Summary

We ended the last chapter pointing to the powerful forces arrayed against finance—the forces of incumbency opposed to the changes unleashed by free access to finance. There are some circumstances in which these forces can be overcome—for example, when a society undergoes significant political change. There are also circumstances in which the self-interest of incumbents becomes aligned with the public interest. One is when new markets open up or new technologies become available. Incumbents, faced with significant new investment opportunities, cannot rely on traditional funding sources (such as internal cash) and may press for better access to finance. Similarly, when a country’s borders open up to external trade, industrial incumbents might have depleted profits while needing to make massive investments to compete with foreigners.

Unfortunately, it is not clear that finance will develop even when industrial incumbents are in need. Incumbents may skew access to finance even more, especially if they can co-opt the government. History suggests that finance is likely to develop only when the government’s ability to play favorites is limited. The opening of a country’s borders to capital flows (and not just to trade) ensures some of the required discipline on government actions. This then suggests that it is the fortuitous combination of a need on the incumbents’ part for financing as well as the discipline on government intervention stemming from borders open to capital flows that channels political efforts toward improving financial infrastructure. The explosion in financial markets around the world in the last three decades is intimately bound with the greater openness in the world economy.

Thus far, we have discussed the conditions under which the political opposition to financial development will be overcome. But once some financial infrastructure is in place, will countries continue to have healthy financial sectors? The evidence here is far from reassuring. Financial markets in countries around the world shrank between 1930 and 1980. What explains this reversal? In part, we already have the answer: cross-border capital flows diminished to a trickle during much of this time. This then provided the setting in which incumbents could reassert their interests and suppress finance. But why did countries close their borders to capital flows? Could it happen again?

We have hopped backward and forward through history thus far. But to answer these important questions, we have to shine a light on the period 1930 to 1980. We have to understand the economic and political environment at that time and the alternative to the market economy that emerged. And we have to understand why that alternative broke down and the problems it has left for us. This is the subject of the chapters that follow.

PART THREE

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THE

GREAT REVERSAL

CHAPTER NINE

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The Great Reversal between Wars

GOVERNMENT respect of property rights is the first step toward the development of financial markets. As we have seen, this respect best arises when property is owned by the most competent and specialized. When, in addition, it is widely distributed, representative government arises. But even in a democratic form of government, there is no guarantee that policies will reflect the needs of the people. Incumbents can capture the policy-making process and enact antimarket legislation. Revolutionary political or technological change can loosen incumbents’ hold on markets, but these are rare occurrences. In the natural course of events, it is competition from outside that curbs incumbents.

If, however, markets rely on open borders to limit the power of domestic vested interests, then we have to ask how politically stable open borders are. Countries tend to remain open when the rest of the world is open. France, as we have seen, faced a defining moment in 1983, when the socialist government had to decide whether to close its borders to capital flows. It chose to remain open because it feared jeopardizing its strong trade links to the rest of Western Europe. Similarly, during the Asian financial crisis in 1998, most affected countries chose to remain open because the rest of the world was unaffected and continued to be open to trade.

There are good reasons why, once a country opens its borders, those borders tend to stay open unless many other countries begin closing their borders. Those that benefit from openness—exporters, importers, multinational firms—gain power and develop their own political constituencies in open countries. Not only do these firms rely on foreign sources for their supplies, but they are also keenly aware of the extent to which the foreign markets for their products can be destroyed by tit-for-tat policies by foreign governments. They then form a countervailing force to those who would want to close borders. Moreover, if other countries are open, a country’s borders are bound to be porous no matter how determined it is to close them down. The economic pressure for cross-border trade will eventually force goods and capital across barriers erected by all but the most austere police states. So both the configuration of power and the permeability of borders will favor the continued openness of a country when the rest of the world is open.

Matters are different when there is incipient pressure in many countries to close down. The constituencies favoring openness will be economically weaker, and thus less politically powerful, when other countries close down. They are also less likely to have an incentive to fight for openness when they see their foreign markets vanish. Moreover, when the collective political will of countries is focused on stopping cross-border flows, it indeed becomes much easier to stop them.

So openness is what economists call a strategic complement: countries want to have less of it when other countries have less of it. Therefore, once some cataclysmic event causes some countries to close their borders, the process can cascade. During the Great Depression, many countries closed their borders to both trade and capital flows. It is important to understand why, and whether it can happen again. Hence, in this chapter, we analyze the historical events surrounding the Great Depression, starting from the economic and political environment at that time, and concluding with a discussion of the forms the antimarket reaction assumed. In Chapter 10, we explain why the antimarket reaction was so strong at this time and why free financial markets gave way to strongly cartelized or government-controlled financial systems. Finally, in Chapter 11, we describe the deficiencies of these systems and obtain a more rounded explanation for why markets have become free again. We travel over some territory that we have already covered, but with a much sharper focus on attempting to understand when financial development can be reversed.

The Gold Standard

In the early years of the twentieth century, the political institution underlying the triumph of markets in most of the developed world was the gold standard. Not only did the gold standard facilitate trade and capital flows, but it also imposed tight budgetary discipline on governments, which made it difficult for them to intervene much in economic affairs.

A country on the pure gold standard essentially used gold for circulating money. If paper money or coins made of other metals circulated, enough gold was maintained in the vaults of the central bank to convert these into gold on demand. It was critical to the working of the gold standard that countries remain committed to maintaining the convertibility of their currency into gold at a constant rate. Once these commitments were credible, it was as if the whole world used a single currency, gold. Because a common currency reduces uncertainty about prices and costs across borders, it leads to an expansion in the volume of cross-border trade and investment. The gold standard was the primary reason countries were so open to trade and capital flows in the early part of the twentieth century.

But the gold standard also limited the range of policies a country’s government could implement. Consider, for example, how a trade imbalance could be rectified. If a country’s imports of goods and services exceeded its exports, it ran a negative balance of trade, which either ate into its reserves of foreign exchange and gold or forced it to borrow from foreigners. If a country’s reserves were insufficient, or foreigners were unwilling to lend, it had to reverse its trade deficit and run a surplus. Under the gold standard, a country could not simply depreciate its currency, making exports cheaper and thus increasing their quantity. Since the exchange rate was fixed, the only way for a country with a persistent negative balance of trade to sell more outside was to produce goods more cheaply by allowing domestic wages and prices to fall, so that the country could become more cost-competitive. Thus, the inability of governments to allow the exchange rate to depreciate gave them one less tool with which to cushion adverse economic events.

But the straitjacket was even more confining. If the country’s banking sector suffered a serious crisis of confidence, the central bank could not lend freely at a low interest rate for fear that the exchange rate would be affected. Instead, it had to hope that confidence would be magically restored or that somehow foreigners would step up to lend freely. Governments were not just impotent under the gold standard; they were dependent on the benevolence of foreign governments that had exchange surpluses to lend.¹

World War I and Its Aftermath

Until World War I, the gold standard worked reasonably well. Its straitjacket restricted incumbents’ ability to distort the rules of the game in their favor, and governments intervened very little in the economy. Moreover, classical economics, with its emphasis on letting market forces find their way, was convenient, at least for those in power, for it imposed the burden of any adjustment on workers, who were forced to accept the lower wages necessary for a country to regain competitiveness.² This was only possible because labor was politically weak. Most countries had only recently moved to universal franchise, and both labor parties and unions were subject to constant harassment. Workers themselves were poorly educated and were slow to absorb the radical ideas that socialist intellectuals were then debating.

That World War I jolted society the world over is probably an understatement. From the perspective of political economy, however, two consequences were particularly important. First, the need to coordinate war production had led to significant wartime centralization of production throughout the economies of continental Europe. The reason for wartime centralization was simple. A decentralized market economy produces for those whose needs can be backed with cash. Military needs during the war were paramount, but it would have been prohibitively costly for the government to continuously outbid private consumers all the time. The military command soon came to believe that the best way to manage was to ban certain forms of private consumption, set prohibitive prices for others, and commandeer production toward war goals—in other words, suppress prices and the private market in favor of a command-and-control system along the lines of the military. They had willing allies. The historian William McNeill describes the control of the war effort in Germany after 1916 thus:

[T]he generals in charge often became impatient with the financial claims and controversies that continually embroiled and sometimes obstructed prompt and deferential obedience to their demands. As shortages rose, one after another, the generals relied more and more on big labor and big business to remodel the economy according to military needs. Each party got more or less what it wanted: more munitions for the army, more profits for the industrialists, and consolidation of their authority over the work force for union officials.³

In many countries, prices were centrally controlled and resources allocated to those uses that were deemed critical to the war effort. Centralization was aided by the cartelization of industry, of the banking sector, and of the workforce because this reduced the number of parties with which the central authority had to negotiate. The reliance on hierarchical command rather than prices to determine the allocation of resources seemed to work, at least for a while. This is not surprising. With a clear objective, such as delivering munitions, and with incentives provided by patriotic fervor, the price mechanism can be suspended for a while without severe costs. Eventually, of course, the task of running a complex economy from the center overwhelms even the most competent management. Severe distortions did build up in the wartime economies. Nevertheless, the relative success of centralized economies suggested that government intervention was not all bad, and many saw it as an attractive model to which to return during the years of the depression.

The second consequence of the war was that the working class became more aware of its power. The trenches during the war served as classrooms, where the working class absorbed more radical ideas. The senseless carnage of a war that left all the main combatants worse off led many to doubt the caliber and motives of their political leaders. Socialist intellectuals now found a receptive following among labor. Organized and awakened labor would no longer continue unquestioningly to absorb the costs of adjustment to macroeconomic imbalances.⁴

With the end of the war, economies had to change significantly to reorient themselves to civilian production and market-determined prices. They also had to rectify the distortions that had built up during the period of centralized control. Industrial strife increased as workers were unwilling to absorb the entire brunt of the adjustment once again.

In spite of this increased resistance, the power of the preexisting order was so strong that countries paid the price to return to a version of the gold standard. By the late 1920s, the gold exchange standard was effectively in place in much of the world. But economies had been stretched by the effort, and according to some economic historians, this may have sown the seeds for what was to come.⁵

The stock market crash of 1929 in the United States and the ensuing recession in the United States were the proverbial straw. With the single biggest consumer in the world contracting, exports plunged all around the world. Balance-of-payment problems worsened in Europe, Japan, and Latin America. With cross-border lending also slowing to a trickle, the required adjustment for a country under the gold standard was clear. Its domestic wages and prices had to fall so that it could start exporting more and generate the necessary surpluses. But with labor no longer willing to accept significant wage cuts, the next “best” way for politicians to restore the balance of trade was to ban imports and subsidize exports. The United States was in the forefront of this movement with the notorious Smoot-Hawley bill. Of course, if every country did this, world trade would collapse, and it did. The world entered a downward economic spiral, and recession turned to depression.

Moreover, as prices fell, debtors had to sell more goods just to generate enough to pay off their fixed debts, so debt defaults increased. Losses at financial institutions mounted, and the threat of a financial crisis put pressure on central banks to intervene and bail out the system. Again, under the gold standard, central banks could not lend freely to bail out the banking system without jeopardizing the exchange rate.

Faced with severe economic conditions, there was pressure for governments to do something. Political conditions made it impossible to give markets the time to sort things out on their own and remedy the mess that some would argue political interference had created. As John Maynard Keynes famously wrote, “In the long run we are all dead.” The pressure grew for more intervention that would ease the growing pain. A frightened electorate threw out governments that waited passively for markets to recover. Newly elected politicians were anxious to do something.

The Political Response to the Depression

In general, politicians blamed unbridled competition in the 1920s for what, from the vantage point of the depression years, seemed like excessive investment by industry, excessive lending by banks, and excessive speculation in the stock market by all and sundry. The antimarket sentiment was reflected in statements made by politicians from very different persuasions. For example, one of the attractions of Nazism was that it would tame the market and place it at the service of national goals.⁶ Hitler felt that economic problems could be overcome by political will alone. He wrote, “The Volk [nation] does not live on behalf of the economy, its economic leadership, or economic and financial theories, but rather, finance and economy, economic leadership, and every theory exist only to serve in the struggle for our people’s self determination.”⁷ Hitler, as had many rulers in the past, found a convenient scapegoat in the Jews for the financial troubles besetting the economy, but the sympathetic ear he found in the German people cannot entirely be unassociated with his willingness to bring the market under political control.

Competitive markets weighed equally on Franklin Roosevelt. In his inaugural address, he, too, blamed the market, finance, and the “outworn tradition” of classical liberal economics for the state the economy was in:

Our distress comes from no failure of substance. . . . Plenty is at our doorstep, but a generous use of it languishes in the very sight of supply. Primarily this is because the rulers of exchange of mankind’s goods have failed through their own stubbornness and their own incompetence, have admitted their failure and abdicated. Practices of the unscrupulous moneychangers stand indicted in the court of public opinion, rejected by the hearts and minds of men. . . .

. . . The moneychangers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of restoration lies in the extent to which we apply social values more noble than mere monetary profit.⁸

He, too, felt it a duty to intervene. In a fireside chat in 1934, he said:

Men may differ as to the particular form of governmental activity with respect to industry and business, but nearly all are agreed that private enterprise in times such as these cannot be left without assistance and without reasonable safeguards lest it destroy not only itself but also our processes of civilization.⁹

But Roosevelt claimed that by intervening, he was only restoring the ideals of the free market because he was fighting monopoly. (Parenthetically, democratic governments always claim to interfere with markets to combat monopoly and reduce risk, two popular but generally incompatible objectives.) In his acceptance of the Democratic Party’s presidential nomination in Philadelphia in 1936, he said:

Throughout the Nation, opportunity was limited by monopoly. . . . For too many of us the political equality we once had won was meaningless in the face of economic inequality. . . . A small group had concentrated into their own hands an almost complete control over other people’s property, other people’s money, other people’s labor—other people’s lives. For too many of us life was no longer free; liberty was no longer real; men could no longer follow the pursuit of happiness.¹⁰

Since the market seemed to be inflicting pain on the many for the profit of a few, Roosevelt concluded:

Against economic tyranny such as this, the American citizen could appeal only to the organized power of Government. . . . Better the occasional faults of a Government that lives in a spirit of charity than the consistent omissions of a Government frozen in the ice of its own indifference.

In summary, politicians with stripes as different as Hitler and Roosevelt knew that something had to be done. Their explanations for what had happened differed, as did the means they sought to employ, but the belief that the government had to replace the failed market was almost universal.

The response of governments to the problems of the depression varied in their details but typically had three common themes. The first was to abandon the gold standard. As Roosevelt declared in his message to the World Economic Congress in July 1933, “The sound internal economic system of a Nation is a greater factor in its well-being than the price of its currency in changing terms of the currencies of other Nations.”¹¹ In Roosevelt’s view, the pain engendered by the gold standard was no longer worth the price. With the greatest economic power in the world withdrawing its support, the gold standard was history.

With no external discipline on the extent to which governments could intervene, they were now free finally to remedy what they saw as obvious defects of the market. So the second theme was to curb competition, from both external and internal sources. Foreigners had access to domestic markets in the past because powerful domestic incumbents saw opportunities in trade. With export markets no longer proving attractive, there was no reason to allow foreigners into the domestic market. Foreigners were the easiest targets because they had no political voice. Imports of goods and people were curbed through prohibitive tariffs and restrictive immigration policies.¹²

Domestic competition was also problematic. The head of the National Recovery Administration (NRA), set up during the depression in the United States, argued that employers were forced into layoffs during the depression as a result of “the murderous doctrine of savage and wolfish competition, [of] dog-eat-dog and devil take the hindmost.”¹³ As Roosevelt put it in introducing the National Industrial Recovery Act, cooperation among firms was needed to push up wages and employment. But

One of the great restrictions upon such cooperative efforts up to this time has been our antitrust laws. They were properly designed as means to cure the great evils of monopolistic price fixing. They should certainly be retained as a permanent assurance that the old evils of unfair competition shall never return. But the public interest will be served if, with the authority and under the guidance of the Government, private industries are allowed to make agreements and codes insuring fair competition.¹⁴

In short, the government offered its blessing to industrial cartels. The government’s desire to curb competition especially hurt new entrants. By contrast, it was most welcome to domestic incumbent firms, which, freed from foreign competition, were happy to reach agreements with other incumbents and do away with new entry into domestic product markets.

An example of the kind of measures adopted was the federal regulation of trucking in the United States. The Motor Carrier Act of 1935 was designed “to protect the public interest by maintaining an orderly and reliable transportation system, by minimizing duplications of services, and by reducing financial instability.” The act exempted the trucking industry from antitrust laws and required all interstate motor carriers to file their rates with the Interstate Commerce Commission (ICC), which had the authority to set minimum rates and suspend rate cuts. Similarly, the ICC had the power to regulate entry into the industry through the grant of operating certificates. The ICC followed a policy of not granting authority to serve a route already served as long as the existing carriers provided adequate service. In other words, the onus was on a potential entrant to prove that the incumbent was doing a terrible job and not that the job could be done better. Needless to say, entry was very limited.¹⁵

The act limited competition not just within the industry but also between trucking and the railways (which had the same regulator). The sizable profits that resulted for incumbents can be gauged by the price of operating certificates—the ticket to becoming an incumbent—which was 15 to 20 percent of annual carrier revenues.¹⁶ Other organized interest groups also benefited.¹⁷ For example, after trucking was eventually deregulated in the late 1970s, the premium earned by unionized trucking employees over nonunionized employees fell from 50 percent to 30 percent.¹⁸

If prices were no longer set in a competitive market, something had to take the place of the market in channeling resources. The centralized control of the economy, only recently disbanded after World War I, provided an attractive alternative, especially given the seemingly total inability of the market to resuscitate itself. For example, the NRA sought to set prices, control overproduction by allocating production quotas, and thus stabilize wages. Its model was the War Industries Board of 1917–1918.¹⁹ While the NRA itself was declared unconstitutional by the United States Supreme Court in 1935, centralized control of industry became firmly entrenched in other countries, especially Germany, Italy, and Japan. So the third common theme was a return to the corporatist management of the economy, with the government allocating resources from its lofty vantage point and substituting for the market.²⁰

It is not necessary for us to enter into the still-unsettled debate about whether intervention was needed or not. Economists still argue over the true causes of the depression—whether it is a classic example of the complete failure of markets or a canonical example of the opposite, a failure of government. What is obvious is that in the depths of the depression, with the economy in disarray, the stock market having crashed, export markets moribund, firms failing in the thousands, the banking system in collapse, and unemployment at unprecedented levels, the public did not believe the free market system worked.

These conditions, as we explain in greater detail in the next chapter, created the fertile ground for an unlikely coalition between the needy and the incumbents. Even when there is a generalized promarket consensus, incumbents succeed in carving out exceptions and protections. But when this consensus breaks down, it is especially hard to resist their influence. Riding on the coattails of the popular revulsion against markets, incumbents reestablished positions that had been much weakened by competitive and open markets.

That the legitimate desire to provide some relief to the growing masses of the needy served as a smoke screen for wealthy incumbents to protect their interests is also suggested by a central item on the reform agenda at this time: control over financial markets. Since this was an effective way to establish control over competition, it was natural that political attention would shift toward the financial markets and institutions. Because the financial sector was in disarray, political intervention could be effectively disguised as an attempt to introduce stability into the system. Clearly, commercial and investment banks would be opposed to controls that would reduce their profitability. If foreign capital had been flowing freely, the possibility of seeing business go to foreign financial institutions or foreign markets would have made the domestic financial institutions extremely reluctant to accept constraints on their activities. Since cross-border flows had virtually stopped, this was not a concern. Moreover, government controls brought with them the prospect of government-enforced cartels, which could enhance rather than reduce profitability.

The precise manner in which intervention took place, as well as the identity of the incumbents who benefited most, differed from country to country, but the outcome was similar: financial markets became less competitive, and only a privileged few retained access to finance.

The Consequences: The Great Reversal

It is useful to start with the effects on a market that is particularly sensitive to political winds and is a bellwether of the case of access to arm’s-length finance: the equity market. In the accompanying table, we report for a number of years the fraction of total fixed investment in a country that is financed through equity issues. In spite of missing data, there is a clear trend. With the exception of Japan, financing through equity offerings plummeted in the 1930s, not only relative to the extraordinary levels reached in the boom year of 1929 (and equity issues are usually plentiful in boom years) but also relative to the more normal level in 1913. Clearly, some of the fall can be attributed to the depression and the Second World War, but the fall was not reversed after the war and may have reached its nadir in 1980, long after the war ended. Interestingly, this pattern is also seen in a country like Sweden, which escaped both world wars.

