic changes were accompanied by a succession of European Union measures that gradually removed international regulations that complicated air travel between the member states.
The British air travel industry is arguably the freest it has been in its century-long history, with consumers, business and the Treasury all reaping the benefits of an inexpensive, safe and convenient mode of transportation. Yet despite the significant progress that has been made, there remain significant hurdles to the realisation of a truly efficient and competitive aviation industry in Britain, namely the way in which the government proceeds with the regulation of airports. This article identifies the major barriers to efficiency in the aviation industry and recommends that clear and strong property rights would resolve many of the problems currently faced.
Background
During the first half of the twentieth century, British airports were fully controlled by the Ministry of Defence. As commercial aviation became more popular and more complex, this inflexible form of administration was relaxed. However, instead of privatisation the British government opted to maintain ownership of most airports and created the state-run British Airports Authority (BAA), which assumed control over Heathrow, Gatwick, Stansted and Prestwick airports in 1966, and Edinburgh, Aberdeen and Glasgow airports in 1971. BAA was eventually privatised under the Airports Act 1986, and though this was an improvement on the previous system of state control, various regulations persist that inhibit the development of a competitive, efficient market in aviation.
The Airports Act 1986 included various regulations such as ‘traffic distribution rules’, which controlled the allocation of flights to various airports, and price controls, which determined how much certain airports could charge to airlines for the use of their facilities. These regulations were intended to be temporary measures that would ‘protect consumers “until competition arrived”’, and were targeted at airports owned by BAA; regulators believed that the company’s large presence in certain markets such as London would allow for monopolistic control and pricing that was unfair to consumers.1 In addition to restrictions on landing, departure, and gate charges, airports were also prevented from selling landing and takeoff slots, which are instead allocated by a system of grandfather rights that permits airlines to use slots if their utilisation of the slot was 80% or higher during the previous year.
In the time since the Airport Act 1986 has been in effect, the commercial aviation industry has experienced explosive growth. The number of passengers using London airports, for example, doubled between 1987 and 2000.2 Both Heathrow and Gatwick airports have been operating close to capacity for years, and demand for landing slots at the airport has become very high. Yet some of the ‘temporary’ regulations that were enacted in 1986 continue to govern the industry today, and cause significant distortions.
Challenges
Price controls remain in place at Heathrow, Gatwick, and Stansted airports, because the Competition Commission believes these airports retain semi-monopoly power that could result in ‘unfair’ pricing. The Civil Aviation Authority establishes maximum charges that these airports may charge. The determination of such prices is not entirely objective and sometimes involves a great deal of subjectivity on the part of the regulator. Peter Scott of the University of Bath School of Management writes: ‘It is clear that the particular maximum price set by the regulator is not the result of the application of some clear economic rule but of informed judgment in the midst of great uncertainty.’3
Price controls strictly limit airport revenues from airlines, forcing airport owners and operators to look elsewhere to raise money. Heathrow, for example, has received substantial criticism in the past for placing too much emphasis on retail stores at the expense of passenger amenities. British Airways CEO Willie Walsh said that this was ‘typical of the English short-termism, lack of planning, lack of investment,’ while former London mayor Ken Livingstone called it ‘shameful’. But, instead of levelling criticism at BAA, Mr. Walsh and Mr. Livingstone should have focused on the activities of the CAA. The price controls explain why the airport concentrates more on retail than passenger comfort: The Economist noted in 2007 that landing fees at Heathrow are one-third lower than comparable airports in New York City, and that retail stores offer one way for the airport to make up for the government-imposed handicap.4 The only way BAA could devote more money and space to passenger amenities would be by raising the fees it charges to airlines. The government forbids this, so passengers suffer the consequences.
Similarly, the legal treatment of landing slots is a relic of the state-controlled system that creates perverse incentives for airlines and misallocates scarce space on runways and taxiways throughout Britain. By law, landing slots are allocated through a grandfather system where airlines that have utilised a slot in the past may continue to use it in the future so long as the airline has a utilisation rate of 80% or higher. If they do not meet this requirement, airlines will lose their slots. This system is a poor way of allocating a resource as scarce as landing slots, and is replete with unintended consequences.
