A Future Perfect: The Challenge and Promise of Globalization

by John Micklethwait

  Of course, it has long been possible to trade goods, but being able to move billions of dollars around the world at the touch of a button is new. Technology has revolutionized capital markets more dramatically than almost any other part of the economy. News programs may still illustrate their reports on the money markets with scenes of hollering traders, but most transactions take place silently, at the touch of a computer key. Indeed, one reason for the wave of mergers and acquisitions that has swept through the banking industry arises from the need to pay for all the high-tech equipment that modern finance demands, as well as for people who can understand it. If you want to find a world-class mathematician nowadays, you might find him at Goldman Sachs sooner than at MIT.

  Inevitably, financial firms are now among the world’s most global organizations. Most traders and bankers spend more time on the phone to people they have never met on the other side of the world than they do speaking with their spouses. This internationalization has not always been a comfortable experience: Deutsche Bank lost a fortune because of one misguided fund manager in its London office, and the Baring family lost their bank because of another in Singapore. But such events seem to have only stiffened the resolve of their peers.

  The “masters of the universe” often assume that the globalization of fip. 51nance is inevitable. In 1998, when Citibank and Travelers Group merged to form Citigroup, their minds were on access to financial consumers in Asia, Latin America, and Europe as much as on those in the United States. During the merger discussions, one of the bankers asked aloud, “Can anyone stop us?” There was a long pause, and then somebody ventured, “NATO.”

  In a world where even The People’s Daily, the organ of China’s Communist Party, carries a weekly financial supplement, this sort of chutzpah is understandable. But in fact the liberalization of the capital markets is both relatively recent and incomplete. At Bretton Woods, national economies were linked together by trade in goods, while capital flows were limited to those necessary to finance that trade. After the war, many governments erected two sorts of barriers: capital controls, a term that strictly speaking refers just to things that affect a country’s capital account in its balance of payments, such as foreigners buying businesses or shares in the country; and foreign-exchange controls, which affect how an exporter uses the foreign currency that his exports earn.

  Worse, as we have seen in South Korea, many countries added a third barrier: a set of controls, either formal or informal, on their own banking system. The postwar social consensus relied on financiers following the national will. Bankers acted more like court treasurers than masters of the universe. In return for being protected from foreign competition, they agreed to act as instruments of national policy. In Japan and its Asian imitators, bankers plowed money into export-related industries; even in the United States, banks were far more interested in national than international affairs. In 1960, for example, only eight of the 13,126 banks in the United States had their own permanent foreign operations.[1]

  This world, in which people needed to have their passport stamped if they carried foreign currency, lasted a long time. Some countries got rid of trade-related foreign-exchange controls in the 1960s, and financiers managed to elude other controls by setting up Euromarkets in which banks took deposits and made loans in foreign currencies. But even after the fixed-exchange-rate system broke down in the early 1970s, many rich countries did not loosen their capital controls for another decade—at about the same time that Latin American countries, responding to their debt crises, reapplied them. According to the IMF, 144 countries still had controls on foreign direct investment in 1997, and 128 imposed rules on international financial transactions.[2]

  Meanwhile, barriers against foreign financial institutions are even more plentiful. South Korea was only one of a number of countries that spent the p. 52 1990s greedily eating up foreign capital yet restricting the role of foreign banks in its domestic markets. Thailand and Indonesia pursued exactly the same policy. In the mid-1990s, foreign-owned banks accounted for roughly one in twenty of the loans made in those countries—about the same as in India. In Japan, the proportion was even lower. Even after the disasters of 1997 and 1998, when their financial systems were desperate for foreign support, many Asian governments found that their regulations prevented them from allowing foreigners to take over banks and brokerages.

  An Investor’s Dream

  How does all this add up? From an economist’s point of view, there is no single, integrated global capital market. Even during the 1990s, only 10 percent of investment in emerging countries was financed from abroad. Indeed, some economic historians use current-account statistics to argue that capital is less mobile today than it was one hundred years ago.[3]

  From a trader’s point of view, there are also gaps. Foreign exchange is now an extremely liquid market, at least as far as the major currencies are concerned, and the international debt markets are not that far behind. But the market for equities is still often frustratingly illiquid: Prices are volatile, information murky, and transactions difficult to clear. Even the Asian contagion took some time to earn the accolade “global.” Despite all those twenty-four-hour markets, it took a whole year for the tremors from the currency devaluation in Bangkok in July 1997 to cause the earthquake in Moscow, and another year and a half to affect Brazil.

  These, however, are demanding standards. From the point of view of a businessperson, investor, or politician, the trend is fairly clear: Capital now moves around the world much more easily than it ever has before. “The electronic herd,” as Thomas Friedman of The New York Times has dubbed the market, may not be able to run quite as freely as he and other optimists believe—there are still fences, even a few regulatory canyons, that either restrict or slow its movement—but the area it can trample (or productively graze upon) has definitely increased.

