The Pin Factory Blog

Despite owing around £1 trillion in public sector net debt (PSND), the Government seems determined to plough ahead with the HS2 (High Speed Rail 2) project, which seeks eventually to build a new high-speed rail route between London and Scotland. Its three Phases are projected to cost at least £50 billion. Most focus currently lies on Phase 1, which aims to provide a high-speed route between London Euston and the West Midlands. The length will be c128 miles and the estimated cost c£17 billion. Whilst there is a consultation process underway, no public enquiry is planned: Royal Assent for the Hybrid Bill is anticipated in early 2015.

The economic justification for HS2 is weak – very weak. Even assuming the aggressive passenger growth projections until 2033 of the project’s promoters, it is very difficult to see how a commercial return can be generated. After all, HS2’s projected capital costs per mile of Phase 1 greatly exceed that of other EU countries – the Financial Times has calculated a multiple of some 4x. And, of course, cost and time over-runs are very likely.

By 2032/33, the construction of Phase 2 is due for completion. This segment of the high-speed rail extends the line from the West Midlands in a Y-configured shape to take in both Manchester and Leeds.

So weak is HS2’s commercial case that the government’s recent consultation document sought to emphasise its non-commercial benefits, such as narrowing the North/South divide. The DfT stated ‘It is those non-monetised benefits which underpin the strategic case for high-speed rail’. The environmental case is even weaker. No material carbon emission benefits can be expected until the Scottish section – if it is ever built – is commissioned, perhaps in three decades time.

In driving ahead HS2, the Government should publish a full financial model, with cost of capital assumptions and revenue sensitivities, so that the real costs – and risks – of HS2 become clearer.

I’ve not yet had the chance to read all 214 pages of the Independent Commission on Banking’s interim review, which was published yesterday. But going by initial impressions, I’m not convinced that their main proposal – requiring banks to ring-fence and separately capitalize their ‘retail’ (as opposed to ‘investment’) operations – deals with the fundamental problems in the banking sector.

Basically, the big problem is that the government effectively subsidizes bank risk-taking by guaranteeing (implicitly or explicitly) that banks cannot go bust. That gives shareholders (whose liability is already limited) an increased appetite for risk, and means they are unlikely to impose any restraints on bank activity. It also means banks can borrow far more cheaply than other corporations, and that its bondholders are unlikely to pay much attention to what is being done with their money. Finally, it means that depositors pay no attention to the stability of the institution they are entrusting with all their hard-earned cash. In short, government guarantees mean there is no market discipline to keep bank risk-taking in check.

Governments then inadvertently compound this problem by setting 'risk-weighted' capital and liquidity requirements. This is intended to offset the problem created by government guarantees by created minimum ‘safety standards’. In fact, these requirements tend to have two unintended, harmful effects. Firstly, they basically involve regulators setting a single cost for various risks. This drives market concentration – in order to comply with the regulations, everyone goes for the same investments at the same time, ensuring that the risks, should they materialize, are systemic. Secondly, these regulations create a strong incentive towards regulatory arbitrage – banks investing in order to ‘game’ the regulations. As well as perverting the allocation of capital, this creates opacity in the market, which also increases the potential for systemic risk.

In short, despite best intentions, government intervention first encourages banks to take more risk, and then ensures that those risks are likely to be both systemic and opaque. It is a recipe for disaster.

On that basis, I’d argue that banking reform should have two key aims. Firstly, it should ensure that banks can fail without triggering a wider financial and economic crisis. In doing this, the reform should make clear to market actors that banks will be allowed to fail if they get themselves into trouble. Secondly, reform should ensure that regulation does not distort capital allocation or drive market concentration.

The Commission’s proposals deserve a more in-depth assessment against these principles than a blog post will allow, but it does seem clear to me that the interim report released yesterday provides – at best – no more than a partial solution to the banking system’s problems.

In the latest of a never-ending stream of moans about UK government budget “cuts”, the Royal College of Nursing warns of looming reductions in front-line staff with the inevitable but unproven danger of a “catastrophic” effect on care.

This is a knee-jerk defence used by all vested interests which confuse the way something is produced with the purpose of the production. The purpose of the NHS is not to maintain a set level of employment; it is to improve the health of its patients.

Progress is meeting a demand for better quality goods and services at lower cost. Throughout history, that has usually meant less labour.

In ancient Egypt, tens of thousands toiled for generations to erect the pyramids but now it only takes a couple of years for a few hundred tradesmen to build the Shard skyscraper, complete with lights, elevators and air conditioning. A single farmer today feeds hundreds whereas a century or so ago his entire (large) family was often barely able to feed itself. A modern factory uses a fraction of the labour now to produce cars that are cleaner, safer and more comfortable than ever.

There’s nothing to suggest that the various government services now on offer shouldn’t be subject to the same historical forces.

