BOOK REVIEW

The Grabbing Hand
by
Andrei Shleifer and Robert W. Vishny

FUTURECASTS online magazine
www.futurecasts.com
Vol. 3, No. 6, 6/1/01.

Homepage

The Politics of Good Governance

Governance:

  The importance of good governance - governance that facilitates profit driven market directed commerce - is once again an important part of a FUTURECASTS book review. "The Grabbing Hand: Government Pathologies and their Cures," by Andrei Shleifer and Robert W. Vishny, examines the role of governance factors in economic development and prosperity.
  &

Politicians do not maximize social welfare and instead pursue their own selfish objectives.

  This is another one of those academic books that sets forth conclusions drawn from previously written academic articles - in this case fairly recent articles written during the 1990s -  that comprise the bulk of the book. It criticizes both the "helping hand" and "invisible hand" models of economic policy, and argues that these should be replaced by a "grabbing hand" model that recognizes the centrality of politics and political considerations in government economic policy. The basic premise is: "Politicians do not maximize social welfare and instead pursue their own selfish objectives."
  &

  The "invisible hand" or "laissez-faire" model fails to deal with reality, the authors correctly point out. They complain that it ignores politics, and so fails to generate viable strategies for the adoption of successful economic policies.

  This, of course, is only part of the truth. There has, in fact, never been a real reliance on broad based laissez-faire economic policy in any of the advanced economic nations.  The broader role that government agencies must play in modern successful economic systems - such as the provision of functional legal and regulatory systems  and the construction and maintenance of infrastructure - is obvious and is recognized by the authors. However, they fail to point out that laissez-faire economic policy is a myth.
  &
  All advanced economic nations have always relied on a web of economic policies designed - albeit not always wisely or successfully - to facilitate commerce. Arguments based on the laissez-faire myth have never been anything more than propaganda slogans trotted out as convenient by all sides - both against particular government policies that are being opposed - or raised as straw men that can easily be knocked down in favor of particular government policies being advanced. 

  A "helping hand" model - recognizing the obvious instances of "market failure" and the need for government economic interventions - was set forth most notably by Richard A. Musgrave and Joseph E. Stiglitz. This model stresses such market failures as monopoly pricing, environmental and social "external costs" such as pollution and unemployment, failure of regional development, and defective credit supply to firms.
  &
  That is all well and good. Unfortunately, their policy prescriptions are the usual left wing nostrums. To cure such market failures, the "helping hand" advocates recommend use of corrective taxes and regulations, aggregate demand management, price controls, government ownership, and economic planning.  Their model supports arguments in favor of "industrial policy."
  &
  Unfortunately, as Shleiffer and Vishny accurately point out, such government economic policies are, in practice, used mainly to serve political goals and only occasionally coincide with social welfare. The actual effect of such policies is usually as burdens on social welfare.

  Here, the authors again provide only part of the truth, and thus in fact understate the case. Government policies adopted with the best of intentions to advance social welfare by manipulation of economic markets are invariably frustrated by the inherent inefficiency and frequent bumbling incompetence of government management processes. Even policies designed to facilitate economic markets frequently have trouble getting it right. At least in advanced nations like the United States, the frustration of stated government intentions are far more likely the result of mindless bumbling bureaucracy rather than the result of evil conspiracies or cabals.
  &
  Nevertheless, the authors are absolutely correct concerning the damage caused by perverse political incentives. The responses of Gov. Gray Davis to California's energy problems provide an excellent case in point.
  &
  Politically painful decisions - involving rate increases and long term contracting at somewhat higher rates - were put off in the hope that the looming crisis would not occur. As the crisis developed, effective policies were still rejected in favor of far less effective and far more expensive and panic driven policies that are designed to deflect political damage. There is a constant effort to direct blame onto others and deflect it from the Davis administration.
 &
  The result has been that a short term energy problem has been transformed into a longer term energy crisis. The rate increases and long term contracts now finally being implemented have become far more expensive than they would have been last fall - major utilities have been driven into or near bankruptcy - and California has expended its huge surplus, is tied to expensive long term contracts that are much longer than the 3 to 5 years needed to get by the crisis, and is incurring massive debts in further efforts to shield the Davis administration from political damage.

