The deeper causes of Britain’s economic stagnation

Mancur Olson is best known for his 1965 book, The Logic of Collective Action, in which he explained why small, concentrated interest groups are more likely to influence policy than large, dispersed groups. Olson’s work, together with that of other public choice theorists, exposed the mechanisms by which interest groups obtain special privileges from government, enabling them to extract ‘rent’ from the wider population. For example, a domestic industry might lobby politicians to introduce import tariffs or environmental regulations to shut out foreign competition. In The Rise and Decline of Nations (1982), Olson contended that over time, concentrated interest groups – facing little public resistance – would come to dominate more and more sectors of the economy, stifling competition and innovation, misallocating resources, crowding out entrepreneurial activity and thereby bringing economic stagnation.

In the recent debate over Britain’s poor economic performance, there has been relatively little discussion of the underlying causes. Olson’s analysis provides a compelling explanation for many of the long-term structural problems now afflicting the UK economy. Much economic activity is now artificial in the sense that it is not the result of voluntary exchange but rather the consequence of state-granted privileges resulting in part from ‘rent-seeking’ behaviour by special interests.

Whole swathes of the nominally private sector are sustained by government regulation rather than consumer choice. Across the professions, occupational licensing restricts entry and raises fees, while at the same time, regulations create artificial markets for professional expertise. Complex tax rules create work for accountants and tax lawyers, for example. Vast industries such as renewable energy and waste recycling have been brought into being by combinations of regulation and subsidies. And major sectors of the economy are now heavily dependent on special privileges granted by the state at the expense of the wider population. Agriculture, energy and public transport are three obvious examples, but a strong case could also be made for numerous sectors including banking (bailouts, QE, etc.), pharmaceuticals (licensing etc.) and vehicle manufacturing (non-tariff barriers etc.). In this context, the success or failure of businesses is frequently dependent on political favours rather than satisfying customers’ preferences. Given such incentives, devoting resources to rent-seeking behaviour is entirely rational, even if it is at the expense of consumers and taxpayers and the health of the wider economy.

Clearly cutting public spending is an important part of reducing the pernicious influence of special interests. It will tend to reduce the share of the ‘private’ sector reliant on government subsidies. But there is little sign that the coalition understands the economic importance of dismantling the web of regulatory privileges enjoyed by concentrated interest groups. Indeed, several government policies have actually increased opportunities for rent-seeking.

Olson was generally pessimistic about the prospects for fundamental reform in stable Western societies. Only extreme events such as wars and revolutions were likely to break the hold of powerful interest groups over policy and restore economic dynamism (arguably West Germany after World War 2 is an example of this). Yet the success of Margaret Thatcher in tackling the unions suggests that it can be done. A similar strategy against ‘middle-class’ professions would be a good starting point.

For an illustrative case study of special-interest influence over policy, and its harmful economic effects, see The High-Speed Gravy Train: Special Interests, Transport Policy and Government Spending.

26 April 2012, IEA Blog

How to abolish the NHS

The National Health Service enjoys strong support among the public, making it almost impossible to introduce radical reforms, even if the performance of the NHS is relatively poor compared with systems in other developed countries.

Over the last thirty years reform efforts have therefore focused on greater private sector involvement within the NHS system and the deployment of some internal market-style mechanisms in an attempt to improve efficiency. In a recent initiative, for example, a private company has been contracted to manage a ‘failing’ NHS hospital.

The problem with such ‘part-privatisations’ is that they typically involve complex contractual arrangements and the creation of numerous ‘interfaces’ between government bureaucrats and the private sector, which may result in increased transaction costs and a reduction in overall efficiency. At the same time, private firms working within the NHS framework remain constrained by a strict regulatory framework on top of rigid contractual commitments. There is therefore little scope for the entrepreneurial discovery and innovation that brings such enormous gains within genuinely free market arrangements.

Moreover, since politicians and officials retain control over funding, the system remains unresponsive to consumer preferences and subject to capture by special interests, particularly producer interests such as the medical and nursing professions and the pharmaceutical industry. Mixed public-private systems therefore risk introducing additional transaction costs while suffocating the potential gains from private sector entrepreneurship. If this results in disappointing outcomes, as is likely, the whole concept of privatisation may be brought into disrepute.

