Thursday, January 27, 2011

The perils of ending a (financial) war too early



In order to build an argument about the aftermath of the 2008 financial crisis, I'm going to make a claim about the First World War that isn't one you tend to hear very frequently:

One of the biggest mistakes made in the First World War was that it was ended too early.

Okay, so how can any right-thinking person justify such a claim? Surely the earlier any war ends, the better? Edwin Starr himself assured us that war was good for absolutely nothing, and was friend only to the undertaker. Every extra day that a war continues is a day in which people can die, and it's probable that many will. So why might the continuation of WWI have been a good thing?

It's always dangerous to deal in counterfactuals, so some of what I am about to claim is bound to be contentious. Some historians will disagree with one or more of my inferences. But I'm reasonably confident that my suppositions are broadly correct.

Many people think that the "Great War" was nothing but a stalemate, a wasteful, static war bogged down in a quagmire with little chance of either side ever making a breakthrough and gaining significant territory. But in fact, one of the reasons that the Germans finally surrendered is that their opponents had demonstrated that such a breakthrough was imminent. The much-improved artillery pieces being used by the remaining Entente powers and their transatlantic allies, the devastating efficacy of the creeping barrage tactics and the ongoing increase in manpower had suddenly rendered the Germans' strategic position virtually untenable. Like a competent chess player realizing that the game is now unwinnable, the king was knocked over. Rather than going through the miserable motions of being forced back into Germany, with protracted losses of soldiers and civilians, the war was brought rapidly to an end, with the agreement of their opponents.

The interesting thing about what happened was that it look place without Germany's territory having ever been violated. Famously, the front line at the time of the armistice was deep inside France and not far from Paris itself. To an uninformed observer looking at the map, it must have seemed as though Germany were "winning the war" at that point. In fact, had the war been allowed to continue, the German lines would have collapsed, and the allies would have surged eastwards into Germany, just as she was invaded and placed under foreign control at the end of World War II.

My suggestion is that it was a tragic shame that this did not in fact happen. It allowed the German people to remain in a psychological state that was completely unlike that experienced in 1945. When Berlin was being policed by allied soldiers after the fall of the Third Reich, there could have been absolutely no doubt in the average German's mind that their leaders had failed the people utterly, had misled them, had brought them to ruin. There was a strong incentive for most Germans to try to dissociate themselves from the shattered Nazi regime, treat it as "other", examine its mistakes, humbly promise to do better and make amends, build a better Germany that would not be so arrogant and pugnacious. It's hard to cling to a sense of proud superiority when your state has been blasted to pieces and is at the mercy of those whom you'd previously considered your enemies and inferiors.

By contrast, very few Germans in 1919 would have taken such a psychological stance, because they had the freedom not to. No troops had marched through their capital. No tanks had driven through their countryside. The surrender when the front line had been inside another country seemed inexplicable. The German nation maintained an angry pride and searched instead for narratives of internal betrayal by a cowardly minority. An attitude of "invictus" remained strong in the public consciousness. And this helped sow the seeds of an even more destructive war two decades later, because the Germans nursed a sense of grievance and injustice, wanted that score settled, and still regarded the victorious allied powers as undeserving and inferior.

Something very similar has happened in the last few years with several of the top banks on Wall St and in the City of London. One has only to listen to Jamie Dimon of J.P Morgan, Lloyd Blankfein of Goldman Sachs and Bob Diamond of Barclays to understand that they regard their banks as "invictus" - unconquered, having required no government assistance and needing to apologize to nobody. Their territory was never violated. Others were to blame; they were not. There is no reason for them to change their ways.

When the central banks bailed out the banking system, they were focussed on ending the war as soon as possible to "save lives". Sadly, they did not seem to give much thought to the knock-on effects that might create an even bigger war in a decade or two. Hank Paulson and Gordon Brown bailed out several banks who were counterparties to Goldman et al. In particular, Paulson gave billions to AIG, who owed it to Goldman, Goldman having deliberately set AIG up as the "mark" in a multi-billion dollar sting using CDSs, as detailed in Michael Lewis's book The Big Short. Goldman received 100 cents on the dollar from AIG. Had AIG not been bailed out by Paulson and the Fed, they would have received next to nothing, and would have been in serious trouble. Indeed, the British and US governments ended up covering the counterparty risks of all the banks, who would have been in tremendous difficulty otherwise. Unfortunately, their actions allowed those banks to make the claim that they had not received a penny in government support. It's the way it looks to the uninformed: it's the equivalent of thinking that the territory map in 1918 tells the whole story. By looking to end the war too early, our governments have allowed the Invictus Myth to survive in the financial community. Their psychological outlook has not altered. They will not change their ways. And we will have another crisis on our hands before long.

