432.0pt; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:Cambria; mso-fareast-theme-font:minor-latin; mso-hansi-font-family:Cambria; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:”Times New Roman”; mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;} p.MsoListParagraph, li.MsoListParagraph, div.MsoListParagraph {margin-top:0cm; margin-right:0cm; margin-bottom:10.0pt; margin-left:36.0pt; mso-add-space:auto; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:Cambria; mso-fareast-theme-font:minor-latin; mso-hansi-font-family:Cambria; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:”Times New Roman”; mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;} p.MsoListParagraphCxSpFirst, li.MsoListParagraphCxSpFirst, div.MsoListParagraphCxSpFirst {mso-style-type:export-only; margin-top:0cm; margin-right:0cm; margin-bottom:0cm; margin-left:36.0pt; margin-bottom:.0001pt; mso-add-space:auto; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:Cambria; mso-fareast-theme-font:minor-latin; mso-hansi-font-family:Cambria; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:”Times New Roman”; mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;} p.MsoListParagraphCxSpMiddle, li.MsoListParagraphCxSpMiddle, div.MsoListParagraphCxSpMiddle {mso-style-type:export-only; margin-top:0cm; margin-right:0cm; margin-bottom:0cm; margin-left:36.0pt; margin-bottom:.0001pt; mso-add-space:auto; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:Cambria; mso-fareast-theme-font:minor-latin; mso-hansi-font-family:Cambria; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:”Times New Roman”; mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;} p.MsoListParagraphCxSpLast, li.MsoListParagraphCxSpLast, div.MsoListParagraphCxSpLast {mso-style-type:export-only; margin-top:0cm; margin-right:0cm; margin-bottom:10.0pt; margin-left:36.0pt; mso-add-space:auto; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:Cambria; mso-fareast-theme-font:minor-latin; mso-hansi-font-family:Cambria; mso-hansi-theme-font:minor-latin; mso-bidi-font-
The depression has provided few laughs. I have though found the contortions of The Economist mildly entertaining; trying to claim that the credit crunch is not really the fault of the bankers and that the solution is to resurrect the set up that caused the depression run by the same folk that got us into this mess.
The favoured way forward comprises a number of things, some no more than aspirations and each in conflict with another. One of the major problems is said to be the imbalance between economies with some running a huge surplus and others a large deficit. This is of course the result of trade. But according to the Economist “The benefits of world trade cannot be overestimated,” adding, “Not that that needs repeating.” The contention sits oddly with calls for countries with large surplus balances such as Germany and China to rely less on trade and promote domestic consumption. It is not clear how that in turn sits with the lauded freedom of capital to move where production is most “efficient” ie cheapest. This farrago is produced by what is supposed to be, what ever its social drawbacks, a self-correcting system. The notion of state intervention to try to correct these anomalies is totally rejected as being either inept or a vain attempt to thwart the natural law that is capitalism.
Even if that were so and even if the capitalist system worked without having to be rescued from time to time, I would find the social price unacceptable. South Africa has a population of whom the vast majority live if not in poverty not much above, and with 40% of able bodied men unemployed. The by-products are murder, theft, rape and AIDS. There must be a better system to one that cannot employ people to make things that those same people desperately need. We have come to accept that we can at best only modify capitalism but looked at from outer space, capitalism must seem plain daft.
I am not an economist but since economists have been united only in being wrong I do not see why I should not attempt an analysis of what has led to the present sorry state and what is required to prevent a similar mess in the future. Economists of repute can make totally opposed analyses and recommend contrary courses of action. Keynes and Freidman can’t both be right but both might well be wrong.
I shall try to start from first principles since it seems to me that in economics certain underlying tenets are accepted without question, tenets that on examination turn out not to be self-evident at all. It is then unsurprising that the elaborate structures built on such shaky foundations under stress come crashing to the ground.
For example, in 1978 Jensen stated, ”There is no other proposition in economics that has more solid empirical evidence supporting it than the efficient markets hypothesis”. The E M H holds that the price of a financial asset- a stock for example- reflects all available information that is relevant to its value. Hence no stock will move far from its correct value. Currently Professor Dewey of Chicago can still attest to the “accuracy of the hypothesis”. He says that if a crash could be forecast that would be part of the available information so the crash would occur immediately. But crashes occur for no good reason. But now the Economist states, ”Seldom has a school of thought fallen from grace as fast as that of efficient markets.” Who but an economist would ever have held such a clearly untenable hypothesis? As Keynes said, the stock market is ”like judging a beauty contest where you are not trying to decide who is the prettiest girl but who the other judges will think is the prettiest”. I suspect that the “empirical evidence” is really the assertion that the price of a stock is an accurate reflection of its worth because otherwise the price would be different. But that would be merely to assert that the price is the proper price. The price of an asset, as with everything else, is simply what someone is prepared to pay for it. If no one wants your shares they are worth nothing.
The fall of the efficient market hypothesis has profound and worrying consequences. Efficient markets would be relatively stable. Whilst there was believed to be some basis for the hypothesis it would have been, like so much else in economics, at least partly self-fulfilling. Because we have ceased to believe the hypothesis, markets have become less stable. Making money through treating money as a commodity requires instability. As I write the Euro is falling, triggered by the Greek National Debt. The received view is that a loan from the rest of the E U would “call the markets’ bluff”. If that proves to be so it will be only because that is what is expected. If the market refuses to do what it is supposed to do, the Euro will continue to fall. It all depends on what individual traders expect to happen and that depends on what a trader expects other traders to do.
Then there is the assertion that what benefits the individual benefits everybody, an assertion held firmly by the rich but with rather less conviction by those worse off.
A further source of confusion is the assumption that the rules that apply to the individual or a small enterprise hold for the country as a whole. The economics of Alderman Roberts’ grocer’s shop were applied by his daughter to Britain as a whole.
