SAVING

CAPITALISM

FROM THE

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Unleashing the Power of Financial Markets

to Create Wealth and Spread Opportunity

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RAGHURAM G. RAJAN

&

LUIGI ZINGALES

CROWN BUSINESS

NEW YORK

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CONTENTS

Cover Page

Title Page

Dedication

Preface

Introduction

PART I: THE BENEFITS OF FREE FINANCIAL MARKETS

CHAPTER 1: Does Finance Benefit Only the Rich?

CHAPTER 2: Shylock Transformed

CHAPTER 3: The Financial Revolution and Individual Economic Freedom

CHAPTER 4: The Dark Side of Finance

CHAPTER 5: The Bottom Line on Financial Development

PART II: WHEN DO FINANCIAL MARKETS EMERGE?

CHAPTER 6: The Taming of the Government

CHAPTER 7: The Impediments to Financial Development

CHAPTER 8: When Does Finance Develop?

PART III: THE GREAT REVERSAL

CHAPTER 9: The Great Reversal between Wars

CHAPTER 10: Why Was the Market Suppressed?

CHAPTER 11: The Decline and Fall of Relationship Capitalism

PART IV: HOW CAN MARKETS BE MADE MORE VIABLE POLITICALLY?

CHAPTER 12: The Challenges Ahead

CHAPTER 13: Saving Capitalism from the Capitalists

Conclusion

Notes

Bibliography

Index

About the Authors

Copyright Page

To our families

PREFACE

IF OUR PUBLISHER had the power to influence current events to promote this book and he did not give a fig for human misery, he could not have done better. Newspapers are full of corporate scandals. The implosion of the Internet bubble has produced the greatest peacetime destruction of paper wealth the world has ever seen. Antimarket protesters have gained strength in country after country. Questions about the viability or the political fragility of the capitalist system, which appeared preposterous when we started this book three years ago, seem reasonable now.

Is unbridled capitalism still the best, or the least bad, economic system? Are reforms needed? And should these reforms go in the direction of fixing the system or of changing it completely? Will the current public disillusionment with free markets outlast the dip in the stock market? Even if the disillusionment is a passing wave, in what form will capitalism survive in the twenty-first century?

Even though our book was conceived and largely written before most of the recent scandals surfaced, it attempts to place them in perspective. Every market boom produces new crooks. And every market bust sets off its witch-hunts. This book aims to see beyond the immediate consequences of market fluctuations to their deeper and more long-lasting effects on the system of free enterprise. Through our focus on financial markets, we seek to identify the fundamental strengths and weaknesses of the capitalist system, not only in its ideal form, but also in its historical realizations.

We base our arguments on a vast academic literature, much of it produced in the last twenty years. But this is not a book aimed at a specialized audience, because we think our message is relevant to the wider public. We eschew the presentation of detailed econometric analysis, not because we do not think it important, but because the flavor of the results can be conveyed equally well through words for the general reader, while the interested can be directed to more detailed sources. This book is also more than simply a survey of a literature—it weaves a broad argument. While we will marshal historical facts, and draw on our own studies, as well as the studies of others, history gives us few natural experiments with which to test all aspects of broad argument. Therefore, at certain junctures, we will try and persuade the reader as much by logic as by the historical authorities and evidence we cite.

The purist may not approve of this approach. Unfortunately, any attempt at integration of different fields, and evidence across time and studies, is usually unsatisfactory to purists, partly because the weights one places on different aspects are pregnant with biases. We would apologize for these were it not for our firm belief that bias is inevitable in all work, and it is competition between biases that generally drives thought ahead.

This has been a shared voyage of discovery in which we have learned much together along the way. We have to acknowledge those who have taught us either directly or indirectly. The modern field of finance has been created during our lifetimes, and we certainly owe an immense intellectual debt to the pioneers, many of whom are still active in research. But we owe a special debt to those who advised us in our early years. In particular, we would like to thank Oliver Hart, Don Lessard, Stewart Myers, John Parsons, Jim Poterba, David Scharfstein, Andrei Shleifer, and Jeremy Stein. We have also benefited tremendously from our colleagues at the University of Chicago’s Graduate School of Business, some of whom have been partners in our voyages of intellectual discovery, while others have provided immensely useful friendly criticism. Douglas Diamond, Eugene Fama, Steven Kaplan, Randall Kroszner, Canice Prendergast, Richard Thaler, and Rob Vishny are a few we would like to name, without diminishing the debt we owe the others. Our book also reflects the joint work we have done with others. We owe thanks especially to Abhijit Banerjee, Alexander Dyck, Luigi Guiso, Mitchell Petersen, Paola Sapienza, and Henri Servaes, whose efforts have helped mold our thinking.

Many people read early drafts of the chapters in this book. Heitor Almeida, Oliver Hart, Peter Hogfeldt, Steven Kaplan, Ross Levine, Rajnish Mehra, Canice Prendergast, Radhika Puri, Roberta Romano, Gianni Toniolo, Andrei Shleifer, and Richard Thaler provided very useful comments. Joyce Van Grondelle did an excellent job (as always) of vetting the references and the bibliography, while Adam Cartabiano, Laura Pisani, and Talha Muhammad helped us check figures and track references down.

Barbara Rifkind helped us put together a coherent proposal, and most important, find John Mahaney, our editor. He has been invaluable in getting us to focus our work so that we can address our various intended audiences in an intelligible way. We owe him thanks for many useful suggestions that have vastly improved the book. Shana Wingert, his assistant, patiently helped us manage the logistics of the book-writing process. Sam Peltzman and the Center for Study of the State and the Economy provided encouragement and crucial financial support during the course of this project.

And finally, personal notes:

Raghu:

I hope my parents will finally have a glimpse in this book of what I do for a living. This book reflects in many ways what they taught me, from the history my father used to read aloud when I was a boy to the love of reading my mother tried to inculcate in me. This book would not have been finished were it not for my daughter, Tara, asking repeatedly, Daddy, have you finished your book yet? Tara, I am sorry this book does not need an illustrator, else I would certainly have used you. I owe you and Akhil many weekends that could have been spent in the park or on the beach. And most of all, I thank my wife, Radhika, for all the love and advice she has given over the course of this project.

Luigi:

This book was written during a difficult period of my life. I want to acknowledge all the people who provided moral support throughout: Elizabeth Paparo, Maria Coller, Francesca Cornelli, Mary Doheny, Leonardo Felli, Enrico Piccinin, Carol Rubin, Paola Sapienza, Abbie Smith, Stefano Visentin, Maria Zingales, and Raghu himself, whose patience and understanding went beyond what could be expected from a friend. I am indebted to my parents for the wonderful education they gave me. I dedicate this book to my children, Giuseppe and Gloria, purpose and joy of my life.

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Introduction

CAPITALISM, or more precisely, the free market system, is the most effective way to organize production and distribution that human beings have found. While free markets, particularly free financial markets, fatten people’s wallets, they have made surprisingly few inroads into their hearts and minds. Financial markets are among the most highly criticized and least understood parts of the capitalist system. The behavior of those involved in recent scandals like the collapse of Enron only solidifies the public conviction that these markets are simply tools for the rich to get richer at the expense of the general public. Yet, as we argue, healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting poverty. Because of their role in financing new ideas, financial markets keep alive the process of “creative destruction”—whereby old ideas and organizations are constantly challenged and replaced by new, better ones. Without vibrant, innovative financial markets, economies would invariably ossify and decline.

In the United States, constant financial innovation creates devices to channel risk capital to people with daring ideas. While commonplace here, such financing vehicles are still treated as radical, even in developed countries like Germany. And the situation in third-world countries borders on the hopeless: people find it difficult to get access to even a few dollars of financing, which would give them the freedom to earn an independent, fulfilling living. If financial markets bring prosperity, why are they so underdeveloped around the world, and why were they repressed, until recently, even in the United States?

Throughout its history, the free market system has been held back, not so much by its own economic deficiencies, as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from two groups of opponents. The first are incumbents, those who already have an established position in the marketplace and would prefer to see it remain exclusive. The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organized labor.

The second group of opponents, the distressed, tends to surface in times of economic downturn. Those who have lost out in the process of creative destruction unleashed by markets—unemployed workers, penniless investors, and bankrupt firms—see no legitimacy in a system in which they have been proved losers. They want relief, and since the markets offer them none, they will try the route of politics.

The unlikely alliance of the incumbent industrialist—the capitalist in the title—and the distressed unemployed worker is especially powerful amid the debris of corporate bankruptcies and layoffs. In an economic downturn, the capitalist is more likely to focus on costs of the competition emanating from free markets than on the opportunities they create. And the unemployed worker will find many others in a similar condition and with anxieties similar to his, which will make it easy for them to organize together. Using the cover and the political organization provided by the distressed, the capitalist captures the political agenda.

For at such times, it requires an extremely courageous (or foolhardy) politician to extol the virtues of free markets. Instead of viewing destruction as the inevitable counterpart of creation, it is far easier for the politician to give in to the capitalist, who ostensibly champions the distressed by demanding that competition be shackled and markets suppressed. Under the guise of making improvements to markets so as to prevent future downturns, political intervention at such times is aimed at impeding their working. The capitalist can turn against the most effective organ of capitalism and the public, whose future is directly harmed by these actions, stands on the sidelines, seldom protesting, often uncomprehending, and occasionally applauding.

This book starts with the reminder that much of the prosperity, innovation, and increased opportunity we have experienced in recent decades should be attributed to the reemergence of free markets, especially free financial markets. We then move on to our central thesis: because free markets depend on political goodwill for their existence and because they have powerful political enemies among the establishment, their continued survival cannot be taken for granted, even in developed countries. Based on our reading of the reasons for the fall and rise of markets in recent history, we propose policies that can help make free markets more viable politically.

After the longest peacetime economic expansion in recent history, an expansion that has seen the implosion of socialist economies, it may seem overly alarmist to worry about the future of free markets. Perhaps! But success tends to breed complacency. Recent corporate scandals, the booms and busts engendered by financial markets, and economic hardship have led to growing distrust of markets. Other worrying signs abound, ranging from the virulent anti-immigration rhetoric of the extreme right to the antiglobalization protests of the rejuvenated left. And imminent demographic and technological change will create new tensions. It is important to understand that the ascendancy of free markets is not necessarily the culmination of an inevitable process of economic development—the end of economic history, so to speak—but may well be an interlude, as it has been in the past. For free markets to become politically more viable, we have to repeat to ourselves and to others, often and loudly, why they are so beneficial. We have to recognize and address their deficiencies. And we have to act to shore up their defenses. This book is a contribution toward these goals.

We start the book by explaining why competitive free markets are so useful. Perhaps the least understood of markets, the most unfairly criticized, and the one most critical to making a country competitive is the financial market. It is also the market that is most sensitive to political winds. Many of the most important changes in our economic environment in the last three decades are due to changes in the financial market. For all these reasons, and because it is a fitting representative of its genus, we will pay particular attention to the financial market.

We start with two examples, the first from a country where financial markets do not exist, and the second from a country where they are vibrant. All too often, finance is criticized as merely a tool of the rich. Yet, as our first example suggests, the poor may be totally incapacitated when they do not have access to finance. For the poor to have better access, financial markets have to develop and become more competitive. And when they do so, as our second example suggests, all that holds back individuals is their talent and their capacity to dream.

