This is the second in a planned series of posts assessing the implications of the global financial crisis for the economic ideas and policies that have been dominant for the past few decades. The large-scale privatisation of publicly-owned enterprises both in capitalist countries like the UK and Australia and in formerly communist countries after 1989 played a big role in promoting the kind of triumphalism that characterised much commentary about free-market capitalism in the 1990s and (to a somewhat lesser extent) in the years leading up to the crisis. How well do arguments for privatisation stand up in the light of the financial crisis.

The case for privatisation had two main elements. First, there was the fiscal argument for privatisation, namely, that governments could improve their financial position by selling government business enterprises. This argument assumed that privately owned firms would have higher levels of operating efficiency, and therefore that the value of those firms would be increased by privatisation. The second argument was a dynamic one, that the allocation of capital between alternative investments would be improved if governments were not involved in the process. Both of these arguments have been fatally undermined by the collapse of the efficient markets hypothesis.

The fiscal case for privatisation must be assessed on a case by case basis. It will always be true for example that if a public enterprise is operating at a loss, and can be sold off for a positive price with no strings attached, the government’s fiscal position will benefit from privatisation. Various early ventures in public ownership, such as the state butcher shops operated in Queensland in the 1920s (apparently a response to concerns about thumbs on scales) met this criterion, and there doesn’t seem to be much interest in repeating this experiment. However, for most recent privatisations in developed countries, the sale price has been less than any plausible estimate of the value of future earnings, discounted at the government bond rate. The fiscal case for privatisation therefore rests on the claim, derived from the efficient markets hypothesis, that the correct discount rate to use is one based on the private sector cost of capital and therefore dominated by the expected rate of return to equity capital.

The choice of discount rate makes a difference because the rate of return to equity has historically been much higher than the rate of interest on government bonds, a gap that can’t be explained by standard economic arguments about risk premiums. Although many explanations of this ‘equity premium puzzle’ have been offered, for present purposes they can be divided into two classes

(i) those which assume that the EMH is true, and imply that the equity premium is a correct reflection of economic risk, independent of equity markets

(ii) those in which the risk premium for equity reflects failures in equity markets that lead people to prefer holding bonds

In the light of the GFC and the events leading up to it, the case for explanations of type (ii) is overwhelmingly strong

The dynamic case for privatisation 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. For infrastructure in particular, the decision processes of Byzantine creations like Macquarie and Babcock and Brown have determined the allocation of investment. Unsurprisingly, the result has been a mess.

I’ve been making this argument for some time, so I can anticipate the immediate response that, if the case for privatisation developed in the 1980s were invalid, it would be necessary to advocate public ownership of all enterprises. I’m never quite sure if those putting forward such arguments are as ignorant of marginal cost and benefit calculations as they appear to be, or whether it’s simply meant as a debating trick. But it should not be hard to see that, if the public sector has lower costs of capital, while the private sector has (at least in a wide range of activities) lower operating costs and greater responsiveness to consumer demand, the optimal economic structure will involve public ownership of some firms and private ownership of others, that is, a mixed economy.