What the Cyprus case tells us

In order to understand the current problems in Cyprus, it is first necessary to know how the mess arose in the first place. Reuters have a very good background article here, and I will use it extensively. The 'series of events' that led up to the crisis commences with Cyprus joining the Euro zone:

Before joining the euro, the Central Bank of Cyprus only allowed banks to use up to 30 percent of their foreign deposits to support local lending, a measure designed to prevent sizeable deposits from Greeks and Russians fuelling a bubble.

When Cyprus joined the single European currency, Greek and other euro area deposits were reclassified as domestic, leading to billions more local lending, Pambos Papageorgiou, a member of Cyprus's parliament and a former central bank board member said.

Following the 2008 crisis, this conservative reputation was to lead to money flowing into the banks in Cyprus as a 'safe haven'. The problem was that the money arriving has nowhere productive to go, so mirroring what had taken place in other economies (e.g. the US), the money ended up in real estate, fuelling a bubble in real estate prices. However, this flow of money could not all be absorbed in real estate, with the Cyprus banks growing at a rate totally divorced from the wider economy. Due to historical ties, the destination of choice for the inward flow of money was an outwards flow towards Greece:

The EBA figures showed 30 percent (11 billion euros) of Bank of Cyprus' total loan book was wrapped up in Greece by December 2010, as was 43 percent (or 19 billion euros) of Laiki's, which was then known as Marfin Popular.

More striking was the bank's exposure to Greek debt.

At the time, Bank of Cyprus's 2.4 billion euros of Greek debt was enough to wipe out 75 percent of the bank's total capital, while Laiki's 3.4 billion euros exposure outstripped its 3.2 billion euros of total capital.

There is considerable more detail that could be added, such as the high returns offered by Cypriot banks, but also underlying the high risk speculation is a finger pointing at lax regulation by the central bank:

Whatever the motive, the Greek exposure defied country risk standards typically applied by central banks; a clause in Cyprus' EU/IMF December memorandum of understanding explicitly requires the banks to have more diversified portfolios of higher credit quality.

"That (the way the exposures were allowed to build) was a problem of supervision," said Papageorgiou, who was a member of the six-man board of directors of the central bank at the time.
The board, which met less than once a month, never knew how much Greek debt the banks were holding, both Papageorgiou and another person with direct knowledge of the situation told Reuters.

It seems that, when reflecting on the lead up to the current mess, the factors that drove the crisis forwards are oddly familiar. If looking at the US crisis, floods of money were pouring into the US in the lead up to the crisis, with that money over-spilling into the real estate market, and thus causing a bubble. Just as in the US, the central bank was happy as long as everyone seemed to be getting richer. In both cases, it was a flood of overseas money entering the economy that underpinned the problems (e.g. see here). 

There is an important point in this story, and it a point that does not receive enough attention. There is a widespread misconception that the politicians and policy makers are in control of their own economies. However, this is a myth. They may have influence on their own economy, but they do not control it. The problems in Cyprus are derived from excessive capital flows, and just as happened in the US, when faced with a wall of money, the Cypriot banks were not going to turn it away, but find a home for it. Thus there is a real estate boom, and this will then drive the Cyprus economy into apparent growth, as ever more money chases a limited supply of real estate, and paper gains in value of real estate create economic growth, without any real underlying increase in the output of the economy. Instead, the increase in output is simply the result of excess credit appearing in the economy.

The difference in the Cypriot and US examples is that the small size of the economy serves to exagerate the same effect. When the Fed acts, it is acting on an economy which is relatively large in relation to the flows of capital throughout the world, so is more influential. In the case of a small economy like Cyprus, the actions of policy makers are swamped by the influence of that same capital. Similarly, the US real estate market was so large, that it was able to absorb a large amount of capital. In other words, it is a similar process that took place, but with differences in degree of effect. We can see a similar process taking effect in other economies. For example, in New Zealand (population about 6 million), the central bank labours under the illusion that it has some control over the New Zealand economy through interest rates targets.

The New Zealand dollar tumbled almost a cent against the US dollar after the Reserve Bank said interest rates will remain at a record low through this year. 

The bank also hinted at a cut to the official cash rate if the currency was higher than justified by economic fundamentals.

The kiwi fell to 81.66 US cents from 82.60 cents immediately before the statement.

This is the interesting point:

Local property prices rose 7.6 percent last month on increasing sales numbers, according to Real Estate Institute figures. New Zealand's property market gains have been driven by a lack of supply in its biggest city, Auckland, and as the Canterbury rebuild gets underway.

