Building for the future

So the government is back on the subject of getting pension schemes to invest more in Britain and British infrastructure. I have Views. Settle down, I’m about to expound those Views at length. You might need a cup of coffee for this one. Or something stronger.

In her Mansion House speech last week, Rachel Reeves set out what she sees as a problem:

“Our pensions market is one of the largest in the world.

There will be ￡800bn of assets in workplace Defined Contribution schemes…

… and ￡500bn of assets in the local government pension scheme…

… by the end of this decade.

Pension funds will always play an important role in the gilt market…

… but for too long, pensions capital has not been used to support the development of British start-ups, scale-ups or to meet our infrastructure needs.

I have long been of the view that this hurts our economy…

… because our highest-potential businesses cannot expand…

… and savers are not seeing the returns on their investment which they deserve.

[The ellipses are all hers. Quite why her thoughts trail off like that I have no idea.]”

This whole premise needs some scrutiny. This piece is quite long enough so I’m only going to look at this through the lens of infrastructure, but related concerns arise in relation to investing in British companies.

Most of the time, the most significant aspect of infrastructure projects is completely overlooked. We focus on the end result: the beautiful bridge, the speedy road, the gleaming hospital. We think about how the projects are going to improve our lives. What we do not particularly notice is the prior investment, and what that prior investment means.

Whenever any infrastructure project, big or small, public or private, is undertaken, someone has to make an investment either of money or of labour (or both). Why would someone make that investment? They are not doing so out of the goodness of their hearts. They are doing so because in one way or another they think it is a worthwhile investment.

So far, so obvious, I expect you think. But that concept of worthwhile investment contains multitudes.

Let’s take a simple example. Imagine you are a peasant in the Middle Ages. You live in a shack. One morning you wake up and consider whether you are going to build a better house for yourself. You will consider many things: the current calls on your time, the cost, the quality of your current living accommodation, the other things you could do with the time. But top of the list or thereabouts would be whether your hypothetical new house would still be standing in a few years’ time. If hordes of barbarians are cantering through on horseback every few years looting and pillaging, you’ll probably make do and mend.

It is obvious when you think about it, but a major reason why things fell into disrepair after the fall of the Roman empire was because it didn’t make sense for anyone to maintain things. It wasn’t that people lost interest in having a nice house or good roads, but that they had no confidence that their work would last. Elite projects like castles and cathedrals were viable in the Middle Ages because the state had sufficient power and interest to secure those. Projects of general welfare like aqueducts or roads were beyond the state’s abilities.

So when an infrastructure project takes place, the investor is making a statement, among other things, that the government is strong enough and just enough to justify the commitment. There has long been debate about why the industrial revolution happened when and where it did. Insufficient attention is given to the need for a stable state before an industrial revolution could take place. Factories and machinery are immobile and vulnerable to attack in times of disorder (as the Luddites showed in the early 19th century). From the fall of the Roman empire up to at least the 15th century and arguably the middle of the 17th century, western Europe was too disorderly to allow for the type of long term planning and investment that an industrial revolution would require. Would you set up a factory in the middle of the Thirty Years War or the English Civil War? You’d have to be very bold indeed.

Anyway, I’ve taken a long time to get to the bit that I really want to talk about and that Rachel Reeves is talking about, which is private sector funding of major infrastructure projects. Governments like this idea in the abstract. Getting someone else to pay for the upgrade of the country sounds wonderful to them. Governments have been doing it for centuries: turnpikes are an ancient version of this. Rivers and canals have long been maintained by private enterprise (the River Lea was the subject of an improvement Act as long ago as 1430, authorising commissioners to make improvements to the river including scouring or dredging, and they could recoup the cost of the work by levying tolls).

When the abstract is made concrete, however, states get less enthused. Investors seek a return on their money. That return is extracted from users of the infrastructure. Those users rapidly forget the time, cost and risk that the investors took and soon resent the price they are asked to pay for using the infrastructure. Turnpikes were unpopular in times past and toll roads remain a target of public hostility. The tolls of the Dartford crossing, for example, inspire fury. Governments do not like unhappy citizens.

In this sense, infrastructure is like a turn-based game, where each player moves in turn. First the government encourages or solicits infrastructure investment. Then the private sector puts money and work into creating and charging for the infrastructure. Then the government has the opportunity to rat on the original deal. We could call this turn-based game Monopoly.

This turn-based element is what causes problems. Investors need either to have trust in the government not to rewrite the rules later or to price for the risk accordingly. This means that there are substantial long term costs to countries whose governments who decide to favour unhappy citizens over infrastructure investors.

This causes a special problem for competitive democracies. The average tenure of a British Prime Minister is a little over 5 years and the median Prime Minister serves a little under 4 years. Long term costs will be felt in the future, in all probability by governments of a different stripe and a different Prime Minister. The risks between the different players are not only asymmetric, they are felt quite differently.

The effect is usually gradual rather than sudden. Markets do not treat the rewriting of the terms of public infrastructure projects as a default, though they may feel the same to those who had invested in them. Governments can lean from time to time on those in charge of projects and make them sharpen their pencils. (Often, it should not be forgotten, government incompetence has left too much fat for the project managers and future governments can usually seek redress on this without, if they are careful, frightening the horses.)

No, we should imagine government credibility in this area as being like a flint wall. Each time the government panders to popular opinion at the expense of those who have invested in and managed a project, some credibility is chipped away. The government can endure only so many chips before its credibility lies in flakes.

Rachel Reeves seems to think that the problem is primarily one of scale of pension funds. I’m highly sceptical. Pension scheme trustees are very open to the idea of infrastructure investment as part of their balanced diet, so long as the projects need to make sense for them in the context of their wider investment strategy and appetite for risk.

But when the government (both the last one and this one) opine on how pension funds should be investing more in infrastructure, I regard this as a tacit admission on the part of government that to date it has failed to provide investors with sufficient confidence in its reliability to put more eggs into that basket. So it is interesting is that despite all these exhortations and despite the fact that the government has made this a policy centrepiece, the government has so far made no attempt whatsoever to address this. Indeed, it has followed up the Mansion House speech with dark noises about how compulsion might be required if consolidation into megafunds doesn’t work. This is not a government seriously thinking about the interests of the investors.

Credibility walls can be repaired as well as damaged. That requires the government to make an investment of its own, showing wary investors that it is willing to take unpopular steps in order to encourage long term investment of this type.

This challenge has been met before. In the 1980s, the Conservative government embarked on a programme of privatisation, judging that many industries in public ownership in practice were poorly managed and had suffered from underinvestment. Margaret Thatcher advocated for it combatively, putting herself at the heart of the debate. By identifying herself with the policy, she showed potential investors that she at least would be highly reluctant to reverse course.

This government, however, like its predecessor shows no signs yet of understanding that it needs to make an investment of its own if it wants to increase private sector investment in infrastructure. If it wants that initiative to succeed, it must show that it strongly supports the means as well as willing the ends. So, Rachel Reeves, what personal commitment are you prepared to make to pension scheme investors to persuade them that the biggest risks of all of such projects –those relating to government behaviour – are under control?