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Is Privatization the Answer?: Not always. Examine the pros and cons carefully

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1988
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Richard Hemming and Ali M. Mansoor

The post-World War II period witnessed an enormous expansion of government intervention in national economies, particularly in the 1960s and early 1970s, when the public sector was seen as a major contributor to economic growth and socio-political stability. However, the weaknesses of public sector institutions and operations subsequently began to show, especially after the major economic setbacks of the 1970s. The pervasive influence of government started to be seriously questioned, especially in the industrial countries, as the inability of economies to adjust to external price shocks led to a deterioration of macroeconomic performance. As a result of this reassessment of the appropriate size and scope of government intervention, there have in recent years been major reversals of policy stance. With the growing populanty of tax reform, deregulation and, in particular, privatization, the relationship between the government and the private sector is changing fundamentally in a growing number of developed and developing countries.

Privatization—the transfer of public sector activities to the private sector—has been frequently discussed in this context. While major programs of asset sales have been introduced in France and the United Kingdom, the rest of the world has so far been slow to follow, particularly developing countries. Only a handful of countries has made any significant progress in this direction. The aim of this article is to review the arguments for and against privatization and to outline some of the problems involved in implementing a privatization program.

Public ownership

Public ownership serves a variety of economic, social, and political objectives and the size and structure of the public sector differs widely between countries because of the different emphasis placed on these objectives (see “Privatization and the Public Sector” by Samuel Paul, December 1985). From an economic point of view, the main arguments in favor of public ownership relate to the failure of markets to secure economic and social objectives. A major concern has been the inevitable tendency of certain markets toward monopoly, especially when technological factors imply that only one producer—a natural monopoly—can fully exploit available economies of scale. Such a situation typically emerges when heavy investment in a network, for example an electricity grid or a railroad, is required. Telecommunications and broadcasting systems have also tended to be regarded as natural monopolies, although recent rapid technological progress in these areas has made this less justified. Public ownership also gives government the freedom to pursue objectives which the market would ignore. Most important among these are goals of social equity, such as access to essential goods and services at an affordable price, and employment. A significant proportion of welfare economics is devoted to establishing the case for government intervention, though not necessarily public ownership, to regulate natural monopolies and to meet compelling social needs. Government intervention is also justified by the presence of external costs and benefits. The pursuit of social objectives often involves an effort to capture positive externalities.

While the boundary between the public and private sectors can in principle be defined by reference to efficiency and equity considerations, the diversity of experience between countries reflects the fact that a number of other factors—economic, political, and strategic—have to be taken into account. Indeed, the motivations for public ownership are so varied that it is impossible to systematically explain inter-country differences in the extent of public ownership. What is clear, however, is that dissatisfaction with the public sector, and public enterprises in particular, is broadly based, and that the source of this dissatisfaction is not solely ideological. There is now widespread doubt as to whether the benefits of public ownership are worth the cost.

Case for privatization

Although some of the objectives of government intervention may have been achieved, other problems have emerged from public ownership. Politicians interfere with the operations of public enterprises; managers are poorly motivated, badly paid, and inadequately monitored; and because of the nature and importance of public sector activities, labor unions tend to be unusually powerful. These factors have combined to reduce the cost or productive efficiency of public production, often leading to heavy dependence on budgetary support. Moreover, public ownership has not fully achieved the additional allocative efficiency that is expected from it. In pursuing their personal goals, politicians, managers, and workers water down some higher-priority objectives of public ownership.

This characterization of the problems associated with public enterprises is clearly exaggerated, but it is not extreme. Indeed, it hardly does justice to some of the more excessive manifestations of these problems. It does serve to illustrate, however, that as a form of regulation public ownership has weaknesses and identifies the avenues through which these are exploited.

