Western capitalism, and its governments, its instititutions and its corporations, are in deep crisis. The credit crunch is a crisis of trust but the loss of trust goes much further.
This blog is about economics, and how so much of it is based on trust, and I rant about how we can rebuild trust – and build a progressive new capitalism - through the transparency that networked technology now enables.
So nasty Mr Ahmedinejad seems to have prevailed and that nice Mr Moussavi has been robbed.
Or not: one or two more informed commentators have actually pointed out that the official results are in line with the most reliable independent opinion polls. Mr Ahmedinejad may just have won the election fairly.
But no one can be sure. Democracy, like justice, must be seen to be done. If the count had been open and public, as it is in the UK, there would be much less scope for either rigging, or for protesting that the result had been rigged. No one trusts the Iranian election results, not just because they were not what we in the west wanted (as if it has anything to do with us) but because the Iranian people didn’t get to see as much as possible how the results were achieved.
The only part of a secret ballot that should be secret is the bit that links a voting paper with a voter (the bit, in fact, that isn’t secret in the UK, where ballot papers have serial numbers on them); everything else should be as open as possible. If the Iranian authorities embraced openness, they might not have had the levels of protest that they’ve had – and they would still have won the election. Or would they?
Iran, like the US and many European nations, is a divided nation: divided between a rural, reactionary red-neck population, and a liberal metropolitan grouping. Cities, particularly great cosmopolitan cities like London and New York , – and, not yet to quite the same degree, Tehran – tend to be more liberal than the rural areas. And they are growing fast; the world is becoming more urban, and as it does, it becomes more liberal. When the urban majority gets out to vote, as it did for Barack Obama in the US, it tends to win. Iran is a young country, and its intelligent, metropolitan youth will prevail next time round. Or the time after; but eventually, Ahmedinejad’s (and Khameini’s) support base will, like the Republican one, die out.
Continuing my ramblings about commission, I refer you, gentle reader, to my earlier posts about Bernard Madoff.
Madoff operated a classic Ponzi scheme, and in my earlier post I postulated that the market as a whole had done the same to its participants, largely as a result of commission.
A classic, or simple, Ponzi scheme, is an investment product producing above-average returns to early adopters by siphoning-off the deposits made by new investors. So long as the scheme continues to attract new depositors, investors get a good return; but it is as fraudulent as a chain letter. It is, of course, exactly the same thing, but less honest. At least with a chain letter you are told how it works, but the inexorable arithmetic is the same in both cases. Madoff made his scheme last for so long by providing only slightly above-average returns, which both made it seem more credible and extended the time-scale of the inexorable arithmetic.
I think that in addition to the simple Ponzi scheme used by Ponzi, Madoff and many others, it is possible to conceive of complex Ponzi schemes. A simple scheme is implemented in a self-contained financial instrument, whereas a complex scheme does the same thing using multiple instruments where the value flows between them; but from the outside, the effect is the same. A complex scheme could then be either contrived or emergent. In a contrived complex Ponzi scheme, the operators of the various instruments deliberately set out to achieve the Ponzi effect and design them to do so. I think that some of the housing/buy-to-let/mortgage frauds may be contrived complex Ponzi schemes; estate agents, solicitors and mortgage brokers are typically implicated in a conspiracy to defraud.
Much more disturbing, however, is the case of the emergent complex Ponzi scheme. In this case, it is the interaction of various financial instruments, each of which is itself entirely legitimate, which leads to a Ponzi effect. One such instrument might be broker’s commission. Indeed, I suspect it is the main villain in my very strong hunch that most of the financial services sector has been operating for much of the last quarter-century as a very large emergent complex Ponzi scheme. Not a deliberate, criminal enterprise, but one nevertheless where the operators have benefitted enormously as punters have lost. I suspect that it is a property of commission-based sales in savings products that a complex emergent Ponzi scheme is inevitable.
Perhaps there is evidence for this, but I think that first I need an adequate algebra to make the case and then to derive relations which can be tested against available metrics.
Time to give those “poor” MPs a rest, and consider another issue which might be germane.
Most insurance-based savings products, such as pensions and endowments, are sold on commission. There is a saying in the insurance industry that insurance is never bought, it is always sold.
In the recession of the early 1980s, and again in the early 1990s, commission-based sales jobs were always on offer. You could earn a lot of money selling life-insurance, but most people I knew were never so desperate as to sacrifice their integrity that far. The jobs were entitled “financial adviser”, but the only skill the “adviser” needed was rote-perfect knowledge of the policy sales pitch. The jobs were sales jobs, pure and simple: If you didn’t sell any policies, you didn’t make any money, and to the punter, commission was the hidden cost of “free” financial advice. “Advisers” were forbidden to disclose the level of their commission; so since solicitors were required by the Law Society fully to account to their clients for any commission they were paid on products bought on their behalf, many life companies refused to sell through solicitors.
