Real Clear Markets

The Economics of America's Crony Society

How crony capitalism undermines economic growth and innovation

Last week's announcement that European aircraft maker Airbus will receive subsides to build a new plant in Mobile, Alabama is yet another reminder that America's economy is being shackled by cronyism.

The problem of crony capitalism comes in a wide variety of policies that benefit specific individuals, firms and industries at the expense of everyone else. From occupational licensing laws to corporate tax breaks, and from federal flood insurance to ethanol mandates, capital is being misallocated due to state and federal policies. As a result, innovation, economic growth and employment are being undermined. However, legislation being considered in the House this week offers an opportunity to signal the commitment of Congress to counter this cronyism.

On June 2, Airbus announced that it had chosen to locate a new production facility in Mobile, Alabama. According to the company's press release, the plant is expected to cost $600 million and to employ around 1,000 people. That's the good news. The bad news is that Alabama's taxpayers will be subsidizing the facility to the tune of around $160 million. That's $160,000 per job.

In its defense, Airbus might argue that its main competitor, Boeing, has long benefited from such subsidies. In March, the World Trade Organization (WTO) affirmed that Boeing had received over $5 billion in illegal subsidies for the development of the 787 Dreamliner, including tax breaks totaling $476 million from Kansas. In an earlier ruling, the WTO had identified over $16 billion in subsidies, including $2.2 billion from Washington State, though not all of those were found to be illegal under WTO rules.

Airbus too has long benefited from government subsidies. In a case finally decided last year, the WTO ruled that Airbus had received $15 billion in illegal subsidies from European governments to develop the A380.

However, the fact that both Boeing and Airbus have received subsidies hardly exonerates them. My parents taught me that two wrongs don't make a right. And this case is no exception. The sucking of tens of billions of dollars of taxpayer money in the U.S. and Europe by the two companies has contributed to the economic malaise on both sides of the Atlantic.

If no subsidies were available, Boeing and Airbus would compete on a level playing field with smaller competitors, such as Bombardier, Embraer and Gulfstream. The various manufacturers would each seek to meet the perceived wants of customers and would be incentivized to innovate newer, better aircraft with lower total cost of ownership. Production location decisions would be based on cost effectiveness evaluations.

Knowledge about which product to buy, where and when is dispersed among the entire population. The late Nobel laureate economist Friedrich Hayek observed in a famous 1945 article, The Use of Knowledge in Society, that the prices resulting from such transactions provide important signals to market participants, enabling them to make decisions about what to produce, where and when. Subsidies effectively distort those market prices and bias investment decisions.

The billions of dollars given by Washington State to Boeing no doubt preserved many union jobs but caused both unionized and non-unionized workers in other states not to be employed. And the provision of subsidies in one state encourages government officials in other states, such as Alabama and Kansas, to offer similar deals in order to "create jobs." Each such job comes at a high price.

The $160,000 subsidy per Airbus job in Alabama looks like a bargain compared to the average cost of "green jobs" created under the U.S. Department of Energy Section 1705 Loan Program. This program, which funded 26 projects, guaranteed approximately $16 billion in loans and is estimated to have created 2,378 permanent jobs. If those loans are not eventually repaid, the cost would be $6.7 million per job. One of the recipients of 1705 was Solyndra, which received $535 million in Department of Energy loans. On March 20, 2009, Solyndra claimed it would create 3,000 temporary construction jobs and 1,000 permanent jobs. On August 31, 2011 it filed for bankruptcy and laid of its 1100 person staff.

The tax dollars that are given in subsidies are not available to taxpayers. So investments and purchases that would otherwise have taken place do not occur. Subsidies can also impact innovation indirectly by reducing competition. When two companies each receive billions of dollars in subsidies, it is difficult for smaller companies to enter the market. With the smaller competitors excluded and the market effectively carved up, the two dominant companies have less incentive to innovate.

