Dangerous liaisons

De jure, we have embraced the Western

tradition, which sees the state manily as a
service provider, but de facto our minds are
still loyal to the concept of the state
conceived by Lenin, the state designed to
enslave and exploit the individuals.

Vyaceslav Dombrovsky, Assistant

Proffesor, Stockholm School of
Economics and Baltic International
Center for Economic Policy Studies

Photo - Eve, licence

Is Latvia a democracy? This is a very hard question, but let’s consider two intuitively simple,
yet very different, views of how things work in this country. Those who believe that Latvia is
clearly a democracy would begin by pointing to the fact that voters elect their
representatives into the Saeima [parliament], which appoints the government. They will also
point out that, if voters are unhappy with the government, or the Saeima, they will vote it
down in the next election. This, the argument goes, will ensure that elected representatives
(wishing to be re-elected) will, most of the time, act in the interests of voters.
In recent years, however, there has been an increasing amount of questioning of whether
the above is an accurate description of how things really work in Latvia. Some critically-
minded people argued that, although politicians are elected by the voters, they mostly cater
to the interests of small but well-organized business groups. They do so by using their
legislative and executive powers to protect the business interests of these groups, and
create profit opportunities for them. When the election time comes, business groups use
these profits to finance expensive election campaigns that help these politicians to get re-
elected. Thus, according to this more pessimistic view, Latvia may be a democracy de jure,
but de facto it looks more like some sort of oligarchy.
I have to admit from the start that I do not have the answer to the important question of
whether Latvia is a democracy de facto as well as de jure. However, I believe I can
demonstrate evidence that will shed some light on the above issues. My focus is on a rather
narrow question of whether political connections matter to the performance of firms. For
example, does making a campaign contribution make firms grow faster compared to similar
firms that made no contributions? In a well-functioning democracy, political connections
should not matter to the performance of individual firms because most voters would not be
happy with the idea that politicians use their office for the profit of some businessmen.
Political parties usually do not admit there is a quid pro quo relationship between them and
people who finance their election campaigns. What we are typically told is that contributions
are simply a token of support for a party’s program, pretty much the same as voting. In a de
facto oligarchy, however, campaign contributions are part of the implicit agreement between
politicians and business interests.
In what follows I will demonstrate convincing evidence that political connections do matter
and, specifically, campaign contributions result in benefits to the firms that make them. I will
also attempt to put these findings in a broader picture by discussing the consequences and
the causes of connections.
Before I go on, however, a likely objection has to be addressed. “So what?” – a critical
reader may ask. There is plenty of evidence of corrupt politicians and their links with
businesses, isn’t there? That is certainly true; there is no shortage of such stories in the
newspapers. This, however, is anecdotal evidence, and this kind of evidence can never be
fully convincing. We know instances when politicians are corrupt and we know instances
when they are not. The important question is whether corruption is an exception rather than
the rule? Or, is it the other way round? In other words, what we need to know is whether an
average firm benefits from being politically connected, and this is precisely the kind of
evidence I aim to deliver.

Do Political Connections Matter?

