[OPE-L] Unfettered finance is fast reshaping the global economy

From: glevy@PRATT.EDU
Date: Mon Jun 25 2007 - 18:20:35 EDT

via Antonio Pagliarone:

Unfettered finance is fast reshaping the global economy
By Martin Wolf

June 18 2007

"In Rome everything is for sale." - Prince Jugurtha in Sallust's ­Bellum

"Yes to market economy, no to market society." - Lionel Jospin, French
Socialist ex-prime minister

Is this latest transformation of capitalism a "good thing"? Post a
question for Martin Wolf

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

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

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

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

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.

The Financial Times Limited 2007

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