Should the government play the markets?

A recent report from the National Audit Office found that the government could have made £750m more from the sale of Royal Mail if it had sold at the highest price the shares reached on its first day. This has led many to blame the government for selling off the family silver at the bottom of the market. Others have pointed outthat the reason for privatising Royal Mail was to subject it to the disciplines of the market, not to raise money. And that no one knows in advance what a share will be worth. Grey markets undervalued the share as well—and of course some advisers said it would rise higher, just as others said it wouldn’t. Perhaps government politicking prior to the sale caused some of the problems. In any case, the value has not disappeared, it has just been distributed differently. There may be weak reasons to question the profile of the distribution (e.g. will it be spent more progressively or efficiently by government?) but realistically we’re talking a small amount of the budget and bear in mind that investors who ordered more than £10,000 of shares were shut out completely.

But one interesting angle is whether this is like Gordon Brown’s gold “sell-off” of 1999-2002. As everyone remembers, Brown, as chancellor of the exchequer, sold off the government’s gold at what turned out to be the bottom of the market, losing out on potential gains easily ten times more than available with Royal Mail. He is widely criticised for this, but I can’t quite see why. I can’t think of any good reason why the government should hold any assets whatsoever. On top of this, there are at least four reasons why the state should not hold any specific assets:

1. The government is not well placed to play asset markets. So there’s an interesting question as to whether the government should hold net wealth. Maybe there are shocks where easy sources of income will evaporate and the government will need to instantly liquidate some assets in order to pay its normal bills, defend the country against external aggressors, enforce the law etc. This might suggest the government needs to hold net wealth. But we know that even very smart and knowledgeable fund managers with all the right incentives only consistently outperform the market due to luck. So what would make us think, outside of one issue I’ll deal with later, that the government’s agents, so universally derided for competence in most contexts, could succeed in this either impossible or just really really really hard task? The UK government’s Royal Mail and gold holdings were vastly out of proportion to those assets’ size in relation to all wealth. If the government wants to hold wealth we know that it should hold a low cost exchange-tracker, as broad-based as possible. Otherwise it will effectively be handing over taxpayer wealth to traders in the markets.

2. Playing asset markets may directly distort those markets. If governments hold given assets (e.g. Royal Mail shares or gold) then it might be because there are social welfare reasons for doing so. It’s at least possible that people have the specific desire for the equity of companies to not be held privately or to be held by the state and this something worth at least factoring in. When it comes to gold then individuals might be glad the government has it as a backstop. And of course the state could just be holding these assets on behalf of its citizens, perhaps because there are economies of scale in so doing. Even if there aren’t benefits to the state holding assets on behalf of citizens, individuals may take these holdings into account as if they were their own, thus causing only small inefficiencies. But I take most of these considerations to be of minuscule empirical importance. Mainly the government’s holdings of assets cannot be justified by these reasons. But since the market will be influenced by their holdings, they will reduce the supply of certain sorts of assets for the market to hold, leading to price shifts and portfolio rebalancing. Since this will be away from the ideal portfolio firms would have held (I can imagine exceptions but none of them are relevant here) this reduces social welfare.

3. Government holding assets means they’re unlikely to be used with allocative efficiency. This depends on some of the considerations in 2, but again they’re very very unlikely to have empirically large impacts. By contrast, there are probably some very empirically large impacts from the fact that few of the government’s assets—totting up to about £600bn, according to a recent ASI report—are ever marketed. As we know from Friedrich A. Hayek’s most important work, market pricing is how we rationally allocate resources in society. This was why Hayek and Ludwig von Mises won the socialist calculation debate as even noted Marxist G.A. Cohen agreed. What this means for assets is that we don’t know whether they are properly used unless we trade for them. An illustration: if the government sold off all its army barracks the army might then rent the selfsame barracks from their private owners. But it’s possible that they would rent somewhere else, and someone might set up a factory or a farm or a theme park on the original site. Without the market competition process we have no idea what would happen and we have no idea what the best use of the land and buildings would be. This applies to big nebulous assets like Royal Mail just as it applies to land and as it applies to gold.

4. If the government holds assets it may have incentives that distort its policy-making decisions. Why does the UK have such an appallingly tight planning regime even though basically all economists think it’s extremely inefficient and damaging? It’s probably because lots of people own houses and these groups tend to be disproportionately likely to vote and are otherwise politically well-connected. If these groups rented their house and owned the same amount of wealth spread across a wide range of assets it’s very unlikely we’d see such economically unjustifiable policies. The same goes, potentially, for government-held assets. After all, the government will be blamed not to mention having less ability to achieve its policy goals if assets it holds lose value. It’s not so much that they’re likely to directly pursue policies designed to boost the value of state assets. But acts of commission are treated differently to those of omission. It seems highly likely that the government will treat policy changes that affect these particular assets’ value differently, just like housing.

