THE SHRINKING FIRM

Increased competition, changes in technology, and widespread access to finance have reduced the advantages of the large, vertically integrated firm. We should therefore expect the largest firms to have shrunk. This is indeed the case. The share of the Fortune 500 firms (the largest firms in the United States) in total workers employed in manufacturing fell from 79 percent in 1975 to 58 percent in 1996. Their share in total manufacturing shipments fell from 83 percent to 75 percent.³⁶

The relatively slower decline in shipments relative to employment is probably because these firms outsourced more. In the 1990s, General Motors moved toward Toyota’s model of buying rather than making intermediate products. Even though it entered a variety of other businesses since the late 1980s, in 2001, General Motors had only 362,000 employees (compared to 750,000 in 1989), and it made 8.5 million cars (compared to 8 million in 1989).³⁷

Perhaps the largest decline in GM’s workforce came when it spun off its Delphi auto-parts unit in 1999. The unit had about 200,000 workers and had revenues of over $30 billion. Interestingly, the breakup was welcomed by the heads of both GM and Delphi. GM Chairman John Smith said on announcing the spin-off:

We have a rich and proud history of self-sufficiency in General Motors. This is a major step to limit that vertical integration. It is not an advantage today to be vertically integrated. We are going to be a much faster company and focus on our core business of building cars and trucks.

Delphi President J. T. Battenberg remarked that independence would enable the new Delphi to be nimbler and better able to attract business from rival automakers, which currently worried about its connection with GM. The company could also use its own stock to provide incentives to employees and help finance its global expansion, making Delphi “a very, very tough competitor.”³⁸

The trend toward smaller organizations is observable more widely. The fraction of employees who work in large establishments in the United States dropped significantly between 1967 and 1985.³⁹ The fraction of private-sector employees who work in establishments with over 1,000 employees declined by 13 percent from 1967 to 1973 and by a further 18 percent from 1974 to 1985. Similarly, the fraction employed in establishments with 250 to 999 employees also declined. Interestingly, this trend toward employment in small organizations is largely seen in goods-producing industries. In the service sector, by contrast, more than two-thirds of industries analyzed over this period showed an increase in employment by large establishments.

The shrinkage in average firm size does seem hard to reconcile with the news of the megamergers that are announced every day in the papers. And some studies do show that, by some measures, average firm size in the United States increased as a result of the mergers in the 1990s.⁴⁰ Nevertheless, the increase in size in the 1990s did not offset the steady decrease that had taken place from the mid-1970s. Much as we like to believe that ours is the age of the megacorporation, we are off by at least a few decades.

Let us now try to draw lessons from the breakup of the large, vertically integrated corporation about how the nature of the workplace might change in the future. To do that, it helps to have a framework to understand the past. Recent work on the economics of the firm provides just such a framework. This is what we turn to now.

Critical Resource Theory and the New Corporation

Academics often get fixated by a single question that, innocuous as it may seem, reflects the central puzzle in their area of study. To economists studying firms, the central question has been “Why is a firm owner’s employee different from her grocer?” Let us explain.⁴¹ The owner pays her employee to work for her. She also pays her grocer for the goods he provides. We believe, however, that she has more power of command over her employee than she has over her grocer. From where does this additional power arise, since it would seem that the only power she has is the power of money—the wage she pays the employee and the price she pays the grocer for goods?

The answer seems to lie in the nature of the relationship between the owner and the employee and the resources the former possesses. If the employee is a temporary worker who has been hired for the day, and if there are plenty of jobs around, then he is in much the same situation as the owner’s grocer. If the owner does not pay his wage or asks him to do more than strictly contracted for, the employee will not deliver his services, much as the grocer will refuse to serve the owner if the latter is overly demanding.

But if the employee has been working for the same firm owner for some time, he becomes specialized to the firm’s assets—the machines it uses, the patents it has, the databases and software on which its processes run, the bureaucratic routines it follows—as well as attached to the people who work for the firm and surround the employee. Thus, the owner has additional power because she controls access to critical resources on which the employee has come to rely and that make the employee more productive.⁴² When the owner fires the employee, she does more than separate the employee from his wages, she separates him from some of the human capital he has built. The grocer, however, has little human capital vested in a relationship with a customer (typically) and is less concerned about being “fired.”

Clearly, the power relationship is not all one-way. When the employee is fired, he leaves a hole in the firm’s processes that has to be filled. To the extent that a replacement may not have the same skills, or will take time to learn the ropes and build relationships with other employees, the employee has countervailing power. This then means that the distribution of power in the relationship between the employer and the employee turns on two questions: how easy is it for the employer to replace the specific employee, and how easy is it for the employee to replace his firm? The harder the employee is to replace and the easier it is for the employee to replicate his work situation, the more the distribution of power shifts to the employee.

This, then, is the simple framework we have implicitly been using thus far. Like all frameworks, it abstracts from the complexity in the real world, but in doing so, it allows us to focus on the underlying source of power in the large, vertically integrated corporation. Because the corporation was vertically integrated, its production processes could be structured and operated in a unique way. Most employees could be trained quickly to operate on only one portion of the production process. Because there was little standardization in production, the skills these employees acquired were not easily transferred to another corporation. So they had little bargaining power, especially because the firm ensured that they had internal competition for their positions. Some employees did indeed oversee far more of the firm’s operations. But again, their skills were not easily carried to competitors. Moreover, because few firms were not integrated, a new enterprise producing intermediate goods did not have a large market. Therefore, managers leaving an existing firm to start up a new venture in the same industry did not have obvious niches they could enter. Instead, if they were serious, they had to raise enough finance to build a fully integrated enterprise. Since these employees, sheltered within the corporation, had little wealth or reputation and few connections, financiers had little incentive to oblige.

In short, employees had few opportunities outside the firm. Because there was little product market competition, firms did not have to harness the innovative energies of their employees and could design workflow so that most jobs were routine: not only did employees have few outside opportunities, but they also were replaceable.

Thus, the critical resource in the large, vertically integrated firm was not the human capital of its employees but its alienable assets—its property, plant, equipment, brand names, and patents—which, having already been paid for, gave it an unassailable position in the market. Owners and top management could exercise power over the employee simply because the law gave them control over access to these assets, and they could separate the employee from them almost at will (perhaps explaining why labor laws were needed then to constrain them). And since ownership of inanimate assets was the primary source of power, there were few limits to the size of the vertically integrated corporation. Simply by owning his plants, Henry Ford could rule comfortably over a vast corporate hierarchy and have tremendous authority over workers he had never seen. He did not have to work to establish authority.

As finance has become more easily available, and as competition has reduced the necessary scale for entry, the “outside option” employees have has improved dramatically. They have a greater chance of starting out on their own by “replicating” the assets of their former employer. The breakup of the vertically integrated corporation has also led to more standardization and greater transportability of employee skills across firms. Increasing competition has meant that jobs can no longer be routine. Instead, the innovative energy of employees has to be harnessed in making the firm more creative and productive. Employees are no longer placeholders performing routine tasks but important assets who significantly enrich their workplace. Power is shifting to the employee.

One way the growing importance of employee skills manifests itself is in the increasing number of positions that are deemed to be of managerial level. In 1983, 10.6 percent of employed civilians in the United States were classified as managers. In 2000, 14.6 percent were classified as managers. By contrast, 16 percent of employed civilians were classified as “operators, fabricators, or laborers” in 1983, and such workers fell to 13.5 percent by 2000.⁴³ We are all becoming managers now!

These economywide statistics do not simply represent jobs moving from low-skill industries to high-skill industries. Even within industries—for example, in banking—the share of jobs going to college graduates has increased considerably in the last two decades. The share of work accounted for by tellers—the most routine position—in the banking industry has been steadily falling.⁴⁴

One possible explanation is simply the increased automation in banking (or, in the jargon, “skill-biased technological change”). But automation could equally well reduce the need for skills—exemplified by the cash register at McDonald’s, which has pictures of the various goods on offer, eliminating the need for the server to be able to read or add.

There is another explanation: bank strategy has had to change to deal with competition. To a large extent, the banks’ primary asset in the past used to be their ability to raise money from captive depositors at low cost and channel credit at a healthy margin to borrowers who, typically, had little choice. Outsiders could own this asset by virtue of their ownership of the bank’s charter. And top management’s control of this asset gave it authority over the bank’s employees. Take, for example, loan officers. While the credit-evaluation skills of the loan officer mattered, they were of secondary importance to the funds that the bank placed in her hands to lend. Without the funds, the officer had little value. And regulatory restrictions on competition meant there were not many banks competing in the same region to which the loan officer could transfer her skills if the bank let her go.

Deregulation allowed banks to open more branches and eliminated ceilings on interest rates. Technological change permitted depositors to interact with distant banks via ATMs or the phone. New institutions like credit-reporting agencies eliminated the bank’s monopoly of knowledge about the creditworthiness of its customers. Taken together, these changes have severely weakened the link between depositors or borrowers and the local bank. With competition, the bank’s owners’ critical asset, their monopoly over customers, has been devalued. Banks have had to scramble for ways of improving their profitability, and employees have become key.

On the retail side, this has meant automating routine work such as check deposits or account balance inquiries and guiding customers who want these services toward machines rather than people. But it also means paying closer attention to which customers are profitable and selling them a variety of high-margin services—such as home equity loans—in addition to the basic checking account for which they come to the bank. Since all banks offer similar products, the employee who is in direct contact with the customer is critical, for she has to evaluate the customer and make the appropriate sales, effectively customizing the bank’s services. The employees who do such cross-selling cannot be the tellers of old who barely had a high school education. Not only do these new employees have to have the educational level to understand a variety of products, but they also have to be able to fashion customized packages for their clients and have the deportment and savoir faire to market those packages in a pleasant way.⁴⁵ Customer relationship officers or account officers, as these positions are called, are management jobs (even though the officer may have no subordinates) and are typically occupied by college graduates. Thus, the routine aspects of a teller’s job have been given over largely to machines, while the nonroutine aspects have been augmented and an entirely new position created.

