Platform author, Warwick Lightfoot is a professional economist with specialist interests in monetary policy, public expenditure, taxation and labour markets. Formerly the economics editor of The European, he was for  many years a frequent contributor to the Wall Street Journal and has written for the Financial Times, The Times, the Sunday Times, the Daily Telegraph, the Sunday Telegraph, and the Guardian. His articles on economics and public policy have also been published in specialist journals that range from Financial World, International Economy, and the Investors Chronicle to the Times Literary Supplement and the Journal of Insolvency Practitioners. Warwick worked in UK government as Special Adviser to the Chancellor of the Exchequer from 1989-92, initially appointed by Nigel Lawson and later reappointed by John Major and Norman Lamont. He was also Special Adviser to the Secretary of State for Employment, the Rt Hon Norman Fowler MP.

His new book, Sorry, We Have No Money is published by Searching Finance.

Sorry, We Have No Money – Britain’s Economic Problem

Two distinguishing features of economic history over the last century have been dramatic experiments with non-market systems for allocating resources in the socialist and command economies and a dramatic expansion of collectivism and public sector activity in economies that would normally be considered as market economies. The experiments with socialist planning and command economies are largely perceived to have been a failure, but the development of a much larger state sector in market based economies in the middle of the 20^th century appears to have yielded genuine social benefits. What is more not far from hindering economic performance it may have enhanced it.

There are, however, diminishing returns to public spending and collective provision. There is also a real cost to public spending. What is more that cost is greater than the simple cash cost, because of the economic distortion created by taxation and allocating resources outside of the price mechanism. These deadweight costs mean that there comes a point where the costs of public expenditure begin to exceed its benefits and economic performance in the medium term starts to be hindered.

UK’s 21st Century Supply-side Challenge

It is not clear where that tipping point is, but it appears that a ratio of public expenditure between 25 to 33 per cent of GDP yields genuine benefits for little or no harm. After public spending reaches one third of national income, it seems that most of the things that collective action can accomplish are under taken. When spending rises beyond that point its costs and distortions begin to inhibit economic performance. The UK, which was in the vanguard of constructing a comprehensive welfare state, reached that position in the 1960s.

The full extent of the structural problem created by excessive public spending is only properly exposed in a crisis like the one we have today and the inflation crisis we had in the 1970s. The parallels are compelling: a severe economic shock; public spending at close to half national output and structural a government borrowing requirement running at an unsustainable level. Both episodes resulted in emergency action to tackle the deficit. In the 1970s Jim Callaghan’s Labour Government was force to do so by the IMF. Today the sovereign debt crisis in Europe provoked by Greece persuaded the Coalition Government to take action in the Emergency Budget and the Comprehensive Spending Review.

The Emergency Budget is necessary to stabilise the government’s borrowing problem, but putting up taxes and cutting public spending so that after five years the budget is roughly balanced with public spending still taking around 40 per cent of national income will not sort out the long-term structural challenge of public spending. Public spending should be reduced further as a share of national income and stabilised at an average ratio of 35 per cent over the economic cycle. Spending above that level starts to raise costs and makes it progressively harder for businesses that face international competition to compete. Manufacturing, in particular, finds it very difficult, unless exhibits very high levels of value added. A public sector that is too large will be a drag on economic performance; however, prudently it is financed.

The Chronic Productivity Problem in the UK Public Sector

An interesting feature of UK economic performance over the last ten years has been the disappointing performance of the public sector The ONS shows that in years when public spending raised its productivity actually fell. Some people such as the Audit Commission have argued that this is because there were improvements in quality that are difficult for the statisticians to quantify. The difficulty is that such improvements are not easily reconciled with the litany of National Audit Office and Public Account Committee reports that catalogue failures in: the new Hospital consultants contract where pay rose by 27 per cent, but hours worked fell and new services promised failed to come through; the GP out of hours service; the primary school numeracy initiative; the adult education. Looking across Whitehall at resource management the Public Accounts Committee concluded that only 20 per cent of policy decisions ire was based on a thorough assessment of their financial implication. Light foot comments that: It appears that more than thirty years of public service reform have had little impact on the efficiency of Britain’s public sector. An agenda of managerial reform that has embraced cash limits, purchaser provider splits, and the creation of executive agencies, the citizen’s charter, contracting out, quasi markets and accruals budgeting and much else has failed to deliver an obvious improvement in public sector productivity. Most of the increased spending since 1997 has been absorbed in public sector pay and cost inflation. The evidence would suggest that a managerial agenda of public sector reform is unlikely to overcome the fundamental efficiency challenges that allocating resources outside the framework of the price mechanism and a hard budget constraint normally implies.

