There is convincing evidence that political connections are pervasive in Latvia and that they provide benefits to the connected firms. This implies that the risk that our democracy is a mere 'façade' is too high to be ignored.
Subversion of Democracy? 0
I have to say that recent publications of scandalous details related to the list of the so-called "Lembergs stipends" caused a strong feeling of déjà vu. Something very similar once happened in Peru, a country on the other side of the world, yet in many respects strikingly similar to Latvia. Thus, I would like to begin with a brief story of Montesinos, the man who nearly single-handedly subverted democracy in Peru. I believe the story offers some interesting parallels as to what might be happening in Latvia.
In terms of political organization, Peru is a country that is not unlike Latvia. It has full set of democratic mechanisms: a constitution, opposition parties, regular elections, safeguards for the independence of the judiciary, a free press, etc. In the 1990s, Peru was run, in the name of President Alberto Fujimori, by its secret-police chief, Vladimiro Montesinos Torres. In the course of exercising power, Montesinos methodically bribed judges, politicians, and the news media. The scale of bribing was so large that Montesinos had to keep meticulous records of his transactions. He required those he bribed to sign contracts detailing their obligations to him. He demanded written receipts for the bribes. Strikingly, he had his illicit negotiations video-taped. Montesinos and Fujimori maintained the facade of democracy: the citizens voted, judges decided, the media reported – but they drained its substance.
Sounds familiar? What we have recently learned about the dealings of Mr Lembergs, the powerful mayor of Ventspils, bears more than a passing resemblance to Montesinos in Peru. Montesino's power came from expropriating the funds designed for the secret-police as well as his connections with Colombian drug cartels and arms dealers. He used this money to preserve and expand his political power by bribing nearly all of Peru's democratic institutions. In turn, Mr Lembergs power came from seizing control of Latvia's most important 'natural resource' – the transit of raw materials from Russia to the West. Materials from criminal investigation into activities of Mr. Lembergs that were leaked to the press suggest that he too was using his own and his Ventspils cronies' new wealth to pay political parties and specific politicians. The reign of Montesinos in Peru came to an infamous end. The government fell after one of Montesinos videotapes was broadcast on television. Fujimori fled to Japan, whereas Montesinos was arrested in Venezuela, returned to Peru, and found guilty of usurpation of authority. Some 1,600 Peruvians faced criminal charges from having been in the Montesinos network.
The Lembergs affair seems far from being finished. One of Excel tables from the 'Ventspils 5% fund', detailing payments to politicians and political parties, has just been broadcasted on the TV3 channel. Nearly all major political parties appear to have received payments from the 'Ventspils fund'. It appears that at least some payments were made for specific political favors, such as apparently rigged privatization of Latvijas Kugnieciba (Latvian Shipping Company) and botching a competitor (Riga port). The above facts raise a number of important questions. First, how much did Mr. Lembergs (and others) succeed in subverting democracy in Latvia? Second, are his activities a cause of serious concern? And third, also the most complicated question is: what do we do now?
Of course, drawing too much of a parallel between Montesinos and Mr. Lembergs would probably be too flattering for the latter. Although we must have seen only a small fragment of the documents from the 'Ventspils 5% fund', I doubt that the scale of its operations was anything close to the network of Montesinos. However, there is one important difference. Montesinos was alone, whereas Lembergs is not. For example, Tautas partija (People's party) is probably the only large party that did not receive any contributions from Ventspils. The likely reason is that it is affiliated with Mr. Škēle, another wealthy businessman who may have his own fund for covert political operations. Moreover, Mr. Lembergs and Mr. Šķēle are not the only businessmen who receive political favors. My own research suggests that businesses receive political favors in exchange for financing election campaigns. Looking at the effect of campaign contributions to Latvijas ceļš (Latvia's Way) and Pirmā Partija (The First Party of Latvia) on firm sales after 2002 election, when the former party was unexpectedly replaced by the latter one, I find substantial increase in sales of the firms connected to the winning party and decrease in sales of the firms connected to the losing party. The bottom line is that there is convincing evidence that political connections are pervasive and that they provide benefits to the connected firms. This implies that the risk that our democracy is a mere 'façade' is too high to be ignored.
