The Rise of a Network: Spillover of Political Patronage and Cronyism to the Private Sector

Abstract: The misallocation of resources in the government and private sectors due to cronyism are widely perceived to be major impediments to economic growth around the world. Distortions in the government and private sectors are typically viewed as distinct and independent sources of inefficiencies. We document that they are related in a way that drastically amplifies efficiency and welfare costs. While the government does not intervene in resource allocation in private markets directly, we show that when members of a group gain access to political power, private firms establish links to the group by recruiting some of its members as executives. Specifically, we document that following a presidential election in Korea, private banks appoint executives from the new president's networks. Subsequently, these banks show a bias in credit allocation to firms linked to the new president's networks similar to government banks. Micro-level data on loans and interest rates, combined with variation in network links for the same firm across lenders over time allows us sharpen the identification of the results. In a parsimonious model of credit allocation, we show that welfare costs increase dramatically when government and private banks share a bias toward the same group of firms. Intuitively, an abundance of funding for in-group firms allows them to overinvest inefficiently, whereas other firms' lack of funding forces them to forego highly profitable investments. If government and private banks' bias in credit allocation is not targeted toward different groups of firms, investment distortions are markedly lower.