THE TRUTH ABOUT PRIVATISATION: # 14: DIVIDENDS

New Zealand Herald political commentator John Armstrong was dispensing advice to the Labour Party on privatisation issues in his column last Saturday (June 11).

First, he wrote:

Labour needs to make merry hell with the foreign ownership bogie – perhaps to a point bordering on xenophobia.

What sort of responsible economic journalism is that?  I dealt with the foreign ownership ‘bogie’ in TAP # 7.  First, selling shares in SOEs to foreigners does not increase net claims on the New Zealand economy.  Second, for a given current account balance, restricting foreign ownership of SOEs is likely to mean higher foreign ownership of other companies.  Does that make any sense?  Third, FDI in SOEs may bring the same benefits as FDI generally: why, on economic grounds, would you want to apply different rules to SOEs?

Mr Armstrong goes on to write:

Labour knows it must also win the pivotal argument surrounding the permanent loss to the Crown of dividends from a one-off sale of up to 49 percent of the shares in each state-owned enterprise.

Labour cannot win that argument because it is false.  I discussed it in TAP # 11.

Let’s first look at the factual situation.  The Crown would lose the future dividend stream and up to 49 percent of the SOE’s retained earnings if a minority interest in an SOE were sold.  Retained earnings of SOEs that are attributable to the Crown and dividends paid to the Crown are included in the Total Crown operating balance. 

On this basis it is easy to demonstrate that Mr Armstrong’s argument is false because there is no net financial loss from a sale.  For a given fiscal deficit or surplus, the proceeds from selling one asset must be used to reduce debt or to invest elsewhere.  That is an accounting identity.  If all transactions are at market values and the buyer can effect no improvement in the SOE’s earnings, the value of the reduced interest payments on debt or on the increased dividends from the replacement investments will fully compensate taxpayers for the sale of the SOEs.  Expected cash flows to the Crown will rise or fall depending on whether the replacement investments are more or less risky than the SOE investment, but risk-adjusted they will be the same.  In other words, the Crown can’t lose from selling an asset at its market value.  Such a sale does not change the market value of Crown net worth.  Nor does it alter the net income stream that can be generated from that net worth.

A similar conclusion is evident from examining the way in which shares and bonds are valued in simple models.   Essentially what I was saying on TAP #11 was that if an SOE distributed its entire net cash flow each year, the present value of the future dividends would, assuming the distribution policy had no adverse effect on the efficiency of the firm’s operations and given the appropriate discount rate, equal the value of the enterprise.  On this static assumption, and assuming away different assessments about risk and uncertainty, a rational investor would be indifferent between selling the asset for its net present value now and retaining it and receiving the future dividend stream because they are of equal value. There is no loss if the share is sold for its market value.

In fact an alternative owner and a different incentive structure arising from a change in ownership may improve efficiency.  In this dynamic situation, the value of the enterprise on its sale may be more than the present value of future cash flows under the existing incentive structure.  Given a competitive sale process, the Crown is likely to end up better off from a financial perspective because bidders would tend to pay what the enterpise is worth to them, taking account of the scope to increase efficiency. This is a key economic and financial argument for privatisation.

Let’s come at the issue from another angle and consider the analogy of a bond.  Suppose I had a risk-free bond of $100 yielding 5%.  The risk free rate of interest is thus 5%.  The present value of the interest stream to infinity (assuming a constant risk-free discount rate) is $5/i=$5/0.05=$100.  In this case the entire interest is paid to the bond holder.  The net present value of the interest stream is equal to the value of the bond.  As a bond holder I am indifferent as to whether to hold or sell the bond.  If the government were the bond holder, no one could sensibly object to a decision to sell it.

The situation is the same with a holder of equity.  Suppose I have a $100 share in a firm that is fully equity-financed and, for argument’s sake, is regarded as risk-free, and it pays out 100% of its profits at a dividend rate of 5%.  I am in the same position as I would be as a bond holder:  I am indifferent as to whether I receive the future cash flows as dividends or take them out up front by selling the share.  Thus if the government were the holder of equity (say, in an SOE) no one could sensibly argue that it would lose financially from a sale.

Of course, dividend rates may be higher but only because of greater risk.  Adjusting for risk and other factors like liquidity, investors should again be indifferent between the two cash flows. Moreover, as noted above, if a share is sold at market value while holding the government’s deficit or surplus constant, taxpayers will be fully compensated for the dividend stream and retained earnings forgone.

