By Roger Latham and Malcolm Prowle
25 March 2010
Has Alistair Darling’s Budget done enough to rein in public spending? Economists, as ever, are divided. In this first of three features on the changing UK economy, Roger Latham and Malcolm Prowle explain what the next few years might hold for public service managers
Winston Churchill had a somewhat sour view of economists. ‘I ask three economists a question, I get four answers – one each from two of them, and two from Mr Keynes,’ he once said. Churchill had a reason for his sarcasm since John Maynard Keynes had written a book critical of him.
But economists rarely do give a straight answer – it’s always ‘on the one hand this, on the other hand that’. So it was perhaps not surprising that, in the run-up to this week’s Budget, groups of them have lined up on opposite sides of the debate about how and when to address the dire state of public finances and the economy.
The difference of opinion, expressed in letters to national newspapers, reflects a basic ideological divide. On the one hand, there are the ‘sound money’ economists. For them, the market economy is self-correcting; recessions and downturns are temporary phenomena; and the best government policy is one that ensures the monetary conditions in the economy are right, but doesn’t interfere any further.
Then there are the Keynesians. For them, the market economy is not self-correcting; it is quite capable of being in a state of equilibrium with unemployed resources and underused capacity. Monetary policy in such circumstances is ineffective – Keynes described it as ‘pushing on a string’. Without deliberate deficit financing by government, the economy might languish in the doldrums.
Deciding who is right in this debate is difficult to resolve by an appeal to the facts. Keynesians, such as Professor Joseph Stiglitz, will highlight a failure of the sound money economists to predict the downturn, and the persistence of the recession. Sound money people will point out that despite significant deficit financing, the economy has not recovered significantly – with growth of only 0.3% in the final quarter of last year. Keynesians would counter by pointing out that much of the increase in public deficit came from propping up the banking system, which is one of the poorest uses of deficit financing.
The battle of words continues and underpins the rival political views on what this week’s and future Budgets should contain. Sound money economists, with whom Conservative leader David Cameron and shadow chancellor George Osborne might sympathise, say that if the Keynesians have their way the impact on the UK’s credit rating and exchange rate will increase inflation, and the deflationary impact of dealing with that will simply extend the downturn. They will have noted the suggestion last week from ratings agency Moody’s Investor Services that the UK had moved ‘substantially’ closer to losing its triple-A rating.
Politicians with Keynesian leanings, such as Prime Minister Gordon Brown and Chancellor Alistair Darling, counter that if the sound money economists have their way, there will be a direct deflationary effect as the deficit is dealt with and the recession will lengthen and deepen as a result.
This intellectual debate is unlikely to be resolved any time soon, if ever, largely because each of the two groups of economists and politicians have a substantially different view of the reality of how the economy works. But one point emerges: those who expected that this recession would be short and sharp are likely to be wrong, and the pressures on public finances from both the demand side and the supply of funds are likely to continue for some time.
The different views were highlighted by the opposing politicians’ views of the Budget. Darling said: ‘The task now is to bring down borrowing in a way which does not damage the recovery or the frontline services on which people depend.’ He stressed that making immediate cuts to public spending would ‘be both wrong and dangerous’. The chancellor also announced that the deficit was likely to be £11bn lower than forecast, at £167bn – and would be halved by 2014/15.
But Cameron countered that this was not enough and a ‘credible plan’ to reduce the debt was needed. The risk to recovery was ‘not in dealing with the deficit now, it’s in not dealing with the deficit now’. The Tory leader added: ‘Every family knows that when your debts mount up, you need to start paying them off or things will only get worse. It is time for the government to learn the same lessons.’
The timing of the cuts programme was discussed in the recent CIPFA/Solace publication After the downturn, which looked at the possible impact on the public sector. Two things in particular were clear from that document. First, what was being asked of the public sector in terms of overall reductions over an extended period exceed any of the changes that we’ve seen in four decades. Secondly, getting back to Brown’s ‘sustainable investment rule’ – public sector debt at 40% of gross domestic product – is likely to take until 2035. Those estimates were based on the figures in last year’s Pre-Budget Report, and this week’s Budget did not improve the outlook very much.
