More Risk, More Trials, More Error, More Success

I was at a Coadec event for encouraging tech start-ups in London on Wednesday. Much of the focus was on demonstrating why London and the UK are better locations for starting businesses than elsewhere. Certainly the Polish and Turkish entrepreneurs seemed to think so, although the Turkish guys did point out they'd tried the US and couldn't get a visa ;-).

That's nice to hear, but a bit underwhelming.

Research from the IEA has already shown it's easy enough to start a business in the UK, though the insistence on the 'employment' model still makes it a bit awkward for small businesses to take on staff. 

The real point is that we can't pick which businesses are going to be successful. The best that we - and government - can do is to ensure "a climate in which enterpreneurship can thrive". In other words, we have to encourage more trial and error. We have to welcome failure in order to see success.

Actually, I think we're okay with failure in the context of genuine innovation. It's a long time since anyone went to prison just being unable to pay their debts as a result of an honest small business failure. A lot has been done to make it easier to clean the slade and start afresh. And UK figures referred to at the Coadec event suggest that entrepreneurs fail an average of 3.5 times before succeeding (although the IEA also suggests that an entreprenuer is more likely to be successful if he or she has been successful before). 

Where we do have a problem, quite rightly, is with failure in the management of our major institutions. In this context, trial and error is acceptable. But running an established business process in a way that results in significant errors or outright disaster is not. Unfortunately, concerns here tend to drive higher levels of (fairly ineffective) regulation, which in turn stifles innovation and competition where it's needed most. Indeed, the European Commission Consumer Scoreboard suggests that the more highly regulated a consumer market is, the worse reputation its suppliers have with consumers - lowest of the low being financial services. In March, the FSA listed the key risks to consumers from FSA-regulated providers as being pressure selling; failing to provide ongoing service to existing customers; poor complaints handling; inefficient day-to-day business processes; cancellation blockages; lack of proper infrastructure; complexity and volume of communications; excessive and/or unfair charges; and changes in terms and conditions without notice or appropriate reasons. The FSA concluded:

"... on the whole, financial service providers were seen to generally fall short on their promises, to the extent that the majority of consumers in the study considered that there had been an erosion of trust between them and their financial providers. In particular, they cited an inability on the part of financial service providers to offer the most appropriate solutions for them."

How do we get these businesses "to offer the most appropriate solutions" to their customers' problems?

It seems to me that our heavily regulated institutions are too risk averse. As a result, genuine innovation among those institutions is virtually non-existent.

The sub-prime crisis, for example, was not caused by banks intending to take on more risk. A shortage of 'safe' assets - a deposit crisis - meant they were actually trying to transform high risk mortgages into low risk bonds, by bundling the mortgages together and cutting them up in different ways, repackaging them and so on. The bank that invented the process way back in the mid-1990's actually did sensibly trial it first, before deciding that it ultimately wasn't sustainable. So the huge errors and bank failures over a decade later resulted from imitators who had adopted the faulty process without adequate monitoring, controls and due diligence procedures that would have told them when to stop. Evidence of this has emerged in the resulting 'fraudclosure' scandal, where no one was sure who owned many of the underlying mortgages when they were called in.

There is no room for complacency on this front, but there's still plenty going around. Even the bank that realised the potential for the sub-prime crisis was recently caught out by its own process failures, allegedly while trying to hedge its existing financial exposures (i.e. reduce risk). These institutions are so smug that they pay half their 'profits' in bonuses even while failing to maintain adequate risk monitoring systems.  

Maybe if they committed themselves to taking more risk to solve their customers' problems instead of their own, these institutions would organise themselves to be better at monitoring and managing that risk than just selling the same old stuff. In doing that, however, they would need to engage in lots of little trials and ensure they had a good understanding of why each trial did or didn't work. We don't need big rolls of the dice. 

But where's the pressure to do this? Governments and regulators the world over are 'clamping down on risk-taking', after all. 

Perhaps the same effect will be achieved by the many start-ups focused on financial services. But again we run into the headwind of regulation and tax incentives, ironically designed to benefit consumers, which only serve to perpetuate the status quo. As recently discussed at the Finance Innovation Lab, regulators and policy-makers will need to improve their understanding of how the innovation process needs to work before customers will be better off.

Image from TVTropes.

Innovation Is Vital For Growth, Not Just Cost-Cutting

There's a lot of concern about how to grow the UK economy. Some have pointed to banks and the public sector as 'the enemies of growth' because they are 'extractive', rather than inclusive 'facilitators'. Government spending is too high, as are taxes, and there's a concern that national public sector pay awards have 'crowded-out' private employers. Banks are not lending. 

But there's much more to this, of course. 

