Why the Government’s plans to rescue the economy don’t seem to be working

The Times captures the mood perfectly: “The economy is plunging deeper into recession despite emergency tax cuts and the multibillion-pound bank bailout, the Bank of England said yesterday.”

What it fails to mention is that this is all utterly predictable and indeed inevitable. The reason that “Cutting the base rate to its lowest level in more than 50 years, the Bank said the outlook now was worse than a month ago, with manufacturing and consumer spending in sharp decline” is that cutting the base rate is not going to have much impact.

The base rate is just one driver of credit, and it is not by far the most important. What is more, it does not address the real problems in the economy, which is that the credit expansion of the last decade has fooled entrepreneurs into thinking that investments were viable when in fact they were not. In some cases, whole businesses will now need to be liquidated as reality crashes in on those who had been fooled by artificially-low interest rates.

Reducing interest rates again cannot solve the problem. Just as the first rule when one finds oneself in a hole is to stop digging, so the first rule when one finds oneself facing the inevitable crash following an inflationary spike is to stop inflating. Further interest cuts (as preached by all political parties) are simply attempts to stimulate more credit expansion, which means further inflation. This will lead to more poor decisions by entrepreneurs and more unviable businesses being created, expanded or propped up. That can only lead to an even bigger crisis in the long run.

“The Bank of England pinned much of the blame for the economy’s slide on the borrowing drought that high street banks have inflicted on consumers and businesses alike” according to The Times, but in doing so the Bank misses the point. The borrowing drought is the result of banks making sensible economic decisions in avoiding making the same kind of loans that got us into this mess in the first place.

For let’s be clear about this: the loans that the banks are currently proving reluctant to make are those that they fear may not be repaid; those that, in American parlance, are “sub-prime”. In a market where asset prices are falling, many homeowners are in negative equity and many businesses are destined for bankruptcy, further lending would not only be stupid, it would be irresponsible.

Far from cutting interest rates, the Bank of England should be raising them so as to reduce the demand for credit and increase the desire of savers to provide it. In doing so, it will not only redress the massive imbalance between saving and borrowing that has led the West to borrow trillions of dollars of the (thrifty) Asians as well as creating money through government-backed central banks, but it will also accelerate the reallocation of “factors of production” between unviable and viable industries. As a result, it might just make this a sharp but short recession, instead of another painfully-drawn-out one.

The Trap: Whatever happened to our dreams of freedom? (part 2)

Last night BBC 2 showed the second episode of Adam Curtis’s new series, The Trap: Whatever happened to our dreams of freedom?

As I explained when I reviewed part 1, the general premise of the programmes is that over the past thirty years, trends in psychology and economics that viewed the people as a rational, selfish individuals interested only in personal gain have come to dominate public policy. Policy-makers have lost faith in the concept of public service and have instead applied market forces to public services in an attempt to give power to citizens (as consumers) and free them from the shackles of bureaucracy. However, Curtis argues that this has in fact backfired, leading to worsening inequality and a collapse in public services and political efficacy.

Part 2, subtitled The Lonely Robot, expanded on these themes with particular focus on the 1990s, and in so doing highlighted both the mistakes of what we call the Thatcherite Revolution and Mr. Curtis’s own erroneous analysis. I will explain these errors below, but first I will provide a synopsis of the programme. Those familiar with it may wish to skip the next six paragraphs and move on to my comments.

The programme began by returning to Buchanan’s Public Choice Theory, which argues that politicians and civil servants actually pursue their own rational interests rather than the public good. Curtis juxtaposed John Major’s efforts to create an internal market in public services that would use the rational interests of public servants to achieve public ends, with Bill Clinton’s interventionist presidential campaign, in which he publicly berated President Bush for his laissez faire approach, saying that if Bush would not use the powers of the presidency to improve America, he should stand aside for somebody who would. Clinton was elected, but before he took office was visited by Alan Greenspan and Gene Sperling, who explained to him that if he tried to intervene in the economy he would just worsen the economic crisis of the early 1990s. They convinced him that the power of governments to effect positive economic outcomes was a chimera; only the market could provide the prosperity America craved. Clinton accepted this advice and presided over one of the greatest economic booms in American history.

However, Curtis criticised the underlying basis of this belief. He argued that the consumer society did not in fact reflect the economics of Adam Smith. Rather, its assumption of the rational individual pursuing self-interest ignored the sympathy and moral sentiment which Smith argued were essential to man’s role in society. Instead, the selfishness of the species stemmed from scientific theory. Curtis dwelt upon and later critiqued anthropological studies of the Yanomamö people of Central Brazil, and also noted the view (promoted by Richard Dawkins, among others) that animals – including man – were merely vehicles and tools for the promotion of their selfish genes. Meanwhile, the revolution in psychological diagnosis described in last week’s programme had led to around half the population reporting themselves as suffering psychological disorder. New drugs such as Prozac appeared to offer a cure. The result was that millions of people took drugs to “normalise” their behaviour and emotions – a practice that some interviewees believed threatened to create a static, stagnant society.

