ECONOMIC RATIONALISM

 

DRAWING THE LINE BETWEEN PUBLIC AND PRIVATE SECTORS

 

by Des  Moore

Director, Institute for Private Enterprise

 

Address to Brighton Rotary

 9th March 2000

Introduction

I have chosen this rather controversial subject to talk to you about partly because I sometimes find that when I admit to being an economic rationalist the reaction is tantamount to admitting that I beat my wife! My initial instinct is then to find a weak excuse to explain why I am sinning - like the guy who explained on his insurance claim form the cause of his accident as

 

• " The guy was all over the road. I had to swerve a number of times before I hit him"

or

 

• "Windscreen broken. Cause unknown. Probably Voodoo."

 

Indeed, for some people economic rationalism (ER) is a form of magic being preached by a way out religious group that has little understanding of how society should function in practice.  By the same token, these Voodoo-accusers only rarely appear to understand what ER is about.

 

I feel sure there are no Voodoo-accusers here. But I would be surprised if there are not at least some misunderstandings about ER.

 

Some Reasons for Misunderstandings

 

Many would say that there are good reasons why people misunderstand ER

 

First, there is no text setting it out in terms that the layman might understand.  A book defending ER was published in 1993, and it contained supportive essays from a wide range of authors, including Nick Greiner, NSW trade unionist Michael Costa and the Reverend Warren Clarnette.[1] That book did not present a coherent overall picture, however. There have also been critiques of ER but these have generally served only to emphasise the poor understanding of the issues.[2] 

 

If an ER text was available it could help to correct some common misconceptions about the effects of economic change and the capacity of people to adjust to change. One such misconception is that, when policy changes have unfavourable initial effects on employment and incomes in a particular industry, that is all that happens. In reality, there are second and third round favourable effects that usually more than offset those initial effects. Reductions in protection of some manufacturing industries, for example, encourage other industries to expand because of the consequent reduction in their costs and the lowering of prices that consumers have to pay.

In fact, living standards have continued to grow quite strongly in the wake of reductions in manufacturing protection, just as they have despite the enormous reduction in the importance of the rural sector over the past fifty years. If anyone had predicted in 1950 that employment in agriculture would be lower in 2000 despite the population more than doubling, they would either have been called mad or, if believed, there would have been calls for "the government" to do something about the likelihood of mass unemployment.[3]

 

Of course, those businesses and employees who are directly in the firing line of such changes experience adverse effects that are often regarded as "unfair". But, if their industries can no longer make a go of it without subsidies of one kind or another, it scarcely seems equitable for others to sacrifice their living standards to help them. Is it equitable, for example, for wharfies to continue to be paid higher wages than they would receive under competitive conditions, resulting in higher prices being paid by others? In some cases, temporary transitional assistance may be justified but the social security system should be the normal method of providing such help.

 

As ER is based on the general idea of economic liberalism, and as there is an extensive literature on that subject, it might be thought that that literature would explain ER. In fact is has only limited relevance to the policy specifics that arouse the antagonism to ER.

 

Indeed, it is differences about policy specifics that are the second cause of misunderstanding about ER. Once you move away from general theory and get down to the nitty-gritty of policy specifics[4], even those who think of themselves as economic rationalist will have disagreements. A current example relates to monetary policy. Economic rationalists support the objective of monetary policy as being to keep inflation low but they disagree about the timing and extent of changes in interest rates that is needed to achieve that.

 

A similar confusion arises about the specifics of policies pursued during the 1980s. The policies of financial deregulation and reductions in protection adopted by Labor during that period were correctly described as ER and that led to ER getting a bad name because many people believed (and still believe) that those policies were the cause of the major recession at the start of the 1990s.[5] I have rebutted those beliefs in the 1993 book already mentioned and I do not want to do more here than assert that the underlying cause of the recession of the early 1990s was not ER policies but the interventionist monetary and/or budgetary policies which Labor pursued during the 1980s. Those policies maintained inflation at a rate that encouraged speculative investment and created a boom-bust situation. Mr Keating was correct in one sense when he said that it was "the recession we had to have" but he forgot to add "because of our faulty budgetary and monetary policies." 

 

The incorrect identification of ER policies with the 1990s recession is typical of the tendency for critics to portray a wider range of policies as economic rationalist than is the case. To some extent this is understandable. It is not unusual to experience difficulty in identifying what some groups with supposedly similar views actually stand for.

