Market pricing information and competition
Background
UK motor insurance companies have been using detailed market pricing information to help set insurance rates for many years. Insurers have been able to check how much their competitors have been quoting for different types of vehicles and different groups of drivers. Available information has been very precise and has allowed predicting prices for individual quotes and up to one month ahead.
The Office of Fair Trading (OFT) is claiming that using such market information limits competition. OFT is threatening (PDF) the largest UK insurers with a continued investigation to make them commit to restricting the use of market pricing information. This commitment will be applicable to all UK insurers, including smaller ones who are not signatories.
There is no valid economic case for restricting access to market pricing information. As a consequence the commitments offered, or any other regulatory action, will not be addressing an identifiable competition concern.
Why OFT’s understanding of the market process is incorrect
OFT’s main economic concern is that access to market pricing information allows a common understanding of pricing positions by insurers. OTF also believes that this common understanding will lead to “successive rounds of signaling and responses by multiple insurers and this could create upward pricing pressure”.
But this is a misunderstanding of the market process. Profit maximizing companies do not increase their prices just because they know how much others charge. If they did, we would see a constant price raises in markets for all goods where companies have this knowledge, that is in most markets. We would see, for example, an upward spiral in prices of eggs, bottled water, newspapers and houses.
Insurance pricing is a reverse auction where insurers bid and the buyer, if she is price sensitive, chooses the cheapest quote. Restricting market pricing information changes the auction from a simple English auction to a less transparent one where at each step the bidders know if they are winning or not and if they are not winning they do not know who is and what the winning bid is. The Revenue Equivalence Theorem (PDF) suggests that both auctions will result in the same price to the customer. The latter one will just converge slower, will be more volatile and hence will make the market less efficient.
It is also hard to think of an intuitive reason why better access to competitors’ prices makes a market less competitive. Telling a class of students what everybody’s grades were in last week’s test makes top students more, not less, competitive.
OTF’s is also concerned that market pricing information could allow a hypothetical cartel to monitor the market and hence to detect deviation from a hypothetically coordinated strategy. If a cartel existed then, I suppose, it would use market information this way. It could also use other means to coordinate rates.
But individual insurers’ interests are in conflict and it is difficult to maintain a cartel without a disciplining mechanism (see, for example, N. G. Mankiw’s Principles of Microeconomics, Chapter 16). I do not know of such a disciplining mechanism in the UK market and neither does OFT. Until such a mechanism develops, and there is no evidence that this is happening, market information is not a threat to competition.
In fact restricting market pricing information will make it harder to start new insurance companies and for existing companies to enter new market segments. This is because new companies, unlike the established ones, do not have historical claims data and therefore need to rely on market intelligence tools to set prices.
Conclusion
Commitment enforced by OFT or any other such restriction of market pricing information will not address an identifiable competition concern. Instead, to the extent to which it will be enforced, it will reduce effectiveness of the market, increase insurance risk, reduce competition and increase compliance cost and consulting fees. It will also mean that seven big insurers, with OFT’s assistance, will collude to limit competition from smaller insurers and potential start-ups.
Reflections on the Shanghai skyline
And, by the way, how did Shanghai come to have such a “Western”-style skyline before the Second World War? Because following the British-Chinese War of 1842 (the “Opium War”), Shanghai was one of the treaty ports in which there emerged foreign “concessions” administered by Western governments to minimize frictions between the Chinese and Europeans and Americans, due to conflicting conceptions of criminal and civil law, and property rights.
By the end of the 19th century, Shanghai had two foreign districts. The French Concession, administered by a Governor-General appointed by the French government in Paris, and the International Settlement (the picture, above, shows what was the “heart” of the International Settlement among the Bund (the waterfront) facing the Whangpoo River).
The International Settlement was administered by a city council of 14 members elected by the foreign rate payers (mostly property taxes) residing in the boundaries of the Settlement. Thus, it was, for all intents and purposes, a self-governing “city-state” under the protection of the Western Powers (which ended up meaning mostly a British and American military presence).
It thrived because it was, for the most part, a laissez-faire-run free city. Other than the municipal works, the dredging of the Whangpoo River up to where it runs into the Yangtze River, and police and fire departments, the International Settlement government basically left “the market” and the residents pretty much alone.
It was this free market environment that created that Western-style skyline that in the 1930s was considered the Asian rival of New York.
And the city was a refuge for many. First, for Western businessmen “escaping” from heavy taxation in other parts of the world. For example, if you look at that upper picture of Shanghai, on the left side you see a building with a green pyramid roof. That was the Cathay Hotel, also known as Sassoon House; it was built by Sir Victor Sassoon, who left Britain with a good part of his fortune in 1927, to get away from the high business and income taxes in Great Britain. (The Sassoon’s were a famous family of Iraqi Jews, among whom was Siegfried Sassoon, the noted German poet and writer.)
Shanghai was a haven for many people escaping real tyranny — not just tax “oppression.” Following the Bolshevik Revolution, thousands of “white” (anti-communist) Russians found refuge in Shanghai. They became famous in the city, not only among the city’s “sing-song” girls, but as doormen at nightclubs and bodyguards for Chinese gangsters who usually preferred the nightlife in the French Concession; and, of course, for the city’s many fine Russian cuisine restaurants. (Russian noblemen, or their sons, were seem playing the balalaika in those restaurants, or even in the streets pulling rickshaws, to earn enough to live.)
But, also, in the 1930s, thousands of German Jews who fled Nazi Germany found refuge in Shanghai, because the city had neither passport nor visa requirements. Many of them settled in the Hongkew district of Shanghai, which had been badly damaged during the fighting between Chinese Nationalist and Imperial Japanese army forces, first, in 1932, and then, again, in 1937.
But under the diligent work-ethic and work effort of these refugee German Jews, much of the Hongkew district was rebuilt and again thriving. And, then, in an irony of fate, when the Japanese occupied the International Settlement following the attack on Pearl Harbor they did not intern these Jews (unlike the systematic roundup and imprisonment and cruel treatment of all French, British and American citizens), because these Jews carried German exit passports. And though these passport were stamped with the infamous “J,” the Japanese viewed them as citizens of their war-time ally.
Shanghai was also the headquarters for numerous religious and secular charities and philanthropies that ministered to the needs and improvements of the Chinese population both in the city and throughout other parts of China. There were voluntarily-funded orphanages, soup kitchens, shelters, schools, and vocational training colleges to give a “helping hand” to the Chinese.
Finally, throughout the second half of the 19th century and up until the 1941, Shanghai’s International Settlement and French Concession were a refuge for many Chinese when revolutions, civil wars, or the general cruelty of Chinese government governors or war lords made life “nasty, brutish, and short.”
There in Shanghai, financial savings were safe in Western banks, and property rights were respected and protected from both illegal plunder and the “legal” plunder of Chinese officials and war lords.
