The allocative function

Once decisions have been made on how the limited national budget should be divided between different groups of activities, or even before this, public authorities need to decide which specific projects should be undertaken. One method that has been used is cost-benefit analysis. This attempts to do for government programs what the forces of the marketplace do for business programs: to measure, and compare in terms of money, the discounted streams of future benefits and future costs associated with a proposed project. If the ratio of benefits to costs is considered satisfactory, the project should be undertaken. “Satisfactory” means, among other things, that the project is superior to any available public or private alternative. Or, if funds are limited, public investment projects may be assigned priorities according to their cost-benefit ratios.

One difficulty with cost-benefit analysis is that every government agency has an incentive to estimate favourable ratios for its own projects. It must, after all, compete with other agencies for funds. No one can be certain as to the returns to be expected from an irrigation canal or a highway. Private investors have also been known to exaggerate their claims in appealing to stockholders, but they are generally subject to market sanctions that encourage them to err on the side of caution.

In addition to the possibility that cost-benefit analysis may be biased by the preformed views of those commissioning the study, there are other, more fundamental difficulties. Almost all proposals have effects that are difficult to value in monetary terms. The siting of a new airport brings problems of noise and property blight to local people and increases the risk that civilians may die in an accident. Putting a sensible value on human life has been a continuing difficulty for those carrying out cost-benefit analyses, even though every project does in fact affect probabilities of life and death. These problems are, of course, not confined to cost-benefit analysis. Additional expenditure on health service or on road safety or better housing or heating old people’s homes in winter all affect the number of people who die prematurely. The failure of cost-benefit analysis to provide answers to the problems of valuing life, or the quality of life, is a reflection of the wider problem confronting all decisions on public expenditure: the influence of subjective judgment.

Until the mid-1970s the proportion of economic activity controlled by the government and the share of taxes in national income tended to increase in most countries. Since then, however, challenges to this growth in the role of government have become increasingly influential, and moves to privatization have been common.

There are several types of privatization. One involves the sale to private owners of state-owned assets, and this is most correctly called privatization. Publicly owned houses may be sold to their occupants. Commodity stockpiles may be reduced or disbanded. Increasingly, however, attention has been turned to the sale of publicly owned industries, thus reversing the move to nationalization that occurred, particularly in western Europe, around and after World War II.

Where the privatized industry operates in a competitive environment, no new problems arise. Singapore has privatized its airline system, for example, which now competes with a mixture of privately and publicly owned international airlines. Where privatization occurs but monopoly continues, however, there are new difficulties. Both Japan and the United Kingdom have privatized their telecommunications networks. Although, in certain limited areas of telecommunications, competition is possible—and has been allowed to develop in both the United States and Britain—technical and legal restrictions inhibit competition in many sectors of the industry.

Regulation is necessary, therefore, to restrict the freedom of privatized monopolies, or near monopolies, to raise prices and to exploit consumers in other ways. In the United States, which has by far the longest history of regulating private utilities, such regulation has normally limited the rate of return that they earn to what is considered a fair level. A disadvantage of this is that it may give the industry no greater incentive to increased efficiency than would exist in public ownership, since higher costs can be passed directly onto consumers. There have been experiments, therefore, with other forms of regulation, which seek to strike a balance between incentives for better performance and the ability to exploit consumers.

A further problem for such regulation is that utilities and similar industries normally operate in both competitive and monopoly markets. They may be inclined to use their monopoly power in some areas to gain unfair competitive advantages in others. Despite these difficulties, an increasingly wide range of industries, ranging from water supply to airports, are now considered candidates for privatization.

Privatization can also mean the dismantling of existing statutory restrictions on competition. State activities are often protected by legal prohibitions on competing private enterprise. German railways, for example, are entirely state-owned, and the law not only prevents competing railroads but severely restricts coach services and limits competitive trucking. The dismantling of such restrictions is seen as one method of improving the efficiency of state concerns.

Another demand of privatization is the contracting out of publicly provided services. U.S. municipalities have often entrusted activities such as refuse collection, and in some cases even fire service, to private contractors, and European countries are increasingly experimenting with similar schemes. These possibilities demonstrate that a service may be government-financed but not necessarily provided by the government; if extended more widely, the concept could yield a different view of the economic role of the state.

