The unions that accused the Government yesterday of being “dictatorial” over public sector pay should have more respect for the people who are footing the bill. Taxpayers who fund these jobs - roughly 700,000 new ones created since 1999 - have a right to expect the Government to show financial discipline. The public sector now employs a staggering one in five working adults, who constitute an economic bloc of their own.

Ministers' attempts to hold down most public sector pay rises to 2 per cent last year caused an outcry among the unions, which represent 60 per cent of public sector workers. They are now fuming at the Chancellor's proposal to replace one-year pay deals with three-year ones. The proposal makes sense, given that expenditure plans are set in three-year cycles. Many teachers and Customs staff are already on such contracts. But others understandably fear that this is a ploy to cut real wages.

Three-year deals would let ministers escape the pain of the annual haggle. Yet given that the years of plenty are over, it might also be advantageous for public servants to “fix” in now for three years, to a sum that will be paid in full, rather than risk pay awards being “staged”, or cut back, at a later date. That is effectively the deal which the Home Secretary offered the police yesterday. They would be wise to take it.

Alistair Darling has rightly rejected demands for a midway break clause, which unions wanted in order to safeguard members against unexpected rises in inflation. He could not agree to something that would be tantamount to index-linking, given that his goal is price stability. At the moment, the chief inflationary pressures in the economy are oil and energy prices. But there is no reason for wage rises to compound the headache.

Having to lump 5.9 million workers together is, however, pretty unsatisfactory. Rigid national pay structures have created the absurd situation in which a nurse in Sunderland is paid the same as a nurse in Swindon, although the cost of living in Swindon is higher. Even London weightings no longer seem to offer adequate compensation for higher housing costs. Ideological resistance to anything remotely approaching the private sector's understanding of performance pay also means that wages only poorly reflect output.

That government wages are effectively higher in the North is reflected in much lower staff turnover in public services there than farther south. Perversely, a government that came to power committed to reducing the economic gap between North and South has helped to entrench that divide by expanding the public sector and by sticking to rigid pay rates that have made it such an attractive employer there. Some parts of the economy, notably in Scotland, have become so dependent on public sector largesse that they seem doomed to fail to revive any lifeline of entrepreneurialism.

As Chancellor, Gordon Brown expressed keen interest in regional pay bargaining, which would have allowed increased flexibility to distribute funds within a fixed overall budget. This was bitterly resisted by the unions, nervous of the implications for pay. But the idea should be revisited. A more flexible system would link reward more closely to productivity. It would more realistically reflect working conditions, cost of living, labour shortages and local markets. That must be the goal in the long term, and unions do themselves no favours by resisting reality.