How to Privatize Successfully - Part I

Changing the economic system is not an easy task. And, of course, it is more complex when carried out half-heartedly. As privatisation is only a part of this process, it may not succeed if done in an isolated manner. It needs certain other changes and a competitive environment to bear fruit.

A case in point is Czechoslovakia. It provides us with a very good learning experience to see how after the fall of a collectivist state the gigantic task of changing the economic system was handled.

Presently, Dr Vaclav Klaus is President of the Czech Republic. He was Prime Minister from 1992 to 1997. Dr Klaus was one of the key members of a movement, Velvet Revolution, which overthrew communism in Czechoslovakia and one of the founders of the Czechoslovak Civic Forum Movement, the leading political organisation following the Velvet Revolution in 1989.

He was the first non-Communist Finance Minister of Czechoslovakia. He is a highly awarded economist and politician, with many publications and awards, including the Schumpeter Prize for Economy. He is of the opinion that it is much more difficult to change the economic system. The starting point of this change in Czechoslovakia was liberalisation and de-regulation of markets.

This move consisted of three main liberalisation's:

i) price liberalisation, ii) trade liberalisation, and iii) business liberalisation. As to the price liberalisation, he says for others it is difficult to imagine but for 40 years people in Czechoslovakia had totally frozen and administered prices. So liberalising prices was a dramatic shock.

Making a comparison, he says Australians spent years or decades discussing liberalising the price of milk in Australia! But in Czechoslovakia they didn't have just one case of milk! They had hundreds, thousands of prices with possibly the same impact upon individuals in different groups of society.

The second move, trade liberalisation, was also a dramatic one. It meant opening the country after 40 years of semi-autocratic and protected economy. And, the third one was liberalisation of entry into the market for all types of enterprises, both private and foreign.

He says these three liberalisation's represented the first stage of transition, and not only changed the whole society but enormously increased the supply of goods and services also. It effected an equilibrium in the market overnight. It interrupted some of the old, deeply built-in behaviour of citizens; it attacked and endangered various old habits they inherited from the communist past.

He readily admits that realising such changes was socially difficult, politically relatively brave but technically easy because most of the measures required just had to be announced. Again citing the case of milk price, he says that to deregulate or liberalise the price of milk Australians, or for that matter anyone, don't need sophisticated theories.

Don't need the involvement of university professors or experts on micro- or macro- economics. It is sufficient to meet at eight o'clock in the evening and to announce on TV that tomorrow morning at 8am the price of milk is free to move. That is what they did in Czechoslovakia.

However, he says, the second stage of transition was not an easy one. It required more positive and constructive activity from the government. Because, it was necessary not only to introduce such passive transformation measures, but also to implement some active measures. It was necessary to build, establish new, and/or transform old institutions and organisations.

And, of course, he rightly admits, the crucial point in this respect was privatisation. But, it was really impossible to wait for the slow emergence of hundreds and thousands of private enterprises - built starting from nothing - and for the slow disappearance of state-owned enterprises which eleven years ago in former Czechoslovakia represented almost 100% of the whole economy. He emphatically says: So we had to privatise. It's an accepted exercise.

Here it is quite relevant to repeat a story that he tells: in one of the conferences of Mont Pelerin Society, he met one Polish guy who was the second member of the Society following him from the post-communist world.

He wrote a very interesting study suggesting that privatisation was a mistake. He is unique, he is alone in this. But do you know why? His disbelief in the capabilities of the government is so absolute that he even wouldn't let the government privatise - that's really rather revolutionary. But he is alone in this respect.

Dr Klaus's narrative of their privatisation is but immeasurably instructive. He says: We had to privatise, we decided, and it was necessary to privatise the state-owned firms on a massive scale, on a wholesale basis, not just individual firms.

This is something I always have to repeat and to stress because everyone compares privatisation in post-communist countries with privatisation in France, Sweden, the Netherlands. I am not an expert on it, but I always say that the brave Margaret Thatcher privatised three or four firms a year, whereas we had to privatise three or four firms per hour! Because otherwise it would have taken a century to do that job. For that reason, we had to use some non-standard methods of privatisation; we had to do experiments and different exercises.

