Posts Tagged ‘equity’

Privatization, in a broad sense, refers to the transfer of a business, enterprise, or social function from public control to private ownership. It has been a cornerstone of the neoliberal economic mantra that has gripped policymakers for the last 3-4 decades, alongside private property, intellectual property rights, and the free market. In this time, hundreds of state-owned enterprises (SOEs) have been fully or partially privatized, in the belief that doing so would make them more efficient, and as a result serve to promote economic growth, and by highly questionable extension, prosperity.

Economists of the current orthodoxy will tell you that the theory is solid, and that the case for privatization is well grounded. The theoretical idea supporting privatization rests on three main pillars:

1) The Principal-Agent Problem: This broadly refers to the situation where the owners of an enterprise are disconnected from its operations. Instead, managers are hired to run them. The owners are the ‘principals’, and the managers are the ‘agents’. While it is in the interest of the owners to have the enterprise run as efficiently as possible, it is in the managers’ interest to work as little as possible while picking up a wage. Thus, the enterprise is inefficiently managed. With SOEs, the citizenry/taxpayers are the owners and so by privatizing, as the theory goes, the principal-agent problem will cease to exist.

2) Free Rider Problem: Individual citizens will not bother themselves with the day-to-day monitoring of hired managers, since they only own a fraction of the enterprise. If everyone owns a fraction and nobody is monitoring, then inefficiencies will arise. Since everyone is trying to ‘free ride’ but nobody is doing any actual monitoring, poor performance will result.

3) Soft Budget Constraint Problem: since SOEs are government owned, they are often available to work outside their budgets since they can rely on government assistance or bail-outs if they make losses or face bankruptcy. Therefore, they are able to get away with lax and inefficient management.

These are the arguments made against SOEs and in support of privatization. But do they hold on closer examination?

1) With regards to the principal-agent problem, it does appear to hold true for SOEs, but there is nothing in the theory to say that it does not also hold true for private firms! Most large corporations are held by varied and dispersed owners – think of the stock market, and how many different individuals, groups and organizations have ownership of a company. Private enterprises are thus also owned by a large number of shareholders, and management is delegated to a group of managers that are hired. Thus, there is little difference in ownership structure that would alleviate the principal-agent problem.

2) Similar to the above point, with diverse and widely spread ownership, the free-rider problem will exist for large, privately-held corporations as well. If I own 10 shares in Microsoft, I will not expend my time and effort to dilligently ensure that operations are being managed effectively – I leave it to someone else to do.

3) Politically generated soft budget constraints are not confined to just SOEs, as large, ‘important’, or politically influential companies can obtain funding and support from governments in times of trouble. We need not look further than the infamous bank bailouts in the US to know that this is just as true for private enterprises as SOEs.

So it seems that all the arguments made for privatization are in fact nothing of the sort. True, they are all valid arguments of pitfalls that can arise in public corporations, and should be kept in mind in their management. But they are also just as valid when it comes to private companies, and there is plenty of empirical evidence to back this up. Regardless, the conception is that SOEs are generally inefficient, after all we always hear about examples of bad state companies on the news, right?

What we rarely hear about are the well-run, highly effective SOEs that exist and operate all around the globe. To give just one example, Singapore Airlines is often talked of as one of the most highly regarded airlines in the world, and yet it is an SOE – 57% owned by Singapore’s Ministry of Finance. In fact Singpore – widely touted as one of the successes of the free market ideology – has an SOE sector that is four times larger than that of Argentina, widely cited as a state that has failed in its development due to the overextension of the state*.

So what gives? Why do only ever hear about bad SOEs, when there are in fact many, many good ones? Part of the reason is the sad nature of reporting. The news tends to focus on bad things: war, famine, sex scandals, and the like. Nobody cares about the ordinary decent citizen living out her life. And nobody cares about the silent, successful SOE, providing water or electricity or anything else to its customer base.

While these arguments do not strictly support state ownership, they make clear that the case against state ownership is highly misleading. The arguments made are, in fact, arguments in favor of effective systems of governance and regulation. The choice between private enterprise and SOE will always depend on many factors that are unique to the country, the industry, the time and the place. But there are specific situations where having an SOE is in fact the right choice:

1) When there are low short-term profitability prospects: the nature of private money is that it seeks a quick buck. As students are taught in economics 101, money now is worth money later, and so no investor will be willing to wait 15 years just to see a return on investment, even if the long-term prospects are sound. Such industries may be set up as SOEs, especially if they are in the strategic interests of the country.

2) ‘Natural Monopoly’: A natural monopoly exists when, due to technological conditions, having only one supplier is the most ideal way to serve a market. Such industries include water provision, or railroads (in the 19th century in the US, different railroad companies used to set up parallel tracks leading to the same places, a horrible inefficiency and waste of money). The main cost of production in these industries is building a distribution network. When there is a natural monopoly, especially in the case of a key service or product such as water, enterprises can charge whatever they want and customers must pay that price, as they have no other choice. This generates a social loss, as the item is priced so as to extract maximum profit, and at the same time, consumers are served less than they would ideally want. Introducing competition has no effect, as the incumbent has all the power. In natural monopolies, SOEs are strictly the best form of ownership.

3) Questions of equity: If left to the private sector, many essential services would not be delivered to those who are not profitable. For example, water provision to the poor, or delivering mail to those in rural locations. In this case, a SOE is necessary to provide these services, as the profit motive is overruled by the equity motive.

In conclusion, there is a time and a place for private enterprise. Only strict ideologues would, in today’s world, propose the strict outlawing of private enterprise. At the same time, only strict ideologues – like those at the World Bank, the IMF, and many academic institutions – would call for privatization at all costs, empirical evidence and common sense be damned. SOEs can often be inefficent and perform badly – but so can SOEs. The solution in both cases is effective regulatory structures, which take incentives into account. It is also crucial to accurate identify and prioritize objectives.

SOEs are often a very useful tool for governments, particularly developing country governments, in the industrial development of a country. Dogmatic ideology that insists at privatization at all costs is both ill informed and harmful to the prosperity of nations.

*in terms of its share of national income, not absolute terms.

** the ideas and data in this article are heavily drawn from Ha-Joon Chang’s excellent book “Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism.” Go read it now.