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Wednesday, June 11, 2014

Private Cities 101

The 21st century will be the century of cities.

Over the next 30 years, 1.8 billion people are expected to move to cities in developing countries. While some will add to existing cities, others will migrate to small towns, transforming them into the megapolises of tomorrow. Shenzhen, for example, was a small fishing village of 300,000 people in 1980. Since being designated a special economic zone that year, it has grown to over 10 million inhabitants.

Understanding the best form of city governance will be crucial to ensuring that the emigrants lead good lives. However, even as economics has moved to focus on institutions, the literature on cities has focused instead on policy outcomes, rent control, zoning, and public transportation.

The process of governance is important for two reasons. First, we cannot know what the ideal policy is. Constraints differ in time and place. Second, even with omniscient mayors knowing ideal policies, there is little reason to expect them to implement those ideal policies.

So rather than focusing on outcomes, we should focus on how to achieve those outcomes. What conditions are necessary to produce the optimal amount of public goods in a city? Asking what is the ideal level of police, street sweepers, and garbage men is just as absurd as asking, “what is the ideal amount of shoe production?” We simply don’t know. Markets constantly adjust between supply and demand, seeking this ideal level.

Of course, cities are not like shoes. They are far more complex. Disentangling the marginal benefits of public transportation, the police, or garbage disposal is extremely difficult. Further, as cities are spatially oriented, the application of the laws of economics differs from how we usually think of economic goods. Thus, the territorial nature of municipal goods is often used to justify the status quo.

However, what if there was a way to align incentives for the provision of local public goods, goods that the private sector doesn’t provide because of an inability to exclude nonpaying customers? What if there exists a system of governance that could provide an alternative to the morass of public interest that stagnates change in cities today? What if these cities could not only provide local public goods but also institutional change to jump-start economic growth? I argue that private cities could do just that.

Proprietary communities

Proprietary communities are communities defined through private property. A common example is a mall. It is owned by a proprietor who rents out space for income. However, in order to increase the value of the store space, the proprietor also must provide public goods, security, lighting, and open spaces inside the mall. Proprietary communities typically lease land to residents, with revenue the result of increased land value from the provision of public goods.

Proprietary communities offer a solution to a host of problems commonly assumed to justify government intervention. Private property internalizes externalities. Proprietary communities take advantage of that fact by creating private property over land spaces traditionally thought of as public domain. They work by creating a residual claimant in the provision of public goods. That is, proprietors keep as income the rents collected through leases after costs are deducted.

Economists tend not to worry about the provision of goods or services when such provision has the potential to make people rich. The private sector does a good job of making cars because people who make great cars will enjoy financial rewards. On the other hand, no one can get rich stopping overfishing, for example, which is why it remains a problem.

Proprietary communities offer people a way to get rich by providing public goods. Public goods affect the value of the land on which they are provided. A classic example is schools. Good schools can increase land value by thousands—if not tens of thousands—of dollars. Similarly, police, roads, parks, and sanitation tend to raise land values. Because a proprietor’s or developer’s income depends on the value of the land he is renting out, he has incentives to provide public goods as part of his total offering.

The two closest examples of proprietary cities are Letchworth and Welwyn, small cities of around 30,000 each founded by Ebenezer Howard on Georgist principles before being nationalized after World War II. Walt Disney World is effectively a private city unto itself, demonstrating the scalability of the idea.

Imagining a modern proprietary city is difficult. Order is defined in the process of its emergence and the market makes fools out of those believing they can predict its path. However, a conservative guess is that a proprietary city might look similar to Sandy Springs, a city in Georgia of 93,000 people, that outsourced public services to private companies after a bankruptcy crisis, obtaining a superior provision of public goods at a lower cost.