 

On the left side of Australian politics, for example, we currently find at one end Blair type third-wayers such as Federal Labor MHR Mark Latham, who wrote recently in the Financial Review that "the state's mandate for social service provision and funding is under siege" as a "growing number of self-reliant citizens are eager to look beyond the institutions of government to satisfy their interests"[6]. At the other end Latham is keeping company  with old style hard-left advocates of social and economic planning, such as Doug Cameron of the AMWU who recently called on Kim Beazley to "wake up to the turning tide of public opinion against free trade." And then we have Mr Beazley himself whose philosophy and policies both seem to be something of a mystery.

 

Then again the Financial Review recently headed an article describing the election outcome in Chile as "Free Market Leftist to Lead Chile" - a quite remarkable outcome really, particularly as the new Chilean President was elected despite being an economist and despite having been educated at an American University! It was an outcome that would be most unlikely in Australia.

 

However, that heading was not as off beam as might appear at first sight.  Sam Brittan, who was for many years the economics correspondent of the London Financial Times, once correctly pointed out that those on the right of the Labor party and the left of the Conservative party tend to support economic liberalism while those on the right of the Conservative Party and the left of the Labor Party tend to oppose it.

 

Accordingly, it is probably fair to say that support for economic rationalist policies, or at least some economic rationalist policies, cuts across party lines. There is certainly a goodly proportion on the right of politics who oppose them, mainly because economic rationalists support change, often quite radical change, and conservatives usually favour gradual or no change.

 

A third cause of potential confusion about ER is that the issue is not simply one of economists versus non-economists. It is true that economic theory generally favours allowing markets and competition to operate with minimal interference and government regulation. But there are also many theoretical arguments in economics that, particularly when considered on their own, qualify this general idea and support government intervention. These theories have led many inventive professional economists (and others) to advance proposals for such intervention on the ground that it will improve either the functioning of markets or the welfare of the community, or both.

 

Cynics might say that economists have to come up with interventionist proposals which purport to improve welfare: if there was general agreement that markets should largely be left to their own devices there would be precious little for economists to do or to argue about! A case can thus be made that there exists something of a mutually supportive "economists club" arguing for more government intervention.

 

But there is more than economists' self-preservation involved here. Many economists have a firmly rooted belief in the need for more extensive government intervention, particularly to help lower income groups. Indeed, particularly in Australia there is something bordering on an obsession amongst a substantial group of economists that governments need to intervene to improve the "fairness" of society by reducing inequalities in income. This reflects the supposed Australian egalitarianism and the notion of giving everyone a "fair go." The net result is that economic rationalists are almost certainly in a minority in the economics profession in Australia.[7]

 

A fourth source of misunderstanding is that many opponents of ER deliberately misrepresent the kind of society that would result from the adoption of economic rationalist policies. A typical misrepresentation is that economic rationalists want a completely laissez- faire economy in which there is no government intervention and the devil take the hindmost. While this is a stupid characterisation it does influence the views of some. 

 

The Case for a Minimal Role for Government

 

This brings me to the mainstream of ER and its motivation. The essence is that  governments should play only a minimal role in regulating both the economy and society and that their existing role is excessive. I will come back in a moment to what might constitute a "minimal" role and where the line might be drawn between the government and private sectors.

 

Before I do, I should indicate the main justifications for government having such a role.

 

First, while some theoretical arguments advanced for government intervention appear sound when taken on their own, they often fail to take account of the intrinsic practical difficulties of a third party (the government) producing good outcomes by intervening to influence what others do, or by trying to run businesses themselves. They particularly fail to take account of the difficulty of assessing how people may react to government policy changes in economies that are themselves constantly changing. Governments also tend to be excessively influenced by lobby groups and to make decisions in the interests of such lobby groups rather than the community as a whole. They frequently try to get elected by vote-buying through promises to build unnecessary dams or such like.

 

Thus economic rationalists (and others) have identified a phenomenon characterised as government failure. This phenomenon has emerged less from new theoretical developments[8] than from practical experience with the operation of government policies. Nor does it deny that there are failures in the private sector. But such failures do not normally impinge on the general taxpayer and the operation of competitive markets usually provides an automatic corrective mechanism. Moreover, the private sector has a built-in incentive not to waste resources because efficient operations usually mean profitable operations.

