Connecting the dots

John Harris has an excellent article in the Guardian, listing the number of politicians in the UK and EU who have retired to lucrative jobs, often in the financial sector. He links that directly to popular distrust of our ruling elite. I want to make the same connection, but via a slightly more elaborate but perhaps more worrying route.

First, let’s think about the financial crisis. The damage caused by that crisis has been huge, and not just because of the recession it caused. In many countries it seems to have permanently reduced the growth in productivity, meaning that compared to a world in which it did not happen we are permanently poorer by a large and growing amount.

Now as an economist I get a lot of stick about my profession failing to predict this crisis. But economists have not been reticent in thinking about how to prevent the next one. The fundamental weakness of the financial sector is the relative absence of capital (equity) compared to other companies. But the adjustments forced on banks since the crisis have been marginal, and certainly not enough to prevent another crisis.

It is natural to ask why. You might think that getting very tough with banks would have been politically popular? Measures could have been phased in to avoid any short term damage to lending. So why have politicians, and the senior civil servants who advise them, been so tentative? (For that matter, why don’t we change the way multinationals are taxed?)

Or if we go to the Eurozone, the decision to stop Greece defaulting in 2010 was the result of fear that the European banking system was too weak to cope. The consequence was crippling austerity for Greece, and bailing out European banks by the back door using Troika loans to Greece. You might think that European politicians would as a result be particularly keen to ensure that this kind of thing would never happen again, but there too action has been very limited.

If we were talking about the United States, the answer to why the financial sector is treated with kid gloves despite the problems it has caused would be obvious: the financial sector provides a huge amount of funding for politicians to spend getting elected/re-elected. In Europe that does not happen so much. But the expectation of financial reward for good behaviour in the form of employment after a politician retires may be just as effective an incentive. 

So any distrust that people have in our ruling elite and the political system that supports them is not some irrational form of envy. Politicians retiring to lucrative jobs is not inevitable and largely harmless. It is a form of corruption. It strikes at the heart of why we had a financial crisis which has made almost all of us a great deal poorer, and why little has been done to prevent another. The main beneficiaries of the public's reaction to economic hardship and elite corruption may be the likes of Donald Trump and Marine Le Pen.      

Five small thoughts on the Autumn Statement

I talked about the big picture here and here, but as ever there is a lot of interesting detail. Here are five thoughts that I have not seen expressed elsewhere.

1) Tax credits. As people gradually began to twig, the U-turn on tax credits is only temporary: most tax credits will become part of Universal Credit when it is introduced, and the cuts there remain. As the Resolution Foundation show, those at the lower end of the income distribution are eventually going to be made a lot worse off.

But it’s still a big victory for those opposed to the tax credit cuts, for two reasons. First, a few years without the cuts are worth having. Second, and perhaps more importantly, Osborne wanted the cuts to come in early so that their memory would be diminished by the time of the next election. That will no longer happen, which might mean that when the time comes they too will be dropped/delayed.

2) Apprenticeship levy. One of the problems economists have with budget/autumn statement commentary is incidence - it is generally assumed that a tax on business is different from a tax on wages. But as the OBR point out, the evidence suggests that higher payroll taxes (‘taxes on jobs’), which this levy essentially is, will be largely met by firms paying lower wages. But if the Chancellor had raised the same amount of money by increasing employees NICs, everyone would be making much more fuss about this tax increase (particularly as he had pledged not to do so).

One point I didn’t hear mentioned is that we used to have an apprenticeship levy - it was abolished by Mrs. Thatcher.

3) Democracy. I’m occasionally told that I’m too critical of this government, and some even suggested on Wednesday that this Autumn Statement represented a move to capture the centre ground. But the Statement included a 19% cut in money provided to opposition parties. The Treasury said it was “time for political parties to pull their weight in difficult times.” I think the chief executive of the Electoral Reform Society was nearer the mark when she said it was “bad news for democracy”.

4) Labour. Talking of opposition, there was a lovely moment at the end of Osborne’s speech where he noted that Labour had suggested maybe a 10% cut in money for police was appropriate, only to announce no cut at all. It was just one more example of how timid Labour has become. Would it have dared increase the stamp duty on second homes/buy to let by so much? And then of course there was the higher minimum wage in July.

