A deflation spiral

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While many lesser commentators are worried about the threat of inflation after the Bank of England's £200 billion Quantitative Easing giveaway (though most of it seems to have been given away to the government), our ASI Fellow Richard Jeffrey says there's actually a real risk of a deflation spiral.

In his latest Cazenove Capital newsletter, he notes that rises in the cost of living (with RPI heading up to 5%) are massively outpacing wage rises (at 1.2% – but just 0.2% in the hard-pressed private sector). Which leaves households pretty skint. Normally the authorities would help out at this stage with a business-boosting cut in interest rates, but they've already taken them down to about as low as you can get. And even these low rates aren't encouraging people to cash in their savings and spend, because in this economic hurricane, they want to keep their rainy-day money to hand.

Sure, business has bounced back a little, as firms who ran their stocks down at the start of the crisis have started producing again. But who has the cash to buy their product? The rising number of unemployed people certainly don't. Neither do those who are in work, since a bloated public sector continues to suck high taxes out of their wage packets (and there's no sign of the public sector, or taxes, being cut anytime soon).

It's a dangerous cocktail, Jeffrey reckons. Consumer confidence remains upbeat, though, so maybe it will work out. But many economists can't see much solid foundation for that confidence. If households too come to believe their hopes are built on sand, well...you don't really want to think about it.

Bank Privatisations – The Reality

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Recent headlines have suggested – rather misleadingly – that an incoming Conservative administration could raise c£70 billion from selling the Government's stakes in RBS and Lloyds. If only this were true.

The reality is that both banks, especially RBS, remain in a parlous state, especially as rising bad loans increasingly exert a malign influence on banks' cash flow.

Assuming a 10% placing discount for any sell-down of the Government's stakes of 84% in RBS and 41% in Lloyds, the total value – based on this week's market capitalisation – would equate to c£29 billion. Compared with the c£45 billion of taxpayers' money already injected into RBS alone, such a return looks pretty meagre.

Remember, too, that RBS's shareholders – due to appalling decisions in the past – are still partly exposed to the £282 billion of 'toxic' assets within the Government's Asset Protection Scheme.

Of course, the share prices of both RBS and Lloyds may rise sharply. If so, in the latter's case, City investors should be canvassed about their response to a part sale of the Government's 41% Lloyds stake.

Significantly, following last October's Initial Public Offering (IPO) in Brazil, Grupo Santander is apparently eyeing a similar arrangement for its expanded UK banking business: any Lloyds offer could be on the coat-tails of this purported deal.

More generally, any plans to resurrect the highly successful privatisation policies of the Thatcher Government should be applauded. And encouraging small shareholders (SIDs) to participate is welcome, even if many privatised companies are keen to remove them from the share register.

For the incoming Government, there are various suitable privatisation candidates, most obviously Royal Mail (without its burgeoning pension fund) and Scottish Water. Sales proceeds, prior to the disposal of any bank shares, could reach £16 billion.

Given the shocking state of UK public finances, aren't privatisation proceeds now more welcome than ever?

Young Writer on Liberty 2010

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With our freedoms increasingly trampled underfoot, the ASI is pleased to announce its 2010 ‘Young Writer on Liberty’ competition.

Open to anyone under the age of 20, entrants are asked to write three short articles on ‘Ways to advance liberty’.The topics are entirely open to you: whether it is adjusting taxation, abolishing ID cards or the decriminalization of drugs, we are open to all views and opinions.

And, because incentives matter, the top prize includes £500 cash, 3 books, all 3 articles published on our blog and the offer of 2 weeks work experience at the Adam Smith Institute. To see all the prizes available, click here.

To enter, you must be under 20 on the entry deadline of April 30th, while each article must be under 400 words long. Simply email your entries, along with contact details and your DOB to charlotte@old.adamsmith.org.

Bad taxes

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I am not convinced there are such things as 'good' taxes, although I admit the possibility. I am wholly convinced that there are bad ones, however.

Adam Smith put forward four maxims whose "evident justice and utility" should guide nations in their tax policy. He wanted equity, with people to contribute in proportion to the revenue they enjoy. Note that this implies a flat, rather than a progressive, rate. He sought certainty, with citizens knowing the amount, the manner of payment and the time it fall due. Any arbitrary discretion would open opportunities for corruption. He specified convenience, with taxes levied in ways and at times most convenient to the taxpayer. And he stressed efficiency, with no taxes that were disproportionately costly or damaging to collect.

Smith did not sanction taxes simply designed to punish people for being rich. The forthcoming 50 percent tax rate fails the tests of both equity and efficiency. It unfairly taxes people at a higher rate simply because they are richer, and it is already causing behaviour distortions that will diminish its yield, probably making it negative.

It is probably not the most unpopular tax, however. When asked to name taxes they dislike, many people seem to nominate Council Tax or Inheritance Tax among their least favoured options. This might be because both are taxes on property, and there is no income stream generated by that property out of which the tax can conveniently be paid.

