A New Era of Monetary Policy

Over the last few years, monetary policy has changed dramatically. Newspapers are littered with terms such as interest rates, money supply and quantitative easing. If you are new to Economics, and interested by what all this means, this may be a good article for you.

This blog explains the basics behind monetary policy before exploring how it has evolved over recent years. I finish with evaluating “forward guidance”, a new monetary policy introduced by Mark Carney, the governor of the Bank of England (BoE).

What is an interest rate?

An interest rate is simply the cost of money (or the price of borrowing money), where ‘money’ is literally the banknotes in your wallet or the balance in your checking account. There are obviously many interest rates, however, when a central bank sets the interest rate, it is referring to the (risk-free) short-term rate on cash deposits, such as the overnight rate between banks.

The most basic economic concept is that in all markets, the price of a good is the equilibrium between supply and demand. An excess demand over supply will lead to a price rise until demand equals supply again and the opposite is true for an excess supply. The money market is no different. People and firms demand money for transactions and the central bank supplies it. Since the interest rate is the price of money, it sits where money demand is equal to money supply. If money supply outstrips money demand, the interest rate will fall until a new equilibrium is reached. Therefore when a central bank says they are reducing an interest rate, what they are really doing, behind the scenes, is increasing the supply of money. By injecting more money into the system, the price of money (i.e. the interest rate) falls.

Conventional Monetary Policy

Prior to the recession, conventional monetary policy involved the BoE simply setting the interest rate (the base rate) each month. If the bank wanted to reduce the rate (for example down to its current level of 0.5%), it would do so by increasing money supply. The BoE does this by buying safe, short-term assets, usually government bonds, from the market. It pays for these assets with money hence increasing the amount of money in the system (increasing liquidity) and reducing the interest rate, as explained above.

The reason the BoE reduced the interest rate so dramatically was to boost the UK economy. The idea is that a reduction in interest rates would encourage spending over saving. A consumer’s return to saving (and the opportunity cost of holding money) falls. Consumer spending is the largest part of GDP and hence the most important factor in boosting an economy. Lower interest rates also encourage a to firm invest more since the cost of financing that investment has fallen. Furthermore, the demand for the pound falls as interest rates fall, depreciating the currency. This in turn increases demand for imports and decreases demand for exports, improving the trade balance. All these factors contribute towards growth.

With any policy come the unintended consequences, which in this case, is inflation. As aggregate demand increases so does the general price level. In fact, the BoE have an inflation target of 2% and must do the very opposite (increase the interest rate) if inflation is too high.  High inflation can be dangerous for an economy for several reasons.

More importantly, excessive monetary policy can lead to a ‘liquidity trap’. This occurs when increasing the money supply can no longer reduce the interest rate. When an economy’s interest rate is close to zero, a central bank can no longer reduce it. Most economies found themselves in this position during the financial crisis, which made them turn to other unconventional methods of boosting the economy, such as quantitative easing.

Quantitative Easing

Many economies turned to QE when rates could be lowered no more. On a very basic level, this involves the central bank buying longer-term and therefore riskier assets, such as longer-term government bonds (gilts). They do this simply by printing money. Technically, this is not true. Central banks use banks as intermediaries. In effect, banks buy longer-term assets from financial institutions, which they in turn sell to the central bank in return for a higher reserve balance (a bank account that a bank holds with the BoE!)

The whole point of this is to reduce longer-term interest rates (‘further out on the yield curve’) and increase the supply of money further.  Conventional monetary policy focused only on short-term interest rates. Although lower short-term rates can feed through to longer-term rates, this is a more direct way of doing so. 

Since yields on government bonds have fallen, is it cheaper for companies to raise capital - lower longer-term interest rates encourage even more investment. As long-term returns to fixed income products fall, investors turn to the stock market instead for better returns, boosting share prices. Most importantly, the hope is that those firms that have sold their assets, spend the money they receive. As banks increase their reserve balances, the hope is that they also will lend more, leading to cheaper long term borrowing costs for the consumer. In the UK, the asset purchase facility (QE) stands at £375bn.

