Martin Wolf is a good barometer of the mood at the top of the financial
system. Here he is, a little over a year ago, on the cusp of the current
crisis, writing about the new features of contemporary capitalism. While not
unmindful of the risks and untested nature of the new financial
architecture, he was largely positive about its contributions and optimistic
about its stability - in marked contrast to his piece last week "A year of
living dangerously for the world" which I forwarded earlier today.
================================================
Unfettered finance is fast reshaping the global economy
By Martin Wolf
Financial Times
June 18 2007
It is capitalism, not communism, that generates what the communist Leon
Trotsky once called “permanent revolution”. It is the only economic system
of which that is true. Joseph Schumpeter called it “creative destruction”.
Now, after the fall of its adversary, has come another revolutionary period.
Capitalism is mutating once again.
Much of the institutional scenery of two decades ago – distinct national
business elites, stable managerial control over companies and long-term
relationships with financial institutions – is disappearing into economic
history. We have, instead the triumph of the global over the local, of the
speculator over the manager and of the financier over the producer. We are
witnessing the transformation of mid-20th century managerial capitalism into
global financial capitalism.
Above all, the financial sector, which was placed in chains after the
Depression of the 1930s, is once again unbound. Many of the new developments
emanated from the US. But they are ever more global. With them come not just
new economic activities and new wealth but also a new social and political
landscape.
First, finance has exploded. According to the McKinsey Global Institute, the
ratio of global financial assets to annual world output has soared from 109
per cent in 1980 to 316 per cent in 2005. In 2005, the global stock of core
financial assets had reached $140,000bn (£70,660bn, €104,490bn: see chart).
This increase in financial depth has been particularly marked in the
eurozone: the ratio of financial assets to gross domestic product there
jumped from 180 per cent in 1995 to 303 per cent in 2005. Over the same
period it grew from 278 per cent to 359 per cent in the UK and from 303 per
cent to 405 per cent in the US.
Second, finance has become far more transactions-oriented. In 1980, bank
deposits made up 42 per cent of all financial securities. By 2005, this had
fallen to 27 per cent. The capital markets increasingly perform the
intermediation functions of the banking system. The latter, in turn, has
shifted from commercial banking, with its long-term lending to clients and
durable relations with customers, towards investment banking.
Third, a host of complex new financial products have been derived from
traditional bonds, equities, commodities and foreign exchange. Thus were
born “derivatives”, of which options, futures and swaps are the best known.
According to the International Swaps and Derivatives Association, by the end
of 2006 the outstanding value of interest rate swaps, currency swaps and
interest rate options had reached $286,000bn (about six times global gross
product), up from a mere $3,450bn in 1990. These derivatives have
transformed the opportunities for managing risk.
Fourth, new players have emerged, notably the hedge funds and private equity
funds. The number of hedge funds is estimated to have grown from a mere 610
in 1990 to 9,575 in the first quarter of 2007, with a value of about
$1,600bn under management. Hedge funds perform the classic functions of
speculators and arbitrageurs in contrast to traditional “long-only” funds,
such as mutual funds, which are invested in equities or bonds. Private
equity fundraising reached record levels in 2006: data from Private Equity
Intelligence show that 684 funds raised an aggregate $432bn in commitments.
Fifth, the new capitalism is ever more global. The sum of the international
financial assets and liabilities owned (and owed) by residents of
high-income countries jumped from 50 per cent of aggregate GDP in 1970 to
100 per cent in the mid-1980s and about 330 per cent in 2004.
The globalisation of financial capitalism is seen in the players as well as
in the nature of the holdings. The big banks operate globally. So
increasingly do hedge funds and private equity funds. In 2005, for example,
North America accounted for 40 per cent of global private equity investments
(down from 68 per cent in 2000) and 52 per cent of funds raised (down from
69 per cent). Meanwhile, between 2000 and 2005, Europe increased its share
of investments from 17 per cent to 43 per cent and funds raised from 17 per
cent to 38 per cent. The Asia-Pacific region’s share of private equity
investment rose from 6 per cent to 11 per cent during this period.