Looking at the long haul, the current downturn might, in hindsight, be seen as a major turning point in western social and economic environments. There are two aspects to this:
- the change in the fortunes of the western economies as a result of the shifting balance of economic power across the world’s nations; and
- the effect on public confidence and trust in UK politicians and the consequential impact on public policy formulation.
The first aspect needs some broader political and historical context. Some 20 years ago, the Harvard political scientist Samuel Huntington identified a major shift of economic, military and political power from the West to the two ‘challenger civilisations’, namely China and the Muslim world. In line with Huntington’s predictions, we have indeed seen a steady shift of financial and economic power away from the West towards newly industrialised nations, including China.
In the past, public sector deficits within the West were substantially funded from private sector surpluses, using a mixture of taxation and debt. But over time these surpluses turned into a deficit. The growth of private consumption in the West in the past decade has largely been financed by the newly industrialised states using their surpluses to buy Western assets and government debt, such as Treasury bills. This has led to a situation where, for example, the dollar exchange rate can be significantly affected by decisions taken in Beijing.
Western nations (especially the UK) will find it difficult to get out of this hole and this situation is likely to have long-term effects on support for the current economic and political arrangements and on the balance of power in the world. Without buoyant internal demand and with more borrowing infeasible, we will need to look to other sources of recovery. The current best option is to rely on an export-led recovery, which would require a favourable exchange rate and a rise in global demand.
The alternative, which is politically unattractive, would be to significantly downscale citizens’ standard of living by reduced consumption, either publicly or privately. In contrast, the very high savings rates and external income inflows for countries such as China mean that they do have internal capacity, through investment and possibly deficit financing from the state, to grow their economies at a much greater rate than Western economies. Thus, while Western economies will have to put up with annual growth rates over the next decade of maybe only 1% or so, those of India and China will register 7%–10%.
The result is that once economies have begun to stabilise, the West will have significantly fallen behind these other countries. This shift of wealth and financial power will inevitably lead to a shift of ‘Great Power’ status. As a consequence, at the end of the transitional period, the changing balance of economic power in the world might have altered the relative position of the UK permanently.
The second aspect, concerning the loss of trust in politics and our political leaders, was a major theme of the CIPFA Manifesto published last year. Even before the recent scandal over MPs’ expenses, the UK was in the lowest quartile of European Union countries in terms of confidence in its national Parliament, and electoral turnout was among the lowest. What would the picture be like today – can we expect an even lower turnout in the coming general election than that in 2005? The main point is that such low levels of trust in politicians can inhibit policy development and implementation, as road pricing and the MMR vaccination programme showed.
It almost seems that when our political leaders make a statement providing some reassurance or advocating a particular course of action it becomes almost counter-productive because the public just do not believe what they are saying and assume the worst. Given the economic and financial situation the UK finds itself in, this could be a real problem since it inhibits the politician’s ability to sell unpopular but possibly essential policies to the general public. This is a real case of ‘chickens coming home to roost’.
So what does all of this arcane political and economic discussion mean for the UK’s public sector? Given that the current public sector deficit is unsustainable, in the longer term it has to be cut. But the economic view taken by the next government will determine the pace and depth of its deficit reduction policy, which in turn will shape the strategic space that public service finance managers will work in.
Two broad scenarios are possible: one is short and sharp, the other prolonged.
If the next government believes it is vital to bring the public finances back to long-term stability quickly (as the European Commission has advised), then it will probably adopt a policy of significant cuts in public spending starting in the financial year 2011/12. In such a situation, there will be only limited time for finance managers to decide where to cut and they are likely to have to rely on quick fixes such as reducing capital spending; freezing staff numbers and pay; cutting services; reducing organisational overheads; and dropping preventive programmes.
However, if the view is taken to phase the deficit reduction over a longer period, then public spending cuts might be fairly shallow in 2011/12 but would increase in magnitude in later years. In these circumstances, there would be more time available to identify possible solutions and different options would be available.
