The Pin Factory Blog

The unrest in India this week should serve as a potent reminder of the tendency of unnecessary and outdated subsidies to become entrenched in a society, as rent-seekers become increasingly accustomed to insulation from normal market forces, leaving others to pick up the bill.

Strikes, demonstrations, and fires disrupted daily life across the country as tens of thousands took to the streets to protest a decision by the Indian government to reduce costly fuel subsidies that had begun to seriously burden the energy-hungry nation’s budget. For years, the country had fixed below-market prices for fuel, mandating that all of its state-owned retailers sell gasoline, kerosene, and gas used for cooking at a discount. The recent decision permits the sale of gasoline at market prices, and, though the state has retained price controls for kerosene, cooking gas, and diesel, these subsidies will decrease.

The price of gasoline is expected to rise by less than eight percent, while kerosene, cooking gas, and diesel will rise by eleven, thirty-three, and five percent, respectively. The Financial Times reports that India spends £10.7 billion annually on subsidies for these products, a burden that the market-oriented reforms will reduce by more than £2.8 billion. These savings are not unimportant for the government, which has increased spending and borrowing to record amounts in recent years, and is trying to reduce its budget deficit of 6.6% of GDP.

Unions and members of the political opposition have attacked the decision as a cruel measure that will harm India’s poorest, as the subsidies have long been defended as necessary to provide access to vital fuels. Yet the reality of the subsidies’ effects could not be very different. The poor in India do not use considerable amounts of fuel, which is instead consumed by wealthier Indians who have been able to purchase appliances and automobiles as the country has grown. Whenever the market price or consumption of fuel increases, as both are likely to continue to do given the scale of economic growth in the region, the Indian government must divert more of its budget away from more critical activities to sustain fuel subsidies that primarily benefit the middle and upper classes.

Furthermore, the economic rent seeking behaviour that is incentivised by the current system encourages government corruption and the concordant diversion of subsidised petroleum, ensuring that much of it does not reach the poor. According to Dr. Bhamy Shenoy, an economist at the International Institute for Sustainable Development, only sixty percent of subsidised kerosene in India reaches its intended recipients.

The Indian government has more to do in the way of eliminating price-distorting subsidies and trade barriers, but its apparent willingness to resist opposition pressure in response to its most recent decision is an encouraging sign of the country’s slow march toward a more open market. The intensity of the opposition to the price hike is suggestive of the oft-observed difficulty of ending subsidies once those who benefit become accustomed to their free ride. As Dr. Shenoy writes: “Once the subsidy genie is out of the bottle, putting it back in is a difficult task indeed.”

Full marks to the dynamic Simon Walker of the British Venture Capital Association, who brought his fellow New Zealander Sir Roger Douglas over to explain how to turn around a failing economy and overblown government That's what he did as NZ Finance Minister in just three short years in the 1980s. Even though he was a Labour Minister, he ripped into trade protections and subsidies, ended exchange controls, cut the deficit, halved income tax, let markets and not the state lead development, and brought honesty and transparency to government accounting.

His key messages? Act decisively, and act quickly. You only get one shot at this. Don't give the special-interest groups time to band together and drag you down.

The only durable changes are the big structural ones: prune a bit off programmes here and there and before you know it, they will sprout again even more vigourously. No upper limit of 25% or even 40% cuts for Douglas. He says you need to ask whether each function and department should exist at all. Their real cost is not the central staff bill, but all the ongoing expenditure programmes they dream up for themselves and others to do. So decide what functions you really have to provide; cut out the inessential programmes and departments entirely; then see how those core functions are best provided, and by whom.

Package your reforms, says Douglas, so that people can see you are protecting the most vital government functions, and can see a chink of light even through the dark days of tax rises and spending cuts. And communicating your plans is vital.You need good people clearly briefing journalists and MPs so they know what your clear objectives are and how you are working towards them. And be frank: tell them the downside as well as the upside, so they are prepared for it when it hits.

