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How Capital Markets Enhance Economic Performance and Facilitate Job Creation

BY WILLIAM C. DUDLEY
US CHIEF ECONOMIST GOLDMAN, SACHS & CO.

BY R. GLENN HUBBARD
DEAN COLUMBIA BUSINESS SCHOOL NOVEMBER 2004

How Capital Markets Enhance Economic Performance and Facilitate Job Creation
BY WILLIAM C. DUDLEY
US CHIEF ECONOMIST GOLDMAN, SACHS & CO.

BY R. GLENN HUBBARD
DEAN COLUMBIA BUSINESS SCHOOL

Introduction
Our main thesis is that well-developed capital markets generate many economic benefits, including higher productivity growth, greater employment opportunities, and improved macroeconomic stability. To focus on these significant benefits, we examine three issues: (1) the importance of capital markets in facilitating superior economic performance, (2) how the capital markets foster job creation, and (3) the necessary preconditions for the development of well-functioning capital markets. Our analysis focuses on two particular sets of comparisons. First, within the United States, how has macroeconomic performance improved over time as the capital markets have become more dominant? Second, across countries, can one explain the superior macroeconomic performance evident in recent years in countries that have well-developed capital markets such as the UK and the US relative to countries such as Germany and Japan, in which the capital markets are much less developed? We highlight the impact of capital market development on the economic performance of the United States because the capital markets are most well-developed in this country. Lessons from the US experience are nonetheless indicative to other economies of the value of well-functioning capital markets.
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Executive Summary

The ascendancy of the US capital markets — including increasing depth of US stock, bond, and derivative markets — has improved the allocation of capital and of risk throughout the US economy. Evidence includes the higher returns on capital in the US compared to elsewhere; the persistent, large inflows of capital to the US from abroad; the enhanced stability of the US banking system; and the ability of new companies to raise funds. The same conclusions apply to the United Kingdom, where the capital markets are also well-developed. The consequence has been improved macroeconomic performance. Over the last decade, US labor productivity has risen and the United States has outperformed economies dominated by banking-based systems. Because market prices adjust instantaneously to new information, the development of the capital markets has introduced new discipline into policymaking. As a result, the quality of economic policymaking has improved over the past few decades. The development of the capital markets has provided significant benefits to the average citizen. Most importantly, it has led to more jobs and higher wages.

By raising the productivity growth rate, the development of the capital markets has enabled the economy to operate at a lower unemployment rate. In addition, higher productivity growth has led to faster gains in real wages. The capital markets have also acted to reduce the volatility of the economy. Recessions are less frequent and milder when they occur. As a result, upward spikes in the unemployment rate have occurred less frequently and have become less severe. The development of the capital markets has also facilitated a revolution in housing finance. As a result, the proportion of households in the US that own their homes has risen substantially over the past decade. Effective capital markets require a firm foundation. This includes the enforcement of laws and property rights, transparency and accuracy in accounting and financial reporting, and laws and regulations that provide the proper incentives for good corporate governance. A welldeveloped financial system is a spur to growth, macroeconomic performance, and more rapid growth in living standards.

Acknowledgement

We thank Sandra Lawson for her work on Section IV: What’s Required for Successful Capital Markets, as well as for her expert editorial assistance; Themistoklis Fiotakis and Peter Stoute-King for their work in gathering and analyzing much of the data used in this paper; and the many others in the Goldman Sachs Economics Group who helped with the data and provided thoughtful comments and guidance.
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Section I: The Dominance of Capital Markets

Modern capital markets have two related parts: (1) the debt and equity markets that intermediate funds between savers and those that need capital, and (2) the derivatives market that consists of contracts such as options, interest rate, and foreign exchange swaps, typically associated with these underlying debt and equity instruments. The debt and equity markets help allocate capital within an economy. The derivatives market helps investors and borrowers to manage the risks inherent in their portfolios and asset/liability exposures (see the boxes on pages 7-8 for a more detailed discussion of these markets). In the United Kingdom and in the United States, both of these parts have grown very rapidly over the past few decades. The capital markets in the United Kingdom and the United States dominate these countries’ financial systems, in marked contrast to France, Germany, and Japan, where banks are more important. Regardless whether one examines the UK or the US over time, or compares the performance with other developed countries on a cross-sectional basis, the conclusion is unmistakable. Capital markets have been the driving force behind the development of the UK and US financial systems. In the US, the capital markets have become the dominant element of the financial system in three ways. First, capital markets now outstrip depository institutions in the financial intermediation process. For example, the share of total credit market debt intermediated by US depository institutions has fallen by half since 1980, to 23 percent at year-end 2003 from 45 percent (see Exhibit

1). As a result, funds raised in US debt markets now substantially exceed funds raised through the US banking system. Second, the US equity market has become more important as an investment vehicle. More than half of US households owned equity in some form (directly, via mutual funds, or in retirement accounts) in 2001 (most recent data available), up from 36.7 percent in 1986. The development of an equity culture in the United States has been spurred by the shift from defined benefit pension plans to defined contribution plans and the widespread use of Individual Retirement Accounts and 401(k) accounts as long-term investment vehicles. Third, the derivatives market has grown extraordinarily rapidly. The notional value of derivatives securities outstanding rose to $197 trillion as of year-end 2003 from about $6.7 trillion at year-end 1990.1 Interest rate swaps represent the biggest share of this market, followed by foreign exchange rate swaps and other derivatives obligations such as fixed income and equity-related options. Credit-derivative obligations are a particularly fast-growing segment of this market.

EXHIBIT 1: U S B A N K I N G S H A R E O F A S S E T S H A S D E C R E A S E D Assets Held at Depository Institutions as a Share of Total Credit Market Assets*
Percent Percent

50 45 40 35 30 25 20 1980 82 84 86 88 90 92 94 96 98 2000 02 04
* Excludes assets held at the Federal Reserve.

50 45 40 35 30 25 20

1

See “Bank for International Settlements Quarterly Review,” June 2004 and November 1996.

Source: Federal Reserve Board.

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In the UK, the equity market E X H I B I T 2 : C O R P O R AT E B O N D M A R K E T D O M I N AT E S I N T H E U S … is also very well developed. However, in contrast to the US, Percent of total nonfinancial corporate debt Percent of total nonfinancial corporate debt 70 70 the debt markets play a lesser role. In the nonfinancial corpo60 60 rate sector, firms still rely on banks and trade credit for much 50 50 of their borrowing. However, even here, the role of the debt 40 40 markets has been increasing. The corporate bond market has 30 30 increased its share of total nonfinancial corporate debt to 26 20 20 percent of total debt in 2003, 10 10 up from 14 percent in 1990 (see 1980 82 84 86 88 90 92 94 96 98 2000 02 04 Exhibit 2). Moreover, London US UK is the center of the global Source: Federal Reserve Board. Bank of England. Eurobond market. Thus, the debt capital markets are better developed in the UK than the relatively decade, the capital markets have continued to low share of nonfinancial corporate debt implies. increase their market share in the UK and the In contrast, in other major developed economies US despite starting at a higher degree of such as France, Germany, and Japan, the banking market penetration. system still dominates credit allocation. As shown Similarly, the equity markets in Europe and in Exhibit 3, for the nonfinancial corporate sector, Japan are less developed than in the United States. the ratio of capital market debt to total debt is At year-end 2003, the market capitalization-tomuch lower in France, Germany, and Japan than GDP ratio for the US equity market was 123 percent, in the United States. Moreover, the capital markets compared to 35 percent and 78 percent for have grown slowly in these countries. For the nonfiGermany and Japan, respectively. The UK market nancial corporate sector, for example, the share of capitalization ratio is lower than the US (74 percent capital market debt in these countries today is still at year-end 2003), comparable to Japan’s, but highwell below its share in the US several decades ago. er than that of Germany. In contrast, it is impressive how, over the past

EXHIBIT 3: … N O T T H E S A M E E L S E W H E R E
Percent of total nonfinancial corporate debt Percent of total nonfinancial corporate debt

25

25

20

20

15

15

10

10

5

5

0 1990 91 92 93 94
France

0 95 96 97
Japan

98

99 2000 01

02

03

04

Germany

Source: Bundesbank. Banque de France. Bank of Japan.

