New Economist

The mixed joys of privatisation

As a rule, I've supported the privatisation of state-owned enterrpises - particularly underperforming ones. In many cases it has lead to more efficient provision and better financial performance than under state ownership. But there are key exceptions. The experience with privatised natural monopolies has been decidedly mixed. The key element of market competition is missing and so one has to rely on a government regulator to keep such firms honest. In Britain, for example, the performance of privatised water companies has been a disappointment, with large price hikes, growing pollution and wastage.

A more glaring concern is the growing use of private firms to finance and operate public works, such as highways or hospitals. In many cases this is done under the so-called Build, Operate and Transfer approach or some variant of it. Such a system has three major problems. First, there is an obvious moral hazard around quality. Private firms have an incentive for their work to last until it is transferred to the state - but not a day longer. That can result in cost savings through inferior materials and workmanship leading to higher maintenance costs. This poses a medium-term budget risk to governments.

Second, in most cases if the venture fails, the taxpayer ends up bailing it out. Just as central bankers are lenders of the last resort, so too governments have often had to come to the rescue. As blogger and economics professor John Quiggin has noted:

..these episodes underline the point that, for essential services, government is the provider of last resort. It can sell the assets, and forgo the associated earnings, but it can’t divest itself of the obligation to step in (and pay up) when something goes badly wrong.

A popular alternative has been for governments to agree to vary the terms of the contract to allow firms to impose higher rentals or charges - for example, for a tollway that is losing money. Of course, either outcome undermines the claim that private firms reduce public risk or deliver more efficient services.

The third, and most fundamental, problem with privately financed public works are that they invariably cost more. Not only do firms have to ensure they make a profit, but they also face a higher cost of capital. This is a point that John Quiggin has been making for many years. Meanwhile, Kelvin Hopkins writes in today's Guardian that the cost of privatisation will haunt us for years to come. He makes the point well:

The illogic of private investment being given incentives to replace public investment is compounded by the fact that the cost of government borrowing is much cheaper than servicing private capital investment. The money markets are generally enthusiastic about lending to government because such lending is secure, which is why the interest charged is low. By contrast, private-sector investment always requires a risk premium and profit-taking.

Government's natural advantage is in raising money cheaply. The private sector's is in running organisations efficiently. Public-private ventures should capitalise on these core strengths, with the government raising the money - perhaps via bonds, as Ken Livingstone has suggested - and the private sector partner running the operation. This makes economic and fiscal sense - but has the key failing of not taking government capital spending 'off the books'.

India's college problem

Today's New York Times discusses the poor quality of much of India's higher education system: A College Education Without Job Prospects

The job market for Indian college graduates is split sharply in two. With a robust handshake, a placeless accent and a confident walk, you can get a $300-a-month job with Citibank or Microsoft. With a limp handshake and a thick accent, you might peddle credit cards door to door for $2 a day.

India was once divided chiefly by caste. Today, new criteria are creating a different divide: skills. Those with marketable skills are sought by a new economy of call centers and software houses; those without are ensnared in old, drudgelike jobs.

Unlike birthright, which determines caste, the skills in question are teachable: the ability to communicate crisply in clear English, to work with teams and deliver presentations, to use search engines like Google, to tear apart theories rather than memorize them.

But the chance to learn such skills is still a prerogative reserved, for the most part, for the modern equivalent of India’s upper castes — the few thousand students who graduate each year from academies like the Indian Institutes of Management and the Indian Institutes of Technology. Their alumni, mostly engineers, walk the hallways of Wall Street and Silicon Valley and are stewards for some of the largest companies.

In the shadow of those marquee institutions, most of the 11 million students in India’s 18,000 colleges and universities receive starkly inferior training, heavy on obedience and light on useful job skills.

Friedman, Keynes or Hayek?

Milton Friedman was a highly original economic thinker. But Paul Ormerod argues on the Prospect magazine website that even in the one area he was proved correct, his work is likely to be outshone by that of another great economist: The fading of Friedman

..Friedman, Keynes and Hayek all identify the problem. It is in their prescriptions of what should be done that they part company. Here, Keynes and Friedman are bedfellows. Both believed that suitably empowered clever chaps could work out rules of behaviour that would smooth the fluctuations of the business cycle. Friedman came up with the rule of an independent central bank controlling the expansion of money at a fixed rate.

Keynes essentially thought that if he and other old Etonians were put in charge, everything would be fine. At the end of the General Theory, he writes, “I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands." But Hayek sharply disagreed. He believed that there are inherent limits to knowledge in human social and economic systems which no amount of intellect can overcome.

Developments in economics are taking the subject in the direction of Hayek rather than Friedman and Keynes. The burgeoning areas of behavioural and experimental economics confirm that, for the most part, decision-makers reason poorly and act intuitively rather than rationally. Theoretical models in which actors have very limited, or even zero, understanding of how their environment operates are having striking success in explaining a wide range of phenomena.