Similarly, on the wholesale side, rather than simply keeping her hand on the spigot controlling the flow of funds, the loan officer has to create new ideas for structured financing for her client firms to attract their attention in an increasingly competitive and crowded market. Innovative and customized deals are the source of profits now rather than the old plain-vanilla loan, which has become a commodity. In fact, machines again, in the form of credit-scoring models, have replaced a lot of routine lending.

In short, the human capital of bank employees, both in terms of their product or industry knowledge and in terms of their client relationships, has become an important source of value to the commercial bank. This has substantially raised the power of those who have not yet been replaced by automation. The frontline employee, who has the personal relationship with the client, has an important bargaining chip in her negotiations with the bank over pay. Banks that have attempted to force their officers to share their relationships with other parts of the bank so that more products can be “cross-sold” have often faced subtle sabotage or seen officers leave, taking their clients with them. The more savvy banks have first sat down with their officers to negotiate sharing of the client relationship and safeguards for the officers’ “property rights.”⁴⁶ These negotiations would never have been necessary in the past.

The deskilling or automation of some jobs and the upgrading of many others is reflected in the growing “returns to skills.” The wage differential between those with a university education and those with a high school education in the United States has increased steadily since the 1980s.⁴⁷ In trying to explain this pattern, some empiricists have departed from simple demand-supply rationales to argue, as we do, that the most likely explanation is that firms are becoming more dependent on human capital.⁴⁸

RESTRUCTURING THE RELATIONSHIP BETWEEN OWNERS AND WORKERS

Competition and access to finance have increased the worker’s importance and widened her options, thus changing the balance of power within firms. The single biggest challenge for the owners or top management today is to manage in an atmosphere of diminished authority. Authority has to be gained by persuading lower managers and workers that the workplace is an attractive one and one that they would hate to lose. To do this, top management has to ensure that work is enriching, that responsibilities are handed down, and that rich bonds develop among workers and between themselves and workers. The emphasis on a kinder, gentler firm in most recent management tomes is not without foundation.

In the vertically integrated firm of the past, steep, overstaffed hierarchies were necessary to control as well as provide incentives for subordinate managers. As firms have shrunk and as managers have more outside options, the steep hierarchies are no longer necessary. In fact, they may now be detrimental. Consider again the loan officer in today’s bank. Every loan officer across the country has access to the same databases containing hard information about clients, such as their profitability, their assets, and their payment history. The loan officer can get ahead only by going the extra step, meeting the client and gathering soft information that is unlikely to be captured on the databases—the strength of the client firm CEO’s handshake, the regard in which she is held by employees, the confidence she exudes . . . But ultimately, the loan officer has to get approval for the loan, which means sending a report up. In part, because soft information does not transmit well up steep corporate hierarchies (how do you report the strength of the CEO’s handshake?), some banks have eliminated entire layers of middle management even while delegating more authority to the front lines. Organizations have become flatter and more decentralized.⁴⁹

There is another reason for the flattening organization. As the centralized command-and-control system that resulted from the ownership of inanimate assets has been weakened, top management can no longer exercise control at a distance. It has to be in the thick of the action or see others take the power it once had.

Consider, for instance, Salomon Brothers’ bond-trading group in the late 1980s and early 1990s. It consisted of extremely talented traders and “rocket scientists” (Ph.D.’s who use mathematical models to uncover financial market anomalies from which the firm could profit) who made enormous sums of money for Salomon. But there was not much that Salomon gave them other than its capital and name. As we have argued above, capital became easily available elsewhere, so Salomon became less and less able to control the group and had to fork out enormous salaries and bonuses just to keep it happy.

In 1991, a misguided attempt to corner the Treasury bond auction by a member of the group led Salomon to lose an enormous amount of capital and besmirched its reputation. Even though John Meriwether, the head of the group, was fired, this had little long-run punitive effect. Over time, a number of talented traders, responsible for 87 percent of Salomon’s profits between 1990 and 1993, left to join him in a new venture, Long Term Capital Management.⁵⁰ Located in Greenwich, Connecticut, it became known as Salomon North for good reason. The bonds of human capital proved much stronger than the bonds of ownership, a fact that even Salomon’s then CEO did not realize.⁵¹

In truth, the bond-trading group had been a part of Salomon in name only. It merely rented space, Salomon’s name, and capital and turned over some share of its profits as rent. Its effective leader was not the top management of the investment bank but Meriwether, who was respected by the group, had become central to its working over time, and was thus crucial to its creation of value. Once his human capital was key to its smooth functioning, whether in making decisions about investments or in resolving interpersonal conflicts, he had power over the group.

Power therefore resides more and more in the charismatic and talented individuals who hold groups of human beings together rather than in the anonymous owners who may have no resource other than their capital or anonymous top managers who reside on the top floor and rarely mingle.⁵² CEOs who realize this understand that they have to become much more involved in activities like job design, the structuring of incentives, and the management of interpersonal relationships so that they knit their workers to the firm. All this requires an intimate knowledge of the situation at ground level: top managers have had to descend from heaven or risk becoming impotent.

Ownership of Knowledge Assets—Is It Déjà Vu All Over Again?

As finance has made many traditional inanimate corporate assets easily replicable, corporations have looked to create new assets that can be ring-fenced, which can then serve as a source of control. In particular, as knowledge, networks, and new ways of transacting with customers have become important, attempts are being made to create legal assets out of these.

Dell Computers has been enormously successful in recent years, not because its personal computers are so much better than those of other manufacturers (the personal computer is essentially a commodity) but because its build-to-order system has given it a much more efficient method of production. Dell now protects its method of doing business with a large number of patents.⁵³ The increasing willingness of courts to grant patents for broad ideas and business methods suggests that we will have a whole new conflict emerging in the future—that between the owners of intellectual property and labor.

Intellectual property like proprietary databases or software is often much harder to replicate than physical assets and, when protected by patents, cannot be replicated legally even by those who have access to finance. Similarly, the value of proprietary networks depends on the number of people linked to them (and offering services through them). When a network attracts enough use, it becomes virtually a monopoly since no other network has enough “liquidity” to compete. Microsoft Windows has become so popular as an operating system in part because so many other people use it and make content for it. What is to prevent these hard-to-replace assets from becoming the critical resource around which a new hierarchical corporation reemerges?

This is not an unthinkable proposition. There is a vital difference, though. In an era of incremental innovation, the plant and machinery of the vertically integrated corporation of yesteryear retained value for a long time, eroding only through normal depreciation. The power of owners therefore eroded slowly. Innovation, however, is needed to create intellectual property, and it can also destroy it quickly (how many of us remember Visicalc, the industry-standard spreadsheet in the 1980s?). If a network does not continue to meet its customers’ needs, it can lose liquidity, and its fall can be as precipitous as its rise. Unlike physical assets, these new age assets have to be continuously renewed by the creativity and toil of the firm’s employees. For one, this means that employees have to be provided with incentives to exert themselves. This naturally limits the power owners have. Second, as long as finance is available to fund innovation, there is always the possibility that an upstart can innovate enough to render completely redundant the knowledge or network assets of incumbent firms. Even in the rare eventuality that these forces are not sufficient, the reader should take comfort that developed societies have rarely respected property rights that hold them completely in thrall. But this is a subject to which we come back later in the book.

Summary

In The Coming of Post-Industrial Society, written in 1973, sociologist Daniel Bell offered a prescient look at the future of developed economies. He argued that the then incipient trend in developed economies of jobs moving from manufacturing to services would continue and that sectors like health care, education, and government, with skilled professional and technical workers, would displace sectors like manufacturing, with largely unskilled workers. All this has come to pass. In this chapter, we have described an analogous phenomenon occurring within traditional corporations, as they have struggled to adapt to greater competition, technological change, and the greater availability of finance. Human capital is replacing inanimate assets as the most important source of corporate capabilities and value. In both their organizational structure and their promotion and compensation policies, large firms are becoming more like professional partnerships.

The popular belief that large corporations are taking over the world is simply not true. While there has been a jump in mergers in recent years, in part because new geographic markets have opened up, the steady trend is toward smallness. Firms are becoming smaller because large corporations have become unwieldy and less easy to control, even while the greater availability of finance has destroyed one competitive advantage they had of being able to finance new investment through internally generated funds.

In fact, the internal capital market within large firms is seen as more of a liability than an asset. The funds large firms pour ineffectively into poorly performing units are now there for everyone to see. Competition, as well as internal pressure, has forced firms to outsource what they cannot do well. Not only has this created more opportunity for entrepreneurship in society, it has also made society more productive.

Firms are now less authoritarian places in which to work. Layers of middle management, whose only role was to supervise, have been removed. Even though politicians have castigated this kind of “downsizing” as firms’ putting profits over people, and even though some downsizing exercises have been carried out without much thought, the end result in our view has been to make the firms correspond better with economic realities. In these leaner firms, there are fewer redundant workers, and the ones that remain have more power and more responsibility. Corporate downsizing, in our view, is not a naked exercise of power by owners of corporations but, ultimately, a reflection of their loss of power and control.

Not only are workers treated much better by employers, but the competent skilled worker has far more options today. The other side of greater worker mobility is, of course, the loss of a guaranteed job for life that used to characterize private-sector employment in most developed countries a generation or two ago. Some, especially the unskilled or the incompetent, might be willing to give up the greater opportunity today for the greater security of yesterday. But for the majority, greater security came at the cost of a more authoritarian workplace and less freedom. The greater equality in wages across job categories was, in part, because the skilled had less bargaining power. As opportunities have grown again, the trend toward wage compression has reversed, and wages better reflect skills. It is a philosophical issue whether this is fair. But from an economic perspective, it is much better to allow wages to reflect the true value of resources so that the right allocation decisions can be made, and to provide social security through other means, than to try to do too much through wages.

