Showing posts with label option value. Show all posts
Showing posts with label option value. Show all posts

Sunday, September 26, 2021

Budget wisdom: keep options open and don't cry over sunk costs

The nation’s economists are realising that what we need is not smaller government but better government – government that delivers value for money. That means stopping the waste of taxpayers’ money. But identifying genuine waste is harder than you may think.

As former top econocrat Dr Mike Keating has argued in a revealing article on the Pearls and Irritations website, the Coalition preaches that smaller government is best, but has failed to deliver it. Even before the pandemic, federal government spending had risen as a percentage of gross domestic product.

Why? Because as it realised after the debacle of its first budget in 2014, the government lacks the voters’ support for big cuts in major spending programs. So it’s been reduced to cutting a narrow range of spending that lacks public support and, otherwise, just trying to keep a lid on other spending.

As economics professors Richard Holden and Steven Hamilton have argued, this penny-pinching has led to many “false economies” – cost cuts that end up costing you more than you’ve saved.

The prevalence of false economy shows that avoiding waste is trickier than many suppose. Take the decision to dump our $90 billion contract for French submarines in favour of US or British nuclear subs as part of the new AUKUS security pact.

This involves walking away from initial payments to the French of, reportedly, $2 billion. Is this a huge waste of taxpayers’ money?

Well, yes and no. We’ve had a lot of second thoughts about the contract since the Turnbull government decided on it. It’s been plagued by disputes, delays and massive cost blowouts. If Scott Morrison is right in believing the move to nuclear subs and a stronger alliance with the Brits and Americans offers us markedly better security arrangements for the future then, no, writing off $2 billion isn’t a waste of money.

Of course, if you want to say the original decision to accept the French proposal was a mistake and a waste of money, you can. But you’ll be relying on the wisdom of hindsight – on you knowing today what Malcolm Turnbull & Co couldn’t have known with any certainty in 2016.

The wisdom economists have to tell us is that past decisions to spend money are “sunk costs”. Whether they turned out to be good decisions or bad, they can’t be undone. So we should ignore them when making decisions today about what we think may happen in the future.

Today, all that matters is deciding what’s the best thing to do to improve our future prospects. If, for reasons of face, we stick with a bad deal rather than moving to a better one, we’re throwing good money after bad. And that would be a waste.

But Holden and Hamilton point to another case where deciding what is or isn’t waste is tricky. Last year, various pharmaceutical companies and university groups around the world were rushing to develop effective vaccines against the coronavirus. At the time, governments couldn’t know which projects would make it through all the trials.

They had to make deals then that would allow them to vaccinate their populations as effectively and rapidly as possible once it was known which potential vaccines had survived the testing.

But Morrison decided to save money by signing up for just two of the possible vaccines: AstraZeneca and one that scientists at Queensland University were working on.

Holden believes Morrison put our money on just those two because they could be manufactured locally, as “a back-door industry policy”. This goal seemed to overshadow the primary goal of ensuring that, whichever vaccines lasted the distance, we’d have all the vaccine we needed ASAP.

But Morrison got caught. The Queensland candidate fell over and AstraZeneca was tripped up by the ill-considered announcements of ATAGI, the Australian Technical Advisory Group on Immunisation.

Holden and Hamilton’s point is that Morrison’s decision to bet on only two of the horses in the vaccine race was false economy, caused by his failure to understand the wisdom of “option value”.

As sharemarket players know, an option is a financial derivative that gives the buyer the right – but not the obligation — to buy (or to sell) the relevant shares at a stated price within a specified period. You have to pay a modest fee for an option contract, but it keeps your options open and minimises the risk of being caught out. It’s a kind of insurance policy.

Morrison should have used the equivalent of options to back every horse in the vaccine race. The cost of buying all those options would have been more than covered by the saving we’d have made by being able to get everyone vaccinated early and thus reduce the massive cost of the present extended lockdowns. False economy strikes again.