Friedman was a brilliant polemicist. He had several highly original ideas about how economies work. Most have proved to be wrong, but at least he had them. And in the one area where he was proved correct, he exercised great influence on policymakers. But even in this area, Hayek’s insights go much deeper and offer a better framework for the research programmes of the 21st century.

A bird's eye view of econometrics

Want to get to grips with econometrics? Look no further. John F. Geweke (Iowa), Joel L. Horowitz (Northwestern) and Hashem Pesaran (Cambridge) offer Econometrics: A Bird’s Eye View (PDF here) in a new IZA discussion paper.

Prepared for the forthcoming New Palgrave Dictionary of Economics and Law, it provides a comprehensive 72 page overview of the subject, including a boggling 386 references! Here is the abstract:

As a unified discipline, econometrics is still relatively young and has been transforming and expanding very rapidly over the past few decades. Major advances have taken place in the analysis of cross sectional data by means of semi-parametric and non-parametric techniques. Heterogeneity of economic relations across individuals, firms and industries is increasingly acknowledged and attempts have been made to take them into account either by integrating out their effects or by modeling the sources of heterogeneity when suitable panel data exists.

The counterfactual considerations that underlie policy analysis and treatment evaluation have been given a more satisfactory foundation. New time series econometric techniques have been developed and employed extensively in the areas of macroeconometrics and finance. Non-linear econometric techniques are used increasingly in the analysis of cross section and time series observations.

Applications of Bayesian techniques to econometric problems have been given new impetus largely thanks to advances in computer power and computational techniques. The use of Bayesian techniques have in turn provided the investigators with a unifying framework where the tasks of forecasting, decision making, model evaluation and learning can be considered as parts of the same interactive and iterative process; thus paving the way for establishing the foundation of “real time econometrics”. This paper attempts to provide an overview of some of these developments.

The authors conclude that econometrics "has come a long way over a relatively short period", and that "both in theory and practice ..[it] has already gone well beyond what its founders envisaged." But there are also a number of difficulties. First, economic statistics are seldom "the results of designed experiments, but are obtained as by-products of business and government activities". They don't always suit economic analysis. Second, models are rarely fully specified:

..the specification of econometric models inevitably involves important auxiliary assumptions about functional forms, dynamic specifications, latent variables, etc. with respect to which economic theory is silent or gives only an incomplete guide.

Third, economic theory is incomplete and:

..on its own cannot be expected to provide a complete model specification has important consequences for testing and evaluation of economic theories, for forecasting and real time decision making. The incompleteness of economic theories makes the task of testing them a formidable undertaking.

In general it will not be possible to say whether the results of the statistical tests have a bearing on the economic theory or the auxiliary assumptions. This ambiguity in testing theories, known as the Duhem-Quine thesis, is not confined to econometrics... The problem is, however, especially serious in econometrics because theory is far less developed in economics than it is in the natural sciences.

Plenty of food for thought here.

Bernanke's official dealings

Despite their professed independence, Fed Chairmen are more 'political' than many realise. Greenspan met a steady stream of politicians and White House officials during his reign. The Financial Markets Center have just published a piece on what they call the Fed Chairman’s Daybook, based on the work of the indefatigable Wharton finance professor Ken Thomas:

Over the years, Fed chairmen have maintained a detailed log of their meetings with members of Congress and the executive branch.  Using this data, scholar Ken Thomas has produced a series of reports that offer a unique window on the central bank’s interactions with the rest of government.

The newest installment of Dr. Thomas’ research provides an inside look at new Fed Chairman Ben Bernanke’s dealings with official Washington during his first four months in office. It includes a list of each meeting Dr. Bernanke held with top officials from the White House, Treasury, Congress and other parts of government during this period as well as a Bernanke Political Index derived from that information.

New pages at the FMC site also describe the central bank’s actions to block access to information on Alan Greenspan’s meetings with other government officials during the former chairman’s final seven months in office. In addition: a retrospective look at the Greenspan Political Index (with a guest appearance by the ghost of Arthur Burns).

On Bernanke's performace to date, Thomas concludes:

In terms of their frequency, Bernanke’s White House meetings in this period are consistent with Greenspan’s seemingly apolitical pattern during President Clinton’s second term. Also, eight of Bernanke’s nine White House meetings were with NEC or CEA principals, rather than Greenspan-style private meetings with top White House or Cabinet officials.

...Overall, Dr. Bernanke averaged 2.2 political meetings of all types per week for his first four months as Fed chairman. This number slightly exceeds the 2.0 average Greenspan recorded during 1996-2000 but significantly lags the 3.1 average he registered from 2001 through mid-year 2005.

