Monday, 3 October 2016

Deutsche Bank: A Vertically Integrated Problem

Recent concerns about Deutsche Bank’s financial position highlight again that banking remains fragile. On Friday Deutsche Bank’s shares fell nearly 9% at the opening bell as investors panicked about news that hedge funds had started to pull business from the company.  This comes off the back of increased concerns about potential writedowns and the vulnerability of its coco bonds at the start of the year.

The immediate trigger for this most recent panic is a $14bn demand by the US Department of Justice to settle allegations related to the mis-selling of mortgage backed securities & CDOs during the 2000s boom. This comes after several other large banks settled similar cases with the DoJ: Bank of America paying a $16.65bn settlement for activities undertaken by it and its subsidiaries including Merril Lynch and Countrywide Financial Corporation, JP Morgan paying $13bn and Citigroup  $7bn. In some cases the fines eventually paid were significantly less than the original sum demanded by the DoJ. There is hope within Deutsche Bank that a similar deal can be struck and a lower amount paid, with recent estimates venturing that the figure could be closer to $3-4bn.

But Deutsche Bank’s bargaining position with the DoJ may be hampered by the specific detail of its activity in RMBS and CDO markets during the boom. Unlike US banks, Deutsche Bank ran a more vertically integrated model of securitization (Exhibit 1) which meant it occupied a different space in the market compared to its competitors. By integrating trustee, listing and other administration functions (which are provided by external parties in most US CDOs) the DoJ will have to consider whether Deutsche Bank’s larger footprint potentially gave it a knowledge advantage.

Exhibit 1: Deutsche Bank entities co-participation in CDOs. Line thickness = #of joint products (values given); size of node = #of CDOs involved with.

To illustrate the point, with the STAtic CDOs that featured heavily in the Senate report on the causes of the financial crisis (373 f. Footnote 1505), either three or four Deutsche Bank entities were usually involved in their structuration: DB’s Irish Deutsche International Corporate Services Ltd., its Cayman Deutsche Bank (Cayman) Ltd., its American Deutsche Bank Securities Inc., Its Luxembourgian Deutsche Bank Luxembourg S.A. and Deutsche Bank (Exhibit 2). These positions were mainly occupied by independent providers in the case of US bank CDOs. Not only that, but Deutsche Bank also sold these services to other market participants (Exhibit 3).

Exhibit 2: Deutsche Bank entities involved in START CDOs 

Exhibit 3: Comparison between Deutsche Bank entities and other major US banks involved in the CDO market

The DoJ will have to consider whether Deutsche Bank’s vertically integrated model gave it access to more information about the quality of the due diligence and thus the underlying collateral in the CDO market. If it believes Deutsche Bank’s structural position meant its employees did know more than their competitors, then - given the febrile context - it might now be financially prudent to consider jail time for the individuals involved rather than fines for the institution. 

Stanley & Tatu.

Sunday, 26 June 2016

Tactics Without Strategy: Brexit And The Politics Of Conceit

With two million Conservative voters seemingly ‘undecided’ last week and Labour voters preponderantly pro-Remain but susceptible to no-shows at the ballot booth, it was tempting to presume before the vote that an event of this magnitude might be decided by something so quintessentially British as the weather. Come Friday morning, it was abundantly clear that was not the case. The gap between Leave and Remain was just under 1.3 million votes, far greater than can be explained by a June downpour. The outcome is humbling.

In due course the referendum defeat will become the textbook reference for political hubris. Cameron’s referendum campaign showed a fundamental underestimation of public mistrust with the political establishment when it committed taxpayers’ money to the production of Remain leaflets. Similarly an appeal to the eminence of its leading voices on the risks of Brexit – prescient though they were – might work when it comes to winning over fearful middle class swing voters in marginal seats, but alienated a large and sceptical cohort who had not done particularly well since the 1990s. This played to Leave’s strengths who were only ever going to run a populist campaign with immigration as the issue ‘the establishment wouldn’t touch’. The more establishment figures Remain wheeled on, the more remote they seemed.  

The referendum loss symbolises Conservative leaders obsession with tactics at the expense of strategy. They built a machine to be elected not govern, perfecting the art of winning small political skirmishes which embrangled them in increasingly intractable commitments. Eventually one intractable position was not going to hold.

