Good and bad objections to positive discrimination
The US Supreme Court has just left one Texan affirmative action scheme in place, but it has recently busted schemes elsewhere. I discuss what libertarians should think about positive discrimination and affirmative action.
Many of the arguments libertarians make against affirmative action/positive discrimination do not hold. For example, it neither needs to interfere with equality before the law, nor does it need to imposed by state coercion. And in its favour, affirmative action may be one way to overcome some of unjust forms on inequality in our society. On the other hand, it is clearly not even close to the best way of dealing with unjust inequality. And some evidence suggests that these schemes actually hurt those they are designed to help. But without sufficient evidence perhaps the best short-term approach is to allow universities to experiment with their admissions process, so they can among them discover the best approach.
The supreme court on 24th June effectively decided to leave a Texan affirmative action programme in place. The programme had two main provisions: (1) guaranteeing any pupil finishing in the top 10% of their year group a place at a publicly-funded university in the Lone Star state; and (2) allowing university administrators to consider race and diversity as part of their admissions criteria.
Both elements work as positive discrimination tools. Guaranteeing places to relatively—as opposed to absolutely—high-achieving pupils should mean that at least some of the effects of school quality are subtracted out. And allowing authorities to take into account race means that deprivation or oppression experienced mainly or exclusively by non-whites may also be factored out. How do we judge whether this is bad or good?
Many libertarians would object that a system of affirmative action either because it violates equality before the law or because it interfered with people's free interactions, and could only come from state involvement. But neither of these claims necessarily hold.
Though it may not necessarily be true in the specifics of this US case, in general we'd generally expect and require that equal application of law took circumstances into account. For example, years of domestic abuse would rightly be considered an extenuating circumstance in a case where a parter accidentally went too far in self defence. Similarly equality before the law in schooling may require taking into account the statistically likely backgrounds of applicants.
The alternative seems less equal, since getting top A-levels at a tough inner-city comprehensive is surely more difficult than at a highly selective school, even given similar parental support. And in still-discriminatory societies people of colour usually have more difficult lives, even past their general social deprivation, and thus we might expect lower grades, even for an equally talented or conscientious student.
The other libertarian objection may have slightly more force. It would be rational for universities that either sought to maximise wealth (through boosting bequests) or academic prestige (through the best students or best research) to neuter out factors that affected school-level performance but would not affect university or later career performance. The factors listed seem like obvious examples of these. But affirmative action may have to go further, not simply aiming for top potential, but also for those who due to their unfairly poor circumstances have lower potential. It would seem to have to go this far if it wanted to attain the goal of fully accounting for circumstances, as some circumstances may reduce potential as well as reducing results in lower tiers of education. In effect, with affirmative action we want to act as if people had never been hampered with worse starts, even if at the university level we want to "leave in" differences in natural talents.
Thus it might be that state pressure would be necessary to get universities to consider more than just student potential. But this is far from certain; the University of Michigan's scheme, which gave 20 automatic points (out of an 100 needed for guaranteed admission) to underrepresented ethnic minorities. It was ruled unconstitutional but while it was in place it was chosen freely by the university. If chosen upon freely then surely libertarians should laud the schemes as admirable voluntary attempts at distributive equality through free association.
But there's a more telling objection to affirmative action: it causes more harm than it does good. In his barnstorming dissent to the judgement, (black) conservative justice Clarence Thomas points out many of the bad effects of the scheme. In his 2007 memoir he said "As much as it stung to be told that I'd done well in the seminary DESPITE my race, it was far worse to feel that I was now at Yale BECAUSE of it." And in his very readable judgement, along with pointing out the similarity—despite their apparently inverse goals—between segregationist and pro-slavery arguments and pro-affirmative action cases, he listed the negative impacts positive discrimination can have on those it's supposed to help.
Thomas cites a 2003 book which claims that "it is a fact that in virtually all selective schools…where racial preferences in admission is practiced, the majority of [black] students end up in the lower quarter of their class." And, according to Thomas, this upward shifting does not result in higher proportions of black or Hispanic students in higher education on average. Instead, minority students go to more selective schools than they would have otherwise attended, which he believes explains their relatively poor performances. This, in turn, pushes them into less challenging schools within those universities, he says, citing figures showing disproportionately high numbers of blacks and Hispanics study social work or education.
Worst of all for Thomas is that—in our flawed society (which won't be changed by this policy alone)—positive discrimination "stamps blacks and Hispanics with a badge of inferiority". One feature of race is that it's often outwardly identifiable, meaning any black or Hispanic student could be seen by others as owing their place to affirmative action, even though most of them in the particular case in question did not gain their place due to the system. He quotes a black student: "I was never able to be as proud of getting into Stanford as my classmates could be…how much of an achievement can I truly say it was to have been a good enough black person to be admitted, while my colleagues had been considered good enough people to be admitted?" This ties into the ideas Elizabeth Anderson explores in her classic essay "What is the Point of Equality?". She imagines a government grant to the less attractive—would they be grateful for the money or would they be deeply hurt by the elevation of subjective preferences to official dictum?
Such concerns, especially packaged with the litany of practical issues and inconsistencies highlighted by Thomas and Prof. Mark J Perry make the issue more difficult, and give us reason to question whether the system is the best means of achieving our genuine concerns about equality. If we can achieve more desirable policies to improve distributive justice like a universal basic income and a negative income tax, then we should definitely not try and engineer equality at the level of the university. In a system with overall distributive justice, differences in education are down to different choices and shouldn't trouble us.
In sum, we can conclude that though neither of the main libertarian arguments against affirmative action hold, it may nevertheless be an undesirable scheme because it actually hurts those it intends to help. But a diverse system is surely preferable to a one-size-fits-all set of admissions policy, and that suggests we'd want to leave universities to decide whether or not they implement positive discrimination for themselves.
If it ain't broke, break it: how to increase prices and profits in the GB retail energy market
Britain’s competitive retail energy market was the first in the world, and for many years the most competitive. It had the most active suppliers, and the most active customer switching. This competition and choice brought better offers for customers. It may not seem like it because of recent energy price increases. But these reflect increases in fuel costs like gas, higher costs of renewable energy and other obligations on suppliers, not a lack of retail competition.
In fact, retail competition was sometimes too fierce, witness the problem with doorstep mis-selling. But Ofgem took action to fix that problem.
Retail profits in the domestic sector used to be minimal; Ofgem calculated that many were negative. New entrants came into the market, but until recently most found it tough to survive.
Retail competition has been enhanced by a dozen switching sites. Each seeks the best way to attract users, to offer the simplest calculations, to include the most relevant information and the clearest comparisons, to facilitate subsequent switching. No other country can boast as lively, innovative and effective market for information and assistance to energy customers as Britain.
So what went wrong? Someone or something had to be blamed for the energy price increases. Ofgem was unable to find evidence of market failure. It concluded that the problem was customer failure. Customers were paying high prices because they were unable or unwilling to understand suppliers’ offers. So the market had to be simplified.
An increasingly bizarre series of proposals and directives has emerged from Ofgem, Government and now Which? magazine for dumbing down the retail market. All are well-intentioned, none shows any understanding of competitive markets, none will increase customer engagement, and all will make customers worse off.