  By focusing squarely on politics as the determinant of government behavior, the authors' "grabbing hand" model asserts the primacy of political strategy in any debate about economic policy. It is a skeptical view - like the "invisible hand" model - "but describes more accurately what governments actually do and therefore focuses more constructively on the design of reforms." Reforms recommended by this "grabbing hand" model generally support methods of limiting predatory government economic interventions.

  "[The objective is to] design institutions that insulate economic agents from the political attempts to prey on them (something the helping hand model does not do) without assuming away the influence of government altogether (as is common in the invisible hand model)."

  The strong tendencies towards government abuse of economic policy - and the importance of devising political strategies to limit those abuses - are thus the primary emphasis of this book. It is designed to "examine the consequences for resource allocation of the choices of policies and institutions made by the political actors, and to consider the cures for the adverse consequences of excessive political power."

Political strategies:

  Political strategies designed to build coalitions in support of reforms that roll back state obstacles to commerce are emphasized. Tax cuts, disinflation, removal of obstacles to entrepreneurship, "depoliticization" of economic decisions affecting growth and productivity, and facilitation of financial markets are all desirable policies, but cannot be implemented without appropriate political strategies and broad supporting coalitions.
  &

  It is not enough to just advocate the privatization of publicly owned or directed economic entities, they stress. The political methods needed to support such policies - to facilitate their success and subsequently maintain those policies - must also be implemented. Thus, it is not enough to privatize troubled state owned or directed banks and free them from political interference. It is also vital to encourage widespread public ownership and offer cheap equity interests to employees to make further nationalization or political interference more difficult. Troubled loans incurred under political direction should be assumed by government to give the banks a chance to succeed.
  &
  Cookie cutter solutions for economic policy simply won't do. Each nation must be analyzed separately to determine such factors as ownership patterns, regulatory structures and legal mechanisms. These factors are each capable of bestowing benefits and/or burdens on an economy. The particular mix for each nation, and the reasons for that mix, must be understood in terms of the political objectives and powers of those who designed and operate the system.

Economic problems in Russia:

  Russia and its current economic policy problems provide an obvious and interesting case in point. The authors note a "chicken and egg" problem.
  &

The transition from a communist government to a government that supports a market economy - that is dedicated to facilitating commerce - is as essential as the transition from government to private ownership.

  Privatization was obviously not effective in the absence of institutions that protect property rights and provide a modern commercial law framework. However, without property owners and a business class to support them, it was politically impossible to establish institutions to protect property rights and facilitate commerce. Thus, it was decided to barge ahead with privatization anyway, in the hope that over time, support for property rights and the good governance needed to facilitate commerce would become sufficiently established to have a predominant impact.
  &
  That this effort has proved difficult - and has resulted in many obvious immediate policy failures - doesn't necessarily undermine the validity of the effort. The authors note that it may have been the only way forward. They express the hope that a growing private business sector will eventually provide effective pressure for needed political reforms.
  &
  The transition efforts from communism to capitalism in several nations are compared by the authors. The speed of economic reform is only one determinant of economic performance, the authors stress. The "transition of government" must also be considered. The transition from a communist government to a government that supports a market economy - that is dedicated to facilitating commerce - is as essential as the transition from government to private ownership.

  "The politicians controlling economic life are almost always interested in using business to achieve personal political and economic objectives."

  These include jobs for political supporters, services at subsidized prices for allies, resources directed not for economic efficiency but for the benefit of friends and allies, and regulatory powers used to create rents for allies and bribes for themselves. 

 Political transition policies must be designed to remove the levers of economic power - and the control of economic resources - from political control. They must be designed to create the legal and administrative structures needed to facilitate market commerce.
  &

Legal and police protection of private property rights - enforcement of contracts - methods of exposing and punishing political corruption - and the regulatory apparatus needed to facilitate market commerce (affecting such matters as antitrust enforcement, securities, banking, intellectual property, and open foreign trade) - have to be created and made reasonably effective.

 

The slowness of political transition retards economic growth.

