three
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)
88
Speculative Finance and Capital Accumulation
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.
89
Speculative Finance and Capital Accumulation
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.
91
Speculative Finance and Capital Accumulation
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.
92
Speculative Finance and Capital Accumulation
(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.
93
Speculative Finance and Capital Accumulation
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
94
Speculative Finance and Capital Accumulation
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
95
Speculative Finance and Capital Accumulation
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).
96
Speculative Finance and Capital Accumulation
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).
97
Speculative Finance and Capital Accumulation
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).
98
Speculative Finance and Capital Accumulation
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'.
99
Speculative Finance and Capital Accumulation
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.
100
Speculative Finance and Capital Accumulation
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.
101
Speculative Finance and Capital Accumulation
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
102
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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 Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Speculative Finance and Capital Accumulation
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
Source: International Financial Statistics CD-ROM, 2001. International Monetary Fund.
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
Speculative Finance and Capital Accumulation
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
Source: International Financial Statistics CD-ROM, 2001. International Monetary Fund.
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
Speculative Finance and Capital Accumulation
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)
Source: International Financial Statistics CD-ROM, 2001. International Monetary Fund.
125