Buses are about redistribution, productivity and a greener future

Labour’s policy for buses is a key part of reversing the impact of neoliberalism on transport since the 1980s. It is redistributive: it helps those who cannot afford to drive to work. Nearly half of all bus journeys are taken by those who have no car, and two thirds of those who travel on buses have an annual income below £25,000 per annum. But it is also a brave policy. By far the most popular mode of transport is by car (or van), and the policy will be portrayed by opponents as putting road building at risk. .

The money recently promised by Labour will mainly go to undoing another impact of austerity. Outside London fares on commercial routes are set by bus operators. Local authorities can provide subsidies for routes that are socially important but not commercially viable. Local authority-supported services outside London have halved in vehicle mileage since 2009 as austerity has squeezed local authority budgets.

But Labour also plan to change the way buses are run outside London. Bus operation was privatised by Mrs Thatcher in 1986. Yet privatisation has in most cases failed to bring the benefits of competition. Largely as a result of a long-term process of consolidation through merger and acquisition, the UK bus industry is highly concentrated with three businesses (Arriva, FirstGroup, and Stagecoach) dominating the sector. Head-to-head competition between operators is uncommon, producing what is effectively a monopoly.

The market failure in this case may be the ability of a large bus operator to stifle any competition by temporarily cutting prices or increasing frequency. That makes the routes unprofitable for a time for the large bus company, but it is also unprofitable for the new entrant. As the financial resources available to the big company are much greater, they have the ability to kill off or take over any competition.There is no regulator preventing this kind of unfair competition.

With new entry unlikely to happen because of the possibility of such threats, the large bus companies can do what every unregulated monopoly does: raise fares and reduce services. That is good for profits and dividends, but bad for passengers. The large bus companies make good profits, and the passenger gets a more expensive or less frequent service. Since 2009, for example, the average price of riding a bus has increased in real terms by over 15%, while the cost of using a car in real terms has hardly changed.

There is a vicious circle here. The cost of running a bus is largely independent of how many people use it, so if usage declines firms put prices up, which in turn discourages passengers. But one important area has seen bus use rise rather than decline, and that is London.

The system in London is rather different from the rest of the country. Contrary to common belief, Transport for London does not own its buses. What it can do that local authorities elsewhere cannot is set routes and fares, with private companies bidding to run each route. That avoids the high fares that come from monopoly, and it also makes it easy to establish a common ticketing system which is absent in places like Manchester. The system used in many European countries for their bus services is similar to London. An important advantage London has is that there is effective competition between bus companies to bid for tenders on routes, which helps keep costs down and maintains efficiency that might be lost in a completely nationalised system.

The success of London compared to most other areas of the country suggests the neoliberal ideal of a bus system free from government ‘interference’ does not work, and local control over routes and fares can provide a better service. It is a classic example of where economics, which recognises the social costs of monopoly, beats a neoliberal ideology that is often blind to the dangers of monopoly. This is why Labour also plan to encourage areas outside London to re-regulate bus services, and support the creation of municipal bus companies that are publicly run.

While a comparison between London and elsewhere shows the dangers of private monopolies charging too high a price for services, is there not a danger that if local government can set fares it will tend to set fares too low? I don’t think this is likely to be a major issue because of two other problems (what economists call externalities) with a profit-based bus service. If people use many cars rather than a single bus this increases congestion and pollution.

Anyone familiar with large towns and cities during rush hour will know what a nightmare congestion can be. Buses can reduce congestion by persuading people not to use their cars. Basic economics tells us that the congestion externality justifies subsidising bus travel or taxing cars. Exactly the same point applies to CO2 emissions and pollution. In this respect underpricing bus travel can be advantageous.

Unfortunately the experience of UK cities suggest that cheap fares alone may not be enough to prevent congestion. In addition congestion outside London may be having a serious impact on the productivity of our cities, as well as increasing pollution and CO2 emissions.

