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Economics

Is there room for Austrian ideas at the top table?

[Editor's note: now that Steve Baker MP is on the Treasury Select Committee, it should be of interest to all Austrianists, and those interested in monetary reform in general, to re-visit Anthony Evans and Toby Baxendale's 2008 paper on whether there is room for Austrian ideas at the top table. Within the paper they also reference William White, of the BIS, who has made several comments in the past that are sympathetic to the Austrian School. The recent BIS Annual Report, at least relative to individual, national central banks, shows some consideration of the distorting effects of monetary policy, and the cleansing effects of liquidation (note that the BIS does not face the same political pressures as supposedly independent national central banks).  It will be of major importance to followers of the Austrian School around the world to follow the progress of Steve as things develop. Below is the introduction to the paper, the paper in its entirety can be downloaded here aje_2008_toptable]

 

Introduction

 

At a speech in London in 2006 Fynn Kydland surveyed ‘the’ three ways in which governments can achieve credible monetary policy: the gold standard, a currency board or independent central banks. After taking minimal time to dismiss the first two as either outdated or unsuitable for a modern, prosperous economy the majority of the speech was focused on the latter, and the issue of independence. However, the hegemony of this monetary system belies the relative novelty of its use. Indeed the UK presents an especially peculiar history, given the genesis of independence with the New Labour government of 1997. A decade is a short time and two large coincidences should not be ignored. First, independence has coincided with an unprecedented period of global growth, giving the Monetary Policy Committee (MPC) a relatively easy ride. Second, the political system has been amazingly consistent with the same government in place throughout, and just two Chancellors of the Exchequer (Gordon Brown and Alistair Darling). These two conditions have meant that from its inception the UK system of central bank independence has not been properly tested.

Our main claim in this article is that monetary policy has converged into a blend of two theoretical approaches, despite there being three established schools of thought. We feel that there is room at the top table of policy debate for more explicit attention to Austrianideas, and will survey emerging and prevailing attention amongst policy commentary.

 

Troubling times to be a central banker

 

Current economic conditions are proving to be of almost universal concern. In the UK general price levels are rising (with the rise in the consumer price index (CPI) hitting 3.8% and in the retail price index reaching 4.6% in June 2008) whilst output growth is falling (with GDP growth slowing to 0.2% in quarter two 2008), raising the possibility of stagflation. This comes after a serious credit crunch that has led to the nationalisation of Northern Rock and an estimated £50 billion being used as a credit lifeline. Most of the prevailing winds are global and are related to two recent financial bubbles. From late 2000 to 2003 the NASDAQ composite index (of primarily US technology stocks) lost a fifth of its value. This was followed with a bubble in the housing market that burst in 2005/06 leading to a liquidity crisis concentrated on sub-prime mortgages. Although the UK has fewer sub-prime lendings, British banks were exposed through their US counterparts and it is now widely acknowledged that a house price bubble has occurred (the ratio of median house prices to median earnings rising steadily from 3.54 in 1997 to 7.26 in 2007) and that a fall in prices is still to come. Also worrying, we see signs that people are diverting their wealth from financial assets altogether and putting them into hard commodities such as gold or oil.

Although academic attention to developing new models is high, there seems to be a request on the part of central bankers for less formal theory building and more empirical evidence.

Alan Greenspan has ‘always argued that an up-to-date set of the most detailed estimates for the latest available quarter are far more useful for forecasting accuracy than a more sophisticated model structure’ (Greenspan, 2007), which N. Gregory Mankiw interprets to mean ‘better monetary policy . . . is more likely to follow from better data than from better models’. But despite the settled hegemony of theoretical frameworks, there is a genuine crisis in some of the fundamental principles of central bank independence. Indeed three points help to demonstrate that some of the key tenets of the independence doctrine are crumbling.

 

Monetary policy is not independent of political pressures

 

The UK government grants operational independence to the Bank of England, but sets the targets that are required to be hit. This has the potential to mask inflation by moving the goalposts, as Gordon Brown did in 1997 when he switched the target from the retail price index (RPIX) to the narrower CPI. Although the relatively harmonious macroeconomic conditions of the first decade of UK independence has created little room for conflict, the rarity of disagreement between the Bank of England and Treasury also hints at some operational alignment. On the other side of the Atlantic the distinction between de facto and de jure independence is even more evident, as Allan Meltzer says,

The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure.’

 

Monetary policy is not merely a technical exercise

 

The point of removing monetary policy from the hands of politicians was to provide a degree of objectivity and technical competence. Whilst the Treasury is at the behest of vested interests, the Bank of England is deemed impartial and able to make purely technical decisions. In other words, the Treasury targets the destination but the Bank steers the car. But the aftermath of the Northern Rock bailout has demonstrated the failure of this philosophy. As Axel Leijonhufvud says,

monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold [italics in original].’

