IEA Blog

In their election document, the country’s Catholic bishops – who are not known for their support of free market economics – pointed out: “A society that is held together just by compliance to rules is inherently fragile, open to further abuses which will be met by a further expansion of regulation.”

It seems that this is precisely the trap into which the UK government has fallen with regard to financial regulation.

The minister in charge of financial regulation is Mark Hoban – who was, at one time, a devotee of free market economics. But, before the election he said he wanted a much more intrusive regulatory regime by the Bank of England.

Every scandal or crisis in financial markets yields a response of more bureaucratic regulation and more boxes to tick. The consequences are increased costs, poorer regulation and reduced competition…

Read the rest of the article in The Daily Telegraph.

The central constraint on economic recovery in the leading economies since mid-2009 has been officialdom’s pressure on banks to raise their capital/asset ratios. Also relevant – but to a lesser degree – have been the calls for higher ratios of liquid assets to total assets. Both the higher capital/asset and liquid asset/total asset ratio are part of a Basel III package of banking rules. The package is to be applicable in a number of “leading countries” – the newspapers sometimes refer to 27 of them – which are unfortunate enough to have decided to belong to this international “club”.

Because of the ongoing bargaining about the Basel III rules (which is mixed up in confusing ways with meetings of the G20 and the European Union), banks have been shrinking risk assets and/or restricting asset growth. They have had to do this in order to comply with official demands, whatever their own business preferences. That has checked the growth of bank balance sheets, including the growth of the deposit liabilities which constitute the quantity of money. The pressure for higher capital/asset ratios has therefore been associated with virtual stagnation of the quantity of money (on the broadly-defined measures) in the USA, the Eurozone, the UK and Japan for about 18 months. Because the growth of money and nominal GDP are related, the recovery has been disappointingly feeble. In most countries unemployment remains close to its peaks. Indeed, in the Eurozone unemployment is still rising.

A salient feature of the world’s leading economies in the last year to 18 months is that the growth of demand and output has typically run at trend or beneath-trend rates despite vast so-called “fiscal stimulus” (i.e., increased government spending and budget deficits) and virtually zero interest rates. However, all is not lost. At its latest meeting the Basel Committee of Banking Supervision agreed to ease the definition of bank capital and, more important, to extend the transition period in which the higher capital/asset ratios would have to take effect. Reports vary, but the deadline now appears to be 2018 (or even 10 years from the finalisation of an accord) instead of the end of 2012.

In 1997 Gordon Brown removed the so-called “self-regulatory” system for financial services under the Securities and Investment Board and created the Financial Services Authority (FSA). The name is all; in fact the “self-regulatory” system consisted of regulatory monopolies ultimately responsible to the Treasury which were a million miles away from market-based regulation which springs up whenever there is a need for it. We forget that before the creation of the “self-regulatory” system in 1986, regulation of investment markets was undertaken by private bodies – and that they were very successful.

Predictably, the FSA has grown into a monstrous gung-ho state monopoly. It has powers to bankrupt and destroy individuals and financial firms in ways that are arguably outside the rule of law. Whilst the Stock Exchange’s motto was “My word is my bond”, the FSA’s appears to be “The more the better” as it hails chalking up “successes” or “results” and writes rule-book after rule-book with no economic rationale for its bureaucratic approach…

Read the full article on ConservativeHome. Click here to download the monograph and here to read the briefing note. See also articles in City A.M. and The Herald.

It is distressing to witness yet another piece of financial chicanery by the British government, which now proposes to substitute the Consumer Prices Index for the Retail Prices Index as the “index-linking” mechanism for a number of private occupational pension schemes. 

The effect, according to experts, will be to reduce the real value of such pensions by about ten per cent over a member’s lifetime in retirement. What a sorry swindle.

It is one thing when the government breaches contracts to which it is itself a party, but to interfere in other people’s voluntary contracts seems to be carrying things a bit far. One might also ask: whatever happened to the Rule of Law?

In the course of my career as a Professor of Finance and Accounting, I came to the conclusion that the two most important qualities in finance were competence and honesty. 

I recently wrote about British government project disasters in an IEA book entitled They Meant Well. I remarked that in England we have always been suspicious of grandiose state projects, and rather surprised if they don’t end in abject failure. So much for competence.

Nobody who has observed the post-war financial scene would dare suggest that British governments have been honest. For example, according to the Retail Prices Index, the pound has lost more than 96 per cent of its purchasing power since June 1947, when it started. Over the period, this represents a rate of currency debasement of about 5 per cent a year. 

The good news is: I don’t propose to reduce my own personal estimate of the British government’s credit rating. It was already standing at the lowest possible level.

In the 15 years to 2007, the British economy had on average faster growth (by about 0.5% to 0.75% a year) than its large European neighbours. A similarly benign context of rising trend output and tax revenues would be very helpful for a new government seeking to reduce government borrowing. There are, however, a number of reasons to be negative about the UK’s prospects for growth.

