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Aggregate fiscal policy under the Coalition

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In this article Simon Wren-Lewis considers the fiscal policy innovations under the Coalition before discussing the choice of austerity. He argues that that choice was a policy mistake which is difficult to explain and has had significant costs for the UK. [A link to Wren-Lewis’s earlier paper on the fiscal policy of the last Labour government, free to view until the election, can be found on the Labour government page .]

When the Labour government came to power in 1997, it made the Bank of England independent, and introduced a new framework for aggregate fiscal policy. Most academic macroeconomists would view both changes as progressive, and in Wren-Lewis (2013) I argue that Labour’s fiscal rules and the transparency that went with them came close to best practice at the time. When the Coalition government came to power in 2010, it also introduced an important institutional reform: creating the Office of Budget Responsibility (OBR). It too introduced a new framework for aggregate fiscal policy: their primary and secondary ‘fiscal mandates’. I would argue that, as with Labour, both changes can be seen as largely progressive.

There is a third similarity between 1997 and 2010. Both governments started with a tight fiscal policy. Labour promised to be more prudent than its predecessor, and the Coalition promised to reduce the deficit faster than Labour. However there was a key difference in the environment in which these pledges were made. In 1997 the economy was growing reasonably well, and interest rates were above 6%. In 2010 the recovery from the largest recession since WWII had only just begun, and interest rates were at their ‘Zero Lower Bound’ (ZLB): 0.5%.

This difference was crucial. The Coalition government’s policy of sharp fiscal consolidation reduced demand at a time when monetary policy could not reliably counteract this deflationary force, and as a result the recovery was delayed. Although fiscal austerity was to some extent put on hold in 2012, the damage had been done. A conservative estimate is that around 5% of GDP was lost forever as a result of this mistake, and it produced the slowest UK recovery on record. It is difficult to understand why this mistake was made and even more perplexing why the major party in the coalition is planning to make the same mistake again after 2015.

  1. The Office of Budget Responsibility

In my study of the Labour government’s fiscal policy record (Wren-Lewis, 2013), I noted that the years before the recession were characterised by over-optimistic fiscal forecasts. This, combined with fiscal rules that with hindsight were not ambitious enough, led to fiscal policy being a little too lax before the recession, although the impact on the deficit was dwarfed by the consequences of the subsequent recession . This over-optimism was an important motivation behind the Conservative plan to create a fiscal council for the UK: the OBR. Under the Coalition, fiscal forecasts were contracted out to the OBR, which would be independent of any political pressure to be over-optimistic.

Fiscal councils have become increasingly popular over the last ten years, but their role and form differ substantially from country to country (Calmfors and Wren-Lewis, 2011). A key question in setting up the OBR was whether it could be independent of government, even though it relied to a considerable extent on government departments for parts of its forecast. The OBR has inevitably made forecasting errors – all macro forecasters do – but there is no evidence that these errors have resulted from manipulation or pressure by government. In that sense the OBR has provided proof of concept.

In political terms the OBR also appears to have been a success, as both parties are talking about the possibility of extending its role. The opposition Labour Party wanted it to cost its post-election plans, and although the government has refused this particular request it has not ruled out this possibility for the future. George Osborne’s long term plans for fiscal policy also hint at a stronger role for the OBR. 

  1. Fiscal rules

The Coalition government introduced two fiscal rules to govern its decisions about aggregate fiscal policy. The primary fiscal mandate aimed to achieve cyclically adjusted current balance within five years, but where that target was rolling (i.e. the next year the target was still 5 years ahead). The secondary mandate was to have debt to GDP falling in 2015. This secondary mandate makes little sense in either theoretical or practical terms, and was abandoned. The primary mandate is more interesting.

Portes and Wren-Lewis (2014) argue that for a country like the UK where deficit bias is not endemic, and where there is an independent fiscal institution like the OBR, a rolling target for some measure of the deficit represents a good compromise between flexibility and effectiveness. It is flexible because it allows fiscal policy to respond gradually to shocks, but it is effective in achieving longer term goals for the debt to GDP ratio and allowing scrutiny by independent organisations. So the principles behind the Coalition’s primary fiscal mandate would have been sound if it had been implemented in normal times. The tragedy for the Coalition, and the UK economy, was that it was applied at the one time it should not have been: when interest rates were stuck at their ZLB.

