Tag: George Osborne

Nick Clegg is right to aim for the centre ground

This morning I got a grumpy email from the Social Liberal Forum, a left-inclined pressure group within the Liberal Democrats. It complained about the apparent support the party is giving to the Conservative policy of aiming for a balanced budget, and so a continuing diet of austerity. It criticised this idea for being economically illiterate. It went on that the policy was

Cold comfort … to the people having to choose between heating their homes and eating this Winter, to those forced to go to foodbanks to feed themselves and their children, to families struggling with the cost of living crisis

They also criticised the party leadership aiming at a “mythical place known as “the Centre ground””, and of being closer to the Conservatives than Labour.

All this illustrates the disarray on the British left on economic policy following the unexpected turn for the better the economy has taken. Previously the left could unite around the proposition that the government’s austerity policy was “too far, too fast”, causing hardship amongst society’s least well off. They took immense comfort from the support of many Keynesian economic heavyweights, who said that, in the absence of growth, the state should disregard the government deficit and stimulate the economy to get it moving – or at least stop making the situation worse through cuts. Hence the government’s supporters being “economically illiterate”.  Yes they said, the government should tackle the deficit, but not until growth has been restored.

Though some might not realise it, that fox has been shot by the economic upturn. It isn’t that those economists were wrong, or that “too far, too fast” did not have economic validity at the time; it is that circumstances have changed. If the economy is growing, it is not a good idea to add further stimulus to it. And the “later” when the government should start to tackle the deficit issue has started to arrive. The awkward question that much government expenditure before the crisis was unsustainable, and would have to be cut in due course, cannot now be dodged.

In response the Labour party has changed the subject. Instead it is focusing on a “cost of living crisis” which they blame on badly behaving businesses, from energy companies to house builders. They are proposing a series of populist but economically naïve policies to change these companies’ behaviour. They appear to have no macroeconomic strategy, and the Shadow Chancellor, Ed Balls, is conspicuously floundering.

Politically, Labour’s strategy is interesting. Instead of following political conventional wisdom by chasing voters who float between the main parties (which is what is meant by the “Centre ground”) they seem to be chasing left-inclined or working class voters who will never vote Conservative, but who do not currently vote at all. Centrist voters are worried about the management of the economy, and seem to think that the Conservatives have the stronger case on that front. Instead of trying to reassure these voters by making it clear that they would continue with austerity policies to bring the deficit under control, they are chasing other voters.

What is even more interesting is that the Conservatives are also showing little interest in the Centre. Centre voters are worried about “fairness”, and the state of public services, where they trust Labour more. But instead of doing much to reassure voters here, they are stirring up headlines on immigration and the European Union, where they are proposing policies that are just as economically naïve as Labour’s. Again, quite apart from fighting off the populist challenge presented by Ukip, they seem so be after right inclined people who are not voting, but would never vote Labour if they did.

So if there is no serious contest for the Centre, and if both of the two bigger main parties are pursuing populist but foolish policies, there is surely an opportunity for the Liberal Democrats. Nick Clegg, their leader, is right to make a bid for this, which his party is doing with its “Stronger Economy, Fairer Society” slogan, which epitomises the centre ground. The critics within the party of this strategy are right to point out that this is not ideological secure space, and will do little to built the party’s weak core vote. But if the party is to hang on to its representation in Parliament it will need the support of floating voters.

And so to economic policy. George Osborne, the Conservative Chancellor, is wrong to make a fetish of budget balance – and perhaps deserves to be called economically illiterate to do so. But it is economically sensible to manage the public’s expectations on what the state can afford. It may be that some economists are right, and that a “trend rate” of economic growth of 2-3% per annum is there for the taking in the medium to long term, as everybody seemed to think before 2007. But there are good reasons to suppose that they are wrong, and that much slower growth is “the new normal”, once a bit of catch-up growth is over. If so we will have to get used to a much smaller state and a less generous benefit system. Floating voters sense this, and will not vote for the Liberal Democrats if they think that they might help the Labour party take risks by reversing austerity. Nick Clegg may or may not be economically illiterate, but he is surely right on that one.