Ofgem was first. It noticed that suppliers based in one area were offering lower prices to customers in their competitors’ areas. In 2009 it decided that requiring suppliers to charge the same price to all customers would bring the benefits of the lower prices to all customers - Right? Wrong. Suppliers predictably found it more profitable to raise their low prices to new customers than to lower their prices to existing customers.
Customers suffered because the low-price offers were withdrawn. They also began to lose interest in switching supplier: the switching rate has since fallen by nearly a half. But suppliers did not lose out from this reduction in competition. Quite the opposite: Ofgem’s calculations show their retail profit margins increasing to an all-time high: from minus £10 per dual fuel customer in May 2009 to about £50 from 2010 to 2012 to £100 now.
In 2011 Ofgem proposed that all suppliers should offer the same monthly standing charge – which Ofgem itself would specify. It overlooked – or didn’t care – that this prohibited tariffs with no standing charge, which are popular with pensioners. And that Ofgem would now be jointly responsible for setting energy prices. Ofgem withdrew its proposal.
Meanwhile, suppliers found other ways to compete – for example by offering lower prices online. Customers benefited – until Ofgem decided that this made the market too complicated. In October 2012 Ofgem proposed that suppliers would be allowed only four tariffs per fuel. This of course is tough on customers with minority tastes, like green tariffs, or even tariffs with no standing charge. And innovation will cease if a supplier can only innovate by withdrawing an existing tariff that supplies about a quarter of its customers. But now it’s simplicity that counts, not the availability of products that customers want.
There are other petty restrictions. Discounts must be the same each year, expressed in pounds not percentages. If this restriction had been in place, it would have banned the best offer in the market earlier this year. And in future it may not be viable for suppliers to offer discounts that don’t use percentages to tailor the discount to the size of bill. But the availability of good offers is no longer a relevant consideration.
At the same time, another bright idea popped up at Prime Minister’s Question Time. Just in time for the County Council Elections. The campaign leaflet says “Conservatives in Government have forced energy companies to put customers on the lowest tariff”. Leave aside that this is not yet enacted, and still just an idea that Ofgem might reluctantly trial. Leave aside too why Conservatives in Government and not Ofgem are now regulating energy companies. Let us just ask: what does it mean and is it a good idea?
If it means that energy suppliers will be forced to put their own customers on to the lowest tariff offered by their rivals, is there the remotest chance of this working? Suppose it means that energy suppliers will be forced to put customers on the lowest tariff they themselves offer. But if a supplier offers a discount on its standard tariff coupled with an exit charge of £50, do we really want to force that supplier to put all its customers on a tariff that locks them in? And if a supplier wanted to offer a discount for new customers, but was forced to put all its existing customers on the same discounted tariff, isn’t it obvious that it would be more profitable not to offer the discount in the first place? Once again, the proposal will drive out the best offers.
The latest bonkers suggestion is from Which? magazine. It says that Ofgem’s proposals for simplifying the market don’t go far enough. The government should require single unit prices for each energy tariff, like petrol prices on a garage forecourt. Simplicity is flavour of the month, and petrol is a competitive market, so what’s wrong with this? Lots.
First, Which? seems to be asking for a single uniform price across the whole of the country. But distribution network charges vary considerably across the country. To impose a uniform retail price or network charge would require massive geographic cross-subsidisation between network operators and between customers that would be neither workable nor obviously equitable.
Second, forcing all tariffs to have a zero standing charge would mean that suppliers would not be allowed to offer a lower unit price to larger customers that are more economic to serve, and suppliers would no longer be interested in attracting smaller customers. The likely impact on different kinds of customers has not been considered.
Third, limiting the variety of energy products so that customers are faced with only one price per supplier would enable and encourage suppliers to coordinate prices. If one supplier breaks ranks then other suppliers will either follow or that supplier will fall back into line. Customers will find that suppliers offer similar prices almost all the time. Where then is the incentive to engage in the market?
All these schemes assume that regulators and governments know more about customers than those who make a living by discovering and providing what customers want. These schemes won’t really simplify the market and they won't persuade customers to engage more. But they will restrict competition, and customers will be worse off because the best offers will disappear. Suppliers will find it costly to comply with the proposed 126 pages of new regulatory red-tape, but the costs will be passed through to customers and the suppliers will grumble all the way to the bank.
Britain’s claim to have a leading competitive energy market and regulatory body is no longer tenable. “If it ain’t broke, break it” may sound like action, but it will not, ultimately, be persuasive to customers.
Busting welfare myths
Myth: Welfare spending that goes on pensions is unreformable.
Reality: The state pension eligibility age has risen too slowly.
Opponents of cuts to welfare often cite the proportion of welfare that goes on pensions (48% or a total of £80bn) as proof that the colossal budget is justified. This is lazy reasoning. The problem is not that pensioners necessarily receive too much money per year, it is that they receive it too soon. Life expectancy is rising fast and people are able to contribute to the economy for longer than they used to. If the government were to raise the state pension age over the next two decades to 70 taxpayers would save hundreds of billions and all would benefit from the contribution of older workers. If this change were made by 2030 pensions would still provide for 15 years of retirement, based on experts' guesses of life expectancy then. Historically this change is long overdue – since 1948 life expectancy has risen by 16% but the accompanying rise in the State Pension age has been a meagre 1% for men and 3% for women.
Myth: capping housing benefits is a long term solution
Reality: the housing crisis will only be solved by increasing supply
The next biggest outlay after pensions is housing benefit. This takes up 11% (£20bn) of the welfare budget. The government has made some savings by putting a cap on welfare at £26,000 (if a household’s benefits are in excess of this figure housing benefit is reduced until they fall into line). A more fundamental solution would be a liberalisation of planning laws to allow development in areas where it is currently blocked. The strangling of supply is the cause of relentless house price and rent inflation. If development rights were auctioned off and the proceeds given to local residents this would alleviate both the problem of NIMBYism and the government’s bloated housing benefit bill. It would also have the corollary benefit of helping young people onto the housing ladder, and would preserve the vast majority of our rural spaces.
Myth: The government’s ‘making work pay’ initiative is merely a cover for cuts.
Reality: Some in-work benefits will have to rise if work is ‘to pay’.
The benefits system is riddled with financial disincentives to move into work. The government is trying to eliminate them so that welfare prevents poverty not job-taking. What is rarely acknowledged is that eliminating disincentives sometimes implies increasing benefits. Notably, those entering work often face aggressive withdrawal rates (Job Seekers’ Allowance and Income Support have 100% withdrawal rates) and if work is to pay these sudden withdrawals will need to be smoothed out. The gist of the Universal Credit is to have fewer people receiving out of work benefits in the long run, but not necessarily to give those on welfare less money. We should therefore be weary of clichéd claims that the Universal Credit is a veil for welfare cuts.
Myth: Immigrants sponge off welfare
Reality: Benefits tourism is miniscule
Immigrants are 60% less likely than natives to receive state benefits or tax credits and only 6.4% of total working age benefits go to immigrants. Further, immigrants from the ‘A8’ (the Eastern European countries entering the EU in 2004) pay 37% more in taxes than they receive in public goods and services. Of course, this tells us nothing about the social impact of the 3 million new people (between 1997-2010) who have moved to Britain, and tried to assimilate into British culture. It does confirm, however, that scare-mongering about benefits tourism is unfounded.
