The Pin Factory Blog

Just over six months into the Coalition Government – much disliked in the Westminster village but more popular outside it – some welcome economic stability has been achieved.

The 10-year gilt yield – currently at 3.6% - is well down on the figure at the May General Election. And, in the meantime, the eurozone has had a torrid time. But 2011 will be challenging for the UK economy – to achieve a 2% growth rate next year will not be easy. In particular, the decision to raise VAT to 20% is bound to impact retail sales. Furthermore, the disarray in the eurozone will hit exports. High job losses - many directly due to the Comprehensive Spending Review (CSR) - will also hold back retail sales.

Undoubtedly, the Christmas ‘like-for-like’ trading figures of the major retail chains will be carefully scrutinised. Many, especially outside the food sector, are expected to report lacklustre sales – a scenario that is unlikely to improve in early 2011. All this negative news would slow down the Government’s efforts, through the CSR, to reduce Public Sector Net Debt (PSND). The latest cost-cutting initiative hits straight at local government through a substantially reduced level of grant – a policy that should be unequivocably applauded.

For decades, much of local government and many public bodies have been desperately inefficient – the scope for savings is formidable. Salaries, too, at the highest levels need to be cut sharply. 

The Government will also be disappointed that bank shares remain weak. Having ‘invested’ a quite staggering £45.5 billion in Royal Bank of Scotland - for whose unparalleled plight no-one is apparently being held accountable – it is unlikely that any substantial sell-down of the Government’s 83% stake will be feasible in 2011. Currently, the ‘investment’ is over £8 billion ‘underwater.’

2011 will be very testing. Is the Coalition strong enough to hold its nerve?

Most market sympathisers know that lower are overall taxes, the smaller is government and the higher are living standards, but for support they concentrate on statistical evidence such as the adverse relationship between economic growth and the level of overall taxes. This evidence is very strong, but an underlying theory showing WHY this is the case would make it far stronger.

Naturally such a theory exists, but it is little known nowadays outside Adam Smith aficionados and the Austrian School of Economics to which both Ludwig von Mises and F. A. Hayek belonged. Even then, I have yet to see a simple and arresting explanation. In The Constitution of Liberty, Hayek refers to the effects of taxation, including “the frequent restriction or reduction of the division of labour”. The Institute of Directors’ Graeme Leach refers to the “deadweight loss” as the loss of output that would have occurred in the absence of the tax – a loss of economic welfare above and beyond the tax revenues collected.

These observations are absolutely correct, but it is probably fair to say that they do not describe in layman’s terms the simple mechanism at work. We must remember what we are up against in the shape of government and the public sector in general (including many schoolteachers and lecturers); the last thing they want is to have their cover blown.

It is nothing short of a scandal that generally respected commentators can still promote government spending as a major plank in getting out of the current recession when (in addition to the fact that such spending was a major plank in creating the recession) it will inevitably reduce output even further. Such a level of ignorance could not possibly exist were it not for the state’s iron grip on the education system via a nationalised school system including a national curriculum. And you certainly won’t find a mention of the topic on the website of the “National School of Government”, the Civil Service training college.

Read the whole article.

Peter Wilby writes a broadly convincing argument in TES against taking the Pisa results too seriously. As the former editor of the New Statesman suggests, comparisons can be misleading. A few potential sampling errors are pointed to, some more convincing than others, but whatever the merit of each, overall his thesis is persuasive. For anyone familiar with the fallibilities of the sciences, none of this should come as too much of a surprise.

Mr Wilby is hoist by his own petard, though. After much sound reasoning he ends by using the Pisa results to attack the US and neoliberalism. Quite why he does this after everything written before is surprising to say the least. I think as a rule one should try not to contradict oneself in the same article, while contradictions between articles should always be forgiven. After all, people have been known to change their minds.

Yet Mr Wilby’s point stands. With headlines and policy cobbled together from some tentative results, it would have been much better if these tests had not received so much attention, or perhaps not taken place at all. Like so much public policy, education has lurched from one failed silver bullet to the next. Today it is teachers’ qualifications, while yesterday it was class sizes. The behemoth of the state is tying itself in a knot, leaving no room for innovation. That governments still have such a uniform model of education within its borders is a sign of how stilted things are – Pisa is a sign of how far we have to go.

