A risky business

The recent equity sell-off has focused investors’ attention on measures of market volatility, which have been abnormally low for much of the last four years. I did point out last summer that implied equity and bond market had fallen to all-time lows, and that there was a risk of a nasty surprise if investors believed that central banks would no longer continue to provide the unlimited support that they had hitherto (here). In the event, equity market volatility measures fell even further, bottoming out in November, whilst both the Fed and Bank of England since have raised interest rates.

Naturally, this raises the question, why now? And the truth is we don’t know. Many ex-post rationalisations have been offered but I suspect that markets had simply been living off fresh air for too long. It is thus possible that someone, somewhere simply placed a sell order that was picked up by algorithmic trading systems and triggered a widespread bout of selling. But nobody was really surprised that markets did correct sharply downwards, even if the magnitude of the correction caught many people out. Indeed, I pointed out last summer that “if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.”

At this stage, I do not have enough evidence to change my year ahead prediction that equities will finish 2018 up by 5-10% on year-end 2017 levels. But that view looks a little more shaky than it did five weeks ago. Whilst much attention focused on the fact that the correction in the S&P500 on Monday was the largest single daily points decline on record, it is only the 39^th biggest percentage decline on daily data back to 1980 (although that puts it well inside the top 0.5%). Slightly more worrying is the fact that exactly 10 years previously, on 5th February 2008, the S&P500 fell by 3.2% on the day – at the time, the 30^th biggest daily fall since 1980. And we all know what happened later that year …

Recent trends in volatility raise a number of key questions. First, is volatility mean reverting? If so, neither the extremely low levels of 2017 nor the elevated levels of today will be sustained. Second, if market volatility measures do move back towards more “normal” levels, how quickly is this likely to occur? And third, is it possible that the trend volatility level has changed (i.e. that investors risk appetite has changed)?

With regard to the first question, the post-1990 evidence does suggest that equity volatility is mean-reverting although it can diverge from the mean for a considerable period of time. On average since 1990, each period of over- or undervaluation relative to the mean lasted for 17 months, which suggests that the period of adjustment is relatively slow. With regard to the second issue, in 88% of cases since 1990 the VIX was within one standard deviation of the mean (although on only 38% of occasions was it within half a standard deviation). One standard deviation represents a 7-point move in the VIX which is relatively tolerable. It is only when we see the kinds of spikes associated with the bursting of the tech bubble between 1999 and 2002, or the post-crisis period of 2008-09, would high equity volatility threaten to derail the markets.

However, there is a risk that an extended period of low volatility sows the seeds for a period of higher vol. Lower volatility during periods of economic upswing tends to result in higher risk taking and excessive leverage, with the result that even small price declines can force investors to dump asset holdings, depressing prices further and generating higher volatility. This triggers a second round of price declines and volatility spikes which could turn into a self-reinforcing spiral. But as it currently stands, despite the sharp spike in equity volatility in early February, the forward vol curve is pricing in a decline back to levels close to the long-run average over a five month horizon (chart). This downward sloping volatility curve is not indicative of a market which is expecting a significant change in risk conditions.

As for the third question of whether there has been a shift in the trend level of the VIX, and therefore a shift in investor risk tolerance, the jury is still out. We will probably only know after a prolonged period of tighter monetary policy. The most four dangerous words in finance are “this time it’s different.” Any data series which shows strong mean-reverting trends should be treated as such until we have overwhelming evidence to the contrary.

All in all, I am inclined to treat the current trends in markets as some of the air coming out of the bubble rather than as the beginning of a more prolonged sell-off. As many people have pointed out, the fundamental factors which drove markets higher in the first place – strengthening growth and the impact of US tax cuts on corporate earnings – remain in play. But the spike in volatility acts as a reminder that markets are like wild animals: they can act unpredictably and you can never tame them, so you have to act cautiously to avoid getting your face ripped off.

