Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 26 May 2014

The state, corporations and markets

I have written in the past that I have no idea how large the state should be, so this issue has no bearing on my views about austerity or fiscal stimulus. In this post I explain why I have no idea. My argument is that the optimal private/public split will depend on a number of particular and highly contextual issues, about which economics will have a lot to say but where it is unlikely to generally point in one direction. It seems worth making this - I hope uncontroversial - point when the current UK government seems keen to privatise or outsource by one means or another so much of the public sector.

There are two claims about government often associated with those who argue in favour of privatisation. One is that markets provide a better allocation system (e.g. here, and follow-ups here and here). For many activities this is undoubtedly true, particularly where markets involve a large number of buyers and sellers, and information problems are small. However much public sector activity is in areas where market imperfections and informational problems of various kinds are endemic. In that situation, market based systems may perform worse than alternatives: a comparison of health systems in the UK and US is an obvious example (e.g. here).

The simple fact that large corporations exist could illustrate potential problems with markets as an allocation mechanism. Large corporations may exist because they find it more efficient to organise activity in a non-market (often hierarchical) manner, or they may exist because markets can be circumvented by rent seeking, or they may exist because of increasing returns. This means markets can be fragile or inefficient. Economics is not a discipline that tells us market allocation is always best, but one that tells us when it may work well and when it may not.

In reality privatisation or contracting out often involves relocating some activity from government bureaucracies to corporate bureaucracies. George Monbiot argues that we are seeing power gradually shift from the former to the latter. The second general argument in favour of this shift is that the profit motive provides an effective incentive system for ensuring efficiency. Yet this argument alone is not enough. It is perfectly possible to run parts of government like a company, where the explicit aim is to maximise profits. Take the East Coast mainline rail company in the UK, for example. It has been running as a publically owned company since 2009, after the private company running the franchise got into difficulties. It appears to have been run very successfully under public ownership, but the government wants to return it to the private sector. The motive does not appear to be pressure from the public or customers.

The complete argument for preferring private sector rather than public sector bureaucracies is that shareholders are better at ensuring managers maximise profits (and therefore efficiency) than politicians. In fact the argument has to be stronger than this: the gain in profitability has to exceed the cost of diverting some of those profits from the public to shareholders. Again I think in many cases this will be true, particularly if checks within government are poor and corruption widespread.

However, control by shareholders may be far from ideal, as the recent debate in the UK about the proposed takeover of AstraZeneca by Pfizer has illustrated: see this article by Martin Wolf for example. One argument that has been made in this debate is that shareholders may be unable to prevent managers focusing too much on the short term, because that enables them to expropriate a share of the surplus in excess of their marginal product. Shareholders’ ability to directly control managers appears weak, and the takeover mechanism itself seems highly ineffective at punishing inefficiency. Martin Wolf argues that the real purpose of shareholders is to provide insurance against unexpected shocks that could otherwise lead to bankruptcy.

The process of tendering for the outsourcing of services paid for by the public sector allows periodic pressures for efficiency. However often the contracts involved are very complex, and so they also provide an opportunity for firms to exploit the inexperience of the civil servants who represent the public. Finally if we want those undertaking public activities to be accountable as well as efficient, then it is not obvious that outsourcing is helpful.

What this all suggests to me is that the costs and benefits of privatisation will vary from case to case, and that this is an area where microeconomic analysis will be central. (For example, see this book by Massimo Florio which looked at the results of the Thatcher privatisations.) In such cases, an ideology that says that the private sector is always better (or worse) is not only unhelpful but dangerous. For example, an ideology that says that private sector provision is always better can be exploited by rent seeking firms. It can lead governments to privatise on unfavourable (to the public) terms, or with inadequate mechanisms in place to ensure value for money and prevent exploitation. At worst, rent seeking firms may be able to exert sufficient control over the political process to make this happen.

Given that my area of expertise lies elsewhere, you might have expected me to consider a macro argument that is sometimes made for privatisation, which is that it can help bring down public debt. This is either a terrible argument all the time, or just most of the time, but which will have to wait for a later post.


15 comments:

  1. The obsession of what relative proportion of the economy's production and resources are in the public and private sectors is peculiar to Anglo Saxon economics.

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    1. Michael Mann, the noted sociologist, has taken recently to thinking of the globe as divided into 'macroregions' sharing similar economic cultures, in which the Anglo-Saxon region is one.

      (From 'Thatcher', E.H.H. Green, 2006) for the 1980s privatisations = total sales £4,394.7 billion. Government outlays for advertising and fees £2,408.6 million. The government forwent £5,805.6 million in undervalued share prices. Thus total government costs were 17.72% of the proceeds of privatisation £8,213.2 million. 1980-90 privatisation campaign = saw shareholders in Britain grow from 3 million to 11 million. However, in 1990 54% of these capital-owners had shares in one company only, and a further 20% owned shares in just two. And moreover, institutional ownership of British companies 1980-90 increased from 72% to 79%.

