Reform Was Inspired by Novel Ideas

In deregulating the economy and establishing the SOEs, reformers were guided by mainstream economic doctrine and by practices in other countries; in reforming the State sector, however, they relied on novel economic concepts as well as on established management theory and on governmental experience. When it decided to open the economy and to put the SOEs on a business footing, New Zealand lagged behind developments in other countries. It suffered from excessive regulation and from undue governmental involvement in commercial activities. In these matters, the adopted remedies broke little new ground concerning the role or structure of government, though implementing them did require leaders willing to take big political risks.

New Zealand's transformation of the State sector was influenced by two overlapping but distinctive sets of ideas, one derived from the vast literature on management, the other from frontier areas of economics. Managerial reform is grounded on a simple principle: managers cannot be held responsible for results unless they have freedom to act, that is, to spend and hire within agreed budgets as they see fit, to make their own choices respecting office accommodation and other purchases, to run their organisations free of ex ante control by outsiders. As simple as this proposition is, it is contrary to the way the New Zealand State sector was managed before reform.

In embracing managerial discretion and accountability, New Zealand reformers drew some lessons from the United Kingdom's Financial Management and Next Steps initiatives, as well as from Australia's Financial Management Improvement Programme. They were acquainted with the precepts of managerial accountability and subscribed to the view that central control of inputs warps managerial incentives and makes it difficult (some would say impossible) for managers to account for their performance. They also were schooled in contemporary accountability mechanisms, such as performance measurement and programme evaluation, as well as with

Table 2. Major Reforms of the Economy and Public Sector, 1984-89*

Deregulation of Foreign Exchange Trading

End of Wage/Price Freeze

Removal of Controls on External Investment/Borrowing

Termination of Interest Rate Controls

Abolition of Export Credit Guarantees

1985

Floating of New Zealand Dollar on Foreign Exchange Markets

Liberalisation of Foreign Direct Investment

Removal of Ownership Restrictions on Financial Institutions

Liberalisation of Entry Barriers to Banking

Liberalisation of Controls on Repatriation of Profit

1986

Tax Reform Through Imposition of Broad-Based Goods and Services Tax

State Owned Enterprises Act Providing for Conversion of Trading Departments into Businesses

Liberalisation of the Stock Exchange

Progressive Reduction of Import Tariffs

Enactment of New Legislation Governing Mergers, Trade Practices, and Consumer Rights

1987

Corporatisation/Privatisation of Various State Owned Enterprises

Abolition of Various Quasi Governmental Organisations

Removal of Tax Concessions on Savings

Introduction of Tight Monetary Policy

1988

State Sector Act Reforming Core Public Service

Reform of the Education Sector

Reform of Personal Income Tax

1989

Public Finance Act

Reform of Old-Age Pension Schemes

Reserve Bank Act, with Target of Price Stability

*Date refers to year reform was initiated; some reforms extended over a number of years before they were completed.

schemes introduced in various countries to give public managers flexibility in using appropriated funds, staff, and other organisational resources. Some had studied Sweden's long-established practice of separating its small policy ministries from the agencies providing services, and thought that this arrangement should be tried in New Zealand.

Managerial doctrine explains many of New Zealand's public sector innovations. But it does not account for the government's recourse to contract-type arrangements, the emphasis on outputs, and other distinctive features of the New Zealand model. To explain these, one must refer to a body of ideas known variously as the new institutional economics, agency theory, and transaction cost economics. Because of their uniqueness and influence, I concentrate on these ideas though they were not the only ones that shaped the reforms, following which we compare them with managerial concepts.

The new institutional economics traces its intellectual roots to a 1937 article ("The Nature of the Firm") by Ronald Coase that sought to explain different forms of business organisation, but it has gained currency in economics circles only recently. The concepts associated with this field provided much of the logic and the blueprint for transforming the State sector. New Zealand is not a country in which ideas moved in one direction and practice in another. Some of the leading architects of the reforms became familiar with these concepts and were eager to apply them. The core ideas account for some of the characteristic strengths and weaknesses of the reforms, for example, the extraordinary reliance on contracts and the emphasis on specifying outputs, as well as the failure to develop the Senior Executive Service and the persistent difficulty in specifying outcomes and the government's ownership interest.

The new institutional economics is grounded on a very old idea: people act in their self-interest. It extends the study of self-interested behaviour beyond market transactions to situations where other values - loyalty, duty, contracts, and other obligations - might be thought paramount. This branch of economics argues that members of a firm are bound together by self-interest, as are the parties to a contract. Self-interest also is a vital motivating force in the Public Service and is as present in the relationship between principals and agents - for example, between Ministers and officials - as among peers. The new institutional economics takes self-interest to its logical conclusion: all economic relations are implied or explicit contracts between parties that have different interests but cooperate for their own purposes. But the very self-interest that motivates parties to contract means that contracts rarely are self-enforcing: one or both parties may seek to implement the bargain in ways that disadvantage the other. That is, they may behave opportunistically. Opportunistic agents may disregard obligations to principals and take self-serving actions at the expense of those they are obligated to serve.