  One reason for this is that financial regulators have discovered that, in the rich world at least, he who takes down his fences fastest prospers most. Throughout the 1980s, pressure mounted on the City of London to follow Wall Street’s lead and embrace deregulation, known as “Big Bang.” Many old-school types forecast ruin if the City got rid of its traditional distinction p. 53 between brokers and jobbers; they also regarded electronic trading floors as an unpleasant American innovation. In fact, Big Bang proved to be a bonanza both for the old partnerships that scrambled to sell themselves to outsiders, often foreigners, at outrageous prices (the Home Counties saw a tidal wave of swimming pools built on the profits) and for the City. London consolidated its grip not just on the foreign-exchange market but also on international equities. The value of international share trading on the stock exchange is rising toward two trillion dollars a year, a third more than the turnover in British shares. Now Continental exchanges have rushed to imitate this success; indeed, for a while Frankfurt stole a march on London in options trading.

  Even Japan has caught the deregulatory bug. “Something finally changed in the mid-1990s,” argues Yoshihiko Miyauchi.[4] Miyauchi, a scholarly-looking, bespectacled figure, is a good example of a species found in financial markets around the world: a liberal who owes much of his success to the fact that his country’s financial establishment has not listened to him. During the 1980s, at the peak of Japan’s success, Miyauchi was one of the few businesspeople to chafe about the country’s “semisocialist” taxation policy and the insular nature of its financial establishment. The upstart company he built, Orix, pioneered leasing and consumer finance in Japan—an area neglected by the big banks and securities houses. By remaining outside Japan’s financial club, Orix had to contend with all sorts of anomalies, such as not being able to issue commercial paper to finance its loans. Rather, its success has been largely a matter of attitude and flexibility: It was one of the first companies in Japan to introduce share options for managers, and it is one of the few Japanese financial institutions listed on the New York Stock Exchange.

  As markets have loosened up, Miyauchi has mov
ed into more areas, snapping up a banking license by buying part of the defunct Yamaichi Securities and starting a telephone-sales operation to sell life insurance. Increasingly, his rivals are not Japan’s somewhat stodgy banks and securities houses but foreigners with the same punchy attitude as Orix, such as GE Capital, Fidelity Investments, and Merrill Lynch. These are powerful names, but Miyauchi seems unconcerned. He regards the arrival of the foreigners as a good thing in principle. (Indeed, as the head of the government’s new deregulation committee, he has campaigned for it.) He also thinks that Japan’s financial market still remains extraordinarily underdeveloped. Only one in ten Japanese firms uses lease finance. And most Japanese still keep their savings, which total some ten trillion dollars, in bank accounts that yield only p. 54 slightly better interest rates than stashing the money under the bed. “There is,” Miyauchi notes dryly, “some room for improvement.”

  The Freedom of Mutual Funds

  This points to the main force behind the growth of the international capital market: the investor. In places such as South Korea, concepts such as “popular capitalism” and “shareholder democracy” might ring a little hollow, but throughout the developed world, an increasing number of relatively poor people have been buying shares and liking the results.

  When waitresses ask, as they put down your cappuccino, whether they should short Dell, it is tempting to abandon all faith in capitalism. But whatever the madness of day traders brings in the short term, buying shares is now both cheap (a trade now costs only about three cappuccinos) and easy. Which would take you longer, buying one hundred shares of IBM on-line or programming your VCR?

  In America, mutual funds now have more money in them than either pension funds or insurers and roughly the same amount as banks. In Europe, where people are gradually getting used to the idea that they will have to save for their retirements themselves rather than rely on an overextended welfare state, there is a growing interest in equities, which have delivered the best long-term results. America’s stock-market capitalization is roughly one and a half times its GDP; in Europe, each stock market is worth around half of its country’s output. One in two American households owns shares or mutual funds. In France, the figure is 15 percent; in Italy just over 10 percent; and in Germany even less.[5] Even if the number of shareholders on the Continent merely increases to British levels, where about one in four people own shares, the capital markets will expand hugely.

  And, in time, this should bring the world closer together. Even with the memory of the financial turmoil of 1997-1998 still lingering, it seems likely that investors will gradually put more of their money outside their country’s borders. The long-term prospects for growth in South Korea and its neighbors still comfortably outstrip those for America or Europe. Before the new Eurozone came into being at the start of 1999, investors in the four main European countries kept at least 85 percent of their money at home. As a result, most German investors had no shares in the oil industry, just as most Dutch people had no shares in the car industry; now they are more likely to buy Royal Dutch/Shell and Daimler-Benz respectively. Flemings, a British investment bank, reckons that it could take two decades for the new pool of money (which it puts at nine trillion dollars) to be fully Europeanized.

  A Capital Democracy

  p. 55 From the perspective of somebody sitting in, say, SBC Warburg Dillon Read’s sixty-five-thousand-square-foot trading floor in Stamford, Connecticut, the deregulation of Western financial centers and the growth in the number of international investors add up to a single unstoppable force. But in many parts of the emerging world, there are plenty of people who feel far less gung ho about liberalization, and there are also a surprising number of critics in the temples of Mammon. “Instead of acting like a pendulum,” George Soros testified to Congress, “financial markets have recently acted like a wrecking ball, knocking over one country after another.”[6] So our final argument for why the capital markets will continue to bring the world closer together is also the most controversial: Basically, they work—even in places such as South Korea.

