Hoover: Austrian or interventionist?

Following an interesting debate with Paul Halsall on Austrian economics and the possibility of economic calculation in a socialist system, Paul posted half the text of an Anatole Kaletsky article in The Times, which made various spurious claims about Austrian economics and history. One of them, which had long ago acquired the status of conventional wisdom, was that the Hoover government had pursued an Austrian approach following the Great Crash, and had thereby exacerbated the following downturn, and discredited Austrian economics from adoption by politicians for ever after. His "evidence" for this is the famous quote from Hoover's Treasury Secretary, Andrew Mellon: "liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate".

I meant to reply to this point, but I wanted to be sure I got my facts straight. That meant doing quite a bit of reading and note-taking, and by the time I had finished, it was really a bit late for a response to Paul. But it seems a shame for the effort to go to waste. So I thought I would post it here, for reference or as a challenge (depending whether or not you lazily accept the myth propagated by the interventionists to cover up for their own culpability, and failure (yet again) of their philosophy in practical application).

Sir Callamity McCarthy - a real villain of the depression

Photo of Callum McCarthyFingers have been pointed in the direction of many different culprits for the critical condition of our economy. I am surprised that they have not been pointed more frequently at Sir Callum McCarthy. We don't need to swab him for gunshot residue; he is spattered in blood, holding a smoking gun.

Two things in particular have made life particularly difficult for people in the past 18 months: energy prices that shot up as world prices went up and then failed to come down at the same rate, and unavailability of credit because of the failure of our financial systems. Of course, Callamity was not totally responsible for either. But he was at the scene of the crime with blood on his hands for both.

The speed at which energy prices rise and sloth with which they fall is a sign of an uncompetitive market. So is massive profit-expansion when costs are rising.

There is a reason why our energy markets are uncompetitive. When electricity was privatised, the Conservative government deliberately separated the generation businesses from the supply and distribution businesses (the Regional Electricity Companies, or RECs). It was essential to creating a liquid trading market for electricity. If suppliers generate most of their own electricity, only marginal production is traded in the markets. That leaves independent generators selling at a disadvantage, when their customers are also their competitors. And the same goes for independent suppliers, who must buy electricity from their competitors.

Early regulators under the Conservative government recognised this, and protected this separation against pressure from the industry, who would like nothing more than to get back to their cozy, lazy, nationalised ways. But from 1998, the regulator began to allow acquisitions that created combined supply, generation and distribution businesses. By 2004, none of the RECs remained independent. All had been subsumed within one or other of the Big Six - the Vertically-Integrated Large Energy (VILE) companies.

In September 1998, Clare Spottiswoode and Stephen Littlechild stood down from their jobs as regulators of (respectively) gas and electricity. Callamity took over, first at Ofgas, and then at the merged regulator of gas and electricity, Ofgem. The extent of his responsibility (and ego) can be seen in the fact that, from 2000, he was acting as both Chairman and Chief Executive of Ofgem.

Efficiencies drive down costs. Competition drives down prices. The mergers allowed by McCarthy destroyed competition. Little wonder that, by 2003, the National Audit Office (under Sir John Bourne) was reporting that the market changes enacted under Labour (many of them improvements on the original design from privatisation) had driven down wholesale prices, but had had much less effect on retail prices. Through his naivety, Callamity undid the benefits of the market improvements, and created the uncompetitive oligopoly from which we suffer.

Repeated attempts since then by the regulator, the competition authorities and the government to identify collusion between the Big Six have failed, because the problem is not underhand behaviour, but the market-power provided by their vertical-integration, which allows them to lock out competitors and maintain juicy profits, without having to literally sit down in a room and parcel out the market between them. It is obvious there is a problem, but no one dares acknowledge that the only solution is to reverse McCarthy's mistake: disintegrate the VILE companies.

In September 2003, Callamity left Ofgem and became Chairman of the Financial Services Authority (FSA). What happened next is common knowledge. The financial services industry engaged increasingly in imprudent activities, prompted by various government measures, and unconstrained by any regulatory action, even as they moved more and more risk off-balance-sheet. An excellent analysis of the development of the problems - "How Not to Solve a Crisis" has been produced by Bill Stacey of the Lion Rock Institute and Julian Morris of the International Policy Network. When eventually the economy could no longer stand all the systemic imbalances that had been allowed to develop, the necessary correction revealed the extent to which Callamity had allowed short-termism and corporate interests in another industry to take priority over good governance.

Callamity's story gives the lie to Gordon's claim that Britain is a victim of global forces and American failings. Britain led the race to the bottom of regulatory supervision. What does Gordon think drove the American government to repeal Glass-Steagall, other than the inability of Wall Street to compete with the lax conditions in the City of London? Wall Street's shackles having been thus loosened in 1999, it would take a regulator of quite stupendous incompetence and lassitude to keep the City ahead in the race. In Callamity, Gordon had just the man for the job. No wonder Callamity had to be quietly shuffled out of his role, as the consequences of his reign became clearer. His continued presence would be a clearer reminder than Sir Fred Goodwin's pension of who is really to blame for our woes.

