An anatomy of crony capitalism

Capitalism is the economic system that arguably underlies all of the big, small, profound, and mundane economic decisions we make every day. The remarkable success of capitalism in the currently advanced economies has been made possible by widespread public support for that system. 

That support has seriously eroded in recent years, especially since the global financial crisis in 2007-08. Increasingly the public is coming to view the system as unfairly favoring the ultra-rich. Even though the nature of the economic system is not a question that people necessarily ask every day, the system is no longer perceived to be producing the same impressive economic results as before. 

It has become common to use the term "crony capitalism" to describe the practices by those in political power to serve well connected special interest groups to obtain wealth, revenues and market share that others toil to acquire on an open, free and competitive market by offering better and cheaper goods and services to consumers than their rivals.

A few years ago, The Economist produced an interesting ranking of countries by the amount of crony capitalism existing within those economies. They used the wealth listing from Forbes to determine how many billionaires there are and how they made their money. They allocated those business sectors to things which are more or less likely to be subject to favoritism. The more those wealthy are concentrated in such business sectors, the more crony capitalism is implied. They find industries that have a lot of interaction with the state are vulnerable to crony capitalism. 

Billionaires throughout the world have especially benefited from crony capitalism in the past 20 years. The worth of individuals involved in crony industries increased by 385 percent from 2004 to 2014 and made up a third of all billionaire wealth worldwide. 

Cronyism and corruption are two sides of the same coin. Crony capitalism draws oxygen from nepotistic administration of the existing institutional frameworks, including the provision of infrastructure and the application of laws and regulations. This is extended, often opportunistically, in the mobilization of political power to bring about changes to those frameworks as circumstances and favorites change. Corruption thrives as those close to the authorities making and enforcing policies receive favors that have large economic value. 

It inhibits the evolution of the capitalist system in an effective developmental sense through time by making the public regulator a part of the very system that it is supposed to oversee. The market then loses the insulation from the exercise of arbitrary state power, thus subjecting the pricing mechanism to manipulation. Cronyism makes the conduct of the government non-transparent, short sighted and incoherent in ways that only serves the interests of the cronies.  Businesses cannot be started or maintained without having a close relationship with government officials to get building and other sorts of permits, government grants, special tax breaks, subsidies and so on. 
Yet crony capitalism appears to have delivered significant economic growth. 

In fact, the combination of rapid growth and pervasive levels of cronyism in many Asian economies is a major puzzle. Over the period 1996 to 2011 the growth rate of average GDP per capita in a sample of Asian economies exceeded more than eightfold the average in a sample of African countries with very similar levels of perceived cronyism. Note also that over the period 1927 to 1946 the average growth rate in the former Soviet Union exceeded that in the United States. Similarly, the crony capitalism that characterizes rapid growth regimes in many Asian economies today also prevailed in Korea and China's Taipei at an earlier stage of their development. 

A number of plausible arguments has been made to explain the causes underlying the Asian paradox such as Vietnam. These arguments identify several different mechanisms through which corruption may have a positive effect on output. For instance, when government rules and procedures inhibit growth, bypassing them through corruption may unleash growth. Bribes can act like a piece rate or price discrimination and give faster or better service to the firms with highest opportunity cost of waiting. Similarly, corruption in the form of theft of publicly-owned assets may lead to an increase in output if the new proprietors of the asset deploy it more efficiently.  

Corrupt officials, like parasites, most often feed off society and benefit only themselves. As corruption becomes more prevalent, ethical people are sapped of their drive to work honestly. But studies show that in an imperfect world, a bit of corruption can function as a lubricant to overcome some of the most intractable problems.  

Take the specific case of Vietnam, the most recent rising economic star in Asia.  Vietnam's development has been remarkable ever since the launching of economic and political reforms in 1986.  Rapid economic growth transformed what was then one of the world's poorest nations into a lower middle-income country. Between 2002 and 2018, Vietnam lifted more than 45 million people out of poverty. Poverty rates declined sharply from over 70 percent to below 6 percent (US$3.2/day PPP), and GDP per capita increased by 2.5 times.  All these happened with cronyism staying alive and well.

According to the Financial Times, "Vietnam has gone straight from collectivism to crony capitalism with not much in between." Crony capitalism in Vietnam takes place both on a wholesale level as well as a retail level. Retail cronyism is generally non-systemic expressions of corruption such as awarding jobs or university admission to people based on connections rather than merit. 

