Politics UK – Page 57 – thinking liberal

How would AV change UK politics?

In my post last week I explained why I am supporting the Alternative Vote (AV) in the forthcoming UK referendum. This case was based on principle. We have a system of single member constituencies. First past the post (FPTP) carries a high risk of unrepresentative candidates being elected. Of the various systems in use around the world to counter the weaknesses of FPTP (primary elections in the US, run-off elections in France, AV in Australia), AV seems to fit the British situation best. I avoided asking what the impact of any change would be: just that the system is more democratic. But there are pragmatic types out there for whom the likely impact of the changes is more important than first principles. Today’s post is for them. It will help show them why it is best to think about principles.

The trouble with most analysis of this in the UK is that it is based on looking at past FPTP results, supported by some opinion polls on second preferences, and then predicting how the outcome would have been with AV. This runs into two problems. First is that the next election is going to be quite unlike the last few, if for no other reason than that the current government is a coalition. The next problem is that AV will change voting behaviours, and the campaign pitches of the political parties. The usual conclusion is that the Lib Dems will benefit quite a bit, Labour marginally, and the Conservatives would lose out. None of these effects would have been enough to change the outcome of elections except maybe the last one. Extra seats for Lib Dems and Labour might have made the current coalition impossible, and even a Labour-Lib Dem one on the cards. That’s enough for most Conservatives. If we had had AV last time, Gordon Brown might still be PM.

The Lib Dems should benefit. About time many will say – since the party is badly under-represented in parliament. More pragmatic types worry that this would give a smaller party too much influence in the choice of coalition partners. But the Lib Dems do face a problem. In order to benefit their first preference votes need to get past either the Labour or Conservative candidates (in England – it’s more complicated in Scotland and Wales). They might then attract second preference votes from whichever of these parties gets knocked out. And yet the classic Lib Dem campaign technique is to persuade voters to vote for them because one or other of the major parties doesn’t stand a chance; this argument has much less resonance under AV. Voters will say that they will simply give the Lib Dems a second preference, and give their first preference to their most preferred party. As a result Conservative or Labour candidates currently in third place might sneak into second, knocking the Lib Dems out. The Littleborough & Saddleworth seat at the last election was a Labour seat that people count as vulnerable to the Lib Dems under AV; but the Conservative vote was strong and under AV they might well have pushed past the Lib Dems into second place, which would, in fact, have made the seat safer for Labour. This could be a big help to the Labour Party in the South West. In Australia the two party system is entrenched (one of the “parties” being a coalition in an electoral pact). The Lib Dems will be desperate for first preference votes under AV, and in the long term it cannot be taken for granted that the party would flourish.

Labour has less to fear. It might help them pick up in areas where they are in third place – now great swathes of England. They may not do so well from picking up second preferences from Lib Dem voters next time – but only because they will have done such a good job of persuading them to vote Labour as first preference. They get some insurance against those voters drifting back. It is a moment of truth for Labour supporters who believe that there is a “progressive majority” – a majority of voters for whom the Conservative Party is toxic. If so the system ensures that the Conservatives never get a majority.

And that is the challenge for the Conservatives. It will be much more difficult for them to sneak in a majority government against the votes of the a majority of the electorate. But many Conservatives believe in something like a “silent majority” – the opposite of the progressive majority. There are lot of people sympathetic to their policies that do not say so, and will not give them a first preference vote. If so, they may pick up a lot of second preferences. This could be particularly helpful to them at the next election, when both UKIP and the Lib Dems will be trying to pick off their voters. If Labour succeeds in pulling past the Lib Dems in South Western seats, then this will make a few seats a bit safer for them, since they will get more second preferences from Lib Dem voters than Labour ones.

For the smaller parties AV is ambiguous. It is difficult to see that extremist parties, like the BNP, will make any headway, since other voters will gang up against them. Their best hope of an MP is under FPTP in a split seat. But UKIP and the Greens may well think they can pick up a majority in favoured seats by scooping up enough second preference votes. In the UKIP case they need to push past the Conservatives, either in what would now be very safe Conservative seats, or in Lib Dem held seats where they can hope to scoop up some Labour voters too. For the Greens the game is to push past the Lib Dems, and scoop up enough of their votes to push past Labour (or the other way round), to mount a challenge on the Tories. In both cases these are long shots, but you need a deal of optimism in politics.

