One of the announcements in the recent UK Budget was the ending of the Private Finance Initiative (PFI), including its revised form, PF2. PFI was introduced by the Conservative government in 1992. Subsequently, it was to become central to the Labour government’s ‘Third-way’ approach of using the private sector to deliver public projects and services.
PFI involves a public–private partnership (PPP). The private sector builds and/or runs public projects, such as new schools, hospitals, roads, bridges, student accommodation, and so on. The public sector, in the form of government departments, NHS foundation trusts, local authorities, etc., then pays the private sector company a rent for the infrastructure or pays the company to provide services. The benefit of PFI is that it allows private-sector capital to be used for new projects and thus reduces the need for government to borrow; the disadvantage is that it commits the public-sector body to payments over the long-term to the company involved.
As the chart shows, PFI became an important means of funding public service provision during the 2000s. In the 10-year period up to financial year 2007/08, more than 50 new projects were being signed each year.
As the number of projects grew and with them the long-term financial commitments of the public sector, so criticisms mounted. These included:
- Quality and cost. It was claimed that PFI projects were resulting in poorer quality of provision and that cost control was often poor, resulting in a higher burden for the taxpayer in the long term.
- Credit availability. PFI projects are typically dependent on the private partner using debt finance to acquire the necessary funds. Therefore, credit conditions affect the ability of PFI to fund the delivery of public services. With the credit crunch of 2008/9, many firms operating PFI projects found it difficult to raise finance.
- The financial health of the private partner. What happens if the private company runs into financial difficulties. In 2005, the engineering company Jarvis only just managed to avoid bankruptcy by securing refinancing on all 14 of its PFI deals.
Recognising these problems, in 2011 the government set up a review of PFI. The result was a revised form of PFI, known as ‘PF2’. PF2 projects involved tighter financial control, with the government acting as a minority co-investor; more robust tendering processes, with bidders required to develop a long-term financing solution, where bank debt does not form the majority of the financing of the project; the removal of cleaning, catering and other ‘soft services’.
Despite the government’s intention that PPPs remain an important plank of its funding of public services, the number of new PFI/PF2 projects has nonetheless declined sharply during the 2010s as the chart shows. Of the 715 PPP projects as of 31 March 2017, 631 had been signed before May 2010. Indeed, in 2016/17 only 1 new project was signed.
The collapse of Carillion
Concerns over PPPs remained despite the reforms under PF2. These were brought dramatically into focus with the collapse of Carillion plc (see the blog, Outsourcing, PFI and the demise of Carillion). Carillion was a British company focused on construction and facilities management (i.e. support services for organisations). It was a significant private-sector partner in PPP projects. By 2014 it had won 60 PPP projects in the UK and Canada, including hospitals, schools, university buildings, prisons, roads and railways.
However, Carillion had increasing burdens of debt, caused, in part, by various major acquisitions, including McAlpine in 2008. Events came to a head when, on 15 January 2018, an application was made to the High Court for a compulsory liquidation of the company.
A subsequent report for the House of Commons Public Administration and Constitutional Affairs Committee in light of the collapse of Carillion found that procurement procedures were fundamentally flawed. It found that contracts were awarded based on cost rather than quality. This meant that some contracts were not sustainable. Between 2016 and the collapse of Carillion the government had been forced to renegotiate more than £120m of contracts so that public services could continue.
The ending of PPPs?
On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there were 716 PFI and PF2 projects at the time, either under construction or in operation, with a total capital value of £59.4 billion. In recent years, however, ‘the government’s use of the PFI and PF2 models had slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007/8 to only one in 2016/17.’
At its conference in September 2018, the Labour shadow chancellor, John McDonnell, said that, if elected, a Labour government would not award any new PFI/PF2 contracts. He claimed that PFI/PF2 contracts were set to cost the taxpayer £200bn over the coming decade. Labour policy would be to review all existing PFI/PF2 contracts and bring the bulk of them fully back into the public sector.
Then in the Budget of 29 October 2018, the Chancellor announced that no further PFI/PF2 projects would be awarded, although existing ones would continue.
I have never signed off a PFI contract as chancellor, and I can confirm today that I never will. I can announce that the government will abolish the use of PFI and PF2 for future projects.
