Monday, June 25, 2012

Privatizing "essential functions" of government

In a recent NYT op-ed, Paul Krugman cites the example of the largely failed prisons privatization in the US, to caution against the privatization of the "essential functions of the government".

Certain essential functions like the provision of primary healthcare, school education, law and order maintenance, mass transit, and so on are indisputably better provided by governments. Other basic civic infrastructure services like water and sewerage, solid waste management, roads and bridges etc too are more efficiently serviced by governments. However, especially in developing countries, it may be desirable that some other services like provision of urban housing, railways, and all infrastructure services to rural interiors etc be delivered through governments.

In all these sectors, the concern is not so much with privatization per se as much as the absence of associated conditions which are a pre-requisite for the success of such private contracting. In all these cases, invariably the market is populated by one or two service providers, who hold virtual monopoly bargaining power over the government. If you call tenders for many of these services, you will be lucky to get more than two bids. Further, given the genuine risks associated with such contracts, the contractors rightly hedge for them. This in turn translates into higher prices and public expenditures. As I blogged earlier, most such outsourcing contracts, if contracted out properly, will involve much higher expenditures than when being run directly by the government.

Such markets invariably fail the Econ 101 test of "competitive markets". Neither is the supply-side strong enough to keep everyone honest, nor is the demand-side broad enough to support a market where cost recovery is possible without government subsidies. Exacerbating the problem is the lack of adequate capacity within the regulatory and administrative bureaucracies to effectively manage and monitor such contracts. In such conditions there are only two possibilities. One, private participants game the market rules and get away with poor quality service delivery, and most often with handsome profits. Two, government provides subsidy support or ends up internalizing some of the privately inflicted costs, thereby leading to accusations of crony capitalism.

All these risks are amplified in the case of developing economy markets. The supply-side is non-competitive and rent-seeking, demand side is uncertain and often inadequate, regulatory provisions incomplete and mostly difficult to enforce, political and social support unsure, and so on. The inherently long-term nature of many such service contracts and its control over scarce public resources/assets makes such contracts attractive acquisitions.  

In this context, of equal, if not greater, relevance is the corrosive results of such privatization. Krugman points to the "corrupt nexus of privatization and patronage that is undermining government" across countries. There is nothing surprising with such outcomes given all the aforementioned problems and attendant risks associated with such sectors. Atleast in the initial stages, without considerable government support, none of the credible and long-term private firms are likely to bid. This would leave the door open for fly-by-night operators who are more interested in asset stripping, knocking away public resources cheaply, and profiteering by cutting corners on quality, safety, and environmental standards.

Post-liberalization India, especially with the recent spate of corruption scandals, is a picture perfect illustration of this thesis.

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