Running on empty

The lights are on in the Treasury but who’s minding the tills? After hiving off so much responsibility for fiscal and monetary policy, the department is not in good shape to tackle the biggest economic crash for decades

Whitehall is always said to work best during a crisis. This theory is now being frantically put to the test at the Treasury as it battles against the worst financial crisis in 70 years and a major and deepening recession in the real economy. But doubts are growing over whether the department is up to the job.

Given the scale and nature of the problems the Treasury faces, some questioning of its ability is inevitable. After all, this is no traditional inflation-based recession, for which there are tried and tested solutions. This time, the department will not only have to develop policies to lift the economy out of recession and stabilise the hugely complex financial system, but it will also have to manage taxpayers’ shareholdings in several semi-nationalised banks. And it will have to implement a plan to reduce significantly the government’s budget deficit over the medium term, with net public borrowing likely to exceed £125bn in 2009/10. This is likely to mean very tight control of discretionary public spending.

No one doubts the difficulty of these challenges. The more contentious issue is whether the radical transformation that has taken place at the Treasury over the past 15 years has given it a fighting chance of dealing with them.

When Tony Blair was prime minister and Gordon Brown chancellor, their relationship was often described as like that of the chair and chief executive of a major company. In fact, they often behaved as though they were chief executives of rival companies, but the analogy is a useful illustration of how the role and influence of the Treasury changed under Brown.

As the Chief Executive’s Office, the Treasury became a ‘Department for the Domestic Front’, using its combined muscle of control of the purse strings and guardian of Public Service Agreements – targets that departments had to sign up to in return for money – to shape large swathes of policy. As the cash flowed, so did the Treasury’s influence. In particular, it wrapped its tentacles around departments responsible for policies that Brown had a strong interest in: welfare reform, social policy, child poverty, international development and microeconomic strategy.

In some cases, such as the tax credits policy, the Treasury simply assumed formal control. Its policy domain was further enhanced through externally commissioned reviews, such as housing (Kate Barker) and health (Sir Derek Wanless).

To facilitate this role, Treasury policy teams became populated with officials with expertise in these areas, replacing the more conventional public spending mandarins. High-flyers were attracted to these posts as they came with real power. A cultural change to reflect the ministry’s new priorities followed. The Macroeconomic and Fiscal Policy Group exerted less of a gravitational pull than it once had, while the Public Service and Growth Group ballooned. At the time it made sense: the delegation of operational control of monetary policy to the Bank of England and the creation of the Financial Services Authority meant the action had moved elsewhere.

Moreover, with 60-odd periods of economic growth, low inflation and economic stability, Treasury officials naturally focused on other things.

Now the good times are over and, as the financial crisis engulfs the wider economy, the Treasury is rapidly having to revert to its traditional position as the government’s finance director. Instead of pushing policy initiatives, it will have to resume its conventional role of saying ‘no’, and macroeconomic and fiscal policies are, once again, the top priorities.

Such role reversal will not be easy. In truth, the process began when Brown became PM in 2007 and Alistair Darling took over as chancellor. Brown was never likely to allow his chancellor the same freedom that he had enjoyed and he is reported to have clashed with Darling over the 2007 Pre-Budget Report. A fall in the growth rate of public expenditure was already under way from 2008.

The challenge for the Treasury is not simply a case of shifting priorities. It’s more profound than that. The economic rule book that has governed its thinking for the past 30 years has been torn up as government is forced into taking a much more hands-on approach to managing the economy. Keynes is back in vogue at Great George Street. Moreover, conversations about full-scale bank nationalisation, unimaginable even 18 months ago, are taking place all the time, while there is growing public pressure for government to restrict bankers’ bonuses and claw back pensions of individual bankers, such as former Royal Bank of Scotland chief executive Sir Fred Goodwin. Times have changed.

