Bill Emmott - International Author & Adviser


Imbalances, inequality and sustainability
Voice - 2009

Political attitudes to inequality are thus, as I have argued, going to change more, and more sustainably, than are corporate attitudes to that issue. The environment for business is changing, but business itself is not. When we move to the second cause of capitalism’s crises, namely instability, the picture is different. Here, there is likely to be quite a big change in capitalism itself.

            The change is not going to come directly in the way in which companies are managed, or the way in which they relate to society. It will come from and in the financial-services industry, and so will affect the way in which other types of company have to think about how they are financed.

            The crash of 2007-09 arose from the banking system itself. It arose because banks had taken on increasing amounts of risky assets, both as buyers and as sellers, in the hope of increasing their profits. Those assets—chiefly credit derivative securities—were traded and held outside the normal, transparent, regulated part of the financial sector, in what has become known as a “shadow banking system”. To circumvent regulations on how much capital they should hold, banks created special “off-balance-sheet” methods through which they traded and held these securities. As a result, the banks themselves did not and could not understand the market in which they were operating. They could not know how big a risk they were taking, because they did not have good information about what risks their counterparts were taking, nor about the overall level of risk.

            This situation, which I described in chapter two, coincided with high levels of global liquidity, in other words cheap and easy-to-obtain money and credit, to produce an explosion in the use of debt. The largest such explosion was in the financial sector itself: debts owed by banks to other financial institutions. But this also brought about increases in the debt levels of households, especially in America, Britain and some other countries of western Europe, and of companies.

            In response to the crisis, and to its origins in the explosion of debt, there has been much talk among regulators and politicians about the need to tighten financial rules and their enforcement. At its meetings in London in April 2009 and Pittsburgh in September 2009, the Group of 20 (G20) summit of rich and developing nations made grand statements about reforming financial regulation, and even of how the bonus-pay systems for bankers need to be changed. But so far, little has actually been done.

            The reason is that governments are scared that reforming financial regulation will raise operating costs for banks, with the result that they will lend less money, which could end up harming the economic recovery. This is correct, in theory at least: the whole purpose of financial regulatory reform would be to raise the costs of risky activities in order to discourage them. It is also true that the economic recovery is quite fragile. During the lost decade of the 1990s, Japan is thought to have damaged its own recovery prospects by raising taxes prematurely in 1997. The fear in America, Britain and elsewhere is that they might damage their recoveries by tightening financial regulation prematurely.

            In my view, this fear is mistaken. In the aftermath of the financial crash, banks are already reluctant to lend, and companies are quite reluctant to borrow. Just as in Japan in the late 1990s, companies decided to reduce their debts even though the cost of borrowing was low, so the same sort of thing is likely to happen in America because corporate managements have seen that high levels of debt make their companies vulnerable to bankruptcy. Moreover, if they expect a long period of falling prices, in other words of deflation, then high debts are doubly dangerous because the real value of debts, in terms of the sales and profits needed to service and repay them, will go up in such circumstances.

            So the true likelihood that tighter regulation for banks would hurt economic recovery is quite low. It would hurt banks’ short-term profits, for sure, and would require them to raise a lot more capital, which is costly. But when they raise capital from other investors they have to pay those investors an interest rate or dividend in return, which means that the banks’ profits are being re-distributed rather than actually eliminated. The ultimate impact on bank lending would be minor, in today’s economic environment.

            Rather than moving slowly for fear of hurting the economy, I would urge regulators and politicians to move faster. Until the new rules of the financial game have been established, how can banks and other financial institutions work out their new strategies, how can they work out how best to organize themselves? Delay is itself damaging. And for the new financial rules to work well, what is needed is global co-ordination among the G20 countries. If some tighten their rules and others do not, the danger is that banks will just move their businesses to countries where regulation is weak, thus undermining the whole endeavour. The most favourable time for global co-ordination is right now, while the global economic crisis is still fresh in leaders’ minds and the political pressure to act to prevent a repeat of the crisis remains strong. My hope is that during the next six months, politicians and regulators all over the world will start to turn their promises into acts.

