Slide 1

Pamphleteers regular Con Keating has kindly agreed to allow us to post this previously unpublished paper which, although it was written by him and Barry Marshall a decade ago, sadly, still remains relevant today. Ed.

crime scene

This article began life as a footnote in our discussion paper ‘Banking on Liquidity: Liquidity, Collateral and Derivativesi. It identifies the ABX sub-prime mortgage securities indexii as the prime suspect for the spark that lit the crisis bonfire. Numerous studies demonstrate that the mix and volume of banking assets was highly inflammable, but few propose plausible first sparks that might then propagate widely. At the time, assurances were offered by Ben Bernanke and others that the sub-prime problem was containable. Nonetheless, markets broadly did break down and the question that we need to ask, and to answer, is how such a breakdown comes about.

A number of authors have diagnosed this as a question of trust and proposed remedies accordingly; by contrast we see this as the breakdown of the convention that, in financial markets, we ignore much uncertainty and risk in pursuit of the gains from trade. This convention is sometimes known as ‘market confidence’. Some distinction between convention and trust is necessary – a convention exists because it provides mutual benefit while trust is unnecessary unless there is a risk of loss. Driving on the left is one illustration of a convention; it benefits all drivers.

car

In the early 1970s, with vivid imagery of ‘lemons’iii in used car sales lots, George Akerlofiv gave us important insights into the effects of adverse selection and uncertainty in marketsv. As we do not know the quality of the car as well as the selling owner, we are exposed to the possibility of exploitation and reflect this in the price we offer to pay. As the potential information asymmetry mounts, distrust prevails and trade declines - then prices reflect only ‘lemons’, poor quality cars. This is a variant on Gresham’s law, that the bad drives out the good. In the absence of the convention, this unfortunate situation, which is a question of trust, will prevail and markets cease to functionvi.

When discussing market valuation in the General Theory, Keynes observed: ‘In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention.... Nevertheless the ... conventional method ... will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.’ [Italics from the original] The crisis has reminded us of this convention – it is a behavioural regularity that sustains itself because it serves the interests of everyone involved. Chuck Prince’s infamous words on this subject would not have earned him such evident opprobrium in more normal times. This is also why, before the onset of crisis, a risk manager’s cautions are usually disregarded and ignored, like Cassandra; the caution is a challenge to the convention that allows the pursuit of the gains from trade.

The central insights for the analysis of convention and its problems of co-ordination have been known for at least as long as Akerlof’s ‘lemons’; David Lewis’ 1969 ‘Convention: A Philosophical Study’vii is the seminal work and Robert Aumann’s ‘agreeing to disagree’ gave a rigorous mathematical underpinning to the topic in 1976.

The analytic key is the concept of common knowledge, where the members of a group have similar knowledge and understanding, and also know that all others possess this knowledge. The situation is the old chestnut where you know that I know that you know, and on... and clearly is related to Keynes’ beauty contest analogy for markets, where to win the competition, it is necessary to predict the face most attractive to others, rather than the face most attractive to ourselves. The iterated self referential nature of the concept of common knowledge makes it complicated and best explained by simple example.

The time-honoured illustration is of an island inhabited by people who have either blue or green eyes. There are no mirrors on this island, so no-one can know the colour of their own eyes, but of course, they can observe the colour of all other eyes. The etiquette is that people who know they have blue eyes should leave the island immediately and that discussion of eye colour among the inhabitants is taboo. No-one will leave the island in this situation. Now we will introduce a truth-telling visitor who informs the island population that there is at least one blue-eyed islander present. This is hardly new information; all of the green eyed islanders can see all of the blue-eyed present. Those who are blue-eyed can also see the other blue-eyed islanders present. The information disparity is slight. If there is just one islander with blue eyes, he now knows immediately that he must have blue eyes since all other islanders are visibly green-eyed, and leavesviii. If there are many (say, M) blue-eyed islanders present then they will leave together on the same day, after that many (M) days have elapsedix. The visitor is merely a catalyst.

This should resonate with market practitioners; how many times have we heard explanations for market movements that we thought were decidedly old news? The market movement only occurred after the news had become common knowledge and was widely understood.

