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Subscribe to Best Practice Best Practice, published by The Lion Rock Institute, is a quarterly journal that sheds light on the best practices in international public policy. Published in Hong Kong, Best Practice is well positioned as a gateway to developments and recommendations in law and policy, making it the essential guide for leading developments in public policy. Subscribers receive benefits and special rates to LRI events. One year Subscription: 4 issues for $600 per year at $150 per issue Two year Subscription: 8 issues for $540 per year at $135 per issue (10% off) Three year Subscription: 12 issues for $480 per year at $120 per issue (20% off) Bulk Subscription: HK $400 per year for 10 subscriptions or above (33% off) International Retail: US $25 per issue Delivery Address

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Inside Best Practice Vol. 1 N0. 2 Summer 2009

20 The Language of Leadership

Ron Manners honours Sir Arvi Parbo for his service and comments on the way forward, not only for Australia, but for all others on the way.

5 6 7

Policy Recommended for the Market

From The Editor

26 The Privatization of

From The Founders

Contributors

Cover Story

8

Rebuilding Market Institutions After the Financial Crisis

Bill Stacey navigates financial risk and regulatory changes and throws us a ladder to climb out of the slump.

Market Crisis of 2008

Anna J. Schwartz suggests how to avoid a replay of the factors that produced the credit market debacle.

17 Monetarism Defiant

Guy Sorman on legendary economist Anna Schwartz – the feds have misjudged the financial crisis.

Editor: Nicole Idanna Alpert Executive Director: Peter Wong Design & Production: Firstline Limited Cover Artist: Bay Leung Best Practice is published quarterly by The Lion Rock Institute to encourage discussion of policy and current issues. Topics and authors are selected to represent a multitude of different views, and those opinions expressed within Best Practice do not necessarily reflect the views of The Lion Rock Institute. The Lion Rock Institute welcomes reproduction of written material from Best Practice, but editor’s permission must first be sought.

John L. Chapman on why privatization is indeed the only hope for renewal of once proud cities.

45 For Sleuthing Amateurs of Economics

The Economic Naturalist reviewed by Michael Mo.

46 Privatization Bears Fruit

in the Big Apple

Privatization in the City reviewed by Lawrence W. Reed.

Odds and Ends

48 Master of Slaves

Jackie Chan has declined the value of freedom to show his obedience.

34 Hong Kong and Capital 50 Patriotic Panic Controls

Jim Walker questions the controls in the betting arena.

Global Perspective Policy Analysis

37 Combating the Spread

Policy Recommended For The Crisis

14 Origins of the Financial

Public Services

Leader’s Bookshelf

of Fake Medicines Through Free Markets and Self-Interest

A low flying plane spotted in Manhattan causes panic.

52 Let’s Not Lose Our Minds

The mass hysteria surrounding the spread of swine flu does little to protect us.

Julian Harris and Alec van Gelder trail counterfeit medicines and suggest systems to help China shed its “Factory Asia” label.

Around The World

42 Restoring the Freedom to Trade

Alec van Gelder on the Freedom to Trade Campaign’s importance.

Editorial Office: Room 1207 Kai Tak Commercial Building 317-319 Des Voeux Road Central, Hong Kong Editorial Tel: +852 3586 8102 Subscription Service: +852 3586 8101 Fax: +852 3015 2186 Advertising inquires: Best.Practice@LionRockInstitute.org Production by: Firstline Limited www.FirstlineDesign.net Best Practice Advisory Board James A. Dorn, Alec Van Gelder, Philip Stevens Tom Palmer, Reuven Brenner, Gary Shiu Richard Wong, Francis Lui, Shih Wing Ching Donald J. Boudreaux

Article Submissions: All articles submitted to Best Practice must be exclusive unless permission has been sought. Articles should range between 600 and 5,000 words but may differ if editor’s approval has been sought. Please send all articles with a cover letter giving a brief summary of the articles along with the author’s fax number, day and evening telephone number, mailing address, email address and short bio. Please send articles by email to Nicole.Alpert@LionRockInstitute.org Certain images within Best Practice are published under Creative Commons licenses. We endeavor to comply fully with the terms of such licenses to ensure attribution of the author of the relevant image. For more information or details about the authors of particular images, please view our website, www.lionrockinstitute.org, or inquire.

Summer 2009

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From the Editor Fancy More Regulation?

T

he movement to increase regulation in order to rebuild the economy has a large following. At the same time, however, it is well known that some of the very regulations enacted years ago with the support of this movement backfired, playing a large role in the formation of the crisis. Knowing which regulations and policies to alter or roll-back is proving to be elusive, and committing to one school of thought amidst this confusion is worrisome. Many new policies have been considered for regulatory change under the auspices of now knowing better. But do policymakers really understand the outcomes of past policy and regulatory change – those that had admirable goals but turned out to be some of the main drivers of the crisis? The CRA regulation, while only one chapter of the tragedy, is notable because its impact was large enough to set the scene by lowering lending standards across the board. Its policy effect was detrimental: banks moved away from a focus on hard credit standards and other institutions proceeded similarly. This whole array of government policies to encourage home ownership vastly distorted the financial system, adding fuel to the fire. An illogical assumption, but still widely held, is that government agencies are able to “correct market failure” despite their bad track records. The thought of a bewildered-empowered tinkering again with financial products and policy (at some points, without having even understood what is up for legislation) is the stuff of nightmares. And yet, it’s our reality today, as improvident home-ownership policies were years ago. We should be wary of new regulations and rules when the political environment lacks necessary knowledge or endeavors to promote political goals. We should be wary when what’s actually happening in markets and businesses is being overlooked. After all, the readiness to pass new laws undermines the rule of law in the first place, which is why this summer’s issue of Best Practice: “Less is More” is dedicated to monetary policy and financial regulations.

Our cover story, “Rebuilding Market Institutions After the Financial Crisis,” by Bill Stacey, explores financial risk and regulatory changes while addressing numerous areas to suggest what shape reforms should take. Anna Schwartz helps us move forward by understanding the past as she explains the factors of the crisis and the expansive monetary policy under the last U.S. administration. Notably, this section, Policy Recommended for the Crisis, indicates that allowing regulations, and the risks involved with them, to play a larger role than the current market devices themselves is too big a risk to take. John Chapman opens our Policy Recommended for the Market section with “The Privatization of Public Services,” in which he details two cities’ government activity compared to that ascribed to markets. Chapman debates that the outcome of cities like Detroit is far from inevitable; the real reason for their failure is a greater size of government coupled with a lack of competition for public services and high taxes. Jim Walker uncovers a betting arrangement of suspect form in “Hong Kong and Capitol Controls” where people in Hong Kong are virtually banned from betting and watching horse races overseas. Best Practice’s Global Perspective Policy Analysis returns with Julian Morris’ and Alec van Gelder’s “Combating the Spread of Fake Medicines.” Both fascinating and helpful, they suggest policies that provide easy and counterfeit-proof systems to make all pharmaceuticals safer. Leader’s Bookshelf reviews enjoyable and influential books and for further enjoyment, Odds and Ends closes this issue with a very entertaining round-up of international happenings. We’ll meet again next season, but until then, let me know what you are thinking – you can reach us at best.practice@lionrockinstitute.org.

Nicole Idanna Alpert

Summer 2009

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From the Founders On Where Hong Kong is Headed

T

he second issue of Best Practice comes at you at a pivotal time in Hong Kong’s history. While the fallout of the financial crisis is still having far reaching impacts on our city, we seem to be seeing through this crisis and already looking beyond. While the financial realm is of course important, it oft seems that the greatest threats to our success come from within. Hong Kong is consistently ranked the freest economy in the world, but those living in Hong Kong are only too aware of when the government intervenes. Sometimes the results are comic – like the recent decision and hopeful reversal not to license shoe shiners. The question has to be asked: Whose idea was it to require shoe shiners to get a license anyways? Are there concerns about unlicensed shoe shiners over-buffing patrons’ shoes to an unsightly sheen? Or if we didn’t restrict the numbers, shoe shiners would take over the city with their pernicious…stools and buffing rags? No doubt there are mid-level bureaucrats earning a decent living off of licensing the absurd. In this case, it is certain they live better than those whose humble livelihood they would seek to extinguish. To those dutifully keeping Hong Kong’s leather bright, this is no joke however, but rather a theft of their honest work and dignity that goes with it. More far reaching in its impact is the proposal for a minimum wage. The economic arguments against it are well known and feared by workers on the edge of employment and employers on the edge of survival. Less understood is the moral damage of it. While the impact of government intervention seems obvious to us here, you have to experience it in social democracies to really see why Hong Kong ranks so well. Restrictive labour laws, of which minimum wage is a starting point for a tsunami of red tape, keep those with the most to gain from honest labour out of the workforce. School dropouts,

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recovering teenage addicts and the unskilled elderly are kept from gainful employment. For the young, never working leads to a life of indolence and crime. On the rare occasion they find work, they find it unfamiliar and irksome. In Europe and North America, those who would clean the streets at a lower than minimum wage instead make those streets dirty with crime and despair. For the elderly and unskilled, being replaced by a less expensive camera from their night watchman job robs them of their ability to contribute to people’s safety and well-being – and their dignity arising from a job done with honour. The elderly of the West are often living quiet lives of desperation, rather than working with pride in later years like those in Hong Kong. The elderly, yet vibrant men, working the alley behind Shanghai Tang are the frontline potential victims of labour restriction that would rob them of their pride. Will we replace it with welfare and the message that their usefulness to the world is done? By introducing minimum wage, will we do the same to young men who are just beginning life, without the full benefit of education? Imagine the impact on these valuable young people who, while not meshing with our rigid education system, can still make an honest contribution to the world. Policy has real impact on real lives. This is the motivation behind the founding of Best Practice. Hopefully we can use it to find a better way, a Hong Kong way, and not repeat the mistakes of the socalled “advanced” economies. Hong Kong’s way has been a better way for many years. We should not be shy to use the world’s best practice – but also create it, so the world may follow in our footsteps.

Simon Lee Chao-fu Andrew Shuen Pak-man Andrew Work


contributors

Bill Stacey

Anna J. Schwartz

Guy Sorman

Ron Manners

Jim Walker

John L. Chapman

The Chairman of Hong Hong’s leading free market think tank, The Lion Rock Institute. He is also on the Board of Advisors of the Mannkal Economic Education Foundation. Professionally, Bill has been an executive with leading financial institutions in Asia and globally. He is currently a partner in boutique equity house, Aviate Global.

One of the world’s greatest monetary scholars. With her expertise on banking and money analysis, she became the president of the Western Economic Association. She also published a book with Milton Friedman, A Monetary History of the United States, which was very influential. At the age of 93, she is still with the National Bureau of Economic Research and is one of the most prominent economists there.

French professor, columnist and author. He has written twenty books that preach the ideals of creativity and modern capitalism. His ideas about renewable energy and environmentalism in his book Progress and its Enemies are particularly controversial. He is currently working on a book on Economy as a science.

A fourth generation prospector with over 40 years of experience in the mining industry in WA. He is Chairman of the Mannwest Group of private companies, and is also the Managing Director of Mannkal Economic Education Foundation, an educational foundation. He is currently working on his next book entitled Heroic Misadventures.

The founder and managing director of Asianomics Limited, an economic research and consultancy company. Prior to establishing Asianomics in December 2007, he was the chief economist at CLSA Asia-Pacific Markets. He was voted best regional economist by the Asiamoney Stockbrokers Poll between 1994 and 2004 as well as frequent number one rankings in the private Greenwich surveys of fund managers in Asia, Europe and America.

An Adjunct Scholar in Economics, working at AEI under the auspices of the National Research Initiative where he researches and writes on the history and impact of private equity investment on the U.S. economy.

Alec van Gelder

Julian Harris

Michael Mo

Lawrence Reed

Eugenio Suarez

Anuj Jhunjhunwala

Project Director of the Trade and Development Programme at International Policy Network, a think tank based in London. His work on trade, health, technology and development issues has been published in many news outlets. Alec holds a Master’s degree in International Economics and Development from UCL in Belgium and speaks English, Spanish, French and Dutch with fluency.

A Research Fellow at International Policy Network, a think tank based in London. He works on international health policy and has recently authored articles on counterfeit and substandard drugs published in many outlets. Last month IPN launched his paper on the topic: “Keeping it Real: Combating the spread of fake drugs in poor countries.”

In his final year of studies at City University of Hong Kong. His experience campaigning for Barack Obama in America inspired him to attempt to apply similar campaign strategies in Hong Kong. Michael is a native of Hong Kong and is fluent in Putonghua. He is also one of the editors of idea4HK think tank and is currently working at The Lion Rock Institute for the summer.

Served as Mackinac Center for Public Policy’s President, a Midlandbased research and educational institute, for its first two decades starting from 1987. At age 55, he became president emeritus of the Center. On September 1, 2008, Reed assumed the presidency of the Foundation for Economic Education, headquartered in Irvington, New York.

Currently an EconomicsPhilosophy major at Columbia College and is also the Treasurer for the Student Governing Board. Eugenio co-founded the University Chapter of the Cuban American Foundation. He interned with Congresswoman Ileana Ros-Lehtinen and was an editor for the Columbia Political Review. He is a native of Miami and fluent in Spanish. Eugenio is currently a Research Assistant in the Barnard Economics Department and working at The Lion Rock Institute for the summer.

A junior at Columbia University in New York City, majoring in Economics-Political Science. He interned in the Louisiana State Governor’s Office where he researched the effects of federal legislation on elderly welfare recipients living on Medicare. He is vice-president of the Columbia University South Asian club and active in the Rotoract service club. Anuj also has a good command of Hindi and is a native of Baton Rouge. He is currently working at The Lion Rock Institute for the summer.

Summer 2009

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policy recommended for the crisis

Brian J. Matis

Wrong directions in regulatory reform are like removing the rungs from a ladder.

Rebuilding Market Institutions After the Financial Crisis Bill Stacey navigates financial risk and regulatory changes and assembles a ladder to climb out of the slump

W

hat will financial institutions look like in the future? What will be the impact of the financial crisis on the shape of the financial industry? Government policy, market process and entrepreneurial innovation are all likely to have an impact on these questions. Policy makers have in practice driven consolidation of the industry

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Best Practice

in the last 12 months, creating banks from the largest securities companies and consumer finance companies. Yet policy makers continue to discuss the separation of commercial banking and investment banking in some form, worry about “too big to fail problems� and hypothesize regulatory changes that would drive industry structure. Markets are planned to be restructured from their original

form to exchange traded variants. Offshore and off balance sheet structures that have a long track record are now being wound up. Little of the policy debate seems well informed by the actual realities of markets and businesses in the industry. Here we look at what market signals might be saying about the future shape of the financial sector and compare that to proposals for change in the industry.


policy recommended for the crisis

Paul Raven

A slippery slope – navigating financial risk

hedging or with sufficient capital to absorb losses. Some hedge funds performed well Several problems emerged within through the crisis. Those that did the financial sector, all with different not, and many that failed, did not outcomes in performance. Foremost cause the systemic risks that had amongst these is arguably failure in been feared in earlier incidents of risk management. Some institutions financial upheaval. within the financial sector started How do we explain these to pull back from the mortgage wide differences in performance? securities market (Credit Suisse and Shouldn’t regulatory reformers be Goldman Sachs) as others (UBS looking at the different performance and Merrill Lynch) increased their of institutions to identify the exposures. There are also banks that direction of industry changes? If a largely avoided the use of off balance regulatory framework had led to an sheet conduits. Some banks managed extremely divergent performance, is to minimize illiquid securities on it realistic to expect new rules made their balance sheet, whilst others had in the same fashion to deliver more huge inventories held for sale. uniformly stable performance? When liquidity became an issue Many of these differences in for the financial sector, there were performance have origins in industry commercial banks that had strong structure. That structure has liquidity from retail deposits, but been strongly influenced by both also some that were underfunded. present and historic regulation. The There were investment banks with separation of commercial banking much stronger committed liquidity and securities companies in the support. Some banks, whilst they United States was a legacy of post had exposures to problem areas, depression legislation. Opportunities managed those risks better, with for finance and insurance companies to operate with more flexibility in some parts of their business are the result of blurring differences between financial products that invalidate old industry boundaries. Still within every segment of the financial industry, there are banks, securities companies and insurers that managed risks better. It follows that financial institution strategy, culture and management was also important. Responding to market, regulatory and institutional change, Pouring oil on the slope, many proposals for change in companies make choices. the financial system are flawed.

