Do Powerful Politicians Play Favorites with Their Corporate Friends?

But Kellogg researchers questioned that conventional wisdom in a recent study. While ascending the government ladder does bestow more power, it also puts politicians under the microscope, as the media and other organizations closely follow their activities for signs of corruption. If the official wants to be reelected, the harsher spotlight could discourage them from practicing favoritism.

“There’s larger scrutiny at the higher levels,” says Kieu-Trang Nguyen, an assistant professor of strategy at Kellogg. Even though the politician has more power to hand out favors, “that comes with a larger risk.” And if scrutiny is sufficiently strong, the researchers speculated, the trend might actually go in the opposite direction: gaining more power could lead to fewer favors.

To test that hypothesis, the researchers analyzed nine years of U.S. Congressional elections as well as firms with ties to the winning and losing candidates. The team used the companies’ stock prices as an indicator of how much the market expected those firms to receive favors from connected politicians. They found that during election weeks, the average value of companies linked to a winning candidate declined relative to firms linked to a losing candidate.

“On average, it’s a negative effect,” Nguyen says. “The stronger scrutiny trumps the stronger ability to give favors to the firms.” The system is “working in the way that we hope that it will work.”

Does Power Corrupt?

Previous studies generally suggested that more political power did lead to more favoritism.

For example, a 1990 study analyzed the fallout when Henry Jackson, the ranking minority member of the U.S. Senate Armed Services Committee, suddenly died. The stock price of firms that employed many manufacturing workers in Jackson’s home state of Washington dropped; so did the stock prices of companies that were political action committee (PAC) contributors to Jackson’s campaign. The next minority committee member in line, Sam Nunn, was expected to ascend to the position of ranking member. Stock prices of companies with a substantial presence in Nunn’s home state of Georgia, as well as PAC contributors to him, rose. The market, presumably, anticipated that Nunn would soon dole out favors to those firms.

“That’s a classic example of what people usually expect,” says Quoc-Anh Do, a visiting associate professor at Kellogg.

But previous research often was limited to a small set of politicians or tended to focus on older representatives, who might not care as much about reelection, Nguyen says. So Nguyen, Do, and their collaborators, Yen Teik Lee at the National University of Singapore Business School and Bang Nguyen at the University of Cambridge Judge Business School, took a different approach. They decided to analyze a broad set of U.S. politicians at a crucial career transition: entering Congress. Many candidates had held state office, where they had presumably been in a position to hand out favors, but they would face much more scrutiny when they ascended to the federal level.

Future Prospects

The team obtained data on 126 close Congressional elections from 2000 to 2008 from the Federal Election Commission. Then, for both leading candidates, they gathered biographical information from a variety of sources to determine a candidate’s educational history, reasoning that previous classmates are likely to be part of their network of contacts. Next, the researchers searched BoardEx data for company directors who had graduated from the same school within one year of one of the candidates. The final data set included 170 politicians linked to 1,171 directors at 1,268 firms.

The team then examined what happened to each company’s stock price starting the day before the election to five days afterward. They reasoned that, if the market predicted that the company would receive favorable treatment from the connected politician, the change in the firm’s expected future income should show up as a change in its stock price.

“The stock price should reflect what the market thinks that the firm will get in the long run—not just next year, but the overall prospects in the future,” Do says.

Not all investors would necessarily be aware of the alumni-network links between candidates and firms. But a small number of investors might follow those companies closely or have insider knowledge of such political connections. Their trading decisions could influence others to follow suit, amplifying the change in stock price.

The researchers chose to focus on tight races, with a vote margin of less than five percent, because the market would not be able to predict the winner before the election. Upon the release of results, prices would adjust—and the researchers could detect the change. In contrast, if one candidate was heavily favored to win, the market would already have adjusted stock prices in anticipation, and changes wouldn’t show up during election week.

A Longer Horizon

The researchers found that having ties to a winning politician actually seemed to suppress firms’ market value. Their average stock-price movement was 2.8 percentage points lower than that of companies linked to the losing candidate. Controlling for factors such as the politician’s party affiliation and which party controlled Congress made little difference in the result.

The researchers then considered if the politician’s age made a difference. Younger representatives were likely more concerned about their chances of reelection than their older counterparts.

“Politicians care about their political careers, so they don’t want to jeopardize that,” Do says. “If they are younger, they tend to care more about it because the horizon is longer.”

The results bore that out: the negative effect of an election win on the stock value of a connected firm was strongest for younger politicians and declined as they aged.

Under the Microscope

The team also assessed the amount of scrutiny politicians had faced at the state level. If a candidate had breezed through state politics without much oversight, they had likely given out more favors in that permissive environment. When they entered federal politics, the increase in monitoring would be larger. Thus, connected firms would probably see a larger drop in their stock prices, the researchers reasoned.

“Now that the politician moves to DC, the firm can no longer enjoy such favors, so that’s a bigger loss,” Do says.

To see if this theory held up, the team examined several measures of scrutiny in each candidate’s state. For instance, if voter turnout was high, and constituents showed strong interest in election news, those were considered signs of harsher scrutiny. The researchers also noted the amount of corruption reported in each state by, for example, determining the number of corruption cases per capita in each state, as reported by the Department of Justice. They reasoned that lower levels of corruption meant that politicians were being more closely monitored and weren’t getting away with bad behavior.

In states with low scrutiny, connected firms’ stock value declined more upon the politician’s entry into Congress than it did in high-scrutiny states. “We should expect the negative gap to be larger among those states, and that’s what we actually find,” Nguyen says.

Since the study shows that oversight matters, she says, it’s important to increase monitoring of lower levels of government too. One concern is that local and regional media coverage has declined over the years, creating a bigger difference between the scrutiny given to state versus federal politics—which might explain why that career transition causes a significant decrease in connected firms’ values.

The results “highlight the role of scrutiny as a very important check-and-balance mechanism,” Nguyen says.