Bookblogging – nearly done!

by John Q on January 15, 2010

I sent off the draft MS of my Zombie Economics book to the publisher last week, but there is still time for improvement. Over the fold is the second, and final part of the privatization chapter.

You can read most of the book (not always the final draft) at my wikidot site.

As always, comments and criticism much appreciated.

Implications (1)


A policy in search of a rationale

From its earliest days, privatization was described as a ‘policy in search of a rationale’. Actually the problem was not so much the absence of a rationale as the presence of too many. As with the war in Iraq, different players in the policy process supported privatization for different reasons, and expected different outcomes. 

Sometimes it was a simple matter of class politics. Privatization is bad for unions, which tend to be stronger and more effective in the public sector. It is usually good for the incumbent senior managers of privatized firms, who move from being relatively modestly paid public sector employees, constrained by bureaucratic rules and accountability, to doing much the same job but with greatly increased pay and privileges, and far fewer constraints. It is always good for the financial sector, which earns billions in fees for managing asset sales, not to mention the returns from advising the bidders, and the pure profits gained in common cases where the asset is underpriced and can be quickly resold at a much higher market value. For politicians eager to bash unions, and politically beholden to the financial sector this was a great deal. Hostility to unions was strong on the political right, particularly after the upsurge in strikes and militancy in the 1970s. 

Governments mostly thought about privatization as a way of fixing problems of public finance. Government ministers short of money to pursue pet projects, to finance tax cuts, or simply to deal with growing budget deficits saw the sale of valuable assets as an easy and politically costless source of cash. The question of what would be done when there were no more assets to sell was left for another day. 

In other cases, faced with the need to spend money modernizing infrastructure, but unwilling to take the necessary steps to pay for it, by raising taxes and charges or by adding to public debt, governments used privatization as a way of shifting the problem to the private sector. The privatization of the water supply industry by the British government, in response to pressure from the European Union to improve environmental health and safety is one well known response.

Economists, at least when they were thinking clearly and speaking honestly, were as one in rejecting the most popular political reasons for privatization: that is was a source of cash for governments, or a way of financing desired public investments without incurring public debt. 

On the first point, it is a basic principal of economics that the value of capital asset is determined by the flow of earnings or services it generates. So the cash gained from selling public assets comes with the cost of forgoing the earnings it would have generated in continued public ownership. In a world where both governments and markets were perfectly efficient the cost would be exactly equal to the benefit and privatization would not change anything. As we’ll see below, things are more complicated than that. But that doesn’t make the idea that selling assets is a source of free cash any less silly.

A more sophisticated version of the same error is to suppose that governments facing debt constraints that restrict investment in desirable projects can get around those constraints by bringing in private investors. Once again, the problem is that the returns (such as proceeds from toll roads) needed to attract private investors represent money that could have been used to service public debt. So, the more private money is used to finance public infrastructure, the smaller the amount governments can invest without running into problems. As the exasperated secretaries of Australian state treasuries once put it, privatization and public private partnerships create no new ‘pot of money’ to spend on public infrastructure. 

Privatization will yield net fiscal benefits to governments only if the price for which the asset is sold exceeds its value in continued public ownership. This value depends on the flow of future earnings that the asset can be expected to generate. The question of how to determine this value remains controversial, and will be discussed later, in relation to the equity premium puzzle.

Because claims about the fiscal benefits of privatization so commonly involved confused or fallacious arguments, most economists generally to focus on the potential benefits of privatization in promoting competition. Although extreme market liberals gave unconditional support to privatization, the majority of economists favored breaking up public enterprises and stripping them of monopoly privileges before privatization. However, since such measures inevitably reduced sale prices, and the opportunities for incumbent managers to enrich themselves, they were rejected in many cases. Going beyond such structural changes, economists emphasized the importance of governance as opposed to ownership. 

The dominant view was that, given appropriate regulation and pro-competitive policies, it should not matter whether enterprises were publicly or privately owned. Hence, assuming private firms were more efficiently run, this view suggested that privatization should always be the preferred policy, provided that opportunities for competition were not compromised in the process.

A variety of rationales for privatization were put forward by a variety of political actors. But more and more, privatization was driven by the power of the financial sector, which benefits both directly and indirectly from privatization. The direct benefits include the massive fees and bonuses derived from managing privatizations. The indirect benefits include the enhanced economic and political power of the financial sector in an economy where all major investment decisions are driven by the demands of financial markets. In the era of market liberalism, this power extended over all major political parties.  As US Senator Dick Durbin said “the banks  are still the most powerful lobby on Capitol Hill. And they frankly own the place,””. He could equally well have been talking about the City of London and its dominance of British politics. The situation in other developed countries was rapidly becoming similar. In Australia, for example, it has become routine for retired politicians to be offered cushy jobs in the financial sector, provided of course that they have followed the right kinds of policies when in office.

The competing rationales for privatization share one common thread. This is the belief that there is always a net social benefit to be realized from converting a publicly owned enterprise into a private firm. Some advocates of privatization (including many politicians) hope that this benefit will take the form of an improvement in the net worth of the public sector, others (including economists) that it will mean lower prices for consumers, and yet others (notably including the financial sector) that they can appropriate the gains for themselves. But this disagreement over who should benefit masks a shared assumption that there are net benefits to be fought over. 

The claim that privatization always yields net social benefits was not always made explicit, but it was implicitly taken as common ground in most of the discussion of economic reform during the era of market liberalism. It is important, then, to understand what this claim entails.

Markets, governments and efficiency

When all the spurious arguments for privatization are stripped away, the central implication of the ideology of privatization is the claim that an economy in which all major decisions on investment, employment and production are left to private firms will outperform a mixed economy where governments play a significant role in such decisions. In particular, provided private firms are free to compete on a ‘level playing field’, they will always have a higher value than they would have under public ownership.

