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Speculative Finance and Capital Accumulation

This chapter presents the main argument of the thesis. It

argues that the slowdown in real output growth and accumulation

within the advanced economies has been caused primarily by the

ascendancy of speculative finance capital. The rise to dominance of

this finance capital both within the advanced economies as well as

internationally through cross-border flows of 'hot' money followed the

deregulationfliberalisation of domestic and international frnancial

markets since the 1970s.

The liberalisation of financial markets and capital flows has been

attributed to several factors. The collapse of the Bretton Woods system

and the floating of the exchange rates that ensued was a significant

factor contributing to the restructuring of the national a.Tld

international regulatory structures. 1 It has been further argued that

the liberalisation of capital markets actually started with the opening

of the Eurodollar market in the 1950s and the breakdown of the

Bretton Woods accelerated the process.2 The recycling of the OPEC

surpluses following the oil price hikes in the 1970s has also been

1 Eatwell ( 1997) argues that with floating exchange rates, foreign exchange risk, which was borne by the public sector under the Bretton Woods, got privatised, necessitating the removal of regulatory barriers which deterred the dispersion of such risks. Thus capital controls were abolished and crossmarket transactions permitted to allow hedging against the cost of fluctuating exchange rates. 2 See Eatwell and Taylor (1998)

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noted to have greatly enhanced the liquidity of the Eurodollar market

with transnational banks accumulating huge reserves seeking

profitable lending opportunities. 3 All this led to increased pressures

for both deregulation of domestic financial markets within the

developed countries as well as liberalisation of international capital

markets. The unravelling of the Bretton Woods in 1973 has also been

widely held as indicative of the end of the 'Keynesian consensus'

within the policy circles of the advanced economies. The events

following the oil price shock of 1973, especially high inflation and

floating of exchange rates, greatly increased instability and

uncertainty within the advanced economies, bringing the two decades

long stable growth period to an end. The backlash against Keynesian

full-employment policy entailed a retum to the laissez faire orthodoxy

in economic theory with arguments decrying government intervention

and regulation becoming fashionable. A significant aspect of the

resurgent neoliberalism was to forcefully advocate financial

liberalisation. Many have analysed this in terms of the increasing

influence of fmancialfrentier interests withih the advanced economies,

whose 'euthanasia' Keynes had passionately argued for in the General

Theory. 4

Domestic pressures for deregulation within the advanced economies

can be seen as a reaction of the rentiers to falling real interest rates

following the high inflation of the 1970s. The liberalisation of capital

markets has in turn led to increased volatility in capital and foreign

exchange markets and high short and long term real interest rates,

much higher on average than the first two post-war decades.s In the

statistical appendix to this chapter, charts 3.1 to 3. 7 show that the

decadal average of real short-term interest rates (treasury bill rates for

3 Lissakers (1991) notes that $400 billion of the $475 billion OPEC surplus was placed within the industrialised countries up to 1981. 4 See Patnaik (2000) and Dumenil and Levy (2001). Smithin's (1996) book on Macroeconomic Policy and the Future of Capitalism is subtitled 'The Revenge of the Rentier and The Threat to Prosperity'. 5 In the recent years both short-term and long term real interest rates have fallen to low levels. The reasons for this are discussed later. However, if we look at decadal averages, average short-term and long-term real interest rates have been higher in most advanced economies since the 1970s.

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Canada, U.K. and the U.S., call money rates for France and Germany

and discount rates for Italy and Japan deflated to real terms by

consumer prices) dips to negative levels in the 1970s for all G-7

economies except for Germany. The average long-term real interest

rates (long-term government bond yields for all countries) are also

negative for Italy, Japan and U.K. in the 1970s and positive but low

for others. In the 1980s both the averages of short-term and long-term

real interest rates rise significantly. While the rates tend to fall in the

1990s for some, they continue to remain at levels much higher than

the in the 1950s and 60s for most economies. This evidence of higher

average real interest rates prevailing in the advanced countries

following fmancial liberalisation in the 1970s, belies the professed

claim of neoliberal theory that unfettered mobility of capital and free

competition in deregulated fmancial markets result in increased

efficiency in the allocation of savings into more productive

investments, thereby leading to lower interest rates. The further claim,

that with lower cost of borrowing for investment and with better

opportunities for laying off risks under financial liberalisation, higher

investment and growth shall follow, also flies in the face of the

experience of slower growth in the post-liberalisation phase.6

The fallacies in the neoliberal arguments are many, the most

important one being the conception of fmancial markets. It is not that

trade in goods and services are carried out in accordance with the

neoclassical mechanism of price adjustments in competitive markets.

However, trade in goods is still significantly different from trade in

fmancial assets because the former's prices are somewhat tethered to

their costs of production and their transactions and carrying costs are

significant. As Keynes ( 1936) had noted long back, financial markets

function in a manner fundamentally different from commodity

6 See Eatwell ( 1997) and Felix ( 1998) who argue that the slower growth in investment and output in the post-1970 period is caused in the main by the higher real interest rates following financial liberalisation. They also provide data on higher real interest rates, lower investment and growth and higher volatility of exchange rates for this period.

90

Speculatzve Finance and Capital Accumulation

markets. It is marked by waves of excessive optimism and pessimism

and speculators far from playing a stabilising role create enormous

volatility in the prices of financial assets in their bid to outguess the

market. 7 Competition within financial markets necessarily implies

increased speculation, which can have adverse implications for capital

accumulation and real growth.

The present chapter, which is based upon this Keynesian theme,

abstracts from govemment intervention and looks at the implications

of financial liberalisation for private corporate investment within the

advanced economies. Implications for govemment intervention,

specifically fiscal and monetary policy, would be looked at in the next

chapter. The first section of this chapter looks at the changes in the

fmancial markets brought about by liberalisation in the post-1973

period. The following section would mainly concentrate on the effects

of deregulation on non-financial corporate investment in the capital

market based financial systems of the U.S. (which holds good for the

U.K. to a great extent). The next section concerns the convergence of

the so-called market based and bank based fmancial systems over the

1980s and 1990s, transforming the latter type of systems like Japan

and Germany into more market oriented ones. This would be followed

by a theoretical discussion on the effect of financial liberalisation and

speculation on capital accumulation drawing upon insights of Keynes

and Hicks. A simple model would be presented to formalise the main

theoretical argument followed by concluding observations.

Financial Markets: Deregulation and Competition

Deregulation of financial markets is theoretically justified in

terms of providing opportunities for wealth holders to hedge against

risks, arising out of fluctuations in economic variables like the

exchange or the interest rate, by spreading risks through

7 Kindleberger's (1978) classic is based upon the important observation that financial markets are characterised by manias, panics and crashes.

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diversification of assets held in different portfolios. A logical corollary

is the melting down of the segmentation of financial markets so that

access to various kinds of financial assets and services is available to

all types of wealth holders, both private agents as well as institutions.

An explosion of financial innovations occurred since the deregulation

of the national and international capital markets since 1973.

Traditional practices of bank lending were displaced by increasing

securitisation, revealing a preference of the banks towards holding

marketable assets. This was accompanied by the emergence of other

non-bank fmancial institutions, like the investment banks, hedge

funds, mutual funds and pension funds, as major players in the

financial markets. While the initial purpose for the establishment of

these various financial intermediaries varies, the net effect was to set

off competition between different financial institutions in order to

provide higher returns to investors, by holding diverse financial assets

in their portfolios and managing their risk-return strategies.