Genuine doubts have been raised about whether the Treasury has the people that it needs to face all these challenges simultaneously. Staff numbers have been cut sharply in recent years, something that the Treasury select committee has expressed real concern about. The HM Treasury annual report 2007/08, published in July 2008, shows the number of full-time equivalent staff in the core Treasury fell by 235, or 17%, between 2004 and 2008. A further 90 posts are planned to be shed by March 2011. This is motivated by a need to meet the 5% a year real cut in its budget target, not because of excess capacity.

In fact, the Treasury has recently had a problem filling policy posts. It launched a major recruitment drive in 2008, which has been only partially successful in plugging the skills gap. This, combined with a shortage of officials with a background in fiscal and macroeconomic policy – partly a consequence of the priority afforded to social and welfare policy posts in recent years – has meant that the Treasury is not as well equipped to deal with things as it would like.

Inevitably, it has had to deal with a skills shortage on the financial services side of things, which were run down following the transfer of operational matters to the FSA. The department’s international and finance team, headed by Tom Scholar, has had to double in size to cope with the tremendous pressures it is under. This has been achieved through redeployment and some external recruitment. Officials involved in the banking crisis have been seriously stretched, working long hours and most weekends.

Some have questioned the merit of bringing in ex-City bankers to help solve problems that banks have caused themselves. Given the nature of the crisis, perhaps the Treasury should be trying to recruit economists from Japan. The real issue, however, is that bankers often lack the political skills needed to translate technical expertise into workable policy. Hence the charge of naivety levelled at City minister Lord Myners over the pension given to Sir Fred Goodwin.

The Treasury downsizing began in the mid-1990s following the publication of the Fundamental expenditure review, which enacted a number of radical changes that are only now being tested by their first major economic crisis. In a bid to make the Treasury less hierarchical and more flexible, the FER removed its middle management (Grade 3). This placed enormous responsibility on its talented but young staff and greatly reduced the level at which decisions are taken. Treasury officials are on average in their early thirties. Tom Scholar is in his late thirties.

David Lipsey’s book The Secret Treasury argues that these moves resulted in a loss of quality control and a weakening of the ministry’s institutional memory. He quotes one senior Treasury official as warning: ‘We are skating on very thin ice.’ This was in 1999, when the economic ice was much stronger.

One consequence of these changes is that today’s Treasury has few staff with experience of fighting a recession or dealing with a major economic calamity. The last recession was 15 years ago, the last major crisis, Black Wednesday, was in 1992. In fairness to Treasury staff, the last major banking crisis was 70 years ago, so it would be wrong to expect any officials to have any first-hand experience. What is less excusable is the ridiculously high turnover rate in posts. Treasury officials rarely spend more than a year in post before moving on. This weakens the department’s skills base and deprives it of specialist expertise.

The biggest immediate challenge is the recession. The Pre-Budget Report, presented last November, contained a number of measures to support economic growth, including a temporary cut in the main rate of VAT from 17.5% to 15% and bringing forward some planned public spending on capital projects. More measures might be announced in the Budget, on April 22, although the chancellor has limited room for manoeuvre because very large budget deficits are already projected for the next few years.

The bulk of the macroeconomic fight against the recession so far, has, therefore, been undertaken by the Bank of England’s Monetary Policy Committee, headed by Bank governor Mervyn King. But, with the Bank Rate now just 1%, its room for manoeuvre has also become very limited. Moreover, the MPC is now of the view that further cuts in the Bank Rate could adversely affect the economy. So it is considering ’alternative policy instruments’, such as purchasing government and corporate bonds.

The chancellor has already given the Bank the authority to buy such assets, through the Asset Purchase Facility, if they are financed by the issuance of Treasury Bills. The MPC, however, is now thinking of going further and financing purchases of corporate bonds by printing money. It will need the chancellor’s agreement.

