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The credit crunch: an effect not a cause

Robert Henderson

 How did we get  into this economic hole?

What we are experiencing is a direct consequence of the dominant economic ideology of the age, laissez faire, an ideology which underpins the general political ideology of political elites in the West, the form of liberal internationalism we call globalism.

This neo-Liberal mentality has brought us to the brink of what is probably the most dangerous economic crisis since the Depression. Perhaps it may turn out to be even more disastrous because countries throughout the world (including Britain) are now so much less self-sufficient than they were in the 1930s, while the scope and speed of communications are beyond anything in existence during the Depression.

Most problematic are the immense and entirely novel opportunities permitted by digital technology, a technological development particularly pertinent to the money markets which are at the root of the credit crunch. No one remotely understands the medium-term let alone the long-term implications for the money markets of the creation of a universal market for every form of financial instrument, which is what the Internet potentially provides, or its potential for destabilising currencies. All that can be done at present is to guess, and guessing when the lives and prosperity of entire populations are at stake is a criminally reckless gamble.

 The consequences  of Thatcherism 

There have been outbreaks of  free market and free trade ideological  dominance in Britain from  the 1840s onwards,  but  since  Margaret Thatcher came to power in 1979 the worship of the laissez faire god has become more devout than ever.

Thatcher introduced something quite new. For the first time in history, a British prime minister and government actively welcomed the wholesale destruction of strategically important industries on the grounds that they could not compete. The doctrine of comparative advantage was pursued by the government in an advanced economy to a degree never previously seen. At the same time she emasculated the unions and began

recklessly selling the family silver with  her introduction of  the idea of privatisation which rapidly placed  almost all of the important nationalised industries in private hands.

Mrs Thatcher was also responsible for one great political act of folly in the name of laissez faire when she successfully fought for the Single European Market. The consequence of this was to rob Britain of its ability to favour its own industry economically (beyond what was already being done) and gave any citizen of another EU country the same rights as a British citizen to be employed in Britain or for any foreign corporation to bid for any public sector contract offered in Britain.

Her ultimate triumph was not only to drive the anti-laissez faire strain from her own party, ( a strain which had survived during previous bouts of  laissez faire dominance) but to eventually force the rest of the British political mainstream to follow suit. The upshot today is that the three major political parties in Britain have as articles of faith both a commitment to free trade and the belief that private enterprise is preferable to public provision in virtually every area or life.

The latter belief has created a novel situation in Britain. Great swathes of economic activity which were once controlled by the state – everything from the great nationalised industries to prisons – have been either sold off or contracted out to private companies.  Once privatised, these erstwhile public operations have become prey to foreigners. Because of post-1979 British governments’ commitment to laissez faire, anyone is allowed to purchase any British company, no matter its strategic importance, and most public contracts are given to the highest bidder regardless of their provenance. Nor in most instances (because of Britain’s membership of the EU) can the privatised industries be subsidised by the taxpayer, a particularly telling restriction in the case of the old public utilities when energy prices are rocketing.

Today, British utilities such as gas, electricity and water are largely in foreign hands, our major airports are owned by Spaniards, we no longer have serious mining or shipbuilding industries, and our largest native owned car manufacturer is the company which produces the Reliant Robin. In addition, many of the iconic names of British business – Bentley, Roll-Royce cars, Tetley Tea, ICI, Cunard, British Steel – have fallen to foreign buyers, while the supposed flagship of the British economy – the City of London – has seen the wholesale transfer of British merchant banks to foreign ownership. The present government has even stood sanguinely by while the London Stock Exchange has come under persistent foreign take-over attempts.

What the credit crunch  is not about

It is not about levels of government spending, although that is probably the next great economic shock which will hit Britain as the economy slows, tax revenues stagnate, the  Public Sector Borrowing Requirement grows and the Enron-style ‘off the books accounting’ involved in the Public Private Partnership (PPP) and Private Finance Initiative (PFI) schemes becomes impossible to hide.

What this crisis is about is the virtually unrestrained working of private enterprise, which has created a titanic pile of indebtedness ranging from dangerously generous mortgages to unsecured debt, much of it promiscuously and casually granted with a significant proportion going to people providing false information.

At the heart of the crisis lies the bundling of risky loans (especially mortgages in the United States – the so-called sub-prime mortgages) into financial packages. These have  been sold on and treated not as toxic debt but much better quality debt, debt which could be used by the banks as collateral against which to borrow. Eventually the game was up as people (especially in the United States) began defaulting on payments and banks stopped lending freely to one another because much of the debt they held was seen for what it was, toxic. Banks had to write off bewilderingly large amounts in bad debts and their store of useable collateral to set against future loans was much reduced.

This crisis is a peculiarly difficult thing for free marketers to explain. They cannot rationally blame it on too much government interference, because British financial institutions have been allowed to run their affairs largely unchecked by government for the better part of a quarter of a century, a process begun by the Thatcher governments when they threw away credit controls, permitted the de-mutualisation of building societies and their transformation into banks (which placed them under less rigorous rules regarding what they could borrow and lend) and generally slackened financial controls and state oversight.

These practices have been assiduously followed by successor British governments, who have failed to control the development of exotic financial instruments such as derivatives and by relinquishing the power to set Bank Rate (Bank Rate being, in theory at least, set by a body independent of the government, the Monetary Policy Committee (MPC) of the Bank of England) and by embracing fiscal restraints imposed by the EU, such as restrictions on state aid to industry and restrictions on the setting of VAT rates.

The upshot is that the present government is left with only two very general means of controlling the economy, the variation of taxation and of government borrowing and spending. These are hopelessly inadequate instruments to deal efficiently with the multifarious financial problems which arise in an advanced economy. For example, if  credit is growing too fast, raising taxes to take money out of the economy may actually fuel further borrowing, at least in the short term, as people try to service the debts they have and to maintain their standard of living, while the additional taxation will have the unwanted extra effect of depressing the economy.

Alternatively, cutting taxes could conceivably reduce borrowing, although human nature being what it is people might actually feel more confident about the future and hence even more willing to borrow. However, even if such action reduces borrowing it will tend to worsen inflation because the amount of money put into the economy will probably be larger than any reduction in borrowing.

The setting of Bank Rate by the MPC is arguably a third weapon in the government’s armoury, because the MPC works to a narrow government set remit of controlling inflation within certain limits and the government has a considerable say, both directly and indirectly, in the appointments to the MPC. The behaviour of the MPC in crisis conditions suggests that they will do what they think politicians want rather than sticking to their remit. For example, they have dropped interest rates in the past eight months when inflation is rising. However, even if the setting of Bank Rate is a third weapon in the hands of the British government, it suffers from the same deficiency as the other two, namely, that it is too broad a measure to deal with many economic difficulties. Worse, since the credit crunch began, the interest rates charged by the banks and other lenders (especially on mortgages) have not shadowed the reductions in Bank Rate as history suggests they should do, but have stayed stubbornly and significantly above Bank Rate.

Of course, all economic interventions by governments have consequences which go beyond the narrow desired ends of the intervention, but the more economic weapons in a government’s hands, the greater the likelihood that they will be able to find one which is best suited to solve a particular problem with the minimum of unwonted side effects. For example, if the multiplier of salary for mortgages had remained by law no more than two times salary throughout the past quarter century, the housing market would have been pegged back by what most people could afford to borrow.

The money supply

There is a vital technical reason why government should control credit: it increases the money supply. To understand why this is of fundamental  importance, it is necessary to comprehend  what constitutes money, a concept which is far from straightforward in the modern world and growing more complex by the day.

A currency based on precious metals formed into coins is a relatively simple thing, because it is to a large degree self-regulating. The practices of debasing the quality of the metal or of clipping the edges of coins to remove some of the metal may be common, but such things can be tested objectively by anyone with the requisite knowledge, for example, by weighing the coin.  Moreover, the amount of physical money is limited by the availability of the precious metal(s) used in the currency.

Once a country moves from a physical currency based entirely on a precious metal to one which remains, in theory at least, fully convertible to the precious metal but which uses paper money alongside coins made of the precious metal, government’s role is expanded in importance because it is ultimately the guarantor of the currency’s integrity.

The final stage of physical money is when the link between a precious metal and the currency is broken and the entire currency rests upon trust. At that point a currency is entirely at the mercy of governments because there is no natural restraint on how much money is printed or coined in base metals.

Describing physical money is the easy bit. The concept of money becomes complicated the first time someone makes a loan. That has the same effect as someone depositing money with a bank: where one person had the money before, now two have it. Once a society develops a banking system, government needs to intervene both because of potential fraud and an expansion of the money supply. That applies in principle even in a supposedly 100% precious metal based currency, because even then there are primitive financial instruments such as bills of exchange which effectively act as money.

The more advanced a society is, the less important physical cash becomes as the instruments by which the money supply is multiplied increases. To see what a confused state we are in today we need only reflect on some of the various measures of the money supply which have been used in modern times in attempts to quantify the money supply:

1        M0 is the total of coins and notes in circulation plus banks’ deposits at the Bank of England.

2        M1 is M0 plus current account deposits

3        M3 is M1 plus all other types of bank accounts (deposit accounts, foreign currency accounts, public sector accounts)

But there are many other financial products which none of these measures catches that

arguably have aspects of money. Anything which can be readily traded for money can in effect be used as money in certain circumstances: shares, the vast array of derivatives, debt itself. For example, if I wish to buy a house in theory I could do so by swapping shares I own for the house.

The Northern Rock Debacle

September 2007 saw the first run on a British bank since the 19th Century with people literally queuing round the block to get their money out. A converted building society, Northern Rock, had been operating a reckless business plan whereby their core business of mortgages was predominantly funded not by deposits but by borrowing on the money markets. When the credit market tightened, Northern Rock were left stranded and were forced to go to the Bank of England (BoE) as the lender of the last resort, which made a loan of 25 billion to them.

Once that news became public, the panic began and the government was forced to guarantee all Northern Rock deposits which committed the taxpayer to a further £25 billion, a total of £50 billion including the loan. The Government then left the bank in limbo until February 2008 as it desperately tried to find a private buyer for the bank. Eventually, it had to admit defeat and nationalised the bank, exposing the taxpayer to another £50 billion of risk as it took over responsibility for the bank’s mortgage book. The taxpayer is now in for a potential liability of £100 billion. To put the scale of the risk in context, the  Treasury  Red Book forecast  for total government expenditure in 2008/9 is £617 billion, so the Northern Rock risk amounts to around 18% of total Government expenditure for this financial year.

All this is worrying enough but just imagine what will happen if a few more banks go belly-up. It is as reckless an act by a chancellor as you can find in British history, for not only are massive liabilities being put around the neck of the entire population, a precedent has been set. If other banks (and quite possibly much larger banks) get into the same position, it is difficult to see how the government could underwrite another Northern Rock let alone one of the clearing banks, especially in the light of the extensive borrowing facilities the BoE has extended to the banks generally. Of course, we are constantly told by the government that the taxpayer is not really at risk as the assets of Northern Rock are solid and that the loans extended to banks generally are held against sound collateral and will cost the banks a pretty penny in a premium on the interest rate they pay. Frankly, why should we believe them when the government cannot even give a guarantee of when the Northern Rock liabilities will be cleared.

Yet it is difficult to see what else the chancellor could have done. If Northern Rock had folded, the rest of the banking sector would have been placed in real danger. The position was not helped by the drawn-out attempt to find a private buyer for Northern Rock (a symptom of the laissez faire mindset of the Government), but that was merely a detail, not the heart of the problem. Had the government nationalised the bank immediately the problem was known, the liabilities would still be on the taxpayer. The scandal is that the lax credit situation was allowed to arise, something which could have been prevented by proper government behaviour over the past quarter of a century.

The developing crisis

Not only have governments been forced in practice to abandon laissez faire, there have been few if any calls for the central banks to stand back and do nothing. Even in the case of Northern Rock the supporters of the “invisible hand” have been loath to let it go to the wall.

Faced with the dangerous mess they created, the banks and big business asked the government to rescue them. The consequence is that the ordinary person gets the worst of all worlds, for they not only have to suffer a contracting of the credit market, but they also have to fund the rescue of financial institutions, either directly in the case of Northern Rock by nationalisation or indirectly through the extension of credit by the Bank of England (as lender of the last resort) to introduce money into the market for the financial institutions to borrow. The ordinary citizen also has to pay in terms of lost jobs, lower pay, poorer conditions and higher prices.

Commercial banks throughout the developed world have run squealing for help to governments, while the major Western central banks have reacted with behaviour ranging from the dramatic to the reluctant. The Federal Reserve has led the way, slashing interest rates dramatically and making tens of billions of dollars in loans to the banks available to the money markets, much of it on distinctly questionable collateral. The European Central Bank (ECB) has been more cautious on interest rates but has also made vast sums in loans available to banks.

Britain has somewhat tardily followed suit, reducing Bank Rate by three quarters of a per cent since September and belatedly providing billions in loans to the banks on collateral of ever decreasing value. The disquieting thing is that no matter what action has been taken, the flow of credit remains stubbornly locked and governments, including Britain’s, are reduced to throwing more and more money at the banks with less and less assurance that the money the taxpayer is risking will ever be repaid.

On 19 April it was reported (for example, The Daily Telegraph) that not only will the Bank of England inject a further £50 billion into the market with the banks using some of the sub-prime mortgage products they invested as collateral, but that the British government will also underwrite credit card debts held by the banks – all this on top of the eye-watering Northern Rock liabilities.

The most frightening thing about the crisis

The truly frightening thing about this crisis is that the people who are supposed best to understand the financial markets, the central bankers, are completely at sea. The Bank of England (BoE) has admitted that its understanding of the money markets is inadequate. Amid accusations that it failed to respond quickly enough to the crisis at Northern Rock, the Bank has admitted that it is struggling to determine the impact of the credit meltdown on the economy.  Charles Bean, chief economist, said assessing conditions in the economy is “subject to considerable uncertainty”. Writing in the Bank’s quarterly bulletin, Mr Bean also stated “One important step in analysing monetary demand and supply shocks involves improving the Bank’s information about credit conditions”.

