The Pin Factory Blog

To return to one of the great questions of our times. Why is it that people are paying any attention at all to people who seem not to know the first thing about the subject of their pontifications? Our example today comes from Lindsay Mackie who is something or other at the new economics foundation. You know, the place a current Lib Dem SpAd once christened "not economics frankly".

The circling and landing of carrion birds on waste tips is common enough. These days, it is being mirrored by what you could describe as the circling of human vultures over the waste disposal industry. Biffa, the waste disposal company that carries out much local authority work, is profitable,...

Well, if it's profitable then it's got nothing to worry about then, does it. But that's not quite true:

Rather, the financial crisis intervened and the company can no longer service this crippling debt.

Oh, so it's not profitable then is it? It cannot pay the costs of doing business from its revenues. Costs are higher than revenues in fact and thus it is not profitable. For yes, the cost of capital really is a cost of doing business. So, we have a deep ignorance of the specific subject under discussion then.

This situation is an object lesson in faulty economics,

Well, yes it is, and I'm glad that you said it not me.

The rest of the piece is about how we should have all sorts of regulation to stop this ever happening again. But what happening again? Someone making a mistake in business? That, sadly, is always going to be with us. And what exactly is it that everyone is afraid of?

In August, a consortium of Chinook Urban Mining, a London recycling specialist, the private equity investor Clearbrook Capital and the American bank JP Morgan bid just £520m for the group. But so far no decisions have been made either to sell, or how exactly to re-structure the debt so that the company is less burdened.

Eh? So one bunch of capitalists have lost a fortune by making a mistake. Another bunch of capitalists are willing to risk their money picking it up and trying to make it better. The firm still exists, the firm will continue to exist, rubbish will still be collected, recycling done and the environment preserved. Err, this is what capitalists are for: screw up and you lose your shirt.

What, actually, is the problem with this system?

A very puzzling call contained in the latest little pamphlet from Compass. You know the sort of thing, the call to arms about what we must do to make this a more caring, sharing and wondrous society. And yes, I read these things so you don't have to. They insist that there should be a European minimum wage:

Europe should therefore move towards a continent wide minimum wage, based on the respective average income.

There's an awful lot of weight that rests upon that word "respective". There are two possibilities. One is that there should indeed be a European minimum wage. One single rate that applies to all jobs in the EU. Which would be either irrelevant or entirely crazed. If it's based on some sort of average of European wages then just about every job in the poorer countries would disappear overnight. Insisting on, say, 50% of German wages in Romania when that's some multiple of average wages in Romania would indeed be crazed. Insisting that Germany meet the Romanian minimum wage would simply be irrelevant.

The other meaning possible is that they think that there should be a minimum wage in each country, based on the relevant wages for that country. The problem with this is the following:

Germany, Cyprus and the Former Yugoslav Republic of Macedonia have statutory minimum wages that do not apply to all or the large majority of employees but are restricted to specific groups which are defined e.g. by sectors or by professions. These are excluded from the data collection. Also excluded are countries where there are no statutory national minimum wages: Denmark, Italy, Austria, Finland, Sweden, Iceland, Norway and Switzerland. In these countries, wages are either determined by negotiations between the social partners, at company level or at the level of each individual contract. Typically, sectoral level agreements are widely applied and have erga omnes applicability, thus constituting de facto minimum wages.

Insisting on a statutory minimum wage in Denmark, Sweden, Germany, Finland.....what effect does anyone think this will have in any manner at all?

Which leaves me really rather puzzled. I'm not sure which box to put Neal Lawson and his band of merry social democrats in. It could be that they're simply ignorant, in that they don't know that there are already minimum wages in most EU countries. It could be that they're stupid in that they don't realise that having them where they do not already exist isn't going to make a damn bit of difference as the same end is achieved in other ways. Or it could be that they really are crazed loons and that they want to impose a minimum wage based on some average of European wages. Which would immediately close down large parts of the economies of the poorer countries.

Which leaves me even more puzzled. Given that these are the only three boxes that they can be put in as a result of this call then why is it that anyone pays any attention to them at all?