So privatisation in Czechoslovakia was extremely difficult both politically and technically. Rather he says: I'm sure that in any country as well, whatever the government does, the politicians are accused either of favouritism - of selecting inappropriate owners - or of not getting the best or highest possible price.

In any individual case, in any Western country, this is the case. When I look in Europe at privatising Air France or privatising one firm in Belgium or one in Sweden or the Netherlands, or elsewhere, it is the same story.

So we [the government] were definitely the perfect option for such criticism because in thousands of cases, some were successful and some were not successful. Some of the future owners succeeded fully, some did not. Some immediately tried to get rid of the assets in a rather cheap way and so on.

But, if privatisation needs to be done, it has to be done because it is the decisive step in transforming the economic system. So, in Czechoslovakia too, Dr Klaus says, privatisation was done and it was the decisive step. It was like crossing the Rubicon. The political costs were unavoidable but it had to be done and to be done as quickly as possible.

Relating other aspects of privatisation, he says: The problem is that the people in my country and elsewhere probably assumed, that because of the undisputed efficiency of the private market economy as compared to the command economy or centrally planned economy, that every firm and economic activity had to succeed.

You know very well that it's not true even in a major, stable, developed economy. And of course it is much less true in an economy in transition with a dramatically changing economic environment, in competition with much stronger partners from the rest of the world, and without sufficient experience.

As is said, "There are no free lunches," Dr Vaclav Klaus reminds that there are no 'free' economic transitions. The 'economic transition' is a very costly process. It's an investment and usually, just like any investment has costs and benefits and the business people know that usually when you make an investment, you pay the costs first and you may get the benefits with a considerable delay. The transition from communism to a free society was an investment in some respects, and the costs were really enormous.

Also, he makes a mention of the size of the costs his country had to go through. And, according to his estimates, in his country they were lower than in other countries. In the first three years of transition they lost one third of their industrial output - one third.

As he says if we take all of the business people, two would succeed and one would collapse. They lost one quarter of their agriculture output - one quarter - and they lost one fifth of their GDP -and it was lower than in most of the countries in transition.

So in Czechoslovakia too, transition and privatisation were connected with many business failures and the one who was blamed was the government, of course, not the individuals owning and managing those firms. He tells that it became fashionable to argue that the failures were caused by unsuccessful privatisation and an insufficient legislative and institutional framework.

And, he admits, there is no doubt that both privatisation and the formation of new legislation of market accompanying institutions was as imperfect as any human activity. But the main problem, in his opinion, was that the citizens were not prepared to accept or to live with the phenomenon of a business failure, both at micro and macro level.

As to foreign help in the process of transition, he tells that sometime back he was asked to give a speech together with German economists to compare the transition and transformation of Germany in the 1950s and the Czech Republic in the 1990s.

He says it was a very interesting exercise; one of the differences was really the fact that there was huge foreign help to Germany. We didn't get it, we have really got nothing in the last ten years, and we didn't ask for it. The role of the rest of the world in this respect was really zero.

Note: This article was completed in July 2007.

Poor show

The credit for any reduction in poverty in the country goes to privatisation, de-regulation and liberalisation, not to the so called pro-poor expenditures.

Over a period of five years between 1999-2004, the government of Pakistan spent Rs.1 trillion on poverty reduction. According to the Finance Ministry, Poverty Reduction Special Programme included budgetary and non-budgetary expenditures both by the federal and provincial governments.

Now, the 'Labour Force Survey 2005' (first two quarters) reports that over the last five years, the government has spent a hefty amount of Rs.1332 billion on poverty-related and social sector programmes to help the poor and vulnerable sections of the society. The PRSP expenditures -- budgetary and non-budgetary -- during 2001-05 stood at Rs.1124 billion; the budgetary expenditures averaged 4.1 per cent of the GDP for the period. Of this, the government spent Rs.316.2 billion on pro-poor sectors exceeding the targeted Rs.278 billion by Rs.38 billion. And, by the end of the third quarter of 2005-06, Rs.250 billion had been spent on pro-poor sectors.

