The Economy Part 2- Cross posted from LPUK Blog

No government can ever control an economy, it can only manage its' response to events in it. We have already argued that we are better able to manage our response to those events if we retain sole authority over our regulatory systems. We do not, and never will, need outside bodies to ruin our economy. We are more than capable of doing that for ourselves. Following on from our earlier piece, we continue to explore how government intervention lead to our present economic predicament.

In the preceding piece I argued that the Mark to Market rules played a significant role in our downfall. But not only did Mark to Market cause rapid asset value deflation, it also created a bubble on the way up. As house prices continued to climb, so then did the value of CDO's. While the crash held them below their real worth, the rising market had them massively over valued.

Thanks to Capital Adequacy requirements, ie banks being able to lend up to their market worth, we saw an expansion in lending ability and subsequently a rush to capitalise on this phony wealth. The rush for lending has in fact got very little to do with the folklore that interest rates were held too low by the Bank of England. Commercial rates were set by individual banks concerned, using LIBOR as a guide only.

Almost secondary to this, while there was no regulatory compulsion to hand out bad loans, (unlike the US), there was certainly a relaxation of rules. While not entirely a bad thing, for many of us did make good returns on investments not accessable otherwise, the financial industry had a perfectly workable regulatory regime replaced with an inferior one (the FSA), not to liberalise our domestic system, but to go some way toward bringing the rest of Europe up to scratch.

This opened up a floodgate of previously unacceptable practices in the UK which various regulators failed to identify and act on. Not least the mis-selling of payment protection insurance and self-certification of earnings on mortgage applications, which allowed people to basically lie about their earnings with the full co-operation of commission paid brokers.

The governments response to this has, as usual, been to close the stable door after the horse has bolted and to use the sledgehammer to miss the nut. The fact that brokers are paid commission is not the heart of the problem. It was the fact they were lending against assets which did not exist. This was a wholly a failure of regulation and intervention by governments against the better advice of the industry. But it's much easier to blame greed and capitalism than to accept that governments have made catastrophic errors.

The libertarian view is that there should be as little regulation as possible but in this modern age with modern and complex systems, we recognise there is a necessity for better regulation. While we may trust in the ultimate self-regulating ability of free markets we most definitely do not trust in the goodness of the human spirit. Generally, if we can find new and innovative ways of being bastards to each other or find shortcuts with damaging consequences, then we will.

However the whole problem with our present approach to regulation is not that there is too much or too little, but the spirit in which it is written and applied. This phenomenon is what Eureferendum refers to as Bureaucratic Spongiform Encephalopathy. Translated, literally, this means "officials with holes in their brains".

Basically, every and any culture – civilisation, if you wish – needs regulation. That's what makes it a civilisation, pulling order out of anarchy. And basically, there are two different and entirely opposing philosophies of regulation. That is the crucial point here: we are not talking about the detail, but the philosophy.

For the purpose of definition, we can call these two philosophies, rule-based and result based. Each have very distinctive characteristics, illustrated by way of contrast.

First, rule-based regulation is based on the premise that all activity can be defined and regulated by means of detailed, tightly-drawn written rules, in order to achieve the desired result. Result-based regulation, on the other hand, recognises that human activity is so diverse and variable that it is impossible to define tight rules. This philosophy, therefore, relies on loosely drafted objectives and guidelines.

Second, rule-based regulation requires absolute conformity with the written rules – even when they are demonstrably wrong or inappropriate. "Success" is defined as conformity. Result-based regulation uses the written rules as guidelines, to be applied intelligently and flexibly, to be discarded or adapted as circumstances demand. Official rules are but one tool in a large and varied toolkit.

Third, rule-based regulation gives very little discretion to enforcement officers, and to those subject to the rules. It operates on the basis of apparatchiks applying the rulebook, who measure compliance with the rules and demand conformity with them, often backed by threats and draconian penalties.

Result-based regulation gives considerable discretion to enforcers, requiring of them a high degree of skill and judgement, asking them to assess activity in terms of whether the overall objectives set are or will be achieved. It allows a relaxed attitude to conformity with the letter of law, but requires adherence to the spirit, and thus permits considerable variation as to the means by which objectives are achieved. Penalties and punishment are regarded as a last resort, and rarely used.

In terms of this financial crisis, the old-style Bank of England was driven by a results-based philosophy. That was the foundation of its success and that is why, under its regime, no British bank collapsed for over 200 years.

Progressively though, with increasing speed, that philosophy has been replaced by the rule-based philosophy, which has spread upwards into the international system as well as downwards. It infects the United States as much as it does the UK as a member of the European Union.

It is that philosophy which spawned the Financial Services Authority, an organisation dedicated to securing conformity with an increasingly complex rule book but one which has no interest in the health of the economy or the financial system. But it is not the cause of the problem. It is a consequence of the shift in regulatory philosophy.

This is easily demonstrable. As Prof. Congdon observed, by and large, the financial services industry complied with the rules. And it went bust. It is the victim of a regulatory system that does not and could not deal with the result – the objective – of regulation, which was to maintain a sound, healthy financial system.

In adopting the rule-based system, that is where we have gone so catastrophically wrong. We need to ditch this system in its entirety and return to a results-based philosophy.

All good stuff. But we are still barking up the wrong tree, for some of us share responsibility in our downfall. There is something more fundamental which drives us to indebt ourselves beyond our ability to pay. In the united States the banks were given the free reign. In the UK, we were. We have all but eliminated risk from our lives.

On matters of health, pensions, employment protection, education and housing we are now absolved from making any individual preparations. In matters of debt we may spend until the cows come home. What is the very worst that can happen? You can spend other peoples money until the cows come home knowing that should anything go wrong you might be asked to fill in a form and your debts will go away, just so long as you don't borrow any more. Consequences? What consequences?

We are children in the eyes of the government, incapable of making grown up choices and so vulnerable that we need protecting not just from the big bad world but also from ourselves. And in seeking to do this it has made us clients of the state and slaves to it. We have built this society over sixty years to the point where the assumption of most people is that the first and only port of call to get something done is the government, and government has gladly assumed this role. It has not taken power but been granted more and more power by us. Governments never take power. They are given it.

But now we are now faced with a government that has outgrown its role as benevolent protector into an all consuming, corporate monolith. It pays for our health and so it dictates what we can eat and drink. Very soon it will partly own our motor industry (again) and so it will dictate what we drive. And what better excuse than an economic crisis to grab more power?

As Jefferson said: "A government big enough to give you everything you want is a government big enough to take everything you have" or words to that effect. But it isn't just the physical things it has taken. It has taken our most precious of assets: Our Independence, self reliance and our sense of personal responsibility. In all possible areas we are wrapped in cotton wool, cossetted and protected to the point where free will barely comes into it. We are bailed out at every turn at the corporate level and the individual level. And that brings us on the the subject of part three. Bailouts.