  The arguments about capital flows are complicated, but they usually come down to balancing one clear advantage against several disadvantages and qualifications. The advantage of financial liberalization is clearly efficiency. Countries that get rid of capital controls and liberalize their banking systems see more efficient investment because markets allocate money better than bureaucrats do. Research by the Milken Institute has demonstrated that economies fare best when capital is cheap, plentiful, and, just as important, allocated fairly.[7] The institute ranked emerging markets in terms of the openness of their capital markets. The top three places went to Asian countries that survived the financial crisis with the least damage done: Singapore, Taiwan, and Hong Kong. The bottom four places went to Indonesia, South Korea, Russia, and Bulgaria, all of which, with the exception of Bulgaria, were devastated by the crisis.

  Nevertheless, the case for the free flow of capital is much less straightforward than that for free trade in goods. Markets for goods and services are reasonably predictable; financial markets are horribly volatile. Much depends on the amount of information in investor’s hands, and even well-informed decisions are often motivated not just by economic fundamentals but by what investors imagine other investors will do—in other words, by a herd instinct. It is all very well to argue that South Korea recovered very quickly, but that only prompts the question of whether it needed to go through quite so much hell in the first place. Chile is often cited as a paragon of free trade that nevertheless has some controls on short-term investment. China, too, has seen substantial growth without loosening its capital controls.

  It is notable that although it is hard to find any respected economist who opposes free trade, several—notably Dani Rodrik of Harvard University p. 56 and Jagdish Bhagwati of Columbia—are much more skeptical about the benefits of the free movement of capital.[8] There is also a fairly large group of people, including Paul Krugman, who think that capital controls can be an attractive temporary cure for countries that get into a currency crisis. Such controls can give a country time to fight off recession by loosening its monetary and fiscal policies, without setting off a huge flight of foreign money.

  On balance, we disapprove of capital controls, especially as a long-term policy—but it is an awkward case to make. Capital markets (rather like the postcrisis South Koreans) suffer from something of a split personality. In one guise, capital is splendidly, even ruthlessly, rational. Gregory Millman has nicely compared traders such as Andy Krieger and investors such as George Soros to the bounty hunters of the Old West, “who enforce the law, not for love of law, but for profit” and who administer “economic justice.”[9] As Walter Wriston, the former chairman of Citibank, puts it, “Money goes where it wants and stays where it is well treated.” Watching Black Monday in Britain or the collapse of the peso in Argentina was like watching a Terminator film: The machine could not tolerate human weakness.

  Yet, at other times, this same relentlessly robotic creature can be just as neurotic as any character yet invented by Woody Allen. Only the most Panglossian free-marketeer would deny that capital markets can sometimes get things wrong. The history of markets is dotted with speculative manias from the Dutch tulip mania of the seventeenth century to the frenzy that preceded the 1929 crash. A century ago, Wall Street was arguably as prone to crashes as emerging Asia is today. The gold standard that lasted from 1870 to 1914 came under repeated speculative attacks from investors.

  The markets have repeatedly misjudged emerging economies. The capital that poured into Seoul (just like the money that flowed into Moscow and Bangkok) spurred the construction of a lot of extravagant buildings and convinced an army of company managers and government bureaucrats that they could get away with borrowing short-term money. In Argentina, the currency board continued to be seen as a boon long after it had in fact become a threat. At the same time, emerging economies are feeble things when set beside the might o
f the global capital markets. Paul Volcker is fond of pointing out that the entire Argentine banking system in the mid-1990s was worth less than the third biggest bank in Pittsburgh.

  Many of the wildest gyrations of the past five years have been blamed on the financial world’s most ineptly named institutions: hedge funds. There are about four thousand such funds, most of which exist in unregulated offp. 57shore markets. They control a total of four hundred billion dollars in equity—which allows them to borrow four or five times that amount—and concentrate for the most part on short-term transactions. Their activities have posed a threat not just to the stability of emerging economies—one fund supposedly had a short position in the bhat that was equivalent to a fifth of Thailand’s reserves—but even to the economy of the United States itself. The collapse of Long-Term Capital Management, whose gambles were based on underlying assets worth more than one trillion dollars, caused such a panic in Wall Street and in Washington that a consortium of big banks, egged on by Alan Greenspan, the chairman of the Federal Reserve Board, clubbed together to bail it out.

  David Hale, the chief economist for the Zurich Group, points out that this sort of highly leveraged speculative fringe is new to the global capital markets. There were certainly currency crises and financial panics in the nineteenth century, but money could not be flicked across borders at the touch of a button, and international investment, which was driven by about twenty-five thousand European families, was usually longer term and usually based on real assets.[10] On the other hand, singling out hedge funds is unfair. The fallout of the scandal made it clear that many of Long-Term Capital Management’s practices were not unique to the world of hedge funds; banks and securities houses all around the world were speculating almost as heavily through their proprietary trading (i.e., gambling) operations.