  Replacement of government control with shareholder control in transition economies - especially under conditions of market pricing and budgetary and monetary stabilization - brought rapid improvements in economic efficiency - which were much faster for private firms than for those still government owned. However, good governance is also essential. Legal and police protection of private property rights - enforcement of contracts - methods of exposing and punishing political corruption - and the regulatory apparatus needed to facilitate market commerce (affecting such matters as antitrust enforcement, securities, banking, intellectual property, and open foreign trade) - have to be created and made reasonably effective.
  &
  In Russia, unfortunately, the institutions that facilitate market commerce are ineffective, and enormous control over economic life has been left in the hands of local politicians. Economic restructuring has been far greater in transition nations like Poland - where new managers and politicians have taken over -  than in Russia and similar transition nations where communist era managers and politicians remain.  The authors convincingly assert that it is this failure to radically replace the old communist politicians and institutions with newer market friendly politicians and institutions - and not any historical or cultural defects - that accounts for Russia's transition problems.

  "Despite similar economic reforms, government in Russia continues to retain substantial political control over economic life and, moreover, often uses this control to pursue predatory policies toward business. The political transition in Russia has not gone nearly as far as it has in Poland, and this slowness of political transition retards economic growth."

Robust local politics and local political budgets dependent on a local tax base are essential.

  Strategies for facilitating successful transitions are suggested. They include campaign support for noncommunist, market friendly politicians - making local government dependent on the local tax base rather than on handouts from above - and the expansion of private shareholdings. Indeed - perhaps their most interesting point - the authors stress the importance of robust local politics and local political budgets dependent on a local tax base.
  &

In both Poland and China, local politicians are dependent on their local tax base, and so have considerable incentive to facilitate local economic growth.

  In Russia, revenues flow down from Moscow to regional governors and then to local political entities, providing little incentive for local politicians to be concerned with growing the local tax base. In both Poland and China, local politicians are dependent on their local tax base, and so have considerable incentive to facilitate local economic growth.
  &
  In Russia, new businesses require multiple permits, inspections, and registrations that often can only be obtained by bribing local officials. Private racketeers also take a cut. Smothering taxes and regulations drive business "underground." There is a huge gray market, which increases the need to rely on criminals rather than on the police for protection of property rights. This also makes it difficult to discern the actual extent of economic progress.
  &
  In Poland, these factors are not a problem, and competition flourishes. Competition is far less vigorous in Russia. Both nations offer only problematic judicial recourse.

  "In both the economy and politics, the replacement of obsolete human capital may well be the central problem of transition."

  "Industrial policy" recommendations are correctly ridiculed by the authors. "Russia needs a state focused on a different set of functions, rather than a bigger state doing more of what it already does so badly." They recommend:

  • Local elections that are reasonably free and fair - to increase public accountability of local politicians and make local politicians more dependent on support from local business;

  • Tax reform on federalist grounds - to make each level of government dependent on resources from its own economic base for tax resources - rather than on handouts from above;

  • Development of legal and administrative agencies needed to facilitate modern market commerce - to deal with antitrust problems, regulate securities markets and banking, encourage development of intellectual property, and open the nation's markets to foreign trade.

Political Factors Influencing Economic Development

Corruption:

 

Deregulation to eliminate opportunities for corruption is the fastest and most effective means to eliminate it.

  Corruption is a major obstacle to economic development. Trying to find and provide incentives for honest bureaucrats is difficult and slow. But deregulation to eliminate opportunities for corruption is much faster and more effective. "Deregulation and liberalization are far more important for fighting corruption than the improvement of incentives and personnel selection inside the bureaucracy." Where regulation is essential or unavoidable, it should be designed to give individual bureaucrats as little discretion as possible.

  Adequate pay for civil servants - stressed by Michael Backman in "Asian Eclipse," reviewed in the April, 2001 FUTURECASTS issue - is also an obviously vital factor in fighting corruption.

Nations with higher levels of corruption have significantly lower rates of investment as a percentage of GDP. Change is unwelcome, since it may force changes in established corrupt arrangements.

