Optimal Privatization for Gaining Political Support

von Furstenberg, George M. Article Optimal Privatization for Gaining Political Support Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: von Furstenberg, George M. (1991) : Optimal Privatization for Gaining Political Support, Kredit und Kapital, ISSN 0023-4591, Duncker & Humblot, Berlin, Vol. 24, Iss. 2, pp. 147-174, https://doi.org/10.3790/ccm.24.2.147 This Version is available at: https://hdl.handle.net/10419/293195 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Pareto-Optimal Privatization for Gaining Political Support By George M. von Furstenberg*, Bloomington/Indiana That system wich evolved over decades was really a kind of vice, was really a kind of cramp on our entire economy, and it made impossible any initiative, any decision-making at various levels, and therefore we had to try and dismantle that command system ... [W]e see that if that process takes too much time, it can create the kind of instability and the kind of implications that will disorganize our entire society. Mikhail Gorbachev speaking to Congressional leaders at the Soviet embassy in Washington, June 1, 1990. I. Introduction Privatization with a grant component could well become highly attractive politically once ideological barriers have fallen. Then the main problem might be how to restrain popular demands for immediate privatization on concessional terms. In reality, however, no such restraint has proved necessary, and privatization has been more curse than blessing for politicians. It * The author, who is Rudy Professor of Economics at Indiana University, was a Visiting Senior Economist with the U.S. Department of State's Planning and Economic Analysis Staff when this paper was written. There his work on privatization and Eastern Europe was stimulated and encouraged particularly by Eugene J. McAllister, William G. Dewald, and, most immediately, by prior work by and with Richard English. He also acknowledges the many useful comments received in the panel discussion on "Privatizing Socialist Economies" conducted on June 30, 1990 in San Diego at a session of the Western Economic Association organized by Dewald and chaired by Gordon Tullock. Comments by Michael Ulan of the U.S. Department of State also have helped improve earlier drafts, but the State Department and the U.S. Government are not responsible for the views expressed. The author has benefitted from conversations with Peter F. Schaefer of the Agency for International Development, Alan Gelb, John Nellis, and Fernando Saldanha of the World Bank, and Edward A. Nassim of the International Finance Corporation, as well as from the brown-bag Seminars on Privatization, organized by Dewald at the State Department. To these and to other persons, whose work is mentioned in the references, he wishes to express his sincere thanks without holding them responsible for any errors remaining in this work. Author's address: Department of Economics, Indiana University, Bloomington, IN, 47405, USA; Phone: (812) 855-4764, FAX: (812) 855-5678. 11 Kredit und Kapital 2/1991 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 148 George M. von Furstenberg has been assailed in a number of countries and met with widespread resistance in spite of mounting evidence of the failure of government as producer and director of economic development. Because it has proved hard to make privatizations proceed on a large scale, political obstacles to the process will be considered in this paper together with its economic promise. II. Recent Approaches to Privatization in East and West There are powerful stakeholders in the system of socialized industry who - as subsidized customers, privileged workers, sheltered managers, or political patrons - favor the maintenance of the status quo. To characterize the situation, not only in Central Europe, Kornai (1990b, p. 141), for instance, has offered the understatement that "neither the bureaucrats, nor the managers, nor indeed the workers [are] enthusiastic adherents of competition or of the marketization of state-owned assets." Not surprisingly, therefore, in some countries, like Argentina, it has proved difficult to make privatizations stick. In others, like in Hungary and Turkey, the process has been interrupted and redirected repeatedly, as yet preventing any pervasive transformation. Even where privatization has been relatively far-reaching, clean, and swift, like in Chile, it has not been viewed as an unqualified success (see Nankani, 1988, pp. 17-45; Yotopoulos, 1989). Particularly in countries whose capital markets are barely developed, privatizations frequently have been discredited by rewarding insider groups. From A to Z, Algeria to Zambia, countries have found it a daunting task to make privatization a popular cause and to avoid political recriminations. There are, of course, a few exceptional cases, such as the United Kingdom and New Zealand, in which privatization has proceeded steadily with broad political support during the past decade. Generally, however, while socialization has often been precipitate and radical, privatization has been hesitant and partial. The purpose of this paper is to establish and apply standards that would move the process along by making it preferred, by almost all the residents of a country, to staying put. Privatization and demonopolization of the bulk of socialist industry are necessary for the development of efficient markets and high-quality products. As in Hemming and Mansoor (1988), the only form of privatization considered here involves the transfer of ownership of public enterprises to the private sector and not such other modalities as the contracting-out of public services to private firms. Starting from socialist economy, this transfer of ownership is a precondition for depoliticizing, deregulating, and demonopolizing economic decision-making. It involves openOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 149 ing up to the world market to let firms discover and seize technological and trade opportunities without the state's rigging. Although privatization does not, by itself, guarantee any of these economic benefits as Yarrow (1989) has shown for the United Kingdom, it makes efficiency gains highly likely, thereby giving it a wealth-creating effect. De Soto (1989) has given a stunning demonstration that freedom of entry and legal security - protected through low-cost licensing and the granting of clear ownership titles together with equal access to offices and courts and impartial and effective law enforcement - must accompany the institution of property rights to make activities relying on such rights universally available and socially productive. Property rights must confer substantial freedom of disposition and establish private responsibility for the consequences of exercising that freedom in terms of profit or loss. Hence the substance of these rights is inversely related to the degree of regulation, "social" imposition and prohibition, and capital and capital-income taxation. Yet while the content of property rights is not guaranteed by having formal title, privatization remains the essential condition necessary for greater efficiency and development. As the Blue Ribbon Commission (1990, pp. 21 - 22) has pointed out, there are good reasons to expect private enterprise, subject to competition and the rule of law, to improve productive, allocative, and innovative efficiency. 1. Speed is Essential for Success There are at least two dangers associated with moving slowly or just waiting patiently under "bypass" strategies for the public sector to be eclipsed by the emergence of a private sector and its internal growth. First the clout and blocking powers wielded by the government through control of its enterprises and the political network that supports them remain formidable and discourage private entry. Second, even after the disciplines and rituals of command economy have been abandoned, government enterprises still operate at social risk and cost, rather than at profit and loss, until they are privatized. The rewards of managers thus continue to be filtered through the political rather than economic process and are not directed toward enhancing the efficiency of current or future operations. Instead, connivance by insiders and political appointees may gut the substance of government enterprises. Leaving socialist industry in limbo thus does not seem to be wise. Rather, both old and new managements of government enterprises should be energized by the certain prospect of privatization and compete for a place in the new order as they did in the United Kingdom once their mandate and authority had been firmly established (Walters, 1989, pp. 197 - 199). n OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 150 George M. von Furstenberg Conditions and concerns that may apply to industrial privatizations at the fringes of highly-developed market economies need not be appropriate for the privatization of socialist economies. Yarrow (1990, pp. 19-21) recognizes this difference when he advises tipping the balance of the arguments toward faster privatization in Eastern Europe although he had questioned "preoccupation with ensuring a rapid transfer of ownership" (1989, p. 343) earlier in Britain. Hinds (1990b, pp. 4-5) also comments on the difference between privatization in the United Kingdom and in Central Europe and puts a premium on speed for the latter. Lindbeck (1990, p. 3) argues that large-scale privatization and supporting reforms have to "move fast and without hesitation so that private property rights become credible. Only then can a proper incentive structure for private ownership be created, with confidence in the private sector about future property rights and favorable working conditions for private firms" (emphasis in original). Apparently favoring a much more gradual approach, Kornai (1990a) has advised Eastern and Central European countries to be prepared for "a lengthy period of coexistence" (p. 101) during which "the tiny isles of the private sector are surrounded by an ocean of state-owned firms" (p. 59). He further cautions that "the sale of state property should not be governed by the guiding principle of speed" (p. 93) and that state property should change hands only "at a real market price" (p. 83). This paper, by contrast, deals with the possibilities for creating a political dynamic that helps push government enterprises onto the market and lets restructuring proceed without waiting for definitive revelation of the "real market price" to be charged for their assets. For state agencies to spend much time on precise valuation and then to hold out for a price equal to appraised value may be a losing proposition: The value of socialist enterprises is likely to dissipate rapidly in factor and product markets that have opened-up to the world. To be able to privatize quickly, however, any government that depends on the consent of the governed needs political cover. This paper, therefore, tries to set up some standards (section III) that a program should meet to garner the broad-based political support necessary for rapid privatization. It also shows how these standards apply in privatizing publicly-owned housing of fairly certain value (section IV) and socialist industry of uncertain value (section V) before concluding this study in political economy (section VI). The conviction underlying much of the discussion that follows is that when the basic economic structures of a society have become discredited and living standards have plummeted, efficiency-enhancing measures can OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 151 gain broad political support. Indeed, mobilizing the general interest against the insiders of the dilapidating regime may be a precondition for discovering economic opportunities and getting onto a path of efficient development. In this way, greater political and economic equality can be the engines of transition to a more efficient regime: equality and efficiency need not be "the big tradeoff" (Okun, 1975; see also Barr, 1987, and Winfield, 1988) they normally pose in established regimes. The remainder of this introduction touches on the social ethics involved in mobilizing broad political support for privatization and explains the concept of concessional privatization and where it has been used. 2. Social Ethics and Politics The debacle of socialist economy has shown first of all that rigorous pursuit of egalitarianism shrinks the cake available for distribution. Furthermore, a pursuit without individual rewards can be sustained only