Sadly, it's true, environmental regulation kills people

Today's reminder of the basic economic lesson, that here are no solutions only trade offs, comes in the fled of environmental regulation. It is most certainly true that at least some such saves lives. But also, near all regulation is also going to cost lives as well. It is the net position that needs to be calculated and taken into account over any specific action, not the gross in one direction or the other.

We have a report on the general circumstance:

Regulations frequently aim to reduce mortality risk, and many of them may succeed to varying degrees. But regulations can also increase mortality risk in various ways owing to unintended consequences.

One of the general observations should be that yes, forcing people to do whatever in a more expensive manner may will save the lives of some of those doing it. But doing things more expensively also means resources that cannot be devoted to other activities, some of which might save more lives. Again, this is just a statement of an obvious economic truth, resources are scarce.

But we can be more specific too, as this example about Bangladeshi ship breaking yards points out. Regulation means that using rich country breaking yards is more expensive. This could be justified, might not be, that's not the point. That point being that there's a reaction to that extra expense:

 More than 800 large ships are broken up each year, the vast majority on Asian beaches. Owners can earn an extra $1m to $4m (£740,000 to £2.96m) per ship when selling to Asian yards via cash buyers, instead of opting for recycling yards with higher standards, says Jenssen.

In that more general sense that's $1 to $4 million per ship broken which cannot be devoted to other matters, resources really are scarce. In the more specific the higher standards at those rich country yards mean more breaking is occurring in these poor country ones. Quite possibly (no, not certainly, jut possibly) leading to an overall increase in danger and death rates than is the rich country regulation were weaker and thus cheaper - but still higher than those poor country yards.

No, this isn't an argument against all an any regulation anywhere. It's only one that insists we do not have solutions, only trade offs. As such our decision making has to be about those trade offs, something all too absent from all too many such discussions.

We agree that falling life expectancy is an economic problem - just a different one

The Office for National Statistics tells us that lifespans aren't going to increase as we once thought they would. We agree entirely that this is an economic problem. It isn't, however, the one that such as Danny Dorling are screaming about.

Since we launched BRAVE NEW EUROPE we have stressed the violence of austerity. In 2013 David Stuckler and Sanjy Basu wrote a convincing book entitled “The Body Economic – Why Austerity Kills” concerning the short term effects upon health of austerity. In this article Danny Dorling and Stuart Gietel-Basten present arguments of how austerity kills long term.

Changes in life expectancy which are coincident with austerity (not that the UK has actually had any, government spending continues to rise in real terms) are not necessarily caused by austerity. This should be clear to any user of the scientific method - a group which may or may not include human geographers and sociologists.

What the ONS has actually said is:

Antibiotic resistance has caused a fall in life expectancy for the first time, the Office for National Statistics has said. 

Life expectancy in future years has been revised down after the statistics authority said that "less optimistic views" about the future had to be taken into account. 

Opinions on "improvements in medical science" had declined, it said, and fears of the "re-emergence of existing diseases and increases in anti-microbial resistance" meant people would not live as long as was previously expected.

We agree entirely that antibiotic resistance is an economic problem. In fact, it's a regulatory problem, we've got the regulations working against economic reality. We should thus change them in order to get them aligned of course.

The standard drug development incentive is the patent system. This is an economic solution to an economic problem, it costs a $ billion (less perhaps for an antibiotic) and a decade to get a new drug approved and once it is then anyone could (and would) copy it. Who would do this for no potential profit, it's a classic public goods problem. The answer is an artificial monopoly in the guise of that patent which protects for a decade of commercial life (20 years in full, minus regulatory approval time). Agreed, not a perfect system but a logical at least reaction to the basic public goods problem.

This does not work for antibiotics. For once a new one is developed we do not allow it to be widely used. We insist, instead and probably quite rightly, that it be held in reserve to only treat those infections which do not respond to the older treatments. That way we delay any build up of resistance to the new drug. But, obviously, we also deny the developers of the new antibiotic their chance to make their money back by widespread use of their new product.

Therefore few to no one develops new antibiotics. The problem here is in our economic system to deal with the public goods problem. We thus need a new one. No not for the entirety of the drug development system, just one to deal with this specific subset of it.

Purely by chance another discussion of the same basic point appeared concerning phages:  

If you want to know why phage therapy has problems evolving in the US, the answer is just three letters: FDA.

As phages are in a continuing red-queen evolutionary game (running as fast as you can to stay in one place) with evolving bacterial defenses and specific phages can be specific to sub-species of bacteria, there is no way of making money in this game if you have to prove “efficacy” to the FDA before you sell your specific phage for a specific sub-species of bacteria that are continually evolving.

To play this game, we will need an automated system to speed up the evolutionary selection of lytic phages as the bacteria evolve with hundreds of variations on the shelf to cover the evolutionary options open to the bacteria. All these variations need instant approval, but that would create a finite risk that the zero risk tolerant FDA won’t allow.