Other indicators of the health or size of financial markets suggest a similar story. Financial markets shrank in size starting in the 1930s and had not recovered by 1980. To understand how this market reversal occurred, we now take a closer look at three countries that represent three different ways in which the government, under the influence of incumbents, intervened in financial markets: Italy, Japan, and the United States.

The Private-Public Nexus in Italy

Italy represents an example of how incumbents used public money to protect themselves and their positions in an economy severely affected by the Great Depression, with consequences that lasted for the following sixty years.

Even before the onset of the Great Depression, the Italian economy had been weakened by Benito Mussolini’s decision in 1926 to revalue the lira. The ensuing deflation was severe. In one year, the total credit extended by the central bank to the banking system shrank by 36 percent.²¹ To compensate for the shortage of domestic liquidity, banks borrowed abroad. In 1930, however, foreign credit became scarce, and domestic deposits started to shrink. This triggered a severe liquidity crisis in the banking system, because its assets were tied up in long-term credit and equity investments. One after another, the major banks asked the Fascist government for support.

Following a pattern it had set in earlier bailouts of smaller banks, the government set up a holding company, which it financed together with the central bank. This company acquired all the corporate shares held in the portfolios of the banks at the higher historical, not current, prices. Thus, the government not only provided liquidity to the banking system, but it also absorbed part of its losses.²² It also became the largest shareholder in a number of firms. Many of the industrial firms thus acquired were themselves on the verge of failing and benefited not just from the rescue of their banks but also from the direct infusion of public money. The two largest banks (Credito Italiano and Banca Commerciale) had acquired a substantial quantity of their own shares in an earlier failed attempt to support their own share prices. So with this operation, the government acquired a controlling interest not only in industrial firms representing 42 percent of the capital of all Italian corporations but also in the two most important credit institutions.²³ The cost of the entire bailout was a staggering 10 percent of GDP—the comparable amount in the United States today would be $1 trillion.²⁴

Unlike with similar bailouts in Germany and Austria, the Italian government did not sell many of its newly acquired companies back to the private sector. Of the few it sold, the most egregious case of privatization was the sale of a controlling block in a gas company, Italgas, to a group of Turin industrialists at less than one-fourth of its market value.²⁵ But in general, however, there was very little pressure from industrialists on the government to reprivatize.²⁶ In part, as the Italian economic historian Gianni Toniolo points out, many of the companies the government had taken over were in capital-intensive sectors and were not very economically attractive because they had highly cyclical revenues and were dependent on military demand. As long as the state continued to run these plants, the private sector obtained the essential inputs it needed, such as steel, without the necessity of absorbing losses in these unprofitable areas.²⁷

Equally important, however, is that even though the public taxpayer had paid for the bailouts, the firms were not nationalized in the traditional sense of the word. The banks and many of the largest manufacturing companies whose control was acquired during the bailouts continued to be listed on the Milan stock exchange and were special only in that they had the government as the main shareholder. But the government did not intervene directly in their running.

Instead, it created an autonomous company, the Istituto per la Ricostruzione Industriale (IRI), to hold and control these stakes. During the Fascist period and for the first two decades after the war, the government’s control over IRI was minimal. The first head of the IRI was not even a member of the Fascist Party.²⁸ Furthermore, even though the head was appointed by the government, he had little control over his operating firms, which were run as separate fiefdoms, accepting only general directives about financing from the center.²⁹ As an example of how little control the Fascist government had, one of IRI’s subsidiaries, the Banca Commerciale, employed many anti-Fascist leaders in its research department, and these leaders came to play a very important role in Italian politics after World War II.³⁰

The point is that after bailing out a substantial portion of the private sector at an enormous cost to taxpayers, the state neither sold its stake back at a fair price nor took active control. The private sector retained control without having to pay for it. Not only did existing managers keep their jobs, but also many of the board members, who represented the interest of the previous owners, retained their seats. Public ownership and control was a facade for a much more complex intertwining of the private and public spheres. For example, Giovanni Agnelli, who owned Fiat, was a director of Credito Italiano, one of the IRI banks, from 1946 to its privatization in 1994.³¹ He also sat on the board of Mediobanca, IRI’s investment bank, between 1962 and 1991.

As a result of such links, shares that had been acquired with taxpayers’ money to save the banking sector were voted in such a way as to protect and enhance private interests. There is no better illustration of this than Mediobanca, the shadowy IRI investment bank that, till recently, had a hand in almost every major corporate finance decision in postwar Italy. Mediobanca was created with government money to provide long-term finance to firms. As its founder and long-term chairman Enrico Cuccia declared to a leading industrialist when Mediobanca was founded, “Together we will rebuild not just Italy, but capitalism itself. The state will put up the money, you [will provide] the entrepreneurship.”³²

Approximately 68 percent of Mediobanca’s shares were owned by the three banks controlled by IRI, 3.75 percent was owned by a group of leading industrialists, while the remaining shares were sold on the Milan Stock Exchange. Despite the absolute majority of shares owned by IRI, Mediobanca was governed by a voting trust in which the 3.75 percent owned by the industrialists and the 68 percent owned by IRI had equal voting power.³³ The stated reason for this agreement was “to protect Mediobanca from the shareholder of the shareholders”—that is, IRI—and “shield the financial institution from political interference that could have been exerted through IRI.”³⁴

Fairly soon, Mediobanca went far beyond its mandate to provide long-term finance to industry. It held enough shares in all the large family-owned firms that its votes were needed for any major decision. It thus protected them from unwanted takeover threats. In fact, Guido Carli, the governor of the Italian Central Bank between 1963 and 1978, called Enrico Cuccia “the sentinel who, as always, protects the empty barrel of Italian capitalism.”³⁵ That government money provided the protection while the public shareholders suffered from the misgovernance of less-than-competent families with no recourse was the least of Cuccia’s concerns. It is not surprising, then, that unlike other countries where the private sector actively pushed for privatization, the industrialists in Italy were content with the prevailing state of affairs, and the IRI, set up as a temporary stopgap measure in the 1930s, owned a large fraction of corporate Italy into the 1990s.³⁶

Paralleling these developments in the ownership and control of firms were changes in access to financing. The governor of the Bank of Italy headed a “Committee for the Protection of Savings and the Granting of Credit,” which had to approve all equity and bond issues. This committee was also given the power to determine bank lending and borrowing rates, the price of bank services, and the allocation of bank liquidity.³⁷ In short, all financing decisions were centrally determined.

Inevitably, the financing that was allowed reflected a desire for stability rather than competition. The number of publicly traded companies (a good indicator of the ease of access of new firms to arm’s-length financing) remained below its 1929 peak until 1986.³⁸ The average age of the companies going public was an elderly fifty-three years in the period 1968–1981 and thirty-five years in the period 1982–1992.³⁹ Young entrants clearly did not have easy access to finance.

With entry by threatening businesses discouraged and competition among financial institutions “managed,” finance allowed neither creation nor destruction. Many of these cozy arrangements persisted long after the depression was over, right into the 1990s. In fact, the system of state ownership and private control might have continued much longer were it not for two outside forces. First, Italy, which was among the founding members of the European Community, had difficulty in satisfying the strict criteria laid down in Maastricht for qualifying for the European Monetary Union. Both its debt and its public deficit were extremely large. In order to reduce both, the Italian government was forced to privatize its holdings in state firms to raise funds. Second, European Union rules prohibited government subsidies even to state-owned companies and thus made it hard for these unwieldy conglomerates to continue living off taxpayers’ money. Once again, it was only thanks to external pressure that the power of domestic vested interests was overcome.

The Demise of Financial Markets in Japan

Japan is similar to Italy inasmuch as the large Zaibatsu (translated as “financial clique”) banks seized the opportunity provided by the Great Depression to push forward a consolidation of the banking sector they had wanted since the end of the nineteenth century. The main difference is that incumbents’ interests matched well with the Nationalist government’s desire to concentrate the financial system in the hands of the few, so that it could better guide the allocation of resources toward the looming war effort. The effect of their maneuvers, however, outlasted the Nationalists’ grip on power and survived well into the 1980s.

Before World War I, Japan was making rapid strides toward developing strong financial markets. Until 1918, there were no restrictions on entry into banking, provided a new bank could meet minimum capital requirements. There were over one thousand banks when World War I began, and by 1920, there were over two thousand banks. The five large Zaibatsu banks accounted for only 20.5 percent of the deposits before the war.⁴⁰

While bank competition helped Japan’s development, it did not please everyone. As early as 1892, the chairman of the Tokyo Bankers’ Association asked the Ministry of Finance “to impose minimum capital requirements on banks as a way of erecting barriers to entry and limiting competition in the banking industry.”⁴¹ Until 1927, however, the opposition of the Lower House (Diet), sensitive to the interest of small banks, prevented the passage of any such legislation.

The banking crisis of 1927, triggered in part by political maneuvers, gave the large banks an opportunity to overcome the resistance of the Lower Diet. The Bank Act of 1927 fulfilled the wishes of the largest banks, by requiring that deposit-taking institutions reach a minimum capital level of 1 million yen within five years. By 1932, at the end of this five-year period, there were only 538 banks.⁴²

At the same time as the banking system was becoming more concentrated, the government’s control over it was increasing. This became especially pronounced as the government sought to direct funds toward supplying the war effort against China in 1937. The government could best prevent firms that were not critical to the war effort from obtaining financing by suppressing small banks and arm’s-length financial markets, both of which were hard to control. These motives coincided with the large banks’ interests in suppressing competition from other sources of finance.

The coalition between large banks and the government thus transformed the once competitive Japanese banking system into a concentrated “main” bank system. By 1945, after a period of bank mergers promoted by the Ministry of Finance, only sixty-five banks survived.⁴³ The five Zaibatsu banks’ share of total deposits, which before the First World War had been just 20.5 percent, had increased to 45.7 percent by 1945.⁴⁴

This private-public nexus also played a part in the demise of the vibrant arm’s-length financial markets. In 1929, 26 percent of the liabilities of large Japanese firms’ balance sheets consisted of bonds while only 17 percent was bank debt.⁴⁵ As bond defaults increased, a group of banks together with trust and insurance companies used the poor economic conditions as the excuse to agree in 1931 to make all subsequent bond issues secured in principle. This immediately made it harder for their clients to issue public debt and made them more dependent on their bank for financing. With the acquiescence of the Ministry of Finance, the agreement was formalized in 1933 through the formation of the Bond Committee we have encountered earlier. Giving banks the responsibility for determining firms’ right to access the public bond markets was like giving a fox that resided in a chicken coop the right to determine which chickens could leave.⁴⁶ The obvious outcome was that a flourishing bond market was killed off. By 1936, bonds were down to 14 percent, while bank debt was up to 24 percent of the liability side. By 1943, 47 percent of liabilities were bank debt, while only 6 percent were bonds.

The equity markets were similarly choked through fiat. The attitude of the government toward shareholders is illustrated by the following statement by a bureaucrat:

The majority of shareholders take profits by selling appreciated stocks, sell in times when the price is expected to fall, and often seek dividend increases without doing anything to deserve them. If these shareholders control the directors of companies, influence strategies, and seize a substantial amount of profits, then the system of joint stock companies has serious flaws.⁴⁷

The Temporary Funds Adjustment Law crimped equity issues in 1937 by mandating that companies seek permission before issuing. The Corporate Profits Distribution and Fund Raising Order required firms to seek government approval for increases in dividends if the level of payout was greater than 10 percent, thus making equity unattractive. Still later, the Munitions Companies Act brought companies under the control of government bureaucrats, and they were allowed independence from the shareholders as long as they “worked in the interests of the nation.” Thus, new stock issues, which accounted for 60 to 75 percent of net industrial funding in 1935 and 1936 fell to 20 percent of funding by 1944–1945.

Japan illustrates yet again the point that the arrangements set up by incumbents persist long beyond the immediate crisis that is the ostensible reason for them and long after the demise of the governments that aided and abetted. Once the banks had power, they were unlikely to give it up easily. Despite their best efforts to break up the bank firm combines established during the period of militarization, the postwar American occupying forces could not prevent their reemerging as the Keiretsu, or main bank system. During the war, the government assigned each munitions company to a “main” bank, which would be responsible for ensuring that no financial need went unmet. Of the 112 companies that had descended from wartime munitions companies, the financial institution designated by the government during the war was still the largest lender and one of the top-ten shareholders in 61 of the firms in 1974. In fact, 88 of the 112 companies still had close ties to their designated institution over thirty years after the war!⁴⁸

Similarly, as discussed earlier, the Bond Committee, set up ostensibly to improve the quality of bond issuance during the depression, survived until the 1980s. Even as Japanese industrial firms invaded the rest of the world in the 1970s, their bond markets remained minuscule. As we have seen, it was only in the early 1980s, as Japanese firms decided to borrow abroad rather than depend on their antiquated financial system, that Japanese banks had to loosen their stranglehold. The powers of the Bond Committee were curtailed. The markets had their revenge as the banks paid the price for years of being shielded from competition, made terrible credit decisions, and drove Japan into an economic crisis that still persists.⁴⁹

The Experience in the United States

The U.S. experience represents a useful counterexample. In spite of similar pressure from incumbents, the United States succeeded in limiting the extent to which the financial system (and the economy in general) became cartelized. This is not to say that there were no examples of regulation introduced to limit competition and favor the incumbents—we will shortly describe one of the lesser-known examples in detail—but that the efforts had more limited success than in Italy or Japan. The causes of this different outcome are worth analyzing if we want to avoid future reversals.

The United States was more federal in character. States had a say, and there was political competition among states. Even though barriers had been erected to the flow of goods across national borders, the United States had a nationwide market for goods and services. So state legislation would not restrain the actions of out-of-state competitors and, thus, could only end up hampering local companies. In addition, powerful local politicians, who favored local incumbents, opposed the centralizing tendencies that were rampant in other countries. This was particularly reflected in the financial arena, where there was an old tradition in the United States of opposing the concentration of East Coast financial power.⁵⁰

Another moderating influence was that the 1920s in the United States had been a period of unfettered entry and competition, especially in the financial sector. No single type of institution dominated the financial sector. So any legislation that emerged would necessarily be a compromise among different interests. Finally, checks on political expediency such as the legislative oversight exercised by the Supreme Court also helped moderate outcomes.

That the United States escaped the wholesale antimarket changes that took place in other countries does not mean that political interests were not at work. But because political power was more widely distributed, the legislation that emerged did not reflect the interests of just one set of incumbents. For example, small banks obtained federal deposit insurance, which ensured their stability and capped their funding costs. Large banks had been trying to coordinate limits on deposit interest payments since at least 1905.⁵¹ The Banking Act of 1933 (also known as the Glass-Steagall Act) gave them what they wanted by prohibiting interest payments on demand deposits and limiting interest payments for time deposits. Investment banks benefited from the securities and banking legislation passed in 1933 and 1934. Not only were commercial banks prohibited from underwriting corporate securities, but legislation also reduced competition within the investment banking industry.

It is worth dwelling on this last point, for it goes counter to the belief that the securities legislation in the early 1930s, with its emphasis on disclosure and transparency, was entirely focused on laying the foundations for a vibrant, competitive financial system. It may have broadly done that, but particular interest groups also shaped the legislation for their own benefit. The legislation on securities issuance offers an example of how seemingly innocuous changes in laws can limit competition severely.

Perhaps the institutions that saw their business affected the most by competition during the 1920s were top-tier investment banks, firms like J. P. Morgan and Kuhn Loeb. Before World War I, only wealthy individuals and institutions invested in securities. In this world, prior relationships—in particular, with foreign investors—were key to an investment bank’s ability to place new security in a reasonable time framework. As a result, a few prestigious houses dominated the underwriting of new securities.

The war changed everything. To finance the war effort, the U.S. government issued more than $21.5 billion in bonds over two years, at a time when the total amount of corporate securities issued in the previous ten years was only $16.6 billion.⁵² To place this large quantity of bonds, commercial and investment banks had to sell to people who had never invested in securities before. From 1917 to 1919, the number of investors who held Treasury bonds exploded from 300,000 to 21 million. National City Company (the precursor to today’s Citibank) pioneered retail sales to the middle-class investor and even had a network of salesmen who went door-to-door. These new distribution techniques substantially increased the speed with which new issues could be placed. They also increased competition in the underwriting market.

The predominant way securities were underwritten then, as now, was through syndicates. The lead underwriter for an issue put together a syndicate of underwriters. Syndicate members were bound by an agreement to sell the security at the same time and at the same price. The syndicate effectively combined the investor lists of various houses, thus broadening the market for a security.

As competition increased, however, syndicate members began to seek an advantage over their rivals by violating the provisions of syndicate agreements that specified the timing and the price of the distribution. Not only did they jump the gun, but worse still, they offered investors a better deal by giving discounts, thus undercutting everyone’s profits. In the past, such deviations could easily be identified and punished by the lead underwriter: the market was small, everyone talked to everyone else, and most of the cultured syndicate members understood the value of genteel cooperation. But with the explosion of the securities business and the large volume of issues coming to market, the top-tier houses had no option but to access the retail market by including the new breed of securities dealers in their syndicates. These did not feel bound by tacit agreements not to compete, and detecting their violations became all but impossible in the expanded market.

Even while money-minded newcomers undercut the profitability of their syndicates, the old houses also faced competition from banks that integrated commercial banking with investment banking like National City. These banks could not only sell to the retail investor through their branches but were also reputable enough to be lead underwriters. Given their sales networks, these fully integrated “universal” banks were not as reliant on syndicate agreements to ensure the profitability of their underwriting. Their share in the corporate underwriting business increased continuously during the 1920s.⁵³

The old established houses looked for respite from competition, and the legislation drafted in the 1930s in response to the stock market crisis gave them the opportunity. The Securities Act of 1933 mandated greater transparency and disclosure in underwriting. But in doing so, it also served the purpose of reducing competition in underwriting.⁵⁴ For example, it eliminated the possibility of underwriters’ selling securities prior to the date agreed upon by the syndicate by making it illegal to do any publicity before a registration statement is filed with the SEC. Since the lead underwriter can easily control this date (the registration does not become complete until the final price is fixed), the act provides the lead underwriter with the legal means to prevent preoffering solicitation. The Securities Act also eliminated the problem of secret undercutting by making it illegal to grant undisclosed discounts.

By eliminating the challenges to syndicates and restoring their profitability, the Securities Act favored the traditional investment banks. Perhaps equally favorable to them was the Glass-Steagall Act, which forced their chief competitors, commercial banks, to get out of the business of underwriting. All this legislation led to a significant increase in the degree to which a few traditional players dominated the industry, a dominance that continues to this date.

The political process by which the investment banks obtained this favorable legislation is also worth noting. The Senate Banking and Currency Committee conducted hearings between 1932 and 1934 into abuses in the financial system. The hearings, named after the chief counsel, Ferdinand Pecora, highlighted a number of cases that suggested that bankers behaved in an ethically unsound way, when not actually perpetrating fraud. These cases were meant to highlight only the tip of an iceberg of abuse and were instrumental in preparing the public for the legislation that followed. Even though no segment of the financial sector escaped unscathed, the Pecora Committee particularly went after the commercial banks.

One charge that should resonate in these times was that the combination of commercial banking and underwriting was fraught with conflicts of interest. Since a commercial bank had loans outstanding to firms, it could favor the interests of its own owners in the following manner: if it had bad news about a firm to which it had lent, it could use its underwriting arm to certify and distribute securities on behalf of the firm to an unsuspecting public and get the firm to use the proceeds to repay the outstanding bank loan. Thus, the bank’s owners would escape booking losses on a bad loan. Similarly, its access to its own unsophisticated depositors could be misused, since these depositors could be sold securities that no one who had any reasonable market experience would touch. It was argued in the Pecora Committee that the conflicts of interest inherent in combining lending and underwriting could, and did, lead to an abuse of trust. The view that banks had betrayed the naive retail investor resonated among a public that had lost tremendous sums and led, almost inevitably, to the separation legislated by the Glass-Steagall Act.