Further, economists seldom recognise that their generalisations and prescriptions impinge on real people and usually on the most vulnerable. For example, economists aver that with an aging population there will have to be less generous retirement provision in the rich economies. It would be news to many British pensioners that they are currently living in luxury. What do they think future pensioners are supposed to live on? I doubt those economists contemplate getting by themselves solely on a State pension. No, economics is made for man not the other way round. The laws of economics are not the laws of nature and certainly not the laws of God. We can order matters better.
There are two fundamental points that are to me obvious but are widely ignored. Where they are acknowledged their implications are not.
Firstly, finance is essentially different from all other commercial activities. With a few exceptions like tour operators, we pay for what we receive at the time – or even later. If a restaurant folds the day after we have dined there we feel no more than regret. If our bank shuts down the money we have deposited is at risk; we cannot take our custom elsewhere if we cannot withdraw our money. If General Motors ceases to trade Ford is likely to rejoice. If Royal Bank of Scotland closes Barclays is likely to be worried. Many claim that the financial crisis would not have occurred has Lehman Bros been bailed out. The implications of this difference are profound. The underlying problem is the nature and function of money, something no one appears to understand.
Secondly, only national governments can make binding regulations. The European Union is not quite a unitary government but some way towards being one. Any international agreement is likely to come unstuck through conflicting national interests and the actions of countries that do not choose to join. Currently it seems unlikely that there will be any banking rules agreed for countries to avoid.
Before I attempt to deal with the implications of those basic points I want to consider three other matters.
Why are not all countries rich or on the other hand all countries poor? Once being rich might have depended on the existence of raw materials close at hand but not any more. Soft water, millstone grit, sheep in the Dales and coal, no longer make it cheap to produce woollen goods in Yorkshire. And in the past innovations took time to disseminate but new ideas now move with the speed of light. Economists say global trade allows production where it is most efficient but in fact they mean where it is cheapest. Cheapness is not just low wages but lax planning rules, available building land, reliable and compliant labour, few environmental restrictions, weak safety regulations and so on; but on the other hand production requires a stable government, no more than a modest level of corruption, and a reasonably low crime rate. There are countries that depend mainly on mining-the oil producers is the clearest case - but there is no unalterable reason why some of the rest should be rich and the rest not. The actual reasons can be summed up as social; Botswana and Sierra Leone both export diamonds but there the similarity ends. Social change is difficult to engineer but without change, aid is largely ineffective, except for disaster relief on humanitarian grounds. It is not more efficient to make toys in China than in America, just cheaper. If economics is the sole criterion we ought to move to a situation where it is efficiency that governs production not cost.
Economists, and certainly The Economist, believe that services are “the backbone of all major economies”. “Services” means financial services but even if you include retailing and the like, services still require something to service; services are secondary. A garage to service cars depends on there being cars to service. Financial services require an economy to serve. To regard services as the basis of an economy is to put secondary before primary. It is nonsense. Belief in that nonsense has a lot to do with our current plight.
The drive in economics is to cut costs. That usually means employing fewer people. The consequence is not necessarily more effort or longer hours since technical advances may produce increased productivity. But unfortunately the sacked workers cannot buy at the same rate so the market contracts. The way out is to push more buying power into the economy to get people spending. It does not seem to matter what people buy, whether it is something they need or even want, provided that they spend. Economists, I assume with a straight–face, say that the Chinese and American economies are complementary; China produces and America consumes – and China lends America the dollars earned so that Americans can go on buying. Obama has warned the world that it cannot rely on America to go on being the world’s consumer, as though America by buying what we produce without paying for it is doing us a favour.
The relationship between production and consumption is in principle simple but in practice inconsistent and illogical. There is much anguish about the ageing population -too many retired and too few workers. But retired people are economically no different from other unemployed. Substantial unemployment shows that we can maintain the gross domestic product without every available person working. The retired are to the employed, as is the United States to China. Or to put it another way with rising productivity we need the retired who consume but do not produce, to keep our ever more productive workers employed. At present the solution advocated seems to be to drive the retired into penury, accept significant unemployment, whilst those in work are busy producing things many of which are not needed and which those with money have to be induced to buy. Technology means that not everyone needs to work producing, to provide a decent standard of life for all. Substantial unemployment means that any shortfall is not due to labour shortage. An ageing population need not create a problem, though it almost certainly will.
These are important matters but even more fundamental is the instability inherent in world trade. The law of supply and demand might work well enough if fluctuations in the latter were small and quickly counterbalanced by changes in the former. If supply exceeds demand by a small amount, prices will fall and people may buy more. But if supply significantly exceeds demand, production will become less profitable, workers will be laid off and buying power will decrease. Manufacturers with falling sales and profits are likely to run down stocks, leading to fall in demand for those items and so it goes on. If demand exceeds supply prices will rise and so will profit, so stimulating increased production. What seems to be ignored is the inertia of production to cope with changes in demand. Different products have different response times and some of those stretch for years. Currently oil production can be increased by the turn of a tap but not production of petrol and diesel. The limitation is refinery capacity and refineries take many years to bring on stream. Bulk carriers take years to complete so with the current depression carriers stand idle with skeleton crews while new vessels still roll down the slipways.
The instability of trade is a serious matter where the country relies on exporting. The riskiness of relying on other countries buying is well shown by the present situation of Japan and Germany. Until lately Germany was being praised as the world’s second exporter with a large credit balance of payments. But with a downturn in demand, Germany has suffered severely. Most economists think the solution is to get trade going again and for a start, complete the Doha round. I would have thought the moral the opposite- depend less on overseas trade. But as I have pointed out already according to The Economist, “The benefits of world trade cannot be overestimated”. As so often in economics, the evidence of the truth of the proposition lies only in its degree of acceptance and the frequency of its assertion.
