In previous posts (1,2), I explained how crony capitalism and rent-seeking can explain many of our current economic problems. Although I drew parallels with the experiences with cronyism in developing economies, there are some important differences that I neglected to mention.

Financing Constraints and Cronyism

Earlier, I highlighted the role that financing constraints faced by new firms can play in inhibiting exploratory investment. As Raghuram Rajan and Luigi Zingales have explained in great detail, financing constraints have caused and helped support cronyism throughout economic history. Incumbent corporates feel especially threatened by free financial markets "because they provide resources to newcomers, who then can make other markets competitive."

Banks may be reluctant to lend to new entrants for entirely rational reasons such as lack of collateral or uncertainty-aversion. Moreover, many developing economies are capital-poor at the early stages of their economic development and their governments often choose to play an active part in allocating scarce capital to chosen industries and firms. In his book on the origins of cronyism in Japan, Richard Katz laid out the extent to which Japanese capital-intensive firms were dependent upon state patronage and approval for their financing needs in the 50s and 60s. Katz takes the example of Kawasaki Steel which struggled to raise capital for Japan's first modern integrated steel facility due to the objections of the BoJ and only succeeded due to the patronage of another government agency, the Japan Development bank (JDB).

Inefficient Crony Capitalism vs Efficient Crony Capitalism

Although there are some similarities (e.g. collateral constraints), it is a stretch to compare the cronyism of capital-poor developing economies with financing constraints faced by new firms in the developed world (especially the United States) today. There are fundamental differences between the crony capitalism faced by the United States and the experience of economies such as India or Japan. As I have highlighted before, our malaise is caused by insufficiently exploratory incumbent firms. However, our economy is sufficiently internally competitive that incumbent corporates are efficient. Crony capitalism in most developing economies and in Japan has been characterised by a distinctly inefficient and uncompetitive corporate sector. Katz describes the high costs and overemployment that are endemic to many of Japan's domestic industries which can only remain solvent due to a myriad of implicit and explicit collusive and protectionist measures. In other words, the protected incumbents in most developing economies not only fail to explore but are exploitatively inefficient.

The exploitatively inefficient crony capitalism of most developing economies is easy to identify. For example, Katz documents the abysmal productivity of Japan's protected domestic sectors. On the other hand, a systemic failure to explore and innovate is more subtle and harder to detect - in fact, the drive towards exploitative efficiency is likely to increase measured productivity in the short run. When Katz argues that America's problems have few similarities to the problems of Japan's dual economy he is only half right.

The most significant difference between inefficient and efficient crony capitalism is in its impact on unemployment and prices. Paradoxically, efficient crony capitalism goes hand in hand with higher unemployment and lower prices. Incumbent corporates are efficient enough to shed workers during the inevitable deleveraging cycle but are unwilling to explore and create the new jobs that will take their place. Intense exploitative competition between the incumbents also reduces price levels in the short run. On the other hand, inefficient crony economies have lower unemployment at the cost of lower economic output and higher prices. Richard Katz's observations on Japan's hidden social safety net are worth repeating in full: "Whereas in Europe, the social safety net is woven out of overt government programs, in Japan it occurs in hidden form. Anticompetitive activities allow moribund companies and flagging companies to sustain themselves so that unemployment is disguised...."Japan is organized so that society's losers don't feel like losers," is how it is described by Takashi Kiuchi, chief economist at the Long-Term Credit Bank."



Might I suggest that this also applies to Intellectual Property "protection"? Certainly the competition problem is more difficult, because foreign companies might be able to work more cheaply, but other than that IP is just as bad for innovation (and might actually be one of the reasons why banks will become more unwilling over time to lend money to newcomers, because they feel they don't stand a chance).

nick gogerty

This is a good article delineating the costs of corruption relative to the competitive dynamics at various levels of an economy. The competitive internal dynamics, intra-industry and how they facilitate economic advancement and innovation are deeply unexplored in economics. Most economists and analysts just look at the economy as a simple set of interlocking pieces instead of each economy as slightly different set of competitive ecological niches behaving with differing rules to deliver or not deliver the goods. The argument you put forward is good and addresses structural variation and adapted behaviors. Most policy and economic debate assumes that finding the right interest rate policy or some other crude lever will solve all problems. This present a crude mechanistic treatment of economy like a machine that overheats or cools down relative to "money" fuel running through it. Poor Structural dynamics and competitive behaviors hurt Japan leading to stagnant growth. Rate policy, "missing demand", demographics etc. most likely have less to do with the "lost" decades, than poor competitive structures allowing for innovation and creative destruction.