Back in the world of public policy, 1997 saw New Labour elected to govern Britain. Labour took the distrust of policy-making to a new level, as demonstrated by the granting of independent powers to the Bank of England. Labour’s means of “incentivising” public servants was to set centralised targets and reward or penalise them accordingly. Curtis cited some of the more ridiculous examples of targets set by the Labour government, including:

• A community vibrancy index
• The quantification of bird-song in the countryside
• A target to reduce world conflict by 6 per cent
• A target to reduce malnutrition in Africa by 48 per cent

The result was not driven and measurable success, but what a member of The Audit Commission called a systemic “gaming of the system”. The NHS would employ people who’s job it was to greet people on admission so that they met their targets of seeing patients within a certain time, though no treatment was given; wheels were removed from trolleys and corridors were renamed wards so that patients could be counted as being in a bed in a ward; the police reclassified crimes as “incidents” so that crime fell; schools taught easy subjects and concentrated on mediocre children so as to raise the number of children gaining GCSE grades A-C. The result was a decline is social mobility to the point where a child born in Hackney was twice as likely to die in its first year than one born in Bexley.

Curtis also critiqued the supposed boom in the US. The apparent rise in the financial markets was based increasingly on dodgy accounting practices rather than reality. Meanwhile the economic progress was increasingly one-sided: one interviewer highlighted three interesting comparative statistics:

• The real term after-tax income of a family in the lowest quintile fell between the 1970 and the 2000s
• The real term after-tax income of a family in the middle quintile rose only slight between the 1970 and the 2000s
• The real term after-tax income of a family in the top 1 per cent rose by an enormous amount between the 1970 and the 2000s

Thus Americans were not only becoming less equal; the poorest were getting poorer.

The result of the revolution of the last thirty years, concluded Curtis, was that politicians were weakened by a mistaken belief that they could not affect change or improve welfare. Politicians were emasculated and corrupted and felt powerless. Meanwhile, the masses were not fulfilled by either consumerism or politics, but were instead doping themselves up on psychiatric medicines. At the same time, scientific evidence was emerging that undermined the selfish-gene and anthropological evidence of the 1970s, John Nash – the father of game theory – had begun to repudiate much of his work, and the free market was under attack by economists who argued for greater intervention and critiqued the rational individual thesis.

So ended the second episode. The third promises to discuss the War on Terror and – I suspect – “spin”.

Sadly, the second programme lived up to all my expectations. Curtis is an excellent documentary maker, but while he highlights genuine and important crises within society and provides a plausible historic context, he tends to misinterpret the causes and thus advocate policies that would exacerbate rather than alleviate those problems.

For a start, Curtis is prone to simple mistakes. For example, his critique of the American economic experience in the 1990s made a schoolboy error, confusing the state of the financial markets with that of the economy. In fact, the eventual collapse in share prices as the Dot Com and dodgy-accounting bubbles both burst had almost no effect on the US economy – the 2001 recession was the shortest and least painful in American history. Similarly, the statistics about relative welfare did not explain how far this was a result of taxes undermining the incomes of the poor (the statistics being post-tax incomes which suffer from heavy taxation), or of the effects of immigrant labourers who generally take low-paid work at the bottom of the economic pile, thus lowering averages without adversely affecting anybody, while they are happy to make a new life for themselves and their families. Similarly, in comparing infant morality rates in two London boroughs, Curtis failed to clarify whether the widening gap was due to a decline in Hackney or an improvement in Bexley.

Other errors, however, are more substantial, and demonstrate that he has fundamentally misunderstood both the classical liberal case and the causes of Thatcherism’s failures. The fundamental example in The Trap is Curtis’s belief that market mechanisms have been injected into public services and have as a result created perverse incentives for deliverers to “game the system” by aiming at achieving targets rather than positive outcomes for citizens; that governments have acted upon the belief that bureaucracies serve their own interests first. This is a profound error. In fact, the supposedly-liberalising agenda of the three (soon to be four) Thatcherite Prime Ministers has been completely undermined by the distrust that both the Conservatives and Labour have for freedom and the market.

