Why do governments take control of entire sectors of the economy? The textbook answer falls into what many economists call “public interest” reasoning. But what really happens turns out to be more complex than what the profession has so far understood.
Markets have limitations, it is said; these limitations are said to warrant the nationalization of an industry or sector. Markets cannot produce certain goods and services, or they cannot produce them optimally, because it is impossible to exclude nonpayers. Or they will overexploit a resource because no one can be excluded, but everyone has an incentive to consume it. Maybe it’s because some sectors are naturally prone to become monopolies that will ultimately exploit consumers. These justifications constitute the list of what figures in the “usual” textbooks in economics for market limitations and which may be used to motivate nationalization in some form or another. For example, Greg Mankiw’s famous textbook, Principles of Economics, proposes ten principles “that represent the heart of economic wisdom,” and the seventh discusses how “governments can sometimes improve market outcomes.” The range of solutions differs, but state provision of some services is argued to be justified.
Some economists, often in the very same textbooks, will retort that governments have limitations too. The temptations of politics might induce the nationalized firm to slack on cost discipline and become wasteful, leading to recurrent bailouts. Politicians may also be tempted to use the nationalized firm as a way to win votes (e.g., a nationalized electrical utility used to subsidize electrification in rural areas favorable to the party in power), even if it is socially costly. Thus, economists simply weigh trade-offs between both types of limitations.
A smaller subset of economists will point out that the motivation of “public interest” is rarely actually there. For example, Randall Holcombe has pointed out that the public interest is often a post hoc rationalization that adds only a veneer of respectability. The underlying reason has always been the political benefits of nationalization. For example, Tyler Cowen has explained that rulers produce public goods if they can extract rents in the process. If public interest rationales are provided, it is merely as a byproduct; the politicians want nationalization for their own sake rather than for the public good.
Nationalizations as “Redistributive Engines”
In a recent paper, I go one step further. The key is to notice that economists of all persuasions have frequently looked only at the particular market in which the state intervenes through nationalization. But that market isn’t the only one affected.
Consider the example of the state taking over lighthouse provision. Lighthouses are a classic example of market failure because the light can guide some ships without reducing its usefulness to others and because ships that do not pay can still benefit from it. Free riders can’t be excluded, so state provision is said to be required.
The economic literature about lighthouses is extensive and famously includes work by Nobel laureate. In the debate over lighthouses, which revolves around questions of the feasibility of private provision, the origins of the market failure, and the quality of government remedies, the more than a dozen scholars involved have rarely if ever ventured out of the market for lighthouses.
That shortcoming allows many to miss why states nationalize. Yet the tidiness of the hoped-for explanations has left some puzzling facts in the archives: In Britain, for example, many cite parliamentary reports on lighthouses, but a large share of them deal with issues of pilotage, as the pilots’ guild, which is still extant today and known as Trinity House, was in charge of producing lighthouses. Substantial attention went to the pensions of pilots, the funds for those injured, and other issues with payments to pilots. Why would such issues be so prominent in the historical discussions of lighthouse provision, but not in the modern literature explaining what happened? These things were not secondary to people then; why are they treated as such now?
Simply put, the answer is that states nationalize when state control makes it possible to assemble a political coalition of actors involved across multiple markets. Viewed in this way, nationalization amounts to a broad rearranging of property rights that—in the words of economist Anthony de Jasay—acts like a big “redistributive engine” for politicians and private actors. In Britain, the pilots’ guild was not only in charge of regulating entry into the pilotage trade, it also held the exclusive legal right and monopoly to dredge sand and gravel from the bed of the River Thames to supply ballast to unladen or outbound ships (i.e., ballastage), while also being a monopoly provider of lighthouses. In other words, three markets (at least) were involved (i.e., ballastage, pilotage, lighthouses).
Now consider electricity. Many districts in Canada and the United States, but also in Europe, nationalized their electrical utilities in the first half of the twentieth century. The rationale was that utilities were natural monopolies that would gouge consumers if left unregulated. The standard approach to evaluating this setup would consist of looking at the performance of the utilities before and after nationalization. But that would be the wrong way of analyzing the outcomes and motivation.
Very often, nationalization was motivated by a desire to reduce rates for key constituencies. In the Canadian province of Quebec, for example, proposals for a public takeover were partly motivated by the desire to provide cheaper electricity to rural areas, which tended to favor the party in power. In Ontario, nationalization (which took place some four decades earlier) was intended in part to benefit industrialists located farther from the best sites for hydroelectric generation, such as Niagara Falls.
