Are the big banks simply paying efficiency wages?

We all know that top bankers at large banks get paid vast sums of money. But quite why is still a matter for discussion. It isn't, cannot be, simply because bankers are greedy. We know that everyone's greedy so that's not an explanation of why some and only some are getting the big bucks. An interesting piece of research gives us further insight:

The next step is to look at executive pay. Unsurprisingly, the chief executives of the big banks come out on top. Between 2010 and 2013, the median total pay, including cash and stock awards, of the CEO of a large bank was more than $57 million, $22 million above the median compensation for the chiefs of smaller firms, according to Mr. Cannon’s research. What drove these paychecks? Not performance but size. Mr. Cannon found no apparent links between compensation and shareholder returns, but he did discover a robust connection between a bank’s assets and its officers’ pay. “There is strong evidence that size has been the key driver of bank executive compensation since the financial crisis,” his note concludes.

People who run larger banks get more money than those who run smaller ones. And that's just about only connection to pay that we can see.

So, if you want to reduce top bankers' pay then reduce the size of the top banks: and since we want to do that anyway, to get rid of the whole idea of too big to fail, why not?

But what this is also telling us is that in the current system the banks are behaving entirely rationally. Or at least potentially so according to the idea of efficiency wages. This is often put forward by Chris Dillow, the thinking man's Marxist. The larger the organisation, and the less detailed oversight it is possible to have of the people running it, the higher the efficient level of wages to pay to those running it. Simply because there's more shareholder value for them to lose if they mess up, and there's more for them to steal if they're that way inclined. We could describe it as bribing them to stay attentive and honest and if that's the way you want to describe it then fine. But it is also efficient, which is why perhaps people do it.

Gary Becker was right, part two: Cuba

For many years Gary Becker wrote a blog with Richard Posner.  In the last entry, shortly before his death at age 83, Becker wrote one entitled "The Embargo of Cuba – Time to Go."  The US embargo of Cuba, began in 1960, was designed to put pressure on Castro's communist government, and if possible to persuade Cubans to overthrow it.  It did not achieve that objective, but it did give Cuba a fig-leaf excuse to explain away the economic failure of communism.

In 1959 Cuban, exporting tobacco and sugar, was richer per head than Taiwan, exporting rice and sugar.  Nowadays Taiwan has a modern, open market economy trading globally, and has a per capita income over five times that of Cuba, where tobacco and sugar are still important exports.  Becker wrote:

Since Cuba no longer provides any significant threat to American interests, there is no sense in continuing to punish the Cuban people with an embargo on trade, nor to provide excuses to its leaders for the poor performance of the Cuban economy.

This is one of the main objections to embargoes: they punish the wrong people.  General embargoes hit the living standards of poor people in countries subjected to them.  Those people are denied access to global goods, and cannot sell what they produce on world markets.  They also hurt the countries that impose them.  The US International Trade Commission estimates that its embargo on Cuba costs America $1.2bn annually, largely through lost potential gains in tourism, agriculture and other industries.

Becker recommended that "free trade is a principle that the United States should follow except in extraordinary circumstances," a sentiment most free market supporters would endorse.  Richard Cobden thought that free trade between nations would eventually lead to peace, and it is true to a large extent that nations which trade with each other learn to negotiate with each other and settle disputes peaceably.  Furthermore, trading nations begin to see each other as partners, to depend on each other for goods, and for their peoples to learn more about each other.

Becker is right.  Raising the Cuban embargo would bring immediate benefit to the people there, and would probably speed up that country's retreat from communism and its entry into the modern world.

Talkin' Bout a Revolution

Well, you know, if you say you want a revolution then you do need to understand what the others who might revolt with you are revolting against. And contrary to a popular misconception it isn't true that all who are willing to revolt against the current order are doing so for the same reasons you are. Or even trying to revolt in the same direction you are. We here at the ASI are of course in the vanguard of the neoliberal revolution, railing against the manner in which the State is captured by special interests, the way that regulatory capture depresses the economy, the way that civil liberties are whittled away in favour of a soft authoritarianism. I, Tim Worstall, am of course an extremist even by our local standards at Great Smith Street (one editor recently dismissed me from a publication on the grounds that I am a "hyperneoliberal" which by the genteel standards of American journalism I might well be). All of which is what makes this analysis in The Guardian so amusing to both I and us:

In the twilight of neoliberalism it's comics such as Russell Brand and Beppe Grillo who puncture establishment thinking.

It's entirely true that Beppe and Brand are railing against the current establishment.

Brand is not an isolated figure. In Italy the comedian Beppe Grillo has been the catalyst for the Movimento Cinque Stelle (Five Star Movement), a populist, anti-corruption organisation which has tried to position itself outside of the traditional left-right paradigm.