Both reports count and boast of gains. For example, the writers of the first report claim that increased pro-poor expenditures appear to have contributed in employment generation. As a result, the unemployment rate that was 8.3 per cent in 2001-02 declined to 7.7 per cent in 2003-2004 and to 6.5 per cent during July- December 2005.

The report claims that since 2003-2004 and till the first half of 2005-2006, 5.82 million jobs were created while the average job creation stood at 1.0-1.2 million per annum. This is quite unfounded and doubtful. One must contend whether it is pro-poor expenditures that helped reduce the unemployment rate or something else: such as de-regulation and liberalisation of the economy. In the same breath, the writers of the report say that the IT sector alone generated 114,737 jobs in 2005-2006. Obviously, the amount spent on deregulation and liberalisation does not come under pro-poor expenditures.

Further evidence strengthens the doubts about the efficacy of pro-poor expenditures in reducing poverty. The report says two sectors, education and health, absorbed half of the pro-poor budgetary expenditures. Sure, how they could generate jobs and reduce unemployment rate to the tune of 1.8 per cent. The gains, according to the report, in education sector are improvement in literacy and enrolment rates; and in that of the health sector is immunisation.

The report also tells about other programmes such as Khushal Pakistan Programme-2 (KPP-2) and Khushal Pakistan Fund (KPF) started during 2005 for poverty alleviation. The KPP-2 is a special programme that aims at initiating small development schemes with an amount of Rs.20 billion to be spent during the current fiscal year under the Public Sector Development Programme (PSDP).

Another boast of the report needs to be checked. The report claims that the percentage of population living below the poverty line, which stood at 34.46 per cent in 2000-2001, declined to 23.9 per cent in 2004-2005. In rural areas it fell to 28.10 per cent from 39.26 per cent while in urban areas from 22.69 per cent to 14.9 per cent. At the same time, it is argued that 'strong economic growth' created employment opportunities. In other words, this implies that high economic growth is a result of pro-poor expenditures.

All this is surrounded by two controversies: i) whether high economic growth trickled down or not; and, ii) whether the number of people living below the poverty line declined or not. Under the circumstances, it may safely be assumed that the relation between poverty reduction expenditures and poverty alleviation gains is not a causal one. With careful research some other factors will be found responsible both for economic growth and poverty reduction. And, surely these factors are de-nationalisation, privatisation, de-regulation and liberalisation of the economy.

Let's look for some other evidence: a report that bases itself on third-party international sources such as IMF, World Bank, world Economic Forum, Global Competitiveness Report, International Country Risk Guide, in its latest edition (Economic Freedom of the World 2006 Annual Report that is actually based on the data for 2004), awards Pakistan the following scores (out of 10; the higher the score the higher the rank and the freer the country economically):

In the area of the size of government (that includes government consumption, transfer and subsidies, government enterprises and investment, and top marginal tax rate), Pakistan's score is both improving and fluctuating: in 2000 it was 6.6; in 2001, 7.3; in 2002, 7.7; in 2003, 7.3; and in 2004, 7.2.

In the area of legal Structure and security of property rights (that includes judicial independence, impartial courts, protection of intellectual property, military interference, and integrity of legal system), Pakistan's overall score is declining: in 2000 it was 4.6; in 2001, 3.4; in 2002, 2.7; in 2003, 2.3; and in 2004, 2.5.

In the area of access to sound money (that includes growth of money supply, inflation variability, recent annual inflation, and freedom to own foreign currency), Pakistan's score is generally on the rise: in 2000 it was 6.5; in 2001, 2002, 2003, 6.8; and in 2004 6.4.

In the area of freedom to exchange with foreigners (that includes taxes on international trade, regulatory trade barriers, size of trade sector, official versus black market exchange rates, and restrictions on capital markets), Pakistan's score is steadily improving: in 2000 it was 4.2; in 2001, 4.7; in 2002 5.9; and in 2003 and 2004, 5.8.

