17.
THE PUBLIC PRODUCTIVITY PROBLEM

The legal jungle and lawsuit culture is all about the over-institutionalization and centralization, which can kill creativity, but there are many other examples of this. In February 1991, William W Lewis - who was a partner in the renowned consulting firm McKinsey and co-founder of their research arm McKinsey Global Institute - organized a meeting to discuss the fundamental health of the US economy. Participants included Nobel laureate Robert Solow, Professor Francis Bator from Harvard University and editors from The Wall Street Journal and The Economist.³⁶⁴

After much discussion, the group concluded that the main difference between the performances of various economies mainly came down to their long-term productivity growth, by sector. Thereafter, the McKinsey Global Institute, along with local McKinsey offices worldwide, began to analyze what promotes and prevents productivity for each country and industry, and these studies have resulted in thousands of pages of research.

In 2005, after this work had been carried out for 16 years, Lewis published in the book The Power of Productivity, where he summarized the main conclusions. One was that high productivity occurs if the government abstains from prioritizing some business areas over others, and if companies are subjected to maximum pressure of competition in their quest to give consumers what they want.

Consumers are key, he concluded. If you give consumers maximum choice, that will bring about maximum competitive pressure, and this will force productivity to increase via innovation and cost-control. Private companies are under constant competitive pressure and often measure current productivity and efficiency almost in real time in order to keep up. Public organizations, however, generally operate without competition. This weakens incentives for creativity and thus provides less innovation and lower productivity growth.

So how slow is productivity growth in the public sectors? McKinsey finds the hair-raising fact: that the long-term productivity growth in the public sector is, typically, around zero. Of course, there have been exceptions to this where the growth rate was slightly positive, but also some where it was found to be negative.

The results of such studies about the (lack of) productivity growth in the public sector is also supported by the fact that countries in which everything is public - socialist economies – have typically, after a first transitional stage, stagnated and then almost always collapsed or evolved into static zombies.

From time-to-time,the UK government publishes productivity studies for the country’s public sector, and these have shown aslight decline in productivity over time.³⁶⁵ While productivity in the UK private sector, for example, grew by 28% within the period 1997-2007, it declined by more than 3% in the state over the same period. This has enormous effects, because if the UK public sector had had the same productivity growth the private sector, it would only have needed to charge half as much in taxes.³⁶⁶

An aspect of the problem can be a focus on the wrong incentives. A classic example of the effect of incentives happened when, in the 19th century, England shipped high numbers of prisoners to Australia. They paid their captains a fixed fee for each prisoner that boarded a boat, but only 40% survived the trip. In 1862, the politician Edwin Chadwik proposed to change the payment method, so that captains instead were paid for each prisoner who arrived alive in Australia. That took the survival rate from 50% to 98.5%. Incentives always matter and McKinsey Global Institute found that, in Japan, hospitals were paid per bed-night, and that meant that patients were hospitalized for an average of 24 days compared to six days in the US, where hospitals were paid for the relevant illness/transaction. However, when it came to diagnosis, Japanese doctors were paid per consultation unit, while the US was paid for consultation time. And guess what? On average, Japanese consultations lasted just five minutes, whereas they lasted 24 minutes in the US.

Wrongly-targeted incentives can lead to bottleneck problems. In many countries with public healthcare, people complain about long waiting lists for, say, hip replacements, and often poor service. Paradoxically, these are the same countries that may offer excellent service and minimal waiting times, if you need surgery for a cat or dog at a vet, or if you want cosmetic surgery. The reason for this enigma is that these tasks are considered less important, which is why the state leaves them to the private sector.

One of the clearest differences between public and private sector services is their different tendency to exhibit creativity and innovation. A curious example is seen in the very different Christian churches in Europe and the US. In Europe, a visit to a church is a trip back in history – virtually nothing has changed over the past 600 years. By contrast, the US Christian churches are highly creative and constantly evolving. Their services feature numerous Christian radio and television channels, amazing gospel music and religious rock groups like best-selling band Jesus Culture. Additionally, there are trendy Christian youth and lifestyle magazines, summer camps, rock operas, passion conferences, online communities and mega churches like Lakewood Church, Second Baptist Church of Houston and North Point Community Church, which every week bring together tens of thousands of worth shippers in giant events, which are broadcast live and can be replayed on the internet. Why are the US churches so creative while the European ones aren’t? It is because the former are not funded by the state like those in Europe.

Another classic example of private versus public creativity is that of universities, where a majority of the top-ranked in the world are private sector organisations, although these represent only a very small proportion of all universities. For example, globally top-ranked universities such as Harvard, Yale, Princeton, Columbia, Chicago, MIT, Duke, Columbia, Brown, Richmond, Stanford, Carnegie Mellon, Pennsylvania and University College are all private.

