It is no secret that lines are often blurred between politics and business. The connection between corporate interests and political power has long been explored by journalists and evidenced by academic literature.
Previous economic research on the subject shows that corporate political connections generally increase the profits and value of businesses whose owners, managers or directors have political ties. However, determining whether politically connected businesses harm the overall economy through misallocation of resources is a more complex undertaking. By studying the fall of fascism in Italy from 1943-1944, two Purdue University researchers have found compelling evidence that political connections cause resource misallocation.
The results from the Mitch Daniels School of Business’ Mara Faccio, Tom and Patty Hefner Chair in Finance and Professor of Management, and John J. McConnell, Burton D. Morgan Distinguished Chair of Private Enterprise and Professor of Management, are outlined in their working paper “Political Connections Cause Resource Misallocation: Evidence from the Fall of Fascism in Italy.” This research was included in the European Corporate Governance Institute’s Working Paper Series in Finance.
It may seem natural to assume that an economy where politically connected companies have more resources is a bad thing, but this conclusion must be based on evidence. For example, what if the connected companies that receive preferential treatment from the government are the best businesses in the economy? We know that an increased sharing of information can sometimes help reduce market frictions. Does this apply to the information shared between corporate and political interests? Or does it do more harm than good?
The real impact of corporate political connections on the allocation of economic resources is difficult to measure. That is why Faccio and McConnell use the collapse of the fascist government in Italy during World War II to study this relationship. Corporate political connections were pervasive during the fascist regime, but upon its demise, these connections were severed almost completely. This allows Faccio and McConnell to evaluate how previously politically connected businesses perform once they can no longer enjoy the benefits political connections provide.
In 1941, the beginning of the end for fascist Italy under the authoritarian rule of Benito Mussolini, 80% of the largest 150 Italian companies had a politician serving as an officer or a director. By 1944, a royal decree deemed fascist politicians ineligible for political office. This decree was further cemented into law by the Constitution of the Republic of Italy in 1948, which formally established Italy as a democratic republic.
Politicians holding key positions within companies at the officer and director level were now largely a thing of the past, as new laws prevented this intertwining of corporate and political interests. So, what happened to the companies that were previously politically connected?
Faccio and McConnell found a robust, economically large, and highly statistically significant drop in performance for these companies after their political ties were severed. In presenting their finding that previously connected companies perform much worse when they are no longer politically connected, the researchers have provided direct systematic evidence that political connections cause resource misallocation.
This misallocation of resources can lead to negative consequences for the economy and the people who comprise it. For example, if politically connected companies receive preferential treatment, it may give them an unfair advantage over their competitors. This can discourage fair competition, as resources could be diverted away from the most innovative and efficient companies toward businesses with better political ties.
“One consequence of resource misallocation by governments is the tendency for those governments to grow larger and impose higher taxes,” says Faccio. “Another consequence is higher prices or lower quality products.”
Consumers may see higher prices or lower quality products in this environment than they would absent government intervention, since politically connected businesses have less incentive to operate efficiently. These companies may not need to minimize production costs as much as they would without corporate political connections, so they may end up passing on these higher costs to consumers in an effort to maintain their profit margins.
Regardless of the specific consequences of the prevalence of politically connected companies in an economy, economic theory generally views a misallocation of resources as detrimental to economic efficiency and growth. In determining that political connections cause a misallocation of resources, Faccio and McConnell have opened the door to discussions about how to best mitigate the damage that corporate political connections can cause.
According to McConnell, some business influence over our current political entities is expected, but the structure of our political and judicial processes matter most in easing its negative impacts.
“So long as political systems operate, people will make efforts to use the political levers to gain favorable access to resources,” McConnell says. “And, as of today, some success is inevitable. The best anecdote to limit resource misallocation is a political process that allows for the election of political officials and a judicial system that enables a jury of peers to penalize culprits.”
