The Arbitration Chambers

Swaps and their risks – a comparison between swap rates, bank bonds and treasuries

Peter Kralj — Mon, 17 Jun 2013 11:26:36 +0000

Prior to the financial crisis of 2007 the treasury yield curve ( the graph that shows the yield on treasury securities plotted against the term of those securities with a duration of between 1 and 30 years) was considered to be a good way of determining the trend in future interest rates.
Before the introduction of the interest rate swap in 1980 this was the only way in which the trend in future interest rates could be determined.
US treasuries (other countries operate in the same way) generally show that the yield on a bond maturing in 30 years is significantly higher than the yield on a bond (or note as the shorter securities are called) maturing in 1 year. Sometimes -this happened in the UK for many years – the yield on the 30 year bond might be lower than on the 20 year bond. This is an aberration resulting from the demand and supply of bonds of certain maturities. It is not necessarily an indication or assessment of future interest rates.
Interest rates on bonds are not determined by market forces determining the appropriate level of interest rates as for example when bonds are first auctioned. When bonds are issued at an auction investors make up their minds what the appropriate rate of interest they require is. In the secondary market bonds are bought and sold for a variety of reasons and the yield from time to time is the result of such buying or selling and not always a rational decision that it is the appropriate rate of return. Interpreting what interest rates will be from the bond market should therefore be done with caution. Nevertheless it is still the best means available for the purpose.
Since the introduction of the interest rate swap the swap yield curve has become an alternative way of calculating or predicting future interest rates.
The two yield curves – treasury and swaps – have never been the same, except for maturities of one or two years. As maturities increase a gap between the two appears and widens with increasing maturities. For longer term maturities – 10 to 30 years – treasury yields have been 25 – 50 basis points less than the corresponding swap rate. At times the difference has been more than 100 basis points.
Treasuries have in the past been considered to be default risk free instruments so that the increasing rate of interest for longer maturities is meant to represent the additional return for the risk that short term interest rates during the term of the bond might increase.
Swaps are arrangements for the exchange of floating rate of interest for a fixed rate of interest and are generally made between two banks. They are considered to be as free of risks as any bank debt. Why then has there generally been a difference between the two yield curves.
Swaps are always quoted on the basis of the fixed rate of interest that will be paid under the arrangement. Thus if Bank A enters into a 10 year swap with Bank B whereby Bank A will pay Bank B the floating rate of interest (Libor) on 100mm and Bank B will pay Bank A a fixed rate of interest of 3% on 100mm the swap rate is said to be 3%.
If the swaps yield curve properly predicts the trend in future interest rates the value of the Libor payments over the 10 year term will be exactly equal to the value of the payments of 3% per annum over the same term. Of course such predictions are never right.
Swaps therefore have a nil value when the deal is struck because the value of the right to receive payments and the liability to make payments are identical.
Unlike bonds, swaps are not bought and sold on the market. There is no auction to determine what swap rate is acceptable to the market even at the time a deal is struck. Their price is determined by individuals.
As time passes and the swap rate changes the swap will no longer have a nil value. Its value will fluctuate as the swap rate for the remainder of the term differs from the original rate. This value is the cost of unwinding the swap at any particular time. In the language of the market one of the counterparties is “in the money” and the other is “out of the money”. There is a risk that the party that is out of the money – the one who would owe the other counterparty money if the swap was terminated prematurely, will default.
It is this risk of default that has generally been the explanation why the interest rate swap yield curve is generally steeper than the treasury yield curve.
That value of a swap however is generally small.In the above example if the swap is terminated prematurely and the new swap rate for the remainder of the 10 year term is 4% Bank A would have to pay Bank B a sum that is equal to the present value of 1% per annum for the remainder of the term. The potential loss if one counterparty defaults is probably never more than 10% of the amount that is borrowed by the customer. If a bond issuer defaults the potential loss includes not only that sum by the principal amount as well.
So long as the swap rates include the price of the risk of default by a counterparty they do not and cannot without adjustment represent the best prediction of future interest rates. Nevertheless this is how they have been and continue to be used.
It is interesting to compare swap rates with bonds issued by a prime bank. The yield on such a bond will usually be higher than the swap rate for the same term. Thus for example the 10 year swap rate might be 3% but a bond issued by Barclays Bank might yield 5% or more.
The position is no different if a bank borrows at a floating rate of interest. If a bank issues an FRN for 10 years it will not be able to do so at Libor but will have to pay a margin above Libor. This is because there is a risk that the bank will default on the bond and the investor will lose his principal as well as any interest rate advantage he might have had if for example interest rates are lower at the time of default.
Swaps are not loans. They end up being a part of a loan. It is true that most swaps are associated with the granting of credit to a customer and that if the swap is done with a customer that customer will have a Libor borrowing and a swap that together constitute a proxy for a fixed rate bond. However swaps done with banks are not like that. They are more akin to bare swaps.
Banks borrow short and lend long. They are therefore unhedged as regards their funding. If a bank makes a 10 year loan but cannot refinance (or rollover) its funding it is in trouble. That is what happened in 2007.
A bank that wishes to hedge its funding risk will issue a bond for the same term as the loan it makes to its customer.
The difference between the bank’s 10 year bond yield and the 10 year swap rate is theoretically the price for this funding risk.
The risk that it will not be able to refinance its loan however is a risk that a lending bank takes when it lends to a customer. It is not a risk that can be passed on to the customer and neither is the customer required to pay for that risk. In the past this risk has been considered to be negligible. We now know that the risk is real.
The yield on a 10 year bank bond is therefore higher than the corresponding swap rate because the risks of default by the bank include not only the risk that interest rates might be lower at the time of default than they were when the bond was issued (this is the same risk as for the swap) but also the potential loss of the principal.
This latter risk is of course the same risk as the refinancing risk when a bank’s funding is unhedged, for when a bank defaults it will not be able to raise additional funds – except possibly from the central bank.
The difference between the 10 year bank bond yield and the 10 year treasury yield represents the risk that the bank might default relative to the US treasury. Bank bond yields are almost always higher than corresponding treasury yields although it is conceivable that a bank’s credit might in some exceptional circumstances be better than that of the country.
On 4 December 2009 a new phenomenon emerged. The interest rate on the 10 year swap was lower than the yield on the 10 year treasury. This situation continued for a considerable period. How could this be? Treasury prices at this time were racing ahead as investors sought the safety of treasuries.
The explanation given by Dr Deventer in his blog of 2/7/2012 (http://www.kamakuraco.com/Blog/tabid/231/EntryId/377/Why-is-the-30-Year-Swap-Spread-to-Treasuries-Negative.aspx) is that the US treasury is no longer perceived to be risk free, relative to the risk of swaps.
A treasury default would lose the investor his principal – 100. The risk of a swap default in the above example would result in Bank A having to pay Bank B not more than 10. The potential risk is therefore considerably less for a swap.
Dr Daventer’s explanation therefore means that the yield on US treasuries is partly to cover the risk of a default.
But how much of the treasury yield represents the price of this default risk and how much represents the risk that interest rates might rise. We simply do not know. We can however make some informed calculations.
If Dr Daventer is right the price for that credit risk is significant. At its peak the 10 year swaps rate was 0.20 % below the yield on the 10 year treasury. Since in normal circumstances the 10 year swap rate was about 30 basis points above the treasury it follows that the price for the risk that the US treasury will default is around 50 basis points. With 10 year treasury yields at one time around 1.4% that is a material proportion of the rate of return and indicates that the risks of default are significant.
Indeed the situation might be considerably worse because since swaps are mostly between banks and since bank credit since 2007 has been perceived to be significantly worse than that of the treasury it is likely that the risk of a default on a swap must be considerable. It is certainly perceived to be more likely that a bank will fail than that the US treasury will default. Accordingly although the risk priced into a swap has on average been around 30 basis points (0.3% of the principal sum borrowed) it is likely that this sum would have increased considerably as a result of the difference in the risk of default. It could therefore be that of the 10 year swap rate about 100 basis points or more represents the risk of a default.
Because swaps do not trade like bonds – indeed they do not trade as instruments at all it is impossible to say that swaps are properly priced or not. Even if they did it is not possible to say what part of the swap rate represents compensation for the risk that short term interest rates will rise and what part represents the risk of default by a counterparty.
It is therefore impossible to tell what part of either treasury yields or swap rates constitutes the price for the risk that short term interest rates will increase and what part represents the price for the risk of a default.
The reality is that swap rates are determined by individuals. They were initially based upon the interest rates on treasuries because treasuries were perceived to be as close to a risk free rate of interest as possible so that the interest rate on a treasury was purely payment for the risk that short term rates would rise.
If Dr Daventer is right then those who calculate the swap rates have no benchmark on which to work because they can only use their own calculations to determine how much of the yield on treasuries now represents compensation for the risk of default.
Of course it is possible to make an assessment of the risk of default. One could use credit default swaps to calculate the price for credit embedded in the yield on treasuries. A similar but more complicated calculation could take place with regard to swap rates.
There is however another possible explanation why swap rates are lower than treasuries which is far more sinister.
The swap rates shown on Bloomberg, which are provided by market professionals, might not be the real swap rates. Attempts at the time when swap rates were lower than treasury yields revealed that none of the swap counterparties were willing to provide swaps at the rates appearing on Bloomberg. The rates on Bloomberg were therefore artificially low.
What benefit is there to a bank in keeping a swap rate artificially low. The answer of course is that at a time when swaps were being prematurely terminated because of the large number of defaults, not least by Lehman Bros, the banks wanted their claims to be as large as possible. The claim against a debtor (and non bank borrowers pay the fixed rate) in respect of a swap that has been terminated early is increases as the swap rate reduces. The banks therefore had an incentive to make the swap rates as low as possible for the purpose of calculating the cost of unwinding.
The authorities have been apprised of this situation but have so far not taken any action.
Things might change, unless Dr Daventer is right.

