Friday, July 9, 2010

Structural Change - The Necessary Pain

The economy of the UK is, it seems, about to undertake some significant structural change, and it is going to hurt. A lot. We still do not know the details of the forthcoming cuts, but analysts are already starting to pull out their calculators, and work out how they might impact upon jobs and businesses. The cuts were never just about reducing the number of civil servants, but about the knock on effects in the wider economy. This from the Telegraph, reporting the analysis of Begbies Traynor:

"We are concerned that the levels of business distress will increase again, potentially from the first half of 2011, once the full effects of the coalition government's fiscal tightening measures impact the economy and particularly amongst those private sector businesses most dependant on public sector contracts," said Ric Traynor, executive chairman of Begbies Traynor.

"It will not be until after the Government's Comprehensive Spending Review in October that we will know for certain the allocation of spending cuts, but there is a growing risk that, even if the UK avoids a double dip recession, it could develop a twin track economy, with public-sector dependent industries facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."

Those sectors most heavily dependent on public sector spending include construction, IT, recruitment, advertising and business services.
The trouble is that this is an analysis which only goes so far. When these private sector organisations hit a brick wall, they will, in turn, hurt other private sector companies that provide goods and services for them. And then there is the withdrawal of the money from the economy as many of these workers, both directly and indirectly employed by the government, move from having employment income to unemployment income. In other words, the cuts in government expenditure will ripple out through the wider economy.

Is this a reason not to cut?

Some might argue that the knock on effects presents an argument not to cut. Better to keep on spending, as the consequences that ripple through the economy are too hard to contemplate. The problem with this view is that, somehow, somewhere, all of the activity of the people working for the government, and the businesses that service the government, must have an origin in productive output from the private sector.

This is not an easy concept to deal with, as the interaction of the public and private sector results in complex relationships. For example, a nurse working in the NHS represents a consumption of resources, but has a real output in terms of health outcomes for patients. This output is real, and might mean a worker being able to work and originate more added value within the economy. However, if we imagine that the nurse was not employed in the NHS, and instead worked in the private sector in another role, then that nurse would be creating an output that might be an origin of the added value that might pay for other nurses.

However, life is not that simple. We do not think of nurses just as adding value in the economy, but performing a role that is rooted in a sense of justice. i.e. many of us think that all people should have access to health care. As such, we do not restrict the activity of nursing to just help people who might go on to add value within the economy. In light of this, the NHS represents a net consumption of added value generated elsewhere in the economy. In order to pay for this, we must be generating sufficient added value elsewhere. Each nurse, for example, will consume goods and services from their pay, and those goods and services may originate from within the economy, or from an external economy.

When the nurse does her shopping, she may buy an avocado imported from another country, and that must be paid for from goods and services exported from the economy. Likewise, when the nurse drives to work in her car, that car may may be imported and somebody somewhere must be providing goods and services to allow for that import. If the nurse buys a domestic good, it may well be that the manufacturer of that good needs to import raw materials, and those must also be paid for from the export of goods and services. There are very few economies that even start to have the potential for autarky and, in the UK, autarky is an impossibility (if the UK is to maintain a reasonable standard of living/quality of life for the people).

Within this nurse example there is a balance at which there will be the 'right number' of nurses to ensure that there is the maximum value creation in the economy to pay for the health services. If there are too many nurses, there will not be enough creators of value to pay for the nurses...of course, it is the aggregate of all people employed in government consumption of value added in the economy that matters, and that is the question of priorities (e.g. the choice between one nurse versus one policeman).

The point that I am making here is that, overall, government is a net consumer, and is entirely reliant upon the added value that is generated within the private sector to fund this consumption. The amount that a government might sustainably consume is entirely dependent upon the amount of added value that is created in the private sector, and this is an unavoidable reality. The problem that arises in government consumption is that, in order to consume, there is an opportunity cost. If worker 'x' is employed in government activity, they are not employed in potential added value creation in the private sector. Likewise, if a company is utilised in supporting government consumption, the workers in that company are involved in that net consumption, rather than the creation of added value which might pay for that government consumption.

Somebody, somewhere, somehow, must be producing goods and services for export (and internal use) in order to support an economy, unless that economy is autarkic. That means that they must have an output which not only provides for domestic needs, but also a surplus to sell at a profit to other countries. Furthermore, the more added value that these enterprises create per unit of labour, the more goods and services that will be available for consumption within the economy, and the more available for export.

