Sunday, 21 September 2008

The value of political connections

In highly politicised economies, where government intervention is common place and many areas of the economy are tightly regulated, rents are unavoidably created, and political connections are an important element of any effort to capture a part of these rents. Thus firms wishing to prosper will develop close connections to the government and its bureaucracy. Heavily interventionist governments are able to favour well connected firms via the granting of contracts, import licences, loans on favourable terms, access to production inputs or in some other way such as privileged access to foreign exchange. In non-politicised, free market economies political connections are worth a lot less because government interventions are minimal and thus the available rents are minimal.

For the case of Nazi Germany, a recent article at shows just how much more valuable where politically connected firms. Hans-Joachim Voth discusses the value added of political connections in his column, Paying the piper, reaping the returns.

He starts by considering how to define what being "connected" to the Nazis means. He writes
Earlier academic work had focused mainly on the actions of managers. We broadened our definition of “connection”, by also analysing supervisory board members. Boards were particularly important in German public companies. Banks, for example, exercised power over affiliated companies through seats on supervisory boards. Any knowledgeable observer of the German corporate scene would have examined board composition to assess the political and economic positioning of a firm. An essential part of the work was to pin down supervisory board membership at the time of the takeover, which we did by analysing contemporary German sources.

In total, we found that 119 firms had connections with the Nazi party prior to January 1933. We counted leading businessmen as connected if they did one of three things:
1. contributed funds to the Nazi party;
2. signed an appeal in the fall of 1932, directed to the German President Paul von Hindenburg, to make Hitler chancellor;
3. contributed to two organisations designed to ’teach the Nazis economics’ – the Keppler Kreis and the Arbeitsstelle Schacht.
One question I have here is, over what period did these connections develop? Also how did the connectedness of the businesses change, if at all, between the Hitler government and those which went before? Business, in particular large businesses, are likely to want to be close to any government. Were businesses "connected" to multiple parties at this time?

To measure the value of political connections Voth and Thomas Ferguson
... decided to look at what the financial markets saw when the Nazi party suddenly came to power (Ferguson and Voth 2005). Instead of having to assess the importance of every interaction between individuals, stock markets have the beauty that people have to put their money where their belief is. If the Nazi party’s rise to power made a big difference to the value of a firm that had given early support to the party, chances are that these contacts mattered.
Voth outlines their method of measuring performance as,
To measure performance, we collected the monthly stock price of 789 firms listed on the Berlin stock exchange. Prices were collected for the 10th of every month, from the day the exchanges opened again after the financial crisis of 1931 to May 1933.

We also collected information on the sector in which firms operated, the dividends they paid, their capital structure, and the overall market capitalisation. We defined 10 January 1933 as the last date before some investors may have suspected that the Nazi party might enter office. Some important meetings had already taken place by this date, but very few would have confidently predicted that on January 30th, Adolf Hitler would be German chancellor. As late as December 31st, many journalists who wrote “the year in review” columns had predicted that the Nazi wave had reached the high-water mark and would be receding.
So, just how big was the Nazi premium? Voth writes
Firms connected with the Nazi party outperformed unaffiliated firms massively. Their share prices rose by 7.2% between January and March 1933 (43% annualised), compared to 0.2% (1.2% annualised) for unaffiliated firms. The politically induced change was equivalent to 5.8% of total market capitalisation. This is a high number by international standards. Johnson and Mitton (2003) estimate that revaluation of political connections in Malaysia during the East Asian crisis wiped 5.8% of share values. While comparable in magnitude, it took 12 months for this change to occur.

Affiliated firms did better, no matter their mode of connection with the party. The return differential favouring connected firms existed for both small and large firms, for firms in nine out of eleven sectors, and for those with high and low dividend yields. We also examined if expected rearmament was to blame for the value of connections, using lists of potential defence contractors compiled by the German armed forces (Hansen 1978). Our finding persists.
One thing Ferguson and Voth can't explain is why connections paid so well. Voth wrties
Around the globe, politically connected firms are more valuable (Faccio 2006). Nazi Germany was no different, but the sheer magnitude of the connection premium is astounding. Why did early connections with the party pay off as handsomely as they did? We do not know if loyalty was rewarded with additional contracts, loans on favourable terms, or in some other way such as privileged access to foreign exchange.
One interesting point Voth does make is,
What is clear is that not enough firms sought to affiliate with the Nazis prior to January 1933 to drive the expected benefit – as seen by stock market investors – down to zero. This means that either many firms expected the benefits from association to be low (the Nazi party’s rise to power may have been a genuine surprise), or that they would not contemplate giving support for a variety of political reasons.
All this suggests that the stock market in Nazi Germany realised the value of political connections to the Nazi Party. Firms which "bet on Hitler" did well. I wonder if what this tells us is that investors expected a very interventionist government with an associated high level of rents becoming available and that those firms closely associated with the Nazi Party where more valuable simply because they were in a better position to expropriate those rents.
  • Ferguson, Thomas and Hans-Joachim Voth, “Betting on Hitler – The Value of Political Connections in Nazi Germany,” April 2005, CEPR Discussion Paper 5021, and Quarterly Journal of Economics123 (1) (2008), 101-137.
  • Hansen, Ernst Willi, Reichswehr und Industrie: R├╝stungswirtschaftliche Zusammenarbeit und wirtschaftliche Mobilmachungsvorbereitungen 1923–1932 (Boppard am Rhein: Boldt, 1978)
  • Johnson, Simon, and Todd Mitton, “Cronyism and Capital Controls: Evidence from Malaysia,” Journal of Financial Economics, 67 (2) (2003), 351–382.

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