Memo to the EU: markets work, capisce?

We’ve another of those stunning misunderstandings from Brussels about how this economy thing works. It’s not so much the European Union itself, it’s the mindset of the people that actually make the rules within it that matters. They’ve not got the idea that markets really do actually work. They’ve decided to set the fees that debit and credit cards can charge:

Consumers face cuts to the air miles, cash bonuses and other rewards they collect from credit cards because of a law passed in Brussels last month.

Capital One, one of Britain’s biggest card providers, has become the first firm to scrap the perks following new EU restrictions on the profits it can make.

In a statement the company said its cards, which paid customers up to 5p for every £1 spent, were “no longer sustainable”.

If you look at the fees in isolation then you might well think, hey, they’re making a lot, stop them! But to look at the fees in isolation is to be more than a bit of an idiot because markets really do work.

So, there’s those fees. And then those consumers who think they’re a bit high and would like to claw back some of that money get to do so. Because competition to gain those high fees means that card issuers start to offer cash back, air miles, discounts, freebies and other goodies. And what selection of freebies, discounts and other goodies people value most will influence their choice of card. Thus consumers get what they value most.

And now we fix the fees, to what in isolation might be regarded as “fair” and all those consumers then lose all of those compensating benefits. Because the people making these rules have looked at this in isolation, without noting that markets really do work and that card holders are already being compensated, in the manner they value most, for those seemingly high fees.

As we say, to look at such things in isolation is to be more than just a bit of an idiot.

Note that the profits that a card company can make are not being regulated. What is being regulated is the revenues one can have: and limiting the revenues that can be made also, inevitably, reduces the revenue that is rebated, leaving profits quite possibly unchanged. No overall benefit to consumers therefore but the tax leeches regulators feel they’ve achieved something.

This isn’t, despite the well known views of at least one of us here, a complaint about the European Union. It’s a complaint about the tax leeches regulators failing to understand that markets already achieve, without intervention, the things that the tax leeches regulators think that only they can bring about. The answer to which is, of course, more markets and fewer tax leeches.

Iceland’s new money and banking proposal. Yes, why not?

Iceland is considering a new report which would rather radically change the banking system of that country:

Iceland’s government is considering a revolutionary monetary proposal – removing the power of commercial banks to create money and handing it to the central bank.

The proposal, which would be a turnaround in the history of modern finance, was part of a report written by a lawmaker from the ruling centrist Progress Party, Frosti Sigurjonsson, entitled “A better monetary system for Iceland”.

“The findings will be an important contribution to the upcoming discussion, here and elsewhere, on money creation and monetary policy,” Prime Minister Sigmundur David Gunnlaugsson said.

The report, commissioned by the premier, is aimed at putting an end to a monetary system in place through a slew of financial crises, including the latest one in 2008.

To be honest, the report (which can be read at that link) is little more than a rehash of the proposals of Positive Money. And worth about as much as such a rehash is going to be. It’s worth pointing out that Julian Simon was actually correct, human ingenuity, and the knowledge it produces, is the ultimate resource. And given that Iceland’s population is some 300,000 people there’s not a great deal of it natively. We have noted around here more than once the problems that stem from trying to extract decent economic ideas from the rather larger population of Norfolk as an example.

The basic idea is that as banks create credit, credit creation is behind boom and bust, put credit creation into the hands of the government and abolish boom and bust. We don’t think that that’s how it will work out. Rather more likely is that politicians will follow the incentives of being able to spend this newly created money without having to tax to gain it and the result will be high and persistent inflation.

However, we’re absolutely delighted that someone undertakes the experiment. Actually, we’re delighted that someone else undertakes this experiment. Good luck to them say we. And we’ll come back in 20 years, see whether there’s been that abolition of boom and bust, been that persistent inflation or not, and then we can make a decision about whether to follow or not.

An interesting view of what bankers actually do

It’s a commonplace in the public square these days that bankers are the evil ones, designing odd products like a CDS or CDO, to trap the unwary investor into parting with all their worldly wealth. and then there’s the occasional expression of a more obviously sensible view, as in this one about Islamic banking:

Many of the instruments Irfan discusses were sold by major banks that saw them as just another opportunity. This is not surprising: Governments and wealthy individuals wanted financing that complied with their religious requirements, and banks gave it to them. Irfan, by contrast, longs for an Islamic finance industry that caters to “small and medium-sized enterprises, retail customers, the man in the street” and offers something “beneficial to everyone, irrespective of creed.”

The actual book is about Islamic financing, a subject we find quite fascinating. For of course the basis of said Islamic financing is an outright denial of something that we hold to be an obvious truth: there’s a time value to money. That there is is what leads to there being an interest rate and also to all those other techniques like discounting to get to net present values and so on. We take these to be simply obvious truths about the universe that we humans inhabit and one can, as experiments have, derive the existence of that time value by studying small children. A baby doesn’t get the idea of delayed gratification for greater gratification, a three year old will usually grasp the idea of two sweeties tomorrow instead of one now and a 6 year old might go for two in a week for one now. This is an interest rate and it does seem to be innate in human beings.