"House price inflation is increasing and the bank does not want to see financial stability or inflation risks accentuated by housing demand getting too far ahead of supply," Mr Wheeler says.
The Reserve Bank estimates house prices increased in real terms at an annual pace of 6 percent last year, and will rise 6.2 percent and 3.6 percent this year and the next.

Although following an earthquake there is a genuine supply problem, this is not the real driver of the real estate market. You will notice that the interest rates are relatively high in comparison with other Western economies. The chart and quote below come from the New Zealand Reserve Bank:

The US Dollar cross rate should be interpreted as one New Zealand dollar buying x US dollars. The TWI (Trade-weighted index) is the nominal NZ dollar exchange rate weighted 50/50 by New Zealand's trade with its major trading partners and the nominal GDPs (in US dollars) of those countries. The graph shows monthly averages.

In October 2000 the New Zealand dollar reached record lows, dropping below 40 cents per NZD. However, after 2002, the currency strengthened considerably, reflecting a strong domestic economy, rising export commodity prices and associated increases in interest rates. The TWI behaved very similarly to the US dollar cross rate over most of the decade .

In 2008, continuing financial market uncertainties and a deteriorating global economic outlook saw many investors move into perceived 'safe-haven' currencies such as the USD. As a result the NZD fell sharply against the USD and other currencies in the TWI (the Japanese Yen and Euro in particular), but these falls proved to be quite shortlived. In part that reflected the way in which New Zealand was hit less hard in the recession than many of the countries whose currencies make up the TWI.

 

In a small economy like New Zealand, here is the problem. They currently have what looks like a real estate bubble.

The country's average salary of $45,000 was more than double that of many lower-income families who struggled to pay rent, Mr Evans said.

"Once you've paid rent and power bills and put petrol in the car so you can get to work, there's not much left over for food."

And then we have this:

The New Zealand property market rebounded from the seasonal lull in listings over the summer break with 13,145 new listings coming to the market in February. Auckland saw its average asking price exceed $600,000 for the third time, while Canterbury’s figure surpassed $400,000, for the fourth time.

It is very clear that the underlying driver of house prices is not wages, as there is a mismatch between income and house prices. Although there may be some supply issues within the house prices (in particular in Christchurch), this would not explain this disconnect between salary and house price. The real driver is that there is an oversupply of credit into the market. To put this simply, if there is 100 units of credit chasing 100 units, and then we increase the supply of credit to 130 units without changing the supply of units, then we will see the cost of each unit increase. Note, nothing has changed in the quality of the units; just by increasing supply of credit is sufficient to increase prices. 

This is why the central bank is not in control. For those unfamiliar with the idea of the carry trade, it works like this. I borrow extremely cheaply in the US with effective 0% interest rates, and then lend that same money into another economy with higher interest rates. I take a risk on the currency in so doing, but the rewards are potentially very high. Even better, if lots of people are doing the same thing as me, the demand for $NZ is increasing and this leads to currency appreciation. Even better, the new money entering the economy creates a positive uptick in the New Zealand economy, and this further strengthens the currency. This is exactly what is taking place in New Zealand now:

The economy grew faster than expected through the tail end of last year, underpinned by the Canterbury rebuild, and that stronger domestic demand is seen as creating medium-term inflationary pressures, even as consumer prices remain subdued in the foreseeable future, the bank says in the monetary policy statement.

"Monetary policy settings must balance this low near-term inflation outlook and concerns about the exchange rate and weak labour market, against increasing signs that output will accelerate and inflationary pressures will pick up."

New Zealand food prices fell 0.3 percent last month, led by seasonally cheaper fruit and vegetables and discounted meat, according to government figures published yesterday.

Food prices account for about 19 percent of the consumer price index, which was tracking below the central bank's target 1 percent to 3 percent band in the December quarter at 0.9 percent.

The bank sees the annual pace of inflation staying at 0.9 percent until the September quarter this year, rising the mid-point of its band in latter half of 2015. Medium-term pressures are expected to come in the housing and construction sectors, with the risks skewed to the upside, it said.

Again, the Christchurch rebuild is undoubtedly a factor, but so is the entry of new credit into the economy. Note that inflation is subdued. If you have currency appreciation, imports become cheaper, and this will help keep inflation in check.

Into this interesting bubble scenario, we have the role of the central bank. The brief fall in the $NZ was probably due to previous speculation that the interest rate would be raised to tame the house price bubble. However, had the central bank increased interest rates, the impact would have been to make New Zealand even more attractive to the carry trade, and thus have the opposite effect to the one intended. The problem is that, in keeping a low interest rate target, there is nothing to pop the bubble in house prices. In other words, until such time as the carry trade winds down, there is nothing that the central bank can do which will tame the house price bubble, with the associated problems that will develop from the bubble.