So where does the referendum result leave things? Economically, we are in a difficult place. The EU will push for an early exit to reduce uncertainty in other EU countries. The longer negotiations are drawn out, the more turmoil will be inflicted on our major trading partners within the EU - there is a good chance they may move into recession, as seems unavoidable for the UK. It is sadly true that they also must make an example of us or risk giving hope to Leave movements elsewhere. Investment, already weak, will retreat until some certainty returns. This is happening in real time, with huge swathes of construction now put on hold. Financial markets are not as robust as we are led to believe and the £250bn injection promised by the Bank of England - presumably a bid to stave off a prospective wholesale run as bank stocks fell 30% – would seem to support that. We have yet to see the effects of a ratings downgrade and sterling devaluation on the economy. It is doubtful that the devaluation will benefit the export sector radically: in four of the last six major periods of devaluation there has been no impact at all. These are not the conditions under which the politics of optimism thrive.

This takes us to the Leave campaign. The campaign was built on an anti-establishment/anti-intellectual ticket led by an old Etonian and another Oxford graduate. It traded on the conceit that many of the UK’s problems could be solved by ‘taking back control’ – an organising metaphor abstract enough to galvanise a body of voters with quite different perceptions about what this meant. The usual accusations about Leave being ‘old, uneducated people in the North’ have already surfaced but the reality is much more complicated: 43% of ABs voted Leave, for example – that’s a lot of skilled workers and professionals. Similarly, the geography of the Leave vote is split between cosmopolitan centres like London, Bristol, Manchester and Liverpool on the one hand and smaller towns and rural areas on the other. The most important indicator of a Leave voter is value-based according to Ashcroft’s polling data: in other words, we are witnessing the reawakening of a particularly cynical, conservative English authoritarian personality which cuts across class and geography. ‘Taking back control’ in this context signalled a variety of things: release from the EU’s institutional sclerosis and immured power bases; rejection of the neo-liberal grip on policy formation; devolution and an improvement in accountability and sovereignty. But for many it primarily meant control of immigration. And the Leave campaign was happy to let people believe that this was precisely what we were voting for.

The problem now is that this puts Johnson and Gove in precisely the predicament of Cameron and Osborne.  The latter were outmanoeuvred tactically, but it is Johnson and Gove who have the larger strategic quandary. The flipside of the Leave campaign’s amorphousness is that all of its voting tribes will expect their vision of Brexit to be delivered: that is the risk with summonsing ‘end-of-truth-and-reason’ politics. Putting aside the inconceivability of honouring the £350m per week to the NHS pledge, they have a much larger problem regarding immigration. If they opt out of the pledge to stop free movement, as pro-Leave campaigner Daniel Hannan has already indicated, those who voted Leave believing it was a vote to control immigration will feel betrayed.

This is ultimately why I am pessimistic. If you lead a populist, anti-immigrant campaign on an anti-establishment platform, and then support an EFTA model that retains free movement, you will discredit yourself and the democratic process. Add to that a rapidly deteriorating economic climate and the resurgent nationalism you were complicit in stoking, and voters will begin to embrace the extreme right. It will take considerable political skill for Johnson and Gove to manage this next phase should they replace Cameron and Osborne. I am not sure it is within their capabilities. Both have a facility with the blunt instrument of populism, but they do not possess the political guile and sophistication to deal with the subtle intricacies of a perceived volte face in such a febrile climate. Farage, however, does have the necessary nous and aggression to point out their deceit.

Can the Left stop this? They are in a difficult position, not least because we are seeing the working out of the legacy of New Labour - its mishandling of the financial crisis and intransigence towards its heartlands. This instilled a sense of injustice, of powerlessness, of being cut adrift. Atavism fills the space left by the dismantled social and economic institutions that build solidarity and community. The Labour Party were correct to move to the left to reconnect with those communities as voters began to defect to UKIP, but they have the wrong leader to deal with the fight to come. The Labour Party needs a brawler, not a history teacher.

Whoever that might be, they will need to address some of the profoundly reactionary sentiments of their ex ‘core vote’. Anti-immigration is now a deeply ingrained and increasingly animating ideology that will be difficult to reverse. A politics of trust, tolerance and understanding to support vibrant communities of difference is needed. This requires a redistributive politics to fund the rebuilding of the economic and social institutions that embed harmony: better jobs, better public services, better social housing. That may grate with the business elites of London and other cosmopolitan centres, but social dislocation is not good for trade and growth either. As Duncan Weldon has pointed out: capitalism needs social democracy to function. The state now has a duty to stabilise capitalism by acting against the interests of its most vocal proponents and greatest beneficiaries. This is the challenge for Labour.