In a Petrie dish of E. coli, you can add a lytic phage that will kill 99.9999% of the bacteria in a few hours but by the next day, the bacteria have evolved resistance to that phage. This is what that CRISPER cas9 gene editing system is all about as the bacteria evolve to cut up the virus meanwhile the phage is mutating and evolving methods of countering the defense.

This does not fit the FDA model for a simple specific chemical and billion dollar decade-long approval systems for each chemical. Changing the US FDA appears to be a near-impossible task and our only hope is that bacteria control system based upon phages will evolve with animal culture in some other country, without FDA interference, and then move to humans outside the US and then, after massive numbers of people go somewhere else to treat multi-drug resistant bacteria, we will consider real change.

Quite possibly an extreme view but note the basic underlying point again. Our regulatory structure, set up to deal with that economic public goods problem, isn't appropriate for the economic incentives in this specific space. The answer thus is to change the regulatory structure to more closely accord with economic reality, isn't it? 

We could even say that, as with Danny Dorling, government action is necessary. But it isn't thus true that the answer is for government to be spraying yet more on the welfare state, is it? Government just needs to be doing what it is doing rather better instead. Sadly, a much harder task.

The clear and obvious merit to offshore banking

That offshore banking is one of the very terrors of the modern world is one of those things widely accepted. Yet it's possible to rework Joan Robinson's observation that the exploitation by capitalists is nothing compared to the misery of not being exploited by anyone. The existence of offshore banking does indeed limit the depredations that domestic governments can make upon our wallets, something very much better than there being no such limits to what they can do.

As Tyler Cowen points out:

Given this background, I’d like to speak up for offshore banking as a significant protection against tyranny and unjust autocracy. It’s not just that many offshore financial institutions, such as hedge funds registered in the Cayman Islands, are entirely legal, but also that the practice of hiding wealth overseas has its upside.

He then gives the example of Saudi Arabia where all the rich people have been locked up in a hotel until they "voluntarily" hand over some goodly portion of their wealth to the State. Then:

A recent study shows which countries are most likely to use offshore banking,......The top five countries on this list, measured as a percentage of GDP, are United Arab Emirates, Venezuela, Saudi Arabia, Russia and Argentina, based on estimates from 2007.

We do generally think that - as Adam Smith pointed out with his invisible hand comment in WoN - that domestic employment of capital is a jolly good idea. Offshore provides the escape hatch by which capital so deployed cannot simply be abstracted by said State. Thus reducing the risk of such deployment, thereby increasing the amount of it.

Precisely because offshore reduces the ability of the State to tax - in however a democratic or authoritarian manner -  it makes us richer. Which is a fair old justification for an economic practice really, us all getting richer being the point of having an economy in the first place.

Precisely because offshore provides a protection of sorts against confiscation that limits the amount of confiscation which is even attempted. Limiting the power of the State isn't the flaw, it's the point.

The tragedy of the £80,000 broadband connection bill

There's a reason economics is called the dismal science - it makes clear some uncomfortable truths. For example, this complaint about an £80,000 bill to be connected to broadband. If it's not worth paying that cost for the benefits to be gained then it's not worth the cost for the benefit, is it? 

The owners of one of rural Scotland’s most popular hotels for walkers and climbers has attacked the dire speed of broadband it can access after being asked to pay £80,000 to get a good connection.

Lesley McArthur, a partner in the Glen Clova Hotel in Angus, said it is forced to make do with an internet speed of only 0.5mbps and the connection disappears altogether if more than one guest decides to log on.

She argued that the remote hotel, which attracts hill walkers across the UK, makes a significant contribution to the local economy but in September was quoted the “absolutely ridiculous” sum of £80,000 by BT for a fibre-optic line.

Although Nicola Sturgeon has pledged that every premises will have superfast broadband with a speed of 30mbps by 2021, she said that the hotel could have lost “a lot of business” by the time this happens.

Let us make the - possibly unwarranted for who knows about BT's pricing but this is going to be true of at least some isolated places within our islands as it is true of electricity supply, piped water or sewage connections - assumption that £80,000 is the true cost. 

The hotel is stating that it's not worth their paying that bill for the economic benefits it brings. There is no spillover effect here, no value of a connection which they cannot capture. Thus, if it's not worth their paying the bill it's not worth anyone else doing so either.

That is, we've not changed the cost benefit analysis by suggesting that the taxpayer should pick up the bill instead. Or BT shareholders perhaps, through a universal service provision. Running broadband, with current technology, to every place out in the boonies (and looking at the map, this really is the boonies) simply isn't worth it. It makes us all poorer, the value added is less than the cost.

So, let's not do it, whoever is paying for it and however. Why would we want to make ourselves generally poorer? 

Down with the killjoys!