One has to begin with a clear definition of ‘political connections’. In my research[1] I look at
two kinds of connections. First, I consider any company that contributed to a political party
directly, or through its shareholders or board members, to be politically connected. For
reasons that will be explained later, I focus on the 2002 national election cycle. Second, any
company with a politician, or an ex-politician among its shareholders or board members is
also considered to be politically connected. Henceforth politicians are meant to be members
of Saeima and/or ministers. I look at all companies and politicians in the 1996-2005
period.[2] My measure of firm performance is annual growth in total sales.[3]
The methodology is as follows.[4] I begin with using the Lursoft database to identify all
active firms that are politically connected using the above criteria. Thus, I identify 844 firms
connected by making campaign contributions in the 2002 election cycle.[5] Note that only
188 of those contributed directly (i.e. as firms), whereas all others did so through their
shareholders or board members. Furthermore, I identify 554 firms connected to 259
politicians (or ex-politicians). As a point of reference, note that, since regaining
independence, there have been a total of 527 national-level politicians. Then, each
connected firm is matched to a similar non-connected firm of similar size (measured by
assets) and in the same industry. Thus, a control group is formed which can be used for
making comparisons between politically connected firms and similar non-connected firms. In
case of campaign contributions, for instance, such a simple comparison reveals that sales
growth of connected firms was nearly twice as high as compared with non-connected
firms.[6] I find that average sales growth rate of donors in 2002 elections was 8%, whereas
average sales growth of similar non-connected firms was 4.3%. For firms connected to
politicians, I find that their average growth rate is 50 percent higher compared with similar
non-connected firms.
At this point a critical reader is likely to object by pointing out that “correlation does not
imply causality”, that there are other factors which might be responsible for this result. For
example, connected firms might have smarter managers and, therefore, be both successful
and politically active. Or, perhaps, causality goes in the other direction, so that successful
firms give campaign contributions, presumably because they can afford it. The confounding
influences can, to a large degree, be controlled for using rigorous regression techniques. The
detailed methodology will not be discussed here but can be found in the original research
paper. Figuring out whether political connections have a causal effect on the performance of
firms is quite tricky. One of the ways is to find an unanticipated external event that would
affect connections. Consider a more intuitive example of electricity, which we know is an
important factor of production for most firms. Inferring its importance by simply looking at
firm performance and consumption of electricity is a hard task. However, if the lights
unexpectedly go out i.e. there is a blackout, this will give us a fairly good idea of the
importance of energy supply.
I argue that there was one instance when the ‘lights went out’ in Latvian politics – when the
Latvia's Way (Latvijas ceļš) party did not get re-elected in 2002. The Latvia's Way played a
very special role in Latvian politics. I think there is a fair chance that future historians will
call the 1991-2002 period the ‘era of the Latvia's Way’. It was in every one of the nine ruling
coalitions in this period. It held the prime minister’s office for most of the period. There is
little doubt that its political influence was enormous. Yet in 2002 election it fell 0.1 percent
short of the 5 percent barrier. This was unexpected as most of 2002 the polls predicted that
the Latvia's Way would get in the Saeima. Another surprise was the First Party of
Latvia(Latvijas Pirmā partija), which got 9.5 percent of the vote, although the polls predicted
in would not get elected. Needless to say, businesses affiliated with the Latvia's Way were in
for a nasty surprise.
I find that a firm lost 2.9% of sales in 2003 for every 1,000 Ls that it gave to the Latvia's
Way, controlling for other factors. Thus, an average donor to Latvia's Way, who gave 6.8
thousands lats, lost nearly 20 percent of sales in the post-election year. This is not a small
amount, as its average sales in 2002 were nearly 1.4 million Ls. In contrast, a firm gained
2.8% of sales in 2003 for every 1,000 Ls that it gave to the First Party, controlling for other
factors. Because an average contribution to the First Party was larger (12.2 thousands Ls),
this implies a 34% increase in sales in 2003. For reference, average 2002 sales of a firm that
contributed to First Party was about 803 thousands lats. This presents formidable evidence
that political connections matter.[7] If the firms, and their board members and shareholders,
contributed merely to ‘support’ their candidates, the election outcome should not have had
such a strong effect on sales.

The Consequences
If one accepts that political connections matter, the question is what it means to us, the
people of this country. Some may argue that the fact that politicians actually provide
benefits to some businesses is not such a bad thing. Perhaps, but it depends on how
businesses benefit from political connections. It is a mistake to think that what’s good for
business is good for a country. The main motive of entrepreneurs is profit. They can achieve
it in a way that benefits the society – e.g. by innovating, producing goods and services and
competing to deliver the best value for money to their customers. However, they also do not
hesitate to profit from securing monopoly power, getting rid of the competition, blocking
entry of new businesses to their market – if they can get away with it. Profit seeking has its
‘dark side’. How can businesses profit with the help of politicians and what are the
consequences?
First, obviously there are plenty of opportunities to fiddle with state procurement. We can
suspect that what public sector buys is more expensive than it should have been, and
sometimes should not have been bought in the first place. Second, connections (e.g.
campaign contributions) could be a down payment to receive some services in the future.
For example, some recent events suggest that it is hard to build anything in the city of Riga
without bribing officials of the city Council. Perhaps those who help elect the winning parties
with their contributions get a discount. The above examples have been much discussed
already and their interpretation is simple. Both cases are instances of theft, and we are its
victims. For example, if it takes a large bribe to obtain a permit to construct a new
apartment complex in Riga, construction firms will treat it as an expense of doing business,
and pass it on to us, the consumers, in the form of higher prices. Clearly, what makes this
theft special is the ignorance of victims, who often do not realize their pockets have been
skillfully picked.
There is a third way of how businesses can profit from political connections and it is the
worst one. Politicians use their office to create monopoly power – by creating barriers to
entry, making life difficult for competitors, and often simply by consistently favoring
connected firms. Economists have called it the production of rents. Unfortunately, one does
not have to look far for examples. Take recent actions by municipal governments, which
would effectively create regional monopolies in garbage collection. Monopoly power means
large profits, and high prices. Moreover, in time such interaction between politicians and
businesses will result in an economy where most firms operate in well-defined niches,
protected by nuanced regulations and the power of their partners in politics. In other words,
we will see creation of a de facto oligarchy in a de jure democracy. There will be no
innovations, no prosperity. The best and the brightest will flee to other countries, leaving
mostly the new plutocrats and those they can fool and exploit. What has been happening in
Russia in the last years is a good example of this.

