The idea that private industry can do most everything better than government is rapidly approaching the level of conventional wisdom, and has produced a seemingly unstoppable wave of pressure to transfer structural functions of the government to the private sector. This idea has always struck me as being based on two easily debunked assumptions, both of which revolve around the mistaken notion that privatization by definition introduces competitive pressures. An invaluable recent report from Project on Government Oversight (h/t Mark Thoma) provided the impetus to think about this further, and resulted in this post.
The Economics of Contracting Out
There are any number of reasons given for contracting out government services to the private sector, but two in particular seem to be cited most frequently:
Claim 1: Private firms are exposed to more competitive pressure, and are thus more innovative and have greater ability to assume risks involved in planning and investment. This means that the private sector will have strong incentives to improve service.
Claim 2: Private firms must compete for contracts, and once they have them remain exposed to competitive forces. As a result, they have no choice but to be more efficient and flexible, and will thus deliver the same service at lower cost.
It does not take the mind of Kenneth Arrow to see that these claims do not hold water, largely because they misdiagnose the organizational imperative. The first objective for any private firm is not competition but profits. And the ways to achieve profits in the real world are by behaving in ways that contradict the assumptions both singly and jointly.
If we assume the presence of competition, the two claims are mutually contradictory. The only reason to invest in innovation is the expectation of higher revenues in the future, which means that alignment with Assumption 1 can only come at the expense of Assumption 2, and vice versa.
The real problem, however, is that the assumption of the presence of competition is completely wrong because of the nature of long-term government contracting out. If a government grants a contract, say for parking meters in Chicago, then all that has happened has been the transfer of a monopoly from the government to a single firm. There has been no competition beyond the initial beauty contest, and there is no competition once the contract is granted because there remains only one provider of the service. Moreover, switching costs for the government become politically, financially and operationally prohibitive once the contract has been granted. As a result, there is no market-imposed discipline to drive the firm to improve its service, and there is no market-imposed discipline to drive the firm to minimize prices (consistent with profit). If anything, the incentives all run the other way, toward maximizing profit by minimizing expenses and maximizing fee revenue.
There is an argument to be made that reputational worries will drive contractors to follow the claims made above. This argument is actually stronger here than it was in cases where Greenspan used it to justify the lack of regulation on banks, but ultimately the failure here is one of contract enforcement. As far as I can see, the teeth in contracts requiring contractors to invest and improve service are rarely invoked, in large part because the groups in government charged with providing oversight are often cut as unnecessary “bureaucrats” when the time comes to trim headcount. Power dynamics appear to be a problem as well, since smaller municipalities and agencies often lack the political clout of giant contractors in cases of dispute. This lack of enforcement power removes the final constraint of accountability.
Worst of all, the alleged superiority of contracting out appears to have become a taken-for-granted script within the government itself. In one case documented by the Project’s report (hereafter POGO), the government chose to outsource work at West Point to a private contractor based entirely on the contractor’s unsubstantiated claims that they would be more cost-effective than the government. The POGO report cites this and other cases in which “the government’s willingness to operate on the belief that outsourcing results in cost savings without any evidence to substantiate that belief.”
The lack of accountability – and the resulting widespread failure of Claim 2 – is on full display in the cases exhaustively documented by the POGO report, which found that government contractors charge on average 1.83 times the compensation of a government employee for the same work, and more than twice the compensation of a similar private sector employee. In some areas, the cost overrun is five times. This cost difference is particularly acute in the Department of Defense (DoD), where contractor staffing in some units reaches 88% of total headcount. As for where the difference goes, look no further than the financial statements of firms like Booz Allen Hamilton, a company that enjoyed 81.5% revenue growth in the second quarter compared to a year earlier.
The Politics of Contracting Out
As for the mechanics of how it works, the Defense Business Board (or DBB) offers a perfect example. Then-Defense Secretary Rumsfeld created the DBB in 2001 as part of his drive to streamline the military services. The members of the Board are private sector executives and are largely a combination of defense contractors and management consultants, many of whom have
cashed in moved into the private sector after government service (some with repeated round-trips, as I mentioned in a prior post) and are now applying their combined knowledge of the private sector and the government to advise the Department of Defense (DoD) on how to operate more efficiently. In practice, this appears to mean that they seem often to advise the federal government on how best to give money to their collective industries through a combination of reductions in spending on full-time government employees and ramped up spending on consultant studies and “efficient” outsourced services.
