In the debate about how to deal with ongoing financial problems, many economists argue that the private sector, faced with an uncertain future and high debt levels, is saving. Therefore the public sector has to step in and run deficits to replace private sector spending. If it does not do this then the economy will contract and overall debt as a proportion of the economy will increase. I have tried to be fair to this argument and on the surface it is quite convincing. One can trace its ancestry to Keynes, who said, to paraphrase, that the government should pay people to dig holes in the ground and then fill them up. Keynes here was talking about the government stepping in to counter a temporary demand shock.

However, what if the government is borrowing money over a prolonged time frame and on a vast scale to pay people to dig and fill in holes? What if this activity were the mainstay of the economy? Even the most devoted Keynesian would agree that increasing spending on hole-digging is not a good idea. Eventually future generations would have to repay the debt incurred by this useless activity. Also, the economy would become be dangerously distorted to service the bloated hole-digging sector.

Unfortunately that is essentially the situation we are in today. Two brilliant papers by Tim Morgan of Tullet Prebon demonstrate that this is the case; ‘Wrong questions give wrong answers’ shows that between 2000 and 2007, economic growth resulted from two sectors, growth in debt-driven CREF (construction, real-estate and finance) and growth in the government. I shall deal with the former in a separate blog. However, the growth in the economy from government basically comes from the government increasing its spending while gaining less and less in return.

In ‘Where’s the money’ Morgan shows that between 1999 and 2010, the productivity of just two departments, health and education, declined by 20 per cent. If we consider this decline as being the equivalent of paying people to dig holes, then the government is indeed spending around £50 billion every year towards this activity. And this ignores the fact that we could reasonably expect productivity to increase with time, given that the public sector was not exactly a model of efficiency in 1998 – so the real amount actually spent by government on useless activities is considerably larger.

Accordingly, the main debate on how to overcome current financial problems should focus on how to deliver higher quality services for less money and hence deliver back the resultant savings to heavily burdened taxpayers, as outlined in Sharper Axes, Lower Taxes.