Renationalisation: back to the future?

The recently released Renationalisation: Back to the Future? by Julian Jessop and Len Shackleton is number 72 in the IEA's Current Controversies series.

The paper discusses the idea, common among a number of political parties in the UK, that some industries should be bought back into government ownership, that is, these industries should be renationalised.

A brief summary of its main points is:

Actual and perceived problems associated with privatised utilities have led to some public disenchantment with these businesses. Polls suggest that there is a popular majority for renationalising them, and there is some cross-party support for this.

Examination of these industries suggests grounds for concern over aspects of their recent operation. However, other criticisms are not substantiated, and there have been significant gains from privatisation which should not be ignored.

Many of the problems of these sectors are not intrinsic to private ownership but are the consequence of continued government intervention and regulatory failure. Some problems – such as the conflict between prices to consumers and cost to the taxpayer – would persist even in the event of renationalisation, and could get worse.

The record of post-war nationalisations was for the most part unhappy. The clamour for taking businesses back into state ownership ignores important lessons from that period, such as the instability of investment hen nationalised industries have to compete against other government priorities.

The cost of renationalisation would be considerable. The issue of compensation to private shareholders is being treated superficially: wider UK share ownership and the increased involvement of foreign investors would make it be much more difficult than in the past.

Foreign nationals would be in a strong position to challenge attempts to acquire assets at less than market value. Such attempts would damage the UK’s reputation for upholding property rights and could also lead to retaliatory measures against the UK’s own large stock of overseas investments.

Proposed new organisational arrangements for renationalised businesses are untested and may lead to continual politicisation, adversely affecting future performance.

It could be more sensible, where necessary, to strengthen the regulation of these businesses with a focus on reinforcing market mechanisms. The aim should be to reduce political interference and reduce disruption to business operations.

Notwithstanding political support for renationalisation from several parties, it seems unlikely that there will ever be complete consensus. Future governments might re-privatise, or threaten to re-privatise. The instability created by this sort of ping-pong would damage these industries’ performance, with consequent adverse effects for customers and taxpayers.

Remember that one way to think about privatisation is that it is a way for a government to commit to a policy of non-intervention in the operation of a firm. Selling a business maximises the "distance" between the government and the firm and increases the political cost to interference with the firm. Renationalisiating a firm reverses this process and makes government interference that much easier. Renationalisation minimises the "distance" between the firm and the government and thus makes political intervention that much cheaper for the government.

Feds should focus on privatisation over new infrastructure spending

From the Cato Institute comes this Cato Daily Podcast in which the Cato Institute's Chris Edwards talks to Caleb O. Brown and argues that President Trump’s massive centrally planned infrastructure proposal misses the mark. Edwards argues that Trump should focus on devolving control of assets and privatize many currently public infrastructure projects.

Is state-ownership detrimental to firm performance? New Zealand evidence

The evidence on the relationship between state-ownership and performance across the globe is mixed, so what does the New Zealand experience have to say on the issue? A forthcoming paper - New Zealand State-owned enterprises: is state-ownership detrimental to firm performance? by Kenny Ka Yin Chan, Li Chen and Norman Wong - in New Zealand Economic Papers looks at the New Zealand situation.

The abstract reads,

This study examines the performance of State-owned enterprises by conducting a contemporary examination in the New Zealand environment. Applying both a cross-sectional and time-series approach, we document significant and consistent evidence that state ownership is negatively associated with firm profitability compared to private ownership. We also find evidence suggesting that state ownership is positively associated with asset turnover and labour intensity, but not associated with labour turnover. This implies that SOEs on average experience a higher asset turnover due to excessive labour employment, compared to private firms.

The paper's conclusion states,

We investigate the relationship between state-ownership and firm performance from two perspectives. Cross-sectional comparisons examine the hypothesis of whether SOEs inherently perform worse than private firms, while time-series analyses test whether performance improves after privatisation. We find consistent results between the cross-sectional and time-series analyses.

The cross-sectional evidence suggests a significant negative association between state ownership and firm profitability, in line with prior research. We do not find a significant relation between state ownership and labour turnover. However, we find SOEs are more efficient in utilising operating assets to generate revenues but are less efficient in terms of labour employment compared to private firms. Consistently, time-series results from industry-adjusted models reveal significant improvements in profitability, as well as declines in both asset turnover and labour intensity after privatisation. Given the lack of compelling evidence on labour turnover, SOEs’ superior efficiency in ATO appears to come at the expenses of excessive labour employment.

The results contribute insights to academia and policy-makers that may be useful. Prior literature has generally only considered performance differences from either a cross-sectional or time-series perspective, so by examining both angles together, our study provides a more holistic view of the issue. Additionally, this study adds to an emerging line of country-level studies (e.g. Ejelly (2009) on Saudi Arabia; Nahadi and Suzuki (2012) on Indonesia; Lau and Tong (2008) on Malaysia), by examining New Zealand privatisations. Given the National government’s campaign of a mixed-ownership model, empirical evidence of the effects of privatisation becomes vital. Importantly, given that both the cross-sectional and time-series evidence finds a positive relationship between private-ownership and firm profitability, the regime to privatise SOEs is not only a method of raising government funds but also a superior form of commercial management.

Overall, this study addresses an apparent gap in the New Zealand literature regarding the performance effects of state- versus private-ownership. This insight is becoming increasingly important in the near future, as the National government continues their regime of partially privatising the major SOEs.

One thing that is worth mentioning is that privatisation should not be seen as a way of "raising government funds". If you really want to raise money then you would just sell monopolies and that would do nothing for the economy. The advantages of privatisation come from increased efficiency and increased competition but efficient firms in competitive markets sell for less than monopolies, so raising fund should be well down the list of priorities. Also, as I have argued before 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 an SOE is not genuine privatisation. This policy means 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. Evidence on the difference in performance between fully and partially privatised firms would be interesting.

Privatisation and information

Over at the Offsetting Behaviour blog Eric Crampton quotes from the conclusion to my recent NZEP paper on the theory of privatisation. Eric highlights the problems that the ex ante restrictions that governments often place on privatisation schemes can cause.

From Walker's conclusion

...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 government’s restrictions on foreign ownership and the desire to sell to ‘Mums and Dads’, both of which restrict 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.

While I completely agree with myself, let me add that ex ante restrictions are not the only cause of problems with privatisation programs. Badly designed ex post rules can also result in bad outcomes from privatisation:

...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.

The easier and (politically) cheaper it is for politicians to interfere with firms after they have been privatised the more likely it is that the results of a privatisation program will be poor. A strong ex post framework which emphasises competition and raises as high as possible the costs to political interference with the privatiased firm the better the outcomes to privatisation are likely to be.

Latest New Zealand Economics Papers

There are actually a few interesting looking papers in the latest issue of NZEP:

Does stadium construction create jobs and boost incomes? The realised economic impacts of sports facilities in New Zealand

by Samuel A. Richardson

Government involvement in facility construction is typically justified on the basis of ex-ante predictions of economic impact resulting from events hosted at the new or upgraded facility. This paper examines the impact of facility construction on construction sector employment and real GDP across 15 New Zealand cities between 1997 and 2009. Results from static and dynamic models indicate that certain types of facilities had short-term (during construction) positive impacts on construction sector employment growth, although only stadium projects generated positive post-construction employment impacts. There is also little in the way of empirical evidence to suggest that new or upgraded facilities had any significant impact on local area real GDP either during or post-construction.