But, in addition, Shanghai’s International Settlement was a cultural oasis for Chinese artists and intellectuals. Here was born the Chinese motion picture industry; non-traditional music and art; and a haven for freedom of speech and the press, that was not allowed in surrounding Chinese administered areas. Here civil liberties were respected and secure.
It was also a property rights-safe place for the development of Chinese-owned manufacturing and industry — not only Western businesses. In Shanghai, these Chinese entrepreneurs were free from the “squeeze,” the Chinese term for bribes and corrupt protection rackets and government official shakedowns.
Like everywhere, in an imperfect world with imperfect people, Shanghai was no “utopia.” But its instituting and general protecting of Western civil and economic liberty, made the International Settlement a place of practical, everyday freedom in that part of the world.
Of course, most Chinese — from intellectuals down to the ordinary (and usually) illiterate Chinese “coolies” — resented the power and presence of the “foreign devils.” And this resent and anger against the power and too-often arrogance of the Westerner, took many forms.
But, de facto, Shanghai’s International Settlement gave many Chinese the personal safety and economic and cultural opportunities they could never have under their Chinese rulers.
This all came to an end in 1941, with the Japanese occupation. And, then, at the 1943 Cairo Conference between FDR, Churchill and Chiang Kai-Shek (the Nationalist, or Kuomintang, head of the Chinese government), the Western powers relinquished their rights to “extraterritoriality,” which was the basis for those foreign concessions in China, of which Shanghai’s International Settlement was the most important and famous.
After the war, from 1945 to 1949, when Shanghai was under the control of Chiang’s Nationalist government, the city suffered through political corruption and abuse, and a hyperinflation caused by the government’s massive printing of paper money to finance its war against Mao’s communists.
And from 1949 until the end of the 20th century, the communist “utopia” left the city in a state of a “frozen moment in time,” with that skyline that had not changed since the 1930s. And which symbolized the possibilities when freedom and property are secure.
— Richard Ebeling is Professor of Economics at Northwood University andformer President of the Foundation for Economic Education.
What a free market in healthcare would look like
Will the pluses outweigh the minuses? That very much depends on how much freedom, choice and competition the reforms are able to inject into the system. As yet, I’m not convinced they do enough to deliver major benefits to the patient – though I am open to persuasion on this, and much will depend on the final legislation and its implementation.
Still, whatever you think of the government’s planned reforms, it is important to realize that there is a huge gulf between what they would create – a government-funded system of heavily regulated, managed competition – and a genuine free market in healthcare. Indeed, if I were being harsh, I’d say the government’s proposals are merely another attempt to make socialism work, rather than a shift to a more liberal system.
Let’s imagine a free market health system. Of course, all the doctors’ surgeries and hospitals would be independent, private operators, which would vie with one another for patients, and compete on price. Some would be standalone companies, others would doubtless be part of big corporate chains. Some would be owned by cooperatives or mutual societies, and others perhaps by charitable foundations. The point is, there would be diversity, and with it choice, competition and independence.
Now look at it from the patient’s perspective. Again, there would be countless possibilities (ranging from private insurers and health maintenance organizations, to old-fashioned friendly societies and mutual benefit organizations), so I’ll just highlight the sort of arrangement I would expect to be most prevalent.
For the vast majority of medical interactions (visits to the GP, for example) people would simply pay out of pocket, or otherwise join some kind of basic medical plan. I’d expect chains like ‘MediSavers’ or ‘DoctorsExpress’ to offer low-cost appointments to all comers, or to offer package deals (say, three diagnostic examinations, an annual health check, and discounts on specialist referrals, elective procedures and medicines). Within that market setting, I’d expect pharmacists to take on a much bigger role, which would drive costs even lower. Indeed, I would also expect to see doctors, dentists, pharmacists and opticians to club together and form all-in-one ‘healthcare supermarkets’, perhaps with gyms and healthfood stores getting in on the action too. As I say, the possibilities are endless.
For most people, in most years, that would be the extent of their healthcare experience. At most, it would set them back a few hundred pounds. But what about bigger-ticket healthcare expenses, like complex operations or cancer treatments? This is where insurance would come in. But not the kind of comprehensive insurance that we see driving massive cost inflation in the US.
Instead, I’d expect something like the Western Provident Association’s XS Health plan to become popular. Even now, in a relatively underdeveloped market, this would allow a 40 year non-smoker to claim for “hospital and out-patient treatment, scans, tests, physiotherapy and cancer cover” and be treated “by a specialist of [his] choice, at a hospital of [his] choice, anywhere in the UK” in return for a premium of £200 per year. What keeps it cheap is the £1,500 rolling excess – essentially, the insured party’s medical costs would be capped at £1,500 in any 12-month period. Should they spend more than that, the insurer would pay all expenses incurred in the 12 months that followed.
Now, OK, £1,500 might seem like a lot. But in a free market (and therefore low-tax) system where people were expected to look after themselves, that is not an unreasonable amount to expect people to keep tucked away for emergencies. And of course, people would be perfectly free to choose an insurance package with a lower excess, or a co-payment instead of an excess, or even one that covered every medical expense from the first £ onwards. Those might be more expensive on an annual basis, but people might think they suited them better in the long term. Who knows? The essence of a free market is a multiplicity of options to suit a multiplicity of preferences.
The thing to note is that this free market that I am sketching out would allow people to tailor their healthcare far more closely to their individual requirements, while also costing a lot less than the current nationalized system does. We’re comparing annual costs of a couple of hundred pounds on primary care and a couple of hundred pounds on big-ticket insurance, plus very occasional larger outlays, with an annual government spend of well over £2000 per person. An improvement, I would suggest.
Of course, there would remain a difficult welfare issue. Presumably even in a free market setting, people would insist on some sort of redistribution to ensure a minimum standard for everyone. But this need not be an insuperable problem. Just as private optical services are currently subsidized for people in certain categories, so could routine visits to the doctor or dentist. As for the insurance element, you could say that if a defined package of coverage cost more than a set percentage of a person’s income, then the government would pay the rest. Naturally, doing anything like that would reduce the savings to the taxpayer, and would also create all sorts of distorted incentives. A balance would have to be struck.
But regardless, wouldn’t this free market system – in which patient choice was everything, in which providers competed to offer higher quality at a lower price, in which the vast majority fended for themselves and those unable to do so were empowered by government to enter the market – wouldn’t this be infinitely preferable to the sort of bureaucratic, managerialist compromise we have today? It might not suit the public sector unions, which is not the same thing as saying it would not suit their members. And it might not suit politicians, although in the long run they’d be as relieved to be rid of the NHS and they were to be rid of British Leyland. For the rest of us, however, it would surely be a huge improvement.
