UK debt crisis: politicians must wake up and smell the coffee

February 17, 2013

Britain now faces its worst ever peacetime fiscal crisis, yet our politicians seem incapable of grasping the seriousness of the situation.

Indeed, when Andrew Lansley suggested recently that a 10% cut in public spending would be required under a Conservative government, he was widely lambasted.

In reality a 10% reduction is unlikely to be enough, while Lansley’s proposal to ring-fence expenditure on health, schools and overseas aid will almost certainly be unaffordable. Indeed, this proposal to ring-fence such expenditure means that a 10% cut in other expenditure will not cut borrowing below the current projections at all!

Next year around one in every four pounds spent by the government will have to be borrowed. This is clearly unsustainable and needs to be addressed urgently to avoid jeopardising economic recovery.

All government borrowing crowds out private sector investment and thus government borrowing stunts the much-needed growth of the productive sector. There is also a real danger that debt will have to be issued at much higher interest rates, thus raising the cost of funding and increasing government spending further.

Increasing taxes to address the crisis would not be a wise decision. The tax burden is already at historically high levels and raising it further would discourage economic activity and would be unlikely to raise much extra revenue.
 
A substantial cut in public spending is therefore the only practical option, going far beyond what has been mentioned so far by Conservative Party spokesmen. And to achieve savings of sufficient magnitude it will be necessary to address the major areas of government expenditure: welfare benefits, pensions, health and education. It is difficult to understand why areas such as foreign aid are sacrosanct, given the well-known damage to the development of the poorest countries that arises from the over-provision of aid.

Unfortunately, the “vote motive” means that politicians are reluctant to be honest about the scale of the debt crisis facing the UK. Future generations do not vote and many of those who will bear the burden have not yet been born. The short-term outlook and self-interested behaviour of politicians, combined with an unwillingness to take the necessary action, are likely to have severe long-term economic consequences.

22 June 2009, IEA Blog

Filed under political economy Tagged with ,

How Boris can beat the RMT

February 17, 2013

The RMT has once again brought London to a standstill with a 48-hour strike. This is a good example of public choice theory at work, in particular Mancur Olson’s logic of collective action. A small concentrated interest (i.e. the tube drivers) is able to exploit the dispersed population of travellers and taxpayers, who have weak incentives to organise in opposition. 

As a result of their rent-seeking activity tube drivers get paid far more than employees in comparable occupations – around £40,000 per year, almost double the wage of a typical London bus driver. The Underground is also heavily overstaffed, which is one reason why the system requires hefty ongoing subsidies.

Given the incentives at work, the task of tackling the problem of inflated salaries, ineffiency and industrial unrest lies with politicians and London Mayor Boris Johnson in particular.

He can take inspiration from Margaret Thatcher and her battle with the NUM. She prepared for the miners’ strike several years in advance and Boris should take a similar strategic approach.

The first step should be to make London more resilient to strike action on the Tube. This means deregulating the buses to allow new market entrants to boost capacity at peak times. It also involves abandoning anti-car socialism with its unnecessary traffic controls, to ensure the road network is utilised to its full potential.

Liberalising the taxi market – for example by ending licensing and allowing shared taxis and minicabs to pick up passengers at the roadside – would further strengthen the Mayor’s hand, even if it means taking on another powerful rent-seeking interest, the black-cab drivers.

More radically, privatising the Underground could be a particularly effective measure, enabling the network to be broken up and sold off to different companies running different lines. Negotations over pay and conditions would then be decentralised. Perhaps most importantly, firms would be free to recruit low-cost non-unionised labour from overseas to replace strikers – for example, train drivers from central and eastern Europe.

Poorly used outer sections of the Tube system could also be closed down – perhaps converted into connecting busways or even toll roads if it proved profitable. This could make better use of existing resources, while further weakening the stranglehold of the RMT.

11 June 2009, IEA Blog

Filed under transport Tagged with , ,

Why PPPs may offer poor value for money

February 17, 2013

For several decades the British economy has been hampered by the poor quality of its infrastructure. Whether in transport, education or health, investment has typically been low by international standards and levels of service have suffered as a result.

Public-private partnerships (PPPs) seemed to offer a solution to this problem. Private capital would be used to fund much-needed projects. Better still, private companies could build and operate the new infrastructure, bringing, it was hoped, huge cost savings.

