The lead article in Volume 22, Issue 3 of the Review of Finance is The Cost of Political Connections by Marianne Bertrand, Francis Kramarz, Antoinette Schoar, and David Thesmar. This paper shows that CEOs with a background in politics don’t shut down potentially underperforming plants, and open plants that they might not have otherwise, to boost employment in the run-up to a local election. This helps politicians in their re-election campaigns – but the firm gets no benefit from politicians in return. Thus, political connections can be costly to firms, in contrast to existing wisdom that they are beneficial.
A New Twist on a Long-Standing Question
Connections between politicians and businesses can lead to major conflicts of interest or instances of favoritism. Perhaps the best known political connection is Donald Trump being sole or principal owner of around 500 businesses (collectively known as the Trump Organization), which may affect the decisions that he takes as President. But political connections can extend far beyond a politician owning a business himself. A politician, or a politician’s relative or close friend, might be a large minority shareholder in a business or a top officer (e.g. CEO, president, vice-president, chairman, or secretary) in a business even without having a large ownership stake. For example, former Indonesian President Suarto was connected to Bimantara and Citra Lamtoro Groups through his children, and Nusamba, Salim, and Barito Pacific Groups through his longtime allies Bob Hasan, Liem Sioe Liong, and Prjogo Pangestu, respectively.
Existing research generally shows that political connections are of significant value to firms, because political leaders grant favors to the connected firms. In a famous paper, Fisman (2001) shows that firms closely connected to Suarto suffered significant stock price declines when there were rumors about his ill-health. In another famous paper, Faccio (2006) finds that when a large shareholder or top officer enters politics, the firm’s stock price rises significantly – and the rise is particularly strong if elected prime minister. Similarly, politically connected firms enjoy higher profits.
But Marianne, Francis, Antoinette, and David note that the relationship needn’t be only one-way. In addition politicians taking decisions to help politically-connected firms, politically-connected firms may take decisions to help politicians – at the expense of firm value. For example, they may fail to shut down plants, or open up new plants, even if not economically justified, to boost employment and help a politician in his re-election campaign.
Politically Connected Firms Create More Jobs …
The authors identify politically-connected firms as ones in which the CEO was previously a cabinet member, i.e. served as a close advisor to a government minister. They focus on France, because it’s common to move from politics to business. 11% of the firms (representing 63% of the assets) listed on the French stock market in the 1990s were controlled by politicians. They also focus on local (rather than national) elections since firms’ employment decisions have a large effect on the local economy, and can potentially swing a local election, but a small effect on the national economy.
Marianne, Francis, Antoinette, and David first confirm that, in France, local employment does increase the chances that a local politician is re-elected. So, do politically-connected firms try to exploit this relationship by boosting employment in the run-up to a local election? They do. They’re less likely to fire workers and close plants, and more likely to hire workers and open plants, than unconnected firms. (The authors do this comparison to unconnected firms to control for local economic conditions which may drive hiring and firing behavior). These effects are particularly strong for close elections, where the firm’s decisions might be particularly pivotal for the politicians’ re-election prospects.
… But Suffer Worse Performance
What do these results mean?
- The authors’ hypothesis is that, outside of election years, firms take decisions that maximize firm value. Thus, the different behavior that we see in election years reduces firm value – the firm doesn’t close down plants or fire workers that it otherwise might, and opens plants and hires workers that it otherwise wouldn’t.
- But a potential alternative explanation is that, outside of election years, CEOs are generally lazy and don’t bother to take the effort to open new plants and hire workers – even though doing so would improve firm value. The re-election campaign spurs CEOs to overcome their laziness and (correctly) open new plants and hire workers, increasing firm value.
- A second alternative explanation is that, outside of election years, CEOs are generally short-termist and shut down plants or fail to open new ones due to a focus on short-term profits. The re-election campaign deters short-termist shut-downs and spurs desirable plant openings, again increasing firm value.
The “lazy CEOs” explanation seems unlikely, because closing down plants and firing workers arguably requires even more effort than opening plants and hiring workers. These are tough decisions to take, and will be met with strong resistance (for example, by trade unions). However, we can test these explanations in the data. The authors find that firms with politically-connected CEOs have 1-2% lower return-on-assets (ROA) than unconnected firms. Similarly, a firm moving from an unconnected to a connected CEO has an ROA that’s 2.2% lower than a firm moving from one unconnected CEO to another unconnected CEO.
In return for doing favors to local politicians, do politically-connected firms benefit? Surprisingly, the authors find that they don’t. They study subsidies and local taxes, which are decisions controlled by local politicians. Connected firms don’t enjoy higher subsidies or lower local taxes in election years. While the authors don’t have data on government contracts, they do have data on sales and find that connected firms’ don’t enjoy higher sales either, which might suggest preferential access to government contracts. The lower ROA of connected firms is also inconsistent with them benefiting in return. Politically-connected CEOs seem to be doing local politicians a favor with no corresponding benefit, harming their firms overall as a result.