The bottom line is that taxpayers are unlikely to be worse off financially from SOE sales and are likely to be better off because of the efficiency gains from a competitive commercial environment. 

Having said all this, the fiscal effects of privatisation are a second-level issue.  The more important efficiency gains from privatisation could also be achieved if the government simply gave away shares to citizens.  It is community welfare, not the Crown’s financial position, that counts and that is where the debate should be focused.  Debate over fiscal effects doesn’t go to the heart of the matter.

Labour would be unwise to follow Mr Armstrong’s advice.

 

 

 

PRIVATISATION DEBATE SHOULD BE RIGOROUS

It’s hardly a state secret that the government is considering some rearrangement of its portfolio of assets if it is re-elected this year.  Its Investment Statement reporting current asset holdings issued in December provides useful information on available choices.

There is much to consider on the why, how and when assets should be transferred from the public to the private sector.  This 2002 study by Phil Barry was commissioned by the Business Roundtable as a contribution to the debate.   It dealt with many of the myths concerning past privatisations.  (I discussed some in my blog of 9 December 2010.)

Another contribution was this article by commercial law academics Susan Watson and Chye-Ching Huang published in the New Zealand Herald of 15 January.  It made the case for partial privatisation, in line with the government’s assumed intentions.  However, it was not the sort of rigorous analysis that might be expected of academics.

Nowhere did it consider, for example, whether full privatisation would be superior to partial privatisation.  Academic studies clearly favour the former over the latter for commercial enterprises.

Nor did it expose the pitfalls of partial privatisations.  These involve continuing (majority or minority) government stakes in enterprises and the risk that political incentives will dominate commercial incentives (and limit the contribution of entities to wealth creation).  Conflicts between the government’s roles as owner and regulator are not resolved with partial privatisation.

We have seen partially privatised companies remain political playthings, a prime example being the former Auckland Regional Council’s nationalisation of Ports of Auckland.  Earlier experience with the partial privatisation of the Bank of New Zealand was also unhappy.

Watson and Huang note that the New Zealand sharemarket would benefit from partial listings, as did the Capital Market Development Taskforce.  But, other things equal, it would obviously benefit more from full privatisation.  Moreover, partial privatisation of the small entities they give as examples – Quotable Value, Learning Media and Asure New Zealand – would hardly be worth the candle.  Game-changing policy must involve major SOEs such as those in the electricity sector.

The article cites Air New Zealand as a model of partial privatisation but unaccountably fails to note that the company’s share price performance since the government resumed majority ownership has been poor.

They also commend the Singaporean Temasek holding company model.  This is also dubious.  The performance of the underlying businesses is not sharply reflected in such a model.

The authors mention the possibility of restricting privatised company shares to New Zealand nationals, and rightly note that this would depress the share price.  The arguments for such restrictions could only be political.  The idea that foreign ownership is a cost of privatisation is misplaced.  The level of foreign ownership in the economy is determined by the cumulative current account deficit or surplus in the balance of payments, not by which assets are for sale.  If foreign ownership of some assets is blocked, foreign stakes in other assets will be higher.  If this is an issue, a better approach would arguably be to simply give SOE shares to their true owners, New Zealand taxpayers.

The value of partial privatisation should not be over-stated (which is probably why the 2025 Taskforce recommended full sales for competitive enterprises).  Phil Barry concludes as follows:

… partial privatisation has significant disadvantages compared with full privatisation. Ownership of partially privatised companies is often widely held (outside the government’s stake) and control is not readily contestable; private investors have limited incentive to monitor the company, relying instead on the ‘deep pockets’ of the government to bail out the company if it gets into difficulty; and the company remains open to political interference. Further, governments, as owners, may be unable to agree for long as to why they own the company, thus making it difficult for the company to develop and implement a strategic direction.

The empirical evidence supports the view that partial privatisation is not a desirable long-run state. Most studies indicate that there is no lasting difference between the performance of fully state-owned and partially state-owned enterprises: that is, that full private control is necessary to achieve sustained performance gains. But as a stepping stone towards full privatisation, partial privatisation has merits.

A better article would have reflected these nuances.

Let the foals thrive

Prime Minister John Key’s statement on an internet chat session that he has ‘ruled out the complete sale of any state-owned assets if National win a second term’ will be a major disappointment to many who had hoped a second term National led government would be bolder on this issue. That they will possibly look to move minority holdings will be a minor consolation.