Public health campaigners are in many ways the modern version of religious puritans. Or at least, that’s the case according to Christopher Snowdon in his new book Killjoys, published earlier this month by the Institute of Economic Affairs.

In the book’s opening chapters, Snowdon outlines the philosophical basis for opposing paternalism of all varieties. He begins with a brief exposition of John Stuart Mill’s utilitarian ‘harm principle’: the idea that the only justification for interfering with the liberty of others is in order to prevent harm to others. It thus follows that coercing someone purely for their own good is unwarranted, according to Mill. There are various arguments used to defend the harm principle, ranging from the idea that “promoting liberty will foster originality” to the claim that “paternalism drains people of their vitality by making decisions for them.” But, in Snowdon’s view, these are not the strongest arguments for adopting a classical liberal view of paternalism:

Mill’s simplest and strongest case for individual liberty arrives...when he writes that a person’s ‘own mode of laying out his existence is the best, not because it is the best in itself, but because it is his own mode’. Since people have different tastes and preferences, it is undesirable for others, even if they are the majority, to impose foreign preferences upon them.

The vast majority of economists lie in the same utilitarian tradition as Mill, and many accept the importance of individual freedom—not paternalism—as a means of maximising overall wellbeing:

...economists believe that markets produce the best outcomes if competition exists and if choices are voluntary. For this, consumers must be reasonably well informed and reasonably rational. Like John Stuart Mill, mainstream economists assume that the average consumer is basically rational, which is to say he generally acts in accordance with his preferences.  

The majority of Killjoys applies this classical liberal approach to contemporary paternalism and the justifications employed by the killjoys who support it. It tackles soft paternalism (sometimes called ‘nudge’ policy), hard paternalism, and finally the most prominent form of paternalism in the contemporary world: “public health” paternalism.

‘Nudge’ paternalism

Snowdon’s evaluation of nudge policy (first popularized by Richard Thaler and Cass Sunstein's 2008 book Nudge) is fairly positive, despite his misgivings about some of work in behavioural economics underpinning it. He appears cautiously optimistic about efforts to correct our cognitive biases by altering ‘choice architecture’ (e.g. adding organ donation questions to driving licence forms or ensuring faster payment of income tax by reminding taxpayers that their money goes to public services). After all, this is simply applying common private sector practices to the public sector in order to make it more effective:

When government action is required for the nudge, it is when the government is already involved. Tax collection, organ donation and driving licences are all within state control. If they can be made more effective and efficient by using the same persuasive techniques  that are second nature in the private sector, why not do so?

However, Snowdon also highlights a key reason to view such soft paternalism with a critical eye. Since “most governments are more paternalistic and less libertarian than the nudge theorists”, there is a serious possibility that such interventions form the basis for a slippery slope into more coercive forms of paternalism.

‘Hard’ paternalism

Unsurprisingly, Snowdon views hard paternalism in a far less positive light. Using Sarah Conly’s unusually candid book Against Autonomy: Justifying Coercive Paternalism as a foil, he demolishes the arguments of those who would ban cigarettes, ban trans fats, increase required savings and even potentially ban soda. Conly’s key argument rests on the idea that humans all share certain universal goals: namely health and financial security. Think like an economist, and you recognize this as a nonsensical justification for coercive paternalism:

If we judged people’s desires by their behaviour – as economists do – we would not conclude that pristine health is their only goal. Even stated preferences do not imply that people prioritise a long life over all other considerations. When The Who sang ‘I hope I die before I get old’ in 1965 they were reflecting a stated preference for living fast and dying young that is not uncommon. A young man who leads an unhealthy or risk-taking lifestyle while claiming to have little or no interest in getting old is being consistent in his stated and revealed preferences.

Conly recognizes the existence of such trade-offs, qualifying her paternalism with the idea that the benefits of an intervention must exceed the costs. But, as Snowdon highlights, her cost-benefit analysis is vague and arbitrary. Like many paternalists, subjective valuation trumps consistent application of her principles:

The more one reads of the paternalism literature, the more one is struck by ad hoc exceptions being made to supposedly universal principles. That these exemptions tend to reflect the public mood of the day only confirms Mill’s fears about the tyranny of the  majority. Smoking and eating dominate both Against Autonomy and Sunstein’s Why Nudge? as if they were in a separate class of risky pursuits. When it comes to activities that pose an acute risk of death at a young age, such as motorcycling and mountaineering, paternalists have little to say other than that participants should, perhaps, be forced to wear a helmet. There must be a suspicion that dangerous sports get a free pass because they are seen as daring, unusual and physically demanding whereas drinking, smoking and drug  taking are undemanding, common and intoxicating.

Snowdon concludes the chapter with an defence of ‘slippery slope’ concerns, using mandatory seatbelt laws as one such example. Such minor infringements of the harm principle aren’t particularly destructive in themselves, but they do “change public perception about the objectives of criminal law.”

