Thursday, 14 April 2016

The writing on the wall


מנא, מנא, תקל, ופרסין
("Mene, mene, tekel, parsin.") 
Monetary units corresponding to menas, shekels, and half measures.

"God hath numbered thy kingdom, and finished it. Thou art weighed in the balances, and art found wanting."
The interpretation of the writing on the wall given in Daniel 5:26-27

"Now Tobiah the Ammonite was by him, and he said, Even that which they build, if a fox go up, he shall even break down their stone wall."
Nehemiah 4:3

In January hundreds of bricks were blown from the walls of Oxgangs Primary School in Edinburgh. Since then 17 schools in Edinburgh have been closed due to issues arising from poor construction.

PFI/PPP (Private Finance Initiative/Public Private Partnership), the approach to capital investment in infrastructure in Scotland, adopted, since the Major government, by the Tories and Labour prior to devolution, and subsequently by Labour/Lib Dem coalition administrations at Holyrood, has come under scrutiny because of these catastrophic failures of projects funded using this approach, such as where parts of schools have collapsed.

This has been widely reported. While the mainstream media (MSM) have certainly been protecting the Labour Party in Scotland from potential adverse political consequences in their reporting of these events, Labour's responsibility for the funding mechanism associated with these projects has been commented on extensively in social media.

As Jack McConnell said in 2002, while First Minister of Scotland: "Let's be clear. We set the standards. We demand the quality and PPPs don't just attract finance; they make sure private contractors deliver hospitals and schools for our communities - on time, within budget, well designed and easily maintained". Labour in Scotland explicitly took responsibility at the time in order to allay concerns about the impact the way the deals were structured may have on project outcomes. Therefore they must take responsibility now.

If we set allocation of blame and political point scoring to one side for a moment, however, can we identify exactly what was wrong with the deals, what can be done to avoid this in the future, and how things can be done better than they currently are? As I see it, there are two issues:

  1. Structuring the deals to make sure outcomes are aligned with objectives and the failings described above are avoided, and 
  2. Financing them in the most efficient way possible: the way that makes sure public money ends up being as much bricks and mortar and as little unproductive private profit as possible.  

The problems with PFI projects historically, that have resulted in sub-standard construction and technical project failure, appear to originate in a fairly basic conflict of interests in the way the PFI deals were structured. The lenders who provided the finance for the projects in many instances retained an equity stake in the assets. That is, once everything is all paid up, those that provided the funds in the first place still own the buildings. In addition they often hold maintenance contracts.

This means that rather than the borrower being the client who instructs the builders and specifies the deliverable, the lender takes control. But the lender has no responsibility to deliver the services for which the assets are required. Of course, the lender must ensure that the debt can be repaid with interest. However, the lender is not competent to determine the project costs for which the debt is incurred because the lender is not required to use the buildings to provide the intended educational or other services. As a result, costs are cut inappropriately resulting in projects that are not fit for purpose.

It should be emphasised that the parties to the deal are all acting as would be expected under the circumstances, pursuing their own interests to the extent allowed by the deal in a perfectly legal and appropriate manner. The problem arises because the structure of the deal itself fails to align this with the objectives of the project. In particular, a conflict of interest arises when one party holds both debt and equity positions in the same project.

The Scottish Futures Trust (SFT), following the NPD (Non Profit Distributing) model which was developed to replace PFI by the SNP administration that took office in 2007, avoids these pitfalls, with strict separation of debt and equity for projects and clarity that the builder's client is the end user so that  projects are specified and delivered accordingly. However, the issue of the most efficient way of raising finance remains.

This is the difficult part, because the Scottish Government has limited room for manoeuvre. Currently it is still constrained by fiscal requirements and limits imposed by the UK Government. So, for example, it is limited in the extent to which it can borrow and issue bonds, and runs its deficit as part of the overall UK deficit, subject to the priorities of the Treasury. Therefore it remains to some extent hostage to the failed Westminster austerity agenda and cannot optimise its approach unconstrained.

The Unionist resolution of this would be to install a more rational government at Westminster that adopts fiscal policies more conducive to sensible financing of capital investment in infrastructure in Scotland. The Nationalist solution would be to provide the Scottish Government with the free hand it needs via Independence. The Unionist objection to this would be to claim that UK Government bonds will be rated more favourably than Scottish Government bonds, resulting in lower costs of borrowing and higher financial efficiency. The Nationalist would respond that this hypothetical situation is really an indictment of the state of the economy bequeathed to an Independent Scotland by the UK, and that one cannot argue simultaneously that everything changes (politically) and nothing changes (economically). We could start the Indyref 2 debate right here.

One question remains to my mind though. Since November 2009 the Bank of England has purchased £375 million of UK Government debt by creating new money in a process called Quantitative Easing (QE). The European Central Bank has a similar €60 billion per month bond buying programme. The purpose of QE is to meet monetary targets: to control interest and inflation rates. What if it was also used as an instrument of fiscal policy?

We would have to adopt a more agile approach to both monetary and fiscal policy, evaluating actions in a more sophisticated way, rather than the current one-dimensional thinking, and considering central banks and governments to be interdependent on rather than independent of each other.  However, what is better: allowing new money to exist only as debt whose disposition is governed only by monetary considerations; or letting that money represent real value, real bricks and mortar, being put to genuine use delivering education and health services for the people whose taxes ultimately end up servicing the debt the bonds represent?

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