So, obviously, it could be seen as a little odd that we not only enjoy but thoroughly approve of these various Islamic alternatives. For they all (things like Sukuk bonds and so on) depend upon the absolute rejection of interest, that very thing that we insist is part of the fabric of our reality. The reason we so like Islamic finance is because all of he successful forms of it are actually constructs that, in the face of the religious insistence that there should be no interest, actually operate in a manner to ensure that there is a time value to money and that there is an interest rate, interest which has to be paid.

Which brings us back to what we liked about that description of banking: they bankers are simply providing what their customers want. Seems a more honest trade than many to us, enabling someone to meet their religious obligations while still saving for their old age and the like.

The problem with the bank levy and other Pigou taxes

This is both extremely disappointing and also par for the course:

The Liberal Democrats plan to hit the UK banking industry with an additional £1bn tax bill, which the party says will help eliminate the country’s deficit.

The supplementary charge will be in addition to the existing bank levy, which is on track to raise £8bn in this parliament, said Danny Alexander, the Liberal Democrat chief secretary to the Treasury.

The annual levy on banks, which was introduced in 2010, currently brings in around £2.5bn a year. Mr Alexander’s proposals are expected to take that up to £3.5bn a year.

The point is that the bank levy is a Pigou tax. There’s an externality in the market which is not being included in prices. The tax is there to make sure that that externality is included in prices.

The externality is that the “too big to fail” banks receive, as they are too big for the government to allow them to fail, implicit deposit insurance over and above that on offer through the normal regulatory schemes to all deposit taking institutions. This means that they can finance themselves at lower than free market rates and it’s the taxpayer that picks up the risk.

The solution, as we noted and praised when the levy was introduced, is to charge an insurance premium on those deposits that are insured in this manner. And that’s how it does work: it’s only on the deposits of the too big to fail banks, it’s only on those deposits which are not insured through other schemes and it takes account of the riskiness of a run in said deposits (thus long term bond finance pays a lower rate than at sight deposits). That’s all how it should be.

And the point about Pigou taxes is that it doesn’t matter what happens to the revenue. Sure, it’s nice to have ‘n’all that, but the point is to correct the market, not to raise revenue.

Thus the idea that the rate should be changed in order to increase the revenue raised is nonsense. It’s violating the very point and rationale for having the levy in the first place.

It’s also entirely par for the course. No politician can see a potential revenue source without wanting to bathe in it. And that, sadly, is the problem with Pigou taxes. They’re economically efficient, rational and make the world a better place. Until we come to the politicians who implement them when, over time, they will inevitably lose their original justification and simply become another method of gouging someone or other so as to bribe the electorate.

What’s economically efficient, rational and making the world a better place when a Minister’s seat is at risk at a looming election, eh?

Better to reverse QE than raise interest rates

That is, of course, a chart of the American, rather than UK, money supply. But much the same has happened to our own money supply under the same QE program. And it’s also telling us that it would be better to reverse QE than it would be to raise interest rates. So the idea that that debt could just be cancelled doesn’t fly we’re afraid.

We all know that at some point we’re going to have decent economic growth again, unemployment will fall to a minimum (that frictional unemployment that reflects people changing jobs, not involuntary unemployment) and that then inflation will start to rise again. We all also know, because Milton Friedman told us so, that inflation is always a monetary phenomenon. And, finally, we all also know that base money creation is more inflationary than credit creation: or boosting M1 leads to more inflation than the same boosting of M4 would cause.

It’s putting those all together that tells us that we should reverse QE. Think through the future: so, we get out of this liquidity trap, this zero lower bound. The velocity of money returns to something like normal. At which point we’ve got two choices as to how to reduce the accompanying inflation. One is to raise interest rates, the standard response. But that works on M4, it slows credit creation. We could also reduce that money supply by reducing M1: reversing QE. And as above, we think that shrinking M1 would have more effect on reducing inflation than reducing M4 would.

Another way of saying the same thing is that the amount we’d have to raise interest rates to choke off inflation will be higher if we don’t reverse QE than if we do. And this will be true for decades to come as we gradually get back to the right sort of relationship in size between M1 and M4. Or, not reversing QE means that we have to accept more economic pain to reduce inflation than if we reverse QE. For decades.

Which rather puts the kibosh on that idea so trendy over on hte left. Which is that as one part of the government owns the debt of the government we could just cancel that debt and reduce the debt burden. But doing that permanently increases that base money supply and thus permanently increases the interest rates we’ll need to slay inflation in the future.

So, reverse QE before raising interest rates.