Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity - Hardcover

Raghuram G. Rajan; Luigi Zingales

Hardcover

ISBN 10: 0609610708 ISBN 13: 9780609610701

Publisher: Crown Business, 2003

Synopsis

Capitalism’s biggest problem is the executive in pinstripes who extols the virtues of competitive markets with every breath while attempting to extinguish them with every action.

Saving Capitalism from the Capitalists is a groundbreaking book that will radically change our understanding of the capitalist system, particularly the role of financial markets. They are the catalyst for inspiring human ingenuity and spreading prosperity. The perception of many, especially in the wake of never-ending corporate scandals, is that financial markets are parasitic institutions that feed off the blood, sweat, and tears of the rest of us. The reality is far different.

•Vibrant financial markets threaten the sclerotic corporate establishment and increase corporate mobility and opportunity. They are the reason why entrepreneurship flourishes and companies like The Home Depot and Wal-Mart—mere fly specks a quarter of a century ago—have surged as they have.
•They mean personal freedom and economic development for more people. Throughout history, and in most of the world today, the record is one of financial oppression. Elites restrict access to capital and severely limit not only general economic development but that of individuals as well.
•Open borders help check the political and economic elites and preserve competitive markets. The greatest danger of the antiglobalization movement is that it will keep the rich rich and the poor poor. Globalization forces countries to do what is necessary to make their economies productive, not what is best for incumbent elites. Open borders limit the ability of domestic politics to close down competition and to retard financial and economic growth.
•Markets are especially susceptible in economic downturns when the establishment can exploit public anger to restrict competition and access to capital. While markets must be free to practice “creative destruction,” Rajan and Zingales demonstrate the political and economic importance of a sustainable distribution of wealth and a baseline safety net. Capitalism needs a heart for its own good!

There are no iron laws of economics that condemn countries like Bangladesh to perpetual poverty or the United States to perpetual prosperity. The early years of the twentieth century saw vibrant, open financial markets that were creating widespread prosperity. Then came the “Great Reversal” during the Great Depression. It can—and will—happen again, unless there is greater understanding of what markets do, who benefits, and who really wants to either limit them or shut them down.

Saving Capitalism from the Capitalists breaks free of traditional ideological arguments of the right and left and points to a new way of understanding and spreading the extraordinary wealth-generating capabilities of capitalism.

About this title

About the Author

RAGHURAM G. RAJAN is the Joseph Gidwitz Professor of Finance at the University of Chicago’s Graduate School of Business. Dr. Rajan is one of the foremost academic experts on banking and comparative financial systems. He is a director of the American Finance Association, an associate editor of the American Economic Review, and a program director for corporate finance at the National Bureau of Economic Research.

LUIGI ZINGALES is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago’s Graduate School of Business. Dr. Zingales is one of the foremost academic experts on corporate governance and is an inaugural fellow of the recently instituted European Corporate Governance Panel. He is a faculty research associate at the National Bureau of Economic Research and a research fellow at the Center for Economic Policy Research.

From the Back Cover

“Economists usually take it for granted that markets are efficient and that a free market system will therefore prevail. Rajan and Zingales do a wonderful job of arguing that free markets, particularly free financial markets, in spite of their many benefits, are under continual threat from a variety of enemies and must be constantly fought for. Although Rajan’s and Zingales’s reasoning is sophisticated, they write simply, lucidly, and compellingly, and their ideas will be accessible to the general reader. The book deserves a large audience, and it would not be an exaggeration to say that the capitalist system will be more secure if it gets one.”
—Oliver Hart,
Andrew E. Furer Professor of Economics,
Chairman, Department of Economics, Harvard University

“Saving Capitalism from the Capitalists is an extraordinary blend of economic and political analysis, on the one hand, and deft policy recommendations, on the other. Everyone interested in a stronger market-oriented global economy should read this book.”—Jeffrey E. Garten,
Dean, Yale School of Management,
Former Undersecretary of Commerce for International Trade

“Free markets aren’t free. Those of us who live and work in the world’s most advanced market economy tend to take them for granted, much as a fish does water. Rajan and Zingales help us look anew and see just how politically vulnerable and fragile markets are. Saving Capitalism from the Capitalists is at once erudite, insightful, and prescriptive, as it moves our understanding of markets far beyond the stereotypical arguments of the right and the left.”—Barry Nalebuff,
Milton Steinbach Professor, Yale School of Management,
Coauthor of Co-opetition and Thinking Strategically

“Saving Capitalism from the Capitalists is an innovative, thought-provoking analysis of the capitalist system. Rajan and Zingales argue that financial markets are critical for spreading the opportunities generated by capitalism. In the last few decades, we have seen the beginnings of the effects of free financial markets on business practices, a revolutionary change that is benefiting all. However, there is a danger in taking these gains too much for granted. In this timely book, the authors point to how politically fragile financial markets are and offer valuable suggestions on how modern economies can build support for them. This is a must-read for every thinking manager, in fact, for anyone who worries about the future of the capitalist system.”—Rajat Gupta,
Managing Director, McKinsey & Company