      There is a nice and funny piece by David Runciman reviewing 'Branson: Behind the Mask' by Tom Bower in the LRB 20 March 2014, which looks at the ways Branson has profited from privatisation in the UK.

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    2. I find in Far Eastern economies even the distinction between public and private is largely irrelevant. A lot of "community federations", "private companies" with government, local and "community association" representatives dominating boards, "private" companies reliant on direct government/central bank lending appropriated from mainly publicly managed post office accounts which is how their monetary policy works...

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  2. Thanks, Simon. Really, this should be absolutely obvious to everyone.

    It annoys me deeply the prevailing view that there is an 'optimal size of the state'. That seems as dubious - and irrelevant - a claim, as that there is an optimal number of Bobs on a company's board of directors. Sometimes Bob is the right man for the job, sometimes he isn't, and yes it's unlikely that an entire board consisting solely of Bobs is the best possible one. But the proportion of Bob is a consequence, not something that is important in itself.

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  3. «One is that markets provide a better allocation system (e.g. here, and follow-ups here and here). For many activities this is undoubtedly true, [ ... ] In that situation, market based systems may perform worse than alternatives: [ ... ] Economics is not a discipline that tells us market allocation is always best, but one that tells us when it may work well and when it may not.»

    This is a notable moment, where our blogger claims the status of heterodox outsider, of renegade of the Washington Consensus and of mainstream Economics, of class warrior. :-)

    Now if only his microeconomic foundations were to become consistent with that :-).

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  4. Economics is not a discipline that tells us market allocation is always best, but one that tells us when it may work well and when it may not. ...

    Great phrasing. I wish this point was emphasized and explained and explored further (in the blogo-sphere and ongoing discussion). Or since it already has been, a pointer to where and when would be great (in a way that reconciled with contemporary econ I know this is heterodoxed a thousand ways)

    Thank you
    Dan

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  5. «It annoys me deeply the prevailing view that there is an 'optimal size of the state'. That seems as dubious - and irrelevant - a claim, as that there is an optimal number of Bobs on a company's board of directors. [ ... ] But the proportion of Bob is a consequence, not something that is important in itself.»

    Ahh that is what I think is the key. My impressions is that the debate on the "size of Government" is a shadow fight.

    In particular that "size of Government" is a euphemism for "size of downwards redistribution", redistribution from incumbents to non incumbents.

    The conservative interests opposed to downwards redistribution seem to reckon in a democracy with franchise not based on income Government is inevitably going to be used as way to redistribute downwards (the "47%" story), and therefore as long as that is true they are for a smaller Government, but tactically, in order to minimize downwards redistribution.

    Government is in large part a group purchase scheme, and I think that what really matters to them is not the size of the purchases, but exactly whom in the group pays the bigger share of the bill and who gets the bigger share of the purchases. That's what property owners and businessmen look at as to joint ventures and combinations too.

    Perhaps there are a few fellow traveler useful idiots of those conservative interests that take the "smaller Government" idea at face value.

    But my impression is that the bulk of conservatives don't care much if at all about the "size of Government" in itself; when big Government supports their interest, and redistributes upwards from non-incumbents to incumbents, their "size of Government" story gets forgotten, and they cheer big Government on. Same when "big Government" tells never-do-wells how to run their lives according to the ideological or theological preferences of their betters.

    It depresses me that liberals (in the historical, not USA sense) and progressives let the debate be put in a misleading "size of Government" frame by conservatives, when the real issue is the distributional aspect of Government.

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    1. @Blissex "Government is in large part a group purchase scheme"

      It can be a group production, consumption/purchase, redistribution etc. scheme.
      Essentially it is a way to exert power on potential free riders to not opt out and frustrate the collective wealth to be created by any such scheme that somehow been agreed (ideally democratically).

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  6. "an ideology that says that the private sector is always better (or worse) is not only unhelpful but dangerous"

    Indeed, and I’d say: in general so.
    In “Governing Governance” the European Liberal Forum presents a better ideology that breaks the false dichotomy between public & private alias government & market by distinguishing THREE complementary governance principles: Relationships, Bureaucracies and Markets.
    See www.liberalforum.eu/en/publications.html?year=2012&file=tl_files%2Fuserdata%2Fdownloads%2Fpublications%2F2012%2FGoverningGovernance.pdf
    It also states that efficiency is not the only goal, but should be supplemented with fairness and social cohesion (and I would add ecological sustainability).
    There are more possibilities for improvement: I would distinguish FOUR basic ways of organising society and economy: belonging (relation/affinity), bureaucracy (power), exchange (dependence) and persuasion (ideology/ideas/ideals/goals).
    I think it is also important to recognise that each of these ways to organise that people get what they need/want have a positive side (they increase collective wealth) and a negative side (they enable rent seeking: taking more from the pie than you contribute to it).
    See www.antenna.nl/wim.nusselder/schrijfsels/economics.htm
    Economics should be a discipline that tells us what COMBINATIONS of ways of organising works best to provide efficient, fair, socially cohesive AND ecologically sustainable outcomes (which politicians should then weigh) in what situations and for what types of needs/wants.
    Economics should be (in the end) institutional (with limited mathematical support) to be politically and socially relevant.