The effects of home heating on asthma: evidence from New Zealand

by Andrea Kutinova Menclova and Rachel Susan Webb

New Zealand, along with the USA and Australia, has one of the highest asthma rates among developed countries and previous analyses attribute this partly to insufficient home heating in certain neighbourhoods. International public health and medical studies corroborate this link but strong evidence of causality is lacking. In this paper, we empirically investigate the effect of home heating on hospital asthma admissions using panel data techniques and controlling for endogeneity. The hypothesis that higher electricity prices (via less adequate heating) increase hospital asthma admissions is tested and receives strong empirical support across a number of model specifications and datasets used.

and, of course, the truly magnificent - he says with all modesty

From complete to incomplete (contracts): A survey of the mainstream approach to the theory of privatisation

by Paul Walker

Privatisation is a common, yet controversial, policy in many countries around the world, including New Zealand. In this essay, we survey the literature on the theory of privatisation to see what insights it provides to the privatisation debate. We divide the literature into two periods defined by their relationship to the theory of the firm. In the period up to 1990, the literature followed the theory of the firm in using a complete or comprehensive contracting modelling framework. By the end of the 1980s, the ownership neutrality theorems highlighted a major weakness with this approach. The contemporary (post-1990) literature took advantage of incomplete contracting models to explain the difference in the behaviour of state and privately owned firms.

Government takes over Serco-run Mt Eden prison

That is the headline on an article at stuff.co.nz. In the article Aimee Gulliver writes,

Corrections Minister Sam Lotu-Iiga announces that the government is taking over Serco-run Mt Eden prison as of Monday.

The government is taking over the management of Mt Eden prison as of Monday, following serious allegations of prisoner mistreatment at the Serco-run facility.

Serco staff will remain on site but a management team will be put in place to oversee the day to day running of the facility.

The decision comes after a series of serious allegations at the Mt Eden prison, where inmates are claimed to have been thrown off balconies in a practice known as "dropping", and physically assaulted.

A question I would ask is, Should we be surprised at this outcome? One reason for saying no comes from the literature on privatisation, in particular the paper 'The Proper Scope of Government: Theory and an Application to Prisons' by Oliver D. Hart, Andrei Shleifer and Robert W. Vishny, "Quarterly Journal of Economics", 112(4) November: 1127-61, 1997. The paper considers the question as to which goods or services the government should provide, with an emphasis on prison services.

The HSV model considers the choice between in-house production and contracting out. The provider, government or private, can invest in improving the quality of service or reducing cost. Given incomplete contracts, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee has. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on noncontractible quality. Cost are always lower under private ownership but quality may be higher or lower under a private owner.

Hence the focus of the HSV model is on quality. 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 basic idea is that the provider of the service, whether it be the government or a private firm, can made an investment to increase the quality of the service or a investment to reduce the cost of the service. It is important to note that quality is reduced by any cost reductions. Neither of these two investments are ex ante contractible. But to implement either of the innovations requires the agreement of the owner of asset. The asset can be thought of as, say, a school or a hospital or a prison. If the owner of the asset is the government then the provider of the service, who will be a government employee, requires the approval of the government to invoke either investment since, in this case, the residual control rights reside with the government. As a result, the employee will receive just a fraction of the returns to either innovation, even if implemented.

If on the other hand the provider is a private sector contractor, then the contractor has the residual control rights and thus does not need the government's agreement for a cost reduction. However, if the contractor wishes to improve the quality of the service and receive a higher price for it, then they have to renegotiate with the government since the government is the purchaser of the service. Under the assumption that the contractor is successful in obtaining an increase in price they capture all such gains. Thus a private contractor will generally face stronger incentives, than a government employee, to improve quality and reduce costs but the incentive to reduce costs can be too strong since the contractor ignores the negative impact this has on quality.

HSV examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Their theoretical arguments suggest that the case for in-house provision is generally stronger when noncontractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatisation is stronger when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government.

They then 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.

With regard to prisons HSV write (p. 1152-4)

Prisons seem to fit reasonably well into our framework. Although in some respects prison contracts are very detailed, they are still seriously incomplete. There are significant opportunities for cost reduction that do not violate the contracts, but that, at least in principle, can substantially reduce quality. Moreover, from the available evidence we have the impression that the world may not be far from the assumptions of Proposition 4. First, the welfare consequences of quality deterioration might be of the same magnitude as those of cost reduction (b(e) and c(e) are comparable). Second, the opportunities for quality innovation are limited (beta(i) is small). Under these conditions, Proposition 4 suggests that public ownership is superior.

Would ex post competition between prisons for inmates strengthen the case for privatization? One possibility is that convicts themselves choose the prison in which to serve their sentences, but this is probably a bad idea, since prisoner choice would encourage contractors to attract customers by allowing gangs, drugs, and perhaps even easy escapes. A more plausible alternative is to have judges choose a private prison to send a convict to, with the idea that judges would send more inmates to higher quality prisons and fewer to lower quality prisons. Private contractors would then have the appropriate incentives to invest in quality improvements, and to avoid excessive cost reductions, to bring in more business. At the moment, such schemes have not been tried, in part because there is a shortage of prison capacity in the United States, but it is possible that they could be tried in the future. One potential disadvantage of such judge choice is that some judges might actually choose lower quality prisons because they want the inmates to get a stiffer penalty, whereas other judges might choose prisons that are soft on inmates. Contractors would then cater to the preferences of the judges, which need not coincide with social welfare.

Finally, the choice of whether to privatize prisons depends on the importance of corruption and patronage. Patronage does not appear to be a huge problem in prison employment in the United States, since the union premium as of this writing is not large. Corruption appears to be a greater concern, at least judging from the available anecdotal evidence. To begin, private prison companies are very active politically. For instance, ESMOR evidently lobbies politicians and makes political contributions to receive contracts {The New York Times, July 23, 1995}. The wife of Tennessee governor Lamar Alexander invested early and profitably in the stock of Corrections Corporation of America, which subsequently got involved very deeply in the privatization of Tennessee prisons with the governor’s endorsement {The New Republic, March 4, 1996, p. 9}.

A related problem is that contract enforcement cannot be taken for granted. The INS report concludes that ESMOR’s changes in policies “hindered INS ability to effectively perform its oversight functions.” The report also notes that ESMOR told its guards not to share information with the INS officials working on the premises, and in one instance encouraged the INS to reassign an officer who complained about the performance of the Elizabeth, New Jersey, facility several months prior to the riot. The report indicates that ESMOR violated the contract in some instances, and also pursued policies preventing the INS from enforcing the contract. But it is also clear from the report that the INS did not do what it could to enforce this contract. The INS report vividly illustrates how a government bureaucracy with relatively weak incentives has trouble enforcing a contract with a private supplier determined to reduce its costs, even if this involves violations of the contract and not just the issues on which the contract is silent.

In sum, our model suggests that a plausible theoretical case can be made against prison privatization. This case is weakened if competition for inmates can be made effective, but strengthened by the relevance of political activism by private contractors. One instance in which the case against prison privatization is stronger is maximum security prisons, where the prevention of violence by prisoners against guards and other prisoners is a crucial goal {The New York Times Magazine 1995}. In many cases, the principal strategy for preventing such violence is the threat of the use of force by the guards.We have shown that it is difficult to delineate contractually the permissible circumstances for the use of such force. Moreover, hiring less educated guards and undertraining them—which private prisons have a strong incentive to do—can encourage the unwarranted use of force by the guards. As a result, our arguments suggest that maximum security prisons should not be privatized so long as limiting the use of force against prisoners is an important public objective. Consistent with this view, only 4 of the 88 private prisons in Thomas’s {1995} census of private adult correctional institutions in the United States are maximum security. In contrast, private half-way houses and youth correctional facilities, where violence problems are less serious, are common {Shichor 1995}.