Opportunism flourishes because rationality is bounded - principals and parties to a contract do not have all the information they need to ensure that the bargain is being honoured, and the cost of getting sufficient information may be very high. In fact, possession of essential information often is asymmetrical: agents know more about their performance than principals do. This asymmetry exposes principals to the risk of capture: agents give principals the information that impels them to act in the interest of those who serve them. "Yes, Minister" behaviour is a well-known form of capture.

Opportunism greatly increases transaction costs - the costs of negotiating and enforcing contracts. Transaction costs explain why some firms are vertically integrated (they produce their own throughput) while others outsource their production. In both cases, the firm operates on the basis of contracts - internal contracts in vertically integrated firms, external contracts in outsourcing firms. A rational firm will structure itself one way or another by analysing the risk of opportunism and transaction costs. These costs are likely to be high when a firm contracts for "specific assets" that have little or no alternative use and when it is difficult to measure performance. In these situations, the firm may internalise production to minimise transaction costs.

New Zealand reformers have been among the first to apply institutional economics to the public sector. They did so in an extraordinary Treasury brief, Government Management, submitted to the Labour government following its 1987 election victory. The first part of this document talks about how markets function (and fail). Rather than extolling the virtues of competitive markets, it concentrates on their limitations, especially those deriving from opportunism in contracting. Although it alleges serious deficiencies in New Zealand government, it deduces these from the logic of institutional economics, not from the systematic study of public organisations. The evidence offered of government failure is slim - an incident here and there - as, for example, mention of the error-plagued Maniototo irrigation project - to illustrate the difficulty the existing system imposed on assigning responsibility for governmental actions. The brief also has an undertone of "everybody knows government is inefficient, so there is no need to prove the point".

The theme of Government Management is sounded at the outset: "The state is not an omniscient and omnicompetent solver of social problems, but rather is subject to largely the same pitfalls that face private solutions to social problems plus other ones" (p. 10). Private and public institutions are hobbled by bounded rationality, the costs of information, dependence on others, and opportunism. "The fundamental problem then is to discover methods of social organisation that relax or minimise these constraints in order to marshall the activities of individuals towards common or consistent ends" (p. 12). Firms are one such type of organisation; governments are another. It is not the concentration of economic power in the firm but the advantages of internal contracting over external contracting in markets that explains its prevalence in industrial society.

After discussing contracting under opportunistic conditions in the private sector, the Treasury brief considers parallel problems in the public sector. It argues that government is prone to opportunism because it lacks the checks on behaviour that come from the need to satisfy customers. Those who work for the State "have a tendency to pursue their own goals, to shirk and to featherbed, and to pay insufficient care in the use of resources that are owned by the 'organisation' or someone else." Furthermore, opportunism is rife in State entities because they "are frequently given conflicting objectives. As a result monitoring is more difficult" (p. 38). The brief is especially concerned about one form of opportunism - the capture of an organisation's policy-making apparatus by service providers. Ministers are vulnerable to capture because civil servants "may hold better information about how government services actually operate." This asymmetry in information "creates the potential for opportunism or subgoal pursuit by the bureaucracy including shirking, budget maximization and generally inefficient policies for society as a whole" (p. 44).

Clearly, different conclusions might be drawn if the brief were argued from different premises, for example, from the posture that civil servants are motivated by a public or professional ethic. We shall consider the implications of assuming self-interest rather than broader public-regarding values later in this chapter.

After arguing that the government is prone to poor management, the brief sets forth the principles that should guide reform of the public sector. A well-run government:

(i) should have clear objectives that inform managers of what is expected and enables their performance to be monitored;

(ii) should be transparent in explicating these objectives and the means by which they are to be pursued;

(iii) should be structured so as to minimise the scope for capture of policy by service providers;

(iv) should give managers and others incentives to achieve government's goals rather than their own;

(v) should ensure the efficient use of information;

(vi) should have incentives and information that enhance accountability of agents to principals; and

(vii) should promote contestability of both policy advice and service delivery.

Most of these principles can be found in standard management literature; they do not depend on the assumptions and reasoning of institutional economics. One need not assume opportunism by government officials to argue that managerial performance and accountability would be improved by clear objectives and robust information systems, or that incentives are important to the behaviour of managers. It is only concerning those matters that are unique to New Zealand - such as separation of policy advice from service delivery and the emphasis on explicit contracts - that one must have recourse to contemporary economics theory.