2011: The economic prognosis
Growth is, of course, driven by the four major components of demand. The first is consumers’ expenditure, which will probably flag this year. Real incomes are being squeezed by a combination of higher taxes and prices inflation running ahead of earnings inflation. CPI inflation will probably be around 3% to 3½% for much of this year. Indeed it may hit 4% in spring, with higher utility prices, rail fares and commodity prices take their toll. RPI inflation is nearer to 5%. In the meantime, earnings inflation is a very modest 2½% and shows few signs of picking-up despite the higher prices inflation. There are no signs of a 1970s-style “wage-price spiral” developing and I do not expect one to develop given the high unemployment rates. If I am wrong on this point then the implication for interest rates is very serious indeed.
Unemployment will also bear down on consumers’ spending. And even though the impending public sector losses are estimated to be a relatively modest 40,000 in 2011/12, according to the Office of Budget Responsibility, unemployment will surely stay around the 2½ million mark. A stagnant housing market is also a negative. House prices look set to weaken further this year, given the dearth of mortgage lending, and could end 5-10% lower than at the end of 2010. And, finally, tight credit conditions and an overhang of debt from the pre-crash years still weigh down the consumer.
Public spending, especially in Gordon Brown’s early 2000s “glory days” of throwing public money at the unreformed public services in the vain hope they would transform them, contributed significantly to GDP growth over the past decade. This is now being reversed. General government spending will ease back this year as the Coalition government struggles to get on top of the £150bn black hole in the public finances they inherited. The mid-1990s provide something of a precedent. Public spending was curbed then and the private sector not only replaced that loss, but grew so buoyantly the economy did very well indeed.
But the mid-1990s were more favourable than now for three main reasons. Firstly, the international background was rosier then. Secondly, the British economy was arguably more competitive in terms of taxation, regulatory burdens and competitive energy prices. In particular, Britain’s current green energy policies are expensive and wealth-destroying. Already our “green” energy policies are adding a 20% “stealth tax” to industry’s electricity costs, thus undermining competitiveness, but this could rise to 70% by 2020. Businesses will simply migrate overseas. And, thirdly, the banking system was in rude good health. This is not the case today in the wake of the financial crisis. Tight credit conditions will inevitably hold back private sector recovery.
The third and fourth components of demand are investment and net exports. The government is expecting big dividends from both. But I have some doubts. Even though business investment performed well this year and the corporate sector is awash with cash, tight credit conditions for SMEs and a subdued growth outlook will surely hold investment back. And net exports have disappointed to date, despite the pound’s weakness over the past 2 years. Granted exports have grown, but imports have tended to grow faster.
But for all these caveats I do still expect growth in 2011. The recovery will surely survive the higher taxes and the spending cuts. Assuming this to be the case, then the Chancellor will do little by way of macroeconomic steering in this year’s budget. His budget will be about “growth” and doubtless introduce measures to improve growth, although they will be modest.
And interest rates? Well, despite the poor outlook for prices inflation, it is vital to note that the higher prices are being driven by globally-determined commodity prices (at least partly). And there will be more to come as looming shortfalls in supply, reflecting production difficulties and/or rising demand especially from the emerging economies, drive up prices. Oil prices are heading for $100pb. There is little prospect of a near-term respite.
But I expect the Bank’s MPC to tread cautiously on monetary tightening unless an inflationary “wage-price spiral” starts to develop – in other words, if there are signs that inflation is becoming internally generated. Whilst there are those who already accuse the Bank of losing credibility because the 2% target is being robustly overshot, I expect the Bank to be pragmatic and weigh up the implications for growth before they act precipitously on interest rates. I would be very surprised if the Bank increased the Bank Rate much this year – possibly to 1.0% or 1.5% by the end of the year. I do not, however, expect further Quantitative Easing.
The Eurozone will continue to worry this year. The European Commission said recently that there are “increasing differences across EU countries, particularly between the core and the periphery”. These differences are tearing the Eurozone apart, despite the bail-out packages. At the core Germany is bounding ahead. But the peripheral economies of Greece, Ireland, Portugal and Spain are being crippled by the Eurozone’s straightjacket, coupled with tough austerity packages. It can surely only be a matter of time before Greece, and possibly Ireland, Portugal and Spain, leave the Eurozone, default on their debts, take the short-term pain and go for growth.
But when will this be? The answer is political rather than economic. It will depend on when the respective governments put the future prosperity of their people above their dogged adherence to the euro. My guess is that the countries will struggle through 2011 with their economic difficulties becoming increasingly, painfully obvious.
Of course there is another way out of the Eurozone crisis. Specifically, there needs to be a permanent mechanism for transferring resources from the relatively competitive member-states to those that are less competitive. Yet the political will is missing, for all the leaders’ rhetoric stressing their willingness to do whatever it takes to secure the euro. As long as a commitment to fiscal integration is missing, the future of the Eurozone as currently configured looks bleak.
Turning to the US, there is rising optimism. Even though the US economic data towards the end of last year were no better than mixed, upbeat business survey results suggest improved prospects. The Fed seems determined to encourage household and business spending with QE2, irrespective of any inflationary implications. Growth could surprise on the upside, perhaps chalking up 3% in 2011. Meanwhile a unified global campaign against China’s cheap currency policy will continue to elude Washington, though the pragmatic Chinese will probably let the yuan appreciate this year against the dollar as part of their attack on inflation.
Who is to blame for the Irish crisis?
The more pressing question that we may ask is whether accepting the money was the best action to deliver Ireland to a prosperous future. If Ireland’s ailment was indeed a lack of liquidity, a short-term loan may indeed be just what the doctor ordered. Unfortunately, today’s crisis is anything but one of liquidity. What plagues Ireland, and the rest of Europe’s periphery, is not a lack of liquidity but a more damaging lack of solvency. Short-term loans will provide little relief from this long-term problem.
What is needed instead of an analysis of the current problems is adeeper reflection of the true nature of the problem at hand. Philipp Bagus’ new book “The Tragedy of the Euro” provides just what the doctor ordered.
Bagus provides the story and reasons for the formation of the common currency. Through auspicious beginnings, the creation of the European Monetary Union has wrought severe consequences far beyond what its founders imagined. While these consequences are now fully apparent, only an understanding of their source will allow us to avoid the mistakes of our past.
Today we should focus on two aspects that Bagus’ book makes clear.
The first is the common interest rate policy that the ECB enacts in Frankfurt. While one nominal interest rate swept over the whole of the Eurozone, divergent inflation rates created wildly different real borrowing rates. Ireland, as well as its Southern European neighbors, is at the heart of the high-inflation periphery of the Eurozone. Indeed, as inflation raged in this periphery compared to the relatively stable European core countries, Irish residents were exposed to lower real interest rates than most had ever seen in their lifetimes.