In the area of regulation of credit, labour and business (that includes regulation of credit and labour markets, and regulation of business), Pakistan's score on the whole is improving: in 2000 it was 5.2; in 2001, 5.6; in 2002, 6.0; in 2003, 5.8; and in 2004, 6.5.

This explains the whole economic picture of Pakistan. Every Pakistani with a little economic thinking knows for sure that since the regime of General Ziaul Haq, the government in Pakistan has been on the way to denationalising the nationalised entities, privatise the state enterprise, de-regulate the state monopolisations and liberalise the economic and business activities, though with a heavy heart. Indeed, it is this process that is responsible for the reduction in poverty, not the pro-poor expenditures whether budgetary or non-budgetary. The above scores testify to this opening of Pakistani economy.

A recent research by Goldwater Institute, USA, confirms that states with low-tax and low-spending (Arizona, Colorado, Florida, Georgia, Missouri, Nebraska, Nevada, South Dakota, Tennessee and Texas) enjoyed sizable decreases in poverty rates during the 1990s, while states with high-tax and high-spending (Alaska, California, Delaware, Hawaii, Massachusetts, New Mexico, New York, Rhode Island, Vermont and Wyoming) actually suffered an increase in their levels of poverty. It concludes that decline in poverty in the 'small government' states strongly confirms the hypothesis that reduced taxes and state spending encourage the emigration of people and businesses to areas where private-sector job growth is able to flourish and become a powerful and effective anti-poverty programme. However, while taxes and business climate alone are not the only factors in reducing poverty rates, they certainly help most in the war on poverty.

A few weeks back, President General Pervez Musharraf said that he had a deep desire to help the poor people of Pakistan. He should realise that it is not a Herculean task. What you need to do, first and foremost, is to improve the functioning of the legal structure and security of the property rights; reduce the size of the government; ensure the accessibility of sound money; assure the citizens of Pakistan freedom to exchange with foreigners; and impose minimum of regulations on markets of credit and labour, and business activity.

This will restore to the people of Pakistan that confidence without which they would never be able to pursue their economic ends on their own. In simple words, people need an environment in which they are free to start a business venture, in which their earnings are safe, their property secure, their freedoms taken care of and their choice is not limited. This will bring real prosperity to them which will last for generations.

Note: This article was completed in December 2006.

Renaissance for Reforms - Introducing a new book

Here is the Introduction by the authors:

The recipe for growth is well-known. Most economists would agree that lower taxes and less regulation can encourage entrepreneurship and job creation. Yet, many governments are unwilling to introduce such reforms. An important reason is concern over a voter backlash. Jean-Claude Juncker, a likely candidate for the EU-presidency after two decades as Luxemburg’s Prime Minister, famously lamented “We all know what to do, we just don’t know how to get re-elected after we’ve done it.” Based on an analysis of 109 governments in developed countries, we would suggest that Juncker’s view is mistakenly gloomy. Although market-oriented reforms may initially meet fierce resistance, governments that introduce them are more often than not rewarded by voters.

In our new book “Renaissance for Reforms” we look at the pace and direction of reforms in 29 OECD governments between the mid-1990s and the end of 2012. We base our analysis on the Heritage and Wall Street Journal Index of Economic Freedom, which annually ranks nations according to parameters such as freedom from corruption, freedom for investments and respect for property rights.  We ask two simple questions: How did the level of economic freedom in these countries actually change according to the Index of Economic Freedom? And were the governments that reformed more often re-elected or not?  

After controlling for the levels of unemployment during the year of election and the year of possible re-election, we examine if these factors are related. In contrast to Juncker’s views, we find that the government that increased economic freedom most were also most likely to become re-elected. Perhaps even more surprising is that this trend is driven by governments on the left. 

Center-right governments that were re-elected increased economic freedom only marginally more on average compared to center-right parties that lost re-election. Governing parties on the left, which lost their bid for re-election, constitute the least reform-oriented group. Left governments that won however increased economic freedom at a 60 percent higher pace than the average center-right governments. 

