Free market?

I’ve been reading quite a lot of articles and comments about the recent Comprehensive Spending Review (CSR) and there is – as you would imagine – a wide variety of different views. What I find quite interesting (to put it politely) are those people with what I think of as right wing (or conservative) views who seem to believe that the state should be smaller and that there should be more of a free market approach to how to provide things in society. The kind of things that I’ve read are along the lines of “get money out of the public sector into the private where it can work to generate wealth”.

What I would really like is for someone to explain (without using the typical rhetoric that uses words like “waste” and “efficiency”) why a smaller state with services being provided through a free market would be better than what we have now. Let me lay out, in general, the reason why I find this free market ideology confusing in certain circumstances. I assume that most people accept that there are some things that should be provided by the public sector. Examples would be the military, policing, etc. There are others, such as education and healthcare, that are probably amongst the kind of things that some would like to see provided by the private sector, rather than by the public sector.

Here’s where I get slightly confused – and hence would like someone to explain the free market ideology to me. If we consider healthcare, it has a total cost of something like £100 billion per year and makes up about 15% of public spending. We could presumably privatise healthcare, reduce public spending by 15%, and return £100 billion back into the marketplace (assuming that we actually do reduce the deficit). Let’s assume that the goal is to continue to provide healthcare for all, but just to do so through the private sector rather than the public. How do we achieve this? To first order, providing healthcare for all must cost about the same whether done through the private or public sector (any efficiency savings will probably be cancelled out by the fact that some profits will have to be made for those who have invested). The cost per person will therefore be about £1500 per year and the cost per family will be something like £5000 – £6000 per year. Currently 50% of jobs in the UK pay £19000 per year or less and 50% of household have income of £25000 per year or less. Given that very little of the £100 billion that is returned to the private sector will go to the lowest earners, how are these people meant to suddenly start paying for healthcare?

One option is that the private sector redistributes wealth so that everyone in employment can afford healthcare. The other is that it is provided directly by employers, although this then begs the questions of what happens to the unemployed and those who are retired. What I want to know is how this is significantly different from what we already have? Roughly £100 billion a year will be spent providing healthcare for people in the UK. This money isn’t going to be available for anything other than providing health coverage, so how does it suddenly generate wealth in the private sector when it supposedly wasn’t when in the public sector?

Possibly my initial assumption is wrong and that those who want a reduced public sector actually do not believe that everyone should get reasonable healthcare. Maybe the idea is that providing health coverage through the private sector would introduce choice. You could choose to have no healthcare, pay very little and get very basic healthcare, or pay a lot and get the best possible healthcare. Presumably this then implies that the unemployed would have no coverage, the lowest earners would only have basic coverage, and only the highest earners could afford coverage similar to what we all get today. If this is what is essentially being suggested by those who support small government, then they are probably correct that the total cost of healthcare will be less than it is today and some money will be consequently available for other, potentially wealth creating, enterprises. What is possibly not recognised, however, is that having a healthy workforce is, in itself, a way of creating wealth (or at least of creating more wealth than a comparable society in which many do not have health coverage).

The third possibility that I can imagine is that those who want small government and more private sector involvement in providing services, really haven’t given it much thought at all and simply believe all the rhetoric that is being thrown around by various conservative thinktanks. You can probably work out that my view, at this stage, is that providing services like healthcare and education through the public sector is preferable to providing it through the private sector. I’m more than happy to accept that some kind of savings could be made and that there may well be inefficiencies in the system, but I’m not – at this stage – convinced that it would be significantly different if it were in the private sector. I am, however, genuinely interested in having someone explain – including all goals and assumptions – why providing certain services through the private sector is preferable to providing it through the public sector.

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Full Economic Costing : Another cut on the way

If you’ve read any of my earlier posts, you’ll know that I’m not a fan of the Full Economic Costing (fEC) funding model that was recently introduced in the UK. In case you don’t know what this is, it is the way in which research is funded in universities. When a researcher wants money to carry out research, they will apply for funding from one of the research councils and the researcher’s university will include all the costs associated with the research. This will include any salaries (or parts of salaries), admin costs, estates and buildings, travel, computing and a sum referred to as “indirect costs”.