with commands from above. This hierarchical element ultimately denies egalitarianism itself: Some find ways to escape from the general impoverishment by turning a profit from political clout. Hence, neither acceptable living standards nor equality in misery can be rescued from increasingly costly coordination failures and "spontaneous privatizations" in economies without well-functioning markets. Rather, the denial of property rights and personal autonomy, ostensibly in the name of equality, eventually leads to a point where the appearance of equality too is undermined. "Nomenklatura" privileges become openly resented, rupturing acquiescence and breeding unrest. In the end, therefore, both equality and efficiency suffer. More importantly, basic human needs, including the essential dignity of having room for individual choice and creation, dear to the original Marxian conception of the final rewards of communism, increasingly fail to be met. For this reason Myrdal (1989, p. 16) concluded in his 1975 Nobel Memorial Lecture that the fundamental changes in working conditions that can overcome state-centered underdevelopment „regularly imply both greater equality and increased productivity at the same time." Even if equality and efficiency did not change in the same direction under the popular privatizations to be discussed in sections III and IV, there would be ample room for raising efficiency while still improving the lot of the least well-off. Only a beneficial effect for the poorest would provide the moral justification which Rawls (1971) required for any disequalizing change. With safety nets hanging low and ragged in what once prided itself as the OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 152 George M. von Furstenberg socialist camp of Europe, one can see that even the least well-off are less wretched and have more hope of improvement in developed market economies, by and large. Thus any disequalizing changes could be so productive for all, including the poorest, as to pass the Rawls criterion. Indeed, politically, it is quite essential for the security of the democracies now emerging in Eastern Europe that the poor, the mass of the population, get a stake in the process of privatization and agree with the broad outlines of its design. 3. Recent Proposals of Concessional Privatization Mass participation and support can be sought through concessional privatization. It involves charging less than the presumed or already going market price for claims to government assets that are widely or universally distributed. It can also involve using part of the proceeds from "full-price" sales to small groups of active investors for transfers to the general population under the egalitarian scheme. Alternatively, full-price sales to active investors of controlling interests in formerly government-owned enterprises can be combined with making the remaining equity available for acquisition through share stamps (analogous to food stamps) or vouchers redeemed in stocks by the population at large. Concessional privatization, in one form or another, has numerous advocates and antecedents. Its extreme, frequently advocated but rarely practiced, is the government-asset giveaway, a term popularized by Brittan (1983). Spurred by events in Central Europe, there has been a resurgence of editorial recommendations of this type of approach in the region (see Grosfeld, 1990, p. 145; Bobinski and Wolf, 1990; Dyba, Jezek and Arbess, 1990) and in Western Europe. Because of the rapidity of the events that began to unfold in summer of 1989, business, economic, and financial newspapers have become the main forum of serious debate. The last of the Western European endorsements noted here appeared in the Economist of July 21, 1990 (pp. 13 - 14) under the title, "The Gift of Capitalism." Editorials earlier that year repeated the basic ideas first advanced by Brittan (1983, 1984a, 1984b) for the United Kingdom and applied them to Eastern and Central European countries, including the Soviet Union (Feige, 1990b; Moore, 1990) and the now extinct GDR (.Bofinger, 1990; von Furstenberg, 1990). Ohashi (1987) and Stolper (1990) have provided useful surveys of earlier, small-scale applications in British Columbia and in the dissolution of the Amana Society in Iowa. Stolper (1990, p. 18) notes that "a wide distribution of diversified assets would supOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 153 port democracy by greatly reducing the economic power of the nomenclatura and greatly increasing the economic power of the electorate." Various (1989), Svejnar (1989), and Crane (1990) have also addressed the question of how to build political support for privatization, a question that is central to this paper and the entire process. III. Political Safety Standards for Privatization In a technical and political sense, privatization is much easier to arrange for public housing than for the assets of socialist industry. Detailing the terms available for privatization in each of these areas provides an insightful contrast. As justified later in this section, the three principles advocated in varying degrees for minimizing political risks to privatization in both areas are: (1) The Treasury shall not suffer any net loss of fiscal resources as a result of privatization lest some citizens lose from the process as future taxpayers or victims of inflation tax. (2) Those with politically-legitimate ownership claims in the assets to be privatized shall be held harmless for loss of the economic rents which these assets would have continued to deliver to them directly under the old regime. (3) Any proceeds from privatization beyond those needed to satisfy the two constraints above shall be distributed broadly, perhaps to the entire population of voting age, to maximize political support for the program of rapid ownership transformation. Each of the three principles or distributional guidelines and constraints needs to be justified. 1. Fiscal Indemnification The amount of revenue which the government should retain from the sale of socialist industry can be gauged only by preparing a detailed budget extending over a number of years. During those years, a tax system would be put in place that could support a greatly reduced level of government spending without further variation in tax rates. Even though concrete application of principles of tax efficiency and intertemporal tax equity is difficult, it may be worthwhile to lay out the major points that need to be considered in setting the level of the fiscal indemnity. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 154 George M. von Furstenberg First of all, why should people be asked to pay the government anything at all for returning "their" collectively-owned property? Certainly in the initial transfer of government-enterprise assets and liabilities to the private sector, that sector as a whole should not have to put up "full price" for the package if other equitable formulae for divestiture can be found. Otherwise privatization would be prevented from making an immediate contribution to the restoration of private net worth that was gutted by decades of socialism. Of course, active investors who acquire direct ownership of government enterprises should always have to pay "at market" for what these enterprises are expected to be worth as going concerns. However, all that these direct investors pay need not be retained by government; it can be redistributed, in part, to the population at large. Buying a resalable asset at below-market prices is equivalent to receiving a gift equal to the discount from market. Hence bestowing such a gift through payment of a "social dividend" is equivalent to letting everyone participate in the privatization on concessional terms, even though few will end up owning and managing the privatized assets. On the other hand, not all the proceeds from privatization should be made available for payout in this way. Indeed popular demands for capital grants from the state are subordinate to the goals of maintaining fiscal stability and protecting future taxpayers from increased liabilities on a presentvalue basis. People thus can be asked to redeem enterprises from government ownership for an amount sufficient to avoid destabilizing government finances. This amount could be equal to any excess of the taxes and dividends that would have accrued to the state from continued ownership over the tax revenues that government enterprises would be expected to pay upon privatization when taxes are designed optimally over time. Hence any loss of future net revenues associated with privatization, calculated on a present-value basis, might have to be made up by the proceeds obtained from the sale of government assets. How might one gauge the loss of net revenue, and why is it likely to be small compared with the gross receipts from government enterprises usually entered in the fiscal accounts of socialist countries? Such receipts have been a major source of government revenue in Eastern Europe, yet a good part of them was recycled in a closed loop. An example taken from Poland may show what could be involved. In 1988, before the fiscal situation had as yet become unsustainable there, tax revenue from the socialized sector amounted to 31 % of GNP. Subtracting most of the subsidies to the population (80 % of such subsidies are assumed to be on products made by government enterprises) and all of the enterprise subsidies (the latter amounted to OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 161 employment with their enterprise is limited than to support inefficient enterprises indefinitely because they were not privatized. It appears, therefore, that partial asset giveaways can be justified even if future taxpayers and the immediate stakeholders first must be held harmless. Indeed, the government should even be able to reduce future taxes because of the "load shedding" above. Moving from vague, and insecure, property claims supported by political influence to secure legal rights established through formal privatizations creates the self-assurance and opportunities necessary for the development of efficient production and functioning markets. Yet no such changeover is feasible unless a winning political coalition can be built around it. In the case of council housing the rate of privatization has been one-fifth of the total publicly-owned stock in 10 years, or 2 percent per annum. Part of the reason for tenants' being slow to take-up the government's offer in the U.K. was that they were entitled to buy their units over an extended period of time, with subsidies continuing to be paid on their behalf as long as they had not purchased. Another was that some households found it difficult to amass the down-payment or to qualify for a mortgage, even though financing for the purchase of units was available. (In summer 1990, Thatcher proposed a "rent-into-mortgage" payment conversion scheme to address this problem.) Most importantly, the depth of the subsidy governs the rate at which tenants can be expected to seek to purchase their unit, a point developed below. 3. Reservation Prices The Treasury may be thought to calculate a reservation price for projects and their units that is consistent with (1), the principle of fiscal indemnification. This price would be set at a level just sufficient to hold future taxpayers harmless for privatization compared with the fiscal situation under continued government ownership. Unlike under some conditions in the U.S. HOPE program (see U.S. Department of Housing and Urban Development, 1990), the local councils in the U.K. are not obligated to replace any housing units sold or to replace public-sector housing stock once it is run down. Hence their reservation price is equal to the site value of the project at the end of its useful economic life minus the operating subsidies and debt service which the Treasury would have to meet on behalf of public housing tenants until that time, all discounted to the present. Relative to market price, the reservation sales prices, thus, would rise as a project nears the point at which it will have to be razed, thereby freeing its OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 162 George M. von Furstenberg site for sale. Raising the sales price as a percentage of the market price on any existing unit over time can reduce the incentive of tenants to defer purchase until shortly before they have to move out of their subsidized unit or until the government's offer expires. Except at the very end of a project's useful life, when privatization would simply