Clearly even the generous private credit available during the noughties merely went on houses and consumer spending, rather than building sustainable and globally competitive businesses, especially in the regions. As Steve Randy Waldman of Interfluidity recently explained in the context of southern Europe's troubles, it's the poor allocation of capital, not lack of finance or high labour costs, that causes "an incapacity to produce tradable goods and services in sufficient quantity." Governments aren't alone in their ability to waste money and other resources.

How do these things fit together?

Experience shows that countries whose governments try to spend more than 30 - 35% of their overall output (GDP) gradually produce less and less. That's because governments impose taxes to pay for spending (and borrowing), and tax is a 'deadweight cost' or economic inefficiency. As output declines, the government receives less and less tax so ultimately must spend less on public services. Those services then start to break down. Eventually, everyone speaks Greek. UK government spending is about 50% of GDP. Yet tax receipts have averaged around 38 per cent of GDP over the last twenty years and have never exceeded 40%. The UK government can a funding gap (deficit) of up to 2.5% of GDP before it becomes a 'structural deficit' - an albatross around the country's neck that takes a special effort to remove - George Osborne's current challenge. By contrast, the Australian and Swiss governments spend around 35% of GDP (source: OECD, IEA, p. 47).

On a regional basis, the UK picture gets worse. Public spending in London and the South East has remained under 40% of regional GDP. But public spending equates to 45% of regional production in the East, and a whacking 70% of what the North East produces. Public spending in England is cruising at 50% of national output, while in Scotland it's at 60% and in Wales and Northern Ireland the good citizens are dragging around a millstone of government expenditure equal to 80% of their GDP  (source: HM Treasury, hat tip IEA, p. 57).

So, if you live somewhere outside London and the South East your community has a choice. Either you ask the government to start spending a hell of a lot less on you. Or you make sure the region produces enough so that government spending only represents about one third of your output. Pick neither and you'll αρχίσουν να μιλούν ελληνικά.

It's possible that high public sector pay rates make both of these tasks harder - it means the government is spending more (on its staff), and it's more expensive for businesses to hire the staff they need, so they charge higher prices and their products are are less competitive.  Public sector pay is mainly agreed centrally, in national pay awards. Those who work in more expensive places than the average, like London, get paid a bit more. But employees who work in places where it's cheaper to live than average don't get paid less. So their communities will find it harder to keep government spending in the right proportion to what their community produces.

But this does not necessarily mean labour costs are the main reason for some regions being more competitive than others. Steve Randy Waldman, of Interfluidity, argues that competitiveness is about capital much more than labour:

"... to the degree that unit labor cost statistics capture what they claim to capture ... European workers, North and South, have come to earn roughly equal pay for equal product. Southern European workers do earn less overall, simply because they produce fewer or lower-value goods and services than their Northern neighbors. [But] unit labor costs are not the problem at all: it is the scale of aggregate output. And what determines the scale of aggregate output? Is it the laziness of workers? No, of course not. We all know that when residents of poor countries emigrate to rich ones, the same weak bodies and flawed characters that produce very little at home suddenly explode into economic vigor. The difference is “capital depth”, broadly construed to include all the physical equipment, business organization, public infrastructure, and governance that collude to enable two small hands and a broken mind to accomplish outsize things. Workers’ pay level is not the problem in Southern Europe [or, say, UK regions]. It is deficiencies in the arrangement of capital, again broadly construed, that have left Greece and Spain unable to produce value in sufficient quantity to compete with their neighbors."

 As a result, Steve suggests: 

1. "If Southern Europe lacks competitiveness, the part of the cost structure that needs to be reformed has to do with rents paid to capital rather than the sticky wages of workers; and

2. "The European periphery was rendered uncompetitive by toxic patterns of capital allocation." For this he cites Arnold Kling's recent paper for the Adam Smith Institute, which concluded:

"...economic progress involves creating new patterns of [sustainable] specialization and trade [PSST]. When new opportunities suddenly emerge, there can be periods in which high productivity growth in industries with relatively inelastic demand creates a surplus of workers. It takes time for entrepreneurs to discover new ways to exploit specialization and comparative advantage, and it takes time for the labour force to adapt to new skill requirements. These real adjustments are needed in order to restore full employment."

In short, the UK and each of its regions needs to foster self-employment and entrepreneurship, by creating an environment in which it's easy to start and grow new businesses. Removing the difference between public and private sector pay may help incentivise public sector workers to move to the private sector - as could laying off more public sector workers. The necessity to find new work may be the mother of invention, after all. But that doesn't remove the ultimate need to focus on fostering the process of creating new businesses for those workers to join.

Image from NE Generation.

 

The Complex Job of Producing Simple Financial Services

There has been a futile tendency amongst regulators to view 'simple' retail financial services as merely 'basic' or 'vanilla' versions of existing products. And the Treasury's aspirations in this area have not improved, at least as of February 2012.

