Category Archives: The economy

Posts about the economy and matters economic

Jobs, Not Yachts!

Philip Green, owner of retailer BHS from 2000 to 2015, is about to take delivery of a £100 million 90m-long luxury yacht. I’m sure it will look very impressive moored next to his other two yachts. Presumably he also has time to take a ride on his speedboat, private jet and helicopter as well. Handy for those commutes between London and his Monaco tax haven.

luxury yacht
What a yacht I got!

Green paid £200m for BHS and sold it for £1 to a City group headed by Dominic Chappell, twice bankrupt and with no retail experience. But don’t worry, Green doesn’t seem to have suffered too much. Within 4 years of buying the company, his wife was paid £400m in dividends. Over the 15 year period, the Green family received income totalling £586m. At the start of his tenure, the BHS pension fund was in surplus by £5m. The company’s pension fund deficit now stands at £571m, valued on the basis the company is insolvent.

Chappell lost no time in profiting from the ownership of BHS. It paid £25m to Retail Acquisitions, the company that bought BHS and which is 90% owned by Chappell. The £25m is a mixture of management, legal and professional fees, salaries and interest payments.

BHS was founded in 1928. It is now in administration.  11,000 employees await anxiously their fate: will a buyer be found so they can keep their jobs? If the company goes under, the pension deficit will be taken over by the government-backed Pension Protection Fund. Under the terms of the takeover, future BHS pensioners will take a cut of at least 10% in their pension payments. Iain Duncan Smith will now doubt blame the 11,000 former BHS staff as scroungers who made the “lifestyle choice” of choosing to work for morally bankrupt billionaires. This is, of course, if he takes time off from campaigning for the UK to leave the EU. If we leave, Britain will then have a free hand to weaken employees’ rights even further.

jobless queue
BHS workers?

One Pound, One Vote

I distinctly remember, a year or two ago, discussing the consequences of our government’s continuing economic policy of free market fundamentalism. I said that, over time, it inevitably leads to a situation where there are too many luxury yachts and too few teachers, doctors and nurses. By “too many, too few” I meant when compared with the public’s preferences if asked directly. The reason is simple. In a market-based economy, money talks. Gradually over time, the “invisible hand” of billions of transactions shifts the priority for the provision of goods and services ever more towards the needs of the super-rich and away from the rest of us. It’s hard wired into the logic of markets.

At a time when hospitals are clocking up record deficits and record shortages of medical and teaching staff are being reported, my comment – intended purely as a rhetorical device – appears to be coming literally true. What a morally despicable world we seem to have created.

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Reasons to Be Cheerful (Part-ly…)

My wife finds it hard to believe, but basically I think I’m an optimist at heart. Despite all the setbacks, humankind will get gradually wiser and we will learn how to make the future better than the past. Over the long term, of course.

I occasionally spot news items which seem to confirm, or deny, this belief. Here’s a couple from last month, on both sides of the argument.

Peak Stuff?

A report from the Office of National Statistics states that there has been a 30% drop in the UK’s consumption of “stuff” between 2001 and 2013. By “stuff” they mean items such as food, fuel, metals and building materials. Some at least of this drop is because we have become cleverer and / or frugal in manufacturing items. For example, much less metal is now used in building a washing machine. Music downloads have replaced vinyl LPs and CDs.

peak stuff
Peak Stuff?

The optimist’s view is that, perhaps, as western consumer societies mature, we choose to buy fewer “things” and instead spend our money on less tangible leisure activities. If this is so, there is a better potential for the sustainability of our lifestyles and more hope for the future of our finite planet. Environmentalist critics say that the ONS figures are flawed as they do not properly take into account how we, as a country, import our environmental damage, for example through imports of manufactured goods from China. Nevertheless, there is at least some evidence of a glimmer of hope for the future.

Beyond Our Means?

To temper my optimism was another story from the same day’s newspaper. The Bank of England reported the biggest rise in consumer borrowing for a decade. Borrowing rose by 9.1% in the 12 months to January. Whilst this has a positive impact on economic activity in the short term, the medium-term implications are more troublesome. A consumer debt spokesman forecast a 17% rise in unsecured debt defaults by 2020. A professional economic forecaster said mortgage-to-income ratios are at record levels. The outlook, when interest rates eventually start to rise, looks decidedly dodgy.

credit card dominos
Credit card dominos

My principal concern is more basic. We Brits are currently living beyond our means. We are repeating the circumstances which led to the 2007-8 crash – only more so. It was excessive consumer debt which got us into this mess in the first place. The resultant bad debts threatened banks and so the government bailed them out, effectively “nationalising” the debt. Britain is uniquely vulnerable to the next global crash. We have an exceptionally lopsided economy. We have too much dependence on financial services – spectacularly so – and too little in other sectors, especially manufacturing. Osborne has done nothing in the last 6 years to correct this imbalance. His policies have, if anything, made matters worse.

Falling Jenga bricks
Our economy…..                                 One small nudge….            And over she goes….

Think of the tower in a game of Jenga. If the size of the base represents the size of the national annual economy, our speculative trading in the City would be a tower nearly 160 bricks high. Osborne is ideologically committed to removing as much regulation as possible – like removing the lower bricks, one by one, in Jenga. One small nudge (financial shock) and the whole teetering pile crashes to the ground.

