Economic Theory

Let’s have less PFI – by reducing the scope of the state

In the UK, a furore has broken out over the failure of a company called Carillion. The focus of the debate is on its involvement with government contracts largely through what is known as the “private finance initiative” (PFI).

Until the 1990s, the government would have built, paid for, and run all hospitals itself, borrowing the money if necessary. Since that time the UK government contracts with private firms such as Carillion to provide services, as well as major infrastructure projects like the building of roads. Since the 1990s, the government has also contracted with such firms to build schools and hospitals. These arrangements can involve the private company both undertaking the work and also providing the finance up front. For example, a company might build and run a hospital, and the government might pay for the services that the hospital provides over the course of 30 or 40 years.

The use of private contractors to provide services and infrastructure through contracts with the government is common all around the world, though models differ from country to country.

The Left is making hay out of the failure of Carillion, arguing that PFI is a manifestation of “neo-liberalism,” and the failure of Carillion is an indication of a broken capitalist system.

One problem with the Left’s argument is that nobody really believes that the government should not contract any service out. If the government is not going to contract out its catering, for example, should it grow all its own food on government-owned farms with government employees? You do not have to reach this reductio ad absurdum argument to realise that the case that some would make in the Labour Party does not stack up.

Indeed, contracting certain government services, and PFI-like schemes should not be a Left-versus-Right issue. At the extreme, of course, to set your mind against contracting out in all circumstances is both perverse and a clear anti-capitalist statement. However, there is no socialist, capitalist, left-wing, or right-wing formula that determines when services should and should not be contracted out, or when PFI should be used.

At the same time, it is very important that those who believe in a free economy do not make the case for PFI and contracting out on “free-market” grounds. Once the government has decided to provide a road, a hospital, or a school, it has rejected the market. Exactly how it provides the service or infrastructure is a pragmatic decision. Contracting out to a private company involves the creation of a supply chain, the transfer of risk, changes to the timing of cash flows, the design of complex contracts, and so on. As such, it comes with costs of monitoring those contracts.

In some areas, contracting out and PFI schemes increase risk for the government by reducing flexibility. In other areas, they decrease risks by fixing costs. Contracts can be incredibly lengthy and require monitoring, but the government does not have to monitor the workforce directly and can merely specify in the contract a set of services to be provided without having to worry about how they are provided.

These are exactly the problems that face private organisations. Should the Institute of Economic Affairs hire its own cleaners, caterers, and printers? Should it contract out the production of Economic Affairs and EA Magazine to a professional academic journal company or keep things in house? Should it own its offices, or rent a serviced office?

In economic terms, which route to take depends on “transactions costs.” If there is an important economic question, related to business or government organisation to which you need an answer, you can save yourself a lot of time by trying to understand and apply the economics of Ronald Coase. Luckily, Coase is profound but writes in straightforward English. His Nobel Lecture is well worth a read. As Coase would have noted, comparing in-house provision with PFI involves comparing the costs of doing things in-house with all the problems that brings (such as the management and monitoring of staff) with the costs of hiring a firm to undertake certain tasks with all the costs of writing, monitoring, and managing contracts.

It would be better if government was not involved at all in the provision of many services and infrastructure projects. The process of competition between different private providers is the best way of discovering the most efficient way of delivering things. However, once you have made government responsible for a service, whether to contract out or use PFI or do everything in-house is a prudential judgement that has to be made. It is an irrational and socialist response to rule out the use of commercial involvement in government services. However, there is no free-market ideology that will tell you in advance when contracting out and PFI work best.

There are ethical issues in the background of this debate. As far as Carillion is concerned, though it does not seem to have done anything illegal, it is suggested that they may have put their directors before their creditors, and their shareholders before their pension fund. As of this writing the situation is not clear-cut, and more information will be revealed in the coming months.

There is, though, something inherently concerning about PFI and other similar arrangements. Explicit corruption is rare in the UK, but PFI-type projects and large government contracts create huge opportunities for corruption, particularly in countries where it is common. Multi-billion-dollar contracts between corrupt governments and companies that have no concern about ethics is what might be called a potential “occasion of sin.” Some people have become very rich from relationships between the private sector and the government. This can happen simply because of the complexity of the contracts involved and the relationships that develop between big companies and big government: It does not have to involve explicit corruption. This whole field is an area with the potential for “crony capitalism.”

Allowing governments to pursue huge infrastructure projects on a “buy now, pay later” basis also encourages log-rolling and rent seeking. If an airport or road improvements can be promised without any immediate cost, such promises become more enticing. Therefore, if the government gets involved in contracting with the private sector, all future cost commitments under PFI-like schemes should appear as debts on the government balance sheet: They should be added to the national debt. The government should not be able to expand its spending envelope whilst hiding the costs.

But, simply removing the private sector from the realm of government service provision is no remedy. It is impractical for the government to have its own direct workforce for every task. Not only that, if we are going to have government involvement in infrastructure projects and in the provision of schools and hospitals, PFI-type models can reduce risks and costs.

