Crony capitalism3

Last week the BBC Daily Politics ran an interesting discussion of crony capitalism between presenter Giles Dilnot and Jesse Norman MP, who has written a concise paper about the subject for the Free Enterprise Group in the Conservative Party.  Unfortunately the discussion is much too narrowly focused on the extent of regulation, whereas the more important issue is its capture.

I think the starting point for any discussion of crony capitalism has to be William Baumol’s work on entrepreneurship.  Here is the abstract to his classic paper Entrepreneurship: Productive, Unproductive and Destructive:

The basic hypothesis is that, while the total supply of entrepreneurs varies among societies, the productive contribution of the society’s entrepreneurial activities varies much more because of their allocation between productive activities such as innovation and largely unproductive activities such as rent seeking or organized crime.  This allocation is heavily influenced by the relative payoffs society offers to such activities.  This implies that policy can influence the allocation of entrepreneurship more effectively than it can influence its supply.  Historical evidence from ancient Rome, early China, and the Middle Ages and Renaissance in Europe is used to investigate the hypotheses.

The reason why calls to abandon capitalism are getting such short shrift is that it has proved unbelievably productive.  Jesse Norman explains how it is both productive and moral, and Baumol’s hypothesis explains why.

Smart and ambitious people will always come up with inventive ways of gaining greater wealth and status.  Greed isn’t new and also isn’t good or bad.  The question is how they do that.  In feudal societies they would physically fight over land, people and property.  Under Communism they would desperately fight for political power, often with extremely high stakes.  By contrast, when capitalism is working well entrepreneurs succeed by innovating and addressing some need that had previously gone unmet.  That drives economic growth.

What we call crony capitalism is when that process breaks down.  When the best way to do well is to play a zero sum game beggaring your neighbour instead of engaging in more productive activities.  That can happen because of failures of corporate governance: smart people get rich by lobbying for unjust rewards at the expense of shareholders.  Or failures of politics: they get rich by lobbying for subsidies or protection against the consequences of risks they have taken, and been rewarded for taking.

There are a number of recent examples in which interference has promoted crony capitalism rather than free markets: extravagant solar subsidies; procyclical banking regulations; and quangos that take money raised in taxes from all businesses and spend it supporting a favoured few.  All of those are instances in which regulatory or fiscal interventions have created an economy in which profits depend more on using politics and the law to seek rents instead of innovating.

Laws that politicians promise will fix the situation are likely to end up being captured in just the same way as existing rules have.  On balance, crony capitalism seems most likely when politics is big and remote from the people who pay the bill.  That might be why decentralised public finances are associated with greater restraint in public spending and greater economic growth.

It isn’t more or less capitalism, or more or less regulation, that will determine how cronyish our economy is, but clear and simple rules built on healthy democratic accountability.

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Matthew Sinclair
Matthew is Director of the TaxPayers' Alliance, author of Let Them Eat Carbon and editor of How to Cut Public Spending (and still win an election)
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