The Big Dig continues to wreak havoc with the Mass. state budget (via the WSJ):

The financial crisis is causing a big row in Massachusetts over tolls.

The Massachusetts Turnpike Authority, already the object of local scorn for cost overruns incurred in the infamous Big Dig road project, faced further public wrath in recent weeks when it proposed a $100 million a year toll increase covering Boston’s bridges and tunnels. At the tunnels outside Logan International Airport, cash tolls would double to $7.

Looming large among the reasons the authority needs the cash are three “interest rate swap” contracts related to the Big Dig that were sealed with UBS AG, Lehman Brothers Holdings Inc. and J.P. Morgan Chase & Co. The deals have gone wrong for the state, adding to its interest burden and confronting it with up to $467 million in potential fees if the firms opt to pull the plug on the contracts.

Interest rate swaps are derivatives and the state was basically betting on interest rates. Why would they do that? The best answer is that interest rates are volatile and someone in the responsible agency thought they could win betting against the investment banks. The state should not be in the business of betting on interest rates but in a volatile environment there is an incentive for government employees to try. Taking risks with other people’s money is always a tempting arrangement.

How do we prevent things like this from happening? Do we make swaps illegal? Do we make it illegal for governments to engage in derivative transactions? That would be treating the symptom of the problem rather than the cause. What we need to do is make interest rates less volatile and remove the temptation to enter into such speculation. The best way to accomplish that? As I wrote in my essay, A New Bretton Woods, there is much lower economic volatility under a gold standard. In that article I highlighted the volatility of commodity prices and exchange rates but the same logic applies to interest rates. Interest rates move primarily because of changes in inflation expectations and under a gold standard those expectations are minimized.

It seems like there are new revelations everyday of losses due to derivative transactions that were allegedly for hedging. That hedging activity would be mostly unnecessary under a gold standard. The capital now tied up in derivative transactions, and the people who are responsible for them, could be put to more productive uses. There are costs to adopting a gold standard but there are some major benefits as well.

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