Adam Smith Institute

At last, after four months of dithering, the UK government has finally decided to nationalize the failed bank, Northern Rock. To their credit, and as if to show how far they have grown from their Old Labour roots, they declare that this nationalization will be "temporary". But as the economist Milton Friedman once noted, "Nothing is more permanent than a temporary government programme".

This particular temporary measure may indeed last a lot longer than the government intends. It's going to be very difficult for the government to extract itself from this business. The new boss that they have put in charge – Ron Sandler, who has appeared at Adam Smith Institute seminars on financial-services regulation – is, it seems, not being paid £1m a ayear to stabilize the bank and quietly return it to the private sector. On the contrary, he says he intends the Rock to "compete vigorously" with the other banks and mortgage lenders.

Right: so the government is going to be running an enterprise which aims to take on, and take business from, the private sector. Until recently the Rock had a fifth of the mortgage business, so it remains a potentially big player that the government's got hold of. And that's not good: London's reputation as a financial market has rested on the fact that governments have let the market get on with it and do not interfere in the running of particular firms.

The government says that nationaization is good for the taxpayer (though estimates suggest that the process could cost us each £3,500). But it's not good for the existing shareholders, who threaten the government with court action over their 'theft' of the bank. The government will brush off these gadflies – but they will be buzzing around, irritating ministers, for years.

There will be even less joy for ministers when they see a bank that they control evicting people and repossessing their homes because (thanks to the credit crunch) they can't pay their mortages. The press will have a field day with that.

If I were a minister now, I think I'd be stepping down and planning my career in the City.

40. "The free market does not work in practice because there is no such thing as perfect competition or perfect information."

The free market needs neither perfect competition nor perfect information. It works on the basis of what there is. Textbooks might talk of such things, and they might be used to make pretty equations and graphs, but they have nothing to do with the real world.

In the market place there is competition all the time. Sellers are competing to sell products at different prices, and buyers are bidding to buy them. When supply is abundant, sellers might have to undercut each other to get their goods sold. When goods are in short supply, customers might find themselves bidding against each other to obtain them. This goes on constantly, changing from day to day and even from moment to moment as new information emerges. None of this has anything to do with perfection. It is a continual process in which available information is acted upon. It does not have to be perfect; all it has to be is better.

Textbook economists might talk of 'equilibrium prices' at which supply matches demand, but no-one has ever seen such a thing in the real world. On the contrary, prices are changing constantly and vary at different times between different types of seller and between different locations.

Some people take the 'imperfection' of markets as a signal to advocate central planning and state direction. They want intelligent minds to supersede the confusing jumble of market interactions and impose a rational order on things. But there is no such thing as perfect planning either, and attempts to plan economies have proved laughably inferior. They have less information, less motivation, and are less responsive. Comparing the record of free markets, imperfect as they are, with planned economies and their imperfections, one sees the market economies winning hand over fist.

Anatole Kaletsky's take on the Northern Rock nationalization in yesterday's Times was spot-on:

Nationalisation... made sense only as a necessary legal stepping-stone to the orderly liquidation that Northern Rock required as soon as it ran out of money in September... To use nationalisation to keep the bank in business and its staff in state-subsidised employment would be a travesty of all the economic principles that “new” Labour has claimed to believe in.

His final paragraph is particularly telling:

All in all, what Mr Darling announced yesterday was a financial and political disaster of almost unimaginable proportions. The Northern Rock saga did not end yesterday; the fiasco has only just started, with the Government now officially in charge.

39. "Even though people are richer on average, they are no happier, so we should stop pursuing economic growth."

Surveys show roughly the same proportion of happy people as there were 20 years ago when standards of living were lower. From this Lord Layard and others conclude that economic growth does not bring happiness and that we should aim for a simpler, more equal society rather than for a wealthier one.

There are things that can be said about wealth brought by economic growth. It makes more opportunities available. At some levels it can remove unnecessary sources of unhappiness such as disease and starvation. It can make it easier to achieve goals, or to lead a more varied and fulfilling life.

Surveys about happiness also show that people say they are happier when they feel their circumstances are improving. They are less likely to profess happiness in a wealthy society that is static than in a less rich society which is advancing. It is the improvement which counts, not the actual level. Jefferson rightly pointed to "the pursuit of happiness" rather than to any given level of it.