Still Cheerful?

So the good news is that we may have taken the first few steps towards a more sustainable future, at least as far as the world’s resources are concerned. But we’re saddled with a government that encourages a “Jenga economy”. Keep smiling…. through gritted teeth!

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Hey You! Get Off of My Cloud!

My earlier blog post Stuck Inside of Mobile aimed to dispel the myth that grammar schools were an engine of social mobility 40 to 50 years ago. The piece provoked some dissent at the time. New information has just been published in the Observer newspaper which supports my earlier assertion. It also adds a new twist to the tale.

ladder to the top
Ladder to the top?

John Goldthorpe is an eminent sociologist from Oxford. Now emeritus fellow of Nuffield College, he is best known for the Goldthorpe class schema, still used as the main classification system for socioeconomic class. Goldthorpe gave a lecture at the British Academy this week on social class mobility. An Observer piece summarizes his position. Goldthorpe’s article encompasses new research by Professor Erzsebet Bukodi at Oxford.

Room at the Top

Goldthorpe’s talk and Bukodi’s research deal with social mobility and the role of education in improving it. Contrary to popular belief, they conclude that social mobility has not reduced over the past 60 years or so. This period was one where access to education, in particular higher education, has expanded enormously. Using his classification scheme, he concludes that the overall rate of mobility has not changed over this period. What has changed are upward and downward components of mobility. 50 to 60 years ago, upward mobility was more frequent than downward, as the number of managerial and professional jobs increased rapidly. In Goldthorpe’s words, there was “more room at the top”.

What’s changed now is that there’s no expansion of top jobs in the economy. People are as much at risk of downward mobility as upward. In fact, it’s worse than this. Technological change and economic policies that export middle-tier skilled jobs (whilst importing the goods produced by them) have hollowed out this medium-skilled sector.

Role of Education

Education is necessary for individuals to aspire to the “better” (and better paid) jobs. But expansion in education alone is not sufficient. For social mobility to improve, Goldthorpe argues, two things must happen. Firstly, the effect of social origin on educational achievement must weaken. Secondly, the effect of educational achievement on social class outcomes must strengthen. Both are needed for the brightest young people to get to the top. At present, too often, it’s the sons and daughters of the richest parents who do so. I can think of a whole load of cabinet figures who confirm this point: supply your own list!

Fear of Falling

Get Off my cloud
Get off!

With no expansion in jobs at the top, there’s only one way to increase upward mobility. That’s by increasing downward mobility. But therein lies the problem: what Goldthorpe calls “psychological asymmetry”. The theory of “loss aversion” strongly supports the notion that parents are even more concerned about their children avoiding movement down the social ladder than they are about them going up. Pretty much all parents want what’s best for their children. Advantaged parents will use their resources – economic, cultural and social – to give their children a competitive edge. They have the sharpest elbows.

Fixing the Ladder

Over the past 35 years, income inequality has increased. Using the image of a ladder, the distance between top and bottom and the spacing between the rungs have both grown. The “hollowing out” of middle-tier jobs means many of the rungs in the middle have broken off. If we want to improve upward mobility, we need to do one, or both, of two things. One is to make it easier to move up and down the ladder. The other is to make more room at the top. To do the first, we need to reduce the level of inequality, narrowing the gaps between the rungs. To do the second, we need to increase R&D investment to expand good, well-paid jobs.

The trouble is, since 2010, we’ve been doing the opposite of this. Tax and spending priorities have favoured the better off. Investment has fallen dramatically and productivity growth has ground to a halt. These have been deliberate policy decisions by a government elected on 37% of the popular vote, run by a party with over 50% of its funding from the super-rich in the City.

Don’t hold your breath: things aren’t going to get better any time soon.

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Energy Policy: Madness, Sheer Madness!

The Competition and Markets Authority don’t get it. (It’s hardly surprising: the clue is in the name). The government doesn’t get it. The “it” in question is having a sane, rational and effective policy for the supply of energy (gas and electricity) in Britain.

Two news items on successive days last week illustrate what I mean.

Madness One

After an 18 month long investigation, the CMA published its findings this week on the workings of the UK’s energy market and how it affects consumers. They found that 70% of consumers were on their supplier’s standard tariff. They concluded that, by failing to shop around, we were being ripped off to the tune of £1.7 billion pounds per year. Their proposed solution? To create a central industry-wide database of all those consumers too lazy (or busy, confused or with poor life skills) to have changed supplier in the previous three years.

In other words, it’s all those bloody consumers’ fault for not acting in accordance with the laws of free market fundamentalism, our guiding secular “religion”.

My earlier blog post Cat and Mouse explains my views on switching energy supplier. In fact, I did do some research within the last year on other suppliers – I’m currently with one of the oligopolistic “big six”. Living in a rural area, there is no mains gas supply – another example of how our market-based energy supply system has failed to provide a 21st century infrastructure, but I digress. Most deals are for dual fuel supply. It boiled down in practice to a choice between the devil I know and one other company, who could perhaps save me a bit over one hundred pounds a year. I then had an online search of customer satisfaction ratings of the other supplier. To put it crudely, they were crap. I’m fortunate enough to consider that £10 a month is not a big deal when judged against the potential hassle of getting through to the new company if anything went wrong. So I stayed put.

