March 14, 2023

Vladimir Lenin was wrong about many things, but his maxim about the Soviet Union’s bureaucratic state apparatus — “better fewer, but better” — was undoubtedly right. Perhaps more than anything, the USSR demonstrated the flaws of rigid central planning. And yet, at the very heart of Western free markets, it not only survives — it flourishes.

Today’s financial rules often seem designed to maximise inconvenience for individuals carrying out small transactions. Despite the stupendous number of business regulations, however, the big events often seem to be missed. The collapse of Silicon Valley Bank (SVB), the bank of choice for large numbers of tech companies, is just the latest to surprise us.

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On Saturday, more than 200 UK tech companies, worth £3.5 billion in venture funding, riled themselves up into a state of panic. They wrote an open letter to the Chancellor warning that they now face an “existential threat”, and suggested that the Bank of England’s attempts to downplay its impact showed “a dangerous lack of understanding of the sector and the role it plays in the broader economy”.

The truth, however, is that shocks like this are inherently difficult to predict. Indeed, it is more or less impossible, unless the central regulator is omniscient. The losses which have caused SVB’s collapse, for instance, seem to have arisen from the bank making complicated bets on interest rates and getting them wrong. It’s easy enough to explain after the event — but it’s very hard to anticipate.

And so Lenin’s maxim springs to mind: it’s better to have a few bright minds capable of thinking outside the box about the resilience of a system than legions of box tickers designing myriad rules which purportedly eliminate risk.

A similar issue confronts Rishi Sunak ahead of his first Budget tomorrow. Apart from the SVB crisis, two financial developments haunt his financial programme. They are both bad — and they both stem from a misguided attempt by regulators to control risk.

The first is contained in the sudden rush of UK companies deciding to quit the London Stock Exchange for Wall Street. ARM, for example, which is based in Cambridge and describes itself as the R&D department for the global semiconductor industry, has decided to place its forthcoming IPO, expected to be valued at some $40 billion, in New York. CRH, the world’s largest building material supplier, is also moving its listing from the UK to the US.

The second concerns recent warnings by pension funds that they face massive losses. Despite the surge in equity values in the stock market, drops of more than 20% are being recorded in funds managed by top outfits such as Aviva. The Retirement Protection Pension Fund of Clerical Medical (part of Lloyds Banking Group) has managed to lose 38.7% of its money in the past 12 months.

The culprit, particularly in the second case, is the burdensome Markets in Financial Instruments Directive (MiFID2). The directive requires investment firms, which includes pension providers, to collect a huge amount of information from their clients, ranging from their preferences on sustainability to their “risk tolerance”. There are many boxes to tick and many forms to fill in; according to Forbes, the MiFID2 regulations contain 1.5 million paragraphs. This sums up the approach of our regulators, who appear to believe that the solution to everything is to write yet more paragraphs. Such behaviour fosters the illusion of control. But it is just that: an illusion. And the outcome has been disastrous for many pensioners.

As individuals move into their 50s, their pension providers are encouraged by the regulations to implement a so-called “lifestyle” investment approach. Their funds are gradually moved from what the regulator deemed to be risky investments, namely equities, to government bonds, designated as safe assets. These bonds are indeed safe in one sense of the word: since the Bank of England was created well over 300 years ago, British governments have never defaulted on their loans.

But their market value is highly sensitive to changes in interest rates. Rates were held artificially low by central banks throughout the 2010s following the financial crisis, but they started to rise last year, even before the turmoil of the short-lived Truss government pushed them up to 4%. And if there is one fundamental principle behind the pricing of bonds, it’s that if interest rates rise, the value of bonds goes down. As a result, pensioners have been left with big capital losses on their portfolios — and all because of a collapse in the values of an asset class which regulators deemed to be “safe”.

The problems of the London Stock Exchange arise from several factors, but the MiFID2 regulations are at their centre. As a result of their risk-averse approach, pension funds have been allocating far less of their assets to shares in companies (equities). According to recent estimates, just 27% of UK pension fund allocation is in equities, compared to more than 50% in the US. And it is equities which are the real lifeblood of any stock exchange; little wonder that firms are defecting to what is now a much bigger market.

Rishi Sunak and Jeremy Hunt will have to contend with this core problem of overregulation if they are to fulfil their desire of Britain becoming “the next Silicon Valley”. Sunak has placed investment and innovation at the centre of his government’s policies. But despite a proliferation of schemes designed to encourage corporate investment over the years, UK levels remain persistently low. According to the OECD in 2021, for example, capital spending in Britain was only 17% of GDP, compared to a developed country average of 22%. In Europe, only Greece was lower among OECD members. And by all accounts, the Chancellor is very likely to persist with the planned increase in corporation tax.

Yet the causal connection between taxation and investment is very well established, as Phillipe Aghion’s 2021 book by The Power of Creative Destruction makes clear. Aghion and colleagues cite a paper in the top-ranked American Economic Review which finds that a 1% increase in the top rate of corporation tax leads to a 6% drop in the number of patents and a 5% fall in the number of inventors. The point here is not a case for finely tuning the exact detail of a taxation regime: it simply has to offer suitable incentives to innovators and inventors.

To be fair to Sunak, he has backed up his words with deeds. Last week, along with the Technology Secretary Michelle Donelan, he launched the first major piece of work from the newly created Department for Science, Innovation and Technology. While some of it does seem to be a re-hash of existing policies, the document recognises that different methods of funding science and innovation need to be tested. After all, a major problem with research councils is that it is very hard to get “left-field” projects financed. These are ones with a very high risk of failure, but which really push the frontiers of knowledge when they succeed. It is much less risky, however, to finance “safe” proposals, which simply add incrementally to knowledge and whose results are essentially known in advance.

Sunak and Donelan propose that institutions known as Focused Research Organisations are tested. Essentially, these are not-for-profit start-ups which are too big for a single academic lab to do and which are too complex for a loose, multi-lab collaboration. The crucial feature of the document is not any particular detail or policy, but Sunak’s apparent understanding of the importance of “try and test”. This holds that, rather than specify in great detail a structure which is predicted to give good results, it is better in an evolutionary environment to try something in practice. If it works, you can then reinforce it. If it doesn’t, you can drop it and try something else.

As for the SVB crisis, the UK’s flexible and speedy response has been equally encouraging. A crisis broke — and rather than form a committee to try and work out the perfect response, the Government acted. A wide range of options was reportedly considered, and the problem was swiftly solved over the weekend by HSBC taking over SVB’s UK arm for just £1.

Sunak, then, unlike his immediate predecessors, appears to understand the complex, inherently unpredictable nature of the modern world. It is a world where agility, flexibility and swift decision-making are the necessary qualities; where a “better fewer” approach is crucial; and where documents with 1.5 million paragraphs are at least 1.49 million paragraphs too long.