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WHY ARE THE UK AND THE US AHEAD?

The shift from depository institution intermediation to capital markets intermediation appears to be driven mostly by technological developments. Computational costs have fallen rapidly. As technology has improved, information has become much more broadly available. This has improved transparency. As this has occurred, depository institutions have lost some of their ability to charge a premium for their intermediary services. Often, borrowers and lenders interact directly, as they find that the lender can earn more and the borrower can pay less by cutting out the depository intermediary as a middleman. The capital markets are more dominant in the UK and the US due to specific attributes of these countries. For the United States, economies of scale and US banking regulation have been important. Scale is relevant because the US is a big economy with numerous large companies. This fact has aided capital market development because securities issuance is characterized by relatively high setup costs, but very low incremental costs as the size of a securities issue increases. This condition implies that as the size of a transaction increases, the capital markets solution becomes much more compelling than the alternative of using depository intermediaries. Banking regulation in the US has two distinguishing features. First, the Glass-Steagall Act of 1933 legally separated the commercial banking and the securities businesses. Although the Act was fatally weakened by the Federal Reserve’s decision to allow commercial bank holding companies to establish “Section 20” securities affiliates in the 1980s, the prohibitions established by the Act were not formally dismantled by Congress until 1999. As a result of the Glass-Steagall Act, securities firms in the United States operated independently of commercial banks for most of the past 70 years. This separation fostered intense competition between the two groups. The fact that most capital-market innovations were developed in the US is presumably due to the innovation spurred by this competitive struggle. In contrast, in Europe and Japan, the financial systems have been characterized by universal banks that have been able to compete in both the commercial banking and investment banking businesses.

Such systems may have stifled the incentives to develop capital market substitutes for depository institution intermediation. Universal banks in Europe have not had strong incentives to undercut their own commercial banking business in order to boost the capital markets side of their business. Second, for much of its history, the US commercial banking system was regulated with the goal of preventing individual banks from achieving much economic power. One way this was accomplished was to limit the ability of banks to expand geographically. Until the past 30 years, banks’ operations were largely restricted to their home states. In some states, banks were even limited in their ability to establish branch banking offices within the state. As a consequence, the US banking system has been much less concentrated than those of other countries. In the UK, development of the capital markets was spurred by London’s long history as a major financial center in the global economy. For example, until World War II, the pound sterling was the world’s reserve currency. Even today, with the UK’s role in the global economy much diminished, London still ranks first in the foreign exchange business. The history of London as a financial center has helped to generate a virtuous circle based on scale. A larger market results in lower transaction costs and greater liquidity. Those factors encourage further development at the expense of potential rival markets in France or Germany. Also, the UK authorities have recognized the strategic benefits of remaining a leading financial center. This objective has encouraged an enlightened regulatory regime, which has caused participants to stay in London or has pulled in business that otherwise might have been done elsewhere. For example, the Eurobond market developed in the UK during the 1960s and 1970s largely because of the US enactment of the Interest Equalization Tax in 1963. This tax change encouraged US corporations to move their bond issuance to London to circumvent the rules enacted in the United States. The development of capital markets in London was also spurred by “Big Bang” in 1986, which ended the fixed-rate equity commission system and spurred the entry of large-scale US investment banks into the London market. “Big Bang” reinvigorated the UK equity market and facilitated the further

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growth of London as a global financial center. Scale and first-mover advantages have also reinforced the development of London as a center for global/European capital markets. Investors and issuers typically want to do business in the most liquid markets. London’s availability inhibited the development of Frankfurt and Paris as major capital markets centers.

Finally, in both the United States and the United Kingdom, capital market development was spurred by the development of a private pension system. The growth of large corporate pension plans created a large group of institutional investors who had strong incentives to operate directly in the capital markets in order to increase the returns on their plans’ assets.

Capital Markets versus Depository Institutions
Saving is funneled from savers to borrowers primarily via the capital markets or through depository intermediaries. In the first case, intermediation occurs through the exchange of securities. The saver invests the proceeds in a financial market instrument issued by the entity (for example, a business or government) that wishes to obtain the funds. In the case of common stock, the transfer results in an ownership stake. In the case of debt, typically there is a contractual obligation to pay interest on the debt and ultimately to repay the debt on a well-defined schedule. The use of securities for capital-market intermediation has two defining characteristics. First, the prices of the securities that set the terms of the exchange fluctuate in response to changes in supply and demand — often on a minute-to-minute basis. Second, the securities can be bought from or sold to third parties. As a result, the investor usually has a good idea of what the securities are worth and can obtain liquid funds by selling the securities to a third party — often at short notice. In some cases, the securities trade on public exchanges (for example, the New York Stock Exchange). In other cases, the securities are traded over-the-counter. This means that prices for the securities are established by individual securities dealers who compete with one another to offer the best prices and execution. The capital markets intermediation occurs via a wide array of instruments, including common and preferred equities, convertible bonds, corporate bonds, mortgage-backed securities, other asset-backed securities, and commercial paper. In the second case in which depository intermediaries play a role, intermediation differs in three important respects. First, the investor does not have a claim on the ultimate beneficiary of the funds. Instead, the investor’s claim is on the depository institution that acts as the intermediary. Second, the price of this claim does not typically fluctuate in response to shifts in supply and demand. Instead, the investor agrees to terms with respect to the rate of interest that will be paid and when the investment will mature. Third, the investor cannot normally sell this claim to a third party. Instead, to end the contractual arrangement early, the investor might suffer a penalty, such as 90 days of foregone interest in the case of early withdrawal of a bank certificate of deposit. Or, in the case of a demand deposit or savings account that has no maturity date, redemption can occur at any time at the discretion of the saver, but always — assuming the bank remains solvent — at par value.
For a more extended discussion, see R. Glenn Hubbard, Money, the Financial System, and the Economy, 5th ed., Reading: Addison-Wesley, 2003, Chapters 3 and 12.

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The Growth of the Derivatives Market
A large financial derivatives market has developed over the past two decades. This market includes interest rate and currency swaps, options, and credit derivative obligations. The notional size — that is, the value of outstanding contracts — of this market is enormous. At year-end 2003, the Bank for International Settlements estimated the notional value of all over-the-counter derivatives at $197 trillion and the value of derivatives outstanding traded on organized exchanges at $17 trillion for futures and $29 trillion for options.* The breakdown for over-the-counter derivatives is shown in the table below. As can be seen, interest rate swaps make up the bulk of all OTC derivative obligations. The derivatives market serves a different purpose than the debt and equity markets. Whereas the debt markets are a mechanism to transfer loanable funds from savers to borrowers, the derivatives market instead primarily transfers risk. This market allows the attributes of a security to be broken down into its component parts. The investor can keep all the risk embedded in the underlying security, or the investor can dispose of a portion of the risk by engaging in a derivatives transaction. For example, an investor could sell a call option on an equity security. In doing so, the investor would transform the uncertain prospects for high returns should the equity move up sharply in value into a fixed payment. The derivatives market is important because it allows investors and borrowers to adjust the currency, credit, and interest rate risks associated with their assets and liabilities, and revenue and expense streams without necessarily having to adjust the underlying asset and liability mix. For example, a corporation might issue long-term, fixed-rate debt in order to reduce its rollover risk. But the company might wish to retain the volatility associated with potential future fluctuations in interest rates (retention would not necessarily raise risk because the interest rate expense might be positively correlated with the company’s revenues). In this case, the corporation might enter into an interest rate swap agreement with a counterparty, agreeing to pay a fixed rate of interest to that counterparty in exchange for interest rate payments that floated with changes in a mutually agreed upon short-term interest rate benchmark, such as LIBOR. By engaging in the swap, the corporation would have reduced its rollover risk without changing its exposure to interest rate fluctuations.