Humans are not the sort to enjoy static contentment. They seek challenges and the thrill of achievement. The peaceful calm of the Lotos Eaters is not for them, and neither are the sheep-pen and the secure pasture. Those who think of happiness as needs satisfied fail to spot that those needs include challenge and change. Humans are aspirational, seeking much more than the provision of necessities. Better a human dissatisfied than a pig satisfied.

It is not up to economic commentators to say what levels of wealth and achievement people are to be allowed to make them happy enough. People themselves will determine the limits, if any. To achieve a society in which more people are happy, far from curbing economic growth, we will aim at one which affords its citizens opportunities for advancement.

32. "The fact that capitalism is in crisis is shown by the constant shifts from boom to bust."

Critics point to stock market and financial volatility as evidence of a "crisis of capitalism." In fact capitalism is always adjusting to new trends and reacting to new events, sometimes sharply, sometimes gradually.

Capitalism goes through business cycles. When confidence is high the market booms, but sometimes business contracts and consolidates. Despite the fluctuations of these periodic swings, there has been a steady growth rate, averaging about 2 percent per annum for over a century. Even the Great Depression of the 1930s failed to deflect the trend of that long-term average.

The business cycle's troughs and peaks are not a crisis of capitalism. Capitalism has shown itself well able to survive these cycles. Despite them, society gets steadily richer, and living standards rise as wealth diffuses through all classes.

Governments have distorted these cycles by manipulating the economy for electoral advantage. They have flooded money and credit into the economy ahead of an election to stimulate a short-term boom and gain support from the feeling of prosperity this induces. This has produced economic dislocation and inflation which had to be squeezed out later with attendant unemployment.

In recent years independent central banks have tried to smooth the business cycle's severities by combining the pursuit of sound money with making credit easier when an economic downturn loomed. It has been a precarious act which cannot necessarily be sustained, but this is not a crisis of capitalism either. It might just be problems arising from one type of financial management.

Capitalism itself is resilient. It adjusts, it survives. Its dynamism contrasts sharply with the rigidity of the planed economies, their consistent failure to deliver the goods, and their ultimate collapse. If people are free to invest in new production, to innovate and seek new markets, the resultant economy shows remarkable ability to survive the periodic shocks it encounters. 

28. "A small rise in inflation is a legitimate price to pay for reducing or eliminating unemployment."

There is no trade-off between the two. A "small" rise in inflation means that the government is creating false demand, and sending false signals about the real cost of investment. Making more money available pushes down the cost of borrowing. It also steals from people by making money worth less than it was, reducing the real value of their savings, and it therefore discourages thrift.

There is over-investment in producer goods as a result of the false demand. This does indeed create temporary jobs, jobs which will be lost as soon as the money which sustains them stops being pumped in. Furthermore, the loss in everyone's purchasing power which results from the inflation means that jobs are lost in the wider private sector because people can afford fewer of its goods and services.

Governments tried in the past to sustain the job expansion by increasing the rate of inflation. All this did was to postpone the day of reckoning for a little while. The "small" inflation does not lead to a reduction in unemployment on any permanent basis. What it does lead to is a larger and larger rate of inflation as government struggles to ride the tiger.

When hyper-inflation comes and the squeeze is applied, all of the "new" jobs are lost, together with many more as the economy plunges into recession. It actually happened in Britain, as in other countries.

The point is that inflation, even at modest rates, distorts the economic process with false signals, and leads to investment in areas where there is not the genuine demand to justify it. The real way to reduce unemployment is to achieve honest money that holds it value and the right conditions for enterprise. Then genuine economic growth will create the new jobs.

27. "Free market capitalism simply cannot meet society's welfare needs."

Strictly speaking, it is not supposed to. It is a method of social and financial organization that allies itself to the individual motivations which help determine human action. It does do two very important things, however.

In the first place it creates the wealth that allows for welfare provision. Under a free economy people in society can become rich enough to afford higher levels of care for those in need. They may do this through charitable organizations, or they may do it collectively through government. Non-capitalist economies tend to achieve poorer results, and cannot usually afford so high a level of provision.