The problem

Private cities would not be necessary if public municipalities successfully and efficiently provided public goods. Unfortunately, this is rarely the case. Cities often fail to provide even the most basic services to the people they are charged with serving, which can lead to the failure of the cities themselves. Detroit, as an extreme example, is a post-apocalyptic industrial wasteland. But even glimmering cities like Portland and Charlotte waste resources on public projects, which end up shifting waste onto the public at large.

And yet apologists for the municipal status quo employ the nirvana fallacy to argue against market alternatives. Any failure of markets to live up to their theoretical ideal is taken as a failure of markets themselves. Government is rarely held to such a high standard. In other words, all too often the sometimes messy reality of markets is compared to some ideal government. Most people simply assume government should provide certain goods and services, and that assumption is rarely affected by the ongoing realities of government failure.

Schools—not just the bricks and mortar, but the education—are often among the top items on a city budget. While there is a consensus on the need to improve schools, most people don’t realize how bad they are. CBS reports that “about half of the students served by public school systems in the nation’s largest cities receive diplomas.” The failure of American public schools is not about a lack of resources either. Per capita spending has more than doubled since the 1970s, showing no corresponding rise in test scores.

The problems with city governments are not limited to their failure to provide public goods. They also actively supply public bads—that is, goods or services which harm the public interest.

One such public bad is rent control. There are few things economists agree on, but almost universally, economists think rent control policies are disastrous. Like many other policies, rent control favors current residents over future residents, dynamism, and economic growth. By putting a price ceiling on rents, investors are discouraged from investing in new housing.

Zoning similarly raises land prices. Edward Glaesar and Joseph Gyourko found that in many American cities the price of a new home was the construction materials. They argue that the primary cause of high housing prices is zoning and other land use controls, not market forces.

Cities enact such disastrous policies because they are often controlled by special interest groups. The fight between Uber and local taxi cartels is an illustrative example. The common critique of Uber is that if it does provide a better service, it should be able to win by playing by the rules. What this argument fails to realize is that the “rules” often exist precisely to prevent this kind of competition. Local companies protect their rents by lobbying for legislation that empowers them over competitors, preventing the creative destruction necessary for economic growth.

Police and justice provision

Police and courts have always been considered a foundational part of government. Allowing private cities to have their own police forces seems like a perversion of justice—that is, selling justice to the highest bidder. What if the poor and minority groups are treated unfairly? But how do actual city police currently conduct themselves? And are there examples of successful private dispute resolution?

Consider New York City. After 9/11, the city created the Demographics Unit, whose primary purpose seems to have been to spy on Muslims. The city eavesdropped on conversations, recruited informants to gather information on mosques, and mapped gathering areas of Muslims. Despite all this, the unit was unable to generate a single lead.

Perhaps the worst policy is stop-and-frisk. It amounts to oppression of minority male youths. An average of over 500,000 stops occurred annually over the last five years. Over 85 percent of those stopped were not ticketed. Such stops are often aggressive and humiliating, violating basic norms of human decency.

Such instances of abuse are not aberrant; they are the norm. Both stop-and-frisk and the Demographics Unit were official department policies. But these problems are not unique to police, they are also endemic in our courts.

There are huge racial disparities in drug sentencing. Despite similar drug use rates between whites and blacks, blacks are incarcerated at 10 times the rate of whites. Debtor’s prison, despite a nominal ban, is also making a comeback. It is increasingly common to jail people for failure to pay fines. Because poor people rarely have cash on hand, their entire lives can be disrupted by a single ticket.

While government police and courts are often assumed to be more competent and judicious than they actually are, the relevant question is, “As compared with what?” Despite their flaws, perhaps they are still better than private police and courts.

There are few examples of private police; however, international trade proves the possibility of private courts. Most international trade is done without resorting to State justice. Peter Leeson found that State enforcement of trade increases trade by, at most, 38 percent. While a substantial amount, it is well below what common assumptions about the need for State enforcement of property rights would imply.

The same logic behind private property rights generally applies to the private provision of legal services. Companies that do a good job of providing legal services attract more business, while companies that are unfair and arbitrary lose business. Private cities would want competent and friendly police to attract the working class and a good legal system to attract foreign investment.