The deteriorating condition of the sub-prime mortgage market was widely known long before the rot set in; researchers from the Federal Reserve of St Louisx have found that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers were to some extent aware of it. By the end of March 2007, the ABX (2006 – 2) BBB indices were trading (or not) at prices between 70% and 80% of notional value, and the slide down from there was precipitous. Academic studiesxi of the pricing behaviour have concluded that the price declines suffered far exceeded those warranted by fundamental default experience. By summer 2007 continued denial of the problems and uncertainty, maintenance of the conventionxii in pursuit of the gains from trade, was no longer viable for market participants, and market breakdown ultimately ensued. By year end UBS, Citibank and Morgan Stanley had all cited the ABX indices when reporting their write-downs of mortgage assets. To the extent that these indices were reflecting more than default experience, this is a channel for contagionxiii and exaggerated loss marking, which lowers the banks’ perceived risk bearing capacity.

These indices clearly conditioned the market for breakdown, but also served another purpose. They are contractible - derivatives may be based upon them and cash settledxiv. Like all indices, they greatly facilitate the writing of OTC derivatives as they lower the ‘lemons’ problems of adverse selection and asymmetric information associated with specific tranches of specific mortgage securities that would usually reduce or eliminate trade. These derivatives were, by design, efficient devices for both hedging and speculative purposes. There is evidence they were used extensively; in the case of Goldman Sachsxv, mortgage short positions reached 53% of the firm’s total value at risk. Fender & Scheicherxvi noted that ‘with markets reportedly overwhelmed by large speculative short positions, market liquidity...has been impaired...

These ABX indices are syntheticxvii and, like all such products, magnify the consequence of an event in the referenced assetsxviii; to the extent that contracts are written on these indices the losses experienced on the actual mortgages are increasedxix. This rendered incomplete and inadequate analyses, such as Bernanke’s, which considered only the outstanding stock of physical sub-prime mortgages and concluded that their scale was insufficient to result in more general contagion.

The ABX indices certainly seem to have been both spark and dry tinder for the conflagration that followed. Those now seeking retribution, or perhaps merely justice, will be disappointed by the inanimate nature of the cause, an index, which makes this impossible. One consolation, that may mollify this constituency, is that, because of the pricing distortions evident, the TARP policy of buying and holding mortgage securities to maturity should prove ultimately very profitable for the US taxpayer.

Market confidence, the convention, requires that fundamental soundness is commonly understood among market participants. This is a lowest common denominator, which admits a role for research and information discovery in fundamental credit analysis, enhancing a bank’s competitive advantage and performance. Trust though is not the issue.

_______________________________________________________________________________________________________________________________________

i Keating C. & Marshall B.,[2010] ‘Banking on Liquidity: Liquidity, Collateral and Derivatives’, Discussion Paper May 2010, available from www.brightonrockgroup.co.uk

ii The Markit ABX.HE index is a synthetic trade-able index referencing a basket of 20 subprime mortgage-backed securities. It was first created in January 2006 but gained broad press visibility in early 2007. Further details and descriptions of these indices and trade in them are contained in both Fender & Scheicher papers referenced below.

iii The remedies tend to focus upon the central role of experience in the restoration of trust and the more technical have used models of repeated games.

iv ‘Lemons’ are cars of poor quality.

v Akerlof G., ‘The Market for Lemons, Qualitative Uncertainty and the Market Mechanism’, Quarterly Journal of Economics 84, 1970

vi Democritus took the idea of asymmetric information in markets to the extreme by describing them as ‘places where men meet to deceive.’

vii Lewis D., ‘Convention: A Philosophical Study’, Harvard University Press, 1969. Reissued by Blackwell Publishers 2002 – ISBN 978–0–631–23257-5

viii The gambler’s adage ‘if you can’t see the fool at the table, it must be you’ is exactly this situation.

ix This follows as every blue-eyed islander can see M-1 blue-eyed islanders and if no-one leaves on day M-1 and none should, must conclude that he also has blue eyes – all do this on day M and leave together.

x Demyanyk Y. & Van Hemert O., [2008], ‘Understanding the Subprime Mortgage Crisis’ Working Paper, Federal Reserve Bank of St Louis 2008.

