Adam Smith Institute

Capitalism is based on failure. But that's no problem, since life is based on failure. That's the view of Professor Paul Ormerod, who outlined the idea at an Economic Research Council meeting I attended in London.

Ormerod points out that over 99.99% of all known species are dead. And roughly 10% of all US companies disappear each year too. Even when things are booming, you get extiction: in 1469, Venice boasted twelve firms engaged in the dotcom boom of its day – printing. By 1474, nine of them had failed. Sound familiar? Some 995 of the 2000 US firms making cars in 1900 disappeared. Of the world's 100 top companies in 1912, just over half survive, but only 19 are still in the top 100 – and most of those have changed beyond recognition.

Yet it's amazing how many people hark back to Marx, complaining that capitalism produces more and more concentration. John Kenneth Galbraith played the same tune in his book The New Industrial State. But by then, big-company America was at its zenith: from there on, it has been a story of the proliferation of new, small companies.

And it's that proliferation – that constant innovation coming from new, small firms – that makes free-market systems so vibrant, productive, and beneficial to humanity. Just as the small mammals proliferated when the dinosaurs declined, so so new small businesses spring up and become larger businesses. America's commitment to (relatively) low taxation and (relatively) light regulation and its (relatively) strong commitment to personal freedom is, I think, the main reason why it consistently outperforms statist backwaters like Europe. The biosphere and the economic sphere change constantly. You have to adapt and innovate. And decentralized, market systems are a lot better at adapting and innovating than socialist ones.

An excellent article in Business Week explains why bubble markets aren’t all bad.

"The stuff built during infrastructure bubbles—housing and telegraph wires, fiber-optic cable and railroads—doesn't get plowed under when its owners go bankrupt," writes Daniel Gross in Pop! Why Bubbles Are Great for the Economy. "It gets reused—and quickly—by entrepreneurs with new business plans, lower cost bases, and better capital structures. And when new services and businesses are rolled out over the new infrastructure, entrepreneurs can tap into the legions of users who were coaxed into the market during the bubble."

For example, this happened during the late 1990s. Speculators predicted that the growth of the Internet would necessitate huge increases in fibre-optic cable. The predictions were incorrect and much more cable was laid than necessary for the intended purposes, but after, business used the cable in an even more beneficial way (see The World is Flat, the steroids part of the ten flatteners section for more on that). The high oil prices hit us where it hurts the most—our wallets. But this too shall pass, and when it does, we will all be better off because of it:

As the "hot money" is flowing in, the investment is building ever tighter and stronger economic ties between the developed and developing economies, creating wealth at an unprecedented rate, building bridges that will strengthen in coming decades. And it's the growing economic vigor of a vastly healthier global economy that is pushing up the price of commodities. These higher prices are encouraging enormous increases in investment in alternative energy and increased agricultural production.

The Institute of Chartered Accountants (130,000 members strong) has just released its quarterly survey of business confidence, which makes predictably grim reading. Business confidence, it says has declined for the fourth quarter in a row. It is now at the lowest level since the survey began.

It may not amount to a recession, where the real economy shrinks over two or more quarters, but the bean-counters expect that the growth in turnover, profits and exports will all slow, and that fresh capital will be increasingly hard to obtain.

It's not just London's enormous financial sector that is feeling the pinch – though, even after the Bank of England's attempts to increase liquidity, that sector most assuredly is. No, the credit crunch seems to be spreading out, affecting confidence for the worse in all sectors of the UK economy. It's going to be a difficult year for businesses of all sizes, in all sectors, and in all regions, the survey concludes.

There's still a debate on how much of the current oil price is a speculative bubble and how much of it is real, but increasingly I think it looks real – reflecting the growing demand for oil and its limited (and highly politicized) supply.

We know from the 1970s what a rapid rise in the oil price does for oil-dependent countries. People use oil, and oil-based energy sources, more sparingly. And more efficiently: US energy intensity (the energy used per unit of GDP created) has been cut by over 40% in the last thirty years. America is getting more bucks to the barrel. Cars are smaller, lighter and more fuel-efficient. Our domestic boilers use less oil. Factories are built to capture and re-use spent heat. And we insulate our homes more effectively.

