Nicholas Macpherson – 2016 Speech on Keynes’s General Theory at 80

Below is the text of the speech made by Sir Nicholas Macpherson, the Permanent Secretary to the Treasury, at HM Treasury in London on 4 February 2016.

Keynes was the greatest British thinker of the 20th century. He had an extraordinary mind. He was a brilliant polemicist. And I am proud that he served in Her Majesty’s Treasury, whose view I shall seek to represent here tonight.

But 80 years on from the General Theory he remains elusive. Partly because he was a creature of his time – the chronic under demand of the inter war years. And partly because his ideas were continually evolving. Keynes was and is a paradox. A liberal who proposed protection. A capitalist who regarded most business people with contempt. A conscientious objector who worked round the clock in support of the war effort.

The General Theory is a masterpiece. It put macroeconomic analysis and policy firmly on the map. It provides huge insights into expectations, uncertainty and the operation of markets. His description of the stock market in chapter 12 should be compulsory reading for economists and investors alike.

It also provided much though not all of the basis for what came to be known as “Keynesianism”: a view that government could not just manage demand but seek to smooth the operation of the trade cycle through fiscal policy.

Whether Keynes himself would have supported such an approach, had he lived, we will never know: the General Theory was focused on addressing persistent depression. Chapter 22 (Notes on the Trade cycle) is almost an after-thought. It was Hicks, Meade and others who sought to operationalise “Keynesianism”.

Now is not the time to set out a defence of the much maligned Treasury view of the 1920s and 1930s. I would merely make two points.

First, the Treasury view evolved over time: as George Peden has shown, it was much more nuanced than some of its critics have claimed. And secondly its focus on monetary policy as a way of regulating the economy, set out in Ralph Hawtrey’s seminal Economica article of 1925 , is still relevant today.

The Treasury policy of loose monetary policy and tight fiscal policy after the UK came off the gold standard in 1931 proved highly effective.

Similarly, in recent years, the speed of the authorities’ interventions on monetary and credit policy have been instrumental in the UK’s recovery.

And so the question I would like to address tonight is whether, beyond the initial loosening and tightening of fiscal policy by the then Chancellor in 2008-09, the Treasury should have made more use of Keynesian policies in recent years.

I will set out 9 reasons why the Treasury remains cautious if not sceptical about an activist fiscal policy. For completeness, I should make clear that many of the arguments apply equally to using monetary policy as a tool for fine tuning: the Treasury has always been as sceptical about crude monetarism as naïve Keynesianism. First, the labour market is much more efficient than it was in the inter war period. Policy since the 1980s has focused on reforming industrial relations, improving work incentives and pursuing more activist welfare to work policies. Just as unemployment peaked at a lower level in the 1990s recession, so did it again in the 2009 recession, with unprecedented real wage adjustment facilitating the maintenance of employment. Keynes’ case for public works in the 1930s rested on his view that nominal (and hence real) wages could not adjust not least because of the strength of the trades union movement.

Secondly, over my working life, there has been a persistent tendency to mistake structural weakness for cyclical weakness. Keynes was writing at a time of chronically low demand but it’s not at all clear that recent experience fits this description. Apart from a brief hiatus in 2011 caused by the Eurozone crisis, unemployment has been falling persistently since early 2010: in the last three years, it has fallen by over a third, while the rate of employment has reached a record high. Throughout this period, until input prices began to plummet in 2014, core CPI inflation remained above its pre-crisis average, and did not fall below 2 per cent on a sustained basis until September 2014. Neither of these indicators are obvious signs of chronic lack of demand, and I doubt Keynes would have seen them as such, while the evidence is building that the growth of productive potential in the UK (and the US) has slowed significantly since the financial crisis. But throughout this period the “Keynesian” prescription has been the same: more stimulus and a higher deficit.

That naturally leads on to my third argument: the issue of asymmetry. For most of the post war period, Governments found it much easier to lower interest rates than to increase them, and to relax fiscal policy than to tighten it. No wonder there was a tendency for inflation always to be a little higher than desirable and for deficits to predominate at the expense of surpluses. Now, Gordon Brown dealt with the former through making the Bank of England operationally independent in 1997. In a democracy, it is difficult to see how fiscal policy could be contracted to an independent body. However, successive governments have sought to address this tendency through elaborate fiscal rules, and more recently through George Osborne’s creation of an independent Office for Budgetary Responsibility.

Fourthly, “Keynesian” demand management is likely to be much more effective in a relatively closed economy, like the United States, than an open economy like the UK. Here, demand expansion has historically fed through into imports and the current account: as Mark Carney recently pointed out, you cannot always rely on “the kindness of strangers” to help solve balance of payment problems. That led Keynes to argue for protection in the 1930s, just as Wynne Godley and the new Cambridge School argued for import controls in the 1970s. The Treasury has consistently set a very high bar when considering protection. Its commitment to Free Trade dates back to Gladstone. And you only have to look at the famous Kindleberger spider web diagram to see the damage protection did to the world economy in the 1930s.

Fifthly, the mythical “shovel ready” infrastructure project is precisely that: a myth. This is nothing new. The Treasury made the same point in the 1930s. But it is more of a problem today given the inexorable growth in planning law and wider regulation. Keynes’s suggestion in Chapter 10 of the General Theory that “the Treasury fill old bottles with bank-notes, bury them…in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise…to dig up” would be the victim of many a health and safety regulation and environmental impact assessment today. In short, the lead times for getting public investment up and running are long and variable.

That leads some latter day Keynesians to advocate short term tax changes. Here, there tend to be administrative lags: for example, a change in the national insurance rate takes six months. That takes you inexorably to changes in VAT, which Alistair Darling reduced on a temporary basis in November 2008: that did bring forward expenditure albeit at some cost. An alternative is to increase current spending. But the problem there is that you can only do that by increasing entitlements, or employment or wages. Such changes are notoriously difficult to reverse.

Sixthly, there are the economic costs to businesses and individuals of continually changing tax rates and spending programmes. Businesses and consumers want a stable tax system. It enables them to plan with certainty. Tax policy is best set in a medium term framework, as for example the current Chancellor has been seeking to do with the corporate tax regime. The move to multi-year spending reviews from 1998 onwards also reflected the view of successive Chancellors that public service managers can spend money more efficiently if there is budget certainty over the medium term.

Seventhly, Ricardian equivalence is also relevant to fiscal policy’s effectiveness. A “permanent” stimulus will lead consumers to conclude that it will have to be financed, neutralising its impact. A theoretical case can be made that any Ricardian offset will be smaller if consumers know that a stimulus is temporary. Nevertheless, they are still likely to “look through” the change to some degree, reducing any inter-temporal effect. Whether for Ricardian reasons or because of wider leakages to imports, the Office for Budget Responsibility has estimated the fiscal multiplier at less than one. And interestingly, Nick Crafts has estimated that fiscal interventions in the early 1930s would not have paid for themselves .

The role of the multiplier takes me to a eighth argument: the sheer magnitude of the fiscal interventions that would be necessary to stabilise the economy. This can best be illustrated either by looking at the extent to which the private sector savings ratio varies year by year; or by the extent to which output diverges from trend. The latter is much easier to estimate ex post than ex ante. But on the face of it, output has diverged from trend by up to 4 per cent of GDP since 1990. Using OBR estimates of the multiplier, stabilising the output gap would have required at times interventions of £100 to £250 billion compared to a neutral stance. And even if a limit was placed on discretionary counter cyclical interventions of, say, 1 per cent of GDP in any one year, there would still be regular changes in policy of up to £18 billion a year. Whether or not that would unsettle the market, it would certainly trigger the damaging effect on economic efficiency I mentioned above.

Finally, I would argue that there are positive benefits (as well as costs) to the trade cycle provided it can be kept within reasonable bounds. As Nigel Lawson has said, “the superiority of market capitalism lies in particular in two areas: the freedom and encouragement it gives to innovation and risk taking…,and the discipline that drives up efficiency and drives down costs. The former is stimulated most during the cyclical upswing, and the latter is compelled most during the downswing. It is at least arguable that if economies moved in a straight line rather than a cyclical pattern, there might, in the long run be less of both these benefits. ” In short, Schumpeter may still have as much relevance today as Keynes.

The Treasury may be sceptical about activist demand management. But that does not mean it abdicates responsibility for economic performance. As the nation’s economics ministry, it attaches a high weight to microeconomic policies that promote growth, productivity and employment.

Since the 1970s, successive Chancellors have sought to create a macroeconomic framework which seeks to create price stability. For the most part the Treasury has relied on monetary policy to achieve that objective: since 1997, an operationally independent Bank of England has been tasked with hitting a symmetric inflation target. Fiscal policy has generally played a subsidiary role, with Chancellors setting it to achieve a medium term objective – a surplus under Nigel Lawson and George Osborne; a current surplus under Gordon Brown – underpinned with a target for the national debt.

