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Archive for December, 2010

The Different Shades of Crony Capitalism

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In previous posts (1,2), I explained how crony capitalism and rent-seeking can explain many of our current economic problems. Although I drew parallels with the experiences with cronyism in developing economies, there are some important differences that I neglected to mention.

Financing Constraints and Cronyism

Earlier, I highlighted the role that financing constraints faced by new firms can play in inhibiting exploratory investment. As Raghuram Rajan and Luigi Zingales have explained in great detail, financing constraints have caused and helped support cronyism throughout economic history. Incumbent corporates feel especially threatened by free financial markets “because they provide resources to newcomers, who then can make other markets competitive.”

Banks may be reluctant to lend to new entrants for entirely rational reasons such as lack of collateral or uncertainty-aversion. Moreover, many developing economies are capital-poor at the early stages of their economic development and their governments often choose to play an active part in allocating scarce capital to chosen industries and firms. In his book on the origins of cronyism in Japan, Richard Katz laid out the extent to which Japanese capital-intensive firms were dependent upon state patronage and approval for their financing needs in the 50s and 60s. Katz takes the example of Kawasaki Steel which struggled to raise capital for Japan’s first modern integrated steel facility due to the objections of the BoJ and only succeeded due to the patronage of another government agency, the Japan Development bank (JDB).

Inefficient Crony Capitalism vs Efficient Crony Capitalism

Although there are some similarities (e.g. collateral constraints), it is a stretch to compare the cronyism of capital-poor developing economies with financing constraints faced by new firms in the developed world (especially the United States) today. There are fundamental differences between the crony capitalism faced by the United States and the experience of economies such as India or Japan.¬†As I have highlighted before, our malaise is caused by insufficiently exploratory incumbent firms. However, our economy is sufficiently internally competitive that incumbent corporates are efficient. Crony capitalism in most developing economies and in Japan has been characterised by a distinctly inefficient and uncompetitive corporate sector. Katz describes the high costs and overemployment that are endemic to many of Japan’s domestic industries which can only remain solvent due to a myriad of implicit and explicit collusive and protectionist measures. In other words, the protected incumbents in most developing economies not only fail to explore but are exploitatively inefficient.

The exploitatively inefficient crony capitalism of most developing economies is easy to identify. For example, Katz documents the abysmal productivity of Japan’s protected domestic sectors. On the other hand, a systemic failure to explore and innovate is more subtle and harder to detect – in fact, the drive towards exploitative efficiency is likely to increase measured productivity in the short run. When Katz argues that America’s problems have few similarities to the problems of Japan’s dual economy he is only half right.

The most significant difference between inefficient and efficient crony capitalism is in its impact on unemployment and prices. Paradoxically, efficient crony capitalism goes hand in hand with higher unemployment and lower prices. Incumbent corporates are efficient enough to shed workers during the inevitable deleveraging cycle but are unwilling to explore and create the new jobs that will take their place. Intense exploitative competition between the incumbents also reduces price levels in the short run. On the other hand, inefficient crony economies have lower unemployment at the cost of lower economic output and higher prices. Richard Katz’s observations on Japan’s hidden social safety net are worth repeating in full: “Whereas in Europe, the social safety net is woven out of overt government programs, in Japan it occurs in hidden form. Anticompetitive activities allow moribund companies and flagging companies to sustain themselves so that unemployment is disguised….”Japan is organized so that society’s losers don’t feel like losers,” is how it is described by Takashi Kiuchi, chief economist at the Long-Term Credit Bank.”

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Written by Ashwin Parameswaran

December 15th, 2010 at 5:53 am

Posted in Cronyism