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Brooks Wilson's Economics Blog: A Review of Rajan’s and Zingales’ “Saving Capitalism for the Capitalists”

Saturday, January 22, 2011

A Review of Rajan’s and Zingales’ “Saving Capitalism for the Capitalists”

Raghuram Rajan and Luigi Zingales make an excellent contribution to economic literature in “Saving Capitalism for the Capitalists.” Their writing style is crisp and animated even as they maintain scientific precision. The authors’ seem to write as concerned but detached outsiders looking into various national economies. Perhaps that is the perspective they gained by living, studying and working in many countries. Anyone with an interest in economics could benefit by reading it including the professional economist; the notes are clear and the authors reference a great deal of economic literature.

Economists have long observed that the laws and institutions within a country determine the level of wealth. If a country is not wealthy, it has bad institutions and those institutions should be changed. This approach treats an economy like a building or a machine to be constructed or fine tuned. Rajan and Zingales approach is almost biological. They theorize that a country’s economic and political institutions grow symbiotically in the same national environment and they offer two types of relationships or capitalisms.

Relationship capitalism is the most common and produces the least wealth. The relationship between economic and political institutions is parasitic.  Because economic laws and institutions do not protect property rights, the ability of an entrepreneur to produce goods and services depends on her political and business relationships. A political regime’s power is also derived from relationships with incumbent firms, unions and other special interests. The political regime protects incumbents’ economic status by limiting competition from internal and external forces. This exposes an internal weakness of relationship capitalism. The ability to protect incumbents is in part dependent on the economic efficiency of the incumbents the political regime protects from efficiency promoting competition.

Change to a commensal symbiotic relationship or arms-length capitalism, comes in two phases beginning with the “taming of the government.” In general, the government is not tamed by a great leader working for the masses but an incumbent politician attempting to solidify his position or eliminate political rivals. To do so, political incumbents must attract new allies and they can only do so with a credible commitment to protect their property. The second phase, the “taming of the incumbents,” comes by exposing incumbents to internal and external competition. Rajan and Zingales see finance as a vital agent of change making competition in capital markets as important as competition in trade. Economic challengers can grow faster when the financial industry is strong because they do not have to rely on profits to fund growth.Arms-length capitalism produces political challengers. Schumpeter’s “winds of creative destruction” blow hard, challenging weak economic incumbents in good times, and spawning more political opponents during downturns. Rajan and Zingales suggest that challenged incumbents will combine with the economically displaced to politically threaten arms-length capitalism using protection of the masses as a pretext to protect the interests of the wealthy owners of the incumbent firms.

The authors propose a set of policies that protect arms-length capitalism and the dispersed wealth that it creates by reducing incumbents’ incentives to appeal to political markets. My review is incomplete but highlights some of the proposals I find most interesting. They begin with a property tax to replace or augment the income tax. An income tax is inefficient, favoring businesses and individuals with extravagant expenditures and resultant lower profits or savings over the efficient who produce large profits or savings. The property tax favors the efficient over the extravagant by subjecting both to the same taxes. They also propose an inheritance tax on transfer of control not on wealth. Because heirs typically do not have the entrepreneurial talents of their progenitors, transfer of controlling interest would increase inefficiency. The tax could be avoided by transferring wealth in diversified portfolios.

Rajan and Zingales also propose an enhanced safety net that insures people directly and not through firms. The presence of the expanded safety net reduces the incentive of those displaced by innovation to act in political markets. Their safety net would concentrate on health and education to allow people to protect themselves through permanent changes in the economy rather than cyclical changes.

As an economist who appreciates the wealth creation of arms-length capitalism and the higher standard of living that it engenders, I find their proposals intriguing. They decrease incentives for malignant action in political markets, protecting economic innovation. They protect the poor and other displaced with minimal disruption of markets and create economic mobility for the motivated and talented of all economic classes.

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