Quite so. But to lump Brand and Grillo together is to entirely misunderstand what each is attempting to say. As far as Brand is concerned we seem to have the standard Teenage Trotskyism that most of us grow out of around our 16 th birhday and the discovery of the opposite sex. Beppe Grillo is a far more complex and interesting phenomenon.

For Beppe has been known to tweet on to his followers (the Movimento 5 Star operates largely through social media) pieces from myself, that hyperneoliberal. And anything more than a cursory glance at the movement's desires and policies show that they wish to move Italian society in a more neoliberal, or even just a more classically liberal, direction. They wish to cull parts of the State, kill off some of those special interests, revive civil liberties and reduce the regulatory capture that plagues Italy.

Just because some ponderous theorists decry neoliberalism it doesn't mean that all revolting against the current order share that analysis. It can be, indeed it is, true that some similarly decry the current state of affairs but are arguing for more of what the theorists decry. Grillo is outside the traditional left/right divide in Italian politics just as we here at the ASI are outside that traditional divide in British. We're both arguing that classical liberal polity, that set of policies that doesn't actually have a home in any of the traditional parties.

We might all be talkin' 'bout a revolution but it's not necessarily the same tables that we want to turn.

Piracy deal ahoy!

After years of impasse, UK Internet Service Providers and the copyright holders of the entertainment world look set to sign off an agreement on internet piracy. According to the Beeb  a 'voluntary copyright alert programme' is to be agreed. Under this, ISPs will identify the IP addresses of alleged copyright offenders and send them ‘educational’ letters on copyright violation and legal alternatives to piracy. Whilst a similar ‘six strikes’ scheme in America sees ISPs able to impose sanctions (such as slowed internet speeds) on persistent offenders, the UK scheme does not. The amount of letters that ISPs can send is capped, and no individual will receive more than 4 letters. Following these, no further action will be taken.

This voluntary agreement breaks a deadlock between content giants, the government and ISPs caused by the Digital Economy Act (DEA). Rushed through in the parliamentary wash-up of 2010, the DEA's copyright provisions instruct ISPs to keep a database of persistent downloaders, and to restrict then finally suspend internet access to those who ignore written warnings.

These provisions are deeply problematic. They force ISPs to police their own customers, burden the companies with compliance costs and ask them to protect another’s intellectual property. Punishing alleged copyright infringers without judicial involvement also undermines the rule of law. Criticized by many politicians, civil liberties groups and the ISPs themselves, none of the Act has been actually implemented.

On the face of it, it’s good that the new agreement is such a watered-down version of earlier proposals. It’s certainly a far cry from what the content industries really want: effective barriers to piracy and access to a list of infringers to hit with ‘compensatory’ legal action. Advocates of internet freedom should be pleased. That said, the agreement doesn’t change the power of copyright holders- they can still get infringing content removed and websites blocked under existing legislation.

Furthermore, skeptics might think that the entertainment industry’s acceptance of the new scheme is just them playing the long game. The programme is meant to run for 3 years but be regularly reviewed. Rights holders have warned that should the scheme prove ineffective they will push for the “rapid implementation” of measures in the DEA.

If the objective is to deter piracy it’s obvious that the scheme will be next to useless: sending ‘educational’ letters will do little to change the behavior of serial downloaders. What it does do, however, is let the entertainment industry claim that a soft approach doesn’t work, and gets ISPs creating a database of copyright infringers that rights holders might win access to in the future. Playing ball now gives the copyright giants credibility to push for more extreme measures later on.

This might seem cynical, but the established entertainment bodies are reluctant to let go of their increasingly outdated business models. Returning to the DEA also gets governments back in the picture, whom copyright bodies often have great success in lobbying. From the ‘Mickey Mouse Protection Act’ of 1998 to the recent EU extension of the copyright in sound recordings, entertainment groups have a knack of preventing their goods from falling into the public domain, and ensuring that governments favor their industry’s profits over actual economic sense.

Understandably, media groups want people to stop illegally sharing their stuff. But instead of lobbying for legislation and slapping fines around the most effective deterrent is to understand consumer’s preferences and offer them valuable alternatives to piracy. Whilst movie bodies get angry at Google for linking to copyrighted material without really tackling their problem themselves, Spotify’s quite probably done more to combat music piracy than blocking The Pirate Bay ever has. However, instead of evolving the copyright industry seems to go out of its way to antagonize consumers, rent-seeking and objecting to even the most eminently sensible of copyright reforms.

Given the entertainment industry’s determination to protect their intellectual property, it’s unlikely that efforts to tackle piracy will end with a voluntary alert system. Whilst innovating companies will continue to find new ways of sharing and monetizing content, for the time being the copyright-holding giants of the entertainment world will remain preoccupied with the wrong prescriptions for piracy.

