Banking Systems in the Crisis : The Faces of Liberal Capitalism [1 ed.] 9781136214394, 9780415517898

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SPINE 21mm

Banking Systems in the Crisis

Edited by Suzanne J. Konzelmann and Marc Fovargue-­Davies

Routledge critical studies in finance and stability

Banking Systems in the Crisis The faces of liberal capitalism Edited by Suzanne J. Konzelmann and Marc Fovargue-­Davies I S B N 978-0-415-51789-8 www.routledge.com

9

780415 517898

SPINE 21mm

Banking Systems in the Crisis

The 2008 financial crisis has severely shaken confidence in liberal economic theory and policy. However, the sharply divergent experiences of the six Anglo-­ Saxon ‘liberal market economies’ (LMEs) suggest that the reality is not so simple. This book traces the evolution of liberal capitalism, from its rebirth amidst the challenges of the 1970s to its role in the genesis of the 2008 crisis – and debates the assumptions underpinning the liberal capitalist paradigm. Close examination reveals variety within liberal capitalism. Not only was there the familiar, ‘hands off ’ libertarian approach adopted by the US, UK and Ireland, but more bounded, better regulated and apparently more stable varieties of economic liberalism also emerged, through the more pragmatic approach taken by Canada, Australia and New Zealand. The evidence is compelling. Whereas the American, British and Irish financial systems were severely damaged by the crisis, those of Canada, Australia and New Zealand proved more robust. This volume explores the degree to which these divergent experiences were a result of better and more intensive supervision, differences in business or political culture, broader commitment to social norms, and the pace of liberalisation. Detailed comparative case studies reveal fundamental differences in the economic and political environments in which economic liberalisation took place, in approaches to finance and in the degree to which it was seen to be an engine for growth. The book concludes that this had a major influence on the evolving economic and financial systems, and consequently, their relative resilience when confronted with the challenges of the 2008 crisis. Suzanne J. Konzelmann is Director of the London Centre for Corporate Governance and Ethics and a Reader in Management at Birkbeck, University of London, UK. Marc Fovargue-­Davies is a Research Associate at the London Centre for Corporate Governance and Ethics at Birkbeck, University of London, UK.

Routledge critical studies in finance and stability Edited by Jan Toporowski School of Oriental and African Studies, University of London, UK

The 2007–2008 Banking Crash has induced a major and wide-­ranging discussion on the subject of financial (in)stability and a need to revaluate theory and policy. The response of policy-­makers to the crisis has been to refocus fiscal and monetary policy on financial stabilisation and reconstruction. However, this has been done with only vague ideas of bank recapitalisation and ‘Keynesian’ reflation aroused by the exigencies of the crisis, rather than the application of any systematic theory or theories of financial instability. Routledge Critical Studies in Finance and Stability covers a range of issues in the area of finance including instability, systemic failure, financial macroeconomics in the vein of Hyman P. Minsky, Ben Bernanke and Mark Gertler, central bank operations, financial regulation, developing countries and financial crises, new portfolio theory and New International Monetary and Financial Architecture. 1 Banking Systems in the Crisis The faces of liberal capitalism Edited by Suzanne J. Konzelmann and Marc Fovargue-­Davies

Banking Systems in the Crisis The faces of liberal capitalism

Edited by Suzanne J. Konzelmann and Marc Fovargue-­Davies

First published 2013 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2013 Suzanne J. Konzelmann and Marc Fovargue-­Davies for selection and editorial matter; individual contributors their contribution. The right of Suzanne J. Konzelmann and Marc Fovargue-­Davies to be identified as the authors of the editorial material, and of the authors for their individual chapters, has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Banking systems in the crisis: the faces of liberal capitalism/edited by Suzanne J. Konzelmann and Marc Fovargue-­Davies. p. cm. Includes bibliographical references and index. 1. Banks and banking. 2. Free enterprise. 3. Global Financial Crisis, 2008–2009. 4. Capitalism. I. Konzelmann, Suzanne J. II. Fovargue-­ Davies, Marc. HG1573.B368 2012 332.1–dc23 2012011024 ISBN: 978-0-415-51789-8 (hbk) ISBN: 978-0-203-09553-9 (ebk) Typeset in Times New Roman by Wearset Ltd, Boldon, Tyne and Wear

Contents

vii ix xi xv

List of illustrations List of contributors Preface List of abbreviations

1 The 'not so global' crisis SUZANNE OLIVIER

1

J. K O N Z E L M A N N ,

MARC

F O V A R G U E - D A V IE S

AND

BUTZBACH

2 The return of 'financialized' liberal capitalism SUZANNE FRANK

J. K O N Z E L M A N N ,

MARC

FO V A R G U E - D A V I E S

32 AND

WILKINSON

3 The United States: 'with freedom and liberty for all' SAULE LISSA

OMAROvA, LAMKIN

CYNTHIA

BROOME,

57

WILLIAMS,

AND

JOHN

CONLEY

4 The United Kingdom: Thatcherism - 'a heavy hand and a light touch' SUZANNE FRANK

J. K O N Z E L M A N N ,

MARC

FO V A R G U E - D A V I E S

WILKINSON

5 Ireland: crisis in the Irish banking system BLANAID

CLARKE

AND

NIAMH

107

HARDIMAN

6 New Zealand: staying in the black JAMES

80 AND

134

LOCKHART

7 Canada: 'bank bashing' is a popular sport POONAM

PURI

155

vi

Contents

8 Australia: economic liberalization and financialization - an introduction SUZANNE

J. K O N Z E L M A N N

AND

MARC

F O V A R G U E - D A VIES

9 Australia versus the US and UK: the kangaroo economy STEVE

OLIVIER

BUTZBACH,

SUZANNE

J. K O N Z E L M A N N

223

AND

FOVARGUE-DAVIES

11 The 'ordoliberal' variety of neo-liberalism GERHARD

SCHNYDER

AND

MATHIAS

SUZANNE

J. K O N Z E L M A N N

250

SIEMS

12 Conclusions

Index

193

KEEN

10 Institutional foundations of the Anglo-Saxon banking systems: some are more liberal than others MARC

186

269 AND

MARC

FOVARGUE-DAVIES

285

Illustrations

Figures 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.15 9.16

General government gross financial liabilities, 2007-2011 Changes in real total gross fixed capital formation, 2006-2011 Domestic credit as per cent of GDP Household net savings rates, 1990-2008 Long-term interest rates, 1990-2008 Equity prices (total market capitalization as a percentage of GDP), 1990-2008 Real house prices: percentage change from previous year, 2001-2008 Real GDP growth, 1990-2008 Value added by financial services as a percentage of total value added Real growth rates Unemployment Private debt to GDP Household debt Aggregate demand and the change in debt: Australia Aggregate demand and the change in debt: USA Aggregate demand and the change in debt: UK Comparison of debt-financed demand Relationship between the debt-financed fraction of aggregate demand and unemployment: Australia Relationship between the debt-financed fraction of aggregate demand and unemployment: USA Relationship between the debt-financed fraction of aggregate demand and unemployment: UK House price indices deflated by the Consumer Price Index Acceleration of mortgage debt: Australia Acceleration of mortgage debt: USA Acceleration of mortgage debt: UK Stock market indices deflated by the Consumer Price Index

3 3 4 6 7 8 9 10 11 194 194 195 196 202 203 203 204 205 206 206 207 208 208 209 208

viii   Illustrations   9.17   9.18   9.19   9.20   9.21   9.22   9.23   9.24   9.25 10.1 10.2 10.3 10.4

Correlation of debt acceleration with share prices: Australia Correlation of debt acceleration with share prices: USA Correlation of debt acceleration with share prices: UK Correlation of debt acceleration with change in employment: Australia Correlation of debt acceleration with change in employment: USA Correlation of debt acceleration with change in employment: UK Bank dependence on real estate loans, Australia and USA Impact of the First Home Owners Scheme on house prices Impact of the First Home Owners Boost on mortgage acceleration and house prices Top 1 per cent income earners’ share of total income in LMEs, 1947–2009 LMEs main trading partners (percentage share of two-­way trade, 2010) Inward FDI as a percentage of GDP Inward FDI as a percentage of GDP, without Ireland

210 211 211 212 212 213 215 217 218 237 243 245 245

Tables   1.1   1.2   1.3   1.4   1.5   1.6   9.1   9.2   9.3   9.4 10.1 10.2 10.3

Household debt levels Owner-­occupied housing rates Annual average percentage change in real GDP Contribution of the financial services sector Financialization and the interactions between the political and banking systems International financial integration as constraining rules or enabling resources Example of a recession caused by growth of debt slowing down Example of a recession caused by growth of debt ceasing Impact of the First Home Owners Scheme on house prices Growth of employment in Victoria from March 2009 till May 2010 Neo-­liberalism at play: market-­oriented regulatory reforms in the six LMEs, 1970–2007 Inward FDI as a per cent of GDP, 1970–2010, median and standard deviation International claims and liabilities by local banks

5 6 9 12 24 24 201 202 217 219 226 246 246

Contributors

Lissa Lamkin Broome is Wachovia Professor of Banking Law and Director of the Center for Banking and Finance at the School of Law, University of North Carolina at Chapel Hill, United States of America. Olivier Butzbach is a Researcher in the Faculty of Political Studies at the Second University of Naples, Italy, and Visiting Lecturer in International Business at King’s College London, United Kingdom. Blanaid Clarke is McCann Fitzgerald Professor of Corporate Law at the School of Law, Trinity College Dublin, Ireland. John Conley is William Rand Jr. Professor of Law at the School of Law, University of North Carolina at Chapel Hill, United States of America. Marc Fovargue-­Davies is a Research Associate in the London Centre for Corporate Governance and Ethics at Birkbeck, University of London, United Kingdom. Niamh Hardiman is Senior Lecturer in the School of Politics and International Relations, University College Dublin, Ireland. Steve Keen is Professor of Economics and Finance in the School of Business, University of Western Sydney, Australia. Suzanne J. Konzelmann is Reader in Management and Director of the London Centre for Corporate Governance and Ethics at Birkbeck, University of London, United Kingdom. James Lockhart is Senior Lecturer of Strategy and Governance, School of Management in the College of Business, Massey University, Palmerston North, New Zealand. Saule Omarova is Assistant Professor of Law at the School of Law, University of North Carolina at Chapel Hill, United States of America. Poonam Puri is Associate Dean of Research, Graduate Studies and Institutional Relations, Osgoode Hall Law School, York University, Canada.

x   Contributors Gerhard Schnyder is Lecturer in Comparative Management at King’s College London, United Kingdom. Mathias Siems is Professor of Law at Durham Law School, Durham University, United Kingdom. Cynthia Williams is Professor of Law at the College of Law, University of Illinois, United States of America. Frank Wilkinson is Emeritus Reader in Economics at the University of Cambridge, United Kingdom.

Preface

Many books have long gestation periods. This one, however (although preceded by a number of papers), is the direct result of a chance purchase of the Financial Times at Cambridge railway station one grey and dank afternoon in 2009. In it was a chart, identifying the current top fifty global banks, compared with those of ten years prior. The comparison was based on market capitalization, since the valuation of some (now notorious) asset classes had become problematic, at best. At first glance, the chart contained few surprises; in the 2009 line-­up, large Chinese banks had come to dominate whilst American and British banks, in particular, were notable by their absence. Yet closer examination revealed some apparent oddities. The most obvious of these was the abrupt appearance of a block of banks from Australia and a similar group from Canada. This raised two immediate questions (the first, as it turned out, of many). First, the OECD’s assessment of the 2008 financial crisis had laid the blame squarely on failures of corporate governance at the level of the individual firms involved, rather than inherent failings in national regulatory systems. Whilst this certainly had some truth in it, if it were entirely (or even largely) the case, a more random scattering with respect to the ‘nationality’ of banks might have been expected. The emergence of a number of national blocs of banks suggested that state-­level factors were also at play. The second part of the puzzle was that Canada and Australia, on the face of it at least, had much in common with the US and the UK. Yet whilst Britain and America had seen their financial sectors and wider economies hit hard by the crisis, Canadian and Australian banks had clearly done much better; and their broader economies appeared to have sustained far less damage. This was a surprise, since all four countries share common cultural roots and are liberal market economies (LMEs) with active financial markets; they were liberalized over a similar timeframe and experienced many of the same macro-­economic challenges. Reading the Financial Times article took us as far as King’s Cross; exploring the many factors contributing to these differential effects, would take us to many more places than that. This question of varying effects within a group of apparently similar economies soon gave rise to a lively discussion. From it, we – and shortly afterwards, a group of researchers also associated with the London Centre for Corporate

xii   Preface Governance and Ethics (LCCGE) at the University of London’s Birkbeck College – concluded that the issue warranted further investigation. Our initial hypothesis was that the explanation would probably be found fairly quickly, in differences in the structure and nature of financial market regulation. However the evidence turned out to be far more multifaceted than we anticipated. Whilst there were, indeed, a number of factors that seemed to contribute to the development of the Anglo-­Saxon economies collectively – along with their financial systems and attendant regulatory structures – there were also more complex, inter-­related processes at play, which could indeed be expected to produce differential outcomes. To investigate these issues, a multi-­disciplinary team of researchers was established, whose members were both willing and able to reach beyond the boundaries of their more narrow areas of academic expertise. For further insight into variation in cultural dimensions of the processes of economic liberalization and financialization, and the often subtle nature of the developments and influences we wanted to examine, the research team was constructed to include contributors from institutions based in each of the LMEs – including Ireland and New Zealand.1 This method of working suited the ethos of the LCCGE and the project has been evolving ever since. Since our study would focus on countries widely considered to be the most ‘liberal’ of the capitalist economies, the initial time frame for analysis concentrated on the period of economic re-­liberalization that followed the post-­war Keynesian era. In response to the economic challenges of the 1970s and the perceived inability of Keynesian policies (of macro-­economic management) to resolve them, there was a revival of liberal economic ideas, the implementation of which gave rise to the re-­appearance of financialized liberal capitalism. However, the reality of financialized liberal capitalism has not been an especially good fit with liberal economic theory – which is at best loosely defined, even by its main advocates. It would thus be surprising if there were, in fact, no variation in the interpretation and implementation of liberal economic policy – and the outcomes this produced. We were therefore interested in understanding the likely differences across the Anglosphere with regard to the nature of markets, the role of the state within them, and in whose interests each economy was presumed to be managed. Of course, according to liberal economic theory, and following thirty years of liberal economic policy, the answer to these last two questions should have been ‘none’ and ‘the markets’, respectively. Why this was not the case in reality formed the basis for a further exploration of the nature of economic liberalism, and in particular the concept of ‘ordo-­ liberalism’ which first emerged in Germany during the interwar years. This conceptualization of liberal capitalism assigns a more active role to the state, whilst still acknowledging the value and importance of competitive markets. Of particular interest here is the emphasis on ‘competitive’ (as opposed to ‘free’) markets, with the state enforcing the ‘rules of the game’. On the face of it, ordo-­ liberalism has much to offer. But amongst other challenges is the obvious difficulty of transplanting this (or any other) variety of economic liberalism into

Preface   xiii another political economy. Thus, the search for better ways of theorizing and managing markets, sadly, does not end there. Our study of the operation of markets inevitably meant looking at the mechanisms involved; as a result, we also explored the evolution and operation of financial market regulation, in progressively liberalizing Anglo-­Saxon political economies. Many of those reading this book will have strong views on both sides of the debate about economic liberalism. Indeed, the recurring swings from liberal to regulated capitalism (and back again) since at least the early nineteenth century, suggest that this has probably always been the case. We have, ourselves, tried to put our own views on this debate to one side, in order to more objectively follow the evidence. Indeed, the fact that liberalized economies have no shortage of regulation – and Keynes’ own, rather creditable performance as an investor – suggest that there may be less of a divide than might, at first glance, be apparent. The analysis thus draws on aspects of both economic liberalism and Keynesianism, essential for understanding how we arrived at the present position. It is also worth pointing out that whilst this analysis re-­examines a great deal of history, we have not had much desire to turn back the clock and simply resurrect old ideas. For as L.P. Hartley famously observed, ‘The past is a foreign country; they do things differently there.’ Old ideas, no matter how deeply held, cannot be regarded as silver bullet solutions that are independent of context or environment. Fresh thinking is needed, along with an ability to evolve new ideas to accommodate changing circumstances. This project is perhaps a first step in that direction. Whilst referencing the past, our perspective is resolutely forward looking – and we hope that the future, too, is a ‘foreign country’. We would like to thank all those who have contributed to this book, in so many ways. It is always invidious to pick out individuals, but we would, in particular, like to thank Linda Trenberth – and Birkbeck’s School of Business, Economics and Informatics – for providing support for the first meeting of the Research Network in London in June 2011. We would also like to thank Justin O’Brien – and the Centre for Law, Markets and Regulation – for hosting a second meeting of the Research Network at the University of New South Wales in Sydney in September 2011. We would like to thank John Cioffi, Melvin Dubnick, Paddy Ireland, Roman Tomasic and Sally Wheeler for very valuable input, both at our meeting in Sydney and as the research for this book progressed to completion. We would like to thank Ian Foster for help with preparation of the final manuscript and the editors at Routledge for their continued support throughout. Finally, we would like to acknowledge Marc’s late father, Peter Barrie Davies (1922–2002). Peter was an ‘old school banker’, who worked for the (then) Midland Bank, and subsequently the HSBC, following its takeover in 1992. People mattered to Peter, who was a firm believer in the financial sector’s crucial role in supporting the productive side of the economy. He saw this as being vital for the creation of opportunity and jobs. Peter watched the rapid rise of personal debt during the 1970s and 1980s with deep unease; he viewed the aggressive marketing of loans and credit cards with particular distaste, observing that

xiv   Preface ‘money needs to be a bit boring – you can rely on boring . . .’ Peter did not live to see the 2008 financial crisis; but it would not have surprised him. His assessment of the UK economy during the late 1990s was brief but to the point: ‘We have to do better than this.’ It is hard to disagree with him now. We hope that this book will help to illuminate the processes culminating in the (as yet unresolved) crisis and that it sparks further debate about a way forward – and perhaps some new ideas about how to resolve the current crisis of contemporary capitalism. Suzanne J. Konzelmann and Marc Fovargue-­Davies March 2012

Note 1 These include The LCCGE at Birkbeck, University of London in the United Kingdom; the Centre for Regulation and Governance at University College Dublin in Ireland; the College of Law and the College of Business at the University of Illinois and the Centre for Banking and Finance at the University of North Carolina in the United States; the Critical Laboratory in Law and Society at York University in Canada; the College of Business at Massey University in New Zealand; and the School of Business at the University of Western Sydney in Australia.

Abbreviations

ABCP ACCC ACT AIB AMP ANZ ANZUS APRA ASC ASI ASIC ASX BCBS BHCs BHCA BIS BMO BNZ CBA CBFSAI CBIFSA CC CCB C&CC CDIC CDOs CFMA CFR CFTC CIBC CMEs CMHC CSE

asset-­backed commercial paper Australian Consumer and Competition Committee Association of Concerned Taxpayers Allied Irish Bank Australian Mutual Provident Society Australia and New Zealand Banking Group Ltd Australia, New Zealand, United States Security Treaty Australian Prudential Regulatory Authority Australian Securities Commission Adam Smith Institute Australian Securities and Investment Commission Australian Securities Exchange Basel Committee on Bank Supervision bank holding companies Bank Holding Company Act Bank of International Settlements Bank of Montreal Bank of New Zealand Commonwealth Bank of Australia Central Bank and Financial Services Authority of Ireland Central Bank of Ireland and Financial Services Authority comparative capitalism Canadian Commercial Bank Competition and Credit Control Canadian Deposit Insurance Corporation collateralized debt obligations Commodity Futures Modernization Act Council of Financial Regulators Commodity Futures Trading Commission Canadian Imperial Bank of Commerce coordinated market economies Canadian Mortgage and Housing Corporation consolidated supervised entities

xvi   Abbreviations DTI EBS EEC EMU ERM ESCB FCAC FDI FDIC FDICIA FEE FHC FHOS FIRREA FMS FSA GATT GFC GDP GLB Act GNP GSEs HSBC IAIM IBRC IEA IFSC IFSRA IL&P IMF INBS IRB IRC ISC ISDA ISE JMB LCCGE LMEs LMI LPTs LTCM MBS MCC MMP(R)

Department of Trade and Industry Educational Building Society European Economic Community European Monetary Union European Exchange Rate Mechanism European System of Central Banks Financial Consumer Agency of Canada foreign direct investment Federal Deposit Insurance Corporation Federal Deposit Insurance Corporation Improvement Act Foundation for Economic Education financial holding company First Home Owner Scheme Financial Institutions Reform, Recovery, and Enforcement Act Free Market Studies Financial Services Authority General Agreement on Tariffs and Trade Global Financial Crisis gross domestic product Gramm–­Leach–Bliley Act gross national product government-­sponsored enterprises Hong Kong Shanghai Bank Irish Association of Investment Managers Irish Bank Resolution Corporation Ltd Institute for Economic Affairs Irish Financial Services Centre Irish Financial Services Regulatory Authority Irish Life and Permanent International Monetary Fund Irish Nationwide Building Society internal rating-­based approach Industrial Reorganisation Corporation Insurance and Superannuation Commission International Swaps and Derivatives Association Irish Stock Exchange Johnson Matthey Bankers London Centre for Corporate Governance and Ethics liberal market economies Lenders’ Mortgage Insurance listed property trusts Long-­Term Capital Management mortgage-­backed security market for corporate control mixed member proportional (representation)

Abbreviations   xvii NAB National Australia Bank NAIRU non-­accelerating inflation rate of unemployment NAMA National Asset Management Agency NatMut National Mutual NHS National Health Service NEDC National Economic Development Council NIE new institutional economics NUM National Union of Mineworkers NYID New York State Insurance Department NZBRT New Zealand Business Roundtable NZSE/NZX New Zealand Stock Exchange OCC Office of the Comptroller of the Currency OECD Organisation for Economic Co-­operation and Development OI Old Institutional economics OL Ordo Liberalism OPEC Organization of Petroleum Exporting Countries OSFI Office of the Superintendent of Financial Institutions OTC over-­the-counter PAYE Pay As You Earn PISA Programme for International Student Assessment POSB Post Office Savings Bank PwC PricewaterhouseCoopers PWG President’s Working Group RBA Reserve Bank of Australia RBC Royal Bank of Canada RBNZ Reserve Bank New Zealand RBS Royal Bank of Scotland SEC Securities and Exchange Commission SIB Securities and Investments Board SME small/medium-­sized enterprise SOE state-­owned enterprise SOX Sarbanes–­Oxley Act SPV special purpose vehicle SRO self-­regulatory organization SSAs State Supervisory Authorities TD Toronto Dominion UNCTAD United Nations Conference on Trade and Development VOL Varieties of Liberalism WTO World Trade Organization Y2K Year 2000

1 The ‘not so global’ crisis Suzanne J. Konzelmann, Marc Fovargue-­Davies and Olivier Butzbach

Introduction The bursting of the American sub-­prime real estate bubble in 2008 plunged much of the world into a crisis of such severity that it prompted many economists to brand it the worst since the Great Depression (Reuters 2009). Although widely perceived to be a crisis of liberal capitalism, by 2009 it was clear that the ‘global’ nature of the Global Financial Crisis (GFC) might well be an oversimplification. Of particular interest was the apparently sharp divide in the experience of the six Anglo-­Saxon banking systems: whilst the American, British and Irish banks were very badly affected by the crisis, those of Canada, Australia and New Zealand performed far better (Financial Times 2009). This gives rise to the somewhat unexpected possibility that there might, in fact, be more than one incarnation of liberal capitalism – and perhaps even a less destructive variant than the financialized neo-­liberal model that has been seen to have caused the crisis. The apparent emergence of two blocs within liberal capitalism, displaying such widely differing experiences, is as surprising as it is puzzling. From a comparative perspective, the corporate governance literature generally argues that different countries cluster into a limited number of political/economic ‘models’ (Albert 1993; Whitley 2000; Hall and Soskice 2001a, 2001b; Amable 2003). Whilst a variety of classifications exist, virtually all of the literature groups the six Anglo-­Saxon countries into the same category of market-­based, shareholder-­ oriented or ‘liberal market economies’ (LMEs), with little or no difference being distinguished among them. According to Hall and Soskice (2001a), LMEs rely on market mechanisms to solve the problem of coordination, both among firms and between firms and their various stakeholder groups (such as employees, customers, suppliers and capital providers). They have open and competitive markets that are protected by strict anti-­trust and competition legislation. Levels of regulation, taxation and government intervention in the macro-­economy are generally low. Labour markets are flexible; and in comparison with ‘coordinated market economies’ (CMEs), such as Germany and Scandinavia, both employment protection and welfare spending are relatively low. The Anglo-­Saxon countries thus share a variety of macro-­economic

2   S.J. Konzelmann et al. features that distinguish them from other advanced economies, notably continental Europe and Japan.1 These six countries also constitute the ‘Anglosphere’. All are former British colonies. They consequently share a common language and cultural roots; their legal systems are based on a common law foundation, with customs and values embracing individualism, freedom, rule of law and honouring of contracts (Bennett 2004). These widely recognized economic and institutional similarities would suggest consistent conditions for doing business and thus the likelihood of comparable economic trajectories. We would therefore have expected a similar experience of the 2008 financial crisis.

In search of a smoking gun In the wake of the 2008 crisis, it became clear that American, British and Irish banks had lost heavily in terms of market capitalization whilst those of Canada and Australia actually gained.2 However, it is the contrast in the scale of bank bailouts that most clearly demonstrates the gulf in the financial market performance of the two halves of the Anglosphere in recent years. By March 2009, the US government’s bailout package accounted for 6.8 per cent of GDP, the UK’s 19.8 per cent and Ireland’s a staggering 43 per cent. By contrast, Australia used only 0.1 per cent of GDP to help struggling banks, with Canada and New Zealand spending virtually nothing at all.3 Such a significant skew in the magnitude of bank bailouts would seem to undermine the assessment that the global financial crisis demonstrates insoluble flaws within liberal, market-­based capitalism as a whole. Moreover, the differential effect of the 2008 financial crisis suggests that broad categorizations of ‘models of capitalism’ – which group some of the worst hit countries with those whose financial systems appeared remarkably stable – may well conceal important differences. Divergent outcomes of financialization Further evidence of the divergent outcomes resulting from the twin processes of financialization and economic liberalization in the Anglosphere can be drawn from trends in government debt and private investment. As Figure 1.1 shows, both the level of government debt relative to GDP and its post-­crisis growth sets Australia and New Zealand apart from the other four countries, with relatively lower levels of both. Ireland is clearly an extreme case in terms of burgeoning fiscal debt; and Canada exhibits both a lower level and slower rate of growth than in the rest of the Anglosphere. In short, the US, UK and Ireland can be distinguished from the other three Anglo-­Saxon countries on the basis of the combination of a relatively higher level and rate of growth in fiscal debt. The macro-­economic impact of the crisis can be assessed by looking at the trends in private investment in the six countries, since the level of investment both reflects the general health of the economy and the ‘good’ functioning of the financial sector. As evident in Figure 1.2, during the period 2006–2011,

The ‘not so global’ crisis   3 350 300

IRE

250 200 150 100

UK

AUS

NZ

US OECD

50 CA 0 0

20

40

60

80

100

120

Figure 1.1 General government gross financial liabilities, 2007–2011 (source: OECD 2011b). Note The vertical axis shows the overall rate of growth in government debt between 2007 and 2011; the horizontal axis shows the level of government debt as a per cent of GDP in 2011.

­ ustralia, Canada and New Zealand performed well above the OECD average A whereas the UK, US and especially Ireland performed far worse. So again, the divide within the Anglosphere can be clearly discerned. However, before undertaking to explain the variation across countries, we first look for the ‘usual suspects’ to determine whether the six LMEs should really be considered a relatively homogenous group. In other words, is our puzzle really puzzling? 140 120 Australia

100

Canada 80

Ireland

60

New Zealand United Kingdom

40

United States Total OECD

20 0

2006

2007

2008

2009

2010

2011

Figure 1.2 Changes in real total gross fixed capital formation, 2006–2011 (source: OECD 2011b, based on Statistical Annex Table 5).

4   S.J. Konzelmann et al. Macro-­economic imbalances Despite differences in their experience of the 2008 crisis, the expectation of a similar fate for the Anglo-­Saxon grouping as a whole, finds support not only in the institutional similarities described above. The macro-­economic imbalances to which the crisis has been widely attributed were also demonstrably present in all six countries (FSA 2009).4 As evident in Figure 1.3, capital account liberalization combined with imbalances in household savings rates between Asia and the West, contributing to the availability – and uptake – of cheap and plentiful debt. By 2005, consumers had taken on debt well in excess of disposable income. An OECD study (2006) revealed the extent of this trend: household debt as a percentage of disposable income amounted to 126 per cent in Canada, 135 per cent in the US, 141 per cent in Ireland, 159 per cent in the UK, 173 per cent in Australia and 181 per cent in New Zealand. By this particular measure, whilst all six countries were vulnerable, the two most exposed countries would appear to be Australia and New Zealand, two of the countries whose financial systems were among the most resilient in the crisis.

300

250

200 Australia Canada 150

Ireland New Zealand United Kingdom United States

100

50

0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Figure 1.3 Domestic credit as percent of GDP (source: OECD 2010a).

The ‘not so global’ crisis   5 The mechanisms by which this debt was absorbed were also remarkably consistent. In these largely post-­industrial economies, the debt funding generated by Asian savings found its way into the consumer sector, inflating a property bubble and significantly increasing the ratio of mortgage debt to GDP. Consumer leverage also rose, with mortgages being made at ever-­higher initial loan-­to-value ratios as borrowers and lenders, failing to recognize the inflating bubble, both assumed that debt burdens would ultimately fall as a consequence of continued house price appreciation. Table 1.1 shows that by 2005, consumer debt accounted for a significant proportion of GDP across the Anglosphere, ranging from 72 per cent (in Canada) to 105 per cent (in the UK). Of this, mortgage debt was the major component, accounting for between 60 per cent of consumer debt (in Canada) and 93 per cent (in New Zealand). Here, again, the six countries do not appear to divide into the discernible groupings revealed by the 2008 crisis. As far as the Anglosphere generally was concerned, much of the money that had previously been saved was now being used to fund mortgages and other loans, effectively super-­charging growing consumer indebtedness. Figure 1.4 shows both the rate and degree to which savings rates declined in the Anglo-­ Saxon world. The potentially negative effects of the reduction in savings were not, however, limited to growing consumer leverage. The application of any surplus income to debt funding (rather than savings) sharply reduced the ability of banks to finance themselves through deposits. This, in turn, increased their reliance on the money markets. The result was to make both consumers and financial institutions significantly more vulnerable to any interruption in the flow of cheap debt, thus building in considerable potential for instability. Yet again, there is little in the pattern of Anglo-­Saxon savings rates to suggest that the two groupings identified above would emerge. Mortgages, the major component of consumer debt, can be used not only to finance homeownership; they can also be used to finance additional consumption (in the form of such things as consumer durables and second homes). As evident in Table 1.2, patterns of homeownership are comparable and relatively high across the Anglo-­Saxon world. The relatively high number of owners (as opposed to renters) could be expected to create other fragilities in addition to increased vulnerability to interruptions in the cheap supply of credit. Not only Table 1.1 Household debt levels

Australia Canada New Zealand USA UK Ireland

Household debt (% GDP)

Mortgage debt (% household debt)

96 72 91 98 105 74

74 60 93 73 74 80

Source: OECD 2006: 137–138.

6   S.J. Konzelmann et al. 15 10

Australia Canada

5

Ireland New Zealand

0

United Kingdom United States

–5

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

–10

Figure 1.4 Household net savings rates, 1990–2008 (source: OECD 2010a).

were consumers and mortgage lenders more vulnerable to fluctuations in property values; they were also at risk of the impact of changes in the cost of funding. This is especially the case when a significant bubble bursts; and it can have extremely negative effects on the lender’s asset book and, by extension, its capital ratios. From a consumer point of view, it can result in ‘negative equity’, where the mortgage secured on the property is in excess of its current market value. Consumption bubbles were not the only outcome resulting from large amounts of cheap debt in the Anglosphere. Whilst the steady decline in long-­ term interest rates, evident in Figure 1.5, made debt-­funding ever more appealing, it also made traditional financial instruments increasingly unattractive to both consumers and investors, due to the low returns on offer. This provided the impetus for financial innovation. But to generate a higher return, the resulting Table 1.2 Owner-occupied housing rates Percentage owner-occupied

Australia Canada New Zealand USA UK Ireland

1996–2003

2006–2010

64 65 66 67 74 78

70 68 68 67 68 75

Source: 1996–2003: OECD 2011c; 2007–2008: Australian Bureau of Statistics n.d.

The ‘not so global’ crisis   7 14 12 Australia

10

Canada 8

Ireland

6

New Zealand United Kingdom

4

United States

2008

2006

2004

2002

2000

1998

1996

1994

1992

0

1990

2

Figure 1.5 Long-term interest rates, 1990–2008 (source: OECD 2010a).

complex products necessarily carried considerably greater risk, putting investors in these products into an increasingly precarious position. Taken as a whole, the conditions described above amount to a significant increase in the financial vulnerability of both consumers and lenders across the Anglosphere. But like the institutional origins that underpin the LME grouping, they also appear stubbornly consistent across the six Anglo-­Saxon economies. So whilst increases in debt funding by consumers, investors and financial institutions might well be seen as contributors to financial vulnerability, the six countries appear to have been similarly exposed. Indicators of financial crisis Studies attempting to identify clear and accurate indicators of impending financial crises suggest that asset price inflation, a significant slowdown in economic growth after a prolonged period of expansion and economic liberalization are strongly correlated with financial instability (Reinhart and Rogoff 2009). If there is little explanation for the differing Anglo-­Saxon experiences to be found in macro-­economic imbalances, then using these criteria as a basis for comparison of their exposure to the risk of financial crisis may offer insight. Asset price inflation Inflation – of both financial assets and real estate – is identified as a key indicator of financial instability. Throughout the 1990s, as evident in Figure 1.6, equity prices increased, especially in the US and UK. After a brief decline during the recession of the early 1990s, the upward trend continued, following a very similar pattern in the four largest Anglo-­Saxon countries, with Ireland and New

8   S.J. Konzelmann et al. 250 200

Australia Canada

150

Ireland New Zealand

100

United Kingdom United States

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

1990

50

Figure 1.6 Equity prices (total market capitalisation as a percentage of GDP), 1990–2008 (source: World Bank 2011).

Zealand lagging behind. As a result of the speculative nature of stock markets – famously described by Keynes as amounting to ‘casino capitalism’ – they do not necessarily provide an accurate measure of the ‘true’ value of the underlying asset. The element of ‘psychology’ of these markets is largely what drives the sudden switches between ‘exuberant optimism’ and ‘unreasonable pessimism’ at the root of the ‘boom and bust’ cycle and the consequent instability of these markets. However, whilst prior to 2002, equity price inflation in Canada and Australia was below that of the US and UK, in the years immediately preceding the crisis, the trends shown in Figure 1.6 are remarkably consistent for the US, UK, Canada and Australia and hence do not suggest a divide in vulnerability when the financial crisis arrived. House prices also fluctuated widely during the decades preceding the crisis. As evident in Figure 1.7, they followed a generally upward trend through the early 2000s and resumed their climb before the crisis hit. Compared with the others, Canadian house price inflation appears to be less erratic; but it nonetheless increased during the decade preceding the crisis, before the housing bubble burst. Asset bubbles are a particularly strong predictor of financial crises when the already inflated price of a given asset is used as collateral to raise further debt. This was especially the case in the US and the UK, where many mortgage holders used their home to raise further debt, resulting in excessive vulnerability to any difficulty in servicing the extra debt – as well as increased risk of negative equity. Many mortgage lenders had behaved in much the same way, in an effort to maintain the supply of mortgages with which to build increasingly risky derivative products. However, whilst the US and UK may have had higher levels of equity extraction, this is unlikely to be a distinguishing factor since, as we have already seen, the level of consumer indebtedness was high across all six LMEs.

The ‘not so global’ crisis   9 35 30 25

Australia

20

Canada

15

Ireland

10

New Zealand

5

United Kingdom

0

United States

–5

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

–15

1991

–10

Figure 1.7 Real house prices: percentage change from previous year, 2001–2008 (source: OECD 2008, 2009, 2010).

Slowdown in economic growth Another indicator of vulnerability to financial crisis is a significant slowdown in an extended period of economic growth (Reinhart and Rogoff 2009). Despite short recessions in the early 1990s and a more volatile environment during the early 2000s, Table 1.3 reveals that average annual growth in real GDP was relatively strong during the decades preceding 2008, when it fell off sharply. The early 2000s saw the bursting of the Dot-­com bubble, which was a blow to confidence in the ‘New Economy’, followed by a series of corporate scandals (at Enron, WorldCom and others) and the aftermath of the terrorist attacks of 9/11. As evident in Figure 1.8, these events contributed to a softening of economic growth. This was particularly the case in the US, where the slowdown contributed to the increase in non-­performing loans in the American sub-­prime real estate sector that ultimately sparked off the crisis. However, with the exception of Table 1.3 Annual average percentage change in real GDP

Canada Australia New Zealand US UK Ireland

1981–1990

1991–2000

2001–2007

2008

2009

2.8 3.0 1.9 3.3 2.7 3.7

2.9 3.6 2.9 3.4 2.6 7.1

2.6 3.4 3.5 2.4 2.6 5.5

0.4 2.3 −1.1 0.4 0.6 −3.0

−2.5 1.4 0.0 −2.6 −4.9 −7.6

Source: OECD 2010a, 2011a.

10   S.J. Konzelmann et al. 14 12 10

Australia

8

Canada

6

Ireland

4

New Zealand

2

United Kingdom United States

0

2008

2006

2004

2002

2000

1998

1996

1994

1992

–4

1990

–2

Figure 1.8 Real GDP growth, 1990–2008 (source: OECD 2010a).

I­ reland’s exceptionally strong growth during the 1990s and 2000s, once again, the patterns of GDP growth are largely similar across the Anglo-­Saxon economies. Economic liberalization and financialization Economic liberalization and deregulation since the early 1970s have also been identified as contributing factors in the crisis (FSA 2009; Reinhart and Rogoff 2009). But recent studies suggest that the Anglo-­Saxon countries’ trajectories were comparable and that all have become considerably more ‘liberal’,5 especially since the early 1980s. The US, Australia, UK and Canada were the four most liberalized of the OECD countries in 1980, a position they maintained in 2000, although the UK had overtaken Australia as the second most liberal after the US (Höpner et al. 2009). The Heritage Foundation, too, ranks the six LMEs among the top ten in their ‘Index of Economic Freedom’.6 The effect of economic liberalization was most apparent in the financial sector, which rapidly replaced other industries as the driver of employment and economic growth, especially in the once dominant industrialized economies of the UK and US (Boyer 2000; Peters 2011).7 The extent of the shift is illustrated in Figure 1.9, which tracks the relative contribution of financial and related services to total value added. Between 1975 and 2007, value added by banks, real estate and other business services as a percentage of total value added increased by 102.7 per cent in Australia, 100.6 per cent in the UK, 87.4 per cent in the US, 75.6 per cent in Ireland and 48.2 per cent in Canada.8 So again, these trends do not suggest the divide in the Anglosphere banking systems revealed by the 2008 crisis. Another major trend in the world’s advanced economies, which was particularly pronounced in the Anglosphere, is the shift to a service-­based economy.

The ‘not so global’ crisis   11 40 35 30

Australia

25

Canada Ireland

20

New Zealand 15

United Kingdom

10

United States

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

1990

5

Figure 1.9 Value added by financial services as a percentage of total value added (source: OECD 2010b).

This followed the breakdown of the post-­war mass production-­based model during the 1970s. As evident in Table 1.4, by 2007, service sector employment accounted for between 67 per cent of employment (in Ireland) and 78.8 per cent (in the US) whilst employment in the financial services sector accounted for between 13.8 per cent of employment (in Ireland) and 21 per cent (in the UK). It is also worth noting that although the US and UK lead the others in terms of the contribution of the financial services sector to total value added and employment, these figures are remarkably consistent across the board. This is in spite of the perception that the US and UK stand out as being excessively reliant on the financial sector as an engine of growth. Nevertheless, whilst Reinhart and Rogoff (2009) identify financial market liberalization as an important determinant of financial crises, on the face of it, the apparent resilience of the Canadian, Australian and New Zealand banking systems suggests that this might not always be the case – and that liberalization could perhaps be achieved without necessarily creating major instabilities. Overall, closer comparison of the six Anglo-­Saxon economies’ institutional frameworks, vulnerability to financial instability and presence (or otherwise) of indicators of financial crisis reveals little to distinguish their financial sectors’ performance during the 2008 crisis. On the contrary, there is considerable evidence to suggest that the Anglosphere evolved in a very similar way. Whilst Canada appeared somewhat less vulnerable than the others, most of the major indicators of financial market instability were, nonetheless, present in all six countries.

60.0 64.0 47.0 NA 60.0 70.0

69.5 71.3 56.1 64.8 65.5 70.9

Source: OECD 2002, 2009 (1970–1985).

Australia Canada Ireland NZ UK US

75.1 75.9 67.0 71.0 76.3 78.8

25.2 18.6 42.6 NA 27.2 12.6

% change 1975–2007   7.0   9.0   4.0 NA 10.0 11.0

12.5 12.7   9.8 10.0 15.5 14.2

1990

15.9 17.7 13.8 16.1 21.0 19.0

2007

127.1   96.7 245.0 NA 110.0   72.7

% change 1975–2007

1975

2007

1975

1990

Employment in finance, real estate and other business services (FIRE) (percentage of total employment)

Service sector employment (percentage of total employment)

Table 1.4 Contribution of the financial services sector

The ‘not so global’ crisis   13 Digging deeper What, then, might account for the sharp divergence in financial sector performance across the Anglo-­Saxon grouping? Given the similarities identified so far, the clues are likely to be found much deeper, in the detail of each country’s experience of the parallel processes of economic liberalization and financialization during the decades preceding the 2008 financial crisis. The return to economic liberalism began, to a greater or lesser extent, in response to the perceived inability of Keynesian economic theory and policy to cope with the inflationary crises of the 1970s. So there was a period of nearly forty years during which the six LMEs evolved the institutions and policies that were in place when the 2008 crisis arrived. This being the case, there are a number of mechanisms by which differences might arise. Macro-­economic events, both during and since the 1970s (such as the ending of the Bretton Woods system and the two oil shocks that followed it), in theory might be expected to impact similar economies in comparable ways. But differing responses and institutional capabilities have the potential to produce significantly divergent outcomes. Even those countries with relatively little interest in economic liberalization would find it difficult to escape its effects. The process of economic liberalization is intimately bound-­up with that of globalization; and both are facilitated by organizations that supported the liberal capitalist paradigm (such as the International Monetary Fund (IMF ) and the World Trade Organization (WTO)). However, even these organizations have found it difficult to impose and enforce a standard prescribed model of economic liberalism internationally. This has been amply demonstrated by the recent negotiations with Greece and Italy over austerity programmes, in an attempt to mitigate the on-­going Eurozone debt crisis. Variation might also arise from differing responses to economic events at a national level, such as the opposing responses of Canada and the UK to the collapse of a number of large financial institutions during the 1980s and 1990s. These responses were partly based on the way the crises were perceived in the two countries, the economic and social role of the sectors to which the organizations belonged, and the position of banks and financial institutions both within the national political and economic system and the country’s psyche (Konzelmann et al. 2012). Whilst their differing responses may not have appeared to be particularly significant at the time, the knock-­on effects during the years that followed would prove to be influential in shaping their financial systems during the decades leading up to the 2008 financial crisis. Differences might also result from more random factors, providing unpredictable, but remarkably potent drivers of change. It is highly debatable, for example, whether Margaret Thatcher – generally recognized as being the driver of economic liberalization in the UK – would have had the opportunity to do so without victory in the Falklands War giving her an unexpected second term in office. As another of Britain’s Conservative prime ministers, Harold Macmillan – when asked by a journalist what the most likely cause of a government being

14   S.J. Konzelmann et al. blown off course might be – famously observed, ‘Events, dear boy, events’. The process of economic liberalization may also be shaped by still more subtle factors, rooted in the culture or makeup of a particular political and economic system. Whilst the City of London was (until recently at least) seen to be a highly respected and vitally important component of the UK economy, in Canada, ‘bank bashing is a popular sport’ (Harris 2004: 167) and in Australia, it has been noted that ‘Banks are bastards – and bigger banks are bigger bastards . . .’ (Maiden 2008).

Towards an answer: the framework for analysis The literature on the 2008 global financial crisis abounds with competing perspectives on the causes of financialization, its ultimate consequences and the near-­collapse of the financial system in many countries.9 Most, though, agree on the nature of financialization as a process of macro-­institutional change in which finance serves as a driver of economic growth and assumes an increasingly important role within the political economy (Krippner 2011; Engelen and Konings 2010; Orhangazi 2008; Epstein 2005; Boyer 2000). The process of financialization has been strongly allied with neo-­liberalism, which is a political paradigm – albeit not necessarily a very coherent one10 – as well as a process by which the central pillars of a country’s political economy shift towards greater reliance on market-­based economic coordination. As an historical process, financialization has been strengthened by neo-­liberal reforms; in return, it has served as a foundation for the neo-­liberal transformation of many economies around the world. As discussed above, whilst there is significant institutional similarity among the six Anglo-­Saxon countries, outcomes resulting from the twin processes of economic liberalization and financialization have differed sharply. The puzzle concerns the contrast between divergence in outcomes, on the one hand, and similarity in both long-­term characteristics of the LMEs’ political economies and rapid expansion of their financial sectors, on the other. Why would the performance of the financial sectors in market-­based economies diverge so sharply? The six LMEs were chosen as a consequence of this empirical puzzle, which is itself informed by the conceptualizations of – and debate about – national models of capitalism. Indeed, our choice of cases is in large part a result of the well-­established tradition of classifying these six countries into one homogenous category. This is the case in all of the various streams of research on comparative capitalism – whether they be identified as ‘liberal market economies’ (Hall and Soskice 2001a, 2001b), ‘market-­based systems’ (Zysman 1983) or ‘market-­ based economies’ (Amable 2003).11 In all of these typologies, there is a sense that these six countries are much more reliant than others on market mechanisms; and their various institutional domains are strongly infused with market logic. The Anglo-­Saxon countries are assumed to share basic characteristics with regard to the institutions of coordination at their core, which include financial markets oriented towards short-­term time horizons; general skills provision;

The ‘not so global’ crisis   15 shareholder-­oriented corporate governance; minimal labour market regulation; and a high degree of product market competition (Hall and Soskice 2001a). Within this literature, there is considerable debate about where countries might best be located within the various typologies, whether hybrid types constitute new typologies and even whether typologies are useful at all. But there is relatively little disagreement with regard to the LMEs, with most scholars locating them firmly within the market-­based camp (Jackson and Deeg, 2006).12 Such clustering does not, however, imply that the six countries studied here can be considered identical in terms of their economic organization and functioning; nor do we make any claim about the degree to which they approximate a ‘pure’ market-­based model. Instead, our aim is to understand cross-­country differences by studying the historical development of economic liberalization and financialization within the Anglosphere. Comparative capitalisms During the 1980s, recognition of the divergence in national policy responses to the stagflationary13 crises of the 1970s led to the emergence of a literature on comparative capitalism (CC).14 Some argued that when confronted with similar economic challenges, different institutional matrices produced differing policy responses which in turn generated a range of discernible national political economy outcomes (Goldthorpe 1984). Others maintained that this was the result of interaction between government policies and institutional frameworks (Zysman 1983). During the 1990s, a second generation of CC studies focused on the impact of globalization on national political economies.15 In this, various authors identified national institutions as the main source of ‘resistance’ to exogenous pressures for convergence. With publication of Varieties of Capitalism (Hall and Soskice 2001b) – and the very lively debates that ensued among comparative political scientists, economists and sociologists – the theoretical sophistication of this literature was enhanced. Insights from this debate that have relevance for our analysis, include: acknowledgement of the central role of institutions in explaining cross-­country differences in macro-­economic outcomes and recognition of the interdependencies that exist among institutions at the level of national political economies; the importance of analysing institutional change across time; and recognition of the central role played by politics and the state. Institutions and institutional configurations Institutions play a key role in shaping a country’s trajectory; and financialization and neo-­liberal reforms can be understood as being two aspects of the same process of macro institutional change. In this context, institutions can be conceptualized as a mix of rules and rule-­like resources that constrain and enable actors’ behavior (Hall and Thelen 2009: 9; Blyth 1997: 230). Institutions have distributional effects; and their emergence, transformation and demise often provokes conflicts (Thelen 2010; Boyer 2000). Within these, the distribution of

16   S.J. Konzelmann et al. power among economic agents is centrally important. However, institutions do not represent rational solutions to clear-­cut problems; in many cases, they are the unintended consequence of the pursuit of strategic advantage by economic agents with unequal power (Boyer 2000). To a large degree, institutional configurations stand at the heart of the CC literature. National varieties of capitalism give rise to specific (or not so specific) institutional configurations that produce ‘a particular systemic “logic” of economic action’, a logic that results in ‘typical strategies, routine approaches to problems, and shared decision-­making rules that produce predictable patterns of behavior by actors within the system’ (Jackson and Deeg 2006: 6). Institutional configurations can therefore be seen as second-­degree institutions, combining first-­degree institutions to produce an overall direction to the broader political economy. It is in this sense that we conceptualize economic liberalization and financialization.16 ‘Institutional coherence’ – a property of the institutional configuration in question – is debated in the literature. It was first introduced by Hall and Soskice (2001a), through their use of the concept of ‘institutional complementarities’, where an institution reinforces the effects produced by another institution. However, this raises a number of issues. First, rather than assuming homogeneity within national economic systems as a given, institutional configurations are the result of a process that may or may not occur – thus, it may or may not generate complementarities (Crouch 2005). A second problem concerns the meaning of institutional complementarities, of which there are at least two kinds: reinforcing complementarities and compensating complementarities (Crouch 2010; Campbell 2011). Reinforcing complementarities are produced when one institution works in a way that reinforces the effects of another17 whereas compensating complementarities appear when an institution compensates for deficiencies of another.18 A third, more sophisticated, type of complementarity can be found in the mix of the two (Crouch 2010). A third issue relates to the presumption of some kind of ‘logic of congruence’ that generates institutional complementarities and is closely linked to their success, most often associated with macro-­ economic performance (Crouch 2005, 2010). In other words, institutions complement each other because they need to; and they need to because institutions are ultimately geared towards macro-­economic performance. Our analysis makes no a priori claim about the internal coherence of the institutional framework characterizing the six political economies under study. Rather, we are interested in identifying specific elements of the institutional configuration present in Australia, Canada and New Zealand that shaped the outcomes of financialization and neo-­liberalization to create less ‘pure’ forms than those encountered in the US, UK and Ireland. These elements apparently made them less vulnerable to financial instability. Particular attention is paid to features of the financial system in each country, since complementarities there are likely to have a strong influence on the particular direction taken by financialization. Another institutional complementarity might be found in the role of stock markets. Arguably, the degree to which stock markets can be used to restructure

The ‘not so global’ crisis   17 industry is a function of their regulation and the prevalent structure of corporate ownership; in countries with widely dispersed shareholder ownership, industry is much more vulnerable to hostile takeover and dismemberment. This can exert a multiplier effect on the skewing of an economy towards finance, by rapidly eroding its productive capacity. It can also have a self-­fulfilling dimension, as companies with this kind of ownership structure have incentives to pay excessive attention to the perceived short-­term interests of shareholders – often at the expense of investment, research and development and longer-­term development of the productive enterprise. An important dimension to the analysis will thus be examination of the degree to which a country’s industrial and productive sector is vulnerable to restructuring through the ‘market for corporate control’. The degree of macro institutional coherence may also be related to the degree of heterogeneity of financial institutions and structures. In analysing complementarities, we accept Crouch’s and Campbell’s conclusion that various kinds might coexist synchronically and diachronically. The coexistence of complementarities may be a source of macro institutional reproduction and change, which allows us to go beyond the assumption that institutional ‘stickiness’ (the root of cross-­country divergence in earlier studies) is the result of lock-­in, maintained by institutional complementarities. We reject the efficiency view of institutions and institutional configurations, adopting instead a distributional view, as advocated by a number of institutional scholars (Thelen 2010; Campbell 2011). This leads us to place particular emphasis on the role of politics and the political system in explaining cross-­country variation. Institutional reproduction and change: gradual and punctuated As already noted, financialization and neo-­liberalization are processes of institutional change, which can be expected to generate differences across the LMEs. Our focus on change avoids the problem of comparative statics which beset many early CC studies – where cross-­country variation was explained in terms of differences in static institutional frameworks. More recently, acknowledgement of this problem has led to a burgeoning literature on institutional change.19 The comparative static bias of much of the CC research, in particular those using the Varieties of Capitalism framework, stems from an emphasis on institutional lock-­in (or interdependencies) as the main source of persisting cross-­ country differences. Following this logic, top-­down change in corporate governance (spurred by the diffusion of international norms and/or increased foreign ownership of domestic firms) cannot crystallize because of the interdependence between institutions of ownership and control and other institutions, such as the labour relations, skill and political systems. This view of institutional coherence led to an exploration of the mechanisms of reproduction rather than change – and of path-­dependent mechanisms of institutional reproduction.20 In this view, change could happen, but only as a result of exogenous shocks. The life-­cycle of institutions could then be described as a series of ‘punctuated equilibria’ – a concept widespread in the political science literature.21

18   S.J. Konzelmann et al. Endogenous change was thus under-­theorized; and even those scholars who tried to break through the stasis by bringing in agency and the role of ideas failed to go much further.22 Such is the case in the ‘ideational institutionalist’ literature (Blyth 1997, 2002; Hay 2001; Gofas and Hay 2009). Building on earlier work by Peter Hall, these studies attributed autonomous causal power to ideas – ‘agents cannot have interests without reference to their ideas about their interests’ (Blyth 2002: 34). The role of ideas could be instrumental, endogenous, and highly contextual; yet it operated mostly at ‘critical junctures’, when, for example, existing institutions were already in crisis due to exogenous shocks (Blyth 2002). This view is close to Hall’s (1993) analysis of paradigmatic change, when the uncertainty created by the crumbling of the old paradigm permits actors to seize upon new ideas and transform them into a new paradigm. In this context, think tanks, academics, lobbyists and the media all play a potentially significant role in translating complex economic theory into something accessible to non-­specialists and hence, in shaping opinion. According to Hall (1993), these agents play a central role in shaping change. This was the case when the Keynesian paradigm was undermined during the 1970s and it has continued to be the case as economic liberalism has evolved and re-­branded itself during the decades since. The role played by these agents in the ‘market for ideas’ can thus be seen as a potential driving force in the direction of the pro­ cesses of economic liberalization and financialization and ultimately, the outcomes realized in the countries in our study. However, ideational views do not provide a theory of endogenous, gradual institutional change outside of such critical junctures; nor does the ‘shared mental models’ approach, which grew out of the rational choice tradition. This approach posits that cross-­country differences in the trajectories of capitalism result from the interaction between global ideas – such as neo-­liberalism – and other, locally shared mental models (Roy et al. 2007). This literature, too, relies on a conceptual framework in which exogenous change and local resistance are of central importance, which is of little use to us here. In recent years, in response to these shortcomings in existing theories, the analysis of gradual, incremental institutional change has gained traction (Thelen 1999, 2004; Streeck and Thelen 2005; Mahoney and Thelen 2010a, 2010b). Insights from this literature are potentially useful in advancing our understanding of change within countries across the Anglosphere. Streeck and Thelen (2005) and Mahoney and Thelen (2010a), for example, identify five modes of institutional change – layering, drift, conversion, displacement and exhaustion – of which layering and drift are the most relevant for our analysis. Institutional layering is ‘the introduction of new rules on top of or alongside existing ones’ (Mahoney and Thelen 2010a, drawing on Streeck and Thelen 2005), whilst drift is ‘the changed impact of existing rules due to shifts in the environment’ (Mahoney and Thelen 2010a, drawing on Hacker 2005). Although these two mechanisms are conceptualized as modes of change, this is seen as incremental change (which is not fundamentally different to institutional reproduction): whenever a new institutional arrangement becomes embedded into a political

The ‘not so global’ crisis   19 economy, this gradual process entails both reproduction (the increased legitimacy of the institution or the increasing returns gained by agents)23 and change (the gradual displacement of other competing or previously dominant institutional arrangements). Whilst these five modes were originally intended to describe individual (first degree) institutional change, we are interested in the applicability of layering and drift to the process of broader institutional change. This is because new layers have the potential to tilt the entire configuration of institutions in a new direction; and changes in one part of the system may shift the use and meaning of other parts. Moreover, some parts of the institutional configuration may be more stable and path dependent than others. This is where we see a potentially fruitful connection between the theory of incremental institutional change and analysis of institutional complementarities (discussed above). Institutional complementarities (or disparities) arise over long periods of time, through processes of (second-­degree) layering or drift, themselves the outcomes of distributional conflicts. Similarly, specific institutional configurations have the potential to generate specific kinds of institutional change (Mahoney and Thelen 2010a, 2010b). However, institutional change should not be seen as a state of constant flux. Institutions are structured over time; and financialization is a process of macro institutional change involving both gradual institutional change and institutional reproduction. Both of these mechanisms are part of the complex web of institutional complementarities; and they are associated with the organization and functioning of the political system, to which we now turn. Politics and the role of the state The emphasis on politics, the political system and the role of the state stems from our understanding of economic liberalization and financialization as political processes and recognition of the political foundations of institutions. Like other institutions, political institutions change over time; and there is an inbuilt dynamism within them, since they represent uneasy compromises, always subject to change. Shifts in the balance of power generate pressures for change, as do ‘institutional entrepreneurs’. One of the outcomes of financialization has been the closer inter-­linkage of the fortunes of businesses, consumers and the financial sector. However, this does not mean that everyone is in the same boat – or that interests do not conflict. The degree to which the interests of consumers, businesses and government are conflicted by financialization determines the ability of the state to develop and implement coherent policy. For example, employee interests in current employment and income security can be in conflict with their interests in retirement income, particularly if their pensions are heavily invested in the stock market. Likewise, productive business interests may be compromised if senior managers are forced to prioritize the short-­term interests of shareholders. How these conflicts are perceived and resolved will have a powerful effect on economic performance. They can also adversely affect the ability of voters to

20   S.J. Konzelmann et al. discern the policy agenda that will best serve their longer-­term interests – and the government that is most likely to deliver it. Understanding the political underpinnings of financialization is thus central in our comparative analysis. Here we draw on the insights of earlier works within the CC literature, paying special attention to the centrality of state institutions in shaping national political economy trajectories and the power relationships at play within collective action problems. The ‘neo-­corporatist’ literature focuses on the collective action problems arising from the relationship between organized labour and business interests. Here, the political system is broadly viewed as the arena where – and instruments which shape – the political conflicts between various social groups. It can thus be seen to be a major source of resistance to exogenous pressure for change (through, for example, globalization). According to Berger (1996: 1), ‘where differences do remain and convergence is slow or uncertain it must be that government and/or powerful groups are using resources generated outside of markets to sustain distinctive economic and social institutions’. However, this literature offers little insight into how such resources might change over time; rather than a possible force for change, it characterizes politics as a force of resistance. It also considers political power to be an attribute of various actors. By contrast, we take the view that power is a relational characteristic (Thelen and Steinmo 1992). Scholars analysing financialization and the neo-­liberal shift in the US, systematically underline the political nature of these phenomena (Dumenil and Levy 2004; Krippner 2011; Boyer 2000). They converge on the view that during the ‘critical juncture’ of the 1970s – which in reality lasted many decades – institutional entrepreneurs (including business leaders and conservative politicians) mobilized resources to shift the institutional terrain on which most of the post-­ war socio-­economic building blocks had been founded (Blyth 2002;24 Hacker and Pierson 2010; Krippner 2011). During the 1990s, interest in the processes of financialization and economic liberalization revived interest in the central role played by the political system in shaping national political economies; and there was renewed interest in the state and in the role of state institutions in shaping national political economies. The CC literature interpreted the effects of internationalization on national systems as mediated by national policies.25 Following this reasoning, national trajectories could be seen to result from a mix of external pressures and ‘domestic pull’. The focus on politics as a key factor explaining macro institutional change emerged from the mobilization of contemporary theories of politics, which are highly relevant for our comparative analysis. In particular, the political system can be viewed as the outcome of both conflicts and coalition-­building (the dynamic view, conceptualized by Hall and Thelen 2009; and Hall 2010) and the existence of veto points (the static view, conceptualized by Thelen 2010). This double view is rooted in the idea that institutions are not just functional devices, but ‘distributional instruments laden with power implications’ (Mahoney and Thelen 2010a: 8); they express political compromise, resulting from ‘social conflict originating in the heterogeneity of interests among agents’ (Amable 2003: 10).

The ‘not so global’ crisis   21 According to Amable, ‘institutions are not primarily designed to solve coordination problems between equal agents with similar interests, but to solve conflict among unequal actors with divergent interests’ (Amable 2003: 10). Thus, any discussion of the role that politics might play in shaping institutions or institutional outcomes must take account of power asymmetries among economic agents, the form of coalition building institutions and interest representation. We take it for granted that there is not much ‘ideational variation’ between and across the six Anglo-­Saxon countries, since all were involved in similar, large scale processes of institutional change associated with economic liberalization and financialization. In this, we accept the view of neo-­liberalism as a broadly ‘shared mental model’ (Roy et al. 2007; Roy and Denzau, 2007) and examine the ways in which politics are structured at the national level to explain differences within the Anglosphere. There is a rich literature in political science addressing this question. Some have shown how electoral rules shape redistribution policies, arguing that proportional representation favours higher levels of redistribution through coalition-­forming constraints (Persson et al. 2007). Others argue that proportional representation systems tend to be more redistributive because, to gain power, left wing parties must form coalitions requiring them to forego part of their redistributional agenda in order to acquire electoral support (Iversen and Soskice 2006). These approaches have been described as ‘Schumpeterian’ in the sense that they embrace a view of politics as a competitive market, in which politicians compete to capture the support of rational, atomistic actors who are chiefly interested in securing higher incomes (Hall 2010). In a more systematic effort to explain how political systems shape national varieties of capitalism, Amable (2003), proposed a series of indicators, including the degree of fragmentation of the political system; electoral rules; interest-­group pluralism and the number of veto players; and the degree of ideological divergence between parties. Based on these criteria, market-­based economies are found to be strongly associated with party concentration, majoritarian electoral rules and a low number of veto players (Amable 2003).

Framing the analysis Our analysis builds on the insights developed within the comparative institutional literature.26 We argue that national institutions play a significant role in accounting for the various directions taken by financialization in the six countries covered. Whilst in some respects this is similar to conclusions drawn by contributors to the CC literature during the 1990s and 2000s, rather than explaining the persistence of ideal-­type differences in the face of pressure for convergence, we are interested in explaining the ways in which national institutions – in particular, the political system – shaped the processes of economic liberalization and financialization to produce different outcomes across otherwise very similar countries. Our study also diverges from previous CC studies in its avoidance of teleological accounts of institutional change; we do not assume that financialization

22   S.J. Konzelmann et al. has only one possible outcome (the 2007–2008 financial crisis) and that we should therefore limit ourselves to uncovering the reasons that the Australian, Canadian and New Zealand financial sectors were much less damaged than the American, British and Irish. That would imply that financialization has a predictable outcome and that whenever this is not reached, factors of resistance should be identified. An alternative strategy is to look for factors of acceleration, or reinforcement, that made the US, UK and Ireland more vulnerable to the crisis than the other three. This mirrors debates around institutional congruence and change that are at the heart of the CC literature. Finally, unlike the firm-­centered analyses at the heart of the Varieties of Capitalism project (Hall and Soskice 2001a, 2001b) and the national business systems strand of the CC literature (Whitley 2000), we do not focus on micro-­ level institutional change. Instead, we are interested in understanding the pro­ cesses of large-­scale institutional change and how they varied among the LMEs. This is because, first, economic liberalization – as a discourse, a set of policy and regulatory practices, a set of reforms and ultimately a specific socio-­ economic outcome (financialization) – occurred at the macro-­economic (national) level, even if it pervaded micro-­level behavior and ideas. Second, ‘politics matters’ in explaining institutional change; and the politics that ‘matter’ matter most at the national level. Financialization and the evolution of liberal capitalism The role of the financial sector and its regulation are at the centre of our analysis. Financial activities can be divided into essentially two areas: providing funds for productive industry – using money to make ‘things’ – and more speculative financial activities – using money to make ‘money’. The balance between these two can have a significant effect on outcomes for the economy as a whole, as well as on the nature of the financial system and the relationship between the regulator and those it oversees. Also significant is the degree to which the financial sector is able to play a global (as opposed to a more domestic) role, with implications for regulation and the volume of funds in circulation. This, in turn, raises issues surrounding the ability of financial institutions to grow to a point where they are ‘too big to fail’, with obvious implications for the stability of the financial sector and the broader economic system of which it forms a part. With regard to financial regulation, much has been written about the rules and institutions, but relatively little analysis has been applied to the ways in which regulation is developed and implemented, and the nature of the relationship between the regulator and those it oversees. There are also ‘soft’ issues surrounding the regulatory function, not least of which is the purpose of the regulatory system and in whose interests it is presumed to operate. These issues clearly have much to do with the way the political system operates. The problem that remains is how the financial system – or parts of it, such as the banking system, central bank politics, etc. – interact with the rest of the economy. In the wake of the financial crisis, the issue of ‘re-­balancing’ has been

The ‘not so global’ crisis   23 widely raised in policy debates. The ability of the financial sector to grow at a much faster rate than the rest of a mixed economy, if unchecked, will eventually result in its relative dominance and hence, undue political and economic influence.27 This process can be accelerated if funds that might otherwise be allocated to funding longer-­term productive businesses are instead allocated to shorter-­ term speculative activities. The question thus arises as to whether the existence of other engines of economic growth – such as agriculture, commodities and manufacturing – might play a role in maintaining a higher degree of balance within a liberalized economy, and how that balance might be either preserved or rebuilt. A whiff of gunsmoke: building our hypotheses Political and financial systems and financialization To understand the effect of the interaction between economic liberalization and financialization within a country, it is useful to examine the inter-­relationship between institutional dimensions of the political system and the banking system. As discussed above, within the political system, the existence of ‘veto points’ is an important determinant of macro institutional change.28 Veto possibilities are a function of the number of veto players and their ideological differences (Amable 2003; Ha 2008). Strong (or weak) veto possibilities give rise to a particular mode of institutional change (Mahoney and Thelen 2010a); and multiple veto points might facilitate rather than impede institutional reproduction and drift (Hacker and Pierson 2010). In other words, where there are few veto points, there is little challenge to the status quo, leading to greater policy stability. By contrast, where there are multiple veto points, the policy status quo is much more likely to be challenged – and possibly replaced. In the banking system, the degree of ‘heterogeneity’ – in terms of both the fragmentation of banking and the existence of strong, competitive alternatives to profit-­oriented commercial banks – can be expected to influence the relative concentration of power held by financial interests. In banking systems with a relatively low level of heterogeneity, financial interests are concentrated (and hence more powerful) whereas in systems where heterogeneity is high, financial interests are more widely dispersed. Table 1.5 illustrates the inter-­relationship of these factors within a national political economy.29 We hypothesize that in political systems where the number of veto points and heterogeneity in the banking system are both high, financialization is likely to be ‘contested’. In this case, we would expect financial regulation to evolve in ways that ensures effective supervision and enforcement. By contrast, given the concentration of interests on the part of financial institutions in banking systems where heterogeneity is low, regardless of the number of veto points in the political system, financialization is unlikely to be successfully challenged – an outcome we identify as being ‘consensual’. In this case, we would expect ‘light touch’ regulatory institutions to emerge. The third possibility is ‘compartmentalized’ financialization, where banking heterogeneity is high (and

24   S.J. Konzelmann et al. Table 1.5 Financialization and interactions between political and banking systems Heterogeneity of the banking system

Characteristics of the political system

Few veto points

Low

High

Consensual

Compartmentalized

Multiple veto points Consensual

Contested

financial interests are dispersed) and there are few veto points in the political system (the status quo is unlikely to be challenged). Internationalization and financialization We do not, of course, assume that the six countries each represent hermetically sealed national cases. Overplaying the nation-­state in inter-­country comparisons can be tempting for comparative scholars since institutional configurations form at the national level, shaped by state laws, regulations and politics (Strange 1997). But this does not mean that we should take the centrality of nation-­states for granted (Crouch 2005). Thus, we treat internationalization as an important variable in the analysis. We assume that nation-­states are not equal in their dependence on international flows (trade and finance) (Radice 1998); and they are linked hierarchically, since national financial systems are highly interdependent. We therefore build two additional hypotheses, based on internationalization. We recognize that international capital flows are an institution and institutions have varying impact, determined by the country’s position within the world economy (whether it is ‘core’ or ‘periphery’ (in trade and finance)) and the degree to which its financial system is integrated with the other LMEs. Table 1.6 illustrates the first hypothesis. In countries at the core of the world economy, international capital flows are likely to be ‘enabling’ to the process of financialization – strongly so where the degree of financial integration with other LMEs is high and weaker where it is low. By contrast, in peripheral countries, international capital flows are likely to be ‘constraining’ to the process of financialization – Table 1.6 International financial integration as constraining rules or enabling resources Degree of financial integration with other VOL countries High

Low

Position within the Core Strongly enabling Weakly enabling world economy Periphery Tightly constraining Loosely constraining

The ‘not so global’ crisis   25 tightly so in those where the degree of financial integration with other LMEs is high and loosely so where it is low. Our second hypothesis concerns the degree to which the globalization of markets (for both manufactured goods and finance) has been embraced and the degree to which the rules under which these markets operate have varied. Whilst globalization has allowed businesses to expand, it has shifted the balance of power between the private sector and the state, increasing the scope for regulatory arbitrage and reshaping economies through shifting employment patterns. Globalization has also buffered the effects of income stagnation for large segments of the Anglo-­Saxon world. By substituting imports for more expensive domestically produced products, the cost of living has been reduced; cheap debt through foreign capital has topped up incomes, permitting an artificially high level of consumption. But products sourced overseas come at the expense of domestic employment, with obvious effects on employment and income distribution. We hypothesize that globalization can be understood as yet another potential institutional complementarity that supports the process of financialization.

The chapters ahead As we have seen, little can be discerned from the aggregated data to explain the difference in the relative performance of the Anglo-­Saxon banking systems. We will thus examine in greater detail, the parallel processes of economic liberalization and financialization of each of the six economies, in turn. This reveals many subtle, but influential, factors that together are able to account for the differences in relative performance. Building on the country case studies, the two chapters that follow present an analysis of the trends they highlight, including the evolution of institutional structures and the varying ways they developed in response to both political and economic change – with particular reference to financial systems. The final part of the book begins with exploration of ordo-­liberalism, an early variant of neo-­liberalism that was first proposed by intellectuals of the German Frieberg School during the interwar years. Following the crises of the 1970s, which were seen to discredit regulated Keynesian-­style capitalism, pre-­ Keynesian ideas about the role of competitive markets were revived, setting-­off the macro-­institutional change that found expression in the parallel processes of economic liberalization and financialization. In the wake of the 2008 financial crisis, rather than abandoning economic liberalism, many – on both the political and economic ‘right’ and ‘left’ – have proposed ordo-­liberalism as a possible alternative to neo-­liberalism (the form of economic liberalism that has been widely seen as causing the crisis). However, just as the markets operating under neo-­liberalism were politically constructed, so, too, are those under any other form of liberal capitalism. So rather than being a clear alternative, we argue that it is difficult to discern a clear structural difference between the ‘ordo’ and ‘neo’ variants of economic liberalism. Ordo-­liberalism will hence not take us very far

26   S.J. Konzelmann et al. towards a resolution of the current crisis of contemporary capitalism, or indeed a less volatile future. In the final chapter, we draw conclusions and consider wider questions emerging from the analysis. For example, to what degree might the six Anglo-­ Saxon countries be experiencing the crisis at different rates, with a delay for those less fully liberalized or globally financialized.30 Is ‘learning’ taking place in those that lag behind? And if so, what can we conclude about liberal capitalism and financialization? We will also consider the possibility that the problem may be located in the inherent instability of a particular brand of Anglo-­ American, highly financialized liberal capitalism, rather than in liberal capitalism more generally.31 Finally, we propose the first steps towards a possible alternative. But before turning to our analysis of the possible varieties within liberal capitalism, we first examine the liberal economic world view and the theories, values and predicted outcomes against which the actual experience of the last thirty-­five years must ultimately be judged.