‘Public health’ paternalism

According to Killjoys, the modern ‘public health’ lobby is just an updated form of the groundless puritanical moralism that Mill sought to combat in his day. Snowdon describes it as “quasi-utilitarian” in its rhetoric, but decidedly not utilitarian in practice. After all, a philosophy that aims to maximise the length of our lives is not the same as one that aims to maximise satisfaction of our rich tapestry of individual preferences:

...‘public health’ paternalism cannot be justified by welfare economics or utilitarianism. It is simply a form of ends paternalism in which health and longevity are assumed to be overriding goals.

The case for public health interventions is clearly strongest when there is no alternative to collective action: “tackling health risks in the share environment which cannot be controlled by the individual, such as air pollution, or those involving people (or animals) who carry infectious diseases.” But the public health lobby has experienced significant mission creep in recent decades:

Since the 1970s...the scope of public health action has moved beyond hygiene and contagious disease to target self-regarding personal behaviour. As Richard A. Epstein explains, the modern ‘public health’ movement ‘treats any health issue as one of public health so long as it affects large numbers of individuals’.

Snowdon is at his strongest when analyzing the politics of public health paternalism. He reveals the different strategies used to curtail individual freedom in the name of keeping us alive longer:

Being a political movement, the literature of ‘public health’ paternalism differs from that  of the academic texts discussed in earlier chapters in two important respects. Firstly, it tends to focus on short-term policy objectives rather than present a full vision of what it thinks society should look like. Long-term objectives are rarely made public, perhaps because the logical outcomes are so extreme that they would alarm the median voter. Only recently, for example, has the goal of cigarette prohibition been openly discussed in the ‘public health’ literature despite it being the only natural conclusion of the anti-smoking crusade.

Appeals to compensating for negative externalities are also exposed as creeping paternalism:

That negative externalities are used by paternalists as an excuse for interference can be  seen in the way they demand taxes be set far higher than the Pigouvian rate [the rate at which the cost of negative externalities are compensated for] and demand excessive regulatory responses to questionable externalities.

He also tackles anti-advertising crusades based on general anti-capitalist hostility to free markets, and various other methods employed by the public health lobby to forcibly impose their own vision of the good life on the rest of us. If you’re going to read just one chapter of the book, make it this one.

Conclusion

Following a section exploring the harms of paternalism—higher costs, substitution effects, black markets, in some cases unintended consequences of poorer health—Snowdon devotes the final chapter of Killjoys to describing effective, welfare-enhancing, classical liberal alternatives to paternalism. More education, Pigouvian taxes, and creating an environment conducive to innovation in harm reduction are all key pillars of this strategy.

Although I didn’t explicitly call myself a libertarian until I was 16, I first felt libertarian after thinking about the smoking ban when I was a lot younger. Back then, my views were based on a purely instinctive disdain for those who think they know how I should live my life better than I do. Many others share this attitude towards different forms of paternalism, and Killjoys gives them the intellectual ammunition to resist modern-day puritans. It’s also a solid introduction to applied economics and looking at the world through utilitarian lens.

You can read Killjoys on the IEA website here, or order the book here.

As we've been saying, there is no Brexit divorce bill

As we've pointed out before there is no such thing as the Brexit divorce bill. This is not to take sides in the current argument - although some of us are known to be highly partial, even prejudiced, upon the subject - it is to point out a basic economic, even accounting, point.

Sunk costs are sunk costs and they do not and therefore should not influence our decisions. This is akin to probability. Before we throw a normal die there is a 1 in 6 chance of any one number. After we have done so then the result has a probability of 1. It has happened. So it is with sunk costs.

Whatever the number is, whether it's €100 billion or whatever change we deign to toss into into the EU's will politic for food begging cup, this is still the wrong answer: 

But those remainers who feel no obligation to defend this government have every right to be as appalled by this £50bn bill as Farage and co. They – we – can see that it’s necessary for a club member to honour their debts as they leave after 44 years of membership. But, boy, what an unforgivable waste of money.

For let’s remind ourselves of the basic truth here. We’ll be paying this money for the privilege of not being in the European club.

This is not true in the slightest. Recall what the EU's position is. You have agreed to pay this as a part of your membership. If you leave you should still pay the amount you agreed to pay.

OK. Or maybe not OK to taste. But quite obviously, if we pay whether we go or stay then it's not a cost of either going or staying, is it? It's a sunk cost, a result of decisions taken in the past and decisions made now won't alter it in the slightest. 

It is true that leaving means we're not signing up to a continual stream of such future payments. But meeting our current contractual obligations is a sunk cost, one that we'll have to pay whatever. It's thus not a useful fact to include in our decision process, just because the decision either way makes no difference to us.

Yes, really, sunk costs are sunk costs. 

Why are Industrial Strategies always such stinkers?