Gary Becker was right, part one: Crime

Gary Becker famously applied economic thinking to whole areas of activity that lie beyond the realm of narrow economic transactions.  One such area is crime.  The prevailing thinking of the day was that criminal activity derived from mental aberration or from social repression, and might be tackled by measures to improve mental health or to upgrade social conditions. In his paper "Crime and Punishment – An Economic Approach" (1968) and in subsequent publications, Becker advanced the alternative view that criminals were basically rent-seeking, trying to secure more of the resources that others produced instead of contributing to economic growth themselves.  He posited that criminals are rational, performing a kind of cost-benefit analysis in which they set the gains they stand to make from a crime against the likelihood of being caught and facing a penalty.

Society can alter that cost-benefit equation in two ways, by increasing the likelihood of detection, or by increasing the penalties faced upon conviction.  Increased police presence is by far the costlier of the two options, while jacking up the penalties can be relatively less costly to do.

Becker's insights have altered the way in which authorities tackle crime.  Zero tolerance, for example, proposes that pursuit of minor offences ("broken windows") can create a climate in which potential criminals feel they are more likely to be caught.  The use of CCTV to identify criminals by recording them in the act is similarly intended to raise the stakes of crime by making its detection seem more likely.  On the other side of the equation the use of longer prison sentences also increases the costs that the potential criminal has to set against the benefits.

It was entirely typical of Becker, and part of his great contribution, that he took economics out from the economy itself and into the activities and relationships in society at large.  Crime was one such area.

There's plenty of brownfield land but perhaps we don't want to build on it

A standard trope in the current arguments about planning permission is that we don't need or want to build on green belt land, or even unproductive agricultural land, because there's so much brownfield land lying around and available. Well, yes, this could be true but why would we want to poison people by sticking houses ontocontaminated land?

Hundreds of homeowners have been told their £400,000 properties could have been built on 'contaminated' land - and it's not safe for their children to play in the area. Environment officers at Tunbridge Wells Borough Council have warned residents of three streets in Paddock Wood, Kent, they may be at risk. They say 'potentially dangerous' chemicals including asbestos and creosote could have seeped in to the ground. The substances could have 'an impact on human health', they added.

This is land that used to be a timber treatment works. And a great deal of such brownfield land lying around the place is contaminated with one thing or another that we now think isn't all that wise to have lying around in a garden.

Fortunately, we do have a solution to this sort of problem. It involves that complex thing called "price". Along with the mystifying to many interactions of "markets".

We could, for example, have a rational and sensible system of planning to allow low density building where people actually want to live, as we outlined in Land Economy. There would then be that magical "price" stuff happening. Brownfield land that was, by virtue of location or ease of cleaning up, worth more than more rural land for building upon would get built upon. That which is not worth more than the costs of clean up would not. And so, by that miracle of "markets" we would be creating the most value possible by creating that valuable housing at the least cost. And, of course, the synonym for "creating the most value" is "making us all richer".

Plus we'd avoid the possibility of poisoning an entire generation of children by insisting that they live in houses built on polluted land.

Amazing what markets unconstrained by ridiculous regulation can achieve really.

By George

Tim Lai argues that George Osborne's deficit reduction plan has been painful, but the right choice given the alternatives. The Conservative party’s prospective Chancellor of the Exchequer, George Osborne, faced a series of problems going into the 2010 general election: a deep and protracted global economic slump following the 2008 credit crunch, paralysed money markets, a spiralling budget deficit and rapidly rising national debt.

The credit crunch arose from the United States’ sub-prime mortgage market.  From the mid-1990s, US government policy aimed to promote home ownership amongst middle and low-income groups.  Regulatory lending standards were reduced, enabling riskier loans to be made.  Separately, expansionary monetary policy after the 2001 crash kept US interest rates low from 2002 to 2004, encouraging borrowers into debt.  As rates ‘normalised’ between 2005 and 2007, mortgage costs rose, house prices softened, over-extended borrowers on highly-leveraged loans became exposed, and mortgage defaults multiplied.

Financial institutions in the globalised secondary mortgage market caught a cold.  Benign capital reserve regulations had allowed them to become over-exposed too, on the back of mortgage-backed securities and collateralized debt obligations funded by short-term inter-bank borrowing.  These complicated bundles of debt were rated as safe by virtue of their diversity, but they proved catastrophically vulnerable to wholesale decline.  Their value plummeted, leaving investment banks with unmanageable debt obligations and no-where to go.  Unable to judge the survivability of existing or prospective counter-parties, they no longer dared lend to each other, and credit froze from August 2007, plunging the global finance sector into crisis.  Government intervention followed on a massive scale, including in the UK, with a coordinated international response to prevent complete market failure; few institutions were allowed to collapse (Lehman Brothers), but many were taken over by rivals (Bears Stearns), bailed out by tax-payers (RBS, Lloyds-TSB, Northern Rock, AIG) or fully nationalized (Bradford & Bingley).  Central banks also injected huge amounts of liquidity into the markets to restore the flow of credit, and they cut base rates to unprecedented levels – the Bank of England rate fell to a record low of 0.5% in March 2009.