The fundamental problem I have with this is that I think it is not straightforward to separate the costs of teaching and research and that they are both an equally important part of an academic’s career. The risk, in my view, is that we will start to value someone’s ability to bring in money more than the quality of their research and teaching. There will be pressure for research to follow the money and also the possibility that teaching will suffer since the direct link between teaching and money is less obvious. This isn’t to suggest that the amount of money that the universities are getting is not appropriate, but simply that we should have a more holistic view of universities and provide the funding in a more general way (i.e., how much does a research university of a certain size need to cover the basic costs of operating).

However, I do think that some universities may have been interpreting the term Full very specifically and have been including anything that they possibly could onto a research grant. Typically a research grant that proposes to employ a junior researcher, buy some computing, pay some travel costs, and pay some of the Principal Investigator’s (PI) salary will be costed at £150000 per year (with the junior researcher’s salary being about £29000 per year). The university gets almost £50000 per year to cover indirect costs and estates and buildings plus another £15000 or so to cover part of the PI’s salary. I don’t want to suggest that a university wastes this money, but I suspect that it is – in general – more than the actual full cost of a typical research project (or at least more than the full cost that could be easily associate with a typical research grant).

I was listening to Radio 4 yesterday evening and they had – amongst others – David Willetts discussing the science budget. He made the point that even though the science budget will effectively see a 10% cut over the next few years due to inflation, he thought that there could be efficiency savings of order 10%. He highlighted, in particular, the possibility (suggested supposedly in a review by Bill Wakeham – a physicist from Southampton) that in fact universities have been including too many things in fEC research grants. Essentially what he seems to be proposing is that research grants are reduced by about 10% and that all of this will come out of the indirect costs. A consequence of this is presumably that the same amount of money will be going into universities, but more of it will be used to cover the direct cost of research and less to cover the indirect. Universities will therefore effectively see a cut in the money that they use to cover infrastructure and other non-direct research expenses.

My personal view is that universities made a mistake in agreeing to the fEC model. My understanding is that there had been a period when universities were supporting research with money that they felt should have been used to support teaching. I believe the initial idea was that some money would be taken away from universities (the portion that supported research) and returned (with some extra added) through research grants from the funding councils. Universities expected to gain money and hence properly cover all the costs of research and teaching. It is quite possible that the reverse will happen. The research councils could agree that the fEC costs are too high and that there should be some kind of cap on the level of non-direct costs on research grants. Universities could therefore end up back where they started with not enough money to cover the indirect costs of their research activities properly. Personally I wish they’d thought more deeply about the consequences of the fEC model and not simply leapt at the possibility of getting more money.

Quantitative easing

So the results of the Comprehensive Spending Review (CSR) have now been announced and they are -in the my view – very depressing. I was listening to George Osborne on Radio 4 this morning and essentially his argument is that this has to be done (some – myself included – disagree) and that he doesn’t even need to have a plan B as his plan A is what we need to do. What is available, according to Osborne, is the ability of the Bank of England to use monetary stimulus if growth should suffer as a result of the spending cuts.

Essentially – as far as I’m aware – this refers to the process of Quantitative Easing. I’m not an economist and I have to admit that I don’t fully understand this, but what I gather is that this involves the Bank of England essentially creating money (crediting its account) and then using this money to buy various financial products. The idea then is that there is more liquidity in the markets, things can be bought and sold, and money can make its way out into businesses who can then pay salaries and carry on operating.