New investment could be detached from the purse strings of the Treasury. It would no longer be so dependent on the short-term imperatives of the public finances. And because the money was borrowed privately, there was no need, at least initially, to count it as public debt.

Moreover, contracts could be written to incentivise firms to complete schemes on time and on budget. The main pitfalls of public-sector procurement – the delays and mammoth cost overruns – could be avoided.

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government – a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.
By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

However, a new study from the Institute of Economic Affairs* suggests that this huge expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity.

A good example is the London Underground PPP. This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

These events seemed to illustrate a key potential weakness of PPPs. When they involve essential infrastructure that government will not allow to fail, it is clear that a high proportion of a project’s risk remains with the public sector.
Yet acknowledging this undermines one of the key rationales for PPPs, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors.

Serious problems have also been evident in the National Health Service (NHS). There has been a huge hospital rebuilding programme over the last 12 years, with 90% of its £12 billion cost privately financed.

While there has been a welcome improvement in the quality of the infrastructure, the long-term charges resulting from the PPP schemes are now causing significant financial difficulties for many NHS trusts. In part this reflects the higher direct costs of private finance. For example, typical interest rates have been around 8%, compared with 4.5% with public finance.

In 2005/06, 50% of trusts with large PPP projects (capital value £50 million or higher) were in deficit, compared with an average of 23%. Such trusts were also more likely to have been placed in ‘special measures’ by the Department of Health.
There is also strong evidence that the ongoing cost of PPPs is forcing trusts to reduce capacity elsewhere, for example, by reducing staff numbers and the number of beds, as well as downgrading the functions of smaller hospitals. Unfortunately this is likely to have a negative effect on patient care.

The experience to date therefore suggests that PPP schemes have failed to live up to their early promise. There are several explanations.

 Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

8 June 2009, PSE magazine

Filed under finance, transport Tagged with ,

What should Cameron cut?

February 17, 2013

The projections in last month’s Budget were terrifying. They suggest that net government borrowing is likely to reach unprecedented levels over the next three years: 

2009-10: £168 bn = 12.4% GDP
2010-11: £173 bn = 11.9% GDP
2011-12: £149 bn = 9.1% GDP

But even these forecasts may be too optimistic. They are based on GDP growth of -3.75% in 2009, +1% in 2010, and +3.25% in 2011.

But if the recession is deeper and longer than expected – say growth of -4.5% in 2009, -1% in 2010 and zero in 2011 – the deficit is likely to be closer to £200 billion for each of the next three years, equivalent to about 15% of GDP. Even when the recession ends, though, the structural budget deficit is still at alarming levels. This would mean almost one in three pounds spent by the government would be borrowed.

Clearly such high deficits are unsustainable and need to be addressed urgently if a funding crisis is to be avoided. Yet raising taxes above already historically high levels is likely to be counterproductive. It will yield little extra revenue in the medium term. A substantial cut in public spending will therefore be the only serious option available to the next government.

If the Conservatives win the next election, David Cameron will be forced to deal with this problem. And tackling the low-hanging fruit – cancelling ID cards, NHS computer schemes and Crossrail, for example – while worthwhile, will not be adequate when around £150 billion of annual spending reductions may be required.

It will be necessary to curtail the major areas of government spending: welfare, health and education. Indeed, emergency cuts, or at least freezes, in welfare benefits and public sector pay may be in order – the kind of measures seen recently in struggling central European countries. Indeed, we should start this year – welfare benefits, pensions and public sector pay should not rise by more than private sector pay rises. If public sector pay cannot be reined in this year it will never be reined in. If welfare benefits are not pegged to wage increases then employment incentives will be diminished.  

However, the crisis also presents opportunities for Cameron to launch positive longer-term reforms that reduce the scope of government. He could start by tackling public sector pensions (a liability of  over £1 trillion), move on to welfare reform and then health and education, promoting competition and efficiency through individual savings accounts and voucher-type schemes while getting rid of the costly bureaucrats.

How could this be done in practice? A voucher scheme could involve a voucher of a fixed money value being given for the first five years of the scheme. Its value in real terms – and certainly relative to national income – would then fall. This could be politically acceptable as it would happen at the same time as huge efficiency savings were achieved.

