The Pin Factory Blog

I'm at the Mont Pelerin Society meeting in Buenos Aires, where I have been learning about the issues facing the future of freedom in South America. One interesting case is that of Chile, whose military government of the 1980s, perhaps surprisingly, introduced a series of free-market liberal reforms. One of these was to change Chile's hopeless chain-letter pension system – that is, one like ours – into a system based on personal savings accounts.

Overall, the system has been a fantastic success. It gave people choice in how they saved, and incentives to do so. Personal savings in Chile are up from just a few hundred million dollars to tens of trillions of dollars today.

But no system is perfect. Self-employed people were not required to join the system, so many such people saved nothing or little. Young workers often did not bother to contribute, reckoning that retirement was a long way off. Low-paid, temporary workers had patchy saving records. The government guaranteed a minimum pension for those who contributed long-term – which, like the pension credit in the UK, gave many workers no incentive to save much at all. Some retired people drew down their pension benefits too rapidly, and ran out of money.

In 2008, Chile introduced a number of reforms to try to get round these problems. There were new supplements for people with little or nothing saved in their accounts. Wealthier people, and some self-employed persons, are now obliged to participate. Younger workers were given subsidy incentives to join. New rules were introduced to make sure that pensioners did not exhaust their accounts before they died. And there were new requirements on people to buy survivors' and disability insurance.

Will this work? My worry is that two-thirds of all pensioners will now receive some government pension support – which must reduce the incentive to save. Public benefits will comprise half the retirement income of the poorest households. The new survivors' and disability insurance will impose a new financial burden on families, which will eat into their savings. The public benefits will cost a noticeable fraction of the government budget – and paying for them will impose an effective tax, and quite a hefty one, on private pensions.

Chile's pension system was a commonsense breakthrough that many other countries have copied. As a pioneering system, it is not surprising that it threw up some problems to solve. But the solutions, I believe, should have been more in the direction of extending market principles rather than extending government interventions. It will be interesting to see what happens – and it will provide a lesson for us all.

A Sequence of Lines Traced by Five Hundred Individuals from clement valla on Vimeo.

This is an interesting example of why planning, at least centralised planning, has such difficulty in working. If the video doesn't appear here, you can see it here. 500 individuals were asked to trace over a line. But each person got to see only the tracing made by hte person before. So the 100th only saw the 99th, the 300 th the 299 th etc. As you can see, by the end there's almost no connection at all to the original idea of a straight line.

All rather reminiscent of the game of Chinese Whispers ("Telephone" to Americans) where the order "send reinforcements, we're going to advance" becomes, after transmission through a number of phone/radio operators, becomes (allegedly) "send three and fourpence, we're going to a dance".

The analogy to the centralised planning of the economy is obvious. By the time the word has moved from the Prime Minister's sofa, to The Treasury, through the civil service, through the layers of management, of rule making and target setting, to those who actually do things, what was originally said has been lost. This could be how we get outreach diversity advisors for example. The original request "Who can advise me on how to reach out to the diverse people's of the nation" from that Number 10 sofa becomes an employment programme for the dimmer outputs of sociologist factories.

And the lesson is similarly obvious. The things that need to be done should be decided by those close to what needs to be done: localism in short. That this might lead to different things being done in different places should not scare us. After all, what needs to be done might vary from place to place and even if it doesn't, the result will still be better than the doing of what no one wants to be done as a result of the instructions being garbled as above.

Telling everyone what to do from the centre just doesn't work for what is being said never turns out to be what is being heard.

The Efficient Markets Hypothesis is something that drives a certain sort of lefty into a slavering fury. For they take it to mean that we are saying that all markets all the time markets is the most efficient method of organising our socio-economic system. Thus when something like the Great Financial Crisis shows that markets aren't perfect they are able to crow that obviously markets aren't efficient and thus they get to tell us all what to do instead.

However, that's not actually what the efficient markets thing is all about. Rather, it comes in several flavours, the "weak" form of which is an obvious truism. When deciding what prices should be in a market markets are efficient at processing the information about what prices should be in a market. The semi-strong form goes on to say that markets will process all information openly available, the strong form that markets will process all information, publicly available or not.