Competition from these institutions transformed the nature of bank

lending itself, which shifted towards more non-bank sources of

profits.s The competition to provide more opportunities for dispersing

risk also led to the evolution of the financial derivatives markets in the

1980s. The innovations of instruments like futures and options were

meant to be financial contracts wherein values of underlying financial

assets like stocks, bonds or foreign-exchange could be hedged against

the risks of exchange or interest rate volatility. However, these

instruments have had the effect of encouraging speculative activities

in the fmancial markets by increasing the possibilities of making

speculative capital gains. Competition for capturing increased share of

the derivative market has led to the innovation of specialised

contracts, like interest or currency swaps in the over-the-counter

8 Carvalho ( 1997) states, " ... the traditional role of financial institutions such as commercial banks seems to be growing increasingly obsolete. In fact, some banks look more like brokers, organizing the placement of securities, than like the intermediaries of credit they once were." Sen ( 1996) quotes from BIS Annual Reports to suggest that non-bank sources of profits have considerably risen as a proportion in gross banking income for the major OECD countries following deregulation of financial markets.

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(OTC) market, which are designed according to customer

requirements. The increase in the proportion of these contingent

contracts in the portfolios of banks and financial institutions expose

them to greater risks. 9

Ironically, financial innovations which were designed to increase the

possibilities of reducing individual risks by spreading them, have

resulted in greatly enhanced volatility and systemic risk for the

financial markets as a whole. McClintock ( 1996) argues on the basis

of a report commissioned by the Bank for International Settlements

(BIS, 1992):

First, increased competition between financial

intermediaries has broadened the potential sources of

systemic failure as well as spread the impact of any

systemic failure over a wider range of institutions and

markets. For example, commercial banks face greater

exposure to hedge funds because of the large lines of

credit they supply to these speculative

institutions ... Second, some derivatives markets have

become more concentrated in the hands of relatively few

market-makers. Larger exposures to one another among

these key market participants increases the repercussion

effects of shocks should one of the key market makers

default on its obligations.

Third, domestic and international linkages between

financial markets have intensified through derivatives

trading. Though designed to reduce price volatility,

derivatives can actually amplify fluctuations, usually at

9 UNCT AD (1995) notes the increasing risk of OTC instruments. Sen ( 1996) quotes from BIS ( 1992), that the off-balance sheet activities of banks have increased with trade in OTC instruments, growing from $500 billion to $ 4080 billion between 1986 and 1991. McClintock ( 1996) quotes BIS figures to show that the total notional principal amounts traded in the derivatives markets (exchange traded instruments, currency, interest and stock options and futures, OTC instruments etc.) grew from $1591 billion in 1987 to $9987 billion in 1992.

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worst possible times such as when liquidity tightens in

markets ... Derivatives transactions may make ... arbitrage

between markets less costly and risky to individual

market participants; however, they are based on an

assumption that sufficient liquidity will prevail across all

markets to close out their positions as and when they see

fit. But an institution may well be hostage to a decline in

liquidity in one market that could trigger liquidity

problems for itself and others in other markets. Such

liquidity problems are exacerbated by a fourth

factor. .. Since many derivatives are off-balance sheet

items, the ability of market participants to assess the

relative risks faced by counterparties is made more

difficult ...

Finally, financial and technological innovations have

increased the speed at which market shocks are

transmitted. Price fluctuations may be transmitted well

before the accompanying information as to the source of

the fluctuations ... The simultaneous use of a range of

markets for funding and position taking purposes

combined with the possibility of rapid transmission of

market shocks act to intensify systemic risk. (McClintock,

1996)(pp.26-27)

The upshot is that competition within fmancial markets assumes a

fundamentally speculative character. Hedging against risk implies

forming expectations regarding prices of financial assets in an

uncertain future and adjusting assets in different portfolios according

to these expectations. This opens up opportunities to make capital

gains by forming appropriate expectations about future price

movements and taking positions accordingly. Although speculation

exists in all markets, financial markets are more conducive for it

because of the highly liquid nature of the traded assets (this is

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discussed later in greater detail). Financial liberalisation by removing

qualitative and quantitative controls over such trade and reducing

transactions costs (improved information and communications

technology plays a crucial role in this) enhances such speculative

activities wherein portfolios are adjusted with increased frequency

with every emerging opportunity for capital gains. This leads to greater

volatility in asset prices thus increasing the risks involved in holding

such assets, creating the demand for newer financial derivatives in

order to spread those risks. Once more instruments get created they

open up further opportunities for speculation.

This pattern of competition within financial markets which generates

endogenous volatility, apart from enhancing systemic risk, also

imparts a short-termist bias to the horizons of expectations since

speculators compete with each other in making profitable use of

increasingly shorter-term changes in prices of assets. iTime being

continuous, there is always a possibility to gain from taking shorter

term positions in markets where price changes can occur by minutes

and seconds. When a large number of speculators actually trade

fmancial assets within very short time periods, asset prices display

high fluctuations in the short term, fuelling short-termism in the

entire market.

This conception of financial markets of course stands in sharp

contrast to the efficient market hypothesis. The proponents of efficient

fmancial markets claim that since traders are rational, they would

value fmancial assets in accordance with their underlying

'fundamental' values. Thus rational traders would trade only in

response to information regarding those fundamentals and the market

value of assets would reflect their underlying fundamental value.

Traders who trade in violation of the rationality principle are believed

to be doing so in a random manner such that their transactions

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cancel each other out, keeping the price of assets close to their

fundamental values. Even when the transactions of the

'unsophisticated' or 'noise' traders are correlated and do not cancel

out, the presence of speculators or arbitrageurs who know the

fundamental values of the assets (and also know that asset prices

would eventually converge towards their fundamentals) are considered

to be playing a stabilising role by selling overpriced assets and buying

underpriced ones. 1o

The problems with this characterisation of efficient fmancial markets

and the stabilising role played by speculators were discussed a great

deal in the backdrop of the Great Depression. Firstly, given the

absolute uncertainty about the future under which they have to take

decisions, market participants form expectations regarding future

asset prices following some rules of the thumb. In such a context, the

concept of a 'fundamental' value of an asset becorhes meaningless.

Traders might often take the prices of assets in the recent past to

extrapolate future prices or follow similar benchmarks to arrive at

decisions rather than forming 'rational expectations'. Secondly, it

follows from the first observation that traders would be susceptible to

a herd instinct in the absence of an objective anchor, where imitating

each others' judgements become rational in the absence of

information or knowledge about the future, as others' actions are

conceived as purveyors of new information and moving in a herd

instils a sense of security. Thus such 'irrational' transactions reinforce

rather than cancelling out one another. Thirdly, even if the

'fundamental' values of assets are known to the speculators,

speculation is all about guessing what market expectations regarding

future asset prices would be within a certain horizon. The fact of this

given horizon makes the knowledge about the 'fundamental' values of

assets (to which prices are believed to eventually settle over the 'long

term 1 irrelevant for speculators, once it is known that prices are going

10 See Fama (1965). Also see Friedman (1953).

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to diverge from those values in the short-term. Since trade in assets

are carried out on the basis of expectations of the prices of assets in

the short-term, the pristine 'long-term' never arrives in reality.

Speculators in their bid to make capital gains, trade in assets on the

basis of their guesses about market expectations (what market

expectations think what market expectations would be and so on).

Therefore, far from playing a stabilising role speculative activities can

cause greater variability in the asset prices and instability in the

financial markets. The observed volatility in fmancial markets

following their liberalisation can be seen as a direct outcome of a rise

in such speculative activities. We now turn to its effect on corporate

investment behaviour.

Financial Liberalisation and Corporate Investment

The traditional i neoclassical theory of investment denied any

influence of finance or the capital structure of a firm on accumulation.