Based on these initial data, it appears that Chairman Bernanke has begun his term honoring the notion of Fed independence by limiting the scale of his interactions with political figures. Hopefully, subsequent data will continue to reflect this relatively apolitical approach.

Consultants don't come cheap

Are consultants milking the UK government for billions for very little result? Brian Appleyard has a provocative piece in the Sunday Times Magazine which argues that they are: Blair's barmy army. While he exaggerates the failures of consultancy and largely ignores the succeses, there are some telling blows. He summarises the problem thus:

Everybody agrees, the MCA included, that consultants can be useful if – and only if – their task is tightly defined and controlled. But, overwhelmingly, government contracts have been vague and subject to constant change. Like your local builder, consultants quietly add on huge costs every time anybody makes a remark about what must be done. Furthermore, they have so far done so with an almost complete lack of accountability.

...The whole thing has simply been the result of a collective delusion: that there are quasi-scientific, objective ways of managing human affairs that transcend all considerations of culture, ethos and environment. Consultants sold this lie, government bought it, and we’re paying for it.

And the solution?

What we need, say some, is our equivalent of America’s Clinger-Cohen Act. This was introduced by two Republican senators in 1996 after a series of cases in which consultancies ripped off the federal government. The act forced all departments to monitor and control every project, effectively imposing a proper management structure where none had existed before. There is no prospect of that happening here and, seemingly, little political will to shake off the burden of the deals already done.

...But there are hopeful signs. Richard Granger is now imposing more stringent controls on contracts for the NHS computer. The failure of the NHS to show anything like the signs of improvement to be expected from Brown’s billions is starting to sink in. Mark Serwotka’s union is threatening a strike ballot in January. There can be no doubt that a project like the NHS computer would be a fantastic idea if it can be made to work, which, sadly, it can’t.

Labour takes stock

The Prime Minister's Strategy Unit published a presentation on its website yesterday. Strategic Priorities for the UK: The Policy Review (PDF) is described as "background for Cabinet discussion of the policy review programme on 19th October 2006". It's quite an interesting, albeit discursive, overview of what the government sees as its key achievements and challenges. Economics editor Larry Elliott summarises the economic material in today's Guardian:

Tony Blair and Gordon Brown believe the economic stability the government has presided over since 1997 is a necesssary but insufficient condition for the big challenge of the next decade - tackling the threat posed by the big emerging economies of China and India.

Over the past decade and a half, the size of the global labour force has doubled to three billion as a result of the collapse of communism in the Soviet Union, China's embrace of the market and the arrival of India as a global economic force.

With the fast-growing developing economies having far lower levels of wages than those in the UK, Labour says the only option is a "knowledge economy" which specialises in sectors such as pharmaceuticals, biotechnology, environmental protection, nanotechnology and financial services.

These are areas where the UK has a tradition of strength, where the profits margins are high, and where the competition from India and China has so far been less evident than in low-cost manufacturing.

Labour has identified two areas that need to be addressed. The first is ensuring that Britain can compete in the lucrative high-skill sectors, where there is some concern that the UK spends less on research and development than its main rivals; that Britain's level of skills compares badly to those in the United States, Germany and Japan; and that the flow of new scientists may be drying up.

Although the government says educational standards have been rising, there are 7 million adults who are unable to read and write. At the other end of the spectrum, the number of undergraduates reading the physical sciences, engineering and technology has been falling, while fewer children have been taking maths and science at A-level.

The government's second concern is to ensure that growth benefits all groups in Britain. Labour admits the very poorest have not shared the benefits of growth, while inequality is more pronounced than it was in 1997.

Infrastructure and India's rich

Some encouraging news from India. Though public infrastructure spending remains woefully inadequate, Bloomberg's Andy Mukherjee reports that many of India's billionaires are now helping to plug the gap: How India's Rich Are Plugging Power, Road Gaps

It's easy, perhaps too easy, to become pessimistic about India's deficient infrastructure. Everything from potholed roads and clogged airports to frequent power blackouts and creaking urban transportation would appear to be daunting, if not intractable, shortcomings.

Sure, the challenges are humongous, and the pace of their resolution is slow. The highly indebted Indian government hasn't the wherewithal to make a decisive improvement, which is estimated to require additional spending equal to 3.4 percent of gross domestic product. That's almost three-quarters of what India is spending on transportation, power, water, irrigation, communications and storage capacity in a year.

The case for glumness is probably overstated.

Private enterprise is playing an increasingly important role. Inadequate public spending is still a huge constraint, yet domestic non-state companies are slowly taking the lead in allocating much-needed capital to some of India's most overlooked requirements.