Tuesday, January 18, 2011

How parasite industries may benefit governments



In a previous posting, I discussed how it was possible for certain individuals or companies to submit large sums in tax at the end of any given year without actually having contributed anything to the economy. If the government became aware of this, would it be motivated to act against it? The existence of antitrust laws and monopolies commissions suggests that governments view some rent-seeking as a bad thing. But there are forces that may push in the other direction, i.e. in favour of allowing such arrangements to continue.

Most obviously, there is the issue of lobbying carried out by the industries who are benefiting from rent-seeking. This may serve to persuade certain politicians to allow a situation to continue even though it is in fact bad for the voters represented by that public servant. Lobbying can take the form of de facto bribes, but also of propaganda, trying to convince the politician that the current setup is actually good for the general public. Some combination of these pressures can and do alter the decisions made by those in authority.

There is also one curious side-effect of parasite activities that tends not to be discussed. This is that it may have the effect of boosting the government's tax revenues, certainly in the short term. This is not an intuitively obvious outcome, so I'll outline an example situation that achieves this result.

Let's return to the example of the money-swiping licence granted to Jones in the previous post. Jones submits four billion in taxes at the end of the year despite doing nothing of value for the economy. What Jones DOES do, however, is to help increase the government's tax haul at the end of the year. But – wait a minute. I've said that Jones contributes nothing to the economy; I'm now saying that her activities boost tax revenues. Surely these two are incompatible? Surely if she genuinely boosts the tax take, this must in fact be a non-zero-sum game, with Jones serving as a bona fide asset to society? And yet this seems wrong, intuitively: all she's doing is swiping money, like a licenced thief. How can these both be true?

The answer is that Jones acts as an instrument for raising the level of general taxation through the back door. Let's imagine that everyone else in the country earns 100k a year, and they pay 25% tax on it. So everybody is paying 25k in tax a year to the government. But Jones manages to swipe 10k off most of them as well. So they pay 25k a year to the government, and 10k to Jones. Ah, but Jones pays 40% of all her takings to the government. So let's recalculate: everyone pays 29k to the government (25k + 4k via Jones) and 6k to Jones herself. The existence of Jones in the system allows the government to grab a 29% rate of tax from everybody instead of 25%. Crucially, the people don't realize they're paying extra tax to the government. They think they're paying only 25k to the state and 10k to Jones. Jones ends up as the focus of their resentment, and the government dodges the blame bullet. The state grabs an extra 4k from everybody, and the extra 6k from each of them is essentially an operating cost of covering the government's tracks and deflecting the blame. (Jones ends up with an immense level of personal wealth as a result of this 6k that is "lost" in every case.)

So there is a significant incentive for the government to allow Jones to keep her licence and keep swiping: it is economically inefficient, but it is politically convenient. An increase in tax revenue, but no increase in blame.

Of course, in the specific case of Jones and the swiping licence, the unfairness would be obvious to all, but it doesn't take a great deal of imagination to see how a de facto swiping licence could exist under the guise of legitimate business. Taking a huge chunk of money in one go always attracts attention, which is why any swiper worth their salt would instead do it through a process of salami slicing, nickel and diming the victim many, many times, ideally using automated processes. Good rent-seekers would tend to be sophisticated, well-organized and in the business of presenting their activities as an essential part of the economy. And the government may have little incentive to interfere if all it sees are increased tax revenues.

Friday, January 14, 2011

The suspicious allure of currency devaluation


On boards discussing economic matters I frequently read opinions expressing gratitude that the poster's currency has been devalued. It seems almost to be regarded as a universal good, a manoeuvre that every country would engage in as frequently as possible were it not for fear of tit-for-tat reprisals from other nations.

The key advantage, we're assured, is that it makes exports more competitive. If the US dollar is devalued, US goods will be cheaper, so more of them will be sold, increasing profits and boosting jobs. Champagne all around.

