On one hand hiring people you know over people you don't know is bad and corrupt. On the other hand it's literally what everyone does because it's the logical, sane, smart decision to make. The #1 way to hire good people for any company is for employees to recommend friends and past co-workers.
But a public institution is not subject to market forces. A public institution doesn't have to compete, won't go bankrupt, being part of government has tremendous influence on other people's lives and is always financed by other people's taxes. Now that changes the equation quite a lot.
What you are forgetting to point out is that companies practicing nepotism have found a local efficiency maximum. That, right now, nepotism is the best way to hire the right people.
Ideally, there would be better methods to evaluate people, and the value in discovering those methods is quite clear.
The practice among those with power or influence of favoring relatives or friends, especially by giving them jobs.
... i think you're mistaking the original meaning with its definition.
: the unfair practice by a powerful person of giving jobs and other favors to relatives http://www.merriam-webster.com/dictionary/nepotism
No, I'm right. Originally it's a familial term. But modern usage includes friends.