In other words, the New Zealand economy is in the hands of others. For example, if a large economy such as the US targets 0% interest, this will lead to carry trade activity, and this will impact on other economies such as New Zealand. Whether New Zealand is a carry trade destination is determined by New Zealand interest rates, but they are determined by factors such as the currency, and the current levels of credit entering the economy. Most importantly, there is the speculation of the capital markets, based upon exchange rate risk, and the exchange rate risk is determined in part by the speculation, and this is divorced from the underlying economy of New Zealand, as their own collective actions are determining the value of the currency. For the carry trade, it is all about timing. Getting in early, and getting out before it unwinds is the key. The more new entrants into the carry trade, the higher the currency appreciation, the more profit to be made. However, the credit creates an artificial boom in the economy, which can rapidly turn to bust as credit based growth starts to reach saturation, and the situation unwinds, including currency depreciation. The carry trader needs to get out before this takes place.

Returning to Cyprus, the key difference is that Cyprus is a Euro economy which meant that, in consideration of the size of Cyprus, the state of the economy had no influence whatsoever on the value of the currency. This disassociation between the underlying economy and the currency, and the wall of money being thrown at the economy, means that there was no currency derived time 'to get out' excepting where the Euro area was perceived to be at risk. This and the reputation for being conservative but providing outsize returns, made Cyprus an attractive destination. The key to the outsized returns was, in turn, the result of lax bank regulation. Regulation gave an illusion of stability, but it was no more than this; an illusion. Cyprus had only one means to control the situation, which was central bank regulation. However, just as with the many cases in recent history, when a flood of money enters into an economy, the economy booms, the regulators always seem to look the other way. Whilst things are 'good', they suddenly freeze, and fail to act. We have now seen this so many times that it is becoming sadly comedic. However, the illusion that all is okay due to regulation always remains, and ultimately contributes significantly to the growth of the problem.

However, one element of the Cyprus problem was not derived from central bank regulation, which was the property bubble. It has yet to unwind fully. However, we can see it time and time again; when a flood of money arrives in an economy, with nowhere productive to go, real estate is the destination of choice. This in turn creates a boom, and a boom that, in the end is unsustainable, being derived not from underlying economic growth, but in increased consumption. As Krugman (goodness, am I referencing Krugman?) points out, this led to a 15% of GDP current account deficit in 2008:

Is this all sounding all too familiar? It should be, because what we are seeing is an exaggerated picture of the reality of many economies. I will pick out the key points:

1. Banking regulators; they fail, fail, fail and fail time and time again when it matters
2. Policy makers only have limited influence on an economy, and the degree of that influence is often far less than is perceived. The size of the economy in relation to capital markets determines the influence.
3. Carry trade bubbles are self-reinforcing, and even more so when removed from currency risk
4. Real estate bubbles are economic weapons of mass destruction, and appear to be primarily derived from carry trade activity
5. Developing an oversize financial services industry is fatal. 

With regards to point (2), even though the US economy is huge, we can see the carry trade undermining the policy of the central bank. As fast as new money is pumped into the economy, it leaks out through carry trade activity and creates mayhem in other economies.  A long time ago (January, 2010) I discussed 'the Masters of the Universe' who suffered the illusion of control over their economies:

What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

One of the points that I made all that time ago was that the US crisis that emerged in 2008 was, in part, derived from the Japanese Yen carry trade, which was driven by the Japanese bank printing money. When we look at small economies, such as New Zealand and Cyprus, we can see the policy spill-over from other countries more clearly. Whilst there are some very clear differenced between the two economies, they share a single common characteristic; the policy makers are not in control. Furthermore, it is apparent that, as I long ago suggested, policy makers are resorting to ever more dramatic policies (e.g. QE Infinity in the US), and we will no doubt see this generate even greater instabilities in the global economy, and also in the lever pulling countries. It leaves us with the troubling question of how the global economy might look as these ever more extreme policies generate yet more extreme policy in response? It is a worrying question, but those 'in control' of policy have yet to even recognise their own position in the world economy, let alone think through the answer to this question.

Note: Thank you Lemming for the comment that prompted this post. Please accept my apologies for not posting, but I have been working 7 days a week again, and could not face more time in front of the computer. I will try to post more regularly, but my work is consuming me at present.

Note 2: I did think about commenting on the 'haircut' policy, but thought that the question of lack of control was more interesting. I hope you agree.

