For much of the 20th century, the general movement of economic policy in capitalist societies was towards an expanded role for the state, including an expansion of the scope and extent of public ownership of industry. The term ‘mixed economy’ was popularized by British economist Andrew Shonfield to describe the economic system of the postwar era.
This system was not a compromise between comprehensive state socialism and free market capitalism, as is often supposed. Rather, in seeking a market system actively managed by governments the mixed economy transcended this dichotomy. It was, and remains, unlike the vaporous offerings of Tony Blair and Bill Clinton in the 1990s, a genuine ‘Third Way’.
At its best, the mixed economy was a substantially more democratic mode of organization than the system of globalised laissez-faire it replaced, and that has been resurgent in recent decades. Under laissez-faire, the property rights of capital owners override the democratic presumption that people should have a say in the major decisions that affect their lives. In a mixed economy, major providers of infrastructure are, or at least should be, responsive to public concerns about, for example, the environment or equity in employment.
This potential was not always realised. Some public enterprises were unaccountable fiefdoms run by their managers or by narrowly-based unions. Overall, though, public enterprises of the mixed economy era displayed a concern with the public good that has been lost in the subsequent era of corporatisation and privatisation.
From the 1980s onwards, the mixed economy came under sustained attack from advocates of privatisation. By the 1990s, books like The End of History and The Lexus and the Olive Tree proclaimed the final and irrevocable victory of market liberalism. But after many failed privatizations, and the failure of global financial markets, necessitating a massive government bailout, it is time to reassess the issues.
The long-run case for privatization 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 financial derivatives 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 global financial crisis 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 reality.
The crucial claim is that privatization always yields net social benefits and therefore that, other things equal the price for which a public asset can be sold will exceed its value in continued public ownership. This claim has never had much empirical support. Rather it has been taken on faith as a consequence of the efficient financial markets hypothesis.
For many privatisations, the sale price is less than a reasonable estimate of the present value of future earnings under continued public ownership, discounted at the real government bond rate. That’s because of the ‘equity premium’ demanded by private investors to bear the systematic risk in returns. The equity premium is the difference between the average rate of return to equity (share capital) and the rate of interest on government bonds. Since equity is riskier than bonds, economic theory predicts that it should attract a higher return on average, so the existence of an equity premium is unsurprising. But the equity premium is much larger than it should be under standard assumptions about risk (in the economics literature, this is called the ‘equity premium puzzle’).
According to the efficient financial markets hypothesis this is a non-problem. If private capital markets are efficient, the private sector cost of capital and not the government bond rate is the appropriate rate for evaluating the returns to public assets and. Provided the private sector is at least as efficient in operational terms, the efficient financial markets hypothesis yields a general presumption of superiority for private ownership.
The global financial crisis has shown that private financial markets are far from efficient. It is reasonable to conclude that the public sector really does face a lower cost of capital, so privatisation has to be assessed on the case by case basis of whether private owners can make sufficient operational improvements to offset their higher cost of capital.
The failure of the case for comprehensive privatization does not imply acceptance of the opposite extreme position in favor of comprehensive public ownership, or that privatization is never justified. There are large areas of the economy, such as agriculture and retail trade, where public enterprises have rarely operated at a profit. No fiscal benefit can arise from public ownership of a loss-making enterprise. Relatively modest reductions in profitability arising from the constraints associated with public ownership are sufficient to offset the benefits of a lower cost of capital.
In particular, arguments about the cost of equity capital are irrelevant for small unincorporated businesses, where there is no reliance on outside shareholders to provide external equity. Such small businesses typically face a high cost of external capital, relying primarily on bank loans. However, the higher cost of capital for small businesses, relative to both government enterprises and large private corporations, is offset by the efficiency advantages of combining ownership and control.
The idea that we must choose between pure laissez-faire capitalism and comprehensive socialization is part of what might be called the Great Forgetting of the lessons of the mixed economy. The mixed economy was not, and is not, a simple compromise between incompatible extremes. Rather it has given rise to an effective, and productive interaction between the private and public sectors. The balance of that interaction will change over time, sometimes requiring privatization of public enterprises and sometimes extension of the public sector through nationalization or the creation of new government business enterprises.
The existing theory of natural monopoly and market failure provides an indication of the areas where public ownership is likely to prove beneficial, as does the observation that, across many different countries, the areas of the economy that have been allocated to the private and public sectors have been broadly similar. The boundaries have shifted from time to time, but, broadly speaking, public provision has been most common in capital-intensive natural monopoly industries, and in the provision of human services such as health and education.
The case for public ownership is strongest in where market failure problems are likely to be severe. In the case of infrastructure industries, several market failures are important. First, because of the equity premium and the associated problem of short-termism, private providers of infrastructure may not invest enough, or in a way that maximizes long-run benefits. Second, infrastructure facilities often generate positive externalities that are not reflected in the returns to the owners of those facilities. For example, good quality transport facilities will raise the value of land in the areas it serves. Finally, there are problems associated with the natural monopoly characteristics of many infrastructure services.
As regards human services such as health and education, there is a large gap between the reality of providing these services and the theoretical requirements for market optimality is so great that economists have struggled to apply economic analysis to these activities. Among a wide range of difficulties, the biggest problems relate to information, uncertainty and financing. The value of health and education services is derived, in large measure from the knowledge of the providers (doctors, nurses, teachers and others) and their skill in applying that knowledge to benefit patients and students. By contrast, the standard economic analysis of markets begins with the presumption that both parties are equally well informed about the nature of the good or service involved. The asymmetry of information is intimately linked to the fact that the benefits of health and education services are hard to predict in advance, or even to verify in retrospect. This in turn creates severe problems financing through market mechanisms such as health insurance and student loans. One way or another, substantial government involvement in the financing of health and education is unavoidable. Once governments are paying some or all of the bill, the most cost-effective solution is often direct public provision.
Conversely, the case for private provision is strongest where the efficient scale of operations is small enough to allow a number of firms to compete and where markets function well, rewarding firms that innovate to anticipate and meet consumer demand, and eliminating those that produce inefficiently or provide poor service. In particular, in sectors of the economy dominated by small and medium enterprises, where large corporations cannot compete successfully, it is unlikely that government business enterprises will do much better. My home state of Queensland provides historical support for this claim, having experimented, unsuccessfully, with state-owned butcher shops, hotels and cattle stations early in the 20th century.
There will always be a range of intermediate cases where no solution is obviously superior. Depending on historical contingencies or particular circumstances, different societies may choose between public provision (typically by a commercialized government business enterprise), private provision subject to regulation, or perhaps some intermediate between the two, such as a public-private partnership.
Unlike most of the ideas discussed, the failure of the ideology of privatization has already been reflected in ‘facts on the ground’. Most of the emergency nationalizations undertaken during the crisis will ultimately be reversed. But the idea that public ownership is always a policy option, and sometimes a necessary choice, cannot easily be banished from public debate. The mixed economy is back, and it’s here to stay.