Too public to fail? The moral hazard with public institutions.

Although it copes most of the headlines lately by being the most extreme case, the financial problems of Greece's public institutions are not one of a kind... If you have a quick look worldwide you will see cities, councils, regions... having similar problems to pay their bills. You can find near-bankrupt cities in the US (specially in California and Florida) Italy, Spain, Ireland, Portugal, Japan... Public management at its worst seems to be the common factor, with some institutions walking on the edge of default.

We are not talking about having trouble finding money for new investments or projects, as this would be a totally normal (although not desirable) situation in the actual environment. They are struggling even to pay the most basic of services, like electricity or waste disposal. This problem may not be totally evident to citizens because said services are still being provided, but it is serious enough for everyone to be concerned about it. 

The question is, why are services still being provided if they are not being paid? Well, because public institutions enjoy preferential treatment from their suppliers and vendors. This preferential treatment is not precisely earned by being a good customer, but because of their size. The public sector represents a very big part of the total earnings for some of these suppliers and vendors, so they can not afford to stop providing them. They prefer the prospect of being paid ten months later (and this is not an exaggeration) than losing such a big client. They simply have no other option but to bear this load, specially when talking about local companies whose only client is the city council.

This creates a big problem though, as the inability of public institutions to pay their bills creates a highly destructive domino effect. Suppliers and vendors do not enjoy the same preferential treatment with their own business partners; they must pay on time as specified on their agreed terms or otherwise their partners will immediately stop serving them. As they do not get the money public institutions owe them, the disruption in their cash-flow creates a need for factoring or other ways of financing. And while this can be good for the financial sector, it is devastating for the companies being forced to use it. Some companies get strangled by those extra financial costs to the point their business is no longer profitable. In the end, this companies are forced to close or go bankrupt, leaving their employees jobless just because they had the worst client possible, a public institution.

The problem with subsidies

There has been much talk lately about whether the United States Government should stop subsidizing domestic oil companies like Exxon, Chevron or ConocoPhilips to name a few. Tax breaks to oil companies are an old time practice in the US and no government, either democrat or republican, has dared to eliminate them. The reason why these tax breaks still exist is not clear for me, as oil has always been a profitable industry, even through energy crisis like the ones in the 70's or the Gulf war crisis in 1990. However, recent talks about the need to eliminate those tax breaks and focus the money on alternate energy have spiked some heated debates across the US, mainly due to the already high prices of gas and the multi-billion benefits of oil companies worldwide. This has put the problem with subsidies back in the spotlight. 

People (and corporations) get used to subsidies really fast and once they are fully integrated in daily life they are just perceived as an acquired privilege, rather than what they really should be: a temporary boost to an ailing or complicated situation/sector. This is a big problem for two main reasons. The first one is that, after their initial effect on containing or lowering prices, the subsidized good or service generally goes up as if nothing had happened, thus rendering the subsidy useless. The second reason is, when government retires said subsidy, prices are expected to go up even more, so people will complain about it. And that people will complain is not an expectation but a true fact.

But despite energy subsidies having a distorting effect on the economy, the clearest and biggest examples of the danger of subsidies I can think of are the homeownership subsidies that caused the Irish and the Spanish housing bubbles. Yes, over-optimistic lending by numerous banks makes them guilty by association,  but they are businesses and they responded to the needs of a market. A market governments artificially created. Governments were the true enablers of said bubbles. I will never understand what (if any) is the noble idea behind subsidizing homeownership through mortgages. If said noble idea was giving access to a decent house to low-income citizens renting subsidies would have worked similarly well, yet they did not appear anywhere. Maybe the reason was that buying a house provides far more tax revenue for a government than renting one does... Whatever the reason was, for me homeownership is not a security but a limiting factor, as discussed in this article.

The only thing these housing subsidies have achieved in both of the examples given is a construction boom together with a price spike, and a quite heavy one. In a normal, not mortgage-subsidized market, even after assuming the natural demand increase caused by higher demographics in the period, the situation would have been very different. A housing and construction boom would have led to lower or stable house prices, never to sky-rocketing ones! Sky-rocketing prices that ended busting the bubble that we can easily trace to the drowning of Ireland and Spain economies in the past two years.

The supply and demand law is at the base of economic liberalism for a reason. It is a force powerful enough to shape any given economic sector with common sense. The market is wise enough to decide on the evolution of a sector. Subsidies should only be used in exceptional cases, or to protect distressed citizens from being excluded from the system (think health for example) but never on a generalized scale or on a long-term basis.

Blaming the coming 2.0 bubble on Facebook

Some time ago, a social network called Facebook raised 500$ million from Goldman Sachs (450 million) and Russian firm Digital Sky Technologies (50 million). This operation valuated Facebook at an astonishing 50$ billion. This is more than other well-established digital firms like eBay or Yahoo and double the market cap of Sony. Yes, I know Facebook has 600 million users or 'potential clients' (in business terms), but until now it has failed to monetize them. Its main source of revenue is advertising, and according to reports Facebook's success in it is far lower than the rest of the web. Its users have a clear objective in mind, communicating with friends, thus they do not pay attention to banners. Brands however, have found in Facebook the perfect channel to communicate with their clients; but Facebook itself is not seeing any money from this... In marketing, having a large audience and knowing a lot of information about said audience is key for success; but until know Facebook has been unable to use this at full power (conspiracy theories of Facebook selling user's personal data to other companies aside) so the 50$ billion market cap comes basically from estimations of the company's potential.

Valuating a company based just on its potential is a tricky thing to do, as subjectivity comes to play. In the example of Facebook, maybe it has the necessary ingredients to earn lots of money, but nobody is cooking them into an edible product as of now. This takes us to the point where some very risky bets are done based purely on instinct, not real-world results or prospections. But investors around the world, sad with the absence of  'bulls' to ride on the way to market recovery did not mind that. They began to salivate on the thought of being part of the rise of a new giant, the social internet companies (commonly called 2.0). As such, when the invitation to the party appeared in the form of the LinkedIn IPO, and later the Yandex (the leading search engine in Russia) IPO the market was all-in.