If the efficient markets hypothesis represents the negative side of the market liberal case, implying that no alternative institution can outperform markets, the case for privatization represents the positive side, implying that more private ownership will always improve economic outcomes.  The market liberal ideology of privatization asserts that, private firms can outperform governments in the production of goods and services of all kinds, including those that have long been funded and provided by the public sector, such as school education. This assertion includes both a short-run component, based on the claim that private enterprises will operate more efficiently than their  publicly owned counterparts and a long run component based on claims that privatization will improve investment decisions.

The short run claim is that, because of the incentives associated with private ownership, private enterprises are always more efficient than comparable public firms. Broadly speaking, this claim is true to the extent that profitability is a good guide to efficiency, which in turn depends largely on the absence of significant market failures. Private firms are controlled by their managers who may or may not be accountable to outside shareholders. In general, both managers and shareholders benefit significantly from increased profitability, though the relationship is more direct for shareholders.

By contrast, public enterprises are accountable to governments and therefore, indirectly to any group to which governments respond. In the presence of market failure, such accountability is likely to be beneficial, since government enterprises are under more pressure to promote better social outcomes, even at the expense of profitability. On the other hand where market failure is unimportant, requirements for accountability are likely to impede efficient decision-making. And, as public choice theorists pointed out in the 1970s, accountability requirements may be used by special interest groups to demand favorable treatment, such as above-market wages for unionized workers, or better service for politically influential customers.

The long-run case for privatization is based on the idea that the allocation of investment will be better undertaken by private firms than by government business enterprises. This claim in turn relies on the assumption that the evaluation of risk and returns undertaken by investment banks, with the assistance of ratings agencies, and the availability of sophisticated markets for derivatives like CDOs will be far superior than anything that could be obtained by, for example, using engineering calculations of the need for investment in various kinds of infrastructure, and seeking to implement the resulting investment plans on a co-ordinated basis. The GFC has shown that, for most of the past decade, market estimates of the relative riskiness and return of alternative investments have been entirely unrelated to related. 


The turning of the tide against privatization predated the financial crisis. Internationally, a number of major privatizations have been reversed. The UK government was forced to denationalize its rail network after the failure of the privately owned operator. In Australia, dissatisfaction with the privatized telecommunications monopoly has led the government to announce that it will get back into the telecommunications business by constructing a publicly-owned national broadband network. New Zealand, where market liberalism was implemented in a radical form in the 1980s and 1990s, renationalized its national airline in 2001 and its railways a couple of years later.  And even relabeled as “choice”, Social Security privatization proved so politically unsaleable that it was abandoned early in Bush’s second term.

More striking still was the collapse, under scrutiny, of nearly all the main theoretical and political rationales for privatization. Some, such as the idea that selling assets provided instant cash for governments were recognized as nonsensical early on, but, like the bigger zombie ideas discussed in this book, keep on coming back. Other rationales such as the hope that privatization would produce competitive markets in industries thought to be natural monopolies have held up longer but have ultimately proved unfounded.

The crucial issue, however, is the claim that privatization always yields net social benefits and therefore that, other things equal the price for which a public asset can be sold will exceed its value in continued public ownership. This claim has never had much empirical support. Rather it has been taken on faith as a consequence of the efficient markets hypothesis. With that hypothesis discredited, it is possible to consider how the public might lose from privatization. To understand the issues it is necessary to take a brief look at one of the enduring puzzles of economics – the high rate of return demanded by investors in equity (company stock and its derivatives) relative to the much lower rate of interest on government bonds.

The equity premium puzzle

The equity premium puzzle is one of those problems that is easy to state in summary form, but hard to explain in the detail necessary to understand it, and impossible to resolve (at least within the ‘rules of the game’ as played by economists in recent decades). The existence of a large equity premium has profound implications for economic analysis of issues ranging from climate change to macroeconomic policy, but it is most directly relevant in relation to privatization, and so I will discuss it here.

The facts are simple and well known. Over very long periods, and in many different countries, investments in equity (that is, stocks and shares) have yielded much higher returns, in the long run, than investments in bonds. The annual rate of interest on US government bonds, adjusted for inflation, has averaged between one and two per cent over the period since the late 19th century. Over the same period, returns on stocks (dividends and capital gains) have averaged around eight per cent.

The difference between the two rates of return, about six percentage points, is called the equity premium. The existence of the equity premium is not, in itself, a puzzle. Stocks are riskier than bonds, and investors expect a higher rate of return to compensate for this risk. The problem is that the premium is much higher than would be expected on the basis of the standard economic model, referred to as the Consumption Based Capital Asset Pricing Model (CCAPM).  

CCAPM starts with the observation that if financial markets are both complete and efficient, they will pool and spread all the individual risks1 faced by households and firms, in much the same way as a life insurance company pools the mortality risks of its group of clients. Once this process of pooling and spreading is completed, the riskiness of the ‘average’ investment portfolio should be equal to the riskiness of the economy as a whole, as measured by aggregate consumption.  So, the risk premium for equity should be determined by the riskiness of aggregate consumption, which is determined by the cycle of boom and recession.

The problem is that when we look at economic fluctuations in this aggregated way, they don’t appear to be very important. A deep recession might produce negative growth of 3 per cent, compared to expected growth of 3 per cent in a normal year, while a powerful boom might produce growth of 6 per cent. But variations of 3 per cent one way or the other should not, on standard views about people’s risk attitudes, justify a significant risk premium.2 In the classic paper that first pointed out the puzzle, Rajnish Mehra and Edward Prescott suggested that if the standard CCAPM model applied, the equity risk premium should be no more than half a percentage point as opposed to the observed value of six percentage points. Either the model is in need of refinement, or the assumption of complete and efficient financial markets is badly wrong. 