I normally try to avoid watching/reading political speeches, and only turned the TV on to see how John McDonnell performed. As I have said before, many on the left are their own worst enemies when it comes to the issue of political spin. They despise it, which is healthy in itself, but they actually need to be far better at it than their opponents because of media bias. Of course some things are so blindingly obvious …

5) Fragile fiscal forecasts. The thing I really dislike about occasions like this is all the emphasis on the aggregate fiscal numbers. Some people seemed surprised that the OBR should make such a big change to its tax take forecast, but as a one time forecaster it did not surprise me a bit. Macro forecasts are very unreliable anyway, and one of the hardest macro numbers to forecast is the budget deficit. Yet people obsess over small changes to the deficit in future years, as if this mattered. It does not.

One final comment on comments. This end of austerity meme is silly. Here is a chart.

An interview that will never happen

Interviewer. Chancellor, in your Mansion House speech you said we must reduce government debt rapidly to prepare for an uncertain future. What uncertain future do you have in mind.

Osborne. As my colleague the Prime Minister put it just six months ago, red warning lights are once again flashing on the dashboard of the global economy. There is Greece, the Middle East, and Ukraine.

Interviewer. But Chancellor, economists are agreed that any imminent global downturn will be more difficult to deal with if fiscal austerity is also being a drag on growth.

Osborne. I am confident that the Bank of England can deal with any immediate threats to the economy.

Interviewer. Even with interest rates already near zero?

Osborne. As the Governor has often said, he has the tools to do the job.

Interviewer. Is that why inflation is currently negative?

Osborne. As you know that has a great deal to do with the fall in oil prices. More generally I think we should celebrate the fact that prices have stopped rising so that real wages and living standards can at last increase.

Interviewer. But isn’t core inflation, that excludes oil prices, at 0.8%? The 2% inflation target is yours, Chancellor. Mark Carney has also said that reducing fiscal deficits will be a drag on growth.

Osborne. To repeat, I have complete confidence in the Governor of the Bank of England to keep the economy on track. I have not been disappointed in my choice of Governor so far, but if I need to reprimand him for any failures in the future I will not shirk from that responsibility.

Interviewer. Going back to the proposed legislation to outlaw deficits, you have also made election commitments to cut some taxes, and intend to legislate to outlaw raising others. That means that public spending will have to be cut to achieve these surpluses. Some people have suggested these laws are just a backdoor means to achieve an ideological objective of a smaller state.

Osborne. That is nonsense. I just think it is important not to place any further burden on this country’s hard working families. These families also know that you cannot go on borrowing forever.

Interviewer. Many people borrow for years to buy a house, and many successful companies continue to borrow to grow. These companies also know that it is best to borrow when interest rates are low, and interest rates on UK government debt are currently very low.

Osborne. And I will never stop trying to take credit for that. But as a prudent Chancellor, I need to ensure we have room to run deficits safely in abnormal times.

Interviewer. Is that to enable the government to undertake fiscal stimulus to support the economy during a major recession?

Osborne. No, that would not be appropriate, as I said in 2009. But as I have also said many times, it is important to allow the automatic stabilisers to operate.

Interviewer. The automatic stabilisers operate even during mild economic downturns, because low growth reduces tax revenues for example. So does your definition of abnormal simply mean when growth would be below average?

Osborne. No, I am talking about more serious events than that, but I will leave the experts at the OBR to decide precisely what is abnormal.

Interviewer. I am sure they would welcome your guidance. But if abnormal does not include mild downturns, and you want to make it a legal requirement to run surpluses during those times as well, that will require either switching the automatic stabilisers off during these mild downturns, or running pretty large surpluses when the economy is on track so as to avoid going into deficit if a negative shock of the normal kind hits.

Osborne. As I said, I think it is important to allow the automatic stabilisers to operate.

Interviewer. Chancellor, I may be being stupid here, but why is it important to allow taxes to fall automatically in a recession, but wrong to actually cut taxes further to help bring the recession to an end quickly, particularly if interest rates are stuck at zero?

Osborne. I think the experience of 2010 shows us the limits of what governments should do. It was right to let the automatic stabilisers increase the deficit following the 2009 recession, but any action by the government to increase those deficits puts our credibility at risk.

Interviewer. Now I’m a little confused. You and your colleagues said repeatedly during the recent election that the deficit in 2010 was so large due to the profligacy of the last Labour government, and not because of the recession. Austerity was because you had to clear up the mess that Labour created. It also seems that a significant proportion of the public sees it that way too. Are you now saying that is wrong?

Osborne. Look, no one is denying that 2008 saw a global financial crisis. It is to prepare for that kind of event that we need to run surpluses, perhaps as you suggest quite large surpluses when the economy is growing normally, to get debt down quickly.

Interviewer. So we need to bring debt down rapidly so that we can afford to bail out the banks again when the next financial crisis hits. I thought you had taken the measures necessary to prevent us having to rescue the banks again.

