Sucking on Subsidies

Richard Kramer: Welcome to Bubble Trouble, conversations between the economist and author, Will Page, and independent analyst, Richard Kramer, that's me, where we lay out some inconvenient truths about how financial markets really work.

Today, Sucking on Subsidies. Government grants, fat contracts, tax credits, state aid, all the cash a company didn't generate on its own. Does it help or did it stoke up problems for a future date? More in a moment.

Will Page: Welcome back to Bubble Trouble. It's great to be here with myself, Will Page, my colleague, Richard Kramer and again, this week, we're going onto the Sucking on Subsidies. That is, we want to get clarity on what subsidies really are, and you just heard these different terms of grants, state aid, tax credits, cash, all these different words that we use to apply money that came from the state that went into the market. This whole podcast is understanding how markets really work, but now we're going to understand the role of the state in making those markets work in the first place. So I got to jump to my first question, Richard, which is what makes a subsidy distinct from all those other words that you used in the introduction?

Richard Kramer: Hi, Will. It's a great question. A subsidy is any point in which the government steps in and covers the costs that otherwise might see private companies be reluctant to bear. So you can have a large corporation flush with cash that says, "You know what, I don't see the long term returns from doing something," but the government is keen that they do. And they step in and give the company an incentive, a little extra cash payment covering the cost that they'd have to bear to enter a new market, develop a new product or polish a technology that the government might've invented themselves or paid for to be invented by research grants to universities or other state-backed projects.

Will Page: Right. So in economics, we often say there's no such thing as a free lunch, but is a subsidy just another free lunch?

Richard Kramer: Well, if you look back to the start of the internet, it was really a project that came out of US government labs, something called DARPA, which was the Defense Advanced Research Projects group and DARPA was really the group that came up with the concept of these computer networks that we are relying on every day. And in many cases, many of the trillion dollar companies we see today are built on the back of research that was subsidized or underwritten by the government.

Will Page: Now on many of our runs on Saturday mornings, I've heard you talk about the work of an author called Mazzucato, an Italian-English economist who lives here in [inaudible 00:02:53] and swims [inaudible 00:02:55] as well. And was has she got to say on this matter? 'Cause it sounds like we're sort of reappraising what a free market economy actually is.

Richard Kramer: Sure. And, you know, her last book, Moonshot Economy, was really about the way in which the government has an active role to play in fostering innovation because there is this natural tendency to assume that all of these companies are led by genius inventors and they never want to acknowledge that they get a leg up from the states. And the flip side of invention is often investments, so a lot of companies didn't come up with the invention themselves, they bought it in. But in all these cases, the moonshots, the- the great leaps forward that they make in innovation, oftentimes, they're built on the back of investment that came from the government as reluctant as the companies might be to acknowledge that.

Will Page: Now if that investment came from the government, if that subsidy came from the government, if that tax credit was designed by the government, who ultimately pays? My simple line of reasoning is the taxpayer, but it doesn't necessarily have to be like that because money can come from various different sources as we've seen with quantitative easing. So who pays for the subsidy?

Richard Kramer: Well, indeed, it does come directly or indirectly from the taxpayer, but as you know, Will, the market can be distorted by debt, whether private or public, and we as the taxpayers are building up a huge pool of debt that ourselves or future generations are going to have to pay off.

Will Page: And let's come to that point when we have to pay it off, but you also have to wean the private company off the subsidy in the first place, and that's got to be problematic. I mean if you're getting used to having a free lunch, who calls time on free lunches and says, "There's no more lunch. Now you have to pay your own bills." How does that process work? I mean subsidies aren't there for an infinite period of time.

Richard Kramer: Well, in some cases, the subsidy is a moving feast. [Laughing] So the government is always funding a range of academic research into cutting-edge technologies that aren't ready for prime time in terms of commercialization. But when they come up to the stage at which they might be commercially applicable, well, they're handed over either for a fee or, indeed, sometimes subsidized as you would say to private companies that can take them forward. It's not the government's role to create products in the market place, but certainly they are es- play an essential role in creating the foundational technologies underneath those products.

Will Page: Can you take that example there and apply it to what happened in the credit crisis where we saw governments effectively nationalize banks, then after a period of time, try and return them back to the private sector, taking the stabilizers off as it were, sort of break down what happened during that process?

