The rot in US version of financial capitalism

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By Liu Junhong (China Daily)
Updated: 2008-10-07 07:44

The world's financial markets face an uncertain and possibly volatile week as investors await details about how the Treasury will implement the government's financial rescue package - and watch for any further fallout from the credit crisis around the globe.

Even though the perfect storm on the New York financial market has come down for the moment, the fact that Washington took such heavy-handed measures regardless of how the market would take it signals the US version of "financial capitalism" is entering an era of undoing its mistakes.

The US has always prided itself as a cowboy who has lived on financial horsebacks, especially since World War II. It has long been in control of the international monetary and financial system, which has helped it rake in enormous riches, indulge in hegemony and maintain economic prosperity.

Since the end of the Cold War, however, the US-dominated international financial order has experienced a series of crises as its flaws manifested. And since the "black Monday" in October 1987, the world has seen a financial crisis of widespread impact almost every 10 years. The subprime crisis can be seen as the latest example.

Alan Greenspan handled a dozen financial emergencies of various descriptions throughout his 19 years as Federal Reserve (Fed) chairman between August 1987 and January 2006, including such significant events as the yen-dollar exchange rate flipping of 1995, the market-rocking effect of the launch of the euro in 1999 and joint intervention of the euro exchange rate by the European Union (EU), the US and Japan in 2000. All these demonstrated the shakiness of the US-dominated international financial order in the post-Cold War era.

As a matter of fact, the current US financial crisis has once again exposed the flaws of the US version of financial capitalism.

First, the US-led capital game has reached its own limit. Financial liberalism has gone wild since the Thatcher cabinet of Great Britain and the Reagan administration of the US set off a wave of "neo-liberalism" in the 1980s. In 1999 the US adopted the new banking law to further ease financial regulation. As a result the sector-specific management of financial operations was broken and mixed-service operations became the name of the game. Known as "financial operations by arbitration", the format allows businesses to gain huge profits by distorting prices so that they can buy low and sell high in the capital game.

As more players entered the market, the game became less and less profitable as the price system stabilized gradually. In order to expand the room for making profits, major American and European financial institutions threw themselves into "financial technology innovations" to develop financial derivatives and establish a man-made "virtual financial world".

Take the subprime mortgage credits for example. They were integrated, split and repackaged into a series of securities-like commodities, which were then sold throughout the world as new virtual financial products after being split and repackaged again and again by downstream retailers. The US lauded this process as the best way to dilute financial risks as well as financial globalization and liberalization.

The problem is that financial risks, like computer viruses, do not expire as they spread out. As people have found out by now, through repeatedly reselling the debt derivatives, the financial industry spread the "viruses" all over the world. And the whole system would be infected sooner or later once a "virus" developed into a full-blown epidemic. That's why the subprime crisis has been deepening and spreading since it broke out last year.

Second, the US market rating system was outdated. Without question the development of financial derivatives can help improve the efficiency of capital utilization and reduce the cost of financing.

The thing is the valuation and trading of financial derivatives require accurate market rating, but the US' financial reform never reached the institutionalized monopoly of market rating firms. The rating agencies brought up by "government orders" early on were still very much in control of the market, where "ethical deficiency" permeated and shielded financial risks, allowing such "viruses" to spread far and wide.

Third, the US financial system suffered from structural imbalance. The country's new banking law has only extended financial institutions' management power, which led to the conglomeration of such businesses, the expansion of the financial industry and fast-growing power it wielded.

On the other hand, as regulators of the financial industry, the Fed, the US Securities and Exchange Commission and the Department of Treasury were still "doing their own jobs" separately according to the old bureaucratic fixture, leaving the financial industry in a room of no regulation.

Fourth, the US has learned it the most painful way that believing "scale equals safety" will cost you big time. While proceeding with the financial reform, the US government was somehow convinced that the bigger financial institutions are the safer they become. As a result Washington threw its weight behind a tide of mergers across the financial landscape that turned the industry structure into a domain dominated by giant conglomerates.

For instance, each of the top three US brokerages boasts assets totaling more than $1 trillion, which is close to the gross domestic product (GDP) of a semi-developed nation. As for Lehman Brothers, the net value of its debts stands at $613 billion. Apparently the subprime crisis has shattered the myth that "bigger is safer" with undeniable facts. It has also made the US government realize, albeit at a tremendous price, the destructiveness of super-sized financial institutions to the whole financial system.

Currently, to neutralize the fallout of the subprime chain reaction, the EU and the US have begun pushing forward a tide of financial regulation and actively working on a new system for "reining in the financial industry".

Meanwhile, Japan, whose financial liberalization has been progressing very slowly, has put forward the idea of building a "market-oriented indirect financial system" in an attempt to break a middle path for "financial capitalism", correct the "market arbitration-determined finance" of the US through the construction of "value creation-oriented finance" and prevent "financial games". Faced with different system options from the US, EU and Japan, China's financial reform is staring at a set of new challenges and risks.

The market reform and industrialization of finance is a required subject that China must learn well in the development of market economy. It is key to efficient transformation of individual savings into national productivity and, more importantly, a systematic condition for maintaining the global competitiveness of Chinese enterprises.

China's favorable balance of current account has been growing as the country's foreign trade expands. The so-called China funds and China capital have been globalizing everyday as financial and opening up have become a key safeguard for the nation's economic reorientation.

Taking a look at the history of international financial development it is not hard to notice that the development of the international financial system has always been accompanied by the process of system construction, correction and reconstruction. To proceed with its financial reform and opening-up China needs to consider such new underpinnings as the country's economic development must not get ahead of itself, its industries and trade are not yet mature, and so are its ways to turn individual savings into investment.

China does not have to slow the pace of market and industrial reform just because the US messed up its own financial system. Nor does it need to copy Japan's model because the neighbor to the east has escaped the subprime tsunami unscathed so far. China still needs to build up its confidence in going ahead with its financial reform along a path best suited to its national condition.

The author is a researcher with China Institute of Contemporary International Relations

(China Daily 10/07/2008 page9)