Finally, when discussing pay, it is hard to ignore the enormous increase in pay for top executives of large corporations, which has been portrayed in the press as naked greed run amok. The high pay is often justified to shareholders as necessary for enhancing the incentives of the top managers to increase shareholder value. Yet there is precious little evidence that higher pay improves incentives to perform at senior levels.⁵⁴ Instead, the enormous wages seem to reflect the increased importance of human capital. Firms pay their managers more, not so much to provide incentives—though couching it in those terms keeps shareholders more docile—but because the labor market for top managers gives them no alternative. As management faces pressure from newly empowered shareholders to perform while at the same time coming to terms with the diminished authority it has within firms, it is all the more important to have the right managers in place. While we cannot say whether the spectacular levels of CEO pay in recent years are excessive or not (hindsight would certainly indicate that some managers were grossly overpaid), and while the occasional “pet” board still rewards its CEO for spectacular underperformance, the trend in higher pay for CEOs the world over cannot be dismissed as simply greed or the sudden discovery that incentives matter.

One statistic best sums up the changes that have taken place: in 1929, 70 percent of the income of the top 0.01 percent of income earners in the United States came from holdings of capital—income such as dividends, interest, and rents. The rich were truly the idle rich. In 1998, wages and entrepreneurial income made up 80 percent of the income of the top 0.01 percent of income earners in the United States, and only 20 percent came from capital.⁵⁵ Seen another way, in the 1890s the richest 10 percent of the population worked fewer hours than the poorest 10 percent.⁵⁶ Today, the reverse is true. The idle rich have become the working rich!

Instead of an aristocracy of the merely rich, we are moving to an aristocracy of the capable and the rich. The financial revolution is opening the gates of the aristocratic clubs to everyone. In this respect, the financial revolution is thoroughly liberal in spirit. Instead of capital, it puts the human being at the center of economic activity because, when capital is freely available, it is skills, ideas, hard work, and inescapably, luck that create wealth.

CHAPTER FOUR

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The Dark Side of Finance

THUS FAR WE HAVE chanted the virtues of free financial markets. Is there no downside to the development of financial markets? What about scandals like Enron, in which billions of dollars of financial contracts collapse in a worthless virtual heap? Can stock prices be reliable measures of value if the NASDAQ market in the United States first gains, then loses, over $3 trillion in value between 1998 and 2001? Is financial liberalization a good thing for a developing country if it results in a banking crisis that lops 30 percent off the country’s GDP and subjects the country to years of economic turmoil? In other words, should we not also pay heed to the dark side of finance? That is what we turn to in this chapter.

Let us first address the issue of financial scandals. Every so often, a financial institution collapses with a rapidity that leads the astonished public to ask, “Are the magnificent downtown headquarters of financial institutions simply fronts for houses of cards built by cardsharps?”

Even though the business of managing, and dealing with, money is likely to attract more than its fair share of rogues, financial markets know this and protect themselves by placing a greater emphasis on reputations and risk controls than other businesses. The proportion of the unscrupulous in the financial business is not very different from the norm. For every Enron, there is a “real” business like Global Crossing whose managers have managed to wipe out their own investors through actions that are, at best, of questionable legality.

Nevertheless, when in trouble, financial firms tend to collapse much more quickly than industrial firms. There is a reason for this. The modern financial firm can create or destroy value much more rapidly than industrial firms. Take, for example, derivatives. They are much like dynamite. Used properly, they can be extremely beneficial, as we have seen. In incompetent or unscrupulous hands, however, they can in a few moments blow a hole in balance sheets the size of which cannot be matched by even years of incompetent management at an industrial firm. When Barings, one of the most prestigious of English investment banks, went into receivership on February 27, 1995, it had outstanding futures positions of a notional amount of $27 billion, while its capital was only about $615 million.¹ A single trader, Nick Leeson, took the bank down. In the first two months of 1995, Leeson succeeded in accumulating a loss of $890 million, on top of the $270 million that he had lost (and hidden) the previous year. Such large bets would simply be impossible in an industrial firm—or even in an underdeveloped financial market.

Further compounding the problem is that financial markets are aware of the possibilities for misbehavior and take action to protect themselves. Debt markets are loath to lend very long term to financial firms because they know that a financial firm’s creditworthiness can change overnight.² They would prefer to lend very short term so that they can reassess the financial firm’s risk periodically. And if there is even a hint of trouble, the financial firm finds that its sources of financing evaporate overnight, which makes the firm’s collapse even more rapid. Salomon Brothers suffered a near-death experience after the government started investigating its attempt to manipulate the Treasury bond auction. The investment bank had to sell over $50 billion worth of assets within a month in 1991 to pay off creditors. If Salomon had indeed gone under, many would no doubt have wondered about the solidity of a business that evaporated at the hint of sleaze.

In short, the liquidity available in modern financial markets, and the leveraged positions possible with new instruments, does expand the scope for ruinous managerial misbehavior.³ But players in financial markets are aware of this and do put in place strong controls to limit such behavior. The rapid collapse of an Enron or a Barings after misbehavior comes to light is, in some ways, a reflection of the value financial markets place on probity and self-control rather than the opposite.

Of course, the collapse of firms like Enron suggests that some deficiencies need to be corrected, but it is not an indictment of the entire financial system. More worrisome are problems that envelop the entire system: for instance, when stock prices take off as if there were nothing anchoring them and then plummet as if there were no bottom; or when the entire banking system is enveloped in a lending frenzy so that anyone who walks in with a half-witted plan gets financing, only to be followed by a bust in which even the most creditworthy get the cold shoulder. The bust suggests that the boom was a search for a chimera. If the financial sector creates or exacerbates these fluctuations, it should be indicted on two counts: first, of misallocating resources and, second, of creating unnecessary risk for ordinary citizens. Can the financial sector get it spectacularly wrong? And does the chance of its being wrong fall as it gets more developed? That is what we ask in this chapter.

Deviations from Fundamental Value

To establish whether the financial sector gets it wrong, we need to know what getting it right means. A firm’s stock price should reflect today’s value of the stream of payments (dividends) the firm will pay into the future—what, in the jargon, is called the “fundamental value” of a stock. Unfortunately, we usually do not have a very precise estimate of the fundamental value because we do not know what the firm’s future earnings, and thus dividends, will be. Hence, in general, we find it very difficult to determine whether the stock market gets it right.

However, there are special instances when two different financial assets are claims on the same underlying stream of dividends. While these are somewhat unique situations, they do allow us to test the law of one price—that is, that two financial assets representing claims on identical underlying real assets should be priced the same.⁴ If the law does not hold, we have to question our faith in the market’s getting it right.

Consider this example. As a result of the 1907 alliance between Royal Dutch and Shell, the oil giant Royal Dutch/Shell has two types of shares that represent claims on the very same stream of cash flows, the earnings generated by Royal Dutch/Shell. As stated in the corporate charter, 60 percent of all dividends and future distributions will go to Royal Dutch shareholders, while 40 percent will go to Shell shareholders. If the companies have the same number of shareholders, 1 Royal Dutch share then has a claim on the same amount of dividends as 1.5 Shell shares (where 1.5 = 60/40). Thus, 1 Royal Dutch share should trade at the same price as 1.5 Shell shares. In practice, however, between 1980 and 1995, the relative prices of those two shares deviated from the theoretical parity by as much as 35 percent below and 10 percent above.⁵

An example of even greater seeming deviation from the law of one price occurred when Palm Computing, the manufacturer of the personal digital assistant Palm Pilot, was floated on the stock exchange. On March 2, 2000, 3Com sold 5 percent of its stake in Palm to the general public, retaining the remaining 95 percent.⁶ It also announced that it would eventually distribute its remaining shares of Palm to 3Com shareholders before the end of the year. Thus, 3Com shareholders would receive 1.5 shares of Palm for every share of 3Com that they owned. Even valuing all the remaining assets of 3Com at zero (implausible because 3Com held more than $10 per share in cash in addition to other profitable businesses), the price of 3Com should not have been less than 1.5 times the price of Palm. In fact, after the first day of trading, the market valued 1 share of 3Com at $63 less than 1.5 shares of Palm. In other words, the stock market was saying that the value of 3Com’s non-Palm business was a negative $22 billion—impossible given limited liability! A negative valuation persisted for more than two months.

Such evidence has started to undermine academics’ belief in the efficiency of markets. The belief was based on a simple, but strong, theoretical argument. If the mistakes made by the market are predictable, then one can easily profit from these mistakes by buying assets that are systematically undervalued and selling those that are overpriced. Furthermore, since transactions in financial markets can be easily scaled up, if these systematic mistakes persist, a trader can replicate this strategy manyfold and become extremely rich. “If you are so smart, why aren’t you rich?” is the daunting question that faces anyone who claims to have found evidence that the market is wrong in pricing some securities.⁷ As long as thousands of smart financial managers are looking for ways to improve the performance of the funds they manage, systematic mispricing as in the case of Shell or Palm should not last more than a split second, the time needed for someone to notice it and start trading on it. As such trades take place—a process called arbitrage—the price of the undervalued security is driven up and the price of the overvalued security is driven down. Thus, arbitrage eliminates the profit opportunity and reestablishes the equality in prices between the two securities.

The widespread belief in market efficiency did not rest on theoretical arguments alone. During the 1970s, an ample body of evidence emerged showing that there were few systematic patterns in stock prices that could be exploited, so much so that in 1978, a distinguished scholar stated, “There is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.”⁸

While much of the work showing that markets are efficient has since been criticized as being inconclusive, the theoretical argument about arbitrage still makes sense.⁹ How can we then explain anomalies like Royal Dutch/Shell and Palm?

One emerging answer is that the simple “riskless” arbitrage to which the theory refers cannot always be conducted in practice.¹⁰ Consider Royal Dutch/Shell. There is no risk of a trader’s losing money by buying the undervalued stock and selling the overvalued stock if she plans to hold the two stocks forever. However, if a trader has to close out her positions before eternity (sell what she owns and buy what she is short) or even has to be evaluated on the market value of her portfolio sometime in the not-too-distant future, then at that time, she faces the risk that the prices of Royal Dutch and Shell might have moved even further apart. Facing the risk of a loss at that time, arbitrageurs will be very cautious in taking large positions in the two stocks, even when there is considerable evidence of mispricing.