The proposed “solution” to the problem of “too many” people not switching suppliers entirely misses the point. All the companies are in the private sector. Public limited companies have a legal duty to consider returns to shareholders above all other considerations. There’s no real competition: gas and electricity (like water supply and railways) are natural monopolies. In the case of the energy firms, there’s no competition in the core service (the pipes and wires), but only at the periphery in billing and customer service. The only innovation in these has been to make the customer do the work of meter reading and moving to paperless billing.

Worse, the proposal throws up a whole list of new problems. There are 37 current energy suppliers, so there’s the potential for 36 lots of junk mail as competitors try to entice you. How safe is the database from abuse? Past experience of the security of centralised databases is not good, let alone one open to 37 companies. Fraudsters and scam-mongers will see another opportunity to exploit the unaware. The Big Six companies are bound to mount a legal challenge to other companies’ access to their lists of customers. And all because the dogma says competition must work.

Madness Two

There was fresh news in the oh-so-long-running saga about Hinkley Point C nuclear power station. You know, the one where the government has spent years trying to persuade the Chinese and the French state-owned EDF to invest in a massively expensive (£18 billion) and risky project to build two new nuclear reactors at the site.

The project is already years behind schedule. Last month, Chris Bakken, the project director, left his job. A week ago, EDF’s Finance director, Thomas Piquemal, left the company. He was known to be a critic of the Hinkley project. Then EDF’s chief executive threatened to pull out of the project unless the French government gives EDF further financial backing. And all this despite the UK government’s “inducements” (i.e. bribes) include offering the firm a guaranteed wholesale price more than double the market rate.

This project is the familiar tale of companies creaming off all the profits and leaving the taxpayer with all the downside risk. Electricity consumers, i.e. all of us, will pay over the odds for the electricity as a further subsidy. And for nuclear power, the downside risks are horrific. In Japan, five years after the tsunami and meltdown, the area around the Fukushima nuclear reactor is uninhabitable for another 24,000 years.

The Energy Elephant in the Room

For a decade or two, the spare capacity to deal with peak load in a winter cold spell has been getting smaller and small and is now dangerously low. Old, dirty fossil fuel plants and nuclear reactors have been closed own but insufficient new capacity has been built to replace them. Lurches of government policy towards renewals, in particular the Tories short step from “greenest government ever” to “green crap” has further deterred investment. It is likely the lights stayed on this winter only because of

elephant
The Elephant?

There’s an elephant in this room. Energy supply should be renationalised. There’s a whole load of reasons: here are the most obvious:

  1. The logic of the market does not apply to a commodity (especially electricity) that should be affordable for all, as it is an essential basis of modern life.
  2. Markets are not good at making strategic decisions over the long term. The certainty of consistent government policy and funding are essential.
  3. The private sector shies away from hard to quantify risk, such as with nuclear power.
  4. The nature of energy supply is a natural monopoly, as mentioned earlier.
  5. Monopolies (and oligopolies as we have in the UK) in private hands will always lead to consumers being ripped off (because shareholders take priority over customers).
  6. Private sector pricing logic tends to disadvantage the poor with poor credit ratings or erratic payment histories, leading to increased inequality in net income after essentials.

Madness

Naoto Kan, Japanese prime minister five years ago, recently said the plan to build Hinkley Point C “did not make sense”. An industry analyst described it as “insane”. I would extend that description to the whole of UK energy policy. Above all, to the belief that consumers can be bludgeoned into behaving according to the diktats of free market ideology.

Madness, sheer madness!

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Pull the Other One, George!

Politicians in government, of all political persuasions, have long lived by the following rules:

  • Whenever there is good news, claim the credit for it;
  • Whenever there is bad news, blame someone else!

Chancellors of the Exchequer are particularly prone to this about the state of the economy.

George Osborne laughingToday, George Osborne tried to pull off this same old trick yet again. Just 6 weeks ago, at the time of his autumn statement, the Office for Budget Responsibility found £27bn down the back of the sofa. Osborne was upbeat, claiming the credit. He announced the “cancellation” of cuts to tax credits (but still introduced by stealth through cuts to universal credit). Now it’s all doom and gloom again. And, of course, it’s now everybody else’s fault:

  • the oil price (previously cited as good news)
  • the Chinese
  • Middle East tensions

… and so on.

So, let’s just remind ourselves of a few facts:

  • Osborne’s false comparison with Greece in 2010 of Britain’s debt killed off a nascent recovery inherited from Labour
  • His target to clear the deficit by the 2015 election failed spectacularly
  • This has been the slowest economic recovery ever
  • Household average incomes are still below 2008 levels
  • The UK has a record balance of payments deficit
  • Our economy is wildly unbalanced towards financial services (1% of global population, 2½% of global GDP, 37% of global financial transactions)
  • No serious attempt to rebalance the economy with over half of Tory Party donation cash coming from the City.