The problem with QE is that if there is no spare capacity to absorb the increase in spending, the policy can be dangerously inflationary. Printing money can lead to hyperinflation such as in Germany in the 1920s post WW1.

Furthermore banks may not lend out their additional reserves (cash hoarding) and institutions may sit on the extra cash without re-investing. There is no policy to force these institutions to spend the increase in money supply.

Forward Guidance

Mark Carney, the new governor of the BoE, was made famous for forward guidance when he implemented it in Canada. He has now done so in the UK. The idea is simple promise. Carney has promised the UK that he will not increase interest rates until unemployment falls below 7% (currently at 7.8%). This has very similar effects to QE. It flattens the yield curve, or in other words, reduces longer-term interest rates and expectations of future interest rates. Carney said he does not expect the interest rate to rise until at least 2016.

Forward guidance is supposed to provide the markets with reassurance and confidence. It allows firms to invest knowing they will not be hit with higher costs of financing their debt in the medium-term and encourages consumers to buy mortgages with the knowledge rates will stay low for a while yet. In summary, it increases spending and borrowing.

Yet the FTSE tumbled and the opposite happened when forward guidance was announced. The first reason for this was that Carney anchored an interest rate change to another variable – unemployment. Tying a future rate rise to the level of unemployment leads to a lot of uncertainty. Firms and consumers cannot accurately predict when unemployment will fall to 7%. In fact, the markets believe that the BoE is far too pessimistic and are predicting a rate rise much sooner in 2015. It also makes a mockery of the monthly unemployment statistics as firms and net borrowers sit and hope that the jobless remain jobless so that rates do not rise. The more optimistic view of the markets hence meant that the yield curve was not flattened as much as Carney would have liked.

Furthermore, there are too many get-out clauses that make the date of a rate rise far too unpredictable. If medium-term inflation expectations become too high then rates will rise. As we have seen, low interest rates cause inflation. With inflation currently at 2.9%, markets fear that this get-out clause is a possibility. Furthermore, the Financial Policy Committee (FPC) can force a rate rise if they believe the policy causes “potential systematic risks”. In other words, the rate can be raised at any time.

My conclusion on forward guidance therefore is that it is a great idea if it is bold. If you can make a credible commitment to keep rates low for a certain amount of time, like he did in Canada, then forward guidance can have the intended consequences. Albeit very risky, a promise such as “I will not raise the interest rate until 2016,” would certainly have the desired effects if credible. However, by tying it to the unemployment statistics and providing too many get-out clauses, the policy does not do much at all. In fact, all has done is bring forward the markets’ expectation of when rates will rise.

Immigration – Dispelling the Myths & Ignoring the Ignorance

Humans have an innate desire to place blame and find a scapegoat. It therefore does not surprise me that immigration in the UK is a touchy subject when it absolutely should not be. The UK, now more than ever, is in dire need of a large influx of immigration yet David Cameron has succumbed to the irrational public pressure to reduce it. This is a perfect example of politics interfering with sound economics.

The conservative party wants to limit net immigration to 100,000 people per year. It has already tightened the rules and imposed a cap on student visas and set a limit for non-EU skilled immigration. Luckily nothing can be done about EU immigrants who have a right to migrate, but even this, which accounts for a third of net migration, may come under scrutiny following a future EU referendum.

Let’s be clear. Immigration in a globally competitive world is fundamentally good and in the case of the UK, absolutely necessary. UK net immigration needs to increase not decrease. The Office for Budget Responsibility (OBR) has been clear on this. UK demographics are changing and our population is ageing. In order to prevent the UK from going bankrupt, we require a large influx of immigrants to pay off our overwhelming debt burden through taxes and work.

Usually anti-immigration arguments are riddled with myths, ignorance and xenophobia. It is time to dispel the myths of immigration so we can overcome the ignorance.