Before discussing that point, we should make two additional points about the Coalition’s primary fiscal mandate. First, it targeted the current balance rather than the deficit, so it excluded public investment. (This may have been one of the reasons for the addition of a secondary mandate.) This gave the Coalition the option of keeping public investment high to support the recovery, an option which they did not take up: instead public investment was cut quite sharply. Second, the target was for the cyclically adjusted current balance 5 years ahead. While the 5 year period makes sense, it would be normal over such a long time horizon to assume that monetary policy would have returned the output gap to zero, making cyclical adjustment unnecessary.

  1. Austerity

In a speech delivered to the RSA in April 2009, George Osborne gave a short account of some history of macroeconomic thought, in which he said that the New Keynesian (NK) model underpinned his whole macroeconomic policy framework. In the basic NK model, monetary policy loses effectiveness when nominal interest rates hit zero, because nominal rates cannot fall further. In the UK they hit the ZLB at about the time he made that speech. In addition the same model says that if interest rates have hit their ZLB, a decrease in government spending will reduce demand and output with a multiplier greater than one.

Thus according to the model that underpinned George Osborne’s policy, fiscal austerity when interest rates are at their ZLB will substantially reduce output. So the Coalition, by introducing a more ambitious fiscal retrenchment than had been planned, was knowingly taking a large risk with the recovery. If the forecast outlined by the OBR in June 2010 proved too optimistic (and all macro forecasts are always subject to wide margins of error), then monetary policy would have to rely on the unconventional and untested tool of Quantitative Easing (QE) to put the recovery back on track.

As we now know, those downside risks came to pass. The OBR estimate that fiscal austerity reduced GDP growth by 1% in both 2010-11 and 2011-12. That means that by 2012 GDP was 2% lower than it could have been. Even if we make the extremely optimistic assumption that all of that lost growth was recovered in 2013, this means that during the first three years of the Coalition government 5% of GDP, or nearly £1,500 for each adult and child, was lost forever as a result of the austerity programme.

A counterargument sometimes made is that without austerity, any positive impact on GDP would have been offset by the MPC raising interest rates, because inflation rose sharply in 2011. This point does not excuse the policy mistake – high inflation was not anticipated in 2010 – but it could influence estimates of the cost of that mistake. I argue in Wren-Lewis (2015) that interest rates were unlikely to have been raised in 2010-11, and in addition that the OBR numbers already incorporate some monetary policy offset.

A cumulated GDP loss of 5% is probably a lower bound for the amount of resources wasted as a result of austerity. The OBR estimates assume multipliers that are based on past evidence, which includes periods where monetary policy was able to offset the impact of any fiscal change. Over this period interest rates were stuck at their lower bound, so monetary policy had to rely on the much more uncertain tool of QE. In this situation, multipliers are likely to be higher than any historic average, and for changes in public consumption and investment could easily exceed one.

If we apply a multiplier of 1.5 to the deviation from longer term trends in public consumption and investment over the first two years of the Coalition, the impact on GDP by the beginning of 2012 could be nearer 4% rather than the 2% estimated by the OBR. If we make the further assumption that this output loss has not been recouped subsequently (which at the ZLB also makes sense), then the cumulated output cost of austerity by the beginning of 2014 could be closer to 14% rather than 5% of GDP (Wren-Lewis, 2015b).

It is tempting to ascribe this policy mistake to a misreading of the Eurozone crisis of 2010, and the view of some at the time that austerity was required to avoid suffering the fate of the Eurozone periphery. (Subsequent events, and particularly the end of the crisis following the ECB’s introduction of OMT in September 2012, suggest the source of the crisis was the failure of the ECB to act as a sovereign lender of last resort.) A recent IMF evaluation (IMF, 2014) reaches exactly that conclusion about its own policy recommendations. However this view appears not to apply to George Osborne for three reasons.

First, unlike the IMF in 2009, he opposed fiscal stimulus when it was undertaken under the previous government. Second, public investment was cut back sharply in the first two years of the Coalition government, even though there was no requirement to do so coming from the Coalition’s own fiscal rules. Third, the Chancellor is proposing a further period of fiscal austerity after 2015, even though interest rates are still at the ZLB.

While it is difficult to find any economic rationale for why the fiscal austerity mistake was made, the consequences for the UK economy are not difficult to discern. In the 13 years of the Labour administration, GDP per head grew at an average rate of over 1.6%: the red line in the chart below. This was below the longer term average growth rate of 2.25% simply because this period includes the Great Recession. In the four years under the Coalition, growth in GDP per head has averaged just less than 1%. As the earlier calculations suggest, this exceptionally slow recovery is at least in part a result of fiscal austerity.