The British Government has announced its Industrial Strategy. The problem being that it's the same as everyone elses' industrial strategy ever. A rag bag of whatever is thought to be fashionable or politically appealing at the time with nary a hint of any actual strategy to it.

Now it's entirely true that we're opposed to the very idea, insisting as we do that the structure of the economy is something emergent from the interactions of people within it. But even so this latest one is a stinker.

For example, we're told that the entire nation is going to be wired up to 5G, there will be superfast broadband everywhere. OK. We're also told that there will be a superfast rail network covering the country. Entirely missing the already proven point, that internet access everywhere destroys the economic case for fast trains. 

Yes, we do already know this - they've already been told to go back and do the numbers for HS2 again.

To explain for those who don't know. In a cost benefit analysis the value of a faster train set is the time saved by those travelling upon it. Business travel is assigned a significantly higher value per hour of travel time saved than leisure. On the grounds that if business types were not travelling to do business they would be in an office somewhere doing business. We wouldn't swear to these figures but £50 to £60 an hour for business types, £10 to £12 for leisure travel is about right.

The economic case for higher speed trains depends very heavily on those higher values for business travel. Both the values and the number of people.

But here's the catch - those numbers come from how the world was decades ago. Including the assumption that being on a train means being unable to do business, one can only sit there travelling to do business. No one who has actually been in a first class compartment in the past decade or two can possibly believe that this is how people work today. Mobile phones, then mobile internet (yes, trains do have it these days) have entirely changed that. Work is done on the move. In fact, scratch a regular traveller and you might well find an agreement that travel time is more productive these days.

Thus the major (and yes, really, it is *the* major) benefit in our cost benefit analysis of fast train sets does not exist. 

That is, if we wire the country so that the internet is available anywhere and anywhen then we've entirely destroyed the economic case for fast train sets. 

Which brings us back to industrial strategies. The claimed argument in favour of them is that they allow joined up government and planning. Yet in practice they always, but always, include stinkers like this. We must spend tens, if not hundreds, of billions on fast train sets when we've just made them redundant by wiring the country instead. This is not big, not clever and not joined up.

It is, instead, just a repeat of the ragbag of the ideas generally thought to be fashionable or politically appealing.

Better, we are certain, to leave the economy to be emergent from the interactions of the people within it than insisting on spraying the wealth of the nation up against the wall in this manner.

Let's stress about our banks a little bit more shall we?

Earlier this morning the Bank of England released the results of its latest set of stress tests for the 7 big UK financial institutions.

Having been up much of the night for a BBC Live 5 interview at 5:30, I've only had time to do a quick take and will leave a proper analysis for another time. But in the meantime, consider this from the Exec Summary:

"The economic scenario in the test is more severe than the global financial
crisis. Significant improvements in asset quality since the crisis mean that
the loss rate on banks’ loans in the stress test is the same as in the financial
crisis. In the test, banks incur losses of around £50 billion in the first two
years of the stress. This scale of loss, relative to their assets, would have
wiped out the common equity capital base of the UK banking system ten
years ago."

The stress is more severe than the GFC? Losses from the GFC were half a trillion, maybe
more. So a stress more severe than the GFC produces a tenth of the losses of the GFC?

"The stress test shows these losses can now be absorbed within the buffers of
capital banks have on top of their minimum requirements.

"Capital positions have strengthened considerably in the past decade. Banks
started the test with … a Tier 1 riskweighted capital ratio of 16.4%. The
aggregate common equity Tier 1 (CET1) ratio was 13.4% — three times
stronger than a decade ago."

Capital ratios based on the RWA denominator are meaningless.

"Even after the severe losses in the test scenario, the participating banks
would, in aggregate, have a Tier 1 leverage ratio of 4.3% …"

Many experts suggest that we should have minimum of at least 15% and Lord King in his memoirs suggests that a core capital to assets ratio of 10% would be a good start.

An increase in book value capital is one thing, but a decrease in market-value capital is another. In market value terms, banks have less capital than before the GFC.

Let’s take the BoE results at face value. Their best stress tests say now that all UK banks would pass their standard.

For them Barclays has a stressed leverage ratio of 3.6%. Pass standard also 3.6%. By my best estimate, Barclays’ market value leverage ratio is well under 2%.

RBS, perennial problem child, has a stressed leverage ratio of 4.0%. Big change from last year’s 2.9%. But it hasn't returned a dividend in ten years. By my estimate, its leverage is well under 3% and could well be much lower.

Santander UK: their stressed leverage ratio 3.3%, while the pass standard is 3.25%.

Last but not least, we should remember Lloyds and Nationwide: each with huge real estate portfolios–let’s hope house prices don’t fall!

Misconduct costs are given as 0.6 percentage points. That is a lot. Remind me, how many of those responsible for the great financial crisis of the last decade are in jail?