Dispelling the Myths

“Immigrants cost us money”

Perhaps the most common and factually incorrect argument is that immigrants cost the UK taxpayer money. The anti-immigration clan fall back on the idea that many immigrants sponge off the state and use the UK as a health or benefit tourist destination. This is wholly untrue and to some extent simply racist propaganda.

Of course there are the few that abuse the system just like there are a minority of UK citizens that do so as well. Yet the overwhelming majority of immigrants are of working age and hold jobs. They pay taxes, national insurance and contribute to spending and our GDP. Most are skilled and many hold university degrees or equivalents. Immigrants add to the economy, increase productivity, increase the flow of ideas and innovation, improve trade links and add new specialisations to a rather one-dimensional economy. Most importantly, as the OECD explains, immigrants without a doubt put more into the pot than they take out.

It is for these reasons that the OBR has recently published a report saying that the UK requires an influx of immigrants to sustain public finances and counteract a talent shortage. The UK is an ageing population. The OBR says that a net of 140,000 migrants per year from 2016 would lead to a net debt to GDP ratio of 99% by 2062. With zero net migration, however, it will rise to an obscene 174%. To maintain the UK 2.75% long-term trend growth, we need the same immigration levels as when Britain was opened up to Poland. Sir Alan Budd calculates that due to changing demographics, trend growth will naturally fall to 2% (an almost 30% decrease in the long run growth rate), unless immigration increases.

State pensions, social care and healthcare will rise from 14% of GDP to almost a fifth in the near future.  Immigrants can pay for this. Hard-working, productive, tax-paying immigrants, usually in jobs that they are far too qualified to be in can fill the gap. If the Tories continue with their plans, a lack of immigration will completely counteract years of austerity and put the UK public finances back in the same dire position.

Of course, a larger population of immigrants leads to larger NHS and welfare costs. The point is not to focus on only the costs when the benefits so obviously outweigh them. Immigration pays for itself and so much more. Many argue that immigrants from the EU, who are free to move, abuse our health and benefits system. But this is also simply not true for the majority. EU immigrants are, on average, younger and more likely to be in work than a native. Ironically, Spain suffers from elderly Brits spending their later years on its beaches.

 A lot of the skepticism towards immigration is simple scapegoating. Something that I hope will one day be eradicated by globalistion and subsequent acceptance of other races. Immigration does not cause recessions. Recessions are caused by bubbles, greed, stupidity, risk taking and poor judgments.  In fact, immigrants can smooth the costs of a recession for those countries that are lucky enough to attract workers to their labour supply.

“Immigrants take our jobs”

A very right wing argument and once again simply not true. To be fairly crude, lets separate migrants into skilled and unskilled workers. You may be surprised to know that 40% of all UK migrants actually hold a university qualification, which is much better than for the rest of the EU. A large majority hold at least a vocational qualification or similar. Skilled workers are highly demanded around the world for obvious reasons and any country would be extremely jealous of the UK’s influx of such a precious commodity. Skilled workers can only add to the economy whether it is through better products, new skills, a new comparative advantage or greater competitiveness of the UK. Either way, a more productive workforce can only increase the standard of living in an economy.

In the UK, construction workers are in fact in very short supply. With rising demand for property, especially with the government’s new Help to Buy scheme, the UK needs more construction workers to fill the supply gap. Without immigration, rising demand may be met with higher prices rather than a larger supply.

As for unskilled workers, most end up in roles that pay near minimum wage. These are jobs that locals are unwilling to take. It is not the case that unskilled workers are pushing down wages and replacing UK natives. Locals are simply not willing to work at the going wage rate. If this is the case, then I see no reason why UK companies should hire equally or less skilled natives for more money than they are worth. If an unskilled worker refuses to work at the competitive wage then the UK needs unskilled immigrants to fill the gap.