mean selling the uncleared site to the private sector, the government's reservation price would be below the market price of the project. For relatively new and durable projects, it could even be negative if the subsidy stream expected is long and deep. In that case the Treasury (or local housing council) could profit from giving the project away to shed its obligations. Tenants have reservation prices for their units in the projects too. If they decide to buy and therefore allow privatization to proceed, principle (2), that of personal indemnification, is necessarily observed since the voluntary nature of the purchase assures that they will be no worse off as a result. Ignoring recapture provisions, tenants will figure on losing the present value of subsidies while gaining ownership of a unit that can be sold without restrictions at market prices. The longer they expect to live in public housing, the lower the net value they would put on their unit in relation to its current resale value. Only if they need to move out "tomorrow" for any reason, would they be inclined to buy almost "at market." Assuming that comparable condominia can readily be priced in the private sector, there would be little risk that the occupant buying the unit would end up with a loss upon resale. 4. Expediting Privatization To meet constraint (1) there is thus a spectrum of projects whose units could be made available at reservation sales prices normally well below market. Depending on the project, discounts could range from 0 to 100 % of estimated market value upon privatization without loss of any money by the government on a present-value basis. On the other side, there is a distribution of reservation purchase prices by tenants all of which meet constraint (2). These prices are distributed over individual housing units and involve discounts ranging from 0 to some percentage normally well short of 100. The exact percentage applied by any tenant depends on the length and depth of the subsidies expected for her or his remaining stay in the unit, the subjective valuation of the subsidy benefits relative to the cost of living in alternative private housing, and the subjective discount rate. "Expected remaining stay" is shorthand for tenants attaching a probability weight to being in residence in any future year, a weight that would, of course, decline OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaming Political Support 163 to 0 if they look far enough ahead. If the probability-weighted stream of these subsidies forgone is valued x, and the estimated resale value of the unit is 2x, the tenant would not be willing to pay more than 50% of the market value for the unit since she or he would be giving up a "vested," i.e., politically recognized, right to future subsidies by buying it. Given the distribution of buyers' reservation prices, the more the Treasury seeks to obtain from privatization above what is needed for fiscal indemnification in the aggregate, the slower the pace of this process. On the other hand, privatization will proceed most rapidly if the Treasury charges no more than its reservation price for the units on average. If all gains from privatization, net of fiscal indemnification, are appropriated by the tenants buying their units, as appears advisable in this instance, the general public could receive no concrete benefit, such as wealth transfers or future tax reductions. For lack of a residual, principle (3) would be bereft of application here. Nevertheless the solution could be not only Pareto-optimal, but politically optimal as well. For it would not be politically attractive to insist that public-housing tenants should share their gains from privatization with the, generally better-off, remainder of the population. The decency of any such "regressive" claim would be widely questioned in Western societies where residents of public housing are regarded as objects of social pity and "uplifting" them to self-reliant homeownership has wide political appeal. It is interesting to consider how different this evaluation of the appropriate distribution of the gains from privatization could be in those Eastern European societies in which most housing is public and heavily subsidized regardless of the income of the occupant. Frequently those with the most access to housing benefit most, much to the chagrin of the rest of the population. Kornai (1990a, p. 81) takes up this grudge when he calls it "absolutely unjustified to sell state-owned apartments to tenants at a price that is but a fragment of the real market price" and lambastes any such practice as "sheer nonsense, especially in view of the fact that the same tenant had for decades been subsidized by the state through low rents." Indeed, in Eastern Europe, tenure can often be passed on within the family. The two distributional guidelines previously applied to privatization of public housing would have led to conclusions quite different from those drawn by Kornai. The reason is that, in the U.K., protection of the stakes of public-housing tenants is viewed as legitimate. In that case the presence of rent subsidies as deep as in Eastern Europe would have meant that buyers' reservation prices would have been very low because tenants would be giv12 Kredit und Kapital 2/1991 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 164 George M. von Furstenberg ing up deep subsidies by buying. The government agency that can save theses subsidies, on the other hand, would have a seller's reservation price that is even lower (or negative) in relation to the resale or market value of the units. Hence, something close to an asset giveaway would be the only deal available if existing tenants' interests were to be respected in Eastern Europe as well. Whether the stakes of insiders are viewed as legitimate thus makes a big difference to the terms that are viewed as acceptable in privatizations. These terms, in turn, are the principal determinant of how fast the process may proceed. V. Mobilizing Support for Privatizing Socialist Industry Public-housing tenants, at least in the West, were originally allowed access to subsidies as a matter of social policy. Privileged workers and managers in socialist enterprises in the East, on the other hand, may be perceived by the populace more as leeches on the rest of society than as objects of social pity. In that case those who hold stakes established under a previous regime need not be compensated unless they are sufficiently powerful to block privatization even under the new regime. Excessive compensation can backfire because it may discredit democratic privatization with the rest of the population. Hence, respecting constraint (2) may not be obligatory here. Furthermore, as already discussed at length in section III. 1, the fiscal indemnification required under (1) may be small in relation to the market value which government enterprises may achieve in privatizations. This will hold even if a large risk premium depresses market value because few of those who buy, or buy into, government enterprises can diversify the extreme valuation risks arising during economic transformations. 