The recent GDP growth figures a fortnight ago proved a welcome tonic after months of economic gloom. Though all the caveats outlined due to the Olympics and the previous quarter’s Bank Holiday apply, the fact that growth was more significant than forecast suggested we might be seeing some signs of recovery at last. More recent developments, however, have been less encouraging:
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The Markit Purchasing Managers’ Index (PMI) for the UK’s service sector showed growth at its slowest pace in two years in the month of October, and fell to 50.6 last month from 52.2 in September (still above 50, below which shows contraction).
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The Markit/CIPS UK Manufacturing PMI fell to 47.5 in October from 48.1 in September (where 50.0 is no change).
But there are good signs on the crucial ‘confidence’ factor:
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The European Commission survey of economic sentiment showed that the overall UK sentiment index from September to October rose by 5.2 points to 97.1, the largest monthly rise since August 2009.
All this suggests that the recovery will continue to be bumpy in the months ahead, with particularly important implications on whether the Bank of England decides to continue on the QE path (which will be decided when the Monetary Policy Committee meet on Thursday). The unconventional monetary policy is increasingly being seen as a blunt instrument amongst economists, and the Treasury Select Committee has recently been tasked with examining its effectiveness. The Bank’s official position is that it is assisting growth, but several prominent MPC members, including Martin Weale, have of late doubted whether more of it would be compatible with the Bank’s inflation target.
HOW TO GO ABOUT CUTTING SPENDING
It’s all gone a bit quiet of late on the spending review which is supposed to be happening in 2013/14 to outline plans for the next four years. This might well be because the two Coalition parties are divided on how to proceed. As we’ve written before, the Autumn Statement is likely to show the Chancellor will meet neither of his fiscal mandates on unchanged policies – and so will have to decide on whether to consolidate further, or to accept that the debt to GDP will still be rising into the next Parliament.
Given this, any future spending review is likely to be very important. But it’s clear from international experience and from the outcomes of the previous spending review that there are lessons which need to be learned.
Our report into the example of Canada, and recent economic analysis, shows that spending restraint tends to be most effective when it is accompanied by significant reforms to both the scope and delivery of state programmes. Attempting to make spending cuts across the board is second-best. In these circumstances, departments tend to postpone capital spending, including such things as maintenance and repair. This can often be a false saving as spending later grows back to former levels within a few years.
It is far better to think about what we want the state to do and to eliminate whole programmes which fail to fulfil objectives. The first Comprehensive Spending Review seemed to proceed in the more undesirable salami-slicing fashion. Both health and foreign aid were ring-fenced for political reasons, and there was no real questioning about the scope of the state – rather it was an exercise is simply continuing to deliver the same services more efficiently.
Given what we hear in the media it might surprise people to find that in terms of the plans the Coalition laid out for spending, they have actually delivered. Spending was actually £8.9 billion less than the Coalition thought it would be by the end of 2011/12. Total managed expenditure for 2011/12 was forecast to be £699.8 billion – actually it was £690.9 billion. This perhaps shows how far the original plan was reliant on growth of tax revenues. But just because the Government has been able to make the savings it says it would, doesn’t mean that there aren’t other important economic considerations to take on board. The overwhelming majority of deficit reduction so far has come from cuts to capital expenditure and tax hikes.
ECONOMIC CONSIDERATIONS
Brian Reading’s excellent recent report for Lombard Street Research, entitled ‘The Blunt Axe’ really honed in with painstaking detail on the lack of attention to economics within the last spending review. His lessons, and identification of mistakes, are really worth highlighting:
1) Rather than analysing the effects of the policy changes on ‘fairness’, the policy changes should be judged by their effects on growth.
Given that a significant portion of UK growth had occurred in industries dependent on credit or government spending over the past ten years, it was always going to be important that the spending review sought to prioritise growth. Yet there was little meaningful analysis of the effects on growth beyond using uncertain OBR ‘multiplier’ assumptions. Instead, the Government undertook an analysis looking at the distributional impact in order to show the package was ‘fair’. The Government also set out by prioritise various things: the NHS; early year provision; international aid; renewable energy technologies and various local hospitals. In any future spending review, the focus should be on growth and this should be examined in more detail. A plethora of aims leads to muddled thinking.
2) Spending should be examined by function and economic category rather than just by department
The Government decided to undertake the spending review largely on a department by department basis. The problem with this is that many of the functions of government or the economic impact categories involved sometimes bridge two or more departments. So, for example, if the government has a target for ‘education’ spending, then they should also consider the education spending which is undertaken by departments other than the DofE, such as BIS. Spending cuts should also be viewed under economic categories, other than ‘current’ and ‘capital’ spending. Total current spending is split into pay bills, purchases of goods and services, grants, subsidies, public servants pensions and debt interest, for example.
3) To judge the economic effects of spending, account should be taken of relative prices
Departmental real expenditure plans are always presented by deflating nominal spending by the GDP deflator, but this doesn’t always give us a great understanding of the amount of services that a certain amount of spending will provide. For example, inflation in the labour-intensive health and social care industries can often be faster than general price inflation. The Government must then decide whether to impose spending totals and hope for improvements in efficiency, or to judge what is required to maintain services assuming efficiency will be largely unchanged.
4) Identifying frontline workers
There was no attempt in the previous public sector spending review to identify, let alone account for the number of ‘frontline workers’ despite a stated ambition to protect frontline services. Any future spending review should re-examine this.
5) Thinking through the implications of public sector pay estimates
Related to point 4), the OBR made its employment projections using estimates of the budgets available and what they expected to happen to pay. But the OBR has been hopelessly wrong in assessing the impact on employment, because the overall public sector pay bill rose three times more quickly than they originally thought it would.
Reading concludes that the Government should announced a Geddes-style commission immediately “
To recommend measures that would reduce the ratio of public spending to nominal GDP to 40% within an appropriate timescale, having particular regard for the impact on present and future growth. In accordance with the Government’s lesser priorities, notably to increase the real resources devoted to the NHS, to consider the extent to which the price of public expenditure on goods and services might move relative to the overall GDP deflator. As it is also the Government’s desire to protect front line services, to examine the impact on front line jobs and productivity consequents of the Committees recommendations.”
CONCLUSION
Reading’s commission for the next spending review would be a step in the right direction, and the economic considerations he has outlined are worthy of further analysis. However, we’d suggest going further and being much more strategic about the scope of the state – rather than looking to maintain as many current state functions as possible whilst reducing expenditure to a set level. The example of Canada showed that it’s much easier to decide what the government should and should not do – and to eliminate whole programmes or layers of bureaucracy where necessary. This is something the CPS will be starting work on soon.
MUST READ:
From here on…
Over the coming months, the CPS Growth Bulletin will examine the Government’s progress in achieving its objectives: reviewing policies, suggesting alternatives and highlighting interesting viewpoints - both from domestic and international perspectives. E-mail
ryan@cps.org.uk if you find something which we should consider.
RYAN BOURNE AND TIM KNOX
CENTRE FOR POLICY STUDIES
DISCLAIMER: The views set out in the ‘Growth Bulletin’ are those of the individual authors only and should not be taken to represent a corporate view of the Centre for Policy Studies.