Fixed interest rates and the swaps market

Peter Kralj — Sun, 16 Jun 2013 19:20:07 +0000

Until 1980 when a borrower wished to borrow money he had to do so on a floating rate basis. That meant that there was a disparity between the term of the loan – which could for example be for 10 years – and the period for which the interest rate was fixed.
The bank – home owners who borrowed on mortgage are very familiar with this principle – would lend the money for a long period – in the case of a mortgage for 25 years. The interest rate however would vary throughout the term of the loan. The borrower could not be certain of his borrowing costs and indeed whether he would be able to keep up with his mortgage installments.
Corporate borrowers were in the same position. Their business could go into bankruptcy if interest rates rose to a level that the borrower was unable to tolerate. Only a few borrowers were exempt from this risk. These were the luck few that could issue long term bonds. They were the so called rated companies. Many were household names. Companies like Shell, BP, Marks and Spencer were able to issue bonds at a fixed rate of interest for periods of 10 years of more.
These fortunate companies were able to raise money without taking any risk that interest rates might fall. Of course the converse was that if interest rates fell the issuer of a bond would not benefit from the reduction and would still have to pay the same agreed fixed rate of interest.
Nevertheless the risk of rising rates was something that concerned the market.
The real problem was the way in which interest rates and inflation interacted. The following example is simple but explains the essence of the problem.
If inflation increased by 1% lenders would – normally – react by increasing their lending rate by 1%. Thus if interest rates were 5% and they rose to 6% that represented an increase in the interest cost to the borrower of 20%. The price of his goods or services would however only be able to increase by 6% in the following year. For large borrowers this disparity would lead to possible bankruptcy.
The solution was to fix the borrowing cost for borrowers.
In 1980 the first interest rate swap was introduced in London. The interest rate swap was a way in which borrowers that could not issue bonds were able to borrow at a fixed rate of interest for a long term. The arrangement operated in this way.
A wanted to borrow 10mm at a fixed rate for 10 years but his credit status was not sufficiently good to issue a bond. His bank – B – would only lend to him at a floating rate of interest (say Libor + 2%). A would therefore find a third party – C – which would issue a bond for 10mm for 10 years at – say – 6%. C would take the money and deposit it with the bank at Libor. C would then pay the Libor rate that it received from the bank to A. A would pay that same Libor rate to B plus the agreed margin and would pay C 6% plus a margin (about 1%) for its efforts. A’s cost of borrowing would therefore be 6% plus the margin it paid to C plus the credit margin it paid to A. C would make its margin and A would have a fixed rate of interest on its borrowings for 10 years.
The swap market grew to several trillions and comprises a vast market with associated legal and regulatory appendages.
Banks now no longer rely upon bond issuers to be counter parties to swaps. They will issue bonds themselves and they run books.
Banks provide regular and updated swap rates to Bloomberg that are used as benchmarks for borrowers who wish to borrow from banks at a fixed rate of interest.
However these rates are not necessarily reliable and following the financial crisis of 2007 their reliability became questionable.
I deal with this issue in the second of these two articles.

