What a Bank Governor should understand

I had a letter published in the Business section of Monday's Telegraph.  It had to be abbreviated for lack of space, but I think the full text is worth repeating here because it explains what it is that the incoming Governor should understand.

Dear Sir,

Next month a new Governor of the Bank of England will be appointed to replace Sir Mervyn King.  A suitable candidate must not only possess rare qualities, but should also understand the causes of the financial crisis in order that they might make a recurrence unlikely.  They should understand that the low interest rate policy pursued by governments and central banks to smooth the down side of the business cycle produced cheap money and easy credit that fuelled a housing bubble.  This was intensified by implicit government guarantees in the US to support loans to borrowers with a high default risk. 

This was exacerbated by rules that required banks to take more mortgage debt, done in the name of prudence, but in fact compounding regulatory error.  Added to this was the fact that the artificially low interest rates drove fund managers into riskier investments because of the low returns on the safer ones.

If the person to be chosen as Governor understands this, they are unlikely to countenance future intervention designed to secure a politically acceptable outcome rather than an economically wise one.  They will be unlikely, too, to punish by a regulatory stranglehold a financial sector that was far less culpable than the politicians who tried to make it serve their interests.

Yours etc.

Madsen Pirie


Anyone who thought it was all down to greedy bankers taking reckless risks and thinks that tighter regulation is the answer is lacking in the insight and understanding we are entitled to expect from the next Governor.

Inflation: the ultimate corruption

Inflation, says Peter Twigg, is the ultimate corruption: the trick used by politicians to conceal vast spending and wastefulness. It is nothing less than a full-scale robbery of the people by the state, and it's high time that more of us realized how pernicious it really is.

The ultimate corruption is the single, most cynical, abuse of the people by the State (your government), in perpetrating the myth that inflation is an economic disease that government cannot stop. The truth is that government perpetuates inflation and that it remains in the government's interest to maintain a level of inflation. The truth is that government makes itself out to be the victim of inflation when in fact it benefits from inflation.

"With the exception only of the 200-year period of the gold standard (1714 to 1914 in Britain), practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people." FA Hayek, Choice in Currency

The truth is that government spends a lot of time and resources continuing the facade that they too are the hapless victims of this scourge called inflation. This illusion is maintained by social science academics having created a whole ‘science’ around the myth of inflation.

Read this article.


On economic ignorance

Madsen takes a poke today on his site at people who don't allow their ignorance of economics to stop them from making illiterate proposals.  In language considerably more temperate that Tim Worstall uses, Madsen suggests that some people think they can bring about a new economic reality simply by wishing it into existence, without the slightest idea of the complexities they are dealing with, or of the unintended consequences that their proposals might bring about:

This tendency seems nowhere more true than in economics.  The average ignoramus hesitates to propose how theoretical nuclear physics should proceed, but feels quite at easy making economic proposals that seem plainly daft to anyone who has the slightest knowledge of the subject.  If anything, economics could well be more complex than theoretical nuclear physics because it deals with objects that are profoundly dissimilar in more respects. Yet some people think they can make a new economic reality simply by wishing it so.

Madsen is right.  Open your newspaper, watch television or read Hansard, and there you'll find scores of them, maybe hundreds. Economic illiteracy has never had it so good.

Beyond fiat currencies

There's a new way to by-pass fiat currencies that governments can debase.  From Euro Pacific Bank come two new cards, one gold and one silver.  Instead of drawing from your cash reserves held in sterling or dollars or whatever, or of spending on credit and paying the bills in such currencies, these cards draw on bullion.  You own gold and silver in a vault, and what you spend is converted into bullion and drawn from your stock:

Now you can actually own precious metals and convert the amount you choose into cash at an instant. Spend cash from your metals backed card at more than 30 million locations and 1.4 million ATM’s worldwide.

With the gold card you spend gold, and with the silver one you draw from your stock of silver bullion.  This solves one of the problems of a commodity-backed currency, namely the ease with which it can be traded in small amounts.  These cards subtract coins and notes from the equation, replacing them by electronic transfers of bullion.

It's an intriguing idea.  If it catches on in a big way, it could give hard-pressed savers some respite from the ravages inflicted upon them by governments through inflation and artificially low interest rates.


Good drugs and supporting markets

Good drugs lead to support for the market system. Umm, no, not that sort of recreational pharmaceutical, that's not what I mean. Rather, that the system which produces good pharmaceuticals is an example of how and why a market based system is superior to a planned one. Take this from Corante, discussing Nassim Taleb's view of finance:

Well, those of you out there who've heard the talk I've been giving in various venues (and in slightly different versions) the last few months may recognize that point, because I have a slide that basically says that drug research is the inverse of Wall Street. In finance, you try to lay off risk, hedge against it, amortize it, and go for the steady payoff strategies that (nonetheless) once in a while blow up spectacularly and terribly. Whereas in drug research, risk is the entire point of our business (a fact that makes some of the business-trained people very uncomfortable). We fail most of the time, but once in a while have a spectacular result in a good direction. Wall Street goes short risk; we have to go long.