And let’s not forget regulation. Removing red tape – for example, the new gender pay audits  – would reduce the government payroll while lowering costs for businesses.

8 May 2009, IEA Blog

Filed under political economy

Cutting government spending should be the main priority

February 17, 2013

Gordon Brown may be advocating a further fiscal stimulus as a means to promote economic recovery at today’s G20 meeting, but, certainly in Britain’s case, implementing such a policy would be reckless in the extreme.  

The Bank of England is pursuing a policy of quantitative easing by buying assets (both corporate bonds and gilts) from non-bank financial institutions. The sellers receive bank deposits in exchange for their assets, thereby increasing the amount of money in the economy. In this way the Bank hopes to offset the deflationary pressures created by the collapse in bank lending.

At some point in the future, bank lending will recover and the velocity of money will increase. The Bank will then wish to reverse the quantitative easing process in order to mop up excess liquidity and avoid high inflation. It can do so by selling the bonds it holds back to non-bank financial institutions, thereby reducing their bank deposits.

But selling these assets will be far more difficult if the market for gilts is already saturated as a result of very high levels of government borrowing. The government is likely to have to raise in excess of £150 billion a year in the medium term. A key question is whether it will be possible for the Bank to sell its assets on top of this, without bond yields rising significantly. If investors are not reassured that quantitative easing is being reversed quickly enough then they may also demand higher yields in the form of an inflation risk premium.

Given high levels of debt, such a rise in bond yields will, of course, damage the prospects of economic recovery – perhaps causing a double-dip recession – and put further strains on the banking sector. It could also prove difficult for the government to service its own repayments. This is the reality of the government massively increasing its borrowing. One way or another, life must be made more difficult for the private sector – in the medium term if not sooner. Indeed, all these pressures may lead to the government inflating away its debts – thus justifying the market’s fears of higher inflation.

Given these horrific risks, the government needs to act quickly. It needs to reassure the markets by slashing its borrowing. This means large spending cuts in the forthcoming Budget. Fiscal policy is set to run against the grain of monetary policy if government spending is not reined in.

2 April 2009, IEA Blog

Filed under tax Tagged with , ,

Are large benefit increases wise in a recession?

February 17, 2013

Benefit rates are set to rise substantially next month. State pensions will rise by 5%, while means-tested payments, such as Jobseeker’s Allowance, will rise by 6.3%. The new rates, based on the Retail Prices Index (RPI), were determined in September 2008, when inflation peaked, but now represent significant increases in real terms.

Higher welfare spending will push the public finances even further into the red. The prospect of yet more government borrowing and tax rises in the future could undermine economic confidence and deter investment in the UK.

Moreover, at a time when many workers are being made redundant and others are facing pay cuts, higher out-of-work benefits will reduce the financial incentives for jobless people to take employment, particularly since in many cases they will also be entitled to Housing Benefit, which pays their rent. Combined with the minimum wage and restrictive employment regulation, this is likely to make the surge in unemployment even worse and condemn many more people to a life of welfare dependency.

It could be said that “rules are rules” and it is just an unfortunate coincidence that benefit levels were set in a “freak” month for RPI. However, imagine inflation had fallen to -5% last September before rising to become positive again in April 2009. Is it credible that the government would have imposed benefit cuts?

12 March 2009, IEA Blog

Filed under welfare Tagged with , ,

The slow death of private property

February 17, 2013

The part-nationalisation of Britain’s banks represents a further extension of state power and the erosion of private property rights. There is a huge danger that under political influence the banking sector will be compelled to pursue socialist objectives rather than maximise returns for shareholders. 

This development would be less worrying had it been an isolated example. However, the erosion of private property rights has been a long, gradual process. World War I played a key role, leading to a step-change in the role of the state and a huge expansion of its powers.

Taxation has been gradually extended ever since, particularly through the expansion of the welfare state, and now takes about 45p of every £1 earned (including indirect taxes). This in itself undermines private property, since the state takes a large share of any income earned from it and will confiscate property if tax is not paid.
 
The de-facto nationalisation of land, or at least development rights, with the 1947 Town and Country Planning Act was another important step. Owners were no longer permitted to use their land as they wished (subject to common law restraints on nuisance and voluntary restrictive covenants etc.). Instead government technocrats would direct land use centrally in a communist-style system.
 