Myth: benefit fraud is rife/ benefit fraud is negligible
Reality: We have no idea how common benefit fraud is
The simple fact is that there are no reliable figures on benefit fraud (and so we have no idea if the public overestimates it incidence). The most commonly used figure comes from a 2011/12 report from the DWP which estimates that 0.7% of expenditure goes on fraudulent claims. But benefit fraud amounts to fooling the DWP into thinking you are entitled to more than you actually are, so to suppose the DWP’s figures are accurate is to suppose that British benefit fraudsters aren’t very successful – which is to beg the question. Polls show that Brits think 27% of the welfare budget goes on fraud, in the absence of more reliable figures we cannot endorse or deny this estimate.
Myth: the public think that 41% of welfare goes on job seekers’ allowance
Reality: they think that 41% goes on benefits for the unemployed
It has become common in some circles to consider the British public misinformed about job seekers’ allowance spending. Brits are accused of being wildly off the mark since only 3% of the welfare budget actually goes on this benefit. This is unfair – the 41% figure comes from a TUC poll which asks how much is spent on ‘benefits for the unemployed’. Unemployed people can receive housing benefit, child benefit, free school meals, tax credits and so on – in other words they receive far more in benefits than just job seekers’ allowance.
Why Marx was wrong about capitalism
Like many public figures who leave a legacy, either in their writings or their deeds, Karl Marx was sometimes right and sometimes wrong. I concentrate on some of the things about which he was wrong.
He was wrong to predict that history would take us to the inevitable triumph of the proletariat and then stop. History shows no signs of doing either. Marx was also wrong to suggest that this would happen first in the most advanced economies as the final stage of capitalism. In fact such revolutions as came took place in less developed economies such as Russia and China. It has not happened in the advanced economies, and this could be because Marx was wrong about something else.
He predicted that capitalism would drive down wages to survival level before its final denouement. In fact as economies became more advanced, both wages and living standards rose to levels not even dreamt of in Marx's day, and this seems to have lowered the pressure for revolutionary change.
Marx was also wrong about something more fundamental. He was wrong about change. I don't just mean that he was wrong about the changes that would come about; more fundamentally he was wrong about how change takes place. He took the Hegelian model of change.
To Hegel change comes about through staccato triangles. A state of affairs nurtures its opposite, and from the violent clash between the two a new state of affairs emerges. Thesis, Antithesis and Synthesis. Violence is at the core of it, and hence Marx's commitment to revoution.
But Marx was a contemporary of Darwin. He had read Darwin's "Origin of Species" and admired Darwin's account of the origins of humankind. He failed, however, to spot the significance of Darwin's theory of change and to incorporate it into his own programme.
Darwin advanced a gradual mechanism of change in which small differences gradually come to dominate over time. It is evolutionary, not revolutionary, and is a much more accurate description of how change usually happens in human societies than was Hegel's account. Indeed, Darwin was right and Hegel was wrong. This means that Marx was also wrong, wrong about change, and wrong about how capitalism would develop.
The point is that capitalism changes and evolves. It has been through many transformations. The capitalism that Marx thought would collapse under its own contradictions is not the capitalism of today - the one this motion refers to.
In the material world organisms evolve. They respond to crises and they change. A similar thing happens with our social practices. They evolve and adapt to new circumstances.
Capitalism has faced many crises, and each time it has evolved and changed. Each time a new form of capitalism has emerged to solve the problems its predecessor faced. This is how human beings progress. We solve our problems by adapting our practices.
Capitalism certainly faced a crisis in 2008, but it is still with us, as yet uncollapsed. It is evolving and responding to the changes that are needed and, as before, when the dust of crisis has settled, it will be a new version of capitalism that goes on to generate more wealth and to expand the opportunities open to humankind.
That new version of capitalism that emerges will have to be one which somehow manages to keep at arm's length the politicians wanting to fix its outcomes for political advantage. Greedy bankers can only take reckless risks if politicians make it cheap for them to do so by turning on the taps of credit and money. Politicians like booms and bubbles because they help them to win elections and office, so procedures must be found that limit their ability to do this. Those whose greed is for power are no less deadly than those who greed is for gain, and both need rules to circumscribe their scope for action.
I wish to make a further point: that capitalism will survive because it is the only valid way we have found that works in practice to create wealth and the opportunities it brings.
Marx was wrong about another important thing. He subscribed to the labour theory of value, believing that the value of a thing arises from the labour put into producing it. Wrong. Value is based on demand. If no-one wants a thing, then no matter how much labour went into producing it, it is valueless.
We all value things differently, which is why trade takes place. We trade because we each put greater value on what the other person has than on what we are offering in exchange. We both gain more value when we trade, and that's how we create wealth.
We produce in order to trade and to create wealth, and we invest in order to produce. That's in essence what capitalism is, and it works - certainly better than anything else that has been tried. And it works more humanely, too.
Yes, capitalism grows more complicated and more ambitious as it evolves, but its principles remain. Capitalism will survive its current crisis. It will be tweaked and modified but it will not collapse, because nothing has ever been found that can replace it or do what it does, or bring the advantages and benefits it brings.
It has brought the resources that have lifted most of humankind above subsistence and starvation, that have enabled us to conquer diseases, to fund education and social services, to enable people to engage in artistic and cultural activities and to enrich their lives with previously undreamt-of opportunities.
That is why this motion, cumbersome and ambitious as it is, is also misconceived, and why I urge everyone to defeat it.
The rights of others: Don't repeal the Human Rights Act. Give it teeth
'Is that you, John Wayne? Is this me?'
The other day I stumbled upon Justified, a newish series about a thirtysomething, cowboy-hat-wearing, gun-toting U.S. Marshal named Raylan Givens. Raylan, the story goes, has been reassigned from sunny Florida to sleepy Kentucky – “punishment” for carrying out what amounts to a daylight assassination of a Miami mobster – following which he promptly misbehaves, sleeping with material witnesses, failing to recuse himself where conflicts of interest arise, and killing a number of human beings per episode. These are problems that the characters, treading the fourth wall, openly acknowledge but do little to fix.
It’s not The Wire. But then, it’s not 2002, and Raylan is a better fit for the conscience of today's United States. Pining for John Wayne, America reminsices as Raylan, self-loathing, naïve and eager to wield raw, unbridled power, apes him; we admire him for falling short. He is a John Wayne for the Drone Age, angry, uncertain, broke and extra-judicial.
It is impossible to suspend disbelief and enjoy the show. in real life, the only thing this cowboy could ride is a desk. Killing is an unfortunate and traumatic possibility in the life of an armed policeman. When it occurs, it is very contentious. Administrative concerns kick in, a lawsuit or public inquiry is often involved and it is often cause for mandatory suspension or early retirement, on account of which “it would be hard to ‘imagine a set of facts’ that would lead a cop to be involved in the deaths of six people,” especially in the first season alone.
But the show's producers grant Raylan the magical power, as well as a pervasive obligation, to do always the right thing; all of his homicides are justifiable, all his warrantless entries effected only after drawing out consent through his wide-eyed southern charm and a buttery-smooth Kentucky drawl.
His plausibility before an American audience depends on it. Obtaining consent or a warrant before you barge into someone's house is a crucial part of being a policeman in the United States, which has a robust and longstanding culture of rights: pursuant to the 4th Amendment of the U.S. Constitution, Americans have a right to be “secure... from unreasonable searches and seizures,” which courts protect vigorously. As a hypothetical example, if police found a bale of contraband in your car boot but didn’t have probable cause (or your consent) to search the car, it is entirely plausible that its discovery, tainted by illegality, could blossom into “the fruit of the poisonous tree,” becoming inadmissible and sending the state’s case up in smoke (you might even get your stuff back).
