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Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

Raghuram R. Rajan and Luigi Zingales

Saving Capitalism from the Capitalists:
Unleashing the power of financial markets to create wealth and spread opportunity

Introduction Capitalism, or more precisely, the free market system, is the most effective way to organize production and distribution that human beings have found. While free markets, particularly free financial markets, fatten peoples’ wallets, they have made surprisingly little inroads into their hearts and minds. Financial markets are among the most highly criticized and least understood parts of the capitalist system. The behavior of those involved in recent scandals like the collapse of Enron only solidifies the public conviction that these markets are simply tools for the rich to get richer at the expense of the general public. Yet, as we argue, healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting poverty. Because of their role in financing new ideas, financial markets keep alive the process of “creative destruction” – whereby old ideas and organizations are constantly challenged and replaced by new, better, ones. Without vibrant, innovative financial markets, economies would invariably ossify and decline. In the United States, constant financial innovation creates devices to channel risk capital to people with daring ideas. While commonplace here, such financing vehicles are still treated as radical, even in developed countries like Germany. And the situation in third-world countries borders on the hopeless: People find it difficult to get access to even

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

a few dollars of financing, which would give them the freedom to earn an independent, fulfilling, living. If financial markets bring prosperity, why are they so underdeveloped around the world and why were they repressed, until recently, even in the United States? Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from two groups of opponents. The first are incumbents, those who already have an established position in the marketplace and would prefer to see it remain exclusive. The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organized labor. The second group of opponents, the distressed, tends to surface in times of economic downturn. Those who have lost out in the process of “creative destruction” unleashed by markets – unemployed workers, penniless investors, and bankrupt firms -see no legitimacy in a system where they have been proven losers. They want relief, and since the markets offer them none, they will try the route of politics. The unlikely alliance of the incumbent industrialist – the capitalist in the title -and the distressed unemployed worker is especially powerful amidst the debris of corporate bankruptcies and layoffs. In an economic downturn, the capitalist is more likely to focus on costs of the competition emanating from free markets than on the opportunities they create. And the unemployed worker will find many others in a similar condition and with similar anxieties to his, which will make it easy for them to organize

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

together. Using the cover and the political organization provided by the distressed, the capitalist captures the political agenda. For at such times it requires an extremely courageous (or foolhardy) politician to extol the virtues of free markets. Instead of viewing destruction as the inevitable counterpart of creation, it is far easier for the politician to give in to the capitalist, who ostensibly champions the distressed by demanding that competition be shackled and markets suppressed. Under the guise of making improvements to markets so as to prevent future downturns, political intervention at such times is aimed at impeding their working. The capitalist can turn against the most effective organ of capitalism, and the public, whose future is directly harmed by these actions, stands by the sideline, seldom protesting, often uncomprehending, and occasionally applauding. This book starts with the reminder that much of the prosperity, innovation, and increased opportunity we have experienced in recent decades should be attributed to the reemergence of free markets, especially free financial markets. We then move on to our central thesis: Because free markets depend on political goodwill for their existence and because they have powerful political enemies among the establishment, their continued survival cannot be taken for granted, even in developed countries. Based on our reading of the reasons for the fall and rise of markets in recent history, we propose policies that can help make free markets more viable politically. After the longest peacetime economic expansion in recent history, an expansion that has seen the implosion of socialist economies, it may seem overly alarmist to worry about the future of free markets. Perhaps! But success tends to breed complacency. Recent corporate scandals, the booms and busts engendered by financial markets, and

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

economic hardship, have led to growing distrust of markets. Other worrying signs abound, ranging from the virulent anti-immigration rhetoric of the extreme right to the anti-globalization protests of the rejuvenated left. And imminent demographic and technological change will create new tensions. It is important to understand that the ascendancy of free markets is not necessarily the culmination of an inevitable process of economic development, the end of economic history so to speak, but may well be an interlude, as it has been in the past. For free markets to become politically more viable, we have to repeat to ourselves and to others, often and loudly, why they are so beneficial. We have to recognize and address their deficiencies. And we have to act to shore up their defenses. This book is a contribution towards these goals. We will start the book by explaining why competitive free markets are so useful. Perhaps the least understood of markets, the most unfairly criticized, and the one most critical to making a country competitive, is the financial market. It is also the market that is most sensitive to political winds. Many of the most important changes in our economic environment in the last three decades are due to changes in the financial market. For all these reasons, and because it is a fitting representative of its genus, we will pay particular attention to the financial market. We start with two examples, the first from a country where financial markets do not exist, and the second from a country where they are vibrant. All too often, finance is criticized as merely a tool of the rich. Yet, as our first example suggests, the poor may be totally incapacitated when they do not have access to finance. For the poor to have better access, financial markets have to develop and become more competitive. And when they

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

do so, as our second example suggests, all that holds back the individual is their talent and their capacity to dream. The Stool Maker of Jobra Village. There is, perhaps, no greater authority on how to make credit available to the poor than Muhammad Yunus, the founder of the Grameen Bank. In his autobiography, Yunus described how he came to understand the importance of finance when he was a professor of Economics in a Bangladesh university. Appalled by the consequences of a recent famine on the poor, he wandered out of the sheltered walls of the university to the neighboring village, Jobra, to find out how the poor made a living. He started up a conversation with a young mother, Sufiya Begum, who was making bamboo stoolsi. He learnt that Sufiya Begum needed twenty-two cents to buy the raw material for the stools. Because she did not have any money, she borrowed it from middlemen, and was forced to sell the stools back to them as repayment for the loan. That left her with a profit of only two cents. Yunus was appalledii: `I watched as she set to work again, her small brown hands plaiting the strands of bamboo as they had every day for months and years on end…How would her children break the cycle of poverty she had started? How could they go to school when the income Sufiya earned was barely enough to feed her, let alone shelter her family and clothe them properly?’ Because Sufiya did not have twenty-two cents, she was forced into the clutches of the middlemen. The middlemen made her accept a measly pittance of two cents for a hard day’s labor. Finance would liberate her from the middlemen and enable her to sell directly to customers. But the middlemen would not let her have finance for then they would lose their hold over her. For want of twenty-two cents, Sufiya Begum’s labor was captive.

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

The paucity of finance, which is all too often the normal state of affairs in much of the world is rendered even more stark when one contrasts it with the alternative: The extraordinary impact of the financial revolution in some parts of the world. To see this, we move to California for our second example. The Search Fund Kevin Taweel, who was about to graduate from Stanford Business School, was not excited by the idea of going to work for a large, traditional corporation. His goal was to start running his own business. Job offers were plentiful, but no one gave him the opportunity to be his own boss. After all, who would trust someone with such little experience to run their firm? The choice was clear. If he wanted to run a company, he had to buy one. But how? Not only did he not have the money, he did not even have enough to pay for his expenses while he searched for an attractive target. Kevin’s situation is common. For millions around the world, the lack of resources to fund their ideas is the main roadblock to riches. All too often, you have to have money to make money. But Kevin overcame this barrier by making use of a little-known financing device called a Search Fund. Little over two years after leaving Stanford, he was running his own firm. A Search Fund is a pool of money to finance a search for companies that might be willing to be bought out.iii Typically, a recent graduate from a business or law school, with no m...

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