Corruption & Crony Capitalism

Teaching note: I would suggest assigning the readings in this capsule and the first three exercises in Part 1 the day before the video. Students could then turn in the fourth exercise and be well-prepared for discussion of the selected excerpts the day following the video. This, then would be a two day exercise, video day 1 and discussion day 2. The material in Part 2 could then be assigned the second day along with the exercises to be turned in the following day but would not require an additional day of discussion.

To understand the commentary, the selected excerpts, the video, the Internet sites, and the exercises in the following discussion the following terms must be understood.

Rent-seeking - obtaining profit by influencing government officials to use the power of the state to create artificial shortages. Examples of rent-seeking include (1) obtaining an exclusive government franchise to produce a good or services, (2) obtaining protection from international competition in the form of a tariff, or quota, (3) obtaining an exemption from antitrust legislation, and (4) obtaining an artificially high, guaranteed (supported) price for a good or service. (Note: rent-seeking entails both legal and illegal means of influencing government officials. Legal means include bonafide political contributions and other forms of legitimate political support. Illegal means include bribes and extortion.) Rent-seeking opportunities are most pronounced in economies where the state plays a key role in directing and regulating the economy. In such rent-seeking societies, the source of wealth-creation is not investment designed to enhance productivity and create product and process innovation but instead investment designed to influence government officials - the key to success is not what you know but who you know and how well you are connected politically. Rent-seeking endeavors, then, consume (waste) resources (capital and human ingenuity) which could have been used to create new products and more efficient production processes.

Corruption - public corruption entails the use of state power by a government official to benefit himself or herself at the expense of the public. Examples of public corruption include (1) siphoning off public funds (tax revenue or borrowed money) into a private bank account or into other private uses, (2) accepting a bribe or a "kick back" from a rent-seeker in return for the unwarranted special privileges, (3) demanding bribes or "kick backs" from individuals for the performance of normal job functions such as granting a building permits or performing inspections. Private corruption occurs when an individual takes advantage of an information advantage in an illegal or immoral manner. Examples of private corruption include (1) insider trading where corporate insiders buy or sell stock based on information not available to the investing public, (2) companies withhold information regarding poor financial performance from their investors, (3) companies sell products or services based on fraudulent information

Crony capitalism - a variety of capitalism where the dominant political leaders use the power of the state to advantage family and friends who receive government created rents and/or the proceeds from corrupt behavior. Examples of crony capitalism include (1) a company owned by a member of the family of the dominant political leader that is granted an exclusive license to import automobiles, (2) a construction company owned a friend of the dominant political leader that always wins state contracts to build public infrastructure projects, and (3) a bank owned by a member of the family of the dominant political leader that receives domestic or foreign loans on favorable terms not available to other banks. [Some authors consider crony capitalism to include circumstances which features a very close relationship between government and favored big business conglomerates where government essentially serves as handmaiden providing subsidies, tax breaks and protection from competition to the favored companies.]

Transparency - a condition where the activities and the financial condition of public and private organizations are open to public scrutiny. Examples of transparency include: (1) a bank (or business firm) that regularly makes its financial condition known its investors, its creditors and its depositors (2) a government agency that makes its rules and procedures clear and known to all those who use its services (3) government agencies that make available regular reports on their revenues and expenditures.

Moral hazard - the propensity to engage in risky behavior when insurance or other guarantees protect the actor from the natural consequences of that risky behavior. Examples of moral hazard include (1) an individual fails to lock his car routinely after he buys insurance that will cover the loss of the car if stolen, (2) a bank loan officer loans out depositors' money to a high-risk project at a high interest rate knowing the bank's depositors are covered by a government-sponsored deposit insurance program, and (3) foreign investors, assuming the host government will "bail out" failing banks, loan money to a bank the financial condition of which is suspect due to a lack of transparency.

Part 1

Commentary
I. The extent to which the Asian crisis was fomented by corruption, crony capitalism, and a lack of transparency is open to debate. But, countries seeking IMF assistance in stemming currency crises where forced to agree to make concerted efforts to eradicate these maladies as a condition for that assistance. The massive outflow of investment funds from affected countries was triggered in part by bank failures resulting from bad loans. The extent of those bad loans was initially unclear due to a lack of transparency. Asian banks made questionable loans in part because of corrupt practices including pressure from governments to favor crony capitalists. Foreign investors invested in Asian banks in spite of a lack of transparency due in part to a moral hazard problem whereby these investors assumed country governments in concert with the IMF would "bail-out" financially troubled banks to stem the outflow of investment funds.

The most direct way to eliminate corruption, crony capitalism and rent-seeking in general is to decrease the role of the state in directing and regulating the economy. However, the requirement for greater transparency requires more effective state regulation of financial institutions. Accounting and disclosure rules, as well as rules against insider trading, must be created and enforced by the state to guarantee an level of transparency that will promote efficient investment.

