Financial Times on Need to Curb UK Public Sector

Adapting to Britain’s mediocre prospects
By Martin Wolf
Published: July 16 2009 20:16 | Last updated: July 16 2009 20:16
If the government of the UK wishes to find a suitable motto, it should adopt the advice of a great Scot. “Great Britain should,” wrote Adam Smith in The Wealth of Nations, “... endeavour to accommodate her future views and designs to the real mediocrity of her circumstances.” Smith offers wise counsel. The country’s circumstances are more mediocre than imagined two years ago. The question is how to respond.

Three things have combined to postpone widespread recognition of the task: first, the government that was in charge when exaggerated optimism became rife is still in power; second, nobody can be sure how mediocre the country’s longer-term circumstances are going to be; and, finally, as Giles Wilkes points out in an excellent new paper for the Liberal Democrat think tank, CentreForum, with modest initial levels of public debt and low nominal and real interest rates, the UK government was right to let its borrowing take the strain.*

The result has been a “phoney war”. Hysteria over a few million pounds in expenses for members of parliament has drowned out discussion of close to £200bn ($330bn, €230bn) in annual government borrowing. But the phoney war will end. How should the UK plan to fight the real one?

It must start by making finance safer. The simple and painful truth is that another such financial shock might even bankrupt the British state. No industry can be allowed to impose such costs – comparable, in fiscal terms, to those of a major war – on a largely innocent public.

Unfortunately, while containing sensible points, the Treasury’s white paper on financial markets is imbued with what I think of as an industrial policy perspective on finance. It accepts, not least, that it should be a goal of policy to “maintain the future pre-eminence of the UK’s international financial services markets”. Alas, a competitive advantage in the supply of global “bads” is really a disadvantage.

Private parties cannot be allowed to gamble with taxpayers’ money. Letting that happen is to provide a gigantic subsidy. The right policy is to ensure that the costs imposed by the failings of finance on the rest of society are properly internalised within the sector. Then, let the market forces we are supposed to believe in decide how big the sector should be. This is why a crucial reform is a credible plan to wind up institutions when they manage to get into difficulty. It is also why higher capital requirements are needed.

Government must also deal with the fiscal legacy of the present crisis. As an immortal borrower with an excellent credit rating it was right to become borrower of last resort in the crisis. The big question is how and when to unwind these deficits.

Nobody can doubt that a huge effort at fiscal consolidation will be needed once the economy recovers. The question is how long such consolidation can be postponed if the economy does not. The danger of acting too soon is that it would deepen the recession. The danger of acting too late is that the debt accumulation might generate a vicious spiral of rising real interest rates and so explosive debt-dynamics.

My guess is that it will be impossible to postpone tightening for very many years, even if the recovery is not as strong as one might wish. But the more credible the commitment to stability, the longer it can be postponed. That can be achieved by cementing the credibility of the independent central bank and by spelling out the details and scale of the spending cuts and tax boosts that will follow recovery.

In his paper, Mr Wilkes focuses on raising taxes on property and the value added tax. The arguments for imposing heavy taxes on site values are very strong. We have just seen, in all too glorious colour, the dire results of turning a nation’s population into land speculators. If necessary, let the cash-poor but land-rich borrow their tax payments from the government, and demand repayment on death. VAT revenues must also be raised, which can be done by eliminating exemptions.

Equally important, however, will be a plan for curbing spending that does minimal damage to the country’s future. Public sector wages and pensions will have to be curbed. The former can be achieved by curbing the aggregate wage bill and letting managers decide the details. This should also drive higher public sector productivity. Beyond that, governments must protect true investment. But neither health nor education can be sacrosanct. What matters is not the overall value of such specific areas of spending, but their benefits at the margin. The UK will never have a better chance than now to rethink public sector priorities and long-term funding.

It is painful to be forced to parcel out the consequences of unforeseen losses. But these losses look permanent and so cannot be avoided. Fortunately, such crises are not all bad. They are opportunities for desirable change. In the case of the UK, change is inescapable. The party that deserves to govern is the one that recognises the pain and embraces the opportunities.

* ‘A balancing act’, CentreForum