xi See Fender I and Scheicher M., [2009], ‘The Pricing of Subprime Mortgage Risk in Good Times and Bad’ Working Paper 1056 European Central Bank May 2009

xii There are many insights that can be gained from this analytic framework and its extensions, for example, the social value of credit ratings and accounting standards . See Morris S. & Shin H., ‘Contagious Adverse Selection’, Working Paper, Princeton University March 2010. The model is simple but congruent with reality, and also renders questionable the ever-increasing demands for transparency. These calls are based on the unrealistic complete efficient markets model of elementary financial theory.

xiii Arbitrage activity where traders sell other unrelated assets in order to buy the underpriced mortgage securities will provide a cross-market channel for contagion.

xiv As these indices are trade-able, they can and did develop a life of their own – unlike, say, an equity index their price did not reflect the arbitrage value of underlying reference assets. In other words they can be regarded as reflecting not just mortgage credit risk but rather mortgage credit and market risk.

xv Memorandum to Members of the Permanent Subcommittee on Investigations entitled: ‘Wall Street and the Financial Crisis: The Role of Investment Banks’ dated April 26, 2010.

xvi Fender I. & Scheicher M., ‘The ABX: How do the markets price subprime mortgage risk.’, BIS Quarterly Review, September 2008

xvii This simply means that they do not rely upon the underlying for settlement, though they reference the price of the underlying.

xviii See Keating & Marshall 2010 above for fuller explanation of this point.

xix They were also prominent instruments in the construction of synthetic CDOs, which accounted for 15-20% of issuance in that market.

Published: Monday, 15 January 2018 10:11

This article is a companion to my formal submission to the Parliamentary Work and Pensions Committee’s Inquiry into Collective Defined Contribution pensions. It deals with some of the more important technical aspects of these arrangements, and may be regarded as completing that submission.

Today’s information technology can enable everything described in this article, and do so extremely cost-effectively.

No pension scheme can be sustained if it operates inequitably among its members. This observation motivates the development of a metric for a member’s equitable interest for use with CDC schemes, and with that the aggregate interest in the assets held by a scheme. A defining characteristic of these schemes is that they have no explicit liabilities, and consequently can have no contractual recourse to external guarantors or insurers based in whole or part on metrics driven by liability values.

The problem reduces to a schema which accurately captures the interests of each and every member while also encouraging solidarity among those members. Through collective risk-sharing and risk-pooling, it should provide explicit benefits to members and offer an incentive to younger non-members to wish to join the scheme. With CDC, a member’s equitable interest reflects their proportional interest in the assets of the collective at any point in time. It is an equitable scheme of arrangement among members.

It turns out that the uniform award structure of traditional DB arrangements does precisely this. It does so through the contribution setting mechanism and embeds this into the scheme. This is the mechanism, in traditional DB, whereby the contribution for a year of service confers an entitlement to some defined accrual, say 1.5% of final salary, regardless of the age of the member. With CDC schemes, this “entitlement” is a best efforts endeavour, not a contractual commitment.

Of course, many other possible schemes of arrangement for determining their equitable interest may be acceptable to members, but this uniformity of award regardless of the member’s age has the dual advantage of simplicity and familiarity from prior use.

Tracking the contributions of members and their associated investment returns is a particular scheme of arrangement. It is one in which members commingle their contributions into a common fund, but have no other risk-pooling or sharing; their claim and its likely outcome is little better than that of an individual DC saver.

The combination of contribution and projected benefits payable defined the award’s contractual accrual rate (CAR), which may be thought of as the rate of return expected on the contribution received. Together these define the trajectory of the member’s equitable interest over its lifetime. This is illustrated below for members aged 25, 45 and 64.

Figure 1: Trajectories for one year’s award for members aged 25, 45 and 64.

 

The equitable interests of members, in this single award illustration, in the assets held by the scheme are simply their proportional shares of the total outstanding interests of all members at a point in time, as shown in figure 2. In turn, this means that transfer values and drawdown under Freedom and Choice may be facilitated. While encashment by members with short life expectations is a potentially costly moral hazard, it turns out that the behavioural anomaly that individuals under-estimate their own life expectation dominates, leaving the scheme on balance better funded, after transfers, for those that remain.

