29 September 2008

Stop Protecting the Savers

Throughout the banking crisis, one thing that all sections of the mainstream political spectrum seem to have agreed on is that savers must have their deposits protected at all costs. That's a shame, because it is precisely that approach which has got us into this mess.

It all comes down to a muddying of the distinction between a "depositor" and an "investor." Under the original meanings, a depositor was somebody who put their money in a bank for safe keeping. Somebody with a safety deposit box is probably the closest thing we have to a genuine depositor today. They make no profit from leaving their assets with the bank; in fact, it costs them money. In contrast, an investor was someone who gave their money to a third party with the intention of making a profit on it, but also with the risk that they might make a loss.

The problem with savings accounts at banks is that they are treated as if they should have the risk free characteristics of a deposit, but also enjoy the risk taking profits of an investment through the interest they get paid. That obviously means that somebody else has to shoulder the risk which is involved in creating the profits and in this case, it is ultimately the taxpayer. The saver gets to take the profits when things are going well, but when they go badly, the taxpayers has to guarantee that the saver doesn't lose any of their original investment.

The mainstream attitude all comes down to the perception of the individual players. Directors, corporate investors and shareholders are criticised for making profit in the good times but being bailed out in the bad, while savers are portrayed as passive victims who must be protected, in spite of the fact that they are just as much beneficiaries of the "privatised profit but socialised risk" scam as the others, if not more so.

This is why, as I've said previously, this crisis is not a result of the free market, but government intervention. In a genuine free market, savers, just like shareholders, would have to accept the losses that arise from bad investment decisions. This is how it works in other industries, where creditors queue up to get what is left after a business fails. By guaranteeing deposits and creating the impression that savers are involved in a risk free activity, successive governments have created the conditions that have resulted in this crisis.

The first step that should be taken now is to re-establish the distinction between "depositor" and "investor."

A depositor, who puts their money with a bank for safe keeping and makes no profit from it, should be well protected, just as they would be if they'd put it in a safety deposit box. The law should treat the bank in much the same way it treats postal services; it is a custodian that has no right to use the property it holds. Any attempt to use that money for investment should be treated as a serious criminal offence for which the Board of Directors of the bank should be ultimately criminally liable, just as they should be if they allow their staff to take assets out of safety deposit boxes. The bank would therefore hold cash and central bank deposits equal to its genuine deposits, which would be paid out to the depositor immediately should the bank fail. In contrast, an investor who puts their money in an account with the intention of earning interest on it should have much less protection. They should be treated as a creditor of the bank and if the bank fails, they would have to wait for the bank to be wound up and its assets sold and then collect whatever percentage of their deposit is available from the proceeds. This leads on to an area where I disagree with many of those with libertarian leanings - the fractional reserve system.

The fractional reserve system of banking allows banks to lend money that is saved with them in such a way that, if all the savers were to try to withdraw their money at the earliest possible opportunity, the bank wouldn't have the cash available, because it is tied up in loans. It is what makes bank runs such a problem. Many libertarians think the fractional reserve system is inherently wrong because of that, but I don't view it that way. Any individual could do the same as the banks do; I could borrow ten pounds from you and write you and IOU. I could then spend the ten pounds, while you treat the IOU as ten pounds available to you whenever you want it, just as you would treat ten pounds in an instant access savings account. The problem arises if you try to get your ten pounds back from me and I don't have the cash, just as it would if you went to the bank and it couldn't pay you back because your deposit is tied up in a loan.

The real problem with the fractional reserve system arises because the government takes the risk out of it. If the banks can't pay their IOUs, the central bank lends them the money. If a bank fails, the government makes sure the IOUs get paid back. If IOUs written by individuals had the same guarantees, IOUs would get written, accepted and spent recklessly, just as the ones issued by the banks are.

We don't need to get rid of the fractional reserve system; we just need to make sure that it is clear to all what risks are and that those risks stay with those who are trying to profit from them. Savers who are trying to profit from their money being lent to others should be told that, if there is a run on their bank and there isn't the cash available to pay out their investment, they will have to wait in line until a loan is paid back and the cash is there, even if that takes years, unless the bank is forced out of business, in which case the saver might not get back their original investment in full.

By putting the consequences of risk taking back with the people taking the risks, we would solve the fractional reserve problem. People would treat putting money in an interest paying account like buying shares - an activity which can bring rewards, but also has risks. People wanting genuine security would put their money in non-interest paying deposit accounts or safety deposit boxes. All of the risks associated with the banking system would stay in the system, rather than being passed on to the government and by extension the taxpayer. The amount of reckless risk taking would reduce and the system would stabilise.