There is, as you will note, absolutely nothing in this at all that says that organising defence as a market will be efficient, or that there should or should not be a welfare safety net. All that is under discussion is how well markets process information. And we seem to have some really rather strong evidence in favour of the strong form:

We estimate the impact of coups and top-secret coup authorizations on asset prices of partially nationalized multinational companies that stood to bene fit from US-backed coups. Stock returns of highly exposed firms reacted to coup authorizations classi fied as top-secret. The average cumulative abnormal return to a coup authorization was 9% over 4 days for a fully nationalized company, rising to more than 13% over sixteen days. Pre-coup authorizations accounted for a larger share of stock price increases than the actual coup events themselves. There is no effect in the case of the widely publicized, poorly executed Cuban operations, consistent with abnormal returns to coup authorizations reflecting credible private information.

As you can see, market prices reflect what the spies are going to do: something which we would regard as being pretty secret information really. Yet markets do process it efficiently, to the extent that what is still secret about what is going to happen moves markets more than what actually happens when it happens.

Yes, of course, the likely explanation of this is spies and their friends loading up on stocks that will benefit from what they're about to do: insider trading in fact. But that's still strong proof of the strong version of the efficient markets hypothesis: for we don't say that the processing of information by markets must necessarily be moral, just that it's efficient. As insider trading is, even if it's not moral/legal.

As an aside, one joy is that I found this research at Henry Farrell's place, who is a co-blogger at Crooked Timber with John Quiggin. Who has just published a book which uses the Great Financial Crisis to prove that the strong version of the efficient markets hypothesis is obviously and clearly wrong. Should be an interesting conversation between the two of them really.

The Congress of the Communist Party of Cuba has just approved a raft of about 300 reforms aim at loosening up the sclerotic state-directed economy. Cubans will be allowed to buy and sell homes, a million jobs will be cut from government, and more self-employment will be encouraged. Foreign firms will be encouraged to invest in Cuba, and there is a plan to reduce state spending.

The obvious question is "Will it work?" and the answer to that is that it probably will, to some degree. In China and Vietnam the Communist governments chose to keep a tight grip on political power, but to allow considerable economic freedom. In both cases considerable growth and improved living standards have resulted, with the emergence of a substantial middle class which has prospered by taking advantage of the changes.

When a country wants to play 'catch-up' to the modern Western economic model, authoritarian government does not seem to be incompatible with economic progress. Some would argue that once a certain level of economic sophistication has been reached, authoritarian government will act as a damper on progress, but Cuba is nowhere near that stage.

Adam Smith's recipe of "peace, easy taxes, and a tolerable administration of justice" allows for much latitude, and different countries have enjoyed success while treading different roads. In general, the more economic freedom Cuba allows to its citizens seeking to better themselves, the more success they will enjoy. Cuba is full of entrepreneurs who have been forced to deal in the black markets. If the burdens of bureaucracy and taxes are made sufficiently light, and that talent is given opportunities, Cuba could rapidly turn itself into an economic showcase for Latin America.

Of course we could help be looking to investment opportunities there, and by stepping up our trade with Cuba. And the United States could help most of all by lifting the sanctions that do nothing to limit government power in Cuba, but instead help to keep its people impoverished. The best course would be for Cuba to replace Communist dictatorship by a representative democracy. But short of that, the second best is for as much economic liberalization as possible, with growth and prosperity following in its wake.

The English school system is not fit for purpose. The government has concluded that the best way to improve standards is to increase supply. This would increase choice and competition between schools, and address the shortages of supply caused by Britain’s rapid population growth over the past decade. The Free Schools project, introduced by the government in 2010, is the main policy by which the government hopes to achieve an increase in supply. The idea behind Free Schools is a good one, but the restrictive nature of the policy has led to disappointing results so far.

Our new report released today, Profit-Making Free Schools: Unlocking the Potential of England's Proprietorial Schools Sector, takes these problems head-on and assesses the gains that would come from opening up the Free Schools programme to profit-making schools. It looks are the challenges facing the government and the excess capacity currently available in the for-profit schools sector.