When passenger loads are light, such as during economic downturns, airlines with valuable landing slots have an incentive to continue flying flights in order to preserve their landing slots for the future, even though their aircraft are nearly empty. Bmi, for example, flew ghost flights to Heathrow airport throughout 2008 in order to maintain their rights to landing slots valued at £770 million.5 This waste is a consequence of the general interference with normal market mechanisms that would allocate slots to the most profitable routes at peak times at airports where runway and gate space are scarce. Airports, meanwhile, are left with little say over which airlines use their runways, gates, and taxiways. Though there exists a market for secondary trading of slots, it continues to be hampered by regulation and is not widely used: SEO Economic Research reported that even as late as 2009, only 1% of landing slots at Heathrow were traded annually.6
The government’s purported efforts to enhance competition through regulation are undermined by restrictions on airport development, which complicate any private effort to build or expand new airports. Whereas in a competitive market, monopolistic activity is quickly eroded by the entry of new producers into the marketplace, strict regulations discourage the construction of new airports, making entry into the market more difficult. Further runway development at Heathrow, Gatwick, and Stansted airports was vetoed by the Coalition government earlier this year, and BAA’s effort to develop a fifth terminal at Heathrow to accommodate passenger numbers that substantially exceeded capacity was retarded by a lengthy eight-year approval process that involved the longest planning inquiry ever held in the United Kingdom.7 There are externalities associated with airport expansion and building, but these are best dealt with at the local planning level, not the national level where they are subject to posturing by politicians.
One of the main arguments used to support the current regulatory framework is that some airports, such as Heathrow, Gatwick, and Stansted, enjoy monopolistic power and if unregulated would be able to charge airlines and passengers ‘unfair’ prices for the use of their facilities. Though there are significant barriers to entry into the airport market due to government regulations themselves, the perception that airports are immune from competitive forces is a fallacy.
Airports have many different types of passengers that use their services for various reasons, and airports face significant competition for each type of passenger from various substitutes. Airports competing for a larger share of the market for domestic passengers or passengers flying between the United Kingdom and Continental Europe, for example, face competition from ferries, rail services, bus companies, and car rental agencies. Airports such as Heathrow, which host a substantial number of international transit passengers, must compete not only with such domestic alternatives, but also with other large international airports. Amsterdam Schiphol, Frankfurt Main, and Paris Charles de Gaulle, for example, provide Heathrow with strong competition for such passengers. If landing fees were raised by an inordinate amount at Heathrow, airlines and passengers would simply opt to fly to less expensive or otherwise more attractive airports elsewhere in the world.
Solutions
The current system of aviation regulation is anachronistic and has created significant distortions in the market. Airports do not have full control over revenue, scheduling or development, and airlines are subject to significant rigidities in route planning which increase the time and cost of travel for passengers and freight. Scarcity is artificially created in the system through strict planning regulations, and British law prohibits airports from efficiently managing this scarcity by raising prices. The result is overcrowding, poor service, and higher prices for consumers. Changes to the regulatory environment must be made in order to preserve the competitiveness of the United Kingdom’s aviation industry, which employs more than 500,000 Britons and contributes more than £11 billion directly to the economy. If the government is intent on discouraging future growth of airports to combat climate change, a market-based approach must be used to efficiently manage the scarcity of airport space in the country.
In order to accommodate higher demand and avoid shortages, airports must be able to set their own prices. These market prices will, in turn, allow British airports to improve their facilities and services, which they must do in order to compete with other airports and modes of transportation. Similarly, well-defined property rights must be created for landing slots, and these should belong to the owners of the airports to be distributed as they see fit, not distributed by arbitrary government rules.
The most logical way forward would be to give complete control over the ownership, pricing, and management of landing slots to the airports, which have the best knowledge of how to allocate their property. This would also incentivise future airport development and expansion where planning concerns allow for it. Alternatively, landing slots could be defined as the fully fungible property of the airlines, which would have the ability to sell their slots to any buyer, whether they were airports, airlines or investors. Either option, as long as the ability to sell the landing slot was included, would be an efficient market system that would allocate scarce landing slots to those who could make the most profitable use of them, and both would be an improvement on the current system. The legal status of landing slots is shrouded in a haze that must be cleared in order to better benefit passengers.
The aviation industry is vital to the United Kingdom’s economic and social wellbeing. Trade, business, tourism and the jobs of millions of Britons all depend upon the success of aviation. Nevertheless, the industry remains subject to a great number of state restrictions and regulations, which exacerbate the scarcity of airport facilities, harm their quality and misallocate routes to inefficient users. Even with the government’s desire to slow the growth of aviation in order to curb greenhouse gas emissions, the system can be managed in a more appropriate manner with the introduction of property rights and an end to price controls. It is time for regulators at the CAA and the Competition Commission to take a break, cut back on regulation, and give passengers, airports and airlines a breath of fresh air.
1) Nienke Hendricks and Doug Andrew, “Airport Regulation in the UK,” In The Economic Regulation of Airports: Recent Developments in Australasia, North America, and Europe, Peter Forsyth, David Gillen, Andreas Knorr, Otto Mayer, Hans-Martin Niemeier, and David Starkie, eds. (Aldershot, United Kingdom: Ashgate Publishing Limited, 2004), 101.
2) “Passengers and Air Transport Movements,” Civil Aviation Authority, “www.caa.co.uk/docs/ 1/ADU%20Airport%20Stats%20Master.pdf” (accessed 6 August 2010).