Tom Forth writes about a recent study that starts with a puzzle. In many countries large cities tend to be more productive than small cities, and economists explain this by talking about agglomeration effects. However this pattern does not seem to be true for the UK if you exclude London. Another way of putting the same point is that UK cities outside London are not as productive as they should be.

The study then looks at transport times to the centre of Birmingham, where the transport system is mainly based on buses. At peak times, when congestion is high, bus journey times into work can double on bad days, and anyone using a bus route has to plan for bad days. So if we think about the effective size of Birmingham in terms of a reasonable time to get to the centre, the city shrinks substantially.

This study shows that as long as cars are free to come into the centre those travelling on buses also suffer. Birmingham is using this study to target investment in bus lanes, which provides a partial answer. Park and ride schemes can help too. Another approach is to again follow London and introduce a congestion charge, but this will only be politically feasible if alternatives are easy, cheap, frequent and reliable.

If we look at cities in France, the big difference with UK cities is metros. Lyon has 4 lines, while Lille and Marseille have two lines each. Birmingham and Manchester have none. Last week I visited the French city of Rennes, population 215,000, that has one metro and is building another. Manchester has a good tram network similar to Lyon, but Birmingham has just one and Leeds none (compared to three in Marseille and two in Lille).

In short, cities outside London lack the transport infrastructure that can make them work productively, but also in a way that reduces CO2 emissions and other forms of pollution. One difference with France is how money is provided. In France every city larger than 100,000 people has a ten-year transport plan, with significant national investment in five-year allocations with ten-year strategies. In the UK cities are good at the strategies and visions but cannot secure funding to realise them.

Once you have well functioning cities you need to provide easy connections to nearby towns. Towns flourish when they are well connected to dynamic cities. Many will argue that this kind of local investment is money better spent than HS2, but I don’t think we should think of these as alternatives. Cities that link quickly to other cities are likely to be more productive, and France’s TGV network puts the UK to shame. The UK has underinvested in non-road transport infrastructure outside London for decades, and we need to make up for this quickly to create a more prosperous and greener future.

A comparison in accountability: Oxfam and the NHS

Although the original allegations in the Times looked weak, it turns out (from an interview with ex-employee Helen Evans by Channel4 News) that the leadership at Oxfam had not been giving the issue of exploitation by a tiny minority of its aid workers the attention it deserved. The deputy chief executive has resigned.

The original allegations concerned actions by some aid worker in Haiti some years ago. Oxfam took action at the time, and the charity has put in place various safeguards since. But nevertheless, it is important the media holds charities to account to ensure they do all they can to avoid this happening again.

But threatening to cut off all government funding is the last thing you should do. The message that sends to other charities is to hide any similar problems they come across in their own work, or worse still stop looking. Any responsible minister would have known that, but perhaps they wanted to get political points from their own side for being tough with a ‘leftie charity’. In none of the BBC coverage I saw (this story was the lead item on the BBC news I watched for four days running) were any questions raised about the government’s actions.

Contrast the behaviour of politicians and the media in relation to what is currently happening in the NHS. Quite simply people are dying because there are insufficient resources to cope with needs. Thousands have had operations postponed, leaving them in pain. Patients are lying in trolleys because there are not enough beds. Huge numbers, more than ever before, are having to wait for more than four hours in A&E.

The reason for all this is not mysterious. Health has been starved of resources by this and the previous coalition government like never before. I have shown the Kings Fund analysis in the past. Here is World Bank data up to 2014. The key point is that health spending as a share of GDP needs to rise to keep up with demand, but since 2010 the government has been shrinking the share of total output spent on health. The downward trend it shows until 2014 has continued and is projected to continue.

This shows neglect on a scale that make the leadership of Oxfam’s misdeeds look trivial. Yet where is the media scandal? The man who has been in charge of the NHS while this has happened and is happening in front of our noses is still in his job. The government continues to fail to provide the resources the NHS needs, while promising to protect the NHS, and yet it has not been held to account for killing people and leaving them in pain by the same media that has been happy to pursue the leadership of Oxfam. The Minister for International Development told the leaders of Oxfam that “an organisation’s moral leadership comes from individuals taking responsibility for their actions”. Quite.