Unfortunately, in presenting the anomalously large risk premium as a ‘puzzle’ Mehra and Prescott encouraged subsequent writers in the literature to search for clever explanations, rather than to consider the economic implications of the puzzle. Under the implied rules of the puzzle solving game, two kinds of explanation were allowed. The first kind were clever refinements of CCAPM, usually based on alternative assumptions about risk and time preferences, such complete and efficient financial markets generated large equity risk premiums. The second, reminiscent of Blanchard’s macroeconomic haikus (see Chapter …) involved introducing a market imperfection into the standard complete and efficient financial markets model, and showing that a large equity risk premium would result.

Although many solutions along these lines have been proposed, none has been generally accepted. The problem is the same as in the micro-based literature. Financial markets are incomplete and inefficient in many different ways, most of which have the effect of making investments in the stock market riskier than they would be in the ideal world assumed in CCAPM. The equity premium is the outcome of complex interactions between investors who cannot insulate themselves from personal and business risks generated by the economy, must deal with banks who are sometimes willing to lend to them and sometimes not, and cannot easily form  expectations about the value of shares. It is unsurprising that they are unwilling to invest in the absence of an assurance of high long run returns.

What matters is not solving the ‘puzzle’ but understanding its implications. In a paper with Simon Grant, I have described some of the most important, as follows

* That the macroeconomic variability associated with recessions is very expensive

* That risk to corporate profits robs the stock market of most of its value

* That corporate executives are under irresistible pressure to make short-sighted, myopic decisions

* That policies—disinflation, costly reform—that promise long-term gains at the expense of short-term pain are much less attractive if their benefits are risky

* That social insurance programs might well benefit from investing their resources in risky portfolios in order to mobilize additional risk-bearing capacity

* That there is a strong case for public investment in long-term projects and corporations, and for policies to reduce the cost of risky capital

* That transaction taxes such as the Tobin tax could be beneficial

Privatization and the equity premium

In the case of privatization, the implications of the equity premium arise from the fact that governments can finance investments entirely by issuing bonds, with the guarantee of repayment based on their capacity to raise revenue from taxes. Private corporations must rely on a mixture of equity and debt with the result that, on average, their cost of capital is around 6 per cent, compared to around 2 per cent for governments. That is, investors value both a government bond returning a safe $2 each year at $100 and place exactly the same value on a typical investment in company bonds and stocks generating an an average of $6 a year. 

This creates a problem for privatization, which can be illustrated by an example. Suppose a government business enterprise is generating earnings of $60 million each year. At an interest rate of 2 per cent, that’s enough to service the interest on $3 billion in public debt (2 per cent of $3 billion is $60 million). Now suppose that the government decides on privatization.  they will want a return of 6 per cent. If potential buyers don’t see any opportunity to increase profits, they will only be willing to pay $1 billion (since 6 per cent of $1 billion is $60 million). So, if the government uses the sales proceeds to repay $1 billion in debt, saving $20 million a year in interest, it will need to find another $40 million a year to replace the lost earnings. 

On the other hand, if private buyers expect that they can increase annual profits to, say $300 million, they will be willing to pay $5 billion for the enterprise. If the government uses the proceeds to repay debt the interest saving will be $100 million a year, yielding a net fiscal benefit of $40 million a year.

If increases in profitability arise from improvements in operating efficiency or from improvements in the value of goods and services provided to consumers, the net fiscal benefit is also a net benefit to society as a whole. On the other hand, if private owners increase profits by cutting wages or reducing the quality of customer services, then losses to workers and consumers need to be taken into account in any assessment of privatization.

In view of the popularity of privatization, and the frequency with which it has been recommended, it is striking that assessments of this kind have rarely been undertaken. Bodies like the International Monetary Fund, which noted in 2000 that there had been few studies of the question, apparently did not feel that the lack of any empirical evidence should qualify their recommendations in favor of privatization. The IMF points to the difficulty of choosing a ‘counterfactual’, that is, of saying what would have happened in the absence of privatization. However, this problem can by overcome either by taking a conservative projection of future earnings under continued public ownership or by examining cases where a proposal for privatization was put forward, with an estimated sale price, but the enterprise was not sold, and remained in public ownership.

What evidence there is comes mostly from developing countries and is decidedly mixed. There are certainly cases, such as that of the steel industry in Brazil where privatization turned loss-making and declining public enterprises into profitable and growing private corporations. On the other side of the ledger, there are cases like that of Russia where privatization was the occasion for wholesale looting, allowing self-described democratic ‘reformers’, not to mention their Western advisors3, to enrich themselves massively. Most cases fall between these two extremes, but the view that privatization is always, or even mostly, beneficial to governments is not supported by the evidence.

Evidence on the fiscal effects of privatization in developed market economies is even more limited, so I’ll cite my own work on Australia. Examining a number of actual privatizations, I found that the government made net fiscal gains in only two cases. In both cases, the sale took place in a bubble atmosphere, with the result that the buyers subsequently resold at a loss. Looking at cases where privatization was proposed, but did not go ahead, the returns to government under continued public ownership clearly exceeded the benefits they would have obtained from selling the assets. On balance, then there was a net social loss in most cases, and this was not offset by benefits to workers (who were mostly worse off) or consumers (who experienced gains on some measures and losses on others).

Budgetary effects

The claim that selling off income earning assets provides governments with extra money that can be spent on public services is based on a confusion between income and capital. It is the same reasoning that led householders to finance consumption by borrowing against the equity in their homes. In the short run, it can produce apparent benefits, but in the longer term using asset sales to finance current expenditure is a road to financial ruin. 