That does not mean that there is no role for fiscal policy. In the recent downturn, the automatic stabilisers played an important role in supporting demand. As George Osborne has said “by not chasing the debt target we…allowed the automatic stabilisers to operate and that is a sensible economic decision… That supports the economy in that sense, during a cyclical downturn. ”

And as a pragmatic institution, the Treasury would never rule out recommending a fiscal response if the conditions were right.

But it is no surprise to me that the response to the recent crisis has focused on monetary policy and the credit channel rather than on fiscal policy. In 2008 we saw the advent of the special liquidity scheme, the credit guarantee scheme and “quantitative easing”. Latterly, we have seen the funding for lending scheme, supplemented by other interventions such as “help to buy” – all of which have been designed to reduce the gap between official interest rates and the rates companies and households pay.

If you have a banking crisis followed by a credit crunch, you need to treat the disease rather than the symptom. Similarly, it’s in the nature of a banking crisis that government deficits are likely to rise, often sharply. That is not a time to take risks with the deficit – there are always inflection points when just a little extra borrowing can do untold damage to how you are perceived in the market. Yields start to rise. Debt servicing costs begin to spiral. And that risk increases if you go into a down turn with an already high debt level.

Some neo-Keynesians may write off the modern Treasury view as expounded by “practical men who believe themselves to be quite exempt from any intellectual influence, [but] are usually the slaves of some defunct economist. [Or] Madmen in authority, who hear voices in the air, [and] are distilling their frenzy from some academic scribbler of a few years back.” But I’d like to think that Maynard Keynes – who understood markets as well as anybody – would have approved of what the Treasury has done since 2008.

Sir Nicholas Macpherson – 2014 Speech on the Economy

Below is the text of the speech made by Sir Nicholas Macpherson, the Permanent Secretary to the Treasury, on 15th January 2014.

Some years ago, I was asked by a senior colleague whether the Treasury was that most political of institutions, willing to embrace the latest political fad and blow with the wind of the prevailing orthodoxy. Or was it unbending and unchanging, forever wedded to the “Treasury view”, much maligned by Keynes and others from the 1920s to the present day.

It was a good question. But like many good questions it contained a false dichotomy. The Treasury exists to serve the government of the day: to promote and achieve its objectives in the financial and economic field. In doing so, it needs to understand, interpret and apply the philosophy and agenda of the governing party (or parties). But it will inevitably also bring to the process the experience and insights of the officials who work within it – an understanding of what works and what does not and an appreciation of previous successes and failures in economic policy.

I entered the Treasury in early 1985, as the recovery was gaining momentum from the recession of the early 1980s, and Nigel Lawson was embarking on a programme of tax reform rarely seen before or since. As I begin my 30th year at the Treasury, I would like to set out some propositions on economic policy, drawing partly on my own experience and partly on the Treasury’s longer history as the nation’s leading economic and financial institution. The propositions partly reflect the age in which we live. And to each of them a greater or lesser ideological spin or emphasis could be applied. But I would like to think they also reflect a certain timelessness. A Treasury view for our time.

First, a belief in free trade links seamlessly the Treasury of William Gladstone to that of George Osborne. The Treasury has always taken the view that the United Kingdom is a small country with few natural resources. Its prosperity rests on trade. And the fewer the impediments there are to trade, the more the economy will grow and the greater the prosperity of the nation.

The Treasury has always been opposed to protectionism and mercantilism. From the repeal of the corn laws to the present day, it has tended to favour consumers over producers, supporting a cheap food policy and thus the living standards of the ordinary citizen. But there is a wider reason for the Treasury’s adherence to free trade: a level playing field for trade reduces distortions, enhances competition and weakens special interest groups.

Historically, the Treasury opposed bilateral trade deals: in the 1890s, the Treasury supported the view that tariff bargains with the likes of Spain and Portugal, promoted by the Foreign Office, were a “commercial sin”. As Chamberlain’s proposals for tariff reform gathered momentum in 1903, my distinguished predecessor Francis Mowatt[1] “was literally in despair … [claiming that] half the cabinet did not appear to understand basic economics.”[2]

And when that great Chancellor, Philip Snowden, finally resigned from the National Government of Ramsey MacDonald, it was over the policy of Imperial Preference and protectionist tariffs agreed at the Ottawa conference. As he had written to MacDonald the previous winter: “some of us are perturbed about the rapidity with which we are drifting into a full protectionist policy … including food taxes … I cannot go on sacrificing beliefs and principles bit by bit until there are none left.”

Since the 1930s, trade policy has become more nuanced, not least because of our membership of the European Union, where the UK has had to accept the vagaries of the common agricultural policy in exchange for being able to shape and access the single market. The Treasury has continued to be a strong advocate of free trade within Whitehall, resisting the siren calls for greater mercantilism and protectionism. The abolition of exchange controls in 1979 was one of its greater triumphs. In recent years, the department has used its influence to advance the case for free trade internationally and in Europe, whether through a stronger focus on trade liberalisation or CAP reform or in the debates around commodity price spikes and what to do about them. And Britain has played a critical role in resisting modern forms of protection, in the form of regulation, and in setting out the case for better functioning international markets and the critical importance of trade.

And just as the Treasury has played a leading role in setting out the implications of Scotland leaving the free trade area that is the United Kingdom, so would I expect it to play a critical role in setting out the economic implications of the options of staying in or leaving the EU, should there be a referendum on our membership in the next Parliament.

My second proposition is really the flip-side of the first, and it is that markets generally work. This may appear a brave proposition following the worst financial crisis in eighty years. And I am happy to acknowledge that there is a legitimate role for the state to step in to correct market failure. The challenge for the Treasury of course is to be clear where intervention will change things for the better.

Now is not the time to give a lecture in classical economics.

But efficient product markets create the competitive pressures to help keep prices down, encourage firms to innovate and to minimise their costs of production – combining factor inputs in the form of labour, capital and land in the most efficient way.

Well functioning capital markets ensure that firms have access to the capital they need, enabling them to finance investment and to expand operations to meet demand. They enable shareholders to place incentives on firms to maximise the efficiency of their operations, and people to maximise their productive potential by borrowing against their future earnings to pay for the acquisition of skills and training.

Well functioning labour markets are also vital for generating growth. Increased labour supply allows employment to rise to meet the demands of a growing economy for increased output. The more flexible the labour market is, the more easily the economy is able to adjust rapidly to take advantage of new opportunities. And well functioning labour markets reward workers according to their performance and skills.

In short “fair and efficient product, capital and labour markets provide the best means of ensuring that as many of the economy’s resources as possible are available to generate economic growth and well being”.[3]

Most change in recent decades has been in the direction of making markets work better. If I compare the market for telecommunications now with when I first moved to London in 1981 – when I had to wait several months to get a telephone installed – it really is a different world. Enhancing competition in other regulated sectors – for example, rail and energy – has posed a greater challenge. However, even in these sectors the extent of competition is significantly greater than it was thirty years ago.

But perhaps the best example of greater efficiency is the labour market. When I joined the Treasury the alternation between Incomes Policy and “free collective bargaining” was firmly embedded in the department’s consciousness. It did not seem to matter which policy was in place: at the end of each cycle, the equilibrium rate of unemployment was higher. The trades union reforms of the 1980s, the move to more active labour market measures in the 1990s, as well as wider structural changes to the composition of the economy, have changed all that. Moreover, there is greater awareness of work incentives at the lower end of the earnings distribution. Over the last fifteen years, the increase in the personal allowance, national insurance changes and the introduction of tax credits and the national minimum wage have all played their part in making work more attractive than welfare. The UK now has one of the most dynamic labour markets in the developed world, reflected in a transformation in the relationship between output and employment. Employment has held up much better in the recent downturn than it did in the 1980s and 1990s.

For me, the lesson of the financial crisis is not that we had too much competition but that we did not have enough. For example, the lack of a suitable bank resolution regime led to the “too big to fail problem”. Barriers to entry led to oligopolistic practices, not least the “LIBOR” scandal and a suboptimal approach to remuneration, itself compounded by a lack of shareholder pressure. And market failures and a lack of competition in the provision of individual current accounts and SME lending have led to a lack of effective consumer pressure. Throw in government failure – the collective underestimation of the build up of risk in the financial system by the Bank of England, FSA and Treasury and the inability of the authorities to work cooperatively to address the crisis as it began to emerge in 2007 – and it is easy to see with the benefit of hind-sight how the crisis came about.

My third proposition relates to an abiding Treasury obsession: the provision of sound money. Price stability enhances citizens’ ability to plan their lives, facilitating basic economic decisions around whether to consume now or to consume later via saving. It enables people to plan their retirement with a degree of certainty. It makes it easier for firms to plan whether to expand or contract, to invest or to save. And at a macro level, it minimises the risk of devaluation of the currency.