“Abuse our educational system”

This one is less frequent but completely illogical. Education is one of the UK’s greatest exports and I strongly believe that it is a grave mistake to limit student visas. Foreign student fees are much higher than Home fees. It is thanks to a large inflow of foreign students that universities are allowed to flourish and stay afloat. Even if a foreign student moves on after her education, she has still invested a large amount of money in the UK educational system.

Furthermore, it is often the case that foreign students stay in the UK and go on to become highly skilled workers here. This is a win-win for the UK. We charge these students extortionately high prices and they then go on to pay taxes and add to the UK economy afterwards. In a highly globalised world, the country with the most productive workforce will usually prosper.

“Too many people”

The idea that immigration leads to overpopulation is misleading. Net immigration, after the EU was established, averaged at 214,000 per year up until 2011. It then hit 165,000 in 2012, which is a modest 0.3% of our population. This is a lower level than Italy or Spain. With an ageing population and lower birth rates than previous decades, this inflow will hardly have a substantial effect on overcrowding. Thanks to large outflows as well, the UK population will not grow any faster than the rest of the world.

As for language, I find it amusing that people become agitated that an immigrant’s first language may not be English. English is still the second most widely spoken language (behind Mandarin) and the most used language in the business world. It is not going anywhere. Immigrants moving to the UK must learn the language to prosper (and be granted entry). So what if it is their second language?

Conclusion

My conclusion in simple. Increase net migration and focus on more pertinent issues. If abuse of the welfare system or the NHS is a concern, then improve controls and the efficiency of the system. Prevent the ease of tax avoidance of the wealthy and encourage new specialisations. Continue to promote the UK as an exporter of education. These will all help to improve future public finances.

Politicians know the benefits of immigration but capping it wins votes. If only politicians could ignore the ignorance, the UK economy would be much better off in the long run.

Rationality and Failing Economics

Do you prefer A or B in each of the following:

(1)  A: 61% chance of winning £5,200 or B: 63% chance of winning £5,000

(2)  A: 98% chance of winning £5,200 or B: 100% chance of winning £5,000

Social sciences evolve over time and Economics is no exception. Being a subjective discipline in many respects, economic theory is constantly being created, modified, rejected and accepted. Theories that were widely accepted for centuries can be discredited by a new data set and entire new sub-disciplines can develop from a single publication.

I therefore find it astonishing that Economics is so resistant to changes at its very core. Economists refuse to budge when it comes to criticisms of the foundations of the discipline, even in the face of damning evidence. At the very centre of most economic theory sits two things: Expected Utility Theory and a concept of rationality, both of which are fundamentally flawed. Even in the presence of overwhelming, undeniable evidence, these two theories form the basis of most economic theory. Undergraduates are still taught the subject using these concepts as the building blocks for the rest of their course.

Expected Utility theory is about decision making. It posits that humans are risk averse and that their “utility” (or happiness) directly depends on their level of wealth. It argues, quite sensibly, that every additional pound you earn adds less to your happiness than the last pound. This is intuitive, £100 to £101 has a larger marginal effect on your happiness than £1000 to £1001.  Rational choice theory views people as selfish, materially interested agents that maximize their utility. A rational person can consume all relevant information and accurately assess their costs and benefits to make decisions. Most importantly, people make consistent choices. Agents understand their preferences and can aptly make decisions. If an individual prefers ice creams to chocolates and chocolates to fruit then he certainly prefers ice creams to fruit.

Obviously this is an unrealistic view of human nature and economists use these as simplifying assumptions in their models to understand human behaviour. Unfortunately this one-size-fits-all ideal is unrealistic. They study “Econs” and not Humans. Of course it makes sense to assume a Human makes consistent choices, but any exceptions to the rule are labeled as irrational and subsequently ignored. Instead, Economics needs to start studying Humans and adapt their definition of rationality accordingly.

Many economists have challenged the status quo over the last century. Behavioural Economics is a sub-subsection of subject that uses psychology in conjunction with economic theory. For example, experiments have shown that a Human’s utility does not depend on the level of their wealth but on changes in their wealth. This seems obvious. A millionaire would definitely be more disappointed to find his wealth stood at half a million than a individual who was previously bankrupt.