These could include organisational and structural reform, such as mergers; technological solutions; innovative and lower-cost approaches to service provision; and a greater focus on service effectiveness. These solutions will take longer to implement and might even need a short-term increase in spending to achieve. However, they should also result in long-term permanent efficiencies.
A number of warnings need to be given. First, public sector managers must not put their heads in the sand and hope that the worst will not happen. Deficit reduction is inevitable and cuts in public spending will take place sooner or later.
Hence, whichever deficit reduction policy is adopted, managers already need to be thinking about what solutions to implement in 2011/12 and later years. Some finance managers facing small reductions in funding in 2010/11 seem to be addressing the issue as a one-off event without thinking how this fits in to the longer-term funding picture.
Secondly, if the prolonged approach is adopted, it is also important not to just sit back and think that the major cuts in funding are some way off and no immediate action is needed. The rationale for the prolonged approach is that it allows time to identify expenditure reductions that involve innovative solutions and avoid damaging cuts. To achieve this, the groundwork needs to start now. The public sector finance profession will be exceedingly embarrassed if two or three years down the track, such longer-term thinking has not taken place.
Finally, financial planning and management approaches will have to change. For example, the incremental approach to budgeting – which involves rolling budgets forward each year (including the budgets of ineffective and inefficient services) – will have to go. Instead, activities of highest priority should be identified and funded accordingly while activities of little intrinsic value should be discarded.
No wonder many are seeing the traditional annual budget cycle merging into a pattern of continuous activity. However, the danger is that in the absence of clear policy steers, this process might degenerate into an attritional struggle of demoralising initiatives, all aimed at short-term saving. In such circumstances, we might miss the bigger changes that are necessary.
So the current debate about future economic policy has significant implications for the configuration and management of the UK public sector. As we have now entered the period between the Budget and the general election, the debate on these issues will become more heated. There’s a lot to lose, but also perhaps something to gain, for those working across our public services.
Roger Latham is president of CIPFA and a visiting fellow at Nottingham Business School. Malcolm Prowle is professor of business performance at Nottingham Business School
www.malcolmprowle.com
25 March 2010
Has Alistair Darling’s Budget done enough to rein in public spending? Economists, as ever, are divided. In this first of three features on the changing UK economy, Roger Latham and Malcolm Prowle explain what the next few years might hold for public service managers
Winston Churchill had a somewhat sour view of economists. ‘I ask three economists a question, I get four answers – one each from two of them, and two from Mr Keynes,’ he once said. Churchill had a reason for his sarcasm since John Maynard Keynes had written a book critical of him.
But economists rarely do give a straight answer – it’s always ‘on the one hand this, on the other hand that’. So it was perhaps not surprising that, in the run-up to this week’s Budget, groups of them have lined up on opposite sides of the debate about how and when to address the dire state of public finances and the economy.
The difference of opinion, expressed in letters to national newspapers, reflects a basic ideological divide. On the one hand, there are the ‘sound money’ economists. For them, the market economy is self-correcting; recessions and downturns are temporary phenomena; and the best government policy is one that ensures the monetary conditions in the economy are right, but doesn’t interfere any further.
Then there are the Keynesians. For them, the market economy is not self-correcting; it is quite capable of being in a state of equilibrium with unemployed resources and underused capacity. Monetary policy in such circumstances is ineffective – Keynes described it as ‘pushing on a string’. Without deliberate deficit financing by government, the economy might languish in the doldrums.
Deciding who is right in this debate is difficult to resolve by an appeal to the facts. Keynesians, such as Professor Joseph Stiglitz, will highlight a failure of the sound money economists to predict the downturn, and the persistence of the recession. Sound money people will point out that despite significant deficit financing, the economy has not recovered significantly – with growth of only 0.3% in the final quarter of last year. Keynesians would counter by pointing out that much of the increase in public deficit came from propping up the banking system, which is one of the poorest uses of deficit financing.