For more perspective on the role of corruption, crony capitalism, and insufficient transparency in the Asian financial crisis, consider the following news story, the four selected excerpts, and the video Asian Values Devalued.

News Story: "For the First Family of Indonesia, an Empire Now in Jeopardy," New York Times, January 16, 1998.

Only hours after President Suharto of Indonesia signed an agreement Thursday morning that required his family to give up some of the crown jewels of their multibillion dollar financial empire, his youngest son stepped from his royal blue Rolls-Royce and into the headquarters of Indonesia's national car project.

"There are many ways to carry on," insisted the son, 35-year old Hutomo Mandala Putra, whose automobile company is among the family-run businesses that have lost lucrative government concessions under the rescue package drafted by the International Monetary Fund "Don't be concerned".

But despite Hutomo's smile and reassuring words, the president and his six children have reason for concern. In the 32 years of his rule, Suharto and his family have firmly entrenched themselves in the economy of Indonesia, a nation of 200 million people, and now find their financial empire under threat.

Interviews in Indonesia and international financial capitals, as well as public documents from the companies involved, offer the outlines of one of the world's great family fortunes, with assets that stretch across the 13,000 islands of the Indonesian archipelago and around the globe.

'This is not South Korea or Thailand or one of the other countries that have turned to the IMF," said a Western ambassador in Jakarta, the Indonesian capital. 'This is not a government run by common politicians or bureaucrats." It is much closer, he said, "to a monarchy, with a king whose authority has never been questioned, and whose children believe their wealth is God-given."
The agreement demanded by the Washington-based economists of the IMF would eliminate many of the government concessions and licenses that have enriched the Suharto family.

Hutomo's car company has lost generous tax breaks that allowed him to undersell his foreign competitors, and he has been stripped of his monopoly on the sale of cloves, the key ingredient in the sweet-smelling cigarettes preferred by Indonesian smokers.

A $1.6 billion power plant project sponsored by his eldest sister, Siti Hardiyanti Rukmana, has been canceled. A bank owned by the president's middle son, Bambang Trihatmodjo, has been closed.

The president's family and closest friends control the production of paper, cement and plywood - cartels that must be dissolved by Feb. 1 under the terms of the rescue plan..........The first family's business operations are symbolic of the type of crony capitalism that has stunted the development of key industries in Indonesia by killing off competition, driving out badly needed foreign investment and keeping prices of food and other commodities artificially high.........Indonesia's lax financial disclosure laws make it impossible to determine the full extent of the Suharto family's wealth, but corporate records and interviews with economists and bankers in Indonesia and other countries disclose that Suharto and this children control hundreds of companies.

The family owns television and radio networks, banks, chemical factories, pharmaceutical companies, shopping malls, hotels, paper and pulp mills, shipping lines and taxi companies.

Hutomo, who is better known to Indonesians by his Western nickname, Tommy, controls the country's leading private airline. Another son controls Indonesia's multibillion-dollar communications satellite industry, while a sister has built many of the nation's toll road. .....Yet while the Suhartos have long defended their business empire by insisting that their businesses are centered in Indonesia and provide jobs to impoverished Indonesians, the first family has continued to move assets abroad.

Some of those investments are criticized by Indonesians as jarringly inappropriate given the poverty at home, notably Hutomo's purchase of Lamborghini, the Italian racing car company, four years age.

For years, foreign governments and many Indonesians seemed willing to overlook the excesses of the Suharto family and the rampant corruption of the government in light of Indonesia's overall economic advance under President Suharto. But that implicit deal has collapsed in the midst of the economic turmoil of recent months."

Evidence of the Suharto family's wealth is everywhere to be seen in even a brief tour of Jakarta, the steamy, smog-choked Southeast Asian metropolis that is home to almost 10 million people.

Visitors often arrive at the capital's international airport on one of the European-made Airbus jets leased to Sempati Air, the airline controlled by Hutomo, the youngest son. Sempati Air is listed in public documents among the assets of Humpuss, Hutomo's conglomerate.

Travelers can exchange foreign currency at the airport branch of Bank Central Asia, one of Southeast Asia's largest banks, which bank documents from last year show is one-third owned by Suharto's eldest son and daughter.

The toll roads from the airport into the city were built by a company controlled by the eldest daughter, Mrs. Rukmana, and several of the billboards along the route advertise the products of the Bimantara Group, the conglomerate controlled by Bambang Trihatmodjo, the middle son. Bimantara listed assets last year of more than $1 billion.

Wealthy visitors often stay at the capital's most sumptuous hotel, the Grand Hyatt Jakarta, which Bimantara lists among its prime assets, and shop at Trihatmodjo's adjoining marble-draped shopping mall, the Plaza Indonesia. The 170-store mall is lined with exclusive shops, including those of Chanel, Gucci, Cartier, Bulgari and Tiffany.