Notes   1 See, for example, Hall and Soskice (2001a, 2001b); LaPorta et al. (1997); Amable (2003); Albert (1993); Whitley (2000).   2 The Financial Times’ (2009) analysis of the change in cumulative market value of the world’s fifty largest banks revealed that, compared with a decade earlier, American and British banks had lost heavily – $633.0 billion and $211.4 billion, respectively. By contrast, Canadian and Australian banks had gained – $97.5 billion and $85.6 billion, respectively.   3 It should be noted, however, that the Harper government in Canada decided in the autumn of 2008 to make available a bailout/stimulus package of C$75bn, corresponding with 4.3 per cent of GDP. Yet, this package can by no means be compared to the US or UK rescue packages. The Canadian ‘bailout plan’ consisted of the government’s commitment to buy ‘good’ – as opposed to ‘toxic’ – assets from the banks so as to inject liquidity into the banking system and, ultimately, the real economy. These funds were thus made available to prevent a slowdown in economic growth rather than to support failing banks. Nevertheless, a proportion of these funds was used to acquire parts of foreign banks that were in trouble and to make strategic acquisitions in attractive markets such as Brazil (Chossudovsky 2009; Heinrich 2009). The figures for the US and UK come from Stewart 2009; the figure for Ireland comes from Reguly 2011.   4 Canada appeared somewhat less vulnerable (in terms of its current account balance and mortgage debt to GDP ratio). See Konzelmann et al. (2012) for a further discussion.   5 Höpner et al. (2009, 5–6) single out three defining principles of a liberal economic order: individual responsibility, decentralized decision-­making and competition.   6 The ‘Index of Economic Freedom’ is based on a range of measures of business, trade, fiscal, monetary, investment, financial and labour market freedom, government spending, property rights and freedom from corruption. See www.heritage.org/index.   7 One important qualification of this general trend concerns the fact that both Australia and Canada have a much larger part of their GDP stemming from extractive industries and mining. This arguably made them less dependent on the finance-­driven growth model that was so prominent in the US and the UK.

The ‘not so global’ crisis   27   8 The figures for 1975 can be found at http://esds80.mcc.ac.uk/wds_oecd/ TableViewer/ tableView.aspx. The 1975 data for New Zealand is not available.   9 See, for example, Rajan 2010; Krugman 2008; Palley 2010; Foster and McChesney 2010. 10 See Crouch 2011. 11 The term ‘Anglo-­Saxon capitalism’, which surfaces here and there to collectively address the six countries studied in this book, has been rightly criticized by Crouch for being semantically wrong (Crouch 2005). Crouch proposes the more obvious use of ‘Anglophone countries’, noting somewhat sarcastically that linguistic unity is, in the literature, ‘the only generalization that really works’ (Crouch 2005: 442). 12 Amable (2003), for example, in analysing five institutional domains (product markets, the ‘wage labour nexus’, the financial system, social protection and education) consistently locates four of the six LMEs – Australia, Canada, the UK and US – within the ‘market-­based capitalism’ cluster. New Zealand is not covered in Amable’s study; and Ireland (as part of the European Monetary Union (EMU)) is included within the Continental European model of capitalism. In assessing national financial systems, too, he puts the same four countries into one cluster, with Ireland being grouped with other countries that have a heavy reliance on foreign capital. 13 ‘Stagflation’ is the co-­incidence of economic stagnation and inflation. 14 For a review of this literature, see Jackson and Deeg 2006. An important earlier precursor to the 1980s and 1990s was Shonfield (1964), who already identified institutions as a key source of divergence. 15 See, for example, Berger and Dore 1996. 16 Hall identifies a ‘social ecology’ (Hall 2010), whereby an institution’s practices, cognitive frameworks and network relations can be analysed together in terms of their interactions with each other. 17 For example, workers’ participation in the corporate governance of German firms reinforces the effects produced by the existence of long-­term bank-­firm relationships in terms of the long-­term, sustainable profit objectives of German firms. 18 Crouch (2010), for example, identified the existence of complementary voluntary social services operating alongside statutory social services in Sweden. 19 See, for example, Blyth 2002; Crouch 2005; Jackson and Deeg 2006. 20 See, for example, Pierson 2000. 21 See, for example, Baumgartner et al. 2009. 22 See Bell 2011, for a critique. 23 See, for example, Pierson 2000. 24 Interestingly, even ideational explanations of those changes, such as Blyth’s, in their empirics actually support a more structural institutional argument (a point raised by Bell 2011). 25 See, for example, Loriaux et al. 1996. 26 For a recent exhaustive review, see Morgan et al. 2010. 27 This argument is similar to that of Campbell 2011. 28 We prefer using the term ‘voting possibilities’ which is broader than veto players and allows us to overcome some of the problems identified with the latter (see Ganghof 2003 for a critical review). 29 The outcome variable builds on the three modes of financialization proposed by Engelen and Konings (2010). 30 As mentioned above, Krippner (2011) argues that financialization and deregulation were responses to the economic crises of the 1970s that provided solutions (such as credit expansion/debt) that now appear to have been temporary only. From this perspective, the problem is systemic (a problem of ‘neo-­liberal’ financialized capitalism worldwide) and the relative good health of some of the case study countries is likely to prove temporary. 31 Some would argue, for example, that liberalization and financialization were solutions to the problems faced by the more socially democratic Keynesian capitalism of the

28   S.J. Konzelmann et al. 1940s–1970s. And that for a while they seemed to have worked (at least to some degree). Growth was maintained, albeit at lower rates than in the post-­war decades. It would now seem, however, that they worked only by encouraging an explosion of debt and by generating a series of asset bubbles which created the illusion of wealth – and which propped up demand to the benefit of all capitalist economies (including less financialized, more productive ones, like China). From this perspective, the solutions to the earlier, general crisis of regulated or Keynesian capitalism (liberalization, financialization, etc.) have now become sources of a new crisis which is gradually spreading from the financial heartlands of the neo-­liberal countries.

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30   S.J. Konzelmann et al. Jackson, G. and R. Deeg (2006) ‘How Many Varieties of Capitalism? Comparing the Comparative Institutional Analyses of Capitalist Diversity’, Max Planck Institute MPIfG Discussion Paper 06/2. Konzelmann, S., M. Fovargue-­Davies and G. Schnyder (2012) ‘The Faces of liberal capitalism: Anglo-­Saxon banking systems in crisis?’ Cambridge Journal of Economics, 36, 2, 495–524. Krippner, G.R. (2011) Capitalizing on Crisis. The Political Origins of the Rise of Finance, Cambridge, MA: Harvard University Press. Krugman, P. (2008) The Return of Depression Economics and the Crisis of 2008, London: Allen Lane. La Porta, R., F. Lopez-­de-Silanes, A. Shleifer and R. Vishny (1997) ‘Legal Determinants of External Finance’, The Journal of Finance, 52, 3, 1131–1150. Loriaux, M., M. Woo-­Cummings, K.E.Calder, S. Perez and S.Maxfield (eds) (1996) Capital Ungoverned: Liberalizing Finance in Interventionist States, Ithaca, NY: Cornell University Press. Mahoney, J. and K. Thelen (2010a), ‘A Theory of Gradual Institutional Change’ in J. Mahoney and K. Thelen (eds) Explaining Institutional Change: Ambiguity, Agency and Power, New York: Cambridge University Press, pp. 1–37. Mahoney, J. and K. Thelen (eds) (2010b), Explaining Institutional Change: Ambiguity, Agency and Power, New York Cambridge University Press. Maiden, M. (2008) ‘Westpac-­St George Merger Won’t Topple Four-­Pillars’, The Age, 15 May. Morgan, G., J. Campbell, C. Crouch, O.K. Pedersen and R. Whitley (eds) (2010) The Oxford Handbook of Comparative Institutional Analysis, Oxford: Oxford University Press. OECD (2011a) Economic Outlook, Vol. 2011, Issue 1, No. 89, online, available at: www.oecd.org/document/2/0,3746,en_2649_34109_2082818_1_1_1_1,00.html OECD (2011b) Economic Outlook, Vol. 2011, Issue 2, No. 90, online, available at: www.oecd.org/document/4/0,3746,en_2649_33733_20347538_1_1_1_1,00.html OECD (2011c) ‘Better Life Initiative: Better Life Index’, OECD: Paris, online, available at: http://oecdbetterlifeindex.org/topics/housing/. OECD (2010a) Factbook, OECD: Paris, online, available at: www.oecd-­ilibrary.org/economics/oecd-­factbook_18147364. OECD (2010b) Main Economic Indicators, OECD: Paris, online, available at: www.oecd. org/std/mei. OECD (2008, 2009, 2010) Key Tables, OECD: Paris. OECD (2006) ‘Has the Rise in Debt Made Households more Vulnerable?’ Economic Outlook 80. December, online, available at: www.oecd.org/dataoecd/40/31/ 39698857.pdf. OECD (2002, 2009) Economic and Social Data Service, OECD: Paris. Orhangazi, O. (2008) ‘Financialisation and Capital Accumulation in the Non-­Financial Corporate Sector: A Theoretical and Empirical Investigation on the USE: 1973–2003’, Cambridge Journal of Economics, 32, 6, 863–886. Palley, T.I. (2010) ‘The Limits of Minsky’s Financial Instability Hypothesis as and Explanation of the Crisis’, Monthly Review, 61, 11. Persson, T., G. Roland and G. Tabellini (2007), ‘Electoral Rules and Government Spending in Parliamentary Democracies’, Quarterly Journal of Political Science, 2, 2, 155–188. Peters, J. (2011) ‘The Rise of Finance and the Decline of Organized Labour in the Advanced Capitalist Countries’, New Political Economy, 16, 1, 73–99.

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2 The return of ‘financialized’ liberal capitalism Suzanne J. Konzelmann, Marc Fovargue-­Davies and Frank Wilkinson

Financial booms and busts have occurred with some regularity ever since the tulip mania of 1636–1637. Yet we tend to treat them as pathologies that happen at other times or in other places. Their frequency suggests that we would be better advised to think of them as a central feature of capitalist economies that our models should aspire to explain. (Bean 2009: 26)

Introduction Liberalized global financial markets are nothing new. A review of the history of financial markets reveals much about their tendency to liberalize and globalize, their inherent instability and their surprising persistence, despite recurring crises. However, it is also important to recognize that all markets are socially and politically constructed;1 they are not the natural phenomenon that liberal economists seem to suppose. The appearance of markets, their scope, operation and regulation – and even their all too frequent failure and need of rescue – have inevitably social and political dimensions, influenced by national culture, politics, pragmatism and force majeure. The political dimension of markets and the way they operate plays a significant role in determining which – and the way by which – economic and social ideas inform policy. Liberal financial markets – a long record of instability Internationally liberalized financial markets and their instability were very much a fact of nineteenth century economic life; and there were major global financial crises or ‘panics’ in 1819, 1873 and 1893. For an understanding of the dynamic of these events and their aftermath, much can be learned from the panic of 1873, which has been described as ‘the first truly international crisis’ (Glasner and Cooley 1997). It resulted in a two-­decade-long depression, initially referred to as the ‘Great Depression’, the responses to which included greater state intervention in the form of protective tariffs and nationalization as well as a shift towards much more conservative economic thinking and policy-­making

Return of ‘financialized’ liberal capitalism   33 (Cameron 2000: 38–40; Garraty and Foner 1991). Some thirty years after the world recovered from this setback, a crisis of even greater severity erupted, usurping the title of the ‘Great Depression’. The post-­1873 episode was subsequently downgraded to the ‘Long Depression’. In many ways, the Long Depression served as a reference point for the Great Depression of the 1930s, as, in turn, the Great Depression does for the aftermath of the 2008 global financial crisis. A feature of both is that political and corporate memory is notoriously short. By the 1920s, economic liberalism was once again the operational norm. In America, during the ‘roaring Twenties’, both consumer durables spending and speculation on the booming stock market were significantly credit-­financed, fuelling a consumer-­led boom and a financial market bubble. In early 1929, consumer demand turned down and the US economy slipped into a deepening recession. Later in that year, the stock market spectacularly crashed, transforming the recession2 into a deep global depression.3 Managed capitalism: the Keynesian interlude During the Great Depression, the failure of laissez-­faire capitalism to deliver its theorized economic and social benefits became abundantly clear. Hitherto, the financial system had succeeded in fending-­off tighter regulation. This was due in no small part to the complex and technical nature of international finance that had enabled ‘private and central bankers sympathetic to financial liberalism to dominate international finance well into the 1920s’ (Helleiner 1994: 28). The establishment of the Bank of International Settlements in 1930 represented an effort to stabilize the financial system by establishing mechanisms to intermediate and depoliticize the process of funding loans and war reparations. However, this failed as the large global imbalances fuelled by war reparations imposed on Germany by the Treaty of Versailles combined with a collapse in market confidence to precipitate the international financial crisis of 1931. The resulting chaos prompted a sea-­change in economic theory and policy. In this, Keynes’ argument that growing economies tend to settle at less than full employment because effective demand lags rising income, opened the way for the state to assume a role in countering involuntary joblessness, by inducing additional expenditure. Keynes also argued against the idea that economic agents have perfect foresight – or even that they know enough about the range of possible future economic outcomes for mathematical probability to be useful in predicting upcoming events. Rather, he reasoned that there is profound ignorance about long-­term economic trends and that markets – particularly financial markets – tend to operate on relatively short-­term time horizons. In Keynes’ view, an unknowable future creates ‘waves of irrational psychology’ in financial markets, which swing from unbridled optimism to overwhelming gloom (Keynes 1936). Individuals and organizations trading in these markets tend to adopt the convention that periods of prosperity (or dearth) will continue indefinitely. As a result, the system is ‘shocked’ into sharp reversals when circumstances change. Therefore, Keynes insisted that financial markets are inherently unstable and

34   S.J. Konzelmann et al. require government regulation if their economically disruptive propensities are to be contained.4 During the 1920s, American economic thinking had similarly evolved; and, in many ways, it had anticipated Keynesian analysis and policy recommendations. These tendencies were reinforced by the onset of the Great Depression (Laidler 1999: 211–212). Important insights into developments in American economic thought during this period can be found in a Memorandum prepared by Currie, Ellsworth and White in January 1932.5 [This Memorandum] sketches out an explanation of the then developing Great Contraction, as well as a comprehensive and radical policy program for dealing with it . . . the main domestic component of that program was to be vigorously expansionary open-­market operations and substantial deficit spending that, particularly in its early stage, was to be financed by money creation; its international dimension involved a return to free trade and serious efforts to resolve the problems of international indebtedness that had originated in the Great War and in the Treaty of Versailles. (Laidler and Sandilands 2002: 516) The financial chaos following the 1929 Stock Market crash and the banking crisis of 1931 produced a fundamental re-­orientation of American economic policy with the ‘New Deal’ reforms, introduced by the incoming Roosevelt administration, two years later. According to Arndt (1944: 34), this ‘was the most spectacular attempt that was made after the great depression to promote recovery by means of a deliberate expansionist policy as the chief stimulus of economic activity, and without recourse to totalitarian control of the economic system.’ However, although Keynesian-­style policies contributed to economic recovery during the 1930s, it was not until the massive economic stimulus of the Second World War that anything like full employment was restored. Bretton Woods – towards a new world order For the Keynesian economic system to function as theorized, it is essential that both monetary and macro-­economic stability and control are established, especially control of finance. Any loss of financial control renders state intervention in the national economy – as well as coordinated action by states in the international economy – increasingly ineffective. After the Second World War, things initially looked promising. Like the First World War, the Second had been, to a large extent, an industrial war. As a result of its scale, it also contained the seeds of globalization. Important lessons were learned about the value (or otherwise) of mass production, management and distribution; and Simon Kuznets’ accounting system for measuring national economic growth had been employed to reveal any unused productive capacity that could be utilized for war-­time production. These benefits were extended internationally by inter-­country cooperation during and after the war.

Return of ‘financialized’ liberal capitalism   35 Consequently, by 1944, vivid memories of the Great Depression combined with a heightened awareness of the possibility of a new world order that could emerge from cooperation fostered by the war. This led to the establishment of the Bretton Woods System. Recognition of the role that trade barriers had played in reducing world trade and exacerbating the Great Depression lent ­priority, under Bretton Woods, to encouraging free trade. At the same time, global financial markets were to be stabilized by the regulation of international capital flows. Currency exchange rates were pegged to the US dollar, which was backed by gold, effectively linking the currencies of all participating countries to gold. Having witnessed the severe disruption to exchange and trade relations caused by speculative capital flows during the interwar years, Keynes and Dexter White, the architects of the Bretton Woods System, believed strongly in international capital controls; and mechanisms by which they might be enforced formed part of the accord. As a result, international trade was prioritized over globalized finance and a more stable, long-­term environment was created within which trade could flourish. In 1947, the General Agreement on Tariffs and Trade (GATT) was established, leading to tariff reductions and plans to reduce non-­ tariff barriers. By stabilizing the international economic environment, Bretton Woods contributed to creating the conditions in which national governments could more effectively operate interventionist welfare states. In addition to the international capital controls of Bretton Woods, recognition of the financial sector’s responsibility for the 1929 stock market crash led to national regulations to encourage greater stability in financial markets. These included the second Glass–­Steagall Act in the US, which effectively separated retail and commercial banking from more speculative investment banking activities. Overall, the post-­war accord renewed international commitment of the liberal ideal of free trade within a framework of managed currencies, based on the recognition that unregulated financial markets posed serious threats to free trade (Helleiner 1994). In short, following the Second World War, across the Anglo-­Saxon world, but especially in the US and UK, there was a major increase in state intervention in the economy, through public ownership and public spending on social welfare and armaments. The state assumed a central role in managing the economy; and there was widespread commitment to full employment and the welfare state. Financial institutions were either put under state ownership or more tightly regulated to ensure that finance fulfilled its creative function of channelling capital to the productive side of the economy. This helped lay the foundations for high wage, mass production industrial economies, in which prices were stabilized and there was greater accord between capital and organized labour. The result, especially during 1952 to 1960, was full-­employment, non-­inflationary growth, rapidly rising living standards and reduced inequality; and this was a period that was widely considered to be the ‘golden age’ of post-­war economic history (Marglin and Schor 2007).

36   S.J. Konzelmann et al. Tarnishing the golden age? Whilst the ‘golden age’ was characterized by regulated financial markets, financial stability, high rates of growth, improved standards of living and reduced inequality, the conditions that exemplify the period of finance-­led neo-­liberal capitalism leading up to the 2008 financial crisis could not be more different. From the 1970s, rates of growth declined, financial instability increased and inequality intensified (Bresser-­Perriera 2010). In short, the early post war political and economic system was, in most respects, the polar opposite of the current one. The role and influence of the state has been radically reduced whilst that of the private sector – finance, in particular – has expanded dramatically. Currencies are at best only lightly managed and the money supply cannot be effectively controlled. Moreover, the Anglo-­Saxon world has experienced widespread deindustrialization of its manufacturing base. How was such a volte-­face possible? And what have been the drivers behind it? This chapter traces the developments that led to the progressive undermining of the Keynesian economic system and the return of liberalized global financial markets. We explore the ‘stagflationary crisis’ of the 1970s, which triggered the revival of pre-­Keynesian theory and policies. This accelerated the processes of economic liberalization, globalization and financialization and created the potential for ‘variety’ within liberal capitalism and, hence, the divergent experiences of the six Anglosphere banking systems during the 2008 crisis.

Globalization and financialization Within less than three decades following the world’s recovery from the ‘Long Depression’, the financial sector had escaped the restrictions placed upon it. It worked its way back to the position it held during the 1920s, from which it had fuelled the asset bubble, the bursting of which contributed so much to the deepening of the Great Depression in 1929. In similar fashion, the rehabilitation of the international financial system – to its pre-­1931 pre-­eminence – began when the ink on the Bretton Woods Agreement was barely dry. However, the revitalization of finance was not the only force at work. The increase in international trade under GATT contributed to macro-­economic prosperity and a steady improvement in living standards throughout the developed world. It also provided incentives for the relocation of production to ever lower cost locations, both nationally and internationally. This prompted de-­ industrialization in high wage industrial regions and, ultimately, countries. As the increasing globalization of private industry progressively undermined the regulatory power of nation states over business, financial markets were also beginning to wriggle free. This gave a major boost to globalization, as the ability to raise funds for corporate expansion and to freely move capital made the alliance between finance and industry crucial to both.

Return of ‘financialized’ liberal capitalism   37 Financial liberalization It is often argued the events of the 1970s were pivotal in the falling-­out of favour of Keynsian-­style macro-­economic management. But the decade of the 1970s was more the occasion than the cause of the revival of economic liberalism. As already noted, for a Keynesian system (in which the state is responsible for macro-­economic management) to be effective, significant controls are required, especially of finance. The first significant testing of the new, more managed international financial world order can be traced to developments as early as the 1950s. The US-­funded Marshall Plan, which played a vital part in rebuilding war-­torn Europe, created an enormous increase in US dollars held by foreign countries and companies. This caused pressure for the creation of a market in which dollars could be freely exchanged; and during the Cold War, London was the preferred centre for Euro-­ dollar trading, especially for the Soviet Union (Helleiner 1994: 81–100). Since the financial sectors of the US and UK had been aspiring to regain the dominant position they had enjoyed before the financial market reforms that followed the 1931 financial crisis, in order to attract international business, the Eurodollar markets went largely unregulated; and they grew rapidly during the 1960s. This was a major step on the road to global financial liberalization (Burns 2006). The laxness of financial market regulation during the 1960s attracted foreign banks and bankers to London (Schenk 2004). But far more importantly, it created ­precedents for the further liberalization that allowed financial institutions to circumvent both domestic financial controls and the Bretton Woods agreement. In so doing, it fatally undermined the foundations of the post-­war system of international financial market regulation (Burns 2006), including its underpinning of Keynesian macro-­economic policy. Low unemployment and rising living standards during the 1950s and 1960s produced a mood of optimism; and, as memories of the stock market crash and Great Depression faded, the atmosphere of caution gave way to one of confidence and innovation. This gradually overwhelmed any lingering concerns about the need for regulating and stabilizing finance. Competition between the financial centres in London and New York encouraged increasingly ‘light touch’ regulation to make them attractive to global finance. Thus, whereas early post-­war reforms had favoured the productive over the speculative use of capital, this priority was reversed as the controls that had restricted the international movement of financial capital during the 1950s and 1960s were gradually loosened and as, in the process, finance and industry were increasingly decoupled. It also sparked the transformation of what had, in effect, been a public international monetary order into what became essentially a private network (Burns 2006: 13). Financial re-­liberalization had begun. Globalization spurs de-­industrialization One of the results of a combination of the freeing-­up of trade (encouraged by  GATT) and increasingly liberated financial markets was an acceleration of

38   S.J. Konzelmann et al. globalization. From the 1960s onward, the growing importance of multinational firms transformed industrial organization and location. These firms relocated production in search of reduced labour and social welfare costs, tax breaks and the docile, non-­unionized labour offered by developing countries and regions. Meanwhile, growing concentration in retailing and the extending global reach of supermarkets acted as conduit for the rising flow of cheap, foreign-­produced consumer goods, especially into the American and British domestic markets. Finance played a crucial role in these developments. Not only did it provide the funds and advice that international corporations needed to fully exploit global opportunities; the loosening of capital controls also facilitated the repatriation of profits. The acceleration of globalization also spurred de-­industrialization in established manufacturing regions; and it significantly weakened the ability of national governments to influence macro-­economic outcomes and to counter the negative effects of de-­industrialization on their faltering economies. Nation states came under growing pressure from free trade and from the concessions they were required to make in order to induce global firms to invest domestically. The private sector was rapidly gaining the upper hand. Financialization of industry This was also a period when the ‘financialization’6 of industry began – a process that continued apace during the decades to follow. In general, liberal market economies (LMEs) have deep and liquid stock markets in which widely dispersed shareholder ownership makes it possible for investors to use the take-­over mechanism as a means of profiting from under-­valued companies (Hall and Soskice 2001). During the 1960s, the theoretic identification of the stock market as an ‘efficient market’ for corporate control and the development of Agency Theory combined to legitimize the stock market’s role in restructuring industry.7 This increasingly focused management’s attention on financial markets and the delivery of ‘value’ to shareholders – diverting their attention from the strategic development of the enterprise itself (Lazonick and O’Sullivan 2000). Especially in the UK and the US, this resulted in a wave of hostile takeovers – financed through debt from the increasingly resurgent financial markets – and requiring asset stripping to repay the leverage. This ‘hollowed out’ industry on a massive scale, shifting the focus of business from making ‘things’ to making ‘money’. As well as the interest it charged on loans, the financial services sector profited from financial advice, new issues of stocks and bonds and the increased opportunities for speculation in financial and commodity markets. Consumer goods markets also became increasingly financialized as providing loans for purchases proved more profitable than cash sales, and as buying consumer goods on credit became increasingly the norm. In turn, the habituation of consumers to high levels of indebtedness not only fuelled bubbles (which ultimately collapsed); it also made consumption increasingly sensitive to changes in monetary policy. Financialization and its destabilizing influence were thus becoming all pervasive.

Return of ‘financialized’ liberal capitalism   39 The final collapse of Bretton Woods During the 1960s, especially in the US, the emphasis in economic policy shifted, from maintaining Keynesian-­style full employment and a high level of effective demand, to a ‘new economics’ focused on growth (Perry and Tobin 2000). But the prosperity of this period masked growing imbalances and by the late 1960s, strains began to show (Marglin and Schor 2007). At this point, the state had the option of intervening to cool the economy. However, according to Gardner Ackley, US President Johnson’s chief economic strategist, they were ‘learning to live with prosperity and frankly, we don’t know as much about managing prosperity as getting there’ (quoted in North 1988: 98). As it turned out, he was proven to be largely correct; and state intervention to cool the economy never came. Coincidently, international competition intensified with the re-­emergence of Japan and the continental European countries as leading industrial economies, along with the rapidly increasing low cost manufacturing in developing countries. Manufactured imports into the LMEs surged, causing a sharp deterioration in the balance of trade, especially in the US. In 1971, in response to its first trade deficit since before the First World War, and under pressure to devalue the dollar, President Nixon announced that the US would no longer back the US dollar with gold.8 This immediately decoupled the other Bretton Woods currencies from gold, lifting exchange rate controls and allowing them to float – thereby enhancing opportunities for speculating on exchange rate movements. Further damage to the Bretton Woods System was to follow. Whilst the US had been tolerant of capital controls by other countries, it had rarely used them itself. Thus, when the UK relaxed capital flow restrictions by scrapping exchange controls in 1979, other countries soon followed suit and any form of regulation of global financial markets came to an end. This was in spite of efforts by Japanese and Western European governments who, in an attempt to maintain a degree of policy autonomy, lobbied unsuccessfully for voluntary capital controls to remain in place (Helleiner 1994). Thus, as a result of action taken by the countries with the most influential financial centres (New York and London), both international capital movement restrictions and currency exchange rate controls were removed. The resulting exchange rate volatility was a milestone in the process by which progressive liberalization displaced the state interventionism of the early post-­ war period. It would also eventually serve as a significant factor in the development of ‘financially engineered’ risk management that later morphed into the ‘dodgy’ financial instruments at the centre of the 2008 crisis.

The 1970s, the demise of Keynesianism and the neo-­liberal ‘counter-­reformation’ The progressive weakening of the Bretton Woods Accord had consequences that would significantly contribute to the global inflation in the 1970s. Since oil was

40   S.J. Konzelmann et al. priced in US dollars, the removal of gold backing for the dollar and its subsequent devaluation in 1971 caused a sharp decline in the Organization of Petroleum Exporting Countries’ (OPEC) income. They responded by announcing that, in the future, oil would be priced in gold. Whilst this was not implemented immediately, the ‘future’ arrived abruptly, when America and Western Europe decided to back Israel in the Yom Kippur war. This enraged Arab oil producers and resulted in the 1973 oil crisis, when OPEC increased the price of oil from three to twelve US dollars a barrel (Hammes and Wills 2005). World primary product prices had been rising since the late 1960s as growing world demand pressed increasingly on scarce supplies; and this world-­wide inflation was given a substantial boost by the quadrupling of oil prices. A second consequence of the oil crisis was the accumulation of large surpluses in the balance of payments of oil-­exporting countries, and large counterpart deficits in the balance of payments of oil-­importing countries. Faced with accelerating inflation and worsening trade balances, industrial countries deflated their economies and, as the economic downturn developed into a major world slump, growth slowed and unemployment soared. This eased inflationary pressure somewhat until 1979, when a second oil-­price shock followed the Iranian revolution. The resulting ‘stagflation’9 hastened sectoral and regional decline in industrial economies, leading to the further destruction of jobs. Consequently, governments faced rapidly rising budget deficits as tax revenues fell sharply, and as the costs to the public purse of mass redundancies and failing industries increased. Since stagflation was attributed to fallacies in Keynesian theory and resulting policy failures, there was a revival of pre-­Keynesian liberal economic beliefs in the monetary causes of inflation and the efficacy of unrestricted markets in determining real economic outcomes. Meanwhile, the ability of national governments to intervene to manipulate the level of effective demand – the foundation stone of Keynesian policy and macro-­economics – had been eroded by the progressive liberalization of international finance and the globalization of industry and markets. Taking all these factors into account, it is possible to argue that the events of the 1970s were neither a consequence of Keynesian policy, nor random economic events with which the paradigm could not cope. Rather, it was globalization and increasing financial liberalization that played the major part in the demise of the post-­war Keynesian system. With international capital controls gone, there was simply too much play in the steering for effective domestic macro-­economic management. Liberal economic thought during the Keynesian interlude: not dead but regrouping The combination of depression and the experience of the Second World War had not only given rise to Keynesian interventionist thought. The custodian of liberal economic theory and policy had been reconsidering their doctrine, especially in the light of recurring post-­war economic crises. Thus, within the classical liberal

Return of ‘financialized’ liberal capitalism   41 e­ conomic school of thought, there were competing explanations for financial market crises and the depressions that usually followed. But the broad consensus was that these events were the consequence of misdirected state intervention. This – in terms eerily prescient of the 2008 crisis – was intended to cast doubt on suggestions that free market operations were in any way responsible for financial crises. In contrast to Keynes’s articulation in the General Theory of a positive role for governments in the management of the economy, there is little in the way of overarching theory setting out a constructive role for the neo-­liberal state. The key underlying assumption of economic liberalism is that free economic interchange is between individuals (people or organizations) and that it is best carried out in self-­regulating markets, which are theorized to transform the inherent selfishness of individuals into general economic well-­being. The market is seen as providing opportunities and incentives for individuals to fully exploit their property – labour in the case of workers, money in the case of finance capitalists – whilst at the same time preventing them from exploiting any advantages that ownership might afford by throwing them into competition with others similarly endowed. By these means, markets are assumed to provide a forum in which the values of individual contributions are collectively determined by the choices of buyers and sellers. Judgements are delivered as market prices, which guide labour and other resources to their most efficient use. Competitive markets are thus theorized as equilibrating mechanisms, delivering both optimal economic welfare and distributional justice. Consequently, economic liberals assert that man-­made laws and institutions need to conform to the laws of free market exchange if they are to not be in restraint of trade and, hence, economically damaging. This logic nurtures a radical anti-­government rhetoric, best expressed in Ronald Reagan’s assertion that ‘Government is not the solution to our problem. Government is the problem’. From this perspective, the effective functioning of markets is best assured by ‘rolling back the state’. In addition to a strong bias against state intervention, neo-­liberals take a staunch position on how the state should get involved if it has to: it should ensure market freedom for economic actors but not intervene as one (Gamble 1996). The notion of self-­organization, which is central to this neo-­liberal creed, however, makes it difficult to identify the specific mechanisms by which the liberal economy operates, and how it might be regulated by the state. This may help to explain why neo-­liberalism has such a remarkable ability when challenged to rapidly metamorphose into something that appears to be entirely different (Peck 2010). However, this again raises the fundamental problem at the heart of neo-­liberal economic theory: any form of state influence means that markets are political constructs rather than the ‘force of nature’ envisaged by Adam Smith, Milton Friedman, Friedrich von Hayek and other liberal economists, whose ideas have been developed since the late 1940s within the Mont Pelerin Society and other right-­wing think tanks (Mirowski and Plehwe 2009). As Chapter 11 reveals, within these institutions, alternative concepts of liberal economic theory, policy, and the extent and nature of state involvement in the economy have long been debated.

42   S.J. Konzelmann et al. New economic liberalism in theory The malleability of economic liberalism allows a great deal of scope for both pragmatism and reinterpretation, giving rise to the possibility of alternative versions. This is illustrated by the initial enthusiasm for monetarist solutions to the problems of the 1970s and the subsequent shift in approach that resulted from their perceived exacerbation of the crisis. From the mid-­1960s, as prices and unemployment rose together, despite counter-­inflationary measures, Friedman (1977) resuscitated pre-­Keynesian monetary theory. He contended that inflation is a purely monetary phenomenon, caused by an increase in the money supply above that needed to finance increases in real output at the current price level. The level of unemployment, he argued, is determined by supply and demand in the labour market; and there is a level of unemployment at which inflation is stable, a ‘natural’ level determined by labour market inflexibility and imperfections. Any attempts to reduce unemployment below its natural level by monetary means would thus be expected to cause inflation to accelerate. Friedman acknowledged the possibility that an increase in the money supply might raise employment above its natural level. But he argued that this would only be a temporary departure as inflationary expectations would be expressed in wage claims adjusted upwards to the higher rates of price increase. (Friedman 1977). This assumption of adaptive expectations was subsequently challenged by the rational expectations theorists, who argued that by experiencing inflation, individuals come to understand the monetary causes of price increases. Thus, any increase in the money supply would immediately trigger expectations of inflation and compensating wage demands; and inflation would adjust smoothly to changes in the money supply. This understanding of the process of inflation theorized to rule out unanticipated inflation and anchor unemployment firmly at the natural rate, regardless of what happened to the money supply and prices. From the monetarist perspective, therefore, inflation is a purely monetary phenomenon; and unemployment is explained by imperfections in the labour market, caused by state, trade union or other forms of intervention in the working of the labour market. When the economy is operating below the ‘natural’ level of unemployment, these interventions are seen to raise labour costs above what employers can afford and/or below what workers are prepared to accept. The greater the imperfection in the labour market, the higher the natural level of unemployment. A group of economists, identifying themselves as ‘New Keynesians’, arrived at the same conclusions as the neo-­liberals but by a somewhat different route. These economists, of which James Meade was a founder member, recognized the possibility of Keynesian involuntary unemployment and accepted that government policy could overcome it and secure full employment. However, they contended that labour market imperfections, especially trade union activities, posed a major obstacle to achieving this objective. Their theory of the labour market, particularly their attachment to the marginal productivity theory of

Return of ‘financialized’ liberal capitalism   43 wages (which is also a tenet of orthodox neo-­classical theory) and their theorizing about the obstacles to full employment locate the New Keynesians firmly in the new economic liberalism camp. Meade (1982), for example, argued that for any given increase in total monetary expenditure, the balance between inflation and employment is determined by the degree of wage pressure generated by trade unions. He took the wages that firms can afford to pay to be determined by marginal revenue product,10 which he assumed to decline as employment rises. Therefore, the level of unemployment at which inflation stabilizes – the ‘non-­accelerating inflation rate of unemployment’ (NAIRU) – is a function of the excess of wages negotiated by trade unions over the level of marginal revenue product at which employers can afford to deliver full employment. The lowering of NAIRU thus requires a moderation of wage increases. According to Meade, this is first, because less and less output may be added to production as more and more men have to work with the given equipment and other resources of the firm; and, second, because the employer may be selling his product in an imperfect market so that if he produces and sells more he may have to lower his selling price (or incur greater selling costs) in order to dispose of the increased output. (Meade 1982: 49) Imperfect competition in the product market is thus seen as driving a wedge between wages and marginal productivity. Other New Keynesians have provided additional explanations for the size of this wedge. Nickell, for example, suggested that it is increased by employers’ taxes, excise tax, real import prices and other non-­labour costs (Nickell 1985: 101). The essence of New Keynesian wage theory is therefore twofold. First, it asserts that the ability of policy to deliver non-­inflationary full employment depends on the willingness of workers to accept a level of real product wage (i.e. wage cost deflated by the price of the product they produce) to ensure the level of profits employers demand, and, in addition, to absorb other non-­labour cost so as to protect the level of profits employers’ require to be willing to offer that level of employment. Second, it assumes that there is some level of unemployment at which workers will comply with these employer demands. In this latter respect, New Keynesians share with Marxists a belief in the importance of the reserve army of labour in delivering employers’ expected profitability by making workers amenable to their employers’ wage demands. New economic liberalism in practice During the 1970s, as inflation appeared out of control, new economic liberalism became the conventional wisdom and monetarism was progressively incorporated into government policy. However, attempts to control inflation by such means triggered deep recessions in the early 1980s and following this policy

44   S.J. Konzelmann et al. commitment to maintaining full employment was abandoned.11 Instead, responsibility for employment and competitiveness was delegated to markets, which were generally deregulated. In a reversal of post-­war policy, large sections of the public sector were privatized and taxes on the wealthy were cut to encourage enterprise. To address ‘imperfections’ in the labour market, trade unions were weakened, legal control of labour standards relaxed, out-­of-work benefits reduced (and made subject to more onerous conditions), and wage subsidization was introduced with the express purpose of lowering the natural level of unemployment and generating more jobs. Finance One problem that policy makers faced was that it proved impossible to effectively control the money supply. Before 1970, the money supply had been directly controlled as part of macro-­economic policy. This was broadly Keynesian and designed to fine tune the economy in order to encourage non-­ inflationary, full employment growth by restricting economic activity when inflation threatened and stimulating it when unemployment increased (the so-­ called ‘stop-­go’ cycle). The ‘stop’ stage included packages of monetary policy measures, including increases in the Bank Rate,12 hire purchase controls,13 reductions in public sector expenditure, and cuts in bank lending – restrictions which were usually reversed piecemeal in the ‘go’ stage of the policy cycle (Radcliffe Committee Report 1959: Chapter VI; Kaldor 1986). Historically, the Central Bank intervened to control bank lending and hence the money supply. This was a system in which banks operated on the originate and hold principle, under which they acquired portfolios of investments of various durations and associated differences in interest rates and held them to maturity. Banks also held a significant proportion of their holdings in high quality short-­term assets, mainly treasury bills, that could be readily converted into cash in the money markets. In this system, the central bank operated as the guardian of the banking sector’s liquidity by standing ready to discount high quality short-­term assets at the official rate of interest. Thus, banking traditionally rested on borrowing short and lending long, with liquidity assured by the central bank’s lender in last resort facility, at a cost to the banks that was determined by the control that the monetary authority exercised over the official discount rate. In turn, both the official interest rate and the ratio of liquid to illiquid assets that banks were required to hold were set by the monetary authority as a means of regulating and securing the monetary base of the economy. Since the early 1990s, however, interest rate policy has been targeted at controlling inflation. The theoretical justification for this was that NAIRU (that level of unemployment at which inflation stabilized) could be reached and maintained by setting the rate of interest at an appropriate level. There can be no denying that inflation fell to low levels from 1992 onwards. But, rather than the NAIRU-­inspired adjustments to interest rates, the more likely explanation for the deceleration of inflation was the fall in import prices

Return of ‘financialized’ liberal capitalism   45 relative to home costs and the increasing proportion of imports in domestic expenditure from the mid-­1970s (Wilkinson 2007). Nevertheless, what is without doubt is that diverting the role of the central bank from regulating bank lending to controlling inflation seriously inhibited its ability to control credit creation by banks. This was further liberalized by changes in banking practice from ‘originate and hold’ to ‘originate and distribute’. Under the originate and distribute model of banking, rather than holding the loans they have made – such as mortgages on residential properties, credit card debt and other types of personal loans to maturity – banks sell them on. For such transactions, labelled ‘securitization’, banks operate through off-­balance sheet, special purpose vehicles (SPVs), usually registered in financial centres abroad. The setting up of SPVs off-­shore is motivated by regulatory arbitrage, that is, by the desire to avoid the regulatory requirements imposed on banks and other deposit-­taking institutions. These include minimal capital requirements, liquidity requirements, other constraints on permissible liabilities and assets, reporting requirements and governance requirements. Others are created for tax efficiency (i.e. tax avoidance) reasons. (House of Commons, Treasury Committee 2008: 20, emphasis in the original) SPVs buy bank loans, funding the transactions by borrowing short-­term on the wholesale money market. They also have committed credit lines from their sponsor banks, who either own or maintain close links with particular SPVs, and who have a vested interest in ensuring that their SPVs are liquid and can continue to operate. SPVs bundle together the loans they have acquired from the banks and use the cash flow from these loans as backing for new securities they create, including collateralized debt obligations (CDOs). These are sold on to pension, insurance, mutual, hedge and other types of funds, and to other banks. By initiating and distributing financial assets, banks diffuse the risk of default on loans they initiate by selling them on, restoring their liquidity in the process, without needing to resort to the short-­term money markets and the controlling hand of the central bank. These developments meant that the money supply became virtually unlimited. In this context, credit creation became virtually limitless until the rising default rate in US sub-­prime mortgages undermined the credibility of CDOs and other securitized products into which they had been embedded, triggering the 2007 credit crunch. At this point, credit creation froze as banks, putting a higher priority on remaining liquidity, refused to lend. The inter-­bank wholesale market then seized up as banks became reluctant to lend to each other because of concerns about who might be holding the now discredited – ‘toxic’ – securitised assets. As banks increasingly resorted to securitization to disperse risk and restore liquidity, and as the supply of credit expanded apparently without limits, lending to households for house buying and consumption grew apace. The effect was a rapid increase in house prices – and the size of the mortgages needed to buy them – and an escalation in unsecured household debt.

46   S.J. Konzelmann et al. The official response to the ensuing financial crisis was unprecedented coordinated governmental intervention to save failing banks and the authorization of injections into the economy of additional liquidity. It was hoped that these measures would stimulate bank lending and economic recovery. However, the failure of this strategy suggests that the problem rests more on the demand for credit than on its supply. Moreover, growing concern about the level of economic activity has meant that economic recovery has been given greater priority in determining interest rates than inflation. This is despite the fact that prices have been given an upward bias by the trend in world commodity prices as demand outstrips supply with the growing threat of the re-­emergence of 1970s style ‘stagflation’. Currently, living standards are declining, unemployment is rising, and public services are being slashed as governments implement austerity measures, designed to cut burgeoning budget deficits. The real economy The period from the early 1990s to the mid-­2000s has been described as the ‘Great Moderation’, characterized by low and stable global inflation, high and steady global GDP growth, and declining levels of real interest rates. This has been especially the case after the bursting of the so-­called technological bubble at the end of 2000 when Greenspan famously saved the show by cutting interest rates. One crucial effect of global prosperity has been the rapid growth in the world’s propensity to save, caused by redistribution of world wealth and income to high savers. Determinants of this phenomenon include accelerated economic growth in China (led by burgeoning foreign trade in manufactures), high saving rates in Japan and growing wealth in Saudi Arabia, Norway and other oil rich countries (as oil prices increased). These expanded savings flowed into the world’s financial markets, enabling borrowers to secure loans at low interest rates. This, together with the enhanced ability of banks to lend, encouraged increased spending on credit and reduced savings in much of the developed world, especially in the US and UK, both of which experienced large and expanding trade deficits. Despite these macro-­economic pressures, inflation remained stable; and official interest rates were kept low, further encouraging growth in overall demand. An important feature of the growing prosperity since the 1970s has been the inequality of its distribution. Explanations for growing inequality can be found in the widespread loss of relatively well-­paid manufacturing jobs and their replacement with low-­paid service sector jobs. This has resulted in a relatively slow growth in average household incomes in the second and third quintiles of the income distribution. Moreover, the deep recession of the early 1980s and 1990s caused unemployment to rise and hours of work to fall. This helps to explain the growing numbers of households on very low incomes. The resulting slow growth in real consumption was somewhat ameliorated by the availability of cheap imports14 and the growth and ‘democratization’ of credit, which

Return of ‘financialized’ liberal capitalism   47 p­ rovided an alternative source of purchasing power (Waldman 2009). But maintaining living standards through cheap imports and debt was at the cost of domestic production and employment; and it exposed often impoverished households to increases in the cost of credit – and the risk of default. Nevertheless, from the early 1990s, there was an extended period of relative macro-­economic stability in the advanced economies. During this period, low interest rates and perceived low levels of risk encouraged households and businesses to fund spending through credit, which banks made available without any constraints. This fuelled a housing bubble which created the increasing household equity that could be withdrawn by using it as collateral to support additional borrowing and consumption (Wilkinson 2012). It also created incentives for financial institutions to borrow more – much of which was off balance sheet – by means of increasingly complex financial instruments. According to Greenspan (2002), these were ‘especial contributors to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-­century ago’. So although there were recurring financial crises during the 1980s and 1990s, ‘successful responses . . . reinforced the view that monetary policy was . . . well equipped to deal with the financial consequences of asset price busts’ (Blanchard et al. 2010: 7). This was consequently a period when asset bubbles came to be accepted as legitimate engines for economic growth. Despite the havoc caused when they burst, the dominant view was that because they are difficult to identify in advance, policy makers need not concern themselves with detecting or preventing bubbles. Rather, ‘it is the job of economic policy makers to mitigate the fall out when it occurs and, hopefully, ease the transition to the next expansion’ (Greenspan 1999). In short, during the 1990s, despite the neo-­liberal claim that discretionary state intervention is economically damaging, there was a shift towards intervention – but it was different from that of the Keynesian welfare state. Rather than a commitment to full employment and economic prosperity, there was a commitment to containing consumer (although not asset) price inflation and to financial crisis management, which effectively socialized the risks and costs of financialization. Thus, whereas the focus of policy during the early post war period had prioritized the interests of the broader economy and society as a whole; during the two decades immediately preceding the 2008 financial crisis, policy increasingly prioritized the interests of finance and investor elites.

The roots of ‘variety’ within liberal capitalism The somewhat amorphous nature of liberal economic theory leaves plenty of scope for both pragmatism and force majeure – factors that allow a range of economic policy alternatives to be classified as ‘liberal’. Moreover, the spectrum of liberal ideas ultimately incorporated into policy is likely to reflect the interaction of competing interest groups in the policy-­making arena. This gives rise to the possibility of ‘variety’ within liberal capitalism. Pragmatism and force majeure can thus be expected to have been a powerful influence shaping the variable

48   S.J. Konzelmann et al. nature of liberal capitalism amongst the six Anglo-­Saxon economies during the decades preceding the 2008 crisis. It is unlikely, however, that their impact has been limited to the nature of policy development; it may also have been influenced by the pace of liberalization. It is also possible that it is differences in both the direction and speed of policy change that explain the differential effects of the 2008 crisis on the six Anglosphere banking systems. The defining features of economic liberalism With such a high degree of fluidity of liberal economic theory and policy in general – and of liberalized financial capitalism in particular – it is essential to identify diagnostic characteristics of a liberalized economy, as well as the pro­ cesses by which they evolve. There are a number of discernible features that define the process of economic liberalization. These will be put into context in the individual country case chapters that follow, where their varying significance and effects will be traced. Here, whilst the ‘four horsemen’ of economic liberalization – de-­regulation/re-­regulation, globalization, financialization and disenfranchisement – are considered separately, it is important to recognize that, in practice, they constitute dynamic and inter-­related processes whose effects are determined, and often amplified, by their interaction. Deregulation/reregulation In many ways, what is commonly known as deregulation can be seen as both a prerequisite for, and a companion process of, a programme of economic liberalization. The lifting of market restrictions is often considered to be an essential precondition to creating ‘freedom’ for market actors. However, since markets are inevitably human political constructs, freedom is a relative concept. The increased freedom of one party within a contract, for example, necessarily impinges on the freedom of the counterparties to that contract. As a result, ‘re-­ regulation’ is perhaps a more accurate description the loosening of market constraints (Way 2005). Demands for market deregulation often create markets whose rules work more in favour of particular capitalist interests than those of others – notably, for example, suppliers or customer firms, workers, the state, other members of society and the environment. This is because the rules of the free market do not, as theorized, favour all actors equally. There are differences in pre-­market access to resources (finance, in particular), networks and markets, which give particular capitalist interests in-­market advantages; and there are likely to be expectations of state intervention in the event of crisis (particularly financial crisis) which prioritize the interests of some over others. Moreover, state intervention does not necessarily serve the agenda or longer-­term interests of the state or society, particularly when the costs incurred are effectively socialized, whilst the benefits remain private. In response to recurring international financial crises since the 1970s, for example, governments have acted decisively –

Return of ‘financialized’ liberal capitalism   49 usually at not inconsiderable public cost – to contain the fall-­out by providing the lender of last resort facilities to financial institutions, countries or markets experiencing a sudden withdrawal of funds.15 This tradition was continued during the crisis of 2008, the costs of which continue to mount as the problems requiring resolving have proven to be protracted. The irony of this is that the financial sector is currently using its free market power to speculate against countries holding debts that were largely incurred in bailing-­out banks and dealing with the aftermath of the financial crisis. Financial interests are now demanding that governments adopt austerity programmes, to extract from their population the wherewithal to pay back to the financial sector the loans secured by governments to prevent the financial sector’s collapse. Globalization Globalization was accelerated by economic liberalization; and since the 1980s it has been credited with securing higher economic growth. This is despite the counter-­evidence of stagnant employment and incomes and declining domestic economic opportunities. Commercial globalization made it possible to substitute cheap imports for more expensive domestically produced goods and services. At the same time, funds from surplus countries flowed into the LMEs’ financial markets, providing cheap credit to top-­up sagging incomes and profits. This enabled households to maintain living standards their incomes could not support; and it allowed businesses to compete on the basis of ever-­lower prices. However, the focus on low cost imports at the expense of investment in home production and new product development has undermined wages and opportunities in the domestic productive, distributive and retail sectors. It has also lowered world effective demand and raised world unemployment because workers producing the cheap products are too poorly paid to consume the equivalent in value to what they produce. Although trade deficits and lost – often unrecoverable – domestic economic and employment opportunities are the downside of cheap imports, they are interpreted by economic liberals as the outcome of rational choices made by informed economic actors. This contrasts sharply with the early post-­war view that trade deficits were leakages from domestic demand and a determinant of unemployment, the countering of which required macro-­economic priority. The process of globalization, itself, fits uneasily against the mantra of free market ‘competition’, especially when the scale of enterprise required for operating internationally requires concentration of economic power. The scale of global business poses the threat that firms are becoming economically more powerful than nation states. Despite the fact that liberal economists have traditionally suspected concentration of economic power as being in restraint of trade, the malleability of economic liberalism has made it possible for its theorizing to accommodate itself to developments that confound its traditional conventional wisdom on the forms of industrial organization which maximize economic welfare. Hayek, for example, justified large firm size as resulting from

50   S.J. Konzelmann et al. entrepreneurial ability in discovering new profit opportunities in a world of profound uncertainty (Kirzner 1997). Schumpeter (1943), in his turn, theorized that monopoly profits were necessary to encourage innovation in an uncertain world. Such theories served to justify the power exercised by large firms as fostering economic progress. They also extended the disciplinary and creative role of markets because, although large size may be the reward for success, big firms can only survive by generating the operational and dynamic efficiencies required to keep their feet in the market driven by the process of ‘creative destruction’ (Schumpeter 1943). One of the most dangerous and insidious possible outcomes of globalization, however, concerns its effect on the ability of the state to influence the economy, both domestically and internationally. Whilst wide income differentials are features of liberal capitalism, nation states, through their ability to tax and spend, can redress imbalances. They can also meet industry’s needs for education, health, effective, labour, welfare and environmental standards – all of which are necessary for effective competition and social improvement but all of which unregulated markets notoriously find difficult to provide. But when the process of globalization de-­industrializes some areas and promotes the growth of ever lower-­wage economies in others, there is no mechanism for redistributing the privatized gains to alleviate inequalities – and their negative consequences – at the international level. The risk of this is a global race to the bottom and the emergence of dangerous instabilities and tensions. Financialization Economic liberalization has also accelerated financialization. During the 1980s and 1990s, the privatization and deregulation of industry served to financialize firms and their shareholders. Attention shifted away from the long-­term performance of the underlying productive enterprise and towards shareholder value, achieved increasingly by sweating the firm’s assets or pursuing short-­terms gains from acquiring (or being acquired by) other firms. Households were financialized by the privatization of public housing and the growth of homeownership, which ignited speculative interests in the ‘asset’ value of houses, rather than their residential worth. Concurrently, the concentration of pension funds in large, specialized institutions financialized pension contributions by investing them on the stock market; it also financialized the pension incomes of retirees, which are dependent on stock market outcomes. Here, a potential conflict of interest arises between current employees and pensioners to the extent that increased stock market values of companies can be generated by increasing profits through wage cutting, downsizing the existing work force and/or acquiring and hollowing-­out companies. At the same time, the destabilization of markets puts the interests of present employees and retirees at greater risk. Financialization may also result from – and be maintained by – policy preferences expressed by the electorate at the ballot box. During the Great Moderation, financialization and globalization appeared to benefit national economies. Increasing household and business borrowing

Return of ‘financialized’ liberal capitalism   51 increased consumption and investment and encouraged growth, despite wage stagnation, reduced profits on productive activities and continued high unemployment. However, the increasingly speculative nature of the booming financial sector and the deindustrialization resulting from the displacement of domestic production by cheap foreign imports made the economic system increasingly vulnerable and unstable. This resulted in new methods of keeping it on track. During the 1980s and 1990s, financialization was used to counter – or perhaps more precisely, to disguise – the economic stagnation following the bursting of one bubble by encouraging the inflation of another and thereby creating what appeared to be a mechanism for perpetuating growth. However, the progressive decoupling of the financial from the productive side of the economy – and the increasing dominance of the former – raises important issues for political and economic management at both the organizational and governmental levels, which are far from being resolved, despite the continuance and depth of the current crisis. Disenfranchization Free markets are theorized by economic liberals as providing economic opportunity and benefits for all who are willing to accept the rule of the market. However, in reality, this has been demonstrably far from the case; and the disenfranchisement of a growing segment of society in the LMEs has been a dominant feature of economic liberalization. Evidence can be found in the widening gap in income distribution and equality, especially in the most economically liberalized countries. This is partly the result of the destruction of middle income jobs through the processes of deregulation and globalization, which – if they have been substituted for – have been replaced by poorly paying jobs that have only served to exacerbate income inequality. Curiously, whilst increased inequality in access to services has been a major consequence of the rolling back of the welfare state, it has also often been accompanied by an increased centralization of governmental control, further reducing the ability of individuals to influence their economic situation and improve their lot. Meanwhile, the re-­regulation of labour markets has shifted the balance of power towards the employer and away from worker organizations and the state in the determination of terms and conditions of work. As a consequence, it has disenfranchised labour, both economically and politically. In much the same way, in the product market, the increasing size and concentration of firm ownership and their widening global reach has weakened the bargaining power of domestic suppliers, squeezing a very large number out of business. More recently, calls for austerity and the resulting assault on the public sector have been producing a similar disenfranchisement of public sector employees, one of the last remaining bastions of organized labour.

52   S.J. Konzelmann et al.

Conclusions Liberalized financial markets have a long history – and an equally long record of generating crises. Whilst these calamities often result in a temporary recourse to greater caution and tighter controls, the mood swings noted by Keynes usually result in a return to old freedoms before long – with inevitable consequences. The central message of Keynesian analysis – that free enterprise economies failed to deliver full employment and generated poverty in the midst of plenty – resonated with a generation which had suffered the privations of the 1930s and the Second World War; and in 1945, they opted for a significant degree of government management of the economy. The global scope of the Second World War, along with the mass industrialization and financial strains that accompanied it, contributed to the establishment of a new world order. It was recognized that full employment and free trade in goods were in many ways incompatible with completely liberalized financial markets. Therefore, a twin track approach of freeing-­up trade, whilst controlling international finance was adopted. For a time, it worked. But the system was eventually brought down by the gradual loosening of controls and the freeing-­up of global finance. In many ways, it was this loosening of regulation that created the problems of the late 1960s and 1970s, rather than the perceived fallacies of Keynesianism. It is certainly the case that the process of liberalization rendered ineffective many of the Keynesian controls upon which the early post war economic system was reliant, clearing the way for a change of paradigm. During the better part of three and a half decades following the stagflationary crises of the 1970s, there has been an ideological shift toward economic liberalism. It promised to enhance personal freedom and to promote a more efficient allocation of resources, both domestically and internationally. However, the outcome was the replication of events of the inter-­war years, during which the unequally shared greater prosperity of the 1920s was bought to an end by the crash of an unsustainable stock market boom and a deep global recession, the full recovery from which only came with the Second World War. The process of boom and bust during the post-­1970s era took place at varying rates and degrees of intensity within the six Anglo-­Saxon countries. In the following section, we explore the process of economic liberalization in each of the LMEs and the extent to which it delivered against its promises.

Notes   1 For a useful overview of the arguments about the political construction of markets, see Fligstein (1996).   2 ‘Recession’ is defined by the Oxford dictionary as ‘a period of temporary economic decline during which trade and industrial activity are reduced, generally indentified by a fall in GDP in two successive quarters’ (http://oxforddictionaries.com/definition/ recession).   3 ‘Depression’ is defined by the Oxford dictionary as ‘a long and severe recession in an economy or market’ (http://oxforddictionaries.com/definition/depression).   4 Keynes believed that control of capital movements was a prerequisite for effective

Return of ‘financialized’ liberal capitalism   53 domestic demand management and necessary in the wider public interest. (letter to Roy Harrod, 19 April 1942, in Johnson and Moggridge (1980)).   5 Both Lauchlin Currie and Harry Dexter White became key policy advisors during the Roosevelt era. At the Federal Reserve Board and later at the Treasury and White House Currie became a leading advocate of expansionary fiscal policy, and White was a co-­architect with Keynes of the Bretton Woods system (Laidler and Sandilands 2002: 515).   6 According to Krippner (2011: 27), financialization . . . refer[s] to the growing importance of financial activities as a source of profits in the economy . . . Some scholars use the concept of financialization to refer to the ascendancy of ‘shareholder value’ as a mode of corporate governance (Froud et al. 2000, 2006; Lazonick and O’Sullivan 2000; Williams 2000). Another use of the term . . . refers to the increasing political and economic power of the rentier class (Dumenil and Levy 2004; Epstein and Jayadev 2005). Finally, the term is sometimes used to describe the explosion of financial trading associated with the proliferation of new financial instruments (Phillips 1994).   7 Agency Theory purports that shareholders are the ‘owners’ of the firm, by virtue of their ownership of shares of stock in it; and managers are hired to be their ‘agents’, charged with responsibility for managing the company in their interests. In companies with widely dispersed shareholder ownership, there is a ‘separation’ of ownership (by shareholders) from control (by senior managers). In this context, a ‘corporate governance problem’ – the protection of shareholders’ investments – arises, which is in theory resolved by the threat of corporate restructuring (through hostile take-­over, merger and acquision, etc.). This serves to incentivize incumbent senior management teams to focus on delivering value to shareholders or risk being replaced by a more effective management team in the event of restructuring.   8 Under the Bretton Woods system, most countries sought to maintain an overall balance of trade, settling international trade balances in US dollars, with the US’s agreement to redeem other central banks’ dollar holdings for gold at a fixed rate of thirty-­five dollars per ounce. The US, however, had not been not overly concerned about maintaining a balance in trade since it could pay its export deficits in dollars. Nor had it taken action to prevent the steady loss of American gold. By 1971, under pressure to devalue its currency, due to the decline in US gold reserves, instead of devaluing the dollar, President Nixon took the advice of Milton Friedman and removed gold backing from the dollar. (See Helleiner 1994: 115–121 for a further discussion).   9 ‘Stagflation’ is the coincidence of accelerating inflation and rising unemployment. 10 Workers’ marginal product may vary between workers in similar employment circumstances because of inter-­worker differences including such things as skill levels, fitness and motivation. Marginal revenue product is marginal product multiplied by the price of the product or service being produced. 11 In 1979 UK unemployment stood at 5.4 per cent, by 1981 it reach 10.7 per cent and by 1983 it was 11.8 per cent. Output in manufacturing was especially badly hit. It fell 13.5 per cent in 1980, ‘a greater fall than during the whole period of the Great Depression of 1929–1932’ (Kaldor 1986: xv). 12 The official interest rate fixed jointly by the Treasury and the Bank of England at which the latter would lend to commercial banks when functioning as lender of last resort, and which was designed to regulate the level and cost of bank lending. 13 The regulation of hire purchase was centrally important in the fine tuning of consumers’ demand in the three decades after 1946. Hire purchase was controlled by adjustments to the proportion of the purchase price required as a down payment, and by changes in the interest rates and the length of the repayment periods which determined the size of the monthly repayments. These proved effective counter-­cyclical measures, but they concentrated the burden of cuts on a narrow range of industries.

54   S.J. Konzelmann et al. 14 The consequence of the deceleration of the rate of increase in oil and other primary product prices, and the sourcing of consumer goods from China, India and other developing economies (see Wilkinson 2012). 15 The most serious of these before the most recent debacle were the 1974 international banking crisis, 1982 international debt crisis and 1987 stock market crash.

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3 The United States ‘With freedom and liberty for all’ Saule Omarova, Cynthia Williams, Lissa Lamkin Broome, and John Conley

Introduction The U.S. role in producing the global financial crisis demands explanation, and yet cannot be fully discussed in one short chapter. Our focus here is on the trends and developments in the financial services sector, both because that sector was central to the dynamics that led to the crisis, and because developments in that sector clearly show the regulatory and economic theories that underpinned the U.S. version of economic liberalism. Examining regulatory developments in the financial sector also serves to bring into focus one of the dominant trends in the U.S. economy over the past three decades, that of ‘financialization’, in which an ever-­greater proportion of financial market activity has come to occur within finance itself, rather than in service to the ‘real’ economy, and in which even industrial companies earn significant, and increasing, shares of their profits from financial transactions, not from the sale of goods or services (Krippner 2005; Mitchell 2011).

U.S. financial services regulation: background In many respects, the U.S. was a pioneer in designing a modern regulatory framework for the financial services sector. As a result of the New Deal reforms, the vast majority of financial institutions and markets in the U.S. are subject to extensive regulatory oversight. Starting in the mid-­1930s, different categories of financial institutions – banks and other depository institutions, securities firms, investment funds, insurance companies – were subject to separate regulatory regimes, which also kept them from directly competing with one another. Securities markets were regulated under the effectively federalized disclosure-­based regime overseen by the Securities and Exchange Commission (SEC); commercial banking was subject to prudential regulation focusing on the safety and soundness of banks; and insurance companies were regulated by individual states under a hybrid model combining consumer protection elements with strong solvency safeguards. The U.S. banking industry comprises several categories of depository institutions, including commercial banks, thrifts, credit unions, and trust companies.

58   S. Omarova et al. The two most unique features of U.S. banking regulation are the so-­called dual banking system, which allows banks to choose to be licensed either by the federal government or by an individual state, and the principle of separation of banking and commerce, which generally prohibits banking institutions from engaging or investing in any non-­banking business. The dual banking system explains the structural complexity of U.S. banking regulation and supervision, in which fifty state bank regulators co-­exist and often compete with several federal bank regulatory agencies, including the Board of Governors of the Federal Reserve System (‘Federal Reserve’), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC). By choosing to be chartered under federal or state law, a banking institution selects its primary regulator and thus the basic regulatory framework within which it will operate. Nationally chartered banks are regulated primarily by the OCC but remain subject to regulation by both the Federal Reserve and the FDIC. State-­ chartered banks are subject to the authority of their home state bank regulatory agency and at least one federal regulator. The Federal Reserve is the principal federal regulator of all state banks that are also members of the Federal Reserve System, and the FDIC is the principal federal regulator of all other state banks that are FDIC-­insured. The Federal Reserve also acts as the ‘umbrella’ regulator for bank holding companies (BHCs), companies that own or control a U.S. commercial bank, although various ‘functional’ regulators retain primary jurisdiction over BHCs’ individual subsidiaries (Broome and Markham 2011). The Dodd–­ Frank Act of 2010 also put the Federal Reserve in charge of supervising designated systemically important financial institutions that do not necessarily control commercial banks. From a substantive point of view, the principle of separation of banking and commerce effectively precludes depository institutions from conducting financial or commercial activities that fall outside the ‘business of banking’ – an undefined term in the National Bank Act of 1863, the core federal banking statute, administered and interpreted by the OCC. Although the OCC has been increasingly liberal in its interpretation of the legal boundaries of bank-­permissible activities, this fundamental restriction remains a significant factor in shaping developments in the U.S. financial sector (Omarova 2009). In the wake of the 1929 stock market crash and in the midst of the Great Depression, the U.S. Congress passed the Banking Act of 1933, which created the federal deposit insurance scheme (administered by the newly formed FDIC). Since 1933, the existence of federal deposit insurance has been an important factor behind the continuing regulatory emphasis on protecting safety and soundness of depository institutions. In pursuit of that goal, a distinct part of the Banking Act of 1933, known as the Glass–­Steagall Act, prohibited combining deposit-­taking (‘commercial banking’) and securities dealing and underwriting (‘investment banking’) within the same corporate structure. The Bank Holding Company Act of 1956 (BHCA) extended activity restrictions to BHCs, defined as companies that owned 25 per cent of any class of voting stock of, or otherwise controlled, U.S. commercial banks. Under the BHCA, BHCs were generally limited to conducting business activities that were ‘closely

The United States   59 related’ to banking. As discussed below, the Glass–­Steagall Act was partially repealed by the Gramm–­Leach–Bliley Act of 1999, which allowed certain qualified BHCs to engage in a broader range of financial activities, including securities dealing and underwriting, insurance underwriting, and merchant banking (Broome and Markham 2011; Wilmarth 2002). Historically, U.S. commercial banks were also limited in their ability to expand beyond their home states and sometimes, depending on state laws, in their ability to establish additional branches within their home states. These geographic and activity restrictions were designed to serve several interrelated policy objectives: preventing undue concentration of financial and economic power, ensuring efficient and fair access to credit, and protecting the safety and soundness of U.S. deposit-­taking institutions. Most of the specific rules and ­regulations governing U.S. banks’ business activities aim at these goals, with ­particular emphasis on the safety and soundness aspect. Non-­depository financial institutions in the United States are generally not subject to the same type and degree of strict balance-­sheet management by the government as are depository institutions. Thus, securities firms and investment banks are regulated under the federal scheme for securities broker-­dealers, established in the Securities Exchange Act of 1934, and administered by the SEC, an independent federal agency overseeing securities markets. Neither securities broker-­dealer entities nor their parent companies are subject to activity or geographic restrictions, as their business was traditionally viewed as pure brokerage of capital markets transactions and investment advice. U.S. securities firms are subject to numerous regulations relating to their net capital, record-­keeping and reporting, hiring and training of personnel, dealing with customers and customers’ assets, marketing and trading practices, and other aspects of their activities. These regulations are aimed primarily at protecting investors from securities fraud and abusive sales practices, rather than protecting the broker-­dealers’ own solvency and financial strength. U.S. insurance companies are chartered and regulated by state authorities under a regime similar to bank regulation. Insurance companies are generally subject to intense prudential regulation, including capital and reserve requirements deemed necessary to support insurance companies’ obligations under their policies. To prevent insolvency, state laws restrict the types of investments permissible for insurance companies. Most states also regulate premium rates, directly or indirectly, and promulgate standard contract forms, in order to ensure more reliable protection and avoid fraud. For decades, these principal segments of the U.S. financial services industry were regulated under separate regimes and generally were prevented from directly competing with one another. Since the late 1970s, however, the evolution of U.S. financial services regulation has been characterized by increasing tension between the changing realities of the financial marketplace and the silo-­ based regulatory structure. Rapid advances in technology enabled unprecedented financial innovation that blurred the familiar lines among different regulated and unregulated segments of the financial services industry. Technology also enabled

60   S. Omarova et al. banking services to be provided outside of the traditional brick and mortar bank branching system. The growth of new financial products and markets often pushed the existing legal and regulatory boundaries. In response to pressure from the financial industry, and consistent with a variety of their own institutional incentives, since the mid-­1980s lawmakers and regulators gradually relaxed many of the existing restrictions on financial institutions’ activities and ability to expand into new geographic markets. This complex process unfolded through numerous statutory and administrative changes in various areas of financial regulation rather than through any single openly deregulatory legislative or administrative act.