Secondly, the free economy itself reduces the need for welfare by a variety of market provisions. Recognizing the demand, people respond with insurance policies, health plans and pension schemes, all of which reduce the need for welfare. By encouraging people to make their own provision wherever possible, the free economy reduces the need for state welfare. Self-provided welfare can usually be tailored more closely to each individual's circumstances, whereas collective provision is often provided on standardized levels based on what are perceived as average needs.

Paradoxically, it can be the state welfare system which makes people dependent upon it. It takes the funds to support its provision which people might otherwise have used to pay for their own. In other words, high taxes make people no longer capable of providing for their own welfare. Two-thirds of those receiving benefits in Britain actually pay more in direct and indirect taxation than they receive back from the state.

Furthermore, state services crowd out private choices for many people. Private education, healthcare and pensions compete with state options which are 'free' at the point of consumption. Private alternatives charge fees, but compete with state services which do not (because they have been paid for through taxation). This severely restricts their availability and accessibility for most people.

24. "A market economy offers people no more than a crass, materialistic life."

What market economies offer are choices and opportunities. They allow people to acquire the wealth that brings new things within reach. In some cases these will indeed be material things. If a person can become sufficiently well off to afford decent housing, enough to eat, adequate clothing and shoes, these are all better than their absence.

But a market economy brings more. It allows people to buy the things that make life more rewarding. They can enjoy music, communicate more readily with each other, travel to places previously out of reach. These, too, are the result of material things. They do not represent a crass materialism, however, because they give the chance to improve life's social interactions and its mind-broadening opportunities. It might take material objects to enjoy music and to visit exotic places, but a person with access to them does not lead a crass life in consequence.

Even beyond the personal possessions that can add to life's experiences, the wealth created by a market economy enables people to afford better services such as health an education. It enables them to enrich their surroundings with fine architecture. Better education opens doors to life's opportunities, and good health brings the possibility of activities such as sports and hobbies. They require material goods to become possible, but the opportunities they offer are far from materialistic.

Wealth is a tool. It enables the holder to trade it for the things they value. Some might indeed use it to acquire more possessions; it is their choice. For others it might be for enjoyment of the arts, the theatre and the concert hall. Some might seek satisfaction in beautiful objects such as antiques of works of art. The wealth created by economic growth gives access to all of these, and it allows us to express our personality by the choices we make.

22. "The free market is unfair because we do not all have equal votes as we do in a democracy."

The argument is that people with more resources unfairly have more market power than others, whereas in a democracy everyone counts equally. We would think it absurd if everyone voted on what kind of MP3 player people should have, and everyone received the one which gained the majority vote; yet this is how democracies work.

In a market we can all choose what type of MP3 player we want, and receive the one we choose, even if it is not the one preferred by a majority. This makes the market a source of greater freedom than a democracy. In a democracy we have to settle for the majority choice on a large package of issue taken together. In a market we can pick and choose to satisfy our preferences on individual items. We can take Apple for some products and Sony for others. We cannot in our government choose different parties for different policy areas.

People do not have the same buying power. Some people can offer goods and services worth more than those of other people. Older people might have more savings or command higher salaries than younger people. Those with more education and skills might become wealthier than others as a result, and the same applies to those with special talents, such as footballers, musicians, or entrepreneurs.

It means that some people can afford more or better goods and services in their market choices. This is because they offer more valuable service to others, and it is what spurs others to try and do likewise. If the rewards were allocated by equal votes, a majority could vote themselves a large share of the total, and make entrepreneurial activity no longer worthwhile. The economy would stagnate and no-one would benefit. This is not the kind of "fairness" that is worth having.

Dan Lewis of the Economic Research Council makes some good points about recession worries in the Yorkshire Post. The last time we were in this pickle, he says, was 2001 - but the then Chancellor of the Exchequer, Gordon Brown, had a full Treasury thanks to a long period of growth initiated by the Conservatives, and he used it to ride out the trough.