Firstly, labour force growth will slow from 2011, partly because that is the year the baby boomers start to retire, and partly because the heavy net immigration of the Labour years has become politically unacceptable and seems certain to be checked. In the years leading up to the recession UK employment typically rose by about ¾ per cent a year. From 2011 labour force growth is expected to be only ¼ per cent a year.

Secondly, while the rate of growth of productivity growth in the private sector was very satisfactory in the first decade of the New Labour government, the level of productivity in the public sector actually fell. Under Labour the public sector has also expanded relative to the private sector, with public sector employment up about 15 per cent since 1997.

Thirdly, associated with the expansion of the public sector has been a rise in taxation, particularly taxation on high earners and income from capital. This has started to cause the emigration of high-productivity, high-income people in international business services, the area in which the UK had been a leader after the Thatcher supply-side reforms and tax cuts of the 1980s. The City of London has been knocked off its perch, which may please the high proportion of the British population who are jealous of its success. The fact remains that the boom in international financial services accounted for about a fifth of the UK’s GDP growth in the 1997 – 2008 period.

Fourthly, in contrast with the reforms to energy supply under the last Conservative government, the environmental movement has led to a long pause in power station investment, and now an apparent rush for high-cost and wasteful renewable energy sources. The heavy resources required for, for example, offshore wind will not available for other more productive uses.

Fifthly, regulatory pressure on the banking industry will increase the cost of bank finance, with adverse effects on the financial viability of a wide range of projects, including investment projects in the utilities sector. A degree of leverage has been helpful in the past, because the return on capital has usually been higher than the rate of interest on borrowing. But with the banks widening margins and increasing fees, the utilities cannot borrow or invest as much as before.

The above is rather ad hoc, but the overall message has to be that the trend growth rate has fallen. No one can know how much. The drop in labour force growth might take about ½ per cent off the trend growth rate and the other factors may altogether have a similar effect. That implies a future trend growth rate of 1½ per cent a year, markedly less than the 2½ per cent a year which has been “normal” in the post-war period. The new government faces an economic challenge every bit as daunting as that which confronted Margaret Thatcher and her colleagues when they took office in 1979.

You might have thought that, with the Eurozone in turmoil, the EU would have no time to pursue its vendetta against hedge funds. Far from it, the latest proposals are even more wide-ranging than most observers anticipated. They involve the establishment of a Europe-wide regulatory authority with the power (presumably) to dictate to the FSA how to police the UK’s financial sector, restricting the ability of hedge funds based outside Europe to sell inside Europe and making it hard for European investors to invest in the rest of the world’s alternative investment vehicles. Although the regulations are aimed squarely at the predominance of London as a financial centre, the collateral damage will threaten every investor, pension fund contributor or life insurance buyer, and ultimately every taxpayer in Europe.

As such, the proposals represent a major expansion of the power of the EU’s unelected and unaccountable bureaucracy and a commensurate reduction in the freedom of European investors, whether institutional or private. It is dispiriting to see how casually the EU can limit the right of investors to choose how and where to allocate their own funds. As far as the restrictions preventing hedge funds from basing themselves wherever the tax and regulatory regime are most amenable, the net outcome is likely to be an alternative investment industry shorn of its hundreds of small funds and instead dominated by a handful of Too Big To Fail behemoths.

The truth bears repeating. Much as commentators and (especially) politicians pointed to the hedge funds as an accident waiting to happen, when the subprime storm actually arrived, its epicentre was in the mainstream banks, not the so-called alternative investment sector. The big problems were squarely located in the large investment banks in the USA – notably Lehman and Bear Stearns – and in those UK high-street banks which had been behaving like investment banks. In fact, some of the earliest signs of trouble appeared in Germany’s own regional savings banks which had been behaving with all the recklessness of an old maid at an all-night rave, with predictable results.

Nor can the hedge funds be said to have played a major role in the Euro’s crisis. The Greek bailout is unavoidable because of the implications of default for the major European commercial banks – in other words, it is a bank bailout in all but name. The hedge funds played no part in creating Greece’s budget deficit nor in concealing its true scale. Their only contribution (if any) was in announcing through the credit default swaps market that Greece was insolvent. The EU’s vindictiveness is explained by the fact that, although the hedge funds are only bit-part players, their walk-on role often involves delivering bad news – hence the short-selling restrictions following only hours after the publication of the hedge funds proposals. The knee-jerk response of populist politicians to shoot the messenger is deplorably immature.

One part of Alastair Darling’s Budget that appears to have received little attention from the media is his plan for a “Credit Adjudication Service“. This new body, it appears, will provide an appeals process for small and medium businesses that have been denied credit by banks.

