Merchants of Debt

The rise of neoliberal Casino Capitalism and why this economy produces more ‘illth’ than wealth.

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Merchants of Debt Kkr and the Mortgaging of American Business

Merchants of Debt: KKR and the Mortgaging of American Business
By George Anders 2002/09 - Beard Books
1587981254 - Paperback - Reprint - 354 pp.

Selected as one of the best business books of 1992 by Business Week.

Categories: Banking and Finance

This title is part of the Business Histories list.

Of interest:

With borrowed money, borrowed management, and a lot of nerve, Kohlberg Kravis Roberts acquired one Fortune 500 company after another in the 1980s, epitomizing both the best and worst of Wall Street's stunning rise to power in the age of casino capitalism. In the compelling book, the author explains why American business became so enchanted by debt; how KKR partners Jerome Kohlberg, Henry Kravis, and George Roberts became billionaires; and how their takeovers affected America's economic strength. This fascinating, behind-the-scenes account show how pride, jealousy, fear, and ambition fueled Wall Street's debt mania - with repercussions to millions of people.

From the back cover blurb:

With borrowed money, borrowed management, and a lot of nerve, Kohlberg Kravis Roberts acquired one Fortune 500 company after another in the age of casino capitalism, KKR epitomized both the best -- and the worst -- of Wall Street's stunning rise to power in the 1980s. In this book, the author explains why American business became so enchanted by debt; how KKR partners Jerome Kohlberg, Henry Kravis and George Roberts became billionaires, and how their takeovers affected America's economic strength. This fascination, behind-the-scenes account shows how pride, jealousy, fear, and ambition fueled Wall Street's debt mania -- with consequences that affected millions of people. Investors and businesspersons alike will find this expose engrossing and informative reading. This book was selected as one of the Best Business Books of 1992 by Business Week.

Referring to an earlier version:

For more than a decade, Henry Kravis and George Roberts have been archetypes, first of Wall Street's boom years and then of its excesses. Their story and that of their firm--the biggest, most successful, and most controversial participant in the age of leverage--illuminates an entire era of financial maneuvering and speculative mania. Kravis and Roberts wrote their way into the history books by concocting one giant takeover after another. Their technique: the leveraged buyout, an audacious way to acquire a company with borrowed money, borrowed management--and a lot of nerve. Their firm, Kohlberg Kravis Roberts & Co., dominated the Wall Street scene in the late 1980s, acquiring one Fortune 500 company after another, including Safeway, Duracell, Motel 6, and RJR Nabisco. Merchants of Debt draws on more than 200 interviews, including recurring access to the central figures and their KKR associates, as well as court documents and private correspondence to couch giant financial issues in human terms. The story of KKR shows how pride, jealousy, fear, and ambition fueled Wall Street's debt mania--with consequences that affected hundreds of thousands of people. Anders addresses three questions: Why did American business become so enchanted by debt in the 1980s? How exactly did Kravis and Roberts rise to the top of the heap? What have buyouts, especially KKR's deals, done to America's economic strength? Here is a gripping saga that takes readers behind closed boardroom doors to show how star-struck young bankers, ruthless deal-makers, and nervous CEOs changed one another's lives--and the whole American economy--over a fifteen-year span.

"For the first fourteen years of KKR's existence, the buyout firm's hallmark could be expressed in one word: debt… As KKR grew evermore powerful, Kravis and Roberts derived their economic clout from a single fact: They could borrow more money, faster, than anyone else," according to the chronicler of this high-flying firm. KKR acquired $60 billion worth of companies in wildly different industries in the 1980s: Safeway Stores, Duracell, Motel 6, Stop & Shop, Avis, Tropicana, and Playtex. They made piles of money by deducting interest expenditures from their taxes, cutting costs in their new companies and riding a long-running bull market.

The juggernaut of Kohlberg Kravis Roberts & Co. began rolling in 1976 when Jerome Kohlberg and cousins Henry Kravis and George Roberts left Bear, Stearns with about $120,000 to spend. The three wunderkind shortly invented and dominated the leveraged buyout as they sought investors and borrowed money to acquire Fortune 500 companies in dizzying succession. They put up very little money of their own funds, but their partnerships made out like bandits. Consider the case of Owens-Illinois: KKR pup up only 4.7 percent of the purchase price. The company's chairman earned $10 million within a few years, the takeover advisors got $60 million, Owens-Illinois was left "gaunt and scaled back," and about five years later, KKR took it public at $11 a share, more than twice what the KKR partnership had paid for it.

In this reprint of his 1992 books, George Anders tells us how they worked: "(t)ime after time, the KKR men presented a tempting offer. The CEO could cash out his company's existing shareholders by agreeing to sell the company to a new group that would be headed by KKR, but would include a lot of room for existing management. The new ownership group would take on a lot of debt, but aim to pay it off quickly. If this buyout worked out as planned, the KKR men hinted, the new owners could earn five times their money over the next five years. Presented with such a choice in the frenzied takeover climate of the 1980s, manages and corporate directors again and again said yes… To top management a leveraged buyout was the most palatable way to ride out the merger-and-acquisition craze."

The author includes a detailed appendix of KKR's 38 buyouts during the period 1977-1992 that presents the following on each purchase: price paid by KKR; percentage of the purchase price paid by KKR's equity funds; length of time KKR owned the company; financial payoff for the ownership group; and the annualized profit rate for investors over the life of the buyout. KKR used less than 9 percent of its own funds in 18 of the 38 cases. In only four cases did KKR put up more than 30 percent of the price. KKR owned the 38 companies for an average of about 5 years. As Anders puts it, "(a)s quickly as the KKR men had roared into a company's life, they roared off."

This behind-the-scene account shows the ambition, pride, envy and fear that characterized the debt mania largely engineered by KKR, a mania that put millions out of work and made a very few very rich. This book is a must read in understanding what happened to corporate America in the 1980s.

George Anders is the West Coast bureau chief of Fast Company magazine. He worked for two decades at the Wall Street Journal, and was part of a seven-person reporting team that won the Pulitzer Prize for national reporting in 1997.

In Merchants of Debt: KKR and the Mortgaging of American Business, George Anders of The Wall Street Journal explores not just Kohlberg Kravis Roberts & Co. but also the impact of the leveraged buyout deals it popularized. Reviewer Anthony Bianco found the book well-researched, fair-minded, and thorough in its history of transactions.

Discussing the $26.4 billion buyout of RJR Nabisco Inc., ``Anders goes beyond what has been previously published,'' Bianco wrote, with his convincing assertion that RJR's post-deal crises pushed KKR close to ruin. Leveraged buyouts in general Anders terms ``one of the most profoundly undemocratic ventures the United States had ever seen.'' Their only lasting impact, he says, was to shift wealth from the mass of corporate employees to a managerial elite allied with Wall Street.

Bianco faulted Anders for shying from sharp judgments and for failing to delve deeply into the motivations and character of KKR's dealmakers. But Anders won unparalleled access to Henry Kravis and his cousin and partner, George Roberts, Bianco noted. Crediting Anders with ``devastating reportage,'' Bianco said, ``His exhaustively researched book provides the closest look yet at KKR's inner workings.''

Excerpted in the Wall Street Journal.

From New York Times Book Review, June 14, 1992

"[S]omething refreshing and important: a book that reckons seriously with Wall Street's innovations and achievements, even as it chronicles its recklessness and intrigues... [A] far more enduring contribution to understanding one of the most dynamic and disturbing periods in American business history."

From Michael Lewis, Author of Liar's Poker and The New Thing

"Excellent... One of the few books that a person can use to evaluate what happened in the financial 1980s. It should be required reading for anyone who got rich, lost a job or watched in consternation as Wall Street's juggernaut swept the U.S. economy."

From Library Journal, June 14, 1992

Kohlberg Kravis Roberts & Co. (KKR) was founded in New York in 1976 by three . . . investment bankers, Jerry Kohlberg, George Kravis, and George Roberts, with the simple purpose of assisting companies to participate in management-led buyouts or leveraged buyouts (LBOs). . . . {The author} chronicles the rise of KKR during the 1980s, the 'age of debt,' and . . . {argues that} a simple formula using borrowed money could be successfully repeated over and over again in corporate takeovers.

This compelling book is recommended for all business collections.

Thayer Watkins' Summary of Merchants of Debt:
Available here.

From Turnarounds and Workouts, February 15, 2003
Review by Gail Owens Hoelscher

From BusinessWeek.Com
The Best Business Books of the Year (1992)

Casino capitalism continues to baffle by Guy

October 06, 2005

In my humble opinion, the instability of financial trading markets all over the world exemplifies the fact that free market behaviour is not always rational behaviour. Although right-wing liberal economic types like to portray packs of investors as some sort of "hive mind", judging the value of stock in real-time and acting accordingly, investor behaviour is typically more instinctive and random than that. People might sell their stock in Telstra, for example, because they want to go on a holiday. If enough Telstra shareholders want to go on a holiday at the same time, the value of Telstra shares will drop if the numbers of sellers outweighs the numbers of interested buyers. It's a pretty dumb example but it holds true. What does such a decision have to do with the actual value of Telstra? SFA, but markets are blind to that, and market analysts will try to rationalise the stock price movement in any remotely credible way that they can.

And what prompted this anti-market spray? The Australian stock market had $21 billion wiped off it yesterday in the biggest single-day loss since the week of the 9/11 attacks. The purported reason for the loss hardly justifies the reaction:

Local traders were anxious after a plunge on Wall Street, which was sparked by a US Federal Reserve warning that interest rates were likely to rise and energy prices were driving inflation higher.

Anything that can devalue Australian companies by $21 billion in a single day sounds more like a corporate disaster than anything else. It's barmy. Put simply, the global marketplace could do without the ridiculous volatility that often ensues in financial markets. Sometimes it seems as though investors might do well to just go and put their surplus capital on red at the roulette table at Star City instead of pumping it into the stockmarket. At least there is a sense of immediate certainty about that sort of transaction. I'm not seriously advocating gambling as much as trying to make a point here, but gambled monies are at the very least not subject to the often inscrutable and senseless whims of shareholders across the country.

Unsurprisingly, given market volatility and the sense that one is gambling, not investing, when buying shares, critical theorist Susan Strange once labelled the instability of modern financial markets "casino capitalism". Make no mistake, investing in financial markets these days is in many ways closer to being a form of gambling than buying property, or putting your money in the bank.

Nic White at October 6, 2005 09:15 PM

This is just the usual October correction. Its a good thing, because it allows investors to get some bargins before the market climbs up again. We just came off a new high, it may look like a crash but the market is still very healthy. This dip is predicted to last only a month or two, or even only a few weeks.
Chris Fryer at October 7, 2005 12:06 PM

You have obviously never invested in the stock market. For a long-term investor it is nothing like a casino. If a stock price goes down that is a paper loss, you do not actually loose money unless you sell the stock.

To a wise investor an event like this is an opportunity. As Nic said, this is a chance to get bargains before the market goes up again.

The market can be irrational. But the great thing about the stock market is you can control your risk. You could invest in bank shares, this way you'd get a relatively stable stock that pays a good dividend. Or you could invest in a speculative stock that might go up exponentially or vanish altogether.

A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire.

Guy at October 8, 2005 11:32 PM

"A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire."

So it's a bit like betting on a few favourites and a few long-shots at the horsetrack, right? ;) I know some gamblers who don't think that they've lost money until they've left the gambling establishment of their choice for the day. Until then, it's just $50 up or $50 down, and the betting continues.

I guess the point I am trying to make is that $21 billion was wiped off the supposed value of companies in a single day, and hardly anything at all changed in a material sense.

It's like if banks decided to randomly revalue the money sitting in your savings account on a real-time basis. On a whim, a significant proportion of your savings could disappear, without anything particularly tangible or real justifying that reduction in value.

The October correctio, as I understand it, is literally a correction - meaning those companies have been over valued in the last year or so, and that is being rectified. As the correction results in a bid, investors and traders panic and sell like mad, and the market dips further before levelling off and climbing again.

Theres relaly nothing to see here, but the media is beating it up something chronic.

Washington DeCoded Inside Casino Capitalism

Inside Casino Capitalism Barbarians at the Gate: The Fall of RJR Nabisco
By Bryan Burrough and John Helyar
Harper & Row. 528 pp. $22.95

By Max Holland

In 1898, Adolphus Green, chairman of the National Biscuit Company, found himself faced with the task of choosing a trademark for his newly formed baking concern. Green was a progressive businessman. He refused to employ child labor, even though it was then a common practice, and he offered his bakery employees the option to buy stock at a discount. Green therefore thought that his trademark should symbolize Nabisco's fundamental business values, "not merely to make dividends for the stockholders of his company, but to enhance the general prosperity and the moral sentiment of the United States." Eventually he decided that a cross with two bars and an oval – a medieval symbol representing the triumph of the moral and spiritual over the base and material – should grace the package of every Nabisco product.

If they had wracked their brains for months, Bryan Burrough and John Helyar could not have come up with a more ironic metaphor for their book. The fall of Nabisco, and its corporate partner R.J. Reynolds, is nothing less than the exact opposite of Green's business credo, a compelling tale of corporate and Wall Street greed featuring RJR Nabisco officers who first steal shareholders blind and then justify their epic displays of avarice by claiming to maximize shareholder value.

The event which made the RJR Nabisco story worth telling was the 1988 leveraged buyout (LBO) of the mammoth tobacco and food conglomerate, then the 19th-largest industrial corporation in America. Battles for corporate control were common during the loosely regulated 1980s, and the LBO was just one method for capturing the equity of a corporation. (In a typical LBO, a small group of top management and investment bankers put 10 percent down and finance the rest of their purchase through high-interest loans or bonds. If the leveraged, privately-owned corporation survives, the investors, which they can re-sell public shares, reach the so-called "pot of gold"; but if the corporation cannot service its debt, everything is at risk, because the collateral is the corporation itself.

The sheer size of RJR Nabisco and the furious bidding war that erupted guaranteed unusual public scrutiny of this particular piece of financial engineering. F. Ross Johnson, the conglomerate's flamboyant, free-spending CEO (RJR had its own corporate airline), put his own company into play with a $75-a-share bid in October. Experienced buyout artists on Wall Street, however, immediately realized that Johnson was trying to play two incompatible games. LBOs typically put corporations such as RJR Nabisco through a ringer in order to pay the mammoth debt incurred after a buyout. But Johnson, desiring to keep corporate perquisites intact, "low-balled" his offer. Other buyout investors stepped forward with competing bids, and after a six-week-long auction the buyout boutique of Kohlberg, Kravis, Roberts & Company (KKR) emerged on top with a $109-a-share bid. The $25-billion buyout took its place as one of the defining business events of the 1980s

Burrough and Helyar, who covered the story for The Wall Street Journal, supply a breezy, colorful, blow-by-blow account of the "deal from hell" (as one businessman characterized a leveraged buyout). The language of Wall Street, full of incongruous "Rambo" jargon from the Vietnam War, is itself arresting. Buyout artists, who presumably never came within 10,000 miles of wartime Saigon, talk about "napalming" corporate perquisites or liken their strategy to "charging through the rice paddies, not stopping for anything and taking no prisoners."

At the time, F. Ross Johnson was widely pilloried in the press as the embodiment of excess; his conflict of interest was obvious. Yet Burrough and Helyar show that Johnson, for all his free-spending ways, was way over his head in the major leagues of greed, otherwise known as Wall Street in the 1980s. What, after all, is more rapacious: the roughly $100 million Johnson stood to gain if his deal worked out over five years, or the $45 million in expenses KKR demanded for waiting 60 minutes while Ross Johnson prepared a final competing bid?

Barbarians is, in the parlance of the publishing world, a good read. At the same time, unfortunately, a disclaimer issued by the authors proves only too true. Anyone looking for a definitive judgment of LBOs will be disappointed. Burrough and Helyar do at least ask the pertinent question: What does all this activity have to do with building and sustaining a business? But authors should not only pose questions; they should answer them, or at least try.

Admittedly, the single most important answer to the RJR puzzle could not be provided by Burrough and Helyar because it is not yet known. The major test of any financial engineering is its effect on the long-term vitality of the leveraged corporation, as measured by such key indicators as market share (and not just whether the corporation survives its debt, as the authors imply). However, a highly-leveraged RJR Nabisco is already selling off numerous profitable parts of its business because they are no longer a "strategic fit": Wall Street code signifying a need for cash in order to service debts and avoid bankruptcy.

If the authors were unable to predict the ultimate outcome, they still had a rare opportunity to explain how and why an LBO is engineered. Unfortunately, their fixation on re-creating events and dialogue – which admittedly produces a fast-moving book – forced them to accept the issues as defined by the participants themselves. There is no other way to explain the book's uncritical stance. When, for example, the RJR Nabisco board of directors tried to decide which bid to accept, Burrough and Helyar report that several directors sided with KKR's offer because the LBO boutique "knew the value of keeping [employees] happy." It is impossible to tell from the book whether the directors knew this to be true or took KKR's word. Even a cursory investigation would have revealed that KKR is notorious for showing no concern for employees below senior management after a leveraged buyout.

The triumph of gossip over substance is manifest in many other ways. Wall Street's deft manipulation of the business press is barely touched upon, and the laissez-faire environment procured by buyout artists via their political contributions is scarcely mentioned, crucial though it is. Nowhere are the authors' priorities more obvious than in the number of words devoted to Henry Kravis's conspicuous consumption compared to those devoted to the details of the RJR deal. In testimony before Congress last year, no less an authority than Treasury Secretary Nicholas Brady – himself an old Wall Street hand – noted that the substitution of tax-deductible debt for taxable income is "the mill in which the grist of takeover premiums is ground."

