Monday, 15 September 2014

This is simply a bad idea: Labour's asset buying fund.

From the Stuff website comes this news:
Labour is promising to create a new national asset buying fund, giving at least $100 million a year to help raise local ownership.

In the last major policy announcement before Saturday's election, leader David Cunliffe revealed the details of his planned sovereign wealth fund, NZ Inc.
Although Cunliffe said the fund would target strategic assets - such as port infrastructure or dairy processing plants - or invest in renewable energy companies, he agreed it could also buy farms or shares in privatised electricity companies.

Labour has said it would not rule out buying back the state assets partially sold in the current term, and the fund appears to be an attempt to court New Zealand First leader Winston Peters into coalition.

Peters has named foreign ownership as a key priority for coalition talks, promising a "buy back" programme of farmland during a speech in Tauranga this week.
While there are problems with the National government's partial "privatisation" policy (more on this below) the answer to these problems isn't to buy back the bits of the firms sold but rather to sell 100% of those SOEs. Also the government is very bad at picking winners to invest in. In addition xenophobia isn't a basis for determining what to invest in.

Why do we want  government ownership? If foreign ownership means a more efficient use of an asset then we want that asset to be in foreign hands. We get a more efficient, and wealthier, economy. If, on the other hand, "local ownership" is more efficient then local private investors will be able to buy and utilise the asset. to our advantage Thus there are either good efficiency reasons for foreign ownership or local ownership will occur without government ownership being necessary. Either way its not clear why we want government ownership.

The fundamental question to be asked is Where is the boundary between what activities the government should carryout and those the private sector should carryout? Insight into this question is provided in Hart, Shleifer and Vishny (1997). Here the issue examined is when should the government carryout production "in-house" and when should it contract out the production of a good or service. In this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

Hart, Shleifer and Vishny apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatisation is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

So what assets does Labour think are "strategic"and thus should be used to produce in-house? And what is a "strategic asset" anyway? The term has no meaning within economics.

Its not clear that the government's past interventions have been in areas where the Hart, Shleifer and Vishny arguments would suggest the government should be involved. Banking, for example, is not a area where cost reduction come at the expense of quality, where innovation is unimportant or where there are any problem with government procurement. So why have the government owning a bank? Also government involvement in Air New Zealand is hard to justify on these grounds. As noted above, the case for private sector provision is stronger when quality reducing cost reduction can be controlled through competition, and the airline industry is very competitive, when quality innovations are important, and we want a high quality and innovative airline industry, and when patronage and powerful unions are a severe problem inside the government, which are things we wish to avoid with an airline. Here private provision makes sense.

So what will be invested in, and how will the assets be picked? And why should the government be involved in these businesses in the first place?

And what of governments, or their agents, picking winners? Some years ago economist Tim Harford had a piece up at in which he tries to unravel why governments so unerringly back losers. Harford points out that "[i]f you want to dismay an economist, just mention the phrase "national champion."" On hearing such a phrase economists automatically think of "wheezing corporate behemoths protected from domestic competition, propped up with generous government subsidies and shielded behind trade barriers." I suspect that the expression "strategic asset" would have much the same affect on economists. Not a pretty picture, it has loser written all over it. So, asks Harford, if governments want to back winners, Why are they so good at backing losers?. He answers,
Partly, it's because picking the winners is inherently a difficult job. Left alone, the market does a great job of rewarding the very best and cutting the rest down to size. Any corporation that gets big and stays big in a competitive environment is likely to be very good at what it does. A corporation that stays big only because of government backing probably won't be.
He then goes on to explain that government favouritism may have a somewhat more sinister logic behind it,
Namely, firms in emerging, competitive industries have virtually no incentive to lobby for government hand-outs, while firms in aging, shrinking industries have the most to gain.
The reason for this is simple he says,
Firms in an open, competitive, growing young industry have little to gain from government support. More government funding for, say, biotechnology, is going to mean more biotechnology companies, more competition and (perhaps) more innovation. That might be good for America, but probably not much good for any single biotech company. Sure, they'll all enjoy the government help, but each must weigh that assistance against the swarm of new competitors attracted by the handouts. No one firm would choose to hire top lobbyists and send them to D.C. to bring back the pork.

By contrast, firms in aging, shrinking, capital-intensive industries have everything to gain from government support. Because the industry is shrinking and it's expensive to enter--think steel mills--the government subsidies and tax breaks are probably not going to attract new competitors. If there are no new competitors, the old guard gets to pocket all the money.
D R Myddelton looked at a related question in his recent book They Meant Well: Government Project Disasters. In this work, published by the Institute of Economic Affairs in London, Myddelton asks How is it that so many major, government-sponsored projects can lose so much money? He points out that the the answer to this question does not lie with malign intentions on behalf of their promoters in government. On the contrary the supporters within government of such projects only have the best of motives, so why do these projects go so wrong?