Richard Kramer: Well, there, if you want to call it an innovation or not, the government stepped in to play a role subsidizing the functioning banking system. Now in some cases in the States, the government took equity stakes, sometimes preferred equity stakes in the big banks. Here in the UK, we ended up with the UK government owning the Royal Bank of Scotland or at least 82% of it. And Will Page, the dour Scotsman who would never bank with RBS, well, ended up as one of the UK taxpayers having a controlling stake in that bank. And if you want to call that a subsidy or you want to call that an investment in continuing to have a functioning economy, it's a matter of semantics. But the government had to step in and underwrite activity that would not have been able to take place on strictly commercial terms in the marketplace, and these distortions happen all the time.

Will Page: Wow. It's taken me back to around the time of that nationalization of the Royal Bank of Scotland. I went back home to Scotland to see my brother. My brother's far more intelligent than me and was spending his time hacking the security systems of RBS Bank, then showing how he did it. And, uh, I used to be a government economist and he would always make fun of me being the dosey civil servant, the complacent civil servant when I was there. So I said to him, "Hey, Tom, now your bank's been nationalized. You're the dosey civil servant. How does it feel to be a complacent civil servant?" And my brother's wit akin is to the movie Withnail & I and his responsible was so classic, he just said, "Oh, you know how it goes. They pretend to pay me and I pretend to work," a beautiful example of the problem of nationalizing private sector for-profit banks as well. And now how- how did that episode end? I mean we have returned Royal Bank of Scotland to the private sector now?

Richard Kramer: I don't think we have fully, if I'm not mistaken, and I think there was ... They did the same with Lloyds. I'm not a banking expert, but I know that those assets stayed on the books for a very long time. And one of the challenges of subsidies is the way in which they get diverted to cover the sins, the past sins if you will, of companies. And in the case of a global financial crisis, what we saw was that after a long period of privatizing the gains, we socialized the losses. So these banks were making money hand over fist, benefiting from the support that they were getting from the government. And then when it all went horribly wrong, and I think you can probably come up with a less polite phrase for it, they ran to the government and said, "Well, we need a bail out. We need help."

And there's clearly been some similar cases just recently coming out of the pandemic where companies went cap in hand to the government saying, "We need subsidies. We need your support," when in the past eight or 10 years, they'd spent most of that time enriching themselves and- and their upper management.

Will Page: We'll get to that in part two because the- the pandemic just sheds a whole new light on this question of subsidies, the pros, the cons, the arguments for, the arguments against. What I'm hearing here is just, you know, this belief in the free market is almost blissful ignorance of the role of the state in allowing the free market to function.

Richard Kramer: Let me step in there and add one other thing. I don't believe there is any real example globally of an economy that is a pure free market. In almost every instance, you will find some functions of the state which have to be subsidized, which do not bear the full cost. And they deliver what in some cases are public goods that benefit everyone in the state. And obviously, the state retains the power in every country I'm aware of to tax its citizens to pay for those public goods, and chooses how to allocate capital towards them, whether it's building roads, educating people, having hospital infrastructure for when you're sick. Whatever it'll be, many of those instances are examples where we're not talking about a pure free market. And we all are grateful for that, but it's a fallacy to think the way companies often suggest that you're just going to fall back on this, "Oh, well, the free market will sort it out," because I am sure as an economist, you know how many instances we see day in and day out of market failure.

Will Page: Now before we go to the break, I want to reel back that problem you raised- you raised where you're saying some of the bad behaving companies are the most likely to get the subsidy, and it just raises this question of the moral hazard, which I just want to close out part one with, which is there is no such thing as a free lunch, but a subsidy kind of looks like one and the most ... to increase your chances of getting that subsidy, you got to behave really badly at the dinner table. Is it fair to say that we have this moral hazard problem in how we grant subsidies that if companies were well behaved, there'd be less need for subsidies in the first place?

Richard Kramer: I'm not sure I'd look at it that way. I would instead go back to something that we touched on in a previous podcast, and I'm sure we'll come back to time and again, which is this notion of regulatory capture. So in the US, for example, you have the single largest line item is the US budget, not a discretionary line item so to speak, being defense spending. I think it was $700 billion last year.

Will Page: Wow.

Richard Kramer: And if you look in the top 10 list of companies paying to lobby the US government, you will undoubtedly see the five largest defense contractors there 'cause they are very adept at knocking on the door, writing the programs that paid for, coming up with the products so to speak, and telling the government what they should cost. And whether you want to call that a subsidy or it's a cost of doing business for them, that is, you know, that is certainly not a functioning of the free market.

Will Page: I get it. I get it. That's really helpful. So it's almost like one man's subsidy is another man's useless aircraft carrier that nobody actually needed.

