Osborne, Cameron and fiscal irresponsibility

Is there anyone left who really believes that George Osborne is cutting public spending because he wants to be prudent with the nation’s finances? Unfortunately I think the answer is far too many.

Most macroeconomists have had deep suspicions or worse for some time, as we could see what damage austerity was doing to the economy. You might say that issue is past as growth has returned, but this would be quite wrong. What is now becoming clear is that the fears that some economists had all along that delaying the recovery in demand would lead to permanent damage to supply have indeed come to pass.

Those who were not macroeconomists should have realised what was going on when the government started cutting taxes. How do you explain cutting inheritance tax one day, and then trying to justify cuts in tax credits because ‘we have to get rid of the budget deficit’ the next, other than helping your own at the expense of the poor?

Even if that did not convince you, I suspect what will happen in the next few years will leave you in no doubt. Everyone knows it is crazy to cut spending that would have generated more income than it costs. Appearing to balance the books by paying for current spending (or tax cuts) by selling off your assets is not being prudent at all. Yet I suspect we will see more and more announcements from the government that do exactly this in the next few years.

To take just one example, we have the announcement of yet more cuts to HMRC, the government’s tax collectors, as part of the new spending review. No doubt we will hear a lot of talk about reorganisations to make the service more efficient. Just as we did with the previous cuts. In March 2015 it took an average of almost 15 minutes to have your phone call answered by HMRC. For the government that is a sign that the service needs less people! I do not know if the OBR allow something for the impact of HMRC cuts in their estimate of overall tax receipts, but if they have not done so already I think they should start.

This is a very obvious example of apparent savings that in fact reduce net revenue. Many more involve cutting public spending in a way that increases costs to the private sector, leading to lower productivity, lower incomes and then lower taxes. But for a politician facing a tame media who just has an eye for the headline numbers none of this matters.

The letter that the Prime Minister wrote to his local council complaining about its cuts has got some publicity. But what I found most revealing was Cameron’s suggestion that the council pay from some ongoing frontline services by selling more assets. The council leader in his reply explains that using the income from these sales to pay for the council’s running costs “is neither legal, nor sustainable in the long-term since they are one-off receipts”. The Prime Minister offered the services of No. 10’s policy unit to help the council. It sounds to me that the council should in turn be offering some of its wisdom next door at No. 11.

Privatisations: why we need a fiscal watchdog

When the government sold its shares in Eurostar (the London to Paris train service) around a year ago, its primary motive according to a recently published national audit office (NAO) report was to reduce the level of government debt. [1] As the NAO says “Some asset sales are justified by government on the basis that the sale will result in improved efficiency for the business but this was not the case with Eurostar.”

The key point with privatisations is that reducing current debt may harm the health of the public finances. Any normal investor would only sell an asset if they thought they could get a price that exceeded what the asset was really worth. Although selling the asset would reduce the government’s net borrowing today, it would increase their net borrowing in the future because the government would not get the dividends the shares paid out.

The fact that the government had the wrong motives is an unfortunate by-product of debt or deficit targets. By necessity these targets have to be ‘realisable’ (to use a term from my paper with Jonathan Portes) - they have to be targets that are within the lifetime of a parliament. But that gives any government an incentive to effectively cheat: to sell off assets (like Eurostar) that help meet targets in the short term, but make managing the public finances beyond this more difficult. (This post discusses the point in more detail.)

So how do we judge if selling Eurostar was a good or bad decision? Reports that there was a general belief that the value of the shares would rise are worrying. To be honest I do not know the answer to this question, but in essence that is my point. Given the clear danger that the government will sell assets just to meet its short term targets, we need some independent institution to assess whether the government is being sensible or is cheating. (In some other cases, like selling off the student loan book, the cheating is pretty clear.)

The NAO had a remit which did not address these issues, although it tries in its report to at least raise them. [2] The obvious body to analyse and publicly report on issues of this kind is the OBR, but this is also not in the OBR’s remit, and at present it can at best only drop hints. With a large privatisation programme over the next five years, the government was never going to extend the OBR’s remit in this way, and (coincidentally?) the Ramsden review does not seem to have addressed this issue directly. The OBR needs to become not just a producer of forecasts, but more of a fiscal watchdog.

Without some independent oversight of this kind, we will have the irony of government ministers arguing that privatisations are needed because we must reduce government debt for the sake of future generations, when in reality they may be increasing the burden on future generations. We need a fiscal watchdog to protect future generations from shortsighted governments.

[1] Although the headline level of public debt is often described as net, it in fact only nets off liquid financial assets.

[2] The key technical issue is discounting, and how you handle uncertainty. Even if the government gets the current market price, that price may be low because the private sector discounts future returns heavily. That heavy discounting may reflect vulnerability in the face of uncertainty, whereas the public sector has much less vulnerability.  