In another era, Callamity would have been left in a room with a whisky and a loaded pistol. Earlier still, his neck would be on the block. We ought to find some similar punishment for him. But what do you want to bet, if politicians are now sensible enough to keep him away from any further public-sector work, that Callamity can look forward to some well-remunerated Non-Exec positions from his corporate friends? Or would even they be too embarrassed to be seen around him?

Government auctions - good or bad?

I have been having a debate with Paul Lockett on Tim Worstall's site, which I have found very interesting and illuminating. The topic was the TPA's green-tax-calculator, and what it said about costs of carbon in this country. I claimed that one thing it showed was that road-use is overcharged and domestic heating is undercharged. Paul gave some very interesting reasons, which I hadn't considered before, why road-use is not as overcharged as I (and I suspect many others) tend to think.

He has certainly persuaded me of his basic point, which (if I have understood it correctly) is that the crude comparison that many of us make between costs of construction and maintenance of roads on the one hand, and revenue from vehicle excise and fuel duty on the other, cannot be taken as a rough indicator of the extent of overcharging (whether for "green-ness" or any other attribution), because there is an element of charging for the use of a scarce resource (road-space) within that balance. As you can see from the exchanges on Tim's site, I still think that there are reasons to believe that the government is charging us more than a market price for use of the roads, but I guess we won't know unless we actually move to full road-use pricing. In my opinion (and this is something I didn't put into the debate, because I am happy to accept the concept, if not the reality of road-use charging), the transaction costs and civil-liberties implications of road-use charging exceed the economic benefits of more accurately tailoring charges to supply and demand, so in a sense, I hope we never find out whether we are being over- or under-charged. But it is an interesting thought experiment.

Anyway, I expanded the debate into a question of the merits (or otherwise) of government auctions, on the basis that the question of whether there was a high initial capital value in a road-use charging system would depend on whether the market created by the government was truly competitive or embedded monopoly privileges. I (unwisely) cited the 3G auction as an example of a bad government auction of monopoly rights. Paul observed:

"I find this comment extremely odd. What else would you propose to do to allocate the use of spectrum, which is a scarce resource? The government hasn’t created a system where competition is limited in the case of spectrum, it is inherently limited."

To which I replied:

"I agree with your distinction between natural scarcity and artificially-enhanced scarcity. This wasn’t the best example for me to pick. I should have used the example of the Non-Fossil Fuel Obligation, which was the first case where I became aware of this problem, but it’s rather obscure. In the case of NFFO, government created artificial scarcities of unknown quanta for a dutch auction. Their monopoly position was so effective that they drove prices down strongly. The problem was that it was so effective and people were thus so desperate to win one of the unknown number of contracts that would be let for their technology, that the optimists bid down the price below where most projects were viable and many realists were shut out. NFFO ended up being a tremendously successful way of driving the price down to a level at which it prevented development of the thing it was supposed to encourage.

The 3G auction nearly had the same effect, delaying roll-out, and nearly bankrupting some of the winning optimists and shutting out some of the realists. But in this case, the water is muddied because the scarcity, as you say, is genuine. Someone would have taken the profits from the excess of demand over supply, and who better than the government on our behalf? All the same, I would have structured it in a different way, separating the natural-monopoly infrastructure-provision part from the service-provision part more clearly (analagous to the structure of the electricity industry in that brief halcyon period after supply and distribution had been split but before Sir Callamity McCarthy* allowed the competitive market to be undone by vertical-integration), and creating a more flexible market for accessing the infrastructure. This would have maintained the competitive threat from new entrants and removed the need for regulation of this part of the business, with tighter but limited regulation (of compliance with the rules, not of prices) over the natural-monopoly part. Having the revenue from sale of bandwidth-rights come in to the infrastructure-provider rather than the government in the first place would make the provision of that infrastructure well-funded and relatively low-risk, which would have helped to get the systems built, rather than being delayed by cash being sucked out of the system by the government maximising its revenue at auction. The risk and benefits could be further shared with society, by government-underwriting of minimum returns for the infrastructure-provider (highly unlikely ever to be needed), and provision for a proportion of profits above the minimum returns to go to the Treasury. This would have kept the cost of money as low as possible, getting the systems built, maintained and expanded as quickly and cheaply as possible.

You may say that if idiots want to overbid (or under-bid in a dutch auction), that is their lookout, it is the market working as intended, and not a sign of a bad mechanism. But we see it time and time again where government is letting contracts for monopoly positions. We have seen it in many public-sector construction projects, where standard practice is to bid a non-viable price in order to win the contract, and then hope to claw it back by renegotiation once the project is under way and the government is frightened to let it fail or be further delayed. That is the real reason why so many of these projects go over-budget and over-time - they were never going to come in on-budget and on-time. The amazing thing is that some occasionally do, not that so many don’t.

The incentives in government-auctioning are to drive honest men out of the market and encourage the crooks. It also tends to inflate ultimate costs, because it is more expensive to put right something done badly than to get it right in the first place. The government is in a unique position, and should try as hard as possible to design mechanisms that ameliorate this impact, even at the expense of reducing the amount of revenue raised. But of course, the public-choice incentives for the government strongly encourage the opposite behaviour."

I have created this post, partly because it is a topic on which I have strong negative experiences (in NFFO) that I wanted to highlight, partly because I don't feel that I have properly explored the alternatives and whether they are any better, and partly so that, if the debate on this subject were to continue, it wouldn't have to divert the debate on road-use charging on Tim's site.