The battle of words continues and underpins the rival political views on what this week’s and future Budgets should contain. Sound money economists, with whom Conservative leader David Cameron and shadow chancellor George Osborne might sympathise, say that if the Keynesians have their way the impact on the UK’s credit rating and exchange rate will increase inflation, and the deflationary impact of dealing with that will simply extend the downturn. They will have noted the suggestion last week from ratings agency Moody’s Investor Services that the UK had moved ‘substantially’ closer to losing its triple-A rating.
Politicians with Keynesian leanings, such as Prime Minister Gordon Brown and Chancellor Alistair Darling, counter that if the sound money economists have their way, there will be a direct deflationary effect as the deficit is dealt with and the recession will lengthen and deepen as a result.
This intellectual debate is unlikely to be resolved any time soon, if ever, largely because each of the two groups of economists and politicians have a substantially different view of the reality of how the economy works. But one point emerges: those who expected that this recession would be short and sharp are likely to be wrong, and the pressures on public finances from both the demand side and the supply of funds are likely to continue for some time.
The different views were highlighted by the opposing politicians’ views of the Budget. Darling said: ‘The task now is to bring down borrowing in a way which does not damage the recovery or the frontline services on which people depend.’ He stressed that making immediate cuts to public spending would ‘be both wrong and dangerous’. The chancellor also announced that the deficit was likely to be £11bn lower than forecast, at £167bn – and would be halved by 2014/15.
But Cameron countered that this was not enough and a ‘credible plan’ to reduce the debt was needed. The risk to recovery was ‘not in dealing with the deficit now, it’s in not dealing with the deficit now’. The Tory leader added: ‘Every family knows that when your debts mount up, you need to start paying them off or things will only get worse. It is time for the government to learn the same lessons.’
The timing of the cuts programme was discussed in the recent CIPFA/Solace publication After the downturn, which looked at the possible impact on the public sector. Two things in particular were clear from that document. First, what was being asked of the public sector in terms of overall reductions over an extended period exceed any of the changes that we’ve seen in four decades. Secondly, getting back to Brown’s ‘sustainable investment rule’ – public sector debt at 40% of gross domestic product – is likely to take until 2035. Those estimates were based on the figures in last year’s Pre-Budget Report, and this week’s Budget did not improve the outlook very much.
Looking at the long haul, the current downturn might, in hindsight, be seen as a major turning point in western social and economic environments. There are two aspects to this:
- the change in the fortunes of the western economies as a result of the shifting balance of economic power across the world’s nations; and
- the effect on public confidence and trust in UK politicians and the consequential impact on public policy formulation.
The first aspect needs some broader political and historical context. Some 20 years ago, the Harvard political scientist Samuel Huntington identified a major shift of economic, military and political power from the West to the two ‘challenger civilisations’, namely China and the Muslim world. In line with Huntington’s predictions, we have indeed seen a steady shift of financial and economic power away from the West towards newly industrialised nations, including China.
In the past, public sector deficits within the West were substantially funded from private sector surpluses, using a mixture of taxation and debt. But over time these surpluses turned into a deficit. The growth of private consumption in the West in the past decade has largely been financed by the newly industrialised states using their surpluses to buy Western assets and government debt, such as Treasury bills. This has led to a situation where, for example, the dollar exchange rate can be significantly affected by decisions taken in Beijing.
Western nations (especially the UK) will find it difficult to get out of this hole and this situation is likely to have long-term effects on support for the current economic and political arrangements and on the balance of power in the world. Without buoyant internal demand and with more borrowing infeasible, we will need to look to other sources of recovery. The current best option is to rely on an export-led recovery, which would require a favourable exchange rate and a rise in global demand.
The alternative, which is politically unattractive, would be to significantly downscale citizens’ standard of living by reduced consumption, either publicly or privately. In contrast, the very high savings rates and external income inflows for countries such as China mean that they do have internal capacity, through investment and possibly deficit financing from the state, to grow their economies at a much greater rate than Western economies. Thus, while Western economies will have to put up with annual growth rates over the next decade of maybe only 1% or so, those of India and China will register 7%–10%.
The result is that once economies have begun to stabilise, the West will have significantly fallen behind these other countries. This shift of wealth and financial power will inevitably lead to a shift of ‘Great Power’ status. As a consequence, at the end of the transitional period, the changing balance of economic power in the world might have altered the relative position of the UK permanently.