Yet if this chain of events represented such an unalloyed cause for celebration, each poster backing devaluation ought to be equally pleased if their boss were to announce a 5% cut in everybody's wages at their workplace on Monday morning. After all, the effects are equivalent: the wage costs are reduced, so the prices of the goods can be reduced. The company becomes more competitive, sells more goods and can stave off redundancies and/or expand its workforce. The only downside for each worker is the minor one of being paid less.

And being paid less is exactly what happens when your nominal wages stay the same but the currency is devalued. When sterling lost around a quarter of its real value over the course of the last three years, everyone on fixed wages in the UK took a 25% pay cut. Most of them simply didn't realize it.

Of course, it's slightly more complex than that. If a country's currency is devalued rapidly, some domestic prices will stay the same – nominally - for a while. I'm being paid 25% less, but so is Smith the baker, and Smith is charging 25% less – in real terms – for his bread, at least for now. But the cost of imports will rise, affecting many domestic prices, so in due course most people will start to feel as though they've each had a pay cut – which they have.

Our general inability to think of things in real terms (as opposed to nominal terms) is one of the reasons why devaluation is such a useful tool for business. It allows people to be given gradual real pay cuts (simply by not increasing their nominal salary over a period of time) without them complaining about it, whereas almost everybody would complain if a nominal pay cut were imposed upon them while the currency stayed stable. The two are broadly equivalent, but our brains just don't tend to work that way. And sometimes the ability to reduce your workers' wages is vital to keep your company in business. As for an individual business, so for the country as a whole.

But devaluation is also a useful tool for the financially sophisticated to gain a bigger slice of the pie: if you have the ability to lower the real wages of those around you without them noticing, while your real wages stay the same, you can outbid them for real assets and cement your economic (and perhaps political) control. Whilst we can each take refuge in defensive assets so that our savings resist the ravages of inflation, most of us have no direct or rapid control of our level of nominal income. Our incomes will probably move up to counterbalance currency devaluation given a little time, but in the meantime those who can boost their incomes immediately can take advantage of the lag. This is an example of the Cantillon Effect, whereby those who are closest to the source of a recent money supply expansion gain a significant advantage in buying up the real wealth in the economy.

So remember: every time you hear that your currency's value is dropping, and you listen to the celebratory voices of many of those in the business community, keep in mind the fact that you've just been handed a pay cut.

Thursday, January 13, 2011

Are taxes paid proof of contribution made?

One of the standard arguments that is wheeled out every time reform of the finance sector is discussed takes the following form:

We can't risk reforming the finance sector too dramatically: if the banks decide to relocate elsewhere, they will take their enormous tax contributions with them, and we'll have shot ourselves in the foot.

In other words, we may not like the vast riches that bankers award themselves, but we'd be silly to kill the goose that lays the golden eggs: sure, they get paid a lot, and that might make us jealous, but they also contribute a lot, and for that we ought to be grateful. (It's often pointed out that this is the theme of Ayn Rand's Atlas Shrugged: John Galt and his Nietzschian supermen - the wealth creators - grow weary of the parasitic and jealous citizens of more modest talents, and so withdraw from mainstream society to "Galt's Gulch", leaving the jealous masses to consider the consequences of having driven off the greatest contributors to society.)

Here's Jeremy Warner writing recently in The Daily Telegraph:

"Once the myriad business services, IT and other support staff that ride on finance's back are accounted for, the City is responsible for rather more than 20pc of tax revenues. The economy would be in a state of ruin without it."

How valid is Warner's claim? It seems to be a compelling argument at first, especially when applied (as here) to the UK. Take away the finance sector, and you lose a whopping 20% of the current tax base.

The only problem with Warner's conclusion is that it is completely unsubstantiated. He makes one critical (tacit) assumption in the process of arriving at that conclusion: that the finance sector is generating non-zero-sum wealth. In other words, he is assuming that the banks generate wealth that would simply not be there without their presence. But this may or may not be the case. I'm going to argue that Warner's argument lacks rigour and is invalid in its current form.

Let me start off by describing an extreme situation in which somebody can pay huge taxes while contributing nothing at all to the economy, then we'll move on to something a little more realistic, and finally ponder where the banks sit along the spectrum of usefulness versus parasitism.