Chart 1 Growth in GDP per head (quarter on previous year’s quarter)

wrenlewiscoal1The original fiscal plan outlined in 2010 was to achieve cyclically adjusted current balance by 2015. No doubt as a response to the faltering recovery, this plan was abandoned in 2012, when the pace of deficit reduction slowed substantially. That the Chancellor was able to do this while still observing his primary mandate illustrates the flexibility of that mandate. 2012 and 2013 also saw the introduction of two schemes designed to stimulate the economy which are at the interface between monetary and fiscal policy: the Funding for Lending scheme, and the Help to Buy scheme. These may have contributed to a sustained recovery in GDP that began in 2013, such that GDP per head in 2014 probably grew at a rate close to its historic average.

  1. Conclusion

The Coalition government introduced two important fiscal policy innovations in 2010 that should be viewed as progressive: establishing the OBR, and adopting a primary fiscal mandate which would have been a good framework in normal times.

The tragedy for the Coalition, and the UK economy, was that the mandate was applied to implement a sharp fiscal contraction at the one time it should not have been, when interest rates were stuck at their ZLB. This was a decision that appeared to fly in the face of mainstream macroeconomic analysis, and – for the majority party in the Coalition at least – does not seem to be explained by unwarranted panic following the Eurozone crisis.

Unfortunately the impact of this mistake on the UK economy has been quite predictable, and helped create an unprecedentedly slow recovery from the Great Recession.

References

Calmfors, L and Wren‐Lewis, S (2011) ‘What should fiscal councils do?’, Economic Policy, CEPR;CES;MSH, vol. 26(68), pages 649-695, October.

IMF (2014) ‘IMF response to the financial and economic crisis’, Independent Evaluation Office, International Monetary Fund, Washington DC.

Portes, J and Wren-Lewis, S (2014) ‘Issues in the Design of Fiscal Policy Rules’, Economics Series Working Papers 704, University of Oxford, Department of Economics.

Wren-Lewis (2013) ‘Aggregate fiscal policy under the Labour government, 1997–2010’, Oxford Review of Economic Policy, Oxford University Press, vol. 29(1), pages 25-46, SPRING.

Wren-Lewis (2015) ‘The Macroeconomic Record of the Coalition Government’, National Institute Economic Review, National Institute of Economic and Social Research, vol. 231(1), pages R5-R16, February.

Wren-Lewis (2015b) ‘The size of the recent macro policy failure’, Mainly macro blog post , 15th February: http://mainlymacro.blogspot.co.uk/2015/02/the-size-of-recent-macro-policy-failure.html

Productivity under the Coalition

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In this piece Ken Mayhew (Oxford) considers the low level and low growth of productivity in the UK, especially in the ‘disastrous’ period since the crisis. He argues the UK needs not just more human capital but a higher ratio of investment to GDP, and a labour market which offers better and higher paying jobs. An article on UK productivity in the Labour government period can be found on the Labour government 1997-2010 page, free to download.

The IFS reported that real take home pay was 1 per cent lower in the third quarter of 2014 than in the third quarter of 2001. Though real wages have started to rise slowly in recent months, there has been a real threat to standards of living in the UK. This is closely associated with a disastrous performance on productivity since the beginning of the recession.

Defining productivity

Productivity can be defined in a number of ways: output per head of the population, output per worker, output per worker hour. Which is the appropriate measure to use depends upon precisely what one is attempting to analyse. Commentators have voiced concern about the UK’s performance on all three measures since the onset of the 2008 recession. Not only has it been linked with the very slow recovery in the standard of living but it is also an important indicator of an economy’s productive efficiency and of the quality of jobs on offer.

Output per head of the population will be influenced not just by the productivity of workers but also by the employment rate. Output per worker is affected not just by the number of workers employed but by the hours they work; for example, it used to be said in the 1960s and 1970s that higher Japanese manufacturing productivity per worker was largely explained by the fact that the Japanese worked much longer hours than people in other developed economies. This note concentrates on efficiency and jobs and therefore highlights output per worker hour.