Richard Kramer: Yeah, well, and alongside that, you can debate the value or the value for money of many of those projects that end up with Raytheon or Lockheed or any of the large US defense contractors, but you're not allowed to audit the Pentagon. So we don't know how that money got spent, whether it delivered, as you would say in the UK, value for money. What we do know is that the entirety of that was paid for from the public purse. So that's a huge industry that is "subsidized" for the public good of national defense, but we don't really have a good measure of how clever the capital allocation behind that was.

Will Page: And not just the capital allocation, but the carousel, lots of money going to defense, but lots of money going from defense to government, and you net off the debits and the credits here and you work out where your balance is, but it just seems like a carousel of cash and that, again, raises the economist question, which is, is that a fair allocation of resources?

Richard Kramer: Yeah, and- and it's extremely difficult to find the downstream impact of all the people who are employed by the defense contractors and whether paying enough taxes and supporting their local communities and so forth, and as you know as an economist, it's very easy to make a series of nested assumptions about the efficacy of- of one plan versus another or the multiplier effect of building a bridge or building a nuclear missile that sits in a silo and- and, hopefully, never gets used.

Will Page: [Laughs] Yeah, that's [inaudible 00:13:13] for you or as Bertrand Russell said the best way to avoid nuclear wars is if everyone has nuclear weapons, which really helps the defense industry. So let's take it to part one there, so I mean my big take from here is it's just double standards, and just one thought sprung to mind there is over here in Europe at least and for the Americans listening, you don't have to [inaudible 00:13:32], but an aircraft carrier called Ryanair whose CEO is very verbose, a term that I've recently learned, and talks a lot about bashing the state and championing free markets. Yet if you look at the story of Ryanair, this low-cost carrier that opened up across Europe, the way they got into the market was through state aid helping open disused airports. It's just I can't kick that example out of my head when I think about the hypocrisy of championing free markets on one side and brushing under the carpet the story of subsidies on another.

Richard Kramer: Absolutely. And let me just add one quick rejoinder on Ryanair, what they did incredibly cleverly was they went to those disused airports in far-flung places in Europe and said, "What will you pay us to bring people [laughing] and support your local tourist economy because you probably have never flown to Mulhouse or Frankfurt-Hahn or all of these- these- these crazy far-flung airports that Ryanair goes to, but who's subsidizing your nine or 23-pound ticket to those places? It's the local tourist authority that wants planeloads of people brought in, and they're willing to pay for it, one would assume it's a rational calculation on the part of the local tourist authority, but it is also a form of state subsidy.

Will Page: Wow. So we'll stick with this, guys, in part two and we'll be back in a moment to explore subsidies in action.

You're back with part two of Bubble Trouble where we're Sucking on Subsidies. And what we've been learning so far is that when we hear of the free market and we champion a free market, we often overlook or brush under the carpet the role of the state in providing subsidies, tax credit, grants, straight up cash to help those markets function. So it's been great kind of lift the lid on the role of the state in a free market.

Now what I'd like look at this in action. Obviously, we've had a 18-month pandemic to deal with. There has been government bailouts galore happening on both sides of Atlantic, around the world even, and it's gonna be an interesting scenario to understand the role of subsidies because we've never been hit with a pandemic before. You could argue these subsidies were desperately needed to keep companies afloat that would have otherwise gone under. We finished part one talking about the skies and Ryanair. I'm really interested in terms of the state benefit that's been going into the airline industry. Richard, jump in here and tell me about subsidies in action.

Richard Kramer: One of the great and perverse examples of recent times is how firms like Boeing or American Airlines or other US airlines came running to the government for bailouts and subsidies during the pandemic when, clearly, their business ground to a halt, but it didn't escape notice that the last decade or so, they'd spent literally all of the excess cash that they generated on buying back stock, which mostly benefits the top management and the shareholders of the company, but didn't leave them with the kind of reserves that they might need in case of a rainy day or a- a pandemic day.

Will Page: That's just siphoning off cash, isn't it?

Richard Kramer: On the one hand, it is. On the other hand, you could say it's an efficient allocation of capital because these companies should generate cash. So having it sit idle on the balance sheet is not really helping them, but certainly, they didn't do enough to prepare themselves for the eventuality that their business might grind to a halt for some unforeseen reason. Their shareholders abhor these companies sitting on cash and they demand it to be returned to shareholders. And it shows that profit maximization for some of these companies is not always the right course, especially in an industry that's notorious for racking up losses like the airlines. I think there are many cases where private companies have failed and the state needs to step in And subsidize the private companies to do the right thing that they should've done in the first place.