Tuesday, 5 April 2016

Panama Leaks In The Context Of Austerity

I always thought the austerity rhetoric had something of ‘the spirit of the Blitz’ about it. Austerity (the rhetoric) instilled a sense of togetherness and inclusion in the British public even if austerity (the programme) had a highly uneven impact on different groups, and was largely ineffectual in improving our country’s economic fortunes. In a country steeped in nostalgia for the Second World War, this kind of appeal to mass public sacrifice had a galvanising effect. The British public accepted the idea that some personal short term pain was necessary, even if they privately wanted to see more of that pain passed on to those they deemed less deserving. It conjured images of rationing, of a British public without heed to class distinctions responding stoically to a time of crisis - we were ‘all in it together’, showing our unity and our mettle in times of adversity. Even our cultural artefacts said ‘Keep Calm And Carry On’, before the Hoxtonistas got their hands on them.

It is perhaps because of the success of austerity (the rhetoric) that the Panama leaks are so potentially damaging. The unpalatable situation that confronts the Conservative party this morning is that at the time David Cameron announced the absolute necessity of austerity to UK citizens, his father had employed the services of Mossack Fonseca to avoid making the sacrifices perceived to be the duty of others less well off than himself. Time will tell if Cameron stood to gain personally from this arrangement, but it is now difficult to avoid the sense that we were never all in it together: it was always one rule for the privileged and another for the disabled, the homeless, the council workers, the nurses, the junior doctors and multiple others who were told that there was no alternative and that we all must give up something for the sake of the many. For a party steeped in family and other money, much of which may prove to be mobile, there will be nervousness amongst Tories tonight because that image is potentially toxic.

The British electorate do not like hypocrites and they don’t like to be taken for fools. It was, after all, the hypocrisy of the Back To Basics programme that undid the previous Conservative administration, as revelations about extra-marital affairs, romps and exotic sexual encounters undermined the party’s authority to wag its finger at ordinary people and preach the merits of self-discipline and the sanctity of the family unit. The routine scandals made the party a laughing stock and robbed them of power for nearly a generation. We are now potentially in Back To Basics Mark II. When asked to make sacrifices, we like to think it is not beyond those who stand to lose least proportionately to muck in; particularly when the financial crisis was in large part an elite debacle in the first place. What we learn from the Panama leaks is that for the rich, including allegedly a relative of our leader, even these modest sacrifices were unacceptable.

Cameron has said that this is a private matter, but it cannot be this time. The context of his own austerity rhetoric makes this new revelation unavoidably public. This can’t be handled like the pig-gate affair which was successfully starved of oxygen; his one-line response is of similar intent. Cameron now stands accused of something much worse: he is accused of being a hypocrite and of taking the British public for fools. And that is much more serious politically.


Tuesday, 29 July 2014

The End Of The Experiment? Part 4

Changing the economic frame/ Making a political difference

“There is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. For the reformer has enemies in all those who profit by the old order, and only lukewarm defenders in all those who would profit by the new order, this lukewarmness arising partly from fear of their adversaries … and partly from the incredulity of mankind, who do not truly believe in anything new until they have had actual experience of it.” ( Machiavelli, The Prince, 1532, Chapter 6)
“For the overriding economic problem discussed in this book, the first necessity is not technical devices but the public acceptance necessary to make them work” (Hirsch, Social Limits to Growth, 1977, conclusion)

It has long been understood that it is politically difficult to introduce a new and untried order of things which upsets the economic status quo. With the slow motion economic failure of the 30 year experiment, it is nevertheless important to ask:  how can we make a difference politically and begin to organise a better world. The answer is not obvious. We have accumulated so many critiques of neo liberalism that, if they were all piled up one on top of another, they would surely by now reach to the moon. And yet, after several decades, we are no closer to defeating neo liberalism.

This disconnect between critical thought and effective action isn’t a problem for everybody. As we have argued in our blog about Thomas Piketty’s Capital, the sales success of that book can be attributed to the way in which it combines fact driven critique of growing wealth and income inequalities with an utopian solution of higher income and wealth taxes. This solution will never be enacted when we live in post democracy where the mass party is no more and the organised working class have been disempowered
But it is a big problem for the team that wrote The End of the Experiment because we wanted to write a book that moved from critique of the thirty year experiment to new political proposals for action and intervention.  Of course we are academic scribblers not political practitioners. But we can break with the dismal TINAF (There is no Alternative Framework) assumption that frames current centre left and centre right politics; and hope that  our arguments can have some performative impact in the next phase of ongoing crisis

In our book, the distinctive form of our critique shapes our concept of the alternative. Because the one centralised, Westminster led dogmatic experiment has failed, we recommend much more diversity of regional and local experiments which provide the basis for discovering answers. Because our critique shows that the generic fix of competition and markets has led to sectoral mismanagement, we recommend a different approach which recognises the heterogeneity of the economy and engages with activity specifics in what we call the foundational economy.