* I was going to explain in a note who Sir Callum McCarthy is, but the incompetent, lackadaisical, credulous fool deserves a post all of his own.

Carbon tax petition

Nick Monether of Greenfields Consulting has launched a petition on the No.10 website, to press the Prime Minister "to Adopt a Carbon Tax ratified and harmonised with the EU and the G20".

As the petition explains:

"The tax payer and/or energy consumer is currently paying to subsidise low carbon technology through a variety of levies and subsidies that share no common price for their efficacy in reducing carbon (or C equivalent) emissions. A well designed tax on carbon emissions, in concert with internationally agreed application methodology, would deliver huge cost and carbon savings to society, with parity and without excessive and costly bureaucracy. We the undersigned urge Government to press to replace costly local, regional and national policies with a global approach that reflects the unity achieved in the removal of CFC emitting products."


There are many details not covered in this petition, but that is the nature of an online petition. I understand that Nick wanted to add a detail that I suggested (to address many people's fears with regard to the impact on "fuel poverty"), but the system wouldn't let him.

Fundamentally, carbon tax is the best way to internalize carbon externalities, and showing support for the principle is important. If you would like to see our myriad nit-picking, micro-managing, counter-productive, bureaucratic, supposedly-green interventions replaced with one simple mechanism that applies equally to all carbon emissions regardless of source, then sign up to this petition now.

Dollar or Euro votes?

Noticed this poster at a tube station today:

EU elections 09 poster: biofuels

My immediate thought was: none of your bloody business.

(After a moment's additional thought, perhaps I should moderate that to: none of your bloody business between the two on the right, and between all three if you internalize carbon externalities with a mechanism more rational than the EU-ETS.)

It turns out that this is part of a series. The others are shown below.

EUobserver points out that these exaggerate the powers of the European parliament. Typical euro-deception. But would it be better if they didn't?

Is this the Euro equivalent of a dollar vote? In free markets, how much gets produced of which goods is determined by the dollars (or other currency) that customers spend (vote) on the products.

In the EU, it seems, how much gets produced of which goods is determined by the political trade-offs between politicians returned as a result of an election on multiple issues.

In a free market, we will gradually discover what works in which circumstances, and are free to have horses for courses, and to change the balance in response to changing market information.

In the EU, the parties who form the ruling coalition (and their electors) are assumed to have 20:20 foresight, deciding what immature technologies will be best for all of us, and imposing them on us by legislation, with all the associated responsiveness and flexibility.

It tells you something about the mindset of the Eurocrats and politicians that they think this is the job of the European parliament, and that the suggestion that they have this power will attract people to the project.

If this is a Euro vote, I don't want it, and I don't want other people to have it either. I want us to cast dollar votes for economic choices. Political votes are to decide those rules that we need for effective cooperation, on questions that cannot be decided more efficiently by dollar votes.

EU elections 09 poster: energy   EU elections 09 poster: packaging  EU elections 09 poster: work/life balance

Is this the dumbest economic argument in the world?

What is market value other than "the community's valuation of the external costs and benefits of the activity"?

External costs and benefits are, by definition, costs and benefits that are external to the market value. If they were within the market value, they would have been internalized, and therefore not be externalities.

So the answer to this rhetorical question is: exactly not that. Or perhaps more precisely: don't talk bollocks.

This guy (Mark Wadsworth) is a free-marketeer, so I am embarrassed to see him displaying such fundamental lack of economics, or even basic logic. But it's typical of the crowd that support Land-Value Taxation.

He must work in financial services.

The Socialist Utopia

From the English Eclectic blog of Paul Halsall, a socialist historian, in somewhat self-deluding response to Iain Dale's suggestion that we might have to cut public spending:

'I would expect that within less than 10 years we will have the computing ability to make effective economic planning possible and ditch the drang und sturm of imaginary "rational markets."'

"Falling emissions in declining economy" shock!

Preliminary data released today (as reported in EurActiv, and picked up by OpenEurope) indicates that emissions from the sectors covered by the EU-ETS fell 6% in 2008.

Naturally, the pro-EU-ETS brigade have hailed this as evidence that the EU-ETS is working. I think they should be a little more cautious.

We need to know to what extent the reduction was the result of the economic downturn, to what extent it was the result of increased energy prices, and to what extent it was the result of the incentives provided by the EU-ETS.

The data is not yet available for the purposes of comparison, but there will be an easy way to test the effect of the EU-ETS, if not the relative roles of the other two factors (and there are probably others).

If we see emissions carry on up in those developed countries not covered by a cap-and-trade scheme while they fell in the EU, it will be reasonable to attribute some of the success to the EU-ETS. If, on the other hand, emissions fell in 2008 in countries that were not subject to a cap-and-trade scheme, we may reasonably infer that the fall was more the result of other factors such as economic tightening and higher prices, and less to do with the EU-ETS.

We also ought to look at emissions relative to indicators of economic health, not in abstract form. Most economic indicators of national prosperity are unsatisfactory in one way or another, but if we take GDP as an imperfect but widely-accepted measure, we should compare the change in emissions relative to changes in GDP in the different areas, not simply the absolute changes in emissions.