We will honour existing contracts. But the days of the public sector being a pushover, must end. We will establish a centre of excellence to actively manage these contracts in the taxpayers’ interest, starting in the health sector.
But does this mean that there will be no more public-private partnerships, of which PFI is just one example? The answer is no. As the Chancellor stated:
And in financing public infrastructure, I remain committed to the use of public-private partnership where it delivers value for the taxpayer and genuinely transfers risk to the private sector.
But just what form future PPPs will take is unclear. Clearly, the government will want to get value for money, but that depends on the mechanisms used to ensure efficient and high-quality projects. What is more, there is still the danger that the companies involved could end up with unsustainable levels of debt if economic circumstances change and it will still involve a burden on the taxpayer for the future.
- Find out how PF2 differs from PFI and assess the extent to which it overcame the problems identified with PFI.
- The government is not bringing back existing PFI contracts into the public sector, whereas the Labour Party would do so – at least with some of them. Assess the arguments for and against bringing PFI contracts ‘in-house’.
- Find out why Carillion collapsed. To what extent was this due to its taking on PFI contracts?
- What were the main findings of the National Audit Office’s assessment of PFI and PF2?
- The government still supports the use of public-private partnerships (PPPs). What form could these take other than as PFI/PF2 contracts? Would the problems associated with PFI/PF2 also apply to PPPs in general?
In his Budget on 29 October, the UK Chancellor, Philip Hammond, announced a new type of tax. This is a ‘digital services tax’, which, after consultation, he is planning to introduce in April 2020. The target of the tax is the profits made by major companies providing social media platforms (e.g. Facebook and Twitter), internet marketplaces (e.g. Amazon and eBay) or search engines (such as Alphabet’s Google).
Up to now, their profits have been very hard to tax because the companies operate in many countries and use accounting techniques, such as transfer pricing (see the blogs Disappearing tax revenues: how Luxembourg saves companies billions and Starbucks pays not a bean in corporation tax, thanks to transfer pricing), to declare most of their profits in low-tax countries, such as Luxembourg. One way of doing this is for a company’s branches in different countries to pay the head office (located in a tax haven) a ‘royalty’ for using the brand.
The proposed digital services tax is a 2% tax on the revenues earned by such companies in the UK. It would only apply to large companies, defined as those whose global revenue is at least £500m a year. It is expected to raise around £400m per year.
The EU is considering a similar tax at a rate of 3%. India, Pakistan, South Korea and several other countries are considering introducing digital taxes. Indeed, many countries are arguing for a worldwide agreement on such a tax. The OECD is studying the implications of the possible use of such a tax by its 36 members. If an international agreement on such a tax can be reached, a separate UK tax may not go ahead. As the Chancellor stated in his Budget speech:
In the meantime we will continue to work at the OECD and G20 to seek a globally agreed solution. And if one emerges, we will consider adopting it in place of the UK Digital Services Tax.
The proposed UK tax is a hybrid between direct and indirect taxes. Like corporation tax, a direct tax, its aim is to tax companies’ profits. But, unlike corporation tax, it would be harder for such companies to avoid. Like VAT, an indirect tax, it would be a tax on revenue, but, unlike VAT, it would be an ‘end-stage’ tax rather than a tax on value added at each stage of production. Also, it would not be a simple sales tax on companies as it would be confined to revenue (such as advertising revenue) earned from the use in the UK of search engines, social media platforms and online marketplaces. As the Chancellor said in his speech.
It is important that I emphasise that this is not an online-sales tax on goods ordered over the internet: such a tax would fall on consumers of those goods – and that is not our intention.
There is, however, a political problem for the UK in introducing such a tax. The main companies it would affect are American. It is likely that President Trump would see such taxes as a direct assault on the USA and could well threaten retaliation. As the Accountancy Age article states, ‘Dragging the UK into an acrimonious quarrel with one of its largest trading partners is perhaps not what the Chancellor intends.’ This will be especially so as the UK seeks to build new trading relationships with the USA after Brexit. As the BBC article states, ‘The chancellor will be hoping that an international agreement rides to his rescue before the UK tax has to be imposed.’
- How do multinational digital companies avoid profit taxes (corporation tax in the UK)?