The ideology of the DBB is on full display in a briefing it delivered to the DoD on downsizing this July in which it attempted to apply so-called best practices from the corporate sector to the reality of impending budget cuts to the Department of Defense. So far so good – that is their mandate, after all – but what jumped out at me while reading the slides was the near-total absence of mentions of contractors in discussions of personnel and headcount. The slides included several mentions of the necessity of “reducing people costs,” but their examples all appeared to have to do with direct government employees. The following slide is an example:
I have no idea what OSD is, but it is telling that the chart shows OSD full-time staff growing to a record 2,708 (posed as wasteful on the prior page) accompanied by a clip-art bubble noting that the margin of error is “+/-5,100 with contractors.” Aside from the statistical absurdity (an interval that includes 0 doesn’t give much confidence, though the ability of contractors to consume negative space is impressive indeed), the chart is a perfect example of the gulf between the actual problem with wasteful government spending and the proposed remedies. Nowhere in the DBB report does it mention the relative cost of government employees vs. contractors, nor is there any sense that perhaps cutting back on overpriced contractors would be a better way to go. In fact, the report barely acknowledges that contractors play a role, which is rather strange given the composition of the DBB. Instead, the proposed remedy is what it has been since the days of Reagan – cut full-time government employees but ignore the ballooning (and significantly larger) costs of contractors.
Even better, the political game appears to be to factor in those ballooning costs as a sign that government is wasteful in order to cut more jobs, while moving aggressively to protect the contractors. Not surprisingly, the current administration has sent mixed signals in this regard. For example, the POGO report cites Obama’s decision to impose a two-year freeze on government salaries while imposing no such cap on contractors or their fees as likely to drive an even larger wedge between government salaries and contractor costs.
The more interesting revelation, however, was that the Obama administration decided in 2009 to save costs by requiring the Department of Defense to pursue an ‘insourcing’ strategy of converting essentially government jobs that had been outsourced back to government jobs (to be fair, the DBB wrote what looks to be a solid set of recommendations for the DoD regarding implementation of this policy). Predictably, this move proved unpopular with House Republicans, whose deep concern over government spending apparently disappears when it comes to contractors. From the POGO report:
The 112th Congress is even taking steps to promote the government’s hiring of contractors, no matter the cost. The House version of the FY 2012 Defense Authorization Bill includes a “sense of Congress” provision that states that insourcing should only occur when it involves inherently governmental functions.
This sort of behavior was bad but business as usual when the economy was growing and revenues existed to pay for it. Today, however, with U6 unemployment hovering above 16% and proposed cuts to the social safety net likely to make matters worse, the proliferation of over-charging contractors will impose very large social costs that will be paid directly by the people. This, finally, seems to be the real underlying pattern in contracting out.
Some examples follow.
The Social Costs of Contracting Out Without Accountability
The decision to give systematic preferences to private contractors as a long-term replacement for government has been shown time and again to deliver disastrous results, especially in cases where oversight is minimal. Three examples come to mind.
The first is the privatization of large segments of the British rail system, which is widely regard as a failure (for a detailed list of problems, see here). Most of the problems appear to have stemmed from a combination of poor incentives, lack of oversight, and mistaken assumptions about the efficiency gains from privatization, leading one observer to conclude:
A more fundamental cause has been that the whole structure, and the powers of the regulators, have been based on the devolution of more authority to private businesses and market mechanisms than the public service role of the railway can bear. The effect was supposed to be that a combination of contracts and regulation would bind the fragmented structure into a cohesive and effective service, reconciling the efficiencies of private sector provision and competition with the public interest, and facilitating the renewal of infrastructure while reducing public subsidy eventually. It is beyond dispute that, in all these respects, the scheme has failed, and failed spectacularly.
The second is the attempted privatization of the drinking water in the Cochabamba region of Bolivia, where the state (under tremendous pressure from the World Bank) sold the concession for the provision of drinking water to a multinational conglomerate. From a report by Public Citizen:
In 1999 the Bolivian government granted a 40-year contract to Aguas de Tunari (a subsidiary of the consortium of London-based International Water Ltd. and San Francisco-based Bechtel Corp.) to run SEMAPA, Cochabamba’s water system. Aguas del Tunari took over in October 1999 and was in full operation by the following January.
An economic report published by the World Bank in June 1999 states that “no public subsidies should be given to ameliorate the increase in water tariffs in Cochabamba.” Therefore, the World Bank knew as far back as the highly secretive bidding process and contract negotiations that citizens of Cochabamba would be hit with price hikes.
Water tariffs, in fact, did indeed increase, by 200 to 300 in many cases, just weeks after Aguas de Tunari took over.
The “cost savings” and “efficiency” introduced by this privatization resulted in water tariffs that totaled up to one third of many residents’ income, and ended in mass protests that ultimately led to the end of the concession.
The third example is the ongoing fiascoes in Iraq and Afghanistan, where contractors now outnumber military personnel, and where accountability-free, high-stakes contracting has become part of normal operating procedure. The list of profit-driven failures there includes electrocution of soldiers by cheap, faulty wiring, the provision of contaminated drinking water, hundreds of fires, and the delayed delivery of body armor (and that’s before we even get to Blackwater/Xe).
I wish I had a more positive note to end on, but with cash-strapped governments and institutional investors ramping up their interactions in the new “asset class” of infrastructure investments, this is only likely to get worse.