A planned system, whether it be an economy, a business or a sector of either, is always trying to reduce the risks of whatever it is that is being done. Most importantly, to reduce the risks  of failure. A market system allows any and everyone to chase their wildest dreams, lunatic or not. That is, a planned economy is short risk and a market one long. 

And the thing is, in order to get the sort of transformations of the entire economy that we need in order to keep this wealth creating juggernaut on the road we need to be long that risk. As William Baumol has pointed out, as Paul Krugman has noted, planned economies have extreme difficulty in increasing total factor productivity. Market ones seem to manage it, as least they have for the past couple of centuries, at a fairly steady clip 2% a year or so decade after decade. This is the very result of such economies being long on risk. People just doing their own thing, without central plannning and risk reduction. Most fail- the vast majority fail- but that's what being long risk means. We explore the possible technological space, find that most of it's not worth anything but are able to quickly seize upon those parts that are.

It's unconstrained exploration that makes market economies work: exactly the very thing that planning abhors and abjures.

Well doesn't that just kill the Peak Oil idea then?

Peak Oil is the idea that one day there just won't be any oil left and civilisation will fall over. Or for the more discriminating but no less wrong, that one day we'll be producing less oil than the oil that is demanded and thus civilisation will fall over. The major problem with these and other flavours of the same prediction is that they ignore price. If demand for oil is greater than supply of it then the price will rise. Thus there never actually is a possible position where there is no oil and civilisation falls over. The newspaper home of this idea here in the UK has always been The Guardian. So it's something of a surprise to see that same paper saying this:

But the truly global implications of the International Energy Agency's flagship report for 2012 lie elsewhere, in the quietly devastating statement that no more than one-third of already proven reserves of fossil fuels can be burned by 2050 if the world is to prevent global warming exceeding the danger point of 2C. This means nothing less than leaving most of the world's coal, oil and gas in the ground or facing a destabilised climate, with its supercharged heatwaves, floods and storms. What follows from this is that the idea of peak oil has gone up in flames. We do not have too little fossil fuel, we have far too much. It also follows directly that the world's stock markets are sitting on toxic levels of subprime coal and gas, a giant carbon bubble ready to explode.

Still nutty of course. For it's still ignoring the role of price: in this case, the relative prices of using oil and having climate change or not using oil and not having climate change. Our whole and entire problem with the whole subject is that, as best we can guess, the no oil no climate change option would be more expensive than the oil and change one. Certainly it would be vastly more expensive if we tried to implement it today. Perhaps it won't be in 50 or 100 years. But that is actually our problem today: no oil today means billions die. This is indeed more expensive than having some climate change.

But there's something else much more interesting here. This idea that we must not, indeed cannot, use all of the fossil fuels we already know about. Fossil fuels that are embedded into the stock market values of a number of companies. If we all believed that these fuels would never be used then they would be valued at nothing (or perhaps a small option value). They're obviously not so we don't so believe.

However, there are those campaigning that we should leave them alone. And one would assume that they expect to be successful at saving the world. Which is something we can test of course, their own beliefs about how effective they are going to be. If they do believe that they'll keep those fuels in the ground then obviously all those energy companies will, in the future, be worth a lot less than they are now. Which is an arbitrage opportunity: they should be short those stocks. If they're not, they don't think they will be successful: if they are they do. So, Greenies, where are your pension funds?

Speaking to the IREF in Paris

In Paris on Thursday I addressed a meeting of IREF, the Institute for Research into Economic and Fiscal Issues, which is a French free market and broadly libertarian outfit whose scholarly research and press briefings try to nudge France in the general direction of soundness.  Given Francois Hollande, they face a tough task.

I was asked to speak about how think tanks might hope to influence events, and I put forward the view that it is not just sound policies that are needed, but ones that are realistic, practical, and likely to bring success and popularity to the political leaders who implement them.  To some extent this involves careful examination of the interest groups which stand to gain or to lose, and an innovative slant to the policies that takes those groups into account.

I delivered the speech in French, having prepared it in advance, and after the discussion there was a most civilized session in which a sommelier introduced some French wines which we then sampled along with charcuterie, cheeses and French breads.  I found myself wondering if it’s a format the Adam Smith Institute might try out to see how popular it might be in the UK.

The unintended consequences of banning price discrimination

British car insurance advertisements are going to change. Right now they are populated by annoying Welsh opera singers, stick cartoon figures, and meerkats. But all of these are likely soon to be made redundant, replaced perhaps by white kittens with pink bows, giggling babies and sophisticated-looking models with designer handbags. So I predict.

Why? Because of the latest daft 'equality' regulation from the European Union. From December 21, insurers will be banned from offering cheaper insurance premiums to women, following a ruling by the European Court of Justice (ECJ). According to motoring groups, it means that women will face a 25% increase in their premiums, despite the fact that they are statistically much safer drivers. On average, women take shorter journeys, obey the speed limits more faithfully and brake less hard. But they could be facing premium bills of £400 on an average family car.