(Sources: IFS, Daily Telegraph, Economics Help.org, The Guardian, my blog post The City, Paragon or Parasite)

All this makes Britain uniquely vulnerable to the next economic turbulence. The Financial Times isn’t fooled. It’s another of George’s political, rather than economic, statements. It’s used as yet another reason for continuing debt reduction as number one priority, with the burden falling disproportionately on the poor. It perpetrates the myth that the government is sticking to a “long-term plan”.

Is there any sane person left in the country who believes this? Come off it, George! Pull the other one!

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The City: Paragon or Parasite?

The City of London claims to be the biggest and most important financial centre in the world. In strictly numerical terms, I’m sure it’s true. According to Wikipedia, it is “the largest financial exporter in the world which makes a significant contribution to the UK’s balance of payments”.

Finance Sector “Facts”

Financial services account for nearly 10% of GDP (national income) and employ nearly 4% of its workforce. Business services and finance combined have risen from 5% of GDP in 1948 to 32% in 2013. Gross Value Added (GVA) is a net figure of the output of a sector less costs of goods and services consumed. On this basis, finance’s GVA is 8% of the economy as a whole. Half of this amount comes from London. The City employs 415,000 people (2014 figure), up 25% on 2009. Financial services paid – or collected, e.g. income tax – 11% of the government’s tax receipts.

The flip side of this is the decline in manufacturing since World War II. Britain’s manufacturing sector has declined more rapidly than elsewhere – see graph below. The contrast with Germany is particularly striking.

GVA attributable to manufacturing

Decline in manufacturing graph(The black triangles above represent spot figures for the UK for 1947 and 1977)

The City: A Source of Economic Instability?

My earlier blog post Two Gamblers and a Pint of Lager discussed how City trading has grown out of all proportion to the “real” economy. In his brilliantly illuminating 2010 book 23 Things They Don’t Tell You About Capitalism, Cambridge economist Ha-Joon Chang explains how things have evolved. Here’s a key part of the picture:

  • Mortgages are repackaged and resold as Mortgage Based Securities.
  • MBSs get repackaged into Collateralized Debt Obligations.
  • CDOs get repackaged into a kind of CDO-squared.
  • And so on.

As Ha-Joon says, “the same underlying assets (i.e. houses) were re-used again and again to “derive” new assets. A massive tower of financial assets teeter on a tiny foundation of real assets. Financier Warren Buffet calls them “weapons of financial mass destruction”. What we have is potential instability on a massive scale. One small disturbance and the whole pile falls over. And, of course, no one really understands what they’re doing: it’s all a matter of faith.

In an interview following the decision to set up the Women’s Equality Party, Sandi Toksvig spoke of the crisis which brought about the near-total collapse of the banking system in Iceland. Only one Icelandic bank survived. It was set up by two women. One of their policies was to only invest in things they understood.

 

The City: Centre of a Web of Tax Havens

Much has been written about the tax avoidance activity of multinational corporations and super-rich individuals: the list is endless. Such activity is made possible by a web of tax havens around the world. Places like Jersey and the British Virgin Islands are part of a number of offshore territories linked to the UK. We have more such tax havens than the rest of the world combined. A 2011 article in the New Statesman describes how the City of London Corporation sits at the centre of this web. It is a local authority, but like no other in Britain. It is exempt from many of the laws applicable to the rest of the UK. Businesses can vote in local elections – the number of votes they have in proportion to the business size. The Corporation has its own representative in Parliament and acts as a cheerleader for the finance industry. It’s the last surviving “rotten borough”.

With over 50% of donations to the Tory Party coming from financial institutions in the City, it’s easy to see why this government really means “the interests of the City” when it talks of “the national interest”. Whether through ignorance or isolation from the “real” world, Cameron, Osborne and company conflate the two. The British Government lobbied hard against an EU proposal to introduce a “Tobin Tax” in 2011 because it said it would damage the City. It made an unsuccessful legal challenge in 2014 to the European Court of Justice. The UK failed in its attempt to ban plans by 11 EU countries to introduce such a tax in their own countries. The Tax is designed to reduce instability (euphemistically called “volatility”) and to cut the finance sector down to size. It works by introducing a tiny (typically 0.1%) tax levy on all financial transactions. As we have seen, given the huge volume of such transactions each day, the tax would potentially raise billions of euros (or pounds).

Large Financial Sectors Damage Economic Growth

A detailed study by Stephen Cecchetti and Enisse Kharroubi of the Bank for International Settlements in February this year showed how too big a finance sector damages economic growth. (Their full, rather technical, report can be found here.)

An earlier (2012) paper showed that once finance grows to a certain size*, which in Britain it has, any further growth in the finance sector depresses economic growth. The trend for the past decade is for finance to grow at 5% p.a. So any further growth in the UK’s finance sector will be bad for the economy.

The 2015 paper shows two ways how the finance sector growth suppresses growth in the real economy. The first is a simple “crowding out” argument: finance “steals” from other sectors the best brains coming out of universities. The second is more subtle. The report shows that those countries with large finance sectors invest proportionately more in real estate, creating property “bubbles”. The sectors which suffer most are the R&D intensive industries. The scope for productivity growth in property is small; in R&D-rich industries it is large. As productivity growth is the main long-term driver of increased prosperity, economic growth is depressed.