The sale of assets to fund current expenditure and tax cuts was pioneered by the Thatcher government in the UK. By the late 1990s, Thatcher’s Chancellor of the Exchequer Nigel Lawson was proudly announcing that the government had replaced the deficits it inherited with surpluses, and celebrated with tax cuts all round. But by the mid-1990s, with the economy having been through a serious slump and no more assets left to sell, the budget deficit hit new records, exceeding 6 per cent of GDP []. It was left to the “New Labour” government of Tony Blair to clean up the mess.

The correct basis for an analysis of the fiscal impact of privatization is a comparison between the price at which a public enterprise can be sold and the present value of the flow of earnings that would be generated by the enterprise under continued public ownership.4 This comparison may also be expressed in flow terms, as a comparison between annual earnings foregone through privatization and the interest savings arising when the proceeds of privatization are used to repay debt. 

In most cases, the income foregone from privatization exceeds the interest saved, resulting in a net fiscal loss. An extreme example was the Thatcher government’s 1985 sale, by public float, of half of the public holding in British Telecom (BT), analyzed by Quiggin (1995). Net proceeds from the sale of the first 50 per cent of BT were about 3.65 billion pounds. 

In 1984-85, BT had a gross operating surplus of about 3 billion pounds and interest liabilities of 0.5 billion pounds, implying a net post-tax profit of around 2 billion pounds, or 1 billion pounds for the 50 per share holding that was sold.  The real bond rate at the time was around 5 per cent. Hence, the income flow from  BT could have serviced public debt of  20 billion pounds. Thus, the British public incurred a loss of more then 15 billion pounds on this transaction.

The loss was partly due to deliberate underpricing. This was reflected in the fact that the share price nearly doubled on the first day of trading.  However, even if the shares had been sold at market value, the loss (that is, the difference between the sale proceeds and the debt that could be serviced by BT earnings) would have been around 10 billion pounds. Quiggin (1995) presents a number of similar examples from Australia and New Zealand. Further evidence is presented by Walker and Walker (2000).

Only on rare occasions has the sale of public assets in sectors like telecommunications and electricity been profitable for governments. During the ‘dotcom’ mania, share prices were wildly inflated, to the point where sales of some public assets, particularly those related to the Internet and mobile telephony, were profitable. Similarly, during the deregulation of the early 1990s, US electric utilities pursued international expansion aggressively, paying high prices for assets that subsequently proved unjustified in commercial terms.  For example, a number of Victorian electricity distribution and generation enterprises, were bought by US utilities and subsequently resold at markedly reduced prices. It is only in exceptional circumstances like this that the privatization of profitable government infrastructure enterprises, run on a commercial basis, is likely to improve the fiscal position of governments.

Fiscal losses from privatization occur primarily as a result of the equity premium, that is, the difference between the rate of return expected by investors in private equity and the rate of interest on government.5 Estimates of the equity premium vary from four to eight percentage points. For illustrative purposes, suppose that the real rate of interest on government bonds is four per cent and the real rate of return on equity is ten per cent, so that the equity premium is six percentage points.

Now consider the privatization of a publicly-owned firm. Suppose, that privatization will not change the profitability of the firm, and that the proceeds of the sale will be used to repay government debt. For concreteness, suppose the firm will earn 100 million pounds per year. Given a required rate of return of 8 per cent, the market value of the firm will be 1 billion pounds. When this sum is used to repay debt, bearing an interest rate of 4 per cent, the resulting saving in interest will be 40 million pounds  per year. In net terms, the public is worse off by 60 million pounds per year.

Exactly the opposite calculation applies in relation to nationalization. If nationalized and privatized firms are equally profitable, governments can issue debt to finance nationalization, and receive profits more than sufficient to service the debt.

This argument does not depend on the relative size of governments and capital markets. The greater capacity of government to spread risk arises from the taxation power, which also facilitates borrowing and lending to smooth consumption over time.

Despite the evidence that privatization mostly makes governments worse off, it continues to be promoted as a solution to short-term financial difficulties. In my own home state of Queensland Australia, the state government has used a budgetary crisis to justify privatization. The publication of a statement by more than 20 of Australia’s leading economists (including some prominent supporters of privatization) pointing out that their rationale was entirely spurious has done nothing to deter them from pushing this bogus argument.

Some notable failures

The election of the Thatcher government, which signaled the rise of privatization as a central component of market liberalism, took place just over thirty years ago. In that time, there have been sufficiently many failures to give us a reasonable idea of when privatization is likely to work and when it is not. The following list of examples is selected to illustrate particularly problematic areas of privatization, as opposed to those where privatized firms fail as a result of bad luck or the failure of individual managers.

The privatization of railway systems has proved consistently problematic. In the United Kingdom, the last major privatization under the Conservative government of 1979-97 was that of the rail system which was divided into two parts. A single company Railtrack owned and managed the rail network itself, while a number of different companies, each responsible for a different region, ran the train services. A series of failures forced the Blair government to denationalize Railtrack in 2002. Dissatisfaction with the private train operators remains intense, and the biggest rail contract, the East Coast main line was renationalized in November 2009.  The partially privatized London Underground was renationalized in 2008. New Zealand similarly renationalized its rail network in 2003, and train operations in 2008. 

Privatization has been at best a mixed success in the telecommunications industry. In most cases, former public monopolies have remained dominant, with the result that the expected benefits of competition have been slow to emerge, while capital expenditure has focused on maintaining market dominance rather than on improving customer service. In Australia, the Rudd Labor government, elected in 2007 has announced plans for a new National Broadband Network which will, at least initially, be publicly owned.

Consistently poor outcomes have been observed where privatization has been extended to the core areas of the welfare state such as education, health, retirement income and criminal justice. 