Changes in the financial marketplace Background In order to appreciate the effects of financial deregulation in the U.S. in recent decades, it is useful to contrast that trend with the structure of post-­Second World War regulation. During the period 1945 through 1971, there were no financial crises in the world (with the exception of a financial crisis in Brazil in 1962), in contrast to the previous 400 years of history in which financial crises occurred roughly every ten years (Kindleberger 1978). A strong global commitment to financial regulation has been argued to be significant in explaining this stability (Allen and Gale 2007). Major features of that regulation in the U.S. have just been described: the separation of commercial and investment banking in the Glass–­Steagall Act and the BHCA; strong federal securities regulation in the Securities Act of 1933 and the Securities and Exchange Act of 1934; and specialized statutes to address specific problems of excessive economic concentration such as the Public Utilities Holding Company Act of 1935 (Karmel 2011). Globally, the post-­Second World War Bretton Woods agreement created a stable currency exchange regime tied to the dollar, which was itself tied to the value of gold, as well creating international financial institutions such as the International Monetary Fund and the International Bank for Reconstruction and Development (today part of the World Bank Group). The U.S. adopted a Keynesian approach at a macro level during the post-­ Second World War decades, starting with the Employment Act of 1946 which for the first time gave the executive branch the responsibility for managing the economy to maintain full employment (Wapshott 2011). This approach used the money supply and fiscal policy to smooth out the booms and busts of the business cycle, with governments acting to fine-­tune monetary and fiscal policy to try to keep both unemployment and inflation low. To the extent there was a trade-­off understood between these two goals, addressing unemployment was treated as primary (ibid.). Yet, although the 1950s and 1960s were economically prosperous, the second half of the Fifties and the decade of the Sixties became increasingly turbulent socially, producing the Civil Rights Movement, the anti-­ war movement, the women’s movement, and then violent riots in major cities in

The United States   61 the late 1960s (Piven and Cloward 1979). These movements, along with the environmental movement in the late 1960s, not only created the conditions for a rapid expansion of federal statutory authority, against which a political backlash soon emerged (Levy et al. 1998), but produced a background of social insecurity that, in conjunction with economic insecurity of the 1970s, created conditions that allowed Ronald Reagan’s rise to power. The 1970s brought pressure on the Keynesian economic and regulatory model in the U.S., as currency exchange rates became volatile and inflation became a more persistent problem. The decade was inaugurated by President Nixon’s August 1971 decision to suspend the convertibility of dollars into gold, which effectively caused the breakdown of the Bretton Woods fixed exchange rate system, leading to increased volatility in currency exchange rates. In addition, two major oil price shocks – one in October 1973 when the price of oil tripled in response to the Arab–­Israeli war, and a second in 1979 triggered by the Iranian revolution – both contributed to increasing inflation, as did military spending on the Vietnam War. While inflation fluctuated between 5 and 11 per cent (Goodfriend and King 2005), unemployment also became a problem during this decade, leading to ‘stagflation’ and an apparent decoupling of the previously understood inverse relationship between inflation and unemployment (Nickell and Bell 1996). Changes in the business model of financial institutions The instability and volatility in interest and exchange rates that began in the 1970s has had profound effects on the development of the U.S. financial services industry during the subsequent three decades. The key trends in this process included an accelerated pace of financial innovation, product convergence, increasing industry concentration, and conglomeration. The spread-­driven banking business became unworkable when the long period of stable interest rates ended in the late 1970s. The business became increasingly volatile when the Federal Reserve announced its intention to control inflation by restricting the growth in the money supply rather than by maintaining interest rates (Broome and Markham 2011). Yet, even as banking became a much riskier business in this new environment, federal laws and regulations continued to restrict commercial banks’ ability to diversify and to attract more money, either by paying higher interest on deposits or by offering a broader range of investment products and services. Investment banks, which were not subject to the same restrictions, took advantage of macroeconomic volatility by creating financial instruments that offered the potential for greater returns to investors – such as money market mutual funds that offered cheque-­writing capabilities – and by steering their commercial clients towards raising capital in short-­term commercial paper markets. Securities firms also began acquiring deposit-­taking and lending capabilities, through control of depository institutions (such as industrial banks and thrifts) that were exempted from the definition of ‘bank’ in the BHCA and did

62   S. Omarova et al. not trigger the limitations on nonbanking activities applicable to BHCs. Thus, by 2007, Merrill Lynch Bank USA, a Utah-­chartered industrial bank owned by Merrill Lynch, one of the largest investment banks on Wall Street, had nearly $55 billion in deposits, making it one of the top deposit-­taking institutions in the country (Spong and Robbins 2007). This process of ‘disintermediation’ – diversion of depositors’ funds and borrowers’ demand away from commercial banks and into capital markets – put increasing pressure on the banking industry, which started developing ways to offer new financial products similar to securities. Large banks, in particular, began moving into capital markets by offering index-­linked certificates of deposit and variable annuities. They also began aggressively expanding their activities in other areas, such as insurance underwriting, commodities and over-­ the-counter (OTC) derivatives trading and dealing. As a result, the banking industry became increasingly bifurcated, with large banks diversifying out of the traditional deposit-­taking and lending business. These banks became increasingly dependent on non-­interest income, and short-­term financing in capital markets through issuance of commercial paper and securities repurchase agreements, or repos (Wilmarth 2002). At the same time, the U.S. banking industry began consolidating. In 1984, there were almost 14,500 banks in the United States, which reflected the historically local nature of banking and the effect of geographic constraints on bank expansion. Some states imposed branching limitations on banks, and the Douglas Amendment to the BHCA effectively restricted banks’ ability to operate across state lines. Under the Douglas Amendment, a bank holding company was permitted to buy a bank in another state only if the statute law of that state specifically allowed such an acquisition by an out-­of-state company. Only in 1972 did some states begin allowing interstate acquisitions in limited circumstances. In the 1980s, states began allowing acquisitions of local banks by companies headquartered in any of the states within a certain defined region, if the acquiring company’s home state granted reciprocal rights to bank holding companies from the target state. In 1985, the U.S. Supreme Court upheld the constitutionality of such state statutes, and bank holding companies went on an acquisition spree. In 1994, Congress passed the Riegle–­Neal Interstate Banking and Branching Efficiency Act (the ‘Riegle–­Neal Act’) that repealed the Douglas Amendment to the BHCA and allowed interstate branching and acquisitions, whether or not permitted by state law. Multi-­bank holding companies consolidated the banks they held in each state and, after 1997, bank holding companies were able to buy banks in other states and merge them into their existing banks. As a result, the number of banks in the United States steadily declined to less than 7,500, as of 2011 (Broome and Markham 2011). Technology, securitization and derivatives Technology fundamentally changed the dynamics of the traditional banking business. Technological advances allowed lenders to standardize their credit

The United States   63 approval process. Credit scoring and score-­driven mass lending replaced traditional relationship-­based lending in retail loan markets. Banks increasingly sought to securitize their loan assets instead of holding until maturity, as a form of capital arbitrage and a method of freeing up more funds for expanding lending. In mortgage lending, securitization was supported by the federal policy of increasing the rate of homeownership among the lower-­income population. The government-­sponsored enterprises (GSEs) established specifically for that purpose, most notably Fannie Mae and Freddie Mac, played the central role in the creation and growth of the secondary market for mortgages (FCIC 2011). Securitization integrated the previously separate credit and capital markets (Engel and McCoy 2007). Investment banks that initially lacked loan-­originating capabilities became principal private-­label securitizers that operated alongside and competed with the GSEs (McCoy et al. 2009). With the stable low interest rates returning in the 1990s and 2000s, investors’ search for yield made mortgage-­backed and other asset-­backed securities particularly desirable investment products. The leading commercial and investment banks rushed to acquire finance companies, thrifts, and mortgage lenders to originate in-­house assets for securitization. Increasingly tough competition among securitizers spurred further innovation and the rise of new, more complex structured products, such as collateralized debt obligations (CDOs) (FCIC 2011). The success of securitization was closely connected to the growth of OTC derivatives. From 1998 through 2011, the notional amounts of all OTC derivatives traded, globally, increased from $94 trillion to $708 trillion (Bank for International Settlements 2000, 2011). OTC derivatives pushed the conceptual boundaries of U.S. financial regulation, because they did not fit neatly into any single regulatory category as a banking product, security, or insurance contract. The field developed rapidly, with large financial institutions – Merrill Lynch, Bankers Trust, JPMorgan, among others – becoming principal dealers in this sophisticated and increasingly model-­driven world. The nature of that business made these competitors very closely interconnected, as they traded and (importantly) hedged their derivatives risk exposure with one another (Wilmarth 2002). These changes in the business and risk profile of financial intermediaries created and intensified the competition between commercial banks, investment banks, and insurance companies, which were becoming increasingly alike. In addition, they were facing increasing competition from non-­U.S. financial institutions trading and dealing in complex financial instruments. At the same time, these businesses that had previously been conducted separately became closely intertwined. Large financial institutions competing in the same markets had a strong interest in expanding their market power and combining their operations. The trend toward conglomeration became particularly visible in the 1980s. In effect, by the late 1990s, the U.S. financial industry became bifurcated: a handful of large and increasingly diversified financial conglomerates came to dominate the financial services sector, while a far greater number of small institutions that continued to engage in traditional business lines controlled a shrinking portion of the industry’s total assets. Thus, between 1989 and 1999, total assets held by

64   S. Omarova et al. banking organizations in the U.S. rose nearly 50 per cent in real terms (from $4 trillion to $6 trillion); ‘the share of total assets held by the fifty largest U.S. banking organizations rose from 55 percent [to] 74 percent’ during that same period of time, and ‘the share held by the ten largest [organizations] grew from 26 percent to 49 percent’ (DeFerrari and Palmer 2001: 47). New investors and the ‘search for yield’ Technological and financial innovation in recent decades also enabled the unprecedented growth in the asset base and importance of various public and private investment funds, including money market mutual funds and hedge funds. Thus, money market funds became a critical source of credit for financial market participants, and one that was outside the traditional banking channels. As of the end of 2008, money market funds managed nearly $3.8 trillion in assets and held 40 per cent of all outstanding commercial paper (which made them by far the largest investor in that vital market), 23 per cent of all repurchase agreements, 65 per cent of state and local government short-­term debt, 24 per cent of short-­term treasury securities, and 44 per cent of short-­term agency securities (SEC 2009). Fuelled by the influx of credit from money market funds and other yield-­chasing investors, the securities repo and lending markets grew as increasingly dominant sources of short-­term leverage for financial activities. For example, in early 2008, the tri-­party repo market peaked at approximately $2.8 trillion (FRBNY 2010). Hedge funds, private investment vehicles that managed assets of institutional and other sophisticated investors, also emerged as powerful new players in this environment. Unlike mutual funds, hedge funds were not subject to regulation by the SEC and did not face any limitations on their ability to incur leverage. Hedge funds pursued a wide variety of highly leveraged trading and investment strategies. These nimble and non-­transparent private funds were also increasingly interconnected with the regulated financial intermediaries – investment and commercial banks – as their trading counterparties, prime brokerage clients, and even competitors. With these fundamental shifts in the financial market, the role of traditional gatekeepers and self-­regulatory bodies also changed dramatically. Throughout the 1990s and 2000s, stock exchanges and other self-­regulatory organizations, public accounting firms, and credit rating agencies increasingly operated under a very different set of constraints and incentives. Financial innovation often made their traditional task more difficult, if not impossible, to perform. For example, rating credit risk of complex financial instruments, such as CDOs, is a qualitatively different exercise than rating the risk of default of a company that issued a bond. In addition, the high profitability of rating structured products distorted the agencies’ incentives to produce reliable ratings. As a result, credit rating agencies notoriously failed to assess the risk of new financial instruments correctly (FCIC 2011). Stock exchanges, which historically performed important self-­ regulatory functions, also experienced fundamental changes in their business

The United States   65 model. Facing increasingly tough competition from foreign exchanges and various alternative trading systems and electronic networks, U.S. stock exchanges, including the iconic New York Stock Exchange, went through a wave of demutualization and mergers (Karmel 2007; Macey and O’Hara 2005). Competing for business across geographic and product lines significantly altered the exchanges’ incentive structure and efficacy as the guardians of market integrity. Thus, by the beginning of the twenty-­first century, the entire landscape of the U.S. financial industry had changed dramatically.

Legislative and regulatory responses to changes in the financial marketplace How did the U.S. Congress and U.S. regulators respond to these profound changes in the financial markets? The regulatory system put in place primarily in the post-­Great Depression era rested on certain fundamental assumptions about the business and risk profiles of commercial banks, securities firms, and insurance companies. As a result of disintermediation, there emerged an increasing number of new types of complex financial products – including OTC derivatives and structured products – that did not fit into traditional regulatory categories (Broome and Markham 2011). Broadly, there were two potential responses: (1) to overhaul the regulatory system, redefining regulatory categories so as to target the risks associated with the new products and markets; or (2) to maintain the existing system and try to fit new products and markets into existing regulatory categories. U.S. lawmakers and regulators followed the latter path. Even as the financial sector went through typical cycles of deregulation and reregulation, especially in response to periodic scandals or crises, the basic regulatory structure remained essentially unchanged. The savings and loan crisis and regulatory reform The savings and loan crisis, which gradually unfolded throughout the 1980s and resulted in the failure of numerous thrifts and banks, led to several pieces of important banking legislation. The Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn–­St Germain Act of 1982 removed many longstanding restrictions on the business activities of thrifts, in the hopes of making them more competitive vis-­à-vis other financial institutions and preventing them from failing. These statutes increased thrifts’ lending authority beyond their traditional niche of home mortgage lending; allowed depository institutions to offer NOW accounts (a form of transaction account to supplement the traditional savings accounts offered by thrifts); and repealed the ceiling on interest rates that could be paid on savings accounts. But these deregulatory measures effectively resulted in thrifts taking on even less sustainable risks. In response, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of

66   S. Omarova et al. 1991 (FDICIA), which sought to enhance prudential supervision of banks and thrifts and established a rigorous ‘prompt corrective action’ regime, which gave the FDIC broad authority to intervene and even take over a depository institution with a declining capital position. The next round of high-­profile reregulation came in 2002, when Congress enacted the Sarbanes–­Oxley Act (‘SOX’) in response to accounting scandals at Enron and WorldCom. SOX sought to strengthen the integrity of U.S. capital markets by, among other things, imposing heightened disclosure, corporate governance, and other requirements on publicly traded companies. None of these new regulatory measures, however, addressed the growing disconnect between the changing realities of the financial marketplace and the static basic structure of U.S. financial services regulation. The first serious warning signs of the problem this disconnect created appeared in the mid-­1990s, when sudden changes in interest rates caused many institutional investors to sustain significant losses on their derivatives. In 1994–1995, these losses led to the bankruptcy of California’s Orange County and Barings Bank, Britain’s oldest merchant bank and adviser to Queen Elizabeth, and spurred a wave of litigation between companies claiming to have been misled by derivatives dealers (Krawiec 1997). In response to these events, several bills calling for regulation of OTC derivatives were introduced in Congress, although strong industry lobbying prevented their passage (Wilmarth 2002). However, it took the near-­failure and government-­brokered rescue of the star-­ studded hedge fund, Long-­Term Capital Management (LTCM), in 1998 to bring the nature of the new regulatory dilemma into sharp focus. A highly leveraged and unregulated hedge fund, LTCM engaged in sophisticated arbitrage trades in derivatives and securities, and experienced a severe liquidity squeeze in the immediate aftermath of the East Asian financial crisis. The LTCM episode demonstrated the inherent vulnerability of a financial system in which unregulated or lightly regulated entities such as hedge funds are able to operate with dangerously high levels of hidden leverage and become closely interconnected with major commercial and investment banks through an intricate web of complex derivatives transactions. Nevertheless, the President’s Working Group’s study concluded that imposing regulatory oversight on hedge funds was not necessary, and that hedge funds’ leverage could be brought effectively under control if their trading counterparties – commercial and investment banks – exercised caution and enhanced their own risk management programs (PWG 1999). (The President’s Working Group (PWG) on Financial Markets, established by President Reagan in 1988, is composed of the Secretary of the Treasury (who serves as its Chairman), the Chairman of the Federal Reserve Board of Governors, the Chairman of the Securities and Exchange Commission, and the Chairman of the Commodity Futures Trading Commission.) As a result, Congress again failed to take any action aimed at bringing derivatives markets or hedge funds under direct regulatory oversight. In fact, shortly after the LTCM rescue, the opposite regulatory response followed.

The United States   67 Deregulation of banking and finance In 1999, after decades of intense policy debates and industry lobbying, Congress passed the Gramm–­Leach–Bliley Act (‘GLB Act’), which repealed the Glass–­ Steagall Act’s prohibition on mixing deposit-­taking and investment banking in a single corporate structure. This statute allowed the formation of cross-­sector financial conglomerates that conduct banking, securities underwriting, insurance, and a variety of other financial activities through separate subsidiaries. Even before 1999, the Federal Reserve had consistently relaxed the limitations on BHC activities, most notably by interpreting Glass–­Steagall Act to permit subsidiaries of a BHC to underwrite securities so long as they received no more than 5 per cent of their revenues from this activity. Emboldened by a federal appeals court’s upholding the legality of this rule, the Federal Reserve in 1996 increased the revenue ceiling to 25 per cent, which enabled numerous BHCs to acquire regional investment banking firms (Broome and Markham 2011). Hungry for more, large BHCs, such as Citicorp, kept lobbying Congress for a wholesale repeal of the Glass–­Steagall prohibitions. A 1998 merger between Citicorp and Travelers Group that combined banking and insurance, and which resulted in one of the world’s largest financial services conglomerates, was premised on an expectation that Congress would pass legislation removing any legal constraints on such cross-­sector acquisitions. While the BHCA provides up to two years to dispose of non-­permissible subsidiaries after an entity becomes subject to the BHCA and its non-­banking limitations (with up to three one-­year extensions), Citicorp was not interested in conforming its acquisition to those limitations. Congress responded by passing the GLB Act. The GLB Act unlocked the potential for those BHCs that qualified for the new status of a financial holding company (FHC) to use their banking subsidiaries’ large balance sheets, high credit ratings, and access to the federal safety net – federal deposit insurance and the Federal Reserve’s liquidity facilities – to build up successful, and potentially risky, non-­banking businesses and compete much more aggressively with investment banks (Omarova 2011). By doing so, the GLB Act contributed to further the bifurcation of the U.S. financial services industry and the concomitant growing concentration of the riskiest activities among a small number of too-­big-to-­fail financial conglomerates. Another critical piece of deregulatory legislation – or more accurately, legislation that ensured that a rapidly expanding market would not be regulated – was the Commodity Futures Modernization Act of 2000 (CFMA), which exempted OTC derivatives transactions between sophisticated parties from any form of regulation (Stout 2011; Hazen 2005). The CFMA was a landmark victory for the largest financial institutions that dominated OTC derivatives dealing and trading market. The law ended a decade-­long jurisdictional dispute between the SEC and the Commodity Futures Trading Commission (CFTC) with respect to swaps and other derivatives that combined the economic features of securities and commodity futures. After the passage of the CFMA, the OTC derivatives markets

68   S. Omarova et al. experienced explosive growth, which increased the degree of complexity, interconnectedness, and undetected risk in the global financial system. In that sense, the enactment of the CFMA was one of the key legal developments that contributed to the latest financial crisis (Stout 2011). The growth of OTC derivatives markets was further facilitated by legislative amendments to the U.S. Bankruptcy Code that allowed for the preferential treatment and netting of derivatives in bankruptcy, which gave an insolvent debtor’s derivatives trade counterparties significant advantage over its other creditors. The International Swaps and Derivatives Association (ISDA), a powerful trade association for OTC derivatives dealers, effectively lobbied for these amendments (Skeel 2010). Regulatory agencies also took actions that had serious long-­term deregulatory effects, especially with regard to derivatives markets. The OCC, the primary regulator of nationally chartered banks, played a particularly prominent role. Beginning in the 1980s, the OCC granted and then gradually expanded the powers of commercial banks to conduct derivatives transactions. Using creative interpretation of the statutory concept of the ‘business of banking’, the OCC effectively removed any meaningful prohibitions on commercial banks trading and dealing in risky derivatives products and even permitted them to conduct some physical equity and commodity trading for hedging purposes. By thus effectively allowing the largest financial conglomerates to use their banks’ financial resources, reputation, and access to the federal safety net to trade in derivatives, given that money is fungible, the OCC’s actions significantly contributed to the explosive growth of unregulated OTC derivatives markets in the 1990s–2000s (Omarova 2009). Not to be outdone, the Federal Reserve used its new authority under the GLB Act to expand so-­called ‘complementary’ powers of certain BHCs by allowing their non-­bank subsidiaries to engage in active trading in physical commodities and energy, finding this purely commercial activity to be ‘complementary’ to their derivatives trading business in commodities. As a result, large U.S. financial conglomerates such as JPMorgan and Bank of America began to conduct successful operations trading in oil, gas, electricity, metals, and other physical commodities, including taking actual physical delivery (Omarova 2009). State insurance regulators also played their role in allowing the OTC derivatives market to grow unchecked. For instance, the New York State Insurance Department (NYID) consistently interpreted state insurance law as not applicable to various derivatives contracts, even where such contracts were functionally equivalent to insurance. In 2000, the Office of General Council of the NYID issued an opinion holding that credit default swaps did not constitute insurance contracts because they did not condition parties’ payment obligations on an actual loss (NYID 2000). But the most significant example of this deregulatory trend may have been the adoption by the Basel Committee on Bank Supervision (BCBS) of the revised international capital accord, dubbed Basel II. The Basel II framework, released in 2004, permitted large, internationally active financial institutions to calculate their capital needs based on their own internal mathematical models,

The United States   69 including their own models’ risk-­adjusted views of their capital and assets. The implementation of Basel II in the United States was a long and notoriously controversial process, primarily because of small community banks’ political opposition and the FDIC’s desire to avoid a sharp fall in capital levels and insistence on maintaining a leverage ratio based on unadjusted capital and assets. In contrast, in 2004, the SEC instituted a voluntary Basel II regime for large investment banks, the Consolidated Supervised Entities (CSE) program, which significantly relaxed the ‘net capital rule’ that had been hard-­wired to preserve the liquidity of securities broker-­dealers’ assets. The CSE program allowed large U.S. investment banks to determine the riskiness of their assets using their own models and then use those models to calculate their regulatory capital needs, which proved to have disastrous consequences. Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley all took advantage of the program (Poser 2009). In the aftermath of the recent crisis, in which each of these large U.S. investment banks either failed (Lehman), was acquired at a discount (Bear Stearns and Merrill Lynch), or converted into BHCs (Goldman and Morgan Stanley), the SEC eliminated the CSE program. The long-­term effects of these deregulatory statutes and agency decisions were profound. By the mid-­2000s, the U.S. financial system was dominated by a handful of large diversified financial conglomerates that were not only too big but also too interconnected to fail (Wilmarth 2011a). Explosive growth of unregulated markets for complex and opaque OTC derivatives and structured products created qualitatively new types of systemic vulnerability and risk that was increasingly divorced from any productive economic activity (FSA 2009). Regulatory arbitrage and loosening of activity and capital constraints enabled rapid financial innovation, but also led to the emergence of powerful alternative credit market – often referred to as the shadow banking system – in which massive accumulations of leverage and risk were hidden and amplified (Blair 2010). The shadow banking system fuelled asset bubbles in real estate and the stock market and led to the continuing financialization of the U.S. economy, defined ‘as a pattern of accumulation in which profit-­making occurs increasingly through financial channels rather than through trade and commodity production’ (Krippner 2005: 181). So, by the mid-­2000s non-­financial firms’ ratio of portfolio income to corporate cash flow was approximately five times higher than in the 1950s through the 1970s (Krippner 2005: 185). As an example, the retail firm Sears Holding Company earned more than half its net income in 2005 from its derivatives trading (Orhangazi 2008: 16). Moreover, the ratio of financial to non­financial profits in the U.S. economy as a whole from 1950 to 2001, while volatile, have increased from between 0.10 and 0.20 from the 1950s through the 1970s to 0.50 by 2001 (Krippner 2005:189). Other measures show similar patterns, such as the average daily trading volume on the New York Stock Exchange, which has increased from 200 million shares in 1990 to 1.6 billion shares in 2006 (Orhangazi 2008: 17). Ultimately, as we know, these developments fuelled massive financial and economic crises throughout the developed and (to a lesser extent) developing world.

70   S. Omarova et al.

Explanatory focus: structural, political, and ideological factors In explaining these developments, which increased the role of finance in the economy and ultimately led to the increased leverage and systemic risk that culminated in the financial crisis, we focus on three key groups of factors: 1 2 3

structural factors, particularly the relationship between regulatory structure and fragmentation in the financial sector; ideological factors, in particular the rise to dominance of neoliberal ­economic views; and political factors, including regulatory capture by the financial industry; the rise of powerful ‘too big to fail’ actors; and the broader erosion of countervailing forces, particularly labour unions.

Structural factors As the U.S. financial services industry was undergoing fundamental changes in its structure and vulnerability to systemic risk, lawmakers and regulators consistently failed to recognize and address these changes by developing a new and more effective regulatory paradigm. To the contrary – as we have shown in the preceding section – to the extent that new activities or products did not fit into the existing legal and regulatory categories, either the products and activities were exempted from regulation or the legal restrictions were loosened to accommodate the industry developments. Regulatory fragmentation in the financial sector created strong incentives for regulatory agencies to protect their regulated institutions from outside competition. The financial services industry heavily lobbied both Congress and administrative agencies to remove legal hurdles in the path of their competition-­driven innovation. As discussed above, Citicorp’s aggressive lobbying efforts and a bold decision to go ahead with its merger with Travelers Group insurance company on the assumption that Congress would act to change Glass–­Steagall to ensure that the merger was (retroactively) lawful served as a major catalyst for the adoption of the GLB Act, while ISDA’s tireless efforts eventually culminated in near complete deregulation of OTC derivatives markets. These are merely high-­profile examples of the massive effort by financial institutions to press policymakers for greater freedom from regulatory and legal constraints. Nevertheless, part of financial regulators’ motivation to loosen legal restrictions on their constituent institutions’ activities was agency self-­preservation and turf protection. The dual banking system created fertile ground for competition among the federal regulator, the OCC, and numerous state banking agencies for chartering and regulatory ‘business’. One of the key tools in that competition was each chartering authority’s ability to expand, within certain limits, the permissible activities of commercial banks it regulated. In FIRREA and FDICIA, passed in the wake of the Savings and Loan crisis, Congress sought to prevent a

The United States   71 regulatory race to the bottom by expressly limiting the permissible activities of state-­chartered depository institutions – thrifts and banks – to activities permis­ sible to their federally chartered counterparts (Broome and Markham 2011). This legislation cut off the states’ ability to attract charters through granting expansive bank powers and effectively put the OCC in charge of determining the scope of all commercial banks’ business activities. The OCC took advantage of its newly strengthened position by creatively interpreting statutory language and aggressively pre-­empting state banking authority, in order to make national banks more competitive vis-­à-vis state banks and, increasingly, vis-­à-vis securities firms and other non-­bank competitors. Thus, when many states attempted to stop predatory mortgage lending in the sub-­prime market during the run-­up to the financial crisis, the OCC intervened, claiming pre-­emption and then doing nothing to address the problem (Wilmarth 2011b). Similarly, the Federal Reserve’s pre-­GLB Act decisions to expand BHCs’ securities dealing and underwriting powers was driven to a great extent by its own interest in strengthening BHCs’ competitive position vis-­à-vis investment banks regulated by the SEC. The GLB Act further solidified the Federal Reserve’s role as an umbrella regulator of newly diversified FHCs, which created additional incentives for the Federal Reserve to allow bank-­centred financial conglomerates to grow stronger and more competitive, not only nationally but also globally. Regulatory agencies outside the banking sector also exhibited strong turf-­ preservation and expansion tendencies, which closely aligned their interests with those of the industries they were regulating. Thus, after the passage of the CFMA (Commodities Futures Modernization Act), the CFTC (Commodity Futures Trading Commission), the federal agency overseeing commodity futures markets, pursued an openly deregulatory agenda. Among other things, the CFTC significantly relaxed its oversight of futures exchanges to enable them to compete against the exploding OTC derivatives markets. The SEC’s move to institute the CSE programme for large investment banks, discussed above, was another example of an agency claiming greater regulatory turf. In this case, the SEC did so by asserting itself as a ‘consolidated supervisor’ of investment bank-­ centred financial conglomerates, thereby enhancing its position vis-­à-vis the Federal Reserve and other banking regulators in the international Basel process. Of course, regulatory fragmentation and turf wars are not inevitably linked to deregulation. By creating a system of checks and balances, such a system could also potentially lead to stronger regulation of financial markets. The pre-­CFMA attempts by the CFTC to regulate OTC swaps as commodity futures provide one example of such an outcome. In 1998, the CFTC announced its intention to regulate swaps as futures contracts, which meant moving them onto organized exchanges. After the industry revolted and under immense pressure from the Federal Reserve and the U.S. Treasury, the CFTC abandoned the idea and its chairwoman, Brooksley Born, resigned her post. Another well-­known example of the positive effects of regulatory fragmentation and diversity was the campaign by Elliott Spitzer, then the New York State Attorney General, to use state

72   S. Omarova et al. anti-­fraud laws to end abusive market practices on Wall Street, which escaped the attention of the SEC. So it would appear that structural factors alone cannot fully explain the deregulatory trends in the U.S. financial services sector in the decades preceding the latest financial crisis. Ideological factors Ideological factors also played a significant role in shaping this process, albeit not in a strictly partisan manner. Deregulation in trucking, airlines, and electricity began during the Carter administration in the late 1970s (a centrist Democratic administration on economic matters), and many of the most problematic deregulatory actions in finance (partial repeal of Glass–­Steagall and refusal to regulate derivatives) were taken during the administration of Bill Clinton, another centrist Democrat on economic matters. Both Republican and Democratic political appointees who headed federal regulatory agencies, starting in the early 1980s and continuing through to the financial crisis, shared deregulatory views, based on faith in markets’ self-­regulation and a belief that government intervention in markets can often cause more harm than good (Poser 2009; Johnson and Kwak 2010; Stiglitz 2010). These beliefs were strongly influenced by the Chicago school of economics, a set of beliefs that gradually began to be taken seriously at the highest policy levels in the U.S. beginning in the early 1980s with the Reagan administration (Van Horn and Mirowski 2009). To summarize these well-­known views briefly: the Chicago school posits that the Walrasian general equilibrium model of supply and demand from microeconomics provides the best basis for macroeconomic policy actions (Stiglitz 2010: 258). In contrast to classic Keynesian economics, the Chicago school believes that since markets are efficient, and will come back to equilibrium if largely left alone, temporary fluctuations such as recessions should not be the basis for government intervention, especially since government spending to try to address unemployment will do little more than increase inflation, in their view. President Reagan, the ‘great communicator’, became a chief proponent of a complex of policies strongly influenced by Milton Friedman and the Chicago school. These policies included ‘supply side’ economics that emphasized cutting taxes, which would increase demand through increasing consumer spending; Friedman’s monetarist approach to fighting inflation, with the Federal Reserve articulating clear inflation targets and increasing the money supply at a fixed rate in relation to those targets; and reducing the power of unions, which were understood to cause wage and therefore price rigidity and thus interfere with markets returning to equilibrium (Stiglitz 2010: 260). Subsequent to the Reagan administration, no Federal Reserve Board Chair has explicitly pursued the dual goals of reducing unemployment and fighting inflation that had previously been understood to be central to the Federal Reserve’s mission, until soaring unemployment in 2009 required Chairman Bernake’s attention. Still, even as this chapter is being written (January 2012), the Federal Reserve is willing to publish a specific target of 2 per cent for long-­term

The United States   73 i­nflation, but states that it ‘would not be appropriate to specify a fixed goal for employment’ (Federal Reserve 2012). Thus, since 1980 most of the top agency officials have believed that their mission was not to interfere with the natural progress of financial innovation, that the best government approach was minimal interference with markets, and that sophisticated actors’ self-­interest and counter-­party surveillance could be relied upon as an effective form of regulation (De Graaf and Williams 2009). The former chairman of the Federal Reserve, Alan Greenspan, was a principal proponent of this new creed, dubbed the ‘Greenspan doctrine’ (Kohn 2005). A succession of Secretaries of the Treasury, including Clinton appointees Lawrence Summers and Robert Rubin, Bush appointees John Snow and Henry Paulson, and probably Obama appointee Timothy Geitner, also subscribed to that ideology to varying degrees. Summers’ and Rubin’s successful campaign to silence the CFTC’s Brooksley Born’s efforts to regulate OTC derivatives was driven, in part, by their belief that she was misguided and simply lacked an understanding of the derivative market’s dynamics (Hirsh 2010). By the beginning of the new century, the Greenspan doctrine had become the dominant ideology underlying and guiding regulatory developments in the U.S. financial services sector. In this new language of financial regulation, the positive significance of free markets was emphasized, while their potential downside was dismissed. No top regulator (other than Brooksley Born) questioned whether, in fact, all those new complex financial instruments always transferred risk to those who were better able to bear it, or whether unregulated hedge funds and other speculators were indispensable and benign sources of liquidity in financial markets, or whether financial innovation could be anything but an unmitigated public good. It took a devastating global financial crisis, and Alan Greenspan’s fall from grace, to dismantle the ideological monopoly of the Greenspan doctrine. And yet, as this chapter is being written (January 2012), no top U.S. regulators have asked the sort of searching questions about market efficiency as have British regulators Adair Turner of the Financial Services Authority or Andrew Haldane of the Bank of England (FSA 2009; Haldane and Davies 2011). Moreover, Alan Greenspan’s January 2012 editorial in the Financial Times, ‘Meddle with the Market at your Peril’, continues to promote the view that improvements to financial regulation need to be enacted with extreme caution, if at all (Greenspan 2012). Political factors But the supremacy of deregulatory ideology in the pre-­crisis era was also a product of something more pernicious than the misguided beliefs of individual agency officials. Regulatory capture is particularly pervasive in the financial services sector, where large and well-­organized industry actors command enormous resources and political power and have keen interest in shaping the regulatory regime to which they are subject. Agency supervisors work closely with the financial firms and often depend on their managers’ cooperation and willingness

74   S. Omarova et al. to share their inside knowledge of the complex details of the firms’ business. As a result, industry actors are able to influence their supervisors’ and regulators’ views (Hardy 2006). The well-­documented ‘revolving door’ between the financial industry and regulatory agencies further enhances the industry’s ability to control the regulatory agenda (Ford 2011). This ideological or cultural capture of financial regulators by the industry is a key explanation for the deeply entrenched deregulatory bias that characterized U.S. financial services regulation in the pre-­ crisis decades (Poser 2009; Johnson and Kwak 2010). Moreover, the system of campaign finance in the U.S., and the state of perpetual electoral activity that arises from the entire federal House of Representatives being up for re-­election every two years, has created a vicious cycle: as the material rewards to participants in finance have increased, in part due to deregulation, so has the industry’s political power – and its consequent ability to secure more deregulation (Hacker and Pierson 2010). To the extent that regulatory agencies have a formal or informal policy mandate to promote the efficiency and global competitiveness of the national financial markets, such agencies become even more committed to adopting rules that are helpful to their regulated industry (Hardy 2006). In the context of increased globalization of the financial markets, it is particularly difficult to counter the industry’s argument that stronger regulation reduces the global competitiveness of U.S. financial products and firms. In 2006–2007, publicly traded U.S. companies began a concerted lobbying effort to roll back some of the accounting and auditing provisions of SOX, under the slogan of restoring U.S. capital markets’ competitiveness. As part of this campaign, the industry sought to force the SEC to scale back its enforcement activities and to reinvent itself as a more industry-­friendly, ‘principles-­based’ and ‘light-­touch’ regulator, similar to the U.K. Financial Services Authority (FSA). The financial crisis revealed the extent of the FSA’s failure to effectively supervise Britain’s banks and led to the abolition of that agency (FSA 2009). Nevertheless, as the immediacy of the financial crisis and bank bailout subsides, the industry is likely to revive the argument for increasing the global competitiveness of the U.S. financial markets by scaling back regulation and allowing financial innovation to proceed without interference. Two other political factors were significant in shaping the power of finance in the U.S. First, there was a collapse of countervailing power, specifically unions. As argued by Jacob S. Hacker and Paul Pierson in Winner-­Take-All Politics (2010), powerful political movements of the 1970s and 1980s in the U.S., such as the environmental movement and the women’s movement, downplayed economic concerns over wages and economic inequality that had been central to labour unions, and concentrated instead on political issues that appealed to the more affluent (Hacker and Pierson 2010). As manufacturing jobs moved offshore, and finance and service industries became more central to the economy, unionization in the private sector declined. President Reagan accelerated the process of declining unionization and declining union power by firing members of the air traffic controllers union (PATCO) who went on strike, by filling the

The United States   75 National Labor Relations Board with pro-­management commissioners who reversed 40 pro-­union precedents, and by appointing judges to the Supreme Court – and, importantly, the lower federal courts – who similarly ruled with employers at the expense of labour (Levy et al. 1998: 31). Thus labour density declined from 20 per cent at the start of President Reagan’s term to 15 per cent in the early 1990s (Levy et al. 1998). Today, labour density in the U.S. private sector is 6.8 per cent; and overall is 12 per cent (Bureau of Labor Statistics 2012). Second, there is in the U.S. a network of extremely well-­funded think tanks devoted to promoting the value of free markets, and denigrating regulation generally. Prior to the 1980s, the policy-­advocating think tank was almost exclusively an enterprise of the Left. But that changed dramatically as the Right adopted the model (Southworth 2008). The Federalist Society, for instance, has chapters at all the top law schools and sponsors debates promoting the value of free markets and deregulation. The Federalist Society also treats new federal judges to week-­long seminars in expensive resorts where its views on regulation, environmental law, and free markets are promoted. The Olin Foundation similarly supports fellowships for students at elite law schools to study conservative legal approaches such as law and economics. The Cato Institute, the American Enterprise Institute, and the Mercatus Foundation, among other public policy think tanks that promote deregulation, have been founded by conservative business interests and been given tens of millions of dollars in funding (Mayer 2010). This support ensures that policy ideas supporting deregulation are broadly disseminated, communicated to the media by sophisticated public relations experts, and taken seriously. One think tank that deserves particular attention in this discussion is the Mont Pelerin Society, which still exists today in relative obscurity but with tremendous intellectual scope. Founded after the Second World War in Switzerland to resist ‘collectivist’ ideologies such as communism and socialism, the Mont Pelerin Society gave succour to many of the people, such as Milton Friedman and Friedrich von Hayek, and many of the ideas, associated with the Chicago school of economics: ‘free markets, limited governments, and personal liberty under the rule of law’, as described by one insider (Plehwe 2009: 2, citing Edwin Feulner). Indeed, von Hayek was the Society’s first President, from 1948 to 1960, and Milton Friedman served as its President from 1970–1972 (Plehwe 2009: 18). From the mid-­1940s through the mid-­1960s, two conservative Amer­ ican foundations (the Volker Fund and the Foundation for Economic Education (FEE)) funded Mont Pelerin attendance by many Chicago economists, and gradually exerted influence to exclude Europeans from American Mont Pelerin Society discussions, particularly Europeans who might see a positive role for the state beyond enforcing property rights or a positive role for labour unions (Van Horn and Mirowski 2009). Using resources collected from various conservative businessmen, the Volker Fund and FEE sought to counter New Deal politics in the U.S. through the ‘investigations’ they funded for over two decades at the University of Chicago, starting in the late 1940s (Van Horn and Mirowski 2009).

76   S. Omarova et al. Two ‘investigations’ housed at the University of Chicago Law School became of particular importance to the development of the Chicago school of both economics, and law and economics. One was the Free Market Project, which was originally funded in the late 1940s to write an American version of Hayek’s The Road to Serfdom, a project in which both Hayek and Friedman were centrally involved (Van Horn and Mirowski 2009: 139–153), and which eventually was made good by Friendman’s Capitalism and Freedom in 1962 (Van Horn and Mirowski 2009: 166). The second was the Chicago antitrust project, which sought to reconceptualize the problem of monopoly away from the political power that monopolies can exercise to a concept of ‘consumer welfare’ that can exist comfortably alongside two or three large companies in each industry so long as productive ‘efficiencies’ can be demonstrated (Van Horn 2009). What the Volker Fund and FEE funding accomplished, along with the institutional and intellectual support provided by the Mont Pelerin Society, was for Chicago economists and law and economics-­influenced law professors to develop ‘a theory of how to reengineer the state in order to guarantee the success of the market and its most important participants, modern corporations’ (Van Horn and Mirowski 2009: 161). Moreover, and of particular import, given its significant support from corporate foundations, that theory came to be widely communicated by corporate America beyond the boundaries of academia and so become influential at the highest level of policy development in the United States. The result has been a three-­decade experiment with progressively more deregulation of financial markets as market participants grew concomitantly wealthier and thus able to exercise increasing political power (Johnson and Kwak 2010; Hacker and Pierson 2010; Stiglitz 2010). Whether America will be able to step back from this experiment and recalibrate its variety of neoliberalism is yet to be seen.

References Allen, F. and D. Gale (2007) Understanding Financial Crises, Oxford: Oxford University Press. Bank for International Settlements (2011) Press release 16 November: ‘OTC Derivatives Market Activity in the First Half of 2011’. Bank for International Settlements (2000) Press release 13 November: ‘The Global OTC Derivatives Market Continues to Grow’. Blair, M. (2010) ‘Financial Innovation, Leverage, Bubbles, and the Distribution of Income’, Review of Banking and Financial Law, 30: 225–311. Broome, L.L. and J.W. Markham (2011) Regulation of Bank Financial Service Activities, St. Paul, MN: West. Bureau of Labor Statistics (2012) News Release, online, available at: www.bls.gov/news. release/union2.toc.htm and Current Population Survey Table 42, online, available at: www.bls.gov/cps/tables.htm#union. DeFerrari, L.M. and D.E. Palmer (2001) ‘Supervision of Large Complex Banking Organizations’, Federal Reserve Bulletin, February, pp. 47–57, Washington, D.C.: Federal Reserve. De Graaf, F.J. and C.A. Williams (2009) ‘The Intellectual Foundations of the Global

The United States   77 Financial Crisis: Analysis and Proposals for Reform’, University of New South Wales Law Journal, 32, 2: 390–415. Engel, K.C. and P.A. McCoy (2007) ‘Turning A Blind Eye: Wall Street Finance of Predatory Lending’, Fordham Law Review, 75: 2039, 2045–2048 FCIC (Financial Crisis Inquiry Commission) (2011) The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of Financial and Economic Crisis in the United States, Washington, D.C: U.S. Government Printing Office. Federal Reserve Board (2012) Press Release, ‘Federal Reserve Issues FOMC Statement of Longer-­Run Goals and Policy Strategy’, 25 January, online, available at www.federalreserve.gov/newsevents/press/monetary/20120125c.htm. Ford, C. (2011) ‘Macro and Micro Level Effects on Responsive Financial Regulation’, University of British Colombia Law Review, 44, 3: 589–626. FRBNY (Federal Reserve Bank of New York) (2010) Tri-­Party Repo Infrastructure Reform 6, online, available at: www.ny.frb.org/banking/ nyfrb_triparty_whitepaper.pdf. FSA (Financial Services Authority) (2009) The Turner Review: A Regulatory Response to the Global Banking Crisis, online, available at www.fsa.gov.uk/pubs/other/ turner_ review.pdf. Goodfriend, M. and R. King (2005) ‘The Incredible Volcker Disinflation’, Journal of Monetary Economics, 52, 5: 981–1015. Greenspan, A. (2012) ‘Meddle with the Market at Your Peril’, Financial Times, 25 January, online, available at: www.ft.com/intl/cms/s/0/1c76d726-4687-11e1-89a 8-00144feabdc0.html. Hacker, J.S. and P. Pierson (2010) Winner-­Take-All Politics: How Washington Made the Rich Richer and Turned its Back on the Middle Class, New York: Simon & Schuster. Haldane, A.G. and R. Davies (2011) ‘The Short Long’, Speech to the 29th Société Universitaire Européene de Recherches Financières Colloquium: New Paradigms in Money and Finance? Online, available at: www.bankofengland.co.uk/ publications/ speeches/2011/speech495.pdf. Hardy, D. (2006) Regulatory Capture in Banking, International Monetary Fund, Working Paper No. 06/34, online, available at: http://papers.ssrn.com/sol3/ papers.cfm?abstract_ id=892925. Hazen, T.L. (2005) ‘Disparate Regulatory Schemes for Parallel Activities: Securities Regulation, Derivatives Regulation, Gambling, and Insurance’, Annual Review of Banking and Financial Law, 24: 375, 382–383. Hirsh, M.S. (2010) Capital Offense: How Washington’s Wise Men Turned America’s Future Over to Wall Street. Hoboken, NJ: John Wiley & Sons, Inc. Johnson, S. and J. Kwak (2010) Thirteen Bankers: The Wall Street Takeover and the Next Financial Meltdown, New York: Pantheon Books. Karmel, R.S. (2011) ‘Is the Public Utilities Holding Company Act a Model for Breaking up the Banks that are Too-­Big-to-­Fail?’ Hastings Law Journal, 62, 4: 821–864. Karmel, R.S. (2007) ‘The Once and Future New York Stock Exchange: The Regulation of Global Exchanges’, Brooklyn Journal of Corporate, Financial & Commercial Law, 1, 2: 355–393. Kindleberger, C. (1978) Manias, Panics, and Crashes: A History of Financial Crises, New York: Basic Books. Kohn, D.L. (2005) ‘Financial Markets, Financial Fragility, and Central Banking’, Remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, Financial Markets, Financial Fragility, and Central Banking, August, Jackson Hole, Wyoming.

78   S. Omarova et al. Krawiec, K.D. (1997) ‘More than Just “New Financial Bingo”: A Risk-­Based Approach to Understanding Derivatives’, Journal of Corporation Law, 23, 1: 1–63. Krippner, G.R. (2005) ‘The Financialization of the American Economy’, Socio-­Economic Review, 3, 2: 173–208. Levy, J., R. Kagan, and J. Zysman (1998) ‘The Twin Restorations: The Political Economy of the Reagan and Thatcher “Revolutions” ’, in L.-J. Cho and Y.H. Kim (eds) Ten Paradigms of Market Economies and Land Systems, South Korea: Korea Research Institute for Human Settlements. Macey, J.R. and M. O’Hara (2005) ‘From Markets to Venues: Securities Regulation in an Evolving World’, Stanford Law Review, 58, 2: 563–600. Mayer, J. (2010) ‘Covert Operations: The Billionaire Brothers who are Waging a War against Obama’, The New Yorker, 30 August. McCoy, P.A., A.D. Pavlov, and S.M. Wachter (2009) ‘Systemic Risk Through Securitization: The Result of Deregulation and Regulatory Failure’, Connecticut Law Review, 41(4): 493–541. Mitchell, L.E. (2011) ‘Financialism: A (Very) Brief History’, in C.A. Williams and P. Zumbansen (eds) The Embedded Firm: Corporate Governance, Labor, and Finance Capitalism, New York/Cambridge: Cambridge University Press. Nickell, S. and B. Bell (1996) ‘Changes in the Distribution of Wages and Unemployment in OECD Countries’, American Economic Review, 86, 2: 302–308. NYID (New York State Insurance Department) (2000) Office of General Counsel Opinion Re: Credit Insurance Policy Issued to Financial Institution, 16 June, online, available at: www.dfs.ny.gov/insurance/ogco2000/rg006161.htm. Omarova, S.T. (2011) ‘From Gramm-­Leach-Bliley to Dodd-­Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act’, North Carolina Law Review, 89: 1683–1769. Omarova, S.T. (2009) ‘The Quiet Metamorphosis: How Derivatives Changed the “Business of Banking” ’, Miami Law Review, 63: 1041–1110. Orhangazi, O. (2008) Financialization and the US Economy, Cheltenham, UK/Northampton, US: Edward Elgar. Piven, F. and R. Cloward (1979) Poor Peoples’ Movements, New York: Vintage Books. Plehwe, D. (2009) ‘Introduction’, in P. Mirowski and D. Plehwe (eds) The Road from Mont Pelerin, Cambridge, MA/London: Harvard University Press. Poser, N.S. (2009) ‘Why the SEC Failed: Regulators Against Regulation’, Brooklyn Journal of Corporate Finance and Commercial Law, 3: 289–324. PWG (The President’s Working Group on Financial Markets) (1999) Hedge Funds, leverage, and the Lessons of Long-­Term Capital Management, Report of The President’s Working Group on Financial Markets, Washington, D.C.: Department of the Treasury. SEC (Securities Exchange Commission) (2009) Money Market Fund Reform, Exchange Act Release No. IC-­28807, 74 Fed. Reg. 32,688, 32,689 (proposed 30 June 2009). Skeel, D. (2010) The New Financial Deal: Understanding the Dodd-­Frank Act and its (Unintended) Consequences, Hoboken, NJ: John Wiley & Sons. Southworth, A. (2008) Lawyers of the Right: Professionalizing the Conservative Coalition, Chicago, IL: University of Chicago Press. Spong, K. and E. Robbins (2007) ‘Industrial Loan Companies: A Growing Industry Sparks a Public Policy Debate’, Federal Reserve Bank of Kansas City Economic Review, 92, 4: 41–71. Stiglitz, J.E. (2010) Freefall: America, Free Markets, and the Sinking of the World Economy, New York London: W.W. Norton.

The United States   79 Stout, L.A. (2011) ‘Derivatives and the Legal Origin of the Credit Crisis of 2008’, Harvard Business Law Review. 1, 1: 1–38. Van Horn, R. (2009) ‘Reinventing Monopoly and the Role of Corporations: The Roots of Chicago Law and Economics’, in P. Mirowski and D. Plehwe (eds) The Road from Mont Pelerin, Cambridge, MA/London: Harvard University Press. Van Horn, R. and P. Mirowski (2009) ‘The Rise of the Chicago School of Economics and the Birth of Neoliberalism’, in P. Mirowski and D. Plehwe (eds) The Road from Mont Pelerin, Cambridge, MA/London: Harvard University Press. Wapshott, N. (2011) Keynes/Hayek: The Clash That Defined Modern Economics, New York London: W.W. Norton. Wilmarth, Jr., A.E. (2011a) ‘The Dodd-­Frank Act: A Flawed and Inadequate Response to the Too-­Big-To-­Fail Problem’, Oregon Law Review, 89: 953–1057. Wilmarth, Jr., A.E. (2011b) ‘The Dodd-­Frank Act’s Expansion of State Authority to Protect Consumers of Financial Services’, Journal of Corporation Law, 36: 893–954. Wilmarth Jr., A.E. (2002) ‘The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks’, University of Illinois Law Review, 2002, 2: 215–476.

4 The United Kingdom Thatcherism – ‘a heavy hand and a light touch’ Suzanne J. Konzelmann, Marc Fovargue-­Davies and Frank Wilkinson

Introduction The decline of British industry, along with monetarism, economic liberalization and the rise of the financial sector are popularly associated with the 1980s and Margaret Thatcher’s Conservative government. But British industry had already passed its peak nearly a century before. Unregulated financial markets were in full swing in London by the late 1950s, with the emergence and growth of the Eurodollar and wholesale money markets there. Monetarist policy was attempted by Heath’s Conservative government during the early 1970s and endorsed by the Labour party leader, James Callaghan, later in the decade; and the need for a loan from the IMF in 1976 laid the foundations for much of what would later become known as ‘Thatcherism’. Britain’s return to economic liberalism during the three decades leading up to the 2008 global financial crisis (GFC) must thus be traced to processes that have roots much earlier. We therefore begin with an examination of the forces that created the system that ultimately collapsed; and this requires a brief exploration of Britain’s ‘imperial hangover’. Britain’s imperial hangover The catalyst for Britain’s ascent to global dominance was, ironically, a crushing naval defeat by the French in the Battle of Beachy Head in 1690. This produced a determination to build a more powerful navy; and since the funds could not easily be raised through taxation, it led to the establishment in 1694 of a private institution, the Bank of England, to raise the money. The industrial effort that followed transformed the economy and spurred domestic and international growth (Hobsbaum 1999). In the early 1700s, England and Scotland merged and the British Empire began to expand. By the end of the eighteenth century, Britain was the dominant colonial power in North America and India; and following the defeat of Napoleonic France in 1815 it enjoyed a century of virtually unchallenged global dominance, during which its empire came to span the globe (Parsons 1999).1 As the first nation to industrialize, Britain’s technological breakthroughs were fostered by commercial and imperial strength, and the country’s high levels of

The United Kingdom   81 literacy and numeracy. Relatively high wages and cheap energy provided incentives for inventors to increase labour productivity (Allen 2009); and, by the early eighteenth century, Britain’s industrial revolution was well underway, with its expanding empire producing a steady supply of productive resources and markets. However, the need to expand industry to match these markets combined with the dominant form of financing – the stock market – to create a situation that would ultimately contribute to the weakening of British industrial hegemony (Rowley 1974). Although joint stock charters were awarded to such monopolies as the East India Company during the seventeenth century, the number of incorporations vastly increased following the Joint Stock Companies Act of 1844; and with the Limited Liability Act of 1855, they moved to the mainstream of British corporate form as shareholders were able to limit their liability to the money they invested in company shares (Orhnial 1982). As family-­owned companies matured and found it increasingly difficult to secure independent funding, the stock market became the chief mechanism for financing corporate growth; and a new class of owners – the shareholder – came into being. In due course, the British shareholder capitalist would succeed the industrial capitalist, who had previously replaced the merchant capitalist. However, funding corporate expansion through the stock market acted as a constraint on size – and hence scale of production and operations (Rowley 1974); and by the late nineteenth century, British industries’ competitiveness began to suffer as other countries, particularly Germany and the United States, caught up. Their abundant supplies of energy and raw materials – and the ability to learn from Britain’s experience – provided advantages, as did their systems of corporate finance (Biggs and Jordan 1967). Whilst British companies depended on the stock market, German and American companies were largely funded by bank loans, a cheaper and more stable source of funding that facilitated growth in both scale and scope, based on investment in the latest machinery and techniques (Readman et al. 1974). This increased competition hastened Britain’s retreat from European and US markets, and increased its reliance on the Empire. By 1951, the share of British exports going to imperial markets had risen from about a quarter in 1870 to over a half; and as late as 1970, more of Britain’s exports went to British Commonwealth countries than to Europe (Broadberry 1997: 6). The relative weakness of British industry was ruthlessly exposed by the two world wars, when Britain found herself not only out-­produced by her adversaries but also having to make up much of the material and financial shortfall from American productive capacity and funding. The end result was near bankruptcy by the end of the Second World War, largely rundown and outdated industrial assets and – with the beginning of decolonization in 1947 – the loss of privileged access to imperial markets. Currency challenges swiftly followed, as sterling – hitherto the currency of the empire – experienced a protracted period of adjustment that would repeatedly shake the British economy. But the British financial sector proved to be highly innovative, remarkably fast growing and, in the end, able to free itself from any dependency on domestic industry.

82   S.J. Konzelmann et al.

Britain’s ‘new deal’: the post-­war consensus The Second World War – and the need to maximize production of war materials and food – had forced a number of structural changes on the British economy. In addition to the adoption of American-­style mass production, which would later adversely impact British industrial relations (Broadberry 1997), the most fundamental change was a move towards increased government control and coordination of agriculture, commodities, industry and utilities. It also inspired a slim volume warning against the potentially dire consequences of excessive government involvement in the economy. Friedrich von Hayek’s The Road to Serfdom, published in 1944, had an almost immediate effect. Initially restricted in circulation by paper rationing in both Britain and America, it was enthusiastically received and sparked considerable debate (Hazlett 1992; Block 1996). But Hayek would have to wait more than thirty years for the arrival of perhaps his keenest disciple: Margaret Thatcher. Britain’s ‘golden age’ Following the War, confidence in the world economy was strengthened by the 1944 Bretton Woods Agreement, which established a coordinated system for regulating international capital flows. The resulting growth in world trade boosted output and contributed to a steady improvement in standards of living throughout the developed world. In Britain, wartime quotas and restrictions were lifted but foreign exchange controls were retained to restrict the export of financial capital, whilst most imported goods were limited by quotas. Meanwhile, British imperial preference and the sterling area, a remnant of its imperial heritage, remained in place (Shonfield 1969; Kuisel 1981; Zysman 1983). During this period, especially 1952–1960, macroeconomic performance was characterized by full-­employment, non-­inflationary growth and rapidly rising living standards; and this was considered ‘the golden age’ of post-­war economic history. For the working class, job security was on a level previously unknown, educational opportunities were opened up for the young and pensioners could enjoy a living income; many households gained access to decent and affordable housing and the NHS provided treatment for all, free at the point of access, financed by national insurance (Morgan 1984; Pelling 1984; Cairncross 1985; Hennessy 1992). Post-­war prosperity reinforced the relative stability of British society as income and social expectations steadily increased (Morgan 2001). During the 1950s, as real incomes rose and buying on credit became more freely available and socially acceptable, more and more Britons aspired to own their home, car and a wide range of consumer durables; they also sought to take overseas holidays (Wilkinson 2012). It was not all smooth sailing, though. The post-­war commitment to full employment often came into conflict with Britain’s historical commitment to sterling; and deficits on trade and balance of payments accounts were transformed into recurring financial crises due to currency speculation. The result was

The United Kingdom   83 a cycle of ‘stop-­go’ in which demand stimuli aimed at full employment would generate balance of payments crises and a sharp reversal in policy to shore up the pound. Nevertheless, the period from the early 1950s to the mid-­1960s brought unprecedented levels of employment, economic growth and living standards. In retrospect, Britain’s golden age was perhaps was less lustrous than it seemed at the time, especially when set against what was happening in other industrial countries. But for the majority of British people, relative stability and contentment compared well with the turbulent interwar years and the traumas of the Second World War. The ideas of Von Hayek and the Chicago School economists would thus have to wait for the chaos of the 1970s – and the loss of faith in Keynesianism – before they would come into their own. Meanwhile, back in the City . . . Like the rest of the British economy, the City of London emerged from the war into a changed world. Quite apart from the rapid dissolution of the British Empire, the Bretton Woods system established a restrictive and closely regulated system for international finance and ushered in an era of managed currencies. Its chief architects, John Maynard Keynes and Harry Dexter White, had been key witnesses to the destabilizing effects of what Keynes described as the ‘massive, sweeping and highly capricious transfers of short-­term funds’ (quoted in Bloomfield 1946: 687) that had precipitated the international financial crises of the 1930s and brought an end to the Gold Standard. The Attlee government, too, recognized the importance of a stable financial system and had set out its plan for domestic finance more closely focussed on economic requirements: ‘The Bank of England with its financial powers must be brought under public ownership, and the operations of the other banks harmonized with industrial needs’ (Labour Party Manifesto 1945). However, in spite of all of this, London’s financial sector would show both agility and inventiveness that would make its industrial counterparts look positively leaden-­footed. It would also demonstrate the ability to side-­step any symbiotic relationship between finance and industry. This dynamism may well explain why pragmatic politicians, with a view to quick results, tended in practice to prioritize the interests of finance over those of industry, with perhaps unintended but nevertheless far-­reaching consequences. The 1929 Stock Market Crash had produced a more sceptical approach to financial services, with the Treasury assuming greater control over monetary affairs. Since the financial community was held responsible for the turmoil, reform focused on stricter control of domestic financial markets and on limiting the power of financiers and the Bank of England (Helleiner 1994: 32). As US Treasury Department Secretary, Henry Morgenthau, told the conference at Bretton Woods, the objective was ‘to drive the usurious money lenders from the temple of international finance . . . [and] move the financial centre of the world from London and Wall Street to the US [and HM] Treasury’ (quoted in Gardner

84   S.J. Konzelmann et al. 1980: 76). The Treasury thus assumed responsibility for monetary policy and for regulating building societies, friendly societies and trustee savings banks; the Department of Trade and Industry (DTI) was made responsible for securities and insurance regulation; and the newly nationalized Bank of England was given the task of keeping the banks in order. However, according to Morgan (1984), nationalization of the Bank of England was a great ‘non-­event’, with little real effect on its traditional relationship with the City. As memories of the stock market crash and Great Depression faded, and as high levels of employment and rising living standards were achieved, the atmosphere of caution gave way to one of confidence and innovation, which gradually overwhelmed concerns about the need for regulating and stabilizing finance. During the 1950s, a number of developments, facilitated by the Conservative Macmillan government’s desire to return to peace-­time normality, progressively loosened restrictions on financial markets (Reid 1982). Credit controls were eased; and in October 1958, hire purchase controls were eliminated, paving the way for the emergence of an effectively unregulated shadow banking system and fuelling a credit-­funded consumer boom. The City was also quick to exploit international opportunities. The 1950s saw the emergence and rapid growth of the unregulated London Eurodollar and sterling wholesale money markets, which provided a means of circumventing the Bretton Woods system (Burn 2006). The Eurodollar market was regulation-­free, created by merchant and overseas bankers in London, for the exchange of foreign currencies, primarily US dollars. The Marshall Plan for rebuilding post-­ war Europe had resulted in an enormous increase in US dollars (Eurodollars) held by foreign companies and countries, creating the need for a market for their exchange. During the Cold War, London became the preferred centre for Eurodollar activities – especially for the Soviet Union (Helleiner 1994: 81–100). When the Midland Bank first began bidding for Eurodollar deposits in 1955, discussions took place about possible violations of the spirit of exchange control legislation (Schenk 2004). However, since such dealings were not illegal, attracted dollars to London (helping to alleviate the balance of payments deficit) and helped raise the status of sterling as an international currency, they were welcomed by the Bank of England. But as the Eurodollar market expanded, concerns were raised about possible risks. When Sir Charles Hambro of Hambros Bank approached the Bank of England to express his disquiet in 1963, the Bank bluntly responded: It is par excellence an example of the kind of business which London ought to be able to do both well and profitably. That is why we, at the Bank, have never seen any reason to place any obstacles in the way of London taking its full and increasing share . . . If we were to stop the business here, it would move to other countries with a consequent loss of earnings for London. (Burn 1999: 241) The absence of regulation of the Eurodollar and Sterling wholesale markets encouraged the migration of foreign banks and bankers to London as the City

The United Kingdom   85 internationalized (Schenk 2004). It also set precedents for other unregulated markets. The growth of wholesale money markets, attracting funds from industrial and commercial institutions, served to further augment London’s standing as an international centre of finance. Not only was it attractive to established merchant and international banks; it also gave rise to new British secondary and fringe banks, which also operated beyond the reach of the regulators. During the 1950s, there was an ‘almost complete agreement . . . that the City depends on its open and international character and that Britain depends on the City’ (Schenk 2004: 339). Moreover, it was widely held that City prospects depended on the strength of sterling. As a result, both Conservative and Labour governments favoured City interests over those of industry. The policy response to successive sterling crises during the 1950s and 1960s was to support sterling by raising interest rates and cutting public sector expenditure, although this raised borrowing costs, reduced growth and increased unemployment. In the end, the main effect of the Eurodollar market was to encourage the ascent of the US dollar as the main international currency. However, by then, the City had learned that it could operate very effectively – and profitably – whatever the status of sterling, with one of its highly profitable services being the reorganization of British industry. The City as an industrial reorganizer The shape of things to come was fashioned by stock market operators who came to be known as ‘corporate raiders’. These included the likes of Tiny Rowland, James Goldsmith and Jim Slater (of Slater Walker), who demonstrated just what could be achieved in terms of industrial reorganization with leveraged finance and inflated share prices (BBC 1999: Parts 2 and 3). Jim Slater engineered his first hostile takeover in 1964, after Cork Manufacturing had increased the valuation of its Chingford office block to £1 million. Prior to this, its shares had been quoted at 13 shillings (£0.65); but after the valuation, they would actually be worth 40 shillings (£2.00) (Slater 1977). Realizing this, Slater, built up a 25 per cent shareholding in Cork, as a prelude to taking over the company. Whilst this was considered ‘un-­gentlemanly’ by some in the City (not unlike the Midland Bank’s first bids for Eurodollar deposits), it was not illegal; and the realization of potentially large profits from undervalued companies rapidly swamped any remaining gentlemanly scruples. The resulting (usually brief ) stellar share prices re-­awakened irrational beliefs in the infallibility of the stock market, erasing any lingering memories of the 1929 crash. Whilst it is difficult to quantify the extent of the resulting carnage, one survey showed that of the 2,126 manufacturing firms (outside the iron and steel industry) quoted on the UK stock exchanges in 1964, more than 400 (close to one-­fifth) had been taken over six years later (Rowley 1974: 72). The number increased substantially in the intervening years; and in July 1973, it was revealed that Slater Walker alone owned more than 10 per cent of forty-­five leading British companies (Rowley 1974: 77).

86   S.J. Konzelmann et al. The rising value of the company holdings of corporate raiders enhanced their ability to carry out ever more acquisitions. Thus, the stock market provided a double advantage: it made target companies vulnerable and gave the raiders a means of exploiting that vulnerability. The realization of quick profits created additional funds with which to carry on the process, as ever larger businesses were taken over and stripped of assets to pay off the debts incurred in their acquisition. The stock market typically responded well to takeover announcements; and given the trust placed in the stock market, the price increases of targeted companies were accepted as evidence of the success of the formula by many – including the financial press (BBC 1999: Part 2). In turn, economists theorized the stock market as a an efficient ‘market for corporate control,’ by which poorly managed companies, whose stock prices reflected managerial incompetence, could be usefully taken over by more efficient management. The knock-­on effect was to convince politicians that a miracle cure for ailing British industry had just dropped into their laps; and policy was adjusted accordingly. However, the reality is that a substantial proportion of acquisitions performed less well after they had been taken over than before (Martynova and Renneboog 2008). It was Harold Wilson’s Labour government that embraced the idea of using the stock market to reorganize industry. In his view, the solution to British industry’s competitive problems was growth through mergers to achieve economies of scale (Beath 2002: 223). In its election Manifesto, the Labour Party had pledged to set up the Industrial Reorganisation Corporation (IRC) to ‘stimulate rationalisation, modernisation and expansion in those fields where British industry at present seems unable to compete with the giant firms of the US and Europe’ (Labour Party Manifesto 1966). The IRC was established in 1966. However, the results were not as promised; and although large numbers of workers were made redundant, the newly formed conglomerates failed to prosper. The IRC ultimately shut down by the incoming Conservative Heath government in 1970. As time went on, the problems for businesses that had been forcibly restructured multiplied (Deakin and Singh 2008). Many were left without the resources to sustain their productive activities; and the large job losses that typically followed hostile acquisitions did little to improve relationships with unions or operational performance (Martynova and Renneboog 2008). This would come back to haunt governments on both sides during the decades that followed. The take-­over boom was eventually ended, not by government, but by the markets themselves. The end of the long property boom, which had fuelled the take-­over spree, spelt serious trouble for many secondary banks, including Slater Walker. Slater, himself, was forced to step down in 1975, to be replaced by none other than James Goldsmith – another well-­known corporate raider. The ensuing turmoil created serious fault lines between the regulators. Correspondence released decades later under the Freedom of Information Act reveals fierce animosity between the Treasury and the Bank of England. In a briefing to the Chancellor of Exchequer, Denis Healy, a Treasury official admitted that ‘We asked the Bank for an analysis of the problems underlying the collapse [of Slater

The United Kingdom   87 Walker] but this has not been forthcoming’ (HM Treasury 2005). Nor was the Treasury impressed by the Bank’s approval of James Goldsmith’s appointment as a replacement for Jim Slater. Brian Unwin, Treasury Under-­Secretary, wrote: Given the history of ‘City’ characters . . . I hope the Bank, who are up to their neck in the Slater Walker affair, are fully satisfied that Mr Goldsmith is a proper person . . . he is hardly a noted banking figure and indeed his reputation as far as the general public is concerned is that of a playboy and speculator. (HM Treasury 2005) Relations between the Bank and the Treasury would remain fraught, a situation not conducive to the effective functioning of Britain’s tripartite financial regulatory system.2 Eventually, the take-­over boom produced the Monopolies and Mergers Commission and the 1973 Finance Bill, requiring public disclosure of all share holdings of 5 per cent or more; and Ted Heath, Conservative Prime Minister, branded the practice of corporate raiding ‘the unacceptable face of capitalism’ (Morgan 2001: 319). However, worse was to come. With growing competition from abroad, demand for imported consumer goods climbed steeply and was financed by borrowing, resulting in deterioration in the balance of payments. Adding to the strain, the now uncompetitive British companies were amongst the largest employers, producing waves of layoffs3 and exacerbating tensions between government and the unions, as workers responded militantly to the falling living standards resulting from inflation and incomes policies during the early 1970s (Wilkinson 2012). In short, whilst early post-­war reforms had prioritized productive over speculative capital, with ‘national compartments constructed around the Fordist-­ Welfare-State concept’ (Burn 2006: 2), the gradual loosening of controls restricting the international movement of financial capital during the 1950s reversed this, effectively decoupling finance from industry. It also transformed what had, in effect, been a public international monetary order into one that was essentially private (Burn 2006: 13).

The 1960s and 70s – not a good time for politicians By the 1960s and 1970s, it was clear that British industry had become progressively less competitive. But the underlying reasons were neither understood nor addressed. Aside from the drawbacks of the dispersed shareholder model of ownership and the loss of large secure export markets within the empire, British industry had also developed a structural problem. The demands of wartime production had resulted in a re-­alignment away from the traditional flexible system of production, reliant on skilled labour, towards a more American-­style capital intensive, mass production system, requiring fewer and less skilled workers, and more and better qualified managers. Whilst the mass production of standardized

88   S.J. Konzelmann et al. products suited the needs of wartime production and American consumers, it did not improve Britain’s competitiveness in Europe, where ‘diversity of tastes was perpetuated by producers’ and retailers’ education of consumers to appreciate the fine distinctions amongst products’ (Piore and Sabel 1984: 198). Britain’s entry into the European Economic Community (EEC) in 1973 abruptly exposed UK industry to further competition, with which it was ill-­ prepared to cope. Another unhelpful effect of mass production techniques was to erode the employment base of skilled workers, upon which the British labour movement was based and to undermine industrial relations (Broadberry 1997). Many workers lost their jobs; and with the threat of more losses to come, the trade unions were in no mood for compromise. This – combined with the heavy loss of productive capacity during the take-­over boom and the over-­valuation of sterling – came to a head during the 1970s and early 1980s. But rather than addressing these problems with a clearly thought-­out, long-­term industrial strategy, successive governments continued to back the City as the driver of both economic development and international status. They forgave occasional ‘misdemeanours’ and nurtured it with progressively relaxed controls and a regulatory structure with yawning gaps. The effects of globalization From the 1960s onward, the progressive relaxation of exchange rate controls and the growing importance of multi-­national firms accelerated the process of globalization, as firms relocated production abroad in an effort to escape higher labour and social welfare costs. This accelerated de-­industrialization in long-­ established industrial regions and significantly weakened the ability of the government to influence macro-­economic outcomes. During the 1970s, the effects of simultaneously accelerating inflation and rising unemployment – ‘stagflation’ – were exacerbated by rapidly rising state expenditure to meet the growing costs of mass redundancies and attempts to salvage failing industries. Throughout the 1960s and 1970s, this led to a steady growth in state involvement in the economy. However, the wide variety of (largely unsuccessful) approaches to ameliorating Britain’s industrial difficulties highlights the increasing desperation of successive governments in addressing challenges they only poorly understood. Governments grope for solutions Both Labour and Conservative governments experimented with French-­style industrial planning, including the creation of the National Economic Development Council (NEDC) in 1962; and during the 1970s, the government tried in vain to reverse industrial decline by restructuring mature industries in both the public and private sectors, including nationalization. Income policies were also periodically implemented, in an attempt to hold back inflation and protect both the balance of payments and sterling. The decentralized nature of British trade

The United Kingdom   89 union organization, however, meant that centralized agreements on minimum wage rates were topped up at plant level by amounts determined by the ability of firms to pay and the bargaining power of shop steward-­led, plant-­based trade union organization. Thus, incomes policies announced by British governments were not only short lived at best, they also aggravated industrial unrest. These experiments with approaches imported from abroad ultimately proved futile as the historically limited British state was unable to manage the process of restructuring (Levy et al. 1998). Even worse, it resulted in widespread disillusionment with public intervention and the subordination of fiscal to monetary policy. The first serious attempt at activist monetary policy was made by the Conservative Heath government in 1971. Research by Charles Goodhart, a Bank of England economist, had previously indicated that ‘the demand for money function was stable and that there was a significant negative coefficient on interest rates’ so that ‘you could rely on interest rate adjustments – and did not need direct credit controls – to maintain monetary stability’ (Goodhart 2003: 26, emphasis added). With this reassurance, quantitative controls on bank lending were abandoned and the monetarist-­inspired policy ‘Competition and Credit Control’ (C&CC) was instituted in 1971. C&CC was designed to liberalize the money markets, stimulate competition among all types of banks and control the availability and cost of credit. Quantitative limits on bank lending were removed, liquidity requirements reduced, and interest rates allowed to play a more central role in the allocation of credit. Accompanying this was a ‘dash for growth’.4 C&CC paradoxically led to uncontrolled credit creation fuelled by reckless mortgage lending.5 House prices increased 77 per cent (51 per cent in real terms) between 1971 and 1973, despite an increase in the official interest rate from 5 per cent at the end of 1971 (then the Bank Rate) to 13 per cent at the end of 1973 (now the newly styled Minimum Lending Rate), revealing the extent to which demand for the owner occupation of houses had been previously suppressed by lending controls. Over the same period, net lending to consumers (i.e. changes in debt consumer debt outstanding) increased more than threefold from £83 million in 1971 to £285 million in 1973.6 At the end of 1973, the government intervened to rein in credit creation. This threatened the viability of the secondary banking sector (which had evolved to circumvent official controls on bank lending), precipitating a Bank of England bailout (named the lifeboat) to forestall a ‘financial panic of nineteenth-­century style’ (Kaldor 1986: 106). The policy reaction to the 1973 financial crisis was the re-­establishment of controls of bank lending by a variety of means (Kaldor 1986) and banking regulation was put on a statutory footing. The 1979 Banking Act gave the Bank of England legal powers to underpin its supervisory authority; it also created a two-­ tier system of ‘recognized banks’ and ‘licensed institutions’ and introduced a scheme to protect small depositors in the event of bank failure. But the Treasury retained ongoing responsibility for the legal framework of banking supervision and the performance of its regulator, the Bank of England. To address growing industrial unrest, the controversial Industrial Relations Act of 1971 was enacted, limiting the power of trade unions by outlawing

90   S.J. Konzelmann et al. wildcat strikes and restricting legitimate ones. This, in combination with experimentation with price and incomes policies, led to confrontation with increasingly militant trade unions. In 1972, for the first time since 1926, the National Union of Mineworkers (NUM) went on strike due to disagreement with the government over pay. The strike was successful; but it resulted in a state of emergency and introduction of the three-­day working week. The NUM went on strike again in 1974, resulting in the calling of a general election, based on the question, ‘Who Governs Britain?’ No one really seemed to know who governed Britain; and as a result of indecisiveness on the part of the electorate, few governments during the 1970s achieved anything approaching a comfortable majority. The hung parliament of 1974 was followed by a narrow Labour win by Harold Wilson, who settled the strike in the miners’ favour, adding to already mounting fiscal difficulties (Harvey 2005: 58). Wilson stepped down as prime minister two years later, to be replaced by James Callaghan. But through by-­elections, Callaghan’s majority was steadily eroded, resulting in a minority government shored-­up by various alliances with smaller parties. Another major concern was the state of public finances. Government borrowing had escalated through domestic economic problems whilst inflation increased the cost of debt. The Labour government of 1974–1979 thus faced serious difficulties in financing its deficits. Callaghan was persuaded by the promises of Monetarism; and in a speech at the 1976 Labour Party Conference, he warned that ‘you could not spend your way out of recession. It only fuelled problems by injecting inflation into the economy. The result was higher inflation, followed by higher unemployment. That is the history of the last 20 years’ (Callaghan 1976). However, the government had not delivered on promised social spending. Worse still, due to a deepening balance of payment crisis, it was forced to go to the IMF for a loan, and in return accept the austerity conditions attached. By 1978, the situation had become so difficult that industrial unrest erupted into the ‘Winter of Discontent,’ during which rubbish went uncollected, hospitals unsupplied and corpses unburied. Inflation exceeded 20 per cent and there was a growing belief that Britain had, in fact, become ‘ungovernable’ (Levy et al. 1998: 22). Although it was not yet clear, a quarter of a century of significant government Keynesian-­style involvement in the British economy was drawing to a close. Throughout the 1970s, the economy was plagued by stagflation; and controlling inflation ultimately trumped any concern about unemployment (Buiter and Miller 1983). Even the Labour Party, in its 1979 election manifesto, identified inflation as its top priority (Labour Party Manifesto 1979). By the close of the 1970s, although attention to finance had produced ‘results’ considered to be in the interest of Britain more generally, they were enjoyed by a smaller and smaller proportion of the population, who were rewarded with an increasingly disproportionate share of the total income (Blundell and Preston 1995; Deaton and Paxson 2004; Goodman and Webb 1994). Meanwhile the numbers claiming working class status, and the power of their trade union representatives and the Labour Party declined. Whilst this trend would continue, there would be one last stand by the NUM before the nature of the

The United Kingdom   91 relationship between the state and the economy – with the notable exception of finance – would change radically.