The Stool Maker of Jobra Village

There is perhaps no greater authority on how to make credit available to the poor than Muhammad Yunus, the founder of the Grameen Bank. In his autobiography, Yunus described how he came to understand the importance of finance when he was a professor of economics in a Bangladeshi university. Appalled by the consequences of a recent famine on the poor, he wandered out of the sheltered walls of the university to the neighboring village, Jobra, to find out how the poor made a living. He started up a conversation with a young mother, Sufiya Begum, who was making bamboo stools.¹

He learned that Sufiya Begum needed 22 cents to buy the raw material for the stools. Because she did not have any money, she borrowed it from middlemen and was forced to sell the stools back to them as repayment for the loan. That left her with a profit of only 2 cents. Yunus was appalled:

I watched as she set to work again, her small brown hands plaiting the strands of bamboo as they had every day for months and years on end. . . . How would her children break the cycle of poverty she had started? How could they go to school when the income Sufiya earned was barely enough to feed her, let alone shelter her family and clothe them properly?²

Because Sufiya did not have 22 cents, she was forced into the clutches of the middlemen. The middlemen made her accept a measly pittance of 2 cents for a hard day’s labor. Finance would liberate her from the middlemen and enable her to sell directly to customers. But the middlemen would not let her have finance, for then they would lose their hold over her. For want of 22 cents, Sufiya Begum’s labor was captive.

The paucity of finance, which is all too often the normal state of affairs in much of the world, is rendered even more stark when one contrasts it with the alternative: the extraordinary impact of the financial revolution in some parts of the world. To see this, we move to California for our second example.

The Search Fund

Kevin Taweel, who was about to graduate from Stanford Business School, was not excited by the idea of going to work for a large, traditional corporation. His goal was to start running his own business.

Job offers were plentiful, but no one gave him the opportunity to be his own boss. After all, who would trust someone with so little experience to run their firm? The choice was clear. If he wanted to run a company, he had to buy one. But how? Not only did he not have the money, he did not even have enough to pay for his expenses while he searched for an attractive target.

Kevin’s situation is common. For millions around the world, the lack of resources to fund their ideas is the main roadblock to riches. All too often, you have to have money to make money. But Kevin overcame this barrier by making use of a little-known financing device called a search fund. Slightly over two years after leaving Stanford, he was running his own firm.

A search fund is a pool of money to finance a search for companies that might be willing to be bought out.³ Typically, a recent graduate from a business or law school, with no money of his own, puts the fund together. The fund pays for the expenses of the search and some living expenses for the principal (the searching graduate). After identifying an appropriate target, the principal has to negotiate the purchase as well as arrange financing. In return for their initial investment in the pool, investors in the search fund get the right to invest in the acquisition at favorable terms. Once the target is acquired, the principal runs the firm for a few years and eventually sells it, pays off investors, and hopefully, keeps a sizable fortune for himself.

In December 1993, Kevin raised $250,000 to fund his search. A year and a half later, with the help of a fellow graduate, Jim Ellis, Kevin identified a suitable target, an emergency road services company. The owner asked for $8.5 million to sell out, a sum that Kevin and Jim were able to raise from banks and individual investors (most of them the original investors in the search fund). In fact, the prospects they offered the individual investors were so attractive, they were able to raise the money they sought in just twenty-four hours!

Under Kevin and Jim’s management, the acquired company grew at an extremely rapid pace, both through internal expansion and through acquisitions. While sales in 1995 were only $6 million, in 2001 they reached $200 million. The company delivered a fantastic return to investors: shares bought by investors at $3 in 1995 were bought back by the company at the end of 1999 for $115.

Not all search funds have such a happy ending. Some principals run out of money before they find an attractive target. Others do succeed in finding a target but are not as successful in running it. In general, however, search funds are very profitable, yielding an average 36 percent annual return to investors and much more to the principals.⁴

But more remarkable than their average return is the concept behind search funds. What is being financed in a search fund is not a hard asset that offers good collateral to the financiers. It is not even a solid business proposition. What is being financed is a search for a business proposition—in effect, a search for an idea. The search fund hints at a world that did not exist in the past, a world where a person’s ability to create wealth and attain economic freedom is determined by the quality of her ideas rather than the size of her bank balance.

The search fund reflects a revolutionary improvement in the ability of a broad sector of people to obtain access to finance. This has had profound implications for their lives, often in ways to which they are oblivious. For example, throughout much of history, labor was plentiful, while only a privileged few had access to capital. As a result, employees were weak relative to capital—in the prototypical large corporation of yesteryear, the owners of capital (the shareholders) or their nominees (top management) made decisions, while those lower in the hierarchy had no alternative but to obey. With the widespread availability of capital from developed financial markets, the human being has gained in strength in many industries relative to the owners of capital. Increasingly, the term capitalism as a description of free market enterprise is becoming an anachronism in many industries.

While this may seem hard to believe in the midst of a recession, the average educated worker or manager in developed countries does indeed have far more choice than before. Phenomena ranging from worker empowerment to the flattening of corporate hierarchies, from the growth of employee ownership to the breakup of large firms, are all, in some significant measure, consequences of the development of financial markets.

The Puzzle

There are many obvious differences between Kevin or Jim and Sufiya Begum. A Stanford M.B.A., whether in his Hickey Freeman suit or in Birkenstock sandals, is indeed far removed from a barefoot villager in Bangladesh with callused hands and nails black with grime. But there are important similarities: both have valuable skills that only need to be supplemented with resources. As a multiple of the value of the income each one expects to generate, the amount of financing they seek is not very different. Neither has hard assets or prior wealth to offer as collateral. Yet Kevin and Jim obtained the funding they needed, while Sufiya Begum continued to be trapped in poverty.

Why could Sufiya Begum not get 22 cents at a reasonable interest rate while Kevin and Jim could raise hundreds of thousands of dollars easily in setting up their search fund? Why are financial markets developed in some countries only and not in others? Will even the countries where they are developed continue to enjoy the fruits of finance, or is the surge in financial markets that we have experienced in the last two decades a temporary lull in millennia of financial oppression?

The “Conventional” Answer

The search fund works because it gives the searching M.B.A. the right incentives. For this, it relies on a variety of institutions. The rights of the principal and those of the investors are clearly demarcated by contract, not just when the fund is set up but going forward. The legal system works so contracts can be enforced at low cost. Secure in their shares, the parties do not have incentives to deceive or manipulate each other. An effective accounting and disclosure system and a reliable system of public recordkeeping contribute to mutual trust. This also helps make everyone’s stakes liquid. The principal knows that he is not locked in to the firm for life but can make improvements to the target firm and then exit by selling his stake in a liquid stock market. Since the market will capitalize the entire future stream of profits, the principal will get a tremendous compensation for his effort in locating underperforming firms. Thus, the best talent is attracted to this business, further improving the level of trust . . .

The main reason why Sufiya Begum cannot get finance at a reasonable rate is that countries like Bangladesh are deficient in institutions: ownership rights are neither well demarcated nor well enforced; there are no agencies collecting, storing, and disseminating information on the creditworthiness of potential borrowers; there is little competition between moneylenders; the laws governing credit are outdated; contracts are not enforced because the judiciary is all too often either asleep or corrupt . . .

To remedy the deficiency in Bangladesh, however, one has to go beyond the conventional answer, “Fix the institutions!” One has to understand first why the necessary institutions do not exist. Perhaps the existing institutions cannot be changed because they run too deep in a country’s history or a people’s psyche. If this were the case, countries like Bangladesh would be condemned to remain underdeveloped for many years to come. Fortunately, as we argue in this book, the historic evidence does not suggest that the legacy of history necessarily dooms a people. Thanks to human ingenuity, whenever allowed to do so, people create substitute institutions if the existing ones cannot be fixed cheaply. In doing so, they demonstrate that institutional change is possible no matter how damned a country is by its history.

Perhaps poor countries lack the necessary endowments, such as trained manpower, wealth, and sophisticated technologies to create new institutions. The difficulty with this explanation is that the logic is somewhat circular: countries are poor because they do not have institutions, and they do not have institutions because they are poor. This sheds little light on how some countries managed to break out of this vicious cycle. It does not explain why some countries that are rich—in 1790, the richest country in the world on a per capita basis was Haiti—never develop the necessary institutions and fall behind.⁵ And it does not explain why countries do not develop the specific institutions that facilitate access to finance, even though they have other basic market institutions. Ten years ago, something like the search fund would have been virtually impossible to contemplate in France or Germany. These countries did not lack the capacity to create the institutions necessary for a vibrant, competitive financial sector: their laws are detailed and well enforced; their people are no less educated than Americans; their industries no less reliant on high technology . . . We have to seek elsewhere to explain why the institutions necessary for competitive financial markets in particular, and markets in general, are so underdeveloped or nonexistent in many countries.

The Politics of Markets

Our explanation is simple. Small, informal markets are no doubt possible without much institutional infrastructure. But the large, arm’s-length markets required in a modern capitalist economy need a substantial amount of infrastructure to support them. These market institutions are underdeveloped when the powerful see them as undermining their power. The economically powerful are concerned about the institutions underpinning free markets because they treat people equally, making power redundant. The markets themselves add insult to injury. They are a source of competition, forcing the powerful to prove their competence again and again. Since a person may be powerful because of his past accomplishments or inheritance rather than his current abilities, the powerful have a reason to fear markets.

Of course, the powerful also benefit from some markets. What use is it being the monopoly producer of bananas in a republic if there is no market in which to sell them? But when these markets exist, the powerful like to control them, as the father of economics, Adam Smith, recognized long ago:

To widen the market and to narrow the competition is always the interest of the dealers. . . . The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted, till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who generally have an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.⁶

The powerful particularly oppose the setting up of infrastructure that would broaden access to the market and level the playing field. The middlemen who have Sufiya Begum in their grasp have the power and the local knowledge to get around the otherwise byzantine system for recovering from defaulting borrowers. Better laws, better demarcation of property, and the creation of public credit-rating agencies would create a vibrant competitive financial market, bring in outside lenders, and make these middlemen’s skills redundant, thus jeopardizing the fat profits they make. Anticipating this, the middlemen would rather not see the market develop at all. What better way than opposing the creation of the necessary institutions?

It is not just incumbents in poor countries who have to fear the increase in competition as financial markets develop. In the United States, which has a vibrant financial market, fully half the top twenty firms by sales in 1999 were not in the top twenty in 1985. By contrast, in Germany, where the financial markets till recently were dormant, 80 percent of the firms in the top twenty in 1999 were also in the top twenty in 1985. While other factors are partially responsible for these differences, financial markets do seem to affect corporate mobility even in rich countries, threatening the establishment.⁷

Our point thus far is a simple one. Those in power—the incumbents—prefer to stay in power. They feel threatened by free markets. Free financial markets are especially problematic because they provide resources to newcomers, who then can make other markets competitive. Hence, financial markets are especially worthy of opposition.

For this to be more than a conspiracy theory, it has to be useful in predicting when and where markets will develop. If incumbents have a stranglehold on power, markets will develop either when the incumbents benefit directly from them or when the incumbents have no other choice. There are at least three phases in the historical development of financial markets that can be easily identified: the initial phase, when a country obtains more representative government and begins to respect property rights; a second phase, when it opens its borders to tame the incumbent groups that would otherwise capture democratic government; and a third reactionary phase, when incumbent groups ride the coattails of the distressed back into power. The phases do not inevitably follow one another, nor do they occur in all countries. But they are general enough to merit greater attention.