In sum, the impact of AV is very uncertain in the UK. The Lib Dems could assert themselves with a permanently larger block of seats, alongside a scattering of seats for the greens and perhaps UKIP. Or the two party system could reassert itself, with the other parties finding it more difficult to pick up enough first preference votes. But the outcome is uncertain for a good reason: electoral politics will be more competitive. Who knows what voters would do?

Cuts: where will all the anger go?

Today the TUC is orchestrating a big demo in London against the cuts. Yesterday the Labour party hosted a “People’s Policy Forum” on the cuts. The focus of both events is anger. The idea that the cuts are unnecessary is actively promoted; all that’s needed is for the rich to pay their due in taxes. The Economist’s Bagehot gives an excellent description of Labour’s forum. The anger is palpable, but where will it all lead?

The Guardian’s Polly Toynbee thinks this will be a turning point, leading to the complete rejection of government policy by the majority of British people. After all, the cuts have hardly started to bite yet. An alternative view is that the anger will transmute into depression, in the classic pattern of grief. And from the depression will come a new consensus about the role of the state in our society.

I am reminded of a change management course I went to as a manager. I was taught that any serious change initiative had to go through four phases: denial (a muted initial reaction as people think the change applies to somebody else), anger (the moment when indivuals realise that the change really does affect them), chaos (the dysfunctional early phases of change) and finally renewal (you finally start to make headway). It is a mistake to think you can jump straight into the renewal stage. Anger is a good sign, because it means you have got beyond denial; and, indeed, it may even help to provoke it a bit (though be careful, as this may prolong the chaos phase). The art of change management is to get through denial quickly, and manage the anger and chaos phases as well as you can. Having to put through a number of change programmes myself, I found this advice very helpful. I would add that it is usually a good idea to take the time let the anger burn out before attempting anything complicated; that way the chaos phase is shorter and less damaging. The fact that the anger is burning bright now is not an unhelpful sign for the government.

The problem for the cuts-deniers is that there is no way out. Taxes on the rich have already been jacked up to beyond the point of sustainability (the 50p tax rate, capital gains tax, reforming pension taxes, the banks tax). It is absurd to think that we can pull in much more from clamping down on tax evasion; if it was that easy, Gordon Brown would have done it ages ago. Jacking up corporation tax will do nothing for jobs. The Keynesian argument may bring in Nobel prizewinners, but it doesn’t offer much comfort either. This runs that if the impact of the cuts is slowed down, the level of unemployment in the transitional period will be less, and this in turn will be less wasteful to the economy as a whole. The same cuts have to be made, only more slowly. Unless a private sector renaissance comes to the rescue, in which case extra taxes come in, which will stop the need for some of the cuts. That seems completely infeasible. It is a wonderful irony that those fighting the cuts are largely anti-capitalist, and yet only capitalism can save them. The fact is that either the “squeezed middle” gets squeezed even harder for more taxes, or the public sector has to suffer some fairly drastic cuts.

And here’s the political problem for Labour. To turf out the government they need the squeezed middle and the outraged public sector workers to gang up – but their interests are opposed. Nothing will stop the cuts. Not even a shock Labour victory in an unscheduled election later this year. The anger has to turn to depression.

And it is not a given that this will rebound on the two governing parties. For most voters, the world won’t end. Labour’s credibility problem will be cruelly exposed in any election campaign. If they want to restore the cuts, they will have to answer who is paying? If they don’t, they will be saying that the coalition was right all along. If the economy flags, as it well might, and the government doesn’t manage to cut the deficit as much as it plans, Labour’s dilemma will be all the more acute. They might be able to say “told you so”, but they won’t be able to restore the cuts.

Labour are trying to recreate the anger of the 1980s against Margaret Thatcher’s government. But this government is nothing like so reckless. Unemployment is still much lower – there no swathes of closed factories and coal mines. And Mrs Thatcher won.

AV: why I am voting Yes to a beautiful British compromise

Referendum Day approaches and the polls are tightening. The public at large has yet to show much interest, but the referendum on the Alternative Vote (AV) is an important event in our political history. Yet nobody can be surprised that the quality of public debate is abysmal. If the arguments put forward by the Yes campaign, desperate not to lose people in technical detail, look a little weak, those of the No campaign seem like a calculated assault on our intelligence. The campaign is being fought on emotions: natural British conservatism pitted against the feeling that our current system is part of a stitch-up perpetrated by the political establishment on the people. I hope this post lifts the level of debate a fraction.