So maybe the government should hold some wealth, I can see the arguments for and I can imagine some arguments against. But if it holds wealth it ought hold assets as broadly as possible: because it’s not placed to take gambles on particular assets; because doing so may distort markets directly; because holding assets takes them off the market and reduces allocative efficiency; and because holding particular assets may distort the incentives facing policymakers. Thus we should praise Gordon Brown for selling off gold just as we should praise Vince Cable and George Osborne for selling off the Royal Mail.

There was no British housing bubble

Marcus Nunes graphed the Housing Stock to Population ratio in the US recently, showing that housing reached something like a steady-state in the US from the mid-1980s onwards. As Philip Stephens says, “The constructing in US housing was exactly what was needed to maintain the housing-population ratio in the face of increased population growth. You cannot have an “unsustainable boom” without oversupply.”

This is what the UK looked like over this period (my thanks to Daniel Knowles for the data):

The long-term trend (black dotted line) is attributable to the tendency in recent decades to smaller households, but what’s interesting is that, not only was there no spike in the run-up to 2008, the growth of dwellings over population actually fell below the trend. This is not what we would expect to see if there had been a bubble in housing production.

Dwellings data is a little bit unreliable, though – splitting a house into two flats creates an extra dwelling – so it might be better to look at the amount of new houses that were actually built. Here’s a chart showing the number of residential construction permits granted over the past forty years:

And here’s the ratio of new residential construction permits over population across the same period:

These charts show that housing construction was actually well below historical levels in the 1990s and 2000s, both in absolute terms and relative to population. It is difficult to see how someone could claim that the 2008 bust was caused by too many resources flowing toward housing and subsequently needing time to reallocate if there was no bubble in housing to begin with.

What this suggests is that the Austrian story about the crisis may be wrong in the UK (and, if Nunes’s graphs are right, the US as well). The Hayek-Mises story of boom and bust is not just about rises in the price of housing: it is about malinvestments, or distortions to the structure of production, that come about when relative prices are distorted by credit expansion.

What did cause the crisis? Jeffrey Friedman has shown that bank regulation (most notably, the Basel accords) was one of the major factors that led to the financial crisis, and Robert Hetzel has outlined a convincing theory that central bankers’ tightening of monetary policy in early-to-mid 2008 was the overriding cause of the world’s economic collapse. There is also the possibility that financial investment in the housing market was a simple error.

I was once convinced that the Mises-Hayek story about the boom and bust was true, but the evidence does not seem to bear this out.

Update: A lot of people seem to be implying that Austrian Business Cycle Theory (ABCT) means: Easy money -> high prices (“bubble”) -> bubble burst, people lose money. This is incorrect. ABCT relies on distortions to the structure of production (that is, the “real” economy) which have to be liquidated over a period of time following the point at which it becomes clear that they are not good investments. If a ‘bubble’ just meant that people had lost money it would not cause a long-running recession, it would just mean that overnight a lot of people had lost money (like a stock market crash). The reason the recession takes time according to the ABCT is that resources have been invested in a sector where price signals take a considerable amount of time to adjust after a credit-induced malinvestment bubble and so it takes a while for people to determine which investments are ‘mal’.

In short: There may have been a price bubble in British housing market, but there was not the production bubble that ABCT predicts.

PS: I am interested in seeing these data for countries like Ireland and Spain, where the Austrian story may be more valid. It is also possible, as Anton Howes has pointed out, that a regional breakdown would show that there were bubble-like expansions in housing supply in certain parts of the UK, which the country-wide figures hide. If you have these data please let me know, either in the comments or by emailing me at sam@adamsmith.org.

Demand Matters

Markets are about supply and demand. Scarcely a more banal thing could be said in economics, and yet some of the time it seems like free-market economists look only at supply. Glance over policy recommendations from a free-marketeer and you’ll often see only tools for freeing up supply—labour market deregulation, planning reform, a bonfire of the quangos, an end to unbalancing subsidies or tax breaks, liberalisation of trade barriers. These are all fantastic things, which we definitely need. And even through the visor of the AS/AD model, even in a slump, these can make things better both by cutting prices and by raising wealth. But either deliberately or unconsciously, these economists are completely avoiding the demand side.

Is this because there are no doctrinaire libertarian things that can be done on the demand side? I’ve certainly heard many policies like quantitative easing called “socialism” by fellow travellers, but I’d like to think that my libertarian-leaning friends were more thoughtful than instinctively dismissing ideas they see as ideologically impure out of hand.