There is therefore a strong case for taking a different approach. Rather than focusing on the gradual introduction of  ‘market reforms’ and public-private partnerships within the NHS system, an alternative strategy would seek to bypass the NHS by liberating the private healthcare sector such that the NHS became less and less relevant as more and more people opted out of state provision to avoid long waiting lists and substandard care. This option has the potential to create a virtuous circle – by reducing burdens on the NHS, taxes could be cut, wealth created, and more people would be able to afford private healthcare, reducing the NHS burden still further and gradually undermining its political base.
But radical regulatory reform is necessary if a dynamic private health sector offering low-cost, high quality and innovative treatment is to emerge. A selection of regulatory changes is suggested below:

– Perhaps most importantly, the compulsory licensing of medical professionals should be abolished. Anyone should be at liberty to practice as a doctor or nurse, with patients relying on brand names or competing voluntary associations to ensure quality. Ending current restrictive practices is essential to enable private firms to increase productivity in the sector.

– Restrictions on the types of treatment available ‘over the counter’ should be lifted to enable patients to obtain medication without recourse to registered doctors and regulated pharmacies.

– Burdensome drug licensing regulations should be rescinded. Instead, the testing of new drugs should be left to private firms and free markets. Reputable companies would have strong economic incentives to ensure the safety of their products, while there would also be far more freedom for experimentation and innovation by new market entrants, with huge potential benefits for patients.

– Prohibited recreational drugs, such as cannabis and opiates, should be legalised to allow the sick to benefit from their numerous medical applications.

– Private firms should be free to bring in low-cost medical professionals from abroad and at liberty to determine rates of pay and working conditions through private contract.

– Legal reforms could enable patients to waive their right to clinical negligence claims.

– Planning controls and building regulations should be liberalised to enable the rapid development of new private healthcare facilities.

Finally, it should be noted that internet technology has mitigated many of the information asymmetry problems that have previously been cited as a rationale for heavy state regulation of health. A combination of new technology and a dynamic, entrepreneurial private health sector could make the NHS increasingly irrelevant.

23 January 2012, IEA Blog

Politicians are to blame if we have crony capitalists

Capitalism has a problem. Increasingly it is viewed as a deeply unfair system favouring a small, privileged elite at the expense of everyone else.

Our politicians have been quick to join the criticism. Last week David Cameron mooted granting extra powers to shareholders to restrain executive pay. Today he will give a speech on how to make capitalism more “inclusive”. Ed Miliband, meanwhile, has attacked “rip-off Britain” and backs forcing firms to consult workers on bosses’ pay levels.

There is a whiff of hypocrisy in some of these statements. Recent government initiatives include a plan to give top executives special access to ministers and a scheme to subsidise mortgages which will be run by the housebuilding industry.

Nevertheless, both leaders are correct in acknowledging the UK has a serious problem with “crony capitalism”. They are wrong, however, about the causes and solutions.

In fact, cronyism is quickly rooted out in a genuinely free economy. Companies that fail to incentivise success fall behind the competition. Cosy and complacent corporate cliques are outflanked by vigorous and innovative market entrants.

That is how markets are supposed to work. But Western economies have moved a very long way from free-market capitalism. It is not just that government spending now accounts for close to half of GDP; most sectors are also very heavily regulated.

For many firms, profits are more dependent on political favours than serving individual customers. Energy companies rely on rigged electricity markets for their reveunues from renewables; rail firms require operating subsidies; the defence industry needs government contracts, and so on. The banking sector is, of course, one of the most telling examples. Without the bailouts, many of the banks now being heavily criticised on pay would not exist.

This level of state involvement brings immense political risks to business. A new regulation, tax hike or subsidy cut can destroy profits or ruin investment plans. George Osborne’s raid on North Sea oil revenues is one recent example; the subsidy cut for the solar-power industry is another.

The incentives for business leaders to develop close relationships with politicians and regulators are therefore very strong. The returns from lobbying are often far higher than the returns from conventional business activity. Indeed, large corporate interests often successfully capture the policy process and use it to shut out competition or obtain favourable treatment. The losers are generally dispersed groups such as consumers and taxpayers, who are powerless to resist.

The answer is not, as politicians propose, to add more layers of regulation to control corporate behaviour. This will strengthen incentives for business leaders to get closer to government – an entirely counterproductive result.

Crony capitalism is inevitable given an intrusive regulatory state. It can only be stopped by removing the payoffs from special-interest lobbying – by a substantial reduction in political influence over business activity.