In the same way, products will be far better when delivered by private companies under competition. When Germany was divided into the market-based West and socialist East after World War II, the East Germans manufactured Trabants and the West Germans produced BMWs, Porches, Mercedes, Audis and VWs.

When the governments’ spending grows as proportion of GDP, a nations’ apparent GDP growth can become very misleading. This happens partly because private services are included in the national accounts in terms of what people have been willing to pay for them, whereas public services are counted on the basis of what they cost, which is often far greater than what people would willingly have paid, or what it would have cost in a competitive market. Also, when we institutionalize services that were previously provided in the homes, they suddenly become part of GDP. For instance, when you take care of your child personally, it doesn’t boost official GDP, but if you let an institution do exactly the same work, it does. This is especially alarming if there is a disproportionate growth in government-driven win-lose or lose-lose transactions, such as administration and controls which the private sector has to match by defensive activities such as tax advice, legal assistance, and so on. Control systems and tax lawsuits add to a nation’s GDP, but not to people’s well-being.

Apparent GDP growth can also be disguised through public lending. Many Western states essentially became static several decades ago and have since only been able to grow through public lending (and by paying evermore people for non-work, from the public purse). Borrowed money may be used for public prestige projects - typically in the capitals and other major cities – that are highly visible. In Roman times, the capital’s inhabitants could watch with awe as the emperors built marble palaces and performed grandiose spectacle shows in Roman arenas, but they did not see that more and more farmland in the province was simultaneously fallowed. Similarly, no one who visited the cafes in Paris or London in 2010, for example, would have sensed that these two countries had lost 25-30% of their industries within the preceding ten years while accumulating massive government debt.

Another reason why deceptive GDP growth together with over-institutionalization comes creeping is this: in the private sector, wages increase in line with productivity, but in the public sector their increase just follows the private sector wage increases, even though there is no productivity increase. The consequence is that the tax burden or government borrowing continues to climb, even if public services are completely unchanged. Or to put it another way: the public sector will constitute a constantly-increasing share of GDP, even if the benefits it provides do not increase at all.

Just think about how important this problem really is: even if we change nothing, it will just get worse and worse until society collapses. The phenomenon is called the “Baumol effect” after the economist William Baumol, and it explains why growth in public debt and constant tax increases just keep going.³⁶⁷

The overall problem is this: when the public sector’s share of the economy grows, the majority, or all, of the growth in GDP can be misleading. The growing GDP number captures the fact that more money is spent, but it does not pick up on whether the money actually creates greater value or was earned before being spent or was, in fact, simply borrowed.

From all these observations, one can conclude that it is important to rein in and, at some point, halt growth in the public sector. However, this turns out to be very difficult to implement in practice.

Why is that? One reason was given as long ago as in 1955, when the magazine The Economist carried an article by English professor and marine historian Cyril Northcote Parkinson, which introduced what is now known Parkinson’s Law. This states that: “Work expands so as to fill the time available for its completion”.³⁶⁸ In addition to this observation, Parkinson noted a tendency for administration, and especially the number of managerial functions within administration, to grow relentlessly, even if the task they had to solve didn’t grow or was in fact declining.³⁶⁹ After studying a lot of statistics, Parkinson concluded that public bureaucracy spontaneously grew by 5-6% a year, regardless of whether their primary mission grew at all. For example, he made a study of what had happened with the English Navy between 1414 and 1928:

Parkinson’s analysis was entertaining and a bit of an eye-opener, but it was not based on a particularly scientific study. However, since then, lots of deeper analyses of these problems have been carried out. One of the findings is described in the “budget-maximizing model”. This was launched in 1971 by university professor William Niskanen, who, among other things, worked as chief economist at Ford, as well as being a consultant for the US government.

Niskanen noted that public sector managers often try to increase their own organizations’ budgets so that they can gain more subordinates and greater power. To justify rising budgets, they will gradually increase the number of tasks their organizations are undertake.

This phenomenon is an example of what is known as “mission-creep”, whereby an organization spontaneously begins to pursue a different mission than originally intended. One example is the EU’s aforementioned transition from being a free-trade organization towards a more paternalistic power-centre.

Niskanen’s main proposal for solving the problem was simply to introduce competition, which simultaneously reduced costs and improved innovation and quality, and also allowed people to get a sense of the reasonable cost/price for any given service.

Another reason for constant public sector growth is that societies normally, at some time, reach a point where you get a so-called “welfare coalition”, where the majority of people now live from the state, why they keep voting for increased public spending. And a final reason can be found in the socalled “Mouritzens 1-3 rule”. As Poul Erik Mouritzen, who is a political scientist from University of Southern Denmark, explains:

“If the government implements an improvement of a certain size, is may perhaps gain an electoral win of 1000 votes. If later, for example for financial reasons, it feels compelled to remove the improvements, the electoral loss according to the 1-3 rule will be 3,000 votes.”³⁷⁰

So according to this rule, in a democracy, voters will predominantly elect those who give more benefits, for which reason the government will tend to grow as part of GDP, at least until an acute economic crises stops and reverses it for a while.