The Adam Smith Institute’s latest report, The Case for NGDP Targeting (PDF) by US economist Scott Sumner, argues that that the Bank of England’s inflation targeting regime was proved inadequate by the Great Recession, and should be replaced. Instead of targeting inflation, the Bank of England should target nominal gross domestic product (NGDP). This is sometimes referred to as nominal income targeting.

In making his case, Sumner argues that:

(1) Inflation targeting is flawed because it depends on inflation indices like the Consumer Prices Index. However, such indices are easily swayed by factors such as exchange rates and sales taxes – which may not require a monetary response. Moreover, inflation indices frequently misprice (or overlook altogether) housing. These issues, inter alia, make inflation indices unreliable as a primary target for monetary policy.

(2) NGDP targeting works because it addresses the dual concerns of macroeconomic policy – inflation and growth – with a single policy target. This prevents the policy incoherence and confusion associated with dual mandates. While it is technically true that the Bank of England’s Monetary Policy Committee has a single mandate (inflation) it is clear to most observers that they are also conducting monetary policy with a strong view to supporting the wider economy. An explicit NGDP target would be more transparent and increase the accountability of the central bank. [Continue reading]

If you run a think-tank you are well used to getting densely-typed or hand-written letters, in which the author proclaims some ingeniously simply idea that will solve all the country's (and probably the world's) economic and political problems. They often come with diagrams, and yes, the use of green ink is surprisingly common among this genre.

Obviously I don't want to be thought part of the green-ink brigade, but maybe there is indeed one pretty simple idea that would solve – well, not all, but a fair number of our problems. It struck me as I was writing my new guide to Milton Friedman, who very much supported it – the simple rule that governments should not be allowed to borrow, nor run up long-term debts for future generations.

For a very long time, it has seemed perfectly natural that governments could and should borrow – to finance expensive wars or infrastructure projects, for example. Keynesian economists saw the occasional deficit as an important way of managing the economy. But once you give politicians the power to borrow, a huge moral hazard arises. It becomes just too tempting, and too easy, to borrow for the purposes of current consumption, rather than future benefit. More expensive schools, rising healthcare standards, more generous pensions, more police, social workers and officials, even bailing out the banks – all can be packaged as an 'investment' in the future. But in fact the principal beneficiaries are we today, who enjoy all these improvements. The losers are the next generation who find themselves bearing the cost.

Gordon Brown, when UK Chancellor, announced the intention to balance the government's budget 'over the economic cycle' and to borrow 'only to invest'. Unfortunately, as I say, much of his 'investment' was in fact simple spending, paid for by borrowing. And since it is not easy to define a 'cycle', we found him moving the goalposts when the books didn't balance. Nor did the rules survive their first major text, the financial crisis.

If governments had to balance their books, the pressure to overspend would be greatly reduced, and more minds would be concentrated on thinking about what government was really there to do, and about the nasty business of how to pay for it without passing the bill on to our children. And the rule should be a definite one – say, that the books have to balance at the end of every five-year period, not over some vague 'cycle'. OK, it may not save the world, exactly; but it would produce much more responsible and honest government.

There are still those who refuse to believe that the Laffer Curve can possibly exist: despite it being simply a mathematical identity, something that simply is true, by definition.

Leaving aside those ignorants, all of the interesting discussion comes in trying to determine what actually is the revenue maximising rate. We know some things with certainty: it'll be different for different taxes, we know that the rate on womens' incomes is lower than that on mens', the long term rate is lower than the short term and so on. But Scott Sumner makes an interesting claim:

I’d argue that this data is strongly supportive of the view that both the US and Europe are near to tops of the Laffer Curve for total taxation. (...) For instance, in Mankiw’s data the Germans raise $13,893/person with taxes of 40.6% of GDP.  The US raises $13,097/person, with taxes of just 28.2% of GDP.

Now the reason this is true is obvious: the US is a richer place than Germany. A lower percentage of a higher sum leads to a very similar total tax take. but recall what the Laffer Curve is trying to state: that lower taxation will lead to faster eonomic growth. This will then increase the tax take. Or alternatively, that higher taxes will lead to slower economic growth and thus a lower than would otherwise be tax take.

And what is it that we see in the data? That those countries with higher tax takes have smaller economies, those with lower tax takes have larger economies. Consistent at least with the Laffer Curve explanation: and consistent with Sumner's contention that that revenue maximising rate is a great deal lower than everyone seems to think it is.

If true (and even I would probably want to see a bit more work done on this before insisting that the US is over the revenue maximising peak) then we've now a really compelling reason to lower government back down below 30% of GDP: for the children. For what this long term Laffer Curve is really describing is how much poorer we're making our children by having so much government now. And given the constant exhortation "But won't someone think of the children!" yes, perhaps we should.

Slash the State for our childrens' sake.

We're told, endlessly, that smoking must be even more highly taxed because smokers cost the NHS oodles of money. Further, that salt, fats, junk food, should all be taxed because fatties cost the NHS lots of money.

This is nonsense, nonsense on stilts.

