What they tell you The rapid development of the financial markets has enabled us to allocate and reallocate resources swiftly. This is why the US, the UK, Ireland and some other capitalist economies that have liberalized and opened up their financial markets have done so well in the last three decades. Liberal financial markets give an economy the ability to respond quickly to changing opportunities, thereby allowing it to grow faster. True, some of the excesses of the recent period have given finance a bad name, not least in the above-mentioned countries. However, we should not rush into restraining financial markets simply because of this once-in-a-century financial crisis that no one could have predicted, however big it may be, as the efficiency of its financial market is the key to a nation’s prosperity.
What they don’t tell you The problem with financial markets today is that they are too efficient. With recent financial ‘innovations’ that have produced so many new financial instruments, the financial sector has become more efficient in generating profits for itself in the short run. However, as seen in the 2008 global crisis, these new financial assets have made the overall economy, as well as the financial system itself, much more unstable. Moreover, given the liquidity of their assets, the holders of financial assets are too quick to respond to change, which makes it difficult for real-sector companies to secure the ‘patient capital’ that they need for long-term development. The speed gap between the financial sector and the real sector needs to be reduced, which means that the financial market needs to be deliberately made less efficient.
Three useless phrases Visitors to Iceland in the 1990s reported that the official tourist guide handed out at Reykjavik airport had, like all other such guides, a ‘useful phrases’ section. Unlike them, I was told, the Icelandic guide also had a ‘useless phrases’ section. Apparently it contained three phrases, which were, in English: ‘Where is the railway station?’, ‘It’s a nice day today’, and ‘Is there anything cheaper?’ The railways thing is, surprising though it may be, true – Iceland does not have any railways. About the weather, the guide was perhaps being overly harsh. I haven’t lived there, but by all accounts Iceland does seem to have at least a few sunny days a year. As for everything being so expensive, this was also pretty accurate and a consequence of the country’s economic success. Labour services are expensive in high-income countries (unless they have a constant supply of low-wage immigrants, as the US or Australia), making everything more expensive than what the official exchange rate should suggest (see Thing 10). Once one of the poorest economies in Europe, by 1995 Iceland had developed into the eleventh richest economy in the world (after Luxemburg, Switzerland, Japan, Norway, Denmark, Germany, the United States, Austria, Singapore and France).
Rich as it already was, the Icelandic economy got a turbo-charged boost in the late 1990s, thanks to the then government’s decision to privatize and liberalize the financial sector. Between 1998 and 2003, the country privatized state-owned banks and investment funds, while abolishing even the most basic regulations on their activities, such as reserve requirements for the banks. Following this, the Icelandic banks expanded at an astonishing speed, seeking customers abroad as well. Their internet banking facilities made big inroads in Britain, the Netherlands and Germany. And Icelandic investors took advantage of the aggressive lending by their banks and went on corporate shopping sprees, especially in Britain, its former adversary in the famous ‘Cod Wars’ of the 1950s to 1970s. These investors, dubbed the ‘Viking raiders’, were best represented by Baugur, the investment company owned by Jón Jóhanneson, the young business tycoon. Bursting on to the scene only in the early 2000s, by 2007 Baugur had become a major force in the British retail industry, with major stakes in businesses employing about 65,000 people, turning over £10 billion across 3,800 stores, including Hamleys, Debenhams, Oasis and Iceland (the temptingly named British frozen-food chain).
For a while, the financial expansion seemed to work wonders for Iceland. Once a financial backwater with a reputation for excessive regulation (its stock market was only set up in 1985), the country was transformed into a vibrant new hub in the emerging global financial system. From the late 1990s, Iceland grew at an extraordinary rate and became the fifth richest country in the world by 2007 (after Norway, Luxemburg, Switzerland and Denmark). The sky seemed to be the limit.
Unfortunately, after the global financial crisis of 2008, the Icelandic economy went into meltdown. That summer, all three of its biggest banks went bankrupt and had to be taken over by the government. Things got so bad that, in October 2009, McDonald’s decided to withdraw from Iceland, relegating it to the borderland of globalization. At the time of writing (early 2010), the IMF estimate was that its economy shrank at the rate of 8.5 per cent in 2009, the fastest rate of contraction among the rich countries.