In defence of economic forecasts

It is becoming rather tiresome to hear the constant carping about the value of economic forecasts, particularly when the critics are responding to forecasts that do not accord with their pre-conceived views. Ed Conway weighed into the debate in The Times yesterday (here if you can get past the paywall), with his claim that “the job of a city economist is not to make accurate forecasts; they’re basically there to market their firms.” As a city economist who has spent a lot of time working with various models generating forecasts to meet client demand, I can say with total confidence that Conway is dead wrong. It’s a bit like saying that we should ignore the views of most economic columnists whose raison d’être is to offer clickbait for the masses.

But the most annoying comments of the week came from Eurosceptic MP Steve Baker who proceeded to denigrate the Treasury’s analysis of the negative economic consequences of Brexit. He noted in the House of Commons that “I’m not able to name an accurate forecast, and I think they are always wrong.” The second most annoying comments, and probably more serious set of allegations, came from Jacob Rees-Mogg who accused Charles Grant, the director of the Centre for European Reform, of suggesting that Treasury officials “had deliberately developed a model to show that all options other than staying in the customs union were bad, and that officials intended to use this to influence policy” (here). Grant denied any such implication and Baker was forced to apologise for providing support to what is an outrageous slur on the impartiality of the civil service.

What all this does illustrate, however, is that factual analysis is being drowned out by an agenda in which ideology trumps evidence. With regard to Baker’s claims that forecasts are “always wrong” it is worth digging a little deeper. No economic forecaster will be 100% right 100% of the time – we are trying to predict the unknowable – but there are acceptable margins of error. HM Treasury surveys a large number of forecasters in its monthly comparison of economic projections, which is a pretty good place to gather some evidence. Our starting point is the one-year ahead forecast for UK GDP growth, using the January estimate for the year in question (at this point, we do not have the full numbers for the previous year).

I took the data over the past five years, for which 34 institutions have generated forecasts in each year. The average error over the full five year period, using the current GDP vintage as a benchmark, is 0.63 percentage points. This is not fantastic, though if we strip out 2013, the figure falls to 0.51 pp.  For the record – and probably more by luck than judgement – the errors in my own forecasts were 0.48 pp over the full five year sample and 0.33 pp over 2014-17, so slightly better than the average. But there is a major caveat. GDP data tend to be heavily revised, due to changes in methodology and the addition of data which were not available initially. Thus, the data vintage on which the forecasts were prepared turns out to be rather different to the latest version. Accordingly, if we measure the GDP projection against the initial growth estimate, the margins of error are smaller (0.5 pp over the period 2013-17 and 0.4 pp over 2014-17).

Without wishing to overblow my own trumpet (but what the hell, no-one else will), my own GDP forecasts proved to be the most accurate over the last five years when measured against the initial growth estimate, with an average error of just 0.16pp over the past four years. More seriously, perhaps, the major international bodies such as the IMF and European Commission tend to score relatively poorly, lying in the bottom third of the rankings. These are the very institutions which tend to grab the headlines whenever they release new forecasts. A bit more discernment on the part of the financial journalist community might not go amiss when it comes to assessing forecasting records.

All forecasters know that they are taking a leap into the dark when making economic projections, and I have always subscribed to the view that the only thing we know with certainty is that any given economic forecast is likely to be wrong. But suppose we took the Baker view that forecasts are a waste of time because they are always wrong. The logical conclusion is that we simply should not bother. So what, then, is the basis for planning, whether it be governments or companies looking to set budgets for the year ahead? There would, after all, be no consensus benchmark against which to make an assessment. Quite clearly, there is a need for some basis for planning, so if economic forecasts did not exist it is almost certain that a market would be created to provide them.

