Why does privatisation sometimes go wrong?

The imposition of flawed privatisation models imposes economic losses far beyond the sectors concerned. Although the problems experienced in privatised industries have largely been the result of political interference and state regulation, their failure may be misused by ideological interventionists to undermine trust in markets more generally.

Both the public and opinion-formers have weak incentives to properly investigate why particular sectors have not performed well and this ignorance can be exploited. If the political culture turns against relatively free markets, the wider efficiency losses are likely to be substantial, as more and more economic activity becomes subject to high taxes and restrictive controls.

Privatisation is a political process and as such will be vulnerable to the problems afflicting political processes in general. Almost inevitably it will be influenced or even ‘captured’ by special interests. As a result, there is a risk that the outcome is not a dynamic free market, or even a lightly regulated sector. At worst, government will regulate the market to enable special interests to extract ‘rents’ from taxpayers and consumers. Such a model would protect favoured interest groups from new market entrants, competition and disruptive entrepreneurship, while participants’ profits might well rely on state subsidies.

As public choice theory would have predicted, many of the privatisations of the 1980s and 1990s did not produce anything approximating to free markets in the sectors concerned. In some industries at least, the period might more accurately be characterised as a shift from ‘state-capitalism’ Model A to ‘state-capitalism’ Model B. This raises the question whether Model B, consisting of heavily regulated markets under nominal private ownership, delivered economic benefits compared with the direct state ownership of Model A.

The answer is likely to depend both on the characteristics of a particular industry and the regulatory structure adopted post-privatisation. In an unhampered market economy, sectors characterised by major economies of scale and vast, inflexible, long-term capital investments – such as the rail industry – are likely to be dominated by large firms exhibiting high degrees of vertical integration. The ‘command economies’ within such firms will exhibit significant knowledge and incentive problems no matter what the ownership model. Thus, ceteris paribus, the benefits of privatisation are likely to be lower in such industries than in naturally more fragmented, dynamic and competitive sectors.

Nonetheless, there are particular problems associated with state ownership that are likely to apply across all sectors. These are explained in detail elsewhere, but include politicisation, producer capture, and poor incentives for entrepreneurship, innovation and cost-control. Where state regulation ensures monopolies, such pathologies may be exacerbated by an absence of competition. The poor results became apparent in the nationalised industries of 1970s Britain. Endemic misallocation of resources led to heavy taxpayer subsidies and poor quality services for customers.

However, some of the privatised sectors exhibit broadly similar problems today. The following (non-exhaustive) analysis therefore draws on theory and recent evidence to summarise some possible reasons why artificial post-privatisation markets could fail to produce efficiency gains compared with the directly state-controlled model that preceded them:

  • Politicisation – The propensity of politicians to interfere in a sector could hypothetically increase post-privatisation, resulting in increased regulation/taxation and concomitant efficiency losses. This outcome may be particularly likely in sectors with high political salience. Any change in the status quo creates risks for policymakers, providing incentives for them to intervene. The costs of such intervention are likely to be opaque and widely dispersed, leading to limited accountability.
  • Overregulation – Politicians may face fewer disincentives to impose costly regulations on a nominally privatised sector than under state ownership. In the former case, the negative effects can be blamed on private firms, whereas in the latter they are likely to be blamed directly on the government, creating higher political costs. Voters and ‘opinion formers’ have weak incentives to become well informed about such issues. Senior officials may benefit from the salary and status opportunities provided by expanded regulatory oversight, while key corporate players in the sector may welcome additional regulation if it serves their interests (for example, by raising barriers to market entry and protecting them from competition).
  • Flotation receipts – Short-term incentives to maximise flotation receipts may encourage the creation of heavily regulated ‘rigged markets’ that reduce the risks facing investors. Large, risk-averse institutional investors, such as pension funds, may prefer a model that effectively guarantees returns rather than entrepreneurial and disruptive freed markets that threaten incumbent players.
  • Transaction costs – Artificial post-privatisation markets may depart significantly from the organisational forms likely to evolve in an unhampered market economy. It is conceivable that in some instances such artificial structures increase transaction costs compared with direct state ownership, thereby reducing allocative efficiency.
  • Restructuring costs – Structural changes may weaken ‘social capital’ within a sector by disrupting working relationships, as well as losing specialist, often asset-specific knowledge and skills through the departure of long-term staff. Organisational cultures may also be weakened or destroyed. The role of such factors in efficient operations may be somewhat opaque to both policymakers and senior management.
  • Moral hazard – If sectors comprise ‘essential’ infrastructure then firms can be sure that governments will step in if they fail. Indeed, rules are typically in place that set out how this would be done. Limited liability laws and the use of special purpose vehicles also limit downside financial risks. These factors may encourage excessive risk-taking and a concomitant misallocation of resources.
  • Rent-seeking – A combination of heavy regulation and private ownership could potentially increase incentives for special interests to engage in rent-seeking activity. Profit-making businesses might have stronger incentives to lobby for regulations and subsidies that increase their profits than the less commercially minded managements of state industries. There is even a danger that ‘crony capitalism’ could emerge, as observed with privatisations in post-Soviet economies.

