sou · GOB311d5 · 2001-01-01 00:00:00 — As Table 4 shows, financial markets declined significantly in many countries between 1913 and 1948 even as a proportion of GDP, and in some cases have not reverted back to their prewar level even today. That World War I was a great disequilibrating event is probably an understatement. Apart from changing the map of Europe, and destroying the peoples faith that their rulers knew what they were doing, the long war accentuated the centralization of many of the economies of . McNeill (1981, p. 339) describes after the implementation of the Hindenberg Plan of 1916 thus the generals in charge often became impatient with the financial claims and controversies that continually embroiled and sometimes obstructed prompt and deferential obedience to their demands. As shortages rose, one after another, the generals relied more and more on big labor and big business to remodel the economy according to military needs. Each party got more or less what it wanted: more munitions for the army, more profits for the industrialists, and consolidation of their authority over the work force for union officials. In other words, the economy was being run like a centralized hierarchy model along the lines of the army. Centralization was aided by cartelization – of industry, of the banking sector, and of the work force – because this reduced the number of parties the central authority had to negotiate with. Prices were fixed, and distortions built up in other sectors, especially agriculture, which finally led to surrender.66 But the aim of maximizing military production was served, and the costs papered over by blaming the weak-kneed politicians for the surrender. For countries like , however, the benefits of command mobilization were further sweetened by . The centralization during the war thus created large domestic hierarchies representing different interest groups, all of which had acquired power when shielded from international markets and competition. By contrast, the groups that would naturally support markets and competition were suppressed and weakened by the relative 66 McNeill, p. Volym D:112 Supplement 24 autarky forced by the long war. The anti-market groups therefore had more powder, and it was of recent vintage. Centralization also created large distortions that had to be reversed if countries were to go back to the market economies of the prewar era. Prices and wages had to adjust, especially if a country were to go back to the Gold Standard, industries that had prospered during war-time autarky would have adjust to international competition, financial institutions would no longer have government guarantees, and would have to learn how to evaluate credit again. Thus the groups that had benefited most from the recent past had to adjust the most – a situation typical of economies in transition. Nevertheless, some countries went back to the market quite easily. In particular, the did not have to depart too much from the market during the war, and also benefited from the enormous purchases made by the , as well as from servicing the export markets the warring parties had abandoned. Others such as emerged with deficits, debts, and inflation. A mistaken attempt by to go back to the Gold Standard at prewar parities led to further downward pressure on wages and led to the General of 1926. was in an even worse situation because it was saddled with war reparations that could simply not be met. Despite the difficulties of adjustment, however, the prewar liberal consensus was strong enough, as well as the of international trade attractive enough for virtually the entire industrialized world to be on the Gold Standard again by 1927.67 But as suggested above, the war had changed the power structure in country after country. Strong interest groups ranging from labor to import-substituting industries were unwilling to bear the risks the market imposed and demanded protection. Government subsidies increased, as did deficits. These deficits could be sustained under the Gold Standard without painful domestic deflation only if some country were willing to finance them by lending. The performed this role only till 1928. As Eichengreen (1996) suggests, perhaps in order to discourage speculation in the stock market, raised interest rates in the in the first half of 1928. Lending to foreign countries by the plummeted to zero in the second half of 1928, Eichengreen (1996, p. In order to stay on the Gold Standard, countries had to either eliminate deficits or raise interest rates and contract credit, both politically painful policies. The stock market crash of 1929 in the and the ensuing Great Depression was the 67 Eichengreen (1996, p. Politics, and Financial Development Volym D:113 With the single biggest consumer in the world contracting, exports plunged all around the world, further aggravating balance of payment problems in Europe, , and Latin . Domestic price deflation was necessary to stay on the Gold Standard, and to generate the surpluses to repay debt, but one countrys deflation was simply a contraction of the export markets for another country. Moreover, as prices fell, with domestic debt largely nominal, defaults increased. Losses at financial institutions increased, and the threat of a financial crisis put pressure on central banks to intervene and bail out the system. Again, under the Gold Standard, central banks could simply not lend freely to bail out the banking system without jeopardizing the exchange rate. With domestic demands for insurance and subsidies increasing, there was increasing pressure for governments to do something. One of the most attractive features of the Gold Standard was that it allowed governments to finance their deficits by borrowing abroad. In fact, for significant periods in the decades preceding 1913, current account deficits exceeded 10 percent of GDP in , , and , while in the surplus countries of , , and , net capital