The truth is that none of the allegations has stood up to modern scrutiny. Not only is there little evidence of the purported abuses in the specific cases examined by the Pecora Committee, but an examination of a much wider sample of cases indicates that, on average, the banks did not sell any worse securities than comparable investment banks.⁵⁵ In fact, through much of the 1920s, universal banks had been distancing their underwriting arms from their lending arms voluntarily, so as to reduce the appearance of conflicts of interest.⁵⁶ The legislation separating commercial from investment banking was politically, not economically, motivated.

So why was the Pecora Committee so one-sided? Some see the Glass-Steagall Act as part of a continuing American tradition of not letting any financial interests get too powerful.⁵⁷ Perhaps the Pecora Committee was just an instrument in this process. Others have argued that Senator Carter Glass, a prominent member of the committee, wanted to get commercial banks out of the securities business, for they had violated his long-cherished belief that commercial banks would be stable only if they made short-term, self-liquidating loans.⁵⁸

There is a simpler political answer.⁵⁹ The top-tier investment houses were better connected politically. Furthermore, they had not had as much contact with the lay public, and therefore there was less value in offering them as sacrificial scapegoats to a public baying for someone’s head. They were also more respectful of, and cooperative with, the committee. Finally, the Roosevelt administration needed a great deal of information in a short period of time to draft the necessary legislation. The traditional investment banks, already well connected politically, offered to provide this information and thus acquired some ability to influence legislation (and the committee). Perhaps momentous legislation does indeed spring from such mundane causes!

Summary

In this chapter, we have argued that the incentives of incumbents to oppose financial development are muted when a country is open. But what determines the decision to be open? How is it affected by incumbents’ interest? While the same groups that oppose financial development also tend to oppose openness, the decision of a country to be open is also influenced by its neighbors. The constituencies favoring openness will be economically weaker, and thus less politically powerful, when other countries close down, since they lose the incentive to fight for openness when they see their foreign markets vanish. For this reason, world economic downturns, such as the Great Depression, can precipitate a reaction in many countries that can lead to a closing of borders. This simultaneous closing down of borders provides incumbents with the opportunity to reassert themselves.

An economic downturn also increases the number of the needy and the consequent political pressure to act. This pressure provides incumbents with a noble mantle behind which to hide their baser interests. We have illustrated how crisis provided cover for the resurgence of incumbents through the experience of three different countries. In Italy, what was presented as an attempt to stabilize the banking system was really a way for the private sector to rescue itself using public money. In Japan, large banks and the military government colluded to dominate the financial sector. While the military government collapsed at the end of the war, the banks acquired their own empires and survive (albeit barely) today. In the United States, there was more political give-and-take, and as a result, the financial system retained some degree of competition. Nevertheless, competition within various segments of the financial sector fell, and access to financing became more limited.

Especially noteworthy is that in all these countries, the privileges obtained by incumbents long survived the governments that were persuaded to put them in place. Many of the restrictions on competition, introduced in the political heat of the times, took over half a century to undo.

Incumbents were able to turn back the markets against the wishes of the promarket constituencies that had grown during the times when the markets had flourished. In large part, this was because they were backed by those who had lost out as a result of the depression—the unemployed worker, the penniless investor, the elderly pensioner, and the destitute farmworker. Why did these people turn against markets during the depression? Is it possible that they might turn again? What lessons does this episode hold for our times? This is what we turn to next.

CHAPTER TEN

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Why Was the Market Suppressed?

OUR ACCOUNT of the events surrounding the Great Depression and the consequent retreat of markets illustrates two points. First, the reversal in financial development was preceded by popular revulsion against markets. Second, the changed attitude toward markets provided a convenient cover for the resurgence of private interests against markets and competition. While the proximate cause of the reversal might have been the public disaffection with markets, the forms government intervention took and its duration are better explained by the machinations of the incumbents. It took over half a century to undo the constraints imposed on markets during these few years.

Could it happen again? To answer this, we have to understand better why significant segments of the public turned against markets in the 1930s. In some part, the reason was the severity and duration of the depression, especially when contrasted with the stability of the managed economy during the First World War or with Communist Russia, which appeared to be making great strides at this time. The stock market crash, the bank runs, the huge surge in unemployment, which in the United States amounted to over a quarter of the workforce, were severe blows. That capitalist economies were subject to booms and busts was not a revelation: the recurrent crises before World War I had already highlighted that. But the duration of the Great Depression undermined confidence that the system would eventually correct itself.

Equally important in the public’s turning against markets, however, was revulsion against the unmanaged risks inherent in a competitive, free enterprise system. Competition and the process of creative destruction not only increase the efficiency of the economic system, as we have argued, but they also increase the amount of risk that individuals have to bear. Workers experience both the euphoria of plenty when their employer does well and the pain of layoffs when their employer fails. Their skills, honed over many years, can become obsolete in a trice if someone in a far-off land comes up with a better product or manufacturing system. Moreover, even as it increases risks, intense competition jeopardizes long-term economic and social relationships, which traditionally insulate people from temporary adversity.

Financial markets can insure some risks, but certainly not some of the most disruptive aspects of market-induced volatility. The risk of an entire industrial sector’s becoming obsolete, the risk of protracted unemployment, the risk of a major downturn—all these are hard for the private sector to insure. Life will seem nasty and brutish to the unfortunates who are hurt by competition and left without opportunity or succor.

The sheer number of the distressed—the unemployed, the retiree who has lost her savings, the small-business owner who has seen his home repossessed by his creditors—obviously increases during economic crises, and so does their political power. In fact, their political power will increase more than proportionally with their number because, in times of crisis, the distressed can overcome the normal difficulties that dispersed groups have in coordinating their actions. Not only do skilled people, who are capable of organization, join the ranks of the distressed, but they also are well aware that there are many others who are as desperate as they are. Moreover, economic scandals are more likely to be uncovered in recessions, rendering the system even less legitimate in their eyes. The normal barriers to organization—the fear of acting alone, the absence of information about others and the lack of clarity about their intent, the existence of palatable alternatives—all fall at such times. The result is that the distressed organize and exert enormous pressure to address politically the adversity inflicted by the market. And their anger combines with the private interests of incumbents into a strong force against markets.

Could we face such a backlash again? There are parallels between the public distrust of markets then and now: a spectacularly successful energy company going bust (Insull then, Enron now), allegations that financial institutions were overly enthusiastic about stock in which they had an interest (Chase then, Merrill Lynch now), allegations of tax fraud by the most visible managers of the go-go era (Charles Mitchell of National City then, Dennis Kozlowski of Tyco now). Matters, however, were substantially worse then. And certainly the economic system has changed considerably since the 1930s. But it is not without weakness.

The political pressure to curb the markets was particularly strong then because there were no buffers in place to cushion people from the blows inflicted by the market. Fortunately, policy makers in developed countries learned the lesson then that some amount of social insurance is necessary to reduce the uncertainty people face with a competitive market and to reduce the number of distressed in case of a downturn. Unfortunately, they learned this lesson in the midst of two great cataclysmic events, the depression and the Second World War, so that the system of insurance put in place then relied extensively on restrictions on the functioning of free markets. With markets’ having become freer, it is no longer clear that the system of insurance put in place then is adequate.

It is perhaps useful to start by examining why politicians are so quick to impose restrictions on the workings of markets, despite their long-term adverse consequences. The decision on March 5, 2002, by U.S. President George W. Bush to impose tariffs on steel imports ranging from 8 to 30 percent offers a timely case study.

The Steel Tariffs

With total world consumption of steel at approximately 730 million tons in 2001, there is excess production capacity estimated at about 270 million tons in the steel industry.¹ Unless there is a sudden, unexpected explosion in the demand for steel, worldwide production capacity should be cut by one-third. In addition, the steel industry has also seen a sustained increase in productivity. In 1980, a ton of domestically produced steel in the United States required ten man-hours; today, the industry average is less than four.² For an industry whose demand is not expanding fast, such productivity gains have to be accompanied by a drastic reduction in employment. Employment in the steel industry in the United States has indeed fallen by more than 10,000 workers a year for the last twenty years, even while production has increased somewhat: in the year 2000, domestic shipments were 20 percent higher than in 1980.³

Not all is gloom in the industry. While some segments are shrinking, others are expanding. As Federal Reserve Chairman Alan Greenspan reminded Congress, “[W]e really have increasingly two steel industries in this country. One is based on the older technologies . . . and the other is the mini-mills, which are evolving at a very dramatic pace.”⁴ The labor productivity of mini–steel plants is seven times higher than that of integrated producers.⁵ Not surprisingly, their share of U.S. capacity rose dramatically during the last two decades: from 15 percent of the U.S. production in 1981 to 50 percent today.⁶

In a situation of overcapacity, some producers have to close down. In a free market, it will be the most inefficient ones. In the United States, these are the old, integrated producers of steel, household names like U.S. Steel and Bethlehem Steel.

Closure is part of the process of creative destruction, and it is very healthy for the economy, for it clears the way for more efficient production and prevents weak firms from dragging the rest of the industry down with them. But it is also very painful for a few. It is of little consolation to the fifty-year-old steelworker to learn that he is the sacrifice demanded by the gods of efficiency. It is natural that he will blame the system and not his own skills or his luck, and he will do whatever he can to try to redress what he perceives as a fundamental injustice in the system. For this reason, thirty thousand steelworkers went to Washington to plead for help.

There are only 160,000 workers producing steel, while 9 million workers are in steel-consuming jobs. Despite being vastly outnumbered, U.S. steelworkers and firms gained the necessary political support to force the tariffs on steel imports. In light of our earlier description of the power of small, focused groups, this is not surprising. Since the cost of the adjustment falls disproportionately on particular groups while the benefit of having a more efficient system is very diffused, the political influence of the victims of competition is much greater than that of the beneficiaries. Old, integrated steel plants are located in states like Philadelphia, Ohio, and West Virginia that were closely fought in the all-too-close 2000 presidential election. Their unionized voters will be pivotal in the next election, as they may have been in the last. George W. Bush allegedly carried the mostly Democratic West Virginia in the 2000 elections because of President Bill Clinton’s failure to do anything to help the steel industry.⁷ It is clear that politics overcame George W. Bush’s principles when he imposed steel tariffs.

What is surprising, however, is the form of support steelworkers obtained. Instead of direct compensation to workers who would lose their jobs, the U.S. government imposed tariffs to protect fewer than nine thousand jobs in the steel industry, which, according to a study, are likely to cost seventy-four thousand jobs in steel-consuming industries.⁸ The tariffs will also cost consumers an additional $5 billion per year. And this is not a temporary lapse in policy making. The steel industry has consistently benefited from trade restrictions and government subsidies. The trade restrictions imposed in the 1980s are estimated to have cost consumers $6.8 billion a year, while the value of government subsidies received by the industry over the same period amounted to $30 billion.⁹ The tariffs do not have effects only in America. Europe has already started levying its own tariffs so as to protect its steel industry from being overwhelmed with foreign steel denied entry into the United States. Thus, in addition to consumers in the United States, the ultimate losers also include steelworkers in poorer countries like Poland and Bulgaria and their dependents.

Why do politicians not provide direct help to individuals who are hurt by the process of creative destruction? Why do they instead interfere with the process by protecting inefficient firms, thus giving them the resources and the incentives to demand even further protection in the future? After all, it would be far cheaper for the United States to retrain each redundant steelworker, and offer him a hefty pension in addition, instead of imposing costly trade restrictions.

We see two reasons for such responses. One is a matter of form (how it looks), and the other is a matter of function (whom it helps). Consider form first. The costs of restricting competition are largely hidden. It seems victimless because it burdens foreigners, customers, and future potential entrepreneurs, none of whom is politically active (and some of whom are not even present). Steel-consuming industries will indeed protest about how much tariffs will cost the average citizen and how many jobs the industries will lose, but they have a reason to protest. Not only are their numbers potentially tainted by their biases, but they are also obscured by the economics underlying them, which the general public has little time, incentive, or ability to evaluate. From the government’s perspective, the costs are off the balance sheet and will not add red ink to an already swollen budget. And from the perspective of workers who retain their jobs, restrictions on competition are only fair and do not impinge on their self-respect in the way that a government handout would have.

It is therefore in the interests of politicians to obscure the nature of the handout involved and present the case for tariffs as an optimal response by a concerned government. For example, Rep. Sherrod Brown of Ohio declared:

Without immediate action by the President, the situation is dire. Inundated by illegal imports, 29 domestic steel companies have either declared bankruptcy or gone out of business in the last four years. . . . In order for the domestic industry to consolidate and survive, the federal government must vigorously enforce U.S. trade laws. [italics ours]¹⁰

In fact, there is nothing illegal about steel imports. And when representative Brown calls for a vigorous enforcement of U.S. trade laws, he really means that the United States should invoke Section 201 of the World Trade Organization Agreement, also known as the Escape Clause, which allows countries to escape temporarily from their commitment to free trade.¹¹

The alternative, a direct budgetary handout to displaced workers, would be far harder to get through politically. The costs would become very obvious to the average citizen, and she would wonder, “Why them and not me?” In other words, the change in form would short-circuit the public’s tendency to remain rationally ignorant. And as the costs spill over into government budgets, politicians would have to make choices between the workers and other politically powerful constituencies that already have entitlements. Finally, the workers themselves would have to face up to the fact that they are indeed living off the benevolence of society, no matter how much it is in society’s interest to be benevolent.

The second reason for these restrictions is function: while restrictions on competition are not the best way to protect workers’ interests, they are certainly the way preferred by incumbent firms. The steel firms would not be helped if their workers obtained direct handouts. In fact, it would then become far easier to close the firms down. The thirty thousand workers bused to Washington are nothing but human shields used to protect incumbent firms’ interests, at the expense of the vitality of the free market system.

The commingling between protection of people and protection of institutions goes beyond simply current jobs. One of the problems of large, integrated steel producers is the so-called legacy costs—that is, the costs of retirement and health benefits that existing firms have to provide to the six hundred thousand retired workers of the steel industry. There is no theoretical reason to entrust responsibility for worker retirement benefits to firms employing them. In the same way as they pay wages, firms could simply pay the necessary amount each month into a private or public trust fund, which would pay workers on retirement (what in modern parlance is known as a defined-contribution plan). But retired workers who depend on the firm for their benefits are another strong external constituency favoring the survival of the firm, which is why firms are unlikely to dispense easily with them. Incumbent firms have indeed erected an intricate defense of human shields to protect their interests.

What we will argue now is that while the unlikely coalition between capitalists and other sufferers from competition is always possible, it is particularly likely in economic downturns. Recessions reduce the benefits of, and thus the political support for, openness, weakening the strongest force for efficiency. At the same time, recessions increase the power of the distressed. Thus, economic downturns, especially downturns that occur simultaneously across a large number of countries, threaten the political stability of the capitalist system. This is what happened during the Great Depression and soon after, and the consequences of the antimarket reaction lasted for fifty years.

Why Is There More Support for Restrictions on the Market in a Downturn?

Unlike incumbent firms, the others who are hurt by competition are normally a dispersed group with an unfocused agenda. Thus, their ability to influence the political scenario is limited. But in times of economic crisis, several factors come together to give them more power. Their sheer number increases, and they have time on their hands. Equally important, the distressed share the common knowledge that many others are in the same hopeless situation and have similar beliefs about the rottenness of the system: scandals, real and otherwise, are typically uncovered in economic downturns, suggesting that the system might be corrupt (and it is easy for the distressed to convince themselves that the corruption is responsible for their state).

Furthermore, in downturns, acts of destruction, such as the closing down of firms and banks and the eviction of householders, predominate over acts of creation. While the “cleansing” may be necessary for the recovery, these are public events that can catalyze the distressed, already seething with resentment over the injustice of the system. They could well be jolted into organizing. Incumbents, who see an opportunity to channel the anger of the distressed against competition, also lend a hand to organize the distressed. And like an angry mob, once organized, the distressed can be used to achieve ends that go far beyond their original intent: they could become a threat to free markets.

Consider a city riot. While the circumstances under which riots start are complex, two conditions seem to characterize many of them: riots explode when there is generalized discontent and a catalyzing event. Generalized discontent alone is insufficient because the discontented face a severe coordination problem. If one person starts throwing stones at shop windows and turns out to be alone, he is treated as a common criminal and ends up in jail. But if a large number of people act simultaneously, the police will be overwhelmed, the protesters will be treated by the authorities as a political movement rather than a criminal gang, and few will end up in jail. Thus, events such as the 1992 acquittal of the policemen who beat up Rodney King trigger a riot not just because they increase the number of the discontented but also because these events are very public: they create the beliefs that allow people to conclude that others will be willing to act.

Political action by the victims of competition has some similarity to city riots. As long as each individual fears he will be campaigning alone, he holds back, since he knows that he will have to bear a large cost with no likely benefit. Economic crises not only create the general awareness that there are many more like him, with little to lose and everything to gain by organizing, but they also provide signal events around which the protesters can organize. For example, in 1931, unemployment in some areas of Chicago’s South Side reached over 85 percent.¹² Many of the homeless unemployed drifted toward the lodging houses, where they were organized by the Unemployment Council. When funds for unemployment relief were cut by half, the unemployed marched in the streets, and the funds were restored.¹³ Through the early years of the depression in the United States, many such protest organizations arose involving farmer groups, worker unions, and veterans’ movements.

Second, times of crisis also tend to be times when corporate scandals come to light, undermining the legitimacy of the overall system. To understand why, we need to appreciate that corporate fraud often consists of a variant of a scheme devised by Charles Ponzi, an Italian immigrant from Boston. Ponzi became famous in the 1920s for offering phenomenal rates of return—for example, 50 percent on money invested for forty-five days—to people willing to place money with him. He invested their money ostensibly in some complex scheme involving postage stamps that no one quite understood.¹⁴ In truth, there was no such scheme. He simply used the new money flowing in to pay interest on the old money. As long as deposits were growing fast enough, his scheme survived. Eventually, suspicious public authorities forced him to stop taking deposits—at which point, the scheme imploded.

Similarly, much corporate fraud in developed countries, where outright theft is less of a problem, consists of Ponzi-like schemes—for example, accelerating the recognition of future earnings to show higher earnings today, hiding expenses and losses through various accounting gimmicks, and hiding indebtedness in subsidiaries. Management’s ability to conceal deceit depends on the firm’s growing its way out of trouble. By contrast, the magnitude of the necessary deceit increases in bad times as the firm’s performance deteriorates. This then makes it harder to conceal the problems, which is one reason why corporate scandals tend to erupt in bad times. Enron collapsed, in part because all the creative accounting in the world could not help it conceal its mounting losses.

Even perfectly legitimate investments sometimes have a dynamic similar to the Ponzi scheme. As more and more investors got taken in by the seemingly unlimited opportunities of the Internet in the late 1990s, money poured into the sector, driving up prices and increasing the return of earlier investors. The new money boosted the return for the earlier money, seemingly justifying the premise of limitless wealth for investors. But when the inflow of money slowed down, prices plummeted, and the entire phenomenon appeared to be a bubble. With the benefit of hindsight, bubbles are easy to recognize. In the midst of them, however, matters are murkier.

It is easy for politicians rummaging amid the carcasses of corporate disasters to find “scandal.” One can always find fault with business judgment. And when further prodding reveals evidence of seeming conflicts of interest, what is actually reasonable business judgment given the available information becomes cronyism or, worse, criminal wrongdoing. This is not to say that businessmen are without blemish (see the next paragraph), only that outsiders are prone to believing that business judgment is more scientific than it actually is. Much is attributed to malevolence that should rightfully be attributed to uncertainty or even incompetence. The point, however, is that the political witch-hunts that start in downturns tend to further erode the legitimacy of the system of free enterprise and provide cover for antimarket actions.

Of course, the actions of some industrialists and financiers, confronted with a fall-off in performance, contribute to the feeling that the markets are rigged against the common man. On seeing their positions going awry, traders double up their bets hoping luck will favor them, in the process flouting their company’s rules and even the law. Doing precisely this, Nick Leeson, a trader for Barings, took his bank down with him. In an attempt to maintain the phenomenal (and quite possibly legitimate) growth in earnings of its earlier years, the management of Enron resorted to accounting manipulation as the market turned more competitive and true profit margins fell.

With ruin staring them in the face, some businessmen might try anything, even if illegitimate, in the hope that the actions will stave off disaster. But since these are wild gambles, they typically do not succeed, and the subsequent investigations reveal the illegality of the actions. Other, perfectly honest businesses also get tarred.

Finally, the representatives of the people, perhaps compensating for their inertia when the scandal is developing or seeing a path to personal advancement, tend to overemphasize irregularities in their investigations. The insinuation is that these irregularities are the tip of the iceberg when, often, that is all there is. We have already mentioned the importance of the Pecora Committee hearings in setting the political stage for the New Deal financial legislation in the 1930s. While these hearings found little evidence that would directly support the ensuing legislation, they did uncover irregularities and possible tax fraud committed by Charles E. Mitchell, National City Company chairman. While only peripherally related to the issues being investigated, these findings contributed to the aura of illegitimacy surrounding the practices of the financial sector.

In sum, then, downturns help reveal patently illegal Ponzi schemes. Failure itself often tends to be seen as malfeasance rather than bad luck or incompetence: Ferdinand de Lesseps was lionized for successfully constructing the Suez Canal but was hauled into court as a swindler after the failure of his attempt to build the Panama Canal, even if he had possibly spent much more effort in setting the groundwork for the latter.¹⁵ And the possibility of failure may lead normally honest businessmen into dishonest acts. Finally, as with the Pecora Committee hearings in the 1930s, some politicians may try to indict industry at large by highlighting a few unrepresentative acts. All these tend to diminish the legitimacy of the competitive system in the eyes of the victims of competition, a system they already view with jaundiced eyes because of what it has done to them.

As spontaneous organizations of the distressed emerge, professional politicians and political parties attempt to capture their energy toward their own electoral gain. Franklin Roosevelt, as we have seen, was not averse to using antimarket rhetoric to appeal to the distressed. And once the politicians capture power and there is a drive to legislate, incumbents are not far behind in directing legislations toward their needs. Thus, much as a riot can be exploited by a few to achieve goals that are not the intent of the mob—it is interesting how often riots that are ostensibly labeled “communal” in India turn into a targeted destruction of especially irksome rival businesses owned by the minority community—the political organizations of the distressed can be used by those who have a broader agenda.

The antimarket agenda of incumbents is particularly strong in global downturns, when the opportunities for trade and investment abroad are few, making openness less appealing. As protectionism increases, legislation pushed by the demands of the distressed and by incumbents has no need to be constrained by concerns about international competitiveness. It feeds into the natural instincts of politicians to avoid immediate and direct costs rather than the hidden costs of market restrictions. The market is easy prey.

Some caveats are in order before we conclude this section. We have argued that downturns lead to a coalescence of interests. This does not mean that one interest prevails—that, for example, incumbent businessmen fully succeed in capturing the agenda. Even while New Deal legislation in the 1930s attempted to create industrial cartels to eliminate price competition, it also brought in legislation giving unions legal status.¹⁶ In practice, there will be give-and-take, but the common agenda will be for a coalition of incumbents, ranging from businessmen to union leaders to politicians, to suppress the free market.

It need not also be that interests dominate ideas. We do not deny the possibility that the world had become more humane and socially conscious in the 1930s and that some legislation was moved by well-meaning politicians who had the public interest at heart. Our point is that certain sorts of ideas have a better chance of finding fertile ground in which to germinate when the ground is fertilized with the right interests. In the 1930s, the dominant fertilizer was antimarket in character. Let us now describe the kind of economy to which it gave rise in the postwar period.

The Political Response

The Great Depression and the Second World War completely changed perceptions about the political viability of state intervention in the economy. The classical economists had preached that governments would make things worse if they intervened. Instead, the lesson politicians drew from the depression was that governments that followed the prescriptions of classical free market economists to do nothing and let the turmoil run its course were turned out of office. By contrast, those that broke with tradition and intervened to support prices and employment had some success and were reelected. In fact, in a number of countries, more than government-built bridges or roads, it was that most traditional of public works, preparation for war, which restored full employment. At the end of World War II, classical economics was in the political doghouse, while government intervention in the economy’s working had become respectable.

People looked to the government to protect them from the vicissitudes of the now disreputable market. Developed countries set up explicit social security systems, providing old-age, unemployment, and health insurance. This created stable government employment that itself contributed to a sense of economic security. Government expenditures on subsidies and transfers, broadly programs of social insurance and redistribution, went up from 4.5 percent of GDP in 1937 to 8.5 percent of a much larger GDP in 1960.¹⁷ While, in 1910, only 20 percent of the labor force in western Europe had some form of pension insurance, and only 22 percent had health insurance, by 1935, the percentages covered were, respectively, 56 percent and 47 percent, and by 1975, 93 percent and 90 percent, respectively.¹⁸

This system of insurance was set in place during the Great Depression and the immediately postwar years, at a time of stretched government budgets, with competing pressing organized demands for subsidy. There was no way a government could deliver on all its promises if the calls came all at once. Since the government was now the backstop to the market economy, and since its resources were stretched, it was natural that it would try to limit the potential calls on its purse. This meant finding allies that would participate in providing the people economic security. What better candidates than large, established corporations? After all, they had to have been successful to get to their current size. These firms also had enough scale to afford an administrative infrastructure that could provide and track employee benefits. But for these corporations to portray security to a people who had seen household names go under during the depression, their future survival had to be assured.

The solution to which most economies gravitated was the natural one. Given the disrepute the market was in, and the natural predilection of politicians to hide costs through market regulation, the political response was to make common cause with the firms’ owners, managers, and unions and suppress competition. Therefore, the short-run steps that had been taken to deal with the problems of the depression became long-term policy. Industrial and financial cartels were allowed to form, and the resulting high profits for member firms and high wages for union members ensured industrial stability. In the long run, industries would ossify and need further protection (the Steel Tariffs of 2002 were just a mild version), but that possibility was too far beyond the politicians’ horizons to matter.

The Rise of Relationship Capitalism

We shall call the system of managed competition that emerged post– World War II “relationship capitalism.” Competition was restricted, in part, through regulatory bodies that set up entry barriers and mechanisms for firms to collude, as we saw in the trucking industry in the United States, and in part through grand, mediated, economywide agreements among relevant incumbent groups. In many ways, this simply continued the policies adopted during the depression. For example, in Sweden, labor, agrarian interests, industrialists and financiers, and the government came together in 1938 in Saljtosbaden to hammer out a pact. Labor obtained stable wages, policies for full employment, and social services; farmers obtained higher food prices and price supports; while the leaders of the private sector obtained industrial peace and respect for private property.¹⁹

Following this pattern, in the 1950s and the 1960s, the top leaders of the ruling Social Democrat Party, the labor unions, and the Federation of Swedish Industry came together every year to determine the country’s economic and social program for the subsequent year in a private meeting at the summer home of the prime minister.²⁰ These agreements between trade unions and associations of employers ensured that no firm could attempt to undercut others to obtain a competitive advantage. Clearly, such arrangements hurt the public consumer, but they were acceptable because the consumer was also a worker. They also gave power to a few organized interests. In many countries, wages negotiated by unions were automatically extended to nonunion workers. Thus, even though, in France and Spain, only 10 percent of the workers were union members, the labor-industry agreement covered more than 70 percent of the workers.²¹

Large segments of the population were, of course, left out of this pact. Potential entrants and small and medium-sized firms did not have the state support that large firms had. Women and the young, who typically did not have long tenures in established firms, also received short shrift. But the system seemed to work, at least for a while. Not only did it offer more security than the competitive, market-oriented system that many countries had abandoned, but it also seemed to facilitate growth. For a while, it seemed as if one could have it all—growth with security. Harold Macmillan, the British prime minister between 1957 and 1963, led the Conservative Party to victory in the 1959 election with the slogan “You’ve never had it so good!”

In addition to direct regulation of competition—which could go only so far—the government relied on its control over finance to manage the economy. Its powers rested on three pillars. The first was the continuation of both active and passive policies that sought to repress domestic financial markets. Equity and bond issues became subject to government approval and were choked off. Similarly, many countries regulated initial public offerings of equity, requiring companies to have several years of positive earnings before listing. Young companies could clearly not meet this hurdle.

Passive policies toward the markets—the failure to create the infrastructure needed to make the market transparent and fair—were equally important. Before 1990, there were laws against insider trading in only 34 out of the 103 countries with a stock exchange.²² More important, only 9 countries even bothered to enforce the insider-trading laws on their books. This state of affairs persisted even though, as we have seen, the enforcement of insider-trading laws substantially reduces the cost to companies of raising equity finance. The failure to mandate better disclosure standards or to endow the financial system with laws and administrative procedures to protect minority shareholders thus prevented all but the most established companies from accessing the equity market. As a result, even in the 1980s, the average age of a European company entering the equity market was forty years.²³ By contrast, in the United States, the typical venture-backed firm goes public today when it is just five years old.²⁴

Massive state intervention in the allocation of credit was the second pillar on which government control over finance rested. Governments nationalized banks. Across a large number of countries, the government controlled nearly 55 percent of all bank assets in 1985.²⁵ They also offered subsidies to banks that made loans on preferential terms to priority sectors. Such directed-credit programs became common in both developed and developing countries in the 1960s and 1970s. In South Korea, directed-credit programs amounted to over 50 percent of total funds mobilized by the financial system in the 1970s.²⁶ In Japan, subsidized loans accounted for 71 percent of the financing of major industries in the reconstruction years immediately after the war and stabilized at a level of between 10 and 15 percent of financing for the rest of the century.²⁷ In France, three-quarters of all loans to business came from the state, the financial institutions (which were quasi-public), or nationalized banks and their subsidiaries.²⁸ Forty-three percent of all loans were subsidized by the state.²⁹ These figures are from 1979, after twenty-one years of uninterrupted rule by conservative governments and before François Mitterrand implemented his grand plan for bank nationalization!

State control of credit is not intrinsically bad. States may want to expand access to financing—after all, the nationalization of banks is often explained as necessary to allow financing to reach traditionally underserviced segments of society. In practice, however, large bureaucracies are extremely ineffective at funding small or young firms, and government-directed credit (at least the portion that is not frittered away in populist giveaways) typically goes toward the government itself and to established incumbents.³⁰

The third and perhaps most important pillar on which government control of the financial system rested was restrictions on international capital movements. It is useful to see why these restrictions were so important to relationship capitalism and why, in the end, they failed. To their failure, which we describe in the next chapter, we owe in large part the revival of competitive markets in recent years.

The Bretton Woods Agreement

More often than not, economic theories have only an indirect influence on policy: they provide the cloak with which politicians can legitimize what seems reasonable given the mood of the moment. Governments intervened in the working of the economy in the initial years of the depression against the advice of the most respectable economists. But eventually, their actions were supported by perhaps the best-known economist of his age, John Maynard Keynes. In his pathbreaking book The General Theory of Employment, Interest, and Money, Keynes argued that it was quite possible for the demand for goods and services in an economy to fall below the economy’s potential to supply them. The resulting excess supply—as evidenced in the unemployment of men and materials—would not automatically and quickly be cured by a reduction in wages and prices, in contrast to the prescriptions of classical economists. Instead, Keynes claimed, it was the duty of the government to step up at such times and bridge the gap between private demand and supply by providing demand of its own through the public works described earlier.

The emerging Keynesian consensus as the end of World War II came in sight was in accord with the public mood. It required governments to continue to play a substantial role in managing demand—in part, through social insurance schemes. But this seemed somewhat at odds with another important lesson learned from the 1930s. Perhaps the path of least political resistance for a government to increase the demand for goods manufactured domestically was to depreciate the exchange rate so that domestic goods would find a ready market abroad and to impose tariffs on foreign goods so that domestic demand could be forced to soak up only domestic goods. Of course, since all governments could play this game, these “beggar-thy-neighbor” policies eventually made trade seize up, and all countries were left worse off.

While free trade was in everyone’s long-run interest, the United States was especially concerned about the short run. It, unlike other developed countries, had emerged from World War II with its industries and finances intact. It was especially worried that the rest of the world would erect barriers to keep out its goods and financiers. Therefore, it looked to set up a postwar system that would keep borders open.

The Bretton Woods agreement, concluded in New Hampshire in 1944, which set the stage for postwar economic reconstruction, was a compromise. It attempted to bind governments sufficiently so that their policies would not wreck international trade—something the United States strongly desired—while giving them enough autonomy to intervene to fine-tune domestic demand.³¹ The route to the first objective was exchange rate stability: in order to prevent competitive devaluations, the agreement sought to peg exchange rates within a narrow band, giving countries the ability to adjust them only in case of “fundamental disequilibrium.” The International Monetary Fund was set up to lend resources so that countries would have the ability to withstand pressures to devalue while they undertook the necessary adjustment in domestic policies.

The political mood, however, was not one in which European governments could ignore the domestic constituencies that had become organized during the depression. With fixed exchange rates, something else had to be sacrificed or the world would be back between the immovable object of the rigid gold standard and the irresistible force of organized demands for government intervention. The sacrificial goat was the cross-border flow of capital.

If capital flows were unrestricted, Keynes worried that governments would not be able to manage domestic demand easily. While he was concerned about the government’s ability to set the level of interest rates, all kinds of government intervention would become more difficult.³² For example, a government might want to “persuade” private banks to offer cheap funds to certain industries. Instead of providing direct subsidies, it might want to keep deposit interest rates low so that banks would still be profitable and use its many levers of power to direct the loans to favored borrowers. But if savers could simply flee the country toward higher world rates, this subsidization would not take place.

More generally, Keynes believed that free capital flows would limit the extent to which government policies could even hint at redistribution from the rich to the poor. As Keynes put it:

Surely in the postwar years there is hardly a country in which we ought not to expect keen political discussions affecting the position of the wealthier classes and the treatment of private property. If so, there will be a number of people constantly taking fright because they think that the degree of leftism in one country looks for the time being likely to be greater than somewhere else.³³

Therefore, the compromise at Bretton Woods was to strive to open borders to trade but to keep them closed to certain kinds of capital flows. For not all cross-border capital flows were to be discouraged. It was essential for the stability of exchange rates that countries with a current account surplus finance countries with a deficit. Moreover, “productive” capital flows that could be employed in developing a country’s real resources, such as foreign direct investment, were also to be encouraged. Thus, capital controls were meant primarily to prevent a twenty-year-old investment banker from moving money across the world to the country providing the highest returns—what government bureaucrats derisively term speculative capital.

Understanding and perhaps even sympathizing with the compulsions of European governments, the United States went against its bankers and agreed to controls on capital flows (though, in what proved to be important for the eventual demise of controls, in the hope of attracting capital that wanted to flee Europe, the bankers ensured that these controls were not watertight).³⁴ In the absence of the competitive discipline provided by cross-border capital flows, domestic financial institutions obtained a monopoly over finance. Productive firms that were not in political favor could not get finance. Capital controls also took away a significant source of budgetary discipline on governments, thus giving them leeway for constant intervention in the economy. As Keynes announced triumphantly, “Not merely as a feature of the transition but as a permanent arrangement, the plan accords every member government the explicit right to control all capital movements. What used to be heresy is now endorsed as orthodoxy.”³⁵

Who Were the Winners and Losers?

Who were the winners and losers in the relationship system? Unfortunately, the grand bargain that was at its center had so many cross-subsidies built in that it is often hard to disentangle who obtained the benefits and who really bore the costs. In general, however, incumbents—whether they were large firms, unionized workers, farmers, or the aged—gained at the expense of outsiders, such as would-be entrepreneurs, foreign firms, unorganized workers, immigrants, or the young.

Consider, for example, the system of pension and unemployment insurance in Italy until a few years ago. The pension system had two components: one provided by companies, the other provided by a state-run mandatory pension system. The contributions under the private pension system were under the complete control of the company’s owner, who could use them as a cheap source of financing for his own enterprise. Workers thus bore a lot of the enterprise’s risk without being compensated for it. Not coincidentally, this gave them a commonality of interests with their employers in suppressing competition. If we stopped here, we would conclude that employers benefited at the expense of workers. But this ignores the other dimensions of the retirement system.

The state-run mandatory pension system was extremely generous. It was a pay-as-you-go system that offered workers benefits that were much larger than the value of the past contributions they had made. New retirees obtained benefits equal to 80 percent of pretax wages earned in their last five years of employment, which meant that many were better off retired than on the job. And a low retirement age of fifty-five ensured that many did retire from their regular jobs, only to moonlight in the underground economy. And for those who were really impatient as well as mildly unscrupulous, the medical guidelines were loose enough to ensure a disability pension well before the normal retirement age.³⁶ Like a Ponzi scheme, such a system can work as long as there is growth in the economy. Since the initial postwar years were years of growth, workers gained on one side what they lost on the other, and companies were the net beneficiaries. The losers were future generations that would have to bear the cost of government profligacy. But the long run was never a concern in relationship capitalism because, after all, as Keynes had said, “In the long run, we are dead.”

A similar pattern can be seen in the unemployment system. Until 1991, the main source of unemployment security in Italy was a law preventing companies with more than fifteen employees from firing workers without “just cause.” While the unemployed were owed no formal payments, workers who lost their jobs received payments from the Cassa Integrazione Guadagni (CIG). The CIG was originally created in 1945 to supplement the wages of workers temporarily laid off from large manufacturing companies during the conversion from military production to peacetime production. Almost imperceptibly, the CIG was extended to other sectors of the economy and eventually covered permanent, and not just temporary, layoffs. Under this system, the government paid 80 percent of the salary of laid-off workers for a period of three months, extendable for no more than a year. In practice, the coverage period was often extended past the statutory limit, especially when a big company was involved.

Another alternative for a company was to force laid-off workers into early retirement. Not only did the state pension system have to absorb the loss of contributions, but it also had to support the retiree for more years. State-owned companies, such as the post office and the railway system, offered another line of support. These acted as “employer of last resort,” especially in the South, where unemployment is endemic.

If we combine all these elements, the system did protect workers, especially those in large firms, from unemployment. It greatly benefited large firms, which had the flexibility to fire and rehire the same workers during different phases of the business cycle without facing any cost of retraining. But it was extremely onerous for rival medium-sized firms, which were large enough to be prevented from firing but not equally well protected by the CIG. And it was a drain on the government coffers.

Of course, the government eventually had to recover these costs from citizens through higher taxes and higher inflation. It could postpone the unpleasant burden somewhat by financing with debt, but eventually, there would be a day of reckoning.

Summary

Relationship capitalism emerged in much of the postwar world partly because of a general disillusionment with markets accompanied by a war-instilled faith in the power of government, and partly because incumbents rode upon the wave of reaction to craft a system that ensured their survival. The atmosphere of general distrust of the markets was based on experiences then that are eerily similar to the atmosphere in which the Steel Tariffs of 2002 were levied (though clearly, matters were much worse then)—a stock market decline, revelations of excessive enthusiasm by investment banks for peddling favored stocks, spectacular failures by high-flying firms of the previous go-go decade, and allegations of tax evasion and accounting fraud by their management . . .

The system had at its heart a grand bargain. Everyone on the inside had his or her small area of privilege. Enough people had privileges to lose if the system changed to ensure that the system had strong political support. The opportunity and risk inherent in the market system had been replaced by the privilege and stability of relationship capitalism.

Of course, privilege for one citizen is oppression for another. For every mature firm that was protected, an innovative would-be entrepreneur was denied entry; for every old white male worker who enjoyed a safe, well-paid job, a young female from a minority community was denied economic independence; for every pensioner who enjoyed a rich and fulfilling retirement, a poor child was not given the basic nutrition that would make him or her a productive citizen. This is not to say that these choices were conscious or that the system did not benefit some like the elderly who had been traditionally underprivileged. The problem was that there was no natural way in relationship capitalism to alter the system of privilege, so that those on the inside who started out underprivileged did not eventually became overprivileged. And for those on the outside, the denial of access became even more oppressive.

Eventually, however, changes in the external environment and the rigidities of the relationship system combined to bring about its downfall and led to the resurgence of markets that we have experienced recently. It is that to which we now turn. With that, we will have come full circle to today.

