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Regulation Magazine

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Readings

The Massachusetts Miracle,
Edited by David R. Lampe
(MIT Press, 1988), 367 pp.

The New Economic Role of American States
Edited by R. Scott Fosler
(Oxford University Press, 1988), 384 pp.

Reviewed by Lawrence B. Lindsey
Lawrence B. Lindsey is professor of Economics at Harvard University.

From the time of the first king who called himself "The Great" when good weather produced a bountiful harvest, politicians have found it useful to exaggerate the benefits of their tenure in office. At the same time, the historical role of economists and other social scientists has been to put these political claims into perspective.

The 1988 presidential campaign saw the addition of the "Massachusetts Miracle" to the millennia-old record of political hyperbole. There is no question that economic conditions are very good in Massachusetts. At issue is the extent to which state government policies helped create those conditions and the extent to which those policies would work if applied to the nation as a whole.

Economists have never taken readily to claims of miracles in the realm of economic phenomena. We do not believe that economic growth is something that results format he incantations of politicians or bureaucrats, no matter how fervent their faith. Governments can stand in the way of economic growth by adapting the wrong policies. But when things go well because politicians have failed to interfere with economic growth, only the most cynical among us would term it a "miracle." In Massachusetts the miracle is alleged to result from political intervention in the economy and not form political benign neglect.

Skepticism about politically induced economic miracles is even more appropriate when considering the activities of states and localities than nations as a whole. States lack the fiscal and monetary tools that central governments possess. In addition any extra stimulus injected into their jurisdictions can easily flow across borders to other states. The most significant contribution that governors can make to their state economies is, in a sense, a negative one: They can end state-imposed restrictions on growth and let the market economy take care of itself.

This view is shared even by economists who tend to favor more government intervention. For example, in The Massachusetts Miracle Lester Thurow writes:

Economic miracles, like instant stardom, don't really occur…Economic success may suddenly become visible, but such miracles are almost always produced by solid fundamentals and these solid fundamentals always have a long history…All too often in history a region has had a real comparative advantage in some type of production and found ways to throw that comparative advantage away. Massachusetts did not do so, and that is to the credit of the citizens who lived there and to the leaders, public and private who lead them.

Hard economic analysis is, there fore, unlikely to provide any support for ht political claims regarding the Massachusetts economy.

Left to the soft analysis of the goodness of intentions, the idea that a miracle has occurred will survive and grow in the public's mind. Subjected to the hard rigors of statistical analysis, the claimed miracle will wither. The "miracle" survives only at the sufferance of the analyst.

The Massachusetts Miracle, edited by David Lampe, is a mixture of hard and soft treatments. Much of the book is a compilation of speeches by politicians claiming that their policies will fix the economic problems of the Commonwealth. This is soft analysis at its softest. The recipe is simple: Say things have never been worse; assert that they got that way because of the policies of your predecessors; lay out a policy that you call "comprehensive"; hope things improve; then claim credit for your success.

For example, the book reprints two 1972 speeches given by Governor Francis Sargent, and 21 pages of excerpts from "An Economic Development Program for Massachusetts"-a 70-page document published by the Dukakis administration in 1976, his second year as governor. Devotees of political rhetoric may find these enjoyable. The 1972 speeches arc typical of Sargent, who was known for his short, declarative style. "Let's look at the facts" was a favorite. Similarly, the 1976 piece is classic Dukakis. Start with a goal: "More jobs and higher incomes for the residents and businesses of the Commonwealth." Follow it with headings labelled "priorities" such as transportation, energy, capital, and labor. (Very few things aren't priorities.) Under each priority set out a number of ''next steps" usually beginning with verbs such as "provide," "appoint," "prepare," "submit," and "complete." A sufficiently comprehensive list of priorities, each with its own next steps, can easily be stretched to 70 pages. But while this may be helpful to those interested in the Dukakis administrative style, you will not find the reasons for the Massachusetts miracle here. Even the book concedes that the plan "ultimately led to little specific action."

A small step up on the rigor scale is provided by the series of seven articles written by economists at the First National Bank of Boston, who are clearly very talented but are constrained to appeal to the mass market. The best article in this series, by Lynn Browne, analyzes the effect of technological change on the business services industry. Browne concludes that state policies, which focused on manufacturing, entirely missed business services, a vitally important industry that contributed much to the growth of the state.

