Vedat Akgiray
Free societies need finance for economic welfare, and progress is almost impossible without a well-functioning financial system. After the industrial revolution, free-market economies with more effective financial systems developed faster and today the global landscape of economic well being evinces this historical fact. However, since 1980s, misoriented waves of deregulation led to a giant industry of finance, size of which cannot be explained by any measure of real production and trade. Today, finance has mostly turned into a game in itself and often become more harmful than useful for societies. This phenomenon is best described as extreme “financialization” of the free-market system and hence the term “bad capitalism.”
Problems with today’s capitalism
Capitalism has been successful in increasing economic welfare globally but only with three fateful consequences: environmental damage, increasing income and wealth inequality, and loss of people’s trust in institutions and social order. Financialization has been not only the major catalyst of these undesirable outcomes but also a problem by itself.
Environmental destruction is the biggest problem facing humanity today. The good news is that, thanks to great efforts by many, public awareness of environmental, social and governance (ESG) issues has increased significantly in recent years. Today, there is a strong public opinion on the imminent need to reverse the trend of worsening ESG conditions. Governments and companies all say that they are committed and most are signatories to serious statements of purpose such as the United Nations initiatives on Principles for Responsible Investment and on Sustainable Development Goals. However, there is still a huge gap between rhetoric and reality, a lack of action by policy makers and, more recently, a deepening erosion of global cooperation.
All seem to agree on the nature of the environment problem but suggested remedies are largely ineffective. They are ineffective because they ignore the power of financial markets, which can easily mitigate any desired impact of ESG policies. As a case in point, carbon-pricing policies around the world cover only less than 10% of global carbon emissions and, even then, finance has already engineered methods of transferring costs of carbon taxes to “others.” We now have an end scenario where people pay to pollute the atmosphere! This is immoral. Policy makers should realize that sustainable development goals cannot be achieved without a conducive financial system.
Today, inequality in income and especially wealth distribution is greater than ever before in recorded history. The richest one-percent own more than 45% of global wealth. The richest 26 people in the world hold more wealth than the poorer half of the world, which is about 3.8 billion people. Similar inequalities are observed within most countries as well. There is a marked concentration of wealth with deep social and political consequences. As wealth is power, opinions of majority do not fully count because they can be easily “engineered.” As finance is the determining mechanism of wealth distribution, extreme financialization is clearly the single most important enabler of worsening wealth distribution globally.
The global financial crisis in 2008 was the worst crisis of all time. In many ways, it was worse than the Great Depression in 1929. People lost their homes and savings. Millions were unemployed. The most troubling aspect was that, people lost their trust in finance and in governments’ fairness in handling finance – globally and domestically. Wide perception is that banks were saved at the expense of people. Ten years after the crisis, its impact is still continuing as rising populism in politics, ethnic nationalism, diminishing will for global cooperation, uncontrolled search for new solutions such as bitcoin, and declining power of central banks and regulators. The results of this loss of trust will be very detrimental when the next financial crisis hits. Current financial system is broken and, unless it is fixed, the future of global social order will be under a continual threat of chaos.
Problems with finance
The financial industry has evolved into a giant self-serving complex system sustainable only through a continually increasing supply of credit and derivatives. Humbert Wolfe observed back in 1930: “In the City, they sell and buy. And nobody ever asks them why. But since it contents them to buy and sell, God forgive them, they might as well” (The Celestial City). If Wolfe could see this day, it is not hard to imagine how bewildered he would be. Today, size of financial markets (around 400 trillion dollars) and level of global financial flows (more than ten times of trade flows) are too much to be explained by any economic measure. By and large, origins and trading of financial assets are often disconnected from real economic activity.
There is too much debt and too little equity in corporate, household and public finances. The level of global debt (total held by households, governments and firms) is close to 300 trillion dollars. This is in a world with a total non-financial wealth of around 170, public equity less than 90 and total GDP of 85 trillion dollars. Simple math shows that this debt cannot be paid back and it will not be paid. The math is easy but the real tragedy is that lives of those who cannot pay back will be devastated. History has shown repeatedly that excessive debt is a call for defaults, crises, and subsequent social trauma.