The Bank’s admission that it needs to improve its understanding of the credit markets comes as John McFall, chairman of the Treasury Select Committee, voiced his frustration following the appearance of Bank of England staff before the Parliamentary watchdog. In an interview with The Daily Telegraph, Mr McFall said: “The responses that people gave were unconvincing as a whole. I’m looking at the system and asking the question: Is it working? And it’s not working” (The Daily Telegraph, “We don’t understand the markets, BoE admits”, by Jonathan Sibun, 24 September 2007).

A failure of oversight by central banks both here and abroad has been compounded by the long period of very low interest rates led by the central bank rates of the leading currencies, most notably by the Federal Reserve (“the Fed”) in the USA, which kept money too cheap for a long time, thus encouraging people to borrow. The prime author of this cheap money was Alan Greenspan, who was treated with quasi-religious awe by politicians and so-called financial experts alike while he was running the Fed. Come the credit crunch and the knives came out for him, vide the famous American monetarist Professor Anna Schwartz: “It is clear that monetary policy was too accommodative. Rates of one per cent were bound to encourage all kinds of risky behaviour…..the Fed failed to confront something that was evident. It can’t be blamed on global events” (Daily Telegraph, 13 January 2008).

The inability of everyone from bankers to governments to provide a solution or even understand what is happening is palpable. In April, Gordon Brown ordered a “summit” with bankers to discuss a way out of the mess and his chancellor Alistair Darling railed against the irresponsibility of the banks for reckless lending, carefully overlooking government’s irresponsibility in this area. Massive amounts of public money have been ploughed in ever more desperately, without the squeeze on lending loosening – “The Bank confirmed it would swap treasury bills for premium asset backed debt owned by the banks. Banks have six months to use the facility. The swap is for 12 months and banks can ask for two year-long extensions, making a total of three years….. The Bank has put no ceiling on the scheme” (Daily Telegraph, 22 April 2008, “Banks hail £50bn boost to liquidity”). That it has had no effect is unsurprising, because the banks have used the money to shore up the holes in their balance sheets.

The effects of the credit crisis

The entire economy is rudely affected by a sudden shortage of credit. Apart from hyperinflation, there is no more toxic disease which can affect a modern economy, especially one dependent on consumer spending. The reduced availability of credit at any price causes an economic slowdown. More expensive credit causes people and organisations to draw in their borrowing horns. The reduction in the amount of money available to spend reduces demand. Reduced demand and more expensive credit drives down profits at best and puts companies out of business at worst. Wages are depressed and jobs are lost. This reduces demand even further.

People habituated to debt find they cannot service what they owe, and default. That is especially important in an economy like modern Britain’s where a large number of people have built their lives on a continuous stream of credit. Things which are heavily dependent on credit, most notably property, lose value. People either cannot pay their mortgage or find them selves unable to sell at all or that the price they could get would be much less than they owe on the property. Even those who are do not end up in a position of negative equity find they have great difficulty in selling both because prospective buyers cannot get a mortgage or because other people are unwilling to sell. Those wishing to move, especially if they wish to trade up, find they cannot easily get a new and larger mortgage.

Britain is more exposed to recession than most because her economy is built primarily on consumer spending, much of which is on non-necessities. Such an economy is inherently more fragile than one which is primarily rooted in the production and consumption of necessities because it is very responsive to changes in economic circumstances. In the language of economists, demand for much of what is purchased in Britain is very elastic.

The economic fragility of most peoples lives

Ever since Harold MacMillan famously declared in 1959 that “We’ve never had it so good”, British politicians have been religiously telling Britons that they are getting wealthier. To support this claim they point to such things as the growth in owner-occupation, the myriad of electronic consumer goods, holidays taken abroad and cost of living indices such as the Retail Price Index (RPI) and the CPI.

Most people have tended to take this at face value until fairly recently. They have ignored the fact if it takes two incomes to maintain a family where one was sufficient before, that is not wealthier. That if most people cannot afford to get on the housing ladder when once they could, that is not wealthier. That if the price of most essentials is rocketing that is not wealthier. And that if the Government uses bogus cost of living indices which ignore housing costs and council tax that is not a true measure of purchasing power.

Data released by the Office of National Statistics showed that household incomes fell last year in real terms, and have risen by only £2.25 a year on average since 2001. The reality is worse because these figures are based on the bogus CPI measure, which excludes housing  costs and council tax . In addition, a majority of the British population do not have savings which would allow them to survive for two months if they lost their jobs, and a large segment of the population lives on incomes well below the average wage, which is still below £30,000. A true recession will consequently hit millions of people very hard indeed.

How do we escape this mess?

The honest answer is there is no certain escape. Nor is a ‘soft’ economic landing likely. Circumstances are forcing more prudent lending behaviour onto private financial institutions, with substantial deposits being required before mortgages are granted, the feckless multipliers of six or seven times salary for mortgages vanishing, credit card limits being reduced, cards withdrawn and new card applications being refused. Unsecured personal loans are being subjected to the same type of scrutiny. The problem is that this is all happening in a rush which creates a tremendous shock to the economic system rather than a controlled decline of credit.

All this will probably cause a sharp contraction in the economy.  This creates a dilemma for the BoE. Its remit is to keep inflation close to 2% as measured by the Consumer Price Index (CPI). Inflation is significantly above that and showing every sign of rising. According to its remit, the Bank should be raising rates not lowering them. Yet the BoE has cut Bank Rate by three quarters of one percent already and is being urged universally by private business and many politicians to cut further and quickly. The likely outcome of such a policy would be our old friend stagflation. Indicatively, the growth in UK output was down to a miserly 0.4% in the first quarter of 2008.

The great problem is the dependence of housing to drive the economy. There is consequently no painless way out of our present predicament. If house prices are kept high by low levels of house building and continuing mass immigration an entire generation will find them selves stranded in a no man’s land where they cannot find good rented accommodation at a reasonable price.

Contrariwise, if there is a correction which brings housing within the reach of first-time buyers we shall have a massive problem of negative equity which will mean existing home owners cannot move and if their homes are re-possessed, being burdened with ongoing debts as their homes are sold for less than they owe. That is the bind governments over the past quarter century have got us into.

What can be done to make a safer future?

There needs to be a sea-change in the mentality of politicians. They need to recognise that government has a vital role in controlling the economy, not via the heavy hand of nationalisation or hideously complicated regulatory regimes, but by simple and effective measures such as restrictions on credit and the use of exotic financial instruments and the protection of strategic industries such as farming and energy supply.

Back to the future is the answer. We need to create a different moral climate. As little as 30 years ago, people still tended to look upon debt as something to be avoided. For the most part people saved up for things they wanted. Part of that caution was enforced because credit was nowhere as readily available as it is now although we were already into the age of the credit card. But much of the frugality was simply cultural; people had been brought up to feel debt was something loathsome and bankruptcy next door to theft. This was a Britain where the morally vital mechanism of shame still had its place.

The credit which was on offer almost always came with some strong strings attached. If you wanted a mortgage you had to save with a building society for quite some time to establish your credentials. When a mortgage was eventually granted, the amount you could borrow was restricted both absolutely (there was an upper ceiling of £13,000 in the 1970s) and by sensible multipliers of household income (commonly twice income and often the mortgage multiplier was applied only to the main wage earner’s pay). 100% mortgages or anything approaching them were not to be found. A deposit of 10% of the property’s price would have been the minimum required and in many cases more would have been asked. Bank loans required a similar establishment of creditworthiness over a decent period and credit card limits were modest. If anything was bought on hire purchase, a substantial deposit was required. The consequence of such a regime was that far fewer people got into serious financial trouble than today.

1        Here accordingly are a few examples of what might be done. Mortgages – the multiplier of salary used to calculate mortgages should be a maximum of three and a minimum deposit of ten per cent required. The re-mortgaging of owner-occupied property to release capital and buy-to-let mortgages should be outlawed.

2        Hire purchase – a minimum of 20% deposit with the monthly repayment no more than ten per cent of the monthly net pay (net pay to be that left after deduction tax, National Insurance and the repayment of any existing debts).

3        Personal loans other than mortgages – a maximum of 10% of net income.

There is also a need to tighten up checks on creditworthiness. Lenders have been incredibly lax about the information that prospective borrowers supply to them. That is a particular problem with credit card issuers who tend to accept whatever the lender says, but it is also a significant problem with mortgages with people allowed to self-certificate their earnings in some cases. The laxity has its roots in the belief by the lenders that they can reliably calculate the percentage of borrowers who are poor credit risks who will default and in the case of loans secured against property, that house prices will continue to rise rapidly, thus increasing the equity the borrower has in the property. The events of the past year have shown that lenders cannot reliably make calculations of defaulters nor rely on house price inflation to increase equity.

What now?

Is there a chance that the laissez-faire mentality of the elite will change and that common sense will prevail? Or will we stagger on in this ideological straightjacket until a true catastrophe strikes?

On the level of common humanity the hope must be that the crisis is contained reasonably quickly, although I think that unlikely. (I am writing this article in May 2008. By the time it is published the danger of a full blown depression may have been averted, although that is improbable because after more than eight months of increasingly desperate governmental pump priming around the developed world there is no sign that the credit crunch is lessening, let alone coming to an end. )

But there is danger in a rapid resolution for if it happens the underlying reasons for this economic trauma may not be addressed by those responsible for the operation of the economy and things will go on as before until the next crisis occurs. The credit crunch is simply the latest in a line of dangerous economic crises stretching back a century an a half which were brought about by the same fundamental problem, the abdication of government responsibility for the economy.

Robotics and the real (sorry, Karl, you got it wrong) final crisis of capitalism

Robert Henderson

Humans and Robots

Robotics is advancing rapidly. Probably within the lifetime of most people now living – and conceivably within the next ten years – there will be general purpose robots (GPRs) capable of doing the vast majority of the work now undertaken by human beings. When that happens international free trade and free market economics even within a closed domestic market will become untenable.  The final crisis of capitalism will be the development of technology so advanced that it makes capitalism in the Marxist sense impossible because machines make humans redundant.

Robots are already undertaking  surprisingly sophisticated work, but almost all are designed to undertake a limited range of tasks(http://www.sciencedaily.com/news/computers_math/robotics/). None is a true GPR. That makes them expensive because of the limited nature of their possible uses and the restricted production runs they can generate. Many of the most sophisticated are either one–offs or counted in single figures. (http://www.telegraph.co.uk/science/space/8330246/Japanese-robot-could-be-sent-to-Space-Station.html).   A GPR will change that. They will be able to work across a wide range of tasks which will both enhance their utility and result in massive production runs. GPRs will become cheap, much cheaper than human labour.

The cost of GPRs will also fall because GPRs will sooner or later reach a stage where they can replicate one another or design and build new types of robot.  This is potentially startling in terms of what might be produced. Let us say that it takes one week for one GPR to create another. At the end of the first week you have two GPRs. At the end of the second week you have four GPRs. Let us suppose you keep on doubling up every week. In thirty three weeks you have more GPRs that the entire present population of the world. In thirty four weeks you have more than twice the population of the world. The only restrictions on production would be government curbs or a shortage of materials and energy to build and run them.

Economic history to date shows that technological advance creates new work. It may have very painful consequences for individuals whose livelihood disappears – the hand-loomweavers of the early industrial revolution are a classic example – but new opportunities for employment arise as an economy becomes more sophisticated and variegated. The hand-loom weaver found work in the new factories; the redundant western factory worker of today in a call centre. At worst they might only get a MacJob but at least it was a job.

But if the GPRs can do the MacJobs as well as the more demanding work, then there will not be any new jobs for humans, not even much supervisory work because GPRs will need little supervising, and less and less as they become ever more sophisticated. Hence, this technological advance will be like no other. GPRs will not only take away existing jobs, they will devour any new work; the easier work first, then the more complex.

The normal human response to such ideas is not reasonable scepticism, but rejection based on a refusal to accept the reality of change, a rejection expressed with ridicule along the lines of the Victorians’ response to the car:  “It will never replace the horse”. Mention robots and people commonly scoff “Science Fiction” to get rid of the matter without further debate. This type of response is natural enough because human beings, apart from disliking change, do not like to think of themselves as dispensable or redundant. Moreover, incessant propagandising by western elites has made it a received opinion of the age that work is becoming ever more demanding and requires an increasingly educated and knowledgeable workforce, something which seems to most humans to make them uniquely capable of doing the jobs of the future and, by implication, this excludes mechanisation (and robots) from the majority of future human employments.

If that were true the dominion of GPRs might be at least delayed. Unfortunately, the reality is that the large majority of modern jobs, in both the developed and developing world, are non-skilled or low skilled. Just sit and ponder how many our jobs need a great deal of intelligence or knowledge. Think of the huge numbers who are employed in call centres, shops, cafes, cleaning, driving car, on farms picking fruit and vegetables or assembling items on production lines which require no more than a repetitive task to be performed. These may be hard work but the training or innate skill required is small. Even work whose nature suggests that it is more demanding of education, training and knowledge such as much clerical work can be readily done by anyone with a reasonable facility with the 3Rs and a familiarity with basic computer operations, such as using a word processor and a search engine, something which the large majority of those in Western labour markets at least should possess. If twenty per cent of jobs in a developed country require an above average IQ or a long period of specialised training I should be surprised. In places such as India and China it will be less as they have taken on much of the repetitive factory production of the advanced world and are less inclined to substitute machines for labour, which is still by western standards very cheap.

