Home > Economics - General > Refuted economic doctrines #2: The case for privatisation

Refuted economic doctrines #2: The case for privatisation

January 3rd, 2009

This is the second in a planned series of posts assessing the implications of the global financial crisis for the economic ideas and policies that have been dominant for the past few decades. The large-scale privatisation of publicly-owned enterprises both in capitalist countries like the UK and Australia and in formerly communist countries after 1989 played a big role in promoting the kind of triumphalism that characterised much commentary about free-market capitalism in the 1990s and (to a somewhat lesser extent) in the years leading up to the crisis. How well do arguments for privatisation stand up in the light of the financial crisis.

The case for privatisation had two main elements. First, there was the fiscal argument for privatisation, namely, that governments could improve their financial position by selling government business enterprises. This argument assumed that privately owned firms would have higher levels of operating efficiency, and therefore that the value of those firms would be increased by privatisation. The second argument was a dynamic one, that the allocation of capital between alternative investments would be improved if governments were not involved in the process. Both of these arguments have been fatally undermined by the collapse of the efficient markets hypothesis.

The fiscal case for privatisation must be assessed on a case by case basis. It will always be true for example that if a public enterprise is operating at a loss, and can be sold off for a positive price with no strings attached, the government’s fiscal position will benefit from privatisation. Various early ventures in public ownership, such as the state butcher shops operated in Queensland in the 1920s (apparently a response to concerns about thumbs on scales) met this criterion, and there doesn’t seem to be much interest in repeating this experiment. However, for most recent privatisations in developed countries, the sale price has been less than any plausible estimate of the value of future earnings, discounted at the government bond rate. The fiscal case for privatisation therefore rests on the claim, derived from the efficient markets hypothesis, that the correct discount rate to use is one based on the private sector cost of capital and therefore dominated by the expected rate of return to equity capital.

The choice of discount rate makes a difference because the rate of return to equity has historically been much higher than the rate of interest on government bonds, a gap that can’t be explained by standard economic arguments about risk premiums. Although many explanations of this ‘equity premium puzzle’ have been offered, for present purposes they can be divided into two classes
(i) those which assume that the EMH is true, and imply that the equity premium is a correct reflection of economic risk, independent of equity markets
(ii) those in which the risk premium for equity reflects failures in equity markets that lead people to prefer holding bonds
In the light of the GFC and the events leading up to it, the case for explanations of type (ii) is overwhelmingly strong

The dynamic case for privatisation 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. For infrastructure in particular, the decision processes of Byzantine creations like Macquarie and Babcock and Brown have determined the allocation of investment. Unsurprisingly, the result has been a mess.

I’ve been making this argument for some time, so I can anticipate the immediate response that, if the case for privatisation developed in the 1980s were invalid, it would be necessary to advocate public ownership of all enterprises. I’m never quite sure if those putting forward such arguments are as ignorant of marginal cost and benefit calculations as they appear to be, or whether it’s simply meant as a debating trick. But it should not be hard to see that, if the public sector has lower costs of capital, while the private sector has (at least in a wide range of activities) lower operating costs and greater responsiveness to consumer demand, the optimal economic structure will involve public ownership of some firms and private ownership of others, that is, a mixed economy.

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  1. Alanna
    January 9th, 2009 at 10:51 | #1

    Agree completely Winton – it all comes down to a moderate approcah to the usefulness of the PPS. Water – crazy. It can cause civil disruption. Electricity – same. Transport and roads – people need it to get to work. Education – mixed but the greater weight should be for access to the majority – ie on the public side. Basic infrastructure – should be recognised for its collective use. Back to JQs suggestion, the most sensible – case by case but with hands off exceptions. Water, electricity and public mass transport systems should be on that list as should be the cost of election campaigns (and no donations at all permitted ever) and an independant broadcaster to keep the bastards honest.

  2. nanks
    January 9th, 2009 at 10:59 | #2

    @Alanna “as should be the cost of election campaigns (and no donations at all permitted ever) and an independant broadcaster to keep the bastards honest.”
    Oh that would be sweet – but more than one independant broadcaster, using a funding method that removes the sort of political disruption we have seen at the ABC for quite a while and SBS more recently.

  3. Barni
    January 10th, 2009 at 06:25 | #3

    You say: …. while the private sector has lower operating costs and greater responsiveness to consumer demand, ……
    The operating costs may be lower due to lower wages and benefits but the difference is more than made up in profits fueled exclusively by greed. As for responsiveness, private ownership will only provide those products/services on which they can make the most money. An example is the major American drug company which has a cure for a kind of childhood brain cancer but will not make it because the number of cases is not enough for them to make the proscribed greedy profit.
    The notion that private enterprise equates to a “free market” is nonsense. A free market is a market for which there are no barriers to entry or exit. Does anything seen in the last century even vaguely resemble this?
    Free market is used like a syllogism – the worst manipulative form of logic, two premises and a conclusion. Premise 1: free is good; premise2 market is good; therefore free market is good. When one accepts such a syllogism all critical thought stops – this is the purpose of a syllogism. It is the favourite tool of all public manipulators and a speciality of right agenda ideologues.