The argument on these points in The End of the Experiment  is dense but it can be simplified and systematised.  The book’s policy argument starts from a contrarian insight about how there is more than one economy. It then focuses on part of the economy by proposing the foundational  economy as an alternative object before proposing chain value and social license as policy principles do which could be developed and articulated through local experiments 

1) The contrarian insight
After thirty years, it is not difficult to see the problems inherent in the current framing of our politico- economic problems in a country like the UK. It is increasingly realised that our economic problems do not have technical solutions with existing management tools. It is widely accepted that the current UK recovery is consumption based, debt fuelled and unsustainably driven by house price rises: if that observation is set in the context of boom and bust over the past thirty years, the implication is that there is no setting of the macro policy levers (fiscal and monetary) which will deliver sustainable UK growth.

The main stream response is denial. The Thatcherite revolution fails because it is incomplete, the answer is more of the same (and please don’t talk about debt based growth). The generic fix of competition and markets is now applied with more force to energy, banking and every other sector; this structural reform is backed by bolt-ons like industrial policy to deal with market failure in the commercialisation of early stage innovation.

This kind of obsessive compulsive behaviour may be increasingly incredible; but it is at the same time difficult to reframe issues and propose an alternative that works. The difficulty relates to habits of thought and organisational peculiarities which are embedded in main stream British politics.

In terms of overall vision, the centre left’s question has always been why can’t we be more like Germany and their difficulty is that they have no policies which would move the British economy away from financialization and onto a more virtuous productive path. Manufacturing output shows no sustained output growth because the aspirations of foreign owned branch firms are limited as are the capabilities of British firms who prefer to compete in sheltered sectors; adding more finance for production or up-skilling the workforce will achieve little without radical changes elsewhere because UK supply chains are constructed around low skill and investment.

As a way of breaking out of this impasse, we turn to the insights of the French historian, Fernand Braudel. First, “there is more than one economy” because the economy is heterogeneous and includes zones that are not competitive. Furthermore, capitalism is as much about monopoly as competition because local monopolies are what many firms want and the state can franchise. These contrarian insights are the basis for our break with main stream thinking.

In the 30 year experiment, the economy was represented as the unitary sphere of competition where all should submit to the imperatives of globalisation; this conceptualisation was reinforced by the aggregation of everything into national income measures with growth and jobs then promoted as the objectives of policy. Against this we argue that a large part of the economy (more than one third) is sheltered from competition; while growth and jobs are socially meaningless objectives when the income gains from growth are captured by the top 10% of households by earnings and because low wage jobs spread welfare dependence

2) Our object is the foundational economy
After recognising the heterogeneity of economic activity, the question is about how to think about the different zones and their interaction. Our focus is on the zone or sphere which we call “the foundational economy”. The foundational has never been an explicit object of policy and (we would argue) has been mismanaged insofar as it has been subjected to the competition and markets fix.

What’s inside the foundational economy? On our calculations, we include the pipe, cable and wireless utilities that deliver water, energy and broadband, transport utilities like rail and bus, food processing and distribution through supermarkets and most of the lower levels of health, education and welfare. Their outputs are mundane goods and services, from processed food to primary education, which lack the glamour or attractiveness found in high tech or knowledge based “key sectors” like aerospace or the creative industries.
The activities inside the zone are diverse in terms of outputs or ownership because the foundational economy produces a bewildering variety of goods and services under private and public ownership. Yet these activities also have a series of shared characteristics which are the basis for our classification.  These goods and services are all foundational because they are necessary to everyday life, consumed by every citizen regardless of income and distributed according to population through branches and networks. They are also typically sheltered and often politically franchised so that the state (through regulation and planning laws) gives the cable tv operator or the big box retailer an effective local monopoly.

When these activities are bracketed together, the foundational economy appears as a large and strategic zone for several reasons. Large because the foundational economy employs one third or more of the UK workforce; strategic because the cost, quality and security of foundational goods and services (such as energy supply and health care) are key determinants of citizen welfare. Indeed foundational activities are funded by a kind of lien on tax revenue and household expenditure; foundational expenditure accounts for 30% on average of weekly consumption in households who have little choice about paying utility bills or buying supermarket groceries.

After a period when low cost provision of many of these goods was taken for granted, the price and security of foundational supply is increasingly an issue. The crisis of foundational supply is related partly to the limits of our small planet and partly to the failed thirty year experiment; thus, our privatized utility operators like BT are investment averse and British infrastructure is increasingly being half-heartedly renewed by billing the customer or taxpayer for investment.

3) Our economic principle is chain value
Our argument on the foundational economy starts from a distinction between two concepts of value (point value and chain value) which is then developed into an argument about how the foundational economy is being mismanaged on point value principles and would be better managed on chain value principles.
Point value means that the measure of success is least cost or highest profit in an individual transaction (or basket of transactions) at a node in an economic chain. Point value is an active and now ubiquitous principle in the calculations of private and public sectors.