The Initial Phase: Respect for Property Rights

For free competitive markets to develop, the first step is that the government has to respect and guarantee the property rights of even the weakest and most defenseless citizen. The greatest threat, historically, has often been the government itself: under the guise of protecting citizens from foreign or ideological enemies, governments used their powerful armies or police forces to prey on their own citizens. In some societies, governments changed character quite early on and became representative of the people, policing their interactions with a firm but light hand and inspiring trust rather than fear. In others, rulers still treat their countries as personal fiefdoms, to be looted as they please. Why were some countries fortunate while others are still damned?

While one-dimensional answers to such questions rarely satisfy, the historical evidence suggests an intriguing pattern: in many of the fortunate countries, the distribution of property, especially land, was typically much more egalitarian. For example, among the countries of the New World, land in Canada and the northern United States was widely distributed, with a sizable number of “yeoman” farmers managing moderate plots of land. In the countries of the Caribbean and in Latin America, the norm was large estates, often run by owners exploiting slave labor or reliant on feudal relationships with the docile local population.⁸

The link between land distribution and responsive government may not be a coincidence. In North America, most farmers were individually too small to create their own police force. It made collective sense to create transparent, representative government in which each citizen was treated similarly according to the rule of law. Moreover, because the yeoman farmer in North America owned his land, he had strong incentives to farm it well and to try to improve his production techniques. Over time, he grew to understand his land—the right crops and the right times to plant and harvest as well as the right scientific techniques to use. Even if ownership was initially distributed almost by accident as immigrants enclosed their plots and started farming them, over time the yeoman farmer grew to be a productive owner of his land. Even the most rapacious government would think twice about disturbing his ownership. It was far better to tax the farmer steadily than kill the goose, so to speak, by seizing his property.

In short, because property was held widely, the propertied in North America pressed for a government that would be open, fair, and respect the rule of law. The small but prosperous farmers had the collective economic might to press for such a government. And because the farmers were close to their property and managed it well, it made economic sense to respect their property rights. All this created a fertile ground for the emergence of a strong free market economy.

Let us now turn to South America. The European colonists set up large plantations and haciendas operated with the help of imported slave labor or docile indigenous populations.⁹ But the estate owners had quite different incentives from the yeomanry in North America. These powerful incumbents had no use for an impartial, representative government. Instead, they had sufficient size to maintain their own police forces and sufficient money to influence whatever government existed.

With the passage of time, civilization forced the emancipation of slaves, and the docile domestic population became aware of their rights. This changed the economics of producing in large estates for the worse. The only way for these estates to remain profitable was for the owners to ensure that the working population had few other economic opportunities—for example, by ensuring that they were starved of education and finance.¹⁰ Far from creating free market institutions, therefore, the powerful incumbents had an incentive to actively suppress them.

Of course, history is too colorful for each country to precisely follow our sketch. But the broad pattern is clear: countries, or even areas such as southern Italy or northeast India, that were dominated by large feudal estates had a difficult time establishing the rule of law and respect for property.

The stranglehold of the incumbent magnates was not unbreakable. But typically, dramatic internal political upheaval or challenge from forces outside a country was necessary for change to take place. In England, the Tudors destroyed the great lords and the church in order to shore up their power, and this led to the rise of Parliament and constitutional government. In Brazil, economic reforms followed the revolution in the late nineteenth century. In the countries of continental Europe, land reform and political reform followed on the seismic waves generated by the French Revolution and the subsequent Napoleonic conquests. Many of these countries joined the ranks of the fortunate. The unfortunate ones, shielded from reforming internal or external disturbances, continued to be slowly strangulated.

The Second Phase: Taming Incumbents in Democracies

The emergence of a constitutionally bound democracy is a big step toward free financial markets because citizens obtain greater assurance that their property will be respected. But it is not sufficient. For even in an industrialized democracy, there are powerful incumbents—established industrial firms and established financiers. They can be opposed to free access to finance simply because they already have enough financing of their own, and the financial markets fund unwanted new competitors.

Incumbents have the power to block the institutions necessary for finance because they are an organized group, focused on their goal, and endowed with plentiful resources. They have a far greater ability to sway legislators and bureaucrats to their view than the larger mass of unorganized citizens. Consider whom the U.S. Congress first sought to help after the terrible tragedy of September 11, 2001. The terrorist attacks affected the entire tourism industry. But the first legislation was not relief for the hundreds of thousands of taxi drivers or restaurant and hotel workers, but for the airlines, which conducted an organized lobbying effort for taxpayer subsidies.

Analogously, if industrial and financial incumbents are opposed to financial development, they have the organization and the political clout to prevent institution building from becoming an important part of a government’s agenda. Finance can languish even if the people want it, simply because they do not have the organization to push for it.

To see how political expediency can overcome the public interest, one only has to turn to the rural South in the United States not so long ago.

For the farmer who needed credit in the rural South in the early years of the 20th century, the alternatives were dismal. Few banks would even consider making agricultural loans, and those who did charged extremely high interest rates. Rural credit was fertile ground for the loan sharks, and year after year, farmers turned over their crops to help pay exorbitant interest charges on loans made to keep their farms operating. Should a crop fail, the chances of a farmer extricating himself and his family from a loan shark’s clutches were virtually nonexistent.¹¹

The root of the problem was that state banking laws in the United States were not designed with the public in mind. Some states did not allow banks to open more than one branch. Many states also debarred out-of-state banks from opening branches. The reason, quite simply, was to ensure that competition among banks was limited so that existing in-state banks could remain profitable. It did not matter that without competition, in-state banks became fat and lazy, and that with limits on branching, banks were too small and risky and thus may not have wanted to make agricultural loans that would tie them even more closely to the vicissitudes of local weather. The people of the state were served badly. But the in-state banks contributed large sums to political campaigns, and their will prevailed for a long time against the needs of the people. It was only in the 1990s that these archaic banking regulations in the United States were finally repealed.

If the most powerful economic players in a state or a country decide to oppose the creation of free market institutions, then there is only one hope for the emergence of markets: competition from outside. This is because the political restraints imposed on domestic competition and markets tend to make domestic players, no matter how powerful internally, inefficient and uncompetitive relative to outside players who have cut their teeth in a more competitive environment. As a result, if competition seeps through from outside across political borders, domestic incumbents have only two choices: remove the regulations that stand in the way of free domestic markets or perish. Typically, they make the rational choice.

This is, in fact, what happened with regulations limiting bank branching in the United States. As technology improved the ability of banks to lend and borrow from customers at a distance, competition from out-of-state banks increased, even though they had no in-state branches. Local politicians could not stamp this competition out since they had no jurisdiction over it. Rather than seeing their small, inefficient local champions being overwhelmed by outsiders, they withdrew the regulations limiting branching. With the exception of a few inefficient banks, studies show that everyone benefited. The withdrawal of these regulations typically led to a significant increase in the growth rate of per capita income in the state and a reduction in bank riskiness.¹²

Similarly, cross-border trade and cross-border capital flows subject incumbents in a country to vigorous competition from outside. Countries are forced to do what is necessary to make their economies competitive, not what is best for their incumbents. Typically, this means strengthening the institutions necessary for domestic markets.

For example, in Japan in the early 1980s, corporate bond markets were tiny. This was because commercial banks controlled the so-called Bond Committee, an official body to which each firm desiring to issue unsecured bonds (bonds that are not backed by collateral) had to apply. Ostensibly, the reason for this arrangement was to ensure that companies marketed only safe issues to the public. The real reason was that banks used the Bond Committee to protect their commercial lending business. Hitachi—then a blue-chip AA-rated firm (AAA being the highest rating)—couldn’t obtain permission to issue bonds and thus had to borrow from the banks at high rates.

The growth of the Euromarket (an offshore market in London) and the opening of Japan’s borders to capital flows in 1980 finally loosened the banks’ longtime stranglehold on companies. Large Japanese firms now bypassed domestic banks to borrow in the Euromarket. There, they faced no collateral requirements, and they could freely issue a wide range of instruments in different maturities and currencies. Whereas Euromarket issues accounted for only 1.7 percent of Japanese corporate financing in the early 1970s, they accounted for 36.2 percent of it by 1984. The Bond Committee was forced to disband—not because the government or the banks saw how inefficient it was but because cross-border competition dictated it.

More generally, during the twentieth century, periods of high international mobility of goods and capital (1900–1930 and 1990–2000) have paralleled periods of maximum development of financial markets. More telling, countries that proved most open to international trade during these eras boasted more mature financial markets. As one example, small countries like Hong Kong, Luxembourg, and Switzerland have to be open by necessity and, not coincidentally, tend to be important financial centers. Open borders limit the ability of domestic politics to close down competition and retard financial and economic growth. They help save capitalism from the capitalists!

The hope, then, for countries like Bangladesh is that as they become integrated into the world economy, the archaic institutions that literally and figuratively imprison their people will be forced to change for the better. People will have free access to finance and, with that, a hope of economic freedom.

In sum, our argument thus far is that each stage in a country’s development brings its own set of incumbents who have an interest in allowing only those institutions that sustain their power. If economic power in the country is concentrated in the hands of those who do not have economic ability—the feudal lords or the inefficient plantation owners—promarket institutions have a chance of emerging only after political change democratizes power. But democratization may not be sufficient. Even in a democracy, incumbents can have their way, relying on the tendency of the general public to be apathetic toward political action. A free press, active political participation, and competitive political parties help mitigate this, but what ultimately keeps a new set of incumbents from capturing a country’s economic policies is competitive pressure from outside a country’s political borders. This pressure forces domestic politicians to adopt more efficient, market-friendly policies, if only to help domestic incumbents survive. Competition among political systems gives free markets a chance.

The Third Phase: The Reaction

But if all that stands between the tyranny of incumbents and competitive free markets is open borders, how stable are markets? Is the opening of a country’s borders to foreign goods and services not itself a political decision, dependent on the mood of a country’s people? If so, do free markets rest on shifting and fragile foundations?

The foundations can shift, but not with every political whim and fancy. A country’s borders are porous. When the rest of the world is open, it is difficult for any single country to put up barriers to the flow of goods, capital, and people. There will always be ways through, around, or under the barriers a country puts up. So when the world is open, a country’s borders will perforce be open unless it is a police state. Incumbent interests will be subdued. This is perhaps why the Asian crisis in 1998, which occurred when much of the world was steaming ahead healthily, did not change the stance of most East Asian governments toward open borders.

Matters can change if a number of large countries close their borders. Not only will such actions weaken the champions of openness in each open country, they will also make it easier for a country to control flows across its own borders. So a reversal in globalization can be contagious. Such concerted action is not unthinkable. Not only can a global downturn reverberate in many countries, it also can turn significant vocal segments of the public against competitive markets and, by association, open borders.

To understand why economic downturns spawn opposition to markets, consider the natural consequences of a competitive and transparent market: it creates new risks and destroys traditional sources of insurance. The dark side of risks is invariably experienced in downturns, and the lack of insurance keenly felt then. No wonder opposition mounts.