Council Tax falls in many cases on people whose home is their main or only asset. Inheritance Tax is backed by its supporters on the grounds that inheritance represents a 'windfall' which can be taxed opportunistically, and that it is wrong for some people to have the 'unfair' advantage of parents wealthy or prudent enough to make provision for them. Yet Inheritance Tax fails not only the convenience test (with no income stream generated by the property to pay it with), but also the efficiency test, in that people's behaviour is distorted by efforts to avoid it, and by the break-up when it is levied of the capital pools so important to new businesses.

George Osborne and his team are rumoured to be looking at some radical tax changes. They could do worse than undertake a review of all taxes, armed with Adam Smith's four maxims. If they did so, I very much doubt that Council Tax and Inheritance Tax would survive in anything like their present form.

New Report: The Broken University

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The government must abolish the cap on university tuition fees, according to a new report from think tank the Adam Smith Institute. The Broken University, by academic and education expert James Stanfield, argues that if the UK is to be a world leader in the higher education in the 21st Century, all institutions must be free to sell their services at whatever price they choose.

Reforming higher education funding

In contrast to other recent proposals, Stanfield’s report emphatically rejects the idea of merely raising the cap on tuition fees, arguing that such a policy not only fails to recognize the independence of universities, but also completely overlooks the various malign consequences of the higher education sector not having a functioning price system. According to the report, capping tuition fees: 

· artificially increases the demand for university places

· causes students to value their education less, and therefore choose inappropriate courses or not work as hard

· results in less overall investment in higher education

· encourages universities to be less responsive to student needs

ASI Fellow, James Stanfield said:

There is a lot of talk about the importance of the universities in our new ‘knowledge economy’. But how effectively can any market work when the government is distorting prices to such an extent?

What politicians don’t realize is that tuition fees ought to send important signals about the relative value of different university courses, and help to co-ordinate the interests of students, universities, and future employers. By dictating what fees may be charged, the government is severely retarding the natural development of higher education.

The report goes on to propose reforms to public subsidy of higher education, calling for an end to the taxpayer subsidizing universities directly, with funding instead being channeled directly to students through an expanded student loans programme. Controversially, the report also suggests that loans be targeted at those students most in need of support, with loans to wealthier students limited to a set percentage of their university fees.

Executive Director of the Adam Smith Institute, Tom Clougherty, added:

The funding system outlined in the report would be a huge step forward. Ending the direct subsidy would empower students, because universities would be forced to treat them as paying customers. In the long run, it would also benefit universities since it would help them regain their independence from central government. And it would also benefit the taxpayer, by ensuring their money was used as effectively as possible.

Stanfield, however, is open about his longer term plans for higher education, making it clear that he believes the government’s £14.3bn subsidy ultimately acts as a transfer of income from the poor to the better off – “taxing the poor to help the rich get richer”, as he puts it – with little economic benefit. He recommends that the government adopt a clear 10-15 year timetable for winding down the government’s support of higher education, so as to give ample opportunity for universities to attract philanthropic donations and corporate sponsorship.

Making Britain a world leader in higher education

Stanfield’s report, which runs to more than 100 pages, also goes beyond university funding to look at the broader question of how to make UK higher education – which he regards as one of our most significant service industries for the future – more dynamic, competitive and entrepreneurial. The report stresses a number of key points:

· Firstly, the government must establish full freedom of entry into the higher education sector for fully private providers. This means ending the historic protection of the word ‘university’, as well as the role of the Privy Council in approving new institutions.

· Secondly, the government should extend those tax benefits currently enjoyed by charitable non-profit institutions to for-profit higher education providers.

· Thirdly, and most importantly, the government must restrict itself to a very limited role in higher education, promoting and stimulating competition rather planning or directing the sector, or using it to meet ‘national objectives’.

Stanfield concludes:

It is clear to me that the government’s involvement in higher education is doing far more harm than good. Despite the best intentions, government attempts to subsidize and centrally plan industrial sectors like steel, automobiles and telecommunications all failed miserably. Higher education is no different. It has the potential to become our most successful service industry and provide a vital boost to our economy – but that won’t happen unless the government is prepared to back off.

Click here for the report.

Press enquiries: 020 7222 4995

A downward cycle

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There's a tide in the affairs of men, which, taken at the ebb, can land you on the rocks in short order. I am beginning to wonder whether America, Britain and other leading economies are indeed launching themselves onto the rocks.

Anyone who has read their Hayek knows how it works. Central banks hate recessions. So they keep interest rates low. People borrow to buy homes and other assets. The bankers see the bubble and rein back. Borrowers and their banks run out of cash. Governments bail everyone out and print more money. Public debt soars and the currency falls in value. Foreign investors get cold feet. Bankers raise interest rates to restore confidence. Everyone is squeezed, and consumer spending falls. There's a recession. Governments bail everyone out and print more money, and off the cycle goes off again, round and round, until eventually you get stagflation, hyperinflation, and a huge collapse.