It may be that I was excessively influenced by my late teenage years. It is certainly etched in my memory that prices rose 16 per cent in 1974, 24 per cent in 1975, 16 1/2 per cent in 1976 and 16 per cent in 1977. For me the provision of price stability is tantamount to a moral issue; it goes to the heart of the fundamental duties of the state. And it is for this reason I disagree with those economists who have argued in recent years that the authorities should seek to encourage consumption by generating excess inflation. For much of the post war period price stability has proved remarkably elusive. I have seen a number of anti-inflation regimes come and go. First, incomes policy. Then monetary targets. Then shadowing the Deutsche Mark informally in the late 1980s and then formally through membership of the exchange rate mechanism of the European monetary system. Each regime had its advantages and arguably represented an improvement on the one before. But each turned out to have its flaw. The relationship between monetary aggregates and inflation broke down the moment the Treasury targeted them (what came to be known as Goodhart’s law). Exchange rate targeting, even when fully supported by the Prime Minister, ultimately had interest rate consequences which undermined the credibility of a policy designed to improve credibility. An unwillingness of the authorities to contemplate realignment within the ERM added to the problem. And the rapid growth of international capital and foreign exchange markets meant that interventions which still just about worked in the 1950s and 1960s became increasingly ineffective, meaning that exchange rate targeting became impossible without much greater economic and political integration.[4]

In the end, the Treasury hit upon a regime which would deliver price stability through inflation targeting. A regime which was developed almost on the hoof in response to Black Wednesday has proved remarkably durable: first, through the monthly monetary meetings chaired by Norman Lamont, Ken Clarke and Gordon Brown, and then through the creation of the Monetary Policy Committee under operational independence of the Bank of England.

Of course, one of the lessons of the financial crisis is that price stability on its own will not deliver stability in output. With the benefit of hindsight a greater focus on credit might have prevented the build up of risk in the system before 2007: the creation of the Financial Policy Committee at the Bank of England with new macro-prudential tools should certainly make the macroeconomic framework more robust in future.

But looking back to the last decade, I think senior Treasury officials – myself included – became mesmerised by the length of the upswing – a record 66 quarters of unbroken growth – and overestimated the power of macroeconomic policy to reduce the amplitude of the trade cycle. As Sir Steve Robson has argued there was “a failure of imagination”[5].

That takes me to my fourth proposition, which is that there are limits to what the state can do to regulate demand. The fact is the United Kingdom is a very open economy. And Sterling long ago stopped having the reserve status now enjoyed by the US dollar. If the economy deviates from trend, the authorities should of course act and they do. But a degree of realism is necessary: the British economy is unlikely to grow rapidly for a sustained period if its main trading partners (the US and EU) do not.

Under successive governments, the Treasury has tended to see monetary policy as the first port of call when it comes to demand. This is because monetary policy is set monthly and can respond quickly, as demonstrated in the financial crisis when the base rate was cut by 475 basis points over the course of a year followed by a programme of quantitative easing worth some 25 per cent of national income.

Monetary policy’s effectiveness has been much enhanced when buttressed by interventions to address credit conditions, whether through the credit guarantee scheme, or more significantly the funding for lending scheme. This reinforces another conclusion, drawn from my time at the Treasury, which is that you can become too hung up on “money” when it is “credit” which matters.

That does not mean the Treasury denies a role for fiscal policy. Successive governments have acknowledged a role for the “automatic stabilisers” – those tax receipts and areas of expenditure, primarily social security, which tend to vary with the economic cycle. In the late 1990s, one of “the key objectives for fiscal policy [was] to allow the automatic stabilisers to play their role in smoothing the path of the economy”[6]. And more recently, the current Chancellor, George Osborne, has told the Treasury Committee: “by not chasing the debt target we have allowed the automatic stabilisers to operate and that is a sensible economic decision, in my view. That supports the economy in that sense, during a cyclical downturn.”[7] And I would emphasise that the automatic stabilisers in the UK have a greater impact than in many advanced economies: the OECD estimates that their impact is over a third greater in the UK than in the United States.

And so fiscal policy can be effective. But in setting it, I would highlight two points.

First, as with many other economic variables, it is important to take into account the stock of debt as well as the flow of borrowing. The last government recognised this by setting a debt rule of 40 per cent of GDP; the current one by seeking to get debt on a downward path. Capital markets may be more open than they used to be and so at the margin an increased public sector deficit may be less likely to crowd out private sector borrowing and investment. And it is a long time since the UK experienced a ‘gilts strike’. But in my view there will always be inflection points where a further increase in borrowing will result in a much bigger increase in funding costs as a number of Eurozone countries have found to their cost. Ex ante it is difficult to know where these inflection points are, which makes the case for erring on the side of caution.

And secondly the Treasury has tended to be sceptical about the efficacy of “fiscal fine tuning”. It is all too aware of the practical obstacles to switching fiscal demand on and off. The mythical “shovel ready” infrastructure project is precisely that – a myth. The lead times in getting public investment up and running are long and variable. Increases in current spending are even more difficult to switch on and off, not least because they involve increases either in public sector employment or in entitlements which are notoriously difficult to reverse. And although some taxes can be changed through the flick of the “regulator” switch, the vast majority have a longer lead time. For example, it can take over six months to implement a 1 per cent change in the rate of national insurance. There is also an economic cost to using fiscal programmes as a regulator of demand: investment projects generally provide a higher return if planned over the medium term as part of a wider infrastructure programme. There is at least a theoretical risk that economic agents see through temporary measures anticipating the future tax increases or cuts in spending needed to reverse them: so called Ricardian Equivalence. And there is a tendency towards asymmetry: democratically elected governments find it easier to loosen policy than to tighten it, just as they did with monetary policy when they were responsible for it. All of this is a long way of saying that fiscal policy is a blunt instrument, and if used actively it is better to use it to support monetary policy from a position of strength, when public debt is low or non-existent.

In this respect, Treasury orthodoxy has come a long way since the Treasury view of the 1920s. But it has also moved on from the high water mark of post war Keynesian orthodoxy when Sir Edward Bridges could say: “The [Annual] Budget is second to none in importance, since by its influence on the flow of income it can be used both to sustain a high level of employment and keep total demand within the limits of total supply”.[8]

Just as the modern Treasury never embraced mechanistic monetarism, so has it never been comfortable with naïve Keynesianism.

That takes me to my fifth proposition which is that governments in the United Kingdom find it difficult to raise revenues beyond a certain point. This is not a value judgement about the size of the state, on which the official Treasury does not have an opinion. It is purely an empirical point. Over my working life I have seen all sorts of tax regimes. When I joined the Treasury, the top rate of tax was 60 per cent. Now it is 45 per cent. The basic rate was 30 per cent. Now it is 20 per cent. The combined rates of employer and employee national insurance contributions has risen from 19.45 per cent to 25.8 per cent. The main VAT rate was 15 per cent; now it is 20 per cent. I have seen new taxes introduced; old ones abolished. Reliefs and allowances have come and gone.

But over that period the share of national income accounted for by taxes and national insurance contributions has remained stubbornly stable: 36.4 per cent in 1985-86 and 34.9 per cent in 2012-13. Its lack of variation is particularly remarkable. Never higher than the 36.4 per cent it was in my first year at the Treasury, and never lower than the 31.8 per cent it reached in 1993-94. Perversely, over the last decade when we have witnessed the biggest economic and financial crisis in generations, the tax take has been more stable than ever: with a low of 33.9 per cent in 2002-03 and a high of 35.6 per cent in 2006-07. (Of course, there is more to the receipts side of the public finances than tax and NICs – interest and dividend receipts account for a further 2 per cent of GDP and historically have been much more variable, accounting for 6 per cent of GDP in 1985-86. But on the face of it they are in secular decline.)

Now, there are all sorts of explanations for the stability of the tax take. It may simply reflect public choice, with taxpayer resistance setting in above a certain point. It may reflect arbitrage domestically between taxes and internationally between tax jurisdictions. It may reflect diminishing returns, in terms of the effectiveness of the Inland Revenue and Customs and Excise, as was, HMRC, as is. It may just be coincidence.

I don’t want to endow the tax take with mystical significance. And certainly other countries have managed to sustain much higher tax takes than the UK, though they tend to be smaller and more cohesive like Denmark.

But to understand the public finances, you need to understand how difficult it is to sustain receipts. Historically, the Treasury tended to overforecast revenue and the OBR is only doing a little better. With growth now accelerating, we are likely to see more occasions where receipts surprise on the upside but, unless we discover the holy grail of locking in tax receipts for good, my guess is that we will be running hard to stand still for many years to come.

