No Stress IV: The flaws in the Bank of England’s 2018 stress tests

A new paper by Kevin Dowd, Professor of Professor of Finance and Economics at Durham University and Senior Fellow at the ASI, explains the inadequacy of the Bank of England’s stress tests and argues that the UK’s banking system is still an accident waiting to happen:

• The Bank of England has now undertaken five annual concurrent stress tests of the financial health of the UK banking system. Like their successors, the 2018 stress tests continue the Bank’s fine tradition of trying to persuade us that the UK banking system is strong when the evidence suggests otherwise. Their results are wholly lacking in credibility.

• The stress tests are compromised by:

  • Conflicted objectives,

  • An inadequate number of stress scenarios,

  • Low pass standards,

  • Reliance on unreliable metrics, and

  • Questionable modelling.

• Their key stressed capital ratios, projected impairment charges, and house price losses are too low to be believable.

• The results from the stress tests are contradicted by the evidence from banks’ latest balance sheets and market prices, which show that banks are weak now, before any stress, rather than strong after a future stress that is supposedly more severe than the GFC.

• The continuing weakness of UK banks after a long economic recovery is testimony to the failure of the Bank of England to perform its core function and rebuild the strength of the banking system after the trauma of the crisis.

Safeguarding Progress: The risks of internet regulation

A new paper by Matthew Lesh, the ASI’s Head of Research, and Sam Dumitriu and Philip Salter of the The Entrepreneurs Network, makes the case for a free, open internet:

• Technology is improving our lives, connecting people, creating communities and contributing to Britain’s economy to the tune of £170bn a year.

• The policy environment is becoming increasingly hostile to technology, undermining the free exploration of ideas and innovation that is essential to economic progress.

• If policymakers want to encourage entrepreneurship they should embrace a culture of ‘permissionless innovation’.

  • Permissionless innovation means allowing entrepreneurs to experiment with new business models and technologies, and only intervening when there are clear, demonstrable harms to the public. 

  • Growing calls to regulate the internet risk undermining progress and threaten the future of the internet and the digital economy.

• Platform liability exemptions are essential to the fabric of the internet, and promote free speech and enterprise.

  • The exemption of platforms, such as Google and Facebook, from liability for the activity of their users was essential for the development of the internet, and digital innovation, and has delivered massive benefits for consumers.

  • Laws forcing platforms to be liable for user content to restrict hate speech have prompted social media companies to engage in excessively risk-averse moderation, threatening freedom of expression. Further measures such as the EU’s new Copyright Directive threaten the capacity of ‘creators’ to remix copyrighted content and share memes, while the Online Harms White Paper is a serious threat to free expression.

• Internet red tape undermines small business, competition, and entrepreneurial activity

  • There is intense competition within the technology sector, including between large online platforms and from startups and small businesses. Platforms help stimulate entrepreneurial activity by providing Corporate Venture Capital and opportunities for exit.

  • Controls such as excessive data regulations, by creating barriers to entry and excessive costs, are particularly harmful to startups and small-to-medium sized enterprises (SMEs) that have lesser financial capacity for compliance.

The report also explains that if the Government wants to achieve an open, competitive and entrepreneurial online space they would do well to follow these Five Principles for Permissionless Innovation:

1. Identify and remove barriers to entry and innovation;

2. Protect freedom of speech and entrepreneurship by retaining immunities for intermediaries from liability;

3. Rely on existing legal solutions, the common law, and competitive pressures to solve problems. 

4. Push for industry self-regulation and best practices.

5. Adopt targeted, limited legal measures for truly hard problems based on evidence.

The Magic Money Tree: The case against Modern Monetary Theory

A new paper by Professor Antony P. Mueller, a German professor of economics who currently teaches in Brazil, unpacks the logic behind Modern Monetary Theory:

• Modern Monetary Theory (MMT) contends that government can spend without restraint and large deficits and debt don’t matter when the economy is not at full capacity. It asserts that the state, as the issuer of the nation’s currency, cannot go bankrupt because it can just keep creating and printing money; taxation exists not to obtain revenue but to oblige people to use a nation’s currency and control inflation; and that all public expenditure can be financed by debt or creating money.