As these political judgments are made, there will be an increasing conflict between politicians and central bankers.

 

Inflation targeting is too simplistic

 

The key problem with the UK is that a monetary system of inflation targeting supposes that interest rates should rise to combat inflation, regardless of the source. Treating inflation as the primary target downplays conflicting signals from elsewhere in the economy. In an increasingly complex global economy it seems simplistic at best to assume such a degree of control. We have seen productivity gains and cheaper imports that should result in falling prices, but a commitment to 2% inflation forces an expansionary monetary policy. As Joseph Stiglitz has said, ‘today inflation targeting is being put to the test – and it will almost certainly fail’. He believes that rising commodity prices are importing inflation, and therefore domestic policy changes will be counterproductive. We would also point out the possibility of reverse causation, and instead of viewing rising oil prices as the cause of economic troubles, it might be a sign of capital flight from financial assets into hard commodities (Frankel, 2006). Underlying this point is a fundamental fallacy that treats aggregate demand as being the main cause of inflationary pressure. This emphasis on price inflation rather than monetary inflation neglects the overall size of the monetary footprint, which is ‘the stock of saved goods that allow entrepreneurs to invest in more roundabout production’ (Baxendale and Evans, 2008). It is actually the money supply that has generated inflationary pressures.

The current challenges have thus led to an increasingly unorthodox use of policy tools, with the British government making up the rules as it went along over Northern Rock, and the Fed going to the ‘very edge’ of its legal authority over Bear Stearns. Paul Volcker made the accusation that ‘out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank’, McCallum’s rule and Taylor’s rule fall by the wayside as the New York Times screams out, ‘It’s a Crisis, and Ideas Are Scarce’.

 

 

Economics

Welfare and the case for honest money

I do not doubt that the Government is sincere in its wish to make Britain “open for business” and to deliver greater life chances through reform of the welfare state. I gave some time to the Centre for Social Justice and now I see many of their ideas filtering through to public policy.  I support those reforms from both a practical perspective and in view of their moral necessity.

The Prime Minister is correct to talk of the culture we have lost, particularly in respect of private shame. I am put in mind of C S Lewis’ book The Abolition of Man: there is, after all, such a thing as right and wrong. Lewis predicted humanity’s ultimate destiny on the path which embraces subjective morality: a dystopian society in which “we find the whole human race subjected to some individual men, and those individuals subjected to that in themselves which is purely ‘natural’ — to their irrational impulses.” 

Some readers will recognise the problem and the dangers but reject the state’s role in finding a solution. However, we do not live in that world where the state is comprehensively rejected. There is a welfare state and it needs reform. The Government is getting on with it, and in the right direction too.

However, what the Government is not addressing is the de-civilising effects of inflation, that is, increasing the money supply.

What is commonly called “inflation” – a rise in the general price level – is an automatic consequence of debasing the currency. And currency debasement has been fierce in our lifetimes: the consequences have been and remain profound.

There is a presentation which, in one form or another, I have given many times. It shows, in a few charts:

  • How the state has grown inexorably since 1900,
  • How taxation reached an apparent limit at rather less than the scale of state spending, remaining there since 1971 or thereabouts.
  • Where our debt projections are heading,
  • How our money has been debased, particularly since 1971.

By the end of the presentation, I have explained our banking, fiscal and economic crisis. Given that what it shows is a monetary and fiscal catastrophe, people receive it surprisingly well. As far as I can tell, people can handle the truth and they want it.

One of the key slides is a price index from 1750-2003:

The grotesque debasement since 1971 – when Bretton Woods finally collapsed – hides the detail of the nineteenth century on a linear scale, so I include the same chart on a log scale. The log chart shows that, despite a number of crises and fluctuations, a pound in 1900 bought about the same basket of goods as a pound in 1800.

In contrast, money has lost almost all its value since the Second World War.

The Ethics of Money Production by Jörg Guido Hülsmann is particularly relevant at this point. Hülsmann writes:

To appreciate the disruptive nature of inflation in its full extent we must keep in mind that it springs from a violation of the fundamental rules of society. Inflation is what happens when people increase the money supply by fraud, imposition, and breach of contract. Invariably it produces three characteristic consequences: (1) it benefits the perpetrators at the expense of all other money users; (2) it allows the accumulation of debt beyond the level debts could reach on the free market; and (3) it reduces the [purchasing power of money] below the level it would have reached on the free market.