It is here that we meet the relationship between government net consumption and the wider economy. Government consumption must not reach a point at which they are consuming so much that there is insufficient surplus to pay for the imports of the country, as the country is not autarkic. If a country is autarkic, the amount consumed by the government is a splitting of resource between private and government consumption, and that is a political question. In the case of a country that needs/wants to import, it is a question of economic necessity that the country produces sufficient surplus of added value which is available to pay for the imports. The greater the consumption of the government, the less surplus is available for export.

We can see this in taxation. If a government is over-consuming relative to the private sector output, there will be higher taxation (or government borrowing). Taxation is the removal of added value in the economy into the hands of the government for government consumption of that added value, meaning that the added value is not available for export. The situation is somewhat confused by the fact that, for example, government employees are taxed, but the origins of the added value is in the private sector. In the case of government borrowing, this just means a deferral of the removal of that added value for consumption now.

What we have is a basic reality that the extent of government consumption is, in the long term, going to be constrained by the opportunity cost of employing 'x' number of people in servicing that government consumption. The principle is simple. If a person is employed as a result of net consumption of the government, they are not employed in creating the added value for the government to consume. In practical terms, this is the constraint upon government; that constraint is, in the end, determined by the absolute numbers of the workforce creating added value in the private sector, and the productivity of those workers.

If an economy is exceptionally productive, it is possible for the private sector to give an absolute greater amount of their added value to the government, and still be able to succeed in competition with others, but the total added value taken from the private sector must be determined by the relative productivity of the total number of workers within the private sector (excluding those supporting government consumption). The question for each economy is how productive the private sector is - or how much added value each worker produces. Fantastically productive workers, in relation to other countries, will allow for a larger public sector than those other workers (whether a large public sector is ever a 'good thing' is debatable, and not the subject of this post).

We can now return to those private sector workers who are (potentially) going to lose their jobs as a result of cuts in government expenditure. As they lose their jobs, some will still be in receipt of government money, in the form of unemployment benefits, but their net consumption from the economy overall will be reduced. They will be consuming less, and will therefore overall contribute to a lessening of the proportion of government consumption within the economy. They are being paid less, and all of the other expenses that surround each employee's activity disappear.

Furthermore, the skills and experience of that employee will become available to the private sector where they might contribute added value that might support government spending overall. Indeed, some employees made redundant will make this transition without any recourse to further government expenditure of overall resource. They will switch into new jobs straight away.

Buried within this scenario, of course, are the personal consequences for those that do lose their jobs. For some, this will be a major problem, and will be distressing. They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain. In over-consuming the resource of the country, they structured the economy in a way which was unbalanced, encouraging workers into sectors and activities that could not be sustained.

For the individuals who took work that was rooted in over consumption by the government, they had no way of knowing that their position could not be sustained over the long term. It really is not their fault that they lose their jobs, but the fault of a government that created an unsupportable structure. This is cold comfort for those workers. Likewise, the businesses that will go bust structured themselves to support the over-consumption, and it is not the fault of the proprietors that they have gone bust. They were incentivised by the government to direct their resources to unsustainable government consumption. Again, this is cold comfort when the axe falls upon their head.

The problem of austerity is that, whatever happens, the shift from government consumption of resource means that those employed in activities to support that consumption are going to be hurt, whether now or later. Someone must be hurt by a transition back to a sustainable path. That this is not their own 'fault' does not alter the absolute necessity of change. The best that can be done is to try to ameliorate the effects. We can all agree on the fact that this is unfair for the businesses and individuals involved, but to place blame on the 'cutters' is to place the blame on the wrong people. It was those that distorted the economy onto an unsustainable path that shoulder the responsibility.

I will end this post with a quote from an interview with the Chief Executive of HSBC, who seems to grasp the point:

"The reality is that is may be good to have full employment, but if that employment is driven by public employment it's telling you something very clearly... something is not functioning in your society."
In this quote, he is grasping the essential reality. Something is wrong when government consumption exceeds the ability for the economy to pay for the consumption.

Note: Over consumption in the private sphere offers similar problems, but the purpose of this post is to discuss government austerity measures.

16 comments:

  1. This is based upon an ideology that the private sector is the only thing that creates value. That is not the case. It is only because the public sector we have created tends to concentrate on 'social' added value.

    Plus a nurse fixing an injury can return an individual to the production of surplus, whereas the death of the individual would remove that surplus production ability permanently. And of course our moral values don't allow the culling of injured individuals which would be the other approach (although throwing them into the mental torture of unemployment appears perfectly acceptable for some reason).