Perhaps ironically, the route to simplicity and transparency is much harder than producing a complex product that no consumer really understands. To produce a simple retail financial service involves first understanding the complexity of the consumer problem being addressed, then figuring out the simplest, most consumable service that will solve it. That's the role of a facilitator. By contrast, those producing complex products are unlikely to be focused on the consumer's problem in the first place, let alone understand it - they're focused primarily on solving their own problems at consumers' expense.

The path to simplicity involves disruptive innovation and critical thought to remove not only the complexity but also the intermediaries ('institutions') who've failed to solve consumers' problems cost-effectively to date. Trial and error, testing and learning, flexibility and adaptability are all key characteristics of this process. Yet our financial services framework is intolerant of them. In fact, a new service could launch and undergo several iterations in the time it takes to get it authorised by the regulators in the first place. Tiny factual differences have seismic regulatory implications in the type of permission or licence needed, and this adds to the time-lag and legal advice involved. We must figure out how to make the process of decent innovation easier.

Having waded through all this treacle to actually produce an innovative, simple product, there is then the challenge of explaining very simply how it works - and on a low budget. I recall Richard Duvall saying that £60m was spent on the launch of Egg, while the marketing spend dedicated to the launch of Zopa was £35k (though the phenomenal PR benefit from launching something truly new was priceless). But perhaps that isn't as much of a disadvantage as you might expect. While we see plenty of pointless, fluffy TV ads for expensive banking products, we don't see much marketing effort devoted to the 'basic' versions. As Professor Devlin found in his research for the Treasury, low fees and ease of switching has dampened traditional institutions' enthusiasm for creating and marketing simple stuff when there's so much money to be made from complexity and inertia.

At any rate, we need to celebrate the really simple, clear and transparent explanations of how our new financial services work. I've set out some examples below from my own experience. Some relate to services that are in beta or brand new, some established. To demonstrate the ability of TV journalists to explain things incredibly simply, I've also included just one piece of excellent coverage that removed the need for the business concerned to produce videos of its own.

Other top-tips on great explanatory clips are welcome.

Nutmeg




Abundance Generation




Elexu



Zopa



Funding Circle




PeopleFundIt

The Enemies of Growth

The Economist article on The Question of Extractive Elites certainly resonated with me last week, as it did with those involved in the subsequent discussion on Buttonwood's notebook. It's another way of looking at the difference between 'facilitators' and 'institutions'.

In “Why Nations Fail: The Origins of Power, Prosperity and Poverty”, Daron Acemoglu and James Robinson, suggest "extractive economies" experience limited growth because their institutions “are structured to extract resources from the many by the few and... fail to protect property rights or provide incentives for economic activity.”

"Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will be ulimtately short-lived."

Acemoglu and Robinson place certain 'third world' economies into the "extractive" category, but place the developed world into an "inclusive" category on the basis that their institutions tend not to be extractive. But as Buttonwood notes, there are elements of developed economies that fit the description of extractive economies, citing banks and the public sector as the most likely candidates - although I would add the institutions that comprise the pensions and benefits industry as another example. And we should define "public sector" quite broadly to include political parties, unions, quangos and so on.

These extractive institutions tend to be linked, since the public sector is not only capable of extracting resources in a way that starves business or crowding out private investment, but it is also responsible for regulating the private institutions that are themselves extractive.

As previously discussed, high levels of public spending and national wage bargains are partly to blame for throttling the UK economy and preventing the development of manufacturing, particularly in regions which struggle to capitalise on the lower cost of living to keep wage costs down. The tax and regulatory framework favours banks and regulated investment institutions over new entrants. 

The current UK government is trying to spend less, but it's refusal to regulate means extractive frameworks are not being overhauled. Of course there is a danger that the new entrants seeking a level playing field may be tomorrow's "extractive institutions". But that would at least imply significant creative destruction in the meantime. Ideally the rise of "extractive institutions" would be kept in check by more dynamic regulatory intervention, but future overhauls may be required.  

That is the politicians' job. But they, too, have a tendency to be the enemies of growth.

Crowdfunding Politics And The Public Sector

In Lipstick on a Pig, I looked at why facilitators will triumph over institutions in the markets for retail financial services. I'm now working on the next book in the series that will demonstrate similar outcomes in the public sector. Political parties, unions, government departments, churches and the European Commission are all in the frame. Do they exist to solve citizens' problems, or to solve their own problems at citizens' expense?  