This is not just a theoretical concern. Long Term Capital Management (LTCM) was set up by John Meriwether precisely to undertake arbitrage trades. The firm looked for situations in which it believed the relative price of two financial securities had diverged from what fundamentals suggested it should be. It bought the theoretically underpriced security, sold the overpriced security, and held the position till prices converged, making a small margin on each such trade—according to one report, just 0.67 cents per dollar invested.¹¹ Of course, such small profits do not pay for all the financial skills that were brought to bear in that talented firm, so LTCM multiplied the size of the bets by taking on debt. With $30 of debt for every dollar of equity, profits per dollar of equity were now a much more respectable 20 cents a year. In fact, the actual amount of leverage was higher, so LTCM reported a return on equity of 47 percent in 1995, 45 percent in 1996, and 17 percent in 1997. These are very healthy returns considering that LTCM purported to take little risk in its trades—so healthy, in fact, that LTCM returned equity to a number of its investors in 1997, hoping to keep more of the profits for the inner circle of partners.

But the risk LTCM was taking was about to reveal itself. Many of LTCM’s trades in 1998 involved selling low-risk Treasury securities and buying high-risk bonds, on the notion that the market had become overly frightened of credit risk. Unfortunately, before the prices came together, they widened—especially after Russia defaulted in August 1998. Even the spread between Royal Dutch and Shell, a position LTCM was taking, widened at that time.

As a result, in the first nine months of 1998, LTCM lost almost 90 percent of its shrunken equity capital, losing 40 percent in August alone. As signs of trouble emerged, the financial markets squeezed the firm further, refusing it credit and making it costlier for it to unwind its positions. LTCM was rescued by a group of banks through the good offices of the Federal Reserve (literally; the New York Federal Reserve provided a conference room where financial institutions decided the terms of the rescue). The positions that LTCM was holding eventually converged and made money, but LTCM as an institution did not survive to see that happen.

The point is that even if there is a tiny amount of risk in an arbitrage trade, it can prove extremely costly for an institution undertaking it, unless it has an unlimited amount of equity to sustain the position. There are limits to arbitrage, so mispricing may not draw forth the quantum of trade needed to make it disappear, and prices may deviate from fundamentals.

With minor modifications, what we have laid out above can explain why the seemingly flagrant mispricing of Palm shares was not quickly rectified. Even though 3Com set a date when it would distribute the remaining shares of Palm to its shareholders (so that each holder of a 3Com share would get 1.5 shares of Palm on that date), and arbitrageurs knew that they could close their arbitrage at a profit on this date, prices did not converge because the arbitrage was not completely risk-free. Because 3Com made the distribution contingent on the Internal Revenue Service’s ruling that the distribution would not attract taxes, 3Com shareholders did not have a guarantee that they would have 1.5 shares of Palm on that date. Even the slightest chance of a negative ruling imposed a huge amount of risk on any potential arbitrageur, since the price of Palm shares oscillated widely. During the first day of trading, Palm, which was sold in the initial public offering at $38 per share, opened at $145 and went as high as $165, before closing at $95.¹² It was too dangerous to lean against the wind! On May 8, 2000, however, when the Internal Revenue Service announced a favorable tax treatment for the distribution and 3Com set a precise date for the distribution, smart money could close the gap without taking risks since the distribution would be made for sure.¹³ With smart investors willing to do the arbitrage, the arbitrage opportunity disappeared.¹⁴

The theoretical argument in favor of market efficiency, thus, is more fragile than it looks at first sight. If arbitrage cannot be easily implemented, prices can deviate from fundamentals without necessarily creating a risk-free opportunity to make money.¹⁵ But this suggests that stock price deviations from fundamental values can persist for long periods of time.

That prices can be away from fundamentals does not explain why they indeed are away from them. Why were some investors willing to pay such a large premium for owning Palm directly instead of buying it through 3Com? As suggested by two of our colleagues, “the answer must involve either irrationality, ignorance, institutional constraints, or insane preferences.”¹⁶ The more traditional economists who believed in market efficiency did not rule out the possibility that some investors might be irrational, but they thought that rational arbitrageurs would prevent such investors from affecting prices.¹⁷ This can no longer be taken for granted.

The possibility that there may be little check on prices’ straying away from fundamentals if enough “naive” investors push prices away strikes at the foundation of the belief that markets are efficient all the time. This is not to suggest that prices will stay forever away from fundamentals. But the mechanism by which convergence takes place will be different. Instead of nipping discrepancies in the bud by arbitraging away mispricing, the smart money may feed the appetites of the naive investors until they can absorb no more, at which point it becomes easier to nudge prices back to fundamentals. But this can imply a long period over which market prices, at least for some sectors, may depart from fundamentals. It can also imply substantial value destruction as resources follow the prices. Consider what many are now terming the Internet “bubble.”

The Internet Bubble

Toward the end of the twentieth century, convinced by the seemingly limitless opportunities opened up by the Internet, millions of individual investors poured their money into Internet and telecommunication stocks. The effect was a sharp surge in prices. Between the end of 1998 and February 2000, the price of Internet stocks rose to over five times their initial value.¹⁸ The crash was equally precipitous. In early 2002, many shares, if they traded at all, were only a percent or two of what they were valued at their peak. To many, this episode was reminiscent of the “Tulip mania” that gripped Holland in the seventeenth century.

In these episodes, the dynamics go roughly as follows. The initial success of a new investment (opportunity or instrument) attracts the attention of unsophisticated investors. Since these investments are new, unsophisticated investors find it difficult to get any guidance on what constitutes a reasonable price. There is always a plausible story that can be concocted to justify the price that is demanded. Hence, they keep buying these instruments, even when hindsight establishes that prices far exceeded any measure of their intrinsic value. Some sophisticated investors may well become aware that prices are out of kilter with fundamentals, but they fear leaning against the wind, because they know that a rapid influx of more unsophisticated investors can drive prices even higher.

In fact, in the initial phases of a bubble, there may be few enough examples of the investment that is sought after (say, Internet stock) that there is not enough to meet the growing demand from investors who hear from their friends, and from financial analysts, how wonderful their own initial returns have been.¹⁹ Thus, already inflated prices might continue rising, reinforcing the interest of investors. But while smart money might not want to stand in the way of the rampaging herd, it certainly soon attempts to profit by it by creating more of the overpriced instrument that is so sought after and selling it to the ever-eager investor. For example, between June 1998 and August 1999, 147 firms changed their name to give the appearance that their business was related to the Internet.²⁰

Perhaps taking the cake for audacity was Zapata, a meat-casing and fish-oil company founded in 1953 by former president George H. W. Bush. On April 27, 1998, Zapata annouced that it would form a new company to acquire and consolidate (not to create) Internet and E-commerce businesses. A few weeks later, it bid for Excite, the second-largest Internet search directory, but the bid was rejected because Excite saw a “complete lack of synergies.” During the early fall of the same year, as the market for Internet stocks deteriorated, Zapata announced it was reevaluating its Internet business strategy. By December 1998, however, Internet stocks were back in favor, and Zapata promptly announced it was getting back to the Internet business, forming the subsidiary Zap.com. On this news, its stock price surged 98 percent! Hope springs eternal in the human breast!

Eventually, of course, the naive public money feeding the bubble starts drying up, and smart money switches from feeding the public what it wants to betting against what it has bought so as to bring prices in line with reality. The bubble bursts, and many investors are left sadder, poorer, and no doubt wiser. For the silver lining is that the implosion of the bubble teaches investors a useful lesson. They learn to evaluate the new investments and understand much better what they are buying. The consequences of the boom and bust eventually disappear. Until, of course, the next generation of investors gets taken in by the next new new thing . . .

Does Financial Development Do Away with Bubbles?

Is mispricing or a bubble a disease of underdeveloped financial markets that is likely to disappear as the financial sector becomes more sophisticated? Clearly, even if there is such a level of sophistication, we are not there yet since investors in the most financially sophisticated market in the world seem to have been infected only recently.

There is reason, however, to believe that something very similar to the Internet boom will not repeat itself quickly. Bubbles are often pumped up by a whole new set of investors who do not have the experience or knowledge to invest carefully. The stock market boom in the 1920s in the United States was fueled in part by individual investors who had no prior experience of stock investing but became comfortable (perhaps overly so) with risk because of their successful investment in Liberty bonds during World War I. Similarly, a significant portion of the trading in Internet stocks was done by the so-called day traders, a whole new set of investors drawn to the markets by the ease of trading on the Internet. As these investors become more acquainted with the many facets of risk, and as the markets transfer money away from the most naive, these phenomena tend to subside.

Nevertheless, there is no guarantee that even in a developed financial market the next new sector with limitless possibilities will not attract its own set of gullible investors. So whether developed markets can resist these booms and busts depends on whether they have enough investors willing to lean against the wind. And here it is not at all clear that a developed market does a better job than an underdeveloped market.

On the positive side, in a developed market, an arbitrageur has many more ways of using his money to correct prices. For example, if an entire market seems overvalued, he can buy puts on the market index (an option to sell at a predetermined price if the price of the index falls) at a fraction of the cost it would take to trade the underlying stocks. Derivatives such as puts allow arbitrageurs to assume very large positions with only limited capital. There is some evidence that the introduction of these derivatives calms down prices. In January 1990, Japanese stock prices started to come off their unrealistic peak when put options on the Nikkei index were introduced.²¹

While new instruments allow arbitrageurs to be a greater force for eradicating mispricing in developed markets (provided naive investors do not use these very instruments to multiply their bets), there is a countervailing force that could reduce the capital employed in arbitrage: the predominance of institutional investors in developed markets.

We have seen that institutions have a cost advantage over individuals in managing a portfolio of investments, so as a financial market develops, individuals buy shares in a mutual fund, delegating the task of picking stocks to a professional manager. Delegation, however, creates a new problem: how does one measure performance? The true measure of performance is the additional return produced over a perfectly safe investment like Treasury bills, per unit of risk taken. In many situations, either return (in the case of investments that are infrequently traded) or risk, or sometimes both, are hard to measure. Moreover, it is unclear over what interval investors should evaluate managers.

What usually happens then is that the financial manager’s performance is measured in terms of “excess returns”—the returns he produces over and above an appropriate benchmark portfolio with a similar level of risk. Since performance measures are updated frequently, investors can decide what interval they want to use to judge their managers. The combination of these two factors, however, distorts the managers’ behavior. Knowing that they are evaluated frequently against a benchmark, financial managers are wary of leaning against the wind.