The Minimum Wage

Apologies for not posting for so long. Also, this is going to be one of the shortest posts I think I have written. I occasionally browse the Mises institute, although I am not an Austrian economist (they have some good points, but others are more questionable). This time round, I stumbled on an article on the minimum wage. This key passage was of particular interest:

The advocates of the minimum wage and its periodic boosting reply that all this is scare talk and that minimum wage rates do not and never have caused any unemployment. The proper riposte is to raise them one better; all right, if the minimum wage is such a wonderful anti-poverty measure, and can have no unemployment-raising effects, why are you such pikers? Why you are helping the working poor by such piddling amounts? Why stop at $4.55 an hour? Why not $10 an hour? $100? $1,000?

The logic appears to be simple and very clear. The 'piddling' amounts is because higher amounts would cause unemployment, and the advocates know it! I do not favour the minimum wage as I have always considered it a misguided tool (I will not go into all my reasons now). However, this single passage seems so simple and logical, it is difficult to argue with. Rarely in economics is there such a simple, concise and clearly expressed argument. Does anyone have a counter-argument to this simple logic, as I would be fascinated to hear it?  Maybe this is too simple?

Another 'automation is bad' argument....

I have just stumbled on a new article which is arguing that automation is not a good thing (see ref below and discussion of the article here) and this follows my discussion of Krugman's Luddite point of view some time ago. They discuss robots, but also quite reasonably discuss other forms of substitution for human labour, such as the ability for computers to calculate taxes, and automated toll collection etc. This new article argues that the rise of automation is going to cause an inter-generational wealth gap:

As shown below, in an admittedly highly stylized life-cycle model, the general equilibrium effects of this generational redistribution can transform enhancements in machines into very bad news not just for contemporaneous young generations, but for all future generations. The model treats all young workers as unskilled agents who invest their savings in the acquisition of both skills and machines. When today’s machines get smarter, today’s young workers get poorer and save less. This, in turn, limits their own investment in themselves and in machines. The knock-on effect here is that the economy ends up in all future periods with less human and physical capital, which further depresses the first-period wages of subsequent young generations. Although the skilled wage premium and the return to capital rises, the net impact of smartening up today’s machines is a reduction in the lifetime wellbeing of today’s and tomorrow’s new generations. In short, better machines can spell universal and permanent misery for our progeny unless the government uses generational policy to transform win-lose into win-win.

As a positive in the article, they recognise that the massive increase in labour in places like China and India has been a force that has driven down global wage rates. They also recognise that China is likely to also go down the road of automation, a point I made in my earlier post on the subject.
I can also at least give them credit for the novelty of their approach to the machines are bad argument.

However, the problem with their argument is very simple. It would apply equally to the Luddites, if not more. Indeed, today, capital is probably less concentrated than in 19th century England. So why is it that the industrial revolution created the many benefits that we still enjoy today?

After all, it was not just weaving in the industrial revolution that was impacted by automation, but many industries. In each case of automation, previously skilled work was automated, and also unskilled work, but the result was a revolution that saw long term improvements in standards of living. Modernity is the product of this revolution. The whole point of automation is to drive down costs of production, and this leads to cheaper goods, and cheaper goods means greater affordability, and more goods being available and so forth. Now if we jump back in time to the time of the Luddites, automation was undoubtedly a bad thing for skilled weavers, but also gave cheaper cloth for everyone else. This cloth was made in factories which themselves created a whole raft of new jobs, for example generating employment for skilled and/or semi-skilled engineers, as well as unskilled work in the manufacturers of the machines. As labour was freed as a result of industrialisation, new products could be made and the general stock of products available increased, and the cost of those products fell. In other words, automation destroyed jobs, but also created new jobs, and provided a wider range of products (and services) as lower costs.

There is no real difference here, except that some of the jobs that are being replaced are white collar. However, the idea that a computer can do complex tax calculations is directly equivalent to a skilled weaver doing complex weaving. The nature of the technology makes no difference, and nor does the status of who is being replaced. Indeed, if we read their introduction, we find this:

But what if the Luddites are now getting it right -- not for labor as a whole, but for unskilled labor whose wages are no longer keeping up with the average? Indeed, what if machines are getting so smart, thanks to their microprocessor brains, that they no longer need unskilled labor to operate?

Evidence of this is everywhere. Smart machines now collect our highway tolls, check us out at stores, take our blood pressure, massage our backs, give us directions, answer our phones, print our documents, transmit our messages, rock our babies, read our books, turn on our lights, shine our shoes, guard our homes, fly our planes, write our wills, teach our children, kill our enemies, and the list goes on.

Yes, technology has always been changing. But today’s change is substituting for, not complementing unskilled labor. Yesterday’s horse-drawn coaches were replaced by motorized taxis. But both required a human being with relatively little human-capital investment – a cabbie -- to drive them.

Tomorrow’s cars will drive themselves, picking us up, dropping us off, and returning home all based on a few keystrokes. This will make cabbies yet another profession of the past.