Productivity under Labour

First, however, it gives some historical background. In his article for OXREP’s issue on the Labour Government’s Economic Record, John van Reenen discussed this background. He split GDP per capita into two components: output per worker and the employment rate. He argued that the growth of UK GDP per capita “outstripped” the US, France and Germany under the 1997 – 2010 Labour Government. The growth of output per worker was better than in Europe but worse than in the US. Conversely the growth of the employment rate was better than in the US but slightly lower than in Europe. He went on to remind us that GDP per capita also grew healthily under the previous Conservative Governments (1979 – 1997) when the country did well in terms of output per worker.

Rehearsing the various reasons advanced by researchers for Thatcher’s and Major’s success, van Reenen considered the argument that Labour might simply have continued to reap the rewards for their policies. However, he argued, it is important to distinguish between levels and growth and that it was implausible to believe that growth could have continued without some further stimuli.

He suggests that Labour’s specific contribution was in three areas.   The first was Labour’s product market competition policies. Noting the increase in higher education participation rates and in staying on rates at school, he tentatively suggested that improvements in human capital might also have had a role to play – though he does acknowledge that there may have been quality problems in what our education and training system was producing. The third explanation he advances is innovation, which he believes may have been stimulated by tax policies to encourage R & D and by science spending via the research councils.

All of this is against a background of long-standing governmental concern about the country’s poor productivity performance when compared with other OECD countries.

And indeed there have been several, at least partially, false dawns. The so-called productivity miracle of the 1980s still left us lagging. Indeed once it was realized that that there had been significant over-recording of capital stock at the beginning of the 1980s and that therefore its growth through the decade was greater than had originally been thought, a significant part of the miracle disappeared. Output growth had been attributed to productivity gains when in fact it was attributable to an increase in capital stock.

In any event it was a strange miracle that took us back to more or less the productivity growth of the 1960s. What in effect we saw was a recovery from the disastrous performance of the 1970s, at a time when most other OECD countries had not experienced such a recovery.

Productivity since the crisis

Whilst it was reasonable for the last Labour government to claim some further catch-up, on output per worker hour we were still behind some of our traditional comparator countries. By just before the onset of the recession, though the gap with rest of the G7 as a whole had been closed, we still lagged the US, France and Germany. Since the beginning of the recession, the UK’s productivity has flat lined whilst other countries have experienced slow growth in output per hour. So, on Office for National Statistics (ONS) numbers for 2013 (Figure 1), we are 31 per cent behind the US, 28 percent behind Germany, 27 per cent behind France, 9 per cent behind Italy and 1 per cent behind Canada. Only Japan performs worse.

Figure 1: Output per hour, 2013

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Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

According to the ONS (Figure 2) output per hour is probably just about at the level it was in 2007, just before the onset of the recession, and the ONS suggests that the gap with the average for the rest of the G7 is at its widest since 1992. In fact output per hour actually fell slightly in 2013 despite the signs of economic recovery and the ONS calculates that it is 15-16 points “below a counterfactual level had the UK’s strong productivity growth prior to the downturn continued”. The ONS continues, “ the productivity gap on the same basis for the rest of the G7 is around 6 percentage points”.

Figure 2: Productivity gaps, 1997-2013

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Source: Reproduced from ONS, “International Comparisons of Productivity”, 20 February 2015

So this raises two questions.

  • First, why could we not catch up with the likes of France, Germany and the US before the recession?
  • Second, why did we fare so relatively badly during the recession?

Why the limited UK productivity catch-up?

Productivity growth can be enhanced by improvements in dynamic efficiency and static efficiency. Dynamic efficiency is all about obtaining productivity improvement via investment – through technical progress embodied in new physical plant and equipment, in knowledge generated by R & D and in increasing human capital through education and training. Static efficiency is about improving the efficiency with which existing productive assets are deployed.

It is conventionally thought that the productivity gains under Thatcher were largely achieved by enhancing static efficiency. Whatever else motivated them, Thatcherite policies towards the labour market had this as a central aim. This was one explicit justification for the measures taken to reduce the power of unions and increase managerial prerogative, as it was for the removal of various forms of low pay protection and for reducing the extent of employment protection.

Similarly privatization and the introduction of quasi-markets into public sector activities, notably health and education, were justified partly on efficiency grounds. It was also argued that private business pursuing the profit motive in competitive and/or suitably regulated product markets would operate more efficiently than state-owned enterprises run by civil servants.

Reform of the tax and social security systems had similar intent. The reduction of higher rates of income taxation was meant to increase the incentive to work; so were attempts to reduce replacement ratios – the ratio of incomes from social security whilst out of work to income in work.