CHAPTER ELEVEN

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The Decline and Fall of Relationship Capitalism

IN THE FIRST two decades after World War II, the system of managed competition that we refer to as relationship capitalism seemed to work well: both continental Europe and Japan, where the system had taken deep root, experienced phenomenal rates of growth in a politically stable environment. But the growth in the immediately postwar decades masked three serious problems. First, the relationship system did not encourage dramatic innovation. This was not necessary initially, when the primary task was reconstruction, but assumed much greater importance later. Second, with the market suppressed, there was no clear way to allocate the monopoly profits the system generated. Finally, the system had no easy way to effect destruction—so that resources could be transferred out of dying industries into sunrise industries. Events eventually uncovered these problems.

What brought the demise of relationship capitalism, however, was not just its inherent weaknesses but also the rising pressure for efficiency coming from international financial markets. The Bretton Woods agreement ultimately failed in its attempt to restrict cross-border capital flows. International capital movements, only a trickle in the beginning, became a flood. This created the political and economic conditions for the resurgence of competitive markets we have witnessed in the last quarter of the twentieth century. To understand all this, let us begin by seeing how relationship capitalism actually worked in the area of finance. There is a reason why we focus on this system. We believe that it, not socialism, has been the natural alternative to free market enterprise. To make a rational choice we have to understand its strengths and weaknesses better.

Relationship Finance at Work

Countries like Germany or Japan went much further and for far longer down the path of relationship finance than did countries like the United States or the United Kingdom. By the early 1990s, Germany was still largely a relationship-based system, while the United States and the United Kingdom had become truly market-based financial systems. So an examination of the differences between these countries in the early 1990s helps highlight how relationship finance differs from market-based finance. Crudely put, in the former countries, capital essentially circulated within a set of related firms and institutions, while in the latter countries, firms often have to raise money from, and return money to, arm’s-length parties—hence, the terms relationship finance and arm’s-length finance. Other terms have been used to describe these different systems: Rhenish capitalism versus Anglo-Saxon capitalism or bank-based systems versus market-based systems.

For example, in 1994, only 16 percent of borrowing by firms in the United States was from banks, while 49 percent was through the issue of securities (like bonds and commercial paper).¹ Unlike bank loans, securities are easily traded and are held by investors who typically do not want to have more than an arm’s-length relationship with the issuing firm. By contrast, 80 percent of corporate borrowing in Germany was from banks and only 10 percent from securities markets. Banks, by the nature of their large illiquid holdings, tend to have much closer and longer-term ties with firms.

There were substantial differences on the equity side, too. Between 1991 and 1995, U.S. corporations annually issued equity amounting to 1.2 percent of GDP. By contrast, German corporations issued equity amounting to only 0.04 percent of GDP. Most telling, there were 3.11 initial public offerings per million U.S. citizens in 1995. The comparable number per million German citizens was only 0.08.²

Even the outstanding equity was held very differently. In 1994, individuals held about half the outstanding shares of U.S. corporations, though by 2000, this had fallen to less than 40 percent. Other nonfinancial corporations held only 14 percent of one another’s shares, and banks held virtually zero. Thus the institutions holding corporate shares in the United States are primarily mutual funds and pension funds, which have an arm’s-length investment relationship with the firms they own. In Germany, individuals held only 17 percent, while banks held 10 percent (and also cast the vote for a substantial fraction of the shares held by individuals). Other nonfinancial corporations held an astounding 42 percent of the shares. Thus, other firms and banks, which typically have a relationship that transcends more than shareholding, own a majority stake in large German firms. Because large institutions rather than individuals own shares in Germany, ownership is much more concentrated. The top five shareholders in Germany owned approximately 42 percent of shares in the average large corporation, while the number in the United States was only 25 percent.

The large shareholders in Germany tend to be much more protective of the management along some dimensions. Depending on how one counts, there were only four hostile takeovers of German firms in the second half of the twentieth century.³ The reaction to German steel company Krupp’s proposed hostile takeover bid for Thyssen (also German, also in steel) in March 1997 perhaps explains why. Thyssen immediately lashed out at Krupp’s “Wild West” tactics (in other words, American-style arm’s-length capitalism rather than the more traditional way of backroom consensus). Krupp’s chairman came under vociferous attack and had to defend himself, among other things, from a volley of rotten eggs thrown by irate Thyssen workers. Politicians right up to Chancellor Helmut Kohl became involved, and pressure was put on Krupp’s bankers (who also had seats on Thyssen’s board) to persuade Krupp to be more conciliatory. While a consensus was eventually reached, and the two firms merged with both managements sharing power, the process was much more highly politically charged and protective of the status quo than would have been the case in the United States.

The relationship system differs from a market-based system on two important attributes: transparency and access.

Consider transparency first. When large, friendly firms and institutions oversee decisions made by a firm’s managers, they are likely to feel little need to reveal the firm’s actual state and its decision-making processes to the public. After all, what will the powerless individual investor do other than get upset if some inconvenient tidbit about managerial incompetence is revealed to him? Far better that the interested parties who own, or have lent to, the firm decide collectively the remedial action to be taken to protect their investment. Moreover, unlike the individual, who may have a fleeting relationship with the firm as he buys and sells its stock in the market, related firms and institutions will care about the long-term future of the firm being governed. Finally, too much transparency could bring large outside investors, determined to make changes. This could disrupt the whole system of relationship finance. At least, this is how a German (or Japanese or Swiss) banker might justify keeping investors in the dark.⁴

Because, whatever the merit in the above rationales, the end result in the German system is that the individual investor, employee, or outsider is left fairly ignorant of corporate affairs. In 1989, a study was undertaken to examine whether multinational firms’ consolidated financial statements had fully implemented OECD (Organization for Economic Cooperation and Development) guidelines on disclosure. Sixty-four percent of U.S. firms studied had fully implemented the guidelines on disclosure, but none of the German firms had done so.⁵ Similarly, a committee scoring the annual statements of the largest companies in each country for the extent of disclosure gave Germany a rating of 67 in 1995. To put this in perspective, an emerging market like South Korea received a rating of 68, while the United States and the United Kingdom had ratings of 76 and 85, respectively: Finally, a study comparing the transparency of financial statements from 34 countries over the period 1985–1998 places the United States at the top while Germany is ranked only in the middle of the group.⁶

Recent accounting scandals in the United States have revealed that a number of firms have deliberately sought to mislead shareholders. In Germany, misleading investors is not an aberration but a tenet of policy. The extent to which German accounting and disclosure have been uninformative is perhaps best brought home by the concept of hidden or secret reserves. In years of high profits, German firms were allowed to stash away some of the profits into a special fund without revealing them to the public investor. In bad years, these profits would be brought back into the bottom line. The logic behind such reserves was accounting conservatism—to set aside for a rainy day. But the true reasons were probably paternalism and self-interest: the public investor could not be entrusted with a true and fair picture, for she might panic unduly and take precipitous action (to the discomfort of incumbent management). So her pretty head had to be calmed with smooth earnings, allowing only those large institutions and firms that were close to management to know the true, awful state. And this could be quite different from what the public was presented.

When Daimler Benz, one of the most venerable of German corporations, wanted to list on the New York Stock Exchange in 1993, it had to restate its accounts according to the accounting rules followed by the exchange (rather than the permissive rules followed in Germany). This revealed a lot about the difference between German accounting and generally accepted accounting practices in the United States: a half-yearly profit of DM 168 million turned into a loss of DM 949 million, a difference of DM 1.1 billion of profit over the half year!⁷

In sum, even though households are the ultimate owners of savings, systems such as Germany’s give them little direct or indirect control over where or how their money is invested. Firms and institutional financiers make all their decisions without informing, or seeking the approval of, the ultimate owners, the individual investors. The German banker Carl Furstenberg probably misrepresented only slightly the views of his fellow managers when he said, “Shareholders are stupid and impertinent—stupid because they give their money to somebody else without any effective control over what this person is doing with it, and impertinent because they ask for a dividend as a reward for their stupidity.”⁸

A second difference between the relationship system and the market-based system has to do with limited access. When information about firms is not made publicly available as a matter of course, borrowers already inside the “system” cannot go outside their narrow circle of financial institutions unless they have an impeccable reputation. These constraints can be compounded by legislation. In fact, till the early 1990s, industrial firms in Germany had to obtain approval from the Federal Ministry of Economics for permission to issue commercial paper and long-term bonds. Approval was granted only if the credit standing of the issuer was satisfactory and if the application was supported by a bank. Additionally, a variety of taxes made nonbank finance extremely costly for the average German corporation. So corporations had limited access to finance outside a narrow circle of financiers.

Even with limited transparency and access, however, incumbent firms may have plenty of finance in the normal course in relationship-based economies, with a far lower burden of disclosure and a longer effective maturity of repayment than in the more transparent, free-access, arm’s-length system that exists in the United States. While it is entirely possible that an orgy of mutual back-scratching might lead the related firms that are inside the system to refuse to discipline the incompetent or dishonest managers in their midst, in practice, they seem to sense that it is in their longer-term interest to do so. So even though outsiders are not allowed to discipline inside managers via the device of hostile takeovers, top managers in Germany and Japan are fired about as quickly, and as often, in response to poor corporate performance as are managers in the United States.⁹ If we also take into account the fact that households in financial systems like those in Germany and Japan, till recent changes, had few alternative avenues in which to invest, the inescapable conclusion is that insider firms in a relationship system may enjoy as easy access to finance as similarly sized firms in a market-based system. Consistent with this, studies typically fail to find a difference in the cost of capital that large, established firms face in the two kinds of systems.¹⁰

So do the differences between these two types of systems matter? We believe they do, and they matter most in times of great change.

The Relationship System and Change

Established firms can easily handle incremental change. Extraordinary change, however, typically requires extraordinary measures, both to change mind-sets and to foster actions. Relationship systems may be incapable of both.

To see why they may not have the mind-set to finance change, let us start with an analogy.¹¹ Suppose you just wrote your version of the Great American Novel and wanted to get it published. You could send it to Fusty House, where a couple of editors would look at it and make a joint decision on whether to publish the manuscript. The book would be published only if both agreed. Or you could send it to Chancy House, where editors decide independently. If an editor rejects the manuscript, you have the option of sending it to another editor within the house who will not know the book’s previous history (Chancy’s editors simply do not talk to one another). Clearly, you, as the author, would prefer to send the book to Chancy House, where the book has more chances of getting accepted and any one editor’s biases against it do not doom it. But which house will make the better choice from a business perspective?

The books Fusty House will pick will invariably be of good quality because they will have been through a more rigorous screening process. But Fusty will also reject many more good books than will Chancy House. Chancy will accept more books and, in the process, reduce the likelihood of rejecting good ones. But it will also publish more rotten ones. Which house has the better system depends, as one might guess, on the relative proportion of good and bad manuscripts that are sent to a house and the relative cost of rejecting a good book versus the cost of accepting a rotten one.

If good books are best-sellers and earn millions, while rotten books just cost a few thousands each in returns, then Chancy’s system is better. If good books sell only a moderate amount while rotten books not only cost in terms of returns but also cost the house its reputation, then Fusty’s system is better. Now let us draw the analogy to the financing of innovation.

A system in which there is plenty of public information tends to be like Chancy: it gives new firms attempting new technologies a better chance of obtaining financing. The reason is that there are many investors from a variety of backgrounds, each of whom has the basic information to assess a new technology. While each investor may be biased, and each investor may receive only part of the information that is collectively known, each investor investigates the firm’s prospects independently. Thus, the firm gets a number of chances to attempt to convince investors of the merits of its technology. If the technology is sufficiently new, it may need all those chances to obtain financing somewhere.

The relationship-based system works in a very different way, much indeed like Fusty. Given the paucity of public information and the limited access in a relationship-based system, the firm has, at best, one or two well-informed financiers who can make an assessment. Since information in such a system is generated through contacts rather than posted publicly, those financiers are likely to talk to one another. So while collectively they may have more information and make a better decision about whether to finance the new technology, the firm will not get much more than a single chance to make its case.

If the technology is a minor modification of tried and tested technologies, the payoffs from funding eventually successful technologies is likely to be small, at least relative to the costs of funding failures. A relationship-based system is likely to be better here because it has the ability to probe deeper and screen out most of the likely failures. The system’s conservatism, as reflected in the extreme scrutiny to which innovations are subject, could lead to the rejection of some worthwhile innovations. But this is not very costly relative to the gains from not funding failures. In normal times, when change is incremental (and innovations are as likely from within the establishment as from outside), the relationship system works well.

If, however, we are in a period of extraordinary change, in which revolutionary innovations may enable firms to create entirely new profitable markets, the free-access, market-based, arm’s-length system is better in making sure that most of these get financed, even though many failures will also be financed. The value from the successes far outweighs the costs of failures at such times, so Chancy’s method—using independent but informed evaluations—works better in financing innovation.

One can even extend the parallel to venture capital, the latter being an institution that seems to emerge only in free-access financial systems with high disclosure. Venture capitalists invest only a little at a time. They continue only projects that look as if they will be great successes but quickly cut short those that look as if they will be dogs. Thus, they reap a bonanza from the successful projects while losing little from those that fail. This sort of return profile makes them willing to experiment, much like Chancy. As a result, entrepreneurs need not be dejected by a single rejection by a venture capitalist since there may always be some other venture capitalist who sees things more their way. Successful entrepreneurs in market-based financial systems often have tales, much as successful authors do, of how they peddled their project from door to door until they eventually found a venture capitalist willing to put pen to checkbook.

Venture capitalists themselves, let alone such tales, are rare in relationship-based economies. They are rare because venture capitalists need a reliable system of disclosure, not just because they fund young companies but also because they get their reward only when they grow these firms to the point that they can be sold on the public equity markets. And for public investors to pay an adequate price for the shares that are sold, they have to be confident of what is truly going on inside the firms. Reliable disclosure makes such confidence possible.¹²

In the last few years, the relationship-based financial systems of continental Europe have been changing and converging to the market-based, arm’s-length models of the United States and the United Kingdom. Some of these countries have introduced new equity markets—such as the Neuer Markt in Germany or the Nouveau Marché in Paris.

While some of these markets may have been set up as a response to stock market euphoria rather than as a result of a fundamental change in approach (and did not survive the technology meltdown), what is particularly interesting for our purpose is how the advent of these markets affected the volume of venture capital financing. The volume of venture capital financing went up substantially in the countries that introduced markets with stricter disclosure rules than that previously prevailing in the country.¹³ This is not just the effect of the creation of a new market, since countries that introduced new markets with disclosure rules equal to or lower than the established exchange did not experience such an increase. Thus, better public disclosure makes it easier to finance at arm’s length and makes it easier to fund revolutionary new technologies.

Even if financing is available, however, it is not safe to assume, as we have done, that established firms will want to undertake projects that lead to extraordinary change. Technological change can render obsolete the expertise of those who run the firm: even though IBM’s personal computer set the industry standard, it was Intel and Microsoft that constantly pushed the technology forward and reaped much of the gains. Part of the reason why IBM did not exploit the possibilities in the personal computer better is that IBM’s agenda was set by top management, which had cut its teeth on mainframes. In an attempt to avoid cannibalizing mainframes, management placed constraints on the development of the personal computer, which undermined IBM’s leadership position in the PC industry. For example:

IBM crippled its own Displaywrite word-processing package [for PCs] by limiting its ability to handle electronic mail, which became a hugely popular application. This was back in the days when IBM still thought of typing as something to be done on a mainframe or minicomputer, and the mainframe people wanted to protect their mainframe-based email system, called PROFS, by keeping email off PCs. In addition, mainframe executives argued that the hundreds of thousands of secretaries who had gotten used to PROFS and the mainframe version of Displaywrite didn’t really want any new features.¹⁴

Were it not for Intel, Microsoft, Compaq, Dell, and many others, it is not clear that the personal computer would have been the enormous success it was. Had the development of the industry been left to IBM and to DEC (Digital Equipment Corporation), perhaps we would be still using personal computers as glorified calculators and typewriters.

Young firms are therefore special when there is a potential for extraordinary change because they have no vested interests in the status quo. More disclosure and transparency, and the associated free access to finance, help the emergence of new firms. In stark contrast, the relationship system is particularly bad at giving newcomers a chance. Newcomers invariably have to become part of the system before they can get finance because no one can trust their accounts or will give them access before they pay their dues. No wonder the average age of corporations making initial public offerings on the Deutsche Bourse between 1960 and 1990 was fifty-seven years, an age that would be deemed ancient for American corporations.¹⁵ Within the United States itself, the deregulation of banking to which we alluded earlier in the book led to a substantial increase in competition in the financial sector in states that deregulated. This was tantamount to a shift from an uncompetitive, relationship system before deregulation to more competitive, arm’s-length financing afterward. Not surprisingly, the rate of creation of new enterprises jumped significantly after deregulation.¹⁶

Relationship finance therefore has at least two strikes against it at times of great change. First, the way the system scrutinizes new ventures makes it more likely that more out-of-the-ordinary new opportunities will be left without finance than in the arm’s-length system: decision by consensus is inherently conservative. Second, the opaque nature of the system makes it discriminate against outsiders, especially newcomers. Thus, those who have the greatest incentive to force change have the least resources to do so. Since the players in the system lack both the mind-set and the incentive to innovate, relationship finance is a serious drag in times of great change.

But there is a third strike also. Relationship systems tend to protect mature incumbent firms that get into trouble. In normal times, this lends stability to the system. In times of extraordinary change, this can keep resources far too long in unproductive uses. There is no better example of the ambivalent nature of the protection afforded by financiers to firms—the fabled long-term view taken by financiers in the relationship system—than Sumitomo Bank’s rescue of Mazda in the 1970s.

In 1974, Mazda Motors was in deep financial trouble.¹⁷ Unlike other Japanese car manufacturers, it was ill prepared for the extraordinary rise in oil prices after the Arab-Israeli War of 1973. Its cars used gas-guzzling rotary Wankel engines, many of them giving at most ten miles per gallon, while competing Japanese car manufacturers produced cars with more conventional, fuel-efficient gasoline engines, giving twice the mileage. With the tripling in oil prices, the latter were far more attractive, and Mazda’s sales plummeted.

Mazda’s productive efficiency was also very low. In contrast to the average Japanese automobile manufacturer, which produced thirty cars per employee annually, Mazda produced only nineteen. Its suppliers were equally inefficient.

It was not clear that Mazda’s management was capable of meeting the challenges posed by the crisis. Since its founding in 1920, Mazda had been run autocratically by members of the Matsuda family, and a third-generation family member, Kenji Matsuda, was now president. Unfortunately, he was much less capable than his predecessors, though no less powerful.

Mazda’s managerial weakness came to the fore in its reaction to the crisis. The firm did not cut production and continued to ship to its dealers, with the consequence that very soon, dealers were stuck with a year’s supply of inventory. The company tried to help dealers finance the inventory, but despite this, dealer morale fell, and salesmen quit in droves. The long-term viability of the firm was threatened since auto sales in Japan were highly dependent on personalized selling. Mazda also did not alert its workers to the crisis. Despite its already high costs and declining sales, it increased wages substantially in 1974, which further weakened Mazda’s financial position.

By late 1974, however, the problems were too grave to ignore. Mazda’s main bank, Sumitomo, decided to make its move. Even though Sumitomo had sent two officers to Mazda in early 1974 to familiarize themselves with Mazda’s operations, it intervened massively only in late 1974. It installed its Tokyo office head as Mazda’s executive vice president and put other executives in charge of Mazda’s key operations. It also announced it would guarantee any financing Mazda might need. Finally, in 1978, Kenji Matsuda was ousted, and the manager who replaced him was essentially Sumitomo’s choice.

New management implemented major organizational changes. Mazda’s management control systems were streamlined, costs cut, and suppliers made more efficient. Labor was persuaded to defer some compensation, and some production-line workers were retrained as salesmen. Labor productivity improved dramatically, so much so that in 1981, production per employee was a remarkable forty-three vehicles per year. Sales also picked up, in part because the Sumitomo Keiretsu (the Japanese term for industrial combine) and numerous other interested parties stepped up their purchase of Mazda vehicles. For example, Mazda’s share of taxis in Hiroshima (its home base) increased from 2 percent to 40 percent between 1975 and 1983.

The limited competition in the relationship system was an important reason why Sumitomo could afford to bail out Mazda. Since the market for loans in Japan was far from competitive, Sumitomo knew that if Mazda survived, it would continue borrowing from Sumitomo at a premium. The prospect of these future profits gave Sumitomo a stake in Mazda’s survival. Thus Sumitomo was able to provide Mazda a kind of insurance against economic downturns that would not be available in a more competitive arm’s-length system.