The reforms recommended by Government Management can be divided into two overlapping categories: those that seek to enhance managerial discretion and accountability, and those that seek to introduce contract-like arrangements in government. The more distinctive the New Zealand reform, the greater the likelihood that it falls into the second category. Arguably, however, the government could have implemented major changes in managerial practice without introducing these novel features. This is not to say that the contractual reforms do not add value; rather, it is to make the point that not all that New Zealand has accomplished is dependent on theories of opportunism, capture, agent-principal problems, transaction costs, and the like. There is a whole superstructure of argument in Government Management that is critical to understanding how the reforms have unfolded, but not necessarily critical to an explanation of what they have accomplished. Another way of stating this point is to argue that a major portion of what has been accomplished has been due to conventional management ideas - freeing managers in exchange for holding them accountable for results - rather than to institutional economics.

The specific changes suggested by Government Management pertain to six areas of New Zealand management: the relationship and responsibilities of Ministers and managers; regulation and employment of the Public Service; the structure of government; budgeting and accounting for public funds; means of assessing performance; and the role of central agencies. Many of the findings and recommendations can stand on their own, without the logical prop of the new institutionalism.

Regardless of their conceptual source, the recommendations are important because they influenced subsequent reforms. They also are important because they set forth the perceived shortcomings in New Zealand government before the changes were enacted.

Ministerial and managerial accountability.

The brief pokes holes in the constitutional doctrine that public servants "act as extensions of the Minister, without having any independent existence and consequently no independent responsibility. The Minister was held to be directly responsible for all departmental activities . . . ." (p. 64). This pretence diluted responsibility: department heads could not be held accountable because any particular action was the responsibility of the Minister; but the Minister could not reasonably be held to account for all the things the department did without his or her direct involvement. To make matters worse, "in most of the public sector the tendency has been to keep managers' discretion to a minimum" by controlling their use of inputs

(p. 58). The ex ante control of inputs "reduces incentives to monitor output and performance and creates incentives for departments to withhold information" (p. 59).

The brief proposes the establishment of a clear chain of accountability, running from the Minister who (in addition to political accountability) should have a major role in appointing the department head, through the department head who would serve under a term appointment, to public servants who would be appointed by and responsible to the department head.

The Public Service.

Before reform, the State Services Commission was the legal employer of all public servants, although it delegated authority to make most appointments to the affected departments. It had legal control of promotions, dismissals, and other personnel actions. This centralised arrangement, the brief argued, impaired the capacity of managers to run their operations. "The ability of managers to recruit, retain, train, and motivate staff is thus a key element in their ability to manage well and thus achieve their organisation's objectives" (p. 70).

The brief suggested that the head of each department be designated its "employing authority," with power to negotiate personnel arrangements, including pay and other conditions of employment. With decentralization of employment decisions, suitable accountability mechanisms should be introduced to ensure that these actions are consistent with the department's budget.

Treasury acknowledged that some might object that this proposal would impair the unity of the Public Service. It responded that the Public Service already was segmented, with professional and technical linkages often as strong as interdepartmental connections. While this undoubtedly was the case, it may be argued that precisely because the Public Service had become increasingly fragmented, care should be taken to reinforce whatever sense of unity remains. This issue has become more compelling in the decade since Government Management was prepared because of the failure of the Senior Executive Service and the growing prominence of individual employment contracts.

The structure of government.

One of the signal contributions of the Treasury brief has been to remind us that the manner in which the work of government is organised matters. The prevailing structure, the brief charged, invites policy capture by sectoral interests. This risk was augmented by the amalgam of policy advice and service delivery in the same agency. Managers were beset by conflicting objectives and had difficulty in serving both the Minister and those benefitting from the department's activities. Moreover, the "conflicting objectives that arise from the combination of policy advice provision and policy implementation within the one organisation tend also to produce a phenomenon known as 'producer capture' . . . "a service-providing agency whose existence is inextricably linked to the continuation of existing policy is likely to be biased in favour or existing policy" (p. 75).

To avert producer capture, the brief urged that policy advice and service delivery be assigned to separate entities. This separation would give Ministers less biased and more varied supply of advice. In this scheme, small policy ministries would oversee implementation by quasi-independent agencies. But Treasury cautioned against so distancing the two types of entities from one another that policy makers would suffer from ivory tower isolation. "Policy advice divorced from considerations of reality is bad advice"; to guard against ignorance and isolation, policy agencies should "build a sufficiently strong relationship with the operational agencies to acquire the necessary knowledge" (p. 77).