Employment Challenges at the centre of the UK’s Public Sector Problem

Public sector managements under both Conservative and Labour governments have been reluctant and hesitant about challenging trade union and other vested interests. The result is that pay is over 12 per cent higher in the public sector than in the private sector and that public sector pay premium has risen over the last ten years. National pay bargaining means that the regional pay premium s are even greater. The argument that public sector pay will be higher because of the composition of the workforce means that it on average it employs higher skilled professionals such as teachers and doctors is not persuasive. The highest public sector pay premium is at the lower end of the earnings distribution. Public sector pensions are and will remain much more generous than private sector occupational pension arrangements. Management of employee performance and attendance in the public sector remains a challenge for employers.

Communities and Regions that are De-Marketised

Parts of the UK are not just de-industrialised, but de- marketised. In many communities the combination of high public sector employment, national pay scales and the poverty traps created by the tax and benefits system has been toxic. In the late 1970s the replacement ratio of benefits to pay was about 60 per cent the IFS estimates that it has fallen to around 56 per cent. Individuals, communities and whole regions have been detached from the market. Many parts of the UK are detached from market economy .The position is analogous the regions of East Germany where high public spending and welfare payments emasculate private enterprise twenty years after the end of the socialist command economy.

Reducing UK Public Spending to 35 per cent of GDP

To reduce the ratio of public spending to the level where it is not imposing a permanent structural drag on economic performance would require policy makers to identify a further 4 to 5 percentage points reduction in public spending in relation to GDP. There are no obvious consumption and production subsidies or loss making nationalised industries to take out in the way that there were in the 1970s. Further realistic reductions of the spending ratio beyond those identified by the Coalition Emergency Budget will require public sector employment, pay and pensions to be reduced. It should be possible to obtain a reduction in spending equivalent to over 2 percentage points. It should also be possible to take out a further 2 percentage points of GDP from social security transfer payment made to households of working age. For example, in 1997 all benefits for children up-rated for 2010 prices amounted to £14.5 billion, the today they cost £35 billion. If public sector pay and social security transfer payments to households of working age were to take account of local labour market conditions such reform would make a significant contribution to re-attaching communities in the UK regions to the labour market.

The UK can have a realistic growth agenda and a welfare state

The underlying message of Sorry, We Have No Money is optimistic .The UK has a serious supply performance problem that it is rooted in public expenditure. That challenge will be aggravated in future years when an aging community has to be supported in the context of much tougher competition from countries such as China and India that will step up their competition across the value added continuum. Yet a manageable reduction in the public spending ratio should ensure that what by historic standards is a comprehensive and generous welfare state should be sustainable, provided there is greater realism about containing its cost. Moreover, although reducing the ratio of public spending is principally about mitigating long-term structural impediments on the performance of the economy, there may be some pleasant ‘crowding in ‘ surprises.

Sorry, We Have No Money – Britain’s Economic Problem is published by  Searching Finance.

Daniel Ben-Ami is a journalist and author based in London. Visit his website here http://danielbenami.com/ . His new book, medical Ferraris For All: In Defence of Economic Progress, treat is published by Policy Press.

The economic and financial crisis of the past three years has led to widespread criticism of economics from the public and much soul-searching among economists themselves. There is a pervasive sense, even within the profession, that the recent turmoil has found the discipline wanting. Many would accept that a new economics is needed. An approach that is better able to help policy-makers anticipate and tackle economic challenges.

By far the most high profile initiative aimed at tackling the perceived shortcomings of economics was the establishment of the Institute for New Economic Thinking (INET) ( http://ineteconomics.org ) in 2009. The institute, founded with a $50m pledge by George Soros, says it: “believes in empowering the next generation, providing the proper guidance as we challenge outdated approaches with innovative and ethical economic strategy”.

