Adam Smith Institute

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.

7. "True socialism has never been tried."

Neither has 'true' capitalism. If it was capitalism that has been tried in capitalist countries, then it was socialism that was tried in socialist ones. We compare like with like. Either we talk about the record of both capitalism and socialism in the real world, with all its compromises and imperfections, or we talk about some theoretical ideal of what each might be, if only the world and the people in it were different.

Too often would-be socialists want to compare capitalism in practice with some idea they have of what a socialist utopia might be like. The truth is that socialism was tried in many countries in different forms and had a deplorable record in all of them. It was characterized by suffering, shortages and the suppression of human freedom. In most cases it was accompanied by mass murder.

This is no accident of a revolution betrayed, but an inherent flaw in the idea itself. It seeks to make men and women into something they are not and do not want to be. It seeks to make them conform to the socialist's vision of what he or she thinks they ought to be. Since real men and women are self-motivated and have their own desires and preferences, in a socialist state they must be forced to behave differently. Compulsion is thus at the very core of socialism.

Capitalism, with its free markets and free choices has, for all its warts, proved more successful, more efficient and more humane. It delivers the goods far better than do socialist economies, and it manages to do so while allowing a far greater range of freedoms. It goes with political freedoms, free media and freedom of association, employment and travel, all of which are denied in socialist countries.

5. "Prices of essential goods should be controlled so that the poor can afford them."

Price caps are one of those things that sound fine in theory but are disastrous in practice. Prices are signals which tell about supply and demand, like the markings on a thermometer tell about temperature. And just as you can't control temperature by bunging up a thermometer, you can't control supply or demand by fixing prices.

When the price rises for scarce goods, it tells people to consume less and maybe switch to alternatives. It tells others to produce more of them because there are profits to be made. The combination of less consumption and greater production acts to redress the scarcity. But it only works if prices can send their signals. If they are fixed by law to shield poorer people from their effects, there is no disincentive to consume, nor any reason to switch to alternatives. Nor is there any incentive for producers to bring more of the goods to market.

If the price of bread is fixed because of rising prices in a shortage, there is no incentive for people to turn to alternatives like other grains or potatoes. Nor is there any incentive for farmers to bring more wheat to market, or for foreign merchants to bring in their wheat to take advantage of the greater returns. There is no signal telling farmers they could profit by planting more wheat next year.

All that happens when prices are fixed by law is that the supply dries up, usually because no-one can make money by selling at the fixed price. Then the state steps in again to ration the scarce goods "fairly", and passes new laws to stop black market dealing in them. We see this happen for bread, fuel, and rented accommodation. Ultimately, the outcome is clear: if you fix the price, you only succeed in choking off the supply and making the shortage even worse.

A really rather interesting result here. Various of the Great and Good are asked what they changed their minds upon over the couse of 2007. Daniel Kahneman says:

The most dramatic result is that when the entire range of human living standards is considered, the effects of income on a measure of life satisfaction (the "ladder of life") are not small at all.  We had thought income effects are small because we were looking within countries.  The GDP differences between countries are enormous, and highly predictive of differences in life satisfaction.  In a sample of over 130,000 people from 126 countries, the correlation between the life satisfaction of individuals and the GDP of the country in which they live was over .40 – an exceptionally high value in social science.

The positional competition may not be doing you any good directly, but if it raises national GDP, it will indirectly help you, and everyone else in the country.

Another snippet from this fascinating upcoming book, Power and Plenty:

Buringh and van Zabden show that European book production rose at roughly 1% per annum between the sixth and eighteenth centuries, from an annual production of roughly 120 manuscripts over the course of the sixth century to the 20 million books printed in 1790. 

The thing that leaps out at me is the incredible power of compounding: we often hear that we should give up this or that little bit of economic growth on this or that grounds, but in the long term that slowing of growth is extremely expensive, look what just 1% leads to.

Another illuminating little exercise is to look at, say, the effects of the Greenland ice cap melting. According to the IPCC this is booked in for sometime after 2500 AD if we don't change our ways. If we assume current trend growth rate (2.75% say...and always asuming that I've used this calculator correctly, no certain thing) then people in 493 years time will be 643,342 (and a bit) times richer than we are. If it is true that the rich should pay for global warming then shouldn't it be those in the future, those more than half a million times richer than we are?

There may be trouble brewing for some microbreweries! A worldwide shortage of hops is starting to make its mark on the price of beer. The cost of some hops, the ingredient that gives beer its distinctive flavour, has quadrupled in price over recent years.

A whole host of factors are behind the current price rise: poor crops, bad weather, and most of all lower prices. All of which has led to a decrease in supply. This is a perfect example of supply and demand economics in action. The price fluctuations that the consumer sees are a reflection of a market that is free.

The price of hops had fallen in recent years due to over production and low demand from breweries. This meant that many producers left the market to grow other more profitable crops, such as cherries and apples. But then as hop production fell, beer had a resurgence in popularity. While the big companies have insulated themselves from this through futures contracts the microbreweries have been left to fight it out over the remainder. It’s all very apparent from the global hop acreage figures, which have fallen from 236,000 acres in 1992 to 123,000 in 2006.

