My column from Thursday’s Fin, with a not so subtle plug for my book.
Ideas are almost impossible to kill, especially when they serve powerful interests. There can be no better example than the efficient (financial) markets hypothesis, that is, the claim that the prices at which financial assets trade represent the best possible estimate of their value, taking account of all available information.
The efficient markets hypothesis ought to have been discredited once and for all by the absurdities of the dotcom boom a decade ago. But as soon as the immediate crisis had passed, with the help of the Greenspan Fed, financial market participants were singing the same old song. The one marginal piece of reform adopted in response to the dotcom disaster, the Sarbanes-Oxley bill was soon being derided as an overreaction.
If the dotcom boom was not enough, surely the near-collapse of the entire global financial system, brought to its knees by absurd speculation, ought to have killed the hypothesis. And indeed, some notable advocates such as Ian Harper in Australia and Richard Posner in the US, looked at the evidence and admitted it was decisive. But most supporters kept quiet when the crisis was at is worst. As soon as a partial recovery became evident they returned to preaching their gospel as if nothing had happened.
But even if no-one wants to admit it, the failure of the efficient markets hypothesis is making itself felt. an example of particular relevance to Australia is the collapse of the market for Public Private Partnerships. The case for PPPs rested directly on the belief, derived from the efficient markets hypothesis, that private financial markets would always outperform governments in assessing and managing risk. So, it was claimed, public infrastructure could be financed by transferring demand risk to private owners.
In the 1990s, governments were desperate to get debt off the books at any price, and signed deals that were massively profitable to the private ‘partners’ and even more costly to the public.
By the 2000s, governments had mostly wised up, and demanded that PPP projects should yield value for money when tested against a ‘public sector comparator’.
It was now the turn of the private sector to engage in over-optimistic dealmaking. With credit standards almost non-existent in the later years of the bubble economy, projects went ahead on the basis of absurd traffic projections, with disastrous results for investors.
In the wake of the financial crisis, illusions are less affordable. There is a big gap between the cost to governments of traditional bond financing for projects, and the return demanded by investors for taking on demand risk.
A traditional PPP deal makes sense only if the parties can find cost savings sufficient to offset the lower capital cost of government bond financing. For projects within the traditional scope of the public sector these conditions are rarely met – that’s why these activities were in the public sector in the first place.
Despite all this, everyone who matters is keen for PPPs to continue. The finance sector needs dealflow, and government bond financing does not yield the kind of fee income they need. Governments still want to get debt off the books, and remain absurdly terrified of the ratings agencies. And while the infrastructure industry is becoming disillusioned with the PPP model, it seems to be the only game in town for many projects.
The solution, for the moment, has been found in ‘availability payments’. The idea is that, instead of receiving a cash payment when the project is completed, the private partner gets a stream of payments, conditional on the project remaining operational. In economic terms, this is just the same as traditional public procurement with a bundled maintenance contract. Why then, go to the added expense and complexity of a PPP arrangement?
The answer may be found buried in a report on the website of Infrastructure Payments Australia which indicates that availability payments ‘may not be viewed as debt owed by the public entity’. That is, although it looks like a debt, and quacks like a debt, governments can pretend that the obligation to make availability payments is not really a debt. It remains to be seen whether Auditors-General will fall for this piece of creative accounting.
As the PPP example shows, the efficient markets hypothesis is a zombie idea. It is not so much dead as undead, buried by a mountain of contrary evidence, but still capable of emerging from the grave and doing immense damage.
John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland. His book, Zombie Economics will be published by Princeton University Press later this year.
John Quiggin 
I fear that absolutely no good will come of this. The Rovian tactic of lying day in, day out, regardless of disproofs has shown itself to be a startingly effective strategy and people, like Charlie Brown and the football, don’t seem to be able to help themselves falling for it just one more time. It still seems to be too difficult to believe that normal looking people could be such immoderate liars.
The absurd behavior of governments in needlessly getting debt off their books by selling revenue generating assets, frequently as a fire-sale and without proper due diligence underscores a problem with government accounting. The way government accounts are set up and reported, unlike the accounts of an individual or business, takes no account of whether borrowing is simply for consumption or to cover losses or whether it is for investment purposes, that is acquiring assets, or in the case of a government, in some cases, building infrastructure.
As government accounts just show debt and assets are ignored debt reduction became an aim in itself, and with the aim the means of reducing debt and the opportunity cost of reducing debt were ignored. I know that lots of government assets are measured but they don’t tend to be reported in an overall way that makes clear that there are assets, including revenue generating assets, on the other side of the balance sheet that typically more than offset the debt.