The overproduction of graduates in both the developed and developing world is a strong indicator of the predominance of simple jobs.  In Britain there is a target of getting 50% of school-leavers to university. At present that does not look like being achieved because the figure has been stuck around 40% for years and the recent massive increase in university fees for UK students is likely to cause even that figure to drop in the future. But even with 40%, experience shows that is far too high a figure because large numbers of graduates are either unemployed or employed in jobs which do not require a degree-level education. The latest Office of National Statistics figures show 20% of recent UK graduates are without jobs, but even before the present  recession began in 2008, graduate unemployment was twice the UK unemployment average at 10.6%  (http://www.statistics.gov.uk/cci/nugget.asp?id=1162). The  figures are worse than they look because graduates in employment include those in jobs for which a degree is unnecessary. In 2010 one in three new graduates were forced to take menial work  (http://www.thisismoney.co.uk/money/article-1697466/Stop-gap-graduates-forced-into-menial-work.html).

The picture is similar elsewhere. In China there are more than six million unemployed graduates (http://www.businessweek.com/magazine/content/10_37/b4194008546907.htm); the USA  had 2.4 million unemployed graduates unemployed as of June 2010  (http://www.usatoday.com/money/economy/employment/2010-12-06-collegegrads06_ST_N.htm) and the Eurozone generally experiences a high level of graduate unemployment  (http://www.barcelonareporter.com/index.php?/comments/graduate_unemployment_rate_one_of_eus_highest/).  The position in less developed countries is considerably worse because the number of graduate-level jobs is meagre and often only available in government funded positions.

Employability also varies according to education below degree level.  Take the country which started the so-called “Arab Spring” uprisings, Egypt, as an example. In 2011 Egyptian high-school graduates accounted for “42% of the workforce, but 80% of the unemployed.” (http://www.afripol.org/afripol/item/237-africa-middle-east-the-jobless-graduate-time-bomb.html?tmpl=component&print=1). Most startling, a 2007 report found that the rate of unemployment in Egypt is ten times higher in the educated section of the population than among illiterates. There education equals disadvantage.  (,http://www.huliq.com/29092/unemployment-in-egypt-highest-among-literate-population).

The hard truth is that most modern work requires less knowledge and skill than was required in the past. A peasant four hundred years ago had to know about his soil, his plants and animals, the seasons, the weather, where natural water was and be able to do a hundred and one practical things such as ploughing, sowing, harvesting, making and repairing of fences and ditches, using tools and turning out cheese and cream and dried meat and vegetables How many jobs today require a tenth of that volume of knowledge? Nor did more demanding work stop at peasants. A 17th century craftsman would have served a long apprenticeship. Jobs which did not require an apprenticeship would have probably required some manual skill. Those who aspired to intellectual employment had to laboriously write and amend their works rather than enjoying the immense convenience of a word processor. That and the cost of writing materials forced them to become precise in a way that virtually no one is today. Perhaps most importantly,  modern division of labour with one person doing a repetitive job was not king. A person making something four centuries ago would probably make the entire item and quite often a variety of items, for example, a 17th century blacksmith would not merely shoe horses but make a wide range of iron goods.

GPRs would arguably have much more immediate difficulty in displacing human labour in a sophisticated pre-industrial society such as England in 1600 than they would today, because of the more complex demands made by 17th century employments. The large majority of  English people in 1600 were employed on the land where subjective judgement rather than decisions made on objective facts were pre-eminent in the days before science and advanced technology entered farming. A very sophisticated GPR would be needed to make such judgements. (I am assuming that GPRs sent to England in 1600 would only have the knowledge available in 1600). Conversely, GPRs today could take over a great deal of employment in Western economies and much of the industrialised parts of the developing world, especially China, because there are so many simple jobs which would be within the capabilities of very basic GPRs.

But that is only half of the story. If most jobs are not demanding of much by way of learned skills and even less of intellect, they do need diligence. Human beings are generally more than a little reluctant to put themselves out in work which has no intrinsic interest for them or which is not very highly paid.. Most people do not have a vocation, or at least not one at which they can make a living. Left with  work which is seen as simply a livelihood, most  just want to do enough to live what they think is a comfortable life. If the job they are doing is laborious and boring and pays not a lot more than is needed to feed and clothe and house them, then it’s a certainty that they will be more than a little resentful. (An old Soviet joke about low wages ran that the communist government pretended to pay the workers and they pretended to work). Resentful equals careless equals idle equals dishonest equals loss of custom equals loss of profit. So what will an employer do when he can employ a robot instead? He will go and gets himself some GPRs which will not get awkward, do what they are told, keep working all the time without being watched, does not make regular mistakes and requires no wages or social security taxes or holidays or sick leave. And it will not be able to sue you for being a bad employer.

The GPRs will have all the capabilities of computers. They will be able to compute and model and display and manipulate data to your heart’s content. They will absorb unlimited amounts of data in the blink of an eye. You need a GPR to speak French, the GPR will speak or translate French. If you want a GPR to explain quantum mechanics, the GPR will produce a lecture by an eminent physicist. You need to fix your car, the GPR will fix your car.

Now, how could any human being compete with that? At that level they could not, but in the beginning at least there will still be a sizeable chunk of jobs which GPRs will not be able to do. These will be the jobs which cannot be reduced to quantifiable tasks; jobs which cannot be done by following an algorithm; jobs which require judgement and jobs which require motivation to achieve a complex end which is not obvious from the units of means which are required to achieve it.  But those type of jobs are only a minority of jobs, probably a small minority, perhaps 20% of the total. If the earliest GPRs could only undertake fifty per cent of the jobs which humans do that would be catastrophic. Human beings will not be able to kid themselves for long that everything is going to be all right.

There will be two further advantages enjoyed by GPRs over humans. In principle there are no limits to increases in the capabilities of GPRs; there is no such human potential in the present state of knowledge. It may be possible in the future to enhance human capabilities dramatically through genetic engineering or a marriage of human and machine to produce a cybernetic means of advancement, although in both cases the question would arise are such beings human? But for the foreseeable future there is nothing to suggest that human capacity can be raised dramatically through education and training, not least because attempts to raise IQ substantially and permanently through enhanced environments have a record of unadulterated failure over the past fifty years or more. Most tellingly, all the claims for raised IQs through enhanced environments involve people without well above average IQs. No one has claimed to have demonstrated that those with IQs of over 150 can have their IQs raised by environmental means. Nor do adult IQs increase as people experience more and learn more. That suggests humans have reached an intellectual plateau in terms of an ability to comprehend by the middle teens. With GPRs as many robots as were wanted of a certain ability uld be created.

The second advantage is that GPRs will come with a guarantee of performance. An employer gets what it says on the tin. Moreover, the performance will be consistent. Humans beings do not carry such a guarantee. The individual’s qualities only become apparent once on the job and are subject to variation according to the physical and mental wellbeing of the person.  This makes them a gamble for anyone who employs them. A faulty or rogue GPR could be repaired or replaced without moral qualms; sacking a human being raises all sorts of ethical questions and matters of sentiment.

The social and economic effects of GPRs  

When the first GPRs appear those in political authority will probably try to say everything will be all right when they are first presented with the problem. Now it might be thought that it would be pretty obvious that a GPR which could do everything the average human could do and then some would spell trouble for the human race, but it never does to underestimate the power of custom, ideology and the sheer unwillingness of human beings to face troubles which are not immediately upon them.  The tired old and worthless comparison with technological change in the past will doubtless be made, namely, that new jobs for humans will be generated by the GPRs. But that will not last long because the reality of the situation will very rapidly force elites to accept the entirely new circumstances.

There would be a dilemma for the makers and distributors of goods and services.. At first it might seem attractive to use GPRs, but as humans lose their employment and purchasing power the question for private business would be who exactly are we producing for? Very few would be the answer. For politicians the question would be how can we finance government including public services when our tax base has collapsed? The answer is we cannot as things stand.

As GPRs threaten to destroy the world’s economy, politicians will be faced with an excruciating dilemma. If GPRs are allowed free rein by governments the consequence will be a catastrophic collapse in demand as humans lose their employment en masse and an inability of the state as it is presently constituted to provide welfare to those put out of work or even to maintain the essential services of the minimalist state such as the police and army.

The situation will be pressing no matter how supposedly rich a country is because the majority of people even in the developed world are actually poor. They are only a few pay packets away from destitution (http://www.retirementsolutions.co.uk/many-britons-have-little-or-no-savings). Even those who own their own home will not be able to sell it because who will
there be to buy?

To begin with attempts will probably be made to control the crisis bureaucratically by instigating rationing and price controls. But that will not go to heart of the problem which is how do you sustain an economy in which most people are not working. In the end politicians will be faced with two choices: ban or at least seriously curb, the use of GPRs or adopt a largely non-market economy. Banning GPRs completely would create a particular problem because some countries would continue to use them and this could lead not merely to cheaper goods and services but technological leaps which exceeded anything humans could do. For example, suppose that a country produced GPRs to their fighting. A country which relied only on humans would be at a hopeless disadvantage.

The widespread banning of the use of GPRs in national territories would severely shrink international trade, because as sure as eggs are eggs not all countries would stop using GPRs  to produce items for export.  Any country using GPRs could undercut any country which banned GPRs. Protectionist barriers against countries using GPRs freely would have to be erected, although human nature being what it is, this would doubtless result in GPR products being supplied through a third country which had ostensibly banned GPR produced goods and services. The likely outcome of such a situation would be for protectionism to grow beyond the banning of GPR products to the banning of products simply because they were suspected to be GPR produced. This would also be a convenient excuse for simply banning imports.

As free trade (or more accurately freer trade) and internationalism generally has been the Holy Grail of politicians in the developed world for a generation or more, the re-embracing of protectionism and state control might seem to be a tremendous psychological blow for western political elites to accommodate.  In practice it is unlikely to give them any great emotional difficulty because elites only have one fixed principle, namely, to do what is necessary to preserve their position. Think how the British mainstream Left, most notably the Labour Party, happily embraced the idea of the market and globalism in the early 1990s after having been resolutely opposed to both only a few years before. Here is Blair in the late 1980s: “We will speak up for a country that knows the good sense of a public industry in public hands.” (The Blair Necessities p52 1988). Dearie me, who would have thought it?

The alternative to a protected economy in which GPRs are banned or severely restricted is a society in which the market is largely defunct. A perfectly rational and workable society could be created in which human beings stopped thinking they had to work to live and simply lived off the products and services the GPRs produced.  The GPRs would do the large majority of the work and the goods and services they provide would be given free to everyone whether or not they had formal employment. No GPRs would be allowed in private hands. Such a situation would mean the market would not make the choice of which goods and services were provided. Rather, the choice would be made by the consumer through an expression of what was needed or wanted before products were developed or supplied.  This could be done by anything from elected representatives to online voting by any member of a community for which goods and services should be supplied. For example, all available items could be voted from by the general population and those which were least popular dropped. The provision of proposed new lines or inventions could be similarly decided.

As for allocating who could have what in such a world, money could be issued equally to everyone in lieu of wages (a form of the social wage). Alternatively, in a more controlled society vouchers or rations cards could be issued equally to everyone for specific classes of goods. Greater flexibility could be built into the system by allowing the vouchers to be swopped between individuals, for example, a voucher for footwear swapped for food vouchers.

In such societies there would be scope for a limited use of private enterprise. People could be allowed to provide personal services, for example, entertainment, and produce goods just using human labour (human-made would gain the cachet that hand-made has now). There would also need to be some greater reward for those who occupied those jobs which still required a human to do them such as political representation, management and administration. The reward could either be material or public approbation. It would not be unreasonable to imagine that in a society where necessary work was at a premium quite a few would take on such positions for the kudos.    There could also be some legal requirement to undertake work when required.

The greatest change resulting from such a social upheaval would be the removal of most of the advantage the haves now enjoy over the have-nots. Because the vast majority of things would be provided by the state one way or another, the advantages of wealth would be greatly diminished. Those with wealth at the time the GRPs forced a change on society might still have their money, but what would they spend it on? Not the goods and services provided by society because they would be sufficient for any  individual? On the luxury goods and services offered by human-labour enterprises? Perhaps, but that would be a petty pleasure. What the rich would have lost is what they prize most, their power. They would not be able to hire other humans easily because why should anyone work as a servant when they already have the means to live? Instead they would have to live as “the little people do” (copyright Leona Helmsley). The historical experience of those with privilege relinquishing it peacefully is something of a desert, but in the circumstances of where no one has to work simply to live they would have little choice.

It would be difficult to build up a great fortune even where money remained the means of exchange, because all that would be permitted outside of socially controlled provision would be that which humans could produce without the aid of GPRs or perhaps without any form of robot, would be items which because of their means of production or provision would be expensive. This would make them luxury items. There would also be an incentive for most people not to buy them because the socially produced items would be much cheaper, in effect free because no work would have been done to earn the money to buy them. Money in such a society would have much of the quality of a voucher.

Perhaps some entertainers and artists might still command high incomes but fortunes made from business would be next to impossible. The vast fortunes made in banking and other financial service providers would not exist because financial services would become redundant in a society which has decided to provide the means of living without working for it. But like the rich generally, what would it really buy them?

Could an economic system akin to those which depended heavily on slaves not be created with GPRs taking the place of slaves which might be owned by anyone? The answer is negative. No slave society has ever relied overwhelmingly on slaves.  In slave societies there is always a good deal of free labour, both because of the scarcity and cost of slaves and the inability of owners to trust slaves to do all work or work without the supervision of free men and women. The demand created by the free part of the population through work or accumulated wealth provide the basis for a market economy in a slave-owning society. In many slave societies, slaves have acquired rights to earn money, own property and have families, all of which bolsters the demand of the free part of the population.  In the case of the GPRs, they would undertake so much of the work there would be insufficient realisable demand to sustain a market economy. There would be no point in private business using GPRs on a large scale because there would be no mass market to serve.

Who would be best placed to survive? 

It might be thought that the people best placed to survive would have been those in the least industrially developed states because they would be less dependent on machines. But the trouble is that there is scarcely a part of the world which had not been tied into the global economy. If a country does not manufacture products on a large scale, it exports food and raw materials and accepts Aid.