 

Figure 2: Proportional equitable interests/ claim on assets

 

 The process of setting a contribution rate for a new award by the trustees needs to take account of two things. First it needs to consider the alternate investment opportunities available to members for their contribution, in order to assure that the scheme offers value for money to members, and second, it needs to consider the investment return that the scheme may achieve. This latter rate will usually be higher than the former.

It may prove to be the case that when return expectations are low, and the required contributions high, that the employer is unwilling or unable to make those contributions. The sponsor may even have an agreement in place that it may pay no more than some specified rate, say 18% of pensionable salaries. In this case, the trustees should lower the accrual awarded for that year, from, say, the earlier suggested 1.5% to say, 1.0%. In this it differs from traditional DB, where changes such as this are infrequent, and usually apply to all future accrual awards.

While this is a cut in the benefits ultimately to be paid, it is known in advance and members could, if they wished, increase their own contributions to compensate in whole or part.

The uniformity with age introduces risk-sharing among members. The differing times to retirement imply different investment accruals (or different contractual accrual rates -CARs) which vary with age. This is illustrated as Figure 3. The corrugations evident in this figure are a product of the granularity of increases in life expectations in this simple model. When expected returns are high, and contribution rates low, younger members achieve lower than average returns while older achieve higher. By contrast, when expected returns are low, and contributions high, younger members achieve higher than average returns, and do so over the entire life of the award, while older scheme members experience lower than average returns. This arrangement is true risk sharing, not some intrinsically inequitable subsidy. It fosters solidarity among members as it represents a form of mutual insurance.

While this phenomenon is present in traditional DB arrangements, it is rendered immaterial to members by the sponsor guarantee.

 Figure 3: Risk sharing arising from uniformity of award

 

The magnitude of this effect between the oldest and youngest members of a scheme, by contribution and average contractual accrual rate is shown as figure 4.

 

Figure 4: Young to old subsidy rate

 

 The assumptions which drive the pension payment projections may be updated from time to time, as experience informs the calibration of those values.

The proportional equitable interest of a member defines the share of scheme assets attributable to that member, and with that transfer values. The value of scheme assets as a proportion of the total of members’ equitable interests is an analogue to the funding ratio in traditional DB; it is the equitable value’s asset cover.

The further benefit of this award structure is that it provides what is effectively a default drawdown or annuitisation schedule. When combined with the equitable asset cover, members may obtain directly the funded pension value and income equivalent of their interest at any point in time. This removes the point in time uncertainty of annuity purchase on retirement associated with individual DC arrangements. It also provides an accurate reference for the calculation of annual and lifetime allowances.

Importantly, it removes any need for the individual to de-risk their portfolio as retirement approaches. Historically such a shift has been very costly; since 1980 risky assets have outperformed safe assets by approximately 3% pa, or put another way, de-risking has halved the post retirement investment returns.

There are further risk management options available in CDC arrangements; these depend in turn upon the precise form of the pension “promise”. Two immediate distinctions are important, which I will describe as Cdc and Cdb. With Cdc the member has access to the full value of the asset fund, in other words the individual may achieve outcomes higher than the pensions “promise”. While with Cdb the member receives at most the “promised” pension, with surpluses being retained in the fund.

In the case of Cdc, there is no further risk sharing with others. If the scheme is in deficit at the point in time that a particular pension payment is due, then only that pension covered by assets will be paid. If the payment of a particular amount of pension is desired by the member they may borrow from their residual equitable interest, should that permit that. The member is merely spreading the risk over time. Such an action reduces their residual equitable interest.

In the case of Cdb, there may be further risk-sharing among members. If the scheme is in deficit, then the full pension promised is paid. At the same time, the equitable interests of active and deferred members are adjusted upwards by an equivalent amount. There are limits to this ex-post risk-sharing, which are discussed later. This has the effect of increasing the magnitude of both the total equitable interest and active and deferred members’ relative interests in the scheme asset pool. With Cdb, the member opting for transfer is entitled to the level of asset coverage subject to a maximum of their equitable interest, which of course, is the pension “promise” value.

