ECB money printing will prop up zombie banks


How to destroy crony capitalism

The recent Oxfam report on inequality and the ‘top 1 per cent’ is riddled with statistical errors. Worse still, its proposed solutions risk harming the poor through ill-conceived government interventions.

Nevertheless, current patterns of wealth distribution raise important questions about ‘crony capitalism’ and the extent to which concentrated special interests have succeeded in rigging markets to benefit themselves at the expense of the wider population.

As might be expected in ‘state-capitalist’ economies characterised by high public spending and pervasive regulation, it would appear that a significant proportion of the ‘top 1 percent’ do indeed owe a large part of their fortunes to special privileges granted by governments.

Several powerful ‘crony capitalist’/protected interest groups can be identified, including:

  • Elements of the financial sector propped up by quantitative easing, monetary inflation more generally, bailouts, taxpayer guarantees, regulation, tax breaks, government-imposed monetary systems, state borrowing etc.
  • Beneficiaries of government contracts, who are often well connected to the political and bureaucratic elites who determine official spending priorities.
  • Landowners whose property was stolen by the state and then transferred into private ownership. This category would include many of the European aristocrats who still make up a significant proportion of their national rich lists, but could also be extended to include mining, energy and agribusiness enterprises benefiting from government land-theft around the world.
  • Property developers, often well connected to political elites, who are able to gain permissions that are unavailable to the general population due to planning and building regulations, and who profit from the resulting scarcity value. They may also be indirectly subsidised by taxpayer-funded transport infrastructure and regeneration grants.
  • Enterprises dependent on state protectionism in the form of illegitimate ‘intellectual property rights’ such as patents.
  • Professionals whose lucrative jobs depend on regulation and/or whose high remuneration relies on occupational licensing. Examples include lawyers, doctors and accountants.

Some of the individuals and firms benefiting from special privileges could of course also thrive in an unhampered market economy based on voluntary exchange – but it seems likely that a high proportion of the above groups would either be eliminated entirely or see a major fall in their relative wealth in the absence of state protection.

The precise impact on overall inequality would depend on the social structures that evolved under a system based on free exchange. However, it is clear that both patterns of wealth distribution and absolute levels of wealth would be very different if markets were freed. Crony capitalism, special-interest influence and rent-seeking behaviour tend to undermine genuine wealth creation. Accordingly, the emergence of ‘distributional coalitions’ is a serious problem for contemporary ‘state capitalism’.

Tackling the cronies will not be easy, but identifying some of the most egregious special interests provides a useful starting point. A combination of honest, free-market money and deregulation would destroy the privileges of the financial sector. Dramatically shrinking public spending would undermine the government contractors. Scrapping patents would subvert that insidious form of protectionism. Planning liberalisation would reduce the advantages of crony-capitalist property developers. And land restitution (which raises many difficult issues) might start to address the widespread government-corporate theft of individual and communal property. Finally, abolishing occupational licensing would bring much-needed competition to state-protected professions.

Unless otherwise stated, all articles on this website are written in a personal capacity.

Osborne’s pre-election gimmicks do little to address Britain’s long-term economic problems

History is unlikely to be kind to George Osborne. Four years after he became Chancellor, the national debt has exploded, the budget deficit remains at dangerously high levels and an increasing share of tax revenues must be devoted to repaying creditors.

The government also faces enormous long-term liabilities which currently do not appear in the national accounts. These include pensions and healthcare commitments that are spiralling due to a rapidly ageing population. The liberalisation of pension regulation announced in today’s budget, while welcome in itself, will not make a significant contribution to resolving this problem. Indeed, other government measures, such as the triple-lock on state pension increases will greatly exacerbate the long-term fiscal shortfall. Similarly, while the Chancellor was correct to focus on poor incentives to save, the impact of policies such as expanding ISA allowances will be trivial compared with the negative effects of loose monetary policy and new disincentives to save introduced as part of the government’s flagship welfare reforms.

To add to the demographic challenges facing the UK, a series of policy decisions, implemented for short-term political gain, have done lasting damage to the future prospects of the economy. One of Osborne’s first moves was to raise harmful taxes such as VAT in a misguided attempt to reduce the budget deficit and avoid additional spending cuts. It has backfired spectacularly by suffocating economic activity, dampening the recovery and as a result actually increasing government borrowing. And despite the depth of the recent slump, the burden of regulation on business has been increased. Tax and labour-market legislation has become even more costly for firms, while energy prices have spiralled due to government intervention.

