The Economist’s Crony Capitalism Index Does Not Measure Crony Capitalism

The Economist’s recent cover story, introducing what it calls the “Crony-Capitalism Index”, has generated a lot of buzz. The study ranks 23 countries (counting Hong Kong separately) based on the Economist’s calculation of the prevalence of politically connected business dealing. The study takes billionaires from the Forbes Billionaires List who are primarily active in certain industries (such as casinos, banking, extractive industries, real estate, utilities, etc.) that the Economist deems “rent-heavy,” and looks at these billionaires’ share of the economic pie in their country. The index has already been used as the basis for media criticism of those countries that scored poorly, such as Hong Kong (1st) and Malaysia (3rd) — indeed, the Malaysian government was so upset that it censored the Economist for the week the index came out.

Some of the results are unsurprising: Russia and India score fairly high in this measure of crony capitalism, whereas Germany bottoms out the list. But other results are more puzzling.  Not only does the index report that Hong Kong has more crony capitalism than mainland China, but also that mainland China has less crony capitalism than either the United States or Great Britain. What gives? Does the United States really have more of a crony capitalism problem than China?

Maybe not. The index suffers from a host of limitations, a few of which the Economist acknowledges, that may explain why some of the results seem so strange. In fact, the results may say more about the methodology of the study and the challenges of comparative measures of corruption than they do about the countries being assessed. Indeed, it’s not clear that this crony-capitalism index tells us anything useful about the quality of institutions or the competitiveness of markets in the countries it ranks.

The crony-capitalism index may pick up the extent of crony capitalism in each country ranked, but the ranking is also likely to be influenced by — and therefore skewed by — a range of factors that have little to with the prevalence of crony capitalism per se:

  • First, the index is likely to be biased against countries in which a large share of the economy is in the Economist‘s “rent-heavy industries,” regardless of how much rent-seeking is actually going on in those industries. For example, in states like Russia (or, for that matter, Norway, which is not included in the index), the natural resource sector is not only large, but it makes up an outsized portion of the economy when compared to, for example, the United States. Likewise, in small city-states like Hong Kong and Singapore, there’s a lot of money to be made in real estate (much as there is in New York City or London), relative to the overall economy of those relatively small jurisdictions. Moreover, as the Economist candidly acknowledges, the index presumes that an industry is as rent-heavy in one country as another. But there’s no reason to assume that oil exploration rights are handed out the same way in Great Britain as in Russia, or that electrical utilities are as able to capitalize on political connections in the United States as in Indonesia. Thus the index is biased against countries dominated by the industries identified as “rent-heavy,” independently of the amount of actual rent-seeking behavior going on in those industries.
  • Second, the Economist study only looks at billionaires (a point it acknowledges). Although the Economist acknowledges this limitation and says it means its index is only a “rough guide to the concentration of wealth in opaque industries,” the bigger problem — which the Economist does not acknowledge explicitly — is that using this cutoff may bias the results so that larger economies, or richer countries, score worse. After all, in smaller economies there may be many oligarchs whose wealth runs merely into the hundreds of millions of dollars, rather than billions — a phenomenon that Forbes recently noted in Ukraine. As a result, smaller economies may be underrepresented in the billionaires list — even if the amount of cronyism is equal or greater — biasing the index against richer countries with larger economies. For similar reasons, the methodology for constructing the index is likely to bias the results against those countries that have privatized these rent-heavy sectors. For example, Russia’s privatization of state-owned industries has created a set of oligarchs with billions in wealth. But in China, as the study notes, many allegedly rent-heavy industries remain dominated by government-owned businesses. These state-owned enterprises may receive similar or greater privileges than privatized companies, but their ownership structure may not result in the creation of billionaires. Why should a state-owned enterprise not count as the beneficiary of “crony capitalism”, just as much as a fully privatized company?
  • Third, again as the Economist also acknowledges, the wealth of crony capitalists is sometimes hidden or dispersed. In China, the wealth of Bo Xilai’s family, which The New York Times reported came largely through links to the state, has been concealed and dispersed among several family members. Or consider a man who has been in the news a lot lately — Vladimir V. Putin. He’s nowhere to be found on the Forbes list, but some estimates have listed him as the wealthiest man in the world based on secret wealth allegedly obtained through his domination of the Russian political system. Again, the issue is not merely inaccuracy (which the Economist acknowledges), but bias: in those countries where it’s either easier to hide one’s wealth, or where there’s a stronger incentive to do so, the crony-capitalism index will understate the true amount of cronyism and rent-seeking going on.
  • Fourth, there’s the focus on personal wealth itself, as opposed to corporate wealth. The Economist notes that America does relatively well in the study because unlike other countries its “energy billionaires” barely register in the overall economy. But that is partly an accident of history: The U.S. energy industry was dominated by extremely wealthy individuals for much of its early development. While those individuals have left the scene and their wealth has become fairly dispersed, many of the public companies those early billionaires created remain strong incumbents and continue to receive many kinds of government support. Likewise, the Economist notes that U.S. financial services billionaires are also fairly small in number and wealth compared to, say, high tech billionaires, making the individual contribution to this index of the U.S. financial services industry fairly small. But to Americans who have just witnessed six years of multi-hundred-billion-dollar financial industry bailouts overseen largely by alumni of the financial industry, the argument that the industry as a whole doesn’t extract enormous rents seems to depend entirely on a focus on personal rather than corporate wealth — on the crony, not the crony company.