If C P Snow was with us now, he would recognise civil servants and business people as two cultures divided by a common language, namely money.  Awarding franchises to whomever forecasts, or pretends to forecast, the highest growth in passenger traffic has finally been shown to be as daft as it is.  How the then Transport Secretary, Justine Greening, a chartered accountant who holds an MBA from one of the world’s most prestigious business schools, failed to recognise the fallacy is beyond words.

The taxpayer cost of this fiasco is reckoned to be £40M and that is before all the consultants involved in the two consequential investigations climb aboard the gravy train (sorry).

No other country uses this system.  No surprise there.  It makes it most likely that the winners will go bust. Recognising that much brings on consequential guesswork to establish the size of the bond that would then be called in.  The franchise system also ensures that UK rail travel will remain more expensive than elsewhere in Europe.

The fiasco is re-igniting the debate between those who think the railways should be re-nationalised and those who want a return to the pre-nationalisation structure where large rail companies were responsible for their own track.  Clearly the advocates of the former policy have forgotten how dreadful British Rail was. The mini-monopolies of the earlier system were not much better.  John Major’s government envisaged that competition between different train operators using the same tracks would increase quality and reduce cost.  The former has worked to some extent.  Rush hours and Network Rail failures apart, the travel experience is better but it certainly has not reduced the price.  The franchise process ensures that prices cannot be reduced because the train companies are desperate to service the cost of the franchise.

All these systems use Discounted Cash Flow whereby one forecasts the profits from the immediate years as well as one can, based on a good appreciation of what the near future holds in store.  The “out years” are all rolled into a single number called “Residual Value” and placed far away in a box on the extreme right of the Excel sheet where the calculations are done.  In theory, forecasts are made of passenger numbers, inflation etc and discounted to a single Residual Value.  It is all quite complex and naïve recipients of the results tend to look at the immediate years and not worry about the number beyond as being too complex and too far off.

Using this inattention, the scam is to put the balancing number needed to secure the contract into the Residual Value box and derive the forecasts from that.  It is hard to imagine Atkins, the transport consultant involved, being party to anything this trivial but the essence of the scam is making the out year forecasts fit the Residual Value required as distinct from deriving the values from the forecasts.  An outsider, even one as illustrious at Atkins, would have difficulty in distinguishing the two processes, especially when, as seems to have been the case, inflation has not been properly accounted for.

But the issue is not what went wrong so much as what should be done in future.  In essence a train operator should only bid for what they can control and leave the unknowns to government.  Franchising should therefore not be based on a single number but on a table showing year by year tolls for the use of the infrastructure as a function of passengers carried.  This should not be by train, as road tolls operate, because that would encourage over-crowding but by passenger mile which would encourage more trains.  Where more than one operator uses the same track, some control would also be required to ensure capacity exists.  The passenger mile fees should be on a diminishing curve so that additional passengers are more profitable for the operator and/or more price discountable.  And the bids should be at present values leaving the actual future year payments to be adjusted by inflation, defined as the inflation then relevant to train operating costs.

None of that is complex although compressing it to a single paragraph may make it seem so.  The underlying principles here are that the operator should only pay for what it can control and has an incentive both to improve the travel experience and to reduce costs to passengers.

Ed Miliband seems to have appropriated Disraeli's famous slogan about 'one nation' government. Whether this is merely a meaningless catchphrase,  an attempt to out-manoeuvre Cameron or has any real policy implications remains to be seen. Having raised the issue, it is interesting and instructive to reflect on nineteenth century government as well as what the phrase might imply for modern politics.

It is notable that Disraeli coined the phrase in 1844 as the 1840s were a decade which represents the high-water mark of Classical Liberal values in Britain and perhaps throughout the world - contemporary American and French had similar Classical Liberal features. That decade saw the repeal of the Corn Laws and Navigation Acts and the apparent defeat of mercantilism and economic nationalism in the UK. It saw the triumph of the Manchester school led by Richard Cobden and John Bright. It is worth remembering that these great strides for liberty were inspired by, amongst others, Adam Smith in the late eighteenth century.

Similar movements towards freedom were being made in the social sphere with, for instance, the abolition of slavery and Catholic emancipation. Fiscal retrenchment was the hallmark of mid-nineteenth century government, with great strides being made to pay down the national debt. How striking a contrast to today's politicians who fail to eliminate the public deficit and . Although Peel re-introduced the income tax in 1842, he and many other politicians were opposed to its use and aimed at its elimination. Peel's government also introduced the Bank Charter Act (1844) - a high-minded but ultimately misguided attempt to create stable, gold-backed currency. It is notable that both parties - Whigs and moderate Tories - were broadly sympathetic to these policies.