The budget failed to tackle these problems. Yet more complexity was added to the tax system: another ill-conceived crackdown on tax avoidance was combined with a series of bizarre tax breaks for favoured sectors. Disappointingly, there was no rolling back of employment rules that are hindering business activity, such as mandatory workplace pensions, the Equality Act and the National Minimum Wage. And instead of reversing the government’s incoherent green energy policies, the Chancellor treated the symptoms rather than the cause of high bills by announcing special help for the heavy manufacturing sector.

But perhaps the most worrying blunder of all is the expansion of Osborne’s policy of subsidising borrowing to ‘stimulate’ the economy. His ‘Help-to-Buy’ scheme may be effective at winning votes from certain target groups, but it is potentially very dangerous indeed for the medium-term stability of the UK economy. Asset prices are already severely distorted by the Bank of England’s policies of low interest rates and quantitative easing. The Chancellor’s sub-prime subsidies risk further inflating the housing market: more households will take on debts that could become unaffordable should interest rates return to normal levels. Thus significant default risk has been loaded onto taxpayers. There are also potentially very serious implications for the banking sector should government policies ignite another boom-bust cycle.

Indeed, there is a strong argument that a significant part of the current economic recovery is artificial in the sense that it has been generated by the easy credit policies of both the government and the Bank of England. Sceptics might point out that politicians have often boosted the economy in the run-up to general elections. The long-term consequences have usually been dire.

Reuters, 19 March 2014

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 PPPs may offer poor value for money

For several decades the British economy has been hampered by the poor quality of its infrastructure. Whether in transport, education or health, investment has typically been low by international standards and levels of service have suffered as a result.

Public-private partnerships (PPPs) seemed to offer a solution to this problem. Private capital would be used to fund much-needed projects. Better still, private companies could build and operate the new infrastructure, bringing, it was hoped, huge cost savings.

New investment could be detached from the purse strings of the Treasury. It would no longer be so dependent on the short-term imperatives of the public finances. And because the money was borrowed privately, there was no need, at least initially, to count it as public debt.

Moreover, contracts could be written to incentivise firms to complete schemes on time and on budget. The main pitfalls of public-sector procurement – the delays and mammoth cost overruns – could be avoided.

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government – a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.
By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

However, a new study from the Institute of Economic Affairs* suggests that this huge expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity.

A good example is the London Underground PPP. This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

These events seemed to illustrate a key potential weakness of PPPs. When they involve essential infrastructure that government will not allow to fail, it is clear that a high proportion of a project’s risk remains with the public sector.
Yet acknowledging this undermines one of the key rationales for PPPs, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors.

Serious problems have also been evident in the National Health Service (NHS). There has been a huge hospital rebuilding programme over the last 12 years, with 90% of its £12 billion cost privately financed.

While there has been a welcome improvement in the quality of the infrastructure, the long-term charges resulting from the PPP schemes are now causing significant financial difficulties for many NHS trusts. In part this reflects the higher direct costs of private finance. For example, typical interest rates have been around 8%, compared with 4.5% with public finance.

In 2005/06, 50% of trusts with large PPP projects (capital value £50 million or higher) were in deficit, compared with an average of 23%. Such trusts were also more likely to have been placed in ‘special measures’ by the Department of Health.
There is also strong evidence that the ongoing cost of PPPs is forcing trusts to reduce capacity elsewhere, for example, by reducing staff numbers and the number of beds, as well as downgrading the functions of smaller hospitals. Unfortunately this is likely to have a negative effect on patient care.

The experience to date therefore suggests that PPP schemes have failed to live up to their early promise. There are several explanations.

 Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

8 June 2009, PSE magazine

Madoff and the regulation of financial markets

The Madoff scandal is yet more bad news for the financial sector. Several major banks may have lost hundreds of millions of dollars in the alleged scam.

An important question is whether this would have happened under a different regulatory environment. Without the false sense of security given by the government regulation of financial markets, investors would surely have been far more careful about where they put their money. They would have investigated the risks involved more fully and favoured reputable, conservative institutions.

