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.

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.

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The Tories should embrace chaos

By Paul Omerod

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.

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Rishi has set himself up to fail

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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.

Liz Truss and Kwasi Kwarteng took what they believed were good decisions. Their massive energy price subsidy would protect people from the cost of living crisis. They thought that cutting taxes would boost growth and prosperity for everyone. It is easy for people to sneer at the latter after the event. But the plain fact is that no-one has discovered a sure fire plan to deliver economic growth. If they had, running the economy would be easy.

As we now know, the markets took fright at the further proposed increases in government debt. Interest rates on the debt soared and the pound collapsed. The Truss government was wrecked. This had always been a risk, ever since in 2019 the government piled up massive amounts of public debt with the furlough scheme. At some point as government debt rises, confidence really drops and interest rates really do double, or even more. But this point is inherently unknowable in advance. It bears little connection with the objective facts.

For example, interest rates were in the 6-8% range in several Mediterranean Eurozone countries in the mid-2010s. But the amount of government debt relative to the size of the economy in, say, Spain, was lower than it is now in the UK. Even now, the UK’s debt position is much better than that, say, of Italy. But it was the UK which the markets attacked and not Italy.

Many commentators on the Left maintain that all this was obvious in advance, that the Truss-Kwarteng policy was bound to end in rapid and ignominious failure. But we might reasonably ask, if this is the case, why these same commentators are not now enormously rich, having used their insight to short UK government bonds.

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By John McTernan

All this was anticipated by Keynes, a much more subtle economist than many of his followers grasp. In his magnum opus, the General Theory of Employment, he championed the idea that extra government spending could help keep an economy out of recession. But he qualified this with two key points. When government deficits rise as a result of increased spending, Keynes wrote that: “The method of financing the policy may have the effect of increasing the rate of interest and so retarding investment in other areas.” He went on to suggest that the psychological effect on “confidence” might also depress private sector spending. The psychology, he asserted, was often “confused”, by which he meant it could move in ways entirely contrary to what a rational assessment of the evidence would suggest.

The second example is much less grand, but all the more telling. Intentions and outcomes can differ even on a small scale. To great fanfare, in 2018 Nicola Sturgeon announced a policy of a minimum price on a unit of alcohol. Scotland has a serious alcohol problem, and this seemed a good idea. The policy was praised by the World Health Organisation. Yet the hard-core older drinkers who were the real targets of the policy seemed to have continued drinking. They paid for it by cutting back the amounts their families spent on food and heating — even before the cost of living became the issue which it is now.

Young people in particular do seem to have cut back on high alcohol drinks. They switched to cheap street drugs instead. These are often unreliable and dangerous products, and the drug-related death rate in Scotland is now four times higher than in England. Sturgeon and the SNP intended to do good with their policy, but the outcome seems to have worsened the situation.

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Why Truss's gamble failed

By Aris Roussinos

If detailed planning really worked, the Soviet Union would have been a great success and not a catastrophic failure. Of course, both governments and firms have to set a vision, a view of where they want to be. But they must never fall into the trap of thinking that the plan is reality. Most of the time, outcomes are different to the intent in the plan. The main risk is that focusing too much on the plan might lead a government or firm to reduce its flexibility, its capacity to respond to surprises, both good and bad. In the old Soviet Union, everything was planned with great precision. No individual enterprise was allowed to fail. But, eventually, the whole system collapsed in catastrophic failure. In the West, individual firms fail all the time, but the system as a whole delivers the goods.

There are worrying signs that, as a result of the furlough scheme, the same Soviet-type mentality is starting to pervade Britain. If a company is in difficulty, some scheme should be contacted so that it is kept alive by taxpayers’ money. The industrial structure should be pickled in aspic. The intention of any such policy would be to do good. The risk is that it simply leads to an economy populated by zombie, low productivity firms.

Sometimes outcomes can be much better than expected. A classic example is Windows. The first releases basically tanked. Microsoft announced that development would stop after the release of version 3.0. In the meantime, they had partnered to develop OS/2 with IBM, the “operating system of the future”. Windows 3.0 sold millions of copies in the first few months and the rest is history.

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How science has been corrupted

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Coca-Cola spent vast amounts of research testing how people would feel about New Coke, which they launched in the mid-Eighties. The plan said it would be a great success. But it met with a disastrous reception in the real world. Coca-Cola abandoned the product within a few weeks despite the huge sums spent on it. Their actions show the value of flexibility and willingness to discard plans in the face of new evidence. The UK government’s reaction to the emergence of Covid in early 2020 shows the danger of inflexibility. The early data from China suggested that the death rate might be of the order of 3-4%. So it was reasonable to have an initial lockdown to try and assess the situation.

But it rapidly became clear that the death rate was in fact much lower. More importantly, at least 95% of all deaths were in two groups which were small compared to the size of the overall population: the over 85s and those with chronic conditions such as heart disease caused by obesity. For the bulk of the population, there was little serious risk to health. Despite this new information emerging quickly, the government seemed to double down on its plan of lockdown and its message of fear.

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Covid was liberalism's endgame

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The complexity of the world does not mean that nothing can be done, that outcomes are random. But it does mean that governments and firms must be flexible. A further implication is that, as far as possible, decisions should be devolved. The closer to a problem you are, the more likely there is to be local, tacit knowledge which is hard to capture in formal documentation and rules.

In fact, successful institutions evolve organically, indicating that excessive government intervention may be both unnecessary and counterproductive. Consider Greater Manchester. The Mayor and the GM combined authority have relatively few legal powers. These in general still reside with the ten individual boroughs. But the combined authority has evolved “convening powers”. This is soft, informal power. A complex system of interconnected organisations and committees has developed and is continuing to develop. And it seems to work. A genuine, connected city-region is coming into being.

The economy and society are essentially more like a biological system than a complicated machine. No matter how complex, a machine can be programmed and controlled. The economy evolves, often in unpredictable ways. Policy-makers, including the new Prime Minister, need to shed the tick-box mentality and recognise this fundamental feature of reality.