Facing up to the ‘D’ word

11 Jun 09
The public sector seems to be in denial about the likelihood of a depression, argues Malcolm Prowle.
By Malcom Prowle

20 March 2009

The public sector seems to be in denial about the likelihood of a depression, argues Malcolm Prowle. But painful decisions must be made sooner rather than later about where the spending axe will fall

The early 1990s was a triumphant time for the free-market economics espoused by Western democracies. After the fall of the Berlin Wall and the collapse of communism in the USSR and its satellites, eastern European countries also adopted ‘post-neoclassical endogenous growth theory’, as then shadow chancellor Gordon Brown described it in 1994. Even the world’s most populous country, the People’s Republic of China, has followed the same model in the post-Maoist era under its reforming leader Deng Xiaoping.

However, in the past year this triumph has begun to have a hollow feel, and some are beginning to doubt whether this model of economic growth will be sustainable. The main question is whether this represents a temporary setback to the world’s economies or if we are seeing the emergence of a new economic paradigm. Is it a recession or a depression?

We know that the UK economy has formally entered a period of recession – defined as a reduction in economic output for two successive quarters. This is characterised by reduced consumer demand, falls in house prices and increasing unemployment. It is seen as an inevitable part of normal business cycles, which take place every ten years or so. However, this is a very different recession for three main reasons.

The first is the impact of the credit crunch, which has led to runs on the banks and a general reluctance to lend. The second is the global impact of the downturn, which was not a serious factor in any previous recession. And the third is the fact that the collapse of manufacturing industry was not one of the primary triggers. Essentially, it is the banking industry that is bankrupt and the banks that are being propped up while other industries are allowed to fail. The size of the British banking sector (compared with the rest of the economy) arguably makes the UK the most vulnerable country after Iceland to major weaknesses in this sector.

The combination of these factors raises the spectre of a depression. This involves a sustained downturn in the economy and is structurally different to a recession. The essence of a recession is that it is a deviation below the normal track of average growth. Policies appropriate to a recession imply a ‘reversion to the mean’.

A depression is not only longer lasting than a recession, but is a shift of the economy to a new equilibrium position with lowered output, persistent unemployment of resources and, generally, deflation of prices. It is an altogether more serious state of affairs, similar to that experienced by Japan in the 1980s and 1990s.

Of course, there are those who say that this is all very different and you can’t learn from history. I would disagree and suggest there is a considerable element of denial at the moment. Clearly, it is in the interests of government to argue that this is a normal recession, which will therefore be short and shallow (although there are exceptions, and even Schools Secretary Ed Balls has said that this might be the worst recession for 100 years, which puts it firmly in the depressionary camp).

A normal recession can play havoc with the public finances of a country. In the UK, the government has been running large budget deficits for a number of years during a period of economic growth. These deficits have been financed by borrowing. Even an ordinary recession usually results in reduced tax revenues and increased need for public spending, thus making the budgetary situation worse and the borrowing requirement even greater. A depression adds a different dimension to UK public finances and could lead to an unprecedented and dangerous position.

Chancellor Alistair Darling should, but probably will not, seriously address these issues in next month’s Budget – and he will need to think radically. A recent report by the Institute for Fiscal Studies gives an indication of the extent of the problem. It said that government borrowing will rise to more than £100bn in 2009/10 and 2010/11 and there will be a £37bn black hole in the finances.

Yet the economic situation has worsened since this report was written. The size of the projected government borrowing creates a nervousness about its sustainability. Writing in The Times at the end of February, Steve Bundred, Audit Commission chief executive, asked if the UK was approaching ‘Armageddon’ levels of debt, pointing out that in normal times government borrowing is around 3% of gross domestic product. At the height of the Exchange Rate Mechanism crisis in 1992, John Major’s Conservative government was borrowing around 8% of GDP. In 1975/76, when the International Monetary Fund was called in to bail out the British economy, James Callaghan’s Labour government had net borrowings of around 7% of GDP. Next year, the figure is likely to reach 12% and this will inevitably rise further.

Although it might be premature to talk about IMF support for the economy, it is fair to question the creditworthiness of the UK government in the eyes of potential lenders. At levels above 12%, and particularly if the world economies are heading for a depression, one has to ask whether there are going to be sufficient people able and willing to lend the government the money that it wants to borrow.

It is worth noting also that the pre-condition for IMF support in 1976 was a 20% reduction in the then budget deficit. In today’s terms, that would imply reductions in public expenditure of £20bn.

At the time of writing, the UK still possesses the prestigious triple-A credit rating but this is not assured. In evidence before the Commons Treasury select committee, Barry Hancock, the head of European corporate ratings at Standard & Poor’s, said that this rating was on the assumption that ‘up to approximately 20% of GDP in the form of bank assets could be problematic in the future’. Twenty per cent of UK GDP would equate to £280bn.

However, it has since emerged that the Treasury is preparing to ring-fence about £400bn of ‘toxic’ bank debt – or 29% of GDP – to draw a line under the financial crisis. Royal Bank of Scotland is said to want to use the scheme for £200bn alone. Questioned about the UK, Hancock told MPs: ‘We are looking at the ratings on an ongoing basis. If there were major shocks or changes, we would look at the rating again.’