The most famous political slogan of that era is 'peace, retrenchment (cuts in government spending) and reform' - something which our modern politicians would do well to emulate. We cannot characterise the mid-nineteenth century as a period of true laissez faire as there was still a great deal of government intervention and whilst government spending was low, it is important to recognise that government was still very activist. There was much government intervention in social life via the Poor Laws and the education system. Nevertheless, the tone of times was towards liberty and equalitarianism (i.e. equality under the laws and the absence of discrimination by government) in general.

The 'one nation' position is one of paternalism and limited egalitarianism. Disraeli used the phrase as a political slogan in a bid to win the support of the new voters enfranchised in the 1867 Reform Act - an Act which created far more voters than its more famous predecessor. In this he was doubtless successful; instead of being destroyed by Reform the Tories successfully adapted. The Whig Party, in Britain (unlike the US) the party of small government and free trade was, by contrast, was consumed by the Liberals. The Tories shifted their position to appeal to the new voters and sought to portray Whiggism as heartless individualism.

The following era saw a gradual shift in political positions of which Disraeli's slogan is a signifier. Whilst Disraeli himself was a showman and a populist, his 'philosophy' such as it is represents an opposition to Manchester values, much as does Bismarck's. Gladstone's Liberals represented a more fiscally conservative, Whiggish position. The 1860s-1880s period should be recognised as witnessing the 'Strange Death of Whig England', the causes of which are contentious but bear a good deal of historical study.

Again, both parties in this period turned to a more interventionist style of government, albeit in a limited fashion. In the sphere of political thought, the 'New Liberals' emerged led by Green and Hobhouse. Herbert Spencer in The Man Versus the State (1884) categorised this shift as the 'New Toryism', a return of paternalist values blended to varying degrees with the contemporary collectivist ideas of socialism, imperialism and nationalism. By 1894 it was possible for the Chancellor WV Harcourt to announce that 'we are all socialists now' as he introduced death duties.

With Gladstone's death the Liberals emerged more strongly as the party of social democracy although the Conservatives, as they became, gradually adopted a more moderate version of this position. This point should not be too greatly over-stated, however; prior to 1914 government spending remained small by contemporary standards, there was little deficit spending and the currency was stable.

This gallop through history leaves much detail out, of course, but it should remind us of one or two very salient points. Ed Miliband is quite within his rights to adopt Disraeli's concept as his own as they both represent paternalism and interventionism. It is worrying, however, that both Miliband and Cameron laud Disraeli whereas very few politicians would adopt a Gladstonian much less a Cobdenite position (including the mis-named Liberal Democrats). It is interesting to observe how political parties tend to adopt slightly moderated versions of essentially the same position and actual ideological divides are rare.

In reality, all three major parties are offering greater or lesser degrees of managerialism. On a more hopeful note, it is also clear that ideas take a long time to become embodied as the prevailing doctrine. The ideas of Smith's generation took 40-50 years or more to become reality. It is our duty, therefore, to generate the ideas and methods to free ourselves from the welfare and regulatory state so that our grandchildren may benefit.  

My fourth very good thing is imports, one of the most misunderstood.

4.  Imports

A common fallacy supposes that nations become rich by exporting more than they import.  Many governments make the effort to augment exports and diminish imports.  This usually involves subsidizing exports by means of grants and lower taxes, and discouraging imports by means of tariffs.  Both of these are more difficult to do under the rules of the World Trade Organization, but countries sometimes find covert ways of achieving these ends.

It used to be thought that a country's wealth was augmented by a positive 'balance of trade,' under which the surplus of exports over imports would bring in more gold and silver than went out, leaving the nation richer.  Adam Smith exposed this fallacy, pointing out that the wealth of nations consisted in the productive labour of its peoples rather than in bars of precious metals stored in its treasury.

In fact it is imports that make a nation richer.  By importing goods that are cheaper than those they can produce themselves, nations have cash to spare as well as the goods.  This makes them wealthier than if they were self-dependent.  Adam Smith said that Scotland could grow grapes and produce wine "by means of hot-walls and glass houses" on the slopes of Ben Nevis, but it would cost them 30 times the price of equivalent French wine.  By buying the French wine, they saved twenty-nine thirtieths of the cost and could spend it on other things.

