Friday, 15 October 2010

The potential impact of public expenditure cuts on Welsh businesses

The current UK government has set itself a target of eliminating the public sector budget deficit over a four year period by a combination of tax increases (notably a VAT hike) and unprecedented cuts in public expenditure. However, the pace of this reduction is causing great concern and there are worries that it could tip the UK and Wales back into recession as seems likely to happen in Ireland. Why is this? Because, particularly in Wales, many companies are dependent on the public sector for business and a downturn in the public sector will inevitably hit business and employment. There are four aspects to this:-
• Providers of public services - Some businesses are direct providers of public services and they are already feeling the impact. Examples of this include companies which provide maintenance of highways, and companies which provide various domiciliary or residential care on behalf of the local social services authority. Warnings of profit reductions are already occurring even before the bulk of public expenditure cuts actually happen.
• Suppliers of goods and services to the public sector - Many businesses rely on public sector procurement of a wide range of goods and services for a large part of their turnover (e.g. consumables, equipment). Again there are already serious impacts. The services sector purchasing managers’ index in June showed a record drop in expectations for business, larger even than during the deepest months of the recession, while there were growing reports of weaker demand from the public sector.
• Construction industry - The construction industry is an area of activity on which many other businesses are dependent. It has suffered a hard time in the past few years and things might get worse. Some construction companies which build schools, offices etc for the public sector are already reporting s financial problems. Moreover any further cuts in public sector capital spending will cause even more problems.
• Consumer confidence - The tax increases proposed in the last budget coupled with the uncertainty about thousands of public sector jobs has damaged confidence among potentially millions of consumers thus impacting on (already fragile) consumer demand. Shoppers also appear to be holding back. Retail sales growth has slowed and businesses fear that consumer spending will suffer this year as public sector jobs are cut and incomes are squeezed.
In Wales it is possible that the public expenditure cuts could lead to a loss of some 40,000 public sector jobs. That is bad enough but using ratios of the number of private sector jobs dependent on public sector spending means that many thousands of private sector jobs might also be at risk. In a country where unemployment has always traditionally been high, compared to the UK average, it is not beyond the bounds of possibility that could Welsh unemployment could hit 20% which is has already done in Spain.
The UK Government holds the view that contracting the size of the public sector will facilitate a regeneration of the private sector, particularly in relation to manufacturing industry. It would be ironic if current policies actually damaged the private sector not helped it.
In these circumstances, one must question the merits of current UK Government policy since although the Government deficit must be reduced, the pace of reduction is too quick and risks economic slowdown or re-entry into economic recession (the so-called double dip recession). Also, the financial markets, who welcome fast deficit reduction, may be more scared by another recession in the UK than by a slower pace of deficit reduction. A loss of confidence is the financial markets could be calamitous.
So what is to be done? Well, while large parts of the private sector are often seen as hostile to the public sector and would like to see public expenditure scaled back, maybe they ought to consider whether the current policy is in their best interests. The two sectors are strongly intertwined and it is naïve to think that a loss for one means a gain for the other. Perhaps, through their representative organisations, businesses in Wales should be lobbying for a change in UK Government policy to have a slower pace of deficit reduction.

How good is the private finance initiative (PFI)

The Private Finance Initiative (PFI) has been one of the most significant broad based public policy developments of the last fifteen years and affects substantially the delivery of public services in most parts of the public sector in the UK. PFI aimed to bring the private sector more directly into the provision of public services, with the public sector as an enabler and, where appropriate, guarding the interest of the users and customers of public services. It is not simply about the financing of capital investment in services, but about exploiting the full range of private sector management, commercial and creative skills and the delivery of certain support services. The PFI policy has been enthusiastically adopted by governments of both major political parties, and over £50bn of capital formation has taken place in the public sector through the PFI.

However, PFI has also generated a huge amount of criticism and controversy. PFI projects are supposed to demonstrate good value for money in the use of public resources compared to the publicly funded equivalent. Also some transfer of project risk to the private sector is supposed to be achieved. Some will argue that it is impossible for the private sector to do this and make a profit while others will say it is achievable through grater innovation in service design and greater efficiency in delivery

Thus a key question is how effective has the PFI policy been in achieving these (and other) objectives. Because of political sensitivities any such evaluation of PFI is a difficult task because of the lack of evidence in the public domain or a lack of reliability in using what evidence is available. Using publicly available information the author undertook a research project aimed at identifying and assessing the effectiveness of the PFI compared to traditional financing routes. The key conclusions were:-

• There is some indication that the PFI model has resulted in additional capital spending in public services over and above what might have been achieved through a publicly financed route. In other words there is some additionality achieved through PFI.
• It is often claimed that PFI is better at curtailing capital cost over-runs. The evidence suggests that capital cost over-runs might have been reduced through PFI, although the reasons for this are not clear.
• Caution must be expressed about the results of many individual PFI project evaluations because of the difficulties of accurately forecasting the costs, and the possible incentive for public sector managers to understate the projected costs of the PFI route in order to get the go ahead for a project.
• Many if not most PFI projects lack any rigorous evaluation of the impacts on service quality.
• The various “external” evaluations of PFI projects that have been undertaken have not reached a unanimous conclusion. In these circumstances, one has to wonder whether there is some bias at play, and whether the methodologies used by each evaluator are comparable.
• Health PFI projects do not seem to have done as well as PFI projects in other areas. This is possibly due the exclusion of large volumes of service activity from health PFI projects, or to the fact that health PFI projects are generally smaller in size than the average PFI project.
• PFI has succeeded in shifting large amounts of liabilities off public sector balance sheets but high levels of risk now exist,

Overall it seems that the jury is still out on the merits of PFI. Unfortunately, the jury will probably never reach a verdict because certain key information about PFI was just not collected, was manipulated for political purposes or has been lost. Hence, all we can do is ensure that for future PFI projects the data required to make an assessment of the projects is collected and is available.