Equality laws, whether based on gender, race or disability, have also undermined private property or, at the very least, freedom of contract. They have given government the power to enforce access by various groups. Yet it is impossible to impose equality laws without engaging in unfair discrimination. For example, disability rules have discriminated against certain businesses, forcing them to pay out for wider doorways, lifts and ramps. For the first time, the Disability Discrimination Act had retrospective effect in this respect.
 
However, there has been something more pernicious about recent acts by this government to undermine private property. The nationalisation of both Railtrack and the banks seemed to come about after government incompetence (or deliberate policy) undermined their values so that they could be bought on the cheap. And regulation has increasingly been used to move control of private property from the private sector to the government without any compensation. One of many examples is the ban on smoking in private pubs and clubs – a policy which has already led to the closure of many businesses.

23 February 2009, IEA Blog

Filed under political economy Tagged with , ,

Heathrow expansion vs. high-speed rail

February 17, 2013

The Conservative Party has proposed an alternative to the £9 billion expansion of Heathrow. A high-speed rail line would be constructed along the route London-Birmingham-Manchester-Leeds to reduce pressure on the airport by lowering demand for domestic flights.

Yet there is a fundamental economic difference between the two options. Whereas Heathrow’s third runway will be privately funded by the airport’s owners, the high-speed line will be funded by taxpayers.

Its estimated cost is £20 billion. But given the history of big government projects and the fact that extensive tunnelling will be required – probably in the cities and certainly under the Pennines – £30 billion plus seems like a more realistic estimate.

It will be impossible for fares to cover the capital costs. On current figures, this would require the allocation of more or less all the passenger revenue from the UK’s entire inter-city rail network. In reality, of course, most railways struggle to cover even their running costs with ticket sales and require additional operating subsidies.

High-speed rail also offers poor value compared with roads. £30 billion would perhaps buy 1,000 miles of motorway, which, if sensibly located, could be expected to carry more passengers and freight than the entire rail network. And the funding could be entirely private, paid for by tolls, particularly if competing routes were also priced.

Finally, the environmental case for high-speed rail is greatly exaggerated. Running at 180 mph uses far more energy than at conventional speeds and the saving compared with air travel is likely to be small. While electric trains can be powered using renewable energy or nuclear power (hence the claims of low carbon emissions), given the limited capacity of such generation the additional demand created will almost certainly require extra fossil-fuel consumption to supply existing customers.

23 January 2009, IEA Blog

Filed under transport Tagged with ,

Green “New Deal” will sink the UK further into the red

February 17, 2013

Will a green ‘New Deal’ help get Britain out of recession? The Liberal Democrats, for example, have proposed the reopening of disused railway lines as a means of boosting the economy.

Yet such policies will increase the level of public debt, making future tax rises more probable and putting upward pressure on interest rates, therefore deterring private sector investment in the UK. Indeed, any jobs ‘created’ are likely to be more than offset by those ‘destroyed’ through the wider economic effects arising from funding the developments.

Worse still, many green projects, such as reopened railway lines, will require continued long-term taxpayer subsidies, both to pay capital costs and absorb operating losses. The green ‘New Deal’ therefore threatens to increase the long-term role of the state in the economy with negative implications for economic growth.

At the same time, as with previous generations of big-government projects, it risks creating a new generation of white elephants which will gradually be abandoned as spending cuts become necessary to balance the books.

Green projects should be justified on their merits (if, indeed, they have any).

5 January 2009, IEA Blog

Filed under environment Tagged with ,

Madoff and the regulation of financial markets

February 17, 2013

The Madoff scandal is yet more bad news for the financial sector. Several major banks may have lost hundreds of millions of dollars in the alleged scam.

An important question is whether this would have happened under a different regulatory environment. Without the false sense of security given by the government regulation of financial markets, investors would surely have been far more careful about where they put their money. They would have investigated the risks involved more fully and favoured reputable, conservative institutions.

Instead of investors in general having a responsibility for monitoring their counterparties we have handed the job over to a government institution. When that fails – tough. Also, the key objective for a financial institution is not to build reputation and trustworthiness but to make sure it complies with what the regulator wants. Financial institutions look upwards towards the regulator and not downwards towards their clients.

18 December 2008, IEA Blog

Filed under finance Tagged with ,

← Older posts

Newer posts →