Not that I want to deny the importance of emotions in making decisions like this. I will start with mine. My views about proportional representation (PR) have fluctuated a bit over time; but my views on AV, from the beginning political consciousness in the 1970s, have always been in favour. First past the post (FPTP) is an outrage; a primitive system that belongs to the age of rotten boroughs and not a modern democracy. AV is an elegant answer to its most egregious features, and the one that is most appropriate to the British culture.

We start with the system of single member constituencies. This is embedded deeply into the British political culture, though I do not regard it as sacred. This carries with it the idea that an MP represents her whole constituency, not just the party and voters that put her there. This is indeed what most MPs claim to think. But if the election is contested by more than two candidates with broad appeal then the process rapidly degenerates into farce and the winner can be elected on quite a small minority of votes. You need a degree in game theory to make your you are voting for the right candidate. This is so obviously wrong that in most elections for an executive office, where you choose one candidate from a diverse field, the system has been abandoned, if it was ever used – from small societies up to presidents of countries, and even Mayoral elections in the UK. The job of an MP is a serious job, and surely exactly the same logic applies to them as to the London Mayor or the Leader of the Conservative Party.

And that should be enough. But the consequential results of the system don’t make it any better. As this video using animals explains, the system soon resolves into a two party system. Any candidate who wants to challenge the party machine and stand against the official candidate usually fails, and worse, lets in the candidate from the opposing party. So a lot of the process of democratic choice is handled by two party machines which do not have a strong incentive to be democratic themselves, for example in the way they select candidates. Of course, if you are a party machine politician you are inclined to think that this is a wonderful political system, but it is fundamentally undemocratic. It is quite clear from the declining combined vote share of the Labour and Conservative parties that the British are losing confidence in the two party system.

So what is the solution? PR is popular, but brings with it plenty of problems of its own which are not directly relevant to the debate. If you support PR the risk of voting No is that a No result is likely to kill the question of electoral reform for generations. The Americans have developed a system of primary elections, which have the effect of undermining the party machines and making them more democratic. It has the major virtue of making all safe seats competitive. The odd Tory proposes it for the UK. A second alternative is to stage run-off elections in seats where there is no overall winner – the French system. Both these systems require a second full-scale public election. They both have the advantage of simplicity: electors make a single choice at each election – the most attractive aspect of FPTP. But two elections mean doubling up the cost, and campaigning costs in the US system are astronomical, giving rich candidates a big advantage. And they both seem un-British. They require a more prolonged period political campaigning. The British like the drama of a competitive General Election (such as last year), but quickly tire of the electoral process. And anyway, neither system is being offered to us in the referendum.

Which leaves AV. This is a built-in run-off system, requiring voters to think ahead about how they would vote if there was a run-off. It loses the simplicity and immediacy of the single decision, but the whole process is decided in a single, easily comprehensible process in a day. How quickly the British would take to it is less clear (we can guarantee that the political parties’ campaigns will try to confuse the picture rather then help explain it), but they would get used to it eventually. It has settled down well enough in Australia, a country that has a very similar attitude to politics to Britain, though its effects there are difficult to disentangle from those of compulsory voting. Incidentally, the suggestion made by David Cameron that polls show that Australians would prefer to move back to FPTP does not stand up to close examination. What many Australians in fact dislike is being forced to mark a preference against all candidates for their vote to be valid – and we are not proposing that in the UK. In Australia AV has not undermined the two party system, as it happens, but it has surely made the two main parties more sensitive to the risks of breakaway groups and so more democratic themselves. Australia’s parliamentarians are a quirky, spiky lot – the sort of people to hold an executive to account, even if it is often not a pretty sight. All in all AV is a beautiful British compromise and I will be voting for it.

I will look at other arguments in the AV debate in later posts. This one is long enough!

Off balance

The think tank Reform is a master of guerilla tactics. It claims to be one of the most influential of right-wing think tanks, but it cannot be described as heavyweight. It flits from one subject to the next, making eye-catching claims and recommendations based on very thin research. Its reports contain thought-provoking insights alongside assertions based on air, amid lots of right-wing waffle. Its most recent offering Off Balance, which looks at economic growth, is a case in point. Based on its headline claims, I had intended to use it as base to blog on the subject of the conflict between economic growth and the pursuit of happiness. But there was nothing in the report that I could get any traction on. I’m afraid this doesn’t say much for the quality of national debate on the economy.