In short, if you want a sound banking system, stop protecting the savers.

20 September 2008

Is Gordon Brown the New Neville Chamberlain?

Whatever else Neville Chamberlain did throughout his political career, he will be remembered for just one thing - returning to England after finalising the Munich Agreement with Hitler and declaring "I believe it is peace for our time." Such big claims are alway liable to come back to haunt you if they prove to be false.

In the ever worsening economic slump, I can't help feeling that Gordon Brown might similarly be remembered purely for his claims that he'd put an end to boom and bust.

If, in 1997, he only expected to be around for one term, it might have been a politically sound statement for Brown to make, even if he didn't believe it was true; you can get away with claiming to have eliminated boom and bust when you're in the boom phase. Of the boom and bust double act, boom has always been the more popular partner. It isn't really boom and bust that joe public wants to see eliminated, just bust. So long as you're out of the way before bust makes a come back and you can blame your successor, you're laughing.

If, on the other hand, Brown genuinely believed that he had put an end to boom and bust, he was both arrogant and stupid. He made certain economic changes, such as giving the Bank of England control over interest rate changes, which created more economic stability, but he completely failed to address the underlying land price cycle which drives boom and bust. By failing to heed the warnings of the likes of Fred Harrison and Fred Foldvary, he's been the architect of his own demise. The ultimate irony is that, by creating stability and constant growth in the boom part of the cycle, he might have made the bust phase worse.

Unless he quickly recognises his mistakes, he's only going to make them worse. His efforts to keep the housing market moving at any cost have turned it, even more than before, into a giant pyramid scheme, with more and more money being pumped in at the bottom to keep an unsustainable chain going. If house prices are falling, it's because speculation had pushed them too high. Continuing to stoke them will just make the inevitable fall even harder.

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17 September 2008

The Banking Crisis

Earlier today, Lloyds and HBOS formally announced that they are in merger talks. There is a lot of comment in the media suggesting that this move has been motivated by the credit crunch. I think that is true, but not in the way the media is implying. In the banking market, where bigger is generally better, merging is always going to be an attractive option. The problem for the banks is that, when times are good, competition rules make merging difficult. When the economy turns messy, it's a completely different story. The government becomes so scared of banks going bust that they throw competition rules out of the window. That presents the banks with a golden opportunity.

I've seen plenty of comment on message boards claiming that the current crisis in the financial sector is a sign that the free market doesn't work, because institutions are being bailed out by the state. As an argument, I think that's pretty poor. The banking sector is not even a vague approximation of a free market. It has high statutory barriers to entry and the state intervenes in a way that encourages reckless behaviour, such as, ironically, by bailing out institutions when they hit problems.

In the UK, the three state interventions in the banking sector which I think cause the most distortion are:

1. The government guarantees bank deposits (to certain levels), which reduces the risk to the depositor and therefore reduces the need for banks to prove to customers that they are well managed.

2. The Bank of England acts as lender of last resort for the banks, which allows them to make riskier liquidity decisions. If banks were at the mercy of their competitors when seeking out liquidity, they'd have to be more prudent.

3. The government implies that some banks are “too big to fail,” which sends out the message that the bigger players will be kept safe no matter how bad the situation gets, which encourages risky behaviour all round. This is one of the major reasons that "bigger is better." The current arrangement offers an implicit guarantee that, if a bank gets big enough, the government will make it immune to some market forces and prevent it from ever failing. The potential for failure is an essential part of a free market; it's what gets the bad practices out of the market. It's not a perfectly smooth system, but like evolution, it pushes things in the right direction. Take failure out of the system and bad practices can build up, until what might have been an individual failure becomes a wider catastrophe.

Add in the fact that the FSA has the statutory objective of "maintaining confidence in the financial system," which is a bit like telling a road safety officer that part of their job is to convince people that the roads are completely safe and risk free and you have a recipe for disaster.

If the current situation shows anything, it's that government intervention has a tendency to solve problems by creating bigger ones.

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13 September 2008

One Country Makes Geo-libertarian Changes

I'm a big fan of the geo-libertarian approach to economics, which is a synthesis of the georgist principle that everybody has an equal claim over natural resources and the libertarian principle that government should be kept small and services should ideally be provided through freedom of choice, rather than by the state.