Will Labour let the Tories win the 2015 election?

Margaret Thatcher’s death on Monday has distracted attention at rather an interesting moment in British politics. There is a vigorous debate about how Labour should fight the next General Election, which should be in 2015 (one of the very few Lib Dem inspired constitutional changes to get through was one on fixed term parliaments). I have picked this up from two articles. First was an article by Guardian journalist Jonathan Freedland last Saturday: Labour must draw the sting from welfare, or lose in 2015. Mr Freedland is nominally an independent journalist, but this article seemed to be very well coordinated with material coming out from the Labour leadership, including a TV interview with deputy leader Harriet Harman. It sounds their leader’s, Ed Miliband’s, party line. Then came former leader and prime minister Tony Blair in a widely reported article in New Statesman: Labour must search for answers and not merely aspire to be a repository for people’s anger. The link is to a summary, which is all I have read; the full article is in a special Centenary print issue. I don’t think either have identified the right strategy for 2015, though Mr Blair is closer.

Both writers attack a complacent view which seems quite popular in Labour circles, and which is often associated with another Guardian writer, Polly Toynbee (though not by either author, and possibly not fairly). This is that the Conservative led coalition is in a mess, having picked the wrong economic strategy, and heartlessly cut important parts of the British system, such as working age welfare. The Conservatives are very unpopular; public anger is raging. They even face a challenge from the far right, Ukip, which is causing panic and leading them to revive their reputation for being the nasty party. Meanwhile Labour have already dealt a mortal blow to their coalition partners the Liberal Democrats, who face a private battle with oblivion in a few dozen constituencies across the country, and are reduced to irrelevance everywhere else. On this reading, all Labour have to do is to ride the anger and say as little as possible about what they would do in government, beyond the implicit or explicit promise to roll back the Tory cuts. The coalition parties will lose the election without Labour having to try very hard to win it.

But both authors suggest that the middle ground of British politics has shifted, to something much sourer than it was before the crisis. Before Mrs Thatcher’s death, the left had been stoking up the anger over the government’s welfare reforms, and especially some changes on housing benefit that they dubbed “the bedroom tax”. But into this maelstrom stepped the novelist A.N. Wilson and The Daily Mail who suggested that odious killer Mick Philpott was a product of the British benefit system, showing that cuts were needed. And then Chancellor George Osborne joined them, to apoplexy of the left. Labour’s anger is genuine, but it does not seem to be hurting the Conservatives. Opinion polls put Labour on about 40% to the Tories’ 30%. Add in more than 10% for Ukip and the right is level pegging with the left before the fight has really started. Labour are appealing to people who already vote for them, or who live in Northern urban constituencies where their votes are not needed.

The threat to Labour is quite clear, with a parallel in 1992, another election in difficult economic time. The weak economy is causing hardship across the board, and not just amongst those on benefits. If the economy picks up in the next two years, the government will get credit. If, as most people expect, things stay grim, then that sour mood will continue. People don’t buy the argument, popular amongst trade union leaders, that bit of extra government spending will stimulate the economy into a virtuous circle of growth. As in 1992 the Tories will claim that Labour’s plans to restore the cuts will simply make things worse by raising taxes. This will be very hard for Labour to fight if they follow the Polly Toynbee strategy, and they might lose rather than gain seats. A Lib Dem meltdown, predicted gleefully by Labour activists, will simply deliver a full working majority to David Cameron.

What to do? Mr Freedland suggests a programme of radical reforms to welfare, which will inspire the public with fresh thinking against Coalition incompetence. Ideas include moving towards the contributory principle for benefits (linking benefits more tightly to contributions, as many other European countries do), increased support for childcare, guaranteed jobs after a year of unemployment, and so on. These reforms will tackle the crisis of legitimacy that Mr Freedland highlights as the problem with the benefits system. This seemed to chime with what Ms Harman was saying on the television, and which I had read elsewhere from another Shadow Cabinet member.