The performance of the UK economy since 2010 fits this negative pattern exactly. Only two sectors of the economy have prospered. Bankers and financial service workers continue to pocket the proceedings of the government bailouts (“quantitative easing”) and pay themselves bonuses as if the 2008 crash hadn’t happened. And the housing bubble is inflating to the point where more and more younger people cannot afford to get on the housing ladder. Productivity growth has been non-existent. A highly visible example is the trend away from automatic to manual car wash services.

*finance employs more than 4% of the workforce or private debt is over 100% of GDP

The Inequality Engine

My earlier post Chain of Fools explained how most of the innovative “products” introduced by finance over the last thirty years have a common characteristic. They provide a way of enriching the traders in finance at least risk to themselves. They transfer wealth from the majority of the population to those rich enough to have spare cash to invest and to employ the services of financial advisers. A good example is quoted in Thomas Picketty’s 2014 book Capital in the 21st Century. Harvard University spends $100 million a year on financial advice, far more than any other university. It gets a 12% return on its investments – three times the US average for university endowment funds. Once you’re rich enough, you can’t help but get richer.

The upshot is that financial services provide, in fact, a very powerful engine driving up inequality. Any attempts by national governments at redistributive policies such as progressive taxes are like walking up a down escalator.

Balance of Payments and Exports

The UK’s balance of payments has been in deficit for the past 15 years, although it can be seen below that matters have been going further downhill since 2010.

Balance of PaymentsThe 2014 deficit in goods of £124bn was offset by a surplus of £89bn in services. Finance services supplied a useful £39bn of this surplus. This is perhaps not surprising as the UK economy is responsible for 37% of global financial transactions (with 1% of global population).

However, in value terms, financial services are a poor way to export. Goods, despite manufacturing representing only 10% of our economy, produce 19% of our exports. Financial services, also around 10% of GDP, contribute only 4% of exports.

The underlying picture is that we consume far more than we produce. This has been propped up by overseas investors continuing to invest in the UK economy. The “crowding out / poor productivity” effect of finance over manufacturing described above means this position is not sustainable for ever.

Other Perspectives on the Finance Sector

Finally, I will summarize the work of two independent-minded professionals, the first legal and the second a former key player in finance itself.

Critical Legal Thinking

A 2012 report by the above organisation forensically dissects the value of the various ways banks and financial intermediaries make their money.

30% comes from fees, which the report concludes are extortionate: their words “protection racketeering, fraud, and spivvery” to be precise. 10% comes from speculative dealing with clients’ money, often against their interests. The report mentions that Goldman Sachs traders use the affectionate term “muppets” to describe their clients of these services. 30% is called “other operating income”, an obscure basket of activity believed to include help to clients to hide their money in offshore tax havens. The final 40% comes essentially from charging higher interest to creditors than the banks need to pay themselves. Banks “earn” this by making themselves the only route for clients to capital – as the report says, by “simply being banks”.

Howard Davies article

Howard Davies, former chairman of Britain’s Financial Services Authority, deputy governor of the Bank of England, and director of the London School of Economics, is a professor at Sciences Po in Paris. So he is someone in the know. His Guardian article from 2014 is entitled “Does London’s financial centre boost or harm the UK economy?

He cites a number of sources, including the 2012 BIS report mentioned above. He makes a few caustic remarks: the expected continuing growth of the finance sector should be good for some other parts of the economy. He cites “Porsche dealers and strip clubs” as examples. His overall conclusions appear to be twofold. Firstly, the net benefit of the finance sector is overstated. And net benefit to the economy as a whole is “mixed”. It’s hardly a ringing endorsement from a man who was at the top of finance tree for so long.

Overall Conclusion

And so to my overall conclusions to the original question: the City, paragon or parasite?

Well, it’s clear that financial services and the City of London in particular are a very important part of our economy and employ a large number of (generally well-paid) people. Any major policy changes which had the effect of destroying large swathes of the sector overnight would be damaging in the short term. Although, of course, finance had a very good try at doing just this in the 2007-2008 crash and the bailout by the government was the lesser of two evils. The finance sector does bring in a surplus on our overseas trade – hardly surprising as the sector is proportionately 37 times larger in Britain than for the world economy. This surplus helps to offset our massive trade deficit in manufactured goods.

But look at the other side of the “balance sheet”. Finance is a major source of economic instability, as the 2007-8 crash showed. It facilitates tax avoidance through its network of tax havens. Its growth is damaging to productivity and long-term growth in the economy as a whole. And it repeatedly creates property bubbles instead of investing in productivity-enhancing industries. Finally, it powerfully drives up inequality.

So, overall, that makes it more parasite than paragon. It’s high time we started rebalancing our lop-sided economy before the next crash.

(Sources for this post include: City of London Corporation, Office for National Statistics, House of Commons Library, Bank of International Settlements, The Economist, The Guardian, New Statesman)

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Chain of Fools

Back in 2009, Adair Turner, former head of the CBI and the financial regulator FSA, called much of what the City of London does “socially useless”. In this post, I will explore this assertion, via a few other ideas on the way.