Reviews

Rajan and Zingales take the Chicago school of economic theory in a new direction with an erudite, comprehensive defense of the free market system, steering a course between conservative isolationists and liberal antiglobalizationists. Only unfettered markets, rather than protectionism, they argue, can provide an environment supporting competition, innovation and economic growth. When businesses suffer losses or fail completely, it means competition is successfully weeding out the incapable-and the authors have nothing but harsh words for governmental attempts to prop up sagging industries through subsidies or tariffs on foreign competitors. They're honest in acknowledging that their "tough break" approach to failure offers little consolation to downsized laborers, but gamely suggest the economically "distressed" should recognize their options and look beyond obfuscating corporate rhetoric about "saving jobs." The book draws strong historical parallels between the half-century market clampdown following the Great Depression, when the public recoiled at the consequences of unmanaged economic risk, and the pessimism fostered by recent high-profile failures and corporate excesses. Because the authors view political support for the free market system as always tenuous, they offer suggestions on how to combat antimarket sentiments by promoting a stronger international market, which would reduce the ability of economic "incumbents" to persuade governments to suppress competition while offering workers some protection against the risks of failure. They argue their case well (though general readers may find some of the more academic passages tough going) and provide a clear new definition for the terms of the free market debate.
Copyright 2003 Reed Business Information, Inc.

The authors, both professors of finance at the University of Chicago's graduate school of business, take an in-depth look at the advantages and shortcomings of free financial systems in a historical context. They argue that although free markets are often reviled, especially during economic downturns, the inherent risks involved and the propensity for some individuals and corporations to corrupt the system can be overcome somewhat. When markets are suppressed, as happened after the Great Depression, competition is stifled, and trade tariffs that are intended to benefit individual nations ultimately harm worldwide economic health. What role, then, should governments play in overseeing financial markets? Historically, so the authors show, respect for individual property rights is the essential first step, and when property is available to the widest classes of people who can actively manage it, the groundwork for free financial trading is laid. For advanced financial systems such as that found in the U.S., the authors propose a balanced approach of government participation, including both measures to provide incentives for free markets and insurance for safety during times of crisis. David Siegfried
Copyright © American Library Association. All rights reserved

Excerpt. © Reprinted by permission. All rights reserved.

Does Finance Benefit Only the Rich?

For the political foundations of free markets to become stronger, society has to become more cognizant of how much it owes them. The first step in mounting a defense of markets is to create awareness about both their true benefits and their limitations. Because the free market system is so weak politically, the forms of capitalism that are experienced in many countries are very far from the ideal. They are a corrupted version, in which powerful interests prevent competition from playing its natural, healthy role. To defend free markets against their critics, therefore, we have to show not only how much of our plentiful lives we owe to them but also why the grim parodies of capitalism through much of even recent history are not truly representative of free market enterprise. And further, we will try to convince the reader that we are not faced today with the Hobson's choice between a corrupt socialism and a corrupt capitalism, as has been the case through much of history. There is a better way, and it is largely within our reach.

One group of markets, the financial markets, attract even more opprobrium than others. Few trained economists in the developed world today would be against free markets in goods and services, but a sizable number can still be found who would oppose free financial markets. Not only are financial markets more misunderstood than other markets, they are also more important because, as we will argue later, free financial markets are the elixir that fuels the process of creative destruction, continuously rejuvenating the capitalist system. As such, they are also the primary target of the powerful interests that fear change. Through much of the book, therefore, we focus on the financial markets as our representative example.

To mount a defense, however, we have to know what we must defend against. So let us now examine what the public believes financial markets and financiers do. One belief that is widely held is that Wall Street is a parasite living off of Main Street. At best, the financier takes from Peter and gives to Paul, while keeping back a significant commission to furnish a luxury apartment overlooking Central Park. Tom Wolfe's The Bonfire of the Vanities perfectly captures this view of financiers. Here is a passage from it in which Judy McCoy explains to her daughter Campbell what exactly her father, a bond salesman, does:

"Daddy doesn't build roads or hospitals, and he doesn't help build them, but he does handle the bonds for the people who raise the money."

"Bonds?"

"Yes. Just imagine that a bond is a slice of cake, and you didn't bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that."

Judy was smiling, and so was Campbell who seemed to realize that this was a joke, a kind of fairy tale based on what her daddy did.

"Little crumbs?" she said encouragingly.

"Yes," said Judy. "Or you have to imagine little crumbs, but a lot of little crumbs. If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake."

Wolfe is not in a minority in deprecating financiers. Works ranging from Shakespeare's Merchant of Venice to Emile Zola's Money have financiers occupying a moral space considerably below that of prostitutes.

