As China and India seek to keep their recent economic growth rolling will their political leaders embrace pro-growth policies such as allowing foreign direct investment in India and in the case of China shrinking subsidies for State Owned Enterprises? Hsieh and Klenow document large total factor productivity differentials across manufacturing plants in China. Here is a direct quote from their paper:
"For example, imagine an economy with two firms that have identical
technologies but in which the firm with political connections benefits from subsidized
credit (say from a state-owned bank) and the other firm (without political connections)
can only borrow at high interest rates from informal financial markets. Assuming that
both firms equate the marginal product of capital with the interest rate, the marginal
product of capital of the firm with access to subsidized credit will be lower than the
marginal product of capital of the firm that only has access to informal financial markets.
This is a clear case of capital misallocation: aggregate output would be higher if capital
was reallocated from the firm with a low marginal product of capital to the firm with a
high marginal product of capital. The misallocation of capital results in low aggregate
output per worker and TFP."
Note that this is a static example where the two firms have identical technologies. In the "real world", when firms face competition they make costly investments to increase their efficiency. Consider an extension of the Hsieh and Klenow discussion above in which "connected firms" do not bother to make such efficiency investments because they know that their connections to government provides easy access to special treatment. In this case, the non-connected firms may give up and not make sunk investments to achieve efficiency because they know that they can't compete with the connected firms. In such a setting, industries will under-invest in innovation a dynamic effect and in then in each round of this game; capital will be misallocated for the reasons that are discussed above. The net effect is bad macro performance.
To return to the title of this blog, during boom times the State can claim that all is fine and the favoritism isn't costly (and they may deny that it is even taking place). During bad times, such inefficiency becomes costly and may prolong the recession itself. In this sense, the fear of recession can act to purge inefficient policies that simply redistribute to connected firms.