The fundamental trouble with Aid is not that it breaks the initiative of the recipient or props up dictators or alters traditional trading patterns or drains countries of money through everlasting interest, although all those are important features. . The killer fact is that it produces a level of population in the Third World which the Third World cannot naturally support. If the  economies of the industrial nations collapse, the Aid will stop and the market for their export of food and raw materials dry up. All of a sudden the Third World will find they cannot feed their populations and their elites will no longer have the means of maintaining order because they will not be able to finance forces to subdue and control the population.  The chaos which will ensue will be aggravated by the fact that the old economic and social relationships have been fractured so that even maintaining a population appropriate to the traditional ways of living will be problematic.

Low-wage developing countries such as China is now will be struck particularly hard because when GPRs are available their labour cost benefits will disappear.

The future

The rate at which robotics evolves will play a large part in how the story unfolds.  The speed with which GPRs replace human beings could be truly bewildering. The example of digital technology to date suggests that the stretch from a primitive GPR doing simple work which can be broken down into physical actions to a GPR with some sort of consciousness or a facsimile of what humans think of as consciousness will not be massive. Such development could well be speeded up by GPRs assisting with development as they attain more and more sophisticated abilities. The faster the development of  really sophisticated GPRs, the more chaos there is likely to be because there will be little time to plan and implement changes or for the human population to accommodate itself psychologically and sociologically to a radically different world

How sophisticated GPRs will get is unknowable, but the development of Artificial Intelligence programs which allow a process of learning are already well established. These have the potential not only to produce the wide-ranging intelligence which would allow value judgements, but also for GPRs to develop in ways which humans cannot predict. (http://www.telegraph.co.uk/technology/microsoft/8344028/Xbox-Kinect-foretells-computers-of-the-future.html).

It is reasonable to assume technology will develop until GPRs are showing behaviour which suggests consciousness. They will make decisions such as what would be the best way of  achieving ends which are loosely defined, for example, an instruction to design a city redevelopment in a way which would have the greatest utility for human beings. At that point the GPRs would be effectively making value judgements. Perhaps they already are doing that at some level. (http://www.telegraph.co.uk/science/roger-highfield/8587577/The-big-plan-to-build-a-brain.html).

This is a real danger with potentially catastrophic world-wide consequences. The problem is getting people in power to address the subject seriously. There needs to be discussion and  planning now about how far GPRs,  or indeed robots or any type,  should be allowed to displace human beings in the functioning of human societies. Nor should we assume humans will happily tolerate GPRs  for reasons other than the economic. Robots which are too like humans make humans uncomfortable, probably because it is difficult to view a machine which looks like a human and acts like a human simply as a machine.  (http://www.telegraph.co.uk/technology/8494633/Japanese-robot-twins-fail-to-bridge-the-uncanny-valley.html)

Apart from the economic consequences, GPRs also offer dangers such as the possibility of the realisation of the tyrant’s dream; an army of unlimited and utterly loyal and obedient servants who will refuse no command and GPRs developing intelligence and human-like qualities so profound humans have difficulty in treating them as slaves.  But those are subjects for another day…

Japan and The Big Society

The response of   Japan to the triple  disaster of a massive  earthquake, gigantic  tsunami and nuclear  power failure  has been surprising. One of the most advanced industrialised states  and the third largest economy in the world has struggled desperately to deal with what is admittedly a dramatic and unusually devastating multiple disaster .  Not only has there been no clear resolution of the  nuclear power station problem  after several weeks, but the response to the distress of those who have lost their homes and all the conveniences of a modern state has been strangely inadequate.  People have been left with not only no homes or power, but without food and clean water.  In the worst affected areas even the legendary honesty and social discipline of the Japanese has begun to break down with looting. (http://www.telegraph.co.uk/news/worldnews/asia/japan/japan-earthquake-and-tsunami-in/8395153/Japan-earthquake-Looting-reported-by-desperate-survivors.html)

Is the inadequacy of the Japanese response simply a result of the scale of the disaster or is there something within Japanese society which has caused the lack of  useful response?   The scale should certainly not be underestimated because the tsunami alone damaged hundreds of miles of coastline to a reported depth of ten miles in some places and the toll of those dead is officially put at 10,000 and the missing at 17,000 as of  25 3 2011 (http://www.telegraph.co.uk/news/worldnews/asia/japan/8405619/Japan-earthquake-death-toll-passes-10000.html).  Moreover, the on-going problem of the damaged nuclear plant must be  a tremendous distraction for the Japanese government. Nonetheless, it does seem rather odd to the outsider that the response to the provision of basic necessities to the dispossessed has been so slow and patchy. It argues for at best a lack of reasonable planning for civil disasters of which there is a high probability. Japan is part of the Pacific “ring-of-fire” earthquake zone and tsunamis are a regular feature of the area. It might be argued that building nuclear power stations in a notorious  earthquake zone   is not the brightest thing to do, but Japan has little by way of natural energy resources so it is possible to see  why they have done it. What is less easy to see is why they should have built stations close to the coast with the obvious danger of a tsunami following an earthquake or even a tsunami overwhelming the station on its own.  

If there was a serious  lack of civil disaster planning why would that be?   After all, the Japanese are famously good at paying attention to detail and behaving in a disciplined social manner.   Perhaps the answer lies in the very social cohesion which has meant that  the development of  the state has been much more restricted than it is in most developed countries.  Japan has a population of 125 million, approximately twice the size of that of  Britain.   The Japanese budget for the present year is  less than £700 billion (http://www.reuters.com/article/2010/12/24/us-japan-economy-idUSTRE6BN0FQ20101224?pageNumber=1). The British Government’s projected  spend for the coming financial year is £710 billion (http://www.telegraph.co.uk/finance/budget/8403115/Budget-2011-graphic-Spending-income-tax-shortfall.html).  Japan spends less than the UK on public provision despite have a population twice as large. This means that the proportion of public spending is very low compared with most developed economies, the Japanese GDP being around £3.2 trillion of which the state spends  less than 25% .  Compare that with UK public spending which is pushing 50% of GDP.  

The surprisingly  low level of  Japanese public spending in itself means that the capacity of the state to deal with major disasters is severely limited.   This difficulty is amplified by the very high Japanese National Debt  which is approximately twice GDP.  Servicing this takes up a good deal of the Japanese government’s budget.   Money for public projects is in short supply and  it is a moot point whether Japan can be said to have a welfare state (http://www.onejerusalem.com/2007/10/14/japan-no-welfare-state/). If you fall out of work or ill in Japan and you are without the support of your family or friends, you can rapidly become  destitute.

Why is Japanese state spending so low?  Most probably it is  a continuation of traditional Japanese social relationships where support comes from  not only family and friends, but the general neighbourhood  and,  in the case of large Japanese companies at least, the organisation of  a person’s life around the place of employment. There is nothing abnormal about such development because it is precisely what happened in other industrialised countries before the state grew large.  Moreover, for many Japanese after  1945 the security offered by a fully-fledged welfare state was  largely substituted  by the giant Japanese companies who offered a job-for-life and  organised an employee’s life around the  business.  Although the job-for-life  culture has suffered considerable degradation in the past twenty years,  it stood in the way of the expansion of the state.

There is an important lesson for Britain and other developed states here. Japanese society is organised broadly as Cameron’s Big Society is supposed to be organised, with the state standing back and individuals forming a nexus of social-help. The problems this creates are only too obvious.  Japan has insufficient state capacity to deal with dramas such as it is currently experiencing or to provide for those who fall by the economic wayside. More generally, the insecurity which prolonged economic weakness produces – Japan has arguably been in recession for twenty years – will tend to make people less and less willing to think of the common good  if the support mechanisms they rely on are  informal and local.  

There is no question that there is often considerable waste in public spending . However, too little public spending is a greater evil than too much (provided the spending does not overwhelm the economy)   because too little leaves no spare capacity  to deal with either chronic problems such as long term unemployment or sudden disasters such as earthquakes or tsunamis.

Why did auditors fail to blow the whistle on the banks?

1. Audit Failure

2. Why does the failure of large concerns matter?

3. Why false accounting happens

4. The incestuous relationship between auditor and audited

5. How collusion may arise between the auditor and their client

6. Is it possible to audit companies meaningfully?

7. The scarcity of IT skills

8. The responsibilities of directors

9. Non-executive directors

10. What can be done to improve matters?

1. Audit Failure

The failure of the massive US energy company Enron in the early years of the century and the incestuous relationship between the company and its auditors Arthur Anderson gave a graphic public example of the dangers of relying on company accounts to provide a true picture of the financial state of a company. Enron went from being worth $80 billion to virtually nothing in a year, yet Arthur Anderson kept on giving them a clean bill of financial health right up to the end.

Since the Enron crash, a series of major private enterprise failures has occurred culminating in the catastrophic financial implosion of major banks and their ilk, most notably those in the USA and Britain. Much has been written about the failures of formal regulatory regimes for banks and their ilk, but surprisingly little media and political attention has been given to the failure of the part played by the general regulatory rules for business – the audit of business accounts- in preventing the excesses of the banks, for example, how did the banks’ auditors persistently accept the value placed on the exotic financial instruments which underpinned the sub-prime debt or time and again fail to uncover fraudulent trading positions of dealers like Nick Leeson?

It is this aspect of failed regulation – the audit of companies – upon which I shall concentrate, an examination which will address the general problems of auditing rather than just those associated with banks.

What is the audit? Any limited liability company in Britain has by law to be inspected to some degree (the level of audit for very small companies is much less onerous than for the larger ones) once a year by a qualified accountant or firm of accountants. The auditors must either certify the annual accounts as a fair representation of the company’s business or certify the accounts with reservations. Where the accounts are blatantly and seriously flawed, the auditors will refuse to sign the accounts and resign as auditors. Such events are very rare indeed in the case of the largest companies.

The audit regimes of different jurisdictions vary in detail, for example, British companies are required to divulge substantially more financial information than their US counterparts. Nonetheless, the regimes in any advanced country are similar enough for statements about auditing problems to be generally pertinent.

2. Why does the failure of large concerns matter?

Before I turn to the practical difficulties of producing honest and accurate audits, there is a prior question to answer, namely, why is the audit necessary? after all, private enterprises which do not take public money for government contract work are simply risking the money of their shareholders and those who extend credit to them.  Pathological free marketers would say that even a large business failure it is merely the market at work and that all will come out in the competitive wash.  Those not afflicted with this quasi-religious belief will see things rather differently. However, the free market case does need to be answered because of its present dominance in politics. So, why is the failure of a large company so important?

Obviously those who lose money or their jobs through the collapse of a large company suffer, but what about the general population? Why should they care? Indeed, many people  shrug their shoulders when they hear of  business failures, thinking “I own no shares, I have no pension with them. I do not work for them. I am not a creditor. It will not affect me.” In the special case of banks they may be concerned about money deposited, but that fear soon evaporates in a country such as Britain as they discover that the government underwrites either all or a large proportion of their deposits.

Those with this I’m-all-right-Jack mentality dwell in a fool’s paradise. In aggregate, business failures of any size are important to an economy, but a large company going bust is particularly bad news, both immediately and in the longer term. To begin with there is a strong possibility that it will have most of its staff concentrated in a few areas or even in one area. If so, it will cause a local crisis. Structural unemployment on the heroic scale of the 1930s or even of the 1980s and early 90s,  when British industries such as coal and steel were rationalised” almost out of existence, may be a thing of the past in Britain  because the country has been cleansed of most of its great manpower demanding manufacturing and extractive industries,  but a company can still employ sufficient people in an area to cause severe economic and social dislocation if it stops trading for it puts out of work its own employees and the employees of firms dependent upon its orders and the  local economy as a whole shrinks as purchasing power is reduced. Beyond the local economy, the taxpayer generally suffers because those now redundant pay no income tax and have to rely on taxpayer funded benefits while the tax take generally in the area is reduced as demand shrinks.

Less tangibly, the failure of a company as large as Enron affects the general confidence of the population.  They think, not unnaturally, that if a company that big can go down the pan, what company is safe?  When people are unsure about the future they tend to reduce their spending. That deflates the economy. but not only do they fear for their immediate jobs. If they have  a private or occupational pension, they begin to ask awkward questions such as “Is it safe?” Those without pensions as yet ask “What is the point of paying into a pension if it goes the way of Enron’s pension scheme?”

These are very pertinent questions to ask.  Private and occupational pensions are heavily linked to the stock market because pension funds tend to hold much of their investment capital in shares. Any large pension fund will be likely to hold shares in  many  major companies. If a large company fails completely or even does very badly, non-state pensions  will suffer. Even state pensions may indirectly feel the pinch because  reduced tax revenues due to a slowing economy means that state funding cannot be so generous.  Moreover, the failure of large companies has a depressive effect on the stock market generally, which again is to the general disadvantage of pension funds, which hold a large proportion of their funds in equities.  

But the ripples spread even further. Companies rely directly and indirectly on the reliability of their audited accounts and the accounts of others. So do credit rating agencies and market analysts. Once confidence in audited accounts falls, then the cost of doing business rises as companies take steps to try to safeguard themselves against losses from honest business failures or outright fraud. They will become more cautious in their business dealings generally. They will attempt to insure against losses. The general cost of borrowing money will almost certainly rise as banks become warier. New investment may become impossible. This is what caused the Asian Crash in the late nineties. Far Eastern companies looked a good bet from their accounts, but many were far from sound in reality. Once the accounts of a few big companies were exposed as works of fiction, a general collapse in confidence followed and even companies which on a trading level were perfectly sound found their supply of new capital drying up.

Finally, there is the loss of the capacity to provide of goods and services . A  large company may fail through incompetence or fraud rather than a decline in demand for their products or competition from other at home and abroad. If that  happens the country and its people lose the opportunity to purchase the goods and services. This may mean either no goods or more probably imported goods  at a higher price. In the case of strategic industries, such as microchips or energy, it can also mean a dangerous dependence on foreign suppliers.

