The following is a summary of Part A of Saving Capitalism from The Capitalists, a wonderful book by Zingales and Rajan. This section of the book opened my eyes to how finance can work for good, and is critical to the development of economies.
Financial markets channel risk capital to those with new, daring ideas. However, they are delicate, and reliant on political goodwill for all the infrastructure to support them. They face threats from two places: incumbent firms facing new challengers, and the distressed unemployed. Hence, its critical to enact policies that help free markets maintain their political viability.
Incumbents are threatened by an important prerequisite to a mature financial market: market institutions. These are courts that can speedily enforce contracts, ratings agencies that can tell how credit-worthy someone is, effective norms for accounting and disclosure, and reliable public record keeping. Finance is reliant on these to understand whom it is lending money to, and at what risk. The Stanford MBAs raising venture-capital for their social-media startup stand on the shoulders of these institutions, and as a result are able to get much better financing terms than the Bangladeshi bamboo-stool maker who is ostensibly doing a much less risky activity.
In the absence of these institutions, finance becomes heavily dependent on relationships and credit often requires collateral before it is extended. With the information and trust these institutions build, finance can operate at arms-length and becomes more democratized.
Outline:
One must understand why these institutions do not exist in some countries. Answers like a country’s history or psyche do not make sense. History has shown that countries can evolve to develop these institutions. Nor does an argument make sense that claims poor countries lack the trained manpower, or wealth or technology. That doesn’t explain why formerly rich countries like Haiti failed to develop these institutions, or why even in countries like France or Germany startup venture financing in the 1980s would have seemed hard to contemplate.
Answer: large, arms-length markets needed for a modern economy need these institutions. But the powerful incumbents, political and economic, fear these institutions for diluting their power: they provide resources to newcomers, and force competition upon them via the free market. In the US, more than half the top 20 firms by sales in 1999 were different than those in 1985. In contrast in Germany whose financial markets were relatively dormant, over 80% of these firms remained the same.
When incumbents have a stranglehold on power, markets develop either when the incumbents directly benefit, or when they have no choice. There are three phases in the development of financial markets, not all necessarily occuring in each instance:
First, the country obtains more representative government and begins to respect property rights. The biggest danger here is the government itself! Historically, this occurred in countries with distribution of property (land) that was more egalitarian (US, Canada) than feudal, large estates (Caribbean, Latin America). When the owner also worked on the land, his production techniques improved -> greater production -> greater tax revenues -> greater respect for property rights.
For large estates, civilization eventually freed the slaves. But the powerful incumbent owners, preferred to starve the population of education and finance to keep them working on their estates. The incumbents had an incentive to suppress free market institutions.
Second, the country opens its borders to tame incumbent groups that otherwise capture democratic governments. Established firms and financiers prefer suppressing competition. These firms already have access to finance. They have the clout and relationships to sway politicians away from institution building. For example, rural farmers needing credit in early 20th century US had few banks offering loans, and those that did charged high interest rates. Some states allowed only one branch per bank. Others didn’t allow out-of-state banks from opening branches. It was a happy oligopoly for the banks. This changed in the 1980s and 1990s with competition from outside, via the ability of out-of-state banks to use tech to extend credit from a distance. Similarly, cross-border trade and capital flows subject incumbents to competition from the outside. Countries are forced to do what is necessary for making their economies competitive, not what is best for their incumbents: typically strengthening institutions that support the market.
For example, Japanese corporate bond markets were tiny in the 1980s. Unsecured bonds needed approval by a Bond Committee (populated by banks!) to ostensibly only allow safe issues to the public. But the real reason was to protect the banks’ lending business. Even AA-rated Hitachi couldn’t raise financing. The growth of the Euromarket and opening Japan to capital flows let large japanese banks bypass domestic banks and raise in the Euromarket. Eventually, the Bond Committee was made irrelevant and disbanded.
Periods of high mobility of goods and capital parallel periods of maximum development of financial markets (1900-1930 and 1990-2000). “Open borders limit ability of domestic politics to close competition, and retard financial and economic growth. They help save capitalism from the capitalists!”
Third, a reactionary stage, when incumbent groups ride the coat-tails of the distressed back into power. How stable are these markets, given that incumbents can shut the borders down? When the rest of the world is moving in an open direction, it is harder for a country to put up barriers. E.g. East Asian Crisis in 1998 didn’t change their stance. But if a number of large countries close their borders, then this can get contagious.
Downturns spawn opposition to markets. Competitive markets produce new risks and destroy traditional sources of insurance. These risks are from expanding opportunities in good times, and reducing them in bad times. Ultimately most are better off, but some do suffer. Insurance: when labor markets are not competitive, firms value lifetime employment by not firing workers during downturns. There is also implicit insurance between firms and lenders, suppliers and customers, etc. which explicit insurance doesn’t match fully.
In summary, one way of thinking about these stages is via the lens of modern US politics. The danger stemming from conservative politics, is to ignore the concerns of the losers or the threat they pose to general prosperity. Liberal politics is equally misguided when it attacks the system that created losers, instead of seeing that it is an inevitable aspect of the market.
A good financial system expands access to finance. In a poor one, the financier who controls access is powerful, and because access is so limited, the financier can make good money while doing little.
Financing is the exchange of a sum of money today for a return tomorrow. This comes with three issues, which financial infra helps mitigate:
First, Risk: even the most honest borrower may not be able to repay the loan. To undertake this risk, investors are promised a risk-premium over safe investments (like a loan to the US govt). A corollary to this is: when the risk is concentrated, it may be hard to find a financier who can bear it. A developed financial system can spread the risk out to many investors in two ways: having secondary markets to repackage and sell the loan, and from having access to credit-histories.
Second, Ignorance or adverse selection: honest borrowers are very sensitive to the interest rate, since they expect to pay back the full loan. As rates rise, only those who don’t intend to pay back remain. Financiers account for this, and raise rates even further, leading to a vicious cycle. Financial infra like credit-histories and scores help mitigate this.
Third, Knavery or moral hazard: when the repayment terms are too onerous, or poorly structured, then even honest borrowers are incentivized to skip repayments. Developed financial markets have information to know when the terms create perverse incentives for the borrow. They can then rely on well understood techniques for contract design, an ability to renegotiate them, and courts that can swiftly enforce them. This provides borrowers with the correct incentives throughout the course of the project.
Lending with collateral is basically what pawnbroking relies on, a practice found even in underdeveloped markets. This relies on making it easy to seize collateral: in England, where it takes a year for houses of delinquent mortgages to be seized and legal procedures cost 5% of the house, mortgage loans are 52% of GDP. In contrast, in Italy it takes 3-5 years and 20% of the house’s cost, mortgage loans are 5% of GDP.
Some well-meaning US states passed legislation protecting some personal property of debtors from being seized (usually the home, and some amount of money), but as a result lending shifted towards the rich, who were now more willing to take loans, with the poor finding it hard to get credit and had to pay higher interest rates. In collateral-dominated lending markets, the poor need assets and a liquid market where they can be possessed and sold by the lenders.
Relationship-driven lending relies on social control, or pressure, from family and friends to ensure the loan is repaid. The microfinance industry is built on this. In Italy, studies found that if a bank officer and loan applicant belonged to the same social club then it was 2.5x more likely that a line of credit would be extended to that firm, a practice known as “insider lending”. This is bad for the economy as a whole because it cannot produce to its full potential, as credit is unevenly distributed. It hurts the poor in two ways: they not only lose an option for self-employment, and have less bargaining power against their employers. It also encourages collusion between bankers, since the information they rely on to lend is not public. This makes financiers less likely to pursue innovation: none of the late 19th century innovations from the steamship to the telegraph were funded by banks.
Some critics of Capitalism favor moving to a Socialist model. However, this exacerbates the problem: previously, the capitalist owners had economic power over the workers, and sought to eliminate competition. In socialism, the state boycotts both political and economic competition and set wages that inevitably benefit favored groups. These favored groups can also change over time in arbitrary ways, eliminating the incentive to invest capital or improve one’s skills, since there is no clarity on the rules of the game.
A better system would be to decentralize power, and disperse it more widely. One way to do this is via better access to finance. Finance that works at arms-length, rather than via relationships. Developed financial markets do this in a number of ways.
First, reduce risk premiums. Developed markets distribute risk widely, and to those who can best bear it. Consider two examples: diversification via modern portfolio theory, and financial derivatives.
Finance academic research led to the development of Modern Portfolio Theory which shows that the risk of an investment should not be considered in isolation, but in the context of an overall portfolio of investments. For instance, viewed in isolation Gold is a volatile commodity but because its is price is inversely correlated with stocks, it reduces the overall volatility of a portfolio that includes gold and stock. Similarly, Americans investing the Vietnamese stock market are much less affected by a downturn in the Vietnamese economy. Their jobs are in America, and their Vietnamese stocks are a small portion of their overall portfolio. Hence, these American investors demand a smaller risk premium compared to Vietnamese investors for the same companies, leading to lower cost of capital for these companies, and enabling their ability to invest and grow operations.
Financial derivatives can slice and dice risk effectively, placing it on those who can best bear it and making risky ventures easier to finance. In France, the government wanted to privatize a chemical company Rhone-Poulenc, with an objective to raise employee ownership. However, employees were not used to owning stock, and so were reluctant to buy. Neither the company, nor the French treasury wanted to guarantee a minimum share price. A US bank, Bankers Trust, said: if employees buy the stock, they guarantee a minimum return of 25% over the next 4.5 years and ⅔ stock appreciation over initial price. They used a technique called dynamic-hedging to trade liquid Rhone-Poulenc shares and bonds to transfer the remaining ⅓ price appreciation into a guarantee for the employees plus a profit margin for itself.
Second, risk management. Many mortgages in California are insured against earthquakes. However, this leaves the earthquake company at risk of catastrophic payout, so in turn it buys “re-insurance” from re-insurers who are geographically spread out. They also issue “cat bonds”, catastrophe bonds, whose proceeds are invested in safe government bonds. If catastrophe strikes, the govt bonds are sold to pay the liabilities, and the cat bond holders forgo income. These are not easy contracts to define (How does one define exactly when the event has occurred?), and require sophisticated lawyers and investment bankers.
Another example, is a security called a viatical. AIDS patients have little money to pay for their treatment but often have life insurance, although that only pays out when they are dead. A viatical is a claim on the insurance payout. It, in turn, has a risk for the buyer, since its not clear when the patient will pass away especially in the light of recent medical advances. So, its best when a number of these viaticals are packaged and sold ensuring a more steady stream of income.
Third, reducing information problems. The simplest example here is having credit-histories that ease lending in the absence of collateral, and connections.
A more complex example is the stock market. This generates information and helps guide future investment. Consider the counter-example of central bureaucrats who some consider to be better suited for planning investments. Hayek recognized that planning needs information, and that information is widely dispersed in society. The stock market acts as this vehicle for surfacing this information to society. Evidence: (1) When firms from underdeveloped markets cross-list their shares on US exchanges (having better accounting and disclosure standards), more analysts follow the company and accuracy of earnings predictions increases, leading to better outcomes. (2) In underdeveloped markets, prices of individual firms move up or down together based on macro-economic factors. This explains 60% of a stock’s price in Poland and 40% in Taiwan but just 3% in the US. (3) Last, in developed markets investment allocations move from dying to growing industries much faster (for the same positive signal about an industry, investment would increase over 7% in the US, versus 1% in India).
Fourth, reducing corporate waste and misappropriation. Managers can often use company funds for their own purposes. In Russia, this explains why oil firms are valued at 1/100th of a similarly sized US firm. This also explains why in some countries the acquisition price of a firm is often much higher than its stock price the next day: in Brazil (65%) and Czech (58%) versus developed markets (2%). Developed markets can enforce laws against misappropriation, and have company ratings agencies which publish guidelines and norms to be followed. Finally, corporate income tax effectively gives governments a large non-controlling stake in companies aligning its interests with those of minority shareholders. For example, the IRS closely scrutinizes price of goods between two firms to ensure income is not being transferred to a low-tax entity or to a manager’s favored firm.
Developed markets also prevent waste by making corporate takeovers easier. Investors can sue management for fraud, but not for underperformance due to the inherent risk of running any business. Large companies have free cash flow and are protected from competition, so this leads them to often invest in plush offices or in pet projects. Corporate takeovers let the bloated parts of a firm be sold, and profitable parts be invested in, acting like undertakers in the economy. This is in contrast to (say) Japan, where old firms linger on.
The last 30 years (prior to 2001) have witnessed a growing role of financial markets in the US. The ratio of stock valuations to GDP went from 66% to 150% in US, and 16% to 110% in France. New markets have opened like Nasdaq, and money market funds have grown to about $2 trillion. New financial derivatives have been introduced like index options, and interest rate swaps. These derivatives have a revenue of $163 trillion in Q4 2001 = 16x US GDP. Individuals can now get credit locally and internationally. Finally, cross-border capital flows have grown 10x in developed countries and 5x in developing during 1970-2001.
We now look at the history of financial development in the US in the 20th century to show how a confluence of different developments led to their growth. In the 1930s, financial markets were curtailed. Roosevelt introduced the New Deal in 1933-34, which added a new legal, accounting, and regulatory foundation. It also introduced banking legislation which hindered competition. Later, in the 1970s these shackles were removed.
Diversification of investments
In academia, Markowitz developed Modern Portfolio Theory which we can summarize, perhaps poorly, as how to properly diversify one’s portfolio. This led to a series of developments: there is a legal notion called the Prudent Man Rule which governs what are reasonable investments for managers of pension funds and similar institutions. Prior to 1979, stocks without dividends were not considered prudent. Relaxing this rule, led to the growth of venture capital, vulture capital (buying out distressed firms to restructure them) and buyout funds (providing exits to entrepreneurs). As a result, from 1980-99, these investments in private equity grew from $5 billion to $175 billion, a sum equal to the total investment in Italy.
It also enabled junk bonds in the 1980s, which were overly conservatively rated by ratings agencies. Milken, the infamous financier who started them, may have oversold their profitability and undersold their risk, but he did enable liquidity for them. In 2001, this is now a $650 billion market and a major source of financing for young, medium-size firms. They are too small/risky for highly-rated public debt markets, and too large/risky for local banks and these firms lack the relationships with large banks. The junk bond market let them escape the tyranny of collateral and connections. The junk bond market also improved governance in large firms: large banks are beholden to their relationships and don’t finance raids on their clients. Junk bonds enable financing for hostile takeovers of incumbents. This leads to a virtuous cycle that makes these incumbents better, leading to drawing more investors to stock markets, leading to more widespread availability of finance.
Cost of trading
Another big change was the drop in the cost of trading, and the consequent growth of the derivatives’ market. Before 1975, exchanges could not offer quantity discounts. So, buying 1k shares had commission of $39, and 100k shares had commission of $39k! Eliminating this reduced cost for large financial institutions. This led to the growth of the derivatives market: academia had explained how to hedge away risks of investment, but fixed commissions made it expensive. This opened up risk management, and financial engineering. It also led to the institutionalization of stock ownership: these investors analyze stocks more rigorously, leading to better use of funds. The average rate of return has grown from 5.5% to 9.9% during 1980-99. This in turn has drawn in more investors, leading to a virtuous cycle of more finance being available for growing the economic pie.
Breakup of Vertically integrated firms
The second industrial revolution led to the concentration of big firms until 1970. After this trade barriers were lifted leading to greater cross-border competition. Oligopolist firms with first-mover advantage in a local economy faced outside competition from differently organized firms. General Motors was vertically integrated, while Toyota relied on suppliers for intermediate goods and developed them in the US. This led to management being able to benchmark the performance of internal divisions against these intermediate-goods firms. Less integrated firms benefited from being able to buy from the best suppliers. Some managers of internal units even pushed for corporate independence. Vertically integrated firms were good at driving down the cost of a static product, but not being flexible for rapidly changing consumer needs.
Technology and Scale
In the 1960-70s, the technology for automation in manufacturing was developed. These let intermediate-goods makers avoid being locked to large production runs for a big client. Flexible systems needed fewer machines for given tasks. This reduced the size of factories, making them easier to finance and start them.
Information technology improvements also reduced the cost of exchanging info with outside firms. This made it easier to transmit product specs, and easier to collect bids.
The assets of legacy companies gradually became redundant. For example, Record companies became very concentrated. Their role was to find music artists, make taps, distribute them and market them. Earlier, small firms found artists and sold to large firms for distribution and marketing, but then internet made distribution much easier.
Worker mobility also increased. Earlier, the skilled manager of an integrated firm was trapped, knowing the specialized processes of that firm. With intermediate firms, processes get more familiar across firms, leading to greater labor mobility. Note: we see this in tech where Facebook and Google are integrated and use their own internal software tools, but startups use common tools. Access to finance also increased opportunities for them to start own businesses. E.g. Intel was founded by Fairchild Semiconductors employees with a new idea which was being ignored by their firm. 71% of firms in US Inc 500 was founded by people who replicated or modified an idea encountered in their previous job.
A major promise of the development of financial markets is that economic resources are allocated well. However, there have often been mispricings and deviations from the Fundamental Value of an asset. The Fundamental value of a stock is today’s value of the stream of payments the firm will make to its owners (dividends).
Sometimes there can be two financial assets that are a claim on the same underlying stream of dividends, and they can get mispriced. Any discrepancies here are opportunities to arbitrage. But there is no riskless arbitrage. The market can stay inefficient far longer than the time horizon of the investors. For example, Long Term Capital Management (LTCM) was a hedge fund that borrowed treasury bonds, and then sold them to buy high-yield bonds that are also high-risk on the analysis that the market had become unduly scared of them. Unfortunately, the market was irrational for longer than LTCM could sustain its position and the firm went bankrupt. Eventually though it was proven to be right as the price of these bonds rose.
A common phenomenon in new financial markets is that of a bubble. New technology is introduced which ordinary investors don’t know how to value. Prices get bid up as a result. Developed markets have financial derivatives to calm prices e.g. buy a put on the market index (an option to sell at predetermined price if market falls). However, the rise of institutional investment blunts the effectiveness of arbitrage, because these managers are judged by how much they beat the market. Hence, they try to stick to the benchmark. The Magellan fund, was a famous mutual fund in the 1990s, which shunned internet stocks in 1996 arguing that they are mispriced. Unfortunately, while rationally correct, the market didn’t agree with them until 2000, and they had to suffer years of underperforming the market.
Mispricing can affect investments. The 1920s and 1987 rise in stock prices didn’t affect real investments. The 1929 crash did depress real investments. The dot-com bubble saw corresponding real investment in companies and telecom. Most was wasted, however, to the sum of around $250 billion. Thus we can see that mispricing and misallocations can happen even in developed markets.
Given this conclusion, we can see some real risks in developing financial markets. When going from a closed, regulated system to an open free-market system the chance of a crisis seems to be higher. In 18 of 26 banking crises in the last 20 years, the financial sector was liberalized in preceding 5 years. However: this is correlation, not causation.
When an economy liberalizes, new competition squeezes profits. New skills are needed to lend in this world where business acumen matter more than collateral or connections. New infrastructure (accounting standards, better contract writing, better debt collection mechanisms) is needed. Until this infra matures, lenders have to make better credit decisions on their own.
It has been established that financial development causes broader economic development. This is not mere correlation. From 1960-89, a sample of 80 countries showed that beginnings of financial development are associated with higher economic growth in the subsequent decade. Countries where credit is allocated by commercial banks rather than central bank are considered more developed.
Is it causation or do financial markets anticipate impending growth and swell? To rule this out, consider two possibilities:
First possibility: If financial development causes growth, it should have much larger impact on some industries than others. Example 1: pharmaceutical drug development takes long time and needs outside investment to sustain. Contrast it to the tobacco industry which can use profits to invest in further growth. In countries where financial markets develop, the pharma sector sees greater growth than the tobacco industry. If metric for development is mature accounting standards, then Malaysia > Korea > Chile and we see corresponding growth of pharma industry is better in this order as well.
Example 2: Banking in US states was restricted to in-state banks, and even in-state banks couldn’t often open more branches. This was gradually opened up to out-of-state banks from 1971-90. This saw loan losses decrease, reduction in loan rates, increase in rates paid to depositors, and GDP rate increased by 0.5-1% per year.
The second possibility concerns Finance and Competition. Finance facilitates new entry. But does this lead to more concentration? After the bank deregulation in US States, these states experienced increase in rate of formation of new enterprises. A measure of competition is the profit-margin. A firm in a more competitive market should have a lower profit margin. In Italy, different regions have different judicial efficiency, which affects finance. Chances of being rejected for loan for the same individual are 2x in certain regions. In developed regions, profit margins are 1.6% lower than underdeveloped.
Case study: cotton textile industry
As a case study, we can consider the cotton textile industry: access to capital is the primary barrier to entry. We can study it to understand effects of finance on competition. Stephen Haber, a Stanford historian studied this market for the period 1850-1950. In this market, the minimum economic scale of production is not super high, incumbent firms cannot build massive plants to compete away nascent competition. Few important patents during this period, and advertising was not important. The main barrier to entry: financing for plant, machinery and working capital.
We focus on Mexico and Brazil as two markets to contrast. In 1800s, the Mexican govt had few revenue sources, mainly customs duties. Governments were unstable, and changed frequently. This made politicians short sighted. In times of war or crises, it was easy for government to default on its loan obligations. This raised interest rates for the govt., sometimes to 200%.
Only a few rich financiers were willing to lend: because they had the little surplus capital, and also the muscle to force the government to pay back. They could also extract favors like the state mints, state tobacco monopoly, salt mining administration, toll routes, etc. These financiers had little incentive to see competition develop. Only 8 banks in 1884, 47 in 1911 of which a mere 10 could lend for more than a year. Old clique had control over the big banks. This suited the government which wanted a stable market for its debt, and didn’t want banks to compete away profits in serving larger public. The biggest bank (Banamex) acquired many privileges like needing to keep only half the reserve-ratio of other banks, tax-exemption, etc. Entry requirements for new banks were onerous: high capital and reserve requirements, and needing to obtain permission from the Treasury and Congress.
The public markets were underdeveloped. Porfirio Diaz, dictator from 1874-1911, brought some stability and reforms. Mortgage lending rules passed in 1884 and free incorporation with limited liability in 1889. Reforms for financing corporations were half-hearted. Financial reporting requirements were loosely enforced. Manufacturing firms often failed to report production numbers. Paucity of public info made people reliant on the rich financiers for certifying and monitoring which companies were safe to invest in. Thus, only the few promoters with connections to the rich financiers were those who could raise equity financing.
Lets contrast this to Brazil. Prior to 1889, it was similar to Mexico. Almost useless stock exchange, small and concentrated banking scene. Many barriers to LLCs: needed permission to incorporate, and promoters didn’t actually enjoy limited liability. Banks could not buy stocks, and no one could buy stocks on margin. The Bourgeois revolution of Europe also went through Brazil. Urban middle class, and powerful coffee planters overthrew the emperor, who was tied to landed aristocracy, and a republic was established.
The government reformed banking: made it easy to setup new banks, removed restrictions on investments, allowed margin loans, made LLC easy. Forced corporations to publicly share information on operations and shareholders. The number of banks went from 26 to 68 from 1888-91. Corporate debt market started and did 32% of investment from 1905-1915. The stock exchange took off.
Uncontrolled liberalization led to a boom and then bust. In 1906 only 10 banks in operation. But while banking was subdued, public debt and equity markets kept going, and financed firms. In 1915, 32 IPOs happened and bonds were 21% of long term corporate investment. Even today in the US, corporate bonds are about 20% of total investment.
Now, we can contrast the growth of the cotton textile industries:
In 1912, 4 of 100 mexican textile firms were publicly traded. 32 of 180 (18%) in Brazil were. Mexico had little debt financing, and only to those with connections. Debt:equity ratio of biggest mexican firms was 0.09%. In Brazil, was 7x more = 0.64% mostly long-term debt from public market. In 1883, Brazil had 44 firms with 66k spindles. 4 largest firms had 37% of market sales. Mexico had 2x firms, 4x spindles and 4 largest firms were 12% of market sales.
In 1915, Brazil had 180 firms, 1.5 million spindles, 4 largest firms were 16% of market. Mexico had 100 firms, 0.75 million spindles, 4 largest firms were 27% of market. Brazil industry grew faster, and became less concentrated. Mexican was opposite. Poor disclosure norms resulted in even foreign financing being directed to largest, and best known firms. During this period, Mexican national income grew from 55% to 95% of Brazil’s. Since demand for textiles grows disproportionately with national income, this should have benefitted Mexico, but it didn’t.