With Corporate Welfare, There's No 'Trickle Down'

Advocates of corporate welfare often claim that when governments privilege a handful of firms, the rest of the economy somehow benefits. This is how the Bush Administration sold the bank bailouts. It's how the current Administration sold the auto bailouts. And it's how the U.S. Chamber of Commerce is trying to sell the Export-Import Bank.

Mounting evidence, however, suggests the opposite is true: economies whose firms sink or swim based on political patronage grow slower and are less stable than those in which firm success depends on an ability to meet the market test.

Economists know that when governments privilege particular firms, the broader economy suffers. Important work in the 1960s and '70s by Gordon Tullock and Anne Krueger showed that when governments dispense privileges, firms expend resources chasing those privileges. They lobby, donate to political campaigns, and employ expensive government-relations operatives. This activity expends real resources even though it fails to create net value for the economy.

In 1990, New York University economist William Baumol extended this work, showing that when governments dispense favors, entrepreneurs spend time brainstorming new ways to obtain privilege rather than new ways to create value. Baumol and the research he spawned shows that this vein of "unproductive entrepreneurship" doesn't just cost the economy at a particular point in time (as Tullock and Krueger showed); it also retards therate of economic growth, doing damage for years to come.

More recent microeconomic research has confirmed that companies that are more likely to seek privileges tend to be less profitable. In a survey of 450 firms from 35 countries, for example, economists Mara Faccio, Ronald Masulis, and John McConnell found that "among bailed-out firms, those that are politically connected exhibit significantly worse financial performance than their nonconnected peers."

Corporate welfare doesn't just undermine growth and depress profits. It also fosters instability.

One cause of instability is that privilege often induces firms to take on extra risks. Researchers at the International Monetary Fund found that the U.S. lenders that lobbied more intensively before the financial crisis tended to assume more risk. And a new report by the New York Fed finds that banks that are more likely to receive a government bailout also assume more risk.

Consider the economic crisis that ripped through Southeast Asia in the late 1990s. For more than a decade, governments there took an active role in allocating capital and labor - the building blocks of growth.

Baumol, with Robert Litan and Carl Schramm, documented the problem in the book, "Good Capitalism, Bad Capitalism." South Korea, they wrote, was "long accustomed to directing its banks to provide loans to the larger South Korean conglomerates (‘chaebols')." This "induced too many banks to invest excessively in the expansion of the semiconductor, steel, and chemicals industries." When the crisis hit, the banks and companies that borrowed from them were "so overextended that the South Korean economy came close to collapse." They show a similar problem bedeviling China and Japan.

Columbia University's Raymond Fisman stated the well-known hypothesis in an important piece for the American Economic Review in 2001: "At the root of this hysteria," he wrote, "were concerns that the capital that had flowed into Indonesia and elsewhere in Southeast Asia had not been used for productive investments." Politically directed investment is often unwise.

How susceptible is the United States to this problem? To assess the politicization of investment in Indonesia, Fisman conducted what's known as an event study. He looked at how the stocks of politically connected firms changed as the health of their benefactor, President Suharto, changed. He found that those firms whose board members and top managers had connections with the president suffered more from these rumors than firms without connections.

A few years later, Fisman and his colleagues conducted a similar analysis of firms connected to Dick Cheney following his selection as George W. Bush's running mate. Happily, they found zero evidence that political connections to Cheney mattered. Investors, it seemed, believed that American politicians were either unable or unwilling to indulge their favored firms with privileges.

Recent research, however, suggests that this may no longer be the case. Massachusetts Institute of Technology economist Daron Acemoglu and his colleagues found that when Timothy Geithner was nominated to be Treasury Secretary in 2008, Geithner-connected financial firms got an unusual boost in stock value.

And just this month, when House Majority Leader Eric Cantor lost his primary election, Boeing's stock tumbled. The good news? Investors think Boeing may lose its Ex-Im Bank privileges. The bad news? American companies now seem to rise and fall based on their political connections.