REAPING THE WHIRLWIND

My wife and I have just returned from a couple of weeks in the USA. Among many

sources of stimulation debate between friends and family threw up a number

key issues of economic interest - two in particular stand out, and they are closely

related:

(i) Whether the lessons of the credit crisis of ten years ago have been

sufficiently learnt to avert a repetition; and

(ii) The palpable disparity between rich and poor.

Starting with (ii), evidence of this phenomenon is inescapable. The close

proximity of immense wealth and extreme poverty co-existing in one place is

painfully obvious to any visitor to New York. Sleek yachts lining up in the North

Cove harbour off the Winter Garden near Wall Street; fun-loving young

professionals paying over a hundred dollars for a modest bottle of Chardonnay in

a downtown restaurant; eye-watering rents in Manhattan.

At the same time, and in the same city, beggars plead for handouts on the

sidewalk outside shops and museums, others stare emptily at passers-by,

clutching paper cups with a few coins, some sleep rough in ATM closets and

subway entrances.

Thus has it always been, I hear you say. Yes, but on both sides of the Atlantic a

new category of poverty has emerged in the form of a class of mainly employed

workers who, until now, struggled but "just-about-managed", to feed, clothe and

educate their children, pay the rent, energy bills and fares: people who might be

called members of the "respectable poor".

Businesses barely viable

But it's even tougher now. Their employers, facing rising costs, similarly find

themselves on the cliff-edge of viability; wage rates are stagnant and large-scale

redundancies loom. Huge numbers of these people now face a tipping point at

which their basic income can no longer meet inexorably rising costs of living,

Over-stretched local government resources mean that public provision has

virtually dried up and the "nouveau povre" now join the ranks of desperate

citizens who provide fodder for loan sharks and payday lenders at extortionate

rates and potentially crippling terms, even forcing them to dispose of the few

possessions that lent them a semblance of respectability. They subsist in a

twilight zone of impending destitution and beggary.

Some commentators point to statistics that show a reverse trend. Incomes have

declined among the highest earners, many working in the finance and insurance

industries. That's because these sectors were hit hardest by the financial crisis.

This may appear to reduce the gap between rich and poor, but if someone who

once earned £5m per year is now earning £2.5m, they are still pretty rich. And it doesn' change anything for people on the lowest incomes, who still struggle to

make ends meet.

There have of course been some improvements for people on the lowest incomes

an increased minimum wage and higher benefits, for example. And more people

are in employment. But overall, incomes have barely increased and the level of

absolute poverty - defined as people below a fixed level of income, seen as the

minimum required to meet their basic needs, has only fallen slightly over the

past decade. So even if inequality may be declining, there is certainly no cause for

celebration.

Taxing the rich is not the answer

Whenever political pundits survey this growing schism their familiar refrain

bewails the inequity they consider to be an embedded feature of our society.

Their traditional plea for reducing the gap by imposing higher rates of

progressive taxes is woefully superficial and misplaced - again, a mechanical

knee-jerk response: this failure to examine causes always leads to the

indiscriminate "top-down" remedy of attacking wealth through the tax system

and using the extra tax revenues to increase public provision in the form of free

healthcare and ever-higher benefits to the poor.

To justify, rationally, this socialist approach, it is necessary to demonstrate that

enrichment of the few is the actual cause of the poverty of others. But that

proposition is by no means demonstrable. There are of course several publicised

instances of enrichment arising from bribery of government officials, setting up

criminal cartels, money laundering and other nefarious activity, all of which are

indictable and punishable - and undoubtedly prejudicial to fair competition. But

by no stretch can these alone be blamed for the gap between rich and poor.

Learn the lessons to prevent a repeat

Unfortunately our political classes remain resolutely blind to the alternative

"bottom-up" approach of removing obstacles to wealth creation for all strata in

society, and instilling a culture of preference for work over welfare: in simple

terms, freeing capitalism to work effectively.

Those obstacles are multifarious and usually fall into the categories of costly

over-regulation inflicted by the brigade of government busybodies paid out of

taxes, and penal business taxes. Both have the effect of discouraging enterprise

and start-up ventures, and of hobbling the ability of businesses to pay their

employees a decent wage.