In the case of RJR Nabisco, 81 percent of the $9.9 billion premium paid to shareholders was derived from tax breaks achievable after the buyout. This singularly important fact cannot be found in the book, however; nor will a reader learn that after the buyout the U.S. Treasury was obligated to refund RJR as much as $1 billion because of its post-buyout debt burden. In Barbarians, more time is spent describing Kravis's ostentatious gifts to his fashion-designer wife than to the tax considerations that make or break these deals.

Fulminations about the socially corrosive effects of greed aside, the buyout phenomenon may represent one of the biggest changes in the way American business is conducted since the rise of the public corporation, nothing less than a transformation of managerial into financial capitalism. The ferocious market for corporate control that emerged during the 1980s has few parallels in business history, but there are two: the trusts that formed early in this century and the conglomerate mania that swept corporate America during the 1960s. Both waves resulted in large social and economic costs, and there is little assurance that the corporate infatuation with debt will not exact a similarly heavy toll.

As the economist Henry Kaufman has written, the high levels of debt associated with buyouts and other forms of corporate restructuring create fragility in business structures and vulnerability to economic cycles. Inexorably, the shift away from equity invites the close, even intrusive involvement of institutional investors (banks, pension funds, and insurance companies) that provide the financing. Superficially, this moves America closer to the system that prevails in Germany and Japan, where historically the relationship between the suppliers and users of capital is close. But Germany and Japan incur higher levels of debt for expansion and investment, whereas equivalent American indebtedness is linked to the recent market for corporate control. That creates a brittle structure, one that threatens to turn the U.S. government into something of an ultimate guarantor if and when things do fall about. It is too easy to construct a scenario in which corporate indebtedness forces the federal government into the business of business. The savings-and-loan bailout is a painfully obvious harbinger of such a development.

The many ramifications of the buyout mania deserve thoughtful treatment. Basic issues of corporate governance and accountability ought to be openly debated and resolved if the American economy is to deliver the maximum benefit to society and not just unconscionable rewards to a handful of bankers, all out of proportion to their social productivity. It is disappointing, but a sign of the times, that the best book about the deal of deals fails to educate as well as it entertains.

This article first appeared in the Wilson Quarterly, Summer 1990
© 1990 by Max Holland

Reviews 'Cowardly capitalism' by Daniel Ben-Ami Prospect Magazine December 1998 issue 36

The dominant image of the financial markets is that of a giant casino. Brash young men in red braces, driven by insatiable greed, gamble with huge sums every day. When the bets go wrong the innocent suffer. Reckless financial markets pose an immediate threat to the future prosperity of humanity.

Susan Strange, who died just after the publication of her lastest book, was one of the most compelling academic advocates of the view that the global casino is out of control. Although she is not a household name, she played an important role in developing the intellectual framework to support the casino thesis. Her Casino Capitalism (1986) is a Keynesian account of the damage inflicted on the world as a result of financial deregulation which was taken up by many better known writers such as William Greider in the US and Will Hutton in Britain.

With the onset of the Asian financial crisis Strange's account of financial markets has become almost mainstream. Her ideas inform many of the discussions about a "new international financial architecture." Economists who would once have scorned her views now agree with her that deregulation has gone too far and that new forms of regulation are needed. The British government has floated the idea of a world financial authority to regulate global finance. The IMF, once a bastion of free market economics, has conceded that capital controls may be necessary under some circumstances.

Mad Money, the sequel to Casino Capitalism, takes into account the impact of information technology and the rise of financial crime. It also places new emphasis on the role of international institutions. For example, she backs George Soros's plan for an international credit insurance corporation as a complement to the IMF.

Yet there is one striking omission from Mad Money. She points out that the dominant theme of her earlier work was the danger of volatility-the gyrations in the price of financial assets. But then she fails to notice that the decade since the publication of Casino Capitalism has been one of relatively low financial volatility. This assertion appears to be contradicted by everyday experience. Every week there is news of a record fall on the London stock market-often followed by a record rise. But such impressions do not take account of long-term stock market growth. A 200-point fall when the FTSE 100 index is at 6000 does not have the same significance as when it is at 1000.

The low volatility of the main world stock markets can be precisely measured. And William Schwert, a professor of finance and statistics in the US, has produced a comprehensive study of the US, Britain, Germany, Japan, Australia and Canada which states that "all of the evidence leads to the conclusion that volatility has been very low in the decade since the 1987 crash."

Strange is not alone in misreading volatility. The striking feature of the past decade is the gap between the fear of risk-taking and the real level of risk. The obsession with risk management is at an alltime high. Financial markets are characterised by fear rather than greed. We should talk of cowardly capitalism, not casino capitalism.

Cowardly capitalism, for example, lies behind the explosive growth in derivatives, normally seen as one of the instruments of financial madness. Derivatives are bets on the way in which the price of financial assets move. They can be used for speculation-and often are-but they are mainly used to reduce financial uncertainty. (A survey of derivative use by non-financial US companies in 1994-95, at the University of Pennsylvania, found that the main use of derivatives was to manage cash flow and reduce risk.)

How do derivatives work? Imagine a British plastics manufacturer that depends on imports of crude oil-priced in US dollars-as its main raw material. The business suffers if the dollar strengthens. One way it can protect itself against this is to bet on a rising dollar. If it does rise the extra cost of the oil will be offset by the money it makes from its derivative contract. This practice is known as hedging. It is similar in principle to life insurance which can be seen as a bet that the policy-holder will die in a given period.

It is certainly possible, through dishonesty or incompetence, to lose huge amounts through speculation in derivatives, but the market is driven by risk aversion rather than recklessness.

Derivatives are far from the only instance of cowardly capitalism. Another example is fund management. Back in 1957 almost two thirds of the London stock market was owned by private investors. Today it is dominated by investment funds such as pension funds, insurance funds and unit trusts. The main rationale of such investment funds is to manage risk. Their guiding principle is: "Don't put all your eggs in one basket." If an investor holds a few shares his portfolio is likely to suffer from high volatility. But a fund manager with a large number of shares can diversify risk. Increases in the prices of some shares can cancel out falls in others.

The intellectual rationale for fund management explicitly casts risk as a problem. In his seminal paper on portfolio theory, Harry Markowitz argues that "the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing." The suspicion of risk-taking is embedded in the intellectual heart of cowardly capitalism.

If the financial markets are so risk averse it is not clear why they should be seen as irresponsible risk-takers. In reality both perceptions are closely related. Financial markets are seen as reckless precisely because of the strength of risk aversion in the contemporary world.

But the act of risk-taking should not be stigmatised, otherwise markets will cease to function properly. Susan Strange's notion of casino capitalism should be ditched or at least modified. And grand regulatory schemes based on the notion of out of control financial markets should be handled with care. In the world of cowardly capitalism, where risk aversion rules, it is more accurate to see money as sad rather than mad.

Mad money

Susan Strange

Stefan Stern - Rise of 'casino capitalism ...

Rise of 'casino capitalism' shakes faith of moderate Monks

By Stefan Stern

Published: November 21 2006 02:00 | Last updated: November 21 2006 02:00

"The prototype of the successful man in modern society is not the scientist, the inventor, the scholar. It is the financier, the gambler and those with social pull. The others share [in the winnings] sometimes, it is true, but their share is modest compared with the oligarchs and tycoons; and they don't usually keep their share for long. They are no match for the commercial prowlers."

A snap-shot of London's Mayfair district, home to the burgeoning hedge-fund phenomenon, in November 2006? Actually, no. The above words were written in 1952 by the Labour politician Aneurin Bevan in his book In Place of Fear. Bevan had a gift - his most passionate supporters would say a genius - for exposing the truth of a situation in language that could be both scintillating and pungent.

Fifty years ago, he criticised the prime minister of the day, Sir Anthony Eden, for his reckless actions during the Suez crisis. "[He] has been pretending that he is now invading Egypt in order to strengthen the United Nations," Bevan said in a famous speech in Trafalgar Square. "Every burglar of course could say the same thing: he could argue that he was entering the house in order to train the police. So, if Sir Anthony Eden is sincere in what he is saying, and he may be . . . then he is too stupid to be a prime minister!" Here was political rhetoric with a touch of prophesy about it.

It was the enduring appeal of speeches such as these that helped draw a good crowd to the fifth annual Bevan memorial lecture in London last week. The lecture was to be given by John Monks, formerly general secretary of the British Trades Union Congress, now the Brussels-based leader of the European trade union confederation.

No one in the audience would have been expecting Bevanite rhetorical fireworks from Mr Monks. That has never been his style. Between 1993 and 2003, he led the British trade union movement with modesty and distinction. He was the moderate's moderate: avoiding confrontation wherever possible and advocating partnership at work between management and employees. Business leaders were happy to do business with him.

They would not have found this lecture so easy to deal with. Confronted by today's turbo-charged capitalism, Mr Monks cast off his former moderation. He even seemed to be on the verge of recanting his commitment to the partnership model. "Partnership with who?" he asked. There has been, he said, a "disintegration of the social nexus between worker and employer - a culture containing broad social rights and obligations. The new capitalism wants none of it."

Mr Monks contrasted businesses' healthy profitability with the ruthless way some have treated their staff recently, whether through large-scale redundancies or the constant threat that jobs may be sent off-shore or outsourced. While median wages have stagnated, record executive salaries are legion.

He admitted that he had possibly been a bit naive in the past. "I did not fully appreciate what was happening on the other side of the table," Mr Monks said. While he sympathised with business leaders for the relentless pressure they find themselves under - "It cannot be easy running a firm . . . when you are up for sale every day and every night of every year" - he was appalled by the increasingly "shameless", short-termist behaviour of overpaid corporate executives. "More and more they resemble the Bourbons - and they should be aware of what eventually happened to the Bourbons."

For someone like me, who has sat through 10 years of reasonableness from John Monks, this speech was remarkable, devastating stuff. Maybe there is something in the Brussels water. Perhaps the ghost of Nye Bevan was speaking through him. Or was it just anxiety over the career choice of his daughter's boyfriend? He is now working for - you guessed it - a hedge fund. Whatever its cause, a challenge was being thrown down.

"All this is too important to be left to the practitioners who have a vested interest in obscuring what they do from the rest of us," he said. And, with bonus season fast approaching, he took one final, sweeping aim at the high rollers of "casino capitalism". Their actions are "dangerous to economic stability, traditional industry and jobs", he said. "I would like to see the City pages of the press more challenging and less respectful on these matters . . . Our future - the world's future - is too important to place in the hands of the new capitalists."

Will corporate leaders - those that have read this far anyway - simply shrug their shoulders and get back to their slashing and burning ways? Is Mr Monks merely offering a wholly predictable, knee-jerk, lefty rant? I do not think so. This general secretary just does not do lefty rants. So business people should take note. When the John Monkses of this world say enough is enough, that the capitalist system itself is sick, you can be sure that elsewhere in the world there is deep-seated, lingering resentment and unhappiness.

Half a century ago, Nye Bevan expressed a similar concern. In In Place of Fear he wrote: "There is a sense of injustice in modern society, and this induces a feeling of instability even in normal circumstances. The rewards are not in keeping with social worth, and the consciousness of this, both among the successful and the unsuccessful, will simmer and bubble, blowing up into geysers of political and social disturbance in times of economic stress."

Reading these words, you can see why so many people were prepared to come out on a dark Tuesday night to see if the spirit of Bevan still had something to communicate 46 years after his death.


Gerard Hanlonf1
Institue for the Study of the Legal Profession, Law Faculty, University of Sheffield, Crookesmoor Building, Conduit Road, Sheffield, U.K., S10 1FL
Received 24 February 1994; revised 1 May 1995; accepted 1 May 1995. ; Available online 24 April 2002.


The central contention of this paper is that a new paradigm is emerging within the area of professional or expert labour. This process entails a shift from a "social service" evaluation mechanism to a "commercialised" mechanism. This change is but one element in a wider range of alterations entailed in the change from a Fordist regime of accumulation to a Flexible Accumulation regime. The paper examines these issues with regard to the chartered accountancy profession. It analyses the socialisation processes experienced by accountants and the evaluation criteria involved in the promotional process to partnership. The evidence for this paper was gathered from qualitative and quantitative research undertaken in the Big Six accountancy practices in Ireland and the USA.

Accountants as "new guard dogs" of capitalism: Stereoty...

Casino capitalism

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Covenanting for justice

The call to a church process

The globalization of economic life

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Covenant and confess

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Controlling speculation in world financial markets
Progressive Christians Uniting

Gordon K Douglass
November 9 2002

Financial markets 101
Early history
The Bretton Woods system
The power of financial actors
Consequences of global financial flows
Policy options
Theological and ethical considerations
A new financial architecture
What Christians can do
Want to know more?
Questions For Discussion

"During my whole career at Goldman Sachs - 1967 to 1991 - I never owned a foreign stock or emerging market bonds. Now I have hundreds of millions of dollars in Russia, Brazil, Argentina and Chile, and I worry constantly about the dollar-yen rate. Every night before I go to bed I call in for the dollar-yen quote, and to find out what the Nikkei is doing and what the Hang Seng Index is doing. We have bets in all these markets. Right now Paul [one of my traders] is long [on] the Canadian dollar. We have bets all over the place. I would not have worried about any of these twenty years ago. Now I have to worry about all of them."

Leon Coopermann, hedge fund manager1

Economic globalization is probably the most fundamental transformation of the world's political and economic arrangements since the Industrial Revolution. Decisions made in one part of the world more and more affect people and communities elsewhere in the world. Sometimes the consequences of globalization are positive, liberating inventive and entrepreneurial talents and accelerating the pace of sustainable development. But at other times they are negative, as when many people, especially in less-developed countries, are left behind without a social safety net. Globalization undermines the ability of the nation to tax and to regulate its own economy. This weakens the power of sovereign nations relative to that of large transnational corporations and distorts how social and economic priorities are chosen.

Economic globalization is most often associated with rapid growth in the flow of goods and services across international borders. Indeed, the economic "openness" of a nation is often measured by the value of its exports, imports, or their sum when compared to the size of its economy. Economic globalization also involves large investments from outside each nation, often by transnational corporations. These corporations often combine technology and know-how with their investments that enhance the productive capacity of a nation. Previous position papers of the Mobilization, contained in Speaking of Religion & Politics: The Progressive Church Tackles Hot Topics2, have dealt with globalization primarily in these terms.

But international trade and investment are only part of the openness that has come to be called globalization. Another part, and arguably the most important, is the quickening flow of financial assets internationally. While a small portion of this flow is directly associated with the "real" economy of production and exchange, its vast majority is composed of trades in the "paper" economy of short-term financial markets. This paper economy is enormous: The value of global financial securities greatly exceeds the value of annual world output of goods and services. Moreover, the paper economy often contributes to crises in the real economy. Thus it is important to the well being of humanity and the planet as a whole, yet it is little understood by most people. This essay undertakes to provide a basic understanding of this paper economy, especially as its more speculative features have multiplied during the last two or three decades, so that Christians and others concerned about what is happening in our world can join in an intelligent discussion of how the harmful consequences of financial markets can be controlled.

Financial markets 101

To better understand this paper economy, one first needs to know something about foreign exchange markets, international money markets, and "external" financial markets.

In an open economy, domestic residents often engage in international transactions. American car dealers, for example, buy Japanese Toyotas and Datsuns, while German computer companies sell electronic notebooks to Mexican businessmen. Similarly, Australian mutual funds invest in the shares of companies all over the world, while the treasurer of a Canadian transnational corporation parks idle cash in 90-day Bank of England notes. Most of these transactions require one or more participants to acquire a foreign currency. If an American buys a Toyota and pays the Japanese Toyota dealer in dollars, for example, the latter will have to exchange the dollars for yens in order to have the local currency with which to pay his workers and local suppliers.

The foreign exchange market is the market in which national currencies are traded. As in any market, a price must exist at which trade can occur. An exchange rate is the price of a unit of domestic currency in terms of a foreign currency. Thus, if the exchange rate of the dollar in terms of the Japanese yen increases, we say the dollar has depreciated and the yen has appreciated. Similarly, a decrease in the dollar/yen exchange rate would imply an appreciation of the dollar and a depreciation of the yen.

Foreign exchange markets can be classified as spot markets and forward markets. In spot markets currencies are bought and sold for immediate delivery and payment. In forward markets, currencies are bought or sold for future delivery and payment. A U.S. music company, say, enters into a contract to buy British records for delivery in 30 days. To guard against the possibility of the dollar/pound exchange rate increasing in the meantime, the company buys pounds forward, for delivery in 30 days, at the corresponding forward exchange rate quoted today. This is called hedging.

Of course, there has to be a counterpart to the music company's forward purchase of pounds. Who is the seller of those pounds? The immediate seller would be a commercial bank, as in the spot market. But the bank only acts as an intermediary. The ultimate seller of forward pounds may be another hedger, like the music company, but with a position just its opposite. Suppose, for example, that an American firm or individual has invested in 30-day British securities that it wants to convert back into dollars after the end of 30 days. The investor may decide to sell the pound proceeds forward in order to assure itself of the rate at which the pounds are to be converted back into dollars after 30 days.