Let us explain in more detail. Competition naturally distinguishes the competent from the incompetent, the hardworking from the lazy, the lucky from the unlucky. It thus adds to the risk that firms and individuals face. It also increases risk by expanding opportunities in good times and reducing them in bad ones, thus subjecting people to a roller coaster of a ride. Ultimately, most people are better off, but the ride is not always pleasant, and some do fall off.

Also, when competition is limited, individuals and firms enjoy various forms of implicit insurance. This can dry up as markets develop. An example should make the point clear. When competition among firms for workers is limited, firms know that their workers will have little mobility in the future. Knowing that their workers will be loyal, firms would rather retrain than fire their workers in times of trouble, providing them some insurance against bad times. By contrast, in a competitive economy, workers have greater mobility in good times. This makes it hard for a firm to justify retraining or holding on to excess employees in bad times because the firm knows full well that the employees need not be loyal when the economy turns around. Similarly, traditional forms of implicit insurance between firms and lenders, suppliers and customers, citizens and communities can all become more strained as markets develop and provide participants more choice. Often, explicit forms of insurance do not, or cannot, fully replace traditional sources.

In short, a competitive market not only creates clearly identified losers, it also deprives them of traditional safety nets. These people become the distressed—the workers whose industries have no future as a result of competition, the investors who lose their entire life savings, the small-business owners and farmers who are overburdened with debt taken to finance investment in rosier times . . . The distressed, staring at destitution, will have a strong incentive to organize and obtain protection through the political system. If they do manage to organize, though, they will demand far more than subsidies. Indeed, their demands are likely to turn against the economic system that led to their plight, especially because these demands coincide with the desires of incumbent capitalists. This is not just a theoretical possibility; it has happened before.

The Great Reversal

The world experienced a period of increasing globalization and a great expansion of markets at least once before. Reflecting on his times, the president of the International Congress of Historical Studies said in 1913:

The world is becoming one in an altogether new sense. . . . As the earth has been narrowed through the new forces science has placed at our disposal . . . the movements of politics, of economics, and of thought, in each of its regions, become more closely interwoven. . . . Whatever happens in any part of the globe has now a significance for every other part. World History is tending to become One History.¹³

Markets were indeed vibrant at the time he spoke those words. But soon after, the First World War and the Great Depression created great dislocation and unemployment. These events occurred at a time when the level of formal insurance available to ordinary people ranged from minimal to nonexistent (only 20 percent of the labor force in Western Europe had some form of pension insurance in 1910, only 22 percent had health insurance, and unemployment insurance was almost unheard of). Workers, many of whom had become politically aware in the trenches of World War I, organized to demand some form of protection against economic adversity. But the reaction really set in during the Great Depression, when they were joined in country after country by others who had lost out—farmers, investors, war veterans, the elderly . . .

Politicians had to respond, but such a large demand for protection could not be satisfied within the tight constraints on government budgets imposed by the gold standard. Hence, the world abandoned the straitjacket of the gold standard, which at that time was the prime guarantor of free trade and free capital flows. Borders closed.

Governments obtained control over access to financial markets, and many countries also nationalized significant portions of their banking systems. With their ability to turn on or turn off finance, governments obtained extraordinary power over private business. In addition, they intervened more directly by nationalizing industrial firms or by setting up government-sponsored cartels. In part, these actions reflected a distrust of the market; in part, they reflected the inadequacies of past government policies. Since the government could not set up a reasonable safety net quickly, it tried to directly limit the size of market fluctuations by limiting competition.

With no external competition, and with the government willing to intervene to protect jobs and firms, incumbents had a field day. They used this period when domestic policies were no longer disciplined by international competition not just to gain temporary advantage but to mold legislation in their own favor so that their advantage would continue into rosier times, when they would not be able to direct the anger of the distressed against markets. The reversal in openness provided the conditions under which markets could be, and indeed were, repressed. And this repression lasted for a long time.

As competition dried up, a few large firms dominated most industries. New entrants did not get a chance. Worse, economies could no longer renew themselves through creative destruction, whereby old and jaded institutions give way to the young and innovative. While all this may not have mattered in the immediate post–World War II years, when the emphasis through much of the world was on reconstruction, eventually the world economy began to slow.

It is only through the progressive opening up of the world economy in the last three decades, driven in no small part by the realization that closed borders produce economic stagnation, that finance, and economies, have become free again.

In sum, history suggests that the political consensus in favor of free markets cannot be taken for granted, even in the developed countries of the world. The political battle has to be fought again and again to preserve economic freedom. Sufiya Begum’s plight, although extreme, is not that distant from us!

The Dangers of the Antiglobalization Movement

Open borders have improved the well-being of a broad swath of people—many of whom are equally oblivious to the role that finance has played in their lives and to the risk that closing borders would pose for them personally. Unfortunately, too few people understand this, which is why antiglobalization protests grow unchecked around the world. With a serious economic downturn, open borders will look less and less attractive, even though they are politically most beneficial at such times.

Markets will always create losers if they are to do their job. There is no denying that the costs of competition and technological change fall disproportionately on some. Unfortunately, it is largely their voice, rather than the desires of the silent majority or the interests of future generations, that will influence politicians. The danger, stemming from conservative politics, is to ignore the concerns of the losers or the threat they pose to general prosperity. Liberal politics is equally misguided when it attacks the system that created losers instead of seeing that it is an inevitable aspect of the market.

Recent developments do not augur well. The increase in militarism across the globe may hopefully be only a minor footnote in history. Regardless of whether it is or not, war fervor tends to increase faith in action by governments, even in the economic arena, while reducing the public’s faith in the logic of open markets. An economic downturn with many cheated of prosperity that seemed to be within their grasp, corporate scandals that undermine the public’s perception that markets are fair, a chance of a prolonged war, and a backlash against open borders—we have seen such conditions before. Markets did not come out well from the encounter.

That is not to say that we have learned nothing from the 1930s. History is not so boring as to repeat itself exactly. Developed countries have built safety nets for their people, though there are holes in even the best of them. But newly developed and developing countries are still reliant on informal safety nets that have frayed long ago under the onslaught of markets. It is not inconceivable that the antimarket movement may gather strength there and then spread to developed countries.

And developed countries have to face new problems. Technological change and the economic growth of countries like India and China are forcing entire industries to shrink and restructure. The aging of populations in developed countries and the consequent need for immigration from developing countries may fuel great political tension in the future, when working immigrants will be asked to pay benefits to the retired old indigenous population. Furthermore, as the retired in the rich West merely own but do not create value, conflicts over property rights can increase.

None of these looming problems is without resolution. But they require policies that are pragmatic rather than ideological, and we will suggest some. Broadly speaking, borders have to be kept open so that countries can enjoy competitive free markets and keep the playing field level. But open borders and free markets also have to be made politically palatable. There is little common ground between free markets and incumbents, but what little there is can be expanded. More common ground can be found between free markets and the distressed. To prevent politics from working at cross-purposes to the market, those who lose out in competition should be helped, not to continue the lost fight but to ease their pain and to prepare them for a better future.

To sum up, the central point of this book is the fundamental tension between markets and politics. Large arm’s-length markets require substantial infrastructure. The difficulty of organizing collective action makes it hard to develop this infrastructure without the assistance of the government. But such assistance suffers from a similar problem: the very same difficulties of organizing collective action make it hard for the public to ensure that the government acts in the public interest. The traditional Left and the Right each emphasize only one side of this tension: the Left the need for government intervention, the Right the corruption of the government. If both are correct, as they undoubtedly are, the political stability of free markets cannot rest on one-sided ideological prescriptions. Instead, it needs a sophisticated web of checks and balances. To see what these might be, we need to understand better why free markets are beneficial, how they emerge, who opposes them, and when this opposition gains strength. These are the issues examined in this book.

PART ONE

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THE

BENEFITS

FINANCIAL MARKETS

CHAPTER ONE

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Does Finance Benefit Only the Rich?

FOR THE POLITICAL foundations of free markets to become stronger, society has to become more cognizant of how much it owes them. The first step in mounting a defense of markets is to create awareness about both their true benefits and their limitations. Because the free market system is so weak politically, the forms of capitalism that are experienced in many countries are very far from the ideal. They are a corrupted version, in which powerful interests prevent competition from playing its natural, healthy role. To defend free markets against their critics, therefore, we have to show not only how much of our plentiful lives we owe to them but also why the grim parodies of capitalism through much of even recent history are not truly representative of free market enterprise. And further, we will try to convince the reader that we are not faced today with the Hobson’s choice between a corrupt socialism and a corrupt capitalism, as has been the case through much of history. There is a better way, and it is largely within our reach.

One group of markets, the financial markets, attract even more opprobrium than others. Few trained economists in the developed world today would be against free markets in goods and services, but a sizable number can still be found who would oppose free financial markets. Not only are financial markets more misunderstood than other markets, they are also more important because, as we will argue later, free financial markets are the elixir that fuels the process of creative destruction, continuously rejuvenating the capitalist system. As such, they are also the primary target of the powerful interests that fear change. Through much of the book, therefore, we focus on the financial markets as our representative example.

To mount a defense, however, we have to know what we must defend against. So let us now examine what the public believes financial markets and financiers do. One belief that is widely held is that Wall Street is a parasite living off of Main Street. At best, the financier takes from Peter and gives to Paul, while keeping back a significant commission to furnish a luxury apartment overlooking Central Park. Tom Wolfe’s The Bonfire of the Vanities perfectly captures this view of financiers. Here is a passage from it in which Judy McCoy explains to her daughter Campbell what exactly her father, a bond salesman, does:

“Daddy doesn’t build roads or hospitals, and he doesn’t help build them, but he does handle the bonds for the people who raise the money.”

“Bonds?”

“Yes. Just imagine that a bond is a slice of cake, and you didn’t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that.”

Judy was smiling, and so was Campbell who seemed to realize that this was a joke, a kind of fairy tale based on what her daddy did.

“Little crumbs?” she said encouragingly.

“Yes,” said Judy. “Or you have to imagine little crumbs, but a lot of little crumbs. If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake.”¹

Wolfe is not in a minority in deprecating financiers. Works ranging from Shakespeare’s Merchant of Venice to Émile Zola’s Money have financiers occupying a moral space considerably below that of prostitutes.

Even while many view them as leeches, others see them as too powerful. Consider these words of Woodrow Wilson during the United States presidential campaign of 1912:

The great monopoly in this country is the money monopoly. So long as it exists, our old variety and freedom and individual energy of development are out of question. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of few men, who, even if their actions be honest and intended for the public interest, are necessarily concentrated upon the great undertakings in which their own money is involved and who, necessarily, by every reason of their own limitations, chill and check and destroy genuine economic freedom.²

Wilson recognized the importance of finance (“a great industrial nation is controlled by . . . credit”) but lamented that its power was used to “chill and check and destroy genuine economic freedom.” Are these two seemingly opposite perceptions—financiers’ being useless while at the same time being too powerful—compatible?