Of course we can't know what innovations have not occurred. Subsidies are thus a classic example of what French philosopher Frédéric Bastiat referred to in his essay, "What Is Seen and What Is Not Seen." What we see is the company that continues to produce goods, often inefficiently, in the wrong place and at the wrong time (both Boeing's 787 and the Airbus A380 experienced lengthy delays). What we do not see are the foregone innovations; they are absent and hence invisible.

But when companies produce goods inefficiently, they usually become vulnerable to competition at some point. This happened all too visibly with subsidized renewable energy companies. For decades, oil and gas companies had been developing techniques of hydraulic fracturing, horizontal drilling, and 3D seismic imaging. In the past few years, these technologies came together to deliver what amounts to a revolution in the extraction of gas from shale deposits, causing the price of natural gas to plummet - and making many "renewable" technologies uncompetitive even with subsidies.

There is another problem with subsidies: companies spend money attempting to persuade governments to hand them over. Economists call this behavior "rent seeking" because the subsidies are a form of economic "rent" (earnings over and above the normal profit that would be earned if the market were competitive). In theory, each company will be willing to spend almost as much lobbying to receive a subsidy as it receives in the subsidy itself - all that matters is that it generates positive rent from its lobbying. These lobbying expenditures effectively dissipate the rents from subsidies, further reducing the resources available for investments in innovation.

Subsidies are a form of cronyism - but they are not the only or even the primary form. In his seminal 1971 paper, The Theory of Economic Regulation, Nobel laureate economist George Stigler observed that regulation by the state is a more important source of rents, benefiting incumbent firms and individuals at the expense of potential competitors (this rent is sometimes referred to as gains from "barriers to entry"). Moreover, Stigler suggested that regulation is sought by the regulated industry - and is designed and operated primarily for the industry's benefit. Consumer activists Mark Green and Ralph Nader largely concurred, writing in 1973, "the verdict is nearly unanimous that economic regulation over rates, entry, mergers, and technology has been anticompetitive and wasteful."

While some forms of regulation have become less prevalent than in the 1970s, in general regulation has increased. Environmental regulation, for example, has become increasingly strict, often benefiting incumbents at the expense of innovative competitors - or even one incumbent over another. As natural gas has fallen in price over the past few years, several states have banned hydraulic fracturing (fracking) and others are contemplating similar bans or other stringent regulations. At the same time, the EPA has introduced several new regulations in the past couple of years the effect of which is to restrict the use of coal as a source of energy. Meanwhile, energy companies continue to receive tens of billions of dollars in tax breaks.

In a fabulous paper published this week by the Mercatus Center at George Mason University, Dr. Matthew Mitchell traces the history of cronyism in America back to the tax breaks given to the East India Company. While that particular instance of cronyism was not well received by Americans, more recent instances have so far not led to widespread protest. The Pathology of Privilege: The Economic Consequences of Government Favoritism provides numerous examples of cronyism, from the $181 billion of subsidies to agriculture - of which 74 per cent goes to just 10 per cent of farms - to the arbitrary sequence of bailouts following the financial crisis in 2008.

Having described the types of cronyism, the author goes on to explain their causes and consequences. Most worryingly, Dr. Mitchell provides instances of cronyism causing widespread economic instability and (associated) diminished trust. The implication is that if the U.S. continues on its present trend, the consequences could be dire.

But as the American revolutionaries demonstrated, the transition to a crony state is not inevitable. This week, the House of Representatives will vote on bill HR 4402, the purpose of which is to streamline the process by which extraction of certain kinds of minerals is regulated and permitted. The legislation almost certainly has flaws and is far from revolutionary, but in its incremental way, HR 4402 might go some way towards reducing the cronyism currently inhibiting the U.S. economy by removing some of the discretion to allocate rents and inhibit economic activity currently enjoyed by bureaucrats and politicians in the permitting process. Much, much more is needed. The only problem is that turkeys don't usually vote for Christmas.

Julian Morris is Vice President of Research at the Reason Foundation.

Julian Morris is Vice President, Research





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