While these three consequences are bad enough, things get much worse once inflation is encouraged and promoted by the state. The government’s fiat makes inflation perennial, and as a result we observe the formation of inflation-specific institutions and habits. Thus fiat inflation leaves a characteristic cultural and spiritual stain on human society

He goes on to write of inflation’s tendency to centralise government, to extend the length of wars, to enable the arbitrary confiscation of property, to institutionalise moral hazard and irresponsibility, to produce a race to the bottom in monetary organisation, to encourage excess credit in corporations and to yoke the population to debt.  He explains how “The consequence [of inflation] is despair and the eradication of moral and social standards.”

That all sounds familiar.

Hülsmann’s work is not scripture of course, but neither are his ideas isolated. Consider Ayn Rand:

Whenever destroyers appear among men, they start by destroying money, for money is men’s protection and the base of a moral existence. 

It is my firm view that inflation – the debasement of money – was the primary cause of the banking crisis. That inflation was a deliberate policy choice of welfare states. You may recall Eddie George’s remarks in 2007 and now Mervyn King has said, “Of all the many ways of organising banking, the worst is the one we have today.”

Moreover, if Hülsmann, Rand and other scholars including Mises and Hayek are to be believed, then inflation is also a major contributor to the moral and spiritual decline of our country. No amount of welfare reform alone will solve that.

All is not lost however. To return to that log-scale price index, money’s value was substantially more volatile in the first half of the nineteenth century than in the second. In 1844, the Bank Charter Act, Peel’s Act, took from the banks the privilege of extending bank notes in excess of specie (coins of inherent worth).  It was recognized that this extension of candy-floss credit un-backed by prior production of real value was a systemic cause of economic and banking crises.

Unfortunately, that Act left the banks unmolested in their ability to create deposits. As our system of money and bank credit has evolved, that loophole, combined with central banking and the socialisation of risk, has delivered us into our present predicament.

It falls to our generation to solve this problem and that is why we established The Cobden Centre.

As Martin Wolf wrote in the Financial Times on 9th November 2010, “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.” And then we wonder why house prices have raced out of reach. We wonder why the basement garages in Canary Wharf are full of supercars while what was once our industrial heartland languishes in state dependency.

I admire the Prime Minister and the coming welfare reforms. I will back them gladly. But, until we end inflation as a way to fund the promises of the welfare state, we shall not have done the decent thing. We shall not have established objective morality in banking and in that lifeblood of society: money.  Honest money is a prerequisite for social progress and it must be delivered if reform is to succeed.

Economics

My Journey to Austrianism via the City


Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.

I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.

I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.

I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.

I am a trader.

I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.

I eat what I kill.

Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.

Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.

I make money work.

I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.

My analysis was steeped in the neo-classical, efficient markets paradigm.

Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.

Credit flowed, people got wealthier, economies developed and all was well.

And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”

Economics

Despair and hope for monetary reform

On Saturday, I spoke again to set out the scale and scope of our financial and monetary mess and again, the audience welcomed the presentation. I find this encouraging: while people are typically horrified by the true levels of debt and debasement that have been entered into by states on our behalf, generally, people are prepared to believe that reform is possible.

I was put very much in mind of two attitudes.

As Sean Corrigan has indicated, Bagehot’s classic treatise is not so much a defence of British monetary orthodoxy as a despairing attempt to show how to survive the banking crises which are inevitable under such a system. As Bagehot wrote:

I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it. [...]

We must therefore, I think, have recourse to feeble and humble palliatives such as I have suggested. [...]

This stands in contrast to the hopeful attitude shown by Jörg Guido Hülsmann in The Ethics of Money Production:

Many will object that it is impossible to bring about such a return [to a universal respect for property rights], now that we have progressed so far on the way toward a global paper money. This is a thoroughly defeatist point of view because it takes the coming disaster (hyperinflation or global tyranny) for granted. Most importantly, however, it is morally wrong. As we have argued, we face a problem of the human will; but this is after all only a problem of the will.

Now, I suppose a thoughtful person might question whether Hülsmann is engaging in hyperbole with his reference to “the coming disaster”. It seems a very reasonable question and, though I don’t propose to begin answering it here, I reflect on the trouble faced, not just by the UK, but by the Eurozone and the USA and also on the actions of their Central Banks, treasuries and legislatures: a broader range of predictions than we are accustomed to has become credible.

Denying the facts of our predicament will not do, but nor will a hopeless despair. The central, optimistic path is serious bank reform working towards honest money. As I reflect on responses to my speeches, from students, Conservatives, businessmen and others, and as I consider the increasing success of grassroots campaigns like Positive Money, I am increasingly persuaded both that Hülsmann is right to reject defeatism and that there are good reasons to believe that the will to deliver worthwhile reform may yet emerge.


You can find Andy Duncan’s review of Hülsmann here.

Antoine Clarke’s fascinating paper The Micropolitics of Free Market Money: a Proposal is also relevant.