 

This is an edited extract from Without Delay: Getting Britain’s Railways Moving.

The future of the railways

This debate marked the launch of my new paper on rail privatisation, Without Delay: Getting Britain’s Railways Moving. The study is heavily critical of the 1990s privatisation model, in which politicians and officials imposed a complex and fragmented structure on the industry, ignoring the lessons of both transaction cost economics and railway history.

 

Ten rail capacity solutions that don’t cost the earth

  • Introduce more flexible pricing to flatten the peak. Passengers would have greater financial incentives to travel during the ‘shoulders’ of the peak, or indeed off-peak, thereby making more efficient use of existing infrastructure and rolling stock.
  • Phase out government subsidies and price controls so that fare levels better reflect industry costs.
  • Convert first class carriages into standard class carriages to accommodate more passengers.
  • Introduce high-capacity ‘economy class’ coaches with more standing room instead of seating (offering lower fare options).
  • Lengthen trains by adding more carriages and extending platforms. Double-length trains could even be used on busier sections and then split part-way through the journey.
  • Deploy improved signalling technology etc. to reduce the necessary gap between trains.
  • Consider using double-decker trains where the engineering costs would not be prohibitive.
  • Address bottlenecks by re-engineering junctions: relatively expensive but still much cheaper than building brand-new infrastructure.
  • Divert freight onto quieter routes, enhancing loading gauges where necessary. For example, intermodal traffic from Felixstowe to the Midlands and North can be sent via the Ipswich-Nuneaton route rather than the southern West Coast Main Line.
  • Allow full vertical integration to end the artificial separation between track and train, and between different franchisees and open-access operators. This would improve the financial incentives to make more efficient use of spare capacity.

Greek bailout fundamentally flawed

The original upload can be viewed here, together with comments.

 

HS2: subsidies breeding more subsidies

The rail industry depends on a very high level of state support. Much of the sector would not be viable without vast taxpayer subsidies and other special privileges.

The government supports the railways in several ways, including:

  • Providing direct subsidies from the taxpayer of about £6 billion a year (not including London Underground or light rail). This is equivalent to approximately 70% of fare revenue and represents a major distortion of the transport market.
  • Guaranteeing Network Rail debt, which has now reached an astounding £38 billion, larger than the national debt of Nigeria, a country of 180 million people. Big increases in such borrowing have enabled the government to hide the true level of taxpayer support by passing some of the costs on to future generations.
  • Imposing price controls on many rail fares, thereby increasing overcrowding, particularly on peak-time commuter services into London from satellite towns such as Milton Keynes.
  • Exempting rail fares from VAT. By contrast, tax is charged on road fuel at a rate of approximately 150%.
  • Adopting planning policies that push new development into areas adjacent to railway stations (for example, Stratford City), while restricting more spatially dispersed car-friendly growth. Also locating large public sector employers around rail hubs, including much of the civil service.
  • Funding ‘business’ rail travel by public sector workers and government contractors.
  • Suppressing competing modes such as road and air transport through high taxes, heavy regulation and restrictions on new capacity.

The artificial nature of the rail market raises uncomfortable questions for advocates of new rail infrastructure such as High Speed 2. Massive taxpayer support, regulated fares, discriminatory tax treatment and distortionary planning policies mean that the case for HS2 is grounded on levels of demand that have been hugely inflated by state intervention.