There was a major push towards privatization of the school system in the United States in the 1990s, led by the Edison Schools corporation, which rapidly became a stock market darling, running hundreds of schools in dozens of states. But Edison was unable to deliver on its promises. The company was delisted in 2003, and is now largely out of the school management business.   Paradoxically, school privatization has been more successful in Sweden, where a voucher system was introduced in the 1990s. However, even with an effectively level playing field,  only 10 per cent of students attend private schools and most of these are non-profit.

In the 1990s, New Zealand attempted to commercialize its public hospital system, turning hospitals into “Crown Health Enterprises”. The results were disastrous, including huge blowouts in debt and a drastic decline in the quality of service to patients. Following the election of the Clark Labour government in 1999, the reforms were abandoned, and the Crown Health Enterprises were folded back into District Health Boards, run by elected members. The US, where the private sector plays a larger role in health services than in any other developed country, spends substantially more on health but achieves notably poor outcome. The reforms introduced by the Obama Administration and the introduction of a pharmaceutical benefit scheme under the Bush Administration have not really addressed these problems.

Perhaps the most pernicious form of privatization has been the expansion of the role of private police, prisons and mercenary military forces. What evidence there is suggests that privatization of the use of state power yields no cost saving. It does, however, yield significant political benefits to the governments that undertake. First, it allows them to avoid political responsibility for improper, and even criminal, use of force. Immigration detention centers are one noteworthy example as are the activities of companies like Blackwater, whose operatives can kill with impunity, subject neither to military nor to civil justice.

Not all privatizations have failed. For example, while infrastructure systems as a whole have strong natural monopoly characteristics, it is often possible to separate competitive or potentially competitive components of the system, in which case privatization may be feasible. In the case of electricity supply, for example, electricity generation is more competitive than transmission and distribution, while the retail functions (billing, arranging connections and so on) are more competitive still).  In such cases, partial privatizations

The most successful privatizations have been those of firms that never really belonged in the public sector, and particularly firms that have been rescued from imminent failure for social or political reasons. Rolls-Royce in the UK and General Motors in the US are notable examples. More generally, where a competitive market can be sustained and there is no special requirement for close regulation, privatization has commonly been successful.

Markets, competition and regulation

The ideology of privatization has some implications regarding regulation that appear, at least superficially, paradoxical. Privatization and deregulation are  commonly seen as going hand in hand (6. . Yet in practice, privatization has been accompanied by the creation of a vast range of new regulatory bodies, and expansion of the powers of many existing regulators. In the UK, the home of privatization has seen the creation of a string of regulatory institutions such as OFTEL (Telecoms), OFWAT (Water), Ofgem (Gas and Electricity Markets), OFSTED (Education) and OPRA  (Occupational Pensions Regulatory Authority) among many others. As well as these specific regulators, industry as a whole is subject to the Office of Fair Trading and the Competition Commission. 

None of these bodies existed in any form in 1970 and all have gained greatly enhanced powers in the era of privatization. And membership of the European Union adds a whole new layer of regulation.

The apparent paradox reflects the fact that public ownership was introduced as a response to market failures, and privatization did not resolve these market failures. In particular, even in cases where public infrastructure enterprises were broken up prior to sale, substantial natural monopoly elements remained. The hopes of privatization advocates that regulation would be needed only temporarily, until robust competition emerged, have largely gone unfulfilled.

There are some benefits associated with the new model of regulation. Under traditional models of public ownership, infrastructure service providers were responsible for management of all aspects of their industry, including such questions as environmental protection and pricing as well as service provision. This did not always work well. Environmental concerns, in particular, were often given scant attention by engineering-dominated organizations. Pricing was driven primarily by requirements for cost recovery rather than by the need to use resources efficiently. In some cases, the creation of separate regulatory bodies has yielded improved outcomes. But privatization is not a necessary step in this progress.

The continued heavy reliance on regulation, and the conspicuous failure of ‘light-handed’ regulatory models such as those applied to electricity markets in the United States and telecommunications in New Zealand substantially undermines the view that public enterprises represent a barrier to the emergence of competitive markets capable of generating socially optimal outcomes. Public ownership is not the only answer to market failure, but, in the absence of strong regulation, privatization is not an answer at all.

What next ?

The failure of the case for comprehensive privatization does not imply acceptance of the opposite extreme position in favor of comprehensive public ownership, or that privatization is never justified. There are large areas of the economy, such as agriculture and retail trade, where public enterprises have rarely operated at a profit. No fiscal benefit can arise from public ownership of a loss-making enterprise. Relatively modest reductions in profitability arising from the constraints associated with public ownership are sufficient to offset the benefits of a lower cost of capital.

In particular, arguments about the cost of equity capital are irrelevant for small unincorporated businesses, where there is no reliance on external equity.  Such small businesses typically face a high cost of external capital, relying primarily on bank loans. However, the higher cost of capital for small businesses, relative to both government enterprises and large private corporations, is offset by the efficiency advantages of combining ownership and control.

The idea that we must choose between pure laissez-faire capitalism and comprehensive socialization is part of what might be called the Great Forgetting of the lessons of the mixed economy. The mixed economy was not, and is not, a simple compromise between incompatible extremes. Rather it has given rise to an effective, and productive interaction between the private and public sectors. The balance of that interaction will change over time, sometimes requiring privatization of public enterprises and sometimes extension of the public sector through nationalization or the creation of new government business enterprises. 

This is, perhaps, not a surprising conclusion, being little more than a restatement of the conventional wisdom that prevailed for much of the period after World War II. Nevertheless, it is inconsistent with the neoliberal ideas that have been dominant since the economic crisis of the 1970s. In the neoliberal framework, the superiority of the private sector and the persistence of large-scale public sector provision of goods and services is assumed to be the result of unjustified political resistance to market-oriented reform.