Some of these are wrong. Anyone working in a major financial institution is aware of the frailties of decision making in those firms. As scale increases, information flows are weaker. As products become more complex, top management knowledge and expertise is typically weaker. As profits in some areas become larger, influence within institutions shifts. Rewarding risk managers for saying no to profit making, but excessively risky opportunities is difficult. Design of incentives in large companies is an inexact science, where teams and individuals make a contribution. Within each of the specific markets where there were problems (mortgages, securitization, credit default swaps, SIVs and conduits, commercial real estate, leveraged finance) there were micro structures, regulatory issues and practices that need to be addressed. However, are there systemic issues that can be identified behind risk management failures in the recent crisis and these challenges? In economics, the theory of the firm, pioneered by Ronald Coase, tells us that firms exist to reduce transaction costs from external markets. Given that large parts of financial markets are amongst the most “efficient” markets that we know, it seems anomalous that in the financial sector there are so many institutions of such size and complexity which pursue greater scale despite the obvious costs. Given the pervasiveness of large firms with huge internal transactions and capital allocations to some extent outside the market, should we be surprised to see apparent “market failures” – in reality failures of managerial outcomes rather than market allocation of resources. Summer 2009

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policy recommended for the crisis

Separation of Commercial and Investment Banking Separation of commercial and investment banking is one of the most common proposals from economists. Part of the idea is that regulators are very focused on depositor protection and that if depositors can be isolated from trading risks, securities activities can be left less regulated. “Too big to fail” problems are reduced and the costs of depositor insurance is lowered. A more radical version of the same proposal would require 100% reserve backed depository institutions.

Compensation Limits Compensation limits are proposed to reduce incentives to take excessive risk and align shareholders with employee interests. Yet legislative proposals entirely miss the point that the “principal-agent” problem at the core of bonuses paid for poor performance arises because of inadequate information, difficulty framing suitable contracts and/ or the high costs of moving to structures with superior incentives. Compensation limits will likely only “work” to reduce incomes in circumstances where they are not needed – where performance attribution is easy and akin to a sales

Pouring oil on a slope – proposals for regulatory change

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Best Practice

Source: World Economic Forum

It follows that many of the proposals for change to the financial system are flawed. Rather than help improve management of risk, they pour oil on the slope.

There are two problems with these proposals. First, it is practically at odds with recent experience that saw “universal” banks as the survivors and largely eliminated big securities companies. Second, and more importantly, the distinction that might once have been meaningful is now moot. Deposit products can take many forms and depositors have shown a desire for yield that will always see them allocate funds away from a narrow depository institution. It is not at all clear why depositors should be protected from securities trading risks, but not credit risks in traditional lending. Indeed in practice, interest rate mismatchrisks have often been as big an issue for bank profitability as credit. In modern financial markets, trading is also an important part of almost all commercial banks. Foreign exchange and interest rate risk management products, as well as simple debt securities like commercial paper, are an integral part of operations. It is not possible to draw a line between commercial and investment banking activities.

My hypothesis would be that many of the failures by firms that contributed to the crisis are the result of the massive structure of legislation, regulation, taxation, supervision, consumer protection and competing non market provision of financial services that make markets less effective than they could be in the financial sector. Asking what regulations we need to reduce the risk of financial crisis is the wrong question. So is asking how we should redesign institutions to reduce risk. The right issue is how to eliminate transaction costs in the financial sector that impair the market allocation of resources which make more pervasive “principalagent” problems and increase moral hazard.

The moves we make on government policy, market process and entrepreneurial innovation shape the future.

commission (e.g., equities broking or advisory businesses). This would drive those activities to boutiques. Limiting compensation will face the same problem as managers of financial institutions where the time frame of profitability is long, capital allocation difficult to determine and individual contributions hard to assess. Promoting rather than limiting markets is a better solution to that problem. Eliminating the “Shadow Financial System” Eliminating the “shadow financial system” of structures that have been largely “off balance sheet” and domiciled in offshore jurisdictions is proposed to increase regulatory scrutiny and transparency. However, the jurisdictional competition provided by the “shadow” system has been crucial to reducing transaction costs – it has allowed


policy recommended for the crisis

efficient dispersal of risks. These very factors led to the growth of the “shadow” system. The answer to the shadow financial system problem is not to eliminate it, but to reduce transaction costs in all jurisdictions.

Higher Capital Requirements Higher capital requirements are proposed to build confidence, provide a buffer for losses to prevent failure and for the largest institutions to limit counterparty risks that could have systemic consequences. However, it can be argued that the very detailed Basle 2 capital requirements were contributors to the crisis as banks shifted systematically to lower capital allocation products and moved away from products where capital requirements were increasing. Capital requirements are a large barrier to entry that makes it harder for new competitors to enter the market. Regulatory requirements have been manifestly too low in some areas, whilst giving counterparties false confidence about capital in others. In the hedge fund industry, prime brokers are effectively the regulators of leverage for their clients. Although they have made mistakes, they have done a

much better job than government regulators of banks or ratings agencies. This might provide a hint of a better model for governing financial leverage and capital than the current approach. Stress Tests Stress tests were designed to reassure counterparties and customers that institutions were financially sound. In practice they undermined confidence in institutions, created a long period of uncertainty and applied arbitrary rules that likely required some banks to raise capital that they did not need. This undermined private attempts to provide capital to the financial system. Financial institutions should continually test their financial stability under low probability, high cost scenarios and make plans to deal with those contingencies. Many did that reasonably effectively. “Sharing” Risks in Securitized Loans “Sharing” risks in securitized loans is a more recent proposal to align the interests of originators of loans Paul Falardeau

Change of Regulatory Responsibilities Change of regulatory responsibilities seems inevitable. It also seems largely beside the point. Unified regulation worked poorly in the U.K. during this crisis (although arguably it was pre-empted by panicked political responses). Fragmented regulation worked poorly in the U.S. In fact, far more systemic risks emerged from heavily regulated companies (AIG) than lightly regulated companies (hedge funds). The very process of changing regulatory institutions adds to costs and makes it more difficult for market participants to adjust to change. Notionally “functional” regulation (e.g., treating providers of services with a similar economic effect equally) seems to make more sense than the institutional regulation of the U.S. However, identifying tomorrows’ systemic risks is more likely to come from competitive processes and competing jurisdictions than a single regulator with that focus. The focus amongst politicians on bringing hedge funds under the umbrella of existing regulators is baffling. After the Long-Term Capital Management (LTCM) crisis, counterparties revisited their relationships with hedge funds, improved their control over collateral and improved management of leverage. These processes proved robust during the crisis, albeit causing problems for some funds. What government

regulators can add to this process is not apparent.

The result of ignoring market signals when shaping regulatory change is increased risk and reduced innovation.

Summer 2009

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policy recommended for the crisis

with investors. However, it will again require participants in the securitization process to be larger and better capitalised institutions, reducing competitive pressures. Many investors do want originators to have “skin in the game,” but the proposed requirement to have a five percent stake in any issue preempts more efficient and lower cost alternatives to the same problem. Rating Agencies Rating agencies arguably carry a significant burden of responsibility for the poor information they provided about risk for investors as the “AAA” brand was broadened to cover different risks. The potential conflicts within the model where issuers pay for the service have been widely discussed. The power of incumbents was driven by lack of competition as much as the fee model. Alternative fee structures could not compete with the privileged position of incumbents that was mandated by regulators. In short, none of the major proposals for industry reform address the underlying drivers of both company and specific market failures. Substantial regulatory changes are needed. There are good models of “deregulation” that increase the scope of markets, adding to the stability and efficiency of the financial system.

Building a ladder on the slope What form should regulatory and institutional reform take? The imperative is to reduce the costs of the industry adapting and allow markets to emerge as substitutes for managerial, legislative and regulatory decisions that all went astray in the crisis. 12

Best Practice

Institutional change and adaptation is very difficult in the financial sector. Elaborate licensing, high capital requirements and complex compliance issues mean very high barriers to entry. This makes it difficult for new firms that are often smaller with better incentive structures and a more focused strategy to emerge. Both consolidation and break up of financial institutions needs to be made much easier and at lower costs. This will allow specialists to set benchmarks as new markets emerge and allow more “boutique” structures with less principle-agent problems to play a bigger role in the industry. Taxation has been a pervasive driver of the structure of financial institutions, product development and leverage. Corporate and transaction taxes lead to innovative product structuring, but also reduce the efficiency of markets and can increase risk. Dealing with the tax issue is not a matter of closing loopholes, rather it requires less and lower taxes to reduce distortions. Only lower tax rates effectively reduce the incentive to amass excessive corporate debt caused by the non deductibility of the cost of equity funding. It should be no surprise that companies and financial institutions in the low tax jurisdiction Hong Kong have much more conservative gearing than many of their international peers. Although currently not in favourable standing, the benefits of jurisdictional competition have been proved by the different performance of regulators globally through the crisis. The trend to convergence, especially focused on systemically important institutions, will reduce adaptation in the financial sector.

Although the world experienced a very global crisis, local problems cause specific responses and improvements from countries and companies. Many improvements in regulation globally came from the specific experiences of small countries like New Zealand in the 1980s or Asia in the 1990s. Efforts to increase transparency in the financial sector are likely to be beneficial, but only to the extent that they are pursued at a reasonable cost. One of the ironies of the “Spitzer” changes to equity research is that it reduced investment in research, the quality of research and the prospects of analysts identifying new information. The reforms decreased access to company management and constrained opinionated research, which reduce the chance of identifying new areas of problems in the sector. Many accounting changes also make it more difficult to understand underlying financial trends. For example, mixing markto-market valuation changes with actual income and expenses in profit and loss statements obscures rather than clarifies. Competition to identify new information is likely to produce better outcomes than just requirements to disclose more information. Incentive changes are also important. It is not as simple as reducing the size of payments or making them longer term. Looking within investment banks, there are many challenges in the most common compensation models. Profitability of trades might not coincide with the calendar year or reporting cycle. Charges for capital allocation to riskier activities are often not done well. Cross subsidies between divisions are legion and allocations to management functions


M. F. Michele

policy recommended for the crisis

Everyone is paying attention to the market.

compared to “producers” are difficult. However, these issues are so important for the industry that they cannot be left to central rules and plans. Management is constantly trying to improve incentives. Where they fail, good people leave to work for competitors or establish themselves as the new competition. Note that many putative compensation “excesses” have coincided with a move away from options based incentives now that these are expensed. Simple models for expensing options often impose too high a cost on long dated and well out of the money options that can provide strong alignment between shareholder and staff interests. Internal capital allocation to optimize returns is also made more difficult by proscriptive regulatory capital rules that open a gap between economic and regulatory capital. Regulatory capital processes should retreat from detailed and proscriptive approaches to simple, general rules that provide minimum guidelines. Markets left to their own devices before the financial crisis were driving substantial changes which at the margin improved the structure of the financial industry. These

changes should not be hampered or ignored. Parts of the industry were consolidating and seeing higher returns with scale. Processing parts of the financial sector were consolidating quickly, sometimes within large firms, sometimes with specialists consolidating across firms. Credit card and merchant processing, custody, trade finance and securities clearing were areas consolidating globally. Alongside this was a trend towards less capital intensive parts of the industry moving into smaller or “boutique” firms in areas like advisory and cash equities. This is probably largely a feature of better incentive structures in smaller firms, where human capital is more important than financial capital. Supporting this trend, new technology has made it easier to operate with “global” coverage on a smaller scale. Even in relatively capital intensive trading businesses, there was a shift of activity and talent from investment and universal banks to hedge funds. Reasons for this would include the greater efficiency of external investors directly allocating capital between strategies (rather than internal management allocation in banks). In particular, external investors were good at removing low return capital from underperforming managers. Clearly, incentive structures were superior for many people within hedge funds. The ability to relatively easily establish (and close) hedge funds meant a dynamic and very competitive market.

Even within large banks, some trading activities moved into more hedge-fund-like internal structures with mixed results. Universal banks were also in the process of breaking up. Many very diversified institutions had exited asset management and insurance. Strategies in the largest financial firms were starting to diverge. These trends were pointers to an industry that would emerge with some of the largest firms providing utility services to a much more fragmented, competitive and market based constellation of smaller firms. Specialisation within the industry was growing. The exchanges market was becoming much more competitive and many over the counter products were migrating to exchange traded alternatives. These trends were not mature, but arguably would have reduced “systemic” risks. In conclusion, attempts to restructure the financial industry are misguided and can in the long-term compound inefficiencies and financial risks in the financial system. The alternative is to focus on making markets work better. This classically requires lowering transaction costs, reducing barriers to entry, increasing adaptability of financial institutions and very importantly, reducing tax burdens and distortions. There are powerful models of this style of reform working well in financial markets around the world. Markets were “reforming” themselves prior to the crisis. It would be a shame if the response to the crisis reduces innovation and adaptation in the financial sector and actually increased risk. Bill Stacey is the Chairman of The Lion Rock Institute and a partner in a boutique HK based securities company.

Summer 2009

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policy recommended for the crisis

Origins of the Financial Market Crisis of 2008 Anna J. Schwartz suggests how to avoid a replay of the factors that produced the credit market debacle Michael Daddino

The Fed had two paths to choose from – inflating the bubble with expansive monetary policy or reining it in by tightening it.

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begin by describing the factors that contributed to the financial market crisis of 2008. I end by proposing policies that could have prevented the baleful effects that produced the crisis.

Factors contributing to the financial crisis At least three factors exercised significant influences on the emer­gence of the global financial crisis. Factor One: Expansive Monetary Policy The basic groundwork to the disruption of credit flows can be traced to the asset price bubble of the housing price boom. It has become a cliché to refer to an asset boom as a mania. The cliché, however, obscures why ordinary folk become avid buyers of whatev­er object has become the target of desire. An asset boom is propagat­ ed by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset. The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 14

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25 basis point increase in August 2006. The rate cuts that began on August 10, 2007, and escalated in an unprece­ dented 75 basis point reduction on January 22, 2008, was announced at an unscheduled video conference meeting a week before a sched­uled FOMC meeting. The rate increases in 2007 were too little and ended too soon. This was the monetary policy setting for the housing price boom. In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-­being of individuals and families. Congress was also more than a bit player in this campaign. Fannie Mae and Freddie Mac were created as government­-sponsored enter­prises. Beginning in 1992 Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low- ­and mod­erate­-income borrowers. In 1996, HUD, the department of Housing and Urban Development, gave Fannie and Freddie an explicit target: 42 percent of their mortgage financing had to go to borrowers with incomes below the median income in their area. The target increased to 50 percent in


policy recommended for the crisis

Factor Two: Flawed Financial Innovations A second factor that influenced the emergence of the credit crisis was the adoption of innovations in investment instruments such as securitization, derivatives, and auction-­rate securities before markets became aware of the flaws in the design of these instruments. The basic flaw in each of them was the difficulty of determining their price. Securitization substituted the “originate to distribute securities” model of mortgage lending in lieu of the traditional “originate to hold mort­gages” model. Additional banking innovations, notably the practices of the derivatives industry, made mortgage lending problems worse, shifting risk that is the basic property of derivatives in directions that became so complex that neither the designer nor the buyer of these instruments apparently understood the risks they imposed and implicated derivative owners in risky contingencies they did not realize they were assuming. Derivatives as well as mortgage-­backed securities were difficult to price, an art that markets haven’t mastered. The securitiza­tion of mortgage loans spread from the mortgage industry to commer­cial paper issuance, student loans, credit card

Woodley Wonderworks

2000 and 52 percent in 2005. For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie had to be “special affordable” loans, typically to borrowers with incomes less than 60 percent of their area’s median income. That number was increased to 20 percent in 2000 and 22 percent in 2005. The 2008 goal was to be 28 percent. Between 2000 and 2005 Freddie and Fannie met those goals every year, and funded hundreds of bil­lions of dollars worth of loans, many of them subprime and adjustable-­rate loans made to borrowers who bought houses with less than 10 percent down. Fannie and Freddie also purchased hundreds of billions of dollars worth of subprime securities for their own port­folios to make money and help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities. Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor peo­ple allowed Congress and the White House to subsidize low­-income housing outside of the budget, at least in the short run. Unfortunately, that strategy remains at the heart of the political process, and of pro­posed solutions to this crisis (Roberts 2008). Fannie and Freddie were active politically, extending campaign contributions to legislators.