Another type of investor may be providing the forward contract bought by the music company. This is the speculator, who attempts to profit from changes in exchange rates. Depending on their expectations, speculators may enter the forward market either as sellers or as buyers of forward exchange. In this particular case, the speculator may have reason to believe that the dollar/pound exchange rate will decrease in the next 30 days, permitting him to obtain the promised pounds at a lower price in the spot market 30 days hence.

The main instruments of foreign exchange transactions include electronic bank deposit transfers and bank drafts, bills of exchange, and a whole array of other short-term instruments expressed in terms of foreign currency. Thus, foreign exchange transactions do not generally involve a physical exchange of currencies across borders. They generally involve only changes in debits and credits at different banks in different countries. Very large banks in the main financial centers such as New York, London, Brussels and Zurich, account for most foreign exchange transactions. Local banks can provide foreign exchange by purchasing it in turn from major banks.

Although the foreign exchange market is dispersed in many cities and countries, it is unified by keen competition among the highly sophisticated market participants. A powerful force keeping exchange rate quotations in different places in line with each other is the search on the part of market participants for foreign exchange arbitrage opportunities. Arbitrage is the simultaneous purchase and sale of a commodity or financial asset in different markets with the purpose of obtaining a profit from the differential between the buying and selling price.

When foreign exchange is acquired in order to engage in international transactions involving the purchase or sale of goods and services, it is said that international trade has taken place in the real economy. When international transactions involve the purchase or sale of financial assets, they are referred to as international financial transactions. They constitute the paper economy.

Financial markets are commonly classified as capital markets or money markets. Capital markets deal in financial claims that reach more than one year into the future. Such claims include shares of stock, bonds, and long-term loans, among others. Money markets, on the other hand, deal in short-term claims, with maturities of less than one year. These include marketable government securities (like Treasury bills), large-denomination certificates of deposit issued by banks, commercial paper (representing short-term corporate debt), money market funds, and many other kinds of short-term, highly liquid (easily transferable) financial instruments. It is these short-term money market securities that account for most of the instability in the global paper economy.

Buying or selling a money market security internationally involves the same kind of foreign exchange risk that plagues buyers or sellers of merchandise internationally. If one wishes to guard against the possibility of an increase or decrease in the foreign exchange rate, one can insure against such fluctuations by "covering" in the forward market. By the same token, the decision about whether to own domestic or foreign money market securities is not simply a comparison of the rates of interest paid on otherwise comparable securities, because one must also take into account the gain (or loss) from purchasing foreign currency spot and selling it forward. Thus, choosing the security with the highest return does not necessarily imply the one with the highest interest rate.

People who trade in international money markets, moreover, need to take into account many other variables, including the costs of gathering and processing information, transaction costs, the possibility of government intervention and regulation, other forms of political risk, and the inability to make direct comparisons of alternative assets. Speculating in international money markets is a risky proposition.

International money markets involve assets denominated in different currencies. External financial markets involve assets denominated in the same currency but issued in different political jurisdictions. Eurodollars, for example, are dollar deposits held outside the United States (offshore), such as dollar deposits in London, Zurich, or even Singapore banks. The deposits may be in banks owned locally or in the offshore banking subsidiaries of U.S. banks. Deutsche mark deposits in London banks or pound sterling deposits in Amsterdam banks also are examples of external deposits. They are referred to as eurocurrency deposits. (The advent of a new common currency in the European Community - the Euro - will require the development of new nomenclature for external financial markets)

External banking activities are a segment of the wholesale international money market. The vast majority of eurocurrency transactions fall in the above $1 million value range, frequently reaching the hundreds of millions (or even billion) dollar value. Accordingly, the customers of eurobanks are almost exclusively large organizations, including multinational corporations, government entities, hedge funds, and international organizations, as well as eurobanks themselves. Like domestic banks, eurobanks that have excess reserves may make loans denominated in eurocurrencies, expanding the supply of eurocurrency deposits. The eurocurrency market funnels funds from lending countries to borrowing countries. Thus, it performs an important function as global financial intermediator.

Early history

The origins of what Karl Polanyi3 called haute finance can be traced to Renaissance Italy, where as early as 1422 there were seventy-two bankers or bill-brokers in or near the Mecato Vecchio of Florence.4 Many combined trade with purely financial business. By the middle of the fifteenth century, the Medici of Florence had opened branches in Bruges, London and Avignon, both as a means of financing international trade and as a way of marketing new kinds of financial assets. Many banking terms and practices still in use today originated in the burgeoning financial centers of Renaissance Europe.

By the early seventeenth century, the Dutch and East India Companies began issuing shares to the public in order to fund imperial enterprises closely linked to Holland and Britain. Their shares were made freely transferable, permitting development of a secondary financial market for claims to future income. Amsterdam opened a stock exchange in 1611, and shortly thereafter, the British government began issuing lottery tickets, an early form of government bonds, to finance colonial expansion, wars and other major areas of state expenditure. A lively secondary market in these financial instruments also emerged.5

Throughout these early years, financial markets were anything but riskless and stable. Consider the famous Dutch tulip mania of 1630, for example. This speculative bubble saw prices of tulip bulbs reach what seemed like absurd levels, yet "the rage among the Dutch to possess them [tulips] was so great that the ordinary industry of the country was neglected." Some investors in Britain and France shared this "irrational exuberance," though it was centered mostly in Holland. Then, not unlike speculative bubbles of more recent vintage, prices crashed6, pushing the economy into a depression and leaving many investors angry and confused.

Paris developed into an early financial center in the eighteenth century, but the Revolution of 1789 dissipated its power. The New York Stock Exchange was formally organized in 1792 and the official London Stock Exchange opened in 1802. The expansion westward of the railroads in the U.S. offered the financial community opportunity to sell railway shares and bonds that quickly became dominant in the financial markets. Indeed, the bond markets of London, Paris, Berlin, and Amsterdam were vehicles for collecting massive amounts of European savings and transferring it at higher returns to the emerging markets of the U.S., Canada, Australia, Latin America and Russia in the century preceding World War I.

Forward markets soon developed, especially in the U.S., in order to counter the impact of long distances and unpredictable weather. As capital and money markets expanded, other new financial instruments came into use. Joint stock companies were formed, enabled by legislation that clarified the distinction between the owners and managers of corporations. This, in turn, helped stimulate the growth of the American stock market in the late nineteenth century. To be sure, financial markets did not grow continuously in the nineteenth century. Lending to the emerging markets was interrupted by defaults in the 1820s, 1850s, 1870s and 1890s, but each wave of default was confined to a relatively small number of countries, permitting growth of financial flows to resume.7

In the four decades leading up to World War I, a truly worldwide economy was forged for the first time, extending from the core of Western Europe and the U.S. to latecomers in Eastern Europe and Latin America and even to the countries supplying raw materials on the periphery. Central to this expansion of trade and investment was an expanding system of finance that girded the globe. The amount was enormous: between 1870 and 1914 something like $30 billion,8 the equivalent in 2002 dollars of $550 billion, was transferred to recipient countries, in a world economy perhaps one-twelfth as large as today's.

During this "Gilded Age" of haute finance, the risks of participating in international trade and investment were generously shared with governments and the banking system. The reason is that foreign exchange rates were kept reasonably stable by the commitment of most governments to the "high" gold standard. In this way, businesses and individuals engaging in international transactions were reasonably certain that the value of their contracts was not going to change before they matured. Their exchange risk was shared with government by its willingness to buy or sell gold in order to keep the exchange rate constant. Because of this assurance, financial flows were reasonably free of regulation.

They were not immune from crises, however. When the sources of financial capital temporarily dried up, capital-importing countries occasionally found they could not expand export earnings sufficiently to avoid suspending interest payments on their debts or abandoning gold parity. On two occasions, the United States faced this possibility. The first was in 1893, when it switched in a sharp economic downturn to bimetallism (which caused William Jennings Bryan to denounce the "cross of gold"), and the second was in 1907, which led to the creation of the Federal Reserve System, handing to the government the function of lender of last resort previously carried out by Wall Street banks under the tutelage of J. Pierpont Morgan.

In his magisterial book The Great Transformation, Karl Polanyi reflected on the pervasive influence of haute finance on the policies of nations even in this "Gilded Age." The globalising financial markets and the gold standard, according to Polanyi, left very little room for states, especially smaller ones, to adopt monetary and fiscal policies independent of the new international order. "Loans, and the renewal of loans, hinged upon credit, and credit upon good behavior. Since, under constitutional government ..., behavior is reflected in the budget and the external value of the currency cannot be detached from the appreciation of the budget, debtor governments were well advised to watch their exchanges carefully and to avoid policies which might reflect upon the soundness of budget positions." Thus, even one hundred years ago the then-dominant world power, Great Britain, speaking as it did so often through the voice of the City of London, "prevailed by the timely pull of a thread in the international monetary network.9

Following World War I, the United States emerged not merely as a creditor country but as the primary source of new international financial flows. At first, the principal borrowers were the national governments of the stronger countries, but as the boom in security underwriting developed in the U.S, numerous obscure provinces, departments and municipalities found it possible to sell their bonds to American investors.10 Just as domestic construction, land, and equity markets went through speculative rises in the 1920s, so too did the U.S. experience a speculative surge in foreign investment. In the aftermath of successive defaults by foreign debtors in 1932, the Senate Committee on Banking and Currency concluded:

The record of the activities of investment bankers in the flotation of foreign securities is one of the most scandalous chapters in the history of American investment banking. The sale of these foreign issues was characterized by practices and abuses that violated the most elementary principles of business ethics.11

Speculation in the stock markets leading up to 1929 offers still another window on the instability of short-term financial flows. A speculative market can be defined as one in which prices move in response to the balance of opinion regarding the future movement of prices rather than responding normally to changes in the demand for and supply of whatever is priced. Helped by the willingness of Wall Street to allow people to buy stocks on margin, people were only too ready to bet prices would rise as long as others thought so too. Day after day and month after month the price of stocks went up in 1927. The gains by later standards were not large, but they had an aspect of great reliability. Then in 1928, the nature of the boom changed. "The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.12

Following World War I, the gold standard itself took on new form. Nations were allowed to hold their international reserves in either gold or foreign exchange. This worked for a while in the 1920s, but as speculation mounted and balances of payments disequilibria grew, fears of devaluation led central banks to try to replace their foreign-exchange holdings with specie in a "scramble for gold." The worldwide result of these shifts in central bank portfolios was an overall contraction of the supply of money and credit that sapped aggregate demand and forced prices to fall and output levels to shrink. Thus, it can be argued - persuasively in our view - that the Great Depression of the 1930s was as much, if not more, the result of mismanagement of money and credit as it was the result of protectionist policies. Protectionist policies were more likely the result of slowed growth and stalled trade. Countries that broke with the gold-exchange standard early, such as Britain in 1931, and pursued more expansionary monetary policies fared somewhat better.

The Bretton Woods system

During the darkest days of World War II, a radically new economic architecture was designed for the postwar world at a New Hampshire ski resort called Bretton Woods. With the competitive devaluation and protectionist policies of the 1930s still fresh in their minds, the mostly British and American delegates to the conference wanted most of all to design a system with fixed exchange rates that did not rely on national gold hoards to keep exchange rates stable. They decided to depend instead on strict controls of international financial movements. In this way, they hoped to allow countries to pursue full-employment policies through appropriate monetary (money and credit) and fiscal (tax and spending) policies without some of the anxieties associated with open financial markets. The role of monetary and financial stabilizer was given to the International Monetary Fund (IMF), which was provided with modest funds to assist nations to adjust imbalances in their external payments obligations. The International Bank for Reconstruction and Development (IBRD, later the World Bank) assumed the task of helping to finance post-war reconstruction.13

The IMF as it emerged from Bretton Woods had inadequate reserves to advance money for the long periods that many countries require for "soft-landings" from big current-account deficits. It would make only short-term loans. To make sure that borrowing nations were constrained, "conditionality" attached to IMF loans became standard practice, even in the early years of the Fund's operation. Policy limitations and "performance targets" tied to credit lines advanced under "standby agreements" began in the middle 1950s and were universal by the 1960s, long before the notions of "stabilization" and "structural adjustment" came into common parlance.

The Bretton Woods agreement also imposed a foreign exchange standard by which exchange rates between major currencies were fixed in terms of the dollar, and the value of the dollar was tied to gold at a U.S. guaranteed price of thirty-five dollars per ounce. By devising a system that controlled financial movements and assisted with the adjustment of countries' balances of payments, the new system succeeded in keeping exchange rates remarkably stable. They were changed only very occasionally, e.g., as when the value of sterling relative to the dollar was reduced in 1949 and again in 1966. This meant that companies doing business abroad did not need to worry constantly about the risk of exchanging one currency for another.

Among the reasons for this remarkable stability was the willingness of the central banks of other countries to hold an increasing proportion of their official reserves in the form of U.S. dollars. It was an essential part of the system that the dollars held by other countries would be seen as IOUs backed by the U.S. offer to exchange them for gold at a fixed pre-war price. But as the balance-of-payments of the U.S. moved more deeply into deficits in the 1960s, there were more and more U.S. dollars held by other countries, and this so-called "dollar overhang" became disturbingly large.15 General de Gaulle called it "the exorbitant privilege," meaning that the Americans were paying their bills - for defense spending to fight the Vietnam War among other things - with IOUs instead of real resources in the form of exports of goods and services.

Strict control over financial movements began to weaken as early as the 1950s, when the first eurodollar (later eurocurrency) deposits were made in London. At first a trickle, limited originally to Europe, these offshore banking operations soon expanded worldwide. The American "Interest Equalization Tax" (IET) instituted in 1963 raised the costs to banks of lending offshore from their domestic branches.16 The higher external rates led dollar depositors such as foreign corporations to switch their funds from onshore U.S. institutions to eurobanks. Thus, the real effect of the IET was to encourage the dollar to follow the foreigners abroad, rather than the other way around. Eurobanks paid higher interest rates on deposits and loaned eurocurrencies at lower rates than U.S. banks could at home. Still another large inflow of eurodeposits occurred in 1973-74 as the Organization of Petroleum Exporting Countries (OPEC) began "recycling" their surplus dollar earnings through eurobanks. Because of their existence, a country such as Brazil could arrange within a reasonably regulation-free environment to obtain multimillion-dollar loans from a consortium of offshore American, German and Japanese banks and thereby finance its oil imports. Net eurocurrency deposit liabilities that amounted to around $10 billion in the mid-1960s, grew to $500 billion by 1980.

These eurocurrency transactions taught the players in financial markets how to shift their deposits, loans, and investments from one currency to another whenever exchange rates or interest rates were thought to be ready to change. Even the ability of central banks to regulate the supply of money and credit was undermined by the readiness of commercial banks to borrow and lend offshore. Hence, the effectiveness of regulatory mechanisms that had been put in place to implement the Bretton Woods agreement - interest rate ceilings, lending limits, portfolio restrictions, reserve and liquidity requirements - gradually eroded as offshore transactions started to balloon.

The world economy developed at unprecedented rates during the roughly twenty-five years immediately following World War II. Growth and employment rates during these years were at historic highs in most countries. Productivity also advanced rapidly in most developing countries as well as in the technological leaders. These facts suggest that the system devised at Bretton Woods worked reasonably well, despite occasional adjustments. To be sure, it helped to sow the seeds of its own destruction by failing to retain operational control of international financial flows. But the twenty-five years of its survival leading up to August 15, 1971, when President Nixon closed the gold window, have nonetheless come to be called by some economic historians the "Golden Years."

Controlling private risk

Fixed exchange rates did not last long after the U.S. stopped exchanging gold for claims on the dollar held by foreign central banks. The pound sterling was allowed to float against the dollar in July, 1972. Japan set the yen free to float in February, 1973, and most European currencies followed suit shortly thereafter. The Bretton Woods gold-dollar system was doomed.

The fact that exchange rates no longer were fixed meant that companies doing business in different countries had to cope with the day-to-day shifts in the dollar's rate of exchange with other currencies. The risks of unexpected changes in the value of international contracts suddenly had shifted from the public to the private sector. Corporate finance officers now had to hedge against possible exchange losses by buying a currency forward and investing the equivalent in the short-term money market, or by investing in the eurocurrency market. The corporations' banks, in turn, tried to match each foreign currency transaction with another contrary transaction in order not to leave each of the banks exposed to foreign exchange risk overnight. Since no single bank was likely to balance its foreign exchange positions exactly, the need arose to swap deposits in different currencies in order to match corporate hedging transactions and to square the bank's books.

The price of this forward cover on inter-bank transactions - that is to say, the premium or discount on a currency's spot value - has tended to accord with the differences between interest-rates offered for eurocurrency deposits in different currencies. This is the connection between the foreign exchange market and the short-term credit markets, between exchange rates and interest rates. Whenever exchange rates move up or down, therefore, their influence is immediately transmitted through the eurocurrency markets to the credit markets.

It is this scramble to avoid private risk that accounted for the dramatic rise in international financial movements following the demise of the Bretton Woods system. By 1973, daily foreign exchange trading around the world varied between $10 and $20 billion per day. This amount was approximately twice the value of world trade at the time. Bank of International Settlements data suggests that the daily average of foreign exchange trading had climbed by 1980 to about $80 billion, and that the ratio between foreign exchange trading and international trade was more nearly ten to one. The data for 1992 was $880 billion and fifty to one, respectively; for 1995, $l,260 billion and seventy to one; and for 2000, almost $1,800 and ninety to one.