Before we go on, there is a need to explain why political connections of the kind that Ventpils fund has been paying for is a bad thing. This is a question that I explored earlier, so I will only outline the main argument here. In short, political connections (state capture) lead to creation of hidden monopoly power in nearly all industries. Ventpils is a clear example of an (rather successful) attempt to create such a monopoly in Latvia through attempts to obstruct development of rivaling facilities in Riga. Another example is Mr. Šķēle's alleged involvement in the recycling business and his alleged attempts to rig the tender process through which local governments choose their suppliers. The only logical economic outcome of political connections is a „facade of free market economy". An entrepreneur will sooner or later hit a „glass ceiling", i.e. realize that he cannot out-compete his politically connected rivals. Consumers would face higher prices from de facto uncompetitive industries. Generally, state capture will perpetuate economic inequality and create an economically and politically advantaged caste of the „well-connected".
The next, and most important, question is: "what do we do now"? Perhaps this question will strike some readers as strange. After all, haven't we just witnessed one of democracy's triumphs? The politicians and political parties that received payments from the 'Ventspils fund' are now known to the voters and their political careers are likely to be finished for good (check out their ratings!). This should also teach a lesson to other (and also future) politicians. All of this is very much true. And yet I think that this is far from being over. The incentives for firms to seek political connections (and for politicians to provide political favors) are still there. As long as these incentives are in place, the 'Hydra' of state capture will grow new heads.
What gives rise to political connections and state capture by the business interests such as Mr. Lembergs and his 'Ventspils fund'? In somewhat simplified terms, the politicians can create 'hidden monopolies' of the kind that have been just described. Typically, these are created by subtly restricting competitive entry into some industry. The number of such 'hidden monopolies' depends on the strength of democratic institutions (e.g. free press) and the human capital of voters, who may or may not recognize such hidden monopolies for what they are. Then, of course, there is state procurement, which can be allocated to politically connected businesses at a high cost to the taxpayer. The bottom line is that such political favors can be very profitable for the connected businesses; hence the incentive to seek such favors and willingness to pay for them.
What makes politicians play ball by creating such 'hidden monopolies' and rigging state procurement contracts at the expense of the voters? Surely they risk their careers if the voters will find out? However, selling favors to businesses may seem very attractive because money can make a big difference in the election campaign. Apparently, many Latvian voters are easily 'impressionable' by catchy TV ads and other tricks used in expensive election campaigns. Thus, politicians have incentives to sell political favors in exchange for campaign contributions because the latter help them get re-elected.
The importance of brainwashing the voters using the media is well illustrated by the data on the bribes paid by Montesinos. John McMillan and Pablo Zoido argue that the size of the bribes indicates how much Montesinos was willing to pay to buy off those who could have checked his power. Strikingly, it turns out that:
"…the typical bribe paid to a television-channel owner was about a hundred times larger than that paid to a politician, which was somewhat larger than that paid to a judge. One single television channel's bribe was five times larger than the total of the opposition politicians' bribes. The strongest of the checks and balances [that underpin democracy], by Montesinos revealed preference, was television." 
I didn't see that the 'Ventspils fund' made any payments to television channels in what little that I have seen, but it does not mean they don't exist. I think Mr. Lembergs has had a very good understanding of the importance of the media. Allegedly, one of Latvia's major newspapers is strongly affiliated with Mr. Lembergs. TV3 channel has also published transcripts from Mr. Lembergs phone conversation with Andrejs Ēķis, the chief of LNT television channel, which suggest that Mr. Lembergs has had lots of leverage there regarding the terms on which he was interviewed, apparently including the right to bar reporters from asking the questions he did not like. Needless to say, attempts of politically connected businesses to buy themselves into the media, especially television, are a cause for serious concern.