I've a feeling that the oil price creeping up to $135 and beyond will do more to reduce carbon emissions than any number of platitudes and plans from Kyoto. That's all mostly rhetoric, and few of the world's politicians are actually living up to their rhetorical commitments. A rising oil price, by contrast, affects us all, and prompts us to change the way we use energy. But that's the market, isn't it?

An article in the New York Times about Spain’s water crisis struck me as another example of the importance of incentives, the problems of bureaucracies, and the superiority of market-based solutions to even the biggest problems.

Basically, we see two sets of responses to the problem of water scarcity in the southern parts of Spain.  On the one hand, a bureaucracy that tried to allocate water to different groups at different prices was created.  Shockingly enough, this response has major problems. People manipulated the system, as resort owners and vacationers planted a few trees and claimed to be farmers to get lower prices.  Meanwhile, farmers who had to pay very little for water began raising crops that needed more water. A trend that is a major cause of the desertification we’re now dealing with. While on the other hand, when costs and the decreasing availability of water actually had an effect, farmers moved towards more efficient irrigation methods and crops that required less water.

Incentives matter. Governments shouldn’t be subsidizing unsustainable lifestyles in arid locations, especially when that will only worsen the situation. If farming is only economically sustainable with subsidized water, people should not be farming there. Water should be more expensive where it’s scarce or hard to access, even if that means fewer farmers or a shift in population towards more fertile areas.  As water gets scarcer, a more market-based system would surely also do more to encourage the development of private desalination plants and water-saving technology, as opposed to simply pouring billions of taxpayer dollars into such projects.

If farming isn’t working out, Spain should move towards less water-intensive industries in those areas and import crops from places with more adequate resources and a comparative advantage. Very high water prices would encourage even the resorts and golf courses to find ways to reduce water usage rather than search for bureaucratic loopholes. People find ways around bureaucracies, but it’s much harder to find a way around the market.

According to Polly Toynbee of the Guardian, we at the Adam Smith Institute are mistaken to question the amount we pay in tax. With disjointed logic, she suggests that we are not paying enough (some of us that is) and this impacts badly upon the poorest. It is a shame that she has not found the time to explore our website a bit further, as she may not have had to go to the trouble of writing the article.

At the Adam Smith Institute we call for the introduction of A Flat Tax for the UK. This proposal includes a tax-free personal allowance of £12,000 that will take the poorest out of the tax net. Also, a low flat tax will stimulate investment, make businesses more productive, and so boost jobs, pulling people out of poverty. The low-paid in work also benefit, for as more jobs are created and the demand for workers goes up, wages will rise.

However, Toynbee might well still disagree with us. In reality nothing short of full-blown Communism accords with Pollyland. Her statist utopia (dystopia) includes not a semblance of meritocracy or individual choice. She has no trust in the people to act for the good of themselves; this is why she and others in Polly's Politburo decide everything for us.

Toynbee fears that tax cuts will become a central policy for all three parties in the next election. Let's hope she is right…

There are a lot of smug faces in Frankfurt right now. Shortly after the Euro was launched, it pitched into the sand, down to US$0.90, and some economists thought it was on the way out. But political economists knew that too much political capital had been invested in the Euro for the EU to let it fail. And, indeed, now it seems to be riding high.

A lot of that is of course because the dollar is languishing due the effects of terrorism, wars, China and the inevitable hangover that follows a credit-led boom. The pound too, if less so. The Euro has become the currency of choice for all those who are nervous about leaving their money in America. And while America and Britain's prospects look grim, the European economies in general seem to be doing OK.

Europe and the Euro may be on the up, but the fundamental problems of the Euro remain. A single currency, along with a single exchange rate, can never be right for all the peoples of Europe all the time. Inflation in Ireland is now 5%, well outside the European Central Bank's 2% target, and inflation in Spain is not far behind. Meanwhile, these economies are not doing well. They got a huge boost from low Euro interest rates during the early years of this decade, and how they too are suffering a hangover. Property prices in Dublin are off by 20% and more, unemployment is creeping back, and people are talking again of stagflation.