Why the Japan bashing, they run a nice external surplus, so how they choose to manage their internal affairs is nobody else's business. I would point out that the life expectancy gap is now 4yrs between Japan & the US (and in yrs of healthy life even larger), might not be a great place to be a capitalist but hardly a hellhole


Foppe - Yes, dysfunctional IP regimes can certainly make things worse. And the system sometimes becomes dysfunctional because of the actions taken by incumbent firms to game the system by accumulating spurious patents etc. Nick - Thanks. I agree - deflation or inflation are not the source of all our ailments! Tim - I apologise if this comes across as Japan bashing and I certainly am not arguing that Japan is somehow worse off than the US. But they could certainly do a lot better if the cronyism in their domestic sectors is tackled. I strongly recommend reading Richard Katz on this subject - if anything he is more optimistic on Japan than most commentators are (as am I).

Bruce Wilder

I found this portion of the argument deeply unsatisfying, and the use of Japan as an example did not help. Every economy has embedded social relationships -- in an efficient capitalist market economy, people behave "as if" they were dealing with one another anonymously, but, of course, they are not. Productivity is mostly a matter of "technical" (back in the day, sometimes called x-efficiency) efficiency, and not the allocative efficiency, on which economists traditionally focus. "Technical" efficiency concerns management, formal organization, tacit knowledge, engineering, etc. Innovation, in the Schumpeterian sense, is mostly about how the changes in allocational efficiency that follow from applying technical or managerial change can be exploited by entrepreneurs. A putative Entrepreneur sees the technical possibility of producing widgets in a new, more productive way. Because resources are priced at marginal product associated with old ways of doing things, entrepreneur is able to bid away resources for his new way, apply them in the new way, and reap a large, albeit possibly transitory gain -- the difference between the cost of resources priced by the productivity of the old way, and the actual productivity realized in the new way. Productivity improvements are increasing the cost of factor resources even as they reduce the cost of final product. Edison expressed the basic Schumpeterian idea, when he asserted that the light bulb would make candles into luxuries. There are issues, here, preliminary to any consideration of finance and crony-ism. One is the purely allocational one: does an innovating industry attract resources? A simple-minded, naive analysis might suggest that an innovative industry would be reducing costs, and therefore be profitable and would expand, taking in resources (e.g. hiring labor, renting land) from obsolete, and therefore shrinking industry. A few minutes thought would suggest that elasticities, not to mention market and political power, would matter a lot to the shape of the scenario. Productivity could rise, but by more than demand expanded, and the result would be a shedding of resources, not growth. Prices of product could fall, and by enough that the rise in "real" productivity could translate into falling marginal product (e.g. wages), a seemingly perverse result that would repel resources from a productivity-enhancing application. A second issue arises from substitution-bias of technical change. Productivity-enhancing technological innovation almost always involves sunk-cost investments, to realize the technical efficiency gain. There are two critically important implications. First, the association of sunk-cost investments with productivity-enhancing innovation means that such innovation tends to be orthogonal to any allocational factor substitution. Technical innovation is a vector perpendicular to, and independent of, the rate of factor substitution along any counterfactual production possibilities frontier. Technical innovation is embedded in the sunk-cost capital investment, including dedicated capital equipment, and gains in total factor productivity mean that, measured against a unit of output, innovation tends to result in ex-post methods of production, which are less labor-intensive AND less-capital-intensive. (Economists, in particular, steeped as they are in substitution and allocational efficiency, tend not to 'get this' aspect of innovation; naive economists will recommend to developing countries that they play to their comparative advantage, and so some advised Japan, for example, to promote "labor-intensive" sectors after WWII, since Japan had overpopulation and little natural resource or financial capital claims.) In general, technical innovations depend for their key economies on control of error and waste. Enhanced control in the organization of production typically limits the options for "labor-substitution" so dear to economists; there's only one seat on the farm tractor. Second, the sunk-cost nature of the investment, which is the core of Schumpeterian innovation, creates a potential uncertainty challenge for financing innovation. Sunk-cost investment implies a inherent handicap on post-investment bargaining over product price; the cost of the sunk-cost invesment will simply not be a consideration for the rational entrepreneur or his customers in the market negotiation. The ability to earn a return on the sunk-cost investment (and, therefore, to repay its financing) depends on some form of "irrational" market power ("irrational" in the sense that it is always irrational to take into consideration sunk-costs in ex-post decision-making; sunk costs are sunk and no longer a consideration for a rational, maximizing agent). Industrial Organization quickly skips down the path to rents, or quasi-rents, from barriers to entry, first-mover advantages, etc., but I just want to draw your attention to the fundamental, and quite general, challenge that productivity-enhancing sunk-cost investment poses to finance. It is not obvious that there are good, general solutions to this fundamental problem. Purely artificial contrivances, like intellectual property, are inherently counterproductive. If an "idea" (representing a sunk-cost investment in thinking or research) is free to communicate, then to maximize its usefulness, it should be free to use. If you charge for its use in an innovative application, it is equivalent to taxing the innovation -- there's a potential dead-weight loss. Real business entrepreneurs, pursuing innovation, must be vitally concerned with their "business model", i.e. their theory about how a return can be earned on a sunk-cost investment, which is likely to affect both factor costs and final product price. The solution always turns on economic rents, though not necessarily in the purely pejorative sense conveyed by Mancur Olson. All businesses in an uncertain world, where sunk-cost investment is the universal requirement for threshold efficiency, are rent-seekers. They have to be; "profit-maximizing" is an undefined term in a world of genuine uncertainty. The control of rent-earning factors are what give firms stability. The ability of large firms to develop and field bureaucratic organizations depends on business models, which secure large rents; it is the margin of the factor rent, which allows the firm to be a reliable nexus of contracts, and cope with uncertainty in the Knightian sense. It is the existence of factor rents, and quasi-rents on sunk-cost capital investments, which gives the economy a structure and a sense of institutional permanence. Sorry for the long lecture -- I don't doubt that you know all of this, but I want to establish a neutral language and tone, before asserting that cyclical context might be key. In particular, I want to focus attention on the interaction of the elasticity problem and the sunk-cost investment problem. Ordinarily, productivity-enhancing investment in innovation will not be a simple morality tale of virtue rewarded. The invisible hand may well shove the innovator onto a treadmill; declining product prices drag down the financial value of increasing factor marginal product. Productivity growth can be so rapid in a sector that the sector must shrink in factor-input terms. The perverse incidence of a market economy means that the returns to innovation flow not to the innovator, but to the non-innovating laggard. Classically, this is the land-owner, earning an enhanced rent from rising labor productivity or public investments in better transporation systems. These problems of adjustment are not necessarily smoothly solved. Economies can get stuck in a cul de sac, where forward progress requires a re-distribution of income and rents, to which incumbent rentiers are reluctant to consent. For the U.S., the Great Depression presented several such problems. One was in electrical utility and power generation. The efficient and productivity-enhancing path involved huge investments in additional power generation and wider distribution, and equally huge reductions in rates. That was not a path that private utilities were eager to embrace, for obvious reasons. The most significant for the U.S. in the 1920s was in agriculture. Up until the closing of the frontier, agriculture was expanding, taking in new resources. The returns to new farmers and new farmland were sufficient to drive the expansive development of the continent. But, at some point between 1890 and 1930, productivity-enhancing innovations were reducing the resources necessary to produce what was demanded. The WWI boom disguised this for a time, making the experience of the 1920s that much more intense. Self-defeating contradictions took over. Cycles of overproduction made farm incomes not just lower, but far riskier and more volatile, frustrating the ability of farmers to finance either the new innovative investments or out-migration. The second AAA (agricultural adjustment act) scheme -- the first one failed and was declared unconstitutional to boot, as I recall) -- established a scheme that successfully managed the income risks, in a way that promoted both out-migration of resources and high-rates of investment (a neat trick, when you think about it -- in and out, simultaneously). Productivity, measured in output per acre, began to rise markedly in 1935 for all major crops, and continued to rise for decades. Japan, I think, got caught in a similar cul-de-sac, associated with rising productivity in manufacturing. Manufacturing across the developed world is at a stage, where it expands in physical output, but shrinks in input. It happened in Japan early and acutely, because the Japanese economy is so intensely dependent on industrial manufacturing. But, it is surely part of the reality on the ground in Michigan and Ohio, as well. The Last Temptation of Finance is to disguise a return on disinvestment as a return on investment.