Despite these large-scale responses, the crunch in inter-bank lending quickly spread to the real economy. Lenders retrenched, seized by institutional paralysis, reactionary risk aversion, and the need to repair balance sheets and meet new regulatory obligations to recapitalise.  Faced with this credit squeeze, general uncertainty, stock-market volatility akin to the Great Depression, fragile cash-flow, household debt, negative equity, a coincident spike in commodity and food prices (which peaked in Summer 2008), and a growing risk of bankruptcy or unemployment, businesses and consumers reigned in as well.

Albeit for different reasons, the UK’s housing market had become dangerously inflated too, and became an important factor in the nation’s economic woes.  Interest rates never dipped as low as in the US, but had nonetheless been attractive to borrowers since the mid-1990s at around 6%, half the 1970s / 80s average.  Liberal lending criteria drew many into the net, tacitly encouraged by successive governments addicted to property-related revenues and the invigorating effect of apparently rising household wealth.  Struck by contagion and credit blight, the UK housing sector crashed (prices fell by 12% from April 2008 to December 2009), followed by domestic consumer demand (spending fell by 4% over the same period). The effect was compounded from early 2009 by events in the Euro-zone, where the banking crash spawned a sovereign debt crisis in some nations, whereby over-spending governments struggled to refinance their debt or bail out their banks.  These economies faired even less well than the UK, with knock-on effects upon trade.  On the supply side, surviving companies turned increasingly inward, delaying new investment or hiring, cutting costs and hoarding capital, with adverse consequences for productivity and output; UK GDP fell by 6.3% between Q1/2008 and Q2/2009.

Predictably, government revenues fell in the economic downturn (from 36.3% of GDP in 2006-7 to 34.5% in 2009-10), whilst expenditures rose sharply (from 44.2% to 51.6%).  Hence, in the run up to the 6 May election, the budget deficit sat at 11.2% of GDP, the fourth largest amongst OECD countries – smaller than Greece’s and Ireland’s but larger than Spain’s, Portugal’s and Italy’s (the so-called PIIGS) – and the national debt sat at 71.3% of GDP, the highest level since WW2.

Amidst this, the sitting Labour government’s expansionary pre-crisis spending plans had assumed strong economic growth, without which deficit and debt would rise further.  In his April 2008 Budget, Alistair Darling, the Chancellor, was forecasting uninterrupted growth of 1¾–3% between 2008-2010, a rapid fall in inflation to 2% by 2009, a diminishing budget deficit of 2% of GDP by 2010, and national debt of less than 40% of GDP, also by 2010.  Six months later, he acknowledged the extent of the UK’s fiscal challenge, but remained committed to a publicly-funded Keynesian stimulus programme, alongside expansionary monetary policy (cf Quantative Easing), low interest rates and falling commodity prices, to mitigate the effects of the ever-deepening recession confronting him.  He explicitly deferred repairing the public finances to the medium-term.  In his last Pre-Budget Report, in November 2009, he conceded that the economy had, in fact, contracted by 4.75% that year, he predicted above-target inflation, projected an in-year deficit of £178 billion or 12.6% of GDP, of which three quarters was structural, and he estimated that national debt would reach £1.3 trillion or 78% of GDP by 2014.  But he only committed to reigning in government spending from 2011, and to halving the deficit over 4 years, with scant detail on how it would be achieved.

There was little here to worry the Keynesian devotee, for whom renewed growth would naturally close the deficit and pay down the debt.  But disquiet amongst others was multi-faceted: that bureaucratically driven capital expenditure would allocate resources inefficiently, distort markets and displace private sector activity; that a globalised economy would dissipate the effect of any demand-stimuli on British productivity; that the inevitable prospect of fiscal consolidation, including through higher taxes, would dissuade consumers and businesses from being significantly stimulated; that incurring further debt rather than convincingly addressing the public finances would undermine the UK’s credit-worthiness and compound the crisis with higher borrowing costs for the government and a deeply indebted electorate (interest on the national debt stood at 4% of GDP in 2009/10, the fifth largest item of public expenditure); that a cumulative total of £25 billion in stimulus measures – which was all that even Darling felt was affordable in the circumstances – would make little impact (cf the $940 billion spent by the US federal government, the effect of which is also disputed).  In short, whilst Darling’s ends may have been laudable, his Keynesian ways were questionable to many and the means he devoted were commonly held to be woefully inadequate.

