Plan to ringfence banks misguided

The British government is right to be examining ways of shielding taxpayers from the costs of bank failure. However, proposals to ring-fence the retail operations of banks, and indeed to give the government to power to order the complete break-up of banks, are deeply misguided. The plans appear to be based on the misapprehension that retail banking is intrinsically safe, while investment banking is intrinsically reckless and dangerous. But recent history would appear to contradict this viewpoint.

Many of the banks that failed were largely or entirely retail operations, including Northern Rock, Bradford and Bingley, and Lloyds/Halifax Bank of Scotland. Indeed, this pattern has been characteristic of numerous economic crises, with institutions focusing on mortgage lending particularly vulnerable to collapse. By contrast, institutions that combine retail and investment arms may be better able to diversify risk. Losses resulting from a collapsing property market might be balanced by gains in other asset classes for example.

There are further problems with the government’s proposals. Clearly the possibility that banks will be forcibly broken up creates risk and uncertainty for investors. There is a real fear that it will put British banks at a competitive disadvantage. The tight regulation of the retail sector will also distort the allocation of capital within the banking sector, with a negative effect on the wider economy.

Worse still, the reforms risk exacerbating the problem of moral hazard within retail banking. The notion that retail banks are ring-fenced, regulated and safe, may further discourage depositors from favouring institutions with conservative lending practices. This echoes one of the major contributory factors to the financial crisis. Reassured by state-backed deposit insurance, regulation and an implicit bail-out guarantee, savers piled into banks that offered higher interest rates but engaged in risky activity, such as Northern Rock.

Rather than focusing on counterproductive ring-fencing, the government should tackle moral hazard head on. Deposit insurance should be phased out gradually and state bail-outs prohibited so that depositors are incentivised to bank with conservative institutions. This in turn would encourage banks themselves to behave more conservatively and to advertise their prudent practices to potential customers. Removing deposit insurance and reducing bailout expectations would change the whole culture of the banking sector, greatly lowering the risk of future crises.

At the same time, policy-makers need to address other fundamental causes of the economic instability that leads to banking crises. Large increases in the money supply instigated by central banks created the unsustainable asset price booms that turned to bust. In many ways, the explosion in bank credit that led to disaster was a symptom of reckless behaviour by central bankers who flooded the markets with liquidity as they attempted to counteract economic slowdowns.

Ring-fencing will do nothing to prevent central bank inflation from destabilising the banking sector; neither will it address the moral hazard that encourages reckless behaviour. It will, however, impose significant additional costs on an industry struggling to recover from a severe crisis, with knock-on effects on those businesses reliant on bank lending to fund new investment. It is not too late to reverse the reform plans and focus instead on addressing the deeper causes of the financial crisis.

6 February 2013, PSE


Why are rail subsidies so high?

Taxpayer subsidies to the rail sector have reached astronomical levels. At £6 billion per year (including Crossrail), they have roughly trebled in real terms over the last twenty years. But the high rate of subsidy has not led to a reduction in fares, which recently have risen above the official rate of inflation. There are two main reasons for the large increase in taxpayer support. The first, and probably most important, is wasteful investment in loss-making new infrastructure. This is the direct result of policies that have aimed to increase public transport ridership and reduce car use.

For much of the post-war period, rail was viewed as a declining industry. Despite previous government efforts to suppress private road transport, the step change in efficiency resulting from the door-to-door transit of passengers and freight led to rapid growth in car and lorry traffic. A policy of ‘managed decline’ was therefore applied to the railways. British Rail received subsidies to keep the system going and there was some modernisation of key inter-city routes, but there was little enthusiasm to attempt to reverse the long-term trend.