The Labour and Coalition governments maintained and probably increased static efficiency. However the UK’s long-standing failure was in dynamic efficiency. Investment/GDP ratios have been stubbornly low compared to many of our competitors, as has investment in R & D. The component of investment on which all governments from Thatcher onwards have placed massive emphasis has been on increasing human capital both via the formal education system and via work-based training.  Even the Thatcher government devoted significant subsidies to private sector training.

Under Blair and Brown the emphasis on human capital became even greater and this emphasis has continued under the Coalition. Originally this emphasis was part of the high skills vision which had initially been popularized in the US by economists such as Thurow and Reich. They asked how a rich country like the US could compete in an increasingly competitive world as more and more “developing” countries became serious players in international trade.

They argued that, for any well- defined product, US producers could not compete at the low end. Imagine a range of specification for that product – it becomes more highly specified the more characteristics it possesses, the more its producer is willing to customize the offer for different segments of the market and the more frequently it changes its specification. Any emerging economy could produce the low spec version of that product and the only factor which could give competitive advantage was price or unit labour cost. US producers would be beaten on price and therefore should move up-market where price was not such a constraining factor.

All OECD governments espoused this vision – the high value-added vision. Accompanying it was the belief that as a country moved up-market, production processes would become more skill intensive. Thus the high value-added vision became the high skills vision. Improving human capital was a necessary condition for successfully implementing such a national strategy. However it was not a sufficient condition.

If firms did not change their product and production strategies the human capital investment could be wasted. As noted above, van Reenen voiced some justifiable doubts about the quality of some of the human capital that was produced. The content of some of the lower vocational qualifications has been dubious, whilst exactly what our universities are producing bears some scrutiny.

But, even if there were no quality problems, there are certainly underutilization problems. Cedefop, studying the 2001-2011 period, estimates that between 10 and 15 per cent of UK workers reported that they did not need their highest qualification to get their job. We were not alone in this.

More revealing, in 2010, again according to Cedefop, about 60 per cent of UK workers reported that they believed themselves to be over-skilled for their jobs. This was a higher percentage than for all but four of the EU 27 countries. These four were Slovenia, Cyprus, Greece and Romania.

So the UK’s experience before the recession suggests that our failure to fully catch up with our comparator countries may well have been down to investment, and not even the stress on human capital investment had the leverage that governments had hoped for.

At the time some commentators were widening the discussion of investment deficiencies and arguing that inadequate infrastructure investment together with over-restrictive planning regulations were adding to our problems. They were also starting to suggest that officialdom often seemed to be slipping from regarding improvements in human capital as a necessary condition for achieving the high skills vision to thinking of it as a sufficient condition.

Why such poor progress under the Coalition?

So why have the last few years proved so disastrous? Investment and R & D performance have remained poor, whilst there is absolutely no evidence to suggest that the underutilization of skill has diminished. The ‘success’ story of the post-recession period has been the rapid growth of employment. Unemployment rose by less than in the major continental economies and fell fairly quickly. Unemployment rates are lower and employment rates are higher.

But the big doubt is about the quality of this employment growth.

Long before the recession struck Goos and Manning had introduced us to the notion of the hourglass labour market. They argued that over a couple of decades there had been growth in “top-end” jobs and in “bottom-end” jobs but that those in the middle had been squeezed – hence the hourglass shape.   Much of the employment growth during the recovery has been in lousy, low-end jobs where productivity is naturally low.

Late last year the TUC claimed that only one in 40 of the jobs created was full time and that the vast majority of employment created was either part time and/or self-employment. Of course neither part time work nor self employed work is necessarily less productive than full time work, but these figures are probably an indicator of this employment being created towards the bottom of the labour market.

A Joseph Rowntree Foundation Report found that in 2011-12 more households with members in work were in poverty than those with only workless members. The report attributes this to part time work and low pay. Thirteen million were classified as being in poverty. Even in better jobs, the fact that all power has been with management and that wage growth has been slow reduces the incentives for employers to increase the efficiency with which they deploy their workers.

Our recent productivity experience is historically unique for the UK and this adds to the worry is that it is not just a temporary blip on the route to a more productive and higher paying labour market. Investment in its many forms remains the key but so does trying to encourage a labour market with better and higher paying jobs.

 

References

Guardian, coverage of IFS report, 30.01.15

M. Goos and A Manning, ‘Lousy and Lovely Jobs - The Rising Polarization of Work in Britain’, Review of Economics and Statistics, February 2007.

