July 20, 2012

This Is What Crony Capitalism Looks Like

Veronique de Rugy

Senior Research Fellow
Summary

The 1705 loan program does expose taxpayers to Solyndra-like waste. But of more concern are the systematic distortions it introduces into the market and the unintended consequences those can have. Loan guarantees are privileges granted to special interests, and there is no better time than now -- when we are running trillion dollar deficits -- to get rid of them.

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In a new paper called "The Pathology of Privilege: The Economic Consequences of Government Favoritism," my colleague Matt Mitchell explains that "Whatever its guise, government-granted privilege [to private businesses] is an extraordinarily destructive force. It misdirects resources, impedes genuine economic progress, breeds corruption, and undermines the legitimacy of both the government and the private sector."

Despite this, Democrats and some Republicans refuse to make the program go away. They defend it on two grounds. First, advocates argue that renewable energy companies do not have access to sufficient credit to support new projects. In addition, the DOE argues that encouraging investment in green technology would create up to 5 million jobs.

But these claims don't withstand scrutiny. Although some 1705 loans went to companies that could not get capital without the government guarantee -- and clearly shouldn't have in the case of Solyndra -- this may be the exception rather than the rule. Indeed, nearly 90 percent of the loans went to subsidize projects backed by large companies such as NRG Energy and Goldman Sachs Group Inc., and would have easily secured access to capital, if the projects were indeed viable. It wouldn't be a stretch to think political connections have a lot to do with who's getting what.

Second, under 1705, $16 billion in loans were guaranteed and 2,388 permanent jobs were created. That means that for every $6.7 million in taxpayer exposure, one job was created. These numbers dispel the idea that this loan program is an effective jobs program.

However, the real problem with the 1705 loan program lies below these numbers. In fact, the Solyndra failure is the symptom of more fundamental problems that make loan guarantee programs a bad deal for Americans.

First, every loan guarantee program transfers the risk from lenders to taxpayers. This creates what economists call a moral hazard problem: because the loan amount is guaranteed, banks have less incentive to evaluate applicants thoroughly or apply proper oversight. These programs privatize gains and socialize losses -- in other words, taxpayers bear the downside risk, but the companies and the banks that receive the guarantees get the upside benefit.

Second, loan guarantees give an incentive to lenders to shift resources toward subsidized projects and away from nonsubsidized ones. This has a cascading effect. For instance, once the government subsidizes a company, that company becomes a relatively safe asset which then attracts private capital, independently of the merits of the projects. That capital is then unavailable to unsubsidized projects, even if they have a much higher probability of success and a more viable business plan. The subsidy can thus hurt the production of green energy, as an unrealistic but subsidized green energy project thrives while other, more viable green energy projects starve.

Finally, every loan guarantee introduces political incentives into business decisions, creating the conditions for businesses to seek financial rewards by pleasing political interests rather than customers. As Mitchell explains this is called cronyism, and it has real economic consequences.

Whatever the intentions that motivated the program, it just doesn't work. The 1705 loan program does expose taxpayers to Solyndra-like waste. But of more concern are the systematic distortions it introduces into the market and the unintended consequences those can have. Loan guarantees are privileges granted to special interests, and there is no better time than now -- when we are running trillion dollar deficits -- to get rid of them.