This changed with the ascendancy of environmentalism within government. With their perspective grounded in radical egalitarianism, environmentalists not only objected to the pollution produced by private road transport; they also resented its social aspects – for example, the way that cars had become symbols of wealth and individual expression. The environmentalist agenda gradually captured university departments, various government bureaucracies, elements of the media and eventually national policy. In the mid-late 1990s, the road construction programme was cut back dramatically and a new strategy introduced. Private road transport would be deliberately discouraged with travellers encouraged to use buses, trams and trains instead.

For the railways this represented a sea change. The new policy meant that rail now had prospects for growth. It did not, however, change the fundamental economics. Since rail involves at least a three-stage journey, compared to the door-to-door convenience of private road transport, it remained unattractive for the vast majority of journeys.

Following privatisation, however, the policy of encouraging more rail travel appeared to be successful. Usage rose by around 50 per cent between 1997 and 2012, to levels not seen in peacetime since the 1920s. This reflected not just the impact of various deliberate policies, but also other trends such as a booming central London economy for much of the period and demographic changes that led to a huge expansion of the ‘inner city’, pushing middle-class families out into the commuter belt to avoid poor schools, anti-social behaviour and fear of crime.

A combination of increased ridership and price controls produced severe peak-time overcrowding on several routes into London. Train operating companies have been constrained in their ability to smooth the peaks using the price mechanism, since season ticket fares on most London commuter journeys are regulated by the government. With a severely limited ability to deploy the price mechanism and other means to make more efficient use of existing rail capacity, the industry has increasingly focused on supplying new infrastructure to accommodate growth. This has proved hugely expensive, however. The final cost of the ongoing Thameslink 2000 upgrade, for example, is likely to be £6 billion. And the Crossrail scheme will cost £16 billion.

Since in commercial terms such projects are loss-making and would never be undertaken in their current form by the private sector, taxpayers have been forced to fund them. Accordingly, wasteful investment in new rail infrastructure is probably the largest single factor in the growth in taxpayer support in the post-privatisation era. Such investment has not been restricted to overcrowded routes in the South-East. The government also funds improvements for blatantly political reasons, in regions where there is little passenger demand. For example, it was recently announced that branch lines in South Wales would be electrified – at taxpayers’ expense, of course. The environmentalist agenda means that rail schemes get priority even though the government’s own cost-benefit analyses show that economic returns from road improvements are far higher.

The second major reason for the increased burden on taxpayers is the artificial structure imposed by the government on the post-privatisation rail industry. Historically, railways that developed in the private sector exhibited a high degree of vertical integration. This meant in practice that the same company owned the tracks and operated the trains, thereby avoiding the transaction costs associated with complex contractual arrangements between highly interdependent separate organisations.

Partly as a result of EU policy, Britain’s privatisation model has been very different, with one firm owning and maintaining the tracks, other firms operating the trains, and another set of firms leasing out the rolling stock. On top of all this complexity, the industry has been tightly regulated by various government agencies. The resulting fragmentation, combined with layers of bureaucracy, needlessly increased costs on the network. In addition, the high levels of regulation severely hindered entrepreneurship. As a result, the productivity-boosting innovations that have cut costs in other industries did not materialise on the railways. Indeed regulation is now so restrictive that private rail firms have effectively become subcontractors for the Department for Transport.

Structural reform would therefore be one of the best ways to reduce the burden on taxpayers. The government should stop prescribing the level of vertical integration and instead free the rail industry to become more efficient. This policy should be combined with a more rational approach to rail investment. A first step is to abolish price controls to remove artificial distortions to fare levels and consumer demand. The provision of new capacity should then be left to the private sector, without taxpayer support. It would make commercial sense to build new infrastructure in high demand locations where it could be funded by fare revenues or land development. Uneconomic projects driven by political motives and special-interest lobbying would no longer get built.

The economic case for phasing out subsidies is very strong. The taxes imposed on individuals and businesses to support the railways destroy jobs and hinder wealth creation in the wider economy. In addition, large parts of the rail industry could thrive without the bureaucratic micro-management that comes with government support. It may seem counter-intuitive, but removing rail subsidies could also end up benefiting passengers, by unleashing entrepreneurship and innovation on the railways that would drive down costs.