Don't mess with tennis
Not so in England. While the Human Rights Act 1998 (“HRA”) gives us the “right” to be free from interference with “with peaceful enjoyment of property, (deprivation)… of... possessions or (subjection of) a person’s possessions to control,” interference which is carried out “lawfully and… in the public interest” is above board. Furthermore, evidence obtained from illegal searches and seizures is prima facie admissible in an English court (which has a discretion, not an obligation, to exclude it). Lacking a credible prohibitory function, the HRA's provisions are less rights, more self-imposed guidelines. They flow from the state rather than delineating its boundaries, their function being to restrain only transgressions deemed by the state itself to be sufficiently grave.
Other “rights” under the HRA are similarly wet. As was made very public over the course of last year's Reform Section 5 campaign relating to the Public Order Act 1986, freedom of speech is far from absolute in Britain, especially when compared to the United States. In America, picketing the funeral of a murdered seven-year-old is permissible; in Britain, however, what is fairly ordinary political speech in the U.S. is not protected, and often criminal, even despite the Section 5 campaign.
It is thus by design. Convention rights are subject to express restrictions, including such as “are necessary in a democratic society... for the protection of the reputation or rights of others.” This is a contentious concept from a civil liberties standpoint and has most publicly been brought to the fore in the context of Section 5. But the debate pre-dates the 21st century, an early iteration taking place in the context of the Public Order Act 1936, the 1986 Act's predecessor.
Quite how far this concept of the rights of others has moved Britain down the slippery slope is only evident when one compares cases decided under the old rule, prior to the passage of the HRA (under section 5 of the 1936 Act), with cases after it. The 1936 legislation reads:
"Any person who in any public place or at any public meeting uses threatening, abusive or insulting words or behaviour with intent to provoke a breach of the peace or whereby a breach of the peace is likely to be occasioned, shall be guilty of an offence."
This is very similar to the Section 5 we know and love. However, in the absence of the HRA the rule was applied far differently, as illustrated by the case Brutus v Cozens from 1973. In Brutus, the defendant dared to interrupt a tennis game at Wimbledon by staging a sit-in while throwing anti-apartheid leaflets in the air; after being peacefully removed from the grounds of the All England Club, Brutus was arrested and charged with “using insulting behaviour.”
At first instance, the judges hearing the case acquitted Brutus; however the prosecutor, perhaps a closeted tennis fan, appealed, arguing that “insulting behaviour” under the 1936 Act was that which was “disrespectful and contemptuous.” The Court of Appeal agreed, and interpreted the statute to also include:
"behaviour which affronts other people, and evidences a disrespect or contempt for their rights..."
...however, this view was decisively overruled on further appeal to the House of Lords, which found that “an insult has a narrow meaning which is... aimed at or intended at a person's susceptibilities... the words must hit the man in question.” The Lords opined that “behaviour which evidences a disrespect or contempt for the rights of others” does not “of itself establish that that behaviour was threatening, abusive or insulting.”
Brutus, therefore, set down two principles. First, insulting, threatening or abusive behaviour must be insulting, abusive, or threatening per se in order to fall within its scope; second, it is perfectly possible to be disrespectful and even contemptuous of the rights and sensibilities of one's fellows without falling within its ambit. The statute banned insults, abuse and threats, it did not ban contempt for the rights of others. The two types of conduct, while potentially very similar in certain circumstances, were legally not the same.
The rights of others
As of 1973, then, the “rights of others” were not a consideration in question relating to freedom of expression. Thirty years later, however, the formalisation of the protection of the “rights of others” by the HRA changed the landscape. In McCann (2002), Lord Hope pointed to it as an express justification to interfere with freedom of speech, adding that “respect for the rights of others is the price that we must all pay for the rights and freedoms that it guarantees.” McCann was followed by Norwood v DPP (2003), where it was found that a criminal conviction for hanging a poster that read “Islam out of Britain” was “a necessary restriction of... freedom of expression... for the protection of the rights of others” (those rights being, as argued by counsel for the prosecution but not expressly confirmed by the Court of Appeal, the convention rights of freedom of conscience and belief, and freedom from discrimination).
Or, for example, see Abdul v DPP (2011), where the convictions of seven Muslim activists picketing the Royal Anglian Regiment on its return from Iraq (using fairly explicit language, but language only) were upheld on the grounds that “it can properly be said, in this particular case, that prosecution and conviction was proportionate in pursuit of... the protection of the reputation or rights of others.”
The decisions in the three individual cases mentioned above do not make express mention as to which “rights of others” are being protected in each; what is clear from each, however, is that the courts are willing to employ a broad-brush application of Article 10(2) of the HRA to justify restraining freedom of speech.
From a civil liberties standpoint, this is unacceptable. The starting point about the “rights of others” is a simple one: in each, the defendants were speaking on matters which they believed “were not abusive and insulting because they were true.” None has a monopoly on truth in politics, and the protest outlined in reported cases, though distasteful, does not involve the application of coercion by the speakers upon their listeners. It is merely the meeting of widely differing points of view in a public space.
Caution is advisable, then, when one hears that the Government is planning to “(pull) Britain out of the European Convention of Human Rights” because, per Chris Grayling, “we cannot go on... where people who are a threat to our national security... are able to cite their human rights when they are clearly wholly unconcerned for the human rights of others."
Where one day the “rights of others” serve to justify the deportation of a particularly infamous philosophical opponent of the British state, on many other days our own courts – not European ones – have shown considerable willingness to construe these “rights of others” to criminalise offensive and inflammatory, yet honestly held, political beliefs of ordinary people.
As the debate on the HRA and its possible repeal unfolds in the run-up to the next election we should not, therefore, be lulled into the commonly held, and false, impression that the HRA protects us as fully as we might like it to. Relating to speech alone, expression relating to the merits of political violence - whether such violence takes place at home or abroad - is thoroughly proscribed by section 1(3) of the Terrorism Act 2006, a vexing dilemma for prosecutors before the Arab Spring, in that their discretion to ignore “plots against the Libyan regime (which) were possibly encouraged years ago” was rather fettered by the “rapprochement” initiated by the Blair government, while concurrently “plots against Syria are openly tolerated."
Written or electronic communications of an offensive but nonetheless firmly political nature remain illegal.
Furthermore, in Section 5, though “insulting” is gone, “abusive” remains – which gives one pause to wonder whether the Reform Section 5 campaign achieved anything significant as, looking to Abdul, the courts are very willing to conflate the two ideas: “the words shouted by the defendants were both abusive and insulting,” it was said at first instance, with Mr. Justice Davis adding on appeal that “it is not... possible to establish in advance a bright line statement of approach whereby prospective conduct or language can be styled as within or outwith the proper exercise of freedom of expression.”
That the only legally safe speech relating to Section 5 seems to be silence speaks volumes about the nature of the “rights” created by the HRA. However, we can sum the problem up in just one sentence. It's not that the HRA goes too far, it's that it doesn't go nearly far enough.