Jeffrey Vinik, the manager of the legendary Fidelity Magellan fund, is often cited as a cautionary example of the consequences of bucking the trend. In the March 31, 1996, report of the fund, he wrote, “I believe it is critical not to be part of the herd when investing in financial markets. Just because investors are moving in a particular direction doesn’t make it the best direction; in fact, often it means the opposite.”²² This was written to justify the Magellan fund’s reducing its holding of technology stock from nearly 40 percent to less than 4 percent and, correspondingly, increasing its investments in bonds and short-term instruments. Unfortunately, following the shift, the Magellan fund underperformed all its competitors. Vinik was probably too far ahead of the herd: his decision was right in 2000 but not in 1996. Needless to say, he and the Magellan fund parted company.

Fund managers who are evaluated against a common benchmark like the S&P 500 index have an incentive to buy the stocks included in the index as a form of insurance, since only severe underperformance triggers dismissal.²³ Even if they suspect the stocks are overvalued, they know they will be excused if they perform very poorly when their benchmark also performs poorly. Hence, they have an incentive to follow the herd, even when they know the right strategy would be to buck the trend. Thus, delegation could reduce the amount of capital that is willing to lean against the wind. Since there is more delegation in developed financial systems, it is possible that developed financial markets might be more, rather than less, prone to mispricing.

The Effects of Mispricing on Investments

Since financial development may not rid us of booms and busts, we should evaluate their real cost. Bubbles clearly have redistributive effects: wealth is transferred from the buyers of overpriced securities to their sellers. If the buyers typically are less than financially sophisticated middle-class individuals and the sellers are rich speculators, this might create some serious political problems in itself. But even if we are willing to ignore this redistribution (and it is not clear we should), there is another important concern: bubbles may affect the real allocation of resources if mispricing affects firms’ real investment decisions (their investment in plant, machinery, and knowledge creation, for example). What is the evidence on this?

The current consensus seems to be that investments do respond to stock prices after we account for fundamentals, but their additional explanatory power is limited.²⁴ Mispricing, thus, can have some effect on investments but not a lot. The ambiguous nature of this evidence is also confirmed by a detailed analysis of significant past stock booms and busts—the leading situations for mispricing: the 1929 boom, the 1987 stock market crash, and the recent Internet episode.

In the second half of the 1920s, stock prices boomed. Between 1925 and 1929, they rose on average 22 percent per year. This did not trigger a corresponding boom in investments. Only in 1929 did real investments surge, growing by 34 percent over the previous year.²⁵ Following the crash, investment plummeted, but much more than predicted by the drop in stock prices.²⁶ While the boom-time stock prices did not seem to trigger excessive investment, the crash seemed to lead to an excessive curtailment of investment. So the evidence is quite unclear on whether mispricing had an impact on investments.

Around the 1987 stock market crash, it is clear that stock returns had no impact on investments. The rapid surge in prices during 1986 and 1987 (on average, a growth rate of 24 percent per year) was not accompanied by a corresponding surge in investments, which remained rather flat (a growth rate of –0.1 percent). By contrast, investments rose in 1988, despite the 8 percent decline in stock prices. The absence of an impact of stock prices on investment around the 1987 crash is also confirmed by a study commissioned by the Conference Board in January 1988. The survey asked top executives whether the stock market crash had affected their investment plans. More than two-thirds answered no.²⁷ In this case, we can conclude that mispricing had no real effects.

The evidence emerging from the latest episode is less reassuring. Between 1996 and 1999, the S&P 500 index had an average return of 27 percent.²⁸ During this period, total nonresidential investments grew on average at 9 percent per year.²⁹ This growth rate reached 10 percent in 2000, perhaps driven by the sustained rise in market prices during the first quarter of the year. In 2001, however, following the stock market decline, total investments dropped by 2 percent. In this instance, thus, the extreme movements in stock prices seem to have had an impact on real investments. The stock market euphoria seemed to have infected corporate managers, especially in the telecommunication sector. The astronomical prices paid for the so-called 3G mobile phone licenses (a technology not fully tested yet) is an illustrative example. The high price at which existing licenses were trading on the market clearly affected participants’ bidding strategies. Now, many of these companies, such as Sonera, the Finnish telecom operator, are giving up for free licenses for which they paid billions only a few months before.³⁰

Fortunately, the money paid in those auctions did not get wasted, at least no more than all the money we pay in taxes, because it went to fill the coffers of various national governments that were running the auctions. We cannot be so sanguine about the real investments that took place during the same time period. While it is too early to make a systematic assessment, the initial reports are alarming. According to one estimate, there is such overcapacity in “bandwidth” that if all the 6 billion people in the world talked continously for a year, their words could be transmitted in a few hours.³¹ No doubt, we will find new kinds of information to send along these wires, and eventually much of this investment will be utilized. But at present, it seems that these investments were too much and too early from the perspective of the shareholders of these firms.

Between 1996 and 2001, telecommunication companies raised $1.8 trillion in the capital markets.³² This represents a lower bound of the amount invested in the sector, since it does not include all the internal cash flow that large operators invested in the business. The market value of the telecommunication companies that did not go bankrupt dropped by an average of 60 percent. The recovery rate for the assets of the companies that did go bankrupt is about 10 percent. It is not unreasonable, thus, to estimate that at least a quarter of the money invested has been wasted. By this measure, the telecommunication boom and bust may have cost nearly half a trillion dollars! The conclusion is inescapable: resources can be grossly misallocated even in countries with developed financial markets.

The Risks in Development

Thus far, we have examined only the desirability of having a developed financial sector. We have not asked if, once a country decides to go for development, the process will be a smooth one. This is not a trivial issue. Many countries have underdeveloped financial sectors that have been severely constrained by limitations on competition: interest rates have been fixed, entry into the financial sector has been restricted, and foreign competition has been disallowed. The sudden liberalization of the financial sector can have much the same effect as forcing a sedentary man who has never exercised in his life to go on an exhausting regimen. The man will either drop dead or emerge invigorated and with a greater zest for life.

In other words, the transition to a competitive free market system is risky. Even if a liberal, market-oriented economy is more productive and fair—and we have just questioned this premise—we also have to ask if the costs for an economy that has spent decades protected from competition to transition to a functioning market economy are worth it. Subjecting these economies at short order to the full gale-force winds of international competition is, according to some, a recipe for disaster.

These cautious reformers may have the weight of evidence on their side. According to a recent study, in eighteen of twenty-six banking crises in the last two decades, the financial sector was liberalized in the preceding five years.³³ In other words, there seems to be a positive correlation between liberalization—government actions such as the freeing of interest rates, the opening of the economy, the deregulation of entry—and financial crisis. One should not immediately conclude that correlation means causation. Often, economies liberalize when they are in a dire way and have no alternative: India’s liberalization took off in 1991 when it was a few weeks away from running out of foreign currency reserves.

But there is probably a more direct connection. When an economy liberalizes, new competition squeezes profits. New skills are needed to lend in a world where business acumen rather than collateral or connections matter. Moreover, new infrastructure—better accounting, more information gathering and reporting, better contract writing, and better debt-collection mechanisms—is needed. When new skills are acquired and the new infrastructure is created, lenders will be able to make better loans than they did in the past. But in the transition phase from the old uncompetitive system to the new one, lenders may have to make decisions without the benefit of the necessary skills or infrastructure. And they do not have the profits to cushion their mistakes or keep their incentives from going awry. No wonder that when an economy liberalizes, so many bankers act like deer frozen in headlights and end up as roadkill.

Summary

In this chapter, we have raised some natural questions about financial development. For every fan who extols the invigorating virtues of competitive financial markets, there are critics who do not believe that these markets can be used as a reliable guide for investment and who point to the resources wasted in mistaken periods of euphoria. Yet others see a competitive, developed financial sector as a desirable end but point to the pitfalls in treating a moribund system with shock therapy. The patient may not survive the cure.

At this point, the reader might recollect the old saw that policy makers would like economists to be one-handed because economists always list on the one hand a series of arguments in favor of a proposition but on the other hand an equally compelling series of arguments against it. We seem to have spoken on both sides of the case for financial development. On the one hand, a free financial sector can play an important role in allocating resources and managing risk, both of which can be immensely valuable for many sectors of the economy. On the other hand, the financial sector can itself be a source of risk, so that it will occasionally waste resources in a spectacular way. With free financial markets having the power to do great good and great evil, should the world really want more financial liberalization?

Fortunately, there is a way out that does not require us to lose a limb each: we can turn to the empirical evidence to see whether the benefits, on average, to a country from financial development outweigh the costs. While anecdotes are useful to illustrate points, they can be carefully selected to support a preexisting bias. To really pass judgment about whether free finance is, on balance, a good thing, we have to move from an analysis of particular episodes and cases to systematic studies of countries over time. Paraphrasing Winston Churchill, is a developed financial sector with competitive, vibrant, arm’s-length financial markets the worst of all financial systems except those that have been tried? This is the question we address in the next chapter.

CHAPTER FIVE

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The Bottom Line on Financial Development

NO ONE WOULD question that resources are necessary for human endeavor, and few would dispute the fact that risk is costly. But the financial markets are only one way to marry resources with ideas while spreading the associated risk. There are others. For example, existing firms could use their internally generated cash flows, or their wealth, to buy ideas from innovators. Alternatively, they could employ the innovators directly. They could thereby do away with some of the functions of a financial system. How can we tell whether financial development is good on net, promoting the matching between resources and ideas, spreading risk, and reducing the cost of funds? The question is especially pertinent given that financial markets can misallocate resources and financial development can increase risks.

We cannot simply look at a country’s level of prosperity. Countries can be prosperous because they are rich in natural resources or because of the fortuitous circumstances of history. Two hundred years ago, the inhabitants of Haiti and Barbados were richer than those of the United States, and until the early eighteenth century, North America was not more developed than South America.¹ In the long run, however, initial conditions tend to be swamped by the effects of growth. So we should have greater confidence in the ability of finance to ameliorate the human condition if we can show that the development of a country’s financial sector increases the rate of growth of its economy.