- Explain how a digital services tax would work.
- Why is a digital services tax likely to be set at a much lower rate than a profit tax?
- Explain the difference between tax avoidance and tax evasion.
- Would it be possible for digital companies to avoid or evade such taxes?
- Is there a possibility of a prisoners’ dilemma game in terms of seeking international agreement on such taxes
- How does a digital services tax differ from a sales revenue tax
Ten years ago, the financial crisis deepened and stock markets around the world plummeted. The trigger was the collapse of Lehman Brothers, the fourth-largest US investment bank. It filed for bankruptcy on September 15, 2008. This was not the first bank failure around that time. In 2007, Northern Rock in the UK (Aug/Sept 2007) had collapsed and so too had Bear Stearns in the USA (Mar 2008).
Initially there was some hope that the US government would bail out Lehmans. But when Congress rejected the Bank Bailout Bill on September 29, the US stock market fell sharply, with the Dow Jones falling by 7% the same day. This was mirrored in other countries: the FTSE 100 fell by 15%.
At the core of the problem was excessive lending by banks with too little capital. What is more, much of the capital was of poor quality. Many of the banks held securitised assets containing ‘sub-prime mortgage debt’. The assets, known as collateralised debt obligations (CDOs), were bundles of other assets, including mortgages. US homeowners had been lent money based on the assumption that their houses would increase in value. When house prices fell, homeowners were left in a position of negative equity – owing more than the value of their house. With many people forced to sell their houses, prices fell further. Mortgage debt held by banks could not be redeemed: it was ‘sub-prime’ or ‘toxic debt’.
Response to the crisis
The outcome of the financial crash was a series of bailouts of banks around the world. Banks cut back on lending and the world headed for a major recession.
Initially, the response of governments and central banks was to stimulate their economies through fiscal and monetary policies. Government spending was increased; taxes were cut; interest rates were cut to near zero. By 2010, the global economy seemed to be pulling out of recession.
However, the expansionary fiscal policy, plus the bailing out of banks, had led to large public-sector deficits and growing public-sector debt. Although a return of economic growth would help to increase revenues, many governments felt that the size of the public-sector deficits was too large to rely on economic growth.
As a result, many governments embarked on a period of austerity – tight fiscal policy, involving cutting government expenditure and raising taxes. Although this might slowly bring the deficit down, it slowed down growth and caused major hardships for people who relied on benefits and who saw their benefits cut. It also led to a cut in public services.
Expanding the economy was left to central banks, which kept monetary policy very loose. Rock-bottom interest rates were then accompanied by quantitative easing. This was the expansion of the money supply by central-bank purchases of assets, largely government bonds. A massive amount of extra liquidity was pumped into economies. But with confidence still low, much of this ended up in other asset purchases, such as stocks and shares, rather than being spent on goods and services. The effect was a limited stimulation of the economy, but a surge in stock market prices.
With wages rising slowly, or even falling in real terms, and with credit easy to obtain at record low interest rates, so consumer debt increased.
So have the lessons of the financial crash been learned? Would we ever have a repeat of 2007–9?
On the positive side, financial regulators are more aware of the dangers of under capitalisation. Banks’ capital requirements have increased, overseen by the Bank for International Settlements. Under its Basel II and then Basel III regulations (see link below), banks are required to hold much more capital (‘capital buffers’). Some countries’ regulators (normally the central bank), depending on their specific conditions, exceed these the Basel requirements.
But substantial risks remain and many of the lessons have not been learnt from the financial crisis and its aftermath.
There has been a large expansion of household debt, fuelled by low interest rates. This constrains central banks’ ability to raise interest rates without causing financial distress to people with large debts. It also makes it more likely that there will be a Minsky moment, when a trigger, such as a trade war (e.g. between the USA and China), causes banks to curb lending and consumers to rein in debt. This can then lead to a fall in aggregate demand and a recession.
Total debt of the private and public sectors now amounts to $164 trillion, or 225% of world GDP – 12 percentage points higher than in 2009.