It is represented in the public company imperative of shareholder value through quarterly earnings and higher stock price; or in private equity through cashing out by selling a portfolio company to meet the equity investors’ demand for high returns which are levered up with cheap debt. But it is also represented in the public sector response to budget cuts and value for money when, for example, in adult home care the local authority cuts the hourly rate paid to the agency supplying care workers.

Point value has considerable intellectual prestige; because it is in one form materialised in all the post 1930s business school calculations of return which take account of the time value of money; as with discounting to calculate net present value. At ordinary rates of interest, such calculations are socially questionable because they devalue the future by attaching a very low value to returns more than 5 or 7 years away.  Practically also, they are place bound because point value represents a trader mentality which ignores broader social consequences.

Point value is embedded in private business models which then pass problems down the chain as with supermarkets which use their power to capture supplier margins. In the public sector, the problem is that the state gains on one account only to lose on another account. Thus, wage cuts will reduce the cost of providing council services but increase the demands for housing benefit and other kinds of welfare support.  Pervasive point value therefore spreads unsustainability as private and public actors trumpet their point success when supply chains are undermined and the welfare bill spirals out of control.

So our alternative is back to the future with the alternative principle of chain value.  We should recover the idea of value as a stream of benefits for (internal and external) stakeholders over time. Benefits are not only financial and measurable through one master calculation because there are several orders of worth and long term uncertainty requires defensive prudence. This requires a different kind of economic calculus which balances the interests of different stakeholders (rather than privileging the investor); and introduces political objectives around the ideal of connected economies which deliver both the benefits of re-localisation and of national standards and inclusive national networks 

One of the central problems is that much of this calculus about interconnection is not actionable within the current British system and is equally unlikely to be realised through  the forms of decentralisation which are currently on offer. The British way after the 30 year experiment is to dispense with intermediary institutions and combine self-governing operating units with centralised political power which micro manages in an interfering way; hence the decision makers are the PLC board or the Academy School governors subject to interference by Vince Cable or Michael Gove. As for devolution and decentralisation, in the bi partisan view, articulated in the Heseltine and Adonis reports, this is a matter of handing decision making and central money to dominant regional elites with very few questions asked.

4) Our political principle is social license
The operationalization of chain value thus requires not so much more government as a different concept of what nested levels of government are and can do. As well as very much less reliance on governance at operating unit level which always promises much more than it delivers.

We are against the post 1979 concept of business friendly government which has dominated in the period of the thirty year experiment. In this frame, government’s role is facilitative as it creates the space in which the incentives of markets and competition do their work; hence the structural reform agenda of lower taxes, market liberalisation, deregulation and privatisation. The only acceptable forms of local and regional policy are infrastructure and training which make the market work better (and now help create competitive agglomerations); industrial policy is about rectifying market failure in commercialising innovation. 

Against this, we make another back to the future argument which revives the 1930s ideas of US thinkers like Berle about how business and community are in a relation of mutual dependence because all business exists under a social contract whereby the corporation should offers responsible behaviour in return for the privileges which allow market access and secure profit taking. This is especially so in the foundational economy where the privileged business gains a local monopoly on the household spend of an immobile population in communities and user groups

Hence our arguments for social license in the foundational economy with the aim of enforcing the obligations of business to the community (which are much broader than those of customer care). The explicit analogy is with the mining industry where a social license about benefits for the local community is the quid pro quo for the right to exploit immobile natural resources. Social licensing in the foundational economy would impose relevant conditions on specific activities. Thus, councils would be obliged to pay living wages while supermarkets should attend to local sourcing; this would need to be backed by social innovation to change business models.

All this has fierce political pre- conditions in that change through experiments with scope and scale requires decentralisation with intermediate institutions under electoral and civil society pressure for change. But, if we do not have the answer and favour diverse experiments, then regional and local government can begin right away with experiments in areas, like adult care, where resistance to change is weakest. The question is whether regional and local governments, under pressure from civil society, can rise to this challenge and through experiments and “ actual experience” demonstrate the potential of this approach in ways which increase not just “public acceptance” but public demands for change.

Manchester Capitalism

The End Of The Experiment? Part 3

The Foundational Economy: A different starting point

If the exhibits in Part II show that the market experiment had many unpredictable and unanticipated outcomes, how does that register in the UK’s core sectors? ‘The End of the Experiment?’ develops three case examples of ‘foundational economy’ activities that demonstrate what’s gone wrong over the past 30 years and how we could do things differently for better economic and social outcomes.
Our starting point is that is that all markets are embedded in politics and that we currently have a problem with political planning. The cases of i) telecoms and broadband, ii) supermarkets and dairy, and iii) retail banking are services most of us use every day. The cases show the increasing prevalence of ‘point value’ calculations and trader mentalities within large, quasi-monopolies, where cashing out often comes at the expense of national outcomes and social objectives. All reveal different fault-lines in their business models that work against societal interests as well as the limits of a generic ‘competition and markets’ framework.