Bubble trouble
Last week, Standard & Poor's, the rating agency, was sued by the U.S. Department of Justice (USDoJ) in a Los Angeles federal court for “knowingly and with intent to defraud, devis(ing), particpat(ing) in, and execut(ing) a scheme to defraud investors in (residential property securitisations) and CDOs, including federally insured financial institutions... and to obtain money from these investors by means of material false and fraudulent pretenses, representations, and promises and the concealment of material facts.”
Even to persons legally trained, this is weighty stuff. One of the most amusing ways I know to frighten an unschooled junior lawyer is to sit him or her down in front of a structure diagram of a securitisation, a jumbled mess of agreements, parties, cashflows, security arrangements, and hedging – and then change slides to display a CDO, a securitisation of securitisations, a stacked jumble of jumbles. (Instant fun.) Despite the visuals, however, such transactions are conceptually very simple: one takes assets that throw off a steady stream of income (such as residential mortgages), models the cashflows arising from them, and creates debt instruments which match the payments from the assets with the payments on the notes. Those notes or bonds are then sold, with the seller recouping the capital value of the assets in the present in exchange for investors' acquiring the future flows of income.
As such, securitisation is a remarkably versatile funding tool: one can quite literally put a chicken sandwich into a securitisation, and emerge on the other side with investment-grade debt. This is achieved through a process called “tranching,” where certain classes of debt receive higher payments of interest but absorb losses first, allowing the more senior pieces to be sold as relatively safer assets. So, for example, with a structure that issues £100 million in notes – £40m “B” and £60m “A” – if there is a shortfall of £30 million, the junior “B” tranche is wiped out by 75%, whereas the position of the senior debt is unaffected.
This is where rating agencies come in. Each agency appointed on a particular transaction assesses how these transactions have been structured by the banks and determines, on the basis of a pre-published (and public) set of criteria, their reasoning for arriving at their conclusions. Based on the amount and quality of credit enhancement for a given deal, they issue ratings to the more senior classes of debt which represent the rating agency's opinion as to the probability of default on a given piece – the better the rating, the lower that probability is.
USDoJ asserts that, as the sub-prime crisis began to unfold over the course of 2007, S&P rated 30 CDOs backed, in whole or in part, by non-prime (low-income borrower) RMBS collateral, and that “S&P knowingly disregarded the true extent of the credit risks associated with those non-prime RMBS tranches in issuing and/or confirming ratings for CDOs with exposure to those non-prime RMBS tranches.” One of these, the complaint points out, was “NovaStar ABS CDO I,” a $374 million transaction comprised of securities which were backed by subprime residential loans and issued in 2006 (76%), 2005 (18%), and 2007 (5%). S&P rated $277 million of the notes issued by the deal as AAA, or the lowest probability of default; however, the deal imploded. The result, as put by the Justice Department, was “near total losses to investors,” who were for the most part federally-insured banks.
This is an example of one small part of a wider evil which requires a $4bn lawsuit to be put right. The nitty-gritty of legal arguments – which does not bear repeating here – hinges on whether S&P's statements on these deals were actionable misrepresentations or protected speech under the US Constitution. The more important question, though, is this: is this a case that should have been brought in the first place?
From a jurisprudential standpoint, the only relevant consideration is that the statute upon which the claim is based has never been used before for this purpose (suggesting that this alleged social ill was not what the drafters of FIRREA 1989 had in mind).
In terms of economic substance, a slightly closer look at NovaStar shows that USDoJ falls very wide of the mark. As of late 2006, the company was a reasonably reputable originator of residential mortgage loans: as reported by the New York Times, NovaStar “boasted 430 offices in 39 states... fast becoming one of the top 20 home lenders in the country,” a “Wall Street darling” with “shares trading at $30 (in 2003), up from $9.50 in late 2002.” It would go higher, eventually soaring to $70 per share: “between 2004 and 2007, for instance, the company raised more than $400 million from investors,” eventually attaining a market value of $1.6 billion, with loan origination to sub-prime borrowers reaching $600 million per month.
The secret behind NovaStar's short-lived success was that the firm originated loans which, in hindsight, a reasonably prudent mortgage lender would not have, with low-quality security and to low-quality borowers. “One NovaStar loan on a property in Ohio totalled $77,500 even though the average sales price for the neighbourhood was $31,685, and the same house had been purchased two months earlier for $20,000,” reported the Times, and virtually anyone – “even... a corpse, the joke went” – could obtain one. NovaStar employed accounting methods that “gave the company lots of leeway in how it valued the loans held on its books,” such as one which “allowed it to record immediately all the income that a loan would generate over its life,” even if the mortgage had decades to run until maturity. As a result, virtually the entire market misapprehended NovaStar's business, including its securitisation business, until the subprime bubble was well into the throes of its (widely unexpected and spectacular) collapse.
When one considers that it is not a rating agency's mandate to perform investor due diligence, but rather to look at the stated characteristics of the income flows presented to it and “assess the likelihood, and in some situations the consequences, of default – nothing more or less,” one understands that if garbage data go in, whether by dint of fraud or endemic asset mispricing, garbage conclusions will invariably come out. It is this which should colour USDoJ's claims when being viewed by objective observers.
The credit enhancement involved in obtaining a AAA rating should, according to USDoJ, “on average, be able to withstand economic conditions similar to those of the Great Depression,” a roughly 1% probability of default. Most of the time the rating agencies get this right: the default rate of AAA-rated notes in structured finance transactions has, in the last thirty years, barely exceeded 0.5%, and even then only reached that historically unusual high in 2008.
But sub-prime RMBS was different, and this was not the fault of the rating agencies. Investors everywhere lost money as a result of the sub-prime crisis because they failed to conduct proper due diligence and were caught up in the largest speculative property mania in history – one which was US-government-fuelled at that. The U.S. federal government was left with considerable additional egg on its face after it then had to bail out these banks with these toxic assets on their books. But, if this lawsuit is to be believed, the primary responsibility for these losses should lie with S&P, which has allegedly perpetrated a massive fraud for its own material gain.
Recent rhetoric emerging from the populist left has capitalised on the suit, with financially illiterate commentators asserting that the rating agencies' giving AAA ratings to toxic assets was “tantamount to a massive betrayal of America.” This is plainly absurd. Many people and institutions made bad calls in the run-up to the great recession. It does not follow that it is appropriate to sue organisations which made a profit throughout, simply because they had no skin in the game. Nor will it do anything to protect the American taxpayer from being the guarantor of last resort, a precarious position in which the American people remain: not despite the role of their government, but because of it.
Blame bailouts for huge budget deficits
“It’s true that right now we have a large federal budget deficit. But that deficit is mainly the result of a depressed economy — and you’re actually supposed to run deficits in a depressed economy to help support overall demand. The deficit will come down as the economy recovers: Revenue will rise while some categories of spending, such as unemployment benefits, will fall.”
Disregard for a moment the key issue regarding this type of opinion - which is that in a depression a government is supposed to run large deficits in order to jump-start a recovery. Let's for now focus only on the argument that a deficit is a result of a depressed economy. What Krugman and the like have in mind when they make this claim is the following; because of the crisis and the credit crunch many businesses fail and consequentially unemployment rises. This creates pressures on the budget deficit, since revenues fall as many businesses are bankrupt and are not paying taxes (on both profits and employee taxes), and on the other hand many new unemployed put pressure on the expenditure side, as the government has to pay out more unemployment benefits. This is all true. All the combined effects of the credit crunch will almost always result in an increased budget deficit. But they will never be so big to make the deficit rise above 10% of GDP as it did in the UK, Ireland or Spain (to mention only a few). Something else was at hand here.