So there is a case to be made for private prisons, but it may not be as strong as for other services currently provided by the government, and it is at its weakest for the case of maximum security prisons. Thus seeing Mt Eden prison back under government management may not be that surprising. Maximum security prisons are an area where government provision can be more effective.

Interesting papers forthcoming in NZEP

New Zealand Economic Papers has some interesting papers due to appear in future issues.

From complete to incomplete (contracts): A survey of the mainstream approach to the theory of privatisation.

Abstract
Privatisation is a common, yet controversial, policy in many countries around the world, including New Zealand. In this essay, we survey the literature on the theory of privatisation to see what insights it provides to the privatisation debate. We divide the literature into two periods defined by their relationship to the theory of the firm. In the period up to 1990, the literature followed the theory of the firm in using a complete or comprehensive contracting modelling framework. By the end of the 1980s, the ownership neutrality theorems highlighted a major weakness with this approach. The contemporary (post-1990) literature took advantage of incomplete contracting models to explain the difference in the behaviour of state and privately owned firms.

The effects of home heating on asthma: evidence from New Zealand

Andrea Kutinova Menclova and Rachel Susan Webb

Abstract
New Zealand, along with the USA and Australia, has one of the highest asthma rates among developed countries and previous analyses attribute this partly to insufficient home heating in certain neighbourhoods. International public health and medical studies corroborate this link but strong evidence of causality is lacking. In this paper, we empirically investigate the effect of home heating on hospital asthma admissions using panel data techniques and controlling for endogeneity. The hypothesis that higher electricity prices (via less adequate heating) increase hospital asthma admissions is tested and receives strong empirical support across a number of model specifications and datasets used.

Does stadium construction create jobs and boost incomes? The realised economic impacts of sports facilities in New Zealand

Samuel A. Richardson

Abstract
Government involvement in facility construction is typically justified on the basis of ex-ante predictions of economic impact resulting from events hosted at the new or upgraded facility. This paper examines the impact of facility construction on construction sector employment and real GDP across 15 New Zealand cities between 1997 and 2009. Results from static and dynamic models indicate that certain types of facilities had short-term (during construction) positive impacts on construction sector employment growth, although only stadium projects generated positive post-construction employment impacts. There is also little in the way of empirical evidence to suggest that new or upgraded facilities had any significant impact on local area real GDP either during or post-construction.

The first privatisation programme?

While I knew there were one-off sales of state-owned firms (e.g. the sale of a majority share in Volkswagen by the German government in 1961 and the sale of Veba shares in 1965) before the 1970s, my understanding had been that the use of systematic, on going, asset sales programmes did not begin until 1974 with a little known privatisation programme in Chile. (On the Chilean programme see Bitran and Saez (1994), Hachette and Luders (1993) and Luders (1991).) Note that this was a few years before the first widely known privatisation programme of the first Thatcher government in the U.K.

But I have now learnt that I was very wrong, 1974 is way too recent. It turns out that the Japanese may have had the first mass privatisation programme. During the period 1874 to 1896 the Japanese government sold 26 large SOEs  (Morck and Nakamura 2007).

Details of the sales are given in the tables below (click to make larger), which is Table 1 from Morck and Nakamura (2007: 566-7). It lists the SOEs divested, details of the transactions, and both the immediate and ultimate buyers:

The motivation, as you may well have guessed, was escalating fiscal pressure on the government, and the reluctant acknowledgement that most SOEs were not worth their gross book values. This lead to the beginning of the SOE sales in 1874 with the Takashima coal mine being offered to the highest bidder. Sales continued for the next 20 years, with the last of the 26 sales taking place in 1896. Only a few SOEs escaped the mass privatization—military suppliers, mints, government printing, railways, postal services, and telegraphs.

Refs.:

• Bitran, Eduardo and Raul E. Saez (1994). 'Privatization and Regulation in Chile'. In Barry P. Bosworth, Rudiger Dornbusch and Raul Laban (eds.), The Chilean Economy: Policy Lessons and Challenges (pp. 329-68), Washington D.C.: The Brookings Institution.
• Hachette, Dominique and Rolf Luders (1993). Privatization in Chile: An Economic Appraisal, San Francisco: ICS Press.
• Luders, Rolf J. (1991). 'Massive Divestiture and Privatization: Lessons from Chile'. Contemporary Economic Policy, 9(4) October: 1-19.
• Morck, Randall and Masao Nakamura (2007). 'Business Groups and the Big Push: Meiji Japan's Mass Privatization and Subsequent Growth', Enterprise & Society, 8(3) September: 543-601.

How not to run a company

At the Offsetting Behaviour blog Eric Crampton reminds us of one of the great stories about the inefficiency of the old Eastern Block. Eric writes,

Remember the story of the West German auto exec who, after touring the Trabant plant, wept because the value of the steel and other inputs going in exceeded the value of the car coming out? The Trabant plant was destroying value.

For those who don't know it, the story comes from a World Bank publication, Transition: a newsletter of the World Bank, Number 5-6, May-June 1996, page 15:

With a view to corporate takeover Volkswagen AG sent a Herr Heuss to Zwickau to find out how the Trabant (relatively cheap, East German cars) were made there. He emerged shocked from the huge plant, babbling "My God!" The Trabant operation was value-subtracting: valuable material, labor, and capital inputs went in at one end; shabby Trabies came out at the other, their bodies made from compacted trash. The final output was worth less than the sum of the inputs. What was not fully understood at the time was that East Germany's whole economy was value-subtracting and cost-unconscious.

I still can't get my head round the idea that "production" is value decreasing! But its something to keep in mind when there are those who would have the government take a much greater role in running the economy and owning firms. It doesn't doesn't always end well.

Coase and the state

Most people see the late Ronald Coase as a defender of free markets, but not all, Bylund (2013), for example, sees Coase as more of a socialist, a supporter of planning, while Ricketts (2014: 52) argues that

One of the characteristics of Coase’s output is that his whole approach to economics makes him very difficult to place in terms of ideology.

So what was Coase's view of the role of the state and planning?

When discussing Coase's approach to public utility pricing Ricketts (2014: 51) writes,

It is important to note here Coase’s scepticism of any government’s ability to know what people were prepared to pay for various outputs or what the opportunity costs of output are. In this he takes a view similar to Hayek (1945) on the information transmitted in prices that are generated through market processes. The prices (and the embedded information about consumers’ valuations and opportunity costs) emerge from market transacting and are most unlikely to emerge from governmental planning. Planning arrangements of all types (within firms as well as governments) rely to a large degree on the information produced across markets.There might be a ‘cost of using the price mechanism’ but there is also a cost of ignoring the price mechanism – deriving from the loss of information that would otherwise be revealed through its operation.

So we see that one argument in favour of using markets, as opposed to using planning, is the loss of information inherent in central planning. But,

On the other hand the foundational insight upon which his work was built that ‘it would seem to be that there is a cost of using the price mechanism’ is equally clearly a statement leading directly to the point that markets have their limits.

