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Preventing the next Carillion

    In the UK, a furore has broken out over the failure of a company called Carillion. The focus of the debate is on its involvement with government contracts largely through what is known as the “private finance initiative” (PFI).

    Until the 1990s, the government would have built, paid for, and run all hospitals itself, borrowing the money if necessary. Since that time the UK government contracts with private firms such as Carillion to provide services, as well as major infrastructure projects like the building of roads. Since the 1990s, the government has also contracted with such firms to build schools and hospitals. These arrangements can involve the private company both undertaking the work and also providing the finance up front. For example, a company might build and run a hospital, and the government might pay for the services that the hospital provides over the course of 30 or 40 years.

    The use of private contractors to provide services and infrastructure through contracts with the government is common all around the world, though models differ from country to country.

    The Left is making hay out of the failure of Carillion, arguing that PFI is a manifestation of “neo-liberalism,” and the failure of Carillion is an indication of a broken capitalist system.

    One problem with the Left’s argument is that nobody really believes that the government should not contract any service out. If the government is not going to contract out its catering, for example, should it grow all its own food on government-owned farms with government employees? You do not have to reach this reductio ad absurdum argument to realise that the case that some would make in the Labour Party does not stack up. The second reason why the Left has a problem is that the PFI schemes have also been promoted by the Labour Party.

    Once the government has decided to provide a road, a hospital, or a school, it has rejected the market. Exactly how it provides the service or infrastructure is a pragmatic decision.

    Indeed, contracting certain government services, and PFI-like, schemes should not be a Left-versus-Right issue. At the extreme, of course, to set your mind against contracting out in all circumstances is both perverse and a clear anti-capitalist statement. However, there is no socialist, capitalist, left-wing, or right-wing formula that determines when services should and should not be contracted out, or when PFI should be used.

    At the same time, it is very important that those who believe in a free economy do not make the case for PFI and contracting out on “free-market” grounds. Once the government has decided to provide a road, a hospital, or a school, it has rejected the market. Exactly how it provides the service or infrastructure is a pragmatic decision. Contracting out to a private company involves the creation of a supply chain, the transfer of risk, changes to the timing of cash flows, the design of complex contracts, and so on. As such, it comes with costs of monitoring those contracts.

    In some areas, contracting out and PFI schemes increase risk for the government by reducing flexibility. In other areas, they decrease risks by fixing costs. Contracts can be incredibly lengthy and require monitoring, but the government does not have to monitor the workforce directly and can merely specify in the contract a set of services to be provided without having to worry about how they are provided.

    These are exactly the problems that face private organisations. Should the Acton Institute hire its own cleaners, caterers, and printers? Should it contract out the production of The Journal of Markets & Morality to a professional academic journal company or keep things in house? Should it own or let its offices, or rent a serviced office?

    Multi-billion-dollar contracts between corrupt governments and companies that have no concern about ethics is what might be called a potential “occasion of sin.”

    In economic terms, which route to take depends on “transactions costs.” If there is an important economic question, related to business or government organisation to which you need an answer, you can save yourself a lot of time by trying to understand and apply the economics of Ronald Coase. Luckily, Coase is profound but writes in straightforward English. His Nobel Lecture is well worth a read. As Coase would have noted, comparing in-house provision with PFI involves comparing the costs of doing things in-house with all the problems that brings (such as the management and monitoring of staff) with the costs of hiring a firm to undertake certain tasks with all the costs of writing, monitoring, and managing contracts.

    It would be better if government was not involved at all in the provision of many services and infrastructure projects. The process of competition between different private providers is the best way of discovering the most efficient way of delivering things. However, once you have made government responsible for a service, whether to contract out or use PFI or do everything in-house is a prudential judgement that has to be made. It is an irrational and socialist response to rule out the use of commercial involvement in government services. However, there is no free-market ideology that will tell you in advance when contracting out and PFI work best.

    There are ethical issues in the background of this debate. As far as Carillion is concerned, though it does not seem to have done anything illegal, it is suggested that they may have put their directors before their creditors, and their shareholders before their pension fund. As of this writing the situation is not clear-cut, and more information will be revealed in the coming months.

    There is, though, something inherently concerning about PFI and other similar arrangements. Explicit corruption is rare in the UK, but PFI-type projects and large government contracts create huge opportunities for corruption, particularly in countries where it is common. Multi-billion-dollar contracts between corrupt governments and companies that have no concern about ethics is what might be called a potential “occasion of sin.” Some people have become very rich from relationships between the private sector and the government. This can happen simply because of the complexity of the contracts involved and the relationships that develop between big companies and big government: It does not have to involve explicit corruption. This whole field is an area with the potential for “crony capitalism.”

    Allowing governments to pursue huge infrastructure projects on a “buy now, pay later” basis also encourages log-rolling and rent seeking. If an airport or road improvements can be promised without any immediate cost, such promises become more enticing. Therefore, if the government gets involved in contracting with the private sector, all future cost commitments under PFI-like schemes should appear as debts on the government balance sheet: They should be added to the national debt. The government should not be able to expand its spending envelope whilst hiding the costs.

    But, simply removing the private sector from the realm of government service provision is no remedy. It is impractical for the government to have its own direct workforce for every task. Not only that, if we are going to have government involvement in infrastructure projects and in the provision of schools and hospitals, PFI-type models can reduce risks and costs.

    The best solution is to get the government out of providing many services altogether. The UK government should transition to funding parents, who would purchase an education for their children from alternative private options. It should not own hospitals but finance the poor to buy health insurance from private providers. The nineteenth century showed how the private sector – sometimes together with local government – can build and finance roads, railways, and ports.

    The government need not be directly involved in any of these areas. As such, PFI is not needed at all.

    (Photo credit: Elliott Brown. This photo has been cropped. CC BY-SA 2.0.)

    Philip Booth is director of Catholic Mission and professor of finance, public policy, and ethics at St. Mary’s University, Twickenham, the U.K.’s largest Catholic university. He is also an actuary and has a Ph.D. in finance, and worked previously for the Institute of Economic Affairs and the Bank of England.