Myddelton considers six projects covering a period of 80 years to find answers. He looks at The R. 101 airship, the groundnut scheme, nuclear power, Concorde, the channel tunnel and the infamous Millennium Dome. A recurring rationale for these grandiose projects has been to boost "national prestige", but this concept has little real value.

Myddelton's explanation for the continual failure of such projects is that failure results from mismanagement, lack of clear lines of responsibility and lack of accountability. The point is made that
[n]one of the six projects was well managed and many of the failures were down to politicians: installing inadequate or over-complex organisations, appointing incompetent managers, or insisting on excessive secrecy.
These problems have their roots in the wider economic problems of undertaking quasi-commercial ventures in the public, rather than in the private, sector. This results, argues Myddelton, in well-meaning politicians and government officials wasting huge sums of taxpayers' money.

The arguments of both Harford and Myddelton should make us apprehensive when governments start talking of "national champions" or "strategic assets" and starting want to back these notions with our money. Odds are things will end badly.

Folsom and Folsom (2014) looks at the history of government investments in the U.S. covering everything from beaver pelts to railroads to green energy, and again things ended badly.

In short, there are good reasons for thinking the government, or its agents, will pick losers rather than winners.

To return to the point made at the beginning that there are problems with the current government's policy of selling 49% of SOEs. To see the problems note that most of the privatisation programmes enacted around the world - including New Zealand, as well as the general political debates that have surrounded the sale of state assets, have taken place with little or no reference to the economic theory of privatisation. Taking a look at the literature on the contemporary incomplete contracts approach to privatisation we can conclude a number of things several of which are directly applicable to the 49% sale programme of the New Zealand government.

First, one of the most important results is what can be interpreted as ``existence results" that show that even in a world of totally benevolent governments privatisation can still be optimal. Secondly, it can be reasonably argued that the practice of selling less than 51% of an SOE does not constitute privatisation. Under such a plan the state remains the primary force responsible for deciding the outputs (and possibly the inputs) of the firm, rather than the market. This means that programmes such as the recent policy by the New Zealand government of selling just 49% of SOEs is not genuine privatisation. The results flowing from the papers utilising the British definition of privatisation implicitly assume that full control is transferred to the private sector. Thirdly some of the results above suggest that the government is involved in areas of the economy where private provision is more efficient. Sectors of the economy like banking, mining and airlines are examples of areas where innovation is likely to be important and competition can deal with any deleterious effects on quality, which suggests that public provision is less likely to be welfare enhancing. See the discussion of the Hart, Shleifer and Vishny paper above. Fourthly, a firm's ownership can depend on its investment requirements since different ownership structures result in different patterns of investment and thus depending on the desired nature of investments different forms of ownership can be optimal. Fifthly, an important driver of several of the results presented above is the degree to which politicians can interfere, ex post, with the operations of the firm. The lower the cost of interference the greater the likelihood of firms being induced to serve political rather than economic ends. This highlights the importance of post-privatisation regulation, and competition, to the outcome of an asset sales programme. Sixth there is an implicit assumption in the literature discussed above that economic efficiency is a major objective of privatisation but the, ex ante, conditions sometimes imposed by governments on the sale of assets often serve political rather than economic ends. Examples of such conditions are things like the New Zealand governments restrictions on foreign ownership and the desire to sell to ``Mums and Dads" which restricts the number of possible bidders. Such conditions also result in fragmented ownership making it difficult for owners to coordinate their efforts to effect the firm's behaviour. In addition given that each ``Mum or Dad" will own only a very small share of any of the firms, they have little incentive to become informed on the firm's activities since they will only capture a very small amount of any improvement in performance they could bring about. These factors suggest that in practice little will change in terms of the behaviour of the SOEs, they will remain, for all intents and purposes, government controlled entities. This contradicts the very reason for privatising SOEs in the first place.

The answer to the problems with the National government's asset sales programme is not a buy-back plan like that being suggested by Labour but rather the opposite: the sale of 100% of the SOEs in question.

  • Folsom Jr., Burton W. and Anita Folsoms (2014). Uncle Sam Can't Count: A History of Failed Government Investments, from Beaver Pelts to Green Energy, New York: Broadside Books.
  • Hart, Oliver D., Andrei Shleifer and Robert W. Vishny (1997). `The Proper Scope of Government: Theory and an Application to Prisons', Quarterly Journal of Economics, 112(4) November: 1127-61.


Brett said...

There's plenty of counter-examples in Europe where SOEs performed very well, as long as they got investment. The French nationalizations were all highly profitable except for a handful of notorious cases, as Dissent has pointed out.

And outside of Europe, we've got the Post Office, Public Utilities, Fannie Mae and Freddie Mac being profitable, etc.

Mark Hubbard said...

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