Country by country reporting and arms length transactions

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Out on the wilder lefty shores of the blogosphere there is this idea that if only multinationals reported their results on a country by country basis then everything would be right with the world. You know the thing, mice would smile when caught by kittens because kittens are, after all, cute. I have to admit that I'm somewhat unconvinced for the idea depends upon another: that each and every transaction within a company should be valued and priced as if it was an arms' length transaction.

Which rather goes against Ronald Coases' justification for the existence of companies in the first place: transaction costs.

Put simply, the argument for which he won the Nobel Prize* was that the reason to have one organisation was that sometimes that is cheaper than having many. The cost of writing, monitoring, justifying, contracts is, or at least can be, substantial. So also can be the cost of having one organisation, there will be overheads and inefficiencies, after all. So, companies will exist when those contractual costs exceed the benefits of a more nebulous network of hirees, and that network will exist when the central costs outweigh the benefits.

But this idea that a company should be taxed as if it were not a company violates these Coasean assumptions. We've agreed that the company exists because it is cheaper for it to exist than to have arms length transactions: so why would we tax it as if it were composed of arms length transactions?

I fear that yet another bright idea from the left is refuted by the real world.

Odd how often that happens, eh?

*Yes, we know, not a real one, Swedish Bank in honour of and no, we don't care.

The Austrian counter-attack

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The IEA has this week fired a huge salvo into the idea that the current crisis resulted from a failure of free markets and an excess of unregulated greed. "Verdict on the Crash" is by a group of heavyweight authors who take apart, piece by piece and line by line, the idea that lenders, bankers, hedge funds and short-sellers ran amok and brought ruin down on all of us. On the contrary, the authors lay the blame squarely on the shoulders of governments with their central banks and regulators.

Central banks flooded the market with money and easy credit, fuelling an asset bubble and sending false signals to business. They distorted risk assessment through their regulatory approach, leading financial institutions to create ever more complex derivatives. Governments and their agencies (like Fannie Mae and Freddie Mac) pushed lending to those at high risk of non-repayment, while their tax and regulatory regimes encouraged complex and opaque methods of increased gearing. They created the illusion that regulation could replace trust and reputation in oiling the wheels of credit.

The IEA's book has deservedly received huge coverage. Its importance is that the powers that be (G20 and downwards) seem determined to misinterpret events and bring in more of the controls, regulations and interventions that lay behind the crisis in the first place. It is very important that the case should be made that this was a failure of governance, not of markets, and the IEA has done us all a favour by putting that case so convincingly. Their report and its summary are accessible on line.
 

Adam Smith gets a makeover

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As part of a number of changes that you will see on the website over the coming months, we have reworked the Adam Smith page in the students section. Click here to take a look at it.

Video of the week

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Funny and convincing (almost).

Blog Review 962

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This is indeed the problem with anti-trust. Even lower prices are regarded as anti-competitive.

GM isn't just being hit by the current troubles. There's decades of bad management there too.

Taking note of the detail behind the stimulus plans: for example, it's taking an age to actually spend the money by which time we won't need to spend it, will we?

Sadly, troughing public sector employees is not a problem limited to the Westminster Parliament.

Sainsbury's profits rose, did they? That's Darling's VAT cut for you.

What we ought to be looking for in an economic theory.

And finally, unfair perhaps, but how some see the BBC.

Causes of the current crisis

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Credit contraction has featured in depressions since ancient times. The “Credit Crunch" we are currently experiencing is primarily due to three factors: (1) the natural human tendency to irrational optimism and pessimism in certain circumstances; (2) the creation of huge amounts of new money through bank credit expansion by central banks and the Fractional Reserve Banking system; (3) quasi governmental enterprises such as Freddie Mac and Fannie Mae in the US (involved in 95 percent of all 2007 US mortgages).

Factor (1)’s effects are obvious; these effects naturally cause and exaggerate cycles. People are optimistic on the way “up" (a boom) and pessimistic on the way “down" (a bust). This by itself, however, is insufficient to cause a boom of the type we have seen. Prices in general can only increase with either an injection of money into the market, or a decrease in the demand for money. If no money were created, a price boom in one market would coincide necessarily with falling prices elsewhere. This would lead to a natural and speedy reasserting of real preferences if some products were undervalued and others overvalued.

Factor (2) is less obvious. Direct government action, as well as its tolerance of fractional reserve banking, gives the illusion to business that more savings are held than there actually are;. Banks offer loans at lower prices due to their greater ability to do so (supply has risen with regards to demand) and this encourages greater investment. This leads firms and entrepreneurs to believe the consumption to savings ratio is more tilted towards savings than it actually is, and thus they invest more, and in more producer goods. Savings are necessarily future consumption, so businesses invest in anticipation of this, and because it costs less to do so. This “malinvestment" is revealed when the process of monetary expansion ceases. Then comes the “bust", and, as savers see through fractional reserve banks, there is a contraction of money and credit (deflation) as the bankrupt and unprofitable enterprises are liquidated through runs or closures. Factor (3) has worked similarly to (2), depressing the price of savings under their market price.