Chain Letters

As a child, I remember receiving the occasional chain letter. In those days, it was an actual letter through the post. They were generally pretty benign. Typically the recipient was asked to do two things. Firstly, to write a letter to the person named at the top of a short list of names in the letter. Secondly, to copy (by hand) the letter to 4-5 friends, deleting the top name and adding your own name to the bottom of the list. By the miracle of the power of arithmetic, you would then receive a large number of letters from far-flung places. Writing 5 letters to the fifth person in the chain should theoretically bring you 3125 (5 to the power of 5) letters in return – if everyone plays the game. At each step, the total number of people needed is multiplied by five.

The problem is, after fourteen rounds, this system requires the entire population of the planet to take part: 5 to the power of 14 is about 6 billion. And then where do you go? So in practice, chain letters might work for a round or two and then quickly fizzle out.

Pyramids and Ponzi schemes

A more sinister version of the chain letter is pyramid selling.

Pyramid sellingNo, no that type. I’m not aware that the Egyptian government has followed Britain’s lead and is attempting to sell off the nation’s assets (usually these days to the Chinese). No, I’m talking about the illegal business practice of selling some spurious goods or service for an up-front fee. The rest of the scheme works much like the chain letter. The same multiplier effects come into play, as those people drawn in then try to sell on to a number of others. In practice, the very few at the top of the pyramid make all the money and a much larger group lose a little each. It’s a zero-sum game.

Byalistock and Bloom
The Producers

A Ponzi scheme works in much the same way. It relies on enticing investors into believing they will make unrealistically high returns on their outlays. Again, in practice, it’s usually only those in the know at the start who make any money. Again, the majority lose. A good example is the scheme set up by Max Bialystock and Leo Bloom in Mel Brooks’ The Producers. They sell shares many times over in failed Broadway musicals to rich “little old ladies” susceptible to Bialystock’s seductive(?) charms.

Financial “Products”

Much has been written over the years about the wonderfully innovative financial “products” dreamed up by City types since the sector was freed from too much nasty regulation. But what are these “products”?

Let’s start first with what is at the heart of traditional markets in goods and services: the transaction. This requires two parties – a buyer and a seller – a product or service and an agreed price for exchange. The producer of the product or service has used resources – physical or human – together with skill, organisation and possibly ingenuity to make something which the buyer values. This may be because the buyer does not have the time, resources or skills to make the product or service him/herself. Provided it’s traded at a fair price, both parties gain from the transaction. The buyer gets the benefit (s)he values from the product or service. The seller gets paid for the time and effort gone into producing it. A win-win game.

Compare this to a typical financial “product”. These are investment schemes of one form or another, offering the opportunity of financial gain under conditions specified by the seller. The buyer trusts the seller to use his skills to maximize the prospects of a gain. The seller invariably minimizes his risk by taking his commission or fee up front. The seller then undertakes some form of speculative investment. If he does well, the buyer gets a profit. But where does this profit come from? The seller has used his knowledge to “play the market” to his advantage on behalf of the client. The only way this is achieved is by hundreds or thousands of other people losing a little each, just like in the pyramid selling scheme. These losses may take the form of actual investment losses or in consequential higher costs in other goods and services. No new wealth is created: this time it’s a win-lose game.

Chain of Fools

Who are the winners and losers in this game? The winners are likely to be those with spare cash to invest: mega-rich individuals and large multinationals – and of course the traders. The transfer of wealth from the many to the few doesn’t have to be very much for each transaction. Tiny margins will do, as the process goes round and round repeatedly. Cumulatively, the effect is massive. Remember from my earlier post Two Gamblers and a Pint of Lager that sums equal to the entire annual output of the UK are speculated in the City every day and a quarter.

As Aretha Franklin sang: “Chain, chain, chain… Chain of Fools”. And who are the fools? It’s us. Turner’s “socially useless” is putting it too kindly.

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Two Gamblers and a Pint of Lager

This is the story of two men with gambling habits and a pint of frothy beer. But there might be a bit more to it than that. There’ll be a short quiz at the end, to see if you’ve been paying attention. Read on…

Poker-Face Dan

poker player
Poker player

Dan lives in a country that is neither particularly rich nor particularly poor. He has a job and his total income is £8000 a year. His friends call him “poker face” as Dan is a mean poker player. His gambling is successful and his poker winnings bring in £400 of his annual earnings. His long-suffering wife Maria is deeply troubled by his habit. She has found out that Dan gambles over £120,000 a year on poker games. Dan says not to worry as he is good at the game. Maria thinks his luck will run out one day and bring ruin to his family.

Oliver: “A Bit of a Flutter”

horse race betting
Betting at the Races

Oliver lives in a much richer country. Also with a job, he brings in a total of £26,000 a year. Oliver’s new girlfriend Amelia really enjoyed the day out at the races they went to recently. But she was a bit surprised by the size of the bets Oliver was placing, including one bet of £5000. Oliver said he likes “a bit of a flutter” on the horses. He told her not to worry: he’s a real expert, studying form and placing his bets with care. In a typical year, Oliver’s betting contributes a useful £3500 to his annual income. Amelia might be a bit more worried if she knew Oliver placed bets totalling £4 million each year – the equivalent of gambling most of his annual salary every day.