O T C D E R I V AT I V E S O U T S TA N D I N G National Amount Dec 2001 Total contracts Foreign exchange Interest rate Other $111.1 16.8 77.6 16.7 Dec 2002 $141.7 18.5 101.7 21.5 Dec 2003 $197.2 24.5 142.0 30.7 Dec 2001 $3.8 0.8 2.2 0.8 Gross Market Value Dec 2002 $6.4 0.9 4.3 1.2 Dec 2003 $7.0 1.3 4.3 1.4

Source: BIS, Quarterly Review.

*

See “Bank for International Settlements Quarterly Review,” June 2004, Statistical Annex, pages A99. For more background on derivative contract, see R. Glenn Hubbard, Money, the Financial System, and the Economy, 5th ed., Reading: Addison-Wesley, 2003, Chapter 9.

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Section II: Capital Markets Improve the Allocation of Capital and Risk
The development of the capital markets has generated benefits and costs of derivatives). two major sets of economic benefits. First, it has Thus the capital markets ensure that capital improved the allocation of capital. Because the flows to its best uses and that riskier activities prices of corporate debt and equity respond with higher payoffs are funded. immediately to shifts in demand and supply, Empirical evidence that supports these changes in the outlook for an industry (and/or conclusions includes: (1) higher returns on capital company) are quickly embodied in current asset in the UK and the US than elsewhere; (2) the prices. The signal created by such a price change persistent, large inflows of capital to the UK and encourages (i.e., by higher prices) or discourages the US from abroad; (3) the stability of the US (i.e., by lower prices) capital inflows into the banking system, despite large fluctuations in industry (and/or company). Businesses with high financial asset prices; and (4) the high rate of returns attract additional capital quickly and private equity investment (including venture easily. When returns drop due to added capacity capital) and initial public equity offerings in or a decline in demand, prices drop, and this the US compared to elsewhere. signal causes investors to cut the flow of new 1 . H I G H E R R E T U R N S O N C A P I TA L capital to that industry. The returns on capital have persistently been The ability of companies in their early much higher in the UK and the US than in stages of development to raise funds in the capital the European Union and Japan (see Exhibit 4). markets is also beneficial because it allows these Recently, the gap in returns has been particularly companies to grow very quickly. This growth in wide. For example, in 2003, the return on turn speeds the dissemination of new technologies capital in the UK and the US was 12.6% and throughout the economy. Furthermore, by raising 11.1%, respectively, compared to 11.0% and the returns available from pursuing new ideas, 6.5% for the European Union and Japan, technologies, or ways of doing business, the capital respectively. The fact that UK and US investors markets facilitate entrepreneurial and other risktend to earn higher returns strongly suggests taking activities. that a capital markets-based economy results Second, the development of the capital markets in a more efficient allocation of capital. has helped distribute risk more efficiently. Part of the efficient allocation of capital is the transfer of risk to those best able to bear it — either because E X H I B I T 4 : R E T U R N O N C A P I TA L H I G H E R I N T H E U K A N D U S they are less risk averse or Percent Percent because the new risk is uncorre16 16 lated or even negatively correlated with other risks in a portfolio. 14 14 This ability to transfer risk facili12 12 tates greater risk-taking, but this increased risk-taking does not 10 10 destabilize the economy. The development of the derivatives 8 8 market has played a particularly important role in this risk-trans6 6 fer process (see box on pages 12-13 for a discussion of the 4 4
1990 91
US

92

93

94

95

96

97

98

99 2000 01
UK

02

03

04

Germany

Eurozone

Japan

Source: National Statistical Agencies. Our calculations.

9

provoked by the Asian financial crisis (1997), the Russian default Index, 12/16/2003 = 100 Percent of GDP (1998), the demise of Long-Term 1 115 Capital Management (1998), the bursting of the US equity bubble 0 110 (2000-2003), and the Argentine -1 105 peso crisis (2002), the number of bank failures has fallen -2 100 sharply compared to past periods of recession and -3 95 1990-99 Average Level Of Dollar = 92.11 financial turbulence. -4 90 As shown in Exhibit 6, only 16 US commercial banks failed -5 85 during the 2001-2003 period. -6 80 Moreover, these banks were 1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 small, accounting for less than Real Broad Trade Weighted Dollar (left) Current Account Balance (right) $3 billion in total assets. In conSource: Department of Commerce. Federal Reserve Bank of New York. trast, at a comparable point in the business cycle in 1990-1992, 412 commercial banks failed, with assets totaling over $120 billion. 2 . I N F L O W S O F C A P I TA L T O T H E U K A N D T H E U S Credit derivative obligations have become an The willingness of foreign investors to continue to important element that has helped protect bank supply capital to the UK and to the US is also evilending portfolios against loss. These instruments dence of the more attractive risk/return characterisallow a bank to obtain protection from a third tics available in these countries. As can be seen in party against the risk of a corporate bankruptcy. Exhibit 5, the US current account deficit — which This protection allows the bank to continue to determines the amount of capital that must be recylend. At the same time, the bank can limit its credit cled back by foreign investors into dollar-denomiexposure to individual counterparties and diversify nated assets each year — has climbed sharply over its credit exposure across industries and geographithe past decade. Despite this increase, the US dollar cally. The decline in banking failures is evidence on a broad, real trade-weighted basis is currently that derivatives have helped to distribute risk more about 11 percent above its average value during the broadly throughout the economy. 1990s. This result demonstrates that foreign capital is flowing to the US willingly. The UK has also had little trouble funding its large current account EXHIBIT 6: U S B A N K C L O S U R E S deficit; in fact, in recent years, the Number Billions of dollars pound sterling has appreciated. 250 70 This shows that foreign investors 60 want to increase their holdings of 200 UK financial assets.
E X H I B I T 5 : D O L L A R D E C L I N E R E L AT I V E LY M U T E D 50 40 30 20 50 10 0 1980 82 84 86 88 90 92 94 96 98 2000 02 04
BIF-Insured Bank Closures (left) Assets (right)

3 . M O R E S TA B L E BANKING SYSTEM

150

The rapid development of the capital markets over the past decade also appears to have made the US banking system more stable. Although there have been some very sharp adjustments in financial assets prices over the past decade
10

100

0

Source: Federal Deposit Insurance Corporation.

4 . G R E AT E R S U P P LY O F E Q U I T Y C A P I TA L A V A I L A B L E T O S TA R T- U P C O M P A N I E S

EXHIBIT 7: GLOBAL PRIVATE EQUITY AND VENTURE CAPITAL 1998-2002 (Billions of dollars, cumulative) Investment North America Western Europe Asia Pacific Other Total $466.2 122.5 46.5 24.9 660.1 Funds Raised $554.8 153.5 54.8 24.9 788.0

The US market also is noteworthy for its ability to provide new equity capital to start-up companies. This provision of capital occurs in two stages. In the first stage, venture capitalists and other investors make private equity investments. Later, in cases where the companies have prospered and developed a successful track record, these companies are taken public and equity is offered to the public through the initial public offering (IPO) process. These two financing channels have been self-reinforcing. The existence of a dynamic IPO market encourages venture capital investment because it provides a viable exit strategy through which venture capitalists can monetize the value of their investments. As a result, entrepreneurs with novel business ideas can obtain funding relatively easily. This has facilitated the development of many companies — especially in technology — that have grown very rapidly and become important firms in the global economy. The existence of the venture capital/IPO nexus helps to facilitate risktaking and speeds up the pace of innovation and the diffusion of innovation throughout the economy. According to a study by PricewaterhouseCoopers, global venture capital and private equity fundraising and investment have been dominated by the United States. Exhibit 7 shows that over the 1998-2002 period, North America (predominately the US) accounted for about 70 percent of the total private equity capital raised and invested. In general, the UK has ranked second to the US.

