Crony Capitalism and Economic Growth in Latin America: Theory and Evidence

Crony Capitalism and Economic Growth in Latin America: Theory and Evidence

by Stephen Haber
Crony Capitalism and Economic Growth in Latin America: Theory and Evidence

Crony Capitalism and Economic Growth in Latin America: Theory and Evidence

by Stephen Haber

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Overview

Crony capitalism systems—in which those close to political policymakers receive favors allowing them to earn returns far above market value—are a fundamental feature of the economies of Latin America. Haber and his expert contributors draw from case studies in Mexico, Brazil, and other countries around the world to examine the causes and consequences of cronyism.

Product Details

ISBN-13: 9780817999629
Publisher: Hoover Institution Press
Publication date: 03/01/2002
Series: HOOVER INST PRESS PUBLICATION Series
Edition description: 1st Edition
Pages: 158
Product dimensions: 6.00(w) x 9.00(h) x 0.50(d)

About the Author

Stephen Haber is the Peter and Helen Bing Senior Fellow at the Hoover Institution. He is also the A.A. and Jeanne Welch Milligan Professor in the School of Humanities and Science and director of the Social Science History Institute at Stanford University.

Read an Excerpt

Crony Capitalism and Economic Growth in Latin America

Theory and Evidence


By Stephen Haber

Hoover Institution Press

Copyright © 2002 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
ISBN: 978-0-8179-9962-9



CHAPTER 1

Anne O. Krueger


Why Crony Capitalism Is Bad for Economic Growth


Until the Asian financial crisis of 1997, economists and policymakers alike devoted much attention to analyzing the causes of the rapid growth of the East Asian economies. Some viewed their growth as a miracle; others (such as the World Bank) attributed it to high rates of capital accumulation. But regardless of the analyst's conclusions, all wanted to learn the lessons of the East Asian successes in order that other countries might emulate them.

Since the crisis, those same economies are said to have had a large number of failures of economic policy; it is even said that there was no success story. Among the failures, a faulty banking system and cronyism are widely regarded as most fundamental. In this chapter, I examine these conclusions. To do so, I do three things. First, I provide an analysis of cronyism and investigate how and why it might have such negative effects as are now alleged. Second, I consider the role of domestic credit expansion in enabling cronyism and in contributing to the crisis. I then turn to the experience of one East Asian country — South Korea — and provide a possible explanation as to how cronyism and the banking system might have performed so well for so long and then have led to the crisis of late 1997. The explanation may apply to other Asian success stories as well — the reason for focusing on Korea is my own comparative advantage in being somewhat more familiar with that economy and economic policies than with the other Asian-crisis countries. Even for Korea, what is suggested is a plausible explanation, rather than a tested and proven hypothesis.

At the outset, however, it is necessary to define cronyism, the subject under discussion. What is normally meant is that some of those close to the political authorities receive favors that have large economic value. Usually, these favors are not outright transfers of wealth (such as forgiving taxes or providing subsidies) but rather take place through provision of economic entitlements. These entitlements can take a variety of forms, but the ones that are most visible in the Asian crisis and the ones under discussion here normally entail ownership of a business or its operation. Ownership may come about when cronies are favored as state-owned enterprises (SOEs) are privatized. More frequently, however, economic entitlements have arisen by enabling the cronies — or, more accurately, the establishments they operate, which I shall call crony-operated establishments (COEs) — to receive privileged access to governmental favors that have economic value. It is a reasonable guess, although it would be hard to devise an empirical test, that the quantitatively most valuable favors received by COEs have been provision of monopoly or quasi-monopoly positions (often through the granting of import licenses only to COEs or the prohibition of imports of import-competing goods) and the extension of domestic credit at highly implicitly subsidized terms. A third form of cronyism — favoritism in awarding government contracts — is no doubt also important and may in some instances have been quantitatively as significant as the first two forms mentioned above.


Cronyism and Its Effects

Until the Asian crisis, it was widely recognized that SOEs were harmful and negatively affected economic growth prospects in most developing countries. In what follows, I shall argue that SOEs are almost exactly the same in their effects as cronyism and for much the same reasons: in both instances, the enterprises owe their existence not to their performance in a competitive market but to the nonmarket criteria by which they were established and are run. There are, of course, differences: the costs of SOEs are probably more transparent as they are normally financed out of the budget, whereas the costs of cronyism are more hidden in that profits are not necessarily publicly recorded and the value of privileged positions (monopolies, protective tariffs against imports of competing goods, favored access to subsidized credit, etc.) can be difficult to gauge; there may be a slight presumption that cronies are on average somewhat more competent as managers and somewhat more motivated to achieve profits and reduce costs. But, as I shall argue below, these are only mild presumptions, and there is undoubtedly a large random component in the performance of SOEs and of COEs.

Since there is much more analysis of SOE records than of COEs, in significant part because of the greater transparency noted above, it is useful to start by reviewing the ways in which SOEs are understood to be harmful to growth. It is then relatively straightforward to consider how COEs are similar to SOEs.

