Rethinking the role of private sector organisations in the process of economic change

Rethinking the role of private sector organisations in the process of economic change

Sam Choon Yin (11/2004)

Introduction

Professor Gustav Ranis was in Singapore in November 2004 and delivered several lectures to the public. Invited by the Lee Kuan Yew School of Public Policy, Professor Ranis is the Frank Altschul Professor of International Economics at Yale University and Director of the Economic Growth Centre at the same university. I had the privileged to attend two of the talks which he delivered. One was held on 10 November 2004 at the NUS University Culture Centre in which he lectured on ‘Economic Growth and Human Development’, based on his paper with Frances Stewart and Alejandro Ramirez of the same title published in the ‘World Development’ (Ranis, Stewart and Ramirez, 2000). In the paper, they tested empirically and found causal relationship between economic growth and human development (measured by infant mortality rate) while cautioning that those countries initially favouring economic growth might lapse in the vicious category (with low economic growth and human development). On the other hand, those with good human development and poor economic growth sometimes move into the virtuous category (with high human development and economic growth). As a consequence, he suggested that where choice is necessary, priority should be given to human development. Should this be the case, gradual development approach as undertaken by China may be more superior than one that is carried out in a big bang manner as in the Eastern European countries.

The other lecture was held on 18 November 2004 at the NUSS Kent Ridge Guild House. The talk was entitled ‘The Evolution of Development Thinking: Theory and Policy’, based on a paper of the same title delivered at the ‘Annual World Bank Conference on Development Economics 2004’ (ABCDE) (Ranis, 2004). It is this second lecture that I would like to focus on in this essay. In one part of his talk, he addressed the search for ‘silver bullets’ to achieve the third world development objectives. This has proven to be difficult as he pointed out, not surprisingly since the objective itself has been changing over time. For example, the use of income per capita as the key objective had been questioned by Sen and Streeten. In fact, in the 1950s and 1960s, some countries like India and Sri Lanka had turned to low unemployment and poverty rates as the key development objectives. During the 1950s, there was also the concern by development economists like Simon Kutznet about the heavy emphasis by economists and politicians on growth in gross domestic product as the developmental objective given its possibility of worsening income equality problem. With the benefit of hindsight, the prediction had not come true in some countries like Malaysia and Taiwan. In the 1970s, attention was paid to the meeting of basic needs developed by the International Labour Organisation (ILO). More recently, attention is paid to human development initiatives strengthened by the development of the United Nations’ Human Development Index (assisted by Sen). Sen’s call for inclusion of freedom, capabilities and lower infant mortality rate had assisted in the development.

There have also been numerous calls recently to increase the standards of institutional arrangements in the context of property rights enforcement, combating of corruption problem and judiciary effectiveness. Andrew MacIntyre (2001) however has argued that they are not sufficient conditions for sustainable development, citing the case of Indonesia where foreign direct investments were still forthcoming during the Suharto period despite the country’s weak institutional arrangements. The study essentially suggests that investors were blinded by the possibility of reaping short-term gains (Indonesia was after all an emerging economy at the time) despite of having to pay bribes to the Indonesian officials. Of course, poor institutional standards had shown to be incapable of achieving sustainable development for the nation, a danger that transitional economies like China may encounter if no significant efforts were put in to address the institutional problems.

Well known economists like Dani Rodrick, Paul Samuelson and Joseph Stiglitz have in recent years questioned the perceived positive impact of globalisation. Citing the Asian financial crisis case for instance, Stiglitz (2002) cautioned the approach of liberalising the financial sector too hastily and quickly, particularly before the necessary institutions are rightly set up. Instead, there are observers who have called for increasing role of the government to intervene at the right places to achieve sustainable growth. This includes its usual role of internalising market failure, providing public goods (including positive freedom like basic needs and enforcement of citizenship rights) and strengthening of the principal-agent relationships. The latter is deemed necessary because of a possible lack of the trust element to effectively align the interest of the principals with that of the agents (say between the professional managers and shareholders; board of directors and shareholders; lawyers and their clients and so on). In addition to the external conflicts, the government must resolve the potential conflicts that may exist between political leaders, bureaucracy and citizens. The business of politics is essentially to resolve such conflicts, and not ignore them.