As for the Treasury forecasts regarding the impact of Brexit on the UK (here) , it may indeed turn out that the economy grows more slowly than in the years preceding the referendum, in which case the view will be vindicated. There is, of course, a chance they will be wrong. But right now, we do not know for sure (although the UK did underperform in 2017). Accordingly, the likes of Baker and Rees-Mogg have no basis for suggesting that the forecasts are wrong, still less that the Treasury is fiddling the figures. I take it as a sign they are worried the forecasts are likely to prove correct that they have been forced to come out swinging.

Janet Yellen: A job well done

Today’s FOMC meeting was effectively the last act of Chair Janet Yellen, whose four-year term expires on 3 February. It is unusual for a one-term Chair not to be offered another term: Her tenure marks the shortest since G. William Miller’s ill-fated 17 month spell in 1978-79 and is indeed the second shortest since 1934 (beating the curtailed chairmanship of Thomas McCabe by a mere 14 days). The Fed Chair is in the gift of the President, so he is quite within his rights not to renew Yellen’s term. Nonetheless, I cannot help thinking that the Administration may be missing out by not giving her another four years.

Compared to her two immediate predecessors, Yellen came across as relatively unflashy and low key. She never sought the limelight in the same way as Alan Greenspan, and as good an academic economist as she is, Yellen never seemed to exude the same star quality as Ben Bernanke (maybe that’s an unfair characterisation but it is purely a personal impression). Yet in her understated way, Yellen has moved the dial further forward as the Fed seeks to move away from the crisis measures of 2008-09. In many respects, Bernanke’s inheritance was the result of years of loose monetary policy and a relaxed attitude to markets under Greenspan. Accordingly, much of his eight years were spent trying to prevent the economic and financial system from collapsing and Bernanke scored high marks for recognising the symptoms of the Great Depression and introducing a massive monetary expansion to combat it.

When Yellen took over in 2014 the economy was on a solid footing but monetary policy was still jammed in high gear, with interest rates at zero and the central bank balance sheet all but maxed out. The decision to start raising interest rates in late-2015 – the first increase in almost nine years – passed off without incident and an additional four increases, each of 25 bps, have not done any damage to the economy or to markets. Yellen also presided over the decision to start running down the Fed’s balance sheet although it will be up to her successor (Jay Powell) to fully implement it.

On the whole, it is likely that Yellen will be judged as a safe pair of hands who navigated the Fed through some difficult waters. It appears that her only failing was to be a Democrat at a time when an avowedly Republican Congress was in place. Whilst it was conservative lawmakers’ distrust of the Fed’s QE policy, fully supported at the time by Yellen, which counted against her, it is ironic that she has overseen the start of balance sheet unwinding – a process which has never been tested in the modern era.

As of next week, Jay Powell will be occupying the big chair and although he is widely seen as the continuity candidate, he may have his work cut out. For one thing, the US expansion is already long in the tooth, and assuming nothing goes wrong beforehand, May will mark the second longest expansion in recorded history. Quite how the Fed will respond if the economy starts to wobble may be an issue for the latter months of 2018. Then there is the question of how the Fed deals with any market wobble. For the last nine years, markets have generally only gone in one direction – upwards – but with valuations looking stretched it may not be too long before the bubble of optimism starts to deflate.

In the past, Greenspan and Bernanke were not averse to nudging monetary policy to help markets along. Whether Powell will act in the same way remains to be seen. But Janet Yellen will not be around for these issues to blot her copybook, which is a pity because the true test of how good central bankers are at their job is determined by their reaction to adversity. So we will never know how good she could have been, but as it is, Yellen can reflect on a job well done over the last four years.

Brexit: The (un)civil war continues

It has been clear all along that Brexit has little to do with economics and everything to do with a view which a certain group within the Conservative Party has of the UK and its place in the world. It is also not news that the form of Brexit which this group intends to pursue is not one which large parts of the electorate voted for – even those who voted in favour of leaving the EU. But it is increasingly evident that this is becoming an obstacle to the smooth running of government as the fissures within the Conservative Party threaten to split it apart.