In some countries, governments have established state-owned enterprises in many lines of activity usually reserved to the private sector in developed countries. SOEs have operated tourist hotels, produced textiles, apparel, and footwear, run steel mills, and been in virtually every line of manufacturing, and most business service, activities. It is widely recognized that SOEs have been loss-making in many countries and have become major fiscal drains. In Turkey, for example, SOE deficits had reached 5.8 percent of GDP by 1980, the year in which economic reform began. Governments that invested heavily in SOEs also attempted to control the private sector by means such as requiring investment licenses, capacity licenses, and/or permits for transporting goods, requiring private sector firms to train, provide housing and other goods and services for their workers, and by imposing price controls. These controls naturally resulted in low rates of return on investment for the private sector unless firms held monopoly positions, often sheltered by import restrictions or prohibitions. Then, private rates of return on capital reflected monopoly positions, not economic rates of return. Since much control over firms was exercised by the authorities, it is reasonable to regard these highly regulated and controlled firms as state-owned enterprises.

In the East Asian countries, however, private firms were generally free to seek profits, and the real rate of return to private capital seems to have (at least until the 1990s — see below) reflected an economic return on capital. Cronyism operated through other mechanisms. In some instances, cronyism resulted from the government's favoring large firms precisely because they were perceived to deliver economic growth. Over time, however, these firms, or more accurately their owners, grew sufficiently powerful that they held considerable influence with top government officials. In many instances, the mechanism for favoring those who were, or became, cronies was the issuance of bank credit.

When rapid economic growth began after policy reforms in the East Asian countries, most had highly underdeveloped banking systems and rapid rates of inflation. Ceilings were imposed on the interest rates that banks might charge for lending (or pay to depositors), usually below inflation rates. Those who received loans from the banks at these controlled rates thus received implicit subsidies from the government. In these countries, various mechanisms were used by governments for directing credit. But regardless of how it was done, the favored borrowers profited significantly.

I postpone until the final section an interpretation of how cronyism evolved over time and contributed to the East Asian crisis. I first want to consider the mechanisms through which cronyism might work in terms of a simple analytical framework.

Assume that the only factor of production is capital and that growth occurs via the real rate of return on capital and the extent of capital formation (new investment). In this model, given the pool of investible funds, the real rate of return on capital determines the total increment in output:

DY = R DK = R I = RS


I start by taking S, or savings, as the increase in the capital stock and hence investment, I, as given. Except when explicitly stated otherwise, it will be assumed that the total level of investment equals domestic savings and is exogenous. I focus on R, the real rate of return on capital. The aggregate real rate of return is itself a weighted average of the rates of return on individual investments times the share of those investments in total investments:

R = sum (RI × FI),


where RI is the real rate of return to capital in economic activity I and FI is the fraction of investment directed toward activity I.

In a perfectly competitive textbook economy, of course, the rate of return on each investment is equal and an efficient allocation of resources — in this case investment — results. Over time, the real rate of return on investment might fall if the capital-labor ratio rose and there were diminishing returns to capital. But diminishing returns to capital are less likely to occur at any significant speed in small open economies, where world demand for their tradable goods is highly elastic, than they would be in a closed economy, where the price of the outputs of labor-intensive goods would start declining as output expanded.

Now consider a two-sector economy in which investments are made. One sector is public: it includes SOEs and highly regulated, privately owned firms (presumably in import-substitution activities). The other is an economically efficient private sector (producing exportables, unprotected import-competing goods, and home goods in competitive activities that respond to appropriate relative prices of inputs and outputs (i.e., world prices for outputs and market-determined factor prices that reasonably reflect opportunity cost). Then assume an allocation mechanism for investment between the efficient private sector, with a rate of return of RP across investments, and state-owned enterprises, with a rate of return RS. By construction, RS is less than RP and may be negative. Then the rate of return on total investment will be

R = FP × RP + (1 - FP) × RS,


where R is the economywide rate of return on investment and FP is the fraction of investment going to the public sector.

The growth rate for the economy will be

GY = R × I/K = R × S/K,


where S is the economy's aggregate savings and equals the economy's aggregate investment, I.

Clearly, the rate of growth will be lower than attainable, and it will be lower by more, the greater the fraction of investment allocated to the state-owned enterprises and the larger the differential between the private and the public sector's rate of return. In many developing countries, state-owned enterprises — not even counting highly regulated private firms — accounted for as much as 50 percent of all savings and rates of return were zero or lower, while rates of return on private economic activity were arguably on the order of 10 percent or higher. The economywide rate of return in those cases would have been about 5 percent, whereas the attainable rate would have been 10 percent (had there been little or no diminishing returns to private investment). If the savings rate was 20 percent, lost real growth of GDP would be 1 percent per annum on these numbers. In more extreme cases of SOE losses at a rate of 5 percent of capital, a 25 percent savings rate, and a 15 percent rate of return on private investment with half of all investment allocated to SOEs, the growth forgone equals the difference between the 3.75 percent increment of GDP that would occur if all savings were allocated to private investment and the 1.25 percent growth that would actually take place — a 2.5 percentage point reduction in the rate of growth of GDP.