Fiscal deceit

Vince Cable, the LibDem minister whose remit includes UK student finance, is apparently having cold feet about the plan to privatise the student loan book. Which is good news, because if ever there was an example of a policy designed to lose money for the public sector (or, as they say in the media, cost the taxpayer more), it was this.

As I explained in this post, if a public asset that generates income is privatised, the public gains the sale value, but loses a stream of future income. The ‘debt burden’ need not be reduced, because although future taxes will fall because there is less debt to pay interest on, they will rise because the government has also lost a future income stream.

With assets like the Royal Mail, we can debate endlessly whether the asset will become more or less efficient under private ownership. If it is more efficient, and therefore profitable, under private ownership, the private sector might be prepared to pay more for it, and so the public sector (and society) is better off selling it – unless of course the government sells it at below its market price! However in the case of the student loan book, it is pretty clear that privatisation is a bad deal for the public sector for two reasons.

First, as Martin Wolf has pointed out, the revenues from student loan repayments are very long term, and pretty uncertain. Any private sector firm that might buy this book is likely to discount these revenues quite highly, and so will not be prepared to pay the government enough to compensate the government for the lost revenue. Second, as Alasdair Smith points out, the main efficiency issue is collecting the loan repayments. Here the government has clear advantages over the private sector, because loan repayments are linked to income, and the government has all the information on people’s income, and an existing system for collecting money based on income.

So selling the student loan book is an almost certain way of increasing the ‘debt burden’ on current and future generations. As Alasdair Smith reports, George Osborne justified the sale by saying that it helped the government with a ‘cash flow issue’. As Alasdair rightly says, the government does not have cash flow issues. This kind of ludicrous policy either comes from ideological fundamentalism (the government shouldn’t own assets) or the need to meet ridiculously tough deficit targets. Whichever it is, every UK citizen loses money as a result.

George Osborne is hardly the first finance minister to play tricks like this, so how do we stop future governments from doing the same? I’m glad to see more journalists, like Chris Cook, making the points I make here. However it would be better still if an independent body, set up by the government to calculate its future fiscal position, was charged with a statutory duty to make these points. At present the OBR does not have that duty, and it feels naturally reluctant to go beyond its remit and pick fights with the government. However, if it became more of a public watchdog, with a remit to flag government proposals that appeared to lose money for the public sector in the long term, that might just stop future governments doing this kind of thing.

Privatisation and government debt

Possibly the worst argument for privatising part of the public sector is a supposed ‘need’ to reduce public sector debt. I think the problem with this argument is obvious to most economists, but as it is repeatedly ignored by politicians, it is worth spelling it out.

As I argued in a previous post, decisions to privatise or contract out should be based on considering the microeconomic pros and cons, which will vary from case to case. This analysis should include political economy considerations, like the extent of public sector corruption, or the ability of firms to extract rents from the public sector.

Suppose that such an analysis left the decision to privatise evenly balanced. Should macroeconomic factors, like the need to reduce public sector debt, ever be used to sway the decision in favour of privatisation? In our recent paper, Jonathan Portes and I argue (here or here) that a government should have some view about what the long run desirable level of public debt relative to GDP should be. Two arguments that could be used to argue for lower long term debt are that paying interest on debt requires raising taxes, which are ‘distortionary’ (they tend to reduce GDP and welfare), or that public debt may crowd out private capital and investment (assuming those are thought to be too low).

If we start out with public debt above its long run target, why not use privatisation to help get us towards that target? To see why that is nonsense, consider the two reasons for reducing debt given above. The first was to reduce the need to raise taxes to pay interest on that debt. While privatisation might reduce debt, it will also reduce future revenues or increase future public sector payments. Privatisation will either mean that the public sector loses the revenue that the privatised activity produced, or the private sector will have to be paid to undertake the outsourced activity. So the net impact on taxes will be zero.

What about the point that public debt may crowd out private investment? Once again privatisation does nothing to encourage additional private sector investment. All that happens is that existing capital and any investment that goes with it are relabelled private rather than public. No additional savings are released to encourage new private sector activity.

Consider an extreme example: Greece. The country is desperate to show that debt can be at least be brought to some sustainable level. So what is wrong with selling off some state asset, like part ownership of a water company for example, to help reduce this debt? Now there may or may not be good microeconomic reasons for doing this, but is there a good macro reason? Selling the asset would allow the Greek government to reduce its debt, but it would also have to raise future taxes, or cut future spending, to make up for the revenue lost from no longer owning that company. If microeconomic efficiency is unchanged, this sale would make no difference to the balance between taxes and spending required to make debt sustainable. Debt interest payments would fall, but so would receipts.

To make the same point another way, if we valued public sector assets and calculated the public sector’s net asset position, privatisation would have no effect on that net number. So why should anyone think that the position of the Greek government had been improved by this asset sale?