1. Uncertain Valuations Unlike public housing, it is almost impossible to determine beforehand the market value of individual socialist enterprises in private hands. Some enterprises may go bankrupt after the withdrawal of subsidies and protective regulations while others may attract new investment from both foreign and domestic sources to make them able to compete in the open economy. Difficulties of valuation, either as going concern or for breakup, are compounded because the values of the underlying tangible and intangible assets of many of these enterprises are also only beginning to be established in free markets as privatization and price decontrol proceed. Under these condiOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 165 tions it may take years before one can distinguish an entity that is bankrupt from one that will turn out to be a gold mine with a high degree of certainty. However, because of offset in appraisal errors, the market value of socialist industry as a whole may be sufficiently calculable to leave ample room for concessional privatization even after meeting constraint (1), and, with far less force than in public housing, constraint (2). What is most distinctive about privatization of socialist industry compared with public housing is this: Even though the ultimate market or resale values are uncertain, a good part of the financial benefits expected from privatization can be transferred directly to the population at large. Doing so would help build broad support for privatization, as required under (3). The question is how this can be done, given the valuation uncertainty, without violating prior constraints. These constraints include not only the obligation to provide fiscal indemnification for future taxpayers but also the obligation to ensure that those who support privatization on selfish grounds are, in fact, benefitted with a high degree of certainty and do not feel duped in the end. 2. Combining Equality and Efficiency A market-based incentive system of rewards and penalties is spontaneously, though not institutionally, disequalizing. There are a few special situations, however, in which equality and efficiency stand not in opposition but in support of one another. The privatization of socialist industry provides such an opportunity for mutual reinforcement. An equal distribution of initial stakes could impel transition to greater efficiency. The model under which it can do so is that of people's privatization, - a direct precursor to what is already known as people's capitalism (Hanke, 1987) in a people's capital market (see Aharoni, 1988, p. 41), particularly in Western Europe. People's privatization would convert state holdings of industrial assets, collected in a privatization trust for reorganization and marketing, to property that is, at first, owned by the trust but then sold for the financial benefit of potentially all (adult) residents of a country. The shares of beneficial, but otherwise passive, participation in the trust distributed at the outset would grow in value as the trust sells its individual holdings to the highest bidders. Making privatization the engine for creating capital gains for potentially all the resident nationals of a country would put political impetus behind it and save it from the taint of unfairness. Blanchard and Layard (1990) have addressed worries that an initially egalitarian wealth distribution would be destroyed by poor people's dumping their allotments almost upon receipt, while rich people buy the shares 12* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 166 George M. von Furstenberg cheap and get richer as they hold them. To limit disequalization they suggest that equal numbers of shares in a few holding companies or privatization trusts be given to everybody, including children, but with children barred from selling theirs. While issuing extra shares to families with children, like child support, may be politically attractive, issuing nontradable shares to children would waste some of the wherewithal for gaining political support for rapid privatization when it is most needed. For this reason, limiting the distribution of shares to all adults or even to all registered voters is politically more efficient. Government-asset giveaways have been given different names for legitimation and appeal to particular groups. In a comprehensive survey, Pirie (1985, pp. 47 - 49) lists "giving to the public" as the fifth of 22 methods of privatization distinguished. He notes that giving away whole industries, even those that would have considerable value in private hands, has been suggested by many conservative thinkers. One of the most prominent of these, Friedman (1989, p. 577), has since called giving government-owned enterprises to the citizens his own "favorite form" of privatization. Conservatives tend to view efficiency gains from privatization as so large that it is unwise for society to wait for them. While accepting privatization by hook or by crook as long as it is fast, they recognize that unchallenged property rights are not likely to be established on a heap of insider wheelings and dealings that the rest of society views as defrauding them of their just inheritance from the state. Even with the most conservative thinkers, a substantially egalitarian one-time distribution thus is a recurring theme. Egalitarian appeal also underlies proposals for homesteading (e.g., Rothbard, 1990) in Eastern Europe and suggestions