Bailout Nation and the Dangers from the Political Allocation of Capital

Just released from the Joint Economic Committee, a new study "Dangers from the Political Allocation of Capital," excerpts below:

Since the financial crisis began in August 2007, the federal government has become increasingly involved with U.S. banks and other financial institutions and U.S. financial markets. The Federal Reserve has greatly expanded the size, duration, and scope of its credit facilities. The Department of the Treasury has agreed to 1) inject up to $100 billion of taxpayer funds into Fannie Mae and $100 billion into Freddie Mac, 2) purchase up to $250 billion of preferred shares in banks, and 3) purchase $40 billion of preferred shares in AIG. Now, Chrysler, Ford, and General Motors along with the UAW are seeking emergency financing to help these automakers avoid bankruptcy reorganizations.

This raised an important question – how would the political allocation of capital affect the performance of the U.S. economy? The political allocation of capital misdirects investment based on political criteria. Product innovation and process improvement in firms suffer. Over time, diminishing productivity gains slow real income growth and reduce real GDP well below its potential. Economists attribute the deterioration of economic performance under the political allocation of capital to several factors:

Information problems. The knowledge necessary to allocate capital efficiently is widely diffused throughout the global economy and costly to obtain. It is impossible for any one person or organization to acquire and to update constantly all of the information necessary to allocate capital efficiently in a complex economy.

Unresponsiveness. A constitutional republic such as the United States places many restraints both legal and practical upon policymakers and bureaucrats. These restraints necessarily slow the response of policymakers or bureaucrats to changing conditions or prospects.

Bias against entrepreneurship and innovation. With the political allocation of capital, there is a bias against funding entrepreneurship in emerging industries producing new goods and services using innovative technologies, and toward funding existing firms in established industries producing known goods and services using conventional technologies. The political allocation of capital discourages entrepreneurship, slows product and process innovation, and retards the development of new technologies.

Political Bias for constituents. Under the political allocation of capital, the natural tendency of legislative policymakers to serve the special interests of their constituents may cause such policymakers to direct or at least to influence the flow of credit and investment to their constituencies.

Resource diversion ("rent seeking"). The political allocation of capital encourages firms to devote management time and firm resources to lobbying activities to secure funding from policymakers or bureaucrats.

Corruption and crony capitalism. Finally, the political allocation of capital may foster corruption. When policymakers and bureaucrats make credit and investment decisions, entrepreneurs and firm managers may be tempted to bribe policymakers and bureaucrats to secure funding for their firms or to prevent their rivals from securing funding.

Conclusion. While the severity of the financial crisis may justify some of the recent federal interventions, these interventions, if not reversed once the crisis has dissipated, may retard the efficient allocation of capital in the United States and thus diminish its long-term growth prospects.