Monday, 26 January 2009



So far the treasury’s rediscovery of Keynes and the use of counter-cyclical capital spending in response to a deep economic downturn has been the credit crunch’s only notable intellectual development. There’s just one problem you see in the run up to August 2007 government was so busy hardwiring as much of its capital spending as possible to the credit and property cycles it’s not clear how this rediscovery of Keynesian economic policy can be put into practice. Oops!

Some examples; PFI/PPP finance was used to pay for everything from new hospitals to military flight simulators. For deals over a certain size the financing would be via a bond “wrapped” by a monoline insurer. Unfortunately, because monoline insurers have been stuffed since 2007 bond issues simply aren’t an option. Instead even big PFI/PPP deals started looking to banks for debt. Except banks simply didn’t (and don’t) have the liquidity to finance major projects and keep them on their balance sheets.

This would be manageable if there was a secondary market at the moment for them to arrange a deal then sell it down too, but there isn’t. Well there is sort of, but the kind of terms and margins being demanded (a) keep changing and (b) are so steep its difficult to imagine the Value for Money test (can the government finance this deal cheaper itself?) applied to every PFI/PPP deal being passed, and anyway (c) banks are only willing to take on board smaller slices of debt, which means more banks are needed for each deal making the whole process more time consuming, convoluted and expensive (the phrase “herding cats” arguably applies to the kind of syndications now being seen).

The reason is straightforward; while PFI/PPP poses relatively little risk, this is reflected in historic pricing rates that simply aren’t regarded as tenable at the moment. The practical result is that while the chancellor last year announced his intention to bring forward capital projects to alleviate the effects of the downturn, the actual number of PFI/PPP deals signed off in 2008 was just 34 compared with an average of 60 per year over the previous decade. In other words there is a dirty great big logjam due to credit constraints.

It gets worse. While the assumption that PFI/PPP finance would remain available was built into all the major capital spending strategies announced by government, most notably the Building Schools for the Future programme, other quasi-government agencies were also expected to do their bit and borrow more to finance the capital expenditure needed to meet government targets. The most notable were the housing associations who, like local authorities wanting to renovate schools, received additional central government tied to their willingness to borrow more. Similarly, further education colleges, like housing associations, were also obliged to sell assets i.e. property, to finance their capex plans, another oops given the current state of the property market.

It gets even worser. You see the size of the social housing stock is intimately connected to private residential property development. Builders typically need to contribute to the provision of social housing to get planning permission as part of what are called section 106 agreements. Now this is something not a lot of people appear to know about including Kate Barker, variously described as Gordon brown’s favourite Housing economist who in her report to government a few years back recommended the introduction of a planning gain supplement i.e. a quid pro quo tax on property value appreciation following the granting of planning permission that was essentially already there. Regardless of that the point is during a boom forcing private developers to contribute to the social housing stock makes sense, but during a bust when new private residential construction orders fall around 60% in Q4 2008 on the 2007 level, the supply of new social housing will fall significantly because fewer people are applying for planning permission.

So there it is. Government capital spending plans were and arguably still are predicated on the assumption that private finance will always be available and that property values/developer activity will keep rising. Neither is the case right now and when private finance is available, it’s at a cost that by historic standards would be judged unacceptable. The various schemes announced by the Treasury in January to ease liquidity constraints are vague enough to accommodate PFI/PPP finance, but they don’t appear to have been written with that in mind. Rather, the explicit references are to commercial and residential property as well as leveraged loans i.e. the riskier businesses banks did to help themselves rather than the lending to government institutions that arguably helps us all.

Thankfully there are some signs this has been recognised most obviously the decision reached on January 26th for government to underwrite the widening of the M25. But, by definition the response so far has been both piecemeal and begrudging, highlighting the traditional criticism of Keynesian economics that by the time government actually responds to a downturn, its simply too late.

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