3) Peter Scott, “Economic Regulation of Airports in the UK,” Centre for the Study of Regulated Industries, University of Bath School of Management, 2004.
4) “The Man Who Bought Trouble,” The Economist, 5 July 2007, http://www.economist.com/ node/9440733 (accessed 4 August 2010).
5) Helen Nugent, “Planes ‘fly empty’ to keep slots at Heathrow,” The Sunday Times, 16 July 2008. http://www.timesonline.co.uk/tol/travel/news/article4340518.ece (accessed 6 August 2010).
6) “How airlines play the aviation slot machine,” Reuters, 3 March 2009, “http://www.forbes.com /feeds/afx/2009/03/03/afx6119917.html” (accessed 9 August 2010).
7) Keith Boyfield, David Starkie, Tom Bass, and Barry Humphreys, “A Market in Airport Slots,” Institute of Economic Affairs, 2003.
The Threat of QE2
And so it comes to pass: the perceived failure of quantitative easing to deliver economic growth has led to calls for even more quantitative easing. The puzzled public are caught between the mounting shrieks of ‘if at first you don’t succeed… but this time with conviction’ on the one hand, and ‘only a fool makes the same mistake twice…’ on the other.
I don’t intend to settle this debate – declaring it ‘right’ or ‘wrong’ oversimplifies what is a complex issue. But there are some important points that are worth emphasising.
Firstly, let’s confront terminology. QE is not exotic or new – it is just printing money. Even if it has the best intentions to not let it escalate into hyperinflation, the Bank of England buying assets on the secondary market is essentially a gradation of the policy that Mugabe’s government has unleashed in Zimbabwe. One arm of government is buying up the debt of the other. We can pretend that those two arms are separate, but that illusion is becoming harder to maintain by the day.
Finding the right solution to the current economic challenges depends on correctly identifying the actual problem. Consider the issue of bank bailouts. The original reason for having a lender of last resort was to provide emergency liquidity during a bank ‘panic’ and to help unwind unsound banks so that they wouldn’t pose a systemic risk. As time has passed since the first round of QE1 we have realised that it wasn’t merely a short-term liquidity problem, but a fundamental one of solvency. This cannot be cured with a quick gush from the monetary spigot, and direct bailouts merely obscure the distinction between liquidity and solvency problems further.
It’s also the case that monetarists are right to mock scaremongering about hyperinflation. When QE1 was launched in March 2009 I warned that we were in for another bout of inflation, and I confess that this has yet to materialise. Yes, the CPI is above target (3.1%), but not to the extent that I (and others) feared. Having said this, we should avoid making the same mistake we did in the build up to the financial crisis by focusing solely on the CPI as our inflation measure. The RPI is at 4.6%, and the PPI for input prices is 9.5%. We should also remember that inflation could manifest itself in asset price bubbles, for example in the gilt market or emerging markets. So although QE might be ‘working’ a little ‘better’ than we realise, we are still waiting for the forecasted inflation to truly bite.
Indeed, those who believe that low interest rates and a fast growing monetary base imply expansionary monetary policy make the same mistake that economists made during the Great Depression. Then, as now, they were actually signs of an inept central bank failing to offset a fall in the broader money supply.
This suggests that monetarists have a case when they argue that QE hasn’t been enough. The fact that gilts have such low yields suggest that markets believe that deflation is the more likely evil (for now), and indeed it is bizarre for central banks to try to inflate their way out of trouble whilst keeping inflation expectations anchored.
Central banks have created a tightrope with hyperinflation on one side and a deflationary spiral on the other, and by attempting to convince markets that they are alert to these threats they can increase the chances of both. Their concerns over inflation mean that they keep inflation expectations low. This increases the chance of deflation.
The excess liquidity that QE creates will find its way into the real economy at some point – possibly after the economy has already begun to recover naturally – and this is why having an exit strategy is so important. Again, the more confidence markets have in the efficacy of such a strategy, the harder it is for QE to ‘work’, but doubts remain as to whether this can be navigated. Some argue that it’s simple to hike up interest paid on reserves, or possibly even confiscate such reserves when banks begin lending again. However, this overestimates the Bank of England’s ability to anticipate events.
Some are concerned by the incentives that bank officials and policy makers face, and question whether they possess the practical skill set and motivation to do a better job of managing the bust than they did with the boom.