Economics

Tonight: Britain’s Trillion Pound Horror Story

Film maker Martin Durkin explains the full extent of the financial mess we are inBritain’s Trillion Pound Horror Story will be transmitted on Channel 4, tonight Thursday, 11 Nov at 9pm:

Film maker Martin Durkin explains the full extent of the financial mess we are in: an estimated £4.8 trillion of national debt and counting. It’s so big that even if every home in the UK was sold it wouldn’t raise enough cash to pay it off.

Durkin argues that to put Britain back on track we need to radically rethink the role of the state, stop politicians spending money in our name and introduce, among other measures, flat taxes to make Britain’s economy boom again.

This is a polemical film presented by Martin Durkin. The film brings economic theory to life and makes it hit home. It includes interviews with academics, economic experts, entrepreneurs and four ex-Chancellors of the Exchequer.

A number of members of the team gave interviews and we look forward to seeing the final result.

Economics

Honest Money at the Libertarian Alliance Conference 2010

Yesterday, I gave a talk at the Libertarian Alliance Conference 2010 entitled Honest Money and the Future of Banking. Please click the image below for the slides.

Video footage of my presentation will be available shortly.

Economics

CentreRight: Douglas Carswell leads the way on bank reform

On CentreRight, I explain that Douglas Carswell leads the way on bank reform:

There is a doctrine which creates wealth and spreads it around. It is just and moral. It works. It is called capitalism and, today, in practice, there is very obviously something wrong with it.

If one were to summarise the doctrine of capitalism in one word, it would be “property”. It is property which enables human social cooperation through production, exchange and consumption. The voluntary exchange of property has rules and these are known as contract.

These two concepts, property and contract, are fundamental to capitalism and yet, in relation to money held on demand in bank accounts, they are applied at best inadequately.

On Wednesday, immediately after Prime Minister’s Questions, Douglas Carswell MP will be introducing a moderate and conservative ten-minute rule bill which would introduce sound property rights and contract to monetary deposits. It is potentially of profound importance and I am delighted to support him.

Read the rest of the article, including a range of relevant links, here.

Economics

Ten plans for financial reform

Since The Cobden Centre was established by original founder Toby Baxendale, Dr Tim Evans, Dr Anthony J Evans and the author, we have assembled ten plans for financial reform which promise to deliver honest money and social progress. These are set out below.

There is today little doubt that the economic, fiscal and monetary crisis through which we are living was caused by the financial system. It turned out boom and bust had not been ended: we found we had been living on credit in a long unsustainable boom. Some of the flaws in the financial system have been pointed out on this site: in short, government intervention and flawed modern financial theory came together in a catastrophic mix.

Contemporary mainstream debate appears to neglect 200 years and more of monetary history, with an assumption that staying within the status quo is the only option. However, the Currency School vs Banking School debate and the Bullionist v Anti Bullionist Controversy were not, it seems, finally settled.

The Cobden Centre’s staff, fellows and board members have differing views on these plans. They are presented as competing routes to better banking and a more stable, sustainable and responsible system of social cooperation in the general interest.

For further information, please see our literature.

Economics

Honest Money through bearer shares, a proposal

By kind permission of Paul Birch, we reproduce his essay setting out a proposal for honest money through bearer shares, previously published on this site in October 2009. Paul’s own site may be found here: www.paulbirch.net.

1. Introduction

Nobody understands money, least of all economists. Too sweeping a statement? Perhaps. But every analysis of the workings of monetary systems that I have ever read has been seriously in error at one or more crucial points. This is true not only of the supposedly impartial opuses of academic economics, but also of the writings of Marxists, socialists, Keynesian dirigists, free-marketeers, anarcho-capitalists, libertarians and utopians of every flavour.

On important issues of monetary policy, then, and whether a free market in money is either workable or desirable, the protestations of the experts must be considered unreliable. In particular, the claims of libertarian-leaning economists, such as Ludwig von Mises, that the operation of “free banking” would be both stable and superior to the system of government monopoly called “central banking” need to be treated with scepticism; they have not proved what they think they have proved.

Here I intend to give a description of certain aspects of the creation and use of money free of major error; it is conceivable that I may not entirely succeed. I shall argue that free banking, as it is usually understood, may be liable to gross instabilities and inefficiencies, especially in a free-market environment, and that a centralised fiat currency has definite advantages. However, I shall then describe an alternative form of free-market banking that appears not to suffer from these deficiencies and into which the current system of state control could be metamorphosed. I shall argue that it is the innate honesty or dishonesty of the banking method that most distinguishes good money from bad; and that it is of the greatest importance to ensure that the laws under which banking takes place are able effectively to restrain all dishonest forms of banking, including those in which the dishonesty is most subtle.