PPPs are a mad idea, and even some of the work of the Productivity Commission has been equivocal when assessing their merits against the old fashioned alternatives.
A common failing of policy analysts and researchers who have looked at PPPs has been to ignore the scope for graft and corruption. The cost of graft and corruption when they attack government are large and persistent, and it can certainly be worth paying a premium to avoid them.
Great column. This token hard rightest cannot bring himself to disagree with a word of it.
“The answer may be found buried in a report on the website of Infrastructure Payments Australia which indicates that availability payments ‘may not be viewed as debt owed by the public entity’. That is, although it looks like a debt, and quacks like a debt, governments can pretend that the obligation to make availability payments is not really a debt.”
This makes me so angry. I read this and I think: National Broadband Network. A great idea currently being perverted, and largely because of the above shenanigans.
“PPPs are a mad idea, and even some of the work of the Productivity Commission has been equivocal when assessing their merits against the old fashioned alternatives.”
On my side of the street when we see the phrase “public private partnership” we read the phrase “fascist economics”. If we cannot do something in a non-cronyist way, we can do it socialist, until we can figure out a way to have a proper non-crony market.
If you do a project in a socialist way, you could still have the department parceling out the work, as much as possible to sole traders. You might still make the revenues to such people tax free. And so you have an allegedly socialist undertaking, with more of a free enterprise feel and vibrancy about it, then anything thats been sold (out?) in the last 30 years.
I know I’ve been rabbiting on about the Eire canal. But that was success. So many small businessmen getting involved with it. Not even the smell of cronyism. The salt manufacturers knew in advance that they would make big gains from the project, so in advance it was known that some of the cost would be paid by a salt tax. Magnificent (slightly lefty) historian Mark Kurlansky described this tax as one of the few in all history that the taxpayer was happy to pay. Everything about that project was a success. And somehow by being stooged by phrases like “private consortium” and “free enterprise” we aren’t building on this sort of success.
Regrettably we don’t live in a perfect world and so someone like myself would recognize that some things need to be done in a socialist way for the time being. But its not written in stone that we need to suffer any sort of cronyism even in the medium term. We ought to set our sights on wiping out any sort of cronyism and anything that smells like it. Then it will be easier to slowly whittle down the socialist side of things where sensible, over time.
Some PPPs don’t benefit anybody – at least in NSW. Here is the latest on the Lane Cove tunnel fiasco: http://www.smh.com.au/business/lane-cove-tunnel-operator-hits-the-wall-20100120-mkca.html
“although it looks like a debt, and quacks like a debt, governments can pretend that the obligation to make availability payments is not really a debt”
A bit like Credit Default Swaps, an innovation the had no other purpose than to provide insurance without being subject to the regulations, regulatory oversight and provisioning required before a company can sell insurance. Because the CDSs were legally defined as ‘derivatives’ rather than as insurance, the provider didn’t have to be encumbered with such onerous, unnecessary and inefficient ‘red tape’.
What an innovation!!
This raises the question, is it financial engineering or language engineering?
EG – failed investments like this are a donation from investors to the road users.
Doesn’t cost the government anything and we get a tunnel that the government would not have built. Great deal for the rest of us.
“This raises the question, is it financial engineering or language engineering?”
It belongs to the language of managers who replace the word ‘problem’ with ‘challenge’ and then blame the outcome on mathematical models. It belongs to the culture of profitable delusion. For, anybody who would have studied relevant theoretical mathematical models would have realised that if CDFs work then there is no need for them because the set of securities spans the pay-off matrix of all assets. Good luck to anybody who wishes to teach relevant theoretical mathematical models – the problem is that those who want to make money from education decide that it would expose students to ‘challenges’ which they don’t want to face.
I wonder what Lipsey & Lancaster would have said?
Nothing too flattering I imagine …
@Ken N
“Great deal for the rest of us.”
This point was covered in the article (para 7). On average, there is a net loss to be borne by someone. As you say, it’s good for the rest of us if the financiers bear more than the whole social loss, but we can’t expect that to happen on average.
Can’t agree, Ken N. The ‘investors’ aren’t people from outside this universe. They include people who directly or indirectly (via superannuation funds) invested their earnings from wages in shares in, say, Leighton Holdings. This company has written off their initial investment, which means that there is a reduction in tax revenue, ceteris paribus. Hence there is a reduction in tax revenue (hence less money for hospitals, etc). Furthermore, usage of the tunnel will continue to attract a toll. I suggest when you think through the problem you’ll end up agreeing with our hosts repeated analysis.