Additional banking innovations made mortgage lending problems worse.

receivables, and other loan categories. The design of mortgage­-backed securities collateral­ized by a pool of mortgages assumed that the pool would give the secu­ rities value. The pool, however, was an assortment of mortgages of varying quality. The designers gave no guidance on how to price the pool. They claimed that rating agencies would determine the price of the security. But the rating agencies had no formula for this task. They assigned ratings to complex securities as if they were ordinary corpo­rate bonds and without examining the individual mortgages in the pool. Ratings tended to overstate the value of the securities and were fundamentally arbitrary. Absent securitization, all the various periph­eral players in the credit market debacle including the bond insurers, who unwisely insured securities linked to subprime mortgages, would not have been drawn into the subsidiary roles they exploited. Securities and banking supervisors knew that packaging of mort­gage loans for resale as securities to investors was a threat to both investors and mortgage borrowers, but remained on the sidelines and made no attempt to halt the processes as they unfolded and transformed the mortgage market. Factor Three: The Collapse of Trading A third factor leading to the emergence of the credit crisis was the collapse of the market for some financial instruments. One particular­ly important instrument was the auction rate security, a long-­term instrument for which the interest rate is reset periodically at auctions. The instrument was introduced in 1984 as an alternative to long­-term debt for borrowers who need long-­term funding; but serves as a short-­term security. In 2007 outstanding auction rate securities amounted to $330 billion. Normally, the periodic auctions give Summer 2009

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the bonds the liq­uidity of a short-­term asset that trades at about par. The main issuers of auction rate securities have been municipalities, hospitals, muse­ums, student loan finance authorities, and closed­-end mutual funds. When an auction fails, there are fewer bidders than the number of securities to be sold. When this happens, the securities are priced at a penalty rate – typically, the state usury maximum, or a spread over Libor. This means the investor is unable to redeem his money and the issuer has to pay a higher rate to borrow. Failed auctions were rare before the credit market crisis. The banks that conducted the auctions would inject their own capital to prevent an auction failure. From the fall of 2007 on, these banks experienced credit losses and mortgage writedowns as a result of the subprime mortgage market collapse, and became less willing to com­mit their own money to keep auctions from failing. By February 2008 fears of such failures led investors to withdraw funds from the auction rate securities market. The rate on borrowing costs rose sharply after failed auctions. The market became chaotic with differ­ent rates resulting for basically identical auction rate securities. Different sectors have been distressed by the failure of the auction rate securities market (Chicago Fed Letter 2008). The flaw in the design of this instrument has been revealed by its market collapse. A funding instrument that appears long­-term to the borrower but short­-term to the lender is an illusion. A funding instru­ment that is longterm for one party must be long­-term for the coun­terparty. The auction rate securities market is another example of ingenuity, similar to the brainstorm that produced securitization. Each seemed to be a brilliant innovation. Securitization produced products that were difficult to price. Auction rate securities could not survive the inherent falsity of its conception. Both proved disastrous for credit market operations.

that made mortgage lending and borrowing appear riskless and encouraged house price increases. If monetary policy had been more restrictive, the asset price boom in housing could have been avoided. The second factor I mentioned that led to the credit market deba­cle was Schwartz disagrees with the premature adoption of Greenspan’s expansive innovations in investment monetary policy. instru­ments that were flawed, principally because pricing the new instruments was difficult. Credit markets cannot operate normally if an accurate price cannot be assigned to the assets a would­be bor­rower includes in his portfolio. The lesson for investors’ embrace of mortgage-­backed securities and other new types of assets that were profitable to many purveyors of services in the distribution of these ingenious ways of making loans is to be wary of innovations that have not been thoroughly tested. The final factor that credit markets have contended with is the col­lapse of trading in selected instruments that revealed their weakness­es. The losses investors experienced as a result will keep these markets from operating until tranquility returns to the credit market as a whole and the weaknesses have been corrected.

How to avoid a replay of the three factors that produced the credit market debacle

Anna J. Schwartz is an economist with the National Bureau of Economic Research.

With respect to the first factor I’ve mentioned – the role of expan­sive monetary policy in propagating the housing price boom – let me first respond to Alan Greenspan’s argument that no central bank could have terminated the asset price boom because, had it done so, the economy would have been engulfed in a recession that the pub­lic in a democracy would not stand for (Greenspan 2008: 523). The argument is fallacious. Greenspan does not explain why the Fed could not have conducted a less expansive monetary policy that did not lower interest rates to levels 16

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Conclusion Much turmoil may still batter the credit markets. Capital impair­ment of banks and other financial firms remains to be dealt with. Insolvent firms must not be recapitalized with taxpayer funds. A sys­tematic procedure for examining portfolios of these institutions needs to be followed to identify which are insolvent.

Reprinted with permission. Cato Journal, Vol. 29, No. 1 (Winter 2009). © Cato Institute. All Rights Reserved.

References Chicago Fed Letter (2008) “Navigating the New World of Private Equity: A Conference Summary.” No. 256 (November). Greenspan, A. (2008) The Age of Turbulence. New York: Penguin Group. Roberts, R. (2008) “How Government Stoked the Mania.” Wall Street Journal (3 October). 2008.


policy recommended for the crisis

Monetarism Defiant Guy Sorman on legendary economist Anna Schwartz – the feds have misjudged the financial crisis

Before the monetarist revolution, most economists believed that the quantity of money circulating in the economy had no influence on prices or on growth.

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nna Schwartz must be the oldest active revolutionary on earth. Born in 1915 in New York, she can still be found nearly every day at her office in the National Bureau of Economic Research on Fifth Avenue, where she has been tirelessly gathering data since 1941. And as her experience proves, data can transform the world. During the 1960s, with Milton Friedman, she wrote A Monetary History of the United States, a book that forever changed our knowledge of economics and the way that governments operate. Schwartz put ten years of detective work into the project, which helped found the monetarist theory of economics. “Not only by gathering

new data but by coming up with new ways to measure information, we were able to demonstrate the link between the quantity of money generated by the banks, inflation, and the business cycle,” she explains. Before the monetarist revolution, most economists believed that the quantity of money circulating in the economy had no influence on prices or on growth. History showed otherwise, Friedman and Schwartz argued. Every time the Federal Reserve (and the central banks before it) created an excess of money, either by keeping interest rates too low or by injecting liquidity into banks, prices inflated. At first, the easy money might seem to boost consumers’ purchasing power. But the increase would be only apparent,

since sellers tended to raise the prices of their goods to absorb the extra funds. Investors would then start speculating on short-term bets – whether tulips in the seventeenth century or subprime mortgages more recently – seeking to beat the expected inflation. Eventually, such “manias,” as Schwartz calls them, would begin replacing longterm investment, thus destroying entrepreneurship and harming economic growth. By contrast, by removing excess liquidity, the central bank can cause the sudden collapse of speculative excess, and it can also hurt healthy recovery or growth by constricting the money supply. There is now a near-consensus among economists that lack of liquidity caused the Great Depression. During the severe downturn of 1930, the Fed did nothing as a first group of banks failed. Other depositors became alarmed that they would lose their money if their banks failed, too, leading to further bank runs, propelling a frightening downward economic spiral. To encourage steady growth while avoiding the pitfalls of inflation, speculation, and recession, the monetarists recommend establishing predictability in the value of currency – steadily expanding or contracting the money supply to answer the needs of the economy. “At first, central bankers and governments did not accept our theory,” recalls Schwartz. Margaret Thatcher was

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policy recommended for the crisis

The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz.

the first to understand that the monetarists were right, following their rules when she came to power in 1979, taming inflation and reinvigorating the British economy. The U.S. followed during the early 1980s, led by Paul Volcker, a Friedmanite then at the head of the Federal Reserve, who, with Ronald Reagan’s strong support, ended raging inflation, though not without a lot of short-term pain. “It was a strenuous experience,” Schwartz remembers. As Volcker tightened the money supply, making credit harder to come by, unemployment spiked to about 10 percent; many 18

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firms failed. But starting in 1983, the inflation beast defeated, a new era of vigorous growth got under way, based on innovation and long-term investment. This lesson of the recent past seems all but forgotten, Schwartz says. Instead of staying the monetarist course, Volcker’s successor as Fed chairman, Alan Greenspan, too often preferred to manage the economy – a fatal conceit, a monetarist would say. Greenspan wanted to avoid recessions at all costs. By keeping interest rates at historic lows, however, his easy money fueled

manias: first the Internet bubble and then the now-burst mortgage bubble. “A too-easy monetary policy induces people to acquire whatever is the object of desire in a mania period,” Schwartz notes. Greenspan’s successor, Ben Bernanke, has followed the same path in confronting the current economic crisis, Schwartz charges. Instead of the steady course that the monetarists recommend, the Fed and the Treasury “try to break news on a daily basis and they look for immediate gratification,” she says. “Bernanke is looking for sensations, with new developments every day.” Yet isn’t Bernanke a disciple of Friedman and Schwartz? He publicly refers to them as mentors, and, thanks to their scientific breakthrough, he has famously declared that “the Great Depression will not happen again.” Bernanke is right about the past, Schwartz says, “but he is fighting the wrong war today; the present crisis has nothing to do with a lack of liquidity.” President Obama’s stimulus is similarly irrelevant, she believes, since the crisis also has nothing to do with a lack of demand or investment. The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz. Lenders aren’t lending because they don’t know who is solvent, and they can’t know who is solvent because portfolios remain full of mortgage-backed securities and other toxic assets.

Ben Bernanke


policy recommended for the crisis

Michael Daddino

To rekindle the credit market, the banks must get rid of those toxic assets. That’s why Schwartz supported, in principle, the Bush administration’s first proposal for responding to the crisis – to buy bad assets from banks – though not, she emphasizes, while pricing those assets so generously as to prop up failed institutions. The administration abandoned its plan when it appeared too complicated to price the assets. Bernanke and then-Treasury secretary Henry Paulson subsequently shifted to recapitalizing the banks directly. “Doing so is shifting from trying to save the banking system to trying to save bankers, which is not the same thing,” Schwartz says. “Ultimately, though, firms that made wrong decisions should fail. The market works better when wrong decisions are punished and good decisions make you rich.” She’s more sympathetic to Treasury secretary Timothy Geithner’s plan, unveiled in March, to give private investors money to help them buy the toxic assets, but wonders if the Obama

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he worst thing for a government to do, though, is to act without principles, to make ad hoc decisions, to do something one day and another thing tomorrow.”

administration will continue to support the plan if the assets’ prices turn out to be so low, once investors start bidding for them, that they threaten the banks. What about “systemic risk” – much heard about these days to justify the government’s massive intervention in the economy in recent months? Schwartz considers this an excuse for bankers to save their skins after making so many bad decisions. “The worst thing for a government to do, though, is to act without principles, to make ad hoc decisions, to do something one day and another thing tomorrow,” she says. The market will respond positively only after the government begins to follow a steady, predictable course. To prove

her point, Schwartz points out that nothing the government has done to date has really thawed credit. Schwartz indicts Bernanke for fighting the wrong war. Could one turn the same accusation against her? Should we worry about inflation when some believe deflation to be the real enemy? “The risk of deflation is very much exaggerated,” she answers. Inflation seems to her “unavoidable”: the Federal Reserve is creating money with little restraint, while Treasury expenditures remain far in excess of revenue. The inflation spigot is thus wide open. To beat the coming inflation, a “new Paul Volcker will be needed at the head of the Federal Reserve.” Who listens to her these days? “I’m not a media person,” she tells me. She rarely grants interviews, which distract her from her current research: a survey of government intervention in setting foreign exchange rates between 1962 and 1985. Never before have these data been combined to show what works and what doesn’t. In her nineties, she remains a trendsetter. Research for this article was supported by the Brunie Fund for New York Journalism. Guy Sorman, a City Journal contributing editor, is the author of numerous books, including the forthcoming Economics Does Not Lie. Reprinted with permission from City Journal Spring 2009.

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policy recommended for the crisis

The Language of Leadership Ron Manners honours Sir Arvi Parbo for his service and comments on the way forward, not only for Australia, but for all others on the way Cliff

“Yes! [with enthusiasm] We are working very hard on just that.” Only 35,000 people attended his AGM, and I was there as a guest, not as a shareholder. In my opinion, Warren Buffett is doing more to restore the image of business in the U.S. than any other single individual. He is achieving this more by example than as a result of his actual net worth.

What is the language of leadership?

he secret of eternal life? Become legislated as a Federal Government program.” –President Ronald Reagan

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Leaders are people who often say things that are unpopular and then see people change their mind about that particular issue. They absolutely ignore opinion polls. This has very little to do with high office, although that does help, because there are more people listening. However, that doesn’t stop people like Prime Ministers talking nonsense. So it’s possible for people in high office to actually not be leaders in this sense. Sometimes those people demand the most approval and get annoyed when people who need approval the least actually receive the most.

By a remarkable set of co-incidences, a couple of weeks ago I found myself talking to Warren Buffett, at his Annual General Meeting (AGM) in Omaha, Nebraska, and asking him a question that was troubling me: “Mr. Buffett, would America be a better country if you could reduce Wall Street’s influence over Washington D.C.?”

There are Immutable Laws of Leadership. One is balance. If you get too far in front of your troops, you start to look like the enemy. General Norman Schwarzkopf said: “Leadership is a combination of strategy and character. If you must be without one, be without the strategy.”

“Courage is resistance to fear, mastery of fear���not absence of fear.”

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Woodrow Wilson remarked: “We grow by dreams. All big men are dreamers. Some of us let dreams die, but others nourish and protect them, nurse them through bad days … to the sunshine and light which always comes.” Wilson believed that vision is the key to understanding leadership, and real leaders never lose the childlike ability to dream dreams. Henry David Thoreau also captured the language of leadership when he suggested that: “We must learn to reawaken and keep ourselves awake, not by mechanical aid, but by an infinite expectation of the dawn.” As well as the ingredients of discipline, persistence and determination, a large helping of wisdom is essential. President Herbert Hoover probably captured it best: “Wisdom consists not so much in knowing what to do in the ultimate as in knowing what to do next.” Knowledge can be memorized but wisdom requires that we think things through. Wisdom is something that enables us to use knowledge correctly. Wisdom resists pressure groups, thinks for itself, and is reconciled to use its own judgement. Courage is Vital, Too. Mark Twain once said: “Courage is resistance to fear, mastery of fear … not absence of fear.”


policy recommended for the crisis

Humility is another ingredient. One of the world’s greatest scientists and philosophers, Sir Isaac Newton, humbly explained his success this way: “If I could see further than others, it was because I stood on the shoulders of giants.”

Leaders must also be decision-makers They must be people of action and it helps if they have developed strong friendships, as life at the top can be extremely lonely without quality colleagues. George Washington knew that when he said: “Associate yourself with men of good quality if you esteem your own reputation; for ’tis better to be alone than in bad company.” Now, fancy having all those qualities and then being stuck with nothing or no-one to actually “lead.” Somehow, with all those qualities, I think that something is bound to turn up! Good leaders also have a habit of developing more leaders. Many years ago, when asked how he developed his key team, the U.S. steel magnate, Andrew Carnegie, replied: “Men are developed the same way that gold is mined. When gold is mined, several tonnes of dirt must be moved to get an ounce of gold; but one doesn’t go into the mine looking for dirt … one goes in looking for the gold.” One of the many leaders discovered and developed by a great leader himself, Sir Arvi Parbo, was the late Keith Parry, whose career I outline in my latest book, due for launch in mid-2009. The book is titled Heroic Misadventures and it started off as a kind of management “how-not-to-do-it book.” But it has developed into something far more substantial and its sub-title is now:

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here is only one way out of this quagmire and that’s by producing more worldcompetitive goods and services for export and for our own consumption.

“Australia: Four Decades – Full Circle.” As I was finishing the book, it suddenly became clear to me that we, as a nation, are entering a political environment as hostile to business and enterprise as we experienced in the 1970s. Before that, in the 1950s and 1960s, public opinion and government policy in Australia strongly supported economic development. As a result, giant strides were made in both material and non-material living standards. However, in the 1970s and 1980s this support was weakened, if not lost. Apart from being periodically rescued by first, the Japanese and later, the Chinese, Australia has been struggling to maintain its standards and has often financed this by heavy borrowing. There is only one way out of this quagmire and that’s by producing more world-competitive goods and services for export and for our own consumption. The future of the nation depends on this, but you all know that already and I’m sure you will enjoy the light-hearted irreverence of my book Heroic Misadventures and the similarities between rudderless leadership, both then and now.

Learning leadership by example from Sir Arvi Parbo It is because of Sir Arvi Parbo’s dedication to good leadership that I focus on his qualities of leadership

here. Sir Arvi is an inspirational, Australian business executive. I remember some wise words of leadership from Sir Arvi Parbo when he was delivering a business breakfast address called “Reflections on Australia” in Perth, November 5, 1991. Sir Arvi was giving us some sense of perspective and commenting how it was that most of the time we were preoccupied with day-to-day problems and grappling with the immediate future. This, he suggested, left us no time for reflection, for standing back and looking at ourselves and what is happening around us. He felt that it was important to do so occasionally and to try and put things in perspective. Sir Arvi made these following comments: “A well proven way to come into public prominence or, if already established, extend one’s influence, is to alarm and create fear in people. This is the standard method used with great success by, for example, extreme environmentalists. The truth does not matter; publicity is what counts. Results of scientific research are being sensationalised, misinterpreted, and misused, while the scientific community, with a few exceptions, watches from the mountaintops of their disciplines and allows this to happen. The reason why activists do not bother about the accuracy of their claims has been recorded by one of Summer 2009

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them, the American climatologist, Stephen Schneider: ‘We have to offer up scary scenarios, make simplified, dramatic statements and make little mention of any doubts we may have. Each of us has to decide the right balance between being effective and being honest.’ Mr. Schneider was predicting a coming Ice Age in the 1970s and is now a staunch protagonist of the global warming theory. This however, does not explain why responsible officials in government departments dealing with such matters allow inaccurate and misleading statements to go unchallenged. Our main problem now is that after years of pandering to minority groups and allowing decision making powers to be gradually taken out of their hands, it is now very difficult for governments to regain control. Procedures, practices and regulations which have been designed to slow down, if not frustrate, any positive action have become a monster with a life of its own. To get rid of this monster needs the equivalent of a Boris Yeltsin standing on a tank.”

