How governments run things


Yes, we know the argument, if only those wise people who had learned how to steal the most votes were put in charge of running everything then we'd all be gambolling in flowered meadows and life for all would be immeasurably better. This argument works right up until we look at what actually happens when the politicians manage to run something. Like, say, the monopoly off track bookie in New York State.

OTB is operating with a negative cash flow of $600,000 to $800,000 a month on a betting handle of $900 million a year, largely because of a revenue-sharing formula dictated by Albany that forces it to pay out more than it takes in after operating expenses...

Yes, the wise and omniscient beings face incentives, just like everyone else, and as everyone likes something for nothing they've set up a bookies so that it must (note, MUST) pay out more than it gets in plus the costs of doing so.

Of course, a bookies isn't that much of a problem but what happens when similar pressures are brought to bear on a more important segment of the economy?

What great advice!  Make more loans, but make better loans.  What a great banker he would make!  I mean, the guy is just amazing, he knows everything about everything.  I’m sure all the bankers in the room slapped their heads in a collective I-coulda-had-a-V8 moment and said as one: “Why  didn’t I think of that!?!"  And of course Putin knows just what the interest rate should be.  14 percent is Just Right.  Pretty amazing to watch a bald guy do a Goldilocks impersonation.

It's not going to work out well, is it?

Aren't you glad that there is at least a modicum of sense in our own government regarding the banks? They're desperate to sell them off, get them out of governmental ownership, before the sillier parts of the Labour Party have a chance to offer such sterling advice.

Thank goodness.

Pension fund problems


Our Regulatory Evaluation Group (REG) held another of its successful lunchtime discussions yesterday, with Paul Thornton OBE (pictured left), head of Gazelle Corporate Finance. The theme was company pension funds – a topical subject in view of the worries about the sheer scale of pension funds that are larger than the companies that sponsored them – like the Post Office pension scheme – and those which have a huge deficit to match – like that of British Airways.

A particular concern for financial managers is whether the huge deficits that have opened up – following Gordon Brown's changes to the accounting and liquidity standards, and of course the effects of falling investment returns because of the financial crisis – are actually making mergers and acquisitions impossible. Already we have seen potential bidders walk away from a deal because the pension trustees have argued that a huge wodge of finance is needed to close their deficit.

In fact, there seems to have been a certain amount of gaming going on between pension trustees and company boards. By making changes to their funding assumptions, the trustees may well be able to increase their apparent shortfall and so scupper a takeover or merger that they don't particularly like.

Nevertheless, a lot of the deficits are all too real. And to some extent that is chickens coming home to roost as companies have underfunded their pension schemes during the good times. I would argue that pension funding requirements should be stated clearly on company balance sheets, so the potential liability is clear. Come to think of it, that is exactly the way the government should run the state pension, and all those index-linked civil service pensions, too. But of course they don't. The government's pension schemes would not even pass its own laws and regulations. Indeed, if the cabinet were private-sector pension trustees, they would all have been carted off to Pentonville Jail long ago. Now there's a thought to keep you happy in an impoverished retirement.

On the work life balance


There's been for some years now a push that we should all reconsider our ideas about the work life balance. You know the sort of thing, the mantras about "ever longer working hours" and the need for these to be limited by governmental fiat. The logic has always rather fallen down in that we all have ever more leisure and thus must be working shorter hours but then logic has never been either a strong point for politicians in search of a cause nor useful in politics generally.

The latest manifestation of this desire to limit freedom has been the insistence that we should ban anyone from working more than 48 hours in a week: something rather brought in via the back door through the European Union. I've never really quite grasped why adults cannot be trusted to make these decisions for themselves really:

Concerns about the economy and rising unemployment mean workers are taking on extra work to bring in an additional income. As many as 2.7 million people, or 15 per cent of workers, have a second job, according to the findings by price comparison website Workers are also spending longer at their main job to earn some extra money, up to 29 per cent compared to 19 per cent a year ago.

You see, it's not just that different people have different opinions of what constitutes a decent work life balance, it is that the same people in different circumstances do (with the grandchildren staying mine has certainly changed). Those two variables simply cannot be happily dealt with in some centrally ordained number of hours that we may work.

Best simply to leave it to the people themselves: as we largely have done for decade upon decade. It does tend to work out that as incomes rise some fraction (eyeballing the numbers, perhaps 10-20%) of that rise in income is taken as greater leisure the rest in more physical consumption of goods and services paid for through work. If that's the way people in general want to take their higher incomes why not simply leave them to get on with it?

Bio-fuels and sustainability


This week Policy Exchange launched a report called "Green skies thinking: promoting the development and commercialisation of sustainable bio-jet fuels". The thrust of their argument is that bio-fuels cannot replace oil as the primary energy source for all transport because of production constraints, but road vehicles can be powered by electricity or hydrogen. However, such options are not open for aircraft, so bio-fuels should be used primarily by them.