The main problem, though, is a knowledge problem – that no central agency possesses the knowledge required to ‘know’ how much money should be in circulation. There is a plausible free market argument to say that under certain institutional conditions (such as competitive banks and no moral hazard), increases in the money supply to offset changes in the demand for money would avoid adjustments having to take place through the notoriously ‘sticky’ real economy. In the same way that inflation creates real effects, so does a monetary deflation, and these effects are neither desirable nor necessary. However, whether this theoretical possibility can be acted upon is another matter. Even if central bankers had the benevolence to try to replicate markets, they most certainly do not possess the omniscience. Expecting such economists to comment on the ‘appropriate’ level of monetary expansion misunderstands the whole point. It is merely wishful thinking to expect central bankers to stabilise MV without returning to the conditions of the original boom – and setting the stage for another bust.
Indeed, attempts to do so exacerbate the paralysis of the economy. Policies like QE increase regime uncertainty and generate systemic instability. They have the potential to make matters worse, and ignore the fact that you cannot buy confidence. The Bank for International Settlements – one of the few organisations that foresaw large elements of the financial crisis – warns about the upside risk of continued low interest rates. Systemic misallocation of capital (including human capital) remains. Excessive risk-taking remains. Over-leveraged balance sheets remain. Volatile capital flows remain. We know that we still don’t know the amount of toxic debt in the economy, so not only are the conditions that led to the crisis still at work, but they are growing as time passes.
For free market economists, there is a positive programme for laissez-faire. Firstly, economic recovery will only come when we begin to rebuild the capital stock through investment. And rather than recapitalise the banks through taxpayer bailouts, it can be done through an increase in voluntary savings. Secondly, the recession itself is a sign that markets are adjusting, and that entrepreneurs are engaging in the recalculation that is required to understand which plans were unprofitable and where capital should be reallocated. Allowing relative prices to adjust as quickly as possible, reducing labour market rigidities, and improving labour mobility will all help with this. These policies are independent of the social safety nets that prevent such adjustments degenerating into long-term unemployment and stagnation, and no one would argue that the recoveries are painless. But it is better to confront the realities of life to allow a recovery to take place than attempt to maintain the economy in a permanent frozen state.
To be sure, such policies will not return us to the euphoria of 2008, but they will generate a platform for genuine and sustainable economic growth. There is an alternative to more QE.
The Browne Review: Myths and reality in university funding
Bright posters complaining about the Browne review's proposals for higher education assail me every time I enter university. Amid calls to arms, they tell me that lifting the cap on tuition fees will exclude poorer students; that higher fees will be a huge mortgage-style debt, burdening thousands of graduates; that the principle of education for its own sake, available to those most able, rather than those with the fattest cheques, is under attack.
These claims are wrong and baseless, generally stemming from those pasting the posters to the university walls not having actually bothered to read the Browne review. Judging by the reactions from the Labour party, and even from some Liberal Democrats, they haven't read it either. You can read the report here, but to save you the trouble, I will use this article to dispel the myths surrounding the report.
Whilst the Browne review recommends a lifting of the cap on tuition fees, it's worth noting what tuition fees actually are. They aren't up-front costs (which would still be borne by the government), and nor are they mortgage-style debts, even if interest were to be charged for richer graduates. The payment of this "debt" is contingent entirely upon the graduate's income.
That income is not the income of the graduate’s family, but the income that a student earns after they have graduated. Essentially, whilst footing the bill, the student bears no risk whatsoever - given that student debt will be forgiven after 30 years, a graduate could spend those full 30 years unemployed after graduating, and not pay a single penny for their degree. Unfair to students? Come off it.
And that's not it: the repayment of student debts depends entirely on the income of the student from year to year. Not the accumulated interest, nor the size of the debt outstanding. If I were to earn £5,000 per month (£60,000 per annum) one year, I would pay only £293 per month. If I were to then lose my job and earn nothing the next year, I would pay no student debt whatsoever for that year. If only all creditors were so generous.
In fact, the Browne review aims to make the situation for students even more comfortable: for example, part-time students will be pay no up-front fees whatsoever, bringing them in line with their full-time counterparts. At the same time, the minimum loans for living costs will remain non-means-tested, and students with family income below £60,000 will receive an enlarged and simplified grant for living costs on top of this.
As if this weren't already enough, the Browne report’s proposed changes in funding would allow universities to expand according to demand rather than government quota. The scandal of thousands of qualified students failing to gain a place through UCAS each year due to insufficient places would be a thing of the past.
Furthermore, the problem of international students being favoured over the less lucrative domestic students will also end if both are required to pay unlimited fees and there are no restrictions on the number of places. Persistent annual annoyances over the delayed receipt of student loans should also be eliminated with the integration of the loan application process into the UCAS application process.
Free of dependence on government grants, universities will be able to exercise institutional independence once more, answering to students as their patrons rather than to bureaucrats. Instead of competing with each other over a diminishing and limited government subsidy, they will be able to attract as many students and therefore as much funding as they can: the potential benefits of this for the quality of research and study are immense.