Sir Arvi’s work abroad In September 1990, I was included in a team of 40 economists and advisors and sent off to Russia (Moscow and St. Petersburg, which at the time was tumultuously undergoing another name change from Leningrad). Our

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challenge was to explain to the Russians how free-enterprise actually works, because it was arriving the following month. To any of the Russians listening, my story – about how to get 500 people together, who trusted you sufficiently to give you their money so you could float a public company to discover and develop resources with the promise of sending them dividends – was about as close to science fiction as they’d ever come. However, the full weight of this challenge sank in when I realized that they had no secure or enforceable property rights, no system of titles, and no legal system of dispute resolution. I came as close to despair as I’ve ever been. We often forget how blessed Australia is with our heritage of the rule of law. I met one of the other delegates who was from Estonia, Mr. Trivimi Velliste, the President of the Estonian Heritage Society. Mr. Velliste explained to me that, for so many years, Sir Arvi had supported his country of birth with optimistic encouragement and constant advice on how best they should rebuild their economy which had long been shattered and destroyed by communism. At another event in Iceland in August 2005, I met the Honourable Mart Laar, the twice-serving Prime Minister of Estonia, who had effectively brought in so many successful economic reforms that

ur challenge was to explain to the Russians how free-enterprise actually works, because it was arriving the following month.

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the Estonian economy was up to a brisk trot again. I was curious to know why Estonia had been courageous enough to introduce a flat rate tax when so many countries, including Australia, simply talked about it, agreed that it would be a good idea and then closed the book on it. Mart Laar modestly commented that his being an historian, rather than an economist, was good for Estonia, as one of the first things he did on being elected Prime Minister was to ask for a good book on economics, so he could gain some ideas on how to get their stagnant economy moving. Someone gave him a copy of Free to Choose by Milton and Rose Friedman (it is supposed that Sir Arvi left a copy floating around there). Among the many ideas Mr. Laar gained from Free to Choose was the benefits to be had by instantly moving to a flat rate tax system, instead of the Marxist-Leninist system of escalating taxes that have unfortunately decimated so many Western economies. I refuse to call our system of taxation “Progressive Tax” as it’s more like a “Regressive Tax.” In his self-effacing way, Mart Laar stated that the idea of flat tax was so appealing and simple he didn’t realize that he was the only European pioneer to introduce such a tax. He said that it had proved to be extremely successful. When Estonia introduced it in 1994, at a flat rate of 26 percent, it enabled his country to enjoy rapid economic growth and pay off Estonia’s national debt. Consequently, Estonia has reduced the rate to 21 percent. Vladimir Putin’s Chief Economic Advisor, Andrei Illarionov, also in Iceland at that time, admitted that


policy recommended for the crisis

Ed Yourdon

1. People do not get what they want or what they expect from the markets; they get what they deserve. 2. The force of a correction is equal and opposite to the deception that preceded it. 3. Capitalism doesn’t always take an economy where it wants to go; but it always takes an economy where it ought to be. 4. The severity of a depression is inversely correlated with government’s efforts to stop it.

A sign of the times? Gray’s Papaya’s ever-available “Recession Special” has taken on a new meaning over the last year.

Russia’s move to a 13 percent flat rate tax was the best thing it had ever done and Russians were actually paying their taxes, and on time, too. By 2005, eleven countries in Europe had activated their economies by moving to a flat rate tax system, and it was like seeing a snowball in motion. Now, in 2009, there are at least 24 flat tax jurisdictions in the world, all in Eastern Europe with the exception of Hong Kong, Jersey, Guernsey, Iceland, Jamaica, Trinidad and Tobago, and Mauritius. The flat rate tax revolution is gaining ground as it quickly rolls from country to country, where competition ensures that the best ideas win. Why does Australia continue to turn its back on the benefits that would accrue from bulldozing its unwieldy and uncompetitive tax system? How effective a simple paperback book can be in contributing to a tax revolution in almost 30 countries.

Lack of leadership in the global crisis On a more recent occasion I had to give a talk on the dreaded “Global Financial Crisis” and I asked Sir Arvi Parbo what his overall view on this was. He felt that we had a lot to learn from the Roman Empire. His comment was: “The Romans tested the integrity of their engineers by requiring them to stand under the bridges they built while the scaffolding was being removed. Today’s financial engineers not only will do their utmost not to be identified as having built the bridge but will be as far as possible from it when it is opened to traffic.” I’m a great believer in markets, mainly because the market is a magnificent institution for conveying information. Bill Bonner of the Daily Reckoning has developed his four rules covering this Financial Crisis and markets generally:

Sir Arvi’s career has spanned many financial downturns, such as the one we are now experiencing, but he always has a cheery anecdote to relieve the tension and to get problems into their correct perspective. I recall him telling the story of the young girl at boarding school who wrote to tell her parents that things were not well: “I am sorry to have to tell you that my dormitory and half the school burned down, but don’t worry about me because I am now living in a flat in town. Don’t worry about that either. I am being looked after – I am living with Roger the school plumber. You needn’t be concerned about this either because I am going to marry Roger – I am three months pregnant with his child.” The next day she wrote again: “Don’t worry about yesterday’s letter. The school didn’t burn down, I’m not living with Roger, I’m not pregnant or about to be married. The fact is I am failing in mathematics and I wanted you to get this problem into proper perspective.” Similarly, getting this Global Financial Crisis into correct perspective is a major challenge for many of us. The correct title for the Summer 2009

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Crisis should be: “The U.S. Financial Crisis that they have successfully exported globally.” In March, I sat through a long Global Financial Crisis Conference in New York where we analysed the causes for the crisis in excruciating detail. Several countries had presentations on how it was affecting each of them differently, also why various countries had different timetables for planned action. I was struck by the completely different situation existing in the U.S. compared with Australia, which made it absurd that people rushed unthinkingly to adopt identical “bailout programmes.” In the U.S., Washington D.C. is to a large extent, controlled and manipulated by Wall Street, whereas in Australia the Big End of Town is generally regarded by Canberra as a bit of a joke and the control strings are pulled from elsewhere. Wall Street embeds senior people in Washington D.C.’s administration and they are there for one purpose only. They were there drafting the various Troubled Asset Relief Program (TARP) bailouts and they were there again with their outstretched buckets to collect all the relief bailout money, and ensure that none of it flowed to productive middle-America. The “stimulus” was not about improving economic efficiency. It was about distributing funds to favoured interest groups. It’s pretty easy for us, over here in Perth, Western Australia, to think we are well insulated from all this financial havoc, but this one is more serious than just seeing a few companies go broke. This time we see many of the world’s sovereign governments in the process of going broke. Iceland has all but gone. Spain, Ireland, Greece 24

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and Portugal have all had their sovereign credit ratings downgraded by the rating agencies, and now the U.K. and U.S. have had their ratings being questioned. All these countries, in different circumstances, face challenges such as property bubbles bursting, the collapse of government tax revenues, and banking sectors tripped up by massive bad loans. How alarming that all their respective governments have responded to this crisis by further increasing borrowing to ruinous levels. Britain is a country drowning in debt, without the option of generating national income from exports, as Australia can. You can easily see how these governments would be attracted to exploiting climate change hysteria to tax carbon (really an indirect tax on consumers). When this happens, the result will be an even more rapid economic contraction. This will be our recession’s equivalent of the 1930s Smoot-Hawley tariff legislation – exactly the wrong thing to do, done at the worst possible time.

Moving forward When judging the causes of the Financial Crisis of 2008 it’s important to look beyond the popular folk-lore of greedy bankers generating new financial products that nobody understood, and that this led to a “market failure.” This is

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only part of the story and the main underlying theme is that intervention by governments in financial markets played a major part in the events that led up to the Crisis. This “government failure” should be the object of serious attention. Government agencies did not spot it coming before market participants did. We should not, then, assume that government agencies can “correct market failure.” There is a strong likelihood that financial market regulation has made matters worse and not better. Indeed, it was government regulation that forced the banks to depart from their prudent lending practices and allocate large volumes of loans changing lending standards. This may have been to gain political popularity but it has left us with a tragic legacy. In the wake of this Financial Crisis, the choice before us is really quite simple. We can either continue this splurge of debt-driven madness in the hope that the bubble will re-inflate and we can get a few more good years out of it, enabling us to retire and leave the mess to future generations – or – we can use thoughtful economic analysis to identify specific problems in financial markets and resolve them with a simple and targeted legislative framework. It is perhaps time to restore the primacy of market discipline – backed up, if necessary, by

hen judging the causes of the Financial Crisis of 2008 it’s important to look beyond the popular folk-lore of greedy bankers generating new financial products that nobody understood.


policy recommended for the crisis

specific legislation targeted at wellunderstood weaknesses. This will preclude governments of various flavours pursuing their popularitybased programmes. Australian philosopher, Samuel Gregg, Director of Research at the Acton Institute in Michigan, U.S., argues that there is something positive coming out of this Financial Crisis, namely, a refocus on the importance of entrepreneurship: “As the global recession continues to shatter wealth and jobs around the world, it’s heartening to know that some people aren’t looking to governments to solve all their economic problems. From shantytowns to developing countries to the once-mighty centres of international finance, thousands of people are turning to their greatest resource – themselves – and trying to create new streams of wealth through the power of entrepreneurial discovery. Over the past 30 years, however entrepreneurship has received renewed attention, partly because of the immense wealth generated by information-technology breakthroughs; but also because many people realized that they had no choice but to be entrepreneurial if they wanted to escape the economic graveyards created by communism and socialism.” This turn to entrepreneurship, however, was not just a question of circumstances. It also reflects who we are as human beings. We need only read the Bible, Aristotle or Austrian Economist, Joseph Schumpeter, to realize that entrepreneurship is something distinctly human. Unlike animals, people possess imagination, reason, and free will. Thus we are capable of being creative and turning into reality our insights into what might be valuable to others.

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he survival of civilization will be jeopardized by the misdeeds of individual dictators…Its preservation, reconstruction and continuation, however, require the joint efforts of all men of good will.”

To conclude We must shoulder our burden with our eyes firmly fixed on the future, but recognize the realities of today. We should certainly not count on hope or wishes or any misguided belief that governments fully understand our contribution to the nation, or the benefits that will flow from encouraging policies that will result in less interference and more entrepreneurship. Let’s hold clearly in our minds the productive future that would allow Australia to take its place in the modern world. This is our responsibility as custodians of a much maligned and little understood industry, in which we have invested so much in terms of technology and capital, and labour, but so little in terms of philosophy or psychology. In doing so, it will become clear to us all that there is a “primary ideal” that we are all striving for, and that if we have not succeeded, then it is for the simple reason that we have been preoccupied in fighting for our “secondary ideals.” Each of us, as executives and individuals, must understand our various industries and beliefs and learn to take part in public policy-making. We must make our views known and inform the public, so that balanced and realistic policies are produced. If we simply settle for being spectators in all this, we will continue to lose the battle.

The whole community has to be involved if Australia is to have a satisfactory future. That’s our biggest challenge and it reminds me of the words of one of my favourite Austrian economists, Ludwig von Mises: “Success or failure of endeavours to substitute sound ideas for unsound will depend ultimately on the abilities and the personalities of the men who seek to achieve this task. If the right men are lacking in the hour of decision, the fate of our civilization is sealed. Even if such pioneers are available, however, their efforts will be futile if they meet with indifference and apathy on the part of their fellow citizens. The survival of civilization will be jeopardized by the misdeeds of individual dictators…Its preservation, reconstruction and continuation, however, require the joint efforts of all men of good will.” And that would be us. Friends – we have work to do! A version of this speech was presented at The 2009 Sir Arvi Parbo Oration at the AMEC Mining Congress in Perth, Western Australia on the 21st May, 2009. Ron Manners is a fourth generation prospector with over 40 years of experience in the mining industry in WA. He is the Chairman of the Mannwest Group of private companies and the Managing Director of Mannkal Economic Education Foundation, www.mannkal.org

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The Privatization of Public Services John L. Chapman on why privatization is indeed the only hope for renewal of once proud cities

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n public administration, there is no connection between revenue and expenditure … there is no market price for achievements.” – Ludwig von Mises Fifty years ago, Detroit was the fourth largest city in the United States, with a population of 1.7 million people, and at $8,500 per year, one of the richest cities in terms of per capita income. It was 3.5 times the size of Indianapolis, the 26th largest city, whose income was almost identical on a per capita basis.1 Today Detroit and Indianapolis are the 11th and 12th largest cities, respectively, with Detroit’s population cut in half from 50 years ago (and losing 3,000 people per year this decade), while Indianapolis has grown by 70% during the same time frame. Remarkably, Indianapolis now has a per capita income 50% greater than Detroit’s.2 How did this happen? One answer, according to the Mackinac Center for Public Policy, is that Detroit’s city government is far larger, more regulation prone, and more bureaucratic than Indianapolis’s city government: the ratio of residents to city employees, a key measure of city government productivity, is 50:1 in Detroit, one of the worst in the United States, but is 203:1 in Indianapolis, one of the best. More broadly, the central issue in political economy concerns

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www.lumaxart.com

Union workers and businesses win with Indianapolis’ formula: a SELTIC like commission driving change, demanding a culture of excellence dominated by competitive bidding, and transparent reporting and openness.

the optimal delineation of the sphere of government activity versus that ascribed to markets, and in this essay we examine this question from the vantage point of municipalities.3 What does economic theory say about the proper role of government, and how do proponents of larger government attempt to justify their argument? Writers from Aristotle to

Locke to Adam Smith have inveighed against government intervention, and indeed, neoclassical economic theory has affirmed the superiority of free markets as the institutional backdrop most conducive to the generation of wealth. However, allies of big government rely on the modern theory that holds that government provision of goods


policy recommended for the market

and services is warranted in cases of market failure or externalities in production.4 Markets are said to fail in the event of natural monopoly (where average production costs decrease with increasing scale, and hence the most efficient industry structure is a single producer) or in the case of public goods such as national defense, where consumption of the good is nonexcludable and nonrivalrous (e.g., the consumption of national defense services, say, unlike the purchase of a home or an automobile, cannot preclude a “free rider” from enjoying the same services). Meanwhile, a popular example of a negative externality is factory pollution, where property rights are not clearly defined; in all these cases, traditional economic theory offers a prima facie rationale for government intervention or regulation. The Austrian School of economics does not countenance the received theory in these instances: Ludwig von Mises pointed out, for example, that monopoly could only technically occur in an instance where a scarce resource was controlled by a single party (e.g., the DeBeers diamond holdings approach this), and thus most observed instances of monopoly were in fact generated by government sanction (e.g., public utilities). Similarly, Austrians point out that public-goods provision as justified by the existence of free riders is often a case of poorly defined property rights.5 Nonetheless, as Tocqueville presciently warned, the activity of government at all levels of society has not been constrained, not even merely to the provision of public goods: the tendency has been for many indisputably competitive services to be provided by municipal, state, or federal governments, often in the name of redressing alleged social ills

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ublic-goods provision as justified by the existence of free riders is often a case of poorly defined property rights.

such as inequality. Via progressive (and progressively increasing) taxation, this has unduly burdened the public purse at all levels, and led to hardship, particularly in many “Rust Belt” cities. In this essay we examine the linkage between taxation and the size of municipal government on the one hand, and economic vitality on the other, which is proxied by data involving population or per capita income changes. Via a case study of one Rust Belt city, Akron, Ohio, we review the recent history of how it has fared comparatively in terms of economic vitality.6 While the picture depicted is bleak and an all-too-predictable consequence of unrestrained growth in government, we then turn to a solution to Akron’s problems — the only viable solution — based on privatization of city services and a lessening of the (tax) burden of government. This discussion is gleaned from well-run cities in the United States. We then conclude with observations about the meaning of these findings for the future of urban America.

