Why we need less government interference, not more

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In the wake of the sub-prime crisis, there's been a lot of nonsense talked about how the financial markets have proved unable to regulate themselves. Apparently intelligent people have been arguing that what we really need is greater government intervention in the markets.

In case these people hadn't noticed, governments are already up to their necks in the markets, particularly the ones in the worst trouble. Fannie Mae and Freddie Mac the twin financial neutron bombs underpinning the US mortgage sector are Government Sponsored Entities (GSE) after all. They were created by the US Government to interfere with the property market because at some point the authorities decided that universal home ownership like full employment was a desirable goal in itself, regardless of whether people could actually afford a home or not.

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Now the very existence of the GSEs threatens to bring down the financial system (you can read more about Fannie and Freddie here: How Fannie and Freddie are pulling the US towards crisis).

These knee-jerk calls for added regulation just show that despite all the talk of Thatcherite revolutions and how we're all capitalists now, plenty of people still don't understand how or why markets work.

One very obvious example of this is the constant indulgence of the idea of a windfall tax on energy companies

How the market system is supposed to work

My colleague David Stevenson wrote about the specific stupidities of a windfall tax on energy on Friday (you can read it here: Why an energy windfall tax is a bad idea). But on a broader note, calls for a windfall tax just show how badly understood markets are. Let's just clarify roughly how they are supposed to work.

If a good or service becomes expensive, that shows that there's not enough of it to go around there's more demand than supply. The companies involved in the sector then make "excess" profits, or to put it more clearly, they rake it in because they were smart or lucky enough to be in the right place at the right time.

But this happy situation won't last forever. Just as in the recent housing bubble, everyone else sees them making money hand over fist and decides "I'll have a piece of that." Or the company itself realises if it can make and sell more goods, it'll make even bigger profits. One way or another, supply rises to meet demand, therefore driving down the price.

It's not a bad system, and the quicker it can get to work, the less pain there is all round. That means you need a clear transparent price, which acts as a signal that we need more of something. And companies need to be able to profit from it, because the extra profits are what acts as an incentive to make the extra supplies available.

Why the Government likes to mess around with the markets

Trouble is, the Government can't bear to see a system that works efficiently. After all, if it's efficient, it can't be a Government-approved and designed system. And that means the Government isn't winning votes or making enough money out of it.

So the Government (and remember that any Government is just a wide conglomerate of special interest groups, all fighting to maximise their chunk of the pie) likes to mess around with the market system to suit its short-term goals.

For example, consumers and therefore, voters don't like rising prices (not energy prices anyway houses are a different matter). So do Governments try to resolve the supply problems? No. In the past (and today, in emerging markets), they tried to control prices instead. One of the reasons that the oil price has kept shooting higher until recently, was that consumers in most emerging markets were hugely subsidised. Despite rising prices, their fuel bills remained cheap, so demand didn't fall.

But price controls don't work. It costs the Government a fortune to keep subsidising prices, and in the meantime, the underlying problem isn't going away. It's only recently that countries such as Thailand and Malaysia, staggering under the cost of the subsidies, have begun allowing petrol prices to rise to reflect the underlying cost of oil. Unsurprisingly, consumers in those countries are now rapidly cutting back on the amount of fuel they use.

Price controls have too many "banana republic" associations for your average developed country now. So another wheeze that they've hit upon is that of the windfall tax.

The problem with a windfall tax

The idea of a windfall tax is appealing, because the very name suggests that companies have got lucky, and found a special situation or loophole, which has allowed them to make huge, ridiculous profits, which it's therefore OK for the Government to tax.

But the trouble with a windfall tax is that it operates as a cap on profits, and rather a random one at that. If a company knows that the more profits it makes, the more likely it is to get hit with a whacking great tax, then it's going to be a lot more cautious about spending money to chase those big profits. In other words, it'll be reluctant to commit the resources necessary to expand supply. That means prices stay higher for longer.

Now I have little doubt that the energy market as it stands doesn't work terribly well. That'll be because governments stick their oar in for their own particular self-interest groups at every point in the market. But a windfall tax isn't going to make it work any better.

So what can you do if you think a company is making outrageously high profits? Here's my suggestion - buy shares in it. That way, you get to share in those profits. But do it quickly. Because soon everyone else will notice that it's making outrageously high profits and they'll want a piece of it. That's markets for you.

Turning to the wider markets

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On Friday, UK shares continued to fall, with the FTSE 100 index sliding 57 points, or 1.1%, to 5,355. Miners led the market lower as metal prices slipped on talk of easing Chinese demand. Xstrata, Rio Tinto, BHP Billiton and Anglo American all dropped 5%. Banks in contrast generally enjoyed a better day as HBOS climbed 4%, RBS 2% and Barclays 1%, though Standard Chartered lost 4% on fears about Asian economies. British Energy declined 4% after the EDF bid fell through, while Centrica slid 6% in sympathy.

Shares in Europe were also down, with the Xetra Dax dropping 1.3% to 6,396 and the French CAC 40 losing 1.8% to 4,314.

US stocks also fell, with the Dow Jones Industrial Average shedding 52 points, or 0.5%, to 11,326, while the wider S&P 500 lost 0.6% to 1,260 and the tech-heavy Nasdaq Composite dropped 0.6% to 2,311.

Overnight the Japanese market also suffered, sliding 1.2%, 161 points, to 12,933, while in Hong Kong, the Hang Seng slipped 360 points, 1.6%, to 22,502.

This morning Brent spot was trading at $124, spot gold at $914, silver at $17.57 and platinum at $1,635.

In the forex markets this morning, sterling was trading against the US dollar at 1.9702 and against the euro at 1.2647. The dollar was trading at 0.6419 against the euro and 107.84 against the Japanese yen.

And in the markets this morning, oil and gas explorer Imperial Energy, which focuses on Russia, has headed higher as it said it had received another possible offer for the group. The group is thought to already be the target of China's state-owned oil group Sinopec.

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