Heavyweight bout – the iron lady vs coal By the late 1970s, Britain had gone from being an imperial power to the ‘sick man of Europe’ in only three decades. This was an intolerable situation as far as Margaret Thatcher (elected prime minister in May 1979) was concerned. A staunch believer in the neo-­liberal economics of Friedrich von Hayek and Milton Friedman – she was rumoured to keep a copy of The Road to Serfdom in her handbag – Thatcher had not viewed the various attempts at intervention by her predecessors with enthusiasm. The coming decade would see three successive election wins for Mrs Thatcher, large-­scale privatization and a significant reduction in direct taxes. It would also see the (by now familiar) bias towards the City not only continue but increase dramatically, with wholesale deregulation and an expansion of credit that would turn Britain from a nation of shopkeepers into a nation of shoppers. Behind the scenes, but centrally important in Britain’s return to economic liberalism, were the right-­wing ‘think tanks’, perhaps the most significant of which significant was the Institute for Economic Affairs (IEA). Having emerged during the 1950s in response to the ideological shift towards Keynesianism, they remained in the background, churning out books and pamphlets, until the opportunity to influence opinion and policy presented itself (Desai 1994; Cockett 1995; Denham and Garnett 1998).7 Not only are they credited with preparing the ideological ground for Thatcherism, they would also play a role in seeing that it endured beyond her terms in office through their influence on the ‘modernization’ of the Labour party during the 1990s (Pautz 2011).8 Britain’s ‘Iron Lady’ Like Edward Heath’s a decade earlier, the Thatcher government was welcomed into power by high inflation, significant unemployment and restless trade unions. Like Heath, her response was a distinctly monetarist one, resulting in sharply increased interest rates and equally abrupt cuts in government spending. The results, inevitably, were similar to those that had caused Heath’s U-­turn in policy. Between 1979 and 1981, GDP fell 2.5 per cent and unemployment rose 13.3 per cent (the highest in Europe); and industrial unrest increased. The Thatcher government looked like it would be short-­lived. But this was where the similarities ended. At the 1980 Conservative Party conference, Thatcher’s now famous response was: ‘You turn if you want to – the lady’s not for turning!’ Thatcher’s saviour, however, came in the unlikely form of Argentina’s General Galtieri and his occupation of Britain’s colony in the Falkland Islands. In 1982, Britain went to war to protect its territory.9 The result was a decisive victory, giving Thatcher a popular mandate that – far from un-­seating her – would carry her through the next election with a large majority. Meanwhile,

92   S.J. Konzelmann et al. things were starting to improve economically. Whilst unemployment remained high, inflation had dropped from a peak of 18 per cent to 8 per cent; and there seemed to be a modest recovery under way. The discovery of North Sea oil in 1970, which commenced production in 1975 and peaked in 1979, had allowed the government to reduce its huge balance of payments and budget deficits. It also provided a significant boost to sterling, turning the pound into something of a ‘petro-­currency’. However, the resulting high exchange rate was another blow to the competitiveness of British industry. One of the first acts of the new government was to abandon exchange controls and further open-­up the UK economy to foreign competition and foreign direct investment. This both accelerated the decline in what remained of British industry and intensified industrial unrest (Harvey 2005: 59). But despite strong pressure from the labour movement to protect domestic industry and employment, Thatcher believed that protectionism would only create inefficiency and competitive weakness. She thus remained committed to allowing the free market to determine the winners and losers in industry; and she challenged the legitimacy of organized labour. Early in her term of office, Thatcher had settled with the miners, as she did not yet feel sufficiently strong to win a confrontation (BBC 1981). By 1983, however, the situation had changed. Having built up substantial coal stocks – and with the increased authority and confidence after the successful Falkland Islands campaign – Thatcher now took on the National Union of Mineworkers (NUM), whom she regarded as ‘the enemy within’. The result was a long and bitter fight by both sides. In the end, both the strike and the power of the NUM were broken; and throughout the 1980s, trade union power was progressively weakened by a series of legislative changes. These included the banning of secondary picketing, removal of the right to trade union immunity from the costs of a strike and imposition of more restrictive conditions for strike balloting – thereby sharply reducing the bargaining strength of shop for organization and the independence of trade union shop stewards (Jarley 2002). Trade union membership also declined sharply, mainly as a consequence of the run-­down in manufacturing and the mass closure of coal mines, so that whereas trade union density in the UK had peaked in 1979 at 55.8 per cent of the workforce, by 1990 it had declined to 38.1 per cent and by 1998 to 29.6 per cent (Fairbrother 2002: 64). Margaret Thatcher’s assertion in an interview with Time Magazine – that ‘we are building a property-­owning democracy’ – signalled changes designed to reshape society, and in all likelihood create working class Conservative voters (Ogden and Melville 1987). Establishing a property-­owning democracy required a substantially increased supply of property for the public to buy – and the means for them to buy it. The property came in the form of public housing and shares in newly privatized British companies. Under the 1980 Housing Act, tenants were encouraged to purchase their council homes, at heavily discounted prices. In the early 1980s, building societies (which had traditionally monopolized house mortgage market) lost their tax and other advantages; and the interests

The United Kingdom   93 rates they paid and earned increased to market rates. By 1983, banks had permanently entered the mortgage market and were gaining market share (Wilkinson 2012). The building societies were now at a competitive disadvantage because the banks had freer access to the wholesale money markets and could offer a wider range of services. This imbalance was redressed by the Building Societies Act of 1986. This Act permitted building societies to compete with banks by offering a wider range of products; and it increased the proportion of funds that building societies could raise in the wholesale money market. Increased competition put downward pressure on rates and fuelled a housing and consumer boom during the 1980s, as attitudes towards debt softened and personal debt burdens rose sharply. Whereas in 1961, seven million British households owned their own homes, by 1987, the figure had more than doubled, to 14.5 million; in 1981, 56 per cent of British households lived in owner-­occupied accommodations and by 1996, the figure was over two-­thirds (Morgan 2001: 566; Office for National Statistics n.d.a; Wilkinson 2012). Thatcher also set out to privatize sectors of the economy that were under public control, and in the process to promote wider share ownership. Between 1979 and 1995, roughly two-­thirds of nationalized British industry was returned to the private sector, at a value of roughly £30 billion (Riddel 1991: 87–92); and regulatory agencies were set up to protect consumers and promote competition. This not only increased public revenues and made possible large tax cuts in 1985 and 1986; it also released the government from liability for declining industries. By 1988, over 20 per cent of British adults owned shares, compared with only 6 per cent in 1984 (Morgan 2001: 566–567). Home and share ownership, however, introduced a new, speculative dimension into these markets. During the boom, confidence in the market and the economy soared, fuelling the bubble. This was sharply reversed, however, when, in October 1987, the stock market crashed; and during the early 1990s, the property bubble followed suit. Nevertheless, by the mid-­1980s, the Thatcher government appeared to have conquered many of Britain’s economic difficulties and there was talk of a ‘British miracle’ (Morgan 2001: 568). The apparent return to prosperity boosted confidence in neo-­liberal economic theory and policy. Less obvious was that a significant shift in relative power had also taken place, with the private sector – finance in particular – increasing its influence, at the expense of the state. Unleashing the City By the mid-­1980s, London had fallen behind New York as an international centre for finance – especially since the 1975 ‘May Day’ deregulation in New York. Thatcher blamed regulation and the ‘old boy’s network’ for this lack of competitiveness and opted for fundamental change. In 1986, ‘Big Bang’ liberalization ushered in radical cultural changes and a period of rapid internationalization, with profound effects on the UK financial sector, and by extension, the wider economy.

94   S.J. Konzelmann et al. Prior to 1986, the City had been composed of small, specialist firms, largely immune from take-­over. Stockbrokers could buy or sell particular shares, but not both; and the buying and selling of shares was intermediated by ‘stock jobbers’, through whose books every transaction went, on a fixed-­fee basis. Whilst this process was cumbersome at times, it made the system more transparent and stable; and it was a significant component of the self-­regulatory system in place at the time. On 27 October 1986, this regime was swept away. The buy and sell sides of brokerage were united and the modern trader was born. Moreover, banks and other financial institutions were allowed to trade in stocks and shares, and they began to acquire brokerage businesses. Concurrently, City firms found themselves increasingly vulnerable to international competition and the threat of hostile take-­over by banks and other financial intermediaries. Computerized trading and a time zone ideally placed between New York and Tokyo put London at the centre of the global financial network. This, and the easing of regulation, attracted overseas banks and resulted in a wave of acquisitions, many by non-­British institutions. This was not restricted to specialist City firms. By 1992, the Hong Kong Shanghai Bank (HSBC) had acquired the Midland Bank – then the UK’s biggest high street bank by market capitalization – and moved its headquarters to London to take advantage of ‘light touch’ regulation. British banks also pursued growth through acquisition. In 1986, Lloyds acquired the Continental Bank of Canada, adding the Trustee Savings Bank and the Cheltenham and Gloucester Bank in 1995. The Royal Bank of Scotland (RBS) acquired the Citizens Financial Group, which itself had made acquisitions, becoming the eighth largest bank in America and giving RBS significant representation in the US market. RBS also acquired NatWest in the 1990s, not long before its acquisition of the Dutch bank, ABN Amro. Through this process, the ‘Big Four’ UK domiciled banks were created. The large London-­based banks were highly internationalized in their business and complex in terms of management systems. As well as changes to consumer banking and the stock market, 1986 also brought regulatory change in the form of the Financial Services Act. This was partly in view of the radical programme of deregulation, and partly a result of the 1984 collapse of Johnson Matthey Bankers (JMB), which had revealed flaws in the 1979 Banking Act and fault lines in the regulatory system itself. To prevent a loss of confidence in the City of London’s gold bullion market, where JMB was a key player, the Bank of England intervened. However, the Conservative Chancellor, Nigel Lawson, felt that the Bank had acted without keeping him informed. A public rift ensued, straining relations between the government and the Bank. This political tension appears to have contributed to pressures already mounting for a change in regulatory structure, especially of securities, financial markets and insurance. A review of the role and functioning of financial institutions and investor protection for securities and other property produced the 1986 Financial Services Act, the first UK legislation to comprehensively regulate the securities industry

The United Kingdom   95 and markets. Professor Laurence Gower was asked to prepare a report on financial regulation and draft a bill based on it. His preference for a stricter, top-­down structure was, however, in the light of the more relaxed regulation evolving in New York, diluted by the government. The system adopted was self-­supervision overseen by the newly created Securities and Investments Board (SIB). City firms conducting business in the UK were required to seek membership in a self-­ regulatory organization (SRO) or direct supervision by the SIB. Since the SIB’s members were appointed by the Treasury, this further eroded the regulatory authority of the Bank. Throughout the 1980s, the supervision of securities and insurance remained the responsibility of the DTI. But as the lines between financial institutions became blurred, the Treasury assumed responsibility for regulating financial services in 1993 and insurance in 1998. With hindsight, it is clear that the Financial Services Act also ended any jurisdiction by the courts over derivative products which might have been considered speculative and therefore in violation of the Gaming Act of 1845 (Schwartz and Smith 1997: 183). This exemption was maintained by the Financial Services and Markets Act of 2000 – under a Labour government. The cumulative effect was to change the face of the City. American banks, in particular, were not slow to exploit the opportunity to circumvent the second Glass–­Steagall Act (which had separated commercial and speculative banking operations in the wake of the 1929 crash) by setting up in London, beyond its jurisdiction. Since the small, specialized companies of the City no longer enjoyed immunity from take-­over, many were swallowed-­up, laying the foundations of the global financial behemoths that would ultimately become ‘too big to fail’. The City had thus been unleashed, and its scope for business hugely expanded. Production industry, on the other hand, although very much slimmed down, had largely pacified unions and stable, relatively low rates of interest. The asymmetry of the British economy was growing. Other things had changed as well: the power of local authorities had been weakened, resulting in a steady concentration of power in central government. According to Morgan (2001: 471) ‘the government’s continuing popularity rested on its claim to have been the architect of new prosperity, based on finance, credit and consumer pump-­priming rather than on mass manufacturing industry as in the past’. Freer trade allowed a consumer culture to flourish whilst the proliferation of financial institutions encouraged a debt culture. However, the gulf between the rich and poor had become much wider. Moreover, the cost in terms of unemployment had been high: from 1.3 million in 1979, the claimant count increased to 3.3 million in 1985, it fell to 1.8 million but had increased again to almost 3 million by 1993. By 1985, the top 6 per cent of Britain’s income earners received 25 per cent of the national income while the poorest 20 per cent had fallen below the 5.9 per cent they enjoyed in 1979 (Wolleb 1989). So difficult were conditions in urban areas that the Church of England produced a report in the autumn of 1985, entitled Faith in the City: A Call to Action by Church and

96   S.J. Konzelmann et al. Nation.10 The report raised awareness of social and economic disparities in British society that had been made painfully apparent during the riots of the summers of 1981 and 1985. By the end of the 1980s, inflation was again on the rise, the pound was weakening, and there were record balance of payments deficits. Prosperity in the south and east coincided with decline in the north and west; and it became clear that the consumer boom had been largely financed with credit. All of this suggested that most of the old problems were, in fact, still there; and a few new ones had been added. Whilst the ‘property-­owning democracy’ had been somewhat realized, it had been achieved through the parallel creation of ‘debt-­servicing dependency’, which would lead to challenges in the decades to come. It effectively financialized the public and created the ‘speculating consumer’ – a cultural change that in many ways mirrored that in the City – as many had bought property for financial, rather than purely housing, needs. This, in turn, meant that governments would be judged on the basis of new criteria, such as house prices and interest rates. Power, as well as influence, had once again shifted decisively towards finance. Major changes, New Labour and its conversion to neo-­liberalism When Margaret Thatcher was unseated as prime minister in 1990, the chaos of the 1970s was a distant memory. However, two echoes of the 1970s remained. The first of these was was the continued unease with EEC membership. The other was the trade unions and their links with the Labour Party. The long period of trade union discontent – which stretched back to the early 1970s and which culminated in the 1983 Miners’ Strike – had, together with its internal ideological divisions, made the Labour Party virtually unelectable. However, the 1990s witnessed a Labour Party reformation with the pruning of its socialistic roots and the reduction of trade union influence. Old Labour gave way to ‘New Labour’; and New Labour signed up to neo-­liberalism. On the other hand, whilst Mrs Thatcher might no longer be prime minister, the Tory party’s swing to the right that had brought her to power was far from spent. European rumblings Britain’s entry into the EEC in 1973 had provided full access to the European Common Market – and divided both voters and politicians in the process. This unease came to a head in 1992, with the negotiation of the Maastricht Treaty. In spite of Britain’s decision to opt out of both the single European currency and the Social Chapter, the crucial decision – that would result in an eventual showdown between Britain’s central bank and currency speculators – had already been made. In 1990, shortly after succeeding Margaret Thatcher as prime minister, John Major took sterling into the European Exchange Rate Mechanism (ERM). In effect, this was a precursor to the single European currency. The ERM was a

The United Kingdom   97 ‘semi pegged’ system, in which currencies had a restricted margin within which to float. Under the Maastricht Treaty, however, the criteria were tightened: inflation could be no more than 1.5 per cent above the average of the three best performing member states; the national balance of payments deficit could not exceed 3 per cent of GDP at the end of the preceding fiscal year nor could government debt exceed 60 per cent; the national currency could not have been devalued in the two years prior to membership; and long-­term interest rates could not exceed those of the three best performing states on inflation by more than 2 per cent. Membership in the ERM did nothing to ease Britain’s problems in defending a fixed exchange rate, which had kept interest rates high throughout the 1980s. Therefore, it was not long before currency speculators began to bet that sterling was overvalued, despite its membership in the ERM. In early September 1992, anticipating devaluation, speculators sold billions of pounds with the expectation of buying them back at a depreciated rate and making a profit on the difference. This put tremendous pressure on sterling. The government intervened, raising interest rates to a peak of 15 per cent and attempting to buy back the pounds that were flooding into the market. But this had little effect; and on 16 September 1992 – ‘Black Wednesday’ – Britain was forced out of the ERM. The official cost of the debacle was, according to government figures, £3.3 billion (HM Treasury 2008). Britain’s forced exit from the ERM and the accompanying sterling devaluation, however, made an important contribution to its recovery from recession. Sterling was left to float, which allowed interest rates to be cut to 7.9 per cent in October 1992; and in November of the following year, interest rates were 5.4 per cent. This caused commentators to revise their description of 16 September 1992 to ‘White Wednesday’; and Norman Tebbit, a minister in Margaret Thatcher’s governments, described the ERM as the ‘Eternal Recession Machine’ (Tebbit 2005). ‘New Labour’ and the ‘Third Way’ Whilst all of this was happening, the Labour Party was undergoing a metamorphosis. Following Margaret Thatcher’s replacement by the rather less authoritative John Major, the Labour Party under Neil Kinnock had high hopes for the 1992 general election. Opinion polls had predicted a hung parliament or a narrow Labour victory. However, in a surprise result, Major handed Labour a humiliating defeat. Kinnock resigned shortly afterwards; and the sudden death of his successor, John Smith, in May 1994, paved the way for Gordon Brown and Tony Blair, who between them would create ‘New Labour’. Social changes during the preceding decade, including the steady increase in property ownership, the sharp decline in trade union membership and the immiseration of an increasing proportion of the population had made the concept of a socialist government, based on trade union support, increasingly untenable. Building on the abolition of the union ‘block vote’ and its replacement by ‘one

98   S.J. Konzelmann et al. man, one vote’ under John Smith, Blair further distanced the party from both the trade unions and socialism, ultimately abandoning the now largely symbolic ‘Clause IV’ in the Labour Party’s constitution, which had hitherto committed it to the social ownership and control of the means of production (Taylor 2009). With this, the Labour Party made a decisive move to the centre. New Labour espoused a ‘Third Way’, embracing liberal market capitalism and the private enterprise economy whilst maintaining a commitment to social justice (Finlayson 2003; Wilks-­Heeg 2009; Buckler and Dolowitz 2004). However, New Labour politics was guided by pragmatism rather than ideology – by ‘what works’ – and its 1997 election Manifesto conceded that, ‘Some of the things the Conservatives got right. We will not change them. It is where they got things wrong that we will make change. We have no intention or desire to replace one set of dogmas by another’ (Labour Party Manifesto 1997). Like the Conservatives, New Labour accepted the notion of a ‘natural rate’ of unemployment and rejected the idea that there was a long-­term trade-­off between inflation and unemployment, prioritizing the former over the latter. Its open economy macro-­economic policy focused on the use of monetary policy – interest rates – to control inflation. The role of the state in the economy would be to assume a stance of ‘fiscal passivity’, supporting supply side measures (including the lowering of labour standards) that encouraged market activities with the objective of simulating growth. New Labour thus prioritized monetary over fiscal policy as a means of stabilizing the economy (Hay 2004). On 20 May 1997, following the landslide election of New Labour, the Bank of England was granted operational independence and assigned responsibility for the monetary policy. This was claimed to remove political influence from the business cycle (Hay 2004). But it also distanced the government from responsibility for interest rates, which had become a politically sensitive measure. The 2000 Financial Services and Markets Act created the Financial Services Authority (FSA) as a single, unified regulator for financial services, with responsibility for banking supervision and the regulation of investment services, securities, mortgages and insurance (Goodhart 2004: 350). It was also responsible for consumer protection and the prevention of market abuse. The Treasury was to have no operational or financial control over the FSA, which was established as a private company, limited by guarantee, to emphasize its independence. There was no formal legislation setting out the respective responsibilities of the three financial authorities; but a Memorandum of Understanding was established, fitting the Bank’s tradition of informality. The Memorandum delineated responsibility: the Treasury was responsible for the legal framework, the Bank for the stability of the financial system as a whole and the FSA for the supervision of individual firms. Further changes hinted at a less centralist approach by the new government. In 1999, a national minimum wage was introduced; and the Low Pay Commission was set up to advise the government about its level. The Greater London Council (which had been dissolved by Margaret Thatcher) was replaced by the Greater London Authority, with its own mayor; and there were devolved powers for Scotland, Wales and Northern Ireland. However, this was no pro-­trade union

The United Kingdom   99 or socialist government. Little was done to relax the laws restricting trade union power. Central control was stiffened in some areas, with both hospitals and schools being allowed, under certain circumstances, to opt out of local authority control and instead be funded directly by central government. Whilst the Bank of England was theoretically free to set its own interest rates, it would have to manage rates to meet the government’s established targets for inflation. Privatization also continued. Although most of the obvious assets had already been disposed of, future government supply contracts were sold off; and there were repeated attempts to at least partially privatize the Royal Mail, which ran into stiff union opposition. But there was precious little support for industry, which had to make do with relatively low and stable interest rates and a reasonably competitive currency. Nevertheless, in a 2009 report from PricewaterhouseCoopers (PwC) on British manufacturing, 2007 went down as the sector’s best year since 1970 (PwC 2009). Margaret Thatcher’s expectations following her replacement by John Major had been belatedly fulfilled; and she was in Malcom Rifkind’s words ‘the back seat driver’ of British politics, even if the chauffeur’s seat was now occupied by a Labour (rather than Conservative) prime minister (Rifkind 1999). Both Blair and Thatcher made complimentary remarks about the other and the overall direction of policy was similar enough to allow the coining of the term ‘Blatcherism’ (Jenkins 2006: 233). The spending spree continues unrestrained – but the ‘bonanza’ ends in disaster . . . The British consumer had also carried over many habits from the Thatcher years into the 1990s and beyond. Credit was cheap and plentiful; and homeowners, in particular, took full advantage. In the UK, the downward pressure on interest rates was orchestrated by the Bank of England’s Monetary Policy Committee, which was charged with regulating interest rates to hit the New Labour government’s inflation target. Mervyn King, Governor of the Bank of England, made extravagant claims about the success of this strategy. In October 2007 he told the Northern Ireland Chamber of Commerce and Industry that one of the most remarkable changes in the world over the past decade has been the fall in interest rates. Some of that stems from the fall in inflation as central banks have regained control after the Great Inflation of the 1970s and 1980s. (King 2007: 2) However, just as the great inflation of the 1970s and 1980s was triggered by the rise in UK import prices relative to domestic costs, the subsequent deceleration of inflation was led by relatively slow growth in import prices, not all of which was passed on in terms of home prices because profit margins and indirect taxes increased (Wilkinson 2007).

100   S.J. Konzelmann et al. One important feature in the growing prosperity since the 1970s was the inequality of its distribution. In the UK, average annual disposable household income (at constant prices) increased from £14,631 in 1977 to £27,370 in 2007, an increase of 87 per cent (Jones et al. 2008: 24). However, only the top quintile (20 per cent) increased its share of total income, from 36 to 42 per cent. The share of each other quintile group declined, in the case of the bottom quintile from 10 to 7 per cent (Jones et al. 2008: 21) Although inflation was generally low – except with regard to asset prices – the inflation of lengthy bubbles in both the housing market and the stock market was viewed positively by homeowners and shareholders alike; and bubbles came to be viewed as a legitimate engine for economic growth. As a result, Britain continued to consume both debt and goods – of which a significant proportion was imported – and personal and fiscal debt soared. As banks increasingly resorted to securitization to disperse risk and restore liquidity, and as the supply of credit expanded apparently without limits, lending to households for house buying and consumption grew apace. The effect was a rapid increase in house prices – and the size of the mortgages needed to buy them – and unsecured household debt incurred by consumers escalated. In 1993, the values of total net lending to consumers and loans secured on dwelling were respectively 32 per cent and 215 per cent of the value of GDP. By 2007, these percentages were 62 per cent and 327 per cent; and two years later despite the credit crunch and the economic downturn, they had risen further to 66 per cent and 353 per cent respectively. The official response to the ensuing financial crisis was governmental intervention to save failing banks and the authorization, in January 2009, of an injection into the UK economy of additional liquidity to the tune of £200 billion, followed by a reduction in the Official Bank Rate to 0.5 per cent in March 2009. It was hoped that these measures would stimulate bank lending and economic recovery. However, the failure of this strategy suggests that the problem rests more on the demand for credit than on its supply. Moreover, the concern of the Monetary Policy Committee with the level of activity of the economy has meant that economic recovery has been given greater priority in determining interest rates than inflation. Currently, UK living standards are declining, unemployment is rising and public services are being slashed as the coalition (Tories and Liberals) government implements an austerity package, designed to cut the burgeoning budget deficit.

Conclusions In 2007, just before the onset of the global financial crisis, Sir David Walker was commissioned by the private equity industry to conduct a review of the adequacy of disclosure and transparency in private equity. The resulting Walker Report revealed that fully one-­third of the mortgages granted in the UK were for equity

The United Kingdom   101 extraction to fund further consumption (Walker Report 2007). Not only had this built artificial growth into the economy, it also built in an inevitable sharp reversal when the bubble burst; and it sharply reduced the resources available to consumers to ride out the resulting downturn. In the wake of the global financial crisis, the tripartite financial regulatory system, set up by Gordon Brown, was berated for not seeing the approaching storm. However, this appears to have been far from the case. One of the doubters was Sir Howard Davies, the first chairman of the FSA, who in 2002 had already questioned the stability of both the credit derivatives market and financial reinsurance in the form of Credit Default Swaps: More recently, these transfers have taken more exotic forms such as synthetic collateralised debt obligations. One investment banker recently described these instruments to me as ‘the most toxic element of the financial markets today’. It’s not surprising that we have been taking a heightened interest in this area. (Davies 2002) He went on to add, ‘I believe that a number of companies should be asking themselves some hard questions about the prudence of their reinsurance practices and, indeed, on both sides about the business ethics of arrangements of this kind’. By 2005, the derivatives sector was not only justifying its initial inclusion in the 1845 Gaming Act, it was rapidly outgrowing the ability of even the companies involved to control it, let alone the FSA. Gay Huey Evans, head of capital markets at the FSA, sent a letter to the chief executives of the big players in the financial sector setting out her concern that: ‘If simple operational procedures are unable to keep up with the pace of market development, the risk of misunderstandings and uncertainty will negatively impact market confidence’ (Evans 2005). It is thus hard to argue that regulators were unaware of the risks accumulating within the financial system. This then begs the question of whether the influence of finance was so pervasive in terms of voter confidence and so important to the economy as a whole as to make decisive policy intervention difficult, if not impossible. The failure to intervene may have had more to do with either an inability to enforce change, due to the UK’s heavy reliance on the financial services sector, the internationalization of global capital restricting the effectiveness of regulation – or both.

Notes   1 For an overview of the rise and decline of the British Empire, see Ferguson 2004.   2 A more public breach resulted when the Conservative Chancellor, Nigel Lawson, felt that the Bank’s intervention in the Johnson Matthey Bankers affair in 1984, had been carried out without his being kept fully informed.   3 Manufacturing employment in the UK fell from 9.1 million in 1966 to 7.2 million in

102   S.J. Konzelmann et al. 1976; it then fell to 6.6 million in 1978, to 5.0 million in 1988, 4.1 million in 1998 and reached 2.5 million in 2010. Meanwhile, whilst employment in manufacturing fell by two-­thirds, employment in doubled from 0.6 million in 1966 to 1.2 million in 2010 (Office for National Statistics n.d.b).   4 Pressures contributing to unemployment during this period were in part a result of the (not yet evident) hollowing-­out of the British manufacturing sector through leveraged buyouts which continued into the 1970s. See also Konzelmann et al. 2010.   5 C&CC resulted in an increase in interest-­bearing deposits of 112.5 per cent between 1971 and 1973, compared with the previous annual increase of 5–10 per cent (Kaldor 1986: 105, fn. 69).   6 Economic Trends, Annual Supplement, 2001, HSMO, Table 4.8.   7 The Institute for Economic Affairs (IEA) had been founded in 1955 by Anthony Fisher, at the request of Hayek; and it was part of the international network of free-­ market thinkers associated with the Mont Pelerin Society. The ‘crisis’ Thatcher confronted when she came to office seemed to verify the IEA’s critique of the Keynesian consensus; it was thus well-­placed to provide an alternative to the policies that seemed to have failed. In 1974, the Centre for Policy Studies (CPS) was founded by Keith Joseph and Margaret Thatcher, to champion economic liberalism in Britain; and the Adam Smith Institute (ASI), founded by Madsen Pirie and Eamonn Butler in 1977, served as a driving force behind the development and promotion of Thatcher’s privatization, taxation, education and health policies (Denham and Garnett 1998).   8 A number of the ASI’s policies were also adopted by the Blair Labour Government; and in 1998, with the foundation of the Institute for Public Policy Research (IPPR) (by James Cornford), Labour had its own think tank, which was instrumental in both the Party’s modernization and popularization of its ‘Third Way’ politics.   9 For a discussion of the turning point caused by Britain’s decision to go to war over the Falkland Islands, see Morgan 2001: 457–461. 10 Faith in the City can be located at: www.churchofengland.org/our-­views/home-­andcommunity-­affairs/community-­urban-affairs/urban-­affairs/faith-­in-the-­city.aspx.

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The United Kingdom   103 Buckler, S. and D. Dolowitz (2004) ‘Can Fair Be Efficient? New Labour, Social Liberalism and British Economic Policy’, New Political Economy, 9(1): 23–38. Buiter, W. and M. Miller (1983) ‘The Thatcher Experiment: The First Two Years’, Brookings Papers on Economic Activity, 2: 315–379. Burn, G. (2006) The Re-­Emergence of Global Finance, Basingstoke: Palgrave Macmillan. Burn, G. (1999) ‘The State, the City and the Euromarkets’, Review of International Political Economy, 6(2): 225–261. Cairncross, A. (1985) Years of Recovery: British Economic Policy, 1945–51, London: Methuen. Callahan, J. (1976) Leader’s Speech, Blackpool: Labour Party Conference, online, avail­ able at: www.britishpoliticalspeech.org/speech-­archive.htm?speech=174. Cockett, R. (1995) Thinking the Unthinkable: Think Tanks and the Economic Counter-­ revolution, 1931–1983, London: Fontana Press. Davies, H. (2002) ‘Strengthening of Insurance Industries Capital Base Needed, Says FSA’, FSA Library, online, available at: www.fsa.gov.uk/Pages/Library/ Communication/PR/2002/011.shtml. Deakin, S. and A. Singh (2008) ‘The Stock Market, the Market for Corporate Control and the Theory of the Firm: Legal and Economic Perspectives and Implications for Public Policy’, Centre for Business Research Working Paper No. 365, Cambridge: University of Cambridge. Deaton, A. and C. Paxson (2004) ‘Mortality, Income and Income Inequality over Time in Britain and the US’, Perspectives on the Economics of Aging, Washington, DC: National Bureau of Economic Research, pp. 247–285, online, available at: www.nber. org/chapters/c10345.pdf. Denham, A. and M. Garnett (1998) British Think Tanks and the Climate of Opinion, London: UCL Press. Desai, R. (1994) ‘Second Hand Dealers in Ideas: Think Tanks and Thatcherite Hegemony’, New Left Review No 203, January/February, pp. 27–64. Economic Trends, Annual Supplement, 2001 edition, No. 27, London: The Stationery Office. Evans, G. (2005) ‘Letter Regarding Operations and Risk Management in the Credit Derivatives Market’, FSA Library Archives, February, online, available at: www.fsa. gov.uk/pubs/ceo/derivatives_22feb05.pdf. Fairbrother, P. (2002), ‘Unions in Britain: Towards a New Unionism?’ in P. Fairbrother and G. Greffin (eds) Changing Prospects for Trade Unionism: Comparisons Between Six Countries, New York: Continuum, pp. 56–89. Ferguson, N. (2004) Empire: The Rise and Demise of the British World Order and the Lessons for Global Power, New York: Basic Books. Finlayson, A. (2003) Making Sense of New Labour, London: Lawrence and Wishart. Gardner, R. (1980) Sterling-­Dollar Diplomacy in Current Perspective: The Origins and the Prospects of our International Economic Order, New York: Columbia University Press. Goodhart, C. (2004) ‘The Bank of England 1970–2000’, in R. Michie and P. Williamson (eds) The British Government and the City of London in the Twentieth Century, Cambridge: Cambridge University Press. Goodhart, C. (2003) ‘A Central Bank Economist’, in P. Mizen (ed.) Central Banking, Monetary Theory and Practice, Volume 1, Cheltenham: Edward Elgar. Goodman, A. and S. Webb (1994) ‘The Distribution of Household Income’, For Richer,

104   S.J. Konzelmann et al. For Poorer: The Changing Distribution of Income in the UK, 1961–1991. Commentary No. 42, London: Institute for Fiscal Studies, online, available at: www.ifs.org.uk/ comms/comm42.pdf. Harvey, D. (2005) A Brief History of Neoliberalism, Oxford: Oxford University Press. Hay, C. (2004) ‘Credibility, Competitiveness and the Business Cycle in “Third Way” Political Economy: A Critical Critique of Economic Policy in Britain Since 1997’, New Political Economy, 9(1): 39–45. Hazlett, T. (1992) ‘The Road From Serfdom: Foreseeing the Fall’, Reason Magazine, July, online, available at: http://reason.com/archives/1992/07/01/the-­road-from-­serfdom. Helleiner, E. (1994) States and the Reemergence of Global Finance, Ithaca, NY: Cornell University Press. Hennessy, P. (1992) Never Again: Britain 1945–51, London: Jonathan Cape. HM Treasury (2008) Freedom of Information Disclosures: Estimates of the Cost of Black Wednesday 1992, online, available at: http:// webarchive.nationalarchives.gov.uk/+/ www.hm-­treasury.gov.uk/about/ information/foi_disclosures/foi_erm4_090205.cfm. HM Treasury (2005) Freedom of Information Disclosures: The Provision of Financial Assistance to Slater Walker Bank in 1975, online, available at: http://hm-­treasury.gov. uk/about/information/foi_disclosures/foi_slater_walker.cfm. Hobsbaum, E. (1999) Industry and Empire: The Birth of the Industrial Revolution, New York: New Press. Jarley, P. (2002) ‘American Unions at the Start of the 21st Century: Going Back to the Future?’ in P. Fairbrother and G. Greffin (eds) Changing Prospects for Trade Unionism: Comparisons Between Six Countries, New York: Continuum, pp. 200–237. Jenkins, S. (2006) Thatcher & Sons: A Revolution in Three Acts, London: Penguin Books. Jones, F., D. Annan and S. Shah (2008) ‘The Distribution of Household Income 1977 to 2006/7’, Economic & Labour Review, 2(12): 18–31. Kaldor, N. (1986) The Scourge of Monetarism, Oxford: Oxford University Press. King, M. (2007) ‘Speech at the Northern Ireland Chamber of Commerce and Industry’, Belfast, 9 October, online, available at: www.bankofengland.co.uk/publications/ Documents/speeches/2007/speech324.pdf. Konzelmann, S., F. Wilkinson, M. Fovargue-­Davies and D. Sankey (2010) ‘Governance, Regulation and Financial Market Instability: The Implications for Policy and Reform’, Cambridge Journal of Economics, 34(5): 929–954. Kuisel, R. (1981) Capitalism and the State in Modern France, Cambridge: Cambridge University Press. Labour Party Manifesto (1997) The Labour Way is the Better Way, online, available at: www.labour-­party.org.uk/manifestos/1979/1979-labour-­manifesto.shtml. Labour Party Manifesto (1966) Time for Decision, online, available at: www.labour-­ party.org.uk/manifestos/1966/1966-labour-­manifesto.shtml. Labour Party Manifesto (1945) Let Us Face the Future, online, available at: www.labour-­ party.org.uk/manifestos/1945/1945-labour-­manifesto.shtml. Levy, J., R. Kagan and J. Zysman (1998) ‘The Twin Restorations: The Political Economy of the Reagan and Thatcher “Revolutions” ’, in L.-J. Cho and Y.H. Kim (eds) Ten Paradigms of Market Economies and Land Systems, South Korea: Korea Research Institute for Human Settlements. Martynova, M. and L. Renneboog (2008) ‘A Century of Corporate Takeovers: What Have We Learned and Where Do We Stand?’ Journal of Banking & Finance, 32: 2148–2177.

The United Kingdom   105 Morgan, K. (2001) Britain Since 1945: The People’s Peace, Oxford: Oxford University Press. Morgan, K. (1984) Labour in Power: 1945–51, Oxford: Oxford University Press. Office for National Statistics (n.d.a) Households – Savings Ratios, online, data collatable via: www.ons.gov.uk/ons/search/index.html?pageSize=50&newquery=household+savings +ratios. Office for National Statistics (n.d.b) ‘Topic Guide to Employment’, online, available at: www.statistics.gov.uk/hub/labour-­market/people-­in-work/employment. Ogden, C. and F. Melville (1987) ‘Thatcher: We Are Building a Property-­Owning Democracy’, Time Magazine. 26 June, online, available at: www.time.com/time/ magazine/ article/0,9171,964699,00.html. Orhnial, T. (ed.) (1982) Limited Liability and the Corporation, London: Croom Helm. Parsons, T. (1999) The British Imperial Century, 1815–1914: A World History Perspective, Lanham, MD: Rowman & Littlefield. Pautz, H (2011) ‘New Labour in Government: Think Tanks and Social Policy Reform, 1997–2001’, British Politics, 6: 187–209. Pelling, H. (1984) The Labour Governments: 1945–51, London: Macmillan. Piore, Michael J. and C. Sabel (1984). The Second Industrial Divide, New York: Basic Books. PwC (PricewaterhouseCoopers) (2009) The Future of UK Manufacturing: Reports of its Death are Greatly Exaggerated, April, online, available at: www.pwc.co.uk/ eng/publications/the_future_of_manufacturing.html. Readman, P., J. Davies, M. Hoare and D. Poole (1974) European Money Puzzle, London: Michael Joseph. Reid, M (1982) The Secondary Banking Crisis 1973–5: The Inside Story of Britain’s Biggest Banking Upheaval, London: Macmillan. Riddell, P. (1991) The Thatcher Era and its Legacy, Cambridge, MA: Blackwell. Rifkind, M. (1999) ‘Major has Every Right to Shop Lady Thatcher’, The Independent, 15 August, online, available at: www.independent.co.uk/opinion/major-­has-every-­rightto-­shop-lady-­thatcher-1112948.html. Rowley, A. (1974) The Barons of European Industry, London: Croom Helm. Schenk, C. (2004) ‘The New City and the State in the 1960s’, in R. Michie and P. Williamson (eds) The British Government and the City of London in the Twentieth Century, Cambridge: Cambridge University Press. Schwartz, R. and C. Smith (1997) Derivatives Handbook: Risk Management and Control, Hoboken, NJ: John Wiley & Sons. Shonfield, A. (1969) Modern Capitalism: The Changing Balance of Public and Private Power, Oxford: Oxford University Press. Sked, A. and C. Cook (1993) Post-­War Britain: A Political History, 1945–92, London: Penguin Books. Slater, J. (1977) Jim Slater: Return to Go, London: Futura Publications. Taylor, N. (2009) ‘Tensions and Contradictions Left and Right: The Predictable Disappointments of Planning Under New Labour in Historical Perspective’, Planning, Practice and Research, 24(1): 57–70. Tebbit, N. (2005) ‘An Electoral Curse Yet to be Lifted’, The Guardian, 10 February, online, available at: www.guardian.co.uk/politics/2005/feb/10/ freedomofinformation. economy. Walker Report (2007) Guidelines for Disclosure and Transparency in Private Equity, London: British Venture Capital and Private Equity Association.

106   S.J. Konzelmann et al. Wilkinson, F. (2012) ‘Real Wage, the Customary Standard of Life and Economic Progress’, Cambridge Journal of Economics (forthcoming). Wilkinson, F. (2007) ‘Neo-­Liberalism and New Labour Policies: Economic Performance, Historical Comparisons and Future Prospects’, Cambridge Journal of Economics, 31(6): 817–843. Wilks-­Heeg, S. (2009) ‘New Labour and the Reform of English Local Government, 1997–2007: Privatizing Parts that Conservatives Couldn’t Reach?’ Planning, Practice and Research, 24(1): 23–39. Wolleb, G. (1989) Trends and Distribution of Incomes: An Overview, Brussels: Office for Official Publications of the European Communities. Zysman, J. (1983) Governments, Markets and Growth: Financial Systems and the Politics of Industrial Change, Ithaca, NY: Cornell University Press.

5 Ireland Crisis in the Irish banking system Blanaid Clarke and Niamh Hardiman

Introduction Ireland has had one of the most catastrophic experiences of financial crisis in the developed world. Along with Iceland and Latvia, also small and open economies, Ireland saw a dramatic increase in bank lending, credit extension practices, and other banking activities in the years preceding the international crisis of 2008. And as in these other two countries, a great deal of this bank borrowing came from international markets. The over-­extension of domestic bank lending had already become apparent during 2007 and 2008, as bank share prices faltered even prior to the fall of Lehman Brothers in the US. In the face of the impending collapse of the domestic banking sector in late September 2008, at a panicked all-­night meeting, the then Fianna Fáil–Green coalition government gave a blanket guarantee not only to depositors but to all bond-­holders of the six main domestic financial institutions. At that point, the Minister for Finance, Brian Lenihan, claimed that this would constitute ‘the cheapest bank rescue in history’ (Carswell, 2008). But the government had stumbled blindly into unknown and rapidly escalating commitments. The enormous scale of the banks’ losses unfolded over the following three years. The cost to the taxpayers of bank recapitalization was eventually estimated at approximately €62.8 billion (Minister for Finance, 2011); Ireland’s total GDP in 2011 was €155 billion (Central Bank, 2012). Almost half of these losses are attributable to a single bank, Anglo Irish Bank, which (along with the Irish Nationwide Building Society) is now retitled Irish Bank Resolution Corporation Limited (IBRC). Most of the remaining losses were incurred by the two oldest banks, the Bank of Ireland, and Allied Irish Bank. A London hedge-­fund manager stated that ‘Anglo Irish was probably the world’s worst bank. Even worse than the Icelandic banks’ (Lewis, 2011). The incoming Governor of the Central Bank, Patrick Honohan, concluded in May 2010 that this was ‘one the costliest banking crises in history’ (Burke-­Kennedy, 2011). The collapse of the banking system caused confidence in the Irish economy to plummet. Ireland was forced to enter an EU–­IMF loan programme in November 2010. By then, the systemic implications of the Irish financial sector liabilities for the European banking system meant that the Irish government came under

108   B. Clarke and N. Hardiman extreme and sustained pressure not to reverse the bank guarantee (Beesley, 2011). The private debts of the failed banks were nationalized; the Irish taxpayers would be saddled with the crushing burden of debt. It has been argued that ‘Other countries have benefited from the Irish socialization of a large share of bank losses, which has significantly contributed to the explosion of Irish public debt’ (Darvas, 2011: 16). A large proportion of the non-­performing loans of the struggling banks was taken into public management (through the National Asset Management Agency, or NAMA), at a sizeable discount, though still potentially over-­valued: while the ultimate value of commercial property remained unknown, residential house prices fell by 47 per cent between 2007 and 2011 (CSO, 2012). The general public debt soared from 25 per cent of GDP in 2006 to 107 per cent at the end of 2011 (Central Bank, 2012). This figure was expected to peak at 118 per cent of GDP (and over 130 per cent of GNP1) in 2013 before starting to decline thereafter (International Monetary Fund, 2011: 14). This figure includes €30 billion of promissory notes to distressed financial institutions. The national debt, net of the bank liabilities, stood at 60 per cent of GDP in 2010 (CSO, 2011: 152). The cost of servicing the national debt increased by over €1.1 billion in 2011 to reach €5.4 billion, accounting for 16 per cent of overall tax receipts (Central Bank, 2012). How had such a calamitous situation come about? In this chapter, we show first that the conditions that gave rise to the crisis, while precipitated by international events, were primarily domestic in origin. We then trace and evaluate a number of factors that contributed to these disastrous outcomes.

Understanding the crisis Three official reports provide much of the framework required for understanding what happened in the Irish financial system.2 The first report involved an examination of the conduct of the banking sector in the run-­up to the crisis. Klaus Regling and Max Watson were commissioned by the Minister for Finance in February 2010 to conduct a preliminary investigation into the crisis in the banking system in Ireland. The objective of the investigation was ‘to consider the international economic and financial environment, and indeed any broader social developments, which provided the context for the recent crisis in the banking sector.’ A central part of their brief was to identify any factors particular to the Irish banking system which ‘exacerbated the impact of the international financial crisis for Ireland’ and to highlight the areas in relation to the conduct, management and corporate governance of individual institutions which required further investigation (Regling and Watson 2010: 48). A second report was commissioned at the same time from Professor Patrick Honohan, an academic economist who had been appointed to the position of Governor of the Central Bank and Financial Services Authority of Ireland, as it was then titled, in 2009. His brief was to investigate the performance of the respective functions of the Central Bank and Financial Regulator over the period from the establishment of the Financial Regulator in 2003 to the end of September 2008.

Ireland   109 The government indicated its intention to use these two reports to produce the terms of reference for a statutory Commission of Investigation, to be established pursuant to the Commissions of Investigation Act 2004. Both reports were published in May 2010 (Honohan, 2010; Regling and Watson, 2010). In September 2010, the Commission of Investigation (Banking Sector) was established, comprising one member, Mr Peter Nyberg, with a mandate to examine why a number of public and private institutions had acted in an imprudent or ineffective manner during the period 1 January 2003 to 15 January 2009. The Commission’s Report was published in April 2011 (Nyberg, 2011). All three reports address the international developments that facilitated the crisis, but they are also unanimous in identifying peculiarly Irish causal factors: Although international pressures contributed to the timing, intensity and depth of the Irish banking crisis, the essential characteristic of the problem was domestic and classic. (Honohan, 2010: 22) Ireland’s banking crisis bears the clear imprint of global influences, yet it was in crucial ways ‘home-­made’. (Regling and Watson, 2010: 5) International developments, however, did not in themselves cause the crisis though they helped precipitate it. The problems causing the crisis as well as the scale of it were the result of domestic Irish decisions and actions, some of which were made more profitable or possible by international developments. (Nyberg, 2011: ii) The principal causes of the collapse of the Irish financial do not centre on the proliferation of complex financial products or of exposure to the US sub-­prime mortgage market. Rather, this was ‘a plain vanilla property bubble, compounded by exceptional concentrations of lending for purposes related to property – and notably commercial property’ (Regling and Watson, 2010: 6). In order to put this into context, we need to consider the rather modest origins of banking in Ireland, and the consequences of the banks having almost unlimited access to credit after Ireland joined the euro in 1999. We need to understand how the expansion of the financial services sector shaped the regulatory regime and its implementation. We also need to consider why property loomed so large as an investment product in Irish life, and the broader political context in which banks were not only permitted but enabled to take huge risks: we shall return to this briefly at the end of the chapter.

The role of banks in the Irish economy The financial services sector was a relatively new phenomenon in the Irish economy: until the 1980s, the principal banks were domestic in ownership,

110   B. Clarke and N. Hardiman running relatively small-­scale operations by international standards (though they were among the larger companies in the Irish economy). The six main domestic financial institutions over the last thirty years were Bank of Ireland, Allied Irish Bank (AIB), Anglo Irish Bank (‘Anglo’), Irish Nationwide Building Society (INBS), Irish Life and Permanent (IL&P) and Educational Building Society (EBS). A key preoccupation of Irish policymakers prior to the boom of the 1990s, following ‘vocal criticism from consumer groups’, was the danger of too little competition in the domestic banking market leading to too little credit (Nyberg, 2011: 28). Indeed, credit rationing was long a familiar feature in both the domestic mortgage and commercial lending markets. Ireland has unusually high levels of home ownership, and therefore high levels of demand for personal mortgages. The historian J.J. Lee has noted a ‘possessor principle’ as a recurring trait in Irish public discourse, which he traces to older remembered experiences of dispossession and the land-­hunger associated with agricultural consolidation in the wake of the mid-­nineteenth century Famine (Lee, 1989). Whatever the deep-­seated cultural reasons may be, investment in property, both private and commercial, has conventionally been taken to be a prudent strategy yielding long-­term gains in value. In Ireland even more than in Britain, people took to heart the notion that an undertaking could be ‘as safe as houses’. Moreover, close connections between the state and the construction industry had been established early on in the life of the independent Irish state, led by the dominant political party, Fianna Fáil (Dunphy, 1995). Public housing projects were not only a popular investment in quality of life, but they were a recurring source of stimulus in an economy that, until the early 1990s, lagged at about 60 per cent of average European GDP (Bradley, 2000; FitzGerald, 2000). During the 1980s, the international trend toward liberalization of capital controls began to change the policy context of banking in Ireland in two ways. First, the Building Societies Act 1989 permitted building societies to expand the scope of their lending activities. Two building societies – INBS and EBS – which had previously focused on providing residential mortgages, were now empowered to make loans for, inter alia, residential housing development. INBS, and to a lesser extent EBS, entered the development finance market where interest margins and fees were greater and greater profits could be earned. A third building society, IL&P, reacted to the increased competition and falling margins by increased lending volumes. The 1989 Act and subsequent amendments facilitated such expansion by permitting building societies to raise wholesale funding, allowing them to increase their loan books at a faster rate than their deposit funding would have permitted (Nyberg, 2011: 23). Second, in the late 1980s, Taoiseach (that is, Prime Minister) Charles J. Haughey saw an opportunity to take advantage of the liberalization of financial services that had begun to accelerate in the wake of the deregulation of the City of London, and the growing volumes of internationally mobile speculative and investment capital then becoming available. He extended the country’s preferential corporate tax regime to the financial sector, and created the Irish Financial

Ireland   111 Services Centre (IFSC) as an international hub of traded financial services (Cooper, 2010). This proved a highly successful strategy, and within a few years the IFSC included subsidiaries of a broad range of the major international financial institutions. Many of these were providing ancillary services to London headquarters. Relatively few were providing services to the domestic Irish market. But the significance of the IFSC was considerable, as we shall see later, in shaping the priorities of the Irish regulatory regime. By the mid-­1990s, Ireland had begun to emerge from the recession that had dominated the 1980s. A combination of benign conditions following the ratification of the Single European Act in 1992 allowed Ireland to engage in a period of very rapid economic growth: the ‘Celtic Tiger’ era lasted from about 1994 until the crash in 2008 (Honohan and Walsh, 2002; Barry, 1999). Ireland had stabilized its earlier macroeconomic imbalances; social partnership contributed to keeping wage increases under control. The longstanding policy mix favourable to foreign direct investment created new opportunities for footloose foreign capital in growing high-­tech sectors, especially pharmaceuticals and information and communications technology, to locate in Ireland in order to gain access to European markets (MacSharry and White, 2000; Ó Riain, 2004). But the Celtic Tiger phase in Irish economic history falls into two phases. The first phase runs to about 2002, by which time it was already becoming apparent that the domestic economy was overheating, and house prices were starting to rise rapidly. The second phase, from 2002 to 2008, is a period during which economic activity came to be dominated much more by property-­related activity. What made the key difference was the availability of cheap credit that followed upon Ireland’s membership of the euro.

The euro and access to cheap credit In January 1999, Ireland together with ten other members of the EU including France, Italy, and Germany, adopted the euro as their common currency. Regling and Watson posed the somewhat rhetorical question, ‘Was it a coincidence that Ireland’s economic fundamentals began to deteriorate when Ireland joined the Eurosystem?’ (Regling and Watson, 2010: 33). As early as June 2001, the Bank of International Settlements (BIS) observed in its annual report that ‘the expansion of credit is an essential ingredient in the build up of imbalances in the financial system and in any concomitant excessive accumulation or misallocation of real capital’ (D’Arista, 2006: 222). There is no doubt that the huge property boom that developed in Ireland during the 2000s was fuelled by the greater availability to the Irish banks of cheap finance. Membership of the Eurozone led to a decrease in nominal and real interest rates and also removed the exchange risk previously associated with European borrowing. As a result, Irish banks became increasingly reliant on wholesale short-­term borrowing in the euro area. By the end of 2006, wholesale borrowing by Ireland in the euro area markets for the aforementioned six Irish financial institutions reached about 39 per cent of the combined loan books. The growth in short-­term borrowing increased at an

112   B. Clarke and N. Hardiman .

even greater rate, such that ‘securities of one year remaining maturity or less amounted to €41bn at end 2006 for the two largest banks, up from €11.1bn at end 2003’ (Regling and Watson, 2010: 33). The other side of borrowing, of course, is lending. The countries of the European periphery – Ireland, Spain, Portugal, and Greece – which as impoverished regions had previously been in receipt of Structural Funds to assist their development, now appeared to offer handsome returns on investments. These countries in effect became akin to emergent economies in the Eurozone context, and lenders were more than willing to accommodate their borrowing requirements. Given the shortage of other good investment opportunities, the money was channelled predominantly into property development in Ireland; Spain experienced a similar phenomenon The absence of euro-­wide regulatory and oversight arrangements meant that lenders as well as domestic borrowers were vulnerable to the illusion that has preceded all property-­related financial crashes, such as in East Asia in 1998 for example, that ‘this time is different’ (Reinhart and Rogoff, 2009). Consumers expected that the combination of lower interest rates and increased competition in the market would increase choice, create more flexible financing packages, reduce the likelihood of overcharging, and improve what was perceived to be a protracted and cumbersome loan approval process for mortgages. All the main Irish banks began to make tracker mortgages available, as well as 100 per cent loan-­to-value loans. Interestingly, it was noted that ‘these developments were viewed by the authorities overwhelmingly in terms of a benign shift to a modernized and competitive market – one that was in tune with developments in the UK and US’ (Regling and Watson, 2010: 29). The greatest demand for credit from the Irish banks and building societies came from builders and property developers. Competition between the Irish lending institutions intensified, as they strove to hold their share of a rapidly expanding market. This led to a significant change in the process of lending as domestic institutions, seeking to differentiate themselves, began to offer more streamlined loan approval processes. This was particularly marked at Anglo Irish Bank, where it was noted for example that ‘the lending culture was such that when applications were problematic, the mindset was “there is a ‘yes’ in there somewhere” ’ (Nyberg, 2011: 32). Considering itself ‘a relationship lender’, Anglo was clearly reluctant to refuse loans to its top customers, particularly when competitors were all too ready to take over these loans. As Anglo’s profits soared, the larger and more traditional commercial banks, Bank of Ireland and Allied Irish Bank, came under intense pressure to relax their own loan approval and risk assessment practices in a struggle to keep pace with Anglo’s performance. Nyberg indicated that in an environment where the supply of credit avail­ able exceeded good quality loan demand, banks relaxed their lending standards. He found evidence in Anglo of deviations from lending guidelines, resulting in approval of loans unsupported by appropriate cash flows and secured by non-­ recourse personal guarantees or guarantees supported by equity in other already leveraged property (Nyberg, 2011: 32).

Ireland   113 The result of these lending strategies was a threefold concentration of assets on the balance sheets of the Irish banks. This featured ‘loans to the property sector in general; loans to commercial property specifically; and within this latter group, development loans to interests associated with a limited number of key developers of commercial property’ (Regling and Watson, 2010: 31). Property-­ related lending soared between 2002 and 2008. Domestic property-­related lending increased by almost €200bn which represents 80 per cent of all growth in credit. This raised the share of property-­ related lending from under 45 per cent of total credit in December 2002 to over 60 per cent in December 2008. (Nyberg, 2011: 14) The effect was to give an enormous boost to the construction industry. The second half of the Celtic Tiger period, which ran from 2002 to 2008, was exceptionally dependent on construction activity as a classic property bubble developed. ‘Competitiveness didn’t matter – from now on we were going to get rich building houses for each other’, economist Morgan Kelly commented with heavy irony (Lewis, 2011). The construction sector accounted for about 20 per cent of GNP in 2006, compared with an OECD average of about 10 per cent, and employment in construction soared to about 20 per cent of the workforce, also twice the international average. House prices rose rapidly, even as planning permission was granted for a rash of new housing developments (Kelly, 2009b). ‘Irish banks were lending forty per cent more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and seventy-­five per cent more as mortgages’ (Kelly, 2009a: 2). The banks overextended their lending on a vast scale. Net foreign liabilities of Irish banks stood at 10 per cent in 2003, but 60 per cent in 2008. All this activity generated a boost in revenue flows to the government: at its peak, revenues directly related to property accounted for some 15 per cent of total revenues, more than twice the OECD average. Government used the bonanza to narrow and weaken the income tax base as part of its ongoing commitment to a strategy of reduction in personal tax liabilities (Dellepiane and Hardiman, 2012). This left it particularly exposed to the emergence of a significant fiscal deficit when the crash eventually came.

Explaining the fall of the Irish banks How had things gone so badly wrong? A number of considerations need to be taken into account. The most obvious place to start is to consider the role of market disciplines in keeping corporate performance on track: evidently something in the Irish experience proved defective. Furthermore, the spectacular crash of the Irish banks suggests something was seriously problematic in the regulatory regime governing the financial sector, whether in the regulatory powers, the institutions, or their implementation. Finally, consideration of these issues leads

114   B. Clarke and N. Hardiman us to reflect upon the wider political context of the expansion of the financial sector, noting in particular the close relationships between politicians, builders, and bankers that developed during the 2000s.

The market for corporate control as a controlling force The market for corporate control theory (MCC), first proposed by Henry Manne in 1965, suggests that mismanagement is reflected in share price because shareholders sell their shares rather than replace management (Manne, 1965). An opportunity thus arises for a bidder to acquire the company cheaply, replace the inefficient managers and turn the company around. The MCC suggests that takeovers have a disciplinary effect on managers. As recently as 2008, Manne has argued that if there is a competitive market for corporate control, there will be no need for any of the other mechanisms for corporate governance other than those voluntarily adopted by contracts and norms (Manne, 2008). Share ownership in Ireland is relatively widely dispersed. Applying MCC to the credit institution market suggests that the share prices of the listed institutions should have dropped to reflect their increasingly poor risk management and corporate governance and consequently the institutions should have been acquired and improved. Yet this did not happen in Ireland or indeed abroad until the latter part of 2007. It has been argued elsewhere that the fundamental prerequisites for the operation of this disciplinary force were not in place (Clarke, 2009). The share prices of the banks did not reflect the inefficiencies which subsequently proved so costly to the global market. Investors did not act in a rational fashion, and there was evidence of ‘irrational exuberance’ and information asymmetries. Lord Turner, the Financial Services Authority Chairman, in his report on bank regulation to the British Chancellor of the Exchequer, acknowledged that all liquid traded markets are capable of acting irrationally, and can be susceptible to self-­reinforcing herd and momentum effects. He commented that, ‘A reasonable conclusion is that market discipline expressed via market prices cannot be expected to play a major role in constraining bank risk taking, and that the primary constraint needs to come from regulation and supervision’ (Lord Turner, 2009: 47). It is interesting to note, however, that some commentators suggest that the market for corporate control operated in a perverse manner. Lord Turner himself suggested that falling spreads and volatility prices drove up the current value of a range of instruments marked to market value on the books of the banks and the hedge funds. This led to higher book profits and reinforced management and trader certainty that they were ‘pursuing sensible strategies’ (Lord Turner, 2009: 25). It thus appears that the challenging competitive conditions encouraged rather than restricted management, and that the herd mentality referred to above prevented most institutions from stepping out of line. Similarly, the Nyberg Commission found that: Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in

Ireland   115 p­ articular, they would face loss of long-­standing customers, declining bank value, potential takeover and a loss of professional respect. (Nyberg, 2011: v) The Irish Takeover Panel is the supervisory authority responsible for monitoring takeovers of Irish ‘relevant companies’.3 The vast majority of these companies are Irish registered public limited companies listed on the Irish Stock Exchange. Takeover activity in Ireland varies from year to year, but overall there is a reasonable level of activity. Since its establishment in 1997, there has been an average of 5.3 takeovers a year, from an annual average of 75 relevant companies. In that time, there have been only seven hostile takeover offers (an average of 0.5 a year), and none of these has been successful.4 In three cases, control did not pass and the targets remained independent. On the basis of this evidence, it would appear that the market for corporate control may not be particularly robust in Ireland. Good corporate governance Although market pressures on banks’ activities may have been relatively weak, it might be anticipated that self-­governance by the banks would ensure that good standards of risk assessment prevailed, and that prudential attention was paid to balancing of assets and liabilities relative to capitalization. Prior to the crisis, a number of different initiatives had been considered, aimed at formalizing and enforcing good corporate governance. The first involved mandatory directors’ compliance statements. This idea had been suggested by a parliamentary committee examining serious and sustained misconduct by banks in facilitating tax evasion (Public Accounts Committee, 2001). Upon the specific recommendation of the Review Group on Auditing (Report of the Review Group on Auditing, 2000: 25), Section 45 of the Companies (Auditing and Accounting) Act, 2003 was introduced, requiring company directors to report annually to shareholders on their company’s compliance with its obligations under company law, taxation law, and other relevant statutory or regulatory requirements. Subsequently, private consultations took place between the Irish Financial Services Regulatory Authority (IFSRA), the Department of Finance, and industry representatives, during which concerns were expressed about the section’s lack of a materiality threshold, its vulnerability to constitutional challenge and its potential detrimental impact on competitiveness. As a result of what Honohan described as deference to ‘industry pressure’, a decision was taken not to implement section 45 (Honohan, 2010: 50–51, note 6). A second initiative involved the introduction of more robust ‘fit and proper’ requirements. This stemmed from the finding in 2005 by the Joint Committee on Finance and the Public Service of numerous incidents of failure by the banks to comply with ‘acceptable standards of behaviour’ with respect to prudential consumer and fiscal obligations in the context of customer charges and interest rates (Report of the Joint Oireachtas Committee on Finance and the Public Service,

116   B. Clarke and N. Hardiman 2005: 9). Patrick Neary, then Chief Executive of IFSRA, commenting on Irish practices of principles-­based regulation (discussed in greater detail later), accepted that ‘[i]n a principles-­based system of supervision, the competence and probity of those who direct and manage firms is a critical element’ (Neary, 2006). Rules were issued by the IFSRA in 2007 requiring directors and managers of regulated market operators to have the necessary qualifications, skills and experience to perform the duties of their position and to be honest, fair, and ethical. The requirements varied by type of financial institution; fitness and probity reviews were not conducted on a statutory basis for all firms. The third initiative mooted by the Central Bank in 2005 was to introduce a corporate governance code for credit institutions and insurance undertakings. The Central Bank prepared a consultation paper, and engaged in a pre-­ consultation with credit institutions in 2005 and 2006. However in early 2007, it decided to delay this code, citing the need to develop and possibly incorporate within the code organizational requirements arising from recent EU-­wide discussions (Honohan, 2010: 54, note 6). This was unfortunate, as the introduction of the code even at this late stage might have shone light on the serious corporate governance deficiencies in some of the institutions prior to the government’s decision in September 2008 to provide blanket guarantees to the banks.5 Across the world, poor corporate governance was identified as a key contributor to the global financial crisis. Failures were identified in Ireland, as elsewhere, in terms of risk control and remuneration, but the small market and the lack of diversity on the boards appears to have exacerbated the problem. Regling and Watson identified four key areas in which bank management and governance contributed to the Irish banking crisis. First, management failed to appreciate the risk entailed by the significant concentration of bank assets in activities related to property, and especially non-­household based commercial property, as described above. Second, lending guidelines and processes appeared to have been quite widely circumvented. The authors referred rather benignly to the ‘tidal wave of uncritical enthusiasm . . . to participate in financing the property boom and to maintain market share’ (Regling and Watson, 2010: 35).6 The Nyberg Commission noted that ‘adhering to either formal or traditional, often voluntary, constraints and limits on banking and finance, does not seem to have been greatly valued in Ireland during the period’ (Nyberg, 2011: 96–97). While these two issues point to ineffective corporate governance and ineffective risk management within the banks, Irish bankers were clearly not unique in this regard (Plath, 2008; Kirkpatrick, 2009; The White House, 2008). A third contributing factor involved ‘very specific and serious breaches of basic governance principles concerning identifiable transactions in specific institutions that went far beyond any question of poor credit assessment.’ These included allegations of practices on the part of Anglo Irish Bank of undisclosed loans to directors, creative accounting, and loans to investors to purchase their own shares. By the time Anglo was nationalized in January 2009, the government accepted that these ‘unacceptable corporate governance practices’ were a ­triggering factor in the nationalization (Department of Finance, 2009). Yet the

Ireland   117 aforementioned governance failures happened at a time when guidelines and processes applied to those financial institutions with a listing on the Irish Stock Exchange. The Listing Rules of the Irish Stock Exchange required such companies to comply with the Principles set out in the UK Combined Code on Corporate Governance (‘the Combined Code’), and to make a disclosure statement either confirming compliance with the provisions or explaining any non-­ compliance.7 The Combined Code set out main and supporting principles relating to directors, remuneration, accountability and audit, and relations with shareholders. It envisaged ‘an effective board’ operating ‘within a framework of prudent and effective controls which enables risk to be assessed and managed’ (Financial Reporting Council, 2006: note 14, section 1A, Supporting Principles 3). Evidence gathered by the Irish Stock Exchange and the Irish Association of Investment Managers (‘the ISE/IAIM Study’) indicated a high level of compliance by Irish listed companies with the Combined Code (Irish Stock Exchange and Irish Association of Investment Managers, 2010). The reason why the Code proved ineffective in this context lies in another finding of the ISE/IAIM Study to the effect that much of this compliance involved ‘box ticking’, and that frequently there was no real adherence to the spirit of the Combined Code. This is consistent with the conclusion of Regling and Watson that ‘the failings of corporate governance seem to have been much more a problem of deficient implementation than defective guidelines and processes’ (Regling and Watson, 2010: 35, note 8). The fourth key corporate governance failure identified by Regling and Watson was poor remuneration policies which encouraged and rewarded risk-­taking. In particular, they criticized management bonuses and awards of substantial stock options to top and middle management (Regling and Watson, 2010: 35, note 8). This is consistent with research from the UK Financial Services Authority which indicated that the structure of bonuses in UK financial institutions allowed management to benefit from risk-­taking whilst ensuring that any losses were borne by long-­term shareholders and society (Financial Services Authority, 2009: para. 2.4). In common with boards internationally, remuneration in Irish institutions became ‘a driver for excessive risk-­taking’. This policy was not caught by the existing corporate governance rules – while the Combined Code emphasized the need for a clear link between pay and performance, it did not build in a risk assessment consideration (Financial Reporting Council, 2006: note 14, section B1, Main Principles). This explains in part why, despite the fact that it was already suffering a decline in its share price, the 2007 Annual Report of Anglo Irish Bank reported that its Chief Executive David Drumm held 1.4 million options to subscribe for ordinary shares, and that his total pay for the year was €3.3 million, which included a €2 million annual performance bonus.

Financial regulation It is clear that norms of professional conduct have not always provided a sufficient incentive for directors to adhere to corporate governance guidelines, and

118   B. Clarke and N. Hardiman that certain boards were unwilling or unable to challenge the executive or to prevent excessive risk taking. For example, in Anglo, the bank with the most spectacular record of failure, Seán Fitzpatrick moved directly from the position of Chief Executive to Chairman of the board in contravention of the Combined Code, was a party to some questionable accounting in respect of Anglo’s balance sheet, and had multiple conflicts of interest in his various business activities (Ross, 2009; McDonald and Sheridan, 2009). As noted above, market forces appear to have been exerting weak pressure on banks to perform to standards that would have averted catastrophe. Voluntary compliance with standards of good corporate governance proved singularly ineffective. This prompts us to consider the regulatory regime in place during the 2000s. We shall look first at the structure of the financial regulation system in Ireland, to consider whether the institutional design left something to be desired, such that the reconfiguration of regulatory powers in the late 1990s created a gap in regulatory oversight. We shall then consider the powers of the financial regulator, and the enforcement of regulatory requirements. In our view, all of these factors played a role in accounting for the crisis in the Irish banking system. But they also need to be understood in a broader political context, which we shall return to in the final part of this chapter. The structure of the regulatory system The scope of financial regulation in Ireland had been progressively increased during the 1990s in response to EU Directives (Westrup, 2012). But as there was no EU-­mandated institutional form of regulation, diverse practices had evolved across EU member states to give effect to the Directives. The shortcomings of the pre-­1990s regime in Ireland had become apparent on a number of occasions. Banks had turned to government for financial rescue, for example in 1984, following the collapse of the Insurance Corporation of Ireland, a wholly owned subsidiary of Allied Irish Bank. Relations between bankers and politicians had also become a matter of public comment at that time, for example when merchant banker Patrick Gallagher was prosecuted for fraud in Northern Ireland, but not in the Republic, where he enjoyed close financial and business links with Charles J. Haughey. The dominant issue during the 1990s was the evidence of the banks’ role in facilitating systematic tax evasion on the part of their customers, which as noted above was subject to a high-­profile investigation by the Public Accounts Committee (Public Accounts Committee, 2001). In 1998, the government, then composed of a coalition between the dominant Fianna Fáil party and the small liberal-­leaning Progressive Democrats, agreed in principle to the establishment of a single regulatory authority for the financial services sector, and appointed a working group under the chairmanship of Michael McDowell (a barrister and prominent Progressive Democrat) to advise it on implementation. The report recommended that prudential and consumer protection regulation of almost all financial firms should be assigned to a single regulatory authority which would be established as an entirely new independent

Ireland   119 organization (McDowell, 1999). In reaching this conclusion, the Group was influenced by the lack of international precedent for combining such a large range of regulatory responsibilities within a conventional Central Bank. A new entity, it concluded, would provide for clarity of purpose in relation to both regulation and customer protection in financial services, and would provide a coherent, robust, and transparent approach to financial regulation. A minority of the Group disagreed and advised that the single regulatory authority should be located within a restructured Central Bank. They advised establishing a separate division for prudential and consumer regulation headed up by a person with equal rank to the Director General of the Central Bank. Upon consideration of the report, a compromise was reached by the government, which amounted to a hybrid system. Rather ominously, Regling and Watson would later characterize this report as ‘an interesting experiment’ (Regling and Watson, 2010: 36). A new structure, the Central Bank of Ireland and Financial Services Authority (CBIFSA), was established8 under the chairmanship of the Governor. This body linked a monetary authority carrying out functions related to the European System of Central Banks (ESCB), and a single regulatory authority entitled the Irish Financial Services Regulatory Authority (IFSRA). The latter was responsible for licensing, prudential regulation of both the banking and insurance sectors, and consumer protection. It had its own board, with an independent chairperson, chief executive and consumer director. The two former post-­ holders, together with some board members of IFSRA, sat on the CBIFSA board. Members of both boards were drawn from a cross-­section of professional and public sector groups rather than being ‘expert Central Bankers’ (Honohan, 2010: 39–40). IFSRA was subject to a duty to act in a manner consistent with the performance by the Governor and the Board of their CBIFSA functions (including the Governor’s role in contributing to financial stability). The CBIFSA Board was responsible for the efficient and effective co-­ordination of the constituent parts of the organization as a whole, and for the exchange of information between them.9 Another of its duties, which was to prove controversial, was ‘to promote the development within the State of the financial services industry (but in such a way as not to affect the objective of the Bank in contributing to the stability of the State’s financial system).’10 Honohan has suggested that ‘the division of responsibilities between the Governor, the CBIFSA and IFSRA was novel and contained the hazard of ambiguous lines of responsibility especially in the event of a systemic crisis’ (Honohan, 2010: 36). It encouraged the establishment of institutional silos, creating difficulties in ensuring coordination between the economists and the regulatory staff involved in regulatory responsibilities. This problem is highlighted by the view expressed to the Nyberg Commission that: it was not the primary responsibility of the [CBIFSA] to evaluate possible problems in domestic financial markets emanating from the behaviour of individual institutions. [CBIFSA] legislation provides that while the [CBIFSA] was charged with overall financial stability matters, the [IFRSA]

120   B. Clarke and N. Hardiman was responsible for identifying and bringing to the attention of the [CBIFSA] any bank-­specific/prudential matters of potential system-­wide significance. Therefore, according to this view, the [CBIFSA] should not question, or be seen as questioning, the [IFRSA’s] activities. As the [IFRSA] did not raise any such concerns with the [CBIFSA], the [CBIFSA] could therefore not have been expected to detect existing or emerging problems. Indeed, it was even suggested that detailed enquiries by the [CBIFSA] regarding the basis for the [IFRSA’s] assessments could have been regarded as an unacceptable intrusion into the autonomous status of the [IFRSA]. (Nyberg, 2011: 66) Honohan also suggested that the overlap between IFRSA and CBIFSA board membership meant that issues within the remit of the IFRSA that fell to be considered also at CBIFSA board meetings would normally have been discussed by the overlapping members beforehand. This, he argued, facilitated IFRSA members voting as a block on matters of importance to the CBIFSA. Finally, he suggested that the ‘unduly hierarchical CBFSAI culture’ discouraged challenge (Honohan, 2010: 16). While this system of regulation can be seen to have had a number of weak points, it secured the confidence of international observers. The IMF 2006 Financial Sector Assessment Program report, for example, was very positive in its assessment of the new integrated supervisory framework, noting that the organizational structure was likely to enhance financial stability (International Monetary Fund, 2006). Honohan noted this would have had a significant dissuasive effect on concerns that might otherwise have been raised about ‘prudential supervision and the risks to financial stability’ (Honohan, 2010: 91). Nevertheless, despite these structural problems, Honohan concluded that it would be hard to show that the complexity of this regulatory structure materially contributed to the major failures that occurred. We need thus to probe deeper into the regulatory regime, to consider the priorities it adopted, the scope of its powers, and the way these were implemented. Principles-­based regulation Regling and Watson concluded that ‘the structure of regulation seems to have been less important in explaining Ireland’s banking crisis than the way in which supervision was implemented in practice’ (Regling and Watson, 2010: 36). While the structure of the regulatory system changed in 2003, the regulatory approach did not. In common with many other jurisdictions, including the UK, the Irish regulatory regime was based on ‘principles-­based regulation’. Although this term has various meanings (Black, 2008), as applied in Ireland it refers to a system where ‘the prudential regulator is not prescriptive in terms of product design, pricing and the specific risk decisions adopted by a firm, as long as that firm has a robust governance structure and an effective oversight and control system’ (Honohan, 2010: 44). It was also referred to as ‘light-­touch regulation’ or market-­based regulation.