Equally important is finance’s ability to create competition for the establishment. Competition is always good for citizens in an economy. But to the extent that this happens because newcomers are financed, finance also spreads opportunity and infuses fresh ideas. Further, it promotes economic mobility, much as a democracy promotes political and social mobility.

Of course, it is easy to find anecdotes “proving” something as well as anecdotes supporting its opposite. To attempt to settle the questions we have raised about the consequences of financial development, in this chapter we examine evidence from systematic studies conducted across or within countries. We begin with the link between finance and economic growth.

Finance and Growth

There is strong evidence that a developed financial sector and a strong economy go together.² But this is not enough to conclude that financial development contributes to making the economy strong. Economists care deeply about the difference between a simple correlation (two events happen together) and causality (one event causes the other). The reason is that it can make a world of difference to economic policy.

An example should make this clear. Birds fly away from a railway track as a train approaches. The birds flying and the train approaching are correlated events, but the former does not cause the latter. If we did not determine the direction of causality, our observation of a correlation would suggest strange policies. In order to speed up the arrival of a tardy train, irate passengers should resort to scaring away the birds sitting on the tracks! Correlation is the basis for superstition, while causality is the basis for science.

In the past, many economists, while convinced that a sound financial sector goes hand in hand with a healthy economy, were downright skeptical that it was a prerequisite for economic development. They believed that the time and investment required to build a well-functioning financial sector were relatively minor. So if there were an economic need for financial markets and institutions, then these would emerge to fulfill the need. They felt that even if the financial sector were underdeveloped when the economic need arose, this would not impede economic growth.³ To convince these skeptics that finance was independently important, one had to show that it caused economic growth.

In the natural sciences, causality is investigated with controlled experiments. In economics, this is generally not possible. Instead, one has to try to identify situations that simulate a controlled experiment.

One way to make a beginning at a causal link is to show that financial development precedes, rather than follows, economic growth. And it does. In a sample of eighty countries over the period 1960–1989, different measures of beginning-of-period financial development are associated with higher subsequent rates of growth in the country’s gross domestic product, its capital stock, and its productivity over the subsequent decade.⁴ Countries where much of the credit is allocated by the central bank rather than by commercial banks are typically considered to have underdeveloped financial systems. If, in 1970, Zaire had had a share of domestic credit allocated by commercial banks equal to the average for developing countries (about 57 percent) instead of a mere 26 percent, it would have grown about 0.9 percent faster each year in the 1970s, and by 1980, per capita GDP would have been 9 percent above its actual level.⁵

This is a first step, but not enough to show causality. After all, the birds departed the tracks before the train without causing its arrival. Do the financial markets simply sense impending economic growth and swell in anticipation? We need more evidence to rule this possibility out.

There are two kinds of evidence that might be convincing. To consider the first kind, let us go back to the analogy. If we wanted to argue that the approaching train caused the birds to fly away rather than vice versa, our position would be strengthened if we could find evidence of the mechanism by which this happened. Specifically, suppose we conjectured that vibrations through the rail track alerted the birds. And further suppose that we had two kinds of rail tracks, one that did not vibrate at all and one that vibrated. We also had two kinds of birds, ones that sensed vibrations and ones that did not. If we found that the sensitive birds flew away much earlier than the insensitive birds when both were on the vibrating tracks than when both were on the nonvibrating tracks, we would be much more convinced that vibrations, and thus the approach of the train, caused the birds to fly rather than vice versa.

Applied to our context, this idea suggests that if financial development really causes growth, it should have a very different effect on the growth of firms in some industries relative to firms in others. To see why, start with the fact that in almost every country, a significant portion of a firm’s investment is financed through cash it generates from operations. This is why, for example, high-growth firms do not pay dividends—they plow whatever cash they generate back into the business. Firms prefer to first use their own cash flow, also termed internal finance, for making investments because they feel they have to pay a substantial premium for money raised from outside (termed external finance). As we argued earlier, outsiders demand this premium because they do not know as much as the firm’s managers about the firm and its prospects and do not fully trust the managers to act in the interest of outside investors.

The process of financial development reduces the cost of external finance by improving disclosure and information dissemination and aligning the incentives of a firm’s management with the interests of investors through clever contracts and speedy enforcement. Therefore, the industries that should benefit most from financial development should be those that, in the normal course, need a lot of external finance. For example, a typical project in the therapeutic drug industry requires a long period of research and development, and substantial investment, before a commercially viable drug emerges. During the process of research, the project is an enormous cash sink, and even the largest drug firm will require external financing. By contrast, the amount of necessary investment, as well as the lag between investment and the generation of cash flows, is likely to be small for a firm in an industry like tobacco. Since they need little long-term outside funding, tobacco firms are less likely to benefit from financial development than drug firms. Therefore, if financial development really causes growth, drug firms (the sensitive birds) should grow relatively faster than tobacco firms (the insensitive birds) in countries with better financial markets (the vibrating track).

They do.⁶ Consider, for instance, Malaysia, Korea, and Chile, which were all moderate-income, fast-growing countries in the 1980s but differed considerably in the standards of their accounting. Accounting standards are a commonly used measure of how much firms disclose and thus of how good a country’s financial development is. In Malaysia, which had the most highly developed financial sector by this metric, the value added by the drug industry grew at a 4 percent higher annual real rate over the 1980s than did tobacco (adjusting the growth rate for each industry by the worldwide growth rate of that industry). In Korea, which was moderately financially developed, drugs grew at a 3 percent higher rate than tobacco. In Chile, which was in the lowest quartile of financial development among the countries in our sample, drugs grew at a 2.5 percent lower rate than tobacco. So financial development seems to affect relative growth rates of industries (the relative speed with which sensitive birds depart the tracks) in the way predicted.

Apart from finding evidence of the mechanism through which finance affects growth, and thus putting a causal connection on firmer footing, we can rule out another explanation for the finance-growth correlation: that financial infrastructure is set up as needed to meet the demands of high-growth industries. It turns out that industries that are small to begin with but depend on external sources for funding seem to benefit as much from financial development as large industries. Since it is unlikely that the financial sector would have cared enough about the needs of these small industries to develop itself in anticipation, it is safe to conclude that the observed correlation between financial development and growth is not because the financial sector is set up in anticipation of demand.

Let us now move to the second kind of evidence that might be persuasive. For this, we go back to the birds. Suppose we had only one type of bird, and these birds were on the track that vibrated relatively little. However, we had the ability to replace the track on which the birds were sitting with the track that vibrated much more. If we repeated this experiment a number of times (and at random times) and found that, after the track was replaced, birds invariably flew off much earlier on the approach of a train than before it was replaced, we could conclude with greater confidence that it was the vibrations that caused the birds to fly away.

The patterns of banking deregulation in the United States created the ideal conditions for such an experiment. As described in the introduction, for a long period, the United States had state laws preventing out-of-state banks from opening branches in the state and in-state banks from expanding their branch network. Some states—called unit-banking states—even had laws restricting banks to just one branch in the state. Competition among banks was muted in states with strict antibranching laws, resulting in bloated and inefficient banks, passing on their costs and indifference to their clients.

Between 1972 and 1991, many states did away with regulations preventing banks from opening multiple branches within the state. The subsequent changes in bank performance were significant. On average, loan losses (the amount banks lose because of poor credit decisions) decreased after deregulation—in the short run, by about 29 cents per hundred dollars of loans made and, in the long run, by about 48 cents per hundred dollars of loans. These are large numbers relative to the total size of loan losses, which rarely amount to more than a few dollars per hundred in a healthy banking system. Also, operating costs decreased by about 4.2 percent initially and by about 8 percent in the long run.⁷ Average compensation for bank employees fell as the industry became more competitive, with wages declining by about 12 percent for males and 3 percent for females (in other words, wages fell but became less discriminatory—a natural effect of competition).⁸

What did all this mean for bank customers? States that deregulated saw a reduction in loan rates to borrowers and a milder increase in rates paid to depositors. So deregulation made bank customers, both borrowers and lenders, better off. Deregulation was tantamount to a quantum jump in the development of the financial sector within a state, because it allowed more efficient banks to provide services at lower prices. If financial development does cause growth, deregulation (the change of tracks) should have had a positive effect on growth rates of per capita income and output in the state (the length of time by which the birds anticipated the train).

It did! The annual growth rate in a state increased by 0.51 to 1.19 percentage points a year after deregulation.⁹ Given that average growth rates over this period were about 1.5 percent per year, this is a huge increase. By contrast, states that did not deregulate over this period experienced an average decline in growth of about 0.6 percent!¹⁰

More recently, a spate of new studies has bolstered these findings. For example, when countries open up to foreign capital inflows (which typically causes indicators of financial development in that country to skyrocket), the country’s growth rates increase significantly. Countries that open up their equity market to foreign inflows experience an average increase in GDP growth rate of about 1.1 percent per year.¹¹

Because of all this evidence, few would now doubt that there exists a causal link between the development of the financial sector and the growth of the economy. This is not to say that a country can be bereft of ideas or talented people and still grow its economy simply on the strength of a streamlined financial sector. Nor does it say that a country cannot grow if the financial sector is underdeveloped: the success of China in the last two decades certainly shows this. Finance cannot create opportunities. It only makes it easier to exploit them: what it can do is identify the areas of opportunity and decline, and achieve a better match by giving to sectors with a future while taking away from those with only a past. Finance can find and mold the clay of opportunity, but it cannot create the clay itself.

Finance and Competition

Growth is not the only metric by which to measure the effects of finance. In Chapter 3, we argued that finance, by reducing barriers to entry, enhances competition and opens the gates to opportunity for firms and for individuals. What evidence is there for this claim?

Financial development seems to facilitate new entry. The deregulation of U.S. banking, to which we alluded earlier in this book, led to a substantial increase in the degree of development and competition in the financial sector in states that deregulated. These states experienced a significant increase in the rate of creation of new enterprises after deregulation.¹² Similarly, more new establishments are created in countries with more advanced financial systems, and this effect is more pronounced in industries that depend more on external finance, suggesting that availability of finance is indeed the cause of this increase.¹³

That financial development facilitates new entry, however, does not mean it necessarily reduces economic concentration: established firms could benefit even more from financial development than entrants, acquiring a greater share of production and squeezing out competition. We therefore have to look at the effects of financial development on competition more directly.

