Crony capitalism: by-product of big government.

• Author: Holcombe, Randall G.
• Position: Essay

Economic policy issues often divide along pro-business and pro-government lines. Pro-business advocates push for tax incentives, subsidies, protection from foreign competition, and regulations that often create barriers to the entry of foreign competitors. Pro-government arguments point to capitalism's abuses and argue that big government is necessary to correct market failures, to regulate business so it will act in the public interest, and to oppose crony capitalism. Pro-business arguments, viewed most charitably, rest on the idea that some government policies create an uneven playing field, and they recommend offsetting government policies to level it. (1) These arguments sometimes rest on the idea that government support can create more economic prosperity than the free market can. (2) Government support can create jobs and help establish infant industries. Regardless of the motivation behind these pro-business arguments, government intervention in the economy to benefit business firms lays the foundation for crony capitalism. When business can profit from government policies, that potential entices firms to pursue benefits through government favors rather than through productive activity. The more government is involved, the more business profitability depends on government support rather than on productive activity, so political connections become all the more important for business success. Crony capitalism is an economic system in which the profitability of business depends on political connections. (3)

Proponents of the argument that more government involvement in the economy and greater regulatory oversight can control crony capitalism misunderstand its actual cause. Crony capitalism is caused by government involvement in the economy, and additional government involvement makes the problem worse.

Crony capitalism is a term that has been used in the popular press, but rarely in the academic literature. However, when one understands crony capitalism as an economic system in which the profitability of business depends on political connections, one sees that a substantial body of academic literature explains its causes and consequences. My purposes in this article are, first, to demonstrate that the academic literature has analyzed crony capitalism's components for decades and that those components are well understood; second, to show that all of these components point toward big government as crony capitalism's cause; and, third, to consider ways in which crony capitalism can be controlled.

Public Policy and Cronyism

The academic literature on the components of crony capitalism comprises models that depict the actual decision-making processes of those in government and their cronies in the private sector rather than simply assuming that the government makes policy decisions that promote the public interest. Economic analysts often suggest that the government intervenes in an economy to correct market problems or to improve economic performance, implicitly assuming that the government is both willing and able to implement the policies that economists' models show would be helpful. Such analysts claim that if the government were to pursue a particular course of action, specific improvements will result. Such recommendations ignore the limits on the availability of information, the incentive structure that government decision makers actually face, and the collective decision-making procedures that actually produce government policies (Holcombe 2012). A real-world government may not be willing or able to implement the recommended policies. Individuals make government decisions, but one individual cannot make the decisions unilaterally, so it is unrealistic to depict "the government" as a single decision maker. Public policies emerge from a collective decision-making process. A recommendation that the government should do "this" to accomplish "that" treats the government as an omniscient benevolent dictator and ignores the possibility that those in government may not have the information or incentives to implement the recommended policy.

The government is not omniscient. The information the government would need to implement the recommended policy is often not available to government decision makers. For example, optimal tax theory requires policymakers to know the elasticities of supply and demand, which exist in theory but cannot be observed in practice. Optimal government production of public goods requires that policymakers know individuals' demands for those goods, but in the absence of a market for those goods, those demands cannot be observed in practice. Optimal policy to correct externalities requires that policymakers know the magnitude of external costs, which exist in theory but cannot be observed in practice. The necessary information is sometimes decentralized so that, as Friedrich Hayek (1945) emphasizes, it is never available to a single decision maker. Policies that can be designed in theory, with perfect knowledge, often cannot be implemented in the real world, where knowledge is imperfect.

The government is not benevolent. Policymakers consider their own interests when they make decisions and shape policies. Because bureaucrats do not profit directly from the good decisions they make but may be penalized for the bad ones, they tend to be less entrepreneurial. William Niskanen (1971) has developed a frequently cited model of bureaucracy that shows that if government bureaucrats attempt to maximize their bureaus' budgets, inefficiently large amounts of resources will be allocated to them. Elected officials often design policies to gain support for their reelection rather than to look out for the public interest.

The government is not a dictator. Even a dictator requires a power structure to keep him in power, so people with political power must provide benefits to those who support them. Such is the case whether a dictator supports his cronies or elected officials provide special-interest benefits to the majority coalition that elects them. In a democracy, many people must agree and work together to implement a public policy. An analysis of public policy must take into account the actual information available to decision makers and the actual decision-making process used to implement policies.

When those in government--bureaucrats or elected officials--are given the power to implement or enforce regulations or to spend money, they have the power to benefit some at the expense of others. This potential lays the foundation for cronyism because people have an incentive to seek government favors and to protect themselves from regulations or expenditures that will put them at a competitive disadvantage. This claim is not a new insight: a well-established academic literature explains and elaborates on it. The common element in this literature is that rather than assuming that because an optimal policy exists in theory, the government will implement it in practice, it takes account of the actual information available to government decision makers and the incentives they face when making decisions.

In the following sections, I describe the literature on rent seeking, regulatory capture, and interest-group politics to show how these ideas relate to crony capitalism. This discussion describes the academic foundation already in place for analyzing crony capitalism and provides a deeper understanding of the mechanisms that create and sustain it.

Rent Seeking and Crony Capitalism

One manifestation of crony capitalism falls under the rubric of rent seeking. When the government can deliver favors to businesses, the latter have an incentive to devote resources to acquiring the favors, which may take many forms. Firms often approach the government with the claim that they have unfair foreign competition, and they seek protection in the form of tariffs, quotas, or regulations that protect domestic firms. Businesses also seek protection from domestic competitors, sometimes in the form of monopoly franchises that prohibit other competitors from entering the market and sometimes in the form of regulatory barriers that increase the costs for the protected firms' rivals. As Gordon Tullock (1967) notes, such firms devote resources to obtaining government favors, expending resources that might otherwise have been devoted to productive activity. These resources are a waste for the economy as a whole--they are "directly unproductive activity," to use Jagdish Bhagwati's (1982) terminology--even though they provide private benefits to the firms that obtain the favors.

Firms increase their profits through government favors, and in exchange they support the politicians who provide the favors. That relationship is cronyism. The profits that arise from rent seeking benefit the firm, but rather than adding value to the economy, as is the case when profits come from productive activity, these profits subtract value. Not only are the resources used in rent seeking wasted, but the profits associated with restrictions that give some degree of monopoly power to rent seekers are economically inefficient for the same reason that any monopoly is inefficient. As Janos Kornai (1986) notes, government subsidies create a barrier to entry--to the benefit of the cronies who receive subsidies and at the expense of their competitors who do not. In some cases, firms may be totally dependent on the government favors and would go out of business but for the government support. Rent-seeking activity is thus one form of crony capitalism.

Anne Krueger (1974) describes how this rent-seeking activity seriously hampered the Indian economy in the 1970s. Many of the best and brightest Indians, she notes, were not engaged in producing anything or adding value to the Indian economy but rather were employed to try to negotiate their firms' way through the morass of government regulations so that they would profit from the restrictions on...