A ratings downgrade could be devastating for the UK. A loss of creditworthiness would imply the government was unable to borrow to finance its budget deficit or would have to pay much higher interest rates. Overall, this suggests that there could be really stormy waters ahead, with the possibility of major real-terms cuts in public spending, unprecedented in modern times. This would pose huge problems for services and it is self-evident that decisions about public spending will be painful.

Before any decisions are taken, the following need to be recognised:

  • expenditure reductions of this magnitude cannot be achieved by ‘efficiency savings’ alone under the current centralised UK model for planning and managing public spending

  • frontline services, such as health, education and policing, need to be protected as far as possible

  • large-scale job losses are inevitable

  • there needs to be a balance between the short- and long-term effects of decisions

  • big chunks of spending will have to be removed, rather than the usual tendency of trying to spread the pain evenly with some crude savings targets applied across all programmes.

There are several areas where large savings might be possible. Publicly funded capital spending, which is projected to amount to £52bn in 2008/09, is one candidate. This, of course, excludes any capital expenditure funded through the Private Finance Initiative. One option would be to cut back substantially on programmes, particularly those that involve new service developments.

Benefits is another area to consider. In 2008/09, expenditure on social protection benefits is projected to reach £169bn, but of course this might be expected to rise substantially during a recession as unemployment increases. Savings could be made by reducing the rates of benefit being paid and/or restricting the eligibility criteria (or enforcing existing eligibility criteria more rigorously).

Inspection and regulation could also be cut back. At all levels of government, a plethora of inspection and regulation services are provided by state organisations, such as the Healthcare Commission and Ofsted, or by units within state organisations, such as local authority planning departments. While such services might be nice to have when times are good, one must question whether they can all be afforded in the current/future economic climate and consider eliminating some or at least reducing them in size.

It is also worth assessing whether the large number of quasi-autonomous government bodies found in virtually all areas of public life are affordable in their present form. One option could be to merge some of the quangos. For example, could the Learning and Skills Council and the Higher Education Funding Council be combined?

Then there is the myriad of social engineering projects, whose role is to give advantages to or reduce disadvantages among various social groups. Although they might be seen as valuable, there are grounds for considering ending them on grounds of affordability and lack of effectiveness.

However, given that many of these have been prime government objectives over a number of years, abandoning the targets in these areas would be strongly resisted in some quarters.

Cutting back-office costs is an obvious source of savings and many organisations have made some progress with this, by rationalising these functions or sharing them with others. But this is just the tip of the iceberg. Managerial infrastructures can also be over-elaborate and expensive and one option for savings would be to cut a swathe through these arrangements.

Pay, of course, is by far and away the largest element of cost in the public sector and any approach to reducing expenditure must take account of this. Careful scrutiny needs to be given to the use of incremental scales, job evaluation exercises, pay restructuring schemes and the like, as in our experience these are usually inflationary. Already there is talk of a pay freeze, which is likely to be resisted by the trade unions.

One controversial issue is the high cost of public sector pension schemes. Some commentators have suggested that a £900bn funding ‘black hole’ exists, which will have to be paid for in the future. However, the most that could be done in this area is to shift to a less generous pension arrangement for new employees, but the financial savings associated with that would take many years to realise.

A radical approach will be needed in discussing real-terms public spending cuts of this magnitude and type, as they raise serious questions about the purpose of public spending, the role of the state in our society and the size and functions of the public sector. Activities that might (or might not) have been seen as desirable when things were good might no longer be affordable.

Furthermore, in pursuing policy objectives in areas such as youth unemployment and teenage pregnancies, governments will need to pay more attention to other levers of public policy, such as leadership, sanctions and targeted taxation, rather than relying on more and more public expenditure. Such rethinks were always desirable but might now be catalysed by unprecedented financial problems.

It is unlikely that true efficiency savings of the magnitude required will be achievable under present arrangements. The UK is one of the most centralised states in the world and its systems of planning, managing and controlling public expenditure are very much a ‘command and control’ model. Where this model has been abandoned in, for example, local government, savings of between 10% and 40% (depending on the function involved) have been achieved simply by getting rid of wasteful, non-value added and redundant activities, especially in relation to inspection. It is this radical approach that could deliver the goods and avoid drastic cuts in spending – but would any government have the political nerve to implement it?

Public sector organisations have to look at the much harsher implications of a worldwide depression in economic activity and plan now for policies that will produce significant real-terms savings in public spending. Implementing those policies urgently represents the best strategy for the public sector.

While this depression scenario is by no means certain, neither is it beyond the bounds of reasonable possibility. One hopes that it does not come about, but each day that passes suggests that it is more and more likely. It is irresponsible to accuse those who wish to discuss such matters as ‘talking the economy down’ or to dismiss such scenarios on the basis of short-term political expediency.

The priority should be for government and others to start to address the issues.

Did you enjoy this article?