Source: PricewaterhouseCoopers.

Similarly, the US IPO equity market is much more well-developed than in other countries. For example, in 2002, there were 274 IPOs in the United States. Although this was sharply lower than the peak of more than 700 in 1999, this still easily outpaced Japan (135) and Germany (6) (see Exhibit 8). The flurry of activity on the Deutsche Börse in 1999 and 2000 during the height of the technology boom is now a distant memory. The success of the US equity market is also visible in other ways. For example, foreign share listings on the New York Stock Exchange and NASDAQ and the use of American Depository Receipts for foreign companies have expanded rapidly over the past decade. Foreign companies who list their shares in the United States include both corporations domiciled in Europe and Japan and companies that have been recently privatized in developing countries such as China.

EXHIBIT 8: I P O I S S U A N C E ( n o . o f I P O s ) US (AMEX, NYSE, NASDAQ) 625 909 874 691 759 656 255 274 Germany (Deutsche Börse) 20 20 35 67 134 135 21 6 UK (London Stock Exchange) 285 347 217 169 161 366 236 193 Japan (Tokyo and Osaka) 59 97 76 67 99 264 147 135

Year 1995 1996 1997 1998 1999 2000 2001 2002

Source: World Federation of Exchanges.

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Buffett versus Greenspan on Derivatives
Warren Buffett, Chairman of Berkshire Hathaway, and Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, have dramatically different views about the usefulness of derivative securities.* Buffett — the businessman — regards them as potentially very dangerous; Greenspan — the Fed chairman and bank regulator — generally regards derivatives with favor. Their views provide a useful point of departure in examining some of the more controversial issues surrounding the rapid development of the financial derivatives market. Warren Buffett summarized his views in his annual letter to shareholders, discussing Berkshire Hathaway’s 2002 results. He sees derivatives as “time bombs, both for the parties that deal in them and the economic system. This conclusion stems from four observations: ” 1. Today’s earnings are based on estimates of derivatives value, which may be inaccurate. Earnings are affected because changes to the value of derivatives flow through the income statement as the derivatives are marked-to-market. The problem is that there often may be considerable ambiguity concerning the appropriate valuation. Suitable markets on which to base a valuation may not exist, or the markets used for valuation purposes may be illiquid. 2. The users of derivatives have incentives to value derivatives in ways that flatter current earnings. This is because compensation may be tied to current earnings, or is just a result of the human tendency to be optimistic. 3. “ ...huge-scale frauds and near-frauds have been facilitated by derivatives trades. ” 4. Derivatives can create systemic problems. For example, at times, derivatives contracts state that when a company’s credit rating is downgraded, it has to respond by supplying additional collateral to its counterparties. This can lead to a full-scale liquidity crisis for the company. Another systemic issue is the “daisy-chain risk” by which a failure of one firm hurts the financial condition of other firms. Buffet cites Long-Term Capital Management (LTCM) as a large user of derivatives whose demise caused significant systemic problems. Buffett concludes: “In our view ...derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. ” In contrast, Chairman Greenspan takes a more sanguine view. He emphasizes: 1. The mark-to-market exposure is far smaller than the notional amount of derivatives outstanding. The Bank for International Settlements estimates that the gross market value of all outstanding overthe-counter derivatives instruments was about $7 trillion at year-end 2003, compared to $198 trillion of notional exposure. 2. The instruments are “ ...an increasingly important vehicle for unbundling risks. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. ” 3. This use of derivatives leads to improved economic performance. As Greenspan notes: “The product and asset signals enable entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers, a process that has undoubtedly improved national productivity growth and the standards of living. ” While Chairman Greenspan notes that only a major economic adjustment will “test the underlying robustness of the derivatives markets, he emphasizes the ” market’s fundamental strengths. These include: 1. Most derivatives are “plain vanilla” interest rate and currency swaps for which valuation is straightforward. 2. Credit risks are increasingly subject to comprehensive netting and margin requirements.

*

For Warren Buffett’s views, please see Berkshire-Hathaway, 2002 Letter to Shareholders at http://www.berkshirehathaway.com/letters/ 2002.html. Chairman Greenspan’s views on derivatives are summarized in his speech “Remarks on Financial Derivatives” to the Futures Industry Association, March 19, 1999, available at http://www.federalreserve.gov/BOARDDOS/SPEECHES/1999/19990319.htm

12

So what should one conclude? In our view, Warren Buffett’s observations, although sensible in many respects, are mostly a case of “throwing the baby out with the bathwater. If one takes his critique at face ” value, an appropriate response would be to avoid longdated derivatives contracts with potentially dodgy counterparties. That would enable one to avoid many of the potential risks that he discusses, but still allow one to take advantage of the many benefits offered by derivatives. The problem lies not with the derivative instruments themselves, but the honesty of one’s counterparties. That risk always exists in business, and can be summarized most simply by the well-known phrase, caveat emptor (“let the buyer beware”). In the case of derivatives, one can also protect oneself by sticking to derivatives contracts in well-developed markets that can be easily used to determine the appropriate valuation. Finally, it is important to recognize that the derivatives market has been stress-tested. In the past decade, we have witnessed the Asian crisis, the Russian default, the demise of Long-Term Capital Management, a nearly 80-percent decline in the value of the NASDAQ, and widespread financial problems in newly deregulated industries such as airlines, energy trading, power generation, and telecommunications. Despite all of this stress, the derivatives exposures associated with these events were resolved without lasting damage to the

US financial system or economy. The derivatives market played a major role in the LTCM crisis. But the problem there was not the derivative exposure per se, but the fact that LTCM’s counterparties allowed LTCM to take on risks totally out of proportion to LTCM’s capital base. This anomaly arose because some Wall Street counterparties were dazzled by the Nobel laureates advising LTCM and did not demand a full accounting of LTCM’s positions. The problem was exacerbated by the fact that many of these counterparties had risk positions similar to those of LTCM. These positions rapidly lost value as LTCM was forced to liquidate its portfolio. As volatility increased, in turn, it raised risk exposures further. A vicious downward spiral of heightened volatility, rising risk, and forced liquidation ensued. The end result was a temporary seizing-up of the capital markets that prompted the Federal Reserve to ease monetary policy. The Federal Reserve Bank of New York also helped to facilitate a recapitalization of LTCM by the investment banking community. This reorganization was done in order to forestall a panicked liquidation of LTCM’s assets that would have caused further market disruption. Although the LTCM crisis was unnerving, it caused no significant or lasting damage to the US economy.