In a groundbreaking study, it reviews Ofsted and Independent Schools Inspectorate reports of the profit-making schools sector in detail, and determines that these schools deliver results that are equal to or greater than all independent schools. In other words, there is no evidence that profit damages outcomes. Crucially, this holds true even in profit-making schools that charge fees roughly the same as the state's per student education expenditure. The report concludes that the excess capacity in the profit-making schools sector can be unlocked by liberalizing the requirements for Free Schools. This project has the potential to be this government's most lasting legacy, but for this to happen Free Schools must be given exactly that – freedom. [Key points]

Download report PDF

Will Wilkinson points to an American behavioural economist's hypothesis that the US's compex tax code might be contributing to people living beyond their means:

What are the consequences of knowing our gross yearly income and not much else? I think it causes us to feel richer than we really are and spend accordingly. Why would this be the case? There’s a phenomenon we call the “illusion of money,” which is the idea that we typically pay attention to nominal amounts of money rather than real amounts. For example, the illusion of money means that if inflation is 8%, and you get a 10% raise, you would feel better than if there was no inflation and you got a 3-4% raise. The basic idea is that we pay attention to the nominal amount rather than the purchasing power, and don’t realize what our money is really worth.In terms of our tax code, this suggests that in the US we focus on our gross yearly income, feel richer than we really are, and consequently end up spending more money.

I wouldn't be surprised if a similar phenomenon existed in the UK, thanks to the vagaries of national insurance, inflation and other stealth taxes, albeit to a lesser extent than in the US. This isn't helped by things like the tax credit system, which make things even more confusing and difficult to navigate. PwC says that household debt stands at around 110% of GDP, compared to around 63% of GDP in 1987.

I don't want to overstate the case – I'm sure historically-low interest rates and successive bubbles have a lot to do with this – but it seems likely to me that the complexity of the tax system might have contributed here, especially in terms of high-interest credit card debt, which a lot of people use to tide themselves over to the next pay day.

So, another argument for tax simplification. Maybe not the most important, compared with the disincentive to work that marginal taxation changes create and the cost of compliance that face firms, but it might resonate more with people concerned about the high household debt levels in this country. I'd like to see how household debt breaks down by socioeconomic group – I suspect that groups at the bottom of the pile tend to have a disproportionate amount of high-interest credit card debt. That would be a bad thing, and if it's partially caused by a confusing tax system, it's one that we could fix quite handily.

Greece was bailed out, then Ireland was bailed out, and now Portugal has been bailed out. All of these countries were made to agree fairly stringent deficit and debt reduction packages. All three face years of fiscal tightness, reduced services and living standards, and low economic growth. It is by no means certain that the populations of these democracies will tolerate this for the length of time it will require to put their affairs to rights.

There is an alternative. It is to let these countries default, offering a percentage of the debts' face value as settlement. There would be turmoil. Some bondholders, including European banks, would lose substantial sums. But at the end of it confidence would return and economies start to grow again without that burden of debt.

The decision was made to protect small depositors, bondholders and to some extent bank shareholders, at the expense of taxpayers. It was an unwise decision, both morally and from the point of view of efficiency. One could argue that small depositors were not a party to the causes of the crisis, and should not be made to bear its burdens. Bondholders and shareholders, however, should have known better.

The main argument in favour of default is that it will be effective in putting a line under the crisis. Instead of limping along for years with lacklustre economies struggling to meet debt repayments, the over-indebted countries can get it over with and turn the page.

It looks very much as if the bailout option has been taken to protect the euro and European banks, but it would not be the end of the world if a few countries that should never have been in the single currency have to leave it. And if a few European banks had to restructure, recapitalize or be taken over, this, too, could be survived. Allowing the euro to lose momentum might be a setback to European political union, but this would be no bad thing.

The bailout strategy might keep things going for a while, with more patches to counter the recurring crises. Or we could take the hit now, accept the consequences of folly, and start to rebuild on firmer foundations. It looks increasingly like the better option, especially if there's a bigger storm on the way… 

The OECD’s annual Society at a Glance report was released this week. The TUC’s Touchstone blog had a post up earlier, highlighting the OECD’s claim that economic growth has not reduced poverty:

However, economic growth and poverty have not been strongly related within the OECD in the past generation. There is little evidence of a relationship between poverty and household income growth in either a positive or negative direction. For example, Ireland has had very rapid income growth over the period and a large rise in poverty, while income growth has stagnated in Belgium in combination with a considerable reduction in poverty.