  4. El Mono
    January 10th, 2009 at 10:23 | #4

    Barni, their is nothing wrongs with a system that makes use of peoples self interest, it is important to a acknowledge the limitations though. Declaring all private enterprise as evil is just as idealogically driven and unhelpfull as ignoring the limitations of the market.

  5. TerjeP
    January 10th, 2009 at 12:44 | #5

    1: free is good; premise2 market is good; therefore free market is good. When one accepts such a syllogism all critical thought stops – this is the purpose of a syllogism.

    I accept the syllogism but critical thought has not stopped. Where the evidence is clear that intervention works to make things significantly better without unbearable cost I’m happy to have intervention. To judge such evidence we should use something comparable to a jury system where the evidence needs to be credible to well more than 51% of the peoples informed represenatives. I’d propose that we allow interventions to be legislated with a sunset clause of no more than 20 years unless a supermajority of 75% of parliament is convinced by the evidence.

  6. piglet
    January 13th, 2009 at 08:22 | #6

    “An element to be kept in mind is that private companies fear the government, and therefore can be more responsive to customers’ complaints.”

    I don’t think that is true. To the contrary, I believe that one big reason why politicians have come to love privatisation so much is exactly the fact that they won’t be held responsible any more. When a government-provided service is performed badly, people know where to complain: it’s the government’s fault. If that service is sufficiently important and popular, it’s quality becomes a high profile political issue. Once that service is privatized, it’s “the market” or “the economy” or whatever. You cannot complain about “the market”.

    Train delays, fee hikes, denied health care? A scandal if the government is responsible. Business as usual if it is a private business decision.

  7. piglet
    January 13th, 2009 at 09:05 | #7

    “Q3. In a sector, such as banking, where there are many successful and popular private operators what is the merit of the government also being a supplier? And which bank should it buy?”

    This is an interesting question and it is related to the financial crisis. Many governments do provide financial services. Switzerland is a major example. Most states operate their own bank (Kantonalbank, some of which have meanwhile been privatized) and the federally owned Postal Service, although not a full bank, is actually the country’s biggest financial services provider (by customers, not by revenue, of course). Having public institutions provide cheap and reliable financial services for ordinary people has been and is still regarded as important, and I believe adds stability to the financial sector. Moreover, a host of co-op savings banks similarly provide banking services. This is “mixed economy” at its best and in my experience, ordinary customers get much better services and lower fees here than in the US where there are virtually no non-commercial banks.

    Germany’s financial sector has a similar structure but the Postbank there has been privatised, and some of the public institutions have been involved in the financial crisis due to lack of oversight. It should be noted that even many government-owned companies have in recent years adopted a “privatization” mindset, increasingly acting like ordinary profit-maximizing coporations, often with the blessing of regulators. That is likely to change now that the consequences are becoming obvious. But the municipality-owned savings banks (Stadtsparkasse or Kreissparkasse) that still serve most Germans are now seen as solid as a rock and customers of the commercial banks are coming in droves to deposit their savings.

  8. January 14th, 2009 at 15:58 | #8

    I commend the article “National broadband: what kind of monopoly?” by Tristan Ewins on Online Opinion. The forum discussion is here.

  9. Kaleberg
    February 4th, 2009 at 09:36 | #9

    I remember the 1960s when NYC privatized commercial trash pickup. I remember a friend of my father’s saying quite simply, “the family”. He was referring to the Mafia and organized crime. Sure enough, that’s who ran commercial trash pickup in NYC into the 1990s when the likes of Rudy Giuliani finally put an end to it. (One undercover cop who pretended to be a building manager did such a good job that the building hired for that job him when he left the police force.) Needless to say, the private sector was able to keep costs relatively high. It’s not sure if anyone saved any money on trash pickup since the Mafia guaranteed each of its operators a profit. Of course the trash pickup guys got lower pay and fewer benefits than if they had worked for the city, but that’s what privatization is all about.

  10. Alanna
    February 4th, 2009 at 11:05 | #10

    Kalenberg#

    Didnt something like that happen in Naples under Berlusconi? Garbrage piled up on the streets (to the utter amazement of the rest of the world ?)

    See these photos for privatised and now mafia run garbage collection. Its a shocker. Unfortunately privatisation doesnt incorporate morals testing. If ever there was a case for nationalising garbage this is it!

    http://www.time.com/time/photogallery/0,29307,1702831,00.html

    and
    http://www.reuters.com/article/worldNews/idUSL0830577220080109

  11. Alanna
    February 4th, 2009 at 18:20 | #11

    62# J’accorde les points Ă  Cent commentaires…

  12. February 19th, 2009 at 03:07 | #12

    Privatisation as a principle has failed. The stimulus package been introduced is a complete negation of the privatisation doctrine which has been preached and forced on developing Economies. The insistence that governments do not have a role to play is now been revised now that they are faced with similar situation. This is Hypocrisy . Now where is IMF that would insist of privatisation before Aid is given to developing?.

  13. February 19th, 2009 at 03:08 | #13

    Privatisation as a principle has failed. The stimulus package been introduced is a complete negation of the privatisation doctrine which has been preached and forced on developing Economies. The insistence that governments do not have a role to play is now been revised now that they are faced with similar situation. This is Hypocrisy . Now where is IMF that would insist of privatisation before Aid is given to developing countries?.

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