There is very little doubt, therefore, that the lion's share of international financial flows is relatively short-run. Indeed, about eighty percent of foreign exchange transactions are reversed in less than seven business days. Only a very small proportion is used to finance international trade and direct foreign investment. The vast majority must be used with the expectation of gain or to avoid losses that may result from changes in the value of financial assets. In general terms, they are speculative, made in hope of capital gain or to hedge against potential capital loss, or to seek the gains of arbitrage based on slight differences in rates of return in different financial centers.

The power of financial actors17

Foreign exchange markets and markets for money and credit seem remote and abstract to most people. This section introduces the real institutions that operate these markets and assesses the nature of their power.

Commercial banks

They take deposits, lend money, and create credit to the extent their capitalization allows. In Europe, they tend to combine commercial and investment banking services, but in the U.S. and Japan they are still kept at least partially separate by regulation. The foreign exchange trading facilities of the largest commercial banks, e.g. Citibank and J.P.Morgan/Chase in the U.S., tend to dominate the market. The banking industry as a whole represents the largest pool of world financial capital.

Investment banks

They facilitate international payments, manage new issues of stocks and bonds, advise on mergers and acquisitions in all industries, and engage in securities and foreign exchange trading as allowed by law. Investment banks (previously called merchant banks in the U.K.) have specialized in particular kinds of derivative products. Derivatives are financial contracts whose value is based upon the value of other underlying financial assets such as stocks, bonds, mortgages or foreign exchange.

Brokerage houses

They handle the bulk of stock exchange transactions and a major part of foreign exchange transactions. Investment banks recently have acquired several of the main brokerage houses in the U.S. The development of investor-friendly methods of buying and selling securities, e.g., over-the-counter markets and electronic brokerage, also have diminished the role of independent brokerage houses.

Mutual funds

They are pools of funds provided by clients that are run by professional investment managers. These collective investments are held in portfolios with various mixes of money-market instruments, bonds and equities. Mutual funds account for the second largest pool of global financial capital.

Hedge funds

They resemble mutual funds, but they are much less restricted in investment activities and techniques. Their customers are high net-worth individuals and large institutional investors. They specialize in complex financial instruments and tend to take significant speculative positions, especially on expected future changes in macroeconomic conditions. They exploit arbitrage opportunities embedded in the relative prices of related securities. They frequent offshore centers and tax havens.

Tax havens

Offshore centers and tax havens shelter perhaps $10 trillion of wealth from capital and income taxation. The British Virgin Islands, the Bahamas, Bermuda, the Cayman Islands, Dublin and Luxembourg are among the most important. Many hedge funds are registered there.

Wealthy individuals

They are an important source of funds, as many of them invest their liquid funds in financial markets. They account for about eighty percent of hedge fund investors.

Private pension funds

They function like annuities, receiving funds today in return for a promise to pay future benefits. With large pools of funds to invest, they tend to depend on investment banks, mutual funds or hedge funds to supervise placement of their assets in global financial markets.

Insurance companies

They pool risks by selling protection against the loss of property, income, or life. Since the risks they insure have various durations, they call for varied investment strategies. A portion of their funds is invested in short-term financial instruments, often through mutual and hedge funds.

Transnational corporations

They produce and sell goods and services in a number of countries. Their finance departments seek the best ways to raise and transfer funds across borders, and administer the transfer prices18 of international trade conducted within the corporation. Some even have in-house corporate banks.

According to recent work by political scientists, the power of these financial actors is based in part on a complicated "process of multiplication" of loans, assets and transactions. Many investors in financial markets buy financial instruments on very thin margins, based on loans obtained by pledging the assets as collateral. This is called "leverage" in the jargon of financial markets. In turn, the borrowed funds are invested in other financial assets, multiplying the demand for credit and financial assets. As demand rises, more sophisticated financial assets are invented, including many forms of financial derivatives. A major portion of the accumulated debt remains serviceable only as long as the prices of most assets will rise or at least remain relatively stable. If prices turn down, they easily can lead to a chain-reaction. If investors respond instinctively like a herd, they will bring a far-reaching collapse that constitutes a crisis.

As the flow of financial assets climbs, some bankers, brokers, and managers of financial institutions become prominent players in the competition for investor dollars. Some become known for picking profitable places to invest and for promoting their selections successfully. This can influence markets if people have confidence in their advice. A notorious example of the influence of prominent players was the attack on British sterling in 1992 by George Soros' Quantum Fund. Believing that sterling was overvalued, the Fund quietly established credit lines that allowed it to borrow $15 billion worth of sterling and sell it for dollars at the then "overvalued" price. Its purpose, of course, was to pay back the loan with cheaper pounds after they had depreciated. Having gone long on dollars and short on sterling, Soros decided to speak up noisily. He publicized his short-selling and made statements in newspapers that the pound would soon be devalued. It wasn't long before sterling was devalued; he made $1 billion in profit.

The point can be made more generally: financial markets are subject to manipulation because they have become socially structured. Market leaders and financial gurus are admired and followed (at least until very recently). The heavyweights thus dominate the business. An obvious consequence of this is that there is a strong tendency in financial markets for further concentration of resources.

Another source of the power of financial actors is their obvious affinity for the rampant free-market philosophy of neo-liberalism. The freedom with which they move financial capital around depends, of course, on the market-friendly policies of the so-called Washington Consensus.19 As long as they are seen as part of the governing coalition, they derive special powers to regulate themselves rather than be controlled by an independent government agency or civil society. Their power also is reinforced by the activities of several collective associations of financial actors,20 which lobby on their behalf.

One more source of power for the financial actors is their knowledge that if they are big enough and sufficiently interlaced with other financial actors, then the "system" will keep them from failing. Consider the case of Long-term Capital Management, a hedge fund partnership started in 1994. It was able to borrow from various banks the equivalent of forty times its capitalization in order to make bets on changes in the relative prices of bonds in the U.S. and abroad. When the Russian government announced a devaluation and debt moratorium in August, 1998, it produced losses that the fund could not sustain. Nor could some of the banks that had loaned large amounts to the fund. Accordingly, the Federal Reserve Bank of New York, fearful that the risk to the entire system was too high, orchestrated a private rescue operation by fourteen banks and other financial institutions, which re-capitalized the company for $3.5 billion.

Financial actors also have the power indirectly to influence non-financial actors such as firms or states. By providing economic incentives to gamble and speculate on financial instruments, global financial markets divert funds from long-term productive investments. In all probability, they also encourage banks and financial institutions to maintain a regime of higher real interest rates that reduce the ability of productive enterprises to obtain credit. The volatility of global financial markets, moreover, brings uncertainty and volatility in interest rates and exchange rates that are harmful to various sectors of the real economy, particularly international trade.

The above stories about George Soros and Long-term Capital Management are good illustrations of the consequences for non-financial actors of actions by financial actors. Both episodes are examples of games that are basically zero-sum, at least in the short-run. Nothing new was produced; no new values were created. In the 1992 case about speculating against sterling, the Quantum Fund's profits were at the expense of the British government, especially the Bank of England, and British taxpayers. In 1998, the losses suffered by Long-term Capital Management came out of the pockets of the stockholders of the banks that bailed it out, as the stock-market value of their shares depreciated. Hence, the financial system tends to feed itself by drawing more resources from other sectors of the economy, undermining the vitality of the real economy.

Consequences of global financial flows

The dominant economic ideology of the last twenty-five years has been embodied in the so-called Washington Consensus. It is a "market-friendly" ideology that traces its roots to longstanding policies of the IMF that encourage macroeconomic "stabilization;" to adoption by the World Bank of ideas in vogue in Washington early in the Reagan period concerning deregulation and supply-side economics; to the zeal of the Thatcher government in England for privatizing public enterprises; and perhaps most of all to the neo-liberal tendencies of the business community and the economics profession in the U.S. The implementation of these policies of economic "reform," by first "stabilizing" the macro-economy and then "adjusting" the market so that it can perform more efficiently, are supposed to pay off in the form of faster output growth and rising real incomes

Among these policy prescriptions is financial liberalization in both the developed and the developing countries. Domestically it is achieved by weakening or removing controls on interest and credit and by diluting the differences between banks, insurance and finance companies. International financial liberation, on the other hand, demands removal of controls and regulations on both the inflows and outflows of financial instruments that move through foreign exchange markets. It is the implementation of these reforms that is perhaps the single most important cause of the surge in global financial flows. To be sure, the influence of technological advances has broken the natural barriers of space and time for financial markets as twenty-four hour electronic trading has grown. The fact that throughout most of the 1980s and 1990s the developed countries suffered from over-capacity and overproduction in manufacturing may also have led the owners of financial capital to look for alternative profit opportunities.

It now is time to ask whether the implementation of all these reforms, on balance, has produced good or bad results. The focus of this section will be mostly on the consequences of large and expanding international financial flows. After all, they are the main concern of this essay. But first, we should ask whether or not the policies of growth and rising real incomes promoted by the Washington Consensus have borne fruit.

Growth and income

There is little doubt that the introduction of the Washington Consensus' policy mix expanded the volume of international trade. As a result, trade in goods and services has grown at more than twice the rate of global gross domestic product (GDP), and developing countries' share of trade has risen from 23 to 29 percent. Increasing numbers of firms from developing countries, like their industrial-country counterparts, engage in transnational production and adopt a global perspective in structuring their operations. The flow of foreign direct investments and foreign portfolio investments has multiplied even more rapidly than trade, despite the financial instability experienced in Asia, Brazil, Russia, and elsewhere in recent years.

The effects of liberalization have not been uniformly favorable, however. After at least ten full years of experience with the Washington Consensus, several recent studies have begun to assess the consequences for developing countries of this experiment in more open markets.21 Except for the years of crisis in a number of the countries studied, most developing countries achieved moderate growth rates of gross domestic product in the 1990s - considerably higher than in the l980s in Africa and Latin America during the debt crisis, but remarkably unchanged in most other regions. Moreover, average annual growth in the 1990s was slightly lower than in the twenty-five years preceding the debt crisis when a strategy of substituting domestic production for imports was in fullest use. When population growth rates are taken into consideration, the growth rate of per capita income in the developing countries studied during the 1990s also was somewhat lower than in the 1960s and 1970s. Toward the end of the 1990s, growth tapered off in many countries due to emerging domestic financial crises or external events. There is little evidence in these figures, therefore, to suggest the strategy of liberalization boosted growth rates appreciably.

Nor did the distribution of income improve in most developing countries in the 1990s. On the contrary, virtually without exception the wage differentials between skilled and unskilled workers rose with liberalization. The reasons for this varied widely among countries, but one of the most important reasons was the fact that the number of relatively well-paid jobs in sectors of the economy involved with international trade, though growing, was insufficient to absorb available workers, forcing many workers into more precarious and poorly paid employment in the non-traded, informal trade, and service sectors or where traditional agriculture served as a sponge for the labor market. Between the mid-1960s and the late-1990s, the poorest 20 percent of the world population saw its share of income fall from 2.3 to 1.4 percent. Meanwhile, the share of the wealthiest quintile increased from 70 to 85 percent.22

Risk and reward

While all markets are imperfect and subject to failure, financial markets are more prone than others to fail because they are plagued with three particular shortcomings: asymmetric information, herd behavior and self-fulfilling panics. Asymmetric information is a problem whenever one party to an economic transaction has insufficient information to make rational and consistent decisions. In most financial markets where borrowing and lending take place, borrowers usually have better information about the potential returns and risks associated with the investments to be financed by the loans than do the lenders. This becomes especially true as financial transactions disperse across the globe, often between borrowers and lenders of widely different cultures.

Asymmetric information leads to adverse selection and moral hazard. Adverse selection occurs when, say, lenders have too little information to choose from among potential borrowers those who are most likely to use the loans wisely. The lenders' gullibility, therefore, attracts more unworthy borrowers. Moral hazard occurs when borrowers engage in excessively risky activities that were unanticipated by lenders and lead to significant losses for the lender. Yet another form of moral hazard occurs when lenders indulge in lending indiscriminately because they assume that the government or an international institution will bail them out if the loans go awry.

A good illustration of asymmetric information is the story of bank lending following OPEC's large increase in oil prices following 1973. Awash in cash, the oil exporters deposited large amounts in commercial banks that then perfected the Euro-currency loan for developing countries. Eager to put excess reserves to use, the banks spent little time discriminating among potential borrowers, in part because they believed host governments or international agencies would guarantee the loans. At the same time, developing countries found they could readily borrow not only to import oil, but also to increase other kinds of expenditures. This meant they could use borrowed funds to maintain domestic spending rather than be forced to adjust to the new realities of higher prices for necessary imports. There is considerable evidence that moral hazard also was present in the Mexican crises in 1982 and 1994, and in the Southeast Asian crises in 1997-8.

Yet another illustration of asymmetric information is the tendency of financial firms, especially on Wall Street and in the City of London, to invent ever more complex derivatives to shift risk around the financial system. The market for these products is growing rapidly, both on futures and options exchanges (two of the several places where derivatives are traded). A financial engineer, for example, can take the risk in, say, a bond and break it down into a series of smaller risks, such as that inflation will reduce its real value or that the borrower will default. These smaller risks can then be priced and sold, using derivatives, so that the bondholder keeps only those risks he wishes to bear. But this is not a simple task, particularly when it involves assets with risk exposures far into the future and which are traded so rarely that there is no good market benchmark for setting the price. Enron, for instance, sold a lot of these sorts of derivatives, booking profits on them immediately even though there was a serious doubt about their long-term profitability. Stories of huge losses incurred in derivative trading are legion. The real challenge before central banks and regulatory bodies is to curb speculative behavior and bring discipline in derivative markets.

A second source of risk in financial markets is the tendency of borrowers and lenders alike to engage in herd behavior. John Maynard Keynes, writing in the 1930s, suggested that financial markets are like "beauty contests." His analogy was to a game in the British Sunday newspapers that asked readers to rank pictures of women according to their guess about the average choice by other respondents. The winner, therefore, does not express his own preferences, but rather anticipates "what average opinion expects average opinion to be." Accordingly, Keynes thought that anyone who obtained information or signals that pointed to swings in average opinion and to how it would react to changing events had the basis for substantial gain. Objective information about economic data was not enough. Rather, simple slogans "like public expenditure is bad," "lower unemployment leads to inflation," "larger deficits lead to higher interest rates," were then the more likely sources of changes in public opinion. What mattered was that average opinion believed them to be true, and that advance knowledge of, say, more public spending, lower unemployment, or larger deficits, respectively, offered the speculator a special advantage.

A financial market that operates as a beauty contest is likely to be highly unstable and prone to severe changes. One reason for this is that people trading in financial assets, even today, know very little about them. People who hold stock know little about the companies that issued them. Investors in mutual funds know little about the stocks their funds are invested in. Bondholders know little about the companies or governments that issued the bonds. Even knowledgeable professionals are often more concerned with judging how swings in conventional opinion might change market values rather than with the long-term returns on investments. Indeed, since careful analysis of risks and rewards is costly and time consuming, it often makes sense for fund managers and traders to follow the herd. If they decide rationally not to follow the herd, their competence may be seriously questioned. On the other hand, if fund managers follow the herd and the herd suffers losses, few will question their competence because others too suffered losses. When financial markets are operated like a beauty contest, everyone wants to sell at the same time and nobody wants to buy.

The financial markets behaved as predicted shortly after several industrial countries, including the U.S. and Germany, abolished all restrictions on international capital movements in 1973. The new system proved to be highly volatile, with exchange rates, interest rates, and financial asset-prices subject to large short-term fluctuations. The markets also were susceptible to contagion when financial tremors spread from their epicenter to other countries and markets that seemingly had little connection with the initial problem. In less than five years, it already was clear that both the surpluses and the deficits on the major countries' balance of payments were getting larger, not smaller, despite significant changes in the exchange rates.

In some cases, a financial crisis can be self-fulfilling. A rumor can trigger a self-fulfilling speculative attack, e.g. on a currency, that may be baseless and far removed from the economic fundamentals (unlike the Soros story above). This can cause a sudden shift in the herd's intentions and lead to unanticipated market movements that create severe financial crises. Consider, for example, the succession of major financial crises that have pock-marked the recent history of international financial markets, including Latin America's Southern Cone crisis of 1979-81, the developing-country debt crisis of 1982, the Mexican crisis of 1994-95, the Asian crisis of 1997-98, the Russian crisis of 1998, the Brazilian crisis of 1999, and the Argentine crisis of 2001-02.

Perhaps the Asian crisis of 1997-98 is the most interesting in this regard, for there were relatively few signals beforehand of impending crisis. All the main East Asian economies displayed in 1994-96 low inflation, fiscal surpluses or balanced budgets, limited public debt, high savings and investment rates, substantial foreign exchange reserves and no signs of deterioration before the crisis. This background has led many analysts to suppose that the crisis was a mere product of the global financial system. But what could have triggered the herd to stampede out of Asian currencies? No doubt several factors were at work. Before the crisis that started in the summer of 1997, there was a rise in short-term lending to Asians by Western and Japanese banks with little or no premiums, a fact that the Bank for International Settlement raised questions about. Alert investors, especially hedge funds, also noticed that substantial portions of East and Southeast Asian borrowings were going into non-productive assets and real estate that often were linked to political connections. In fact, some of the funds pouring into non-productive assets were coming out of the productive sector, mortgaging the longer-term viability of some real economies. Information about the structure and policies of financial sectors was opaque. Thus, opinions began to change among key lenders about the regulation of financial sectors in several Asian countries and their destabilizing lack of transparency. Suddenly, several important hedge funds reduced their exposure by shorting currency futures, followed quickly by Western mutual funds. The calling of loans led quickly to deep depression in several Asian countries. It has been estimated that the Asian crisis and its global repercussions cut global output by $2 trillion in 1998-2000.