The articles in the final group-analytically the strongest-were written by analysts of particular industries. Like Lynn Browne's piece on business services, each tells us of a particular success, but does not give the reasons why the Massachusetts economy as a whole prospered. One of the best, by Nancy Dorfman of' MIT, looks at the belt of high technology industries around Route 128. Dorfman concludes that the high-tech boom did not emerge from any effort by state or local governments to attract firms. Rather, the
area's universities and existing high-tech industries provided good reason for new firms to locate nearby, a phenomenon that Dorfman calls "agglomeration externalities."

Other detailed pieces look at the importance of small businesses, higher education, and the defense boom. These articles succeed in finding reasons why the sectors they discuss did well; in no case is intervention by state authorities given as a reason. The reader is left with a list of particular reasons for the success of particular sectors, but no overview on how these sectors fit into the state's overall growth. The reader is forced to put the pieces together himself.

The Massachusetts Miracle therefore presents an apparent paradox. The only articles that address the overall performance of the state are the nonanalytic claims of the politicians and their critics in the business community. The analytic articles, on the other hand, indicate that these political issues have nothing to do with the result. The editor is left to conclude that although a remarkable turnaround did occur, "no individual or organization from business, academe, or government can claim credit for consciously engineering this development. It happened by itself, fostered by a remarkable combination of favorable conditions that emerged from the particular culture of the region and by chance."

The New Economic Role of American States, edited by R. Scott Fosler, begins its seven-state analysis with a look at Massachusetts and its economic development policies. Fosler could not have selected better authors for the Massachusetts study. Ronald Ferguson, assistant professor at Harvard's Kennedy School of Government, and Helen Ladd, professor at Duke University's Institute of Policy Sciences and Public Affairs, have outstanding academic records of research into the economics of state and local governments, and of Massachusetts in particular.

Given the potential for a hard analysis of the "miracle," the Ferguson and Ladd piece is somewhat disappointing. It does have a number of interesting and important sections, however. They provide an interesting short history of the Massachusetts economy dating back to the industrial revolution. Their text is also much better than The Massachusetts Miracle in detailing the economic development strategies actually tried by Massachusetts.

The litany of agencies involved in economic development is instructive by itself. For example, the Wednesday Morning Breakfast Group (WMBG) worked closely with the Centers for Community Economic Development (CCED), which in turn created Community Development Corporations (CDCs) as well as a Community Development Finance Corporation (CDFC). At one point, the authors discuss the role of the WMBG, coupled with the CDFC and pressured by the CDCs, in creating the Massachusetts Industrial Mortgage Insurance Agency (MIMIA).

While students of bureaucracy will find these details interesting, most readers will find their eyes glazing over at the alphabet soup. But there is an important point in the alphabet soup that readers should be careful not to miss. These agencies and pressure groups arc exactly what an activist economic development policy is all about. Each agency must be created, its members appointed, and its activities funded. The 70-page Dukakis "Economic Development Program for Massachusetts" was the blueprint behind this bureaucracy.

The bias of the authors seems to be that these agencies matter. Fully 15 pages are devoted to the bureaucratic proliferation of the first Dukakis administration, but less than 4 pages are given to the King administration that followed. One of King's first acts was to abolish The Dukakiscreated Office of State Planning. Apparently the destruction of a bureaucracy makes a much less exciting tale than its creation.

The Massachusetts section of the book ends with a chapter entitled "Creating the Future," which is devoted to the second Dukakis administration. It details the creation of the second-term Dukakis bureaucracies including the Massachusetts Development Bank, the Bay State Skills Corporation, the Centers of Excellence program, and grass roots Growth Policy Committees. This emphasis on the bureaucratic aspect of state policy lends credence to the politician's notion that economic development is accomplished by political incantation.

Although the majority of their analysis is from a bureaucratic perspective, Ferguson and Ladd reject this incantation approach in their conclusion: "Our analysis of job growth in Massachusetts suggests that statewide economic indicators in Massachusetts are not very different today from what they would have been in the absence of many new state programs and agencies." They find an advantage in the proliferation of agencies, however: "At the same time, political processes that fashioned the initiatives helped foster a political culture that currently allows for smoother resolution of political-economic issues.' In short, the hard numbers show the programs to be worthless, but good intentions must be worth something.

It is particularly unfortunate that Ferguson and Ladd did not include the detailed results of their hard analysis in this chapter. The details can be found in their seminal study, "Economic Performance and Economic Development Policy in Massachusetts" (Discussion Paper D82-2, the State-Local Intergovernmental Center, Harvard University). This study, which provides a rigorous statistical test of the importance of state policies in the economic development of the state, shows that firmer conclusions are indeed possible. The authors compared job growth in each industry in Massachusetts with job growth in the same industries nationwide. This enabled them to measure how well Massachusetts would have done if it had only done as well as the nation did as a whole. Any difference between that and the state's actual job growth, they concluded, could be attributed to the performance of state officials.