Bruce - When I refer to cronyism in Japan, I'm only referring to the cronyism in their domestic sectors, not the export sectors we're typically familiar with. Many of the domestic sectors are characterised by tariff/implicit cartel-like barriers and inflated prices and are more similar to emerging economies like India pre-liberalisation than they are to the US. Again, I'd strongly recommend reading Richard Katz on this subject who refers to this phenomenon as the "dual economy" - an efficient export sector and an inefficient domestic sector. I'm obviously not opposed to the Schumpeterian story of temporary rents as the incentive for innovation. I'm more concerned when these rents become permanent via Olsonian mechanisms and cause stagnation/collapse. On the subject of rising productivity leading to falling output, one industry may shrink but till now capitalist economies have found other things to produce and consume via "exploratory" investment. If we reach the limits of this process, then we're firmly in Marxian end-of-capitalism territory!

Bruce Wilder

Again, I apologize for my long lecture, above. It was more for me, than you. The implication for Japan is that there's a relationship between the high productivity, export industries and the low-productivity domestic sectors, and it lies in the development strategy adopted in the 1950s, which has now played out, exhausting its potential for forward-movement. Japan is in a macroeconomic cul-de-sac, with microeconomic foundations (to coin a phrase), and with no way easy way out, politically. I think Krugman and Koo and the rest do Japan a bit of a disservice, when they abstract the macro-financial aspects of Japan's situation, and ignore the extent to which Japan's economic structure was set in place by a more-or-less deliberate and highly successful development strategy, which rested on BOTH a highly efficient export sector and some highly-inefficient domestic sectors (especially agriculture and service industries), not to mention absurdly high rates of financial saving by households. I'm not objecting to Katz detailing the reality of the outcome of that development strategy run aground. Nor am I asserting a philistine "lump of labor" fallacy. What I am asserting is that macroeconomic phenomena rest on a microfoundation of a dynamic economy, where technical efficiency dominates allocational efficiency, and the free substitution of labor for capital, or vice-versa, is not a feasible option. The "lumpiness" is in the technology-embedding capital stock. Keynes envisioned an economy in which it is possible for some people to literally fall out of the circular flow, and have no feasible way to get back in. The classical model asserts that labor and capital can be smoothly substituted, and that, therefore, excluded resources can bid their way back into the circular flow, by driving down prices, to wit, wages; deflation can cure a depression. Experience suggests deflation exacerbates depression; I'll leave the financial aspects of that -- debt deflation, etc. -- to others. What I am trying to draw your attention to, behind the organizing role of rents, is the sunk-cost investment in capital stock, and the political contest, not just over rents, but over the division of income between Labor and Capital. The technology-embedding sunk-cost nature of productivity increasing investment is a signficant micro constraint on macro possibilities. That constraint can be experienced as "lumpiness" and there are significant economic problems involved that do not lend themselves easily to solution on first-best, panglossian terms. In the U.S. Great Depression, a significant problem centered on wages in highly productive industrial processing industries, where mass-production technologies were advancing very rapidly. Wages had to rise, despite significant de-skilling and massive macro unemployment, for the economy to arrive at a prosperous equilibrium. And, wages in industrial manufacturing did rise, due to the promotion of industrial unionism. (Paradoxically, only a rising labor share in income could drive the necessary capital investment; a rising income share for capital could have been achieved only by reduced capital investment.) In general, I think income distribution is driven by risk distribution and the availability of insurance (and, of course, associated political power, but I think in terms of economics, first, politics, second). Rents are the "real" economy foundation of insurance, which is, of course, a monetary institution, and the incentive structure of the micro economy. It's because I have this view of the "real" microfoundations of macro, that I really admire what you are trying to do here, on your blog. I find it stimulating. If I seem deaf or dense, I apologize; unrequited love needs to irritate the beloved. ;-) Hope you have a great holiday.


On Japan, I couldn't agree more. The current malaise is deeply connected to the strategy they followed post WW2. The conventional diagnosis that creating inflation will cure the problem is naive and wrong. Most economists underestimate just how hard it is to execute dramatic U-turns in economic strategy without causing serious disruptions. I think China will face the same problem as Japan did 20 years ago in successfully shifting away from its current strategy. On income distribution, I don't disagree that in a nth best world, things like unionism can be a force for the good. What I've been trying to investigate is whether a transfer of income to labour can be achieved in a more organic manner - hence my writings on the role of exploration/new entry in forcing increased investment and reduced profit, cash etc on the incumbent firms. The blog is just my way of thinking out aloud - criticism is welcome and you definitely don't need to apologise. Thanks for the comments and have a great holiday season!


On the wider point, I think this argument would be much improved if it could make a distinction between crony capitalism and industrial policy (especially in developing countries). Precisely because there is a large grey area in between. It is hard to argue that industrial policy has not been helpful in some cases (e.g. the Asian Tigers, or even Japan post WW2).


aelle - my impression is that all industrial policy atleast the way its defined in Asia ultimately leads to some form of cronyist paralysis. But this does not mean that this policy was a bad idea. In the case of Japan or China, it almost certainly was better to follow an industrial policy that would eventually lead to economic stagnation after becoming rich than it is to remain poor. I'm more optimistic about Japan than this post hints at - I think they're close to the end of this stagnation. On the other hand, China may be just entering the beginning of their cronyist stagnationist phase.


Thanks for your reply, which I certainly agree with. Maybe the problem in designing an industrial policy is to avoid its capture by already entrenched crony interests, which would tend to negate its exploratory potential. After all, if the only problem is that the policy ultimately leads to well-established sectors with associated cronyism, then on its original terms it has already succeeded, but targeted subsidies have been allowed to become mere rents.


aelle - Thanks for your comments.

Rent-Seeking, The Progressive Agenda and Cash Transfers at Macroeconomic Resilience

[...] competitive sclerosis that afflicts most developed economies today. Although there are significant differences between cronyism in the developing and developed world, there is also a very significant common [...]