So markets have advantages but also limits. Ricketts goes on to say that the great contribution Coase made was to show that the market versus the state dichotomy is a misspecification of the organisational problem facing all communities.

In a world of positive transactions cost the question is where in the great space between individual market transacting and full collective planning it is best to operate (Ricketts 2014: 52).

The position in that space in which you end up will depend on the costs of the various contractual arrangements that could be utilised and will be a matter of business judgement, in a broad sense.

Thus Coase's market supporting credentials are in many ways consequentialist. A point that the deontologist defenders of the market, including many libertarians, will not approve of.

Ricketts writes,

Coase’s ‘market supporting’ credentials do not therefore derive from a position that market contracting is always best.They derive from his point that only the ability to try out different organisational settings and subject them to a test of survivability will reveal what structures are most productive. It is the existence of competition between alternative solutions to the problem of economising on the cost of transacting that is important. Planning and market transacting are both potentially helpful (indeed ideally equally so at the margin) and ‘what this mix should be we find as a result of competition’ (Coase 1992, p. 716). (Ricketts 2014: 53).

The notion that markets are not always "best" is important in the Coasian framework. With the advancement of public-private partnerships, privatisation and contracting out in the West and the collapse of the formerly ‘planned economies’ of the East the boundary between state and private production shifted towards more private provision. At the most general level we have witnessed a substitution of contract (private production) for internal organisation (public provision).

The old plan versus market debate mutated into a much more complex debate about institutional structures. Policymakers now had to consider whether public objectives might be better served by contracting with private suppliers rather than organising production within bureaucracies or state-owned firms (Ricketts 2014: 53).

As I have noted before authors such as Hart, Shleifer and Vishny (1997) 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. But the expanded utilisation of contract implies that judgements about transactions cost have now became central to policy decisions.

In principle these decisions would be taken on the basis of careful appraisal of alternative available contractual settings, as recommended by Coase. Public choice and other political pressures are, however, as capable of influencing judgements about contract as they are about decisions in nationalised or state-owned enterprises. In addition, many contracts can involve very long periods of time, the disposition of large amounts of specific capital and very complex objectives. Such contracts are very likely to require renegotiation as time advances, and the transactions costs incurred therefore can be very significant. Examples in the UK include Private Finance Initiative contracts to build and maintain schools and hospitals or provide accommodation for defence personnel. Public Private Partnership agreements have been used (with notable associated problems) to upgrade infrastructure such as the London Underground (Ricketts 2014: 53).

The takeaway message here is not that the use of contract is wrong but that the multifarious circumstances will often suggest differing contractual responses. One size does not fit all

In general terms what can we say about Coase's approach to the question of the public versus private provision and about Coase's approach to economics more generally?

Coase did not engage in fruitless methodological controversy. His work used conventional terminology and was, to a degree,‘conservative’ of the established tradition. Nevertheless it did highlight the limitations of static neoclassical analysis. Organisational problems and contractual responses derive ultimately from imperfect information and the uncertainty that inevitably accompanies the passage of time.A world of perfect (zero-cost) information would be a determinate one – the future mapped out and encapsulated in a set of agreements covering all future time periods. In fact, institutions such as money or the firm emerge as a way of coping with the fact that we do not inhabit such a world.They enable us to keep our options open and to respond to emerging events. Coase (1937, p. 391) himself wrote of the cost not only of negotiating contracts but of renegotiating them to take account of changing circumstances and ‘the difficulty of forecasting’ or exactly specifying what another party is to do over an extended time period.The response to these contractual costs was ‘the firm’ – a set of loosely specified contracts of employment with a central agent with the flexibility to alter (within limits) the employees’ activities over time (Ricketts 2014: 56).

Coase can be seen as somewhat Marshallian in that Coase's conception of economic life was not one of static equilibrium, as in the neoclassical approach, but of a complex evolving system. In this he followed in the tradition of Marshall, who saw economics as having more affinities with the study of biology than physics.


Ref.:

• 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.

Pyramids v. privatisation

One way to think about privatisation is that it is a way for a government to commit to a policy of non-intervention in the operation of a firm. Selling a business maximises the "distance" between the government and the firm and increases the political cost to interference with the firm. But is it the only way? One common business structure seen around the world is a pyramid-type organisation. In such a the controlling owner at the top of the pyramid controls a firm indirectly through layers of intermediate companies. Such a structure is common among government owned organisations, the question is Why?

An answer to the second question above involves answering the first question. In short the use of pyramid structures is a way for government to attempt to commit to a policy of non-intervention without going the whole way to privatisation. A pyramid is a (partial) way of separating firms from political interference.

The development of organisational pyramids give governments more credibility in committing to nonintervention than simply a policy prescription that calls for increased delegation of decision rights to managers of SOEs. This is because the complex organisational structure of pyramids increases the government's cost of obtaining sufficiently timely information to interfere in the day-to-day operations of the firm, and thus prevents an intervening government from imitating a pyramidal strategy. The added complexity of the pyramid structure reduces the "bosses" access to the information needed to intervene in the day-to-day operations of a firm at the bottom of the pyramid and thus protects the managers of that firm from the interference of government officials leaving the managers more exposed to market forces.

Such a organisational structure will not be as effective as actual privatisation - the discipline of bankruptcy, for example, will be weaker under any form of government ownership than it would be under private ownership - but is likely to be more efficient than direct control by government ministers or officials. In situation where privatisation is difficult or impossible for political reasons a pyramid structure may be a second-best solution.

To test this idea that pyramids act to insulate managers from political interference, Fan, Wong and Zhang (2013) focus on the case of China. The Chinese setting, they argue, has several important advantages for this purpose. First, in China, state assets and their controlling ownership are not freely transferable across firm boundaries. As a result, state owners almost always possess 100% of the equity ownership of a pyramid’s firms, which precludes equity financing from serving as the primary reason for a pyramidal structure. Further, because state owners are unable to use outright sales as a means to transfer decision rights in a firm to a third party, as is typical in a market economy, a transfer of decision rights that increases autonomy can be achieved only via a mechanism—such as a pyramid—which is short of an actual transfer of ownership. Second, China’s market economy is young. This allows us to investigate corporate pyramids near their inception, during a time when decentralization has been a chief part of the country's market reforms. Third, China’s markets and geographic regions provide sufficient variation in institutional settings to facilitate measurement of controlling owners' (i.e., local governments’) incentives to decentralise decision-making power to firm managers through pyramidal organisational structures.

Their empirical evidence is consistent with the hypothesis outlined above. In particular, using a comprehensive sample of 742 initial public offering (IPO) firms, majority owned by local governments in China, they find that local governments form more extensive pyramids when they have incentives to lower firm political costs arising from interference. The government's weaker incentives to intervene induce it to credibly transfer decision rights to management through pyramids. While the reduction of SOE political costs leads to more decentralisation of power through pyramid formation, adding more layers could increase agency costs, as the higher information costs make monitoring more difficult. Their empirical results show that more extensive pyramidal structures are associated with stronger legal or market discipline on firm managers, indicating that stronger institutions reduce agency problems arising from empowering management. Further supporting the conjecture that pyramids insulate firms from government intervention, they find a significant positive association between the number of pyramidal layers and the extent of firm managerial professionalism, employment efficiency, total factor productivity, and profitability. In additional analyses, they survey government officials in charge of state asset management and find evidence that managers of the firms who are part of pyramid structures have more decision rights than managers of the firms who are directly linked to the governments.