The result was an artificially induced boom in interest rate sensitive investments. The effects on the housing market – from Dublin to Donegal – are more than apparent today. The culprit was not some sort of irrational optimism sweeping the island of Ireland; this was a classic case of an Austrian business cycle – a credit induced boom causing an unsustainable change in investment and consumption patterns (see here, here and here). This time it is at the hands of the ECB.
To preempt a rebuttal, and to paraphrase American economist Tyler Cowen (no relation to Brian Cowen, to my knowledge at least), it was still Irish investors who made these bad investments. Regardless of who made the interest rates as low as they were, it was still the hands of Irish citizens that spent the money – wisely or not.
Cowen uses an example of the government subsidizing the cost of bananas to illustrate his point. If bananas are artificially cheap and you purchase piles of them and pile them on the roof of your house and your roof collapses under the crushing weight, who is to blame? While it is no doubt obvious that the blame can only lie at the hands of the person who bought the bananas, we may do well to ask what happened to the incentive structure that normally stops a person from crushing his roof with excess bananas.
Irish investors are not without blame in the current crisis. A surplus of cheap credit was made available to them. This could have been used wisely or unwisely. It just turns out that most of it was used in nonproductive manners. Mea culpa, the Irish can plead.
That being as it may, what is done is done. Ireland’s roof has collapsed and it must now search for a way to stop it from happening again. As long as the Irish inhabit Ireland we will probably not see an end to using cheap credit when it is made available. Given the similar reactions all over the world to the global liquidity gusher that occurred at the hands of the world’s central banks over the last decade, I do not think that any other nationality could evade such a consequence either.
That leaves us with removing the other cause – the ECB. Removing the common interest rate policy from the European Union would remove the incentive structure that resulted in such crises in the Eurozone’s periphery. An Irish exit from the Eurozone would undoubtedly cause some short-term pains – an adjustment to the Irish pound would entail a massive recalculation by Irish entrepreneurs. It would however remove the imbalances and skewed incentives that fostered such an artificial boom to develop in the first place. By saying slán to the euro, the Irish will be setting in place a strong foundation to rebuild their house upon.
Understanding how the European Central Bank was formed, operates and is influenced politically is instrumental to understanding the current malaise that engulfs Ireland. No Irish person should feel qualified to comment on the current crisis that inflicts their homeland without understanding the root issues at stake. Philipp Bagus’ “The Tragedy of the Euro”, is the single best resource that one can read to understand the causes, consequences and cure for the recession plaguing the European continent today.
Britain’s Borrowed-Time Bomb
The trouble is that Britain’s national debt, which the Treasury expects to peak at about 70% of GDP in 2013-2014, does not tell the whole story. Indeed it barely tells half the story. Alongside those strictly financial obligations to its creditors, Britain has also promised itself a huge raft of social benefits that it hopes its children will be good enough to pay for. And like someone ordering an expense-account lunch, it has inclined to be generous with other people’s money.
On top of that, British baby boomers are now reaching retirement, and seemingly doing their best to live forever. New figures published last month showed that men at the retirement age of 65 can now expect to live until 87, and women to 90. In other words, members of this bulging generation look to be living on taxpayer-funded pensions for at least the next quarter of a century. The cost of state pensions has already risen by a quarter in the last 15 years. Some of that is due to Gordon Brown’s expansion of the public-sector workforce, which has particularly generous pensions terms. But more is due to the sheer numbers coming through. Today, over-80s account for one in 25 British people; 50 years from now, they will be one in eight. Without reform, this giant Ponzi scheme is bound to collapse.
Along with pensions, older people use a lot more health care—another expense-account lunch, through Britain’s National Health Service system. Since 1947, health-care spending has risen to 16.5% of GDP from 2%. The NHS budget increased by 40% under the Brown years alone. Health-care costs will be just as big a strain on future public finances as pensions. Older people rely on other social services too, which the shrinking minority of younger workers are also expected to pay for.
Bodies such as the University of Munich and the Bank for International Settlements have already expressed alarm at the volume of these so-called “intergenerational obligations.” Standard & Poor’s reckons that U.K. debt could hit 100% of GDP by 2013, from just 30% a decade ago, and many leading economists agree.That is the point at which ratings agencies start putting you on credit watch. Certainly, Britain has a mature debt profile. But if gilt ratings did get downgraded below A, they would be expelled from the indexes of top-rated sovereign debt, and promptly dumped by bond funds, accelerating the problem even further.
The new Adam Smith Institute report looks at three scenarios. One is that the government’s planned spending “cuts”—which are actually only reductions in the rate of increase of public spending—carry on until 2015 and then future economic growth (rather generously assumed at 2.5% per year) goes wholly into public spending. Britain’s public debt would then hit 100% of GDP as early as 2019. If the proceeds of economic growth are shared 50-50 between higher spending and debt reduction, the crunch will still come, but 12 years later, in 2031. If future growth were devoted entirely to debt reduction—which would amount to unimaginable and unprecedented self-restraint by politicians—Britain would still be in the red until 2041.
It is plain that Britain cannot continue in this way. So what is to be done?
The first task is to get a handle on the scale of the problem. The U.K. welfare state has grown up through a long series of political initiatives, with no real thought given to its future cost. If we are to avoid collapse we need to know how deep that black hole really is. Politicians must also admit the long-term costs of the benefits they generously vote us today. Any policy that shifts costs onto future generations should come with that price tag attached, so we know how much of a burden we are loading onto our children.
Second, we need to adjust our benefits now in order to keep them affordable in the future. The government already plans to raise the pension age by a year, to 66; but with life expectancy rising two years every decade, the threshold should be nearer to 70.
Third, we ought to be paying more of our own bills—investing in our own pensions, insuring our own health. It’s time we own up to the fact that expecting our children to pay for our comfort is not just risky, it is utterly immoral.
Published in Wall Street Journal here.
Raising VAT looks like a self-inflicted wound
That’s bad enough on its own to raise questions about the Government’s plans. Does it really make sense to be willfully damaging the private sector economy, when the recovery is still so fragile?
We should not make the mistake of thinking we are already out of the woods: after all, a Eurozone crisis could easily trigger another financial crash. If Ireland, Portugal or – worst of all – Spain tank, the British economy will need all the help it can get.
Unfortunately, the OBR’s prediction does not even tell the whole story. The economy is incredibly complex, and tax rises have all sorts of effects that take time to work their way through the system, setting off a variety of other reactions as they do so.
So raising VAT won’t just reduce consumer spending and hit retail profits: it will also cause job losses, as sellers cut their overheads and producers reduce production. That will mean more people out of work and claiming benefits rather than paying taxes, and even less people going out and spending. The vicious circle is complete.
Independent economists have looked further into the future, and considered the impact that raising VAT will have over the next few years.