Some time before that, the cosy City club of life insurers had an agreement about the maximum levels of commission they would pay their sales people. Today, such an agreement would be unlawful; but back then, it was binding on its members. However, a small City merchant bank, Hambros, set up a life department and didn’t join the life insurer’s club. After all, Hambros were already a member of the Accepting Houses Committee (which had nothing to do with life insurance, but was another cosy City club). Hambros decided to ignore the maximum commission rule, and pay its sales team much higher commission than anyone else. This was a very successful strategy, and Hambro Life quickly became bigger than its parent. Hambro Life eventually became Allied Dunbar. The interesting thing about this is that Hambro Life grew its market share only by paying its sales staff high commission. It had nothing to do with the benefits to policy holders.
All the major life offices paid commission to their sales staff. The main exception was the Equitable Life, whose sales staff were paid salaries. Unfortunately, shorn of the incentive of commission, they were less succesful, so the Equitable resorted to sweetening its sales offering with a promise (a guaranteed annuity rate) that would eventually destroy the organisation.
The lack of transparency in commissions led to many abuses. Various systems of regulation were imposed over the years, with the life offices fiercely resisting commission disclosure for years. Now, however, commission must in most cases be disclosed. There is no such thing as free financial advice, and independent financial advisers started charging fees, offsetting them against the commission they received.
One of the biggest problems emerged with endowment mortgages. Endowment mortgages used to be quite a good idea, for tax reasons. There used to be a 50% tax credit for life insurance premiums, and there was also full tax relief on mortgage interest. So if you took out an interest only loan, the interest is payable in full for the full period of the loan, and the tax relief would be continuing, whereas with a repayment mortgage the interest (and thus the tax relief) reduces over time. Tie in an endowment policy, with its 50% tax relief, to deal with the principal of the loan, and you had a product that, in theory at least, could save the borrower some tax. However, tax credit on life insurance premiums was abolished in the 1980s, and mortgage interest tax relief was curtailed (it, too, is now abolished). This made endowment mortgages much less efficient; but they were entrenched. Estate agents were paid commission for arranging endowment mortgages; lenders regarded the additional security of a life policy as justification for increasing the loan-to-value ratio beyond the 85% with which they had been comfortable in the past, and everyone benefitted, except of course those who bought such policies. It quickly became apparent that they were never going to pay out the full value, and it was clear that most endowment mortgages sold after about 1988 were mis-sold. Many of the brokers who mis-sold them were commission-only agents. My partner and I were one of many victims of this; we received no compensation because we had changed the mortgage to a repayment basis and weren’t going to suffer unduly. Apart from having a life policy that we had bought on the firm assurance (an express promise from the long-vanished broker) that on maturity it would pay out at least the full value of the mortgage, and is worth less than we have paid for it in total. The endowment fiasco was certainly a prime example of commission-based sales causing market failure.
Endowments and pension products are basically the same thing. Commission disclosure seems to me to be a sine qua non for any commission-based sales, but I would say that wouldn’t I, and it’s not really enough. After all, when I bought my duff endowment mortgage, I knew the broker was going to get most of my first year’s endowment contributions, even if I didn’t know exactly how much; I still bought the policy. The problem is that it inevitably distorts “best advice”. There are rules about what financial advice advisers can give, which de-skills them and reduces a complex subject to a series of regulated tick-boxes. It’s going to be hard for a broker or adviser to advise against buying a savings product, even if objectively such advice is the best for the client concerned, when to do so means that he will not be paid. It demands an unrealistic expectation of the adviser’s integrity.
Commission creates a short-term/long-term mismatch, and this is really where it goes wrong. I’m talking here just about long-term regular savings contracts like endowments and money-purchase pensions, but we will see how the problem extends to all commission based sales, including vanilla stockbroking. As a saver, my interests lie in the long-term performance of the product, whereas my adviser’s interests like in the attached commission. Twenty-five years’ time matters for me, not for the broker. So a first step could be to require an alignment of interests. If my broker is to get commission, it should be paid in the form of units in the fund backing the policy he sells me. If he needs money now, he can borrow it at commercial rates against the security of those units, just as I have done for my mortgage.
Transparency is all over the papers these days, with the Daily Telegraph’s release of the details of individual MPs’ expenses claims – in a neatly orchestrated release showing the Telegraph’s political leanings.