Of course these imports have to be paid for, and exports make that possible.  We export to gain the wherewithal to enrich ourselves through imports.  It need not be manufactured goods we export.  It can be services such as insurance, skills such as design, or the returns on our own overseas investments.

The US humorist, P J O'Rourke put it succinctly: "..imports are Christmas morning; exports are January's MasterCard bill."  Imports make us richer, and exports make it possible.  The self-sufficiency which is advocated as a virtue is the road to poverty.  It denies us the specialized and skilful services of far-flung producers anxious to provide us with goods at lower prices than we can make for ourselves.

...here is one of my favourite poems by Ogden Nash, which is as appropriate now as it was when he wrote it in the midst of the US government's measures to prevent 'overproduction' during the Great Depression.

One From One Leaves Two

Higgledy piggledy, my black hen,
She lays eggs for gentlemen.
Gentlemen come every day
To count what my black hen doth lay.
If perchance she lays too many,
They fine my hen a pretty penny;
If perchance she fails to lay,
The gentlemen a bonus pay.

Mumbledy pumbledy, my red cow,
She’s cooperating now.
At first she didn’t understand
That milk production must be planned;
She didn’t understand at first
She either had to plan or burst,
But now the government reports
She’s giving pints instead of quarts.

Fiddle de dee, my next-door neighbors,
They are giggling at their labors.
First they plant the tiny seed,
Then they water, then they weed,
Then they hoe and prune and lop,
They they raise a record crop,
Then they laugh their sides asunder,
And plow the whole caboodle under.

Abracadabra, thus we learn
The more you create, the less you earn.
The less you earn, the more you’re given,
The less you lead, the more you’re driven,
The more destroyed, the more they feed,
The more you pay, the more they need,
The more you earn, the less you keep,
And now I lay me down to sleep.
I pray the Lord my soul to take
If the tax-collector hasn’t got it before I wake.

— Ogden Nash

The third in my series is profits, much-maligned but essential for progress.

3.  Profits

The role of profit is much misunderstood.  Some denounce profits as if they represent money that rightfully belongs to others, but profits are the reason for the wealth-creation that has so benefited the world.  We postpone consumption so that we can enjoy more of it later.  There would be no reason to do so otherwise.  By using wealth to create more wealth in the future we can have access to more choices and opportunities.  The prospect of making a profit leads us to invest, and the investment creates new products and processes and new efficiencies.  Profit is the difference between the cost of the inputs that go to create something and the price that others will freely pay for it.

Sometimes people are envious of high profits and think them somehow unfair.  In fact the high profits encourage others to enter and start up in competition, which in turn benefits the consumer by increasing choice.  Moreover high profits motivate others to start up new ventures in the hope of doing likewise.  Thus profit is the incentive for increased economic output, as well as for the introduction of new products onto the market. 

Profits do not represent wealth taken from others, but wealth created by added value and exchange.  Without profits there would be no reason to forego present consumption by investing.  Profits thus make us look to the future and what we might achieve in it, and lift our eyes above the present gratification that would prevail otherwise.  Profits are the incentive which sets people on the road to economic expansion and the self-betterment which it makes possible.

Marxists erroneously suppose that profit represents exploitation, a price higher than the labour cost of producing goods.  They err in supposing that value derives from labour costs.  In fact it derives from demand, and is in the mind of the person contemplating the object, not in the object itself.  It is because we value things differently that we trade.  The investor hopes that people will value the goods produced more than the price that will be asked for them, and that this will be more than it costs to produce them.  Profit benefits people rather than exploiting them, and it does so by making available new goods that they value and are willing to buy.

For the second of the very good things that tend to receive a bad press, I highlight bankruptcy.

2.  Bankruptcy

When an individual or firm goes bankrupt, a legal process is instigated to discharge debts that cannot be repaid.  In former times such debtors might have been put into a debtors' prison and languished there for years.  The process weighs assets against liabilities and allows the debts to be discharged at some fraction of their nominal value, leaving the debtor free of the burden, albeit subject to rules of financial behaviour and with a blemish on their credit record which can last for years.

