As soon as Sir Nicholas Hytner called the Arts Council of England's theatre policy “bollocks” I knew the council must have got it about right. Bollocks is one of those aesthetic terms that describes a funding decision with which you disagree, and is generally used in theatrical circles when your annual grant is reduced or even withdrawn.

The reason I instinctively think that the ACE must be right is that it has been doing its job, which is to look hard at the output of longstanding recipients of subsidy and then to decide that the time has come for someone else, who is producing more interesting work, to have a go. The outrage is inevitable - it goes with the territory.

I remember, when chairman of the Scottish Arts Council, being torn to shreds by a House of Commons select committee that objected to the withdrawal of funds from a much loved theatre group whose performances, in our view, had been in decline. “Elitist!” roared an exasperated MP. “You're just a committee of elitists.”

Which was true, of course. The word elitism stems from the Latin eligere, meaning to select or choose. Those who choose are exercising a judgment, which, in the case of the Arts Council, they are constitutionally required to do. And the judgment they have made on this occasion is that excellence should be rewarded at the expense of those who are slightly less excellent. This is a welcome change (a “rebalancing” was the word used by one ACE insider) from a previous era in which art was sponsored not because it was notably good but because it met some preordained target, such as promoting education, encouraging access or supporting social inclusion.

That approach has been deftly sidelined by Sir Brian McMaster, former director of the Edinburgh International Festival, who, at the request of James Purnell, the Culture Secretary, has just issued an important report on how best to support the arts. He has been unequivocal in his championing of the highest standards:

“Those that give out and those that receive public subsidy have a responsibility to ensure that from every penny spent, the greatest value is extracted. Distributors of public funds should not spend money on what is not, or does not have the potential to be, excellent. Nor should they be putting subsidy where it is not needed, where the market can sustain an artist or an organisation without compromising their artistic integrity.”

Sir Brian applied those criteria mercilessly during his Edinburgh tenure. Thus, Scottish Ballet was regularly excluded from the programme until, under its present artistic director, it achieved international standards of performance. Scottish Opera had no automatic entry to the repertoire, and certain highly regarded composers rarely featured, because that high regard was not shared by the one man who mattered most - the director himself.

To complain, therefore, that the ACE has decided to endorse that vision of excellence is self-defeating. Amid all the sound and fury, the oddest comment came from the actor and director Sam West, who said that the McMaster report seemed to represent a genuine rethink of Arts Council policy. He then went on to say that, by implementing it, the ACE had shot itself in the foot. One man's shot in the foot, however, is another man's considered judgment - someone has to decide what is good and what is bad.

Theatres in England have no reason to complain about the level of subsidy they have been receiving. Six years ago they were given an unprecedented bonus when they received £25 million in government funding to revive regional theatre. The result was more ambitious productions, bigger audiences and the opportunity to experiment with new work. Those who built on that foundation are continuing to do well. The others, apparently, less well.

If, as a result, harsh judgments have had to be made about theatres such as the Bush, the Bristol Old Vic, the Northcott in Exeter and others, then this is an inevitable outcome of the selection process. Not only is government funding finite - though it has increased above inflation this year - it cannot be to the benefit of the arts that every organisation continues to receive regular funding, however varied its performance is. Only the French subsidise their arts companies regardless (“on ne peut pas quand même laisser tomber un opéra,” one venerable French official once told me.) Here, they are judged, by their peers, on the basis of how well they have performed and how available their productions have been.

Of course, determining what constitutes excellence and who should be making that decision is the most contentious matter in the cultural world. Arts councils are never popular; their panels are usually held to be too narrow, too bureaucratic and too introverted. But in my experience they are just as human as those outside who protest at their decisions. Most panels draw on artists, actors, directors and practitioners who are motivated by an enthusiasm for their art form and a desire to see it practised at its highest level. The present proposals from the ACE are not even the last word on the matter - there will doubtless be some last-minute reviews.

All in all, the theatre is making a greatly overinflated fuss about a process that is the least bad ever invented. The alternative might be to withdraw arts subsidy altogether, and allow the market to dictate the outcome, US-style. With the prospect of a recession impending, and more cutbacks in public funding, it just could be that the arts will have to survive not on the bounty of a government body but on whether they can find an audience to support them. Now that really would be bollocks - wouldn't it?

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