The government are in denial about what is happening, and the media allow them to get away with it. Of course there have been countless reports about the crisis in the NHS, but we have not seen the kind of sustained and coordinated media focus on who is responsible that we saw with Oxfam. This is not about sexual exploitation in another country some years ago, but about people dying and in pain right here right now.

And incredibly, it is actually worse than this. The same politicians have attempted to use immigrants as a scapegoat for what is happening, whereas in fact immigrants provide more resources that could be used for health spending than they take out. Yet time and time again ministers can get away with this lie in the broadcast media. Worse still, one part of the government is busy preventing doctors the NHS desperately needs from coming to work here. And finally, I have never heard anyone in the broadcast media question why the government is starving the NHS of resources with such devastating effects. Its silence on the growing privatisation of NHS services is almost total, even though the vast majority of people do not want this.

This reminds me of the US election, where the media spent far too much time going on about Clinton’s emails and far too little time on Trump’s obvious unfitness to be a POTUS. But in this case there is no competing narrative, no two sides to balance. The media is simply failing to hold the government to account for allowing totally avoidable death and pain. This is what the UK has become in just seven years. A country that is happy to treat those who run charities as close to criminals, but shrugs its collective shoulders while the government destroys the NHS in front of our eyes.

Decreasing the size of the state is very unpopular

I last talked about this question from the British Social Attitudes survey in 2014. Here is the latest version of this longstanding survey question (source and exact question here).

A point I made in the last post was that the percentage of people wanting lower taxes and less spending has always been less than 10%. If you believe the survey, and I see no reason not to, there has since 1983 been no public appetite for reducing government spending in order to cut taxes.

All the action over time is between those who want things to stay as they are, and those who want higher spending and taxes. As public spending has been cut in recent years, so the number of people wanting more spending and higher taxes has increased. However that proportion is still not up to the level it was in the 1990s.

Does this survey suggest that half the population want a larger state, and hardly anyone wants a smaller state? That depends on what you mean by the state. The question actually asks about spending on “health, education and social benefits”, so it seems reasonable that this is what people are responding to. They are taking as given that the government in the UK provides these things, and are simply expressing their view about whether they want more of these goods and are prepared to pay for them. The question does not ask about whether these goods should be produced by the state or by private contractors working for the state.

When the public are asked about who should own and run various activities, there is clear support for more rather than less public involvement. (Chart source.)

These numbers are from last year, so the collapse of Carillion and the problems with the East Coast rail line are likely to push public opinion even further away from the privatisation ideal. Note that only about 10% want privatisation of the NHS, which has continued rapidly under this government. A government that reduces government spending and taxes, and pushes privatisation of the NHS, seems like a government of the few and not the many.

I remember being told how nervous the last Labour government was when they decided to raise NIC rates to fund an increase in NHS spending. They had committed to not raising the basic rate of income tax in order (they thought) to be able to win elections. Given the data above, you might wonder why. But then I remembered how the Labour PLP had decided that they had lost the 2015 election by being too left wing, again without any real evidence. Perhaps the lesson of these two poll results is that the gap between what people actually want and the received wisdom of the Westminster bubble is very large.

What Carillion tells us about public sector outsourcing

Jeremy Warner, an editor at the Telegraph, once said there are either big state people or small state people. I felt the same way following the reaction to the collapse of Carillion: there are either private good, public bad people or public good, private bad people. Of course, reality is somewhere in between.

Corillion went bust because of cost overruns or delays in three large construction projects. The nature of such projects involve that kind of risk, but clearly the company - despite its size - was not resilient enough to withstand those failures. It did not go bust because of privatisation of public services, unless you think the government should build its own hospitals or roads. If anything, it shows that those contracting out public contracts were getting a good deal.

There will always be public projects contracted out to the private sector. Much of the increase in public investment planned by Labour if it wins the next election will be undertaken by private firms. Getting the contracting relationship right is difficult and fraught with dangers.

