Accidental advance in economic management

If you were Chancellor of the Exchequer, and you could think of a way of spending billions of pounds on public projects, without raising taxes or the public sector borrowing requirement, and without political or financial controversy, you would a lmost certainly jump at the chance.

It is not surprising, therefore, that Kenneth Clarke has chosen to do just that with his Private Finance Initiative. Equally unsurprisingly, Labour has chosen not to oppose him. After all, it is hoping to be in his shoes one day.

Up to £6bn of government contracts, ranging from the Channel Tunnel fast link to the redevelopment of the Department of Social Security Newcastle offices, will be signed this year as part of the PFI. Instead of being funded by the Government, these contracts will be paid for by the private sector. The Government will still pay, but later, in the form of rent or leasing fees.

The PFI is a subtle but dramatic change in the way government manages the economy. For better or worse, it really heralds the end of the PSBR as the centrepiece of economic management.

Private money has always been available for public projects. But traditionally it has been acquired through the issue of government bonds. For a while, until the Treasury drew up some rules to prevent possible abuse, it was possible for government to borrow money from the private sector by back-door means. Now it has become legitimate again: the PFI in effect lifts many of these Treasury restrictions.

In particular, it releases government to engage in "hypothecated borrowing" - borrowing that is tied to a particular asset, rather than being counted as part of the general pool of national debt. For example, instead of borrowing money for a prison, building the prison and paying interest on the loan, the Government can now hire a private company to borrow the money. It then pays the company a rent for the prison. The company uses the rent to pay the loan interest.

Why is public spending under this guise more desirable than good old fashioned public spending? The Government's answer is that it is appropriate for projects that gain from being managed privately. But that looks a thin rationale. Private finance is notnecessary to yield that particular advantage. Contracting out the work to private management on a fixed-price contract achieves the same objective, with the benefit that it places the big cost risks on to the private company.

The Government argues that it is not just the management of the construction that matters, but the operation of the finished product as well. We don't just pay a company to build a new prison. Nor do we just rent a new prison from a private company. Under the PFI, we can retain them to manage their prison as well.

That would provide a fine justification for distinguishing old-style borrowing and new-style private finance, were it to describe the PFI. But it doesn't. The PFI is being used far more loosely. New trains for the Northern Line, for example, are going tobe operated by London Underground. The borrowing for them looks mightily like normal public borrowing, even though it will not count as part of the PSBR.

The reason it escapes inclusion is because imaginative Treasury finance experts have cooked up some risks to place on the contractor. That way it does not look like a plain government-backed loan. But the inescapable conclusion must be that the PFI is primarily a wheeze to allow more public spending without it showing up in the PSBR.

In the early days of Thatcherism, the PSBR was seen as so important that it dictated the thrust of policy in almost every area. The rationale was that public borrowing has an important bearing on the growth of broad money supply. Building new trains, forexample, might have to be sacrificed to keep the PSBR in the right shape for macro-economic management purposes.

Over the years, however, the PSBR has taken on a different role. It is now seen as an important preventive measure to avoid mistakes in other policy areas. In particular, it is a vehicle for imposing discipline on public spending.

The trouble is that the PSBR is peculiarly inappropriate as a means of bearing down on public spending. As it makes no distinction between capital spending (which leaves you with an asset at the end of the year) and current spending (which does not), it has tempted governments operating under a five-year electoral cycle to trim capital spending at the expense of current. We have ended up with too few trains, and too many transport officials.

To get round that problem, one would ideally want to replace a PSBR target with a "CGNW" target: a target for the annual Change in Government "Net Worth" - the change in the value of government assets in the year. To do that, you should subtract from thecost of building trains the value of the trains that you have at the end of the period. It is a far more sensible target.

The irony is that putting capital spending into the PFI is equivalent to moving on to net worth targeting. It means government spending shows up in the current account, while capital spending is off the books. Even if it is an accounting wheeze, the PFI may still compensate for the errors that come from using an imperfect target, the PSBR.

There are reasons therefore for thinking that the PFI is a sound development. It is a step towards the sensible rebalancing of current and capital spending. But, as so often in our economic management, Britain seems to have stumbled - rather than walked - into this positive forward step.