The most accident-prone drivers, of course, are young men. They are less experienced, enjoy speeding and barking, and drive more at night – often in the company of inebriated friends who egg them on to take risks. Which is why young men aged 17-22 pay average premiums of £1,604 compared to the £1,127 paid by females of the same age, according to the Automobile Association. A survey by the comparison website uSwitch.com reports that just over one in eight (13%) female drivers think they will not be able to afford to keep motoring. Apart from the inconvenience, that may also reduce the employment prospects of women who depend on their own transport to get to work safely.

The ECJ ruling is motivated by noble intentions – to remove discrimination between the sexes. But it is economically illiterate. And the trouble with economically illiterate legal or political decisions is that they produce widespread unintended and indeed unwelcome consequences.

The illiteracy here is the belief – and how often we hear it – that insurance is about 'pooling risk'. That instead of bearing the whole risk of certain events individually – ill health, car accidents, household disasters – we each chip in a little and compensate those who suffer when the risk becomes reality.

In fact, insurance is nothing of the sort. It is about putting a price on a risk. The insurer calculates your risk, and charges you a premium that reflects the likelihood of the misfortune actually happening to you, the amount that they would have to pay out to compensate, and a little bit of profit for the service they give you – which is peace of mind. And as information technology advances, such risks can be calculated more and more precisely. Houses in certain postcodes, for example, are more likely to be burgled than those in others. But more than that: whether you live in the middle of a street or on the corner, in a house or an apartment block, on the ground floor or the first floor, behind a door with secure locks or not – all these are relevant factors, and insurers price them accordingly. The same is true of motor insurance. If you are young, male, or you drive a flash red car, you are more likely to cost the insurers money than if you are older, female, in a modest runabout. You pay more to reflect those risks.

It may sound unfair, but in fact this price system does a useful job, encouraging people to minimise the risks they expose themselves to. For example, one reason why young men have high accident rates is because they drive at night with those tipsy pals of theirs. But insurers are now trialling in-car technology that reports motorists' driving habits back to them. And a young person who agrees not to drive late at night can, as a result, get cheaper premiums, reflecting the lower risks.

Of course, people cannot change their sex – or at least, it is not easy and hardly worth doing solely to get cheaper insurance. So the insurance price difference between men and women is not something that can be moderated by an easy behavioural change. Hence the notion that women are being discriminated against. Someone in an area with high burglary risk can install locks and alarms. Men are pretty well stuck with being men, with all their faults.

But trying to make equality legislation take the strain is mixing up markets and civics, and trying to make markets do things they are quite unqualified to do. Once governments start manipulating prices, perverse incentives and disruptive effects ripple out through the entire economy, and nobody knows that ultimate damage they will wreak. It is better to let the price system do its job, then deal with any unwelcome results through the welfare system. We do not ensure that everyone has access to food by putting price caps on supermarket prices. We know that if we did, pretty soon the shelves would be empty. Instead, we give cash to needy people. Likewise, if we want to keep down the insurance premiums of men so they equalise those of women, we should subsidise men through the tax system, not force the insurance providers to do it. Either way we will get perverse incentives and will see more, dangerous, male drivers on the road, so either way it is a daft policy. But when you mess with the price system, that is what happens.

Insurers, of course, certainly do not want customers who they cannot charge the proper price for, and who are more likely to cause them to pay out. More than ever, they will be pursuing female customers, rather than male. The enterprising ones will be advertising insurance in ways and through media that are so girly that no self-respecting red-blooded male would go near them. If you like kittens and babies, you are in for a treat.


Adam Darwin

Matt Ridley, author of "Genome" and more recently "The Rational Optimist," gave Tuesday's annual Adam Smith Lecture before a packed audience at St Stephen's Club.  His title, "Adam Darwin," explored similarities between the insights and observations of Charles Darwin with those of Adam Smith who had written a century earlier.

One similarity is that evolution works in nature by a selective death rate.  It is not a random process which leads some to survive and others not.  The ones that make it are those with some mutation which increases their survival chances, even by a small amount.  Nature can build up incredibly complex mechanisms through a series of minute changes which do this.

Those who succeed in the market are often those with an innovation that brings them an advantage.  It might be new technology of new methods of achieving better productivity.  The firms that fail are again, not the result of a random process, but those which lack the crucial advantage that innovation has brought to others.

In the world of nature sex plays an important role in mixing up combinations of genes so that innovations occur more frequently than would otherwise be the case.  In the world of human activity there is an equivalent in which ideas can intermingle and interact, producing new combinations and innovations.  The more trade, exchange, and contact there is, the more there are likely to be new ideas to be tried out.  As in nature, the ones that bring advantages survive at the expense of those which do not.

Ridley stressed the co-operative nature of trade and exchange.  Human beings exchange things to the advantage of both, and do so uniquely among groups which have no kin or tribe relationship.  We co-operate with strangers to mutual advantage, and this has led to the extraordinary achievements that humanity has made.

Ridley's speech was an intellectual tour de force, elegantly delivered, and a superb contribution to the Institute's lecture series. The lecture will be uploaded to Youtube and posted on the blog shortly.