Unfettered finance is fast reshaping the global economy
Saturday, 23 June 2007
Martin Wolf
"In Rome everything is for sale." - Prince Jugurtha in Sallust's Bellum Jugurthinum "Yes to market economy, no to market society." - Lionel Jospin, French Socialist ex-prime minister.
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.
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.
"In Rome everything is for sale." - Prince Jugurtha in Sallust's Bellum Jugurthinum "Yes to market economy, no to market society." - Lionel Jospin, French Socialist ex-prime minister.
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.
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.