Ireland   121 Such a policy was consistent with the Irish government’s ‘Better Regulation’ policy, one of the principles of which stated: ‘We will regulate as lightly as possible given the circumstances, and use more alternatives’ (Department of the Taoiseach, 2004). It is important in this context to note that the supervisory approach in Ireland did not become lighter during the 2000s, but that ‘it remained very accommodating in a radically changed environment’ (Regling and Watson, 2010: 38). A problem identified by the Honohan report which was perhaps not so commonplace was that the underlying philosophy was oriented towards trusting a properly governed firm; it was potentially only a short step from that trust to the emergence of a somewhat diffident attitude on the part of the regulators so far as challenging the decisions of firms was concerned (Honohan, 2010: 44) In describing the regulatory approach of the Bank prior to the crisis, the word ‘trust’ appears repeatedly. The chairman of IFSRA was reported as stating that ‘for the principles based approach to work there must be mutual trust, between ourselves and industry and a shared aspiration to do our best together’ (Honohan, 2010: 44). This led to a regulatory approach which was ‘excessively deferential and accommodating; insufficiently challenging and not persistent enough’ (Honohan, 2010: 16). This in effect inhibited the IFSRA from taking quick and decisive action against banks with governance issues or with obvious liquidity concerns. While acknowledging that the Banking Supervision Division of the IFSRA may have been under-­resourced, the Nyberg Commission suggested that resource limitations alone would not account sufficiently for the lack of action: The essential information was readily available in the banks’ regulatory returns and (publicly available) in annual reports. Also . . . the serious governance and procedural problems in INBS (the Irish Nationwide Building Society), and to a lesser extent in Anglo, were known to the [IFSRA] for years. Furthermore, there are no signs of the [IFSRA] requesting increased resources. What unfortunately seems to have been lacking is professional scepticism or suspicion on the part of the [IFSRA] that all things might not be as well as they seemed on the surface. (Nyberg, 2011: 63) This problem was exacerbated by two considerations facts referred to earlier: the statutory objective of the CBIFSA to promote the financial services industry in Ireland, and the increase in competition in the marketplace. The buccaneering attitude to loan approval adopted by Anglo Irish Bank, short-­circuiting normal risk assessment practices, enabled it to grow at astonishing rates. In its 2006 Annual Report, Anglo boasted of a ‘Ten year compound annual growth rate in

122   B. Clarke and N. Hardiman profit before tax of 39 per cent’ (Hennigan, 2010b). This put tremendous pressure on Bank of Ireland and AIB; one former bank executive interviewed by financial journalist Michael Lewis reported that they succumbed by ‘writing checks to Irish property developers to buy Irish land at any price’. Former Anglo Irish executives ‘spoke of their older, more respectable imitators with a kind of amazement. “Yes, we were out of control”, they say, in so many words. “But those guys were ****ing nuts” ’ (Lewis, 2011). This created an environment that was described by Honohan as one which placed ‘undue emphasis on fears of upsetting the competitive position of domestic banks and on encouraging the Irish financial services industry even at the expense of prudential considerations’ (Honohan, 2010: 16). The Nyberg Commission also concluded that ‘concerns about a loss of market share by Irish banks to potentially less regulated foreign competitors may have inhibited forceful action by the [IFSRA]’ (Nyberg, 2011: 65). Finally, Honohan described an unwillingness on the part of the CBIFSA to acknowledge the real risk of a looming crisis and to pre-­empt it. There appeared to be a great fear that ‘rocking the boat’ would lead to a potential adverse public reaction, thus ‘spoiling the party’ (Honohan, 2010: 16). Let us remember too that Anglo in particular was widely viewed domestically and internationally as a success story by the marketplace, rating agencies, politicians, and the media. The Nyberg Commission suggested that this communal lack of judgement stemmed from the tendency to widespread group-­think (including ‘disaster myopia’) in Irish banks during this period (Nyberg, 2011: 87). Interestingly, it expressed the view that there was no evidence that this was more prevalent in Ireland than elsewhere (Nyberg, 2011: 49). This view of market pressure is consistent with the comment by former Citigroup CEO Chuck Prince that ‘as long as the music is playing, you’ve got to get up and dance’ (interview in the Financial Times, 9 July 2007). But clearly the role of the regulator is to turn off the music before the party gets out of hand.11 Instead, as the financial situation worsened and the credit institutions became less sound, ‘the earlier desire – not to rock the boat – was overtaken by a fear of frightening the horses’ (Honohan, 2010: 96). It is the scale of the myopia that is distinctive in Ireland though. The Nyberg Commission noted that ‘the extent to which large parts of Irish society were willing to let the good times roll on until the very last minute (a feature of the financial mania) may have been exceptional’ (Nyberg, 2011: ii). It may be therefore that the regulatory regime was not faulty in design, but that the very point of the system of regulation was to lower the burden of compliance, and to ensure that the legal requirements of risk regulation were light (Taylor, 2011: 8). Ireland sought to be a player in the globalized market for financial services. The International Financial Services Centre (IFSC) was a significant provider of employment and of tax revenues, employing over 30,000 people and yielding some €2 billion in tax revenues in 2011. Its reputation as a place in which it was easy to do business had to be protected, indeed so much so that it had acquired the reputation during the 1990s as the ‘Wild West of European finance’ (O’Toole, 2012; Lavery and O’Brien, 2005). One of the first European

Ireland   123 banks to fail in the wake of Lehman’s was Depfa Bank, an IFSC-­based subsidiary of a German bank. Its liabilities were the responsibility of its German parent; but the liquidity problems it experienced in 2008 were understood to have developed because of the freedoms available to it through its incorporation under Irish law. The IFSC’s shadow banking system continued to be largely unregulated even after the collapse of the domestic banking system, and its securitization practices were relatively unaffected by the global crash. The importance of the IFSC to Irish policymakers coloured their sense of the importance of maintaining a regulatory distance from financial services, and this is likely also to have affected their sense of the regulatory requirements appropriate to the domestic banks too. We might conclude therefore that not only a consequence but also a central priority of principles-­based regulation was to maintain the threshold of intervention at a high level. It is reported that ‘the bankers loved it, it was regulation without rules’ (Ross, 2009). Even this extraordinarily light regulatory regime was too much for Seán Fitzpatrick, former CEO and Chairman of Anglo Irish Bank, who argued in 2007 that: It is time to shout stop. The tide of regulation has gone far enough. We should be proud of our success, not suspicious of it. Our wealth creators should be rewarded and admired not subjected to levels of scrutiny which convicted criminals would rightly find intrusive. (Hennigan, 2010b) It would not be too long before Fitzpatrick was himself arrested on suspicion of fraudulent behaviour. But it was too late to prevent his bank from causing enormous damage to Irish public life. Regulatory enforcement An essential component of any regulatory regime is an enforcement strategy to ensure compliance. In the period preceding the financial crisis, Honohan acknowledged that the preferred approach to regulatory implementation on the part of IFSRA was to seek voluntary compliance with legislation, codes and rules (Honohan, 2010: 43): ‘there were no sanctions imposed on credit institutions and none that might be said to have reflected significant prudential concerns’ (Honohan, 2010: 58). While IFSRA had the capacity to utilize its powers of administrative sanction, there was clearly a marked reluctance to apply those powers in relation to micro-­prudential functions. The hands-­off role of the financial regulator in the run-­up to the crisis has raised many questions about awareness in the regulator’s office of the extent of over-­reach in the banks’ balance sheets, and of the scale of their reliance on the short-­term interbank lending market. Honohan commented on the thin staffing available to the financial regulator Patrick Neary between 2006 and early 2009. But this situation seems to have been consistent with reports that the regulator deliberately ‘kept on-­site inspections of the banks’ books down to a minimum

124   B. Clarke and N. Hardiman and gave prior notice in advance of such inspections’; he declared on his appointment in 2006 that ‘we will seek to implement the rules to the minimum extent necessary’ (Ross, 2009: 79). There was little evidence of the organizational and social distance normally required for effective regulatory enforcement. Career mobility between the boards of the Central Bank and the commercial banks was not uncommon, and indeed directors of both AIB and Bank of Ireland held simultaneous appointments on the board of the Central Bank (Clancy, et al., 2010: 14; Clancy and O’Connor, 2011: 19). Regulatory staff and bank directors often socialized together. In September 2008, against the backdrop of this deliberate policy of light touch regulation, Neary nevertheless: insisted that Anglo was not insolvent and that it had enough assets to cover its debts: ‘there is no evidence to suggest Anglo is insolvent on a going-­ concern basis. It is simply unable to continue on a current basis from a liquidity point of view’, he told the Taoiseach. (Brennan and Oliver, 2010) From the establishment of the office of the financial regulator in 2003 to October 2008, not a single Irish bank had been fined as a result of an inspection. In contrast, in Britain over a comparable time-­period, the Financial Services Authority had imposed over £14m in fines to banks and building societies (Ross, 2009: 81). On the other hand, some commentators have gone further and suggested that the financial regulator tacitly condoned some of the questionable practices of the board and senior managers in Anglo. In September 2008, ‘when Anglo official Willie McAteer told Patrick Neary that the bank would have its books in order by the end of [2008], it is claimed the former Financial Regulator said: “Fair play to you, Willie” ’ (Oliver, 2009). At that time, the share prices of the Irish banks were already under sustained attack, and it was only a matter of days before the banks would find themselves in danger of outright insolvency. By the time the regulator began to take a tougher approach with the banks and indeed with their auditors, toward the end of 2008, the damage had long since been done. Nyberg suggests that the financial regulator’s reluctance to adopt a tougher line sooner can be explained in terms of fear of litigation – of the legal cost and reputational damage entailed by pressing a case against a financial institution and losing (Nyberg, 2011: 62). But potential reputational damage of this sort pales before the real loss of confidence in the efficacy of the system caused by Neary’s appearance on the current affairs programme Prime Time two weeks after the fall of Lehman Brothers. Michael Lewis comments on his performance, and quotes economist Colm McCarthy’s reaction to it, as follows: Neary, for his part, looked as if he had been dragged from a hole into which he badly wanted to return. He wore an insecure little mustache, stammered rote answers to questions he had not been asked, and ignored the ones he

Ireland   125 had been asked. . . . Here he was, on their televisions, insisting that the Irish banks were ‘resilient’ and ‘more than adequately capitalized’ . . . when everyone in Ireland could see, in the vacant skyscrapers and empty housing developments around them, evidence of bank loans that were not merely bad but insane. ‘What happened was that everyone in Ireland had the idea that somewhere in Ireland there was a little wise old man who was in charge of the money, and this was the first time they’d ever seen this little man,’ says McCarthy. ‘And then they saw him and said, Who the **** was that??? Is that the ****ing guy who is in charge of the money??? That’s when everyone panicked’. (Lewis, 2011)

The political context of the property bubble Much has been written about the persistent tendency of Irish governments to engage in pro-­cyclical fiscal policy. There are many weaknesses in the institutional design of decision-­making: governments have displayed a propensity to overheat the economy for electoral purposes during periods of growth, resulting in a need to take corrective action during the ensuing downturn in a manner that intensifies the impact of recession (Lane, 2010; Benetrix and Lane, 2009; Lane, 1998; Conefrey and FitzGerald, 2010; Hardiman, 2010a, 2010b; Honohan, 1999). By the early 2000s, Ireland was already in the grip of another such upswing. But this time, it was amplified by the scale of the cheap credit available as a result of Eurozone membership. Government took some initiatives in the early 2000s to dampen the housing market through tax increases, but these were overturned as the 2002 election approached; soon afterwards, a new round of fiscal tightening by then Minister for Finance Charlie McCreevy was over-­ruled by Taoiseach Bertie Ahern, again with electoral considerations in mind. Tax incentives for property purchase, for commercial development as well as for individual residential purchases, were left in place until after the 2007 election. ‘From 2003, property seemed a one-­ way bet’ (Taylor, 2011: 4). Why was the speculative bubble allowed to grow so rapidly, and why was government so slow to recognize the risks associated with untrammelled lending for property development? Two puzzles arise here. The first concerns the nature of the relationships between politicians, bankers, and builders that intensified during the housing boom. The second issue is why no one shouted stop. Golden circles and the ‘cement economy’ During the 2000s, in Ireland as in Spain, construction activity gave a significant fillip to economic growth. Notwithstanding some political concern that house prices were escalating very rapidly, and that this even risked destabilizing the social partnership wage agreements of the early 2000s, the Fianna Fáil-led governments between 1997 and 2008 welcomed the employment generated, the

126   B. Clarke and N. Hardiman revenue streams created, and the apparently unstoppable rise of Irish builders and property developers as major players not only at home but across Europe. This sector of Irish economic activity had been actively encouraged through a series of budgetary incentives (TASC, 2010). Tax reliefs for construction in some instances ran counter to other declared policy objectives, such as concentrating population growth in key towns to ensure balanced spatial development. Some local authorities, who controlled planning permission, proved to be the source of serious and systematic corruption, as developers and builders engaged in direct bribery to achieve their objectives (Tribunal of Inquiry, 2012; McDonald and Sheridan, 2009). But this was only one mode of operation. More visibly, builders and property developers sought the company of government ministers and others in positions of influence, socialized with them, and were conspicuously present at Fianna Fáil fund-­raising activities such as the annual high-­ profile party hospitality suite at the Galway Races. The ‘Galway Tent’ became a byword for corrupt relations between politicians, banks, and property interests (O’Toole, 2010; Cooper, 2010; Leahy, 2009). A network of those with related interests developed: many of these private sector individuals were placed on the boards of state enterprises, and politicians were ever eager to be included in their company (Clancy, et al., 2010; Leahy, 2009). A particularly striking feature of this new Irish elite was that many of them still regarded themselves as social outsiders. This chimed with one aspect of Fianna Fáil’s self-­presentation as the party of workers and small farmers, harking back to its early days in the 1920s and 1930s. Many of the builders and property developers were self-­made men with relatively little formal education. Former Taoiseach Bertie Ahern, who stepped down in 2008 just as the crisis was looming, commented later on the enormity of the developers’ losses. Since they were now bankrupt, their losses were close to bankrupting the whole country. Yet he spoke with unaffected sympathy about them as follows: Seán Dunne’s lost a lot of money on it. Seán’s just one of the guys. I know a lot of them, like (Jimmy) Flynn, (Noel) O’Flaherty and the Baileys. You meet the Baileys at Croke Park (the national stadium for Gaelic games) every time you go there. You can’t avoid getting a slap on the back going in from them. Most of these guys lost their shirt. I feel sorry for them. (Mackay, 2012b) The sense of identification with the activities of Irish property developers, and of support for the banks who were facilitating them, also had a tinge of nationalist pride to it, particularly when Irish speculators engaged in high-­profile British acquisitions such as the Savoy Hotel in London. One builder spoke of his pride in building a housing estate ‘on what was once the great Ascendancy estate of Castletown in Co. Kildare: “It was time the Irish went through the front gate” ’, after the dispossession of his great-­grandfather who belonged to the class of impoverished tenant farmers many of whom had been evicted from their landholdings during the nineteenth century (O’Toole, 2010). Similarly, some of the

Ireland   127 self-­made millionaires were said to feel more at home with the informal approach of Anglo Irish Bank than with the Bank of Ireland, which had been viewed until well into the 1970s as favouring employees who were members of the Church of Ireland over Roman Catholics (McWilliams, 2009). As author and journalist Fintan O’Toole has noted, ‘If the control of land is left out of the equation, the sheer scale of the Irish property bubble is impossible to fathom’ (O’Toole, 2010). The principal reason for the scale of the bubble in Ireland was the price of building land. In north county Dublin, a prime growth region, a mere twenty-­five owners were shown to have controlled over 50 per cent of all building land in 2005, enabling them to control the release of land and thereby to manipulate the price of property. Land costs alone rose from 10 per cent of the final cost of a house to up to 50 per cent at the peak of the boom. The cost of road development was similarly grossly distorted by propertied interests (O’Toole, 2010). Ideas and debates: why no one shouted stop The Nyberg Report identified ‘a conspicuous lack of timely critical debate and analysis’ by bank analysts and the public at large, aligned with a sense of complacency in the government, other authorities, banks, and customers as a particularly Irish aspect of the crisis (Regling and Watson, 2010: 5). Part of this may be attributed to the fact that Ireland had never experienced a serious property crash, and the sustained period of success led investors and regulators to become complacent. What was described as ‘a national speculative mania’ (Nyberg, 2011: 94) took place in Ireland as ‘an uncritical enthusiasm for property acquisition . . . became something of a national blind-­spot’ (Regling and Watson, 2010: 34–35). There was an almost unanimous consensus that growth could be sustained in this manner. Dissenters were ignored, dismissed, and on occasion belittled. Some were even dissuaded by the apparent continued success of the credit institutions. It was also alleged that some stayed silent for fear of attracting possible sanctions. The Nyberg Commission voiced a suspicion that there may have been a strong belief in Ireland that contrarians, non-­ team players, fractious observers and whistleblowers would be informally (though sometimes even publicly) sanctioned or ignored, regardless of the quality of their analysis or their place in organizations. (Nyberg, 2011: 96–97) The group-­think involved had many willing participants and few to offer strong counter-­arguments. External assessments of the Irish economy noted their concerns about overheating and property prices. But in the absence of a European regulatory authority, they were in no position to warn about the dire exposure of the banking sector, and the tenor of the comments was on the whole favourable (O’Leary, 2010). Advice from the Department of Finance lacked input from skilled economic and other analysts, and although an official inquiry

128   B. Clarke and N. Hardiman by Canadian Robert Wright gave officials the benefit of the doubt, accepting their claim that they had issued verbal warnings despite the signal absence of documentary evidence to this effect, other commentators were not so convinced (Independent Review Panel – Department of Finance, 2010; Lucey, 2011). This is not to say that there were no dissenting voices at all. The signs were clearly visible; some economists and commentators gave them vigorous voice. But the political leadership, on the whole, simply did not want to hear. Bertie Ahern dismissed the gathering criticism testily, saying ‘Sitting on the sidelines, cribbing and moaning is a lost opportunity. I don’t know how people who engage in that don’t commit suicide because frankly the only thing that motivates me is being able to actively change something’ (RTE News, 2007). Yet later he insisted ‘I can’t remember anyone at any level telling me, “The banks are giving hundreds of millions of euros to developers, and they’re borrowing this at short rates, so if anything happens to them, they’re caught” . . . I know some people say “you should have asked” ’ (Mackay, 2012a). But what the markets knew, the politicians should surely also have known: On March 17, 2007, hedge funds launched attacks on weaker quoted banks, like HBOS and Anglo Irish Bank. They had spotted fatal flaws in the balance sheets. The share prices of Ireland’s financial shares plunged as opportunists in the market exploited the folly of a few bankers living a lie. They could read fantasy balance sheets. And yet European banks kept shovelling money at the guys who had gone walkabout. A stockbroker’s report at the same time described Anglo as ‘a building society on crack’; even the normally sanguine NTMA boss Michael Somers admitted that he had limited his agency’s exposure to Anglo. The warnings were everywhere, if the overseas bankers were looking for them. (Ross, 2010)

Conclusion The scale of the Irish financial crisis represents the destruction of a whole model of development that had evolved during the 2000s. Because of the guarantees provided by government to the domestic banks, it is also a catastrophe for ordinary Irish citizens. At the core of the disaster is the utter failure of the ‘light-­ touch’ model of regulation. We have considered a variety of explanations for the disasters that overtook the Irish banking system. Market-­based corporate governance disciplines proved ineffective, and codes of practice associated with good corporate governance provided little resistance to the incentives to increase risky lending practices. While the structure of the regulatory system and the powers and resources available to the financial regulator were contributory factors, a more fundamental problem was that tougher regulation was not viewed as either necessary or desirable, either by the regulator’s office or indeed by government itself. The reasons why the regulatory failures took the form they did cannot be understood without

Ireland   129 acknowledging that this approach to regulation was tacitly endorsed by government and state officials themselves. The failures of the Irish financial system reflect the limitations of a particular approach to regulation. But a deeper truth emerges, which is that during a critical period in the 2000s, government priorities were more attentive to the interests of the bankers, the builders, and property developers, than they were to considerations of good governance.

Notes   1 GNP or GNI is generally taken to be a better guide to the state’s fiscal capacity in Ireland, in view of the scale of transfer pricing and profit repatriation in the export-­ oriented multinational sector. See, for example, Hennigan (2010a).   2 For a note on the authors of these reports, see the Commission of Investigation into the Banking Sector in Ireland, online, available at: www.bankinginquiry.gov.ie/Biographies.aspx.   3 As defined in Section 2 of the Irish Takeover Panel Act, 1997 as amended.   4 These figures do not include statements of intention to make a possible offer which were not welcomed by the target companies and did not lead to offers being made.   5 A Corporate Code for Credit Institutions and Insurance Undertakings was introduced and came into effect in January 2011 (Central Bank, 2010).   6 While they asserted that poor liquidity management and funding policy abounded, they accepted that this was harder for managers to determine at the time.   7 The original version of the Combined Code was published in 1998 by the Financial Reporting Council and amendments were introduced in 2003, 2006, 2008, and 2010. In 2010, the Code was re-­titled the UK Corporate Governance Code.   8 Central Bank and Financial Services Authority of Ireland Act 2003.   9 S.5A(1)(a) Central Bank Act 1942 as amended. 10 S.5A(1)(b) Central Bank Act 1942 as amended. See also Honohan, 2010: 37. 11 William McChesney Martin Jr., one-­time Chairman of the Federal Reserve (1951–1970), was quoted as characterizing his role thus: ‘I’m the fellow who takes away the punch bowl just when the party is getting good.’

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6 New Zealand Staying in the black James Lockhart

Introduction New Zealand has a predominantly land-­based economy from which both soft proteins and fibre products are marketed to the world. Over the last three decades various governments have attempted to overcome the nation’s dependency on agriculture with little success. Significant shifts in monetarist policy and the removal of layers of interventions during the 1980s have failed to significantly redistribute resources in the manner first anticipated. Now, post the 2008 global financial crisis, New Zealand’s agriculture is the primary source of the nation’s economic recovery. In 2010, export receipts from the entire manufacturing and information technology sectors barely equalled that of New Zealand’s largest dairy cooperative (Callaghan 2011). New Zealand has benefitted from multiple golden ages of agriculture, especially in the 1950s and again in the late 2000s. Over this fifty-­year period New Zealand inadvertently became a centrally planned command economy (the most interventionist state outside of the Soviet Bloc); and, having been subjected to deregulation and monetarism in the mid-­1980s (known locally as Rogernomics) emerged as one of the most free and competitive economies in the world: albeit an economy with large local government holding both regulatory authority and monopoly powers, and a large state-­owned sector subjected to increasing performance demands drawn from private sector expertise. From the extremes of Keynesiasm on the one hand, to near conventional neo-­ liberal deregulation on the other has emerged an economy still reliant on agriculture; with significant public sector investment; and freedom to compete in markets. However, this outcome was far from deliberate. The collapse of the Keynesian economy, its salvation through deregulation and the abrupt ends at which deregulation was terminated – not once but twice – were influenced as much by external social factors as they were policy makers. At times New Zealand’s policy makers have been credited with foresight (Clark and Williams 1995; Walker 1989), and at other times their efforts have been condemned (Kelsey 1999). Competitive tension exists between the private and public sectors for resources, and dependency on the state from significant tracts of society remain.

New Zealand   135 Much of what has gone on is labelled ‘the New Zealand experiment’ (Holmes 1994; Kelsey 1999; Davey 2000). It attracted interest from economists, policy makers and commentators around the globe. It also attracted severe criticism from within New Zealand when righting the economy was supposedly more important than meeting social needs. That is despite five decades of rising social spending to meet such needs (Newman 2011). At times parochial interests have achieved disproportionate influence over policy. These interests have included agriculture, organised labour (unions), government’s own education and health providers, social service providers (ditto), large business and, what is by global standards, a tiny financial market. By contrast the banking sector remained relatively mute, conservative and supportive of sustained economic growth throughout. The aim of this chapter is to present New Zealand as a case study of resilience, acknowledging luck and good fortune, as much as sustained economic policy development and management.

The Great Depression Prior to the Second World War successive New Zealand governments, like those in other Anglosphere jurisdictions, were committed to balancing the budget ‘at nearly any cost’ (Hawke 1997: 177). Government was managed like any other household. Hawke reports that ‘fearful (but unspecified) dangers would be realised if it [New Zealand government] were extravagant and incurred debts’. Budget deficits were met by government borrowing from the trading banks through the issue of treasury bills, which provided the banks with another source of investment. But borrowing for anything other than ‘seasonal fluctuations in government revenue was prima facie evidence of extravagance’ (p. 178). Austerity prevailed motivated by a strong work ethic, full employment, significant exports and minimalist state intervention. The gradual revival of the New Zealand economy following the Great Depression brought with it increased government intervention in banking. The passing of The Reserve Bank of New Zealand Act 1933 provided government the means to establish a central bank in 1934 (Hawke 1973). Key influencers over its establishment included Sir Otto Niemeyer (op. cit.) financial controller at the Treasury and a director of the Bank of England. Sir Otto’s influence is indicative of the close ties between New Zealand and Britain at the time. During the mid-­1930s Keynesianism first emerged in New Zealand by way of the government’s policy on low interest rates. In 1934 the banks were ‘collectively required to reduce interest rates’ on borrowing (Hawke 1997: 178). Dissatisfaction with exchange rate variation from 1930 – at the time New Zealand ran a fixed exchange rate with the British pound described as natural parity – provided additional motivation for the establishment of a central bank (op. cit.). The primary purpose of the Reserve Bank was to ‘exercise control over monetary circulation and credit so that the economic welfare of New Zealand was promoted’ (op. cit.: 31). At the time New Zealand used the gold standard and prior to the establishment of the Reserve Bank New Zealand banks held their own

136   J. Lockhart gold reserves. The establishment of the Reserve Bank required the centralisation of gold reserves. Debate surrounded not centralisation, but what price the central bank should pay the trading banks for their gold reserves. The net result of this was the eventual widening of the gap between sterling and the New Zealand currency, UK£100 = NZ£125. At the heart of the pre-­war debate was the nationalisation of private assets, beginning a debate over both the boundaries and control of private and public assets that continues today. Gold reserves were considered the property of banks, and hence private, with the exception of those held by the Bank of New Zealand, the government-­owned trading bank (Hawke 1997). In 1935 the first Labour government came to power and with it the immediate adoption of a wide range of Keynesian and social democratic policies. These included bringing the newly formed RBNZ back under government control (RBNZ 2007); the introduction of import and export controls; nationalisation of the marketing of dairy exports (Ward 1975); the availability of free medical care; and the development of a comprehensive welfare system. They did not, however, proceed with the nationalisation of the trading banks (Hawke 1997), as previously envisaged by Labour candidates (Sutch 1966). The emergence of distrust between the banking sector and government resulted in the trading banks harbouring assets in London rather than New Zealand.

1935 to 1949: central banking, Keynesiasm and the Second World War The impact of the Second World War on the banking environment was mostly confined to the loss of manpower (Hawke 1997) and policy. The British government contracted for dairy produce and meat and paid for these commodities free on board in New Zealand. Payment was made through the Reserve Bank, and in so doing removed much of the trading banks’ exchange business. Numerous other interventions – largely untested Keynesian controls – were introduced including fixed interest rates, linking wage and price increases, lending advance control policies and so on. The domestic banking industry subordinated sectional interests without protest to support the war effort. However, patriotic feelings towards stabilisation and intervention declined rapidly with peace. In 1948 currency revaluation occurred to near parity with the British pound, and government remained committed to tightening monetary policy controls to restore the current account deficit created by the war effort. The wartime controls introduced by the Labour government were carried over more extensively and for a longer duration than those applied in most other developed countries (Hawke 1997; Brash 1996). But by 1949 the broader population had tired of ongoing shortages. In a country with an over-­abundance of food and fibre this reaction was hardly surprising, and dissatisfaction towards the Labour government escalated. When reassured by the National Party’s commitment to retain the social welfare reforms introduced by Labour they lost the election.

New Zealand   137

1949 to 1984: big government, central planning and control For four decades between the end of the Second World War and 1984 successive governments retained and further entrenched Keynesian monetarist and fiscal policies. Exchange rate interventions, price and wage controls (Lockhart 1990), import substitution, trade barriers and capital controls were all erected in an attempt to insulate the economy from the rest of the world (Brash 1996). At the start of this period New Zealand benefitted from unprecedented global demand for agricultural commodities (RBNZ 2007). New Zealand was ranked the third highest economy in terms of GDP per capita in 1953 behind only the United States and Canada, and ahead of Switzerland (Cleland 2001). However, by the end of the period – 1985 – New Zealand was eighteenth. Significant change occurred in New Zealand society over those forty years. As a dominion New Zealand had rapidly developed under the security provided by British forces, particularly the Royal Navy. In return, New Zealand committed to Britain disproportionate resources and manpower to both world wars. Despite mixed views of support across the political spectrum – the Labour Party was particularly vocal in not supporting Britain during the Great War – New Zealanders’ sense of commitment to Britain remained unquestionable. However, after the Second World War alignment and influence gradually shifted from Britain to the United States of America and later Australia. New Zealand became militarily connected to Australia and the United States through ANZUS, in what was a three-­way defence pact committing cooperation on defence matters in the Pacific. The American military influence spilled into other exchanges, such as visitors, ‘general and learned publications’ (Easton 1988: 71), academic sabbaticals (both ways) and scholarships (including Fullbright, Kellogg and Nuthall), and growing trade practices which in turn appears to have shifted the locus for policy ideas. Until that time economic and fiscal policy was demonstrably influenced by that of Britain, New Zealand’s growing relationship with the United States, first through defence ties and second through trade and enterprise, resulted in a rapid change in the source of such influences. While the decades preceding 1984 were punctuated by some remarkable events, the 1970s oil shocks and New Zealand’s ‘Think Big Policy’ in particular, monetary and fiscal policy largely remained consistent throughout. Successive governments from both sides of the political spectrum sustained Keynesian policies culminating in the ubiquitous intervention of the Muldoon (conservative) government in the early-­1980s. Despite terms of trade soaring during the 1950s, as a result of the Korean War, economic growth remained slow. Agricultural productivity remained remarkably constant until the late 1970s when significant price support and input supply interventions were introduced to stimulate national production. On the back of strong terms of trade successive New Zealand governments committed to a series of significant infrastructure projects, roading, housing, and electricity generation and distribution (RBNZ 2007).

138   J. Lockhart Governments through the period The first government during this period was the National government led by Sid Holland. While largely remembered for its military intervention in the 1951 Watersiders’ strike it was not the first New Zealand government to interfere between unions and employers when the national good was at stake. The wartime Labour government had deployed military personnel on the wharves in both 1942 and 1944 (Law Commission 1990; Taylor 1986). Despite these interventions the dividing lines between the two major political parties eventually emerged. The Labour Party was aligned with wage workers, government employees and Maori. By contrast the National Party was increasingly aligned with farmers, employers, manufacturers and those in professions. Sid Holland’s government, now led by Keith Holyoake, was narrowly defeated by Labour in 1957. For the first time in two decades the election was dominated by a financial policy debate with Labour introducing a PAYE system for salary and wage earners. However, following the collapse of butter prices in Britain in 1958 the government was confronted with a balance of payments crisis. In response, the finance minister introduced what is widely remembered as ‘The Black Budget’, with increased taxes on beer, tobacco, petrol and cars for which the government was criticised as being puritanical, miserly and wowsers. The Labour government never recovered from this budget and was voted out in the first of several major political swings to characterise the second half of the century. Under Keith Holyoake National remained in power for the next three elections. During that period Keynesian policies were increasingly adopted. Election issues concerned New Zealand’s participation in Vietnam, for example, rather than monetary or fiscal policies that are best seen as ‘steady as she goes’. The 1972 election was won in another major political swing, this time to the left, by Labour. However, their charismatic leader, Norman Kirk, was to die in office leaving their government with Bill Rowling, immediately criticised as being both ineffectual and weak. The electorate responded, leaving a second Labour government in office for only one term. The incoming National government adopted Keynesian principles at a rate greater than any government in its past. Keynesian policies remained entrenched, drawing government policy over the next nine years into corners of the economy previously only occupied by free enterprise. Influential businessman and social commentator Sir Bob Jones (1996: 13) observed that by ‘1981 . . . New Zealand had become a near-­complete socialist command economy, with nearly all of its large industries state-­owned’. State industry was described as ‘moribund through inefficiency and overstaffing’ all conducted in a ‘non-­competitive environment ordained by government’. No government was prepared to address the long-­term implications of New Zealand’s relative economic decline. Instead successive governments introduced layer after layer of interventions, little of which had any positive impact on the performance of the economy. Amongst these measures was the Think Big strategy developed in response to the global energy crises of the 1970s (Gustafson 2001). This strategy included four large energy-­base projects (Davidson 2010)

New Zealand   139 of which the benefits have been contested ever since. More importantly, at the start of the period New Zealand was, in both relative and absolute terms, economically prosperous. By the end the country was one of the poorest in the OECD. A key feature of the economy, with its subsequent impact on the community through much of the period, was full employment Hawke (1984). Unemployment remained at less than half a per cent of the workforce (Snively 1988: 141), giving support to the remark ‘that in New Zealand it was possible to know all the unemployed by name’. But it was the public rather than the private sector responsible for such high employment. Ministries and government departments were used as an employment soak. This level of employment – unprecedented in the OECD – was neither without expense nor translated into economic and productivity gains. By the late 1960s changes in government policy gradually began favouring wealth creation through exports over full employment (Hawke 1984). As a consequence unemployment slowly rose to nearly 1 per cent by 1969. Finance markets and the banking sector A mere twelve trading banks were been established between 1840 and 1987, and at any time a considerably smaller number operated in unison (New Zealand Bankers Association 1997: 7). With the exception of the Bank of New Zealand, nationalised by the Labour government in 1945 for NZ£7,933,000 (Bank of New Zealand 2011), and more recently Kiwibank, they have all been privately owned and largely dominated by foreign ownership (from Britain and more recently Australia). In addition to the trading banks were savings banks, which from 1948 were distinguished by a state-­guaranteed deposit repayment (Familton 1966). Nine trustee savings banks operated in the mid-­nineteenth century alongside what was the state-­owned Post Office Savings Bank (POSB) (Russell 1985). The amendment of the 1948 Act in 1957 enabled the reestablishment of fourteen regional trustee savings banks (Grimes 1998) over the next decade from which two of the current trading banks, ASB Bank Limited and TSB Bank Limited, trace their roots. A wide range of non-­bank financial organisations also existed prior to the economic reform programme begun in 1984. These organisations operated under a ‘raft of differing Acts of Parliament and regulations’ (Grimes 1998: 296) and included official short-­term money-­market dealers; merchant banks; finance companies; private mortgage lenders (via solicitors); stock and station firms; life insurance offices; friendly societies and credit unions; trust companies; building societies; superannuation and provident funds; and three specialist government funding agencies, namely, the Rural Banking and Finance Corporation of New Zealand; the Housing Corporation of New Zealand; and the Development Finance Corporation (Grimes 1998). By the turn of the twenty-­first century, while large in number, these non-­bank financial organisations made only a small contribution to the finance sector in New Zealand.1 The Rural Bank, central government’s rural financier, had been sold to private interests in 1994 (RBNZ 2011); the Development Finance Corporation, central government’s venture

140   J. Lockhart capital provider, had collapsed in 1989 (Maier 2010); alongside several notable merchant banks following the share market crash of 1987; and many of the building societies had consolidated or been acquired by the trading banks when the regulatory advantage of not being a bank was removed. With the exception of the superannuation and provident funds a well-­defined group of mostly ‘B’ grade finance companies remained outside of the trading and savings banks. The majority of these, some seventy, subsequently collapsed following the global financial crisis owing about NZ$1.3 billion (Peebles 2010). The New Zealand Stock Exchange (NZSE, now NZX) traces its roots to the 1870s Otago gold rush. During that time a number of regional exchanges were established. In 1974 the remaining regional exchanges were consolidated to form one national exchange in Wellington. In June 1991 the NZSE implemented computerised trading making obsolete over 120 years of the outcry market. The Exchange was demutualised in 2002, creating a limited liability company (also listed) trading as NZX. At 30 June 2009 the New Zealand exchange had 233 listed issuers with a total market capitalisation of NZ$49 billion. As importantly the Reserve Bank (2010) reports that in 1986 some 25 per cent of household assets were held in shares. By 2010 this level of relative investment had declined to a mere 7.6 per cent. A trickle of deregulatory policy emerged during National’s last term in office (1981–1984), voluntary unionism and shop-­trading. But by 1984 the broader population had become largely disenfranchised. Conservative voters were attracted to the recently established New Zealand Party, founded by Sir Bob Jones with the sole intention of ridding National of office. The government was widely blamed for adherence to increasingly interventionist and ineffective policies (Condliffe 1969; RBNZ 1981, 1984). And, a balance of payments crisis was looming on a scale not previously encountered before in New Zealand. Government deficits were increasing significantly faster than GDP (Hawke 1984).

1984–1990: deregulation and economic reform The motivation for economic reform was twofold. The first, and most obvious, was the parlous state of the economy inherited by the Labour government. New Zealand was, as had been Australia in the 1920s, at the brink of defaulting on debt. The second was a view deeply held by key cabinet ministers, especially Douglas, that there had to be a better way (Douglas 1980; Prebble 2006; Lange 2005; Richards 2010) than the continuation of ineffective interventionist policies that had dominated since 1935: the policies from which the nation’s relative wealth had been in constant decline. These views were invariably shaped by critical reflection2 (Douglas 1980; Hawke 1984); domestic universities notably Canterbury3 (Brash 1996; Whitelock 2010); a group of Reserve Bank and Treasury policy wonks; economic reforms in the United Kingdom and United States; and, lastly, the Chicago School of Economics. Three decades of failed economic policy produced the magnitude of economic reform (Brash 1996). Nothing introduced was especially unique globally,

New Zealand   141 nor were the consequences naively anticipated by government. What makes the 1984–1993 deregulation unusual was the rate at which monetarist and economic reforms were introduced; the total disregard to democratic process (Jones 1996); and, the abruptness at which the reform process was suspended (Lange 2005). None of which were planned but were the consequences of necessity in what was, at the time, a simple political structure (Rankin 1995). Therefore, against this background it is reasonable to expect them being greeted as an economic miracle on the one hand or a colossal failure on the other (Kelsey 1995, 1999). Consequently, the economic reforms of twenty-­seven years ago are still held responsible for recent failures, be that the Pike River Coal Mine explosion, leaky buildings or the collapse of finance companies (McCrone 2011). In 1980, Roger Douglas, wrote a short monograph titled, There’s Got to Be a Better Way! Douglas was a third generation Labour member of parliament whose father was a ‘radical trade unionist’ (Douglas and Callen 1987: 10). The book opens with a question to all New Zealanders, ‘how do we break out of our present economic and social morass?’ (Douglas 1980: 9). What followed was a pot pourri of economic, fiscal, monetarist, social and infrastructural reforms of which some are Keynesian, some broadly neo-­liberal, and in the context of this discussion, others distinctly ordoliberal by comparison. However, the common principle appears to be logical and rational thought driven from the view that performance of much of the economy could be improved by doing things differently, and that improvement was in relatively easy reach for all New Zealanders. But to do so New Zealanders had to change their view of the world – especially their dependency on the state. In place was a receptive government, including a core group of ministers, namely, Palmer, Prebble, Lange, Moore and Caygill (Douglas and Callen 1987) equally supportive of change mandated by an electorate receptive to change. Therefore, it is not surprising to see the initial reforms enacted with little resistance within government or broader parliament. However, from the outset the reforms were greeted with howls of protest first, from the agricultural sector; second, from the manufacturing sector; and, third, from the public sector, of which the last had been a traditional Labour constituency. Other influencers The role of Treasury, in terms of policy development, was also supportive: although not necessarily unanimously. An influential ‘Group’ (Easton 1988) within Treasury responded to the opportunity in a manner expected of policy makers – what they considered to be in the best interests of the nation. Therefore, mutual support existed between Treasury, on the one hand and key Ministers on the other. The source of ideas is more intriguing. Bollard (1987: 9) goes to considerable detail to identify the nature and source of American influence throughout this period. His identification of the routes of transmission from the United States to New Zealand, via the producers of economic developments and the users of economic developments, is endorsed by Miller (1988), Easton (1988), Evans (1988) and McCann (1988). He also observed that a direct route

142   J. Lockhart between US producers of economic development and NZ users of economic development was potentially dangerous (Bollard 1987: 10) citing financial sector reform as an example. That the theory behind these reforms emanated from the Chicago School, while not necessarily Chicago, is in little doubt. However, resonance with local needs at the time and a willingness by key politicians to find a better way created an environment for unprecedented change, regardless of what the constituency expected (Jones 1996). However, both Quigley (1984) and McCann (1984) cautioned against considering the reforms especially radical. When compared to the ‘near-­complete socialist command economy’ described by Jones (1996: 13) an environment of market competition (Konzelmann et al. 2012), not necessarily market freedom, was viewed as extreme. From the outset the reforms were seen by the union movement as ‘illogical and socially dangerous’ (Campbell 1984: 9). And, it was this sticky sector (Carlstrom et al. 2006), the bastion of Labour Party support since 1938, which was ultimately to bring the process to a standstill in 1988. At the time of the change of government both the United States of America and Great Britain were well through their respective reform processes lead by Ronald Reagan and Margaret Thatcher respectively. The motivation for, and effectiveness of these reforms was not lost on Douglas. More importantly, the employment of recognisable neo-­liberal policy regardless of its rigour, untested assumptions, and its paradoxical relationship with the state attracted considerable support from the influential private sector think tanks, business leaders and Reserve Bank policy analysts. All of whom held the view that small government was better than large. Brash (1996: 5) observed that the New Zealand reform process differed to that applied elsewhere in that ‘it was probably the world’s first example of a “big bang” approach’. He too acknowledges that the comprehensive nature of economic policy failure at the time merited the ‘correspondingly comprehensive reform programme’. By contrast, Kelsey (1995: 348) argues that the monetary crisis was, ‘provoked partly by Douglas himself ’ finding little merit in much (if any) of the reforms, the rate that they were introduced, or the subsequent outcomes achieved. She offers a view that forces well beyond the electorate managed to conspire the outcome of the 1984, 1987 and 1990 elections enabling a process of reform to continue unimpeded throughout these nine years. Beneficiaries The reform process was first embraced and in turn promoted by big business. In particular the prospect of asset sales provided a mouth-­watering feast for a well-­ identified group of listed companies, financiers and independently wealthy businessmen comfortable with scale mergers, acquisitions, capitalisations and listings. In 1984 government courted business by way of an economic summit attended by 230 of New Zealand’s most influential businessmen and women and select international guests. The purpose of the summit, signalled prior to the election, was to develop consensus among respective private and public sector

New Zealand   143 lobby groups (Douglas and Callen 1987). Outside of government the precarious state of the economy was not well understood and parochial interests, as opposed to national good, had held sway over the limited policy making – as reflected in Kelsey’s (1995) contempt for the reforms. Douglas and Callen note that New Zealand had ‘developed an economy where every major productive group was being subsidised or assisted by the consumer and (emphasis added) the taxpayer’ (p. 74). The second aim of the summit was to ‘try and unwind that tangled web’. The consensus resulted in the following points: • • • • •

a consistent framework which took account of all the inter-­related ­elements of the economy; fiscal, monetary and exchange rate policies which would allow investment to flow into areas where it is used most effectively; optimum use of modern technology in management and work practices; lifelong education and training to improve both economic performance and social equity; and government, management and unions to ensure sufficient understanding of the need for change. (Douglas and Callen 1987: 78)

With the summit came a significant change in lobbying that remained largely unchanged until 1999 when sectoral interests were met by Third Way (Chatterjee et al. 1999; Giddens 1998, 2001) policy. Until the summit the traditional business lobby groups comprising the Chamber of Commerce, Manufacturers Federation, Employers Association Federation and Federated Farmers enjoyed a close relationship with the National Party, but did not engender support from Labour. The various unions, including the Public Sector Association, were demonstrably aligned with Labour. Think tanks The New Zealand Business Roundtable was established in 1984 by Alan Gibbs, who appointed former Treasury analyst Roger Kerr, as CEO. Gibbs was a close friend of Douglas (Douglas and Callen 1987). The Business Roundtable emerged after the 1984 summit with the vision of creating an open, dynamic economy and a prosperous, fair, cohesive society (NZBRT 2011). In doing so, the Business Roundtable’s vision echoed the sentiments of Douglas, like-­minded ministers, The Group, and US and UK influences. Importantly, the historical lobby groups representing both sides of the employee-­employer spectrum remained parochial, as did Federated Farmers and, therefore, contributed little to the policy reform process at the outset. For many years afterwards the Business Roundtable (as well as the New Zealand Institute of Economic Research and The Centre for Independent Studies) were to maintain both influence and a principled, if predictable, approach to the policy debate. Much later, in 2000, the Helen Clarke government was to marginalise the

144   J. Lockhart i­ndependent think tanks, excluding them from her own economic summit with the retort that their views were well known. The government may, however, have unwittingly created a Trojan Horse. While the business lobbying remained principled vested interests quickly emerged, notably once the process of asset sale began. The asymmetrical capture of financial rewards from some of the reforms created discontent (that continues today), especially when select individuals repeatedly benefitted from rushed asset sales, ineffective governance structures and arbitrage opportunities now considered insider trading. These individuals included investment bankers Sir Michael Fay and David Richwhite and corporate raider Sir Ron Brierly. Fay and Richwhite were heavily involved in asset sales and their subsequent liquidation between 1986 and 1993. They personally benefitted from the sale of the Bank of New Zealand, Tranz Rail, and Telecom New Zealand gaining over half a billion dollars at the same time as their minority shareholders lost NZ$277 million. Fay and Richwhite also made NZ$274 million from sales of Telecom New Zealand share options in September 1993 without having to put up any capital in advance. In 1984 Brierly Investments Limited was the largest company in New Zealand by market capitalisation, and in 1987 had 160,000 shareholders, with a stake in over 300 companies, including the largest shareholding in Air New Zealand. All three appeared to have had a disproportionate influence over the actual sale process of specific assets. New Zealand’s process of economic reform: pitfalls and success Such was the impending monetary crisis that Spencer Russell, Governor of the Reserve Bank and Bernard Galvin, Secretary to the Treasury informed the incoming Labour government of the need to immediately devalue the currency by 20 per cent (Douglas and Callen 1987). Three weeks earlier that advice had been 15 per cent, and two months prior to that 10 per cent. Coupled with a three-­month extension of the current freeze on prices, services and fees; the removal of interest rate controls; and, the Economic Summit New Zealanders learned and began accepting the enormity of much needed change. The 1984 Budget, a milestone document in New Zealand’s economic history, attempted to align resource allocation with market needs, while maintaining the concept of equity and fairness. Douglas and Callen argue that it was probably the most radical Budget in New Zealand since Labour’s introduction of the social welfare system in 1938. The document signalled the start of a home-­grown reform process, driven by necessity, and implemented by a well-­defined group of New Zealanders committed to making the country a better place to live. To be sure, there were influences from abroad. New Zealand may have built an insulated economy but, unlike the Soviet Bloc, it was not isolated from ideas. However, the catalyst was the change in government in 1984 and their response to the undisclosed balance of payments crises: a government who initially put economic welfare ahead of the parochial interests they traditionally served.

New Zealand   145 Government set out the steps for economic reform in the 1984 budget (RBNZ 1984: 594). The immediate devaluation was followed by a staged removal of export incentives; deregulation of the financial sector; implementation of an active debt sales programme; tightened monetary policy; and agreement on wage-­fixing processes once the wage-­price freeze was lifted (RBNZ 1984). The measures introduced by Douglas in the Budget, therefore, fell into three broad categories. There were those designed to remove distortions in resource allocation so resources could be used in a more efficient manner. This required that productive sectors were exposed to market prices, whether they were international or domestic. A second group of measures was designed to ensure that social programmes were directed at those most in need. The third group of measures was directed at removing the distortionary impacts of the tax system. A significant shift from direct to indirect (consumption) tax was proposed, coupled with the introduction of greater equity in ‘personal tax and equity systems’ (RBNZ 1984). The net effect was a decrease in the budgeted Government deficit in 1985. Monetary policy was directed at ‘permanently lowering inflation’ (RBNZ 1990: 252) which had exceeded the OECD average for more than the last decade. Therefore, the reforms were both conventional and predictable in a neo-­liberal sense. The response to the Budget was generally supportive (Douglas and Callen 1987). However, it was not without opposition from those with sectoral interests. The agricultural sector, cosseted from market forces for decades, was near immediately exposed to global price signals, the distortionary impacts of input subsidies, price stabilisation and price support schemes being immediately removed. The special status of the official short-­term money lenders was removed during the reforms. Some restrictions on trading banks were also removed, putting immediate pressure on finance companies and merchant banks to be more competitive (Douglas and Callen 1987). However, domestic interest rates soared, attracting increased demand for Kiwi dollars and, under the regulated exchange environment, the Reserve Bank was forced to supply. Inevitably government was forced to float the dollar. Restrictions on overseas borrowing by private investors and financial institutions were removed and unrestricted access to the New Zealand capital market was provided (Douglas and Callen 1987). Exchange controls were disestablished and the prescribed ratios of government stock to be held by financial institutions were removed. The dollar was floated in March 1985. Later that year deregulation of financial markets was completed when legislation allowing new banks to enter the market was introduced. As the regulatory controls were removed so too were ‘special status and privileges’ (p. 150) despised for so long by Douglas and his colleagues. The last major focus of reform was the commercialisation of state-­owned enterprises. Much has been written about the performance of state-­owned enterprises (SOEs), privatisation of some of these assets, their success and their failures (Lockhart and Taitoko 2004). The broad process involved separating non-­commercial activity from trading organisations. Trading organisations, as

146   J. Lockhart SOEs, were given a profit objective; CEOs were given private-­sector-like objectives and accompanying responsibility; commercial criteria would be used for performance measurement; and restructuring would occur under boards appointed generally from the private sector (Douglas and Callen 1987: 227). Some of the principles were then applied, in more prescriptive form, to government ministries and departments with non-­commercial activities. The Bank of New Zealand was the first state-­owned commercial institution to attract private sector capital when 13 per cent of its stock was floated in 1987. By later that year all the SOEs were in place, of which some were first corporatised then sold, such as Forestcorp and Post Office Bank. Others were to remain in the transitory state of SOEs, while others, such as Air New Zealand (Lockhart and Taitoko 2004) and Government Print were sold with little transition and little consideration to their governance or majority stakeholders’ intentions. A tired electorate However, as suddenly as the reform process began, it ended. In 1998 Lange sacked Douglas. At issue appears to have been the introduction of a flat, rather than progressive, tax rate (Lange 2005). Lange’s appetite for reform had run its course. Critics of the reforms, such as Kelsey (1995), neglect the rapid termination of the reforms under the second Lange government when having fired Douglas and rearranged his cabinet he declared ‘a breather and a cup of tea’ (Perigo n.d.; Manning 2005). Lange was attuned to Labour’s traditional constituency who were suffering increased unemployment (at the time 6 per cent) and alienation from the monetarist environment that had been created. While the asset sale programme continued its course through to the 1990 election no emerging fiscal, monetarist or deregulatory policy emerged. New Zealand was left with a sticky labour market. From the sidelines Sir Roger Douglas (1993, 1997) continued to contribute to the policy debate in his personal and principled capacity before eventually re-­entering parliament in 2008 as a List MP4 for the ACT Party.5 Discussion of the reform process cannot ignore ANZUS. The Treaty was made null and void when David Lange barred nuclear powered or nuclear armed ships from using New Zealand ports or entering New Zealand waters. While this event is somewhat peripheral to economic reform it denotes a shift to independence not previously pursued by New Zealanders, and emerging irreverence to the United States of America.

1990–1999: reform resumed and then parliamentary paralysis In the 1990 election National won an astounding sixty-­seven seats of the possible ninety-­seven. This was the largest majority in New Zealand’s parliamentary history. The fourth National government took steps to rein in ballooning public spending and to again put the books in order. They succeeded and brought

New Zealand   147 the Budget into surplus by 1994. With an export-­led recovery New Zealand began to boom and unemployment fell through the 1990s after peaking at 10.9 per cent in 1991. Ruth Richardson was appointed the Minister of Finance, and for National’s first term in government she near-­single-handedly resumed the reform process left largely untouched since 1989. The government introduced substantial labour market reforms, and resumed the asset sale process, but not before it had had to bailout the BNZ by NZ$380 million to avoid collapse. This bailout represents the start of a process of principled interventions in both private sector and public sector assets continued by governments on both sides of the House (e.g. Air New Zealand, New Zealand Rail, South Canterbury Finance and AMI). Government then sold its 57 per cent share in the BNZ to the National Australia Banking Group in 1992 for NZ$850 million. Jim Bolger’s government remained in power until 1999. The 1993 election left the Party with a majority of two seats, having won fifty of the ninety-­nine seats with 35 per cent of the vote. Also that night a referendum on electoral systems established that Mixed Member Proportional (MMP) representation would be used for future elections, replacing the simple First Past the Post system used in New Zealand since democracy was introduced in the mid-­ nineteenth century. Subsequent MMP governments, all established by way of coalition, have had to curtail extensive policy reform as no government has been elected with a majority. As noted, the appetite for reform under National was largely confined to the Minister of Finance (Richardson 2008) and with the exception of a substantive rewrite (Bolger 2008) of employment law, and tightening (by necessity) of fiscal policy, little substantive and lasting change was introduced. The resumption of conservative ‘steady as she goes’ politics and creating a decent society (Bolger 2008) dominated thinking, rather than wealth creation through the pursuit of growth by way of monetarist and deregulatory economic policy. The resumption of reforms under Bolger’s conservative government was, again, rarely acknowledged by critics and was abruptly ended – the second time – by the introduction of New Zealand’s MMP electoral process in 1993. National held on to government through various coalition arrangements through the 1993 and 1996 elections, and produced New Zealand’s first women prime minister, Jenny Shipley, in 1997 by way of a democratic cabinet reshuffle. But by the end of National’s third term they appeared bereft of both ideas and lacked support. This was despite leading New Zealand through a remarkable period of growth, low employment and low inflation, most of which are attributed to the reforms of the previous decade (Bollard and Gaitanos 2010). New Zealand had weathered ‘local’ storms of the East Asian crisis (1997), and while yet to encounter the perceived or real Y2K problems (in 2000); dot-­bomb (2000–2001); the terrorist attacks on the Twin Towers, Pentagon and White House (2001); and SARS (2003), the economy was showing remarkable resilience (Bollard and Gaitanos 2010). That the nation’s economic resilience was again being driven by agriculture and higher global commodity prices was all too often neglected by  policy makers who, in the last throw of the dice, deregulated the remaining

148   J. Lockhart societal marketing boards (Israeli and Zif 1971; Lockhart 1997) resulting in the virtual collapse of the export apple and pear industry a decade later.

1999–2008: The Third Way From the outset the new Labour government, in a manner reminiscent of that of 1938, wanted more and better targeted social policies and spending. Labour had discovered The Third Way (Giddens 1998) and was quick to promote the benefits of further income redistribution and social spending as the only means of creating a decent egalitarian society. However, they took care to disrupt few of the economic and financial policy gains of the last two decades. In doing so, Michael Cullen, the Minister of Finance, was frequently characterised in the manner of Uncle Scrooge while ministers around him sought to provide remedies by way of welfare redistribution and social spending at levels never encountered before. The Third Way was immediately embraced in New Zealand by academics (see Chatterjee et al. 1999; Kelsey 1999); and, union leaders (see, e.g. Chatterjee et al. 1999) alike. The introduction of The Third Way also attracted endorsement from the Australian Labour Party (Driver and Martell 2002: 76). Importantly local Labour Party politicians heralded it as a significant departure from the dominant economic policy logic – neo-­liberalism – of the preceding fifteen years (Maharey 2003). New Zealand politicians, supposedly reflecting the view and aspirations of the electorate, are statists by nature. One of the few exceptions was Sir Roger Douglas who, first as a member of the Labour opposition, then Minister of Finance, and later an MP for the ACT party, steadfastly held to the view that business and communities were more effective decision makers than central government, and that they were largely capable of being responsible for their own welfare. Under New Zealand’s activist (Malpass 2011) government model the electorate is then typically observed to respond to, rather than lead the electorate’s thinking and actions. Governments since 1938 have a history of being voted out when the electorate has lost confidence in their ability to serve. No government has been voted in on the basis of blindingly new policy. In 1984, 1990, 1999 and 2008 successive governments were changed due to disenfranchisement, and perhaps even boredom – predictability – rather than courageous oppositions offering ex ante policy reform. The Clarke government was no exception. Social reform was on the agenda, but economic and financial policy was by and large sacrosanct. However, amidst that tension some visionary legislation impacting on the export sector was introduced, particularly the Dairy Industry Restructuring Act (2001) creating Fonterra; and the Kiwifruit Restructuring Act (1999) creating Zespri with subsequent amendments to the 1999 Kiwifruit Exporting Regulations in 2004. Both represent a light hand of domestic regulation, which focuses competition offshore. They followed in the footpath of the New Zealand Horticultural Export Authority Act 1987, introduced in the face of deregulation.

New Zealand   149 Fortunately for Labour the economy was relatively strong throughout this period. During the preceding decade the economy had grown at over 4 per cent per annum (Bollard and Gaitanos 2010) and sustained growth was required to finance the social expenditure envisaged. It was during this period that the creation of financial products elsewhere was constrained only by the imagination of vendors, and their success constrained only by the gullibility of purchasers. By comparison banking operations remained relatively simple (Bollard and Gaitanos 2010: 18). The four Australian banks continued to dominate the local market. However, the creation of government-­owned Kiwibank in 2002, with an aggressive pursuit of the low risk mortgage domestic market, contributed to competition and increasingly liberal lending by all banks to the sector. In 2007 Rennie reported that government spending was NZ$20 billion higher than in 2000, an increase of 32 per cent in real terms. That increased spending had been distributed across health, education and social security, arguably, to little effect. Government spending at that time had reached 40 per cent of GDP (Malpass 2011) compared with 35 per cent in Australia. New Zealand’s interpretation of The Third Way, financed through strong economic growth, created an unprecedented government deficit that later coincided with the GFC. By 2007 the benefits of sustained economic growth had all but been spent. For example, Rennie (2007) calculated that the extra NZ$20 billion could have been used to fund tax cuts on a magnitude that nearly all income tax could have been abolished. Worse, social indicators across a range of outcomes showed little improvement and on occasions, such as, productivity scores in the health sector (Malpass 2011), actually deteriorated. Reading and math outcomes based on the OECD’s PISA scores (Programme for International Student Assessment) appear to have declined while violent crime actually increased. All while public servants increased by 15,000 employees: an outcome that subsequently proved to be unsustainable.

Summary The economic reforms were implemented with what is regarded now, but unknown at the time, as a strong Austrian School of influence (Brash 1996). Merton (1968) would have viewed it as an adumbration, recognising Douglas’s original views as a set of theories of the middle-­range. Importantly, it was Douglas’s ability to mobilise a group of similarly minded policy makers across a broad spectrum of government and private sector interests that ensured the reforms were implemented, at least in part. While the process has much in common with neo-­liberal monetarist policy, the role of the state remained unchallenged, social programmes untouched, and sticky sectors (labour, health, education and local government in particular), by virtue of the lack of competition, were created. When Lange stepped in it was nothing more than an act of chance leaving a mixed – possibly ordoliberal – economy. At the time big business was seen to be capturing disproportionate benefit from economic reform, possibly at the expense of wage and salary earners. However, social expenditure

150   J. Lockhart continued unchecked. That New Zealand had the most centrally regulated economy outside of the Soviet Bloc prior to the reforms has all but been forgotten. The neo-­liberal reform process was rapid, motivated through necessity, and arguably anti-­democratic. Much of the electorate had little understanding of what was likely to come. Within four years, however, the prime minister’s appetite for reform collapsed – a ‘tea break’ was called. Following a change in government in 1990 the reform process continued, again for only a limited time, before the change in the electoral system (MMP), which required coalition governments, again brought the process to a standstill. That New Zealand has been left with a mixed policy environment comprising large government and substantial public sector investment in state-­owned enterprises is pure luck. Disproportionate expenditure is allocated to various benefit programmes, whose sustainability, with the exception of government-­funded superannuation for retirees, is rarely debated. The economy’s resilience, however, may well be attributed to highly productive primary sectors – forestry, fishing and agriculture, and an emerging manufacturing sector, especially in the ICT domain. Whether or not this endstate is adequate in the long term or replicable elsewhere is a moot point. But for the time being anyway, catastrophic earthquakes aside, both the economy and community have been spared much of the indignities of the GFC. That is not to suggest that New Zealand is some form of nirvana, income disparity exists, as do degrees of child poverty among recognisable communities. Educational and health outcomes can be observed to be asymmetrical. However, resolving these ingrained societal issues requires a robust and resilient economy, anything else appears to produce less than First world outcomes for all.

Notes 1 Exact figures are difficult to establish because much of the secondary finance sector was held by private interests. In 2000 the collective asset backing of banks and non-­ banks was some NZ$150–160 billion and NZ$8–10 billion respectively. The non-­bank sector, therefore, contributed only 5–6 per cent of New Zealand’s entire financial sector which proved a considerable advantage at the time of the GFC. 2 The discussion around deregulation is rooted in the first alternate budget offered by Roger Douglas while in opposition in 1980. However, the leader of the opposition, Bill Rowling, was so incensed by the content of the alternate budget that he immediately removed Douglas from the front bench (Douglas and Callen 1987). Douglas’s alternate budget was then published as his 1980 monograph. The publication of these two documents provided the necessary catalyst for a broader group of policy analysts at the Treasury and other ministries to explore alternate means of reforming the economy. Note that near all of the policy papers and commentaries by Begg, Cameron, Duigan, Easton, Jennings, and Kerr were published after 1984, in ex post (positivist) fashion as opposed to being normative. The catalyst for thought leadership of the reforms lies largely with Sir Roger. 3 Brash (1996: 18) noted that the most common academic background of those involved in the reform process was probably the University of Canterbury – in the late eighties, the Secretary of the Treasury, one of the Deputy Secretaries of the Treasury, the Governor of the

New Zealand   151 Reserve Bank, the Minister of Finance, and the Opposition Shadow Finance Minister were all graduates of Canterbury, and three of the five had been to the same state-­funded secondary school! None of the five had studied at Chicago, and only one had studied in the U.S. Equally important is Brash’s observation around the nexus of influence – Treasury and the Reserve Bank. But he failed to recall that the Deputy Prime Minister at the time was a Chicago Law School graduate. 4 List MPs, as opposed to constituency MPs, were created through the introduction of New Zealand’s variation of Mixed Member Proportional representation in 1996. 5 ACT Party – Association of Concerned Taxpayers. The principal object of the ACT Party (Association of Concerned Taxpayers) is to promote an open, progressive and benevolent society in which individual New Zealanders are free to achieve their full potential.

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7 Canada ‘Bank bashing’ is a popular sport Poonam Puri

Introduction Although often criticized for their lack of creativity and risk aversion (Nivola and Courtney, 2009), Canadian banks survived the recent financial crisis with a remarkable level of profitability, high-­grade liquidity, and public confidence, not seen in other jurisdictions. While financial institutions around the world collapsed or accepted government bailouts to remain viable, Canadian banks only required a modest government mortgage purchase program to insure high risk mortgages (Porter and Schwab, 2008). These factors led the IMF to regard the Canadian financial system as a paragon of international best practices (Nivola and Courtney, 2009) and the World Economic Forum to rank it the soundest financial system in the world (Porter and Schwab, 2008). The resilience of Canada’s financial sector is largely due to its conservative behaviour and regulatory framework, and the high degree of public trust in the Bank of Canada and other financial regulators (PwC, 2009). This chapter traces the development of the Canadian financial system from the end of the Second World War until the start of the 2007 financial crisis, and investigates the core events and philosophies responsible for shaping Canada’s present banking system. It finds that Canada’s commitment to the principles of the 1964 Porter Commission and the stable monopoly of the Big-­Five banks enabled Canadian financial institutions and regulators to adopt a stable, long-­ term approach. Further, as a result of both culture and particular events such as the 1985 collapse of Canadian Commercial Bank and Northland Bank, Canadian banks have developed a conservative business model, which resists price-­based competition, encourages a diversified portfolio with limited risk tolerance, and causes Canadian banks to maintain capital reserves well in excess of their regulatory targets. However, Canadian financial institutions and regulators face future challenges in harmonizing the efforts of securities and financial regulators, addressing what information can be properly reported as an off-­balance sheet asset, and managing their increased global market presence following the 2007 financial crisis. Historically, Canada’s financial policies have been heavily influenced by international pressures and, in particular, American securities regulation and the

156   P. Puri globalization of financial markets. Similarly to the Thatcher government in the United Kingdom and Reagan in the United States, Canada experimented with neoliberal policies during the 1980s by electing two consecutive conservative governments with strong commitments to free enterprise and deregulation (Darroch and McMillan, 2007). However, Canada’s path involved far fewer dramatic policy shifts; many of these neoliberal changes were incorporated gradually and were tailored to respond to domestic events and political pressures. Furthermore, the move towards increased deregulation has largely been replaced by a more principles based regulatory framework (Northcott et al., 2009). This more conservative approach has caused Canadian banks to develop diversified portfolios, which more effectively balance their risk and leverage, while meeting their capital adequacy requirements (Bordeleau et al., 2009). This chapter argues it is Canada’s commitment to highly efficient and flexible banking regulations that has made Canada’s unique approach so resilient. This is not to say that Canada has escaped the 2007 financial crisis completely unscathed. The 2007 Asset-­Backed Commercial Paper (ABCP) crisis revealed that Canada’s financial markets are not immune from the risk of a catastrophic failure. When the subprime mortgage crisis began to grip the United States, Canadian investors holding largely unregulated ABCP began to question the security of these investments and, as a result, the turnover of these instruments ground to a halt. However, the rapid response of Canadian financial and securities regulators – notably the Bank of Canada and federal Minister of Finance Jim Flaherty – and financial institutions to contain this emerging crisis was demonstrated by the ability of Canada’s financial system to impose accountability and effectively quarantine these defaults before they could spread to other sectors of the market. Although the traditional model of conservatism sheltered the Canadian economy at the peak of the financial crisis, the pro-­cyclical capital retention of Canadian banks slowed the recovery of Canada’s lending markets and leaves questions of whether the system could suffer a second wave of more sustained bank defaults. This chapter proceeds by identifying the major stakeholders in the Canadian financial system and then chronologically, through ten sections highlighting the key themes and actors from each period. The first section discusses the economic boom and growth of the regulatory state in Canada from 1945 to 1960. The second section discusses how the 1964 Porter Commission on Banking and Finance established the main policy objectives for Canada’s financial regulators. The section on the 1965 Kimber Report introduces the tension that exists between provincial securities regulators and federal financial regulators. The next section discusses the maturation of Canada’s financial sector during the 1970s and early 1980s. This leads into a discussion of the collapse of Canadian Commercial Bank and Northland Bank, and the findings of the 1986 Estey Commission, which was convened to explore this collapse. The sixth section addresses the 1987 and 1992 Bank Act amendments, which allowed banks to acquire investment dealers. This is followed by an examination of how the 1992 bankruptcy of real-­estate giant, Olympia & York caused Canadian banks to

Canada   157 develop more conservative lending practices. Eighth is a discussion of the MacKay Report on bank mergers and the 1997 Bank Act amendments, which liberalized the restrictions on foreign banks operating in Canada. Next is an examination of the Canadian approach to implementing the 2004, Basel II Capital Accord. The chapter then concludes with the 2007 Asset-­Backed Commercial Paper Crisis and contemplates several legislative hurdles that Canadian regulators will need to address in coming years.

Stakeholders This section briefly highlights the primary government, regulatory, and private actors in the Canadian financial system. In doing so, it will highlight the central themes and tensions between these actors, which are explored in greater detail throughout the chapter. Canada’s federalist structure has defined the development of the financial sector and regulatory environment by creating form-­based distinctions between the types of financial institutions and preventing regulators from fully harmonizing the financial and securities regulatory systems. Under section 91of the Constitution Act, the federal government has exclusive jurisdiction for the incorporation and regulation of banks, bankruptcy, and control over monetary policies. Canada’s ten provincial and three territorial governments have jurisdiction under s.92 of the Constitution Act to incorporate deposit-­taking institutions such as credit unions, and to regulate property and civil rights matters, including the trade of securities and the ability of creditors to foreclose on property given pursuant to a security interest. The constitutional separation between banking and securities regulation has been a recurring source of friction in Canada’s financial regulatory framework and has resulted in a push for the creation of a national securities regulator. In the context of financial services regulation, the absence of a national securities regulator creates regulatory duplication and inefficiencies among the thirteen provincial and territorial securities regulators, and significantly inhibits Canada’s ability to fashion a comprehensive response to financial crises as they emerge (Halpern and Puri, 2007). The consequences of this regulatory gap are explored in the final section through a discussion of the 2007 ABCP crisis. Within the federal government, the management of the financial system falls under the jurisdiction of the Minister of Finance, who is conventionally an elected member of parliament appointed by the prime minister. Since 2006, Canada’s Minister of Finance has been Jim Flaherty. The Minister of Finance is responsible for establishing the macro-­economic policies, government borrowing, and is Canada’s chief representative to the global financial community. As Canada’s financial system has developed, the Minister of Finance has assumed increased stature in Canada’s regulatory environment; below this will be discussed in the context of the 1997 proposed mergers of four of Canada’s five largest banks. Supporting the work of the Minister of Finance are a series of federal departments and agencies who work, largely behind the scenes with private financial

158   P. Puri institutions, to ensure the effective regulation of Canada’s financial system. The principal players are the Bank of Canada, the Office of the Secretariat of Financial Institutions, Canadian Deposit Insurance Corporation, and the Financial Consumer Agency of Canada. Interagency cooperation is facilitated through the regular meeting of the Financial Agencies Supervisory Committee, composed of the heads of the aforementioned organizations. The Office of the Superintendent of Financial Institutions (OSFI), created following the findings of the Estey Commission, is an independent office that reports to the minister of finance. OFSI is responsible for establishing prudential­based financial regulations, such as leverage and capital adequacy standards, risk allocation, and monitoring systemic risk factors and providing compliance and enforcement services. OSFI is assisted in its supervisory work by the Financial Consumer Agency of Canada (FCAC), which serves as a consumer advocate and ensures that financial institutions are providing adequate disclosure to the public. The Bank of Canada is an independent, non-­partisan crown corporation governed by the Bank of Canada Act. As such it operates ‘free from fear of [political] interference’ (Royal Commission, 1933). In this context, it is responsible for implementing the federal government’s monetary policies, ensuring established inflationary targets are met, setting interest rates, and controlling currency supply. The Bank also offers stability for the financial system by serving as a lender of last resort, providing liquidity to financial institutions, and managing government-­issued securities. In order to safeguard the independence of the Bank of Canada, much of its work in supporting Canada’s financial system is done behind the scenes, as seen in the ABCP crisis. In addition to the Bank of Canada’s role as a liquidity provider and lender of last resort, further market stabilization is offered by the Canadian Deposit Insurance Corporation (CDIC), which provides insurance up to $100,000 on deposits held at Canadian chartered banks and other lending institutions. CDIC also collaborates with other regulators to monitor the performance of these institutions and may intervene as a receiver if a bank encounters liquidity problems. The Canadian Mortgage and Housing Corporation (CMHC) is a federal agency which provides access to home mortgages for persons who are ineligible for private financing, insures all ‘high risk’ bank mortgages (any mortgage with less than 20 per cent equity) and distributes mortgage backed security products (CMHC n.d.). These mortgage-­backed securities are AAA rated (Moody’s, 2011) and guaranteed by the government for sale on public markets. In 2010, CMHC had $293 billion in total assets, which places it just behind Canada’s five largest national banks (CMHC, 2010). Although, CMHC voluntarily complies with regulations set out by OSFI and other regulators, it is not subject to direct regulation or enforcement by these agencies. Canada’s banking system is dominated by five large national banks – Royal Bank of Canada (RBC), Toronto Dominion Bank (TD), Bank of Nova Scotia (Scotiabank), Bank of Montreal (BMO), and the Canadian Imperial Bank of Commerce (CIBC) who collectively hold $2.6 billion of the $3.0 billion in total assets held by OSFI registered banks (PricewaterhouseCoopers, 2011). Since the

Canada   159 end of the Second World War, these banks have dominated Canada’s financial sector and established branches throughout the country. In the late 1980s and early 1990s, Canadian commercial banks were allowed to merge with investment banks, resulting in the majority of large investment houses being acquired by these commercial banks. The impact of these mergers will be discussed in greater detail in the section on the 1987 and 1992 Bank Act amendments. In addition to the national banks, a number of smaller regional banks and provincially incorporated credit unions operate in Canada. In Canada, there are a total of 152 deposit-­taking institutions regulated by OSFI, twenty-­three are domestic banks, twenty-­six are wholly independent subsidiaries of foreign banks chartered under Schedule II of the Bank Act, twenty-­eight are foreign bank branches chartered under Schedule III, and the remaining seventy-­five institutions are trust, loan and cooperative credit associations (OSFI, 2012). All foreign banks operating in Canada are subject to the same regulatory oversight as domestically owned banks. Foreign banks are classified under the Bank Act as either Schedule II or Schedule III banks, based on the nature of their operations and relationship to the parent bank. Schedule II banks are allowed to offer a full range of financial services within Canada, provided they do not access or leverage using their parent institution’s assets. Schedule III [branch] banks are allowed to maintain their affiliation with their parent institution and are not held to the same corporate governance standards as Schedule I or Schedule II banks, but they are limited in the services they provide. The five Schedule III banks in Canada chartered as ‘Lending Branches’ are only limited to offering credit from their parent’s global assets. The remaining twenty-­three Schedule III banks are chartered as ‘Full Service Branches’ and can receive wholesale deposits of $150,000 or more from financially sophisticated investors, in addition to providing credit to the general population from their parent’s global assets. The three largest foreign banks are HSBC Bank Canada, ING Bank of Canada, and Bank of America, National Association (PwC, 2011). The proper role for foreign banking institutions has been a constant influence in the development of Canada’s financial landscape, with legislators tending to be highly protective of Canada’s financial sovereignty. These tensions were particularly evident in the findings of the Porter Commission and the 1997 Bank Act amendments. Overall Canada has a mixed economy, which balances natural resources, agriculture, services, and manufacturing sectors. Despite a high number of publicly traded companies per capita, Canada is a comparatively small player on international capital markets, holding only 3 per cent of the world’s total capital (Puri, 2009). However, Canadian investment tends to be outward looking with a high rate of investment in foreign markets. Similarly to the United States, Canadian consumers hold a high amount of personal debt – on average 153 per cent of their disposable income (Canadian Business, 2011). Despite this high debt to income ratio, the Canadian mortgage market remained stable throughout the 2008 recession. This is in part due to the more conservative mortgage requirements in place in Canada and the preference by Canadian banks to hold the mortgages they issue internally, rather than assigning them to third-­party

160   P. Puri investment banks for securitization (Booth, 2009). Generally, to be eligible for a mortgage a mortgagor must provide a 20 per cent down payment on the property, receive an independent appraisal of the land value, and provide comprehensive disclosure of all income sources and employment.