Douglas says his biggest boost came from making state programmes properly commercialised, and giving local managers the power to manage. Some state enterprises halved in size because managers knew that most of the jobs were non-jobs, and productivity soared. 'Able people had been trapped in jobs that didn't use their talents,' says Douglas.

Civil servants were put on five-year contracts and performance pay – overspending shuddered to a halt because civil servants lost money if they overspent. Ministers and chief executives would agree employment contracts, pay, pensions and so on for their own workforce – ending the bureaucratic 'grade' culture. And any pensions promised to civil servants had to be fully funded.

You can read more about New Zealand's reforms – known as Rogernomics – in our report The Kiwi Effect.

On this day, in 1740, at the age of 17, Adam Smith set off for the University of Oxford. He had won a scholarship as Snell Exhibitioner, and was to study at Balliol College. The trip on horseback from his native Scotland took more than a month.

Smith's time in Oxford was not happy, though it taught him something about incentives. As he would write decades later in his great book The Wealth of Nations, "The discipline of colleges and universities is in general contrived, not for the benefit of the students, but for the interest, or more properly speaking, for the ease of the masters." College life was arranged such that the academics got paid whether or not they actually taught their students. Smith concluded that "In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching."

However, Balliol College was blessed with one of the world's great libraries, from which Smith was able to educate himself. He left Oxford a year earlier than originally planned, exceedingly well informed, and very much wiser.

There's a new voice in the fierce debate about whether we need fiscal responsibility ahead of economic stimulus by government. It is that of Italian-born Harvard Professor Alberto Alesina. He has done empirical research on those countries which applied fiscal tightening, and which saw economic growth follow. He found nine good matches (and some non matches).

Alesina also uses psychological, as opposed to purely mechanistic, accounts of the dynamic response to fiscal tightening, arguing that economic players change their responses when they see governments making fiscal responsibility a priority.

Alesina argues that austerity can stimulate economic growth by calming bond markets, which lowers interest rates and promotes investment. In addition, he says, deficit-cutting reassures taxpayers that more wrenching fiscal adjustments won't be needed later. That revives their animal spirits and their spending. Alesina says that as a way to shrink deficits, spending cuts are better for growth than raising taxes.

This bears massively on George Osborne's decision to prioritize measures to cut the debt and the deficit, rather than follow the voices calling for more borrowing-induced government spending to sustain and boost economic activity. If Alesina is right, Osborne will be seen in retrospect to have made the right decision.

Over the last year we have seen Labour’s line on the economy develop. Firstly, debt rose because of the action needed to secure recovery. Secondly, we should be hostile to the Coalition’s cuts. Thirdly, the cuts threaten to plunge us into a double dip recession. All three of these are a deception.

[1] It is certainly true that debt rose faster as we entered recession, with low tax receipts and more government payments, combined with bailouts and stimulus (whose merits I do not assess here). However, the Labour government, its regulators and the Central Bank must take much of the blame for getting us into the crisis in the first place. Furthermore, spending and debt once Labour dropped the Tory spending plans were already on an unsustainable trajectory, before the crisis even began (not to mention the further spree and the off balance sheet debts).

[2] They have attempted to create a dividing line. Unfortunately not only are they on the wrong side, appearing delusional, but their own spending plans implied substantial cuts too. Their rhetoric too often forgets the opportunity cost of government action and the existence of a private sector. If they want to be taken seriously again, they must get a hold of reality and be honest.

[3] If we enter a double dip recession, it won’t be the Coalition who’s to blame. Labour never led us to a robust recovery, if 0.3% GDP growth counts as a recovery at all. The effects on the real economy have yet to all unfold, we must one day unwind the printing presses, and many of our trade partners that have followed socialist policies and failed to tackle their debt addictions’ are stagnating. Further adjustments due to the Labour era mal-investments, government burdening the productive private sector, limited trade demand and declining confidence pose the greatest threat of extending the crisis. Responding to debt and unleashing private enterprise are the only way to escape.