Last week, Boris Johnson again broke ranks with his cabinet colleagues via a series of pre-briefed news articles by calling for additional NHS spending, with newspaper reports suggesting he was pushing for an extra £100m per week (£5bn per year) after Brexit. Recall that Johnson was one of the prime supporters of the claim that the UK would be able to save £350m per week after leaving the EU, a large proportion of which could be channelled towards health spending. Whatever you think of Johnson as a politician, his call for additional NHS spending is well made. According to the OBR’s projections, total health spending is set to decline from 7.2% of GDP in FY 2017-18 to 6.8% by 2019-20. Simply to hold spending constant as a share of GDP implies increasing funding by £166m per week by 2020. But as is often the case with Johnson, there is usually more than meets the eye and the rest of his cabinet colleagues clearly did not think much of his attempts to hijack the political debate.

Meanwhile, Chancellor Philip Hammond is the focus of ire from the Leavers following his speech at the World Economic Forum in which he called for a soft Brexit that would result in only “very modest” changes to the UK’s relationship with the EU. The prime minister has been called upon to sack her Chancellor as concerns mount amongst pro-Leave MPs that the UK is “diluting Brexit” and that it may become an EU “vassal state” during the transition period. This comes at a time when leaked reports prepared for the government suggest that in the absence of a trade deal with the EU, output would be 8% below the pre-referendum baseline over a 15 year horizon. A free trade agreement with the EU – the current favoured option – would result in a 5% decline in output whilst the soft Brexit option (i.e. continued single market membership) would result in a 2% decline in GDP. All of which comes after Brexit Secretary David Davis refused to release impact assessments covering 58 sectors of the economy when requested to by parliament, claiming they did not exist.

All this is, to be sure, a deeply unsatisfactory state of affairs and it highlights the weakness of Theresa May’s position. Despite Boris Johnson’s constant flouting of collective cabinet responsibility, such is the strength of his grassroots support that the prime minister is unable to remove him without jeopardising her own position. If she were to bow to the minority group of hardline MPs calling for Hammond’s departure, the other half of the party would similarly revolt. There is thus mounting concern that there may be a challenge to May’s leadership – a procedure which requires the support of just 48 MPs – although since most Conservatives believe this would hasten their exit from government, this is not anybody’s favoured scenario.

But the Conservatives only have themselves to blame. It was their party that called the referendum, and their government which decided the terms on which they would seek to leave despite being warned of the dangers. Theresa May has compounded the problem by not offering any leadership on the Brexit issue. She has not articulated what she wants from the EU, other than the closest possible relationship, and in the words of FT commentator Philip Stephens, “Mrs May, it is obvious, has no organising vision of the shape of Britain’s post-Brexit relationship with its own continent ... As things stand, history will remember her as an accidental prime minister who foolishly squandered a parliamentary majority in an election she had no need to call — the worst prime minister of modern times with the exception, of course, of her immediate predecessor, David Cameron.”

Former LibDem leader Nick Clegg, also writing in the FT, noted that as it currently stands the proposed transition period which will run beyond the end of the Article 50 period in March 2019, will leave the UK powerless; a member of the EU in all respects but one – the ability to have any say in writing EU legislation. This is very much the position Norway finds itself in now. Why this comes as any surprise to anybody beats me. I pointed out in 2015 that such a Norwegian outcome “would appear to be even less optimal than that which the UK faces today.”

There is increasingly little faith in the government’s ability to square this circle. It clearly appears that Theresa May gambled on the UK’s ability to quickly achieve a deal with the EU without thinking through the implications of what this might entail. In that sense, she is very much in tune with those elements of her party who have spent much of their political career either ignoring or misreading European issues. And now she is their prisoner.

