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which is equally good. This book is an impassioned and erudite defense ...
on 13 February 2016
This review is for Rajan's other book - Saving Capitalism from capitalists, which is equally good.
This book is an impassioned and erudite defense of the free markets enterprise system. Raghuram Rajan, a Chicago economist, currently the governor of the Reserve Bank of India, presents a breathtaking bird’s view of the development of the arm’s length financial system, variedly known as capitalism, globalization or the free markets system.
The book’s title is revealing. Saving capitalism from the capitalists. The authors contend that capitalism’s worst enemies are the capitalists themselves. Who are these capitalists? The industrial and financial incumbents in a national economy, who conspire to stave off the financial markets so as to choke the sorely needed finance to those innovators and entrepreneurs who seem to threaten the existing economic order. These status quoists present the mortal danger to capitalism, the authors aver.
The book is divided into 4 parts. The first part emphasizes the basic premise that finance liberates and goes on to prove it with empirical analyses. They beautifully juxtapose a poor stool maker in Bangladesh against the savvy MBA graduate in America, and draw an economic comparison that transcends narrow socio-political factors. Theirs is a simple, yet powerful argument. The arm’s length financial system, which they define as the one where the lender is at an arm’s length from the borrower (a Chinese wall so to speak), as seen in the equity and debt capital markets, enables even the most downtrodden in the society to rise above the perennial curse of poverty, when financial innovation and engineering work to present the needy with the capital to undertake simple entrepreneurial activities that would ensure his survival, and providing the investor with the requisite returns on the risks so taken.
The authors’ main contribution is the delineation between the arm’s length and the relationship based financial systems in the capitalist world. The authors tear the mask off of the pretentious capitalists, thereby bringing clarity in the existing obfuscated notions about capitalism. Arm’s length financial system works by marrying capital and entrepreneurship without having them in direct contact. The capital markets such as debt, and equity epitomize this, where the investors or lenders in all probability never meet the entrepreneurs who are the ultimate users, underpinned by a solid, vigorous financial system, capable of evaluating and diversifying risk, through myriad players including credit ratings agencies, and regulators. Collusive practices borne out of years of constant touch, rampant in even the most regulated (in fact, even more so in the over regulated) of banking environments are minimal. A pre-emptive strike against corruption is achieved. The authors present the example of post war Japan. The Japanese banks connived to tie the Japanese corporations permanently to them. The public, reeling under economic hardship, were convinced that the villain was the capital market. The political class got together with the incumbents to form a Bond committee, whose permission would be required for corporations to issue equity or debt in Japanese markets, effectively placing the wolf in charge of the chicken coop. AAA rated Japanese companies like Toyota were forced to seek finance from the banks at extortionate costs of capital, said to be akin to daylight robbery by some historians. The general public had one important avenue of investment cut off. This went on unchecked for decades, the banks relinquishing their control only in the 1980’s in the face of international competition, which enabled Japanese companies to circumvent local markets and issue bonds in Europe. The authors conclude that for capitalism to succeed in improving welfare, vibrant capital markets must take root.
Prominent economists such as Joseph Stiglitz, Amartya Sen prescribe sequencing of financial reforms to prevent crises such as the East Asian one in the late nineties and the one in Russia post the Soviet Union collapse. They posit that the domestic economy be exposed to stiff foreign competition only after the local companies have become stronger. The authors aver that it is precisely this policy that allows the incumbents to steal the thunder right under the nose of the avuncular, credulous public. They have enough clout to get protectionist bills passed through to the detriment of the larger public, have policies enacted that favor them. The existing banks have material private information about companies seeking finance due to the long term nature of their relationship, enabling them to hold these companies hostage. For should they refuse them finance, no outside entity would step in. After all, if the bank with its open access, deems the corporation unfit for financing, why would anyone else? The lot of the corporations is also not so bad. They may effectively be tied to the bank, but this lack of access to outside finance also means fewer upstarts competing for a share of the market. A cozy relationship emerges among the incumbents who all go to the same elite clubs and hatch closed door deals, putting a spanner in economic growth. Transparency is the first victim. And then the dark side of finance emerges-wastage of resources, value destruction, concentration of political power (resources) in the hands of the inefficient, prompting those with economic power to undertake fewer entrepreneurial ventures. The Bombay club in India, formed in 1993, was such an offshoot of the progenies of incumbent industrialists who had made merry during the license raj era and were now frightened at the prospect of foreign competition.
Obscene corporate excesses and scandals, resulting in social and political upheaval become the norm. And the system becomes socialistic in character, albeit under the guise of capitalism.
And uprooting these incumbents proves an even more daunting task than at the beginning. Only international competition forces them to give up their hold on power. A sequential reforms policy thus brings more harm than good. Trade and capital liberalization is the way forward for rapid strides in the economic arena.
Give the capitalist system a chance, the authors plead. Not all financiers are the Shakespearean Shylocks. Excesses do happen and exacting a pound of flesh is surely an excess. But in a world where no effective mechanism exists for a guarantee of repayment of the invested capital, nobody would be willing to part from his capital, even at the most tempting rates, fearing moral hazard. It is also the financial system that comes up with innovations like reverse mortgage that give the elderly a shot at a respectable retired life, viatica that supplies the terminally ill with the much needed medicines, and health care.