What Mr Blair is suggesting is not clear, certainly from the article summary. He asks questions rather than provides answers. He does not seem to be going down the radical reform line, though. He suggests things like building more houses (in his case probably by building private sector houses on green belts), more computerisation of government services, and using DNA databases to tackle crime more effectively. Overall this is much closer to what the Coalition is already suggesting. On the economy, he does suggest industrial strategy, but not re-balancing. He even suggests rebuilding the finance sector. But then he does not accept that the British economy was more vulnerable than others to the financial crisis. More pleasing to liberals, he suggests challenging the right on Europe and immigration – though this can be read as justifying his policies when he was last in power.

Mr Freedland’s approach would be a serious mistake. If the Coalition has shown anything, it has shown just how difficult reform is, especially in hard economic times. All reforms create winners and losers. Politically the winners keep quiet, but the losers shout like mad. And reform ideas put together quickly tend to fall apart quickly. Any programe of radical welfare reform would fall apart under the full weight of attack, led by a press pack that still tends to set the political agenda. They will be portrayed as expensive and muddled; and any areas where savings are suggested will be attacked vigorously so that the losers’ voice is heard. It is simply too late to be radical. The country has reform fatigue. Remember the referendum on reforming the electoral system? An idea that seemed quite popular at first fell apart under concerted attack from the right.

Mr Blair is closer to the mark only because he seems to be less radical. But his central idea of trying to restore the reputation of the last Labour government is surely a dead letter. What Labour should be doing is learning from the way he secured a landslide at the 1997 election. He did this by signing up to 95% of the Conservative government’s policies, with a few carefully chosen and well publicised exceptions, while appearing more cohesive and inclusive than his opponents.

Likewise Mr Miliband needs to sign up to the bulk of the welfare reforms, with some token exceptions. Unfortunately reversing the “bedroom tax” would be a poor choice: the change only applies to social housing tenants, so private sector tenants either have to be included at great expense, or else they will protest as to why they are being left out. Personally I would would focus mainly on reducing the costs of childcare at the expense of some pensioner benefits – though the coalition parties might jump on this bandwagon.

But Labour needs to act now if he is to do something like this. The activists will hate it: so they need enough time for the fuss to die down, before they return to their visceral hatred of the Tories for motivation. But I don’t think Mr Miliband will go down that road, though.

David Cameron is not a particularly effective Prime Minister. But he is the most skilled politician amongst the party leaders. He has an excellent instinct for the political middle ground, and he is slowly but surely manoeuvring Labour into a cul-de-sac. Whether he will win a majority in the 2015 election is open to doubt: but I would bet good money on the Tories being the largest party.

 

 

It’s official: the Budget was a disaster

When George Osborne launched his 2012 Budget, I was one of a minority of people to praise it.  I admired the boldness of his move on the top rate of income tax, even if I did not approve of it.  And often Budgets look better (or indeed worse) in hindsight that they do at the time.  But that happy fate will not await this Budget.  Today the third successive retreat was announced from its proposals, this time on tax relief for charities – following VAT on hot food, and the taxation of caravans.

I haven’t followed the issues on hot food and caravans in any detail.  The former, at least, looked quite reasonable – and extending the base of VAT is quite sensible policy.  The regressive impact of such an extension (i.e. the idea that they affect poorer people proportionately more that the rich) is generally overdone by lobbyists and mischief making politicians.  The charity issue (limiting the amount of tax relief on charitable donations) was an idea that looked more sensible the more I thought about it.

What went wrong was the politics.  The measures came out of the blue and sowed panic.  As I blogged at the time, the charity lobby has shown formidable political skill.  The sort of skill that this government seems to lack.

This does not bode well for the stormy European waters ahead.  Downing Street needs an Alistair Campbell – a no nonsense head of communications with a feel for the tabloids – who once again have shown their ability to set the political agenda.  And his 0r her brief must be to make the Coalition as a whole look good.  It doesn’t help that both Tories and Lib Dems are spending so much time trying to show differentiation from each other, however understandable that might be.

The budget – the coalition at its best

George Osborne is gradually cementing a reputation as an effective Chancellor of the Exchequer and skilful politician.  He certainly understands coalition politics and how to play for the longer term.  Yesterday’s was a very interesting budget.