The second aspect, concerning the loss of trust in politics and our political leaders, was a major theme of the CIPFA Manifesto published last year. Even before the recent scandal over MPs’ expenses, the UK was in the lowest quartile of European Union countries in terms of confidence in its national Parliament, and electoral turnout was among the lowest. What would the picture be like today – can we expect an even lower turnout in the coming general election than that in 2005? The main point is that such low levels of trust in politicians can inhibit policy development and implementation, as road pricing and the MMR vaccination programme showed.
It almost seems that when our political leaders make a statement providing some reassurance or advocating a particular course of action it becomes almost counter-productive because the public just do not believe what they are saying and assume the worst. Given the economic and financial situation the UK finds itself in, this could be a real problem since it inhibits the politician’s ability to sell unpopular but possibly essential policies to the general public. This is a real case of ‘chickens coming home to roost’.
So what does all of this arcane political and economic discussion mean for the UK’s public sector? Given that the current public sector deficit is unsustainable, in the longer term it has to be cut. But the economic view taken by the next government will determine the pace and depth of its deficit reduction policy, which in turn will shape the strategic space that public service finance managers will work in.
Two broad scenarios are possible: one is short and sharp, the other prolonged.
If the next government believes it is vital to bring the public finances back to long-term stability quickly (as the European Commission has advised), then it will probably adopt a policy of significant cuts in public spending starting in the financial year 2011/12. In such a situation, there will be only limited time for finance managers to decide where to cut and they are likely to have to rely on quick fixes such as reducing capital spending; freezing staff numbers and pay; cutting services; reducing organisational overheads; and dropping preventive programmes.
However, if the view is taken to phase the deficit reduction over a longer period, then public spending cuts might be fairly shallow in 2011/12 but would increase in magnitude in later years. In these circumstances, there would be more time available to identify possible solutions and different options would be available.
These could include organisational and structural reform, such as mergers; technological solutions; innovative and lower-cost approaches to service provision; and a greater focus on service effectiveness. These solutions will take longer to implement and might even need a short-term increase in spending to achieve. However, they should also result in long-term permanent efficiencies.
A number of warnings need to be given. First, public sector managers must not put their heads in the sand and hope that the worst will not happen. Deficit reduction is inevitable and cuts in public spending will take place sooner or later.
Hence, whichever deficit reduction policy is adopted, managers already need to be thinking about what solutions to implement in 2011/12 and later years. Some finance managers facing small reductions in funding in 2010/11 seem to be addressing the issue as a one-off event without thinking how this fits in to the longer-term funding picture.
Secondly, if the prolonged approach is adopted, it is also important not to just sit back and think that the major cuts in funding are some way off and no immediate action is needed. The rationale for the prolonged approach is that it allows time to identify expenditure reductions that involve innovative solutions and avoid damaging cuts. To achieve this, the groundwork needs to start now. The public sector finance profession will be exceedingly embarrassed if two or three years down the track, such longer-term thinking has not taken place.
Finally, financial planning and management approaches will have to change. For example, the incremental approach to budgeting – which involves rolling budgets forward each year (including the budgets of ineffective and inefficient services) – will have to go. Instead, activities of highest priority should be identified and funded accordingly while activities of little intrinsic value should be discarded.
No wonder many are seeing the traditional annual budget cycle merging into a pattern of continuous activity. However, the danger is that in the absence of clear policy steers, this process might degenerate into an attritional struggle of demoralising initiatives, all aimed at short-term saving. In such circumstances, we might miss the bigger changes that are necessary.
So the current debate about future economic policy has significant implications for the configuration and management of the UK public sector. As we have now entered the period between the Budget and the general election, the debate on these issues will become more heated. There’s a lot to lose, but also perhaps something to gain, for those working across our public services.
Roger Latham is president of CIPFA and a visiting fellow at Nottingham Business School. Malcolm Prowle is professor of business performance at Nottingham Business School
www.malcolmprowle.com
