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Collective punishment?
By Efrat Neuman
Tags: Israel News

The economic crisis that has engulfed the world's economy for almost two years has once again brought to the fore questions and extensive public debate about those entities we sometimes cynically refer to as the "tycoons." What is their contribution to the crisis? Should governments bail out the mega-companies that borrowed money from the public during economic boom years, and then found themselves embroiled in existential difficulties during the current depression?

Prof. Yishay Yafeh of the Hebrew University's school of business administration has clear opinions about big business and the harmful influence it can have on the economy and the government.

"To get rid of it in a worthwhile way, I first have to examine what will happen if it is not around," he says in an interview with The Markerweek. "If the expectation is that the market will be more competitive - and in the Israeli context this is a reasonable expectation - maybe I wouldn't actively strive to get rid of big businesses, but I also would not try to help them ... Unless we break these groups now, there is a possibility that in the future such action will not be feasible."
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Yafeh recently returned from a sabbatical at the International Monetary Fund in Washington, D.C., where he worked with Simon Johnson, a professor in the school of business management at the Massachusetts Institute of Technology, and former director of the IMF's research department from 2007-2008. Johnson, who compared the financial oligarchy in the United States to that in emerging markets, said in a recent article that interest groups favoring the business elite played a key role in fomenting the crisis in the United States, and are using their political clout to halt reforms that could extricate the economy from its free fall.

Yafeh, who became interested in Asian studies (in addition to economics) while studying for his B.A., wrote his doctoral thesis at Harvard in the mid-1990s on Japan's big-business families and how America dismantled them.

You economists are criticized for researching many marginal issues. Why is the study of so-called groups significant?

Yafeh: "It's easy for me to answer that because today you cannot discuss barely any topic related to emerging markets without understanding the concept of business groups. In almost all emerging markets, and in some developed countries as well, there are conglomerates that dominate the economy. You cannot engage in a macro-economic analysis of [South] Korea, for instance, unless you understand the structure of the economy that five families control."

And what about Israel? Do we have to deal with this issue here or is it superfluous because Israel is a developed market?

"Of course, you have to. The business groups represent a combination of characteristics that could give rise to bad things, and this is true of such groups all over the world. These combinations ... have a damaging potential.

"The assumption is that if I encounter someone on many fronts, I may be less inclined to fight him. This facilitates a process of cartelization: If I have long-standing ties with someone, and a long-term horizon, then it is less desirable for me to turn against him. The same thing happens with groups active in various fields. Another problem is the tendency toward family management and involvement. If it's a grocery store that passes from father to son, that's not the public's business. But if it is a big, multi-disciplinary corporation, then it's a significant problem."

You are talking of implications, but help us understand whether there are such "families" in the Israeli economy.

"Economist Konstantin Kosenko at the Bank of Israel found that among the 650 companies traded on the stock exchange, some 160 are connected to business groups. It doesn't sound like much, but the bigger the companies are, in terms of their value, the greater the chances that they will belong to such groups. Are we like the worst places? I don't think so. In Korea almost everything is Samsung and LG [owned and controlled by the Koo family], whether it's a gas station, a hotel, a train or a car. Here the big companies' presence is not so great per se, but many belong to groups that constitute Israel's largest business enterprises."

The Japanese model

What effect does the existence of these groups have on democracy, the regime and the press?

"All over the world the strength of these powerful groups derives from close ties to the government. In many countries the relations between the groups and the government change over the years. Japan offers an example. During the 19th century there were many government-run factories there (textiles, shipping yards), which were privatized. Families close to the government, such as Mitsubishi's founder, received a lot of property and later also government contracts for arms, ships and so on. They grew under the government's patronage. "

Called zaibatsu, a Japanese term referring to industrial and financial conglomerates, the "big four" family-controlled businesses - Mitsubishi, Mitsui, Sumitomo and Yasuda - dominated their country's economy in those days.

Yafeh: "Some 30 to 40 years later the government was already under their patronage. The big groups 'owned' parties in the parliament and by then it was clear they were in control."

After World War II the Allies discovered the harm to democracy caused by monopolistic power and social inequality, which emanated from the huge wealth the conglomerates had amassed. The latter were also the war's main beneficiaries because of their heavy industries and involvement in arms sales. During America's wartime occupation, about one-third of the assets in the Japanese market shifted from the four families to others. The Americans prepared a "blacklist" of the family-dominated groups, and anyone on it was required to transfer shares to a specially created body and received compensation for the shares. The Japanese stock exchange opened in 1949 and began trading the shares of the bought-out companies. This spelled the beginning of the end of corporate family domination.

