Riot reading

Handy guide to the week's riot writing: eight explanations and eight excellent riot commentaries from the press/blogs. What am I missing?

Werner-nomics (or how to turn debt into jobs)

After my last post on stimulating growth, inspired by the riots, I stumbled across an article on the q-finance website by Richard Werner, the rebel economist from Southampton University. As a layman’s introduction to his ideas on credit and economic growth, it was pretty thought provoking. 

Werner is a heterodox (as in, not orthodox) economist whose theories on credit creation and money are proving a major challenge to mainstream economics. He invented the term “quantitative easing” while working on the Japanese banking crisis in the 1990s and his book “New Paradigm in Macroeconomics” has been hailed as a classic in the making. Despite his dubious choice of words, he recently become a Qualified Member of Finance Watch and seems to be working hard to live up to his 2003 Davos billing as a “Global Leader for Tomorrow”.

Here is a summary of the article and a few thoughts about what it could mean for growth:

Growth pains

Violence among unemployed north Londoners, panic in the financial markets, teetering public debt – the UK is really missing economic growth. It seems we need a hit of good economic news quickly, before things turn even uglier. 

But before grabbing the economic morphine of QE and tax cuts, shouldn't we check if they will actually improve the way we use our resources, rather than merely expanding credit and inflating asset values?

What’s missing from Cameron’s public services white paper

Private equity firm Blackstone escaped most of the blame for Southern Cross’s demise on Monday (see previous post How Blackstone made its £600m from Southern Cross) but the techniques it used to make its windfall raise serious questions about whether private equity firms are appropriate owners for public service providers.  

The questions are relevant now because David Cameron has just published his White Paper on public service reforms, detailing plans to open nearly all public services to the private sector – schools, hospitals, rehabilitation, childcare, council services, visa application centres etc - with virtually no safeguards against financial engineering or against brave new social enterprises being swamped by big business (see Peter Holbrook's post).

The White Paper has some good suggestions, such as allowing social enterprises, charities and employee-led mutuals to compete for services whose provision had grown stale under the state.

But it contains big contradictions, mostly relating to the role of the private sector and highly relevant to private equity. Here are some suggestions for making it safer.

How Blackstone made its £600m from Southern Cross

Five years before Southern Cross failed, private equity firm Blackstone owned the company and its main freeholder for two years in which time it engineered a profit of £600m - pretty impressive given that the UK care home group had annual operating cashflow of only £50m. Blackstone has faced accusations of profiteering and worse ever since.

This post tries to explain how Blackstone made its money and where it really came from.

ICB submission

Click "Read more" to see the full text of my submission to the Independent Commission on Banking

Retail ringfence is not good enough, George

George Osborne sounded the death knell for enforced full bank separation this week at the Mansion House dinner, when he gave full – and premature – backing to the ICB’s interim recommendation for retail ringfencing.

It was bad news for taxpayers and the economy, but all is not lost. There are three steps the ICB can still take.

Will ICB proposals on bank capital keep taxpayers dry?

Problem: The ICB proposals for bank capital are too low and plans for debt bail-ins and resolution plans too weak to protect taxpayers from the next bank crisis.

Solution: Double the capital requirements by earnings retention and paying bonuses in equity, or opt for full structural separation.

At half time it’s KONP 1 – Cameron and Lansley 0

The government yesterday said it was in listening mode over health reforms, a significant victory for all the Keep Our NHS Public, Save Our NHS, NHSDirect Action, Health Emergency and other campaigners fighting its health reforms.

But the Health and Social Care Bill is not dead yet and there is plenty more lobbying to do. Thanks to this government pamphlet and Andrew Lansley’s own patchy media performances on Wednesday, there should be some easy wins ahead for the campaign...

Alternatives to the Lansley plan

One of the problems for those of us that oppose Andrew Lansley’s health reforms is that it’s hard not to sound negative. “Kill the Bill!” is not a constructive slogan. "Here's a better one!" might be more effective.

We need an alternative but most people (like me) haven’t a clue where to find one. Apparently, there are pretty good health systems in France, Holland and Switzerland, even the US system has its good parts. A cursory look at these - courtesy of good old wikipedia - throws up a few ideas about what kind of NHS we might ask for instead.

The main finding is that all those systems cost a lot more than the 7.7% of GDP we're used to paying. The chart above shows how cheap the NHS is compared to other systems (click here for more data).

Another is that no one has really cracked the problem of getting the efficiencies of competition without paying for profits and suffering from cherry picking, monopolies and other market failures. In general, the more competitive systems seem to cost more overall, which must be a puzzle for economists.