 

The most striking example of government failure has been the mess produced by the attempts at economic planning in Eastern Europe and the old Soviet Union, leading to the collapse of communism as the realisation dawned amongst even those in power in those countries that they were missing out badly in terms of living standards. It was the Russians' ability to laugh at themselves and the government that really kept them going. Their joke portrayed Boris as a pessimist when he said "Russia has become such hell and everything is so bad that it couldn't get worse" and Ivanov as an optimist when he responded "it will, it surely will."

 

The privatisation movement started by Margaret Thatcher was another reaction to government failure, reflected in the very poor results produced by government enterprises, not only in financial and economic terms but also in the delivery of quality services to consumers. The privatisation movement has now spread around the world, with Australia a relatively late starter and still struggling to handle the lobby groups that seek to retain special treatment often disguised by public enterprises. 

 

It is relevant to recall that probably the most important boost to government interventionism came as a result of the recession of the 1930s.  Many saw that as reflecting a fundamental flaw in capitalism requiring government intervention to prevent inevitable wild fluctuations in markets and to smooth out the fluctuations in the business cycle. Keynes wrote his famous General Theory in 1936 in the midst of the recession and for a time most governments and academics around the world became disciples of Keynesian policies. Such policies were supposed to correct for market failure and, from them, developed the theory that governments could trade-off inflation and unemployment by varying the budget deficit to offset spending changes in the private sector.

 

But many economists have in recent years concluded that there were major errors in government policies during the 1930s recession and there is increasing questioning of how well Keynesian policies have actually worked subsequently. I cannot here do more than make two points.

 

First, the current Australian Government's official policy is not to try to adjust the Budget deficit to offset swings in the private sector and that is pretty much accepted bipartisan policy at both the Federal and State Government levels. It is also now widely, though not universally, accepted amongst overseas governments and international economic organisations.

 

Second, at last year's Conference of Economists two prominent overseas economists told their audiences that Keynesian theory itself is outdated[9] and one even claimed that a "huge amount" of inflation cannot be explained by economic theory. That confirmed the conclusion reached by many of those who, like myself, did "the hard yards" in Treasuries, that is, that successful attempts by government to manipulate demand to correct for market failure are more likely to be the result of good luck than good management. It is acknowledged amongst even today's apparently sophisticated economic modellers that it is difficult to identify major turning points in business cycles - and, if you can't do that with confidence, it is difficult to justify government intervention to correct for the outcomes of such turnings.

 

This does not mean that all governments and all economists have given up on advocating or pursuing Keynesian policies. But, while there remains a not inconsiderable body of true believers, the balance has shifted against reliance on a theory which emerged during a major recession and whose application in practice has left much to be desired. ER has had a substantial victory here.

 

The second main justification for giving government a minimal role is that there is a strong case for allowing individuals freedom to make their own decisions and pursue their own interests unless in doing so they harm others. That case is enhanced

by the increase in education. Educated people can generally be expected to act more responsibly but, even more importantly, education increases the capacity of individuals to look after themselves and to be held accountable for their actions and decisions. Moreover, higher education standard combined with higher living standards inevitably mean that individual members of the community want to be able to choose the life style they lead, and are increasingly doing so. Governments continue to have an important role in restraining the impact of some life style choices  on others. But individuals are increasingly reluctant to pay taxes that restrict their choices unless they are convinced that governments are putting those taxes to good use.

 

ER values individual freedom as a precious commodity that should not lightly be impinged upon by governments that claim to be better able to make decisions for us. Yet it is ironic that economic rationalists are sometimes characterised as "right wing" or even "fascist" while those who support more government and more restrictions on individual freedom often somehow manage to get away with portraying themselves as the good guys who are the only true democrats.

 

Drawing the Line Between Private and Public Sectors

 

So, where do economic rationalists draw the line between allowing free play of market forces and individual decision-making, on the one hand, and having the government intervene on the other?

 

In reality, there is no clearly defined line, as will be clear if I turn to one or two specific policy issues. We may be able to pursue other issues in question time.

 

Redistribution of Incomes, Taxation and Social Welfare

 

The issue of what is and what is not a "fair" distribution of income is probably where most disagreement occurs. Interventionists argue, for example, that greater redistribution  is justified because those on low incomes get more satisfaction or utility from spending an extra dollar than do those on high incomes. However, pursuit of such an approach would lead logically to attempts to equalise all incomes - a sure recipe for revolution!