Sumitomo also had other reasons to save Mazda. Its privileged position in the uncompetitive banking system implied a responsibility to share the burden with the government of reducing economic instability. Other client firms also had come to expect that help would be provided if they were in need. A bank that did not play by the rules when it could well afford to do so would soon find business hard to come by.

Was the rescue worth it? Here the answer is more ambiguous. In the short run, Mazda recovered. It may, however, have been a mistake to ignore the signals obtained from Mazda’s poor performance. A reinterpretation of the Mazda example is that perhaps Mazda deserved to be taken over by another automobile manufacturer: after all, it was in trouble again in the early 1990s, when it had to be rescued by Ford! Maybe it should have been shut down, thus reducing the overcapacity with which the automobile industry has been plagued in recent years. Who knows whether the net long-run benefits to Mazda from Sumitomo—the guarantees and the credit, less the interest payments, the tied deals, and the long-term submission to Sumitomo’s direction—were positive? And even if positive, did this deal make sense for Sumitomo’s depositors and equity holders, or for Japan as a whole?

Unfortunately, as we have argued, the relationship system makes it difficult to undertake such a cost-benefit analysis: after all, that is why the system is so attractive to politicians. How does one value the loss borne by other members of the Keiretsu for being “encouraged” to buy Mazda cars? How big are the profits forgone by Sumitomo for spending so much of its managers’ time in rescuing Mazda? It is precisely the opacity of the relationship system that makes it so appealing from a political perspective: it is easier to hide the cost of the cross-subsidies. But it is precisely this opacity that condemns the system to make mistakes. And all the mistakes go in one direction—toward protecting unviable incumbents. The fabled long-term view of the relationship system may, in fact, be very short-term.

In sum, then, the relationship system allows neither dramatic innovation nor necessary destruction. And it has one additional deep flaw. One may not agree with the way the market allocates resources, but there is no denying its impartiality. The problem when the market is dispensed with is that there is no good rule to allocate rewards or punishment. While economic merit is the only criterion in a market system, less quantifiable motives such as solidarity and equity assume importance in its absence. Eventually, whatever the stated objectives, resources and rewards go to powerful incumbents rather than the truly needy or deserving.

Let us now see how relationship capitalism fared and why, despite its obvious appeal to incumbents, it was unsustainable in the long run.

The Decline and Fall of Relationship Capitalism

There is no denying that relationship capitalism seemed to work—at least, at first. Economies grew at tremendous rates in the immediately postwar years. In Western Europe, real per capita income grew 80 percent between 1950 and 1970; in Japan, it grew by 163 percent.¹⁸ What is also remarkable is that this incredible growth was achieved with relatively few social tensions, thanks to the cushion provided by the relationship system.

The relationship system may indeed have been appropriate initially. Workers with stable jobs and safe futures were willing to spend, so consumer demand, which had plummeted during the depression and had been suppressed during the war, got a boost. And on the supply side, the absence of competition did not seem to hurt—at least, initially. In the first few postwar years, the primary task was reconstruction. The next step in much of the developed world was to modernize, to compensate for years of neglected investment, and to catch up with the innovative American corporations, which seemed to dominate the world. The nature of the investments to be made for recovery and catch-up was fairly clear. The innovation that was needed was incremental. As we have argued, relationship systems are fairly good at this kind of innovation. So initially, the market’s role in guiding the allocation of resources could be dispensed with. But the costs of the relationship system eventually became clear as innovation and destruction became more important to the world economy.¹⁹

In the flurry of reconstruction, when economies were growing at a tremendous pace in the 1950s and 1960s, it was easy for incumbents to agree on splitting the pie. There was so much more of it every year that all differences could be papered over. But as growth slowed, disputes over the economic pie increased. Unionized workers demanded more, as did government employees, farmers, teachers, students, the elderly, the poor . . . Companies opened their coffers, and wage costs soared. Governments opened their purse, and the transfers and subsidies column in government budgets grew significantly in the 1960s. From 9.7 percent of GDP in 1960, it went up by over half to 15.1 percent of GDP in 1970 for developed countries.²⁰ The consequence of corporations’ and governments’ trying to reconcile the enhanced expectations of their workers or citizens with their now more limited budgets was rising inflation.²¹

The quadrupling of oil prices by OPEC countries in 1973 created a new problem for economies already struggling with stagnation and inflation (“stagflation”). Many industries had to be restructured. But in a system of relationship capitalism, there are few price signals to indicate which firms deserve to be shut down. Moreover, the system is geared toward bailing out rather than closing down the distressed, partly because firms are such an integral part of the social security system and partly because incumbents have so much political clout. Economies became weak because they could neither obtain the information to know which firms to close nor summon the political will to effect the necessary destruction.

Even though there were inner stresses within the system as relationship capitalism faced difficulty in allocating rewards in slowing economies, and even though the system became increasingly inefficient as it could not withdraw resources from declining industries, there was great stability built into the system. Because so many benefited from it, and those who did not had little organization or voice, it was unlikely that internal contradictions alone would cause it to break down in countries where it was deeply entrenched. But a new challenge was coming from outside, which ultimately forced change: the breakdown of the Bretton Woods system.

The Bretton Woods agreement did succeed in increasing the volume of trade, so domestic economies faced increasingly fierce foreign competition. But Bretton Woods also ultimately failed in its attempt to suppress cross-border capital flows, and this compounded the degree of competition. It is instructive to understand why Bretton Woods failed, for it was loopholes in the original Bretton Woods agreement that gave capital a chance. The small crack in the Bretton Woods architecture widened over time and ultimately brought down relationship capitalism.

At Bretton Woods, Keynes had proposed obligatory cooperative controls on capital. In other words, if somehow private French wealth could evade French capital controls and find its way to the United States, under a cooperative system, the United States would be obligated to return it to the French authorities. These draconian measures would have made the system of capital controls leakproof. Pressure from the U.S. delegation, especially the bankers, however, ensured that this proposal was watered down in the final draft and effectively rendered inoperative. This was the crack in the system.

In the late 1950s, a market started up in London whose primary virtue was that it was free of government interference and control. The market originated when the British government, in order to protect the value of the pound sterling, imposed restrictions on the ability of British banks to finance trade among countries outside the sterling area. The banks then met the demand for loans, and skirted the capital controls, by offering dollar loans against the dollar deposits they had from foreign depositors. Thus was born the Eurodollar market, initially a short-term market in which dollar deposits and loans were made.²²

The market obtained further impetus during the Cuban missile crisis, when Russian banks, which were afraid of having their American accounts frozen, shifted their dollar reserves to London. For British financial authorities, beset with the weakness of the sterling and the need to maintain capital controls, the Eurodollar market provided an attractive way to restore London’s position as a premier financial center. As a consequence, they regulated with a light hand, providing legal and supervisory support whenever needed.

But perhaps the greatest support to the market was given involuntarily by the United States. As the United States started running deficits during the 1960s to finance the war in Vietnam, dollar holdings outside the United States ballooned. To prevent dollars from leaving the country at an even greater pace, the U.S. government imposed an interest equalization tax on purchases by Americans of foreign securities. The tax essentially raised the effective annual cost to foreigners of borrowing in the United States by one percentage point.²³ As a result, foreign borrowers now turned to the Eurobond market.

As the United States became more desperate to staunch the outward flow of dollars, the measures to stop citizens lending to foreigners became ever harsher. In 1965, “voluntary” restraints on foreign lending by U.S. banks were introduced, extended to other financial institutions, and made compulsory in 1968. Initially, the U.S. banks met the foreign demand for dollar loans through their overseas dollar deposits, thus evading the new capital controls. But they soon discovered that the Euromarket also enabled them to evade domestic restrictions such as reserve requirements and the interest rate ceilings on deposits imposed by depression-era regulation. United States banks were not the only ones to be attracted to the Euromarket. For multinationals, the Euromarket provided a convenient location to maintain dollar balances earned abroad, without fear that their use would be restricted by future government action.

Despite being inconvenient at times to either the United States or the United Kingdom, the Eurodollar market thrived. It was on British soil, but eventually, many of its major players were American. So neither country could unilaterally close it down. And with both countries competing to make their financial centers dominant in the world and attract international finance, they could not make common cause to shut it down.

With the increase in cross-border trade, the volume of rootless capital also increased. Multinationals could delay or hasten the timing of payments and receipts, and trade could be overinvoiced or underinvoiced (an importing firm desiring to keep capital abroad could simply ask the supplier to bill it more than the true value of the goods and place the difference—the extent of overinvoicing—in its name in a foreign account). All these actions created pools of capital that could be deployed. The Euromarket provided a legal venue from which, and to which, capital could flow without being subject to national regulation. Even before the formal breakdown of the Bretton Woods agreement, and despite the existence of formal capital controls, these markets could supply large firms in a country with finance that had no national strings attached.

As capital became more mobile, governments started losing control over certain policies. In the fixed exchange rate regime mandated by Bretton Woods, a country’s ability to maintain low interest rates and favor particular industries was threatened if savers could take their money to the Euromarket and if those who were denied credit by the government could borrow there. Similarly, macroeconomic management—squeezing inflation by maintaining high interest rates—was made more difficult if the high interest rates attracted a flood of capital from outside.

In 1971, the Bretton Woods agreement collapsed, as the U.S. government suspended its commitment to convert dollars to gold at the price of $35 an ounce. While the reasons for its demise are not relevant for our story, it is relevant that cross-border capital movements hastened its end. In response, countries clamored for a general tightening up of capital controls, as they saw their freedom of policy action becoming constrained. They also demanded action against the Euromarket, the base for what they saw as unwarranted speculation. But by this time, the United States, seeing an opportunity to reestablish itself as the world’s premier financial center, had become a staunch supporter of fully open borders. The official U.S. view in the 1973 U.S. Economic Report of the President to Congress now was:

[R]estrictions have a distorting influence whether they are focused on trade in commodities, in services, or in assets (the capital account), and this parallelism should be recognized in the rules governing the reformed international monetary system. In contrast, the provisions of the earlier [Bretton Woods] system made a sharp distinction between controls on trade and other current transactions and controls on capital transactions.²⁴

Cross-border capital was no longer a pariah. The United States’ enthusiasm was not entirely on principle. It clearly saw opportunity for its own financial sector in intermediating the potentially large flows of capital that were building up.²⁵ It became almost evangelical, preaching openness at international forums while holding up cooperative international attempts to control these flows. With the largest economy in the world not willing to control these flows, and with substantial activity already taking place across their borders with the Euromarket, countries had little choice but to open themselves up. By the late 1980s, much of the developed world was open to cross-border capital flows.

The point is that the halfway openness to trade but not capital mandated by Bretton Woods, which created space for government intervention and brought domestic financial markets under government direction, was possible only if there was cooperation among countries. But because of the desire of some countries to attract financial business to their shores, cooperation broke down, and the plan to promote trade at the expense of finance proved unviable in the long run.

As feared by Keynes, the emerging cross-border flows started imposing discipline on governments. It is useful to outline the nature of this discipline a little better. Foreign investors are not stupid enough to demand a blind uniformity of governments or countries. Contrary to the common allegation of critics, international investors do not demand that all countries should have the same social security system, the same securities laws, the same national brands, the same food, the same theater . . . They demand, however, that government decisions be transparent and advance the interest of the country’s economy—after all, this is what would give investors the most confidence in the security of their investment.

Governments complain all the time about speculative short-term investors who sell their investments and depart the country without understanding government policy. These complaints sound much like those of firm managers who wail plaintively that the stock market undervalues them. In truth, investors are far savvier than they are given credit for. Their departure usually signals that government policy is both opaque and targeted at appeasing certain interest groups. Since foreign investors have little clout in domestic policy circles, their only weapon in opposing these policies, which are often against the national economic interest (and hence left opaque by the government), is to depart. It is not that they do not know or do not understand; it is that they understand too well.

Of course, fleeing foreign investors cause a rapid fall of the country’s exchange rate. To retrieve the situation, the government must either explain why its policies are not detrimental or change them. This, then, is the source of discipline. For governments in relationship systems, it meant they could no longer continue to direct subsidized credit toward favored large firms or promote the cartelization of entire industries. Such actions hurt the economy at large and were possible only when capital controls protected and disguised such malfeasance.

With large firms no longer protected, competition heated up, and innovation became more important, as we have described in Chapter 3. Advances in information and telecommunications technology, as well as in management, meant that corporate innovation could no longer afford to be incremental. The deficiencies of the relationship system in promoting disruptive innovation came to the fore, compounding the problems we have already noted—that the system did not offer a relatively objective way to allocate surplus in a slowing economy and it did not offer an easy way for resources to be withdrawn from dying industries and firms. Countries knew that they could not realistically contemplate the option of unilaterally withdrawing from the world economy, given its potential future growth. Therefore, they had to become more competitive or watch their national industries perish. With at least three strikes against it, countries knew they had to dismantle the extensive regulatory infrastructure that made the relationship system possible. Free markets were again in ascendance.

With competition becoming legitimate, the malign neglect of domestic financial markets became history. One fact to which we have already alluded in fragments summarizes well what could happen if the powers that be became interested in developing financial market infrastructure: the number of countries (in a sample of 103) adopting regulations against insider trading shot up from 34 to 87 in the 1990s. The growth rate in the number of countries enforcing these laws was even higher, going from just 9 to 38. And enforcement, more often than not, followed the opening of economies to capital flows, suggesting that openness was a factor in promoting regulatory change.²⁶ It is not just a coincidence that financial markets boomed all over the world during this period. All they needed was the dismantling of political barriers.

The Effects on Economic Security

Since the security provided by relationship capitalism relied intimately on the absence of competition, it is useful to see how the breakdown of the system changed economic security. We described how the Italian system was supported by subsidies from the government, which was paying for them through higher debt, higher taxes, and higher inflation. Increased international capital mobility, however, limited all these sources of government finance. When capital is free to move across borders, it naturally moves where it expects to be treated better. Since large budget deficits signal current and future taxes and/or inflation, capital shies away from countries that lack fiscal discipline.

Of course, the first reaction of a country faced with an exodus of capital is to contemplate reintroducing capital controls. But this is problematic in the new environment. First, capital controls can only force domestic capital to stay, but they cannot force foreign capital to come in. In fact, they will certainly scare away foreign investors who desire liquidity. Second, when international capital markets work, it is very difficult for a country that is open to trade to prevent capital flight. Underinvoicing of exports and overinvoicing of imports soon become a national sport. Any attempt to prevent these activities only increases the bureaucratic burden imposed on citizens, without stopping the exodus of capital. Italian students will well remember, as one of us does, all the different forms one had to complete in 1987 to get permission to obtain foreign exchange to pay the small application fees to U.S. universities!

Without cooperative controls on capital, it was impossible for a single country to restrict capital movements unilaterally. Hence, even Italy had to give up controls and set its budgetary situation in order. This process was made politically imperative in Europe because the Maastricht Treaty, signed in 1991, required countries joining the European Monetary Union to set their budgetary houses in order. Italy had to bring its fiscal deficit below 3 percent of the GDP. This gave Italian politicians an additional excuse to tighten their belts. But it would be wrong to attribute the change in Italy solely to the treaty. In a world where capital is mobile, Italy had no choice. Had it chosen not to join the Euro, Italy would have had a harder time convincing capital to stay, forcing even tighter fiscal discipline.

With the government’s hitherto limitless pockets emptying, the system was forced to change. In 1991, the quantity of “temporary” unemployment insurance was reduced, and tighter limits were imposed on when it would be available and when it would be extended. In 1992, state agencies, such as the postal and railway systems, were transformed into corporations. This seems like a minor change, but a corporation, when insolvent, can be liquidated. And state-owned companies could no longer count on the government’s bailing them out. Not only did the need for fiscal discipline limit government intervention, but also the European Union started to fine countries that subsidized firms. State-owned companies, faced for the first time with the prospect of default, lost any desire to act as “employer of last resort.”

There were other changes. Reforms in 1995 and 1997 made the pension system less generous, and early retirement was no longer an option. To minimize the pain imposed on workers by pension reform, the government allowed workers to choose where their new contributions to the corporate pension would go. This took away a cheap source of financing for companies.

With the state subsidy that papered over all problems vanishing, the inefficiencies of relationship capitalism became more obvious. Employers, having lost their cheap source of internal funds and their ability to dump excess workers on the state, lobbied for legislation that would rid them of the constraints they had tolerated for so long. Political support for right-wing parties that promised deregulation increased. And the government has attempted to meet these new demands, most recently by proposing legislation giving companies the flexibility to hire and fire workers.

Overall, Italy, like many other countries, has become more market-based, more flexible, and more efficient. This has certainly hurt the grand coalition that benefited from the relationship system, for it has lost the cozy certainties of yesteryear. But the large minority who were left outside the system and thus squeezed by it—the would-be entrepreneurs, the young, the foreigners—have come into their own. And society is better off in many ways, as we saw in Chapter 3, for it can freely harness the talents of all its citizens rather than only the talents of a privileged and shackled majority.

Ideas versus Economic Forces

In emphasizing the fundamental importance of economic and political forces in the rise and fall of the managed economy as well as the parallel fall and rise of finance, we have skirted the role of ideas. Others, by contrast, have seen the economic events of the twentieth century as a battle of ideas, Keynes versus Hayek, Friedman and Stigler versus Marx, and so on. Keynes himself suggested that he belonged to this camp when he wrote:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. . . . Sooner or later, it is ideas, not vested interests, which are dangerous for good or evil.²⁷

We do not dispute the fact that ideas eventually matter. But in history as in stand-up comedy, timing is everything. Politicians espousing particular ideas do not come into a position of authority unless the circumstances are ripe for them and the vested interests are either supportive or overcome. Hayek wrote The Road to Serfdom, his searing critique of the managed economy, in 1944, but it was only with Margaret Thatcher’s accession to power in 1979 that a major government was willing to espouse his ideas. Did it take so long for his ideas to be recognized, or were the circumstances just not right?

It is economic and political circumstances that open the way to leadership for charismatic politicians like Margaret Thatcher and Ronald Reagan. Deregulation and the taming of inflation are two economic successes with which Reagan is credited. Yet the deregulation of airlines and trucking took place under his Democratic predecessor, Jimmy Carter. And it was Carter who appointed the eventual hero of the fight against inflation, Paul Volcker, as chairman of the Federal Reserve. Our point is simply that the move toward markets preceded the leader who is seen as one of their saviors. As described in this chapter, the revival of markets had much to do with the weaknesses of the relationship system—its inability to allocate rewards, leading to growing inflation, and its inability to reallocate resources, especially in the face of an enormous adverse shock like the 1973 oil price hike. At the same time, the increasing flow of international capital because of competition between London and New York for supremacy as financial centers further highlighted inefficiencies in the old system. The breakdown of Bretton Woods was the beginning of the end for relationship or managed capitalism.

That said, ideas are not unimportant. Ideas offer a template when the circumstances are right. They also have other uses. They give a veneer of academic respectability to a predetermined agenda or an overlay of moral justification to what is otherwise indefensible. Even someone as rapacious as Philip IV had to undermine the Templars’ reputation for moral integrity before stripping them of their assets. Not doing so would have allowed the population to easily overcome their rational ignorance and see his action as naked expropriation. Perhaps one benefit of reading this book is that our readers will be able to discern more easily the self-interest in antimarket actions that are cloaked with public-interest rhetoric.

And politicians are also not unimportant. Few would have had the determination of a Margaret Thatcher in standing up to the radical unions, or the golden voice of a Ronald Reagan, who managed to convert complex themes into simple and stirring ideas. But attributing too much to them and too little to economic forces is dangerous. For example, there are many who want to slow down the movement of global capital through some kind of new global architecture along the lines of Bretton Woods. What they do not realize is that the free flow of capital may be the key to preserving much of the liberalization they value and take for granted. To restrict capital flows may be to push us back toward the days of relationship capitalism. Those who trust in the current crop of politicians and their promarket leanings alone, without recognizing the economic forces that have made them relevant, would not recognize this danger.

