X-efficiency in the public sector and economic effects of public spending

A debate about fiscal policy that should focus on losses of X-efficiency in the public sector and economic effects of public spending

The IMF’s October 2023 Fiscal Monitor focuses on the fiscal implications of the decarbonisation and the green transition. In an interview with the Financial Times ahead of the publication Victor Gaspar, the IMF’s head of fiscal affairs argued that countries needed to rein in public spending and raise revenues or risk central banks’ efforts to curb inflation. This reflects the observation in the IMF’s October 2023 World Economic Outlook that ‘with fiscal deficits and government debt above pre-pandemic levels and debt-service costs as a share of GDP rising’. The IMF therefore argues that ‘tightening the fiscal stance is warranted in numerous cases to restore room for budgetary manoeuvre’.

General Government Interest Payments (Percent of general government revenues?

Fiscal and Monetary Policy are needed as arms of macro-economic management. 

As public debt increases there will be more focus on the role and cost of fiscal policy in economic management. In the two decades after 1990 economists and policy makers thought that monetary and fiscal policy could be separated out and neatly compartmentalised. The conceit that monetary policy could operate separately from fiscal policy and the wider political accountability that only governments can bring to policy decisions was ended in the Autumn of 2008. The Federal Reserve could not take the necessary steps to stabilise the US banking system and economy without a mandate from Congress and taxpayers. Across the advanced economies central bankers were only able to operate because they had the support of taxpayers and monetary and fiscal policy effectively became fused. Even then after the financial crisis had been stabilised monetary policy and quantitative easing could only function with support of taxpayers and finance ministries. 

Clarifying the appropriate roles of the different instruments of macro-economic policy

So, the starting point for thinking about the role of fiscal policy and the function of public debt in a modern economy is to recognise that the two branches of macro-economic policy should not be artificially separated, they need to be coordinated and combined. Part of this should recognise the circumstances where one set of instruments has more purchase than the other. In episodes of disinflation and very low interest rates monetary policy will lose traction as a source of stimulus as it did between 2008 and 2021. In those circumstances the key source of stimulus will come from the use of fiscal policy. The failure to make use of active fiscal stimulus between 2010 and 2020 helps to explain the low rates of growth among advanced economies and the increasing evidence then of advanced economies beginning to lapse into a sort of stationary state sort secular stagnation. The power of fiscal policy to stabilise economies and stimulate recovery has been demonstrated by the measures taken during the Covid public health emergency between 2020 and 2021, led by the US Federal Government’s fiscal stimulus.

When there is inflation of the type generated by the scale of the Covid stimulus measures, the recovery of demand and activity in the context of constrained demand, to avoid a general inflation that goes beyond the impact of erratic powerful relative price effects on a price index, monetary policy has bite and has the traction too cool demand. The present protracted episode of inflation is the result of the slow and hesitant response of central banks to the powerful stimulus provided by the Covid fiscal measures.

When monetary policy has traction, it is a much more flexible tool for demand management than fiscal policy. First it has the potential to influence all decisions on consumption, investment and saving. Whereas the impact of changes in taxation and spending are confined to the economic agents directly affected by them with some second and third round multiplier effects. Second, changes in monetary conditions work with long and variable lags, but the process of policy implementation and lags involved with fiscal measures tend to be greater making their effect tardier. Third, measures to tighten fiscal policy to slow economic activity can usually be evaded by households and businesses using their balance sheets to borrow to carry out investment or consumption decisions that would otherwise be thwarted. In short, when there are normal positive real interest rates, and an economy needs to be slowed down to control inflation monetary policy has the necessary bite in contrast to fiscal policy that is clumsier.

The structural role of the public sector 

Policy makers in advanced economies need to clarify their thinking about the different roles that public debt and fiscal policy should have. There is the role of fiscal policy as part of economic management that was neglected for a generation or more. There is the role of fiscal policy in providing public services that when properly calibrated with private markets contributes to making economies work better, but when clumsily pursued can hinder the workings of markets and the economy overall. And there is the role of fiscal policy and public debt markets in facilitating governments to manage political and social shocks, such as war and environmental and public health crises. Debt is a way of smoothing costs over time.

In what the historian Simon Sebag Montefiore has called the comfortable rich democracies there is a common fiscal and public sector challenge. Over some seventy years governments have turned to the public sector to replace and supplement market activity going way beyond the provision of classic public goods to providing merit goods and services and to smooth household income over the life cycle and the redistribute income between household to relieve poverty and to create greater opportunities to enjoy economic welfare than the dispersion of income in a market economy would yield. The ambitions of policy makers in countries, such as Britain that pioneered this  were huge, as Winston Churchill expressed it to create a welfare state that would care for people from the cradle to the grave. Yet complex social pathologies remain entrenched, there are huge differences in outcomes by class in terms of education, lifetime earnings and health. While complex cycles of intergenerational deprivation appear intractable. 