An extreme example: legalized appropriation

Let's imagine that your country's government has a strange brainwave and decides to allocate a special licence to one individual in the country, at random. The terms of the licence allow its holder to stop anybody they like on the street and demand a payment of ten thousand dollars (/pounds/euros etc) from them, to be paid by the end of the month. The money so taken is treated as income, and is subject to taxation. Because it's so easy to make large sums of money this way, almost all of it falls into the country's highest taxation bracket, which I'll say is 40%.

The licence is given (after a lottery) to somebody called Jones. At the end of the first year following its introduction, Jones has acquired a vast sum of money: let's say that it's ten billion dollars. (Note as an aside that Jones works hard every day to make this sum: she accosts nearly three thousand people a day, powering away like a trojan. Jones is by no means lazy.) Jones therefore pays almost four billion dollars in tax to the government: a huge sum, by anybody's standards.

But what contribution is Jones actually making to the economy?  She can point to the huge level of tax she's paid, and make the claim that she has funded hospitals, schools, the armed forces...surely her four billion dollars powers the economy, making life easier for other people? When it's suggested that Jones has been given unfair powers to acquire money, and that the terms of the licence should be changed, or that she should be taxed more heavily, she makes this counterargument:

If you try to make it harder for me to maintain my current level of income, I will leave the country, taking my tax dollars with me. Indulge your jealousy if you like, but if you drive me away, you will face a loss of four billion dollars from your tax base. Do you really think this is a good idea?

To somebody who didn't understand what Jones was doing to acquire her income, and who only saw the levels of taxation that she contributed, this would be an intuitively plausible argument: Jones pays four billion in tax! That helps our economy! Yet what is Jones's actual contribution?

It's zero.

Jones makes no contribution whatsoever. She simply moves money around. It's the other people in the economy who generate the wealth; she just skims it off. She's able to operate as a parasite. The taxes she paid were earned by others, but the licence allows a situation where somebody examining the ledger at the treasury would think that it was her who had earned the money and made the contribution.

Note, by the way, that it isn't being rich that makes her a parasite. It's the manner in which she acquired the riches that is parasitic. By contrast, the likes of Steve Jobs and Ingvar Kamprad are not parasites. They create real goods and services that people/companies/governments want. Even venture capitalists, who do not create goods and services themselves but facilitate others to do so, are not parasites: they are proto-wealth generators. By contrast, Jones is able to get rich without creating or facilitating any goods or services demanded by the market.

A less extreme example: monopoly

It's not especially likely that any of our governments are going to hand out licences for individuals or companies to take money off others with nothing in return. It seems to offer them no advantages (although I'm going to suggest in a later blog post that this is not necessarily the case), and the public would be able to see clearly how unfair the setup was. But there are ways that economic agents can gain powers that are broadly equivalent to a licenced cash-swiper. Specifically, if an agent is able to extract economic rents, it has the power to charge - and receive - more money for a good or service than it ought to be able to able to in a free and fair market. An obvious example of this is a monopoly: if an agent can prevent rivals from entering a market for a desirable good, it can charge excessively for that good. This ends up being the equivalent of the swiping licence, which is one of the reasons why monopolies are discouraged by government laws and regulations. (In general, good government discourages any activity that allows somebody to get rich without providing anything useful in return. The Chicago economist Gary S. Becker once asserted that the single best reason to discourage theft is that it is inefficient: it requires effort on the part of the thief, yet no value is added to the economy.)

If contributing huge tax receipts was by itself deemed to be proof of the economic value of any given company, monopolies would be encouraged rather than discouraged. After all, a company that has a monopoly will be making much greater tax contributions than one that is not allowed to maintain monopoly powers.

Am I saying that all bankers are de facto thieves?

No. I should make it very clear that I'm not. What I'm arguing here is simply that pointing to the taxes submitted by any individual or corporation at the end of the financial year does not by itself demonstrate that those agents are making a valuable contribution and that the economy would suffer if they stopped doing what they were doing (or moved elsewhere to do it). The licenced money-swiper and the monopolist in our two examples make huge tax contributions, but we can see that their real contribution is zero (or very low). So playing the tax receipts card is an invalid move; you need to do more work than that to show that the entity in question is an asset to the economy. When Warner assents dumbly in response to the finance sector's threats to leave, he's falling for a fallacious argument, and discouraging proper investigation of the matter. 

But do I happen to think that banks are de facto thieves/monopolists? The answer to that question is not pertinent to the argument here. I'll leave that to you to decide for yourself, but most importantly, I hope that you'll recognize that it is a question worth asking.