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Chris Cook: The hazards of moral hazard

Friday 27 November 2020

The government may allow a council to fail to set an example to others. But this isn’t a time for setting examples

The London Borough of Croydon is bust. The town has issued a Section 114 notice, indicating that it cannot meet its commitments – and any spending not mandated by statute will need to be run past the town’s finance officer. This is a local failure, for sure. It is Croydon councillors who ignored warnings about the finances over several years. But it is also a national policy problem.

Croydon is, as it happens, where I grew up – and I have a long track record of complaining about how badly administered it is. The auditors’ notes reveal that the council forgot to keep up the paperwork for a little holding company through which it owned stakes in some local developments, and so the company was dissolved. I am not enormously surprised.

The proximate reason for the collapse was the pandemic. It is a dormitory town, a retail hub and a nest of large offices. But Croydon was also one of the councils nearest the end of the financial gangplank. The town budget had been run too hot coming into the crisis – it kept too little in reserve for rainy days. It is its own fault that it had so little slack to absorb a shock.

According to the auditors’ reports, the town’s spending on social care kept rising – and swamped the town’s budget. The auditors noted: “70 per cent of the Council’s spend is on demand-led services (children’s and adult social care) where the focus has been on improvements in service delivery without sufficient focus on controlling the related costs.” 

At the same time, the council held the equivalent of only 4 per cent of its annual income in reserve cash that could be spent without restrictions: “The Council has had the lowest level of all London Boroughs of General Fund and Earmarked General Fund Reserves as a percentage of net service revenue expenditure and the reported level of reserves has continued to decrease in each of the previous three years,” the auditors noted. Things were on the slide before the pandemic.

As Graham Atkins at the Institute for Government notes, the council’s decision to start buying up local commercial property also left it at risk. He notes that the town “had the sixth highest level of interest and investment income as a percentage of spending of any London council”. It is hard to put precise figures on this, but one measure implies that the council has spent around £200m in this area.

There are good reasons to be wary of listening to the pleading of a council with weak budget controls that has spent big on discretionary projects. That, indeed, is the central government’s starting point. It is almost an iron law of the British state that its first concern is moral hazard: “If we bail you out now, what example will that set?” But here is another rule: during a crisis that will not recur, moral hazard generally doesn’t matter. 

After all, it is unlikely that towns will start burning off their reserves to overspend on commercial projects or social care in the coming years in the hope of getting a bit of help with debt relief during a future global pandemic. You can probably be generous now knowing that people will not be expecting another year like 2020 any time soon. 

Indeed, there is a converse problem with financial contagion. Having seen that the government will let councils fall over during the crisis, the officers in other councils will be extremely brutal about their own financial situation. These are people taking a bigger role in contact-tracing; the people who run the care homes; the people who organise school transport for vulnerable families; the people who look after the most vulnerable. Do we want them to start cutting back? 

Croydon is planning to make savings on social workers to balance its budget during a pandemic. It might be that Croydon – and other boroughs – do need to sell off their investments to deleverage their balance sheets. But do we want them to do it now – in a mid-pandemic fire sale? 

Indeed, it is worth going back to first principles. The most important strategic priority is getting through the pandemic. It is not an endorsement of any town’s prior management to think this is the wrong time to have them recast their balance sheets and services. The Treasury should plug up more gaps now. We will have time to argue about what the operating surpluses should be in normal times when normal times return.