The merits of Anglo Saxon capitalism

As we all know one of the differences between the Anglo-Saxon variant of capitalism and others such as Rhineland such is the way in which economic activity is financed. They tend to use banks to finance both the debt and equity portions of a business, we tend to use markets to do so. For us large companies tend to issue shares, bonds, commerial paper, and even small companies don't get their equity from banks, only their debt financing.

As an aside it has hugely amused me the way in which recent events have had everyone spitting at the banks, insisting that they be cut down to size. And then the very same people (yes Mr. Hutton, we're lookin' at you) insist in the next breath that we must have Rhineland capitalism, the one in which the banks loom even larger in the financing of industry.

But that is an aside. What we really want to know is which is the best method of financing industry?

The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.

It would seem that the draw of being able to float a company increases the incentives to make it truly independent of the original guiding force, the entrepreneur. And as is mentioned, we very much want companies to both outgrow and outlive their founders. So it would appear that it is the Angoo Saxon variant that wins this little part of the battle then.

So rah rah for The City then, eh?

Hester's bonus

I was on Sky News earlier today talking about Stephen Hester’s £1m RBS bonus. To tell the truth, it isn’t a subject I relish tackling – there’s more nuance there than it’s easy to communicate in a short TV debate. For one thing – and I made sure to stress this upfront – I don’t believe that RBS should exist today, at least not in its current form. Bailing it out in 2008 was a big mistake, and if we’d let it go to the wall, we’d be much better off now.

And then there’s the point Gordon Kerr made in his recent Adam Smith Institute report The Law of Opposites, that bonuses are sometimes driven as much by the flaws in the International Financial Reporting Standards, which allow banks to recognise years of very uncertain future income as current profit, as they are by genuine performance. I decided not to bring this up. Nor did I get the chance to nail the real corruption at the heart of the financial sector – the central bank and its constantly expanding balance sheet.

Like most libertarians, I am ambivalent about the financial sector: on the one hand, the government should not interfere with free enterprise or use Britain’s most important industry as a political punchbag; on the other hand, there’s more than a whiff of crony capitalism around parts of the financial world, and I hate having people assume that everything that happens in the City must, by definition, be the product of the free market. That just ain’t so.

All that said, the furore over Hester’s bonus makes for a truly unedifying spectacle. The fact is that the taxpayer has been lumbered with 82 percent of RBS, and is on the hook for billions of pounds of liabilities. I’d never had put us in this position, but we are where we are and if we want our money back we’d be well-advised not to run RBS into the ground. The company needs top-quality leadership, and in the banking world that costs something. Moreover, we need to remember that this bonus is being paid entirely in shares, which seems a good way of aligning executive interests with shareholder (i.e. taxpayer) interests. That’s no bad thing.

My opponent, The Guardian’s Philip Inman, made the usual point that (a) nobody deserves to be paid that much and (b) bankers shouldn’t get such big bonuses when they’re already paid seemingly enormous salaries. My answer to the first point was a simple one: who are we to determine how much someone ‘deserves’? As soon as you interfere in the market here, everything becomes a deeply politicized value judgement. The second point is, I think, based on a lacking of understanding of the way financial firms operate. The reason so much of bank pay comes in the form of bonuses rather than fixed salary is that bank revenues are unpredictable and volatile. In that context, a (relatively) low basic salary with a large variable component makes perfect business sense. Not everything bankers do is a conspiracy against the public interest.

Ultimately, the point I want people to take away from my appearance is this: if taxpayers own 82 percent of a company, it is right that the government closely scrutinizes the executives on their behalf. I’m all for giving more power to shareholders. But in doing this, it is vital that the government pursues taxpayers’ economic interests, not their own political ones.

Stakeholder Capitalism

One of yesterday’s headlines, “Davos elite confronts capitalism crisis”, reflects the widespread view that the financial crisis shows that capitalism has failed and “we need another economic model”.

The anti-capitalists see making money from other people’s needs as wicked.  Business should be there to help people, they say.  Of course, communism was seen as good because profiteering was illegal, but that was a main reason for its collapse:  it removed the profit incentive.