Osborne. We have done what we can, but it is important to maintain London as the leading financial centre, which means keeping banks profitable and allowing them to pay large bonuses to attract the best international talent. We do not want to impose regulations so severe that these banks and other financial companies go elsewhere. We made these points many times before 2008.

Interviewer. Thank you, Chancellor. That has been very helpful in understanding why you believe we need to legislate for budget surpluses. One last question if I may. Can you tell me what percentage of donations to the Conservative party come from the financial sector?

The war with the banks has to be fought on two fronts

Trying to prevent another financial crisis was always going to require fighting on two fronts. The first, which gets most of the attention, is to change the rules and framework of regulation. That involves imposing higher capital ratios and leverage ratios, as well as restricting the activities that banks can engage in. Some progress has been made on that front. The second involves political change, and here I’m not sure any progress has been made. 

The banking sectors in most countries were responsible for the financial crisis. Increases in leverage on the scale shown here were just courting disaster. Big mistakes were made by regulators in allowing this, but the source of the problem was the actions of those in the financial sector. That crisis showed us that ‘too important to fail’ creates a huge market distortion, which mainly benefits those working in banks. The battle to change the status quo is therefore of huge importance.

I’m not an expert in these matters, but my impression is that some progress is being made on the first front. Banks have of course resisted much of this, saying that it would discourage lending and therefore hurt the recovery. Stephen Cecchetti argues that this has not happened. What has been hit is bank profitability, which indicates changes are having the desired effect. Cecchetti suggests as a result that more could be done, and this seems an understatement. Recent work by the IMF suggests that big banks continue to attract large implicit subsidies, while Admati and Hellwig present a well thought out case for much higher capital ratios. Until this happens, our money will continue to help fund bank bonuses.

So on the first front, some progress has been made but much more needs to be done.[1] However the recent case of Citigroup and the US congress illustrates all too clearly why we need a second, more political battle. [2] The story is very simple. The Dodds-Frank act that became part of US law in 2010 prevents US banks from using deposits to undertake certain ‘speculative’ activities. That was one of the victories on the first front discussed above. One of these speculative activities, and possibly the most dangerous in scale, is derivatives trading. On the 11th of December last year, as part of the last minute deal to prevent another US government shutdown, congress passed a provision that exempted derivatives from Dodds-Frank. The provision was based on drafting by the US bank Citigroup.

Why would Congress undo its own legislation in this way? The answer is not hard to find. US banks contribute huge amounts of money to fund the campaigns of those that run for congress, be they Democrat or Republican. It spends huge amounts on lobbying. Members of government often have or will work for these banks. Of course regulators can also be captured by those they are supposed to regulate. This could all be described as institutionalised corruption.

The only big difference between the US and the UK or Europe is that these things are a little more open in the US. City contributions make up a large proportion of Conservative party donations in the UK, and the other parties are hardly indifferent to wealthy donors who made their money in the financial industry. Lobbying is extensive and there are plenty of legislators with links to the financial sector. As Tamasin Cave notes, the UK comes second only to Switzerland for the number of people moving through the “revolving door” between the finance sector and officialdom. Whether Europe’s attempts to put a cap on bankers’ bonuses made economic sense or not, the fact that the UK Chancellor and Treasury were prepared to try so hard to prevent it happening shows who calls the shots in the UK government. Similar points can be made about the extent of lobbying and industry links in Europe.      

The Citigroup case shows how any immediate gains achieved on the first front can be steadily eroded by the political influence of the banks as the memories of the financial crisis fade. Now it might have been prudent from the US banks’ point of view to wait a bit before doing this so openly. Simon Johnson rather optimistically suggests that Citigroup’s blatant move may end up with its breakup. Alternatively Citigroup may just know they have the political upper hand. In the UK, it is difficult to know where an effective challenge to banks' political power will come from, and good reasons to think that any challenge would not be successful. [3] Such a challenge would be hugely popular, but more than popularity is required to counter the influence of money and power.

[1] In particular, the importance of simple regulation that cannot be gamed seems not to have been sufficiently appreciated.

[2] The case is unfortunately not an isolated example.