One measure of the degree of competition is the profit margin. All other things being equal, a firm in a more competitive market should have a lower profit margin. If firms in areas that have better access to finance have lower profit margins, this would suggest that access to finance makes competition more intense. To check this, let us go to Italy, where there are tremendous variations across regions in the quality of the infrastructure necessary for good finance—such as an efficient judicial system. This affects access to finance: an individual with similar personal characteristics has twice the probability of being rejected for a loan in certain Italian regions than in others, even after adjusting for economic factors that should matter.

These regional differences in access to finance seem to affect competition at the local level. Firms in the most financially developed regions have a profit margin 1.6 percentage points lower—about a third below the average profit margin of 5.9 percent—than in the least financially developed region. Reassuringly, this effect is present only for small and medium firms: large firms can raise funds nationwide, and competition in industries with large firms should not be affected by local financial development.¹⁴

Perhaps the most persuasive evidence of the effects of finance on competition would come if we found an industry in which access to capital is the primary barrier to entry and then compared competition in this industry across a number of countries over time.

Such an industry indeed exists—the cotton textile industry—and it has been studied by Stanford University economic historian Stephen Haber.¹⁵ The minimum economic scale of production in this industry has historically not been large; therefore, incumbent firms could not build tremendous barriers to entry by setting up massive plants. Moreover, over the period it was studied—approximately the second half of the nineteenth century and the first half of the twentieth century—there were few important patents in the industry, and advertising did not play a major role. As a result, the main barrier to entry was the financing required to acquire the small but not insignificant amount of plant, machinery, and working capital needed for production. Haber compared the industry in two countries that took very different paths toward financial development, Mexico and Brazil.

Financial Markets in Mexico and Brazil around 1900

Over much of the nineteenth century, the Mexican government had only a few sources of revenue, such as customs duties, and these were very volatile because of large and abrupt fluctuations in foreign trade.¹⁶ Governments were also unstable, and finance ministers changed frequently. As ministers had only a short horizon, they found it expedient to default on the government’s obligations, especially in times of crisis or war. As a result, the rates of interest on government loans were high and volatile, touching 200 percent at times.¹⁷

As with other predatory governments, the Mexican government found that only a few rich financiers were willing to lend to it. This was not only because these financiers were the main possessors of surplus capital but also because only these financiers had the muscle to ensure that the government would try to repay. Thus, there was a symbiotic relationship between the government and its principal lenders, which translated into the latter’s obtaining a variety of concessions, including the state mints, the state tobacco monopoly, the salt mining administration, toll routes, and so forth.¹⁸

These financiers had little incentive to see competition develop. The beginnings of even a basic banking system had to wait till 1864, with the establishment of the Banco de Londres y México. There were only eight banks in 1884 and just forty-seven in 1911, of which only ten could legally lend for terms of more than one year.¹⁹ Moreover, even the small banking system was very concentrated. In 1895, the three largest banks accounted for two-thirds of the capital invested in the system.²⁰ Of course, the clique of old financiers also had control over much of the banking system.

The concentration of the banking system was in the interest of the government. The government wanted to retain a stable market for its debt, and this could not be achieved if banks competed away profits while serving the larger public. So the largest bank, Banamex, the prime government financier, had many privileges, including reserve requirements that were half that required of other banks, an exemption from taxes, and the sole right to open branches. Entry requirements for other banks were onerous, including high capital and reserve requirements and the necessity of obtaining permission for entry from both the secretary of the Treasury and Congress. It does not take much to guess how often authorization for entry would be granted to someone outside the circles of power.²¹

The public markets were also underdeveloped for much of the century, mainly consisting of various vintages of government debt differing primarily in when they were likely to default. Eventually, however, under Porfirio Díaz (effectively the dictator of Mexico from 1877 to 1911), some stability was brought to the government and its finances. Foreign loans were raised, and the proceeds were used, in part, to restructure old government debt. Nevertheless, the government was still dependent on a fairly narrow set of domestic financiers—in particular, the large banks such as Banamex.

The government did undertake some reforms. Laws governing mortgaging lending were passed in 1884, and a law allowing free incorporation with limited liability was established in 1889.²² But the reforms facilitating the financing of corporations were, at best, halfhearted. For instance, financial reporting requirements were loosely enforced. Manufacturing firms often failed to publish balance sheets for years, even though required to do so by law.²³ Of course, the paucity of public information made the public reliant on the few large financiers for certifying and monitoring the companies in which it was safe to invest. It should be no surprise that only the few promoters who had connections to prominent financiers could raise equity.

Brazil, before the collapse of the empire in 1889, had very similar policies toward financial markets and institutions as did Mexico. There was an organized stock exchange in Rio de Janeiro since the beginning of the nineteenth century, but it was not used to finance firms. Between 1850 and 1885, only one manufacturing firm was listed on the exchange, and its shares traded in only three of those thirty-six years!²⁴ The banking system was small and concentrated, again primarily because the government wanted a stable source of finance. Finally, there were many barriers placed in the way of the limited-liability corporation. Promoters had to obtain the permission of the imperial government to incorporate and even then did not enjoy limited liability: an investor was held responsible for a firm’s debts even after he had sold his stock. Banks were prohibited from investing in stock, and investors could not buy stock on margin.²⁵

However, Brazil, unlike Mexico, had the kind of bourgeois revolution that swept through continental Europe in the latter half of the nineteenth century. The urban middle class and powerful coffee planters led the movement that overthrew Emperor Pedro II. They viewed the emperor as too closely tied to the old landed aristocracy and felt that a republic would better suit the interests of industrialization.

After the setting up of the republic, policies toward the financial sector changed significantly. The government was now interested in transforming an agrarian, slave-based economy into a modern industrial economy. Slavery had been abolished and new entry permitted into banking in the last year of the empire. The new government opened the banking system up further to entry, removed restrictions on what banks could invest in, allowed margin loans, and made limited liability easy for corporations. It also continued the policy of requiring corporations to publish their financial statements regularly and list the names of their shareholders as well as the shares each controlled. Thus, the investing public had fairly good information on the firms and who controlled them.²⁶

The result was a huge expansion of the financial sector. The number of banks exploded from twenty-six in 1888 to sixty-eight in 1891. In the first year of the boom, stock-trading volume in the hitherto sleepy Rio de Janeiro stock exchange was almost as much as in the past sixty years combined! A market for public corporate debt also started up. New debt issues financed 32 percent of investment in the period 1905 to 1915.

With such rapid and largely uncontrolled liberalization, it would have been surprising if there were no accidents on the way. It takes time for supervisory authorities to learn how to regulate in a liberal environment, and it takes experience for a businessman to learn how to make money when all restrictions are removed. The clever are ever present to take advantage of situations of euphoria. Almost inevitably, the boom turned into a speculative bubble and then a bust. The banking system nearly collapsed, and in 1906, there were only ten banks in operation.²⁷ But the reforming genie had been let out of the bottle. Even though the banking system became moribund, the equity and public debt markets continued to serve as a source of finance for firms. In 1915, there were as many as thirty-two initial public offerings on the Rio Bolsa (the Rio stock exchange). In that year, twenty-four firms raised debt from the public market, and bonds accounted for 21 percent of long-term corporate capital.²⁸ To put this in perspective, today even in countries with highly developed debt markets like the United States, only about 20 percent of total investment is financed through corporate debt issues.

To summarize, Brazil’s arm’s-length markets and, for a period, banks were ready to finance firms, while Mexico had a concentrated banking system that doled out money only to its favorites. The differences this made in the ways the textile industry was financed were significant. In 1912, only 4 of the 100 operating firms in the Mexican textile industry had publicly traded equity. By contrast, 32 of the 180 firms (18 percent) in the Brazilian textile industry were publicly traded in 1915. The publicly traded Brazilian firms were also among the larger ones, accounting for 34 percent of total output.²⁹

There was very little debt financing available to the Mexican firms, and when available, it was those that had connections that obtained it, and much of it was short-term. The debt-equity ratio of the largest cotton producers in Mexico, which presumably had the greatest access to finance, was only 0.09 between 1907 and 1913. By contrast, the debt-equity ratio of large textile firms in Brazil in 1914 was seven times larger, at 0.64, consisting mostly of long-term debt raised from the public market.

Most interesting is how the different extent to which the financial sector in each country developed affected the textile industry. In 1883, Brazil had forty-four firms with approximately sixty-six thousand spindles. The fraction of sales accounted for by the four largest firms was as high as 37 percent. In 1878, Mexico had almost twice as many firms, four times as many spindles, and its four largest firms accounted for only 16 percent of sales. Thus, the Mexican textile industry started out much bigger and less concentrated.³⁰

A few decades into the Brazilian republic and the Mexican Díaz dictatorship, the figures reversed. In 1915, Brazil had 180 firms, nearly 1.5 million spindles, and the 4 largest firms accounted for only 16 percent of sales. By contrast, in Mexico in 1912, there were only 100 firms, approximately .75 million spindles, and the 4 largest firms now accounted for 27 percent of sales.³¹ Not only did Brazilian industry grow faster, but it also became less concentrated! A natural explanation is that the more tightly controlled Mexican financial sector dribbled out finance to its favorites, resulting in both the slower growth and the increasing concentration. Interestingly, the poor enforcement of disclosure rules made it difficult even for foreigners to subvert the status quo. As a result, they financed only the largest and best-known firms that already had access to financing, exacerbating the concentration. This is a pattern that persists even today in countries that open up cosmetically to foreign financing without deep-rooted reform.

It is important, of course, to check whether other factors could be responsible for the outcomes in the textile industry. In the textile industry, the differences in outcomes cannot be attributed to differences in the growth rates of the two countries or differences in demand for textiles. Mexico’s national income grew between 1877 and 1910 from 55 percent of Brazilian income to 93 percent. Its per capita income grew ten times faster than Brazil’s (Brazil had much greater population growth due to immigration; otherwise, Mexico would have had a larger national income). Since the demand for textiles grows disproportionately with per capita income, all the evidence suggests that the Mexican textile industry should have grown faster. It did not, suggesting that financial underdevelopment inhibited competition and growth in textiles.