A single large failure will not capsize a first world economy on its own, although it can do a great deal of trouble – Wall Street lost 2% of its value after Enron collapsed.  But often one large failure will signal others. There is a good reason for this: such failures almost invariably occur in difficult economic times, either at the very end of overheated boom or on the downturn.  In boom times, incompetence and even fraud can be hidden by a company because confidence is high, money is plentiful and cheap and customers  easy  to  find,  legal regulation  becomes  lax  and self-regulation next to non-existent. Financial castles in the air can be  and are happily and rapidly constructed.  Come recession, the fruits of incompetence and fraud rapidly ripen to the point of collapse and exposure. If one large company has been caught by incompetence or fraud, you may bet the farm on a number of others having fallen into the same trap.

If audits are fair and accurate, the chances for reckless or criminal behaviour are greatly reduced. That is why they are essential to the efficient functioning of economies which are predominantly capitalist. The problem is that time and again audits fail to be either fair or accurate. To understand why this is so we need to understand the reasons and methods of those within companies who would  act dishonestly or incompetently, the process of auditing and what practical steps can be taken to prevent abuses by both directors and auditors.

3. Why false accounting happens

 False accounting occurs for two general reasons. The first is the “honest” reason: accounts are falsified simply to keep a  company afloat. This is very common. It may often have a moral slant to it as many employers who own the companies they run have a genuine sense of responsibility towards their staff as well as their own interests.

The other reason why accounts are falsified is fraud for the direct benefit of the individual.  This has three basic forms. The first is when the directors of a company dishonestly influence the price of shares through the provision of false information, directly or indirectly,  to the  markets to hide the poor performance of a company and persuade shareholders and suppliers that it is still a viable and attractive going concern. Higher share prices and misleadingly favourable accounts can also trigger very large bonuses and share options.  

The second form of fraud is the direct attempt to steal the assets of a company.  This often occurs in cases where directors are all in the know and have started off falsifying the accounts to keep a company afloat. They get to a stage where it is obvious the company is going under and the directors suddenly take what they can and run. However, it can also be fraud which consists simply of taking money or assets by one or more people – who need not be directors – without the directors as a whole knowing that fraud is being perpetrated.

4. The incestuous relationship between auditor and audited

The relationship between auditor and audited can be very close regardless of the size of a company (private limited companies with few shareholders are very prone to having a tame auditor, especially family owned businesses), In the case of very large companies the relationship between company and auditor becomes very incestuous. Very few firms of accountants have the capacity to perform such audits – in Britain, perhaps three could handle a company the size of Enron.  This means that the same handful of accountancy firms carry on auditing the larger companies more or  less regardless of their performance, simply because there is no one else to do it. For the same reason governments are reluctant to act against such audit firms no matter how they behave, because to do so could result in audits for the largest companies becoming a practical impossibility. There is probably not one large firm of auditors in Britain which has in the past 30 years not been involved in some serious failure to uncover financial wrongdoing.

The primary problem with the audit as a regulatory instrument is that the auditor has a vested interest in keeping the company audited sweet because there is money in “them thar audits”. Auditors go from year to year or  even  decade  to decade with the  same  companies, happily drawing their auditing fees, which can be very substantial in a large company – Enron paid Arthur Anderson $25 million for their last audit. The incentive not to kill the goose that lays the golden egg is obvious,  and the auditor may be tempted to turn a blind  eye  to irregularities ranging from trading whilst insolvent to outright and wilful criminality.

Accountants will often tell you there is no money in auditing. Well, up to a point, Lord Copper. As auditing is a statutory requirement and qualified accountants have a monopoly of the work, there is little excuse for auditing not to be profitable. Indeed, at the smaller end of the trade auditing is a staple of an accountant’s practice. The larger the company, the more complicated matters become. Small companies frequently have their accounts audited by their accountant and little else done. Large companies commonly purchase a range of non-audit related services from their auditors, for example, management consultancy and sophisticated accounting and financial services software. (Enron paid more in consultancy fees ($27 million) to Arthur Anderson than they paid for their audit.) Auditors will drop the  price of the audit to entice the customer to buy the non-audit services. The audit may even appear as a “loss leader” in the audit house’s ledgers. But of course it would not be offered at a “loss leader” price if the other non-audit fees were not forthcoming. It does not require much imagination to see that such non-audit fees are going to end if the accounts being audited are not passed as satisfactory. It is worth adding that amounts paid by large companies to auditors for non-audit services are small compared to the value of the businesses they audit and the financial resources they command.  What after all was the $27 million Enron paid Arthur Anderson for consultancy work in their last trading year when compared to the billions Enron commanded?

Why is this laxness tolerated? Because the government cannot act, even in a purely legislative sense, too harshly against auditors for they know that if they make the rules for auditing too onerous, it may dissuade so many accountants from undertaking audits as to make the legal requirement to have accounts audited a practical impossibility. In the case of those accountants auditing the largest companies, there is a particular problem because none of the accountancy practices which have the capacity to undertake such audits has clean hands.  If the largest audit firms were brought to book for their failures to audit meaningfully, the government might as well relieve the largest companies of their obligation to be audited for there would be no one left to do it.  

The sad truth is that whatever regulatory legislation a government might pass to improve audits would be virtually a dead letter in practice if the audit profession does not wish to play  ball.   Government  does  not have the  capacity to meaningfully police auditing and could not in practice acquire it.  Because of the technical expertise required, the only people who could do it are accountants and they are never going to work as paid government employees in any numbers. That is so because accountants in private practice can both earn much more than public service could possibly offer and be their own masters – this is a general problem for public service with jobs which require expertise with a high value in the private market.

But even if sharp accountants could be persuaded to work for the government, their numbers would always be vastly less than the numbers needed to police audits meaningfully. In fact, the active policing of any law involving a fraud is always something of a confidence trick because the numbers of fraudsters are invariably vastly greater than the forces the state can muster against them.

5. How collusion may arise between the auditor and their client

The turning of a blind eye to irregularities may happen tacitly, that is, both auditor and the company to be audited understand what the “deal” is without anything being said – you get the fees, we get the clean bill of financial health. However, outright conspiracy between the auditor and the audited to suppress the true financial state of the company must happen reasonably frequently because apart from those instances which result in criminal charges, there are  any cases of publicly reported company failure which involve such dramatic  failures of auditors to qualify accounts that it is difficult to imagine they are down to simple negligence or incompetence. In Britain, think of the failure of auditors to unmask the corrupt behaviour of Robert Maxwell (Mirror Group), Asil Nadir (Polly Peck) and BCCI.

Such a conspiracy might include all the partners in a accountancy firm or just one. Where a large company is audited, the number of people  required to carry out the audit is substantial.  There is consequently a good chance that irregularities will be known to quite a number of people and a conspiracy might seem impossible to keep within the conspirators.  However, most of the people who do the physical auditing are not partners or even qualified accountants, accountancy trainees being commonly used as the auditing footsoldiers. Such people have a vested interest – progressing their careers – in keeping quiet if  they think the audit is being conducted dishonestly and also lack both the expertise to unravel fraud and the access to the overall audit data, which access often may be necessary to see a fraud.

6. Is it possible to audit companies meaningfully?

he problem for the auditor is how to balance the time available for the audit with the amount of data to be audited. As the data for a company of any size always vastly exceeds the time available all an auditor can do is sample the data. But that is only the start of his difficulties. Take the most basic act of auditing, comparing one document with another to verify that a transaction has taken place. The auditor checks one against another, say an electronic record against a paper invoice. One substantiates the other. What then? Does the auditor simply take the records at face value or does he institute further checks such as contacting a supplier of the audited company to see whether an invoice ostensibly from the supplier was actually issued by the supplier? The norm is that records which seemingly corroborate one another will be taken as genuine because the auditor simply does not have the time to check further all of the documents he inspects. The  best that can be done is to investigate more fully a sample of the documents the auditor  has chosen for inspection. But that means he is down to investigating a sample of a sample, and even if he does it rigorously, the chances of discovering that data has been falsified are pretty slight because most frauds will only affect a small part of a company’s records.

Interrogation software can be used go “data mining” on computerised records, but the best one can ever do with the manual data (which is probably the most easily identifiable source of irregularities) is sampling. Moreover, even where computer files can be interrogated efficiently – something dependent upon the IT skills of the user – that produces another sort of problem: the large volume of extracted data to be scrutinised. There is only so much time and effort that can be put into an audit.

If the directors are determined to obstruct an audit by supplying false or incomplete data as Enron routinely did in the most complicated and opaque manner,  I doubt whether it is possible to meaningfully audit a company of any real size, let alone one as enormous and as complicated as Enron. Their main accounting trick  was the creation of fictitious revenue  by setting up a complex chain of dummy companies, that is, companies owned and controlled surreptitiously by Enron,  which pretended to trade with Enron as independent customers and the hiding of debt in those companies.  A satirical email which did the rounds at the time of the Enron collapse was perhaps not far short of the mark:

Capitalism – You have two cows. You sell one and    buy a bull. Your herd multiplies, and the economy    grows. You sell them and retire on the income.

Enron Venture Capitalism – You have two cows. You sell three of them to your publicly listed company,  using  letters  of  credit  opened  by  your   brother-in-law  at the bank,  then execute  a   debt/equity swap with an associated general offer so that you get all four cows back, with a tax  exemption for five cows. The milk rights of the six cows are transferred via an intermediary to a Cayman  Island company secretly owned by the majority shareholder who sells the rights to all  seven cows back to your listed company. The annual report says the company owns eight cows, with an option on one more.

But whatever the size of company, the auditor is always at the mercy of his client in the sense that he can only work from the data the client gives him. A false set of plausible “books” is presented and there is not much an auditor can do in practice because of the constraints of time and money. And a false set of “books” is all too possible these days because computers have made the business of falsifying records a doddle. Keeping two sets of books manually involves considerable effort, with computers all that needs to be done is keep two separate accounts programs running. one truthful, one bogus, Moreover, with computerised systems changes to hide fraud can be made without leaving the obvious tell-tale signs of alteration commonly found within manual systems such as rubbings out, pages torn from ledgers, obvious attempts to change data and other evidence of human interference.

Computers also affect the veracity of paper documents. As a reasonable stab at counterfeiting banknotes can be made using run of the mill IT equipment, it is not difficult to imagine how easy it is to forge other documents which have no security features built into them.

Suppose I want to forge an invoice from a regular supplier to account for money which in reality has been siphoned off illegally. I take an actual invoice from the company. I scan it in and then use a graphics package to remove the original sales data and to put in the false data. I then print out the forged invoice (using similar paper to the original) which for all the world looks like the other genuine invoices I have from the supplier.  

There is also the problem of the auditors ability as an investigator. Investigators like salesmen, are born not made. You can make a natural investigator better by training and giving him experience, but you can never make someone without the natural talent a good investigator. That is because an investigator must be someone with initiative, someone who does not require a textbook to tell them what to do. Many auditors frankly do not have that quality in any great degree and are literally incapable of conducting a serious investigation rather than a “tick and turn” inspection, that is merely satisfying an audit by taking things at face value. . Indeed, the type of personality which makes a good technical accountant – attention to detail, accuracy in small things and so on – may mitigate against him being an efficient investigator. As already mentioned, it is also true that the least able and experienced members of an accountancy firm are put to audit work, while the more able and experienced do the consultancy work.

7. The scarcity of IT skills

Even after 25-30 years of computerised accounting systems being the norm, auditors all too often lack the computer skills needed to interrogate electronic data in a sufficiently sophisticated manner, something which is far from simple for even someone with good IT skills when they are dealing an unfamiliar computerised records and accounting system. It could be argued that such skills should be made mandatory for auditors dealing with large companies with complex computerised accounting systems. That idea like many a legislative wheeze sounds attractive at first glance. The problem is that people with such skills are thin on the ground and very costly. If the employment of such people were made mandatory, large firms of auditors might well be unable to employ the staff they need. That  in turn could lead to the auditing of all  limited companies becoming impractical.

But let us assume for the sake of argument that there were sufficient people with IT skills and they could be enticed to work for  auditing firms, what then? Very few of those IT competent people will also have the accountancy skills needed to properly perform an audit. Nor is it probable that sufficient people could be trained to have both at a high level, because the dual training would simply take too long and be too costly. Consequently, auditors without high level IT skills would often have to work through IT specialists without accountancy skills. Apart from the immense cost implications of this, there is also the problem of meshing the IT specialist and the accountant together. As any systems analyst will tell you, the point in the creation of a new system where things are most likely to go wrong is the process of the computer illiterate customer telling the systems analyst what he wants of the system he is asking the systems analyst to design. Accountants without advanced IT knowledge are all too likely to ask for things which do not produce the data they want.

8. The responsibilities of directors

Directors, both executive and non-executive have legal obligations to take all reasonable steps to ensure that their company trades within the law. That obligation includes the presentation of an honest set of accounts.

Directors cannot be passive and automatically escape the consequences of any criminality or gross incompetence. Ignorance of wilful criminality or of gross incompetence in maintaining records adequate to show the true financial position of a company, does not excuse directors from their obligation, although it may be enough to save them from criminal charges.

Directors have limited liability in normal circumstances. However, if it can be shown that the directors have not met their legal obligations as directors, for example criminality is proven or inadequate records have resulted in a company making a loss, their limited liability can be removed. However that is  extraordinarily rare, which suggests that either the law is inadequate or there is a tacit understanding amongst those with the power to take action to remove their limited liability, especially the large pension and other managed funds, that pursuing individual directors would not be playing the game. As we shall see the law would appear to be adequate if it were only enforced. .

Nowhere is this reluctance to act  better seen than in the aftermath of the banking crisis which caused the present recession. Not one of the directors of the Royal Bank of Scotland or HBOS has been subject to criminal or civil action. Being a banker is a small-risk occupation for those at the top. As the Government almost invariably steps in when it is a bank going bust, being a banker is a one way bet: the bank makes money you get the vast remuneration: the bank fails the taxpayer steps in and you do not suffer any punishment such as summary dismissal, the removal of limited liability if you are a director or criminal proceedings, but instead leave with a massive pay-off at worst

Section 174 of the 2006 Companies Act details the duties of the directors as follows :

(1) A director of a company must exercise reasonable care, skill and diligence.