A glance at the latest Forbes magazine list of 40 richest Indians should prove that point. Except for the ``knowledge- economy'' czars -- the computer-software and generic-drug exporters who are mostly sticking to what they know -- almost everyone else on that list is investing in infrastructure.

To cite a few examples:

Are China's poor better off?

Not everyone in China is benefiting from the economy's stellar growth, according to a new World Bank report. FT Beijing correspondent Richard McGregor reports that China’s poorest worse off after boom

China’s poor grew poorer at a time when the country was growing substantially wealthier, an analysis by World Bank economists has found. The real income of the poorest 10 per cent of China’s 1.3bn people fell by 2.4 per cent in the two years to 2003, the analysis showed, a period when the economy was growing by nearly 10 per cent a year. Over the same period, the income of China’s richest 10 per cent rose by more than 16 per cent.

“Preliminary analysis on Chinese data indicates that average income of the bottom decile went down slightly between 2001 and 2003, whereas all other income categories saw significant increases,” said Bert Hofman, the bank’s lead economist in China. “Our analysis suggests that a considerable number of people below the poverty line were hit by an income shock – they only kept up consumption by spending their savings.”

The findings challenge the basis of government policies aimed at narrowing the country’s politically sensitive wealth gap. ...China, which had relatively even income distribution in 1980 when it embarked on market reforms, is now “less equal” than the US and Russia, using the Gini co-efficient, a standard measure of income disparities.

...The fall in income for the poor cannot be explained by declining farm incomes, as food prices were rising at a faster rate than urban prices in December 2003. Over the period that the study covers, inflation was low and in one year, 2002, negative.

The findings challenge the basis of government policies aimed at narrowing the country’s politically sensitive wealth gap. Hu Jintao, China’s president, who came to power in 2002 and is likely to win a second five-year term next year, has made narrowing the gap between rich and poor a centrepiece of his administration’s economic policies.

China, which had relatively even income distribution in 1980 when it embarked on market reforms, is now “less equal” than the US and Russia, using the Gini co-efficient, a standard measure of income disparities.

The Wall Street Journal also reported the findings today: In China, Growth at Whose Cost? The story, by Andrew Batson and Shai Oster, points out that "the poorest of the country's 1.3 billion people are getting even poorer."

From 2001 to 2003, as China's economy expanded nearly 10% a year, average income for the poorest 10% of the country's households fell 2.5%, according to an analysis by the World Bank that has been presented to the Chinese government. Those roughly 130 million Chinese earn $1 a day or less, the World Bank's global benchmark for poverty.

Meanwhile, the nation's total income rose sharply, and other income groups saw gains, suggesting that the rich are getting richer at the expense of the poorest.

The reason for the income decline at the bottom isn't clear. The World Bank hasn't completed its analysis and its conclusions haven't been published. Even so, the data call into question an economic model that economists have held up as an example for other developing nations.

"This finding is very important. If true, it sheds doubt on the argument that a rising tide lifts all boats," said Bert Hofman, the World Bank's chief economist in China.

...The World Bank's Mr. Hofman says the bank's analysis shows the majority of China's poorest 10% appear to be only temporarily poor, thrown down by some setback like sudden illness, the loss of a job or the confiscation of land. That suggests that a basic social safety net, like medical insurance or unemployment benefits, could help move them back out of poverty. Only about 20% to 30% of the poorest appear to be long-term poor, and even they have some savings.

Unfortunately I have not been able to find the report on the main World Bank website, or their China website. If anybody can send me a link, I'd appreciate it.

UPDATE: Dave Altig at Macroblog has also posted on this report. He comments:

Temporary bouts of economic hardship are clearly a much different thing than persistent poverty traps.  And if, in fact, poverty is predominantly transitory, we should perhaps be more circumspect about declaring that a rising tide fails to raise all boats.

Tax: wrong again

One of the tiresome feature of British economic debate are the regular warnings from City economists and others that the UK Budget is about to hit the wall. In nine years under Chancellor Brown it never has. Not that the state of the Budget is in fine shape, mind - government borrowing is sizeable given the robust growth of recent years. But neither is revenue falling off a cliff, as some would have you believe. Gary Duncan informs us in today's Times of a Pre-Budget bumper tax boost:

Bumper tax revenues last month allowed the Treasury to register its biggest cash surplus for any October since 1999, a welcome boost for Gordon Brown less than three weeks before what is likely to be his last Pre-Budget Report. The surge in key tax receipts last month tempered fears that strains on the public finances will force Mr Brown to raise his 2006-07 borrowing forecasts.

Of course, that wasn't enough for the doomsayers:

But City economists said that, with public spending continuing to run markedly ahead of plans, the Chancellor may still end up deeper in the red over the full financial year than he hoped in March.

Ho hum. My bet is come next year's Budget, the doomsayers will be proved wrong again.