The view can be summarised by the proposition that the cost of

capital for a firm does not depend on the firm's particular fmancial

structure and its market value or capital investment would not be

influenced by fmancial factors like the retention ratio, debt equity

ratio or dividend payments. 11 Mounting evidence for the fact that firms

finance their capital investments primarily out of internal funds

(mainly retained earnings) supplanted the neoclassical theory with

other explanations, the crux of their arguments being that financial

factors affect investment because the opportunity cost of internal

funds are substantially lower than the cost of external finance. 12 If the

11 Known as the Modigliani-Miller proposition; see Modigliani and Miller (1958). For an exposition of the neoclassical theory of investment where the solution to the intertemporal optimisation problem of the firm is independent of its financial structure, in keeping with the Modig1iani-Miller proposition see Hall and Jorgenson (1967). 12 See Fazzari, Hubbard and Petersen (1988). Their line of argument is that internal finance constrains investment when demand is high and external finance requires a cost premium due to asymmetric information between the borrowing firm and lending banks or shareholders. Therefore firms finance their investments according to a 'financial hierarchy' or a 'pecking order' where internal funds are preferred over debt finance and debt over equity finance, in accordance with the intensity of the information problems associated with various types of financing. Also see Myers and Majluf(1984).

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neoclassical theory had held, then the capital structure of firms would

have been indeterminate because of the indifference of firms towards

sources of finance. The fact that firms choose to finance most of their

investments through internal funds rather corroborates the theory of

manager-owner (shareholder) conflict wherein managers prefer

internal funds over external finance in order to protect their autonomy

vis-a-vis other stakeholders. 13 This view alters the simplistic

neoclassical theory of the firm where as rational agents firms

maximise their profits. The objective of a firm now becomes an arena

of conflict between different stakeholders trying to establish their own

interests over others.

The sort of investment behaviour implied by Tobin's q-theory, where

new investment is undertaken when the market value of a firm

exceeds its replacement cost, is based upon the assumption of

'efficient' fina.Itcial markets.14 The efficient market hypothesis posits

prices of securities in the stock market as those prices for underlying

capital assets (and therefore the market value of a firm as that value)

which best reflect the information on the basis of which capital

investment decisions should be taken. This view of market efficiency

has been extended to argue that the discipline of the capital market is

necessary to prevent firms from 'overinvesting' or 'growing beyond

optimal size'. 15 Moreover, it has been suggested that in order to

minimise the 'agency cost of free cash flow' and maximise the returns

13 The first significant contribution to this theory of corporate governance was by Berle and Means (1932). The Agency Theory in Corporate Finance (signifying a principal-agent problem in financing investment) took off from their basic proposition that managers and shareholders in a modem corporation have divergent objectives, constraints and information as well as different time horizons. See Crotty (1990) for a critique of the theories of investment in the works of Keynes, Tobin and Minsky on the grounds of' conflation' of ownership and management. 14 See Tobin and Brainard (1977) for the exposition of the q-theory. 15 See Jensen (1986). He argues that corporate managers have incentives to grow beyond the 'optimal size' because growth increases manager's power and control over resources, as well as their compensation, which is linked to growth of sales. Accordingly, managers have a tendency to misuse the 'free cash flow' ("cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital") at their disposal, by investing in wasteful projects rather than returning the money to shareholders. Therefore the 'problem' for him is "how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organizational inefficiencies" (emphasis added).

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to the owners of capital, debt is a better instrument than equity since

the former entails a strictly enforceable legal contract which assures a

predetermined flow of returns, in contrast to equities where dividend

payments are contingent upon discretionary managerial policy. Thus

leveraged buyouts (LBOs) and mergers and acquisitions (M&As) are

favoured instruments which allow highly leveraged frrms/private

parties to takeover the growth-oriented firms which have low leverage

and dividend pay-outs (the 'cash cows1- The M&A wave of the 1980s

in the U.S. has been argued, in the light of this theory, to have

brought about the much needed restructuring of corporate governance

through the disciplining device of the market. The capital market,

according to agency theory, had efficiently allocated resources by

catalysing the exit of firms that were suffering from chronic excess

capacity and favouring the entry of those in the sunrise industries.l6

Apart frorrl a total absence of any understanding regarding the

demand side of an economy as to why excess capacity exists, the

orthodox agency theory also falters in its conception of the functioning

of capital markets. The efficient market hypothesis wherein fmancial

markets are believed to possess and process all relevant information

efficiently lies at the heart of the theory. In contrast to this benign

view about the capital market, many have attributed the experience of

slow growth and under-investment by the corporate sector to the

former's short-termist character. Financialliberalisation resulted in a

phenomenal rise in the number of institutional shareholders who

tilted the balance of power in the market in their favour over the

16 Jensen (1993) in his Presidential Address to the American Finance Association argues that changes in technology, deregulation of markets and globalisation since 1970s comprise a modem 'industrial revolution' and events like the emergence of the 'modem market for corporate control' (mergers, takeovers, high yield (junk) bonds and LBOs) were associated with the beginning of this 'revolution'. He simultaneously argues that the 'industrial revolution' has caused huge excess capacity because of the nature of technological innovations (obsolescence-creating and capacity-expanding) accompanying the 'revolution', along with other factors like oil price hike and global competition in product and labour markets. This argument is then followed by an advocacy of further deregulation of capital markets (market for corporate control) in order to favour the Schumpeterian exit of high cost firms and reduction of excess capacity, citing the failure of the internal control systems of the corporations. His arguments are mainly targeted against the re-regulation ofthe capital markets introduced in the wake of the M&A 'excesses ofthe 1980s'.

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1980s.l7 Given the fact that these institutional investors (pension

funds, mutual funds etc.) hold company shares along with other

financial assets within their portfolios, and are mainly interested in

short term capital gains (as noted in the earlier section) a rise in their

holdings of shares brought about higher volatility in the stock markets

as prices of stocks adjusted with increased frequency due to

increasingly frequent portfolio adjustments. Higher returns from

shares were naturally demanded in such a scenario where share

yields had to compete with the yields of other financial assets.

Squeezing higher returns from the corporations by the fund managers

was a major motive behind the M&A wave of the 1980s, where those

funds played crucial roles both as sellers of large blocks of shares in

takeovers as well as investors in the buy-out funds and junk bond

markets.lB The corporate restructuring of the 1980s appears to have

been driven more by fmancial than by technological innovations, with i

short term capital gains accruing to financial institutions as a result

of t.;.eir speculative trading in company shares and junk bonds.

It is this view which gets reflected in the arguments of those who

called for a change in the structure of capital markets in the U.S. and

the U.K., alleging that short-termism in the fmancial markets led to

under- investment in the 1980s.l9 The main argument of the critics of

the capital market based investment system of the U.S. concerned the

17 See Donaldson (1994). Gompers and Metrick (2001) show that large institutional investors nearly doubled their share ownership ofU.S. corporations from below 30% to above 50% in between 1980 to 1996. Porter (1992) notes the same increase as, from 8% in 1950 to 60% in 1990. 18 Mitchell and Mulherin (1996) have reported that nearly half of all major U.S. corporations received at least one takeover offer in the 1980s. A total of 35,000 M&A transactions took place between 1976 and 1990 amounting to a value of$2.6 trillion (1992 dollars), according to Jensen (1993). Holmstrom and Kaplan (2001) report that the volume of transactions in Acquisitions has averaged at around 5% of GDP in the U.S. over the 1980s and has reached an unprecedented 15% of GDP by 1999. Andrade, Mitchell and Stafford (2001) note that while evidence on improved post-merger corporate performance/profitability is ambiguous, shareholders of a target firm in a takeover bid earns a 16% announce period abnormal return compared to 12% average annual return on an ordinary share, i.e. a shareholder of a target company can earn in over 3 days what a normal shareholder earns in 16 months. Franks and Mayer ( 1996) found no evidence of poor company performance and takeover bids. 19 The Project on Capital Choice, co-sponsored by the Harvard Business School and the Council o:: Competitiveness. The argument presented here is drawn from Project Director Michael E. Porter's paper (Porter, 1992) which summarises the projects' papers. Cosh, Hughes and Singh (1990) make similar arguments in the U.K. context.

