26 August 2011

For years government has been using private money for capital projects and public money for services. Guest blogger Ian Mulheirn, Director of the Social Market Foundation, thinks neither offers value for money. Perhaps it’s time to switch them round.

Adrian Brown posted an excellent and thought-provoking piece earlier this week on government’s inability to price, distribute and understand risk in its efforts to improve public services. In it, he cited this week’s SMF paper on risks to the viability of the Work Programme, and the Treasury Committee’s recent report on the poor value for money offered by PFI for infrastructure projects. These two apparently unrelated policies, he argued, illustrate how attempts to push excessive risk onto contractors are a false economy for the taxpayer.

That’s absolutely right: government needs to realise that more risk transfer doesn’t lead to better risk management. There are a variety of types of risk involved in each project. Government’s aim should be to transfer only those risks that it is within contractors’ powers to mitigate through innovation and efficient delivery. Indeed on that measure, the Ministry of Justice has a struggle on its hands to transfer much risk for re-offending outcomes without some deeper reform of the prison system.

Brown also draws the parallel between PFI and payment by results (PbR) – the commissioning approach for the Work Programme - as off-balance sheet borrowing. That raises a further question: if the Treasury Committee thinks that the higher cost of private capital outweighs any efficiency benefits of using the private sector, isn’t the same true of PbR in welfare to work or offender rehabilitation?

Two kinds of efficiency

Well not quite. The cost of private capital is high, but the benefits depend on the uses to which it is put. In textbook terms, markets can deliver two different types of efficiency gains. The first, ‘static’ efficiency, involves providers delivering things more cheaply at a single point in time. This is the kind of efficiency that is a central justification for PFI: get a hospital built, minimise the costs and cut out the budget over-runs. But the scope of such economies is limited, and for the most part the state is just left with an expensive loan. The Treasury Committee is right to be sceptical that saving here could outweigh the costs of private finance at 3-4% above government debt.

Public services, by contrast, offer much more potential for a second kind of efficiency: efficiency over time, through innovation in how services are delivered. Welfare to work providers paid by results have to adapt continually, finding better ways to join up complex services for their clients and understanding the needs of an ever-changing labour market. The ‘dynamic’ efficiencies offered by innovation here promise huge dividends. And potentially ones much larger than the additional costs associated with using private capital.

The right money in the wrong places?

On this reading, UK policy has had things the wrong way for a while now: raising private finance for capital projects while using public money to run conventional services. That’s why the present government is right to look to open up public services to markets where possible since the opportunities for innovation in the delivery of complex and tailored services is vast. But the corollary of the argument is that it should be seeking to deploy more public capital to address the UK’s vast infrastructure challenges.

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