(2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with—

(a) the general knowledge, skill and experience that may reasonably be

expected of a person carrying out the functions carried out by the director

in relation to the company, and

(b) the general knowledge, skill and experience that the director has.

How can the directors of the nationalised or partly nationalized British banks –  RBS, HBOS, Lloyds TSB and Northern Rock – be said to have met these requirements? Lloyds TSB have even admitted that inadequate due diligence was done before the takeover of HBOS. Yet there has been no suggestion of taking criminal or civil action against them. .

There is also the question of general competence. The alarming truth is that the executive directors of the banks almost certainly did not understand the complex financial packages being devised by their investment arms which led to the crisis. On 10 February 2009 the recently removed executive directors of the RBS and the HBOS appeared before the Commons Treasury Select Committee: Sir Fred Goodwin (ex-RBS chief executive) and Sir Tom McKillop (ex-RBS Chairman),e Andy Hornby (ex-HBOS chief executive) and Lord Steveson of Conandsham (ex-HBOS Chairman).

During their examination by the committee, each of the four directors on show was asked to detail their formal banking qualifications. All four had to admit that they had none. I am generally an enemy of credentialitis, but in this case technical qualifications are necessary to ensure that the directors understand the very complex financial instruments being used and the exotic accounting practices employed by large corporations. If failure to understand such things does not amount to gross negligence what does?

The Companies Act allows shareholders, subject to the agreement of a court, to sue directors for negligence, default, breach of duty or breach of trust. No attempt has been made to removed their limited liability to allow this to happen. Nor, as far as I can discover, has any attempt has been made to get bank directors banned from holding directorships in the future. Why have the institutional shareholders not started such legal action to remove limited liability from directors so they can be sued? Why has no politician raised the possibility of banning ex-bank directors from being directors in the future? The only plausible reason is the tacit class interest encompassing politicians, bankers and large institutional investors, the last being the only non-governmental people generally with the financial muscle to fund actions to remove the limited liability of directors. There is a simple legal way to stop them enjoying the fruits of their ill-gotten gains: remove their limited liability and ban them from holding directorships for life.

As for criminal charges, I wonder if something could not be done under the laws relating to fraud. There must come a point where recklessness behaviour becomes fraud because the director knows they are taking chances which will most probably not come off. For the future we need a law of reckless endangerment which would make any director who endangered a bank or allied institution through their criminally reckless behaviour to be punished by the criminal law.

Far from being punished, bankers who have left the banks they have helped ruin have received  gigantic pay-offs to reward them for their incompetence. The case best known to the public is that of Sir Fred Goodwin of RBS who originally was to receive an immediately payable pension of more than £700,000 per annum,(since reduced to a more modest £400,000 odd ) but he does not stand alone. To take a couple of other examples, according to the Telegraph (27 Feb 2009) “Eric Daniels, the chief executive of Lloyds Bank, which has accepted tens of billions of pounds from the Government, could receive almost £10 million in pay, perks and bonuses this year”, while Adam Applegarth, the chief executive of Northern Rock when it failed, a bank so badly damaged that it is now wholly owned by the British taxpayer, reportedly  trousered £760.000 (Northern Rock boss to get £760,000 payoff Telegraph Tony Undercastle 31/03/2008).

When it comes to human behaviour, it is always risky to say that something has never happened, but I will stick my neck and say that there is no instance of a director of a large public company audited in Britain ever publicly blowing the whistle on criminality or recklessness verging on criminal irresponsibility and getting the backing of their board to publicly expose what was going on. I think one would even be hard pressed to find a director of such a company who has publicly exposed breaches of the law or recklessness on his own authority whilst still sitting on the board.  In the case of Enron a so-called whistle blower, Sherron Watkins, was not in fact a public whistleblower. She merely told senior Enron executives that massive debt was being hidden. When the senior executives did nothing, she followed their lead and kept quiet until after the company collapsed.

9. Non-executive directors

The sinecure is alive and well in boardrooms. Non-executive directors (or their foreign equivalents) are meant to bring some particular benefit, for example contacts or expertise, and a certain independence of mind to a board. That is the theory,  In practice, and especially with large companies, non-execs have a pretty dismal record of bringing neither particular benefit nor independence of mind to their position. Where were  Enron’s non-execs when what appears to have been outright fraud was being practised? How did Robert Maxwell manage to perpetrate the frauds that he did within the context of public limited companies  packed with non-execs? What were Marconi’s non-execs doing as the management  through sheer recklessness reduced a company worth £30 billion with a cash balance of £3 billion to one worth less than £1 billion with £4 billion of debt within 18 months in the 1990s? More dramatically why did the bank non-execs fail so spectacularly to raise concerns about the exotic financial instruments and other reckless behaviour which led to the banking collapse of 2008 They were  at best simply drawing their salaries whilst doing as little as possible .

The truth is that non-execs in the vast majority of cases are no more than PR wallpaper. The case of the former Tory Minster, John Wakeham, is instructive. Wakeham is an accountant by training with considerable commercial experience before he went into politics. Not only did he accept a non-exec directorship with Enron, he also agreed to chair  Enron’s audit committee.

In theory, Wakeham was the ideal non-exec. He had particular expertise (accountancy), contacts (politics) and was not dependent on Enron for his main remuneration – apart from his then position of Press Complaints Commission chairman (for which he received £150,000) Wakeham also held 16 other non-exec directorships. Yet it did not make a blind bit of difference. Enron and their auditors were able to do what they did without a peep from Wakeham. I will leave readers to judge why Wakeham behaved as he did.

Wakerham’s situation when he was with Enron also raises a very interesting question: how it is possible for any person to head the PCC and hold as many directorships as he did (and Wakeham is far from being the champion in terms of numbers of directorships) and meaningfully satisfy his obligations as a director. Commonsense says it is not possible, even for the most conscientious and able man.

But non-execs are all too often not conscientious or able. They sit on boards to lend their names (a title is always very useful on the letterhead) and to give the illusion that a company is being properly scrutinised by those not involved with its  day-to-day management. The non-exec in return gets handsomely rewarded for doing very little and causing even fewer waves.

How are non-execs appointed? The Old Pals Act is the answer often enough. In the case of very large public companies there is a magic circle of non-execs who circulate around the companies.

10. What can be done to improve matters?

When one contemplates the practical difficulties involved in policing fraudulent or grossly incompetent behaviour by directors and auditors, the temptation is to throw up one’s hands in despair, yet something radical clearly needs to be done for at present, directors can act negligently or even fraudulently with near impunity. If you want to be a fraudster with little chance of going to prison, go into business on your own account. If you maintain at least the semblance of attempting to trade normally, generally you will be safe from criminal prosecution. If action is taken, the worst that can happen is normally a ban for a few years from being a director of a company, although in practice this is often a dead letter for very little check is made on their future employment. They may not formally be directors, but all too often they are to be found controlling companies through nominees (if the companies are small) or are employed as consultants.

How can matters be improved? Consider the practical restrictions within which any state-prescribed audit must exist. The state could never undertake the business of auditing itself because it would be impossible for the state to employ accountants in sufficient numbers to undertake the auditing. Nor, for the same reason, can the state police auditing even to the degree that it can make checks on the reduction of VAT or income tax under PAYE.  The best the state can do is investigate after the damage is done and even then the lack of accountancy expertise directly employed by the state means that the state has to rely largely  on accountants  in  private  practice to undertake the work of investigation.

If a regulatory system is reliant on private individuals – the directors, auditors and suchlike – to behave honestly and competently but cannot make any meaningful general check on them, the only course left is to work on the minds of such people. The most potent way to do that is to make the penalties for fraud and incompetence by directors and auditors severe and their application exemplary, which means prison, heavyweight fines and banning them from any position of responsibility within a company for substantial periods, including life in the worst cases and any director who has liquidated three companies. The same willingness to prosecute should apply to any other person involved in a gross misrepresentation or outright fraud connected to a company, for example lawyers, credit agencies, financial journalists, and politicians. In addition, the state should provide the means to pursue civil actions for damages against those who defraud or act with. The strongest incentives they can have to behave properly are convincing threats of imprisonment and personal financial ruin.

If the removal of limited liability is to be effective, the ability to recover of assets passed to family members and any other third party by a director must be greatly improved.  At present all that can be done is to try to show that the assets passed to a third party were passed simply to keep the assets from the director’s creditors, something which in practice is the devil‘s own job. What is required is a law that would allow assets to be seized if the third party could not show they had acquired them in a manner other than by receiving them from the director in question either directly or indirectly – a frequent ploy by directors who own all or much of a business is to pay a third party, normally the wife, substantial remuneration for work they do not do.

I would also advocate a new criminal offence to deal with situations where a prosecution is presently difficult or impossible because the directors are claiming gross incompetence to explain the collapse of a company or the unexplained vanishing of company assets. Directors should face criminal charges for such failures as inadequate or missing records as and the inability to account for missing company assets. These should be strict liability offences, that is, offences where intent does not have to be proved merely the fact that something has or has not been done. 

The position of non-executive directors needs to be tightened. As many of them do little more than lend their names (and sometimes their titles) in the manner described by Trollope in “The Way we live now”, the complete banning of non-execs would be no great loss. Any particular expertise a company needs can be brought in at non-directorial level. The same applies to people with contacts. The same applies to general independent advice on running the company.

The argument that non-execs provide oversight is unsustainable because they rarely if ever blow the whistle on corporate misbehaviour. Nor, as the example of British banks has recently shown, do they often have the expertise to understand the business they are supposedly overseeing. There might be a case of a small number of independent non-execs voted for by the smaller shareholders (to exclude the class interest between directors and the big managed funds), but the problem there would be whether sufficient people with the right expertise could be found to fill such roles. I would very much doubt whether they could be.

It might seem logical for audit firms to be restricted to auditing work. That sounds fine in theory but it raises two severe practical problems. The first is obvious: what if insufficient accountants are willing to set up audit-only firms? Obviously the system of audit as we know it would collapse.  That problem could conceivably be overcome by the government using taxpayers’ money to pay audit-only firms a substantial retainer to add to their audit fees to make the work worthwhile.  However, even if that did work, such a solution is unlikely to overcome the second problem, at least for the larger audit firms. Bright young would-be accountants, particularly with the larger accountancy practices, join because of the variety of work which is available. This provides them with not merely a good accountancy background but also valuable general management and business skills.  An audit-only company would not provide such a background. It is also true that audit work is pretty dull.

What could be done instead of having audit-only firms? A halfway house is possible. Auditors could be forbidden by law to offer other services to a company they are auditing. That will mean they have to adjust their audit and non-audit fees, but it is a practical suggestion in the sense that it could be done. It could reasonably be objected that faced with such rules accountancy firms, especially the large ones, might drop auditing.  In theory they might, but the majority of firms undertaking audits either have that as their main business or it is profitable for them. Even the larger firms would find auditing profitable if they stopped using it as a loss leader to entice clients to buy other services. If no auditor was allowed to do this, all would be forced to raise the cost of audits.

Whatever is done would of course leave the problem that only a small group of audit firms can handle very large companies. That can to a degree be addressed by especially strict oversight of the auditors of such companies, but it will always be a problem. The application of penalties should be auspiciously rigorous where collusion or fraud occurs in such companies and audit firms.

Insolvency law needs to enforced more strictly. However, that does present difficulties. In theory, a company unable to meet its debts is insolvent and should cease trading,  but few if any companies have not been technically insolvent at some time, not least because trade is often strongly seasonal. But if that was the standard by which businesses operated the economy would collapse. What businesses do is trade while they have reasonable expectations that debts will be met in the course of normal trading fluctuations or they believe they have the ability to raise fresh capital through such devices as bond and rights issues.  Of course, what constitutes a reasonable expectation is debatable and that gives great scope for interpretation by auditors as well as directors.  The line between fraudulent trading and misjudgement of a company’s circumstances is not always an easy one to discern. However, there are many blatant examples of companies going into administration or liquidation with debts which are simply so overwhelming that it stretches credulity well past breaking point to imagine that the directors had any reasonable belief that they could trade or borrow themselves out of an insolvent situation. (Think Portsmouth FC).

It is also important to realise that the audit at present is a narrow exercise designed to assess the past financial year. It is not meant to judge the broader viability of a company such as its longer term potential to trade legally. There is a case for giving the auditor responsibility for making broader judgements, for example, whether a company‘s borrowing is such as to overwhelm it with a slight change in circumstances, for example, a hike in Bank Rate. 

But no matter what steps are taken to enforce penalties against directors or to improve oversight, the policing of private business like all other policing in any society with pretensions to be free, involves a large dollop of public consent. It relies on the honesty and good will of both those running a company and those with the duty to check the financial state of a company. Consequently, the general moral tenor of a society will to a considerable extent determine the volume of dishonesty in business.

The fact that at present directors rightly believe that they have little chance of being held responsible for their incompetence or criminality means, quite naturally, that they are more likely to behave in such ways. But their propensity for doing so is also bolstered by thirty years of laissez faire propaganda by businessmen, academics, politicians and much of the mainstream media which has promoted the idea that state regulation is an evil, that the “free market” will police itself in a way ultimately benign to society as a whole and that Gordon Gecko’s “Greed is good” is by implication a worthy aspiration for everybody. That has created a moral vacuum which desperately needs to be filled. We need to get back to the idea that honesty is not merely a moral virtue but a necessity for a stable and prosperous society. Enforcing the law more assiduously and creating new laws where necessary, is one way to achieve that. Another is for politicians to stop their uncritical acceptance of so-called free markets (in reality, state controlled markets through anti-monopoly laws and privileges such as patents and limited liability) and start advocating a more pragmatic and broader approach to economic policy based on what actually happens rather than what an ideology tells them will happen.