The bottom line is that although lists and rankings are always fun and tend to generate buzz, this so-called “crony-capitalism index” probably doesn’t tell us much about relative rates of crony capitalism in these countries. Perhaps rather than using some easily accessible data like the number of billionaires, it might be more fruitful to look at data that measure the actual relationships between these companies and their governments. For example, levels of state support through government-backed loans or subsidies, or the number and kind of political connections between successful firms and governments.

8 thoughts on “The Economist’s Crony Capitalism Index Does Not Measure Crony Capitalism

  1. Great post, Eden. I was surprised at how crude The Economist’s methodology was, given that certain shortcomings in the index – such as including multimillionaires in the list rather than relying only on the Forbes billionaire list – seem like they could have been remedied relatively easily. I agree with all of your critiques, particularly in light of the fact that The Economist looked at only 23 countries and therefore could have taken a more granular/qualitative approach.

    However, I do think that the index has some value, even if the rankings are relatively meaningless. The Malaysian government’s response alone suggests that The Economist has hit on something significant. To me, the index’s broader conceptual framework and The Economist’s predictions about the future of crony capitalism, rather than the rankings themselves, are the more interesting aspects of the cover story. In particular, in the companion article to the index, The Economist predicts that crony capitalism will enter a period of decline for three reasons: (1) governments have an incentive to foster well-functioning markets and thus to promote the rule of law, (2) developing economies are shifting away from rent-seeking industries because (a) economies naturally progress from infrastructure and commodities to non-rent seeking industries as they mature, and (b) international investors are wary of rent-seeking industries, and (3) now that global growth is stagnating, politicians have an incentive to promote growth through open markets.

    I think this prediction should be reckoned with and are independent of the shortcomings in The Economist’s methodology. Even if we accept The Economist’s conceptual framework, my initial reaction is that The Economist’s prediction about the future of crony capitalism is based on flawed reasoning. In countries where government officials have a personal stake in a crony capitalist system and where democratic checks on government are weak, I wonder to what extent reasons (1) and (3) hold. And, as The Economist itself acknowledges, even sophisticated industries in mature economies – examples may include the financial sector (as you discuss in your post) and internet companies in the US – are arguably plagued by rent-seeking. Companies in these industries have no shortage of investors in the US. Therefore, reason (2) might be in doubt as well.

    • I agree with you, Anna (and with Eden, as well). There are certainly serious flaws in the reasoning here. I wonder if it would be best to look at this ranking as setting out the *potential* for crony capitalism, rather than a description of the actual amount of crony capitalism that exists in each country.
      Also (and this is a little tongue in cheek), let’s not totally dismiss the issue of crony capitalism in the US – http://www.nytimes.com/2014/03/28/us/politics/major-gop-donor-tests-his-influence-in-push-to-ban-online-gambling.html?_r=0.

      • Haha — thanks for the link, Phil!

        While you’re right that one way to reframe the data is around the “potential” for crony capitalism, I’m not sure such a study would tell us much, either. For one thing, most of the same biases would exist. Secondly, I’m not sure what the relevance of the billionaires would be at that point — why not just look directly at how much wealth exists in the various crony industries, i.e., the size of those industries? At that point, though, all we’re finding out (again) is how industries are distributed among economies. Thirdly, the study would become arguably even more circular, since we’d be saying there’s a potential for cronyism in industries that we consider cronyist. And lastly, I suppose that there’s always a potential for cronyism in practically every industry.

        Alternatively, could we reframe the study as going to “risk,” rather than “potential” of cronyism? Risk seems to be a more targeted concept, since these are theoretically high risk-of-rent industries. But between you and me, I’m not too motivated to save the study by finding it a new purpose.

        • Oh yeah, I agree. I don’t really think that this is a great study in the first place. My point is that even if we give it the most sympathetic reframing, it’s very indirect, and probably not all that useful.

    • You’re definitely right, Anna, that the Economist’s cover story went beyond the index they created and included other reporting about crony capitalism. Whether the arguments you noted will hold, I think, is a very fair question. My sense is that those arguments are not particularly novel and might be somewhat naive. While there’s certainly a general incentive to create open markets and promote the rule of law, those incentives have probably always existed. The question is not whether it’s in the interest of some disembodied, theoretical politician to promote a noncorrupt economy: it’s whether individual politicians who might have more to gain privately in a system that does not maximize the national interest will act as rational maximizers of that national interest.

      Personally, I don’t find the arguments that convincing. If politicians always did the things that seemed most in the interests of their nations’ economies, we’d live in a very different world, indeed…

  2. I concur with many of the flaws that you note. But the rise of billionaires is a real phenomenon that might have a more powerful impact than diffuse family, state, or corporate wealth. Wherever the exact cutoff is made, the top 0.01% is on the rise (http://www.theatlantic.com/business/archive/2014/03/how-you-i-and-everyone-got-the-top-1-percent-all-wrong/359862/#comments). Heck, this might even make Miguel Cabrera a good signing :-) (http://fivethirtyeight.com/datalab/cabreras-millions-and-baseballs-billions/).

    • Couldn’t agree with you more on that first point, Jesse — and welcome to GAB!

      Billionairism (I’m making up words all over the place in these comments) certainly has effects throughout the economy and society. Certainly, in some countries, the massive personal aggregation of wealth has been both caused by and led to cozy relationships between those private persons and government. But let’s not forget that we have many more corporate “persons” who are billionaires than we have natural person-billionaires. And, as I pointed out in my original post, I’m not sure why the Economist assumes that aggregation of wealth in natural persons is more dangerous or more of a symptom of economic cronyism than aggregation of wealth in corporate persons.

      • Corporate persons have — in theory — independent boards and shareholders with diverse financial and political interests. Concentrated power and interests in natural persons seem intuitively more dangerous.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s