The logic is fine as far as it goes, although of course it takes it as a given that we will all be going to hell in a handbasket if carbon dioxide emissions are not drastically cut back. And we might well see flights in a generation's time largely powered by economically viable algal bio-fuels. But what has sustainability got to do with it?

The term has become a convenient catch-all for environmentalists' policy prescriptions for pretty much everything we do. But the supply of jet fuel is at present perfectly "sustainable", in that the demand for flights can continue to be met for the forseeable future. When oil prices rise sufficiently high for alternatives to become viable, things will change. Something which can only be sustained by use of high and continuing public subsidy does not deserve to be called sustainable.

The mantra of sustainability assumes that future generations will continue to use resources in the same way as we do. A quick review of the last two centuries would surely be enough to show the fallacy of that argument. And if we do not need to second guess how our grandchildren might choose to live their lives, then there is a strong case for regarding sustainability as just another fashionable but failed concept.

Martin Livermore is the director of The Scientific Alliance

Credit Rating Agencies


It's been a year since the meltdown of financial markets began, yet the media and politicians are still wielding pitchforks against City Bankers. In some cases this is understandable: even if their decisions were being driven by expansionary monetary policy, it is hard to deny that many bankers took extraordinary financial risks, pocketed their bonuses, and then passed the losses on to the taxpayer. That's not the way free markets should work. However, there is another set of financial institutions that seem to have evaded the limelight for now – the Credit Rating Agencies (CRAs).

These companies – such as Moody's, Standard & Poor and Fitch Ratings – were charged with assessing and attributing risk to financial derivatives created by banks. These ratings, ranging from AAA through to C, would then determine the risk involved with those securities and hence the price and demand for them. This seems a pretty trivial task for companies with vast resources and expertise until you realize that these companies gave securitized debt, containing toxic sub-prime loans, a AAA rating.

Naturally with such a seductive low-risk rating these securities were bought up by banks and in the end it was these, which caused the stagnation of inter bank lending. This kind of asymmetric information in the derivatives market added to the crisis. Yet little has been done to reform CRAs. President Obama has proposed 'reforms' which would basically be a slap on the wrist, but there has been no full-scale investigation as to why these debts were given such high ratings (apart from the companies blaming faulty models). The first major move was from a US pension fund which is attempting to sue three of these agencies for $1 billion.

More should be done. Evidence in the IEA's Verdict on the Crash: Causes and Policy implications points towards a systemic failure in CRA strategy, with too much emphasis placed on mathematical modeling, rather than economic reasoning. Interestingly, the solution may be the reverse of current government proposals: a reduction in regulation. Reducing regulation would increase competition in the credit ratings market (where market entry by new firms is currently nigh-on-impossible), increasing the number of different 'opinions' available and bringing an end to the all-too-cozy oligopoly of present-day CRAs.

All Hail the Glorious Bolivarian Socialist Revolution!


It really takes a certain amount of cunning, if not good sense, to turn a coffee exporter, one acknowledged to produce some of the finest Arabica in the world, into a place where it is now difficult to get a cup of coffee. But that is indeed what Hugo Chavez has just managed to do in Venezuela. How is it possible to do this?

Well, first set the price at only half what it is in neighbouring Colombia. Then watch as some 250,000 quintales (around 100lbs in a sack) get smuggled over the border into that country. Then gasp in amazement as less coffee is harvested domestically, the crop falling from the usual 1.5 million quintales to 1-1.2 million. Then congratulate youself on how you've been able to make coffee cheaper for the masses: demand has risen to 1.8 million quintales.

The final coup de grace is of course that you've got to go and find some more coffee somewhere:

Most estimates of how much Venezuela needs to import hover around 300,000 45-kg bags, to ensure supply until the 2009/2010 harvest begins in October. Experts say Brazil would be a likely supplier.

"We're talking about two months of supply," Nelson Moreno, head of the small and medium-sized roasters, told Reuters.

"Stocks, including reserves, will be entirely depleted by the third week of August," Moreno said.

For, you see, having fixed the price so that supply and demand cannot balance, you cannot use the price system to either ration the coffee, dissuade people from consuming it nor encourage private individuals to import it: or not export it illegally in the first place.

All Hail the Glorious Bolivarian Socialist Revolution!

As Johan Norberg points out in connection with this story, PJ O'Rouke, as so often, had it right:

The only thing you need to know about socialism is that you can´t get good Chinese takeout in China and that Cuban cigars are rationed in Cuba.


A rare good law


Under a sea of bad law from this administration, the Freedom of Information (FOI) Act is an oyster. It provides anyone who requests it a right to public information and obliges public authorities to release it; often information which they otherwise would have kept secret (because of embarrassment) or simply not bothered to go to the trouble of providing (why bother?).  It has made public life more open, transparent and accountable. But as with all good things, costs are involved and getting hold of information is not as easy as it may at first seem.