That takes to me to my next proposition which is that spending control matters. I covered this issue at length in last year’s lecture and so I will spare you repetition. Suffice it to say, that in a world of constrained receipts, the quality of public expenditure matters as much as the quantity, which is why since the Gershon Review in 2004 successive governments have placed so much emphasis on efficiency and productivity. More recently, the Review of Financial Management carried out by Richard Douglas and Treasury Second Permanent Secretary, Sharon White, will help ensure we can “maximise the value secured for every pound we spend”[9].

My seventh proposition, the importance of the supply side, is a long standing Treasury obsession, and not surprisingly, if you take the classical economist’s view that in the long run the nation’s income is determined by the supply of labour and capital and the productivity of each. However, in the modern era it is an area in which the Treasury has played an increasing role. The senior structure of the department itself recognises this with John Kingman, Second Permanent Secretary, heading up the Economics Ministry function.

I have already mentioned the importance of the labour market and competition – the two areas where probably the biggest achievements of supply-side policy have been made in recent decades. But the modern Treasury also sees itself as having a critical role in terms of encouraging enterprise and entrepreneurialism, for example through changes to the corporate tax system. The Treasury has also prioritised innovation – reflected in the priority attached to science spending over the last decade, and new reliefs to support research and development.

And it has also sought to support interventions to improve the skills base of the country – generally, by seeking to encourage policies which promote choice, encourage access and improve functioning of markets. Looking back over thirty years, I would not want to exaggerate the Treasury’s influence – education has tended to be dominated by the Department of Education, under various guises, and by the professionals. However, the Treasury’s influence has perhaps been greatest in relation to changes in funding of higher education, an area where the UK still has a comparative advantage. The Treasury may no longer directly fund the universities, as it did up until the early 1960s, but it can still change the rules of engagement: for example, the Chancellor’s recent removal on the cap on student numbers.

But perhaps the supply side area where there has been the greatest change in attitude during my time at the Treasury is investment in the nation’s infrastructure. I would highlight a number of changes. First, the separation of the capital and current budgets, and the decision of successive governments to target the current budget. Secondly, persistent Treasury pressure to free up the planning process. A further change has been the decision in the 2010 and 2013 spending reviews to allocate a growing proportion of capital spending according to the economic return of individual projects. And finally there has been the institutional change of setting up Infrastructure UK in the Treasury. IUK’s role in drawing up the National Infrastructure Plan, supporting projects through guarantees and advising departments on individual projects has begun to have a real impact on the delivery of new infrastructure.

That brings me to my next proposition which is that institutions matter. The granting of operational independence to the Bank of England has done much to enhance the credibility of macro-economic policy. The Debt Management Office is much acclaimed internationally and has sold £1.35 trillion of debt since it came into existence. The independent UK Statistics Authority has enhanced the credibility of economic statistics, while the independent Office of Budget Responsibility has improved the quality of economic and fiscal projections. All these changes have strengthened the macroeconomic policy framework and therefore the Treasury. Thus, the Bank of England’s operational independence both over monetary and macro-prudential policy has enabled the Treasury to concentrate on its ‘principal role’, whether in setting the monetary policy remit, for example through the publication of the new monetary policy framework at last year’s Budget, or substantive changes to taxes and spending. This has been much on my mind in recent weeks. In previous times, with an impending date with the electorate, all the pressure from Number 10 and even Number 11 would have been to come up with reasons why underlying growth was higher and thus the deficit lower, the better to justify a letting up on consolidation.

My penultimate proposition is that you need rules but you should never become fixated by them. Over the last thirty years, I have seen a number of monetary and fiscal rules come and go. All have been well intentioned, and based on observed relationships between one economic variable and another. Historically, the Treasury has tended to become mesmerised by the framework it has created, whether the Gold Standard or monetary targets or more recently the “Golden Rule”. Of course, rules are there to be observed and targets are there to be hit. But there is also a risk that economic policy makers become so fixated by the intricacies of targetry, that they cease to see the woods for the trees. Treasury officials should never become evangelists or missionaries; they should always retain a healthy scepticism, the better to see when a policy framework is producing perverse results. That is why it is important to focus on the substance. Is the deficit too high or too low? Is it falling at a credible speed? Are prices broadly stable? That is not to deny a role for economic concepts such as cyclical adjustment. Quite rightly, successive governments have tried to incorporate the cycle in the setting of policy. But ultimately economic policy will be judged by real world results rather than statistical or economic constructs. This is one reason why I subscribe to a Gladstonean[10] way of measuring economic activity: the receipts which come into the Treasury day by day do not lie.

My tenth and final proposition is that the Treasury is only as effective as the people within it (or, as Lord Bridges somewhat archaically put it, “in the end men matter more than measures”[11]). The financial crisis placed a high premium on expertise and experience. And, although Treasury staff did a great job, after a faltering start with Northern Rock, the crisis has led us to review how we recruit and retain talent. The Treasury continues to attract very high quality recruits. The last graduate recruitment attracted over 1000 applicants for some 40 posts. But, as Sharon White’s review of the Treasury’s management of the financial crisis made clear, we need to be better at developing and then retaining the professional expertise needed to wrestle with challenging issues, for example around tax, financial services and corporate finance; and also economics where Dave Ramsden, the Chief Economic Adviser, has built up a much stronger macroeconomics function than was in place in 2007.

We have sought to place greater emphasis on bringing in expertise at senior levels: I would highlight the recruitment of Charles Roxburgh from McKinseys, and Indra Morris from Accenture. But we can also attract the best from Whitehall. The Treasury is not a monolithic institution. There is an extraordinary level of debate which has always gone on in the Treasury and I hope always will do – there is a long tradition, unusual in bureaucratic institutions, which sees it as healthy to expose debate between officials, irrespective of seniority, in front of Ministers. Staff surveys indicate that officials feel more “safe to challenge the way things are done in the Treasury” than in any other department in Whitehall – a really important barrier to group think. Indeed, the proportion of staff answering positively to this question is a full 10 percentage points higher than the next most positive department, the Department of Energy and Climate Change.

What sort of qualities do we look for in Treasury recruits? A former permanent secretary put it to me that “you need a first rate mind supplement by a certain toughness”. A former special adviser, now a front bench politician, once said to me that what he was looking for in an official was “judgement”. For my part, I look for a healthy scepticism – but never cynicism – which will challenge anything and everything, while also demonstrating creativity – an ability to come up with solutions on the basis of limited information in conditions of uncertainty. I would also add that you need to handle and manage people, and above all be patient. If you are an official and you have a good idea, you need to be able to sell it. That’s partly about the age old art of persuasion. But it’s also about knowing when to deploy the idea, and grabbing opportunities when they arise.

Peter Hennessy once put it to me that the lot of the Treasury official is to deal with disappointment. As he put it, consolidation and recovery in the post war period has been “routinely punctuated by the greatest orgy”. I am an optimist. Disaster is not inevitable. Treasury officials should always be prepared for the worst. But, drawing on some of the propositions I have set out this evening, they should also hope for the best.

 

Footnotes

[1] Mowatt’s other claim to fame is that his step son was that extraordinary poet Count Stenbock described by Yeats as “scholar, connoisseur, drunkard, poet, pervert, most charming of men”. Stenbock was mentally ill, his condition not helped by his addiction to opium and alcohol. In 1895 he allegedly attacked Mowatt with a poker: Stenbock died in the ensuing struggle.

[2] Free Trade Nation, Frank Trentmann (2008) p86

[3] Productivity in the UK: the evidence and the government’s approach (HM Treasury, 2000).

[4] See also Dave Ramsden on “The Euro: 10th anniversary of the five economic tests” (MEG98)

[5] BBC, Great Offices of State, Episode 3.

[6] Pre-Budget Report, November 2000: Building Long term prosperity for all, p18

[7] Oral evidence to Treasury Committee, 13 December 2012

[8] Treasury Control (the Stamp Memorial Lecture) 1950

[9] Chief Secretary’s foreword to the Financial Management Review, December 2013

[10] “The best mode of making an estimate of the rate of increase in the wealth of the country is to resort to the income tax. No other criterion is comparable to it, for, though it may not be an exact index of the truth in this matter, yet, as between any one period and another, I believe it is an index on which we may safely rely” Mr Gladstone’s Budget Speech, 10 February 1860

[11] The Treasury, The Rt Hon Lord Bridges, 1964

Sir Nicholas Macpherson – 2013 Speech on the Origins of Treasury Control

Below is the text of a speech made by the Permanent Secretary to the Treasury, Sir Nicholas Macpherson, on 16th January 2013 in London.

Some 60 years ago, Sir Edward (later Lord) Bridges gave the Stamp Memorial lecture, in which he described the many ways in which the Treasury had changed since the end of the First World War.  He chose Treasury Control as the lecture’s title.