 

 

 

 

 

 

  Corruption breeds on itself. Where government offices are for sale, they are worth the most to the most corrupt agents. Where bribery can cut the time and cost of government regulation, the corrupt competitor has an advantage over the honest competitor.
  &
  Thus, the authors point out, "cost cutting" corruption destroys honest competition, and reduces the likelihood of discovery since all parties to the corrupt transaction benefit from it. Making sure that taxes, fees and customs are collected and regulations observed should be effective in reducing corruption since payers get no advantages, and are thus more likely to complain about bribe seekers. (However, as the authors elsewhere note, time is also a valuable commodity that is frequently exchanged for bribes.)
  &
  These authors, too - like Michael Backman in "Asian Eclipse," reviewed in the April, 2001 FUTURECASTS - conclude that pervasive petty corruption is more obstructive than high level single payment corruption. To keep down pervasive petty corruption, there should be multiple sources of government permits so that applicants are not dependent on individual officials. Multiparty elections create competition for public office that also tends to reduce corruption. Multiparty elections also tend to restrain tax and fee levels.
  &
  Despotisms that are in secure control will limit pervasive petty corruption, and thus permit economic growth and increasing opportunities for insider corruption. However, anarchic situations smother economic activity with pervasive petty corruption and rent seeking and thus ultimately reduce the total rewards for corruption.

  "In India, taking a road between two towns indeed requires paying a bribe in every village through which the road passes. Taking goods inland in Zaire is more expensive because of corruption than bringing them from Europe by ship to a port. In 1400 there were sixty independently run tolls along the Rhine. Along the Seine there were so many tolls that to ship a good twenty miles cost as much as its price. In contrast, rivers in England were free of such tolls." 

- - - 

  "Russia under Communism had a monolithic bribe collection system. With the Communists gone, central government officials, local officials, ministry officials, and many others were taking bribes, leading to much higher bribes in equilibrium though perhaps lower corruption revenues, just as the model predicts. Similar stories are told about Africa after independence, when the colonial corruption machines disintegrated [cite omitted]. The evidence is strikingly consistent in showing the superiority of monopolistic bribe taking over that by independent monopolists."

  In this way, too, multiparty elections provide benefits. The authors point out that they substantially limit corruption. Also, the federalist nature of government in the United States creates competition between states, thus limiting the levels of taxation, fees, regulation, and corruption likely to be imposed at the state and local level.
  &
  It is thus unremarkable that nations with higher levels of corruption have significantly lower rates of investment as a percentage of GDP. Change is unwelcome, since it may force changes in established corrupt arrangements.

  "To invest in a Russian company, a foreigner had to bribe every agency involved in foreign investment, including the foreign investment office, the relevant industrial ministry, the finance ministry, the executive branch of the local government, the legislative branch, the central bank, the state property bureau, and so on. The obvious result was that foreigners did not invest in Russia. Such competing bureaucracies, each of which can stop a project from proceeding, hamper investment and growth around the world, but especially in countries with weak governments."

Foreign aid:

  Foreign aid is recognized by the authors as playing an effective political role even when it is an economic waste (as it usually is). The economic impact of foreign aid is minor while the political impact may be very substantial. Aid to Boris Yeltsin is justified on this basis. The authors advocate using aid to support economic and political reformers.
  &

Rule of law:

  Property rights and rule based legal systems are essential ingredients in any program for economic development. Government institutions must provide protection against breaches by private parties and by government agencies as well.

Absolute despotism:

  Despotic government generally undermines economic development. The authors provide some interesting historic analysis of the connection between economic prosperity and the avoidance of absolute despotisms.
  &

Despots actually had little incentive to take the long view with respect to the development of their states. They needed immediate resources to fend off threats from without and within.

  They cite the experience of Southern Italy, which was more prosperous than Northern Italy until it was taken over by the d'Hautevilles in the eleventh century. By 1500, that relationship was reversed as the city states of Northern Italy successfully resisted conquest by a centralizing power. Similar results occurred when the southern Low Countries (Belgium) were conquered by the Hapsburgs, while the northern Low Countries (Holland) successfully revolted in the 16th century.
  &
  The authors present historic statistical evidence showing that absolutist governments were associated with low growth, as measured by growth of commercial cities, during the eight hundred years prior to the industrial revolution. They explain that despots actually had little incentive to take the long view with respect to the development of their states. They needed immediate resources to fend off threats from without and within. The odds of peaceful succession to heirs for more than a generation or two were considerably less than 50% in many nations. While successful princes were able to form the cores of modern nation states, they were no blessing to subject peoples.