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  7. "Economics is not a discipline that tells us market allocation is always best, but one that tells us when it may work well and when it may not. ..."

    Really?

    Railways, whether they have been under public or private ownership, whether bullet trains or local trains, have performed consistently well in Japan.

    Railways, whether public or private would probably work well in either case in a place like Switzerland.

    The experience in Britain is that trains, public or privatised, generally do not work well (I think we can agree on that despite the exception you give).

    What does micro-theory have to say about why?

    OK you might say it is investment, but why are some countries happy to maintain this investment?

    I think we need to understand something about social, political and institutional structures.

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  8. «in Britain is that trains, public or privatised, generally do not work well»

    Ahhh I suspect that our blogger use "may work well" in the sense of "Economics", that is *relative* to preferences and value for money.

    If the British public or their elites don't want to spend the effort and money to make the railways "work well" in an *absolute* sense, that's outside "Economics".

    «we need to understand something about social, political and institutional structures.»

    Starting with Veblen and his notion of the conflict between property owners and what he calls "engineers".

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  9. «privatisation campaign = saw shareholders in Britain grow from 3 million to 11 million. However, in 1990 54% of these capital-owners had shares in one company only, and a further 20% owned shares in just two.»
    «in Britain is that trains, public or privatised, generally do not work well»

    These two seemingly unrelated comments are linked... By my usual memory of what probably was the most important turning point in political history in a long while.

    This was a study by a conservative think thank that proved *not only* that people who owned shares, owned cars, owned houses voted for Conservatives far more than Labour; and that people who had pensions, used public transport, rented houses voted for Labour far more than the Conservatives.

    That seems obvious as presumably stock, car, house ownership correlated with income, education and class, that is with being an incumbent.

    The additional finding of that study was that the different in voting patterns remained (if weaker) even given equivalent income,education and class.

    That is in particular that working class and lower middle class voters who were vested in car, share or house property, even if barely, voted Conservative far more than others who weren't.

    This epochal study was at the basis of the Reagan/Thatcher "revolutions", and was a major (but not sole) motivations for Right-To-Buy, privatisations with share distributions, and the assault on public transport.

    So were born the "Blow you! I am allright Jack" Thatcherite/Blairite Southern working and lower middle classes. A massive programme of social engineering that cost the UK taxpayers enormous sums (the "family silver") to create more Conservative voters:

    http://www.independent.co.uk/news/uk/politics/margaret-thatchers-legacy-spilt-milk-new-labour-and-the-big-bang--she-changed-everything-8564541.html
    «More than 1.25 million tenants took advantage of the “Right to Buy” scheme, which raised £18bn and converted thousands of Labour voters into Conservatives – though as council-housing stock shrank, homeless beggars appeared on the streets for the first time in 30 years.»

    Thatcher's (or perhaps was it rather Rifkind's?) success in taxpayer-funded social engineering is still celebrated by Conservatives, for a recent example in the Spectator:

    http://www.spectator.co.uk/columnists/politics/8886331/the-party-modernisers-are-thatchers-true-heirs/
    «His Chancellor and chief political strategist, George Osborne, is constantly looking for new ways to create Tory voters.»

    Thus more taxpayer-funded social engineering such as Help-to-Buy, plus allowing and indeed encouraging defined contribution pensioners to put their meagre pots into boosting property prices as "forecast" by Boris Johnson:

    http://www.telegraph.co.uk/finance/personalfinance/pensions/10717846/Budget-2014-the-Lamborghini-ride-that-says-power-to-the-people.html
    «I think the vast majority will want to put their pots into the market with the greatest yield over the past 40 years – and that is property;»

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  10. It seems the government feels that nationalised banks should be returned to the private sector as soon as possible. I wonder if it is micro-theory or ideology, or something else behind their reasoning.

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    1. Economic theory and political ideology are chicken and egg: they procreate each other.

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  11. "However much public sector activity is in areas where market imperfections and informational problems of various kinds are endemic."

    If you ever happen to have the time and knowledge required to write about these issues, I would love to see you post something specifically on these peculiar problems. It's always these cases where several problems seem rig the board against our social goals that economics is the most interesting to talk about. Plus, it would give us yet another chance to see how a good economist proceed to interpret the situation and to solve these problems.

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