There is one last point worth noting. For those inside the relationship system, the world was indeed safer. Some have expanded this into a full-blown critique of the market economy, arguing that it does not allow for the same level of safety.²⁸ In some ways, this is irrefutable. Insiders were safe because they were privileged. This is, in part, why so many of them are against the process of opening up that is broadly termed “globalization.” It was the outsiders in society who bore the risk, not only of short-term economic volatility but also of inevitable long-term decline. But taken as a whole, therefore, from the perspective of both insiders and outsiders, and considering that without change, the long term was bleak, it is not immediately obvious that the move to the market economy has increased overall economic risk.

There is a more specious argument that is sometimes made. Critics of markets argue that competition requires that workers be left uninsured, increasing the risk they ultimately bear in the market economy.²⁹ The logic these critics offer—that competition demands that workers be constantly threatened with the prospect of starvation, else they will slacken off—takes a very dim view of workers. Since competition pushes everyone toward “best” practices, these critics suggest that the world will inexorably move toward the practices in the country with the least amount of social insurance. These ideas are reflected in the widespread fear that “unfair” competition from workers in developing countries will force developed countries to cut down on social security.

This fear is not realistic once one moves away from a medieval view of incentives. Fear is not the best motivator and is probably quite ineffective or even detrimental in a variety of situations. If a worker is less anxious about the future, she may invest more in building firm-specific human capital and work more enthusiastically and creatively. So a country can be more productive when it provides its citizens insurance. Since productivity determines who wins out in the long run, competition from countries that do not provide their citizens security need not drive the level of social insurance in other countries to zero. Though it is true that competition makes certain forms of informal insurance more difficult, by no means does it rule out all insurance.

Workers in developed countries do have to worry about the possibility that some social insurance they currently enjoy may in fact be excessive, consisting of entitlements they acquired in the grand bargain offered by the relationship system when markets were far less competitive. Certainly, these entitlements will come under competitive pressure from workers in developing countries, but the pressure is no different from the pressure on excessively high wages.

This does raise the point, however, that many of our systems of social security were structured for a different world—a world of managed competition. The market economy does introduce a variety of risks that were not a concern in the relationship system. How to prepare citizens better to meet these new sources of volatility in their lives is the subject of the next two chapters.

Summary

We have now come full circle. In the first part of the book, we described the changes that have taken place in finance in recent decades and how they have affected the lives of people. We then asked what circumstances helped a financial system overcome the political constraints that kept it underdeveloped. Having seen how financial development could take place, we then raised the possibility that financial development could be reversed and described the circumstances under which that had happened in the 1930s. In this chapter, we described the relationship system that emerged to provide the insurance that was demanded by citizens after the experience of the Great Depression. It was a system that was cobbled together to meet pressing demands, without thought for the long run. The system worked well initially, but it survived unchanged into the long run, when its deficiencies became apparent. Because it could not respond, either to the macroeconomic changes that took in the late 1960s and early 1970s or to the revival of finance and cross-border competition, it is now history in many countries.

The lesson we have learned is that markets are not all-conquering. Antimarket coalitions can build up and gain strength because markets do have their weaknesses. That markets have revived in recent years is, in no small part, due to the fortuitous set of macroeconomic disturbances that highlighted the weakness of the relationship system. Moreover, they have revived only after decades of being suppressed. The good news is that it takes the concerted actions of the most important nations to “ban” competition, so we can rely on national self-interest to break down such cooperation eventually. The bad news is that competition can disappear for a long time. We have to take more care to shore up the market’s defenses. But we first have to understand where the threats to the market economy can come from today. And this is what we move to now.

PART FOUR

———————

HOW CAN

MARKETS

POLITICALLY?

CHAPTER TWELVE

———————

The Challenges Ahead

FOR NEARLY TWO centuries, scholars and politicians have debated the future of capitalism. Its critics, most prominent among them Karl Marx, have seen capitalism as intrinsically unstable, full of contradictions that will lead eventually to its collapse. Its supporters see it as the best way to allocate resources and rewards. Some even hint that the democratic capitalistic society is not just a phase in the historical evolution of economic systems but its ultimate end.¹ In the middle are all those searching for a “third way,” a kinder and gentler form of capitalism or a more market-driven form of socialism.

Our view in this book, which draws in many ways from a long tradition at the University of Chicago, has elements in common with all these positions, though it does not identify fully with any of them. We do think that capitalism—more precisely described today as the free enterprise system—in its ideal form is the best system to allocate resources and rewards. But the forms of capitalism that are experienced in most countries are very far from the ideal. They are a corrupted version of it, in which vested interests prevent competition from playing its natural, healthy role. Many of the accusations against capitalism—that it oppresses workers, that it creates private monopolies, that it is only an instrument for the rich to get richer—relate to the corrupted, uncompetitive systems that exist rather than a true free enterprise system.

Yet this cannot be a defense of capitalism, in the same way as the socialists cannot claim that the near inevitability with which socialist regimes turn repressive and kleptocratic is not intrinsic to the system of socialism but an aberration. If socialism is fundamentally flawed in its belief in the perfectibility of man, in its belief that man will overcome his narrow individualism and become an expansive social being, is capitalism also not fundamentally flawed in its belief in the perfectibility of markets, in its belief that markets will overcome the narrow interests of their participants and survive free?

We do not believe that capitalism is fundamentally flawed, because we believe that markets can be given the political support to remain free. Much of this book has been about why that support is necessary: markets cannot flourish without the very visible hand of the government, which is needed to set up and maintain the infrastructure that enables participants to trade freely and with confidence. But who has an interest in pushing the government to support the market? For even though everyone collectively benefits from the better goods, the services, and the equality of access that competitive markets make possible, no one in particular makes huge profits from keeping the system competitive and the playing field level. Thus, everyone has an incentive to take a free ride and let someone else defend the system. A competitive market is a form of public good (a good, like air, that is useful but hard to charge for), and somewhat paradoxically, collective action is needed for its maintenance.

Given its dependence on political goodwill, democratic capitalism’s greatest problem is not that it will destroy itself economically, as Marx would have it, but that it may lose its political support. Capitalism’s biggest political enemies are not the firebrand trade unionists spewing vitriol against the system but the executives in pin-striped suits extolling the virtues of competitive markets with every breath while attempting to extinguish them with every action. Adam Smith recognized the inexorable tendency toward suppressing competition when he wrote, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”² Unfortunately, all too often and in all too many countries, the conspiracy enlists the help of the state in enforcing limitations on competition.

These limitations are best seen in the constraints placed on financial markets in country after country, over much of history. Free financial markets are not only problematic for incumbent financiers but also spawn competition for incumbent industrialists—hence, the need to suppress them directly by legislative fiat or keep the institutions they need underdeveloped.

Marx also understood that capitalists would enlist the power of the state in securing their position when he and Engels wrote in The Communist Manifesto that the government is essentially “a committee for managing the common affairs of the whole bourgeoisie.” But he thought that the problem was specific to bourgeois democracies and would disappear in a socialist state. Unfortunately, all the socialist revolution did was to change the identity of the elite and strengthen their hand by eliminating not just economic competition but all semblance of political competition.

Given all this, free enterprise capitalism is not the final stage of a deterministic process of evolution. It is better thought of as a delicate plant, which needs nurturing against constant attack by the weeds of vested interests. It is useful to consider where the weeds might spring from in the future, for that will help us build the appropriate defenses.

The market is threatened by two diverse groups: the incumbents, who want to retain their position and thus have a strong incentive to suppress any potential source of competition, and those who lost out, who would be happy if the rules of the game that caused their troubles were changed. The long-term feasibility of free markets rests on reducing the incentives of each of these groups to proceed against the market and limiting their chances of success if they do proceed.

The way to limit the chances of success of vested interests is not to expand the power of the state but to narrow its ability to take inefficient economic actions favoring the few at the expense of the majority of its citizens. In the same way as inefficient economic entities are forced to improve by competition, inefficient governments can be forced to improve, not so much by competition in the political arena, where the committed few can organize and thwart the will of the majority even in a democracy, but by forcing their subjects to compete in the economic arena. A powerful device to achieve this is to keep borders open to the flow of goods and especially to the flow of capital. The country’s capitalists will then feel the impact of bad government policies, and they will become a force for good, market-liberating reform. The move by many countries in the last thirty years from a centrally managed, relationship-based economy with a heavily controlled financial sector to a free market economy with vibrant financial markets can be attributed to both the increasing trade and the increasing international financial flows across the world.

But open borders spawn political opposition themselves. Technological change and increasing international competition will create entirely new categories of the distressed. Can the political opposition be contained? And what are the biggest political challenges to markets in the years to come? That is what we turn to in this chapter.

Can the Interest Groups Be Contained?

Before we describe the looming challenges, it is useful to see an example of how economic institutions can adapt to defuse the incentives of interest groups to coalesce against market forces. Consider the evolution of the U.S. bankruptcy code in the nineteenth century. The economic role of bankruptcy law is not just to provide a mechanism for creditors to collect their money but also to offer a form of insurance to debtors, relieving them from some of their debt burden when it becomes overly oppressive. When a borrower owes so much that he has small hope of repaying it, he will have little incentive to exert effort to earn money, because any extra dollar earned, while requiring his blood and toil, will simply go to repay creditors. Both debtors and creditors may be better off in such situations if some of the debt is forgiven or renegotiated down in a bankruptcy proceeding. Debtors will have an incentive to work harder if they know there is some chance of repaying their debt and keeping their business, while creditors will get something back instead of nothing at all.

A modern bankruptcy code provides a mechanism by which debtors can get relief. In providing this flexibility, somewhat paradoxically, bankruptcy legislation enhances the security of property in two ways. First, it allows creditors to charge up front for the possibility that they will have to offer relief, thus protecting their property. At the same time, it heads off any need for debtors to organize politically, preventing them from arbitrarily wiping out their debts. This further enhances the security of property and the sanctity of contract.

But in early-nineteenth-century America, the contractual environment was not developed enough that a debtor could simply file for bankruptcy and escape his debts. Information about debtors was poor, few institutions existed to monitor them closely, the markets for repossessed assets in the nascent economy were limited, and the country was large enough that bankrupts could wash away their stigma by simply moving. If lenient bankruptcy laws had been perpetually in place, debtors would have had less resolve to pay, creditors would have pushed up interest rates to compensate, and fewer ventures would have been profitable enough to finance. Economic activity would have dwindled as credit dried up.

As a result, during much of the nineteenth century before the passage of the Bankruptcy Act of 1898, which forms the basis of the current law, there was no formal federal bankruptcy law in place in the United States. Instead, in periods of severe economic crisis, the sheer number of distressed debtors and their miserable conditions grew. As one contemporary described the 1837 crisis, “Society has played out its last stake; it is checkmated. Young men have no hope. Adults stand like day-laborers idle in the streets. None calleth us to labor. . . . The present generation is bankrupt of principles and hope, as of property.”³ The political pressure exerted by the distressed forced Congress to respond. Through much of the nineteenth century, federal bankruptcy laws were enacted in response to harsh business conditions, only to be repealed soon after. The passage of the Bankrupt Act of 1800 came soon after commercial losses in the 1799 war with France, and it was repealed in 1803.⁴ The Bankrupt Act of 1841 followed the great banking panic of 1837 and the subsequent depression. The very Congress that enacted it repealed it in 1843.⁵ The Act of 1867 followed the post–Civil War contraction, was much amended, and was finally repealed in 1878.

The number of people who took advantage of the bankruptcy acts was substantial. For example, 33,739 persons took advantage of the Bankrupt Act of 1841, and over 90 percent were discharged of their debts. The amount of debt involved was approximately $440 million at that time, an enormous sum in today’s dollars.⁶

While creditors were often politically opposed to debt relief, politicians did recognize that if it did not take place, the consequences could be worse. As Senator Harrison Otis of Massachusetts wondered in a debate on debt relief in 1821,

What may be expected when their numbers shall be increased and they seriously commence a system of measures for obtaining that relief by their active efforts, which is denied to their supplications. What could be more appalling and inauspicious to men of property, and the Government itself, than to see organized self-created corporations of debtors embodied in all the great commercial towns and formed into one vast combination, to influence elections! What state of things more dangerous than an universal alliance among all classes of debtors, public and private, to effectuate their own freedom through the instrumentality of persons chosen into Congress with no other recommendation?⁷

Because private contracting could not provide the desired amount of leniency in harsh times, politics stepped in to provide relief if too many suffered. But if a debtor failed alone in more normal times, he was left to his own devices. More important, property rights, and the incentives provided by private contracting, were in place most of the time.

But periodically violating creditor rights was no panacea. What guarantee was there that organized debtors would stop at repudiating their current obligations? Could a debtors’ revolt not spread to questioning other forms of property? To leave relief to concerted political action was tantamount to playing with fire.

A better solution eventually emerged. As financial markets and institutions developed, as information and communications technology like the telegraph knit the country together (so that, for example, debtors could not escape the stigma of bankruptcy by going west), as markets for assets improved in liquidity, creditors became more able to monitor their loans and obtain repayment. Some permanent leniency was possible. This is why there was a broad trend in the legislation that was contemplated over the nineteenth century. The bankruptcy laws that were enacted, albeit for short periods, became progressively friendlier to debtors, encompassing more of them and giving them more relief.⁸

The point is that there are solutions that help keep the sphere of markets and the sphere of politics separate while recognizing the imperatives of both. In considering some of the coming challenges that we will describe below, it is important to think of creative ways that the implicit tussle between free markets and politics can be managed, so that one does not destroy the other.

To think about solutions, however, we have to see the challenges more clearly. That is what we now turn to.

The Political Environment and the Coming Challenges

Recent corporate scandals and suggestions of extensive conflicts of interest among the guardians of trust in the market—such as the accountants, the investment bankers, and the analysts—are forcing people to ask the age-old question of whether there are in fact two tracks in the market economy, one for the very rich and one for everyone else. The $735 million earned by Gary Winnick, the CEO of Global Crossing, while his company was heading toward bankruptcy, the $112 million earned by Jeff Skilling, president and CEO of Enron, in the three years before his company collapsed after being accused of phony accounting practices, the $240 million earned by Tyco’s Dennis Kozlowski before he was fired and accused of tax fraud undermine the faith people have in the fairness and justice of the market. It is not that people are concerned about disparities in wealth: very few Americans question the enormous amounts earned by superstar athletes like Michael Jordan and Tiger Woods. They can observe firsthand Michael Jordan’s superior talent, and they are willing to accept that he deserves what he makes. In the boom years, this was also true for corporate America. But corporate disasters like Enron or Global Crossing have undermined the belief that corporate leaders deserve what they make or that financial analysts really understand the stocks they tout, creating room for envy and resentment. As we have seen, it is in these situations of public mistrust of market forces that antimarket forces find it easier to coordinate and act.

The public resentment in the current economic downturn feeds into a more long-standing distrust of markets that is embodied in the antiglobalization movement. While some of this movement is age-old protectionism in a new-age guise, there are also many groups involved in this movement that genuinely perceive global markets as unfair. Not all these groups understand what they are protesting against. Some long for the things the modern economy appears to crowd out (such as time, friendships, family, and conversation) and the things it appears to destroy (such as open spaces and a clean environment). It is change that they fear, and globalization is unfortunately the most visible and rapid form of recent change. The more discerning protesters see that the inadequate infrastructure that countries have for coping with some of globalization’s adverse consequences, rather than globalization itself, is the problem. But it is easier to make common cause against globalization than focus on the more mundane task of fixing the infrastructure.

Already, politicians are responding in the natural way to the downturn by erecting tariff barriers and offering domestic subsidies, a way that is not only shortsighted but also completely oblivious of the lessons of history. The steel tariffs in the United States have been followed by a farm bill that increases the level of subsidies available to the agricultural sector substantially. This will inevitably enrage developing countries, which would willingly forgo all the foreign aid developed countries offer if only the developed world would reduce the extent to which it pampers its domestic agricultural sectors. Developing countries will respond by being more reluctant to lower their tariff barriers, for unfortunately, history suggests that protectionism is contagious.

We are in a dangerous period of hangover, the morning after the ecstasy of a boom. Many feel betrayed by the bust and are demanding action against the markets. And even when the economy picks up, as sooner or later it inevitably will, new challenges are coming that will cause severe dislocation in society. These could be exploited by the few to constrain the market, so it is important to understand what they are.

Technological Change

For centuries, technology has created new products and new ways of making them that render workers and their skills redundant. While the dislocation stemming from technological change is not new, its pace has increased tremendously. Moreover, it is now affecting the professions that have not much changed their way of doing business over the centuries. Because it will affect those who have not yet learned to fear for their jobs, its political impact will be all the more severe.

With the increasing sophistication of computers and software, it is not just trivial tasks that are being performed by the computer but also sophisticated tasks that hitherto required years of experience. Drafting, for example, used to be a significant component of an architect’s job. Computer-aided design software has made this skill all but irrelevant. Older architects now find themselves at a serious disadvantage relative to younger colleagues who have been taught to use the software as an integral part of design. Even if older architects do not draft anymore, their ability to supervise and coach their younger colleagues is much diminished. In the race for career advancement, an entire generation has been handicapped.

Other jobs are vanishing because customers now have access to information and transactions technology to which only intermediaries had access earlier. Stockbrokers used their privileged access to research reports in order to entice customers into maintaining trading accounts with them—in the process, generating large brokerage fees. Now Internet brokers offer all the research customers need and charge minuscule trading commissions. Travel agents are also finding business increasingly difficult as customers not only have access to the same information they have but can sometimes get better rates directly from airlines and hotels. This does not mean that all stockbrokers and travel agents will vanish overnight, but that many will not survive, and the ones that do will work very differently from the way they work today.

Technology is also having a differential impact within professions. Take our own, teaching in universities. Using new communication techniques, one gifted professor can teach students in many locations around the country. While technology will increase the demand for such superstar teachers, it will reduce the demand for the merely good, and the demand for the mediocre may vanish completely. Teaching is a job that has been performed the same way for thousands of years, by people who have not feared becoming redundant even in the worst of economic depressions. This will change. While the new economy will increase the demand for education, it may not have room for all of us.

Not only is technology making certain human skills obsolete quickly, it is also creating entirely new sources of distress. As research into genetics progresses, scientists will more easily identify those who are likely to die of particular diseases at a young age. This knowledge has important benefits. It alerts individuals to warning signs and lets physicians diagnose and intervene more quickly. But those who are identified as highly prone to certain debilitating diseases will find it hard to keep jobs that involve substantial training by their employers, get insurance, or even maintain normal social relationships.

Imagine that you receive bad news from the medical lab: you have a genetic predisposition to a debilitating, irreversible disease. Though you may feel fine now, you anticipate a bleak economic future. You have everything to gain, and nothing to lose, by seeking redress through political action. If you organize with others in the same situation, together you will constitute a powerful political force because of your sheer numbers. You will be unlikely to settle for handouts if there is a possibility of also suppressing the disease-identifying technology (simply leaving it up to the individual to disclose if she chooses is tantamount to giving her no choice; those who test well will disclose their results, with the implication that anyone who does not disclose is predisposed to disease). If you achieve a ban on the technology, you restore the status quo ante—and your fears about getting health insurance and good jobs will evaporate. That society will be worse off today, and that pharmaceutical firms will not get the data to help future generations, will not particularly concern you—after all, for most sufferers, the gain will far exceed any sense of altruism they might have.

The fear that political constraints may be placed on the use of valuable new technologies is not unfounded. Twenty-one states in the United States already restrict the use of genetic records for employment purposes, even though this debate and genetics technology are still in their infancy.

Competition from Emerging Economies

Another challenge comes from hitherto distant lands. China and India, accounting together for over 2.5 billion people, are finally on the move. Never before in history have so many people become wealthier at such a pace. While the peoples of these and other developing countries add to the global economic pie in many ways, they will also compete for jobs that they can do more cheaply and more efficiently. This will engender enormous tensions, which will have to be defused.

The challenge from emerging economies is not unrelated to the challenge from technology, for technological advances will lead to competition in sectors that hitherto were immune to competition. Consider the following: a typical secretary in New York is about as well educated and productive as a typical secretary in Mumbai, India. They both use the same word-processing and presentation software, the same fax machines, the same E-mail programs to communicate over the Internet. The secretary in New York, however, makes about thirteen times the salary of her Indian counterpart.⁹ In part, the salary differential reflects the difference in the cost of living in New York and in Mumbai. But even accounting for this, the Indian secretary makes only a fraction of the salary the American secretary makes. The reason for this difference is that secretarial work has, thus far, been immune from foreign competition. Immigration controls and perhaps an affinity for being in Mumbai keep the Indian secretary far from New York. Thus, her willingness to work at a lower wage has little effect on New York secretarial wages.

