Crony Capitalism: Lessons from the Great Recession

In recent years, the federal government has bailed out many of the nation’s largest businesses. During the Great Recession and its aftermath, it was the investment banks and automakers.  Just last year at the start of the Coronavirus pandemic, it was the airline industry.

After the Great Recession, lawmakers said never again. They passed the 2010 Dodd-Frank Act in hopes of avoiding future bailouts to banks. But instead, the law created a new “orderly liquidation” authority which granted immense discretionary governmental power to bailout and to regulate Wall Street firms and the wider economy.

Unfortunately, these lawmakers had learned the wrong lesson from the Great Recession. The government did not need more power or more discretion. It already had plenty of power. Indeed, it was this very power that led to the favoritism, the bending of the rules, and the reckless risk-taking that created the Great Recession. Government chose which existing regulations to enforce and which ones to bend, and they decided who was bailed out and who wasn't.

This was textbook crony capitalism: the power of government and the rule of people—rather than the power of the market and the rule of law—to decide who will benefit and who will not.

Regulatory capture is a particular type of crony capitalism. It happens when people at regulated firms and their government regulators develop mutually beneficial relationships. The regulated firms benefit by receiving less supervision, protection from competition, or even government bailouts. The government regulators benefit from lucrative post-government employment, political contributions, or favors to friends and families.

Meanwhile, the economic harms of regulatory capture are widespread. Competing businesses are prevented from entering markets. Consumers are forced to pay higher prices with fewer options. And taxpayers are on the hook for future bailouts.

Fannie Mae—the government-sponsored mortgage loan company—epitomizes the nature of regulatory capture as a form of crony capitalism. Fannie Mae maintained a close relationship with regulators and lawmakers during the decades prior to the Great Recession. It secured jobs for friends and relatives of elected officials, including one of the architects of Dodd-Frank, Congressman Barney Frank. Fannie Mae arranged for “sweetheart” loans to politicians that oversaw laws that directly affected Fannie Mae’s business, including the other architect of Dodd-Frank, Senator Chris Dodd.

In exchange, Fannie Mae was provided with implicit financial guarantees from the government, favorable regulatory treatment, and was shielded from competition. Of course, when the Great Recession hit, the implicit financial guarantees became explicit: Fannie Mae was bailed out by the government.

This was the lesson we should have learned from the Great Recession. Crony capitalism—particularly through regulatory capture—caused financial policies to deviate from a set of clearly defined rules and instead regulators ruled as they saw fit.

The right reform isn’t to give lawmakers even more powers. Instead, Congress must reform the law, including the bankruptcy law, so as to let a failing financial firm go into bankruptcy in a predictable way without causing spillovers, while continuing to let people use the firm’s services. This would re-enforce the rule of law and apply it equally to all businesses regardless of political connections.