    The impact on economic prosperity of absolute political power that can impose confiscatory taxes and indulge in arbitrary takings is rightly emphasized. The authors compare results under absolutist princes and non absolutist princes. However, they neglect another threat to civil, property and commercial rights that has recently gained prominence - the political inability to provide protection from theft and/or conflict. Anarchic situations are obviously worse even that absolute despotism - and indeed often provide the pretext for the establishment of absolute despotism.
  &
  Indeed, the ability of powerful centralizing princes to create sufficient military force to fend off invasions from Asia was - despite their periodic European conflicts - undoubtedly essential for the economic development of the new nation states and for the lesser European political entities as well.

Rent seeking:

 The pervasive extent of "rent seeking" and corrupt government offices has become an obvious problem in many nations currently striving to establish market economic systems. "Rent seeking" is defined by the authors as "any redistributive activity that takes up resources." Bribes, taxes, fees, regulatory expenses, and similar costs cut growth, attract talent from productive activities, and absorb labor.
  &

Heavily regulated systems increase the opportunities for bribery and the rewards for rent seeking.

 

Tax reduction frees labor and capital resources for productive work.

   Talent is attracted into rent seeking positions instead of into entrepreneurial and other productive activities by heavily regulated and corrupt economic systems. Heavily regulated systems increase the opportunities for bribery and the rewards for rent seeking.

  "Although few activities are purely rent seeking or purely efficiency improving, the general point remains: talent goes into activities with the highest private returns, which need not have the highest social returns."

  High levels of taxation slow economic growth. "[C]ountries with smaller government consumption relative to GDP grow faster." Tax reduction frees labor and capital resources for productive work.
  &
  The authors conclude:

  • The more extensive rent seeking becomes, the greater the returns for rent seeking. The existence of rent seekers forces people to adopt defenses against them - frequently involving the use of other rent seekers. A lawyer must be employed to defend against law suits, a gangster may have to be employed to protect against gangsters, and an army must be raised to defend against threatening armies.

  • When rent seeking begins to reduce the returns to productive activities sufficiently to reduce rent seeking returns themselves, the latter fall less than the former, increasing the relative attractiveness of rent seeking over productive activities.

  The analysis of the obvious occupies many pages, but the analytical efforts remain nevertheless far from convincing. Like almost all economists, the authors feel professionally obligated to provide econometric analyses - even in instances where mathematical forms of reasoning are not appropriate. Mathematical logic can give a false sense of numerical precision and can mask a shallowness that omits outcome determinative factors and crosses the line into invalidity.

  The authors analytical methods imply that there are only two stable possibilities -- one where there is no rent seeking, and productive returns are optimized - and the other where rent seeking drives down all productive activity to subsistence levels. Anything in between is unstable, because there remain positive returns for increases in rent seeking that invite further rent seeking until productive activities are reduced to subsistence levels. "This may explain why countries find it so costly to switch out of rent-seeking equilibria and often need major government or institutional reform to do so."
  &

A society whose institutions allow talented people to reap the rewards of entrepreneurship and innovation is likely to prosper, but a society whose talent flows to rent seeking rather than entrepreneurship reduces the level of income, but its more damaging effect is to lower the rate of innovation, technological progress, and growth.

 

Heavy rent seeking burdens increase the risks and decrease the rewards of enterprise.

  A legal system that protects property rights is recognized as a way out of this problem. Nevertheless, in their efforts to provide an econometric analysis of the problem, the authors use the numbers of engineering students and lawyers as proxies for determinants of entrepreneurial or rent seeking influences. They correlate large numbers of engineering students with an entrepreneurial environment, and large numbers of lawyers with a rent-seeking environment, in analyzing representative nations during the period from 1970 to 1985. 