I believe there is universal agreement that the imbalance in world trade is a bad thing. I believe that is correct but why I will leave for the moment. I can see no feasible way in which those imbalances might be corrected under the current system.
The world could be and to some degree is, a single economic unit. But there is no reason why it should be and totally unacceptable social costs in trying to make it one. The world could be and to some degree is, divided into near self-contained economic units. If the economic unit coincides with a political unit it becomes possible to enforce regulations for the protection and benefit of all citizens. The politico/economic unit, which may be a single large state, needs protection otherwise it will be undercut by those who play by less stringent rules. To put the matter differently, a major reliance on trade is the source of our social and economic ills, not the cure.
Let me be more specific. The United States is the world’s largest economic unit. It could make almost everything its citizens need or desire. Laptops can be made more cheaply but less efficiently in South Korea. However, it is not clear why it is a good thing to import laptops and close down assembly in the U S A. Do the Koreans not want laptops?
Currently China has been forced to change by the steep decline of international trade. China’s G D P is nonetheless growing at a remarkable 8% despite the depression, on the basis of a rapidly expanding domestic market. The Chinese – clever fellows – have realised that doing without themselves to let US citizens buy cheaply, is not in fact a good idea; better to consume what you produce.
The economic aim in all countries should be to increase the welfare of its members. That will not occur if imports supplant items that could be made or produced locally, and those who might have made the imported items are unemployed. Unemployment is waste, as well as being a social disaster.
I suggest that countries introduce a modest import tax – say 5% - on any class of goods that can be produced – manufactured, processed, grown or mined- within the country. Unless productivity is higher in the exporting country, cheap imports will be the result of practices that would not be tolerated and might even be illegal in the importing country. Of course goods will become somewhat more expensive but that will be offset by a decline in unemployment and hence the cost of social security. I am not convinced that citizens would be worse off even financially. And the country would be substantially protected from the vagaries of world trade. The aim would not of course be to end international trade but to reduce it substantially. I shall try to deal later with the internal consequences and opportunities.
I can foresee two objections. Firstly the tax would reduce competition. To avoid that the politico/economic unit would need to be large enough to support several producers. That is not so with large aircraft. There are only two manufacturers as it is and much suppressed subsidy. Large merchant shipbuilding is another difficult case, and so indeed is merchant shipping and fishing outside territorial waters. Vehicle manufacture will I am sure be advanced as another exception. Here economic production is said to require a mass international market. I am unconvinced. Morgan manages to survive producing nine cars a week and the cars are not all that expensive. But there is the matter of quality and choice as well as price. The French buy French cars not because the country makes the best cars but out of patriotism. The French have decided that to preserve a domestic car industry it is worth driving cars that perform less well than the best of the imports. Of course the French pretend that their cars are in fact better. The French have brand loyalty and the brand is France. The French have in practice decided to limit their choice and the country has benefited in consequence.
The second objection is likely to be an adverse effect on developing countries of a reduction in their exports. (Why “developing”? That is an assumption. When Zimbabwe is called “developing” the word has lost all meaning.) Developing is too narrow a classification anyway. Export here means export to the affluent states– to Western Europe, North America, Japan, Australia and New Zealand. The less-affluent can be divided crudely into four classes: those that export manufactured goods- electrical appliances, electronics, hardware, clothing; those that export agricultural products- rice, cotton, tea, coffee, meat, grain, fruit; those that export minerals especially oil; and those that export little of anything. This last can be split into what we think of as “developing” countries mainly the countries of sub Saharan Africa and a miscellaneous group that have little in common but fall outside my other classes; countries such as Pakistan, the Balkan states, Egypt, the central Asian states, Myanmar, Cambodia, North Korea and so on. Some countries fall into more than one group – Brazil for example -but most essentially do not.
Manufactured goods
Manufactured imports to the “western” countries come overwhelmingly from Southeast Asia from India to Korea. The region has a total population of approaching three billion. By contrast the affluent states number no more than three quarters of a billion. The latter cannot absorb all the exports that the former could produce. The major market for Southeast Asia’s goods must be Southeast Asia itself. However, it is not clear to me that the export to the affluent countries of goods those countries could produce themselves, benefits the exporting country –or the importing country either. As I have pointed out, currently China seems not to be suffering as a consequence of a sharp decline in exports.
I have yet to read an account of the functioning of the export market in manufactured goods. But I assume that a Chinese maker of toys sells to a U S firm such as Toys R Us. He is paid in dollars that he can convert into Yuan to pay his workers and run his factory. The Chinese central bank now has dollars. What use is that? Some is needed to pay for imported raw materials especially iron ore and oil that are traded in dollars. Some is used to buy a stake in the firms that supply those materials and to buy tracts of African on which food crops can be grown. Some will be used to buy things that China does not produce; for example aircraft and some machinery. But I would guess that the major portion is invested overseas, in the main as dollars earning yet more dollars. This creates a problem. The U S needs to reduce its trade deficit but that means reducing its imports from China or increasing its exports and ideally both. But both require American manufactures to be cheaper and imports from China dearer. But that in turn requires a devaluation of the dollar or the appreciation of the Yuan. Both would reduce the worth of Chinese dollar holdings. To prevent that the Chinese would buy dollars, although why buying a currency should stop its decline is one of the many axioms of finance that are to me far from self-evident. Put propping up the dollar will just tend to make the problem worse.
Agricultural goods.
I hear the cry repeatedly that the developing world suffers from lack of fair access to the rich world’s market. Agricultural tariffs and subsidies bedevil the Doha round. But no one is specific about the goods involved.