Here's what a few of the alternatives look like, in ascending order of cost, and some features we might look to adopt from them for ourselves.

UK politics and the AV: time to consider mini-referenda

A likely outcome of the Alternative Vote system, subject of the upcoming May referendum, is that it would push election campaigns further into the centre ground as MPs try to widen their appeal.

This raises the risk of rogue governments adopting policies for which they have little mandate, as with the UK coalition’s post-election lurch to the right, and raises the question whether AV on its own is enough. Perhaps it should be followed by other democratic reforms, such as mini-referenda?

Youth unemployment: another misguided case of ‘leave it to the market’

Alice Roosevelt Longworth once joked that “the secret of eternal youth is arrested development”.

That certainly resonates with me but if Teddy Roosevelt’s eldest daughter was right, today’s school leavers should remain young for a very long time. Those hoping to develop into employees face the toughest job market since most of them were born.

The TUC’s February Labour Market Report shows youth unemployment approaching one million. A quarter of these are considered long-term unemployed having been without work for longer than a year, the highest level for seventeen years.

According to the TUC’s blog, one of the first things the government did when coming into power was to cut the Future Jobs Fund introduced by Labour and replace it with nothing. Is this another case of mistaken reliance on markets?

More NHS materials

Unison, the health workers union, takes apart the government's myth-buster document (see earlier posting For and against NHS reform  - in their own words) in a response called "Rebutting the rebuttals"

Sample letters to write to MPs and GPs, and other Unison docs here

Survey by the Royal College of General Practitioners, which finds that a majority of GPs oppose the marketisation of the NHS and fear the reforms will cause "irreparable and irreversible damage to the NHS."

Follow the legislative progress of the Bill through the committee stages. Only two more committee meetings after today's, scheduled for 1 and 3 March.

Excellent article on Channel 4 website by junior doctor on likely effect of the reforms "NHS surgeon: Lansley reforms are a 'phony revolution'"

NHS price competition – what the academics think

Here are some links to academic research on the effects of price competition on healthcare. You probably know the conclusions already but here they are spelled out with links to the relevant research papers and the dangerous parts of the draft Bill.

Also, some handy resources for NHS campaigners:

• Blog from the The Centre for Market and Public Organisation (see two excellent recent posts from Carol Propper, The Health Bill, the NHS and the facts and Price competition to be (re)introduced in the NHS
• Appleby’s BMJ article questioning the government's use of stats
• A collection of quotable soundbites from LSE and other health economists
• Another blog like this, with summaries and links to academic evidence
• BMJ editorial on the dangers of structural reorganisations
• Ben Goldacre’s Guardian Bad Science column that reviews the evidence for reform (full of links)
• The BMA (doctors’ union) statement against "always damaging" price competition
• Richard Taylor’s proposal for a new political party - NHS Concern - to turn the May council elections into a referendum on health reform
• Blog from health think-tank Altarum Institute against price competition

Now for the nitty gritty...

Save the NHS, push for limits on private health provision

Here’s an idea to stop the government from gutting the NHS - push for an amendment that limits the percentage of the NHS budget that GPs can farm out to the private sector.

An unexpected champion for this might turn out to be David Miliband, who landed one of the few real blows on the government’s health reform plans in yesterday’s Commons debate.

Caveman economics

Caroline Spelman got duffed up on the Today programme this morning over her plans to sell-off the nation’s forests. “You’re going to have to back down on this, aren't you?”, asked nature-loving interviewer, John Humphrys.

We can only hope he’s right. But whatever happens to our woods, Spelman’s justification for the sell-off highlights a worryingly backwards approach to economics from the government.

For and against NHS reform - in their own words

UPDATE: New book due out in April "THE PLOT AGAINST THE NHS" by Colin Leys & Stewart Player, promises to expose the creeping privatisation of the NHS. A previous Colin Leys book "Market Driven Politics: Neoliberal Democracy and the Public Interest" (reviewed in detail here) concluded that the marketising of health and public broadcasting was "incompatible with democracy and, in the long run, with civilised life."
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The government's disastrous Health and Social Care Bill has its second reading in parliament tomorrow, Monday. There will be a debate and a vote, after which the Bill can proceed to the committee stage and be picked apart clause by clause by MPs on the health committee.

Under "read more" below you will find two documents that set out the cases for and against.

The first is a government Q&A note written to help health ministers defend the Bill against its many critics. In an Orwellian flourish, the questions and answers are referred to as "myths and facts" (my favourites are Myths 4 and 10, so brief, so flimsy).

The second is a briefing note prepared by Unison, the public service trade union, challenging specific clauses in the Bill. If you don't want to read the whole document, a summary of Unison's main arguments is here.