  These proxies have obvious weaknesses. Writing in the early 1990s - when the U. S. was producing many lawyers, few engineers, and experiencing (for other reasons) two decades of slow growth - they concluded that the U. S. no longer provides a favorable environment for entrepreneurs, and is doomed to continued slow growth.
  &
  Here we have a prime example of the shallowness of much econometric analysis and why it has such a wretched record at economic forecasting. Everything has to be simplified to the point where it can be expressed as an equation and provided with numerical measurements. Outcome determinative elements and meaningful subtleties are necessarily omitted.
  &
  All government is evaluated as a fungible mass of rent seeking activities of equivalent wastefulness in all nations. Transportation infrastructure projects are grouped with the cost of the prince's polo ponies. The costs of independent judiciaries are evaluated the same way as the costs of politicized judiciaries.
  &
  How do you get engineers without education? How do you get enforceable property rights without lawyers and an independent judiciary? How can you so crudely distinguish between public and private education or public and private policing?
  &
  The authors recognize the existence of complicating factors. Nevertheless, they rely heavily on the lawyer/engineering student ratio as an admittedly rough measure, but "the best measures of rent seeking and entrepreneurship we could find." The weaknesses of this line of analysis are broad and obvious. The statistical problems and complicating factors easily overwhelm the proxies relied upon - even when adding additional factors such as revolutions and coups, general education levels, and government consumption.
  &
  Relying on this obviously flawed econometric effort, it is not surprising that the authors assume that communist Russia was in a state of good equilibrium prior to its collapse. That the Soviet Union's economic failures and economic decline had been continuous for decades before its collapse is obvious despite its production of many engineers and few lawyers during that period.

  Nevertheless, the authors' general conclusion is obviously correct.

  "[T]he allocation of talent is a potentially important channel through which the institutions of a society influence its economic performance. A society whose institutions allow talented people to reap the rewards of entrepreneurship and innovation is likely to prosper, but a society whose talent flows to rent seeking rather than entrepreneurship reduces the level of income, but its more damaging effect is to lower the rate of innovation, technological progress, and growth."

  Innovation is particularly vulnerable to government rent seeking, since new businesses have few resources with which to clear the many regulatory hurdles that governments can impose. Established businesses that have loyally supported incumbent political leaders are often aided by governments against upstart competition. Heavy rent seeking burdens increase the risks and decrease the rewards of enterprise.

Socialist Myth and Reality

Autocratic socialism:

 The portrayal of benevolent socialist central planners grappling with the complexities of production and distribution is challenged by the book. Instead, it assumes that socialist planners - like capitalists - are self interested.
  &

Efficient resource allocation thus is impossible under socialism rather than merely difficult, since it is not in the self interest of the socialist planners - who benefit from shortages and price distortions. Monopolistic output restrictions are thus far more likely under socialism than under capitalism.

  Efficient resource allocation thus becomes impossible under socialism rather than merely difficult, since it is not in the self interest of the socialist planners - who benefit from shortages and price distortions. Monopolistic output restrictions are thus far more likely under socialism than under capitalism.

  "Even without computational complexities, socialism with self-interested planners will not result in efficient resource allocation."

  Also, free market prices do not work without property rights. Without the right of the producers to keep the profits of commerce, market prices will not cure shortages.

  "Successful price reform, like most other reforms, boils down to allocating property rights to producers and therefore ultimately depends on privatization of profits."

  The elimination of shortages is thus practically impossible for socialist systems. This applies to both necessities and discretionary goods.

  "[Socialist] bureaucrats intentionally plan shortages in order to invite bribes from rationed customers. If a market cleared, firms in an industry could earn profits, but most of these profits would accrue to the state treasury, not to the managers or the ministries. The key feature of socialism is that the decision makers who determine the prices and output of firms do not, to a first approximation, keep any of these profits. In contrast, when there is a shortage of a good, potential customers try to obtain it by offering bribes and favors to the bureaucrats in the ministry (and to the managers of firms). - - - To collect bribes, socialist industries will always try to produce a level of output entailing a shortage at official prices."
  &
  (However, planned quotas must be fulfilled. This is often achieved by producing a vast oversupply of shoddy goods that nobody wants.)

  The authors offer analytical models that demonstrate that a socialist industry's objective is to maximize the value of bribes. This is, unfortunately, frequently true. However, here, too, their analysis is far from convincing.