Tonight, I plan to roam a little more widely and to consider the origins of Treasury control itself.  But, as a preface to my lecture, I cannot put it any better than Bridges himself:

To those of you who may regard this as an arid prospect, I would say … that having spent nearly all my working life in this business, I find in it today more of interest, indeed at times of excitement, than I did as an apprentice thirty years ago.

The rise of the Treasury

The Treasury’s origins lie back in the mists of time.  It is younger than the Royal Mint but older than any other department.  The Treasury’s role in the Middle Ages almost certainly merits a separate lecture.  I do not propose to go into it tonight.

Instead, I shall confine myself to the modern era: the period since the post of Lord High Treasurer first went into Commission, four hundred years ago last June.  Tonight, I want to examine how the Treasury became the dominant institution within Whitehall; to what it owes its power; and why it is more than just a common or garden Finance Ministry on the continental model.

I would attribute the rise of the Treasury to three factors, which played themselves out in the two hundred year period from the Civil War to the rise of Gladstone:

– war as a spur to financial innovation;

– the Treasury’s inextricable links to Parliament;

– and its ability always to be just ahead of the rest of Whitehall in terms of quality of administration.

I will then touch on how Treasury control evolved in the 20th century, and finish with some contemporary observations.

First, war.

The Second Dutch war of 1667 perhaps did more to strengthen the Treasury than any other.  The war itself was a disaster, culminating in the Dutch raid on the Medway, during which some fifteen English ships were destroyed, with the flagship HMS Royal Charles being captured without a shot being fired and towed back to Holland as a trophy.  But above all it was a triumph of Dutch finance and administration.  This was a country whose population was a quarter of Great Britain’s, but which managed to deploy more money to finance the war.

Charles II realised it was time to reform the Treasury.  Out went the Lord High Treasurer, the Earl of Southampton.  In came, a new Treasury Commission.  The King had been much influenced in exile by the administration by committee he had seen in Holland and France.

Charles II faced down his Lord Chancellor, Lord Clarendon, in insisting that “he would choose such persons, whether Privy Counsellors or not, who might have nothing else to do, and were rough and ill natured men, not to be moved with civilities or importunities in the payment of money”.  Lord Ashley as Chancellor of the Exchequer had a good understanding of finance; Sir Thomas Clifford had been a Commissioner of the Navy and Sir John Duncombe one of the Ordnance Commissioners, while Sir George Downing – the Secretary – was a skilled financier, as well as a property developer.

The new Commission was quick to assert its authority over the Privy Council and Secretaries of State.  Within a week of their appointment, they demanded to be informed of every petition which would involve a charge on the revenue, and the right to give their opinion on the petition itself and the state of the revenues as a whole.  The King agreed.  Eight months later, when one of the Secretaries of State had presented a warrant for hay for the deer in New Park without the Treasury’s knowledge, the Commissioners demanded yet more power.  As a result, all money warrants for the Navy, Household, Guards and Garrisons were now to be countersigned by the Treasury Lords, and Warrants for the regulation of the revenue were to be passed by the Treasury.  Moreover, as the Order in Council of January 1668 made clear, “no free gifts or pensions might be granted until the petitioner had set forth the value of the thing sued for, and the Treasury Commissioners have reported thereon”.

The strengthening of the Treasury over the next forty years was reflected in the relative ease with which it funded the War of the Spanish Succession, the most expensive war Great Britain had fought to date and which more than doubled the national debt.  The rapid development of the City of London, combined with the setting up of the Bank of England with the First Lord’s support, ensured a much more favourable funding environment.  Indeed, Marlborough’s victories could be funded on the back of relatively benign interest rates.  Not all were happy: Swift’s History of the Last Four Years of the Queen contained forceful condemnation of Godolphin and the whole system of “Dutch finance” – that is “the pernicious counsels of borrowing money upon publick funds of interest”.  Unfortunately, the Treasury blew some of its hard won credibility by a cunning plan to convert floating government debt into stock in a chartered trading company – the South Sea Company.

The Napoleonic Wars represented a further ratcheting up in the role of the state increasing the share of national income accounted for by public spending temporarily from 12 per cent to 23 per cent.

But more importantly, the size of the national debt rose inexorably: from £2 million or about 5 per cent of GDP in 1688 to £834 million in 1815 (twice national income).  This put a high premium on the Treasury’s ability to finance wars, both through borrowing and innovations in taxation (Pitt introduced the income tax in 1799): the Treasury’s success on both these fronts was instrumental in Britain’s eventual victory.  Debt interest payments accounted for a half of public spending between 1820 and 1850.

Secondly, the Treasury’s influence in the House of Commons was critical to its ascendancy.  The most potent symbol of this was the emergence of the First Lord of the Treasury as Prime Minister in the early 18th century.  To this day, if you knock on the door of No 10 Downing Street, it is not the title of Prime Minister which is on the name plate but First Lord of the Treasury.  Only the Marquess of Salisbury of modern Prime Ministers has declined to be First Lord.  But Salisbury always had a particular aversion to the Treasury: in 1900, he could say:

“by exercising the power of the purse, [the Treasury] claims a voice in all decisions of administrative authority and policy.  I think that much delay and many doubtful resolutions have been the result of the peculiar position which, through many generations, the Treasury has occupied.”

Alongside the First Lord, the Second Lord (the Chancellor of the Exchequer) became increasingly important as the 18th century progressed.  The Parliamentary Secretary or Patronage Secretary, as the Chief Whip is known to this day, was also of critical importance given the importance of sinecures to 17th and 18th century public life.  And the junior Lords of the Treasury were important cheerleaders for the Treasury’s agenda.  And so the influence of the Treasury in the House of Commons grew; to this day, the Government still sits on the Treasury Bench.  As Henry Roseveare put it:

“with every extension of the financial basis of government, the Treasury’s access to the roots of power grew more secure.  At best, ambition to control the largest departmental empire – at worst, a desire to have some fingers in the till – ensured the attractiveness of the ‘place the money groweth’.  It was plausibly rumoured in 1690 that two members of the Treasury Commission had paid £200,000 ‘upon the nayle’ for their places”.

But the Treasury’s role in Parliament was not confined to personnel.  Until the 17th century, Parliament’s role was to agree to taxes, often to finance war.  But the King had considerable freedom to spend the revenue pretty much how he wanted.  The Civil War, Restoration and Glorious Revolution changed all that.  Again, it was the ubiquitous Downing who was the author of a change in procedure, introducing the principle of “appropriation of supply”.  He persuaded Charles II to incorporate in the bill which sought to finance the Dutch war in 1665 a provision appropriating the £1¼ million exclusively for the pursuit of the war, and through the rest of Charles’ reign this became a device which increasingly curbed the royal prerogative.  Admittedly, it took time for the principle of appropriation to become embedded, largely because expenditure financed by the Civil List – which included the small domestic departments of Whitehall as well as the King’s personal expenses – remained outside the system of annual votes.  However, during the course of the 18th century Parliament steadily chipped away at the Civil List, with the result that more and more expenditure became subject to annual votes.  By the time William IV came to the throne in 1830, the Civil List only covered the expenses of the Royal Household.  More recently, the Sovereign Grant Act of 2011 completed the process by bringing financial support to the Royal Household into annual estimates for the first time.

At the same time, Parliamentary control of the revenue side of the budget became increasingly regularised, which also strengthened the role of the Treasury.  House of Commons resolutions of 1706 and 1713 conceded the right of financial initiative to the representatives of the Crown – in short Treasury ministers.  And the setting up of the Consolidated Fund in 1787 – “a fund into which shall flow every stream of the revenue, and from which shall issue the supply for every public service” – made it impossible for revenue to be diverted to expenditure not covered by votes.

Thirdly, the Treasury tended to be ahead of other public institutions in terms of the quality of its administration.  My point here is that for the Treasury to be in control it did not need to be at the cutting edge; it just had to be ahead of the Whitehall pack.  Under Downing’s Secretaryship, the Lord Commissioners improved the organisation of the Treasury: introducing basic principles of administration such as record keeping and “Treasury minutes”.  They also used exhortation to get better service from the Exchequer – which dealt with payments and accounts: thus, the Treasury minute book of 3 June 1667 records:

“The officers of the Exchequer called in and told that their ordinary hours of attendance are not sufficient and… they are to take care that there be no further occasion of complaint of …a refusal to attend longer”.

G M Trevelyan concludes in his England under Queen Anne that the best modern traditions of the permanent Civil Service emerged in the Treasury at this period.  However, progress was slow.  It was not until 1776 that  that much maligned Prime Minister Lord North introduced a series of reforms designed further to improve the performance of the Treasury : in particular, the principle that each Treasury official should “personally transact the business assigned to them”, thus ending the prevalence of pluralism or absenteeism; the introduction of training; and the principle of merit informing promotion – or as the relevant Treasury minute puts it “ability, attention, care and diligence of the respective clerks, and not their seniority”.  In effect, the age of sinecurism was over.