Copies of the research paper referred to above are available, on request, from the author.

Comprehensive Spending Review: How much will it really tell us

The scale of the UK government’s budget deficit is well known as is the current government’s aim to eliminate this deficit over a four year period. To this end the emergency budget in June outlined the following measures:-

• A £6bn reduction in public expenditure this year
• Substantial increases in taxation most notable an increase in VAT
• Substantial changes to welfare benefits system designed to reduce the costs
• Major “real terms” reductions in government expenditure over a four year period which would average a 25% reduction across all government departments but with some departments (e.g. health) being protected

Little additional detail about the timing and nature of these huge and unprecedented reductions in public spending were given in the budget but we were told that this would be forthcoming in the Comprehensive Spending Review (CSR) which would be published in the autumn.

Since that time there has been enormous speculation about what the CSR might contain. There have been endless attempts by several Government Ministers to get their departments treated as a special case, which should have a lower level of cuts, while a number of other initiatives (e.g. abolition of the Audit Commission and a range of QUANGOs) have already been announced.

Clearly the details of the public expenditure cuts will have huge implications for a wide range of constituencies including:-

• Public sector employees whose jobs are under threat
• Businesses who rely on the public sector for much of their turnover
• Recipients of public services
• Politicians who may be blamed for the cuts

Not surprisingly, everyone is now waiting with baited breath for all to be revealed in the publication of the CSR on 20 October. Or will all be revealed?

The CSR will be a very high level document and will indicate the aggregate changes in government spending and the likely levels of reduction that each government department will suffer. Thus people employed in the criminal justice sector will have more to fear if the CSR indicates a higher than average reduction in that sector. Other trends may be discernable such as:-

• An indication that Government intends to cut spending on big IT systems will have implications for IT companies who get a lot of business from the government sector
• Companies in the defence sector will find out whether the Royal Navy is going to get two, one or none new aircraft carriers and this will be of great interest to them.
• The CSR will probably give an indication of the level of government capital expenditure in the years to come and this will be of interest to those in the construction industry.

However, much of what will be contained in the CSR will probably be opaque and its precise impact will depend on decisions made at lower levels of government. Thus an indication that central government will reduce the grant funding made to local authorities tells us very little until we know where these cuts are to take place and how local authorities will implement them.

The CSR is an important document and we will all scan its contents trying to find nuggets of information. However, in many instances we may still have to wait some time for things to become clear. Watch this space?!

Tuesday, 5 October 2010

Reducing Public Spending: The man from Whitehall knows best – or does he?

In 1992, the then Leader of the House of Commons, the late Robin Cook, stated that “Britain was the most centralized state in the EU”. Many will also argue that the UK is one of the most centralised states in the world. Indeed some months ago the Economist journal suggested that the UK was the second most centralised country in the developed world after New Zealand which is, after all, a tiny country. As a consequence of this, English public services are planned and managed via a strongly top-down command and control process driven from Whitehall and Westminster with limited regional or local discretion.

The coalition government is engaged in a policy of making unprecedented reductions in public service expenditure over a four year period. I would suggest that the magnitude of public expenditure cuts being looked for can only be achieved through a limited number of broad approaches, namely:

1. Salami slicing or “Death by a thousand cuts”
2. Strategic withdrawal from certain front line services
3. Control of public sector staff costs
4. Reconfiguration of public service structures
5. Innovation in service delivery
6. Quantum efficiency improvements

The top-down command and control approach is capable of delivering savings in relation to: strategic withdrawal from services, control of public sector staff costs and reconfiguration of public service organisations. Indeed it is clear that all of these approaches are being (and will continue) to be deployed by the government. However, it is naïve to think that innovation and large scale efficiency improvements
can be imposed by the same top down approach. Experience, worldwide, in the public and private sectors indicates that to achieve savings such as these there are a number of pre-requisites including: local empowerment, internal cultural changes, management capacity and skills, and time. The top-down approach precludes that and it can even make things worse. The 2007 Nobel Prize for economics was awarded to Hurwicz, Maskin and Myerson for their work on mechanism design. One of the key points of their complex ideas was that governments seem to fail to understand that people will change their behaviour in response to new rules and targets imposed from on high. NHS targets are a good example. Some aspect of the service is thought by the centre to be inadequate, and so a central target is set without taking into account the fact that a manager will thereby have a strong incentive to move resources from other services in an effort to meet the target. In doing this wrong decisions are sometimes made. The departing manager of the Maidstone and Tunbridge Wells Hospital Trust attributed the C-difficile outbreak that resulted in 90 deaths to this cause.

Unfortunately the top-down approach still seems to hold sway with conversations taking place, behind closed doors, in Whitehall and Westminster about how the cuts should be implemented with only limited consultation with the rest of the country. We all wait with baited breath for the decisions to be announced in the CSR on 20 October. Ministers can pretend to the public that the cuts are going to be achieved, largely, by “efficiency savings” but in my experience they will not. There just isn’t the time for reflection and large scale and real cuts in service are likely to take place. This is not scaremongering by a politician but a judgment from an academic and finance professional based on evidence. Medium term financial projections from local authorities that I have seen suggest to me that salami slicing is extremely prevalent in their future expenditure plans.

The man from Whitehall does not know what is best. It is absurd to think that correct decisions about public services in Barnsley, Bradford, Birmingham or Bristol can be made from an office in London. When will Whitehall and Westminster realize this?