Interest rates inflation and property valuations

Peter Kralj — Thu, 13 Jun 2013 14:40:50 +0000

I have discussed this matter before at some length but have never properly considered the part that valuers have played in what most people now accept was a property bubble that started – at least in the UK – in the 1970s.
I use a real example to illustrate my points.
In 1975 I purchased my first home. It cost 13,600 and my salary as a 25 year old newly qualified accountant was 3,400. The property was sold earlier this year for £370,000, a multiple of 27.21 times. The salary of a newly qualified accountant today is around 40,000. That is a multiple of 11.76 times.
The value of that particular property has therefore increased in real terms by 2.3 times. That, everybody will agree is a serious capital gain.
How did property come to increase in real terms to such an extent. Was it because property values were too low in 1975 or are they too high today.
Properties are valued by surveyors. When surveyors value commercial property they use the same method of valuation that all professionals use when valuing a company or any business or income generating asset. They use a yield approach. Any capital asset – except for precious metals, antiques, old masters and similar non income producing assets that are considered to be merely stores of value – generate income regularly. A farm produces wheat, sugar or vegetables, a coal mine or oil well produces oil, companies produce dividends and bonds produce interest. Property produces rent.
Owner occupiers think that they are not producing any rent but in fact they are. They are saving themselves having to pay rent to occupy that particular property and therefore their investment produces the rent that they are saving. In reality the owner occupier wears two hats, he is an investor and a tenant. As investor he receives (from himself acting as tenant). All properties produce rent, that is their yield.
Depending on the risks and uncertainties involved the value of any asset is equal to the yield multiplied by a certain amount. The more risky and uncertain the income the lower will be the multiple of that income in calculating the value of the asset.In general most companies are valued on the basis that they will yield around 10% – they are valued at 10 times their current profits. That profit will rise with inflation so that 10% is theoretically inflation linked. Property investments have traditionally been valued on the basis that they will yield 6% – 7% plus inflation. Inflation for property is of course dependent upon the market rent, but over a long period that tends to resemble the general rate of general inflation. It would be unusual if it did not.
For reasons that are unknown to me residential property valuations are based upon an entirely different approach. They are valued on the basis of “affordability”.
Put simply the theory is that the valuer asks what the occupier of the particular property can afford to pay to live there. The rent on that property is the starting point but it may be a bit higher or lower. The valuer then takes that sum, and carries out a present value calculation, using not any standard inflation linked yield but the rate of interest that a bank will charge in the particular year for a mortgage. In effect he says “what mortgage will the buyer be able to afford if today’s interest rate remains the same for 25 years”. The result is the mortgage that can be supported. If that particular rate of interest is for a loan of 90% of value the valuer takes the mortgage sum multiplies by 100 and divides by 90. That is the value of the property.
The property that I bought in 1975 was valued in that way. Interest rates were 15%. I borrowed 90% = £12,240 and my mortgage installments were £1,894 per annum, a considerable proportion of a salary of £3,400. There was little left over. The ratio of mortgage payments to gross salary was 56%. This is the ratio of affordability.
That valuation was wrong and that approach – and not sub prime lending – has led to the financial catastrophe we face today. I shall explain the connection later.
The valuers – and the banks that employed them – made a number of errors.
Firstly they assumed that interest rates would remain at 15% for 25 years. This was foolish. Interest rates could have come down or gone up. They also ignored the rate of inflation as well as the relationship between interest rates and inflation.
By assuming that interest rates would stay at 15% they in effect assumed that inflation would stay around 12% for 25 years. This was an equally foolish assumption. Inflation could have gone up or down.
If their assumptions had been correct then my salary would have increased annually at 12% while my mortgage installments remained at £1,894 per annum. The ratio of mortgage payments to my salary would have got smaller and smaller and I would have had more and more surplus money to spend. That is in fact what happened.
There were of course two other possibilities. One was that inflation would increase, and the other was that inflation would decrease. The valuers ignored these possibilities in assessing what I could afford over the next 25 years.
What would they have said had they properly considered these possibilities.
If inflation had increased from 12% to – say – 20% then it is logical to assume that interest rates would have risen from 15% to 23%.
In these circumstances my salary would have increased by 20% from 3,400 to 4,080. My mortgage installments however would have increased from 1,894 to 2,831, an increase of 49%. The ratio of mortgage payments to gross salary would have increased from 56% to 69%. In all probability I would have faced a negative equity position. This situation was not uncommon in the 1990s.
However the risks taken by the bank would not have been great. Sooner or later inflation would have peaked and at that stage my salary increases would continue – so long as there was any inflation – and my financial circumstances would have got better and better as the ratio of mortgage installments to gross salary fell.
Of course if inflation fell – say from 12% to 5% – and interest rates also fell – which is what happened – one does not need a calculator to see that even if my salary only increased by 5% if my mortgage installments fell because of the fall in interest rates I was going to be substantially better off.
But the real question is whether the valuation was right.
If inflation and interest rates had increased the above calculations indicate that a very strange and curious situation would have arisen with regard to property valuations. Again using the numbers above, if the valuers based the value of my property on affordability and their calculations indicated that the maximum amount that a buyer in my position was able to afford in 1975 was 56% of his gross salary then he would taken 56% of my increased salary (4,080) = 2,284. That would have determined the maximum mortgage that could be afforded at the new interest rate of 23%. The mortgage that could be sustained at that level of installments is 9,877 and the house would therefore have been valued at 10,975.
In short the affordability methodology used by valuers would result in a fall in property values at a time when inflation was increasing by 20%. Absurd, you might say, and I would have to agree.
The situation we are in today is therefore precarious. Interest rates have fallen and so has the rate of general inflation.
Interest rates today are around 4% and inflation is around 2%.
A 100,000 mortgage at 4% on a house valued at 120,000 requires installments of 6,401 per annum.
If interest rates remain at 4% and the mortgagor’s salary increases at 2% per annum he will continue to be better off as his ratio of affordability increases. If such a person had a salary of 15,000 his ratio of affordability would be 43%. As his salary increases – even at 2% per annum – he becomes better off as his ratio of affordability falls.
If inflation however increases to 5% and interest rates increase to 7% the salary of the mortgagor in the above example will increase to 15,750. His mortgage installments however will increase to 8,581, an increase of 34%. His ratio of affordability will increase from 43% to 54%. The property will also have fallen – assuming the valuers wish to retain the same ratio of affordability – in value to 87,700. The home owner would be in serious trouble.
Again, I repeat for emphasis, at a time when there is general inflation of 5% house prices valued on the basis of affordability will fall by 27%.
This is the mathematical danger that we face today and it is all the result of valuers using an incorrect valuation technique.
The proper way to value a property is to use an appropriate yield and to value it on the basis of the yield and the rent.
The rent on my first property in 1975 was around £2,400 per annum. In effect, by using the bizarre affordability method of valuation, the valuer valued the property at a yield of 17.65%, or a multiple of 5.7 times earnings. Since the rent on the property was set to increase – logically – in line with general inflation that was an absurdly low valuation.
The proper valuation of such a property should have been at a yield of around 7%, or 14.29 times rent. That would have produced a valuation of around 34,285, which is 2.5 times the price at which I bought the property.
Of course if I had purchased the property for the correct valuation – 34,285 I would have had to borrow 30,856 at 15% which would have resulted in an annual mortgage bill of 4,773, which was more than my salary.
That would have killed the mortgage and property markets stone dead.
That kind of mortgage was of course wrongly priced. The proper approach of the banks in times of high inflation is to lend on an inflation linked basis. Had they done so they would have lent me money at 4% plus inflation. My mortgage installments would have been – had I borrowed 30,856 – 1,975 per annum, which is more or less what I was paying, but subject to one difference. My mortgage installments would rise at the same rate as inflation. Thus the proportion of my salary that I would have had to pay in mortgage installments (my affordability) remained the same as on the date that I took out the mortgage and I would only be better off if I got promoted or got real salary increases.
What were the consequences of this bizarre approach to property valuations.
Firstly of course as existing buyers sold out they made unreal profits. New buyers were suddenly faced with more and more expensive homes. Government lowered interest rates to assist the new buyers but we have now reached a limit as interest rates are at rock bottom.
Properties are now being sold at yields of around 3% in the best areas of London, down from the ridiculously high 17.65% at which I bought my first home. Can yields go down further? Yes they can.
What does this mean for persons entering the market today?
The rule I outlined above about inflation remains the same. If there is inflation whether it stays the same, goes up or goes down the buyer will be better off gradually, if and only if interest rates follow the rate of inflation.
Interest rates are now at rock bottom. They cannot go any further without becoming negative. We may have reached the limit.
The real danger is that interest rates will increase or stay the same and inflation becomes negative – deflation. That is why there is such a fear of deflation. Deflation will result in lower salaries and the same or higher mortgage payments.
That would not happen if banks lent on an inflation linked basis. Both the bank and the borrower would be protected, and so would depositors.
With deflation one’s salary will fall gradually, while interest rates remain high. If interest rates rise higher than inflation there will also be a problem. With such low rates that is where the risk lies.
This could all have been avoided if valuers had done their job properly all those years ago. It is not too late for them to change course and adopt a proper basis of valuation.
It is true that the risks of interest rates rising higher than inflation or remaining the same while there is deflation are small. Governments think that they can control inflation. They are probably wrong.
This increase in property values was not, as we would all like to believe, without consequences. If values of some things increase in an economy in which there is no inflation then the value of other things must fall. In our case it was pension funds. Pension funds have lost more or less £ for £ all the value that has gone into property. As property values increased because of the strange method of calculating affordability pension funds have been losing value, until they are now worth only a fraction in real terms of what they should have been worth.
The stock markets have also hardly increased in nominal value – and therefore have fallen in real terms – since the year 2000. Income from savings is now negligible.
What is to be done. Should one continue to invest in properties at these ever reducing yields? That would make sense if there is room for increases in value, but the errors of the past have not only been overcome but exceeded. Property values are now too high. Yields are too low. Properties that have a value equal to around 15 times the rent are probably properly valued. Others are not.
That is the correct benchmark for valuations and it should be ignored at ones peril.
Other have made the argument that I do not understand that people take pride in home ownership, that owners are not interested in yields and multiples, that a property is like an oil painting – yield is therefore irrelevant.
My answer is that oil paintings are for those who have so much money they can afford to be extravagant. Most of us are not in that position. We cannot spend what we cannot afford. Property valuations should follow this principle.