What fascinates me the most is that Behavioural economists have highlighted many flaws to the convention yet the discipline is still resistant to change. All exceptions to the rule or predictable irrationalities are simply banished to the sub-discpline of Behavioural Economics.  This is the equivalent of a mathematician using the rule that 2+2=5 in all of her calculations and then adding a footnote that says in fact 2+2 may actually equal 4. Economists prefer to assume their concept of “rationality” and analyse what would happen in an ideal world where the oddities of inconsistency do not exist.

Having read Daniel Kahneman’s ‘Thinking Fast and Slow’ I have been enriched with examples that leave economists dumfounded. Many of the examples below are directly from his book, which I strongly recommend.

Allais Paradox

I gave you a question at the start of this article. If you are like most people then you chose A in (1) and B in (2). You probably thought I might as well go for the higher amount in (1), after all there is only a 2% difference in chance. However, in (2), I can have £5,000 with certainty so why risk the gamble at all? This logic seems incredibly fair, but it is completely irrational according to economists. The reason being that the chances of winning both prizes have increased by the same amount (37%) in both cases. If you preferred A in (1) then a consistent choice would be A in (2).  The chance of winning the larger amount has increased by the same percentage as the smaller amount, so why switch to the smaller amount?

Behavioural economists associate this irregularity with the effect of certainty and regret. Humans wildly underestimate high probabilities in the presence of certainty. The weight people place on the 2% difference in each case is much larger in question (2). Furthermore, the regret effect would not be present in (1). If you win nothing in (2) by choosing to gamble you would probably kick yourself for taking the risk at all. The decisions most people make are of course inconsistent but I would not describe what the majority do here as irrational. They did not fit the rule because the rule does not consider the effect of certainty and emotions. The rule needs to change. This famous example shocked economists when first introduced, but once again, was written off as an unusual exception to consistent behaviour.

Interestingly, at the other end of the spectrum, the idea of overweighting small odds explains why a lot of people play the lottery and gamble. When the probability of something increases from 0% to 1%, there is a possibility effect. Humans tend to overweigh the 1% and this leads to risk seeking behaviour. For example, if I gave you the choice between simply taking £500 now or a gamble that offers you 50-50 odds on winning £1000 or nothing, then being risk averse, you will probably choose the certain £500. However, if I lowered the odds, and offered you £10 with certainty or a 1% chance of £1000, you will almost definitely take on the gamble. But in both cases, the gamble and certainty have the same expected value and a risk averse individual should always prefer the certain money. The possibility of the large prize and the smaller certain amount leads to inconsistency (you’re a Human, not an Econ!).

Linda & Karl

My favourite example that perfectly illustrates a human’s capacity to be completely illogical is taken straight from Kahneman’s book. Consider the fictional character Linda below:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Given the description, now rank the following scenarios in order of likelihood:

1)    Linda is a teacher in elementary school

2    Linda is part of a feminist movement

3)    Linda is an investment banker

4)    Linda is social worker

5)    Linda is an investment banker and part of a feminist movement

Given her description, most people would not be surprised if Linda were a social worker, part of a feminist movement or even a teacher and these are usually ranked very highly. The study investigates the other two scenarios (3&5). Most respondents thought it very unlikely that Linda was an investment banker. They were more likely to believe that Linda was an investment banker and part of a feminist movement, which at least agrees with part of her description. If you were like 90% of the respondents, you would have ranked 5 above 3. 

For those of you who understand Venn diagrams, you may have already guessed this is utterly illogical. All investment bankers who are also part of feminist movement wholly belong to the set of investment bankers. No individual can apply to scenario 5 without applying to scenario 3 whereas there are obviously investment bankers who are not part of a feminist movement. The probability of 3 is without question larger than 5 regardless of the description.  This is an obvious failure of human reasoning but it is widespread. Humans tend to focus on the representativeness of the situation rather than statistics. Statistics and logical thinking take time and the law of least effort will force you to jump to the illogical conclusion with confidence. Of course at closer look, it is absurd to rank 5 above 3.