It should be recognised that these transfers are small in the context of the fund. If we consider a scheme where pensions payable are 5% of the value of the fund and the scheme equitable interests are 80% covered, this adjustment is only 1.25% of the fund value. This is well below the level of uncertainty associated with pension projection parameters and indeed the confidence intervals of expected return judgements. This is effectively a 1% addition to the total equitable interests of pensioners and a 1.67% increase in the individual interests of active and deferreds. It is of the order of 2-3 basis points in the realised investment return. It is a small fraction of the annual variation in asset portfolio values. This is considered more fully later, when considering when pensions may need to be cut.

This latter representation should make evident the flexibilities that arise from the ultra-long nature of a co-operative member mutual scheme, and the time that this affords trustees to identify and if necessary, rectify persistent imbalances, or mis-estimations. The emphasis on annual sufficiency, rather than deficit repair and precautionary actions, is not incidental; it is a reflection of the going concern nature of the member mutual enterprise. The question of sustainability is simply a matter of treating all members equitably and offering value for money consistently.

Another way to regard CDC schemes is as traditional DB minus the sponsor guarantees, which as guarantees are costly, should result in superior outcomes for members. The question of hedging the true risk factors, longevity and inflation, expands from the cost benefit question whether they should be hedged to the wider if and when. Bear in mind that increased longevity results in a very remote cash flow cost, while inflation’s effects are immediate.

It is, however, clear that the costs of hedging these risk factors, as well as the uncertainties in returns expectations should be a fraction of that now evident and associated with the sponsor guarantee. The cost of the sponsor guarantee expresses itself through several channels; through explicit deficit repair contributions, through overly cautious asset allocations, through depressed wage growth, and arguably, through the social costs of the cessation of provision.

It is growing increasingly clear that new analytic methods, such as machine learning and artificial intelligence, hold the prospect of improving considerably the speed of identification of persistent departures from expectations and the formulation of more precise and accurate expectations.

So when should pensions be cut in a CDC arrangement? Or equivalently: how much risk to members’ pensions is there in mutually offered funded pension?

The setting is the DB type pension (Cdb) of some fixed proportion of, say, final salary. Typically, for mature schemes these represent amounts which are normally in the range 3% - 5% of scheme assets. Obviously if scheme assets fully cover proportionally the equitable interest of pensioners, then no cuts are necessary. This is clearly a “going concern”, in good health.

We would also note that balance sheet insolvency is not a binding constraint (nor is it illegal to operate a balance sheet insolvent company), but the inability to meet a payment due, cash flow insolvency is binding.

If the assets of the scheme do not fully cover the equitable interest, then the pension payment would be at risk, but at this point, a risk sharing agreement comes into play. The pension payment is made in full – the top-up being “provided” from the assets attributable to other non-pensioner members of the scheme. In any year, the amounts of this top-up are quite modest. To illustrate this let us consider a scheme which is 80% funded, the equitable interests of pensioners are 40% of the scheme total and pensions amount to 5% of the value of assets. As earlier, the top-up, or transfer among members, is just 1% of the total equitable interest, or 1.25% of scheme assets. Even if the deficit or shortfall is 50%, the transfers only amount to 2.5% and 3.13% respectively. As was noted earlier, this transfer of assets triggers a reciprocal and compensating increase in the equitable interests of non-pensioner members.

Now the first problem that needs to be addressed by trustees concerns the cause of the deficit which led to the insufficiency. Has this arisen from a fundamental misestimation of the implicit investment returns available or is it simply the result of the transient “animal spirits” of markets, and likely to self-correct. Clarification of these issues gives rise to the need for a forbearance period, during which the risk-sharing mechanism will operate. Clearly that mechanism needs to be related to both the magnitude of the deficit and the resultant support transfer.

The straw man offered is that a 10% deficit should admit a ten-year forbearance period, a 20% deficit five years, and 50% just two. Some further rules are needed to allow for sequences of deficits. Increasing deficits shortens the forbearance period, so a 20% deficit has a five-year forbearance period and if this increases in year one to 50% the forbearance period shortens to just two years from that date. Some clarification of the rules is needed to accommodate partial recoveries; suppose that the 50% deficit shrinks to just 20% in the first year, then the forbearance period becomes five years, but the clock started the year previously, leaving just four years of ongoing forbearance.