Existing subsidies are breeding future subsidies, with the UK’s transport sector and economic geography becoming ever more maladapted and distorted in the process.

Flaws in the ‘Northern Powerhouse’

Derelict factory 156There have been various attempts to regenerate the cities of the North over the last fifty years or so. All have failed to transform the region. As a Policy Exchange study put it, ‘attempts to regenerate British cities over the past ten, twenty or even fifty years have failed. The gap between struggling and average cities, let alone between struggling and affluent cities, has continued to grow. Geographical inequality is growing’. Once-thriving northern cities are now heavily dependent on central government subsidies. The ratio of public spending to ‘gross value added’ is around 50 per cent higher in the North of England than in London and the South East.

The cost of failed regeneration efforts has also been substantial. Stronger regions have been weakened due to the additional tax burden imposed on them to pay for such initiatives. And weaker areas have become trapped in state dependency, with high levels of government expenditure and national pay rates crowding out the private sector – for example by absorbing skilled labour – thereby hindering entrepreneurship and the production of wealth.

There is also a heavy indirect cost from distorting the UK’s economic geography and leaving it maladapted to current conditions. Essentially government policy has attempted to fossilise patterns of development that grew up in the Industrial Revolution, even though many of the reasons for economic activity concentrating in northern cities have long since disappeared. The result is that capital and labour have been misallocated to suboptimal locations. For example, subsidies to the North have reduced the incentive for people to seek more productive employment in other parts of the UK, once again harming the stronger regions and the economy as a whole.

In this context, this government’s plan to re-invent regional policy through the concept of a Northern Powerhouse would appear to be ill-conceived. As with previous attempts at regeneration, the plan is built on vast taxpayer subsidies from central government, imposing significant costs on the wider economy. And rather than allowing patterns of economic activity to evolve through voluntary exchange, this represents a top-down attempt to push development into favoured locations. Unfortunately there is a high probability that politicians will once again end up ‘picking losers’ rather than winners, and that the policy will squander resources on areas whose deep-seated problems will not be solved by yet more state intervention.

A key component of the Northern Powerhouse plan is the idea that by improving transport links between major centres such as Leeds, Manchester and Sheffield, the North can benefit from the kind of ‘agglomeration economies’ enjoyed by London. In other words, the hope is that better transport links will enable the region to behave more like a single city, with, for example, residents of Leeds and Sheffield easily able to work in Manchester and so on. The government hopes to achieve this by building High Speed 3, a multi-billion-pound, trans-Pennine rail link that will cut journey times between the city centres of Manchester, Leeds and Sheffield to around half an hour.

There are indeed substantial economic benefits from such clusters of economic activity. For example, thicker labour markets may lead to the better matching of workers to jobs and increased firm density may lead to greater knowledge sharing and to increased specialisation in supply chains.

However, it is also clear that current government plans will fail to produce most of these benefits. The population of the north is far more dispersed than that of Greater London, with many of its conurbations fragmented into smaller centres and a high degree of suburbanisation. This means that high-speed rail links between the major city centres will not deliver fast enough door-to-door travel times to enable the region to function as a single economic unit. Typical commutes will remain too time-consuming and too expensive for the labour markets to combine.

To give a practical example, take someone who lives in the wealthy suburbs of north Leeds and works in Manchester. The bus trip to Leeds station takes say 35 minutes in the morning peak, but in practice the commuter has to allow 50 minutes to give some leeway for transfers and the walking involved. The 30-minute high-speed trip to Manchester takes the total up to 80 minutes, and then the worker faces say a 10-minute walk to his office – making a total of 90 minutes or a 3-hour round trip (about three times the average).

Such long journeys would be unacceptable and/or impractical for the vast majority of potential commuters, effectively adding 40 per cent or more to the length of the working week. Moreover, the cost – about £3,500 a year based on current fares and possibly much more if HS3 charged a premium – makes this option prohibitive for many workers.

Moreover, high-speed rail will be almost entirely useless for the many businesses that rely on road transport to move goods and equipment. Building the kind of dense public transport network seen in London in the more sparsely populated North would be prohibitively expensive and not economically viable. The obvious flaws in the HS3 proposal are symptomatic of centrally planned, big-government projects that are driven by politics rather than commercial imperatives.