Loss of government autonomy

Both economic theory and the experience of managing the external financial affairs of nations tell us that it is virtually impossible to maintain (1) full financial mobility, (2) a fixed exchange rate, and (3) freedom to seek macro-economic balance (full employment with little inflation) with appropriate monetary and fiscal policies. Only two of these policy objectives can be consistently maintained. If the authorities try to pursue all three, they will sooner or later be punished by destabilizing financial flows, as in the run up to the Great Depression around 1930 and in the months before sterling's collapse 1992. If a government tries to stimulate its economy with lax monetary policy, for example, and players with significant market power like George Soros sense that at a fixed exchange rate, foreigners will be unwilling to lend enough to finance the country's current account deficit, they will begin to flee the home currency in order to avoid the capital losses they will suffer if and when there is a devaluation. If reserve losses accelerate and more players follow suit, crisis ensues. The authorities are forced to devalue, interest rates soar, and the successful attackers sit back to count their profits.

For nations wishing to retain reasonably independent monetary and fiscal authority in order to cater to domestic needs, the solution is to allow the exchange rate to move up or down as conditions in the foreign exchange markets dictate, or to establish some sort of control over the movement of financial instruments in and out of the country, or to devise some combination of these two adjustment mechanisms. The debate over whether fixed or flexible exchange rates is the wiser policy continues to rage in academic quarters and in finance ministries all over the world. For the most part, the international business community prefers reasonably fixed exchange rates in order to minimize their costs of hedging foreign currency positions. Thus instituting some form of control over speculative financial movements may be an appropriate solution to the "trilemma."

The capacity of a nation to levy enough taxes to finance needed public expenditures is another important reason to retain independent authority. A central function of government has been to insulate domestic groups from excessive market risks, particularly those originating in international transactions. This is the way governments have maintained domestic political support for liberalizing trade and finance throughout the postwar period. Yet many governments are less able today to help citizens that are injured by freer markets with unemployment compensation, severance payments, and adjustment assistance because the slightest hint of raising taxes to pay for these vital public services leads to capital flight in a world of heightened financial mobility.

This is a dilemma. Increased integration into the world economy has raised the need of governments to redistribute tax revenues or implement generous social programs in order to protect the vast majority of the population that remains internationally immobile. At the same time, governments find themselves less able to maintain the safety nets needed to preserve social stability. It seems reasonable to suppose, therefore, that doing things that will bolster the ability of governments to levy sufficient taxes - curbing tax avoidance by transnational corporations, controlling offshore tax havens, regulating capital flight - would help make globalization slightly more democratic.

Winners and losers

The people who benefit from speculative financial movements are, for the most part, better educated and wealthier than the vast majority of fellow citizens. They are the elites, whatever the country. As noted above, they have fewer connections to the real economy of production and exchange than most people. And their purpose in trading financial assets, again for the most part, is to make a profit quickly rather than wait for an investment project to mature.

People who do not participate directly in the buying and selling of short-term financial instruments are nonetheless influenced indirectly by the macroeconomic instability and contagion that often accompany interruptions in financial market flows. This is true for people both in developed and developing countries. In developed countries, the voracious appetite of financial markets for more and more resources saps the vitality of the real economy - the economy that most people depend upon for their livelihood. It has been shown that real interest rates rise as a result of the expansion of speculative financial markets. This rise in real interest rates, in turn, dampens real investment and economic growth while serving to concentrate wealth and political power within a growing worldwide rentier class (people who depend for their income on interest, dividends, and rents).23 Rather, the long-term health of the economy depends upon directing investable funds into productive investments rather than into speculation.

In developing countries, attracting global investors' attention is a mixed blessing. Capital market inflows provide important support for building infrastructure and harnessing natural and human resources. At the same time, surges in money market inflows may distort relative prices, exacerbate weakness in a nation's financial sector, and feed bubbles. As the 1997 Asian crisis attests, financial capital may just as easily flow out of as into a country. Unstable financial flows often lead to one of three kinds of crises:

  • Fiscal crises. The government abruptly loses the ability to roll over foreign debts and attract new foreign loans, possibly forcing the government into rescheduling or default of its obligations.
  • Exchange crises. Market participants abruptly shift their demands from domestic currency assets to foreign currency assets, depleting the foreign exchange reserves of the central bank in the context of a pegged exchange rate system.
  • Banking crises. Commercial banks abruptly lose the ability to roll over market instruments (i.e., certificates-of-deposit) or meet a sudden withdrawal of funds from sight deposits, thereby making the banks illiquid and possibly insolvent.

Although these three types of crises sometimes appear singly, they more often arrive in combination because external shocks or changed market expectations are likely to occur simultaneously in the market for government bonds, the foreign exchange market, and the markets for bank assets. Approximately sixty developing countries have experienced extreme financial crises in the past decade.24

The vast majority of people in the developing world suffer from these convulsive changes. They are tired of adjusting to changes over which they exercise absolutely no control. Most people in these countries view Western capitalism as a private club, a discriminatory system that benefits only the West and the elites who live inside "the bell jars" of poor countries. Even as they consume the consumer goods of the West, they are quite aware that they still linger at the periphery of the capitalist game. They have no stake in it, and they believe that they suffer its consequences. As Hernando deSoto puts it, "Globalization should not be just about interconnecting the bell jars of the privileged few."25

Social solidarity

Karl Polanyi in The Great Transformation sought to explain how the "liberal creed" contributed to the catastrophes of war and depression associated with the first half of the twentieth century. Polanyi's central argument, which in fact can be traced back to Adam Smith, is that markets do indeed promote efficiency and change, but that they achieve this through undermining social coherence and solidarity. Markets must therefore be embedded within social institutions that mitigate their negative consequences.

The evidence of more recent times suggests that the global spread of free-market policies has been accompanied by the decline of countervailing institutions of social solidarity. Indeed, a main feature of the introduction of market-friendly policies has been to weaken local institutions of social solidarity. Consider, for example, the top-down policy prescriptions of the IMF and World Bank during the developing world's debt crisis in the 1980s. These policies evolved into an intricate web of expected behaviors by developing countries. In order for developing countries to expect private businesses and financial interests to invest funds within their borders and to boost the growth potential of domestic economies, they needed to drop the "outdated and inefficient" policies that dominated development strategies for most of the postwar period and adopt in their place policies that are designed to encourage foreign trade and freer financial markets. Without significant adjustments in the ways economies were managed, it was suggested, nations soon would be left behind.

The list of Washington Consensus requirements was long and daunting:

  • Make the private sector the primary engine of economic growth
  • Maintain a low rate of inflation and price stability
  • Shrink the size of the state bureaucracy
  • Maintain as close to a balanced budget as possible, if not a surplus
  • Eliminate or lower tariffs on imported goods
  • Remove restrictions on foreign investment
  • Get rid of quotas and domestic monopolies
  • Increase exports
  • Privatize state-owned industries and utilities
  • Deregulate capital markets
  • Make currency convertible
  • Open industries, stock, and bond markets to direct foreign ownership
  • Deregulate the economy to promote domestic competition
  • Eliminate government corruption, subsidies and kickbacks
  • Open the banking and telecommunications systems to private ownership and competition
  • Allow citizens to choose from an array of competing pension options and foreign-run pension and mutual funds.

In a provocative article, Ute Pieper and Lance Taylor point out that market outcomes often conflict with other valuable social institutions. In addition, they emphasize that markets function effectively only when they are "embedded" in society. The authors then look carefully at the experience of a number of developing countries as they struggled to comply with the policy prescriptions of the IMF and the Fund. In almost every case, they demonstrate conclusively that the impact of these efforts was to make society an "adjunct to the market."26

An appropriate balance is not being struck between the economic and non-economic aspirations of human beings and their communities. Indeed, the evidence is mounting that globalization's trajectory can easily lead to social disintegration - to the splitting apart of nations along lines of economic status, mobility, region, or social norms. Globalization not only highlights and exacerbates tensions among groups; it also reduces the willingness of internationally mobile groups to cooperate with others in resolving disagreements and conflicts.

Policy options

History confirms that free-markets are inherently volatile institutions, prone to speculative booms and busts. Overshooting, especially in financial markets, is their normal condition. To work well, free markets need not only regulation, but active management. During the first half of the post-war era, world markets were kept reasonably stable by national governments and by a regime of international cooperation. Only lately has a much earlier idea been revived and made an orthodoxy - the idea adopted by the Washington Consensus that, provided there are clear and well-enforced rules-of-the-game, free markets can be self-regulating because they embody the rational expectations that participants form about the future.

On the contrary, since markets are themselves shaped by human expectations, their behavior cannot be rationally predicted. The forces that drive markets are not mechanical processes of cause and effect, as assumed in most of economic theory. They are what George Soros has termed "reflexive interactions."27 Because markets are governed by highly combustible interactions among beliefs, they cannot be self-regulating.

The question before us then, is what could be done to better regulate financial markets and to bring active management back into the task of "embedding" markets in society, rather than the other way around? Monetary authorities such as the Federal Reserve System in the U.S. and the central banks of other countries were formed long ago in order to dampen the inherent instabilities of financial market in their home countries. But the evolution of an international regulatory framework has not kept pace with the globalization of financial markets. The International Monetary Fund was not designed to cope with the volume and instability of recent financial trends.

Capital controls

Given the problems outlined above about short-term speculative financial transactions, one might wonder why national policy-makers have not insulated their financial markets by imposing some sort of control over financial capital. The answer, of course, is that some have continued trying to do so despite discouragement from the IMF. For example, some have put limitations on the quantity, conditions, or destinations of financial flows. Others have tried to impose a tax on short-term borrowing by national firms from foreign banks. This is said to be "market-based" because it operates by altering the cost of foreign funds. If such transactions were absolutely prohibited, they would be called "non-market" interventions.

A more extreme form of financial capital controls, one that controls movement of foreign exchange across international borders, also has been tried in a number of countries. This form of control requires that some if not all foreign currency inflows be surrendered to the central bank or a government agency, often at a fixed price that differs from that which would be set in free market. The receiving agency then determines the uses of foreign exchange. The absence of exchange controls means that currencies are "convertible."

The neo-liberal argument opposing financial capital controls asserts that their removal will enhance economic efficiency and reduce corruption. It is based on two basic propositions in economic theory that depend for their proof on perfectly competitive markets in the real economy and perfectly efficient gatherers and transmitters of information in financial markets. Neither assumption is realistic in today's world. Indeed, a number of empirical studies have reported the effectiveness of capital controls in controlling capital flight, curbing volatile capital flows and protecting the domestic economy from negative external developments.

Developing countries have only recently abandoned, or still maintain, a variety of control regimes. Latin American countries traditionally have used market-based controls, putting taxes and surcharges on selected financial capital movements or tying them up in escrow accounts. Non-market based restrictions were more common in Asia until the early 1990s. Many commentators believe that their sudden removal in the early 1990s was a contributing cause to the Asian financial crises in 1997-8. The experience of two countries, Malaysia and Chile, with capital controls is especially instructive.

Malaysia, unlike its Asian neighbors, was reluctant to remove its restrictions on external borrowing by national firms unless they could show how they could earn enough foreign exchange to service their debts. Then when the Asian crises hit, its government imposed exchange controls, in effect making its local currency that was held outside the country inconvertible into foreign exchange. After the ringget was devalued, exporters were required to surrender foreign currency earnings to the central bank in exchange for local currency at the new pegged rate. The government also limited the amount of cash nationals could take abroad, and it prohibited the repatriation of earnings on foreign investments that had been held for less than one year. Thus, Malaysia's capital controls were focused mostly on controlling the outflow of short-term financial transactions. Happily, the authorities were able to stabilize the currency and reduce interest rates, leading to a degree of domestic recovery.28

Chile, on the other hand, tried to limit the inflow of short-term financial transactions. It did so by imposing a costly reserve requirement on foreign-owned capital held in the country for less than one year. Despite attempts to stimulate foreign direct investment of the funds, most of the reserve deposits were absorbed in the form of increased reserves at the central bank. In turn, this created a potential for expanding the money supply, which the government feared would lead to inflation. Rather than allow this to happen, the government "sterilized" the inflows by selling government bonds from its portfolio. But this pushed down the prices of bonds and pushed up the interest rates on them, discouraging business investment. Finally, when prices of copper (Chile's primary export) fell sharply in 1998, the control regime was scrapped.29

The tobin tax

A global tax on international currency movements was first proposed by James Tobin, a Yale University economist, in 1972.30 He suggested that a tax of one-quarter to one percent be levied on the value of all currency transactions that cross national borders. He reasoned that such a tax on all spot transactions would fall most heavily on transactions that involve very short round-trips across borders. In other words, it would be speculators with very short time-horizons that the tax would deter, rather than longer-term investors who can amortize the costs of the tax over many years. For example, the yearly cost of a 0.2 percent round trip tax would amount to 48 percent of the value of the traded amount if the round trip were daily, 10 percent if weekly and 2.4 percent if monthly. Since at least eighty percent of spot transactions in the foreign exchange markets are reversed in seven business days or less, the tax could have a profound effect on the costs of short-term speculators.

Of course, for those who believe in the efficiency of markets and the rationality of expectations, a transactions tax would only hinder market efficiency. They argue that speculative sales and purchases of foreign exchange are mostly the result of "wrong" national monetary and fiscal policies. While we readily admit that national policies sometimes do not accord with desired objectives, they nonetheless have little relevance for speculators focused on the next few seconds, minutes or hours.

Tobin did not intend for his proposal to involve a supranational taxation authority. Rather, governments would levy the tax nationally. In order to make the tax rate uniform across countries, however, an international agreement would have to be entered into by at least the principal financial centers. The revenue obtained from the tax could be designated for each country's foreign exchange reserve for use during periods of instability, or it could be directed into a common global fund for uses like aid to the poorest nations. In the latter case, the feasibility of the tax also would depend on an international political agreement. The revenue potential is sizeable, and could run as high as $500 billion annually.

There are two other advantages often cited by proponents of the Tobin tax. Tobin's original rationale for a foreign exchange transactions tax was to enhance policy autonomy in a world of high financial capital mobility. He argued that currency fluctuations often have very significant economic and political costs, especially for producers and consumers of traded goods. A Tobin tax, by breaking the condition that domestic interest rates may differ from foreign interest rates only to the extent that the exchange rate is expected to change (see p. 10), would allow authorities to pursue different policies than those prevailing abroad without exposing them to large exchange rate movements. More recent research suggests that this is only a very modest advantage.31

An additional advantage of the tax is that it could facilitate the monitoring of international financial flows. The world needs a centralized data-base on all kinds of financial flows. Neither the Bank for International Settlements nor the IMF has succeeded in providing enough information to monitor them all. This information should be regularly shared among countries and international institutions in order to collectively respond to emerging issues.

The feasibility issues raised by the Tobin tax are more political than technical. One of the issues is about the likelihood of evasion. All taxes suffer some evasion, but that has rarely been a reason for avoiding them. Ideally all jurisdictions should be a party to any agreement about a common transactions tax, since the temptation to trade through non-participating jurisdictions would be high. Failing that, one could levy a penalty on transactions with "Tobin tax havens" of, say, double the normal tax rate. Moreover, one could limit the problem of substituting untaxed assets for taxed assets by applying the tax to forwards, swaps and possibly other contracts.

Tobin and many others have assumed that the task of managing the tax should be assigned to the IMF. Others argue that the design of the tax is incompatible with the structure of the IMF and that the tax should be managed by a new supranational body. Which view will prevail depends upon the resolution of other outstanding issues. The Tobin tax is an idea that deserves careful consideration. It should not be dismissed as too idealistic or too impractical. It addresses with precision the problems of excessive instability in the foreign exchange markets, and it yields the additional advantage of providing a means to assist those in greater need.

Reforming the IMF

The IMF was established in 1944 to provide temporary financing for member governments to help them maintain pegged exchange rates during a period of internal adjustment. With the collapse of the pegged exchange rate regime in 1971, that responsibility has been eclipsed by its role as central arbiter of financial crises in developing countries. As noted above (p. 20), these crises may be of three different kinds: fiscal crises, foreign exchange crises, and banking crises.

Under current institutional arrangements, a nation suffering a serious fiscal crisis that could easily lead to default must seek temporary relief from its debts from three different (but interrelated) institutions: the IMF, which is sometimes willing to renegotiate loans in return for promises to adopt more stringent policies (see above); the so-called Paris Club that sometimes grants relief on bilateral (country to country) credits; and the London Club that sometimes gives relief on bank credits. This is an extremely cumbersome process that fails to provide debtor countries with standstill protection from creditors, with adequate working capital while debts are being renegotiated, or with ways to ensure an expeditious overall settlement. The existing process often takes several years to complete.