John McDonnell tells us that we'll all make massive profits from government spending

There are two - useful anyway - possible responses to this latest assertion of John McDonnell. One is hollow laughter, the second is a more robust stream of Anglo Saxon. For what he's saying is that it doesn't really matter what government spends borrowed money upon, it's all still bound to make us richer.

Well, yes.

By focusing on the cost of government borrowing (currently close to an all-time low, thanks to tiny interest rates) rather than the enormous social and financial returns on investing that money, the right creates a narrative that investment costs society rather than benefits it.

Lurking behind this is an assumption that a government cannot invest productively – the belief that government borrowing is akin to burning money. This is nonsense used to support the economic approach that has led our country to this pass. Very clearly, government investment can and should be used to support economic growth, as the OECD and others recommend – as indeed this Tory government, in some small way, is coming to recognise, committing a small amount of borrowing for investment. The meaningful question is whether that investment is wise, given the costs – rather than presuming that only costs exist.

Or as he's expanded upon:

Asked by BBC Radio 4’s Today presenter Mishal Husain how much extra it would cost to service public debt under Labour, McDonnell would not give a figure, saying extra borrowing would “pay for itself”.

The problem with this argument is that it is nonsense.

We can, dependent upon how Keynesian we want to be, make the argument that in a depression and the like then government spending upon near anything can make us all richer. It's not a view we subscribe to particularly but we'll acknowledge that it's out there. That isn't where we are though, is it? We're at or at least about full employment, there's little to no spare capacity in the economy. Thus a simple and pure increase in spending isn't the answer to whatever remaining problems we have - that would just cause inflation.

What is necessary for McDonnell's argument is that whatever the borrowing is spent upon is worth more than the cost of the borrowing. For purists we should also be insisting that it creates more value than alternative uses of the same money - opportunity costs or crowding out. This is possible, certainly. The amount spent upon enforcing property rights is the very basis of our having a functioning economy at all thus it's obviously true that some at least government spending passes this test.

But this isn't the hurdle which must be leapt. Rather, we need to know that the marginal spending will pass it. At which point we might look at the two major infrastructure projects currently under discussion, HS2 and the Swansea Lagoon. Both of which fail their cost benefit analyses. That is, they make us poorer, not richer. As they do so they clearly and obviously do not manage to pay back their construction costs, let alone the interest on the borrowings to finance them.

In the past this was also not true of the Edinburgh tram system, the Humber Bridge, the Tanzanian ground nut scheme and that multitude of other bright ideas that the political process has spent our money upon.

It is indeed theoretically possible that government can add value. It even does so, which is why we continue to have it. We've little to no evidence that this is true of the various building sets that politicians love so much. Therefore, how about not spending our money upon them? 

After all the private sector will already be doing those things that are clearly and obviously identifiable as profitable....

The 2017 Bank of England Stress Tests – What to Expect

Key points

• The key issue is and always was the (lack of) resilience of the UK banking system.

• It is mathematically impossible to take a weak banking system, subject it to stress and come up with a resilient banking system.

• The BoE stress tests are worse than useless because they offer false risk confidence, like a cancer test that cannot detect cancer.

• The biggest risk facing the UK banking system is the Bank of England’s complacency about it.

The results of the next set of BoE bank stress tests are due to be released tomorrow morning.

The key issue, as always, will be the BoE’s attempt to portray a resilience that isn’t there.

These stress tests work as follows. We start off with the banking system at the start of 2017. The BoE then puts the banking system through a couple of hypothetical stress scenarios and focuses on the stressed capital ratios at the peak of the stress at the end of 2018. These are to be compared to the relevant pass standard: a bank passes the test if the stressed capital ratio is at least as high as the pass standard.

So we have the capital ratios, the stress scenarios and the pass standards.

The BoE will focus on the capital ratios that look most impressive, portray the stress scenarios as severe and keep the pass standard as low as it thinks it can get away with.

Think of the stress tests as a parlour a game that the Bank likes to play. The Bank has to persuade us that the banking system is strong. Whether it is or not is another matter and doesn’t matter. The Bank plays the role of Tommy Cooper and has a number of tricks up its sleeve or wherever. Our (analysts’) role is to catch them out. It’s great fun.

Capital ratios

The BoE’s favourite capital ratio is the ‘CET1 ratio’, the ratio of Common Equity Tier 1 (CET1) capital to Risk-Weighted Assets (RWAs). However, results based on this ratio are not the worth paper they are written on, because the RWA measure is highly unreliable (because it is highly gameable and makes no sense anyway), and the BoE’s own chief economist Andy Haldane has discredited it.

This leaves us with a class of capital ratios known as leverage ratios. A leverage ratio is the ratio of core capital to the total amount at risk. The BoE will want to maximise this ratio by selecting the highest numerator and the smallest denominator.