  In a multiparty democracy, dissatisfied consumers are also dissatisfied voters. Only economic decline threatens incumbency.
  &
  Socialist economic segments (public utilities) in a multiparty democracy are indubitably inefficient and rigid, but are far from universally corrupt. Nor do they have a predominant interest in maintaining shortages. Nevertheless, as the authors point out, in such nations as Brazil and France, a bribe can materially speed up the installation of phone lines. In the United States, the adequacy of energy supplies has in recent decades taken a back seat to other political considerations - with predictable results that are now coming to pass.

The alternative to profit driven capitalism is bribery driven socialism.

  Nevertheless, here, too, the authors' assertions are persuasive. For the vast majority of socialist states and socialist industries in single party or autocratic states, their conclusion is obviously true.

  "Shortage is thus not just the coincident consequence of the difficulty of socialist calculation, it is the most generic consequence of the true objective of people who run socialist industries."

  Socialist industries not only have the widely recognized problem of weak incentives to produce, they also suffer from powerful incentives to cut both output and price to create shortages and maximize corrupt rent seeking opportunities (bribes). The alternative to profit driven capitalism is bribery driven socialism.
  &
  Thus, there can never be enough funds to fulfill the promises of government programs. Even with access to infinite inputs, socialist industry would still produce output shortfalls.

  Here, we have an analytical explanation for the cynical assertion that - if a socialist state in the Saharan Desert wanted to build a beach on its Mediterranean shore - it would have to import the sand.

  The socialist price increases in the Soviet Union in April, 1991, actually caused a reduction in supplies, the authors point out, since the price increases cut bribery opportunities and corrupt incentives to produce and distribute goods. However, the freeing of prices in January, 1992, that resulted in much larger price increases than in April, 1991, instantly resulted in store shelves filled with goods and the elimination of queues. The difference was that, in January, 1992, employees, managers and suppliers were permitted to keep substantial shares of their profits. "The goods shifted from sale through the back door to sale through the front door."
  &
  In large capitalist firms, the authors note, the issue of who keeps the "profits" also arises, and explains tendencies towards corruption in agents and lower and middle management.

The benevolent dictator fallacy:

 Benevolent dictator assumptions are contradicted by both real world experience and strong contrary incentives. Even secure monarchs do not maximize the efficiency of their total estate, the authors point out. They are more interested in maximizing the efficiency of their own revenues.
  &

  This explains tendencies towards mercantilism and the establishment of monopolies. Where secrecy becomes important for a dictator and a ruling elite, the collection of revenue from bribery requires shortages.
  &
  Most dictators, however, are insecure. Resources for armies and police take precedence. Firms are organized to maximize control (like franchised monopolies or the communist collective farms). Management positions are held by supporters rather than by experts, prices are set to transfer resources to supporters, and opponents and suspected opponents are suppressed.

Market socialism under multiparty democracy:

  Unfortunately, the prospects are little better under democratic socialism. Even if democracy is possible when government controls all economic power - and even in addition to the obvious implementation problems of socialist management - the real objectives of government undermine the possibilities for market socialism under democratic governments.|
  &

  The problems of public enterprises in Western Europe are cited.

  "Despite extensive mechanisms for independent governance, most public firms in Western Europe are subject to heavy handed government interference."

  Featherbedding and political favors are widespread. Neither majority rule nor pressure group influence are conducive to economic efficiency. There are frequent instances of majority tyranny over minority interests. However, small interest groups with intense interests frequently triumph over very large interests with diffuse interests.
  &
  The authors concede that democratic governments frequently force inefficient outcomes on capitalist entities, too. Taxation and regulation give the government power over private economic entities, but not as much as when government owns those entities. Socialist governments "can afford to pay for much more inefficiency."

  Somehow, the authors neglect the obvious response of capital flight. If capitalist governments impose too many obstacles to profitability, assets will be milked rather than maintained, capital will flee from the inefficient sectors, and new development in those sectors will cease. The inevitable deterioration of the stock of apartments under rent controls provide many examples.

  The authors conclude:

  "Under both capitalism and socialism, the democratic process does not generate governmental objectives consistent with the pursuit of efficiency. But under socialism, the government turns these inefficient objectives into much more damage to the economy than does a capitalist government. The theoretical case for economic efficiency under democratic socialism simply does not hang together."