There is a growing consensus that this problem is best resolved with creation of a new international legal framework that provides for de facto sovereign bankruptcy. This could take the form of an International Bankruptcy Code with an international bankruptcy court, or it could involve a less formal functional equivalent to its mechanisms: automatic standstills, priority lending, and comprehensive reorganization plans supported by rules that do not require unanimous consent. Jeffrey Sachs recommends, for example, that the IMF issue a clear statement of operating principles covering all stages of a debtor's progression through "bankruptcy" to solvency. A new system of emergency priority lending from private capital markets could be developed, he suggests, under IMF supervision. He also feels that the IMF and member governments should develop model covenants for inclusion in future sovereign lending instruments that allow for priority lending and speedy renegotiation of debt claims.32

At the Joint Meeting of the IMF and the World Bank in September, 2002, the policy committee directed the IMF staff to develop by April, 2003, a "concrete proposal" for establishing an internationally recognized legal process for restructuring the debts of governments in default. It also endorsed efforts to include "collective action" clauses in future government bond issues to prevent one or two holdout creditors from blocking a debt-restructuring plan approved by a majority of creditors. The objective of both proposals is to resolve future debt crises quickly and before they threaten to destabilize large regions, as happened in Southeast Asia in 1997-98.

Member countries rarely receive support from the IMF any longer to maintain a particular nominal exchange rate. Because financial capital is so mobile now, pegged exchange rates probably are unsupportable. But there are special times when the IMF still might give such support during a foreign exchange crisis. International lending to support a given exchange rate is legitimate if the government is trying to establish confidence in a new national currency, or if its currency is recovering from a severe bout of hyperinflation. Ordinarily the foreign exchange should be provided from an international stabilization fund supervised by the IMF.

National central banks usually supervise and regulate the domestic banking sector. Thus, banking crises normally are handled by domestic institutions. This may not be possible, however, if the nation's banks hold large short-term liabilities denominated in foreign currencies. If the nation's central bank has insufficient reserves of foreign currencies to fund a large outflow of foreign currencies, there may be circumstances when the IMF or other lenders may wish to act as lenders-of-last-resort to a central bank under siege. Nations like Argentina that have engaged in "dollarization" are learning about the downside risks of holding large liabilities denominated in foreign currencies. The best way to avoid this problem is for governments and central banks to restrict the use of foreign currency deposits or other kinds of short-term foreign liabilities at domestic banks.

Overall, what is most needed is the availability of more capital in developing countries and much quicker responses, amply funded, to emerging financial crises.. George Soros has argued powerfully that the IMF needs to establish a better balance between crisis prevention and intervention.33 The IMF has made some progress in prevention by introducing Contingency Credit Lines (CCLs). The CCL rewards countries that follow sound policies by giving them access to IMF credit lines before rather than after a crisis erupts. But CCL terms were set too high and there have been no takers. Soros also has recommended the issuance of Special Drawing Rights (SDRs) that developed-countries would donate for the purpose of providing international assistance. Its proceeds would be used to finance "the provision of public goods on a global scale as well as to foster economic, social, and political progress in individual countries."34

A growing number of civil society institutions, however, oppose giving more money to the IMF unless it is basically reformed. They point out that it is a committed part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. They see the IMF as an instrument of the U.S. government and its corporate allies. The conditions it attaches to loans for troubled countries often do more to protect the interests of first world investors than to promote the long-term health of the developing countries. The needed chastening of speculative investors does not occur under these circumstances. There is evidence that in several major crises, IMF requirements for assisting nations have in fact worsened the situation and protracted the crises. The IMF opposed the policies that enabled Malaysia to weather the crisis in Southeast Asia, for example, while it urged the failed policies of other Southeast Asian nations. The vast literature cited by Pieper and Taylor (p. 22) is a convincing chronicle of earlier missteps. For such reasons as these, some civil society institutions argue that, unless IMF policies are changed, giving the institution more money will do more harm than good.

Fortunately, the IMF's policies are beginning to change, partly as a result of criticisms by civil society institutions, but more through recognition of the seriousness of the problems with the present system. In the wake of recent financial crises, leaders in the IMF as well as the World Bank are looking for ways to reform the international financial architecture. Arguably, their emphasis is shifting away from slavish devotion to the prescriptions of the Washington Consensus and toward more state intervention in financial markets. Joseph Stiglitz, the Nobel Laureate who has been particularly critical of the IMF, nonetheless acknowledges that its policy stances are improving.35

The IMF has begun to recognize the importance of at least functional public interventions in markets and the need to provide more supporting revenues. It has realized that controls on external financial movements and prudent regulation can help contain financial crises. It has abandoned the doctrine, long the backbone of structural adjustment policies, that raising the local interest rate will stimulate saving and thereby growth. Both the IMF and the World Bank have rolled over or forgiven the bulk of official debt owed by the poorest economies.

Whether these and other promising changes in IMF thinking and policy formation are sufficient to assure that its future responses to crises will be benign still is not clear. While celebrating what they view as belated improvements, many critics of the IMF among civil society institutions are not convinced that they are sufficiently basic. Even if the IMF avoids repeating some of its more egregious mistakes, some believe that it is likely to continue to function chiefly for the benefit of the international financial community rather than the masses of people. Rather, they believe that, at least in the long term, it would be much better for control over international finance to reside in new institutions under a restructured United Nations. They favor the U.N. because it has a broader mandate, is more open and democratic, and, in its practice, has given much greater weight to human, social, and environmental priorities.

Many civil society institutions want the primary focus of reform to be on taming speculation, restoring the control of their economies to nations, and embedding economies in the wider society. They believe that if these policies are adopted there will be less need for large funding to deal with financial crises. There remains, however, the fact that such crises are occurring and will continue to occur for some time. The IMF is the only institution positioned to respond to these crises. Hence, even for those who sympathize with the goals of the civil society institutions, there is a strong argument for more financing for the IMF.

A world financial authority

A variety of public and private citizens and institutions have recently proposed the establishment of a World Financial Authority (WFA) to perform in the domain of world financial markets what national regulators do in domestic markets. Some believe it should be built upon the foundation of global financial surveillance and regulation that have already been laid by the Bank for International Settlements in Basel, Switzerland. Others regard it as a natural extension of the activities of the IMF. Still others are less interested in the precise institutional form it would take than in the clear delineation of the tasks that need to be done by someone.

Its first task probably should be to provide sufficient and timely financial assistance during crises to avert contagion and defaults. This requires a lender-of-last-resort with sufficient resources and authority to disperse rescue money quickly. Perhaps the best example to date is the bailout loan to Mexico by the U.S. Treasury and the IMF at the end of 1994. It supplied sufficient liquidity for Mexico to make the transition back to stability and to pay back the loans ahead of time. The management of the Asian crises in 1997-8, on the other hand, was badly handled. The bailout packages offered by the IMF were not only significantly smaller than in the Mexico case; they also were constrained with so many conditions that a year later only twenty percent of the funds had been disbursed. This slow response to the crisis probably worsened the contagion. Surprisingly, the error was repeated in the Russian crisis in 1998 and the Brazilian crisis in 1999.

A World Financial Authority also should provide the necessary regulatory framework within which the IMF or a successor institution can develop as a lender-of-last-resort. As long as domestic regulatory procedures function properly, there will be no need for a world authority to be involved, any more than to certify that domestic regulatory procedures are effective. In countries where domestic financial regulation is unsatisfactory, the WFA would assist with regulatory reform. In this way, the WFA could aid financial reconstruction, reduce the likelihood of moral hazard, and give confidence to backers of the operation.

There is little appetite today, especially in Washington, to create a new international bureaucracy. This fact gives support to the idea of building the WFA from the existing infrastructure of the Bank for International Settlements (BIS). The BIS is a meeting place for national central bankers who have constructed an increasingly complicated set of norms, rules and decision-making procedures for handling and preventing future crises. Its committees and cooperative cross-border regulatory framework enjoy the confidence of governments and of the financial community. It may well be the best place to govern an international regulatory authority at the present time.

Theological and ethical considerations

While Christian theology cannot provide us with detailed recommendations on how to correct the adverse consequences of speculative financial movements, it can provide us with an empowering perspective or worldview. Our theological expressions of the faith describe the source of our spiritual energy and hope. They betray our ultimate values and the source of our ethical norms. They shape how we perceive and judge the "signs of the times."

God's world and human responsibilities

Nothing in creation is independent of God. "The earth is the Lord's and all that is in it, the world, and all those who live in it." (Ps. 24:1 NRSV) Thus, no part of the creation - whether human beings, other species, the elements of soil and water, even human-made things - is our property to use as we wish. All is to be treated in accord with the values and ground rules of a loving God, their ultimate owner, who is concerned for the good of the whole creation. All of God's creation therefore deserves to be treated with appropriate care and concern, no matter how remote from one's daily consciousness or existence.

The doctrine of creation reminds us that our ultimate allegiance is not to the nationalistic and human-centered values of our culture, but rather to the values of the loving Maker of heaven and earth. When we seek plenty obsessively, consume goods excessively, compete against others compulsively, or commit ourselves to Economic Fate, we are worshiping false gods. Modern idolatries are often encountered in economic forms, just as in the New Testament's warnings about the spiritual perils of prosperity in the parables of the rich, hoarding fool (Luke 12:15-21) and the rich youth (Matt. 19:16-24 and Luke 18:18-25).

The fact that so much of financial speculation is divorced from the real economy of production and exchange suggests that its paper transactions are more like bets in a casino than an essential component of God's real economy, which seeks the good of all creation. It is wrong to subject people to the effects of wholesale gambling. The fact that the practice of financial speculation is secretive, compulsively competitive, and frequented by lone rangers, moreover, hints at a cult of false idols. Its practitioners, including especially day-traders, seem interested only in exceedingly short-term personal financial advantage, unconcerned about the long-term consequences of their actions or their impact on others. This also indicates a degree of idolatry that contradicts the doctrine of creation.

Image of God

The conviction that human beings have a God-given dignity and worth (Gen. 1:26-28) unites humanity in a universal covenant of rights and responsibilities - the family of God. All humans are entitled to the essential conditions for expressing their human dignity and for participation in defining and shaping the common good. These rights include satisfaction of basic biophysical needs, environmental safety, full participation in political and economic life, and the assurance of fair treatment and equal protection of the laws. These rights define our responsibilities in justice to one another, locally, nationally and - because they are human rights - internationally.

Financial speculation often leads to unmanageable floods of funds into and out of host societies, creating unwanted bubbles and panics. Financial speculators normally ignore the human consequences of their activities on the rights of people in host societies, where economic adjustments are shared widely and painfully. Their primary interest is short-term personal financial gain. The absence of a sense of covenantal unity with their brothers and sisters of the developing world is a sad commentary on the governing ethic of speculators in the capital markets. Their arrogance calls for some form of control over foreign exchange and financial capital markets.

Justice in covenant

The rights and responsibilities associated with the image of God are inextricably tied to the stress on justice in Scripture and tradition. We render to others their due because of our loving respect for their God-given dignity and value. The God portrayed in Scripture is the "lover of justice" (Ps. 99:4, 33:5, 37:28, 11:7; Isa. 30:18, 61:8; Jer. 9:24). Justice is at the ethical core of the biblical message. Faithfulness to covenant relationships, moreover, demands a justice that recognizes special obligations, "a preferential option" to widows, orphans, the poor, and aliens, which is to say the economically vulnerable and politically oppressed. Hence, the idea of the Jubilee Year (Lev. 25) was meant to prevent unjust concentrations of power and poverty. Jesus' ministry embodies concern for the rights and needs of the poor; He befriended and defended the dispossessed and the outcasts.

The fact that the liberalization of trade and finance has failed to improve the distribution of incomes, indeed, that it has widened the gap between rich and poor in virtually every country, is not a sign of distributive justice but of its opposite. The standard of living for the least skilled, least mobile, and poorest citizens of many developing countries has declined absolutely. This, too, is an unjust result of a broken system. The fact that governments that wish to assist the vulnerable and weak of their societies are less able to do so, in part because they no longer can levy sufficient taxes on foreign interests, is a violation of justice in community.

Sin and judgment

Sin is a declaration of autonomy from God, a rebellion against the sovereign source of our being. It makes the self and its values the center of one's existence, in defiance of God's care for all. Sin tempts us to value things over people, measuring our worth by the size of our wealth and the quantity of goods we consume, rather than by the quality of our relationships with God and with others. Sin involves injustice because its self-centeredness defies God's covenant of justice, grasping more than one's due and depriving others of their due.

Sin is manifested not only in individuals, but also in social institutions and cultural patterns. These structural injustices are culturally acceptable ways of giving some individuals and groups of people advantage over others. Because they are pervasive and generally invisible, they compel our participation. They benefit some and harm many others. Whether or not we deserve blame as individuals and churches for these social sins depends in part on whether we defend or resist them, tolerate or reject them.

The fact that the freeing of financial markets has permitted financial speculators to engage in high-risk gambles without regard to the consequences for others is abundant evidence of both individual and institutional sin. The policies of the Washington Consensus frequently lead to adverse consequences for the poor and the environment, even as its proponents gain advantages from the implementation of such policies. They are another serious expression of social sin in our time. These policies inevitably increase the concentration of economic power in fewer hands. The fact that the global spread of free-market policies has led to the decline of countervailing institutions of

social solidarity means that it is easier for the centers of economic power to corrupt governments, control markets, alienate neighbors, manipulate public opinion, and contribute to a sense of political impotency in the public.

The Church's mission and hope

The church is called to be an effective expression of the Reign of God, which Jesus embodied and proclaimed. This ultimate hope is a judgment on our deficiencies

and a challenge to faithful service. God's goal of a just and reconciled world is not simply our final destiny but an agenda for our earthly responsibilities. We are called to be a sign of the Reign of God, on earth as it is in heaven, to reflect the coming consummation of God's new covenant of shalom to the fullest extent possible.

A new financial architecture

In her path-breaking book, Casino Capitalism,36 Susan Strange likens the Western financial system to a vast casino. As in a casino,

"the world of high finance today offers the players a choice of games. Instead of roulette, blackjack, or poker, there is dealing to be done - the foreign-exchange market and all its variations; or in bonds, government securities or shares. In all these markets you may place bets on the future by dealing forward and by buying or selling options and all sorts of other recondite financial inventions. Some of the players - banks especially - play with very large stakes. There are also many quite small operators. There are tipsters, too, selling advice, and peddlers of systems to the gullible. And the croupiers in this global finance casino are the big bankers and brokers. They play, as it were, "for the house.' It is they, in the long run, who make the best living."

She goes on to observe that the big difference between ordinary kinds of gambling and speculation in financial markets is that one can choose not to gamble at roulette or poker, whereas everyone is affected by "casino capitalism." What goes on in the back offices of banks and hedge funds "is apt to have sudden, unpredictable and unavoidable consequences for individual lives."

It is this volatility, this instability in financial markets that has given rise to recurring financial crises. They must be tamed. In the wake of recent financial crises, people are beginning to look for ways to reform the international financial architecture. Although it is difficult to move from general theological convictions to specific proposals, we offer the following suggestions for consideration by Christians and other persons of good will.

  • Capital controls should be an integral part of national strategies to tame the financial system. They can be made an effective and meaningful tool to protect and insulate the domestic economy from volatile capital flows and other negative external developments.
  • Regulatory and supervisory measures should supplement capital controls when appropriate. They should include regulation of financial derivatives and hedge funds. Regulation is a necessary complement to domestic capital controls. Nations influenced by hedge funds and their complex financial instruments should seek international cooperation, including the governments of host countries, to regulate their practices.
  • A new international legal framework should be created, which provides for de facto sovereign bankruptcy. The existing international system for dealing with insolvent governments is woefully inadequate. Provision must be made for automatic standstills, priority lending, and planned reorganizations.
  • An international transactions tax (like the Tobin tax) should be designed and implemented to discourage short-term speculative capital movements. It is neither "too idealistic" nor "too impractical." It would reduce short-term trading and strengthen the defensibility of the exchange rate regime.
  • International cooperation should be sought to curb dubious activities of offshore financial centers. Strict international regulation and supervision of offshore centers is essential to curb tax and regulatory evasions. They also are a primary conduit for money laundering and various criminal activities.
  • The IMF's responsibilities as a lender-of-last-resort should be enhanced, expanding its authority and resources to make possible quick action to avert financial crises. The IMF must have effective and swift mechanisms to increase the Fund's access to official monies in times of crisis, including authority to borrow directly from financial markets under those circumstances.
  • A World Financial Authority based on the cross-border regulatory framework of the Bank for International Settlements should be developed. It should provide the necessary regulatory framework within which the IMF or a successor organization can develop as a lender-of-last-resort.

Of these recommendations, perhaps the most controversial is that more funds be given to the IMF. We noted above that much of the criticism of the IMF is justified. We also acknowledged that the IMF is improving its policies. We hope that these improvements will continue. Meanwhile, there is no other viable candidate to serve as lender-of-last-resort - an absolutely essential feature of any new financial architecture.

The major reason some civil society institutions resist funding the IMF further is its history of misguided structural adjustment policies, policies that are now widely recognized to have caused widespread suffering. We hope that recent changes will improve this situation as well and enable the IMF to perform the important role we recommend for it.

Along with the World Bank, it is beginning to contextualize its performance criteria and conditionalities, taking much more seriously the unique circumstances of particular economies. It is listening more and nitpicking less. To be sure, the IMF is not likely to abandon its policy of making its loans conditional on the adoption by borrowing countries of mutually agreed economic policies. Even so, there is considerable evidence that when it has had more resources on hand, conditionality has been correspondingly wiser and less draconian.