Presentation problems: winning the debate on fees
However, there are problems with the review. The first is not a matter of policy, but a matter of presentation. The fault lies not with the review itself, nor with Lord Browne, but with the way it has been represented by its backers in government. These pose further short-term problems with regards to getting the proposals through Parliament.
It should be made obvious that this isn't a rise in up-front costs, that the new loan system is favourable to universities in terms of independence and funding, and that the report students from poorer backgrounds by removing barriers to entry. The benefits to part-time students in particular should be stressed, and the increase in funding towards living costs celebrated.
As a possible strategy, tuition fees ought to be a term that applies only to up-front costs, with something akin to "graduate income repayments" used to describe the Browne review's proposals. This could help bring more Liberal Democrat MPs on board with the changes by highlighting the difference. Winning a debate on graduate income repayments would lend itself to gaining wider public acceptance for the reforms.
The current approach of assuming that a rise in tuition fees will be automatically unpopular, and then attempting to balance the public perception by pointing to the increase in university funding and government contributions to living costs will only be self-fulfilling: tuition fees will remain unpopular, and the other measures will be seen as sops to an aggrieved student body.
A distinction between up-front "tuition fees" and future "graduate income repayments" would strike at the heart of the problem, demonstrating the benefit to full-time and especially part-time students. This is also necessary if poorer students aren't to be put off attending places with high headline fees, at least in the short-term.
Policy problems: unintended consequences
The policy problems are potentially more serious in the long-run. The structure of the proposed student loans system means that government bears all of the risk. Students only pay back depending on their income in a given year, whilst universities receive all of their funding up-front from the government.
The Browne review has come up with an inadequate solution to this problem: it proposes a levy system whereby universities charging above £6,000 per year keep less and less of the fees they charge, up to the point where those charging £12,000 will keep only 73% of the total (i.e. £8,760).
The reasoning behind this is flawed: it assumes that the increasing levy will act as a disincentive to charge more, effectively keeping fees at around £6,000. The truth is that whilst universities and students continue to bear no risk, they have every incentive to raise the fees as high as possible, regardless of the levy, in the knowledge that it will have no effect whatsoever on the size of students' annual repayments.
In fact, the levy would add to the pressure to increase fees by withdrawing the amount kept by the university. Although it would have an effect on graduates' overall repayment over the 30 years, the effect on applicants' decisions is likely to be minimal given how far in the future it is likely to financially affect them (in the long-term, once the myth of high headline up-front fees is dispelled).
Essentially, whilst there may be some form of loose competition on the headline figure of debt, it would not be particularly effective with regards to keeping prices low given that the annual price of the repayment will be identical regardless of the headline fee: it is an illusion to think of this as price competition.
The unintended consequence of this risk-free environment for students and universities, coupled with a levy on increased fees would therefore be to drive fees higher, placing further strain on the government's ability to provide loans up-front, and perhaps prompting future government interference to mitigate this effect.
Fortunately, the accrual of interest gives more incentive for richer students to pay their fees up-front or as quickly as possible, reducing the risk borne by the government. On the other hand, unease voiced by Liberal Democrat politicians in recent weeks suggests that the option to pay up-front is deemed "unfair".
Any movement to ban these payments will impose an unnecessary burden on the government, merely adding to the risk borne in providing student loans, and reducing still further the disincentive for universities to charge ever higher fees: universities would lose the ability to compete on price for richer students who would ordinarily pay up-front. The unintended consequence of banning the up-front payment option would therefore be to increase fees still higher.
A further problem with the risk-free environment for universities and students is that universities still have little incentive to respond to student demands. Whilst they may compete in price terms on the headline fee figure, the fact remains that annual repayments by students will remain the same no matter how much they charge.
The Browne review suggests the drawing up of student charters if a university decides to increase fees, with a trade-off of minimum standards of teaching and support. However, these are likely to be toothless if left to students and universities to negotiate alone: the lack of risk borne by students leaves universities with minimal incentive not to raise fees as high as possible, regardless of student demands.
At the same time, this inexorable rise in fees due to insufficient disincentives to raise them will prompt government to interfere more and more in the drawing up of student charters, given that they will pay these higher up-front fees in the students' stead. This would heavily dilute the institutional independence achieved by shifting from government grants to student funding.
As well as providing little incentive to keep fees low or students happy, the risk-free environment for students will prevent a lifting of the cap on fees from having any effect on graduate inflation and vast increases in the numbers of applicants. As the university system would still essentially be free at the point of use, demand is likely to increase unabated.
Whilst universities will be able to absorb the excess demand by expanding the number of places they can offer, as allowed by the Browne review, they will have still less incentive to increase standards for students: the fees paid by lots of newcomers would more than compensate them for the noticeably vocal dissatisfaction of a few existing students. Only once the vast new intake is absorbed will universities be forced to compete with one another for students' patronage.