Strategies for Privatization

Inherent inefficiency of government management:

 Rationally implemented privatization invariably results in massive improvement in economic efficiency. The theory that publicly owned enterprises can more accurately reflect social marginal costs, maximize social welfare, and reflect externalities, simply never shows up in practice.
  &

  The reality is that publicly owned enterprises are highly inefficient due to a variety of political pressures. Nor do government enterprises cure externalities. They are often the worst polluters, and favor political supporters rather than the most needy.
  &
  Inefficient practices include featherbedding, inefficient location of facilities, credit allocations, inefficient allocation of subcontracts, directed trade patterns, and pricing below marginal costs (railroads in Europe, agricultural goods in Africa) to benefit political supporters. (This, of course, is just a minor part of the deplorable picture of inherent inefficiency in government management practices.)
  &
  The authors analyze featherbedding proclivities to illustrate the impact of political imperatives on economic efficiency.

  Featherbedding is cited as the most common inefficiency of public employment. It is far more obvious - and politically costly - for politicians to subsidize private firms as a means of maintaining employment than it is simply to forego the profits from public firms. 

  "[P]olitical benefits per dollar of extra spending on labor exceed political costs per dollar forgone by the treasury from such spending."
  &
  However, protectionist tariffs and government price fixing are common - protecting sugar plantations, inefficient steel plants, and the dairy industry in the United States, for example - and agricultural subsidies are widespread.

  Numerous examples of government owned enterprises with operating costs about 50% higher than similar private firms - and some that produce practically nothing yet exist to keep people on the payroll - are provided.
  &
  In the United States, privatization involves mainly the contracting out of local public services. Savings routinely equal more than 33%. Government agencies providing municipal services in the United States typically employ 20% to 30% more people for a given output level than do private contractors, and pay 10% to 20% higher wages and higher benefits than do private contractors. Nevertheless, despite substantial levels of privatization, census figures indicate that the provision of services by local governments is still rapidly increasing.

Privatization decisions:

  The factors that seem to influence the probability of in house or contracting out decisions are analyzed. After much effort - and admittedly dubious results - they unremarkably conclude that "politicians give up their patronage benefits when they become too expensive." Politicians do not willingly surrender their reigns of power. Factors of ideology and efficiency also have some impact, but are apparently less significant.
  &

  Of course, many opportunities for political misdirection of cash flows remain even among private firms, the authors recognize. Regulation, subsidies, and tax breaks are widely used for such purposes. They offer an analysis of "how reallocation of cash flow and control rights [privatization] change outcomes."
  &
  With privatization, even government protectionist, price fixing, credit allocation, and similar political interference still leave private managers with powerful incentives for efficient management. There are natural restraints to the level of such mercantilist or industrial policy activities, since they invariably result in politically unpopular levels of taxation and/or inflation. "By making the politician internalize the cost of the inefficiency borne by the manager and shareholder," privatization encourages restructuring for more efficient operations.
  &
  The authors conclude, among other things, that:

  • Privatization "without commercialization" - by means of continued heavy regulation that directs firm policy - may make matters worse. Such industrial policy can reduce the "costs" to politicians of their use of control for political ends.
  • Effective limits on corruption increase the effectiveness of privatization.
  • However, corruption may actually increase efficiency by permitting managers to "buy their way out of" political constraints.
  • A profit driven firm with substantial outsider ownership increases pressure for restructuring for efficient operations.
  • Substantial numbers of outsider investors also increase the difficulty of political interference.
  • Substantial levels of worker ownership or control structures can undermine incentives for efficient operation.
  • Such techniques as government holding companies with substantial investments in private companies increase political influence (as do credit allocation policies).
  • Inflationary monetary expansion can undermine incentives for efficient operation. A monetary policy dedicated to maintaining the value of the currency prevents widespread subsidization of inefficient industries (and even penalizes widespread protectionist practices) by limiting resort to the printing presses to meet expenses. It is important that government should have to rely on economic prosperity for the tax revenues needed for its activities.
  • Effective privatization is more likely in nations with an independent civil service and/or other protections from aggressive political control over state firms.
  • Privatization must be profit driven and market directed to succeed. Unprofitable entities remain beholden to politicians for the subsidies that support them and thus must do political bidding.

Please return to our Homepage and e-mail your name and comments.
Copyright 2001 Daniel Blatt