An additional obstacle to the success of the plan is the mediocre level of human capital in many areas of the North. Poor levels of education, skills and entrepreneurship, as well as local cultures that are not always conducive to wealth creation, often mean that the benefits of improved transport infrastructure are not forthcoming. This perhaps explains why Doncaster remains one of the poorest towns in the UK, despite its fast rail links to London and excellent road connectivity.

There are also strong elements of hypocrisy and double standards in the government’s plans. At the same time as policymakers are attempting to deliver agglomeration economies in the North, their policies actively undermine them in London and the South East. In particular, strict planning controls, including green belts and other ‘zoning’, are hindering the growth of the capital. This has a knock-on effect on labour mobility. By pushing up rents and house prices, planning policies deter people from moving from the North to London, even when such relocation would enhance their opportunities to succeed in the labour market. Accordingly, such controls have a highly negative impact on productivity and output, since workers are less likely to find employment that fully reflects their skills. Reduced labour mobility will tend to increase unemployment and underemployment, thereby raising welfare spending.

Rather than focus on a flawed attempt to produce agglomeration economies in the North of England, fighting against the logic of economic geography and pools of mediocre human capital, it would make far more sense to remove the barriers to a greater clustering of activity in London and the South East.

Such a laissez-faire policy would not require the vast subsidies associated with the Northern Powerhouse. As shown in the 1930s, deregulation would suffice for the provision of housing, while market pricing would enable far more efficient use of already dense and high-capacity transport networks. Land development could also help fund new infrastructure, built on a commercial basis without subsidy.

In terms of agglomeration economies, it makes far more sense to allow activity to cluster than to disperse it artificially to suboptimal locations. In particular, giving London the freedom to expand much more rapidly could see its population far outstripping other centres in Western Europe, facilitating the thicker labour markets, knowledge sharing, niche services and specialised clusters that attract talent and encourage high productivity.

Whether some kind of Northern Powerhouse develops, London expands, or both, should be determined by market processes rather than the whims of politicians. There may well be a revival of the North, but if it happens it will be despite government intervention, not because of it. Unless successful cities are allowed to grow and unsuccessful ones to decline, the UK’s economic geography will become increasingly maladapted to current conditions, with ‘zombie cities’ dependent on state handouts draining the life out of the more productive areas of the economy.

 

 Further reading:

Failure to Transform: High-Speed Rail and the Regeneration Myth

A shorter version of this article was published on the IEA Blog, 4 June 2015, where a comment thread is also available.

Election result could push HS2 costs even higher

Westminster 133x102As a taxpayer-funded, big-government project that confiscates property and despoils swathes of countryside, High Speed 2 is anathema to genuine conservatives. Even within the modernised, rebranded Conservative Party there remains significant opposition.

This hasn’t been fully reflected in MPs’ voting record. Politicians often put their careers before principle. They won’t rebel against their own leaders unless there is a reasonable chance of it succeeding. HS2 was never likely to be stopped in Parliament while it was supported by Labour and the Liberal Democrats.

The slender government majority dramatically increases the power of backbench Tory MPs, however. As shown by the Major years of the 1990s, they now have the power to cause immense disruption.

This is likely to translate into ‘logrolling’ behaviour – i.e. the trading of favours. Backbenchers will be able to trade their support for vital legislation in return for concessions on policies that matter deeply to them.

MPs along the HS2 route will therefore have ample opportunity to exploit the government’s weakness (although whether they choose to do so will depend on the resolve of the individuals concerned).

Unless there is a major change in the policy of opposition parties, this would probably not jeopardise the project itself, at least initially. It would mean, though, that the MPs could have the whip hand when it came to demanding more spending on environmental mitigation in their constituencies.

Possible outcomes include longer tunnels, route changes and more generous compensation for affected residents – measures that would add significantly to the already bloated costs. While those close to the line would benefit, taxpayers would lose out. Concentrated interests would once again triumph over the wider population.

Another increase in the project’s budget would also present difficulties for governments already struggling with high public debt and sluggish economic growth, particularly given the huge off-balance-sheet costs of HS2. In the longer run, it could therefore make full or partial cancellation more likely.

 

See The High-Speed Gravy Train for more detailed analysis of the political economy of High Speed 2.

See the Economics of HS2 page for short introductions to the key aspects of the scheme.