If a scheme is still in deficit at the end of this forbearance period, then the pension payable is simply the funded level of the pensioner members’ equitable interests. To avoid an actual cut, the pensioner may choose to borrow against, or bring forward, some of his or her residual equitable interest. If and when the asset coverage of the scheme recovers, the cuts imposed will be restored, but doubtless some members may have died in that interim.

If payments to pensioners are cut, so also, and to a similar degree, are the equitable interests of non-pensioner members.

There is also the issue of the amount of their equitable interest that non-pensioner members might be happy to risk in support of pensioners. This is constrained also by the possibility that excessive support would reduce the asset pool to a level from which recovery is not possible. A level of 10% of the non-pensioner members’ equitable interest seems plausible, particularly when it is understood that this is a maximum exposure. Figure 1 below examines the support payments for a scheme paying 5% of (initial) assets in annual pensions. The scheme has a contractual accrual rate (CAR) or expected investment return on assets of 5.5% pa.  The evolution of asset portfolio is shown for the period 1999 – 2013. This period captures the worst experience of the 1899 -2015 period – it is an all equity UK index portfolio with high volatility. In fact, the likelihood of a sequence as poor as that observed, between 2000 and 2002, is less that one in a thousand. The asset coverage level is arbitrarily set to 1 in 1999. The asset coverage of the total equitable interest falls to a low of 63%, implying that significant cuts would otherwise be appropriate.

The largest level of support in any year amounts to 1.83% out of the total 5% payable. The cumulative support over the five years of deficits reaches a maximum of 4.87%. This is 8.1 % of the non-pensioners’ equitable interest, when these members account for 60% of the scheme.

Put another way, in this the worst experience of any period since 1899, it was unnecessary to cut pensions in payment.

 Figure 5: Funding coverage, annual and cumulative pension support

More sophisticated analysis, allowing for the reciprocal increases in non-pensioner equitable interests, and the modified shortfalls arising from that, increases the cumulative support to 5.42%, which is 8.38% of the non-pensioner interests.

By supporting pensioners over this period when scheme asset coverage would not otherwise merit this, non-pensioner members have increased their equitable interest, their pension “entitlement” by a total of 9.67%.

Extensive simulation of the scheme and this 10% support for pensioners indicates that it only becomes necessary to cut pensions in payment in less than one case in a thousand. In no case, does this level of support result in an irrecoverable “death spiral”.

This differs from other simulations, where much higher cut rates are evident. This difference arises from the fact that those models have extremely volatile, capital market consistent, pseudo-liability values while here the equivalent, the members’ total equitable interests exhibits a smooth progression as time unfolds.

The presentation to scheme members is simple. If you place at risk of partial loss, 10% of your equitable interest in the scheme in support of pensioners, you may expect to enhance your own pension outcomes by a similar or larger amount.

Understanding of this point makes it clear that rather than promoting intergenerational unfairness, risk-sharing in CDC actually promotes intergenerational solidarity. It also demonstrates that these are not just rebranded “with profits” policies as there are no equivalent mechanisms or incentives within those.

Published: Wednesday, 03 January 2018 10:55

Visit any medium size Italian City and you will find independent coffee shops and family run restaurants. The service will be good, the cost similar to the UK and the quality of the product excellent. I’ve never had a duff meal in Italy on any budget. Sunday lunch in Arezzo was a delight. Half the guests were extended family, so the food and wine were wonderful for a modest budget.

Compare that to the UK, where chains will dominate. They are generally understaffed, on zero hours contracts and the “living” wage. I accept that compared to the equivalent in my youth, the general UK standard is much higher than then. To illustrate my point, I waited in a queue for 13 minutes to buy a coffee last week.

Whenever I have the chance now in the UK I always choose a non-chain pub, restaurant, hotel or coffee shop.

I was thinking about this experience after discovering my old copies of EF Schumacher’s “Small is Beautiful” and a “Guide for the Perplexed”. The latter title would be a good description of what is needed for 2018. It was published 40 years ago this year, the same year in which Schumacher died.