            What is meant by “tighter financial regulation”? Basically, the answer divides into three parts. First, stricter rules about the disclosure of financial transactions: what is needed is that all the G20 countries agree to set new rules that require trading in derivative securities to be made through recognized and approved exchanges and settled through approved clearing houses, with the transactions and holdings declared on the banks’ proper balance sheet rather than hidden away. Second, new rules requiring higher levels of capital to be held by banks to match these derivatives exposures, with the result that trading in risky assets is discouraged (because capital is costly) and that banks hold fatter cushions of capital as a whole. Third, in countries where regulators permitted financial firms to hold higher levels of leverage (ie, debt) and to operate with quite illiquid (ie, hard to sell) assets on their balance sheet, the rules need to be changed to limit the permitted levels of leverage and to require banks to hold more liquid assets. The importance of liquid assets is that if the bank runs into financial trouble, they can be sold to raise money fast, so that it can pay its bills. They are like a further form of capital cushion.

            Some experts want regulators to go further. Simon Johnson, former chief economist of the International Monetary Fund and now a professor at the Massachusetts Institute of Technology, has argued in several different articles, that two additional problems need to be faced: one is the overwhelming power of what he calls the “financial oligarchy”, by which he means the leaders and owners of the biggest Wall Street firms such as Goldman Sachs. He uses the term “oligarchy” to imply a similarity to the powerful billionaires who dominate the politics and capitalism of Russia. Johnson believes the financial oligarchs have been able to influence politicians and policy-makers excessively, forcing them to relax regulations in ways that favour the bankers rather than the economy or society. Johnson’s second problem is financial innovation: he believes that regulators need to distinguish between innovations that bring benefits to the economy and society, and those that benefit only the profits of financial firms.

            In my view, Simon Johnson is correct to say that these are problems, but he is wrong to say that special solutions are necessary. The problem of financial innovation is especially difficult to solve, on its own: how can regulators know in advance which new financial ideas are beneficial to society and which are not? This is the sort of thing that only becomes clear with hindsight. It would be better to focus on capital and on raising the cost to financial companies of taking risks, by enforcing full transparency and higher capital requirements. That will discourage damaging innovation. The problem of the financial oligarchy is a good and genuine explanation of why things went wrong in American regulation—just as similar political lobbying occurred in Japan during its bubble economy period. But it can be prevented from recurring if financial regulation in general is tightened, as that will raise the costs and reduce the profits of the banks.

            This is all quite technical stuff. What would it mean, in terms of the stability of capitalism and the operation of the financial system?

            We know from long experience that the stability of capitalism cannot be guaranteed for ever. There have been financial crises throughout capitalist history. Such crises will occur again in future. But they occur essentially because complacency or new thinking leads the financial system to reduce its precautions against danger, and because complacency mixed with greed leads capitalists to take greater risks. The memory of the losses in this current crash will guard against that complacency for quite a long time, and will keep the financial precautions—in other words, rules and capital—strong for quite a while too.

            What will change, as a result of the tightening of regulation, will be the operation of what can be called Anglo-American finance. By that name is meant the practice of allocating funds through open, public capital markets rather than principally through traditional banks, as in the old Japanese or German “main bank” systems.

Both types of financial system have their disadvantages. Anglo-American capital market finance is impersonal, which means that funds can come from many diverse sources and be driven by very open and varied flows of information, but the lenders do not know much about the ultimate users of their funds and so do not care very much about them, and as we have seen it can be unstable. The “main bank” systems of Japan and Germany in the 1970s had the disadvantage of being rather restrictive and often opposed to innovation: the loan officers at the main banks knew a lot about their traditional customers and helped them when they were in difficulty, but they were suspicious of new companies and new ideas. In a main bank system, Bill Gates of Microsoft and Steve Jobs of Apple might have found it hard to raise any finance.