Civil service unions find themselves firefighting on all fronts. Microphones are being thrust to record their outrage on the possibilities of 25% departmental cuts, then 40% cuts, then cuts in their pensions and redundancy payments. They've had to search the phone book to find plausible numbers of cuts in front-line policing and nursing. They've been expected to tell broadcasters that our children's future is at risk by stopping the school building programme dead in its tracks. Meanwhile, one minister says that rich over-60s should pay their own bus fares. The RAC says people should pay directly for the roads they use. Even the expense claims of Tony Blair's security staff are under public scrutiny. Where is it all going to end?

The point is that it shouldn't end. The magnifying glass has to be put over every part of the public sector. Do we really need new school buildings? Well, in many places we do, but in others that I know, the local people weren't even consulted, and thought that rebuilding was a complete waste of money. Should taxpayers really stump up for free bus passes, or winter fuel and Christmas bonuses, to wealthy pensioners? Or buy sweeties for Tony Blair's protection squad?

This isn't the usual overspent-government penny-pinching exercise. Sure, many a mickle mak's a muckle, and many a muckle adds up to quite a chunk of taxpayers' cash. But there are limits to what you can achieve by freezing pay or budgets, searching out efficiency cuts or salami-slicing a few percent from every budget: tell managers to make cuts and all that happens is that they tell their under-managers to make cuts, who tell their under-managers, and so on, until the only folk who get cut are the ones actually doing the work. You really do need to look at every job, and programme, and department, and ask whether you really need them at all.

Private-sector companies do this every day; and interestingly, since the election, time-and-motion firms say growing numbers of public bodies are asking their help too. What they will be told by the experts is to forget trying to pinch a penny here, another there. They need to take some time and conduct a fundamental review of what they exist for. Then they need to work out how those aims are best delivered – which might be by someone else – and cut out all the stuff which isn't part of their core purpose. They will emerge from that process less distracted by marginal activities, more focused on their fundamental role, and better structured to deliver what they exist to deliver. As part of that, it is perfectly right that they should think about how they would cope with budget cuts of 25%, 40%, even more, and what of value would be lost. If anything.

A recent report from the RAC Foundation by Stephen Glaister suggests a ‘pay as you go’ system for roads. It calls for an elimination of vehicle tax (roughly £250/yr), cuts to fuel duty (57.19p/li), and regulatory oversight.

Basic reasoning tells us scarcity imposes cost and public goods fall to the tragedy of the commons. Traffic and road conditions exemplify the marriage of these phenomena well. The proposed scheme is really semi-privatization through contracting. It shifts major costs to those who actually use the roads. Moreover, the institution providing the roads is held accountable in a more direct way than publically managed roads.

Whatever company woos the government well enough and wins the bid is subject to regulation. Regulators will ensure fractions of revenue are set aside for road upkeep. In reality, this means the company will just do as the regulators demand and not keep the roads to an efficient standard. However, the report also calls for oversight to ensure efficiency. This seems impossible since government management is precisely why reform is needed. Although Glaister acknowledges these potential problems, there’s little to be done about it.

It’s important to keep a critical eye on how political motives and regulatory inefficiencies alter outcomes. There are always unfair and unjustified winners at the cost of others when private enterprise and government are partners. Still, the report is a leap in the right direction and researchers like Stephen Glaister should be applauded.

In opposition, the Tories were keen to invigorate the House of Commons EU Scrutiny Committee, both to restore legislative authority to the House and to ensure that proposed new EU legislation was properly challenged. Successive governments hitherto have ensured that the Scrutiny Committee never came to any conclusions, still less held the Executive or the EU to account.

Before the election, the Tories promised to enable the Committee to do what it is supposed to do. A pamphlet co-authored by Theresa May spelt out what was required. In February, David Cameron made much the same point: “And one of the biggest constitutional changes in our history - our membership of the European Union - has practically passed Parliament by. We are hopeless, totally hopeless, at scrutinising the European legislation, regulation and spending that affects our country.”