Thus pyramids achieve some of the depoliticisation aims of privatisation in cases where privatisation itself is, at least in the short term, impossible.

Ref.:

• Fan, Joseph P. H., T. J. Wong, and Tianyu Zhang (2013). 'Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids', Journal of Law Economics and Organisation 29(6): 1217-1252.

A bad question

From the Homepaddock blog we learn,

Enough signatures have been gathered to force a politicians’ initiated referendum on asset sales.

The question we’ll be asked is:

“Do you support the Government selling up to 49% of Meridian Energy, Mighty River Power, Genesis Power, Solid Energy and Air New Zealand?”

This is a bad question since as written I would have to say no to it. As I have said before there are good reasons for thinking the partial sale plan isn't a good one. But just because I don't like the partial privatisation plan doesn't mean I support continued government ownership of these assets, which is, I'm sure, what will be claimed if you say no to the question.. The problem with the question is that we are not told the alternative. If we don’t sell 49% of the shares what do we do? let the government keep them, bad idea; sell 100% of the shares, much better idea.

So can we have a better question, please.

Why is it that the expression "third way" always worries me? 3

Let me make a few quick comments in reply to Jason Krupp. First let me apologise for any misrepresentation I may have made, this was unintended.

My point about the meaning of ownership is that even taking into account "democracy and the nature of general elections versus specific referenda" taxpayers do not have the rights defining ownership. The residual controls rights for SOEs are not in the hands of taxpayers, these rights are held by the government or its bureaucracy. I fail to see how your dinner companion can in anyway think they are an owner of any SOE in that they do not have residual control rights over any SOE. Or at least this would be my reply to them.

My point about the government being the single shareholder isn't that having a single shareholder is bad, its about the government being a majority shareholder. I would argue that there is likely to be little difference in the operations of an SOE as long as the government is the majority shareholder. Thus an SOE under 100% government ownership will look much like an SOE with 51% government ownership. Hence my comment on the García and Ansón paper.

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that  the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees,  the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added).

As to having millions of people acting in the role of shareholder this may or may not be a good thing. It is not clear that we need to "foster a savings culture in New Zealand", there is no saving problem here - see, for example, Le, Scobie and Gibson (2009) and Le, Gibson and Stillman (2012) for more on this.

Even if we want, and don't have currently, a "thriving equity market" its not clear that this should be an aim of a privatisation program. The aim should be efficiency and productivity. Roger Douglas made this point in an article from the New Zealand Herald.

"Privatisation is not really about how much money you get for the asset, that's important, but the more important issues are to get the regulatory environment right so that competition can take place in the industry.

"What you measure your success by is the productivity that flows following the corporatisation / privatisation process."

The New Zealand sharemarket may not be thriving, but is it the government's job to fix this, any more than it is the government's job to fix or support any other sector of the economy? I can't help thinking it is not the job of any government to bolster the sharemarket, that is the job of the those who run the sharemarket.

Refs:

• Le, Trinh, Grant Scobie and John Gibson (2009). Are Kiwis saving enough for retirement? Evidence from SOFIE, New Zealand Economic Papers 43(1): 3-19.
• Le, Trinh, John Gibson and Steven Stillman (2012). Wealth and saving in New Zealand: evidence from the longitudinal survey of family, income and employment, New Zealand Economic Papers 46(2): 93-118.

Why is it that the expression "third way" always worries me? 2

The following comes from the comments section to my previous posting Why is it that the expression "third way" always worries me? and is from Jason Krupp author of the New Zealand Institute piece I was commenting on. Let me thank Jason for taking the time to write this comment.

Dear Anti-Dismal:

I enjoyed the article, and you raise many valid points, though some of the positions you attribute to me are a little off.

Firstly, it's the critics of the mixed ownership who've claimed New Zealanders already own the state owned assets. In fact I remember a particular dinner conversation in which one guest said of the partial float “why should I pay for what’s already mine?”.

As for the complicated morass of property rights, democracy and the nature of general elections versus specific referenda, well, I’m sure you’ll agree that it’s too broad to tackle in the 500 words I had to work with.

Also, in a piece of this nature you have to take a few short cuts, such implying Government ownership when referring to a single shareholder. Should I have spelled it out?
Perhaps, but I’m giving the reader the deductive benefit of the doubt – one I’m confident they’ve made.

This need for short cut extends to the share ownership issue you’ve taken umbrage with. Of course we won't have 4.4m shareholders for long as some will sell and some will hold because there is a free market to sell them - something that wasn't available in the Soviet example you used.

But those who sell can use those funds for other things – investing in a business, paying down debt, splashing out at the shops – which have upside benefits for the economy and the government’s coffers.

And adding millions of people to the shareholder roll is a good on many levels. It’s a fantastic way of building up knowledge in the equity market, which we need if we are going to foster a savings culture in New Zealand.

I’m sure you’d also agree that a thriving equity market (which we don’t have at the moment, but it’s getting better) is essential if we’re going to lower the cost of capital for New Zealand businesses, which is notably higher than across the Tasman.

Lastly, “selling 100 per cent of the SOEs by any means would mean that this is at best a one-off trick” is exactly the point, albeit a Hayekian one. If, as a politician, you know you can’t sell the family silverware to get you out of debt, you’re likely to think a bit more carefully about what you’re getting into debt for (actually that might be a little naive).

In conclusion, you’re right, the third way is not that clear at all, but equally neither are the benefits/costs of other options.

Jason Krupp
The New Zealand Initiative

Why is it that the expression "third way" always worries me?

 In the latest issue of "Insights" from the New Zealand Institute Jason Krupp argues for A third way on asset sales.

Krupp argues that

The anti-privatisation camp, rightly or wrongly, have taken glee in pointing out that the Government is selling off assets that generate higher dividend returns than the equivalent interest rate on our public debt.

If true, then it just tells us that the method of sale is wrong, the government is not capturing the full amount of money it could if it used a different method of sale. Answer, change the method of sale.

Also Krupp says,

Critics have also noted retail investors will be paying for these assets twice, since they’re technically owned by all New Zealanders anyway. Plus, those who don’t participate are having part of their national wealth snatched away from them.

This is just plain wrong, New Zealanders do not own the SOEs. Oliver Wendell Holmes Jr. asks the question: What are the rights of ownership? His answer,

They are substantially the same as those incident to possession. Within the limits prescribed by policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one. (The Common Law, p193, (1963 edn.))

Clearly the "public" does not have the rights Holmes refers to, he government (or its bureaucracy) has them. Following Grossman and Hart ("The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration", Journal of Political Economy, 94: 691-719) economist's tend to define the owner of an asset as the one who has residual rights of control over the asset; that is whoever can determine what is done with the asset, how it is used, by whom it is used, when they can use it etc - note that ownership is not defined in terms of income rights. Under "public" ownership it isn't the "public" who has the control rights, its the government. The "public" can not determine what use is made of a "public" asset, rather its use is determined by the politicians and managers in command of it.

Madsen Pirie at the Adam Smith Institute blog puts it this way

The state sector may have the name of the public filled in on the dotted line, but the public do not own it in any meaningful sense of the word. All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the bureaucracy in command of it.

and

Because the public has no choice over whether to pay for state services, or to choose what quality of service is appropriate for them, they have no power over them. In their absence it is the managers and workforce who increasingly direct the services to meet their needs and convenience instead of those of the public.