It is being touted that (under a system yet to be set up, and pre-empting the decisions of the Kelly review) expenses should be audited by a new body, independent of Parliament. It is, of course, a stupid idea. Firstly, no body can ever be independent of Parliament, because Parliament as our representative is the sovereign body of the Kingdom. To whom will this new auditing body be accountable, if not to Parliament?
But there is a much cheaper, and much simpler solution, which requires no quango and no expensive quangocrat to run it. Simply, every claim an MP makes for reimbursement of expenses must be published before it can be paid. With the receipt. And an explanation of why the claimed expenses are wholly necessary towards the performance of parliamentary duties.
We, the people, are the true sovereigns of the nation; our MPs must be accountable to us. If they publish their expenses claims, we can audit them ourselves.
Even with post-hoc publication, which is now inevitable, MPs are going to be a lot more circumspect about their expenses claims than they were in the past. But prior publication will be an even more effective discipline. In fact, I shall be making a submission to Kelly directly.
The chancellor’s muddled and unremarkable budget has introduced lots of bad things (it was a very good day for the tax advising profession: more complex tax systems mean more work for them, not more money for the state), but I just want to comment on “Efficiency Savings”.
It seems to me that this is never more than a convenient balancing item in government budgets. Add up the money in, add up the money out, and the difference you call “Efficiency Savings”. You make all sorts of claims that by being better at running Government, you will be able to save money. “Efficiency Savings” are never credible; but there’s slightly more justification for opposition parties to claim that they’ll be able to introduce them. But if the government of the day, with twelve years of office behind it, claims that it will make some £9bn of efficiency savings, the only rational answer is to ask why they’ve allowed £9bn of inefficient expenditure to continue for so long.
If the running of government was a lot more transparent – if we could examine the books of every department, online, in real time – we could help the government and the opposition make those efficiency savings; it wouldn’t take much sleuthing by some of the more dogged newshounds of the traditional press and the blogosphere to find those egregious departmental expenditures on fruit and flowers or whatever. The population at large is an untapped resource, which for far less money than the National Audit Office costs to run, will be far more effective.
The Liberal Democrats have today announced a new tax policy.
As tax policies go, it’s not bad – a step in the right direction, but it’s still an attempt to patch up a broken system rather than create a better one. The LD’s objectives – to make taxation fairer and more progressive, by eliminating loopholes and exemptions – are admirable; but will struggle when the problem isn’t in the tax code, but the tax base.
Income, while it might seem the most obvious thing to tax, is very difficult – because it’s hard to measure. The tax system differentiates income and capital gains, and taxes one at a lower rate. The lib dems have said that under their new policy they will be taxed at the same rate. But while capital gains tax has its own system of allowances, there will still be tax-avoidance hay to be made by deciding whether a particular dob of dough is income or capital gains.
The answer: tax it all as cashflow. No arguments, a lot less work for tax advisers.
In my opinion, much of the evil that besets our modern economy can be laid at the feet of joint-stock corporations – that is, companies. Limited liability creates moral hazard, and cuts conscience (which cannot be measured in the currencies by which corporations account for their actions) adrift.
But this is not an excuse for taxing corporations. There are two reasons it is wrong to tax corporations. Firstly, it is undemocratic. A democratic society should tax only its voters (remember the Bostonians: “no taxation without representation”), and corporations do not have a vote. Politically, of course, it is easier to tax bodies which do not vote, but that does not make it right.
The second reason corporations should not be taxed is that corporation tax is regressive. In a progressive tax system, the profits of a corporation should be taxed via their members. A corporation is nothing more than a collection of people, its shareholders. Not all shareholders are fat cats; many, in fact, are pensioners, or those saving for a pension. Some, however, are indeed fat cats. Now, in a progressive tax system, the fat cats should pay proportionately more than the pensioners. But if you tax the corporation, they all pay the same. Corporate taxes benefit fat cats, and damage pensioners.
On the other hand, corporations are not conscionable persons. The have a mythical legal personality, but without a conscience can have no human rights. So they have – or should have – no right to privacy, nor have any power to enforce any obligation of confidentiality. Corporations should be absolutely transparent in their dealings. This transparency is the price that a corporation should be made to pay for the privilege of not paying tax.
The other day I was talking about tax reform – a favourite subject of mine – with a couple of bright American friends. As he poured himself another large glass of red wine, one friend said, “It’s obvious – we should start by taxing sin”.
The other agreed, and both were much more content with the soundbite than willing to engage with my arguments in favour of Cashflow Taxation, so – as the red wine was dulling our collective intelligence – I let the matter drop, and the ranting moved on to something else.