• MMT, whose theoretical foundations can be linked to the Marxist economic theories of Michal Kalecki, have come to prominence in recent months because of advocacy by the far-left of the Democratic Party in the United States and some left-wing commentators and campaigners in the United Kingdom.

• MMT advocacy, particularly in the political sphere, is often driven by Utopian thinking by those who want massive unaffordable public spending programmes.

• MMT is rejected by most economists. A recent survey by the University of Chicago found that no economic expert thinks that countries that borrow in their own currency need not worry about deficits because they can print money to finance debt. Similarly, none thought that it is possible to fund as much real government spending as you want by creating money.

• There are a number of serious flaws in MMT:

  • MMT asserts, with limited evidence, that there is substantial unused economic capacity that government spending can activate. However, in practice, when government excessively expands the monetary supply (prints money) the impact is inflationary, if not hyperinflationary - as was the case in the Weimar Republic, Zimbabwe, and today in Venezuela.

  • MMT depends on governments knowing much more than they possibly could and acting more rationally than politics allows. It depends on government knowing precisely the natural rate of unemployment, and therefore when to spend, to stimulate activity, and when to tax, to drain the excessive inflationary impact of creating money. This ignores ignorance.

  • MMT is premised on substantial public employment policies to create economic activity for the unemployed. This policy underestimates the bureaucratic costs and the coordination problems that come with public employment policies. Only autocratic governments would have the means to enforce such policies.

Beyond the Call of Duty

• There is about £7.5 trillion worth of property in the UK, but we tax it in strange and inconsistent ways: residential council tax is regressive and its valuation system hasn’t been updated since 1993; businesses pay at high rates; and homeowners pay rapidly escalating transactions taxes (stamp duty land tax), but private residences are part-exempted from inheritance tax and exempted from capital gains tax.
• Transactions taxes are widely seen as especially damaging levies by economists: a representative Australian government review found their stamp duty destroyed 75p of wealth per £1 raised.
• This makes stamp duty land tax around 4x more harmful per pound than income tax and 8x more harmful than VAT; some alternative taxes, like a carbon tax, would have small economic benefits rather than harming efficiency.
• Taxing housing transactions keeps people in houses that are either too small, too big, or too far away from jobs, which are especially harmful when the housing supply is so tight, as it is in the UK today.
• In the short term the Treasury should abolish SDLT and replace the lost revenues by reforming council tax – fixing the regressive top end of the system with a more proportional, or even progressive, tax on rental and imputed rental values would bring in the needed revenues easily, with far smaller economic costs.
• Eventually the UK should rationalise its property taxation system by abolishing SDLT altogether, and then rolling council tax, and business rates into one system, with everyone paying the same rate, set at roughly 20% of imputed rental income, comparable to extending VAT to property services. This would be roughly fiscally neutral on a static analysis, but may lead to large increases in revenue over time, which should be used to reduce other taxes.
• The UK should consider decentralising property taxation, but this is a separate step which does not need to be considered simultaneously. Abolishing SDLT is attractive whether or not the overall local taxation and governance system is reformed.

Read the whole paper.

Against the National Living Wage

• The National Living Wage, announced in the 2015 Autumn Statement and effective from 1 April 2016, effectively takes control of the Minimum Wage out of the hands of the Low Pay Commission and gives it to the government.
• Whereas the LPC had a mandate to balance both pay and employment concerns, free from political pressure, the issue is now politicised.
• There are worries that abandoning this framework will threaten employment: the Office for Budget Responsibility projected last year that 60,000 fewer jobs will be created under this regime than the previous status quo.
• This paper reviews the empirical evidence on the direct and indirect impacts of increases to the Minimum Wage.

Read the whole paper here.