2. What is Money?

So what is money? A deceptively easy question, that. Answers from the past include “gold”, “silver and gold”, “a medium of exchange”, “a promise to pay”, “a store of value”, “a measure of demand”, “just another commodity”. Such answers hold a germ of truth, but only lead to controversy, because they miss the essential point. All along we’ve been asking the wrong question. Instead, let us ask a new one:

What is the function of money?

The function of money is to keep track of who owes what to whom. In a world in which there is division of labour and in which we obtain diverse satisfactions by the voluntary exchange of goods and services we have need of an accounting device to permit this exchange to take place at minimal cost and without undue coercion or confusion. This accounting device we call money. Simple barter is not enough, because the goods I want are seldom held by the person to whom I can render service.

Imagine a central register, detailing every transaction entered into by each and every person, and containing a list of all the favours owed by each and every person to each and every other person. That would do it. It would be hideously complicated, but it would work. Fortunately, though, we needn’t go to such lengths, because in a market economy most of that data is redundant. All we really need to know is the current balance to the account of each person — how much the rest of the world owes him or how much he owes the rest of the world — and even that need not be centrally recorded.

In a market economy, then, the function of money is to reduce the transaction costs of honest trade (including gifts and bequests other than those directly in kind) by reliably and efficiently registering the indebtedness resulting from previous transactions. The details of those previous transactions no longer matter; only the present net position counts (except for incomplete transactions, such as when you have bought an item but not yet paid for it).

So, if the function of money is to keep track of honest trade, can we now answer the original question in a more enlightened and constructive way? I think we can.

Continue reading “Honest Money through bearer shares, a proposal”

Economics

Jump Back From the Debt Crevasse

With what Mr Spock might call the fascinating financial news stories we have all seen in the last week or so, most people are coming around to the idea that we are on the edge of some kind of financial abyss. Is our drop into this abyss inevitable, in the best historicist tradition of the Marxists, or is there some clear route which can steer us away from a fall into a double-dip recession, or even a hyperinflationary depression, which is merely sitting around awaiting our discovery?

We at the Cobden Centre believe in the creation of a good sound currency system based upon honest money. However, the route to that may prove long and hard, and perhaps too long and too hard to get us quickly out of our current mess. Is there a simpler fix we can apply in the meantime?

Floy Lilley of the Mises Institute believes there is. She has been examining some financial reforms of the mid 1980s, in which New Zealand found itself in a remarkably similar position to our own current morass, with massive government debt and a large client state suffocating what remained of a shrinking productive sector.

How did the New Zealand government solve this problem?

Maurice P. McTigue, the former Minister of Works in New Zealand, led the assault. Some of the measures he instigated included reducing the Department of Transportation from 5,600 to 53 and reducing the numbers in the Forest Service from 17,000 to 17. In his own department, Mr McTigue remained the sole employee out of 28,000.

In a lecture he gave in 2004 (reproduced below), Mr McTigue explained how they achieved their remarkable turnaround in New Zealand’s fortunes, and how they escaped their own 1980s debt crevasse.

Alas, Ms Lilley believes our current UK Coalition government is incapable of adopting the bold measures taken by the New Zealand government:

Britain, too, is at a crossroads. Its political leaders cannot bear the thought of not spending, so they have stopped thinking about it. They are falsely convinced that any cuts in public spending would destroy the country’s basic public services and stop any economic recovery from ever beginning. Their economists have this backwards. The British population can look forward to ever-increasing taxation under the thumb of a coercive and costly bureaucracy whose monetary policies serve the state, but do not serve people.

Floy Lilley

But just in case there are any UK politicians out there who want to know how New Zealand did it, here is Mr McTigue’s 2004 lecture, as delivered to the students of Hillsdale College in the United States:

Rolling Back Government: Lessons from New Zealand

If we look back through history, growth in government has been a modern phenomenon. Beginning in the 1850s and lasting until the 1920s or ’30s, the government’s share of GDP in most of the world’s industrialized economies was about six percent. From that period onwards – and particularly since the 1950s – we’ve seen a massive explosion in government share of GDP, in some places as much as 35-45 percent. (In the case of Sweden, of course, it reached 65 percent, and Sweden nearly self-destructed as a result. It is now starting to dismantle some of its social programs to remain economically viable.) Can this situation be halted or even rolled back? My view, based upon personal experience, is that the answer is “yes.” But it requires high levels of transparency and significant consequences for bad decisions – and these are not easy things to bring about.