Nevertheless, there are arguments against government intervention which should not be forgotten or tossed aside. What we want to point out in this essay is that such arguments could have been exaggerated particularly those arguments in favour of privatisation. The reason being that those problems associated with the public sector and its enterprises are also susceptible in private sector organisations. Let me explain what I mean.

 

Objectives, Budgeting and Bureaucrats

It is well known that government actions are motivated by the government’s desire to maximise net social benefit. Public sector economists define the social welfare function to include the utility functions of a majority in the society. More specifically, welfare economists like Arthur Pigou had called for the government to correct market failure to improve allocation of resources and restore equilibrium rather than to improve the nation’s economic performance (this points was made by Professor Jomo). This could be carried out by (1) implementing policies to internalise externality problems and (2) provision of public goods. In the other branch of economics, the public finance school, governments are deemed essential to provide stability in the economy, ensure efficient allocation of the nation’s scarce resources and enact appropriate redistribution policies, in what has been termed the Musgravian functions of government (Musgrave, 1959). A distinctive feature of the above is essentially the government’s ultimate role to promote sustainable development in the nation although this may end up not the case in reality. For instance, self-interested political leaders may be concerned merely about being re-elected. As a consequence, there may be a tendency for them to create short-term results potentially at the expense of long-term growth. For instance, forests may be cleared to make way for construction of factory sites for the multinational corporation claiming its essentiality to create jobs for the people. Taxes may be cut to attract such corporations while imposing financial liabilities to future generations.

William Niskanen (1971) has talked about the bureaucracies’ intention to increase their budgets for the current and subsequent years. He predicted that bureaucrats are total budget-maximising individuals. In a later paper, Niskanen modified his assumption from one where bureaucrats are interested in maximising total budget to one that maximises discretionary budget (Niskanen, 1991). The latter is referred to as the difference between total budget and the minimum cost of producing the output expected by the political authorities. This is in recognition of the fact that it is also in the interest of the bureaucrats to minimise costs associated with their works so as to enhance their chances of meeting the personal objective as defined in the utility function which include such things as pay, power, prestige, patronage, perquisites and ease of running the bureaucracy.

The implication of Niskanen’s study is that the bureaus might concentrate too excessively on capital-intensive operations to justify their demand for more funds. In addition, there may be a tendency for the bureaus to bring forward future projects to the present, again to justify the expansion of the budget size. The problem might have been magnified because it is difficult, if not impossible, to observe the outcomes of some decisions made by the bureaus. Even the voters do not have much incentive to check or monitor the behaviour of bureaucrats but preferring to be free riders instead. The sponsors on the other hand may lack the incentive to exercise their power for fear of offending the influential bureaucrats. The problem is exacerbated by the necessity of the sponsors to rely on the bureaucrats to furnish them with information about production. As a result, the latter could take advantage of this loophole and inflate the funds required. 

It is important to recognise that the problem is not exclusively applicable in the public sector. Private sector organisations are equally susceptible to the problem. Theoretically, professional managers as agents should be committed to maximising long-term value of the firm thus requiring them to work closely with the various stakeholders (this make sense since it is not possible for the firm to raise its market value if the consumers or suppliers are not happy with the firm). Unfortunately, the professional managers are often tempted to go for short-term gains even if the corresponding decisions are harmful to the company in the longer term.

Michael Jensen (2003) blames this on the budgeting process. He has pointed out that linking bonuses with budgets or targets set internally tends to reward people for lying and destroy long-term value of the firm while punishes those who genuinely care for the long-term benefit of firm. As Jensen notes, ‘Tell a manager that he or she will get a bonus when targets are realised and two things are sure to happen. First, managers will attempt to set targets that are easily reachable, and once the targets are set, they will do their best to see that the targets are met even if it damages the company to do so’ (Jensen, 2003, p. 382). Realising that the targets have not been met, managers may attempt to accelerate shipments to the customers (even if they know that the stocks would be returned the next year) and push-up revenue for the current year while attempting to move expenses from this year to the next. Such measures may be adopted even if the overall profits could be reduced for both years. It is also possible that the managers deliberately announce increment in the products’ price in the following year, not for any reason except to encourage customers to place their orders earlier so that the managers could meet their targets and obtain the promised bonuses.