Institutional change

Another critique of private cities is that they would be used by the rich to escape the poor; that they would become enclaves of privilege among poverty. While some private cities would undoubtedly serve primarily the wealthy, the majority would serve the poor. Capitalism is mass production for the masses. There is far more profit in serving the poor and middle class than the wealthy.

Further, because the income of proprietors depends on the value of the property they own, they are more inclined to serve the poor. There is far more potential for increases in land value in low-income regions than in high-income regions. Wealthy communities tend to already have a relatively effective provision of public goods.

In fact, the group that could benefit most from private cities is people in the developing world. Economists have reached a consensus that institutions are the most important determinant of economic performance. The rules of the game, how people interact, determine economic growth. For example, China, in the most effective humanitarian measure of the twentieth century, lifted 400 million people out of poverty with special economic zones.

Hong Kong, Singapore, and Dubai all illustrate the power of institutional change to spur economic growth. Hong Kong, a tiny peninsula with no natural resources, has become one of the wealthiest regions in the world. Singapore had a similar rise to wealth under Lee Kuan Yew. Dubai, just a desert 20 years ago, adopted good institutions and became a global financial center known for its ambitious buildings and abundant luxuries.

What prevents growth in the developing world is that governments not only fail to protect property rights, they actively violate them. Developing countries only protect the property rights of elites. Trade and investment are reduced because large portions of the population are unable to enter the global economy. Capital formation among non-elites is impossible because of the omnipresent threat of expropriation by the government.

Economist Hernando De Soto finds that the Philippines recognizes 43 percent of property in urban areas. Haiti recognizes 32 percent, while Egypt recognizes only 8 percent. Successfully integrating these populations into the modern economy is necessary to lift them out of poverty.

However, institutional change is extremely difficult. The elites try to keep the system in place because change threatens their rents. Further, as Russian privatization shows, even de jure change is not enough. Private property rights do not exist independently of the political institutions that enforce them.

Paul Romer advocates charter cities as a solution. A host country in the developing world would allow a rural region to import a developed world legal system and administration. A First-World country would act as a guarantor, importing its institutions and thereby stimulating economic growth. Private cities could play a similar role.

Private cities would also have several advantages over charter cities. First, they would better provide traditional public goods. Second, they would have more choice in the legal system they chose to provide, enabling them to pick and choose an ideal legal system for spurring economic growth. Third, they would be more open to experimentation. Freed from the constraints of a guarantor government, they would be able to abandon failed practices and adopt successful ones more quickly than a charter city.

An additional advantage of private cities is that they incentivize institutional change. Institutional change is rare because of the logic of collective action. While the gains outweigh the costs of protecting private property rights, the gains are dispersed and the costs are concentrated. Those benefiting from such change have an incentive to free-ride, letting others agitate for the change.

Private cities reverse the logic of collective action. By concentrating the gains of institutional change in a proprietor known prior to the change, the proprietor is incentivized to advocate for such change, increasing the likelihood of successful economic liberalization.

The best example for this change is Walt Disney World. Fred Foldvary summarized this well in Public Goods and Private Places. “Abrogating nearly all state laws,” he said, numerous district acts were combined so governance took place under a uniform entity. Voting rights were apportioned by the number of acres owned in the district, ensuring Disney would control the board. Walt Disney World is also exempt from numerous state laws.

Perhaps more important is the potential for self-replication. Because private cities are profitable, there is a built-in mechanism for their proliferation. Successful private cities will discover new profit opportunities. Further, once the potential economic development becomes apparent, countries will become more accepting of territorial institutional change. This ensures that the benefits of private cities can be accessed by as many people who need them, helping to lift the world’s poorest out of poverty.

Find a Portuguese translation of this article here.

  • Mark Lutter is writing his dissertation on proprietary cities at George Mason University.