We should probably also take account of changes in population, as each additional head in developed countries tends to increase emissions by the per capita average.

Another give-away would be if the reduction over the course of a Phase of the EU-ETS were more than required by the mechanism. The mechanism is designed only to deliver just enough, and provides absolutely no incentive to go further, so if we see emissions fall to well below the cap, we will know that something else (e.g. economic decline or offshoring of industry) was up.

And we ought to remember that one swallow does not make a summer. We would need sustained evidence over several years that industries covered by the EU-ETS were reducing their emissions relative to their output by more than industries outside the EU-ETS (or other cap-and-trade schemes), to be able to attribute the reductions to the EU-ETS rather than to other factors. 

The preliminary figures for 2008 emissions strongly suggest that the price of EUAs (allowances under the EU-ETS) should fall further than their already low level (at which many large companies are already saying that there is insufficient incentive to invest in emissions-reducing technologies). With a minimal carbon-price, delivering further emissions-reductions over the coming years, other than as a result of a general reduction in output due to the state of the economy and the cost of energy, will be a challenge.

Scrappage and broken windows

Henry Hazlitt, in his marvellous Economics in One Lesson, cites Frederic Bastiat's exposition of the broken window fallacy. The fallacy is that vandals breaking a shopkeeper's window have benefited the economy, because the glazier will get work and money that he otherwise would not have got, and he will spend that money on goods that also would not have been sold if he had not had this piece of business, and the producers of these goods will likewise spend their money, etc...

What those taken in by this fallacy have failed to notice, observe Bastiat and Hazlitt, is that the shopkeeper is now as much down for the cost of replacing the window as the glazier is up. The money that the shopkeeper spent on the window would otherwise have been spent on other goods (for instance, a suit), whose producers are also therefore disadvantaged by this outcome, and will therefore have less money to spend on other goods, etc...

At one step removed, there are as many losers as winners. But the shopkeeper himself is worse off, because after the vandalism and expenditure he simply has a new window, whereas without the vandalism, he would have had a perfectly serviceable window, and a new suit.

As Hazlitt points out, "the broken-window fallacy, under a hundred disguises, is the most persistent in the history of economics. It is more rampant now than at any time in the past. It is solemnly reaffirmed every day by great captains of industry, by chambers of commerce, by labour union leaders, by editorial writers and newspaper columnists and radio and television commentators, by learned statisticians using the most refined techniques, by professors of economics in our best universities. In their various ways they all dilate upon the advantages of destruction."

Hazlitt was writing in the 1940s, but the observation is more true now than ever.

Usually, the fallacy is quite well-disguised. But we have a blatant example being promoted at the moment: the idea of a car scrappage scheme to pay people to scrap their old cars and buy new. This is not just vandalism, but state-sponsored vandalism.

Would it have reduced the economic harm done by the vandal if the replacement window had been paid for by the shopkeeper's insurers rather than by him directly? No. In fact, the need to put money aside in advance to cover the risk that this might happen has caused the shopkeeper not to spend money on goods that otherwise would have been bought for many years before the incident. Insurance premiums, whether paid in advance or recovered through increases subsequently, and whether paid solely by the shopkeeper (e.g. if he has paid more in premiums than he claims, or if he loses a no-claims bonus) or spread across all the clients of the insurer, are an economic cost necessarily heavier (because of the operating costs of the insurer and the time-difference between provision and claim) than the value of the work to the glazier. Insurance would have increased the economic cost, not reduced it.

The fact that the costs of scrappage are spread amongst all taxpayers is equally irrelevant to the question of the economic cost of the scheme. The additional money that we all pay in tax, so that the Government can encourage people to scrap cars that were sufficiently serviceable that their owners otherwise wouldn't have scrapped them, is money that will not be spent on goods which we value and which the producers would be as keen to sell as the car producers are keen to sell their cars.

Would it have reduced the economic harm if the shopkeeper had replaced his window with an improved model - perhaps one that showed his products better, or that reduced his energy bills? Reduced the harm, yes, but not eliminated it. If the shopkeeper valued the improved window as much as the suit, he could have bought the window anyway without being forced to do so by the vandal. The fact that he was planning to buy the suit tells us that he felt he was getting more benefit from a new suit than from a new window. Making the best of a bad deal does not mean that the deal is not bad, nor that the shopkeeper was as happy to make a virtue of necessity as to spend his money how he preferred.

So it is with the benefits of the scrappage scheme - to the environment and to the participant in the scheme (who has an improved car). There are many things we can do to improve the environment, and many ways to spend our money to that end. A new car is not necessarily the best way of pursuing this objective. If the person with the old car also lives in a home with poor insulation and glazing and an ancient, inefficient boiler, they might have got more bang for their buck (both environmentally and in terms of their quality of life) from improving those other features and hanging on to their old car. The scrappage scheme will have created an incentive to spend money in a way that would disadvantage the supposed beneficiary, the producers of the unsold domestic goods, and the environment, in order to put off temporarily the necessary adjustment to a more economically-sustainable level of production in one particular (and not particularly green) industry.

The scrappage idea can seem quite attractive and relatively painless, at first sight. But it is, in reality, hopelessly and irredeemably wrong. We wait to see whether Chancellor Darling can resist the siren calls, or whether he follows the rest of Europe down this blind alley in his forthcoming budget.