19 January 2012, City AM

New plans by Grant Shapps are a recipe for increasing homelessness

Housing minister Grant Shapps recently announced plans to make the unauthorised subletting of social housing a criminal offence, with offenders facing up to two years in prison. The stated rationale is to free up dwellings for those on council waiting lists. But the policy fails to address the distorted economic incentives facing social tenants and in practice it is likely to exacerbate housing shortages while extending official intrusion into the private lives of tenants, lowering incentives for family formation and reducing labour mobility.

Criminal sanctions will raise the costs associated with unauthorised subletting, and this will tend to reduce the activity. However, such a reduction also means that those who previously rented such property from social housing tenants will be pushed into alternative accommodation, adding to housing waiting lists (either directly or indirectly through displacement in the private rented sector).

Moreover, it cannot be assumed that reducing subletting will free-up enough dwellings to compensate for this effect. Given long waiting lists in many areas – and much higher private sector rents – tenants will be reluctant to give up their social tenancies. With the option of subletting less attractive, more may choose to stay put rather than cohabiting or moving away to seek work. Some may live with partners most of the time while visiting their official residence periodically to maintain the tenancy. (By vacating the dwelling they would risk moving to the bottom of the waiting list should the relationship break down). Thus the likely effect of the crackdown on subletting is to increase the proportion of social properties that are empty or under-occupied. This in turn may increase the risk that the dwelling deteriorates (e.g. from damp) or is targeted by vandals or squatters – as the government’s own research on subletting recognises. 

Then there is the question of enforcement. There are practical difficulties in determining whether the correct people are occupying a dwelling, particularly if traditions of privacy are respected. There are grey areas such as friends and relatives coming to stay for a few weeks. The crackdown is therefore likely to involve further authoritarian intrusion into private lives. The economic costs involved in employing specialist inspection teams, instituting contested eviction procedures, prosecuting offenders and imprisoning them are also likely to be significant.

Rather than trying to cure the unintended consequences of state intervention with more intervention (the flawed approach of the government’s welfare reforms in general), Shapps should instead focus on removing the distortions responsible for the shortage of low-cost dwellings. Liberalising the planning system and rescinding burdensome building regulations would free the private sector to provide cheap housing as it did in the 19th century. Social housing, together with the £20 billion annual Housing Benefit bill, could then be phased out, with voluntary organisations catering for those with special needs.

11 January 2012, IEA Blog

Infrastructure stimulus will be counterproductive

As the economic slump persists, calls are growing for an increase in infrastructure spending as a means of boosting growth. Both David Cameron and Nick Clegg have announced plans for the delivery of planned schemes to be speeded up in order to bring forward the alleged benefits.

In theory, investment in infrastructure has tremendous potential to promote recovery. Improved transport links can reduce journey times and deliver significant productivity gains. Businesses can pass on their savings to customers in the form of lower prices, which in turn boost demand for their products and services. Transport investment can also increase productivity by lowering the costs of trade, which in turn promotes competition and specialisation, as well as facilitating greater economies of scale.

Energy investment can be similarly beneficial. Lower energy bills reduce business costs and increase productivity by enabling greater use of labour-saving technology. The released labour can then be put to other productive uses.

The policy of increasing infrastructure spending during a slowdown is therefore very appealing; however, there is one major problem: politics.

Politicians and senior government officials have very poor incentives to invest efficiently. Instead, they are likely to allocate resources in order to boost their own positions. Politicians may seek to satisfy special interest groups and increase their chances of re-election; senior officials may seek to enhance their power and status by consolidating their department’s influence over policy. In addition, ideological considerations – such as a focus on ‘fairness’ or the environment – may trump economics when it comes to investment decisions.

A further problem is the loading of financial risks onto taxpayers. Politicians and bureaucrats may be less concerned than private investors about making bad investments that lead to huge losses.

The history of infrastructure spending bears out these concerns. A high proportion of investment has been directed towards loss-making projects that have failed to make anything close to a commercial return. Worse still, many schemes have required ongoing operating subsidies to keep them going. Capital expenditure has been written off.

Recent examples of loss-making projects include the tram schemes constructed in several major UK cities over the last two decades, the Channel Tunnel Rail Link (High Speed 1) and the upgrade of the West Coast Main Line. In today’s money, the total cost of these schemes is in the order of £25bn.

Part of the problem is that politicians seem to favour high status ‘big projects’ over smaller schemes that offer much better value for money for taxpayers. The government is now supporting big and expensive rail projects, such as Crossrail (£17bn) and High Speed 2 (HS2, £34bn). Both of these schemes are likely to be loss-making. Taxpayers, not commercial investors, are funding their construction. Realistic projections of passenger numbers also suggest that fares will struggle to cover operating costs, meaning taxpayers will face an ongoing subsidy burden for decades to come.