The solution to the problem as Jensen suggests, is not to discard the budgeting system but to change the way people are rewarded. Bonuses in his view should be a function of actual work done and accomplishments, not work done relative to the set targets in the budgets (that is, whether the targets have been met or otherwise). The suggested solution involves encouraging the firms to reward staffs that are genuinely concerned with the long-term of the firm therefore promoting persons of higher intrinsic motivation to work while short-term materialistic ones are avoided, a practice that has long been advocated in the public sector.

Jensen also puts the blame on externally set targets in the form of overvalued equity prices (Jensen, 2004). He defines overvalued equity as one where the existing firm’s stock price is higher than its underlying value, so high that the managers cannot, except for pure luck, deliver to justify the value. There are several reasons why a firm’s equity price may be overvalued, including (1) the emergence of ‘something new’ like high-tech and telecommunication firms and internet ventures, (2) misled data furnished by the professional managers represented in the firm (they have the incentive to inflate performance measures to enjoy higher prestige, power, pay and greater ability to access cheap loans), (3) the existence of misinformed investment banks, research houses and audit firms about the future prospect of the firm, and (4) the existence of a large number of na´ve investors.

Because the Chief Executive Officers and Chief Financial Officers suffer if they cannot meet the expectations of the capital market and analysts, they may choose to manipulate the financial statements like pushing the revenue forward and/or moving expenses from the present to the future therefore leading to loss of reputation and intrinsic value of the firms that are caught doing this. This was the case for Enron, EToys and Nortel among others. Jensen illustrated his point using several examples including that of Enron, which as estimated, had been overvalued by US$40 bullion (the market value was believed to have peaked at US$70 billion when the company was worth US$30 billion). Obviously, the managers could have corrected or reduced market’s expectation about the firm’s value or reset the company’s value through legitimate means (as what Warren Buffet had done in his letter to Berkshire shareholders). Instead, they chose to manipulate the accounting information and hide its debts through off balance sheet partnerships.  Essentially, the above illustrates the possibility of ‘bureaucrats’ (agents) to maximise budgets regardless of whether they are represented in the public sector or private sector organisations. Claming this to be an exclusive problem in the former is in my view exaggerated.

 

Libertarian, Public Choice and Corruption

            Let me move on to the arguments against increasing role of the government put forward by the Libertarians like Milton Friedman and Frederick von Hayek. The Libertarians have constantly challenged the increasing role of government, claiming that the government’s existence may pose restrictions to individual’s freedom to make decisions. It is deceiving as they claim to focus too exclusively on the ends arising from government intervention, which may appear very appealing and positive (maximising of social welfare). The means of attaining this objective should not be ignored. If individuals’ freedom to choose is restricted due to government regulations and bureaucratic decision-making, the potential expansion of the economy may be limited. However, this argument may have been too strictly applied in the context of public sector governance. Freedom to choose is never realised in the real world, not in public sector corporations nor private sector organisations. Choices are often influenced and to some extent restricted by culture, religion, family values, absence of the trust element and corporate norms in addition to regulations imposed by the government. All these have an effect on the principal-agent relationship implying that the agency problem is susceptible both in the public sector and private sector organisations.

            Proponents of the Public Choice Theory like James Buchanan, Gordon Tullock and William Niskanen have suggested that the agency problem is very much applicable in the public sector. In their seminal work ‘The Calculus of Consent’, Buchanan and Tullock concluded that public officers could be self-interested individuals just like anyone else. They may be involved in making decisions that benefit themselves rather than the principals (or public) whom they are supposed to represent (Buchanan and Tullock, 1962). Engaging in acts of corruption (like bribery, extortions, cronyism and nepotism) is common among public officers to reward themselves more than what they actually deserve. Of course, the ideal case is to recruit individuals who genuinely enjoy serving the public, the old and poor, in which case, minimal incentives are required to motivate them. In reality however, observing the true interest and personality of public officers is not possible thus requiring the principals to provide monetary incentives and impose monitoring mechanisms to manage the behaviour of the agents (public officers and bureaucrats). Mitigating the corruption problem usually involves a combination of opportunity-reducing and incentive-reducing strategies. The former includes measures to deregulate the industries, privatise public enterprises, leverage on technology advancement (like the use of electronic tax-filing system), and raise the penalty costs and the perceived probability of catching the offenders. Reducing the incentives for corruption may require the government to pay competitive salaries to public officers to a level that is at least comparable to their counterparts in the private sector.