Among the luminaries on INET’s advisory board are several Nobel laureates (George Akerlof, Amartya Sen, Michael Spence and Joseph Stiglitz), two former chief economists at the International Monetary Fund (Simon Johnson and Kenneth Rogoff), high profile economics writers (John Kay of the Financial Times and Anatole Kaletsky of the Times), and many others. Additional notables spoke at its inaugural conference including Dominique Strauss-Kahn (the managing director of the IMF) and Adair Lord Turner (the chairman of Britain’s Financial Services Authority).

But the high-powered character of INET’s leading supporters itself raises an intriguing question. In what sense can the economics they advocate be considered genuinely new? Although some accounts have portrayed INET as a radical organisation, bent on overturning the economic orthodoxy, it is hard to take such claims seriously. Many of INETs supporters apparently consider themselves critics of the mainstream but it is hard to avoid the conclusion that they are themselves pillars of the establishment.

Since there is no official statement of INET’s thinking it is difficult to critically assess its claims to newness. There are certainly significant differences between the leading thinkers who support the organisation. But Kaletsky’s Capitalism 4.0, his recent book suggesting the world is entering a new era of economic pragmatism, is a good starting point. In it he argues that the recent economic and financial crisis has discredited “market fundamentalism” (free market economics) and paved the way for its replacement by a less doctrinaire form of economic thinking.

Kaletsky suggests that the new economics will satisfy three conditions. First, it will accept that a market system is not a static system in equilibrium but one that is constantly evolving. Second, it will have to accept that effective government and dynamic private enterprise are symbiotic. Third, it will need to focus on the inherent unpredictability of human behaviour and economic events.

The striking thing about this list is that it is so mainstream. It would have been accepted as a moderate list well before the crisis of 2008. Even in the economics departments of elite American universities it would have been accepted by many. In the world of practical policy it is totally line with the orthodoxy.

Take Kaletsky’s final points about the unpredictability of human behaviour. Daniel Kahneman and Vernon Smith won the Nobel prize for their work on behavioural finance back in 2002. Admittedly Kahneman is a psychologist but there are many other influential proponents of behavioral economics including Robert Shiller and Richard Thaler (of “Nudge” fame).

The notion of the state and market working together is if anything even more mainstream. Outside of the world of high economic theory it is hard to find many economists advocating a state as limited as that favoured by the likes of Milton Friedman – essentially providing a framework for law and order as well as key public works. For example, despite all the talk of the “Washington Consensus” in the developing world, the World Bank’s annual World Development Report argued explicitly against the idea of a minimal state as far back as 1997.

Economic practice was even more different from that favoured in the textbooks. Even before the crisis struck – in 2006 state spending in Britain was equivalent to about 38% of GDP and in America it was about 35%. – and since then it has risen significantly. America, often viewed as the bastion of market capitalism, the state was responsible for huge public spending programmes, an activist monetary policy and extensive forms of regulation.

It is hard to avoid the conclusion that Kaletsky is over-estimating the difference between economics before 2008 and since. Free market economics, or neo-liberalism as some prefer to call it, had a brief heyday in the late 1970s and early 1980s. But since then economics, certainly in practice, has taken a more pragmatic turn. Even the contemporary discussion of the need for cuts is typically pitched as a regrettable necessity to balance the books rather than as part of an ideological drive to roll back the frontiers of the state.

Of course it is unfair to pick on Kaletsky but it is hard to find radically new ideas from other proponents of the new economics either. For instance, Joseph Stiglitz, not only a Nobel laureate but a former chairman of President Bill Clinton’s Council of Economic Advisers and chief economist of the World Bank, also fails to propose novel ideas. In Aftermath (Allen Lane 2010) he suggests less emphasis on material consumption and more on protecting the natural environment. However, the notion of sustainability, which is essentially what he is advocating, was adopted as United Nations policy in the 1980s.

It is had to resist the conclusion that the advocates of new economics are more interested in rescuing mainstream economics than burying it. No doubt they want changes of presentation and emphasis but the fundamentals of the viewpoint they uphold is essentially unchanged.

None of this is to suggest that all is well with orthodox economics. There is certainly much that needs to be done to strengthen the discipline. But before rushing to declare a new era or to devise a new economics perhaps it is time to rehabilitate what are essentially old ideas. In particular the close link between economic growth and social progress, central to Adam Smith’s political economy in the eighteenth century, would be an excellent place to start.