Many of the city's boutiques were bought out in April for the wedding of Hutomo, whose vow-taking before 3,500 guests in a Jakarta theme park was the social event of the year.

Southeast of Jakarta is Hutomo's 425-acre, two-mile international-standard automobile race track, which was built in the early 1990s at a reported cost of $50 million.

Hutomo has long been a fan of Grand Prix racing. In 1994, he led a group of friends in a $40 million purchase of Automobili Lamborghini, the Italian automaker known for its sleek racing cars, which sell for hundreds of thousands of dollars. Recent Lamborghini corporate documents identify Hutomo as the major shareholder in the company.

For the rich, a weekend away from the chaos of Jakarta often means a trip to Bali, where the first family owns or controls many of the island's plushest resorts.

In a recent promotion brochure for his conglomerate, Hutomo disclosed that he and a Singapore company owned the Four Seasons Bali, sister to the luxury hotel on East 57th Street in Manhattan. (A spokesman for Four Seasons said she did not know of Hutomo's interest in the resort.) Rates at the Bali resort begin at $635 a night, and each of the 147 rooms has its own outdoor plunge pool.

Selected Excerpts

From The Lexus and the Olive Tree, by Thomas J. Friedman (1999)

I believe globalization did us all a favor by melting down the economies of Thailand, Korea, Malaysia, Indonesia, Mexico, Russia and Brazil in the 1990s, because it laid bare a lot of rotten practices and institutions in countries that had prematurely globalized. Exposing the venal and corrput Suharto family in Indonesia is no crisis in my book. Exposing the crony capitalism in Korea is no crisis in my book. Exposing the totally corrupt insider dealings in Thailand is no crisis in my book. All these systems would have crashed sooner or later. (p. 164).

In reference to Indonesia..."'When politicians, members of the President's family or Finance Ministry officials came calling, bankers felt compelled to extend loans even for projects they figured would be unprofitable, and when repayment of the loans became doubtful, they concealed the problems,' wrote Shiraishi Takashi, a Kyoto University expert on Southeast Asian finance. (p. 137)

From The Return of Depression Economics by Paul Krugman, , W. W. Norton & Company, (1999)

What we should have noticed was that the claim that Asian borrowing represented free private-sector decisions was not quite the truth. For Southeast Asia, like Japan in the bubble years, had a moral hazard problem - the problem that would soon be dubbed crony capitalism........

Let's go back to that Thai finance company, the institution that borrowed the yen that started the whole process of credit expansion. What, exactly, were these finance companies? They were not, as it happens, ordinary banks: by and large they had few if any depositors. Nor were they like Western investment banks, repositories of specialized information that could help direct funds to their most profitable uses. So what was their reason for existence? What did they bring to the table?......

The answer, basically, was political connections - often, indeed, the owner of the finance company was a relative of some government official. And so the claim that the decisions about how much to borrow and invest represented private-sector judgments, not to be second-guessed, rang more that a bit hollow. True, loans to finance companies were not subject to the kind of formal guarantees that backed deposits in U.S. savings and loans. But foreign banks that lent money to the minister's nephew's finance company can be forgiven for believing that they had a little extra protection, that the minister would find a way to rescue the company if its investments did not work out as planned. And the foreign lenders would have been right: in roughly nine out of ten cases, foreign lenders to finance companies did indeed get bailed out by the Thai government when the crisis came.

Now look at the situation from the view of the minister's nephew, the owner of the finance company. Basically, he was in a position to barrow money at low rates, no questions asked. What, then, could be more natural that to lend that money at a high rate of interest to his friend the real estate developer, whose speculative new office tower just might make a killing - but then again might not. If all went well, fine: both men would have made a lot of money. If things did not turn out as hoped, well, not so terrible: the minister would find a way to save the finance company. Heads the nephew wins, tails the taxpayer loses.

One way or another, similar games were being played in all the countries that would soon be caught up in the crisis. In Indonesia middlemen played less of a role: there the typical dubious transaction was a direct loan from a foreign bank to the company controlled by one of the president's cronies. (The quintessential example was the loan that broke Hong Kong's Peregrine investment Holdings, a loan made directly to Suharto's daughter's taxi company.) In Korea the big borrowers were banks effectively controlled by chaebol, the huge conglomerates that have dominated the nation's economy and - until very recently - its politics. Throughout the region, then, implicit government guarantees were helping underwrite investments that were both riskier and less promising than would have been undertaken without those guarantees, adding fuel to what would probably anyway have been an overheated speculative boom. (pp. 88-89)


On the other side, many Westerners have turned the story of Asia's crash into a sort of morality play, in which the economies received their inevitable punishment for the sins of crony capitalism. After the catastrophe, everyone had a story about the excesses and corruption of the region - about those finance companies, about Malaysia's grandiose plans for a "technology corridor," about the fortunes made by Suharto's family, about the bizarre diversification of Korean conglomerates (did you hear the one about the underwear company that bought a ski resort, and eventually had to sell it to Michael Jackson?). But this morality play is problematic on at least two counts.