"There's no shame in going to the IMF". Oh really?

What does it mean if a government has to go to the IMF for funds?

  • The government couldn't run a balanced budget.
  • The economic outlook was so poor that there was little prospect of the budget coming back into balance over a reasonable timeframe.
  • The government couldn't raise taxes sufficiently to bring the budget back into balance over a reasonable timeframe, without doing more harm than good to the economy.
  • The government wouldn't cut public spending sufficiently to bring the budget back into balance over a reasonable timeframe.
  • Lenders were so pessimistic about the government's ability to bring the budget back into balance over a reasonable timeframe that they were not willing to lend as much to the government as it needed to cover its net obligations.
  • The central bank was so pessimistic about the government's ability to bring the budget back into balance over a reasonable timeframe that it was reluctant to print enough money to pay for government debt (because of fears that, when it came to unwind some of the monetary expansion, the gilt market would be flooded with a combination of central-bank assets and government new issuance, making the unwinding impossible and collapsing the value of new and existing gilts). 
  • The government was so cowardly, that it would rather turn to the IMF for expensive funds and instructions on what it must do to balance its budget, than figure out, implement and take responsibility for the necessary cuts itself.

No shame in going to the IMF?

Only for a government that has no shame.

The public-choice incentives of the economics profession

I am a supporter of and enthusiast for the Institute of Economic Affairs (IEA), the leading free-market think-tank. So I was shocked to read, in what I think is the best post I have seen on Guido's site, that the IEA's Shadow Monetary Policy Committee (SMPC) are unanimously in favour of a policy of Quantitative Easing (QE).

The IEA was founded after Anthony Fisher sought the advice of Friedrich Hayek on what to do about the increasingly socialist trend of British politics after the war. Hayek advised him not to go into politics, but to try to change the intellectual climate, to fight the battle of ideas. So Fisher founded the IEA to fight this battle, recruiting Arthur Seldon and Ralph Harris as the thinker and persuader of his organisation, and with Hayek as a substantial intellectual influence.

Hayek was a leading figure in the Austrian school of economics (to which I adhere). Hayek and any self-respecting Austrian would be profoundly opposed to QE. The school believes in removing the power of governments to manipulate their currencies, whether through commitment to a genuine gold standard (as advocated by Hayek's mentor and my hero, Ludwig von Mises, and by Hayek himself originally), or through denationalising money and creating a system of competing currencies (as became Hayek's preferred option). The IEA published works by Hayek and others to this effect, and Seldon advocated the approach. In this, as in other respects, Austrian economics was a significant part of the IEA's challenge to the leftwards trend of politics in the UK, which ultimately came to fruition with the election of the Thatcher government in 1979.

It wasn't the only influence. Milton Friedman and the monetarist approach became increasingly influential on the IEA and on the Conservative Party. But Hayek and the Austrian school remained important influences on both groups. Which is why it is such a shock to find that the Hayekian view has been completely marginalized in the SMPC.

I know that the Hayekian perspective has not been marginalized in broader IEA circles (though it is somewhat embattled). So why is it not represented on the SMPC? The answer, it seems, is that it is increasingly hard to find economists in the UK who hold to the Austrian (or at least sound-money) view, particularly in the macro-economic, monetary-policy field. The sound-money tradition - the attitude that once distinguished us from our more profligate neighbours to north and south in Scotland and France* - has almost disappeared from British academic circles. In fact, I am told there are only two credible contenders - Kevin Dowd and Anthony Evans. I don't know why neither of them has been invited onto the SMPC, but it is admittedly a small pool compared to the massed ranks of monetarists.

Austrian economists have an excellent record of forecasting future outcomes. The approach avoids the unreal abstraction that causes many people to doubt the value and truth of economics. Its conclusions and lessons are more important than ever, and experience provides ever more illustrations of the failure of the leading mathematical, interventionist schools of economics - Keynesianism and monetarism, which actually have more in common with each other than do monetarism and Austrian-school economics. And yet British universities and academics have almost completely eliminated it from the syllabus. Why should that be?

It occurs to me that there is a good public-choice explanation for this. Public-choice theory is the name given to Buchanan and Tulloch's extension of economics into the political realm. Conventional political studies and socialist philosophy viewed policy-makers as well-intentioned, well-informed, altruists. They were interested only in doing right, and the challenge was merely to establish what was right. Buchanan and Tulloch pointed out that politicians and other public-sector employees are actually subject to economic forces in the same way that market participants are subject. For instance, they have powerful incentives to favour the short-term over the long-term and to favour activism over laissez-faire.

But economists, whether employed by universities, government departments, or in large commercial organisations, have similar incentives. Not many economists get hired for telling their potential employers that markets are unpredictable, uncontrollable and best left to their own devices.

Commercial organisations will want economists who can make cases why the government should intervene in their sector in a way that is advantageous to their employer, or how they can best manipulate their position in the market to maximise profits.

The civil service will not want its economists to tell politicians that their interventions are at best pointless and usually harmful, and that market corrections are necessary and good for the economy and should be allowed to play themselves out. The civil service will want economists who can draw up schemes that satisfy politicians' desire to be seen to be doing something about whatever issue arises.