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increased reliance of the corporations seeking external finance on

what they called 'fluid capital' i.<:::. the finance provided by money

managers.2° The efficiency of financial markets was called into

question not only in terms of whether it optimally processes

information regarding long term growth prospects of a firm or its

specific investment projects, but by pointing to the fact that the

relevant information for the major players in the stock markets

(mainly the fund managers) relate to short term changes in stock

prices and not the 'fundamentals' (net present value of cash flows).

Therefore the nature of finance in the stock market becomes

increasingly short term along with the rising dominance of

institutional investors. Due to the short term nature of finance, the

corporations were forced to undertake only those investments which

could earn high and immediate financial returns in terms of

maximising current stock prices, rather than long term investments, I

especially those whose returns are not measurable in the short run

(R&D for instance).

All this brought about a major change in the behaviour of the non

fmancial corporate sector. Earlier, managerial autonomy was favoured

since the objective of the firms was to. grow by making capital

investments.2 1 Under the new tenets of corporate governance, where

maximising shareholders' returns became the main objective, firms

shifted from the strategy of 'retain and reinvest' to 'downsize and

distribute'. Cost-cutting measures like lay-offs, cuts in investment in

intangible or non-marketable assets and wage cuts were increasingly

resorted to along with higher dividend pay-outs, in order to prop up

20 Porter (1992) states, "The performance of U.S. money managers is typically evaluated based on quarterly or annual appreciation relative to stock indices, and they thus seek near term appreciation of their shares, holding stock for an average of only 1.9 years. Due to legal constraints on concentrated ownership, fiduciary requirements that encourage extensive diversification, and a strong desire for liquidity, these investors hold portfolios involving small stakes in many, if not hundreds, of companies". (p.8)( emphasis added). 21 Chandler (1990) argued that due to the large risks of investments in capital intensive industries, managers should have the discretionary power in strategic decision making since long term commitment and organisational 'learning' is required to minimise such risks and maximise the benefits of such experience.

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stock prices.22 Defiance towards the stock markets would have invited

takeover bids, either forcing a change in the investment strategy of the

firm or changing the management itself. To prevent such a

predicament firms had to keep their stock prices sufficiently high,

often incurring high levels of debt in order to buy back stocks.23 The

corporate restructuring was of course initiated by the preference of the

banks and other financial institutions in funding takeovers and LBOs

rather than capital investments, since the gains accruing to

institutional shareholders following the former kind of activities were

much higher. By the 1990s, however, maximisation of stockholder

value became a more entrenched and institutionalised objective for

the corporations themselves because compensation of managers of

corporations became increasingly stock option based, which aligned

their interests with those of the stockholders.24 This aligning of

interests has led to what has come to be called the .financialisation of i

the non-fmancial business. The acquisition of fmancial assets by non-

fmancial corporations increased from the 1980s onwards along with

their returns from such financial inve~tments.2s Thus the

22 Lazonick and Sullivan (2000) attribute the noted increase in the incidence of job loss in the U.S. from I 0 percent in the 1980s to 14 percent in the first half of 1990s to the 'downsize and distribute' strategy of the corporate sector. Although a higher incidence of job loss or retrenchment cannot solely be explained by this and has to do with the overall state of demand in the economy and the rate of capacity utilization by firms, their argument makes sense if such a corporate strategy is seen to be depressing overall demand. They also note that dividends rose substantially in the 1980s and 90s compared with the 1960s and 70s, although profits were lower during the former period. The corporate pay-out ratios were 49.3 and 49.6 in the 80s and 90s respectively, compared with 42.4 in the 60s and 42.3 in the 70s. See ibid. Fig.3, p.22. 23 In order to avoid takeovers, corporations incurred debts to retire equities (buying back shares) thus increasing shareholders returns. Holmstrom and Kaplan (2001) note that between 1984 and 1990 and from 1994 onwards, U.S. non-financial businesses were net retirers of equity. Mayer (1998) suggests similar trend for U.K. in 1980s. For a discussion on the significant increase in the corporate debt in the U.S., see Bernanke and Campbell (1988) along with the comments by Benjamin Friedman and Lawrence Summers. While sharp differences remained over the implications of the debt level, there was a general agreement on the fact that the level of debt was very high in the 1970s and 1980s compared to the earlier post-war decades. 24 Hall and Liebman (1998) notes that equity based compensation made up almost SO% of total CEO compensation in 1994 compared to less than 20% in 1980. 25 Crotty (2002) notes that the value of NFCs' financial assets as a percent of the value of tangible assets increased steadily since 1984 and reached 100 percent by 2001. He points to the data problem involved in correctly estimating this share, since the increase in the proportion of financial invesil .. ents is attributable to a category, 'other miscellaneous financial assets' in the Federal Reserve's Flow of Funds Accounts, which is a statistical residual. From Internal Revenue Service data, he also calculates (while mentioning the data problems involved here too) that the share of gross portfolio income

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transformation of the non-fmancial corporate sector, which resulted

from the liberalisation of fmancial markets and the dominance of the

institutional investors, entailed increased investment in acquiring

financial assets, often through increased borrowing, compared with

capital investments in physical assets.

Globalisation and the Convergence of Financial Systems

The short-termist bias inherent in stock market based financial

systems was earlier held responsible by somP. for the slower growth of

the U.S. and the U.K. compared with the bank based systems of

Japan and Germany in the 1980s.26 However, the defenders of the

market based system deny the speculative and short-termist character

of the fmancial markets. They argue that the fluctuations in stock

markets arise because of continuous evaluations of long term growth

prospects of the firms by stockholders, on the basis of continuously

emerging information, conforming to rational behaviour under

uncertainty. The advocates of efficient markets and financial

liberalisation hold the recent experience of high growth in the U.S. in

the latter half of the 1990s as a success for market based fmance over

the bank based system and an evidence of market efficiency. It is

argued that the capital market based systems have been successful in

allocating capital to the emergent and innovative firms (especially in

information and communication technologies and biotechnology)

which has led to higher growth and employment in the U.S. and U.K.

compared to Japan and Germany. The latter countries have been

criticised for having inefficient fmancial systems that do not favour the

growth of innovative firms in the emergent industries. In fact all

(interest receipts, dividends and realized capital gains) of the NFCs in their total cash flow has increased through the 1970s and 80s. 26 See Mayer (1988) for instance. He argued that the bank based system helps in developing 'commitment' and 'trust' whereby bank debt assumes all the characteristics of equity finance, most importantly sharing of the risk of illiquid capital investment ('willingness to sustain losses in expectation of future compensation'). On the other hand competition in stock markets maKes equity financing closer to short term debt finance. He showed a substantially higher contribution of internal finance to physical investment for the market based systems of the U.S.(90%) and U.K.(IOO%) compared with the bank based systems of Japan (65%) and Germany (73%).

103


advanced economies are persuaded to emulate the efficient market

based U.S. model to usher in higher rates of innovation and growth.