The mixed economy

Determining the right balance between the public and private sectors in a mixed economy does not require any radical innovations in economic thinking. The main task remaining for economists is to understand more fully the capital market failures that make the cost of equity capital so high. There are a number of factors involved, and the implications for the cost of equity capital depend on the interactions between them. First, as was discussed in Chapter 2, equity markets are subject to irrational bubbles and busts. The result is that equity investments fluctuate more than does the true economic value of the corporate profits from which returns to equity are derived. Since equity is riskier than it should be under the assumptions of CCAPM, investors will demand higher average rates of return. Second, many important risks, such as the risk of becoming unemployed, cannot be traded away, and this ‘background risk’ leads investors to be more averse to equity investments that yield low or negative returns in a downturn, when the risk of unemployment is high. Finally, equity markets have shown themselves to be uneven playing fields where large and politically powerful firms like Goldman Sachs are guaranteed high returns while ordinary investors lose out.

To the extent that these failures can be overcome, the equity premium will decline and the case for private provision of goods and services will be strengthened.7 In the meantime, economists need to abandon the search for a clever solution of the equity premium ‘puzzle’ and  focus more on the implications of the messy reality.

The existing theory of natural monopoly and market failure provides an indication of the areas where public ownership is likely to prove beneficial, as does the observation that, across many different countries, the areas of the economy that have been allocated to the private and public sectors have been broadly similar. The boundaries have shifted from time to time, but, broadly speaking, public provision has been most common in capital-intensive natural monopoly industries, and in the provision of human services such as health and education.

The case for public ownership is strongest in  where market failure problems are likely to be severe. In the case of infrastructure industries, several market failures are important. First, because of the equity premium and the associated problem of short-termism, private providers of infrastructure may not invest enough, or in a way that maximizes long-run benefits. Second, infrastructure facilities often generate positive externalities that are not reflected in the returns to the owners of those facilities. For example, good quality transport facilities will raise the value of land in the areas it serves. Finally, there are problems associated with the natural monopoly characteristics of many infrastructure services.

As regards human services such as health and education, there is a large gap between the reality of providing these services and the theoretical requirements for market optimality is so great that economists have struggled to apply economic analysis to these activities. Among a wide range of difficulties, the biggest problems relate to information, uncertainty and financing.  The value of health and education services is derived, in large measure from the knowledge of the providers (doctors, nurses, teachers and others) and their skill in applying that knowledge to benefit patients and students. By contrast, the standard economic analysis of markets begins with the presumption that both parties are equally well informed about the nature of the good or service involved. The asymmetry of information is intimately linked to the fact that the benefits of health and education services are hard to predict in advance, or even to verify in retrospect. This in turn creates severe problems financing through market mechanisms such as health insurance and student loans. One way or another, substantial government involvement in the financing of health and education is unavoidable. Once governments are paying some or all of the bill, the most cost-effective solution is often direct public provision.

Conversely, the case for private provision is strongest where the efficient scale of operations is small enough to allow a number of firms to compete and where markets function well, rewarding firms that innovate to anticipate and meet consumer demand, and eliminating those that produce inefficiently or provide poor service. In particular, in sectors of the economy dominated by small and medium enterprises, where large corporations cannot compete successfully, it is unlikely that government business enterprises will do much better. My home state of Queensland provides historical support for this claim, having experimented, unsuccessfully, with state-owned butcher shops, hotels and cattle stations early in the 20th century.

There will always be a range of intermediate cases where no solution is obviously superior. Depending on historical contingencies or particular circumstances, different societies may choose between public provision (typically by a commercialized government business enterprise), private provision subject to regulation, or perhaps some intermediate between the two, such as a public-private partnership.

Unlike most of the ideas discussed, the failure of the ideology of privatization has already been reflected in ‘facts on the ground’. Most of the emergency nationalizations undertaken during the crisis will ultimately be reversed. But the idea that public ownership is always a policy option, and sometimes a necessary choice, cannot easily be banished from public debate. The mixed economy is back, and it’s here to stay.

1 The technical term is ‘idiosyncratic risk’.

2 The logical implication, that recessions don’t really cause any economic damage, was derived by Robert E Lucas. Perhaps the singleminded devotion to theory required to push economic logic to such absurd conclusions is one of the characteristics needed to win a Nobel Prize!l

3 In the most notable case, Harvard University paid $26 million to settle charges of self-dealing arising from the activities of its Russia Project, a team set up in the 1990s to promote privatization (

4 For a complete analysis of the welfare effects of privatization, it is necessary to take account of the effects of privatization on workers, consumers and the public at large. In most cases, privatization makes workers worse off. Effects on consumers are more mixed, but are rarely significant. It follows that, if governments are worse off in fiscal terms as a result of privatization, society as a whole is usually worse off as well.

5 Other factors, such as politically motivated underpricing are relevant in some cases, including that of British Telecom.

6 they are items 8 and 9 in the list of 10 policy prescriptions in John Williamson’s original description of the ‘Washington consensus’

7 The rise of the ‘information economy’ is a two-edged sword here. On the one hand, more information should improve the functioning of financial markets. On the other hand, information as an archetypal ‘public good’, suited to free public provision, so the areas of the economy where private markets yield the best outcomes are likely to contract in relative importance.



Tim Worstall 01.15.10 at 11:42 am

“The claim that privatization always yields net social benefits was not always made explicit”

You keep saying “always”….and then go on to show that sometimes there are and sometimes there aren’t such net social benefits.

But no one (OK, no one I know of which opens me up to the who voted for Nixon rebuke) argues that all privatisations everywhere will always have net social benefits.

The argument is always about which will and which won’t. Even us neo-liberal nutters at the Adam Smith Inst haven’t been going around shouting for the privatisation of the Armed Forces or the criminal justice system.