Hops then wouldn't be a bad investment for the farmers of South East England. Unfortunately it takes three years for a hop field to produce, so in the meantime beer drinkers are going to face slightly different tasting and higher priced beers. And unfortunately for some microbreweries, they may go out of business, especially if the taste of their beers is not able to match up to the price.

One of the perks of this wonk land stuff is being sent books before their publication date so that we terribly important people can tell you what to think about them before you read them. As with the upcoming "Power and Plenty" which bills itself as an economic history of the past thousand years. I found it fascinating and it'll provide me with all sorts of wondrous arguments to deploy in times to come, some of which I'll sketch out in the next few days here (no, don't worry, I'm not going to try a comprehensive review of such a complex book in a blog post).

One of the things I like about it is the way that little factoids pop up which explain, make clear in a simple manner, quite complex situations. At one point we're told that the Mongols commanded the services of 50% of the world's horses. At a time when the animal was both the transport to the battlefield and the tank equivalent once there this rather explains some of their success, doesn't it? Another is

...the number of operative hours to process 100 lb of cotton was over 50,000 for spinning by hand in India. In England it was cut to only 2,000 by the 1779 invention of Crompton's mule, and fell to 300 by 1795 and 135 by 1825, compared with 40 in 1972.... 

That after two centuries only 0.1% or less of the man hours are required to do the same thing as before rather explains why our cupboards are filled with a multiplicity of clothes while our forefathers had, if they were lucky, two outfits, daily and Sunday best.

The excellent point is also made that such technological advance really rather required international trade: without it, the domestic market would quickly have become flooded and the economies of scale would never have appeared. 

Paul Krugman makes a point about the US mortgage market :

The WSJ reports that homeowners whose mortgages are bigger than their houses are worth are starting to walk away from their houses, even if they could afford the mortgage payments.

This will have some Brits, those with memories of the early 90s and negative equity, rather scratching their heads, for you can't walk away here. If you owe more than the house is worth and it is sold, or foreclosed upon, you still owe the bank that gap. This is something that is generally not true in the US: most mortgages are non-recourse (and thus Jingle Mail: posting the keys back to the bank and loading up the pick up truck). That is, they are secured against solely the property, there is no recourse to the general income of the borrower nor other of their assets (this is subject to a number of qualifications, it depends State by State and usually is only true for primary mortgages).

What this means in the grander scheme of things is that what happened to consumer spending in the UK in those 90s is not a good guide to what might happen to it in the US in the coming year or two as the bubble unravels. Similarly, given that it is the lender that has to eat such losses in the US, nor is what happened to the banks here. We can also take this a stage further and point out that whatever happens in the US in the coming year or two will not be a good guide to what might happen here if there is a large fall in house prices.

I agree this is a slightly geeky point but watch out for those commentators who fail to grasp it: the differences in the mortgage contracts are sufficiently large that the effects of negative equity upon consumer spending (and thus the wider economy) could be wildly different. 

According to reports in yesterday's Financial Times, the government are finally going to heed our advice and put the Tote (the state-owned betting company) up for auction. As we have consistently argued, from our influential 2004 report At Odds With Taxpayers to the present day, this is the only fair and straightforward method of finding out what the Tote is actually worth, and getting good value on the sale for UK taxpayers.

The government's original plan was to simply sell the Tote to the racing industry and the Tote's management at a knockdown price - "for the good of racing". However, the ASI challenged the government through a formal complaint to the European Commission's Competition Directorate, which twice ruled that the government's backroom deal with the racing industry would constitute an illegal use of state aid.

In any case, the racing industry and the Tote's management have only managed to muster £330 million, well short of the £400 million valuation placed on the Tote by PWC, the accountancy firm.

However, if the Treasury now goes ahead and auctions off the Tote, the price realised may be north of £500 million, according to our City sources. That is good news for UK taxpayers, and good news for racing too - since the government plans to give something back for 'the good of racing'.

However, it is worth remembering that horse racing as a sport and business has never been more prosperous. It would be far better to put the revenue raised towards cutting some taxes and maintaining some sports grounds, so that British kids can get some more exercise.

The Prime Minister still likes to crow over making the Bank of England independent when he was chancellor. He is keen to take credit for every success, but when the fan gets clogged his McCavity alter ego is assumed. In any case, recent occurrences have shown the Bank's independence to be purely cosmetic: they are culpable when inflation targets are missed, but when they try to avoid moral hazard by not bailing out Northern Rock, the Treasury takes over.

What the Northern Rock debacle has illustrated is the weakness of Brown's tripartite system of financial regulation (divide and rule) where the boundaries are blurred and the Treasury maintains close control. This kind of regulation is a feature of the government's approach to everything from the NHS to quangos – and it doesn't work. Everyone who is anyone in the City knew Northern Rock was in trouble months before it collapsed through the most normal of banking failures: borrowing short and lending long. Why did the situation get so out of hand?

Another failing was highlighted by the Bank of England's decision not to inject liquidity into the markets over the summer, as the European Central Bank and the US Federal Reserve chose to. As James Harding put it in The Times:

Was this because it was not sufficiently in touch with the financial markets? Was it because the Financial Services Authority knew what was needed but, under Gordon Brown’s model of tripartite regulation, did not have the authority to make it happen? Was it because the Bank is mandated to meet inflation targets but, unlike the Fed, does not have an equal responsibility for nurturing growth?