By keeping the system free at the point of use, and allowing students to bear no risk on their repayments, the number of graduates will continue to rise, further prompting other students to go to university for sub-standard degrees even when it is not the best option for them, under the perception that a degree is the only viable route to employment as their number increases.
In short, degree inflation will continue undiminished, with the additional prospect of graduates from the worst universities unable to find jobs, and consequently paying back none or very little of their fees. These graduates in particular will pose a further challenge for taxpayers: by having to bear the risk on the up-front costs, unsuccessful and low-earning graduates will essentially represent defaulters in the eyes of the government as lender.
This may then prompt further government interference with the independence of universities to mitigate this effect. Already, the Browne review proposes that the government enforce minimum standards of entry in order for a student to qualify for the loan.
Solutions: avoiding undesirable consequences
Very simple alterations to the Browne review's proposals would prevent many of these problems.
The best option would be the introduction of small, yet easily affordable up-front costs to students, of about 5% of the headline annual figure, instead of the government levy on fees above £6,000. For example, a university charging £3,000 would charge £150 per year in up-front costs, and a university charging £12,000 would charge £600 per year. These sums would be small enough to be affordable or easily covered by bursaries, whilst large enough to deter vast inflation in the headline fee.
These up-front sums would solve the majority of the problems listed. On the presentational front, they could easily be described as real tuition fees, facilitating the necessary distinction between tuition fees and "graduate income repayments" mentioned above.
These small up-front tuition fees would mean that students would bear some of the risk on their loans, reducing the risk borne by the taxpayer in providing full up-front costs. They would be better than the levy at reducing an explosion in the size of headline fees by forcing universities to justify increases in the headline fee directly to students rather than to no-one at all.
This would lend force to the proposed student charters: in the majority of cases, government input would be totally unnecessary, and they would arise on their own. This would maintain the institutional independence of universities achieved by other recommendations in the Browne review, making them answerable to students alone.
The temporary illusion of price competition between universities charging different headline fees would be replaced by the very real up-front price competition for student patronage. If a student sees a university charging something like £300 more in real tuition fees, (a difference in the headline figure of £6,000 and £12,000 for example), they will put that university under enhanced scrutiny and even more pressure to prove its worth or else apply elsewhere, taking their funding with them. Overvalued universities would suffer, and undervalued universities would gain students.
A policy of small real up-front tuition fees would go some way to solving the problem of degree inflation. By making students face even a small proportion of their headline fee up-front, they are more likely to think twice about opting for a sub-standard degree, perhaps exploring other alternatives such as apprenticeships or work. This would call a halt to the rapid rise in the number of university students, allowing students to pursue whatever is best for them in an environment where a degree is no longer the only or best way to a job.
By reducing the demand for sub-standard degrees, the real tuition fee would also mean that the government would not need to interfere ever further in the loan process: the moderate 5% up-front fee would effectively be a form of deposit on the loan.
A proposal that has achieved a lot of coverage and attention is a possible rise in the cap to £9,000 rather than its removal. To do this would be misguided: it would provide a price at which all universities will charge, solving none of the policy problems mentioned above. The upward pressure on prices due to the huge demand for university places and the lack of risk borne by students and universities would simply allow all universities to charge at the increased rate, providing none of the price competition or increased quality envisaged by the Browne review.
The option to pay full up-front fees should remain for students from wealthier backgrounds. This would reduce the risk borne by the government on student loans, whilst adding extra real price competition to universities: the difference between an annual payment of £150 and £600 as suggested above may be enough for most, but the difference between £3,000 and £12,000 would provide an added incentive for universities to keep their headline fees lower, or else force them to justify higher prices with higher quality.
Ed Miliband's New Labour economics
Having told Andrew Marr that "the era of New Labour has passed", Ed Miliband was surprisingly kind to the project when he addressed business leaders today. New Labour recognised the importance of economic efficiency as well as social justice, of wealth creation as well as the distribution of wealth, he told the CBI.
"Enterprise and job creation are fundamental to the good economy and good society, and I will lead a party that understands that at its core," he said. It would be pro-business (the CBI loved that, naturally) – but "in a different way".
I wonder if it will. Of course, when you talk to the employers' trade union you have to be nice about business and employers. But is there a real change under the skin of Labour? Is there even a real change under the skin of Ed Miliband?
His solutions sounded – well, distinctly Brownian. A bit of subsidy here, a little tax rebate there, a support somewhere else, and firmer regulation all over.
And, of course, a Miliband administration would seek to "create jobs in the industries of the future". Whatever they are. If you or I could predict what the industries of the future were, we'd be billionaires. I'm not quite sure how Miliband proposes to identify them.