Today’s Herald, a paper not exactly known as a bastion of free market reform, has an editorial titled Open the SOE stable and let the foals thrive. In a blog on that editorial David Farrar remonstrates that we may be alone in the developed world in having a bipartisan policy of no asset sales.

I suspect he is correct. In an article I wrote before the last election in 2008 titled ‘Privatisation: New Zealand Swimming Against the Tide’ I wrote:

With the National Party’s decision not to move any state-owned enterprises to the private sector in its first term if elected this year, we appear to have a new political consensus between the major parties in New Zealand: privatisation is bad.

This contrasts with the earlier consensus that privatisation is good. A few years ago the World Bank observed that “Privatisation is now so widespread that it is hard to find countries not using the approach: North Korea, Cuba and perhaps Myanmar make up the shrunken universe of the resistant.

Since then I have blogged that even Cuba is taking steps toward privatisation. We are in dubious company.

The common mantra in New Zealand that privatisation of state assets is somehow ‘right wing’ is simply not true. Indeed, in 2007 a British MP commenting on the significant privatisation achieved by Tony Blair’s Labour party wrote:

Now that Blair has been and gone, you would struggle to find a serious politician in any party who would advocate state ownership of any industry as a 21st-century model. Indeed the idea of the state running our utilities, airlines or railways now seems archaic and even faintly ridiculous.

It is an undisputed fact that over time and on average businesses do better in private rather than public ownership.  

John Key is rightly respected as a pragmatic and trusted leader with the common touch and plenty of common sense and business acumen.  He has the ability to raise public understanding of the economic gains that would ensue from privatising state assets – particularly lower prices and better services for the public. Privatisation should not be seen as ideological – it is a pragmatic course of action that the public should understand. Why not at least try?

Meanwhile privatisation continues at a steady pace in Australia, the most recent being the sale of Queensland Rail by the Queensland Labor government, the second largest Australian privatisation after Telstra.

To see the 2025 Taskforce’s recommendation on the issue click here (scroll down to government assets).

What’s Wrong with Neoclassical Economics?

A new Occasional Paper on the Business Roundtable website should be a useful resource for teachers of economics and participants in economic policy debates.

Written by Wolfgang Kasper, emeritus professor of economics at the University of New South Wales, Australia, an earlier version was delivered to the joint conference of the New Zealand Association of Economists and the Law and Economics Association of New Zealand in June this year.

For years I had urged Wolfgang to write a paper spelling out the limitations of neoclassical economics in understanding how the world works.

He resisted the idea (“nobody believes in neoclassical ideas any more”).  I told him he was wrong: various economics educators in New Zealand continue to teach on the basis of defunct human capital, and politicians attack free-market policies on the false assumption that they are grounded in neoclassical economics.

Finally Wolfgang relented and wrote the paper.

Neoclassical economics can be traced back to the work of British economist Alfred Marshall and to some extent even further back to ‘classical’ economists such as Adam Smith.  It is characterised by a focus on static equilibrium conditions in markets and the economy – like how supply and demand are matched and at what prices.  It does not explore the dynamics of the economic system, and in particular has little to say about entrepreneurship and economic growth.

As Wolfgang says in his paper:

The poverty of neoclassical economics becomes evident when one realises that key concepts – such as competition, enterprise, profit, the costs of transacting business, the need for law and other rules of coordination (institutions) – have simply been ‘assumed away for simplicity’s sake’. It is also imbued with a wrong-headed pessimism, derived from nineteenth-century agricultural reality (law of diminishing returns).

Almost as though on cue, a classic example of the persistence of neoclassical misunderstandings came to light just as Professor Kasper’s paper was being printed.  The New Zealand Herald, which features a constant diet of op eds by anti-market critics such as Jane Kelsey and Bryan Gould, printed this article by Auckland secondary school economics teacher Peter Lyons, whose articles also appear frequently in Herald columns.

It was entitled ‘Mantra of free market ideology wearing thin’ and contained a familiar theme: “In the past 25 years New Zealand has embraced the free market ideology of of neoclassical economics.”

As someone involved in some of the reforms, I can certify that none of the economic advisers of the governments concerned were slaves of neoclassical economics.  While recognising its insights they were well aware of its limitations as identified by Wolfgang Kasper, and drew on a far wider and richer body of economic literature.  A reading of relevant official documents would make this immediately apparent.