The best solution is to get the government out of providing many services altogether. The UK government should transition to funding parents, who would purchase an education for their children from alternative private options. It should not own hospitals but finance the poor to buy health insurance from private providers. The nineteenth century showed how the private sector – sometimes together with local government – can build and finance roads, railways, and ports.

The government need not be directly involved in any of these areas. As such, PFI is not needed at all.


This article was first published on the Acton Institute’s Transatlantic Blog.

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

7 thoughts on “Let’s have less PFI – by reducing the scope of the state”

  1. Posted 03/02/2018 at 08:43 | Permalink

    As always, a well-argued case made in favour of small Government – this time, on the reasons why use of PFI for the provision of public services has not delivered – as was promised by the governing elite, at the time.

    Actually, the current band of elite politicians are listening to those who are suggesting that Government should get out of the business of providing some public services altogether.

    Take, for example, the task of equipping the Armed Forces with military equipment to defend this country. A job Governments have consistently failed at, for as long as anyone can remember.

    Instead of subsidising the defence industry in perpetuity, this minority Government is now seeking to elicit input of private sector investment capital into defence equipment programmes to replace taxpayer funds, which will serve to take the burden off the public purse.

    In its latest policy statement on defence procurement expressed in the refreshed Defence Industrial Policy document which was published just before Parliament adjourned for the Christmas recess, the Government says:

    “We want to encourage more private venture capital into the defence sector, including from non-traditional defence suppliers. Co-investment (where both industry and Government jointly invest) is commonplace in the civil aerospace and automotive sectors, and we want to see more of this in defence”.

    Government policy documents are, almost always, framed in language which is deliberately ambiguous in meaning (to sow confusion), leaving them open to multiple interpretations – indeed, as many times as there are readers. However, in this case, the message behind the words cannot be clearer.

    After decades of propping up the defence industry with unquestioning support, the Government is realistic in its aims and recognises that the private sector will not willingly put forward or risk its own money. Nevertheless, it has come to the conclusion that industry’s appetite for self-funding will only be boosted when the instrument of competition is applied more rigorously.

    Defence procurement officials are famous for sticking to tried-and-failed practices of the past, which is why the new Secretary of State for Defence has taken to invoking the oft quoted saying “If you always do what you always did, you will always get what you always got” in relation to the behavioural change he is expecting of people directly underneath him at MoD.

    To this end, it would be a mistake for MoD to underestimate the formidable resistance that will be put up by defence contractors, or to resort to the failed approach of gentle persuasion and talking, to try to convince them to stake their own money. Nor will the presently applied ‘sudden death’ competition (which reduces the field of bidders from six to one abruptly, thereby removing the incentive for the single Contractor to perform) cut it anymore.

    Instead, the Government should select the winning Contractor from a choice of industry teams, by running a multiple-phase winner-takes-all competition (see this illustration on the basis of a level playing field genuinely open to all-comers, including non-domiciled suppliers, with the rules of the contest declared at the outset – and combine it with use of Government’s considerable power of coercion, exercised judiciously.

    Accordingly, each Bidder should be invited to declare that part of the bottom-line Selling Price for the overall programme which is to be paid for, from his own (or third party) funds to advance the developmental status of his starting-point for the Technical Solution – as a separate line item on DEFFORM 47, to enable Abbey Wood Team Leader to make a like-for-like comparison. The more money bidders put in, the less MoD will have to contribute, and the lower the risk that the Team Leader will be censured for exceeding the sanctioned budget. See this illustration on how it works.

    Normal commercial pressures and market forces inherent within the context of a multiple-phase winner-takes-all competition will, in themselves, compel defence contractors to take a business decision to voluntarily make a contribution from their own funds – not, because the Government says so, as some people in the pay of the State with inflated egos seem to think, but because of the omnipresent threat from the Competition! It will not even require expenditure of procurement officials’ time, in trying to persuade bidders to put forward their own money – saving MoD an enormous amount in overhead costs.

    Such a feat has not been achieved on any previous equipment acquisition programme for the UK’s Armed Forces, not least, because no one (including the Secretary of State for Defence) has being able to provide convincing evidence of any private sector capital invested – instead, this issue has been dominated by lies, disinformation and spin.

    In staking their own funds, bidders implicitly acknowledge and accept a proportionate share of programme risks, so relieving the strain on public finances and with it, ensuring that MoD gets more for its money than it would otherwise do. Additionally, the long-standing practice of bidders concealing technical risks from MoD will cease immediately.

    An added benefit to be derived from compelling bidders to borrow funds from third parties such as Finance Houses or private equity partners to pay for the cost of developing their Technical Solutions is that, the monitoring and scrutinising function will be automatically transferred from MoD to the lending institutions, who are likely to be much more rigorous and demanding regarding day-to-day performance than disengaged, here-today-gone-tomorrow procurement officials – yet another good reason why the headcount at MoD’s arms-length defence procurement organisation at Abbey Wood, Bristol should be cut even further!