Indeed, it all took me back to the Wilson government's attempts at "picking winners". That economic "strategy" was based on the absurd idea that a few distant government politicians and officials knew what we should be investing in better than the millions of specialists, entrepreneurs and financiers whose careers and livelihoods depended on betting correctly on the future.
All the more surprising that Miliband thinks he can identify "the industries of the future" when he believes his predecessors got it wrong. They engineered, he told the CBI, an over-reliance on the financial services sector, which left us painfully exposed when the whole thing fell in ruins. Manufacturing, he argued, deserved more emphasis, and "government needs to step in". And Britain should be going for the high-skill jobs, not the grunt work. (I thought that pitching us more towards high-end skills and away from metal-bashing was what Blair and Brown had in mind when they boosted the financial sector. This version sounds rather like "the white heat of the technological revolution" all over again.)
So a Miliband government would "step in" to force the banks to lend to small businesses, and so on and so on. There's no obvious end to it.
But if I ran a manufacturing business and government offered to "step in", I'd run a mile. I'd remember the scores of little schemes and incentives and tax allowances that Gordon Brown extended to business, hoping to push it where he thought it should go, and all the distortion and confusion and form-filling that they produced. But here is Miliband promising more of the same – new schemes for job training, encouraging employers to raise the skills base, and so on. Re-skilling Britain may be a worthy objective, but it's more likely to be achieved by officials and politicians butting out, cutting the burden of regulation and taxation, and letting business people get on with the wealth-creation job that they know far better than any government ever will.
Published in Guardian Comment is Free here.
International aid should be abolished
The Comprehensive Spending Review was a step in the right direction, but I agree with Philip Booth and others when they say that there should be far more cuts down the line. But the biggest mistake was the announcement that the Department for International Development’s (DfID) budget will be increased by 37 percent by 2015.
It undermines the narrative that the country will be suffering the cuts together and shows a tone-deafness in cutting spending at home while increasing it abroad. But worse, it exacerbates the problem that development aid does an immense amount of harm to the developing world, and this spending increase will only make things worse.
Over 95 percent of the money that the government gives in aid is goes to the governments of developing countries rather than to charities like Oxfam and the Red Cross. Many of the governments that we give aid to are corrupt dictatorships: for example, the top five recipients of DfID government-to-government aid in 2008/09 were Sudan, Burma, Ethiopia, Democratic Republic of Congo and Zimbabwe.
And aid money does not simply correlate with bad governance, it causes it. When governments are not reliant on their own citizens for revenue, they have no need to be accountable to them either.
According to Zambian economist Dambisa Moyo, over 70 percent of government revenues in sub-Saharan Africa come from overseas aid. These governments have no need to implement pro-growth policies that free markets and improve their countries. On the contrary – the poorer they are, the more money they get from the West – aid money incentivizes bad governance and rewards corruption.
But even to a relatively responsible government like India, which receives millions of pounds in aid from Britain, aid is a colossal waste of money. India has had year-on-year growth of over 8 percent so far in 2010, and has its own space and nuclear weapons programmes. It even has its own foreign aid programme. At a time when the future of Britain’s own nuclear programme is in question, how can the Chancellor justify increasing aid money to the Indian government?
By 2015, DfID’s budget will be over £11bn – this is one seventh of the entire amount saved by the Comprehensive Spending Review, and nearly double the amount spent on the police. Overseas aid worsens the situation in the developing world, and Britain cannot afford it. It should be abolished, for the good of the country’s finances and for the world’s poor.
Published in The Spectator here.
George Osborne has only tinkered with the welfare state
There’s no doubt that the Comprehensive Spending Review contains severe cuts. But it is misleading to focus too much on specific areas of spending, while neglecting the bigger picture. Overall spending is only going to fall by 2 or 3 per cent in real terms, returning us to 2008 levels of spending. It’s hardly the public sector apocalypse that some commentators would have you believe.
Indeed, there is a case for saying that George Osborne should have gone further. The Labour government increased spending by almost 60 per cent between 1997 and 2010, so there remains plenty of waste to target. Nevertheless, efficiency can only take you so far. Even if you trimmed every ounce of fat from the public sector, governments would still struggle to keep spending under control, because demographic changes mean that the burden of the welfare state is going to grow unbearably large in the years ahead.
One respected international organisation, the Bank of International Settlements, has even predicted that our debt will soar to more than five times GDP by 2040 if we stick with current policies – a disastrous state of affairs, which would leave us spending three-quarters of our tax revenue on debt interest payments.
And here’s where George Osborne’s spending review falls down. Although he tinkered around the edges of the benefits system, and even announced a rise in the retirement age, he failed to question the fundamental assumptions behind the modern welfare state. But questioning those assumptions is precisely what we need to.
I’m not talking about free schools, or the NHS internal market, or even Iain Duncan Smith’s welfare plans, welcome as all those things are. What I’m talking about is abandoning the comprehensive, universal, free-at-the-point-of-use ethos that formed the basis of the post-war settlement.