The greater efficiency of the market based system was claimed on two

counts. Firstly, the fact that stock prices of the ICT companies were

high despite zero or even negative short term cash flows has been held

out as proof for the claim that markets take a long term view of growth

prospects and provide efficient price signals for the reallocation of

resources in high growth industries during a period of rapid

technological change.27 Secondly, greater incentives for innovations

have been attributed to the flexibility available in the market for

corporate control with greater opportunities for initial public offerings

(IPOs) and takeovers, which favoured the growth of venture capital

through which highly risky investments could be undertaken.2s

Another set of arguments has gained currency in the backdrop of this

claim for superiority of the market based system. In short the

suggestion is that different systems have 'comparative advantages' in

different types of investments. While the bank or intermediary based

systems are better suited for traditional firm specific capital

investments, market based systems do better in financing innovations

like in the high technology investments. Since investments in

innovative firms involve greater uncertainty, it is held that the stock

markets, which reflect a greater diversity of opinion and provide

greater flexibility than individual intermediaries or banks, tend to

allocate resources more efficiently. Thus it is argued that there are

trade offs between fmancial systems with the bank or intermediary

based ones lagging behind in innovations and the market based ones

suffering from greater financial instability and lack of dedicated

investments. This view while noting a gradual convergence towards

27 See Holmstrom and Kaplan (2001), pp. 138-139. 28 See Black and Gilson (1998).

104


market based system does not attribute any 'absolute advantage' to

any one of the two. 29

The problem with these arguments regarding the superiority of stock

markets in fostering innovations lies in the way innovation itself is

visualised. Innovation is a dynamic process and is embodied in new

investments. There cannot be a given set of technological possibilities

between which the market is supposed to choose and reallocate

capital. Innovations may emerge in time from within the process of

accumulation or can be purely exogenous. But whatever be their

source, innovations have to be embodied in the real process of capital

investments and higher rates of the former cannot coexist with lower

rates of the latter. Stock prices can respond favourably to a higher

rate of innovation and investment in some emergent industry.

However, to suggest that the higher rate of innovations and

investment was brought about by favourable price signals from the

stock market is to tum the process of innovations on its head.

The nature of innovations signified by the high technology industries

in terms of their contribution to productivio/ and output growth in

U.S. in the 1990s has itself been questioned.30 While the late 1990s

U.S. experience would be discussed in greater detail in the following

chapter, the myth about the positive role of the stock markets in

bringing about innovations needs to be refuted summarily. The sharp

fall of the new technology stocks' prices since March 2000 has

established the fact that the abnormally high stock prices constituted

a speculative bubble and had little to do with the real long term

growth prospects of these firms, since many of them did not manage

to earn any profit till the stock prices crashed.31 The nature of the new

29 For this argument see Gale and Allen (200 l) and Carlin and Mayer ( 1999). 30 Gordon (2000) is the most quoted work in this regard. 31 Shiller (2000) found no econometric evidence over a range of fundamentals to justify the abnormally high price-earnings ratio for the technology stocks. Econometric analysis :.lso does not provide any robust relationship between stock market development and ICT development in Singh et. al. (2000). They argue that venture capital is not necessarily efficiently provided by stock markets and is compatible with bank based systems as well as government intervention.

105


technology has been such wherein a lot of innovations actually

occurred outside the R&D departments of large corporations. The

stock markets' exuberance over these new technology firms had been

characteristically speculative bringing about very high stock price

appreciations following their IPOs. To an extent the rising stock prices

did benefit the growth of the IT industry since the optimism of the

stock market led to a large number of start-ups, which attracted

substantial investment in the form of venture capital.32 However, the

rise in venture capital funding was crucially dependent upon high

stock market retums through IPOs. Thus, once the stock price bubble

burst and market retums collapsed, such investments dried up. The

ephemeral nature of this so-called technology driven boom reflects the

fact that speculative motive for making short term gains played a

much bigger role in the boom rather than the suggested efficiency of

the markets in the reallocation of capital into innovative industries.

The Japanese and the European financial systems have been rapidly

converging towards the 'American' model over the recent past, with

the 'success' of technological innovations in the U.S. and the bid to

emulate them being cited as both the cause as well as the

justification. But on closer examination the causality does not seem to

be so. While the apparent success of the U.S. economy in the late

1990s, in contrast to slower growth in Japan and Europe during that

period, catalysed the trend towards fmancial deregulation and opening

up, significant changes in the financial structures had already been

initiated in the latter since the 1970s and 80s.

The post-war Japanese fmancial and industrial structure had been

characterised by a close link between banks and corporations (the

Main Bank System) with large proportions of corporate equities lying

in between the banks and corporations (cross-holding of shares), with

32 According to Gompers and Lerner (2001) about 60% of the funds raised by the Venture Capital Industry went to IT industries in 1999. Notably, pension funds and insurance companies were major contributors to these venture capital funds.

106


individuals or institutional shareholders being insignificantly small in

number. This system of close association between bank and industry

was hailed as one of the key factors behind the success of the

Japanese economy, in maintaining high levels of investment and

output growth in the post-war period. This implied tightly regulated

domestic capital markets and control over cross-border capital flows.

All these came under heavy strain during the post-1973 developments

in the world economy. Both domestic and intemational pressures led

to the deregulation of the bond markets in the mid-1970s and

eventually the liberalisation of foreign exchange controls in the early

1980s. The main implication of these changes was to weaken the

strong bank-corporation linkage, which underlined the Japanese

fmancial system.

The Japanese corporations, in their bid to raise fmance in competitive

terms, tumed towards the domestic stock market as well as the

European and U.S. capital markets, using new instruments (equities

and warrant bonds). The banks also increased their lending to

fmancial intermediaries and real estate development companies at

competitive interest rates, significo/ltlY reducing the proportion of

industrial financing. The initial result was a huge bubble in land and

stock prices during the late 1980s, which involved the participation of

banks and corporations who made substantial short term capital

gains. Once the bubble burst in 1990, the economy moved into a

recession that continued throughout the decade with the banks

having accumulated trillions of yens as 'bad loans'.33

Ironically, however, the protracted recession in the Japanese economy

in the 1990s following fmancial deregulation in the 1970s and 1980s,

has provided ground for further liberalisation with the Japanese

Government initiating the 'Big Bang' financial reforms from 1997

33 See Lazonick (1998) and Allen (1996) for an account of the transformation of Japanese financial structure and corporate governance since 1970, as well as the jus en debacle following the stock market crash leading to the banking crisis of the 1990s.

107

Spect~lative Finance and Capital Accumulation

onwards. The large corporations and banks of Japan as well as

governments and fmancial interests in the U.S. and Europe have

pushed these reform measures. The . steps include complete

deregulation of foreign exchange transactions and removal of

restrictions on banks, trust banks, insurance companies and security

brokerages from entering each other's markets. Those more sceptical

about the prospects of a Japanese recovery following these further

doses of deregulation, accept this as a fait accompli, arguing that

without 'international standardisation of fmancial regulation' the

Japanese financial system would face a 'hollowing out'.34 Thus the

fear of capital flight under the free mobility of finance along with

related compulsions in maintaining uniform regulatory structures

seems to be the major driving force towards the convergence of

fmancial systems rather than technological change.

Similar trends towards a more market oriented fmancial system are

also visible in Europe. Market capitalisation to GDP ratios for

Germany and France have significantly increased over the 1990s, with

IPOs and foreign listings increasing sharply since the mid-1990s. This

has followed the deregulation of fin~ncial markets accompanying the

European Monetary Union (EMU).3S In Germany, the earlier bank

dominated system has been gradually replaced by the increasing

importance of the stock market, and integration with international

fmancial markets. Deregulation of the fmancial system has led

corporations to substitute bonds and equities for bank loans on the

one hand and banks and insurance companies into diversifying their

activities away from fmancing corporate investments to managing

financial assets in domestic and foreign capital markets on the other.

