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.


Pseudo-markets versus voluntary networks – libertarian strategies for rolling back the state

broken chain 197Libertarians should not put much faith in the extension of ‘pseudo-markets’ as a means of rolling back government. A more radical strategy is needed.

The pseudo-markets approach involves setting up some kind of market-like structure in a largely government controlled sector. A typical example is education vouchers. Parents receive state-funded vouchers, which they then use to ‘purchase’ education for their children. To the extent such systems facilitate choice, competition and entrepreneurship they may provide benefits for participants. But there are also significant downsides. Pseudo-market structures are often afflicted by high transaction costs (partly because parasitic special interests benefit from artificial complexity). And since state funding is retained, the misallocation of resources remains entrenched and pervasive. Using education once again as an example, this could mean that government would carry on funding the teaching of those children who were gaining little from formal education, or indeed losing out due to the opportunity costs.

Moreover, with government funding comes government control. Under any plausible voucher system, only education providers that met certain politically determined criteria would qualify for state funding. In practice this would mean official control over the curriculum and other key elements such as admission rules. Even if a more flexible system were introduced initially, it would only take a few scandals – renegade schools adopting practices that were deemed unacceptable – for stricter eligibility controls to be instituted.

Another highly regrettable aspect of pseudo-markets is their creation of ‘distributional coalitions’ of groups that depend on government subsidies and regulatory privileges. Given strong financial incentives, private firms providing voucher-funded schooling would likely be far more effective at rent-seeking than the moribund government institutions they replaced. Similar examples abound, from the US ‘prison-industrial complex’ to Britain’s ‘privatised’ rail industry. Indeed rent-seeking activities may actually lead to an expansion in government support, with even more resources appropriated through taxation.

These state-dependent special interests would also have strong incentives to capture the regulatory framework in order to shut out competition and increase their returns. Thus large education firms would inevitably lobby for government protection in the form of stricter licensing of providers. They could also successfully promote expanded services to politicians, as a means of achieving various social objectives. Similarly, potential investors such as state-privileged pension funds favour rigged markets in order to reduce risk and guarantee returns. And parent-voters are likely to resist any attempt to reduce the value of handouts such as education vouchers, particularly given the skewed distribution of the tax burden. Indeed, the relative transparency of vouchers etc. compared with more opaque intra-state funding mechanisms would arguably make it even harder to reduce government spending. It is easy to see how the introduction of pseudo-markets in so-called public services can degenerate into yet another shakedown by special interests.

If pseudo-markets risk being counterproductive in terms of rolling back the state, they do at least provide lessons for the development of more effective strategies. Incentive structures would appear to be a key consideration. Clearly the retention of an element of state funding encourages rent-seeking behaviour that undermines attempts to reduce government involvement. This suggests that instead of attempting to reform ‘public services’, libertarians should focus their efforts on approaches that reject them completely. Accordingly, activists should develop strategies that first bypass and later supplant state institutions entirely.

Samuel Edward Konkin argued that a libertarian society could be achieved through the extension of the counter-economy – non-legal shadow markets that, due to their voluntary nature and greater efficiency, would eventually displace governments. The plausibility of such an outcome may be questioned in the context of modern surveillance states. Nevertheless, a less ambitious ‘quasi-agorist’ or ‘neo-agorist’ approach that sought to extend non-state networks could indeed be an effective strategy for undermining dependence on and support for government services.

Konkin was also highly sceptical about the efficacy of libertarian participation in politics. Yet, to the extent that libertarians do have political influence, it should perhaps be targeted towards removing those regulatory barriers that prevent individuals, families and communities from bypassing state institutions. Looking at education once again, this might for example involve campaigning for the removal of legislation that prevents homeschooling, requires the licensing of non-state schools or mandates education up to a certain age. Many such rules are relatively obscure and have little political salience, suggesting that in some instances concentrated pressure would result in reform.

Of course in some places, such as the UK and in many US states, there are relatively few barriers to methods of opting out such as homeschooling. Effective strategies may then revolve around raising awareness of these possibilities through the dissemination of information and practical methods of implementation. Ivan Illich, for example, advocated the development of ‘learning webs’ which would allow children outside formal state schooling to access appropriate expertise and learning materials. Indeed, contemporary homeschooling networks pool skills and materials to enrich children’s education and capture economies of scale.

Such non-state networks are clearly far superior to pseudo-markets in terms of preserving and extending liberty: Provision is voluntary and does not depend on theft of resources; incentives for rent-seeking are absent because there are no government officials to lobby for funding/special privileges; top-down politicisation and social engineering is extremely difficult to impose on such decentralised structures; and allocative efficiency is likely to be much higher than under state systems, because the investors in education (i.e. parents, extended families and small community groups) possess local, time and place specific knowledge (e.g. the talents of a particular child and local employment opportunities), as well as having strong incentives to control costs.

Libertarian objectives are also enhanced by the wider effects of extending non-state networks. Reduced dependence on government handouts is likely to undermine political support for predatory politics and the funding of ‘public services’. At the same time, non-state networks that develop in a particular sector can extend into other activities. For example, connections that develop through a homeschooling network can form the basis of counter-economic activities and the voluntary exchange of goods and services outside government regulatory frameworks. Networks could also develop around subcultures that resisted governments on ideological grounds, effectively becoming refuges for political dissidents (e.g. by facilitating escape to a safe location). Thus a strategy of exiting ‘public services’ and developing voluntary alternatives has the potential to snowball into the creation of resilient sanctuaries from the state offering protection from government aggression. The contrast with counterproductive pseudo-markets is stark.

Unless otherwise stated, all articles on this website are written in a personal capacity.