Instead of creating a true market, with individuals holding the power as consumers and using their power over the money to reward success and punish failure, the past thirty years has seen the greatest centralisation of power in Britain since the Stewarts attempted to introduce an absolute monarchy. Distrustful of what a true market might produce, successive governments have endeavoured to micromanage the public services from Whitehall. Thus, instead of eliminating the power of self-interested bureaucrats, they have made local authorities and public services answerable to central government, made delivery departments answerable to the Treasury, and made the Treasury answerable to a small coterie around the Prime Minister and the Chancellor. This has led not to liberty and a genuine market, but to an over-regulated, over-centralised, overly-bureaucratic system. This is not what either classical- or neo-liberal economists would have suggested.

A real market that genuinely empowered people and lifted the dead hand of bureaucracy from our shoulders would put citizens in control. Rather than being answerable to civil servants in Whitehall, deliverers would be answerable to citizens through the latter’s ability to allocate funding. As Friedman demonstrated in theory and Sweden demonstrated in practice, voucher schemes not only drive up standards but they are particularly beneficial to the poorest in society. Sweden – that paragon on Social Democracy – has similarly had a very positive experience with creating a healthcare market.

Sadly, this kind of freedom is not to Curtis’s taste. For him the volatility and unpredictability of the market is disturbing, and the freedom of the individual is a myth. He prefers the certainties of Statism and the comfort of the community. But with the lack of hindsight that only a shift of generation can provide, he ignores the bleakness of the last period of interventionist government and the abject failure of Statist solutions. One need not look to pre-1990 Eastern Europe for evidence of the failure of state planning; dirigiste France’s youth unemployment of 25 per cent and Germany’s stagnant economy are lessons enough for us. Governments are incapable of managing so complex and delicate a system as the economy, which rely on incalculable pieces of information. Economies are, in essence, merely a mirror of society as a whole, and efforts to manage economies are therefore efforts to manage society. Whether it is through dictating how many hours an employee may work or through confiscating a portion of their earnings for central distribution, such efforts are inherently illiberal and should be kept to a bare minimum.

The desire of recent governments to end the old bureaucratic tyranny is laudable, but their efforts have been risible and their methods misguided and ultimately counter-productive. Only by genuinely empowering citizens through giving them the power to allocate their resources – be they those they earn or those transferred to them by a welfare state – and allowing the consequences of those decisions to have their effect, will we improve the quality of public services and benefit society more generally. Into the bargain we will re-invigorate the population who, being now in control of their own destiny and no longer supplicants at the mercy of the state, will rediscover the moral sentiments that Smith and Mill thought vital elements of a fully rounded person.

I have separately reviewed part1 and part 3. Curtis's conclusion and my analysis of it are discussed in a final post.

EXCLUSIVE: Mervyn DID draft a letter to Gordon!

It's amazing what one finds in the rubbish bins behind Threadneedle Street!

Obviously the person who drafted this letter realised they didn't quite need it after all:


Dear Gordon,

As you may have noticed, inflation appears to be spiralling out of control. The consumer price index (CPI) is now at its highest since 1995, while the retail price index (RPI) is at its highest since 1991. I imagine it must be pretty embarrassing, presiding over an economic record worse than that of the Major administration, which Labour have been criticised so vocally over the past decade.

I feel duty bound to provide an explanation for this rising inflationary tide. I attribute it to a number of key factors, none of which are beyond the wit of man to cure.

1. House prices

House prices have spiralled over the past decade. This has a direct impact on RPI and has also facilitated unprecedented levels of equity withdrawal, fuelling consumer price rises.

House price rises are largely to do with property speculation. While interest rates can curb house prices to a degree, they are a blunt tool in that they also affect other lending and borrowing. High interest rates would, for example, reduce investment. One means of curbing property speculation without harming investment would be to introduce land value taxation, which economists recognise is among the least distortionary form of taxation. Sadly, the Government has shown no willingness to investigate this option.

2. Public spending

A grotesque rise in public spending over the past five years has increased inflation. A particularly egregious example has been overly-generous public sector pay rises that bear no relation to productivity gains.

3. Public borrowing

The Pre-Budget Report forecasts net debt at the end of March 2007 of £503.9 billion. This budgetary imprudence has injected massive liquidity into the public sector and the economy more widely. Effectively, more money is chasing the same number of goods.

4. Taxes

In the pre-budget report the Government added 1.5p/litre to petrol duty. This has been the major factor in the 2p rise in the cost of a litre of petrol, which in turn accounts for two-thirds of the rise in CPI last month.

5. Trade barriers

Cheap imports of goods from emerging Asian manufacturers has applied downward pressure on prices, particularly in clothing and electrical goods. Sadly, the Government and the European Commission (led by Trade Commissioner Peter Peter Mandelson) have imposed additional and ongoing quotas on Chinese textile imports. This is in breach of our commitments under the World Trade Organisation. The result is that customers have been forced to purchase more expensive European products, pushing up retail prices.