Akron, Ohio’s experience with growing government and subsequent economic health Akron was once a proud industrial city, and home to the largest tire makers in the world. Aligned with manufacturers in nearby Pittsburgh, Cleveland, and Toledo, Akron supplied the automotive industry in Detroit, and was known as the world’s “rubber capital.”7

The city has been in a long-term secular decline, however, and city government is now dominated by the longest-running mayor in the city’s history — 20 years and six terms.8 A review of this period is in order, therefore, to assess economic growth in relation to the current administrative regime there. For this analysis, the US Census Bureau’s Statistical Abstract of the United States and the Mackinac Center for Public Policy (a Michiganbased institute studying regional economies) are reliable data sources yielding the following observations: • The leading indicator of regional growth is population. While the US economy and population steadily advanced since 1987, Akron’s population declined by 21,000 since then, to the current total of 209,000 residents. At the start of the current mayor’s tenure, Akron was the 66th largest city in the United States; today it is the 92nd. From among the 100 largest cities in 1987, this is one of the most precipitous drops in the rankings, indicating an unusually poor growth environment relative to peer cities. Further, during 1990–2000, the latest decade for comparative data, of the 239 cities in the United States with population of at least 100,000 people, Akron ranked 212th in population growth, with a net loss of 6,108 residents. In contrast, other Midwest cities with demographics comparable to Akron fared far better: Cedar Rapids, Iowa (+11,904); Grand Summer 2009

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Best Practice

• Discussed below, one key “best practice” for cities battling bureaucratic waste is privatization or competition for municipal services. Indianapolis saved $480 million in the 1990s via competitive bidding or privatizing 75 services which had previously been 100%-government owned and controlled, from golf courses to print shops to janitorial services. Similarly, Ed Rendell saved Philadelphia $275 million with competition for 49 services. Yet this is one “best practice” that has never been tried in Akron.10 • Akron is an aging city: of 239 cities in 2000, Akron ranked 45th in terms of percentage of population over age 65 (13.5%), and if corrected for retiree cities in the Sun Belt, Akron fares comparatively more poorly. This signifies a lack of entrepreneurial vibrancy borne of a poor record in attracting new businesses and is a dangerous indicator in terms of prospective economic growth. • In terms of poverty and its most effective antidote, vibrancy of employment, Akron has long fared comparatively poorly; between 1999 and 2005, the percentage of residents

in poverty increased from 17.5% to 20.1%, which was 45% higher than national figures. Conversely, Akron had the 47th highest unemployment rate (of 239) in the United States in 2000; examining metropolitan statistical areas (MSAs) shows little improvement, as Akron currently has the 117th highest unemployment rate (5.8%) of 369 MSAs. • Employment begets income, which generates wealth and economic stability; the obverse of this is also true: prolonged periods of high relative unemployment generate decline. Among the top 100 cities in the United States, Akron has the 18th largest foreclosure rate; by contrast, Pittsburgh, Buffalo, and Syracuse are 80th, 83rd, and 92nd, respectively, indicating more resilient growth potential elsewhere in the Rust Belt. • Lastly, Akron is best compared to the state of Ohio, which takes in four bigger cities and a few smaller ones (Dayton, Youngstown), all having similar demographics. These data, shown for the most recent year available since 2000, portray the relative performance of Akron’s government at generating growth:

Comparative Statistics from the 2000 Census Metric

Akron

Ohio

Population change, 1990–2000

-2.7%

4.7%

Population change, 2000–2003*

-2.2%

0.7%

High school grads

80.0%

83.0%

College grads

18.0%

21.1%

Home ownership %

59.4%

69.1%

Mean house value

$76,500

$103,700

Median household income

$31,835

$40,956

Per capita income

$19,500

$25,000

Per capita retail sales

$8,023

$9,181

Poverty rate, 1999

17.5%

10.6%

* Connotes relative decline continuing into 2000s for latest available comparative data; Akron population loss is now -3.2% from 2000 to 2007.

Source: US Census Bureau

Rapids, Michigan (+8,127); Green Bay, Wisconsin (+5,616); and Rockford, Illinois (+6,173). All give lie to the notion that the decline that Akron experienced was “inevitable.” Different policies and leadership produced different results elsewhere. • Across 20 years, the current city government has pressed for numerous tax increases, implying Akron is underfunded. Yet according to the 2000 census, in measuring city government taxes per capita, Akron was 50th highest (of 239), at $668 per resident. So, Akron’s decline is not a story of an undertaxed city with an underfunded government. To the contrary, among the 239 largest cities in the United States, the majority of the lowest-taxed cities are in high-growth regions (e.g., Texas, Florida, inland California). This confirms empirical research in economics, which has repeatedly shown that high tax regimes act as a drag on employment and income growth. • High taxation in turn can breed bureaucratic waste: as stated above, a key measure of “bureaucratic bloat” in municipal government is the ratio of city residents to full-time city employees. Again, Detroit (50:1) is a poorly managed city with a wasteful government; Indianapolis (203:1), conversely, is run efficiently, and even Los Angeles is 108:1. The ratio for Akron is 86:1, which is hardly a ringing endorsement of efficient city operations and judicious deployment of taxpayer funds.9 Akron’s city employees also average $74,700 in total compensation, or 2.3X the median household income (and 3.5X per capita income) of the city’s population, a clear indication of patronage.


policy recommended for the market

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ts best – and only – hope, however, lies in replicating what has worked elsewhere, and involves cutting government and increasing the sphere of private sector activity. In sum, Akron is seriously declining: since 1987, the US economy is 70% bigger in real terms, but Akron has lost 21,000 people. This period has been one of poor leadership, borne of an entrenched government, unfriendly to business and growing both absolutely and relative to other municipalities in size and scale of operation. However, economic decline is not inevitable, and Akron can achieve a strong turnaround, given its considerable assets. Its best — and only — hope, however, lies in replicating what has worked elsewhere, and involves cutting government and increasing the sphere of private sector activity.

Case study of private sector solutions: Indianapolis

(1) Creation of the “SELTIC” (“Service, Efficiency, and Lower Taxes for Indianapolis Commission”) — SELTIC was composed of nine private-sector volunteers, primarily leaders in the business community, who in turn chaired subcommittees with more volunteers with various needed functional expertise or skills. SELTIC’s mandate was to study every activity of city government, from wastewater treatment to business licensing. The goal: make every city service higher quality, less expensive, and business friendly — or eliminate it altogether. Best practices were gleaned from other municipalities or the private sector, and benchmarking was done for competitor cities and suburbs. SELTIC reported to Mayor Goldsmith, and became an outreach vehicle for new business recruitment. This commission was the driver of the ensuing miracle in Indianapolis, and has been copied all over the United States. Under Goldsmith, Indianapolis cut its budget and

Carl Van Rooy

Indianapolis in the 1990s provides a lodestar as a model. In the early 1990s the city and local economy were still restructuring from an earlier stagnation in which, as in Akron, durable manufacturing jobs had been lost; the population of Indianapolis was 15,000 less than in 1970. While the city had begun to diversify into services such as health care in the 1980s, only the government sector had grown materially (Indianapolis is the state capital). Further, property tax and county income tax rates had exploded, and were up 25% and 350%, respectively, during the 1980s.11 Mayor Stephen Goldsmith took office in 1992, committed to a

turnaround based on privatization of city services, and creating a climate more conducive to entrepreneurship. During his eightyear tenure as mayor, the city’s population increased by nearly 50,000 residents, induced by a more business-friendly environment and its corollary, smaller government. The Indianapolis turnaround was engendered via a three-part program:

accrued savings of $480 million in eight years (based on straightline projections dating to the early 1980s); cut its employee workforce from 4,650 to 3,400 (improving its efficiency ratio of residents to employees to one of the best in the nation, well over 200:1); cut property taxes four times; held its income tax steady after ten years of increases; and saw its municipal debt upgraded to AAA.12 Finally, unemployment declined from 5.2% to 2.3% during Goldsmith’s eightyear tenure, beating the national averages absolutely and relatively. As a result of this impressive performance, over 3,500 mayors, governors, and councilmen came to Indianapolis to learn how it was done in the late 1990s. A long literature in Austrian economics details how and why governmental bureaucracies fail in the real world; in brief, there are problems with incentives, and failures to exploit knowledge that can solve problems in society.13 Further, absent private property, there is no entrepreneurship — what Israel Kirzner refers to as the driving force of the market economy — and thus poor coordination and use of resources. The SELTIC commission provided empirical validation to

Since the launch of privatization programs, business and job opportunities have flourished. The government is more efficient than before, attracting businesses and people moving back to Indianapolis.

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(2) Commitment to excellence via privatization — In business or government, monopoly can be inimical to economic growth. Monopolists retard quality and customer service, increase costs, and impede innovation, and America’s best-run municipalities now choose private competition over monopoly wherever able. This was the secret to the Indianapolis boom, which other cities have now replicated, and it is Akron’s best hope for its future. How does it work? Indianapolis’s SELTIC started with a “yellowpages test”: dozens of city services, from janitorial to print shop to sewer billing to golf course management, were analyzed to see if private-sector vendors offered the service in the yellow-pages. If so, a competitive bidding occurred for contracts to provide the service. This is outsourcing with a twist, however, because if the private vendor won the bid, it absorbed the city’s AFSCME (American Federation of State, County, and Municipal Employees) unionized workers. In fact, during Goldsmith’s 8-year tenure, not one city employee became unemployed; the employer merely changed, with Indianapolis insisting that comparable pay and benefits be initially maintained.

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And in unique arrangements, AFSCME sometimes continued to represent the workers under nowprivate ownership. Eventually, 75 services were put to competition: sometimes the city employees won the contract; sometimes a private firm won; but in all cases, huge savings and efficiencies emerged. This is how Indianapolis cut 43% (1,200 workers) of its non–public safety workforce, and shaved $480 million from its budget in 8 years.14 And happily, the public sector union, AFSCME, generally applauded Indianapolis’s public-private partnership excellence, especially when workers received incentive bonuses allowed by new ownership and governance. The lowered burden of government unleashed the private sector of the Indianapolis economy across the board: per capita income was up by a fourth at decade’s end, and employment growth averaged 1.4% every year during the 1990s. Many cities have copied this formula now for the same reasons: Green Bay, for example, privatized its transit system, with cost savings of 7% annually and improved service quality. Managed competition was instituted in Phoenix and Charlotte for waste collection, Buffalo for recycling, and Dallas for vehicle fleet maintenance. Ditto for Los Angeles golf courses, Riverside County’s libraries, and facilities maintenance

ot one city employee became unemployed; the employer merely changed, with Indianapolis insisting that comparable pay and benefits be initially maintained. 30

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this thesis, and was an essential part of the revivification of the city of Indianapolis.

Detroit and Indianapolis were thriving fifty years ago, but Detroit has fallen far behind. One theory behind its disintegration is that Detroit’s city government is far larger, more regulation prone, and more bureaucratic than Indianapolis’ city government.

in Cincinnati. Virtually every municipal service is easily amenable to competition (if not outright privatization), with impressive results in better quality and efficiency, lower costs, lower taxes, and improving job-creation environments.15 From the foregoing, it is clear that Akron needs to seek efficiencies and cost improvements in order to lower city spending. Why? Because taxes must be lowered for Akron to revive. Only 20% of US cities have more onerous tax structures than Akron, and there is a significant correlation between low taxes and job growth. For example, since 1990 Akron has lost 14,000 people, and Green Bay has gained 7,000 with similar demographics; Green Bay’s per capita tax burden is less than half of Akron’s. And, Green Bay’s per capita income is now 25% higher, while its resident/city-employee ratio, again a key measure of municipal government productivity, is 27% better than Akron’s. Similarly, in 1999, Goldsmith’s last year, Indianapolis had a budget of $545 million (in 2007 dollars), and employed 3,400 (down 1,200


policy recommended for the market

from eight years earlier); Akron’s 2007 budget is almost as big at $490 million, with only 2,400 employees. Worse, Indianapolis had a population then of 780,000 — nearly four times that of today’s Akron. Clearly, Akron city government is inefficient and the primary reason for the long-term downdraft in growth, and needs a SELTIC in the manner of Indianapolis. (3) Transparency — Private-sector innovation brings tools to generate efficiency, quality, and integrity: activity-based costing, performance measurement, audits, and explicit contract requirements were all part of Indianapolis’ success. This enforces a culture of excellence in contrast to, say, Akron’s city managers, none of whom — even in the year 2008 and “post-Enron era” — have written job descriptions against which performance can be judged, according to the city of Akron’s finance director. As an example, the website for the city of Akron contains the 2007 annual budget in a document of 27 pages; it is impossible to glean details from this summary.16 Mayor Jim Schmitt of Green Bay, whose website, by contrast, contains a detailed 192-page city budget audited by a third party, summed up what such a culture breeds. Schmitt, who moved his economic development team next to his office and spends over half his time in business recruitment, said that “entrepreneurs know what they’re doing; the best thing we can do is get out of their way.” Their creative ideas and systems, he said, help both private and public sectors become better. Indeed, football wasn’t the only winner in Green Bay this fall: WS Packaging Group, a $380 million-in-revenues manufacturer of labels, coupons, and

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chmitt, who moved his economic development team next to his office and spends over half his time in business recruitment, said that “entrepreneurs know what they’re doing; the best thing we can do is get out of their way.”

packaging, has just committed to move to the city, and population is up by over 1,000 in Schmitt’s 4-year tenure.17 Indianapolis, and more recently cities like Green Bay, offer a blueprint for the renaissance of Akron: 1. a SELTIC-like commission driving change, 2. demanding a culture of excellence dominated by privatization and competitive bidding, and 3. transparent reporting and openness. It is a formula by which Akron’s union workers and businesses can win, and it confirms a fundamental verity propounded by Austrian economists with respect to the ironclad nexus between limited government and economic growth.

Summary Municipal governments that grow raise the tax burden on their residents, and this in turn acts as a drag on both the future tax base and economic growth of the area. The decline of Akron, Ohio is a clear example of this, and the resurgence strategy of Indianapolis in the 1990s is the only path to a reversal of fortune in this case. Indeed, a long-term view of this is instructive, as per Detroit and Indianapolis

discussed at the outset. While both are Midwestern cities with a heavy industrial base, they are at opposite ends of the spectrum in terms of size and scope of municipal government: the size of government for each city is in inverse proportion to their levels of per capita income. Indianapolis continues to grow, while Detroit’s population is declining on a weekly basis now. In closing, it is instructive to reiterate why privatization is indeed the only hope for renewal of once proud cities. In his 1944 book entitled Bureaucracy, Mises distinguished between “bureaucratic management” and “profit management.”18 He explained that neither incentives nor exploitation of useful information are optimal under bureaucratic management, and by definition there could be no rational calculation via profit and loss. Hence, coordination of resources will never be optimally efficient. That is to say, it is in the very nature of government management (bureaucracy) that it will be inefficient, and prone to corruption. Conversely, after privatization, operations and cost efficiencies improve because once incentives are in place and aligned, and people are empowered and incited (by the lure of profit) to utilize “particular knowledge” of markets, methods, Summer 2009

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policy recommended for the market

David C. Pearson, M.D, www.PearsonFaces.com

3 There are two major drivers of differences in the relative economic efficiency of municipalgovernments. First, some city executives are simply smarter and more effective in execution. Mises points out that while there is no profit-and-loss accounting (economic calculation) for the services of, say, a police force guarding a large facility, the fact that municipal bureaucracies exist alongside private enterprise may allow observation of economic methods from the private sector (e.g., one city may discern, say, that only 20 policemen could do the job where 30 are employed in a city run by less astute executives). Secondly, some cities simply take on services which may be more effectively provided by the private sector (e.g., golf courses, print shops, fleet maintenance, etc.). And once under city management, the very nature of bureaucratic management, according to Mises — again, devoid of profit-and-loss accounting tools — guarantees less efficient operation. Mises mentions a third reason — often found in municipal government operations — that breeds inefficiency: corruption and racketeering. All these combine to generate diseconomies of scale in municipal government.

Municipal governments that grow raise the tax burden on their residents, and this in turn acts as a drag on both the future tax base and economic growth of the area.

competitive conditions, et al., performance improves.19 Finally, Mises also warned of a byproduct of bureaucratic management: the “vanishing” of the “critical sense.” He again described this phenomenon in “macro” terms (e.g., the German people giving up on a liberal order during the 19th-century prelude to Bismarck’s socialism), observing how the docility of a whole people could arise in the face of a dictator. But this obviously occurs in enterprises operated by municipalities, too, which are not subject to the competitive whip of profit-and-loss competition. It is perhaps the final guarantor of the certain failure of bureaucratic enterprise, relative

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to the initiative, entrepreneurship, integrity, and pride witnessed in the private sector. Indeed, the very hope of Akron — and cities like it — is embodied in this latter mindset. John L. Chapman, Ph.D. is the NRI Fellow in Economics at the American Enterprise Institute. Reprinted with permission from Mises.org. 1 See http://www.census.gov/hhes/www/income/ histinc/msa/msa3.html (http://www.census.gov/ hhes/www/income/histinc/msa/msa3.html). 2 See Indianapolis Star, December 22, 2007. The figures are $21.6k and $14.7k, respectively, for Indianapolis and Detroit. Additionally, in the last year the unemployment rate in Detroit has fluctuated between 8–9%, while it has remained inside 4% in Indianapolis.