Multinational tax avoidance

Peter Kralj — Sun, 26 May 2013 18:37:40 +0000

The way in which multinationals from Google to Apple, from Dell to Microsoft operate internationally in order to reduce their liability to tax has been described as being “legal”, meaning “lawful”. They have claimed that they pay all the tax that they are required to pay, that they follow the spirit as well as the letter of the law.
The opposite seems to be the case.
Only one – apparently according to the Sunday Times – of these companies has had its practices subjected to scrutiny, Dell in Spain, and the courts found that their schemes are unlawful. It is likely that if Apple, Microsoft, Google and others were subjected to the same judicial challenges their arrangements will be found to be unlawful.
Commentators are so scared of the laws of libel that they are not willing to even suggest that the schemes used by these multinationals are unlawful that they have decided – without any evidence to support their contentions to say that they are “legal” or “lawful”. I make the point about equating “legal” and “lawful” simply because they do in reality mean different things. “Legal” means to do with law, as in legal process, whereas “lawful” means complying with the law.
Only one suggestion has been put forward to eliminate the tricks and schemes that these multinational companies use to avoid UK and other overseas tax, and that is the taxation of group consolidated profits apportioned to various countries on the basis of the ration of turnover.
How would this work and why would it work.
The payments that are claimed as tax deductions by for example Apple UK to its Irish associated company and that reduce Apple UK’s taxable (and accounting) profits to nearly zero, disappear when Apple Inc consolidates it group accounts. This is because of the rule that payments by one group company to another offset one another and are therefore ignored and irrelevant.
Apple Inc has an interest in making its consolidated group profits as large as possible in order to keep its share price as high as possible – this helps management who are of course interested most of all in their bonuses and share options.
The group accounts of (for example) Apple Inc will also who the worldwide turnover of the group. All that is required is for the UK, for example, to tax Apple UK on Apple Inc’s world wide profits multiplied by the ratio that its UK turnover bears to it consolidated group worldwide turnover.
Of course the politicians who are anxious to do nothing will argue that this requires agreement between all the countries of the world. Otherwise Apple (for example) might end up paying tax on more of its profits than it actually earns.
That is not a tenable argument. It will merely be necessary for other countries to use the Alternative Minimum Tax calculation that already exists in the US. Each country which is anxious not to tax Apple on more than its total profits would use the above calculation or it local taxable profits calculation whichever is lower.
Of course if the UK is determined to go it alone and does not want to infringe Apple’s rights to fair taxation it could use a very simple mechanism.
All that is necessary is for the UK to impose a withholding tax on any payments by the UK company to any of its overseas subsidiaries, unless agreed separately by treaty. Or alternatively if that is not possible to disallow as a deduction any payments to associated companies that is not proven to be at the market price. In addition Apple UK would have to substitute for its turnover the sale that made by any group company that are subject to VAT in the UK.
Apple – according to the Sunday Times – has argued that it is in favour of tax reform and would be happy to repatriate its overseas profits so long as tax is in “single digits”.
That kind of power is not one that in a democratic society is given to large corporations. They should not be allowed to hold the country to ransom. Taxation policy is in the hands of the politicians and not large corporations.

Thatcher the financial mismanagement and trade union power

Peter Kralj — Sun, 21 Apr 2013 07:27:40 +0000

Most people who remember the 1970s and 1980s will say that Thatcher tamed the unions. They will say that Britain was riddled with strikes in the 1970s.
There is no doubt that during her government trade union disputes diminished materially. How and why did that happen. Why did the 1970s see so much trade union disputes.
Most people blame the unions when there is a strike.That is not unreasonable because it is the trade unions who have to walk out and start a strike. However it is not necessarily fair or reasonable to do so. One really should examine why the trade unions were striking.
Again most people today will say simply that the trade unions went on strikes on the 1970s because they were greedy and wanted a larger share of the income that their businesses were generating.
The reality is that the 1970s were racked by spiraling inflation. Inflation is the result of government mismanagement. The Heath government of the early 1970s was responsible for the inflation that occurred. It is true that the trigger for inflation was the increases in the oil price by OPEC but countries like Germany and Japan who were large importers of oil did not suffer very much inflation as a result. The Heath government’s policy – of which Thatcher was a member – was to counter the oil price increases by increasing the UK money supply. The result was massive inflation reaching eventually 28%.
Most workers asked for their real wages to be maintained. Of course 28% was just an average. Some businesses were not able to increase their prices by 28% so their workers could not get 28% increases. Other businesses were able to increase their prices by more than 28% and their workers wanted more than 28% increasees.
That is what inflation does. It creates instability.
It was not the Unions that created inflation it was the British Conservative government of the time. To blame the Unions for it is unfair and unreasonable.
Nevertheless Thatcher noticed that it was not really the trade unionists that wanted to go on strike but their bosses. The system for calling strikes was wrong. It allowed the trade union bosses to decide. She changed the law and forced the trade union bosses to ask their members. Interestingly the members frequently decided that they did not want a strike. That was Thatcher’s success and for that she has to be congratulated. She devolved trade union power from the bosses to the members. She enfranchised trade unionists.
She did however eventually close down the coal industry. In retrospect that was probably a mistake since coal mining is a viable industry. Australia benefits greatly from exporting coal to China.
Thatcher’s management of the economy however was also distinguished by the sale of government property through privatisation. Not only did she sell state assets including large amounts of housing at a discount, thereby benefiting those who bought those assets, but she dealt imprudently with the proceeds of sale which were massive.
The assets that she sold were capital assets and should have been used either to provide for future pensions or other entitlement programmes, or she should have used the proceeds to pay down government debt. Instead, following her dogmatic view that the market knows best, she gave it all away in taxes.
That is foolish and incompetent financially because tax breaks recur annually but sales of assets stop when you have no more assets to sell. You can only sell them once.
The selling of state assets carried on for some time. During the period in which such sales continued the tax breaks could be funded. When all the assets had been sold off there would be trouble. That trouble ended when state assets had been all sold off around the time of her departure in 1990.
The government then embarked on another “cost saving” device in order to be able to continue with the tax breaks. They called it Private Finance Initiative (“PFI”). It was later to change its name but in substance it meant that all new government capital expenditure should be financed by the private sector and leased to the government.
Anybody with a spread sheet would have worked out that on average after 15 years the government would be spending more than they would have done if they had borrowed the money themselves in the usual way. That 15 year period ended in 2005.
This ties in very well with the situation in which we now find ourselves. Our taxes are far too low. We simply cannot afford to pay for all our commmitments. That would not have happened had the government not sold off capital assets and used the proceeds for repeatable tax breaks. It would not have happened had government not got into PFI. PFI merely kicked the can down the road.
Thatcher’s tax breaks were meant to make us all more industrious. We would create new businesses, new wealth and end up paying more taxes. There would be less unemployed and all would be fine.
That was a foolish act of faith. The reality was very different.
Unemployment soared and although it fell it never went down to where it was before 1979. Indeed today it is around 2.5mm – in 1979 it was around 1.5mm. That 2.5mm figure is probably wrong because there are many more “disabled” who are in reality unemployed.
There was a lot of new wealth created but it was merely redistributed. People became fabulously rich at the expense of others. The process is still going on and the losers in this redistribution of wealth exercise that Thatcher started is continuing. Creating new wealth is not easy, redistributing wealth is relatively simple, particularly for those in positions to award themselves large increases in pay.
Thatcher also misused North Sea Oil. Had she saved it – like a good housewife that she claimed to be would have done – we might be in the same position as Norway, which is not the richest country per head in the world. Instead she used it for tax breaks. Those who got the tax breaks spent it on holidays and new kitchens and bathrooms and extensions to their houses, and cars and clothes. They behaved like grasshoppers not like ants. They did not provide for their pensions. They assumed – understandably – that these tax breaks would be permanent.
The strikes ended because inflation fell, not because of Thatcher. She mis-managed the economy. She sold capital assets and used the proceeds for recurring expenditure. That is unforgivable. PFI merely kicked the can down the road and made the can larger.
All the growth in GDP over the past 30 years has been funded by borrowing that we now cannot repay.
That is the Thatcher legacy. Her policies were continued by Blair. The financial crisis in which we are now is the Thatcher legacy – financial imprudence, ballooning borrowing, increasing unemployment and injudicious optimism about innovation and economic growth based on dogma.
Of course none of this is what she said would happen. She said that her policies would result in lower not higher unemployment. She said that she opposed borrowing. She never appeared to have considered the use of one off capital to fund recurring expenditure.
The big questions is was she naive or merely a financial incompetent.