One consequence of quantitative easing is that it is likely to result in inflation. At first glance this seems fairly obvious as money has simply been added into the economy, without actually increasing the net value of the economy. What £1 can buy should therefore decrease. It’s probably not as simple as that since it presumably depends on the actual values of the products that the Bank of England has bought in order to get the money out into the marketplace. If they are able, reasonably quickly, to resell these products for a value consistent with what they paid for them, they could then remove this money from the marketplace and everything cancels. Presumably the amount of inflation must depend – to a certain extent – on the difference between the actual realisable value of the products bought by the Bank of England and the amount that they paid for these products.

The net effect of quantitative easing is presumably then that there is more money in the marketplace and so products can be bought and sold and salaries can be paid. However, it will probably result in some amount of inflation, so everyone would presumably effectively be taking a pay cut of – possibly – a few percent. The alternative would be to make a few percent of the working population redundant, so quantitative easing does something reasonably positive, since it could be preventing some unemployment. However, it is clearly not progressive in that everyone sees their salary devalued by the same percentage. Since low income workers probably spend almost all of their disposable income, they are probably more affected by this inflation than high earners who can save some fraction of their income and earn interest.

Presumably an alternative to quantitative easing would be simply to increase tax for a few years. It could amount to the same thing since it would be reducing people’s salary by a few percent, and the money raised would make it into the marketplace through public sector projects or by paying public sector workers. It’s presumably a little safer in that the consequences of quantitative easing could be quite unpredictable, and it could be more progressive in that it could be aimed at the higher earners (of course being progressive doesn’t appear to be high on the current government’s agenda). Essentially, the government has chosen to make massive public sectors cuts – rather than raising money through taxation – and the only mechanism they have for stimulating growth (if it is required) could have the same effect as taxation would have had. Still not obvious that the government’s approach is the only one that makes sense, or maybe I’m completely wrong and don’t understand anything.

The “greatest macro-economic mistake in a century”

Interesting article in the Guardian today about David Blanchflower’s views on the upcoming cuts. David Blanchflower was, until recently, a member of the Bank of England’s Monetary Policy Committee and is known for being something of a maverick; regularly voting in the minority.

Essentially Blanchflower thinks the government is making a huge mistake in making cuts of this magnitude and are, in fact, being extremely cowardly. As the title of this post indicates, he has also described the proposed cuts as the “greatest macro-economic mistake in a century”. I hope he’s wrong, but my gut feeling is that he is not. What I think makes perfect sense is his comment that even though you do need to cut the deficit, there is no economic theory that says you have to do it extremely quickly. Why is there an insistence that it has to happen within this government? I’m getting somewhat tired of hearing government ministers insisting that there is no alternative and that it is all the previous government’s fault (although there is some merit to the latter). It’s clear that the longer it takes, the greater our total debt will become. However, if we cut too fast and too deep, we risk another recession, reduced revenues and having to borrow more money anyway.

I notice that Alan Johnson, the new shadow chancellor, has now released his plan for cutting the deficit. He is proposing a combination of cuts and tax rises – aimed primarily at the banking sector. It’s probably a little too late, but I much prefer this to the government’s plan of reducing the deficit mainly through cuts. Firstly, I think that the cuts are going to influence a number of things that are fairly crucial to the UK’s well being. Higher education and research funding being things that influence me directly, but the benefits system and policing are two other areas that may be severely affected. There is a second reason why I think tax rises are justified together with cuts.

A cut of £83 billion is equivalent to 3.3 million people earning an average salary (£25000). I’m not necessarily suggesting that 3.3 million people will lose their jobs, but 10% unemployment is not necessarily unlikely. The cuts also mean that £83 billion has left the UK economy, it hasn’t simply gone back into private industry. Private industry is unlikely to suddenly generate £83 billion in wealth overnight. Private industry is also unlikely to reduce profits and the salaries of those in employment simply to reduce unemployment levels (they can’t really employ more people without finding the money to do so). The unemployed are therefore likely to remain unemployed for quite some time. Combining cuts with tax rises means it’s more likely that we will be able to manage a smooth transition from the public to the private sector. I know the CEOs of major corporation will argue that this will inhibit growth, but I’m not convinced. What is more, essentially insisting that 10% of the working population are forced into unemployment so that the wealthiest can continue to get wealthier seems entirely wrong. That doesn’t really feel as though we’re all making equivalent sacrifices for the future of the UK. I hope the government rethinks its strategy before Wednesday’s CSR announcement, but I doubt it.

