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.

How Scotland could flourish by unilaterally keeping the pound

Between 1716 and 1844, Scotland had one of the world’s most stable and robust banking systems. It had no central bank, no lender of last resort, and no bank bailouts. When banks did fail, it was shareholders who were liable for paying back depositors, not taxpayers. Scottish GDP per capita was less than half of England’s in 1750; by the end of the era in 1845 it was nearly the same. Now that George Osborne has ruled out a currency union if Scotland votes for independence, the Scots have an opportunity to return to this system more seamlessly than any other place in the world could.

As I said to the press this week, there’s nothing really stopping Scotland from continuing to use the pound unilaterally. (Unless the remaining UK introduced strict foreign exchange controls, which would be absolutely crazy.)

What the Chancellor’s announcement actually means is that the Bank of England (BoE) would no longer consider Scottish interests when it determines monetary policy and that illiquid Scottish banks would no longer be able to use the BoE as a Lender of Last Resort.

I’m not sure that the first point really matters at all. Scotland’s five million people can’t have much of an influence over the BoE’s policy for the UK’s 63 million people as it is. And, frankly, I’m not sure the BoE knows what it’s doing well enough for it to matter whether it cares about you or not.

The second point is the interesting bit. George Selgin has pointed to research by the Federal Reserve Bank of Atlanta about the Latin American countries that unilaterally use the dollar. Because these countries – Panama, Ecuador and El Salvador – lack a Lender of Last Resort, their banking systems have had to be far more prudent and cautious than most of their neighbours.

Panama, which has used the US Dollar for one hundred years, is the most useful example because it is a relatively rich and stable country. A recent IMF report said that:

By not having a central bank, Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages. The authorities emphasized that these features had contributed to the strength and resilience of the system, which relies on banks holding high levels of liquidity beyond the prudential requirement of 30 percent of short-term deposits.

Panama also lacks any bank reserve requirement rules or deposit insurance. Despite or, more likely, because of these factors, the World Economic Forum’s Global Competitiveness Report ranks Panama seventh in the world for the soundness of its banks.

I suspect that there would also be another upside. Following Walter Bagehot, central banks are only supposed to lend to illiquid banks, not insolvent ones. Yet since the start of the Eurozone crisis the ECB has clearly made significant bond purchases to prop up both insolvent banks and insolvent governments. This may have been a lesser evil than letting them collapse altogether, but it’s hard to say that this kind of moral hazard is not present.

So, given that some countries do survive and even flourish without a central bank, how would Scotland do it?

The basic mechanics, I think, would be this: in a hangover from the old free banking period, Scottish banks currently issue their own banknotes. After independence, they could continue issuing their own notes that entitle the bearer to GBP on demand. BoE pounds, in other words, would be the ‘base money’ that Scottish banks use to back their own private currencies, in the same way gold was used during the last Scottish free banking era.

A banknote from a Scottish bank would be, in effect, a promissory note redeemable on demand in BoE-issued pound sterling. (Scottish notes are already promissory notes, but issuance is closely regulated by the BoE.) Of course, there should be nothing stopping banks from issuing notes redeemable in something else, like US Dollars, gold, Bitcoins, or Tesco Clubcard points. Scottish banks would have to arrange private clearing houses, as they did in the last free banking era, to provide loans to illiquid banks, or they could follow Panama in simply maintaining very high reserves.

No bank would have monopoly privileges: any ‘bank’ could issue notes and it would be up to the market to decide whether to accept them as money or not. As Selgin explains here, banks free to issue their own notes will set their reserve ratios according to people’s demand for money, stabilising nominal spending.

With respect to other regulations, I quote Selgin again:

It is, in any event, desirable that there be no Scottish public authority capable of bailing out insolvent banks and of thereby introducing a moral hazard. Deposit insurance should be resisted for the same reason. Foreign banks should be admitted, by way of branches rather than subsidiaries, and should enjoy the same rights as Scottish banks. (Of course the major “Scottish” banks are themselves no longer really Scottish anyway.) Finally, re-establishing some form of extended liability (though not necessarily unlimited liability) wouldn’t be a bad idea.

We take no position on Scottish independence — it is up to Scottish voters to decide. And while a return to free banking in Scotland may seem fanciful, this week’s announcement makes it much more likely. Keeping the pound and treating it as the ‘specie’ on which banks can base their notes would make the transition virtually seamless for the average Scot, while giving them a banking system that is unrivalled anywhere in the world for being stable, open, and free.

Our reaction to the Autumn Statement

Here were my comments on what I thought were the key points of the Autumn Statement:

  1. Raising the pension age sooner than previously planned will be unpopular, but it is the right thing to do. With an ageing population we will experience a fiscal crisis unless we raise the pensions age and, ultimately, move to a system of private pensions savings accounts so the system is robust to any demographic shifts.
  2. Borrowing has been £111bn in 2013/14, which is equivalent to £304m/day or £12.6m/hour. It’s great that the deficit is falling faster than previously (though not originally) projected, but the numbers are still staggering.
  3. The economy is recovering, but compared to this point in previous recoveries, growth is still sluggish. The Bank of England’s mandate is muddled and should be replaced with a single target to stabilise aggregate demand and return nominal GDP to the level it was growing towards before the financial crisis. This would also offset the effects of government cuts, stopping the cuts from having any negative macroeconomic impact. (Ben Southwood, Head of Macro Policy, comments further below.)
  4. The cap on total welfare spending seems like a PR stunt. It will be modified every year and doesn’t make much sense in any case: what happens if/when negative economic shocks create lots of unexpected unemployment?
  5. The development budget was heralded, but the best tool for development is letting in more immigrants from poor countries, because immigrants send money home – indeed, they sent 3 times as much money to poor countries as was sent in total official aid last year. And this is good for our economy too.
  6. It’s bizarre to give LIBOR fines to charities. It simply makes no sense. What’s the connection between LIBOR and military charities?
  7. The pensions triple lock is about buying votes. Many pensioners don’t need more money and there is no real reason to redistribute wealth to them over other groups in society.
  8. Help to Buy and other expanded mortgage subsidies completely miss the cause of expensive housing. If more houses are built (increasing supply) then prices will fall. This will happen if we liberalise the planning system. Throwing money at the housing market will drive prices up and do little to increase supply. Rolling the Green Belt back by one mile would free up enough land to build one million new homes.
  9. Corporation tax is a terrible tax and, though the government’s cuts are welcome, it should be abolished altogether. Corporation tax largely falls on workers’ wages and as such it is an invisible and regressive tax on earnings.
  10. The Chancellor’s confirmation that the personal allowance will rise to £10,000 is good news, but the government should go further and peg it to the minimum wage rate to reduce the tax burden on the working poor and help to make work pay.
  11. Cutting employers’ National Insurance contributions for workers under 21 is a good move and highlights the cost of employer NICs to jobs. Employer NICs are a jobs tax and the government should be aiming to abolish them altogether.
  12. Ultimately, there was no mention of reform to planning, immigration or monetary policy – the three things most important to Britain’s economic prospects. The Chancellor has done a good job at balancing the books but he should look to making significant structural reforms that would really get the country booming: liberalising planning to allow hundreds of thousands of extra homes to be built; scrapping the net migration cap to allow talented immigrants to work here and fee-paying foreign students to study here; and giving the Bank of England a new mandate to target Nominal GDP to ensure a stable macroeconomic environment.

Ben Southwood, Head of Macro Policy at the Institute, also commented:

“It’s understandable, now that the economy looks finally to be recovering, that the chancellor has moved his focus away from monetary policy, but it’s also worrying.

“Economies can absorb financial crises but they cannot absorb inconsistent monetary policy and massive drops in demand. We need George Osborne to change the Bank of England’s remit, requiring it to stabilise demand according to strict rules.

“A rule-based monetary policy will stop the economy from overheating into unsustainable booms, and dive-bombing into harsh recessions.”

Mark Carney bottles it with baby steps

Mark Carney had the leeway to make radical change here but he’s bottled it with baby steps.

The ‘Carney rule’, promising low interest rates and the possibility of more quantitative easing (QE) until unemployment is low or inflation rises, is definitely an improvement on the current regime. It gives firms clearer guidance on the future stance of policy, removing some of the uncertainty in the world economy today. I expect it to deal with some of today’s demand shortage, and more importantly tomorrow’s expected demand shortage.

But unemployment and inflation come from both aggregate demand (which the bank can control) and aggregate supply (which it has essentially no control over). Since neither of these numbers distinguish between changes in supply or demand, the Bank is still fumbling in the dark with its guesses over whether a change in inflation comes from demand (which means it should react) or supply (which means it shouldn’t). This means firms are still left guessing, and it means that uncertainty still reigns.

What we really need is a truly rule-based system that takes discretion away from nine ‘wise men’ and uses market forecasts to create real stability. That system is nominal income targeting.

Welcome Mark Carney, now here’s what you need to do

Today Mark Carney becomes the new governor of the Bank of England, gaining oversight not only of UK monetary policy, but also financial regulation, as part of the Bank’s newly-expanded responsibilites. When George Osborne revealed he had managed to persuade Carney to take on the role there was great fanfare and excitement. This was firstly because the Canadian economy has performed relatively well through the recession and secondly because Carney has shown himself open to innovations in central banking, though he has not implemented any in his time at the helm of the Bank of Canada.

Carney talked up the benefits of targeting the level of demand in the economy—though only for exceptional times—in a recent speech. And one would expect that the chancellor, for the £870,000 he has agreed to pay Carney, is open to significant change, notwithstanding the insignificance of the minuscule changes he himself made to the BoE’s remit in the budget. Put together, these facts give cause for some optimism for someone like me, who supports targeting the level of demand.

So instead of speculating on what the superstar economist actually will do, I will outline the basics of what Mark Carney should—and could do:

I.  Target levels instead of rates—this means bygones are not expected to be treated as bygones, and market actors do not worry about worse-than-expected outcomes because the central bank has committed to sorting them out

II. Target NGDP (demand) instead of inflation—this means supply moves don’t lead to the wrong sorts of tightening or loosening of monetary policy, also means demand is stabilised directly, instead of an arbitrary part of the outcome of demand; stable demand means no recessions caused by nominal factors and no unsustainable booms

III. Target the forecast instead of the outcome—this is what matters for expectations, which are basically all that matters for employment contracts, loan/debt contracts, investment etc. etc. Expectations are the key, so it’s insane to ignore them

IV. Target market, not internal forecasts—set up an NGDP-linked bond, like the RPI-linked bond, and target the spread between the vanilla bond and the linked bond to get an objective idea of where to aim. Guesses where people have skin in the game are systematically better than the relatively costless estimates produced by private consultancies and the Bank’s internal team. But even if they’re wrong it doesn’t matter because expectations are all that count, and the spread between the bonds IS the market expectation. Driving that to a particular point is success, regardless of what happens.

In general the road ahead must be one of rules and discipline, not the translucent discretion of nine unelected barons.They must keep demand steady so we can focus on improving the supply capacity of the economy, and so there is no excuse for fiscal stimulus, with all its flaws. If you still need convincing, read Scott Sumner’s 2011 Adam Smith Institute monograph “The Case for NGDP Targeting”.