The financial crisis of 2008/2009, itself the unwinding of cascades of mortgage

debt with zero chance of being repaid, provided an opportunity to install a sound

and stable approach to public finances. In the USA the task of reappraising the

system fell to Ben Bernanke, Chairman of the Federal Reserve, and Hank Paulson

Secretary of the Treasury. But, in the furnace of the post-Lehman catastrophe,

they chose the sticking plaster approach and bought some time, followed by

years of unbridled money-printing that was replicated by central banks in the UK, Japan and Europe, where - even now - the ECB supremo, Mario Draghi, is

unashamedly printing 50 billion euros per month!

Central bankers claim that these bouts of rampant "quantitative easing" (QE)

staved off a bigger crisis - but did it? Could it? Had they never heard of the

inescapable process of unwinding that reveals the inescapable consequences of

this folly? Capital destruction, interest rate distortion and malinvestment in all

its forms. In masterminding their supposed salvation they reaped a whirlwind

that will leave cracks in the monetary edifice too wide to be papered over this

time.

QE has ushered in its own randomly redistributive effects, for example helping

those already on the property ladder at the expense of those who cannot afford

to own their own home. This applies throughout the economy and is a primary

driver of income inequality. Even back in 2012, a Bank of England report showed

that its quantitative easing policies had benefited mainly the wealthy "early

receivers" of the new money: 40% of those gains went to the richest 5 % of

British households.

The mechanics of QE

It's worth pausing for a moment to reflect on the QE mechanism itself. The

process requires the central bank to buy financial assets (treasury bonds, gilts or

other high class debt) from financial institutions (commercial banks, insurance

companies, pension funds, blue-chip financial corporations) in the money

market, and pay for these assets with freshly "minted" money, electronically

created by the Bank's own computer.

According to a reliable report, the Bank of England's buying was carried out

in a secret room on the first floor, reached by windowless corridors. The entire

process, which took around six months, required the staging of auctions three

time per week, each beginning at 2.15 p.m. and lasting no more than 30

minutes. The selling banks, operating as intermediaries for clients such as

hedge funds or insurers, submitted their best offers, and a computer ranked

them by price. Those deemed to be good value by the Bank, no doubt by

reference to yield and term, received the Bank's money in exchange for the

bonds.

The selling banks and their clients could do as they pleased with the newly

acquired money - the possibilities ranging from adding it to their reserves by

sitting on it, to lending it to other institutions or private clients who, in turn,

used it to go on extravagant shopping sprees for investment assets like land,

equities, fine art, London property, vintage Château Latour - or arbitraging in

the bond market. The incoming flood had the effect of pushing up asset prices,

and anyone with assets grew much richer.

All those working in the financial markets owe a huge debt of gratitude to QE

But for many others, especially young people with few assets, this era of

unprecedented central bank largesse has been characterised by job insecurity,

rising house prices, sluggish real wages and widening inequality between the

"1 per cent" and the rest. As the new-found wealth seeks more outlets, lending to entrepreneurs and

small businesses becomes widespread. Defenders of QE: sometimes point to

this "trickle-down" effect as some sort of justification for a policy that is, in

truth, diabolical in its social consequences. They claim that, in theory, the

trillions that central banks inject into the market through their bond

purchases should slosh through the economy as they are lent and re-lent,

lifting all the boats in the harbour. But that is little more than wishful thinking

and takes no account of how the new billions actually behave when released.

Had earnings kept pace in the same time frame, the rapidly increasing house

prices wouldn't matter so much. But they didn't. The average house price in

the UK has increased to six times earnings, compared with a historical average

of four, according to the Nationwide building society. House prices relative to

incomes are at least a fifth dearer than their historical averages, according to

OECD. For property owners this has been a bonanza. For young people with

lower home-ownership rates, it has been a disaster.

This collateral misallocation of resources was, from Day One, utterly

predictable. Just think about it: you don't have to be an economic genius to

work out that flooding the system with free money, untethered to anything

more real than a computer keyboard, must lead to an increase in prices

and, and given the biased nature of its distribution, must lead to the further

enrichment of those already owning assets while blighting the relatively

meagre holdings of the poor.

The perceptive Irish/French economist Richard Cantillon understood this clearly

when he wrote, some 300 years ago: "In short, the early receivers of the new

money will increase spending according to their preferences, raising prices in these

goods at the expense of a lower standard of living among the late receivers of the

new money or among those on fixed incomes who don't receive the new money at

all."