Public-Private Partnerships under the Coalition

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In this first article on Coalition Economics, Paul Hare (Heriot-Watt University) addresses the UK government’s approach to public-private partnerships. His findings reflect changes in the approach taken since 2010; the scale of investment resulting; and the range of ongoing criticisms.

  1. Introduction

This short paper is an update of Hare (2013), sketching how both the policy and practice relating to public-private partnerships (PPP) and the private finance initiative (PFI) have evolved since the end of the last Labour Government in May 2010.

As soon as it assumed power, the Conservative/Liberal Democrat coalition government (referred to below as the Coalition, for short) was quick to declare that Labour’s form of PPP would no longer be pursued, and that a new model to support public infrastructure would be developed. How this new model evolved, and how well (or otherwise) it has worked, are examined below.

In Hare (2013) it was found that a good deal of much needed public infrastructure spending – on schools, hospitals, and other public facilities – had taken place under the PPP banner, including some spending that might not otherwise have gone forward. While ostensibly, the reason for funding infrastructure through the PPP route was to achieve more efficient construction (lower cost, on budget, on time), and to share risks with the private funders, an underlying justification (often not acknowledged) was the desire to build more schools, hospitals, etc., without the associated capital costs appearing  in the public accounts. In other words, accounting rules in effect at the time allowed what was for all practical purposes public capital spending to be carried out without adding to the public debt.

Towards the end of the period of Labour government, the accounting rules changed, and most PPP-type spending is accounted for correctly at departmental level, but at National Accounts level, much still does not add either to the deficit (current account) or to the debt (capital account) of the public sector.

How effective were the investments carried out under the PPP and PFI headings? The evidence is quite mixed, though with some indication that capital costs and project completion times were often better managed than under the alternative of conventional public sector projects (as was confirmed in a National Audit Office report, NAO, 2009; though the data needed to make these judgements properly was not always available, see NAO, 2011, p.6).

It was far from clear whether much project risk was ever effectively shifted, however. And the principal legacy of these numerous projects is a stream of capital charges (to give the private investors a return on their capital) and service costs (PPP projects usually bundled in some service provision) extending for as long as 30 years or so. These have already proved to be a difficult burden on school and hospital budgets, among others.

Has the Coalition managed to do any better in this important area? We review that next.

  1. Developments in PFI and PPP

Having declared that the Labour Government’s approach to PPP, notably the PFI, was not fit for purpose, the Coalition worked to develop a new/amended model.  It started by announcing, in October 2010, an Infrastructure Plan for the nation (HM Treasury, 2010; subsequently updated several times), under which it was envisaged that £200 billion would be spent on infrastructure capital projects over the ensuing five years (see Helm, 2013). Much of this was expected to come from private sources, and it was never wholly clear how much of this spending would be ‘new money’ (i.e. public spending not already committed under some other heading).

The House of Commons Treasury Committee reviewed PFI as it had operated under the old model, publishing its findings in 2011 (see HoC, 2011). It found that PFI projects faced a cost of capital exceeding 8%, as compared to the Government’s ability then to borrow long term at 4% or less. The Committee were sceptical whether other purported benefits of the PFI approach were often sufficient to justify this higher capital cost.

Despite changes in official accounting rules, they found that far too much PFI remained ‘off budget’ and was therefore still not counted as part of public deficits or debt (see Heald and Georgiou, 2011); Departmental public spending rules also still allowed PFI projects to be treated as ‘additional investment’, not part of the allotted capital budget. The Committee urged the Government not to allow much PFI spending without a very clear focus on the Value for Money (VfM) criterion.

CoalitionEconomics_HareTab1

The new version of PFI, quickly dubbed PF2, was announced in December 2012 via the publication of a Treasury paper, HMT (2012a), with an accompanying guide to new PFI contracts (HMT, 2012b; running to 400 pages), and a much shorter user-guide issued by Infrastructure UK (Infrastructure, 2012). According to Buisson (2013), the basic PFI model remains essentially intact, with a few changes to address perceived weaknesses. The changes are summed up briefly in Table 1, above (click for full-size version).

Only a small number of new projects has been approved under PF2.  According to HM Treasury data, at March 2013 (more recent data appears not to be available) just 23 new PF2 projects were in procurement with a total expected funding requirement of £3,547.3 million. Treasury data also show that in the financial year 2012-13, 15 PF2 projects were signed, with a funding requirement of £1,539.3 million. The same data source also identified each project’s equity holders and their respective shares; most holders being private, contrary to the intention expressed in the first row of Table 1.