Let’s follow the money and find the faultlines

The End of the Experiment?’ cases show how, in different ways, we have ended up with socially and economically dysfunctional outcomes. This is unsurprising when much of the foundational economy is dominated by shareholder value driven business models. There are some generic overlaps such as confusion marketing but all in all three cases the key drivers are financial because giant PLCs compete on two dimensions: (1) the product market to win customers; (2) the capital market to generate the narratives and numbers expected by stock market investors.

The former publicly owned BT in its modern guise shows a marked reluctance to invest in a national network of fast broadband. This unsurprising result is the legacy of privatisation where BT demonstrates a preference for distributing dividends - £20 billion distributed since 1984 – and buying back its shares. The outcome is that its super-fast fibre optic broadband terminates at the cabinet adjacent to, rather than on, the premises. The government’s aim of rolling out super-fast broadband nationally meets BT’s corporate requirements, but does it necessarily meet social needs, particularly when the company expect the state to subvent an extension of the network to rural areas?

Supermarkets present themselves as supporters of British farmers, but a point value mindset often harms stakeholders as suppliers are squeezed upstream. In dairy farming the farmers are visible and vocal complainants, but the invisible and silent victims are often the milk processors in the middle of the chain. In the decade since 2001, processors’ share from a litre of milk has declined from 35% to 19% while supermarkets have maintained margins through a form of predatory contractualism.

Retail banks’ rely on the pressure selling of products to customers where the proceeds are applied to cover branch costs. This is a necessity under a shareholder value driven model in the context of free banking. This often results in numerous mis-selling scandals – the fines for which are treated as a basic cost of doing business. The policy response is nearly always to encourage new entrants, without any understanding of either the destructive competition in the product market or the unreasonable capital market demands for high returns on equity which underlie the dysfunctional business model.

Is this the outcome of market competition?

All three cases play out in different ways but all have socially and economically dysfunctional outcomes. All manage to deliver acceptable stock market returns (although some supermarkets are under pressure). But all crucially depend on their supply chain positioning at key pinch points which gives them power over suppliers or customers. The pursuit of ‘point value’ strategies means that position is exploited to extract value immediately at the expense of a stream of benefits over time. Value is maximised at the point of transaction to benefit the shareholder; profits are levered on suppliers and customers without regard to the social/national interest.

The 30-year experiment has above all enshrined generic competition as its mantra. And to varying degrees, with governments of different hues, this is the principle that has underpinned policy. So within this context, how, in such a large portion of the economy, have these PLCs maintained return on equity and profit margins?  Equally, how have PLCs limited the effects of competition when firms are competing amongst themselves inside each sector?

The key features that have prevented the erosion of margins and returns are (a) the companies avoid direct price competition through confusion marketing which is actively used in all three sectors (e.g. bundling to make comparisons difficult); (b) PLCs inside sectors operate using similar business models –often narrated to emphasise differences –that create an opera of stereotyped competition with emphasis on a part e.g. service, plus (c) PLCs using ‘point value’ as a means of exploiting local power relations to take margins off other stakeholders.

There are alternatives but they require vision and framing

The normal treatment of corporate excess and scandal is to claim that it is the result of ‘market failure’ which requires ‘more competition’. These framing devices dominate the rhetoric of Select Committees, policy reports and other outputs. The recommendations are always generic: encourage new entrants, educate consumers, limit monopoly excess. In doing so, the frame narrows our field of the visible and limits our imagination about what alternatives are possible.

The success of this framing has been overwhelming. But there are many other experiments beyond the free market that perhaps meet social and economic need more successfully. These experiments focus on co-operation and co-ordination to rebuild fragile or fragmented supply chains that resulted from the 30 year experiment. They include modest innovations by local authorities in the UK trying to re-glue the supply chain fragments by co-ordinating private sector partners; building agglomerations of expertise and overlapping functions in their area. These experiments also emerge spontaneously in the private sector: for example, Morrison’s vertically integrated meat supply chain secures supply and investment-driven efficiencies. Similarly Tesco’s intervene in the milk supply chain by guaranteeing, via the processors, a minimum price per litre that effectively puts a floor under competition. Alternative forms of ownership may also change the characteristics of competition: municipally owned utilities in the US compete successfully against PLCs, despite operating with quite different priorities. These different examples do not necessarily require central state planning or co-ordination since they involve the rebuilding supply chains from the bottom up.