1945–1960: the post-­war boom years The fifteen years following the end of the Second World War were a period of economic growth and transition for the Canadian economy. The years following the war were significant to the development of the Canadian financial system as many of the predecessors to modern day financial institutions were developed during this period and the public became comfortable with greater regulation and government intervention in the markets. This section explores the stakeholders and pressures, which shaped the early development of Canada’s financial system and provided the basis for the wide range of policies and recommendations suggested by the Porter Commission. Under the Bretton Woods system, Canada began to move away from its historical allegiances to the United Kingdom and cautiously entered the globalized economy. Despite supporting the establishment of the International Monetary Fund and World Bank on the international stage, Canada was originally cautious of ‘the extent to which fiscal and monetary measures can be used to restrain the kind of inflationary pressures that have existed in Canada since the outbreak of WWII’ (Royal Commission, 1949). However, by the time the Royal Commission on Canada’s Economic Prospects was convened in 1957, Canada had begun to accept a greater role for monetary policy in the government’s overall economic strategy. In the ten years following the end of the Second World War, Canada experienced rapid growth as the economy transitioned from wartime production to commercial ventures. This brought increased urbanization and dramatically increased the role of government. With the Great Depression still fresh in the minds of Canadians, government was expected to play an increasingly proactive role in overcoming the imperfections of the capitalist system, by establishing a comprehensive regulatory framework and institutions to prevent a similar meltdown, manage economic development, and provide for the needs of an increasingly urbanized society (Bradford, 1999). The Canadian government embraced these expectations by creating a strong social safety net as part of the post-­war nation building. However, this proactive role of government caused other stakeholders to assume more passive roles in Canada’s economic development (Bradford, 1999). The creation of the Industrial Development Bank in 1944 (forerunner to the Business Development Bank of Canada) and the Canadian Housing Corporation in 1946 (the forerunner to CMHC) was reflective of the pervasive role of government in driving post-­war economic growth. However, the costs of these programmes made them unsustainable and feasible for only a very short time. Consequently, these interventionist policies were replaced with indirect control through government regulations and the monetary system.

Canada   161 Although traditional Keynesian economics discouraged the use of monetary policy (as opposed to direct stimulus) to stimulate economies, the post-­war gold standard and newly established Bank of Canada, provided a novel avenue for government regulation of the economy (Shearer, 1977). The Bank of Canada dramatically grew in scope and expertise as its role in managing currency reserves and interest rates became increasingly multifaceted. Private banks benefited from the rapidly growing economy and favourable credit environment in the post-­war period. It was during the initial period of rapid economic growth that the current Big-­Five national banks dramatically expanded their asset base and national reach (Royal Commission, 1964). However, by the 1950s the post-­war boom levelled off and the capacity of government programming was reaching its limit. In 1954, the Bank Act was amended to give banks the ability to issue consumer loans secured by personal property. Since banks were no longer required to choose between higher-­risk, unsecured credit or rejecting an individual’s loan application, they were able to significantly expand their credit market, to diversify the nature and terms of the loans they offered, and to increase the extent to which capital could be leveraged. Secured lending also broadened the range of investment vehicles banks could prepare and the market for debt-­interest securities. Another major change made to the Bank Act allowed banks to have real-­estate mortgages insured through the Canadian Housing Corporation. Changing the mandate of the Canadian Housing Corporation from a mortgage company to an insurer helped the government privatize the mortgage market in a controlled manner, and expand the significance of banks and credit in the Canadian economy (Freedman, 1998). Despite the move towards increased acceptance of monetary policy and the emergence of modern secured lending, there was still a great deal of ideological ambiguity on the proper role of these new institutions. Regulation and financial institutions tended to be regarded as instruments that the government was free to use to affect Keynesian economic policies (Bradford, 1999), rather than having clearly defined and independent administrative functions. Although, much of the groundwork had been laid for a comprehensive regulatory system, the Canadian financial system lacked the unity required to implement effective regulations. Recognizing this shortcoming, the Royal Commission on Banking and Finance – the Porter Commission – was convened to provide the theoretical foundation for Canada’s financial system.

1964: The Royal Commission on Banking and Finance – the Porter Commission This section addresses the findings of the 1964 Royal Commission on Banking and Finance (Porter Commission), which framed the relationship between the Bank of Canada and the government and established the policy foundation for Canada’s present-­day financial regulatory system. The findings and recommendations of the Porter Commission provide the theoretical basis for Canada’s

162   P. Puri present-­day financial system and introduced neoliberal principles to Canada’s financial regulatory environment far earlier than in other jurisdictions. Further, the Porter Commission’s framing of the national interest as sovereign control over Canada’s financial institutions caused legislators to use share ownership limits and restrictions on foreign banking in Canada to help promote a strong, national banking sector. Central to the findings of the Porter Commission were the concepts that: 1 2 3

4

Canada should promote competition among financial institutions by regulating the structure rather than the conduct of financial institutions; Financial regulators should be independent from political interference in so far as they are implementing the policy of the government but are ultimately required to follow the policy directions of government; Financial regulation should be built upon the borrower-­lender relationship, thus the mandates of financial regulators should be harmonized to provide clear and effective protection for these parties; and Disclosure is the most effective method mitigating the risk factors inherent in any financial system, while protecting the independence of the free market.

In the early 1960s Canada was facing increasing pressure from foreign investment as the dramatic expansion of Canada’s financial system following the end of the Second World War and the 1954 liberalization of the Bank Act began to draw foreign capital into Canada at an alarming rate. In 1957, the Royal Commission on Canada’s Economic Prospects identified increased foreign investment as an emergent concern and highlighted its implications for Canadian nationalism and the risks to Canadian businesses and natural resources if Canada did not develop clear policy objectives for its financial system. In addition, there were also concerns at the time about the poor economic conditions that had taken hold in the late 1950s and early 1960s. Under pressure to provide reprieve for consumers and businesses, the government had maintained a post-­war policy of capping interest rates on bank loans at artificially low levels. However, the ‘flexible’ exchange rates that existed in the 1960s significantly limited the ability of the Bank of Canada to address issues of inflation, market stability, and foreign investment, which had been exacerbated by recent growth in the financial sector after 1954 (Fortin, 2010; Shearer, 1977). Consequently, strict monetary controls that were required to maintain this delicate balance of low interest rates had the effect of rendering the home mortgage market unprofitable for the chartered banks (Freedman, 1998). These tensions reached a tipping point in 1961 when Bank of Canada president, James Coyne, publicly disagreed with Prime Minster Diefenbaker’s economic policies, in particular the government’s decision to renew the interest rate caps on bank loans. The Porter Commission was convened in response to this crisis and was tasked with providing clarity and vision for Canada’s financial system. In preparing their report, the Commission was heavily influenced by

Canada   163 reports from the United States (Commission on Money and Credit) and the British (Radcliffe Committee). However, both reports were criticized for their failure to develop workable principles that could be directly incorporated into their jurisdictions’ regulatory framework (Slater, 1965). By contrast, the Porter Commission started from the assumption that no regulatory system can or should aim to fully protect all investors from all risks. Instead, efficiency and competition should underpin the regulatory system. This can best be achieved through a two-­pronged financial regulatory framework. First, the consumer protection regime should provide depositors with full disclosure of all information relevant to assessing the security of their deposits. Second, prudential regulations should govern the internal operations and structures of these organizations, so they are organized in a responsible manner that helps resolve imperfections in the system such as informational asymmetry and irrational evaluation of risk by investors. When these two regimes are satisfied, market forces will be able to efficiently select and allocate resources between market participants and guard against risk. Rather than advocate a full-­scale overhaul of the Canadian financial system, the Porter Commission reiterated the traditionally conservative approach of Canadian regulators and advocated ‘less sweeping modifications to existing practices’. Instead, regulators were encouraged to engage directly with the communities they serve and harmonize their efforts with other enforcement agencies, thereby affording them greater public legitimacy (Coleman, 1991). In this sense, the role of financial institutions, including the Bank of Canada, is seen to be a conduit for the public interest and therefore must comply with and implement the policies of the government of the day. This recognition of the relationship between regulators and the public at large also underscores the important role that financial regulators must play in considering and balancing interests that broadly fall within their statutory mandate. In developing their framework, the Porter Commission placed lending and borrowing at the core of the Canadian financial system. Within this model, banks are simply intermediaries that facilitate lender–­borrower relationships and enable credit arrangements that would not be possible on a party-­to-party basis (Slater, 1965). Other financial instruments and interests are also seen as radiating outward from this point. By focusing on how any particular action contributes to the core purposes of the financial system, regulators are better positioned to develop principles-­based regulations that provide a sound foundation for more technical and specific regulation of particular activities and instruments. Moreover, the instrumental role for the bank within this paradigm helps regulators effectively locate the appropriate balance when seeking to enhance efficiencies in the system or promote increased competition among financial institutions (Dodge, 2011). In 1967, the Bank Act was amended to incorporate the policy objectives of the Porter Commission. Increased competition among banks was encouraged by removing the 6 per cent ceiling on bank loans while at the same time prohibiting any collusion between banks on the interest rates they charge on loans or offer on deposits. Increased market liberalizations were also achieved by removing

164   P. Puri restrictions on the kinds of investments that banks were permitted to make and allowing banks to own other financial institutions, with the exclusion of trust companies. Despite strongly endorsing a free market approach, the 1967 amendments also included several amendments designed to promote fairness and the national interest. Foremost of these changes was a prohibition on any one person owning more than 10 per cent of the voting equity and an absolute limit of 25 per cent of the shares of the bank. This was designed to prevent self-­dealing and the monopolization of control over Canada’s financial institutions. Additionally, these changes made it far more difficult for foreign investors to acquire significant influence over Canadian banks (Freedman, 1998). Finally, deposit insurance was introduced to promote investor confidence and encourage investors to keep their wealth in Canadian accounts. The recommendations of the Porter Commission can be seen as forerunners to the neoliberal policies that were adopted worldwide during the 1980s. By embracing these principles fifteen years before the United States and United Kingdom, Canada was able to introduce these changes on an incremental basis, test their effectiveness, and develop a principles-­based regulatory framework that better responded to the needs of Canadians. Consequently, an understanding of the Porter Commission’s recommendations for sovereign control over Canada’s banking sector and the use of neoliberal policies provides a strong analytical framework for interpreting subsequent changes to Canada’s regulatory framework.

1965: Report of the Attorney General on Securities Regulation in Ontario – the Kimber Report Closely following the Porter Commission report was the Report of the Attorney General on Securities Regulation in Ontario (1965, known as the Kimber Report). Similar to the Porter Commission, the Kimber Report has served as the theoretical basis for securities regulation in Canada. This discussion of the Kimber Report highlights the similar use of disclosure as the basis of both the financial and securities regulation systems and the longstanding recognition of the regulatory gaps created when securities are provincially regulated and financial institutions are under federal jurisdiction, as seen in the 2007 ABCP crisis. Under the Canadian constitution, the trade of securities fall under provincial jurisdiction and is subject to separate enforcement regimes in each province. This disjointed approach was identified by the Porter Commission as a missing element in Canada’s ability to effectively harmonize and integrate the regulation of all financial regulators under a single umbrella. This principle was developed further by the 1965 Kimber Report, which addressed the matter more discretely from a securities regulation perspective. The Kimber Report was commissioned by the Ontario Attorney General in response to several high profile insider trading cases and the perceived inability of Canadian securities regulators to effectively regulate capital markets. In building

Canada   165 upon the findings of the Porter Committee, the Kimber Report emphasized the role that disclosure-­based regulation can play in promoting competition and using market forces to regulate corporate behaviour. The Report further emphasized the role of disclosure in enabling investors to make informed and rational decisions on where to invest their money and thereby promoting investor confidence. The similar policy rationales and commitment to free markets that the Kimber Report and the Porter Committee reflect have helped to overcome the jurisdictional divide between federal financial regulation and provincial securities regulation and helped ease the transition of banks into the investment industry in the mid-­1980s. The broad visions cast by both the Kimber Report and Porter committee for the future of financial and securities regulation also had the effect of encouraging the development of two comprehensive regulatory systems with substantial overlap. Consequently, given the expansive nature of both regulatory systems, collective action and choice of jurisdiction issues may emerge, thereby limiting the ability of the financial system to develop comprehensive responses to issues that involve both the banking and securities sectors. In response to these collective action problems, the Kimber Report discussed the possibility of creating a national securities regulator. In subsequent years, the idea of a national securities regulator created either at the federal level or by agreement among the provinces has received significant discussion and spawned a system of nationwide regulatory instruments. However, the inability to reach a consensus among the provinces has stalled significant progress towards a national enforcement model. The lack of a national securities regulator creates a jurisdictional gap that significantly limits the ability of federal regulators to guard against catastrophic failures emerging from the public stock market. As will be explored in greater detail in the discussion of the 2007 ABCP Crisis, volatility in the securities market leaves banks exposed to collapses in the securities market. Although the disclosure-­based system advanced in the Kimber Report mirrors the model for financial regulation outlined by the Porter Commission, both committees accurately identify the fact that any harmonization efforts will be limited by the ability of the jurisdictions to cooperate and the speed at which regulators can respond to emergent crises will be limited. Furthermore, a focus on the regulation of securities in isolation by the provinces risks moving the focal point of the financial regulatory system away from the Porter Commission’s lender–­borrower relationship and onto the way debt and equity-­based securities are traded. Consequently, a central challenge for Canada’s financial regulatory system is to indirectly address the externalities and risks created by the absence of a national securities regulator. The recommendations of the Porter Commission and Kimber Report fundamentally changed the nature of financial services and regulation in Canada. However, the abstract nature of the Porter Commission’s policy goals handicapped the ability of regulators to achieve the objectives of increasing competition and limiting foreign influence in the financial sector (Chant et al., 1976). Further, securities regulators were significantly limited in their ability to implement the recommendations of the Kimber Report because of the fragmented and

166   P. Puri duplicative regulatory systems required in each of the thirteen provinces and territories and the strict adherence to the four pillars of financial services. These tensions became more pronounced as Canada’s financial sector expanded throughout the 1970s and 1980s and contributed to many of the issues arising in the years to come.

The 1970s and early 1980s – growth and maturation In the 1970s and early 1980s, the Big-­Five banks began to assert their influence over financial markets, and as a result of the lack of effective domestic competition they were able to shift to a non-­price based competition model and develop a conservative business model which emphasized high profit margins and risk aversion. The ability of the Big-­Five to consolidate their near monopoly in the Canadian banking industry was largely driven by the rigid separation of the securities, trusts, and commercial finance companies from the chartered banks and the Bank Act’s outright exclusion of foreign banking institutions. These factors encouraged the development of a shadow banking industry, with foreign banks acquiring control over the more liberally regulated credit unions and trust companies, eventually forcing regulators to develop the substance-­based approach to regulating banking activities under the Bank Act originally contemplated by the Porter Commission. Although regulators superficially endorsed the principle of increased competition among financial institutions, competition was framed narrowly and did not consider the ability of non-­bank institutions to compete with banks in specific industries such as motor vehicle financing (Chant et al., 1976). In supporting the traditional four pillars model for financial regulation, it was argued that expanding the range of activities that banks were permitted to engage in would lead to an overall decrease in market competition (Galbraith and Guthrie, 1977). It was anticipated that rather than compete with commercial finance or trust companies, the large banks would simply acquire these corporations and eliminate any existing competition in these sectors. However, this also meant that banks were able to fortify their privileged relationship with consumers, as their primary provider of financial services (Dean and Schwindt, 1976). These limits also had the unintended consequence of discouraging consumers from exploring other banking institutions outside of the Big-­Five. By the end of the 1970s, the Big-­Five banks had expanded their market share to control over 90 per cent of Canada’s banking industry (Dean and Schwindt, 1976). The lack of competition within Canada’s banking industry enabled the Big-­Five to align their interest and lending rates with each other and achieve very high profit margins. In the ten years immediately following the 1965 Porter Commission, the growth of Canada’s large banks dramatically outpaced their American counterparts as well as provincially regulated credit unions (Nichols and Hendrickson, 1997). High profit margins, combined with a lack of domestic competition, encouraged Canadian banks to adopt a more conservative business model, which included more conservative lending policies and proportionately large capital

Canada   167 reserves. Thus, rather than accept increased risk by aggressively competing over an already captive market, Canadian banks developed a tendency to engage in non-­price based competition by focusing on brand loyalty and customer service (Dean and Schwindt, 1976). These anti-­competitive behaviours were facilitated by the ‘rudimentary’ disclosure laws and a deferential regulatory environment in place at the time (op. cit.). Despite the obvious weaknesses of this model from a consumer perspective, the lack of competition among Canadian banks caused Canada’s largest financial institutions not to feel the same pressures as their international colleagues to accept high risk loans or dramatically reduce their profit margins in order to attract consumers. This risk adverse environment encouraged Canadian banks to develop a conservative and self-­regulating culture that was instrumental in their ability to work with financial regulators to maintain stability in periods of economic hardship. The Porter Commission’s proposed limits on foreign investment were originally designed to promote the development of a strong domestic financial services sector and enable the Bank of Canada to more readily implement its monetary policies. However, these restraints had the unintended consequence of funnelling foreign investment into provincially regulated, ‘near-­bank’ institutions such as trust companies and credit unions. Although these ‘near-­banks’ were intended to service smaller, more localized interests, the influx of foreign investment created a shadow banking industry capable of competing directly with the chartered banks on a national scale. Thus the policy goal of enabling local deposit-­taking institutions, to incorporate without having to meet the high capital requirements of the chartered banks was superseded by the dramatically expanded market risk brought when foreign investment enabled ‘near-­bank’ institutions to expand to an unprecedented size (Owens and Guthrie, 1998). Further, these foreign owned ‘near banks’ were able to gain what was seen to be an unfair competitive advantage over more stringently regulated chartered banks. In response to the emergence of this parallel banking system, the government commissioned the 1976 White Paper on the Revision of Canadian Banking legislation. This paper called on legislators to enact a more substance-­ based definition of ‘bank’ within the Bank Act which focused on the nature of the service provided by these institutions and their relation to consumers (Dean, 1976). However proponents of the ‘four pillars model’ for financial regulation argued that liberalizing the range of activities that banks were allowed to engage in would destroy any currently existing competition in sectors that banks were not presently permitted to operate in and encourage conflicts of interests. Therefore, the 1980 Bank Act amendments attempted to broker these two positions by expanding the definition of ‘bank’ to focus on the nature of the services provided and clarifying the range of services that banks were permitted to engage in. This had the effect of bringing foreign banks within the definition of ‘bank’, and thereby precluding their ability to gain control of provincially regulated trust and deposit-­taking institutions (Owens and Guthrie, 1998). Foreign banks operating in Canada were given the option to be chartered

168   P. Puri under either Schedule II or Schedule III of the Bank Act. These new schedules imposed different regulatory frameworks on foreign banks depending on the nature of the services they offered in Canada. Foreign banks could either choose to operate branch offices under Schedule III, or accept more stringent regulation, similar to that of the domestic banks if they wished to offer a full range of financial services. Through these reforms, regulators were provided with the machinery necessary to effectively regulate this shadow banking industry and parliament affirmed its commitment to a principles-­based approach to bank regulation in Canada. The 1970s helped to firmly establish the hallmark conservative tendencies of Canadian banks and regulators. The lack of meaningful competition in the banking industry enabled the Big-­Five domestic banks to develop the conservative lending practices that facilitated their economic stability. By the time the federal government allowed foreign banks to compete with domestic institutions, the ‘Big-­Five’ were already firmly established with consumers. However, the 1980 amendments remain significant because they affirmed the Porter Commission’s recommendation for a unified, principles-­based financial regulatory system and established the broad scope of present-­day financial regulation.

1985–1986: The Estey Commission and collapse of Canadian Commercial Bank and Northland Bank The 1985 collapse of Canadian Commercial Bank (CCB) and Northland Bank and subsequent Commission of Inquiry provided the first true test for Canada’s financial regulatory system and forced both regulators and banks to make changes to ensure that similar events and risk factors did not threaten Canadian banks in the future. These events provided four clear lessons for the Canadian financial system. First, it highlighted the vulnerability that can arise when banks are highly invested in a single market. Second, it demonstrated that no risk should be treated as safe and encouraged regulators to implement specific leverage and risk-­adjusted capital limits. Third, the Canadian government’s refusal to bail out these institutions with public money set a clear precedent for future events. Finally, the collapses demonstrated the shortcomings of Canada’s regulatory framework, in particular the limited powers of the Office of the Inspector General. As a result of the far-­ reaching changes that followed the Estey Commission’s report, Canada’s regulatory framework received the institutional reconfiguration and resources required to respond to the challenges of the modern economy. The 1986 Commission of Inquiry into the Collapse of Canadian Commercial Bank and Northland Bank (Estey Commission), highlighted many of the shortcomings of the existing oversight mechanisms designed to review the audited financial statements of banks and monitor risk in Canadian financial institutions. The collapse of Canadian Commercial Bank and Northland Bank strengthened the risk-­averse attitude of Canada’s financial regulators and national banks, and demonstrated the need for a full and plain risk profile for all financial institutions. This was achieved by replacing the Office of the Inspector General of Banks

Canada   169 with the Office of the Superintendent of Financial Institutions, which was given broader powers to set prudential regulations and the discretion to manage the risk and leverage profiles of individual banks. Further, the Canadian Deposit Insurance Corporation was empowered to intervene as a receiver in the event that a bank is nearing the point of insolvency. These reforms and the temporal proximity of the collapse of CCB and Northland Bank to the Basel I accords is highly significant, as it is likely they influenced Canada’s decision to mandate that Tier 1 capital consist of 75 per cent common equity and retained earnings for the purposes of assessing capital adequacy requirements, and impose a simple, non-­risk-adjusted, leverage ratio on Canadian banks. The Estey Commission found that the collapse of CCB and Northland Bank was due to serious misrepresentations of the status of various assets within these banks. Although external auditors were employed by the banks to review their books, they failed to probe into irregularities, including the extensive use of warehouse loans, and examine the implications that would arise when these loans came due. This oversight was perpetuated by the general ‘wink and nod’ practice employed by the Office of the Inspector General of Banks, which tended to rely on the external auditor’s reports as the basis of its regulatory activities instead of conducting any additional due diligence of its own (Giammarino et al., 1989). Further, the Estey Commission noted that these banks were highly vulnerable because their loan portfolios were concentrated in the Alberta and British Columbia real estate and energy markets. Thus, when these markets went into recession, the risk held by these localized banks was dramatically magnified. In reviewing the conduct of regulators and auditors, the Estey Commission was critical of the lack of formal guidelines for auditing and reporting financial statements. This ambiguity enabled the banks to mislead both the markets and regulators by manipulating the flexible standard of ‘market value’ when preparing disclosure (Giammarino et al., 1989). The Estey Commission concluded that auditors should adhere to the General Accepted Accounting Principles; however, specific principles should be developed for banks, which require auditors to expressly note any material discrepancies or shifts in management’s financial reporting (Waterhouse, 1988). The intention of these reforms was to better enable auditors and other oversight agencies to take a proactive role in reviewing the prudential management and changes in organizational structure of banks, instead of simply responding to anomalies after they arose (Waterhouse, 1988). Thus, it was suggested that auditors and regulators review financial statements anew and clearly disclose any changes in the bank’s financial structure, regardless of whether they are perceived to simply be a product of management’s discretion in operating the bank or indicative of more significant financial issues. The second major concern raised by the Estey Commission was the moral hazard created by the Canadian Deposit Insurance Corporation’s (CDIC) guarantee on bank deposits. Despite suggestions from the Canadian Deposit Insurance Working Committee to adopt flexible insurance rates, the CDIC charged all banks on the same fee schedule regardless of their risk profile (Giammarino et al., 1989). These two factors were seen to create a disincentive for banks to

170   P. Puri effectively manage risks and investors to conduct due diligence. This, in turn, resulted in risk not affecting the price of financial services offered by banks (Smith and White, 1988). In canvassing the range of possible solutions to this moral hazard, the Estey Commission considered the American deposit insurance model, which forces consumers to assume greater risk and emphasizes the role of the private sector in acquiring insolvent banks. However, such an approach was found to be ill suited to the Canadian market because of the size of the Big-­Five banks and concentration in the banking industry. It would be near impossible to find a suitable private sector buyer in the event that one of these banks became insolvent (Smith and White, 1988). Second, the Estey Commission preferred enhanced consumer protection over risk distribution. It was concluded that the unsophisticated consumer is likely to place full reliance on the approval of regulatory agencies and is unlikely and often incapable of conducting sufficient due diligence to accurately identify potential weaknesses in the bank’s financial position (op. cit.). Finally, the Estey Commission was critical of the Office of the Inspector General and Bank of Canada’s proposed government and industry-­backed bailout of CCB and Northland Bank. The Estey Commission found that regulators lacked the necessary regulation, resources and expertise to implement such a bailout and found that the information provided to government agencies and the management of Canada’s major banks was ‘inadequate for the guidance of the meeting in the decision to rescue the bank or allow it to fail’ (Estey Commission 1986). Therefore, the Estey Commission recommended that regulators develop the requisite expertise to be able to properly structure comprehensive rescue techniques if such a situation were to arise in the future. Further, it was recommended that regulators retain more detailed records of the banks’ loan portfolios for long-­term monitoring and to provide parties interested in participating in a bailout with comprehensive disclosure of the insolvent bank’s financial assets. Consequently, in the years following the collapse of CCB and Northland Bank, regulators were able to prepare for and develop policies for responding to banking crises in a timely manner. In response to these concerns with the CDIC, the Estey Commission (1986) amended the mandate of CDIC to enable ‘direct examination . . . of the quality a bank’s loan portfolio, particularly where a bank is emitting trouble signals’. This was intended to add an additional layer of protection to the existing regulatory framework and establish the CDIC as an advocate for the interests of unsophisticated depositors. The Estey Commission recommended the Office of the Inspector General be merged with the CDIC to enhance communication and cooperation within the financial regulatory system. These changes were implemented in the 1987 legislative amendments resulting in the creation of the Office of the Superintendent of Financial Institutions (OSFI). This office was designed to centralize prudential regulation within a single office and enhance the capacity of regulators to scrutinize the financial disclosure of banks. The lessons learned from the collapse of the CCB and Northland Bank influenced Canada’s adoption of the Basel I accord in 1988. Central to the collapse of

Canada   171 these institutions was the treatment and presentation of risk within a financial institution. The failure of these banks clearly indicated to Canadian regulators that not all risk can or should be treated as a constant. The recession in western Canada in the early 1980s illustrated to regulators how investments that were once deemed to be relatively safe can rapidly deteriorate with changes in the economic cycle, particularly when those assets are concentrated in a particular industry (Booth, 2009). Regulators were acutely aware of the variable nature of risk and the role it can play in dramatically impacting a bank’s solvency. It was in this context that Canadian regulators decided to introduce a non-­risk weighted leverage ratio to Canada’s regulatory framework and restrict the ability of banks to remove certain assets from their balance sheets. Canada has traditionally favoured providing investors with a full picture of a bank’s capital reserves. In implementing the 1988 Basel I Capital Accord, Canada did not permit banks to use a risk-­adjusted measure of capital to discount the total assets on a bank’s balance sheet (Bordeleau et al., 2009). This decision reflects the legacy of the CCB and Northland Bank collapses, where what were originally regarded as low risk mortgages and loans to the natural resource sector became extremely vulnerable by the recession in western Canada and thereby forced western Canadian banks to absorb massive, unanticipated losses. Canadian regulators have chosen to regard a bank’s risk profile as time-­specific and flexible indicia that OSFI will consider on a case-­by-case basis when confidentially establishing a bank’s individual leverage ceiling. This confidential target is used to provide regulators with greater independence in setting leverage targets and to avoid undue market reactions concerning changes in a bank’s leverage target or a regulator’s assessment of their risk profile (Freedman, 1998). To provide consumers with a complete picture of a bank’s assets and exposures, Canadian leverage ratios are met in relation to the bank’s total assets, rather than using a risk-­weighted calculation, which may distort a bank’s true liquidity and mislead consumers (Bordeleau et al., 2009). Further, Canadian regulators have since strengthened the risk-­adjusted capital adequacy requirements under Basel II by requiring banks to hold 7 per cent Tier I capital (as opposed to 4 per cent under the Accord), which must be composed of 75 per cent common equity and retained earnings, thereby limiting the ability of banks to use high grade investment products to dilute their Tier I capital reserves. This approach to leverage and capital adequacy requires Canadian banks to maintain proportionately larger and higher quality capital reserves than their international colleagues, and limits the vulnerability of Canadian banks to macro-­economic shifts, which tend to have a large impact on the default rates of what were initially considered to be low-­risk investments (Northcott et al., 2009). Consequently, Canadian banks are in a much stronger position to absorb unanticipated losses than jurisdictions that have developed capital adequacy standards that are intended to protect against losses emanating from a bank’s more volatile investments. The lessons learned from the collapse of CCB and Northland Bank and the recommendations of the Estey Commission greatly influenced the Government’s

172   P. Puri position in the adoption of the Basel I Capital Accord. Through this experience, regulators and banks realized that not all risk should be treated similarly, nor should banks be allowed to treat certain risk as safe. Thus the use of a specific, non-­risk weighted leverage ratio encouraged banks to manage their risk and adopt a more diversified portfolio. Finally, through the creation of OSFI and the strengthened mandate of CDIC, regulators were placed in a stronger position to verify the financial disclosure provided by banks and ensure the long term stability of Canadian banks. Although the collapse of CCB and Northland demonstrated the risks of a narrowly held portfolio and the government’s unwillingness to bail banks out of financial hardship, the Big-­Five banks experienced the consequences of being highly invested in a single source, first hand, when real-­ estate giant Olympia & York filed for bankruptcy in 1992.

1987 and 1992 Bank Act amendments – bank ownership of investment dealers In 1987, Canada allowed banks to acquire ownership of investment dealers – twelve years prior to the repeal of the Glass–­Stegall Act in the United States in 1999. Following these amendments, Canadian banks acquired the majority of large investment dealers in Canada, further consolidating control of Canada’s financial services industry in the Big-­Five banks. Consequently, unlike private banks such as Lehman Brothers and Bear Stearns in the United States, the merged commercial and investment banks in Canada became subject to regulation by both provincial securities and federal banking regulators (Puri, 2009). This section will explore how the partnership between investment and large commercial banks has increased the stability of Canadian lending and securities markets and mitigated the risks of collective action problems in responding to potential runs in the stock market. After the Great Depression, Canada followed the lead of the United States’ Glass–­Stegall Act by barring commercial banks from directly owning investment houses or controlling them indirectly through a subsidiary. Traditionally, commercial and investment banks were seen to serve distinct purposes in the market. Thus, in an attempt to guard against potential conflicts of interests and collusion, the separation between the four pillars of the financial services industry was stringently enforced. Although banks were permitted to own securities for their own portfolios they were not permitted to underwrite the distribution of securities or provide investment counselling to consumers (Freedman, 1998). However, as the global economy began to accelerate in the 1970s and 1980s, banks became increasingly involved in short-­term financing and syndicated loan markets. This shift in the lending activities of banks made it increasingly inefficient to restrict the ability of banks to securitize these loans and distribute these assets on public markets. In the securities market, investment dealers had taken to financing their clients’ securities purchases directly rather than relying on bank credit, thus further blurring the divide between investment banking and commercial banking (Freedman, 1998). The expanded lending activities of

Canada   173 investment houses had the effect of increasing their exposure to market shifts without adequate capital reserves to withstand these downturns. Therefore, the consolidation of these two industries enabled the Canadian securities market to benefit from the financial stability of Canada’s commercial banks. In order to promote Canada’s competitiveness on the international stage and domestic stability, the federal government and provincial securities regulators liberalized banking and securities legislation to permit banks to more fully engage in the securities market. In 1987, limitations on the ability of financial institutions to own shares in investment houses began to be progressively phased out. In 1992, the conflict of interest provisions in the Bank Act were relaxed to allow banks to create investment bank subsidiaries, participate in the distribution and underwriting of securities, and offer investment counselling services that were traditionally provided by investment houses, trust companies, and insurers. This had the effect of temporarily increasing competition in the marketplace as banks were forced to compete with one another in an effort to provide comprehensive financial services to consumers. However, soon after the limitations were removed, the Big-­Five Canadian banks merged with Canada’s major investment dealers. With the exception of a few private investment banks, Canada’s investment banking industry is, unlike the United States, presently managed by the large commercial banks and thus is indirectly subject to regulation by both securities and banking regulators (Puri, 2009). One of the primary consequences of the mergers between commercial and investment banks was that Canadian banks direct ownership of and responsibility for their investment portfolio’s risk. Unlike the United States, where these interests can be assigned to and securitized by a large investment bank, Canadian banks have chosen to undertake these activities in-­house, through a subsidiary (Freedman, 1998). This development promoted greater conservatism in Canadian lending behaviour and fund management, more diversity within a financial institutions portfolio, and reduced the risk of collective action problems arising from a financial crisis in the securities market (Booth, 2009). In addition to the structural reforms, two other notable amendments were made in 1992. First, the federal government codified the general practice that Canada’s federal financial legislation would be reviewed and amended in five-­ year intervals. This provides greater predictability for Canadian banks and helps mitigate the potential for short-­term political interference in the banking sector. Second, despite the broad liberalization of permitted banking activities, strong lobbying by industry-­specific commercial financing companies such as the automotive financing sector prevented banks from being able to acquire downstream links to commercial companies (Harris, 2004). This decision reveals that despite the massive economic clout of the Big-­Five banks in Canada, the federal government sought to maintain a balance between all various economic players (Harris, 2004).

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1992 Olympia & York bankruptcy The 1992 bankruptcy of Canadian-­based real-­estate firm Olympia & York provided the first major test for Canada’s Big-­Five banks, and in particular the Royal Bank of Canada and Canadian Imperial Bank of Commerce, who were highly exposed as major creditors and investors to Olympia & York. Upon insolvency, Canada’s Big-­Five banks held over $2.3 billion of the nearly $17 billion outstanding liabilities declared by Olympia & York upon bankruptcy in 1992 (Ghosh et al., 1994). These loans were largely tied to Olympia & York’s Canadian real estate holdings and development of Canary Wharf in the Great Britain. Although Canadian banks were highly exposed in this international bankruptcy, the Canadian government adopted a hands-­off approach by refusing to guarantee payments from Olympia & York’s Canadian holdings to the Canadian banks. The directed exposure of the Big-­Five to Olympia & York’s bankruptcy forced Canadian banks to re-­examine their commercial lending practices in order to limit their single source exposure and develop new risk assessment models to better adjust for unanticipated shifts in the risk of their core holdings. Canadian banks incurred significant losses in the collapse of Olympia & York. However, the overall impact on their financial health and investor confidence was mitigated by the contagion effect, which dispersed losses in the bond markets and share value internationally rather than having the market’s reaction coalesce around Canadian banks (Ghosh et al., 1994). Consequently, all of the Big-­Five Canadian banks showed a profit in the foreign exchange market in the quarter following the collapse (FX Week, 1992). The reaction of global markets is extremely telling because it reveals a tendency on the part of international investors to retain their Canadian holdings during a financial shock, rather than bearishly withdrawing their investments upon the first sign of instability. This behaviour may be due to the concentration in the Canadian banking industry. Since investors in Canadian banks have fewer options in where they invest their money, they are forced either to maintain their position in the face of volatility or fully withdraw their Canadian holdings. Thus the lack of choice for investors in Canadian banks helps promote stability in these financial institutions. The bankruptcy of Olympia & York provided two clear lessons for Canadian banks. First, it demonstrated the risk associated with having a large percentage of their loan portfolio in a single venture and caused banks to re-­examine their lending policies (FX Week, 1992). Second, the refusal of the government of Canada to intervene to assist the banks during the bankruptcy set a clear policy precedent that the government will not bail out large banks if their loans default. Thus the collapse of Olympia & York encouraged greater independence and accountability by Canada’s large financial institutions and encouraged them to develop internal risk management protocols similar to what would be required under the 2004 Basel II Capital Accords.

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MacKay Report on bank mergers and 1997 Bank Act amendments on foreign branch banking in Canada In 1997 the Bank Act was amended to permit foreign institutions to operate full service bank branches in Canada for the first time. This, combined with the federal government’s rejection of the proposed mergers of Royal Bank of Canada with the Bank of Montreal, and Toronto Dominion Bank with the Canadian Imperial Bank of Commerce in 1998, marked a shift in the policy of bank regulation that saw a greater emphasis on consumer choice and competition in all areas of the financial services industry and caused regulators to become more accepting of the role Canada’s Big-­Five banks play in promoting stability in the marketplace. In addition, this section indicates how Canada’s policy of allowing foreign banks to engage in full service lending based on their total global assets caused Canadian firms to export their loans to more risk-­tolerant markets and how the prohibition on large bank mergers encouraged domestic banks to maintain their more traditional, conservative banking roles. As part of its five-­year legislative review in 1997, the Department of Finance sought to recast the Porter Commission goals of increasing competition in the financial services sector by placing increased emphasis on maximizing consumer choice and efficiency in the financial services marketplace (Harris, 2004). Because of the government’s experience with the deregulation of investment bank ownership rules, legislators were hesitant to equate the expansion of banking activities with increased competition in the financial services industry. Thus, Finance Minister Paul Martin indicated that the government would not permit banks to expand into new markets such as vehicle leasing and financing (Harris, 2004). Following Martin’s lead in preparing their recommendations for legislative reform, the Senate Standing Committee on Banking, Trade, and Commerce focused bringing Canada into compliance with the financial institutions provisions of the General Agreement on Tariffs and Trade and North American Free Trade Agreement, and on enhancing the ability of foreign banks to fully participate in Canadian markets (Senate Standing Committee on Banking, Trade and Commerce, 1996). In 1999 the government permitted foreign banks, with prior ministerial approval, to offer loans based on their total international assets and to take ‘wholesale’ deposits of $150,000 from ‘financially sophisticated’ investors, whose investments were too large to be guaranteed by the CDIC. Unlike foreign bank subsidiaries under Schedule II of the Bank Act, these newly established Schedule III institutions were not subject to Canadian corporate governance standards and were able to operate with smaller capital reserves and more limited reporting requirements. These reforms were designed to promote global competition in Canadian lending markets by removing barriers for foreign banks wanting to offer credit in Canada and integrating Canadian financial markets into the global economy, without compromising consumer protection or the stability of the Canadian financial system (Senate Standing Committee on Banking, Trade, and Commerce, 1996). In addition, foreign banks sought to capitalize on

176   P. Puri the weaker Canadian dollar, which made it profitable for American institutions to lend to Canadian firms at discounted rates while discouraging Canadian banks from engaging in high-­risk international investments (Booth, 2009). These reforms ultimately created a two-­tiered lending market, which more broadly distributed credit risk, while concentrating deposits in Canada’s major financial institutions. The findings of the Task Force on the Future of the Canadian Financial Services Sector (MacKay Report) were intended to complement the foreign banking reforms proposed by the Senate Standing Committee on Banking, Trade, and Commerce. The Task Force had an extremely broad mandate to explore matters beyond Canada’s structural regulation of the financial system, in particular the industry’s ability to service the future needs of Canadians. In its 1997 Interim and 1998 Final Reports, the Task Force identified serious concerns with the ability of Canada’s highly concentrated banking system to provide adequate choice and a full range of financial services to Canadian consumers. Without robust domestic competition among financial institutions, the Task Force felt that the national banks would reduce the range of services offered to maximize profits. Consequently, the Task Force promoted adoption of a general policy that would encourage the development a vibrant community-­based banking sector to offset the Big-­Five banks, prohibitions on mergers among Canada’s large financial institutions, and a requirement that Canada’s national banks be widely held. These conclusions provided detailed justification for Finance Minister Martin’s decision to agree with the Competition Bureau’s recommendation and rejected the merger of four of Canada’s Big-­Five financial institutions. Following the proposed mergers, the Task Force was asked to review its 1997 Interim Report and give specific consideration to the issue of bank mergers in Canada. A central issue in the proposed mergers was the size of the resulting financial institutions. Had these mergers been successful, the two institutions would have been among the largest banks in the world (Legault, 1998). Given Canada’s relatively small population of 30.2 million, these world-­leading banks would have been grossly disproportionate to the domestic demand. Moreover, in reviewing the role of Canada’s Big-­Five banks, the Task Force indicated that these institutions occupy a privileged place in the Canadian market due to their capacity to influence the underlying Canadian economy and near monopoly status. Building upon the findings of the 1985 Green Paper on the Regulation of Canada’s Financial Institutions, the Task Force argued that competition and widely held ownership of Canada’s banking system was necessary to prevent collusion and manipulation of Canada’s financial system by either domestic or international actors. Consequently, the Task Force recommended amending the 10 per cent share-­ownership limits under the Bank Act, to impose a new rule preventing a person from jointly or in concert with others, exercising ‘control’ over the operation of a large bank. Although the primary justification for prohibiting the 1998 mergers of Canada’s Big-­Five banks was to protect competition, the decision also had benefits

Canada   177 from a regulatory perspective. First, cooperation and integration among the five large national banks facilitates self-­regulation and an entente among these actors. The emergence of two large national banks could offset this symmetry, promote polarized views on Canada’s regulatory approach, and give rise to collective action problems. Second, this fundamental shift in Canada’s financial system would have imposed significant financial strain on regulators who given their present funding, might lack the resources to effectively scrutinize such large institutions (Legault, 1998). Finally, the finance minister’s decision forced Canadian banks to adopt a more restrained position in entering global markets as opposed to following more bullish growth patterns of UK banks such as the Royal Bank of Scotland (Booth, 2009). Although the MacKay Report’s focus on expanding the number of small, community-­based banks was ultimately overshadowed by its commentary on large bank mergers (Harris, 2004), the Bank Act was amended in 2001 to provide for new ownership regimes based on size and enhanced disclosure requirements. These changes provided the minister with increased powers and the discretion to determine whether a bank with assets over $5 billion is widely held and also allows banks with $1–5 billion in assets to be closely held if prior ministerial approval is received. The requirement for large banking institutions to be widely held effectively blocked future mergers of the large- and medium-­sized banks and clarified the minister’s role and function in reviewing bank mergers (Keefe and Johnson, 2002). Under present legislation, the minster has the final authority to either approve or deny a proposed merger after reviewing the market impact analysis from the Competition Bureau and the OSFI’s review of the potential impact on the health of the financial system. Finally, the Financial Consumer Agency of Canada (FCAC) was established in 2001 to assist OSFI in enforcing the consumer protection elements of Canada’s regulatory framework and monitors the self-­regulating activities of the banks. The FCAC also serves as a consumer advocate and public interest watchdog by directly negotiating with banks to ensure the interests of consumers are considered in any strategic changes or branch closures, and requires banks with equity over $1 billion to publish annual statements describing their contribution to the Canadian economy and society (Keefe and Johnson, 2002). The changes to Canada’s financial system in the late 1990s allowed consumers to scrutinize and gain a better understanding of the activities of Canada’s large financial institutions and provided a model for incorporating consumer interest that has been followed by other jurisdictions including the United States. More importantly, they indicate a recognition and acceptance of the major role Canada’s large national banks have in Canadian society and the willingness of Canadian regulators to work cooperatively with these institutions to maintain their long-­term sustainability and the economic stability of Canada’s financial markets. Consequently, the changes in this period can be seen as coming to terms with the structure of Canada’s financial marketplace and fostering the cooperative relationship necessary to effectively implement the Internal Rating Based Approach of the Basel II Capital Accord.

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2004–2007: Implementation of the Basel II Capital Accord The traditionally conservative nature of Canadian banks made them well suited to assume increased responsibility under the 2004 Basel II Capital Accords. In moving towards an internal ratings based, risk-­adjusted capital framework, Canadian banks were not required to make significant changes to their portfolios. Instead, Canada’s existing regulations and the standard practices of the Big-­ Five banks were similar to the requirements of the Basel II Capital Accord. Consequently, the Basel II framework was primarily a shift in the way banks reported their assets and a formalization of their internal risk management protocols. Further, given the concentrated nature of Canada’s financial services industry, the stringent international banking provisions of the Basel II Capital Accord applied to the majority of banking activity within Canada rather than a select few internationally active institutions (Dupuis, 2006). This section will discuss how the culture of Canada’s banking system and OSFI’s superadded regulations designed to complement the 2004 Basel II framework placed Canadian banks in a strong position to absorb the shocks of the financial crisis. From the Canadian perspective, the defining element of the Basel II Capital Accord was the requirement that banks play a more proactive role in evaluating their internal risk factors. Although this approach offers a more comprehensive picture of a bank’s individual risk factors, its effectiveness is ultimately contingent on a bank’s intimate understanding of how these risks impact their particular organization (White, 2009). Canada’s incremental approach to regulatory reform and the lessons learned from the collapse of Canadian Commercial Bank and Northland Bank, and the Olympia & York bankruptcy caused Canadian banks to develop a more detailed understanding and conservative treatment of their institutional and portfolio risks. More importantly, the Basel II framework fit with a broader trend on the part of Canadian banks towards less volatile holdings such as government bonds and insured loans, and a dramatic reduction in their corporate loan exposure, from 90 per cent in 1989 to 50 per cent in 2002. By contrast, the corporate loan exposure of American banks had remained constant around 60 per cent during this period (Illing and Paulin, 2005). This shift in the assets of Canadian commercial banks was complemented by OSFI’s corporate governance guidelines, which called for a clear distinction between the audit and risk management policies and procedures of financial institutions. Thus by the time the Basel II framework was developed, Canadian banks already had in place strong risk management frameworks, which only required modest improvements in order to implement the Accord’s Internal Rating-­Based Approach (IRB) for evaluating a bank’s internal risk factors. Additionally, from the regulatory perspective, Canadian officials had the resources and infrastructure in place following the findings of the Estey Commission to independently verify the disclosure being made by Canadian banks under the new IRB (Ford, 2010). The concentration in Canada’s financial services sector also made the implementation of the Basel II framework far more efficient and effective. Since the Basel II Accord applies primarily to internationally active banks and allows

Canada   179 smaller domestic banks to be regulated under less rigorous standards, large segments of the financial services industry may operate outside of the Basel II framework in highly diversified economies. However, since Canada’s large national banks hold over 90 per cent of the market share, the vast majority of the financial services were governed by Basel II (Dupuis, 2006). Consequently, there is less risk of Canada’s financial system being exposed to a bank run emanating from smaller, less stringently regulated institutions. Finally, in implementing the Basel II Capital Accord, OSFI maintained an additional layer of regulation designed to buttress against market cycles and ensure the quality of Canadian banks’ capital reserves. OSFI recognized both the potential benefits and limits of risk-­adjusted capital under the Basel II Capital Accord. When all risks are known, this measure provides an effective measure for incentivizing banks to diversify and act prudently, and provides a degree of cyclicality in a bank’s capital reserve requirements. However, as indicated by current Bank of Canada Governor, Mark Carney, the accuracy of risk-­adjusted capital is limited by our knowledge and perception of what is in fact a safe asset and what is a potential risk (Senate of Canada, 2010). If a large class of assets are downgraded in an economic downturn a bank may fail its capital adequacy requirement when it cannot obtain sufficient common equity to meet these increased standards (Illing and Paulin, 2005). Thus in order to mitigate against these cyclical tendencies, Canadian banks have been required, since the 1980s, to meet individually established leverage ratios based on their total, non-­riskweighted assets to Tier I and Tier II capital reserves. The continued use of a simple leverage ratio combined with OSFI’s requirement that Tier I capital be composed of 75 per cent common equity and retained earnings ensures that the capital reserves of Canadian banks are able to serve their intended purpose of providing liquid, loss bearing capital, which can effectively absorb financial shocks (Senate of Canada, 2010). Thus when the economy first began to show signs of the financial crisis in early 2007, Canadian banks had well-­diversified portfolios, strong risk-­management protocols, and highly liquid reserves capable of absorbing the coming economic shocks.

2007: The Asset-­Backed Commercial Paper crisis The well-­balanced financial sector and regulatory framework developed in Canada over the past sixty years ensured that the banking sector was in a strong position at the start of the financial crisis and able to absorb external market shocks. However, despite this stringent regulation, Canadian banks were not able to completely insulate themselves from the dramatic collapse in investor confidence and trading activity that followed from the emerging crisis in the United States. This vulnerability was particularly evident in the August 2007 Asset-­ Backed Commercial Paper (ABCP) crisis, which exposed how Canada’s financial system could be undermined by market runs and tested the ability of Canadian banks to take corrective action to contain the crisis before it could spread to other segments of the financial sector.

180   P. Puri Following the American sub-­prime collapse, Canadian investors began to question the security of the ABCP they were holding. Similar to the situation in the United States, the ABCP market in Canada was largely unregulated and the institutions securitizing these products were not required to issue a long-­form prospectus detailing the assets underlying this commercial paper. As investor confidence declined and demand for these products slowed, issuers became unable to pay out the ABCP when it matured and roll over the maturing notes. In order to prevent widespread defaults, Canadian banks intervened to freeze the $32 billion in non-­bank sponsored ABCP market for sixty days to allow time to restructure the market. Despite the initial reluctance of some Canadian banks to intervene in the non-­bank sponsored ABCP market, consensus was eventually reached with the Pan-­Canadian Investor Committee, agreeing to purchase the non-­bank sponsored ABCP (Covitz et al., 2009). However, when Canadian banks attempted to make an insurance claim for the losses incurred on the $84 billion in bank-­sponsored ABCP they had voluntarily reclaimed, their claim was denied as the decision to freeze the ABCP market was deemed not to be a ‘total market disruption’; rather the liquidity crisis was said to have affected only to the $32 billion in non-­bank sponsored ABCP. Therefore Canadian banks were forced to accept significant write downs on their $84 billion in bank-­sponsored ABCP and invest considerably in the purchase of non-­bank sponsored notes. Nevertheless, this timely intervention proved successful in that it helped bolster confidence and provide stability to Canadian financial markets until a more comprehensive solution could be reached. The Pan-­Canadian Investor Committee eventually entered into a court-­approved restructuring for the ABCP market which guaranteed all investors with less than $1 million in total holdings a full return on their investment and provided for a full release from liability. Consequently, Canadian banks have been able to avoid the costly and highly publicized class action lawsuits that have beleaguered American financial institutions. Following this restructuring, the ABCP purchased by Canadian banks was resold to investors and presently trades at between 50–75 per cent of its prior value. Although Canadian banks were not as severely impacted by the 2007 ABCP market collapse as in other jurisdictions, the crisis nonetheless revealed several shortcomings in Canada’s financial regulatory framework. Similar to other jurisdictions, Canadian banks were allowed to place ABCP in their off-­balance-sheet accounts. As a result, they were not required to maintain capital reserves against these assets (Chant, 2009). The treatment of all ABCP as similar, low-­risk investments highlights the failure of Canadian securities regulators to fully appreciate the complexity of the derivatives market. Second, the ability of the ABCP collapse to directly impact the financial markets underscores the regulatory gap that was created when federally regulated banks were allowed to sell and guarantee their ABCP in provincially regulated security markets, which exempted both bank and non-­bank sponsored ABCP from the full prospectus requirements. The lack of harmonization and integration between financial and securities regulators and the lack of disclosure on these notes may have exacerbated the market speculation that caused the run in ABCP markets.

Canada   181 The ability of Canadian banks to take aggressive action in the early days of the financial crisis was possible because of their highly liquid capital reserves and the concentration of Canadian financial markets. Although Canadian banks held ABCP as off-­balance-sheet assets, they had sufficient liquidity in their existing capital reserves from on balance sheet assets and as a result of the leverage ratio requirements they were able to quickly access the capital required to freeze the ABCP market. This intervention was possible because of the size of Canadian banks, the diversity of their investment portfolios, and the willingness of all major financial institutions to work cooperatively. Had Canadian financial institutions been more specialized in particular market segments, similarly to the United States, they may have lacked the capital reserves to fully guarantee these investments. The concentration of Canada’s financial system under the umbrella of the Big-­Five banks helped offset the weakness in the financial sector and enabled Canadian banks to take ownership for their financial products. The willingness of Canadian banks to intervene to stabilize the ABCP market is also attributable to the customer service and reputation-­based competition in Canada’s financial markets. Because ABCP was regarded as a conservative investment and held by many institutional investors such as government, corporations, and pension funds, the banks sought to mitigate the negative publicity from the market collapse (Chant, 2009). Therefore, the timely response of Canada’s financial institutions to the ABCP crisis demonstrates how both Canada’s regulatory environment and the industry culture have played key roles in promoting economic stability and prudent financial management.

Conclusion This chapter has sought to explore the development of Canada’s financial sector and regulation since the end of the Second World War with a view to identifying the reasons underlying the strong performance of Canada’s banks in the 2008 recession. Based on the preceding discussion, three principal themes can be established. First, despite dramatic developments over the past forty-­five years, financial regulators have remained committed to the 1964 Porter Commission goals of efficiency, competitiveness, and independent prudential regulation. This has provided market participants with a consistent and predictable regulatory environment to operate in and fostered a congenial relationship between regulators and banking institutions. Second, historically and as a result of contemporary developments such as the collapse of Canadian Commercial Bank and Northland Bank in 1985, Canadian banks and regulators tend to behave conservatively and have avoided excessive risk taking in search of increased profitability. This conservative behaviour has also been reflected in the diversified holdings of Canadian banks, use of a simple leverage ratio on a bank’s total assets, and the tendency of Canadian banks to maintain capital reserves well beyond OSFI’s capital adequacy requirements. Finally, the near monopoly held by the Big-­Five commercial banks has provided increased stability to Canadian

182   P. Puri capital markets by reducing price-­based competition and the incentives for banks to engage in risky lending practices. These three core themes were accentuated by the gradual evolution of Canada’s financial sector. Canada’s Big-­Five banks had established their near monopoly by the 1960s. This provided market stability and helped regulators develop long-­term profiles of Canada’s major financial institutions, which have been useful for effective prudential regulation. Furthermore, Canadian financial regulation has evolved incrementally since the release of the Porter Commission’s report. As a result, Canada has been able to modify its regulation in response to emergent threats and policy issues and focus on the effective administration of the existing regulatory framework. This incremental growth also allowed Canada to avoid many of the dramatic policy and political shifts between heavily regulated markets and neoliberal deregulation. This has been seen in the use of Canada’s trust-­but-verify approach to bank disclosure following the Estey Commission’s report and the continued use of a simple leverage ratio as part of Canada’s regulatory framework. Consequently, the success of Canada’s financial sector has been largely due to the willingness of Canadian financial regulators and institutions to ensure that the regulations in place operate to their fullest capacity, rather than focusing narrowly on modifying particular rules and policies. Moving forward, the Canadian financial sector faces several key challenges as its regulatory framework continues to evolve. In late 2011, the Supreme Court of Canada ruled that the federal government does not have jurisdiction to create a national securities regulator (Reference Re Securities Act, 2011). As a result, Canada will remain vulnerable to regulatory gaps between banking and securities regulators – similar to what occurred in the ABCP crisis. The ABCP crisis also illustrates the recurring issue of off-­balance-sheet reporting. Although the risk created by these assets is partially buffered by the OSFI leverage ratio requirement, off-­balance-sheet assets create an incomplete picture of a bank’s financial status, which may mislead parties reviewing a bank’s financial health. Finally, Canadian banks have assumed increased prominence following the recession, with TD bank climbing from twenty-­second in 2010 to twelfth in 2011 global rankings (Krouse, 2012). Thus, regulators will have to contend with the risks that come with Canadian banks being in a stronger position to compete on global markets.

References Booth, Laurence. (2009) ‘The Secret of Canadian Banking: Common Sense’, World Economics, 10(3): 1–17. Bordeleau, Etienne, Allan Crawford and Christopher Graham. (2009) Regulatory Constraints on Bank Leverage: Issues and Lessons from the Canadian Experience, Discussion Paper no. 2009–15. Ottawa: Bank of Canada. Bradford, Neil. (1999) ‘The Policy Influences of Economic Ideas: Interests, Institutions, and Innovation in Canada’, Studies in Political Economy, 59(Summer): 17–60. Canadian Business. (2011) IMF Warns about Canadian Household Debt, December 22,

Canada   183 online, available at: www.canadianbusiness.com/article/63296--imf-­warns-about-­ canadian-household-­debt-says-­house-prices-­overvalued-by-­10. Canadian Mortgage and Housing Corporation. (n.d.) History of CMHC, online, available at: www.cmhc-­schl.gc.ca/en/corp/about/hi/index.cfm. CMHC (Canadian Mortgage and Housing Corporation). (2010) Summary of Financial Results, online, available at: www.cmhc-­schl.gc.ca/en/corp/about/anrecopl/ upload/ Summary-­of-Financial-­Results.pdf. Chant, John. (2009) The ABCP Crisis in Canada: Implications for the Regulation of Financial Markets, A Research Study Prepared for the Expert Panel on Securities Regulation, online, available at: www.expertpanel.ca/documents/research-­studies/ The%20 ABCP%20Crisis%20in%20Canada%20-%20Chant.English.pdf. Chant, John, James Dean, J.A. Galbraith, Douglas D. Peters, John W. Popkin, G.L. Reuber, Henri-­Paul Rousseau, and J.E. Toten. (1976) ‘[The 1966 Bank Act: Emerging Issues and Policy Choices]: Comments’, Canadian Public Policy, 2(3): 380–410. Coleman, William D. (1991) ‘Monetary Policy and Legitimacy: A Review of Issues in Canada’, Canadian Journal of Political Science, 24(4): 711–734. Estey Commission. (1986) Commission of Inquiry into the Collapse of Canadian Commercial Bank and Northland Bank, 1986, online, available at: http://epe.lac-­bac.gc. ca/100/200/301/pco-­bcp/commissions-­ef/estey1986-eng/estey1986-eng.htm. Covitz, Daniel, Nellie Liang, and Gustavo Suarez. (2009) Evolution of a Financial Crisis: Panic in the Asset Backed Commercial Paper Market, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington DC. Darroch, James L. and Charles J. McMillan. (2007) ‘Entry Barriers and Evolution of Banking Systems: Lessons From the 1980s Canadian Western Bank Failures’, Canadian Public Administration, 50(2): 141–165. Dean, J.W. and R. Schwindt. (1976) ‘Bank Act Revision in Canada: Past and Potential Effects on Market Structure and Competition’, Banca Nazionale del Lavoro Quarterly Review, 116: 19–49. Dodge, David. (2011) Public Policy for the Canadian Financial System: From Porter to the Present and Beyond, Centre for the Study of Living Standards – New Directions for Intelligent Government in Canada, online, available at: www.csls.ca/festschrift/ Dodge.pdf. Dupuis, Jean. (2006) Basel Capital Accords. Ottawa: Library of Parliament, Parliamentary Information and Research Service. Ford, Christie. (2010) ‘Principles Based Securities Regulation in the Wake of the Global Financial Crisis’, McGill Law Journal, 55: 257–307. Fortin, Pierre. (2010) The Bank of Canada and the Inflation-­Unemployment Tradeoff, Ottawa: Bank of Canada, online, available at: www.bankofcanada.ca/wp-­content/ uploads/2010/09/inflation.pdf. Freedman, Charles. (1998) ‘The Canadian Banking System’, revised version of a paper delivered at the Conference on Developments in the Financial System, New York, online, available at: www.bankofcanada.ca/wp-­content/uploads/2010/01/tr81.pdf. FX Week. (1992) ‘Despite Olympia & York, Canadian Banks Post Solid FX Gains in Second Quarter’, June 5, online, available at: www.fxweek.com/fx-­week/ news/1538533/despite-­olympia-york-­canadian-banks-­post-solid-­fx-gains-­in-second-­ quarter. Galbraith, J.A. and A.L. Guthrie. (1977) ‘Canadian Banking Legislation Ottawa Style: Principles or Pragmatism’, Canadian Public Policy, 3(1): 101–106.

184   P. Puri Ghosh, Chinmoy, Randall S. Guttery, and C.F. Sirmans. (1994) ‘The Olympia and York Crisis: Effects on the Financial Performance of US and Foreign Banks’, Journal of Property Finance, 5(2): 5–46. Giammarino, Ronald, Eduard Schwartz, and Josef Zechner. (1989) ‘Market Valuation of Bank Assets and Deposit Insurance in Canada’, The Canadian Journal of Economics, 22(1): 109–127. Halpern, Paul and Poonam Puri. (2007) ‘ “Canada Steps Up” – Task Force to Modernize Securities Legislation in Canada: recommendations and discussion’, Capital Markets Law Journal, 2(2): 191–221. Harris, Stephen L. (2004) ‘Financial Sector Reform in Canada: Interests and the Policy Process’, Canadian Journal of Political Science, 37(1): 161–184. Illing, Mark and Graydon Paulin. (2005) ‘Basel II and the Cyclicality of Bank Capital’, Canadian Public Policy, 31(2):161–180. Keefe, Blair W. and Stephen Johnson. (2002) ‘Recent Development: Overview of Revisions to Financial Institutions Legislation’, Banking and Finance Law Review, 17: 379–392. Krouse, Sarah (2012) ‘Wells Fargo Leapfrogs HSBC as Largest Western Bank’, Financial News, January 5, online, available at: www.efinancialnews.com/story/2012-01-05/ wells-­fargo-becomes-­largest-western-­bank-market-­capitalisation. Legault, Michele F.A. (1998) ‘Meeting the Regulatory Challenge: Reconciling the Government’s Policy Objectives with the Bank Ownership Rules’, Banking and Finance Law Review, 13: 409–447. Moody’s (2011) Ratings and Reports: Canada Mortgage and Housing Corporation, online, available at: www.moodys.com/credit-­ratings/Canada-­Mortgage-and-­HousingCorporation-­credit-rating-­600010928. Nichols, Mark W. and Jill M. Hendrickson. (1997) ‘Profit Differentials Between Canadian and US Commercial Banks: The Role of Regulation’, The Journal of Economic History, 57(3): 674–696. Nivola, Pietro S. and John C. Courtney. (2009) ‘Know Thy Neighbor: What Canada Can Tell Us About Financial Regulation’, Washington, DC: The Brookings Institution, online, available at: www.brookings.edu/research/papers/2009/04/23-canada-­nivola. Northcott, Carol Ann, Graydon Paulin and Mark White. (2009) ‘Lessons for Banking Reform: A Canadian Perspective’, Central Banking, 19(4): 43–53. OSFI (Office of the Secretariat of Financial Institutions). (2012) Who We Regulate, online, available at: www.osfi-­bsif.gc.ca/osfi/index_e.aspx?DetailID=568. Owens, Richard C. and Neil Guthrie (1998) ‘ “Foreign Banks” and the “Business of Banking”: Reforming Canada’s Foreign Bank Access Regime for the Global Marketplace’, Banking and Finance Law Review, 13: 343–385. Porter, Michael E. and Klaus Schwab. (2008) ‘The Global Competitiveness Report 2008–2009’, World Economic Forum, online available at: http:// www3.weforum.org/ docs/WEF_GlobalCompetitivenessReport_2008-09.pdf. Puri, Poonam. (2009) ‘Legal Origins, Investor Protection, and Canada’, Brigham Young Law Review, 2009: 1671–1700. PwC (PricewaterhouseCooper). (2009) Canadian Banks 2009: Perspectives on the Canadian Banking Industry, Toronto: PwC. PwC (PricewaterhouseCooper). (2011) Canadian Banks 2011: Perspectives on the Canadian Banking Industry, Toronto: PwC. Reference Re Securities Act, 2011 SCC 66. Report of the Task Force on the Future of the Canadian Financial Services Sector. (1998) Ottawa: Department of Finance (contains Interim Report of 1997).

Canada   185 Royal Commission. (1933) Proceedings of the Royal Commission on Banking and Currency, Canada, Ottawa, 1933, online. available at: www.scribd.com/doc/ 9626270/ Royal-­Commission-on-­Banking-and-­Currency-1933-CANADA-­Proceedings-Vol-­1-to-­ 6-Highlights. Royal Commission. (1949) Report of the Royal Commission on Prices, Canada, Ottawa, 1949, Ottawa: King’s Printer. Royal Commission. (1964) Report of the Royal on Banking and Finance, Canada, Ottawa, 1964, (Porter Commission) online, available at: http://epe.lac-­bac.gc.ca/ 100/200/301/pco-­bcp/commissions-­ef/porter1964-eng/porter1964-eng.htm. Senate of Canada. (2010) Proceedings of the Standing Committee on Banking, Trade and Commerce, Submissions by Bank of Canada, Governor Mark Carney, April 29, online, available at: www.parl.gc.ca/Content/SEN/Committee/403/bank/pdf/ 06issue.pdf Senate Standing Committee on Banking Trade and Commerce. (1996) ‘1997 Financial Institution Reform: Lowering the Barriers to Foreign Banks’, Senate of Canada, online, available at: www.parl.gc.ca/Content/SEN/Committee/352/bank/rep/lbf-­tc-e.htm. Shearer, Ronald A. (1977) ‘The Porter Commission Report in the Context of Earlier Canadian Monetary Documents’, The Canadian Journal of Economics, 10(1): 34–49. Slater, David W. (1965) ‘The Report of the Royal Commission on Banking and Finance’, The Canadian Journal of Economics and Political Science, 31(3): 421–429. Smith, Brian and Robert W. White. (1988) ‘The Deposit Insurance System in Canada: Problems and Proposals for Change’, Canadian Public Policy, 14(4): 331–346. The Report of the Attorney General’s Committee on Securities Legislation in Ontario, 1965. (Kimber Report) Ontario: Queen’s Printer. Waterhouse, John. (1988) ‘The GAAP in Bank Regulation’, Canadian Public Policy, 14(2): 151–161. White, Mark. (2009) ‘Remarks by Mark White, Assistant Superintendant, Regulation Sector, Office of the Superintendant of Financial Institutions (OSFI) to the Osgoode Hall Financial Regulatory Conference’, October 19, online, available at: www.osfi-­bsif. gc.ca/app/DocRepository/1/eng/speeches/mw_osg_e.pdf.

