XI. Public and Private Enterprises: Finding the Right Mix

During the 20th century the economic importance of the state grew all over the world. In developed countries central government spending accounted for less than 10 percent of gross domestic product (GDP) in the early 1900s, but by the 1990s that share had grown to nearly 50 percent in many of those countries (see Figure 11.1, Data Table 4). Historians point out that the Great Depression of the 1930s and economic competition with socialist countries contributed to this government expansion. But the data suggest that this expansion probably continues. Over the past 35 years the share of government spending in the GDP of developed countries roughly doubled.

In developing countries the economic role of government grew dramatically in the second half of the 20th century, after the end of colonialism and in pursuit of such development goals as industrialization and social equity. In many of these countries the state was striving to mobilize resources and direct them toward accelerated economic growth, rather than just to stabilize the economy, as in most developed countries. Until the 1980s the pattern of state-dominated development—which included centralized planning and state control of the economy—was widely followed. Still, the share of government spending in the GDP of developing countries is less than half that in developed countries (see Figure 11.1, Data Table 4). Does this mean that a growing share of government spending in GDP should be seen as a sign of development?

The Dilemma of Public-Private Ownership

Government budgets in developing countries are not only proportionately smaller, but they are also structured differently. In developed countries more than half of government spending is devoted to social services, including pensions, unemployment insurance, social security, and other transfer payments. In developing countries much less government spending goes for social services and much more is used to subsidize commercial (that is, selling goods and services) state-owned enterprises. Unlike other state-owned enterprises that provide free public services (for example, schools and health clinics), these state-owned enterprises could also be run for profit by private firms. Governments, however, sometimes prefer to keep them under their direct control. The share of commercial state enterprises in GDP and in gross domestic investment tends to be higher in poorer countries (see Figure 11.2).

Is a high share of state enterprises a problem? Is it good or bad for the economic growth and development of developing countries?

Those who want to preserve extensive state enterprises argue that:

• Only government is capable of providing sufficient investment for technical modernization of major national industries.
• Only direct government control over certain enterprises can prevent socially unacceptable high prices for basic goods and services such as energy, housing, and transportation.
• Only government ownership of the biggest enterprises can help avoid mass unemployment.

On the other hand, proponents of privatization point out that the experience of many countries demonstrates that , state enterprises are usually less efficient than private firms as measured by their profitability. One of the main reasons is that state enterprise managers have little or no incentive to pursue profitability for their enterprises. Easy access to government subsidies and government-guaranteed loans effectively remove the threat of bankruptcy. Besides, it is often hard to run state enterprises at a profit because governments tend to keep state enterprises’ selling prices artificially low, and because rules often do not allow these enterprises to lay off excess employees. In countries where the share of state enterprises is high, their typically low efficiency can hinder economic growth. In addition, governments have to cover the financial losses of these unprofitable enterprises. To meet the resulting budget deficits, governments often have to either print more money and thus cause inflation, or borrow and build up their domestic or foreign debt. In both cases national economies are destabilized and growth opportunities are lost.

Note that this argumentation focuses on profitability as the main indicator of economic efficiency. Indeed, an enterprise’s profitability summarizes all the indicators of economic efficiency as seen from the viewpoint of its private owners. But from the point of view of national economic growth and development, social costs and benefits, which are not reflected in profitability, can be no less important. For example, when a privatized enterprise achieves profitability by dismissing its excess workers, the economy as a whole does not necessarily become more efficient. If economic conditions prevent the fired workers from finding other employment or starting their own business, this downsizing might lead to an overall economic loss for the country because people were moved from low-productivity jobs to zero-productivity unemployment. Additional social costs might include increased child labor/lower educational achievement, a heavier load on the government budget for providing social services, higher crime, and greater social and political instability (see Figure 6.4).

Given all that, when is it preferable to keep enterprises under government ownership? What is the ideal size and composition of a country’s public sector? And can there be any general answers to these questions independent of ideological beliefs?

In fact, it is increasingly recognized that, generally speaking, state intervention in economic activities is justified only where the market system (based on private ownership) fails. But market systems are not the same in different countries. In particular, in developing countries markets are underdeveloped and in some sectors even nonexistent. For example, there are often no private enterprises interested in purchasing agricultural produce from small farmers and marketing it domestically or internationally. So governments have to fill this gap by creating state-owned marketing boards, engaged in business activities which, in more developed countries, are carried out by private firms.

Furthermore, even in well-established market economies there are five basic situations, called market failures, where the private sector tends to underproduce or overproduce certain goods and services:

• underproduction of public goods such as defense, law and order, roads, and environmental protection;
• underproduction of goods and services with positive externalities (for example, public health and education) and overproduction of goods and services with negative externalities (for example, cigarettes - see Chapter 8);
• overpricing and underproduction by natural monopolies, for example by electric and water utilities;
• insufficient supply of social services such as pensions or medical and unemployment insurance;
• insufficient information available to some parties affected by market processes (for example, information about the quality of food products and medicines available to consumers whose health is at risk).

