Value of Connections of the United States

It is well-known that who you know and who you are connected to matters greatly for your business success in many countries. This is nicely documented in several papers that show how connections to powerful politicians have a huge value in countries with weak institutions.

For example, in a famous paper Ray Fisman used an event study methodology exploiting rumors about the health of the Indonesian dictator President Suharto to show how close connections to Suharto were greatly valuable: these adverse news reduce the stock market value of the firms connected to him.

Similar results were found, among other places, in Malaysia by Simon Johnson and Todd Mitton and in Pakistan by Asim Khwaja and Atif Mian.

But the consensus view has been that such connections don’t matter in countries with strong institutions such as the United States.

In fact, Larry Summers used this as the basis for his argument for why the response to financial crises should be different in the United States in his Ely Lecture to the American Economic Association: strong US institutions imply that policies that should not be tried in Indonesia or Malaysia because of concerns about cronyism and corruption could be adopted with little worry in the United States.

This view was supported by work that applied similar methodology to the United States. For example, other work by Ray Fisman, together with co-authors, found that the value of connections to Dick Cheney were small or nonexistent.

So US institutions do seem to work as they are supposed to.

Recent work by Daron, Simon Johnson, Amir Kermani, James Kwak and Todd Mitton finds something quite different, however.

Focusing on the announcement of Timothy Geithner as President-elect Obama’s nominee for Treasury Secretary in November 2008, they report robust and large returns to financial firms with connections to Geithner. Connections here are defined either from Timothy Geithner’s meetings with financial firm executives during the previous two years when he was the President of the Federal Reserve Bank of New York, or from his overlap on non-profit boards with these executives. What’s going on?

One possibility is that this just reflects the fact that firms that had such connections are also those that would have actually benefited from the safe pair of hands that Timothy Geithner would bring to the job of Treasury Secretary. Though plausible, this explanation does not receive any support from the data:  controls for characteristics that could capture such benefits do not change the results, and in fact the results hold when comparing firms of very similar size, profitability and leverage, and similar risk and stock market return profiles.

Another possibility is that the same sort of shady dealings that went on in Indonesia, Malaysia or Pakistan are also present in the United States — or at the very least were thought to be present by stock market participants. But this seems very unlikely, and there is no evidence to support this. Timothy Geithner appears to be an honest technocrat, with no interest in doing favors in order to get campaign contributions or financial gain.

Instead, the paper suggests a different hypothesis: “social connections meets the crisis”.

Namely, the excess returns of connected firms may be a reflection of the perception of the market (and likely a correct perception) that during turbulent times there will be both heightened policy discretion and even more of the natural tendency of government officials and politicians to rely on the advice of a small network of confidants. For Timothy Geithner this meant relying on, and appointing to powerful positions, financial executives from the firms he was connected to and felt comfortable with. But then, there is no guarantee that these people would not give advice favoring their firms, knowingly or perhaps subconsciously (for example, they may be under the grips of a worldview that increases the perceived importance of their firm’s survival for the health of the US economy).

So Larry Summers is probably right that strong US institutions preclude the sort of dealings that went on in Indonesia under Suharto or in Malaysia under Mahathir Mohamad. But this does not mean that connections don’t matter or that we should not worry and be vigilant about them, particularly during turbulent times when important decisions have to be made quickly and the usual mechanisms for scrutinizing important policy decisions are weakened or suspended.

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