Regardless of the fact that, according to the British Bankers’ Association, 85% of credit requests by small and medium businesses are already granted, how can a free banking market exist when a government appointed body can call into question the economic decisions of a bank manager?

Banks are companies. They are responsible to shareholders, not to society collectively, not to the wider economy and certainly not to the government. It is in their interests to lend to a company with a sound business plan, who they believe will pay the money back and be a viable enterprise. Clearly they will refuse credit when they believe a business project is an unsound investment.

These decisions must be left up to the individual company. An appeal body cannot possibly understand the level of nuance that a bank will. It also lacks the incentive a bank has to ensure that the investment is a wise one. The reality is that lending decisions are complex –  a one-size-fits-all approach will not work in a sector with different private companies working to different priorities and risk assessments. If Barclays and RBS have different risk assessment profiles, how can an appeal body decide which one is “right”?

Ultimately this muddle results from government ownership of Royal Bank of Scotland and Lloyds. The politicisation of money lending is not the way to encourage enterprise; rather we should allow banks to make informed decisions about the situations where it makes sense to lend and those where it does not. As we saw in the United States with the impact of the Community Reinvestment Act, this is not a path we should go down. That Act mandated the amount of loans that banks had to make to low-income borrowers, resulting in loans being made which were not financially viable. Indeed, attempts to spread the risks of these loans led to the disastrous bundling of ”sub-prime” mortgages to be sold on the secondary market.

The government is ill-suited to picking winners, and having a government agency attempting to second guess bank managers is not the way to a thriving and successful market economy.

The news that the UK has dropped out of the top-ten countries in the Index of Economic Freedom should act as a wake-up call to the politicians wishing to form the next government. The country’s score dropped from 79 to 76.5, the second largest fall among the world’s twenty largest economies (only in the USA is economic freedom declining even more rapidly). Worse still, the 2010 Index is based primarily on data from July 2008 to June 2009 – before December’s disastrous Pre-Budget Report and the arbitrary supertax on bankers’ bonuses.

Under New Labour, Britain has fallen far behind leading economies such as Hong Kong (score: 89.7), Singapore (86.1) and Australia (82.6). The UK has moved closer to the low-growth economies of continental Europe.

The implications are extremely serious. The prospect of further tax rises and more burdensome regulation will deter the private investment needed to bring about a vibrant and sustained economic recovery. Moreover, there is a growing risk that multinational businesses will move their UK operations to countries where there are fewer restraints on their activities.

The next government should therefore act quickly to reverse this worrying trend. In particular, urgent steps are needed to tackle very high levels of government spending (the UK scores just 41.9 out of 100 on this component of the Index). The imperatives of the current fiscal crisis mean either large tax rises or severe cuts to public expenditure will be necessary. These shocking figures on economic freedom strongly recommend the latter.

Countries trade on their reputations. It is not just the number of eager, materialistic consumers that causes businesses to invest in one country as opposed to another. The hospitality of the host nation – and especially its government – is also of huge significance.

Two of the most the attractive features investors will consider are private property rights and the rule of law. The reasons are obvious. Without protection of private property, investors cannot guarantee that they will get to keep the proceeds of their investment (or even the initial stake). Whether it is petrochemical firms being bullied out of half their shares in Siberian oil and gas fields, or banks having their profits taxed heavily, the effect is the same: the investor will look elsewhere in the future. The same follows for the rule of law: if politicians can use the tax authorities to attack those that are both successful and unpopular, investors will steer clear.

Of course, one might argue that no investor will be deterred by the decisions of Gordon Brown and Alistair Darling. In six months time they will be nothing more than economic bogey-men; names that bankers use to scare their children. Their ability to do harm will have ended at the ballot box. So how much harm can a windfall tax on bank bonuses really do?

Firstly, the election may change nothing. George Osborne wouldn’t rule out a windfall tax on bank bonuses either, while Vince Cable wants to tax bank profits to create an insurance fund for the sector.

But more importantly, in the minds of investors, even a one-off windfall tax conveys the message that British politicians view high profits or incomes like bandits view a passing caravan.

There is a real issue regarding taxpayer liabilities: the banks owe vast sums to the exchequer, so Vince Cable may be right to say that “a special tax on the banks’ profits” should last as long as the “banks continue to depend on taxpayer guarantees”. The banks certainly should pay their debt off as quickly as possible – though it would only delay repayment if taxes damaged the banks’ ability to generate the profits from which the debt must be paid.

But it is entirely different to say that banks profits should be taxed more heavily than those of other businesses even after the debt is paid off, or that individual bankers (who are needed to generate the profits from which the debt will be paid, and who will only do so if they have incentives to do so) should be the targets of a special tax regime. Hitting those who generate wealth with high taxes may indeed drive talented people and successful institutions abroad. More importantly, applying different laws to different groups undermines a free society and damages the fundamentals of the economy. That’s no way to end a recession.