The discussion of structural reform concluded on a tentative note by suggesting a need for flexibility: ". . . a considered approach which addresses particular agency structures on a case-by-case basis in the light of resource constraints and current priorities will be needed" (p. 79). This is precisely how the restructuring of departments has progressed. In some, policy and service provision have been decoupled; in others, they continue to be tied together.

Budgeting and accounting.

Cash-based budgeting was developed over generations in New Zealand (as in other countries) as a means of controlling government spending. But although this form of budgeting made it government's paymaster, Treasury found numerous shortcomings in accounting and budgeting pertaining to th

e information and incentives provided managers. "Our present system of funding government expenditure based on annual cash appropriations does not provide the right incentives for public sector managers to make the best use of the resources available. Nor does it encourage them to provide information on the full cost of activities or the outputs achieved using available resources" (p. 82). Cash-based accounting, Treasury argued, does not provide a full and accurate account of the cost of activities, especially when capital assets are used; it does not take account of future commitments, or of guarantees and other contingent liabilities; it controls the inputs purchased rather than the outputs produced; and it fails to provide information on the government's (or an agency's) financial condition. A cash-based system distorts incentives by encouraging managers to underestimate the cost of programmes; bid for incremental allocations rather than evaluate the use of resources already at their disposal; enter into unbudgeted commitments for future years; spend their full annual appropriation; and to conceal costs by promoting non-cash resources and interventions, such as tax expenditures and regulations.

Treasury's key recommendation was that the budget and appropriations be "based on an assessment of the full resource cost of those decisions" (p. 83). Although it still will be necessary to control cash, the government should manage costs on an accrual basis. In addition to an accrual accounting system, the government "would also need an accrual budgeting system so that actual results can be measured against plans and budget. The accounting system would need to be on the same basis as the budgeting system to avoid the possibility of conflicting objectives" (p. 83-4).

New Zealand has been the only country to move in tandem on both accounting and budgeting reform. Accrual budgeting significantly escalated the stakes in financial management reform, for the basis of decisions had to be altered, not only the form of financial statements. This bold recommendation actually facilitated reform by giving managers a clear message that they must quickly develop information systems to support full cost-based accounting and budgeting.

Assessing performance.

The brief identified several impediments to the proper assessment of managerial performance. Managers were given unclear and sometimes conflicting objectives; they were blocked by input controls from using resources to their best judgment; and they had inadequate information on the volume of outputs and the efficiency with which resources were used. The important point made here, and not always followed in other countries, is that assessing performance is not a stand-alone capability; it must be congruent with an overall system in which managers have authority to act and are appraised on the basis of their actions. Without this framework, assessing performance "will be an end in itself rather than a means to bring about improvement. In this situation managers have little incentive to cooperate in the process by divulging adequate information to allow a reasonable assessment to be made" (p. 86).

A robust performance measurement system, Treasury urged, requires ex ante specification of objectives. Performance assessment was seen as part of the incentive structure for managers. Consideration of how well the organisation is doing should be part of the appraisal of the mangers' performance. The cognizant Minister should be involved in the rigorous review of department heads; these reviews should feed into the negotiation of employment contracts.

The central agencies.

Treasury and SSC administered the input controls that dominated public management before reform. With the dismantling of those controls, the central agencies had to change their roles. The brief had more to say on what Treasury and SSC should no longer do than on what they should do in the new regime of managerial discretion and accountability. It noted that "the extent to which existing controls can be abandoned will depend . . . on the success with which objectives are able to be clearly specified and performance of managers assessed against them" (p. 91). But it concluded that "considerable further analysis is required before the final nature of the control function, and the extent of centralised functions, can be deduced with any confidence. . . . The greater the reform the smaller is the role for central control agencies" (p. 93).

The brief had some difficulty describing where these agencies would fit in once the public sector was transformed. The logic of managerial responsibility dictates withdrawal of Treasury and SSC from most interventions in the operations of departments, but "the fact that the activities of individual agencies may have implications for others suggests that the need for central oversight or co-operation will remain" (p. 91). There is a thin line between assisting and meddling, between letting departments find their own way and steering them in the right direction.

In concluding its recommendations, the Treasury brief returned to an argument it had repeated several times. "No matter what the starting point, achievement of improved management outcomes will only be possible if the system is treated as a whole" (p. 95). The new system will transform public management only if reform is comprehensive and integrated. It will not suffice for change to be piecemeal, as if one were picking from a menu of techniques. The argument is compelling when one considers the inextricable linkage of freeing managers and holding them accountable. The first without the second would open the door to abuse; the second alone would make people responsible for actions they did not control.

The total package approach to reform pointed in the direction of a legislative onslaught on the old order. With strong political leadership, the government could move faster and accomplish more by prescribing a course of action than by having each department set its own pace. Why delay when there is consensus that the system was broken, and exciting, confident theories showed how it should be fixed?

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