Universities will want economists whose papers influence policy (and which are therefore, by definition, activist). They will want economists whose views and specialities maximise the chances of obtaining research grants.

Monetarists appear to have the answers. Their analysis and policy prescriptions can vie with the Keynesians and other neo-classical, mathematical schools for the favour of those who pay the bills.

Not so Austrians. Austrians reject the idea that policy can improve the outcome of markets, other than through the creation of an institutional framework that protects property rights and enables exchange. This is of no earthly use to rent-seeking businesses, vote-seeking politicians, or grant-seeking universities. So Austrians are gradually, over time, driven from these organisations. The very people who could have told banks that there is no such thing as a free lunch, governments that monetary, trade and budget imbalances eventually have to unwind, and universities that economics must be based on sound philosophy and not just mathematical models of scenarios where all the reality has been abstracted out, are not there to give this advice, because it is deeply inconvenient.

So Austrians must live in the real world. This is good for understanding how economies really work, rather than how they ought to work if only pesky humans could be more like the models predict. But it is bad for influencing policy, in a world where the value of your advice is not measured by the strength of the argument but by your station in life.

That is where organisations like the IEA should come in. Let's hope that they see sense and correct the bias towards monetarism on the SMPC. And let's hope against hope that some balance and philosophy can be miraculously restored to the study of economics in the UK. After all, haven't we just found out that the world doesn't work quite like Gordon's favourite - neo-classical endogenous growth theory - would expect?

I suggest that the IEA, to show that its heart is still in the right place, should publish a public-choice analysis of the incentives acting on the economics profession. But which economist would be brave enough to carry out the study? 

What to do about MPs' expenses:

Besides each candidate's name on the ballot paper should be their declared annual budget. The successful candidate's budget will be raised from local taxes. There will not be any indexing. There will not be any expenses or other allowances - the candidate has to live within their declared means. If a candidate cannot live within their declared means, they can stand down and a by-election should be held.

This would focus candidates on how much money they really need to run their affairs. In office, it would focus their attention on not spending money they don't need to spend. The lack of indexation will give them a strong incentive to oppose inflationary measures. The public, not the MPs, will be the arbiters of what each MP deserves, and not on a uniform, collective-agreement basis (as at present), but according to the needs and merits in each case. Constituents will know that they got the candidate and the budget that they deserved. Good MPs may be able to put in a higher budget and still be elected, rewarding them for their effectiveness.

Of course, getting MPs to vote for this system may be quite tricky...

Tax sovereignty

Tim Worstall covers the efforts by Dan Mitchell to persuade the American government to step back from its efforts to clamp down on tax havens. This is picked up and expanded at Sounds in the Hickory Wind (nice blog, added to the blog roll).

I agree with a lot of this, as I have already posted. But I think some nuance is needed.

Where do you draw the line on honouring sovereign rights and encouraging tax competition, which I agree with, and preventing complicity in the sheltering of criminal proceeds? We are investing in Switzerland at the moment, and the tax position is one of the many attractions, but that is a legitimate transaction, which I feel no need to conceal. Is not some degree of international cooperation to deal with illicit transfers warranted, and would not some degree of transparency be a part of that?

For instance, should we be pushing for a system where a foreign government would present evidence of criminality to a court in a tax-haven country, and if the court were satisfied that the evidence did demonstrate criminality, details of that person's transactions would be provided to the petitioning government, who would be able to launch proceedings in the tax-haven's courts for recovery of the funds, on an agreed basis? Wouldn't some treaty to that effect respect sovereign rights sufficiently, but cut down the rampant laundering that is going on in some of these locations?

The prudential cost of the financial crisis

"Borrowers have been warned they face higher mortgage rates for up to nine years as banks hit customers with the cost of tighter regulation."

So begins the lead article in the Money section of this week's Sunday Times. The problem, it seems, is that the regulator has ordered them to increase their capital ratios.

So it's the regulator's fault, is it? Nothing to do with the imprudent lending in the lead up to the crisis? Prudence has been restored, not because the banks realise they made mistakes, but because they have been ordered to be more prudent. The guilty party is the one ordering prudence. And the cost is the cost of regulation, not the cost of good banking practice. Anyway, don't worry, because prudence will last only as long (nine years) as necessary.

And what happened to reserve requirements? Banks are in the business of borrowing money from some people (savers) and lending it to others (borrowers). The system cannot work efficiently if they have to rely on their own cash to lend (unless banks own most of the economy, they won't have enough of their own cash to meet demand from borrowers). But that is what the drive to increase capital ratios is trying (partially) to achieve.

There are two options to improve our financial stability. They are not mutually-exclusive, but they do have very different implications. Banks could improve their reserve ratios and/or they could improve their capital ratios.

  1. To improve their reserve ratios, they would have to offer higher savings rates to match the higher borrowing rates, until the two balanced. The gap between the two rates should not expand significantly - they would rise in parallel.The prudent (savers) benefit. Borrowers pay. Banks' margins remain similar, but volumes fall (because of the cost of borrowing) and therefore so do banks' profits (and bonuses).
  2. To improve their capital ratios, they have to increase the gap between saving and borrowing rates, to increase their margins on their activities. Savings rates fall as borrowing rates rise. Banks' clients of both types (saver and borrower, prudent and imprudent) suffer, though savers suffer more and borrowers suffer less than if greater emphasis were placed on increased reserve requirements. The banks (and their bondholders, shareholders and employee bonuses) gain.