Reflections from snow-topped mountains

One of the main strands of Donald Trump’s appeal to the American public is that he is an outsider. Of course, that is not true – and never has been.  As the president said in a speech in Arizona last year, “I was a good student. I always hear about the elite. You know, the elite. They're elite? I went to better schools than they did. I was a better student than they were. I live in a bigger, more beautiful apartment, and I live in the White House, too, which is really great.” So it probably should not have been a great surprise that he became the first sitting president in almost two decades to attend the World Economic Forum’s jamboree for the great and the good in Davos[1].

Not surprisingly, Trump was the star of the show and the positive message Europe heard was that “America First does not mean America alone.” But he also pointed out that the world "cannot have free and open trade if some countries exploit the system" and that Washington "will no longer turn a blind eye to unfair trade policies." The WEF’s annual report indeed highlighted that the risk of some form of conflict was high on the list of issues which could derail the current friendly economic environment. The WEF notes that “charismatic strongman politics is on the rise” that has hastened the move away from the rules-based multilateralism which has underpinned the peace and prosperity of the post-WWII economic system. The US has blocked appointments to the WTO’s seven-member Appellate Body during Trump’s tenure, and two seats are currently waiting to be filled. A weakening of the WTO’s ability to resolve disputes does nothing to assuage concerns that trade tensions between the US and China could yet become a major problem.

But one of the biggest curiosities of the Davos bash is that it should happen at all. One of the reasons why “strongman politics” is on the rise is that many millions of ordinary voters feel left behind by the advance of the global capitalist economy, which appears to benefit the very few at the expense of the many. Two weeks ago BlackRock CEO Larry Fink distributed a letter addressed to the CEOs of global companies arguing that “society is demanding that companies, both public and private, serve a social purpose.” Economists such as Milton Friedman would not agree. Writing in 1970, Friedman argued that a business executive who exercises social responsibility in the course of their work “must mean that he is to act in some way that is not in the interest of his employers”. Businesses which do anything other than maximise profits were “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades” and were guilty of “analytical looseness and lack of rigor.”

Arguably Friedman’s view is flawed because it fails to distinguish between short-term and long-term profit maximisation and ignores the non-pecuniary benefits which flow from social activities. Companies which simply attempt to maximise profits each year, whilst failing to treat their customers and employees with respect, will fail. But that is a different proposition to suggesting that companies exist to serve a social purpose. In any case, many large firms have long since taken ideas of social responsibility on-board in drawing up their corporate sustainability programmes. Corporates do have a duty to act responsibly, of course, and those which fail to do so are held up to scrutiny. The problems faced by Volkswagen following the revelation that it falsified diesel engine emissions highlights that there are costs associated with acting in a non-socially responsible manner.

But the more I listened to what Fink had to say, the less I was convinced by his message. Another of his Davos pronouncements was that too many people are excluded from the workings of financial markets as a result of financial illiteracy and more work has to be done to ensure “they don't feel frightened of moving their money into long term instruments.” Given that Fink is the CEO of a primarily passive investment fund, there is a certain irony (to say the least) in his desire to get more people involved in financial markets. His point that a lack of involvement ultimately hampers efforts to generate decent retirement incomes was valid. But at a time when many people are finding their incomes being severely squeezed, they simply do not have the excess resources to devote to financial investing – a problem the likes of Fink do not have.

I have no doubt that Fink’s views – and those of his fellow grandees – are motivated by a genuine concern that the system from which they have benefited is under threat, and that they believe there is a strong case for redistributing some of the wealth. Perhaps they not aware of how their argument in favour of caring capitalism comes across – it does sound like a ‘let them have cake’ view.  Many people simply feel that they are being screwed and want a piece of the pie. That said, when it falls to the rich to talk about solving global inequality problems, it is small wonder that the ordinary voter has little faith in governments.

---

[1] In the interests of disclosure, I should point out I was not there. I assume my invitation was lost in the post.

Whose data is it anyway?