We have all become very dependent on debt and we are often happy to find new debt to consume more. Such irrational behaviour stems from the fundamental sociological changes brought about by the internet in the 1990s. Quoting from Good Finance: “Information was now freely and easily available to all people around the world. Everybody knew how everybody else lived, what they wore, the houses they lived in, the cars they drove, the trips they made, how they shopped and so on. With the additional push by platform-based business models to continual search for a “better everything” in life, consumption in excess of income quickly became the global lifestyle. Consuming more than income is possible only by borrowing. And the giant finance industry now had all the tools and freedom to design credit products for almost anyone who wanted and for any income and risk profile. Consumption euphoria was satisfied and often fueled by conveniently available credit, which further pushed up consumption on more debt, and so on.” Given such a self-feeding cycle of extravagance, global debt could only get bigger, and it did.
There are also other reasons to prefer debt. Compared to equity (partnership) contracts, modern debt and debt-based contracts are much easier to design because they often contain unfair terms of sharing risks and returns between the lender and the borrower. Any contract with unfair terms is bound to end with default by either side because default by one party implies an extra benefit for the counterparty. This is probably what is meant by “the dark side of debt.” All past crises have proven this fact. Furthermore, tax codes and financial regulations in all countries favour debt financing over equity financing for corporations. Finally, borrowing to invest for more votes has become a popular behaviour of politicians around the world. Everything – consumer behaviour, laws and regulations, politics – is in favour of more and more debt, and often short-term debt
The financial system has become too complex and opaque, with multiple layers of intermediation and senseless use of mathematics. Many financial products are so complex that nobody, including the developers themselves, can fully understand their real-life effects but they are still widely traded! Notional value of derivatives has been around 600 – 700 trillion dollars for more than a decade. Financial intermediation is quite profitable for intermediaries, which means it is expensive for people. Finance is probably the only industry without economies of scale: unit cost of financial services do not decrease, as industry size gets bigger! Complexity makes purposeful regulation and supervision very difficult. Supervisors are also blocked out from platforms of dark trading, tax havens, and applications of bank secrecy. As a result of all these, the link between owners and users of capital has become untraceable, making effective corporate governance and stakeholder engagement almost impossible.
Finance has transformed from a necessary mechanism to serve the society into a problem for the society. Unfortunately, despite all technological advances and lessons from recent financial crises, academia and policy makers resist updating their mind-sets and tools. After a decade into the global financial crisis, all and even more of the reasons that led to the crisis are still much alive today. In order not to have recurrent financial crises, which are always socially damaging and cause political instability, the world needs a new paradigm of finance. We need to formulate a new “social contract” between regulators / policy-makers and financial markets / people. This contract should redefine the role of finance in our lives and the real purpose of regulation and economic policies.
The first step towards good finance is to break the growing vicious cycle of credit and debt. Short of this, regulation can never save the system, and it will always have to save the firms at the expense of the people. In a properly regulated industry, fates of firms are determined in free markets, not by governments. Otherwise, bad capitalism will drive out the model of free markets and this cannot be good for humanity.
References
Akgiray, V. (2019) Good Finance, Bristol University Press, United Kingdom.
OECD (2019) “Owners of the World’s Listed Companies” www.oecd.org/corporate/
Credit Suisse Research Institute (2019) Global Wealth Databook 2019, www.credit-suisse.com
Vedat Akgiray is currently a Professor of Finance and Director of the Center for Corporate Governance at Bogazici University in Istanbul. Among his students since 1990 are several prominent academicians, central bankers, ministers, managers of banks, stock exchange and funds. From 2009 to 2013, he served as the Chairman of the Capital Markets Board of Turkey. He led the team designing and writing the new Capital Markets Law of 2012. He also served on the IOSCO Board, the FSB of G20, and the Monitoring Board of the IFRS Foundation. He actively participated in re-designing the international regulatory architecture after the 2008 crisis.