    It is perfectly possible for the public sector to deploy capital to grow food and build houses. The money to do that is simply created, and the demand for the money ensured by legally enforced taxation. In such a public sector owned operation, the individuals are still adding value and still creating a surplus in primary production. That frees off others to work in secondary production. Very soon you have China.

    So the myth that the 'public sector' is not productive is merely truth by repeated assertion from, surprise, surprise, the owners of private production who don't want the competition.

    Remember that we only have unemployment (and an advanced economy!) because we have money and taxation.

    Unemployment is there as a suppression on labour costs that drives more money to capital rather than labour. It is a buffer stock at a very low consumption value which for some reason we pay to remain idle. The individuals in that buffer stock suffer measurably.

    Quite why we pay the unemployed in the way we do I don't know. Either you pay people enough to keep them out of poverty and create enough 'buffer jobs' to get at least some value out of them for the money, or you pay them nothing and let them suffer properly. Paying somebody to be idle is ridiculous.

    Yes the Labour Government utterly failed to deploy the public sector resources effectively and unbalanced everything, but cutting the costs of government will remove that demand from the economy and that will cause more and more people to fall into the 'buffer zone' of unemployment. You will get a deleverage effect that will cause many more to fall into the zone than have been cut.

    What should have happened is that the 'buffer' should have been improved first to ensure those in it do not fall into poverty.

    For example if you replaced benefits with a universal pension (payable to those 'productively engaged), and eliminated the minimum wage, then all the public sector jobs you 'cut' could simply be turned into volunteer positions. The savings would then be the difference between the 'universal pension' and the excessive New labour wage paid (less a bit for admin costs).

    And of course the private sector would then create jobs in the current 'dead zone' between volunteer and minimum wage.

    The result is that individuals may move from a higher standard of living to a lower one, but importantly they are still engaged in production - maintaining skills - and not in abject poverty.

    The pain may be necessary (to ensure that the output of the public sector is worth the money), but it doesn't need to be as acute for individuals as it is going to be.

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  2. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain.

    There is no convincing evidence that public sector jobs were “unsustainable” in the first place.

    I suppose the “proof” is that the UK has a current account deficit.

    In 2005, the UK had £49.4 billion trade deficit. But 35.8% of this trade deficit was paid for by 17.7 billion pounds in the net foreign factor income, since UK residents own a huge amount of foreign assets themselves, and the UK mostly gets a positive investment return on its ownership of foreign assets. The current account in 2005 was thus £31 billion or about 2.5% of GDP. This was paid for by a capital account surplus. Despite repeated current account deficits, the UK still gets more in foreign factor income than foreigners get from the UK. All the evidence suggest that the UK current account deficits are sustainable:

    http://www.nuffield.ox.ac.uk/users/nickell/papers/TheUKCurrentAccountDeficitandAllThat.pdf

    If the UK was really “living beyond its means” it would have a balance of payments crisis.

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  3. CE

    You'd have loved one of the panellists on Question Time the other night. He pontificated: "Keynes showed that in times of recession it really is best to pay one man to dig holes and another to fill them in in order to stimulate demand", or words to that effect. I suspect that a majority of people believe this to be true. I have had numerous conversations with intelligent people who think that anyone employed by the government is not a burden on the economy because at least they are doing something slightly useful and paying tax that can, of course, be used to build schools'n'hospitals.

    The problem is that we start from a fait accompli where the welfare state already exists and appears to work, and people cannot comprehend that perhaps it was an unsustainable system all along. I don't think that many people can handle the idea that it may take decades or even entire lifetimes for the consequences of certain decisions to finally arrive; most people think that economic performance can be measured and acted upon in real time. When 'the cuts' inevitably result in reductions of GDP and an increase of debt-to-GDP ratio (as they will), many people will take this as hard, scientific proof that the spending should have continued. One of your more prolific commenters has already declared this as true for Ireland, as its debt-to-GDP ratio has risen following cuts in government spending.

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  4. The idea there are going to be 'cuts' in government spending is nonsense. Spending under the new govt plans will be 9% higher in 2014/15 than now. Some cuts.

    Admittedly some of that extra spending will be on servicing the debt, but there are not going to be swathing budget cuts. That doesn't mean that lots of high profile services won't be cut - the standard public sector response to not getting as much money as they want is not to improve efficiency and provide the same service but at lower cost (as the private sector tries to do) but to cut front line services in order to put pressure on politicians to increase spending again.

    Expect plenty of this in the next few years.

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  5. " They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place..". I agree. But will a public that was stupid and ignorant enough to vote New Labour three times be capable of making the distinction?