Krupp continues,

Indeed, it could be argued that the efficiency drag of a single shareholder [the government] can already be seen, with Contact Energy and TrustPower (two private companies with diverse shareholder bases) offering the highest returns on equity in the sector. Returns from the state-owned firms lag behind these two companies by a noticeable margin, even though they’ve been operating as private entities for over a decade.

The issues here isn't so much that there is a single shareholder, its that the shareholder is the government. A firm with a single private shareholder would act differently from the SOEs. This is one reason for not liking partial privatisation, the government keeps control with its 51%.

If you look at the economics literature you will find that fully private companies outperform mixed ownership firms. Some insight on this is offered by a recent paper in the Scottish Journal of Political Economy (Volume 59, Issue 1, pages 1–27, February 2012). The paper "What Drives the Operating Performance of Privatised Firms?" by Laura Cabeza García and Silvia Gómez Ansón argues that the greater the amount of privatisation the better the performance of the firm. Not an entirely surprising result as the full force of market discipline can only be applied if the firm is fully in private hands but it is something for the government to keep in mind. It would suggest that any performance improvements due to the government's partial privatisation plans will be modest. The abstract reads,

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees, the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added)

When you look at the performance of mixed ownership firms they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude

'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].'

So fully private firms out-perform mixed ownership firms.

Krupp then asks,

So, given these compromises, has the hybrid privatisation been worth it?

In my view there are at least 6 reasons for thinking hybrid privatisation will not be worth it:

• First, selling only 49% of the shares in the companies is unlikely to make a huge difference to the way the SOEs are run. In particular the sell off will not make the firms any more efficient since the government will still be the controlling shareholder.
• Second, if the government really does want to maximise the income it gets from the sales selling 49% is not a good idea. 51% is worth a lot more than 49%, that is people will pay a premium for control.
• Third, selling to "Mums and Dads" will do nothing for the amount of money raised, since Mums and Dads will need a discount to make them buy shares.
• Fourth, selling to "Mums and Dads" will do nothing for the efficiency effect of having private owners, since there will be too many "Mums and Dads" for them to be able to coordinate their effects to effect the firm's behaviour.
• Fifth, 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. This is another reason why performance is unlikely to change.
• Sixth, the discipline of bankruptcy or takeover is not greater since the government is still the controlling shareholder and is unlikely to let either of these options happen.

Krupp ends by saying,

Frankly, it’s too early to tell, but it’s interesting to consider that there could have been a third option: just giving the shares away (as pointed out by Professor Sinclair Davidson of the Royal Melbourne Institute of Technology).

While the government would give up a dividend stream, that’s traded off against the $10 billion it would inject into the economy at a local level.

It also scratches two other important itches; it instantly creates 4.4 million equity investors, and removes the political temptation to win votes by blow-out spending, knowing you can sell off parts of the balance sheet when the debts come due.

It should be noted that giving shares away has been used before, especially in the old Soviet Union, but its not clear that its outcomes where that successful. You also have to ask, Why do we want "4.4 million equity investors"? What we want is an ownership structure that results in the most efficient use of our resources, How can we know that having "4.4 million equity investors" is that structure? I'm guessing that most people would not want their shares and thus would simply sell them which results in fewer than "4.4 million equity investors", which seems to defeat Krupp's aim of creating these investors in the first place. All it would do is change who gets the rewards from selling the shares. This may, or may not, be a good thing.

As to the aim of removing the "political temptation to win votes by blow-out spending", selling 100% of the SOEs by any means would mean that this is at best a one-off trick.

All in all its not clear that the third way is the right way.

Privatisation in New Zealand

This is a video of a presentation given by Sinclair Davidson a few weeks back at the New Zealand Initiative on privatisation and public choice.

Why does the public oppose privatisation?

This question is asked by Sinclair Davidson over at The New Zealand Institute. Davidson writes,

Privatisation provides an interesting case study for free-marketeers. Almost everyone is opposed to the notion, yet those same people often buy the stock. So what is it about privatisation that everyone hates?

There are at least three arguments why voters may dislike privatisation. First, there is Bryan Caplan’s voter bias argument. Caplan has argued that voters suffer from four sources of bias – an anti-market bias, an anti-foreign bias, a make work bias, and a pessimism bias. Privatisation as a policy hits all them. Government using markets to sell assets to foreigners who will lay off workers? That couldn’t possibly work.

Then there is Thomas Sowell’s conflict of visions. Privatisation as a policy goes to the very core of the political debate. What is the appropriate role and function of the state in civil society and in the economy?

For those of us who suspect the answer to that question is ‘minimal, at best’, privatisation is an uncontroversial policy. For others not so much.

The thing to remember is that elite opinion holds that the state can and should do more, not less. This remains the case 30 years on from the Thatcher, Reagan, Douglas, and Hawke-Keating eras.

State ownership has many plausible theoretical arguments to support it. The theoretical arguments for privatisation seems weak. It is the empirical evidence that supports the principle of privatisation for many people. But without a clear theoretical basis for the policy, we run into the third problem that privatisation policy faces.

Ok up to this point. What I don't get is why he says that the theoretical base for privatisation is weak when there is a, albeit, relatively recent - post-1990 - literature that provides a solid theoretical base for privatisation. See below. Now I admit its not the kind of material that your average bloke in street is going to read sitting up in bed of a Sunday morning, but the job of the economist then is to make this bloke sit up and take notice.

As to what the theory of privatisation is let us start by noting that there is a surprising overlap between the theory of the firm and the theory of privatisation. The theory of the firm gives us a framework for the theory of privatisation. Hart (2003: C69) makes this clear when he writes,

"Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms, A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals). Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B".

and

"[ ... ] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership". Hart (2003: C70)

The incomplete contracting framework gives an approach which can be utilised to study the difference between public and private ownership. In fact incomplete contracts are a necessary condition to explain the differences between the two forms of ownership. In a world of complete or comprehensive contracts there is no difference between private and state owned firms. In both cases the government can write a contract with the firm that will anticipate all future contingencies - it will detail the managers' compensation, the pricing policy of the firm, how changes in technology will the change the firm's products etc - and thus the outcome under both forms of ownership will be the same.

This intuition has been formalised into a series of what are called Neutrality Theorems. These theorems formally establish the conditions under which private or public ownership of productive assets is irrelevant for the final allocation of resources. In short they show the conditions under which ownership of the firm does not matter.

Of all the assumptions on which the neutrality results hinge the most important requirement is, as noted above, that complete contingent long-term contracts can be written and enforced. But writing complete contracts is only possible in a world of zero transaction costs. In a positive transaction costs world only incomplete contracts can be written but contractual incompleteness creates a role for ownership - making decisions under conditions not covered in the contract. It is only within such an environment that we can explain why privatisation matters, that is, why the behaviour of state owned and private companies differ.

These neutrality results also show why the previous, roughly pre-1990, theoretical privatisation literature was largely unsuccessful. That literature took a `complete' or `comprehensive' contracting perspective, in which any imperfections present in contracts arose solely because of moral hazard or asymmetric information. But as Hart (2003: C70) notes

"[ ... ] if the only imperfections in are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights').

Applying this insight to the privatisation context yields the conclusion that in a complete contracting world the government does not need to own a firm to control its behaviour: any goals - economic or otherwise - can be achieved via a detailed initial contract. However, if contracts are incomplete, as they are in practice, there is a case for the government to own an electricity company or prison since ownership gives the government special powers in the form of residual control rights".