Wholesale cronyism is systemic expressions of corruption such as employing only party and their family members and associates to government jobs or to jobs in state-owned enterprises. These coexisted with extensive market-oriented and outward-looking economic policies which helped Vietnam achieve sustained and inclusive economic growth. Political and social stability, young population, and geographic location positioned Vietnam at a competitive advantage for Foreign Direct Investment (FDI). The reliance on patronage and personal relationships with members of the ruling party remains essential for both domestic and foreign investors to conduct business. With the lack of administration and adequate laws for competitive markets posing a serious problem, joint ventures have been the most common way for foreign businesses to begin operations in Vietnam. 

Vietnam enacted reforms such as reducing permit requirements, simplifying company establishment procedures, and the establishment of 'one stop-shops' that offer a plethora of services. Vietnam's regulatory quality and ease of doing business generally improved over the years, reflecting a leveling of the playing field between the private sector and the state. Vietnam negotiated large-scale free trade agreements to reduce trade barriers among countries on both sides of the Pacific Ocean. While the removal of tariffs is seen as an encouraging sign for more equitable business management, the case of McDonald's shows that the presence of foreign companies is hardly a sign of lessening crony capitalism and corrupt business practices. 

Structural problems in the land and credit markets and the dominance of state-owned-enterprises remain obstacles to the private sector. Vietnamese authorities frequently change regulations without prior notice. These regulations are often applied in an opaque manner. Both domestic and foreign private companies and even mission-driven international institutions allow the leaders in the Communist Party of Vietnam (CPV) to set terms and conditions in order to work in Vietnam. CPV leaders, for the most part, have maintained control over dissent and resisted calls to improve political rights. 

The upshot from above is capitalism—competitive or crony—has created prosperity. By channeling energies into production and innovation, it has enabled billions of ordinary people to live better than their predecessors. But capitalism has also widened the gap between rich and poor through cronyism and the capture of government by special interests. 

While inequality between nations has diminished with the rise of China, India and other nations, inequality between rich and poor within nations has gotten worse. The bottom half of the world owns less than 1 percent of the world's wealth, while the top 1 percent of adults own 47 percent. The economic system appears to be "rigged" to benefit the wealthy using political power to enrich themselves, relatives and friends.  

How does that work? Powerful politicians award government contracts to their cronies regardless of whether they have the necessary expertise.  Sometimes, the cronies will form a joint venture with an influential business to bid for the contract instead of the business bidding for it directly.  The entire arrangement is designed to safeguard the politician's commission.  

Prices will be inflated to account for the commission or kickback. Legitimate businesses are unable to get the contracts due to the favors given by politicians to selected businesses.  Real skills, expertise, and know how is not recognized. Getting contracts depends critically on "know who" rather than "know how". The powerful politicians also influence the policies of financial institutions to favor their cronies to obtain and default on credit.  Rentier and parasitic businessmen prosper as a result while true entrepreneurs languish. 

A malevolent facet of such wholesale cronyism is its susceptibility to being marketed as morally benign. Crony capitalists justify favoring certain groups on the grounds that these groups are deserving of favoritism. This overlooks the pernicious effects of such a system on incentives to invest in education and entrepreneurial activity because, under crony capitalism, connections lead to advancement, not educational achievement or entrepreneurial creativity. Crony capitalism worsens the distribution of income. Some privileged asset holders earn rents which induces them to invest. These rents usually come from everyone else in the society. 

The flip side of cronyism is to look at economies that are open to people making fortunes without having political connections. The more this is possible, the greater the economic freedom we can assume exists within that economy. Being low on the cronyism list is a sign that opportunities are more equal even though outcomes may be unequal, as they will be in any market economy. But it is not necessary to know the President or his brother in order to be able to make money. Economics Nobel Laureate Angus Deaton pointed out that increase in self-made billionaires signifies that the economy is vibrant with low barriers to entry. Fortunes which come from producing something people want is just fine. Getting rich because you know the right politicians is less so. 

The solution therefore is to clean up capitalism. End subsidies and protections for businesses, dismantle monopolies and unwind red tape. At the same time, the government must play a bigger and better role in areas where the profit motive of capitalists can't be relied upon to meet the society's needs. 

The author is an economist.