The Frothy Pint

Frothy pint
Frothy pint

A man walks into a pub and orders a pint of lager. He notices whilst it’s being poured that it looks a little frothy. “Beer’s a bit lively tonight” he says to the barmaid. She just smiles and says nothing. The man takes his drink to a table and sits down. He notices his beer still looks frothy. In fact, there’s only two-thirds of a teaspoonful of liquid in his glass; the rest is head. He takes the drink back to the bar and complains. The barmaid shrugs and says there’s nothing she can do: it’s always like that. The man sits down slowly again, still feeling he’s been cheated. (Sorry if you were expecting a good punchline!)

What’s Happening Here?

Well, I confess, this story is not really about Dan, Oliver and the pint of lager. It concerns the global economy in 2015 and financial services in particular. Economic statistics quote numbers so huge – total world income, for example, is around 74 trillion US dollars a year – it’s hard to relate them to anything real. So I’ve scaled everything down to more human-like terms.

Let’s start with the pint of frothy lager. As recently as 1975, roughly 80% of all global foreign exchange transactions involved the real trading of a product or service. Only 20% were speculative, betting on the rise or fall of prices, exchange rates or some such. Since the liberalisation of financial services in the 1980s, the proportion of speculative transactions has increased almost beyond belief. The speculative stuff now accounts for nearly all the activity: only 0.6% of transactions involve something tangible. That’s equivalent to the two-thirds teaspoon (3.4ml) of actual beer in the pint (568ml) glass.

Dan and Oliver represent the global and the UK economies. Daniel is, apparently, a popular man’s name in Peru. Peru comes half-way down the International Monetary Fund’s ranking of 183 national economies, in terms of income per head of population. Oliver and Amelia are the most popular boys’ and girls’ names in Britain, which comes 27th in the IMF’s rankings.

Dan’s income of £8000 is the average global income per person. £26,000 is UK middle income. Financial services represent about 5% of the world’s income, but 13% for the UK.

Globally, money equal to the entire planet’s annual output (or income) is traded every 14 working days. In Britain, our annual GDP is traded every one and a quarter days.

Compare Britain’s place in the world with these three numbers:

  • 1% of the world’s population
  • 2.5% of the world’s income
  • 37% of the world’s daily financial transactions.

After the 2010 election, David Cameron promised to rebalance Britain’s economy away from an over-reliance on finance. With over 50% of Tory Party donations coming from financial institutions in the City, don’t bet on real reforms any time soon.

A Short Quiz

Think back to the concerns of Maria and Amelia, with their partners’ gambling habits. Considering the state of affairs in financial services in Britain and around the world, do you think the current situation is:

  1. perfectly OK as it is,
  2. a bit worrying, or
  3. stark raving mad?
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Two Castles (part 2)

… but castles built on sand!

In the first of these two posts on the power of the human imagination I covered the case of religion. This one is on:

Free Market Fundamentalism

I will firstly look at the false doctrine which has monopolised economics thinking for 35 years and then at the specific case of the thinking that caused the 2008 global crash.

Religious Style Dogma

Neoliberalism – what I call free market fundamentalism – began to have an impact on Western political thinking, particularly in the US and UK, from the late 1970s. Its ideas began to take hold from work by Milton Friedman and others, drawing on Friedrich Hayek, at Chicago University. Chile, under the dictator General Pinochet, was an early practitioner of these ideas, with disastrous results for the majority of Chileans. The ideas then took hold in Western governments, in influential bodies such as the World Bank, International Monetary Fund and World Trade Organisation. Central to the new doctrine was the rejection of Keynesian economic ideas, the supremacy of the free market, lower taxation and reduction in the role and scale of government.

The effects, over the past 35 years, can be summed up as follows:

  • Economic growth in the developed countries slowed to about half of the rate of the previous 30 years
  • Income and wealth inequality increased dramatically: only the very rich have seen a rise in living standards
  • The scale and frequency of major economic crises increased.

It’s obvious to me that this 35-year experiment actually failed with the crash of 2008, but government and other key institutions have carried on as if nothing wrong has happened. University departments have been teaching this doctrine as if it were the only way to run an economy. This has led to students from several universities holding protests demanding that their syllabuses are widened to explain the 2008 failure and to include teaching rival economic theories.

Osborne Machiavellian Prince
Osborne: Machiavellian Prince of the FMFs

The dominance of free market fundamentalism has all the hallmarks of old-style religion. And just like such religion, it is based upon false premises:

  1. The only motive human beings have in making (economic) decisions is the pursuit of material self-interest. Not so: see my earlier post Being Human II: The Four Cs, or as highly-regarded Cambridge economist Ha-Joon Chang puts it: “… we have many other motives – honesty, self-respect, altruism, love, sympathy, faith, sense of duty, solidarity, loyalty, public-spiritedness, patriotism and so on” from 23 Things They Don’t Tell You About Capitalism (2010).
  2. Market participants (companies, individuals) know what they are doing, i.e. they make rational decisions. Again, to quote Chang: “The world is very complex and our ability to deal with it is severely limited”. A trivial example is people queuing at a busy bus stop so that everybody doesn’t have to remember the order in which people arrived. 1978 Nobel prize-winning economist Herbert Simon wrote about “bounded rationality”, which describe how people’s ability to make rational decisions is severely restricted when faced with complex problems. Government regulations, the notorious “red tape”, work by restricting choice and simplifying problems, reducing the risk that things may go wrong.