In practice, these two different systems have merged in recent decades. The American venture capital industry operates rather like a main-bank system, with the venture-capitalists trying to get to know their borrowers intimately. In Japan and Germany, companies now raise more funds on capital markets than before, and banks themselves participate more freely in those capital markets. The arrival of fairly free movements of capital across borders, as countries removed their capital controls in the 1980s and 1990s, and as information technology advanced too, has spread the influence of capital markets, and thus of Anglo-American finance, all around the world.

The impact of tighter financial regulations will be to push finance back in the direction of the main-bank systems of the past, and away from Anglo-American finance. The costs of capital-market operations will rise; lenders and borrowers will become more averse to taking risks; the idea of knowing your borrowers more intimately will come back into fashion, as it will look like a good way to reduce risks and to make more profits. But it will not do so completely. This will be a shift of balance, not a revolution.

A good illustration of this shift of balance can be seen in the private equity industry, the industry that produced such famous American names as Kohlberg Kravis Roberts, The Carlyle Group, and Ripplewood. These firms began as a form of venture capital: rather than just lending money or buying a diverse portfolio of shares like conventional financial institutions, the private equity firms bought big stakes in companies, or sometimes the whole company, in order to get directly and intimately involved in their management. They replaced public equity—ie, publicly traded shares on the New York Stock Exchange—with private equity, ie, close control by private owners. That was their origin. But in the past decade, they changed: most of their investments were financed by debt, not equity, and they operated generally by forcing the companies they bought to increase their own debts. After all, debt was cheap and easy to obtain. But this is no longer the case, and with tighter financial regulations it is not going to be the case again, any time soon. So the balance of the private equity industry will change: it will shift away from debt, and back towards its original business model.

Investment funds will still, in this new world, be looking for ways to make a decent return. The sources of those funds—pension schemes, insurance companies, university endowments and the like—will still exist. In fact, the growth of sovereign wealth funds in China, the Arab countries and elsewhere is producing a new, and huge, source of funds for investment. Taken as a whole, capital is not likely to be scarce. The question is how it will be allocated. If traditional banks now pay higher returns to investors, as they are forced to raise more capital, then more of these investment funds will go to banks. But they will also go to other financial intermediaries that can show they have sufficient knowledge and dedicated staff to assess and manage the money profitably: in other words, private equity companies, hedge funds, and other investment funds. The Anglo-American form of finance is not dead. But the balance is going to change.

For companies themselves, the main change will be a reduction in their desired levels of debt. The idea that holding debt is somehow “efficient”, because interest costs can be used to reduce tax bills, will fade away. Managements will from now on see high levels of debt as risky, because they require the firm to be able to continually refinance that debt when it comes due. They will therefore shift back towards more reliable forms of financing: principally equity capital, but also longer-term relationships with banks. The number, type and geographical range of financial firms that offer this sort of “reliable”, intimate and long-term form of finance will increase. Capitalists, after all, are very good at adapting themselves to new circumstances, to new demands. Financial capitalists will be no exception.

Cleaner, greener, more balanced

So the two big changes in capitalism, following the global economic crisis, will be the rise in the political attention given to inequality, and the new financial regulations designed to reduce the capitalist system’s instability. Of course, a more general change will also take place: slower economic growth in the West, combined with high unemployment and probably deflation or at least stable prices, will force companies to offer products and services that are more fully designed for these leaner, more austere times. In addition, the two other changes that I wrote about in earlier chapters will have a major effect: the revaluation of the Chinese currency; and the trend towards more environmental controls, aimed at reducing greenhouse gas emissions and global warming.

            The environment will have the most profound effect on capitalism all over the world. The rising cost of energy, driven first by shortages of oil supply. The introduction of carbon taxes and trading schemes for carbon dioxide emissions, designed to put a price on carbon pollution and thus to discourage it. The increasing preference of consumers for cleaner energy sources, especially in their cars and other vehicles, mainly because of cost considerations but also thanks to growing awareness of the implications of climate change. These trends will continue to shape capitalist choices, investments and innovations not just for a few years but for decades to come. Sooner than most people realize, we will all be driving battery-powered electric cars; sooner than most people realize, solar power is likely to become commercially viable, as higher energy prices stimulate more technological research and development all over the world.

