By Roger Latham and Malcolm Prowle | 1 February 2011

The UK is not boldly going where no other government has gone before in its efforts to reduce the deficit. At least 24 OECD countries have paved the way and they have clear lessons ministers would be wise to heed

This feature first appeared in Public Finance

As UK public sector organisations prepare their first budgets following October’s Comprehensive Spending Review, those working in the public finance area know that we are facing an unprecedented situation. Certainly, it is the first time that we can remember hearing senior managers in public services say that they seriously doubt whether what they will be asked to do will be consistent with their beliefs and values, or indeed will be achievable. Not surprisingly, many have been looking around to see if any other countries have successfully made the substantial shift in resource base that is currently being demanded in the UK.

Countries generating large budget deficits with increasing levels of public debt need to implement policies to ensure a ‘fiscal consolidation’ and there are good international examples of how to do this. It’s useful to look at recent cases in advanced economies, focusing on members of the European Union and Organisation for Economic Co-operation & Development, to see what lessons they offer for the UK.

There is much OECD evidence on the many fiscal consolidations that have taken place and the factors that are likely to produce success (see box opposite). It is worth noting though, that of 85 fiscal consolidations across 24 OECD countries in recent decades, the average consolidation was around 2% of gross domestic product over a two-year period.

The current consolidations of 8% or more of GDP and the longer timescale are at the very top end of previous experience. In some cases, such as Ireland, they go well beyond anything seen since the mid-1970s.

Four main lessons for the UK emerge from these examples.

The first is that the severity of the effect on the public sector will depend on how the rest of the economy responds. If there is strong growth in the private sector over the next four to five years, this will be significantly eased. This happened in Canada and Sweden, and so the impact on public finances of a rise in unemployment and a collapse in taxation revenues was avoided.

If the private sector fails to grow sufficiently in the UK, there is a real danger that public spending will not come down fast enough and taxation revenues will not increase enough to avoid a further round of cuts, above the target already announced for the next five years. In this case, as has happened in Ireland, the impact on public attitudes would be seriously detrimental, and political difficulties would lie ahead.

This should be the single biggest item on the ­government’s risk register, and somewhere there should be a ‘Plan B’ for what will happen if growth is not as strong as expected. Given the weakness in global demand, the potential dangers of protectionist ‘beggar my neighbour’ responses, and the impact on consumption of public sector unemployment, this places real pressures on the ability of manufacturing and services to lead the export-led growth that will be needed.

The second lesson from countries that have made this fiscal transition successfully is that no areas of the public sector should be exempted from the cuts. By deciding to protect, even at a zero base, the National Health Service and schools budgets, the coalition government has placed significant pressure on all other elements of spending, and on the welfare budget. The net consequence is that there will be significantly greater cuts than expected and, as we have seen with the student tuition fees, the net change to individual groups’ circumstances will be considerable.

Ministers need seriously to question whether the least efficient area of the NHS has greater value than some of the lesser prioritised services, and whether the impact of the welfare cuts on poorer income families with higher public sector dependencies, and on geographical areas of the country with higher public sector dependency, is acceptable. There will inevitably be intergenerational comparisons made here between the protected pensioners’ perks and the increased debt levels of young people.

The third factor in the success or failure of any deficit reduction programme is how well regulated the banks are. Western governments initially avoided the Japanese experiences of the 1980s by taking immediate action to recapitalise their banks after the 2008 banking crisis. However, as Ireland has shown, leaving an unreformed and under-regulated finance sector does not provide any certainty that the pattern of speculative boom and bust will not continue.

The danger is that a fresh financially-driven crisis might develop before a full transition can be made in public sector finances. In the UK, the financial sector has recovered significantly and is earning profits that support public expenditure by taxation and help the economy to grow. But this has put the government in a bit of a bind over the issue of regulation. Threats to increase the level of regulation are vigorously countered and the banking sector threatens to move elsewhere. Nevertheless, if this area is left unchecked, there is a danger that people will feel that individuals and not the banks are bearing the burden. If this sense of unfairness becomes embedded, the issues that have emerged in Iceland and Ireland might crop up here.

The final lesson that has emerged from other ­countries’ experiences is, unsurprisingly, that radical approaches will be needed. As Albert Einstein said: ‘You do not solve the problem by using the same thinking that created it.’ Given the significance of the change required, traditional techniques for budget reductions are unlikely to be successful. Canada’s comprehensive approach and genuine public consultation (see case study above) seems the least that is called for. In the UK, much of the public consultation is based on a relatively limited set of questions and options. There is a real danger that if people are not involved in the solution, they will not feel responsible for it. The consequences in terms of negative campaigns, protests and legal challenges will only prolong the transition.

There is also a strong argument for major reform in the way that public ­service organisations and the economy are managed. Some of the devolved thinking outlined in CIPFA/Solace publications and the government’s ‘Big Society’ ideas need to be ­implemented radically to enable truly ­innovative solutions.