Market economies and the illusion of choice

One of the prime arguments for introducing business practices, private money and private business into public provision is that it improves choice. British citizens, increasingly referred to as consumers or customers rather than patients, passengers or any other appellation which emphasises the public nature of the provision, supposedly want choices of schools for their children and to go to the “best” hospital or to enjoy the “superior” service coming from private companies with public provision contracts such as those running the railways or utilities such as water or gas.

Take the case of the privatised railways. Before privatisation all a passenger had to do was buy a ticket and get on a train. The only thing the passenger had to consider was whether there was a time or date restriction on the ticket. Now, the passenger has to not merely worry about time and date, but whether he or she is getting on a train run by a particular company – how many people have been on an intercity train when the ticket inspector has got into a dispute with someone who has bought a ticket for the train’s destination but it is the wrong ticket for that particular train? The customer is also besieged by a bewildering array of pricing, far more than was on offer when the railway was state owned.

I doubt whether the average passenger welcomes either the multiplicity of carriers or ticket prices. A person can have too much choice. Human beings want some but not a vast amount, which merely becomes confusing. If you want to travel somewhere you do not want it to be a demanding exercise in both finding out what the cheapest fare is and ensuring that the terms of the ticket are not inadvertently breached.

Does market competition produce greater choice even in a “free market”? There is a good argument to say it does not. The natural tendency of a free market is to produce reduced competition. Governments of all colours in countries which have a large free enterprise component to their economy recognise this by maintaining anti-monopoly legislation. (What are called free market economies are in fact state regulated economies and regulated in the most fundamental way, ie the prevention of increase of market share beyond a certain point).

But anti-monopoly legislation only prevents the worst anti-competitive excesses. There is still very wide scope for anti-competitive forces, especially in capital intensive and technologically advanced industries – think Microsoft and operating systems or airliners in a market of two or three suppliers.

But the process is a general one. Even enterprises which are not innately capital intensive are affected. Retailing is a good example. A hundred years ago department stores were still in their infancy. Supermarkets and shopping Malls unknown. The vast majority of purchases were made from small, privately owned shops or from open air markets. Most of the shops specialised in a narrow trade.

Today we have far fewer shops and markets. Supermarkets and Shopping Malls abound. The chain stores of at most a few dozen companies become ever more pervasive. There are many fewer specialist shops. The private retailer is assaulted from all sides by the large multiple-store retailers and increasingly succumbs as the public is seduced by the immediate temptations of price and convenience without regard to the social long-term consequences of what they do. The privately owned shop does not even have to be in the immediate vicinity of a giant chain store to suffer. It merely has to be within reasonable driving distance of the chain store. The consequence is that the poorer areas of larger towns and cities and country villages and small towns are denuded of their shops. The choice of the poorer residents of such places is tremendously reduced. The wealthier do not of course care about this because it has no direct effect on them. They have the wherewithal to either live in areas well serviced by stores and services or can afford to drive to the large supermarkets or have goods delivered from far afield. Such developments fall within the remit of government. It is not for Government to operate supermarkets but it is within their remit to prevent commercial behaviour which is anti-social.

What constitutes choice anyway? Is it, for example, having more shops offering a smaller range of products or fewer shops offering a greater range of product? In practice fewer shops will mean reduced variety of product as well as service. But what of all the choice in giant supermarkets you say? Do they not have a much greater range of product? Surely they provide more choice. They may provide a greater range in one place but that is all.

The advent of industrial-style agri-farming, the bringing in of increased amounts of imported food from around the world and introduction of new manufactured foods may give the impression of greater choice, but is an illusion. The number of varieties of staple fruits and vegetables has been massively reduced, as have the various breeds of farm animals.

Of course, the providers of anything which sells can always say “If people didn’t want it they wouldn’t buy it”. But that begs the question of what alternatives are available. If only three types of washing powder were available doubtless they would sell massively more than any one brand does now. That does not mean they are more popular merely that people have to have such a product and were forced to buy one of the three brands available. Such restriction of choice is increasingly commonplace . We fool ourselves if we buy into the laissez faire economics  = more choice.

Most people cannot make provision for the future

Cameron’s  Big Society is predicated on the idea that people are generally able to provide for  themselves.  This is clearly not the case in vital  areas such as healthcare, education and pensions, not least because most people do not earn enough to pay for such things for themselves and their dependants.  Nor, particularly in the case of saving for old age, is it reasonable to expect most people to do so wisely even if they can afford to invest.

To expect the vast majority of human beings to be expert enough in financial matters to make wise private investment decisions is absurd,as absurd as expecting every man to be his own lawyer. Therefore, all but a few of us will turn to supposedly expert advisors for advice. The problem with such people is twofold: they often have a vested interest  in selling or promoting a particular product and even when they do not, they are frequently bad judges of the financial future. (If investing was easy and certain for the so-called experts, all financial institutions would be permanently hugely successful).

When someone sells you a private pension plan or insurance, he does not do it out of the goodness of his heart. He does it because he earns a commission or fee from it. As the pensions mis-selling scandal of the Thatcher years showed, that incentive drives many, probably most, financial service consultants to sell the product most beneficial to their income rather than to the customer.

The customer can also get misled if he takes reputedly independent advice, whether this be from a self-described independent financial adviser or out of the financial pages of newspapers and magazines or investment newsletters. The advice given may be anything but independent. Unbeknown to the client, an advisor may get a commission for recommending an investment and media share tipsters often have no scruples about recommending shares which they know to be poor performers, either because of direct inducements from the companies or because they work for a company which gets business from the sharetipped. Share tipsters can also make a profit by “ramping up” a price in shares they hold by recommending it or depress a share by criticising it and then buying at the depressed price.

Those recommending shares or financial products are in a wonderful position: they can tip to their heart’s content without taking any responsibility for their tips. No tipster has a consistent record of predicting successful investments. Quite a few have utterly dismal records over years. Indeed, so poor is their general performance that one might ask whether it is any worse than randomly selecting investments. It may even be worse. As Woody Allen once remarked, “A stockbroker is someone who invests your money until it is gone”.

The Daily Telegraph put the matter of share tipping to a sort of test in 2001. It employed a professional tipster, an astrologer and a four year old child to notionally invest £5000 in the stock market. The professional tipster applied his supposed expertise. The astrologer selected her shares using her star charts. The four year old child chose by repeatedly tossing (at the same time) a number of pieces of

paper in the air with the names of shares written on them. At each toss she caught one. After a year all the investments had lost money, but the four-year-old-child lost least, followed by the astrologer with the supposed financial expert bringing up the rear quite some way behind.

A rational examination of the actual performance of tipsters and advisors could only lead to the conclusion that predicting the future economy is a mug’s game. Why would an expert do worse than a four-year-old child and an astrologer? Well, it could have been a fluke, but an unlikely one as both the child and the astrologer did better. More probably the financial advisor’s knowledge is a positive hindrance. A parallel is with the football pools. Many people have a very considerable knowledge of the form and general state of professional football clubs. Yet these people do not appear to be any better at predicting results than the punter who knows nothing about football and does the pools by putting a pin in the matches or has fixed numbers.

The truth is that no one can guarantee investment for a secure future or even come anywhere near to it. All calls for private provision replacing public in whole or part should be placed in that context.  Not only that but account has to be taken of the great variety of abilities found in a population.   IQ is distributed so that around ten per cent of the British population have IQs of 80 or less.  An IQ of 80 is the level which most psychologists working in the field of intelligence testing judge that a person will struggle to live an independent life in a sophisticated modern society.  Add in the differences in education, social status and wealth and the idea that most people can make their own provision for a pension becomes unreasonable. Take into account the high cost of living, especially the ever rising cost of housing and raising children, and falling pay and  it becomes farcical. 

As for the broader  idea that  individuals should, if they have the means,   pay for their healthcare, education and   insurance to cover periods when they are not working,  to expect all but a small part of the population to do is clearly nonsense when the average annual pre-tax UK  income is around £26,000 with many earning below £15,000.

What shall we do about the old?

The most problematic of all public provision is what to do about the old. The value of actuarial calculations – the statistical analysis of risk based on instances of the risk occurring – made sense for pension calculations when life spans from generation to generation were fairly stable. Because of our ever increasing ability to cure and prevent disease and to provide a more materially certain livelihood for the majority, life expectancy in the future is no longer easily predicted. Even if the wilder extremes of SF are avoided, it is reasonable to assume a significant rise in life expectancy in the next forty years. The rise does not have to be dramatic to make a nonsense of pension provision made today – even a five year rise in the average would have dramatic consequences for pension planning.

A substantial rise in the average lifespan does not necessarily imply some major scientific breakthrough to slow or even reverse ageing. All that would be required is for scientific advances to reduce the diseases which kill many before they reach the average age of death. In other words, more people survive to the ages which are now the average lifespans. It is quite conceivable that within the next 40 years simply reducing early death could extend the average lifespan by ten years.

More dramatically, it is conceivable that science may extend human lifespans substantially beyond their current limits. Work on animals such as mice have resulted in greatly extended lifespans simply by restricting food intake from early in life. If human lifespans are extended greatly all pension bets are off. In such circumstances no meaningful actuarial prediction for pensions could be made for the odds would be that further, unforeseeable increases in life span would occur continuously after the initial scientific breakthrough was made. The fact that such scientific advances are possible in itself makes current pension planning hideously uncertain.

What should we do as a society to plan for the future lives of the old? Let us assume that average lifespans are extended simply through the diminution of early death rather than from any radical scientific discovery, what then? If the average lifespan of Britons rises to, say, 90, over the next 40 years, an obvious move would be to delay retirement. But that raises a problem. Most people could probably work to 70, but beyond that the incidence of severe but non-fatal disease rises steeply. Keeping people alive longer does not at present equal keeping them fitter. More 70+ year-olds means more people suffering from various forms of dementia, crippling diseases such as arthritis and people simply too physically weak to undertake work which could provide an income to support them. Hence, extending the retirement age, for both state and private pensions, is only a partial answer unless science advances enough to massively reduce the infirmities of old age.

It is also true that many people are struggling to cope with their job long before the current age of retirement. People in manual jobs cannot be expected to work to 70 and those in heavy manual jobs or those in jobs which require physical strength and fitness such as grassroots policing, are probably past useful employment by the age of 50, certainly by 55. In principle they can retrain to lighter work, but in practice this is very difficult. People who have spent their lives working with their hands in a workshop or in the open air often do not take easily to working in an office or shop. Moreover, the pay they will get from such “second career” jobs is likely to be low, which is both a disincentive to work and may leave the person unable to support themselves fully.

But even if a person can adapt to new ways or has been throughout their lives in the type of employment which can be carried on into old age, the odds are that they will struggle to remain in employment as they reach late middle age. Employers are prejudiced against the older worker for various reasons. Part of that reason is financial – the cost of employing them is high compared with a youngster – but it is also in large part to do with the adaptability and energy of the young compared with the old. In a time of ever increasing technological change the natural resistance to change and learning becomes ever more of a handicap than it was in the past. Government can pass whatever age-discrimination laws it wants but employers will still find ways to employ who they want to employ without falling foul of the law (short of a law which insists that a percentage of people in an organization had to be in various age categories).

However much as we may like to believe – and I write as a budding wrinkly myself – that experience compensates for youthful enthusiasm, the truth is that all of us become much less receptive to new ideas as we get older, energy falls, physical strength fails, our memory diminishes and concentration becomes harder. Consequently, employers  have good cause for employing younger people in most jobs. Of course experience does count and in some jobs can be valuable well into old age, but in most jobs it does not count for much after the age of 60. Even in “people” related employment, which the older person is supposedly better equipped to handle, experience may be a positive disadvantage. For example, suppose an employer wants to employ someone  serving the public. It may well be that the average customer for the business prefers to be served by someone young and employing the old would be the kiss of death for the business.

The position of the older worker is being further undermined at present by the high levels of immigration, both official and unofficial. Most of this immigration is of the young, much of it young males. These young workers will tend to take much of the work which would otherwise be available for the older Briton. Stop the immigration and employers will be forced to turn to British workers. It is as simple as that.

Even in the most benign likely circumstances – an extension of the average lifespan by five or ten years through the deduction of early death, it is clear that many people will require support for a very long period of retirement or reduced employment. Some of that may well come from private pensions and savings. But clearly for a very large part of the population adequate private resources guaranteed to support someone for 30 odd years will be beyond their grasp. Hence, state provision sufficient to allow people to live in old age is a must.

If great scientific advances are made which greatly extend life we shall simply have to start planning again from scratch. Obviously if average lifespan was increased to, say, 150, the whole perspective of a life would have to change. There are any number of exciting or disturbing possibilities. For example, it might be that only the newly conceived or newborn children could have their lives increased by a new treatment. We would then be in a position where that generation and succeeding generations had the increased life span while anyone born before the treatment became available lived to an average age of 90.

The other great concern about pensions is demographic. The population is ageing and the British birthrate is substantially below (around 1.7 children per woman) the replacement level (roughly 2.1 children per woman). The doomsday scenario is insufficient working people to pay the pensions of the old in the future. If we were talking about a demographic change which was going to take place overnight I would be worried. However, we are not. Rather, the demographic effects will be worked out over thirty or forty years. Past experience suggests that society will evolve to make the necessary arrangements. We cannot foresee what the birthrate will be in five years let alone twenty or thirty.

The currently fashionable solution for the future pension bottleneck – importing large numbers of young immigrants – would be no answer in the long term. The young people who arrived in this generation would eventually grow old and would need people of working age to support them which would mean more immigration which would mean more old people to support in the next generation and so on ad infinitum, a literal absurdity because any territory has a limit to the number of people it can support. In other words, confronting the problem of a demographic  imbalance would merely be delayed for a generation or two by immigration.

The most important thing is that we do not put all of our eggs in basket. It would be wise now for the Government to begin a state pension fund into which one per cent of GDP (currently around £11 billion) was put each year.  This fund would not be touched for 20 years at least and would be used to ease any future pension problem arising from a tax shortfall due to a smaller working population.

