resilience, not stability

Archive for the ‘Cronyism’ Category

The Great Stagnation and Special Interests

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In the last couple of months, I wrote three posts [1,2,3] that tried to explain our recent economic experience as a consequence of the increased rent-seeking that goes along with a prolonged period of stabilisation. My analysis was restricted to the post-2008 period which has thrown up some anomalous patterns that cannot be explained by conventional macroeconomic theory (Keynesian or Monetarist). In particular, I focused on two patterns:  the disconnect between corporate profitability and unemployment (highlighted by the rapid rise in labour productivity), and the fact that this increased profitability has so far only led to increased corporate cash balances and not to increased investment. Both these patterns, although unique, still possess an ancestral lineage that can be traced back to the Great Moderation. Recoveries have been becoming increasingly jobless since 1991 and the “corporate savings glut” has been a common feature since atleast the 90s in the United States, Europe and Japan. To some commentators (notably Michael Mandel and Peter Thiel) our current problems are the result of a prolonged innovation deficit, a view that has been expanded upon by Tyler Cowen in his excellent new book ‘The Great Stagnation’. In my opinion, this innovation deficit is atleast partly driven by increased Olsonian rent-seeking.

It’s difficult to prove that innovation has fallen due to increased rent-seeking. How can we measure the innovation that could have been in the absence of special interests? One approach is to look for industries where the developed economies of the United States, Europe and Japan are not at the forefront of innovation. Tyler Cowen correctly notes that much of the growth in developing economies comes from “catch-up” growth but this is not always the case. As the Economist notes, some of the best innovation in frugal healthcare is now coming out of China and India and much of this innovation has been slow to make its way into the developed economies. The Economist identifies the price-insensitivity of developed markets and regulatory red tape as reasons but this is an incomplete explanation. The same dynamic is visible in financial services where almost all the genuine innovation is taking place in developing economies (e.g. mobile banking in Africa and India), and although financial services has its share of regulatory red tape, it is certainly not price-insensitive.

A hint as to the real problem can be found in the unusually honest comment from a GE executive in the Economist article who admits that “the sales and distribution systems at firms like his, set up to sell $100,000 scanners, are ill-suited to sell versions at a tenth of that price”. As [amazon_link id=”0060521996″ target=”_blank” ]Clayton Christensen[/amazon_link] and James Utterback identified long ago, incumbent firms are almost never responsible for disruptive product innovations. These are inevitably originated by new entrants into the industry. As Christensen noted, disruptive innovations often result in worse product quality in the short term and drastically reduced profit margins that cannot sustain the incumbents’ cost structure. To expect an incumbent in this situation to take a leap on an uncertain innovation that at best will result in dramatically reduced profits is unrealistic. This highlights the damage done by the pervasive presence of special interests in any industry. Rent-seeking becomes the dominant niche that outcompetes all exploratory innovation by new entrants.

Despite this rather gloomy analysis, there is a silver lining. In the long run as the disruptive innovation becomes established, it is inevitable that the technology will spread even to the most rent-infested economies. This highlights the benefits of nation-level diversity in the global economy and the folly of pursuing homogeneity in global regulatory regimes. As Kenneth Boulding said: “If you have only one system, then if anything goes wrong, everything goes wrong.” As long as the “Olsonian cycles” of the major economies are not perfectly synchronised, the global economy may be able to maintain a healthy pace of innovation albeit in a stop-start manner.

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Written by Ashwin Parameswaran

January 31st, 2011 at 4:49 pm

Posted in Cronyism

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

The Great Recession through a Crony Capitalist Lens

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In this post, I apply the framework outlined previously to some empirical patterns in the financial markets and the broader economy. The objective is not to posit crony capitalism as the sole explanation of the below patterns, but merely to argue that the below patterns are consistent with an increasingly crony capitalist economy.