A similar failure to focus on statistics is of Karl who lives in the US:

Karl is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.

Is Karl more likely to be a librarian or farmer?

An intuitive answer jumps straight for librarian. The description fits the stereotype. Yet people fail to factor in the base statistics. There are 20 male farmers for every librarian in the US. Even if you believe that the description above is 20 times more likely to represent a librarian than a farmer, you should still choose a farmer. An Econ would have used this thought process. However, you did not consider the base statistics, even if you knew them, because Humans prefer to focus on the fitting story of representativeness whilst statistics fall by the wayside.

Framing

There is a disease that will kill 600 people in the next year. The government has two options:

A)    If they adopt procedure A, 200 lives will be saved

B)    If they adopt procedure B, there is a one-third probability that 600 people will be saved and a two-third probability nobody will be saved

The expected value of saved lives in both procedures is 200, but most people prefer not to take the gamble and choose procedure A. There is an aspect of regret if B is chosen and an effect of certainty in procedure A. However, when the procedures are reworded and presented to another group the results are startling:

A)    If they adopt procedure A, 400 people will die

B)    If they adopt procedure B, there is a one-third probability that nobody will die and a two-third probability that 600 people will die

The procedures have not changed but they have been ‘framed’ differently. If you are like most of the respondents, you probably will prefer the gamble this time. The effect of regret disappears as option A is now guaranteeing a certainty of deaths rather than lives saved. This is completely inconsistent. Economics cannot deal with emotions like this. When the two groups are shown the other frame, most people struggle to decide which procedure to choose. Which one would you choose given both frames? Framing is important in reality which is why many food manufacturers write “90% fat free” rather than “10% fat” or why a doctor will tell you there is a “95% survival rate” rather than a “5% mortality rate.” Framing also occurs when using numbers instead of percentages. A dog rescue appeal will not tell you that 0.1% of dogs are neglected but will instead say that 1 dog in 1,000 are left neglected. It invokes an image of a single neglected dog and has been proven to raise larger donations.

Regression to the mean

Humans fail to understand how important luck is in our lives, something an Econ would never do. In an Israeli army training camp that Kahneman visited, the captain was adamant that it was better to shout at an officer who had performed terribly rather than praise an officer who had been exceptional. He had found that those he shouted always performed better next time round and those he praised always did worse. This was a gold mine for Kahneman.

The captain had made up a casual story in his head that somehow praise lead to complacency and aggression instilled a fear of repetition. However, the results he found can be simply explained by statistics. There are two things involved in performance: skill and luck. There is no doubt that skills are involved when an officer performs well, but unless that officer is consistently exceptional, there is always a large amount of good luck involved. Therefore, when he praised an outstanding officer whose performance subsequently dropped, this was not due to complacency, but due to less luck and the same amount of skill. In mathematical terms, this officer had regressed towards the mean (moving towards his average). When the captain shouted at recruits and they subsequently improved, this is because they had better luck and the same skill the following time. They regressed towards the mean once again. Of course skill is important but people rarely put enough weight on the value of luck.

Anchors

Was Ghandi older than 35 years old when he died?

How old was Ghandi when he died?

Answer the above questions and note your answer. Unless you know the answer for sure, the first question almost certainly affected the second answer. If the first question had been was Ghandi younger than 130 years old when he died, your answer would have almost certainly been higher for the second question. The first question should have no importance on the second but your mind was anchored to 35. It has been shown that people tend to focus on the arbitrary number provided and move away from it until they find a sensible answer. Anchoring is a clever negotiation technique used by firms, unions and governments.