The middle, Davos, ground is that making profits in moderation is acceptable provided it takes place within the “stakeholder” context.  In other words, business should not be preoccupied by making money for its shareholders but should also take care of suppliers, customers, employees and society as a whole.  A corporation should only be given a licence to trade if it meets these wider responsibilities.  Profit is still basically reprehensible but is accepted as necessary to meet these social goals.  The hysteria generated by NHS reform suggests this view is widespread.

The pious folk who believe this rubbish have forgotten, if they ever knew, that profits provide everyone’s income whether it be in employment in the private sector, or via taxes in the public sector, or through their investments.  Cash flow needs to be positive and marketing provides the cash flow.  It’s actually quite simple: make money and do not be distracted by corporate responsibility.  Making money makes everything else possible. The alternative is that we continue to decline.

Yes, a firm needs to have a fine reputation, marketers call it “brand equity”, but that is a means to an end, not an end in itself.  Customers will favour businesses they know, respect and trust.  So building brand equity builds long term profit.  Sensible firms leave purely charitable activities to their shareholders.

According to the political chatter, the financial crisis and economic slowdown have shown that we need a new economic model. Some believe Angela Merkel can put such a model on the blackboard and national GDPs will be rejuvenated. The chatterers are gloriously unspecific about what this model might be. The nearest the chatterers have come is to cite the economy of China but anyone doing so does not understand China.  It is simply at an earlier stage of a similar model to ours.  The state owned enterprises have failed and are being phased out; private enterprise is flooding in. Their corporate leaders are just as rapacious and profit-oriented as any British Victorian factory owner.  Quite a few rip off their customers and/or Western partners.  In general they work harder for less reward and have become the world’s factory by moving gradually towards the Western economic model.  My Chinese dictionary does not have a Chinese word for “stakeholder”.

Yes, even free markets need some rules.  I’m not sure we should go as far as the Chinese, who execute those found guilty of corruption, as much as some on the Left might like to apply that model to bankers receiving excessive remuneration. But regardless, our decline and the rise of China show that the capitalist economic model actually works rather well: the fault, dear Brutus, lies in ourselves.

From the desk of the CEO of Worstall Industries

Nigel,

I must thank you for your time the other day, my apologies for being so late in replying. I do wish you luck in your new role as an advisor on Corporate Social Responsibility, or as you put it in our meeting, CSR. Can't handle acronyms myself but I'm sure your new consultancy is more with the zeitgeist than the now aged "Diversity Matters" that you tried to sell me a few years ago and much more so than the "Mandy for Political Diversity" that was the one before that. As I've said, that we were at school together means you're always welcome to pitch your latest to me, just as I am, as an old schoolfriend (yes, I am still sorry about that taking the fly half position off you in the First XV but come along now, moving over to the second stream cross country wasn't that bad, was it?) allowed to listen to yet reject your pitch.

And the problem with your CSR stuff is, well, you say that it's good business to do right by people. Which, yes, of course, it is. Which is why we do right by people all the time. While we fail occasionally, we give our customers what we've promised to give them for the money thay have spent. Similarly, those who work with us know the deal, sign up voluntarily and similarly get dealt with by the deal agreed.

Your argument though goes a lot further. It seems to be that if we splurged the shareholders' cash on, say, abolishing hunger in Africa (when our job is in fact making adult nappies in Barnsley) then everyone would love us more, buy more of our product and thus make the shareholders greater profits.

And the thing is, there really are times when this is true. We have found that allowing the employees to use company property for their own charitable money raising activities has increased employee loyalty (which, as you know, means lower wage demands in future!). Similarly, we have found that career breaks, sabbaticals, have increased our retention of senior and valuable staff. Certainly, my company paid four months over the winter on St Maarten investigating low paid female labour helped to keep me with the company!

But there does seem to be a point that you're missing Nigel. We run a company on behalf of the shareholders: our duty is, without skimming off too much for ourselves, to make them money. And these social responsibility things, well, yes, they might make the shareholders money. Treat the staff right, the customers right, yes, perhaps a little bit of local community bits and bobs where we have factories.

But what you were suggesting is that we should be fire hosing money at the Guardianistas' topic de jour. And given that our workers (well, Bob in HR) and our customers (and if they are, by the time they need our products it doesn't matter) are not in fact Guardianistas, well, where is the profit increase we'll get from spraying money as The Guardian would have us do so?