As we saw in part 1 of this post, it is possible to build great cathedrals and great intellectual arguments on false assumptions. The same applies to the advocates of free market fundamentalism. The next section illustrates the crucial example which led to the 2008 global financial crash.

A Case Study: Fool’s Gold

Gillian Tett is a highly respected journalist for the Financial Times. She has a PhD in social anthropology from Cambridge University. She wrote the book Fool’s Gold in 2009. She uses her anthropologist’s insight to tell the story of the group of highly intelligent, innovative bankers who invented the complex new financial products which led to the 2008 crash.

The story starts in Florida in 1994, when a group of J.P. Morgan employees held a conference to develop ideas to develop the market in derivatives. These are complex products which “sit on top” of traditional loans and mortgages. But these traditional products are bundled up and repackaged in a way in which they can be sold again in a different form which, on the face of it, reduces the risks of default. These clever people worked out that at this bundling and repackaging process could be repeated and re-sold. Banks could then earn commission several times over on ever-more complex products based upon a given set of “real” assets (e.g. property). The whole scheme involved complex mathematical models using the ever more powerful computers becoming available.

There was one problem, however. In a certain set of highly unlikely circumstances, there was a risk of huge losses derived from assets worth a fraction of the money at stake. But the computer programs which produced the figures for the products did not contain any way of expressing this small risk. The risky circumstances were so unlikely that J.P. Morgan and subsequently all its competitors launched these new products and made a lot of money.

Actually, there was another problem. Once everyone in banking had jumped on the bandwagon, nobody other than the original group understood about the tiny risks. Neither did the financial regulators. In other words, nobody selling the products knew what they were doing.

But – wait for it – there was a third problem. Those tiny risks weren’t as tiny as the original clever people thought. Most people who’ve looked at the workings of markets will have heard about “bulls” and “bears”. These exemplify the lemming-like behaviour of market traders when sentiment changes from optimism to pessimism. (A good example is when, in 2010, George Osborne falsely compared the UK economy to that of Greece). When the markets got themselves into one of these spells of irrational behaviour and everyone started selling, the whole house of cards fell down. Matters were saved from getting much, much worse by the intervention of those institutions so hated by free market fundamentalists: national governments. This means that the original clever people got their models wrong.

So deregulation – leaving markets to themselves – is crazy when they don’t make rational decisions: they don’t know what they’re doing!

Conclusion

So people don’t behave like Hayek and Friedman said they do. And the only people who have benefited from continuing the pretence are the super-rich, large corporations and the politicians who represent them.

Overall Conclusion

By linking together this and my previous post, my overall point is that it is possible to build a very sophisticated logically consistent set of ideas (and real objects like cathedrals) based upon false assumptions. Other obvious examples are the Tea Party movement in the USA and our own UKIP. Modern communications makes it easy for like-minded people to network their ideas for mutual reinforcement, untroubled by inconvenient truths.

These towering “castles” can look very impressive. They can bring great joy and comfort, for example, in my “magical” Lincoln moment. But they can also bring tremendous grief and pain – think of murdering pro-life extremists in the USA motivated, ultimately, by the loopy idea of “ensoulment”. The more impressive-looking these “castles” become, the more likely people are to believe the whole package of ideas is true. But if real foundations don’t exist, these are no more than castles built on sand.

 

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Inequality Damages Your Wealth

One of the assertions made by free market fundamentalists is the “trickle-down effect”: making rich people richer by cutting their taxes benefits everyone, as their extra wealth trickles down to the rest of us. I have long doubted this; a recent IMF report provides further evidence that this is not so.

To quote from the report:

If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.”

The report goes on to say that the positive effect on growth holds true also for increasing the share of income for the middle classes – it’s only when the richest get more that we’re all worse off overall. This is hardly surprising. The poor tend to spend more of their income, not least on the basic necessities of life. The rich are more likely to save theirs – and, for the richest, often tuck it away in some offshore tax haven!

Spirit Level

In their 2009 book The Spirit Level, Richard Wilkinson and Kate Pickett demonstrated that more unequal societies had worse performance over a range of social outcomes:

  • Community life and social outcomes
  • Mental health and drug use
  • Physical health and life expectancy
  • Obesity
  • Educational performance
  • Teenage births
  • Violence
  • Imprisonment and punishment
  • Social mobility

The book goes on to state a plausible mechanism to explain why inequality has an adverse effect on each of these outcomes. If growing inequality does indeed cause all these societal problems, it’s not hard to imagine that the overall growth in the economy is reduced as well.

Concentrating Wealth

Britain does worse than most comparable countries when it comes to wealth inequality – and we’re getting more unequal faster than them. The graphs from the IMF report illustrate this, showing the proportion of all wealth owned by the top 1% and the bottom 90% of the population, for 1980 and 2010.

Top 1 percent and bottom 90 percent sharesIn the UK, the top 1% own almost as much wealth as the bottom 90% of the population. Only the USA has greater inequality and the gap between the blue (1980) and green (2010) bars is biggest for the UK. Sweden, by comparison, although getting worse, shows that it doesn’t have to be this unequal.

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