I have put emphasis on a couple of points. Take the example of the frivolous machine that massages our backs. This is a product which replaces a human masseur. That must be a bad thing, right? However, there is now employment in the manufacture of a new machine, and one which makes having an affordable massage available to more people. Automation has allowed this to be achieved, and for those (unlike me) who value a good cheap massage, their life is improved by this becoming affordable. Or take the idea of machines reading our books. For the blind, this constitutes (I guess) a huge potential improvement in their lives, and again, the development of software and manufacture of computers to do this is a source of employment. Sure, braille producers will eventually go out of business, but would we begrudge the availability of the books for the blind due to this loss of employment. In a recent example, Excel software undoubtedly would have led to less employment for the less skilled account clerks, but also would have created greater demand for those who could interpret accounts. Now, some of that interpretation is automated, and this in turn will reduce the need for skilled interpreters of accounts. In neither case did the employment world fall in as a result.

The important point is that in the introduction to the paper there is a whole list of new consumer goods and devices that were previously unimagined and that directly or indirectly result from the technology of automation. Who could have imagined a mobile phone 50 years ago (notwithstanding science fiction), but here they are. As technology improves further, other unimagined devices, services and consumer products of all kind will become available, whilst existing products will become cheaper and more widely available. New skills will be in demand. For example, as result of relative affluence in some countries, more people can afford to eat out, and this generates new demand for labour that is skilled, semi-skilled or unskilled. It allows for new leisure pursuits to be developed such as bungi-jumping. All of this is contingent upon the expansion of productive capacity, and automation does exactly this.

Just as the stock of types of goods increased and cost of goods fell in the industrial revolution, so the same will happen today, as exemplified in the examples the authors give. It really is no different. Where once there were skilled hand loom weavers, there were then other skilled and unskilled jobs that were created in their stead. This net increase in the availability of types of goods and reduction in the cost of producing goods can only be a good thing. However, automation of any kind sees a short term cost to those who are replaced.

The real difference today is nothing to do with automation, but is to do with something the authors themselves highlighted. There is indeed the question of the supply of labour in the world, and competition is particularly intense between unskilled labour. However, there is also intensifying competition in the middle as countries such as China seek to expand their higher education and increase the supply of graduates. This is nothing to do with automation, and everything to do with the supply of labour. As such, they are correct when they suggest that new Western workers face a challenging future, but are wrong about the reasons. I am genuinely puzzled at the revival of Luddism, and the rather odd justification for it. Is it simply fear of change? Comments welcomed.

Note: I realised I forgot a key point in the post just after hitting publish. What the authors are mistaken on is that they see automation as creating income inequality. What is actually taking place is greater income equality in which income is being redistributed to places like India and China, whilst income inequality within countries increases due to the oversupply of labour overall. Capital wins in a situation of an oversupply of labour as labour is unable to bargain for a greater share of profits. It really is very simple. Their claims of greater income inequality only stands up if looking within a country, not if looking between countries.


Sachs, J. D. and L. J. Kotlikoff (2012). Smart Machines and Long-Term Misery, National Bureau of Economic Research.

Reforming Law and Order: Drugs Reform

It seems that it has been a very, very long time since I have posted on the subject of solutions to the UK's current fiscal crisis. My posts on the subject of reform have been mostly well received by readers, but I am not sure that this proposal will please many. However, it is perhaps the most simple reform that I have proposed, and would play a very significant role in cutting the costs of law and order, and would make the UK a significantly safer place as well.

My proposed reform may have you spluttering in your coffee. It is very simple. It is to legalise all drugs. And I mean all. I was hoping to be able to show you a video called 'Breaking the Taboo' to convince you of many of my arguments, but it has puzzlingly stopped being made freely available, and attempts to watch it describe is as a 'Private Video'. Although the film is focused on the US, the arguments made in the film are far more widely applicable. The film presents a persuasive argument in favour of drugs legalisation, and features some somewhat surprising supporters; Bill Clinton, Jimmy Carter as well as many other senior politicians. The argument is simple, and that is that the 'war on drugs' has long been lost, and the cost of the war is greater than the benefits. It is both a financial and moral cost that is discussed. Wired offers a good summary of the film:

Breaking the Taboo is straightforwardly honest about its message from the start -- the war on drugs is futile and misguided, and it makes people's lives miserable. It makes its points clearly: the drug war has devastated South American countries; it has devastated poor communities in the US; it's given rise to a huge prison-industrial complex in the US; countries that have approached drugs as a health problem and not a criminal one, like Portugal, the Czech Republic or the Netherlands, have fewer problems with organised crime and addiction. It's even narrated by Morgan Freeman, giving it that warm tone of reliability (Gael García Bernal narrates the Spanish-language version).