So the intro seems to imply a rather more blinkered view that the later explanation really allows for: we all agree that swometimes privatisation makes things better and sometimes it will make things worse. So it’s not “always” it’s “it depends” for the reasons you lay out.

As to Railtrack, yes, that was one of our ideas (before my time there) and you’re right, it hasn’t worked out as hoped. But “deprivatisation” is a rather anodyne way of describing the withdrawal of previously promised subsidy only for the subsidy to be increased one the “deprivatisation” had taken place.

Finally, on management having short term horizons: well, yes, perhaps, but then so do politicians. The next election is as far as most of them can see and there’s abundant evidence that at least some companies (the oil majors for example) have planning horizons of a generation or more. Rather longer than most politicians can bring themselves to see (pension schemes for local and state public sector employees in the US being a reasonable example).


derek 01.15.10 at 12:59 pm

We know politicians have short terms horizons: that’s why they privatize!


Nick 01.15.10 at 1:54 pm

The problem with privatisation is that it is subject to the same public choice incentives as just running the damn public services. That’s why they are subject to failure so often. But they have worked sometimes. No one in the UK is ever going to suggest reviving NHS spectacles.


P. Baker 01.15.10 at 2:01 pm

I don’t know much about economics, but now that you’re near the end of your project I’d like very much to read a post about your book blogging experience: whether this very public way of writing a book was rewarding, and in what ways (quality of the comments, altered incentives to finish, etc.), and whether you plan to do it differently for your next project.


Ben Hyde 01.15.10 at 2:10 pm

confused: “The GFC has shown that, for most of the past decade, market estimates of the relative riskiness and return of alternative investments have been entirely unrelated to related.”

That’s the only use of the mnemonic GFC. Should the last word should be “risk”?


Yarrow 01.15.10 at 2:22 pm

More nits:

forced to denationalize its rail network

forced to renationalize?

The first kind were clever refinements of CCAPM, usually based on alternative assumptions about risk and time preferences, such complete and efficient financial markets generated large equity risk premiums.

Is there a word or two missing in this sentence?

denationalize Railtrack

renationalize Railtrack?

political benefits to the governments that undertake.

that undertake it?


Ben Hyde 01.15.10 at 2:30 pm

Since the lender signals how much he trusts the counter party via the interest rate when is money is lent, I am greatly amused to realize that Markets trust Governments more than they trust themselves.


Barry 01.15.10 at 2:36 pm

“The problem with privatisation is that it is subject to the same public choice incentives as just running the damn public services. That’s why they are subject to failure so often. But they have worked sometimes. No one in the UK is ever going to suggest reviving NHS spectacles.”

This is my opinion, as well – I wonder how many studies have been done?
In a government with good accountability, high transparency and low corruption and good efficiency, privatization would probably work well, but yield lower benefits,
for obvious reasons.

In a government with the opposite, the government runs things like sh*t, but privatization would be a morass of corruption, secrecy, bribery and absolute lack of accountability, and would make a bad situation worse (for examples, see ‘US, Presidential administrations, Bush II and Reagan”).


Doug K 01.15.10 at 4:58 pm

another example of privatization implemented on the ‘magic market fairy’ principle, and failing spectacularly, is Eskom (energy/power) in South Africa. Wikipedia has a good short summary,


Billikin 01.15.10 at 10:52 pm

Proofreading nit:

“market estimates of the relative riskiness and return of alternative investments have been entirely unrelated to related.”

“unrelated to reality.” ?


Billikin 01.15.10 at 11:00 pm

IIUC, the battle of Falujah came about when four Blackwater mercenaries entered the city (which was then off limits to U. S. soldiers) and were killed. Contractors were also implicated in the Abu Ghraib tortures.

One problem with privatization of government services is that the government retains responsibility without retaining control. I think that is why so many regulatory bodies arose in the wake of privatization in Britain. Does not the retention of responsibility mean than at least some risk remains socialized, while profits are privatized?


BillCinSD 01.16.10 at 3:36 am

something seems missing here

“Not all privatizations have failed. For example, while infrastructure systems as a whole have strong natural monopoly characteristics, it is often possible to separate competitive or potentially competitive components of the system, in which case privatization may be feasible. In the case of electricity supply, for example, electricity generation is more competitive than transmission and distribution, while the retail functions (billing, arranging connections and so on) are more competitive still). In such cases, partial privatizations

The most successful privatizations have been those of firms that never really belonged in the”


BillCinSD 01.16.10 at 3:41 am

“By the late 1990s, Thatcher’s Chancellor of the Exchequer Nigel Lawson was proudly announcing that the government had replaced the deficits it inherited with surpluses, and celebrated with tax cuts all round. But by the mid-1990s, with the economy having been through a serious slump and no more assets left to sell, the budget deficit hit new records, exceeding 6 per cent of GDP”

This seems wrong — in the late 1990s there were surpluses but in the mid-1990s no assets were left to sell and the budget deficits were at 6% of GDP? Either the years are off, or the use of this data in the paragraph is off.


Tim Worstall 01.16.10 at 9:29 am

“By the late 1990s, Thatcher’s Chancellor of the Exchequer Nigel Lawson”

Quite. Lawson went before Thatcher did. So late 1980s. By late 90s there were surpluses again or damn nearly so. Ken Clarke was Chancellor then (Major and Lamont in between the two).


Tim Wilkinson 01.16.10 at 7:45 pm

if the standard CCAPM model applied, the equity risk premium should be no more than half a percentage point as opposed to the observed value of six percentage points. Either the model is in need of refinement, or the assumption of complete and efficient financial markets is badly wrong.