The risky nature of Iceland’s financial drive since the late 1990s is increasingly coming to light. Banking assets had reached the equivalent of 1,000 per cent of GDP in 2007, which was double that of the UK, a country with one of the most developed banking sectors in the world. Moreover, Iceland’s financial expansion had been fuelled by foreign borrowing. By 2007, net foreign debt (foreign debts minus foreign lending) reached nearly 250 per cent of GDP, up from 50 per cent of GDP in 1997. Countries have gone to pieces with far less exposure – foreign debts were equivalent to 25 per cent of GDP in Korea and 35 per cent of GDP in Indonesia on the eve of the Asian financial crisis in 1997. On top of that, the shady nature of the financial deals behind the Icelandic economic miracle was revealed – very often the main borrowers from the banks were key shareholders of those same banks.
New engine of growth? Why am I spending so much time talking about a small island with just over 300,000 people that does not even have a train station or a McDonald’s, however dramatic its rise and fall may have been? It is because Iceland epitomizes what is wrong with the dominant view of finance today.
Extraordinary though Iceland’s story may sound, it was not alone in fuelling growth by privatizing, liberalizing and opening up the financial sector during the last three decades. Ireland tried to become another financial hub through the same strategy, with its financial assets reaching the equivalent of 900 per cent of GDP in 2007. Like Iceland, Ireland also had a bad fall in the 2008 global financial crisis. At the time of writing, the IMF estimate was that its economy contracted by 7.5 per cent in 2009. Latvia, another aspiring financial hub, has had it even worse. Following the collapse of its finance-driven boom, its economy was estimated by the IMF to have shrunk by 16 per cent in 2009. Dubai, the self-appointed financial hub of the Middle East, seemed to hold on a bit longer than its European rivals, but threw in the towel by declaring a debt moratorium for its main state-owned conglomerate in November 2009.
Before their recent falls from grace, these economies were touted as examples of a new finance-led business model for countries that want to get ahead in the era of globalization. As late as November 2007, when the storm clouds were rapidly gathering in the international financial markets, Richard Portes, a prominent British policy economist, and Fridrik Baldursson, an Icelandic professor, solemnly declared in a report for the Iceland Chamber of Commerce that ‘[o]verall, the internationalisation of the Icelandic financial sector is a remarkable success story that the markets should better acknowledge’.1 For some, even the recent collapses of Iceland, Ireland and Latvia have not been enough reason to abandon a finance-led economic strategy. In September 2009, Turkey announced that it will implement a series of policies that will turn itself into (yet another) financial hub of the Middle East. Even the government of Korea, a traditional manufacturing powerhouse, is implementing policies aimed at turning itself into the financial hub of Northeast Asia, although its enthusiasm has been dented since the collapse of Ireland and Dubai, after which it was hoping to model the country.
Now, the real trouble is that what countries like Iceland and Ireland were implementing were only more extreme forms of the economic strategy being pursued by many countries – a growth strategy based on financial deregulation, first adopted by the US and the UK in the early 1980s. The UK put its financial deregulation programme into a higher gear in the late 1980s, with the so-called ‘Big Bang’ deregulation and since then has prided itself on ‘lighttouch’ regulation. The US matched it by abolishing the 1933 Glass-Steagall Act in 1999, thereby tearing down the wall between investment banking and commercial banking, which had defined the US financial industry since the Great Depression. Many other countries followed suit.