They're not new points, but then the whole point of Breaking the Taboo is that it's for people who may not have heard these counterarguments made so succinctly and matter-of-factly -- that's what the title of the film is referring to, the proposition that speaking about drugs as anything other than a problem that needs to be wiped out with force is a taboo topic among much of mainstream society. It heavily features the 2011 Global Commission on Drug Policy, the organisation which released a report declaring that the war on drugs had "failed", something made more notable by the number of former high-ranking public officials it included in its ranks -- including three former presidents and one former prime minister.

The views expressed in the film mirror many of the views I have held for a long time. For example, the US prohibition of alcohol provides a case study of the impacts of drug prohibition; it launched an organised crime crime wave. Al Capone was not fiction, but fact. This is from Wikipedia and, although requiring additional citations, the account conforms with more reliable sources I have seen:

Organized crime received a major boost from Prohibition. Mafia groups limited their activities to prostitution, gambling, and theft until 1920, when organized bootlegging manifested in response to the effect of Prohibition.^[67] A profitable, often violent, black market for alcohol flourished. Powerful criminal gangs corrupted law enforcement agencies, leading to racketeering. In essence, prohibition provided a financial basis for organized crime to flourish.^[68]

Rather than reducing crime, Prohibition had transformed the cities into battlegrounds between opposing bootlegging gangs. In a study of over 30 major U.S cities during the prohibition years of 1920 and 1921, the number of crimes increased by 24%. Additionally, theft and burglaries increased by 9%, homicide by 12.7%, assaults and battery rose by 13%, drug addiction by 44.6% and police department costs rose by 11.4%. This was largely the result of “black-market violence” as well as the diverting of law enforcement resources elsewhere. Despite the hope of the prohibitionist movement that the outlawing of alcohol would reduce crime, the reality was that the Volstead Act led to higher crime rates than were experienced prior to prohibition and the establishment of a black market dominated by criminal organizations.^[69]

Furthermore, stronger liquor surged in popularity because its potency made it more profitable to smuggle. To prevent bootleggers from using industrial ethyl alcohol to produce illegal beverages, the government ordered the poisoning of industrial alcohols. In response, bootleggers hired chemists who successfully renatured the alcohol to make it drinkable. As a response, the Treasury Department required manufacturers to add more deadly poisons, including the particularly deadly methyl alcohol. New York City medical examiners prominently opposed these policies because of the danger to human life. As many as 10,000 people died from drinking denatured alcohol before Prohibition ended.^[70]

The current state of the 'drug war' mirrors the prohibition era, and this is one of the points made in the film 'breaking the taboo'. The cure is doing more harm than the problem. Support for legalisation is appearing from the most unlikely sources; for example, just recently, I found an article in the Spectator which argued that the only way to end the horrendous violence engulfing Mexico is to legalise drugs, even making the comparison with the prohibition era. Putting it very simply, prohibition of drugs creates crime, and criminalises large numbers of people who would otherwise likely remain law abiding. As well as the social costs, drug prohibition is very, very expensive. This is a point made in a recent report by the Transform Drug Policy Foundation (TDPF).

The TDPF report commences by pointing out that no cost benefit analysis has ever previously been undertaken for legalisation of drugs, and yet assertions have been made as if this were not the case. The upshot of this policy is summarised here:

Despite the billions spent each year on proactive and reactive drug law enforcement, the punitive prohibitionist approach has consistently delivered the opposite of its stated goals. The Government’s own data clearly demonstrates drug supply and availability increasing; use of drugs that cause the most harm increasing; health harms increasing; massive levels of crime created at all scales leading to a crisis in the criminal justice system; and illicit drug profits enriching criminals, fuelling conflict and destabilising producer and transit countries from Mexico to Afghanistan. This is an expensive policy that, in the words of the UN Office on Drugs and Crime, has also created a raft of negative ‘unintended consequences’.

My intention is not to reproduce every point in the report, but there are some examples that I would like to highlight (note, they are conservative on the costs of prohibition, and conservative on the benefits of a legal and regulated market), such as their calculation of savings under four scenarios (p.7):

Scenario A: 50% fall in use, net benefit = £13.943 billion
Scenario B: No change in use, net benefit = £10.834 billion
Scenario C: 50% increase in use, net benefit = £7.724 billion
Scenario D: 100% increase in use, net benefit = £4.616 billion

These are just for heroine and cocaine legalisation and regulation, and their estimates are indeed very, very conservative (e.g. they exclude costs of the large contribution of the UK government to global enforcement of prohibition). Further, although there are often attempts to suggest that legalisation will increase usage, this is argued without evidence. Indeed, since the Misuse of Drugs Act of 1971, intended to stop the use of drugs, this is the outcome (p.11):