There are two classes of product; foodstuffs and agricultural raw materials. The chief of the former are wheat, meat and dairy products. Trade is overwhelmingly between the rich countries and none comes from the poor nations. There are lesser but still important commodities that the rich world does not produce; tea, coffee, cocoa and cane sugar. The last is a scandal; the rich world produces a heavily subsidized and inferior product from beet. There is a third group comprising essentially Mediterranean crops that only some rich countries can grow; wine and citrus fruits are the most important but again those do not come from the poor countries with the exception South Africa. The most important agricultural raw materials are cotton and wool. Wool does not come from the developing world and neither does the majority of cotton that is traded internationally. A fair market in cotton would be a significant help to some countries in Africa but the amounts involved are unlikely ever to be large.
A tax on the import of agricultural goods that the importing country does not produce, would have negligible impact on the under developed world. Subsidies and tariffs already have a greater impact with a number of products.
Finance and money.
Goods and trade is only half the problem, and the easy half at that. I do not understand money and I suspect that no one does. I suspect also that economists, bankers and government ministers have fooled themselves that they do by developed systems of huge complexity. That seems to me likely since the systems often result in contradictory actions. Students are loaned money, which is a current cost that might be paid back later. The point of the Public/Private Finance Initiative is the opposite; to pay later for what we cannot afford now. The Government raises money through bonds; it then prints money – quantitative easing – to buy back those bonds. Why does the government not just print the money in the first place? It comes to the same thing. The idea is said to be to “pump money into the economy” but those who get money from selling their bonds back to the government are unlikely to spend it; they will simply “invest“ in something else. The money the Government might spend on infrastructure to bolster the economy is quite different from the money it has put into dodgy banks. It has to find the former but not the latter. The money put into banks is simply a “ledger entry.”
I find the importance attached to share prices perplexing. If the Dow-Jones climbs it is hailed as good for the economy and if it falls as worrying. I can see that a company when it first issues shares gets the money, in return for which the shareholders get a proportion of the profits. But when I sell shares the company gets nothing. Indeed the main aim when buying shares is to sell later at a profit; the dividend is a lesser consideration. Is the stock exchange no more than a casino? A company whose shares are doing well is likely to have a high credit rating and so be able to borrow more cheaply but that is an incidental benefit and could be achieved in other ways. Indeed the argument, used not only with shares, that the share price provides “information” I find thin. It amounts to a collective judgement and that depends more on the trend of the share price than any objective evaluation of the company.
And that brings me to that curious commodity “confidence”. I am told that a respectable way of gauging the future in economics is to ask people what they expect. As Sir Robin Leigh-Pemberton, a former governor of the Bank of England remarked, “It is difficult to stop a currency rising when sentiment is running in its favour.” So what is likely to happen is what people expect to happen and it is likely precisely because they expect it. Whether there is a rational reason behind the start of a stampeded I doubt; there is certainly no means of knowing. Once started though the trend certainly has a life of its own. Politicians make optimistic pronouncements intended to promote “confidence”. The statements of politicians and bankers are examined for any hint that all might not be well - on the assumption that “they” know something “we” do not. There is no doubt about the importance of “confidence” but no way of controlling it and scant evidence that reason plays much part in engendering it.
Money also bothers me; it is very peculiar stuff. Money was invented because barter was cumbersome and inflexible. To act as money one needs something durable, portable, scarce, valued– and useless. If it were useful it would be just another commodity, valued for what you needed it. Gold and to a lesser degree silver, was the answer. But why should we value something that is useless? The conquistadors lust for gold and silver puzzled the locals; why did the invaders want those useless metals? Gold is not all that valued in itself, even as an ornament. Essentially gold is valued because we regard it as valuable. We regarded it as valuable because it was used as a currency. It is uncomfortable to use as a token what itself has no value. So it seems to me we came to believe that gold had some fixed intrinsic worth against which all other commodities could be measured. If there was a good harvest gold bought more grain but gold itself did not change. Even now an economic downturn leads to a “flight to gold.” That is about as rational as a belief in fairies. But gold or any other currency is only what it can buy. So at any particular time the value of the currency is a function of something like the basket of commodities that go to make the consumer price index. But what is required to make that basket changes with time, and so does the value of the golden token. A loaf of bread is roughly the same from year to year; it has a near constant nutritional value. In years of plenty gold or any other currency buys more bread; in times of scarcity less. It is the value of gold that varies.
Then also the quantity of gold and silver tokens is not constant. If too few, trade is hampered; if too many they become worth less – as the Spanish discovered with silver. It seems to me that the value of the currency determines prices and prices determine the value of the currency. If the price of the basket of goods doubles does that mean that the goods are worth more or that gold – or indeed any currency – is worth less? Is inflation goods costing more or money buying less? It is all a game and a vital one but it only works if we all play by the rules- except that it is unclear what those rules are. Within a country one can regulate the currency whether gold or not. The merit – and defect – of the gold standard is that it facilitated international trade; it was the world’s reserve currency. But in a contrary sense the gold standard would not have come about without large-scale international trade.
There is certainly no reason why a particular rate should have been chosen. Eighty Lira to the ounce was literally set in stone by Mussolini but why 80 and not 90? There was nothing to stop a country changing the rate and in the nineteen thirties the U S A did precisely that. But that of course undermined the principle of the gold standard. Fixed exchange rates are no different than the gold standard but like the gold standard there is noting to prevent a country changing its rate, and that is what countries did from time to time when there were supposed to be fixed rates. Floating rates have their drawbacks but I’ll come to that later.
Certainly floating rates do not stop trade imbalance. Every economist believes that huge imbalances are a bad thing and I would not quarrel with that. Economists may say that the Chinese and US economies are complementary but most also believe that China’s huge surplus and Americas vast deficit is not a good thing. But there is no obvious remedy. Appreciation of the Yuan and depreciation of the dollar would help. China does not see that to be in its interests; its enormous dollar holding would be worth less and its exports would become dearer. Exporting countries are urged to boost domestic spending, although that sits oddly with the concept of trade as the great beneficial driving force of economic progress. To the degree that a country could encourage domestic consumption it may judge that not to be in its best interests. In a free market economy there is only so much a government can do anyway.