Thus privatisation matters only in an incomplete contracts world. In such an environment the allocation of residual control rights will differ and so the behaviour of publicly owned firms will differ from that of privately owned firms and thus ownership and therefore privatisation will become meaningful. This is the basic approach taken in the post-1990 literature.

Schmidt (1996a) considers a monopolistic firm that producers a public good in a world of incomplete contracts. (Schmidt (1996a) is variant of Schmidt (1996b). 1996b considers the case of privatisation to an employee manager while 1996a applies to the case of privatisation to an owner-manager. While this second case is less realistic it is simpler and does not require the assumption that the manager is an empire builder that is utilised in 1996b.) His model is multiple period with the privatisation decision being made in the initial period. That is, the government must decide whether to sell the SOE to a private owner-manager or keep it in state hands and hire a professional manager to run it. Importantly knowledge concerning the firm's cost is private information known only by the firm's owner. Given this, privatisation amounts to a transfer of private information from the government to the private owner. In the next period the manager selects his effort level and the state of the world is then revealed. The importance of the manager's effort level is that it affects the probability of the state of the world. A high level of effort from the manager results in productive efficiency being enhanced and costs being lowered for any level of output. In the last period, the government selects the transfer scheme and payoffs are revealed.

When the firm is an SOE the government observes the firm's realised cost function and thus can implement the first-best allocation by choosing the ex post efficient level of production. But the manager's wage will be fixed, since contingent contracts can not be written, and thus independent of level of output. Given this the manager has no incentive to exert effort and the government knowing this will therefore offer him only his reservation wage.

On the other hand when the firm is in private hands the government does no know the exact cost structure of the firm. In an effort to get the private owner to produce the efficient level of output the government must provide an incentive via the payment of an informational rent.But if transfer are costly it will be impossible to implement the optimal allocation and therefore the cost to private ownership is an inefficiently low level of production. However given the rent payment provides an incentive to increase effort, productive efficiency is greater.

Schmidt's main conclusion is therefore that when the monopolistic firm produces a good or service which provides a social benefit, there is a trade-off between allocative and productive efficiency that needs to be considered when deciding if a firm is to be privatised. The equilibrium production level is socially suboptimal but the incentive for better management results in cost savings. Considered overall the welfare effect of privatisation should be positive for cases where the social benefits are small, but social welfare will be greater under public ownership for those cases where production exhibits large social benefits.

An important implication of this is that a case can be made for privatisation even when the government is a fully benevolent dictator who wishes to maximise social welfare. Even if all the deficiencies of the political system could be remedied it is still possible for privatisation to be superior to state ownership.

In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm's manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm's investment. A rational expectation of such an expropriation would reduce the incentives of a public firm's manager to make the required investment. For a private firm, the manager's incentives to invest are better given that both the firm's owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm's cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm's management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm's managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.

Shapiro and Willig (1990) consider a world in which there is a public-spirited social planner or framer who decides on the nationalisation/privatisation outcome and sets up the governance structure for the enterprise chosen. The framer's decision is driven by the informational differences between private and public ownership. The important pieces of information are: (i) information about external social benefits generated by the firm; (ii) information concerning the difference between the ``public interest" and the private agenda of the regulator; (iii) information about the firm's profit level (cost and demand information). In this paper there is also a regulator who sets the regulations that control the private firm and who pursues a different agenda from the framer.

Assume that either information about profitability is known before investment is decided upon or that there are costs to raising public funds. In these cases the neutrality results mentioned above don't hold. The equilibrium behaviour of the minister who is in charge of the firm is virtually unconstrained and he will set the activity levels of the firm as to maximise his utility. The regulator of the private firm has a more complex problem to deal with. This involves the designing of regulatory scheme which ensures non-negative profits for the firm. Given this is a case of optimal regulation under asymmetric information we would expect to see the firm enjoying informational rent, which are proportional to the activity chosen. As public funds are costly to raise these transfers are costly to the state.

The trade-off in this model is driven by how easily the public official can interfere with the operations of the firm. If the public official's objectives are the same of the (welfare maximising) framer, i.e. the public official has not private agenda, then public ownership is optimal. In this case private ownership reduces performance since the firm extracts a positive information rent. But when there is a private agenda then a reduction in discretion may increase welfare. Politicians find it easier to distort the operations of a firm in their favour when that firm is an SOE and under the direct control of the minister. The regulated private firms does earn a positive rent but is less subject to the control of the regulator. This means that regulated private firms are likely to out perform SOEs in poorly functioning political systems,which are open to abuse by the minister, and where the private information about the profitability of the firm is less significant. This makes it easier for the regulator to get the firm to maximise social welfare.

In Boycko, Shleifer and Vishny (1996) information problems do not explain the difference between public and private firms. Here it is differences in the costs to a politician of interfering in the activities of the different types of firms that explains the effects of privatisation. The starting point of the paper is the observation that public firms are inefficient because they address objectives of politicians rather than maximise efficiency. One common objective for a politician is employment. Maintaining employment helps the politician maintain his power base. In their model Boycko, Shleifer and Vishny assume a spending politician, who controls a public firm, forces it to spend too much on employment. The politician does not fully internalise the cost of the profits foregone by the Treasury and by the private shareholders that the firm might have.

Boycko, Shleifer and Vishny argue privatisation can be a strategy to reduce this inefficiency in state-owned enterprises. By privatisation they mean the reallocation of control rights over employment from politicians to a firm's managers and the reallocation of income rights to the firm's managers and private owners. The spending politician will still want to maintain employment and can use government subsidies to `buy' excess employment at the private firm. In this model the advantage of privatisation is that it increases the political costs to maintaining excess employment. It is less costly for the politician to spend the profits of the state-owned firm on labour without remitting them to the Treasury than it is to generate new subsidies for a privatised firm. Given that voters will be unaware of the potential profits that a state firm is wasting on hiring excess labour they are less likely to object than they are to the use of taxes, which they know they are paying, to subsidise a private firm not to restructure. This difference between the political costs of foregone profits of state firms and of subsidies to private firms is the channel through which privatisation works in this paper.

Shleifer and Vishny (1994) is a continuation of research stated in Boycko, Shleifer and Vishny (1996). As with the 1996 paper Shleifer and Vishny assume that there is a relationship between politicians and firm mangers that is governed by incomplete contracts and thus ownership becomes critical in determining resource allocation. As noted above the Shleifer and Vishny model is a game between the public, the politicians and the firm managers. The model derives the implications of bargaining between politicians and managers over what the firms will do. A particular focus is on the role of transfers between the private and state sectors including subsidies to firms and bribes to politicians.

To consider the determinants of privatisation and nationalisation Shleifer and Vishny utilise what they term a "decency constraint" which says that the government cannot openly subsidise a profitable firm. To do so would be seen as politicians enriching their friends. The first, obvious, point made is that politicians are always better off when they have control rights. Control brings political benefits, via excess employment, and bribes, to allow a reduction in the excess employment. Both the Treasury and the politicians prefer nationalisation. (Remember that as a SOE the Treasury has income rights and the politician has control rights.) to subsidising a money-losing private firm. Control brings bribes and even without bribes politicians get a higher level of employment and lower subsidies when they have control. The Treasury likes the smaller subsidies that come with nationalisation. When it comes to profitable firms politicians like control or Treasury ownership because these firms have a strong incentive to restructure since the profits go to the private owners and they lose little in terms of subsides due to the decency constraint. To ensure the firms achieve political objectives politicians need control. Given the decency constraint politicians don't want managers who have control rights to also have large income rights since the decency constraint means smaller subsidies are lost if employment is cut and income rights mean the managers gain from restructuring and maximising profits. Politicians who have control prefer higher private and lower Treasury ownership since higher private ownership implies higher bribes. Without bribes the private surplus is extracted via higher levels of employment.