Or, to put this all another way Nige me old mate, we're a profit maximising organisation and we already do as much CSR as we think will maximise profits. It is indeed true that we don't know everything but that idea of yours that we should sponsor that youth LGBT dance troupe seemed a bit off. An aged one seems closer to our target market and the one that we already do sponsor, well, their "Caught Short in Age" dance is to be remembered.

Anyway, so sorry about this, but we won't be hiring your consultancy on this one although, as I say, we're always open to new ideas. If you can show us something that increases our profits we'd be most grateful: but we think we're doing the most CSR that does that already.

Finally, well, we've both about 15 years of working life in us left and I'm sure that you will be able to, in this final third of working life, find something out there that I actually want to buy from you.

All the best!

Tim Worstall

Even Obama gets it

Recognising a great opportunity when he sees it, US President Obama has announced a series of measures to boost the demand for natural gas whose price there has recently plunged on surging supply due to ever improving extraction technology and rapid development of shale gas reserves.

Now, Obama’s proposals may not quite meet classic market strictures for policy initiatives: he wants tax breaks for trucks powered by gas and grants to communities who have ideas for encouraging the use of natural gas.

But contrast that with the hemming and hawing over here about going after our own shale gas reserves. Not for us any cheap’n’cheerful solutions to high energy prices or a partial solution to any climate change agenda. No, we remain intent on crucifying ourselves to uneconomic windmills, leaving us twisting in the wind - when it blows but not when it blows too much.

We’re all fretting about the need for a growth agenda to get us out of the current doldrums and this is an industry with huge potential for domestic investment and export opportunities, not to mention a welcome relief in the cost of living. Growth, jobs, exports, higher disposable income – what’s not to like?

Natural gas may not be the ultimate solution to any climate change worries but it’s better than the alternative – coal, petrol or fuel oil. However, we seem intent on making the perfect the enemy of the good. There’s only two ways to effectively reduce carbon emissions: shut down the economy or spur its growth to generate sufficient funds for the required investment. Natural gas is a golden opportunity to accomplish the latter.

Quango merry-go-round

Quangos were invented in the 1960s but not much used until the Thatcher administration saw them as a means of downsizing government and reducing ministerial meddling.  They have blossomed since causing the Coalition to make big claims that they would cull their number and their costs.

As we now know, what the Coalition says and what it does may not always match.  The claim was to push autonomy down to locals and reduce the coverage of central government.  In fact the reverse is happening.

Last week’s National Audit Office report on the quango reduction is most illuminating.  200 or so quangos will be culled but much nif not most of their staff will be absorbed into Whitehall departments. Ministers will again be able to meddle directly.  These new costs have not been set against the savings and thus the net position is far from clear.  What is clear from the NAO report is that the claimed savings are overstated.  And once the quangos are safely back in their departments, which is more likely – renewed growth or shrinkage?

One example is the “Local Better Regulation Office” which was invented only recently by the last administration and a prime candidate for the bonfire.  Instead it is being incorporated in Vince Cable’s BIS department as the “Better Regulation Delivery Office”.  Note that local is becoming national and central government is being expanded.

Meanwhile regulations continue to pour out, ignored by our MPs.

The Coalition will doubtless ignore the NAO report as they have so far.  Wouldn’t it be better if they got together and produced a full list of quangos as at May 2010 showing which continue roughly as now, which are being absorbed into their departments and which are being culled without replacement?  We are entitled to know this broad picture, the numbers employed and the costs.  Maybe an MP will ask these questions?

Hayek on the euro

"In many respects a single international currency is not better but worse than a national currency if it is not better run. It would leave a country with a financially more sophisticated public not even the chance of escaping from the consequences of the crude prejudices governing the decisions of the others. The advantage of an international authority should be mainly to protect a member state from the harmful measures of others, not to force it to join in their follies."

— FA Hayek, The denationalization of money: the argument refined

President Obama's definition of fairness is precisely the opposite

In his State of the Union address, President Barack Obama called for higher taxes on the wealthy (defined as anyone who earns more than he thinks they ought to). He argued that "Now, you can call this class warfare all you want... But asking a billionaire to pay at least as much as his secretary in taxes? Most Americans would call that common sense." We all know that ‘common sense’ is an oxymoron. Let’s consider Obama’s logic with a purely hypothetical example:

Evil Billionaire Warren has an income in various forms of $200,000,000. He pays tax at an overall rate of 10% which on that sum gives his tax contribution via income tax as $20,000,000.