Thatcher – the divisive and contradictory

Peter Kralj — Wed, 10 Apr 2013 07:45:59 +0000

Whilst there is something unseemly about parties to celebrate the death of Mrs T one has to ask why there is such unprecedented hatred amongst some sections of the community. One also has to question the misinformation and myth being spread about by her supporters as well as from independent commentators.
Thatcher did what most politicians do but she did it far more radically. Politicians have a very limited ability to create wealth. Their real and direct power is in redistributing wealth. Thatcher did so to a far greater extent than any of her predecessors.
Not only did she lower the higher rates of tax thereby unleashing one of the largest redistributions of wealth from shareholders to white collar workers that is still taking place, she went far further than any of her predecessors or successors anywhere in the modern world.
The lowering of the higher rates of tax not only gave an immediate handout to the higher paid and potentially higher paid but it made being highly paid or overpaid worth while. High tax rates are not there only to raise more tax, which is something that modern politicians do not seem to understand. High tax rates also act as a barrier. They stop people with the power to decide their own pay from demanding too much. Once those barriers were removed a vast amount of redistribution of wealth in the private sector understandably took place. This is still going on.
Redistributions of wealth of course benefit those who receive more. Those are Thatcher supporters. They argue that they supported her because of her strategic ability, her taking on the over powerful trade unions and such like but in reality it was much simpler than that. They profited from large redistributions of wealth. Why would they not like her.
Of course benefiting the better paid and the top people will hardly win elections. The second election was about the profit of war so we can dismiss that. However the aftermath of the second election was all about redistribution of wealth. How did she persuade so many to support her.
The answer is property. She presided over a large scale disposal at below market prices of state owned property. That was a redistribution of wealth on a very large scale. Those who profited, predictably – whether they are referred to as a property owning democracy or not were understandably delighted and supporters.
The other large scale redistribution of wealth occurred through the medium of borrowing. Borrowing ballooned. One of the Thatcher myths is that she was frugal, that she did not like borrowing, that she wanted balanced budgets. In fact she was anything but.
She claimed to be opposed to inflation. In fact she fueled inflation, albeit in the property market.
Borrowing enables wealth redistribution to be not instantaneous but to span long periods, sometimes generations. The person who profits as a result of the borrowing by another receives the benefit first. He is usually the seller of something – a property mostly – at an inflated price. He and various professionals profit as a result. The borrower buys an item that is inflated in price. That borrower will be unable to repay and the asset will not be worth the price that the buyer paid. That event will not be discovered for many years. We are going through that phase now. Those who profited of course liked Thatcher.
Those who have to pay the price, whether through the bankruptcy of the banks or the borrowers who overpaid, will not be identified for many years, indeed after her death.
Thatcher and her advisers did not understand this. Her successors still do not understand this.
The real evil of inflation is redistribution of wealth.
Of course she also would down industries that, given proper management, might have been viable. She redistributed wealth from the UK to the far east on the spurious basis of competitiveness. We are seeing the harm of that strategy now.
Many of the jobs that she destroyed have never came back.
When unemployment rose sharply during her first period in office she was interviewed – more than once – and she said that the rises in unemployment would be temporary. They were necessary “hard” decisions – hard for others of course not for those who took them – to bring us back to recovery. The position would get worse, she said and then get better than it was when she took office.
She never delivered on that promise. Unemployment rose from 1.4mm to 3.5mm but has never got back to even the 1.4mm it was in 1979.
She said she wanted to increase saving – the frugal housewife image. In fact she increased debt in unprecedented amounts until we are now bankrupt. The only solution of the government is to keep increasing debt indefinitely. Mathematically of course that is impossible.
Thatcher broke the power of the trade unions by insisting that the members should vote. Previously the trade union bosses were allowed to use block votes to decide industrial issues. These block votes allowed a trade union boss to vote a block equivalent to the number of members he had according to his own wishes. This was clearly wrong.
However Thatcher and her advisers failed to notice the glaring anomaly that the corporate bosses also wielded block votes. All the fund managers were entitled to vote at general meetings of companies based on the number of shares held in their funds although these shares were beneficially owned by their members. The members were not given a vote. The block vote was maintained for the white collar workers, but was eliminated for the white collar workers. Doubtless it was thought that white collar block votes would be used properly by the fund manager bosses, whereas blue collar votes would be abused by trade union bosses.
This system of block votes by fund managers still exists which is why salaries of exectives are out of control.
Thatcher was opposed to restrictive practices and did all that she could to remove them from the work place. There were exceptions of course, such as her own trade union – the legal unions – the bar and law society. Their restrictive practices were not only maintained but still exist today. Doubtless this is because it is for our benefit.
She claimed to despise bureaucracy, referring to what bureaucrats produced as “useless pieces of paper”. Yet she unleashed upon the UK at least a torrent of private sector bureaucracy the likes of which we have never seen. The number of laws and regulations that irritate ordinary people simply increased with the amount of people working in offices, which she encouraged. She did not seem to realise that people who worked in offices increasingly produced “useless pieces of paper”. She thought that government bureaucracy was bad but never stopped to think that private sector bureaucracy might be worse and less controlled.
She claimed to be a great supporter of the rule of law but like so many lawyers forgot what the term meant. It was meant to distinguish between rule by law, which was blind and indiscriminate, and rule by man or woman which might suffer from prejudice. She seemed to think that rule of law meant applying the laws even if they were not indiscriminate. Indeed she seemed to consider that what was done by authorities according to their discretion was a rule of law, which of course is the antithesis of a rule of law.
She was inconsistent and contradictory. She was vindictive, such as when she pursued an ex MI5 officer to Australia for daring to write about his past work. She lost her case in the Australian courts and her representative – now a member of the House of Lords – admitted that he had lied under oath. Neither he nor she were ever punished for that.
She was undiplomatic and arrogant and foolishly thought that she would win over people by being belligerent, thereby setting a bad example to the young.
She once claimed that she was keeping interest rates high because she wanted to increase lending (she said saving but it means the same thing) and reduce borrowing. Nobody laughed.
Such were the inconsistencies and contradictions of the so called “iron lady”, a title bestowed upon her with great irony by the Russians, and which she lapped up.