A further oddity about money is saving. We save money now to be able to buy in the future. But what we buy in the future must in general, be produced then. We will get a share of future G D P to which we shall not be contributing. That makes sense for an individual but it does not for a country. The retired will have to be supported by the efforts of those in work at the time. Saving does not change that. Savings can of course be used immediately to finance developments that increase G D P, although it is not clear to me that most investments do that.
The uses of money
There are it seems to me three ways in which money is used; firstly the original function as a token to allow buying and selling, secondly as “capital” to be lent to permit someone to buy in order to make something or develop an idea, thirdly as a “commodity” that can itself be bought and sold. The second and third are claimed to be difficult to separate but that may be because the former is beneficial and the later is gambling; gamblers like to call what they do “investing”. Money as a commodity and the whole business of financial innovation is claimed to have been responsible for the increase in wealth in recent decades but I have yet to read any convincing explanation of how that has come about. The Economist states as a fact that regulation, however necessary, will limit growth. The tax on bankers’ bonuses will drive “talent” abroad and London as a financial centre will go into decline. Whether true or not, treating money as a commodity has led to the current credit crunch; on that there is universal agreement. I shall regard ‘”financial services” as covering all dealings in money other than direct loans- derivatives, share trading, securitisation, credit default swaps, short selling, futures and the like.
The value of financial services?
The National Lottery is in effect a voluntary tax; it is a painless way of extracting money from the voters. Economically it would make no difference if the slice taken by the Treasury and assigned to “worthy causes”, were raised from income tax or Value Added Tax. The Lottery makes no contribution to the wealth of the nation; it is a harmless diversion. Are financial services any different- except that they are clearly not always harmless?
Financial services do not pay V A T so presumably like the Lottery they do not add value directly either. Of course many worthwhile and indeed vital activities do not pay VAT; schools, hospitals, courts, social services, the police, the armed forces and a host of others. These are a direct drain on resources and have to be funded both directly and indirectly from “added value”. Most are an indirect contributor to the wealth of the nation. Education trains the workforce of tomorrow. It should also turn out a more enlightened populace and that also is a good thing.
Financial services do not enrich the cultural life of the nation, nor do they directly add value, so any net contribution must come from their benefit to the productive side of the economy. Are they of any more value than the Lottery? Financial services may make one country richer by making other countries poorer, something I shall come to later.
It is true that ”financial services” employ a large number of people, and that the institutions and their employees contribute substantially to government revenue, but so does the Lottery. This is not a valid argument. The tobacco industry used to be defended on similar grounds. The money not spent on cigarettes is spent in other ways so generating jobs and contributing to revenue.
Some examples
I have not the knowledge to dissect all the products of financial engineering; I will just set out what I understand of a few.
The “carry trade” involves borrowing money in a country where the interest rate is low and buying another currency where the interest rate is high. If the exchange rates do not alter you just pocket the difference in the interest rates. On the Efficient Market Hypothesis the value of the currency with the higher rate should decline by exactly the amount to cancel out the profit. That rarely occurs and “investors” hope to spot situations where the overvalued currency will not fall or not fall by enough to negate the profit. I do not see who gains by this except the shrewd – or lucky – “investor”.
“Selling short” involves hiring shares and selling them hoping their value will decrease so that you can buy them back for less than you made when you sold them. You then return the shares to their owner. You can even “sell short naked’ when you do not even need to hire shares. I do not see that either society or the economy gains. It is claimed that the exercise provides “information”, but of what sort and to whom I have been unable to discover.
“Futures” I understand is an agreement to buy a commodity at a set price at some set future date. There is an advantage to the producer since he can plan with confidence. If the contract were with the user there would be an advantage to him as well. But where the buyer is merely an intermediary who hopes the future price will be above that agreed, the benefit is less obvious.
Credit Default Swaps I believe involve packaging debts – mortgages and other loans – and selling the package. That removes the debt from the books of the institute making the loan. The debt may then be further removed from the original transactions by insuring the package. The practice has proved to be disastrous because the packages were “a pig in a poke”- none knew what the packages contained until some of the debts turned bad, notably the sub-prime mortgages. The practice would have been less of a disaster if the contents of each package had been clear. But still the practice would have encouraged rash loans financed by leverage.
Leverage I understand is the borrowing of large amounts of money on the security of much smaller amounts. I would have thought that might be a good thing if the money were used to support economic activity; not a good thing if used for financial speculation. Either way this seems to me to be creating money not so very different from “quantitative easing”. If it is not, then leverage must one day lead to an unpleasant reckoning; one institute calling in its loan leading to a domino collapse.
To say that Financial Services contribute to GDP seems to me to be a function of the way GDP is calculated. Everything goes in. The term suggests that it measures Product, which one might suppose is what is produced. But as I have suggested many activities, including both the necessary and the worthy, do not contribute to the nation’s wealth. An activity that does not pay VAT presumably does not add value in the narrow sense. Financial Services to not pay VAT. Currency trading may make money but does not add value. GDP does indicate product since what is spent must be produced; those that spend cannot spend what has not been produced. Government expenditure is part of G D P although the money comes from taxation, partly from tax on producers, partly from non-productive parts on the economy and partly from those paid out of the public purse; the last is simply recycled money. The money to support horse racing, betting, sport and so on must also come from those who produce. To resurrect the tired metaphor of the national cake only one section of the community actually makes the cake. Part of the cake goes to the producers, some goes to keep the system going, part goes to those who train the chefs and others, some goes to those who amuse the rest of us all, some goes towards those who try to make a bigger cake, but some goes to those who just grab a slice. Into which category do Financial Services fall?