The following would be the key points on my list:

* Recognising the importance of economic growth. Contemporary economics is incredibly defensive about the potential of rising output to improve human welfare. Any talk of growth is hedged by numerous caveats including the notion of environmental, moral and social limits. Others want to redefine prosperity in non-material terms. Now, at a time when austerity is starting to be imposed, it is more importance than ever to emphasise the importance of growth.

* Transforming the third world rather than sustaining poverty. The aspiration should be to transform poor countries into rich ones rather than simply ameliorate the worst excesses of poverty. Scarcity should be abolished worldwide.

* Promoting innovation. Rediscover the importance of key principles such as taking risks, be prepared to engage in “useless” research such as the Large Hadron Collider, working hard and expecting failures.

* Reducing regulation. This should involve reducing not only the number of rules – “red tape” – but what could also be called “green tape”: regulations that embody the notion of limits. These should include the precautionary principle and sustainability; both of which embody a cautious and narrow approach to economic progress.

* Ending the obsession with bankers. The moralistic obsession with “greedy bankers” is a distraction from the vital task of rebuilding a healthy economy.

* Remembering that the economy should not simply be viewed from the perspective of the consumer. Humans are not just consumers of goods and services but producers who can find solutions to the problems they face. The power of human ingenuity to overcome economic challenges should not be underrated.

Once some of the old insights of economics are rediscovered we will be in a better position to tackle the genuinely new.

Ferraris For All: In Defence of Economic Progress ,

is published by Policy Press.

In our launch essay for the Platform section of the EPC website, prostate Angus Hanton argues that the government has used too high a discount rate for unfunded public sector pension liabilities – now at 5.5% compared to 3-4% in some other countries. This means that when those UK public sector pensions become due, sickness the unforseen liability could be as much as £1 trillion pounds.

By Angus Hanton.

Angus is an entrepreneurial business economist. He has three online enterprises in buying and selling woodland www.woodlands.co.uk trading domain names with www.giraffe.co.uk and home storage, malady see www.storage.co.uk.

The government’s calculation of the national debt is about £900 billion, projected to grow by more than 50% over the next 5 years or so to about £1.4 trillion. It is those figures that are worrying the international financial markets. This debt is owed mainly in the form of government bonds but the government also has some other very significant commitments.  The largest of these is its commitment to pay pensions.  This includes: state pensions payable to most citizens; pensions for civil servants; and pensions for workers in state bodies of which the NHS is the largest.

These government pension liabilities are not matched by accumulated pension funds.  This contrasts with the private sector where both employers and employees pay pension contributions.  These payments build up a fund out of which future pensions are paid.  Companies in the private sector are required to have independent consultant actuaries to assess the adequacy of these funds to meet future liabilities.

Pension obligations are government commitments but are not included in the government’s calculation of its indebtedness.  The size of these commitments can be worked out by estimating the future payments and then calculating the present value of these future payments.  This process of taking a future liability or asset and working out its value today is known as “discounting”, on the basis that money held now is worth more than money to be received in the future, and similarly future commitments are assumed to have a lower value than present ones.  The central question in calculating the present value of future assets and liabilities is what discount rate to use.  This is sometimes called the “social discount rate”.

To put the scale of this into perspective, we know that the Government Actuary’s Department estimates the present value of these unfunded pension liabilities at about £2.2 trillion, so even in the context of the official government debt the numbers are very large.  Of this figure, £1.4 trillion relates to the state pension and £800 billion to pension commitments for government and other public sector employees.  To get to these figures the Actuary’s Department uses estimates of life expectancies and then takes the sums which are expected to be paid and discounts these back to their present values using a discount rate.  It uses a discount rate of inflation plus 3.5% per annum.

This discount rate is used fairly consistently throughout the UK government and is set out in the Treasury’s “Green Book”1.   It is therefore worth looking a little at how this inflation plus 3.5% figure is arrived at.  The basic idea is that 3.5% is made up principally of two elements – the social time preference for having benefits sooner rather than later, which is put at 1.5%, added to the rate of per capita growth in the economy.  This growth rate is put at 2%, based on a past real growth of 2.1% per annum in the period 1950 to 1998.  It is very much open to question whether this extra 2% should be used in discounting pension liabilities but presumably the argument is that as the country’s wealth increases the liability becomes progressively easier to afford.  This is additional to adjustments for inflation. The pensions liabilities are generally index-linked so higher inflation will not reduce the liability.