Tuition fees – Do they really know what they’re doing?

Although not surprised, I am quite disappointed with the Browne report. I haven’t read it in detail, but at first glance it reads as something in which the outcome was essentially known from the beginning. There appears to be very little discussion of the fundamental reasons for the existence of a higher education (HE) sector, and it appears to assume that the current funding model has to change. The basic idea from the report is that tuition fees would be uncapped and that students would be lent the money to cover the tuition fees, and to help cover the cost of living. It seems unlikely that fees will actually be uncapped, but will probably rise to about £6250 per year with an additional £3750 per year for living expenses. Students will therefore accrue debts of about £10000 per year. If this does end up being the case, Universities will supposedly actually gain nothing, in that the government is likely to cut the HE budget by an amount equivalent to the extra amount that the HE sector will get through tuition fees. The main thrust of the Browne report is that the money lent to a student will only be paid back once the student earns more than £21000 per year and would be written off 30 years after the person has finished their degree.

Fundamentally I think it is wrong and I believe that a free market Higher Education (HE) sector will not be as effective as one that is primarily funded by the public and that is largely free to pursue excellence. However, rather than going into a long discourse about why I think this is the case, I thought I would present some basic consequences of the Browne report – assuming that it is accepted as the new model for funding the HE sector.

A little while ago I was playing around with distribution functions and managed to produce one that largely matches the income distribution in the UK. It’s shown in the figure below. It’s not perfect but it has approximately the correct mean (£25000), the correct median (£19000) and the 10th, 25th, 50th, 75th and 90th percentile incomes are very close to the actual values for 2007/2008.

The table below is taken from the Browne report and it shows the amount of money that someone will pay per month to repay the loan they were given to cover tuition fees and cost of living expenses.

At first glance it doesn’t seem unreasonable; the highest earners pay more per month than the lower earners. There are, however, a couple of things one can do straight away. The payment as a percentage of total income is straightforward. It is also likely that there will be interest, at about 2.2%, that will accrue once someone crosses the £21000 threshold. One can therefore calculate how long it will take for someone to repay the loan. These are both shown in the figure below. The solid line is the payment as a percentage of income, while the dashed line is the number of years it will take for someone to repay the loan, capped at 30 years after which the remainder is written off. Included in this calculation is the assumption that people’s salaries will rise with inflation at a rate of 2.2 % per year (for simplicity, the same as the loan interest rate).

What the above figure shows is that everyone earning, today, between £21000 and £32000 per year will repay for the full 30 years. Those earning close to £32000 per year will be paying almost 3% of their income for the entire 30 years. If we go back to the income distribution figure that I showed at the beginning of this post, one can calculate that about 45% of those in employment (about 15 million people) earn £21000 per year or more. Since slightly more than 40% of school leavers go to university, we can assume that almost everyone earning £21000 per year or more will have gone to university and will therefore be repaying a student loan. If this is the case, almost 5 million people will have their income reduced by between 1% and 3% for 30 years. If one considers those who will pay for 10 years or more it amounts to almost 9 million people. Someone earning £50000 per year will pay almost 5% of their income for 10 years in order to pay back their student loan. Almost half of all those earning £21000 per year or more will therefore effectively have their tax raised by 1% or more for 30 years, while 2/3 will have an effective increase of 1% or more for at least 10 years. Of course, inflation could be higher than I assumed and so the repayment period may reduce slightly, but it is unlikely to change things significantly.

One can also determine how much each person will pay. This is shown in the figure below. The full amount will only be repaid by those earning £32000 per year or more. Someone earning £32000 per year will end up paying more than £40000 over a period of 30 years, while someone earning £100000 per year will pay £32000 over a period of about 4 years. This illustrates that the middle income group will pay much more than the highest earners who will be able to repay the loan very quickly.

