In December, the US Financial Crisis Inquiry Commission (FCIC) decided, in a majority vote, to delay its report on the 2007 crisis by a month. FCIC’s reasoning behind the delay was to undertake a more detailed analysis of the crisis. At the same time, its chairman Phil Angelides remarked that powerful interest groups were trying to undermine the findings of the report. These comments, along with recent developments in advanced economies, point to an interesting development in the study of economic systems.
In 2009, economist Simon Johnson wrote a thrilling article in The Atlantic titled “The Quiet Coup”. In it, he pointed out that there was a disturbing similarity between the 2007 crisis and previous emerging market crises in the crucial culpability of elite businesses. He noted how, after the Asian economic crisis of 1997-98, the economies that had till then been referred to as “tigers” were branded crony capitalists whose success depended on close relationships between businesspeople and government officials. A similar devolution had earlier been seen in Latin American economies as well.
Johnson wrote that in 2007, the US was in a similar boat—its once admired economic model was just another version of cronyism, with a few financial firms dominating both economy and polity.
Almost 12 years before Johnson’s article, economist Jagdish Bhagwati had pointed to this relationship in a now famous paper, “The Capital Myth”. Bhagwati’s objective, however, had been different. He had identified what he had then called a “Wall Street-Treasury complex”, which had led to the US treasury to ask emerging economies to open up their capital accounts—a move that would have clearly helped Wall Street. From this, Bhagwati had cautioned developing countries against opening up to capital inflows.
In subsequent years, the Wall Street-treasury complex turned out to be much more powerful than even Bhagwati (and others) had imagined. It soon became a “revolving door mechanism”, with people from the treasury moving to Wall Street behemoths and vice versa. The best example of this was Henry Paulson, the former chief of Goldman Sachs who was made treasury secretary in 2006; his role in managing the financial crisis is now being questioned.
One of the major victims of the new scrutiny was the US Federal Reserve system. Private banks/financial firms also happen to be owners of the 12 Regional Feds, and have a major say in electing Regional Fed presidents. This is a classic case-study on conflict of interest, but has never been questioned. As the crisis broke out, there were reports of how chief executives of certain financial firms that received Fed bailouts had also elected Timothy Geithner as New York Fed president before the crisis. Geithner was later appointed as secretary of treasury by President Barack Obama.
There are now calls to change this organization structure, which has remained unquestioned since the Fed’s inception in 1913. Meanwhile, cronyism has grown deeper roots despite the crisis, with financial firms gaining both size and clout. In an interview with The New Yorker in July, former Fed chief Paul Volcker narrated how financial firms had lobbied to weaken his proposed Volcker Rule, which sought to separate commercial banking from speculative finance.
And it is not just the US. Similar problems are found across most advanced economies that have been affected by the crisis. There is widespread public anger in the UK over the strong banking lobby, which is preventing the government from taking control of banks even as high bonuses continue to be paid out to bankers. In fact, the government has given up on rising bonuses, and simply expects banks to pay less this year to mitigate rising public temper. Ireland, once called a Celtic tiger, now blames its housing and banking sector lobby for the crisis.
All these developments have also generated interest in research into the linkage between politics and finance. The International Monetary Fund (IMF) in its December 2009 Research Bulletin covered several issues and upcoming research surrounding this topic. Research findings indicate that lobbying lenders/mortgage firms have weaker standards compared with others.
We are seeing similar cronyism trends in India as well. Till November, the Indian economy was creating waves in global economic discussions. The Economist predicted that India would grow faster than others because of its favourable demographics and vibrant democracy. The scenario changed after scams broke out in quick succession at the end of 2010, and evidence of crony capitalism emerged. In the early days of 2011, outlook reports on the Indian economy have become pessimistic over governance and corruption problems.
Of course, the Indian public has always known about the existence of cronyism, unlike in the US, where such realization was muted. But the difference this time was that market participants judged crony capitalism would impact India’s economy and markets.
Another difference is that these events have been unearthed in India without an economic crisis as such. India is both lucky and unlucky in this regard. On the one hand, the government does not have to make sudden, crisis-driven changes to policy. On the other, few countries have ever reformed without a major crisis.
All of this hints at the fact that crony capitalism is no longer limited to developing economies. Indeed, it seems to be an accompanying component of economic development. Just like financial economists who don’t factor in crises in their economic models, we consider crony capitalism only as an aberration in a study of comparative economic systems, and limit it to case studies. Policymakers who should be safeguarding their economies from falling into this trap themselves seem to be dancing to the music of businesses.
However, economists can no more ignore cronyism as a developing country phenomenon caused by weak institutions and lack of policy focus. They should also explain how to mitigate if not avoid this problem. Going ahead, research on corruption and lobbying should become more mainstream.
Amol Agrawal is an economist with STCI Primary Dealer Ltd
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