China poses a considerable risk, as well as being a driver of global growth. China has very high levels of consumer debt and many of its banks are undercapitalised. It has already experienced one stock market crash. From mid-June 2015, there was a three-week fall in share prices, knocking about 30% off their value. Previously the Chinese stock market had soared, with many people borrowing to buy shares. But this was a classic bubble, with share prices reflecting exuberance, not economic fundamentals.
Although Chinese government purchases of shares and tighter regulation helped to stabilise the market, it is possible that there may be another crash, especially if the trade war with the USA escalates even further. The Chinese stock market has already lost 20% of its value this year.
Then there is the problem with shadow banking. This is the provision of loans by non-bank financial institutions, such as insurance companies or hedge funds. As the International Business Times article linked below states:
A mind-boggling study from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, amounting to US$15 trillion, or about 130% of GDP. Meanwhile, fears are mounting that many shadow banks around the world are relaxing their underwriting standards.
Another issue is whether emerging markets can sustain their continued growth, or whether troubles in the more vulnerable emerging-market economies could trigger contagion across the more exposed parts of the developing world and possibly across the whole global economy. The recent crises in Turkey and Argentina may be a portent of this.
Then there is a risk of a cyber-attack by a rogue government or criminals on key financial insitutions, such as central banks or major international banks. Despite investing large amounts of money in cyber-security, financial institutions worry about their vulnerability to an attack.
Any of these triggers could cause a crisis of confidence, which, in turn, could lead to a fall in stock markets, a fall in aggregate demand and a recession.
Finally there is the question of the deep and prolonged crisis in capitalism itself – a crisis that manifests itself, not in a sudden recession, but in a long-term stagnation of the living standards of the poor and ‘just about managing’. Average real weekly earnings in many countries today are still below those in 2008, before the crash. In Great Britain, real weekly earnings in July 2018 were still some 6% lower than in early 2008.
- The Lehman Brothers Crash And The Chaos That Followed – Everything You Need To Know
HuffPost, Isabel Togoh (15/9/18)
- Ten years after the crash: have the lessons of Lehman been learned?
The Guardian, Yanis Varoufakis, Ann Pettifor, Mark Littlewood, David Blanchflower, Olli Rehn, Nicky Morgan and Micah White (14/9/18)
- Financial crisis 10 years on: Who are the winners and losers?
Independent, Kate Hughes (14/9/18)
- Investment winners and losers 10 years after the crash
Financial Times, Kate Beioley (14/9/18)
- Nine Lessons From the Global Financial Crisis
Bloomberg, Mohamed A. El-Erian (13/9/18)
- Lehman — why we need a change of mindset
Deutsche Welle, Thomas Straubhaar (14/9/18)
- ‘The world is sleepwalking into a financial crisis’ – Gordon Brown
The Guardian, Larry Elliott (12/9/18)
- Economists warn of new financial crisis on anniversary of 2008 crash
Channel 4 news, Helia Ebrahimi (15/9/18)
- Financial crisis 2008: Five biggest risks of a new crash
International Business Times, Nafis Alam (14/9/18)
- Carney warns against complacency on 10th anniversary of financial crisis
BBC News, Kamal Ahmed (12/9/18)
- A cyberattack could trigger the next financial crisis, new report says
CNBC, Bob Pisani (13/9/18)
Information and data
- Explain the major causes of the financial market crash in 2008.
- Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
- Summarise the Basel III banking regulations.
- How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
- What are the main threats to the global economy at the current time? Are any of these a ‘hangover’ from the 2007–8 financial crisis?
- What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
- Find data on household debt in two developed countries from 2000 to the present day. Chart the figures. Explain the pattern that emerges and discuss whether there are any dangers for the two economies from the levels of debt.
The IMF has just published its six-monthly World Economic Outlook. This provides an assessment of trends in the global economy and gives forecasts for a range of macroeconomic indicators by country, by groups of countries and for the whole world.
This latest report is upbeat for the short term. Global economic growth is expected to be around 3.9% this year and next. This represents 2.3% this year and 2.5% next for advanced countries and 4.8% this year and 4.9% next for emerging and developing countries. For large advanced countries such rates are above potential economic growth rates of around 1.6% and thus represent a rise in the positive output gap or fall in the negative one.