of voucher (e.g., Moore, 1990 and see Drabeck, 1990, pp. 7 - 8) and social-dividend (Farrell and Schares, 1990) schemes. Terms such as people's privatization, equal-shares (Stolper, 1990), or socialist (Feige, 1990a) privatization have a similar ring. They emphasize the restitution of state property to the people at large. Government asset giveaway has been recommended under these names also in cases where, in the view of the proponents, those targeted to acquire ownership would not have the money or financing to take up their stakes from the state or where equity markets did not exist until the government's asset giveaway put equities into play. Focusing more on efficiency aspects, Hinds (1990a, pp. 47 - 50) and Dhanji and Milanovic (1990, pp.22-3 6) have provided the most thorough recent discussions of the entire approach and some of its immediate alternatives. Saldanha and Milanovic (1990), Vuylsteke (1990, pp. 20 - 22), and Hinds (1990b) have given further thought to the organization of the state's OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 167 holdings for rapid privatization and to competition policy prior to the appointment of management beholden to private owners at the enterprise level. English's (1991) "privatization by general fund", on the other hand, emphasizes financial modalities and the roundaboutness of the process that makes those who end up owning and using the industrial assets acquired from the government's holding trust pay "full price". This outcome can be achieved by having the privatization trust sell its industrial holdings to the highest bidder, foreign or domestic, as value is brought out, with the sales proceeds, net of any debts to be settled by the trust, then passed through to potentially all the adult resident nationals of a country. What Feige (1990b; 1990c) and English (1991) pointed out in this way is this: It is possible to give away collectively (negotiable, but initially not redeemable, shares in the privatization trust or closed-end investment company of speculative value), for the sake of equality and broad political support, what can and must, nonetheless, be bought at market prices individually (shares in the individual enterprises bought, mostly by active investors, from the trust) to assure efficient allocation and use of capital. By decoupling the dispersed holdings in the trust from the, quite possibly concentrated, acquisition of individual-company blocks of shares sold by the trust, principal-agent problems of operational control could be overcome (see Dhanji and Milanovic, 1990, p. 26). Thus using the initial degree of freedom, provided by the availability of government assets, for egalitarian distribution need not get in the way of efficient combination: rather, an equal start would promote the process of privatization on which efficiency gains depend. 3. Combining Fiscal and Investor Indemnification In the spirit of people's privatization, the process should not start by transferring to the mass of individuals risks so large and incalculable that quite a few of them may realize losses on their original subscriptions from which it was rational to expect gains. This injunction, however, does not mean that individual government enterprises or shares in holding companies or asset trusts must be given away just because of bankruptcy risk or because the shares might turn out to be very nearly worthless once the debts are settled. Rather, the price can be set in such a way that the proceeds expected to be derived from the shares will meet the requirement of fiscal indemnification while still getting widespread acceptance of these shares from the population at large. What follows holds equally for (i) direct privatization of individual government enterprises through "people's shares" that are rationed out to as many eligible adults as will apply for them, and (ii) roundabout privatization by general fund or trust. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 168 George M. von Furstenberg Technically, what is given away in these instances is equivalent to a call option whose strike price is equal to the tax payment required per share. If this "option" did not have a fixed expiration date, the strike price would have to be raised over time to prevent tax erosion that would tend to lock buyers into the originally-issued shares and deprive the government of receipts of predictable value. Either way, the payment intended for fiscal indemnification would be due only upon first resale of the stocks, which would be equivalent to exercise of the call option in the idiom used above. The buyer would receive a new stock certificate free of contingent tax lien once the tax had been paid. Some of these tax-free certificates should also have been given immediately to institutions or foundations operating in the public interest, and to banks in exchange for government-enterprise debt, to start a market. If the value of such tax-free stock certificates did not reach the amount of tax due, taxable stocks would not be sold, and no tax liability would be precipitated. In this way it would be assured that those accepting stocks or privatization-fund shares could only gain, not lose, the first time around as they would make no down-payment to acquire the shares originally issued. If the value per nontaxable share, say in the first 2 years after issue, had stayed below the tax liability but above zero, that liability could be reduced to the average value in the second year, or less, to prevent indefinite lock-in for taxable stocks. It would also be possible to impose a capital-gains tax upon sale, having given shares in the privatization trust a cost basis of zero. I would not favor such a tax because it applies at the margin, its yield is difficult to project, and it is a bad habit to get into. Still this shows that it is not difficult to think of ways in which the commandment, "Thou shalt not lose from people's privatization," could be quite strictly observed while still indemnifying the Treasury and future taxpayers. Lack of personal buying power, thus, can be overcome and so can much of the valuation uncertainty. The uncertainty of tax yield that derives from the uncertainty of valuation of government enterprises can be reduced most easily if there is an all-encompassing, and