We can also use the distribution function that I showed at the beginning of the post to determine how much money the government can recover every year. It’s not necessarily exact, but here is what I assumed. Everyone earning over £21000 per year went to university and has to repay a student loan of £30000 pounds. Everyone works for 40 years after graduating, but the loan is only repaid for the first 30 years (any remaining parts of the loan are written off after 30 years). The fraction of people in a given income bracket who will be repaying at any given time is therefore the number of years those people have to repay for, divided by 40. It turns out that if this was already in place and people today were repaying a student loan, the government would recover about 8 billion pounds. Here’s where I have a problem. There are currently 1.2 million people at British universities today. If the government is lending them £10000 each, they are then lending £12 billion and recovering £8 billion. Unless I’m mistaken, this ratio will always remain the same. The government will only ever recover 2/3 of the money because at least 1/3 of those who go to university will not finish paying within 30 years and quite a lot of those are only paying back interest.

If I’ve got this right (which maybe I haven’t as I’ve been trying to do this while my son keeps clambering all over me) the government is about to cut the HE budget by about 4.2 billion and will recover this money by increasing tuition fees. The money for the increased tuition fees will be loaned to students, resulting in an increase in the effective taxation of about 2/3 of those earning above £21000 by at least 1% for at least 10 years after they graduate. Ultimately, however, the government will only recover 2/3 of the money lent which, in today’s terms, will amount to a loss of about £4 billion. Furthermore if they simply increased the level of taxation for those earning above £21000 by 1.5%, revenues would increase by £9 billion. I don’t know about everyone else, but I would rather pay 1.5% more in tax and have a publically funded HE sector, than pay something like 4% for 10 years after graduating (or 1% for 30 years) and end up with a supposedly free market HE sector. I’m of course ignoring that this is still £3 billion less than the £12 billion required for all the 1.2 million students so students would still need to borrow something to cover cost of living expenses and to pay some top-up fees.

Maybe I’ve made some kind of silly mistake or maybe my assumptions are too simplistic but it seems quite possible that – to reduce direct funding to the HE sector by £4.2 billion – the government is going to introduce a graduate tax that could result in some paying 4% more in tax for a decade after they graduate, and after all that the government will still end up paying £4 billion per year to the HE sector. Effectively the government will introduce a very complicated taxation system for middle earners who will lose significant amounts of money just when they’re trying to have families and buy houses and as a result of this, the government will effectively save £200 million. Am I stupid or are they?

Budget deficit

I listened – last night – to the House of Lords Science and Technology Select Committee session with David Willetts. In general I was impressed, both with those on the committee and with David Willetts himself. Phil Willis (the ex Chairman of the House of Commons Science and Technology Committee) was a member of the committee and he was, as usual, well informed and articulate. He asked a very interesting question about why we are planning to cut research budgets while many other countries (Germany, France, Spain, Japan, China, USA) are ring-fencing or increasing their research budgets. He also pointed out that our total public debt is comparable to or less than that of many of these countries. David Willetts’s response was that the problem is not necessarily the total debt, it’s our current deficit – the amount we need to borrow in order to cover the difference between expenditure and receipts. This is illustrated in the figure below that I have taken from the treasury website. It shows total public sector spending (blue bars) and total public sector spending (yellow bars). The deficit is the difference between these two values.

As can be seen in the above figure, there was actually a surplus in the late 1990s. In about 2001 we started running a budget deficit, but it remained at less than 3% of GDP until 2007-2008 when it suddenly ballooned to about 10% of GDP. This is a big number and does mean that we are borrowing a large amount of money at the moment. This is what confuses me though. If the economy recovers, then the deficit should return to 2007-2008 levels within a couple (maybe a few) years. If we were to do nothing, we would need to borrow a large amount of money and although this may make the city a little nervous, it’s hard to see how the economy itself would suffer. People would remain in employment, education and healthcare would still be well funded, and research budgets would not need to be slashed. What is more, the small print on the above figure says that the public sector spending is the “Total managed expenditure, including the temporary effects of financial interventions.” Maybe I don’t know what this means, but I assume it means that one of the reasons for the large deficit is that we’ve been bailing out the banking sector. If right, we’re facing massive cuts entirely because we’ve had to bail out the banking sectors who already are making profits of billions of pounds a year.