I am convinced that the way GDP is calculated is perverse and has perverse consequences. At the time I write the GDP growth of Britain has just struggled above zero whereas that of the USA is more than 5% yet unemployment in the UK is lower than in the USA and is falling not rising, house prices are rising in the former country and still falling in the latter. Production must be falling in the USA despite GDP being on the rise. But the US is deemed to be bouncing back whereas Britain is thought to be still stuck and since “confidence” counts for so much, that view may be partly self-fulfilling.
The activities of investment banks and other investors - commodity futures, Credit Default Swaps, buying and selling shares – do not in directly “add value”. It is claimed that they do so indirectly; some economists attribute the world –wide increase in GDP over the last decade or so, primarily to these financial institutions. The mechanism is however never spelt out. I for one remain unconvinced that the claim is justified. These financial instruments have made a lot of money for some – and more recently cost a lot of money to us all.
Does the U K benefit from “the city” being the world’s second international financial centre? We are assured that this is so but again I have come across no reasoned case in support. We are told that if the successful operators are not allowed to pocket huge bonuses they will emigrate taking their skills with them; as a result the City of London will decline as a financial centre and take the UK economy down with it. I can understand that Britain benefits from banks being located here that make their profits by trading overseas but other benefits elude me. Similarly no one explains what are these valuable skills that we might lose.
Where does the money come from?
If I hire £100,000 worth of shares for £1000 from you and sell them, but later buy the same shares for £90000 when they have fallen in value, I am £9000 better off and you are £1000 richer than you would otherwise have been. Where does the £10000 come from? If the shares rise to say £110000 you are still £1000 better off but I am £11000 the poorer. Who gets the £10000 difference?
Soros made many millions by selling and buying £S before and after “Black Wednesday”. Did Britain lose that money? Britain certainly lost the money spent in vainly trying to prop up Sterling by buying pounds, and Soros certainly gained a lot, but at whose expense?
I suggest that the money simply appears out of the air and may disappear back to the same place. –not so different from quantitative easing. Money, in a sense, only exists when it is spent. If my house is worth £200000 that sum does not exist unless I sell. If I bought the house for £100000, leaving borrowing aside, I cannot buy a Ferrari with the £100000 profit. The stock market falls by 10% and a vast sum is “wiped off assets” but nothing in the material world changes, at least not immediately. Those holding shares are only poorer if they sell their shares and then only to the sense that they would have been richer had they sold those shares earlier.
Does it matter economically if a futures trader pockets a million pound bonus? That depends on what he does with it. If he puts it under the bed and leaves it there he might as well not have had it. If he buys shares he is merely adding to the value of those bits of paper - or these days the numbers in an electronic record; that is monopoly money until the trader converts it into a form where he can buy something tangible. He can of course do that directly, spending to support a lavish life-style. That at least creates employment. Indeed according to Galbraith it was such spending that kept the U S economy buoyant in the nineteen twenties. The bonus might be used to finance some productive enterprise. But only that and personal spending has to be found from what the country produces; they are the only activities linked to tangible objects. The fortunate trade might buy an old master. Whether that would be productive depends of what the seller did with the money; the seller has in effect received a bonus.
If the trader converted the monopoly money into real money by spending it, that would be equivalent to quantitative easing. He would have the benefit of spending the cash and the amount in circulation would have been very slightly increased.
The whole financial market is I believe only relevant to the real economy because we believe it to be relevant – and because it is currently mixed up with straightforward lending. It is the difficulty of borrowing – shortage of credit - that is our current problem. Making money out of money ought to be viewed as a diversion, like betting on the horses, and taxed accordingly.
The National Debt
I do not know what to make of the national debt. As I have said already the rules that apply to a country or rather to its government or to its central bank, are different from those that apply to an individual. A central bank can decide that it is richer today than it was yesterday. With the money it has decided to award itself it can pay off some of its debts. That is a procedure I cannot follow as an individual.
Why does a government need to borrow? The national debt exists in the form of government bonds. These are taken up as investments as a safer alternative to shares. The difference is that the government may actually spend what it borrows. Since consumption must come from production, that is simply a way of transferring resources. Of course the lender reckons to get his money back but as like as not he will turn the proceeds into monopoly money by buying shares. However, currently most of the borrowed money has gone to prop up banks. The U K government owns the larger part of most banks. These are assets and in the commercial world could be set against liabilities, the liabilities being the bonds. So most of the borrowing is a book keeping transaction. I do not know whether the assets are counted against the national debt but they should be. I do not know whether other countries have used the proceeds of bonds to buy assets to the same extent.
It is claimed that buying back bonds boosts the economy. But that depends on what the sellers do with the money; turn it to monopoly money most likely. Quantitative easing is used to reduce the national debt not to stimulate the economy. Nothing wrong with that of course.
Reducing the National Debt
If I as an individual were in debt, to pay it off I would have to save or earn more or perhaps both. If I were self-employed saving in running my business would be likely to be self-defeating by leading to a decrease in profit. If painless cost cutting were possible I would have done it. But increasing profit is likely to require spending more.
As I have pointed out sundry times the finances of a country operate differently from those of an individual. However, in most respects a country is like the self-employed. If a country cuts back it is likely to “earn” less; innovation will be sacrificed, unemployment will rise, spending will decrease, But that is what the Irish government is applauded for doing and Greek government is being urged to do. A government rarely spends on luxuries that can be cut without pain; returning man to the moon is perhaps an exception. Cutting research or higher education or health spending would result in a poorer future. Moreover, the way GDP is calculated reducing spending, whatever the money is spent on, reduces GDP and the National Debt is presented as a proportion of GDP.