While the objective of privatization is often to increase the efficiency of government activities, its implementation may also have important effects on government revenue. Any savings that result from lower costs lead directly to lower tax rates. Where budgeting procedures do not distinguish between capital and current transactions, the proceeds of privatization sales provide a once-and-for-all boost to revenues. The availability of this source of funding for state activity has given an artificial attractiveness to privatization, especially in the United Kingdom. If an industry is sold for the present value of its expected earnings and if these earnings are the same in public and private ownership, privatization should have no net impact on public finances. If it is expected to be more efficient in the private sector, government finance, on balance, gains. If it is sold for less than the maximum revenue that would be obtained—and this is often the case, either because of the difficulty of selling assets as large as nationalized industries or because the government wishes to secure a wide dispersion of share ownership—the impact is likely to be negative.

Government spending is not the only way in which government allocates resources. Its regional policies will determine whether domestic and overseas investors build factories in particular places, while its taxation policies will determine whether they build them at all. Government competition and merger policies affect the structure of industry and commerce, while regulatory activities—setting the number of hours shops may be open or who may buy cigarettes—have profound effects on commercial activities.

Government also affects allocations by setting the legal and administrative framework within which the economy functions. It may specify minimum wage levels or control the siting of new ventures and the activities of existing ones. Such activities of government profoundly affect the allocation of resources, but they are rarely monitored or subject to serious control.

Stabilization of the economy (e.g., full employment, control of inflation, and an equitable balance of payments) is one of the goals that governments attempt to achieve through manipulation of fiscal and monetary policies. Fiscal policy relates to taxes and expenditures, monetary policy to financial markets and the supply of credit, money, and other financial assets.

The use of fiscal and monetary policy as a means of stabilizing the economy is relatively recent, for the most part a development of the period after World War II. During the 19th century the only stabilization policy was that associated with the international gold standard. Under the gold standard, if a deficit occurred in a country’s balance of payments, gold tended to flow out of the country. To counteract this process, the monetary authorities would raise interest rates and stiffen credit requirements, causing a fall in prices, income, and employment; this in turn led to a reduction in imports and an expansion of exports, thus improving the balance of payments. If a country had a surplus in its balance of payments, gold tended to flow in; this meant that the interest rate fell and the supply of money and credit was increased. As a consequence, imports were stimulated and exports discouraged so that the surplus in the balance of payments tended to disappear. The adjustment mechanism also included another important element: capital movements between countries. When interest rates fell in surplus countries and rose in deficit countries, mobile international financial capital tended to flow from the former to the latter, contributing to the elimination of deficits and surpluses in the balance of payments. The working of this mechanism was partly automatic and partly the result of deliberate actions by the monetary authorities in each country.

In this form of stabilization policy, external stability was achieved at the cost of stability in the domestic economy: fluctuations in domestic prices, incomes, and employment functioned as the levers for bringing about equilibrium in the balance of payments. Occasionally governments attempted to reduce the impact of this mechanism on the domestic economy, particularly on the price level. In particular, governments in some surplus countries took “sterilization actions” to prevent the gold inflow from increasing the supply of money and credit to the maximum extent. This could be done if the central bank offset its purchases of foreign exchange and gold with sales of government securities on the domestic credit market.

A somewhat more ambitious type of stabilization policy emerged in the period after World War I. During the late 1920s and early 1930s the need to reduce unemployment acquired more urgency. Previously, the exchange rate, the balance of payments, and occasionally the price level had been considered more important than the situation in the labour market. During the 1920s unemployment in Great Britain rose to very high levels (between 20 and 30 percent of the labour force). Consequently, there was much discussion of whether employment could be increased by actions of the public authorities. At first, the discussion in Great Britain centred on the feasibility of public works programs as a means of putting men to work; there was a growing belief that these programs might also be a good means of raising the general level of economic activity through their effect on purchasing power. Some maintained that budget deficits would also raise the level of economic activity. An active part in this discussion was taken by the economist J.M. Keynes, and also by the Liberal Party, which in 1928 published proposals for government intervention entitled Britain’s Industrial Future.

The first countries to adopt the new policies were Sweden and Germany. When the Nazi Party took power in Germany in 1933, its rearmament policies helped to reduce unemployment and to stimulate the economy. In Sweden, the new Social Democratic government attempted in more modest ways to expand the economy and ease unemployment through increased government expenditures in 1932–33. In the United States, a very limited attempt was made by the administration of Pres. Herbert Hoover; but Franklin D. Roosevelt made a more aggressive effort with such projects as the Works Progress Administration (WPA), which carried on its payroll an average of more than 2,000,000 workers per year from 1935 to 1941. Unemployment, however, persisted at a high level until World War II, although there was a significant drop from a level of about 25 percent in 1933.