What we’re seeing around the world at the moment is what I would call a silent revolution, reflected in a change in how people view government accountability. The old idea of accountability simply held that government should spend money in accordance with appropriations. The new accountability is based on asking, “What did we get in public benefits as a result of the expenditure of money?” This is a question that has always been asked in business, but has not been the norm for governments. And those governments today that are struggling valiantly with this question are showing quite extraordinary results. This was certainly the basis of the successful reforms in my own country of New Zealand.

New Zealand’s per capita income in the period prior to the late 1950s was right around number three in the world, behind the United States and Canada. But by 1984, its per capita income had sunk to 27th in the world, alongside Portugal and Turkey. Not only that, but our unemployment rate was 11.6 percent, we’d had 23 successive years of deficits (sometimes ranging as high as 40 percent of GDP), our debt had grown to 65 percent of GDP, and our credit ratings were continually being downgraded. Government spending was a full 44 percent of GDP, investment capital was exiting in huge quantities, and government controls and micromanagement were pervasive at every level of the economy. We had foreign exchange controls that meant I couldn’t buy a subscription to The Economist magazine without the permission of the Minister of Finance. I couldn’t buy shares in a foreign company without surrendering my citizenship. There were price controls on all goods and services, on all shops and on all service industries. There were wage controls and wage freezes. I couldn’t pay my employees more – or pay them bonuses – if I wanted to. There were import controls on the goods that I could bring into the country. There were massive levels of subsidies on industries in order to keep them viable. Young people were leaving in droves.

Spending and Taxes

When a reform government was elected in 1984, it identified three problems: too much spending, too much taxing and too much government. The question was how to cut spending and taxes and diminish government’s role in the economy. Well, the first thing you have to do in this situation is to figure out what you’re getting for dollars spent. Towards this end, we implemented a new policy whereby money wouldn’t simply be allocated to government agencies; instead, there would be a purchase contract with the senior executives of those agencies that clearly delineated what was expected in return for the money. Those who headed up government agencies were now chosen on the basis of a worldwide search and received term contracts – five years with a possible extension of another three years. The only ground for their removal was non-performance, so a newly-elected government couldn’t simply throw them out as had happened with civil servants under the old system. And of course, with those kinds of incentives, agency heads – like CEOs in the private sector – made certain that the next tier of people had very clear objectives that they were expected to achieve as well.

The first purchase that we made from every agency was policy advice. That policy advice was meant to produce a vigorous debate between the government and the agency heads about how to achieve goals like reducing hunger and homelessness. This didn’t mean, by the way, how government could feed or house more people – that’s not important. What’s important is the extent to which hunger and homelessness are actually reduced. In other words, we made it clear that what’s important is not how many people are on welfare, but how many people get off welfare and into independent living.

As we started to work through this process, we also asked some fundamental questions of the agencies. The first question was, “What are you doing?” The second question was, “What should you be doing?” Based on the answers, we then said, “Eliminate what you shouldn’t be doing” – that is, if you are doing something that clearly is not a responsibility of the government, stop doing it. Then we asked the final question: “Who should be paying – the taxpayer, the user, the consumer, or the industry?” We asked this because, in many instances, the taxpayers were subsidizing things that did not benefit them. And if you take the cost of services away from actual consumers and users, you promote overuse and devalue whatever it is that you’re doing.

When we started this process with the Department of Transportation, it had 5,600 employees. When we finished, it had 53. When we started with the Forest Service, it had 17,000 employees. When we finished, it had 17. When we applied it to the Ministry of Works, it had 28,000 employees. I used to be Minister of Works, and ended up being the only employee. In the latter case, most of what the department did was construction and engineering, and there are plenty of people who can do that without government involvement. And if you say to me, “But you killed all those jobs!” – well, that’s just not true. The government stopped employing people in those jobs, but the need for the jobs didn’t disappear. I visited some of the forestry workers some months after they’d lost their government jobs, and they were quite happy. They told me that they were now earning about three times what they used to earn – on top of which, they were surprised to learn that they could do about 60 percent more than they used to! The same lesson applies to the other jobs I mentioned.

Some of the things that government was doing simply didn’t belong in the government. So we sold off telecommunications, airlines, irrigation schemes, computing services, government printing offices, insurance companies, banks, securities, mortgages, railways, bus services, hotels, shipping lines, agricultural advisory services, etc. In the main, when we sold those things off, their productivity went up and the cost of their services went down, translating into major gains for the economy. Furthermore, we decided that other agencies should be run as profit-making and tax-paying enterprises by government. For instance, the air traffic control system was made into a stand-alone company, given instructions that it had to make an acceptable rate of return and pay taxes, and told that it couldn’t get any investment capital from its owner (the government). We did that with about 35 agencies. Together, these used to cost us about one billion dollars per year; now they produced about one billion dollars per year in revenues and taxes.