There a two schools of thought about coalition governments.  One may be characterised as “lowest common denominator”: all the bold ideas are knocked out and we are left with a few messy compromises that lack any kind of coherence.  The second is the “natural selection of ideas”  in which the ideas of the various parties have to compete on their merits and the weak ones don’t survive, the sum being better than any party would produce individually.  Britain’s first post-War coalition, formed by politicians unfamiliar with how coalitions work, has seen both types of policy formation at work.

The coalition started well.  The initial policy programme was full of bold ideas, while dotty ones (cutting inheritance tax for example) did not make the grade.  But things soon degenerated, as activists on both sides sensed betrayal.  This was especially evident on the NHS, where we are left with a messy compromise that is almost certainly worse than either party would have produced on its own.  But the 2012 budget shows a reversion to the “natural selection” model, for which credit must go to both George Osborne and the Lib Dem leader Nick Clegg.

One of the interesting features of the budget has been the disappearance of budget “purdah” – the absolute secrecy surrounding budget proposals.  Mr Clegg made the early running in the media game with his bid for an acceleration of increases to personal allowances.  But Mr Osborne clearly understood this to be an opportunity rather than a threat – in this case to reverse the top rate of income tax of 50%, which until a month or so ago looked to be entirely off the agenda.  A few years ago the Lib Dems had a big conference battle over this top rate (before Labour introduced it, as it happens) and rejected the 50% – so there was evidently some Lib Dem ambiguity over the tax, which Mr Osborne was able to exploit.  And indeed world thinking has long since turned against such high marginal rates, even for the very rich.

Meanwhile, weaker Lib Dem ideas about how to tax the rich more efficiently did not make the cut.  This applied to the Mansion Tax on high valued property.  Such an idea (though based on land rather than total property value) appeals to theoretical economists, but has two major practical problems.  First is that property is not the same as cash, and that owners of such valuable properties may struggle to pay, and hence create a fuss.  The wider the scope of tax, the more of a problem this is.  The second problem is that it has to be based on a theoretical valuation rather than hard and fast fact.  This is one of those things that becomes more of a problem the more that you think about it.  Property (or anything else) is worth what you persuade somebody else to pay for it, which depends on many factors unique to the individuals taking part in the transaction and the time they make it.  A host of practical issues follow.  The eventual compromise of an increase in stamp duty for properties over £2 million, combined with a clampdown on stamp duty avoidance, looks like a much better idea to me.

The idea of limiting allowances to higher income people so that effective tax is no less than 25%, the “Tycoon Tax” – attributed to Mr Clegg in the proposal process, though not coming out of any Lib Dem official policy – also looks like a very sensible proposal – and this made the cut.

Mr Osborne was also able to push through further cuts to the main Corporation Tax rate.  I have some reservations about this: companies are sitting on too much cash – if they don’t invest it, then the best way of getting this wealth back into the economy is to tax it.  But there is logic to it to help retain footloose international capital, something that the country has been quite good at, but needs to stay in the game.  And it’s not as generous as it looks, since allowances have been kept in check.  In fact the big thing UK companies have been asking for is more generous capital allowances – but the footloose companies aren’t so bothered about this, and the Chancellor did not budge.  I’m not sure that capital allowances have been set at the most efficient level – but I do know that business leaders always ask for too much, and the game is often more about tax avoidance than real investment.

One idea was not leaked in advance.  This was the phasing out of the age-related personal allowances.  This “granny tax” has attracted most of the press attention this morning, with howls of protest that the Labour opposition are seeking to exploit.  Yet the reasoning behind this change is solid enough.  Pensioners have done pretty well under the reforms already implemented by the government, and this is a nasty, complicated piece of work.  Although it is true that many pensioners have been punished by the general reduction in the value of savings since the crisis began, this allowance is a bad way to deal with the problem.  What is actually needed is for the economy to return to health, so that we can get back to a real interest rate of about 2% or so from its current negative value.  It was brave to take on the pensioner lobbies like this, and Messrs Osborne and Clegg (to say nothing of the PM David Cameron) deserve credit.  Critics suggest it may go down as a fiasco like Gordon Brown’s cut of the 10% tax band, or the negligible increase to state pensions the last government implemented when inflation appeared to be very low.  Both were politically very damaging, to Mr Brown and to Tony Blair respectively.  But this policy does not create cash losers (denying benefits to those who haven’t got them yet – rather than taking them away from those that have).  It may even mark a turning point in the battle of the generations, as younger voters start to appreciate just how generous the state is to pensioners, and shift their ire away from the much less costly immigrants and benefit claimants.