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  6. Cynicus, you distinguish between different parts of the private sector, but not between different parts of the public sector. Should not those parts of the public sector that produce goods and services (e.g. education, road maintenance) be analysed differently from those that merely transfer resources?

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  7. But sadly - they WILL blame the cutters. They always do. And so, in due course, we'll get another round of the "angelic" spenders to start the whole mess again.

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  8. Anonymous: A quite reasonable point. The short answer is 'yes' which is why I gave the case of the nurse creating output. I hoped that I had illustrated that I accepted that **some** government activity does create output, but perhaps I was not clear enough.....

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  9. Lemming: I really like the bit about paying tax.....using money that is borrowed which means that somebody later will be paying that tax....net tax contribution over the long term = 0

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  10. Neil Wilson,
    A brilliant point. The existence of a number of productive nationalised industries also demonstrates that governments can create value, e.g., China National Offshore Oil Corporation, Anshan Iron and Steel Corp., CODELCO, Petrobras, Singapore Airlines, PSA International, Neptune Orient Lines, Chartered Semiconductor Manufacturing, Sing Tel, SembCorp.

    Response to Lemming

    "Keynes showed that in times of recession it really is best to pay one man to dig holes and another to fill them in order to stimulate demand", or words to that effect. I suspect that a majority of people believe this to be true.

    This is the usual reductio ad absurdum argument trotted out by anti-Keynesians. Name me one person who seriously advocates it. Moreover, Keynes said nothing of the sort either: he facetiously said that if people were not able to do anything else then they could do that, but never seriously advocated it.

    Most employees of the government do things of enormous objective value to the community and business: maintaining law and order/ enforcing contracts, healing the sick, building public infrastructure, education, R&D – this is ALL effectively a subsidy to the private sector that makes the cost of their private business far less expensive. Get rid of it and private costs would shoot through the roof.

    The problem is that we start from a fait accompli where the welfare state already exists and appears to work, and people cannot comprehend that perhaps it was an unsustainable system all along.

    As I said above, there is no proof at all that it’s “unsustainable.” There has been a very fundamental link between the public sector and the private sector in all countries since the advent of the mixed economy back in the 1930s.
    The fundamental flaw with the fixation on the public sector is ignoring excessive private debt. The consumption expenditure of people with excessive private debt also consumes domestic non-tradable goods and services, domestic tradable goods and services and imports.
    Given that aggregate demand was artificially boosted by excessive private debt, it’s the dysfunctional financial system that ought to be the main target for blame, not the government, whose social services, education, R&D etc is a boon to the economy.

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  11. English is not my native language, so forgive any mistake.

    Response to Lord Keynes,

    "Most employees of the government do things of enormous objective value to the community and business: maintaining law and order/ enforcing contracts, healing the sick, building public infrastructure, education, R&D –"

    First of all, nothing is of objective value. But it is true that some things that the government do has value (at least percieved by most people, including me). But that is not the point. The real issue is asking if the voluntary sector would do it in a better way. You have to think that the government takes away resources from the voluntary sector by force and then does things with them. This is going to produce some value (it would be outrageous if it did not), but it does not mean that if those resources where left to the voluntary sector it would not create more value, or do the same the government does using a lot less resources. In fact, this almost always the case.

    "this is ALL effectively a subsidy to the private sector that makes the cost of their private business far less expensive. Get rid of it and private costs would shoot through the roof."

    This is terribly falacious. The government is taking resources away from the voluntary sector (taxes) and then giving them some services (you call it a subsidy). But if the government was not taking away those resources, the voluntary sector could provide those services in a more efficent way, so everything would be cheaper.

    Explained in another way, if the government would not provide this services (subsidy) but did not take money away from the voluntary sector, the voluntary sector could pay for those services with this money the government is not taking now, and they could even get those services in a more efficient way, thus making everything cheaper.

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  12. Most employees of the government do things of enormous objective value to the community and business: maintaining law and order/ enforcing contracts, healing the sick, building public infrastructure, education, R&D – this is ALL effectively a subsidy to the private sector that makes the cost of their private business far less expensive. Get rid of it and private costs would shoot through the roof.

    CE, was it you who once wrote of your experiences working in the UK for some sort of government-funded agency designed to promote links between a university and local businesses? There can never be any scientific proof of the incorrectness of Lord Keynes' assertions above, but I found your experiences (if it was you) very persuasive! I seem to remember something about your department providing free web services for local businesses, which undercut local web designers and yet wasn't up to a professional standard, so businesses always tried the free services first and then went to the professionals later - a total waste of time and effort. And wasn't there something about providing incredibly expensive receptions at the university to promote cooperation with local businesses which were of no identifiable benefit to anyone?