Even while many view them as leeches, others see them as too powerful. Consider these words of Woodrow Wilson during the United States presidential campaign of 1912:

The great monopoly in this country is the money monopoly. So long as it exists, our old variety and freedom and individual energy of development are out of question. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of few men, who, even if their actions be honest and intended for the public interest, are necessarily concentrated upon the great undertakings in which their own money is involved and who, necessarily, by every reason of their own limitations, chill and check and destroy genuine economic freedom.

Wilson recognized the importance of finance ("a great industrial nation is controlled by . . . credit") but lamented that its power was used to "chill and check and destroy genuine economic freedom." Are these two seemingly opposite perceptions--financiers' being useless while at the same time being too powerful--compatible?

They are, and they characterize financiers well, but only in an underdeveloped financial system--a system lacking in basic financial infrastructure such as good and speedily enforced laws, clear accounting standards, and effective regulatory and supervisory authorities. The reason why these beliefs are valid is simple. Talent and business acumen are worth nothing without the funds to put them to work. A good financial system broadens access to funds. By contrast, in an underdeveloped financial system, access is limited. Because funds are so important, the financier who controls access is powerful, but because access is so limited, the financier can make money doing very little. His role is simply that of a gatekeeper, keeping the rich within the gates safe while keeping out those who would compete for resources. He thus validates both Judy McCoy's view that he scrounges crumbs from the pie that others create and Woodrow Wilson's view that financiers "chill and check and destroy genuine economic freedom."

Why is finance so limited in an economy without financial infrastructure? Financing is the exchange of a sum of money today for a promise to return more money in the future. Not surprisingly, such an exchange can be problematic. First, even the most honest borrower may be unable to live up to her promise, due to the uncertainty intrinsic in any investment. Thus, financiers have to bear some risk. When the risk involved is substantial and concentrated, it becomes difficult to find people willing to bear it. Second, promises are hard to value. People who do not intend to keep them are more willing to promise a lot. Hence, the very nature of the exchange tends to favor the dishonest. Finally, even individuals with the best intentions may be tempted to behave in an opportunistic way when they owe money. In an economy without the infrastructure to mitigate these problems, financing becomes restricted to the few who have the necessary connections or wealth to reassure financiers. The financier can prosper simply by acting as a gatekeeper. As we explain in this chapter, the limited access to finance severely reduces the choices citizens have in determining the way they work and live.

In the next chapter, we explain why this does not need to happen. With the appropriate infrastructure in place, the intrinsic problems we describe can be overcome, so that the financier can broaden access to funds and enhance economic freedom. And this is not just utopian thinking. As we describe in Chapter 3, the revolution that has taken place in the U.S. financial markets in the last twenty years has already enhanced economic freedom greatly, placing the human being rather than capital at the center of economic activity. All this suggests that those who want to oppose free access to finance and the attendant freedoms it brings need focus merely on holding back the institutional infrastructure needed for a modern financial market. The problems intrinsic to finance will do the rest by restricting access. Once we understand this, we will be ready to embark on the rest of the book.

The Problems Instrinsic to Financing

Chance, ignorance, or knavery--in the jargon, uncertainty, adverse selection, or moral hazard--can intervene to prevent financing from being repaid. Let us quickly explain why.

Few investments are perfectly safe--there is typically some uncertainty about whether they will succeed. To attract funds to risky ventures, individuals or firms undertaking them have to promise their investors a risk premium over what they would earn on safe investments. In a developed financial system, financiers reduce the premium required of a borrower by spreading risk widely over a variety of investors or allocating it to those investors who can best bear it. Because financiers in an underdeveloped financial system do not have the ability to distribute risk appropriately, the risk premium their investors demand is high, and finance becomes extremely costly.

The problems caused by uncertainty are exacerbated because not all people are intrinsically honest. Without extensive information on a borrower's past credit history, it is hard for a financier to tell the honest from the dishonest. Even if there is a default, it is not easy to separate bad luck from crookery. Since the dishonest are hard to identify and punish, financiers with limited information again have to resort to charging high rates.

There is a limit, however, to the rates a financier can charge. One problem the financier faces is termed adverse selection. Honest borrowers who intend to repay are very sensitive to the interest rate. They expect to bear the full burden of repaying the high rate. The higher the rate is, the more honest borrowers will drop out of the pool of applicants, realizing that the credit is not worth the high repayments. By contrast, borrowers who have no intention of repaying will apply for credit and remain in the pool of applicants, no matter how high the rate. In short, the higher the rate is raised, the more the pool of applicants will be "adversely selected" to be primarily bad borrowers. But the higher the concentration of bad borrowers, the higher the interest rate a financier should charge to break even, in light of the higher expected rate of default. This is a vicious circle. The more he raises the rate, the more the financier needs to raise it, till the point at which all good customers are discouraged from borrowing. A...

Edition details

• Publisher: Crown Business
• Publication date: 2003
• Language: English
• ISBN 10: 0609610708
• ISBN 13: 9780609610701
• Binding: Hardcover
• Edition number: 1
• Number of pages: 384