Monday, 10 August 2015

The rise of finance and capitalism

Fostered by a growing incorporation into joint stock companies, the progressive adoption of limited liability, the development of capital markets and the use of fiat money, credit rose to become one of the main drivers of economic growth under capitalism.

Yet, from the beginning, this growth in credit and banking raised many concerns, because it would subordinate the production to money making, giving a special advantage to those with access to money and increasing the scope for speculation at the expense of entrepreneurship.

Before addressing these concerns, I shall give first an overview of today’s relative importance of financial and non-financial assets in global wealth.

According to estimates given in Wolf (2010), four economies (USA, Euro-Zone, UK and Japan) held 80% of the $140 trillion in world wealth held in financial assets in 2005. This amounted to 316 percent of world output, up from just 109 percent in 1980.

The breakdown of the global stock of financial assets was: equities ($44 trillion), private debt ($35), public debt ($23) and bank deposits ($38). A substantial share of these assets are held by households and nonprofit organizations.

For instance, in the USA they had 73.5% of all private sector financial assets, mostly in deposits ($6.1 trillion), debt securities ($3.1) and equity ($14.6 trillion in total, mostly directly $5.7 and indirectly through pension funds $4.9). If to this huge sum we add financial derivatives then the ratio between financial and tangible assets (mostly real estate) easily reaches more than 3 to 1.

Such a large degree of financialization, puts financiers at par with other leading groups associated with system change, like the merchants during the commercial revolution and industrialists in the industrial revolution.

So, many see this development as a symptom of financial capitalism rents dominating the economic motives and feeding a time-bomb of debt and speculation which will end in disaster. Before discussing its consequences one needs to assess first its true dimension.

In this regards, the obvious question, is: why do we need so many financial assets when they are often defined just as a pro rata share on a claim? If such claims were only on property titles on existing non-financial assets the ratio would be simply 1:1. However, claims may be also on future assets (financial or non-financial) and their income as well as on contracts (bets) on future events. This distinction is important because while the first is still linked to expectations about future economic growth contracts are mostly related to expectations about expectations and so can easily turn into a form of gambling.

Although speculation has a positive role in providing liquidity and risk sharing, when it goes beyond the needs of markets for goods and services one cannot distinguish between speculators and gamblers in a casino.

But, the fact that some investments are similar to casino games does not mean that financial assets do not have an utility per se. Financial assets are important for the safekeeping and accounting of non-financial assets, to facilitate the transfer, holding and hoarding of such assets (across space, through time and between asset holders) and for risk-sharing and part-ownership. This said, they may also have utility for entertainment, like a roulette in a casino.

However, since most financial assets are not collateralized by non-financial assets this turns them into promises, with a small cost of production, an easiness of transferability and volatile prices. Therefore, there are reasonable concerns that their growth may be subject to wide fluctuations and a cause of periodic crises. Such crises may arise in banking, in currency markets or in securities markets. Sometimes, these crises may even occur simultaneously, spread globally and may lead or lag the business cycle.

Some people are also critical of the growing collusion between financial and political elites. This is nothing new. Already during the emergence of banking in the XV century the bankers played a leading role in the financing of permanently indebted kingdoms. Even in periods of expansion, kings like D. Manuel in Portugal, Henry the VIII in England or Charles V the Holy Roman Emperor were permanently indebted to finance their wars and growing royal courts.

Such loans were frequently interest free and obtained against business concessions for tax farming and other monopolies. Default on such loans was frequent, but their impact in the economy was mitigated by the smaller size of governments and the fact that bankers mostly used their own capital. Then, like now, the obvious solution was to diversify by lending to other merchants and non-sovereign borrowers. Given the growing size of government and managerial capitalism now diversification can only be achieved by strengthening the market capitalism sector.

Another concern is whether the current system creates major global imbalances which favor some countries or are a threat to global stability. Indeed, in the past 25 years there was a major shift in the flows of international capital which now go from emerging and less developed economies to a handful of developed countries, whereas in the past they moved in the opposite direction. The table below shows the recent trend among four of the six major countries ( the other two are China and Saudi Arabia), which account for about 80% of global saving and borrowing.

The table shows that as a percentage of domestic GDP the current imbalances are around 3%, a value that can be sustained over a long period of time. However, it also shows that the UK and USA have had persistently negative savings which were largely financed by Germany and Japan (plus China and Saudi Arabia).

Moreover, it also shows that, with the exception of the USA, non-financial firms have become net savers which is a worrisome signal in terms of finding profitable investment opportunities domestically or reluctance to return capital to shareholders.

So why is investment being directed mainly to the UK and USA? This is a very complex issue. On one hand these two countries benefit from having the most sophisticated capital markets and from being perceived as the most politically stable countries. On the other hand the lack of investment by domestic firms suggests that they may be lagging in technological development and compromise their future competitiveness.

A negative view on this rising role of finance has traditionally been expressed through the so-called immorality of making money out of money, the waste of human talent and resources in non-productive activities (a claim also made in the feudal system against priests and soldiers) and the creation of firms that are too big to fail. This has led some to question the role of the firm, suggesting that instead of value creation to shareholders they should instead aim at maximizing customer satisfaction. For instance, Peter Drucker (1973) claimed that the “only valid purpose of a firm is to create a customer”.

As explained before, these claims are erroneous because the profit motive is one of the fundamental requirements for competition and customer satisfaction.

Indeed, the rise of finance is the inevitable consequence of economic growth and widespread private and institutional capital accumulation. It is therefore a positive feature of capitalism, despite the fact that from time to time some financial markets may get carried away causing some volatility in employment and economic activity.

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