Similarly, governments in the United States, Britain, Australia and many other countries that embarked on liberal economic reforms around the same time as New Zealand were not driven by narrow neoclassical economics.  Again a reading of official documents would quickly confirm this.

Professor Kasper responded to Peter Lyons in this article.  Regrettably, the Herald declined to publish it.

I worry about bad economics teaching in our classrooms and lecture rooms.  I worry too about the effect of bad economics on public understanding when newspapers do not publish critical responses.

Professor Kasper’s paper should demonstrate that those who attack liberal economic policies on the grounds that they are based on neoclassical economics are attacking a straw man.

Obsessive Compulsive Disorder

Yesterday I read a commentary in the NZ Herald loaded with erroneous claims about the Education (Freedom of Association) Amendment Bill. It was signed by a group of student association leaders (with a strong vested interest in retention of the status quo) arguing that student association membership should be compulsory.

In fact the case for voluntary student membership (VSM) is overwhelming. The New Zealand Business Roundtable made a submission on the Bill strongly in favour of it. Without delving too deep into the issue here I thought I’d comment on a few of the glaring misconceptions in the piece (placed prominently opposite the editorial page in the Herald).  

The subheading:

Student leaders outline what is wrong with Act’s bid to make association membership voluntary

The signatories are not student leaders, they are students’ association leaders elected by a tiny minority of students (typically 5-10%). The vast majority of students would not be able to name their association leader. A 5-10% voter turn-out does not give anyone a mandate as a leader.

The decision of National members of a parliamentary select committee to ignore tertiary institutions, students and the public by supporting an Act bill to impose voluntary student membership on students’ associations is disgraceful.

‘Impose voluntary’ is an oxymoron. Impose means being forced to do something. Voluntary is the ability to choose. This Bill would give students the opportunity to choose whether or not they want to belong to an association.

Students don’t want this. Tertiary institutions don’t want this. The committee received 4837 submissions on the bill, with an overwhelming 98 per cent opposed.

The number of submissions, for or against, is not an accurate representation of how students think. If only 5-10% of students bother to vote in the students’ association elections, you would hardly expect a tidal wave of written submissions (which aren’t compulsory like essays or association membership). You would, however, expect organised association representatives and employees with a vested interest to submit en masse.  The idea that trade union membership should be made compulsory if most submissions to a select committee favoured it doesn’t pass the laugh test.

If it is a decision made on the principle of freedom of association, it is flawed. Students have less choice; they will no longer be able to come together as a universal collective.

How absurd. Under VSM, students can still join an association to come together as a collective if they choose. And when have students ever come together universally? On any issue there will be differences of opinion among students. Accordingly, under freedom of association, students can form groups, unions and associations on issues of concern of their choice.

Students’ associations nationwide work hard for students. They provide vital services such as welfare, representation and advocacy for students who cannot make ends meet, have problems with a landlord or need help resolving a grievance.

If that is the case then there is no reason why students presented with the information would not choose to join an association. Unfortunately though, student unions are often notoriously badly run – see Victoria University law student Jenna Raeburn’s excellent submission for examples.

As a direct result of the passage of this legislation, students will see an increase in costs as tertiary institutions scramble to introduce services that all stakeholders consider essential.

All stakeholders? Union leaders do not represent the views of all students who are the most important stakeholders. New Zealand taxpayers are also stakeholders because they subsidise tertiary education, and it is likely that taxpayers, and students, would consider many of the ‘services’ provided by associations as non-essential if not wasteful. For example, I understand that 70% of the 2009 VUWSA budget comprised administration costs. Furthermore, some services could be sold or contracted out and it is likely that in general costs would go down.

The current law is flexible and inclusive. It does not breach freedom of association, as students have a choice whether to join their associations, both on a collective level through a referendum and an individual level through opt-out provisions.

A collective referendum does not provide freedom of association. That would be akin to forcing all New Zealanders to join the National Party – if a majority of people voted to in a nationwide referendum. The ‘opt-out provisions’ consist of exemptions on religious or ethical grounds, but the membership fee must still be paid and goes to a charity of the students’ association’s choice – so the association still controls the membership fee.  Hardly freedom of association. 

All workers in New Zealand (except under exceptional circumstances eg consumer protection in the case of professions such as medicine) are rightly entitled to freedom of association, yet currently students are subjected to compulsory union membership. VSM is a no-brainer.

David Farrar blogs on this here