What was encouraging more and more countries to adopt a growth strategy based on deregulated finance was the fact that in such a system it is easier to make money in financial activities than through other economic activities – or so it seemed until the 2008 crisis. A study by two French economists, Gérard Duménil and Dominique Lévy – one of the few studies separately estimating the profit rate of the financial sector and that of the nonfinancial sector – shows that the former has been much higher than the latter in the US and in France during the last two or three decades.2 According to this study, in the US the rate of profit for financial firms was lower than that of the non-financial firms between the mid 1960s and the late 1970s. But, following financial deregulation in the early 1980s, the profit rate of financial firms has been on a rising trend, and ranged between 4 per cent and 12 per cent. Since the 1980s, it has always been significantly higher than that of non-financial firms, which ranged between 2 per cent and 5 per cent. In France, the profit rate of financial corporations was negative between the early 1970s and the mid 1980s (no data is available for the 1960s). However, with the financial deregulation of the late 1980s, it started rising and overtook that of non-financial firms in the early 1990s, when both were about 5 per cent, and rose to over 10 per cent by 2001. In contrast, the profit rate of French non-financial firms declined from the early 1990s, to reach around 3 per cent in 2001.
In the US, the financial sector became so attractive that even many manufacturing companies have turned themselves essentially into finance companies. Jim Crotty, the distinguished American economist, has calculated that the ratio of financial assets to non-financial assets owned by nonfinancial corporations in the US rose from around 0.4 in the 1970s to nearly 1 in the early 2000s.3 Even companies such as GE, GM and Ford – once the symbols of American manufacturing prowess – have been ‘financialized’ through a continuous expansion of their financial arms, coupled with the decline of their core manufacturing activities. By the early twenty-first century, these manufacturing firms were making most of their profits through financial activities, rather than their core manufacturing businesses (see Thing 18). For example, in 2003, 45 per cent of GE’s profit came from GE Capital. In 2004, 80 per cent of profits of GM were from its financial arm, GMAC, while Ford made all its profits from Ford Finance between 2001 and 2003.4 Weapons of financial mass destruction? The result of all this was an extraordinary growth in the financial sector across the world, especially in the rich countries. The growth was not simply in absolute terms. The more significant point is that the financial sector has grown much faster – no, much, much faster – than the underlying economy.
According to a calculation based on IMF data by Gabriel Palma, my colleague at Cambridge and a leading authority on financial crises, the ratio of the stock of financial assets to world output rose from 1.2 to 4.4 between 1980 and 2007.5 The relative size of the financial sector was even greater in many rich countries. According to his calculation, the ratio of financial assets to GDP in the UK reached 700 per cent in 2007. France, which often styles itself as a counterpoint to Anglo-American finance capitalism, has not lagged far behind the UK in this respect – the ratio of its financial assets to GDP is only marginally lower than that of the UK. In the study cited above, Crotty, using American government data, calculates that the ratio of financial assets to GDP in the US fluctuated between 400 and 500 per cent between the 1950s and the 1970s, but started shooting up from the early 1980s with financial deregulation, to break through the 900 per cent mark by the early 2000s.
This meant that more and more financial claims were being created for each underlying real asset and economic activity. The creation of financial derivatives in the housing market, which was one of the main causes of the 2008 crisis, illustrates this point very well.
In the old days, when someone borrowed money from a bank and bought a house, the lending bank used to own the resulting financial product (mortgage) and that was that. However, financial innovations created mortgage-backed securities (MBSs), which bundle together up to several thousand mortgages. In turn, these MBSs, sometimes as many as 150 of them, were packed into a collateralized debt obligation (CDO). Then CDOs-squared were created by using other CDOs as collateral. And then CDOs-cubed were created by combining CDOs and CDOs-squared. Even higher-powered CDOs were created. Credit default swaps (CDSs) were created to protect you from default on the CDOs. And there are many more financial derivatives that make up the alphabet soup that is modern finance.
By now even I am getting confused (and, as it turns out, so were the people dealing with them), but the point is that the same underlying assets (that is, the houses that were in the original mortgages) and economic activities (the income-earning activities of those mortgage-holders) were being used again and again to ‘derive’ new assets. But, whatever you do in terms of financial alchemy, whether these assets deliver the expected returns depends ultimately on whether those hundreds of thousands of workers and small-scale business-owners who hold the original mortgages fall behind their mortgage payments or not.
The result was an increasingly tall structure of financial assets teetering on the same foundation of real assets (of course, the base itself was growing, in part fuelled by this activity, but let us abstract from that for the moment, since what matters here is that the size of the superstructure relative to the base was growing). If you make an existing building taller without widening the base, you increase the chance of it toppling over. It is actually a lot worse than that. As the degree of ‘derivation’ – or the distance from the underlying assets – increases, it becomes harder and harder to price the asset accurately.
So, you are not only adding floors to an existing building without broadening its base, but you are using materials of increasingly uncertain quality for the higher floors. No wonder Warren Buffet, the American financier known for his down-to-earth approach to investment, called financial derivatives ‘weapons of financial mass destruction’ – well before the 2008 crisis proved their destructiveness.
Mind the gap All my criticisms so far about the overdevelopment of the financial sector in the last two or three decades are not to say that all finance is a bad thing.
Had we listened to Adam Smith, who opposed limited liability companies (see Thing 2) or Thomas Jefferson, who considered banking to be ‘more dangerous than standing armies’, our economies would still be made up of the ‘Satanic mills’ of the Victorian age, if not necessarily Adam Smith’s pin factories.
However, the fact that financial development has been crucial in developing capitalism does not mean that all forms of financial development are good.
What makes financial capital necessary for economic development but potentially counterproductive or even destructive is the fact that it is much more liquid than industrial capital. Suppose that you are a factory owner who suddenly needs money to buy raw materials or machines to fulfil unexpected extra orders. Suppose also that you have already invested everything you have in building the factory and buying the machines and the inputs needed, for the initial orders. You will be grateful that there are banks that are willing to lend you the money (using your factory as collateral) in the knowledge that you will be able to generate extra income with those new inputs. Or suppose that you want to sell half of your factory (say, to start another line of business), but that no one will buy half a building and half a production line. In this case, you will be relieved to know that you can issue shares and sell half your shares. In other words, the financial sector helps companies to expand and diversify through its ability to turn illiquid assets such as buildings and machines into liquid assets such as loans and shares.
However, the very liquidity of financial assets makes them potentially negative for the rest of the economy. Building a factory takes at least months, if not years, while accumulating the technological and organizational know-how needed to build a world-class company takes decades. In contrast, financial assets can be moved around and rearranged in minutes, if not seconds. This enormous gap has created huge problems, because finance capital is ‘impatient’ and seeks short-term gains (see Thing 2). In the short run, this creates economic instability, as liquid capital sloshes around the world at very short notice and in ‘irrational’ ways, as we have recently seen. More importantly, in the long run, it leads to weak productivity growth, because long-term investments are cut down to satisfy impatient capital. The result has been that, despite enormous progress in ‘financial deepening’ (that is, the increase in the ratio between financial assets and GDP), growth has actually slowed down in recent years (see Things 7 and 13).
Thus, exactly because finance is efficient at responding to changing profit opportunities, it can become harmful for the rest of the economy. And this is why James Tobin, the 1981 Nobel laureate in economics, talked of the need to ‘throw some sand in the wheels of our excessively efficient international money markets’. For this purpose, Tobin proposed a financial transaction tax, deliberately intended to slow down financial flows. A taboo in polite circles until recently, the so-called Tobin Tax has recently been advocated by Gordon Brown, the former British prime minister. But the Tobin Tax is not the only way in which we can reduce the speed gap between finance and the real economy. Other means include making hostile takeovers difficult (thereby reducing the gains from speculative investment in stocks), banning short-selling (the practice of selling shares that you do not own today), increasing margin requirements (that is, the proportion of the money that has to be paid upfront when buying shares) or putting restrictions on cross-border capital movements, especially for developing countries.
All this is not to say that the speed gap between finance and the real economy should be reduced to zero. A financial system perfectly synchronized with the real economy would be useless. The whole point of finance is that it can move faster than the real economy. However, if the financial sector moves too fast, it can derail the real economy. In the present circumstances, we need to rewire our financial system so that it allows firms to make those long-term investments in physical capital, human skills and organizations that are ultimately the source of economic development, while supplying them with the necessary liquidity.
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