For those who might think that the textile industry in developing countries is a special case, it is instructive to look at competition in the U.S. cotton textile industry over a similar period of time. Much of the cotton textile industry was in New England, and finance in New England through much of the nineteenth century was “relationship-based.” Industrialists started banks so that they could lend to their own enterprises. What prevented a small clique from getting a complete stranglehold over access to finance was that there was free entry into banking. And there was an increasingly large number of banks. From 17 banks in 1800, New England went up to 505 banks in 1860.³² Also, over time, as accounting became more trustworthy and laws were better enforced, finance became less insider-based, expanding the availability of finance even further.

The evidence strongly supports the role of finance in enhancing industrial competition. Not only was the concentration of the textile industry in the more financially developed United States always less than it was in Brazil or Mexico, it also decreased steadily over this period of time as the availability of finance expanded. So while the top four firms controlled 12.6 percent of the market in 1860, their share had fallen by 1920 to only 6.6 percent.³³

Finance in Declining Industries

The discussion so far illustrates the importance of a developed financial system in a growing industry. The role played by finance, however, is even more important in declining sectors. By permitting new entry, arm’s-length finance can help an industry adapt to change. Let us stay with the textile industry and examine what happened to it in the United States in recent years.

In the last few decades, the U.S. textile industry has been declining under the intense pressure of foreign competition.³⁴ While in 1976, there were 275,000 shuttle looms in the industry, by 1997, there were only 10,000. There were only two-thirds as many textile plants in the United States in 1992 as there were in 1972. Jobs in textiles declined about 35 percent over this period. These numbers suggest an industry in severe decline, with very limited need for external finance. The reality, however, is more complex.

Plants have indeed shut down. But there has also been significant new entry. For example, between 1987 and 1992, 31 percent of the existing plants shut down. But in 1992, new entrants controlled 28 percent of plants. It might seem paradoxical that new firms opened shop at the same time old, established firms shut down and left the industry. But this turnover greatly facilitated the transformation of the industry.

Firms have become more capital-intensive—for example, they now use more robotics—and employ fewer workers. As a result, the U.S. textile industry has become more productive—partly because surviving firms have become more productive, partly because those firms that have been forced to exit have been unproductive ones, and partly because new entrants have been more productive.

U.S. textile firms have also started producing new products such as Gore-Tex and Polartec that did not exist before. As a result, the industry has managed to increase exports even while imports into the United States have surged. In this dramatic restructuring, new entry has played a crucial role, overcoming incumbents’ resistance to change. And new entry is greatly affected by the ability to access external resources. Thus, even in declining industries, the role of finance is key.

Individual Mobility

What we have just seen is that finance helps upstart corporations enter and challenge the establishment, thus keeping competition keen and refreshing. Let us now see if it also helps expand opportunity for individuals.

One obvious way to measure how finance expands opportunities is to assess its impact on the probability that individuals will start out on their own. Self-employment, whether as a plumber or a storekeeper, typically requires initial funds. For all but the lucky few who were born wealthy, the financial system is the only source for these funds. Thus, a more developed financial system should make it easier for individuals to become self-employed. What is the evidence?

Across Italian regions, differences in availability of finance translate into differences in individual mobility. Even after controlling for other regional differences, an individual living in the most financially developed region is 33 percent more likely to start out on her own than an individual with the same characteristics living in the least financially developed regions.³⁵ By reducing the importance of the initial wealth, financial development also allows people to start out younger on their own (as in the search fund example in the introduction). In the most financially developed regions, entrepreneurs are on average 5.5 years younger. Thus, financial development has a significant impact on economic mobility.

Another way to measure mobility is to look at the very rich and see how they came by their wealth. Since 1987, Forbes has put out a list of the world’s richest people, indicating whether they inherited the bulk of their wealth or whether they are self-made. The last year for which Forbes reported all the people whose wealth exceeded $1 billion was 1996 (after that, the number of billionaires became too large). We start by looking at the number of billionaires present in each country in 1996. This is largely before the Internet boom created a whole new generation of instant (and ephemeral) billionaires. To compare countries with very different sizes, we divide the number of billionaires by how many million people live in that country.

The country with the highest frequency of billionaires per million inhabitants is Hong Kong (2.6), followed by Bahrain and Switzerland (1.7), and Singapore (1.4). At the bottom of the distribution, we find poorer countries like Peru (0.04) but also rich countries like Norway (0) and South Africa (0.05).

More revealing than the frequency of billionaries is the frequency of self-made billionaires per million inhabitants. Not surprisingly, countries that have grown fast recently, such as Japan or the Asian Tigers—Hong Kong, Singapore, South Korea, and Taiwan—tend to have a high frequency of self-made billionaires. What is interesting is that the frequency of self-made billionaries per million inhabitants in the United States (0.26 per million) is much higher than that in the large European countries: the United Kingdom, Germany, and France have on average 0.08 self-made billionaire per million inhabitants.

There is a very strong positive correlation between the frequency of self-made billionaires in a country and the size of its equity market. This correlation is not just due to Hong Kong, which stands out on both measures. If we eliminate the former British colony, the positive correlation persists. An increase in the size of the equity market from the level in France (50 percent of GDP in 1996) to the level in the United States (140 percent of GDP) would be associated with an increase in the frequency of self-made billionaires in France from 0.07 per million to approximately 0.30. All the difference between the United States and France in the frequency of self-made billionaires per million inhabitants can be explained by the better-developed financial markets in the United States!³⁶

All we have is a correlation, which, as we have previously emphasized, is not evidence of causation. A lot of other factors, such as the extent to which a country favors free enterprise, may affect the ability of an individual to accumulate a fortune during her lifetime. As long as these other factors are relatively constant, however, we can eliminate their influence by looking at changes in the frequency of billionaires per million people over a certain period of time. Since the earliest survey conducted by Forbes is in 1987, we look at the changes in the frequency of self-made billionaires between 1987 and 1996. During this decade, the frequency of self-made billionaires tends to increase most in countries that started the decade with a more developed financial system. The effect on the frequency of inheriting billionaires is much smaller.

FINALLY, does it really matter if the rich are composed of those who inherit their wealth rather than those who are self-made? It does! Countries in which those who inherit their billions account for a large fraction of the GDP grow more slowly and spend less on innovation than other countries at similar levels of economic development.³⁷ Firms controlled by heirs tend to have lower performance within their industries and lower spending on research and development.³⁸ Perhaps the strongest evidence that inheritance has adverse effects on the creation of wealth comes from the stock market. When a publicly traded firm appoints an offspring of the founder as a CEO, the stock price drops by 1 percent, while when it appoints an outsider, the stock price goes up by 2 percent.³⁹ These differences in market reaction do indeed reflect its anticipation of differences in performance. Firms run by an offspring of the founder experience an 18 percent decline in return on assets in the two years following the appointment.

The problem is not just inheritance but the absence of financial development. More financial development would allow the would-be rich to compete with inheritors, forcing the latter to show that they deserve to keep control of their inherited firms. It would also allow good entrepreneurs to buy out incompetent inheritors, thus preventing valuable resources from being run into the ground. While some inheritors might refuse to part with control at any price, developed financial markets mitigate the size of the problem. It is excessive inherited wealth in a financially underdeveloped society that is particularly harmful to national prosperity.

Summary

Every revolution that sends bankers to the guillotine soon finds the need to resurrect them as the wheels of commerce grind to a halt. Finance lubricates the process of economic growth. It also expands economic opportunities for those without resources. The Austrian economist Joseph Schumpeter wrote in 1911:

That the structure of modern industry could not have been erected without it [finance], that it makes the individual to a certain extent independent of inherited possessions, that talent in economic life “rides to success on its debts,” even the most conservative orthodoxy of the theorists cannot well deny.⁴⁰

Since he wrote those words, many theorists have indeed disputed whether finance does play such a role. Recent evidence suggests that Schumpeter was right.

Critics have then moved from questioning whether finance has any effect to complaining about the risks associated with the process of liberalizing the financial sector. Financial crises are indeed more likely when a country liberalizes. This should not be surprising. In the same way as a man who never stirs out of bed cannot be hit by a speeding car, an economy that does not liberalize will not suffer a crisis but will slowly die from a sedentary lifestyle.

In fact, the process of liberalization is harmful primarily for countries with a weak institutional environment—characterized by widespread corruption, inefficient government bureaucracies, and inadequate contractual enforcement.⁴¹ Instead of embracing competition, established firms in such countries try to fight it. They get enmeshed in a web of defensive cartels and connected lending that renders the whole system opaque, inflexible, and especially prone to adverse economic shocks.

It might be tempting to suggest that countries with a weak institutional environment should postpone financial sector liberalization till they strengthen their institutions. We disagree with such a prescription. The institutional environment, as we will argue, is not independent of the degree of competition and openness in the economy. A powerful few acquire positions of power in an underdeveloped environment and are loath to see institutions improve. Their grip on political power will weaken only if competition reduces their economic power. So the institutional environment will be unlikely to improve without competition.

This means that even countries with weak institutions will be better off embracing liberalization even though they will face heightened risks of crises. There is evidence to support this view.⁴² Policy makers should take measures to reduce the costs of a potential crisis on the most vulnerable as well as the risks of a political backlash. But ultimately, the citizens have to be satisfied by the knowledge that with the heightened risk from liberalization comes the prospect of a very real return.

We started this book claiming that capitalism—or more precisely, the free market system—is the most effective way to organize economic activity and that free financial markets are at the core of such a system. The first part of this book was devoted to substantiating this claim. We have seen that despite all their imperfections, free financial markets create opportunity, breed competition, foster innovation, and ultimately promote growth. Furthermore, while capitalist systems seem full of problems, many of these problems are a result of the underdevelopment of finance and are likely to diminish as finance develops.

Now that we have seen that, on balance, free financial markets contribute greatly to spreading prosperity and opportunity, we immediately face the question “Why do some countries have flourishing financial markets and others not?” This question is what we turn to in the second part of the book.

PART TWO

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WHEN DO FINANCIAL

MARKETS EMERGE?

CHAPTER SIX

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