There are a few problems here. The first is the puzzling assertion that Belgium has “stagnated” in the last generation. The OECD’s own figures (XLS file) say that Belgium’s per capita GDP has grown by about 50% since 1980, adjusted for inflation and purchasing power parity ($19,000 approx in 1980 to $30,000 approx in 2010, in 2000 prices). Ireland’s has grown by about 200% ($11,000 to $31,000), but it started from a base about a third smaller than Belgium’s. Belgium’s growth rate was certainly a lot lower than Ireland’s, but they’ve converged on roughly the same point.

A bigger problem is the definition of poverty, which is relative and considered within single countries. It’s quite misleading to claim that Irish economic growth didn’t reduce poverty. The OECD uses a relative definition of poverty – the "percentage of persons living with less than 50% of median equivalised household income". Poor people in Ireland (and Belgium) are a lot less poor than they were thirty years ago with regard to the options they have available to them. The gap between them and the rich might be wider, but this matters less to most people than their life expectancies, economic security levels, and other absolute values. Saying that economic growth made poor people a lot richer but rich people even more rich is quite different to saying that “economic growth and poverty have not been strongly related within the OECD in the past generation”.

But let’s set aside debate over absolute vs relative definitions of poverty and take the relative definition for granted. Why is relative poverty only considered within one country and not globally? Comparing a poor Irish person’s wealth level to a poor Bulgarian person’s wealth level over the last thirty years would give quite a different picture. Maybe, say, Ireland’s economic growth attracted large numbers of immigrants who were still earning far more in Irish “poverty” than in “wealth” in their own country. The figures would show an increase in Ireland’s relative poverty level, even though by any measure everybody was better off than before.

The standard measure of inequality, the Gini coefficient, gives Tanzania and Malawi a more “equal” score than New Zealand and Japan. I know where I’d rather be, rich or poor. The measure of inequality itself is not worthless, but defining poverty as inequality within one country certainly is. By any measure of actual outcomes, economic growth is good for the poor. And if a measure of poverty doesn’t reflect that, it’s a bad measure. 

It's a hard life, I know, but this week I'm in Buenos Aires at a meeting of the Mont Pelerin Society, the association of liberal and free-market scholars, businesspeople, thinktankers, politicians, journalists and others, originally founded by the great FA Hayek in 1947. The focus is on liberty and economic growth in Latin America – neither of which is in very good shape.

The Chilean historian Claudio Veliz suggested some of the reasons for this. The region had 300 years of colonial centralism, he argued, and still carries much of that centralist baggage. With its Spanish roots, it inherited the top-down, authoritarian, civil law system of continental Europe rather than the bottom-up, liberal, common law traditions of Britain. "The widest stretch of water in the world is the English Channel," said Veliz, commenting on this deep and crucial intellectual difference.

Capitalism, as Marx put it, rose from the rubble of feudalism. So the United States benefited from that common law tradition, an individualist, permissive approach driven by and created for the benefit of a rising bourgeoisie of individuals who wanted to trade and prosper without being held back by self-appointed authorities. But by the time Latin America was colonised, the prescriptive legal tradition of continental Europe had taken root among the colonizers. The most it could hope for was the Napoleonic idea of enlightened despotism.

This thesis suggests that countries with such a past could never prosper. But I am not convinced. After all, Latin American countries have been hugely rich in the past. At the beginning of the twentieth century, Argentina was one of the richest countries of the world, not far behind the United States. Venezuela grew rapidly before the Second World War, and continued growing after it to become around 85% as rich as the US in the 1950s. Only then did the rot set in. History and institutions may indeed weight down a country. But such experience shows that, if the conditions are right, ordinary people, entrepreneurs and traders, can turn around almost anywhere. All it needs, as Adam Smith put it, is 'peace, easy taxes, and a tolerable administration of justice'.