Another example of misunderstanding, this time by Vernon Small in yesterday’s Dominion Post (2 June 2011).
First, he asks:
How does it make sense to sell shares in safe, well-performed assets earning good profit, such as the state generators, to lower debt that costs much less to borrow than the earnings stream you are flicking off?
Simple intuition should have made Mr Small pause before asking this question. If the proposition were true, the government should be borrowing even more heavily than it is today in order to invest in global sharemarkets (maybe taking over the New Zealand private sector along the way) on the grounds that equity returns are higher than returns on debt. Indeed it could finance all its spending that way.
Those who chased higher returns from finance company deposits have learnt a lesson that has apparently escaped Mr Small – that higher returns come at the cost of greater risk. Governments that gear up, buying $1 million of risky assets for every $1 million of government bonds that they issue, do not create any wealth for taxpayers. Rather, they expose taxpayers to greater risks. This is particularly likely to harm those in the community who are least able to protect themselves against the risk of government cutbacks when government investments turn sour.
This is not an academic point. Back in the 1980s Sir Roger Douglas found that taxpayers had lost around $7 billion in dollars of the day from previous governments’ investments and guarantees relating to energy projects. That was when GDP was around $47 billion. The addition to the net public debt represented around 15 percent of GDP. That burden makes the projected cost of the Christchurch earthquakes look quite small.
Another fundamental point is that ‘good profits’ are not an enduring feature of state-owned businesses.New Zealand’ s economic history is littered with examples of losses rather than profits from state-run commercial activities, and of the failures of such companies to achieve their cost of capital (see earlier posts on Air New Zealand). Politicians commonly have many non-commercial objectives, and few commercial skills. Political imperatives will out. (Currently the Labour Party is saying state electricity generators should not have to pay commercial dividends.)
A further point is that even if it were true that the investments were as safe as government bonds, contrary to Mr Small’s assertion, the costs of the debt that could be retired if the asset were sold would exactly match “the earnings stream you are flicking off”. Suppose, for example, that the investment returns $12 million a year safely and the cost of servicing each $100 million of government bonds is $6 million a year. Any investor who pays $1 for a 6 cent return will accept having to pay $2 in order to get a 12 cent return. It follows that the sale of the asset will fetch $200 million under these assumptions. The public debt could be reduced by $200 million, reducing debt servicing costs by $12 million a year. This exactly matches the return forgone by selling the asset.
In short, no value is created for taxpayers from issuing $200 million of low-risk bonds and using the proceeds to buy $200 million of either a safe or a risky investment. Sure, the riskier the investment, the higher the expected net return for taxpayers, but this is offset by the greater risk. Mr Small tries to avoid this problem by referring to the investment as ‘safe’, but in doing so he contradicts his assumption of a higher return.
He is trying to have it both ways, but either way the argument is fallacious.
In any case, the reality is, as I have pointed out in this series, that the government is likely to be better off financially from SOE privatisations because, on average and over time, private owners run the businesses more efficiently and the government will capture some of the efficiency gains in competitive sales.
The article goes on to argue that privatisation:
… does not address the central issue driving the country’s indebtedness – the mountain of private debt accumulated to buy houses and farms.
In fact it is relevant to this issue too. The foreign liabilities are the outcome of the large current account deficits under the previous government which were due in part to the loss of international competitiveness. By increasing efficiency in the non-traded goods sector of the economy, privatisation can contribute to improving the competitiveness of our traded goods industries.
Finally the article states:
Selling state assets to reduce debt is irrelevant to the debt problem in the eyes of overseas lenders and rating agencies.
Tell that to the Greek government, which is currently under huge pressure to step up its privatisation programme to try to avoid further bailouts or debt restructuring!