Further Illustration of the Implications of Public Finance

equal to the government’s implicit costs of capital. This is nothing else than a form of subvention, which, in fact, is prohibited by competitive legislation.

Economic theory attests that it is beneficial for a social planner, i.e. the government, to ensure that certain public goods such as highways are provided, but economic theory also promotes fair competition and that for any given purpose the most efficient means are chosen. Our analysis so far assumes that the public and private parties are identical in their capabilities, so it is awkward that the analysis automatically leads to choosing the public alternative. In fact, this is wrong: there is no reason why a government should favor a public party over a private party when alternatives are available, and the government is effectively violating sound economic principles captured in legislation as well. The government could, in principle, borrow on its general credit and leak the funds at the same cost of capital to the private party, which would ensure a fair competitive setting, which is shown by arrow (5) in the figure above.

5.4 Further Illustration of the Implications of Public Finance

stimulate investment and total production leading to increased welfare by providing all domestic businesses with low cost capital.

5.4.2 Consequences of the Unconsidered Implicit Costs of Public Finance The appeal is that the government could borrow on its excellent credit rating and subsequently leak these funds at the same cost of capital to all private firms. However, should this occur, the international financial markets would eventually realize the actual risk inherent in the governments deteriorating loan portfolio, which would obviously include some very risky ventures (stimulated, partly, by cheap capital), lower the general credit rating of the nation as a consequence, and thereby correct the pricing of capital inevitably. Thus, by the logic of induction, because the practice is undesirable if extended indefinitely, it follows that the practice must be undesirable for a singular case too. Where alternatives are available, a government should not arbitrarily subsidize some economic parties by allocating funds at a lower cost than is fair within the framework of capital markets: The cost of capital must reflect the actual risk involved.

Of course a single infrastructure investment is insignificant on a national scale and thus has little effect on the general rating of a nation and cost of borrowing. However, despite the practical appeal, the main theoretical problem remains plain: by financing projects on a general credit rating, a government may distort the cost of capital used to finance individual ventures, promote unfair competition, and taken to extreme would eventually result in an average (higher) pricing of loans through the mechanism of credit rating within the international financial markets. As already noted, economic theory does insist that it is beneficial for the government to intervene and ensure certain economic activity, but in comparing alternative arrangements to organize this activity, a public or any other alternative should not be favored by supplying it at an unfair price of capital.

From the perspective of a private PPP candidate the government effectively favors a public party by supplying it with unnaturally cheap

capital, which in the case of a capital-intensive infrastructure project is a decisive competitive advantage, and in fact equal to the government’s opportunity cost. By confusing its role as a social planner and a producer unit, the government distorts the functioning of markets. A public option may not be economically the most low-cost alternative, but it is nevertheless chosen when low-cost capital offsets higher production costs.

The practice however practically appealing is simply not economically sound. The reliance on the government’s excellent credit rating and funding of infrastructure does not deliver a free lunch. To finalize the argumentation, let us once more illustrate this idea, this time with a slightly different representation (Figure 22).

A government is tempted to think that it can benefit a domestic economy by borrowing funds from the international financial markets (1), leaking these resources to a producer (2), who invests these in a venture (5), which in this case is an infrastructure project.

Government

Ventures I Producers

(3)

(5) (1)

International Financial Markets

r_f

D

r_d

D I r_p

(4) Domestic Economy

D r_f (2)

Figure 22 Summary of paths available to finance the production of infrastructure

The appeal is that a domestic economy saves on debt service costs, because it needs to return only an interest of r_f on the debt capital the

government raises, where as it should return a higher r_d on the debt capital that a private producer would raise (4). The glitch, however, is that the government could produce the exact same outcome by borrowing (1) and subsequently investing (3) the funds in the international financial markets.

The domestic economy would in this case make an investment profit that offset precisely the higher costs of debt service that a private financing alternative incurs. The domestic economy does not benefit from financing tricks – the economy relies on fundamental production efficiencies.

5.4.3 Equitable Comparison of Public and Private Suppliers

The government’s low default risk and low-cost capital is grounded in government ability to raise taxes. Assuming a public producer is less efficient than a private alternative, higher production costs are paid out of taxes and if risks materialize, additional tax funds are routed into the project to cover the resulting costs. In a PPP, the expected costs of risk are captured in the cost of capital, and the expected economic performance is captured in B and C projections.

Traditional Procurement

PPP General Credit

Budget Finance

Asset Based Project Finance

Public Supplier Private Supplier

(1) (2)

Figure 23 Level evaluation of public and private supply alternatives

To evaluate a public and private led production on a level, fair basis, the government should, itself, finance on a project basis (1), or allow the private party access to the low-cost funds available on the government’s credit rating (2). The figure above (Figure 23) illustrates this idea.

Although this practice would make the alternatives fairly comparable in production cost terms, it would still not account for transaction costs – most importantly the contractual hazards that arise from information asymmetry between the government and suppliers, but also the contractual inefficiencies that may be prevalent in government agencies.

6 COMPARATIVE EFFICIENCY OF PUBLIC-PRIVATE