Would things be materially different under private ownership? A private firm can be characterized as one for which the product market guides prices and output while the capital market (including the market for corporate control) constrains costs. A firm that cannot sell its products will not make profits; unprofitable firms will go bankrupt or be taken over. The market therefore regulates firms, providing the incentive for them to achieve both productive and allocative efficiency. As in the case of the description of the problems associated with public enterprises above, this characterization is exaggerated but not extreme. It would be unwarranted, however, to base any conclusion about the general superiority of private ownership on a comparison of the two.

Certainly, some of the worst excesses of public ownership would be diminished by a shift to private ownership. Simply taking public enterprise decision making out of the political arena and withdrawing government financial backing will eliminate some inefficiency. But where such a change involves the mere transfer of a public monopoly to the private sector with its monopoly power left intact and no change in the regulatory regime, such gains will be limited. Many of the problems associated with public enterprises arise not from the fact that they are publicly owned; rather, they reflect an absence of market discipline. Therefore, by exposing public monopolies to competition—which provides the incentive to seek both productive and allocative efficiency—significant efficiency gains are likely to result.

For a more detailed discussion see IMF Occasional Paper Number 56, Privatization and Public Enterprises, January 1988.

Privatization and competition

Most public enterprises are not subject to national or international competition. Many benefit from statutory protection of their monopoly status or some other artificial barrier to entry by competitors. Privatization of such enterprises will not succeed in making them more efficient unless it is accompanied by economic and financial liberalization so that market forces are allowed to influence enterprise behavior. In this context, it has been argued that it is inappropriate to dismantle protective barriers except in conjunction with privatization, since continued financial backing by governments will permit public enterprises to exclude private competitors in a newly liberalized market. However, the answers in such cases are tighter budget constraints and appropriate regulation to limit predatory or anti-competitive behavior by incumbents, be they in the public or private sector.

For a variety of reasons—such as the need to generate maximum revenue or to secure the compliance of management and workers—it may be thought appropriate to restrict competition at the time of privatization. Not only does this call into question the motives of a privatization program, it also makes it difficult to believe that liberalization will ever take place. The maximum efficiency gain will result from privatization accompanied by liberalization. Efficiency considerations also suggest that where conflict is likely to emerge liberalization should precede privatization, even if this results in some potential buyers of public enterprises losing interest in completing a purchase.

To the extent that public ownership reflects circumstances in which markets do not work well or produce outcomes that are considered socially or politically undesirable, removing barriers to competition would be insufficient or inappropriate. Natural monopoly, for example, is a market outcome; to introduce competition in a natural monopoly setting the market has to be redefined. For example, one solution is to make the right to run a natural monopoly the object of competition, by auctioning franchises to the private sector. This approach has been most widely adopted in the areas of local broadcasting and transportation. Also some activities associated with natural monopoly, such as maintenance, are likely to be contestable, and these can be contracted out to the private sector. Contracting out has been successfully employed in a wide range of public services, such as street cleaning and garbage collection. But to the extent that the core activities of natural monopolies are inherently noncontestable, because they involve large national networks, public ownership is likely to remain the most efficient way of regulating such activities. Certainly the experience with alternative forms of regulation suggests a degree of bureaucratic and legal complexity that could admit as much inefficiency as public ownership.

Social objectives would also be subjugated in a private market. The public sector can support loss-making activities of social value through cross subsidization by profit-making concerns; in a liberalized market, the private sector will undertake only profitable activities and leave social needs to be met by other means. A question naturally arises as to whether these needs are best met through public ownership. Certainly, the private sector can be induced, for example through the payment of subsidies, to provide essential services to sparsely populated areas and to employ people even when it is unprofitable for them to do so. The issue should then be one of cost-effectiveness of different types of interventions. But this will tend to be dominated by less precise considerations related to the proper role of government in a mixed economy. These considerations will, in all likelihood, result in a range of priority social objectives which will continue to be met by the public sector in general, and public enterprises in particular.