 

By contrast, while economic rationalists fully agree that governments should assist those who are on low incomes and/or are disadvantaged because of some incapacity, they are also concerned at the many adverse effects that can and do arise from the redistributive process.  This means that, although they agree that governments are justified in taxing higher income groups more than others - and then redistributing those taxes via social security benefits such as old age and disability pensions and unemployment benefits - they want to confine any net redistribution to those who are genuinely disadvantaged.

 

Economic rationalists point out that the proportion of the population receiving benefits seems to be on a continuing upward path and that this is occurring even though living standards are increasing, which should logically cause the proportion needing benefits to be falling. For example, between 1978 and 1998 the proportion of the working age population receiving benefits increased from 10 to 18 per cent, and now involves 2.6 million people. Moreover, the greater part of this increase has not been due to higher unemployment.

 

Why is this happening?  The principal reason is that political parties have indulged in vote buying - they have made it easier to obtain such benefits, thereby in the process actually extending them to middle and upper income groups. If we count in education and health benefits, something over $20 billion per annum is paid to such groups.

 

You might ask whether this matters. After all, if the higher income groups are in a sense simply getting their taxes back, it might appear that no harm is being done. This overlooks, however, the disincentive effects from both higher than necessary taxation and from the benefits themselves. If people are having costs met by governments that they could afford to meet themselves, then they are likely to work less and to save less. Either way the national income is less: there is less cake to be distributed.

 

Economic rationalists also point out that advocates of greater redistribution to help "the poor" often base their case on incorrect facts. For example, such advocates are frequently reported as lamenting the increase in inequality of incomes since the early 1980s - which they naturally attribute to the alleged application of economic rationalist policies. In fact, there has been no increase in income inequality over this period - the rich have been getting richer but so too have the poor.

 

Moreover, it is usually overlooked that most of those who were poor in the early 1980s have by now either moved up the income scale or had their incomes increased.[10] Of course, a small proportion of the population will always remain stuck at the bottom of the pile - but that is what the social security system should be used for, not as vote buying mechanism or an outlet for those who like to parade their social consciences in public.

 

It is also relevant that poverty "means different things to different people".[11] As a matter of common sense observation it is surely difficult to believe that nearly 20 per cent of the Australian population live in "poverty". Yet the definition most commonly used in Australia produces that result by drawing the poverty line for a family of two adults and two teenage children at (in 1996) a net income of nearly $26,000 a year.[12]  That is not a large income but nor could it seriously be regarded as leaving the family in difficulty in paying for the basic necessities of food and shelter.

 

The regular updating of this poverty line to take account of changes in living costs also means that the proportion said to be living in poverty stays much the same. Poverty has therefore become a relative concept, defined by reference to the proportion whose incomes are at the bottom end of the income scale at any particular point in time. This definition is maintained even though those incomes may be increasing in real terms and even though, as noted, many move up the income scale. 

 

So, where do we end up on the appropriate extent of income redistribution and social welfare? The answer is that there is no simple answer. What ER tells us is that it is difficult to justify the present extent of social welfare on either economic or social grounds and that  "the poor" are defined so widely, and without proper regard to their future prospects, as to undermine the case for more assistance for that group as currently defined.

 

Privatisation, Competition and Monopolies

 

The support by economic rationalists of privatisation is another source of antagonism, arousing particular resentment at sales of assets that are said to "belong to the people" and to provide "essential services." But, if the people own assets, their elected representatives should be able to sell them, just as those representatives borrowed the people's capital to buy or build them in the first place.

Critics need to ask themselves why there has been no significant reversal of the over 15,000 privatisations world-wide in recent years, including under Labour in the UK. Indeed, The Age recently reported a visiting Minister of the Blair Government as stating that he had no hesitation in leaving major essential services in the hands of private owners. It also quoted him as saying "Quite the opposite. We pushed on with it. I opened up the energy consumer market and there are now 143 companies operating at the retail end. It's added a whole new dimension to economic initiative and new business in Britain."[13]

 

That sums it up quite well. The essential case for privatisation is not the commonly portrayed one that it provides funds to reduce government debt. Rather, it is that the private sector generally operates enterprises more efficiently and provides a better quality service, partly because it faces competition of various kinds and partly because, having had to pay for the assets, private owners naturally want  to make them work profitably.