Instead of investors in general having a responsibility for monitoring their counterparties we have handed the job over to a government institution. When that fails – tough. Also, the key objective for a financial institution is not to build reputation and trustworthiness but to make sure it complies with what the regulator wants. Financial institutions look upwards towards the regulator and not downwards towards their clients.

18 December 2008, IEA Blog

Despite all the pain, we must not bail out the struggling banks

The news that HBOS is likely to merge with Lloyds TSB is further evidence that the credit crunch will completely transform the UK banking sector. Effectively, this will be a takeover of HBOS by Lloyds TSB. The former bank has seen its share price dive in recent days, raising fears about its future.

Given the recent collapse of Lehman Brothers, creditors are understandably cautious about lending to other vulnerable institutions.

Assuming the merger goes ahead, it could be bad news for the employees of both banks, including those at the HBOS offices in Yorkshire. Significant job losses are inevitable as the new bank seeks productivity gains by purging the organisations of waste and duplication. Undoubtedly, a high proportion of branches will close.

Unfortunately, this comes at a time when unemployment has begun to rise sharply. It will not be easy for former bank employees in Yorkshire to find relatively well paid jobs that reflect their skills and abilities, particularly at a time when other financial institutions are shedding workers.

In the short term, the outlook is grim.

Yet such rationalisations will be necessary to help the banks rebuild their capital and restore profit levels. And the economy as a whole will gain from such consolidation in the long term as the efficiency of the banking sector increases. Such “creative destruction” is often painful for the individuals concerned, but it is essential for continued economic growth and higher living standards.

Another issue is the effect on customers. In 2001, the competition authorities prevented Lloyds TSB from taking over Abbey National. The merged entity would have accounted for a quarter of the retail banking market. HBOS and Lloyds TSB combined are likely to make up a similar share, and will control 28 per cent of mortgages. However, the Government is determined to avoid another Northern Rock style bailout, and under the circumstances competition concerns will be waived.

This is the right decision. The UK has a large number of banks, including several former building societies, that offer a wide range of services to customers. The sector is also open to competition from overseas banks, as demonstrated when Spanish group Banco Santander entered the market through the acquisition of Abbey National. Accordingly, there is little prospect that the merged bank will significantly affect the choices available to consumers. And, of course, the alternative option would be far worse.

In the event that HBOS faced collapse, it would almost certainly be bailed out by the Government, following the precedent set by Northern Rock. The effects would be disastrous.

Millions of small shareholders, many of them workers, or savers who were allocated shares when the Halifax converted from a building society into a bank, would get next to nothing. Their confidence in the Stock Market would be shattered. Investment in other banks, even by large financial institutions such as pension funds, would probably be negatively affected. Starved of capital, it would take the banking sector longer to recover.

Taxpayers would be faced with liabilities that dwarfed those of the much smaller Northern Rock, perhaps running into hundreds of billions of pounds. The budget deficit, which already breaches the so-called “golden rule”, would be sent even further into the red.

At a time when the economy may be entering recession, this would severely limit the Treasury’s room for manoeuvre. In the absence of politically difficult cuts in public spending, it would put upward pressure on both taxes and interest rates.
There are also longer term implications from governments bailing out banks. Such actions may encourage riskier behaviour among bankers by reducing the downsides associated with failure.

At the same time, bank customers, reassured by both bailouts and deposit protection schemes, have reduced incentives to deposit their savings with conservative, risk averse institutions.

Given that the Government has effectively guaranteed their money will be safe, they will tend to patronise whichever bank pays the highest interest rates, even if it engages in the kind of risky lending practices that brought down Northern Rock.

Another danger is that expensive bailouts will provoke calls to increase the level of financial regulation. These should be resisted.

The banking sector is already very heavily regulated. In the United States, strict rules that forced banks to lend to risky borrowers in the sub-prime market helped cause the current problems. And regulations also incentivised bankers to create the complex financial instruments that are now proving so difficult to unravel.

Perhaps most importantly, more red tape will raise costs and reduce the flexibility of banks to deal with the current crisis. In the longer term, it will also stifle competition by making it more difficult for new entrants to begin trading in the banking sector.

The UK is fortunate to possess well developed financial markets. Providing the Government can avoid the temptation to over-regulate, these markets will continue to provide the best solutions for the current banking crisis, whether through rights issues, acquisitions, or mergers. Expensive government bailouts should be avoided at all costs.

19 September 2008, Yorkshire Post