Against this background, and in keeping with the Conservatives’ ‘small government’ instincts, Osborne adopted a more aggressive strategy that attacked the deficit immediately and aimed to eliminate it more quickly.  His headline targets were to reduce government spending from 47% of GDP in 2009-2010 to 41% in 2015-2016, cut borrowing from 11% to 2% and begin bringing public debt down.  A notable objective during the process was to preserve the confidence of bond markets and keep borrowing costs low.  Ahead of the election, the Conservative Party’s manifesto had committed to: macro-economic stability founded upon savings and investment; low interest rates; effective prudential supervision of the financial markets and; at its core, a credible plan to eliminate the bulk of the structural budget deficit over the course of a single Parliament.  The substance emerged on 22 June, in the new Chancellor’s emergency budget, where he described an ambitious strategy to cut public expenditure by 6.3% of GDP over four years, with more than three quarters coming from spending cuts and the balance from higher taxation.  He also announced most of the major muscle moves for his strategy:

• An immediate in-year cut of £6 billion had been announced soon after the election as a nod to the markets. He supplemented this (whilst also leaving most of Labour’s pre-existing measures in place) with a public sector pay freeze, an accelerated rise in the state pension age, the elimination of middle class tax credits, a change from Retail to Consumer Price Index for calculating welfare benefits, better scrutiny of the Disability Living Allowance and restrictions on Housing Benefit.  In subsequent budgets, he: cut Child Benefit for high-earners; increased public sector pension contributions; introduced ‘career average’ rather than final earnings as the basis for defined-benefit public sector pensions; placed an overall cap on welfare spending and; committed to running a balanced budget over an economic cycle. • On taxation, he increased VAT from 17.5% to 20%, introduced a bank balance-sheet levy, created a 28% Capital Gains Tax band for higher-rate earners (up from 18%) and signalled reviews on tax indexation and financial dealings as sources of additional revenue.  Later, he also ramped up the Revenue’s anti-tax-avoidance operations. • To support growth, he lifted the threshold for employers’ National Insurance contributions, began a phased reduction in corporation tax from 28% to 24% (later extended and accelerated to reach 20% in 2015-2016), took steps to increase the personal income tax allowance from £6,500 to £10,000 (later raised to £10,500 – a flagship Liberal Democrat measure adopted by the coalition government), resurrected a previous link between the basic pension and earnings, and declared support to various regional infrastructure projects.  This was followed by a suspension of above-inflation rises in petrol duty, the controversial reduction of Labour’s top rate of income tax from 50% to 45%, the introduction of ‘funding for lending’ and Help to Buy schemes aimed at encouraging banks to lend to small businesses and nudge developers into building new housing, and limited relief from green levies for businesses. • Finally, by way of oversight, he had already announced the creation of an independent Office for Budget Responsibility.  In the Autumn of 2010, he also instigated an overhaul of the regulatory framework for the financial sector under the Bank of England, which gained wide-ranging powers for prudential regulation under its new Governor in 2013. This extensive catalogue of measures went a long way to addressing the deficit over time, but a gap remained for government departments to bridge during the Comprehensive Spending Review that followed his emergency budget.  Having reaffirmed the party’s commitment to protect the health and overseas aid budgets, which represented almost 20% of all government spending, other areas faced eye-watering average cuts of 25% – up from 14% if nothing had been ring-fenced).  This was later ameliorated by other savings (notably from Child Benefit), but nonetheless remained at 19%.  In practice, the pain was unevenly spread, from 7.5% for Defence and 11% for Education, through 25% for the Home Office and Ministry of Justice, to over 60% for Communities & Local Government.

Osborne’s plan for fiscal consolidation was severe, and risky.  Many feared it would kill off a weak recovery, plunge the economy back into recession and prolong the nation’s woes.  Foremost amongst his critics was the Labour opposition.  But his approach did gain the endorsement of the money markets, sovereign rating agencies and international institutions (including, initially, the International Monetary Fund), all key audiences.  Subsequently, with a depreciating pound, stubborn inflation, rising unemployment, weak private sector investment, feeble productivity growth and, in 2011, the prospect of double-dip recession, he fought off strong pressure to reign back on his programme – and retrospective analysis later determined that a double-dip recession did not, in fact, occur.  By the same token, he resisted further fiscal tightening in early 2013, when Moody’s removed the UK’s AAA credit rating, and when it became clear he would miss his key targets, such that the deficit will is not now expected to clear until 2018-2019, borrowing is forecast to remain above 2% of GDP until 2017-2018, and the national debt is unlikely to fall until 2016-2017.