The British Retail Consortium, for example, has calculated that it will cost 30,000 jobs next year, and a total of 163,000 jobs by the end of 2014. David B Smith, a visiting professor at the University of Derby, has also run the VAT rise through his respected Beacon Economic Forecasting model, and found that the 20 per cent rate will increase the number of people claiming unemployment benefits by 236,000 over the next 10 years.
Worse still, Smith suggests raising VAT will worsen the budget deficit by 0.1 per cent in 2010-11, 0.6 per cent in 2011-12, and 0.4 per cent in 2012-13. That doesn’t sound like much, I know, but when you are borrowing £17m per hour, and already spending £120m a day servicing the interest on your accumulated debt, every penny counts. We simply can’t afford self-inflicted wounds like the VAT increase.
Sure, it might raise a few billion extra for the Treasury in the short term – but not without doing a whole lot of damage elsewhere.
To be blunt, the end does not justify the means.
We should also consider the impact that raising VAT to 20 per cent is going to have on inflation, which is already stubbornly high on the Government’s preferred CPI measure (at 3.2 per cent), and higher still (at 4.7 per cent) on the Retail Price Index, which more closely reflects people’s living costs. On Smith’s model, inflation is 1.2 per cent higher in 2011 than it would otherwise have been, thanks to the VAT rise.
For pensioners and people dependent on their savings, this is a cruel blow. They have already seen their incomes hammered by low interest rates and high inflation, and now the Government is making things even worse.
Let’s not forget that five per cent a year inflation will mean the value of your cash falling by more than 30 per cent over the next five years, which is no small beer.
Nor should we overlook the effect that inflation has on the poor and vulnerable, who are usually unable to demand higher wages to offset price increases, and therefore face watching their living standards collapse around them.
Of course, there is one positive thing we can say about raising VAT, and that is that it isn’t nearly as damaging to the economy as raising some other taxes, like those on income or capital gains.
But given that the Government has already raised capital gains tax by 10 per cent, and has chosen to keep Labour’s 50p income tax rate (even though the Institute of Fiscal Studies says it will lose them £800m a year), they don’t get many brownie points for that.
On so many issues – from welfare reform to public spending – the coalition Government has made a good start.
But there is one thing they are sorely lacking, and that is a credible agenda to get the private sector economy growing strongly again.
After a decade of rising taxes and endless red tape, British businesses and entrepreneurs are crying out for change. Raising VAT to 20 per cent is a regrettable step in the wrong direction.
Published in the Yorkshire Post here.
Tax and spend destroys living standards
Most market sympathisers know this, but for support they concentrate on statistical evidence such as the adverse relationship between economic growth and the level of overall taxes. (2) This evidence is very strong, but an underlying theory showing WHY this is the case would make it far stronger. Naturally such a theory exists, but it is little known nowadays outside Adam Smith aficionados and the Austrian School of Economics to which both Ludwig von Mises and F. A. Hayek belonged. Even then, I have yet to see a simple and arresting explanation. In The Constitution of Liberty, Hayek refers to the effects of taxation, including “the frequent restriction or reduction of the division of labour”. (3) The Institute of Directors’ Graeme Leach refers to the “deadweight loss” as the loss of output that would have occurred in the absence of the tax – a loss of economic welfare above and beyond the tax revenues collected. (4)
These observations are absolutely correct, but it is probably fair to say that they do not describe in layman’s terms the simple mechanism at work. We must remember what we are up against in the shape of government and the public sector in general (including many schoolteachers and lecturers); the last thing they want is to have their cover blown. It is nothing short of a scandal that generally respected commentators can still promote government spending as a major plank in getting out of the current recession when (in addition to the fact that such spending was a major plank in creating the recession) it will inevitably reduce output even further. Such a level of ignorance could not possibly exist were it not for the state’s iron grip on the education system via a nationalised school system including a national curriculum. And you certainly won’t find a mention of the topic on the website of the “National School of Government”, the Civil Service training college.
All taxes are based on the exchange of goods and services
How, then, can the fact that every rise in overall tax levels means a net reduction in aggregate living standards (a net reduction which in my estimation for the UK at present is about three-quarters of the tax rise) be brought to the attention of the wider public? (5) It is not as if the theory is complicated. Consider, for example, tax in the form of tariffs or import duties. A tariff is a simple tax on cross-border trade and even its advocates must appreciate that it reduces such trade – that is the intention! Now consider tariffs on trade within a country’s borders – in other words, taxes. Again, such tariffs reduce trade, this time internal trade. Borders make no difference to the outcome; the price of trading is increased, and those participants whose preferences for the exchange are not strong enough to accept the additional cost will cease to participate.
Naturally, the higher the tariff, the greater the loss. A 50 per cent tariff would remove very large numbers from the relevant trades and exchange. Let’s face it; a 50% tariff is halfway to a 100% tariff, which would entirely eliminate all trade and exchange if effective, and take us back to the Stone Age – or worse. (As Adam Smith himself said, “nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog”. Man is the only animal that carries out voluntary exchange and he owes his prosperity to this.)
The only difficult point to grasp is that all taxes are effectively tariffs, i.e. taxes on exchange or trade (which means that a 50% tariff is a reality in the UK). When you think about it, there’s nothing else to tax. Excise Duties, VAT, Corporation Tax, Income Tax, Council Tax, Rates, and so on are all derived from trade. If you provide me with food and I provide you with clothing, it matters not whether Government takes its cut on the trade itself, or from you and me as providers and recipients of the goods. The only activity that eludes tax is providing for oneself, and oneself only, in the form of DIY (do-it-yourself).
Households are tax havens
The above reasoning leads to an example so simple that it could be easily taught in primary schools. Trade and exchange within a household is not taxed at all. So a married couple (say) can enjoy the fruits of Ricardo’s law of comparative advantage without any government rip-off. If the female is a great cook, and the male a great gardener (or vice versa), each can concentrate on what they do best. But a similar pair of people who are friends but don’t share a home cannot, strictly speaking, do the same without being taxed. This means immediately that under a 50% tax on exchanges, each of them needs to be at least twice as productive at his/her own speciality if these specialities are to be put to full use. If this (quite high) productivity hurdle is not reached, each partner will carry out both activities, entirely for himself/herself, so as to avoid the tax, which has thus entirely removed the division of labour but has yielded nothing. Since each is working inefficiently for half of the time, there is a loss of total output. This is the deadweight effect. (6)
Child’s Play
At this point the basic argument has been made. The introduction of a 50% tax on the exchange of goods and services within a household would remove large swathes of division of labour in the household, which accordingly suffers a very significant loss of productivity. Any normal child of primary school age would be able to see the results daily (“why are you doing that, Dad, and making a hash of it to boot?”) and would understand that something similar happens outside households if the same taxes operate. There is no reason why this cannot be taught in primary schools; it certainly seems more useful than learning Mandarin! (7)7. While a modicum of teaching in the private sector remains outside government control, a campaign aimed at private schools to teach this simple fact may just work. (Naturally a successful campaign at state schools would be even better!)