They are, and they characterize financiers well, but only in an underdeveloped financial system—a system lacking in basic financial infrastructure such as good and speedily enforced laws, clear accounting standards, and effective regulatory and supervisory authorities. The reason why these beliefs are valid is simple. Talent and business acumen are worth nothing without the funds to put them to work. A good financial system broadens access to funds. By contrast, in an underdeveloped financial system, access is limited. Because funds are so important, the financier who controls access is powerful, but because access is so limited, the financier can make money doing very little. His role is simply that of a gatekeeper, keeping the rich within the gates safe while keeping out those who would compete for resources. He thus validates both Judy McCoy’s view that he scrounges crumbs from the cake that others create and Woodrow Wilson’s view that financiers “chill and check and destroy genuine economic freedom.”

Why is finance so limited in an economy without financial infrastructure? Financing is the exchange of a sum of money today for a promise to return more money in the future. Not surprisingly, such an exchange can be problematic. First, even the most honest borrower may be unable to live up to her promise, due to the uncertainty intrinsic in any investment. Thus, financiers have to bear some risk. When the risk involved is substantial and concentrated, it becomes difficult to find people willing to bear it. Second, promises are hard to value. People who do not intend to keep them are more willing to promise a lot. Hence, the very nature of the exchange tends to favor the dishonest. Finally, even individuals with the best intentions may be tempted to behave in an opportunistic way when they owe money. In an economy without the infrastructure to mitigate these problems, financing becomes restricted to the few who have the necessary connections or wealth to reassure financiers. The financier can prosper simply by acting as a gatekeeper. As we explain in this chapter, the limited access to finance severely reduces the choices citizens have in determining the way they work and live.

In the next chapter, we explain why this does not need to happen. With the appropriate infrastructure in place, the intrinsic problems we describe can be overcome, so that the financier can broaden access to funds and enhance economic freedom. And this is not just utopian thinking. As we describe in Chapter 3, the revolution that has taken place in the U.S. financial markets in the last twenty years has already enhanced economic freedom greatly, placing the human being rather than capital at the center of economic activity. All this suggests that those who want to oppose free access to finance and the attendant freedoms it brings need focus merely on holding back the institutional infrastructure needed for a modern financial market. The problems intrinsic to finance will do the rest by restricting access. Once we understand this, we will be ready to embark on the rest of the book.

The Problems Intrinsic to Financing

Chance, ignorance, or knavery—in the jargon, uncertainty, adverse selection, or moral hazard—can intervene to prevent financing from being repaid. Let us quickly explain why.

Few investments are perfectly safe—there is typically some uncertainty about whether they will succeed. To attract funds to risky ventures, individuals or firms undertaking them have to promise their investors a risk premium over what they would earn on safe investments. In a developed financial system, financiers reduce the premium required of a borrower by spreading risk widely over a variety of investors or allocating it to those investors who can best bear it. Because financiers in an underdeveloped financial system do not have the ability to distribute risk appropriately, the risk premium their investors demand is high, and finance becomes extremely costly.

The problems caused by uncertainty are exacerbated because not all people are intrinsically honest. Without extensive information on a borrower’s past credit history, it is hard for a financier to tell the honest from the dishonest. Even if there is a default, it is not easy to separate bad luck from crookery. Since the dishonest are hard to identify and punish, financiers with limited information again have to resort to charging high rates.

There is a limit, however, to the rates a financier can charge. One problem the financier faces is termed adverse selection.³ Honest borrowers who intend to repay are very sensitive to the interest rate. They expect to bear the full burden of repaying the high rate. The higher the rate is, the more honest borrowers will drop out of the pool of applicants, realizing that the credit is not worth the high repayments. By contrast, borrowers who have no intention of repaying will apply for credit and remain in the pool of applicants, no matter how high the rate. In short, the higher the rate is raised, the more the pool of applicants will be “adversely selected” to be primarily bad borrowers. But the higher the concentration of bad borrowers, the higher the interest rate a financier should charge to break even, in light of the higher expected rate of default. This is a vicious circle. The more he raises the rate, the more the financier needs to raise it, till the point at which all good customers are discouraged from borrowing. At that point, the financier certainly does not want to lend because he knows that the only customers willing to borrow are the ones who will not repay!

In short, there may be no interest rate that allows lending to be profitable, so the financier simply denies credit to applicants who do not have a solid credit history. In an underdeveloped system, this leaves a large fraction of the population without any access to credit.

Uncertainty and dishonesty are not the only problems a financier faces. Even an intrinsically honest borrower may take actions contrary to the financier’s interests—a phenomenon known as moral hazard—when the terms of repayment are poorly structured. For example, if repayments become too onerous, the borrower may see that the only way he can even hope to repay the loan is by taking on greater risk. Such “gambling for resurrection” may be against the financier’s interests because the projects the borrower takes on may be disasters most of the time. In a developed financial system, the financier has the information to know when the borrower’s financing terms start creating perverse incentives for the borrower. He has the skills to write the right kind of new contracts and can rely on an efficient legal system to help restructure the old contracts (a nontrivial task when a borrower has many financiers) and enforce the new ones. In a system in which the techniques of contract design, contract renegotiation, and contract enforcement are underdeveloped, it is hard to provide borrowers with the right incentives throughout the term of the project, so financiers are again reluctant to lend.

The Tyranny of Collateral

Because the financier risks losing his money to uncertainty, adverse selection, or moral hazard, he hesitates to lend when the financial infrastructure is not adequate to resolve these problems. But he can still protect himself by requiring collateral—valuable assets that the financier can keep in case the borrower defaults. This is the principle behind pawnbroking, which is prevalent even in the most underdeveloped economies.

Collateral reduces the problem of uncertainty, since the lender can recover some, or all, of his loan even if the venture fails. It also reduces information asymmetries—it is often easier to value physical assets than to value character. Moreover, the borrower will find it costly to put up valuable collateral if she intends to decamp with the proceeds of the loan, because she will lose the collateral. Thus, a collateral requirement can force rogues to self-select themselves out of the pool of applicants for loans, leaving only those bona fide applicants who fully intend to pay back the loan.

The potential loss of her collateral also makes the borrower think twice before adopting a riskier course of action. Collateral’s twin effects, of keeping rogues from applying for loans and reducing the borrowers’ incentive to take undue risks, make it a valuable device in encouraging lending. The potential financier sees lower risk in a collateralized loan, while the borrower benefits from the consequent lower interest rate the financier charges.⁴ In most underdeveloped economies, and in the ghettos of even the developed ones, collateralized borrowing may, in fact, be the only way to obtain finance from outside the circle of family and friends.

The romantics among us cannot, or do not want to, recognize the logic of this economic transaction. They castigate Shylock when he comes for his pound of flesh but do not see that this is the collateral that enabled the merchant of Venice to borrow. Furthermore, a dispassionate economic transaction is marred by the vile nature of (who else?) the financier and his hatred for the borrower. The logic, however, is impeccable. The borrower in need is prepared to sacrifice something valuable in order to obtain finance. In fact, were it not for the gruesome nature of the collateral and the prior strained relationship between the contracting parties, the collateral would be perfect. The lender has better use for money than for the pound of the borrower’s flesh and would not collect unless the borrower defaulted. The borrower values his flesh immensely and would not default lightly.⁵ We cannot merely look at the unfortunate eventuality when the financier comes to collect on the collateral to portray the transaction as inequitable.

Study after study has shown that the easier it is for a financier to seize collateral, the more lending takes place. The ease with which a creditor can collect on pledged collateral differs among countries. In England, for instance, it takes a lender on average a year and a sum of approximately 4.75 percent of the cost of the house to repossess a house from an insolvent borrower. Mortgage loans amount to 52 percent of gross domestic product (GDP) in England. In Italy, a country with roughly the same GDP per capita as England, it takes between three and five years at a cost of between 18 and 20 percent of the value of a house to foreclose on it. Mortgage loans amount to a far lower 5.5 percent of GDP.⁶

Politicians in the United States give us yet more evidence that the ability to pledge collateral is important. In an attempt to protect households from the consumer credit industry that “forced” them to take on too much debt, the Commission on the Bankruptcy Laws argued in 1973 that it would be beneficial for less-well-off households if they could retain some assets after filing for bankruptcy. The commission advocated that a substantial portion of household assets be exempted from seizure by creditors (these assets are called “bankruptcy exemptions”) so that poor households would have the wherewithal to make a fresh start.

Following these recommendations, a number of states adopted exemptions. Some of these were extremely generous. For instance, in Texas, a bankrupt can retain his house no matter how expensive it is, in addition to $30,000 of other property. A bankruptcy exemption is a form of insurance: it prevents the borrower from losing everything in case of a personal calamity. This can make borrowers more willing to tolerate high debt levels. But it also prevents the exempt assets from serving as collateral, making lenders less willing to offer loans.

Higher state bankruptcy exemptions led to a significantly higher probability that households would be turned down for credit or discouraged from borrowing.⁷ Poor households were disproportionately adversely affected. Since their house is often their only form of collateral, the exemption laws effectively deprived them of their only means of obtaining finance. They had much less access to borrowing in the high-exemption states, and paid higher interest rates, than in the low-exemption states. By contrast, rich households typically have enough unprotected assets to borrow. The diminished willingness of financiers to lend after the passage of the exemptions did not affect them much. In fact, their debt went up in high-exemption states: rich households became more willing to borrow because more of their assets could be protected from seizure. Thus, financial legislation that was intended to help the poor households ended up hurting them and benefiting the well-to-do. We will see example after example of this in the book—more perhaps than one could ascribe purely to legislative ignorance of economics.

The inequity in collateral requirements is therefore not that the lender will seize assets if the borrower defaults—the borrower can avoid this in the first place by refraining from borrowing. The problem is that only those with assets can borrow. In many ways, the world of underdeveloped finance is as in Matthew (25:29):

Unto everyone that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.

In such a world, wealth, not productive ideas, begets finance.

Some argue that matters are not so bleak for the poor. In an insightful recent book, The Mystery of Capital, Peruvian economist Hernando de Soto notes that the poor in much of the developing world have property that could be pledged as collateral if its legal status were not murky.⁸ For example, houses built in the Dharavi slum in Bombay are solidly constructed and sit on prime land. But since they are encroachments on government or private land, they have no legal status. Because their property cannot serve as collateral, de Soto argues, the poor have no access to finance. The solution to this problem, he suggests, is to offer the poor clear title to their land.

While there is substantial merit to his idea, it is no panacea. If the poor are squatting on someone else’s private property or, as is typically the case in the developing world, government land, legalizing encroachment could lead to a free-for-all to occupy the remaining land, leading to widespread insecurity of property, the opposite effect of that intended.

If, on the other hand, the poor have had a long history of occupying the land and have the sanction of the community in doing so (parenthetically, it is astonishing how easily age and custom sanctify the murky origins of property), the incentives created by legalizing may not be altogether perverse. But if it is the local community that enforces property rights, then it is unclear that a title from a remote government would be enough to make the property good collateral. It would take a really brave bank officer to attempt to repossess a house in the Dharavi slum against the wishes of the local mafia, and an even braver individual to move in, displacing the original occupant. In other words, some of the poor may have collateral, but unless there is a ready liquid market in it—and legalization is only one step in creating that market—it is unclear that they will still be able to borrow. A better approach to improving the access of the poor, especially those among them who have no assets, would be to develop the financial infrastructure more broadly. We return to this later in the book.