That’s a pity because the report does contain a very interesting idea, on monetary policy, in its final chapter. The muddle and confusion within which this gem is set will unfortunately detract from it. This idea is that interest rates have been set too low in the US, UK and Euro zone (for different reasons), which distorted the market for savings and investment, and that this was the prime cause of both the financial crisis and the unbalanced world economy. Because interest rates were too low, there was too much borrowing, too much consumption, asset bubbles, and not enough proper investment in the developed economies. Interest rates will need to be higher if our economies are ever to rebalance properly. This means that the conduct of monetary policy over the last two decades, including the development of inflation targeting, has been fundamentally flawed. Loyal followers of this blog will recognise something like this case being advanced by this humble undergraduate economist (Time to rethink the Bank of England). Unfortunately the report’s authors have little to say on how monetary policy should be conducted in the future, beyond better prudential regulation of financial services.

What of the the rest of the report? At headline level it all sounds quite sensible: we need more free market policies, with three priorities in particular: reducing the deficit, reforming public services, and a better business environment. Sensible, but potentially highly contentious in each case – but you won’t find much in the text that takes the debate forward. In particular there is a deep confusion over the concept of competitiveness, most apparent in its airy claim that:

The future competitiveness of the UK economy demands a move to a high-wage, high productivity workforce.

This is candyfloss economics; its reasoning collapses as soon as you touch it. Businesses compete; countries don’t (except warfare and sport). If the country’s productivity stagnates, for example because our system of education is weak, then overall living standards will suffer: we will be able to consume less. Period. The exchange rate takes care of competitiveness. The are very good reasons to improve our education system (the context of this quotation), but competitiveness is not among them.

I could go on, but honestly the report isn’t worth it. At a turning point in our economy it is such a pity that so much of our debate about the subject is so lightweight.

Losing voters we never won

Any Liberal Democrat activist will have been nearly buried by comments from people saying that they will never vote for the party again. Mostly these are genuine, and polling shows that the party has lost half its support. But I have long had a feeling that many of these complainants never voted for the party in the first place. Nice to get some evidence of this from this post in politicalbetting.com . It seems that in at least one poll, more people said they voted Lib Dem at the last election than voted Labour! So many people want to join the betrayal bandwagon that they have actually forgotten they did not vote for us. No doubt they thought about it, and the sense of betrayal comes from even thinking of voting Lib Dem!

The strange cohesion of the Liberal Democrats

I was at the Liberal Democrat conference in Sheffield last weekend. The most striking thing about it was how upbeat it was. Disagreements were downplayed; discussion was civilised; people didn’t seem to be spooked by the polls, still less the demonstrators outside the conference hall. And yet the party has lost half its popular support, performed atrociously at the Barnsley by-election, and comes under daily attack for supporting what are seen as vicious Tory policies. “You’re shafted,” a (perfectly friendly) local member of the public told me when I was walking between venues. What’s all this about?

The obvious explanations don’t seem to be strong enough. The novelty of being in government has certainly not worn off; and attack, especially of the vitriolic sort we saw on display by the demonstrators, tends to induce solidarity. But a lot of members and activists are genuinely unhappy about the policies of the coalition government; it is often said that policy has been captured by an unrepresentative rightwing clique surrounding Nick Clegg.

The party’s democratic constitution helps. To many political pros no doubt these processes look like weakness, conceded to encourage people to join and stay as members. But they give countless opportunities for members and activists to feel consulted and involved.

The party’s leadership deserves some real credit here. The party’s internal machinery for policy making has been generally respected, in contrast to Paddy Ashdown’s leadership in the 1990s. Many critics have been co-opted in the policy formation process. Predictions that party conference would quickly be made irrelevant have proved unfounded (I remember Mark Littlewood, former director of communications, almost gloating about this in the coalition’s early days).

The leadership’s sensitivity to criticism, and wish to avoid needless confrontation from within the party was on display at Sheffield. The biggest issue faced by the conference was the NHS reforms. These are radical, controversial, and seem to go well beyond the coalition agreement. A rather defensive motion was put before the conference by the leadership, and an amendment submitted that was highly critical of the direction of government policy. The leadership quickly conceded defeat. Previously Paul Burstow, the health minister, who proposed the main motion, had been highly supportive of coalition policy. But he quickly said that he was in listening mode and accepted the amendment. At an earlier consultative session, Norman Lamb, part of Nick Clegg’s inner circle, appeared to admit that mistakes had been made over health policy, among other things. What the consequences of all this are for coalition policy in health and elsewhere is unclear, but we are expecting changes.