Many economists believe that the appropriate discount rate should be the risk-free real interest rate, which should be equivalent to the government’s cost of borrowing.  Using UK index-linked interest rates2 to show the government’s real cost borrowing suggests they should be using a rate of under 1% (plus inflation).  This demonstrates that a rate of 3.5% (plus inflation) is significantly too high.    One argument that has been advanced for keeping the discount rate so high is that borrowing rates are artificially low at the moment, but it is hard to sustain this argument unless the government knows something that the markets don’t.

At a quick glance these rates – 3.5% over inflation or 1% over inflation –may look fairly similar but in fact the impact of choosing one rate rather than the other on the present value of pension liabilities is extremely large.  Let’s assume, for the sake of simplicity, that the average pension liability is payable in 25 years, and that current inflation is 2%.  In that case we should in fact be discounting the liability by 1% over current inflation (being 3% in total) rather than the government’s rate of 3.5%  plus inflation (being 5.5% in total).  Using these lower discount rates, derived from the government’s cost of borrowing, the unfunded pension liability is very much larger at about £4 trillion rather than £2.2 trillion.  Even if one gives the government some benefit of the doubt and takes a discount rate as high as 2% over inflation the pension liability still amounts to £3.1 trillion which is almost a trillion pounds more than current estimates.  This equates to an extra liability, expressed in today’s money, of £40,000 per family in the UK.

The government in the Treasury “Green Book” accepts that lower discount rates should be used for very long term liabilities such as climate change because, it is argued, unless a lower rate is used future generations’ interests will be unduly discounted and their interests virtually ignored. The Green Book sets out a (rather arbitrary) table of lower discounts for longer term liabilities so that, for example, after 30 years the rate excluding inflation reduces to 3% and make progressive reductions for longer periods, so that for liabilities (and assets) which are 300 years away a discount rate of only 1% is advocated.  The government certainly wants climate change measures to make sense so in order to justify them in economic terms it uses lower discount rates for assessing much longer term costs (and benefits) suggesting that even some in government have doubts about the discount rates they use.

How did the government get into the position of using such a high discount rate for pension liabilities?  Maybe there is a problem here of vested interest – it suits the current government to have its liabilities understated by the use of a high discount rate.  Also, the conceptual difficulties in this area make it one where most non-economists fear to tread.  Until fairly recently it was perhaps arguable that the real risk free return on assets was as high as 3.5% and that economic growth might justify such a high discount rate, but it is much harder to argue for this when growth has dropped and drivers for future growth are hard to find.

What do other people think the discount rate should be?  A survey3 for the Asian Development Bank of different countries in 2007 shows that there is considerable variety in what discount rates are employed around the world.  However, the US uses, for its calculations, the interest rate on treasury debt which has  a  maturity comparable to the maturity of the liabilities.  Where they choose a fixed figure it is between 0.5 and 3% but in any case they do a sensitivity analysis (ie they work out what their liabilities would be based on different discount rates).  In an important 1993 OECD paper4 economists warned of the increasing risks posed by “pay as you go” (ie unfunded) pension schemes.  Their calculations were based on discount rates in the range of 3% to 4%. This compares to a discount rate now being used in the UK of 5.5%.

In summary, the government is using a discount rate that is significantly too high.  It is using that rate for a very large liability where much of the liability will become due many years ahead with the result that its pension commitments are being underestimated by about a trillion pounds.

The implications of this may affect:

(1)   the UK’s credit rating;

(2)    the balance of equity between generations;

(3)    policies on retirement ages; and

whether state and public sector pension commitments need to be reviewed – even if this requires retrospective changes to entitlements.

2 UK Debt Management Office Index-linked bonds information, showing current yields:

http://www.dmo.gov.uk/index.aspx?page=Gilts/Indexlinked

3 Asian Development Bank survey – “Theory and Practice in the Choice of the Social Discount Rate for cost benefit analysis: A survey.”

http://www.adb.org/documents/erd/working_papers/wp094.pdf

4 OECD study of Pension Liabilities in the Seven Major Economies 1993:

http://www.oecd.org/dataoecd/40/56/2025882.pdf