If we now move from an untaxed household to a hypothetical (similarly untaxed) community, the standard of living will be much higher (due to the vastly greater division of labour and the similarly greater number of tasks which can be undertaken). But since each worker is now concentrating on his/her speciality nearly all the time rather than only half of it, any reversion to DIY is doubly damaging.
Thus the UK’s 50% tax (all taxes combined) knocks out all divisions of labour which don’t carry an extra 100% productivity compared to DIY. You have to be more than twice as good at your speciality to carry it out, pay the tax, and still be ahead of the game. This is a big hurdle, and here I’m ignoring the regulatory costs involved (“health and safety” for example). Note also that the behavioural changes come into being before the tax is (or would be) paid, so it is impossible to collect as if the trades and exchanges were still operating.
The larger the community, and the greater the diversity of natural resources within it, the greater are the opportunities for the division of labour and higher living standards. On a world scale, low taxes and genuine free trade (as opposed to trade “managed” by governments) would maximize the division of labour i.e. the use (and promotion) of comparative advantage around the world. (8) The scope here is huge, bearing in mind that global, cross border trade as a percentage of total trade has only just reached its pre-1914 level.
We now need to verify (or otherwise) whether the conditions of a small community still hold on both the national and international stage.
The tax effect operates at the margin
First of all, we must look at the effect of overall rates which differ from my 50% illustration. One of the problems with most of the literature on this topic is that the debilitating yet often silent effects of tax is that the statistics used to estimate the adverse relationship between economic growth and tax do not properly cater for the different levels of overall taxation. This is crucial; the effects of a tax hike of one percentage point are far greater if tax is already high as opposed to very low. My estimate that a move in the UK of total taxes from 30% to 50% has meant a loss of one sixth of national output would be far less marked in a move from 10% to 30%. (9) Or more simply put, a move from nil tax to 50% would not remove all output except strict DIY, whilst a move from 50% to 100% does just that!
Is an “all taxes combined” rate still realistic on a world stage?
It may be argued that because each of the myriad of businesses and other economic agents act only with regard to their own tax situations, the use of an aggregate tax rate is no longer applicable. “Thus,” the argument goes, “while we can accept that income tax might be responsible for the lack of old-fashioned nannies or the similar lack of chauffeurs for sales reps (as opposed to for big company executives), it doesn’t follow that the disincentive is on average 50%”. But the fact that every market participant faces a smaller array of taxes is irrelevant. If all taxes were levied only on the consumer as expenditure taxes or tariffs the true rate of 50% would be exposed. (A single tax is still favoured by many serious economists, one of the most popular being an expenditure tax.) (10)
Hayek’s triangles: A necessary digression
Before proceeding further, a digression on the structure of economies will help us to understand the bones of the Austrian School Theory of the business cycle, and introduce the triangles of F. A. Hayek. In essence the argument is as follows. (Please also note the charts which follow.)
(i) In developed economies, a crucial element is the presence on a large scale of capital goods, provided via previous saving which in turn requires partial abstinence from consumption. For example, take Robinson Crusoe stranded on a desert island, who needs to eat fish to live. At first he uses a fishing net hastily cobbled together, but sees the enormous possibilities of working from a boat. To find the time to build one, for a while he must survive on some combination of fewer fish, less sleep, less exploring, and so on. Building the boat is a huge drag for him but when it is finished his fishing will be far more productive. He has saved time and resources to build capital equipment and multiply his output beyond recognition.
(ii) A developed economy has made very large savings, over many years, in order to build capital equipment – factories, machinery and so on. This lengthens the overall time-period to produce goods and services but the wait is worth it as the goods eventually come on stream – of high quality and in huge quantities. Anybody can fashion a very simple wooden pencil in a few weeks, for example, but their mass production involves thousands of processes from all over the world and takes a decade or more to reach the shops from the original logging of cedar trees (more still if the growth of the necessary trees is taken into account, which it should be). (11)
So the hallmark of a developed economy is a long period of production, with a massive pay-off in both quality and quantity.
(iii) In free markets, all this is held together by the infrastructure of businesses, whose total spending dwarfs all government and consumer spending (broadly GDP) by a factor of around four. In particular, market interest rates are unknowingly determined by consumers and savers in their relative propensities to consume or save. This is what determines the length of the production periods. Low time-preferences for goods “now versus later” mean that consumers are prepared to wait for something bigger and better for relatively little reward in terms of interest in the meantime, whilst high-time preferences mean “I want it now (or soon)”. If market interest rates are sabotaged by government (as they are) the incredibly delicate structure of the economy is torn apart. Artificially low interest rates result in an artificially long and unsustainable production structure and the following recession is a purge to a more sustainable structure in tune with what are undoubtedly significantly higher consumer time-preferences – although at some point these “I want it now” preferences will moderate as the need for greater saving kicks in.
Back to taxes, the division of labour, and business expenditure
As mentioned above, in developed economies, business expenditure is far higher than GDP, which is little more than government and consumer spending. Business expenditure is a good measure of the length of the productive period shown in the above charts. In turn, that length illustrates the depth of the division of labour. The biggest sufferers from high tax are savers, whose savings enable a long production period by providing money for investment. We are now seeing in the UK and the USA a contraction in the division of labour, which means a contraction in average living standards in future. Already in the USA business expenditure last year slumped by 10% – a far greater fall than that of government or consumers. (12) The UK picture is likely to be similar.
In other words, both government spending – i.e. tax and future tax to pay back borrowing – and consumer spending have careered out of control and point to an even greater reduction of the division of labour in future. Indeed there is evidence that this has been going on for two decades or more. (13)
The vast majority of politicians haven’t the foggiest idea of such changes or their import. But the fact remains that in all private sector business activity, the demand for the division of labour has its own structure fashioned under the silent influences of taxation, and the supply of expertise and skill operates in unison. Thus, just as under lower taxes domestic issues such as cleaning, house-maintenance, decorating, and many other DIY tasks around the home would be contracted out to specialists, so a typical business today combining a PA/secretary/typist, a finance director/pension scheme manager, a book-keeper/accountant, and various factotums, would (under lower taxes) would similarly split them up into deeper specialities – either within the firm or, more likely, contracted out. (Under higher taxes the reverse will apply). Without the tax wedge, the greater division of labour would allow more contracting out to take place, the average size of firm would be smaller, and the number of businesses would be larger. (14)
Perhaps anti-capitalism protesters against giant global companies, having first learned that global cross-border trade has only recently returned to its pre-1914 position, should focus on campaigning for lower taxes as a means to promote smaller firms. Knowledge of the underlying principles behind economic activity would be a good counterbalance to the hopelessly misguided economic thought that currently dominates.