Canadian historians noted this political motivation, but its broader implications were not explored. Subsidized rural electrification or subsidized industrial rates through a nationalized firm can produce an inefficient allocation of land and labor. For example, when rural electrification is subsidized, too much land remains devoted to farming, rather than importing food from places better suited to agricultural production, and too many workers remain in agriculture rather than moving into manufacturing or services. Similarly, subsidized industrial electricity rates require higher taxes or higher rates for nonindustrial customers, thereby encouraging an inefficient concentration of resources in electricity-intensive heavy industries.
The costs are therefore dispersed throughout the economy in ways that are difficult to observe. Even if the state-owned provider appears to perform as well as the private provider, conventional comparisons may overlook substantial costs created by the nationalization itself. The “redistributive engine” creates massive overlooked costs.
In other words, nationalization is never an intervention in only one market. It is an institutional reorganization that changes the terms on which many markets operate. Evaluating it solely by examining output in the nationalized sector systematically biases the analysis in favor of the state.
American Lighthouses as an Example
The case of lighthouses in America is the best illustration of this. Prior to 1789, lighthouses in America were provided either privately or by state governments. Lighthouses were important to port cities, as they increased trade volumes. The different states funded them with what were known as “tonnage duties,” which were essentially user fees for port services inclusive of the lighthouse.
One particular feature of lighthouses is that local shipowners tended to rely less on them than foreign ships since they knew the local waters and perils tied to them. Thus there was a tendency to set different rates on ships depending on whether they were local or foreign. But this opened a strong temptation—to piggyback shipping protectionism onto the tonnage duties. If a shipowner from New England could impose even a slightly higher duty for the lighthouse on a foreign shipowner, he’d increase his competitive edge against him. Even small differences in tonnage duties, given the profit margins, were sufficient to give strong edges, and in practice, the duties could be several times higher for foreign ships. In the name of safer shipping, the New England shipowner might effectively kick his competitor out of the port.
But through the colonial and confederation eras, competition between states kept this temptation largely in check. A state or colony that tried to discriminate more against foreign shippers would see ships redirected to another port and thus lose in trade volumes and other revenues. This competition among governments acted as a strong check on protectionist tendencies. As a result, the ratio of rates applied to foreign ships against domestic ships maxed out at 4:1, with some colonies and states applying no discrimination at all, and the average being closer to 2:1.
Following the new Constitution, tonnage duties became the domain of the federal government, and no states were allowed to impose them. This ended the check against discriminatory duties via competition between states. In 1789, rates were set at six cents per ton for American ships—but at 30 cents per ton for ships with commercial treaties with the United States, and 50 cents per ton for others. In practice, this meant a discrimination ratio of 5:1 to 8.7:1. In 1804, new legislation increased the discriminatory duty by 50 cents per ton, raising the ratio to 16.7:1, and another 50 cents in 1812, putting the ratio at a prohibitive 25:1. By 1812, foreign ships had to pay 94 to 144 cents more per ton. These were equivalent, on average from 1789 to 1815, to a surtax of 1.26 percent of the value of cargo, or between one-tenth and one-seventh of profit margins on voyages. It is thus understandable that the tonnage duties eliminated all foreign ships from American ports: in 1789, some 47 percent of ships entering American ports were owned by foreigners importing goods; by 1810, it was less than 10 percent.
Lighthouse federalization gave shipowners the protectionist barriers they desired. Ultimately, this protection came at a cost in the form of higher freight rates, higher import prices, more expensive ships, and reduced competitiveness for exporters, who had to pay more to access foreign markets. It also created a centuries-long rent-seeking relationship between shipowners and the state, still visible today in the form of the Jones Act. In that sense, the shadow of the federalization of tonnage duties remains with us.
At the same time, tonnage duties were structured in a way that created a hidden tariff topping the statutory tariffs on imported goods. When historians estimate tariff rates, they typically divide tariff revenues by the value of imports. Yet this measure excludes the protectionism embedded in tonnage duties, even though these duties also acted as a tax on foreign trade and imported goods. Once tonnage-duty revenues are incorporated, the hidden tariff amounted to an additional 0.41 percentage-point tariff between 1790 and 1815. Mercantile interests beyond the shipping industry therefore also stood to gain, as foreign goods became slightly more expensive relative to domestically produced alternatives.
