Macroeconomics of public sector reform: Philip Lane
Philip Lane outlines the importance of public sector efficiency to Ireland’s economic recovery.
Baumol’s disease is the one of the most widely-accepted propositions in macroeconomics. This refers to the regularity that the cost of domestically- produced labour-intensive services tends to trend upwards relative to the cost of manufactured goods as a society grows richer. This is mainly explained by differential productivity growth between the services and manufacturing sectors, since the scope for capital deepening and technological change has historically been stronger in the latter than in the former. The same level of cost-reducing innovation has not occurred in the services sector, so that we observe around the world an upward drift in the relative cost of providing domestically- produced private and public services. Some types of services can be outsourced to lower-wage economies, which mitigates the cost trend.
For this reason, all countries face a challenge in maintaining the provision of public services while containing the overall level of taxation. Furthermore, there are concerns in many countries that the organisation of the public sector does not provide sufficient incentives for managers and workers to deliver services in the most efficient and lowest-cost manner. Accordingly, the technological challenge of managing the Baumol’s disease phenomenon is accompanied by an array of organisational complexities. Finally, the political sensitivities involved in the provision of public services add a further dimension, since the interactions among managers, unions and service recipients occur both directly and indirectly via the intermediation of the political system.
These factors help to explain why public sector reform is such a complicated and tortuous process. The optimal approach to the management and implementation of change will differ across different categories within the public sector and the international record shows that there are no ‘silver bullet’ solutions.
Still, from a national perspective, an efficient public sector is an important source of wealth and comparative advantage. In one direction, if a target level of public services can be delivered with fewer workers and other inputs, this means that more resources are available to the private sector, allowing the private sector to grow more quickly. In the other direction, if a given number of public sector workers can produce more services and higher-quality services, this directly raises national output, through the contribution of the public sector to gross domestic product. To be visible in the data, this requires that the measurement of the national accounts fully adjusts for improvements in the quality of public services. In fact, since public services are a large proportion of the domestic sector of each economy, the efficiency of the public sector is a key driver of differences in income per capita across countries.
For this reason, macroeconomists routinely advocate that governments place a high priority on rooting out public sector inefficiencies. In the context of the EU-IMF programme for Ireland, the growth of the Irish economy is a key factor in determining the sustainability of the sovereign and banking sector debt levels, so that productivity in the public sector is a natural policy target.
However, it is important to be aware that some of the most powerful growth effects of public sector reform will only be achieved over a medium-term horizon. In particular, the downsizing of the public sector will mean that more of the labour force is available for private sector employment. In the medium term, this should boost growth by relieving skill shortages in the private sector. However, in the short term, the high level of unemployment means that labour shortages are not a constraint on private sector growth.
This is why it is so regrettable that public sector reform did not take place during the boom years, during which the private sector could have absorbed the release of workers from the public sector. Looking to the future, an important lesson is that the culture of public sector reform should be maintained during cyclical upswings, since reform is far less costly during upturns than during downturns.
Philip R Lane is Professor of International Macroeconomics at Trinity College Dublin.