This model can be complicated in a number of ways: The domestic savings rate could be an increasing function of the overall return on investment, in which case the savings rate would increase as the fraction of investment going to the private sector increased. In the extreme case given above, if the domestic savings rate fell from 30 percent when the real rate of return was 15 percent to 20 percent when the real rate of return averaged 5 percent, the resulting drop in the growth rate from capital accumulation would be from an attainable 4.5 percent to 1.0 percent, with half of investment allocated to the SOEs.

One could also make savings a function of disposable income and model the government budgetary process as one in which taxes were increased to cover SOE losses or the take of cronies, to anticipate an argument below.

One could also model a country in which politicians took as a goal that a specified target percentage of output should originate in public sector enterprises, in which case alpha s would be rising over time as the return on private investment threatened to increase the relative size of the private sector; with the declining share of investment in the private sector, the growth rate could drop even further. The state enterprises might experience a declining rate of return on investment over time, as politicians saddled enterprises with excess staff, poor location, and other costs. As the rate of return turned negative, growth would decelerate. If one combined the declining rate of return on investment with the share of output target, the overall rate of growth could decline over time and, if the real rate of return on public sector enterprise investments turned negative, could indeed become negative.

Since population growth rates are positive in developing countries and high in many, labor force growth is also a source of real GDP growth. For countries with rapidly growing populations, however, the difference of 2 or 3 percentage points of real GDP growth per annum can be the difference between rising real per capita incomes and standards of living and falling ones.

An interesting issue — connected with cronyism — arises with regard to the granting of monopoly positions; in many countries, SOEs were established to produce import-competing goods; once the SOE was in production, imports were no longer permitted, and the SOE had a monopoly of that particular good. The economic rate of return to such an activity was negative to the extent that resources that could have earned a higher return in other activities were diverted to the SOE; with monopoly rents, however, some SOEs were financially profitable. For purposes of analyzing cronyism, the granting of monopoly positions can be regarded as a form of taxation (of consumers or private producers, depending on whether the SOE produces final consumer goods or intermediate goods) with a commensurate rise in the savings rate to cover the economic losses associated with the enterprise. In the national income accounts, of course, monopoly profits accruing to state-owned enterprises are treated no differently than other profits, and the opportunity costs of resources allocated to high-cost, import-competing industries are not reflected.

Before considering cronyism directly, it is useful to consider one possible variant of the SOE model. That is, suppose that, instead of investing in SOEs at negative real rates of return, the government were to use resources to provide for palaces, airplanes, luxury automobiles, and other luxuries for the ruling group, or elite. Suppose that a fraction of savings, equal to that allocated to SOE investments in the situation outlined above, was diverted to these purposes through taxation or through deficit financing (including possibly even borrowing from abroad).

To analyze the effects on growth, there must be two additional specifications. The first question is whether the palaces, airplanes, and luxury automobiles are maintained at public expense. The second is how these expenditures are recorded in the national accounts. Consider first the case where the airplanes, palaces, and other consumption items are maintained at private expense once diverted to the ownership of the elite and where these expenditures are recorded in the national income accounts as investments. In that circumstance, the rate of return on these expenditures is zero, and the case is precisely the same as that modeled above, with the specification that the return on investment is zero. If, instead, these expenditures are recorded as consumption, the domestic savings rate falls commensurately, but the impact on growth is identical. Of course, if the resources to finance the consumption expenditures (or the SOE investments) are raised in ways that reduce the domestic savings rate, the negative impact on growth is even greater.

If the palaces, airplanes, and other luxury items are maintained at public expense, however, the ensuing maintenance costs are equivalent to losses incurred by SOEs. If maintenance costs are a constant fraction of the stock of these consumption goods, and the stock of such items increases more rapidly than output over time, the overall rate of economic growth will decline unless the capital stock rises at an increasing rate.


(Continues...)

Excerpted from Crony Capitalism and Economic Growth in Latin America by Stephen Haber. Copyright © 2002 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Table of Contents

Contents

Acknowledgments,
Contributors,
Introduction: The Political Economy of Crony Capitalism Stephen Haber,
1 Why Crony Capitalism Is Bad for Economic Growth Anne O. Krueger,
2 Sustaining Economic Performance under Political Instability: Political Integration in Revolutionary Mexico Stephen Haber, Noel Maurer, and Armando Razo,
3 The Evolution of Suffrage Institutions in the New World: A Preliminary Look Kenneth L. Sokoloff,
4 Party and Faction in the Imperial Brazilian Parliament William Summerhill,
5 Economic Crises and Reform in Mexico Aaron Tornell,
Index,

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