Obvious though this point may be, it illustrates a problem with most fiscal policy rules. Most rules need to involve what Jonathan and I call realisable operational targets: goals that politicians can aim for (and be judged by) within the lifetime of administrations and parliaments. Privatisation is one of a number of devices that flatter the short term public finances with no impact (or worse) on the long term position. (Considerably worse if the asset is sold far too cheaply, as in the most recent UK case for example.) Because fiscal rules inevitably focus on the next few years, politicians will always be tempted to use these devices to in effect cheat those rules. This is why it is vital to have effective fiscal councils to work alongside any rules. These independent institutions need to be able to shout when they believe only the letter and not the spirit of these rules is being met. The UK’s fiscal council, the OBR, does not have this kind of mandate, and can therefore only note when policies have this kind of effect (see here, paras 1.8-9).  

The state, corporations and markets

I have written in the past that I have no idea how large the state should be, so this issue has no bearing on my views about austerity or fiscal stimulus. In this post I explain why I have no idea. My argument is that the optimal private/public split will depend on a number of particular and highly contextual issues, about which economics will have a lot to say but where it is unlikely to generally point in one direction. It seems worth making this - I hope uncontroversial - point when the current UK government seems keen to privatise or outsource by one means or another so much of the public sector.

There are two claims about government often associated with those who argue in favour of privatisation. One is that markets provide a better allocation system (e.g. here, and follow-ups here and here). For many activities this is undoubtedly true, particularly where markets involve a large number of buyers and sellers, and information problems are small. However much public sector activity is in areas where market imperfections and informational problems of various kinds are endemic. In that situation, market based systems may perform worse than alternatives: a comparison of health systems in the UK and US is an obvious example (e.g. here).

The simple fact that large corporations exist could illustrate potential problems with markets as an allocation mechanism. Large corporations may exist because they find it more efficient to organise activity in a non-market (often hierarchical) manner, or they may exist because markets can be circumvented by rent seeking, or they may exist because of increasing returns. This means markets can be fragile or inefficient. Economics is not a discipline that tells us market allocation is always best, but one that tells us when it may work well and when it may not.

In reality privatisation or contracting out often involves relocating some activity from government bureaucracies to corporate bureaucracies. George Monbiot argues that we are seeing power gradually shift from the former to the latter. The second general argument in favour of this shift is that the profit motive provides an effective incentive system for ensuring efficiency. Yet this argument alone is not enough. It is perfectly possible to run parts of government like a company, where the explicit aim is to maximise profits. Take the East Coast mainline rail company in the UK, for example. It has been running as a publically owned company since 2009, after the private company running the franchise got into difficulties. It appears to have been run very successfully under public ownership, but the government wants to return it to the private sector. The motive does not appear to be pressure from the public or customers.

The complete argument for preferring private sector rather than public sector bureaucracies is that shareholders are better at ensuring managers maximise profits (and therefore efficiency) than politicians. In fact the argument has to be stronger than this: the gain in profitability has to exceed the cost of diverting some of those profits from the public to shareholders. Again I think in many cases this will be true, particularly if checks within government are poor and corruption widespread.

However, control by shareholders may be far from ideal, as the recent debate in the UK about the proposed takeover of AstraZeneca by Pfizer has illustrated: see this article by Martin Wolf for example. One argument that has been made in this debate is that shareholders may be unable to prevent managers focusing too much on the short term, because that enables them to expropriate a share of the surplus in excess of their marginal product. Shareholders’ ability to directly control managers appears weak, and the takeover mechanism itself seems highly ineffective at punishing inefficiency. Martin Wolf argues that the real purpose of shareholders is to provide insurance against unexpected shocks that could otherwise lead to bankruptcy.

The process of tendering for the outsourcing of services paid for by the public sector allows periodic pressures for efficiency. However often the contracts involved are very complex, and so they also provide an opportunity for firms to exploit the inexperience of the civil servants who represent the public. Finally if we want those undertaking public activities to be accountable as well as efficient, then it is not obvious that outsourcing is helpful.

What this all suggests to me is that the costs and benefits of privatisation will vary from case to case, and that this is an area where microeconomic analysis will be central. (For example, see this book by Massimo Florio which looked at the results of the Thatcher privatisations.) In such cases, an ideology that says that the private sector is always better (or worse) is not only unhelpful but dangerous. For example, an ideology that says that private sector provision is always better can be exploited by rent seeking firms. It can lead governments to privatise on unfavourable (to the public) terms, or with inadequate mechanisms in place to ensure value for money and prevent exploitation. At worst, rent seeking firms may be able to exert sufficient control over the political process to make this happen.

Given that my area of expertise lies elsewhere, you might have expected me to consider a macro argument that is sometimes made for privatisation, which is that it can help bring down public debt. This is either a terrible argument all the time, or just most of the time, but which will have to wait for a later post.