The strong Euro does Ireland, in particular, no favours. Its main customers are the UK and America after all, with whom it has strong cultural, linguistic and ethnic ties. A lot of people presume that Ireland's boom was due to its membership of the EU, of EU subsidies and cheap credit thanks to Euro membership. In fact, Ireland's real growth was pushed off by an enlightened tax policy that drew business to Ireland, and certainly, access to the wider European market and some infrastructure grants certainly helped, as did changing social patterns and the participation of more women in the workforce. But that real boom was compounded by an inflationary boom that was down to Euro membership. In the long term, the Irish would have been better without it. And that hasn't changed.
 

Britain is eating more fresh fruit. So should ministers be congratulating themselves that their 'five a day' campaign, backed by all those NHS 'five a day officers' is really, er, bearing fruit? Or that the public money being spent on including more fruit and vegetables in school lunches has made kids swap Golden Wonder for Golden Delicious?

Probably not. Certainly, people are more health conscious than they were – partly because they are living longer and the reality of illness is more apparent to them. And they figure that eating fresh fruit is healthier than snacking on scones. But there is no clear evidence that the government's campaign has made the difference.

No, there are other, supply and demand, effects at work here. On the demand side, one reason why the UK is eating more fruit is that there are more of us to eat it. The population is growing, and the country is eating more of anything. Much of the population increase is due to immigration, and much of that has been from Africa, the Middle East, and Asia, where people tend to eat more fruit than native Brits because it is cheaper and more accessible: and the habit survives when they migrate here. Another reason is the fact that we are all getting richer, and so we can afford luxuries like imported fruit. No longer need we wait for the short British summer before we can enjoy our fruit.

In the 1950s and 1906s when I was growing up, we always had strawberries on my father's birthday in June. It was the first time of the year that they were available. We gorged ourselves on them, because a few weeks later the season would be over, and we would have to wait almost another year for them to return. But then early strawberries started coming in from Jersey, or they were grown under glass and polythene cloches, and the season extended.

What made the real difference on the supply side, though, was the spread of the jumbo jet. Under its vast cabin lies a vast cargo space. And when you're flying 400 tonnes of aircraft down to Chile, Florida, South Africa or New Zealand, it really costs hardly anything to bring back a tonne or two of blueberries, oranges, mangoes or kiwi fruit in the hold. That made new kinds of exotic fruit available to people who were fed up with Britain's own apples and pears. It meant that soft fruits like strawberries became available all year round. And economic development in places like Chile in particular made fruit production more efficient. So fresh fruit became that much cheaper and more affordable.

The result is that we're enjoying more fruit more often, which must be a good thing. But it's not down to ministers. It's down to the market.

Dr Eamonn Butler is author of The Best Book on the Market (Capstone, 2008)

Across the pond at the Mises Institute, Llewellyn H. Rockwell, Jr. has written a succinct defense of free-market capitalism entitled Everything You Love You Owe to Capitalism. Rockwell argues that:

The whole of our world is covered with lessons about the merit of economic liberty over central planning. Our everyday lives are dominated by the glorious products of the market, which we all gladly take for granted. We can open up our web browsers and tour an electronic civilization that the market created, and note that government never did anything useful at all by comparison.

However, as the size of government and still limited freedoms both sides of the Atlantic shows, the lessons of history have not been heeded. Rockwell puts this down to ignorance, suggesting that most people accept the existence of wealth in one place and poverty in the other as a given.

Using the painfully authentic scenario of a group of self-proclaimed socialists having a luxurious lunch, while criticising capitalism in isolation from their present surroundings. The solution of this ignorance for Rockwell is for economic education. His own elightenment came from reading Henry Hazlitt’s 1946 classic Economics in One Lesson. Still as true as the day it was written.

 

...Especially about the future. Tim Harford points this out in his column in the FT:

There is a simple reason why most economic forecasts are useless, which is that forecasting is hard. We don’t fully understand the underlying economic processes that produce the results we wish to forecast (growth, inflation, house prices), nor can we measure all the variables accurately, nor anticipate the sudden shifts caused by politics or technological change.

