Enterprises try to exploit a competitive advantage through the use of their government connections. And whenever governments intervene, bureaucrats gain more power, and invariably distort the markets. The graft issues in Russia & China, the US housing bubble, and the host of scandals currently swamping India are all related to crony capitalism. Can this ever be stopped?

William Gamble

The recent telecom scandal in India provokes a question about its market economy. Does India, like Russia, have crony capitalism? But before we can answer this question, we have to determine exactly what crony capitalism is. How and why is it created? How does it affect growth? And perhaps the most important question is whether it can be stopped.
 
The term 'crony capitalism' originated during the Asian financial crisis of 1997. For most of the 1990s, many economists, financial analysts, and investors treated the Asian 'Tiger' countries (South Korea, Taiwan, Hong Kong, Thailand, and Malaysia) with the reverence that is today reserved for BRIC (Brazil, Russia, India and China) countries. All that came to an end with the collapse of the Thai baht in July of 1997. To explain the collapse of economies that had been hailed as a new and more perfect model for rapid economic growth, economists created this pejorative term where a supposedly moral failure was the cause of their bad predictions.
 
The reality is that enterprises are simply trying to exploit a competitive advantage through the use of their connections. The problem with crony capitalism is that these connections are invariably connected to a government. It is the government that distorts the market.
 
Crony capitalism is sort of 'anti-antitrust'. It exists when the government itself colludes to decrease competition which eventually hinders the growth of the entire economy. The more accurate term would be the one coined by the great economist Mansur Olson. These are distributional coalitions or power groups who can utilise their greater resources, organisation, and networks to improve their position at the expense of competitors.
 
Crony capitalism is also not simply limited to emerging markets or developing countries. It exists everywhere with often disastrous consequences. The current housing catastrophe in the United States is directly due to a local form of crony capitalism. The two mortgage giants Fannie Mae and Freddie Mac exploited their close connections and semi-government status to prevent appropriate limitations on their activities. By becoming involved in legislation and even making major contributions to campaigns, they were able to avoid scrutiny and reform long enough to help create and invest in a housing bubble that eventually collapsed with horrendous consequences.
 
The oligarchs of Russia are certainly prime examples of crony capitalism. But they can hardly function without the aid of the government. For example according to the Kremlin's own statistics, Russia loses over 1 trillion roubles ($35 billion) a year through rigged state tenders. A draft new law rather than curb this theft will most likely institutionalise it.
 
The new law is instructive because it illustrates crony capitalism's methodology. It accomplishes its goal of restricting competition by eliminating limits on power. The law increases a bureaucrat's discretion and reduces transparency. Bureaucrats are allowed to preselect suppliers and can set requirements that can only be met by connected companies willing to compensate these officials. This is not exactly a shrinking of a moral universe, but rather constructing a system of government that reallocates wealth in a specific manner.
 
In contrast in China, the authorities have developed a distinct form of crony capitalism with Chinese characteristics. In most countries private companies achieve competitive advantage by distorting the legal landscape. Although this certainly occurs in China, most of the distortions are created by the state to give competitive advantage to its own companies. In a sense the genius of the Chinese system is that it bypasses the middleman and provides both profits and bribes to the government officials who have created a system that mainly benefits them.
 
The real problem with crony capitalism is that those involved become rentiers whose only economic incentive is to increase their income by increasing the restrictions. The annual survey taken by the American Chamber of Commerce of China shows that over 70% of the companies doing business in China said that they were "subject to regulatory discrimination" and over 30% felt that the problems had "become more difficult" over time.
 
The paradox of crony capitalism is that it exists because the power given to government officials to protect citizens provides them with an economic incentive to enrich themselves. More law may not help. Creating watchdogs may just create more rent seekers. Game theory postulates that and agents' best move is to suborn the watchdog.
 
Less government and intergovernmental competition are more effective. In India recently, as a response to the telecom scandal, the Supreme Court has become far more active in pursuing corruption.
 
Transparency, bureaucratic discretion, a free and protected press all can have economic consequences. One of India's tycoons, Anil Ambani and his company Reliance lost 25% in market value after some of his malfeasance was revealed.
 
Ultimately democracy is the best control. The Congress party in India might only be interested in curbing corruption-when the BJP, the main opposition, sees it as an issue central to winning an election.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])