8 Australia Economic liberalization and financialization – an introduction Suzanne J. Konzelmann and Marc Fovargue-­Davies1 Introduction The challenges of the 1970s encouraged a return to economic liberalism in Australia. However, the process assumed a relatively balanced form, due in large part to the existence and relative strength of countervailing political and economic forces that mitigated against the imposition of a narrow policy agenda by a dominant central government. Economic liberalism was incorporated into policy by the labour governments of Bob Hawke (1983–1991) and Paul Keating (1991–1996), under the banner of ‘economic rationalism’; and the process of economic liberalization was overseen by mostly liberal or labour – rather than conservative – governments. Australia’s economic rationalists had a mainstream post-­war view, blending Keynesian macro-­economic theory with neo-­classical microeconomics, based on a simple model of perfect competition that allowed for market failure, market imperfection and externalities (Quiggin 1997). From this perspective, government intervention was justified in order to correct market failures and stabilize the level of employment and output (Patience and Head 1979). Rather than being imposed by the government and economic rationalists, however, the process of economic liberalization in Australia was a negotiated one that sought a balance between the concerns of business, markets and the broader community (Argy 2001). Following its election, the Hawke Labour government held a politically successful national economic summit that created a tripartite system, extending the accord between government and organized labour to include business interests (Quiggin 1998). It also continued the social democratic policy of earlier liberal governments: the expansionary fiscal policy inherited from the Fraser government was maintained and extended; social welfare benefits were raised and a national health insurance system was introduced. Thus, economic liberalization in Australia did not result in a dismantling of the welfare state; and it was not accompanied by deregulation. Instead, it involved a range of relevant stakeholders and was accompanied by reregulation designed to ensure that markets operated effectively and that the private sector profit motive did not impede the provision of public services or the public good (Argy 2001). According to Berg (2008)

Australia, an introduction   187 the most striking attribute of the last few decades is how Australian governments have matched privatisations and liberalisations with regulatory expansion, rather than retreat. Governments have shifted away from the direct provision of services, to the regulation of those services

Australia’s ‘corporate cowboys’ bite the dust The decades preceding the turbulent 1970s, however, were not without their challenges, particularly on the financial side of the economy. During the 1950s, the institutional lines between financial firms in Australia had begun to blur; and while major banks were tightly regulated by the Reserve Bank of Australia (RBA), by 1960, every big bank had acquired an equity stake in a major finance company. Finance companies operated in the profitable ‘fringe’ banking sector, beyond the jurisdiction of central bank controls. Having begun in hire-­purchase, finance companies became increasingly entrepreneurial; and by the 1960s and 1970s, they were heavily engaged in property speculation with the ‘corporate cowboys’ of the day (Sykes 1994). Although the banks extended very little finance to the speculators, their finance companies were less cautious. This fuelled a property bubble that burst in 1974, causing a devastating string of corporate and financial failures. In 1979, amid growing concern about the effectiveness of existing regulations, the government commissioned a review of the financial system, the Campbell Inquiry. The 1981 Campbell Report noted that Australian banks had become significantly involved in non-­banking business activities through their ownership of equity stakes in finance companies, money market companies, superannuation funds and insurance brokers (Bain and Harper 2000); and its recommendations resulted in the introduction of an institutional system of regulation, composed of four main regulators: the Reserve Bank of Australia (RBA) was responsible for banks; the Insurance and Superannuation Commission (ISC) for insurers and superannuation funds; the Australian Securities Commission (ASC) for securities market conduct and disclosure; and the state and territory based State Supervisory Authorities (SSAs) for building societies, friendly societies and credit unions. The Campbell Report also paved the way for liberalization of the financial system. In 1983, Australia’s New Labour government was welcomed into office by a major currency crisis, brought about by speculators fearful of the change in government. The government’s leaders ‘immediately realized that long-­term stability depended on reassuring a wary business community’ (Helleiner 1994: 165). In response, the 1984 Australian Financial System Review recommended further financial liberalization. However, the result was instability and scandals in both the corporate and financial sectors of the economy; and in 1990, Australia entered a severe recession, dominated by financial failure (MacFarlane 2006). According to Sykes (1994: 1), The corporate booms and busts of the 1980s were the greatest ever seen in Australian history. The boom saw a bunch of corporate cowboys financed to

188   S.J. Konzelmann and M. Fovargue-Davies dizzying heights by greedy and reckless bankers. Large sectors of Australian industry changed hands. The mayhem did not extend to the non-­financialized side of the economy, however. Whilst Australia has well-­developed stock markets and many listed companies with dispersed shareholder ownership, this form of ownership is not the norm. Share ownership tends to be concentrated; and there is high incidence of founding family and inter-­company control. According to Clarke (2007: 145), ‘all the evidence suggests that Australian business has maintained an unusually high degree of block-­holder control’. In 1999, only eleven of the twenty largest public quoted companies did not have a shareholder that held 10 per cent or more of the equity, with a similar pattern among smaller companies (Clarke 2007; Stapledon 1998). It is unsurprising then, that in Australia, the takeover market is not particularly active. Dignam and Galanis (2004) conclude that the discipline mechanism of the American and British market for corporate control ‘is absent from the Australian listed market’ and that ‘block-­holders exercise control over key decisions as to the sale of the company’. Speculation in the residential housing sector was also constrained. Although the Australian housing market was frequently used to combat recession, via the extension of subsidies to first-­time house buyers, it did not produce the speculative activity experienced in other countries. Australian homeowners maintained an interest in the residential – as opposed to the asset – value of their houses. This is despite the fact that the Australian mortgage system is a product of minimal intervention, the last of which was phased-­out during the early 1990s with the collapse of the New South Wales government-­owned equivalent to America’s Fannie Mae (Stapledon 2009). The nature of the Australian house financing system is one in which mortgages have traditionally been limited to a level where debt servicing accounts for less than 30 per cent of a borrower’s gross income. More recently, this was adjusted such that income above the ‘costs of living’ serves as the basis for assessing mortgage affordability (Laker 2004: 6). As the costs of living can be considered independent of income level, wealthier individuals can expand debt further than others. As a result, only those who can afford to take on the debt can secure mortgage loans. Australian mortgage loans are insured by Lenders’ Mortgage Insurance (LMI), which covers 100 per cent of mortgage debt, transferring the risk of credit exposure to the insurer. Although there was some securitization of mortgages during the 1990s and 2000s, a strong ownership culture combined with non-­deductibility of interest and no capital gains tax on owner-­occupied property provide strong incentives for Australians to build equity in their homes. At the same time, high property market transparency and the predominance of Listed Property Trusts (LPTs) as issuers of mortgage-­backed securities contributes to the relative stability of the mortgage-­backed security (MBS) market in Australia (Australian Securitization Forum 2008). LPTs are legally required to report their activities and underlying collateral performance to the regulators. Concern about maintaining high quality

Australia, an introduction   189 assets means that banks tend to operate an ‘originate to hold’ strategy – holding loans to maturity, rather than selling them on. Thus, although MBSs are present in the Australian financial system, they do not account for a significant proportion of the market; and given the nature of house financing in Australia, there has been little or no growth in the volatile sub-­prime sector.2

Financial market liberalization – but with regulatory reform In Australia, financial markets are seen as integral to the performance of the economy as a whole, rather than being an end in themselves (Nieuwenhuysen et al. 2001; Courchene and Purvis 1993). The core of the financial services industry is a branch banking system in which a few large banks provide retail, commercial and investment banking services nationwide. Branching and diversification of financial services are seen as contributing to reduced vulnerability to regional and market shocks, significant economies of scale for the banks involved and, hence, market stability. At the same time, competition among the banks is considered to be in the public interest (Department of Industry 1997). A balance between the public interest and the commercial interests of Australian business was achieved by the government’s ‘six pillar’ policy. This was initiated by Paul Keating in 1990 when he blocked the merger between the ANZ Bank and the National Mutual insurance company and extended the ban to any merger between the four largest banks (Commonwealth Bank (CBA), Westpac, NAB, ANZ) and the two largest insurance companies (AMP and NatMut). The six-­pillar policy was maintained until the 1996 Wallis investigation into financial system reform, which exposed the largest banks and insurance companies to the same level of take-­over pressure as other publicly listed companies. Thus, in 1997, the merger ban was lifted for the two insurance companies, but not the four largest banks, resulting in the present ‘four pillar’ policy. The 1996 Wallis Inquiry had followed the 1991 Martin Inquiry into the effects of financial liberalization and the extent of bank competition. Its primary objective was to reduce the potential for regulatory arbitrage and increase neutrality within the Australian financial system. In particular, the Wallis Inquiry explored the idea of a ‘twin peaks’ regulatory model, favoured by the Treasury Department and ultimately recommended it to the Howard government (Bakir 2003). The result was the 1998 creation of a new single prudential regulator, the Australian Prudential Regulatory Authority (APRA) and the Australian Securities and Investment Commission (ASIC). APRA took over prudential regulatory powers from the RBA and ISC; and ASIC took over responsibility for consumer protection and market integrity from the ASC, ISC and Australian Consumer and Competition Committee (ACCC). To coordinate financial regulation among the different branches of government, the Council of Financial Regulators was set up, composed of representatives from the RBA, APRA, ASIC and the Treasury. In March 2001, the failure of Australia’s second largest insurance company, HIH Insurance, prompted further prudential regulation, bringing most insurance companies, previously only lightly regulated, under the jurisdiction of APRA.

190   S.J. Konzelmann and M. Fovargue-Davies In response to the increasing ease with which financial institutions could practice regulatory arbitrage, Australia was a signatory to the Basel II Accord.3 Basel II represented an attempt to extend consistent, international regulatory criteria to banks, especially those that had outgrown national jurisdictions. Among its recommendations was specification of the amount of capital to be held against assets on banks’ balance sheets which included a risk weighting criteria on differing asset classes. Australian banks chose to match, or preferably exceed, the capital reserve requirement recommendations of Basel II and they voluntarily opted for a higher ratio of capital against assets, which although not adding to returns or growth, contributed positively to financial stability (IMF 2010). Australia also takes a ‘principles-­based’ approach to regulation in which financial institutions are required to ensure that they meet both the intent and the prescription of legislation; this approach (in contrast to a ‘rules-­based’ approach) is believed to encourage competition and innovation as well as to make the financial market more attractive to international financial institutions (Pan 2011). In short, the instability resulting from early steps towards economic and financial liberalization was met with reforms that ultimately served to strengthen Australian prudential regulation during the decades preceding the 2008 crisis.

Summary and overview The Australian financial sector is predominantly composed of a relatively small number of domestic and largely immobile banks and financial institutions, subject to ‘twin peaks’ regulation, in which separate regulators have responsibility for soundness and for conduct of business oversight. Financial market liberalization was matched by flexible regulation designed to ensure that markets were stable and operated effectively. The continuous development of prudential regulation in response to the challenges of liberalization and shifting market conditions reflects the strong tradition of respect for government and for the public interest, which is well summarized in the credo of the Australian Constitution: ‘peace, order and good government.’4 The relative strength of Australian regulation – and its regulators – may also reflect popular sceptical opinion about banks and financial interests. According to Malcolm Maiden, ‘banks are bastards; bigger banks are bigger bastards’ (Maiden 2008).5 Perhaps this helps to keep the banks – and the bankers – in their proper place within the political and economic system. In Australia, whilst the challenges of the 1970s undermined confidence in the state’s ability to manage the economy, it did not weaken support for the social welfare state. Australian economic liberalism thus emphasized the merits of competition in markets (rather than focusing purely on market freedom); it sought to limit the role of the state in the provision of services, but without compromising access to basic health, education and income security. Economic liberalization was therefore accompanied by regulation designed to permit the market to function effectively; and to the degree that public services were privatized, the state assumed a strong role in regulation in the public interest.

Australia, an introduction   191 Economic liberalism in Australia was interpreted and implemented by successive Liberal and/or Labour governments, in an incremental process that involved the cooperation of economic liberals and modernizing social democrats; and those policies that were seen to best serve the interests of society were evolved through a process that encouraged learning to take place when challenges were encountered. The existence of countervailing forces, including strong regional governments and effective mechanisms for the participation of a range of stakeholders, including citizens and representatives from both sides of industry, resulted in a more ‘balanced’ approach to economic liberalism that in some respects served to enhance the capacity of the Australian state. Despite the logical coherence of Australian economic liberalism, however, it is important to note that the process of incorporating it into policy was evolutionary, rather than consciously planned. So the relative resilience of Australia’s financial sector in the wake of the 2008 crisis may have been more a factor of luck than design.

Notes 1 The discussion in this chapter is largely drawn from Konzelmann and Fovargue-­Davies 2012. 2 Between 2003 and 2006, whereas MBSs as a proportion of outstanding residential loans averaged 20.1 per cent in the US, they accounted for only 7.9 per cent of residential loans in Australia (IMF 2008: 107). 3 The list of signatories to Basel II, and the date of Australia’s accession can be found at: http://archive.basel.int/ratif/convention.htm. 4 It is interesting to note the contrast with the American credo: ‘life, liberty and the pursuit of happiness.’ 5 Malcolm Maiden is business editor for The Age.

References Argy, F. (2001), ‘Liberalism and Economic Policy’, in J. Nieuwenhuysen, P. Lloyd and M. Mead (eds) Reshaping Australia’s Economy: Growth with Equity and Sustainability, Cambridge: Cambridge University Press, pp. 67–85. Australian Securitization Forum (2008), The Financial Services and Credit Reform Green Paper Submission by the Australian Securitization Forum, online, available at: www. afa.asn.au/Portals/0/Green_Paper_on_Financial_Services_and_Credit_ Reform.pdf. Bakir, C. (2003), ‘Who Needs a Review of the Financial System in Australia? The Case of the Wallis Inquiry’, Australian Journal of Political Science, 38(3): 511–534. Bain, E. and I. Harper (2000), ‘Integration of Financial Services: Evidence from Australia’, North American Actuarial Journal, 4(3): 1–19. Berg, C. (2008), ‘Regulation and the Regulatory Burden’, Institute of Public Affairs, online, available at: www.ipa.org.au/news/1630/regulation-­and-the-­regulatory-burden/ category/1. Clarke, T. (2007), International Corporate Governance. A Comparative Approach, Oxford: Routledge. Courchene, Tom and Douglas Purvis (1993), Productivity Growth and Canada’s International Competitiveness, Kingston, Ontario: Bell Canada Papers on Economic and Public Policy.

192   S.J. Konzelmann and M. Fovargue-Davies Department of Industry (1997), Merger Enforcement Guidelines as Applied to a Bank Merger, Ottawa: Supply and Services Canada. Dignam, A. and M. Galanis (2004), ‘Australia Inside Out: The Corporate Governance System of the Australian Listed Market’, Melbourne University Law Review, 28(3): 623–653. Helleiner, E. (1994) States and the Reemergence of Global Finance, Ithaca, NY: Cornell University Press. IMF (2010) ‘Australia: Basel II Implementation Assessment’, IMF Country Report 10/107 May, Washington, DC: International Monetary Fund, online, available at: www. imf.org/external/pubs/ft/scr/2010/cr10107.pdf. IMF (2008) ‘World Economic Outlook (April 2008): Housing and the Business Cycle’, New York: International Monetary Fund. Konzelmann, S. and M. Fovargue-­Davies (2012) ‘Anglo-­Saxon Capitalism in Crisis? Models of Liberal Capitalism and the Preconditions for Financial Stability’, in G. Wood (ed.) Elgar Handbook on Institutions and International Business. Cheltenham: Edward Elgar (forthcoming). Laker, J. (2004), ‘The Australian Banking System – Building on Strength’, paper presented at the Business Banking 2005 Conference, Sydney, 10 November. MacFarlane, I. (2006), ‘The Real Reasons Why It Was the 1990s Recession We Had to Have’, The Age, 2 December. Maiden, M. (2008), ‘Westpac-­St George Merger Won’t Topple Four-­Pillars’, The Age, 15 May. Nieuwenhuysen, J., P. Lloyd and M. Mead (eds) (2001), Reshaping Australia’s Economy: Growth with Equity and Sustainability, Cambridge: Cambridge University Press. Pan, E. (2011), ‘Structural Reform of Financial Regulation in Canada’, Transnational Law and Contemporary Problems, 19: 796–867. Patience, A. and B. Head (1979), From Whitlam to Fraser: Reform and Reaction in Australian Politics, Melbourne: Oxford University Press. Quiggin, J. (1998), ‘Social Democracy and Market Reform in Australia and New Zealand’, Oxford Review of Public Policy, 14(9): 79–109. Quiggin, J. (1997), ‘Economic Rationalism’, Crossings, 2(1): 3–12. Stapledon, N. (1998), ‘Housing and the Global Financial Crisis: US versus Australia’, Economic and Labour Relations Review, 19(2): 1–16. Sykes, T. (1994), The Bold Riders: Behind Australia’s Corporate Collapses, Sydney: Allen and Unwin.

9 Australia versus the US and UK The kangaroo economy Steve Keen

This book is predicated on the ‘somewhat unexpected possibility that there might, in fact, be more than one incarnation of liberal capitalism’, with one key piece of evidence for this being ‘the apparently sharp divide in the experience of the six Anglo-­Saxon banking systems: whilst the American, British and Irish banks were very badly affected by the crisis, those of Canada, Australia and New Zealand performed far better’ (Chapter 1). However, while I concur that there is much variation in capitalism, this is variation within a species. Just as there are fast cats, big cats, domestic cats, and wild cats, but there are no amphibious or reptilian cats, there are wide variations in how different capitalist economies may experience a financial crisis, but there are no capitalist systems without banks and debt-­based finance. The variations between the US, UK and Australian experience of the ‘Not So Global’ crisis are very large, but they are predominantly differences of empirical degree, rather than manifestations of qualitatively different capitalist systems. In particular, Australia’s apparent escape from the financial crisis can be largely explained by precisely the same factors that explain why the US’s crisis was so deep, and why the UK’s lay in between the two.

A tale of three countries Australia, the USA and the UK have certainly experienced very different ‘Global Financial Crises’ since this crisis began in late 2007. Both the USA and the UK suffered serious falls in real output almost immediately, while Australia had only a belated and very brief flirtation with falling output. This was reflected in vastly differing outcomes for unemployment. Unemployment rose rapidly in the USA and doubled over the pre-­crisis level. It rose substantially for the UK – and is now rising again. Australia, on the other hand, saw unemployment rise from an already comparatively low 4 per cent to a peak of below 6 per cent, from which it then fell to 5 per cent – however it is also rising again, with no net job creation having occurred during the calendar year of 2011. So is the Australian economy so qualitatively different that it was capable of taking in its stride a financial crisis that crippled its Anglo-­Saxon capitalist

Figure 9.2 Unemployment. 12

11

3

Australia USA UK

0 2013

4

2013

5 2012

6

2012

7 2011

8

2011

9 2010

10

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2008 2009

Figure 9.1 Real growth rates.

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2004

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2007

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–5

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–4

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Australia USA UK

–6

Australia   195 brothers? The financial data certainly points out some differences – but some striking similarities as well. All three countries have experienced a rapid growth in private debt1 compared to income – with the UK being the stand-­out debtor since 1987 – and today’s levels far exceed those recorded in the Great Depression.2 All three countries reached peak levels of debt shortly after the crisis began – early 2008 for Australia, early 2009 for the USA, and early 2010 for the UK. But though the trend was similar in all three countries, debt reached far higher levels in the UK and USA than Australia. Drilling deeper still, more similarities emerge. This defining characteristic of this financial crisis was the involvement of households in the web of debt, and on that front, the leading contender is not the USA, but Australia. Despite all the focus on subprime lending in the USA, household debt grew far more rapidly in Australian than in the United States: household debt more than tripled in Australia from 1990 till 2010, whereas it rose only by 50 per cent in the USA. The UK however had the highest ultimate household debt level, of 104 per cent of GDP in early 2010. At this stage, the hypothesized anomaly remains: Australia has had a similar increase in household debt to the US and UK, and a similar increase in aggregate private debt (though not to the same levels),3 but a far better economic performance since the crisis began. However, a more detailed analysis removes the anomaly: the different experiences of these countries can all be traced to the same dynamics of private debt.

500 2008

Australia USA UK

450 400

Per cent of GDP

350 300 250 200 150 100 50

Figure 9.3 Private debt to GDP.

2015

2010

2005

2000

1995

1990

1985

1980

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1970

1965

0

196   S. Keen 110

2008

Australia USA UK

100 90 80 Per cent of GDP

70 60 50 40 30 20 10 2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

0

Figure 9.4 Household debt.

Debt in a capitalist economy A non-­economist might expect that so obvious an element of the economy as debt would be well understood by economists. That expectation is unfortunately false, since the majority of economists were of the opinion – prior to the crisis – that private debt was economically unimportant. After the crisis, some have acknowledged that this belief may have been a falsehood, but even they maintain that the level of debt is unimportant – all that can matter is its distribution. Paul Krugman’s recent writings are indicative here. In an as yet unpublished research paper, he and his co-­author acknowledged that mainstream economic theory ignores private debt: If there is a single word that appears most frequently in discussions of the economic problems now afflicting both the United States and Europe, that word is surely ‘debt.’ . . . Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models – especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy. (Krugman and Eggertsson 2010, pp. 1–2)

Australia   197 However, they justified at least part of the neoclassical decision not to consider debt in macroeconomics on the argument that the aggregate level of debt is irrelevant: Consider, for example, the anti-­fiscal policy argument we’ve already mentioned, which is that you can’t cure a problem created by too much debt by piling on even more debt. Households borrowed too much, say many people; now you want the government to borrow even more? What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, debt wouldn’t be a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset. (Krugman and Eggertsson 2010, pp. 2–3; emphasis added) Krugman reiterated this proposition in a subsequent blog post, when he dismissed concerns about the aggregate level of debt (which he defined as the sum of public plus private non-­financial debt): People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources. That’s not to say that high debt can’t cause problems – it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011) Krugman and Eggerston modelled this vision of debt mattering not because of its level, but its distribution, by expanding the number of agents in the standard neoclassical macroeconomic model from one to two – one of whom was ‘patient’, the other being ‘impatient’. Starting from a model without production,4 they introduced borrowing and lending between these agents: Imagine a pure endowment economy in which no aggregate saving or investment is possible, but in which individuals can lend to or borrow from each other. Suppose, also, that while individuals all receive the same endowments, they differ in their rates of time preference. In that case, ‘impatient’ individuals will borrow from ‘patient’ individuals. We will assume, however, that there is a limit on the amount of debt any individual can run up . . .

198   S. Keen Specifically, assume for simplicity that there are only two representative agents, each of whom gets a constant endowment (1 / 2)Y each period . . . the two types of individuals differ only in their rates of time preference. We assume initially that borrowing and lending take the form of risk-­free bonds denominated in the consumption good (Krugman and Eggertsson 2010, pp. 4–5)5 Though Krugman’s work is an advance on the neoclassical mainstream, in which debt is not even considered, there is one crucial way in which it remains hopelessly irrelevant to the real world: it includes debt, but not banks. In a world with debt but without banks, the only form that lending could take is the one Krugman models, in which a patient agent foregoes consumption now by lending to an impatient agent. The rise in the debtor’s consumption is offset by the fall in the lender’s, and overall there is no macroeconomic impact. But in the real world, lending is done by banks that, as Schumpeter put it, create spending power ‘out of nothing’, by the double-­entry bookkeeping operation of simultaneously creating a deposit and a loan: It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing (Schumpeter 1934, p. 73) Schumpeter is emphatic that the process of credit creation gives additional spending power to the borrower, without reducing any existing saver’s spending power: Credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. (Schumpeter 1934, pp. 106–107) Schumpeter does not deny that some investment is financed by a transfer of existing funds from savers – hence resulting in a fall in spending by saver-­ consumers and an offsetting increase in spending by borrower-­investors, with no overall macroeconomic implications. But he insists that the primary source of investor spending comes from the endogenous expansion of the money supply, which gives spending power to entrepreneurs without sacrificing the existing spending power of savers, so that rising debt does have macro­ economic effects: even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which . . . does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is

Australia   199 available in strict logic. This method of obtaining money is the creation of purchasing power by banks (Schumpeter 1934, p. 73) Schumpeter’s academic perspective on how money is created received practical support in the later observations of the then Vice-­President of the New York Federal Reserve, Alan Holmes, when he criticized ‘Monetarist’ proposals for controlling the growth of the money supply. He noted that the ‘money multiplier’ model of how money is created that Monetarists used was fallacious, because it: suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. (Holmes 1969, p. 73; emphasis added) This has since been abundantly empirically confirmed by researchers in what is known as the ‘endogenous money’ tradition (Moore 1979; Graziani 1989, 2003; Fontana and Realfonzo 2005). Even neoclassical authors undertaking empirical research have found strong links between change in debt levels and investment: These correlations confirm the impression that debt plays a key role in accommodating year-­by-year variation in investment. (Fama and French 1999, p. 1954)6 In Schumpeter’s vision, bank-­created credit that adds aggregate demand without detracting from the spending power of existing agents is the means by which the entrepreneur achieves the monetary means to put his ideas into action: the entrepreneur – in principle and as a rule – does need credit, in the sense of a temporary transfer to him of purchasing power, in order to produce at all, to be able to carry out his new combinations, to become an entrepreneur. And this purchasing power does not flow towards him automatically, as to the producer in the circular flow, by the sale of what he produced in preceding periods. If he does not happen to possess it . . . he must borrow it . . . He can only become an entrepreneur by previously becoming a debtor . . . his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society. (Schumpeter 1934, p. 102, emphasis in the original) Unfortunately, creatively destructive entrepreneurs are not the only ones to whom banks lend. Schumpeter’s student Hyman Minsky pointed out that the primary source of demand for ‘Ponzi Financiers’ is bank debt. Rather than

200   S. Keen investing with borrowed money, these borrowers primarily buy existing assets, and hope to profit by selling those assets on a rising market. Unlike Schumpeter’s entrepreneurs, whose debts today can be repaid from genuine profits tomorrow, Ponzi Financiers always have debt servicing costs than exceed the cash flows from the assets they purchase with borrowed money. They therefore must expand their debts or sell assets to continue functioning: A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt . . . Ponzi units can fulfil their payment commitments on debts only by borrowing (or disposing of assets) . . . a Ponzi unit must increase its outstanding debts. (Minsky 1982, p. 24) Therefore in a credit-­based economy, there are three sources of aggregate demand, and three ways in which this demand is expended: 1 2 3

demand from income earned by selling goods and services, which primarily finances consumption (Biggs and Mayer 2010; Biggs, Mayer et al. 2010); demand from rising entrepreneurial debt, which primarily finances investment; and demand from rising Ponzi debt, which primarily finances the purchase of existing assets.

Schumpeter’s and Minsky’s perspectives thus enable us to integrate credit, asset markets and disequilibrium analysis into an alternative macroeconomics. In a credit economy, aggregate demand is the sum of income plus the change in debt, and this demand is expended on both goods and services and purchases of existing assets. Debt therefore has both positive and negative connotations for the economy: it finances the expansion of economic activity via innovation and investment, but it can also cause asset bubbles and, eventually, an economic crisis if too much of this debt is directed to Ponzi Finance. This is precisely what occurred in the last two decades. Therefore, contrary to Krugman’s analysis, the aggregate level of debt does matter, because the demand from entrepreneurs for investment goods, and the demand from Ponzi Financiers for financial assets, are both funded by the increase in debt. We live in a credit-­based world – rather than the mythical barter world of neoclassical economics (Graeber 2011) – and in this world, aggregate demand is the sum of incomes plus the increase in debt. This is then expended buying both newly produced goods and services, and claims on financial assets – shares and titles to property. Variations in the rate of growth of private debt therefore have a direct impact on macroeconomic and asset market performance. These non-­neoclassical propositions on the role of changes in aggregate debt in macroeconomics can be summarised in two propositions:

Australia   201 1 2

aggregate demand equals incomes plus the change in debt, and this is expended on both goods and services and net turnover of existing assets7 (shares and property); and the change in aggregate demand therefore equals the change in incomes plus the acceleration of debt, and this will affect change in output and change in asset prices.8

These propositions imply that changes in debt will have profound effects on the macroeconomy and asset market – versus the ‘null hypothesis’ put by Krugman, and neoclassical economics in general, that the aggregate level of debt has no relevance to macroeconomics. The impacts can be illustrated by a simple numerical example. Consider an economy with a GDP of $1 trillion that is growing at 10 per cent per annum, with real growth of 5 per cent and inflation of 5 per cent, and in which private debt is $1.25 trillion and growing at 20 per cent per annum. Total spending on both goods and services, and financial assets, is therefore $1.25 trillion: $1 trillion is financed by income, and $250 billion is financed by the 20 per cent increase in debt. If in the following year (when GDP is $1.1 trillion), the growth of debt simply slows down to the same rate at which nominal GDP is growing (without affecting the rate of economic growth), then the growth in debt will be $150 billion (10 per cent of the $1.5 trillion level reached at the end of the previous year). Total spending will therefore be exactly the same as the year before: $1.25 trillion, consisting of $1.1 trillion in GDP plus a $150 billion growth in debt. However, since inflation is running at 5 per cent, this amounts to a 5 per cent fall in the real level of economic activity – which would be spread across both commodity and asset markets (see Table 9.1). If instead the growth of debt stopped, then total spending the next year will be $1.1 trillion, a 15 per cent fall from the level of the previous year in nominal terms, and 20 per cent in real terms. This would cause a massive slump in demand for goods and services, assets, or both, even without a slowdown in the rate of growth of GDP (see Table 9.2).

Table 9.1 Example of a recession caused by growth of debt slowing down Variable/year

Year 1

Year 2

Nominal GDP Growth rate of nominal GDP Real growth rate Inflation rate Private debt Growth rate of private debt Change in private debt Nominal aggregate demand (GDP + change in debt) Real aggregate demand (deflated by 5% inflation rate)

1,000 10% 5% 5% 1,250 20% 250 1,250 1,250

1,100 10% 5% 5% 1,500 10% 150 1,250 1,190

202   S. Keen Table 9.2 Example of a recession caused by growth of debt ceasing Variable/year

Year 1

Year 2

Nominal GDP Growth rate of nominal GDP Real growth rate Inflation rate Private debt Growth rate of private debt Change in private debt Nominal aggregate demand (GDP + change in debt) Real aggregate demand (deflated by 5% inflation rate)

1,000 10% 5% 5% 1,250 20% 250 1,250 1,250

1,100 10% 5% 5% 1,500 0% 0 1,100 1,048

As extreme as these numerical examples might appear, they actually understate the impact of the change in aggregate debt during the crisis.

Aggregate demand and the change in debt Figures 9.5 to 9.7 effectively speak for themselves: the crisis was driven by the dynamics of private debt, the scale of the turnaround in the rate of growth of debt was massive, and variations between the three countries in this phenomenon were substantial and in line with the variations in their macroeconomic performance.

1.6 � 106 1.5 � 106 1.4 � 106

GDP GDP + change in debt

1.3 � 106 1.2 � 106 A$ million

1.1 � 106 1 � 106 900,000 800,000 700,000 600,000 500,000 400,000

Figure 9.5 Aggregate demand and the change in debt: Australia.

2014

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300,000

2 � 107 1.9 � 107 1.8 � 107

GDP GDP + change in debt

1.7 � 107 1.6 � 107 1.5 � 107 US$ million

1.4 � 107 1.3 � 107 1.2 � 107 1.1 � 107 1 � 107 9 � 106 8 � 106 7 � 106 6 � 106 5 � 106 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

UK pounds million

Figure 9.6 Aggregate demand and the change in debt: USA.

2.5 � 106 2.4 � 106 GDP 2.3 � 106 GDP + change in debt 6 2.2 � 10 2.1 � 106 2 � 106 1.9 � 106 1.8 � 106 1.7 � 106 1.6 � 106 1.5 � 106 1.4 � 106 1.3 � 106 1.2 � 106 1.1 � 106 1 � 106 900,000 800,000 700,000 600,000 500,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.7 Aggregate demand and the change in debt: UK.

204   S. Keen Australia’s debt-­financed demand grew strongly over the period from its last recession in 1992 – when the change in debt was briefly negative – and then fell sharply in 2008–2010. However it did not turn negative, and continues to add to aggregate demand. The USA’s debt financed demand collapsed starting in early 2008, and went from a $4 trillion boost to aggregate demand then to a $2.5 trillion cut by early 2010. US aggregate demand thus collapsed over a two year period from over $18 trillion to under $12 trillion. The UK’s debt dynamics have been much more volatile than for the other two countries, but also collapsed from a strongly positive boost to aggregate demand in early 2008 to a slight negative in 2010. Debt-­financed demand has since continued to fluctuate, but is now trending down while the US change in debt is trending up (though is still negative). Figure 9.8 rescales the change in private debt by GDP, to enable the debt dynamics of the three countries to be more easily compared – both before and after the crisis began. Before the crisis, the USA and Australia followed similar paths, though the debt-­boost to aggregate demand was higher in the USA than Australia, while debt-­financed demand was highly volatile in the UK and simply massive – equivalent to more than 60 per cent of income-­financed demand in 2006. After the crisis, debt-­financed demand continued to boost aggregate demand in Australia – though the boost dropped to the lowest levels experienced since the recession of the early 1990s. It collapsed in the USA, and fluctuated wildly in the UK. 70 60 50

Australia USA UK

Per cent of GDP

40 30 20 10 0

0

–10 –20 –30 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.8 Comparison of debt-financed demand.

Australia   205 This simply quantifies the scale of the change in debt – the factor that neoclassical economists in general have ignored, and even envelope-­pushers like Krugman (Krugman 1996)9 have only considered tangentially. To make the case that the change in debt does have significant macroeconomic effects, we have to correlate these changes in debt against key economic and financial variables.

Macroeconomic performance and asset markets

Per cent of aggregate demand

60 16 55 15 50 14 45 13 40 12 35 11 30 10 25 9 20 8 15 7 10 6 5 5 0 4 –5 3 –10 2 Debt-financed demand Unempoyment –15 1 –20 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Per cent of workforce

Schumpeter’s argument that new debt is the main source of investment demand implies that the change in debt should be strongly correlated with GDP and employment; Minsky’s argument that new debt is the main source of Ponzi demand – which is expended primarily but not exclusively on buying assets rather than goods and services – implies that there should be a strong correlation between the change in debt and asset prices. Krugman’s argument that the level of debt has no macroeconomic significance implies no relationships in either case (though there is a minor means by which change in debt is included in some neoclassical analysis – see Bernanke, et al. 1996). In fact, the relationship between the debt-­financed fraction of aggregate demand10 and unemployment is significant and substantial in all three countries. In Figures 9.9 to 9.11, I use the same scales so that the relative impact of debt-­ financed demand across different countries can also be gauged.

Figure 9.9 Relationship between the debt-financed fraction of aggregate demand and unemployment: Australia. Note Correlation = −0.71.

Per cent of aggregate demand

Per cent of workforce

16 60 15 55 14 50 13 45 40 12 35 11 30 10 25 9 20 8 15 7 10 6 5 5 0 4 –5 3 Debt-financed demand –10 2 –15 1 Unemployment –20 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.10  Relationship between the debt-financed fraction of aggregate demand and unemployment: USA.

60 16 55 15 50 14 45 13 40 12 35 11 30 10 25 9 20 8 15 7 10 6 5 5 0 4 –5 3 Debt-financed demand 2 –10 Unemployment 1 –15 0 –20 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Per cent of workforce

Per cent of aggregate demand

Note Correlation = −0.92.

Figure 9.11 Relationship between the debt-financed fraction of aggregate demand and unemployment: UK. Note Correlation = −0.68.

Australia   207

Index March 1987 = 100

The proposition that there is a relationship between the change in debt and the level of asset prices – which of course is strongly at odds with the now utterly discredited ‘Efficient Markets Hypothesis’ (Fama and French 2004; see also Keen 2011, pp. 270–296)11 – cannot be tested using the change in debt, since there is an obvious secular trend to increasing debt-­financed demand up until 2008, as there was also to asset prices. However it can be examined by considering the relationship between the acceleration of debt and the change in asset prices – especially since the availability of data on mortgage debt enables a direct comparison between acceleration in mortgage debt and change in house prices. Though these three countries have to date had very different histories of house price movements (see Figure 9.12), movements in house prices all have strong correlations with the acceleration of mortgage debt. To show this, I define the ‘Credit Accelerator’ (originally called the Credit Impulse in Biggs and Mayer 2010; Biggs, Mayer et al. 2010) as the change in the change in debt over a time period, divided by GDP at the midpoint of that period; in Figures 9.13 to 9.15, I consider only the acceleration of mortgage debt. Clearly, though these three housing markets have to date had very different histories, they have in all cases beaten to the drum of the dynamics of debt. What of the most volatile asset market: the share market? Here there are numerous reasons why a tight correlation would not be expected. First, the

300 290 Australia 280 USA 270 260 UK 250 240 230 220 210 200 190 180 170 160 150 140 130 120 110 100 90 80 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.12 House price indices deflated by the Consumer Price Index.

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Real house price per cent change p.a.

Mortgage acceleration per cent of GDP p.a.

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–30 –6 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.13 Acceleration of mortgage debt: Australia12 Note Correlation = 0.59. 6

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Figure 9.14 Acceleration of mortgage debt: USA. Note Correlation = 0.78.

Real house price per cent change p.a.

Mortgage acceleration per cent of GDP p.a.

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–30 –6 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.15 Acceleration of mortgage debt: UK. Note Correlation = 0.84.

500

Index deflated by CPI 1985 = 100

450 400

Australia (ASX) USA (DJIA) UK (FTSE)

350 300 250 200 150 100 50 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.16 Stock market indices deflated by the Consumer Price Index.

210   S. Keen

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Figure 9.17 Correlation of debt acceleration with share prices: Australia. Note Correlation = 0.26.

Real share price change per cent p.a.

Debt acceleration per cent of GDP p.a.

change in aggregate private debt includes debt intended for genuine investment and speculation on house prices, as well as that used to take speculative positions on sharemarkets. Second, even though credit is the fuel, sentiment plays a major role in determining whether that fuel is applied to or withdrawn from this riskiest of markets, and money can be put into and pulled out of sharemarkets much more rapidly than it can in housing (Figure 9.16).13 Nonetheless, the correlations exist (Figures 9.17–9.19). Returning to the real economy, credit acceleration plays a pivotal role in employment change in all three countries – for the simple reasons that, as Schumpeter argued during the last Depression, the primary source of funds for new investment is the endogenous expansion of credit, and as Minsky pointed out, Ponzi demand (which spills over partially into demand for commodities) emanates from credit expansion too (Figures 9.20 to 9.22). The empirical data thus shows that Australia beats to the same credit drum as do the USA and UK. Therefore, though there are substantial objective differences between these economies, to a large degree the differences in their relative economic performances since 2007 can be traced back to differences in their levels and rates of growth of debt: the qualitative interpretation that Australia is a different ‘incarnation of liberal capitalism’ is not compelling. My perspective is at odds with mainstream analysis, which attributes Australia’s avoidance of a serious crisis to a range of positive factors, including its

80

30

60

20

40

10

20

0

0

–10

–20

–20

–40

–30

–60

–40

–80 Acceleration

–50

Real share price change per cent p.a.

Debt acceleration per cent of GDP p.a.

40

–100

Price change

–60 2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

–120

Figure 9.18 Correlation of debt acceleration with share prices: USA.

40

80

30

60

20

40

10

20

0

0

–10

–20

–20

–40

–30

–60

–40

–80

–50

Acceleration Price change

–100

–60 –120 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.19 Correlation of debt acceleration with share prices: UK. Note Correlation = 0.36.

Real share price change per cent p.a.

Debt acceleration per cent of GDP p.a.

Note Correlation = 0.24.

5

20

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15

3

10

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–5

–1

–10

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–3

–20

–4

–25

–5

–30

–6

–35

–7

–40

Accelerator

–8

–45

Employment change

–9

Change in (100 unemployment rate) p.a.

Credit acceleration per cent GDP p.a.

25

–10 –50 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.20 Correlation of debt acceleration with change in employment: Australia.

25

5

20

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15

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1

0

0

–5

–1

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–2

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–25

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–30

–6 –7

–35 –40

Accelerator

–8

–45

Employment change

–9

Change in (100 unemployment rate) p.a.

Credit acceleration per cent GDP p.a.

Note Correlation = 0.7.

–10 –50 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.21 Correlation of debt acceleration with change in employment: USA. Note Correlation = 0.77.

25

5

20

4

15

3

10

2

5

1

0

0

–5

–1

–10

–2

–15

–3

–20

–4

–25

–5

–30

–6

–35

–7

–40

Accelerator

–8

–45

Employment change

–9

Change in (100 unemployment rate) p.a.

Credit acceleration per cent GDP p.a.

Australia   213

–50 –10 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 9.22 Correlation of debt acceleration with change in employment: UK. Note Correlation = 0.51.

r­ egulatory regime. For example, Hawtrey attributes Australia’s crisis avoidance to ‘A culture of intermediation, not securitisation . . . Australian banks are highly capitalised . . . A diversified and stable funding base . . . Healthy profitability . . . Sound corporate governance . . . Effective financial system regulation [and] Separation of commercial banking from social assistance measures’ (Hawtrey 2009, pp. 104–112).14 On the last point, he notes: An invaluable contributor to the strength and stability of Australian banks is the quality of the prevailing regulatory framework, known as the ‘twin peaks’ approach. Australia adopted a functional approach to regulation recommended in the 1997 Wallis Commission report, consolidating prudential regulation from 11 predecessor agencies into the Australian Prudential Regulation Authority (APRA), and market-­conduct regulation into the Australian Securities and Investments Commission (ASIC). The Reserve Bank (RBA) has oversight of financial system stability. The Council of Financial Regulators (CFR) provides a useful forum to address emerging trends and policy issues. The CFR consists of high-­level representatives of the RBA, Treasury, APRA, and ASIC, and meets regularly. In the event of a crisis, the CFR serves as the key coordinating body for developing an official response. (Hawtrey 2009, pp. 110–111)

214   S. Keen The emphasis on the importance of regulation in distinguishing Australia from the US and UK implies that there was something qualitatively different in the institutions managing and the philosophy guiding bank regulation in Australia. It is quite feasible that Australia’s institutional arrangements could be superior to the USA’s and UK’s, but if so this is more luck than good management, since the philosophy is the same across all three countries.

Better banking regulation? The Wallis Committee was formed by the incoming Howard Liberal Government to investigate the impact of financial deregulation, given the financial crisis of 1987 and recession of the early 1990s that followed the deregulation recommended by the Campbell Committee of 1979–1981. Despite the severity of those crises, the Committee was in thrall to the Efficient Markets Hypothesis vision of the role of finance. Ian Harper, the most influential academic member of the committee, summarised the Committee’s analysis as follows: The general flow of the argument may be represented in the following simplified manner: Proposition 1: The financial landscape in Australia and elsewhere in the world is changing . . . Proposition 2: In order for our financial institutions and markets to compete in this changing environment, and to enable users to access financial services on the most commercially favourable basis, the Australian financial system must continue to improve its efficiency and lower cost. Proposition 3: Efficiency improvements and cost reductions are best secured through enhanced competition and contestability. Conclusion: Regulation of the Australian financial system should be revised and reconfigured so as to promote competition and contestability while preserving financial system safety and stability. (Harper 1997, p. 288) Far from being a contributor to systemic instability, deregulation was lauded as having contributed to a more accurate pricing of financial assets: Financial sector efficiency has improved in several respects since deregulation. More efficient pricing in securities and foreign exchange markets has improved resource allocation. The productivity of financial sector participants has risen in many cases, as has their dynamic efficiency (that is, their ability and willingness to engage in product innovation. (Harper 1997, p. 289) The main emphasis of the reforms that instituted the regulatory framework in place in Australia in 2007 was that competition was the best guarantee of

Australia   215 s­ ystemic stability. Regulation was in fact regarded as a potential source of problems, rather than as a prophylactic against them: ‘Prudential regulation can have adverse effects on efficiency, competition and innovation and there is scope to adjust existing regulation to reduce these effects’ (Wallis, et al. 1997, p. 297). Similarly, though securitisation played a far smaller role in the growth of mortgage debt in Australia than the USA, this did not reflect a more guarded philosophy about securitisation. The Wallis Committee was as enthusiastic about the benefits of mortgage securitisation as any pre-­crisis US regulator: Securitisation plays a valuable role in contributing to the competitiveness of the Australian finance sector, and its long‑term success will be a function of the extent to which it provides a sustainable cost advantage over other forms of financing. (Wallis, et al. 1997, p. 524) More recently, the increasing use of securitisation, which represents a lower cost method of providing home loans, has enabled mortgage originators to enter the home loan market and bid down prevailing mortgage interest rates. 40

FHOB Start

Australia USA Per cent of commercial bank loans

35

30

25

20

15

0 1974

1978

1982

1986

1990

1994

1998

2002

2006

Figure 9.23 Bank dependence on real estate loans, Australia and USA. Note FHOB: First Home Owners Boost.

2010

2014

216   S. Keen The rapid growth of mortgage securitisers has turned the market for housing finance into one of the most competitive segments of the Australian financial system. (Wallis, et al. 1997, p. 625) Thus, though Australia’s institutional arrangements and mix of bank versus securitised loans differed from those in the USA and UK, clearly this was more by accident than by design. The same discredited ‘Efficient Markets Hypothesis’ perspective that supported deregulation in the USA and UK was alive and well in Australia prior to the 2007 crisis. The main impact of the lower level of securitised loans in Australia may well be that the expansion of mortgage debt was more of an on-­balance-sheet phenomenon in Australia than the USA (see Figure 9.23).

The kangaroo is still a mammal A credit-­aware perspective on the data thus shows that Australia’s macroeconomic and asset market performance are largely driven by the same factors that drive macroeconomics and asset markets in the USA and UK. There are differences, but these are scale issues rather than qualitative ones. The questions that arise are no longer of the ‘does Australia represent a different incarnations of liberal capitalism?’ class, but more quantitative – such as ‘Why did credit growth not collapse as much in Australia as in the USA when the crisis hit?’ That particular question has an important but relatively mundane answer: ‘Because government policy delayed it’. One relative peculiarity of the Australian government since the mid-­1980s has been its use of the housing market as a means to stimulate the economy during a downturn, via the extension of grants to first home buyers (Keen 2010).15 Introduced first in 1983 by the Hawke Labour government as a means to combat the recession that preceded its election, the First Home Owners Scheme has since been reintroduced, doubled and (for new homes) even trebled on four occasions since – twice by a Labour government (1988 and 2008) and twice by a Liberal one (2000 and 2001). This represents a bipartisan commitment to manipulating asset prices as a tool of macroeconomic policy. One every occasion bar one, the Scheme has led to a rise in real house prices – and on that one occasion in 2000, it was soon after doubled in 2001 (from $7,000 to $14,000, at a time when the median house price in Sydney was $331,000). From 1951 (some years after a rental control scheme was abolished) until the Scheme was first introduced in 1983, the average quarterly real house price change in Australia was 0.1 per cent (and statistically not significantly different from zero). After the Scheme’s introduction, the quarterly change was 0.9 per cent; when the Scheme was active, quarterly real price appreciation averaged 2.2 per cent, and on the two occasions when it was doubled, the quarterly rate of change was 3.1 per cent.

270 260 250 240 230 220 210 200 190 180 170 160 150 140 130 120 110 100 90

Index 1983 1988 2000 2001

14

12

20

12

20

08

20

06

20

04

20

02

20

00

20

98

20

96

19

94

19

92

19

90

19

88

19

86

19

19

19

19

84

2008

82

Index 1980 = 100

Australia   217

Year

Figure 9.24 Impact of the First Home Owners Scheme on house prices.

The Scheme affects house prices by increasing both the amount of debt that first home buyers can take on when bidding for a house, and the number of first home buyers in the market. It affects the economy by increasing the rate of growth of debt. The end result is that government manipulation of this key asset market has become a macroeconomically effective but socially and economically dangerous policy tool in Australia. Its impact in 2008 – both in terms of the change in house prices, and the increase in debt – was the major reason that Australia avoided both a house price

Table 9.3 Impact of the First Home Owners Scheme on house prices Quarterly real price change

Before FHOS

After FHOS

All Data

During FHOS

Between FHOS periods

When FHOS doubled

Mean Min Max Std. Dev. Count

0.1% −5.5% 3.9% 1.7% 131

0.9% −3.7% 7.9% 2.2% 112

0.4% −5.5% 7.9% 2.0% 243

2.2% −2.3% 7.9% 2.7% 25

0.3% −2.3% 3.0% 1.3% 50

3.1% −0.9% 4.9% 1.8% 7

218   S. Keen FHOB

2.0

Start

FHOB

20 End

16

1.5

12

1.0

8

0.5

4

0

0

Real house price change p.a.

Mortgage acceleration per cent GDP p.a.

2.5

–0.5

–4

–1.0

–8

–1.5

–12

–2.0 –2.5 2007

Acceleration

–16

Real price change 2008

2009

2010

2011

–20 2012

Figure 9.25  Impact of the First Home Owners Boost on mortgage acceleration and house prices.

crash and a deep recession in 2008–2010. An 8 per cent rate of decline in real house prices in 2009 was turned into a 16 per cent rate of increase in prices in 2010, while the increase in mortgage debt injected about $100 billion into the Australian economy over an eighteen-­month period (when compared to the trend in mortgage debt before the Boost was introduced). This credit injection into the economy was twice the scale of the government fiscal stimulus over the same period, which itself was the third largest in the world (as a percentage of GDP) after China and South Korea. Of course, as a minerals exporter, Australia also benefited from the growth of China caused in large measure by its enormous post-­crisis stimulus programme, but this effect kicked in well after the crisis itself. During the crisis itself, employment fell more in the mining States of Western Australia and Queensland than in the rest of the country, while the first State to record a rise in employment was Victoria. It was also the State the provided the largest supplement to the Federal Government programme, offering up to $14,000 additional dollars for first home buyers purchasing a new house in non-­metropolitan areas. The stimulus had its desired effect, and boosted the industries one would expect: employment in real estate in Victoria grew by over a sixth in just over a year, from the depths of the downturn for Australia in March 2009 until May 2010 (when the effects of the First Home Owners Boost began to dissipate; see Table 9.4).

Australia   219 Table 9.4 Growth of employment in Victoria from March 2009 till May 2010 Industry

Growth

Growth rate

Real Estate Accommodation &Food Administration Construction Professional Finance Mining Education Total Victoria Retail Health Other Services Total Australia Wholesale Information Technology Agriculture Transport Electricity Arts

6,319 27,173 12,564 28,769 19,635 9,267 988 14,848 104,602 11,288 8,325 2,706 158,710 2,211 408 −2,378 −5,339 −3,353 −10,957

17.6% 15.2% 14.2% 12.5% 9.8% 9.7% 9.3% 7.4% 3.9% 3.8% 2.8% 2.5% 2.1% 1.9% 0.6% −2.9% −3.7% −9.4% −17.0%

Marsupial touches There are of course substantial differences between Australia and the US and UK that have not been taken into account in the above. Australia’s geographic location and its endowment of minerals have meant that it benefited greatly from the growth of Asian economies in the last two decades. In particular, it received much of the benefit from China’s extraordinary post-­2007 stimulus programme, via much higher volumes for its exports and unprecedented prices for minerals. But these again reflect not a different ‘incarnation of liberal capitalism’, but a different position in the supply chain of global capitalism.

Conclusion Time may well confirm that Australia did in fact survive the economic crisis that began in 2007 better than any other Western nation, and that its favoured fate was due to its distinctive institutional and regulatory framework that set it apart from its erstwhile Causasian siblings the USA and the UK. But until substantially more time has passed, the proposition that Australia avoided a severe economic downturn and serious ramifications for its banking sector is deserving of Zhou Enlai’s misinterpreted remark on the French Revolution: it is ‘too early to say’.16

220   S. Keen

Notes   1 Data sources for post-­Second World War private debt levels are: for the USA, the Federal Reserve Flow of Funds, Table L1 (http://federalreserve.gov/releases/ z1/ Current/data.htm); for the UK, the Office of National Statistics data that was used to produce the 2011 Budget report (see www.ons.gov.uk/ons/rel/naa1-rd/united-­ kingdom-economic-­accounts/q3-2010/united-­kingdom-economic-­accounts--no--72. pdf ); for Australia, the Reserve Bank of Australia’s Statistical Bulletin Table D02 (see www.rba.gov.au/statistics/tables/index.html).   2 Australia’s private debt was 65 per cent of GDP at the start of the Great Depression, versus a peak of 158 per cent in early 2008; America’s debt level was 177 per cent of GDP in 1930, versus a peak of 303 per cent in early 2009; UK data is not available.   3 One caveat here though is that the Australian data – from the RBA – does not necessarily correspond to the UK and US data with regard to finance sector debt. Both the US and the UK publish breakdowns of private debt into household, non-­financial business, and financial sector debt. Australia’s data – in RBA Bulletin Table D02 (see note 1) – includes household and non-­financial business, but not finance sector debt. Recent international debt statistics allegedly assembled by Haver Analytics and Morgan Stanley infer that, when finance sector debt is included, Australian aggregate private debt levels are equivalent to those of the USA, and UK private debt (though the official statistics include financial sector debt) is actually twice the level published here (see www.dailypressdot.com/uks-­debt-reached-­huge-numbers/754465).   4 The analysis was later extended to include a neoclassical model of production as well.   5 If you are a non-­economist, and are reading an extract from a technical economic paper for the first time, and you are now gagging, good! Your reaction is entirely justified, as I will shortly explain.   6 In a draft version, they stated this even more clearly: ‘Debt seems to be the residual variable in financing decisions. Investment increases debt, and higher earnings tend to reduce debt.’   7 The net turnover of existing assets is the product of the fraction of assets sold each year, times their prices, times the quantity in existence.   8 The change in income plus the acceleration of debt will affect change in output levels and prices, as well as change in asset prices, turnover of assets, and the quantity of assets.   9 Most economists who try to apply evolutionary concepts start from some deep dissatisfaction with economics as it is. I won’t say that I am entirely happy with the state of economics. But let us be honest: I have done very well within the world of conventional economics. I have pushed the envelope, but not broken it, and have received very widespread acceptance for my ideas. What this means is that I may have more sympathy for standard economics than most of you. My criticisms are those of someone who loves the field and has seen that affection repaid. 10 Defined as the change in debt, divided by the sum of the change in debt plus GDP. 11 Unfortunately, despite its empirical refutation, most economics departments continue to teach this logical and empirical travesty. 12 There was a definitional change in debt in 1990 which caused a break in the credit acceleration data for 1991. 13 In the sense that the downside risk of shares is far higher, on a far shorter time scale, than the downside risk in property. 14 It is undeniable that there was less securitisation in Australian lending than in the USA. However, some of the other factors noted as positives may not turn out to be so over time. For example, the fact that American banks were also highly profitable up until 2007 did not stop the crisis breaking out there in late 2007. 15 Other important Australian government interventions in the private housing market include ‘negative gearing’, which enables speculators to write off losses on property

Australia   221 speculation against their incomes from other sources, and a tax regime that taxes capital gains at half the rate that income is taxed. However these are permanent features of the Australian property landscape, whereas the introduction of or alteration to the ‘First Home Owners Scheme’ has been used as a counter-­cyclical tool on five occasions since 1983. 16 It is alleged that his remark referred to the impact of the student riots in 1968 rather than the French Revolution of 1789; see www.ft.com/intl/cms/s/0/ 74916db6-938d11e0-922e-00144feab49a.html#ixzz1PDuP8ZzG.

References Bernanke, B., M. Gertler, and S. Gilchrist (1996). ‘The Financial Accelerator and the Flight to Quality’, Review of Economics and Statistics 78(1): 1–15. Biggs, M. and T. Mayer (2010). ‘The Output Gap Conundrum’, Intereconomics/Review of European Economic Policy 45(1): 11–16. Biggs, M., T. Mayer, and A. Pick (2010). ‘Credit and Economic Recovery: Demystifying Phoenix Miracles’, SSRN eLibrary, doi.org/10.2139/ssrn.1595980. Fama, E. F. and K. R. French (1999). ‘The Corporate Cost of Capital and the Return on Corporate Investment’, Journal of Finance 54(6): 1939–1967. Fama, E. F. and K. R. French (2004). ‘The Capital Asset Pricing Model: Theory and Evidence’, The Journal of Economic Perspectives 18(3): 25–46. Fontana, G. and R. Realfonzo (eds) (2005). The Monetary Theory of Production: Tradition and Perspectives. Basingstoke: Palgrave Macmillan. Graeber, D. (2011). Debt: The First 5,000 Years. New York: Melville House. Graziani, A. (1989). ‘The Theory of the Monetary Circuit’, Thames Papers in Political Economy Spring: 1–26. Graziani, A. (2003). The Monetary Theory of Production. Cambridge: Cambridge University Press. Harper, I. R. (1997). ‘The Wallis Report: An Overview’, Australian Economic Review 30(3): 288–300. Hawtrey, K. (2009). ‘The Global Credit Crisis: Why Have Australian Banks Been So Remarkably Resilient?’ Agenda 16(3): 95–114. Holmes, A. R. (1969). ‘Operational Constraints on the Stabilization of Money Supply Growth’, in F. E. Morris (ed.) Controlling Monetary Aggregates. Boston, MA: The Federal Reserve Bank of Boston, pp. 65–77. Keen, S. (2010). Hand of Gov: The Housing Bubble – Fact or Fiction? Sydney: CLSA. Keen, S. (2011). Debunking Economics: The Naked Emperor Sethroned? London: Zed Books. Krugman, P. (1996). ‘What Economists Can Learn From Evolutionary Theorists’, a talk given to the European Association for Evolutionary Political Economy online, avail­ able at: http://web.mit.edu/krugman/www/evolute.html. Krugman, P. (2011). ‘The Conscience of a Liberal: Debt Is (Mostly) Money We Owe to Ourselves’, New York Times, online, available at: http:// krugman.blogs.nytimes. com/2011/12/28/debt-­is-mostly-­money-we-­owe-to-­ourselves/2012. Krugman, P. and G. B. Eggertsson (2010). ‘Debt, Deleveraging, and the Liquidity Trap: A Fisher-­Minsky-Koo Approach’ [2nd draft 14 February 2011]. New York: Federal Reserve Bank of New York and Princeton University, online, available at: www.frbsf. org/economics/conferences/1102/eggertsson.pdf. Minsky, H. P. (1982). Can ‘It’ Happen Again?: Essays on Instability and Finance. Armonk, NY: M. E. Sharpe.

222   S. Keen Moore, B. J. (1979). ‘The Endogenous Money Stock’, Journal of Post Keynesian Economics 2(1): 49–70. Schumpeter, J. A. (1934). The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle. Cambridge, MA: Harvard University Press. Wallis, S., B. Beerworth, J. Carmichael, I. Harper, and L. Nicholls (1997). Final Report of the Financial System Inquiry. Treasury, Canberra: Australian Government Publishing Service.

10 Institutional foundations of the Anglo-­Saxon banking systems Some are more liberal than others Olivier Butzbach, Suzanne J. Konzelmann and Marc Fovargue-­Davies

Financialization and neo-­liberalization: twin processes of macro institutional change We argued in Chapter 1 that institutions, consisting of rules and rule-­like resources, play a centrally important role in determining a country’s trajectory, through their influence on the behaviour of actors within the political and economic system. To address the empirical ‘puzzle’ of the contrasting experiences of the six Anglo-­Saxon financial systems during the 2008 financial crisis, we considered how institutional configurations within each country – and within their financial systems, in particular – might have influenced the outcomes associated with the parallel processes of neo-­liberalization and financialization, unleashed by the paradigm shift of the 1970s. In the course of this macro institutional change, we saw institutional complementarities inherent in each country’s political economy as playing a key role in shaping the processes of institutional reproduction (reinforcement of dominant institutional arrangements) and institutional change (displacement of previously dominant institutional arrangements); and we identified institutional layering (the introduction of new institutions on top of or alongside existing ones) and institutional drift (institutional change resulting from changes in the environment) as being potentially influential modes of institutional change. To shed light on the factors that might explain the divergent experiences of the Anglo-­Saxon banking systems, we examined the institutional complementarities that served to enable or constrain the process of financialization and neo-­ liberal reforms within the six countries. We hypothesized that central among these were interactions among institutional determinants of the political system (i.e. veto possibilities) and the banking system (i.e. heterogeneity of financial interests) and interactions among institutional dimensions of internationalization (i.e. international capital flows and the degree to which the financial system is integrated with the other liberal market economies (LMEs)) and financialization (of government, business and consumers). We expected to find that based on these determinants, we could identify countries that had evolved a ‘purer’ form of financialized liberal capitalism and, hence, a financial regulatory system that

224   O. Butzbach et al. would provide less protection in the face of a crisis like that experienced in 2008. If our hypotheses were correct, we would expect to see a clear sub-­grouping of the US, UK and Ireland, on the one hand, and Canada, Australia and New Zealand, on the other. This chapter summarizes our findings in comparative fashion. Neoliberal regulatory reforms in the six countries Across the Anglosphere, there are striking similarities associated with the parallel processes of neo-­liberalization and financialization, particularly with respect to the progression and overall direction of policy reforms. This chapter focuses on the Anglo-­Saxon banking systems, and the comparisons that may help to explain the puzzle of why such a sharp divide in their performance became apparent in the wake of the 2008 financial crisis. From the 1970s onward, the institutions regulating financial services were significantly modified. What at first appeared to be a process of deregulation, however, could be more accurately described as one of reregulation. As financial markets were desegmented and liberalized, new regulatory institutions were set up to control both the new, more liberal financial markets and the new actors that emerged within them. Important among these were non-­bank financial entities and collective investment funds. As evident in Table 10.1, commonalities can be found in key financial market reforms resulting from the move to neo-­liberalism following the crises of the 1970s. Yet it is important to note that these are not unique to LMEs; they mirror a wider shift in economic policy in most advanced industrial economies. Whilst neo-­liberal reforms were not simultaneously adopted within the Anglosphere, the direction of regulatory reform was broadly comparable. Perhaps surprisingly, Canada was the first of the Anglo-­Saxon economies to experiment with neo-­liberal policies, following the Porter Commission in 1964. The US and the UK followed in the early 1980s, Australia and New Zealand in the mid-­1980s and Ireland in the late 1980s. As the country case studies reveal, LMEs were often inclined to implement more radical versions of neo-­liberal policies than adopted elsewhere. But there are clear differences in the policy frameworks that were evolved in Australia, Canada and New Zealand, on the one hand, and the US, UK and Ireland, on the other – differences which, as we have seen, would have significant repercussions. The changing role of the central bank is particularly interesting, possibly reflecting a pattern specific to the LMEs and instrumental to the process of financialization. Anglo-­Saxon central banks were traditionally charged with responsibility for supervision and control of the banking sector, with the Treasury generally being responsible for monetary policy. During the 1980s and 1990s, however, they assumed an increasingly important role in the shift to supply-­side, market-­enhancing monetary policy. Following the inflationary crises of the 1970s and early 1980s, the focus of policy shifted, from maintaining full employment to controlling prices. The political challenges associated with controlling inflation (using contractionary policy) combined with the neo-­liberal

Foundations of Anglo-Saxon banking systems   225 concern about market freedom to encourage a shift in the division of governmental responsibilities. Increasingly, the central government assumed responsibility for ensuring market freedom whilst the central bank was charged with managing inflation. In 1989, the Royal Bank of New Zealand was the first of the LMEs’ central banks to be granted operational independence and assigned responsibility for monetary policy (inflation targeting and the setting of interest rates); during the 1990s, the rest followed. The Bank of England (after the 1979 Banking Act), the Central Bank of Ireland (after the 1989 Central Bank Act) and the US Federal Reserve (after the 1999 Gramm-­Leach-Bliley Act) also extended their regulatory powers beyond deposit-­taking credit institutions. This was not the case in Australia and Canada, where specific regulatory agencies had been set up, early on, to deal with non-­ bank financial entities. The regulatory structure that emerged from three decades of reform thus ranged from a unified structure (with a single regulatory agency covering all segments of the financial industry) in the UK, Ireland and New Zealand; to a ‘twin peaks’ structure in Canada and Australia; and a fragmented structure in the USA. In the wake of the crisis, both the unified and the fragmented structures have been heavily criticized whilst the twin peaks structure has been credited with preventing some of the excesses contributing to the crisis and the regulatory failings of the other two systems. Changes in financial and non-­financial firms’ behaviour In Chapter 1, we reviewed trends in the aggregate data charting the process of financialization within the Anglosphere since the 1970s. The country chapters then looked more closely at the structure, functioning and evolution of financial systems – banking, in particular. This revealed comparable trends during the decades preceding the 2008 financial crisis. Among these was the restructuring of banking and the emergence of large financial holdings through mergers and acquisitions. Especially in the US, a sharp bifurcation can be discerned during the 1980s and 1990s between, on the one hand, a relatively few large financial conglomerates and, on the other, a multitude of small, local banks (often non-­profit institutions). This took place in the UK and Ireland as well, and was largely the result of the financial sectors internationalizing to a much greater extent than they did in Canada or Australia. Consequently, their financial sectors were able to grow to be much larger.1 By contrast, the Canadian banking system is dominated by five large domestic banks, with branches in all of the Canadian provinces. The Australian banking system, too, is primarily domestic, with four large Australian financial institutions – the ‘four pillars’. Although foreign banks were permitted into the Australian financial market following the lifting of restrictions on foreign entry in 1985 (designed to increase competition), they ultimately failed or withdrew, leaving the four pillars stronger than ever. Whilst New York’s stock market had been extensively liberalized during the 1970s, it was not until the 1986 ‘Big Bang’ deregulation of the City of London –

Regulatory structure

Changes

Canada

• Regulation is split • Regulation is split between three between three bodies: bodies: Bank of the RBA for monetary Canada for policy; APRA for monetary policy; supervision of depositOSFI for taking institutions, prudential insurance and regulation of superannuation individual banks companies; and ASIC and monitoring of for oversight of systemic risk; and corporations and the minister of securities finance for political leadership. • A Financial Agencies Supervisory Committee facilitates communication among federal financial regulators • Banking is federally regulated; securities are provincially regulated

Australia

New Zealand

United Kingdom

United States

• Unified • Unified • Complex and • Unified regulatory regulatory layered regulatory structure under structure since regulatory structure since the Central the 2000 structure 2010 Bank (RBNZ) Financial • Gramm–Leach– • Originally (after • The Reserve Services and Bliley Act of 1971), the Bank Act of Markets Act, 1999 gave the Central Bank New Zealand which created Federal Reserve was the licensing (1989) requires the FSA as a Board umbrella and supervisory registration of single, unified authority over authority for banks and financial non-banking commercial empowers the services subsidiaries banks. RBNZ to regulator owned by newly • In 1989, money undertake • Bank of England recognized brokers, financial prudential given greater financial futures traders, supervision of regulatory holding building societies registered banks power under the companies and Trustee 1979 Banking • Federal or state Savings Banks Act following charters were brought the secondary available under the Central banking crisis of Bank’s control; 1973–1974; as were granted collective operational investment funds independence (in 1990). and assigned • First responsibility rationalization in for monetary 2003 policy in 1997 • In 2010, all financial regulation was brought under the umbrella of the Central Bank

Ireland

Table 10.1 Neo-liberalism at play: market-oriented regulatory reforms in the six countries, 1970–2007

Banking regulation

Privatization

• Most Australian banks • Canadian banks are privately owned, have historically with exception of The been privately Commonwealth Bank owned and State Banks, which were founded as government-owned institutions and privatized after the 1987 Stock Market Crash • The Commonwealth Bank was partially privatized in 1991 and fully privatized in 1996

continued

• Most large Irish • NZ Banks have • British banks • US banks have banks (Bank of historically have historically historically been Ireland, Allied been privately been privately privately owned Irish Banks, owned, with the owned • In 2009, the Anglo Irish exception of the • Northern Rock Treasury Bank) have Bank of New and Bradford & acquired large historically been Zealand (now Bingley were equity stakes privately owned owned by the nationalized in (preferred • The state-owned National 2009 stock) in Agricultural Australia Bank) • In 2009, the Citigroup and Credit • Kiwibank Treasury Bank of Corporation was (3.7% market acquired large America sold to share) is a equity stakes in Rabobank in subsidiary of the Royal Bank 2002 New Zealand of Scotland and • The Industrial Post (a stateLloyds Banking Credit Company owned entity). Group (set up in 1933 to encourage investment in industry) was bought by the state from by the Bank of Scotland in 2001 • Allied Irish Banks Ltd was effectively nationalized in December 2010 and delisted in early 2011

De-segmentation

Table 10.1  Continued

• A corollary of privatization has been the development of ‘one stop shops’ by the major banks, with banks now offering everything from traditional banking to brokerage services

Australia

Ireland

New Zealand

United Kingdom

United States

• In 1980, the • At the time of • Following • Following the • The Depository definition of ‘Big Bang’, deregulation in 1986 ‘Big Institution ‘banking’ in the which allowed 1984/1985, Bang’, banks Deregulation Bank Act was outside banks were and financial and Monetary expanded to cover corporations to permitted to institutions were Control Act of provincially own member acquire permitted to 1980 and the regulated depositfirms, the Irish prudentials, acquire Garn–St. taking institutions Stock Exchange building brokerage Germain Act of • The 1987 and 1992 was a part of the societies and houses and 1982 permitted Bank Act Stock Exchange merchant banks insurance thrifts to expand amendments of the UK and companies, beyond allowed commercial Republic of giving rise to mortgage loans banks to acquire Ireland ‘one-stop-shop’ funded by investment dealers • The Building financial savings accounts • The 1999 Bank Act Societies Act institutions to other lending amendments 1989 enabled and checking permitted Schedule building account II foreign banks to societies to equivalents provide branch expand the • The 1996 banking services to scope of their Federal Reserve individual investors activities, ruling permitted • Canadian banks allowing them to BHCs to own dramatically offer a broader investment reduced their range of banks with some corporate loan financial revenue portfolios services limitations throughout the • The 1999 1990s and 2000s, Gramm–Leach– from 90% of Bliley Act lending activities to (GLBA) allowed 60% BHCs to expand

Canada

continued

beyond activities ‘closely related to banking’ to activities that are ‘financial in nature’, repealing the Glass–Steagall Act’s separation of commercial banking from investment banking • The Federal Reserve subsequently permitted trading physical commodities and energy as a complementary activity; and the OCC facilitated growth in bank participation in the OTC derivatives market

Interest rate regulation

Table 10.1  Continued Canada

Ireland

New Zealand

United Kingdom

United States

• A non-legislative • Following the • In 1999, Ireland • The Reserve • In 1931, the • In the late charter between the 1967 Porter joined the EMU. Bank uses Bank of England 1970s, the federal government Commission In order to monetary policy was Federal Reserve and the RBA gave the Report, interest qualify for to control subordinated to Board RBA complete control rate caps were membership, inflation, the Treasury in announced that over interest rate removed from 1992 to keeping it interest rate it would control policy • Concentration in 1999, the within a policy inflation by • Inflation targeting the Canadian Central Bank of medium term • In 1997, the restricting banking industry Ireland target band Bank of England growth in the since the 1970s has exercised active (1–3%). Retail was granted money supply caused minimal interest rate rates of interest independence rather than interest rate controls are thus directly and assigned maintaining competition among • As a member of related to the responsibility interest rates Canadian banks the Eurozone, rate set by the for interest rate and reduced risk interest rates Reserve Bank. policy taking were set from 1999 onwards by the board of the European Central Bank

Australia

Enhanced competition

• Entry into Australia’s banking sector was restricted until 1985, when 16 foreign banks were allowed into the market to encourage competition. • Ultimately, all foreign bank entrants failed or withdrew from the market, leaving the ‘Four Pillar’ banks (Commonwealth, Westpac, NAB and ANZ) even more dominant than they were prior to the opening up of competition

• The 1964 Porter • In the wake of Commission ‘Big Bang’, the established tax-incentivized competition as the International central policy Financial objective of Services Centre Canadian bank was established regulation in 1986 to • In 1998, proposed attract traded mergers by four of financial the five largest services to banks were refused Dublin because of anti• In 1989, competitive effects increased The stringent competition was regulation of foreign driven by the banks operating in liberalization of Canada effectively the building precluded society sector competition from • The 1992 foreign banks in European consumer banking Communities (Licensing and Supervision of Credit Institutions) Regulations provided for mutual recognition of the provision of banking services within the EU

continued

• In 1971, • The 1994 Competition and Riegle–Neal Credit Control Act permitted removed lending interstate caps on banking and individual interstate banks, but branching sought to control which increased the overall competition in supply of banking and money. permitting • The 1986 interstate Building consolidation of Societies Act banks allowed mutual societies to compete with banks in a wide range of products and services

Financial Market (non-banking) liberalization regulation

Table 10.1  Continued Canada

Ireland

• Various state-based • During the 1990s, • The Investment bourses have been a majority of large Services amalgamated into the investment dealers Directive 93/22 Australian Securities merged with was Exchange (ASX), now commercial banks. implemented a private company This subjected into Irish law • The ASX now them to regulation through the regulates (and profits by both federal 1995 Investment from) listings on all financial regulators Intermediaries manner of exchanges, and provincial Act and the from the stock market securities 1995 Stock to contracts for regulators and has Exchange Act, difference caused Canadian allowing for banks to be more investment accountable for intermediaries, their portfolio risk exchanges and • The 2007 Assetmember firms to Backed operate on the Commercial Paper basis of an Crisis exposed the authorization regulatory gap from a between federal competent financial and authority in provincial another securities jurisdiction regulation

Australia

New Zealand • The 1950s and 1960s saw the emergence and growth of unregulated Eurodollar and wholesale sterling markets in London • The 1986 Financial Services Act – ‘Big Bang’ – liberalized financial services and brokerage activities

United Kingdom

• During the 1980s and 1990s, stock exchanges were demutualized and merged • The 2000 Commodity Futures Modernization Act exempted over the counter derivatives from regulation • The Bankruptcy Code permitted preferential treatment and netting of derivatives in bankruptcy

United States

Enhanced competition

• The 1978 Securities Act defined nonbank deposit takers. • From 2005, the Reserve Bank was appointed sole prudential regulator • In 1984/1985, the regulatory advantages of not being a bank were removed

continued

• 1986 ‘Big Bang’ • During the liberalization 1970s and (see above) 1980s, money market mutual funds with cheque-writing capabilities competed with bank checking accounts • Commercial paper was used by investment banks as a substitute for loans from banks • The 1999 GLBA allowed control of banks by financial firms • Banks and investment banks compete in the development of securitization structures

Capital controls

Removal

Table 10.1  Continued Canada

Ireland

New Zealand

United Kingdom

United States

• The Foreign • During the 1990s • In 1992, capital • In 1984/1985, • Starting in the • During the early Investment Review and 2000s, controls were widespread 1950s, with the 1980s, capital Board vets Schedule III temporarily direct controls emergence of controls were applications for foreign banks took reintroduced on financial the unregulated lifted foreign purchases of advantage of the following intermediation Eurodollar Australian assets weak Canadian problems with and foreign markets in • In practice, foreign dollar. By maintaining a exchange were London, the purchases of exploiting the fixed exchange removed effectiveness of Australian assets are strength of their rate in the ERM • Credit and capital controls virtually unregulated: currency, they • Since 1999, foreign began to break the blocking of a were able to membership of exchange down. However, foreign purchase is provide more the Eurozone supply were they were normally a major news affordable credit to has prevented indirectly nominally in story Canadian the possibility of administratively place in the UK companies. capital controls controlled by until 1979, when The weak Canadian interest rate they were dollar also meant that changes formally lifted. Canadian banks were Since to be ill suited to engage in effective, capital foreign lending. controls need to Between 2002 and be enforced at 2008, the Canadian both ends of a dollar appreciated transaction, this dramatically, forced other increasing the value countries to of Canadian bank follow suit – and holdings immediately it attracted more prior to the financial foreign capital crisis to London

Australia

Foundations of Anglo-Saxon banking systems   235 together with rapid improvements in information technology – that extensive international financial operations became truly viable. This increased the divide, in terms of the possible scale of financial globalization, between the US, UK and Ireland, on the one hand, and Canada, Australia and New Zealand, on the other, with far-­reaching effects. Not only would it underpin the ‘too big to fail’ dilemma; in the more globalized systems it would also introduce the threat of regulatory arbitrage, and shift the balance of power away from regulators and the state to the private sector financial institutions. As well as taking advantage of market de-­segmentation and liberalization to grow rapidly, many financial institutions also fundamentally changed their business model, to the same end. Whereas the traditional model was one of ‘originate to hold’, there was a general shift to ‘originate to distribute’, involving either actually, or apparently, selling assets to remove them from the balance sheet and create cash with which to generate more assets. This process was greatly facilitated by securitization, which was theorized to spread risk so widely that its effects would be negligible. Whatever the merits of this view, it also encouraged relaxation of lending standards based on the assumption that any additional risk would be passed on and dissipated. During the 1980s and 1990s, to operate this new system, ‘shadow banking’ emerged: assets were shifted from the parent bank’s balance sheet into what was nominally a separate non-­bank entity. However, shadow banking took different forms in the six LMEs. In Canada, where foreign banks were impeded from entry, shadow banking permitted the entry of foreign capital into non-­chartered, provincial financial institutions. By contrast, in the US, the objective was different since there were fewer restrictions on foreign capital. The American shadow banking system, which was also one of much greater scale, was used to drive profits – and ultimately, share price. The shifting of assets from the parent bank’s balance sheet also offered other possibilities – notably, the ability to circumvent the need to hold regulatory capital against them. Here again, there is a divide within the Anglosphere. American and British banks tended to exploit this option whilst Australian and, especially, Canadian banks generally pursued a more conservative approach. De-­segmentation also facilitated both the acquisition and securitization of consumer credit. Here, rather than merely escaping regulation, the system acquired another purpose – sourcing higher risk (and hence higher return) loans to boost returns from the structured investment products based on them. This search for yield was to prove instrumental in triggering the 2008 crisis. In Canada, Australia and New Zealand – and, perhaps more surprisingly, the UK – there was less enthusiasm for creating securitized products. This contrasts sharply with the US and, more recently, Ireland, where the first securitization, in 1999, opened the floodgates: by 2009, securitized products in Ireland amounted to 38 billion euros (Jackson 2009). Securitization was thus accompanied by an increase in risk-­taking by financial institutions across the Anglosphere. It also brought an easing of credit standards, particularly in the residential mortgage markets, which helped to inflate property bubbles. The central influence of the property market is especially striking in

236   O. Butzbach et al. Ireland, where the boom was fuelled by cheap credit during the 2000s as a result of joining the Eurozone and the multiplication of wholesale operations by mortgage lenders. The US is another noteworthy case since mortgage lenders had relaxed credit standards almost completely, prioritizing structured investment products over the quality of the loans themselves – assuming that rapid securitization would transfer the risk. The outcome, however, was the triggering of the 2008 financial crisis. Overall, by taking advantage of regulatory changes or trying to circumvent them, both financial institutions and regulatory structures were extensively altered in all six Anglo-­Saxon countries. This resulted in greater risk-­taking, financial conglomeration, financial innovation, increasing cross-­country competition and securitization – but as evident above, to varying degrees across the Anglosphere. These differences in the micro effects of the macro institutional change that is financialization would prove to be decisive in determining the different national-­level experiences of the 2008 financial crisis. Feedback effects As discussed in Chapter 1, financialization and neo-­liberalization generate feedback effects, which, in turn, result in institutional layering (both through incremental change and path-­dependent reproduction). Two types of feedback effect can be identified: (1) a ‘regulatory dialectic’ effect, that links changes in financial firms’ behaviour with changes in regulation; and (2) a ‘macro’ effect, that connects financialization with declining labour income. ‘Regulatory dialectic’ effects occur whenever the behaviour of regulated firms reinforces the need for regulations that further affect behaviour. The term, coined by Kane (1991), was used by Guttman (2008) to describe how financial innovation has been used by banks: it ‘undermine[s] existing regulations only to drive their newfound freedom too far, [to] create conditions of crisis, and so invite re-­regulation in response’. This invitation, of course, is not always taken up. The American reaction to the Savings and Loans crisis during the 1980s was surprisingly muted – as was the UK’s response to the Johnson Matthey Bankers debacle. By contrast, Australia’s response to the activities of its ‘corporate cowboys’ of the 1980s and Canada’s response to the collapse of Confederation Life in 1994 resulted in significantly tighter regulation. The ‘macro’ feedback effect, which operates through income inequalities, is far more consistent across the Anglosphere. As evident in Figure 10.1, income inequality has increased dramatically since the late 1970s. This has produced feedback effects encouraging the wealthy to defend their positions (Hacker and Pierson 2010). It has eroded both wages and the legitimacy of trade unions. Growing income inequality has also had the effect of marginalizing left-­wing movements and parties, thereby further weakening the position of workers and low-­wage earners. It has also influenced the political process, to the advantage of the wealthy (and finance). Another effect has been the financialization of wage earners and the poor as credit has increasingly been used to maintain living

Foundations of Anglo-Saxon banking systems   237 20 18 16 14

Australia

12

Canada

10

Ireland

8

New Zealand

6

United Kingdom

4

United States

2 0 1940

1950

1960

1970

1980

1990

2000

2010

2020

Figure 10.1 Top 1% income earners’ share of total income in VOL countries, 1947–2009 (source: Alvaredo et al. n.d.).

standards in the face of declining incomes and social welfare provision (Guttmann and Plihon 2008). The dynamics of income inequality helps to explain the strength of financialization in different countries and its role within the political economy. Ireland is a case in point. Smaller and traditionally poorer than the other Anglo-­Saxon countries, its development since the 1980s was predicated on the growth of two sectors: finance and real estate. The financial-­property sectors thus played a key role in Ireland’s adoption of neo-­liberal reforms; and it accelerated the process of financialization there. Housing policy was also used as an economic stimulus in Australia; and policies promoting homeownership helped to inflate real estate bubbles in both the UK and US. Whilst the role of real estate asset bubbles in legitimizing a finance-­driven economic development strategy has yet to be analysed in more systematic terms, our six case studies demonstrate the importance of property booms and busts in the development of finance and financial regulation in the Anglosphere. It is with regard to regulation that significant differences emerge to help explain the divergent outcomes from otherwise similar processes of financialization and neo-­liberal reforms.