All British banks are “too big to fail”

The media is alive with politicians, bankers and economic commentators saying British banks must be broken up so they are not “too big to fail”.  The Governor  of the bank of England  Mervyn  Kingof England Mervyn King was at it last week (htttp://www.thisislondon.co.uk/standard/article-23927727-well-let-banks-fail-says-mervyn-king.do) and the new chief executive of Barclays, Bob Diamond, has had his say today. (http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8365101/Barclays-chief-Bob-Diamond-says-let-banks-fail.html)

The idea is a literal nonsense statement. To begin with the whole of economic history shows that a run on any bank above the size of a local bank with one or two branches is likely to spread the contagion to other banks. Indeed, even runs on small banks can have a snowball effect bringing ever larger banks to default as the nexus of borrowing and lending unravels. This is what happened in the USA during the Great Depression when their highly fragmented banking system saw the phenomenal number of approximately 9,000 banks fail before the America’s entry into the second World War in 1941 finally broke the economic spell with the sudden need for vast amounts of servicemen and war-related materials driving down unemployment.

Britain’s present position is different from that of the USA in 1929. None of her banks are really small for even the smallest building societies which converted to banks in the past twenty-five are far removed from a local bank with half a dozen or fewer branches. Not only that, but the ten largest banks control 90% of the UK banking market (http://www.economicshelp.org/blog/uk-economy/top-10-british-banks/). This produces two difficulties: the danger of a wholesale collapse of confidence in banks is greatly amplified because of their size and the damage done by a failure of any of them would be both great and immediate. For example, suppose Barclays was simply allowed to fail. It is inconceivable that the failure would not lead to a run on all the UK banks.

Those saying banks should be reduced in size so they are not “too big to fail” have a further hurdle to pass beyond that of the lessons of economic history. The internationalisation of banks makes the idea of governments forcing banks to become “small enough to fail” impractical. For example, how would a government force an international bank to split off its British banking from the international business? Unless this could be done, the contagion might well start overseas and spread to the British banking end. The same general objection applies to the idea of splitting retail from investment banking. If an international bank refuses to do it there would be little a British government could do because they could not afford to say do this or cease trading in Britain. But even if the international problem could be miraculously overcome, it is difficult to see how the UK parts of banks such as Barclays could be split into different parts small enough to be “allowed to fail”. Divide Barclays into ten separate companies and each part would still be large.

It is also difficult to envisage a situation whereby a British government would cease to guarantee deposits up to a sizeable or withdraw entirely from its position as lender of the last resort. The continuation of those two engagements would amount to a great deal of moral hazard remaining.

Most fundamentally, whatever system was put in place; whatever political commitments were given, if a run did begin on a British bank it is most improbable that a government faced with the reality of such a failure, with the threat of contagion spreading to other banks, would fail to step in. The only way to stop the bankers running riot again is to nationalise the banks. Fail to do that and we are likely to have a re-run of the present disaster in the not too far distant future because already the banks and their ilk are behaving , as far as present circumstances allow, much as they did before the failure of Lehman Bros in 2008, dreaming up new types of complicated derivatives, paying themselves grotesque amounts of money and laughing at those outside their magic insiders’ circle.

Selling Britain by the pound: the immorality of privatisation

Does a British government have the moral and legal right to sell off industries and property owned by the state? In Britain the answer m is that it can legally do so. Barring restrictions agreed to in treaties, most particularly the Treaty of Rome and its successor treaties, a British government may legally do what it wishes. It may also repudiate existing treaty obligations. Parliament may in principle pass any law it wishes. That demonstrates the danger of having a political system without any  constitutional bars to government action.

But if privatisation is legal, it does not follow that it is morally justified. To begin with to sell that to which no legal title exists  would be illegal in any circumstance other than the special circumstance of Parliament passing a law to make it legal. That governments have no natural; legal ownership of that which is privatized can be seen from the fact that these are enterprises and property which were either developed from scratch by government or were taken over by the state, often from municipal undertakings which were public developments in themselves. In each case taxpayers’ money was used to either start or acquire them and in every case they were sustained and developed with taxpayers’ money.

For Britons who bought shares privatisation was a form of taxation. They paid money for that which the state already held on their behalf.  It was the greatest confidence trick in history,  selling people what they already owned. Non-British taxpayers purchased that which was not morally the State’s to sell. But the deceit went beyond this. By selling that which was held in common for the British, they robbed those Britons who did not purchase shares and the future generations who would have no stake in that which was sold before they were born.  

In many instances, especially after the first flush of Thatcher’s privatization bonanza, there has not been a public flotation , so that the public had not even the say of shareholders in how what was once held in common was managed.  The British government moved from being confidence tricksters to fences, selling what they did not own for what they could get, which, as is the way when thieves sell to fences, was always  far below the real value of that which was sold.  

Privatisation could perhaps have been morally justified if every British citizen had been issued free shares in each privatized industry, which they could then have held or sold as they chose. The Government would not then have had the proceeds, of course, but it should be remembered that the prime reason given by Margaret Thatcher for privatisation was that it would modernise great British industries through the invigorating blast of free enterprise. Ostensibly at least the raising of money for the government was not the prime motivation.

The money received from privatisation has simply vanished into general government expenditure. Had the money been earmarked for particular projects dear to the public’s heart, such as new hospitals and schools or placed in a separate fund to help pay the state pension in the years when it is anticipated that those working will substantially decline in relation to those who are retired, at least the public would have something concrete and identifiable to set against the loss of public assets. As it is the public as a whole has nothing.

It is of course impossible to prove whether taxes would have been higher or that government expenditure would have been lower if there had been no privatisation proceeds, but it is a fair bet that extra money in government coffers has simply meant additional government expenditure without a proper regard to whether the expenditure was warranted. That is the common experience of governments and public money.

The money obtained through privatisation should not be viewed as pure gain in terms of government expenditure. Privatisation has caused a great deal of what private business euphemistically call  downsizing”. The resultant unemployment costs – unemployment pay and other benefits  – have to be set against the privatisation receipts. In addition, a large proportion of those who have gained alternative employment have found themselves earning a good deal less than they did previously. That equals less tax paid.

Privatisation has been a great cheat practised on the British people.

What should be provided directly by the state?

 Certain things should be reserved to the state as a matter of absolute principle. They are defence, foreign policy, policing, justice, the implementation of judicial sentences and decisions and the administration of welfare. They should be reserved absolutely because either they involve the use of force or the threat of force, punishment or the distribution of taxpayers’ money in areas such as unemployment benefit.

For reasons which I shall shortly examine, the state should also directly control any essential service which is a natural monopoly. What counts as a natural monopoly? Railways and utilities such as water and energy are examples They are natural monopolies because it is simply not practical to have competing lines running to the same destinations or competing utility pipes and cables supplying the same area.

It is possible, as has happened in some of the British privatisations, to allow different companies to compete to supply services such as trains, energy and water, but that is at best an insufficient or incomplete competition and at worst a wholly bogus one because the actual lines of supply – the railway track and the pipes or cables – still have to be maintained and owned by some organisation, private or public. That means the infrastructure has to be either owned publicly or, if owned by a private company, the company must be rigorously controlled by the state, as is the case with the British telephone landline infrastructure which is owned by the privatised erstwhile nationalised company British Telecom.

British government interference with natural monopolies since privatisation has gone far beyond controlling the infrastructure. In the case of the railways, a considerable public subsidy has been paid and continues to be paid to the private operators. In every monopoly industry a regulator has been appointed to control both prices and, in theory at least, to force companies to do things such as provide a certain level of investment in new equipment and to be conscientious when it comes to maintenance and operation of the infrastructure. To pretend that these monopoly industries are private companies working in a free market is patently absurd. They are effectively public services contracted out to private contractors.

A few services only work as monopolies, the classic example being the universal letter post, that is, letters delivered to any part of a territory for the same price. This only works if it is a monopoly because if there is competition from private companies or municipal postal services they will take sufficient of the profitable trade in the towns and cities to make it impossible for the universal supplier, in this country the Royal Mail, to subsidise the loss making deliveries to parts of the country outside the main urban centres. No private company would ever provide universal coverage unless they had a monopoly.

Why should the state directly control essential monopolies? Firstly, because there is no opportunity for meaningful competition and consequently the state must step in to prevent abuse of the monopoly position. To do that, as we have seen, it has to interfere very strongly with the running of the monopolies. In practice, it can only efficiently do this if it directly controls the monopoly.

If the state subcontracts an essential monopoly to private business or allows private business to buy a monopoly two general problems arise. The first difficulty is that a private business may at any point fail as a business or simply refuse to continue with a contract if it is not making money for the business. If that happens the state is over a barrel because it does not have the resources to immediately take over the enterprise, nor is it probable that another private company would be able or willing to step in at a moment’s notice – the worst outcome would be the cessation of a vital industry. Nor, if a company failed, is it obvious how a Government would prevent its assets being sold by a liquidator. In principle when Railtrack failed – the company which after privatisation had the responsibility for maintaining the infrastructure of the British rail network – the shareholders owned the assets (the railway infrastructure including much highly profitable land) and the creditors had a legitimate charge on them.

Clearly no government could allow the railway or vital industries such as water, gas and electricity simply to go under, either at the national or regional level. Hence, any government will, when shove comes to push, have to pay through the nose (your taxpaying nose in fact) to maintain the threatened industry, whether that be through enhancing a contract to make it more profitable, granting more profitable contracts to a new private contractor or through the payment of outright subsidies. A government is in a similar bind if a company is doing a bad job: they cannot simply sack them because who is to take their place?

Natural monopolies also raise other problems if they are in private hands. There is insufficient public control over areas such as maintenance and strategic planning. Good British examples can be found in the privatised water and energy industries. In the case of water the privatised companies have failed to invest adequately to stop the considerable loss of water from cracked pipes. Nor has a single reservoir been built in England since privatisation. These investment failures have occurred despite the water companies consistently making healthy profits. The Water Regulator huffs and puffs but achieves little because the water companies know he can do little. Indeed, he has to date not even fully used the powers he has despite issuing many warnings to the water companies. And the Government? Well, they could pass a new law giving them direct powers over the water industry but what then? If a water company simply refuses to do what is needed where does the Government go? Nowhere fast is the answer.

With energy it is the strategic planning which is emasculated. Successive British governments have allowed Britain to sleepwalk into a position where the country went rapidly from being self-sufficient in energy to becoming a net importer. This was entirely predictable as it was known long before it happened that North Sea oil and gas was going to decline substantially from the beginning of the century. Despite this no meaningful strategic planning has taken place since privatisation with governments until very recently childishly claiming that it was not for them to interfere in the actual provision of energy now the industry is privately owned (the Blair Government has just woken up to the strategic danger of being dependent on foreign supplies but even now -2006 – no definite decision has been made on future British energy policy). The upshot of this lack of planning has been rapidly rising energy prices since 2005.

If water and the energy utilities had remained in public ownership, the fact that politicians had ultimate responsibility for them would have ensured that maintenance and strategic planning was not neglected because no politician or government could afford to be blamed for a water crisis or soaring power prices. Government could also subsidise prices, something it cannot do now even if it chose to because of EU competition rules. The same principle applies to most of the privatised industries – take away the political responsibility and the profit motive rules.

Certain things are simply too important to be left to private efforts. Natural monopolies such as the railways, water and gas are literally essential to the survival of an advanced state such as Britain. Because of that stark fact alone they need to be treated as something much more than a commodity which can be simply left to the market. They should to be seen for what they are, strategic assets, and placed firmly under national control.

There is a further general reason why essential monopolies should be in public hands – the need for general provision. Left to private enterprise, even with an unfettered monopoly only the profitable parts of an industry would be supplied. Roads and railways would only be maintained if the traffic warranted it. Gas, electricity, water and telecommunications would only be supplied where sufficient profit could be made. The problem is we do not want roads and railways only over profitable routes, or the utilities such as gas and water supplied only to urban areas. We want them over the entire country. Only public provision can truly satisfy that need. Of course, private companies can have a duty to provide a general provision placed on the them but what if none is willing to take it or they take on the responsibility but then fail to meet it? The government then has to decide to either subsidise the company directly or to loosen the contract conditions to which the company has agreed.

 The final type of enterprise which the state should always take in hand are those which experience tells us are beyond the resources of private business. Private enterprise can never be trusted to handle really massive projects. A classic example of this is the Channel Tunnel. Margaret Thatcher insisted that no British public money would be involved and that private enterprise would bear the entire cost. It soon became clear that this was a nonsense. The Tunnel itself was completed but the companies which built it were not so much bankrupt as on another planet called Debt. And this was despite the very serious amounts of money pumped into the enterprise by the French Government, both directly and indirectly. The situation was rescued, if one can dignify what happened with the word, by the banks and other creditors rescheduling debts so far into the future that they all but vanished and the French Government surreptitiously pushing in more money via the French banks. To this day, the Channel Tunnel is the whitest of white private enterprise elephants, with the latest ” debt restructuring” always just around the corner.

Direct provision also has a further benefit. While assets are publicly owned and employees directly paid by the state, it is politically much more difficult to reduce or abolish that part of public provision. If the provision is supplied by a private company their contract can simply not be renewed or cancelled. If the provision is directly supplied, the government has the ticklish problem of having to take responsibility for the redundancies, something which greatly raises the profile of the removal of the provision.

The best example of the dangers of losing direct provision is the gradual privatisation by stealth of the NHS. To suddenly privatise the entire NHS would be impossible, but salami slice it over ten or fifteen years by continually increasing the private sector involvement and the position is completely different. Then the politician can use excuses such as “So much of it is in private hands now that the rest might as well be,” “We can’t have such a comprehensive service because private companies can’t provide it” and “Costs have risen so much that we have to cut this or that”. The whole system will be such a confused mess of public and private that the public will not know what to think. Also, the privatisation by stealth may have surreptitiously changed the way the public view the NHS so they see it no longer as a national institution but merely as a provider of medical care through disparate means. That in itself would reduce the moral outrage needed for any successful public protest.

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