But while the near future for economic growth seems positive, the IMF is less optimistic beyond that for advanced countries, where growth rates are forecast to decline to 2.2% in 2019, 1.7% in 2020 and 1.5% by 2023. Emerging and developing countries, however, are expected to see growth rates of around 5% being maintained.
For most countries, current favorable growth rates will not last. Policymakers should seize this opportunity to bolster growth, make it more durable, and equip their governments better to counter the next downturn.
By comparison with other countries, the UK’s growth prospects look poor. The IMF forecasts that its growth rate will slow from 1.8% in 2017 to 1.6% in 2018 and 1.5% in 2019, eventually rising to around 1.6% by 2023. The short-term figures are lower than in the USA, France and Germany and reflect ‘the anticipated higher barriers to trade and lower foreign direct investment following Brexit’.
The report sounds some alarm bells for the global economy.
The first is a possible growth in trade barriers as a trade war looms between the USA and China and as Russia faces growing trade sanctions. As Christine Lagarde, managing director of the IMF told an audience in Hong Kong:
Governments need to steer clear of protectionism in all its forms. …Remember: the multilateral trade system has transformed our world over the past generation. It helped reduce by half the proportion of the global population living in extreme poverty. It has reduced the cost of living, and has created millions of new jobs with higher wages. …But that system of rules and shared responsibility is now in danger of being torn apart. This would be an inexcusable, collective policy failure. So let us redouble our efforts to reduce trade barriers and resolve disagreements without using exceptional measures.
The second danger is a growth in world government and private debt levels, which at 225% of global GDP are now higher than before the financial crisis of 2007–9. With Trump’s policies of tax cuts and increased government expenditure, the resulting rise in US government debt levels could see some fiscal tightening ahead, which could act as a brake on the world economy. As Maurice Obstfeld , Economic Counsellor and Director of the Research Department, said at the Press Conference launching the latest World Economic Outlook:
Debts throughout the world are very high, and a lot of debts are denominated in dollars. And if dollar funding costs rise, this could be a strain on countries’ sovereign financial institutions.
In China, there has been a massive rise in corporate debt, which may become unsustainable if the Chinese economy slows. Other countries too have seen a surge in private-sector debt. If optimism is replaced by pessimism, there could be a ‘Minsky moment’, where people start to claw down on debt and banks become less generous in lending. This could lead to another crisis and a global recession. A trigger could be rising interest rates, with people finding it hard to service their debts and so cut down on spending.
The third danger is the slow growth in labour productivity combined with aging populations in developed countries. This acts as a brake on growth. The rise in AI and robotics (see the post Rage against the machine) could help to increase potential growth rates, but this could cost jobs in the short term and the benefits could be very unevenly distributed.
This brings us to a final issue and this is the long-term trend to greater inequality, especially in developed economies. Growth has been skewed to the top end of the income distribution. As the April 2017 WEO reported, “technological advances have contributed the most to the recent rise in inequality, but increased financial globalization – and foreign direct investment in particular – has also played a role.”
And the policy of quantitative easing has also tended to benefit the rich, as its main effect has been to push up asset prices, such as share and house prices. Although this has indirectly stimulated the economy, it has mainly benefited asset owners, many of whom have seen their wealth soar. People further down the income scale have seen little or no growth in their real incomes since the financial crisis.
- Clouds gather over global economy, casting long shadow on Europe
Politico, Pierre Briançon (18/4/18)
- IMF warns rising trade tensions threaten to derail global growth
Reuters, David Lawder (17/4/18)
- IMF outlook contains cause for celebration but a horrendous hangover is looming
The Guardian, Greg Jericho (18/4/18)
- World trade system in danger of being torn apart, warns IMF
The Guardian, Larry Elliott (17/4/18)
- IMF Warns of Rising Threats to Global Financial System
Bloomberg, Andrew Mayeda (18/4/18)
- IMF issues warning on global debt
BBC News, Andrew Walker (18/4/18)
- The IMF has a simple message: the global recovery will peter out
The Guardian, Larry Elliott (17/4/18)
- Global growth is built, alas, on shaky foundations
The Irish Times, Martin Wolf (18/4/18)
- Government debt
The Economist (19/4/18)
- This Is How Much Money the World Owes
- For what reasons may the IMF forecasts turn out to be incorrect?