But even as the UK’s credit-worthiness was downgraded, economic indicators began to improve, led by rising employment and followed by falling inflation, stronger growth and recovering house prices.  By May 2013, the deficit had, at least, stabilised.  A year later: unemployment is below 7% and record numbers have jobs; inflation is 1.6%, well below the Bank of England’s 2% target; incomes are rising faster than prices; the economy is expected to grow by 2.7% in 2014 (faster than any other major economy) and has all-but reached its pre-crisis level; and the budget deficit is down by a third and falling.  In short, notwithstanding the delay in meeting his main targets, the ends to which Osborne committed himself in 2010 are largely realised or firmly in prospect.  But does that make his strategy the right one?

Amongst the foremost strengths of Osborne’s approach, he maintained the confidence of the money markets and protected borrowing rates.  It is improbable that the UK would ever have been unable to sell its bonds, as those nations bailed out by the troika of the European Commission, European Central Bank and IMF were unable to do during the Eurozone crisis, but a loss of confidence would almost certainly have raised the cost of government and personal borrowing, swallowing up the Exchequer’s scarce resources and compounding the financial difficulties of individual debtors and struggling businesses (the UK’s 10 year bond yield fell from 4.28% in February 2010 to a record low of 1.38% in July 2012, and stood at around 2.67% in late April 2014; by contrast, Spain’s peaked at 7.6% in July 2012 and was 4.29% in April 2014; Greece’s peaked at 48.6% in March 2012 and stood at 8.6% in April 2014).  The creation of an independent OBR and the consolidation of responsibility for financial stability and prudential regulation under the BoE played to the same ‘confidence’ narrative by strengthening fiscal transparency and economic governance.  The theorist (including the OECD and IMF) would also look favourably upon Osborne’s spending cuts as a more effective way to close the budget deficit than a higher taxes, and upon his increase in consumption tax as less distorting and constraining on growth than taxes on income, production or investment.  But both spending cuts and higher VAT are regressive and, politically, they demanded to be offset.  Raising the personal income tax allowance (and manipulating the higher rate threshold to limit the benefit to higher earners) did this, whilst also incentivising employment over welfare dependency.  So, too, eliminating middle-class allowances and introducing higher-rate capital gains tax.  Meanwhile, cutting corporation tax, employers’ National Insurance contributions and moderating rises in fuel duty will have supported private sector growth, albeit this effect was notably sluggish.  In summary, Osborne’s package of measures seems balanced and well calibrated to deliver effect without breaking voters’ endurance.  Whilst risky, it was also politically astute, underlining the Tories’ reputation for economic competence and forcing Labour toward fiscal conservatism in an attempt to shed their reputation for profligacy.

His approach has not been without its weaknesses, however.  Most notably, the commitment to ring-fence health spending has severely exacerbated cuts elsewhere and distorted service provision across the board.  It has also sheltered 20% of total government spending from the most rigorous examination.  This may have been a political concession the Tories had to make to gain office in 2010, but it was constraining and unlikely to be repeated in 2015.  Another commonly levelled criticism has been that universal pensioner benefits were left untouched.  In view of dramatically improved health and life expectancy, and the less wearing nature of most modern occupations, many have also argued that Osborne should have gone further with raising the state pension age.  But senior citizens are a growing constituency and the group most likely to vote.  They cannot easily be ignored and, indeed, the Tories even reiterated their expensive commitment to protect the value of state pensions via the ‘triple lock’, which assures indexation by the greatest of inflation, wages or 2.5%.  Elsewhere, Labour’s capital investment cuts, amounting to 1.5% of GDP, were left in place.  Granted, new and important capital spending was subsequently announced (much of it using private sector money) but, amongst all else, it could sensibly have been disbursed earlier, helping to create economically conducive conditions for the recovery.  In short, the government’s strategy has had its economic shortcomings, some of them quite serious, but most have been driven by political expedience or necessity; ever will it be thus.

The circumstances facing the government have also presented opportunities, some of which have been embraced more readily than others.  For example, the chance to refashion and shrink government has been clear, but seems largely to have been taken ad hoc, without any central or overarching examination of what the state is for.  The OBR forecasts that public sector employment will have shrunk by up to 1.1 million by 2018, spending has become more targeted and public services have been opened up to other providers; but this does not amount to a fundamental philosophical transformation.  A root-and-branch overhaul of the UK’s complicated and behaviour-distorting tax code is overdue – for example, to remove the increasingly artificial distinction between income tax and National Insurance, to enhance rewards for investment and production, and to eliminate the most harmful forms of economic rent.  Less punishing or stigmatising bankruptcy laws, akin to those of the United States, might encourage enterprise.  And an examination of the energy sector could more faithfully price carbon emissions, evaluate the cost and maturity of emerging green technologies and agree sensible bridging strategies around nuclear generation and shale oil and gas.