What explains the growth in financial intermediation and the activity of the
financial sector? The answers are much the same as for the globalisation of
economic activity: liberalisation and technological advance.
By the mid-20th century the financial sector was highly regulated
everywhere. In the US, the Glass-Steagall Act separated commercial banking
from investment banking. Almost all countries operated tight controls on the
ownership of foreign exchange by their residents and so, automatically,
ownership of foreign assets. Ceilings on interest rates that lenders could
charge were common. The most famous of these, “Regulation Q” in the US,
which forbade the payment of interest on demand deposits, promoted the
development of the first significant postwar offshore financial market: the
eurodollar market in London.
Over the past quarter-century, however, almost all of these regulations have
been swept away. Barriers between commercial and investment banking have
vanished. Foreign exchange controls have disappeared from the high-income
countries and have been substantially, or sometimes even completely,
liberalised in many emerging market economies as well. The creation of the
euro in 1999 accelerated the integration of financial markets in the
eurozone, the world’s second largest economy. Today, much of the global
financial sector is as liberalised as it was a century ago, just before the
first world war.
No less important has been the revolution in computing and communications.
This has permitted the generation and pricing of a host of complex
transactions, particularly derivatives. It has also permitted 24-hour
trading of vast volumes of financial assets. New computer-based risk
management models have been employed across the financial sector. Today’s
financial sector is a particularly vigorous child of the computer
revolution.
Global financial assets, Interest rate and currency and Global M&A deals
Two further long-term developments help explain what has happened. The first
is the revolution in financial economics, notably the discovery of options
pricing by Myron Scholes and Fischer Black in the early 1970s, which
provided the technical underpinning of today’s vast options markets. The
second is the success of central banks in creating a stable monetary
background for the world economy and so also for the global financial
system. “Fiat” (or government-created) money has now worked well for a
quarter of a century, providing the monetary stability on which complex
financial systems have always depended.
Yet there is also a shorter-term explanation for the explosive recent growth
in finance: today’s global savings and liquidity gluts. Low interest rates
and the accumulation of liquid assets, not least by central banks around the
world, has fuelled financial engineering and leverage. How much of the
recent growth of the financial system is due to these relatively short-term
developments and how much to longer-term structural features will be known
only when the easy conditions end, as they will.
What then have been the consequences of this vast expansion in financial
activity, much of it across international borders?
Among the results are that households can hold a wider array of assets and
also borrow more easily, so smoothing out their consumption over lifetimes.
Between 1994 and 2005, for example, the liabilities of UK households jumped
from 108 per cent of GDP to 159 per cent. In the US, they soared from 92 per
cent to 135 per cent. Even in conservative Italy, liabilities rose from 32
per cent to 59 per cent of GDP.
Similarly, it is ever easier for companies to be taken over by, or merge
with, other companies. The total value of global mergers and acquisitions in
2006 was $3,861bn, the highest figure on record, with 33,141 individual
transactions. As recently as 1995, in contrast, the value of mergers and
acquisitions was a mere $850bn, with just 9,251 deals.
With the vast size of the new private equity funds and the scale of the bond
financing arranged by the big banks, even the largest and most established
companies are potentially for sale and break-up, unless they enjoy special
protection. The market in control of companies, to which private equity is
an active contributor, has greatly increased the power of owners
(shareholders) over that of incumbent management.
The new financial capitalism represents the triumph of the trader in assets
over the long-term producer. Hedge funds are perfect examples of the
speculative trader and arbitrageur. Private equity funds are conglomerates
that trade in companies, with a view to financial gain.
In the same way, the new banking system is dominated by institutions that
trade in assets rather than hold them for long periods on their own books.
With the orientation towards trading come explicit, rather than implicit,
contracts and arms-length dealing rather than long-term relationships.
So-called “relational contracts” are no longer worth the paper they are not
written on. They are subject to the solvent of new opportunities for profit.