First, while cronyism and corruption were very real in Asia, they were nothing new. Korea's chaebol were essentially family enterprises disguised as modern corporations, whose owners had been accustomed to special treatment - preferred access to credit, to import licenses, to government subsidies - for decades. And those were decades of spectacular economic growth. It was not a pretty system by Western standards; but it did function very well for thirty-five years. The same may be said, to a lesser extent, of all the countries caught up in the crisis. Why did their flaws become crucial only in 1997?

And a related point: if the crisis was a punishment for the sins of the Asian economies, how was it that economies that were by no means equally far down the path of development all hit the wall at the same time? Korea in 1997 was not far short of being a developed nation, with per capita income comparable to that of southern European countries; Indonesia was still a very poor country, where progress could be measured in terms of how many calories a day people managed to consume. How is it that such an ill-matched pair could simultaneously be plunged into crisis?

The only answer that makes sense to me, at least, is that the crisis was not (mainly) a punishment for sins. There were real failings in these economies, but the main failing was a vulnerability to self-fulfilling panic.

Back to bank runs: in 1931, about half the banks in the United States failed. These banks were not all alike. Some were very badly run; some took excessive risks, even given what they knew before 1929; others were reasonably well, even conservatively managed. But when panic spread across the land, and depositors everywhere wanted their money immediately, none of this mattered: only banks that had been extremely conservative, that had kept what in normal times would be an excessively large share of their deposits in cash, survived. Similarly, Thailand had a badly run economy, that had borrowed far too much and invested it in very dubious projects; Indonesia, for all its corruption, was much less culpable, and truly had the virtues those wise men imagined; but in the panic those distinctions did not matter.

Were the Asian economies more vulnerable to financial panic in 1997 than they had been, say, five or ten years before? Yes, surely - but not because of crony capitalism, or indeed what would usually be considered bad government policies. Rather, they had become more vulnerable partly because they had opened up their financial markets - because they had, in fact, become better free-market economies, not worse. And they had also grown vulnerable because they had taken advantage of their new popularity with international lenders to run up substantial debts to the outside world. These debts intensified the feedback from loss of confidence to financial collapse and back again, making the vicious circle of crisis more intense. It wasn't that the money was badly spent; some of it was, some of it wasn't. It was that the new debts, unlike the old ones, were in dollars - and that turned out to be the economies' undoing. (pp. 99-101)

View the video Asian Values Devalued (45 minutes)

Exercises
1. Describe an example of rent-seeking similar to those noted in the definition above. Do the same for corruption, transparency, crony capitalism, and moral hazard.

2. In the first Krugman excerpt, Krugman characterizes the entire financial crisis as a moral hazard problem. Explain his reasoning.

3. Constrast Friedman and Krugman on the issues if whether or not the financial crises in Asian reflects the morals failings of affected countries.

4. Describe an example of rent-seeking, corruption, crony capitalism and a lack of transparency from the video Asian Values Devalued.

Suggest Related Readings
1. Linda Y.C. Lim, "Whose 'Model' Failed? Implications of the Asian Economic Crisis," The Washington Quarterly (Summer 1998), pp. 25-42. [Lim comments directly on Krugman's contention that the Asian crisis is an result of a moral hazard problem.]

2. Paolo Mauro, "Why Worry about Corruption?" IMF Economic Issues No. 6. [http://www.imf.org/ at this site select publications and enter author and title above]

Part 2

Commentary
Regardless of the possible role of corruption, crony capitalism, and a lack of transparency in fomenting the Asian financial crises, several recent empirical studies find a negative correlation between these maladies and long run economic growth. In economies with high levels of corruption and crony capitalism, resources are diverted from their most productive uses into projects that benefit those well-connected politically. Additional resources are consumed (wasted) in rent-seeking activities simply currying the favor of governmental authorities. Furthermore, countries gaining a reputation for corruption, crony capitalism, and a lack of transparency, find it increasingly difficult to attract short and long term foreign investment.
Consequently, these countries experience low rates of economic growth.

Exercises
1. Summarize the nature of the statistical evidence of a negative association between corruption and economic growth as summarized by Paulo Mauro, "Why Worry about Corruption?" to be found at the Internet address noted in the suggested readings above.

2. Explain briefly one cause, one consequence and one cure for corruption as noted by Paulo Mauro in "Corruption: Causes, Consequences, and Agenda for Further Research" to be found at:
http://www.worldbank.org/fandd/english/0398/articles/010398.htm.