Clearly, after our debt binge, we need to increase our savings rates to restore some degree of equilibrium. But we are pursuing option 2 almost exclusively. Rates for borrowers go up, for savers go down, and banks pull in the difference.

The argument of the intelligentsia, amongst whom this is widely agreed to be the right approach, is that to increase reserve requirements now would take money out of the economy at a time that it can least afford it. But increasing capital ratios takes money out of the economy too, and from both groups (savers and borrowers), rather than just from the people who need to tighten their belts (borrowers). This is actually the time that we can least afford not to do it.

Of course it will be painful, as borrowing gets even more expensive and less available, more businesses go to the wall, jobs are lost, and the economy shrinks. But these changes have to happen anyway. There is no avoiding a return to a more sensible equilibrium between borrowing and saving. The question is whether we let it happen, take the pain and then start again more sustainably, or whether we try to prevent the inevitable, ameliorating the immediate pain but prolonging its duration and extending the damage. And whether the ones who should suffer most pain (which is coming one way or the other) should be those who were less, or those who were more prudent.

The latter is the solution of America of the Great Depression and New Deal and Japan of the Lost Decade. Contrary to the journalists and economists who state blindly that "the recovery began in 1932", it didn't, and it won't work this time either. If somehow our governments and central banks manage to reinflate the economy (e.g. by printing money) without correcting this balance, they will only be preparing the ground for an even bigger crash later.

At some point, we have to accept that there is a natural balance in these things, that the interest rate reflects and corrects the changes in this balance, and that centralized direction cannot overcome this basic law. The impositions of regulators only reflect our attitudes and responses to this law. They do not create the costs, they just influence who incurs them and when, and thereby the lessons that people take from economic developments. Are we teaching the right lessons at the moment?

Scottish pots and Swiss kettles

Gordon Brown wants us to make a mental connection in some way between our financial troubles and the competitive tax regimes in countries like Switzerland.

I have just come back from Switzerland, where we are looking at investing. The attractions are many, but include the fact that Switzerland is not in the EU (and if the opinions of my contacts are representative, are likely to remain so), the stability of the economy, the security of one's money from expropriation, the more rational attitude to planning, the highly devolved nature of its democracy, and the relative restraint they show in government expenditure.

The Swiss tax-take as a proportion of GDP is a good five percentage points lower than ours. When you consider the obstacles they face in the provision of public services, and the much higher quality and better value in those services, that is amazing.

Imagine how expensive British government would be if every village had to be reached by miles of winding hairpin bends up precipitous slopes, assaulted with snow and salt in winter, and Mediterranean temperatures in summer.

Imagine what the bus services would be like.

Imagine how our trains would run, and what they would cost, if most of our major cities were separated by vast mountain ranges requiring tunnels many miles long. 

Imagine the excuses of the politicians for the state of an economy that enjoys few natural resources, no direct access to the sea for trade, and wholly surrounded by a mammoth competitor determined to inflict the costs of its social model on you.

And yet, with few of our advantages and many disadvantages, the Swiss run a more successful economy, with better public services, lower taxes, a higher quality of life, and greater social cohesion, than we can dream of.

How do they do it? Gordon would like us to believe that it is because money is pouring in from abroad because of the tax regime. And the tax regime in parts of Switzerland is certainly cheaper than ours (each canton sets its own tax levels in significant aspects, so there is no universal rate). In particular, inheritance tax can be low (zero in some areas) and tax on employment is generally lower than ours. That may have something to do with their high levels of commercial continuity and reinvestment of capital, and high levels of employment.

But those low taxes are not particularly funded to a greater extent by inward capital flows than are our more plentiful government extortions. As one of my contacts pointed out when I compared the level of investment in Austrian and Swiss ski resorts, the Austrian government has ploughed hundreds of millions of schillings and euros into supporting investment by their tourist industry, and yet find themselves facing a repeat bill as the equipment ages and needs replacing before the nation has begun to recover its costs. The Swiss, if they want to build a lift, have to raise the finance privately. Hence, they build less, but they try to build only what is viable. That (and similar attitudes across the economy, other than in agricultural support, where they are more profligate even than the EU) keeps the tax bills down, at the cost of placing a greater responsibility on the Swiss population not to be self-indulgent at taxpayers' expense and only to pursue investments that can be justified in hard economic (rather than woolly social) terms. How unreasonable of them to make themselves an attractive destination through the illicit means of prudence and hard work.

In any case, Gordon shouldn't be throwing stones in his highly-elaborate fiscal glasshouse. Under Gordon's watch, Britain enjoyed a huge surge of inward "investment", largely based around the City's financial services to Russians, Arabs and others who had been notably successful in exporting the loot from the expropriation of their countries' natural resources.

Two sure signs of massive in-flows of wealth into a country are asset-price bubbles and a strong currency. On that basis, until the bubble burst, the UK was clearly being more successful (with the help of monetary, fiscal and regulatory policy) at attracting dodgy money into the country. While our property prices were nearly doubling to reach absurd levels, Switzerland's property values increased on average by under 20%.