4 While beyond the scope of this essay, the Austrian literature offers a substantive critique of neoclassical theory with respect to market failure and externalities; see, for example, the writings of Walter Block, Roy Cordato, Randall Holcombe, George Reisman, et al. James Buchanan criticizes the modern theory in his 1968 book The Demand and Supply of Public Goods (Chicago: Rand McNally), and of course developed an entirely new paradigm for viewing these issues (public choice), in which government failure was depicted as the empirical norm for regulatory and interventionist programs which neoclassical theory had predicted to be ameliorative. Nonetheless we briefly summarize the standard theory justifying government. 5 And, as Ben O’Neill has pointed out here recently (http://mises.org/story/2769) , it is not at all clear that free riding is harmful to economic agents, absent coercion. 6 A disclaimer is in order: I am not a disinterested observer in Akron. My greatgreat-great-grandfather settled there in 1831 in a farmhouse still used today; I am a sixth-generation Akron native; and, I am a product of Akron public schools. Akron’s recent fortunes, however, mirror many cities in the Midwest, which are often controlled by one dominant local political party for multiple election cycles, and have witnessed concomitant growth in municipal government and in the range of services government provides. 7 The headquarters for Goodyear, Firestone, B.F. Goodrich, General, and many lesser tire companies were once all in Akron; today, only Goodyear (founded in 1898) remains, with a much smaller workforce of management and R&D personnel only. Astonishingly, not one tire is made in Akron any longer, as production has moved to the less-unionized south or overseas. Michelin (France), Continental AG (Germany), and Bridgestone (Japan) are now


policy recommended for the market

the world’s biggest tire makers, a position Goodyear held for most of the 20th century. Tires were the main product focus, but other rubber and polymer-based products, for both industrial and commercial use, have long been a part of the mix. 8 The mayor of Akron was president of the US Conference of Mayors in 2004, and has been described by the local newspaper, the Akron Beacon Journal, as providing two decades of leadership from which the city of Akron “has substantially benefited.” The same newspaper, however, has criticized questionable practices such as the hiring of “consultants” in unilateral decisions or no-bid contracts, or having a minimum-wage parking lot attendant fired from his job for not recognizing the mayor and insisting on a $5 parking fee payment the mayor tried to evade. The colorful personality of this politician and the details of his perquisite consumption and governance are beyond the scope here, other than to note that his is an entrenched administration, and a classic case to which proponents of term limits point. 9 According to the City of Akron 2007 Budget, there are 2,409 city employees, indicating a resident/employee ratio of 86:1. 10 A distinction should be made between pure privatization, in which the governmental entity sells (or otherwise relinquishes) a service unit to owners in the private sector (such as when, say, the Thatcher government in Britain sold off state-owned utilities like British Telecom to private investors, and BT became a wholly investor-owned company, traded on the London Stock Exchange), and competitive bidding for outsourced service provision, in which the governmental entity outsources a service to market-based competitors via a bidding process. The latter still involves government management and oversight, but is at least an improvement from the provision of the service by a government-owned or controlled monopoly. Below we detail the case of Indianapolis: 75 service units were affected by the “privatization” push, utilizing that term to include competitive contracting and outsourcing in some cases, while in other cases a private firm won the contract for the service and absorbed the city’s employees into its business. Indianapolis thus reduced city employee headcount from 4,600 to 3,400 between 1992 and 2000. In a minority of cases, the city business unit actually won in an open bid against private contractors, and thus “retained” the business, but the competitive whip of the process itself led to productivity gains of the work unit, postcontract. These units were also able to sell their services to other entities or municipalities, so they became revenue centers, and the employees got bonuses based on unit performance. Clearly, competitive contracting and outsourcing still involves government control over resources that may be best suited to the private sector (why, for example, should a municipal government own and run a golf course?). However, as shown below, the Indianapolis strategy for shrinking city government and the tax burden is tantamount to the reverse of Lenin’s New Economic Policy of 1921: Lenin allowed for market measures and private

property and production to flourish after 1921, arguing that conditions only permitted introducing socialism “step by step.” Where possible, Indianapolis privatized completely, while in other cases the breaking up of de facto government monopoly service provision, via competitive contracting and outsourcing, certainly creates the opportunity for eventual privatization by manifestly highlighting service level, cost, and quality improvements. 11 Indeed, there is an undeniable connection between local tax rates and population growth. In 1980, according to the National League of Cities, per capita income of city residents nationwide was 90% of their suburban counterparts. That figure had imploded to 59% by the end of the decade, after heavy tax-rate increases in most municipalities were tried to make up for a declining tax base; a primary reason for the decline was departure of residents to suburban areas with more favorable tax regimes. In Indianapolis, this problem was still manifest a decade later; for example, the net property tax burden on an $80,000 house in Indianapolis in 1999 was $1,474. The same house was assessed only $1,074 in adjacent Carmel, Indiana, or $1,037 in Greenwood, another suburb. In downtown Indianapolis the property tax rate was $12.63 per $1,000 of valuation; surrounding townships averaged $7.51. Source: City of Indianapolis, 1999, A Competitive City. 12 The bond rating improved because agencies saw (a) the deep cuts in spending and smaller government (city payroll went from 4,600 to 3,400 in 8 years), (b) cutback on regulations and licensing (i.e., the SELTIC commission and Goldsmith were pro-entrepreneur and eliminated red tape), (c) lower rates and an improved tax base borne of a better climate for the private sector, and (d) increasing entrepreneurship — new business formation and population started growing again, and after earlier population losses there were 50,000 more people in Indianapolis at decade’s end. This materially helped Indianapolis’ long term financial posture by lowering financing costs. 13 The works of Ludwig von Mises (e.g., Socialism (http://mises.org/store/Socialism-P55C17. aspx) , 1927; Bureaucracy (http://mises.org/ store/Bureaucracy-P47C17.aspx) , 1944; and Human Action (http://mises.org/store/HumanAction-The-Scholars-Edition-P119C17.aspx) , 1949) of course are replete with this theme, and in general, the impossibility of economic calculation in a socialist society (of which municipal government is a microcosm). As one example of this, the SELTIC commission identified pothole paving as a service which might be outsourced to private vendors. The commission inquired of the city’s roadway maintenance department what it cost to fill a pothole on average, and received the reply that the department did not know. There were no activity-based costing tools in place to gauge this, and no incentives to economize on labor or material costs. This was obviously one of the 75 services identified as candidate for privatization. 14 Actually, at the end of his eight-year term, Mayor Goldsmith’s operating budget for the

city was $18 million lower than his first year, and straight-line projections coupled with real decreases yielded over $600 million in savings. The city had dramatically downsized, and become one of America’s most efficient. The lower taxes that accompanied a declining budget sparked business growth. 15 Of course many Austrian economists hold this to be a weak proposition; even police services can be privatized. For example, Murray Rothbard’s 1970 book, Power & Market (http://mises.org/store/Power-and-MarketP322C18.aspx) (Kansas City: Sheed, Andrews, & McMeel) offers an excellent theoretical defense of this thesis. 16 See the budget at http://ci.akron.oh.us/ finance/07bud_in_brief.pdf (http://ci.akron. oh.us/finance/07bud_in_brief.pdf). According to the finance director of the city of Akron, the city is audited by the State of Ohio, where more detailed records of city spending can be obtained. 17 Green Bay’s budget can be found at http:// www.ci.green-bay.wi.us/forms/financial_report. pdf (http://www.ci.green-bay.wi.us/forms/ financial_report.pdf). 18 The book (http://mises.org/store/BureaucracyP47C17.aspx) is a continuation of Mises’s theme in the socialist calculation debate, which referred to the “macro” issue of economic efficiency under capitalism and socialism; Mises (and Hayek) held that rational calculation — and, by extension, efficient utilization and coordination of scarce resources — were impossible in a socialist society, absent property, prices, and profit-and-loss accounting, along with a void in entrepreneurial exploitation of both tacit and explicit knowledge. But in Bureaucracy (http://mises.org/store/Bureaucracy-P47C17. aspx) , Mises also extends this analysis to management of enterprises, both private and public, and the consequences of the absence of profit-and-loss accounting tools and incentives for management. His observations are embodied in usually ineffective government management practices observed today. See Bureaucracy (http://mises.org/store/ Bureaucracy-P47C17.aspx) (published in 1944 by Yale University Press, New Haven). 19 As one example of the 75 services outsourced, privatized, or opened to competitive bidding, vehicle fleet maintenance trimmed its workforce by 29% in the first four years of bidding, spending fell from $11.1 million in 1992 to $9.1 million in 1995 (which equaled the 1988 budget), turnaround time for cars went down even though the fleet size had increased due to the advent of take-home police cars (workers began to operate in worker-managed teams, and ended featherbedding practices — the number of cars serviced within eight hours jumped from 70% to over 80%), and billable hours per mechanic rose an impressive 21%. The number of annual written complaints about the department decreased from 149 to 5 in this timeframe. This all came about once incentive and information problems, always latent under bureaucratic management, were eliminated.

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Hong Kong and Capital Controls Jim Walker questions the controls in the betting arena

The Heritage Foundation

Distribution of Economic Freedom

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passed the Gambling Ordinance (Chapter 148 Section 8) which states: “Any person who bets with a bookmaker commits an offence and is liable – a) On first conviction to a fine of $10,000 and to imprisonment for 3 months; b) On second conviction to a fine of $20,000 and to imprisonment for 6 months; c) On third or subsequent conviction to a fine of $30,000 and to imprisonment for 9 months, Whether the bet is received within or outside Hong Kong.” This truly is a draconian ordinance worthy of any restrictive, authoritarian regime. In the government’s defence of such a law, it stated to Legislative Council members that it was protecting Hong Kong citizens from the temptations of gambling. However, it went further. The law can be applied to any foreign visitor to Hong Kong as well. In other words, the government decided to protect any foreign national – who may come from a country in which it is perfectly legal to gamble

he controls are, as always with the start of such things, selective and dressed up in language that suggests the government is protecting its citizens, and tourists, from themselves.

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Jim Walker

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or fifteen straight years Hong Kong has been named the freest country in the world in both the Wall Street Journal and Heritage Foundation’s Index of Economic Freedom. In 2009, Hong Kong slightly extended its lead over second-placed Singapore and scored a possible 90 out of 100 in the index. But here’s a question: does the Index take into account that Hong Kong imposes capital controls on its residents and visitors? The controls are, as always with the start of such things, selective and dressed up in language that suggests the government is protecting its citizens, and tourists, from themselves. In 2002, the Hong Kong government

Hong Kong residents owning horses abroad are essentially banned from watching their own horses race under current Hong Kong law, leading to a monopoly on the racehorse-betting industry by the Hong Kong Jockey Club.

with bookmakers – from the ravages of gambling. It does so by offering them a fine and imprisonment – there is no mention of counseling. Why might this be of interest to people living in Hong Kong? After all, there are no bookmakers in Hong Kong. The only legitimate betting agency in the territory is the Hong Kong Jockey Club operating through its outlets at Sha Tin and Happy Valley racetracks and its roadside venues. Betting is allowed in these locations on Hong Kong horse racing, selected soccer games, including the English Premier League, and the Mark Six lottery. What more could a Hong Kong resident want? What if a Hong Kong citizen happens to own racehorses in the U.K.? It is legal for Hong Kong residents to own these racehorses but, according to Hong Kong law, it is illegal for them to bet on them. And, it is illegal to bet on


policy recommended for the market

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hat is worse, because of this absurd restriction, Hong Kong residents who own racehorses overseas cannot even watch their own horses race. from anyone located in Hong Kong, (it is not just the gambler that is threatened with legal penalty – the bookmakers are too) they will not open an account with anyone with a

David Wong

them because betting must be done through a bookmaker that is located outside Hong Kong. What is worse, because of this absurd restriction, Hong Kong residents who own racehorses overseas cannot even watch their own horses race. In order to be able to access the Internet networks that show U.K. racing, one must place a bet on the race. But since all U.K. bookmakers have been informed of the illegality of accepting bets

Under current Hong Kong law, the Hong Kong Jockey Club, pictured here on the grounds of the Sha Tin Racecourse, is the only legitimate betting forum in the territory.

Hong Kong address – physical or IP. If one visits Singapore, the second freest country in the world according to the Heritage Foundation, they can bet on their horse in the U.K., and can even watch it run via the Internet without being subjected to any capital controls. If one lives in China, they can register with William Hill (a leading U.K. bookmaker), place bets over the Internet and, if they have good Internet access, watch the races online as well. The same is true for the other Special Administrative Region, Macau. Indeed, if one tries to open an account with William Hill, Hong Kong does not appear as an option in the ‘country of residence’ list. Why is all of this the case? Is it really because the Hong Kong government wants to protect its citizens from the gambling ‘disease’ or is it because it wants to protect its own revenues? The timing of the Gambling Ordinance gives the game away. In 2002, Hong Kong was in its fifth year of deflation following the Asian Crisis. Its public finances were in a mess with concern growing about the extent of the deficit. Time Magazine published an issue with the front page headline, “The Death of Hong Kong?” In prior years it had been established that the government – and the Hong Kong Jockey Club – had been losing out on much needed gambling revenues to illegal offshore bookmakers. Syndicates running books on Hong Kong racing (and influencing its outcome) were Summer 2009

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policy recommended for the market

Spectators and Bidders at the Happy Valley Racecourse

the stuff of legend in the 1990s. It was important and sensible for the government to address this abuse. First of all, the existence of illegal syndicates making money off of race fixing in Hong Kong places all legitimate punters in the territory at a disadvantage. That in itself was reason to act. Second, it is equally understandable for a racing authority to protect its copyright. All racing authorities do that. No bookmaker, either inside or outside a jurisdiction, has the right to accept bets on specific sporting events without paying a license fee to the owner of the event data, the information pertaining to each race, such as the horse’s name, the trainer, the jockey and, most importantly, the form. This is the core business of the established racing authority and it is only right that it receives payment for its proprietary information. Anyone using that information for the purposes of ‘making a book,’ i.e., accepting bets on the race at specified odds, is guilty of theft, plain and simple. Third, it is understandable for

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a government to wish to protect its citizens from unscrupulous or unlicensed bookmakers. Unofficial – usually known as illegal – bookmakers are normally involved in crime, money laundering or outright fraud. Sometimes innocent citizens have to be protected from themselves. But surely, that is the extent to which governments should be involved with their citizens. To ban them from betting with legitimate bookmakers in such territories as the U.K., the U.S., Australia, Japan, and many places over which Hong Kong has no authority, nor any quibble with the ownership of the betting rights is an abuse of power and an encroachment on personal freedoms. Heritage Foundation please take note. The days of worrying about the Hong Kong government’s fiscal position are over. The need for draconian legislation to stop betting flows from leaving the country passed with Hong Kong’s revival in the mid-2000s. The time to bring Hong Kong back up to best practice with respect to offshore betting is long overdue. At the very

he need for draconian legislation to stop betting flows from leaving the country passed with Hong Kong’s revival in the mid-2000s.