Rather than rely on the tentative, much better to build upon surer ground. There can be no doubting that the private sector does stuff better and cheaper than government run and regulated stuff – therefore, in education we should keep government to an absolute minimum, only interfering when we can be as certain as we can be that we are not making things worse.

John Redwood MP has asked a series of parliamentary questions to see how well the coalition government is doing with its 'one in, one out' policy on regulation, and put the results on his blog. As the table below shows, things could be going better:

I'm reminded of one of my favourite Bastiat quotes: "Government, a vast, organized, living body, naturally tends to grow. It feels cramped within its supervisory mission. By now, its growth is hardly possible without a succession of encroachments upon the field of individual rights."

The trouble is that deregulating is much more difficult than regulating, which is why I've never been convinced that the 'one in, one out' idea would prove a particularly good one. Regulation is a serious business, and dealing with it requires a proper strategy.

Our 2005 paper Deregulation, by Tim Ambler and Keith Boyfield, proposed a nine-point strategy for fighting the regulatory state. For each main source of regulation (the EU, Whitehall, the Regulatory Agencies) you should first stem the flow of new regulation, then cut the burden of existing regulation, then try to minimize compliance and enforcement costs.

A recent McKinsey report suggested another sensible approach: review regulation sector-by-sector, and then eliminate any barriers to competition, productivity, and growth.

Done properly, deregulation should be a win-win for politicians: it will boost growth and cut the cost of the state. But it doesn't happen by itself – a real, long-term concentrated effort is needed if deregulation is going to get anywhere. Will this government succeed where so many before it have failed?

Eamonn has a piece in the Wall Street Journal Europe today on our report 'On Borrowed Time', released last month, which poses a stark choice: between Britain's AAA credit rating (and the economic stability that this implies) and the welfare state in its current form. The quadruple timebombs of pensions, welfare, education and healthcare will, as the population gets older, balloon in size, ultimately bankrupting the country:

Britain has managed to preserve its AAA credit rating during the world financial crisis, but its luck will run out unless it gets to grips with the spiralling costs of its welfare state. Its obligations to future pensioners, the cost of free medical care to an aging population and scores of other state benefits are imposing a growing burden that Britain's next generation may prove unable to afford. It might take 10 or 20 years to get to that point, according to analyst Miles Saltiel in his report "On Borrowed Time," published by the Adam Smith Institute. But there is every prospect of Britain then facing a fiscal crisis that will make Ireland's woes appear insignificant by comparison.

The trouble is that Britain's national debt, which the Treasury expects to peak at about 70% of GDP in 2013-2014, does not tell the whole story. Indeed it barely tells half the story. Alongside those strictly financial obligations to its creditors, Britain has also promised itself a huge raft of social benefits that it hopes its children will be good enough to pay for. And like someone ordering an expense-account lunch, it has inclined to be generous with other people's money.

Some of the prognosis is terrifying but all is not lost – yet. Read the whole thing.

Boris Johnson was on great form yesterday reminding all the more-progressive-than-thou Europhiles about their snooty disdain for Eurosceptics during the 1990s over the EMU. Those of us who pointed out that the eurozone was never an optimal currency area were mocked as nationalists and retrogressives who blamed the EU for every problem. Now, as Boris has pointed out, the euro has been exposed as a shambolic political project and its sidelined critics have been proved right. Even people like Barry Eichengreen, who loudly supported the euro project, have recanted. The whole issue is analogous with another element of monetary policy where outsiders are routinely mocked – money and banking in general, the outsiders being the Austrian school economists.

The Austrians – who generally favour either free banking or gold-backed 100% reserve banking – are usually ignored. The Austrians, like the eurosceptics, disagree with the new way of running the money supply: where previously interest rates were set by the loanable funds market as a function of the number of people lending and the number borrowing, now they are set initially by central banks. Under the old system, investment in one area could only happen if savings were made in another – so the lending and borrowing system accurately reflected where resources were being applied in the real economy. In the new system, artificially-low interest rates create a combination of excess consumption fuelled by borrowing and excess investment – again, fuelled by borrowing. This is unsustainable and leads to bubbles, which ultimately burst.