The Paradox of Low Volatility and High Correlation

As many commentators have pointed out [1,2,3], the spike in volatility experienced during the depths of the financial crisis has largely reversed itself but correlation within equities and between various risky asset classes has kept on moving higher. The combination of high volatility and high correlation is associated with the process of collapse and typical of the Minsky moment when the system undergoes a rapid delevering. However the combination of high correlation and low volatility post the Minsky moment is unusual. In the absence of bailouts or protectionism, the economy should undergo a process of creative destruction and intense exploratory activity which by its diffuse nature results in low correlation. The combination of high correlation and low volatility instead signifies stasis and the absence of sufficient exploration in the economy, alongwith the presence of significant slack at firm level (micro-resilience).

As I mentioned in a previous post, financing constraints faced by small businesses hinder new firm entry across industries. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead.

The Paradox of High Corporate Profitability, Rising Productivity and High Unemployment and The Paradox of High Cash Balances and High Debt Issuance

Although corporate profitability is not at an all-time high, it has recovered at an unusually rapid pace compared to the nonexistent recovery in employment and wages. The recovery in corporate profits has been driven by a rise in worker productivity and increased efficiency but the lag between an output recovery and an employment recovery seems to have increased dramatically. So far, this increased profitability has led not to increased business investment but to increased cash holdings by corporates. Big corporates with easy access to debt markets have even chosen to tap the debt markets simply for the purpose of increasing cash holdings.

Again, incumbent corporates are eager to squeeze efficiencies out of their current operations including downsizing the labour force but instead of channeling the savings from this increased efficiency into exploratory investment, they choose to increase holdings of liquid assets. In an environment where incumbents are under limited threat of being superceded by exploratory new entrants, holding cash is an extremely effective way to retain optionality (a strategy that is much less effective if the pace of exploratory innovation is high as an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray). Old jobs are being destroyed by the optimising activities of incumbents but the exploration required to create new jobs does not take place.

This discussion of profitability and unemployment echoes many of the common concerns of the far left. This is not a coincidence – one of the most damaging effects of Olsonian cronyism is its malformation of the economy from a positive-sum game into an increasingly zero-sum game. The dynamics of a predominantly crony capitalist economy are closer to a Marxian class struggle than they are to a competitive free-market economy. However, where I differ significantly from the left is in the proposed cure for the disease. For example, incumbent investment can be triggered by an increase in leverage by another sector – given the indebted state of the consumer, the government is the most likely candidate. But such a policy does nothing to tackle the reduced evolvability of the economy or the dominance of the incumbent special interest groups. Moreover, increased taxation and transfers of wealth to other organised groups such as labour only aggravate the ossification of the economic system into an increasingly zero-sum game. A sustainable solution must restore the positive-sum dynamics that are the essence of Schumpeterian capitalism. Such a solution involves reducing the power of the incumbent corporates and transferring wealth from incumbent corporates towards households not by taxation or protectionism but by restoring the invisible foot of new firm entry.

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Written by Ashwin Parameswaran

November 30th, 2010 at 7:27 am

The Cause and Impact of Crony Capitalism: the Great Stagnation and the Great Recession

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The core insight of the Minsky-Holling resilience framework is that stability and stabilisation breed fragility and loss of system resilience . TBTF protection and the moral hazard problem is best seen as a subset of the broader policy of stabilisation, of which policies such as the Greenspan Put are much more pervasive and dangerous.

By itself, stabilisation is not sufficient to cause cronyism and rent seeking. Once a system has undergone a period of stabilisation, the system manager is always tempted to prolong the stabilisation for fear of the short-term disruption or even collapse. However, not all crisis-mitigation strategies involve bailouts and transfers of wealth to the incumbent corporates. As Mancur Olson pointed out, society can confine its “distributional transfers to poor and unfortunate individuals” rather than bailing out incumbent firms and still hope to achieve the same results.

To fully explain the rise of crony capitalism, we need to combine the Minsky-Holling framework with Mancur Olson’s insight that extended periods of stability trigger a progressive increase in the power of special interests and rent-seeking activity. Olson also noted the self-preserving nature of this phenomenon.  Once rent-seeking has achieved sufficient scale, “distributional coalitions have the incentive and..the power to prevent changes that would deprive them of their enlarged share of the social output”.


