Tuesday, December 13, 2011

Pros and cons of privatization

Here is an interesting piece on privatization and sale of assets by John Quiggin, who is a professor of economics at the University of Queensland and author of Zombie Economics.

The balance between the public and private sector is always changing, so privatization is not of itself good or bad. The only general answer to the question of whether to sell public assets is: “It depends.” Before looking at the central arguments that determine the desirability of privatization in any given case, it is useful to consider the policy in its historical context.

With the emergence of sovereign debt problems as a central policy concern, however, privatization is back on the agenda. Selling assets seems to be an easy way for governments to raise cash. Meanwhile, economic arguments about the costs and benefits of private and public ownership remain unresolved, and have been further complicated by the challenges to economic theory posed by the financial crisis.

While there are many arguments for and against privatization in particular cases, in general the most common argument for privatization is that it provides hard-pressed governments with a source of ready cash. But this argument is not as clearcut as it might seem. Selling an asset yields an immediate financial benefit, but it requires governments to forgo the earnings or services the asset would otherwise have generated.

The obvious question is whether the proceeds from selling an asset are more or less than the value of the earnings forgone. In principle, this is a straightforward question. We can look at the amount of interest saved if the proceeds from the sale were used to repay public debt and compare those savings to the earnings that would be generated under continued public ownership. Alternatively, but equivalently, we can convert a projected stream of future earnings into a present value, discounted at the rate of interest on public debt. If the proceeds from the sale exceed the present value of forgone earnings, privatization has improved the government’s fiscal position.

There are two factors that will determine the outcome of an exercise of this kind:

First is the operational efficiency of the firm under private and public ownership. In general, a firm operating in a competitive market will do better under private ownership. However, if the market requires extensive regulation—to deal with monopoly or externality problems—the advantages of private ownership are diminished and may disappear.

Second is the relative cost of capital, taking appropriate account of risk. In general, even after allowing for default risk, governments can borrow more cheaply than private firms. This cost saving may or may not outweigh the operational efficiency gains usually associated with private ownership.

Still, it remains relatively rare to see privatization subjected to this simple empirical test. I have analyzed a number of Australian and British privatizations of the 1980s and 1990s and found that very few of them increased public sector net worth (Quiggin, 1995; 2010). The privatizations undertaken by the Thatcher government, widely applauded at the time, were among the worst in terms of their effects on the net worth of the public sector. Most notable was the sale of 50 percent of British Telecom for a mere ₤3.7 billion, at a time when its pretax earnings were about ₤2.5 billion a year.

So, when is sale of public assets desirable?

First, like all large organizations, governments have changing goals and objectives. Assets that were useful in one context may be superfluous in another. For example, as the U.S. military has become smaller and more professional, the need for army bases has declined, and some have been closed and sold. Rational asset management makes sense regardless of views about privatization and public ownership.

Second, some enterprises are unprofitable under public ownership, perhaps because of political constraints on such matters as hiring and firing, but can be sold to private investors who are not subject to these constraints. In cases of this kind, there is a clear fiscal benefit. However, it is important to consider whether the constraints in question are inherent in public ownership and whether the question of structural reform can be separated from that of private or public ownership.

Finally, if a government is in such dire straits that it can no longer borrow at the prevailing low rates for high-quality public debt, often it makes sense to sell income-earning assets. The interest saved is more than the earnings forgone. In cases of this kind, privatization may take place at fire-sale prices—not an optimal outcome. A preferable alternative is for international lenders such as the IMF to provide liquidity while efficient adjustments (including asset sales where these pass the benefit-cost test) are undertaken.

The verdict

In general, however, the idea that governments can improve their financial position to any significant degree by selling assets is an illusion arising from a focus on accounting numbers rather than economic realities. The economic argument for privatization is that it will lead to more socially efficient provision of goods and services, more competitive markets, and greater responsiveness to consumer needs and preferences. The strength of this argument, and of counterarguments based on market failure, varies from case to case.

The strongest case for privatization arises in the wake of rescues like that of General Motors in the United States and, several decades earlier, of Rolls-Royce in the United Kingdom. Firms like these, operating in competitive markets and with no particular need for regulation, never belonged in the public sector. In the ordinary course of events, faced with severe financial difficulties, they would have gone out of business. However, given their iconic status, governments were willing to risk public money to keep them going. In both these cases, the rescue was successful and the firms were returned to private ownership.

[…] In summary, privatization is valid and important as a policy tool for managing public sector assets effectively, but must be matched by a willingness to undertake new public investment where it is necessary. As a policy program, the idea of large-scale privatization has had some important successes, but has reached its limits in many cases. Selling income-generating assets is rarely helpful as a way of reducing net debt. The central focus should always be on achieving the right balance between the public and private sectors.