13

Section III: Capital Markets Help Facilitate Superior Economic Performance
The improved allocation of capital and risk sharing facilitated by capital markets has led to superior economic performance. As the capital markets have become more developed in the UK and the US, the economic performance of these countries has improved. In addition, the gap in the relative performance of the UK/US compared to that of Europe and Japan has widened over time as capital markets have become more dominant in the UK and the US. We find evidence of the superior economic performance in five major respects: (1) higher productivity growth, (2) higher real-wage growth, (3) greater employment opportunities, (4) greater macroeconomic stability, and (5) greater homeownership.
1. HIGHER PRODUCTIVITY GROWTH

In the United Kingdom, labor market reforms and the privatization program initiated by Prime Minister Margaret Thatcher in the 1980s undoubtedly played an important role. After all, during the 1950s, 1960s, and 1970s, the UK economy was in relative decline, despite the existence of comparatively well-developed capital markets.
2. HIGHER REAL WAGE GROWTH

Not surprisingly, higher productivity growth accrues to workers in the form of higher real-wage growth. Exhibit 10 illustrates the respective performance of real-wage growth on a five-year moving average basis. As can be seen, the UK and US performance has tended to improve over time. Moreover, real-wage growth has persistently tended to be higher in the UK and the US than in France, Germany, or Japan.
3 . G R E AT E R E M P L O Y M E N T O P P O R T U N I T I E S

Over the past decade, the growth rate of labor productivity in the UK and US has increased, and the gap in performance relative to Europe and Japan has widened (see Exhibit 9).2 The capital markets have played an important role in this process. First, the capital markets helped improve the allocation of capital, thereby raising the average return on capital. Second, the capital markets facilitated the allocation of risk and helped provide a mechanism by which startup companies could raise capital. With respect to the United States, part of the superior performance evident in Exhibit 9 is due to two factors: (1) the more rapid development and dissemination of technology in the US, and (2) the greater flexibility of the US labor markets. The ability to adjust labor needs quickly means that US firms have greater incentives to rapidly adopt new labor-saving technologies compared to countries where labor markets are more rigid.3

At the same time, higher productivity growth and higher real-wage growth have not impeded employment creation in the UK and the US compared to Europe and Japan. As shown in Exhibit 11, employment growth in the UK and the US has generally been substantially higher than in the European Union and Japan. Moreover, the UK and the US have been able to operate at significantly lower unemployment rates than in the European Union (see Exhibit 12 on page 16). This stems directly from the superior productivity growth performance. Higher productivity growth allows these economies to operate at a higher rate of labor resource utilization without this tightness generating an increase in inflation. In economists’ parlance, higher productivity growth lowers the non-accelerating inflation rate of unemployment (NAIRU).

2 3

We use a five-year moving average to smooth out cyclical influences. US productivity growth is biased upward slightly, compared to other countries by the use of quality adjustments. However, this difference is insufficient to explain the large gap in productivity performance.

14

E X H I B I T 9 : PRODUCTIVITY GROWTH * HIGHER IN US
Percent change, year ago Percent change, year ago

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04
US UK Germany Japan Eurozone * Data plotted as five-year moving average.

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5

Source: OECD.

E X H I B I T 1 0 : …SUPPORTING REAL WAGE GROWTH *
Percent change, year ago Percent change, year ago

6 4 2 0 -2 -4

6 4 2 0 -2 -4

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04
US UK Germany Japan Eurozone

* Data plotted as five-year moving average.

Source: OECD.

E X H I B I T 1 1 : EMPLOYMENT GROWTH *
Percent change, year ago Percent change, year ago

3 2 1 0 -1 -2

3 2 1 0 -1 -2

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04
US UK Germany Japan Eurozone

* Data plotted as five-year moving average.

Source: OECD.

15

E X H I B I T 1 2 : UNEMPLOYMENT RATES *
Percent Percent

12 10 8 6 4 2 0 1990 91
US

12 10 8 6 4 2 0 92 93
UK

1.5% of those in the labor force have been unemployed for 27 weeks or longer. Second, the higher level of resource utilization means that the US is better positioned to address the demands of an aging population than Europe or Japan. Although the US faces serious long-term budgetary issues, those problems pale in comparison to those faced by Europe and Japan (see box on page 18-19).
4 . G R E AT E R M A C R O E C O N O M I C S TA B I L I T Y

94

95

96

97

98

99 2000 01

02

03

04

Germany

Japan

Eurozone

* Data plotted as five-year moving average.

Source: OECD.

Exhibit 13 illustrates the linkage between productivity and NAIRU. Real wage growth in the US is strongly related to the unemployment rate. At a 4.5 percent unemployment rate, real wage growth has averaged about 3 percent; but at higher unemployment rates, real wages grow much more slowly. This means that the “safe” non-inflationary level of unemployment in the US depends on the productivity growth rate. The productivity growth rate determines the growth rate of real wages that is sustainable without generating an increase in the inflation rate. The end result is that labor E X H I B I T 1 3 : STRONG PRODUCTIVITY GROWTH utilization is much higher in the ALLOWS LOWER UNEMPLOYMENT US than in Europe. For example, Productivity/Real Compensation Growth the overall employment rate in 5 Europe among potential workers Statistical Link Between was just 81 percent of the US in Real Compensation Growth 4 2003. In addition, Euroland and Unemployment Rate workers toil roughly 15 percent 3 fewer hours than their US counAssumed 4 terparts. How much the hoursProductivity 2 Trend=3% worked shortfall is due to choice — preference for leisure over Assumed 1 work — higher taxes on work, or Productivity NAIRU with NAIRU with Trend=1.5% lack of opportunity is uncertain. 1.5% Prod Trend 3% Prod Trend The increased utilization of 0 3% 4% 5% 6% 7% labor resources has a number of Unemployment Rate benefits. First, the US economy Source: Goldman Sachs US Economic Research estimates. has a relatively low rate of structural unemployment. Only about
4

Both the UK and US economies have become much less volatile in recent years. In the UK, this is evident in the current expansion, which now has lasted nearly 12 years — the longest UK economic expansion in the postWorld War II period. In the US, the business cycles also have shown greater durability. In particular, the last expansion, which ended in 2001, was the longest of the postWorld War II period. The preceding expansion, which ended in 1990, was the third-longest in the post-war period. In addition, when recessions have occurred, they

See “Euroland’s Secret Success Story,” Goldman Sachs Global Economics Paper No. 102, p. 7, January 16, 2004.

16

have tended to be milder. For EXHIBIT 14: example, in the US, both the US RECESSIONS/UNEMPLOYMENT RISES HAVE BEEN MILDER 1990-1991 and 2001 downturns Percent change Percent change were shallow recessions, marked 6 6 by modest rises in the unemployment rate (see Exhibit 14). As a 4 4 result, fluctuations in the civilian unemployment rate have dimin2 2 ished. In the case of the US, for 0 0 example, the trough-to-peak rise in the unemployment rate during -2 -2 the most recent downturn was only 2.4 percentage points, the -4 -4 second smallest rise in the post1948-49 53-54 57-58 60-61 69-70 73-75 80 81-82 90-91 2001 war period. In contrast, over the Change From Cycle Peak to Trough post-war period, the unemployReal GDP Unemployment Rate ment rate rise associated with Source: Department of Commerce. Department of Labor. recessions has averaged 3.6 percentage points. In the UK, the unemployment rate has not risen Third, in the United States, the capital markets by more than 1 percentage point for more than have helped make the housing market less volatile. a decade. With the development of a secondary mortgage Capital markets have helped to reduce economic market and the elimination of interest rate ceilings volatility in three ways. First, because the capital on bank deposits, “credit crunches” of the sort that markets use mark-to-market accounting, it is more periodically shut off the supply of funds to home difficult for problems to be deferred. As a result, buyers, and crushed the homebuilding industry pain is borne in real time, which means that the between 1966 and 1982, are a thing of the past. ultimate shock to the economy tends to be smaller. In contrast, when depository institutions get into Today, the supply of credit to qualified home buyers trouble as a group, the pressure for regulatory foris virtually assured. The result has been to cut the bearance increases. Deferral causes the magnitude volatility of activity in the economy’s most interestof the problem to increase. Usually — as can be sensitive sector virtually in half. This change is a seen with the US saving and loan crisis and in the truly significant improvement, because it means that case of Japan’s decade-long banking crisis — this the economy’s most credit-sensitive sector is now forbearance just creates a much bigger problem that more stable (see box on pages 21-22). poses a greater threat to macroeconomic stability. Second, by providing immediate feedback to 5 . G R E AT E R H O M E O W N E R S H I P policymakers, the capital markets have increased the The revolution in mortgage finance has increased benefits of following good policies and increased the the ability of households to purchase their own cost of following bad ones. Good policies result in homes.5 The closing costs associated with obtaining lower risk premia and higher financial asset prices. a residential mortgage have fallen, and the terms Investors are supportive. Bad policies lead to bad (for example, the loan-to-value ratio) have financial market performance, which increases become less stringent. At times, homeowners investor pressure on policymakers to amend their can obtain 100 percent financing to purchase a policy choices. As a result, the quality of economic home. As a result, the proportion of households policymaking has improved over the past two in the US that own their own homes climbed to decades, which has helped improve economic 69.3 percent during the second quarter of 2004, performance and macroeconomic stability (see up from 63.7 percent at the end of the 1980s. box on pages 20).
5