This 'something else' was large government bailouts of fallen banks.
Ireland, Spain, UK, and of course the US all had problems with the bursting of the housing bubble, a consequential rapid decline of the construction sector and altogether a huge impact on personal wealth. This however wasn't enough to cause a huge budget deficit. Its persistence is a result of a depressed economy, but the initial cause of unsustainable public finances in Ireland, Spain, UK and USA were large government bank bailouts. The three European countries are usually the argument Keynesians use to attack the euro austerity, since all of these countries had stable public finances before the crisis (Greece is a case by itself), while now austerity is hurting their recovery prospects.
Claiming that American, British, Spanish or Irish troubles began with austerity is simply misleading. Their troubles began with what was an application of a typical textbook Keynesian solution to a crisis = bailouts and large stimuli. This triggered their public debt to rise and their deficits to widen. Bankruptcies of small businesses and rising unemployment couldn't have single-handedly risen the deficit above 10% of GDP, or the debt-to-GDP close to (or above) 100%. It they did, this would have occurred in a much longer time span. But clear evidence (which Keynesians like to call upon) points out that large budget deficits and booming public debts arose immediately as a result of bailouts and stimuli in 2008 and 2009:
Source: IMF; World Economic Outlook 2012
As shown in the graphs, all four countries started experiencing troubles as an immediate reaction to government bank bailouts and fiscal stimuli policies. They all had low and sustainable debt-to-GDP levels (Spain and Ireland below 40% and 30% respectively, UK around 45%, and the US around 60%), which in a few years escalated to close to 90% for the UK, over a 100% for the US, 70% for Spain and close to 120% for Ireland (which is a four-fold increase of debt for this country in only three years). As for the budget deficit, Spain and Ireland had a surplus prior to the crisis, while the UK and the US both had relatively small deficits. After 2008/2009 their deficit-spending bailout solution yielded its first results. Have in mind that in neither of these countries austerity didn't kick in until late 2010. After it did however it did little to improve the state of public finances and still hasn't stopped the rise of public debts in none of the four examples.
After the evident failure of this approach that caused the unsustainability of their public finances, European countries started to combat the deficit via tax hikes and selective budget cuts, instead of focusing on lowering the tax burden, relaxing the regulatory environment, and applying a broad set of institutional reforms aimed at clearing the instabilities of the labour and capital markets.
They made two big mistakes - application of immediate Keynesian policies thought to work in the short run (reminder, this is 2013, five years after the crisis had started - the short run is over), followed by a selective and wrong application of (let's call them) neoclassical policies.
The obvious failure of the stimulus deficit-spending solution, particularly with its effect on public finances, should be sufficient evidence not to call for these types of solutions for quite some time.
Bailouts of banks are to blame for the huge budget deficits of Western nations, says Vuk Vukovic.
If elections have consequences, then so does economics
Kristol elaborated on the GOP fallout: ‘The Democrats picked up seats in the House and Senate, and the President is in good shape ... the Republicans in the House will be able to get some concessions and some compromises, but I think there will be a deep budget deal next year, it will be an Obama-type budget deal, much more than a Paul Ryan budget deal, type budget deal. And elections have consequences.’
Kristol’s musings were the subject of much Democratic smugness and Republican alarm, with his singular sacrifice for the greater good echoing Cato’s 10th Letter:
No man living laments the calamities brought upon his country, more than I do those brought upon mine: Yet I freely own, that I think the paying off the nation’s debts, and restoring, by that means, the kingdom to its power, its grandeur, and its security again, was an end worth all the evils which we have yet suffered; an end which ought, if possible, to have been purchased with greater than we have yet suffered, if it could not otherwise have been purchased. I think that it ought to have been done, though attended with many ill circumstances; and might have been done, even upon those hard terms, with justice to private men, and honour to the nation. We are not a people without it; nor is it worth while to dispute about the best cabin in a ship that is sinking.
But not only elections have consequences; so do economics. For those who believed that GOP intransigence on ‘tax cuts for the wealth’ — or ‘tax cuts for the economy’, a rhetorical ploy by one knowing Republican wit — was motivated by selfish greed, no doubt this volte face must come as a welcome return to common sense. To their peril, they ignore the findings of the Laffer curve.
Named for Reagan-era economist Arthur Laffer, the curve charts government revenues against taxation rates, based on the idea that at both zero and one hundred per cent taxation the State will collect no monies, but that somewhere along this curve are rates for optimum private sector growth (nurtured by the provision of public goods by the State) and optimum government revenue. ‘The uniform, constant, and uninterrupted effort of every man to better his condition’, wrote Smith, ‘the principle from which publick and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government, and of the greatest errors of administration (II.iii.31).’
Ultimately, the question must be focussed on what the market will bear. It is one thing if additional taxes will be no more than an irritant for entrepreneurs and corporations; quite another, though, if these additional burdens occasion distortions and disincentives to economic activities. Such conditions met one of Smith’s definitions of a bad tax, for ‘it may obstruct the industry of the people, and discourage them from applying to certain branches of business which might give maintenance and employment to great multitudes (V.ii.b.6).’
For adherents of Laffer, studies indicate that the threshold lies at government expenditure at about 18-20 per cent of GDP; that is, up to this point most business activity will continue unabated, but once this nominal level has been crossed, then extraneous considerations enter into business calculations. (Thus, there is a gap between growth-maximisation and revenue-maximisation on the Laffer curve, the difference being that greater government pressure via increasing tax rates will result in slowing private-sector profits.)
What this means is that applying additional taxes past their maximisation point will not result in higher revenues, but lower — bringing neither justice to private men nor honour to the nation. The nineteenth-century French economist Frédéric Bastiat popularised this economic phenomenon as ‘That Which Is Seen, and That Which Is Not Seen’:
Between a good and a bad economist this constitutes the whole difference—the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favorable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.
A step in foresight to improve the nation’s finances proves in hindsight a wounding blow to the public treasury. A century earlier, Bastiat’s compatriot the Baron de Montesquieu proclaimed pithily in The Spirit of the Laws that when savages ‘are desirous of fruit, the cut the tree to the root, and gather the fruit. This is an emblem of despotic government.’ Now savagery and despotism are camouflaged as enlightened policy.
Though unaware of Laffer curve economics, Cato was not unmindful of its effects. ‘If, in taxing labour and manufactures, we exceed a certain proportion, we discourage industry, and destroy that labour and those manufactures,’ he astutely noted. ‘The like may be said of trade and navigation; they will bear but limited burdens: And we find by experience, that when higher duties are laid, the product is not increased; but the trade is lost, or the goods are run.’
Key to policy formation is whether America has reached or exceeded the optimum marginal tax rates for optimum government revenue; and whether increases in the one will lead to increases in the other. Indicators are that the threshold has been met: record amounts in bank reserves and corporation coffers suggest that current levels are curtailing business growth, as does anecdotal evidence from CEOs and small business owners who fear that further taxes and regulations will eat into viable profit margins. Yet, were the highest marginal tax rates decreased toward growth maximisation levels, innovators and entrepreneurs would doubtless invigorate the market, boosting tax revenues further — another facet of Bastiat’s counterfactual analysis.