To the extent that economics is concerned with the study of how resources are allocated, a system of property rights impacts on the way these resources can be used. For example, if a person owns a piece of land they can choose (within limits) what to do with it e.g. build a house or let it lie fallow. Other people have no right to determine how the land can be used. In a modern market economy, transactions between individuals involve the transfer of property rights and form the basis of the price determination process we see at work every day. These rights are backed up by a legal system designed to enforce the entitlement to a given bundle of goods (or services) and to record their transfer from one person to another.

However, in the digital age the distinction of property rights has become much more blurred. I was reminded of this recently by an article in The Economist which quoted Nikhil Pahwa, an Indian digital-rights activist, as saying “When they say, ‘Big data is the new oil,’ I answer, ‘But my data is not your resource.’” The context of his quote is India’s biometric ID scheme, Aadhaar, whose database is apparently rather leaky with the result that many people’s personal details find their way into the public domain. But it could equally be applied to the likes of Facebook, which owns the world’s largest personal dataset. At issue is whose data is it? 

Technically, of course, it belongs to the individual who posted it. But Facebook’s terms of service state quite explicitly that “you grant us a non-exclusive, transferable, sub-licensable, royalty-free, worldwide license to use any IP content that you post on or in connection with Facebook.” In other words,  although you own the content Facebook has carte blanche to do what they want with it. From the company’s perspective this is great because it has a huge database upon which it can let loose its AI algorithms to generate ever more sophisticated consumer profiles. One of the great concerns expressed by network campaigners is that such huge databases act as a barrier to entry to smaller companies attempting to break into a particular market, because the lack of access to data means that their consumer profiling will always be inferior.

And this takes us right back to Pahwa’s point: Is it right that the data which we own, and which we give away for free, should be used by a profit maximising organisation to enrich shareholders? In their defence, big data companies argue that they do not charge for their services – Google clicks do not cost the user, so in that sense we are getting something for nothing. Except that is not quite true because we pay for it by giving up some data about ourselves, which may be trivial in isolation but when combined with the billions of pieces from other users, goes to make up a huge mosaic which Google can use to target its adverts more effectively. 

In an interesting paper by Imanol Arrieta and co-authors, the argument is made that data providers should be paid for the information they yield in order that they are compensated for their contribution to the world of AI – information which might in due course be used to displace workers replaced by machines. As data hoarding by Big Data companies increasingly raises public interest concerns, it is likely to provoke the interest of regulators keen to cut down the monopoly power of Google, Facebook et al. It would not be the first time that regulators have taken an interest in tech-related issues: Twenty years ago, the US government opened antitrust proceedings against Microsoft, accusing it of establishing a monopoly position and engaging in anti-competitive practices. And if data really is the new oil, as many commentators contend, recall how in the early twentieth century the US government forced the breakup of Standard Oil, accusing it of being an illegal monopoly.

Big Data companies are already potentially feeling the heat from the US Federal Communications Commission, which voted in December to dismantle its existing net neutrality rules. These rules prevent broadband suppliers from treating different groups of consumers differently, and the likes of Google, Facebook et al are concerned that changes to the rules could impact upon their business models if they are discriminated against by internet service providers (ISPs). As an aside, there are many who argue that net neutrality impinges on the property rights of ISPs, but that is a subject for another day. 

In order to alleviate regulators concerns, it might be prudent for the Big Data outfits to take some pre-emptive actions which show that they are taking mounting social concerns more seriously. For example, there is a case for suggesting that at least part of the data they collect could be shared across a range of platforms thus creating an open-source database (after suitable efforts have been made to anonymise it). After all, it is a public resource – it is “our” information. Of course, this might mean an end to much of the apparently “free” content currently available online. However, both the tech industry and society as a whole are going to have to do some hard thinking about how to balance privacy issues against the cost of online services. If this does not happen, it is likely that government will take the decisions for us, which may not be to anyone’s liking.

Public-private partnerships: An assessment

Modern economies depend on infrastructure that we generally take for granted. Indeed, we often only notice it when it fails. But the capital investment to build the roads, rail and hospitals upon which we depend does not come cheap, nor indeed does the funding required to run them on a day-to-day basis. Increasingly, therefore, governments have turned to the private sector to provide the required funding.