We view the increase in homeownership as a positive economic development. After all, the US government has made homeownership an important goal of policy. This can be seen in the tax deductibility of mortgage interest expense and the creation of two large government-sponsored enterprises, Fannie Mae and Freddie Mac, that were established to develop a mortgage securities market and thereby reduce the cost of residential mortgage loans.
17

A Vibrant Labor Market Provides Support for an Aging Population
Europe, Japan, and the United States all face significant challenges in accommodating the retirement and healthcare needs of their aging populations. In all three regions, old-age dependency ratios are likely to rise sharply over the next few decades. However, the problem facing the US is much less serious than the difficulties faced by Europe and Japan. Part of this difference reflects the fact that the US Social Security system is less generous in terms of its benefits. The retirement age in the US tends to be higher than in most European countries, and the proportion of income that the US Social Security system replaces at retirement is generally lower than in Europe and Japan. But this does not tell the whole story. The vibrancy of the US labor market is another key element that reduces the burden of an aging US population. First, the active labor market supports more rapid population growth in the US through a more liberal immigration policy. As a result, the population growth rate in the US is much higher than in Europe and Japan. Thus, the old-age dependency ratio rises much more slowly in the United States compared to Europe and Japan (see exhibit on page 19). Presumably, the more liberal immigration policy is at least partially encouraged by the success of the US economy in generating employment opportunities. If the US labor market were moribund and the unemployment rate were high, then a backlash against immigration would likely have developed. Immigration rates would fall and this would have caused the average age of the US population to rise more rapidly. Even illegal immigration into the United States appears sensitive to US economic performance. As shown on page 19, when the US economy is performing well, arrests of illegal immigrants at US borders tend to increase. This shows that the success of the US economy in creating jobs directly influences immigration. The ability of the US economy to generate employment opportunities can be seen most clearly in the recent increase in the labor participation rate among older workers. As shown on page 19, over the past decade, participation rates for both the 55-64 year old and 65 year and older groups have increased. This increase would not be possible without a vibrant labor market. Second, as discussed earlier in the main body of the paper, productivity growth and real wage growth are higher in the United States than in Europe or Japan. This growth is important because it means that the US economy will expand more quickly, which in turn helps to generate the tax revenue needed to finance the nation’s retirement and health care entitlement programs.

18

O L D A G E D E P E N D E N C Y R AT I O S *
Percent Percent

70 60 50 40 30 20 10 0
1950-54 60-64 70-74 80-84 90-94 2000-04 10-14 20-24 30-34 40-44
US UK Japan Germany France Italy * Calculated as the number of people 65 years and older divided by the number of people 14-65 years old.

70 60 50 40 30 20 10 0

Source: United Nations. Bureau of Census. Our calculations.

E C O N O M I C O P P O R T U N I T Y D R AW S UNDOCUMENTED MIGRANTS
Percent Thousands

3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5

1800 1600 1400 1200 1000 1991 92 93 94 95 96 97 98 99 2000 01 02 03 04
Note: Years are US fiscal years (ending in September). US Unemployment Rate (left, inverted) Southwest Border Patrol Apprehensions (right)

800

Source: Departments of Labor, Homeland Security.

U S L A B O R PA R T I C I PAT I O N R AT E
Percent Percent

17 16 15 14

64 62 60 58

13 12 11 10 1970 75 80 85 90 95 2000
Age 65 and older (left) Age 55 to 64 (right)

56 54 52

Source: Department of Labor.

19

Capital Markets Result in Improved Policymaking
The capital markets have played an important role in improving economic policymaking. This improvement has occurred because the capital markets act as longterm discounting mechanisms that provide nearly instantaneous feedback to policymakers. When policymakers threaten to embark on bad policies, equity and bond risk premia tend to rise. Stocks and bonds go down in value. These price signals raise a red flag to lawmakers about the wisdom of pursuing the policies in question. In essence, because the capital markets anticipate future developments, they reduce politicians’ incentives to do things that provide short-term gains that might improve their prospects at the polls, but that bring long-term costs that will ultimately hurt the nation’s economic performance. The importance of the capital markets in disciplining policymakers has presumably also increased because of the emergence of an investor class. The rise in the number of households that invest in the equity market and in mutual funds means that declines in financial asset prices may also erode political support. Several decades ago, most voters held their investable funds mainly in depository institutions, where there was no mark-to-market risk. Also, their pensions were provided mainly by defined benefit plans, where the market risk was borne by the sponsoring corporation or government entity. Again, the voters were insulated from market fluctuations. In the space of 20 years, an increasing proportion of households became investors. More households have come to invest in the stock market and in equity mutual funds. Moreover, defined contribution pension plans have proliferated at the expense of defined benefit plans. In these plans, the household assumes the market risks associated with these pension plan investments. The proportion of households with investments in equities in some form had climbed to above 50 percent by 2001. The consequence is that voters now care much more than before about how the financial markets are performing. This shift increases the disciplinary role played by the capital markets. A few examples can highlight this linkage between the capital markets and improved policymaking: 1. Bank of England given independence in setting monetary policy. The United Kingdom’s forced exit from the ERM in 1992 set in motion the series of events that culminated in the Bank of England’s independence in conducting UK monetary policy. The Labour Party decision to establish an independent Monetary Policy Council in 1997 was designed to reassure financial markets worried about the Labour Party’s historically poor track record in avoiding boom/bust economic cycles. 2. Independence of the Federal Reserve from US administration pressure. At various times in the past, administration officials would criticize the interest rate policies pursued by Federal Reserve officials. This tactic became increasingly counterproductive as market participants — worried that the Federal Reserve might alter its policies under administration pressure — demanded greater risk premia. The administration’s admonishments of the Fed tended to increase market volatility and drive down bond prices. As the capital markets became increasingly dominant, the executive branch eventually learned that this vocal pressure had become counter-productive. Today, the executive branch leaves interest rate policy to the Federal Reserve, and administration economic spokespeople refrain from commenting on the Federal Open Market Committee’s interest rate decisions. 3. The Budget Enforcement Act of 1990. This legislation was passed, in large part, because of worries among bond market participants concerning the long-term budget outlook. This act established the so-called PAYGO provisions, which essentially required that new tax cuts or spending initiatives must be financed by offsetting tax increases or spending reductions. The implementation of the PAYGO provisions was an important factor that helped push the budget balance from a large deficit in 1992 to a surplus by 1998. Unfortunately, the PAYGO provisions subsequently lapsed and have not yet been reinstituted.