Now that is fairly obvious, and it's why economists have predicted successfully nine of the last three recessions. It might also be why I pay so little attention to macroeconomics (no, it's not solely because I can't get my head around the mathematical models) and prefer to assume that if we get the microeconomics of the incentives that people face at least roughly right then theings will pretty much work out OK.

There's a larger point there though: one that Hayek made repeatedly. We simply don't know enough about the economy to be able to plan it: if we can't even forecast growth or inflation, then how can we forecast sufficiently well to be able to plan anything else? The number of houses needed? The technological changes that are going to happen? The demand for sugar? It's simply not possible to do so thus we shouldn't even be trying.

Harford does point out that at least baby steps are being taken though. One major problem with the forecasts is that not only don't they anticipate changes called "structural breaks", a change in technology say which changes the necessary assumptions of the models. Not only do they not anticipate them (and thus make them useless) they fail to even recognise them when they have happened.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

This is an advance: at least we can now say why our model has failed to mimic the real world, even if only after the fact. No doubt in another century or two we'll be able to predict such structural breaks and at that point perhaps planning, perhaps even socialist calculation, might be possible.

So, until 2208 we seem to be stuck with the only useful calculation and planning method we've so far discovered, markets and their interactions. It's good to get these things sorted out for a few lifetimes at a time, isn't it?

I'm an economic optimist. But the news just now does seem pretty awful. Consumers are nervous and spending less. Surveyors say house prices are plummeting faster than any time in the last 30 years (including the 1990s 'negative equity' period). Meanwhile, inflation has hit 3%. The price of manufactures is up 7.5% on the year to April. The pound is sliding, pushing import prices up. Public-sector trade unions are re-asserting themselves as they find that the government's 'generous' 2.5% wage rises don't actually keep abreast of inflation.

Will cheap imports from China continue to help us, though? Well, they've helped get us through a period that should have been a lot rougher than it was. Unfortunately they also helped convince us that the boom was never-ending. But now the Chinese themselves – and residents of other developing countries – are getting wealthier. They want the same computers and clothes that they've been exporting. They are demanding more the world's commodities like timber, steel, and cement, as they build new roads, houses, and factories. The West is finding that commodities and manufactured imports just aren't so cheap any more.

The fact that so many prices are tied to the dollar doesn't help either. US experts think the dollar slide may have bottomed out, but the fact that oil is priced in decrepit dollars is one reason why it's been soaring up from $100 a barrel. Many other wages and prices in developing countries are also tied to the dollar. It's not good inflationary news. And as Hayek tells us, inflation is a real killer because it overwhelms the subtle signals of the price system with a sort of inflationary white noise. Sure, the collapse has been sudden and the financial threats large: so I can see the case for easy money right now, even at the risk of some inflation. But once we all have confidence in the banks again, that inflation will have to be taken under control. The summer of discontent hasn't even started yet.

The cyclone in Burma reminds us of the misery inflicted by human disasters as much as natural ones. The (all too common) human disaster of totalitarian governments leaves people trapped under regimes which think that they know best. They know best how to plan and run the economy, they know best where people should live and what they should do, they know best how people should conduct their personal, cultural and spiritual lives, and they know best how to meet what nature throws at them.

Except they don't. They don't have a thriving economy because, as Hayek showed us, information is over-concentrated at the centre, and decisions are out of date or just inappropriate by the time they get out to the sticks. And they are unable to deal with natural disasters for much the same reason: information is slow to get to the decision-making centre, slow to be processed by the bureaucracy, and slow to get acted on. Economic backwardness, and the fact that capitalism is seen as a threat means that there is less capital – trucks, helicopters, cranes, hospitals, utilities – that can be focused on dealing with natural disasters.

Richer countries, by contrast, can build more strongly, defend themselves from storms, floods and earthquakes more effectively, and repair the damage more quickly. There is more capital to throw at the problem, more decisions are made locally, and more people are willing to get stuck in without waiting for the government to tell them what to do. If you want an example, remember the Hurricane Jeanne in 2004 that killed over 3000 people in poor Haiti but only 5 in rich Florida.

And yet, some people seem determined to compound the misery by keeping poor countries poor – refusing their imports in order to protect our own manufacturers, or demanding that they rein back industrial development in case it pollutes the atmosphere. If you really want to help the planet and the lives and welfare of all who live in it, my prescription would be liberal democracy and free trade. That's the best form of aid we could give to anyone.

