A policy in search of a rationale

From its earliest days, privatization was described as a ‘policy in search of a rationale’. Actually the problem was not so much the absence of a rationale as the presence of too many. As with the war in Iraq, different players in the policy process supported privatization for different reasons, and expected different outcomes.

Sometimes it was a simple matter of class politics. Privatization is bad for unions, which tend to be stronger and more effective in the public sector. It is usually good for the incumbent senior managers of privatized firms, who move from being relatively modestly paid public sector employees, constrained by bureaucratic rules and accountability, to doing much the same job but with greatly increased pay and privileges, and far fewer constraints. It is always good for the financial sector, which earns billions in fees for managing asset sales, not to mention the returns from advising the bidders, and the pure profits gained in common cases where the asset is underpriced and can be quickly resold at a much higher market value. For politicians eager to bash unions, and politically beholden to the financial sector this was a great deal. Hostility to unions was strong on the political right, particularly after the upsurge in strikes and militancy in the 1970s.

Governments mostly thought about privatization as a way of fixing problems of public finance. Government ministers short of money to pursue pet projects, to finance tax cuts, or simply to deal with growing budget deficits saw the sale of valuable assets as an easy and politically costless source of cash. The question of what would be done when there were no more assets to sell was left for another day.

In other cases, faced with the need to spend money modernizing infrastructure, but unwilling to take the necessary steps to pay for it, by raising taxes and charges or by adding to public debt, governments used privatization as a way of shifting the problem to the private sector. The privatization of the water supply industry by the British government, in response to pressure from the European Union to improve environmental health and safety is one well known response.

Economists, at least when they were thinking clearly and speaking honestly, were as one in rejecting the most popular political reasons for privatization: that is was a source of cash for governments, or a way of financing desired public investments without incurring public debt.

On the first point, it is a basic principal of economics that the value of capital asset is determined by the flow of earnings or services it generates. So the cash gained from selling public assets comes with the cost of forgoing the earnings it would have generated in continued public ownership. In a world where both governments and markets were perfectly efficient the cost would be exactly equal to the benefit and privatization would not change anything. As we’ll see below, things are more complicated than that. But that doesn’t make the idea that selling assets is a source of free cash any less silly.

A more sophisticated version of the same error is to suppose that governments facing debt constraints that restrict investment in desirable projects can get around those constraints by bringing in private investors. Once again, the problem is that the returns (such as proceeds from toll roads) needed to attract private investors represent money that could have been used to service public debt. So, the more private money is used to finance public infrastructure, the smaller the amount governments can invest without running into problems. As the exasperated secretaries of Australian state treasuries once put it, privatization and public private partnerships create no new ‘pot of money’ to spend on public infrastructure.

Privatization will yield net fiscal benefits to governments only if the price for which the asset is sold exceeds its value in continued public ownership. This value depends on the flow of future earnings that the asset can be expected to generate. The question of how to determine this value remains controversial, and will be discussed later, in relation to the equity premium puzzle.

Because claims about the fiscal benefits of privatization so commonly involved confused or fallacious arguments, most economists generally to focus on the potential benefits of privatization in promoting competition. Although extreme market liberals gave unconditional support to privatization, the majority of economists favored breaking up public enterprises and stripping them of monopoly privileges before privatization. However, since such measures inevitably reduced sale prices, and the opportunities for incumbent managers to enrich themselves, they were rejected in many cases. Going beyond such structural changes, economists emphasized the importance of governance as opposed to ownership.

The dominant view was that, given appropriate regulation and pro-competitive policies, it should not matter whether enterprises were publicly or privately owned. Hence, assuming private firms were more efficiently run, this view suggested that privatization should always be the preferred policy, provided that opportunities for competition were not compromised in the process.

A variety of rationales for privatization were put forward by a variety of political actors. But more and more, privatization was driven by the power of the financial sector, which benefits both directly and indirectly from privatization. The direct benefits include the massive fees and bonuses derived from managing privatizations. The indirect benefits include the enhanced economic and political power of the financial sector in an economy where all major investment decisions are driven by the demands of financial markets. In the era of market liberalism, this power extended over all major political parties. As US Senator Dick Durbin said “the banks are still the most powerful lobby on Capitol Hill. And they frankly own the place,"”. He could equally well have been talking about the City of London and its dominance of British politics. The situation in other developed countries was rapidly becoming similar. In Australia, for example, it has become routine for retired politicians to be offered cushy jobs in the financial sector, provided of course that they have followed the right kinds of policies when in office.

The competing rationales for privatization share one common thread. This is the belief that there is always a net social benefit to be realized from converting a publicly owned enterprise into a private firm. Some advocates of privatization (including many politicians) hope that this benefit will take the form of an improvement in the net worth of the public sector, others (including economists) that it will mean lower prices for consumers, and yet others (notably including the financial sector) that they can appropriate the gains for themselves. But this disagreement over who should benefit masks a shared assumption that there are net benefits to be fought over.

The claim that privatization always yields net social benefits was not always made explicit, but it was implicitly taken as common ground in most of the discussion of economic reform during the era of market liberalism. It is important, then, to understand what this claim entails.

Markets, governments and efficiency

When all the spurious arguments for privatization are stripped away, the central implication of the ideology of privatization is the claim that an economy in which all major decisions on investment, employment and production are left to private firms will outperform a mixed economy where governments play a significant role in such decisions. In particular, provided private firms are free to compete on a ‘level playing field’, they will always have a higher value than they would have under public ownership.

If the efficient markets hypothesis represents the negative side of the market liberal case, implying that no alternative institution can outperform markets, the case for privatization represents the positive side, implying that more private ownership will always improve economic outcomes. The market liberal ideology of privatization asserts that, private firms can outperform governments in the production of goods and services of all kinds, including those that have long been funded and provided by the public sector, such as school education. This assertion includes both a short-run component, based on the claim that private enterprises will operate more efficiently than their publicly owned counterparts and a long run component based on claims that privatization will improve investment decisions.

The short run claim is that, because of the incentives associated with private ownership, private enterprises are always more efficient than comparable public firms. Broadly speaking, this claim is true to the extent that profitability is a good guide to efficiency, which in turn depends largely on the absence of significant market failures. Private firms are controlled by their managers who may or may not be accountable to outside shareholders. In general, both managers and shareholders benefit significantly from increased profitability, though the relationship is more direct for shareholders.

By contrast, public enterprises are accountable to governments and therefore, indirectly to any group to which governments respond. In the presence of market failure, such accountability is likely to be beneficial, since government enterprises are under more pressure to promote better social outcomes, even at the expense of profitability. On the other hand where market failure is unimportant, requirements for accountability are likely to impede efficient decision-making. And, as public choice theorists pointed out in the 1970s, accountability requirements may be used by special interest groups to demand favorable treatment, such as above-market wages for unionized workers, or better service for politically influential customers.

The long-run case for privatization is based on the idea that the allocation of investment will be better undertaken by private firms than by government business enterprises. This claim in turn relies on the assumption that the evaluation of risk and returns undertaken by investment banks, with the assistance of ratings agencies, and the availability of sophisticated markets for derivatives like CDOs will be far superior than anything that could be obtained by, for example, using engineering calculations of the need for investment in various kinds of infrastructure, and seeking to implement the resulting investment plans on a co-ordinated basis. The GFC has shown that, for most of the past decade, market estimates of the relative riskiness and return of alternative investments have been entirely unrelated to related.

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