Other objectives

While the promotion of efficiency, both economic and social, is central to the discussion of privatization, this policy has also been assigned other objectives. Most notably, privatization has been suggested as a means of reducing deficits. Although the proceeds from the sale of a public enterprise are typically treated as negative capital expenditure in fiscal accounts, thereby reducing the deficit, the reduction is only temporary. Rather than being a structural measure akin to a tax increase or an expenditure reduction, an asset sale is more closely related to bond financing in its impact. In both cases, there is an implicit commitment to raise additional revenue in the future—in the case of an asset sale to replace forgone income, and in the case of a bond issue to service debt. Only if an enterprise is run more efficiently and profitably in the private sector, will the budget benefit from privatization on a permanent basis.

Privatization may also be seen as a means of diluting the strength of public sector trade unions. But, competition accompanied by the risk of bankruptcy resulting from tighter budget constraints is likely to be more effective in this respect; otherwise, the answer lies in trade union reform and other legal sanctions, not privatization. Another objective may be wider share ownership. This may be desirable, especially if it reflects concerns for increasing and more equitably distributing income and wealth. But efficiency gains, however achieved, are the key to increasing total income and wealth, while taxes and transfers can most directly influence the distributional consequences of such gains.

Developing country perspectives

Privatization is essentially an industrial country phenomenon. Little of the rather limited privatization that has occurred outside the major programs of asset sales in the United Kingdom and France has taken place in developing countries. This may seem surprising. Public ownership is far more extensive in developing countries, where public production was viewed as essential given the underdeveloped nature of resources and markets. The consequences in terms of efficiency were quite adverse. Certainly, many developing countries are considering privatization as a means of achieving some much needed retrenchment of the public sector, and a number of privatization programs are being put in place. For example, the World Bank is now supporting programs in about 15 countries (see accompanying article by Mary Shirley.) But, with the exception of Bangladesh and Chile, enterprise sales have so far been scarce, and privatization (more broadly defined to include leasing, contracting out and other similar activities) has been slow to get off the ground in most countries. Even liquidations, which require no private sector participation, have been modest.

Part of the explanation for this slow progress is the few enterprises that are actually suitable candidates for privatization, the practical difficulties in effecting privatization, and the sociopolitical obstacles to carrying through this type of program. Many of the most inefficient loss-makers may not be attractive to the private sector; resources are often not available to finance privatization; or interested buyers may be unacceptable, for example because they belong to particular ethnic and religious groups, or are foreigners. These problems, however, can be addressed; indeed, privatization may itself be part of the answer, insofar as it mobilizes private capital, encourages local entrepreneurship, and promotes risk sharing with the private sector. But the answer lies mainly in liberalizing domestic economies and in adopting a more open attitude to foreign investment. The process can be helped by innovative solutions to problems of securing foreign involvement in the domestic economy. Debt-to-equity conversions represent one such innovation. A number of Latin American countries, including Argentina, Brazil, Chile, and Mexico, are encouraging foreign banks to exchange debt for equity, with a view both to reducing their debt and to stimulating foreign investment.

Moreover, as the earlier discussion emphasized, it is not sufficient to simply turn to the domestic or external private sector. Rather, it is necessary to create an environment where resource allocation can be guided by greater reliance on market signals. This will benefit not only the public sector, but also the private sector. In developing countries, enterprises in both sectors tend to be protected by high tariff and nontariff barriers behind which inefficient artificial monopolies develop. In this respect, the scope for enhancing efficiency through privatization is probably greater in developing countries than in industrial countries. But to realize these gains it is even more important in developing countries that privatization be accompanied by liberalization in general, and trade liberalization in particular. The case for privatization, at least on economic grounds, is not as clear as it is often made out to be, and the instances where it is the appropriate policy options are frequently limited, especially in developing countries. Its justification rests heavily on grounds of efficiency and its success on accompanying measures to promote a more competitive economic environment. While the creation of competition—with or without privatization—is central to improving the efficiency of an industry and the economy, it is probable that the public sectors will remain large throughout the world. This will be especially so in developing countries, where market failure is more widespread and non-economic benefits of public ownership tend to take on greater significance. As a consequence, the design of mechanisms to improve the efficiency of enterprises that must remain under government control will continue to constitute a major challenge for public policy.

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