Gladstonean reforms

In many ways, the forces behind the inexorable rise of the Treasury came together under William Gladstone, who dominated the Treasury of the 19th century.  He was Chancellor, four times, and First Lord, four times, combining the two posts both in 1873-4 and 1880-2.  According to his biographer HCG Matthew:

“Gladstone acted independently [as Chancellor].  He also acted aggressively.  His years at the Treasury coincided with reform of that institution from within, which Gladstone both shared and encouraged.  The Treasury was asserting its right to control the activities and personnel of the Civil Service as a whole.  Gladstone asserted the political position of the Chancellor in the Cabinet, in Parliament and hence in the country generally”.

To this day, Gladstone’s influence still dominates the Treasury.  The current Chief Secretary – the first Liberal Treasury minister since Sir John Simon – has a picture of Gladstone on his wall.  And Gladstone’s image also dominates the Chancellor’s study at 11 Downing Street.  Gladstone’s economic principles of sound money and free trade have endured in the Treasury for 150 years.  And at a time of austerity Gladstone’s focus on candle-ends lives on.  The context of Gladstone’s original reference still has a certain resonance: when the Hon F A Stanley (later 16th Earl of Derby) was appointed Financial Secretary to the Treasury in 1877, Gladstone wrote to Sir Algernon West:

“Stanley is clever but can an heir to the Earldom of Derby descend to the saving of candle-ends, which is very much the measure of a good secretary to the Treasury?”

Writing in 1950 Sir Edward Bridges was a little defensive about Gladstone’s approach:

“It recalls at once the wish believed by many to be still endemic in Treasury Chambers, to refuse all proposals of expenditure however worthy the object.”

And preferred to interpret it “as a sign of the exceptionally prudent housekeeping appropriate to those who are handling other people’s money”.  To this extent, the fabric of the Treasury has always contrasted with other great institutions, such as the Foreign and Commonwealth Office and the Bank of England.  I think Gladstone would have been proud of the Treasury’s recent adoption of cheaper paper and the reduction in the size of desks, and a move to desksharing, the better to maximise rental income here at 1 Horseguards Road.

It was Gladstone who commissioned the Northcote-Trevelyan report of 1854 which ushered in recruitment by open competition and promotion on merit.  Indeed, it was Gladstone who pressed Trevelyan to recommend open competition when his early drafts showed signs of compromising on this principle.  Not for the last time in Whitehall, there was considerable foot-dragging about implementation – between 1854 and 1868 only six departments made use of open competition in relation to 28 posts in all.  But Gladstone’s Chancellor, Robert Lowe gave it renewed impetus in the late 1860s.  According to Hennessy.  Lowe was “a tormented soul … [whose] deeply unappealing manner and striking albino appearance had not endeared him to his contemporaries”.  Nevertheless, he insisted that all Treasury posts were open to competition  and sought to impose the same principle on all other departments, though the Foreign Office and Home Office exempted themselves on the grounds that performance in those departments hinged on character and not intellect.  And other departments like the Department for Education failed to honour the agreement.  And so the Treasury tended to be the main beneficiary of a reformed university system.  This resulted in the Treasury attracting a more able – though not a more diverse – intake.  For all his support of meritocracy, Lowe had a curious obsession with the social composition of his elite, telling the Select Committee of Civil Service Expenditure in July 1873, that he valued:

“The education of public schools and colleges and such things, which gives a sort of freemasonry among men which is not very easy to describe, but which everybody feels.  I think this is extremely desirable”

And when challenged by his inquisitor that it might be

“a great hardship upon [a naturally intelligent] man [that he] should find that because he has not the good fortune early in life to be at a public school, or to have learned Greek iambics he is to be debarred from the highest departments of the public service”

Lowe replied:

“He accepts the situation with a knowledge of what it is, and I see no hardship whatever in it…. And very likely with all his qualifications and merits he might be found wanting in the very things to which I attach very great value in the upper class; perhaps he might not pronounce his ‘h’s’ or commit some similar solecism, which might be a most serious damage to a department in case of negotiation. “

It was Gladstone who provoked by the Lords’ rejection of a Paper Duties Bill in 1860 brought budget procedures into the modern era.  He determined that all tax proposals should be consolidated annually into a Finance Bill.  But more importantly, in terms of theatre, it was Gladstone who perfected the modern Budget speech, with its attendant rituals and traditions.  Central to a Gladstone budget speech was a focus on what the country could afford.  As he put it in 1860:

“it would not be fair to speak of the great increase in the expenditure of the country without considering the great extension of the means by which that increase is supported …  We ought to have a clear knowledge of the proportion which our wealth bears to our expenditure, in order that we may be able to take a comprehensive view of our financial position”.

And when his increasingly fragile Budget box was finally pensioned off in 2010, it is no coincidence that the National Archive – to whom the box belonged – chose to present the Chancellor with a new box modelled on Gladstone’s, albeit updated for the Elizabethan era.

Gladstone’s reforms to Treasury control were themselves a response to the increase in expenditure arising from the Crimean War.  Of course, the Treasury did not control everything.  Sir Charles Trevelyan could still complain to a Select Committee in the mid-19th century that though the Treasury had managed to get the War Office and Admiralty to use cheaper stationery, the Foreign Office and Home Office continued to use paper of a very expensive quality.

In 1861, Gladstone set up the House of Commons Select Committee on Public Accounts – a crucial ally to the Treasury in ensuring that public money is spent wisely and as Parliament intended.  And the Exchequer and Audit Departments Act of 1866 brought together the procedures of Estimates, Appropriation, Expenditure and Audit into one coherent system.  The inefficient and unwieldy Exchequer was finally swallowed up by a strengthened Audit Office under an independent Comptroller and Auditor General.  In 1872, the Treasury introduced the system whereby permanent heads of departments would be nominated as ‘Accounting Officers’: they would sign off the Appropriation Accounts submitted to the Comptroller & Auditor General in effect taking responsibility for the economy and efficiency of spending, as well as accounting accuracy.  And, although there were subsequent attempts to diminish the role of the Accounting Officer, for example by making the Principal Finance Officer rather than the Permanent Secretary responsible, the Treasury has always resisted any change to the core principles of the Accounting Officer regime.  As Warren Fisher, Permanent Secretary to the Treasury between the wars told the PAC in April 1921:

“it should not be open to any permanent head … to say “please, sir, it wasn’t me” … Pin it on him in the last resort and you have got him as an ally for economy’.

There have been subsequent revisions to this mid-19th century settlement.  For example, the Resource Accounts Act of 2000 replaced cash accounting with modern accounting practices and opened the way to Whole of Government Accounts.  More recently the Clear Line of Sight project has sought to create even better alignment between planning, control and accounting for public spending.

We have also seen substantial changes to how public expenditure is planned.  First, through the Plowden reforms of the early 1960s, which sought to replace annual control of supply with volume planning of functional programmes on the basis of a multi-year public expenditure survey.  And more recently through the adoption of a top down approach to public expenditure planning in 1992, and the adoption of fixed multiyear spending totals under Gordon Brown, Alistair Darling and now George Osborne.

But the basic Gladstonean principles of spending control and accountability remain in place.  The Treasury is accountable to the House of Commons for the stewardship of public spending.  But through its alliance with the Public Accounts Committee – formalised through the Concordat of 1932 and more recently through the modern bible for Accounting Officers, Managing Pubic Money – it effectively delegates responsibility for the efficiency and effectiveness of public spending to departments.  As Warren Fisher put it, rather than the Treasury acting as:

“the single handed champion of solvency keeping ceaseless vigil on the buccaneering proclivities of Permanent Heads of departments”, “the Heads of Departments should work together as a team in the pursuit of economy in every branch and every detail of the public service”.

To this day, the Treasury relies on the implicit threat of a Public Accounts Committee appearance and potential censure of an Accounting Officer if a department spends in excess of the estimates voted by Parliament.  And also on the National Audit Office’s powers to carry out value for money studies of particular areas of public spending, ranging from the award of national rail franchises to the sale of Northern Rock.

Very occasionally the guild of permanent secretaries will grumble about the NAO and PAC, either for missing the point or trivialising complex issues.  But I would tend to attribute this to the discomfort of being held to account.  I am in no doubt that the PAC, under the chairmanship of Edward Leigh and Margaret Hodge, supported by Amyas Morse the C&AG, have made a real difference to the quality of public administration.  And I speak from experience, having appeared before the Committee some eleven times over the last two years.  I welcome and endorse the Committee’s determination to “follow the pound” from the Treasury through to the front line of public services, whether in a Jobcentre or an Academy school.