    It is one thing for elite politicians to make ambitious statements in glossy documents for public consumption, and quite another to get front-line procurement officials to implement this policy so that it delivers the outputs, as promised. The acid test will be the actual figure in pounds sterling quoted by bidders on DEFFORM 47 – any number greater than zero will be clear indication that effective implementation of this policy is under way. To enable Parliament to scrutinise the ongoing effectiveness of this policy, it should insist that the Government makes data on private sector investment capital committed during each phase of equipment procurement programmes available, on a regular basis.

    The ultimate aim is to gradually cut the Government’s contribution of funds down to zero, commensurate with achievement of levels of competitiveness in the Defence Industry comparable with that exhibited by world-beating, export-orientated, advanced technology non-defence companies in the UK – which happen to pose a nil cost burden upon the taxpayer. Indeed, they are net contributors to the Exchequer, because they pay their full share of corporation tax dues!

  2. Posted 07/02/2018 at 23:01 | Permalink

    There is a lot of press about Carillion and its debt burden etc, valuations of intangibles, but the questions no one seems to have asked is who were the clients that wouldn’t pay, what were the debtor days and what really caused a cashflow crisis? Are UK public bodies partly to blame or is it all the fault of the directors?

  3. Posted 09/02/2018 at 16:17 | Permalink

    There are several disadvantages in the PFI system. And here are a couple of them:
    1. Inflexibility and poor value for money: Long service contracts may be difficult / costly to change – especially when the management of a project seems to have gone wrong. There have been many stories of flawed projects for example private firms contracted out to provide car parking, cleaning and other services in hospitals built and run as part of a PFI. Infrastructure may not designed to last more than the length of the contract and will need replacing or maintenance costs will be high.
    2. Risk: The ultimate risk with a project lies with the public sector (government). Private finance agreements are complicated to organise and there is no guarantee that the private sector will make a better cost benefit analysis of a project than the public sector.

    But according to my research, which I did with the help of the site, I can highlight some advantages of this program:
    1. Delivery: The private sector is not paid until the asset has been delivered. New PFI projects are nearly all fixed price contracts with financial consequences for contractors if delivered late. PFI firms pay tax which in theory could make the projects cheaper overall for the government.
    2. Dynamic efficiency: Private sector better placed to bring innovation and good design to projects, higher quality of delivery, lowering maintenance costs. The bidding process for PFI projects creates competition at point of tendering.

    Therefore, the failure of one company is not a reason to completely distrust this system; it’s only an occasion to look at the shortcomings and try to eliminate them.

  4. Posted 23/08/2018 at 15:34 | Permalink

    Interesting article!

  5. Posted 12/11/2021 at 06:30 | Permalink

    I’d like to point out a few benefits of this programme:
    1. Payment to the private sector is deferred until the asset is delivered. Nearly all new PFI projects are fixed-price contracts with financial penalties for contractors that deliver late. PFI companies pay taxes, which might theoretically save the government money on projects.
    2. Dynamic efficiency: The private sector is better positioned to contribute project innovation and smart design, as well as improved delivery quality and cheaper maintenance costs. At the moment of tendering, the bidding procedure for PFI contracts fosters competition.

    As a result, the failure of one firm isn’t a cause to dismiss the system entirely; rather, it’s an opportunity to examine the flaws and strive to address them.

  6. Posted 05/12/2021 at 21:20 | Permalink

    I didn’t have any expectations concerning that title, but the more I was astonished. The author did a great job. I spent a few minutes reading and checking the facts. Everything is very clear and understandable. I like posts that fill in your knowledge gaps. This one is of the sort.

  7. Posted 19/06/2023 at 12:23 | Permalink

    The issue of government contracts and the use of private firms to provide services and infrastructure is a complex one, with arguments from both the Left and the Right. It is important to approach the topic with an understanding of the practical considerations and costs involved.

    While some argue that the failure of companies like Carillion points to a broken capitalist system, it is crucial to recognize that the decision to contract out services is not inherently a Left-versus-Right issue. It is a pragmatic choice that involves weighing the benefits and risks associated with contracting out versus in-house provision.

    Contracts with private firms, such as PFI schemes, can offer benefits like fixed costs and specialized expertise. However, they also require careful monitoring and the design of complex contracts. On the other hand, in-house provision allows for more control but comes with its own challenges, such as managing staff and resources.

    Ultimately, the decision of whether to contract out or provide services in-house depends on a careful consideration of transaction costs and the specific circumstances of the situation. It is not a one-size-fits-all approach and requires a thorough analysis of the trade-offs involved.

    Ronald Coase’s work on transaction costs can provide valuable insights when evaluating the most efficient and effective approach. Understanding the economics behind such decisions can help navigate the complexities and make informed choices.

    Overall, the discussion should focus on finding the right balance between the benefits and costs of contracting out, considering the specific needs and objectives of each situation.

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