We achieved an overall reduction of 66 percent in the size of government, measured by the number of employees. The government’s share of GDP dropped from 44 to 27 percent. We were now running surpluses, and we established a policy never to leave dollars on the table: We knew that if we didn’t get rid of this money, some clown would spend it. So we used most of the surplus to pay off debt, and debt went from 63 percent down to 17 percent of GDP. We used the remainder of the surplus each year for tax relief. We reduced income tax rates by half and eliminated incidental taxes. As a result of these policies, revenue increased by 20 percent. Yes, Ronald Reagan was right: lower tax rates do produce more revenue.

Subsidies, Education, and Competitiveness

What about invasive government in the form of subsidies? First, we need to recognize that the main problem with subsidies is that they make people dependent; and when you make people dependent, they lose their innovation and their creativity and become even more dependent.

Let me give you an example: By 1984, New Zealand sheep farming was receiving about 44 percent of its income from government subsidies. Its major product was lamb, and lamb in the international marketplace was selling for about $12.50 (with the government providing another $12.50)per carcass. Well, we did away with all sheep farming subsidies within one year. And of course the sheep farmers were unhappy. But once they accepted the fact that the subsidies weren’t coming back, they put together a team of people charged with figuring out how they could get $30 per lamb carcass. The team reported back that this would be difficult, but not impossible. It required producing an entirely different product, processing it in a different way and selling it in different markets. And within two years, by 1989, they had succeeded in converting their $12.50 product into something worth $30. By 1991, it was worth $42; by 1994 it was worth $74; and by 1999 it was worth $115. In other words, the New Zealand sheep industry went out into the marketplace and found people who would pay higher prices for its product. You can now go into the best restaurants in the U.S. and buy New Zealand lamb, and you’ll be paying somewhere between $35 and $60 per pound.

Needless to say, as we took government support away from industry, it was widely predicted that there would be a massive exodus of people. But that didn’t happen. To give you one example, we lost only about three-quarters of one percent of the farming enterprises – and these were people who shouldn’t have been farming in the first place. In addition, some predicted a major move towards corporate as opposed to family farming. But we’ve seen exactly the reverse. Corporate farming moved out and family farming expanded, probably because families are prepared to work for less than corporations. In the end, it was the best thing that possibly could have happened. And it demonstrated that if you give people no choice but to be creative and innovative, they will find solutions.

New Zealand had an education system that was failing as well. It was failing about 30 percent of its children – especially those in lower socio-economic areas. We had put more and more money into education for 20 years, and achieved worse and worse results.

It cost us twice as much to get a poorer result than we did 20 years previously with much less money. So we decided to rethink what we were doing here as well. The first thing we did was to identify where the dollars were going that we were pouring into education. We hired international consultants (because we didn’t trust our own departments to do it), and they reported that for every dollar we were spending on education, 70 cents was being swallowed up by administration. Once we heard this, we immediately eliminated all of the Boards of Education in the country. Every single school came under the control of a board of trustees elected by the parents of the children at that school, and by nobody else. We gave schools a block of money based on the number of students that went to them, with no strings attached. At the same time, we told the parents that they had an absolute right to choose where their children would go to school. It is absolutely obnoxious to me that anybody would tell parents that they must send their children to a bad school. We converted 4,500 schools to this new system all on the same day.

But we went even further: We made it possible for privately owned schools to be funded in exactly the same way as publicly owned schools, giving parents the ability to spend their education dollars wherever they chose. Again, everybody predicted that there would be a major exodus of students from the public to the private schools, because the private schools showed an academic advantage of 14 to 15 percent. It didn’t happen, however, because the differential between schools disappeared in about 18-24 months. Why? Because all of a sudden teachers realized that if they lost their students, they would lose their funding; and if they lost their funding, they would lose their jobs. Eighty-five percent of our students went to public schools at the beginning of this process. That fell to only about 84 percent over the first year or so of our reforms. But three years later, 87 percent of the students were going to public schools. More importantly, we moved from being about 14 or 15 percent below our international peers to being about 14 or 15 percent above our international peers in terms of educational attainment.

Now consider taxation and competitiveness: What many in the public sector today fail to recognize is that the challenge of competitiveness is worldwide. Capital and labor can move so freely and rapidly from place to place that the only way to stop business from leaving is to make certain that your business climate is better than anybody else’s. Along these lines, there was a very interesting circumstance in Ireland just two years ago. The European Union, led by France, was highly critical of Irish tax policy – particularly on corporations – because the Irish had reduced their tax on corporations from 48 percent to 12 percent and business was flooding into Ireland. The European Union wanted to impose a penalty on Ireland in the form of a 17 percent corporate tax hike to bring them into line with other European countries. Needless to say, the Irish didn’t buy that. The European community responded by saying that what the Irish were doing was unfair and uncompetitive. The Irish Minister of Finance agreed: He pointed out that Ireland was charging corporations 12 percent, while charging its citizens only 10 percent. So Ireland reduced the tax rate to 10 percent for corporations as well.