So it is essentially government interventions in the market, especially through central banking and artificial money creation, together with natural human tendencies, which created the bust whose effects we are now experiencing.

Smart meters or smart consumers?

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The government, in its wisdom, has now announced plans to install "smart meters" in all homes across the UK by 2020. These would allow consumers to see what their actual gas and electricity consumption is at any time, and also do away with meter readers, as readings can be collected wirelessly by the supplier. There would also - in principle at least - be no need for call centres to deal with complaints or revised readings.

The cost is estimated as £7bn, or roughly £15 per household for each year from 2010 to 2020. Energy companies claim that £10 of that would be funded by their own cost savings, while the remainder would be more than offset by savings made by more aware consumers. Maybe, but experience suggests that costs are probably underestimated and savings overestimated. For example, it seems inconceivable that all 26 million electricity and 22 million gas meters would work perfectly all the time, so call centres would still be needed to some extent. And what will be done about the people who have prepayment meters?

Experience also suggests that smart meters will polarise people into those who become obsessed with turning off all possible devices (but many of whom are probably already obsessed by energy saving) and those who simply ignore them. The impetus for the move comes, not surprisingly, from the government plans to reduce carbon dioxide emissions. The claim is that energy use would be reduced by 2%. The likelihood is that such savings will not materialise and, by the time all the meters have been fitted, carbon dioxide will no longer be seen as the driver of climate change. The energy companies (and smart meter manufacturers) will gain, but meter readers and call centre employees will lose.

Martin Livermore is the Director of The Scientific Alliance

Regulation gamekeepers

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Maybe the best poachers are ex-gamekeepers but one has to wonder why the Tories, when seeking new guidance for regulation in general and the Financial Services (FSA) in particular should turn to the previous gamekeepers of regulation who so conspicuously failed, namely Sir David Arculus and Sir Philip Sassoon respectively.

Sir David Arculus is a past Chairman of the Government’s Better Regulation Task Force. This was long on motherhood statements (“regulations should be better rather than worse") but ineffective in substance. The number of regulations rose to an all time high on his watch and, as the National Audit Office confirmed, the Impact Assessment process became a tick the box exercise as distinct from the robust challenge it was billed to provide. Sir David’s argument was that his influence would be greater in confidence and “within the tent". Some modest improvements have been made to process but regulations pour out unchecked and no public evidence of any success exists. Specifically, UK impact assessment was and remains entirely divorced from the EU regulatory system it was supposed to challenge – see “Worlds Apart: The EU and UK Regulatory Systems" published by the British Chambers of Commerce this month.

Sir Philip Sassoon was until recently a senior Treasury mandarin and closely connected with the FSA which has so manifestly failed the nation in its fundamental role.

I have no quarrel with Arculus or Sassoon both of whom are intelligent, knowledgeable, well connected, and well-intended people. The issue is why the Tories, when seeking new solutions, should turn to two people steeped in, and largely responsible for, the present conventions. Ask a bus driver how to get to Brixton and he will tell you the route he has always taken.

Both the Arculus and Sassoon reports have good points to make. No doubt some marginal improvements could be made but they are thinking within the box they have created. A conspicuous problem with the existing systems is the number of unrelated committees dealing with volumes of paperwork to no effect. They are unconnected with each other and, because they are merely advisory, unconnected with planet earth. What does Arculus recommend? More advisory bodies. Symptomatically, these reports pay little attention, and make almost no direct reference, to the other reports in their areas, some of which were commissioned by the Conservative Party.

The Daily Mash hits the nail firmly on the head

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MP becomes first ever person to forget he had paid off his mortgage.

Boom politics

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A report today by a committee of MPs – and we know what high standards they have – blames the banks' bonus culture as a major source of the financial crisis. The remuneration system, they say, worked to encourage bankers to go out and make deals, without worrying whether they were good or bad deals. They got the cash either way. But naturally, a lot of the deals they engineered were indeed bad.

That's true. But what brought on this bonus culture in the first place? The cause is actually down to the political system.

For the past twenty years, politicians really have believed that they were saving us from boom and bust. Any time there was a blip in the market, like the 1987 stock market slide, or after Russia defaulted on its debt, or most spectacularly after 9/11 – they 'saved' the system by flooding the world with cheap credit. Interest rates after 9/11, for example, came down from 6.5% to just 1%. With credit six times cheaper, people of course borrowed a lot more, buying houses, shares, securities, any asset they could. So many people were buying, that these assets shot up in value.

The response of the banks' management was rational. In this boom atmosphere, almost everything succeeded. Buy an asset today, it would be worth more tomorrow. Since all deals seemed to work, they naturally rewarded staff who made more deals. Of course, when the bubble burst, they all discovered just how dodgy some of these deals were.

But when you are looking at the causes of this crisis, you have to go behind the bonus culture, and not just stop there. What caused that culture was not 'greed' by the banks. They didn't all suddenly get together and decide to be really, really greedy. It was the politicians who engineered the boom that made this perverse culture seem perfectly rational. Physician, heal thyself.