Fear of Finance and Global Realities
Statement before the Oiso Experts Seminar Foreign Trade Council and USIS Tokyo American Center
© Peterson Institute for International Economics
It would be extremely difficult for any Japanese economic decision-maker to be unfamiliar with the efficiency arguments for why openness, competition, and deregulation are beneficial sector by sector. Professional economists and American negotiators, as well as domestic consumer advocates, have been pressing this logic for years. Leaving aside the prospect that the opponents of greater Japanese integration with the world economy do so out of narrow self-interest-for then there would be no point in attempting to discuss and persuade-the resistance must stem from a belief that the effects on the whole of Japanese society are negative and outweigh the sum of the benefits from reform of specific industries and markets. In short, there is fear that global competition will harm the viability of Japanese society as currently organized.
This fear is by no means limited to Japan. Throughout the developed countries there is concern that globalization will enforce a market discipline which will drive all economies to same model. In particular, there is fear that financial liberalization will force adherence to a perceived American model of market individualism. While there are those who would argue that such an American model is an ideal worthy of emulating, on this occasion I will argue instead a more important and probably more reassuring point: financial liberalization has significant positive effects on the economy as a whole beyond its sector, and these can be gained without disturbing underlying social relationships. Taking a macroeconomic view of financial reform both in theory and in practice as it has played out in numerous industrial democracies gives the lie to the fear of finance. And if globalization of finance does not come into conflict with a nation's ability to pursue its own broader social goals, surely opening and reform of other sectors in an economy presents no threat.
Why Finance Belongs in Markets not in Clubs
It may seem strange to base a general argument about the net benefits of deregulation in the sector of the Japanese economy where there has been arguably the greatest opening, from the 1995 US-Japan Financial Services Agreement to the 1996 announcement of the "Big Bang" plans to recent regulatory roll-backs. Yet, it is important that this move be understood as in Japan's self-interest, and advancing that interest greatly, rather than as a concession to American pressure or as a desperation response to the current post-Bubble economy. It was not long ago, remember, that many Americans were looking at the main-bank relationships of Keiretsu and all that went with them as a possible solution for what was thought to be the excessive "short-termism" of American investors. Therefore, those who view the current move towards liberalization as a swing in fashion or worse might be forgiven. They would be mistaken nonetheless.
Corporate finance should be conducted when possible through arms-length transactions in open markets, rather than on the basis of institutionalized private relationships. The reason is that finance is based on information. Is a proposed investment a worthwhile project? Does that investment continue to pay as expected when implemented under changing conditions? How do the changing fortunes of that investment relate to changes in other investments? In other words, the job of an investor is to evaluate, to monitor, and to assess risk. These are not easy tasks. Information is imperfect, which is the economist's way of saying that not all information available is equally credible and free of bias, and not all information can be utilized at no cost or without judgement. In other fields of endeavor where difficult matters are in dispute - from the arena of democratic politics described in John Stuart Mill's On Liberty, to that of scientific inquiry discussed by Karl Popper in The Open Society - the prescription is to have ideas freely compete since no one has a monopoly on the truth. So it is with investments; some will bet right and some will bet wrong, but only by the variety of opinions being brought to life will we find out which projects and firms should last.
The idea behind the main bank-Keiretsu relationship banking model, or the similar German Hausbank model, which I have studied extensively, is that the transactions-based model of finance imposes a cost and misses a benefit. The supposed cost is that arms-length investment will be volatile; the benefit foregone would be that close relationships provide better information than can otherwise be gotten. Economic research has shown that these issues in theory do not appear in practice. On the one hand, the volatility of investment is driven far more by macroeconomic shocks affecting the economy (as all of Asia has learnt too well of late) than by "short time-horizons", and relationship banking makes investment swing far more in response to such shocks than when investment is securitized. The strongest evidence for this fact is a line of research looking across countries which shows that firms with bank ties are not less constrained by temporary liquidity problems than firms which rely primarily on markets for financing, once business cycles are taken into account. Moreover, despite recent events, it is at least plausible that macroeconomic volatility is diminished by transnational capital flows versus the baseline of depending solely upon domestic sources of savings and investment for stability.
On the other hand, the informational benefits to investors and firms of having lenders become insiders are even less apparent. Knowing more about a company neither removes the incentives for board members to overlook or be deceived by mismanagement, nor substitutes for the barrier that this raises to the investor pursuing other investments, or the firm seeking new or cheaper capital. Just ask the individual shareholders of Metallgesellschaft, Sumitomo Trading, Barings Bank, or Schroeder Construction how well their interests were protected by having most of those companies' equity held and decisions made within a club.
Moreover, the relationship investing argument cannot survive its own logic. The larger firms in a society should be the ones which can go directly to the markets, given their strength and reputation and diversification, while the smaller and start-up firms should be exactly those with the most to gain from tight financial relationships. Yet, whether in Japan or Germany or France or Switzerland, to list a few major economies with relationship investing, it is the largest and best known firms which have the ties to the financial leadership, while there is no venture capital available for new firms. This indicates that something other than gains from improved information is what motivates these financial relationships, and that these relationships do more to lock-in capital than allocate it efficiently.