. . . and Connections

A financier in an underdeveloped financial system may be willing to lend even without collateral if he knows the borrower and has other levers of control over him. Repayment of amounts borrowed from within the circle of family, friends, and neighbors, for instance, can be enforced through the threat of social ostracism, as in the Grameen Bank example presented in the introduction (apart from maternal overconfidence in one’s progeny’s capabilities, this probably explains why the single largest source of external funding for start-up businesses is from family and friends).⁹ But the poor tend not to have rich friends or relatives. So, again, it is typically the rich who have the right connections to obtain financing.

The paucity of public, reliable, timely information about borrowers can only reinforce the narrowness of the group that has access to finance. When mechanisms for reliable transmission of information are not in place, a financier’s primary source of information is from personal relationships in the surrounding community or from business transactions. Since information about the creditworthiness of the borrower is key, friends, relatives, and business associates are the most likely recipients of his loans. In the absence of reliable real-time information, a financier will also rely more heavily on reputation. Established businesses, which have been around for a longer time, stand a better chance of having developed that reputation. Once again, financing tends to gravitate toward a small clique of incumbents and those closely tied to them.

As one example of the importance of connections, membership in social clubs seems to affect the lending policies of banks in Italy, a country where disclosure is still very deficient and there are few mechanisms for the reliable transmission of information.¹⁰ A bank is two and a half times more likely to extend a line of credit to a firm if its loan officer belongs to the same club as the owner of the firm than if he does not. It is also seven times more likely to be the firm’s main bank (that is, the bank with the largest share of loans to the firm). Not only does belonging to the same club enhance the likelihood that credit will be available, it also increases the magnitude of credit available. The loans made by banks to firms whose owner shares the same club are 20 percent larger than the loans made by banks whose officers are not as close socially.

Recently, this type of finance has been derided as crony capitalism, something peculiar to Eastern or Latin cultures that are overly tolerant of corruption, at least by Western standards. But historical studies indicate that lending to related parties reflects financial underdevelopment in an economy rather than some cultural propensity toward being devious. New England banks in the early nineteenth century lent a large proportion of their funds to members of their own boards of directors or to others with close personal connections to the board.¹¹ What prevented this practice from being overly oppressive was that free entry was allowed into banking. Nevertheless, because only the rich or reputable could set up banks, finance was effectively restricted to incumbents. “Insider-lending” practices were a solution to the primitive informational and contractual infrastructure at that time and did not persist once infrastructure developed.

Should We Be Concerned?

That finance ends up benefiting the rich is often attributed to active discrimination against the poor. We hope we have convinced the reader that when financial infrastructure is underdeveloped, financing is not easy. The financier will naturally gravitate toward financing the haves simply because they have the collateral or connections to assuage his concerns. Any rational lender would behave the same way. In fact, economists call such behavior rational discrimination, to differentiate it from the more traditional form of discrimination, which is based on individual distaste for specific groups.

Nevertheless, should we be concerned? We believe yes, both because the economy cannot produce as much as its potential and because what it does produce is not distributed fairly.

Clearly, the wealthy and the well connected are not the only ones with talents. If not all the talented can obtain the resources necessary to carry out their ideas, society is the poorer for it. Furthermore, without access to external finance, one avenue of opportunity—self-employment—is shut off. As a result, the poor are doubly damned, not only because they lose an option but also because their bargaining power when they work for those who have resources is weakened.

Equally invidious, as we will see, is that when the few control all resources, they find it easier to collude to make profits off the rest of the economy. For instance, if reliable information is not publicly available about borrowers, it is easier for bankers to get together in the proverbial smoke-filled room and agree to divide up the market. After all, in an environment in which information is inadequate, it is costly for an “outside” banker to compete a firm away from an established relationship with its traditional banker: since the “inside” banker knows much more about his client firms than outside bankers, the only firms that the outsider is likely to come away with are probably ones that the inside banker did not find profitable.¹² With limited outside competition, banks will find it easy to form cartels. It is no wonder that the Pujo Committee, created in 1911 by the United States Congress to investigate the prevailing practices in the financial sector, found that

the possibility of competition between these banking houses . . . is further removed from the understanding between them and others, that one will not seek, by offering better terms, to take away from another, a customer which it has theretofore served. . . . This is described as a principle of banking ethics.¹³

The Pujo Committee labeled the financial sector “the money trust,” reminiscent of the trusts or cartels in railroads, steel, and oil that were attracting opprobrium around that time.

When financiers collude, they see little reason to upset the status quo. This has other effects—for example, that they do not want to take on risk by encouraging innovation. Justice Louis Brandeis, appointed to the Supreme Court by President Wilson, wrote a searing indictment of finance in his book Other People’s Money. He decried the reluctance of banks to support innovation, listing a series of innovations during the nineteenth and early twentieth centuries that had changed the world. These ranged from the steamship to the telegraph. None, he claimed, was funded by banks.

In sum, finance in an underdeveloped system tends to be clubby, uncompetitive, and conservative, an apt description of finance in the United States in the beginning of the twentieth century. What effect did it have on individual choice and economic freedom? This is what we now turn to.

The Second Industrial Revolution and the Importance of Finance

Until around the middle of the nineteenth century, the U.S. (and world) economy had few firms with more than a hundred employees. Most were managed by their owners. The historian Eric Hobsbawm contrasted the 150 top families in Bordeaux (France) in 1848 with the 450 top families in the same region in 1960 and found that the largest group in the latter period, the salaried business executive, was completely absent in the earlier time.¹⁴

The reason for the emergence of salaried managers was that a new organizational form emerged in the latter half of the nineteenth century: large, vertically integrated firms that Harvard business historian Alfred Chandler calls the modern business enterprise. Many of these firms were founded in the late nineteenth century or the early twentieth century but dominated their respective economies until recently. Their durability is remarkable. Of those firms on the U.S. Fortune 500 in 1994, 247, or nearly half, were founded between 1880 and 1930. The early firms include Kodak, Johnson and Johnson, Coca-Cola, and Sears, founded in the 1880s, and General Electric, PepsiCo, and Goodyear, in the 1890s.¹⁵ Firms have been even more durable in Germany. Of the thirty largest German firms ranked by sales in 1994, 19 were founded between 1860 and 1930, and 4, even earlier. The 19 firms include household names like Daimler Benz, BMW, Hoechst, Bayer, and BASF.¹⁶

Why did these giants emerge? Chandler argues that advances in transportation (in particular, the advent of the railways) and in communications (the telegraph) made possible larger markets for goods. The large volumes of goods that were required allowed manufacturers to amortize setup costs and capital investment quickly. As a result, large, capital-intensive manufacturing units sprang up to exploit technologies that could realize lower per-unit costs than smaller outfits. For example, before the introduction of the Bessemer process, which makes steel from molten pig iron, there were hundreds of blast furnaces in the United States. None produced more than 1 or 2 percent of national output. With the diffusion of the Bessemer process, manufacturers were forced to increase scale. As a result, by 1880, the entire production of Bessemer steel came from just thirteen plants.¹⁷

The scale of transformation can be gauged by the fact that between 1869 and 1899, capital invested per worker in the United States nearly tripled in constant dollars. To measure productivity increases due to technological improvements, economists use a concept called total factor productivity growth. It is the component of growth in the value of goods and services produced by an economy that is left over after accounting for the increased use of capital and labor. Total annual factor productivity growth, which had held steady at about 0.3 percent in the United States throughout much of the nineteenth century, rose to 1.7 percent between 1889 and 1919. These unprecedented increases in industrial growth have led economists to call this period the second industrial revolution.¹⁸

According to Chandler, these firms had three distinctive characteristics.¹⁹ The first was, of course, the enormous investment in production facilities so as to exploit potential economies of scale and scope in production. But the inherent scale economies also gave the early entrants first-mover advantages: once they set up on a large enough scale and learned how to produce at low cost, it made little sense for other firms to enter. The initial entrants had already gone down the learning curve without the irritation of competition and were thus better prepared to compete. With the knowledge that the alternative to driving out new entrants was to be driven out themselves, the early entrants also had an incentive to compete fiercely to protect their investments. Moreover, as they became profitable, their earnings from operations could give them the resources to fight price wars. By contrast, new entrants not only had to make large initial investments but also had to suffer huge losses while going down the learning curve before they were in a position to compete effectively. Few potential entrants had the necessary internal financial resources or the confidence of financiers to support such entry. As a result, capital-intensive industries soon became oligopolistic, with a few firms dominating the market and very little entry occurring. It is no wonder these firms have proved so durable!

A classic example of such a firm was John D. Rockefeller’s Standard Oil trust, formed in 1882 out of a previously loose alliance of the major kerosene producers and refiners. The purpose of forming the trust was not primarily to establish a monopoly, though it later came to be seen as that. The alliance already held a monopoly and controlled over 90 percent of American refineries and pipelines.²⁰ Instead, it was a way of centralizing control through ownership so that economies of scale could be realized. Refineries were shut, others reorganized, and new ones opened so that all the oil could be forced to pass through a few large refineries. While the average refinery in 1880 had a daily capacity of 1,500 to 2,000 barrels of kerosene, Rockefeller plants had a capacity of 5,000 to 6,500 barrels of kerosene.²¹ And in 1886, the trust chose to build a plant in Lima, Ohio, that could process 36,000 barrels a day!²² So while the cost of production for plants of average size in 1885 was 1.5 cents per gallon, Standard Oil’s cost was only 0.45 cent per gallon.²³

The second characteristic Chandler ascribed to these titanic firms was that they integrated both forward and backward. They built a nationwide (or even international) sales and distribution network that could sell goods in the large new markets. The reason the firms had to create their own networks rather than rely on others to retail their products was simple. They were too big and the products too specialized for an independent distributor to handle. If the independent distributor specialized its sales force to handle a large manufacturer’s products well, it would soon find that it was overly dependent on the manufacturer and would face the inevitable erosion in margins as the manufacturer took advantage of this situation. On the other hand, if its sales force remained unspecialized so as to handle the products of all the existing manufacturers, no manufacturer would feel adequately served. Since market share was so important in keeping production costs low, few large manufacturers were willing to rely on the uncertain motives of an independent sales and distribution network, and many developed their own. For similar reasons, they also integrated backward to secure their supply networks.

Again, Standard Oil epitomizes these developments. It owned pipelines and railcars. It had tremendous power over the railroads because it was a large-volume user, so much so that it not only commanded low freight charges but also set the charges for smaller independent rivals. For example, in 1885, a Standard Oil employee struck a deal with a railroad such that the railroad charged Standard Oil 10 cents for each barrel of oil shipped while a pesky rival was charged 35 cents. In addition, Standard Oil was to be paid 25 cents for every barrel of oil the rival shipped! If the railroad did not comply, Standard Oil threatened to build a competing pipeline and drive it out of business.²⁴ Clearly, even if Standard Oil did not own its entire distribution network, its power was such that it effectively owned it.