But if tonnage duties were taken by the federal government, how would states fund their lighthouses? In fact, people at the Constitutional Convention understood the two to be connected. Jurist Adam Grace notes that “those in favor of a uniform discriminatory tonnage policy—such as Madison and Fitzsimons—had a strong motive to lay the responsibility for lighthouses on the federal treasury in order to justify the imposition of tonnage duties (…)” and, in doing so, were “securing complete federal control over the domestic–foreign tonnage differential.”
The answer was for the federal government to take over the lighthouses as well. Politicians would gain from this, as it was a considerable source of patronage, around which they could build their political machines. The patronage included not only the appointment of lightkeepers, but also the contracting of supplies and construction of lighthouses, buoys, and other navigational aids. Alexander Hamilton, notably in multiple letters to George Washington, understood this mission: Out of 144 letters written by Hamilton regarding lighthouses, all but seven contained directives and considerations about appointments, provisioning contracts, and construction contracts—very often to individuals who were part of his political faction. When the Jeffersonians took over, they did the same thing. By the 1840s, the joke carried in newspapers and Congress was that lightkeepers were first and foremost drunks making political speeches on behalf of those who appointed them.
So why did state governments relinquish patronage? It stands to reason that they too liked to dispense patronage to their local machines. The answer is that the federal government used a carrot-and-stick approach. On the carrot side, it gave states subsidies for many years—well in excess of usual operating costs—to cede the lighthouses. On the stick side, Hamilton recruited the help of pilotage associations, whose political influence was immense; they conducted some of the first strikes in American history and frequently were able to bend state and local governments to their desires. He won them over by offering relief payments for impoverished pilots and their families, as well as the services of a state-funded Marine Hospital. This was ultimately enacted in 1798 in the Act for the Relief of Sick and Disabled Seamen. The pilotage associations—notably the Boston Marine Society—brought pressure to bear on state governments that were reluctant to cede their lighthouses.
Now, notice the broad coalition that emerged through rearranging multiple markets at once. The public saw the lighthouse. Shipowners saw protectionism against their foreign competitors. Merchants saw hidden extra tariffs. Pilots saw welfare programs. Politicians saw appointments and patronage. State governments saw fiscal relief and political threats. The coalition succeeded because different participants supported the same policy for different reasons.
And ultimately, there were more lighthouses. America saw an exceptional expansion of its lighthouse network—far ahead of nations like Britain and France. True, some lighthouses were built according to political needs, but the increase in maritime safety was real. Thus, on that very narrow ground, federal provision probably did make people better off. But that is indeed too narrow. When we account for the protectionism in shipping—implying higher freight rates—the higher tariffs and federal taxes, and the patronage, we find that the whole scheme was far less beneficial.
The Island Fallacy
When the history of lighthouse federalization was written for the United States, historians celebrated the benefits (i.e., that there were more lighthouses). The same is true of many nationalizations: canals in the United States, electrical utilities in Canada, water utilities in the United States and Britain, and telephone systems and railways in Britain, Ireland, and France, among many others. The costs were often omitted, forgotten, or treated as peripheral.
What remains is the “island” that the state leaves us to examine: the nationalized sector itself, stripped of the broader fiscal, regulatory, and political changes that made nationalization possible. This creates what might be called an “island fallacy,” whereby a nationalized industry is evaluated as though it were an isolated unit whose performance can be measured independently of the effects on other markets via tariffs, taxes, regulations, privileges, subsidies, and patronage that are associated with nationalizations. By being asked to look only at that market, it seems easier to buy the “public interest” motivations that are advanced as justification.
But because nationalization rarely involves only a single market, this is a dangerous acquiescence. To create the political coalition necessary for nationalization, governments typically alter conditions across multiple markets, allowing different constituencies to extract rents from different parts of the intervention. Those effects may appear in higher taxes, protection from competition, subsidized prices and rates, regulatory privileges, patronage opportunities, distorted investment, or altered patterns of trade and production. The island fallacy is therefore especially dangerous because it directs attention toward the visible performance of the nationalized industry while pushing many of the costs that made that performance politically possible outside the frame of analysis.
Understanding why governments nationalize—as part of a broader attempt to secure rents for a wide political coalition—is important not only for explaining why nationalization occurs. It is even more crucial for understanding how nationalization, rather than the free play of market forces, ultimately affects living standards. Examples from the past may be easiest to see, but the pattern all but certainly holds true today as well, and many new discoveries remain to be made in this area of economic history.