The government clearly has questions to answer about why it continued to award contracts after the profit warning, and we need some informed analysis to determine whether the government, as they claim, had fully protected all but one (!) of these projects and will not lose any money as a result of the collapse. As David Allen Green suggests, this smacks of ministerial failure. (The link also shows public procurement can have its funny side.) Also why was the position of the “crown representative” who was meant to be overseeing scrutiny of, among others, Carillion left vacant? The government should also ask whether companies should be allowed to pay large dividends when their own pension fund is underfunded. And why Carillion's auditors, KPMG, gave it a clean bill of health when its balance sheet was already showing signs of stress

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To see what lessons the collapse of Corillion does have for the debate over whether the public sector should privatise certain of its activities or do them in house, we need to go through some of the pros and cons

There is one main benefit of contracting out public services, which is that it can save money. To mention ‘the market’ here is not very helpful, because with one buyer and only a few sellers for something (the contract) agreed once every few years, this is hardly a normal market. [1] It is instead about the incentives faced by managers and workers, both in achieving efficiency and fostering innovation. Managers have a clearer incentive system in a private sector firm to maximise profits, and that incentive is provided by the need to bid low to win the contract and nevertheless make a profit. As Carillion shows, margins on most public sector outsourcing are not large. In that sense Carillion confirms that part of this mechanism is working. A single public sector entity cannot replicate this advantage, unless it too is in competition with private sector firms. In short, competition improves incentives.

One important qualification to this argument involves information. The temptation of a bidding system based on the lowest price is to cut quality. So the public sector has to have a clear means of not just specifying quality in the contract, but of ensuring the contract is being fulfilled once it is awarded. Sometimes politics can get in the way of that happening. For activities where quality is difficult to observe, contracting out is not a good idea.

Another qualification involves the attitude of public sector workers before privatisation. If they, for whatever reason, internalise the need for efficiency and innovation, because for example they can see how both improve the outcome for customers, then contracting out to the private sector will achieve little. The NHS could be a case in point.

A further problem with privatisation is finance. When people argue that public money should not be wasted paying the shareholders or creditors of private firms, they are both right and wrong. They are wrong in the sense that without contracting out the same amount of money has to be raised by the public sector, and so it “wastes” money by having to pay interest on government debt. But they are right in that the rate of interest on government debt is much less than the rate of interest a private firm has to pay on any debt, or in the form of dividends to shareholders. The reason for this is that investors do not like risk: people who lend to the UK government know they will always get their money back, while as the shareholders and creditors to Carillion have just found this is not true for private sector firms.

This is why PFI projects undertaken just so that the borrowing is done by the private rather than the public sector are costly from an economic point of view. It is why it makes sense to exclude public investment from any fiscal rule: fiscal rules that restrict public investment are an open invitation to politicians to undertake PFI type financing. In my view the best constraint on public investment is the expected social return, assessed with the help of an independent body. It is often said that PFI type projects ‘avoids risk to the taxpayer’. Again this is the wrong way round. It is far easier and cheaper for the public sector to take risks than the private sector, so PFI projects are paying far too high a price to avoid risk to the public sector. 

Another problem related to risk is the interrelationship between what the private company contracts to do and what actually happens when government forecasts go wrong, as they always will. This may have happened with the East Coast line “bailout” (but if it was, we should be told), and it did happen with privatising the probation service. Public sector contracting out forces each side to commit to guesses about the future, whereas if everything remains in-house there can be much more flexibility. There is also the cost of having to train more civil servants in the art of writing good contracts.

One further problem that Carillion reminds us of is that privatisation runs the risk of a degree of interruption if the company goes bankrupt. Disruption is nothing new. If privatisation is to have any benefits, the contract from the public sector has to come up for renewal every few years, and if the private sector provider is changed that will involve some dislocation of service.