Margaret Thatcher – an assessment

Peter Kralj — Tue, 09 Apr 2013 08:21:35 +0000

There is no argument that she was divisive, or that she was determined – some say head strong. She found it difficult to work with others and did not tolerate dissent. However what can be described as flexibility could appear contradictory and conflicting, or unprincipled. For example she said she loved democracy yet consorted with dictators if they agreed with her policies on other matters. She called the ANC terrorists and appeared from her actions to support Apartheid. Yet she claimed to be against discrimination based on race. She claimed to favour freedom yet she banned the British Olympic team from going to Moscow. I leave the political assessment to others and deal only with economic policy.
Thatcher’s rightful place in history is that she did something that had previously never been done. She reversed the process of nationalisation of industries and businesses. Nationalisation was considered to be something that happens when a government wants to support a dying industry in order to preserve jobs. The government takes the company over and it becomes a nationalised entity. Thatcher considered this to be a waste of money. One wonders how she would have applied that principle to the banks. The truth is one cannot tell because her principles were inconsistent, even though she articulated changed principles as if they were written in stone.
British Leyland was a failing company in the 1970s. It was noationalised by the then Labour government to prevent job losses. It did indeed turn out to be a waste of money. Today’s equivalent is Royal Bank of Scotland which was nationalised because it was insolvent.
Many nationalised businesses of course did not become nationalised as a result of insolvency. They were nationalised from the start. Like the military and the police, the governments of the day considered that rail, water and other utilities, including the post office were so important strategically that they should not be in private ownership.
There were in fact good free market economic arguments for not permitting the rail system and the water and electricity companies to be privately owned. These utilities were not amenable to the forces of supply and demand. There is no elasticity of demand for water, to take the extreme case. No matter what the price of water is we have to have it. It is therefore not an appropriate commodity to place in the market.
The arguments against transport and electricity are less strong but once again the elasticity of demand is very limited.
The government overcomes this problem by imposing a pricing bureaucrat – called a regulator – who determines the price. Since the main function of markets is the determination of the price one wonders why these businesses were placed in the market.
Neither Thatcher nor her advisers appreciated these points. So wedded were they to the free market as the source of all good and so viscerally opposed were they to the possibility that government had a part to play in supplying anything of value that they ignored the fundamental principle that market forces are only suitable in determining the price of a commodity when there is elasticity of both supply and demand for it.
The Thatcher government would have loved to privatise the national health service. They would have been wrong to do so because once again there is no elasticity of demand for medicine. Indeed many of the problems in the health service – delays and waiting lists – are largely the result of doctors practising privately and within the state system. They were prevented from privatising it because of political forces that opposed such a move and not because of fundamental economic principles.
Of course socialist governments also did go too far in nationalising certain industries and businesses.
It is true that Britain was the poor man of Europe when Thatcher came to power. It is also true that she “broke” the “power” of the trade unions and Britain became prosperous again.
However it was not economic policies that made Britain a force internationally. It was war, and war with a second rate country – Argentina. Nevertheless she did it. The Falklands war was a turning point and permitted her to do what she could not have otherwise done economically.
Those who support what she did to the trade unions claim that it was the unions who were stifling British industry. British had become a word to describe poor workmanship and late delivery, a far cry from what it had meant in the past, when it was a sign of quality and efficiency.
Of course it takes two parties to have a dispute. The task of management is to manage and that includes industrial relations. When industrial relations turn bad it is the fault of management. Yet nobody in the UK blamed management.
Curiously once the government destroyed the power of the unions – they did this by insisting that members voted and not their leaders – and industrial relations returned to normal management was rewarded. It was not the members who were rewarded for being effective. All the glory went to management.
There is no doubt that there was considerable industrial strife in the 1970s, but there is no clear explanation as to why management was not held responsible. They are responsible for what happens on their watch. If their workers revolt it is their fault. That is why they earn the big bucks.
The reality of course is that there was a struggle between management and blue collar workers as to who should get the larger share of the cake. Why the blue collar workers must of necessity be the villains in such an argument has never been explained. Management has a duty to lead. If they cannot get their work force to co-operate then it is a failure of management.
When success returned – at least in terms of profits – after Thatcher why was it that management got all the credit and not the blue collar workers.
When Jim Callaghan became Prime Minister he warned that Britain was living beyond its means. He warned that Britain was only sustaining a life style to which it was not entitled by borrowing. The outcome was to end Britain up in the arms of the IMF, which forced austerity on Britain.
Thatcher agreed. I remember her giving a speech in which she said that Britain had become a land of beg and borrow. She said that a woman who was experienced in balancing the household budget could be trusted not to spend more than the country earned. She advocated not spending what we did not earn. She supported austerity and reduced borrowing.
Yet amazingly she unleashed on Britain 3 decades of unprecedented borrowing the likes of which the world has never seen before. Our borrowing, which had led us into the hands of the IMF, ballooned until it is now in aggregate equal to around 5 times one year’s GDP. It was that unprecedented borrowing that gave the impression that we were all better off. Great apparent prosperity was created by this borrowing binge. Economic activity appeared to take place but it was all fueled – yes all – by debt. That prosperity was an illusion.
She unleashed massive inflation in the housing market. Why she and her successors think that inflation in property prices is good I cannot imagine. None of her economic advisers seem to have warned her of the dangers. Of course there is a difference between consumables and durables but nobody has explained why inflation in consumables is bad but inflation in durable goods is good. Inflation is inflation. It is all bad because it redistributes wealth without justification and indiscriminately.
She allowed the banks to print money like there was no tomorrow.
Banking and money is a curious feature of an advanced economy. Money is the measure of value. It should be as stable as possible. Her economic advisers and idols were the monetarists of the era – Hayek, Friedman and Walters. None of them or their disciples seem to have appreciated that inflation in property is as bad if not worse than inflation in the price of bread, if for no other reason because they are not making any more of it (land that is).
This advocate of honest and stable money gave us today’s crisis, created by the borrowing binge which became possible only through market forces operating without control on something that should be stable – money. This advocate of saving and less borrowing got us hooked on borrowing. Now we – or some of us – have to pay for it.
She opened the door not to real enterprise but to massive private sector redistributions of wealth into the hands of a select well educated minority. Those who have to pay the price are now being identified. They are not too pleased when they are selected to pay the price of the redistributions of wealth from which the substantial minority have profited.
She reduced taxes at the top so rapidly that it made those who had the power able to profit from doing nothing more than they did before.
She destroyed British industry. Certainly she did not support lame ducks but she did not regenerate them. She merely let them go to the wall or into foreign ownership where proper managers were able to co-operate properly with the work force and to get good work out of them, with fair rewards – a far cry from the class ridden British society whose attitude is that the blue collar workers are to blame for all the problems and the white collar workers are to be praised when things go well and excused when things go badly.
She virtually destroyed the pensions industry so that now nearly half the country does not have a pension.
Rest in peace Mrs T. We will pay the price for your economic mismanagement.