The IMF now recognizes that it can leave more decisions to developing countries partly because these have better informed and more sophisticated employees than was once the case. Certainly in Latin America and Asia and increasingly in Africa, country economic teams are better qualified technically than the lower rung Ph.D.s from American and European universities to whom the IMF and World Bank entrust their missions. Local economists can do financial programming and standard macroeconomic modeling as well as or better than the people from Washington can; they also know how to do investment project analysis. To be sure, decisions about financial and project plans must include input from many other elements of a society.

We can encourage the IMF (and World Bank) to reverse the typical procedure in setting conditions for multilateral loans. Instead of waiting for it to specify the policies that must be followed to justify additional financing, country economic teams, in consultation with other agencies of their government, should be allowed to propose economic programs to the IMF. Disagreements between Washington staff assessments and the local teams could be resolved directly or by third-party arbitration. The scope of economic conditionality could also be restricted, for example, just to a balance-of-payments target, while the country could pursue its own agenda regarding inflation, income distribution, and growth.

What Christians can do

A primary part of the "principalities and powers" referred to in the Bible is composed of the political-economic institutions and processes that govern how people relate economically to each other and to God's whole creation. The church has a stake in their design. Yet many church members feel powerless to change basic political-economic reality. They think either that the economic conditions of society result "naturally" from the forces of markets that are only marginally within the power of human control, or that economic conditions result from powerful interests that are beyond the reach of ordinary citizens. Thus, there's nothing that can be done about it, or there's nothing we can do about it.

On the contrary, Mobilization for the Human Family believes that the political economy is shaped by deliberate social policy decisions; that conditions at any given time are the result of those decisions; that conditions can be changed by human decisions; and that the will of a nation's and the world's citizens about what the commitments and purposes of the nation and the world should be can be expressed in the political economy through the framework of democratic process provided in our national and transnational polity. Accordingly, we offer below some suggestions for action that may be taken by individual Christians and by our churches and their denominations to correct some correctable flaws of financial globalization.

Actions by individual Christian

  • Pray for persons working in governments, international organizations, institutions, and non-governmental organizations who are trying to work toward a better world, including especially a world financial architecture that better assures fairness in capital markets.
  • In the management of personal and family investments, seek fuller understanding of the uses to which the banks, companies, mutual funds, and investment counselors are putting your money. Avoid speculative investments that are likely to be made without regard to their consequences for others.
  • Reflect upon decisions about work and career choices that are consistent with a Christ-like commitment to economic justice for all.
  • Organize Bible study in your local congregation, where possible together with people of other backgrounds and life-styles, to learn and identify with God's continuing struggle to seek economic justice in the world.
  • Commit oneself to some voluntary organization that is trying to promote greater economic justice in the local and/or global economy.
  • Become involved politically in your area or nation, seeking political and economic change in the direction of economic justice.

Actions by churches and denominations

  • Concern for economic justice must be fully reflected in the prayer life, worship, and educational programs and mission outreach of all congregations.
  • Seek assistance from members who work for banks, brokerage houses, and mutual funds to help mould an educational program that will assist members of the congregation to become more socially responsible investors.
  • Seek collaborative programs among clusters of congregations, perhaps with the aid of local Councils of Churches, to provide educational opportunities where Christians and other faith groups can come to understand some of the complex economic issues amidst which they live and work. Since virtually nothing is now available to explain the problems of financial speculation, this paper could be used to assist study of this phenomenon.
  • Over and beyond educational programs, local churches - again perhaps best working together in the same neighborhood or town - can enter into a deliberate dialogue or partnership with one or more voluntary bodies in the civic society, so as to put their energies into the health of the wider society. Engagement with the International Forum on Globalization (l009 General Kennedy Avenue #2, San Francisco, CA 94129) is a good way to explore the means of influencing the debate on the globalization of trade and finance.
  • At the denominational level, churches should review their investment criteria to reassure themselves that social responsibility is a primary goal of their financial management.
  • Also at the denominational level, agencies responsible for the formation of social witness policies need to monitor global economic indicators on a continuing basis in order to assist its programmatic agencies to form effective and timely social witness regarding the local and national consequences of the globalization of trade and finance.

Want to know more?

Globalization is a vast topic. For a general introduction, see Sarah Anderson and John Cavanagh, Field Guide to the Global Economy (New York: New Press, 2000) and Thomas Friedman, The Lexus and the Olive Tree: Understanding Globalization (New York: Farrar Straus Giroux, 1999). A classic introduction to the financial side of globalization is Susan Strange, Casino Capitalism, (New York: Mnchester University Press, 1986). See also Kavaljit Singh, The Globalisation of Finance: A Citizen's Guide (London: Zed Books, 1999) and John Eatwell and Lance Taylor, Global Finance at Risk: The Case for International Regulation (New York: The New Press, 2000). The best introduction to the Tobin Tax is Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996). For how church people might react, see Pamela Brubaker, Globalization at What Price? (Cleveland: Pilgrim Press, 2001).

Questions For Discussion

  1. How have the linkages and interconnections of international finance impacted your life? On balance, do you regard them as advantages or disadvantages for a healthy Christian life?
  2. The frequency and severity of recent financial crises have fueled calls for a radical redesign of the rules of global finance. If you were the advisor to an international commission asked to design "A New International Financial Architecture," what would you recommend?
  3. Do you favor allowing sovereign nations to declare bankruptcy? What Christian traditions might be invoked to support or deny such an action?
  4. A growing number of civil society institutions oppose giving more money to the IMF. They point out that it is part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. Yet this paper suggests that the IMF needs more money. As a committed Christian, which view do you favor?
  5. Is it too late to expect justice in a globalizing world? Since much of the direction the global economy has taken is irreversible, how can a balance between market and society be negotiated? How might Christians play a role in those negotiations?


1. Reported by Thomas L. Friedman, The Lexus and the Olive Tree (New York: Farrar Staus Giroux, 1999) p.101.

2. John B. Cobb, Jr., (ed), (Claremont, CA: Mobilization for the Human Family, 2000)

3. Karl Polanyi, The Great Transformation. The Political and Economic Origins of Our Time (Boston: Beacon Press, 1957/1944)

4. Denys Hay (ed), The Age of the Renaissance (New York: McGraw-Hill, 1967) p.22.

5. Heikki Patomaki, Democratising Globalization (London: Zed Books, 2001) p.40.

6. Peter Garber, Famous First Bubbles: The Fundamentals of Early Manias (Cambridge, MA: MIT Press, 2000). The quotation is from Charles Mackay, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds (London: Bentley, 1841) p.142.

7. For a summary of the vast literature on pre-World War I foreign lending, see Albert Fishlow, "Lessons from the Past: Capital Markets in the 19th Century and the Interwar Period," in M. Kahler (ed), The Politics of International Debt (Ithaca: Cornell, 1985).

8. Ibid, p.90.

9. Polanyi, op. cit. p.14.

10. J. T. Madden et al, America's Experience as a Creditor Nation (Englewood Cliffs, N.J.: Prentice-Hall, 1937), p.74.

11. Reprinted in Madden et al, p.205.

12. John Kenneth Galbraith, The Great Crash, 1929 (Boston: Houghton Mifflin, 1954), p.16.

13. For a helpful summary of the British and American plans at Bretton Woods, see Raymond F. Mikesell, The Bretton Woods Debates: A Memoir (Princeton: IFC Essays in International Finance no.192, 1994)

14. Jacques J. Polak, The Changing Nature of IMF Conditionality (Princeton: IFS Essays in International Finance, no. 184, 1991.

15. Robert Triffin, Gold and the Dollar Crisis (New Haven: Yale University Press, 1961.

16. The IET taxed foreign borrowings in the U.S. with the intention of reducing the acquisition of dollars by foreigners; the U.S. government thought the dollar "overhang" was getting too large.

17. This section draws upon Heikki Patomaki, Democratizing Globalization: The Leverage of the Tobin Tax, (New York: Zed Books, 2001), chap. 2.

18. The prices a company charges itself for goods or services purchased from one of its entities and sold by another. Multinational corporations with business operations in many different countries try to charge prices that minimize their overall tax liabilities.

19. Roughly, a consensus between the U.S. Treasury, the IMF, the World Bank, and the business community about the policies most likely to achieve free trade and rapid growth: fiscal austerity, privatization, deregulation, and free movement of financial capital.

20. International Organization of Securities Commissions, the Joint Forum on Financial Conglomerates, the International Swaps and Derivatives Association, and the Institute of International Finance..

21. See, for example, Amartya Sen, Development as Freedom. (New York: Alfred A. Knopf, 1999); Lance Taylor (ed), External Liberalization, Economic Performance and Social Policy.(New York: Oxford University Press, 2000); Dani Rodrik, The New Global Economy and the Developing Countries: Making Openness Work. (Washington: Overseas Development Council, 1999); Enrique Ganuza, Lance Taylor, and Rob Vos (eds), Economic Liberalization and Income Distribution in Latin America and the Caribbean. (New York: United Nations Development Programme, 2000).

22. United Nations Development Programme, Human Development Report. New York: Oxford University Press, 2000.

23. David Felix, "Asia and the Crisis of Financial Globalization," in Dean Baker et al., (eds) Globalization and Progressive Economic Policy (Cambridge, U.K: Cambridge University Press, 1998) pp.163-91.

24. Jeffrey D. Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca, N.Y: Cornell University Press, 1998)

25. The Mystery of Capital, (New York: Basic Books, 2000) p.207.

26. "The Revival of the Liberal Creed: the IMF, the World Bank, and Inequality in a Globalized Economy," in Dean Baker op cit., pp. 37-63.

27. See his Underwriting Democracy (New York: The Free Press, 1991), part 3, and his On Globalization (New York: Public Affairs, 2002) ch. 4.

28. For additional details, see K. S. Jomo (ed), Malaysian Eclipse: Economic Crisis and Recovery, (New York: Zed Books, 2001)

29. For more information, see Kavaljit Singh, Taming Global Financial Flows New York: Zed Books, 2000) pp. 158-78. See also Carmen & Vincent Reinhart, "Some Lessons for Policy Makers Who Deal with the Mixed Blessing of Capital Inflows," Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca: Cornell, 1998) pp. 93-124.

30. Given in 1972 at Princeton University and published subsequently as "A Proposal for International Monetary Reform," Eastern Economic Journal 4 (July-October, 1978) pp 153-9.

31. Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996) passim.

32. Jeffrey Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Kahler, op. cit., pp. 256-59.

33. George Soros, On Globalization, op cit, ch. 4.

34. Ibid, appendix.

35. Joseph E. Stiglitz,, Globalization and Its Discontents (New York: W.W. Norton, 2002)

36. (Manchester, U.K: Manchester University Press, 1986)

The crime and oppunity thesis [in Casino capitalism Insider trading in Australia]

Australian studies in law, crime and justice

The crime and oppunity thesis

Published in:
Casino capitalism? Insider trading in Australia / R Tomasic
Canberra : Australian Institute of Criminology, 1991
ISBN 0 642 15877 0
(Australian studies in law, crime and justice series) ; pp 69-78

You can succeed by relying on fundamentals but inside information beats fundamentals.
(A Sydney broker)

The reasons for the apparent proliferation of insider trading both in Australia and overseas are manifold. The recent rash of insider trading activity is often attributed to the level of greed which is said to drive the securities industry. This factor should not be discounted, but it is clear that other factors are also at work not the least of which has been the unprecedented range of opportunities for insider trading in recent years. The relationship between crime and opportunity is well established within the criminological literature but little has been written about how this relationship arises in the context of insider trading, a crime theoretically punishable theoretically until recently by five years gaol and/or a $20,000 fine in the case of individuals and a fine of $50,000 in the case of corporations.

Likely insider trading situations

Almost exclusively, brokers said that insider trading would take place in the market for shares and not in the options market. The range of opinions about the types of shares involved was very wide. On one view, it would depend on "what was flavour of the month". The most commonly identified risk groups were mining, speculative, exploration and gold shares. Various explanations were put forward as to why mining stocks attract insider trading. One broker said that insider trading is most likely to occur in this broad area because "there are all sorts of people on the site". Other reasons were that this is "where there are things like drilling reports" and "a leak from a geologist could create insider trading". Also, "drillers and assayers know and word filters through". As the mining boom of the late 1960s and early 1970s showed, there is ample scope for mine site workers to insider trade or to act as agents for brokers and others in transmitting the latest data.

Among the less specific opinions was one that insider trading is more likely in new, up and coming super stocks which involve newer players". It was said to occur "in less professional areas where there are more opportunistic stocks". A Melbourne broker said that it is more likely in relation to "smaller less frequently researched stocks, rather than larger [company securities]". An obvious point often referred to is that for insider trading to be successful, it is necessary to move the price and in this respect gold mining stocks were described as the most reactive to any information. Where the companies have lower capitalisation insider trading will have greater effect on prices and it is easier to move prices of these stocks. Shares in entrepreneurial mining companies, described as Western Australian cowboy companies, and perhaps in high technology companies, are said to be tightly capitalised and likely to move quickly on a rumour. The number of people in a company was also said to be a factor as "insider trading tends to occur more in smaller companies controlled by one or two people" or in second board stock "which is more tightly held by a small group of people".

There was no consensus amongst brokers about whether insider trading is more or less likely in second board stock. But despite their differences on this point most brokers shared an uncomplimentary opinion of second board companies. However, the financial advisers agreed uniformly that the area of the market where insider trading is most likely to occur seems to be in the lower quality stocks, such as the speculative, mining and second board stocks. An interesting observation was that originally insider trading was limited to tightly held stock, but in the last two years vast amounts of money have been available and this leads to more insider trading. Cross directorships, trading on rumours, stocks that respond to good news, and stocks whom players are share trading to enlarge their business profits, were seen as situations which led to insider trading. There was no common view among Stock Exchange officials on this matter.

The general view among the market observers was that insider trading is more likely to happen in lower quality stock. One observation was that insider trading occurs across the whole spectrum but another was that "it is less likely in trading bank stock. It happens on a bulk scale in speculative stock. The second board is an invitation to misbehaviour". A journalist said that "insider trading occurs even in reputable companies and share dividend schemes using options are the likely methods". The views about the second board were as conflicting here as they were amongst other groups. On the one hand "the second board is not deep enough", and on the other, "insider trading occurs in the second board, but not exclusively".

It was rare to find lawyers saying that insider trading was likely to be found in industrial or blue chip securities. The nearest exceptions to this occurred when they were speaking of takeover stocks generally, although it seemed likely that "insider trading will occur in relation to anything which is volatile". Generally, the lawyers considered that insider trading would be most likely to occur in relation to speculative, volatile, mining, second board, or lower quality securities, or in respect of securities in smaller companies where there was a high level of ownership by a relatively small number of shareholders. To this extent, their expectations were similar to those of the brokers. The regulatory community saw speculative, mining, takeover, high technology and low price/high volume stock as the most likely areas. Gold stocks in particular were often identified. Many of the regulators took the view that insider trading was prevalent "over the whole range of market activity".

It seems likely that insider trading occurs throughout the whole of the Australian securities market, but it is more likely to occur in certain specific areas than in others. The market's evaluation of particular classes of securities, such as mining and exploration stock during the late 1960s mining boom, and high technology and takeover stocks in the early 1980s, gave rise to insider trading which suggests strongly that insider trading is often a matter of opportunity. The extent of insider trading can also be influenced by the volatility of the stock in question and the degree to which the ownership of securities is tightly held amongst a relatively narrow group of shareholders. This is not to suggest that insider trading does not occur in relation to the "blue chip" securities of large public companies, but it is more likely to be successful in moving market prices in lower quality stocks. The likelihood of insider trading occurring in large Australian public companies should not be discounted, especially in takeover situations.

Opportunities for insider trading

Insider Trading has been described as an opportunistic crime. It is carried out when an opportunity presents itself and by persons who take advantage of the opportunity. The difficulties of quantifying the extent of insider trading and perhaps in detecting it, might be due to the opportunistic and random nature of the practice. It was therefore of particular interest to find out what opportunities existed for insider trading. The first questions on this topic asked interviewees about the frequency of conflicts of interest arising from access to price sensitive information. The brokers reported that conflicts of interest were a constant factor in the industry or, at least, that they were very common. They were said to arise especially when a broker is engaged in corporate advisory work. It was claimed that these conflicts were usually resolved properly. In the context of conflicts it is useful to refer to comments with respect to the treatment of information gathered in the course of research, especially information provided to brokers by listed companies. A Melbourne broker explained that in his firm, "any research undertaken by the firm goes back to the company first". The same practice is followed by another Melbourne firm where "the research information is kept secret until it is checked with the company and then it is published".

It was of interest to establish whether there is any house trading by brokers on the information collected by them in the course of research. Several brokers explained the position in their firms and at the same time described the process of gathering information. A Sydney broker responded, "some companies refuse to see brokers; they rely on section 128 to avoid them. Others, with less market status, are anxious to see them to build up the share price. Of those who talk, it is amazing what they say, but some companies do not tell the truth. There is a great deal of monitoring of companies these days. Here, there is no house trading but some institutional analysts are not prevented from trading". Another perspective on the practice was obtained from a senior broker who said that "market research is done in the hope that it picks up price sensitive information. This is only ever done on a formal basis; it does not disclose inside information. The information is ultimately used by the firm to disseminate to its clients. The firm does not trade on this information but we will pass it on early to institutions. Trading on research information is common elsewhere, especially in those stocks where a small amount could move the price".