But nor should the threats be underestimated that Osborne faced to his strategy.  It seems likely that excess productive capacity, scarce credit, general uncertainty, risk aversion, and turmoil in the Euro-zone export market did, indeed, serve to dampen private sector investment and to delay the substitution of public sector spending that Osborne’s plan required.  Faced with multiple challenges, banks also remained stubbornly reluctant to lend to business.  Most indicators came to point strongly in the right direction, but his timetable had already been compromised by this earlier sluggishness.  Inflation could have knocked things off track too; although fuelled by temporary phenomena, the cumulative and persistent effect could have forced an unwelcome rise in interest rates.  Instead, deflation became the greater threat.  Disappointing private-sector investment and a persistently fragile Euro-zone left exports weak, perpetuating a potentially destabilising trade deficit.  A resurgent housing market raised the fear of a new bubble, and saving remained unattractive.

In summary, whilst imperfect, Osborne’s deficit reduction plan withstands scrutiny.  At a time when others were reluctant to face (or publicly admit to) the economic challenge in prospect fro the nation, he described it as he saw it and was clear on his objectives from the outset, with respect to government spending, borrowing and debt; he laid out his timetable; and he deployed a strategy to deliver, balancing savings against revenues and using effective measures that, in many instances, had reinforcing secondary effects.  But it is always difficult to prove cause and effect in real-world economics, where innumerable inter-dependent factors are at work, which cannot be evaluated in isolation.  Hence, the extent to which Osborne’s actions were the cause of the positive economic outcomes that followed will always be debatable.  But on the balance of rather extensive circumstantial evidence, it is reasonable to conclude that his strategy was successful.

Nor is it easy to contemplate alternatives in the absence of any meaningful counterfactual.  Some present President Obama’s stimulus package in the US as the sort of Keynesian response advocated by Labour.  But the effect of this federal spending was substantially diminished by the sharp cuts forced upon the states, most of which are required by law to maintain a balanced operating budget.  The US, with the world’s reserve currency, also enjoys very different borrowing terms in the bond markets to the UK.  At the opposite end of the spectrum, the much more severe austerity visited upon the PIIGS by the troika, in order to restore their fiscal credibility, is widely viewed to have prolonged recession and aggravated unemployment well beyond anything the UK endured (Greece, Spain and Italy remain in recession in May 2014, with Greek and Spanish unemployment still exceeding 25%).  In short, George Osborne’s flawed offering may have been about as good as it could reasonably have been.

What joy, it's Mariana Mazzucato again

We've pointed to Mariana Mazzucato's umm, interesting views on government aid to research before here. She seems not to have grasped the most basic concept underlying the very existence of such aid in the first place. But here she is wading in on what should be done about the Pfizer takeover offer for AstraZeneca:

Pfizer wants to buy AstroZeneca, a British firm, to cuts its high overheads and especially to pay the lower UK tax rate (20%) – the cheap way the UK attracts "capital"– rather than the 40% US tax rate

Given that the US rate is 35% we might assume that Ms. Mazzucato's command of the facts is somewhat lacking.

And what is happening to big pharma's research and development? In the name of "open innovation" – the admission that most of their knowledge comes from small biotech and large public labs – big pharma have been closing down their own R&D (reducing total numbers of researchers), as well as moving the remaining ones to be close to those labs. Big pharma is no longer in the innovation business, using its own resources to fund the high-risk ideas, most of which will fail. It has become more risk-averse and prefers to focus on the D of R&D and please shareholders. Mergers and acquisition strategies reduce expensive overheads and costs (of which research infrastructure is the highest).

And there is another, umm, mis-statement of the facts. It's the D in R&D that is the expensive and risky part of drug development. You'll not have much change out of $300 million (at the least!) for running a series of Phase II and Phase III trials of a new drug. And yes, drugs do indeed fail to get approved even after such tests, let alone during them. That's actually the function that big pharma performs in the current system: having the financial beef to be able to pay for this very expensive and high failure rate stage. She's simply got things the wrong way around here.

But we can and should go further for she's entirely garbling the whole point of having government contribute to the provision of public goods:

Government could also retain a golden share of the intellectual property rights (patents) which public research produces, and/or make sure that the prices of the new drugs reflect how the taxpayer paid for the most high-risk research.

Sigh. The entire point, the only point, to having government subsidise basic research is because basic research is a public good. That is, the results (ie, we know that heroin cures pain, Hurrah!) are non-rivalrous and non-excludable. This means that they are also extremely difficult to make any money out of. So, we assume that this difficulty with making a profit will lead to less innovation and research than we might like there to be. Great, so, government steps in to correct this possible market failure.

But you can't then go around demanding that government gets a cut of the profits when the only reason government is there in the first place is because it's dang hard to make profits out of this research. If it's easy to make profits then government doesn't need to fund it: the only reason for the government funding is that profits are hard to capture.

