Hutton on the Transport White Paper

Will Hutton might be less than 100% sound on the capital markets, but he is often excellent on public policy and infrastructure and he has an excellent article in yesterday's Guardian on the recent Transport White Paper:

There isn't an adult in Britain who does not believe that our transport system is overcrowded, unreliable and unfit for purpose...

Last week's white paper on the future of rail maintains the British tradition. There is to be tinkering at the margins ... but the Department of Transport has shrunk from any serious ambition to scale up British capacity.

The heart of the problem is the Treasury's attitude towards public debt and the way it calculates the payback from public infrastructure projects... its approach to infrastructure spending remains in the dark ages - an outlier of 19th-century thinking.

I might quibble with '19th century thinking' - in many ways the Victorians understood the importance of infrastructure spending better than we do now - but otherwise Hutton is spot on. By using a metric for assessing cost/benefit analysis that is hugely skewed (and probably a hang-over from Thatcherite thinking rather than the 19th century), the Treasury is failing the country, holding back economic development and producing more misery. The requirements of tackling climate change and supporting growth require congestion charging over all urban areas, massively increased spending on rail, and a widespread application of the polluter pays principle to transport (which means higher taxes for SUVs and air travel and subsidies to bicycles and buses).

Is Economics an Equilibrium Discipline?

An interesting post on the Street Light Blog, on currency misalignments, suggests an interesting question: is economics an equilibrium discipline? The very idea of a misaligned FX rate suggests that the natural state is an aligned one: perhaps the fundamentals move faster than the markets adjust, so FX is never in equilibrium. Perhaps (in the language of statistical mechanics) the relaxation time is much longer than the average time between forcings. Actually that makes a lot of sense...

Update. Paul Krugman seems to agree, at least in a limited context:

A free-market economy can get trapped for an extended period in a bad equilibrium in which good things are not demanded because they have never been supplied, and are not supplied because not enough people demand them

Who is getting hurt in equity/credit?

There are, if not falling cubes, then certainly some falling knives out there. Indeed the current market gyrations seem to suggest a dislocation between the equity and credit markets as well as a weakening of sentiment. As the often amusing Naked Capitalism puts it:

[...] fixed income types speak of truly grim conditions, of the markets for riskier credits having shut down completely, and concerns that the market seize-up could extend its reach to better quality credits. By contrast, many of the equity market participants sounded relatively sanguine, believing that the credit markets are working through a repricing of risk, but that earning yields are sufficiently high so as to be able to withstand an increase in yields.

Meanwhile according to the FT:

Fear now rules the credit markets, where the effective cost of ensuring against a default, in both Europe and the US, has increased by more than half in barely a month. A steady drip of bad news has prompted fears that the subprime debacle could trigger a credit crunch, raising the cost of financing worldwide as investors are forced to sell healthy investments to make good their losses.

Most recently, the equity markets have shown only modest falls, but credit rationing is in full swing, and spreads have moved out markedly, to the extent that they are visible, from the ridiculously tight levels of the first half of the year.

Now this would all be merely interesting, were it not for capital structure arbitrage. CSA posits a relationship between the equity and credit markets, and CSA funds use models based on this relationship to put on equity vs. credit positions. The first generation of these models were based on Merton's work or elaborations of it. What I would really like to know is how models like these, calibrated to the conditions earlier in the year, are performing at the moment. To end with the FT again:

...we may well be in the middle of a regime shift

In fact it could even be that the new regime was the last four years or so, and what we are seeing now is a return to more 'normal' conditions, albeit one that is proceeding in jumps.

The Death of Metronet

The collapse of Metronet and the attendant comment suggests it might be worth saying something about risks in equity and debt finance.

The classic model of a company is that it can raise money in two ways: by issueing shares, or by borrowing money. The best thing that can happen to a lender is that they get paid back: there is no upside to making a loan other than receiving your interest. Therefore lenders demand that they get paid before shareholders - if a company has funds, it must pay its creditors first, and only after that do shareholders receive a dividend. Moreover if a company cannot pay its debts, debt holders can typically seize the company and sell or liquidate it to get (some of) what they are owed.

In exchange for taking the risk that they might not receive anything, shareholders collectively own the company and so receive anything that is left after debt holders have been paid. This is sometimes called a residual interest: it is potentially high risk and high reward position, since if the company's earnings can't support its debt, they might get nothing; but if earnings are high, then there is a lot left for them after interest costs.

One key capitalist idea, then, is that shareholders take risk in exchange for potentially big rewards. If you don't like the idea that you might lose everything, don't buy equity.

Now consider a company in a long term PFI contract such as Metronet. The rewards are potentially very high, as the profits of someone like Amey indicate. But so are the risks, as we see with Metronet or the late and unlamented Railtrack. Is this a good deal for the tax payer?

There are two arguments for PFI: a specious one; and a sensible one. The specious one is that PFI gets infrastructure built without the government having to raise money. But that is just accounting trickery: the tax payer pays eventually, after all. A PFI contract is an ongoing liability just as a bond issued by the government to pay for maintaining the underground without a PFI contract would be.

A private firm doing government work will demand an extra return over and above what they think it will cost in order to pay their shareholders: they are right to do that as their shareholders are taking risk. So on average PFI contracts are more expensive than their fair cost. Are they still the best that is available? That depends on whether the PFI contractor can get the job done and make their profit for less than it would cost the government to do the job themselves. There is a natural assumption that private enterprise is more efficient than government - that may even be true - but is it so efficient it makes up for the extra profit shareholders demand?

Here's a view from the capital of London financing, Canary Wharf, to end.

Japanese jitters

Nuclear safety fears after quake according to the BBC. Certainly building a nuclear reactor is an earthquake zone might strike a naive observer as reckless. But then anything that depends on safe confinement for hundreds of thousands of years is reckless. The nuclear industry appears to have a decent safety record over tens of years. Who really thinks they can stretch it to building something that is good for ten thousand times that long? What would it mean to try to prove you could do that? Until there is a compelling answer to that question, I am nervous about increasing our reliance on fission power.

(The building site is in Ottawa.)