22 January 2013, LSE

Do we need to make further spending cuts?

George Osborne is taking a reckless gamble by extending his fiscal target out to 2017/18. Government borrowing will now remain at dangerously high levels for a prolonged period. Worse still, the deficit reduction plan could easily be derailed by lower-than-forecast growth. The Chancellor is relying on robust growth in the medium term to boost tax revenues and enable him to meet his targets without the need for radical spending cuts. This outcome cannot, however, be guaranteed. Recent history shows that OBR forecasts are extremely unreliable. Borrowing in 2013/14 is already likely to be almost double the figure originally expected. If stronger growth fails to materialise, the UK could quickly lose the confidence of the bond markets and face a debt spiral. Given the risks, a wiser Chancellor would have taken a much more conservative approach. Deeper cuts would have made Britain much more resilient to future growth shocks.

6 December 2012, City AM

The Chancellor is still gambling on strong medium-term growth

At the time of the last Autumn statement, the Office for Budget Responsibility (OBR) was predicting growth of 0.7 per cent in 2012, followed by 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. Yet again, these forecasts have been downgraded, to -0.1 in 2012, 1.2 per cent in 2013, 2.0 per cent in 2014 and 2.3 per cent in 2015. Forecasts of strong growth of almost 3 per cent have now been put back to 2016 and 2017.

Despite the unreliable nature of such forecasts, the Chancellor is still gambling that strong medium-term growth and the consequent increases in tax revenues will allow him to meet borrowing targets without making radical spending cuts. So far this strategy has not been successful. As a result of lower-than-expected growth over the last two years, government borrowing in 2012/13 on a like-for-like basis will be around 50 per cent higher than projected in the original deficit reduction plan. Borrowing in 2013/14 is now forecast to be almost double the figure expected back in 2010. At around 7 per cent of GDP, it will remain at a similar or higher level than in several countries currently experiencing debt crises, such as Italy, Spain and Portugal.

In addition, there are good reasons to believe that the long-term ‘trend’ rate of growth in the UK has declined over the last decade or so. This reflects a large rise in public spending – to a peak of 50 per cent of GDP – as well as an expanded regulatory burden on businesses. Moreover, various government stimulus policies since 2008 have hindered recovery by preventing necessary adjustments, such as the liquidation of boom-time malinvestments and the reallocation of resources to more productive activities. Going forward, significant increases in energy and transport costs, resulting from the government’s environmental policies, are likely to have a negative effect on economic output. And, as the Chancellor mentioned in his statement, the ongoing euro zone crisis adds further uncertainty to the medium-term growth outlook.

In this context, the Treasury is taking a major risk in basing its deficit reduction plans on growth forecasts that are likely to be inaccurate. Given that government borrowing remains at dangerously high levels, and that the confidence of the bond markets could quickly be eroded if outcomes disappoint, there is a strong case for taking much more radical action to reduce public spending. The real terms reductions in working-age benefits are a good start, but the Chancellor could also have acted to cut age-related benefits, as well as abandoning the coalition’s deeply unpopular plan to increase foreign aid. Significant medium-term savings could be achieved by cancelling major projects such as Trident and High Speed 2. The IEA’s recent publication, Sharper Axes, Lower Taxes, provides a long list of potential savings.

5 December 2012, IEA Blog

Energy Bill will impose immense costs on households and businesses

Today’s agreement on energy policy, ahead of the forthcoming introduction of the Energy Bill, shows the government remains committed to meeting ambitious targets on greenhouse gas emissions and renewable energy. The economic cost will be immense. The Department of Energy and Climate Change quotes a figure of £110 billion of investment in the electricity sector alone (by 2020), a high proportion of which will be used to expand offshore wind capacity and connect it to the national grid. This investment will be funded by higher bills.