However, while we concentrate on the practicalities of putting the necessary changes into effect, there are three things that it would be dangerous to ignore.

First, there is a clear need for better communication with the general public. A recent survey found that 30% of people believed that their local authority wouldn’t be making significant cuts, and an amazing 13% of people believed there would be more money to spend on services in the next financial year.

Secondly, there is the whole issue of fairness. At every step we need to be asking ourselves not only whether the change is practical and will provide the required outcome, but how it will appear to the general public and to those affected.

Thirdly, we need to remember that there are also some very substantial longstanding issues that we can’t allow to drift. The impact of demographic change and the long-term consequences of climate variation are just two of the bigger items. Ignore these and we might solve the immediate crisis only to be confronted with a much bigger one.

Case Study

1: Canada runs dry

In the late 1980s and early 1990s, Canada found itself with an unsustainable public sector deficit of around 8% to 9% of gross domestic product, largely as a result of the collapse of over-stimulated speculative economic bubbles. But it managed to bring the situation under control in a relatively short period of time. This involved tax increases and large-scale spending cuts (20%), implemented by a comprehensive zero-based budget review. Driven by a ‘Star Chamber’ arrangement from the top, every single service was asked to justify itself against five key questions:

> Is the service core to the community?
> If it is core, does this public authority have to do it or could others do it?
> If another organisation can do it, does it need external support in order to do this?  Could another organisation do it more cheaply than us?
> If we have to do it, can we do it better?
> Even if we can do it better, can we afford to do it at a level that affects the communities’ well-being?

This exercise was backed up by public consultation on priorities. There was a general concern that the public finances should be put back on an even keel, so the budget changes had widespread support in principle. Given the significance of the change, it was somewhat surprising that some of the more traditional approaches such as ‘salami-slicing’ did not gain public support. There were some unexpected results – the public supported increases in some areas of public spending but cuts of 50% or even 100% in others.

Although the fiscal consolidation was successful, the consequences were not painless. Hospital waiting lists shot up, some hospitals were closed, and thousands of medical staff lost their jobs. Hospitals that remained became more overcrowded and infection rates rose. In education, average class sizes rose from 25 to 35. Science and transport budgets were halved, defence was cut by 15%, and many of the significant cuts were made at provincial and local rather than national level.

2: Tiger at bay

While the examples of Sweden and Canada relate to the 1990s and the situation is now stabilised, Ireland is still in the throes of a crisis. As in Iceland, it involves dramatic rises in the banking sector to the point where it dominated the relatively small economy and presented a significant risk to the much smaller ‘real economy’ that had been the traditional mainstay of its prosperity.

The immediate crisis was staved off when the Irish government gave an unconditional guarantee to underwrite all deposits in Irish banks. Though this short-term and expedient move saved the day, long term it has had serious consequences. Because of the difficulty of determining the liabilities of Irish banks since the government effectively assumed responsibility for them, Ireland has gone through three successive rounds of public sector cuts and reductions in welfare payments.

Although it has tried valiantly to stave off the need for international loan support, which formed the basis of the Iceland solution, it has in the past few months had to recognise the need for this in the face of an escalating sovereign debt crisis.

The Irish people showed an initial tolerance and acceptance of the need for drastic action to handle the public finance problem, but increasingly the impact of repeated reductions has damaged public morale and confidence. As happened in Iceland, it seems likely that a disenchanted public will exact a penalty on the current government at the imminent election.

3:  Smorgasbord of cuts

The essential problem in Sweden in the 1990s was the tendency of the Swedish Parliament to soften the draconian changes suggested by the Executive in a series of budget amendments. The net result was an escalation in the level of public spending. This in turn prolonged the accumulation of public sector debt, which reached 50% of gross domestic product around 1994 and peaked at 80% around 1998, before the situation was brought under control.

The action taken in Sweden was to make changes to budget priorities a ‘zero-sum’ game. Within the overall resource envelope, any change that involved increasing expenditure had to include a lower priority item that would be cut to fund it.

As a result it became increasingly difficult to generate the necessary coalitions to pass a successful budget amendment. The number of such amendments dropped dramatically, and this helped to bring the budget under control.

As in Canada, all areas of public spending were examined. Göran Persson, Swedish finance minister at the time of the consolidation, told the 2010 CIPFA annual conference that it was essential to make the change early, make it once, and ensure there were no sacred cows. It was also vital that long-term liabilities – such as pensions – were equally looked at so that the new rules ensured that the deficit could not creep up again in future. It was made clear at every opportunity that ‘nothing was off the table’ and nothing was exempted.

Roger Latham and Malcolm Prowle are respectively visiting fellow and professor of business performance at Nottingham Business School and joint authors of a forthcoming book on planning and managing public services in a time of austerity. Some of these issues will be debated at CIPFA’s first international conference, being held in London on March 15-17

This article first appeared in the February edition of Public Finance