Will Page: Sticking with that for a second here, I want to come back to this moral hazard. I- I get the term too big to fail or what's that famous analogy, if you were the bank, a million pounds, then you've got a problem. If you owe the bank a hundred million pounds, then the bank's got a problem. Surely, the nature of the business you're in determines your ability to argue for that subsidy 'cause cash is finite. Only so many people can get it. And the nature of the companies and the functions they perform will determine the likelihood of them being able to sort of hold the government to ransom in terms of who gets that bailout.

Richard Kramer: And a lot of those subsidies have to get put into some form of infrastructure. And the airlines will certainly argue that shuttling people around the US is a critical part of the US transport infrastructure. And in the same way as defense contractors will argue that- that tanks are a critical part of the national defense or- or construction firms will say we- we really need to repair all of those thousands of bridges around the US that are falling down. But that subsidy needs to be put in where the economics for the private sector either are uncertain or simply have too long of a payback to encourage people to invest. And the more return that investors are looking for, the higher expectations they have of return, the less they're willing to proceed without some form of subsidy and you find those subsidies in the strangest places, and that's when you've heard the phrase pork barrel politics ...

Will Page: Yeah, I never knew what word meant. I've heard that word for years. Can you please explain to the Brits what pork barrel politics means?

Richard Kramer: So that's when you have a piece of legislation working its way through the branches of US government, and attached to it are completely separate clauses which say, "We need funding for bridges or schools or defense or anything in a particular area." So you might have a group of representatives in a certain region of a country that frankly are not incented to vote for a package of- of measures designed to prevent drought, which is going to affect the southern half of the states and the northern half would be immune.

But to get those northern representatives to vote along with it, you have to attach something, and that's where the pork barrel comes in that you have a barrel of pork, uh, some extra sweeteners if you will that are attached to a piece of legislation that subsidize the pet projects of those who need to be brought along to support the main aim of the legislation. And it's really a measure of the horse trading that goes on in US politics, and it also goes on in UK politics, to wangle additional subsidies out of the government for pet projects that matter to one or another legislator.

Will Page: So when you've got them by the balls, their hearts and minds will follow.

Richard Kramer: Something like that.

Will Page: We've done the good and the bad of subsidies, and you've also alluded to some of the behavior. I wonder if we could get a little uglier as it were. Within the management companies, from theory to practice, do you have any examples of what the management teams within companies who receive subsidies can do to manipulate where that free lunch ends up?

Richard Kramer: Look, I'm no expert of the pharmaceutical sector, but certainly, that's one sector that not only generates a substantial portion of its revenue from public spending, certainly in the UK, it all comes out of the NHS and who feasts off the NHS and whether they charge three times as much to the NHS as they do to private firms is an open question. But also in the pharmaceutical industry, they certainly rely on a lot of university research that's heavily subsidized by the government. And a lot of the universities both in the US and the UK are state universities. They're subsidized with public money. Their budgets are backstopped by the government. And they do a lot of pathbreaking research that gets commercialized by pharmaceutical firms. And so in that sense, it's getting a rather large explicit subsidy from the state for products that they then commercialize and sell back in part to the state.

Will Page: I guess it must be a bit of an irony there if these companies were to protest at higher corporate taxation levels given they're simply returning back some of the cash which the state gave them in the first place.

Richard Kramer: And you have in the UK, you have the National Institute for Clinical Excellence which manages to get prices which are dramatically lower for the exact same drugs from the exact same companies for UK consumers because they club together and buy on behalf of 60 million users as opposed to the US where it's a bunch of private companies or insurance companies that are paying for specific treatment, uh, and those large companies can play a divide and conquer game among them.

Will Page: So getting towards our smoke signal section and I- I- I wonder, I think I mentioned this in our podcast a couple weeks ago, the famous Warren Buffet quote, "Only when the tide goes out do you discover who's been swimming naked." I think this week's smoke signal, Richard, it would be great if we could tail end to that cause, which is I would imagine over the next 18 months, a lot of these huge subsidies will be getting called back. A lot of companies will be weaning themselves off the level of state aid they've got used to during the pandemic and that is going to reveal some companies which are basically wearing no clothes. So take us through your smoke signals for this week's podcast based on the fact that we're going to have to get used to subsidies getting a little fewer as opposed to greater going forward.