Then there is quantitative easing. I can see no inevitable risk of inflation. The pension fund from which the central bank buys back the bonds is not likely to start buying goods so extravagantly as to cause inflation- or indeed to buy anything at all. This is monopoly money. Of course it can be converted at some time into real money but in the case of a pension fund that might be no bad thing. In a time of high unemployment and spare capacity I cannot see any adverse consequences to a bit of quantitative easing to reduce the national debt. Quantitative easing to fund projects of long-term benefit – say a Severn Barrage- might also not be inflationary at a time of depression.
Whether or not there were adverse side effects I suspect would depend more on whether those were expected or not. As so often with finance what happens is what is expected to happen and simply because that is what is expected.
Currency manipulation
If a particular stock is sought in large quantities its value rises. That is partly because “sentiment” is running in its favour; that is the herd think someone is on to a good thing. There will be a shortage of the stock but that would not of itself drive up the price if no one wanted to buy. But of course the stock would not then be likely to rise.
You can try to manipulate the price by buying your own stock as the Guinness Director’s did. But that is illegal. In any case it only works if no one knows what you are about.
But central banks can buy their own currency quite openly and so strengthen the currency. I would have thought the ploy would achieve the opposite, showing the currency to be in a rocky state. As I write I would not be buying Greek Government bonds rescue package or no rescue package
If floating ensured that currencies were at their true value relative to each other there would be no profit in currency trading. As it is trades take place within milliseconds to capture minute arbitrage situations. Money is certainly not just what it can buy. The Economist runs a “Big Mac” index comparing the cost of that standard item in $US at the prevailing exchange rate, in different countries; there are huge differences.
The role of financial models
One cause of the credit crunch was the reliance on mathematical models that claimed to eliminate risk. This may have been the underlying cause of the crunch since it encouraged risk and greed. Berstein in his seminal 1996 book “Against the Gods” wrote, “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk.” To quote The Economist, ”The formidable combination of mathematics and computing power blossomed in the 1990s in the development of “value at risk”, a way for banks to calculate how much they could expect to lose when things got rough.” VAR is plain daft and not in the least sophisticated. It does not need computing power and only a very blinkered mathematician- one with no knowledge of statistics- could have produced it and only the most ignorant and gullible could have believed it. Into that last class come the world’s bankers. I have written about VAR elsewhere but it is not difficult to describe the exercise. VAR assumes that the daily movements of the stock exchange – the Dow, the FT, the Hang Sen-are randomly distributed. They are not of course nor would anyone of sense expect them to be. A test of normality is not difficult but no one seems to have thought a test to be necessary. Nothing in the real world is random but some things are near enough for certain purposes. The purposes do not include the risk of unusual events; to calculate that, the events would have to be almost precisely normally distributed. Calculating the reliability of the mean though, does not require a close fit, but that is not what VAR is about. In practice, falls that “ought” not to occur more than once a century happen quite often. This has caused great surprise; the theory could not be wrong so it must have been extraordinary bad luck. If something occurs more often than you expect, it is your expectation that is at fault. But it is worse than that. The whole enterprise is ridiculous. The record of daily stock exchange movements for the last century is there for all to see. The best guide to how frequently falls of a certain size are to be expected is how often they have occurred in the past. To assume a certain mathematical distribution based on incorrect assumptions, in order to calculate something that you already could find out by simple enumeration, is perverse to say the least.
The rare events are often referred to as “black swans”. That is an unfortunate metaphor. It suggests that the rare events are quite distinct from the usual run, whereas in fact there are “swans” of various shades of grey. Economic “black swans” are not like earthquakes in their occurrence, and if similar in effect that is because we suppose the opposite.
The Black-Scholes model for derivative trading is more sophisticated. I am too mean to buy the books I would need to understand the model but I would have mistrusted on principle something that reckoned to replace the crystal ball. My mistrust, as it turns out, would have been well justified. But Black and Scholes got a Nobel Prize for this effort. The eminent economists who recommended the award could not have understood the model but I assume were reluctant to admit that. What does that say about academic economics?
What I find both difficult to credit and deeply worrying is that the financial system, whose breakdown has caused such distress and indeed misery, has been in the hands of people prepared to accept concepts about as likely as perpetual motion.
The solution to the “financial services” problem.
There is small doubt that investment banking has been the cause of the credit crunch and that in turn has produced the economic downturn. Why the former should have produced the latter is not obvious. Like so much else in economics, the consequence occurs more because people expect it to occur than for any rational reason. None-the-less regulation could curb the excesses and prevent another meltdown. But memories are short. Already there is strong resistance to effective regulation.
The fundamental question is the benefit of financial services. We are told that those services have been responsible for the growth in G D P over recent decades, which more than offsets the recent downturn. No one explains the mechanism by which this is supposed to have occurred. The financial instruments I have looked at do not seem likely to have benefited the economy. Increase in overall wealth comes from invention and efficient production. Production requires capital and so to a lesser degree does invention. But it is normal banks not investment banks that are the source of loans. Will it be a disaster if these “talented” chaps denied their bonuses emigrate? Will it matter in London ceases to be a major financial centre? China has done rather well without “financial services
A few suggested steps
1 Split investment banking from normal “high street” banking. The Chairman of the Bank of England has suggested that so it must be feasible. Roosevelt did it. Obama plans to do it. Normal banks would deal with direct loans to “customers”, deposits and normal transactions.
A high street bank should not become insolvent but if it did it would have to be rescued. If an investment bank became insolvent then so-be-it.
2 Make short selling illegal. That again is feasible; it has been done. I would have thought selling what you do not own should be illegal anyway; you cannot sell a hired car.
3 Require a 10% deposit for a mortgage and repayment at a sensible fraction of net income. Making mortgages easy to obtain simply drives up prices and asks for trouble. The solution is more houses not easier mortgages. Require those providing mortgages to hold a high percentage of loaned money as deposits.