These five situations call for some kind of government intervention. But even where markets clearly fail, government provision of undersupplied goods and services is not necessarily the best option. We have already discussed the reasons for the typically low profitability of state enterprise management. Add to that the possibility of corruption among government bureaucrats (see Chapter 16) and you get what came to be called "government failure." Increased awareness of this problem is among the reasons explaining why some governments of developed countries are searching for alternatives to state ownership, such as new models of public-private partnership, based on privatization plus close government regulation or government funding for private provision of public goods. An extraordinary example of such an alternative solution to both market and government failures is provided by the new phenomenon of public funding for private prisons in the United States.¹ But particularly important for sustainable development of most countries is the ongoing debate about the optimal public-private interaction in providing water and sanitation services.

As of 2000, about 2 of every 10 people in developing countries were without access to safe water; 5 of 10 lived without adequate sanitation; and 9 of 10 lived without their waste-water being treated in any way. As a result water-related diseases rank among the top reasons for child mortality (see Chapter 8) and adult illness. Moreover, in Africa and Asia--where the world’s poor are concentrated--the overall trends in the 1990s showed little or no progress. The main argument in favor of private companies’ involvement is that it will help mobilize the additional investment needed for bringing water and sanitation services to a greater number of people. On the other hand, experience shows that privatization often leads to increased tariffs unaffordable to poor households and sometimes to outright exclusion of poor rural areas viewed as unprofitable by private providers. Only pro-poor government regulation, including subsidies for the poor and special economic incentives for private companies to work for the poor, can neutralize these drawbacks of private service delivery. Overall, the experience of various countries appears to present a mixed picture of success and failure both in mostly public and in mostly private service delivery, and the conclusion may be that no single solution fits all countries. However, there is general agreement that the final responsibility for providing such vital services as water and sanitation (as well as basic health and education services) lies with governments.

Is There a Trend toward Privatization?

By privatizing all the enterprises that can be successfully run by private firms, governments can often make national economies more efficient, on the one hand, and free their budgets from the burden of subsidizing loss-making enterprises, on the other. As a result they are able to focus on tasks that cannot be handed over to markets, such as building human capital and providing for human development (see Chapter 1) or developing and implementing national development strategies (see Chapter 17). For example, according to some estimates, shifting budget funds from state enterprise subsidies to public health care would have allowed central governments to increase their health spending by about four times in Mexico and five times in India. Alternatively, Mexico’s central government could have increased its education spending by 50 percent, and India’s by 550 percent.

But if governments are to shift away from supplying marketable goods and services, there must be active private sectors that are ready to take up their activities. In some cases reducing the economic prominence of state enterprises is even possible without extensive privatization, mainly by means of market liberalization that leads to accelerated growth of the private sector. That was the case in the Republic of Korea in the 1970s and 1980s, and in China in the 1980s and 1990s. But more often, particularly where public sectors are much larger than private sectors and so absorb a lot of scarce national resources, special privatization programs are needed.

Since the 1980s many developing and some developed countries have adopted privatization programs. You can attempt to judge their scale by examining data on government proceeds from privatization in Data Table 4. Note that this indicator depends not only on the scale of privatization but also on its methods. Selling state enterprises to outside owners normally brings more revenue than selling them to enterprise managers and employees, while voucher privatization (such as in Russia in 1991–93) brings no revenue at all. The most impressive privatization took place in former socialist countries over the 1990s. Their transition to market-oriented economies required unprecedented mass privatization of formerly dominant state enterprises. For the different starting points and speeds of privatization in this group of countries, see Figure 11.3. Among other regions of the developing world, privatization programs were implemented in Latin America and Southeast Asia, while in Sub-Saharan Africa the process was less pronounced.

Unfortunately, in some transition countries radical market reforms have resulted in neglect of the state’s vital functions, such as law and order or critical social services. Important programs in education and health, for instance, have been cut along with or even instead of cutting subsidies to money-losing enterprises. Such policies have not only damaged people’s welfare, they have also eroded the foundations of these countries’ further national development. Another case of the government’s questionable priorities involved an African country, where local authorities attempted to improve the economic efficiency of their water services by cutting water supplies to a settlement whose residents were unable to afford increased user fees. Shortly after that a cholera epidemic broke out in that province and nearly 14,000 people became infected.

Many experts argue that, although state-dominated development has failed, so would "stateless" development. Think about it: why are an effective state and a viable private sector both important for development?