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least, the government should amend the Gambling Ordinance to make it clear to residents and visitors that they will not be penalized for betting on a horse race, or any other sporting event outside Hong Kong that is not part of the betting services already offered by the Hong Kong Jockey Club. It is also time to decriminalize gambling with legitimate offshore bookmakers who are offering a service in the locations for which they are licensed. In that way, those who are lucky enough to own horses outside Hong Kong could bet on their own horses and actually watch it race through the wonders of modern technology. Until that is the case, Hong Kong will remain one of the most restrictive gambling jurisdictions on the planet, guilty of encroaching on personal freedoms and restricting the free flow of capital. Once established in law, such seemingly small abuses of freedom have a tendency to grow and multiply. What will be next – restrictions on shared dealings by Hong Kong citizens in the U.S. and other markets because they are avoiding stamp duty? Time for change before Hong Kong loses its number one ranking. Jim Walker is the founder and managing director of Asianomics Limited, an economic research and consultancy company.


global perspective policy analysis

Combating the Spread of Fake Medicines Through Free Markets and Self-Interest Julian Harris and Alec van Gelder trail counterfeit medicines and suggest systems to help China shed its “Factory Asia” label Christina Rudy

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“near scandal” is how the China Daily described the death of patients in Hong Kong hospitals last year – deaths thought to have been caused by substandard drugs.1 Meanwhile the outbreak of swine flu has led the Pharmacists Association of Hong Kong’s president to warn that many online versions of Tamiflu are fake.2 Drugs of poor quality, and even fakes containing deadly ingredients, plague especially the poorer parts of the world with Africa most severely affected. A recent study found over a third (35 percent) of antimalarials in major African cities were substandard,3 while a survey across Angola, Burundi, and the Congo declared that almost half (46 percent) of all drugs failed quality tests.4 Many of these drugs are counterfeits, often including no active ingredient whatsoever. Yet, as the recent revelations in Hong Kong demonstrate, the problem is by no means confined to the least developed countries. In the U.K. earlier this year, for example, counterfeit drugs worth a quarter of a million pounds were discovered in a raid.5 A couple of weeks later, the U.K. agency MHRA (the Medicines and Healthcare Products Regulatory Agency) discovered a batch of counterfeit insulin pen needles.6 Referring to a seizure of fake erectile dysfunction, anxiety and weight loss drugs, an MHRA official declared “[e]nquiries suggest that the counterfeit medicines originated from China.”7 Dangerously substandard and counterfeit products seem to go hand in hand, with certain areas suffering chronically from both. Some health activist groups contend that “substandard drugs” must be treated entirely separately from “counterfeit drugs”; 8 the latter, they argue, are “deliberately and fraudulently mislabelled” rather than drugs that are poorly made

simply due to neglect or mistake. The distinction, however, is of little difference to victims, and is typically impossible to maintain in the field. Regarding the aforementioned 35 percent of failed antimalarial drugs in Africa, how many of these can be proven to have been deliberately made badly? Moreover, who cares? If they fail to work, the effect is the same. Almost all counterfeit drugs will be substandard (why produce a fake if you can make a high quality version?). Similarly, substandard drugs are in a sense counterfeits as they are not what they purport to be. A substandard artemisinin drug which fails to cure malaria cannot claim to be a genuine antimalarial product. All such drugs are therefore “fakes.” The inescapable reality for Hong Kong is that China is thought to be one of the hubs of fake drug manufacturing in the world, although it likely trails India in this regard. Many of India’s 20,000 drug manufacturers purchase raw products (active pharmaceutical ingredients, API) Summer 2009

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global perspective policy analysis

Toby Forage

from China, where the state is desperately trying to be seen to clamp down on producers of fake pharmaceutical materials, having admitted that fake medicine selling has become “rampant in recent years.”9 At the root of the problem in China are fetters on liberal institutions; stifling a competitive market in high quality consumables are press restrictions, government favouritism and a lack of independent, reliable civil law. According to the Wall Street Journal, a Chinese reporter intent on drawing attention to dangerous cases of melamine-contaminated milk (that ended up killing several children) was gagged by the state’s Propaganda Department. Meanwhile, political interference in the courts is a possible reason why victims cannot obtain redress from companies guilty of supplying dangerously substandard products. Following the poisoning of thousands of American pets via Chinese pet food, owners are close to a $32 million settlement – yet multiple cases filed by Chinese citizens, including those who have suffered from melamine poisoning, have been thrown out by the courts.10 Li Guorong, the General Manager of China United Intellectual Property Protection Center, elucidates on

While some health activist groups contend that “substandard drugs” must be treated separately from “counterfeit drugs,” the distinction is of little difference to victims.

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t the root of the problem in China are fetters on liberal institutions; stifling a competitive market in high quality consumables are press restrictions, government favouritism and a lack of independent, reliable civil law. the political interference that can thwart action against counterfeiters. Radical action against counterfeiting, he says, would “destabilize a government where counterfeit factories and warehouses are often owned by local military and political grandees.”11 Devoid of a free press, free courts, and certainly anything approaching a free market, China continues to have the unenviable but justifiable reputation for substandard and counterfeit products. In spite of the vested interests mentioned by Li Guorong, this has caused the government much consternation. Desperate to offset the bad publicity and keep China’s economic growth on track, it has responded with a wave of authoritarian posturing and scapegoat seeking. In September 2008, a previous head of the State Food and Drug Administration was executed, having been found guilty of accepting bribes to pass drugs.12 This is the particularly unpleasant Draconian end of the state’s efforts to be viewed as clamping down on substandard products. At the less brutal end, regular announcements are made demonstrating state intervention. Recent examples include the announcement of an “inter-agency conference” on the continuing crackdown on fake drugs, and a pledge from these departments that online counterfeit peddlers “will face severe punishment” from now on.13 The latest stunt is to make celebrities punishable as accomplices, if they endorse medicines that turn out to be fake or substandard.14 Yet while the macho government posturing continues, so does the production and sale of fakes. While the Chinese state’s more heavy-handed measures are not met with worldwide approval, there is a tendency in health policy circles to resort to reactionary calls for greater regulation. The way to thwart substandard products, so the argument goes, is through stronger, more heavily funded drug regulatory agencies, and huge


global perspective policy analysis

teams of inspectors.15 And over the past couple of years these calls have been chorused by socialist campaigners who claim that many anti-counterfeiting measures are part of a global conspiracy by rich Westerners to enforce intellectual property standards throughout the world. This, they argue, has nothing to do with public health. The inescapable reality History, on the other hand, for Hong Kong is that suggests that the quality of China is thought to be one of the hubs of fake drug goods (such as medicine and manufacturing. food products) increases precisely when trademarks can be enforced, and brands are allowed to compete amid a competitive market. Regulators do not, and cannot, monitor and drive up the quality of millions of products traded globally every day. In nineteenth-century Britain, food contamination was a common problem, especially due to copper usage in the production of certain goods. As a consequence, some companies gave up ‘coppering’ – such as Crosse & Blackwell, the producers of pickles. Initially their sales fell, yet soon people realised the safety benefits, and the company went on to become the trusted, successful brand it still is today. Trademarks, competing on quality, raised the safety standards in an open market. Regulation, meanwhile, poses even further problems, particularly in countries with a weak rule of law. In such places, political interference in the courts and prevalent corruption render the imposition of new legislation and regulation futile. In fact, each additional layer of regulation can simply provide more opportunity for the corruption that fake drug peddlers thrive on. This is doubly true as the rules are most likely to be applied to legitimate producers, as they are well defined and thus more vulnerable. Health sectors are notoriously vulnerable to corruption, and examples abound of this being exploited for the trafficking of fake medicines. In the Indian state of Orissa, different teams of state health department employees are responsible for purchasing drugs for hospitals and monitoring quality, while local drug inspectors are supposed to weed out problems. Late last year it emerged that officials at each of these levels were involved in a scam that saw fake medicines being fed into state hospitals. All, it emerged, were being bribed by counterfeiters.

Other cases include the theft of drugs from state hospitals, which are then sold in black markets which are, unsurprisingly, heavily populated by fakes. Former World Bank economist Maureen Lewis has revealed shocking levels of medicine theft, including an average leakage rate for drugs in Uganda of 73 percent. Meanwhile an investigation by Sierra Leonean BBC journalist Sorious Samura found that drugs donated by UNICEF were being sold on the streets. One culprit admitted: “The government sold it [the pharmaceuticals] to us and that is not a secret.” The drugs are “sold everywhere, even by petty traders in street corners.” The consequence of such scenarios is that people cannot be sure of who produced the drugs they are purchasing. In areas of particularly weak trademark laws, brands are virtually unused altogether, with many people purchasing drugs loose or in unbranded envelopes.16 If producers of high quality medicines cannot legally protect their brands from counterfeiters, they face little incentives for entering a market – leaving a tempting vacuum for counterfeiters and shoddy producers of cheap medicines to fill. Yet there is hope. Even where trademark protection and the rule of law are weak, new technologies offer ingenious means of preserving the identity of high quality brands. For several years companies have tried to protect their brand packaging with devices deemed difficult to counterfeit – holograms, for instance, or idiosyncratically coloured and shaped drugs. However, the counterfeiters are never far behind, and have managed each time to replicate such drugs with terrifyingly impressive accuracy. The challenge, therefore, is to create a system so difficult to counterfeit that it becomes economically unviable to do so.

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f producers of high quality medicines cannot legally protect their brands from counterfeiters, they face little incentives for entering a market – leaving a tempting vacuum for counterfeiters and shoddy producers of cheap medicines to fill. Summer 2009

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Daniel Agostini

global perspective policy analysis

Mass serialisation is offering such a solution. This involves a producer labeling every single package with some kind of unique code. The producer has access to a database storing all these codes (and corresponding information about each package), and allows the end users (either a pharmacist or a patient) to check the code on their product against this database. There are several ways for this to happen. In some wealthier countries pharmacists carry out this duty and can check, for example, a unique barcode. This will communicate with the producer’s database and confirm that the product is genuine. It also confirms that the product is not beyond its expiry date, and is not part of a batch suspected of being faulty. Another advantage of this system is that it allows more efficient recalls of products that may not have been produced to expected standards. In poorer countries, the resources for such a system may not be available. Furthermore, some pharmacists have been found to be in league with counterfeiters and cannot be trusted. Therefore a system in which patients check the code themselves may be more favourable; such a system is already being rolled out, and involves the patient checking a code stored behind a scratch panel. They then text this code to a phone number and receive a text message back informing them whether or not the product is genuine. In June 2009, the organisation GS1 Hong Kong launched a system incorporating several of these methods, all based around product serialisation. The project is being piloted in shops at Hong Kong airport, where text messaging and RFID (radio frequency identification) technologies look to ensure that products such as health

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supplements, Chinese medicine and consumables are genuine.17 Technology might be filling a valuable stop-gap, but it must not be a supplement for a legal environment that empowers entrepreneurs to make investments in innovation, and further encourages them to register and develop brands. Rather than heeding the calls for stronger regulation and ever powerful domestic and supranational regulatory agencies, the best guarantors that customers and – most important of all – patients can be sure the medicines they purchase from pharmacies, hospitals and supermarkets are high-quality and authentic is a simple brand protection system. Unfortunately, there are no quick fix solutions or obvious ways for China to immediately bolster its protection and enforcement of trademarks. After all, China passed relatively stringent IPR laws that were mostly compliant with international standards in 1993, yet its lack of enforcement has consistently triggered outrage from some of its largest trading partners. Without effective institutions, such as the rule of law, an effective judicial system that has a cheap and effective way of resolving disputes, and a free press, the implementation of stronger laws protecting IPRs has achieved little success. The loudest calls for better IPR enforcement have often stemmed from the world’s biggest producers of IP, based in the United States. As a result, American politicians consistently threaten to slap further trade barriers on China, and the United States Trade Representative has kept China on its Priority Watch List for IPR violaters. Unfortunately, outside of the occasional token seizure of counterfeit products, foreign pressure has failed to deliver much in terms of improvement. However, the internal dynamics have slowly shifted in China and two developments in recent years suggest that two significant vested interests are beginning to understand why it is in China’s own self interest to bolster the country’s protection of trademarks.

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echnology might be filling a valuable stop-gap, but it must not be a supplement for a legal environment that empowers entrepreneurs to make investments in innovation.


global perspective policy analysis

First, the country’s rapidly changing economy is paving the way for R&D-based businesses and other higher-value-added enterprises to be significant job and growth-creators. These businesses are helping China shed its inaccurate “Factory Asia” label. The concerns of these wealth-creators are gaining momentum, and their concerns can only be ignored by policy-makers at their peril. Already, there are signs that these legitimate producers are increasingly frustrated that their innovation and ingenuity are being falsely represented by fraudulent producers – both at home and abroad.18 Second, the slew of product safety mishaps as mentioned above have frightened consumers who are increasingly demanding that the standard of widely available products improve. When the immediate heavyhanded response isn’t seen to address the fundamental problem, the interests of consumers and legitimate business are likely to form a powerful vested interest to promote lasting change in the protection and enforceability of trademarks. These two developments have created vested interests which Beijing and regional governments must be more accountable. Eventually, the authorities must heed the calls of those who seek to bolster the system for registering trademarks in China and to open up the country’s corrupt and opaque judicial system. Simplifying that process requires careful consideration about adopting the best practices in other countries. When the ugly specter of fake drugs appears, a common reaction is to ask “what can government do to protect us?” On reflection, it is wiser to ask what government should stop doing, and focus on how it exacerbates the problem. Taxes, tariffs and nontariff barriers on pharmaceuticals target the poor and vulnerable, drive up prices and deter companies of legitimate products from entering the market – creating a vacuum for fake drugs to fill.

These interventions are indefensible and provoke counterfeiting. With stronger intellectual property protection companies can preserve the identities of their products, utilising innovative new technologies where they deem necessary. Patients can have faith in the products they are consuming and take civil action when substandard items cause harm. With the growth of China’s innovative sector, such an environment is within reach. Julian Harris is a Research Fellow and Alec van Gelder is a Project Director at International Policy Network, a development think tank based in London. 1 http://www.thestandard.com.hk/breaking_news_detail. asp?id=13061&icid=3&d%0A_str=20090310 2 http://www.thestandard.com.hk/news_detail.asp?pp_cat=11&art_ id=82650&sid=23989072&con_type=1 3 Roger Bate, 2008 4 Gaudiano, M. C., Di Maggio, A., Cocchieri, E., Antoniella, E., Bertocchi, P., Alimonti, S., Valvo, L. 2007. “Medicines Informal Market in Congo, Burundi and Angola: Counterfeit and Sub-Standard Antimalarials” Malaria Journal, 6(22). 5 http://www.ifpma.org/PressReviewEmail/PressReviewDetail.aspx?nID=116 66&SD=bhYJTVuKTjCORxxE1bEqHg%3d%3d 6 http://www.reuters.com/article/rbssHealthcareNews/ idUSLR95435020090327 7 http://www.nursingtimes.net/whats-new-in-nursing/primary-care/ mhra-seizes-suspected-counterfeit-weight-loss-and-erectile-dysfunctiondrugs/2007613.article 8 http://www.msfaccess.org/main/access-patents/counterfeit-substandardand-generic-drugs/ 9 http://www.china.org.cn/government/central_government/2009-05/26/ content_17840269.htm 10 http://www.policynetwork.net/main/article.php?article_id=945 11 http://online.wsj.com/article/SB124146383501884323.html 12 http://www.mywaterfilterblog.com/drugs-found-in-drinking-water/ would-capital-punishment-deter-government-and-corporate-officials-fromcorruption-in-the-usa 13 http://callcenterinfo.tmcnet.com/news/2009/05/17/4183830.htm, http:// www.ifpma.org/PressReviewEmail/PressReviewDetail.aspx?nID=12103&S D=XMsUxqGUt%2b1eTXBT1PDM1A%3d%3d 14 http://blogs.telegraph.co.uk/peter_foster/blog/2009/05/27/whats_ happening_in_china_270509 15 Caudron, J., M., Ford, N., Henkens, M., Mace, C., Kiddle-Monroe, R., Pinel, J. (2008), ‘Substandard medicines in resource-poor settings: a problem that can no longer be ignored,’ Tropical Medicine and International Health Volume 13 number 8: 1062–1072 16 The study referred to at the beginning of the article – in Congo, Burundi, Angola – found that in half the cases drugs were sold without the original primary packaging, with the name of the active ingredient, strength, the expiry date, and, only in some cases, the producer’s name and country written in pen (according to Roger Bate, 2008) 17 http://www.infoworld.com/t/security/hk-launches-measures-againstcounterfeit-products-079?page=0,0 18 Hille, K., “Trademark pirates raid China’s top companies,” Financial Times, 22/09/2009

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around the world

Restoring the Freedom to Trade Alec van Gelder on the Freedom to Trade Campaign’s importance

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e are now in the midst of a severe global economic downturn. The credit crunch has spilled over into the “real” economy and world trade flows have contracted by over nine percent – the biggest collapse since 1982. In addition to nationalising banks and taking over automobile industries, governments have responded in potentially even more harmful ways: by engaging in trade protectionism. Faced with rising unemployment and collapsing financial markets, politicians have felt strong pressure to “do whatever it takes” to protect domestic jobs. This response has popular appeal but could yield disastrous consequences. In many cases, governments are creating new trade barriers – or increasing existing barriers – to give local or national businesses an advantage over foreign competitors. New subsidies, tariffs, arbitrary regulations and even outright trade bans threaten to make a bad situation far worse by isolating economies, driving away investment and propping up inefficient industries with ever-greater government control. Instead of investing in their businesses, uncompetitive firms are investing in lobbying, queuing up to demand that their governments shelter them from more competitive products or services. Worse still is the hypocrisy of the situation. During the G20 meetings