Notes & References
1. Reeves, R. (2009) Daily Telegraph, 13th November.
2. See for example, ‘The driving forces of economic growth’ OECD Economic studies 2, 33 (http://www.oecd.org/dataoecd/26/2/18450995.pdf) , the IOD’s recent publication ‘How to save £50 billion’. and www.heritage.org/index, www.fraserinstitute.org
3. Hayek, F. A. (1960) ‘The Constitution of Liberty’.
4. Leach, G. (2009) ‘The negative impact of taxation on economic growth’ Institute Of Directors.
5. Arthur, Terry, ‘Economic Affairs’, March 2003.
6. This assumes for illustrative purposes that the relative advantage is the same for both parties and that both activities are required to the same extent.
7. Suggested in January 2009 by Ed Balls, current Schools Secretary.
8. Here we should note that, as Ricardo showed, there are still efficiencies to be gained even if A is more productive than B in all activities.
9. This estimate is perhaps more a guesstimate. The effect depends on the statistical distributions of the additional productivity under specialisation. My estimate assumes that the additions between 0% and 100% add up to a similar total to the additions of more than 100%. This seems plausible and I believe it is futile to try and nail this down any further; this is especially so given that my estimate fits in very well with all the statistical data.
10. In fact the actual burden of nearly all taxes, including sales or expenditure taxes, is shifted back to income taxes, from those who physically pay them. See Rothbard, M, ‘Man, Economy, and State, with Power and Market (Chapter 12), Mises Institute. (2004)
11. Read, L. (1998) ‘I….. Pencil’, The Foundation for Economic Education, Revised Edition. (fee.org/doc/i-pencil-3/ )
12. Corrigan, Sean. (2009) ‘Tangible Ideas’, Diapason Commodities Management.
13. The Capital Letter, Capital Insight, May 2002.
14. Coase (1988) ‘The Firm, the Market, and the Law’, Chicago, University of Chicago Press. Ronald Coase argued that business firms exist to avoid some of the transaction costs which would otherwise be necessary.
Time for Ireland to say slán to the euro?
The latest bailout will put every Irish man, woman and child on the hook for an additional €20,000, regardless of whether they lent a “helping” hand to produce such an imbalanced state of affairs. While the morality of indebting innocent citizens to save culpable bankers is questionable, it may be time to reassess if there was a better roadmap to recovery that the Irish could have followed.
In late 2008 a popular joke circulated about Ireland’s future: What’s the difference between Ireland and Iceland? One letter and about six months.
Iceland was quickly descending into its deep nadir. A decade of highly inflationary monetary policy had left the Icelandic economy awash with credit. Money flowed into the stock market, consumers’ goods, housing and, eventually, foreign investments. Secured by an explicit bailout guarantee from the Central Bank of Iceland, the domestic banking industry soon ballooned to 1,100 percent of 2008 GDP. Activity was centralized in a mere three banks, which together controlled 80 percent of total Icelandic banking assets. Secured by a stable krona exchange rate, banks, entrepreneurs, and individuals increasingly borrowed in foreign-denominated debts – primarily Swiss Franc, Japanese Yen. Eventually 80 percent of total consumer borrowing was concentrated in these two currencies.
Ireland’s recent excesses were no less impressive. Private non-financial sector debt soared to almost 200 percent of GDP, among the highest in the Eurozone. The Irish government’s budget deficit for 2010 is reckoned to amount to over 32 percent of GDP.
While the Icelandic government decided to nationalize the banking sector, it soon became apparent that the size of it problems dwarfed the ability to deal with it. Instead of inflating the money supply, the Central Bank of Iceland effectively filed for bankruptcy. Indeed, given the size of the banking sector’s foreign-denominated debts it is unlikely that the CBIcould have inflated its troubles away – adverse exchange rate movements would have cancelled any positive effects from printing new krona to pay off foreign debts.
By choosing the bankruptcy path rather than continued bailouts, the Icelandic economy fell into a deep immediate decline.* Within months of Iceland’s “bankruptcy”, its stock market had fallen more than 95 percent from its 2007 highs. The krona depreciated by 60 percent against the euro. While such drastic adjustments were devastating for the short-run, they were necessary to provide entrepreneurs with the essential signals to aid economic recalculation, and to promote coordination. The decline in the krona exchange rate provided domestic producers the necessary cost advantages to recommence becoming exporters to the world. At one point Iceland, a country with no domestic automotive production facilities became a net exporter of autos as the devalued krona made export of the surplus stock of vehicles profitable.
The combination of a general unease to lend to the Icelandic government and a devalued exchange rate made it increasingly difficult for the Icelandic government to continue running budget deficits. Austerity measures that other countries have discussed, but lack the commitment to enact came into place – not necessarily by choice, but by necessity.
Ireland’s inclusion to the Eurozone made it impossible to correct its situation through an exchange rate decline. As exit from the Eurozone was a political impossibility, a stream of bailouts and guarantees – implicit and explicit – became the norm for Icelandic investors and politicians. Ever increasing amounts of public sector debt piled on an already unsustainable situation. Banking imbalances worsened, yet the situation was never fully addressed until the credit markets dictated that it could not continue. With Irish politicians unable to secure affordable credit on the bond markets, a concerted bailout from the EU, ECB and IMF was pushed upon the newly domesticated Celtic Tiger.
It is instructive to evaluate how each country has fared in the two years since this global crisis erupted. While Ireland’s nominal GDP remains in freefall, Iceland’s has stabilized and is starting to show faint signs of recovery. Real wages, which have been negative in Ireland for over two years started showing positive growth in Iceland earlier this year. As inflation has stabilized in Iceland, the country is showing strong signs of recovery. A significantly devalued krona has allowed the country to return to competitiveness, with commensurate growth in its GDP. In contrast, the lone piece of good news coming from Ireland this past week was that a portrait of Brian Cowen had finally been found to hang in Ireland’s national parliament, Leinster House.
Iceland’s pain was severe, but at least short-lived. Ireland’s recovery is still nowhere on the horizon, despite two years of investor uncertainty concerning and continually worsening situation. While the old joke asked pejoratively what the difference was between Iceland and Ireland, today is a good time to revisit the question. If Ireland could become Iceland in 6 months and one letter it would be a miraculous recovery. With some dedication and perseverance, the Irish could turn their economy around. Saying goodbye to the euro would be a step in the right direction.
~
*This is not to imply that the Icelandic case was free of bailouts. Several international consortiums provided emergency liquidity support to the government. What Icelandic policymakers did not pursue was a continued propping up of an unsustainable oversized banking sector, one which was impotent to combat the effects of higher interest rates or a liquidity constrained world. Philipp Bagus and I document Iceland’s boom and bust in our forthcoming book “Deep Freeze: Iceland’s Economic Collapse” (Auburn, AL: Ludwig von Mises Institute).