These are all experiments related to building the foundational economy.

Looking at the three cases in the book it might be easy to conclude that these are just examples of ‘bad company behaviour’. But that would be an alibi and deny the need for something more than just the restatement of more competition and more markets with the usual bolt-ons like industrial policy. But doing something different requires a fundamental reframing of our problems that should include interventions through licensing for social objectives. However, that will require political will not generic fixes for the generic rhetoric of market failure.

Manchester Capitalism

Thursday, 3 July 2014

The End Of The Experiment? Part 2

The free market experiment began with the Thatcher government of 1979 and continued under Major, Blair and Brown. Looking back, many of the changes that occurred in the UK were not well anticipated by the arguments made for markets at that time. Yet despite these undisclosed outcomes, our political classes have yet to consider a 'null hypothesis' result.

The 1980s experiment was premised on a set of visionary promises about what the market could deliver. The vision centred on a critique of the State as a blockage on jobs, growth and competitiveness and a distorter of price signals in a market setting. Drawing on the sentiment, if not the detail, of the Bacon and Eltis thesis, it was argued that the public, non-marketed sector ‘crowded out’ private sector investment and enterprise. Similarly the debate over the public utilities was transformed by an Austrian view that the market would bring the rigour of competition and efficiency of co-ordination to cumbersome public utilities industries. The solution was wholesale de-regulation and privatisation to release entrepreneurial spirit and build an enterprise culture that would benefit ‘the public’ in its multiple identities: as producers, consumers and taxpayers.

The reforms may have had effects, but they were often not the effects that were expected. Surprisingly, public sector job creation increased, both absolutely and relative to private sector job creation under Tory administrations (figure 1). 86.4% of net new jobs created from the beginning of the Thatcher administration to the end of the Major administration came from the public sector. Whilst some of that is explained by the economic cycle, it was mostly the result of a secular decline in manufacturing jobs (over 3m net jobs were lost) which the growth of financial services could not rebalance (only 250k net new jobs were created). By the end of New Labour in 2007 this figure had risen: 4.4m manufacturing jobs had been lost since 1979, with only 330k new financial services jobs created to compensate. What the Conservatives - and later New Labour - discovered was that public sector jobs were a necessary cost, ‘filling in’ for (not crowding out) anaemic private sector job creation and buying in public quiescence at a time of unrest.

Figure 1

Equally unanticipated  was the lack of new entrepreneurial sole traders and SMEs, despite the promise that deregulation extended. From 1992 (when our time series began), the number of full time self-employed workers was virtually flat, until redundancy forced expansion after the 2007 crash. Instead, there was a growth in casualised, insecure low paid jobs: part-time self-employed jobs increased 116%, while part time workers for corporations increased 32% (figure 2). At the same time, large firms failed to show the entrepreneurial flair promised in the discourse of free markets, choosing often to sacrifice high risk/high return activities for modest returns, low risk activities plus scale. The free market experiment, in other words, created an environment where capital satisfices: large companies calcifying around the apparatus of the state, lobbying hard for the release of ever more low return but safe public activities.

Figure 2

This pattern of satisficing was also evident in investment, which always carries risk because it is a gamble on management's strategic and orgranisational competences. The free market experiment promised to stimulate investment, but these problems stubbornly remain. Investment as a % of GDP fell from 17.6% in 1980 to 14.4% in 2013; and the UK continues to have the lowest investment share of GDP among all G7 countries (figure 3).

Figure 3

If the hypothesis that markets would stimulate private sector job growth and investment proved faulty, it equally did not capture unexpected drivers of growth in a more marketised economy. Both Tory and Labour administrations assumed that growth would come from operating efficiencies, competitiveness and specialisation forged within dynamic markets. What they did not anticipate was the importance of credit and asset prices as key sources of growth in a liberalised economy. The push of newly minted credit against real estate assets allowed households to cash out equity gains as income. That income was spent, and GDP rose. It is a staggering fact that housing equity withdrawal was equal to 104.2% of GDP growth under the Thatcher administration and 101.7% of GDP growth under Blair (figure 4). And whilst equity withdrawals were not always spent on items accounted for under GDP measures, its contribution to growth should not be underestimated.

Figure 4

So what were the outcomes? It is clear that the opportunity culture did appear for some: house-flippers, upper income employees in the state subvented sectors, the (subsidised) financial services industry and certain professions all did well. But for many, the disposable income inequalities that emerged put a ceiling on opportunity as income mobility rates fell. By the end of the 1970s the tenth richest households (D10) had five times as much disposable income (before indirect taxes) as the tenth poorest households (D1). By the 2000s the average ratio was almost ten times. These effects were further amplified by the shift from direct to indirect taxes which hit the poor disproportionately: D10 to D1 inequality was 13.4 times on average over the 2000s, up from just over 5 times at the end of the 1970s by this measure (figure 5).