‘You know what?’ Kristol concluded, ‘It won’t kill the country if we raise taxes a little bit on millionaires. It really won’t, I don’t think.’ But the financial argument is not about the supposed merits of any nominal marginal tax rate on the highest incomes (moral issues are another matter), but on its effects on the total American economy. Kristol sees only short-term political compromise and is blind to long-term revenue shortfalls; his apparent graciousness in electoral defeat is economic illiteracy in disguise.
Political equivocations cannot trump economic realities. By masquerading as a commendable compromise to save the nation’s sinking finances, will the ship of state surely be lost.
The Benefit-Industrial Complex
Lesser known is (2) that “under Universal Credit, the default position will be that all housing costs for both social and private sector tenants” – currently paid out as a single, discrete benefit but soon to be subsumed within the benefit cap – are to be paid directly to claimants, whereas previously it was paid directly to claimants' landlords.
That the second of these proposals should be controversial is a little surprising, considering the fact that paying one's rent is the sort of thing most people will do for a substantial majority of their working lives. So I was puzzled to see Mark Easton, BBC News' Home Editor, excoriating the government, and accusing it of being “secretive*... on a matter that affects the lives of hundreds of thousands of the most vulnerable people in Britain”: the proposal to, in his words, “force social housing tenants to pay their own rent”.
Easton's objections followed three lines. First, he argued, social landlords' business plans rely on suffering only 2% aggregate arrears; such plans would be thrown into disarray if Housing Benefit claimants are given responsibility for managing their own affairs (which, he argues, would increase monthly arrears to as much as 30%). Second, he continued, existing social tenants have “little or no experience of monthly budgets,” get their benefit in cash weekly, and therefore are not predisposed to – or capable of – managing their own finances. Finally, he concluded, many have not chosen to access banking facilities or do not have regular access to the internet, both of which are necessary to use the new Universal Credit regime.
The capacity argument has been invoked frequently in relation to the Universal Credit – Shelter, for example, made representation during the public consultations preceding the 24 November Report of Session on Universal Credit that there is “considerable apprehension as to how many social tenants will manage their incomes”.
This argument is probably honestly made out of concern for humanity and backed by evidence. That it also makes it morally appropriate to burden the taxpayer for the market risk of landlords in the Housing Benefit tenant market arising from failure on the part of welfare beneficiaries to manage their finances is another question, especially when we consider the practical character of the libertarian reply.
Human beings have paid rent with reassuring frequency for millennia and statutory frameworks have regulated these payments since 1772 – 1772 B.C.E., that is (cf: the Code of Hammurabi, sections 50 and 51). Furthermore, the internet access required by Universal Credit is available free of charge at public libraries and for a small fee on mobile phones and at internet cafes around the country. The internet is used daily by billions of people of all ages, creeds and nations, and with highly variable degrees of intelligence. It is no stretch to say that able-bodied adult British claimaints of sound mind should be able to combine these two competencies and pay their bills.
Politically, Easton's concern for social landlords and their businesses is more interesting. Trials of the beneficiary-pays system have shown that the increase in arrears has made letting to DWP tenants uneconomic, and the reform means that private sector landlords “will pull out” of the benefit claimant housing market (at page 93) – a problem amplified from the perspective of local authorities who are duty-bound to find housing for these persons and “increasingly... have to advise people to look for housing in the private sector.”
What is left unsaid by Easton is the scale of the private sector's involvement in welfare provision relating to housing. It is vast. In Northern Ireland alone, the Select Committee's report notes, “we think ['think?'] there are 60,000 private landlords who currently receive payment of Housing Benefit direct – about £250,000,000 a year” – £4,100 per landlord, or £148.00 for every man, woman and child in Northern Ireland. While I do not have exact figures to hand, if this were extrapolated on a per-capita basis nationally, the level of private sector benefit realised would rise to nearly £10 billion – roughly 45% of the total Housing Benefit bill, and nearly 1% of GDP, roughly equal in heft to the 2012 Olympic Games.
Viewed thus Housing Benefit is less a welfare program than a national industry, operating on the scale of value-added giants like automobile manufacturing (£54bn) or defence (£45bn) and capable of distorting the market to the detriment of the working taxpayer. As a component of income allocated towards housing, Housing Benefit has long outstripped private wages. As a subsidy it disrupts the supply of property for private renters, providing what is in effect a national minimum rent while driving up rents for non-beneficiaries in the process, thus striking the propertyless taxpayer from three directions.
And as a safety net it fails too – while senior editors of the BBC and Labour MPs invoke in the system's defence the inability of its beneficiaries to demonstrate the financial acumen of a Bronze Age Babylonian tenant farmer, the Commons Work and Pensions Committee report on the subject states, matter-of-factly, that “many benefit claimants will never be able to take up or return to work.” When the question of whether Britain can continue to afford its welfare state is an open one, this is clearly the wrong approach.
Quite irrespective of the relative merits of welfare provision, the existing system is ripe for reform. The government's efforts to date are a welcome first step.
* So secret, in fact, that his article was published a full two days (24 November) after a report published by the House of Commons Work and Pensions Committee on the subject (22 November), and after months of public consultations with interested parties. But I digress.
Financial thought crimes
The most tangible policy response to the ‘main’ financial crisis of 2007-9 has been the series of (on-going) reforms of the system of financial regulation in those countries that were most affected by the crisis in question. The need for such reform, and the nature of the reform that is thought to be required, have both been adopted as received wisdom by the majority of policy-makers. However, given the risks normally posed by received interventionist wisdom, it is worth giving some thought as to whether or not the current approach is, in fact, the most appropriate one. Accordingly, the purpose of this article is to consider the nature of the current reforms, and then to set out some alternative, and rather different, policy prescriptions.
Litigious Albion
In the United Kingdom, the attention that the financial crisis has received has been intense. Accordingly, the political and official appetite for reform has not waned. For example, as of November 2012, the Financial Services Bill is before Parliament, a Parliamentary inquiry into ‘banking standards’ is under way, and the draft Banking Reform Bill has been published. In addition, a Financial Stability Board (FSB) working group, led by the Chairman of the Financial Services Authority (FSA), the main British financial regulator, has announced its intention to focus on the activities of the so-called ‘shadow banking system’.
The regulatory reforms that have been, and are being, implemented can be divided into two broad categories.
Firstly, those relating to conduct.
Secondly, those relating to stability.
In essence, conduct regulation relates to the way in which financial services providers interact with clients, counterparties and the public at large. Its range is very broad, covering virtually every aspect of financial businesses’ commercial activities, and applying to businesses ranging from a self employed financial advisor to a universal banking behemoth.
There are, of course, ample reasons for becoming exasperated with the way in which conduct regulation has developed. However, it is a subject that warrants substantive consideration in itself, and it is not intended for this article to cover it in anything other than summary form. Instead, the rest of this article will concentrate upon financial stability regulation.
Financial Stability
The financial crisis threatened the stability and survival of numerous financial businesses, of various types and sizes. However, the ones that were of most significance were the commercial banks, whether ‘pure’ commercial banks or the commercial banking arms of universal banks. The reason for their significance is the nature of some of the roles that commercial banks play in the modern economy, as follows.
Firstly, they provide the bedrock of the economy's payment transmission system.
Secondly, they are the creators and guardians of a substantial proportion of the economy's money supply.