This perspective is logically and empirically robust. That is not to say that it is necessarily correct – far smarter people than I have rejected it – but those who are convinced by it are ignored and mocked by the political establishment (and often the academic establishment too). How often have you heard a politician wringing his hands about the absence of a coherent explanation for the financial crisis? They’re apparently unaware that the Austrian school gives a rather good one. So too for the journalists who paint Chicago school monetarism as the ‘free market’ school of monetary policy.

The same mockery that faced sceptics of the euro now faces Austrian sceptics of the central banking system. The new sceptics should learn from the old sceptics’ vindication, as well as the old saying: First they ignore you, then they laugh at you, then they fight you, then you win.

Over Christmas many readers won't have time to visit the blog every day, but would still like to keep up to date with the blog. There are three simple ways you can do this.

1) Following us on Twitter. You can find us at @adamsmithinst.

2) Liking us on Facebook.

3) Subscribing to our RSS feed. This is a little more complicated than the above if you don't already use a feed reader like Google Reader, but there's a pretty good guide to using Google Reader here. This is how I keep up to date with the blog when I'm away and is a good way to read a whole post without having to click through.

Of course, all of these are already in the sidebar on the left but they tend to blend into the scenery of the site. We'll be continuing to post throughout the Christmas period so be sure to follow us in some form while you enjoy the festive season!

Update: Ampers has posted an alternative guide to RSS in the comments which might be easier to follow. Well worth a read.

Forest, the lobby group which defends the right to smoke, has put together the above video criticizing the EU's proposals to try to disrupt smokers' lives by banning cigarette displays in shops and, incredibly, introduce plain packaging rules to cigarettes. The question of whether you enjoy smoking or not is irrelevant – what matters is that adults are allowed to make their own decisions without meddling from the government. Unfortunately the EU seems to have no regard for civil liberties – their consultation document, outlining the arguments for and against smoking restrictions, doesn't mention these concerns at all.

The video features Eamonn Butler and other liberal voices, and is linked up with Forest's petition against the EU measures here.

As the coalition government slogs through the quagmire of implementing its goal of deficit reduction, a timely report from McKinsey Global Institute underscores the urgency of the mission.

In short, McKinsey argues that the past three decades featured a decline in the investment rate of mature economies, leading to the decline in real interest rates that fed the global credit bubble. They’re now forecasting a “potentially enormous wave of capital investment” driven by emerging markets and putting “sustained upward pressure” on interest rates.

It’s that prospect of generally higher rates that makes cutting the UK’s budget deficit so critical. At the risk of some over-simplification, it can be argued that the nation’s current government and personal debt load has been largely due to funding pre-mature consumption rather than long-term investment. Feel-good government programs, unfunded pension obligations, over-priced houses, glitzy kitchens, flash cars and exotic holidays were all bought on tick.

The McKinsey study doesn’t make specific forecasts of precisely when and by how much rates will start to rise. It does suggest, though, that, if real interest rates return to their average since the early 1970s, then a rise of 150 basis points would be in order. And they reckon that the rise in long-term rates may start within five years as investors start to price in this long-term structural shift.

Broadly, that timetable is in line with the UK government’s schedule of deficit reduction. To avoid spiralling debt service costs from the forecast rise in interest rates, it must not be deflected from its strategy, even as its impact turns ugly on the streets. And it would be smart to borrow long now while rates are still low.

Paying off the bill soon for past consumption excesses, whether government or personal, would leave the UK well-positioned to benefit from McKinsey’s anticipated “wave of capital investment.” It’s a tough world out there but the UK has formidable business expertise in engineering, architecture, infrastructure, communications, legal and financial services, food processing, agriculture, biotechnology, education, retailing, mining and oil & gas.

A mature and ageing economy like Britain’s has little alternative than to reduce domestic over-consumption and to increase under-investment in foreign growth opportunities.