If you know that someone will always be there to bail you out if things go wrong, you’ll make worse decisions.
Economist János Kornai called this the “soft budget constraint”. He thought it explained a lot of the pathologies in Eastern European companies and economies before the fall of the Soviet Union.
Companies knowing that they’ll be bailed out don’t keep a sharp eye on their accounts. The same holds for local governments – and their electorates.
Wellington City Council has gotten itself into a fair bit of trouble. It has started hinting that it wants support.
If central government politicians had read a bit of János Kornai, they would know to be cautious. Or at least to couple any assistance with new requirements for future spending. If Wellington council and its ratepayers also read Kornai, they would understand why.
Kornai first saw the soft budget constraint in action in Hungary in the 1970s. State-owned enterprises were told to maximise their profits – yes, even in communist Hungary. But chronic loss-makers were not allowed to fail. The government propped them up. The budget constraint facing state-owned enterprises was soft, rather than hard. Under pressure, it wasn’t a real bottom line.
Hard budget constraints impose disciplines. If a company runs out of money, it goes bankrupt. Its equity-holders lose their shirts, and it is either sold at a sharply reduced price or broken up so its assets can be put to better use.
The most inefficient firms are winnowed out. Those that remain are more productive.
The very real threat of being run out of business sharpens incentives within firms. Shareholders watch their boards. Boards watch the management. And managers try to earn profits and avoid losses.
That all changes when companies, or local councils, expect external assistance.
Kornai was writing in 1986, but his work describes Wellington 40 years later. “A rather frequent course of events is this: at first, overly optimistic cost estimates are made; then, the cost overrun is finally covered from public sources.” Because the public will pay the excess costs, and a lower cost estimate makes a project more likely to be approved, optimistic cost estimates are to be expected when budget constraints are soft.
Kornai warned of the consequences when local councils can reasonably expect that “even careless spending does not lead to a financial catastrophe.” But he notes the very real trade-offs. A company or council in distress will always present a sympathetic case. Allowing the budget constraint to turn soft “has mercy” on the distressed organisation but makes distress more likely.
Kornai discussed Hungarian municipal debt rescues that favoured profligate councils at the expense of prudent ones. While the amounts were not macroeconomically significant for the country as a whole, it sent the wrong message. “It boosted the expectations of decision-makers inclined to spend irresponsibly: their budget constraint is soft. It supports their self-confidence: whatever they do, they will survive and be bailed out. If they also possess good political connections, their chances and their slice … are still greater.”
And that brings us back to Wellington.
Over decades, Wellington City Council and its voters have made terrible choices. Convention centres are not good civic investments. Wellington decided to build one on a funding plan requiring ongoing ratepayer support. Despite knowing its water pipes were in very poor shape, the city put about half a billion dollars into redoing the town hall and library.
While essential renewals at the sewage treatment plant remained underfunded, Wellington committed about another half billion dollars to a sludge plant aimed at reducing the amount of sewage solids that wind up at landfill – part of the council’s waste minimisation efforts. The main sewage treatment plant then failed, and the volume of barely-treated waste now flowing into the sea hardly seems minimal.
Mayor Little and Deputy Mayor McNulty point to looming affordability issues for Wellington’s ratepayers. They’re right. McNulty was quoted as saying, “It’s just not affordable. It is beyond the capacity of ordinary people to pay.”
It will be eye-wateringly expensive to simultaneously pay for all the things Wellington’s councillors voted to buy, and for the necessary upgrades to the water pipes.
But zero people outside of Wellington are to blame for Wellington ratepayers’ predicament, with the arguable exception of central government moving too slowly to help Wellington lift heritage restrictions. Wellington council spent irresponsibly, either with the support or resigned indifference of its ratepayers. The bill is due. Nobody else should be asked to cover it.
Kornai warns that saying no can be hard and isn’t always the right course. But if central government cannot say no, it should change expectations so that councils behave as though they face a harder budget constraint. A rescue now would tell other councils what to expect when their own bills come due.
Councils should be forbidden from investing in large projects unless those projects are authorised by a referendum of affected ratepayers, specifying the cost of the project and the special levy imposed on ratepayers to cover it.
New Zealand used to have this kind of ratepayer authorisation mechanism. It’s time to bring it back.
To read the article on The Post, click here.