Cronyism and its Discontents

Type:
SCID Working Paper 54

Author(s):

Published:
03/1/00

Region:
General

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Abstract:
There are interesting parallels between the management of state-owned enterprises (SOEs) and enterprises run by crony capitalists. With SOEs, low real rates of return are generated for a variety of political reasons: to expand employment, to favor regions, to appoint the well connected as managers, and to continue to operate uneconomic enterprises.

In the case of crony capitalism, owners of companies receive credit and may expand because their firms' size is a political asset ("too big to fail"); they may mislocate in the country's capital to be close to those they wish to influence, regardless of cost; and because they receive subsidized credit regardless of prospective real returns, cronies can persist in business even when their activities are no longer economic. In effect, just like SOE's, they too are subject to a soft budget constraint.

Nothing about the lessons of recent crises in emerging markets implies that the economic growth of the 1960s and early 1970s was not spectacular: it was. Opportunities for very high real rates of social and private return were unleashed and were seized with consequent rapid growth. That many financial systems were underdeveloped and the criteria for lending were flawed, undoubtedly led to some misallocation of loanable funds, although bankers can make mistakes, too. But as the huge opportunities for profit that had arisen because of the alignment of incentives with real payoffs were seized, economies developed, and the scope for misallocation of investible funds increased.

As the real rate of return on capital fell for whatever reason, and the implicit subsidy in domestic credit also dropped, the flaws in financial systems and the commitment to cronies (or chaebols) became increasingly costly, just as SOE losses mount over time.