            The revaluation of the Chinese currency will have a different sort of impact on capitalism. It will come, as I argued in chapter two, because foreign pressure on China to bring its exchange rate system into line with all the other big economies’ currencies is soon going to coincide with a domestic Chinese interest in controlling inflation and boosting domestic demand. This will be easier if the Chinese currency is made convertible into other currencies, and so its price is traded more freely, just like the yen, the euro and the dollar. In addition, this will increase Chinese influence all over the world, for it will mean that other countries’ foreign reserves will include the Chinese Renminbi, and more countries will denominate their trade in Renminbi. A great power will then have a great currency, and Chinese companies that want to expand abroad by buying foreign assets such as companies, brands or mines will be better able to do, as the currency in their hands will be more valuable.

            This increase in the power of China in particular, and Asia in general, is a familiar, long-term trend. The rise of Asia was begun by Japan, and has been proceeding for many decades. The present rebalancing of the world economy, by revaluing the Chinese currency and increasing Chinese imports, will just accelerate this long-term trend, at least for a while. But it is also likely to have three further consequences.

            The first is that China will emerge as a major financial centre. Already, China plays a vital part in global capital flows, thanks to its high household and corporate savings rates and to the surplus it has been running on its balance of payments. But as long as the Renminbi has not been convertible, most of these capital exports from China have had to flow out through western financial institutions and through financial centres in other countries: Hong Kong, certainly, but also London and New York.

Convertibility of the Renminbi will change that situation, dramatically. Companies will be able to go directly to investors in China to raise capital, through the Shanghai stock exchange, through Chinese banks or through Chinese corporate bond markets. As almost all Chinese banks are currently still state-owned, and as in the past year those banks have been forced to expand their lending dramatically in order to support the economy, there must certainly be some doubts over how efficiently these banks will be able to function in the international markets and over whether they might in the near future suffer big losses from a rise in their non-performing loans. But if that proves to be the case, then other financial intermediaries in China can expand to provide the capital demanded by international borrowers, through the stock and bond markets. The next decade is likely to be the era during which Shanghai emerges as one of the world’s top financial centres, rivaling Tokyo as the most important and powerful financial centre in the Asian time zone.

The second consequence, related to this emergence of China as a financial centre, is that currency arrangements in Asia will become increasingly focused on the Renminbi. This is because China is the biggest trading partner for most Asian countries (including Japan). So the key exchange rate for the Korean won, the Malaysian rupiah or indeed the Japanese yen will not just be the one with the dollar but also the one with the Renminbi. Asian governments will want to try to influence that exchange rate against the Renminbi, in order to ensure that their countries’ exports to China remain competitive. This focus on the Chinese currency is likely, in my view, to renew the political and intellectual impetus for the construction of an Asian currency system.

Such a system would not, and could not, develop as far as Europe’s single currency, the Euro, has. Politically, a single Asian currency would be impossible to achieve. The economies of Asia are also far more disparate in their wealth, structure and strengths than those of the European participants in the Euro. But what Asia can try to build is a system of exchange rate management of the sort that Europe constructed during the 1970s and 1980s. In Europe, participating currencies undertook to maintain their exchange rates within pre-agreed bands against each other. The point was to try to reduce currency volatility, as well as to discourage each other from using protectionist measures to control trade. Bit by bit, this form of economic co-operation also made the participating countries feel more comfortable with each other in political terms. The habit of co-operation has a powerful effect.

The third consequence of a Renminbi revaluation is that it will force Chinese companies to move upmarket, to higher technologies and in to more sophisticated global markets. This is already happening in some sectors, notably telecommunications equipment. But a big currency change, with the expectation of further currency appreciation in future years, will force Chinese owners and managers to change their business models and approaches too.

This means, for sure, that big Chinese companies will move closer to the markets and models used by Japanese companies. Competition between Chinese and Japanese companies will intensify, just as it has in the past between Japanese and Korean firms, especially in cars and electronics. This will put even more pressure on the Japanese economy, Japanese capitalism and Japanese society to adapt to this changing world situation. For that reason, the final chapters will be devoted to Japan.



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