[3] An example of what UK governments can try and get away with in the interests of large corporations is provided by the case of Jeremy Hunt and News Corp. In November 2010 Culture Secretary Hunt sent a memo to the Prime Minister which began “James Murdoch is pretty furious at Vince’s referral to Ofcom.” That was Vince Cable’s referral of News Corp’s proposed takeover of BSkyB. The memo argued News Corp’s case. As Stuart Weir documents, Hunt was hardly a disinterested party in this. When Vince Cable was subsequently forced to relinquish his role in the affair because of comments he made to constituents, it fell to Cameron to appoint someone who was seen as more impartial. He appointed Hunt to take over. When civil servant Gus O’Donnell was asked to oversee the propriety of the appointment, Hunt’s memo was not disclosed to him. 

Banks, economists and politicians: just follow the money

Economics rightly comes in for a lot of stick for failing to appreciate the possibility of a financial crash before 2007/8. However it is important to ask whether things would have been very different if it had. What has happened to financial regulation after the crash is a clear indication that it would have made very little difference.

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis? I think they would have been ignored then even more than they are being ignored now. The single most effective way of avoiding another financial crisis is to reduce the political influence of the banking sector.      

[1] The optimum amount of equity is not 100%, in part because some (subsidised) borrowing does increase discipline on bankers. For a good discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative to the state picking up the bill is to inflict losses on depositors, but the economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has got itself into with this following the Cyprus crash: see also Simon Johnson here.

[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch operation in modern history, where a banking crisis involving private sector debts was turned into a public sector debt crisis. While I would be the last person to defend the macroeconomics status quo, I also think there is an element of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory tells us a lot of useful things about how to get out of the recession, if only politicians would take some notice.  

Information, Money and Politics

A post that helps put the mainly in mainly macro

                A Conservative Party Treasurer is caught on camera trying to solicit £250,000 from businessmen by offering to, among other things, feed their suggestions into the policy process at No.10. Having just passed NHS Reform that will greatly increase the involvement of the private sector, David Cameron suggests privatising parts of the road network. Are we seeing either end of a single process here?

                To which one might respond, as Chris Dillow does, plus ca change. Others, like Stuart Weir, take a less sanguine view. Let us look to the US, which we often need to do to see what happens next. Here we find Paul Krugman helping to uncover the activities of the American Legislative Exchange Council (ALEC). According to Krugman ALEC drafts legislation which is often adopted word for word by US states, is funded by the usual right wing billionaires and corporations, and which has a particular interest in privatisation. It or associated organisations may as a result see advantage in having laws passed that increase business for some of those privatisations, like prisons for example, although of course they would never act on that interest. And equally evident is that this could not happen here.

                But what exactly is wrong with all this? Presumably it is legitimate for a lobbying organisation to draft legislation that furthers its interest. The organisation does not force legislators to pass it. And what is wrong with people with lots of money using it to fund such organisations? Of course corporations have interests, but it is up to politicians whether they are listened to or not.

                One thing we can object to is secrecy. It is generally regarded as good practice to declare personal interests where appropriate.  For similar reasons it seems appropriate that organisations and think tanks disclose the source of their funding. As George Monbiot has found, in the UK at least that is quite hard to persuade them to do. I cannot see any justification for keeping this information secret. The default position is that we should be automatically suspicious of any organisation that allows its benefactors anonymity, and discount its output accordingly.

                Why does disclosure matter? In an earlier post, I talked about how the media tends to have two ways of framing issues: either there is general consensus, or there are two sides to every question. With that two category model, it is quite important which category the media decides to put a particular issue into. Moneyed interests can manufacture controversy through think tanks, as has happened with aspects of the climate change debate. It is therefore important that everyone, including the media, know where organisations get their finance. More generally, the media needs to be a little braver in going beyond the spin and ‘following the money’.

                There are also limits on what money should be allowed to do in the political process. If some organisation or individual offered to directly buy your vote, this would be illegal in most places. Where it becomes less clear is when we move to political advertising. Now of course if we try and pretend that advertising is just about providing information, and that there are adequate safeguards to ensure advertised information is always ‘true’, then we might believe the more information people have the better. However those would be foolish things to believe.

                In a previous post I wrote ‘money buys votes’. Immediately on writing that my academic self thought, hold on, should I not qualify that a bit, but then I thought don’t be silly. Of course advertising in elections, as one commentator pointed out, does not guarantee that votes will follow, just as advertising a commodity can be more or less successful. But the correlation is surely positive. If advertising is about persuasion, or more pejoratively manipulating minds, then should we allow one political party a greater opportunity to do this than another? If the answer is even a qualified no, then I think we are entitled to put limits on how much money political parties or their supporters can spend. (In the UK this is done at election time, but the logic implies limits should operate at all times.) It also, in contrast to Chris Dillow’s view here, suggests that there should be limits on how much individuals are allowed to contribute to political parties.