Rising inequalities between households should be understood within a broader context of disenfranchisement as household's lost their stake in GDP growth. At the beginning of the 1980s average disposable household incomes were – effectively – a lien on growth. That changed by the mid-1980s, so that by 2011 (when our series ends) the disposable household income growth of the bottom 90% of households had not kept up with GDP (figure 6). And even the top 10% of households had only just kept pace with GDP growth. Where did this share go? Labour’s pre-tax share of GDP fell 3.5 percentage points from 1979 to 2010 - this was almost identical to the growth of financial corporation gross operating surpluses share of GDP, which increased 2.9 percentage points; although taxes on products and production also claimed a similar increased share of GDP.

Figure 5

Figure 6

These unexpected outcomes may truly surprise us. But surprises are commonplace in all experiments. Learning from those unanticipated results – in this case – seems something that our political classes are less willing to contemplate.

Part 3 will be posted next week...

Manchester Capitalism

Monday, 30 June 2014

The End Of The Experiment? Part 1

Our new book, The End Of The Experiment? From Competition To The Foundational Economy  is now available  as an ebook on Kindle. Over the coming weeks we will be outlining its argument and we begin here with a sketch of the historical and intellectual context of the work.

The British economy has been in relative decline since the last quarter of the 19th century, and there has been debate about the sources of that decline since at least the great ‘national efficiency’ debate prompted by the failings revealed by the Boer War.  Britain, it seems, is the subject of eternal experiments. In the post-war years there have been two. The first was the post-war settlement, which delivered historically unparalleled prosperity and generous public goods in the form of the welfare state. That settlement floated on the ‘long boom’ (the thirty glorious years) and it sank alongside that long boom in the 1970s. For over thirty years now we have lived through a new experiment, symbolically inaugurated by the victory of Thatcherite Conservatism in 1979, but an era of experimentation which also encompassed the heady years of New Labour domination. That experiment had several well known features.  It created ‘flexible’ labour markets;  it dismantled the command economy represented by publicly owned industries;  it placed a bet on the creation of a ‘branch’ economy in manufacturing in a global division of labour, and on a financial services revolution in London; it prompted an outsourcing revolution which saw numerous public services franchised to private corporations; it created an audit state; and it ushered in a new era of micromanagement by the Whitehall elite.

The starting point of our book is the failure of this latter experiment.  The public occasion of failure was the great financial crisis, but the roots lie much deeper.  Our book explores four great deficits left by the thirty year experiment:

  • A competitiveness deficit: productivity stubbornly lags behind our competitors; the financial services sector  has failed to generate employment; and ‘branch’ manufacturing  has failed to solve the problem of the trade deficit.
  • A sustainability deficit: the post-war settlement delivered generous public goods; we show (for instance  in our broadband chapter and in the separate studies of the rail industry carried out in CRESC) that the privatised system isn’t delivering a sustainable infrastructure.
  • An accountability deficit: the thirty year experiment was legitimised in the language of accountability, but it has created new worlds of unaccountability – out of control corporate elites, franchises in privatisation and outsourcing shrouded in opaque accounting, constant uncertainty about accountability lines between politicians and service deliverers.
  • A competence deficit: the age of experiment has also been  a new age of fiasco -  outsourcing, PPI, rail privatisation, financial regulation; a hollowed out civil service unable to police the new franchises.

The metaphor of an experiment has an appealing ring: experimentation is, after all, the standard method by which the sciences learn, by  testing, refuting or confirming theories. But the British history of experimentation is very different: we show in the book that we live in a state that finds learning from experience very hard. There seem to be three political reasons for this:

‘Hyperpoliticisation’: in a world of extreme micro-management everything is turned into adversarial politics and what in the book we call the ‘antidote fallacy’

The closing of the metropolitan political mind: a drastic narrowing in the social and institutional range of elite recruitment (symbolised by the disappearance of the mass political party and domination of  politics by a narrow class of  professionals) is part of the problem; an equal problem is the rise, since Thatcherism, of a ‘TINAF’ mentality: There Is No Alternative Framework, and this drastically  narrows  the range of possible dissent from the official ‘line to take’.

The shrivelling of professional expertise.  Thirty years of centralisation and increasingly tight control of professional elites have left  (beyond devolved government) shrivelled alternative institutions in civil society  - and alternative sources of ideas.

We will develop these themes further over the next three blogs.

Manchester Capitalism