Arguably Britain is now on this cycle. The pound lost a third of its value against the dollar over 2008-09, and despite recovering a bit it has fallen sharply again. And let's face it, the dollar isn't in great shape either. The British media say that the fall in recent days has been because of polling fears of a hung Parliament come the election of (probably) May 6. Actually, it is more like fear of Gordon Brown's high-spending, high-borrowing government being re-elected. Investors know that Britain needs tough action to sort out its financial position, and there seems little chance of that if Brown stays in power. One part of me thinks it would be no bad thing if Britain fell weeping into the arms of the IMF. It would be painful, but at least they would sort out the mess and stop the downward cycle.

Are we all doomed?

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The annual investment forum in Tokyo of CLSA (Credit Lyonnais Securities Asia), a hugely influential group of fund managers, has heard a grim forecast from Dr Marc Faber, a market analyst with some success at forecasting crises. Universally pessimistic, he is dubbed "Dr Doom" by the industry. His forecast is that the US cannot service its growing mountain of debt, and that its debt repayments could hit 50 percent of tax revenues within 10 years. If this happens, he thinks the US will go bankrupt.

Dr Faber then ventures beyond market conditions to warn us of a coming "dirty war" which will shut down the internet and mobile phones, and see city water supplies being poisoned. He advises buying farmland and living rurally to escape the violence and biological attack which will afflict cities. He also suggests buying gold and precious metals "because they can be carried." In Asia he advises buying into agriculture and water treatment to play on future food and water shortages.

Chilling stuff, but will it happen? Doomsayers don't have a very good record. Humanity seems to muddle through despite the catastrophes so regularly predicted. Part of the reason is that we alter our behaviour to avoid them. We develop new technologies such as those which enabled the "green revolution" to avoid the threatened starvation. We will not all choke on the nightmare levels of pollution forecast because we are constantly developing ways of dealing with it and avoiding it. We haven't all died yet in a nuclear holocaust because we changed the way we behave once nuclear weapons entered the frame.

This is not to say Dr Faber is wrong – although I believe he is. It is just that he, like other doomspeakers, downplays what Julian Simon called "The Ultimate Resource," the creative ingenuity of humankind. Despite the gloomy forecasts that civilization would be wiped out by a new ice age, a population time bomb, a silent spring, or the depletion of scarce resources, we have proved quite adaptable and quite resourceful at dealing with problems.

I doubt Dr Faber's hedge fund audience will all rush take his advice. Maybe a few will hedge their bets by buying just a little farmland and just a little gold. The rest of us will probably bet on humanity again, rather than disaster.

Change we can believe in

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It has been posed here before, but the question remains – why aren’t the Conservatives doing better? One fundamental issue, in my opinion, is that the Conservatives have confused style with substance. Let me explain…

In the wake of the 2005 election, the Conservatives came to a realization. All the polling data showed that their policies were very popular, until they were attached to the Conservatives. Then they became unpopular. Essentially, the Conservative brand was toxic.

So David Cameron was elected leader with a mission to ‘decontaminate’ the brand. This involved posing with huskies, denouncing chocolate oranges and swapping the ‘torch of liberty’ logo for an oak tree drawn by a toddler. It also involved talking more about the quality of life and social justice, and less about the economy.

All of which was fine, to begin with. But at some point marketing started to determine policy positions. The point of decontaminating the brand, surely, was so the Conservatives could ‘sell’ smaller government to the electorate. But instead, the Conservatives decided to announce their unilateral economic disarmament, pledging to match Gordon Brown’s (profligate) spending plans. And unfortunately for them, they did this shortly before economic policy once again became the big issue.

To this day, the fundamental confusion remains, even among Conservative MPs and candidates. Are they in favour of a smaller state, or not? Are they going to reverse Gordon Brown’s tax increases, or aren’t they? Are they going to stop the government borrowing £20m per hour, 24/7, or are they going to carry on and hope the problem goes away?

Ultimately, this is why the slogan “vote for change" is uninspiring. Voters don’t know if there’s going to be any change at all. And if there is going to be change, voters don’t know what sort of change it is going to be.

Perhaps David Cameron should just take a leaf from Adam Smith’s book, and promise to deliver ‘peace, easy taxes, and a tolerable administration of justice’. To borrow a phrase, that would be change we can believe in.

Biofuels – an everyday story of lobby groups

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The Department for Transport commissioned E4tech to undertake a study of the overall impact of its biofuel target on forests and other undeveloped land. The study, seen by the Times, shows that millions of acres of forest will be logged or burnt down to create the plantations required to supply biofuel targets. The Adam Smith Institute criticized from the outset the use of edible crops to produce fuel for vehicles instead of food for the malnourished. Now the findings show that the use of palm oil and similar products involves a vast release of carbon when forest and grassland is converted to plantations. The verdict is that biofuels actually pollute more than diesel when their overall impact is assessed.

The obvious question is why was such a perverse policy was implemented? The answer might well be that a toxic combination of environmentalists chanting "renewables" combined with farming lobbies chanting "subsidies," proved irresistible to politicians seeking votes. David Cameron says he is poised to announce clear policies that set out the Conservative position. An immediate candidate would be a rethink of the commitment to biofuels, to stop the damage before it gets any worse.