thus maximally diversified, privatization trust. Setting tax liability on a single-trust share will help achieve fiscal indemnification with a much higher degree of certainty than fixing different speculative tax amounts for shares in less diversified trusts some of which may become worthless. The question of how properly to motivate the unitary government privatization trust - or rather the several competing divestiture-management companies it should commission to sell the trust's various holdings and liquidate it - need not concern us here. Once there is a clear mandate for rapid divestiture, such questions can be submitted to the OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 Pareto-Optimal Privatization for Gaining Political Support 169 competent advice of investment houses and underwriters in London and New York. 4. Vouchers to Deal with Monetary Overhang? Privatization could be used to reduce monetary overhang in some of the socialist shortage economies by getting people to pay for shares right away. To produce the monetary contraction required to avoid general inflation when prices are decontrolled, the government could use the proceeds to repurchase public debt from the state banking system. The entire operation thus would end up shrinking the financial assets and liabilities of the state banking system and contract the money supply by substituting government real for monetary assets in private portfolios. Auctioning off shares to domestic residents is often criticized as favoring those who managed to enrich themselves through abuse of power under the former, socialist regime. Yet the critics rarely offer alternative solutions to the problems presented by monetary overhang and ill-gotten gains. Nevertheless, insisting on cash in advance would rule out combining the allure of equality with the benefits of efficiency in generating popular support for privatization to transform socialist economies. In preparing for German monetary union early in 1990, the central bank developed plans that would have combined (the avoidance of) monetary overhang and "people's privatization" in an interesting way. Residents of East Germany would have been given buying power over shares in the East German enterprises to be privatized in lieu of creating a monetary overhang through conversion of East (German) Mark into DM at an undesirably high 1:1 rate. Although this plan eventually came to naught, it is worth describing in some detail. To prevent contributing to raising the money balances of East German residents well above those they would be expected to hold in view of their expected income and new portfolio-diversification opportunities, the German Central Bank (Deutsche Bundesbank, 1990) preferred making the monetary exchange at a 2:1 rate. Then 1 East Mark would command only 0.5 DM immediately, but this exchange would be sweetened with lowinterest bearing certificates for the balance. These five-year certificates-of-deposit (CDs) would bear a below-market interest rate of around 3%, and a face value equal to another 0.5 DM per East Mark exchanged. They would be redeemable in stock of formerly government-owned enterprises for at least five years, starting soon, after issue, or in cash (at par) with the privatization fund, but only after 5 years. In the latter case, the privatization fund would OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41 170 George M. von Furstenberg draw on the cash assets already accumulated from the sale of shares in individual enterprises to groups of active investors and borrow in the capital markets as needed to redeem in cash any of the CDs presented. To direct redemption to stocks, an equity-conversion premium would be granted implicitly by allowing the CDs to be used at face value to purchase stocks at market prices well before the end of the five-year waiting period that would apply before there could be cash redemption at par. Shares in formerly East-German government enterprises would first have to be brought to market by selling to the highest bidders, with only a portion reserved for redemption of CD claims arising from the conversion of money balances by East German residents. These redemptions would then take place at the prices established in the underwriting. With the Bundesbank plan rejected in favor of 1:1 exchange for most of the money balances of East German residents, privatization ceased to be a matter for the people. Through the spring of 1990, the then still East German "fiduciary institution" (Treuhandanstalt), or privatization trust, barely moved, intending to hold back any proceeds from privatization to subsidize operating deficits and to restructure the trust's vast holdings. In this way, public-sector waste, insider featherbedding, and political manipulations could have continued for a long time. The fiduciary's law and management were changed in July 1990. The new law required the immediate breakup of the socialist combinâtes into share companies or limited-liability companies that would at first still be whollyowned by the trust. Establishing such companies involves fixing their assets and liabilities and then proceeding to an examination of the entire business, management and accounting systems being instituted. Passing this examination allows the initial balance sheets and income statements, that form part of the prospectus for privatization, to be approved. Since July 1990, the trust has made large working-capital loans to the businesses it owns, many of which would otherwise be failing. The enterprise losses financed by debt claims taken on against the trust's assets substitute in part for unemployment insurance and related benefits that would otherwise have to be paid from the general budget or the social trust funds. Keeping failed government enterprises going is an indication that fiscal and personal indemnification have won out over people's privatization. Had an expectation of the latter been allowed to become concrete and attractive to the East German public, it could have kept competing uses of the proceeds from privatization in check by counterbalancing both the fiscal claims of the state and the personal claims of stakeholders in government enterprise. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.24.2.147 | Generated on 2023-01-16 13:00:41