How to leave EMU
This was already obvious. History clearly shows that monetary unions only survive in the long run if they conform to one of two patterns. One is between a minnow and a whale – eg., Luxembourg and Belgium from the 1920s to the 1990s; Ireland and the UK from the 1920s to the 1970s; or Panama, Ecuador and El Salvador and the United States (different periods). In those cases, the whale sets monetary policy to suit itself and completely ignores the minnow. The other possibility is between (roughly) equal countries, which also form a fiscal union. Any other monetary union will ultimately break down. One does not have to go back in the past to the Latin or Scandinavian Monetary Unions of the late 19th/early 20th Centuries. Just look at the Czech and Slovak Republics. After Czechoslovakia broke up on 1st January 1993, the two countries were to keep the single Czechoslovak koruna; by 8th February (less than six weeks later) the monetary union had broken up. Moreover, history is full of examples of how monetary unions break up – eg., following the dissolution of the Austro-Hungarian Empire, of the Soviet Union or of Yugoslavia.
That there is no formal route to leaving EMU is therefore irrelevant. A sovereign country that wishes and decides to leave the eurozone can and will do so. No one is likely to go to war to stop it. The questions therefore become, why would a country leave and how can it be done? Need it really be as messy and painful as The Economist claims?
As to why a country would leave, the answer is – in theory – simple. A country will leave the euro when the pain or cost of membership exceeds the benefits. In the case of the southern European countries, this includes the pain of continued uncompetitiveness and the need for painful and protracted structural reform to regain competitiveness (eg., in the cases of Spain or Italy, some combination of 25% nominal wage cuts or between 25 and 50 years of no wage increases), as well as fiscal retrenchment. In the case of Germany, the pain is the continued need to bail out southern Europeans who refuse to reform (leaving aside the issue of whether Germany is in fact helping to create the problems of southern Europe through its insistence on export-led growth).
This being said, there are three important caveats. The first is that although over a period of time, the pain of remaining in the eurozone may exceed the pain of leaving, the pain of leaving is likely at any given time to exceed the pain of staying. Second, before a country leaves (as opposed to is expelled from) the eurozone, it will need at least one senior mainstream politician supporting the idea. And third, one should not underestimate the willingness of the continental European political elites to inflict pain on their peoples in pursuit of what they see as ‘the greater good’.
Perhaps the most important of these caveats is the second. Ideally, for a country to leave the eurozone, it should come as a surprise and happen rapidly. But with the entire relevant political elite in the eurozone countries still committed to the EMU project, this is unlikely to happen. This means that leaving the eurozone would be preceded by a possibly prolonged by certainly open debate. But, in turn, this creates further problems.
What are then the problems with leaving EMU? There is one set of problems connected with the pre-discussion leaving; there are three further main problems connected with and subsequent to the leaving. Whilst not underestimating any of them, they can all be dealt with.
With the exception of Germany, which would leave EMU in order to revalue its currency, any country leaving EMU does so in order to devalue. This means that if EMU exit does not come as a surprise (which is highly unlikely, partly because of the public debate issue referred to above) the pre-exit period will be characterised by attempts by all concerned to protect themselves from the devaluation effects. This will include foreign creditors postponing payment to domestic debtors; and by foreign debtors insisting on early payment from domestic creditors. Both households and companies will withdraw funds from their domestic banking system, either keeping cash in hand or transferring deposits from, eg., Greek banks in Greece to non-Greek banks outside Greece.
Keeping cash in hand does perhaps not sound like much of a devaluation defence. But all euro notes and coins have national characteristics. The coins all have a national side; the notes have a national registration letter in the serial number (Greece is Y, Italy is S, the UK, should it ever join, is J, and so on). Any country that leaves the eurozone will at least initially have to use its ‘national’ euros as a currency, while remaining eurozone members will continue to use ‘their’ euros. A Greek concerned about Greek eurozone exit and devaluation can therefore protect himself by withdrawing his savings and insisting on receiving banknotes with, eg., X (Germany) in the serial number.
At its extreme, this could mean a wholesale flight of all bank deposits in a country deemed at risk of eurozone exit. That would threaten to collapse the banking system and that country’s economy – if banks lose all their deposits they also have to shrink their assets, that is to say call in their loans. But no business sector could withstand having to repay all its loans in advance and in one go. One way of solving this would be for the government to pass an emergency decree allowing it to borrow in the central bank (technically, this is currently illegal, but in an emergency that could be overturned) and then replace all bank deposits lost by capital flight. However, this also means a large rise in the government debt, further undermining public finances.
EMU exit itself would be announced by proclaiming that of a certain date, all local assets and liabilities would be denominated in the new domestic currency at a pre-set exchange rate. Again, ideally this should be done at once (eg., announcing EMU exit on a Sunday morning with immediate effect), combined with the imposition of capital controls, but, again, that is unlikely to happen.
Following EMU exit, any country leaving would most likely be exposed to lawsuits from outside creditors who object to being repaid in the new, devalued currency. However, it could try to pre-empt this by promising to honour euro-denominated external liabilities until roll-over. This depends on the size of its liabilities and whether it wishes to try to preserve some goodwill by taking on the exchange rate risk instead of putting on the lenders.
A second issue concerns what currency to use in the future. The Economist highlights this as a key problem. That is going too far. As noted above, for at least an initial period, a devaluing country would use ‘national’ euro notes and coins. This is similar to the period following the break-up of the Austro-Hungarian Empire, when the existing banknotes were simply stamped with the symbol of the relevant successor state. Even later, when a true national currency is reintroduced, it could conform in size, shape and weight to current euro notes and coins, avoiding the need for new machines and a complicated switch.
A completely different post-exit issue is how a country would fare on international capital markets following devaluation. There has been some concern that a country that defaults (and devaluation is default by other means) would be shut off from capital markets in the future, with no one willing to lend to it. This is almost certainly wrong. History shows that if the only threat creditors hold over a country is a refusal to lend if it defaults, then it should default. Moreover, it can be assumed that a country that leaves EMU and devalues not only gains an immediate competitive advantage, but also gains the longer-term advantage of an independent monetary policy that can be set to suit the country. This should, all things being equal, provide a powerful boost to the exiting country’s output growth, certainly so in the near term. That should improve public finances, at least in the near term. Add to that the fact that it would initially have to pay higher interest rates, it is very unlikely that lenders would refuse to provide new funds. (Judging by the past behaviour of capital markets, they would in fact probably be knocking at the doors of the relevant Finance Ministry bearing funds.)
There is no question that to leave the eurozone and EMU would be a messy and complicated procedure, with substantial risks. But these are not insurmountable, nor should it be forgotten that there are some clear advantages – both for the country leaving and for those staying. To rule it out completely is to ignore not only the lessons of the past, but also the fact that ultimately, countries are ruled by their self-interest, not by the devotion to an abstract and badly-conceived idea.