While bankruptcy undoubtedly involves some social stigma that most people would seek to avoid, it does have advantages to society as well as to the individuals it releases from debt.  A discharged bankrupt is no longer burdened by the debt, and is free to work again and to earn money without it all being consumed in repayments.  If he or she went bankrupt as a result of a failed business enterprise, they become free, after the passage of time, to try again.  Some highly successful business people have failed to get it right the first time, and have experienced bankruptcy on the road to eventual success.

Most lenders who extend loans to business know that risks are higher among 'subprime' candidates, and set their repayment terms sufficiently high to cover the losses from those who go bankrupt.  While failure might be devastating and distressing for the individual, however, it has economic and social benefits.  Failure enables capital and assets to be redeployed from businesses that have not worked towards new ventures that show more promise.  It is the financial equivalent of clearing out the less hardy plants and animals and leaving their ecosphere available for the hardier strains.

The economist Joseph Schumpeter spoke of the "creative destruction" wrought by innovative ideas and businesses that led to the demise of established ones.  Bankruptcy is part of the process by which failing firms close down and are replaced by newer and more successful ones.  Although governments might try to reduce bankruptcies and failures by propping up firms in trouble, they do the economy and the prospects for future growth no favours by doing so.  The failure of some is an important ingredient in the success of others.

Establishing a higher threshold for personal income tax was under much discussion last month — a precursor for conference season debate.  Under the banner of ‘Fairer Tax in Tough Times’, the Liberal Democrats presented plans to increase the scheduled threshold of £9,205 to a suggested rise of £10,000.

Not slow to capitalise on this ‘leak’, the Spectator’s blog drew attention to a Centre for Policy Studies report published by Lord Maurice Saatchi and Peter Warburton in 2001, Poor People! Stop Paying Tax!, that itself recommended £10,000 at which the low-paid began to pay.  For the think tank that Margaret Thatcher and Keith Joseph built, it is absurd that the State ‘even taxes people who can’t afford to pay tax at all.’  But insult is added to injury:

Governments put up tax, which reduces individual incomes and creates more dependence on the state.  And citizens claim more state benefits to compensate.  And so it goes on until the government is claiming billions of pounds a year in taxes from citizens who also claim billions of pounds a year in benefits from the government.

This political duel over who is truly the friend of the poor should set off a policy debate on taxes in general; namely, is it better for taxes to be wide and shallow — that is, paid by everyone, allowing for overall rates to be low — or narrow and deep — again, paid by the wealthy few who are considered able to pay them and, necessarily, rather high?

Read this article.

Some things that are good and beneficial are frequently disparaged because they are misunderstood.  I have selected a few such things to put the case in favour, pointing out the good that they do.  These points will be familiar to many of our readers, of course, but they might equip other people with arguments that can defend these ideas against critics.

1.  Advertising

Some suggest that advertising is wasteful, diverting resources into promoting goods that might otherwise be used to lower the price.  It has even been claimed that advertising is coercive, tricking a gullible public into buying goods and services by bombarding them with positive images instead of trying to sell on the basis of quality.

In fact advertising is informative.  It tells the public what goods are available, in what varieties and at what prices.  It is a very competitive industry, with creative minds vying with each other to find new and attractive ways of appealing to what the public is looking for, and of emphasizing the merits that people seek in the goods they buy.

Advertising is often used to promote new or improved products by announcing the edge they have over their rivals.  It is self-regulated, not permitting ads that try to sell goods by making people feel inadequate or inferior without them.  Instead they have to stress the positive aspects of their products.

Some intangible associations add value to products by creating an image for the product that enhances the enjoyment of it.  Malt whisky in India is promoted as an aspirational product, so the young Indians who sip it enjoy not only the whisky, but the feeling that they are headed for success.  And long after the whisky has gone, the memory of that feeling might endure.  When some products are bought, the purchaser buys into a lifestyle linked to them by advertising, and enjoys the intangible associations they bring.

Sports companies are sometimes criticized for promoting expensive brands that young people are encouraged to buy into.  But the fact is that many teenagers are still discovering who they are, and the brands help them to assert an identity linked to their associations.

Far from being wasteful, advertising promotes competition, and that keeps prices keen and quality high; and the images created for products enhance the value of those goods to the purchaser.