When you combine those two viewpoints, you get the geo-libertarian position that, economically, the state should be limited to collecting charges for using natural resources (oil drilling permits, land rent, broadcasting licences, etc.), taking only as much of the revenue as is necessary to fund the essential functions of government (courts, land registry, etc.) and paying the rest out in equal shares as a "citizens' dividend."

While I make an effort to promote these ideas, I've never really believed that there is much chance of them being widely adopted, because they go against the mainstream political momentum. Georgists struggle to gain ground, because many of the wealthy supporters of mainstream politicians benefit from special privileges over natural resources, such as control over large swathes of land or exclusive access to gas and oil fields. Libertarians struggle to gain ground, because most politicians want more power and work to create the impression that giving them greater control is the only way to make things better.

However, over the last week, I've gained a little hope that geo-libertarian ideas might make some progress after all, after one political leader announced his plans to introduce a citizens' dividend to replace large parts of his government's spending. In a speech outlining the changes, he said "Corruption is linked to bureaucracy everywhere in the world. The solution to ending corruption is to end this administration which manages money spending, and put the money directly in people's hands." About the education budget he said, "Put it in your pockets and teach your kids as you wish, you take responsibility."

So, who is this visionary? Muammar Gaddafi, the leader of Libya!

The leader of the oil rich nation said, "Libyans, with oil money directly in their hands and bureaucracy dismantled, will set up a genuine popular administration and form a society of the masses ruled by a genuine direct democracy."

Of course, talk is often cheap and it still remains to be seen if Gaddafi will convert his talk into action, but just to have a political leader expressing these ideas is a major step forward.

So, it seems that the country leading the way on progressive economics is an authoritarian military dictatorship. I don't know whether to laugh or cry.

You can read more about the story through the BBC or Reuters.


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11 September 2008

Windfall Taxes - A Slap in the Face for the Rule of Law

One of the fundamental principles of the rule of law is that there should be no punishment for an act which was not a crime at the time it was committed. This prohibition of ex post facto laws, as they are known, is reflected in both the European Convention on Human Rights and the American Constitution.

So, if I had a cup of coffee yesterday and the government made coffee illegal today, it shouldn't be possible for somebody to charge me with breaking the law, as what I did was legal at the time I did it. Similarly, if I was arrested for being drunk and disorderly yesterday and today the government increased the maximum sentence for being drunk and disorderly to life imprisonment, it shouldn't be possible for me to be imprisoned for life, as that was not the maximum sentence when I committed the offence.

As well as applying to criminal acts, the avoidance of ex post facto taxation is a valuable principle in a democracy, not just because it is consistent with the rule of law, but also because the ability to restrict the tax flow to the government is an important form of protest for those who have serious objections to government policy. This can only happen if the taxpayer is aware the tax before it is levied.

Thankfully, almost all taxes pass the test of not being retrospective. If the government says it is going to levy a tax on my car, I can sell it. If the government says it is going to increase income tax, I can get a lower paid job. If the government says it is going to increase the tax on land or buildings, I can downsize. If the government says that is going to increase the tax on tobacco or alcohol, I can stop buying them. Even with a poll tax, I can leave the country or even kill myself if my moral objections to the government are so severe. Whatever you think of these taxes, it is clear that each of them is levied on an activity which occurs after the government has enacted the tax.

There is one set of taxes which completely ignore this principle and that is windfall taxes. There is currently pressure to levy a windfall tax on the previously declared profits of energy companies, but such a tax would clearly be ex post facto; the companies didn't know about the tax when they earned the profits and there is nothing they could now do to avoid the tax.

As well as being unjust, these taxes are often based on ideas that arise out of anger rather than rationality. Often the taxes are levied on the basis that the companies are making "excess" profits, without any justification of what excess means, but an underlying implication that the customer is somehow being ripped off. This ignores the possibility that the companies may be making a profit because they are simply doing a good job. A gas supplier, for example, may make a profit by predicting the wholesale market in gas correctly and buying gas when it is cheapest.

Creating uncertainty around tax issues can also discourage investment, causing companies to move into more predictable markets, resulting in weakened competition and potentially a poorer deal for the customer in the long run.

Calls for windfall taxes may be well intentioned, but in the long run they can harm the people they are supposed to help. The whole thing looks even more absurd when you consider that there is already a tax on profits, in the form of corporation tax, which ensures that companies pay more tax as they make more profit, but in a much more open and honest way.


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