State pensions and welfare

Peter Kralj — Sat, 30 Mar 2013 09:16:56 +0000

We are told regularly in the UK that bus passes and heating allowances that are paid to all pensioners in the UK should not be paid to “millionaires”.
The basis of the argument seems to be that many pensioners do not need a heating allowance in the winter time or indeed a bus pass. They should pay for their traveling if they can afford it.
On its face this is a popular assertion and the Liberal Democrats – the left wing of the present coalition government – support these claims and are pushing for savings in government expenditure to be made by making these allowances means tested.
This approach only makes sense if we regard payments made to government in return for a promise in the future to be non binding. If I made contributions to an insurance company all my life that after my 60th birthday the insurance company would pay me a certain sum during winter as a contribution to my energy bill there would be no question that the insurance company should pay up, no matter what my circumstances were and no matter whether the insurance company might have to reduce dividends to shareholders or bonuses to executives to enable the payment to be made.
Why should a promise made by the government be treated any differently.
It is the same with bus passes. If I had paid regularly to an insurance company for the privilege of traveling for free after age 60 I would expect the insurance company to pay up no matter what our respective circumstances were.
A promise is a promise.
Why should a promise made by the government be treated differently from a promise made by a private sector entity.
The difference of course is that promises made by governments are not legally binding on other governments. That does not make the argument morally right. It would be equally possible for a law to be introduced that says that if insurance companies in the examples I have given cannot afford to pay bonuses and dividends to shareholders then they can choose to only pay those pensioners who are not “millionaires”. That is the substance of what is being proposed.
The principle seems to be that when times are hard then the millionaires should pay to save their government from bankruptcy and to protect the poor.
If that is indeed the principle then the approach advocated by Mr Cable and his Lib Dem colleagues and indeed many others should not be restricted to these two trifling items of expenditure. Why not extend it to pensions.
The government claims that welfare payments comprise 1/3rd of government expenditure. This statistic is the result of including state pensions in the figure. Pensions account for around 150 billion of government expenditure, which is around 1/4th of government expenditure and therefore the largest portion of so called welfare costs.
Pensions are somewhat different to bus passes and heating allowances. Unlike bus passes and heating allowances pensions are paid both in the private and public sector. Those who are paid a pension in the state sector earn that right and have indeed contributed towards the right to receive that pension. The amount of state pension that one receives depends upon how much National Insurance a pensioner has paid in his lifetime. Although state pensions are not subject to legally binding contracts they have the same moral force. A pensioner who has paid all his life to both state and private pension should not be treated differently by the two.
The private insurance company that operates his private pension cannot say to a pensioner; “times are hard this year, I need to pay bonuses and dividends to shareholders and you do not need it because you are a millionaire, so I am not going to pay you what I promised to pay”. Yet that is what the government proposes to do – assuming that the principle applied to bus passes and heating allowances is followed to its logical conclusion, and it does so on the basis that it has the power to do so through legislation.
Of course it has the power through legislation to give the insurance company that same benefit. So why pick on state pensions only. Why not legislate for private pensions to be protected by law if they cannot afford to pay what they promised. There is no moral justification for that approach in either case.
Any payments to pensioners are in reality an increase in the taxes that they are paying. One could easily regard what a pensioner pays to the state less what one receives from the state as a net payment to the state. By withdrawing what the state pays, whether in heating allowances, bus passes or state pensions, the net contribution by pensioners to the state is increasing.
The effect of what is being proposed is identical to increasing the tax that pensioners pay – at least the better off ones.
Few will be aware that pensioners above a certain age get a higher personal allowance than ordinary taxpayers. Why not eliminate that benefit as well for millionaire pensioners?
So the net result of what is being proposed is that pensioners who are millionaires should pay more net tax than non pensioners. Why? Why should millionaires who are below pensionable age not also pay more?
Yes we know the spurious argument. They will all leave and we will all be worse off.
Of course those who threaten to leave are the same ones who are arguing about taxing pensioners more.
So we are to penalise pensioners because they cannot leave.
The substance of what is being proposed is that children want to take more from their parents for themselves.
What kind of society is this in which millionaire children say to millionaire parents “we need it more than you do, you cannot leave the country, we can, the state needs more money, we will take it from you instead of from both of us. You will have to reduce your living standards but not us.”
Nice guys!!! Are these the kind of children that we have bred. I don’t think so. It is merely necessary to explain to them the substance of what is being proposed and the effect of the implicit threats to abandon the country.
Of course the reality is that people will not leave. They did not leave in the 1970s when Britain was the sick man of Europe. Few did but it made no difference. The arguments about the threat to leave are spurious and self serving.