However, I think that the payments of the 'Ventspils fund' do tell us something about what Mr. Lembergs feared most. I reproduce the table from TV3 "Nekā personīgā" below. Similarly to McMillan and Zoido (2004), I hypothesize that the size of the bribe should reflect the importance of political parties that could have checked Mr. Lembergs power. The table is likely incomplete and yet it leads to potentially striking conclusions. The biggest amounts seem to have been paid to the youngest parties such LSDS+LSDSP (Latvian Social-Democratic Workers Party) as well as Jaunais laiks (The New Era). The smallest sums went to LZS (Farmers' Union)– the party most closely affiliated with Lembergs. This may suggest that what Mr. Lembergs feared most was the entry of new political parties.
Fragment from investigation materials published by TV3 (reproduced from Diena.lv)
This provides an important clue on what needs to be done to make state capture more difficult. Just like in a market economy, there needs to be effective competition between political parties, which can be achieved by reducing barriers to entry for new political parties. This is important for two reasons. The first one is the most obvious: voters can only benefit from the supply of new politicians with new ideas of how to deliver services in a better way or how to do it in a more cost-efficient way. The second one is less obvious but also quite important. Absence of barriers to entry disciplines current politicians by subjecting them to a credible threat that failure to deliver will result in their prompt replacement.
However, I think there is serious problem with barriers to entry for new political parties. To understand this, try to put yourself in the shoes of a young political party, i.e. a "political start-up" that wants to win the elections. Winning election against an incumbent party requires costly political campaigning, which is a full time job of many people. The required financing is so large that I doubt that most political start-ups can finance their campaigns using their own savings or loans from "friends and family". Using bank loans is also not an option because winning political office does not guarantee a future cash flow, at least, not legitimately. Thus, a political start-up is similar to a business start-up in that both need to raise financing in order to start operations. The crucial difference, however, is that political start-up does not or, to be more precise, should not, generate private profit. However, lenders will only lend to the start-up that will generate profit, i.e. provide valuable political favors in case of being elected into public office. Thus, a political start-up faces a dilemma. In order to obtain financing for its election campaign, it must sign a contract with the Devil, i.e. promise private investors like Mr. Lembergs a return on their investment. In this case, however, they betray their electorate before they even begin campaigning for the elections. In contrast, an 'honest' politician who would not provide political favors to businesses is unlikely to get any financing for his election campaign. No wonder they call politics a "dirty business".
To sum up, although it may seem that there is no shortage of new political parties, I suspect most of them are tainted because of how they must have received financing for their election campaigns. It seems that there is a vicious circle of campaign contributions leading to political favors, and political favors leading to more campaign contributions. Starting a political party implies the need to obtain campaign contributions, for which the party will have to provide political favors. The circle must be broken. One solution is to use taxpayers' money in order to reduce barriers to entry into the 'political market', i.e. to help political start-ups finance their activities That is, the priority is to introduce state financing of political parties and their election campaigns as an accessible alternative for political start-ups. Working out the details of this is difficult and will take time, but it needs to be done. In addition, there is a need to continue enforcing full transparency in party financing. There has to be constant scrutiny of who is paying political parties and what these payments are for. Otherwise, the 'hydra' will grow new heads in no time.
 The story is based on John McMillan and Zoido, Pablo. (2004). “How to Subvert Democracy: Montesinos in Peru.” Journal of Economic Perspectives, 18(4): 69-92
 See Vyacheslav Dombrovsky. (2008). “Campaign Contributions and Firm Performance: The “Latvian Way”.” Stockholm School of Economics in Riga and BICEPS Working Paper. [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1168298]
 Vyacheslav Dombrovsky, "Dangerous Liasons"; http://www.politika.lv/en/index.php?id=15794
 Līga Rozentāle, "Atkritumu konkursa noteikumi labvēlīgi ar Šķēli saistītam uzņēmumam"; http://www.diena.lv/lat/politics/politika/atkritumi
 John McMillan and Zoido, Pablo. (2004). “How to Subvert Democracy: Montesinos in Peru.” Journal of Economic Perspectives, 18(4): 69-92
 John McMillan and Zoido, Pablo. (2004). “How to Subvert Democracy: Montesinos in Peru.” Journal of Economic Perspectives, 18(4): p. 69