Time to change

Expected Utility theory and rational choice theory isn’t all bad. It provides a framework for the discipline and has some intuitive suggestions. It provides a base for theoretical work in which we can slowly adjust assumptions to reach realistic conclusions. Economics needs a base and it is unrealistic to incorporate all human “irrationality” into every model.

However, there are some instances, as described above, that are so predictably irrational that it is absurd not to adapt our baseline. Given the overwhelming evidence, only some of which I have summarised here, surely it is time for Economics to incorporate Humans, even slightly, into their model of rationality. It is no longer acceptable to label the inconsistent majority as irrational. Economics is a study of human behaviour and economists must realise that Econs differ from Humans in many respects. As Ariely once said, Economics “makes the man fit the model rather than the other way around.” It is time for this to change.

Should We Cap Bankers' Bonuses?

George Osborne’s move to reject the bonus cap proposal is a brave one. Brave but correct. He will receive a lot of stick from a banker-bashing electorate, but by not succumbing to public pressure, he has voted with the UK’s best interest at heart. A banker bonus cap is purely political. Whilst it would win a lot of public approval, it would severely damage the UK in the short, medium and long run. The only problem is that that UK is isolated. Out-voted 26-to-1, a bonus cap is almost a formality unless Osborne can gain some allies before the vote in April.

The bonus cap proposal is a result of the European parliament trying to assert some authority as we move one step closer to a banking union. The idea is to cap banker bonuses at 100% of base salary or 200% if shareholders agree. It is perhaps quite convenient that the news of a bonus cap was quickly followed by RBS’s announcement of a £607m bonus pool despite £5.2bn losses. Is it fair that a bank, which is 81% owned by the taxpayer, should reward their staff handsomely for a 400% increase in losses?

Most of the EU says absolutely not, hence the proposal’s overwhelming support. The UK however, whose financial sector makes up 10% of its GDP and is the biggest hub within Europe, can see past the political support to the catastrophic unintended consequences that will result. So much so that the UK is even considering the ‘Luxembourg compromise’ from EU law, which allows a member state to block a majority decision if it is against national interest.

Why cap bonuses?

A common mistake is to think that a bonus cap is about fairness and equality. Many would argue that obscene banker bonuses need capping simply because they are unfair or need to be brought down in line with the rest of the economy. This is simply not the case. Nations have voting, taxation and redistribution at their disposal to alter income inequality and to determine how rich the rich can be. If the reason were purely political then this is an entirely different ‘Hayek vs Marx’ debate. Neo-Keynesian economics and capitalism urge the state not to intervene in competitive markets unless there is a market failure, especially with a draconian policy such as a salary cap.

The reason for the cap proposal is because there was a market failure. One of the reasons for the financial crisis was too much risk-taking. As explained before, it is the state’s role in a capitalist society to step in to correct market failures. In this case, to prevent future recessions. The idea is that extreme bonuses, many multiples of a base salary, lead to a short-termism that encourages banks and employees to take on too much risk. CEOs have very short life spans and bonuses distort their incentives. It is thought that this short-term outlook and the search for better returns at the expense of higher risk was a key factor in the collapse of the financial sector.

So the argument follows that capping bonuses would reverse these incentives, create longer-term goals and reduce risk-taking. There is also the accountability argument that links back to RBS. Bonuses are paid out even though the company is mostly state-owned and has performed poorly. In this case, it seems sensible that the shareholders should be able to prevent extreme bonuses. Until the bank is returned to private hands or to profitability, there is an argument to say that bonuses are simply not morally acceptable.

These arguments are fair. I do believe that bonuses are extreme and sometimes ironically unjust. But a bonus cap is still a bad idea….

Avoid a Cap

Vehemently opposing a bonus cap is the only option the UK has. A bonus cap should only be introduced if it makes the residents of the UK economy better off. If your arguing it should be done because it involves some sense of retribution or punishment towards banks then you’re a biting your nose off to spite your face. The reason being that a cap will make the UK economy worse off and no more protected from a financial crisis. (Also while we are at it, we should probably be punishing the regulators, state, rating agencies and indebted consumers).