As a result of these two investments, in manufacturing scale and in integration, each industry came to be dominated by a few vertically integrated giants, with few independent suppliers in intermediate markets. Interestingly, once the pattern of limited competition in intermediate markets was established, it probably became self-reinforcing. The vertically integrated firm had distinctive products and standards. Any supplier of intermediate products would have to produce a very specialized product with only one likely buyer—not a prospect that would elicit much interest from prospective suppliers! With fewer opportunities for niche players, it is not surprising that in the United States, the period of emergence of these large, integrated corporations in the last quarter of the nineteenth century coincided with the beginning of a century-long decline in the fraction of the self-employed as a proportion of the total population of nonagricultural workers. It is only in the 1970s that the steady decline has been reversed, not just in the United States but in other developed countries as well.²⁵

The third characteristic of the large firms that dominated industry toward the end of the nineteenth century was the emergence of a hierarchy of professional managers. This was a natural consequence of the first two characteristics. In earlier times when firms were small and capital investment minuscule, the owner and his kith and kin were enough to manage the firm. This was the natural order, even if there were others who could perhaps manage the firm more ably. Why entrust the management of the firm to a possibly untrustworthy outsider and risk the chance of his stealing the firm or its profits from you? Even if he did not literally make away with the firm, there was little to prevent him from learning the firm’s secrets and using his savings to set up as competition. After all, the capital investment required was insignificant. And if he was more able than the owners to start with, he could indeed prove fierce competition. Why tempt fate for the sake of a few dollars more?

While the owners of the small firms of the first industrial revolution chose not to rely on professional managers (as evidenced by the complete absence of the latter class in Hobsbawm’s picture of Bordeaux in 1848), the owners of the large firms of the second industrial revolution had no such alternative. It was impossible for these behemoths to be managed by a single family. Professional managers were needed to coordinate and control the vast operations of these firms. What kept them from setting up their own rival enterprises? Or even if they did not break away, what kept them loyal to their owners, steadily returning them a dividend year after year instead of feathering their own nest?²⁶

The greater ability of owners of the firms of the second industrial revolution to control their managers was precisely because these firms were capital-intensive and finance was underdeveloped. Managers, even very senior ones, could not contemplate life outside the firm. They could not set up as suppliers of intermediate goods (producing, for example, brake linings for an automobile assembly line), since the market for intermediate products was thin. A new entrant could hope to survive profitably in the long term only as a vertically integrated enterprise. But such an enterprise required vast amounts of financing and even then faced the uncertain prospect of a bloody, unprofitable battle against the incumbent. Financiers were not so foolhardy, even if the prospective entrant could furnish the collateral, or had the connections, to get a start! So the firms’ vertical integration, and their first-mover advantage, protected them against competition, not just from outsiders but also from their own management.

The modern business enterprise required very specific functional and product-related skills of its managers.²⁷ Given that there was little market for intermediate products, there was no need to standardize processes (to a common industry standard) within the firm at each stage. Each firm had its own idiosyncratic processes. There was far less benchmarking or adoption of industrywide “best practices.” In combination with the limited competition, the consequence was that jobs across integrated firms were not strictly comparable. And even if a manager saw a comparable position in a rival, he would find it difficult to move because of “gentlemen’s agreements” among players in the industry not to poach one another’s employees. Because the manager’s skills were highly specific, he had little hope of being employed in a commensurate position outside the industry. Managerial jobs were jobs for life. If a manager were to find his owner oppressive, or a poor paymaster, he had little redress.

Because work practices were specialized, the firm could also not easily hire trained managers from the outside. But by overstaffing the ranks, the firm could create internal competition for management that would keep wages in check.²⁸ With few outside options and some internal competition, the manager had no alternative but to be loyal.

Fear cannot, however, be the only source of motivation. Given the enormous concentration of power in the hands of the owners of the modern business enterprise, they had to find some way of providing positive reinforcement to managers who performed well. In large part, firms achieved this, perhaps unknowingly, by creating steep organizational hierarchies, in which the owner communicated with lower management only through intermediate managers in the hierarchy. This organizational pyramid was no doubt necessary—given natural limitations on a manager’s span of control—to coordinate the enormous organizations. But also intermediate positions in the hierarchy accumulated some power because they were the channels through which the owner communicated with, and controlled, the mass of lower-level employees. In other words, the steep hierarchy was a way for the owner to cede some power to intermediate management by giving it control over still lower-level employees. Higher levels in the hierarchy carried with them higher pay (and less overstaffing) and were a reward for employees who dedicated themselves to the firm.²⁹ No wonder these firms spawned strong cultures and the stereotypical organization man.

At the bottom of this organizational pyramid were the common workers. If unspecialized and unskilled, they were paid low wages. But since these workers were not particularly tied to the firm in any way, the firm had little power over them. If dissatisfied, these workers could pack up and leave, securing an equivalent job elsewhere. The truly disadvantaged were the skilled workers, who, because they were specialized to the processes of their firm, could not leave without abandoning a substantial portion of their human capital. The firm had power over these workers in the same way as it had power over the managers. But unlike managers, skilled workers did not occupy critical positions in the hierarchy and obtained little countervailing positional power inside the firm. It was the wages of the skilled workers and, to a lesser extent, management, but not the wages of the unskilled workers, that were repressed in these large organizations.

Interestingly, between 1890 and 1950, the period of the rise of Chandler’s large industrial enterprise, there was a tremendous compression of the wages of educated, white-collar workers relative to blue-collar workers.³⁰ The ratio of wages of clerical employees to those of production workers fell from approximately 1.7 to 1.1 between 1890 and 1950. Since, typically, the educated are also relatively more skilled, these facts are consistent with the consolidation of industry into large, monolithic organizations shackling the skilled and compressing the wage differential. Of course, other factors also partly account for this compression—as with all economic resources, ultimately demand and supply determine the relative prices of skilled labor. Our point is simply that organizational change may have had a profound additional influence.

All this is not to say that skilled workers were powerless. It has been shown that, on average, wages in democracies are higher, perhaps because workers in a democracy can form organizations such as unions or they can support worker parties that try to secure them rights outside the economic process.³¹ It is perhaps no coincidence that strong labor movements soon followed the emergence of the modern business enterprise. But political intervention in a fundamentally economic matter is no panacea, an issue we examine later. Moreover, worker rights secured through political intervention are, perforce, general in nature and not tailored to specific situations. They are often riddled with loopholes, so that they can easily be circumvented by astute owners, or too rigid, diminishing the viability of the firms being regulated. There had to be a better way to achieve a balance of power. That is what we examine in the next chapter.

Summary

Financiers are accused of being useless parasites yet feared because they have too much power. In this chapter, we have tried to explain that there is no contradiction in these beliefs. In the modern economy, access to finance is vital. When the financial system is underdeveloped, a small group of financiers can control whatever limited access there is to credit. Ironically, the less financiers do to broaden access, the greater is their individual power. They therefore do little more than guard the gates of the temple, keeping all but the wealthy and the well connected from obtaining access. They are indeed powerful, but the power they have is the power to deny, not create, and they “chill and check and destroy genuine economic freedom.” Many of the evils of capitalism—the tyranny of capital over labor, the excessive concentration of industry, the unequal distribution of income in favor of the owners of capital, the relative lack of opportunity for the poor—can be attributed, in some if not substantial measure, to the underdevelopment of finance.

That said, individual financiers in such a system are not particularly unpleasant people; they only do what comes naturally to them given the constraints the system imposes. Even the distasteful Shylock, in his pursuit of collateral, is only taking the contract to its natural end. Were the courts to place impediments in his way, credit would become even scarcer.

Given the right infrastructure, however, financiers can overcome the tyranny of collateral and connections and make credit available even to the poor. They become a power for the good rather than the guardians of the status quo. In the next chapter, we explain in greater detail how this is possible.

CHAPTER TWO

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Shylock Transformed

SOCIALISTS like Marx and Engels argued that the way to reduce the power of the owners of capital was for the state to hold power itself by expropriating all private property that was used as a means of production. But this solution only worsens the problem. In a socialist state, the power associated with ownership passes on to the state. While, in theory, the state could be benevolent and act in the best interests of the workers, in practice, the state acts in the best interests of those in power. And the power of a state bureaucrat over workers in a socialist state is considerably more than that of the greediest entrepreneur in a capitalist economy because the government in the socialist state also determines the level of competition it faces.

Competition, as all company owners know, is inconvenient because it disciplines their most rapacious tendencies. So radical socialist governments typically abolish both economic and political competition. As a result, while company owners in a capitalist economy cannot set wages completely arbitrarily, partly because they have to compete to some extent with other owners for workers and partly because they are restrained by the political process, the government in a socialist economy can pretty much decide what it wants to pay. While, theoretically, it could set wages (and other prices) in the most efficient fashion, in practice, it will set them so as to benefit favored groups. Moreover, the lack of restraints on the government implies that the favored groups (other than itself) can change arbitrarily over time with the government’s whims and fancies. No one will have the incentive to undertake long-term investment—whether in acquiring specialized skills or in building physical capital—when there is no clarity about what the rules of the game are. Thus, the societal pie shrinks, and more and more of what remains goes to the ruling clique because they have the arbitrary power to determine shares. The socialist economy eventually fails to increase the size of the societal pie or even to redistribute the shrunken remains equitably.

The socialists had the wrong answer to the right question. The right answer is not to concentrate economic power even more but to disperse it more widely. And one way to do this is to expand access to finance. In this chapter, we examine how a developed financial system overcomes the frictions to which we have alluded and improves access to finance.

Reducing the Risk Premium

One obstacle in the way of broadening access to finance is the degree to which risk is concentrated in an underdeveloped system. A developed system distributes risk widely and allocates it to those who can best hold it. We now describe some ways in which a developed system spreads risk and reduces the risk premium demanded by investors to part with their money.

During the 1950s, Nobel Prize–winning work by Harry Markowitz and James Tobin showed that the risk of an investment should be considered not in isolation but in the context of the overall portfolio of investments an individual or a firm makes. The price of gold, for instance, is very volatile. Thus, in isolation, gold is a very risky investment. If added to a stock portfolio, however, it can reduce the overall volatility of the portfolio because gold prices tend to rise during recessions, when stock prices generally fall (technically, the price of gold is negatively correlated with equity prices). A well-diversified investor can tolerate a risky investment that he would not be willing to hold if that were his only investment.

Portfolio investment and diversification were made possible by one of the more ingenious economic institutions created by mankind, the limited-liability joint stock company. Prior to the enactment of legislation in the mid–nineteenth century allowing free incorporation with limited liability, owners were jointly and severally liable for the debts of a company (except for the few rare cases in which owners had obtained special government assent to limitations on their liability). This meant that if an owner’s partners were paupers, the owner’s fortune bore the brunt of the repayment to debtors. Moreover, the owner had to know the management intimately before investing since his loss from trusting an unscrupulous operator was unlimited. Therefore, an investor could not own stocks in more than a few companies, else he would not be able to give each company the close attention it demanded.

Limited liability limits an individual investor’s responsibility to the amount of capital he invests. This enables him to diversify his risk across many investments, because his exposure to any single investment is limited. To the extent that he is well diversified, he is reliant on the average scruples of society, which are easily discernible, rather than on those of any individual management. Thus, the institution of limited liability draws in passive investors who expand the pool of capital willing to absorb risk, and it also allows investors to hold well-diversified portfolios, reducing the risk any one investor has to bear. The larger pool of capital willing to finance risk and the greater tolerance for risk means that larger, riskier projects can be financed and access to finance expands.

