The failure of Hackney’s privatised benefits service lies at the heart of this week’s threat by local government secretary Stephen Byers to take control of the troubled council’s finances.With the prime minister apparently determined to push ahead with greater business involvement in public services, the council’s predicament also serves as proof that the private sector does not hold all the answers to improving public services.Hackney’s 10-year, £70m revenues and benefits contract with software services company ITnet began in 1997. Last November, the audit commission reported that the borough’s housing benefit system was “in a poor state” with some 17,000 claims awaiting assessment. The council claims the company was taking “months” to turn claims around.

After much wrangling, ITnet finally stopped providing the service to Hackney in April this year, leaving the borough with what it claims is a backlog of 120,000 items of unprocessed correspondence, relating to an unknown number of individual cases.

More importantly, Hackney has to foot a substantial bill for benefit errors and overpayments. The council’s leadership initially expected these to total up to £4.5m in the current year. Now that the borough has set up its own in-house benefits team, which is sorting through the backlog, that estimate has risen to at least £11m.

An ITnet spokeswoman disputed Hackney’s claims, claiming that the council’s correspondence backlog claims were “ludicrous”. The company had improved the council tax collection and housing benefit services it provided, she said, and is running a successful service in the London borough of Hounslow.

Nonetheless, the extent of the errors and overpayments caused senior officers at the council to threaten to issue a section 114 report, which effectively freezes spending, last week.

The report would have blocked Hackney from entering into any new financial commitments until the council has met to consider the document. If this happened, the borough might not have been able to renew the short-term or agency contracts of staff in education, benefits and social services.

The council’s leader, Jules Pipe, whose Labour group recently gained overall control, said: “Although there are identified potential overspends in some of our budgets, these issues have been completely dwarfed by the unforeseen costs that we now face as a result of the failures of our revenues and benefits service.”

The council says it will go to the courts to try and claim back an initial estimate of up to £30m, but it will not come quickly enough to stave off a potential overspend in the current financial year.

Meanwhile, the government is allowing Hackney to borrow enough money to see it through this crisis, and Mr Byers is working with the audit commission to decide whether and how to intervene in the borough’s finances.

Hackney council was not the only organisation to suffer from the break-up of the benefits contract. ITnet itself faced a grilling in the media and the City, with the dispute resulting in the company changing its accounting policy – a move that hit its profits.

The dispute also focused media attention on ITnet’s work in Islington. The council is revising its contract with the company in the wake of what leader Steve Hitchins calls its “unsatisfactory” performance.

Hackney cannot have been the easiest of places to try to run the government’s complex housing benefit system. ITnet claims it inherited a hefty housing benefit backlog and an IT system that was years out of date.

ITnet took over the revenues and benefits service just as political tensions in the council were coming to a head. Hackney became hung in 1996, and a lack of political leadership combined with some bitter disputes and a programme of radical managerial change to cause chaos across the council.

The creation of public private partnerships in local government has often been seen as a remedy for poorly performing services. ITnet’s case proves that no matter how mighty or successful a private company may be, it will never provide a magic solution to the public sector’s problems. Tony Blair should take note.