Inneresting – so according to the CCAPM, the excess/unexplained equity premium weighs in at about 11 times the real/expected risk premium? Would it be quite wrong to describe this as indicating that overall financial-market failure has a magnitude of 1,100% of unavoidable financial-market riskiness? (And is it unreasonable to say that ‘market failure’ is any failure of reality to match the artist’s impression of perfect competitive equilibrium that’s painted on every pro-market billboard? And if it isn’t, what is it exactly? And is it just too economics 101 to put much of this down to a wide variety of jealously guarded barriers to entry?)

The logical implication [of an efficient financial markets hypothesis?], that recessions don’t really cause any economic damage, was derived by Robert E Lucas. Perhaps the singleminded devotion to theory required to push economic logic to such absurd conclusions is one of the characteristics needed to win a Nobel Prize!

The problem there, surely, is not in following the theory to its (absurd) logical conclusion, but in failing to note that this reduces the theory itself to absurdity. Might a more common way of operating consist of fudging the issue in order to stop short of the logical conclusion in all its absurdity? (Less singlemindedness, more doublethink?)


Tim Wilkinson 01.16.10 at 7:53 pm

Tim Worstall @1: But “deprivatisation” is a rather anodyne way of describing the withdrawal of previously promised subsidy only for the subsidy to be increased once the “deprivatisation” had taken place.

So must a description of events in economic history avoid being anodyne? Certainly “The withdrawal of previously promised subsidy only for the subsidy to be increased once the ‘deprivatisation’ had taken place” fits the bill of a more dramatic/tendentious way of supplementing the description: a bizarre choice of additional detail which results in a grossly misleading way of describing what happened to Railtrack.

In fact the events you choose to focus on were more like a junky who gets on the phone to Mum and with dark mutterings about going under manages to get her to say she’ll lend him another tenner, only to find on arriving at her house that she’s thought about this ‘going under’ business, decided there’s no point in being taken for a ride again while only delaying the inevitable, and refuses.

Do you really mean to suggest that poor old Railtrack was chugging along well enough until targeted for destruction by hostile forces, starved of funds and replaced by a successor pampered with huge subsidies for political reasons? If that is your motif, you might want to compare the levels of subsidy before and after the privatisation of what were to become separate firms running network, operations, rolling stock, maintenance etc.

(Such vertical fragmentation hadn’t been the case under BR, for reasons which are bleeding obvious. To avoid being too anodyne, one might add that some of those reasons were made particularly obvious via the medium of actual bleeding. At the time Railtrack was renationalised, the Hatfield crash had finally made reversing past neglect unavoidable, but all the money had gone to feed that dividend habit. That – well, not the dividend bit of course, or the neglect – was the reason -Nick Cotton- Railtrack was demanding yet more ad hoc funding.)

Shorter: what a load of old bollocks.


Greg 01.17.10 at 3:20 am

Another proofreading nit:

In “On the first point, it is a basic principal of economics …”, “principal” should be “principle”.
I have always wondered why, even at the height of the privatisation mania, governments did not privatise their Treasury/Exchequer departments. After all, those departments were the main proponents of privatisation within government.

The advantages are clear. There are quite a few potential suppliers of treasury operations, so there should be savings from a competitive market. As for the other main function of Treasury departments, policy advice: advice is always available for free. And, of course, private enterprise always does a better job.



John Quiggin 01.18.10 at 12:47 am

Thanks to everyone both for nitpicks and substantive comments. In particular Barry at #8 does a nice job of making a point I should have included already.


Ted 01.18.10 at 7:40 am

A counter-factual history exploring options available to Thatcher and others other than privatization would be neat. Maybe in the sequel.


Alex 01.18.10 at 10:34 am

By late 90s there were surpluses again or damn nearly so.

Not really, or even at all. The PSBR (as was) for ’96-97 was £26bn, down somewhat from £46bn in ’93-94, which was then the peacetime record in terms of GDP. This really is worstall, as Daniel Davies says.

Further, as you well know, the Government didn’t “withdraw previously promised subsidies” from Railtrack. Railtrack, Railtrack-in-Administration, and Network Rail all continued to draw subsidies from the Government. What the Government so rightly refused was a request not just for extra, ad-hoc subsidy but for a second extra, ad-hoc bailout within less than a year, for a company that was still paying a dividend yield of over 5 per cent.

It is also worth remembering that Railtrack never had any guarantee from the Government. Its management did, however, like to give the tacit impression to the world at large that such was the case, as this considerably improved the terms of their financing and hence the company’s profitability and their own compensation.

(Strangely enough, the current Mayor of London, Boris Johnson, who saw fit to accuse Transport Secretary Stephen Byers of being worse than Robert Mugabe over the issue, seems entirely happy to be the owner of not one but three railways in his current employment, and to be in charge of a massive PFI maintenance contract that has been, ah, renationalised and placed under the management of his services at London Transport Ltd. Is it possible that the mayor is a blowhard who will write anything for money?)


dsquared 01.18.10 at 11:51 am

Wrongstall writes:

Even us neo-liberal nutters at the Adam Smith Inst haven’t been going around shouting for the privatisation of the Armed Forces or the criminal justice system.

yes you have.


Tim Wilkinson 01.18.10 at 3:11 pm

I think Chris Mullin has already done something along those lines.


Tim Wilkinson 01.18.10 at 5:07 pm

(#22 was to Ted @19. Must have come across the page lying around unrefreshed among a profileration of tabs.)

Alex @20 – but the Nick Cotton analogy @16 was less anodyne.


dsquared 01.19.10 at 12:49 pm

late to the party on #20 and #21 but this really is an open and shut case – a company which claims to be unable to finance vital capital investment and is financially unviable without open-ended support from government, but which pays a dividend, really isn’t worth anyone’s time and effort defending.

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