This is not to say that secretarial wages are determined arbitrarily. Like all prices, they are determined by demand and supply. One factor determining the supply of secretaries is their alternative employment possibilities. Suppose a secretary’s alternative job is as a steelworker. There is a world market for steel (provided protectionism does not close it down), so no country can afford to pay its steelworkers much more than what they contribute at the margin to output. That U.S. steelworkers are paid much more than Indian steelworkers is because U.S. steelworkers are substantially more productive. Therefore, because U.S. steelworkers are more productive, the U.S. secretary is paid more, even though she herself is not more productive. Thus, in the United States, the secretary earns a hefty salary because she controls a scarce factor: labor. But what is scarce is secretarial labor in the United States, not secretarial labor in the world. And technology is increasingly making it possible for all kinds of labor to be supplied at a distance.

As the cost of communication falls, a Chicagoan complaining about his utility bill is just as likely to find a middle-aged woman in Manila, Philippines, on the other end of the line as an American. In the past, human-capital-intensive activities such as answering customer complaints had to be done on-site, so the displacement of American jobs could be moderated through immigration controls. These, obviously, no longer can be used to retain jobs answering telephones.

Not every job will be at risk. But competition will be intense for the most routine jobs, which typically tend to employ the most people. Over time, competition will move to more skilled activities as foreigners learn the local standards. While large firms may still employ partners in big accounting firms to advise them on arcane tax-minimization strategies, the small-business owner may well deal over the Internet with an Indian or a Chinese accountant who has familiarized herself with U.S. laws. A Russian physician may perform an operation over the Internet at a fraction of the cost that a Western European physician would charge. Of course, there will be barriers initially to such cross-border transactions, but once trust and confidence has built up, we see no natural limitations to such activities. In fact, one of us is a director of a company that offers real-time, personalized mathematics homework help out of Madras to students in Singapore and the United Kingdom. An important reason it was able to convince clients is that Cambridge University, through its mathematics outreach program, stood behind the venture, providing the necessary certification.

In short, while workers in “traded” industries like steel have faced up to foreign competition for decades and have adapted to it, for many in “nontraded” service sectors, this will be something they have never experienced before. They currently enjoy compensation in excess of what they would earn in a worldwide competitive market. An increase in competition will jeopardize this excess compensation. Hence, like the steelworkers, these new victims of competition will mobilize to try to block it. But unlike with physical goods, border controls will be ineffective. So if the distressed in the service industries organize, they will press for much more intrusive actions to keep out the foreign menace.

They will have strong incentives to do so since their very livelihoods will be at stake. When a worker loses her job as a result of a downturn in the business cycle, she has a fair expectation that she will regain her job when the cycle turns up. When she loses her job because her industry is technologically obsolete or because foreign competition closes it down, she is unlikely ever to regain it. These new risks create a new type of economic distress. In earlier times, the distressed could retain hope in the market as long as they were given enough to tide them over the cyclical downturns. A worker today who has lost her career cannot regain faith in the future with mere handouts. She needs a new lease on life, not a temporary subsidy.

The Fear of Developed Economies

Even while developed countries fear competition from cheap, skilled, educated labor from developing countries, the latter fear that their industries could be wiped out overnight by multinationals with global brands, with strategies honed in highly competitive markets, and with access to cheap power and capital. In the same way as workers in the developed world see cheap, low-cost labor in the developing world as an unfair threat (no matter how much this fear is disguised as concern for the working conditions and benefits of developing-country workers), owners and managers in the developing world see the better infrastructure in the developed world as unfair. In truth, each side has a source of comparative advantage, which will help it compete. And in a world of open borders, each side can benefit from the other’s strengths, the developed world getting access to cheap labor and the developing world getting access to infrastructure. But all this will imply dislocation and distress in the short run. And the developing world is even less prepared than the developed world to handle it.

In some developing countries, the preconditions for respect for property or for creating market infrastructure have not yet been established. Property is highly concentrated in the form of large feudal landholdings or monopolies, especially in extractive industries. Not only can these countries not cope with volatile, competitive markets, but their dominant political groups have little interest in creating the infrastructure that would allow them to cope.

But even in developing countries that have a sizable and widely held manufacturing and service sector, there is no guarantee that there will be political support for a competitive market. The reason is simple. All too often, too many of the firms that populate these countries are uncompetitive. This matters: inefficient incumbents have more of an incentive to lobby for protection, not just because they cannot face competition but also because they have little prospect of gaining in an expanded market. This is not just theoretical speculation. The most active lobbyists for protection in the U.S. steel industry are indeed the larger, older, less innovative, and less profitable firms, in which top managers typically have had long tenures on the job.¹⁰

One reason many firms in developing countries are inefficient, despite their access to cheap labor, is that they have been protected for a long time against domestic and foreign competition and have consequently become slow and lazy. Equally important, however, is that these firms are not managed by the best talents available.

To see why, consider the following. As is well known, the largest firms in the United States are typically not managed by their owners but instead run by professional managers. With the increased pressures of competition and the quickening pace of technological change, more is required of top management. Professional managers are easier to fire when they do not perform. In recent years in the United States, many more CEOs have been found to be inadequate for their jobs, fired, and replaced with outsiders. While in the early 1970s, only 10 percent of CEO successions (a change of CEO) were forced departures, in the early 1990s, this percentage more than doubled. Similarly, while in the early 1970s, only 15 percent of the incoming CEOs came from outside the firm, in the early 1990s, twice as many were outsiders.¹¹

In order to obtain the management they need in an increasingly competitive world, this evidence suggests that firms look farther and wider and dispense more quickly with managers who are not up to the mark. But such a change requires an outsider-dominated governance system: it is easier to fire top managers when they do not control a large fraction of a firm’s voting rights and when they are actively monitored by outsiders on the board.¹² Unfortunately, these are not the conditions prevailing in most of the world. Many companies are controlled by insiders, who acquired that right at birth rather than in the marketplace.¹³ Heir-controlled firms, as we have seen, tend to be managed particularly poorly.¹⁴ In a rapidly changing world with immense dislocation, such entrenched management is likely to have strong incentives to co-opt the distressed into demanding protection. A classic example of such an organization is what is loosely termed the Bombay Club in India, an amorphous organization led by the scions of the old, venerable business families, which strongly opposes opening up the economy.

Another serious concern in developing countries is the near complete absence of a formal safety net for those hurt by competition. In the quest for growth, many countries have neglected to build a reliable system of social security that will help citizens buffer the market’s volatility. Transfers and subsidies still occupy a small part of the government budget: in a sample of newly industrialized countries, it is about one-quarter of what it is in developed countries.¹⁵ As a case in point, until the Asian crisis in 1998, even South Korea had little in the way of unemployment compensation and had to institute such a scheme rapidly when faced with worker demonstrations.

Of course, the low level of government social spending is somewhat misleading because some spending that has found its way into the public sector in developed economies (such as old-age pensions) is still in the private sector in these newly industrialized countries. But in part, it reflects a belief that the role of the government is only to create market infrastructure, while social networks can provide insurance in case of adversity. This belief has served countries well during the period of rapid economic growth. But with the expansion of the market economy, social networks tend to break down: it is suggestive that Singapore passed legislation in the 1990s empowering parents to sue children who did not support them in their old age!¹⁶ Legislation, however, is unlikely to fully repair social bonds that have been sundered by the market, and the absence of a significant explicit safety net can leave a citizenry overexposed to short-term fluctuations.

The developed world has to care about these vulnerabilities in the developing world. As developed and developing economies become more intertwined, not just through trade in goods but through services, they are becoming more exposed to disturbances in each other. Moreover, as trade moves from manufacturing to services, the degree of mutual dependence and specialization is likely to increase: it is arguably harder to change your accountant or the firm that maintains your system software than to change the firm from which you purchase steel. It is also hard to build inventories of services to serve as buffers. Of course, businesses will attempt to diversify risk by sourcing from multiple countries. But diversification has its costs and its limits.

There is a silver lining to these interdependencies. When, in May of 2002, the governments of India and Pakistan started threatening each other about the possibility of a nuclear war, domestic businesses in those countries became alarmed at the possibility that foreign buyers would get scared off by increased perceptions of risk. As a result, businesses in India and Pakistan put pressure on their governments to tone down the rhetoric. Business is placing limits on politics. These benefits notwithstanding, growing global integration is exposing the world to new risks of disruption that have to be addressed.

Aging Populations

No analysis of the potential future threats to the political viability of free markets can ignore the dramatic effects that the rapidly aging population in developed countries will have on the distribution of resources.

With decreasing birthrates and increasing life expectancy, the population of developed countries is aging rapidly even while it has slowed to near zero growth. In 1970, there were 17.2 million children under age five and 3.7 million adults over eighty in the United States. By 1995, the figures were 19.6 million and 8.1 million, respectively, and by 2040, they will be 25 million and 26.2 million, respectively.¹⁷ And the United States, with substantial immigration, is not even close to being the most rapidly aging country. According to projections, by 2010, Japan will have fewer than three working-age adults for each elderly citizen, and by 2050, it will have only 1.5 taxpaying workers per pensioner. At that time, Italy will have fewer taxpaying workers than pensioners.¹⁸

A smaller and smaller working population will have to support a larger and larger group of the nonworking. The size of transfers each worker has to make to give the elderly their promised retirement benefits will keep increasing. If no change occurs, future working generations will pay more and more to the elderly while expecting less and less for their own old age. This will set up a clash of interests between the incumbent old and the younger working generation, between those that democracy renders powerful because of their numbers and organizational power and those that economics renders powerful because of their control over human capital. Historically, a mismatch between political power and economic power has represented a threat to the security of property rights. Such a threat is possible again in the future.

Another source of tension arises from the international distribution of resources. If the productive capabilities of the economy fall as the population ages, then consumption goods will have to be imported. In anticipation of this, developed economies will have to invest abroad, not in other developed economies, as has been the trend in the past, but in younger, developing countries. Developing countries need to develop the capacity to absorb these investments in sensible ways.

Moreover, if developed countries are to hold significant quantities of financial claims on developing countries, they will demand safeguards to ensure that they will not be dispossessed at a later date when they need to cash in those investments. We have seen that, historically, respect for property rights emerged when owners were sufficiently represented politically to make expropriation politically difficult and when expropriation hurt the expropriator in the long run. Clearly, investors from developed countries have had little or no political representation in developing countries, at least since the days of gunboat diplomacy. So whether their rights will be respected hinges on whether, going forward, developing countries will find it costly to expropriate owners in developed countries. Population aging will force developed countries to be increasingly reliant on the climate of respect for property in developing countries. It is in our collective interest that market infrastructure expand worldwide.

International Governance

This then brings us to questions of international governance. We have argued that the cause of markets is helped within a country if its large industrial and financial firms are competitive, for they will then not have to rely on shackling the free market to survive. Internationally, the cause of free markets is helped if the dominant political power is also an efficient producer, for it then wants to press others to open up their borders. During the nineteenth century, England, which at the time was the most industrially advanced nation and politically very powerful, promoted free markets around the world. A similar role has been played by the United States in the post–World War II period. It is periods when the political leadership of the world changes hands or when the dominant political power loses its economic leadership that we are especially likely to face ambivalence about open markets.

The United States is still the dominant economy in the world as well as the sole superpower, but neither attribute is unchangeable. Certainly, with the steel tariffs and the farm subsidies, we see the consequences of U.S. economic weakness in some sectors impinging on its commitment to open borders. What if weakness spreads? Will the United States continue to champion free markets?

Of course, the United States is only one country. Competition among different political entities can still further the cause of the market even if a major player jumps ship. The danger we see here is the growing political integration among countries of the type occurring in Europe: it reduces political competition and makes coordinated antimarket moves more feasible.

In its early years, what is now the European Union was the European Economic Community (EEC)—a focused attempt to break down national barriers in Europe to promote trade and enlarge the market. When it was largely intent on a narrow, promarket goal, it was a force for the good, and coaxed many countries to liberalize. In ensuring equal access to foreigners, countries also were forced to level the playing field for their own citizens, thus fostering the development of competitive arm’s-length markets.

As the aims of the European Union have broadened to go beyond market expansion and trade liberalization to a common program of governance, its directives could well have the potential of becoming more intrusive and illiberal (it should not be forgotten that even the EEC promoted protectionist agricultural policies).

Consider an extreme but illustrative case. Suppose after a severe stock market crash, the European Union decides that too many companies brought to market were little more than a dream and a prayer. It decides to tighten the rules under which companies can issue shares on the market, a move that incumbents across countries might well support because it starves entrants of financing. Given that these rules would apply immediately in all neighboring countries that a new European firm might conceivably think of tapping, that potential entrant might be hard-pressed to raise finance under the new rules, making the rules much more effective and making incumbents in each country more eager to press for them with the union. By contrast, if a single country tried to impose those rules, it would see the potential entrant go to a neighboring country to raise finance. Thus, the migration of business to friendlier political entities is a very strong disciplinary force for keeping policies market-friendly. This force is suppressed when neighboring political entities coalesce.

That policies are still market friendly is, in part, because member countries have veto power over serious economic change. As the union broadens its membership, there are pressures to reduce the areas over which member countries have a veto. This will make the union more of a political monopoly, with attendant dangers to markets.

Summary

After decades of uninterrupted expansion of markets, in which free markets, especially financial markets, have tamed, converted, or conquered those who opposed them, it is easy to get overly complacent. Borders are more open than ever before, reducing the ability of domestic politicians to play favorites. And the generous systems of social security set up by developed economies since World War II, while trimmed a little in recent years, still provide insurance to most in the developed world. Thus, buffers are in place to prevent an antimarket reaction from coalescing. Does all this not ensure the viability of free markets going forward?

Not necessarily. Technology is advancing rapidly. In addition to changing the skills that are valued and thus creating entirely new legions of the distressed, it is bringing competition from developing countries to the doorsteps of professionals in developed countries. Even though the uncertainties facing the average worker in the near term (whether she will have enough to tide her through the next downturn) have diminished, they have been replaced by profound anxiety about the long term (whether she will have the skills to earn a living for enough years to support a steadily lengthening span of retired life).

Developing countries are facing intense competition, but they do not have the stabilization or coping mechanisms that developed countries have put in place over the years. Both developed and developing countries are becoming mutually dependent, a dependency that will only grow as populations in the developed world age. How can the tensions these mutual dependencies create be managed without setting off political movements to close borders and suppress markets? All this is the subject of the next chapter.

CHAPTER THIRTEEN

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Saving Capitalism from the Capitalists

THE MAIN POINT of this book is that free markets, perhaps the most beneficial economic institution known to humankind, rest on fragile political foundations. In a competitive free market economy, the decisions of myriad anonymous participants determine prices, which, in turn, determine what is produced and who is rewarded. The invisible hand of the market substitutes for bureaucrats and politicians in all these decisions. This has engendered the misperception that markets do not need governments. But markets cannot flourish without the very visible hand of the government, which is needed to set up and maintain the infrastructure that enables participants to trade freely and with confidence.

Here is where the political tension arises: The very same difficulties of organizing collective action that necessitate the intervention of the government also make it hard for the public to ensure that the government acts in the public interest. Organized private interests can thus have their way against the larger interests of the public. The nightmare scenario, which has played out before, is that under the cover of obtaining security for the distressed, the incumbents also obtain security for themselves by repressing the market. The victim is the free market and all those who look to it for opportunity.

In the last chapter, we outlined a number of scenarios that could cause a rapid rise in the number of distressed, both in developed and in developing countries. We also explained what type of incumbents might have the strongest incentive to feed on the fears and hopes of the distressed.

Having outlined the threats, we now move to proposing solutions. Given the fundamental tension that is at the heart of the problem, there is no magic bullet. A call for forceful action by the government runs the risk that the action will be distorted by incumbents. A call to neuter the government runs the risk that the necessary infrastructure will remain underdeveloped and the market will be overexposed to political backlash during the inevitable process of destruction. The only way out is a set of proposals that can collectively check and balance each other so that the government supports, but does not intrude on, the functioning of the market. In isolation, each proposal may seem benign, or even counterproductive. But together, they become a force to foster free markets.

Our proposals rest on four pillars. First, incumbents who are not overwhelmingly powerful and who are capable of being competitive are less likely to attempt to constrain market forces. So an important pillar of policy should be to ensure that the control of productive assets is not concentrated in a few hands and that those who do have control also have the ability to use the assets well. Second, competition will create losers. A safety net is essential for the distressed, one that does not simply help the distressed cope with business cycle downturns but helps them bounce back from the complete loss of a career. Third, the scope for political maneuvering can be limited if borders are kept open. Of course, in extremis, borders will be forcibly closed down by antimarket forces, but that is why all four pillars should be seen as mutually reinforcing. Finally, the public should be made more aware of how much it benefits from the market and what the costs of seemingly innocuous anticompetitive policies are, so that the public is less willing to remain passively on the sidelines. Let us examine these proposals in detail.

Reduce Incumbents’ Incentives to Oppose Markets

We cannot wish away the fact that economic power translates to political power. No matter what kinds of campaign finance reforms are proposed and enacted, some form of the “golden rule”—he who has the gold makes the rules—will always apply. But the nexus between economic and political power is of special concern in two situations. If a few incumbents have much of the economic power, they can rely on their own political clout to achieve business ends and may feel little need to establish transparent rules that make markets accessible to all. This is more likely to be a problem in a country that does not have an established market infrastructure because the pressure to create it will then be low. More dangerous still than this benign neglect of the market is if the incumbents are incompetent at business, for they may then actively attempt to suppress the competitive market so as to preserve their own positions.

The two concerns are not unrelated. An example may help fix ideas. The diamond trade in India is dominated by a small community of Palanpuri Jains from Gujarat. For nearly half a century, these traders have worked in secrecy, dealing largely with other members of extended families, to buy, cut, polish, and resell diamonds around the world. Working without legal contracts, they have been so effective that nine out of ten diamonds in the world now pass through India.¹ The reason this system has worked so far in a country with a creaky legal system is that it is based on trust. The community will ostracize anyone who violates the implicit understanding among traders. The problem, however, is that outsiders cannot participate in the system, and insiders have no incentive to create a more arm’s-length, transparent system: it is easier to build trust when profits are large and trading is only among a few, well-known people.

The concentration of trading in a few hands can be harmful if the system stops working as well. And there are signs of this as trade expands and business has to be done with more and more outsiders: a courier recently absconded with $10 million worth of diamonds, and two Bombay traders lost their clients’ money in stock speculation (they were so ashamed, they committed suicide).² But members of the community are not eager to accept modernization and professionalism, however necessary they are, because these changes will also bring competition. Change is therefore coming slowly, perhaps overly so. The point is, concentration of economic power, even if currently benign, need not always remain so, especially if the privileged few have their own ways of doing business.

This suggests two goals of policy: to keep economic power from getting overly concentrated—an aim that is especially pertinent to developing countries—and to ensure that those who control economic resources are capable of using them efficiently.

The two goals are often, but not always, compatible. For example, it is clear that a policy of subjecting firms to competition from the outside helps keep them efficient: there is little pressure on a protected industry to become competitive, and it will use the windfall profits earned while being protected to lobby for more protection instead of taking the steps necessary to restructure. The Indian Ambassador car (a version of the British Morris Oxford) was introduced in 1957 and sold virtually unchanged till March 2002, simply because it had little domestic, and no foreign, competition during much of its history. Even a purportedly temporary cessation of discipline, such as the recent steel tariffs in the United States, which are slated to disappear in a few years, risks creating incumbents who cannot compete and who will fight to make the barriers permanent.

But in order to compete at the right scale in a world market, a firm from a small country may end up accounting for a significant portion of that country’s economic output. Firms like Nokia in Finland do have significant domestic clout. Whether such a firm uses its domestic clout responsibly, helping improve the access of others to the market, or whether it uses it to constrain their access and monopolize domestic resources will indicate whether more instruments of policy have to be brought to bear.