Such schemes generally involve a private investor assuming financial, technical and operational risk in return for a guaranteed fixed return from the public sector which acts as the final consumer of the service provided. This risk transfer puts the onus on the private sector to deliver a project as efficiently as possible in order to maximise the difference between the initial outlay and the revenue stream provided by the government. As a consequence, the public sector is off the hook for any cost overruns associated with big capital investment projects. A further advantage for the government is that much of the finance for such projects is treated as an off-balance sheet item in the public accounts which obviously flatters the public sector debt position, and provides an incentive for governments to put projects out to private sector tender.

In addition to capital investment, numerous day-to-day functions (e.g. the cleaning of public buildings, rubbish collection, IT and even law enforcement in the US) are increasingly contracted out to the private sector. The idea is that opening up the bidding process to competitive tendering puts downward pressure on costs so that we get the same services as before, only at lower cost. But the practice is rather different. A recent report by the UK National Audit Office found “no evidence of operational efficiency” in the hospital sector and that “the cost of services, like cleaning, in London hospitals is higher under PFI (Private Finance Initiative) contracts.” The NAO also found evidence that in an attempt to meet pre-specified levels of service “the contractually agreed standards under PFI have resulted in higher maintenance spending in PFI hospitals.”

Another problem, which was thrown into stark relief this week following the announcement that Carillion Plc – a major UK government contractor – has gone into liquidation, is the extent to which risk is really transferred away from the public sector. Although the company has ceased to trade, the economy still depends on many of the services which it provided. If no other buyer is found and the government does not step in, services such as the running of schools and prisons, the maintenance of railway infrastructure and the construction of major hospital projects, will cease. This is unthinkable. After all, Carillion ran all the catering, cleaning, laundry and car parking at the James Cook Hospital in Middlesbrough (NE England). A collapse of ancillary services will mean the closure of the hospital, which the government simply cannot allow to happen. So it could be forced to step in.

The UK railway industry has proven to be particularly troublesome with regard to private sector participation. The system is designed such that operators bid for a licence to run a rail franchise for a fixed period and it is their responsibility to balance costs and revenues to ensure it can make a profit over the lifetime of the contract. There have been numerous instances of problems in the bidding process, including dubious bids and companies suffering financial difficulties. The latest such occurrence took place in late 2017, when the government allowed the private sector operator of the main London-Edinburgh route simply to walk away from its contract without any penalties after it overbid for the franchise, with the result that it cannot now make sufficient profit from the deal. Virgin Trains will not now pay a reported £2 billion, which is the sum outstanding over the remainder of the franchise which runs until 2023.

It has been widely suggested that this was allowed to happen for political reasons. A company that walks away from its obligations is unable to bid for a tender for the next three years. With a number of other franchises coming up for renewal over that period Virgin would be ineligible to participate, which would be bad for them and reduce the government’s choice of partners nominally capable of running such a franchise. Whatever the truth of the matter, the government’s action creates moral hazard by undermining the basis of private sector participation if taxpayers are acting as the ultimate backstop.

There are thus serious questions as to whether public-private partnerships (PPPs) deliver value for money, particularly when the government can raise finance at a lower cost than the private sector – the UK government can borrow at rates just over 1% whereas the private sector weighted average cost of capital (WACC) is above 4% (chart). Moreover, PPPs generally deliver a rate of return between 10% and 15%, implying that PPPs are very lucrative for the private sector. This might be acceptable if private investors were bearing all the risk, but where the government is forced to act as a backstop this is clearly not a good deal for taxpayers. Consequently, serious consideration has to be given as to whether PPPs are meeting the needs of taxpayers. This does not necessarily mean that they should be abandoned altogether, but they need to be used more judiciously to meet public investment needs.