21 November 2008
As the recession takes hold, how should local government prepare for the tough days ahead? Roger Latham offers ten top tips for finance directors
The US philosopher George Santayana said: 'He who does not learn from history shall be condemned to repeat it.' What we've seen in the world economy in the past six months has happened before, and in all probability will happen again. The conditions that led to the credit crunch have recurred from the South Sea Bubble through to the Wall Street crash of 1929 and beyond.
So we have to look to earlier periods in history to understand the mentality that overtakes the market when it is in speculative mode. The best book on this, The great crash, was written in 1954 by economist John Kenneth Galbraith.
The similarities in conditions in the mid-1920s, early-1930s, the 1990s and early noughties were numerous. For a start, there were the easy credit terms with low interest rates, which allowed people to borrow to speculate. The ability to trade on the margin allowed extreme positions to be taken with very little immediate outlay. Then there was widespread use of derivative financial instruments, which permitted a volume of trading greater than could be supported by real assets. At the same time, the use of 'leverage' created a situation where the increased value of assets was concentrated on the small amount of risk capital with proportionately multiplied returns to that capital. This was exacerbated by a high degree of interlinking between financial institutions in terms of ownership, takeovers and liabilities. Above all, in all three periods, there was an absolute certainty that economic growth was without end and the value of assets could rise without limit.
In this case, it is unsurprising that the credit crunch so far mirrors the pattern of the crash of 1929. First, the drop in the real economy preceded the collapse of the financial and stock markets. During the last boom, funded by consumer credit, the limit of what could reasonably be afforded was reached. The asset price inflation began to eat into people's ability not only to fund their current consumption, but in some cases to actually function in the local economy. The hike in energy prices merely exacerbated an existing tendency.
Secondly, the downturn in the real economy was enhanced and amplified by the financial and stock markets. As increased margin calls to cover debts were made, the leverage – which had enhanced returns – worked dramatically in reverse to amplify losses. The interlinking between financial bodies transmitted the growing tide of liabilities, so an adjustment became a downturn, became a recession, and might yet prove to be a depression.
Thirdly, the contagion of the financial and stock markets was then, and is now, being transmitted back to the real economy as a modern equivalent of 'Gresham's Law', where bad assets drive out the good. To pay for losses on the 'toxic assets', assets with real value have to be sold and that deprives the real economy of the funding necessary to continue its activities. The people more likely to be involved in the speculative activity, using their surplus income generated by an increasingly uneven distribution of income, now have to curtail their consumption to fund the drop in asset values on which they depended. Eventually, the whole economy settles to a new, lower equilibrium level.
There are, however, ways in which finance officers and treasurers can lessen the implications of the credit crunch. The tips set out below are a distillation of the collective wisdom of a number of senior colleagues. They cannot, of course, be comprehensive. In a few years' time, with the benefit of hindsight, they might look irrelevant but at present they are the vital issues.
Tip one: prepare for the long haul. The effects of the credit crunch might last longer and be deeper than you anticipate and some analysis, in particular about cash flow, needs to be undertaken. If things do go on for longer than expected then the current level of debt being used to finance interventions is going to start to have an impact on the public sector's ability to fund services in the future. So, think about what will you do if overall funding gets tight.
Tip two: watch out for the secondary effects. They might 'boomerang' on you. As well as the immediate effects on your organisation, there is the impact on your suppliers. What would you do if a major supplier in education or social care went under? Existing contractual arrangements around the Private Finance Initiative are already showing signs of pressure. In the long term, the implications on the pension fund will show up in increased employer contributions. Will these still stand, or would there be further changes?
Tip three: efficiency is more than a priority, it's a necessity. You might have thought the 2007 Comprehensive Spending Review sounded bad enough, but more will be needed. It's unlikely that will be achieved by the usual pattern of efficiency savings drawn from shared services, efficiencies of scale, and the introduction of new technology. Genuine transformational changes to the way services to the community are provided will be needed if they are going to be maintained. Start planning for this now. Such change takes time to get agreement, let alone get implemented. Don't wait for the worst to happen – assume it will.