6. Immigration

The low inflation enjoyed by the UK over the past two years has been in part due to immigration. As my colleague, David, pointed out a couple of weeks ago, the availability of highly skilled Eastern European workers has kept wage demands within sensible limits. Sadly, the Government has decided not to take advantage of another wave of immigration from Romania and Bulgaria, instead imposing a daft and distortionary quota system. This has removed a further buffer against inflation.

As you will see from the above factors, there is a clear single cause of inflation. Sadly, it is beyond my authority to do anything about it. I think it’s over to you, old chap.

I remain your humble servant,

Mervyn.

Don’t swallow that note, or that argument, either

Yesterday, Adrian Sanders MP wrote an entry in his blog (speakers on when you visit it!) entitled Don’t swallow that coin, in which he argued that early doubts about the euro have been proved unfounded. I am unable to leave a reply on the blog (MySpace is fighting me!) so I am obliged to do so here.

Though it is true that early scepticism about the euro has given way to cautious optimism, the evidence that Mr. Sanders gives for hailing it as an untrammelled success is flawed. His statement that “the new currency is competing with the Dollar for top spot in the world's list of currencies” is at least a bit premature. The Euro accounts for only 25 per cent of global foreign exchange reserves as compared with 66 per cent for the dollar.

Similarly, his claim that “ more and more of the world's goods and resources are being priced in Euros rather than Dollars”, though perhaps true, may exaggerate its significance. While the accession of ten new members to the European Union (and in three days it will be 12) has required them to peg their currencies to the euro rather than to the dollar, the enlargement process is stalling, and anyway is ultimately limited. A few other countries may be seeking to shift their own currency peg to the euro, but the dollar remains the yardstick by which others are measured.

In fact, some of Mr. Sanders’ claims are frankly outlandish. That the face value of printed notes is now greater than that of the dollar, having doubled in five years, is neither relevant nor automatically to be welcomed. The dollar’s fall relative to the euro may have assisted this transition, but it is not helping European exporters (at least, not on the Continent). Meanwhile, the fact that the money-supply has doubled in five years is usually a sign of inflation.

Of course, if the European Central Bank had deliberately chosen an inflationary policy it might be understandable, as some of the larger Euro-zone countries have been struggling with deflationary pressure over the past few years. Certainly anything that could save Germany and France from their stagnation should be welcomed. However, the UK has been happily free of deflation and growing steadily over the past few years – in fact it is inflation that under Gordon Brown has been causing us concern. Thank heavens, therefore, that we have an independent central bank that can respond to our specific economic circumstances!

Mr. Sanders attempts to ridicule Britain’s monetary independence by suggesting that “by staying out, [all] we retain [is] the Queen's head on the bits of paper we exchange for goods and services, our banks make massive profits out of us, and we keep our coins”. In fact, the Bank of England has done (and forgive me for what must be one of the most apposite puns in history) a Sterling job in maintaining price stability – far better than the ECB, which has overseen a mini-recession in Germany while other member-states have witnessed inflation.

Furthermore, the pound has managed to steer a course between the euro and the dollar, which is handy because half our trade (the half Mr. Sanders ignores) is still with the dollar zone. So while Mr. Sanders may be right to say that “If you run a business that trades with the Euro zone you pay exchange rate commissions to the banks on your transactions, that increase your costs and reduce your competitiveness”, he neglects the fact that if you run a business trading with the dollar zone and we had adopted the euro, you would have experienced massive and unpredictable volatility in exchange rates that would have disrupted any long-range economic calculations. This is far less of an issue for our European neighbours, as they have increasingly shifted from trading globally to trading regionally, but the fact that they are doing so does not prove that the Single Market generates better returns than global trade; it merely proves that trade will follow the path of least resistance.

Mr. Sanders’ suggestion that “The Euro is achieving … a single currency zone and market that could match and compete with the Dollar and US economy on equal terms” is ludicrous. The European economy may be as large as that of the USA, but this was not caused by the Euro. Neither has the euro-zone’s economy performed as well as that of the dollar zone, though America does appear to be moving into a period of slower growth.

It is clear from his blog that Mr. Sanders has been drawn in by the economic (supra-)nationalism of the euro’s perceived success against the dollar and has lost sight of the real goal, which is the British economy. This is a shame. Whether Britain will fare better within the euro-zone or with its own currency is a matter of national policy that should be based on sound economic reasoning and not a puerile competition with the Americans over whose currency is the biggest. I would heartily concur with Mr. Sanders that one should not swallow either euro or British coins. I suggest one should not swallow his argument, either. Whether we decide to swallow the euro will require more – and more elevated – debate than Mr. Sanders provides.