One final point, which is contingent on what I hope will be a temporary state of affairs. Nowadays the management overheads for private sector firms are likely to be far higher than in the public sector, for reasons that have little to do with management quality. Ben Chu sets out how much management was being paid at Carillion compared to equivalent public sector managers. And what on earth were shareholders doing allowing the directors to relax clawback conditions on management’s pay if things went wrong, which even the Institute of Directors described as “highly inappropriate” and “lacking effective governance”. In truth the public sector is much better at stopping managers using their monopoly power to be paid over the odds than the private sector appears to be.

So the economist’s answer on public sector outsourcing is, it depends: on all the factors outlined above and probably more I have momentarily forgotten. (Like economies of scale and expertise: no one would ever suggest the public sector makes its own paperclips.) Where the balance will be is bound to be case dependent. But it would be incredibly surprising if at least some of the outsourcing undertaken by this government was not ideological rather than evidence based. This suggests that Labour, if it wins the next election, should undertake a thorough independent review when it has all the facts at its disposal. That at least might ease fears that we will lurch from one ideological position to its opposite.

[1] This is an interesting example of a longstanding debate with myself. If you want to claim that much of this kind of outsourcing represents neoliberal ideology at work (which it probably does), and also that neoliberalism is all about the market, then your definition of a market has to be pretty wide. But of course a large firm like Carillion, as Ronald Coase said, involves the large scale supersession of the price mechanism. By which he meant that firms are an alternative to markets, and large firms suppress what would be market activity if it was replaced by lots of smaller firms buying and selling to each other. This is a contradiction at the heart of neoliberalism as market worship: firms are alternatives to markets. 

Osborne, Cameron and fiscal irresponsibility

Is there anyone left who really believes that George Osborne is cutting public spending because he wants to be prudent with the nation’s finances? Unfortunately I think the answer is far too many.

Most macroeconomists have had deep suspicions or worse for some time, as we could see what damage austerity was doing to the economy. You might say that issue is past as growth has returned, but this would be quite wrong. What is now becoming clear is that the fears that some economists had all along that delaying the recovery in demand would lead to permanent damage to supply have indeed come to pass.

Those who were not macroeconomists should have realised what was going on when the government started cutting taxes. How do you explain cutting inheritance tax one day, and then trying to justify cuts in tax credits because ‘we have to get rid of the budget deficit’ the next, other than helping your own at the expense of the poor?

Even if that did not convince you, I suspect what will happen in the next few years will leave you in no doubt. Everyone knows it is crazy to cut spending that would have generated more income than it costs. Appearing to balance the books by paying for current spending (or tax cuts) by selling off your assets is not being prudent at all. Yet I suspect we will see more and more announcements from the government that do exactly this in the next few years.

To take just one example, we have the announcement of yet more cuts to HMRC, the government’s tax collectors, as part of the new spending review. No doubt we will hear a lot of talk about reorganisations to make the service more efficient. Just as we did with the previous cuts. In March 2015 it took an average of almost 15 minutes to have your phone call answered by HMRC. For the government that is a sign that the service needs less people! I do not know if the OBR allow something for the impact of HMRC cuts in their estimate of overall tax receipts, but if they have not done so already I think they should start.

This is a very obvious example of apparent savings that in fact reduce net revenue. Many more involve cutting public spending in a way that increases costs to the private sector, leading to lower productivity, lower incomes and then lower taxes. But for a politician facing a tame media who just has an eye for the headline numbers none of this matters.

The letter that the Prime Minister wrote to his local council complaining about its cuts has got some publicity. But what I found most revealing was Cameron’s suggestion that the council pay from some ongoing frontline services by selling more assets. The council leader in his reply explains that using the income from these sales to pay for the council’s running costs “is neither legal, nor sustainable in the long-term since they are one-off receipts”. The Prime Minister offered the services of No. 10’s policy unit to help the council. It sounds to me that the council should in turn be offering some of its wisdom next door at No. 11.

Privatisations: why we need a fiscal watchdog

When the government sold its shares in Eurostar (the London to Paris train service) around a year ago, its primary motive according to a recently published national audit office (NAO) report was to reduce the level of government debt. [1] As the NAO says “Some asset sales are justified by government on the basis that the sale will result in improved efficiency for the business but this was not the case with Eurostar.”

