Academic journal article Economic Inquiry

Crony Capitalism and Financial System Stability

Academic journal article Economic Inquiry

Crony Capitalism and Financial System Stability

Article excerpt

I. INTRODUCTION

Prior to the Asian financial crisis, the cozy relationships between corporations, governments, and banks were seen as a potent force for economic growth and development. In the wake of the crisis, these same links were derogated as crony capitalism and blamed for many of the economic ills suffered by the now wounded tigers.

In this article, we examine the institution of crony capitalism. Under conditions in which the Second Welfare Theorem does not hold, there is a role for government. Some governmental institutions do encourage more risky, high-payoff entrepreneurial activities. Our aim is to examine crony capitalism as a potential source of government activity that enhances economic productivity. In addition, we explore the conditions under which the government activity can instigate a financial crisis. (1)

We begin with a characterization of the relationship between banks and project owners, sans cronies. In this economy, project owners, or borrowers, have access to both positive and negative expected net present value (NPV) projects. We consider a perfectly competitive banking industry. The representative, risk-neutral bank can write incentive compatible loan contracts that induce risk-neutral borrowers to undertake the positive expected NPV projects by requiring that the borrowers take an equity stake in their projects. Under the equilibrium loan contract, only positive expected NPV projects are funded, the bank earns zero profits, and, by appealing to the law of large numbers, the representative bank does not suffer from bankruptcy risk.

We next introduce a crony system under which the government agrees to guarantee some fraction of its cronies' loan payments in the case of project failure. Crony status garners a project owner pecuniary and possibly nonpecuniary benefits. The government's guarantees are promises and as such are not the result of formal legislative or executive action or formal loan negotiation. (2) Rather, these guarantees can be seen as a mechanism by which the government makes sub rosa rewards to its friends and family and also buys their political loyalty. Crony lending makes up only a small part of a bank's balance sheet, so the attendant risk cannot be diversified away. To ensure its solvency, the representative bank must put its own capital at risk. Given a project owner's crony status and the loan guarantee, the bank writes a crony-specific loan contract that takes the crony's incentives into account as well as the bank's need to remain solvent should a crony's project not pay off.

In this setup, a financial crisis is an ex post event. It is identified by a simple condition: A bank becomes insolvent. A financial crisis is triggered when the government fails to honor its guarantees. One can imagine several factors that could contribute to such a failure. For instance, perhaps a government faces unforeseen external constraints (e.g., constraints imposed by the International Monetary Fund and/or the government's revenues are inadequate). Or, alternatively, it reneges on its implicit contingent liabilities because there has been a change in government personnel.

We extend the model economy by introducing crony effort. More specifically, cronies improve the return distribution of the projects they undertake by putting forth unobservable effort to garner nonpecuniary benefits, such as political power and prestige. We also show that such crony systems may induce project quality improving effort if the nonpecuniary benefits to crony status are high enough. If this is the case, a crony system would not necessarily lead to reductions in output or increases in bank portfolio risk, but the demise of a crony system would.

Much has been written about the Korean chaebol and the Japanese zaibatsu, what some consider classic crony institutional forms, but we use Occam's razor to pare the institutional structure of crony capitalism to its bare minimum: Crony project owners receive implicit financial support from the government. …

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