During Governor Dukakis's first term (from 1975 to 1979), private sector employment in the state rose by 274,000. Had Massachusetts industries done as well as their national counterparts, 353,000 jobs would have been created. The net contribution of state officials therefore amounted to a net loss of 79,000 jobs. The additional bureaucracies were not harmless manifestations of good intentions, they actually reduced the state's performance relative to the nation.

In contrast, the period 1979 to 1983 was one in which Governor Edward King sharply cut back the bureaucracy. Had state industries done as well as their national counterparts, a total of 29,000 jobs would have been created in the Bay State's private sector. A total of 117,000 private sector jobs were actually created in Massachusetts during this period. Thus, the net contribution of state policy during this period was a net gain of 88,000 jobs.

This is the kind of hard data that makes the talk of a miracle sound ridiculous. No such miracle took place. The state's industries grew just as fast as their national counterparts, as above-average performance of the King administration just offset the below-average performance of the Dukakis administration. An analysis of job data since 1983 shows that the state's job creation rate was almost exactly at the rate one would expect given national growth and the mix of industries in Massachusetts.

The Massachusetts Miracle may have made its mark in the field of political hyperbole, and it launched its greatest believer into national politics. But the common sense judgment of economists and other social scientists still holds. The best thing that state officials can do to help their states develop economically is stay out of the way. Don't overtax. Don't over-regulate. When we succeed in getting that message across to politicians, we can really write books about economic miracles.


Arguing with Success, without Success

Privatization: An Economic Analysis,
by John Vickers and George Yarrow
(MIT Press, 1988), 464 pp.

Reviewed by Sir Alan Walters
Sir Alan Walters is a senior fellow at the American Enterprise Institute.

This book is one of a series on the regulation of economic activity published by the MIT Press. The first four chapters arc devoted to a review of what the authors regard as the relevant theory of incentives, ownership, competition, and regulation. This is a competent survey of the literature, although it appears to contain no new insights. The main contribution of the book is in chapters 5 to 11, which describe and analyze the United Kingdom's privatization program.

It should be noted at the outset that virtually all major elements of Prime Minister Margaret Thatcher's economic reform program have met with mass opposition by academic economists. This is true despite the considerable political and economic success of her program. Privatization is no exception; indeed the success of privatization in Britain is serving as a model for many other countries. So it should not be surprising that Vickers and Yarrow, like other academic economists, have devised theories about why privatization has been a dismal failure and why their prognostications of disaster will be borne out sometime in the future. The book forecasts that "the government is undermining the long-run success of privatization in Britain."

On the whole, however, the authors approve of privatization. Oddly enough they do not consider, except in one short paragraph, the biggest and most successful privatization of all, that of public housing being sold to sitting tenants. Instead, the authors examine the conversion of state-controlled corporations into privately controlled corporations. Their complaint is about the way it was done-particularly that shares were sold too cheaply so that wealth was redistributed in the "wrong" way. (Incidentally I will give a prize to anyone who can show me a privatization program where the opposite allegation is made!) They say that the exchequer gave up valuable revenue by selling shares at a discount to small shareholders and workers. Anyone with a knowledge of marketing will see such a criticism as suspect. Ensuring that the shares were bought and held by the workers and small shareholders reduced the probability of renationalization and virtual expropriation by some future (socialist) government. This insurance against future socialist predators enhanced, perhaps greatly, the value of the shares. And if one takes account of the demonstration effects on parallel and future privatization, the advantages of such underpricing become even more apparent. Give-aways maximize. The authors display similar naivete at various other points in their exposition. For example, they argue that one of the main reasons for privatization was to reduce the Public Sector Borrowing Requirement to meet target levels. All those involved, including the Prime Minister, have no such illusions about the difference between public spending and asset sales; we may have been ill-informed, but I do not think any of us were as misguided as the authors so confidently assert.