Unhealthy NHS reform

The UK coalition government today introduced its Health and Social Care Bill 2010-11 to parliament for first reading. In its short life so far this Bill has, to quote Malcolm Tucker, been about as popular as a turd on a trampoline. The cross party Health Select Committee described it as inefficient, risky and a hand-grenade thrown into the system, and newspapers reported mass public concern including a petition that's gained 10,000 signatories already.

Officially, the Bill will let GPs, with their detailed knowledge of local patient needs, decide how resources are spent instead of primary care trusts. So far so sensible, but something sinister lurks alongside, which the government sweetly calls “liberating the provision of NHS services”.

In translation, this means allowing private companies to replace NHS providers if they can beat them in competition. Care will still be free, but the providers may answer to shareholders not voters.

Bonuses: disclosure is not the only weapon

What happened: Chancellor George Osborne decided not to implement UK bonus disclosure rules proposed by Sir David Walker. The rules would have forced banks to disclose in anonymous bands how many employees earned more than £1 in a year.

What it means: 2010 bonuses for UK banks will be paid without the new disclosure rules. Shareholders will not be able to challenge boards on staff pay. Public outrage, already heightened by austerity measures, will be less than it might have been, but meaningful reductions in bank pay and reform of risk-inducing compensation practices will be delayed.

What happens next: Osborne will write to European finance ministers to seek European agreement on bonus disclosure. He will find a willing audience on the Continent, especially France, but less likely in the US. The result may be European disclosure rules next year or later, watered down by the UK to compete with Wall Street. In the meantime, banks are raising basic salaries to compensate for lower bonuses.

Comment: Few people now doubt that high financial sector pay was central to the financial crisis; it feeds asymmetric risks, encourages economic rent-gouging and has contributed to the under-capitalisation of lending banks. Sir David Walker's disclosure rules were supposed to help shareholders control financial pay but now Osborne has back-tracked it is worth asking - would they have been enough, and what other options are there?

Basel 3 may hold the key to monetary reform

If radical monetary reform is too much too soon, perhaps a little-discussed part of Basel 3 holds the answer.

Monetary reform is rapidly gaining the public’s interest, something the Basel rules on bank capital adequacy have never quite managed. But perhaps Basel has a special role to play in helping monetary reform come of age.

Calls for monetary reform are being led by a small band of unorthodox economists whose ideas are catching on in these austerity days.

At its heart is the realisation that today's money is in fact credit, or debt, and it is mostly created by private banks when they add digits to people’s bank accounts.

As a plethora of online presentations explain (type “how banks create money” into google), it’s illegal to print bank notes but not to create digital credits – the online equivalent - as long as you’re a bank and you follow the rules.

This is how fractional reserve banking works in a digital age but the realisation has potentially big implications for politicians fighting deficits and stagflation.

How to get banks lending to SMEs

David Cameron enjoyed his swipe at the banks today, using his speech at the party conference to lambast them for not lending to small and medium sized enterprises. He wants the economy to get moving despite huge public spending cuts and said he’s fed up with banks not doing their bit. Sadly for us, lending targets and prime ministerial taunts won’t help, even if they are fun.

How about some other options; couldn't we harness some of the billions the Bank of England is creating through quantitative easing to lend to SMEs? And what about the new Basel 3 rules, they must have something to offer?

A suggestion for commodity hedging

Problem:  influx of assets into soft commodity derivatives is increasing volatility and imposing costs for producers and food companies.

Solution:  treat commodity hedging as a utility public service. Financial players would state their purpose as hedgers or speculators, with different regulatory regimes applying to each. Regulators could vary the mix and capture rents for the public benefit.

Stock exchanges: stop the robots

Regulators must stop the robots from ruining our stock exchanges, according to democrat Senator Ted Kaufman.

In a 5 August letter to SEC chairman Mary Shapiro, Kaufman warns that some algorithmic trading harms long term investors and dominates the equity markets in a way that brings no social utility. He describes some murky algo practices such as trading on advance information about other people’s orders, collecting unearned liquidity rebates and unnecessary intermediation, to support his case.

The Senator has picked up a useful ally in Gillian Tett, who used her FT column today to back his call for a review of high frequency trading. Tett explains his argument that the benefits of the narrow spreads which high frequency trading supposedly brings may be outweighed by hidden costs, leaving only a “thin crust” of liquidity that evaporates in bad times, as with the flash crash of 6 May.