Operational responsibility for the conduct of monetary policy in the UK is, therefore, shifting. The Treasury is again taking a role – not in setting interest rates, which remains the prerogative of the MPC, but in deciding the appropriate scale of asset purchases to be financed by printing money. The ‘Alistair and Mervyn show’ might be about to hit the road. It remains to be seen whether Treasury staff are well placed to support such a ‘show’.

The government has responded to the recession by establishing the National Economic Council, chaired by the prime minister and comprising 21 secretaries of state and ministers, ‘to co-ordinate economic policies across government’. It is presented as complementary to the Treasury – a body where ideas can be tested and the response to the recession can be speeded up. However, the NEC could create tensions between the department and Number 10 as it provides a forum for the prime minister, who has a reputation for micromanagement and ten years’ experience as chancellor, and his close ally Shriti Vadera, to interfere in Treasury affairs.

The department’s preferred approach, even in a crisis, is a measured one, centred on the established spending and budget processes. Number 10, on the other hand, prefers frequent announcements and initiatives that risk pushing the Treasury into doing things it is uncomfortable with.

What about stabilising the public finances? Net government borrowing could easily exceed £125bn (8% of GDP) in 2009/10. Brown’s ‘golden’ and sustainable investment rules have been comprehensively broken and something needs to be put in their place. The Conservatives want to create an independent Office for Budget Responsibility to advise on the size of the spending envelope, an attempt to radically depoliticise fiscal policy. But they might find this idea less attractive once in government.

What is clear is that it will not be possible to reduce the debt solely through the benefits of an economic recovery, so tax increases (some have already been announced for 2010/11) and/or spending cuts, relative to current plans, will also be necessary.

This will require a change of approach from the Treasury. Officials will need to rediscover, to borrow Lipsey’s phrase, their ‘abominable no-men’ instincts. Some insiders and Whitehall watchers wonder whether the Treasury, having got so accustomed to spending money, has the right people in place to find the necessary cuts. If this is the case, it might consider bringing back some retired officials with the relative know-how.

The Treasury also has to deal with the aftermath of the UK’s worst financial crisis since the 1930s. The existing ‘tripartite’ system of regulation, under which the Bank is responsible for monetary stability and the infrastructure of the financial system, the FSA is responsible for supervising banks and financial markets and the Treasury is responsible for the overall institutional structure of financial regulation, appears to have failed. Lord Turner, chair of the FSA, has called for a ‘revolution’ in the way the financial sector is regulated. A review of these arrangements could conclude that too much accountability has been passed from the Treasury to the Bank and the FSA and recommend an increased role for the department in the future.

In the meantime, the Treasury has to manage a complex web of relationships with the Bank of England, the FSA, international bodies and overseas governments. It is also getting used to its affairs being in the news on a daily basis, compared with just twice a year (at the time of the Budget and the Pre-Budget Report) when the economy was doing well. A shortage of press officers might mean that the Treasury is not getting its message across.

The financial crisis has also given the department a more specific new role. It has acquired, on behalf of taxpayers, ownership and part-ownership of several banks, which it is attempting to manage through the arm’s-length UK Financial Investments Ltd. A huge amount depends on whether this body can be made to work effectively. The new chief executive is a Treasury mandarin, John Kingman, who has little direct experience of running banks.

At this stage, it is difficult to judge how well the Treasury is doing. The recapitalisation of the banking system last autumn won praise from many quarters – not least Nobel economics prize-winner Paul Krugman – and was emulated by governments around the world. But the jury is still out. The crisis continues.

The Conservatives have made up their mind. They have promised a series of measures designed to bolster the Treasury’s credentials as a finance director. They will scrap the PSA architecture, move tax policy into the Department for Work and Pensions and prioritise public expenditure scrutiny.

Any verdict on the Treasury must accept that it finds itself in uncharted territory and is having to improvise, as are economic ministries the world over. It does, however, seem reasonable to suggest that some of the organisational reforms relating to skills and size mean that the Treasury sometimes gives the impression that it is trying to fight the recession with one arm tied behind its back.