Another explanation of how research information is dealt with was provided by a broker who responded that "research obtains price sensitive information but how often is it inside? At presentations the companies should be more guarded. Information that is not generally available to the public comes out. The information then goes to clients. In this firm advisers would not go out and buy shares; the house would buy shares and disclose to clients that it is selling as a principal. It is more likely in small firms for brokers to trade on research information". An enigmatic statement was that "companies are always giving information but it is not insider trading. The research reports go to clients. Trading by the house before advising clients could go on but the information could be wrong or your interpretation wrong. Profit forecasts do not affect prices much".

Another insight into industry practices came from a Sydney broker who asked, "how often is information from research price sensitive?" He pointed out that "high level executives do not give much away" and asked, "is it inside information or smart analysis?" In his firm, "there is no house trading on this information - it goes to the client first. It would be stupid to breach trust. Not many brokers have the same degree of self-control. This firm is always aware of surveillance and the potential danger to its business". Perhaps the frankest exposition of the treatment of information gathered from companies came from a broker who told us that he sees companies "at least once a week and gets superior information. Some managements talk freely and you get price sensitive information from them. With research information we either trade for the house or send it to institutions. We trade in big companies only if it is inside information from leaks from banks or advisers. It will be a problem with screen trading. All companies try to bull the price of their shares". When financial advisers were asked about the frequency of conflicts of interest, the overwhelming view was that it was a common event. There was little comment about the way in which such conflicts were resolved but it was interesting to note that the accountants made similar replies to the effect that, "professionals don't find it a problem". The merchant bankers suggested that they can handle conflicts better than brokers.

The response to this question from the Stock Exchange officials suggested that they are not close enough to the daily workings of the market to be able to comment accurately. On the subject of the use of research, one official felt able to tell us that "in section 128 terms, brokers do engage in insider trading but some of the information could be found out by individuals". He admitted having "some difficulty with the practice of trading first before passing on the information to clients. It is unwise and unethical". From what the market observers reported, it seems that conflict of interest is ever present. When asked about the treatment of price sensitive information gathered during market research, the answers provided were varied. One observer reported that he was "not able to say how often price sensitive information is given out by companies". Another of the group was of the opinion that "brokers obtain price sensitive information but it is not devastatingly inside information. They probably trade on it and then pass it on to the client. Small investors are not treated as well. Some brokers are subsidiaries of the companies whose shares they are ramping". A more emphatic response was that "research is used before it is made public". But even stronger was the explanation that "analysts quite often get price sensitive information; boards tell them what they want to tell them; circulars are speculation, puffery, to get the price up. Larger companies are better scrutinised and much cleaner in insider trading terms. I would not be surprised if there is house trading nor if there was passing on to affiliates. This is consistent with the ethical standards in the broking world". An authoritative explanation came from the ex-broker who reported that "talks with companies are directed at getting sensitive information. A skilful broker will get it wittingly or unwittingly. Brokers do house trade on it. They buy shares to provide them to persons who are acting on their recommendation".

The lawyers were able to appreciate the issue of conflicts better than other groups in the study. Their views were that conflicts of interest are a particular problem for persons in company management who trade in shares. Brokers were also identified as a group for whom conflict situations were common and several lawyers pointed out that brokers tend not to be able to manage such situations well. While the regulators considered that conflicts were not likely to arise in CACS, they tended to the view that conflicts would be common in the private sector for merchant bankers, advisers and within companies. One assessment was that "such conflict is probably quite frequent, it depends on the opportunities which arise".

Insider trading and corporate control

A view is sometimes put that traders deliberately build up their holdings in order to obtain price sensitive information to assist them in their trading. The almost universal view amongst brokers was that traders would not seek a place on the board solely as a method of obtaining price sensitive information. The main reasons for such a view were that "it is an expensive way of doing it; a long way for a quick trade" as one broker put it. Once on the board, "your hands are tied" said another broker. Those who did not dismiss the possibility said that "it could happen" and that "it is not common but it certainly happens" or that it might happen "in smaller companies".

The qualifications to some responses provide insights into the process of obtaining information. A Melbourne broker responded that "boards do not necessarily know everything; the information flow is controlled by CEOs and accountants. It is not an efficient way of obtaining information". A Sydney broker explained that "a lot of information is wrong. Banks get better information than brokers; auditors get better information; lower level people get information probably before the directors do". The ease of obtaining price sensitive information was referred to by one broker when he responded that "some brokers might take this approach but it is too expensive. Non-brokers can obtain information and do research without going on to the board" Just how easy this was, was demonstrated by the comment that "brokers can go to the company and get information".

This question also yielded some insights into how insider trading is conducted. A Sydney broker responded that "most is unplanned, it depends on information falling into your lap". According to a Perth broker "it is easier to insider trade off the board [of directors]" and according to another "it is sometimes better not to go on to the board". A Perth broker expressed the opinion that "going on to the board does not give rise to an insider trading problem, it is more a long-term propositions.

Most of the financial advisers thought that it was not common to build up holdings in a company merely in an effort to obtain access to price sensitive information. Going onto the board was either a very expensive way of obtaining information or a means of achieving other goals such as the control of the company. The majority view of the ASX officials was that this does not happen, "[b]ut, a person would be dumb not to use a position on the board or to ignore information".

The market observers had similar views to other groups. A wide range of views were provided by them. It was said to be "quite common" or "routine", that "it happens in second board and lower main board companies" and that "it often occurs". A different view was that "it is done mainly to get control and participate in the company". Another observer repeated the point that "it is a very expensive way of doing it. The board is the last place to do it". One of them responded that "they don't really need to, they can use contacts as Boesky did".

Some lawyers shared the view that "some people who have got on to major company boards have only paid lip service to insider trading controls", but the more common view was that it would be a very expensive way of trying to obtain price sensitive information and that "there are usually better ways of getting price sensitive information". The regulators likewise felt that getting onto the board for this purpose would be rare because, as one regulator observed, "persons who insider trade can obtain the inside information without being on the board". Once on the board, additional constraints upon the traders are seen to operate - "... once a person is on the board he is an insider and the risks of being caught increase".

Is price sensitive information necessary for success?

For the most part, brokers believed that it was possible to succeed without access to price sensitive information and that success comes from relying on fundamentals. A Sydney broker thought that "price sensitive information is just a help. It is not vital". Another of his colleagues went so far as to say that "it is probably better not to rely on it". One surprising view was that "inside information is not important at all" to success in the stock market. Price sensitive information was, however, generally seen as valuable, particularly as fundamentals are of more long term importance. Price sensitive information is seen to be very important for making short term profits but over the long haul, success is seen to be based on the fundamentals. Access to price sensitive information, but not necessarily inside information, will enhance the prospects of success. For quick profits, it appears necessary to have access to price sensitive information.

The almost unanimous view of the financial advisers was similar to that of the broke price sensitive information is not necessary for success. Good research, astuteness, and relying on the fundamentals were mentioned as the factors for success. It was pointed out by some that price sensitive information is not necessarily inside information and that if a person has access to such information the chances of success are greater. Likewise, the most common view of the market observers was that success is possible without price sensitive information and that the approach of relying on fundamentals was the best method for success. The view that price sensitive information was not essential was also held by most of the lawyers.

The general view amongst Stock Exchange officials, predictably, was that success is possible without price sensitive information. One view was that "you can succeed without it. The Stock Exchange runs not on facts but on fashion - there is always good value stock that is ignored. Success does not depend on insider trading". The regulators' majority view was that it was possible to succeed without access to price sensitive information, but some had serious qualifications and there were a good proportion who doubted the possibility of success without it, especially in the long term.

Market conditions and insider trading

The overwhelming view within the broking group was that insider trading was more likely to occur during periods when the market is very active in a bull market and when there are takeovers. Most brokers felt that takeovers were more likely to occur during bullish market conditions. A bull market was said to be the most likely time for insider trading to occur because, "there is more activity" and "more people are interested". A development of this theme was that in a bullish period, the level of activity means a lower chance of detection. Special events, such as "during periods when there are takeovers and discoveries, special breakthroughs or sudden developments" were seen as likely to contribute to the level of insider trading. A comment consistent with the majority view was that insider trading "will occur in any market, but it can be pin-pointed more in a bear or drifting market".

The financial advisers said that active markets and periods during which takeovers and major reconstructions were taking place were more likely to sustain insider trading. One fund manager thought that it was more likely to occur in "a bear market where assets have been undervalued". A merchant banker summarised the conditions in which insider trading is likely to be found as follows: "in a bull market, when there is good news, and in a bear market, when there is bad news". The Stock Exchange officials were once again unable to express a single community view. "It is more likely in an illiquid market" said one. Another replied that "I cannot say whether it would be a bull or bear market". Insider trading appears likely to be most prevalent during periods of heightened market activity, such as ill a bull market, takeover situations and in situations where major discoveries or innovations were known to have occurred. It was also evident however that insider trading could occur in a bear market, when there was bad news about to break. The level of volatility in the market could also be important in encouraging persons to insider trade. Volatility in prices is a critical factor in undertaking a successful insider trading operation.

Takeovers and insider trading

It has often been said, and other research tends to show, that there is a distinct relationship between takeover activity and the level of insider trading. Participants in the study were asked whether they could think of takeovers where they suspected that insider trading had taken place. Most brokers at least suspected that insider trading is associated with takeover activity. According to one, "takeovers are a great example of insider trading. The majority of cases involve leaks. This is the easiest form of insider trading to prove". Takeovers are regarded as the special events that are likely to move prices and create the climate for insider trading. The basis for this widely held suspicion is the movement in prices prior to the announcement. One broker considered it "interesting that share prices lift pre-takeover". An explanation commonly referred to was the fact that in just about every takeover, there are so many people involved. It is very rare that the price does not move and part of that movement comes from insider trading". According to a Sydney broker, "some merchant banks leak, especially on West Australian deals". Of course, it is possible that share prices move upward in the pre-takeover period because takeover targets are often identified in the course of market analysis and because prices tend to move on rumours of takeovers An interesting feature of this phase of the interviews was that even though participants were not asked to do so, it was not uncommon for them to name specific takeovers where they thought that there had been insider trading and, in fact, discuss chapter and verse the insider trading that took place.

Financial advisers said that there is a link between takeovers and insider trading. Some said that they knew of specific cases while others suspected that there was a link. This question inspired a mixed reaction from the ASX officials. Some quite clearly doubted that there was such a link, but one replied that "in takeovers it is hard to believe that there is no insider trading". The observer group most strongly suspected that insider trading took place during takeovers. One respondent said that "it is frequent and it is demonstrated on graphs". An even more emphatic response was "hell yes-just look at the price movements and turnover a month to two weeks prior to a takeover. The leaks are in the targets - [from their] clerks, lawyers, CACS, bankers and accountants". On the subject of leaks, another view was that "the leaks vary. Sometimes they come from the board but more often well below the board in the advisory groups where there is terrible chicanery". One person who has been associated with many spectacular takeovers reported that it was common for members of the advisory team to be encouraged by directors to engage in share trading. The attitude of lawyers to this link was probably best summarised by a Sydney lawyer who explained that, "you often wonder about some large takeovers. Insider trading need not only occur in small corporations, but associate and warehousing questions are more common in takeovers". The regulators on balance believed that there was a relationship, although there was once again a problem of hard evidence of insider trading being available. It seems clear that there is often a connection between insider trading activity and takeovers. Those closest to the market, such as brokers and merchant bankers, were particularly certain of the existence of this relationship and most other groups on balance also saw a link. Only the ASX officials seemed to question the existence of this linkage. Their views need to be treated with caution in this regard in view of the preponderance of industry opinion to the contrary.

Takeovers were pin-pointed as likely insider trading situations due to the profits which could be made by buying shares ahead of a takeover and because of the long chain of advisers and other persons who are involved in preparing the takeover.

Insider trading as a crime - how serious?

One might speculate whether, if insider trading is not regarded as a serious matter by people within the securities market, it is tolerated more than if it were seen to be serious. It was found that insider trading is generally not regarded by brokers to be serious or as significant as other forms of market conduct. A Melbourne broker responded that he could "think of many more examples of forms of abuse other than insider trading". The more significant forms of conduct were market rigging, which is "more serious and easier to do"; manipulation by false rumours; corporate fraud; churning of clients; staff malpractices; linked advisers; ramping; warehousing, and "other rorts such as loans to directors, and asset purchases by directors in smaller listed companies. The public is being ripped off left right and centre by these rorts". Perhaps the comment that best reflected the brokers' view was that "within the industry we are laid back about insider trading. Warehousing, circumventing the Takeovers Code and the actions of the big players are serious matters. Insider trading is one of a number of imperfections in the market".

Only one of the financial advisers was prepared to describe insider trading as a serious problem but a number shared the view that "in terms of its frequency, insider trading is a small matter but it has the potential to destroy the market". None of the Stock Exchange officials ranked insider trading highly as a problem. One described it as "no more serious than other abuses". On the scale of market abuses one official observed that "insider trading is comparatively minor. Ramping is much more serious for shareholders than insider trading, as many shareholders are likely to suffer. Insider trading gets undue attention because of the public perception. We are very concerned about unenforced legislation or poorly written legislations. The lawyers generally did not rank insider trading as the most important form of market abuse but they acknowledged that it was often a difficult assessment to make. One explained in these terms, "it is hard to say how important insider trading is. Honesty is an important thing about securities markets. Emphasis should be placed upon making people tell the truth. Insider trading is in this category".

It appears that the industry view of insider trading was that it was not as quantitatively serious as other examples of market abuse but that it was perhaps potentially more serious. Some of the evidence that emerged from the round of post1987 corporate collapses supports the view that there are forms of illegal and undesirable activity which are more common. Indeed, the example set by the high profile business identities could encourage insider trading. If it is not regarded as a serious matter in the range of things that happen in the market, where the opportunity arises to engage in insider trading, why not take it? When account is taken of the risks of being prosecuted, the attraction of insider trading is even greater.


The opportunities for insider trading in Australia have been, and continue to be, extensive. This is not simply a matter of greed but the result of a complex web of values, market conditions and professional or peer group tolerance of insider trading. As the Chief Manager of the AMP's Investment Operations Research Division said in evidence before the Griffiths Committee, "(t)he people who would have the clearest idea of what is happening are the people in the broking firms who are taking the orders. Of course, they have to be careful that they do not spoil any good business that they have by dobbing anybody in" (Griffiths Committee, Hansard, p. 207).

The frequency and extent to which conflicts of interests occur within the securities industry are such that many cannot handle these conflicts well. This was particularly said of brokers, especially those who do not have a great deal of background and training in the industry. Price sensitive information gained on a selective basis from corporations seems to be widely used for principal trading especially by brokers and financial advisers, who not infrequently trade in this way before making such information public or releasing it to clients. This is an institutionalised opportunity for insider trading. Insider trading is not likely to be the main motivation for those seeking positions on the company boards. There is considerable pressure within the securities industry to obtain access to price sensitive information as mere good market analysis is often not enough to attract clients. Spectacular gains and quick profits are more easily achieved by insider trading but over the longer term the fundamentals are the more reliable route to success.

One of the more blatant opportunities for insider trading arises from the readiness of companies to selectively divulge price sensitive information about their corporation to brokers, institutions and large shareholders. Often there may be good reasons from the company executives' point of view for doing this, but it is nevertheless grossly unfair and is contrary to the notions of a properly informed market. It has been all too convenient for brokers and others who receive such information to argue that the availability of this information does not guarantee a profit or that this information is often misleading or that it is research. Attempts to explain efforts at obtaining such information as the product of good research, are merely rationalisations. There is room for greater control of the release of corporate information to ensure that all investors are given an equal opportunity to take advantage of the market opportunities which this information creates.

The market operates upon the basis of the comforting myth that success comes from market analysis; so long as your market analysis is correct or you study the fundamentals, you will be able to succeed. Brokers clearly have an interest in perpetuating this abstract, theoretical view of markets. Whilst it is true that this method is likely to bring success in the longer term, particularly with blue chip stock, most interviewees acknowledged that resort to inside information is superior to reliance upon fundamentals, particularly in the shorter term. In an over-analysed and competitive market, the temptation for financial intermediaries to obtain inside information is enormously attractive. Ironically, it is industry insiders, those who are arguably in the best positions to undertake analysis of fundamentals, who rely most upon inside information, rumour and herd instincts. Perhaps this is inevitable to a certain degree, but it seems that too much reliance may be being placed upon such short-cut methods for the market to be healthy and for the public to have confidence in it. Many in the industry seem to share this view. More timely disclosure of price sensitive information would reduce the premium value of that information and would reduce both the opportunity for and the scope of insider trading. Such disclosure would, as well, contribute positively to greater market efficiency.

It is no surprise to find that situational factors in the market such as technological and mineral discoveries and company takeovers provide major opportunities for insider trading. A bull market, especially where share prices are highly volatile and there is a great deal of activity, provides many easy opportunities for insider trading. Finally, the apparent tolerance of insider trading and peer group support for insider traders who have not been convicted are important factors in enlarging the opportunities for insider trading. When this is associated with the perception of many market professionals that insider trading is not necessarily the most serious problem facing the market, the risks for insider traders seem to be much reduced. Although insider traders would not concede the point, insider trading is a more significant issue than most other forms of market abuse, because of the potentially devastating effects on market confidence and market participation of perceived widespread insider trading.