This again seems to indicate that the deficit should reduce, fairly quickly. Again, I understand that our debt will grow if we don’t cut it quickly. Currently we pay 43 billion in interest on our debt. If we increased our debt by one-third, we would be paying about 60 billion a year. It is a lot of money and I’m all in favour of reducing our deficit and, over time, reducing our debt. Given that our deficit is likely to return to pre-financial crisis levels of about 3% of GDP, a reduction of about 9% in public spending (given that public spending makes up about one-third of our economy) could remove the structural deficit and – in the short term – essentially cover the interest payments. What is more, a modest increase in taxation together with a modest reduction in public spending could produce the same result without the carnage that the proposed cuts are likely to produce.

My gut feeling is that this is largely idealogical. It is an opportunity for an essentially conservative government to reduce the size of the public sector. Today’s proposal that students fees could be uncapped and could double in the next year or so, seems to be first step in this direction. Furthermore, it is very difficult to see how removing this amount of money from our economy on such a short timescale won’t do some damage. I accept that not cutting the budget will result in an increase in public debt, but at least we could be reasonably confident that the economy should continue to recover. A goal to cut an amount comparable to the 2007-2008 deficit so that within a few years we’re running a balanced budget and can work towards reducing our debt would seem to be a much more sensible option. It’s quite possible that I misunderstand this competely and I’m pretty sure some people will think this to be the case (probably fairly safe from actually being attacked for this as not many people are reading this). Essentially my view is that we are facing ideologically driven cuts that are justified on the basis of a large deficit resulting from us bailing out the banking sector. If we can convince the right people that cuts of this magnitude are suicide, maybe we can also convince them that cutting the science budget will also do much more damage than good.

Child benefits

I initially agreed with George Osborne’s proposal today to remove child benefits from those who earn more than about £44000 per year. Whatever people believe, these are amongst the highest earners in our society. Only something like 15% earn £44000 a year or more, so this isn’t really affecting the middle income group (although the fact that only 15% earn more than £44000 pa is slightly disturbing). At the moment, a family with 2 children will get something like £33 a week, so a total of about £1700 a year. However, having read a little more, I am slightly concerned about how this is going to be implemented.

Firstly it seems like it might not be determined by the household income, but by whether or not one of the parents (or guardians) earns more than £44000 per year. Potentially a single person household with an income of £44000 pa could lose child benefits while a household with two earning £43000 each could retain its child benefit. What is more, it is quite likely that this will be implemented in the form of an on-off switch. If you earn £44000 pa or more you get no child benefit. If you earn £43999 or less you get full child benefit. At the boundary there will therefore be people who earn less but effectively take home more. I still don’t understand why, in this age of computing and IT, we can’t have a system that ensure no one earning less than someone else can end up with more because of some kind of benefit (in fact there seem to be a number of examples of this type of thing in the UK – makes the system simple but not very fair).

Although the above suggests that it might not be implemented in a manner that would be regarded as fair, what has possibly changed my opinion is something a little subtler. Even in the US, you get a tax deduction for every child irrespective of income. Even though we are talking about the higher earners and, for some, losing £1700 a year may not mean much (I suspect that this isn’t true for those earning close to £44000 pa) it just feels slightly wrong that there will be some families with children who will get no benefit compared to other equivalent families who either don’t have children or whose children are now adults. I know it is a small amount of money for the highest earners and they clearly wouldn’t base their decision to have children on whether or not they can get a £1700 benefit per year. It just feels like it says something rather negative about what we value in our society.