The key point with privatisations is that reducing current debt may harm the health of the public finances. Any normal investor would only sell an asset if they thought they could get a price that exceeded what the asset was really worth. Although selling the asset would reduce the government’s net borrowing today, it would increase their net borrowing in the future because the government would not get the dividends the shares paid out.

The fact that the government had the wrong motives is an unfortunate by-product of debt or deficit targets. By necessity these targets have to be ‘realisable’ (to use a term from my paper with Jonathan Portes) - they have to be targets that are within the lifetime of a parliament. But that gives any government an incentive to effectively cheat: to sell off assets (like Eurostar) that help meet targets in the short term, but make managing the public finances beyond this more difficult. (This post discusses the point in more detail.)

So how do we judge if selling Eurostar was a good or bad decision? Reports that there was a general belief that the value of the shares would rise are worrying. To be honest I do not know the answer to this question, but in essence that is my point. Given the clear danger that the government will sell assets just to meet its short term targets, we need some independent institution to assess whether the government is being sensible or is cheating. (In some other cases, like selling off the student loan book, the cheating is pretty clear.)

The NAO had a remit which did not address these issues, although it tries in its report to at least raise them. [2] The obvious body to analyse and publicly report on issues of this kind is the OBR, but this is also not in the OBR’s remit, and at present it can at best only drop hints. With a large privatisation programme over the next five years, the government was never going to extend the OBR’s remit in this way, and (coincidentally?) the Ramsden review does not seem to have addressed this issue directly. The OBR needs to become not just a producer of forecasts, but more of a fiscal watchdog.

Without some independent oversight of this kind, we will have the irony of government ministers arguing that privatisations are needed because we must reduce government debt for the sake of future generations, when in reality they may be increasing the burden on future generations. We need a fiscal watchdog to protect future generations from shortsighted governments.

[1] Although the headline level of public debt is often described as net, it in fact only nets off liquid financial assets.

[2] The key technical issue is discounting, and how you handle uncertainty. Even if the government gets the current market price, that price may be low because the private sector discounts future returns heavily. That heavy discounting may reflect vulnerability in the face of uncertainty, whereas the public sector has much less vulnerability.  

Fiscal deceit

Vince Cable, the LibDem minister whose remit includes UK student finance, is apparently having cold feet about the plan to privatise the student loan book. Which is good news, because if ever there was an example of a policy designed to lose money for the public sector (or, as they say in the media, cost the taxpayer more), it was this.

As I explained in this post, if a public asset that generates income is privatised, the public gains the sale value, but loses a stream of future income. The ‘debt burden’ need not be reduced, because although future taxes will fall because there is less debt to pay interest on, they will rise because the government has also lost a future income stream.

With assets like the Royal Mail, we can debate endlessly whether the asset will become more or less efficient under private ownership. If it is more efficient, and therefore profitable, under private ownership, the private sector might be prepared to pay more for it, and so the public sector (and society) is better off selling it – unless of course the government sells it at below its market price! However in the case of the student loan book, it is pretty clear that privatisation is a bad deal for the public sector for two reasons.

First, as Martin Wolf has pointed out, the revenues from student loan repayments are very long term, and pretty uncertain. Any private sector firm that might buy this book is likely to discount these revenues quite highly, and so will not be prepared to pay the government enough to compensate the government for the lost revenue. Second, as Alasdair Smith points out, the main efficiency issue is collecting the loan repayments. Here the government has clear advantages over the private sector, because loan repayments are linked to income, and the government has all the information on people’s income, and an existing system for collecting money based on income.

So selling the student loan book is an almost certain way of increasing the ‘debt burden’ on current and future generations. As Alasdair Smith reports, George Osborne justified the sale by saying that it helped the government with a ‘cash flow issue’. As Alasdair rightly says, the government does not have cash flow issues. This kind of ludicrous policy either comes from ideological fundamentalism (the government shouldn’t own assets) or the need to meet ridiculously tough deficit targets. Whichever it is, every UK citizen loses money as a result.