The budget does nothing for macro-economists.  There is no bold, imperial stimulus to “get the economy moving”.  But nobody was expecting that.  Overall this budget is a credit to the Coalition government.

George Osborne, Ed Balls and the confidence fairy

Paul Krugman, the economics Nobel laureate and New York Times columnist, likes to talk of the “confidence fairy”.  It is a critique of right-wing “supply side” economists, who advocate cutting back on taxes and public expenditure and reducing government regulation.  These counter the criticism that such policies suck demand out of the economy and cause unemployment with the idea that confidence in the soundness of the government’s policies would boost business investment and consumption, and so create jobs.  But such beliefs have no more substance that a belief in fairies.

Mr Krugman believes in solid government management of aggregate demand of a type that is often called “Keynesianism”.  He was bitterly critical of the Obama government for not trying to enact a much bigger stimulus programme in 2008, at a time when the usual criticism was that he was spending to much.  These same arguments are emerging in the UK between the Chancellor of the Exchequer George Osborne and his Labour Shadow Ed Balls.

To be fair, Mr Osborne and his supporters, especially the Lib Dem ones, never made much use of the confidence fairy in the sense that Professor Krugman uses it.  The confidence they that they had in mind in supporting austerity was that of investors in government bonds, and the scary consequences of losing it.  But ultimately Mr Osborne does believe that business and consumer confidence will provide the economic growth and employment he seeks.  But what fewer people understand is that the policies advocated by Mr Balls and Professor Krugman require the confidence fairy too.

Let us consider the logic of the “Keynesian” stimulus.  Cut VAT as Mr Balls suggests and put this money in consumers’ pockets, who go out and spend it, creating jobs, which create further demand.  The Keynesian multiplier (no need for quotation marks here) does its stuff and £10bn of government stimulus might increase total demand in the economy by perhaps £20bn in a year.  But then what?  The extra demand has helped offset the cost (so the £10bn direct cost has been reduced to perhaps £6bn), but the national debt has still gone up.  But growth drops back to zero (or worse) unless there is yet another stimulus package of yet more tax cuts or government spending programmes.  To the extent that these measures are temporary (such as the temporary tax cuts advocated by Mr Balls, or the job programmes and extensions to unemployment benefit favoured by Professor Krugman) then the whole process goes into reverse, multiplier and all.  And if the programmes aren’t temporary, the government structural deficit has just got a lot bigger.  Unless the confidence fairy waves her magic wand.

And it is this boost in confidence that lies behind the case for government stimulus.  It is reinforced by the metaphors used to describe it, such as “kick-start”, “getting the economy moving” or the word “stimulus” itself.  A catalyst that improves confidence and hence gets businesses to invest and consumers spending more and saving less.  And the results would indeed be magical.  By spending and borrowing more you would reduce borrowings in the medium term by more than a strategy based on austerity.  But without the fairy it works no more than the supply-side policies do.  The problem is deferred and made worse, not solved.

So can such a stimulus boost confidence?  In the right circumstances it certainly could, such as those induced by a temporary external shock, perhaps literally as in an earthquake (one of the reasons why earthquakes seem to do such little damage to an advanced economy).  And here there is a genuine divergence of view.  Mr Balls, who perfectly literate economically, does not believe that the British economy pre crisis was fundamentally unsustainable, and so thinks that it should be relatively easy to recover the lost ground.  In economist-speak the British economy has plenty of spare capacity.  A number of professional economists, including the FT’s Samuel Brittan, one of my heroes, seem to agree.  But government economists and many others, apparently including the independent Office for Budget Responsibility, disagree.  The previous economy was over dependent on debt spending by consumers and government and cheap imports, sustained by an overvalued exchange rate and financial support from abroad that can no longer be counted on.  Mr Brittan thinks that the lower capacity of the economy is a self-fulfilling prophesy (i.e the longer the economy is depressed, the more difficult the recovery), but personally I think that the 2007 economy was in a very bad place, and was always going to take a long time to sort out.

