The Growing Dangers of Cronyism

The 2012 campaign trail has been rife with accusations of “cronyism” from both sides.

Anger over backdoor deals between government and business has spurred an uptick in legislation, regulation, and oversight. Here’s the problem: with an increase in government comes an increase in privileges for special interests. And in the end, taxpayers and consumers get the short end of the stick while politicians and their cronies reap the rewards of having friends in high places.

So, why does cronyism occur? In my paper, entitled The Economics and History of Cronyism,released today by the Mercatus Center, I cite two factors: government power over the economy and the discretionary power available to particular government officials.  If there was ever a doubt that this connection existed, consider this study from MIT, which shows that in the days following the leak of Tim Geithner’s appointment to Treasury Secretary, stocks of firms having any pre-existing connection to him jumped by about 15 percent. Clearly, the market expected firms that were connected to Geithner to do better, all other things equal.

So what’s wrong with this cozy relationship between business and government? It’s not just that cronyism takes wealth from the less politically organized to give to the more politically organized, but also that this taking and giving destroys wealth. For example, when the government bails out its cronies (think former Treasury Secretary Paulson and AIG), it destroys wealth in several ways.

First, by taxing people to get the bailout funds, it reduces the incentive for taxpayers to be productive. Even if the bailout is financed with borrowed funds, borrowing now means higher taxes later. Additionally, business risks are transferred from companies and banks to the taxpayers footing the bill.

Second, by giving money to companies that can’t make it on their own, the government diverts capital from where consumers want it used to where the government wants it used. As we’ve seen in the case of Solyndra and so many other subsidies, the government doesn’t always hit the mark when it comes to good investments.

Finally, when politicians dispense special privileges to certain businesses, a vicious cycle ensues: Businesses put their financial resources towards currying favor with politicians rather than investing those resources in their product and their customers. In short, the government doesn’t do a very good job of picking winners and losers. As Lawrence Summers, Obama’s former economic adviser once said, “...the government is a crappy [venture capitalist].”

Cronyism isn’t a zero-sum game that takes from some and gives to others; it’s negative-sum. The losses to the losers substantially outweigh the gains to the usually less numerous winners. That’s something both sides of the political aisle should be able to agree on. The solution to cronyism is not more politicians meddling in private business. It’s the opposite: Let the free market do its job and level the playing field.