The question must come to the enquiring mind –if the capital markets are so good, why did it take them so long to arrive and why are they continuously challenged and threatened. And the authors do not disappoint on this score. They take the reader on an enchanting odyssey through the late nineteenth century to the present. Critically presenting, analyzing and dissecting the financial history. Their analysis of the emergence of free capital markets in the 1890’s, the flourishing in the first half of the twentieth century, and the subsequent suppression in the period between the two world wars that extended to the 1980’s is nothing but superb. They finely critique the process by which capital markets emerge-the resistance they face early on; the continuous challenges posed by the incumbent industrialists and financiers; and how circumstances conspire to tie the interests of the naturally antithetic classes ‘the industrialists and the workers’ together leading to their commingling. They join hands to demand protection from insalubrious competition-domestic and foreign. The politicians are spurred to action- imposing restrictions, quotas, tariffs. Financial markets are deliberately suppressed. The authors cite multiple empirical studies that show how such actions inexorably lead to an economic crisis.
The arguments are persuasive, finely backed as they are, with empirical studies. After showing how the markets were suppressed till the 1980’s, they go on to show how the failure of Bretton Woods agreement led to their revival. The spectacular global economic rise in the past 3 decades was seen because of the reemergence of free capital markets. To put things in perspective, India’s own superlative economic performance came about only when the archaic license raj structures were pulled down in the early 1990’s. India’s public sector banks had also more or less stifled access to finance to all but a few, leading to the emergence of a few dynastic industrial houses, who were in the thick of things to pocket all the government projects and contracts. And in those days, corporate profitability was determined not by market competitiveness but by the government projects seized. A classical sign of the diseased relationship financial system. It’s the unshackling of the economy that led to India’s current position as an economic powerhouse.
The book is structured into four parts, the first one champions the case of free capital markets, alleviating concerns about the hedonistic lifestyles and behavior of some financiers. The second is an exposition of how the markets emerge-the challenges (government, incumbents) to be overcome. The third is an analysis of the recorded history when the free markets were again suppressed, which ends with an investigation into the weaknesses of the systems that replaced free markets. The fourth and the most important is on- making markets politically legitimate, socially acceptable, and addressing the risks that are inherent, to make them more palatable.
The authors advocate several policies to aid the suffering of those who get displaced in the ‘creative destruction’ of the competitive process. The unemployment debates raging on various political and policy fora are now spilling onto the streets. The cyclic unemployment, part and parcel of business cycles, which though painful, was accepted in the belief that when the economy starts booming again, the unemployed would regain their jobs. However, the 2000’s have shown a worrying trend. Jobless recoveries. Monetary and fiscal measures put the economy back on track, but investment doesn’t pick up, unemployment persists. Structural unemployment is increasingly replacing cyclic unemployment. Jobs are not temporarily unavailable, they are getting permanently lost. Technological innovations, brought about by the free markets enterprise, have made tremendous contribution in enhancing human knowledge and made life easier. But they have also made several human skills redundant. The jobs that are lost now are because of automation, not business cycles. This has made the unemployed see the capitalists as class enemy. Wall Street excesses, accounting scandals and exorbitant salaries highlighted particularly in economic downturns are making the public antagonistic towards the free markets. Calls to restrict foreign trade, protection for industries (championed by both the management and the workers- who fear losing their jobs) are becoming increasingly shrill. The authors provide the penetrating insight that, when everybody has open economies, it is difficult for a single nation to have closed borders. In the same way, when everybody starts enacting beggar-thy-neighbor policies by turning the spigot off, the incentives for domestic pro-free markets agents become weak (whose goods no longer have access to foreign markets) and economies become isolated, reducing the discipline imposed by international trade and competition, effectively putting the clock back.
In times such as these, when lampooning globalization has become the latest fashion trend in the august drawing rooms of the intellectuals and the high society, this work is timely, and most sobering. It masterfully exposes the hidden agendas of the incumbents-industrial and financial and how those in whose best interests it is to embrace free markets unknowingly fall prey to them. It is not a diatribe against anyone or anything, which is too often the case with books that purport to educate its readers. It is an impassioned defense but with a healthy dose of dispassionate analysis. This book was written in 2003 (while the Indian revised edition was only recently released, to capitalize on Mr. Rajan’s popularity in India following his elevation as the governor of the RBI), but is even more relevant today with the 2008 financial crisis, Euro zone crisis and weaknesses in global economy, threatening to derail the good work of past decades. Raghuram Rajan who had predicted the 2008 crisis and has written a riveting book on it (Fault Lines), has again proved to be prescient with the kind of drama unfolding today in the debates about economics in a post crisis world that Mr. Rajan prophesied almost a decade back. Anyone with even a passing interest in economics and finance would surely find this book enriching. It also serves as a textbook outlining the financial institutions and markets underpinning the international monetary system. It should in fact be made required reading in business schools. The authors have a humble aim, which is to educate readers. Anyone, who ventured to complete it, would undoubtedly agree that it has done so.