The reason for too much risk-taking in the financial services industry is because banks are “too big too fail.” The security of a bailout leads to a moral hazard that encourages too much risk-taking. The bonuses in itself are not enough to create a risk culture and are in fact a result of and not a cause of the moral hazard. 

The lead up to the financial crisis was a period of low interest rates and a savings glut. In the search for better returns, banks looked for new ideas. Securitisation was one of them. Securitisation on its own is not a bad thing. In fact it allows companies to reduce and hedge risk. However, this new invention was coupled with two other factors. The first is a dangerous lack of knowledge of the products being created from governments, consumers and even banks. The second is the protection of a bailout. This lead to excessive risk-taking without any true understanding of what was happening until ex-post. The point is that the risk-taking in the financial sector is not originating from high bonuses. High bonuses are just another result of moral hazard.

In fact, banks pay high bonuses in order to stay competitive and attract the best talent. After all, the firm’s capital is their staff’s ability. Whether you like it or not, this is the culture of the industry. Unless a bonus cap is global, it will be hugely detrimental to the UK.

Here is what it will do... It will drive away talent in something called a brain drain. Over time, new financial hubs will flourish such as Singapore, Hong-Kong, China and the US. As the best talent moves away from London, the EU banking sector will lose competitiveness and restrict EU growth. Are we really considering damaging our true comparative advantage? We will be simply handing our competitors the golden snitch.

The only way UK firms would be able to keep their staff is by enlarging base salaries many times over (allowing for bigger nominal bonuses in turn). This is what happened with RBS. Restricted by the taxpayer, a graduate joining RBS could earn up to £60K, much more than the going rate at bulge bracket firms. So bonuses may not even reduce the amount a banker will be paid. In fact, bankers will go home at yearend with the same six-figure salary but with fewer incentives to do well. With pay a lot less related to performance, you divert incentives in the complete opposite direction. Bonuses also allow for flexibility which large base salaries do not. We have to remember that banks are in the business of risk management. We do not completely want to strip banks of the incentive to search for risk and return. It is this search for risk that allows banks to loan to small and medium-sized companies.

Here is another key factor. Even if bonuses do encourage risk-taking, we are not immune to financial meltdowns from outside of Europe as proved by this recession. If banks paying large bonuses outside the EU cause excessive risk-taking and a global meltdown then that will hit the UK. The world is far too globalised to believe that individual trading blocs alone can prevent a global recession.

What should be done instead?

What needs to be done is to align the incentives of bankers and the general economy. This can be done through regulation. We need to remove the moral hazard of a ‘too big to fail’ mentality. This involves installing a set of rules that mean banks can cover their losses and will find it hard to take on enough risk in the first place.

This is already happening. Basel III is the new regulatory framework that has come down from the G20 (a global level). It is currently being implemented in the EU. It involves increasing Tier 1 capital level, improving liquidity and leverage. It has banned proprietary trading (Volcker rule) and has proposed to ring-fence retails arms. Whilst I believe the regulation may have gone too far, this is the sort of regulation that will make banks robust enough to cover the losses of a recession or prevent it in the first place.

If the EU cannot overcome the urge to alter salaries within the industry, then there are methods other than a damaging salary cap. For example, the remuneration code in the UK ensures banks must pay at least 50% of bonuses in shares (or options), which creates a longer-term employee view. It mandates that 40-60% of bonuses must be deferred for 3-5 years and also allows banks to legally claw back bonuses preventing future negligence and inducing accountability.

These rules and the Basel III regulation will prevent risk-taking over the new few years, perhaps even by too much. Robust banks are less likely to fail and capital buffers mean banks will absorb a lot more of the losses. The legislation is already in place and being processed. An additional bonus cap is purely political. It will damage the UK economy, restrict growth and make everybody worse off.

In a period where the UK is desperately looking for growth, let’s not implement rules that will push talent away and destroy our comparative advantage.