outflows touched 9 percent.68 With international lending virtually negligible, even this incentive to adhere to the Gold Standard disappeared. Thus with export markets moribund, and no possibilities of borrowing, the constituencies in favor of adhering to the Gold Standard were weakened, and country after country abandoned it. A natural consequence was the external discipline on subsidies and distortions was removed and a number of measures mitigating the effects of the markets – erecting tariff barriers, providing unemployment subsidies, providing subsidized credit, bailing out unviable institutions, increasing government investment – were put in place. The command and control structure only recently disbanded after the war provided an attractive template. In general, the return to the centralized political management that had been first explored during World War 1 became unmistakable by the mid 1930s. This top down grab for power was extremely dangerous in the case of some countries that harbored unsettled grievances from the past. In particular, , and started rearming. These powers had even less interest in maintaining the existence economic order, in particular because of its large reparation dues. As Polanyi (1944, p. 68Bordo, Eichengreenand (1999, p. 69McNeill, p. Volym D:114 Supplement 24 was now eager to hasten the downfall of traditional world economy, which still provided international order with a foothold, and she anticipated the collapse of that economy, so as to have the start of her opponents. She deliberately cut loose from the international system of capital, commodity and currency so as to lessen the hold of the outer world upon her when she would deem it convenient to repudiate her political obligations. She fostered economic autarchy to ensure the freedom required for her far reaching plans. She squandered her gold reserves, destroyed her foreign credit by gratuitous repudiation of her obligations and even, for a time wiped out her favorable trade balance... The command economies of these rogue countries could therefore direct resources effectively towards military build-up. Their neighbors could not respond effectively without themselves adopting more centralized structures. Markets and centralized power are, in general, incompatible. Markets dance to their own tune, and therefore are not responsive to the dictates of centralized power, especially if unaccompanied by monetary reward. By contrast, centralized power wants to mould the economy in its own image as a hierarchy, so that prices and competition do not interfere with the furtherance of its own agenda. The popular groundswell for insurance, the escape from international discipline, and now the need to focus resources on rearmament further strengthened the legitimacy of centralized power. Instead of merely mitigating the adverse effects of the market, it now worked to narrow its sphere and expand the sphere of hierarchies. In , for example, this implied favoring financial institutions over arms length markets. In 1929, Japanese firms raised 26 percent of their debt from bond markets, and only 17 percent from banks. After went off the Gold Standard in and intervention in markets increased, the banks with the acquiescence of the , formed a in 1933 which determined which firms could issue bonds, on what terms, and when. All bonds were required to be collateralized, and banks were to serve as trustees for the collateral in exchange for a substantial fee. Giving banks the responsibility for determining firms' right to access the public bond markets was like giving a fox who resided in a chicken coop the right to determine which chickens could leave. The obvious outcome was that a flourishing bond market was killed off. By 1936, bonds were down to 14 percent while bank debt was up to 24 percent of liabilities. By 1943, 47 percent of liabilities were bank debt while only 6 percent were bonds.70 70 These figures are from Teranishi (1994). Politics, and Financial Development Volym D:115 Moreover, the number of banks declined dramatically over this period as banks were (often forcibly) merged to eliminate inefficient competition. In the span of a few years, the banking system had become much less competitive, and competition from the bond markets was eliminated. And as the country moved towards war, the banking system came under the administrative control of the government. generally, the market does not occur naturally, but is a man- made institution, in need of rules and protection as Polanyi (1944) argues. Unfortunately, there is no focussed constituency for the defense of markets, especially in bad times. In particular the very competitive nature of the market that makes it hard to effect cross-subsidies also comes in the way of accumulating funds for coordinated defense. Thus a fundamental freerider problem affects the production of these rules and this protection. market participant takes for granted the existence of the market, and thus has only a small interest in spending resources to protect it. The paradox therefore is that only coordinated hierarchical interests can defend the market. But these domestic interests may not be interested in the genies of competition and discipline unleashed by the markets unless forced or enticed by the outside world. In the 1930s, the outside world had shut down. Moreover, once a country walls itself off, the outside world has to be very attractive before it opens up again. Unlike markets, entrenched hierarchies have the power to defend themselves. So the market can be in retreat for a long time. Once the banks had power, they were unlikely to give it up easily. Despite their best efforts to break up the bank firm combines established during the period of militarization, the post-war American occupying forces could not prevent them reemerging as the Keiretsu or main bank system. Even as Japanese firms invaded the rest of the world in the 1970s, their