Tip four: look out for displacement of policy objectives. Existing policy priorities at central and local level are going to change and with them the existing funding arrangements. A thorough review of policy priorities with hard-nosed thinking about what would be sacrificed is needed at management and member level. Not everything can be given equal priority and some planning on the basis of real priorities is essential.
Tip five: place shaping on hold? Some of the proposals currently being considered by planners and proposed by developers are going to come to a grinding halt. The value of assets and the cost of borrowing might suspend some long treasured plans. The community facilities promised through Section 106 agreements and the like might not come to fruition. Unless you're simply going to put your place- shaping objectives on hold, you'll need to revisit your ambitions in the light of reduced economic circumstances and determine what is deliverable and what is not. Don't forget the community cohesion aspects either. Some communities will have expectations based on promises made and if there are cuts they will be keenly aware of the fairness or unfairness of these.
Tip six: a collapsing capital programme? Valuable parts of your capital programme might be underpinned by capital receipts based on assumptions of land and property values that are now unachievable. Unless you want to sell assets at a loss and fund the difference permanently from debt, you might have to consider scaling down ambition. Alternatively, refinance in another way and aim to replace the debt used at some future time. If this is the strategy then take a careful look at the terms and conditions of such debt, which will require careful treasury fund management.
Tip seven: check the pattern and flexibility of service demand. As the local economy faces the squeeze, so the pattern of demand for public services may itself alter. If you're pinned into a pattern of service provision that you can't vary, by contracts or unavoidable requirement, then the increased demand can only come from increased expenditure that you can't finance. Leisure facilities, debt management facilities, trading standards and environmental health might also suffer an increased level of demand and the impact on families might create stresses in education and social care. You need to think now where your budget flexibility lies.
Tip eight: tax base losses. The impact of the current financial arrangements means the initial impact of the credit crunch on the tax base is more a problem for central government. But it is not going to be long before these experiences are visited on local government through the grant system arrangements and responsibility for tax collection. After years of campaigning for the return of the non-domestic rate, the impact of the credit crunch might actually persuade the government to hand it back to local government – just at a time when it can't use the buoyancy to create improved services.
Tip nine: propping up the local economy. There will be a strong pressure to act locally in line with Keynesian policies and continue local public spending and employment, even if it is funded by local taxation – in the local equivalent of a 'balanced budget multiplier'. Local government is strictly limited in its ability to do this. No open credit creation borrowing strategy is possible, deficit budgeting is not allowed, and the government has a strong grip on local taxation. However, some things can be done. Training programmes, local purchasing policies, business advice and local mortgages are all ways to make a positive intervention. Establish immediately what you will and won't do in discussion with the business community to avoid raising unrealistic expectations.
Tip ten: don't forget the people. The morale of your organisation might take a real hammering. Staff might see services that they have laboured to build up being dismantled while uncertainties about jobs and their personal situation might start to affect the authority. As the recession begins to bite, people will look within the organisation for leadership. Being clear about what's going on and how the organisation will handle it will become important, and communicating that message openly and honestly to your staff will become essential. Attempting to spin a particular message or being overoptimistic or unrealistic will not wash. At the same time that you're looking after the morale of your staff, you also need to look after your own wellbeing – because if you go down, the organisation is going to be damaged too.
In anticipation of the effects of the recession, CIPFA is already looking to next year's annual conference to provide an opportunity to discuss, to find some solutions, and help for its membership. So we'll be looking at ideas for achieving transformational change and the personal resilience needed to cope with the situation.
And, finally, we need to remember that 'it's an ill wind that blows nobody any good'. Some of our environmental, recycling, transport, congestion and climate change objectives might be easier to achieve in an economy that is intent on frugality, efficiency and saving, and places less emphasis on conspicuous consumption.
Roger Latham is CIPFA vice-president and the former chief executive of Nottinghamshire County Council