City bonuses to be restricted by the EU

Peter Kralj — Mon, 04 Mar 2013 09:52:29 +0000

Despite all the agreement by politicians and commentators that city bonuses are unconscionable now that the EU has done something about it these same commentators, led by our own intrepid Mayor Boris Johnson, are out in force, condemning the EU for the disaster that will fall upon London and the UK as a result.
The predictions are all the same and have gained currency throughout the UK. The “brightest and the best” from the city of London will leave, go to another country – Zurich or New York – where they will carry on the same sort of business with as much success, except that their success will be the success of Switzerland and the US and a corresponding loss to London and the UK. The UK exchequer will, we are told lose, firstly the taxes that these incredibly clever people will pay on their bonuses as well as the untold profits that all of us make as a result of their cleverness and for which they do not receive any compensation or recognition. In short these people are so clever and generous that they put into our economy far more than they take out and we will lose not only the taxes on their bonuses but the additional benefits that they bring to us.
These assertions are the usual self serving claims that accompany any move to restrict the incomes of the articulate middle classes. They are all based upon assumptions. Inevitably, just as in the case of the trade unions when redundancies are threatened their arguments are altruistically based. I shall now analyse them more fully.
The first and most simple claim in favour of larger and larger bonuses is that if you pay people more they will pay more tax and that must be good for the exchequer. That is self evident but simplistic. If it is as simple as that why not pay everybody large sums of money so that they will pay more tax. Clearly that is unsustainable because the employer will not be able to afford it. We can therefore ignore the simple proposition that the payment of big bonuses as such is good because the more they receive the more tax they pay.
If it is sustainable and affordable by the employer however payment of bonuses or higher salaries does results in more tax to the exchequer. One cannot however ignore the fact that such additional income is not as profitable as it might at first seem. Income tax in the UK is paid at – now – a maximum of 45%. It starts at 20%. The rate of corporation tax however is 25%. All payments of salary or bonuses are tax deductible to the employer so the payment of bonuses reduces the amount that the exchequer collects from corporation tax. The rates of income tax and corporation tax may indeed be different but the difference makes the additional revenue quite small. The additional tax collected by payment of bonuses is only 20% of such bonuses.
When bonuses suddenly rained upon the lucky few in the city in the 1980s there was no outcry. There were no predictions of gloom and disaster. Nobody complained. Nobody saw the problems that we all agree arose as a result. Nobody analysed the situation for dangers or imbalances. Strangely London, which until then had been living under a maximum income tax rate of 83% on earned income and 98% on unearned income, was still the undisputed leading financial capital of the world. The US and Switzerland had considerably lower tax rates. Yet there was no exodus of “brightest and best” people from London to the US or Switzerland. People stayed here for various reasons. They liked it here. They liked the life, they had families. There were several reasons. They complained about high taxes but life was perfectly pleasant. The pubs were full and life went on. Few paid the high taxes. Companies did not pay dividends. They held on to their profits. They did not pay bonuses or large salaries. They reinvested their profits in the businesses. Businesses were successful and employed large numbers of people. They could afford to invest and employ more people.
Nobody shirked as a result of high taxes. We got on with our work. We enjoyed our work.
Now we are told that we are all greedy mercenaries. We will only work for massive bonuses. If we are taxed too highly we will all leave or go on strike. Look at the French. All are leaving as a result of their high taxes. This is of course nonsense. Only two eccentric French persons have left. One, an actor who clearly thinks the law should not apply to him, has gone to Russia. The other a businessman who has gone to Belgium. The rest have stayed on. It is not easy to move from one’s roots. Go to South Wales if you doubt what I say. There is no work there yet the young stay on, unemployed and with nothing to occupy them they stay where they were born. That is how most of us are.
In the gloom of the 1960s and 70s when emigration to Australia and Canada were at their peak the UK population did not fall. Indeed those who went to Australia did so not because taxes there were lower but because they could not get jobs here. There was allegedly a “brain drain” to the US. These were mainly doctors, who went there for more money. I remember talking to a doctor at the time. He was quite famous and a senior consultant, later to become a professor of cardiac surgery. He told me that he could multiply his salary by 10 if he went to the US. Yet he did not want to. His life here was pleasant and he enjoyed his work. He was good at it. At that time, dispite the exodus of doctors to the US the UK was still regarded as a leading light in medicine. Our teaching hospitals were amongst the best in the world. Our professors were invited to lecture all over the world. Their research papers led the field. After all, who would you expect to do best, a doctor who was more interested in money or one who had a real vocation and loved his job and possibly his country more than money.
Living in London is pleasant and most people are willing to live where it is pleasant. A salary of £200,000 should make life here very enjoyable. Why jeopardise that for a few more dollars. Most people will stay and do their work diligently. We are not all money grabbing greedy people who will only work for unconscionable amounts of money.
The other assumption is that those who get the big bonuses are the ones who earn big sums of money for their employers. That is an incorrect premise. Large organisations operate in teams. For every £ of profit there are many involved. Bonuses are divided in accordance not of market forces but dictatorship of the bosses. The boss, understandably, pays the biggest bonuses to those whom he likes most, not those who are the most important in the process of earning profits. It was for ever thus.
Even if we consider investment banking to be a worthwhile activity there is an army of investment bankers out there – about 120,000 since 2007, who would gladly work for no bonus at all. Market forces, if they applied at all, should result in the wages of investment bankers going down. Of course the socialists that head up the large banks know how to overcome market forces. They just claim that they want the best and you have to pay for the best. Everybody wants the best. We want the best teachers, the best taxi drivers, etc. Why not pay them all millions? It is a nonsensical argument. Nobody is the best. These so called best people merely have good academic qualifications, which they share with untold numbers of others. They can be replaced by an army of young persons with equally good academic qualifications who emerge regularly year after year.
We have to accept that there is a tendency to pay as much as we can get away with paying. It is nothing to do with market forces, one merely has to avoid legal and occasionally financial constraints. Otherwise businesses can pay whatever they can. Those who make the payments are of course not the owners – except in small businesses and small businesses do not pay large bonuses. They are themselves employees taking advantage of the weakness of shareholders.
But back to bonuses and large pay for bankers. Every £ paid of profit made by an investment bank is generally a zero sum gain. The bank makes a bet against another bank. One wins, the other loses. The one that wins gets a bonus. The one that loses does not. There is no economic growth as a result. There is no profit or benefit to the country – as they claim. Someone, somewhere has to pick up the tab for the corresponding loss. In corporation tax terms one investment bank makes a profit while another makes a loss. No additional corporation tax is collected as a result. No benefit to the country accrues as a result of these gambles.
Sometimes – very occasionally – investment bankers do provide a service for new construction or businesses. Their excessively large remuneration is often covered by and included in the cost of borrowing and we all know where that has got us. Most bankers bonuses are paid for by borrowing directly or indirectly. How does that happen. Take a common case of a large property. The investment banker’s bonus is included in the cost of the property which is funded by debt. The debt cannot be repaid but that does not happen until many years later. By then the investment banker has taken his money and run. He does not wait until the loan is repaid. Even if it is it is probably repaid by some other buyer buying at a higher price that is not sustainable. Other investment bankers get bigger bonuses that are included in the ever inflating price of that property. That is how bonuses are paid and covered up economically. They are not beneficial to the economy. They are a drain on it. It is pure wealth redistribution. Somebody has to pay the price. That price is austerity. Bank bonuses lead to austerity.
London will remain the leading financial centre in the world even if bonuses are limited. There is in reality no need for bonuses at all.
A myth recently put about in the press is that bankers’ base salary is quite low. It is not. It is higher than that of most lawyers or accountants and other professions.
Lawyers are amongst the highest paid in the country. They are not going anywhere to practice English law. Accountants might go abroad but where? There are hordes of accountants everywhere including in the Indian sub continent and in Russia, where the Institute of Chartered Accountants has offices. There is no great demand for our accountants.
Finally of course if there is an exodus because of the limitation of bonuses this can easily be solved by inviting foreigners to fill the jobs and giving them a tax holiday, if that is what it takes. I am sure it will not come to that.
Of course many of our jobs in offices are parasitic upon real wealth creation. They merely participate in the wealth created by others. Many of these parasitic jobs are entirely redundant and add to the cost of production without any appreciable benefit. There is perceived benefit but in reality there is none. If these people were to leave and ply their trade elsewhere we would probably be better off.
The job of investment banking is simple. It is not complicated, does not require great learning. A few weeks of training is all that is generally required and indeed provided. The large number of successful investment bankers is testimony that “anybody can do that job”. They can, if they are truly useful, easily be replaced. It is a business not a profession. What goes to investment bankers makes what goes to shareholders less. The shareholders are pension funds. The result is that bonuses are money redistributed from pensioners to investment bankers so that they can buy their third villa in the South of France.
Nothing will happen if bonuses here are restricted. We should raise taxes back to 83%. That will clear out some of the highest and most mobile persons who are harmful to our economy and political stability and who take out more than they put in. Tax rates should be raised not to collect more tax but to reduce the obscene salaries that are being paid with no appreciable benefit to the country or the shareholders of the companies that have to bear the cost and who would not pay them if they were truly enfranchised.

Gilts lose AAA status

Peter Kralj — Mon, 25 Feb 2013 17:22:28 +0000

So one of the ratings agencies lowered the UK credit status from AAA to AA1.
The Cassandras predicted a collapse of the £ and many similar woes. We are told that if the value of the £ falls our imports will become more expensive. That is true only if our imports are priced in a currency other than the £. If they are priced in £ then the foreign seller will receive less in his currency for the goods he exports to the UK.
Even if our imports are priced in $US for example whereupon they will become more expensive in £ our exports will – if priced in $US – become cheaper in £ terms. That should result in exporters either pricing their exports in $US, whereupon they will receive more £ for their goods or alternatively increase their sale price in £, leaving the price for the buyer effectively the same in $US and increasing the £ profits of the UK exporter.
The net effect will therefore be very small. Indeed if we were exporting more than we imported we would profit from a devaluation. If we import more than we export we will be marginally worse off.
What about interest rates. We are told that the downgrading will result in interest rates increasing. Government interest rates do not increase like that. If the Gilt market fell, yields would rise. The government will however only be penalised if and when and to the extent that it issues new bonds. The effect will therefore only be marginal.
The reasons for the rating agency’s downgrading is something rather obvious – absence of growth.
That implies that unless there is growth the government will be unable to repay its debt – at least as easily.
Yet strangely enough this vast borrowing arose during or just after a period of apparently endless growth.
In fact all that growth was illusory. It was entirely funded with debt, at any rate over the past 30 years.
The Thatcher revolution was a debt bubble. Strange to think that she made such a virtue about being a good housewife who did not borrow and beg, and who lived within her means. In fact she unleashed the biggest borrowing glut of all times.
Where borrowing is funded with debt it means that only one sector of the economy is producing more goods. The other sector is consuming such goods and paying for it with an IOU. That IOU says that the consumers of the increased growth will some day reciprocate. To date they have not. What are they going to do to reciprocate, produce another application for a smart phone !!
It is likely that there is no more growth out there.
The government blunders blindly asking for banks to increase lending. The banks only want to increase lending against real estate and then only if the real estate will increase in value, which is something that will happen if they lend enough. The result of course is inflation in property prices, no real growth, only illusory growth.
A large part of the growth of the past 30 years has been in the price of housing. That was grossly inflated by the inflation in the property market. Yet the value of the new houses built was reflected in the growth figures at these excessive prices and then discounted by the rate of general inflation which does not include house price at least not as such.
The banks cannot lend to credit worthy customers. There are none. There are no new ideas except for toys. There are possible changes in life style but change does not mean improvement. Different does not mean better.
Borrowing has enabled many defunct business that were replaced by new ideas and concepts to stay afloat giving the appearance of growth. Once the debt life support is removed they will wither and die.
That is the reality we have to face. The government does not want to face that reality. They prefer to inject more debt and inflation into the system and leave the problem for another day.
They cannot do so indefinitely. Pressing the balloon on one side merely makes it expand on the other. There are no quick fixes and a return to reality will be painful.