We can’t continue paying today’s pensions with today’s tax revenues, for example – the sums just don’t add up. We need to move towards a fully funded model like Chile’s, where people have to save for their own retirements, and the sooner we do so the better. We can’t afford to make the NHS sacrosanct either: we must learn from Singapore, where people have to put money aside for their health costs, and government support is targeted only on those who can’t take care of themselves.
These are just two examples, but their guiding principle can be applied across the board: government should always act as a safety net, but nothing more. In the long run, that mature reassessment of the welfare state is the only way we will avoid fiscal calamity.
Published in the Daily Telegraph here.
Science is better off without the government
Through the Department for Business, Innovation and Skills (Bis), £3.79bn is currently spent on science funding. The Spending Review is expected to reduce this. But despite the outcry from many in the scientific community, this is good news for science as well as for taxpayers.
The British Government only started to fund science after the Great War, well after the technological and economic surges of the agricultural and industrial revolutions had taken place. The fact is that these revolutions required no government funding. World War I and II led central planners and intellectuals to conclude that, like a war, they could plan an economy from the centre. Since then, government has been spending increasing amounts of taxpayers money to fund science, with the great leap forward taking place under Gordon Brown, when the science budget effectively doubled.
Many defend the government funding science through universities on the basis that it is a public good, a good that the whole of society benefits from, that would not be funded to the same extent privately. However, although it can indeed be a public good, it is also, and to a greater degree, a private good. In fact, this is how a great deal of scientific research is still funded and how it has been through the ages. The modern world was built upon private investment and we continue to thrive because of it.
The economists Edwin Mansfield and Zvi Griliches have found strong correlations between companies’ investment in scientific research and profits, while in the sweeping Sex, Science and Profits, Dr Terence Kealey has done much to demonstrate that the government is not necessary for science to flourish. This is why, despite government funding, IBM is one of the largest research institutions in the world.
Crucially, not all spending on science has equal bang for its buck. A thorough Organisation for Economic Co-operation and Development (OECD) report in 2003 concluded that it is private sector money, not government money, that turns scientific research into economic growth. In the same way that people are always less careful spending other people’s money, the government is less careful spending money on scientific research than the companies that are set to rise or fall on the backs of their decisions. Added to this, the OECD report concluded that money spent by the government is crowding out private sector investments.
In other words, inefficient government funding is displacing more efficient private funding. By collectively taxing all companies for scientific research, the centralised planning of the government has usurped the dispersed and local knowledge of the private sector. In the real world, free markets, trade and competition drive economic growth, not the government pulling money out of the productive private sector and distributing it amongst universities.
If the government wants to encourage increased spending on science, the least inefficient tactic would be to offer increased tax breaks to companies investing in research through universities, but even this is not essential given how integral research is to many companies’ profitability.
Published on BBC Science here.
There’s a simple way to clear the university logjam
Today, more than 100,000 students with decent grades will begin the scrabble for the smallest number of clearing places in decades. Droves of young people will be turned away proving what everyone already knows: university finances are in a mess.
What’s the solution? Some advocate uncapping fees, which is just a short-term sticking plaster. Others want to tax graduates, which would put funds into the Treasury, but not necessarily the lecture hall.
In the past we have copied good things from America’s best universities — and, if we want the only long-term solution to our funding problem, then we need to adopt US money-raising methods. We need to build up endowment funds that aid poorer students and liberate the number of spaces at college from what the Government thinks it can afford.
Harvard’s endowment fund stands at more than $25bn, built up from private donations and judicious management. It allows the university to admit its high-achieving students on a needs-blind basis: all are picked on merit alone, and scholarships are awarded only to the needy. We should start to put UK universities on the same road. It will take serious money and radical incentives.
Americans are generous. It is an American tradition to make your pile, then use it generously. Bill Gates and Warren Buffett do on a grand scale what many Americans on more modest incomes do too. We lack that culture and the tax rules that encourage it, and we should change that.
US tax law fosters generosity. Money given or bequeathed to a university comes straight off their taxable income without complex rules and covenants. Money given to a university is money the US Treasury has no interest in.
We should follow suit. Gifts to universities should be taken off total income, leaving only the balance to be taxed. The same should apply to gifts from businesses.
We should also promote bequests. Those leaving money to universities should have their estates qualify for matching tax relief, so 20 per cent of an estate left to a university would remove inheritance tax from a further 20 per cent. A person leaving half their estate to a university would face no inheritance tax on the other half.
The aim, must be to make giving to universities, whether you are dead or alive, the norm. Education boosts social mobility — and we should be helping universities to build up the funds to offer a life changing chance to everyone who merits it.
Published in The Times