How to reduce budget expenditure?

02. septembris, 2009


Vjačeslavs Dombrovskis

"Well how can you?", many would say. Reduce wages of school teachers, doctors, etc. further? Lay off more of them? Pensions? Well, no, no, and no. Further budget cuts are possible, and they might not be so painful. The problem is that most discussion of public expenditure narrowly focus on only three aspects: (i) reducing wages in the public sector; (ii) layoffs; and (iii) the so-called "structural reform". The first two options have probably been largely exhausted. I've always had doubts about the size of the possible public sector efficiency gains through this structural reform. I mean, design of structural reform requires substantial competence in the public sector. Given that lack of competence is one of the factors that brought us here, we're back to square one. There is one more aspect of government activity that has been ignored, however. I am talking about public procurement.

Public procurement is huge – at about 17% of GDP. The state is buying lots of things from the private suppliers, ranging from toilet paper to the ‘Palace of Light’. “So what?”- you may ask. Well, the thing is that the government is probably paying last year’s prices for what it buys. And those who have reservations about the bureaucrats’ honesty would also point out that many public procurement contracts are rigged and contain ‘kick-backs’, implying that the prices are inflated. Yet what Latvia is going through, all according to our “stabilization plan”, is internal devaluation. This means that wages and prices must go down via market adjustment. The wages are falling, thanks to the 200,000 unemployed. This exerts downward pressure on the level prices, with deflation being the result. This suggests a solution to the problem of budget deficit.

Thus, what the government should do is to TERMINATE ALL PUBLIC PROCUREMENT CONTRACTS, invoking the force majeure clause.

From Wikipedia:

Force Majeure (French for “superior force”), also known as cas fortuit (French) or casus fortuitus (Latin), is a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, or an event described by the legal term “act of God” (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract.

This country is going through what might the biggest fall in GDP that has ever occurred in peace-time (anyone has data on this?). In my view, this fits the definition of an “extraordinary event”. So, step 1: terminate all public procurement contracts. Step 2: offer existing suppliers to re-enter the contracts on the same terms but with one exception. Say, a 20% lower price. In the event that the supplier disagrees, a new price survey would conducted immediately among all eligible suppliers. Given how hard the recession is, I don’t think there would many suppliers that would argue. Note that we’re talking about potentially huge savings of the order of 3.4% of the GDP here. This would go a long way towards reducing the budget deficit.

Basically, all I am saying is that the public sector should take advantage of the deflation process. It’s easy to check whether I am right using a simple methodology. Start with finding a few competent and trustworthy people. Let them draw a relatively small but random sample of procurement contracts within each ministry. Have them conduct a discreet price survey for each of the contracts by telephone. Compare obtained prices to those in the government contracts. I am sure we would see huge differences.

I expect three kinds of opposition to this proposal. First, the lawyers are likely to point out that things are much more complicated and they will probably be right. The legal risks are not insignificant. The attractiveness of this solution would depend on careful analysis of public procurement contracts and the resulting assessment of the expected future liability. However, the legal costs are likely to be mitigated by two factors. First, I think many firms would accept the offer and, therefore, forfeit their right to go to court. Second, even if the court would come to conclusion that this was unlawful and, therefore, government is liable, this would still take several years for them to figure all this out. And who knows, maybe legal scholars will spend the next ten years writing dissertation about this! However, when he courts will finally sort out whether the government is to pay damages in, say, five years from now, the interest rate they would use would still be much below today’s market rates faced by the Latvian government! How would that be different from a loan from the IMF?

Second, I expect opposition from a number of politicians because public procurement, probably, contains a good deal of political payoffs. Such a solution would mean that politicians would have to default on their promises to the supporters in the private sector. Understandably, the well-connected who benefit from public procurement would not like this.

Third, some people may point out that this is a sort of internal default. It probably is. However, how is this different from the effective default to the pensioners, teachers, and doctors? It’s all a matter of who is it that politicians decide to hurt. The pensioners? Or, the well-connected businessmen?

Extraordinary situations demand extraordinary solutions. This is one of them.

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