20

The Revolution in Housing Finance
The capital markets have helped facilitate a major transAnother favorable consequence has been a sharp formation of the US mortgage financing system over rise in the proportion of households that own their the past 25 years. This has made the housing sector homes in the United States. As shown below, the share much less cyclical because housing transactions have of households that own their homes had risen to 69.3 become much more resilient to interest rate increases. percent during the second quarter of 2004, up from Before 1978, the principal residential mortgage-lending 63.7 percent at the end of the 1980s. institutions in the United States — savings and loans, The revolution in housing finance has also led to another radical transformation that has been important mutual savings banks, commercial banks, and credit in making the economy less cyclical — the dramatic unions — were subject to interest rate ceilings on the drop in the cost of obtaining a mortgage loan. As a deposits they offered, and the secondary market for result, the cost of mortgage refinancing has tumbled. mortgage securities had not yet been born. In this The consequence has been an improvement in the ability environment, the housing industry went through sharp of monetary policy to provide stimulus to the economy boom/bust cycles. Lacking an alternative channel of during periods of weakness. When interest rates fall, finance, it tumbled whenever increases in market households tend to refinance their homes. This provides interest rates rose above the legally mandated deposittwo sources of support for economic activity. First, the rate ceilings, sucking funds out of the banks and thrift interest rate on the refinanced mortgage falls, freeing up institutions. The market then soared when interest funds that can now be spent elsewhere. Second, when rates fell back below these ceilings, unleashing a they refinance, homeowners often increase the size of torrent of pent-up demand that had accumulated their mortgage loans. This results in an influx of funds during the preceding contraction. that can be used to support consumer spending. As This system started to unravel in the escalating shown on page 22, the revolution in housing finance has interest rate environment of the late 1970s and was led to a large increase in mortgage equity withdrawal. completely overhauled in the 1980s. Deposit rate ceilThis change is one reason why consumer spending held ings were eliminated, alternative financing vehicles such up well during the 2001-2003 period, even as employas the variable-rate mortgage were introduced, and the ment and investment spending faltered. mortgage-backed securities market was created. Of all the changes, the last was probably the most critical because it provided a much-needed link between the HOUSING ACTIVITY LESS VOLITILE, mortgage market and other segL E S S R AT E - D R I V E N I N L A S T T W O D E C A D E S ments of the US capital market. Percent change, year ago Percentage points The result has been a dramatic 30 1.5 decline in the cyclical volatility of housing activity and its sensitivity 20 1.0 to interest rates. Since 1986, when 10 0.5 deposit-rate ceilings became extinct, annual changes in housing 0 0.0 starts have been much less volatile than before and less correlated with Standard Deviations -10 -0.5 changes in long-term interest rates (see exhibit at right).
-20 1966-1985
Housing Starts (left) 10-Year T-note (right)

-1.0 1986-2004
Correl. Coeff. (right)

Source: Department of Commerce. Federal Reserve Board.

21

U S H O M E O W N E R S H I P R AT E
Percent Percent

70 69 68 67 66 65 64 63 1980 82 84 86 88 90 92 94 96 98 2000 02 04 Source: Department of Commerce.

70 69 68 67 66 65 64 63

M O R T G A G E E Q U I T Y W I T H D R AWA L H A S S U P P O R T E D S P E N D I N G
Index, 1990 =100 Billions of dollars

10000 8000 6000 4000 2000 0 -2000 1991 92 93 94 95 96 97 98 99 2000 01 02 03 04

600 500 400 300 200 100 0

* All equity extracted from existing homes. Mortgage Refi Apps, 4-Wk Mov Avg (left) Mortgage Equity Withdrawal* (right)

Source: Mortgage Bankers Association. Federal Reserve Board.

22

Section IV: What’s Required for Successful Capital Markets
Academics and policymakers generally agree that financial development is associated with superior economic performance. All else being held equal, countries with better-developed financial systems have higher levels of per-capita real GDP. Moreover, the evidence strongly suggests a causal element running from financial market development to superior economic performance (see box on page 25). What should countries do so as to be able to reap the benefits associated with the process of financial development? Once they have built up their bankbased systems, how do countries move to the capital markets-based system that is superior at the later, more advanced stages of economic development? Financial system development does not occur overnight. As Federal Reserve Chairman Greenspan noted in the wake of the 1997-1998 Asian and Russian financial crises, developing a financial infrastructure requires a significant commitment of resources. In some cases, the payoff will only be seen decades later. Emerging economies that are focused on short-term growth and poverty alleviation may be reluctant to make the investment in this arena when the payoffs are not readily visible or are unlikely to be achieved quickly. Nevertheless, the investment is worth it. In the early stages of financial development, the fundamental requirements for both a bank-based system and a market-based system are largely the same. Both require a basic institutional framework that includes well-defined property rights, bankruptcy laws, and competition laws; regulatory institutions for banks, markets, and corporations; and an effective judicial system that can uphold and enforce these. Some academics argue that the legal system is key to creating an environment in which growth can flourish. Others focus on the need to prevent corruption and to establish macroeconomic policies that are conducive to sustainable growth, as well as building robust political and economic institutions. Good management, accountability, and transparency in the public sector set the tone for good management at the corporate level. Good public finances are also important, though this is not always sufficient to ensure economic stability. Political support for the idea that these prerequisites are fundamental to both financial development and economic growth comes from the Millennium Challenge Account (MCA), a new organization established by the Bush administration. The MCA will disburse US development funds to countries that meet specified macroeconomic and political performance indicators, including government effectiveness, rule of law, and control of corruption (all as measured by the World Bank Institute). The criteria also include country credit ratings, inflation rates, budget deficits, and regulatory quality. The thinking behind the MCA is that creating incentives for countries to take the steps that will help to foster their economic development creates the conditions that will allow aid to be used effectively. Once the macro-policy framework is in place, further steps can strengthen the financial system. Banking regulation is particularly important. In fact, a well-regulated banking system remains important even once capital markets have begun to assume a larger role in the economy. Some commentators, including Alan Greenspan, suggest that the strong bank-based systems in Europe may have helped to shield the region from the fallout of the late-1990s financial crises. In Australia, the diversification gained from the combination of a robust capital market and a strong banking system may have provided similar protection from the regional contagion associated with the Asian crisis. Accordingly, prudential banking regulations, including strict enforcement of capital adequacy ratios, are needed, as is strong, effective oversight. Banks may also need to develop advanced credit-assessment strategies before they greatly expand the scope of their lending. In the wake of the emerging-market crises of the 1990s, which showed how weak institutional structures can exacerbate the risks of liberalization, recent academic work has focused on the need to space out reforms to avoid overloading a developing system during the transition from a bank-based to a market-based system (see box on page 26 for a discussion of financial reforms pursued by China and Singapore). Although there is no strong consensus on the appropriate sequence — or pace — of reforms, there is agreement that this transition should be undertaken gradually and carefully. The specific order of reforms is likely to depend on conditions in the local and regional economies, the state of the local banking system, the quality of the supervisory system, and the exchange-rate policy.
23

Key steps include: The creation of well-supervised money markets, debt and equity exchanges, and efficient clearing and settlement systems that support the provision of liquidity to the financial markets and reduce systemic and market risk. Regulatory policies that encourage secondary trading, including mark-to-market rules. The lifting of any controls on deposit and lending rates. The disavowal of explicit state-offered credit guarantees or deposit insurance, and an end to any state ownership of financial institutions. This would help to eliminate the problem of moral hazard that skews bank lending and constrains capital markets. The lifting of any restrictions on banks’ “nontraditional” activities. This can encourage banks to enter the capital markets and promote competition in ways that appear to have been so helpful in advancing the capital markets in the US. A credible and largely independent central bank. Improved transparency and disclosure for all market participants: central banks, regulatory agencies, banks, corporations, and investors. Incentives for market intermediaries to gather better information and conduct better risk assessment. Harmonization of accounting rules and principles with international standards. A focus by the legal system on strong protection of minority shareholders, rather than of creditors. Boosting public confidence in markets is an important step. Opening of domestic markets (and brokerages) to foreigners who can deepen liquidity and introduce competition — even if this sometimes results in higher volatility. Encouraging the development and participation of institutional investors, including insurance companies and private pension schemes. In recent decades, institutional investors have
24