EG: The investors took a risk and lost. That’s the way a market economy works. If the tunnel had been built with taxpayers’ money, the same destruction of wealth would have occurred though it would not have been visible. The only way that destruction of wealth could have been avoided was not to build the tunnel.
As a frequent user of the tunnel I am happy.
Now, I agree that private financing of infrastructure does not make sense. It is off-balance sheet financing by an entity that does not have a balance sheet. Whatever you think of governments (and in my case, that’s not much) they are good at borrowing money so should own capital intensive assets that no not require management skills. Governments are lousy at running businesses so with few exceptions they should not. But that’s a different argument.
@ken n
“The investors took a risk and lost. That’s the way a market economy works.”
This is the text-book model of how the market economy works. In reality there are several layers of managers between ‘the investor’ (ie those people whose savings are used) and those who took the risk and lost.
“I agree that private financing of infrastructure does not make sense.”
So we agree on that which is the subject in question.
Yes, we are agreed on that. What we do not agree on is whether the Lane Cove Tunnel and the Cross City Tunnel (the other project on which the equity investors lost their money) are examples of why private financing of infrastructure does not make sense. Indeed these were rare cases in which the public did very well.
@Ernestine Gross
Financial management is all about finding ways of putting investors money in their own pockets. Managing this is a constant challenge, hence it requires continuous innovation fueled by generous rewards through ‘performance’ bonuses. Just like in the mafia, all the managers get ‘performance’ bonuses. In the mafia it is called ‘dirtying up’. When the mafia runs a scam, they insist that everyone who knows about it gets at least some of the money (including anyone honest who doesn’t want anything to do with it, but is too scared to inform on them). The idea is that by forcing some of the money on them, the mafia has ‘dirtied them up’. They are now involved in the crime so they will be reluctant to ‘spill the beans’. Dirtying up was a great managerial innovation from a family oriented pioneering firm.
@ken n
ken n, where we don’t agree on is whether the term ‘investor’ and the term ‘public’ are adequate or even useful. I said they are inadequate and I gave my reasons.
You said you benefit from the Lane Cove tunnel (but you are not the public). On the other hand, you may have lost money too (eg if say Leighton Holding shares are in your personal portfolio or in your superannuation portfolio) and you still may be losing money if the toll is calculated on a cost of capital exceeding that required for public funding (JQ’s point). I refer back to my initial post (which, incidentally, does not differ from JQ’s reply except for some more detail. )
@Freelander
I don’t think I can agree with you; the term ‘Financial Management’ can mean anything from a student trying to make ends meet (eg sending a cheque to the wrong address to gain time for payment of a bill – an example of small scale working capital management) to a proverbial housewife, with or without a credit card, making purchasings within a cash (or cash plus credit) budget to a person deciding whether to rent or buy a house to a owner-operater enterprise to a corporation to a multinational corporation to a State Treasurer to a Federal Treasurer to the Head of Venezuela (with or without oil revenue) to a NGO working in Haiti at present.
@Ernestine Gross
One of the investors in the Lane Cove tunnel is a billionaire from Hong Kong. There is no reason at all for us to care about his losses. Another is Leighton. While we should care about Leighton’s Australian shareholders, as I recall a large minority shareholder in Leighton is a German company. Again, their welfare is not our problem. The tunnel may well get sold for a fire sale price to an Australian company, like Transurban, and the motorists still get to use it. They will pay a toll, but since driving in the tunnel is a voluntary activity, we can safely assume that the toll is no more than the value obtained by the motorists, and probably less.
@ken n
Lane Cove Tunnel and Cross city tunnel – and you say Ken, the public did very well out of them. I dont think so. The public had to donate (give up) lanes for both of these dodo projects so anyone who wanted to continue travelling for free on roads that previously were constructed by governments and built for “public use” and on which they were not charged had to give up roads for this little privatisation escapade and found themselves in a worse traffic jam than before and lets face it – neither the Lane Cove section or the cross city tunnel travel very far at all for the exhorbitant fees charges.
Oh and people who earn less generally live further from the city – so they are your user pays beneficiaries.
The PPS on these dodos lost money becuase people avoided them in droves – get the message Ken??
They were nice deals cooked up between the government and the private sector each hoping for a big cut out of the poor underserviced and overcharged “public.”