Numerator: Basel III postulates two measures of core capital, Tier 1 capital and Core Equity Tier 1 capital. Tier 1 is larger than CET1 because it includes Additional Tier 1, e.g., Contingent Convertible bonds or CoCos. However, CoCos are unreliable as core capital so the leverage ratio should always be measured using the narrower/smaller CET1 measure. The BoE prefers to use Tier 1 because that boosts the reported leverage ratio, but the BoE has no valid reason to use the Tier 1 measure instead of the CET1 one.

Denominator: Traditionally, the leverage ratio (or capital-to-assets ratio, as it was called) used Total Assets (TA) as the denominator. However, Basel III introduced a new denominator known as the Leverage Exposure (LE), which was meant to take account of some of the off-balance-sheet risks that the TA left out. Curiously, for most UK banks, the reported LE is less than the reported TA. Go figure.

In the last year or so, the BoE has also come up with a new trick. In the face of lobbying from the banks, the BoE has authorised a new LE – let’s call it LE BoE – that consists of the old LE minus banks’ deposits with the central bank. So we now have the old LE measure, as per Basel, and the new smaller LE UK measure.

There is also the distinction between book-value and market-value. Most financial economists would suggest that market-value is more informative, especially when market values are less than book. The ratio of market to book values is the Price-to-Book (P2B) ratio, and the average P2B across the big 5 banks is about 67%. The most obvious interpretation of such a low P2B ratio is that the banks are carrying losses that are not reflected in their accounts (a red flag!). An alternative explanation is that markets expect the banks to make low profits in the future, i.e., so their business models are questionable. But either way there is a systemic concern and the BoE is in denial.

Sir John Vickers and I have been arguing for some time that the BoE should pay more attention to market-values and, at the very least, report market-value-based results in its stress tests. The BoE refuses to do so, perhaps because doing so would make for less impressive headline results.

Note that to argue that market values are more informative than book values is not to say that market values are in any sense ‘perfect’ or to buy into a strong form of the Efficient Markets Hypothesis.

Market values also provided a better indicator of looming financial distress than book values did ten years or so ago.

The stress scenarios

The risk management literature recommends that stress testers should use multiple sets of scenarios for a simple reason: if there are too few scenarios, then there is a danger some material risk will be overlooked. We definitely don’t want that.

Traditionally, the BoE uses just one main macroeconomic scenario. This year, it will use two.

The pass standard

In the past, the pass standard for the Tier 1/LE was 3%.

As a general rule, the pass standard should be no less than the minimum required leverage ratio (otherwise the exercise makes no sense). This 3% comes from the Basel III capital rules, which impose a minimum required (Tier 1/LE) leverage ratio of 3%. Since Basel III also specifies that at least 75% of Tier 1 capital should be CET1 capital, this 3% leverage ratio translates into a minimum CET1/LE ratio of 2.25%.

More recently, the BoE introduced a second minimum required leverage ratio: the ratio of Tier 1 to TA should be at least 3.25%. I would describe this second leverage ratio requirements as long overdue baby steps in the right direction.

How high should the leverage ratio be? Well, in his book The End of Alchemy, Mervyn King suggest that a ratio of core capital to TA of 10% would “be a good start”. Many economists suggest a minimum of at least 15% and maybe more: see, e.g., this famous FT letter by Anat Admati and 19 other distinguished financial economists.

In short, the current pass standards/minimum required leverage ratios are nowhere near high enough.

UK banks’ current leverage ratios

The table below gives some key leverage ratios for the biggest five UK banks.

Take Barclays. Using Tier 1/UK LE as the leverage ratio – one suspects that this will be the one that the BoE will be pushing – the leverage ratio is 5.1%. But if we replace Tier 1 with CET1 and replace LE with TA, then the leverage ratio falls to 3.9%. Then apply the market-value adjustment and the leverage ratio falls to 1.7%. One can read off the leverage ratios for the other banks in a similar manner.

The (unweighted) market-value average CET1/TA leverage ratio across the banks is 3%, a nice round number.

A loss of 3% would wipe out their capital.

I would suggest that these leverage ratios do not paint a picture of financial resilience that any reasonable person would recognise as such – and this is the current situation before any stress is applied.

The Bank’s challenge is to take this set of already weak banks, seriously stress them and then demonstrate their post-stress resilience. Good luck on that.

IFRS 9

On January 1st 2018, the new accounting standard IFRS 9 comes into force to replace IAS 39. IFSR 9 is intended to remedy some of the flaws in IAS 39 associated with the latter’s incurred loss model, by which losses are not recognised until incurred. Were IFRS 9 implemented as originally proposed, banks would have to report losses expected over the next 12 months and the banks would take a capital ‘hit’ as the new regime came into force. It is a matter of consider public interest to know how large that ‘hit’ might be.  