bond markets remained miniscule. It was only in the early 1980s, as Japanese firms decided to borrow abroad rather than depend on their antiquated financial system that Japanese banks had to loosen their stranglehold. The powers of the bond committee were curtailed. The markets had their revenge as the banks paid the price for years of being shielded from competition, making poor credit decisions and driving into crisis. The intensity of the anti-market revolt varied country by country, depending on the severity of the economic shock and the countrys inherent propensity to centralize. In particular, the different legal and institutional environments provided a different degree of protection against the anti-market backlash. Countries with a civil law system became an easy prey for the political movements advocating a command and control system. After all, civil law, since its Roman origin, has been Volym D:116 Supplement 24 an instrument of the State in expanding its power.71 Thus, the new political objectives, be they a stronger military or a more substantial redistribution of resources, could easily permeate the legal infrastructure of these countries. The most extreme example is , where the communist government that took power after WWII found no need to change the , because it could be easily adapted with minor changes to the new regime. Not only did the anti-market reaction have greater ability to change the rules in Civil law countries, it could also do so faster since the legislator makes the law, and he has the power to change them as he sees fit. Common provided a stronger bulwark against centralization. First, the English common law tradition was shaped by the struggle between the Crown and the aristocracy. As a result, it emphasizes restraining the government and protecting the individual, making more difficult the centralization of the economy. For example, during the First World War, while and became command and control economies to facilitate military production, still retained the spirit of voluntarism in war production, see McNeill (1981, p. Second, Common is based primarily on judicial precedent, rather than upon the act of a legislator. Thus, a new political climate is less able to transform the structure of society. For example, attempt to cartelize the U.S. economy failed not because of political opposition, but because of the resistance of the U.S. Supreme Court, which struck down several key pieces of the New legislation. Third, even though Common is hard to change from the center, it evolves at the periphery, and innovates around legislative or administrative roadblocks set up by the center. In our view the decentralized nature of the Common system, and how it responded to the political anti- market forces can explain the continued vibrancy of financial markets in Common countries even when markets elsewhere declined. It is always dangerous to try to reduce the richness and complexity of the historical evolution of many countries to one single factor. Obviously, many other concurrent events played a role in the extent of the success of the anti-market revolt, not least, the magnitude of the shock the countries had to face during this period and the proximity of the countries in to those rearming. Also, we have emphasized Common as the primary liberal institution that saved markets in Anglo-American economies, while any of the liberal institutions that permeate countries of English origin could have helped restrain the anti-market reaction. 71 Finer (1997). Politics, and Financial Development Volym D:117 We can, however, offer some support to our thesis that the centralization of the legal system makes it vulnerable to political pressure. Such a test is provided by a recent comparative study of the evolution of U.S. bankruptcy procedures.72 Both these countries are based on Common . Constitution, however, left the right to regulate bankruptcy to the Federal Government, an exception to a system where all corporate governance rules are decided at a state level. The British system has no such provision. This represents the perfect natural experiment of our claim that legal centralization itself leads to greater political interference: two initially identical systems that evolved in similar environments, but which differ mainly in the degree of centralization of the legislative process. the years the U.S. bankruptcy procedures departed significantly from its British counterpart, which remained substantially unchanged. Consistent with our claim, these deviations introduced a prodebtor bias, in response to political pressure in that direction. Our brief review of the historical evolution of financial markets seems consistent with the predictions of the political theory. The reason why at the beginning of the 19th century emerged as the financial center had primarily to do with its political situation. A fortuitous combination of a dominant elite who could benefit from financial development and a weak and decentralized government that could not interfere (and actually had an interest in promoting development so as to be able to finance itself) lead to the growth in the financial market. The subsequent retreat of markets was due to a convergence of anti-market forces: a bottom-up demand of insurance arising from the masses that for the first time acquired some political power and e top-down for national security that required a coordination of natural resources. The analysis also suggests that while a Common law system protects a market economy, it is neither a necessary nor a sufficient condition for a successful financial market. Instead, our analysis emphasizes the importance that political consensus (or lack of) plays in the development and defense of markets in general and financial markets in particular. 