"The same thing happened, more or less, in Korea," Yafeh explains. "During the 1970s, families such as Hyundai and LG were under the president's thumb, and depended on government help in the form of contracts and subsidies. By the 1990s the situation turned around. Korea's current president is Hyundai's former CEO. There is a popular saying in Korea that it is 'the Republic of Samsung.'"

Do you believe that at this stage, in Israel, these large business groups need the government or is it the other way round?

"We passed the stage where groups depended on the government during the privatization that took place in the 1990s. How much power do they have today? I don't know. But there are worrying symptoms and unhealthy trends. Nevertheless, we do not see here irritating phenomena such as Italy's Berlusconi [Prime Minister Silvio Berlusconi, who is also a real-estate and insurance tycoon, and owns various companies] or Hyundai's former CEO, now president of Korea."

How does the world perceive the family-dominated conglomerates' influence over the media?

"It is very extensive, but my assessment is not based on careful research. The more families diversify their activities, the more they make inroads in the media. We are not in a catastrophic situation, but the tendencies are not healthy."

What makes you think that?

"Take, for instance, Bibi's [Prime Minister Benjamin Netanyahu's] meeting with 'market leaders' before he assumed the premiership. And the fact that 'tycoons' have become celebrities and there are constantly reports about them and what they have purchased. I don't like it, and I don't think you would see such things in England, for example. By the way, the control premiums in Israel - i.e., the amount one is willing to pay in order to control a company - are higher than in other countries and that, too, is not a good sign."

What about the influx of various corporate groups, families and wealthy individuals in academia?

"Here and there you see families' attempts to enter the academia, such as Eliezer Fishman's contribution to the Hebrew University's finance and real-estate center and Shari Arison's involvement in the business school at the Interdisciplinary Center in Herzliya ... I have not heard that Fishman has tried to intervene in the institute's academic content; I don't believe such a phenomenon, which I would consider dangerous, is happening there. But this is quite a widespread phenomenon in Turkey, for example. I attended a convention in a university there, which is named after a family. You might be able to justify this in underdeveloped countries, arguing that groups assume the roles of institutions that do not exist. Korea lacked good organizations for manpower training, so Hyundai opened a research institute that compensated for the universities' weaknesses. The same thing happened with the Tata Corporation in India. But in Israel, despite all of its problems, a different, developed system exists in academia.

"Groups in underdeveloped markets might replace other types of institutions. For example, ineffective mechanisms for enforcing contracts are replaced by arrangements made between the groups. Or, underdeveloped financial markets are replaced by an internal financial capital market, and so forth."

Will Israeli academia be harmed?

"It could happen as universities become poorer and tycoons become wealthier ... [But] I don't see anything of this kind in Israel. This is not a positive trend and if we continue conducting ourselves as we do now, we might get there, but we have not yet reached that point. That is to the credit of the families - or of academia.

"The positive things identified with the existence of business groups tend to happen during the first stages of economic development. You could say, for instance, that Samsung and other groups built Korea. This is also the opinion usually found in the professional literature. If they [the groups] do good things at all ... it is usually when they assume the role of certain institutions that do not yet exist. But at some point they become 'entrenched,' and then the bad phenomena surface and can be damaging to competition and democracy, and [you find] links between capital and government."

At what stage are the groups you refer to in Israel, today?

"We are definitely not at a stage where they would be an asset. We are not lacking financial markets or institutions."

In what other areas do you see problems with the existence of such groups?

"There is a potential for cartelization and developing political influence. There is also a problem with the fact that they tend to appoint the second generation to senior positions - something that happens in many countries."

'Positive examples'

In the article Simon Johnson and three American colleagues published a year ago in the Journal of Financial Economics, they presented data relating to 93 family-run businesses in Thailand. They found that the larger the family - especially, the more sons the founder has - the greater the number of administrative positions that will be filled by relatives, as compared to the proportion of staff hired from outside. Moreover, there is a strong, positive link between the owner/family size and its involvement in controlling its business interests.

The study showed that companies run by big families, and especially by sons, show weaker financial results than other companies. This correlation is particularly strong when the founder is no longer active and has transferred full control to his heirs.