His Lovely Secretary Debbie has a taxable income of $40,000. She pays tax at a rate of 20%. Shocking! How can she pay a higher tax rate than Evil Bill? Her tax contribution is $8,000.

But wait. Isn’t there a problem here? President Obama clearly stated that a billionaire ought to pay as much in taxes as his secretary. But his secretary is paying far, far less in taxes than he does. If we asked Warren to pay as much in taxes as his secretary I think he would be pretty pleased to do so as this would represent 0.004% of his income.

Of course, I’m being somewhat facetious. Clearly President Obama was suggesting that billionaires and secretaries should pay similar rates of tax. However, I find it extremely disingenuous to use the word ‘fair’ when referring to such a situation. The billionaire is, after all, contributing vastly more as an absolute sum than the secretary. ‘Fairness’ means an equal share is paid by all – thus fairness would mean, in the strictest sense, that the billionaire and the secretary paid exactly the same absolute amount of tax.

We might portray Obama’s argument as meaning that fairness means an equal proportion is paid by all so that Warren and Debbie pay like proportions on their income and he might well have a case. However, the billionaires he criticises are merely obeying the laws which governments have created as a result of attempting to manipulate and control economic activity. Unless they are guilty of tax evasion, in which case they are subject to legal recourse, billionaires can hardly be criticised for obeying the law. If governments wish to construct absurdly complex tax regimes filled with loopholes and opportunities for tax planning and arbitrage, it is hardly the fault of billionaires if they then do exactly what government is incentivising them to do. One might argue that the wealthy are able to lobby for favourable tax regimes, but this is an argument to simplify and remove the arbitrary conditions from all tax regimes in order to prevent them doing so and not to introduce further discrimination and complexity.

His use of the word fairness ultimately begs the question of why Obama is advocating progressive taxation which, by its very nature, is unfair. By increasing the proportion of tax paid on incomes over certain arbitrary thresholds those deemed to be too rich or too wealthy are simply being discriminated against. To Obama, earning more than $1million clearly means one is a proper target for discrimination. Why should such individuals be discriminated against any more than any others, especially as they are already – like Billionaire Warren – contributing a greater absolute amount of taxation?

If all taxes were simple and flat there would be no tax planning, no avoidance and everyone would simply pay a genuinely fair share. There would also be a lot of unemployed bureaucrats, accountants and lawyers who could go and get productive jobs instead of constituting a government-induced burden on the economy. Such a tax regime would be genuinely fair. Of course, we could then point out that most of what the taxes are paying for should not be the function of government and unfairly favours special interests but this is a different question. Flat, proportional taxes are the only means of creating fair taxes but they are not what Obama is arguing for - when he says fair he actually means unfair. 

Annual Review 2011

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Open publication - Free publishing - More free market

Ireland and the law of unintended domino effects

Ireland bailed out its banks to stop the much vaunted but never explained domino effect of banks going down.  As a result its debt went up, and its AAA credit rating went down.  Most investment funds are required to be established in AAA countries. So, it is said, Ireland’s financial industry is increasingly moving abroad to places like Luxembourg.

How’s that for a domino effect?

When individuals make a mistake, it may have a domino effect.  But so do the state's mistakes.  The only difference is that when the state creates a domino effect it will be of far greater magnitude than an individual's.

On top of that, the state making mistakes is more likely than an individual making mistakes, because of Hayek's Knowledge Problem: central decision makers simply do not have the knowledge about individuals' choices and opportunities that those individuals have. That state intervention usually has side effect is generally accepted — the left's response is to mend it with more regulations which in turn will fail.  State failure is therefore not so much a domino, it is a spiral.

The domino effect was the argument which was successfully used by politicians to explain why they bailed out the banks with taxpayers' money.  The domino effect of banks collapsing remains elusive, but in the UK the domino effect of bailing them out is very real indeed: the debt rising to £1 trillion; no growth; and sky-high unemployment.