What a difference an election day makes! All other select committees are having chairmen chosen democratically by back benchers – the sole exception is the EU Scrutiny Committee. David Cameron and the Chief Whip have decided that Ministers will vote too.

Has the Executive woken up to the threat of having an EU Scrutiny Committee that does its job? The government’s independence and room for negotiation in Brussels would be certainly be compromised – not least their current freedom to wave through regulations in the spirit of European co-operation, even when they are bad for Britain. With 30 new Directives on the way now, this is a very pertinent topic. It is vital that the Committee has a chairman who will make sure that EU matters receive proper Parliamentary attention.

It is worth remembering that EU regulations burden British industry twice as much as their Whitehall counterparts. On that basis, they should get twice as much attention. But one gets the impression that the Government, briefed by their civil service mandarins of course, would rather bury all EU matter in the sand. It would be much better if David Cameron followed through on what he said in opposition.

Tim Ambler is a Fellow of the Adam Smith Institute and an Honorary Research Fellow at the London Business School. For a review of the EU Scrutiny Committee’s work see Ambler and Chittenden (2009), Worlds Apart: The EU and British Regulatory Systems, British Chambers of Commerce.

Ministers asked to come up with 40% 'cuts'

I’m getting a little frustrated with the way the government are presenting their plans to cut spending. The 40% cuts splashing around the newspapers this weekend – like the 25% cuts we’ve been talking about previously – are not 40% cuts at all. In fact, they are 40% reductions on projected increases. This manner of presentation, which does not accord with the way real people perceive budgets, isn’t just misleading and liable to strengthen opposition to necessary cuts; it also perpetuates the Brownian doublespeak that portrays higher spending as inevitable, desirable ‘investment’ and makes any attempt at fiscal rectitude seem like a dastardly attempt to cut vital services.

Now that we have broken free of Gordon Brown’s policies, we should also liberate ourselves from the terms he set on the debate. The baseline assumption should be that spending rises only in line with inflation. Less than that is a cut; more (regardless of previous projections) is an increase. Linguistic clarity will undoubtedly aid responsible economic management.

Government in secret talks to toughen strike laws

One thing you can be sure of, however, is that no matter how modest or even illusory the spending cuts are, the public sector unions are going to resist them bitterly. It scarcely matters that their demands are utterly unrealistic – they have grown used to government largesse and are prepared to throw their toys out of the pram at the slightest provocation. So it is no wonder plans are afoot to curb union power, perhaps by requiring a certain percentage of a union’s membership (not just those voting) to approve strike action.

Of course, anti-strike laws are a classic example of intervention begetting intervention. If governments did not regulate employment so stringently, and freedom of contract reigned supreme, we could just leave employers and workers to get on with it. Employers would be able to dismiss workers who breached their contracts or even sue them for non-performance, but they would have to balance the benefits of doing that with the enormous costs it would impose. Similarly, unions could call strikes without the authorities breathing down their necks, but would know that their positions were not guaranteed while doing so. This balanced relationship would encourage co-operation and negotiation, not the confrontation inspired by the current set-up. But as it is, new rules to govern unions (which ought really to be wholly private institutions) are probably a necessary evil.

Dr Jeffrey John may be next Bishop of Southwark

Another area the government should not be involved in is the selection of bishops. And yet according to The Times, “the Prime Minister is know to support” the candidacy of Dr Jeffrey John, an openly gay cleric, for Bishop of Southwark. The traditional practice of the Church of England short-listing candidates and then handing the final decision to the Prime Minister and the Queen is outdated and should end. A disestablished Anglican church should then be free to follow whatever path sees fit.

And in other news...

The hot weather may be slightly unpleasant for those of us who work in offices without air-conditioning, but one of many silver linings in the news that vineyards in the South of England are expecting a bumper harvest. We already produce excellent sparkling wines and perfectly acceptable whites, but so far production has been too limited to allow competitive pricing. And before the climate change lobby claim this as evidence of dangerous global warming, they should remember that the Romans raised grapes and made wine in England in the first century AD. Catastrophe, I think, is unlikely to be lurking round the corner.