These two factors explain the Government’s willingness, at the time of the crisis, to intervene in order to prevent the failure of individual commercial banks, and of the commercial banking system as a whole. After all, a full commercial banking collapse would have destroyed the bulk of the country's payments system, and would have caused a large proportion of the money supply to evaporate. Clearly, the consequences of such a failure would have been very serious indeed.
However, the Government’s intervention came at a heavy price. The most frequently cited cost is that of (re)capitalising certain banks. However, the total cost of the intervention was much higher, and the cost is an on-going one. After all, using monetary policy as a means of providing systemic subsidy will inevitably introduce serious distortion, as indeed will rescuing failing financial businesses.
Naturally, the Government is keen to avoid such costly intervention in the future, as well as avoiding the controversy and opprobrium of being seen to subsidise and rescue an extremely unpopular industry. That, alongside a desire to avoid the economic disruption that banking crises tend to entail, explains the Government’s interest in financial stability regulation.
In essence, stability regulation is regulation that is intended to ensure that financial businesses are less likely to fail, or at least are less likely to fail in a manner that causes widespread disruption. This applies both to individual businesses and to the financial system as a whole.
On a firm-specific basis, financial stability regulation effectively involves monitoring and intervening in the way in which a business is structured and run, in order to ensure that the business in question operates in a way that the regulators consider to be prudent. On an economy-wide basis, it effectively involves moulding the financial system's structure and activities, with the aim of ensuring that the system operates in a way that the regulators consider to be prudent, stable and orderly.
A Matter of Philosophy
The theory that underpins financial stability regulation is largely as follows.
The commercial banking system will eventually become unstable if it is left to operate in a normal commercial manner. Given that the wider economic costs of a systemic banking collapse are likely to be serious, the Government will always have a duty to ensure that the commercial banking system does not fail. Therefore, Government supervision of the system is required: firstly, to ensure that bank failures are less likely to occur; secondly, to ensure that any failure can be managed or contained; and thirdly, to ensure that the costs of any Government rescue are minimised, and preferably eliminated. Furthermore, Government supervision of the broader financial system is required, in order to ensure that the commercial banking system is not imperilled by the failure of other financial businesses.
Given what is known about the wisdom of Government regulation and intervention in general, the theory outlined above is not very reassuring. After all, replacing potential commercial misjudgements with potential regulatory misjudgements is hardly a recipe for success. Furthermore, the theory is thoroughly dispiriting in its myopia, pessimism and timidity.
Of course, it cannot be denied that commercial bank failures are, at present, a very serious threat. In addition, it cannot be denied that certain established features of commercial bank operations render such banks fundamentally unstable: fractional reserve banking; high leverage; and asset / liability mismatches all pose a threat to a commercial bank's stability. Furthermore, it is certainly the case that the status quo ante was not acceptable.
However, is there a plausible alternative to closer supervision and regulation? Arguably, there is.
In essence, the commercial banking system suffers from two major weaknesses.
Firstly, the system is highly concentrated.
Secondly, commercial banks currently operate in a manner that is too risky and unstable.
Those two weaknesses will now be considered in turn, and suggestions will be made as to how the situation might be improved.
Concentration
The most robust defence against a systemic collapse of the commercial banking system would be for the system in question to comprise a much larger number of participants, and for those participants to be somewhat more equal in size and ‘weight’. That would, of course, represent a marked change from the current situation, in which a small number of large banks dominate the system.
Therefore, one Government objective should be the fragmentation of, and increased competition within, the commercial banking system and market. After all, the rewards of such fragmentation and competition would be great indeed; the banking system would be more robust, and bank customers would enjoy the usual benefits of increased competition. To its credit, the Government does appear to be aware of this. However, more work is required.
The basic ‘problem’ that has led to the emergence of a small number of large banks is that commercial banking tends to benefit markedly from economies of scale, especially as far as ‘utility’ activities such as running a branch network, collecting deposits and transferring payments are concerned. However, technological developments do mean that smaller banks should now be better able to compete than was the case in the recent past; a large branch network is less important than used to be the case, and inter-bank payments are relatively simple and efficient. Therefore, there is certainly potential for the relative advantages derived from economies of scale to be eroded.
How might the Government encourage the fragmentation and increased competition referred to above?
Firstly, it should refrain from the temptation arbitrarily to decide on the ‘optimal’ structure of the commercial banking system. Competition law should certainly be used when appropriate, but of itself, competition law is not going to have much of an effect in the absence of more fundamental changes.
Secondly, it should ensure that small commercial banks are not arbitrarily prevented from obtaining direct access to the main inter-bank payment systems.
Thirdly, it should reduce the regulatory barriers to entering the commercial banking system and market. The commercial barriers are high enough as it is, but regulation is making the situation much more difficult than needs to be the case. Accordingly, bank regulatory requirements should be lightened, and the regulatory treatment of small banks should be particularly lenient.
Fourthly, it should implement those reforms that are necessary in order to reduce the tendency for commercial banks to be run in an unstable fashion; arguably, the tendency in question is more beneficial to larger banks than is the case for their smaller competitors. More precisely, the factors that contribute to that tendency are more beneficial to larger banks than they are to smaller ones.
Instability
As indicated above, certain features of commercial bank operations render such banks fundamentally unstable. Of course, it would be impossible to eliminate all of those features, for they are largely integral to the commercial bank business model. However, the degree of risk involved would almost certainly be reduced if commercial banks were subject to stronger commercial discipline.
One basic advantage that commercial banks enjoy is the fact that in ‘normal’ times, most of their creditors, and short term creditors especially, pay insufficient attention to those banks’ stability and creditworthiness. This allows commercial banks very easily and quickly to raise large amounts of debt capital at low rates of interest, thereby encouraging rapid growth and large amounts of leverage. It also tends to render such banks able and willing to acquire assets at rates and prices that do not fully reflect credit risk. In short, it encourages risky behaviour.
One reason for a lack of attention to bank creditworthiness is the trust that most members of the public have in commercial banks; after all, they are willing to treat commercial bank deposit liabilities as money. That, of course, is their choice. However, the situation is not helped by the fact that certain Government activities not only discourage vigilance on the part of bank creditors, but also encourage more aggressive and less disciplined action on the part of commercial banks. Accordingly, one of the most decisive steps that the Government could take in order to improve commercial bank stability would be to cease such activities.
The Government should take the following policy measures.
Firstly, it should be very clear that no commercial banks, or indeed any other financial businesses, would be rescued in future.
Secondly, it should eliminate Government-backed bank deposit insurance.
Thirdly, it should cease supporting the illusion that stability regulation can avoid bank failures.
Fourthly, it should avoid undermining the ordinary principles of insolvency law, as applicable to banks; a commercial bank is a business, and the failure of a commercial bank should be regarded as an ordinary business failure.
Finally, the Bank of England should eliminate its role as the lender of last resort; a central bank should regard the concept of emergency lending to a commercial bank with as much scepticism as the concept of emergency lending to a grocery shop.
Conclusion
Most of the policy measures outlined above are, by the standards of current received wisdom, highly unorthodox, and probably even heretical. However, it is to be hoped that they might, at the very least, encourage policy-makers to begin to regard commercial bank stability as an ordinary commercial problem, and one that might be solved by the sensible application of ordinary commercial and economic principles.