72 and Sussman (1999). Volym D:118 Supplement 24 The fundamental conclusion of our analysis of the causes of financial under-development can be summarized by paraphrasing 1992 campaign slogan: It is politics, stupid!. This extremely simple message, though, several important lessons, which might be useful in addressing current and future policy challenges. First, unlike the logical conclusion from recent studies relating financial development to legal origin, our analysis offers hope to those countries that have not had the good to be colonized by the British. Instead of abandoning a legal tradition (not an easy task even if it did not destroy the specific capital of lawyers), they only have to deal with the politics. Clearly, reforming the political system is not much easier than reforming the legal system. However, it may be relatively easy empowering constituencies in favor of financial development. This is extremely important for transition economies. It is not sufficient to design the rules appropriately, it is also necessary to strengthen the political support for the market in the longer term. The importance of this point can be appreciated by looking at the different long term effects of privatizations in and . Both plans were well thought out. If anything, the Russian plan could pride itself on using top U.S. legal scholars to design its corporation law. The Russian reform could be considered the ultimate social experiment in which the right set of laws are introduced to promote financial development. But the Polish reforms have proved more resilient. The Polish plan placed the shares of state enterprises in big mutual funds, that could not directly run companies, but could large enough blocks to control them. Individual investors were then given shares in the mutual funds. This created a powerful group in favor of market development: mutual fund managers. This group successfully fought for more disclosure and more transparency. It was crucial that the role of outside monitors was given to mutual fund managers, as opposed to bank managers. Bankers have a vested interest in maintaining the market opaque in order to exploit the return to their investment in information. Undoubtedly, was more difficult terrain to start with. But the problems were potentially compounded by the political constituencies empowered by the reforms. The shares of state enterprises were given directly to the citizens, while the control was handed over to corporate SOU 2000:11 Politics, and Financial Development Volym D:119 These managers (former communist appartchiks who are still very influential) found themselves in the position of the rich in our parable. They controlled monopolist firms and had all the interest in opposing any move toward a more transparent and efficient market, which would have implied less independence for them and more opportunity for entry for competitors. Not surprisingly, few would associate the terms transparent and good governance with Russian firms, and the financial sector is moribund. A second implication is that outside forces are extremely important in supporting markets. Outside forces such as financial and industrial investors tend to be more immune to cooptation or threats from the government. They do not benefit from many of the politically motivated internal transfers and subsidies. Not being part of the cozy domestic compact, they rely on transparency and legal enforcement. As a result, their interests coincide with those of markets, and they are more sensitive to attempts to shut it down, imposing some discipline on unbridled central power. In the 1930s and 1940s the anti-market revolt was able to proceed to its natural conclusion primarily because the Gold Standard fell apart. Similarly, the resurgence of financial markets in the 1980s is in large part due to the liberalization of trade and capital movements. In this respect, the role played by international organizations is ambivalent. On the one hand, they had, and still have, a tremendous effect in promoting the cause of liberalization in many countries. Union, for instance, is more promarket than any of its individual member (with the possible exception of the ). helps prevent tariff wars, which proved to be so devastating in the 1930s. On the other hand, the centralization of political power in these organizations runs the risk of weakening the salutary role of outside forces. In a hypothetical new world order, ruled by a supernational Government, outside forces would disappear. There would be no foreign countries to emigrate to, no foreign market to access for capital, no foreign competitors to enter the market. A supernational Government will find it easy to intervene, cross-subsidize, and regulate when the internal domestic forces demand it. The threat to markets is obvious. And the threat of an anti-market revolt is always latent, ready to explode at the first sign of a major crisis. In fact, in the wake of last year East Asian crisis, many pundits and Government officials started to invoke severe anti-market measures. This is inevitable, because, as we said, markets tend to destroy many primitive forms of insurance, for which they provide very substitute. Thus, the severity of a shock is felt much more strongly in a market economy, creating discontent, which can be easily used at the political level. The pain produced by the shock Volym D:120 Supplement 24 is very salutary from an economic point of view. It is an essential part of the working of a market economy, which accentuates the need for action, accelerating the recovery. But it is extremely costly from a political point of view, especially because pain is not a political message that sells well. All too often, before the market revives itself, the Government intervenes to diffuse the cost of the crisis, slowing the road to recovery. The fear of a political backlash should caution us against taking for granted that financial development is unidirectional, and that the generalized consensus in favor of markets is irreversible because of their obvious efficiency.