Yafeh: "If the Lee family that controls Samsung were to place some 'idiot son' in a managerial position, there could be a macro-economic danger: The company is much too extensive for the family's 'idiocy' to affect only its own business. Naturally, many times family firms succeed during the first generation, but the [financial] situation worsens during the second. Indeed, if they are big and entrenched enough, the second generation already becomes everybody's problem."

He adds that as such collective enterprises become stronger and more consolidated, they may succeed in blocking - or, alternatively, supporting - various reforms: "There are positive examples as well. Such groups in Mexico have supported free trade with the United States, which is a positive thing, because they think they can benefit by exporting to their northern neighbor. Groups are not always in favor of bad things, but in Korea there is the opposite example, where the big enterprises opposed reforms in corporate governance.

"Another problem connected with groups is that of the oppression of the minority shareholders, what is called 'tunneling.' If there is a pyramid of a holding company that owns 51 percent of Company A, which owns 51 percent of Company B, the family at the top has full control of the company at the bottom, but the right to draw only a quarter of the profits. That leads to the suppression of the minority shareholders, because those who are in control have an interest in getting the money to the top, from which they can draw it.

"There is considerable evidence about this, from different countries, although this hasn't been checked in Israel. The lower the firm is in the pyramid, the less profit remains there as compared with the profits of firms situated at the top ... Korea's LG, one of the big pyramids, has a credit-card company that is located high up. Several years ago it got into trouble and had to be bailed out. This was done by selling some of its shares, at an exaggerated price, to companies lower down the pyramid. This system perpetuates the lack of liquidity in the financial markets ..."

What is the economic, democratic and social price societies pay for group control?

"There is a potential for losing good ideas initiated outside the groups, which will never have a chance of seeing the light of day. We have no clue as to how many good ideas are lost because of this. There is a possibility of cartelization that in Israel's situation is very difficult to prove. How many companies in IDB, which Nochi Dankner controls, create a cartel in a certain branch? We have no data concerning this.

"It has been almost impossible to prove a cartel's existence unless there is physical evidence, whether written testimonies or minutes of conversations. That is why it is almost impossible to say how much they [group-run firms] harm competition. Democracy is harmed mainly because of regulations that do not favor the public, but are aimed at the interest groups. There is also a potential damage inasmuch as you cannot get rid of the well-entrenched groups."

So what is the solution?

"There are very few historical anecdotes about successfully dismantling groups, but one can mention two such cases: The first concerns the zaibatsu in Japan. The second is in the United States, during the Great Depression, when a tax was imposed on all transactions inside any given group, which undermined the rationale for maintaining it. I'm not sure it would help, but one might consider a decision to impose a heavy tax on all kinds of financial transactions within such groups. Perhaps that would somehow uproot the desire to build pyramids.

"Groups are not good for any democracy, but in most places there are no attempts to get rid of them. It's not that Hyundai or Samsung are bad companies, but they have already made their contribution to Korea."

Yafeh notes that in many ways, the structure of company ownerships in Israel is an anomaly: "Prof. Andrei Shleifer of Harvard, who is undoubtedly the most quoted economist in the world, has jointly authored with others a series of papers that have turned financial economics upside-down. He examined the differences in the extent of protection that countries' financial systems give small investors. For various historical reasons, countries that inherited what is referred to as British common law provide small investors with better protection than countries that inherited the French system, including France, Spain and South America. In the common-law countries there is a combination of broad disclosure and legal liability, so if a firm has harmed a small shareholder, he can know about it and take legal action.

"When the investor is well protected, the stock exchange develops and ownership becomes decentralized: Mrs. Cohen will not be afraid of exploitation and the person who controls the company will not be afraid to sell it because he knows he may get a good price because the buyer is not afraid of being duped.

"According to Shleifer's model, a codex of laws is supposed to protect the small investor. He checked various countries to see whether such laws existed, and found that wherever the small investors' rights were better protected - the market was more developed. In Israel there is a high degree of disclosure, but the market is not as developed as its description in the law books. The law here theoretically protects the small investors, since the element of disclosure is fairly developed, but an individual's ability to act after discovering he has been wronged is limited. Theoretically, there are courses of action, such as class action, but in practice they are not really possible."

Why? What are we missing?

"I am not sure what we are missing and discussed this with the former head of the Israel Securities Authority. If we ask the Authority's current chairman, Zohar Goshen, he would probably say we are missing a court that specializes in economic matters."
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