 

Critics often make the point that efficiency isn't everything and that governments have a responsibility to ensure that every citizen has direct access to "basic" services, such as electricity, water, and phone. However, that argument itself has little substance. Governments nowadays rightly play little or no role in ensuring direct access to  "basic" services such as food or clothes and those on low incomes are provided through the social security system with the purchasing power needed to allow the basics to be obtained.

 

Even where a political decision is made to provide special assistance to low income and other groups directly geared to a particular service, it is still best to leave the private sector to operate the service on a commercial basis. The government can provide a special subsidy through the budget, as is done by way of subsidies to pensioners for electricity and transport, and to rural phone users.

 

Unfortunately, in response to various lobby groups governments are spreading these "special" subsidies in the same way as they have with social welfare benefits. The special subsidies for phone services in rural areas have probably already wiped out the benefits from the part-privatisation of Telstra, for example[14]. Again, in Victoria it appears that, when electricity enterprises start next year to compete for household business, they will be required to operate a uniform tariff across the State despite geographic differences in the cost of providing electricity. It is difficult to see any justification for such special subsidies.

 

Hostility also sometimes arises to privatisation, or to requirements that public enterprises operate more as businesses, when this leads to an increase in charges for a service. It naturally seems strange that moves designed to improve efficiency could lead to increased prices. This is what happened when water services were privatised in the UK and it is has been happening to water charges in some rural parts of Victoria.

 

The explanation is that the increase in prices occurs because the public enterprise was under-charging. This not only resulted in economic waste because of over-use but it was also inequitable - why should users of, say, country water supplies receive it at subsidised prices? In the UK the under-charging also led to the provision of poor quality water because the enterprises were making insufficient profits to finance the investment needed to keep the quality up.

 

Concerns are also sometimes expressed at the potential for private sector monopolies to develop, resulting in exploitation of consumers. While such concerns often take inadequate account of the availability of competitive forces, this is an area where economic rationalists again have no in principle difficulty in supporting government intervention to protect consumers.

 

Environment and Education

 

The areas of environment and education provide further examples of the ready in principle acceptance by economic rationalists of the need for government intervention to protect or enhance the welfare of the community. The basic logic here is that, in certain circumstances,  "externalities" arise if governments intervene. That is, any costs imposed on individuals arising from the intervention are judged to be outweighed by the benefits that accrue to the community at large.

 

Thus, government intervention to regulate and control the level of pollution is  appropriate because individual  factory or car owners have no economic incentive to limit the extent to which they emit pollutants and there would otherwise be excessive pollution. This is a clear example of where the market fails. Similarly, government intervention to ensure that the community is well educated by providing free and compulsory primary and secondary education is accepted as providing net "spin-off" benefits both economically and socially because everyone benefits from having a more educated community.

 

However, as with other areas of government intervention, economic rationalists argue that there is a limit beyond which intervention should not go. In the case of higher education, for example, the individual has ample incentive to invest in educating him or her self because graduates generally earn higher salaries. Accordingly, ER tells us that government assistance for higher education should be more limited.  ER also favours having privately run universities and does not accept that this would result in a lowering of standards.[15]

 

Conclusion

 

I  have tried to make it clear that, although  ER favours a minimal role for government, there are quite a few areas where it supports government intervention on either economic or social grounds, or both. In the time available I have not been able to outline all areas where there may be a case for intervention nor  have I been able to delve far into the detail of where lines should be drawn.

 

However, I hope that it is now reasonably clear that the basis of ER is both practical and theoretical - practical in that the private sector is generally more efficient and is also more concerned to satisfy consumers and theoretical in that individual freedom  to make decisions should be constrained to the minimum possible extent.

 

It is also important to recognise that ER is not simply about economic efficiency. Where to draw the line between the government and private sectors involves value judgements about what is and what is not equitable, as well as whether the outcome is likely to improve the country's national income. This comes out most clearly in considering the appropriate extent of income redistribution but government intervention on other policy issues raises important equity issues on which different value judgements will be made.

 

What ER tells us is to be innately suspicious of arguments for intervention because all too many cases those pushing the interventionist arguments are pushing either their own barrows or some barrow that reflects their own interventionist  view of how the world should be organised. History alone tells us that we should avoid jumping on to such barrows and tread our own paths.