Fast forward to 2008, however, and we find ourselves in exactly the reverse position. Brown simply failed to turn off the public expenditure taps, so we have a budget deficit of 3.1 per cent of GDP – inexcusable after 15 years of growth. What this means is that there's just no money for a Keynesian expansion this time to stave off recession. Just a few days ago, we found out from the Office for National Statistics, that net borrowing in the financial year to December was running at £43.6bn – a staggering £11bn increase on the year before. 

It's worse than even that, Dan. By 2001, the UK's postwar economy - centralized, state controlled, bureaucratic, high-tax inflation-ridden - had been largely opened up to market forces by Mrs Thatcher's reforms. Lower taxes and greater growth enabled the national debt to be reduced. But now, after ten years of Gordon Brown, there's even more top-down centralization, business is strangled and controlled by a spaghetti of regulation, civil-servants intervene everywhere, taxes have risen hugely and inflation is on the way up.

Lewis might well be right that the UK can avoid a recession - two quarters of negative growth - and I hope he is. But I wouldn't start from here.

13, "We should create public sector jobs to boost employment."

There are no public resources, except those which government takes away from its citizens. If government is to spend money on projects, this means that private citizens are deprived of those funds.

Government can appear to create jobs by means of public spending. They can enter the market as purchaser for certain projects, and see new jobs apparently created in response. These new jobs owe their existence to that government demand, and many depend on it for their continuation, in that unless the spending continues at that level, the new jobs may disappear.

Government funds such projects by taking funds from the private sector, either by open taxation, by stealth taxes, by borrowing, or even through inflation. Either way, it takes away the funds which sustained jobs in the private sector. People have less to spend on the goods and services of private business; they have less available to invest in it. This means that temporary, government-created jobs are at the expense of real, lasting jobs in the private sector.

Furthermore, government commands goods and services inefficiently. It costs more for government to perform many deeds than it does for private business to do the same. This is because government bureaucracy is often more cumbersome and more costly. Lacking competition, there is no pressure to make it efficient.

Government-created jobs are often capital intensive, such as infrastructure jobs in road or bridge-building, and use a great deal of costly equipment for each person employed. By contrast, the luxuries foregone when the private sector is subjected to extra taxation tend to be in labour-intensive service areas such as dining out, hairdressing, etc.

The effect is to ensure that more jobs are destroyed than can be created. The problem is that political leaders are usually praised for the visible new jobs, without being blamed for those which quietly disappear from the private sector.

12. "Brands are basically a con to make people pay higher prices for goods than they merit."

A famous brand usually commands a higher price than the unbranded competitor, but there's a reason for that. In the absence of personal knowledge of the seller, such as you might get in a local economy, the brand serves as the label of trust. Because people have had good quality and value from the brand, they can count on it. The producer values the reputation for excellence because it brings customers back for more, and brings in new ones.

The brand thus has commercial value. It is like a seal of quality, indicating to customers what they can expect and rely on. This is the basic reason why they are advertised and why, incidentally, they are counterfeited. A producer of dubious quality goods can try to palm them off by stealing the name and reputation of the famous brand.

There is more to brands. Their advertising often conveys images that people associate with the brand, so that consumers buy the association as well as the brand itself plus its reputation. In developing countries certain brands of Scotch whisky are regarded as 'aspirational,' advertised as linked with success. Consumers are buying more than the whisky; they are expressing an association with success and a determination to succeed themselves. These so-called 'intangibles' are not to be sneered at. They are among the most durable of consumer goods. The feeling of aspiration might be remembered long after the whisky, together with its attendant hangover, have been forgotten.

The teenager, trying to express an identity independent of parents, can choose brands associated with qualities that he or she feels illustrate the character that they are or want to be. Brands can thus serve to project an identity and to declare something about a person. People pay the premium because these things are worth paying for.

11. "The stock market is just a casino."

People back stocks and shares like they bet on roulette numbers and sometimes they win, sometimes they lose. This is why some call it a casino, but the reality is different. Firstly, the outcome of a roulette wheel is random. The outcome of the stock market is not. It is influenced by many factors, including the state of world politics, investor psychology, actions of banks and governments, accidents of nature, human actions, and global economic trends, to name but a few. Skilled investors might read trends and work out which ones count, and calculate which stocks are likely to rise, which to fall. This is not true in a casino.