But even if you don’t accept this, there is another problem.  The extra confidence induced by a stimulus package can be overwhelmed by outside events, such as the Euro crisis.  The UK economy, much more than the US one, is dependent on the world economy and is open to such shocks.  Right now looks the wrong time to bet on a calm world economy.

Time the British woke up to the crisis in Europe

It is a commonplace for Britain’s politicos to sadly shake their heads and complain that the Euro crisis demonstrates a woeful lack of political leadership.  Regardless of the fairness of this charge in respect of Angela Merkel, say, it clearly has resonance for Britain’s own leaders.  There seem to be two camps: ravingly impractical Eurosceptics, and sheer paralysis from everybody else.  The mood amongst Europhiles (as I witnessed at fringe meeting at the Lib Dem conference) is akin to deep depression.  It is time for this to change.

To be fair some key players have been showing something less than paralysis – George Osborne and Nick Clegg have both been conspicuous in raising the seriousness of the situation with their international colleagues – but their pronouncements are hardly more helpful than anybody else’s.  They aren’t bringing anything to the party and they aren’t trying bring our own public alongside.

The first point is that the Euro crisis has serious implications for Britain, much though most people seem to think it is happening to somebody else.  This is for two main reasons.  First is that this country would be caught up in any financial disaster.  Our oversized banks are deep in the mess; Euro zone countries are vital trading partners for a country very dependent on trade – especially given that international financial services are so important to us.  Our fragile attempts at recovery risk being completely blown off course.  Forget Plan B if this lot breaks.

The second reason it matters to Britain is that resolution of the crisis could take the European Union in a direction that is against our interests.  Britain leads the single market wing of the union: the chief Euro zone countries are more protectionist in their instincts.  We risk being shut out of the design of critical architecture – much as the Common Agriculture Policy was put together in our absence.

How to proceed?  We need to tackle the dark spectre head on: the best resolution of the crisis involves changes to the European treaties.  To change the treaties will require a referendum here (let’s not weasel out of it this time).  If we face up to that challenge now, it will show real courage, and help get things moving.

But, of course, we would need to see something in return.  Changes to the treaties that would further our interests.  These need to be to promote the single market, to protect London (and Edinburgh) as centres for financial infrastructure, and to reduce unsightly bureaucracy and/or operating costs of the Union (the siting of the European Parliamnet at Strasbourg needs to go on the table, at least).  Given our understanding of finance, we might well have useful things to say on the Eurozone architecture too – even though we clearly can’t be part of it.

To do this our leaders (the Prime Minister and the Deputy Prime Minister in the lead) need to build two sets of alliances.  The first is within the British body politic, so that the referendum can be won.  This needs to cover Tory pragmatists (David Cameron, George Osborne and William Hague), the Labour leadership and, preferably, the SNP.  The Lib Dems have an important role in making this hold together since, by and large, they understand the Union the best.  Mr Clegg’s experience of deal-making in the European parliament counts for a lot.  The next set of alliances is within the Union itself, to create a Single Market bloc.  The obvious candidates are the Nordic countries, Ireland and the Netherlands, together with many of the newer members in central and eastern Europe.

This will be very difficult.  That’s the point, almost.  The reward is a stabler EU, constructed more to our taste, even if we must concede some powers to an inner core of Euro area countries.  Everybody wins.  And by taking on the wilder Eurosceptic fringe, including their newspaper backers, it will cheer all right-thinking people up.  It’s time we stopped being paralysed by fear and came out fighting.