In an separate but related story, the paper reports that two day-traders in Norway were indicted on charges of market manipulation after they stumbled across – and exploited - a trading pattern that tricked programme trading computers into raising their prices. Despite the breach of market rules, plenty of people cheered the duo for beating the machines: “Robots are designed to push the market but when someone pushes the robots it is suddenly a criminal offence,” was one comment on a Norwegian chat forum, according to the report.

Behind both these stories lies an unease about the growing dominance of robot trading. While not quite an android invasion, the increasing use of computers to arbitrage short-term price anomalies is a sinister development whose effects are not well understood. But it accounts for nearly 70% of US equity trading, making it an important source of revenue for stock exchanges.

Appropriating or creating, economists must tell us which is which

John Kay returns to one of his favourite topics in today’s FT: the Robber Barons of the Rhine, who in the 13th century charged illegal tolls on cargo passing their stretch of the river. Old-school baddies like Werner von Bolander and Philip von Hohenfels, who lived in fabulous castles and plundered their neighbours, are a colourful metaphor for modern finance, which Kay uses to make this point:

"The distinction between the creation and the appropriation of wealth – between those who add value to the cargo and those who help themselves to a fraction of it as it sails by – is vital, if not always clear. But our ability to recognise it will determine, not just the fate of individuals, but the future of modern capitalism."

When Adair Turner suggested there might be good finance and pointless finance, he was probably thinking of this. Despite the City's appalled reaction, many people felt they knew exactly what he was on about.

Kay’s distinction between “brigandry and productive business” exists and has been tackled before without resorting to communism, despite the theoretical difficulties.

Update on Global Bank Levies

Problem: several different bank taxes have been proposed but none have been implemented, partly as there is confusion about what each should be for

Suggested approach: widen the debate to publicise all the benefits of each tax, then push for internationally coordinated asset levies together with national taxes on bank profits and selected financial transactions.

Since the last post here on this hot topic, two major developments have moved the debate a long way forward. The IMF has proposed two new bank taxes: a Financial Stability Contribution and a Financial Activities Tax, and a popular movement aimed at funding development (the Robin Hood campaign) has pushed financial transaction taxes onto the international agenda.

At the end of this month in Toronto, G20 leaders are likely to discuss global levies and transaction taxes, despite opposition from host country Canada and others. Germany, France , the UK and USA are keen for a bank levy on assets. No consensus exists on profit and transaction taxes.

So what’s on the table?
(22 June update - UK has introduced an asset levy and said it will consider a profits tax).

Conflicted credit ratings

Problem: ratings agencies conflicted by their issuer-pays business model

Solution: fund agencies through a levy on security purchases, distributed according to demand

The conflict that ratings agencies have between offering objective advice and being paid by issuers has inspired a number of proposals.

Most recently, the head of European credit research at Schroders, D. Patrick McCullagh, suggested that investors pay their investment managers to assess credit quality as part of buy-side research, consistent with the caveat emptor principle, with the cost picked up as a management fee borne by investors, in whose interests the rating is conducted. But is it the best solution?

Capitalism and the stable state

Problem: economic growth + population growth + finite resources = crisis, somewhere along the line

Solution: reduce the aggregate requirement for economic growth by enabling businesses to profit from resource reduction instead of top line growth

As any school-kid knows, capitalism rewards individuals for making and selling things. To form capital and reward entrepreneurs there must be constant economic expansion. Business schools teach that growth is an elixir for turning ambition into production and ultimately wealth. This is so widely accepted it is part of our identity. Meanwhile, the human population continues to grow in all but the richest countries, while demand for natural resources is growing so fast that some are bound to run out. What gives?

Accounting independence

Problem: The big four accountancy firms are facing reform calls over perceived conflicts of interest, since they are paid by the companies they audit and sell consultancy services to the same clients.

Solutions: Complete separation of the audit and consultancy wings of the big firms or financial separation of audit and consultancy profits, together with some specific changes to the UK Corporate Governance Code on how auditors are appointed.

Private equity and debt interest taxation

Problem: Tax rules that allow debt interest to be offset against profits create a preference for debt over equity funding, which contributes to over-gearing and systemic risk and encourages financial engineering and short-termism, especially in private equity

Solution: Equalise the tax treatment of debt and equity, instead of the current system where dividends are taxed but interest can be deducted from taxable profits. Policy Exchange (p60-66) estimates that if debt and equity were taxed equally at 10%, headline corporate tax could be reduced from 28% to 17% for the same tax revenue. The idea has many supporters including John Plender at the FT, Bank of England, IMF, Institute of Fiscal Studies and Conservative Party.