For more on these concerns, see my October 3rd letter to Alex Brazier. This letter requested that the BoE report stress test results based on fully loaded IFRS 9, i.e., IFRS 9 when fully phased in. Since Mr. Brazier did not offer any such reassurance, one can expect the BoE to fudge this issue and it will be interesting to see how they do it.  

General issues with stress tests

All regulatory stress tests suffer from generic problems:

1. The most basic is a lack of credibility. Even if the BoE genuinely believed that the UK banking system was in poor shape, they could not possibly admit to it, in part because they have an obligation to promote confidence in the banking system, and in part because such an admission would imply that the BoE had failed to fix the system, despite their repeated promises that they had done so. So when the BoE reassures us that the banking system had successfully passed the stress tests, well, they would say that, wouldn’t they?

2. The stress tests fail to identify important risks facing the UK economy. The IMF and the BIS have been warning about these for years. The stress tests are worse than useless because they give false risk comfort, a bit like the comfort of a cancer test that does not detect cancer.

Stress tests are just superstitious implements with a veneer of financial rocket science. Financial rocket science isn’t reliable either. Remember the Global Financial Crisis? Relying on this stuff is like using chicken entrails to warn of earthquakes, the difference being that sometimes the chicken entrails get it right.

3. The track record of regulatory stress tests is an appalling one. Regulatory stress tests told us that the Icelandic, Irish, Cypriot and Greek banking systems were sound. Whole banking systems, not just individual banks. Each failed not long afterwards and the stress tests failed to warn us. False risk comfort.

These problems are sufficiently serious that the only way to fix the stress test programme is to scrap it. But how would we be able to assess the state of the banking system, you might ask? Answer: by getting the accounting standards right. Gimmicks like stress tests don’t help.

The biggest risk facing the UK banking system now is, thus, the Bank of England’s own complacency.

Highlights from last year’s stress tests

We should keep in mind some of the highlights from last year’s stress tests and one suspects that similar issues might arise this time round as well.

What was striking last year was the number of errors of fact made by the BoE, both in its November 30th press conference and in the later January 11th 2017 TREASCOM meeting, when BoE witnesses were caught unaware by a story on News at Ten the previous evening. I detailed these in No Stress III last September.

Let me give Governor’s Carney’s remarks at that press conference as an example:

The resilience of the system during the past year in part reflects the consistent build-up of capital resources by banks since the global financial crisis. … the UK banking system is well placed to provide credit to households and businesses during periods of severe stress. […]

That conclusion is corroborated by the 2016 stress test [which is] broad, coherent and severe …”[…]

[The adverse stress scenario led to] system-wide losses of £44 billion over the first two years of the stress – five times those incurred by the same banks over the two years at the height of the financial crisis. (My italics)

This is nonsense. 44 ÷ 5 = 8.8 so Governor Carney seems to be suggesting that the losses from the peak years of the GFC were under £9 billion. However £9 billion is small beer and if he is right, then what was all that GFC fuss about?

In any case, Carney’s £44 billion ÷5 = < £ 9 billion two year loss is not right.   

Consider:

• The BoE recently estimated that HBOS alone experienced losses of £34.6 billion in 2008-2009 and losses of £52.6 billion in the period 2008-2011. HBOS was not even among the big 4 banks.

• Among the big 4, RBS experienced a loss of £40.7 billion in 2008 alone and losses in excess of £51 billion over the period 2007- 2010.

The issue is not the losses reported over any two-year period, but the losses incurred bearing in mind that banks were reluctant (for obvious reasons) to reveal their true losses and had every incentive (e.g., they wanted to get to be bailed out) to kick the can down the road. The relevant issue is not the reported losses but the cumulative losses since the start of the GFC.

So how large are these, actually?

I am not aware that the BoE has tried to work this number out, but several experts whom I trust have made attempts to estimate these numbers:

• Tim Bush from PIRC came up with the number > £ 98.4 billion back in 2011, which he has since suggested might be an understatement. His estimate was a cautious one, but the number itself is alarming and is in any case much greater than Carney’s £8.8 billon.

• James Ferguson of the MacroStrategy Partnership suggested a year ago that the cost might be £450 billion.

For some time I thought that Mr. Ferguson’s number was right but I am now wondering whether his number is high enough.

What made me think again is this chart from a recent speech by Martin Taylor, a member of the Bank of England’s Financial Policy Committee:

This chart reports losses of over £350 billion (and I emphasise billion not million) by early January 2009. Goodness, if the losses were over £350 billion then, one must wonder what they must be now. The honest answer is that I do not know, but in any case, one can say fairly confidently that these losses are likely to be more than the £8.8 billion suggested by Dr. Carney.

If the BoE cannot get such critical points right, then its credibility is shot and that is surely the central message.

Further reading

K. Dowd (2017) No Stress III: The Flaws in the Bank of England’s 2016 Stress Tests. London: Adam Smith Institute (September 14). Press release and summary here.