It is no surprise, therefore, that the cross-holdings of postwar capitalism
in Japan and the bank-dominated equity ownership of postwar Germany have
both evaporated.
Moreover, the presence on share registers of large numbers of foreigners,
who are fully prepared to exercise their rights of ownership and are
unconstrained by national social and political bonds, has transformed the
way companies operate: the successful shareholder revolt against the plans
of Deutsche Börse’s management for a takeover of the London Stock Exchange
is an excellent example. Thus is global financial capital eroding the
autonomy of national capital.
Another consequence has been the emergence of two dominant international
financial centres: London and New York. It is no accident that these are
located in English-speaking countries with a long history of financial
capitalism. It is no accident either that Hong Kong, not Tokyo, is generally
viewed as the leading international financial centre in Asia, even though
Japan is the world’s biggest creditor country. Hong Kong’s legacy is
British. The legal tradition and attitudes of English-speaking countries
appear to be big assets in the development of financial centres.
How then should one evaluate this latest transformation of capitalism? Is it
a “good thing”?
Powerful arguments can be made in its favour: active financial investors
swiftly identify and attack pockets of inefficiency; in doing so, they
improve the efficiency of capital everywhere; they impose the disciplines of
the market on incumbent management; they finance new activities and put
inefficient old activities into the hands of those who can exploit them
better; they create a better global ability to cope with risk; they put
their capital where it will work best anywhere in the world; and, in the
process, they give quite ordinary people the ability to manage their
finances more successfully.
Yet it is equally obvious that the emergence of the new financial capitalism
creates vast new regulatory, social and political challenges.
Optimists would argue that the new financial system combines efficiency with
stability to an unprecedented degree. Publicly insured banks not only take
fewer risks than before but manage the ones they do take far better.
Optimists can (and do) also point to the ease with which the global
financial system coped with the collapse of the global stock market bubble
in 2000 and the terrorist attacks of 2001 – in particular, the absence of
any large bank failures at that time. They would point, too, to a diminution
in the frequency of global financial crises this decade.
Pessimists would argue that monetary conditions have been so benign for so
long that huge risks are being built up, unidentified and uncontrolled,
within the system. They would also argue that the new global financial
capitalism remains untested.
Regulating a system that is this complex and global is a novel task for what
are still predominantly national regulators. Co-operation has improved.
Reports, such as the International Monetary Fund’s Global Financial
Stability Report and its national equivalents, provide useful assessments of
the risks. New groups, notably the Financial Stability Forum founded in
1999, bring regulators together. But only severe pressures can give a good
test of the system.
The regulatory challenges are big enough. But they are far from the only
ones. Lionel Jospin’s hostility to what he called a “market society” is
widely shared. Powerful political coalitions are forming to curb the impact
of the new players and new markets: trade unions, incumbent managers,
national politicians and hundreds of millions of ordinary people feel
threatened by a profit-seeking machine viewed as remote and inhuman, if not
inhumane.
Last but not least are the challenges to politics itself. Across the globe
there has been a sizeable shift in income from labour to capital. Newly
“incentivised” managers, free from inhibitions, feel entitled to earn vast
multiples of their employees’ wages. Financial speculators earn billions of
dollars, not over a lifetime but in a single year. Such outcomes raise
political questions in most societies. In the US they seem to be tolerable.
Elsewhere, however, they are less so. Democratic politics, which gives power
to the majority, is sure to react against the new concentrations of wealth
and income.
Many countries will continue to resist the free play of financial
capitalism. Others will allow it to operate only in close conjunction with
powerful domestic interests. Most countries will look for ways to tame its
consequences. All will remain concerned about the possibility for serious
instability.
Our brave new capitalist world has many similarities to that of the early
1900s. But, in many ways, it has gone far beyond it. It brings exciting
opportunities. But it is also largely untested. It is creating new elites.
This modern mutation of capitalism has loyal friends and fierce foes. But
both can agree that its emergence is among the most significant events or
our time.
_______________________________________________
pen-l mailing list
[email protected]
https://lists.csuchico.edu/mailman/listinfo/pen-l