The leadership’s basic narrative is not seriously contested. The Liberal Democrats had no alternative to the coalition that would not have done even more damage. If they had declined the opportunity, the party would have “bottled it” and suffered disastrously at a rapidly called second election that the Tories would have won outright. And the Lib Dems have won a lot of concessions, and are managing to turn a lot of party policy into law. You only have to look at what the Tory right is saying. All this is difficult to translate into a clear message for the public, but it helps instill a degree of confidence among activists. The feeling is palpable that things will turn the party’s way in due course, and party’s critics will be confounded. Again.

10 years of Spiked

Yesterday was the 10th anniversary of this online journal. Spiked represents a different sort of liberalism to the type that I associate with. It stands up for freedom all right; in the words of its editor Brendan O’Neill in his 10th anniversary piece Spiked exists to:

…to fight the good fight for freedom, progress, growth, tolerance and a bit of Enlightened spirit.

But it sets itself against pretty much any attempt by the established political leadership to uphold liberal values. It finds itself against the idea that climate change is a threat worth doing anything about; it was against the smoking ban in public places; it got quite hysterical about Cleggmania. It has defined its enemies as “miserabilists” or, the current favourite, “misanthropists”. I browse their weekly email digest and sometimes click through to their articles. What do I think?

I want to like them. I may disagree with them most of the time, but it helps to have challenge. The problems start when I click through. Mostly, the articles just aren’t very good. They are usually too long and self-indulgent; they rarely credit the strength of the other side’s case. If you have the patience you can dig out the odd cogent argument and the occasional interesting observation. There is a general tide of negativity usually directed against an ill-defined “elite”. There can be quite a lot of description of abstract ideas. For example, one writer (Daniel Ben-Ami) in criticising the the fad for well-being economics spends so much time describing how these ideas evolved, and the other ideas it is associated with, that he scarcely engages with the ideas themselves. It mostly reads like contributions to undergraduate journals, but Spiked’s writers should have grown up by now. Unfortunately those that have got beyond the undergraduate ramblings (for example Mick Hume, the founding editor) just seem to rant rather than engage in sensible argument (for example this article about the judgement that caused the Littleborough & Saddleworth by-election). It is a striking irony that a journal attacking “miserabilists” is so miserable itself, without a positive word to say for any establishment position.

Just as striking is how defensive Mr O’Neill’s celebratory article is. He spends a lot of time trying to fend off the argument that Spiked takes its positions purely to wind people up, rather than out of a coherent set of principles. I suspect the problem is not the lack of a coherent view as an unwillingless to engage properly with the opposing argument; people won’t try to understand you if you make no effort to understand them. They also seem unwilling to host much of the way in genuine discussion on their website; I have had only one of a dozen letters published; looking at the letters page today, it hasn’t been updated this month at all.

Would Spiked’s world view start to fall apart if they did try to engage properly with the ideas? That would be an over-complacent view from a “left-liberal” like me; but I would like to read more stuff that is properly argued. Surely a missed opportunity.

The real meaning of the Barnsley result

The BBC and the Today programme could barely conceal their delight about the Barnsley Central by election result, gloating over the drop in the Lib Dem vote from 2nd to 6th place. On this their coverage did not differ much from the rest of the media. Indeed this was spectacular. But it wasn’t the only spectacular thing about the result. For the first time ever in a parliamentary election UKIP claimed second place, as the Tory vote plummeted.

This should give us pause. It means that the Tories are leaking votes to the right, with UKIP, not the Greens, standing a real chance of being the leading protest party. Come the General Election, the Tories should have little difficulty in clawing the votes back. But that won’t stop their activists from panicking in the meantime. That puts David Cameron in a tricky position. His newly-acquired left-leaning voters offer the Lib Dems their best chance of clawing back lost ground; any moves to appease the UKIP tendency will simply drive these voters into their waiting arms. Couldn’t happen to a nicer bloke.

There is a second pause for thought. If the Tories leak votes to the Lib Dems on the left and UKIP on the right, they will benefit much more from AV than conventional wisdom has it. Unfortunately their supporters are probably too thick to understand this, on past performance, and so they will continue to campaign vigorously for a No vote. Mr Cameron is clever enough to appreciate this, no doubt adding to his dilemma.

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.

Reflections on the Isle of Wight

I’m just back from a few days break in the Isle of Wight. It so happens that the Economist’s Bagehot has just blogged on the subject of the island, which was the lasting point of his print column last week.

The island has a bit of a charming, time-warp feel about it. But Bagehot points out that its people are ahead of the game in one aspect – realising the implications of the coming parliamentary boundary changes. Interesting to reflect that it has half the population of the borough of Wandsworth – and yet the latter can’t even support a decent local newspaper.