Private equity benefits include:

• Modernizing investee companies
• Helping industry to shed non-core assets
• Challenging PLC management
• Sheltering companies in transition from quarterly public reporting
• Restoring bankrupt companies with fresh capital
• Providing an alternative source of returns for diversity-seeking investors
• Adapting PE business model with the economy and needs of their investors (or limited partners, LPs)

Problems from PE reliance on financial engineering:

• Makes unviable LBOs viable purely for tax reasons
• Transfers wealth from taxpayers through interest deductibility
• Diverts R&D spend and capital investment to service debt
• Miss-allocates resources as buyout firms target cashflow companies instead of turnarounds
• Increases bankruptcy risk through unsuitable capital structures, eg high gearing against cyclical earnings, adding to welfare costs from unemployment and inequality
• Reduced customer service has economic costs, especially in infrastructure and health
• Distribution of PE-related leveraged loans increases financial systemic risk, especially as PE refinancing peak in 2012 approaches
• Transfers equity yields from future pension savers to current PE investors
• Distorts the tax system by blurring income and capital, allowing inefficiencies such as the taxation of carried interest as capital

General policies against short-termism:

• For executives, make share-based incentives vest over longer periods to reduce gearing incentives, link executive pay also to non-financial measures related to delivery of the corporation’s purpose such as customer ratings, market position and market share
• For equity owners, equalize the time horizons of asset managers and their underlying investors to remove the pressure for short-term gains, such as geared dividends or takeovers
• For lenders, restore discipline to securitisation through higher disclosure, retention of risk by originators, independently funded credit ratings and more buy-side diligence.

Reforms to the PE industry:

• For the General Partners, or managers, of PE firms, improve transparency on the true origin and extent of returns, including effects of fees and tax subsidies, and extent of true risk taken by GP after fees.
• Reward operational turnarounds through long-term tax incentives, while discouraging financial engineering through higher taxes on debt.
• Exclude PE firms from tax grouping rules (as with OEICs) and keep liability for acquisition debt and the risks from over-gearing at bidder level
• Extend the “Source of Strength” doctrine from bank holding companies, requiring PE firms to provide assistance for subsidiaries at risk of bankruptcy. Rank GPs with LPs so that financial assistance is funded with clawbacks on PE management fees and carried interest as well as investor funds

Problems with tax reform of debt interest:

• Abolishing debt interest deductibility could push firms into bankruptcy, needs transitional implementation
• May not stop excessive gearing through sale-and-leasebacks, needs coordinated provisions
• Does not address credit bubbles caused by low interest rates and excess savings in China and Germany
• Could reduce investor returns if profits are retained

The EC’s proposed Directive on Alternative Investment Fund Managers is pushing for measures...

Global bank levy I

Problem: taxpayer funded bail-outs (or private gains and social losses; or bank “pollution”)

Proposed Solution: Countries would impose a bank levy to recover past and future bail-out monies. It may be charged on banks, insurance companies, PE and hedge funds, depending on local preference. Could be applied to ‘risky activities’ as in the US by wholesale funding, or on turnover, profit or remuneration. Currently under discussion in the US, Germany, France and the UK, with implementation possible in other G20 countries.

Benefits: Repays bail-out money to the taxpayer. Helps restore public finances. Pays for future bail-outs in advance. Changes banks’ social and economic contract with society. Promotes social and financial stability by reducing excess bank profits. Could reduce systemic risk if levied on wholesale funding. Could address bonus culture if levied on remuneration. Incentive for banks to self-regulate if levy is set according to peer group risk levels, or banks’ individual systemic importance. Could lead to voluntary structural reform (eg narrow banking) by penalising bank holding companies. Could lead to international cooperation in other areas of financial reform.

Disadvantages: Only recovers a portion of public losses as it excludes GDP costs of recession. Slows down the rebuilding of bank balance sheets and their ability to lend. Worsens moral hazard by making the public guarantee explicit. Easy to pass through to bank customers and shareholders. Implementation could favour bigger banks and discourage new entrants to the industry. Needs agreement on what constitutes systemic importance or risky activity. Needs agreement on whether the purpose is to raise revenue or change behaviour. Encourages regulatory arbitrage between countries. Does not address rentier behaviour or agent/principal problems. Dissipates the momentum for structural reform of finance.

Suggestion: Implement primarily as a revenue-raising measure with a sunset clause after ten years. Separate the levy entirely from structural reforms, to avoid wasting political momentum, but leave it as a bargaining chip against the bank lobby for structural reform if needed. Implement with resolution and recovery regimes (living wills) to contain moral hazard, and with a competition review to minimise pass-through to customers and shareholders. Implement unilaterally with scope for subsequent coordination with other countries.