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in November 2008 and April 2009, leaders of the world’s biggest economies warned of the dangers of a rising spectre of protectionism. They pledged to avoid measures that would further reduce world trade. Yet that is exactly what governments are doing. According to a World Bank report released in March 2009, 17 of the G20 countries have implemented protectionist policies since the G20 pledge in November. Unfortunately, these misguided measures are not unique to the world’s biggest economies. Since September 2008, more than 50 policies judged to restrict trade have been enacted according to the World Trade Organisation (WTO). In response to a global escalation in food prices at the beginning of 2008, many countries implemented trade restrictions or outright bans on food exports. The sad irony is that these measures turned a difficult situation into an outright crisis in many parts of the world. This trend is particularly worrisome when we consider the effects of protectionism following the U.S. stock market crash in 1929. The Smoot-Hawley Tariff Act of 1930

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dramatically escalated tariffs and other trade barriers. Just like today’s barriers, the Act’s proponents claimed it was necessary to guard against the full impact of the global recession. Smoot-Hawley, and the retaliatory titfor-tat tariffs imposed by other trading partners, contributed to a radical shrivelling of world trade from a total value of $68 billion in 1929 to just $24 billion in 1932. Smoot-Hawley is one of the reasons why the 1929 crash-induced recession ultimately became the Great Depression. Moreover, this protectionism also triggered a wave of economic nationalism and resentment that ultimately contributed to a breakdown in international relations and the outbreak of the Second World War. Global trade has evolved considerably since the 1930s. Shipping and communications technology have revolutionized the global supply chain. Workers in dozens of countries are often involved in processing and delivering products to a truly global marketplace. This international division of labour has created trillions of dollars in wealth, hundreds of millions of new jobs and

moot-Hawley, and the retaliatory tit-for-tat tariffs imposed by other trading partners, contributed to a radical shrivelling of world trade.


around the world

helped more than a billion people lift themselves out of poverty. Trade is now better governed: the WTO and hundreds of other trade treaties impose swift and harsh penalties for countries that violate the terms of these agreements. But this progress must not be taken for granted. Since the outset of the financial crisis, governments have moved their “applied” tariff rates much closer to the upper “bound” limit defined by the WTO. Governments are inventing new ways to circumvent the conventional rules set by the WTO and other treaties. And this doesn’t even speak to other domestic policies that can impact trade: counter-productive regulation and legislation, overlyaggressive anti-trust policy that discriminates only against foreign companies, safety standards based on the “precautionary principle” which come at the expense of agricultural producers in other countries, and so on. All of these policy levers have been employed by politicians who seek short-term political gain by favouring domestic interests at the expense of consumers and broader economic development. Meanwhile, subtle trade barriers have the potential to tear apart the closest of trade partners. A salient example is the Buy American clause in President Obama’s stimulus package. This policy requires that stimulusfunded projects buy only U.S.-made steel, iron and manufactured goods. These provisions already have sparked outrage from Canadian producers – and even from some American businesses that have operations and supply chains that work their way through Canada. Some Canadian towns have already campaigned to “Not Buy American” and there are strong calls to nationalise the campaign.

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he Freedom to Trade (F2T) Campaign, a global grassroots effort to promote free trade and to educate policy-makers and the public. Fighting back against these interventions – and subsequent retaliation – requires a truly global network of committed free trade proponents to make simple, effective arguments that demonstrate the folly of protectionism. International Policy Network and the Atlas Global Initiative have launched the Freedom to Trade (F2T) Campaign, a global grassroots effort to promote free trade and to educate policy-makers and the public. The campaign seeks to raise awareness of the benefits of free trade, to alert the public to the looming dangers of protectionism, to uncover “stealth protectionism” as it occurs, and to oppose existing and new protectionist measures. Launched in London on April 1, 2009 (ahead of the G20 meeting), the F2T campaign comprises a coalition of over 70 think-tanks spanning five continents and 50 countries. The Lion Rock Institute is Hong Kong’s only member of the F2T coalition. One of our first initiatives was to distribute a petition in support of free trade that has been signed by over 3,500 opinion leaders, entrepreneurs, distinguished economists and academics, policymakers and others. To distribute its message, the campaign is channeling argument through both “old ” and “new” media. We are syndicating op-eds and briefing papers, and coordinating global speaking tours with renowned trade experts – but we’re also creating short videos, using blogs, Facebook,

and Twitter. F2T material has been translated into twelve languages, ensuring that the free trade message is promoted widely in languages spoken by at least six billion people. Through our global network of active campaigners, we hope to collectively name and shame the protectionists, and to win the emotive discussion about trade by showing the human face that benefits from falling trade barriers. While trade flows have so far been one of the major casualties of the global recession, encouraging trade by reducing barriers is the quickest route to recovery. We hope you will join our campaign to take on the protectionists! • Visit and link to www.freedomtotrade.org. The site features current news about trade issues around the world, videos, and more resources. • Sign the free trade petition at the website • Subscribe to our YouTube channel: youtube.com/Freedom2Trade • Join our Twitter feed: twitter.com/ freedom2trade • Join our Facebook Group: “Freedom to Trade, Say No to Protectionism” Alec van Gelder is the Coordinator of the Freedom to Trade Campaign and Project Director at the International Policy Network. For more information about the Campaign, email him at Alec@policynetwork.net.

Summer 2009

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Call For Papers Consider adding your ideas to the debate and publish your work in Best Practice. Published in Hong Kong, Best Practice is well positioned as a gateway to developments and recommendations in law and policy, making it the essential guide for leading developments in public policy. Best Practice encourages all who have interest to submit their work for consideration. Submissions are considered on a rolling basis and original submissions are given priority. We encourage submissions of review articles, case studies, policy research and will consider editorial comments as well. Best Practice is published by The Lion Rock Institute, the authoritative voice in its field in Hong Kong. If you are looking to publish material concerning public policy, we hope that you will consider Best Practice first. Please send your work to nicole.alpert@lionrockinstitute.org for consideration.

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leader’s bookshelf

For Sleuthing Amateurs of Economics The Economic Naturalist reviewed by Michael Mo

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s the new high school curriculum is going to be instituted this coming September, teachers giving liberal arts lessons might have to find a good introductory book for a variety of topics. When it comes to lecturing on economics, teachers unwilling to bore students with lectures on economic policies can instead appropriate more interesting examples of economics from everyday life.   This is what Professor Robert Frank, author of The Economic Naturalist: In Search of Explanations for Everyday Enigmas, has done. He has compiled a collection of student works and questions from his introductory to upper-level economics courses taught at Cornell University. Some of the questions Professor Frank explores include: 1. Why do some cars have their gas pump doors on the left, while some are on the right? 2. Why are DVD boxes the same height and width as VHS boxes, even though DVDs are much smaller than VHS cassettes? 3. Why do taxi drivers quit early on rainy days? 4. Why are brown eggs more expensive than white ones? 5. If a “cup” is supposed to be 8 ounces, why is the smallest cup of coffee listed on the Starbucks menu a “Tall,” which contains 12 ounces?  If any of the above questions has piqued your interest, you really

should not miss Professor Frank’s book.  Although the explanations that Frank offers in his book may be overly simplistic and inadequate for an MBA graduate, the book is ideal for those unfamiliar with some of the more complicated topics in economics. Compared to the bestseller Freakonomics, which seeks not only to explain but also to give thoughtful insights into a given subject through more rigorous investigative methods, the analysis found in The Economic Naturalist is a bit more superficial and tends to explain economics without really delving into complex statistics and formulae. If you are seeking sophisticated answers complete with complex economic models, then perhaps this book isn't the right choice for you; if, however, you are seeking a pleasant, easy read that will simultaneously entertain and educate you, then this book is a solid decision.  Nonetheless, this book is a great introductory lesson in economics. For those high school students stumped by the curves, graphs, and economic models found in most contemporary economic textbooks, the book helps give a framework for economics. Such a quick fix in cultivating students’ interest towards studies has rarely been seen, neither by a new curriculum, nor a completely new subject. Professor Frank has given out assignments for students to investigate daily phenomena and

The Economic Naturalist: In Search of Explanations for Everyday Enigmas Author: Robert H. Frank Basic Books New York, NY 240 pages

attempt to answer the scenario with economic theories. Students are not required to account for what has been understood correctly, as the aim of this project is to stimulate curiosity of people towards economics. If economic principles could have been told in such a fascinating way, the public should have a higher level of awareness of what our economy is going through, as well as an ability to assess the effectiveness of any fiscal policies.  The Economic Naturalist is a must read for students with interest, yet little background knowledge, in economics. If only our upcoming education reform can provide professors with such an engaging style as Frank's. Michael Mo, Hong Kong.

Summer 2009

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leader’s bookshelf Grufnik

Privatization Bears Fruit in the Big Apple Privatization in the City reviewed by Lawrence W. Reed

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One of the country’s foremost authorities on privatization, E.S. Savas, sheds light on all forms of private delivery of public services in pioneering cities like Phoenix and Indianapolis. Anaheim, Calif., the reader learns, contracts out for no fewer than 122 activities. But the main focus of the author’s attention is New York. “Privatization in the City” is, without a doubt, the most complete and readable account available of how the Giuliani administration pulled New York’s public services from the municipal dumpster, spiffed them up and cut their cost.

Who should read this book? Any mayor who wants to get things done and doesn’t believe they must be done the same as ever. Any city council member who wants to improve services and avoid raising taxes. Any city manager who wants to know how to use competitive John Brian Silverio

hen most Americans think of Rudy Giuliani, they recall his leadership in the aftermath of the Sept. 11, 2001 attacks. They might also know him as a tough prosecutor who brought crime rates down and cleaned up the city, or as the mayor who slashed the number of people on welfare by 60 percent. What is much less known outside of the Big Apple is the remarkable extent to which he deployed the private sector to fix day-to-day problems in city services. The Giuliani record from 1994 to 2001 is loaded with powerful lessons for cities big and small.


leader’s bookshelf

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forces to modernize the way a city runs. Any union member who still mistakenly thinks privatization can’t work. And any frustrated citizen who needs facts and examples to encourage local officials to get off the dime. Of 82 privatizations proposed by the Giuliani administration, 66 were accomplished, benefiting both service users and the taxpayers who paid for them. The city was able to cut costs by more than $6 billion, saving the average family of four nearly $3,300 over eight years. Twentythree city taxes were reduced or eliminated. Giuliani proved the city could be governed, something many observers had come to doubt by the early 1990s. Giuliani, says Savas, “abandoned New York’s failed policies and infused new values, making government work for the benefit of the public in a city long ruled by narrow interests.” When the administration opened up the city’s Department of Parks and Recreation to competition, just the threat of it prompted city unions to dramatically improve operations. Voluntary support for cultural institutions increased when the city cut its subsidies. A private, nonprofit group called the Central

Park Conservancy now manages the world’s premier urban park. The sale of city-owned assets including gas stations, parking garages, residential buildings, two radio stations, a television station, a luxury hotel and even the Coliseum exhibition center generated one-time revenues and stopped the flow of annual subsidies for loss-incurring enterprises. Competitive bidding saved millions of dollars for fleet management, school custodial operations, water-meter reading and dozens of other services. Not so successful were Giuliani’s efforts to privatize hospitals, prisons and the city’s Off-Track Betting Corporation. Among the lessons Savas gleans from those experiences are these: the process of privatization must be open and transparent; union opposition can deter firms from bidding and sabotage the effort from the start; and a campaign to educate the public can sometimes be crucial to success. Nonetheless, Giuliani was able to summarize his privatization accomplishments with these words: “We now have a broad array of privatization programs that impact nearly every aspect of the city government. ... We divested ourselves of businesses that more appropriately belong in the private sector ...

Privatization in the City: Successes, Failures, Lessons Author: E.S. Savas CQ Press Washington, D.C., 2005 335 pages

Now these properties generate tax revenues and private-sector jobs.” Nearly 70 pages of the Savas book are consumed by Appendix B: Privatization Initiatives in Detail. This valuable addition provides short descriptions of functions, services and assets; the date when they were privatized and by what method; and a word about the benefits and implementation. Rudy Giuliani was by all accounts, from friend and foe, an extraordinary mayor. He set about to fix a nearly dysfunctional city and succeeded by pursuing what made good management sense. Privatization was a core component of his strategy. That doesn’t necessarily mean that he’d make a good president, but saving a major city is a qualification most candidates can only envy. Lawrence W. Reed is president emeritus of the Mackinac Center for Public Policy, and is now president of the Foundation for Economic Education. Reprinted with permission from the Mackinac Center for Public Policy. Summer 2009

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odds and ends

Master of Slaves Jackie Chan has declined the value of freedom to show his obedience

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f the Chinese nation should be controlled, so should Jackie.   From Jackie’s definition of “too much freedom,” he’d probably be happiest as the newest citizen of Pyongyang. In a pluralistic society, there must be clashes between ideologies and it is all about give and take among various interest groups. Jackie upset many Chinese people with his words, and I suppose he hasn’t yet experienced the peaceful transition of power between Labor and Liberals in the land down under (no wonder his house near Canberra has been burned out).  

The intention of Jackie to deliver such a speech is obvious – to please Beijing. When the Central Administration has been pushing hard for “harmonized governance,” it is certain that Jackie would like to portray himself as tuned-in. Ironically, his latest film, Shinjuku Incident, has been banned for screening in the Mainland because it does not “harmonize enough.” Ultimately, it is Jackie’s right to please an authority for political convenience and ruin his pocket. Giving up his freedom is his right even though it philosophically appears unjust to become a slave of a

political power. So Jackie, the people of China should be controlled? Let’s hypothesize and instate some new controls. Say we make extramarital affairs illegal and those who are found guilty should be insulted in Tiananmen Square. If so, I bet Jackie will turn himself into a complete Aussie. Michael Mo, Hong Kong Advertisement

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odds and ends

Patriotic Panic A low flying plane spotted in Manhattan causes panic

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n April 27, 2009, a Boeing 747 and two F-16s were spotted flying in Manhattan near the site of one of the most catastrophic terrorist attacks on American soil. Panic ensued.  Everyone must wonder: there must have been sound reasoning to support this perceived assault. Surely it was a well planned event for a practice evacuation? Or maybe it was to check New York City’s emergency response time? Or, I don’t know, maybe the Obama administration “needed to update their photo files”? A photo op for Air Force One?

Well, that settles it – no need to panic. I’m sure all the folks with post traumatic disorder after 9-11 will be enchanted to see patriotic images of the President’s private 747 soaring by the Statue of Liberty. Yes, wave your flags and let us rejoice! Pardon me? Most of these pictures are classified?  Well, it must be an issue of national security. We must not succumb to our emotions. If those sensitive photos fall into the hands of evil terrorists our safety would be in great peril. I am glad that the U.S. President, Barack Hussein Obama, and his administration have taken charge of the situation. First, failure to inform

the Mayor of New York was an astute political maneuver – override the competition. Not allowing citizens without proper clearance to view these photos is a bold and commendable stab at eradicating terrorism. And finally, we thank you Mr. President for the mysterious resignation of Louis Calder, the Director of the White House Military Office. This shows that the Obama administration will not accept nor condone errors of judgment. By the way, for the photos that were released – they could use some Photoshopping. Eugenio Suarez, New York Illustration: Bay Leung

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odds and ends

Let’s Not Lose Our Minds The mass hysteria surrounding the spread of swine flu does little to protect us

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Illustration: Bay Leung

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all it “swine flu,” “Mexican flu,” “H1N1,” or even “new flu” – whatever you call it, just be sure to pick a name that ensures complete chaos and fear amongst the general populace. After being labeled as a pandemic by the WHO earlier this year, the disease has fomented paranoia and confusion wherever it has spread – with ridiculous consequences. In April, the Egyptian government, afraid that its constituents may contract the disease by eating swine, slaughtered nearly 300,000 pigs despite a clear lack of evidence that any of these pigs carried the disease. As of this article, China and Russia have yet to lift import bans on American pork products. Even U.S. Vice President Joseph Biden got into the mix, stirring up the paranoia by exhorting Americans to avoid enclosed spaces like trains and airplanes. Biden said that given the circumstances, Americans should completely avoid all crowded, confined areas. A stimulus to the economy that would have been, for sure. The misinformation surrounding the spread of swine flu (now referred to as “H1N1” by the WHO and by major media outlets) has seemingly permeated all aspects of society.

Walk around Hong Kong for a couple of hours and it is easy to see such fear: stores proudly proclaim that they “disinfect door handles every 3 hours,” people walk around wearing flimsy face masks that have been proven ineffective in preventing the spread of viral, airborne diseases (SARS redux, anyone?), and there have been instances in which entire planeloads of people have been quarantined because of a single traveler’s innocuous sneeze. With this kind of paranoia rampant throughout the world’s

major cities, it is easy to see why even the most harmless of coughs would send an entire restaurant of people running out the door. Here’s a thought: don’t go crazy. Yes, take your precautions against the disease. Wash your hands regularly and cover your nose and mouth when you sneeze. Go to the doctor if and when you feel sick. But for the sake of humanity, just drink the Corona already. It’ll be good for you. Anuj Jhunjhunwala, New York



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