played an important role in the deepening of the capital markets in both the UK and the US. A shift in regulatory approach from one that is strictly rules-based to one that is more focused on risk management. As constraints are lifted and capital markets become more complex, opportunities for “gaming” a rules-based regulatory system grow, making the overall system more vulnerable. A focus on risk management allows greater flexibility and should reduce the system’s vulnerability to shocks. The regular issuance of government bonds of varying maturities. Government benchmarks can help to establish a yield curve and a guide for credit ratings for privately issued debt. China has tapped international bond markets, despite its massive foreign reserve holdings, to do exactly this. Most academics agree that capital account liberalization should be among the last steps on the path toward a US-style capital market. This change is an important part of financial liberalization, but it requires a stable macro environment, a strong prudential framework in the financial sector, capable risk and liquidity management, and strong monitoring. One clear lesson of the Asian crisis is that liberalization must be accompanied by improvements in banking regulation and that the process needs to be undertaken very carefully. Restrictions on short-term capital inflows may be appropriate while domestic banking systems are beefing up their prudential regulations. Foreign-exchange regimes must also be considered in the context of capital markets development. Currency pegs can be especially dangerous after capital accounts are liberalized. Countries wishing to liberalize their foreign exchange regimes will need to strengthen their prudential standards so as to provide a strong bulwark against the potential risk posed by rapid withdrawals by overseas investors. The creation of a derivatives market should also be among the later steps — as it has been in the US and the UK. While derivatives can help to deepen liquidity and manage risk, they require greater monitoring and are probably only suited to the bestdeveloped capital markets. Expectations matter throughout the process. A government that is truly committed to developing its capital markets will need to make its intentions clear and be convincing. In most countries this means persuading investors and lenders that no government bailout will be forthcoming in the case of a crisis. Establishing this credibility is not easy, but

steps may include disavowing implicit guarantees and standing back from small-scale solvency crises. A capital-markets regulatory framework should be viewed as a continuous work in progress. Recent steps to improve corporate governance and to crack down on trading abuses by mutual funds in the US demonstrate that no regulatory regime can remain static for long. Ongoing improvements in corporate governance, market transparency, banking regulation, and convergence of international accounting stan-

dards will be needed if capital markets are to continue to deliver the types of economic benefits outlined in this paper. At the international level, the World Trade Organization is pursuing global liberalization of financial services, which is expected to offer new opportunities as well as bring new challenges. This important change may be a project for the future, however, given the current emphasis on negotiations over agriculture and tariffs.

The View from Economic Research Academia — Financial Market Development Does Lift Growth
A vast body of economic research examines those factors that are the major determinants of economic growth. One strand of this literature investigates the importance of financial institutions and markets in facilitating economic growth.* The consensus view is that financial development is associated with superior economic performance. All else being equal, countries with better-developed financial systems have higher levels of per capita real GDP In addition, the evidence strongly suggests that . there is a causal element running from financial market development to superior economic performance. Countries with better-developed financial systems tend to grow faster in the future, all else being equal. However, on the issue of what types of financial market development lead to superior economic performance — banks versus capital markets — the evidence is inconclusive. Academic research reaches no clear-cut conclusion concerning whether a capital market-based system or a bank-based system is better. The lack of clarity on this issue may stem from two limitations of existing research. First, economists have had difficulty in creating summary measures that can accurately characterize the development of banks versus capital markets. Typically, the stock market’s importance is modeled by the ratio of market capitalization to GDP or by a measure that captures the amount of trading activity. The measure of banking system development is usually a bank credit -to-GDP variable. We are skeptical whether these variables are robust enough to isolate the impact of financial market development on economic performance.
*

For example, they are not able to capture the importance of the development of the derivatives market. Second, the academic studies that seek to examine the linkage of financial structure to economic performance typically look at a broad array of countries at different levels of economic development. This mixing of countries may obscure the benefits that stem from a capital markets-based system at more mature stages of development. After all, the consensus of most research is that a banking-based system should work better than a capital markets system when the legal and regulatory structure is less well-developed. That is because banks can enforce good corporate governance as a precondition to obtaining bank loans. Also, when financial accounting information is not readily available or not standardized, banks may be better placed to obtain the information needed to assess the creditworthiness of their borrowers. This point implies that for countries at earlier stages of development, a banking-dominated system may deliver superior economic performance. In contrast, the recent experience of the US suggests that a capital markets-based system is superior at a later, more advanced stage of development. We believe that the economic performance of the United States over the past decade provides strong evidence of the benefits of well-developed capital markets. That is because US economic performance has improved over time, both absolutely and relative to other G-7 countries in which the capital markets are much less well-developed.

See, for example, “Finance and Growth: Theory, Evidence and Mechanisms,” Ross Levine, March 18, 2003, for a survey of this literature. Also, “Economic Growth: The Role of Policies and Institutions. Panel Data Evidence from OECD Countries,” by Andrea Bassanini, Stefano Scarpetta, and Phillip Hemmings, Economics Department Working Paper No. 283, Bank for International Settlements.

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Designing Capital Markets: Singapore and China
Two countries in Asia illustrate the long path toward financial market development — and the importance of maintaining strong banking sectors even while shifting toward a greater reliance on capital markets. Singapore’s financial system has developed in the context of a robust institutional framework. All of the basic elements — a strong legal system and regulatory regime, transparency, and good management — have been in place for years, with tight regulation. The 19971998 Asian financial crisis did much to accelerate the development of the country’s financial system. The Monetary Authority of Singapore (MAS), which regulates both banks and capital markets, responded to the crisis in two ways: by adopting a more risk-based approach to banking regulation and by fostering the development of the capital markets. The MAS now sees its supervisory work as being guided by a focus on risk-based supervision rather than blanket regulation, and it seeks to reduce systemic risk rather than to prevent individual failures. Disclosure is a key element of the regulatory structure. Singapore is considerably more advanced than many countries in Asia in emphasizing technology to deepen its markets. In 2003, it became one of the first members of the Continuous Linked Settlement System, which eliminates foreign exchange settlement risk. Consumer education has also become a priority in recent years, as the MAS has moved away from merits-based regulation. Recognizing the country’s vulnerability to regional contagion, Singapore since 1998 has undertaken several steps to boost its bond markets. It began by issuing government debt on a regular basis to create a benchmark for corporate bonds and by introducing regulatory changes to increase liquidity. Singapore liberalized its foreign exchange regime to encourage foreign issuers. It has also established a regulatory framework for structured products. China has had much further to go than Singapore in its financial development. When the reform era began in the late 1970s, the country lacked even the most basic infrastructure for a financial system. Property rights had to be recognized, commercial and securities laws drafted, regulators separated from market participants, and the judiciary strengthened. China has made considerable progress in developing both its banking sector and its capital markets over the past 25 years. Through restructurings, privatizations, and a loosening of administrative controls, the banking sector is gradually being transformed from an arm of the state into a collection of independent companies with authority over credit allocation. Prudential regulations are being introduced. The key challenge facing China’s banking sector — one that will need to be more thoroughly addressed before the moral hazard problem disappears — is the non-performing loan problem. China’s major banks are estimated to have bad loans worth 58 percent of GDP on their books. Although the government has established some asset management companies and conducted some bank recapitalizations, it has hesitated to tackle the nonperforming-loan problem head-on. Development of the capital markets has been a high priority for the past decade. China allowed foreign investors to participate in domestic equity markets fairly early in the process and is steadily opening the capital markets (as well as the banking sector) to foreign competition. The regulatory structure has also evolved, although it has sometimes lagged developments on the ground. For example, the China Security Regulation Commission was not established until roughly two years after the opening of a Shanghai stock exchange. Earlier in 2004, Chinese authorities in Beijing offered a program to expand the size, liquidity, and transparency of the capital markets, particularly the domestic bond market; expand participation by foreign firms and institutional investors; improve auditing rules, corporate governance, monitoring, and risk management; and reform the tax system to spur investment in these markets.

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© Goldman, Sachs & Co. 2004. All rights reserved.

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