The shift to the funded pension scheme has also contributed to the

34 See Suzuki ( 1997). 35 EIB papers ( !999).

108


growth of institutional investors managing market based

instruments. 36

Thus integration with international capitals markets has meant a

move towards more market oriented systems for the previously

insulated bank-based systems like Japan or Germany. This

convergence of financial systems has occurred in accordance with the

needs of financial investors to have uniformity in the regulatory

structures of different economies, so that the financial systems can gel

into a unified whole. This is necessary for the unfettered access to

assets by wealth holders and speculators of all the advanced

economies. The new technologies play an important role in this, from

enabling the collating and dissemination of information regarding

prices and availability of assets to facilitating actual trade in them

across geographically distant markets. To this extent the convergence

of fmancial systems is indubitably technology driven. But at the heart

of the transformation lies the need for globalised fmance capital to

ensure access to assets and markets everywhere.

Finance, Speculation and Fluidity: Preference

The central issue to which we tum now is the relation between

fmancial liberalisation and economic growth. The promoters of

liberalisation have invoked Schumpeter's theory of economic

development to argue that the development of fmancial intermediation

is necessary for economic growth and econometric evidence is cited to

show that financial development has not only accompanied but

preceded economic development. 37 Based upon this it is posited that

36 For a discussion on the recent changes in corporate governance in Germany, see Franks and Mayer (19991998). For a discussion on pension reforms in Germany, see Sullivan (1998). Remsperger (200 I) notes that, "German share markets have been marked by a tendency to adapt to Anglo-American structures ... the number of cross listings of German shares abroad and foreign shares here in Germany has increased. In 1997 there were 700 domestic companies and 2, 784 foreign companies listed on German stock exchanges; by August of this year (200 1) the figure had ballooned to 1 ,080 domestic companies and 8,964 foreign companies." 37 See King and Levine (1993) which is a standard references to this literature. Also see Arestis and Demetriades (1997) for a critique where King and Levine's methodology of cross-country regression analysis is questioned as well as the direction of causality in Schumpeter' theory.

109


fmancial deregulation would improve the alloc.ative efficiency of credit

which in turn would promote innovations and investment leading to

higher growth. The debate centering on this assertion has, however,

not put sufficient emphasis on the main issue at stake.3s Schumpeter

had emphasised the centrality of credit in a capitalist economy on the

grounds that credit creates purchasing power which needs to be

transferred to the entrepreneurs in order to enable them to innovate

and invest. Thus financial intermediation in Schumpeter is closely

linked to entrepreneurship, investment and innovations. The relevant

question therefore, rather than being whether Schumpeter was right

or wrong, should be: does financial liberalisation allow for the

Schumpeterian kind of financial intermediation, which is conducive to

growth and innovations? Financial intermediation within a market

based system, besides providing fmance for investment, has another

important function in providing avenues for holding wealth. Following

Keynes, it largely came to be understood and accepted that both these

functions of fmancial intermediation far from being harmonious often

lead to conflicting interests. Keynes' basic contention was that the

desire for liquidity of private wealth holders and the illiquid nature of

capital investment poses a problem for accumulation, and competitive

fmancial markets being themselves characterised by uncertainty and

speculative activities aggravate the problem instead of solving it.

The developments over the past decades since 1973, which involved

the deregulation of fmancial markets and a tremendous increase in

cross-border transactions of fmancial assets, have brought that old

problem back once again to the centrestage. The changes in financial

intermediation have all been in the direction of facilitating higher

retums and more flexibility for wealth holders across the advanced

38 The debate is often posed as between the view that growth follows development of financial intermediation, attributed to Schumpeter ( 1959) or Hicks (1969) against the one that financial development follows economic growth, attribtJt~d to Robinson (1952a). The former is held as suggesting that investment is supply (capital) constrained while the latter suggest that it is constrained by demand.

110

Spemlative Finance and Capital Accumulation

economies rather than for providing finance more 'efficiently' for

capital investments. The latter was being done anyway over the post

war period till the early 1970s, which showed up in very high rates of

accumulation and output growth. In a way it can be argued that the

demands for changes in fmancial intermediation in order to secure

better terms for wealth holders followed from the success of the high

growth regime itself, since the protracted period of prosperity by

generating more wealth and leading to its concentration, strengthened

the bargaining power of the rentiers. Other factors like the oil price

shock, inflation and floating exchange rates, all of which had

threatened to erode or increase the uncertainty regarding the value of

the wealth within the advanced economies, were also responsible for

bringing about the change towards more liberalised fmancial markets.

The effect of these changes, as noted earlier, has been to reduce the

average rate of accumulation and growth in all the industrial

economies. This puts a question mark on all claims about deregulated

fmancial markets in providing fmance more efficiently for

accumulation and economic growth.

The discussions in thcr earlier sections suggest the following stylised

facts about advanced capitalist economies in the post-1973 period.

Firstly, liberalisation has ushered in a transformation of financial

intermediation with banks and fmancial institutions competing with

each other in providing more attractive returns to wealth holders, in

order to gamer larger market shares. The need to provide higher

returns to wealth holders and the availability of a diverse range of

assets following fmancial innovations, have led to increased

speculation by the fmancial intermediaries in national and

international markets. Advances in technology have lowered

transaction costs and vastly improved flows of information, which has

allowed for continuous ,.adjustments of portfolios in response to

emerging opportunities for making capital gains, also shortening the

time horizons over which assets are held. This short-termism within

111


the fmancial markets has put a premium on flexibility wherein there

is an increased desire to 'stay liquid' in order to manage assets in a

'fluid' manner. 39

Secondly, speculative activities have engulfed all markets with the

decontrol of capital movements by providing access to different

markets for all types of intermediaries. Therefore, assets like company

stocks and bonds have to compete with other fmancial assets, all of

which are held together in diverse proportions in the portfolios of

various market players. Volatility, arising out of the speculative

activities in one market (say the foreign exchange market) is thus

transmitted to all markets including those, which have the function of

providing external fmance for private investment in illiquid capital

assets. Maximising the short term yield for external fmance, mainly

stocks, has replaced the long term growth objective of firms in this

backdrop, which has also led corporations to seek higher returns

through fmancial rather than capital investments.40 Speculative

bubbles in the stock market can at times give more returns to

corporations than capital investments, as has been noted most

prominently dut;iflg the new technology boom in the U.S. This

possibility has made firms less willing to lock in their assets in

irreversible or illiquid capital investments. They rather prefer to adopt

39 A formal discussion on liquidity and fluidity follows. 40 As has been noted earlier, firms finance large parts of their capital investments from internal funds. This, however, does not make it immune from the pressure to increase share yields due to the threat of takeover. Contrary to the claims of mainstream corporate finance theorists, takeovers are associated more with size rather than 'efficiency' or profitability gains. Larger firms even when they are less profitable are more immune to takeovers than smaller but more profitable ones, due to their larger accumulated stocks of liquid assets and higher capacity to leverage (see Singh, 1992; Chamberlin and Gordon, 1991). Large corporations can therefore pursue a strategy of maximising shareholder value at the cost of capital investments and yet grow through M&A, by virtue of the strength of its shares. A takeover/merger needs to be seen as a financial investment, following which the financial value of the firm get enhanced, while in many cases capital investments are cut down in the process of restructuring. If such a strategy is adopted, while large corporations would grow in size and market share, overall investment might decline since capital investments are being cut in favour of financial investments like LBOs, share-buy backs etc. While takeover related activities seem to be the most dominant form of financial investments by firms they also make profits by taking speculative positions in other markets like venture capital, financial derivatives and bonds. The scale economies available to large corporations also help them in minimising transactions cost for financial investments. For instance a large corporation can easily open its own financial subsidiary or a specialised department for financial research.