The right to public information is not well understood among public officials, even among those responsible for FOI compliance. Protecting the organisation from the public is too often their main concern. Getting the information needed is often dependent on whether you are sufficiently tenacious or are lucky enough to have asked a motivated FOI official who doesn’t see it as his job to disrupt you. The Act is not popular with many officials whose information is requested. They see it as bureaucratic and inefficient. It is both, but this usually merely highlights another reason why the state should not be involved in the activity in question. It is not proof that accountability in public office and for public money is a bad thing.

Three things should be done to improve the situation. First, some exemptions need to be watered down and one ‘commercial interests’ (except ‘trade secrets’) should be abolished. Second, the penalties for organisations and officials found to be in breach should be stiffened. The consequences of ignoring the law are often thought to be laughable, with good reason. Applicants whose information was wrongly withheld should be modestly compensated and officials who knowingly or negligently ignore the law should be personally liable. Third, the Information Commissioner’s Office should ensure that all complaints are investigated as quickly as possible so that blame can be attached to organisations while the staff who made the errors are still in post, before they move on.

The end is nigh?


The result of the Norwich North by-election – with a huge swing to the Tories, who now have a majority of more than 7,000 – has not only humiliated the Labour Party but triggered serious internal friction.
The by-election was caused by the resignation of Dr. Ian Gibson after he was effectively deselected by the 'star-chamber' of the Labour NEC. If Gibson had not been targeted by the star-chamber, an election would not have been called and Labour would still hold their North Norwich seat. Conflict in the party comes as a result of Gibson being ‘targeted’ after the expenses scandal. There has been a longstanding tension between Gordon Brown and Ian Gibson, as such it is not surprising that Ian Gibson was one of only five Labour MPs referred to the Star Chamber regarding expenses. More high profile members, such as Hazel Blears and Jacqui Smith, were spared the star-chamber treatment so as to retain an image of party unity. It is fairly evident that Gibson was initially used as cannon-fodder by the party to create an imagine that they would not stand for expenses corruption. Gibson trumped Brown by resigning, leaving the party with even more serious problems.
The Labour party now faces a crisis. They could be facing a historical downfall with little prospect of recovery. If they enter the next election with the possibility of coming third, any support they currently have will be sapped. This does not necessarily need to happen. Cameron is not on the home stretch yet, and elections have an uncanny way of throwing up surprises when they’re least expected. But as things stand, the Labour Party is a sinking ship and Gordon brown is acting as one hell of an anchor.

Au Revoir to the UK Financial Sector


As reported in our letter to The Times of June 24, the Chancellor and Prime Minister seem to have agreed the French inspired proposals to hand financial regulation, albeit not supervision, over to Brussels. We surmised that to have been the price of Sarkozy’s attendance at the G20 meeting in April.

What was puzzling us then and since is why neither the City nor the Tories have risen up in protest. Do they believe Lord Mandelson’s soothing words that he will see the City all right? More likely is that the large British banks would actually prefer EU to British regulation and are lobbying to that end. Angela Knight has said as much in Parliament’s house magazine in the last few days. This is carrying hostility to the FSA too far. EU regulation is bound to blunt the UK's pre-eminence in financial services.

The financial crisis has revealed just how dumb our banks can be. Little seems to have changed since. Will someone please stand up for our last remaining major industry?

UK water – is Ofwat being realistic?


Yesterday’s eagerly awaited draft determination announcement by Ofwat, regarding the water pricing regime between April 2010 and March 2015, confirmed modest price cuts in real terms and a near £21 billion five-year capital expenditure plan. Good news for consumers.

Shareholders, though, were less happy as Ofwat chose a 4.5% post-tax  Weighted Average Cost of Capital (WACC) figure, which was below market expectations. No wonder shares in the remaining publicly quoted water companies fell.

In today’s volatile markets, setting a credible WACC, which can endure until March 2015, is nigh impossible. Yields on water shares are closely correlated with gilt-edged stock; between March and June this year, the yield on 10-year government bonds rose by some 100 basis points.

Factor in, too, the planned issuance of gilts until March 2015, which could amount to an astonishing £800 billion, and it is clear that forecasting long-term yields is only for the brave. 

In the event of its WACC figure being materially awry, Ofwat did offer some hope of financial restitution - through the ‘substantial adverse effects’ clause in the list of notifiable items by which interim price rises can be awarded. 

In today’s announcement, Thames Water is an obvious loser. There is a near chasm between its own WACC assumption – close to 5.25% - and the 4.5% of Ofwat. A confrontation at the Competition Commission seems almost inevitable.

The tighter WACC being proposed by Ofwat is on the back of lower valuations of water stocks, which are now trading – in some cases - below their Regulatory Asset Value (RAV).

In reality, between now and November, when Ofwat publishes its final determination, expect considerable activity on behalf of the water companies to drive up Ofwat’s WACC assumption much closer to 5%. A lacklustre gilt auction before then would be very helpful.