Hamish McRae: Achieve more with less money. That's the blueprint for Britain's essential services

Worries about the efficiency of public spending are mounting.

Worries about the efficiency of public spending are mounting.

As the spending review begins, the Treasury will have to turn its idea that there are large efficiencies to be extracted into practice. You may remember in the Budget that Gordon Brown argued public spending could carry on rising, but that much of the increase had to be funded from greater efficiency rather than more tax. Meanwhile, the study under Lord Gershon of the efficiency of the public sector will shortly be published. And a separate study is being carried out by Sir Tony Atkinson about the accuracy of measurement of public sector productivity.

In advance of all this, however, NHS efficiency has been declared to be much higher than previously shown by a rewriting of the figures. National Statistics has been persuaded to say that the output of the NHS rose by 24 per cent between 1996 and 2003, not the 16 per cent previously reported.

Given the Government's propensity to massage NHS figures - for example, cutting waiting lists by delaying the date on which patients are formally put on a hospital's list - this has naturally aroused suspicions that it is on the fiddle again. Actually, the change is probably justified. The NHS's productivity cannot have been falling as much as the previous figures suggested, and I expect that were the figures carried back a few years, the record under the previous government would also have looked better than it did.

Still, there is an underlying problem. For example, many people will feel that Tom Winsor, the retiring rail regulator, is right when he suggests government intervention (and in particular the forcing of Railtrack into administration) has led to expensive mistakes. This is not to say public services have deteriorated. Rather, the commonsense judgement would be that they have improved but not by as much as they should have given the huge increase in the money spent on them.

The fact is that public spending in Britain has risen more rapidly since 2000 than it has in any other large developed country. The OECD figures for the Group of Seven are shown in the chart. In the 1997-2000 period, spending in the UK fell as a proportion of GDP, as it did in all the other G7 nations bar Japan. But since then, the UK has gone from being second to bottom to the middle of the pack. The spending tap was turned on just ahead of the 2001 election and has been kept open ever since.

In macro-economic terms, it must make sense to increase the public sector deficit in a time of slow growth. You can have a debate as to whether the Government should have cut taxes rather than boosting spending, but in macro terms the policy has been a success: the UK has come through the last economic cycle with steady growth, unlike every other G7 nation. In micro-economic terms, the performance has been less impressive.

In 2000, says a European Central Bank study on public sector efficiency, Britain was equal seventh in a world league of 23 countries - an OK performance if not a wonderful one. According to this study, if we were as good as the most efficient nations - Japan, the US and Luxembourg - we could achieve the same output with 16 per cent less spending. That would equate to spending of around 35 per cent of GDP. If you accept our own official figures, our public sector efficiency has declined since 2000, so presumably the gap would be even larger now.

We'll have to wait and see what the Gershon review suggests. One critic of our public spending performance, Ruth Lea, the director of the Centre for Policy Studies, suggests the target should be to get spending down to that 35 per cent of GDP. I suppose the Chancellor would agree that efficiency needs to be increased but the additional resources should go into increasing output.

That leads to the wider debate on whether high public spending damages economic performance. To what extent, for example, is continental Europe's poor economic performance vis-à-vis the US and the UK a function of its higher taxation and large public sectors? A fair bit of academic evidence suggests that it is a big factor, but tackling that will cause huge political headaches. In any case, I suspect that the level of public spending will be determined on more practical grounds: governments will be constrained by a lack of revenue in maintaining their spending, let alone increasing it.

In the UK, for the past three years, revenues have repeatedly come in under budget. Spending has been maintained and the gap financed by additional unplanned borrowing. This is expected to carry on through to 2007: the total upward revision to borrowing is £80bn.

The most worrying aspect is that this extra borrowing has taken place during a period of decent growth. The annual rate of growth in the first quarter of this year is now reckoned to be 3.4 per cent, the fastest since 2000. In the City, this is starting to alarm people. HSBC reckons that taxes will have to go up to maintain the present spending plans. You can catch the alarm in the Bank of England in speeches by the Governor, Mervyn King, about the balance between fiscal and monetary policy. The easily decoded message is that the Bank will have to raise interest rates by more than it would like because of the boom in public spending and borrowing.

The Chancellor can probably roll things forward for another year, borrowing a bit more than planned, and so maintain spending without further tax rises this side of the election. But the pressures on his successor will be enormous. Either there will have to be tax increases, or there will be cuts in spending plans, or both. To say that is not to make a political point. Looking at the numbers, it is hard to see what else can happen. Ed Balls, the Chancellor's economic adviser, has decided to resign and stand for election as an MP. I'm sure the ticking time bomb was not the prime motivation, but the timing was good.

The better news is that there is common ground between the parties that public sector efficiency both can and must be increased. This has to happen because the revenues simply aren't available. Expect this spending review to set the tone for the next decade or more. It will be a period when the public sector comes under strong pressure to do more with less, and in particular to achieve the same sort of productivity gains seen in the private sector.

Don't assume the worst on interest rates

So the US has duly begun the upward climb of interest rates. The decision by Federal Reserve chief Alan Greenspan to increase rates by 1.25 per cent was, however, tempered by a dovish statement that rises would take place at a "measured" pace. The gloss is that the Fed did not want to cause alarm, as it did in 1994 when it ended the last period of low interest rates with a rapid series of rises.

Estimates of where rates will go are all over the place, as you would expect at this early stage of the cycle. Capital Economics, in London, expects rates of 1.75 per cent by the end of the year and 3 per cent by the end of 2005, but notes that this is lower than the market expects - around 4 per cent by end 2005.

Meanwhile, the European Central Bank has not raised the cost of borrowing yet - but then it does not need to because inflationary pressures are not mounting, as they are in the US. Besides, higher rates are the last thing Europe's largest economy needs: German retail sales are down 5.2 per cent year on year, even worse than expected.

From a UK perspective there are two things to be said. The first is that increases in rates are not going to be capricious or disorganised. The sequence and level of the rises will depend on a combination of inflationary pressures and economic buoyancy. Because the UK economy is growing fast - 3.4 per cent is well above long-term trends - the scope for further rate increases is clear.

But that does not necessarily mean they will climb right through next year. It is perfectly plausible that British rates will peak before the American ones do if inflation fundamentals justify that.

The second thing is that everyone in Britain focuses on the short-term, headline Bank of England rate, but the actual cost of finance is determined also by longer-term rates: people can fix their mortgages and, if long rates remain low, get good deals. Long rates are fixed by the market.

If the UK remains a low-inflation zone, two things happen: the Bank will not need to increase short rates and the market will not push up long ones.

Moral: look at long-term rates on both sides of the Atlantic as much as the latest pronouncements of the central bankers.