It is important to point out that such investment decisions are essentially political in nature. According to the government’s own cost-benefit analyses, there are a very large number of transport schemes with far higher returns than Crossrail and HS2. Some, such as the Heathrow expansion, would have been entirely privately funded. Yet most of these initiatives will never be undertaken. Scarce resources will instead be devoted to wasteful high-profile vanity projects.

However, there is an argument that when it comes to promoting recovery, long-term returns are perhaps less important than boosting short-term demand in the economy. Keynesian economists argue that increasing public spending can create a positive multiplier by utilising idle resources. For example, if unemployed people are given jobs, they then have more money to spend on goods and services.

There are, however, several reasons why stimulus policies are unlikely to succeed in achieving a sustainable recovery.

Firstly, public spending absorbs resources that would otherwise be available to the private sector – a process known as ‘crowding out’. Private sector investment will tend to decline as the role of the government expands.

Secondly, stimulus policies inevitably involve higher levels of government borrowing. Increased public debt puts upward pressure on interest rates, raising the cost of loans for private investment. It also raises expectations that taxes will rise in the future to pay off the debt, which in turn reduces investors’ confidence in the long-run performance of the economy.

Finally, public spending creates vested interests that depend on continued government support. After the recession is over, it becomes difficult for politicians to withdraw subsidies for activities initiated during the stimulus programme. The role of the state may increase permanently as a result of policies undertaken during slumps, with highly negative long-term economic effects resulting from a higher tax burden and less economic freedom.

Historical evidence appears to support critics of stimulus policies. For example, many commentators now view Roosevelt’s New Deal as a failure in terms of promoting recovery from the Great Depression. Wasteful spending on new roads, dams and irrigation projects arguably ‘crowded out’ private sector investment on more productive enterprises. Indeed, the US went back into recession in the late 1930s – in 1938, for example, living standards were lower than they had been 15 years earlier in 1923.

More recently, infrastructure spending spearheaded efforts by the Japanese government to lift the country out of prolonged stagnation. Once again, the economic record suggests that this was unsuccessful. Worse still, the ill-fated stimulus programme has left Japan with a national debt at over 200% of GDP – higher than Greece and Italy.

So even if stimulus spending were somehow allocated efficiently, there would still be major downsides. In reality, there is little reason to expect that the UK government will invest any more successfully than other governments. Indeed, recent evidence suggests that infrastructure investment will be wasteful, politically driven and will incur losses that burden taxpayers for decades to come.

19 December 2012, PPPJ

Pride before a fall: Osborne looked to special interests, not the UK’s perilous state

The Autumn Statement showed that George Osborne has failed to grasp the gravity of the economic crisis facing the UK. Urgent action was needed to brace the economy for double-dip recession and the fallout from the euro crisis. Instead, the chancellor announced a big increase in government borrowing, together with a series of measures that, while attractive to key groups of target voters, will do little to encourage growth.

Worse still, collapsing growth means the government’s deficit reduction plan is now in tatters. Government borrowing has been increased by £110bn over the next four years, meaning a staggering £350bn added to the national debt.
This may in fact be a best-case scenario. The Office for Budget Responsibility predicts slow growth of 0.7 per cent in 2012 but then assumes a healthy recovery, with growth rising to 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. But given the severity of the euro crisis, high levels of public and private debt, and the possibility of a downturn in overheated emerging markets, it is equally plausible that Britain will go into recession next year, followed by several years of stagnation.

A wise chancellor would be preparing for such a scenario. Vague talk of contingency plans does not pass muster.
A double-dip recession would decimate tax revenues while adding to welfare spending through higher unemployment. If UK GDP were just five per cent lower than predicted in 2015, for example, this would reduce the annual tax take by around £35bn.

Under such circumstances, with the budget deficit remaining unsustainably high, the chancellor cannot assume that the UK will retain investor confidence and continue to pay very low interest rates on its debt. With high debt and low growth there may be little to separate Britain from the struggling economies in the rest of Europe, such as Spain and Italy.
Given the severity of the potential risks, Osborne should have had the courage to announce further cuts – at least enough to return the deficit reduction plan to its original trajectory. He should also have taken far bolder steps to encourage growth, through radical deregulation and by rationalising the tax system.

He could, for example, have cut spending by uprating benefits rates in line with average earnings rather than inflation. Planned increases in foreign aid – deeply unpopular with a sceptical public – could have been abandoned at negligible political cost.