    When you hear stories like these you just know that this sort of thing is being repeated thousands of times up and down the country, but it would be impossible to prove it to Lord Keynes' satisfaction.

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  13. Sorry, but I also meant to acknowledge Hugo's comments in my previous comment.

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  14. But if the government was not taking away those resources, the voluntary sector could provide those services in a more efficent way, so everything would be cheaper.

    No, it wouldn't.
    If fact it would be more less efficient.
    Take highways: you would have competing highways to the same city wasting resources and then pushing the cost of transport up because the private sector must get a profit on the highways. A public planned highway efficiently builds one highway and makes it free for use.
    Also, take the highly expensive and inefficient US medical care system. It's largely inefficient because of the private part of it: bloated management in for-profit HMOs that ration health care by wasting resourses in pouring over people's policies to deny them payment to people to increase profits.

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  15. Methinks everyone is being too absolutist in the position they adopt.

    Would the private sector provide roads more or less efficiently than the public sector? The only true answer is "possibly, but no one can know for certain, it all depends on how its done."

    Would privately organised and administered hospitals use money more efficiently than NHS hospitals? Possibly, but no one can know for certain, it all depends on how it's done.

    To ask the same question in reverse: would GP services be cheaper and more efficient if all GPs were direct employees of the State (rather than the current position of most being employees of privately owned and run GP practice companies)? The answer is the same.

    Roads, medical services, education, policing, armed forces and many other things done by government have to be done by someone and they have to be paid for. They are genuine value-added services whether they are run by government or privately and whether they are funded out of tax or in another way.

    The unsustainable part of government spending is in two parts.

    First, the additional costs (if any) of providing these services through government rather than by private service providers. My inference is that there are additional costs because there are few if any incentives to operate more efficiently. To my mind the only way to approach this issue is to require the managers in the public sector to maintain current levels of service whilst cutting their budget. Allowing them to reduce the level of service provided to the public must not be an option. That you or I might not know how savings can be effected is neither here nor there; when backs are against the wall and savings have to be found they will be found. They are found all the time in the private sector by paring-back bureaucratic processes that do not directly add value.

    Secondly, those areas of government spending that add no or little value must be discarded entirely as unafforable luxuries. I mean such things as (i) talking-shop Quangos, (ii) "carbon budget" calculators, (iii) swathes of people employed to tell us what to eat and drink, (iv) subsidies to the arts and to professional sports bodies (the government pays millions each year to the multi-billion pound football industry, it's complete madness) and (v) "equality and diversity" regulation (what is needed is clear laws and enforcement of breaches not layers of paper-pushing regulators sending out questionnaires and "guidance").

    How far these two steps go in reducing the overdraft will determine whether any of the value-added services should be reduced on the ground of unaffordability.

    Lord Keynes is correct in saying that private debt is a serious problem but he is wrong in suggesting that it is somehow nothing to do with the previous government. Of course it is primarily the fault of those who borrowed money they cannot now readily afford to repay. But the previous government took no step to limit private debt, presumably because the extra spending brought in extra taxes that could be used to pay for some of their additional spending plans, despite being warned by many observers that there was a serious underlying problem. Those spending plans appeared to be affordable only because of the unsustainable private borrowing. It follows from this that part of government spending is necessarily unsustainable because it is dependent on unsustainable private sector activity.

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  16. "No, it wouldn't.
    If fact it would be more less efficient.
    Take highways: you would have competing highways to the same city wasting resources and then pushing the cost of transport up because the private sector must get a profit on the highways. A public planned highway efficiently builds one highway and makes it free for use.
    Also, take the highly expensive and inefficient US medical care system. It's largely inefficient because of the private part of it: bloated management in for-profit HMOs that ration health care by wasting resourses in pouring over people's policies to deny them payment to people to increase profits."

    Yes it would.

    How can you be sure there would various highways and not only one? Also, in my country, Spain, the government takes care of building the roads, and it has double roads to several places because it has one toll highway and another non-paying road. Also, historically when the voluntary sector has built roads it has done by forming cooperatives of the locals. Your answer does not make sense.

    And the USA health system is a red market, a government controlled market. Its obviously inefficient. Go back in history to when the USA government started regulating the USA health care system and you will see that it exactly when costs started rising.

    You can not go around saying that government regulations are good and then criticize a heavily regulated system as an example of what you dont support.

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