NCPA - National Center for Policy Analysis

Relationship Capitalism

December 4, 2003

Business practices based on personal relationships -- say between bankers and clients or family members -- can actually retard economic growth, say economists. The replacement of such "relationship capitalism" by impersonal institutions and laws favors competition and innovation.

In countries where legal institutions to enforce contracts and require financial disclosure (transparency) are weak, personal trust is essential for business. The downside is that it is a closed system where what matters isn't what you know but whom.

Developed countries have made this transition:

  • In the United States, state laws used to limit banks to a single branch or block out-of-state banks. As a result, farmers, for example, had difficulty obtaining financing, since small local banks were reluctant to risk their limited capital on unpredictable weather.
  • But in the last couple of decades, technology allowed out-of-state banks to compete without branches and states gradually lifted restrictions. The withdrawal of these regulations significantly increased the growth rate of state per capita income and reduced bank riskiness.
  • Similarly, from 1936 until the 1990s, Italy's major companies and banks were entangled in a complex ownership web that made both hostile takeovers and large-scale start-up financing virtually impossible.
  • The system provided government subsidies for inefficient companies and politicians used the banks to control the country -- but the external pressures of European Union requirements got Italy to break up its closed corporate system.

Similarly, India's big businesses enjoyed access to government-controlled financing and were protected from competition. But when India began to open its economy to foreign trade, it reformed its stock market, improved corporate governance, instituted an electronic stock exchange and developed derivatives markets. Many new banks entered both the corporate and retail markets.

Closed financial systems live on in much of the world, stifling economic development.

Source: Virginia Postrel, "Should You Know Your Banker?" Economic Scene, New York Times, December 4, 2003; based on Raghuram G. Rajan and Luigi Zingales (both, University of Chicago's Graduate School of Business), "Saving Capitalism From the Capitalists" (Crown Business).

 

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