Crony capitalism results in a homogenous, tightly coupled and fragile macroeconomy. The key question is: Via which channels does this systemic malformation occur? As I have touched upon in some earlier posts [1,2], the systemic implications of crony capitalism arise from its negative impact on new firm entry. In the context of the exploration vs exploitation framework, absence of new firm entry tilts the system towards over-exploitation1 .

Exploration vs Exploitation: The Importance of New Firm Entry in Sustaining Exploration

In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” True innovation is an act of exploration under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

The assertion that dominant incumbent firms find it hard to sustain exploratory innovation is not a controversial one. I do not intend to reiterate the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot explore effectively but simply that they can explore effectively only when pushed to do so by a constant stream of new entrants. This is of course the “invisible foot” argument of Joseph Berliner and Burton Klein for which the exploration-exploitation framework provides an intuitive and rigorous rationale.

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.

On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure2 . It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

The Crony Capitalist Boom-Bust Cycle: A Tradeoff between System Resilience and Full Employment

Due to insufficient exploratory innovation, a crony capitalist economy is not diverse enough. But this does not imply that the system is fragile either at firm/micro level or at the level of the macroeconomy. In the absence of any risk of being displaced by new entrants, incumbent firms can simply maintain significant financial slack3. If incumbents do maintain significant financial slack, sustainable full employment is impossible almost by definition.  However, full employment can be achieved temporarily in two ways: Either incumbent corporates can gradually give up their financial slack and lever up as the period of stability extends as Minsky’s Financial Instability Hypothesis (FIH) would predict, or the household or government sector can lever up to compensate for the slack held by the corporate sector.

Most developed economies went down the route of increased household and corporate leverage with the process aided and abetted by monetary and regulatory policy. But it is instructive that developing economies such as India faced exactly the same problem in their “crony socialist” days. In keeping with its ideological leanings pre-1990, India tackled the unemployment problem via increased government spending. Whatever the chosen solution, full employment is unsustainable in the long run unless the core problem of cronyism is tackled. The current over-leveraged state of the consumer in the developed world can be papered over by increased government spending but in the face of increased cronyism, it only kicks the can further down the road. Restoring corporate animal spirits depends upon corporate slack being utilised in exploratory investment, which as discussed above is inconsistent with a cronyist economy.

Micro-Fragility as the Key to a Resilient Macroeconomy and Sustainable Full Employment

At the appropriate mix of exploration and exploitation, individual incumbent and new entrant firms are both incredibly vulnerable. Most exploratory investments are destined to fail as are most firms, sooner or later. Yet due to the diversity of firm-level strategies, the macroeconomy of vulnerable firms is incredibly resilient. At the same time, the transfer of wealth from incumbent corporates to the household sector via reduced corporate slack and increased investment means that sustainable full employment can be achieved without undue leverage. The only question is whether we can break out of the Olsonian special interest trap without having to suffer a systemic collapse in the process.

  1. It cannot be emphasized enough that absence of new firm entry is simply the channel through which crony capitalism malforms the macroeconomy. Therefore, attempts to artificially boost new firm entry are likely to fail unless they tackle the ultimate cause of the problem which is stabilisation []
  2. It is critical that the personal consequences of firm failure are minor for the entrepreneur – this is not the case for cultural and legal reasons in many countries around the world but is largely still true in the United States. []
  3. It could be argued that incumbents could follow this strategy even when new entrants threaten them. This strategy however has its limits – an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray. As Brian Loasby remarked : “For many years, Arnold Weinberg chose to build up GEC’s reserves against an uncertain technological future in the form of cash rather than by investing in the creation of technological capabilities of unknown value. This policy, one might suggest, appears much more attractive in a financial environment where technology can often be bought by buying companies than in one where the market for corporate control is more tightly constrained; but it must be remembered that some, perhaps substantial, technological capability is likely to be needed in order to judge what companies are worth acquiring, and to make effective use of the acquisitions. As so often, substitutes are also in part complements.” []
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Written by Ashwin Parameswaran

November 24th, 2010 at 6:01 pm