Trouble is the public got annoyed, angry and avoided it at the “in your dreams” prices they estimated, hence volumes went kaput, the private sector operators went bust and hey guess what – now they are slugging it out with the State government in courts. Surprise, surprise – Lawyers cost more than roadworkers – oops. Boo boo. May have been cheaper just to build the things publicly for no charge, save emmissions, save jams, save accidents, save piecemal widenings elsewhere and save face. Thats what we pay taxes for.
These two PPS tunnels were exercises in pure greed – nothing more, nothing less.
The only reason they dont build the roads themselves anymore is because the pathetic state government doesnt know how to build them. The department of public works is a shell and the RTA has been stripped to the bone along with many other public service departments.
The “rightly” rich also dont want to pay much income tax remember? Politicians are members of the “rightly” rich.
@Alice
“The only reason they dont build the roads themselves anymore is because the pathetic state government doesnt know how to build them.”
Now, this cuts to the core of a problem with the idea of ‘privatise and regulate’, IMHO. My simple mind tells me that you can only regulate effectively what you ‘know’ (have technical and managerial know-how).
@Uncle Milton
Now now, Uncle Milton – are you suggesting that the idea of a ‘global economy’ is for various nationalities to ripp each other off?
A commenter by the name of Crocodile once wrote that the threads tend to be very long when I post. So I opt out now with the remark that I liked JQ’s article.
@Ernestine Gross
Couldnt agree more Ernestine…lack of technical and managerial know-how on the part of governments also leads to inneffective regulation. And as loss of public expertise has increased it has become easier for governments with less know how to outsource the regulatory oversight as well doesnt it?
Hence the mess we are in?
Geraldine, it’s just standard welfare economics. For example, in evaluating whether a change in international trading arrangements is good or bad, we ask “what’s in it for us?” not “what’s in it for us and them combined?”.
And it’s not a rip off, at least not in competitive markets. If the investment had worked out, the foreigners would have been better off, but their welfare gain would not have counted in our welfare. But as it turned out, they lost. That is their problem, not ours.
@Uncle Milton
Geraldine?? I think you mean Ernestine.
@Ernestine Gross
The financial management I was referring to is that undertaken in the big end of town where they get to play the best game of all called “other people’s money”. Amazing what you can do when it is “other people’s money”.
@Alice
Apologies. I was listening to a Geraldine Doogue podcast as I was writing.
Nice article.
Pity that it looks like there will be a renewed push for more PPPs from both the State and Federal government’s. With such a significant private sector market pushing the government down the path of PPPs for thier own benefit, the government no longer has either the capability nor the appetite to resist their advances. So, we the taxpayer, will get to pay more for services.
In Queensland, we might get lucky. If the new PPP projects are delayed then the government might get to witness the pain from the failure of the Airport Link project. I suspect that Clem 7 will be a little down on patronage forecasts but by opening early they have secured themseleves a tidy buffer. In addition the Clem 7 forecasts were reasonably sensible. Airport Link on the other hand had forecasts that were almost double normally accpeted capacity maximums. Combined with the already multiple variations that have been approved suggests that they wont have the same sort of buffer.
While still a couple of years away, when it fails, maybe the government will have a good hard look at itself. Or then again it might just spin it’s way through.
“This raises the question, is it financial engineering or language engineering?”
Its language engineering. We are talking about “scames, schemes, and ripoffs…” as Celente explains it.
Fractional reserve itself doesn’t seem like a scam because of a thousand years of desensitization to it. But a credit default swap? Thats a scam Its all part of a suite of numbers rackets, like what you’d expect from Tony Soprano.
If the Americans had taken a sensible, neutral approach to the bailout, then all these various scams would have been wiped out comprehensively. They kick things down the road for so long, but sometimes the market really does speak. And the market did speak and what it said was that all these high-bonus operators were really just hyped-up bums and con-artists. The derivates industry would have been almost completely wiped.
Most banks under sensible bailout conditions (massive debt retirement through new cash indjection, not regarding any institution in particular) would have been forced to sell off branches and go into retrenchment in order to get hold of the massive amounts of new cash to make good on their commitments. But the bigshots would have all gone under and their creditors would have them in court.
Now they are just filling up their pockets with cash.
@Graeme Bird
On that I agree Graeme Bird. The bailout should never have happened and the money should have been directed to a main street bailout. Stuff the banks. Now they know they are immune unethical business continues as normal or worse than before.
The financial services sector is a grotesque parody of what the financial aervices sector should be.