            One should recognise that the corruption problem is not limited to the public sector. It is also a common phenomenon in private sector organisations since powerful entrepreneurs in the US like Vanderbilt, Rockefeller, Morgan and Harriman handed over their control to ‘outsiders’ thus broadening the ownership. But there is no guarantee that the managers, as agents, would make decisions that benefit the owners. Consider the following. Often, the managers are able to offer contracts to someone close to them without going through the formal or proper procedures. In banks, managers may offer loans to a friend or relative without proper checks on his/her credit worthiness thus subjecting the banks to unwanted but minimisable risk. With respect to procurement, it is possible for a manager to purchase materials at a higher price because he/she has received bribes from the seller. It is also possible for a manager to travel excessively and furnish his/her room with unnecessary electronic gadgets instead of returning excess cash to the shareholders. More seriously perhaps is the act of manipulating company financial statements like hiding liabilities and inflating profits to reward managers more than what they actually deserve no thanks to executive compensation schemes which increasingly link managers’ compensation with company performance.

The above are some of the common acts of corruption that can take place in a typical private sector organisation, and the causes are very much similar to what has been postulated by the Public Choice Theory. Like the public sector, the persons-in-charged of private sector organisations may be self-interested who care merely about his/her personal interest, rather than that of the shareholders. But when improper acts are discovered, the stakeholders would eventually have to pay the price. The notion of passing the control power of enterprises from the public sector to private sector (under the banner ‘privatisation’) should be seriously reconsidered for it may not yield the intended results due to the problems described above with respect to corruption in private sector led organisations.

 

Conclusion

            What are the implications derived from our discussion so far? First, in view of the increasing corporate scandals erupting around the world, it may be useful for private sector organisations to emulate some of the good practices in the public sector. While one should not dismiss the fact that improvements in the public sector has been attributed to the transfer of private sector management practices to the public sector (Dopson and Stewart, 1990), a reverse on the emphasis should be seriously considered. Second, while much have been written about privatisation, the intended benefits of privatisation would not be forthcoming if the problems alluded in this paper are not sufficiently addressed. These concerns are often associated with public sector enterprises but as this paper has illuminated, they are equally applicable to organisations which were privately owned.            

 

References

 1.                  Buchanan, James and Gordon Tullock, 1962, The Calculus of Consent, University of Michigan, Ann Arbor.

2.                  Dopson, Sue and Rosemary Stewart, Public and Private Sector Management: the case for a wider debate, Public Money and Management, Spring, pp. 37-40.

            3.                  Jensen, Michael, 2003, Paying People to Lie: The Truth about the Budgeting Process, European Financial Management, Vol. 9, No. 3, pp.: 379-406.

4.                  Jensen, Michael, 2004, Agency Costs of Overvalued Equity, Negotiations, Organisations and Markets (NOM) Working Paper No. 04-26, and European Corporate Governance Institute (ECGI) Working Paper No. 39/2004 (May).

5.                  Jensen, Michael and Kevin Murphy (with the assistance of Eric Wruck), 2004, Remuneration: Where we’ve been, how we got here, what are the problems, and how to fix them, Organisations and Markets (NOM) Working Paper No. 04-28.

            6.                  MacIntyre, Andrew, 2003, The Power of Institutions: Political Architecture and Governance, Cornell University Press, US.

7.                  Musgrave, Richard, 1959, The Theory of Public Finance: A Study in Public Economy, McGraw Hill, New York.

8.                  Niskanen, William, 1971, Bureaucracy and Representative Government, Aldine Atherton, Chicago.

9.                  Niskanen, William, 1991, A Reflection on Bureaucracy and Representative Government, in Andre Blais and Stephane Dion (editors) The Budget Maximising Bureaucrat: Appraisals and Evidence, University of Pittsburgh.

            10.              Ranis, Gustav; Frances Stewart and Alejandro Ramirez, 2000, Economic Growth and Human Development, World Development, Vol. 28, No. 2, pp. 197-219.

11.              Ranis, Gustav, 2004, The Evolution of Development Thinking: Theory and Policy, paper prepared for the Annual World Bank Conference on Development Economics, Washington, D.C. May 3-4, 2004.

            12.              Stiglitz, Joseph, 2002, Globalization and its Discontents, Allen Lane/Penguin Books, Great Britain.