There are good reasons to suggest to people that perhaps they shouldn't smoke: it's not particularly good for them after all. But having suggested, having checked that they are aware of the trade off they are making, that's as far as we should perhaps go. Taxing smokes highly because demand is relatively insensitive to price is also fine: we do have to get tax revenues from somewhere. The case for doing something about obesity is of course much stronger. Over and above the danger of ill heath to the porkers themselves there is of course the societal pollution of us all being confronted with the snorting beasts in the streets. Quite enough justification for us to tax them (by the way, the definition of obesity is 20 lbs heavier than the person complaining about obesity).

But to argue that either hamburgers or tabs lead to costs to the NHS is simply wrong:

The researchers found that from age 20 to 56, obese people racked up the most expensive health costs. But because both the smokers and the obese people died sooner than the healthy group, it cost less to treat them in the long run.

On average, healthy people lived 84 years. Smokers lived about 77 years and obese people lived about 80 years. Smokers and obese people tended to have more heart disease than the healthy people.

Cancer incidence, except for lung cancer, was the same in all three groups. Obese people had the most diabetes, and healthy people had the most strokes. Ultimately, the thin and healthy group cost the most, about $417,000, from age 20 on.

The cost of care for obese people was $371,000, and for smokers, about $326,000.

And as Kip Viscusi has pointed out, when you add in the costs of the state pensions that those who die young don't get, smoking and gorging save the government vast sums of money.

There are perfectly good arguments to use in persuading people to not smoke or to eat well. "Wouldn't you like to live longer?" is a useful one for example. But if the answer that comes back is "No, I'd prefer to have a cigar right after this triple scoop sundae" then that's just up to the individual and how they wish to chart their course through this vale of tears we call life.

Lying to everyone about the costs of health care just doesn't help at all. So could various people please stop doing it? Thank you, much obliged.

Matt Ridley's come up with an interesting idea: The Tourniquet Theory. There are times when radical action like wrapping a tourniquet around a limb is a very wise thing indeed to do. Like, say, when the lower part of said limb has been ripped off and your heart is now pumping your life's blood into the dirt. There are other times when it's not so sensible: like applying a tourniquet to the neck in order to control a nosebleed.

This analogy can then be applied to, say, our actions over climate change. Biofuels are the neck type:

The production of biofuels may have led to at least 192,000 additional deaths and 6.7 million additional lost disability-adjusted life years in 2010. These estimates are conservative [and] exceed the World Health Organisation’s estimates of the toll of death and disease for global warming. Thus, policies to stimulate biofuel production, in part to reduce the alleged impacts of global warming on public health, particularly in developing countries, may actually have increased death and disease globally.

Sadly, many more of the things that we're doing seem to be of the neck type as well. For example, wind simply isn't reliable enough to provide the power that we'll need in the future. Even if we covered both the land and the seas with the things we still won't have a reliable electricity generation system. Not using gas on the basis that it's running out also seems to be of the neck, not saving a life, type. For shale gas, frakking, means that once again we've invented a natural resource by advancing technology.

I know that I'm repeating myself yet again when I say that I do think that climate change is a problem, one that we should do something about. But what has me in near despair is that all of the things we are actually doing aren't the right things to be doing. They're very much more like strangling the economy to cure a nosebleed than they are a necessary and vital part of maintaining life.

It's not just that trade allows us to partake of the entire cornucopia of delights that the wider world can provide: it's that the poor get rich when we so partake. Have a look at this chart of Chinese manufacturing wages.

Now I agree, a $1 an hour, as much as $2.50 in a city, these aren't the sort of wages that are going to trigger a mass transfer of population from London to Beijing. We actually make it illegal for you to sell your own labour for less than around $9 an hour.

But look at the rise in those wages! More than doubling* in only six short years! This is stupendous growth, virtually unheard of anytime, anywhere.

There are those who say that we shouldn't in fact be buying these things. Partly because doing so deprives some of our own (it doesn't), partly because those wages being paid are exploitative in some manner (they're not). But, for a moment, just pretend that these things are true. It would still be morally righteous for us to go on buying Chinese goods, if that's what we desire to do. For look at the effects of our doing so: the poor are getting rich.

And isn't that what we all want to happen, the poor to get rich? 

* Yes, it is nominal wages but even so it's an astonishing rise given China's inflation rate.

A new tartan has just been unveiled in honour of Adam Smith. Commissioned by the Scottish Economics Society, it has been designed by Dr David Wishart of the University of St Andrews. Its colours and pattern combine the Ancient Smith tartan (dating from 1886) with the Douglas Hunting tartan (pre-1819), thus also honouring the important contribution of Margaret Douglas, his mother, in raising Adam Smith.

The Adam Smith Institute has congratulated the Scottish Economics Society on their initiative, stating that:

“The tartan design is an excellent one that does honour to the memory of Adam Smith and the contribution he made, not only to Scottish thought, but to the world's understanding and the progress of humankind. It is a fitting tribute to one of Scotland's greatest sons.”

It is expected that ties and scarves will be produced in the new Adam Smith tartan for followers and fans of the father of modern economics to wear with pride.