An Italian economist and former head of fiscal policy at the IMF Vito Tanzi and German Government economist Ludger Schuknecht in Public Spending in the 20^th Century: A Global Perspective catalogued the dramatic increases in social expenditure in advanced economies during the middle decades of the 20^th century. He identifies two clear patterns. The initial big increases in spending often providing or financing a service, such as education or health for the first time resulted in obvious measurable improvements in social outcomes and were associated with a better functioning macro-economic performance. Increased spending in later decades, often to address perceived deficiencies in previously created social welfare programmes, was much less successful in terms of measurable social improvement and the overall economic welfare of the economy. Worse in some economies, Britain being a good example of expansion of the public sector in the 1960s and 1970s appeared to hinder the performance of the private sector, potentially constraining its capacity to finance an expanded public service. These problems are present throughout the OECD, in the EU, Scandinavia and the USA. 

Fiscal Rules as devices to accommodate higher public spending

In Europe economies such as the UK and members of the EU and euro-zone have developed fiscal rules to try to address the challenges of large public sectors that need to be financed. At their best fiscal rules are ineffective and more honoured in breach than in observation. In the UK they have been destined to fail because they were introduced and constructed to reassure electorates and financial markets, that deficits and the stock of public debt would be controlled in relation to national income, allowing discretionary changes in both taxation and public expenditure increasing the size and cost of the public sector. 

The UK’s golden rule, only borrowing to finance public sector investment gave ample opportunity to increase spending not least because its application turned on the definition of what was investment and the spending that could be scored for finance by borrowing. The Private Finance Initiative and Public Private Sector Partnerships were merely accounting devices that enabled public spending to take place off-balance sheet at greater cost in overall public expenditure terms. Identifying public sector capital spending as benign to be borrowed for and current spending as cost to be taxed for was asinine. A hospital building without the current spending to employ surgeons and nurses is useless. Just a school with a newly built physics laboratory but no specialist physics teacher will yield disappointing science results. The public sector capital stock must be supported by current or revenue expenditure to get the benefits of it. Moreover, there is a big difference between the private sector borrowing to accumulate its capital stock and the public sector. The private sector asset will have both an economic and a financial return. Whereas the public sector asset may have an economic and a social return it will not have a financial return.

Public Spending has a real resource cost, aggravated by the deadweight costs 

Public spending has a real economic cost that is greater than its cash cost. This deadweight cost arises from the opportunity costs involved in public spending and the economic distortion that arises from financing it either through taxation or borrowing. How public spending is financed is a second order question. It is the total cost of spending at the margin that is important. This means advanced economies that spend high ratios of GDP through their public sectors need to interrogate the effectiveness of the spending and its marginal return to ensure that it exceeds the full deadweight cost involved. This is where the debate about fiscal policy should be steered in rich advanced economies. 

Fiscal rules focused on debt are beside the point

Fiscal rules that focus on borrowing, deficits, and the stock of public debt in relation to GDP are largely redundant. The big question is the cost of spending. Fiscal rules focused on debt are looking at a second order matter. They are a distraction from the difficult debates that ought to take place about how much should be spent through the public sector and what that spending should be. Moreover, when there is an adverse economic shock fiscal rules are rightly junked to enable the state to act as a collective shock absorber. This what rightly happened between 208 and 2009 and between 2020 and 2021.

Awkward questions about efficiency and X-inefficiency in public spending

In most OECD economies there is an awkward debate that needs to be pursued about the efficiency of public spending. It is an uncomfortable discussion about rent seeking in the public-sector, public-sector producer and trade union interests, the need to better manage public sector employees and to address long standing issues that relate to disappointing measured productivity in countries, such as the UK. The concept of losses of X-efficiency was developed to explore why private sector businesses were not always efficient. 

The concept was first explored by an economist at Harvard, Hervey Leibenstein in an article Allocative Efficiency vs. X-Efficiency that was published in the American Economic Review in 1966. X-efficiency helps to explain why companies might have little motivation to maximise profits in a market where the company is already profitable and faces little threat from competitors. The key issue is that a manager deploying a shareholders’ resources will not steward them with the same care as they would their own money. The loss of X-efficiency is inevitably greater in public sector agencies, which have soft rather than hard budget constraints and where the employees enjoy high levels of employment protection and job security. It is this awkward nexus of issues that the rich comfy economies with big public sectors need to focus their attention on.

Warwick Lightfoot 

16 October 2023

Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992.