While diversification cannot eliminate all risk in a portfolio of stocks (for example, all stocks tank when a large economy like that of the United States enters a recession, so U.S. economic risk is hard to diversify away regardless of where the investor is located), it can substantially reduce it. The broader the spectrum of investors who can bear a risk, the more easily it is borne. For example, citizens of Vietnam are likely to have enormous exposure to that country’s economy—their jobs depend on the economy’s doing well, as does the value of their financial assets and real estate. By contrast, American investors typically have little exposure to Vietnamese risk. Any Vietnamese shares they hold constitute only a small portion of their overall portfolio of stocks. For the Vietnamese investor who has little access to international financial markets, a downturn in the local economy is a major disaster. For the American investor, it is a fleabite. If, therefore, the Vietnamese government allows American investors to buy shares, not only will the economy’s risks be placed on the broader shoulders of American investors, but also the return premium investors require of Vietnamese companies will fall. This will reduce the companies’ cost of financing, allowing them to undertake more investment.

There is evidence that firms’ cost of equity financing falls, and corporate investment increases, when a country opens up its markets to foreign investors.¹ This seems to occur, in part, because the incoming investors have a greater tolerance for domestic risk: stocks of firms exposed to risks that are hardest for domestic investors to diversify away but that are easy for foreign investors to bear have the highest run-up in price when a country opens up its stock market to foreign investors. The greater the amount foreigners are allowed to invest in such stock (even countries with open markets have rules preventing foreigners from investing in some firms or holding more than a certain fraction of a firm’s outstanding stock), the greater the run-up in price. Since an increase in stock price reflects a fall in the required return, the evidence suggests that open financial markets can reduce how much is demanded of business ventures by spreading the risk and placing it well. As a result, valuable but risky ventures get financed.

This is what Judy McCoy from The Bonfire of the Vanities does not appreciate: it is in large part because financial markets keep the cost of capital low that in the year 2000 alone, $26 billion was spent by the major drug manufacturers in the United States on the development of lifesaving drugs. Financiers do help build roads and hospitals, and even invent drugs, but in a way that is invisible to most people.

While stocks are crude instruments for allocating risk, financial derivatives can slice and dice risk precisely, placing it on those who can best bear it and making risky ventures even easier to finance.² Since the 1970s, major developments in financial economics have greatly expanded the potential uses of derivatives. The critical breakthrough was made in the early 1970s when three professors at M.I.T. came up with the eponymous Black Scholes Merton options-pricing formula. The formula helped put a precise price on these complex instruments. Equally important, theoretical studies also showed how banks could sell these instruments to their clients and then offset their risky positions by undertaking a set of trades in more liquid markets.

Consider an example of how useful derivatives can be in encouraging investment in stocks by those who are traditionally unwilling to invest. In 1993, the French government wanted to privatize Rhone-Poulenc, a chemical company.³ One of the stated objectives of the government was to enhance employee ownership of the company, in part to make privatization more politically palatable. In France, however, stock ownership was not very popular. Employees were reluctant to buy shares in their own company, even at a large discount, for fear of losing some of the money invested. Rhone-Poulenc did not want to provide a guarantee of a minimum share price to its own employees, and the French treasury did not want to offer it either, possibly for fear of the political backlash in the event of a significant drop in the stock price.

A U.S. bank, Bankers Trust, proposed the following deal, which met everyone’s requirements: if employees were to buy the stock, they would be guaranteed a minimum return of 25 percent over four and a half years plus two-thirds of the appreciation of the stock over its initial level. Bankers Trust agreed to be responsible for the risk that the stock price would fall—in which case, the stock would not provide the minimum return of 25 percent to investors, and Bankers Trust would have to make up the difference. In return for offering the guaranteed minimum return, Bankers Trust obtained the one-third of the stock price appreciation that employees were willing to forgo.

Bankers Trust did not bear any risk itself. Using a technique called dynamic hedging, it traded liquid Rhone-Poulenc shares and bonds in the financial markets to transform the one-third of share price appreciation it was to get into a guarantee for the employees plus a tidy profit margin for itself. The bank was able to honor the commitment to employees and, at the same time, protect itself fully. In the process, it allowed the government to meet its political objectives and employees to get a security that met their risk appetite.

More generally, through risk management using derivatives and dynamic hedges, financial firms like banks and investment banks reduce the risk of their financing activities to acceptable levels. This allows them to raise money from investors and fund firms with risky but worthwhile projects, thus expanding access and spreading wealth.

RISK MANAGEMENT is valuable but not easy. A tremendous amount of innovation goes on in the modern financial sector so as to allocate risk properly and expand access to finance. Take, for example, a bank financing a home in an earthquake-prone area in California. The banker has the house as collateral, but he will worry that an earthquake might destroy it. So he will demand that the owner of the house purchase earthquake insurance. A Californian insurance company, however, is not very well diversified against earthquake risk. An earthquake could trigger a spate of claims that could force the firm to default. This is, of course, a source of concern to policyholders. After all, who wants to buy insurance if the company will default when you file your claim?

Such large-scale risks are known in the industry as “catastrophic risks,” or cat risks. They can be substantial. Hurricane Andrew in 1992 resulted in a loss of nearly $20 billion for the U.S. insurance industry, while the Northridge earthquake in 1994 resulted in a loss of $13 billion.⁴ By some estimates, an earthquake along the New Madrid fault (running through the midwestern states of the United States) could result in a loss of over $100 billion. Such losses can bring many an insurance company to its knees. The insurance company will find cat insurance very valuable because it helps avoid such a meltdown while at the same time inspiring confidence in its customers and giving them access to home financing.

How can the insurance company insure itself? One way for the insurance company to lay off catastrophic risk is to buy insurance from reinsurers that are well diversified across geographic areas. Since catastrophes rarely occur simultaneously across the world, the hit sustained by the reinsurer when an earthquake hits California is small relative to the size of the premiums it collects from all over the world. So the individual buys insurance from an insurance company, which, in turn, buys insurance from a reinsurer, and so on . . . Ultimately, the risk of loss from a California earthquake is borne by investors in the reinsurance company that lies at the end of this chain. However, since the risk has been spread so widely, no individual investor has to be overly concerned about it.

Reinsurance can be very expensive if a few companies monopolize the business. Fortunately, there is an alternative: sharing the risk directly with individual investors. Recently, insurance companies have started issuing cat bonds. When such a bond is issued, the proceeds are invested in safe securities such as government bonds. In the event that a specific catastrophe hits (say, the California earthquake), the government bonds become the property of the insurance company, and it uses them to pay the claims filed by its policyholders. The cat bondholders get nothing. If, however, no catastrophe hits, the cat bondholders not only get paid the interest on the government bonds (and the principal on maturity) but also get an additional premium to compensate them for the risk they bear. Everyone wins through this innovative instrument. The homeowner gets the insurance he needs for the loan, the insurance company gets much-needed funds in the event of the earthquake, while bondholders get high interest rates at all other times. As long as the bondholder is not from California, and as long as she holds only a small fraction of her wealth in the bonds, she need not become too concerned about losing the entire value of the bonds in the remote eventuality that a sizable earthquake hits California.

Despite their seeming simplicity, it is not easy to create securities such as the cat bond. Myriad issues have to be settled before ordinary investors are willing to buy them. For example, how does one know when a catastrophe has occurred? Since so much money turns on this definition in a cat bond, it is important to be precise. One could base the definition on the total amount of damage caused, but how does one estimate this? Who will do the estimation? Even if an unbiased party can be trusted to collect damage reports and put them together, it may take weeks or even months for a precise estimate to come out. The insurance company needs the money long before then to pay claimants. The definition could be based on the total amount of damage done in a particular square mile. But that square mile may have escaped relatively undamaged . . . Any ambiguity in how the security will work is an additional source of risk, for which the investor will demand additional compensation. Therefore, before an innovative financial instrument such as a cat bond can be issued, all these questions have to be answered clearly so that the investor can price the security in full knowledge of what is her due. The investment bankers and lawyers who create such instruments do earn their pay!

Another interesting example of how financial innovation can improve our access to funds comes from a recently introduced security called viatical. The name viatical comes from the Latin viaticum, meaning a “purse given to a traveler in preparation for a journey.” Here is what it does. AIDS patients often have little money to pay for their expensive treatment. Even if they bought life insurance before contracting the disease, they cannot benefit from it personally. The idea behind the viatical is to allow infected people to trade what is sometimes their only valuable possession—their insurance policy—to help enhance the quality of their life before they die.

The viatical is essentially a claim on the life insurance that will be paid on the death of a person infected with AIDS. The security may seem macabre, and financiers may appear to be trafficking in death, but it fulfills a very real need: by securitizing the life insurance policy, the financial market transforms an illiquid asset into funds that the patient can use and enjoy in the last days of his life. Financial innovation again broadens access.

Of course, there is a fair amount of risk involved for the buyer of the viatical. The timing of the patient’s death is not certain, and the disease is recent enough that reliable statistics are not available. In addition, medical advances can prolong the life of patients to the detriment of investors in these securities. Given these risks for investors, it is best for a number of insurance policies to be packaged together and securities sold against the income they produce. Not only are the risks of investing more widely dispersed and thus better borne, it also makes the securities more palatable. Investors do not have to be on a deathwatch for a particular individual, with all the moral recrimination that that can bring.

This example is particularly useful in illustrating the ease with which finance can attract moral opprobrium. On the one hand, this security could be portrayed as yet another example of heartless financiers willing to profit from sick people. On the other hand, the security serves a very useful, even morally laudable, function: to provide dying AIDS patients (and more recently, other kinds of terminally ill patients) with the money that will ease their pain and suffering in their final days. Interestingly, it is the very existence of profit-minded investors (a.k.a. “greedy” speculators) who are willing to shut their minds to the implications of the security they are buying that makes this market possible. It is because pecunia non olet—money has no odor—that the AIDS patient can get succor. This apparent contradiction is not surprising to economists. As Adam Smith, the father of modern economics, wrote, it is not because of the benevolence of the baker that we eat fresh bread every morning but because of his desire to make money.

Reducing Information Problems

In addition to uncertainty or risk, we described two other obstacles that stand in the way of broadening access to finance: the limited information financiers or investors have about borrowers and their prospects and the possibility that borrowers may not act in the best interest of the financier. As financial infrastructure develops, financiers can overcome both obstacles. First, consider the problem of limited information.

In the small, self-contained communities of the past, the local banker generally obtained information about the creditworthiness of borrowers through the grapevine. Today, enormous corporations maintain data on the credit history of borrowers. For example, Dun and Bradstreet (D&B) collects information about a firm from millions of on-site and telephone contacts with business owners and managers as well as from government filings, the firm’s banking and trade partners, and public news sources. In the last three decades, the number of firms on which D&B has records has grown 6.3 percent per year, a rate over two and a half times the real growth of the economy!⁵

The wider availability of information has greatly expanded the availability of credit. It is fairly easy for credit histories to be verified anywhere in the United States, so potential borrowers are no longer tied to their local banker. Moreover, the availability of information about a borrower in real time through these credit agencies allows a lender to intervene quickly when he sees the borrower getting into difficulty. This helps limit the lender’s losses.

One indication that the extraordinary expansion of information availability has increased borrower choices and credit availability is that small firms in the United States have been able to borrow from increasingly distant lenders over time. While a small firm’s banker was, on average, no more than sixteen miles away in 1976, in 1992, she was sixty-eight miles away on average, more than four times farther away.⁶