We can also think of this another way. The reason we have government is so that we can gain these public goods that we can only have through government. So to complain that government is producing public goods without any reward is near lunatic: that's just government doing what government is there to do. It's like complaining that your umbrella keeps the rain off you. Yes, what else do you want it to do for you, cook your tea or something?

Mervyn King on Thomas Piketty

In the Sunday Telegraph former Bank of England Governor, Mervyn King, reviews Thomas Piketty's book, "Capital in the Twenty-First Century," and carefully shows where and why it is wrong.

He points out that technology and globalization "have raised the demand for special talent and lowered it for unskilled labour."  The Wimbledon prize money is 33 times what it was (in real terms) forty years ago, whereas manufacturing wages have merely doubled over the same period.

Returns go to the winners of the tournament, whether in tennis, finance, law, computing, advertising or other occupations. The “winner takes all” mentality has invaded many walks of life, although the identity of the winner changes over time.

King takes on Piketty's central claim that the rate of return on capital (r) exceeds the rate of economic growth (g), and his assumption that this will lead to ever greater concentration of wealth.  King questions the idea that "the owners of capital reinvest all their profits and the spendthrift workers consume all their wages."  Where, he asks, are the families that have pensions and own houses?  And what about the sovereign wealth funds that are important forms of collective ownership?

A key issue King identifies in Piketty is his failure to take into account risk in investment. "Adjusting for risk," he says, "average rates of return have historically been much closer to growth rates."  Indeed, King notes that the current risk-adjusted rate of interest is below the growth rate.  Where Piketty claims that the period 1910-1970 was exceptional because of major shocks, King suggests that the risk premium "which constitutes a large part of the rate of return on capital," reflects the possibility that major shocks could happen again.

King tells us that the share owned by the top one percent has fluctuated up and down, but is lower today than it was 200 years ago, and "a similar story can be told for Britain and Sweden. In Europe, the concentration of wealth among the elite remains far below what it was in the 19th century."

Although Piketty concentrates on capitalism's alleged failings, King says one should not ignore the achievements of a market economy in creating growth and reducing poverty.  Quite so.  No-one has found a better way to raise living standards for billions of people.  The wealth of a market economy has funded education, healthcare, sanitation, the arts and scientific research as well as raising material prosperity.  Piketty's attack on it is but the latest in a series emanating from the Left, and King has done us all a service by undermining it.

Twelve problems with Piketty's capital

Piketty’s thesis is that the rate of return on capital exceeds the general rate of growth (r > g). So, barring wars, capital owners accumulate a larger and larger share of the world’s wealth. 1. This theory does not fit the facts. In the modern economy, it is not the rich who are getting richer, but the poor. The failure of communism and the spread of trade has lifted perhaps 2 billion people off dollar-a-day- poverty.

2. Capital is not like a tree that drops fruit into the owner’s lap. Capital has to be created, accumulated, applied, managed and safeguarded if it is to produce any income at all. Capital owners can and do fail at any one of those points.

3. Capital is certainly destroyed by war from time to time. But it is destroyed every day by folly, misfortune, miscalculation or being outperformed by competitors. The difficult thing is keeping wealth. Losing it is easy.

4. Capital carries risk, not a word that features much in Piketty. Utility-type capital with more predictable returns produces higher returns, entrepreneurs making risky investments demand higher returns. There is no one ‘r’.

5. Even a small amount of risk undermines Piketty’s belief that capital owners will get richer for ever. Stuff happens: it is hard to predict what returns will be next year, never mind in ten years or a hundred.

6. The risk-adjusted rate of return on capital is modest, and falling, as it has been doing for decades. Adjusted for risk, Piketty’s thesis does not fit the facts.

7. Capital is only one factor of production. You need labour and brains too. If capital took a larger and larger share, wages would soon be bid up. The 19th Century saw huge capital accumulation – but huge rises in living standards too.

8. The most important form of capital in our service economy is human capital. That’s not confined to a few rich people, but owned by all of us. Investing in it delivers a far bigger payback than the returns on financial or physical capital.

9. The success and rapid rise of poor immigrant groups, from Ellis Island to modern Europe, shows that you do not need to own financial or physical capital to generate income and accumulate wealth fast.

10. Capital-owning societies are actually more equal. Pre-tax, not greatly; but post-tax, with their health, education and welfare programmes, they are very much more equal. And it’s better to be poor in a rich capitalist country.

11. Piketty’s savage global redistribution would destroy capital, and sacrifice its productive power for society. Massive capital taxes create instability (Cyprus) or ruin (Zaire). High taxes also cut people’s investment in their own human capital.

12. If you want to make the world more equal, try open immigration. The world’s poorest live where capital is sparse and unprotected by the rule of law. Let them become participants in the productive, capitalist, wealth-creating process.