A number of questionable claims are made to justify the policy. Firstly, it is claimed that new investment is required to ‘keep the lights on’ since a significant proportion of coal-fired power stations will close within the next few years.  In fact, environmental policies – in particular the EU Large Combustion Plant Directive (LCPD), which is supported by the UK government – are forcing the closure of coal-fired power stations which are not fitted with desulphurisation plants. In other words, the potential reduction in generating capacity is itself largely the result of environmental regulation.

Then there is the claim that meeting the targets on emissions and renewable will add only a small amount to bills. In reality, these policies are already inflating electricity prices by a very large degree. This is because government regulation effectively forces power companies to generate electricity from high cost sources and limits the extent to which they can deploy low-cost sources such as coal. The Renewables Obligation and feed-in-tariffs are two ways in the electricity market is rigged to achieve this result. And as long ago as the 1990s the ‘dash for gas’ was partly spurred by the imposition of EU regulations on coal-fired generation. It is telling that in US states that have refused to adopt European-style green policies, electricity prices are now over 50 per cent lower than in the UK. Indeed, DECC itself has estimated that by 2015, climate change policies will be adding 26 per cent to domestic electricity prices and 10 per cent to domestic gas prices. The impact on commercial users will be similar. This estimate implies an extra burden on energy consumers of approximately £12 billion per annum. Other environmental policies such as the LCPD will push up prices even further.  Moreover, there will be additional negative effects on the wider economy. For example, rising energy costs are likely to add to the political pressure to raise welfare benefits for those on low incomes, who spend a disproportionate share of their income on utility bills.

Despite the huge costs being imposed within the UK, these policies are unlikely to make a discernible difference to climate change. Firstly, Britain accounts for only a tiny fraction of global greenhouse gas emissions. Moreover, developing countries are rapidly increasing their carbon output. Secondly, higher energy costs in the UK are likely to displace economic activity, particularly energy intensive industries, to countries with lower costs such as China, a process known as ‘carbon leakage’. If production is less energy efficient in developing countries, as is often the case, this may actually lead to a rise in emissions. Given their questionable overall effectiveness, there is surely a strong case for the British government to moderate its green energy policies to take greater account of their impact on households and businesses. At the very least, the government should ensure that targets are met at the lowest possible cost by reforming fiscal and regulatory frameworks so that they treat different sources of emissions similarly.

23 November 2012, IEA Blog

The impact of fuel duty on work incentives

According to a review commissioned by the Department of Social Security, ‘the costs of travelling to work will … be a factor in some people’s decisions about whether to look for or accept employment’. Indeed, one survey found that 50 per cent of unemployed people cited ‘extra costs such as travel’ as a major cause for concern about leaving benefits. Moreover, ‘travelling costs will also be a regular expense which may influence decisions about whether to remain in a particular job’. Studies of low-income families suggest that earnings from low-paid employment are significantly reduced by travel-to-work costs, with a particularly acute problem in rural areas. Since around two-thirds of working adults who travel to work do so by car or van, it is clear that motoring taxes – and fuel duty in particular – have a significant impact on travel-to-work costs. 

The impact of travelling costs on work incentives is likely to be most pronounced for those individuals that already experience very high effective marginal tax rates (EMTRs). Within certain income ranges, some workers face EMTRs as high as 96 per cent. High EMTRs reflect the withdrawal of welfare payments such as housing benefit and tax credits, as well as the imposition of income tax and national insurance. While EMTRs of over 90 per cent are experienced in quite narrow income bands, EMTRs of 70 per cent or over affect a large number of employees on relatively low incomes.