Get ready for a big fight over bank reform

The recent shenanigans over the government deal with the banks (project Merlin) now make more sense, following Anthony Hilton’s revelation in the Evening Standard (reported here in Lib Dem Voice).  The deal was weak on the banks because the banks did not get what they really wanted – which was to emasculate the Independent Commission on Banking Reform.  George Osborne was quite happy to oblige, it is reported, but the members of the Commission threatened to resign en masse.  This means that if the Commission does propose anything radical, an important part of the government will be against it.  This will (or should) provoke a major national debate.  Time to start marshalling the arguments, and to be all them more ready for the flood of obfuscation and irrelevant arguments that is bound to surround such a debate.  Let me offer some thoughts.

Even in a quick and selective overview, I have shot over 1,500 words.  I offer this below, but for those without the patience to read through this, my conclusions are these:  it is necessary to restrict the activities of wholesale banking so that the returns it makes are substantially lower in ordinary years, and the losses they make in bad years are also much lower; it is also important to make the banks less interconnected.  International reforms on bank capital are already doing some good, but we should not be afraid to do more since we are particularly exposed to a future crisis here in Britain. When it comes to the important business of improving finance to support small and medium sized businesses and innovation, we will need new institutions – the big banks will be of little use; the state must promote this type of financial innovation.

One thing is for certain: the established banks will not like any effective reform.  If Mr Osborne is taking their side, we can expect a battle royal.  It will take both determination and guile to face them down.  I will be reflecting on the latter in future posts.

What’s the problem?  First, there are two clear and legitimate issues for state policy.  We want to avoid the risk of another expensive state bailout of the banking system like that which was forced on us in 2008-2009.  Second we want the banks to lend more, at better rates, to small and medium sized businesses with decent prospects, in order to promote job-creation and the improved efficiency of our economy.  A third issue is politically toxic, and drawing most of the attention – that a lot of bankers seem to be grossly overpaid, with bonuses drawing particular anger.  It is less clear whether this is a legitimate issue for government interference, but we need to understand the issues here nevertheless.

Time to clear the decks a bit so that we can concentrate on what’s really important.  Here are some red herrings, to switch metaphors:

  • Bank bonuses are often blamed for promoting the crisis, on the basis that they distort incentives and incite reckless behaviour.  But why aren’t shareholders, whose stakes are at risk, managing this?  In fact the shareholders were as much a part of the problem in the banking crisis as bonus-crazed staff.  It is the incentives for shareholders that need real attention; sort this out, and the shareholders will sort the staff out.
  • Bankers’ pay is not comparable to that of film stars, sports stars or other entertainers who attract massive rewards.  Entertainment stars are a retail phenomenon which, with modern communications, works on a winner-takes-all basis in a mass market.  This is different on two counts from banking: the mega-profits are on the wholesale side of the industry; and it isn’t winner takes all either – a huge number of individuals and firms are able to attract oversized pay, not a lucky few in sea of wannabes.
  • In fact the issue isn’t really banker’s pay, but why the banks can afford to pay them so much.  Investment banking is hugely profitable in the good years.  This high level of profitability is a sign of wasteful economics, not a reward for value added to society.  A properly functioning industry is not particularly profitable because competition reduces profits.  A company at the frontier of technical innovation can deliver big profits and still be economically worthwhile – but this is not what is going on here.  There has been a lot of innovation in the banking industry, but not much of it has been to the overall benefit of society.
  • For the British, a defining moment of the crisis was the fate of Northern Rock, which had to be bailed out.  The reason why a bailout was forced on the state was that retail deposit insurance arrangements were inadequate, which caused a run, and put too many individuals’ savings at risk.  This problem has largely been fixed, and what happened to Northern Rock is pretty much irrelevant to the ongoing debate – it is simply a source of obfuscating arguments.
  • It is the banks that are the real problem, and not other players like hedge funds and private equity.  These institutions may be responsible for some egregious behaviour, but they also address a big weakness in our system of finance: an excessive aversion to risk in most investment institutions. They are not systemically dangerous. To the extent that they are dangerous, it is because of the ease with which they can get finance from the investment banks and over-leverage…which brings the problem back to the banks.
  • Finally dodgy lending by banks was at the bottom f the crisis, but it is not the main problem that needs to be fixed.  The question is why did so many lenders felt able to suspend the laws of proper management and common sense, and how were they allowed to carry on doing so for so long?  The answer is because it was too easy for them to pass buck to somebody else, in the form of securities put together by the investment banks. Securitization was justified at the time as a method of spreading risk – but this proved a fallacy.