Richard Kramer: Sure. And before I do, I'll just mention the greatest subsidy of all which is we've been through one of the most expansionary monetary policies known in the history of mankind in the past 18 months in terms of money printing and that has been a huge subsidy with zero interest rate policies everywhere in the world, you know, that has been a huge subsidy to the banks and to the financial sector. It has effectively made money free and is the single greatest subsidy that we will have to wean ourselves off across the economy to where everything from returns in the stock market will have to be higher to compensate for that and mortgages will cost more, and all of the- all of the various bubbles that we're seeing today whether they're bubbles or not, whether they prove to be bubbles or not will have to withstand at some point paying more for- for investment capital. And so that's the core subsidy of all.

Will Page: If- if I- if I can just add some demographics on that one. I mean if you think about the credit crisis starting around 2007, interest rates dropping to bottom in 2008, where are we now 13-ish years on, pretty soon you're going to have people going in to study economics at the age of 16 not knowing what it was like to have interest rates above the rate of inflation. Isn't that crazy? [Laughs]

Richard Kramer: Mmm, it is crazy.

Will Page: You were taught that in economics like once upon a time, something mad happened, that was the exception. Now it's the norm. What? Interest rates are above the rate of inflation and exceeding [inaudible 00:25:06]. What's going on here? It- it- it's gathering to think that a 16-year-old will soon not know, will not have lived under normal economic times.

Richard Kramer: Yeah, and when we go back and look at, you know, w- our discussion about Robin Hood and the YOLO traders, well, for them, YOLO, you only live once is a rational reaction to the fact that you're not going to get any returns from the cash sitting in a bank, so you may as well gamble with it on the stock market, right or wrong.

But let's go through the smoke signals. I think the first thing that people need to be sensitive to is what portion or percentage of- of innovations or business a company gets from the government? And as we talked about, it's a two-edged sword. If they haven't paid for lobbying, uh, or bought off politicians, they might not win that big government contract. And the government's a very rich customer to have, in many cases, it might overpay, but its ability to keep paying in- in perpetuity may not be the same as- as you find in a commercial enterprise when you come up with a great product. So you really have to be careful with companies to delve into how reliant they are on government spending and will the governments have the budget in perpetuity to keep supporting them?

Will Page: Now it's not a subsidy exactly, maybe a bit removed from this, but I just want to throw this curveball. When we looked at the government contract for AWS and Microsoft, that bidding war, is that something that kind of falls into this category or is that different?

Richard Kramer: Well, that's a good example of where winning a large government contract can become hotly contested terrain and highly politicized.

Will Page: Right.

Richard Kramer: And that's a good reason why you want to be cautious about companies that rely heavily on government spending because they can fall out of favor as much as they can be in favor.

Will Page: Okay, keep smoking, number two, cigarette number two.

Richard Kramer: And number two, you know, you have to step back and look at the relative performance of sectors that live or die by government mandate, whether it's utilities or defense or education, and they're going to have a very different logic to them than the sectors like retail, for example, that don't rely on the government, that- that are in cutthroat businesses with relatively low margins where the difference between an excellent retailer making a couple points of margin and allows you one which goes bankrupt is pretty stark. So I think that- that you can see that there's two different classes of companies depending on how reliant they are on those subsidies, how addicted they are to that government contract, and the risks involved when you have a change of government or the tide turns, for example, in the UK against allowing foreign investors to buy out all of the companies that are listed on the London Stock Exchange, which is happening one after another right now.

Will Page: Wow. This dependence in the state. A neighbor in the Scottish borders of ours was heavily involved in military aircraft, and whenever you'd ask him just a very innocent question, how's business, he'll sorely say, "Oh, it's terrible. Governments aren't causing enough wars."

Let's wrap it up. I mean my big takeaway from this podcast, my thanks to Richard Kramer for your revealing those inconvenient truths about the free market and your putting the spotlight on the Royal state, but I go back into regulations, something we discussed in the past as well. If the purpose of competition or is geared solely towards the interest of the consumer, it almost feels, Richard, like the right hand isn't talking to the left hand because the role of subsidy could be a- a cost to the consumer. A, they got to pay the tax, he needs to finance the subsidy, but B, they might have to pay a cost in some of the adverse outcomes of that subsidy, higher prices, inefficient businesses. So it just makes me feel that what we've done with this week's Bubble Trouble is show how markets are at a crossroads. You can giveth with one hand, taketh away from the other. You can regulate to perfection, but you can undermine that perfection by rolling out subsidies as well.

You've been with myself, Will Page, and my colleague, Richard Kramer, and this has been Bubble Trouble. If you're new to Bubble Trouble, we'd encourage you to follow the podcast wherever you listen. Bubble Trouble is produced by Eric Nuzum and Jesse Baker at Magnificent Noise. You can learn more at bubbletroublepodcast.com. See you next time.