112


a more flexible approach by acquiring a larger proportion of liquid

assets in order to use the opportunities for making speculative gains

as they emerge in time.

Thirdly, in the context of globalisation and free mobility of capital, the

distinction between market based and bank based financial systems is

rendered irrelevant. The nature of financial intermediation and

corporate investment has converged towards the trend characterising

the market based systems mentioned above. Thus capital

accumulation for the advanced economies as a whole can be

conceived as being constrained by the tendency towards

fmancialisation and speculation.41 These stylised facts set the stage

for a simple model of a representative advanced capitalist economy

undergoing financialliberalisation.

Model

lh our world agents are risk-neutral and live for two periods. In

this world let us assume an agent to hold one unit of wealth at the

beginning of the initial period. At the beginning of period 1 only two

assets are available to her, a short-term asset with a yield of n per

period per unit of nominal holding and a long-term asset with a yield

r2. We assume, r2 > n.42 The agent's asset choice made at the beginning

of a period lasts for the period as a whole.

41 Stockhammer (2000) finds a negative relation between rentiers' share of non-financial business (his index for measuring financialisation) and capital accumulation, which supports his hypothesis that the slowdown in accumulation in the advanced economies is caused by increasing financialisation of nonfinancial business. His regression results are strong for U.S. and France. The weaker result for U.K. is explained by the fact that U.K. had slower rates of accumulation during the Golden Age. The trend for Germany is different because it was a late starter in the trend towards financialisation. 42 In a world where r2 < r1, no one would hold the long-term asset, which cannot be an equilibrium outcome if the long-term asset is in positive net supply. Following Kalecki (1937) and Robinson (1952b ), our long-term asset is riskier due to 'capital uncertainty', therefore requiring a higher risk premium to be held over other assets. This risk arises because our long-term asset represents a motive for committing finance on a long-term basis. This corresponds to the finance needed for an irreversible investment project where capital is locked in for a certain period. The asset can be sold before its maturity, but only at some capital loss. The short-term-asset is 'liquid', i.e. 'more certainly realisable at short notice without loss'. (Keynes, 1930). This is the typical asset that would be held in a portfolio which an agent wants to operate in a 'fluid' manner, "to take advantage of opportunities for profitable

113


At the end of period 1 (or the beginning of period 2) there is an

opportunity to hold an asset with a very high yield per unit of nominal

holding, say r' > r2 > n. but the opportunity occurs with probability

p.43 If the opportunity occurs, the agent converts her entire wealth

into the high yielding asset. However, the agent undergoes a

proportional capital loss c (O<c<1), while converting the long-term

asset, reflecting its illiquidity. The expected wealth E of the agent after

2 periods would in case she holds the long-term asset in period 1 be,

E1 = p[c(l + r2 )(1 + r')]+ (1- p )(I+ r2 Y (3.1)

and in the case of holding the short-term asset in period 1,

(3.2)

E1 would always dominate Es unless the capital loss c is substantial.

To make the choice problem relevant, therefore, we assume,

(1 + n} > c (1 + r2}, or simply, r1 > c r2.

Now, it can be easily seen that if pis large enough the agent would

hold all wealth in the short-term asset in period 1 despite r2 > r1.

There is a critical value of p at Et = Es,

(3.3)

Above p' the agent would not hold the long-term asset in period 1.

investment, which may arise in the future but cannot now be foreseen." (Hicks, 1989). The yield of the short-term asset is lower than the long-term one because of its liquidity and low risk. 43 Here p is not equivalent to any particular probability distribution, commonly assumed in models of choice under uncertainty. It is more of a notional concept. A further discussion on p would be undertaken later.

114


s p

p' L'

0 M

L

figure 3.1

If the x-axis measures the proportion of wealth held in the long-term

asset and the y-axis p, then the asset demand schedule for the agent

looks like the step function Sp'L'M of figure 3.1. Now, let us extend

this relationship for the economy as a whole.44 We assume that the

capital loss c varies across different agents in the economy. Other

things remaining the same, p' would therefore vary across agents. p

L

L

'-------------IL

figure 3.2

44 This bears some similarity with Tobin's {1958) exposition of a downward sloping liquidity preference schedule.

115


With large number of agents having different p', a smooth downward

sloping schedule like LL in figure 3.2 can be derived by aggregating

the individual step functions of figure 3.1 over all agents in the

economy. The LL schedule shows a negative relationship between p

and the aggregate demand for long-term assets in the economy. The

LL schedule depicts what can be called the 'fluidity' preference of the

economy. An increase in the opportunities for making capital gains in

the future, increases the desire of agents to operate their portfolios in

a fluid manner and therefore decreases the demand for long-term and

illiquid assets.

Financial liberalisation can be thought of as enhancing the

opportunities of making large capital gains, thus leading to a rise in p,

through the increase in the number of both instruments and markets

where speculative positions can be taken. This increases the fluidity

preference of the economy as a whole. In terms of figure 3.2, ceteris

paribus it is an upward movement along the LL schedule whereby the

demand for the long-term asset declines. The fall in the demand for

long-term asset implies that its yield r2 has to rise in order to maintain

its attractiveness. Thus, with fmancial liberalisation the spread

between the yield of the long-term asset and the short-term asset (r2-

n) would rise.

The logic of the asset choice problem of the model can be applied to

the investment decision of a firm. For a capital investment project

some. amount of fmance needs to be locked in. This is comparable

with the holding of an illiquid long-term asset with a yield equivalent

to cash flows from the project. Just as the long-term asset can be sold

before redemption only with a capital loss, similarly the investment

project can only be abandoned before completion by incurring a

substantial cost. On the other hand, even if a comparison of the

discounted stream of cash flows from an investment project reveals

higher returns compared to the cost of capital, the decision to

ll6


undertake the investment can be delayed in order to gain further

information in an uncertain world, which imposes a 'waiting premium'

over and above the cost of capital.45 If the decision is actually delayed

due to increase in uncertainty, then the funds have to be held in a

liquid form and hence the demand for the liquid asset would increase.

The spread between the required rate of return from the investment

project and the yield of liquid assets would rise.

Therefore, the relative liquidity of assets and the spread between their

yields is linked to the time horizon of finance. Our model suggests that

following financial liberalisation, the speculative motive of making

large capital gains in the future increases fluidity preference and

raises the demand for short term assets in an economy. This short

termism increases the required rate of return on long-term finance

needed for capital investment. For a given expected rate of return on

capital investment, this can lead to a slowdown in capital

accumulation. The increase in the rate of interest on long-term

fmance can be seen either as a reflection of the rising unwillingness

on the part of banks or other fmancial intermediaries to extend long

term credit to firms to fmance their capital investments, in a world of

liberalised fmance, or as a representation of the fact that firms

themselves have become more wary of undertaking capital

investments.

The crucial variable p in our model representing the probability of an

opportunity to make a windfall gain is not suggested to be a calculable

measure. In an uncertain world where opportunities for capital gains

exist, it is conceivable that agents would form some 'sensible'

expectations about the likelihood of such gains. What is assumed in

the model is that agents would be able to make judgements regarding

notional relative magnitudes of p, even though its actual values

45 A waiting premium over and above the risk premium makes 'hurdle rates' substantially higher than cost of capital in times of increased uncertainty, like higher volatility in the exchange rate. See Dixit (I 992).