Accordingly, travel-to-work costs can make a large difference to the financial incentives to enter work. Case studies illustrate the magnitude of the effect. A single person over 25 in low-cost rented accommodation would typically be around £70 per week better off in a full-time job paying the minimum wage than on benefits, which works out at £1.75 an hour. However, if average costs for those driving to work (about £20 per week) are applied, this means the person is now only £50 per week better off, or £1.25 an hour. When a realistic estimate of the time spent travelling is incorporated, the effective hourly rate falls further to around £1.10 an hour. Thus, in this case study, under plausible assumptions, travel-to-work costs reduce the returns from entering work by almost 40 per cent.

A significant proportion of motorists, such as many in rural areas, face very much higher costs.  Travel-to-work costs of £40 per week would reduce the benefit of working to just £30 per week, equivalent to just 75p per hour, a drop of almost 60 per cent. At this point the financial incentives for entering employment may be extremely weak, particularly since there are likely to be additional in-work costs such as food and clothing. Worse still, several groups, such as single-earner families or households in private rented accommodation receiving large housing benefit payments, face even weaker incentives to enter relatively low-paid work. In such cases, travel-to-work costs may mean work does not pay or even makes the household worse off.

The AA estimates that fuel accounts for approximately two-thirds of car running costs (which do not include ‘standing charges’ such as insurance and VED). This suggests fuel duty accounts for roughly one third of the costs of those travelling to work by car or van. As the government introduces welfare reforms designed to improve work incentives, there is a strong case for policymakers to consider in detail the effect of travel-to-work costs, of which motoring taxes form a major component. 

The economic impact of motoring taxes is analysed in a new IEA paper, Time to Excise Fuel Duty?

19 November 2012, IEA Blog

A radical proposal for privatising the UK’s road network

For decades governments have used motorists as a cash cow. Fuel duty and road tax now raise around £35 billion a year, while less than £10 billion is spent on road maintenance and improvements. Indeed, as motoring taxes have increased, investment in new road capacity has collapsed.

Transport policy has gradually become dominated by a green agenda that seeks to reduce emissions and shift journeys to public transport. In terms of revenues, however, this policy is beginning to backfire.   

Drivers are now buying smaller and more fuel-efficient cars, meaning they pay much less tax. Electric vehicles also threaten a collapse in receipts.

The potential shortfall explains the urgency with which the government is exploring new ways of charging motorists. This week it emerged that officials are considering a two-tier system of road tax, with motorists paying a higher rate if they wish to use motorways.

Charging that better reflects different levels of usage makes sense. But motoring taxes are a very crude way of doing this. Ideally, charges should reflect infrastructure costs and congestion levels. Drivers should pay more to use an expensive urban motorway with huge peak demand than a relatively empty rural motorway, or a minor road that has barely been improved since the 1930s.

In practice an efficient road network can only be obtained through more widespread pricing. The government, however, is not well suited to the management of a tolled network. Pricing and investment decisions would be influenced by special interests and political expediency. Tolls would probably be added on top of existing taxation, or unwarranted environmental levies imposed. Under political control, many of the benefits of road pricing would be lost.

A better long-term solution is therefore to transfer ownership and control to the private sector. Pricing would then be based on consumer demand rather than political calculation. New investment would be directed to those locations where the highest returns could be achieved. Productivity-boosting innovations would also be possible, such as raising speed limits and increasing lorry weights.

But privatisation and pricing need to be combined with a very substantial reduction in motoring taxes to be both politically acceptable and economically efficient. In the IEA’s new report, Which Road Ahead: Government or Market?, we set out a way of achieving this. Flotation receipts from the privatisation of motorways and trunk roads – estimated at around £150 billion – would be used to abolish road tax and reduce fuel duty by at least 75 per cent. Public spending on transport would gradually be phased out and in the longer-term the Treasury would also enjoy a large increase in general tax revenues as efficiency gains such as lower congestion fed through into higher economic output.

The denationalisation of roads is therefore a win-win policy. For most drivers, tax cuts would mean cheaper journeys despite the introduction of tolls. And for the government, substantial short-term flotation receipts would be followed by a lower spending burden and a major boost to the wider economy.

30 October 2012, City AM