Taxing sin, though, is a really rotten basis for a tax policy. It might have its merits as a means of controlling sin, but it’s rubbish for raising revenue – and the worst thing about it is that it’s regressive, leastways if you count the most obvious sins of tobacco and alcohol. There was a doctor the other week suggesting that chocolate should be taxed, because it’s making us all diabetic. Which is nonsense in so many ways. If you were to ask me what I think is responsible for the epidemic of type 2 diabetes, I’d say pop: particularly the practice of feeding children sugary drinks when they are thirsty. Never mind the chocolate, it’s the calories in ‘beena and pop hitting a metabolism that hasn’t yet registered hunger that cause the damage. And it’s not the chocolate but the sugar it contains that’s the trouble. So we should, perhaps, add sugar to the list of sinful items ripe for punitive and deterrent taxation. Jolly good, another way to tax the poor without feeling guilty about it. An even better wheeze than the National Lottery!
These days, of course, the worst sin of all is being environunfriendly; and before the credit-crunch hit home, all the main parties were talking about “green taxes” as a virtuous, and painful only in the right places, way of raising money. The same criticisms apply. Green taxes are a good thing if they mean we change our behaviour, but they hit the poorest hardest because poor people tend to spend a larger proportion of their income on fuel. So to stop them being regressive, green taxes have to be accompanied by a complicated programme of countervailing subsidies – such as free home insulation – which will absorb much of the revenue raised. Consequently, as everyone insulates their home and behaves more greenly virtuously in other ways, the tax take falls.
Since we choose to live in a society which spends thirty or forty percent of its income on universal state-provided goods and services such as education, health and defence, we need to find a lot more money than sin taxes can possibly raise. By all means, tax sin as part of a sin reduction strategy; but if it works, it’ll be the lack of funds that lead to closing hospitals, not the lack of patients. Mainstream funding still needs to come from mainstream economic activity.
Today, the British body politic is outraged at the discovery that Sir Fred Goodwin, the former chief executive of the Royal Bank of Scotland, is – at the age of 50 – drawing a pension of £650,ooo per annum. Heck, most of us would be more than happy with a twenty-fifth of that from age 70; but then we haven’t by our actions brought the economy to its knees and forced the government to take over the bank we were charged with running.
As the details emerge, it seems that there was no obligation to pay this pension now; he would, it is true, have been entitled to it from retirement age, but because he was asked to resign, he was, at the discretion of the Board, allowed to draw it immediately.
The Board could and should have sacked him. The failure of his fiduciary obligations to shareholders alone would surely have been sufficient; and even Sir Fred could surely not have had the chutzpah to sue for unfair dismissal. But the chairman, Sir Tom McKillop, chose to do a mate a favour. After all, corporate thieves must stick together; and Sir Tom, by not just firing Sir Fred, has compounded the insult to shareholders and taxpayers.
But the failure of corporate governance goes much wider than just the overpayment to a fat cat. In the wider scheme of things, the £16m of Sir Fred’s pension pot is but a drop in the ocean; even if it were all recouped it would amount to barely 0.2% of the trading losses made last year, under Sir Fred’s stewardship. It is undoubtedly wrong that he should get that money, but it is a symptom, not the cause of the problem.
The Government, non-execs, auditors, fund managers and other institutional shareholders all believed the story that Sir Fred’s wondrous salary was worthwhile, because he was so good at his job. But the Emperor has no clothes; many of us have been saying so for years, and the only reason the vain courtiers did not is that they were all complicit in the fraud.
Enough of the vitriol. I hope Sir Fred will prove me wrong, do the decent thing, donate his pension to the starving, and get a job stacking shelves in Morrisons until he is really too old to work. I sha’n't hold my breath.
But I shall continue to argue for much deeper reforms to corporate governance in all sectors. Boards need to be properly accountable to their shareholders. It is a convenient legal fiction that says that the shareholders are the company; the truth is that the company is, first and foremost, its managers and senior executives. Shareholders are merely a source of capital; the objective of the management is to pay them as little as possible, whilst paying themselves as much as they can legally get away with. The law does its best to make sure that other stakeholders – shareholders, employees, bondholders, customers – aren’t ripped off too badly, and auditors in particular are supposed to make sure that the accounts are kept properly, but everyone who was supposed to be keeping things in balance was – to a greater or lesser extent – in on the scam.
Now here’s a suggestion: company directors should get paid only the minimum wage, per hour, for their work, with the balance, up to the market rate for the job, paid in equities which vest (and can thus be cashed in) at a rate of 10% of the outstanding balance per annum. You see what I’m trying to do? I’m trying to align the interests of directors with those of shareholders. Naturally, they’re in opposition, which is why you need corporate law, and the principle of fiduciary duty, to force them together. But that hasn’t been working very well recently, so we need to look at it differently.
But