Those actions could be taken by a country and perhaps with other regulations might avoid a future grave crisis but they leave the international financial structure essentially unaffected. A country would continue to have limited control over its own economy.
The fundamental problem
It is clear to me what is required but not how the desired result can feasibly be achieved. For example, lender and borrower should have a direct relationship; that keeps both sides “honest”. But if debts from various sources are packaged, sold and then insured, the debt has become a product in its own right, not a contract between lender and borrower. Making the composition of a packaged debt clear would certainly help, but that sidesteps the fundamental problem. However, the lender owns the debt and, as with shares, there is no fair way of preventing him selling what he owns.
Taxation
Taxes have two purposes; to raise money and to affect behaviour. Most do both; taxing cigarettes raises money and discourages an unhealthy habit. But it is as well to keep the aims separate. A government can become reliant on the revenue from a tax on cigarettes and reluctant to discourage use. It can be much the same with the taxes paid by financial services whether or not those services contribute to economic welfare.
A transaction tax.
If one cannot prohibit undesirable financial activity, might it be possible to make it less profitable? Such practices might then be indulged in less frequently and less recklessly.
Currencies I understand are traded too and fro within seconds making a large profit from a small fraction of huge sums. If say as little as 1% of the total transferred had to be paid on each trade, this undesirable practice would cease. Similarly speculate buying and selling of shares, packaging of debt, the “carry trade” would be made less attractive. A transaction tax might replace VAT and it would apply more widely. VAT is in fact a transaction tax but levied on the profit not the total sum. A transaction tax could replace capital gains tax. It would though also apply to a capital loss.
A transaction tax is clearly feasible; the stamp duty on property sales is a transaction tax. The seller would pay the tax.
I have not the expertise to workout all the ramifications of such a tax but I cannot foresee any overriding adverse effects. It might drive “financial services” to seek friendlier climes but I believe that would be no bad thing. Other countries might well follow suit. Such a tax would discourage specialist firms making components but would also discourage a complicated supply chain with its attendant administrative complications and vulnerability. Toyota is in deep trouble because of a fault in a component supplied to it. The French medical system produces good treatment but requires the patient to pay and then be reimbursed for every service; a simple operation may involve half a dozen services with administration absorbing quite half the total cost.
The economy of a country
To repeat I believe contrary to the received economic wisdom, the aim should be to reduce international trade both in goods and in money. Both fatally undermine a country’s ability to order its own affairs. That might not be wholly undesirable if there were effective international regulation. But coming to agreement is unlikely since what suits one country may not suit another. Even if an agreement is reached there is no mechanism to enforce it; no agreement will hold when it suits any country that it should not. International trade in goods and money has produced the imbalances thought to be a fundamental cause of the crunch and the depression. There are loud calls to correct those imbalances but no indication of how that can be achieved. I suggest that a standard import tariff by all countries on goods that are produced locally, and also a transaction tax, would in combination achieve that; and fragile international regulations would not be needed. Above all a country would be able to assume control of its economic affairs. What then should the government do?
The aim of economic policy should be full employment not just ever increasing G D P. Unemployment is a personal misfortune, is socially divisive and economically makes no sense. A system that requires many to remain idle when there is work that needs to be done that the idle would be willing to do, is nonsensical. If that is the inevitable result of the free market system then we must find something better.
Within the capitalist system more or less as it is, cheap money and public works would help to boost employment. I doubt that would be sufficient- currently they are not - and even if it were, there are other social problems as well as unemployment. How society might be better organised is a large and complex subject- none larger and more complex. That of course implies “social engineering” but capitalism is itself a form of social engineering. Currently society rewards socially undesirable actions.
Let me take just one example although an important one; the interaction of the constitution, politicians, the form of government and nationalisation. To start from the last it seems to me clear that no industry that requires a “regulator” –OFCO, OFWAT and all the other OFs- should remain in private hands; the existence of a regulator is an admission that capitalist competition is not working. But to move onto the penultimate point no one has found out how to make a nationalised industry operate efficiently and harmoniously. No one has in fact examined the problem because politicians have other priorities and so does the Civil Service. A nationalised industry has been handed over to a managing director to be run as though it were large private company. That does not work nor was it ever likely that it would. Politicians are not elected for their management skills and those who are attracted to doing and making are unlikely to go into politics. Politicians, whether believing in much state intervention or little, are bored by the graft of making things work. And that brings be to the constitution. Some democratic constitutions are better fitted to produce an efficient managerial government than others. The U S A is close to ungovernable since the aim of the Founding Fathers was to keep government power to a minimum. That was the result of a frontier society and a belief in the individual. The President proposes but Congress disposes. That is not a good system more than two centuries later. The U S A is not the same country that it was at the time of the Declaration of Independence. No electoral system has produced efficient government; that is not what the systems set out to do. Once that mattered relatively little; now it matters a great deal.
A radical way to create jobs would be to subsidise all those employed or self employed. The aim would be to make labour cheaper; we are always told that the minimum wage costs jobs. Prices should fall to compensate for any tax increase that might be needed. Further in the U K for example if the current 2.5 million unemployed were to be cut to half a million there would sufficient saving to support a subsidy of about £500 a year. Then there would be tax paid by those extra 2 million employed. Perhaps still not enough. The subsidy might be cut as “full employment” – actual about 3% - was approached.
The immediate problem
The pressing problem at the moment is shortage of credit. That is what is depressing output and creating unemployment. In U K we need more houses but they are not being built because mortgages are in short supply. That increases the shortage and drives up prices requiring larger mortgages.
Governments have propped up banks and urged them to lend but without adequate result. Governments actual own many banks so the government could simply order those banks to lend. The state can order the bank to do what is in the national interest, even if that is not in the narrow sense commercially the best course for the bank. The state may have to accept any loss but that may be a price worth paying if the economy expands and unemployment falls.
P SYMMONS Feb 2010