For example, during Tony Blair’s first term from 1997 to 2001 the economic freedom score in the UK increased by 1.2 points. True to Tony Blair’s reputation as a champion of New Labour’s moderate policies, the economic freedom score of the country increased by 1.6 points during his second term. Based on this track-record, Labour managed to win a third election, during which Blair handed over power to his more left-leaning rival Gordon Brown. As the leadership changed, so did the direction of reform. Between 2005 and 2010 the United Kingdom’s economic freedom fell by 2.7 points. The next election was won by the conservatives. 

A commonly held view is that parties on the right introduce market reforms in order to boost growth, whilst those on the left mainly reduce economic freedom and aim to spread the wealth through welfare systems. In fact, countries that have successfully increased their levels of competitiveness have seen both sides of politics pulling in the same direction. Bob Hawke, former leader of the Australian Labor Party led his party to four consecutive victories in 1983, 1984, 1987 and 1990 based on wide ranking economic liberalizations. Paul Keating, the reformist treasurer under Hawke, took over party leadership and won a fifth victory in 1993, in an election initially thought to be unwinnable for Labor. Since then both conservative and left governments in Australia have continued on the path of market reform. The end result is more than two decades of consecutive growth. 

Similarly, Canada was in very bad shape when Paul Martin, minister of finance in the newly elected left-liberal government, took office in 1993. The government made the difficult choice of market reforms, focusing on reduced spending through action such as abolishing transport subsidies for farmers as well as market liberalizations and lower taxation. Many interest groups objected to the changes. And yet, the Canadian Liberal party won a second term in 1997. The party campaigned on the promise to continue to cut the federal deficit, thereby creating a budget surplus which would allow tax cuts as well as repayment of Canada’s national debt. After another term of reformist policies, the liberals managed to win the elections again in 2000. In 2003 Paul Martin took over the reins and won yet another re-election. Conservative governments have since built upon the same policies, transforming Canada into North America’s new free market role model. 

Why is it that governments on the left in particular can be rewarded by introducing market reforms? One explanation might be that this attracts centrist or even right-wing voters to the left. Another is that leftist government can couple market reforms with social features. A research survey by the OECD observes that when markets are opened up, competition often leads to higher employment. This tends to increase income equality, since those who would otherwise not work, or work only part-time, will raise their income. The same reforms can also help those with high productivity to raise their income compared to others, which instead will lead to higher income inequality. Hence, market liberalizations can lead to lower or higher equality, depending on which of these two factors come to dominate. There are good reasons to combine market oriented reforms with policies that strengthen the less well-off in society, such as strengthening publicly funded school programs. 

Today many governments are wary of reforms. Change is seen as unwanted in the short term, and politically difficult to implement. This can explain why some governments in particularly Southern Europe are stuck on a path to failure. A common view is that “Juncker’s curse” will doom governments that are bold enough to change the status quo by cutting government handouts or liberalizing the economy. Our analysis of recent history shows that this impression is mistaken. Change is anything but easy to introduce, but can prove popular in the long term by boosting growth and employment.  Of course, policies must always be adjusted to the particular needs of each individual country.  

Pakistan has historically relied much on trade and enterprise for its prosperity. Currently however ranks as the 126^th freest nation on the Index of Economic Freedom. The countries score is both below that of the world average and the regional average. In some areas, such as fiscal policy and government spending, Pakistan already has good conditions for a well-functioning market economy. Also business and monetary policies score high. The hinders to development are mainly found in corruption and lack of protection for private property. By strengthening market economic institutions greater wealth and job opportunities can be created for the broad public, whilst funds are generated for social programs. Such institutional changes will take time and political will to introduce. But once in place, they can influence long term competitiveness and prosperity. 

Nima Sanandaji, PhD at the Royal Institute of Technology and policy analyst.

Stefan Fölster, Professor of economics at the Royal Institute of Technology, and director of the Reform Institute.

The authors have written the new book ”Renaissance for Reforms” which is co-published by Timbro and the Institute of Economic Affairs.

Note: This was originally posted in March 2014.