The Causes
If you agree that political connections are a concern, the natural question is what can be
done about it. There is no shortage of proposals as to how to put an end to corruption but
many of them are of the “forbid-and-forget” variety. For example, there are proposals to
outlaw campaign contributions from private individuals and finance election campaigns
exclusively from the state budget. I have serious reservations about the effectiveness of
such naïve solutions. In the example with campaign contributions, firms were forbidden to
make contributions but effectively continued to do so through persons connected with them,
e.g. its board members and shareholders. Or, take the recent controversy with the election
campaign of the People’s Party (Tautas partija). Where does freedom of speech end and
political campaigning begin? I am skeptical of the effectiveness of simple ‘solutions’ because
they go after symptoms one can readily observe, but do not address the underlying causes
of the problem.
What are the causes? The essence of the problem can be sketched in the following way.
Businesses seek profits. Politicians and public officials can provide profits to businesses by
conferring monopoly power in sophisticated, hard-to-observe ways – if they can get away
with it when election comes. In turn, businesses can use part of their new profits to finance
‘brain-washing’ election campaigns for the politicians that help them. As a result, the state is
captured by special interest groups, and democracy is subverted. Unfortunately, there is no
simple solution to this problem. There is no magic switch, no legal act that can forbid
something, no money that can be given to somebody to make things right. Yet a number of
issues follow from the above and I will discuss them briefly.

Cause #1: Worship of the ‘state’

It is a sad legacy of our Soviet past that we look up to the state as if it were some sort of
divine entity, which ought to be present in all areas of people’s lives, attempt to solve all
problems that arise. This is in great contrast with the Western liberal tradition, which sees
the state as mainly the service provider for the free people: “the government of the people,
by the people, for the people”. De jure, we have embraced the Western tradition, but de
facto our minds are still loyal to the concept of the state, which was conceived by Lenin and
the likes, the state designed to enslave and exploit the individual. As a result, there is a
widespread confusion about our relationship with the ‘state’. Unfortunately, most people do
not seem to realize that the ‘state’ is not a divine entity but an institution that is run by
people, who have their weaknesses. An important consequence of this confusion is that too
much power is vested in the state.
Consider an example with traffic police. Ordinary policemen are paid very little (about 300-
400 Ls) but they wield substantial power on the road. One of these powers is that they seem
to enjoy quite a lot of freedom in how they enforce traffic regulations. They are seldom
engaged in patrolling the streets, which is effective from the viewpoint of enforcing
regulations but not very profitable. Police usually hides in locations where drivers are likely
to break the rules. This is certainly a profit (bribe) maximizing strategy – some accounts
suggest that daily revenue from taking bribes is about the same as official monthly salary.
Part of the explanation is that the police is run in a way that policemen have too much power
to conduct their business as they please, and so they choose lots of ‘hiding’ and little
patrolling.

Cause #2: Ethnic Division

One of unwritten rules of Latvian politics is the ‘100-X’ rule, which states that the process of
coalition formation begins by subtracting X, the number of seats in the Saeima that belongs
to the ‘Russian’ parties. Due to historical reasons, ethnic Latvian majority has a grudge
against and the Russian-speaking minority, maybe for good reason. The majority
consistently makes sure that the minority pays its taxes but has no voice in how the
government is run. It is a sad fact that most ethnic Latvians explicitly or implicitly vote to
‘keep the Russians out’ and the political parties are only happy to oblige. If a large part of
population genuinely enjoys disenfranchising another part of population on ethnic grounds,
there really isn’t much that can be done about it. However, those who take pleasure in
‘keeping the Russians out’ should be aware that this is done at a price.
Voting does not work very well when there are many issues at stake, especially when some
issues are very sensitive. Simply put, people who vote to keep the Russians out forego the
opportunity to vote for good kinder-gardens. Corrupt politicians also benefit enormously
from ethnic divisions. If voting didn’t break along ethnic lines, perhaps anti-corruption
election platforms would garner more votes than they do now. Sometimes the efforts to
conceal true motives behind the ‘keeping the Russians out’ slogan border on the absurd. For
example, whenever someone is critical about People’s Party’s expensive Palace of Light
national library project, he is labeled “anti-Latvian” and accused of acting in “Moscow’s
interests”.
Cause #3: Voters’ Human Capital
It is an old maxim that every people get the government they deserve. Politicians find
suspicious partnerships with businesses attractive only in so far as they can get away with it
in the elections. And they can only get away with it if the voters are uneducated, ignorant,
and disinterested in what is going on. If the mass of voters is content with being ruled,
without questioning the rule, de jure ‘democracy’ is the best deal they are ever going to get.
___________________________

[1] Vyacheslav Dombrovsky, "Political Connections and Firm Performance: The Latvian Way",
Stockholm School of Economics and Baltic International Centre for Economic Policy Studies
[2] For the exception of banks, state-owned companies, and non-profits organizations.
[3] Any measure of performance based on reported profits would certainly be suspect
because of widespread perception of tax evasion.
[4] See the accompanying paper for more details on research methodology.
[5] January 1st to October 5, 2002.
[6] Average in this case (and in the next example) refers to the median and is calculated
over all years.
[7] Please see the original paper for some other interesting findings on the effects of political
connections.
This work by www.politika.lv is licensed under a Creative Commons
Attribution-Noncommercial-No Derivative Works 3.0 Unported License.

Published on 1 april 2008