Most projects were funded through a special purpose vehicle (SPV) set up for the purpose, and these too were listed. These modest recent numbers contrast with the total PFI commitment reported a year earlier, March 2012. At that time there were 717 projects in the Treasury database, involving a total capital spend of £54.7 billion; total expected repayments on these projects (covering both return on capital, and the unitary charges), over a period of up to 30 years, came to £301.3 billion.

Not a great deal of time has elapsed since the above changes were brought in as part of PF2, but the House of Commons Treasury Committee has already attempted to review the new model (HoC, 2014). Their report raises some interesting questions about how PF2 is supposed to work, and its likely effectiveness.

The Committee particularly questioned accounting and budgetary issues; value for money; and securing private investment. On the first question, the Committee repeated earlier concerns about much PF2 spending remain  off budget in the National Accounts, and doubted whether the innovation of a ‘control total’ would greatly change the incentives to seek private finance for a proposed project (see Table 1).

On VfM, there was concern about the likely cost of capital under PF2, with its expected higher equity contribution. In addition, while projects are all to be evaluated using the guidance in the Treasury Green Book (HMT, 2011), a VfM quantitative assessment tool was withdrawn by HMT in December 2012, and an alternative tool has not been provided. Hence projects could be approved without undergoing a full quantitative assessment. There was also a risk that splitting out ‘soft services’ from PF2 projects could increase contractual complexity by requiring multiple contracts. Last, attracting private investors in sufficient numbers for competition to keep down the required returns on equity involves a significant flow of PF2 projects coming forward, and this had not yet materialised.

Recent press reports illustrate some of the problems that PFI projects have encountered, notably in the health sector. Thus FT (2014) reports on the first NHS Trust to buy out its PFI contract, replacing private funding with a loan from the local council, and enabling the Trust to cut its charges by £3.5 million per year over the next 19 years. And Telegraph (2011) claims that 22 NHS Trusts were struggling to balance their books due to the high payments expected under PFI contracts, while also noting some examples of waste, including an empty school (no longer needed) for which the local authority would be paying the private investor until 2027. This highlights a drawback of the PFI model, and the new PF2 variant, namely the lack of flexibility in resource use.

In Scotland, while the overall PFI/PF2 framework remains available, and has been extensively used, the Scottish Government has opted to develop its own new model for public-private partnerships, under the heading of Non-Profit Distributing PPPs (or NPDs) (see Scottish Government website, Scottish Futures Trust website).

An NPD project has three features:

  • there is enhanced stakeholder involvement in project management (though I confess to being unsure what this can mean);
  • there is no dividend bearing equity; and
  • private sector returns are capped.

Thus the model does not prevent private sector partners from making a reasonable profit, it merely seeks to limit that profit.  The Scottish Futures Trust is currently delivering through the NPD model a £3.5 billion pipeline of major infrastructure projects, which includes some major motorway improvements as well as projects in health and education.

  1. Conclusions

Finally, then, has the Coalition advanced matters much as regards PPP investments? A few points suffice to sum up the current situation.

  • PF2, the new model, has brought in some modest changes to the original PFI model, but the changes appear less substantial than has been claimed.
  • The flow of activity under the PF2 banner – both numbers of projects and funds committed – has slowed down considerably since the Labour years.
  • Scotland has been experimenting with an interesting alternative model, the NPD model, which is already funding a good deal of infrastructure spending.
  • Many of the shortcomings of PFI, reported by the National Audit Office and other bodies in the later years of the Labour Government, are still being reported today – both as legacy issues from PFI projects, and as issues affecting PF2 projects.

It seems that despite much well intentioned effort, the UK has not yet found a model for PPP that delivers solid net benefits without the accompanying drawbacks. It is a difficult area to get right.

 

References

  • Buisson, Andrew (2013), ‘From PFI to PF2: The reform of the public private partnership model in the UK’, London: Norton Rose Fulbright LLP.
  • FT (2014), ‘NHS trust becomes first to buy out its PFI contract’, Gill Plimmer and Sarah Neville, London: Financial Times (read online)
  • Hare, Paul (2013),’PPP and PFI: The political economy of building public infrastructure and delivering services’, Oxford Review of Economic Policy, vol.29(1), pp.95-112
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