Thus, there is a positive effect of financial liberalization on an economy beyond gains in the efficiency of the sector itself. When a goods-producing sector liberalizes, the economy sees a one-time benefit in greater productivity in that industry, e.g. when construction markets are opened, buildings become cheaper once and for all. When a financial sector liberalizes, not only does finance become cheaper in the sense of financial firms behaving more efficiently, capital is better allocated amongst investments in the entire economy from that time forward. Liberalizing normal good (like construction services) gives a one-time boost to the level of economic growth, but liberalizing the financial sector increases the rate at which the economy can grow indefinitely. That is why the German economy is moving rapidly away from its historical relationship banking system, not because of outside pressure to deregulate or because of global forces. Its engineering start-ups were still born or, like SAP, forced to jump the additional hurdle of going abroad to raise capital; its largest firms, like Daimler-Benz, found that they could lower their cost of capital by escaping their relationships and going directly to markets.
Breaking Financial Clubs, Retaining Social Cohesion
While financial sector liberalization is a prime example of an instance where there are spillover benefits on the economy as a whole of opening a sector, it is also the source of fear that financial discipline erodes social order. Some hold that where finance makes pursuit of profit king, individualism rises and individuals and social cohesion suffer. If these fears are justified, the macroeconomic benefits of financial liberalization might be outweighed by other economic and social costs. As summarized in Table 1, it is reassuring to note that there is no evidence justifying these fears.
Table 1: No relationship with relationships
United Kingdom (pre-1979)
United Kingdom (post-1979)
The table sorts the major industrial democracies along two categories - whether the economy relies on relationship-based corporate finance, or on market-based corporate finance; and whether the society displays social cohesion (domestic peace, equality of income, consensual politics) or social disunity (violence, pockets of poverty, divided politics). While this categorization may appear to be somewhat subjective, observable objective economic and legal factors would support this distribution.
The primary message of this table is that there is no relationship between the openness of the financial system - and therefore, presumably, of the governance of corporations-in a nation, and the social solidarity displayed by that nation. If the fear of finance were justified, all the countries considered would sort into the upper left and lower right boxes of the table. Instead, we find that a number of countries known for their support and maintenance of social peace (Canada, the Netherlands, Sweden) also have "Anglo-American" style market-based finance. Moreover, countries can change one or another aspect of their socio-economic system without necessarily affecting the other component. Following the election of Margaret Thatcher as Prime Minister in 1979, the United Kingdom moved sharply away from the tradition of social solidarity which had been in place there since the Second World War, but its financial system remained the model of arms-length market transactions it has been throughout the 20th century. Italy, beginning with the "divorce" of the Banca d'Italia from the Treasury in 1981, undertook a number of measures to liberalize its financial markets (including the encouragement of foreign banks' entry into their markets), but did not change its social arrangements.
One pattern, which does emerge from the table, confirms the point made in the previous section. The countries in the right column, that is those that have market-based financial systems whatever their social arrangements, include all the major countries which displayed strong economic performance (as measured by GDP growth) in the 1990s. The countries in the left column, that is those with relationship-based financial systems, comprise most of the slower growing economies of recent years. Of course, financial efficiency is not the only determinant of economic growth; if one were to look at the 1970s or early 1980s, the relative performance of the left-column countries such as Japan or Germany would improve markedly. That earlier performance, however, can be attributed to a number of temporary factors such as technological catch-up, gains from shifting labor out of agriculture into industry, education of the work force, and Cold War driven trade inequities. In a world like the present, where these countries all face essentially the same market conditions with roughly equal technology and stable workforces, it is logical that financial efficiency would become a primary determinant of relative economic performance - and it is likely to remain so.
National Autonomy Without National Models
Despite the fears voiced in many quarters of many countries about globalization, and especially about the liberalization of finance, countries remain as able as they ever were to set their own courses with respect to social organization. For trade negotiations and assessments of regulations, there may occasionally be confusion (intentional or not) about whether the maintenance of specific social institutions represent barriers to market access. From the broader macroeconomic perspective, however, decisions about the way a society is organized and the extent to which its markets are open and liberal are independent of each other. A nation can maintain whatever social arrangements it is willing to pay for, and the promotion of sectoral efficiency only gives more rather than less resources with which to make those payments.
A look at the diversity of national experiences glossed over in Table 1 just emphasizes this point. France is statist, Germany is federalist, and Italy is near-stateless, with all that implies for how and how much the economic decisions of their citizens are regulated. The United States has suffered from extreme pathologies as unemployment has varied from low to high to low again, while Spain has borne enormous persistent unemployment with meaningful social strain only beginning to show. The idea that there is any one model for countries, and their convergence to that model is dependent upon their economic organization, is false on its face.
By the same token, modern industrial democracies - including Japan - cannot be thought of as unitary entities or as integrated systems in which one component cannot be changed without altering all others. Social cohesion underlying a sense of nationhood must not be mistaken for the existence of some national model which is fragile to the outside world. Countries can grow economically despite certain aspects, as others and I have argued Japan grew in the past despite the mistaken insulation of its financial system and other sectors from competition and globalization. One cannot reason backwards that if a country did experience good economic performance in a period then every aspect of that country's economic organization during that period was necessary or even salutary.
The choice for Japan with regards to deregulation and market access in a global economy is therefore made easier rather than tougher by looking beyond the microeconomics. While I would not presume to enumerate what Japanese social values are to be maintained, I am comfortable in asserting that the protection of the concentration of financial decision-making in the hands of a small club of firms and banks is not required to support those values. Similarly valid doubts can be raised about the social importance of rice farmers or airline managers or other groups protected from competition-is their extraction of money beyond their fair earnings from other individuals and firms within Japan necessary to maintain income equality and domestic peace? Meanwhile, the macroeconomic disaster in the midst of which the Japanese economy currently sits is in large part due to the predictable effect of keeping finance away from market forces and the allocative mistakes that encouraged. Economic gain is possible without social cost if Japan's decision-makers will allow themselves to recognize that fear of finance has no real basis.