The report makes the point about increased usage very strongly, with this section quoted below just one example:

The proposed deterrent effect is poorly supported by empirical research. The Science and Technology Select Committee report in 2006 on the drug classification system ‘Drug Classification: Making a Hash of it?’60 stated that:

“We have found no solid evidence to support the existence of a deterrent effect, despite the fact that it appears to underpin the Government’s policy on classification. In view of the importance of drugs policy and the amount spent in enforcing the penalties associated with the classification system, it is highly unsatisfactory that there is so little knowledge about the system’s effectiveness”.
The Government rejected this finding and responded with:

“The Government fundamentally believes that illegality is an important factor when people are considering engaging in risk-taking behaviour. The exposure to criminal sanction, in particular through sentencing, influences perceptions and behaviours. It believes that the illegality of certain drugs, and by association their classification, will impact on drug use choices, by informing the decisions of dealers and users. Imposing penalties on the offence of possession is intended to deter use, particularly experimentation by young people. Whilst the Government accepts that there is an absence of conclusive evidence in relation to the deterrent effect of the existing classification structure, there is some evidence from the Offending, Crime and Justice Survey that the deterrent effect of harsher sentencing was greater among those admitting to the supply of a Class A drug, compared with other offences. The Government will consider ways in which the evidence base in the context of the deterrent effect can be strengthened.”61

However, in the field of evidence-based policy making what the Government ‘believes’ is neither here nor there, and there is notably no evidence provided to support the ‘belief’ of the system’s effectiveness as a deterrent (it was not made clear which evidence from the Offending, Crime and Justice Survey was being referred to). In the absence of this or any other credible evidence, this ‘belief’ can only remain an untested assumption.

The report accepts that estimating future use under a legalised and regulated scenario is difficult to calculate, for example with different effects and impacts according to the type of drug, and different impacts upon sub-types of population etc. However, although they give the scenarios, they consider the increased usage scenario for heroine as unlikely, and their discussions certainly point in this direction. I will not make my argument here, and will leave their conservative assumptions in place, but I think the most likely outcome would be a significant reduction in use of drugs like heroine, and an increase in the use of drugs like cannabis (used as an alternative to alcohol). Much would depend though on the nature of the regulation for each drug, and I broadly agree with the regulation scenarios they give in the report for each drug type.

I have to emphasise that the TDPF report is filled with caveats, is restricted to the impacts of just two drugs, but I also have to emphasise that it is very, very conservative. I very strongly urge you to read the report if you have any doubts. Excepting the moral panic and emotive arguments, legalisation of drugs is the single easiest reform that could be made to save significant amounts of government expenditure. However, as the film 'Breaking the Taboo' identifies, drugs policy is hard to separate from rhetoric and moralising. This is the problem of the idea of being 'soft' on drugs. However, the problems of drugs is largely a problem of illegality, rather than a problem of drugs per se. I am sure that many readers will have doubts, and concerns. For these readers, I cannot do justice to all of the arguments in a post, and I would urge you to read the report, and also try to see 'Breaking the Taboo'. It has never been the case that the arguments for legalisation and regulation were not compelling; it is just that, until recently, they were never given wide airing. It has taken 40 years of failure in the 'war on drugs' to finally allow the arguments some traction.


Note: If you want to understand the arguments for drugs legalisation in a less weighty format, I strongly recommend Ben Elton's humorous book 'High Society'. Although a comedy novel, he also very clearly presents the arguments in favour of legalisation, which he weaves in amongst the narrative. It may not be a 'serious' book, but the argument made is nevertheless serious.

Note 2: I changed my mind on discussing my own views on the impact of legalisation and regulation on usage and will give one example of my reasoning, with the case for regulation of heroine by making it available as a prescription. For current addicts, this would see the addicts switching from buying from illegal dealers to obtaining the drug on prescription, which would be cheaper and safer. As a result, the heroine dealers would be put out of business. As such, the availability of heroine to potential new users would be restricted to people who were willing to actively seek a prescription. It seems that someone one day saying to themself that they would like to take heroine is quite unlikely. Even if a person did, for some odd reason, decide to start taking heroine, they would be advised of the risks and addictive nature of the drug before starting.

By contrast, for anyone who has encountered the world of illegal drugs, the ease of access and the 'culture' of the 'drugs world' is a world apart. It is easy to see how people are exposed to, and eventually try drugs like heroine. For an addict, selling drugs, and actively encouraging new users can help support their own habit through dealing the drug. Under the prescription scenario, I suspect there might be some exceptional and rare cases of existing addicts introducing new users, but this would result in far less new addicts than having people actively encouraging new use, for example by existing addicts who can use new users to pay for their own habit. I suspect that, as addicts recover (and without illegality they would be in the 'system' and availability of help would improve), heroine use would very rapidly decline to a small number of long term addicts.