George Osborne is hardly the first finance minister to play tricks like this, so how do we stop future governments from doing the same? I’m glad to see more journalists, like Chris Cook, making the points I make here. However it would be better still if an independent body, set up by the government to calculate its future fiscal position, was charged with a statutory duty to make these points. At present the OBR does not have that duty, and it feels naturally reluctant to go beyond its remit and pick fights with the government. However, if it became more of a public watchdog, with a remit to flag government proposals that appeared to lose money for the public sector in the long term, that might just stop future governments doing this kind of thing.

Privatisation and government debt

Possibly the worst argument for privatising part of the public sector is a supposed ‘need’ to reduce public sector debt. I think the problem with this argument is obvious to most economists, but as it is repeatedly ignored by politicians, it is worth spelling it out.

As I argued in a previous post, decisions to privatise or contract out should be based on considering the microeconomic pros and cons, which will vary from case to case. This analysis should include political economy considerations, like the extent of public sector corruption, or the ability of firms to extract rents from the public sector.

Suppose that such an analysis left the decision to privatise evenly balanced. Should macroeconomic factors, like the need to reduce public sector debt, ever be used to sway the decision in favour of privatisation? In our recent paper, Jonathan Portes and I argue (here or here) that a government should have some view about what the long run desirable level of public debt relative to GDP should be. Two arguments that could be used to argue for lower long term debt are that paying interest on debt requires raising taxes, which are ‘distortionary’ (they tend to reduce GDP and welfare), or that public debt may crowd out private capital and investment (assuming those are thought to be too low).

If we start out with public debt above its long run target, why not use privatisation to help get us towards that target? To see why that is nonsense, consider the two reasons for reducing debt given above. The first was to reduce the need to raise taxes to pay interest on that debt. While privatisation might reduce debt, it will also reduce future revenues or increase future public sector payments. Privatisation will either mean that the public sector loses the revenue that the privatised activity produced, or the private sector will have to be paid to undertake the outsourced activity. So the net impact on taxes will be zero.

What about the point that public debt may crowd out private investment? Once again privatisation does nothing to encourage additional private sector investment. All that happens is that existing capital and any investment that goes with it are relabelled private rather than public. No additional savings are released to encourage new private sector activity.

Consider an extreme example: Greece. The country is desperate to show that debt can be at least be brought to some sustainable level. So what is wrong with selling off some state asset, like part ownership of a water company for example, to help reduce this debt? Now there may or may not be good microeconomic reasons for doing this, but is there a good macro reason? Selling the asset would allow the Greek government to reduce its debt, but it would also have to raise future taxes, or cut future spending, to make up for the revenue lost from no longer owning that company. If microeconomic efficiency is unchanged, this sale would make no difference to the balance between taxes and spending required to make debt sustainable. Debt interest payments would fall, but so would receipts.

To make the same point another way, if we valued public sector assets and calculated the public sector’s net asset position, privatisation would have no effect on that net number. So why should anyone think that the position of the Greek government had been improved by this asset sale?

Obvious though this point may be, it illustrates a problem with most fiscal policy rules. Most rules need to involve what Jonathan and I call realisable operational targets: goals that politicians can aim for (and be judged by) within the lifetime of administrations and parliaments. Privatisation is one of a number of devices that flatter the short term public finances with no impact (or worse) on the long term position. (Considerably worse if the asset is sold far too cheaply, as in the most recent UK case for example.) Because fiscal rules inevitably focus on the next few years, politicians will always be tempted to use these devices to in effect cheat those rules. This is why it is vital to have effective fiscal councils to work alongside any rules. These independent institutions need to be able to shout when they believe only the letter and not the spirit of these rules is being met. The UK’s fiscal council, the OBR, does not have this kind of mandate, and can therefore only note when policies have this kind of effect (see here, paras 1.8-9).  

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.