Now, the real issues.  The first is that wholesale banking (services delivered largely within the finance industry, and not to retail customers – mainly investment banking) is much too profitable for too much of the time.  Why? This deserves more analysis, but one problem is clear from the bailouts.  Banks are making bets that pay off well most of the time, but deliver occasional disaster.  If you add up the bets that pay off with the costs of the disasters, then profitability may not look excessive.  But when disaster strikes the downside for bank employees – and shareholders – is limited, and others have to come in to bail them out.  In fact many bankers seem to think of the disasters as acts of God that really shouldn’t be their problem.  This leads to the risks being systemically underpriced.  What to do?  The critical thing is to look at how the bets are financed, and to limit the amount that is done through borrowed money rather than the shareholders’ own capital.  When things go bad, it the money banks (and various intermediaries they do business through) borrowed from elsewhere and can’t repay that cause the systemic problems, not the loss of their own capital.

The second problem is contagion.  If one institution fails then it can bring down others with it, forcing the government to bail the firm out, and creating a wider moral hazard problem referred to as “too big to fail”.  The essential problem is that too many financial institutions are lending too much money to each other.  Retail bank customers can be dragged into this mix, which tends to force governments’ hands.  This is a tough one to tackle, but the key points are to reduce the amount of lending between financial institutions (as in the previous paragraph) and to make sure that banks with retail deposits don’t lend them to other financial institutions, or severely restrict such lending.  While trading in securities by investment banks rightly attracts attention, the lending of money to other financial institutions that is used directly or indirectly to buy securities is just as much a problem.

The third problem is the lack of interest by banks (shareholders as much as managers) in lending to smaller businesses.  The problem is that to be successful this type of business requires information and relationships, and this requires good quality human input.  And that’s expensive.  We see big banks polarising into two types of business: wholesale services within the finance industry or mass retail services using computer algorithms and call centres.  Not much space in the middle.  I don’t think our big UK banks will ever be good at this; it is just too late.  We need innovative new institutions.  Two avenues are worth investigating: trying to improve venture capital facilities, and setting up publicly sponsored and locally focused institutions to lend to businesses, perhaps drawing inspiration from the German and Swiss systems (see this interesting paper from Civitas).

Basically this boils down to two things: cramping the style and reducing the profitability of investment banking.  And encouraging innovation in the supply of finance to small and medium sized businesses.  Forcing the current banks to lend more to businesses will not help; they simply won’t understand what is needed.  Making the big banks separate investment and retail banking would probably be a helpful reform, but it is not necessary and would not be sufficient.  Barclays have managed to insulate their retail from their investment banking businesses quite successfully.  Retail banks become exposed by lending money to investment banks or to the shady investment vehicles they create without them being part of the same organisation.

Some progress has been made on restricting investment banks internationally.  New international rules on capital are already putting investment banking profits under pressure, although not yet to the extent that they are having to cut pay (see this article in The Economist).  Is this enough?  Britain is uniquely exposed to financial crises, and we were lucky not to go the way of Ireland and Iceland, with mass bank failures on our hands. We can’t expect much solidarity from our European friends, given how stingy we have been to them.  An oil crisis is in the works; property prices could yet fall further; monetary policy and fiscal bailout have run out of road.  We shouldn’t shy away from extra measures to reduce our exposure.

Forcing the banks to cut pay is going to be tough going – but it is only then that we will know that reform is working.  High pay is rooted into the culture of these organisations.  Probably some banks will have to fail first.  We must hope that this will be the orderly winding down of some units, but we can’t rule out something worse.  And that leads us to a key paradox that will be at the heart of the argument.  Measures to make banks behave more safely may well cause some systemic instability.  The idea isn’t to abolish financial earthquakes, but to make them smaller and less threatening – even at the price of having more of them.