Instead, several new spending announcements were made, using money that could have been used to reduce government borrowing. Ill-conceived “credit easing” policies will mean taxpayers will guarantee risky loans to businesses and first-time buyers. Additional enterprise zones were announced, even though these subsidise firms to relocate to sub-optimal locations. An extra £1bn was found for the Regional Growth Fund for England, despite five decades of failure in regional policy and governments’ lamentable record at picking winners.

Much was also made of extra infrastructure spending: £5bn extra over the next three years plus significant additional investment from the private sector. Unfortunately, a high proportion of this expenditure is politically motivated and the economic returns will be negative. Loss-making public transport schemes will require ongoing operating subsidies, creating significant future liabilities for short-term political gain.

The counterproductive gimmicks were combined with almost a complete absence of policies to reduce burdens on businesses and thereby encourage growth. Osborne made some welcome statements on the need to liberalise planning controls, reduce the cost of employment law and simplify business taxes – but few concrete measures were announced.

In fact, current government policies are likely to work in direct opposition to many of the chancellor’s announcements. For example, new regulations forcing builders to produce expensive “zero-carbon” homes will dwarf the impact of special help for 100,000 first-time buyers. Indeed, Osborne recognised the calamitous impact of the government’s green policies when he announced subsidies for energy-intensive industries struggling to cope with spiralling costs.

The lack of action on deregulation is mirrored in tax policy. Several tax rates are now so high that they actually lower revenues by destroying incentives to work and invest. The Autumn Statement was a golden opportunity for Osborne to signal his intention to rationalise the tax system. In particular, a cut in the 50p rate of income tax would have increased tax revenues and sent a strong message to international investors that the UK offers a pro-business climate.

On this and other issues the chancellor proved too timid to step up to the challenge. He missed his chance to prepare the country for economic turmoil by cutting spending and removing key impediments to growth. It now seems likely his hand will be forced by events.

30 November 2011, City AM

Euro crisis: the dangers of fiscal integration

European leaders are advocating greater fiscal integration in response to the ongoing euro crisis. Despite their professed euroscepticism, David Cameron and George Osborne have offered their support for this approach. Yet such a policy would probably be ineffective at preventing future crises and could further damage European economies in the long-term.

One option being considered is stricter EU supervision of national governments’ borrowing levels – a rigorously enforced version of the failed Stability and Growth Pact. If this policy had been imposed during the last decade it might conceivably have moderated some aspects of the Greek crisis (although for many years the Greek government hid the true level of its debts and several other governments ‘cheated’ to meet the Maastricht rules). Strict fiscal controls would not however have addressed the effects of a one-size-fits-all monetary policy applied across diverse eurozone economies. Indeed, Ireland and Spain were among the most prudent eurozone governments during the recent boom period, with low budget deficits and low national debts. The problems in these countries largely resulted from inflationary bubbles which eventually collapsed.

A key question is how EU fiscal authorities would behave towards countries where credit booms had collapsed leading to a large fall in tax revenues. A strictly enforced fiscal stability rule would force national governments to cut expenditure immediately, even if this meant breaking commitments to electorates. In economic terms this could be a welcome development in that would preclude counter-productive Keynesian fiscal stimulus measures. However, the political incentives created by such economic shocks are a cause for serious concern.

National politicians would have strong incentives to blame the EU for severe depressions (and indeed the eurozone clearly does magnify boom-bust credit cycles in some countries). Accordingly, EU institutions, with their agenda of increasing integration, would have strong incentives to attempt to counteract economic and political instability with large fiscal transfers from the centre. In other words, counter-cyclical public spending by national governments could be replaced by fiscal bailouts/stimuli at EU level.

More and more vested interests would become dependent on such spending, making it difficult to roll back and leading to an enlarged role for the central EU authorities. There is therefore a strong likelihood that fiscal integration would eventually lead to the creation of a ‘transfer union’, with stronger countries subsidising weaker ones. The stronger economies would be damaged by higher taxes, while the transfers would crowd-out private-sector activity in the weaker economies, preventing their recovery – as we see in peripheral regions of the UK that are heavily dependent on subsidies from the South-East. An additional danger is that fiscal integration would eventually lead to tax harmonisation – destroying the benefits of tax competition. In conclusion, fiscal integration threatens to undermine the competitiveness of the EU’s more successful member states and thereby speed up the region’s already rapid relative economic decline.

27 October 2011, IEA Blog