Vickers' and Yarrow's gravest complaints are leveled against the privatization of the great utilities-British Telecom, British Gas, and British Airports. "Too cheap," of course, but also too much monopoly power left in the hands of the new corporations-monopoly power not suitably curbed by the new regulatory systems. They are right in complaining about the constraints on competition in telecommunications and gas, but their complaints need to be tempered by economic and political realities. For example, the authors clearly think that it would have been better to break up British Telecom along the lines of the American Baby Bells, but they do not mention the cost of doing so. As Mrs. Thatcher's former adviser, I can testify that all the relevant ministers, including the Prime Minister, were very keen on such a break-up. But we were eventually convinced that, because of the need to allocate liabilities and assets and prepare separate accounts, such a move would take at least two, perhaps three, years to implement. With the need to search for a new political and economic "window of opportunity," this would have delayed privalization even longer. In the meantime, British Telecom would have remained nationalized. Similarly, having been peripherally involved in the deal that induced the British Telecom competitor, Mercury, to commit itself to sinking a large amount of money to develop a basic network, I find this discussion quite innocent of the central issues. It is also clear today that there is much more competition in telecommunications than was conceivable at the time of transfer of ownership.

Vickers' and Yarrow's big bone of contention is the regulatory system. Their discussion of competition concludes with a non sequitur: "where the threat of entry simply does not exist and cannot be made to exist, direct regulation of the dominant firm is then required." After a very long discussion of the theory of regulation of private industries, they offer only a general outline of the government's administration of the nationalized industries. Even more surprising is the fact that the authors, who place such faith in regulation, do not discuss the actual consequences of regulatory systems. As many scholars have -shown, such as Gilbert Walker in Britain and James Nelson in the United States, regulation in the transport industries over almost 150 years has virtually always had effects opposite to those intended by legislators. This nettle is neither exposed nor grasped. Nor do the authors tell us how well the covert system of regulation worked in any of the nationalized industries.

The reader will also find no discussion of the enormous changes in management and administrative structure that precede and accompany privatization. British Telecom, for example, had been run like a government department with cash accounting only and rigid functional lines of responsibility. There is no mention of the reorganization required to equip this behemoth with a modern management structure and suitable internal incentives for efficiency.

Perhaps most surprising is the failure to mention the first great privatization in 1954-56: that of the nationalized trucking industry. This example provides ideal conditions for the study of privatization. The regulatory system remained unchanged for almost 30 years, which is ample time to examine the long-run effects of a change in ownership the authors rightly regard as so important. And since part of the industry (the National Freight Corporation) remained in public ownership until 1982, when it became one of the financially most successful privatizations, cross-section analysis may also be possible.

Another omission is that, rather parochially, the authors do not survey the evidence of the efficacy of privatization in other countries, except for the United States. Such a circumscription of their task is perhaps understandable, although they should have provided references and a summary of this evidence, which, I can testify, had a considerable impact on public sector decision-making.

An innovative aspect of the Thatcher privatizations was the development of a new system of regulating the utilities. The ministers in the Thatcher government were well aware of the gulf between the ideal of regulation and the reality of practical application. In particular they were determined to avoid the absurd waste of having a maximum rate of profit (that is, a 100 percent marginal tax rate above the maximum rate). The minimum intrusion that was politically acceptable was a maximum average-revenue condition applied to a basket of services where there was some considerable monopoly power comprising roughly one-half of British Telecom's total value added. This regulation was known as the RPI-X rule (retail price index minus X). In the case of British Telecom, X was set at 3 percentage points, implying that the corporation could increase its (monopoly basket) prices, on the average, by no more than the annual percentage increase in the retail price index minus 3. This rule was set for five years. When it was reset for the next five years, X was raised to 4.5 percentage points, a rather more stringent target. The idea was that by reducing the size of the basket as competition developed (such as phones on a cable network), price controls would eventually be phased out.

The authors arc highly critical of this new regulatory arrangement. They assert that it amounts to much the same thing as a maximum rate-of-return system, although I cannot follow the argument by which they reach such a conclusion. The differences, in the short run, have been pointed out by S.C. Littlechild (Regulation of British Telecommunications, Report to the Secretary of State, Department of the Treasury, February 1983) and, in the long run, by Ingo Vogelsang ("Price Cap Regulation of Telecommunications Services," Rand Corporation, February 1988). The authors also object to the possibility of discrimination within the basket, but the point has been to design an arrangement that allows flexibility instead of imposing the same detailed forms of price control with all their rigidities.

After presenting their criticism, Vickers and Yarrow supply no alternative system of regulation. This is a pity. A system of regulation similar to the RPI-X system is proposed by the Federal Communications Commission, and it would be useful to have a balanced analysis of the options.

In the final analysis, I would commend this book as the most comprehensive account yet published of privatization in Britain. It is most useful as a source book. However, one should pursue many of the authors' arguments further than they do and one should balance their diet with a pinch of the salt of reality of regulatory systems.



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