With all the bankruptcies in the airline industry over the last few years, companies blame high fuel prices, the war in Iraq, the industrialization of China and India, and several other factors for their difficulties. But Southwest Airlines, based in Dallas, Texas, took a different approach that is paying dividends as oil prices rise. In 2000, the company realized fuel prices could rise dramatically and hedged their gas price.

As Moira Herbst wrote,

For 2008, 70% of its fuel needs are hedged at $51 a barrel. That means that while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that... For 2009, the company is covered about 55% at $51 a barrel; for 2010, 30% at $53 per barrel; and for 2011 and 2012, at more than 15% at $64 and $63 per barrel, respectively.

Although continuing this strategy will prove more expensive as fuel prices continue to go up, Southwest has continued to make profits while other airlines have failed. Former CEO of American discount airline JetBlue David Neeleman hoped to follow a similar strategy, but the company rejected his Idea.

As airlines continue to fail and the number of bankruptcies continues to rise, it is not difficult to imagine the Federal Government following the same path it did in the 1980s with Chrysler and recently with Bear Stearns. But Southwest proves that innovative thinking and sound strategy can carry a company through the most difficult times. Government intervention allow less wise companies to unfairly take away Southwest's business, once again rewarding incompetence and penalizing intelligence.
 

In all the discussion of the American sub-prime mortgage market, few people have pointed out that the US government actually compels banks to make loans to poor people in poor neighbourhoods – regardless of whether those loans are prudent and are likely to be repaid.

It started with the Community Reinvestment Act of 1977, which aimed to support community groups, but in 1995 the Act was extended and beefed up, giving regulators far more powers to punish banks who refused to lend to people in poor urban neighbourhoods – so-called ‘redlining’ – because they considered the risks too high in those particular areas.

Congress's idea, obviously, was to extend to poorer people the same rights and enjoyment of home ownership that the middle-class majority possessed. But in fact it precipitated the banks into giving loans to some rather shaky people. Quite simply, they feared retribution by the regulators if they did not.

As a result, sub-prime loans mushroomed in the late 1990s. Not too bad for as long as the US economy was booming. But booms inevitably burn out and then the banks started to realize the magnitude of their dodgy contracts. And now, the whole world is being sucked into this crisis, and ordinary, prudent bank customers find themselves and their money frighteningly exposed. That's the cost of American political correctness. Thanks, guys.

George Osborne's non-dom tax policy is now in tatters. It wasn't a bad policy, all in all, to make non-domiciled investors stump up a bit of cash to pay for the public services that they enjoy by dint of living here. The proposed burden was modest, and the policy had been tested out on the business community before it was announced. I don't think I would have proposed it (on the ground that the UK needs every investor it can get, and there are plenty of places round the planet who are willing to tear up the tax forms and welcome them in). But nobody really objected too much.

Indeed, it went down pretty well with the general public. Whereupon (unfortunately) Chancellor Alastair Darling thought that he too could stick these rich foreign investors for some cash to help fill his budget deficit – and, in haste to steal Osborne's halo and without any consultation, promptly overdid it.

So now we've had a stream of non-domiciled investors mumbling and grumbling that they might – or will – soon be leaving the country for more agreeable and lower-taxed places, like Bermuda or Switzerland, where policy is less fickle and arbitrary, and where you can plan your business for the longer term. The latest, according to reports, is Brevan Howard, a $22bn investment fund currently based in London's Pall Mall. But that's just the latest of dozens.

So at a stroke, Darling has killed off the UK's hard-won status as a buzzing international investment centre where non-dom enrepreneurs are welcome and left in peace to get on with making money for themselves and, indeed, all those Brits they work with and invest in.

To will back that status, Osborne – when Chancellor – will have to do far more than just promise a somewhat lower rate of tax. Investors' confidence in UK policy has, unfortunately, been shot away by the government's arbitrary, opportunistic attack on them. Osborne will have to say that he'll restore the status quo ante – and sign in blood that it won't change again during his term of office – before the big fund managers will think about returning.