The problems do not only arise because of what happens among bureaucrats and voters, but also from the behaviour of benefit receivers. They experience a scenario akin to sharing a table in a restaurant with 20 people you don’t know. So each person orders a far more expensive meal than would have been the case, if the person should have paid for it alone, or if it knew the others personally and thus felt an obligation for constraint. So everybody will shamelessly overindulge while each hope, that the others are more responsible. When the bill finally arrives, everyone is chocked. This is an example of what economists call “the called the tragedy of the commons”.

Five additional issues should be mentioned here. The first is political leaders’ occasional infatuation with the power that you can gain by having a large state. Many politicians are, in fact, preoccupied with the idea of becoming a global power (or at least be “heard in the world”) through centralization. However, their citizens are seldom particularly interested in global political power - they’d rather have jobs, pensions, a good environment and low crime rates.

Another reason why the states just keep growing is that welfare transfers create changes to moral norms and social behaviours, which means that people in an “entitlement society” become less and less shy about dipping into the public purse (more about that later). The consequence of this is that social transfers increase beyond what was predicted, which is then compensated for with higher taxes, lending or by cutting down on basic services.

Lack of monetary incentives is also a factor. First, if public sector employees receive big bonuses, it may easily cause a public outcry. Second, the public sector has, on average, a higher union density and more centralized wage-bargaining than private sector industries, which prevents strong individual performance-based pay schemes.

Further to that we have the so-called “insider takeover” problem, whereby the employees of an institution begin to primarily serve themselves instead of focusing on clients (this is also a variation of the mission-creep phenomenon). Insider takeover is extremely common in both the private and public sector, but within private companies it is contained by competitive pressures. Within the public sector, on the other hand, it is far more frequently allowed to continue, and the effect is typically seen after privatization of state functions, after which it is not uncommon for a very large proportion of the workforce to be let go while customer service is improved significantly. Good examples were the European telecom monopolies before privatization, which were massively over-staffed, while it could take months or even years to get a phone line.

When an organization is subject to insider takeover, it is more likely to become “extractive”, as economists Acemoglu and Robinson have called it (we looked at that in chapter six).³⁷¹ The classic example is the public institution which identifies an opportunity for savings but evades this for fear that its budget will then be reduced in the following year. This pattern is quite well known among those who sell capital equipment such as car fleets or computers to private and public institutions, who note that public sector managers often seek to accumulate expenses during the last months of the current fiscal year, whereas private managers are more likely to push them into the beginning of the following year. The obvious reason is that public sector managers are seeking to maximize their costs and thus justify the same budget the following year, whereas private sector managers want to maximize their profits in the current year to win bonuses.

Both actions are selfish, but the consequences for society are different. In private companies, people try to maximize their profits through creativity and cost-savings. In the public sector, on the other hand, they optimize by increasing their budgets and organization as much as possible. In fact, it is not unusual that the state responds to a lack of results in a project by expanding its budget instead of closing or revising the activity.

Another issue that goes some way to explain the lack of productive growth in the provision of public services is the so-called “flypaper effect”, which allows bodies that distribute public funds to keep much of them for their own organizations.³⁷²

The third problem is the so-called “Kronos effect”, named by American professor Tim Wu.³⁷³ Kronos was a god in Greek mythology, who ate his own sons to prevent them from taking the throne from him. What Tim Wu pointed out was that a service provider’s instinct is to attempt to stifle innovation from outside their organization that could harm their own position of power. He saw examples of this in IT organizations which gained initial success through innovation, but which forever after would fight any attempt from outsiders to develop innovations that would make their own redundant. These attempts would almost always fail, after which they would lose out. The Kronos effect is also widespread in public organizations, which try to prevent private competitors entering their field. The typical arguments used here are that “all citizens should have the same service”, “private services will only be for the rich”, or “it is dangerous if the relevant services are provided by someone with a profit motive.” If the same principles were applied to other sectors such as the car industry, we would all be driving Trabants.

TRABANT 601 S DELUXE. THIS IS WHAT A CAR MADE BY GERMANS WITHOUT A PROFIT MOTIVE LOOKED LIKE IN 1988. IT NEEDED 36 SECONDS TO REACH 100 KM/H (60 MPH), WAS HIGHLY POLLUTING AND TENDED TO RUST VERY QUICKLY.

All those phenomena are elements of a broader theory complex called public choice theory, which describes how bureaucrats often will act collectively against the interest of society, while acting perfectly rationally from their own perspective.

The sum of it all is lack of innovation and productivity growth. The reason is wrong incentives. It can be summarized as follows: