Works of Raghuram Rajan- Saving capitalism from capitalists

Capitalism enterprise along with strong political foundation is the growth driver of an economy. Financial markets being the hub for exchange of funds contribute significantly to the economy but their role is often not as easy to understand. Capitalism encourages innovation, entrepreneurship, creative destruction where old ideas are replaced by new fresh ideas leading a way towards greater economic freedom. Financial markets act as the make-or-break case in making the country competitive. Indeed we can learn lesson from financial crisis that have surfaced over a period and try not to replicate those mistakes by placing adequate controls, proper route for channelizing finance and understanding creditworthiness of individual or firm before lending credit. Free market economy without political or government intervention cannot survive as a sustainable model for long term economic growth.

Does Finance benefit only the rich?

There are two versions of free market enterprises existing in the world. Free markets or capitalism encourages meritocracy, feasible exchange of goods and services among various parties involved boosting trade, employment and encouraging entrepreneurship. But on the other side, there exists corrupted version as well in which powerful interests of the rich prevent competition from playing its natural role and thus, it is not representative of free market enterprise. To top it all, free financial markets have added fuel to the process of creative destruction that was evident during 2008 financial crisis. It elicited a very nice example from the book Bonfire of the Vanities, which explains how financiers acting as intermediaries to borrowers and lender of funds seek for little crumbs (commissions) such that one day they will have enough crumbs to make one gigantic cake.

The greatest monopoly in US is money monopoly where money power is concentrated in the hands of few men who try to exploit the system to make gains for themselves thus destroying genuine economic freedom. Role of a financier is that of a watchman or gatekeeper who in situations of limited resources controls both parties (rich and middle class), thus, he has the power to whom to give money and to whom not. Financing is defined in the book as exchange of sum of money today for a promise to return money in the future. Problems intrinsic to financing are uncertainty or risk, adverse selection or moral hazard which puts one’s money invested in danger of not earning return or even eroding capital.

Financier’s main job is the allocation of risk i.e. spreading out risk across portfolio also called as risk hedging or diversification. Thus, risky investments charge more premiums to compensate for the reward of high returns expected and opportunity cost of remaining invested in that security. Important connections with financiers or lender of funds can ease access of credit and also increase the magnitude of credit available. In case of adverse selection, honest borrowers drop out of opting for the funds when the interest rate is high and borrowers with poor credit history or have no intention of repaying apply for such financing and thus creating bad pool of applicants i.e. adverse selection and further cash flows expected out of the investments are affected. Solution to this problem can be to introduce collateral which reduces uncertainty of payments and valuation of physical assets is easier than that of character. Study has shown that more lending of funds occur when financier can easily seize the collateral.

An example is elicited to which we Indians can relate to. Dharavi slum in Mumbai area where there are lots of illegal construction and thus such property cannot serve as collateral. One suggestion that may arise is that Indian Government should clear title for the land to the poor. But such effort can have opposite effect as it will encourage many more slum dwellers for illegal construction in such sites in order to have access to Government’s initiative of title for the land .Importance of finance was much more evident during second industrial revolution and explained by an example of John D. Rockefeller’s Standard Oil Trust, an alliance sought to gain monopoly controlling 90% of American refineries and pipelines, such that economies of scale can be achieved through joint cost. Another important characteristic was the emergence of hierarchy of professional managers. As the family business grew leaps and bounds, professional managers were needed to control large diversified operations of firms adopting industry wide best practices.

Both managers at senior and junior positions along with unskilled workers at the bottom of organizational pyramid were exploited by owners of the firms during the second industrial revolution rendering them powerless. Due to emergence of democracies, labour unions came into being protecting the interests of workers, giving them the right to proper wages and avoid exploitation by owners of firm.

Shylock transformed

The power of capitalism in the wrong hands has done more harm than good for the nation. Socialists like Karl Marx proposed that state or the government should be the prime authority to control the economy and not the owners of capital. Government can pretty much decide whom it wants to finance, what should be the price. But this system of financing if not regulated within the confines of the government will benefit the favoured groups. The socialists had the wrong answer to right question which meant that access to finance should be expanded to all and not limited or pre-decided by the authorities.

Nobel prize winning author- Markowitz argued that risk of and investment should be understood in terms of risk overall portfolio of investments for an individual or firm, finding out the relationship or co-relation between two asset class. Thus, he talked about risk diversification. A well-diversified investor can tolerate a risky investment if he is invested in a portfolio with two stocks which show negative co-relation with each other. Limited liability that an individual enjoys if he invests in the firm today limits his exposure to the risk such that in case of bankruptcy of firm, he will at maximum lose out on all the capital he invested into this firm. Risk management using complex financial instruments like derivatives is explained by an example of dynamic hedging-deal done by Banker’s trust to encourage employee stock options in France. It was proposed that Banker’s trust would give minimum 25% guaranteed return on stock options plus two-third appreciation of stock to employees of Rhone-Poulenc and Banker’s trust would keep the rest one-third appreciation of stock.

There are many factors that increase availability of credit. One such is wider availability of full information to the public. Dun and Bradstreet (D&B) collects information about a firm through telephone contacts of business owners and managers, news sources, firm’s banking and trading partners and their records have grown over 6.3 percent over a year. VC (Venture capitalists) has become quite the norm for start-ups springing up in every nook and corner of the world. Minimum return that such VC firms expect is around 50% as they spend time and effort excessively to advice and plan out strategy for the firm to grow. VC’s also doe get involved in the company’s management and influence business decisions when the performance of company is not up to the mark.

Financial revolution and Individual economic freedom

There is large scale revolution in finance in the developed countries of the world in last three decades with increasing proportion of listed stocks as percent of GDP, increase in stock market capitalization and revolving consumer credit such as credit cards with borrowers having access to funds from domestic as well as foreign investors. With diversification into private equity market such as venture capitalists which finance start-ups, buyout firms which finance the acquisition of existing companies and vulture firms which buy debt of financially distressed firms in hope that debt restructuring will improve financial health of the firm. Junk bonds became increasingly famous with issues increasing from $1billion to $30 billion. Junk bonds are low-rated bonds with less risk and high yield if invested in diversified portfolios. There was growth in market for derivatives with the Banker’s trust being the pioneer. Vertically integrated firms dominated capital intensive industries in second industrial revolution as they wanted huge profits from brand names and assets associated with it. Cross border trade increased competition among firms. Vertically integrated firms enjoyed much advantage as explained by General motors and Toyota example.

With the advent of new technology in 1960’s and 70’s in manufacturing capital intensive sectors using high-end machinery and robots replaced much of the unskilled labour workforce. In this era, workers were motivated not to stick with firms for too long and looked for skill up gradation, career switch options thus increasing worker mobility. In US average worker has had nine jobs between ages 18 and 34. Also, entrepreneurship is encouraged as managers with good work experience combine their vision and skill-set to dwell into unexplored areas. Even though there has been jump in mergers and acquisitions due to newly developed geographic markets, firms are increasingly becoming smaller as large corporations tend to become bureaucratic over time and there is growth of development in-house capital market for firms. With increased competition, emergence of small firms and entrepreneurship, less authoritarian rule for workers and increase worker mobility is paving a way for greater financial development and improving health of economy.

Dark side of Finance

The various scandals and turmoil economy had to face due to poor financial system at place questioning its ability of regulation and integrity. Enron accounting fraud and 2008 financial crisis are examples help to explain the other side, i.e. dark side of finance which has surfaced leading to 30% fall in country’s GDP due to a banking crisis. It is argued that financial firms are much weaker and collapse quickly than industrial firms as financial firms can create value easily. Derivative complex financial instruments in use today are waiting like time bomb to explode. With increasing liquidity and easy availability of credit to leverage their positions, financial firms play with new instruments which can have adverse impact on the economy as a whole.

A firm’ stock price should reflect future cash flows discounted to reflect present value is the main basis for fundamental valuation of stock. This sis explained by the example of Royal Dutch shell oil giant. Long term Capital Management firm started by John Meriwether to undertake arbitrage trades such that buying under-priced and selling overpriced value of stock and profiting by small margin due to arbitrage. Further this firm increased its bets to target higher profit margins and was successful too.

It was involved into selling low-risk Treasury securities and buying high risk bonds, which led to increased risk exposure and when Russia defaulted on its payments in August 1998. LTCM was headed towards bankruptcy. Internet bubble in early 1990’s encouraged many private equity firms to pour in capital in new start-ups even without a sound business plan in hand. Such was the case that with stocks prices soaring high, they plummeted such as compared with tulip mania in 17th century. Bubbles often arise due to lack of knowledge and experience of investors investing in booming stocks and just following a herd mentality. Thus, it cannot be said with certainty that financial development will help one identify the emerging bubble early-on and possibly avoid investing in such markets. With liberalization of economy, new competition squeezes profits and thus, new infrastructures along with new and upgraded skill set of workers are needed to drive growth.

Bottom line on financial development

There are various attempts have been made to resolve the argument whether financial development is necessary for growth of economy. Finance encourages competition, infuses fresh ideas and enhances economic mobility. There is a correlation between financial development and growth of economy but presences of one does not influence another. This was example by a beautiful of bird travelling to and fro on a railway track and train approaching it as co-related events but not an example of causation. For process of financial development to gain momentum, firm needing external financing should indeed increase over time. As evident for high-growth firms not paying dividends and ploughing back the cash generated back into business and thus doesn’t have to look for external financing options.

Banking deregulation in the United States encouraged competition among banks, decreased loan losses and also made both borrowers and lenders better off as there was a reduction in loan rates to borrowers and increase in rates paid to depositors. It is argued that finance cannot create opportunities, but only mould it or exploit it. Countries opening up their equity market to foreign investments results in GDP growth rate of over 1.1 percent per year. Financial markets in Mexico and Brazil in 1900’s are studied in greater detail encouraging industrial growth especially for textile market due to increased competition, financially strong system at place. With easy entry into various industries due to availability of arm’s-length finance which can cause an industry to look out for new avenues and change its working. With firms becoming more capital intensive and employing technology are replacing unskilled workers thus, boosting productivity.

When do financial markets emerge?

The greatest impediment to development of capitalism or free market enterprise was the rapacity of governments. Thus, the first step to develop well rounded financial system was to tame the government, giving more power to people through proper and wide distribution of property. The need for central authority-government as it enjoys comparative advantage and put various economic reforms and policies into the system and controlling it in the best interests of the wider audience. 

The Great Reversal

Government respect of property rights is the first crucial step towards financial development for that country and it is not guaranteed that policies or reforms implemented will reflect the needs of the citizens of that country. During Great Depression of 1929, many countries closed their borders for any international trade and capital flows was limited. Gold standard acted as the facilitator of trade during early twentieth century that the same time imposing tight budgetary discipline on governments. Gold was used for circulation of money in many countries back then. But later there were certain issues arising from balance of trade and governments became increasingly depended on foreign governments due to exchange of surpluses and also the exchange rate remain fixed not allowing it to depreciate causing further problems in decision making during adverse economic downturn.

Post World War I, led to questioning about gold standard and there were two major consequences out of it. First one being need to coordinate war production led to wartime capitalization as the military expenditure was costly and there were bans imposed on private consumption to aid military funding. Second one is the working middle class became more aware of its power. There was a move towards market determined prices. Financial markets shrank in size drastically starting in 1930’s and not showing recovery signs until 1980s. During 1930s many reforms were suggested in US too and one such was banking act of 1933 also known as Glass Steagall act which necessitated the need for separate banks for commercial and investment purposes, thus banks were given a choice to either do only commercial banking or investment or merchant banking but not both.