The Treasury in the 20th century

If Gladstone established the main principles of control, they have continued to evolve since his retirement in 1894.  Most importantly, the size of the state grew in the 20th century.  Indeed, there were incipient signs of this in his last administration when Harcourt reformed the estate duties.

But – in succession – rearmament in the run up to the First World War; the creation of the welfare state under Lloyd George; the First World War itself; Neville Chamberlain’s further extension of the state into social security and housing in the 1920s and the great depression changed the role of the Treasury inexorably.

Treasury control evolved in two ways.

First, its finance ministry role became more strategic, particularly in the second half of the 20th century.  Not only did the Treasury  retreat from managing the civil service – the Fulton report on professionalising Whitehall led to sponsorship and leadership of the Civil Service moving first to the Civil Service department and then to the Cabinet Office.  But the Treasury also delegated the setting of pay to departments in the early 1990s, and has tended to increase delegations on more general spending.  For example, when I joined the Treasury in the 1980s I had to approve Forestry Commission spending on a hut in the Lake District costing just £15,000.  Today, the relevant delegation for Treasury approval is £100 million.

The Treasury has pulled back from other areas too: from running the central catering organisation of the civil service; the telecommunications agency; and more recently from sponsoring the Office of Government Commerce an organisation dedicated to achieving better procurement.  We have been happy to transfer the latter to the Cabinet Office, whom under the Paymaster General, Francis Maude, is doing an excellent job in driving forward the efficiency agenda.

And it is not as if these changes have made the Treasury less effective in controlling public spending.  Over the last fifteen years or so, the Treasury has been much more effective at delivering public spending outturns in line with plans than it was in the 1970s and 1980s.  It has been the planning of revenue – reflected in continued shortfalls in tax for a given level of national income – which has been the perennial problem of the public finances.

But almost in parallel with its abdication of control of the civil service, the Treasury acquired a new role to supplement its finance ministry responsibilities: that of an economics ministry.  To some degree, this happened by stealth.  Bridges detected a change emerging during the 1920s where “the Treasury staff began to think of expenditure rather less in terms of the prospect of the spending of so much public money and rather more in terms of the employment of resources”.  It was the Second World War which really changed the Treasury.  First, through the enlisting of a staff of distinguished advisers including Keynes, Catto, Robertson and Henderson.  Secondly, through a new approach to macroeconomic policy and demand management: as Bridges put it “1941 marks the date when a new theme was introduced to the making of the Budget, namely the inflationary- deflationary scheme, a conscious attempt to use fiscal measures to hold the balance between the money in people’s pockets and what they could buy with it…It is now a well established and important feature of the general aims of Treasury control”.

However, the Treasury’s dominance of economic policy making was largely fortuitous.  Until the 1950s, economic planning responsibilities resided in the Cabinet Office.  It was that department which had serviced Ramsey MacDonald’s Economic Advisory Council.  And during the war it was the Cabinet Office – through its Economic Section – which was responsible for planning and forecasting.

It was only when Sir Stafford Cripps became Chancellor in 1947 that responsibility for coordinating functions on economic policy moved to the Treasury, the Economic Section moving over from the Cabinet Office some six years later.  This change, along with the nationalisation of the Bank of England in 1946, the adoption of a Keynesian approach to demand management and the creation of the Bretton Woods system meant that the Treasury was not only responsible for the macroeconomic policy framework but also for operationalising it.

Of course, some areas of economic policy remained more contested: in particular, those relating to microeconomic policy and the supply side.  Harold Wilson took a dim view of the Treasury’s capacity arguing that “the only thing we need to nationalise in this country is the Treasury, but no one has ever succeeded” .  His creation of the Department of Economic Affairs with a remit to prioritize economic growth reflected the view that the Treasury was too laissez-faire and that its commitment to controlling public spending was somehow antithetical to the promotion of growth.

As Sam Brittan said even before he took up a post as an “irregular” in the DEA:

“the snag in most … plans for … an economics ministry is that there is something called finance quite apart from economics or production.  In fact the instruments by which production is influenced … are the budget, monetary policy, exchange rate policy and one or two very general controls”.

But it was far from inevitable that the DEA would fail.  Other countries – in particular, Germany – have managed to create strong Economics Ministries alongside strong Finance Ministries.  But fail it did not least because the National Economic Plan could not withstand the pressure on sterling through the mid-1960s.  And it fell to the Treasury to pick up the pieces.  As Sir Douglas Wass said in the 1970s:

“as the attempt of the DEA failed … so it fell on the Treasury to fill that gap and to concern itself with the supply potential of the economy”.

And thereafter the Treasury has progressively built up its role on the supply side – not least because of the recognition that ultimately it is microeconomic policy which is most likely to promote growth.  As Nigel Lawson said in his Mais lecture of 1984:

“The conventional post-War wisdom was that unemployment was a consequence of inadequate economic growth, and economic growth was to be secured by macro-economic policy … Inflation, by contrast, was increasingly seen as a matter to be dealt with by micro-economic policy … But the proper role of each is precisely the opposite of that assigned to it by the conventional post war wisdom”.

Privatisation, labour market reform, and growth policy – whether through innovation, infrastructure, deregulation, and skills – have all become a focus of Treasury activity in recent decades.  This perhaps accelerated under Gordon Brown, with the Treasury setting up the Enterprise and Growth Unit in 1997, and bringing together work on personal tax, labour market and distributional issues.  Both groups live on to this day, as does the Treasury’s enhanced role on tax policy – transferred from the Inland Revenue and Customs and Excise in 2004.

The abolition of exchange controls in 1979 began a process which would transform the City of London, and the Treasury has had to play a bigger role in relation to the financial sector.  The 1979 and 1987 Banking Acts put banking supervision on a statutory basis.  Responsibility for securities services and insurance moved from the DTI to the Treasury in the 1990s.

The financial crisis itself has had a big impact on the structure of the Treasury – with significantly more officials working on financial service issues.  The banking interventions have had serious finance ministry implications, not least on the Treasury’s own finances – with its balance sheet ballooning and – for a time – dwarfing all other activities.  But more important still is the economics ministry role of shaping a financial service regime which better suits the needs of the economy.  Financial service legislation both here and in the EU has become a hardly perennial.

The financial crisis also raised important questions about the Treasury itself.  Like the Bank of England and many others, the Treasury underestimated the build up of risk in the financial system.  And although the Treasury ultimately assumed a leadership role in resolving the British banking system in the autumn of 2008, it had a faltering start reflecting limited capacity in financial services following the run on Northern Rock in 2007.  It is important that we learn the lessons from that period.  We are currently implementing the recommendations of Sharon White’s review of the Treasury’s management response to the financial crisis.  And I am particularly pleased that Charles Roxburgh is joining us from McKinseys as Director General to lead our work on financial services.

And it is in recognition of the Treasury’s enduring and intertwined role as an economics and finance ministry that I recently restructured the senior team with the creation of an additional second permanent secretary, with Tom Scholar and John Kingman respectively in charge of the Treasury’s finance and economics ministry functions, supported by the Chief Economic Adviser, Dave Ramsden, whose group of economists roam across both areas.

As Alistair Darling put it in 2008, “macro and micro policy are not only indivisible – they reinforce each other”, and more recently George Osborne has said:

“My experiences at the Treasury have made me even more convinced that Wilson was wrong to think that finance ministry objectives and economic growth are natural enemies.

The Treasury must be more than just a finance ministry – it must be the driver of economic reform across the government…

When I look back at the decisions I have taken, I ask myself.

Would a finance ministry faced with a huge budget deficit have reduced corporation tax to boost growth?

Would a finance ministry looking for Whitehall budgets to cut have protected science spending, even though it’s one of the easiest taps to turn off?

I believe it would have been more, not less difficult to make these tradeoffs if there was an institutional split – and it’s right that the Chancellor of the Exchequer is accountable for getting that balance right.”

However, for those of you who think that the Treasury’s power has become excessive, it is worth taking you back to the early 1960s.  Then it not only managed the whole Civil Service, but directly funded the overseas aid programme, higher education, museums and art galleries – these cultural institutions were deemed too important to be entrusted to ordinary Whitehall departments.  At the same time, the Treasury of those days was not only creating the macroeconomic framework, it was also operationalising it by setting interest rates when and how the Chancellor saw fit.  And it was presided over by five permanent secretaries and seven deputy secretaries.