And further than that, there are things we can do to make the demand side more libertarian, at least if we don’t make the perfect the enemy of the good. School voucher systems are not decried for their “socialism” by libertarians despite the fact that under these systems schools are still paid for and run by the state. Monetary policies that are more free market (and more sensible) than our current one should be looked upon in the same way. It’s not the case that anything short of abolishing the central bank is “socialism”—unless we want to completely devalue the word. And even if an intermediate policy were a form of “socialism” or “central planning”, the realistic alternative is not a free market in money, but an abysmal central plan!

What are these intermediate policies that free-marketeers seem to be ignoring? Firstly there is nominal income targeting, which relies on markets both to stabilise demand and to allocate that demand among competing industries according to consumer preferences; and secondly counter-cyclical taxes, which rise automatically in good times and fall in bad times. Those are both thoroughly libertarian and entirely focused on demand.

In fact, the two most important libertarian economists of the 20th century—Friedrich A. Hayek and Milton Friedman—both endorsed demand-side policy, in the right circumstances. Friedman blamed the US Great Depression on the Federal Reserve, allowing a massive collapse in the money supply and aggregate demand. Hayek said that after the inevitable collapse of a misallocated capital structure there could also be “secondary deflations”, where aggregate demand collapses and there is a costly adjustment period. Both would support monetary policy to deal with this issue—stabilising demand, so as to avoid painful adjustments from big inflationary or deflationary shocks. If money is non-neutral in the boom, why would it be neutral in the downturn?

One response libertarians might make is that Say’s Law shows there is nothing we can do about demand. But Say’s Law clearly doesn’t hold in the short-run, and Austrian economists who rightly critique the assumptions economists often make about equilibria should be absolutely clear of this. In the short-run, a dip in aggregate demand—absent any response from the government, central bank, or hypothetical free banks working together—necessitates a period of deflation. But we know that (at least nominal) wages are sticky-downwards, meaning that calling for an adjustment to the new equilibrium means calling for years of the grave evil of unemployment foisted on millions. Say’s Law reasserts itself in the medium- to long-run, and by then the misery and destruction of potential wealth has all already happened.

What libertarians are missing is that the relentless focus on supply is leaving them almost completely out of the conversation, and thus leading to worse policy than necessary. If free marketeers were talking about the best things to do on the demand side, as well as on the supply side, then there would be less of the all-eggs-in-one-basket big project spending stimulus, and more diverse market-oriented ways of countering the demand shortfall.

Kick the ‘wise men’ out of the Bank of England

In today’s City AM, newly-minted ASI fellow Lars Christensen (aka The Market Monetarist) writes on the ‘Carney rule’. The Carney announcement is a tiny step in the right direction, he says, but as long as the ‘wise men’ of the Monetary Policy Committee are running monetary policy, policy will be erratic and unpredictable, preventing adequate planning by firms and adding to market panic in economic downturns. Instead, we should have a strict rules-based system of nominal GDP targeting:

A much better rule would have been to commit to stabilising the level of nominal GDP (NGDP), a measure of aggregate demand, keeping market expectations of NGDP growth on a 4 or 5 per cent growth path. This should be combined with an open-ended commitment to expanding the money base to hit this target. This would avoid the nitty-gritty of the Carney Rule and be clearer and easier to communicate to markets.

Monetary policy based on the discretion of “wise men” leads to market uncertainty and panicky jolts as investors react to tiny changes in central bankers’ pronouncements. Replacing the MPC with rules-based policy would bring discipline and predictability to the Bank of England far beyond what was outlined yesterday.

I would prefer to have no Bank of England at all, with money emerging from the market as outlined by Hayek in 1976. Having said that, perfect is not the enemy of good — replacing the discretion of ‘experts’ with predictable, market-led rules would be a huge step in the right direction. If Carney’s new rule fails, it may come on to the agenda sooner than we think.

Milton Friedman on the Negative Income Tax

Milton Friedman was born 101 years ago today. The video above isn’t as snappy as many of the great Friedman videos online, but I like it because it shows the kind of libertarian Friedman was. Instead of dismissing any policy that fell short of abolishing the state as ‘socialism’, he came up with innovative and practicable steps towards a freer and richer world. His policy proposals are still relevant and fresh (unlike many of FA Hayek’s, for instance) — as a replacement for existing welfare, a Negative Income Tax today could liberate people from the benefits trap. Daniel Hannan’s piece on Friedman and school vouchers — another idea as fresh and important today as it was when he first proposed it — is well worth reading too.