- Why are emerging and developing countries likely to experience faster rates of economic growth than advanced countries?
- What are meant by a ‘positive output gap’ and a ‘negative output gap’? What are the consequences of each for various macroeconomic indicators?
- Explain what is meant by a ‘Minsky moment’. When are such moments likely to occur? Explain why or why not such a moment is likely to occur in the next two or three years?
- For every debt owed, someone is owed that debt. So does it matter if global public and/or private debts rise? Explain.
- What have been the positive and negative effects of the policy of quantitative easing?
- What are the arguments for and against using tariffs and other forms of trade restrictions as a means of boosting a country’s domestic economy?
I recently found myself talking about my favourite TV shows from my childhood. Smurfs aside, the most popular one for me (and I suppose for many other people from my generation) had to be Knight Rider. It was a story about a crime fighter (David Hasselhoff) and his a heavily modified, artificially intelligent Pontiac Firebird. ‘Kitt’ was a car that could drive itself, engage in thoughtful and articulate conversations, carry out missions and (of course) come up with solutions to complex problems! A car that was very far from what was technologically possible in the 80s – and this was part of its charm.
Today this technology is becoming reality. Google, Tesla and most major automakers are testing self-driving cars with many advanced features like Kitt’s – if not better. They may not fire rockets, but they can drive themselves; they can search the internet; they can answer questions in a language of your choice; and they can be potentially integrated with a number of other technologies (such as car sharing apps) to revolutionise the way we own and use our cars. It will take years until we are able to purchase and use a self-driving car – but it appears very likely that this technology is going to become roadworthy within our lifetime.
Artificial intelligence (AI) is already becoming part of our life. You can buy a robotic vacuum cleaner online for less than a £1000. You can get gadgets like Amazon’s Alexa, that can help you automate your supermarket shopping, for instance. If you are Saudi, you can boast that you are compatriots with a humanoid: Saudi Arabia was the first country to grant citizenship to Sophia, an impressive humanoid and apparently a notorious conversationalist who does not miss an opportunity to address a large audience – and it has done so numerous times already in technology fairs, national congresses – even the UN Assembly! Sophia is the first robot to be honoured with a UN title!
What will be the impact of such technologies on labour markets? If cars can drive themselves, what is going to happen to the taxi drivers? Or the domestic housekeepers – who may find themselves increasingly displaced by cleaning robots. Or warehouse workers who may find themselves displaced by delivery bots (did you know that Alibaba, the Chinese equivalent of eBay, owns a warehouse where most of the work is carried out by robots?). There is no doubt that labour markets are bound to change. But should we (the human labour force) be worried about it? Acemoglu et al (2017) think that we should:
Using a model in which robots compete against human labor in the production of different tasks, we show that robots may reduce employment and wages […] According to our estimates, one more robot per thousand workers reduces the employment to population ratio by about 0.18–0.34 percentage points and wages by 0.25–0.5 per cent.
Automation is likely to affect unskilled workers more than skilled ones, as unskilled jobs are the easiest ones to automate. This could have widespread social implications, as it might widen the divide between the poor (who are more likely to have unskilled jobs) and the affluent (who are more likely to own AI technologies). As mentioned in a recent Boston Consulting Group report (see below):
The future of work is likely to involve large structural changes to the labour market and potentially a net loss of jobs, mostly in routine occupations. An estimated 15 million UK jobs could be at risk of automation, with 63 per cent of all jobs impacted to a medium or large extent.
On the other hand, the adoption of automation is likely to result in higher efficiency, huge productivity gains and less waste. Automation will enable us to use the resources that we have in the most efficient way – and this is bound to result in wealth creation. It will also push human workers away from manual, routine jobs – and it will force them to acquire skills and engage in creative thinking. One thing is for certain: labour markets are changing and they are changing fast!
- What do you think is going to be the effect of automation on labour market participation in the future? Why?
- Using the Solow growth model, explain how automation is likely to affect economic growth and capital returns.
- In the context of the answer you gave to question 2, explain how human capital accumulation may affect the ability of workers to benefit from automation.
 Daron Acemoglu and Pascual Restrepo, Robots and Jobs: Evidence from US Labor Markets, NBER Working Paper No. 23285 (March 2017)