Thanks partly to the Leveson Inquiry and a vengeful Rupert Murdoch, we're building a great picture of self-interest, greed and fear of transparency in key parts of the UK public sector. Riding hard on the heels of Horsegate - which perhaps typifies the alleged link between politics, journalists and police - we've of course had the allegation that Peter Cruddas, former Conservative Party Treasurer, claimed that a donation of at least £200,000 would get you to dinners with David Cameron and George Osborne, as well as the opportunity to get your policy concerns fed into the "policy committee at number 10." Cruddas claimed "my job is to get the donors in front of the Prime Minister." The Tories say "No donation was ever accepted or even formally considered by the Conservative Party" on the cruddy basis that Cruddas was suggesting (my italics). Cruddas has resigned. 

You might also consider that the Cruddas Affair has overtones of the 'Cash for Honours' allegations. And clearly politics is Big Business because campaigning, in particular, is expensive.  The UK's political parties spent over £30m on the 2010 general election (down from over £40m in 2005). And that's nothing compared to the estimated $6bn that will be spent by candidates trying to win the coming US election (as opposed to $5bn last time around).

But let's not confuse the activities of the party officials with those of party MPs and Peers who are acting in their capacity as UK government ministers. The party people can't speak for the government. The Cruddas Affair, like the Cash for Honours idea, smacks more of a lame attempt at positioning the allure of political influence as bait on the real - and less controversial - hook: the chance to hobnob with other wealthy donors in a grand setting. You could equate the plight of anyone who climbs aboard that bizarre bandwagon to investors in Madoff's ponzi scheme or 'stupid Germans from Dusseldorf' who offered insurance against sub-prime mortgage defaults. The truth is you may not need to pay any money at all to get policy suggestions into a committee at number 10, depending on the quality of the suggestion. And the sort of people who could afford large cash donations could also simply pay lobbying firms to push their pet policies around Whitehall and Westminster to greater effect. They might even simply buy lunch.  

All of which tends to suggest that the managers of political parties have little genuine interest in policy at all, let alone solving the problems of ordinary people, and are instead merely preoccupied with choosing socially attractive candidates and wealthy fools to pay for their election. 

But enough sunlight appears to have shone into this murky world for the political leaders, at least, to realise that offering to pimp the PM or sell a peerage won't really bring in the dosh. Nervously, they are casting around for an alternative. As recently noted in the Guardian, all three UK political parties last year dismissed recommendations by the oxymoronic Committee on Standards in Public Life to limit political donations to £10,000 per donor per year, require union members to opt-in to their subscriptions being used to fund the Labour Party, to provide £3 of public funding per vote, and to allow tax incentives for small donations. Now Labour have suddenly suggested that a cap of £5,000 would be sufficient, while the Tories want a cap of £50,000 - which happens to double as a membership 'fee' for their clubby "Leader's Group" though "50 City donors" gave them more than that in the year to June 2011 (isn't it notable that these figures are stale by time of publication?). 

In other words, the major parties lack confidence that an open, transparent appeal to ordinary citizens will yield the necessary war chest. Could this be because they don't believe their policy offering is compelling enough to persuade enough citizens to part with just a few pounds each...?

This myopia has parallels with the political approach to the UK bank lending crisis. Even when 'welcoming' the evidence that ordinary people are directly funding each other's personal and business plans, the politicians still cling to the notion that Big Money will eventually pull through. As a result, they refuse to make the formal changes to the tax and regulatory framework necessary to level the playing field for non-banks, implying that this whole mass-collaboration thing is somehow just a sideshow. 

Of course, as discussed in Lipstick, the same malady affected many other 'institutions' who've lost out to 'facilitators' whose primary focus is solving others' problems instead of their own.  Just ask the ad agencies whether they think their clients find Google and Facebook more compelling recipients of advertising expenditure than the traditional media.

Refreshingly, some officials like the Bank of England's financial stability director, Andy Haldane, concur:

"In the UK companies such as Zopa, Funding Circle and Crowdcube are developing this model. At present, these companies are tiny. But so, a decade and a half ago, was Google."

And none other than the current UK Chancellor said in 2007:

“With all these profound changes – the Google-isation of the world’s information, the creation of on-line networks bigger than whole populations, the ability of new technology to harness the wisdom of crowds and the rise of user-generated content – we are seeing the democratisation of the means of production, distribution and exchange. … People… are the masters now.”

On April Fools Day, I suggested that smokers and drinkers might target the excise duty they pay on beer and cigarettes at specifichealth services. I wasn't being entirely facetious. There's no reason why a majority of voters shouldn't find it compelling to direct specific elements of their taxes or savings to specific public services, projects or even political parties. But enabling that to happen would require a little more ministerial interest in granting formal regulatory status to direct finance platforms. 

Will the lure of campaign crowdfunding prove too tempting to resist further? The Tories could offer dinner with Cameron at the Olympic Stadium.