I would argue that the Treasury of today is much more strategic.  It tends to work through others.  For example, it sets the monetary policy target.  It delegates its operationalisation to the Bank of England.  It determines the regulatory framework, but delegates its operation to the FSA soon to be succeeded by the Prudential Regulatory Authority at the Bank.  It sets the public expenditure totals: it falls to the departments and the Cabinet Office through the Efficiency and Reform Group to drive forward the efficiency improvements necessary to maintain services at a time of falling public spending.  It determines that there should be two economic and fiscal forecasts a year.  But it leaves it to an independent Office of Budget Responsibility to provide them.  Growth policy is developed in partnership with the Department of Business and others, and operationalised through a number of departments and agencies.  Indeed, it has no choice if the Treasury is to remain a lean and agile department of around 1000 officials.  And to underline this, its senior management structure is half the size it was in the 1960s.

Treasury control has evolved.

But I believe it remains something which Downing and Gladstone – if they came back today – would recognise.

As George Osborne said at a dinner to celebrate the foundation of the Treasury Board in 1612:

“… The people assembled here today – serving under different administrations and different policitcal parties – have understood that the responsibility for the health of the public purse and the stability of the economic system is heavy one, fraught with difficulty and beset by competing claims and often requiring the answer no.”  But “The spirit of the Treasury created 400 years ago –born of a desire to bring order to the public finances, managed by persons of merit – survives to this day”.

I could not put it any better than that.

Sir Nicholas Macpherson – 2011 Demos Speech

The below speech was made by the Permanent Secretary to the Treasury, Sir Nicholas Macpherson, made at Demos on 8th March 2011.

The Treasury has had an extraordinary few years: a banking crisis followed by recession and a ballooning budget deficit.

But, even by those standards, the last year has been a defining one.

We delivered two budgets, in March and June.

We have been through only the second political transition in thirty years.

We delivered a Spending Review.

We have navigated through a sovereign debt crisis in Europe.

And we have embarked upon the biggest reform of financial regulation since 1997.

On top of this, we have made a number of institutional and organisational changes, in particular the creation of the Office for Budget Responsibility.

At the same time, the Treasury is getting smaller. Staffing levels which peaked at 1420 in September 2009 currently stand at 1260 on a like for like basis.

In my view, the Treasury will enter the new financial year with greater credibility as the nation’s finance and economics ministry.

This is partly because of what the department has achieved: in particular, the sheer scale of the fiscal consolidation. But also its associated outcomes: long gilt yields have fallen by 30 basis points over the last year, while they have increased by 130 basis points in Spain.

It is also partly about the way in which we have gone about these tasks. The official Treasury forged a strong working relationship with the new Government and quickly learned how to work with the first coalition in 65 years. I would like to think this was down to careful planning on our part. But credit should also go to the open and constructive way in which the new administration approached the civil service. Similarly, the successful delivery of the Spending Review relied not only on classic Treasury skills of analysis and negotiation, but also on an inclusive approach, both within and beyond Whitehall. And we are adopting a similarly open and consultative approach to the reforms to financial regulation: it is critical that any reforms are built to last.

And it is also because organisational changes have strengthened the Treasury’s influence.

The creation of the Office for Budget Responsibility is a good example. Its clear remit and independent status makes its forecasts that much more credible. And it strengthens the Treasury’s hand on fiscal policy since adjusting the forecasts to avoid difficult decisions is no longer an option.

We have also managed to effect this change in a way that minimises the duplication of work between the Treasury and the OBR. This is not only a good thing in terms of saving the taxpayer some money, but it also means we can maintain the macroeconomic analytical capacity that we need to be effective. For example, these changes have allowed our Chief Economic Advisor, Dave Ramsden, to spend much more time on analysis and policy advice, building up economic capacity across Whitehall, because it is now Robert Chote and colleagues that spend their time worrying about the forecast.

Other institutional changes have further strengthened policy making and the Treasury. The creation of the Office of Tax Simplification has created a force against unnecessary complexity; the absorbing of the Office of Government Commerce in the Efficiency and Reform Group by the Cabinet Office has enabled the Treasury to concentrate on its core objective of public spending planning and control; and the abolition of the National Economic Council has addressed the risk of the Cabinet Office becoming an economics ministry, which would have led to duplication and potentially confusion of policy responsibility.

The Treasury’s strength derives from its institutional and strategic coherence and the breadth of its oversight. As Britain’s economics and finance ministry, it is perhaps the only national institution that has a genuine interest in both public and private finances and in the economic success of households, businesses and public services.

The Treasury’s finance ministry role is clearly central. Only the Treasury can plan, control and account for public spending, and set the strategic direction of tax policy. And it has been doing it for eight hundred years.

But the Treasury also has an important economic policy role, on financial services, in the international arena, in steering macroeconomic policy, and in improving the supply side.

The Treasury’s effectiveness also derives from its small size. This requires the Treasury to be agile and to focus relentlessly on its core functions.

The Treasury is set to become smaller still. I expect staffing levels to be around 1000 in 2014, the smallest in my time at the Treasury (once machinery of government changes are taken into account).

We have recently carried out a Strategic Review of the Treasury – the first fundamental examination of the department’s role in two decades. It concluded that the department’s finance ministry role is vital, and none more so than in the coming period when making the consolidation stick must be the department’s number one priority. However, the economics ministry role remains as relevant as ever. But in carrying it out, the Treasury works best when it is operating at a strategic level: creating the framework or legislation, and leaving it to others to put it into operation. And so the challenge is to define clearly the boundary between the Treasury and its partners which maximises alignment and minimises duplication.

One example of this is public service reform. The Treasury needs to focus on the big strategic risks, rather than spread itself too thinly, interfering in what should be the responsibility of departments.

Another example is financial regulation. With the enactment of the forthcoming legislation, it will be the Bank of England which is responsible for macro-prudential policy, as well as prudential regulation and for the resolution of banks in a crisis. But we will still have responsibility for the framework as a whole and will need to retain a capacity to be an intelligent interlocutor and to take charge in a crisis when taxpayers’ money is put on the line. This is not new; the monetary policy framework follows a similar model, but the Strategic Review pushes us to be more rigorous in applying this approach across the Treasury’s other areas of business.

And it is right that responsibility for the financial services framework remains in the Treasury, as it has since the 1990s.

The banking crisis underlined the linkages between financial and economic policy. That is informing the Government’s reforms to the Bank of England; and it has also reinforced the importance of the Treasury’s historic relationship with the Bank. Moreover, most new regulation emanates from Brussels, it is finance ministers who take the important decisions on financial service issues whether in the EU Council of Economic and Finance Ministers, or in the G20 at a global level. And the Government’s interventions in the banking sector in recent years have involved fiscal as much as economic policy judgements.

Another good example of our focus on creating clear partnerships is tax. The Treasury is best placed to ensure tax policy decisions are taken in the context of wider financial and economic policy: and its proximity to Ministers means that it is well placed to take into account the fundamentally political nature of tax raising. But Her Majesty’s Revenue and Customs have a critical role in ensuring that tax policy is informed by operational and implementation issues. They are inevitably closer to the detail and data. The relationship works best when the comparative advantages of each institution are exploited, and where the two institutions can challenge each other from a position of mutual respect. The relationship is not a contract: it is more like a marriage than an arms treaty.

But the Treasury’s effectiveness is not just about the way we are organised, or about how we work with our main partners. It is also about the people we have working here.

The events of recent years have demonstrated the need for a flexible workforce that can move quickly and effectively into new priority areas, with a set of skills that allows them quickly to deliver.

This is not to say that our staff should be moved around so frequently that they cannot develop expertise in critical areas. And in the past the Treasury may have celebrated youth a little too much over experience.

Recent events have also placed a high premium on expertise. Here, I think we have made real progress. We now have a critical mass of tax professionals. Our economist cadre is strong. And we have strengthened financial management expertise, as well as attracting people with operational experience of delivering public services. We are managing staff’s careers more proactively. And our best staff are increasingly going out of the Treasury on secondment to deepen their experience, whether working in a local authority or a front line department or the Bank of England. In my view, we now have a much more plural workforce which is better placed to deliver the right mixture of challenge and experience, as well as mitigating the risks of mono-cultural group think.

The areas where expertise has made the most difference are those most directly affected by the recent crisis: debt management and financial stability. Of course, we need to learn the lessons of the causes of the crisis. And that is informing the Treasury’s painstaking approach to legislation. But the professionalism with which the Treasury handled the crisis from the autumn of 2008 onwards has been recognised by external commentators. Only last week, Lord Myners said

“the analysis, advice and support I received from…[Treasury] officials… was as good as any I experienced in 30 years in the private sector and at least as good as that received from commercial parties advising the Treasury”

We have so far been successful in retaining expertise and that allowed us to deal more effectively with the sovereign debt crisis in Europe and the subsequent loan to Ireland. And the challenge will be to retain the right staff as our headcount declines.

It’s been a challenging few years for the Treasury, as it has been for the global economy. But I believe the Treasury has come through stronger as the nation’s economics and finance ministry and is well placed to deal with whatever lies ahead.