Note 3: I welcome comments, but would ask that you try to make yourself familiar with the details of the pro-legalisation arguments before doing so.

Bash the Bankers or the State?

I don't much go in for the sport of 'banker bashing', as I see the responsibility for the failures in the banking system sitting at the feet of politicians and other policy makers. Notwithstanding this, I have noted two articles, both of which could be said to be of the bashing variety, but which nevertheless capture some of the problems and the ongoing ludicrous situation of the banks being immune from their own failures. The first comes from Matt Taibbi in the 'improbable' Rolling Stone magazine. Matt has been railing against the excesses of the banks for a long time. His writing is polemical, includes ad hominems, and a list of other 'sins', but he nevertheless makes some very good points. Somebody needs to. This is in his introduction:

It was all a lie – one of the biggest and most elaborate falsehoods ever sold to the American people. We were told that the taxpayer was stepping in – only temporarily, mind you – to prop up the economy and save the world from financial catastrophe. What we actually ended up doing was the exact opposite: committing American taxpayers to permanent, blind support of an ungovernable, unregulatable, hyperconcentrated new financial system that exacerbates the greed and inequality that caused the crash, and forces Wall Street banks like Goldman Sachs and Citigroup to increase risk rather than reduce it. The result is one of those deals where one wrong decision early on blossoms into a lush nightmare of unintended consequences. We thought we were just letting a friend crash at the house for a few days; we ended up with a family of hillbillies who moved in forever, sleeping nine to a bed and building a meth lab on the front lawn.

I will not quote endlessly from the article but his introduction sums up the situation, in his unique style, rather well. Regular readers will know that I was firmly opposed to any bailouts at the time of the financial crisis blowing up, and have been firmly against ever since. Of course, the massive scale of the bailouts in the US only became apparent a long time later, thanks to Bloomberg's persistence in pursuing the detail of the Federal Reserve's support for the banks, at a grand total of over $7 trillion in guarantees and lending limits. The interesting thing about the Taibbi article is that it puts some of the details of the kind of shenanigans that were taking place, such as how bank executives benefited from the support. Again, I will not detail the article here, but my interest is that Matt seeks to foment outrage, and he is right to do so. The reason I mention Matt's article is that I had it in mind when I read this:

At the behest of its former chief executive, Maurice Greenberg, AIG (AIG) is considering joining a lawsuit filed by its shareholders against the government. On Wednesday, according to the New York Times, Greenberg, 87, will try to persuade the AIG board that the terms of the company’s $182 billion government bailout were too onerous, the interest rates were too high, and ultimately, that AIG shareholders got a raw deal. What’s that about biting the hand that feeds you?

Since this article, AIG have rapidly retreated from the lawsuit in the face of general public outrage.  The first reason I write this post is that the initial action of AIG is beyond belief, and indicates that they are entirely incompetent.The second reason is a more fundamental concern; they actually must have thought that they could use the law to achieve their ends. This suggests that financial institutions really believe that the law in the US is putty to be toyed with. No sense of a functioning judicial system would give even the slightest inkling that AIG could win, but AIG nevertheless believed they might do so. Such an impression can only come from experience, and this returns to the many points made in Matt's article. The situation is one in which the US government and the federal reserve, and the judicial system seem completely under the influence of the major banks and financial institutions.

Matt is seeking to foment outrage and I am guessing that, when surveying the world around him, he must be baffled that there is so little outrage. And there is so little. The nearest thing to popular outrage were the sit-in protests whose name I cannot even remember (I did visit one of the sit-in sites, and found that the protesters had nothing coherent to say). Other than this, there seems to be little popular outrage, and I find this odd. It seems that key institutions of state have been, and continue to be, corrupted by these major financial institutions. My belief is that part of the problem has been the focus on the ills on the banks, or 'banker bashing', when the ills are actually to be found in the state institutions that are supporting them. I will even go as far as to say the banks are not to blame. Why, when they have every reason to play the game as they can do, would they do otherwise?

Yes, there might be some personal ethics that might prevent the banks acting to use the system as they do but that is not the point. Banks, by their nature, are institutions aimed at making money and they will therefore seek to further this interest. There should never have been a state system that allowed their rampant corruption in the first place, and that system is and can only be the responsibility of the state. In summary, just as Matt must look around him with bafflement, I find myself doing the same. Where is the outrage, and demand for reform?