There’s another one the French lost!

When we in New Zealand looked at our revenue gathering process, we found the system extremely complicated in a way that distorted business as well as private decisions. So we asked ourselves some questions: Was our tax system concerned with collecting revenue? Was it concerned with collecting revenue and also delivering social services? Or was it concerned with collecting revenue, delivering social services and changing behavior, all three? We decided that the social services and behavioral components didn’t have any place in a rational system of taxation. So we resolved that we would have only two mechanisms for gathering revenue – a tax on income and a tax on consumption – and that we would simplify those mechanisms and lower the rates as much as we possibly could. We lowered the high income tax rate from 66 to 33 percent, and set that flat rate for high-income earners. In addition, we brought the low end down from 38 to 19 percent, which became the flat rate for low-income earners. We then set a consumption tax rate of 10 percent and eliminated all other taxes – capital gains taxes, property taxes, etc. We carefully designed this system to produce exactly the same revenue as we were getting before and presented it to the public as a zero sum game. But what actually happened was that we received 20 percent more revenue than before. Why? We hadn’t allowed for the increase in voluntary compliance. If tax rates are low, taxpayers won’t employ high priced lawyers and accountants to find loopholes. Indeed, every country that I’ve looked at in the world that has dramatically simplified and lowered its tax rates has ended up with more revenue, not less.

What about regulations? The regulatory power is customarily delegated to non-elected officials who then constrain the people’s liberties with little or no accountability. These regulations are extremely difficult to eliminate once they are in place. But we found a way: We simply rewrote the statutes on which they were based. For instance, we rewrote the environmental laws, transforming them into the Resource Management Act – reducing a law that was 25 inches thick to 348 pages. We rewrote the tax code, all of the farm acts, and the occupational safety and health acts. To do this, we brought our brightest brains together and told them to pretend that there was no pre-existing law and that they should create for us the best possible environment for industry to thrive. We then marketed it in terms of what it would save in taxes. These new laws, in effect, repealed the old, which meant that all existing regulations died – the whole lot, every single one.

Thinking Differently About Government

What I have been discussing is really just a new way of thinking about government. Let me tell you how we solved our deer problem: Our country had no large indigenous animals until the English imported deer for hunting. These deer proceeded to escape into the wild and become obnoxious pests. We then spent 120 years trying to eliminate them, until one day someone suggested that we just let people farm them. So we told the farming community that they could catch and farm the deer, as long as they would keep them inside eight-foot high fences. And we haven’t spent a dollar on deer eradication from that day onwards. Not one. And New Zealand now supplies 40 percent of the world market in venison. By applying simple common sense, we turned a liability into an asset.

Let me share with you one last story: The Department of Transportation came to us one day and said they needed to increase the fees for driver’s licenses. When we asked why, they said that the cost of relicensing wasn’t being fully recovered at the current fee levels. Then we asked why we should be doing this sort of thing at all. The transportation people clearly thought that was a very stupid question: Everybody needs a driver’s license, they said. I then pointed out that I received mine when I was fifteen and asked them: “What is it about relicensing that in any way tests driver competency?” We gave them ten days to think this over. At one point they suggested to us that the police need driver’s licenses for identification purposes. We responded that this was the purpose of an identity card, not a driver’s license. Finally they admitted that they could think of no good reason for what they were doing – so we abolished the whole process! Now a driver’s license is good until a person is 74 years old, after which he must get an annual medical test to ensure he is still competent to drive. So not only did we not need new fees, we abolished a whole department. That’s what I mean by thinking differently.

There are some great things happening along these lines in the United States today. You might not know it, but back in 1993 Congress passed a law called the Government Performance and Results Act. This law orders government departments to identify in a strategic plan what it is that they intend to achieve, and to report each year what they actually did achieve in terms of public benefits. Following on this, two years ago President Bush brought to the table something called the President’s Management Agenda, which sifts through the information in these reports and decides how to respond. These mechanisms are promising if they are used properly. Consider this: There are currently 178 federal programs designed to help people get back to work. They cost $8.4 billion, and 2.4 million people are employed as a result of them. But if we took the most effective three programs out of those 178 and put the $8.4 billion into them alone, the result would likely be that 14.7 million people would find jobs. The status quo costs America over 11 million jobs. The kind of new thinking I am talking about would build into the system a consequence for the administrator who is responsible for this failure of sound stewardship of taxpayer dollars. It is in this direction that the government needs to move.

Reprinted by permission from IMPRIMIS, the monthly journal of Hillsdale College