117


remain incalculable. The central point is that an agent when allowed to

speculate in more market::; and over more instruments would find her

opportunities for speculation to have increased. Following this she

would consider her probability in making speculative gain to have

increased too. In the case of financial markets across the world

becoming so well integrated that price movements are perfectly

synchronised across asset markets, this logic would not apply since

then access to one market is as good as access to all others. But as

long as price movements in different markets are dissimilar, the

subjective probability of making capital gains can increase with an

increase in the opportunities for speculation. It is not relevant whether

actually the probability increases or not. It might not and under

certain circumstances it might as well. What is important is the

psychology of the agent that her chances have increased. The same

holds true for the economy as a whole, when it undergoes fmancial

liberalisation. Consider a case where initially investors are only

allowed to invest in the domestic stock market. Now, with fmancial

liberalisation investors are allowed to trade in other stock markets

across the globe. The opportunities for trading and making capital

; gains having increased with the increase in the number of markets

available for trade, investors would collectively consider the

probability for making such capital gains to have increased. This

would increase the fluidity of finance for the entire economy, raising

the interest rate for long-term finance leading to a slowdown in

accumulation.

The smooth downward sloping LL schedule does not have any

particular significance. It arises out of the assumption of diversity

among agents regarding the value of c. If the value converges for

different groups of agents, then there would be discontinuities in the

schedule. In case of such discontinuities the economy may witness

sharp increases in the demand for long-term assets or flights to liquid

assets. There can also be liquidity traps over certain ranges of c when

118


there is a convergence of opinion upon very profitable opportunities

waiting in the future.

Concluding Observations

This chapter has argued that the observable slowdown in

advanced economies is significantly attributable to financial

liberalisation. Deregulation of financial markets has greatly enhanced

speculation in the economies following which there is an increased

tendency for fmancial institutions and firms to seek higher returns

through capital gains rather than financing capital investments. Due

to the prevalence of the speculative motive, there is greater fluidity

and an increased reluctance to commit finance for illiquid physical

assets. This has increased the spread between the short-term interest

rate and long-term rate relevant for investment in the advanced

economies.37 With the increase in the long-term rate relevant for

investment, aggregate private investment . has got depressed in all

advanced economies on an average. Moreover, since speculation and

therefore the preference for fluidity in an economy is not under the

control ofthe State under free capital mobility, the link between short

term interest rates set by Central Banks in advanced economies and

the long-term rate relevant for investment has got significantly

weakened after financial opening. The long-term rate can remain high

due to increased fluidity preference even when the short-term rate is

cut by a Central Bank. We shall see the implications of this in the

following chapter where we consider the problems related to State

intervention under liberalised finance.

It is tempting to make some observations regarding the relationship

between the arguments made in this chapter and those underlying

Minsky's fmancial fragility hypothesis.46 Minsky's theory concerns the

37 The long-term rate relevant for business investments should not be confused with the yield on longterm government bonds, since they diverge significantly. The increase in the relevant long-term rate for investment is reflected for instance in demands for higher dividends by shareholders. 46 See Minsky (1982).

119


speculative positions taken by firms and financial intermediaries in

the course of a business cycle, which leads to bankruptcies and

disintermediation once expected profitability declines over the

downturn. Thus increased speculation by firms and intermediaries

increases financial fragility of the economy. The notion of speculation

in Minsky's theory, however, is quite different from the one contained

in our argument. In the former, banks take illiquid positions by

extending credit to speculative and Ponzi firms during the upswing in

the expectation that future cash flows would enable firms to meet

their debt commitments. In our argument firms are themselves not

willing to become illiquid due to their speculative motive of making

capital gains in the future. However, if certain firms are willing to

make capital investments but the sources of external finance are

characterised by fluidity and short-termism, then those firms would

be borrowing short-term in order to invest long-term. In fact a

liberalised economy allows more opportunities for firms to secure

fmarice from various external sources in foreign markets even if

domestic intermediaries are unwilling to lend. This possibility, which

can lead to increasing financial fragility following Minskian dynamics,

also seems to be a plausible outcome of fmancial liberalisation. On the

whole it can be argued that increased speculation can lead to both

economic stagnation and increasing fmancial fragility.

A lot of debate has taken place on the primacy of 'real' causes over

financial ones in causing stagnation and crisis. It has been argued

that the increase in financial investments in the advanced economies

has been caused by the falling real rate of return from capital

investments. It is conceivable that a demand constrained scenario,

where rates of return on capital investments are lower, leads to a

greater concentration of resources in fmancial activities promising

higher rates of return. But then it needs to be explained what

constrains demand in the first place. Our argument posits increased

speculation following fmancial liberalisation as a proximate cause for

120


the depression of investment demand within the advanced economies.

Increase in speculation can depress accumulation even when the rate

of return on capital investment does not fall, provided that the

expected speculative capital gains on holding financial assets are high

enough. But that is not to deny the possibility of a fall in the returns

from capital investments. Increasing speculation in financial markets

and falling returns on capital investments feed back into each other.

As Keynes had noted, when a capitalist economy increasingly

resembles a casino, the job of investment is generally 'ill done'.

121

7

6

5

4

3

2

1

0

-1


Statistical Appendix

Chart 3:1 Decadal average of real interest rates (long-term & short-term) in Canada

Decades

Ia TREASURY BILL RATE.GOV~BIIT BONDYIB..D> 10 YRS.j Source: International Financial Statistics CD-ROM, 2001.1ntemational Monetary Fund.

6

5

4

3

2

1

0

-1

-2

-3

Chart 3:2 Decadal average of real interest rates (long-term & short-term) in France

SO's

Decaes

I a CALL MONEY RATE • oovERNM 8111" BOND YIELD I

90's

Source: International Financial Statistics CD-ROM, 2001. International Monetary Fund.

122

5

4.5

4

3.5

3

2.5

2

1.5

1

0.5

0


Chart 3:3 Decadal average of real Interest rates (long-term & short-term) In Germany

SO's 60's 70's

Decades

80's

I c CALL MONEY RATE • GOVERNM aiT BOND YIB..9

90's


i Chart 3:4 Decadal average of real interest rates {long-term & short-term) in Italy

Br-------------------------------------~------------------------

-6~--------------------------------------------------------------

Decades

I c DISCOUNT RATE (SliD OF PERIOD) • GOVERNM SliT BOND YIB..D I Source: International Financial Statistics CD-ROM, 2001.1nternational Monetary Fund.

123


Chart 3:5 Decadal average of real interest rates (long-term & short-term) in Japan

5

4

3

2

0

-1 SO's

-2

-3

-4

Decades

jc DISCOUNT RATE(ENDOFPERIOD) •GOVENMENT BONDYJao j


Chart 3:6 Decadal average of real interest rates (long-term & short-term) in UK

5.--------------------------------------------------------------4+-----------------------------------------~------------

3+----------2+-------~--

0 -f--.--1 +--~~----~~----~ -2+-------------------------~

-3+---------------------~

-4+----------------------~==~----------------------------

-SL----------------------------------------------------------Decades

I c TREASURY BILL RATE. GOVT BOND YIB.D: LONG-TBW I Source: International Financial Statistics CD-ROM, 2001. International Monetary Fund.

124


Chart 3:7 Decadal average of real interest rates (long-term & short-term) in US

6~--------------------------------------------------------------

5+-------------------------------------------

4+-------------------------------------------

3+---------------------------------------~

2+------------------

0 +----&...o-

·1 +--------------------------------------------------------------

·2L---------------------------------------------------------------Decades

)c TREASURY BILL RATE• GOVT BONDYJaD: 10 YEAR)


125

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