The reality is that Gordon and his European pals are not motivated by righteous indignation, but by the pressing need to eliminate the few examples of countries whose more prudent economic management stands as a glaring reproach to our Great Leader's incompetence.

And this is the man that some European and British politicians are reported to want to make leader of an international financial regulatory body. In earlier, better times, he would have been left in a quiet room with a loaded pistol for what he has done to our country. Can we at least not reward the greatest incompetent in our political history with an extension of his powers? Surely there is some unoccupied Scottish island, from where he can cause no more trouble, on which he can be dumped and left to rot?

"Do nothing" conservatives

We might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action... No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times.

Barack Obama in a couple of years' time? Gordon Brown now, if only (as he surely thinks would be best) he were running America too?

No, Herbert Hoover in 1932, talking about the magnificent programme of government-intervention that had prevented the Crash from deteriorating into a Depression.

When our intelligentsia talk about the current circumstances being the result of laissez-faire and the cure being a massive dose of interventionism, we appear to be in the "second as farce" iteration of history.

The 1920s - the previous NICE decade

John Prescott has just repeated, on Newsnight, the Labour party's favourite myth, barely challenged by the opposition, media or academia. According to the myth, the Labour government ran the economy successfully for the decade preceding the onset of depression, as evidenced by low inflation, low unemployment and uninterrupted growth.

We all know the fiddle on unemployment statistics, incentivizing people to move on to Incapacity Benefit, and then trapping them there. If we take the number of people of working age not in employment as the measure, rather than the number of people collecting Jobseekers Allowance, then it is not true that we had low unemployment.

That illusion attracts a fair amount of criticism. What is rarely challenged is the claim that the Labour government must have been managing the economy well because they achieved continuous growth with low inflation. That depends how you define inflation. If you define it as increases in an arbitrary price-index, then it is true. But if you define it as increases in the broad money supply, it is not true.

M4 money supply vs CPI


The price-index school dominates the economics profession. Although I believe it is a mistaken focus, I don't intend to get into a sterile debate about the semantics. What is interesting is (whatever terms and definitions your use), how useful the concepts they describe are as indicators and predictors of stability, risk, prosperity, etc.

To most economists and commentators, the low CPI and relatively-low RPI figures prove that all was well with the economy, and that what we are suffering now is a blip unrelated to previous events. Interestingly, this is a close reflection of the debate over the lead-up to the 1929 crash and the Great Depression. Central banks, then as now, were focused on maintaining a stable price level. The US Bureau of Labor Statistics Index of Wholesale Prices was 93.4 in June 1921, rose to 104.5 in November 1925, and fell back to 95.2 in June 1929 (Murray N. Rothbard, America's Great Depression, Ch.6). Consumer prices were similarly stable. On the other hand, capital goods prices (particularly stocks and real estate, but also food and farm products) rose significantly. And, as Rothbard details, the total (broad) money supply increased from $45.3bn to $73.26bn.

Monetarists would say that everything was fine in the 1920s expansion and that it was only the wrong policies implemented from 1929 onwards that caused the ensuing crash and depression. Austrians would say that the monetary expansion caused imbalances in the economy that would inevitably have to be corrected at some point, and that the crash was inherent in the previous development. They would agree with the monetarists that the correction was unnecessarily prolonged and exacerbated by policy, but they would not agree on the nature of some of the policy mistakes.

The monetarists' main criticism is the failure to counteract the monetary contraction from 1929 with an expansive/inflationary monetary policy. We are in the process of testing this theory. A couple of articles, one at DollarDaze and one at ZealLLC demonstrate the extraordinary extent to which Bernanke is trying to reflate. And, in broad money terms, the UK is expanding more dramatically than the US or any other major economy, at 16.3% p.a.

We will find out in due course whether it is a good thing for central banks and politicians to intervene to steer the economy like this. They may or may not succeed in the short-term, and if they fail, we may say that they fell at the first hurdle. But even if they draw us out of recession quicker and with a less severe contraction than expected (say bottoming before the end of the year and with house prices, stock markets and GDP down by less than 20%, 40% and 2% respectively from their peaks), we will then find out if their medicine is more deadly than the disease. We will have to see if they can prevent a stronger surge of inflation when the upturn comes (or worse still, before that, in the form of stagflation), due to the huge expansion/devaluation of money. And just as the monetary inflations of the 1920s and 2000s manifested themselves in capital not consumer prices, we should keep an eye out during the period after the retrenchment is halted, not just for the consumer price indices, but for wherever the extra money may create a bubble.

If the expansionist policies that currently unite the Keynesians and monetarists either fail to have the desired effect or have painful after-effects, perhaps the majority of the economics profession will acknowledge that there is a problem with their paradigm, and that they ought to give more consideration to the Austrian approach. (Probably not, on past performance, but one clings to hope of the resurgence of reason.) After all, it was the Austrians who succesfully predicted the Great Crash and the Credit Crunch (and other crises). The interventionists repeatedly claim that no one could have seen it coming (ignoring the fact that some did) and without any embarrassment then proceed to tell us what we ought to do about the problems that their models failed to predict. And if they try to cling on regardless, perhaps natural selection (i.e. their paymasters' shortage of real cash) will do what their consciences fail to do.

A huge contraction in the number of interventionist economics "experts" - now there's a deflation to look forward to.