Given that politicians like control, Why would they ever privatise a firm? To explain privatisation the interests of taxpayers must become more prominent. Given this the decision to privatise then becomes the outcome of competition between politicians who benefit from government spending (and bribes) and politicians who benefit from low taxes and support from taxpayers. We would expect privatisation to take place when political benefits of public control are low, and the desire of the Treasury to limit subsidies is high. This is most likely to occur when the political costs of raising taxes to pay subsides is high and when the political benefits from excess employment are low.

The final paper to be considered is Hart, Shleifer and Vishny (1997). Again 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. 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.

So arguing that the theoretical basis for privatisation is weak is, I would argue, wrong and the job of any economist arguing for privatisation is to explain this theory to the public, no matter how difficult that may seem.The theory is there and if you want to argue for privatisation you need to find a way of making it  intelligible to the general public.

Davidson continues,

The promoter’s problem suggests that you can’t always trust the person trying to sell you something. Given that voters have such poor opinions of politicians, this might be especially true for a privatisation policy. It is easy to believe that past privatisations may have been successful, but that is no guarantee that future privatisations will be.

To be sure, not all privatisations are successful and some can be described as having failed after the fact. But the rate of failure is lower for all firms.

For an example of a not so successful privatisations one only has to look at the first large scale privatisation programme in Chile in the mid-1970s. Luder (1991) writes in his abstract,

Between 1974 and 1989, the Chilean government privatized 550 state-owned enterprises (SOEs). Before 1974, all but a handful of major corporations were SOEs. About 50 of the largest enterprises privatized during the 1970s fell into government hands again, only to be re-privatized later. This was due partly to the economic and financial crisis affecting most Latin American countries during the early 1980s but also was a consequence of the privatization modes used. This paper analyzes that unique privatization experience so as to extract policy lessons. The analysis focuses on economic conditions, objectives of government policy, privatization modes, and the divestiture effects on employment, fiscal revenues, public sector wealth, spread of own- ership, and capital market development. (Emphasis added)

In the text Luders writes,

Between 1974 and 1990, the Chilean government privatized about 550 enterprises under public sector control. These included all but a handful of the country's largest corporations. Moreover, the reversal during the early 1980s of the most important divestitures carried out during the first round of privatizations (1974-1978) allowed the government to apply different modes of divestiture during the second round (1985-1989).

and

Consequently, the government intervened in 16 financial institutions. It liquidated a few of them and put in a sound position and re-privatized the remainder. That is, the government, which did not legally own the financial institutions, assumed complete control of a high proportion of the assets it had privatized during the 1970s. These financial institutions included the main commercial banks, whose owners controlled the major pension fund administrators (AFP) and large commercial and industrial enterprises. Because intervention blurred the ownership relationship of these enterprises—i.e., they neither belonged to the public sector nor were owned by the private sector—this group of enterprises was called the "odd sector." Re-privatizing these enterprises as well as other traditional SOEs constituted the second large privatization effort that the military regime carried out.

In short, when privatisation goes wrong, it really can go wrong! Much of the 1970s privatisations had to be redone in the 1980s because they didn't get it right the first time.

Davidson ends by saying,

To my mind, privatisation is always a good thing. But there is a sting in the tail. Very often the proceeds of privatisation are used to buy down debt – in other words, validate past irresponsible government spending. The capacity for debt and deficit is unlimited while the stock of government assets that can be sold off is limited.

The challenge is to embed privatisation schemes into a broader reform agenda.

He is right here, a consistent well thought out reform package is needed. In particular sound market regulation must be in place so that the markets that the SOEs are privatised into are as competitive as possible. Markets have to be opened to competitors before the SOEs are privatised so that the (former)SOE has no incentive to lobby for slow and cautious market liberalisation or better still no liberalisation at all.

This does raise the issue of whether the current government's idea of a partial privatisation of some SOEs is a well thought out reform package. I would say no.

If you look at the economics literature you will also find that fully private companies outperform mixed ownership firms. Some insight on this is offered by a recent paper in the Scottish Journal of Political Economy (Volume 59, Issue 1, pages 1–27, February 2012). The paper "What Drives the Operating Performance of Privatised Firms?" by Laura Cabeza García and Silvia Gómez Ansón argues that the greater the amount of privatisation the better the performance of the firm. Not an entirely surprising result as the full force of market discipline can only be applied if the firm is fully in private hands but it is something for the government to keep in mind. It would suggest that any performance improvements due to the government's partial privatisation plans will be modest. The abstract reads,

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees, the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added)

When you look at the performance of mixed ownership firms they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude

'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].'

So fully private firms out-perform mixed ownership firms.

Why might the government's idea not work? Simply put there are 6 reasons I can think of:

• First, selling only 49% of the shares in the companies is unlikely to make a huge difference to the way the SOEs are run. In particular the sell off will not make the firms any more efficient since the government will still be the controlling shareholder.
• Second, if the government really does want to maximise the income it gets from the sales selling 49% is not a good idea. 51% is worth a lot more than 49%, that is people will pay a premium for control.
• Third, selling to "Mums and Dads" will do nothing for the amount of money raised, since Mums and Dads will need a discount to make them buy shares.
• Fourth, selling to "Mums and Dads" will do nothing for the efficiency effect of having private owners, since there will be too many "Mums and Dads" for them to be able to coordinate their effects to effect the firm's behaviour.
• Fifth, 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. This is another reason why performance is unlikely to change.
• Sixth, the discipline of bankruptcy or takeover is not greater since the government is still the controlling shareholder and is unlikely to let either of these options happen.

Note to self, write shorter posts from now on!

Refs:

• Boycko, Maxim, Andrei Shleifer and Robert W. Vishny (1996). `A Theory of Privatisation', The Economic Journal, 106 no. 435 March: 309-19.
• Hart, Oliver D. (2003). `Incomplete Contracts and Public Ownership: Remarks, and an Application to Public-Private Partnerships', The Economic Journal, 113 No. 486 Conference Papers March: C69-C76.
• 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.
• Laffont, Jean-Jacques and Jean Tirole (1991). `Privatization and Incentives', Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.
• Luders, Rolf J. (1991). `Massive Divestiture and Privatization: Lessons from Chile'. Contemporary Economic Policy, 9(4) October: 1-19.
• Schmidt, Klaus (1996a). `Incomplete Contracts and Privatization', European Economic Review, 40(3-5): 569-79.
• Schmidt, Klaus (1996b). `The Costs and Benefits of Privatization: An Incomplete Contracts Approach', The Journal of Law, Economics & Organization, 12(1): 1-24.
• Shapiro, Carl and Robert D. Willig (1990). `Economic Rationales for Privatization in Industrial and Developing Countries'. In Ezra N. Suleiman and John Waterbury, (eds.), The Political Economy of Public-Sector Reform and Privatization, Boulder: Westview Press.
• Shleifer, Andrei and Robert W. Vishny (1994). `Politicians and Firms', Quarterly Journal of Economics, 109(4) November: 995-1025.