On the other side of the Atlantic, Gary Cohn, Trump’s Chief Economic Advisor was explaining the Trump Tax Reforms to CEOs and asked them how many would increase investment and wages. It was clearly a surprise to him that the response was far from overwhelming.

On this blog I have a number of times suggested ways in which the consensus on the dominant economic model, sometimes unhelpfully lumped into the term “neoliberal” is becoming more fragile.

The assumption is that lowering corporate taxes will unleash entrepreneurialism, stimulate investment, grow the economy and lift all boats. Hold on! When corporate taxes were higher in the US and UK in the 1970s and before, investment growth, productivity growth, GDP growth and wage inequality were moving in a positive direction. I’ll leave the worshipping of growth for a separate post. Here I want to focus on the “low tax myth”.

Earlier this year I was in a meeting with a range of companies, SME’s on the topic of the skills shortages. All complained about the UK’s woeful skills record, yet the highest training budget in the room was less than 3% of turnover. Compare that to the German Mittelstand and you can see why the productivity gap, as described by Michael Mainelli in an earlier post is so entrenched. The attitude in the room was they wanted to have low taxes but at the same time someone else had to pay for skills development.

I want to argue here that the low tax regime of the UK has led to low R&D investment, low training and development and weak investment in productivity growth. In fact, the UK regime has created a rentier economy where the returns to capital exceed those to labour.

Returning to our coffee shop example, a few people in the centre earn £1m plus and most of the wealth is sucked out of the local economy, compared to Italy where it if locally recycled.

So, if we want a high investment, highly skilled productive economy, I think we could now argue for higher corporate taxes but greater incentives for productive investment in capital and skills training and greater investment in infrastructure, from transport, energy and broadband.

I confess to sharing the scepticism that government is not inevitably a good guardian of the public purse. However, I could cite Singapore and South Korea in infrastructure. I would prefer Swiss, Swedish and Italian railways to ours. I am not arguing for nationalisation. What I think is needed is massive devolution within England and a strengthening of local governance.

Look at the way California is going its own way on climate change despite the White House directions. I have argued on this blog before that Social Enterprise and Cooperative models have their place in a modern dynamic capitalist economy.

To deal with the challenge of intergenerational unfairness, tax allowances could be made larger for companies employing people under 25 to ensure early opportunities for school leavers and graduates to join the workplace. Similarly, with an ageing workforce, tax allowances could be made for adapting workplaces to better accommodate older workers with greater employment flexibility for those who wish to work on beyond normal retirement age (whatever that may be!).

I’m keen to incentivise real entrepreneurship, innovation and risk taking over low risk financial engineering.

Lord Adonis is making major complaints about the state of UK infrastructure as Trump has in the USA. A personal example illustrates this. I was in rural Sri Lanka a couple of months ago and downloaded the Time faster than I can in rural Shropshire. The UK isn’t in the top 50 in terms of Fibre infrastructure.

With both Brexit and Trump, much has been made of the search for identity and anger against “remote elites”. I think this is true of business as much as it is of governments.

As Bobby Kennedy remarked 50 years ago:

“The Gross National Product measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America - except whether we are proud to be Americans.”

We are approaching the season of goodwill. I hope that you will get the chance for good food, good company and good health. Merry Christmas.

So, have a great 2018. Remember that small is beautiful in perplexing times.

Chris Yapp December 2017

Published: Thursday, 21 December 2017 11:41

Shortly after the referendum result I was involved in a number of scenario workshops to understand how the vote might turn into new directions for a number of sectors including financial services.

It is always important to consider low probability, high impact outcomes in any futures work, especially where the outcome may have 30-50-year impacts or even more as I believe Brexit will.

I’d like to share one of these ideas here as much of the media reporting is, in my opinion, too narrow and responsive to immediate events and lacks a narrative.

Let’s start with my own position, just to be clear on that. I agree with M. Barnier that there is no example of a Trade Deal for Financial Services. Therefore, I think that the idea that the UK and EU27 can deliver a deal in an area for which there are no templates much faster than in areas where the process is known and understood requires heroic assumptions that defy gravity to mix metaphors.

It is also clear that companies based in the City want to move as little as possible, as the lifestyle that London affords is hard to replace. However, the difficulties in recruiting talent are already apparent.