There was emergence of relationship capitalism in the post war world II period as there was distrust among markets during which steel tariffs of 2000 were levied, accounting fraud and a stock market decline resulting in great depression. Bretton woods agreement in 1944 in New Hampshire gave apromise for post war economic reconstruction facilitating trade between countries and achieves exchange rate stability, encouraging cross border capital flows under the umbrella of economic policies. Eventually it led to collapse of Bretton Woods’s agreement and fall of relationship capitalism followed by cartel of oil producing nations OPEC in 1970s to come up with policies and reforms to influence world prices worldwide.

Key Challenges Ahead

With advent of technology, which increases the lay-off rate by firms to replace moderate unskilled workers by advanced machinery and automation process controls, aging population looking for benefits and support from government, thus increasing government spending in this sector without reaping any future returns. Also it is facing stiff competition from emerging economies from India and China due to presence of cheap labour and increasing cross-border relations. On the other hand, developing economies fear the entry of multinationals from developed economies through global brands, highly competitive markets, more viable business model and huge capital funding at place.

As it is known that in free market enterprise, invisible hand of the market is at play and often it is thought that there is substitute for bureaucrats and politicians.Markets cannot flourish without government intervention and resources provided by it. In order to make huge profits, private players ignore the interests of public- such that he who has the gold makes the rules. A classic example of Diamond industry is in trade with high entry barriers for anybody outside Jain community leading to less transparent system. Two goals of policy are suggested, firstly, to keep economic power from getting increasingly concentrated and second is the efficient use of economic resources for the greater benefit of the public and not merely serving private interests. Various such instruments are proposed for this such as anti-trust laws, property tax, and better corporate governance, insuring people and not firms and safety net for distressed.

Lessons from the Great Recession

There is high uncertainty about the growth prospects when recession comes into picture as demand decreases and accumulated debt haunts until there is a ray of hope for revival of economy. Households and countries reduce their spending and purchasing power decreases. Keynesian pundits have advised to pour more money into the economy such that it will increase household spending, government made easy credit available to households to pump growth, benefits to the jobless to reduce unemployment rates leasing expansionary monetary policy such that it resulted in stagflation in near future. So, Government planned to control inflation buy continuing deficit financing with inflation figures sky-rocketing at start but slowly due to deregulation of many industries like banking, aviation, electric power, etc. productivity began to pick up in US and UK.

Focus shifted to efficiency, boosting entrepreneurship and innovation, increasing competition and that the same time increased income inequality as the rich got richer and poor got poorer. So along with widening income good there was availability of cheap consumer goods. Post war era, incumbent firms enjoyed quasi-monopolistic profits and distribute their income among shareholders and workers. But due to deregulation of many industries, new entrants started penetrating the market to gain market share fuelled by easy access to finance. As companies were put under pressure to take more risks, they headed towards more risky financial instruments like derivatives and anybody with good education and right skill set was hired by to notch firms to lead their businesses. Laying off workers was common norm, as technology started replacing unskilled workers to increase productivity and it is argued that in the race between technology and education, education has lagged behind. Also,Government’s decision to enhance public’s access to finance, such that middle class workers bought expensive homes, cars and clothes to keep up with their rich neighbours. In early 1900s, US leaders increased lending to middle class with poor credit history with many US households opting for easy credit facility led to increase in real estate prices in US and led to housing bubble burst. Various measure that can be employed to put economy back in track is y allowing free entry, reduce employment protections leading to more private sector jobs, subsidies for firms hiring young talent and support for older unemployed youth, encourage finance for new business ventures to boost employment and thus drive economic growth.

Conclusion

Capitalism and political intervention go hand in hand, with increase in privatization, deregulation of many industries and widespread liberalization. Thus free markets should not be too free and thus competition is encouraged creating a level playing field allowing new entrants to contribute to economy in wholesome way. A truly free competitive market creates a narrow path such that capitalism is in its best form very unstable and easily degenerates into system for the incumbents, by the incumbents and of the incumbents, thus encouraging monopoly, increasing entry barriers and discouraging healthy competitive environment. Greatest danger for the market to grow is not that it is headed towards socialism but moving towards relationship system such that decreasing competition and reducing risk.

Tags: development financials governance indian economy inflation unemployment