There is a more serious difference. The stock market helps to finance business and industry. When a firm issues stock, people buy it in the hope of gaining dividends from its profits, and of seeing the value of their investment increase as the company prospers. The shareholders are co-owners of the company, and their fate is bound in with its own. If it makes money, so do they. When people buy stock from others and drive up the price, they do so because they think it is or will be worth more than the share price suggests. When a firm's shares rise in this way, the nominal value of the company increases accordingly, and it becomes easier, and usually cheaper, for it to obtain finance for development and expansion.

The stock market resembles a town market, in that people are clamouring to buy and sell, and prices reflect the fact that some shares are popular and some less so. It thus sends signals about where investment is needed and where it can be most profitably applied. It tells people from moment to moment the state of the economy, and where they might usefully participate in it.

One of the hugely annoying things about the "debate" over the Laffer Curve is that there are still those who deny the very existence of the concept. Something which is absurd, for at the extremes it's a simple mathematical truism. At times (say, a 100% tax rate) reducing taxes will increase revenues collected. The strongest Laffer Curve argument, that reducing tax rates always increases total revenues collected (reducing a tax rate from 50% to zero say) is as similarly incorrect as the denial that reductions ever do.

The true argument is always about at which tax rate do we increase revenues, at which reduce? This argument being complicated by the fact that we have several different effects going on, depending on which tax we're talking about (effects on capital and labour taxation will be different, given different mobilities) and so on. Perhaps the most important point to make though is that cuts (or rises) in tax rates will not work in a linear manner. Amounts raised will vary dynamically.

But what is surprising in this latest working paper from the IMF is quite how low a tax rate can go and still show Laffer effects: not just a dynamic response to the lower rate, but more revenue collected both in total and as a percentage of GDP:

To illustrate the potential effects of tax rate cuts on tax revenues consider the example of Russia. Russia introduced a flat 13 percent personal income tax rate, replacing the three tiered, 12, 20 and 30 percent previous rates (as detailed in Ivanova, Keen and Klemm, 2005). The tax exempt income was also increased, further decreasing the tax burden. Considering social tax reforms enacted at the same time, tax rates were cut substantially for most taxpayers. However, personal income tax (PIT) revenues have increased significantly: 46 percent in nominal and 26 percent real terms during the next year. Even more interesting PIT revenues have increased from 2.4 percent to 2.9 percent of GDP—a more than 20 percent increase relative to GDP. PIT revenues continued to increase to 3.3 percent during the next year, representing a further 14 percent gain relative to GDP.

Yes, there really is a Laffer Curve, and its effects can be seen at much lower tax rates than those we currently tend to think they can be. It might also be worth noting that, as with the ASI's own proposals for a flat tax, the heavily increased personal allowance raised (yes, raised, not lowered) the progressivity of the tax system as a whole.

More revenue, greater progressivity and lower tax rates. Well, why does anyone oppose such a system? 

8. "Big business only cares about profits."

The implication of this is that everything else is ignored or over-ridden in their reckless and immoral pursuit of profit. It's not even close to the truth. The fact is that business is carried out by business-people who have the same moral constraints on them that other people do. Indeed, because of the nature of their activity, they have rather more.

Business isn't about swindling people or tricking them into parting with what they can ill afford for something they don't want. On the contrary, the business-person gives them goods and services they'd rather have than the money. In return they give up something the business-person would rather have – the money. Both parties gain from the transaction. The overwhelming majority of business-people engage in honest, even honourable activities.

Business activity is based on trust, in that the buyer trusts the seller to deliver the goods, and that they will be of the expected quality, while the seller trusts the buyer to pay for them as agreed.

Of course business seeks profits; that's the point of it. But if it seeks to maximize short-term gains by sacrificing quality and integrity, it's in trouble, and it knows it. Businesses gain new customers and repeat customers by their reputation for fair dealing. It's a long-term strategy to build up and sustain trust. It's against a firm's interest to short-change its customers or fob them off with shoddy goods. Its reputation and its trade will soon suffer.

Big business cannot meet its customers face to face as a small trader can to build up a relationship of trust. This is why it is more important for big businesses to protect their reputation and their brands; it stands in the place of the personal knowledge that characterizes small firms. Business cares not just about profit, but also about keeping its good name.