Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism

post, water or transport – the cost of delivering a letter to an address in the remote mountain areas of Switzerland is much higher than to an address in Geneva. If the firm delivering the letter was solely interested in profit, it would raise the price of letter delivery to the mountain areas, forcing the residents to reduce their use of the postal service, or might even discontinue the service altogether. If the service in question is a vital one that every citizen should be entitled to, the government may decide to run the activity itself through a public enterprise, even if it means losing money in the process.

All of the above reasons for having SOEs can be, and have been, addressed by schemes whereby private enterprises operate under some combination of government regulation and/or tax-and-subsidy scheme. For example, the government may finance (through a government-owned bank, for example) or subsidize (out of its tax revenue) the private enterprise undertaking a risky, long-term venture which may be beneficial for the country’s economic development, but which the capital market is unwilling to finance. Or the government may license private-sector firms to operate in natural monopoly industries but regulate the prices they can charge and also the quantity they produce. It can license private-sector firms to provide essential services (e.g., post, rail, water) on condition that they provide ‘universal access’. Therefore, it may appear that SOEs are no longer necessary.

But the regulation and/or subsidy solutions are often more difficult to manage than SOEs, particularly for developing country governments. Subsidies require tax revenues in the first place. Collecting tax may seem straightforward, but it is not easy. It requires capabilities to collect and process information, calculate the taxes owed, and detect and punish evaders. Even in today’s rich countries, it took a long time to develop such capabilities, as history shows.[18] Developing countries have only limited abilities to collect taxes and, consequently, to use subsidies to address the limitations of the markets.As I pointed out in chapter 3, this difficulty has been recently compounded by the reduction in tariff revenues following trade liberalization – especially for the poorest countries that have a particularly high dependence on tariff revenues in their government budgets. Good regulation has proved difficult even in the richest countries, which have sophisticated regulators commanding ample resources. The messy outcome of British rail privatization in 1993, which resulted in the de facto re-nationalization of the rail tracks in 2002, or the failure of electricity deregulation in California, which resulted in the infamous blackout in 2001, are merely the most prominent examples.

Developing countries are even more deficient in their capacity to write good regulatory rules and to deal with the legal manouevring and political lobbying by the regulated firms that are often subsidiaries of, or joint ventures with, gigantic well-resourced enterprises from rich countries. The case of Maynilad Water Services, a French-Filipino consortium that took over water supply for about half of Manila in 1997, and that was once hailed by the World Bank as a privatization success story, is very instructive in this regard. Despite having secured, through skillful lobbying, a series of tariff hikes that were not formally permitted under the terms of the original contract, Maynilad walked away from the contract when the regulator refused to grant yet another tariff hike in 2002.[19]

State-owned enterprises are often more practical solutions than a system of subsidies and regulations for private-sector providers, especially in developing countries that lack tax and regulatory capabilities. Not only can they do (and, in many cases, have done) well, under certain circumstances they may be superior to private-sector firms.

The pitfalls of privatization

As I have pointed out, all the alleged key causes of SOE inefficiency – the principal-agent problem, the free-rider problem and the soft budget constraint – are, while real, not unique to state-owned enterprises. Large private-sector firms with dispersed ownership also suffer from the principal-agent problem and the free-rider problem. So, in these two areas, forms of ownership do matter, but the critical divide is not between state and private ownership – it is between concentrated and dispersed ownerships. In the case of the soft budget constraint, arguably the distinction between state and private ownership is sharper, but even here it is not absolute. For, as we have seen, politically important private-sector firms are also able to get financial help from government, while SOEs can be, and, on occasion, have been, subject to hard budget constraints, including management change and the ultimate sanction of liquidation.

If state ownership itself is not entirely, or even predominantly, the root cause of problems with SOEs, changing their ownership status – that is, privatization – is not likely to solve the problems. What is more, privatization has a lot of pitfalls.

The first challenge is selling the right enterprises. It would be a bad idea to sell public enterprises with natural monopolies or those providing essential services, especially if the regulatory capability of the state is weak. But even when it comes to selling off enterprises for which public ownership is not necessary, there is a dilemma. The government usually wants to sell the worst performing enterprises – precisely those that least interest potential buyers. Therefore, in order to generate private sector interest in a poorly performing SOE, the government often has to invest heavily in it and/or restructure it. But if its performance can be improved under state ownership, why then privatize it at all?[20] Therefore, unless it is politically impossible to restructure a public enterprise without a strong government commitment to privatization, a lot of problems in public enterprises may be solved without privatization.

Moreover, the privatized firm should be sold at the right price. Selling at the right price is the duty of the government, as the trustee of the citizens’ assets. If it sells them too cheaply, it is transferring public wealth to the buyer. This raises an important distributional question. In addition, if the wealth transferred is taken outside the country, there will be a loss in national wealth. This is more likely to occur when the buyer is based abroad, but national citizens can also stash the money away, if there is an open capital market, as seen in the case of Russian ‘oligarchs’ following post-communist privatization.

In order to get the right price, the privatization programme must be done at the right scale and with the right timing. For example, if a government tries to sell too many enterprises within a relatively short period, this would adversely affect their prices. Such a ‘fire sale’weakens the government’s bargaining power, thus lowering the proceeds it receives: this is what took place in a number of Asian countries after the 1997 financial crisis.What is more, given fluctuations in the stock market, it is important to privatize only when the stock market conditions are good. In this sense, it is a bad idea to set a rigid deadline for privatization, which the IMF often insists on and which some governments have also voluntarily adopted. Such a deadline will force the government to privatize regardless of market conditions.

Even more important is selling the public enterprises to the right buyers. If privatization is going to help a country’s economic future, the public enterprises need to be sold to people who have the ability to improve their long-term productivity. Obvious as this may sound, it is often not done. Unless the government demands that the buyer has a proven track record in the industry (as some countries have done), the enterprise may be sold to those who are good at financial engineering rather than at managing the enterprise in question.

More importantly, SOEs are often sold off corruptly to people who have no competence to run them well – massive state-owned assets were transferred in a corrupt way to the new ‘oligarchy’ in Russia after the fall of communism. In many developing countries, the very processes of privatization have also been riddled with corruption, with a large part of the potential proceeds ending up in the pockets of a few insiders, rather than in the state coffers. Corrupt transfers can sometimes be effected illegally, through bribery. But they can also be done legally, for example, where government insiders act as consultants and get high fees in the process.

This is ironic, given that one frequent argument against SOEs is that they are rife with corruption. However, the sad fact is that a government that is unable to control or eliminate corruption in its SOEs is not suddenly going to develop the capacity to prevent corruption when it is privatizing them. Indeed, corrupt officials have an incentive to push through privatization at all costs, because it means they do not have to share the bribes with their successors and can ‘cash in’ all future bribery streams (e.g., bribes that SOE managers can extract from input suppliers). It should also be added that privatization will not necessarily reduce corruption, for private-sector firms can be corrupt too (see chapter 8).

Privatization of natural monopolies or essential services will also fail if they are not subject to the right regulatory regime afterwards. When the SOEs concerned are natural monopolies, privatization without the appropriate regulatory capability on the part of the government may replace inefficient but