Regulatory differences – ideas and path-­dependence Alongside the similarities, Table 10.1 also reveals significant differences in the outcomes associated with regulatory reforms. These differences have less to do with the overall direction of regulatory changes, which is broadly comparable, than with the intensity of financialization and neo-­liberalization. A continuum can be drawn, ranging from a high degree of financialization associated with radical neo-­liberal reforms at one extreme, to a lower degree of financialization associated with moderate neo-­liberal reforms at the other. When the Anglo-­Saxon

238   O. Butzbach et al. e­ conomies are positioned along this continuum, the two sub-­groups that appeared in the wake of the 2007–2008 financial crisis – our initial empirical puzzle – can be discerned. In the three countries hardest hit by the crisis – Ireland, the US and the UK – the weakness (or even absence) of compensating or mitigating institutions allowed neo-­liberal reform and financialization to be more extreme (and to create greater vulnerability) than in Australia, Canada and New Zealand. A closer look at the changes in financial regulation across the Anglosphere reveals subtle but significant differences. The liberalization of banking markets in Canada, for example, was gradual and it was kept under the tight control of regulators. In 1997 and 1999, successive amendments to the Bank Act allowed limited foreign access to Canadian financial markets; but it set limits on mergers and on the extent to which banks could undertake leasing activities, reinforcing the more conservative approach of Canadian banks. Similarly, neo-­liberalization in Australia and New Zealand was less consistent and linear than it was in Ireland, the UK and the US. When restrictions on foreign entry into the Australian banking sector were lifted in 1985 to encourage competition, sixteen foreign banks entered the market; but they eventually failed or withdrew, leaving the Australian banking system a predominantly domestic one. By contrast, the US, UK and Irish financial systems were highly internationalized during the period of neo-­ liberal reforms – and, hence, increasingly difficult to supervise and to regulate. Such differences can be ascribed to two sets of factors. The first are country-­ specific factors associated with national regulatory styles (Vogel 1996). These are highly path-­dependent and operate at the crossroads of culture and institutions; they are also shaped by differences in policy ideas across the Anglosphere. The central role of ideas in times of (rapid) institutional change – as opposed to times of incremental institutional change, where there is no need for new ideas to dispel uncertainty (Blyth 2002) – was discussed in Chapter 1. The case studies of Australia, Canada, Ireland and New Zealand reveal how influential the policy ideas introduced and implemented in the US and UK have been. They have been further popularized through the activities of right-­wing think tanks, such as the Mont Pelerin Society in the US and the Institute for Economic Affairs in the UK. However, governments and political parties also have ideas of their own about what the ultimate goals of neo-­liberal reforms should be. These are often influenced by significant interest groups that are able to shape the policy-­making process. It is also notable that in the US and UK, the process of neo-­liberal reform was branded with the name of its principle standard bearer – ‘Reaganomics’ in the US and ‘Thatcherism’ in the UK. Ideas can also serve to moderate the reform process. In Australia, for example, regulatory reforms were tempered by ‘economic rationalism’ – a blend of Keynesian and neo-­classical economics that allowed for government intervention to correct market failures. As a result, although Australian regulators were believers in competition and the efficient market hypothesis (as revealed by the 1997 Wallis Commission Report), their ‘twin peaks’ model embodied a balanced approach to financial re-­regulation. Another example can be found in the

Foundations of Anglo-Saxon banking systems   239 case of New Zealand, where politicians are ‘statist by nature’; they were thus less inclined toward radical neo-­liberal reforms, even during the neo-­liberal decade of 1984–1993. In Canada, a cultural tendency to be at best wary of banks, and a tendency to more strictly control them, also mitigated against wholesale liberalization of finance – and due warning was taken from the few, more spectacular failures that did occur. By contrast, Reagan’s assertion that ‘government is the problem’ gained traction in the US, as did the similar views expressed by Margaret Thatcher in the UK. Both administrations were able to make fundamental changes in the institutional structure and operation of their respective economies, due to powerful government majorities and successive terms of office. The process of reform would thus build institutional complementarities with which to perpetuate itself. The second set of factors concerns timing. It can be argued that both the early – and more incremental – adoption of neoliberal reforms and the early experience of financial crises have the potential to lead to more prudent behaviour on the part of policy-­makers and regulators alike. This fits well with the opposing experiences of Canada and Ireland. In Canada, neo-­liberal reforms were introduced well before they were in the other LMEs. Canada’s early adoption may have allowed it to introduce changes on an incremental basis and test their effectiveness, paving the way for more balanced regulations. By contrast, Ireland is a ‘late neo-­liberal reformer’ – with most pro-­market regulatory changes taking place during the 1990s and 2000s. It therefore had little time for learning before the arrival of the 2008 financial crisis. Similarly, it could be argued that the early experience of financial crises may have induced governments to legislate. The bursting of the Australian property bubble in 1974, for example, resulted in recommendations for tighter regulation in the 1981 Campbell Inquiry Report; and the failure of a large Canadian insurance trust during the 1990s was met with commensurate regulatory reform. However, as Blyth (2002) has shown, crises are as likely to be perceived objectively as they are to be socially and politically constructed; and there are crises that are not recognized as such – and therefore do not lead to the questioning that might be at the root of more moderate approaches to neo-­liberalization and financialization. This is largely what lies behind the US’s and the UK’s failure to tighten regulation in response to the Savings and Loan Crisis and the failure of a number of large financial institutions, respectively, during the 1980s. In short, whilst the country case studies reveal the influential role of different policy ideas and path-­dependence, the outcomes from neo-­liberalization and financialization cannot be meaningfully understood without reference to the structure, organization and functioning of political and the administrative systems within which they progressed.

The structure of the political system Neo-­liberal reforms do not correspond to a set of narrowly defined political preferences. Economic liberalization, financialization and ‘light-­touch’ market

240   O. Butzbach et al. regulation were promoted and implemented in a bipartisan way within the Anglosphere. They were also the outcome of a process of institutional layering and drift that occurred over a number of decades and was influenced, one way or the other, by events including changes in government and parliamentary majorities. Whilst neo-­liberalism is strongly associated with the right-­wing administrations of Margaret Thatcher and Ronald Reagan, the country case studies reveal that both centre-­left and Labour governments were also instrumental in pushing for neo-­liberal reforms. Such was the case in Australia, when the 1984 Financial System Review, under a Labour government, recommended further financial liberalization and in the UK, during the late 1990s and 2000s, when New Labour endorsed policies favourable to the financial interests in the City of London. The structure and functioning of the political system, and the administration operating within it, also played an important role in creating the conditions that resulted in diverging outcomes from financialization and neo-­liberalization. The country analyses suggest that durable coalitions were significant in promoting and furthering the neo-­liberal agenda. This was especially apparent in the case of Ireland, where the strong ties established in the 2000s between political parties (in particular Fianna Fáil) and property developers led to a ‘cement economy’. Also apparent were the sociological elements driving the process – in particular, the common origins and shared cultural references of corrupt politicians and ‘self-­made’ business men. Similarly, the ‘cosy relationship’ between British politicians, regulators and financial actors can be seen to be a basis for a policy coalition that furthered the interests of British financial conglomerates. Another mechanism creating a policy coalition is the power of lobby groups – especially financial services lobbies. In the US, these groups were instrumental in pushing for favourable reforms and watering down ‘hostile’ ones (such as the Dodd-­ Frank Act); regulatory capture proved to be a particularly significant factor in this case. Another factor shaping the processes of neo-­liberalization and financialization was the existence, number and influence of veto possibilities – the ability of political actors (regulatory agencies, policy-­makers, government officials, political parties, labour unions, lobbies, interest groups) to block, slow down or dilute regulatory changes considered hurtful to their interests. The relative strength of unions was a factor, as were more general attitudes towards labour. In the US and the UK in particular, unions were greatly weakened during the 1980s and the 1990s, both in their capacity to promote alternative economic ideas and to act as veto players. The structure of the political system itself was also a source of greater or lower veto possibilities. Whilst neo-­liberal reforms progressed more easily with strong parliamentary majorities and stable governments, the parliamentary paralysis in the 1990s in New Zealand – the result of coalition governments with narrow majorities – slowed down the neo-­liberal reforms that had been unleashed during the 1980s. Beyond a strict definition of the political system, factors such as the fragmentation of regulatory agencies that might inhibit their capacity to effectively operate should also be considered; such was the case with the American neo-­liberal reform process.

Foundations of Anglo-Saxon banking systems   241 Veto possibilities and compensating institutional mechanisms are not limited to the political system. One of the hypotheses put forward in Chapter 1 was that less obvious variables, such as subtle differences in the structure and organization of financial systems, could also help to explain differential outcomes.

The structure of the financial system It is already clear that banks and financial institutions followed broadly similar trends during the period of economic liberalization. This highlights both financialization as a process of macro institutional change and the advance of neo-­ liberal policy. However, the country case studies also reveal a number of less obvious – but nonetheless significant – differences in the organization and governance of national financial systems that might contribute to varying outcomes. Especially significant among these are: (1) the business model of large financial conglomerates; (2) the consequences of financial market concentration; and (3) the functioning of the market for corporate control. Desegmentation and the subsequent emergence of large financial conglomerates does not necessarily produce a culture of risk-­taking and excessive reliance on capital markets. All six countries saw the emergence of large national banking groups. But these banking groups did not all behave in the same way. The mergers between commercial and investment banks in Canada, following the 1987 Bank Act Amendment, for example, resulted in investment banks being managed by commercial banks, not the other way around, as in the United States. Neither was there a comparable increase in the presence of foreign banks and institutions. Canadian banks maintained their conservative business model throughout the period of neo-­liberalization and financialization; and they showed little enthusiasm for mortgage securitization. Australian banks, too, remained largely national, rather than global; and like their Canadian counterparts, they did not share the American appetite for dramatically expanding their lending to the sub-­prime sector. Instead, there was a warning from the regulator against lending into the housing sector at reduced standards – along with encouragement to increase lending to business. A high degree of market concentration could thus be a double-­edged sword, leading to greater risk-­taking in some cases – especially where the ability to operate across regulatory jurisdictions was present – but less in others where greater transparency and influence was available to the regulatory structure. In Canada, for example, the 90 per cent market share enjoyed by the five large domestic banks since the 1970s, along with long-­standing restrictions on the entry of foreign banks, allowed them to maintain high profit margins without taking too much risk. This echoes Hick’s famous saying that ‘the best of monopoly profits is a quiet life’ (Hicks, 1935: 8). Corporate governance is another area where small differences matter – and where another paradox emerges. It is in those countries where the market for corporate control was most developed and active (Ireland, the US and UK) that we see the greatest failures of governance – including the ‘too big to fail’

242   O. Butzbach et al. problem. As evident in the country case studies, whilst Australia, Canada and New Zealand also had very active takeover markets during the period of neo-­ liberalization, foreign bank entry was limited. This is in spite of the positive effects – according to adherents of economic liberalization – that this might be expected to have on bank efficiency.2 However, self-­regulation in Ireland the US and the UK failed to produce the benefits predicted by the mainstream corporate governance literature (i.e. transparency, accountability and healthier long-­term performance). The Irish case is illustrative; not only did the market for corporate control fail to operate as a mechanism conducive to good corporate governance, it had largely the opposite effect. The 2009 Turner Report revealed that in Ireland’s case, increased reliance on capital markets contributed to the inflation of asset price bubbles. Higher book profits also drove banks and traders in the US and the UK to ‘believe that they were pursuing sensible strategies’. In short, formal compliance with corporate governance requirements did not prevent the failure of market-­based strategies adopted by American, British and Irish banks. Overall, institutional differences in the organization and governance of national financial systems served to reinforce each other; and they played themselves out as compensating mechanisms in the evolution of neo-­liberalization and financialization. Political and regulatory systems generated layers of institutions that propelled reform in one direction or another. Whereas features of the banking and financial systems in the US, UK and Ireland actively promoted liberalization and financialization, in Australia, Canada and New Zealand, cumulative compensating effects served to limit the reach – and more volatile consequences – of financialization in those countries.

Globalization, financialization and neo-­liberal reforms The extent to which national economies and financial systems are dependent upon international finance and trade flows, and the interdependence between countries, also help to explain the divergence in outcomes associated with financialization and neo-­liberal reform. We have argued that globalization generates institutional resources that either enable or constrain financialization and neo-­ liberal reform; and we noted the ideational influences of the US and the UK on the other four countries. We now focus on trade and financial links. Three dimensions of globalization are of particular relevance: (1) the degree of trade integration across the Anglosphere; (2) reliance on external finance; and (3) the internationalization of the banking sector. Degree of trade integration with other LMEs The charts in Figure 10.2 reveal the regional/country breakdown of two-­way trade shares for the six LMEs. As evident above, there are important differences in terms of trade integration among the six Anglo-­Saxon countries. Drawing on the notion of ‘interaction networks’, proposed by comparative sociologists working within the world-­systems

Foundations of Anglo-Saxon banking systems   243 Australia

Ireland

5%

12%

10%

21%

21.2%

5%

20.1% 37.7%

68%

UK

UK

US

US

New Zealand

Regional trading block

Regional trading block

Row

Row Canada

New Zealand

2%

21%

26%

1%

21%

0% 3%

4%

9%

73% 40%

UK US Regional trading block Row

Australia Canada Ireland UK US Regional trading block Row

Figure 10.2 LMEs main trading partners (percentage share of two-way trade, 2010) (source: US: US Census Bureau; Australia: Department for Foreign Affairs and Trade; Canada: Industry Canada (April 2011); UK: HM Revenues and Customs; Ireland: Department of Statistics).

244   O. Butzbach et al. United Kingdom 1.0%

United States

1.8% 4.6% 17% 11.1%

1% 3%

33.9% 64%

12%

47.6%

Australia

Canada

Canada

Ireland

Ireland

UK

US

Regional trading block

Regional trading block

Row

Row

Figure 10.2 Continued.

tradition (Chase-­Dunn et al. 2000), one could attribute to each country a position within a continuum that extends from ‘core’ to ‘periphery’. It is clear that the US is at one end – with little overall trade dependence on the other five countries. The UK and Australia also have a relatively low dependence on trade with the other LMEs; as a result these countries can be considered – to varying degrees – ‘core’. By contrast, Canada is much more dependent on the US, both for its imports and exports; New Zealand is dependent on the UK and Australia and Ireland on the US and UK. Thus, these countries could be considered ‘peripheral’. This classification turns out to be of limited use since trade interdependence does not, by itself, explain differential effects of the 2008 financial crisis. The direction and intensity of cross-­border capital flows, however, is much more revealing. Reliance on external capital Figure 10.3 shows inward foreign direct investment (FDI) as a percentage of gross domestic product (GDP) over a forty-­year period, which is a good proxy for dependence on foreign capital. As evident in Figure 10.3, there are large fluctuations over time, especially since the mid-­1990s – especially in Ireland. Thus, we reproduce this information in Figure 10.4, but excluding Ireland.

Foundations of Anglo-Saxon banking systems   245 30 25

Australia

20

Canada

15

Ireland New Zealand

10

United Kingdom

5 2009

2006

2003

2000

1994

1991

1988

1985

1982

1979

1976

1973

1970

–5

1997

United States

0

–10 –15 –20

Figure 10.3 Inward FDI as percentage of GDP (source: UNCTAD, n.d.). 10 Australia

8

Canada

6

New Zealand

4

United Kingdom United States

2

–2

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

0

–4

Figure 10.4 Inward FDI as percentage of GDP, without Ireland (source: UNCTAD, n.d.).

The pattern of data in Figure 10.4 gives rise to three observations. First, despite fluctuations, across the Anglosphere, there is a broad upward trend in capital flows as a proportion of GDP from the mid-­1980s onward. Second, during this same period, volatility has increased greatly: the two peaks correspond with the large asset bubbles of the late 1990s and the mid-­2000s – followed by sharp declines when they burst. Third, although there are differences between countries, these do not alter the overall clustering. Table 10.2 provides information about median values and standard deviations for inward FDI as percentage of GDP.

246   O. Butzbach et al. Table 10.2 Inward FDI as a percentage of GDP, 1970–2010, median and standard deviation

Australia Canada Ireland New Zealand United Kingdom United States

Median

St. Dev.

1.68 1.62 1.36 1.68 1.73 0.76

1.527208 1.856961 7.580482 1.51793 1.965001 0.740503

Source: UNCTAD n.d., our calculations.

The data in Table 10.2 – and Figures 10.3 and 10.4, above – do not allow us to discriminate between the two sub-­groups within the Anglosphere. The US holds a peculiar position, in the sense that it is much less reliant on FDI than the other five countries. Of further note, the median value for Ireland is misleading since, as Figure 10.3 and the standard deviation reveal, inward FDI has been highly volatile during the past twenty years. Finally, both the median and standard deviation for Australia and New Zealand are very close, revealing a similar trend in both capital inflows and outflows in these two countries. Globalization of banking A third approach to analysing the effect of internationalization on the outcomes generated by neo-­liberalization and financialization is to examine the growing international activities of domestic banks, both in lending and in financing. Table 10.3 illustrates the trends for the past fifteen years, excluding New Zealand, which is not covered by BIS data. Table 10.3  International claims and liabilities by local banks

Claims

Liabilities

Australia Canada Ireland UK US Australia Canada Ireland UK US

1995 – Q41

2008 – Q1

% change

19,027 57,140 35,331 1,123,563 600,673 31,933 77,675 44,328 1,399,801 870,168

79,260 264,753 630,942 5,966,361 3,363,218 130,715 289,008 1,281,752 6,769,252 3,845,989

417 463 1,786 531 560 409 372 2,892 484 442

Source: BIS n.d., our calculations. Note 1 For Australia, the data starts in 1997 – Q1.

Foundations of Anglo-Saxon banking systems   247 As evident in Table 10.3, the banking systems in Australia and Canada are less intensively global than they are in the UK, US and Ireland. This is in line with what was discussed above, in terms of differences in regulation and the behaviour of financial institutions across the six countries. Whereas Canada, Australia and New Zealand all experienced some degree of resistance to financial globalization, the US, UK and Ireland did not. In Canada, for example, the 1964 Porter Commission was to a large extent a reaction against the destabilizing effects of international capital flows; and it resulted in tight regulation of foreign bank entry into the Canadian credit market. By contrast, following entry into the Eurozone, Ireland gambled on its capacity to attract foreign capital. It positioned its financial services centre as a hub for global finance and extended its very favourable corporate tax regime to financial firms. The UK, although seen here to be a ‘core’ country, especially with regards to its position with respect to international capital flows, made the choice early on to promote the interests of the City of London at any cost, first by currency support during the 1950s and 1960s, and then by favourable regulation during the period of neo-­ liberalization. The US, as well, has a history of accommodation with regards to international finance; and competition between London and New York during the period of economic liberalization has produced ever looser financial regulation in both countries.

Conclusions The country analyses shed light on key similarities between the six Anglo-­Saxon economies in terms of the processes and outcomes associated with neo-­liberal reforms and financialization. They also reveal important differences. Closer examination of the structure and organization of the political and administrative system, domestic financial systems and the degree to which the six LMEs rely on international capital flows, however, do not, when taken separately, explain the divergence in outcomes we observed in Chapter 1. Moreover, we have not taken ‘luck’ into consideration – luck in the productive specialization of Australia, New Zealand and Canada, which left them less exposed to the 2007–2008 shocks in world financial markets. Nor is luck in the timing of interventions taken into account. Canadian regulators, for example, intervened in the asset-­ backed commercial paper market in early 2007, just before the crisis erupted in the US mortgage-­backed securities market. However, when interactions and feedback effects are considered, institutional complementarities that served to enable and constrain the parallel processes of neo-­liberalization and financialization become apparent. This permits us to begin to draw conclusions about outcomes realized. Interaction between domestic financial structures, veto possibilities within the political system and varying degrees of financialization, for example, do help to explain how particular types of institutional layering evolved and why the parallel processes of neo-­ liberalization and financialization produced such significant variation within the Anglosphere.

248   O. Butzbach et al. Although concentration of financial interests is evident in all of the LMEs, in Canada and Australia, the predominantly domestic nature of the financial services industry did not skew the balance of power away from the state as much as it did in the US, UK and Ireland. In these countries, neo-­liberalization and financialization permitted large international financial institutions to grow to become ‘too big to fail’ whilst diversification of the services they provided increasingly undermined the ability of a unified national regulator to effectively supervise and regulate them. Moreover, internationalization and the possibility of regulatory arbitrage shifted the balance of power away from the state, to the advantage of private financial institutions, further undermining the state’s capacity for financial market regulation. We will return to the further conclusions that can be drawn about ‘variety’ among the LMEs in the Conclusions chapter ahead. But first, we examine an alternative model of economic liberalism – ‘ordoliberalism’ – which, although lost for many years as the neo-­liberal school ascended to dominance, has been recently resurrected by those on both the political and economic right and left.

Notes 1 However, it was not a phenomenon unique to the LMEs since most banking systems evolved into hybrids (in terms of organizational forms and structures), with the process of hybridization being underway by the late 1970s in other advanced industrialized countries such as Germany (Deeg 1999, 2010), France and Italy (Butzbach 2007). 2 See, for example, Sturm and Williams 2004.

References Alvaredo, F., T. Atkinson, T. Piketty and E. Saez (n.d.), ‘The World’s Top Income Database’, online, available at: http://g-­mond.parisschoolofeconomics.eu/ topincomes. BIS (n.d.) Bank of International Settlement statistics, online, available at: www.bis.org/ statistics/index.htm. Blyth, M. (2002), Great Transformations: Economic Ideas and Institutional Change in the Twentieth Century, Cambridge: Cambridge University Press. Butzbach, O. (2007), ‘Varieties within capitalism? The modernization of French and Italian saving banks, 1980–2000’, Perspectives, number 54, March. Chase-­Dunn, C., Y. Kawano and B. D. Brewer (2000), ‘Trade Globalization since 1795: Waves of Integration in the World-­System’, American Sociological Review, 65(1): 77–95. Deeg, R. (2010), ‘Institutional Change in Financial Systems’, in G. Morgan, John L. Campbell, Colin Crouch, Ove Kaj Pedersen and Richard Whitley (eds) The Oxford Handbook of Comparative Institutional Analysis, Oxford: Oxford University Press, pp. 312–351. Deeg, R. (1999), Finance Capitalism Unveiled: Banks and the German Political Economy, Ann Arbor, MI: University of Michigan Press. Guttmann, R. (2008), ‘A Primer on Finance-­Led Capitalism and Its Crisis’, Revue de la régulation: Capitalisme, Institutions, Pouvoirs, nos. 3–4. Guttmann, R. and D. Plihon (2008), ‘Consumer Debt at the Center of Finance-­Led Capitalism’, Paper presented at CEPN/SCEPA Conference ‘Globalization and Inequality:

Foundations of Anglo-Saxon banking systems   249 Are Growth Regimes in Open Economies Bound to be Biased? A Comparative Analysis of the U.S. and Europe in the 2000s’, Paris, February, online, available at: www. univ-­paris13.fr/cepn/IMG/pdf/wp2008_09.pdf. Hacker, J.S. and P. Pierson (2010), Winner-­Take-All Politics: How Washington Made the Rich Richer – and Turned its Back on the Middle Class, New York: Simon & Schuster. Hicks, J. R. (1935), ‘Annual Survey of Economic Theory: The Theory of Monopoly’, Econometrica, 3(1): 1–20. Jackson, C. (2009), ‘Securitication in Ireland’, Presentation to the OECD Working Party on Financial Statistics, 2 November, online, available at: www.oecd.org/dataoecd/ 1/1/44044426.ppt. Kane, E. J. (1991), ‘Financial Regulation and Market Forces’, Swiss Journal of Economics and Statistics, 127(3): 325–342. Sturm, J. E. and B. Williams (2004), ‘Foreign Bank Entry, Deregulation and Bank Efficiency: Lessons from the Australian Experience’, Journal of Banking and Finance, 28(7): 1775–1799. UNCTAD (n.d.) United National Conference on Trade and Development statistics, online, available at: http://unctad.org/en/pages/Statistics.aspx. Vogel, D. (1996), Kindred Strangers: The Uneasy Relationship Between Business and Politics in America, Princeton, NJ: Princeton University Press.

11 The ‘ordoliberal’ variety of neo-­liberalism Gerhard Schnyder and Mathias Siems

Introduction Contrary to Margaret Thatcher’s well-­known slogan that ‘there is no alternative’ to a radical market liberalism, not all liberal theories support the simplistic idea that the ‘government is the problem’. A core example is ordoliberalism. The aim of this chapter is to engage with the defining features of ordoliberal theory1 and distinguish it from other varieties of liberalism. By comparing ordoliberalism to other varieties of liberal theory we also show that it is not an isolated theory that mattered only in Germany from the 1930s to the 1960s but that it is closely related to other liberal and institutional concepts. Our focus is not the analysis of how precisely ordoliberal concepts have been implemented throughout the twentieth century; rather, we discuss their theoretical implications and attempt to explain differences with other brands of neoliberalism against the backdrop of the historical context. Still, it is worth noting that the literature on the role of ideas in political science provides ample evidence that ideas and interests are intrinsically related and both matter in politics and economics (cf. in particular Blyth 2002; Hall 1989). The remainder of this chapter is structured as follows. The first part explains the core features of ordoliberalism. Then, we address US neoliberal schools of thought and in particular the influential Chicago school. This approach to liberalism is often portrayed as being opposite to ordoliberalism but both varieties of liberalism also share some often-­neglected similarities. Next we deal with the various approaches to institutional economics, which overlap with ordoliberalism to an even more significant degree than the Chicago school. The final part concludes.

Core features of ordoliberalism ‘Ordoliberalism’ was originally conceptualised by the economist Walter Eucken and the lawyers Franz Böhm and Hans Grossmann-­Doerth at the German University of Freiburg during the interwar period (Boas and Gans-­Morse 2009).2 Drawing on the concept of ordo, the Latin word for ‘order’, ordoliberalism refers to an ideal economic system that would be more orderly than the laissez-­faire

The ‘ordoliberal’ variety of neo-liberalism   251 economy advocated by classical liberals (Oliver 1960, 133–134). While there are many overlaps with other forms of neoliberalism, two distinctive features of ordoliberalism can be identified: a prominent and positive role for the state in upholding the liberal economic order and the importance of the ‘social question’ due to the need to embed economic activity in a sound society. Indeed, Peck (2010, 17, 65) characterises ordoliberalism as a humanist form of liberalism that seeks to achieve a socially embedded market through state intervention. In the following paragraphs we discuss these specificities of ordoliberalism in some detail. First, the crucial and positive role of the state to create the conditions for a liberal economy, which led to the seemingly contradictory concept of ‘liberal interventionism’ coined by Alexander Rüstow, is a hallmark of ordliberalism as the German version of neoliberalism (cf. Ptak 2009). To be sure, in its original formulation all forms of neoliberalism distinguished themselves from the nineteenth century laissez-­faire liberalism by acknowledging a positive role of the state. While classical liberal theories conceived of laissez-­faire as a means, the twentieth century neoliberalism rejected this view and saw competition as the means to achieve a free economy (Peck 2010, 3–4). However, as we will show below, this fundamental difference between neoliberalism and laissez-­faire liberalism has been increasingly eroded during the second half of the twentieth century, in particular in the US. The role of the state is rejected and often goes barely beyond the guarantee of the ‘rule of law’ and an ‘independent’ central bank. Ordoliberalism advocates a more positive role that the state has to play and a more sophisticated theorisation of the state (cf. Van Horn 2009). The members of the Freiburg School argued that for the free market to function effectively, the state should assume an active role, supported by a strong legal system and appropriate regulatory framework. Without a strong government, they argued, private interests, in a system characterised by differences in relative power would undermine competition (Oliver 1960; Boarman 1964; Gerber 1994). Moreover, the rules of the game should not favour the powerful and wealthy (Gerber 1994, 38). This assessment was based on the experience of the Weimar Republic (1919–1933) during which ordoliberalism emerged. The weakness of the Weimar democracy and its perceived permeability to interest group influence led early ordoliberals to lean towards a preference for strong government bordering even on support for non-­democratic authoritarian rule. Ptak (2009) argues that this constitutes a proximity with a nationalist theory of the state – such as the anti-­liberal theory by Carl Schmitt – and made the ordoliberal conception of state and society compatible with the Nazi ideology. But it is also close to the crucial classical liberal claim of the separation of state and society, i.e. that neither should the state infringe on civil society, nor should it be ‘colonised’ by private interests of any kind. This crucial concern of ordoliberalism with striking an appropriate balance between private and public power (Peck 2010, 59) was present in ordoliberal thinking since the 1920s. To be sure, the rhetoric of strong state and the early ordoliberals’ disdain for the seemingly harmful party politics

252   G. Schnyder and M. Siems of the Weimar Republic, which brought about disorder and instability, may have made some of these authors sympathetic to Schmitt’s claims for a strong state capable of leadership. However, the isolation of the state from particularistic interests is clearly a liberal claim and most ordoliberals did not approve of Schmitt’s rejection of a Weberian bureaucracy and hence the rule of impersonal legal-­rationalistic norms in favour of a strong executive power, governing ‘at will’. Second, ordoliberalism stands for a ‘sociological’ conception of the economy, which stressed the need for a market economy to be embedded in a functioning society and the fact that the ‘market economy constitutes a narrow sector of societal life only’ (Röpke 1946, 82–83; cf. Peck 2010, 61). Eucken (1932) used the concept of ‘interdependence of orders’ in order to underscore that the economic order is interdependent with all other governmental, societal and cultural orders in a society. The ‘social question’, i.e. preventing the negative effects of ‘proletarianisation’ of the working class, was a major concern for ordoliberals. To be sure, the ordoliberal postwar programme of the Social Market Economy developed mainly by Müller-Armack was at the outset explicitly conceived of as an alternative to universal welfare (Ptak 2009). However, the theoretically strong role for the state, the importance attributed to the ‘social question’ and the pragmatic and ‘irenic’ way of implementing the ordoliberal precepts in postwar Germany,3 made it possible for left-­wing ideas to re-­appropriate the concept of the Social Market Economy and increasingly introduce social policy as part of the package (Ptak 2009). Peck (2010, 58) calls the pragmatic, outcome-­oriented neoliberalism of the German ordoliberals the ‘first third way’, which contrasts with Hayek’s principled, procedural rules-­oriented neoliberalism. Rather than fundamentally objecting to state intervention that relied on taxation to finance its activity, some ordoliberals such as Alfred Müller-Armack and Alexander Rüstow (1957) have shown sympathy with the idea of social policy and the welfare state as long as it was market-­conforming (cf. Siems 2004, 27). To be more precise, Rüstow (and Röpke) rejected ‘purely material’ social policies, i.e. those advocated by supporters of the welfare state, and developed instead the concept of Vitalpolitik, which should aim to improve people’s living standards and well-­being not just through cash transfers, but by including a transformative structural societal policy (strukturelle Gesellschaftspolitik) including for instance questions of housing standards (cf. Ptak 2009, 104). Contrary to socialist ideas, these policies were not aimed at a social egalitarianism, but rather at stabilising the ‘natural order’ of society where different social strata co-­existed. Eucken’s concept of ordo, was indeed based on Thomas Aquinas’ medieval conception of a hierarchical natural order in society, which led different commentators to label ordoliberalism as ‘socially reactionary’ (cf. Ptak 2009). Be that as it may, the fundamental opposition to the state’s legitimacy to tax and redistribute income was much weaker in ordoliberalism than in other schools of liberalism. The rather traditionalistic conception of a social order based on the medieval Thomist concept of ordo contrasts with a strong modern conception of individual

The ‘ordoliberal’ variety of neo-liberalism   253 freedom in the economic sphere; a contradiction which Herf (1984) has termed ‘reactionary modernism’. The ordoliberals believed that liberalism – the freedom of individuals to compete in markets – should be separated from laissez-­faire – the freedom of markets from government intervention. Thus, they favoured a rigorous competition law, but also state intervention (cf. ‘liberal interventionism’) in order to ‘de-­concentrate’ economic power when a market became dominated by one or a few large players. This leads ordoliberals to be more willing to err on the side of too much state intervention than other neoliberals would be. While the principle of in dubio pro libertate was accepted by ordoliberals too, market concentration was seen as the greater evil than limited state intervention. This distinguishes them notably from other neoliberals like Friedrich von Hayek who also accepted the principle of a need to de-­concentrate economic power, but saw in the ‘invisible hand’ of the market a sufficient mechanism to make market-­power concentration a merely temporary phenomenon, and refusing on these grounds, state intervention to de-­concentrate economic power (Gamble 1996, 72). As we will show in the next part, this is also a crucial difference that emerged between ordoliberalism and the Chicago brands of neoliberalism during the 1950s. It is precisely regarding this aspect that Walter Eucken, one of the most influential representatives of the Freiburg School, criticised laissez-­faire liberalism for holding onto the belief that the market is a ‘natural given’ order which occurs spontaneously if the state does not hamper its emergence (Foucault 2004). On the contrary, Eucken’s understanding of the market and of competition is very much at odds with the classical (and neoclassical, see below) liberal notion that markets constitute some sort of natural order, which requires protection from state interference. In Eucken’s view, market and competition can only exist if a strong state establishes an economic order. The state’s role must be clearly delimited; but in the area where the state has a role to play, it needs to be powerful and active. For ordoliberals, government is the solution to the problem, as long as it is the right kind of government. Only specific constitutional and regulative principles created and upheld by the state can establish competitive markets. It is not about rolling back the state to free the underlying natural market order. Rather, it is about a strong state creating a functioning and humane economic order (Goldschmidt and Rauchenschwandtner 2007; Eucken 1932; Rüstow 1953 and 1957). This conception of markets and the state made an active competition policy one of the hallmarks of the ordoliberal political programme. In particular one of the earliest ordoliberals, Franz Böhm was a very strong believer in the need for a strong and rigorous competition law (Siems 2004, 37). His views had strongly influenced the elaboration of the first German Competition Act (Gesetz gegen Wettbewerbsbeschränkung; GWB) after the Second World War and were reflected in the Josten proposal of 1949, which would have included both a plain prohibition of cartels and legal and political intervention to prevent and reverse the concentration of economic power (Quack and Djelic 2005, 259). It is interesting to note that the US occupation authorities while strongly favourable to a prohibition of cartels similar to the one enshrined in the US Sherman Act of 1890, were much less supportive of the second part of the proposal and were

254   G. Schnyder and M. Siems indeed favourable to an ‘oligopolistic’ organisation of the German economy, based on the US example (ibid.). This contrasts starkly with one of the central claims of the ordoliberal school, namely, creating an economy where production is decentralised and takes place in relatively small units (Röpke 1950 and 1981; Rüstow 1953 and 1957). This episode illustrates a major difference between German and US neoliberalism to which we come back in the next part: for ordoliberals, like for classical liberals such as the Chicago economics professor Henry Simons, it was not the state but private monopolies that were the main enemy of a free society. In order to preserve a free society, the state had to be strong and impose a rigorous competition policy. Indeed, establishing the competitive order necessary for a free society was the raison d’être of the state (e.g. Rüstow 1932). Röpke, at the very beginning of the ordoliberal school of thought, too defined the aim of ordoliberals as fighting for ‘the idea of the state and against the lack of freedom in which private economic monopolies – supported by government leading a shadow existence – keep the economy captive’ (Röpke 1923; quoted in Megay 1970, 425). The concern for interdependencies and the sociological understanding of the economy leads ordoliberals also to be open to more interdisciplinary approaches than economics since the ‘marginal revolution’. Röpke explicitly argued for an anthropological-­sociological approach to markets and the economy in order to achieve a truly socially-­embedded market economy (Peck 2010, 61). The ‘interdependence’ or ‘coexistence’ idea explains why ordoliberalism seems less prone to the hubris of other neoliberals who advocate the application of market principles to all areas of human life both in practice (e.g. the New Public Management) and academia (e.g. Gary Becker’s extension of neoclassical models of man to the phenomenon of marriage). Aaron Director a founding member of the Chicago School considered ‘politics’ to be negligible in economic analysis and Chicago neoliberals generally deny the existence of power in market relations (cf. Van Horn 2009). Ordoliberalism seems more aware of the limits of the market mechanisms and competition and of the legitimacy of other ordering principles that may coexist in other areas of a society. Competition and market forces were thus not seen as a universal, absolute principle, but as one that had to be confined within a given economic order. According to Wilhelm Röpke, another major figure in ordoliberalism: [w]e must stress most emphatically that we have no intention to demand more from competition than it can give. It is a means of establishing order and exercising control in the narrow sphere of a market economy based on the division of labor, but no principle on which a whole society can be built. From the sociological and moral point of view it is even dangerous because it tends more to dissolve than to unite. If competition is not to have the effect of a social explosive and is at the same time not to degenerate, its premise will be a correspondingly sound political and moral framework. There should be a strong state, aloof from the hungry hordes of vested ­interests, a high standard of business ethics, and undegenerated community

The ‘ordoliberal’ variety of neo-liberalism   255 of people ready to cooperate with each other, who have a natural attachment to, and a firm place in society. (Röpke 1950, 181; our translation, emphasis added) In academic terms, this also implies that ordoliberalism is – in this respect at least – closer to classical economics than neoclassical ones, in its openness to interdisiciplinarity and a willingness to understand national economic systems as a complex whole – or a national business system – with many interdependent parts, rather than focusing merely on questions regarding the understanding of individual behaviours and utility calculations.4 As regards its political impact, it is frequently said that ordoliberalism has influenced the European Economic Community (now EU), in particular in terms of its approach to competition law. According to Nölke (2011, 14), while ‘the overall influence of German ordoliberal scholars in other economic regulatory policies has waned since the 1960s, it continued to have a remarkable stronghold in EU competition policy for several decades’ (similarly Wilks 2009; but see also Akman and Kassim 2010). However, internationally, ordoliberalism has increasingly been pushed into the background by the rise of the US neoliberal doctrines and in particular the Chicago School of law and economics. The Chicago School has not only been politically tremendously influential, notably through the international financial institutions based in Washington DC, but has also acquired a status of undisputed dominance in neoliberal theory. Ptak (2009: 126) claims that even in the area of competition policy the Freiburg School has quickly converged with US neoliberal theory. The appointment of Friedrich von Hayek in 1962 to a chair at the University of Freiburg after an eight-­year spell in Chicago is seen as a symbol of this convergence (also Foucault 2004). The dominance of US neoliberalism may hence have obliterated somewhat the differences between ordoliberalism and other neoliberalisms. By the 1980s Thatcher’s bon mot that ‘there is no alternative’ may hence hold some truth at least in terms of relative dominance of one stream of neoliberalism over the others. As contributors in Mirowski and Plehwe (2009) show, neoliberalism from its inception has evolved as a transnational intellectual project (also Peck 2010). Different schools have hence influenced each other notably by means of exchanges through the Mont Pelerin Society. However, it is still important to distinguish ordoliberalism as a coherent and distinct political philosophy and economic theory. As such, ordoliberalism may have achieved its most distinct and complete form during the first postwar years when its theoretical premises were fully developed and when it was at the height of its political influence. It is this version of ordoliberalism of the 1950s that we use as benchmark in the next section to compare it with the US neoliberalism.

Ordoliberalism vs. US neoliberalisms From the outset, neoliberalism was an international intellectual movement that was initiated at the Walter Lippman Colloquium in Paris in 1938, which united

256   G. Schnyder and M. Siems neoliberal thinkers from the US, France and Germany. It was then mainly purported by the Mont Pelerin Society founded by Friedrich von Hayek in 1947. This led to a situation where neoliberals of different brands communicated and exchanged ideas on a regular basis. Contrary to a widespread view that ordoliberalism is a purely European school of thought, the founding fathers of ordoliberalism were strongly influenced by US (neo)liberals. For example, Eucken was strongly influenced by the view of classical liberal Henry Simons, professor at Chicago, and agreed with him that monopoly in all its forms, including large corporations, are ‘the great enemy of democracy’ (Van Horn 2009, 204, 209). Therefore drawing the distinction between ordoliberals and US neoliberals too starkly would be erroneous in particular in the immediate postwar years. There were clearly points of agreement. In this section we further explore the relationship between ordoliberalism and different brands of US neoliberalism, which have arguably become the politically most influential versions. The differences are starkest with the most extreme form of neoliberalism, i.e. libertarianism of the Rothbartian anarcho-­capitalist vintage (Rothbart 1978). Roger Scruton (1982) defines libertarianism broadly as a radical form of laissez-­ faire liberalism. One characteristic of such schools is that in the name of individual freedom, they ‘wage war on all institutions’, including not only the state, but even marriage and social institutions like the family (cf. Gamble 1996, 108). To be sure, only extreme forms of libertarianism such as the ones advocated by Rothbart (1978) and, to a lesser extent, Nozick (1974) would go as far as rejecting any kind of social norms as a constraint of individual liberty. Yet the legitimacy of the state’s tax monopoly and monopoly of legitimate violence are but the US (and Austrian) neoliberalism’s ‘principled anti-­statism’ (Peck 2010, 54) pushed to the extreme. Indeed, it is certainly more than a coincidence that Rothbart was once Ludwig von Mises’s PhD student at New York University. The ‘market-­first’ (Peck 2010, 65) approach of Chicago and its belief in markets as self-­healing natural orders, made neoliberal thinkers and politicians increasingly receptive to even the most utopian forms of anti-­state libertarianism. Rothbart’s rejection of the state’s monopoly of legitimate force for instance can be seen at work in the privatisation of penitentiary institutions and the rise of private security firms. To be sure, in many instances, such movements of ‘rolling back the state’ had soon to be complemented by movements towards neoliberal re-­regulation, simply because markets turned out not to be able to play the role they were supposed to play in theory (Peck 2010). Yet, the neoliberals’ early agreement that the state had to play a positive role in the economy that goes beyond the night-­watchman state of the nineteenth century had increasingly been forgotten in the US. Since the 1950s even mainstream Chicago School economists and lawyers have increasingly embraced a more optimistic view of the play of markets and an increasing suspiciousness of state intervention to correct market failures. Conversely, ordoliberals – while broadly adopting the ‘equilibrium theory’ of neoclassical economics (Ptak 2009) – remain much closer to the Austrian school of economics regarding its focus on the ‘rational irrationality’ of capitalism

The ‘ordoliberal’ variety of neo-liberalism   257 (cf.  Schumpeter’s ‘creative destruction’). Indeed, ordoliberalism acknowledges the destructive tendencies of markets and sees state action as a necessary correction to these tendencies. The US neoliberals’ view on the illegitimacy and damaging effect of even the most basic state intervention in the economy and indeed society, is a fundamental difference between ordoliberalism and US neoliberalism and relates to the above-­ mentioned belief that markets are ‘natural orders’ rather than a man-­made social construct. The market and not the state is the ‘state of nature’ and state intervention is a corruption of this natural order and a constraint on individual liberty. The implication of this is a radical anti-­government rhetoric, which is not limited to far-­right libertarians, but has also influenced the policy choices made in the US (and elsewhere) since the 1980s. A striking example is Ronald Reagan’s one-­liner: ‘Government is not the solution to our problem; Government is the problem’. From this perspective, the effective functioning of markets was best assured by ‘rolling back the state’ (or reducing it to a protector of property rights)5 in order to make way for market mechanisms, theorised to be inherent in any human society. As mentioned above, this difference between US neoliberals and ordoliberals was not present from the outset, but emerged increasingly since the 1950s. Since then US neoliberalism seems to have increasingly evolved backwards into some form of ‘retro-­liberalism’, or what ordoliberals used to call ‘paleoliberalism’ of the nineteenth century anarcho-­capitalist brand (cf. Peck 2010, 17). In the late 1940s when neoliberal thinking was boosted by the establishment at the University of Chicago of a new research programme on Free Market Studies (FMS), established by von Hayek and financed by the William Volker Fund (Van Horn 2009 and 2011), differences with German neoliberalism started to increase. While the academics working on this programme (Aaron Director, Edward Levi, Milton Friedman, etc.) first defended ideas close to Simons’s more classical liberalism, during the early 1950s they started to depart from classical liberalism. In particular, the question of monopoly power, market dominance by ever larger corporations and competition law, led the academics of the ‘Second Chicago School’ to defend increasingly non-­interventionist laissez-­faire policies that contrasted starkly with classical liberals’ concern not just with concentration of political-, but also economic power. The leniency with which the Chicago School started to look on big business was the crucial difference to the ordoliberals. While the ordoliberals, during the same period in Germany, attempted to establish a competition law, which would rigorously fight economic power concentration and thus support production in small- and medium-­sized (SME) companies (see above), the Chicago neoliberals increasingly turned their attention away from the concentration of economic power towards the (supposedly) increasing state power in the US, but also abroad. The diverging paths that the two streams of neoliberalism started to take after the Second World War can at least partially be attributed to the differences in the historical context. On the one hand, the role of neoliberalism in Germany was one of contributing to a massive exercise of ‘state building’ after the fall of the Nazi dictatorship. The new Bundesrepublik’s legitimacy – established in 1949 –

258   G. Schnyder and M. Siems was closely intertwined with the precept of a liberal economic order to whose establishment the ordoliberals contributed directly. In such a situation a radical anti-­statism did not make any sense. The goal was, on the contrary, to establish new state institutions, which would draw their legitimacy on the guarantee of individual political and economic liberty (Lemke 2001; Foucault 2004). In the US, on the other hand, the neoliberals’ main adversary became increasingly the welfare state, which was expanding with Roosevelt’s New Deal policies. The fear of ‘collectivism’ and ‘socialism’ was further spurred by the Cold War and the international situation where the US became the main power opposing the Soviet Union and the diffusion of communism. It is no coincidence that the radicalisation of the Chicago School and its increasing anti-­government ideas coincided roughly with the rise of McCarthyism (late 1940s, early 1950s) in which the suspiciousness of any form of ‘collectivism’ – including the welfare state – reached its apex. In other words, while the task of building a strong and functioning state on the ruins of the Third Reich prevented the German ordoliberals from adopting anti-­state views, the US neoliberals were certainly encouraged by the public debates during the 1950s to increasingly see collectivism and the state – and not private economic power – as the main enemy of a liberal society. In the process, US neoliberals also came to increasingly accept ‘big business’ as a legitimate form of economic organisation, something that classical liberals contested and even neoliberals doubted as late as the 1940s. Friedman is on record as having proposed to the FMS measures that would eliminate the separation of ownership and control in modern corporations by transforming directors into owners. According to him this would ‘eliminate holding companies’, it ‘would make mergers more difficult’, and, as a result, it should also ‘retard the tendency (if it exists) toward increasingly large and monopolistic organizations and stimulate the breakdown of existing giant corporations’ (quoted in Van Horn 2009, 215). Similarly, Aaron Director, in his presidential address to the Mont Pelerin Society in 1947 stated that [t]he unlimited power of corporations must be removed. Excessive size can be challenged through the prohibition of corporate ownership of other corporations [. . .] and perhaps too through a direct limitation of the size of corporate enterprise. (quoted in Van Horn 2009, 212) These radical liberal anti-­concentration arguments seem astounding in the light of the approach to competition policy that the Chicago School developed starting in the 1950s. In particular in relation with the follow-­up research programme to the FMS – the Antitrust Project – Chicago neoliberals increasingly defended the view that private monopoly power was merely a transitory phenomenon, which will ultimately be eroded by market forces. By considering that, in the face of a monopoly, competition would still play and ultimately erode the monopoly, the Chicago school moved from a stance opposed to the concentration of economic power to a hands-­off, laissez-­faire approach towards markets characterised by an unswerving

The ‘ordoliberal’ variety of neo-liberalism   259 belief in the self-­healing powers of markets. In other words, the Chicago School started to embrace during the 1950s a ‘the-­market-can-­do-no-­wrong’ ideology based on the neoclassical belief that markets tend towards competition not monopoly if left to their own device. In some sense, the maxim in dubio pro libertate has increasingly been confused with the maxim in dubio pro foro, implying that the market per se – not the competition it creates if functioning – constitutes the ordering principle, which maximises individual liberty. Monopolies, it was held, could resist the competitive forces of markets only where governments openly supported them (Friedman 1951: 17). All three main proponents of the Chicago programme published articles during the 1950s with diametrically opposed views on the danger of economic power concentrations and monopolies to their views expressed during the 1940s (Director 1951; Friedman 1951; Director and Levi 1956). This radical departure from classical liberalism is considered as the birth hour of the US neoliberalism and constitutes a crucial break with the German ordoliberalism (cf. Van Horn 2009, 216ff.). It was at that historical juncture that US neoliberals – paralleling the evolution of US public discourse that reached its apogee in McCarthyism – started to see the government as the problem, not the solution allowing the maintenance of a competitive market economy. This volte-­face regarding the role of the state also implies a reversal of liberal positions vis-­à-vis the concentration of economic power. ‘Big business’ is accepted as inevitability in a modern economy, something that thinkers of the left such as Galbraith (1967) and German communists (cf. the idea of STAMOKAP, or state monopoly capitalism) but also rather right-­leaning intellectuals have observed for a long time (Schumpeter 2003[1943]). Large companies have come to be seen as the basis for economic efficiency (economies of scales) and US economic power abroad (international competition in increasingly liberalised markets). This would ultimately contribute to the vulnerability of the US variety of liberalism. Indeed, the leniency with which concentration of economic power in the financial industry was accepted constitutes arguably one of the major causes of the Global Financial Crisis of 2008–2011 in that it allowed banks to grow ‘too big to fail’ (see also Siems and Schnyder 2012). Without overstressing the influence that such academic debates had on concrete policies, it is no small irony of history that the robustly anti-­concentration draft proposal for the first German Antitrust Law (the Josten proposal of 1949, which was strongly influenced by Böhm’s view; see above), was watered down during the 1950s not just because of business opposition, but also because of the US occupation authorities preference for an oligopolistic market structure. This preference was apparently also related to a concern of creating strong capitalist companies in an era of communist threat to the capitalist economic world order (Quack and Djelic 2005, 259). This may not directly have been a consequence of the new developments in Chicago, but it is striking to see that in 1956 – a year before the German competition law was finally adopted – Director and Levi had published an article summarising the Chicago School’s new doctrine on antitrust, which advocated the use of a ‘rule of reason’ by judges (as opposed to applying automatically fixed rules) to

260   G. Schnyder and M. Siems monopoly situations and stating that industries dominated by just three or four companies could no longer be considered as necessarily being a case of excessive concentration (Director and Levi 1956: 287). Indeed, oligopolistic industries were now considered to be a characteristic of a new era of capitalism and splitting up oligopolies would mean punishing companies for the successful and efficient pursuit of economies of scale (cf. Van Horn 2009: 224). In other words, monopolies were no longer considered as being necessarily the result of abusive and coercive exclusionary practices, but could result from successful internal growth strategies aimed at increasing efficiency (Director and Levi 1956: 290). Given that monopoly power did not stem from exclusionary practices and was not enhanced by such practices, they were hence not to be considered as illegal per se. To sum up, most contemporary schools of neoliberalism go back to the effort of the interwar period to revive liberal theory in order to ‘save’ the crisis-­ridden capitalist market economies from socialism and collectivism. At the outset, they shared common goals and many common precepts. To be sure, many commentators, notably on ordoliberalism, may underestimate the communalities and overdraw the differences between different schools (e.g. Foucault 2004). Ptak (2009, 99) states that ‘ordoliberalism is substantially less different from other streams of neoliberal thought than many have thought’.6 However, there are clear indications that different streams of neoliberalism have indeed specific features and the meetings of the Mont Pelerin Society – the ‘peak organisation of world neoliberalism’ of sorts – were often characterised by very strong conflicts and heated debates, notably over the role of the state (Peck 2010). It is telling that it never managed to formulate a ‘manifesto’ defining what neoliberalism is and what role the state should play, despite attempts to do so during the first meeting in 1947 (Peck 2010; Plehwe 2009). The minimal common denominator which the Mont Pelerin Society did manage to define was a six-­point document formulated in terms of areas of need for further research (Plehwe 2009). Tensions continued to a stage where Hunold, a Swiss businessman and ordoliberal, and Röpke finally left the society in the early 1960s over a dispute with von Hayek. Therefore, while ordoliberalism certainly cannot be understood as a theory completely independent and distinct from other neoliberalisms, it still seems sufficiently different from other streams to create considerable space for debate and diversity. It goes beyond the scope of this chapter to show how these differences mattered in terms of their impact on concrete policies. Yet, the struggle over the first German competition law after the Second World War, shows that such seemingly academic debates, may very well have had considerable influence on economic outcomes (Quack and Djelic 2005). The next section explores the modernity within ordoliberal theory by pointing out similarities that it held with newer institutional approaches in economics.

Ordoliberalism and institutional approaches to economics Ptak (2009, 126) sees ordoliberalism as an ‘embryonic neo-­institutionalist doctrine avant la lettre’. Indeed, it seems to have some affinities with the recent resurgent ‘institutional approaches’ to economics, which tend to come back to a

The ‘ordoliberal’ variety of neo-liberalism   261 more socially grounded understanding of economics than the narrow, non-­ sociological form economics has increasingly taken since the ‘marginal revolution’. The ideas of Walter Eucken and colleagues are also sometimes referred to as ‘German Institutional Economics’ (Richter 1999) or the ‘Freiburg School of Law and Economics’ (Vanberg 1998). Such terminology is not surprising, given that ordoliberalism is interested in the relationship between state law and markets, addressing both the constitutive principles of the market economy and regulatory principles that make it function smoothly (see Aßländer 2011, 43–44). It is therefore worth exploring how ordoliberalism is related to other institutional approaches to economics. Even classical economics did not ignore the role of institutions. Yet it was usually taken for granted that institutions are available to guarantee the enforcement of contracts (Kirstein 2006). More specifically, David Hume can be regarded as a predecessor of both institutional economics and ordoliberalism. Hume highlighted the general role of a supportive government in order ‘to promote the conventions of justice and virtue, and embed them in institutions’ (Dow 2009). In particular, Hume suggested that the economic constitution of the state should be based on principles of private property, freedom of contract and personal liability, similar to ordoliberalism (Richter 2011). A more direct predecessor of ordoliberalism can be seen in the old institutional economics of the early twentieth century, the most prominent proponents being Thorstein Veblen, John R. Commons and Wesley Mitchell. Of course, the views of old institutionalism were not homogenous, and Veblen’s critical attitude towards capitalism was not shared by ordoliberals such as Eucken and Böhm.7 Still, at a general level, institutional economics and ordoliberalism share the endeavour to understand institutions more precisely, in particular in the way they interact and influence human behaviour. Vatiero (2010, 691) also identifies similarities in their approach to competition policy: Many connections between OI [Old Institutional economics] and OL [Ordo Liberalism] can be stated. Both of them had been dominant paradigms, and above all they share the common idea that a legal system does not lead necessarily to a restriction of ‘human interaction’ as in Douglass North’s definition of institutions. The law could liberate individuals’ opportunities and activities and extend freedoms. In particular, the institutionalist Robert Lee Hale advocated ‘freedom through law’, which is also the title of his most important book. Similarly, OL relies on (competition) law being seen as a liberation rather than a constraint.8 Interestingly, Vatiero contrasts this similarity with a different view of New Institutional Economics (NIE), referring to North (1990). Though NIE too is a conglomerate of different approaches, some more historical, some more conceptual, in general it is more neoclassical than the old institutional economics and ordoliberalism in embracing the use of mathematical and econometric methods (see Kirchgässner 2009).

262   G. Schnyder and M. Siems However, frequently, the literature also highlights similarities between ordoliberalism and the NIE. According to Cesaratto and Stirati (2011, 18) both subscribe to the idea that, while ‘the market economy is the best instrument to achieve social welfare’, there remains to be ‘the role of the state in establishing and protecting pro-­market institutions’. Kuhnert (2008) observes that due to these commonalities ordoliberalism attracts growing attention in the English-­ speaking world. More specifically, Richter (2011) discusses similarities between ordoliberalism and Williamson’s transaction cost economics: though Walter Eucken and others did not explicitly use the term of transaction costs, their ‘ideal typical description and ordering of institutional frameworks by way of “isolating abstraction” ’ (ibid., 1), is seen as akin to Williamson’s approach (for the latter see e.g. Williamson 1985). In the last few decades, a number of additional theories, schools and concepts have been developed which are related to ideas of both institutional economics and ordoliberalism. Explicit parallels have been drawn between ordoliberalism and Buchanan’s Constitutional Economics, both being interested in the foundations needed for a functioning market economy (Richter 1999). The concept of Regulatory Capitalism has been linked to NIE (Levi-­Faur 2005, 17). It argues that it is mistaken to regard the current economy as being purely ‘neoliberal’ but rather that ‘[t]he corporatisation of the world is . . . a product of regulation and the key driver of regulatory growth, indeed of state growth more generally’ (Braithwaite 2005). Thus, it can also be said that it shares with ordoliberalism an interest in the regulatory framework underpinning national and global economies. An alternative interpretation is offered by Peck (2010): he interprets the rise of ‘the regulatory state’ and the re-­regulation of policy areas from which the state had previously retreated, as reaction to the failure of anti-­state liberalism not as a logical complement to it. Re-­regulation is seen as a pragmatic – and theoretically fundamentally inconsistent – reaction to the failure of the laissez-­faire system put in place following neoliberal precepts. Finally, it is worth noting the interdisciplinary scope of ordoliberalism, integrating law and economics, in order ‘to give the economic process the desired legal form’ (Meijer 2007, 183). Thus, ordoliberalism is linked to contemporary law and economics, as there is an overlap between the NIE and law and economics (Posner 1993). Of course, there are differences as well: at its core, ordoliberalism is an approach to political economy, while it also has wider ramifications which bring it close to a ‘political philosophy’, a social theory or even a Weltanschauung. NIE on the other hand is more narrowly an economic theory, and law and economics the application of economic methods to law. There are also aspects of law and economics, in particular its empirical extension to law and finance (see Siems and Deakin 2010), which are more market libertarian than ordoliberal thinking.

Conclusion This chapter has shown that ordoliberal concepts are not isolated phenomena but that they are related to institutional economic ideas under different names. Such

The ‘ordoliberal’ variety of neo-liberalism   263 ‘ordo-­institutional’ perspectives have gained in appeal in the context of the current financial crisis, because they seem to attenuate extreme views of market libertarianism, while still accommodating broadly neoliberal, anti-­Keynesian and anti-­socialist ideas. We have also explained that there have always been different liberal theories not all of which support the simplistic ‘government is the problem’ idea (cf. Plehwe 2009). Indeed, ordoliberalism constitutes such an alternative to Chicago School neoliberalism. Ordoliberalism should not, however, be seen as a theory that will remedy all of neoliberalism’s weaknesses since both share some basic assumptions. A look at the history of this school of thought shows that ordoliberalism has coevolved with other neoliberalisms in a consciously coordinated process of academic exchange in which von Hayek played an important role (see Gamble 1996; Kolev 2010). Yet, there are also fundamental points on which ordoliberalism is distinct from US neoliberalism, and has increasingly grown distinct during the early postwar decades. Ordoliberalism may hold some lessons for present-­time policy makers in order to prevent the possibility of a recurrence of a financial and economic disaster like the one the world witnessed since 2008. The weakness of the left in most industrial countries and the framing of the crisis as a result of state – and not of market failure – seem to indicate that the post-­crisis economics will not be a simple return to Keynesianism, but will continue to largely rely on neoliberal policies. In such a context, ordoliberalism may be an important source to inform policy makers in order to at least avoid the libertarian excesses of previous decades (for details see Siems and Schnyder 2012). It is an interesting thought experiment to speculate about what a neoliberal economic system would have looked like that took its inspiration from ordoliberalism rather than from the anti-­state neoliberal ideologies that were declared during the 1980s to be the only way out of the crisis of Fordism. Ordoliberal theory reminds us, for instance, that any economic order has necessarily to be embedded in a sound society where a certain living standard and security is guaranteed for all members of society. Ordoliberals never aimed to install a generous, universal welfare state or pursue egalitarian goals but still put the individual’s emotional, economic and cultural well-­being at the centre of a functioning market economy. This neo-­Kantian concern for ‘human dignity’ seems worthwhile considering when devising strategies out of the current crisis since ‘broken societies’ are not a fertile ground for economic activity, entrepreneurship and growth. Ordoliberalism also shows that in a functioning democracy, classical liberal aversion towards the state may have become absurd given that the fundamental idea is one of a government by the people for the people. US neoliberals, in their decades-­long struggle against socialism and soviet communism, have come to equate the democratic state with the authoritarian regimes against which the classical liberals developed their theories. This leaves modern societies with a lack of means to govern and restrain ever more global and powerful economic interests (see Soros 2008). The more optimistic view of the role of the state in ordoliberalism opens up new ways of thinking about how the state might contribute to the development of a sustainable economic order.

264   G. Schnyder and M. Siems In this context, the most important lesson that this theory may have for policy makers after the Global Financial Crisis of 2008–2011 is to remind us that the concentration of economic power in private hands and the emergence of dominant corporations was once considered by liberals of all brands as a major threat to any economic order and democratic society. This knowledge has been lost in the postwar decades among adherents to the Chicago School who embraced a rather blue-­eyed belief in the self-­correcting forces of markets. This historical shift away from a traditional suspicion of large organisations may have contributed to the emergence of an unsustainable banking system with many financial institutions growing too big to fail. Ordoliberalism also points out that such economic power is not just an economic, but also a political problem, thus breaking with another tenet of the Chicago School, which argues that ‘politics’ and ‘power’ do not matter (cf. Director 1951). Thus, the ordoliberal openness to a multifaceted understanding of economic phenomena and multidisciplinary analysis may provide us with intellectual tools to work towards a sounder basis for financial and economic regulation.

Notes 1 Arguably ordoliberalism does not constitute one single and coherent theory. Authors that are commonly associated with the movement defended quite different views on certain aspects (cf. Kolev 2010). However, in this chapter we seek to single out a number of points that can be considered as the defining features of what is commonly defined as ordoliberalism and are hence shared by the large majority of its proponents. 2 It should be noted that designating the German neoliberals of the Weimar period as ‘ordoliberals’ to distinguish them from other brands of neoliberalism is strictly speaking an anachronism. The term ‘ordoliberalism’ was first used in a 1950 issue of the review ORDO. The proto-­ordoliberals who did not necessarily form a coherent school of thought before the Second World War would refer to themselves mostly as neoliberals, a term which is said to have been coined in 1938 by Alexander Rüstow – later one of the central members of the ordoliberal group – at the Colloque Walter Lippman in Paris. 3 The ordoliberals concern to maintain social peace contrasts starkly with the confrontational strategies of the US and UK governments during the 1980s, for instance. 4 It is interesting to note that the idea of ‘interdependence’ seems quite close to, or at least compatible with, the idea of complementarities between the institutional spheres of a national business system, which has recently gained prominence in the comparative analysis of capitalism in political economy (cf. Hall and Soskice 2001). 5 See Cioffi 2009, 243 (‘The legal liberalism underlying the American market model relies on an enforceable framework of legal rights and obligations that facilitate and inform market transactions.’). 6 See also Lai 2011, 7: Friedman won his Nobel Prize in the age of nuclear deterrence not because of his libertarian pro-­market views, but because his policy proposal for tight control of money supply in an era of double-­digit inflation. It is said that Friedman’s policy perspective is similar to ‘ordoliberalism’ developed by the German economists Eucken and other. 7 It is also worth noting that in the book on economic policy by Eucken (1990) which can be seen as the clearest description of ordoliberal views, there are no references to any proponents of the (old) institutional economics.

The ‘ordoliberal’ variety of neo-liberalism   265 8 Note also the similarity of the OI and OL conception of institutions with recent developments in institutional theory in political science and political economy, which argues – contrary to North – that institutions are not just constraints, but can also be resources for actors (Jackson 2010).

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12 Conclusions Suzanne J. Konzelmann and Marc Fovargue-­Davies

The making of markets Economic liberalization is not a precisely defined process – even by its main advocates. It is typically identified as involving de-­regulation with an emphasis on ‘free’ markets, but even these identifiers are misleading. The process of de-­ regulation is perhaps more appropriately described as one of re-­regulation since it is usually not so much about the removal of regulation as it is a re-­orientation of the ‘rules of the game’ (which is likely to privilege certain groups over others), despite the freeness implied in the process. This in turn creates the second incongruity; the use the terms ‘free’ and ‘competitive’ – often interchangeably – to describe liberal markets. Economic liberals argue that markets should be free from government intervention; and individuals (and organizations) should be free to compete in markets. However, as we have already seen, markets are not, in fact, the force of nature that many liberal apologists claim them to be. They are political and social constructs (Fligstein 1996); and the ability to effectively compete in markets is likely to depend upon the state ensuring that they perform as intended. Truly competitive markets require intervention – by law and the state – to ensure a level playing field that allows market actors to compete on meaningful criteria. This gives rise to the question of how, to what extent and when the state should intervene – not whether the state should intervene at all. Moreover, since markets are vulnerable to domination by particular interest groups as their economic power increases, they can never really be ‘free’ in the sense that economic liberals theorize them to be. As evident within the Anglosphere, the re-­regulation of markets in general – and financial markets in particular – during the decades preceding the 2008 financial crisis, increasingly privileged the interests of private financial elites (albeit to varying degrees in different countries). However, their rescue, through internationally coordinated government intervention, effectively socialized the costs (whilst the benefits remain private). This was hardly in the spirit of liberal values, where the freedom of markets from government intervention should have demanded the refusal of state intervention during the 2008 financial crisis. Whilst it is very likely that markets with this sort of freedom would have proven to be self-­regulating after a fashion, the adjustments would in fact have been

270   S.J. Konzelmann and M. Fovargue-Davies unsustainably brutal and almost certainly unacceptable, politically and socially. Thus, the US and the UK – arguably the most strident supporters of the free market – ultimately intervened to a massive degree (as they had for all of the financial crises that preceded it). Ireland was also forced to respond accordingly. Further, interventions in Canada, Australia and New Zealand after the 2008 financial crisis, while of a considerably smaller scale, still occurred. Previously captured private benefits were replaced with socialized costs in these countries. The loose definition of economic liberalization in general, and the rather more precise way that liberal markets can be theorized as being ‘free’ and ‘competitive’, might be a source of the apparent variety we observe within liberal capitalism. Whilst the general direction of the process of economic liberalization was the same within the Anglosphere, the way that markets were constructed, how they evolved, the manner in which they operated and the way that they were regulated varied substantially. As a result, there is perhaps a stronger case for arguing the existence of ‘varieties of liberal markets’ rather than ‘varieties of liberal capitalism’.

Dissecting the Anglosphere During the decades preceding the 2008 financial crisis, the six Anglo-­Saxon countries experimented with liberal capitalism and experienced its many contradictions. Thus, rather than attempting to use the imprecisely defined concept of economic liberalization as a basis for analysis, we have chosen instead to examine four inter-­related processes that are characteristic of liberal capitalism: re-­regulation, globalization, financialization and disenfranchization. Not only have these been accelerated by economic liberalization, they have also reinforced it, producing increasing asymmetry of resource, opportunity and influence within the Anglosphere. Whilst these processes are considered individually below for the sake of clarity, the extent to which they interact, and their interdependencies, should not be underestimated. In many instances they demonstrate high levels of complementarity, periodically supercharging the process of neoliberal change, and at other times, stifling reform. Re-­regulation As discussed above, although economic liberalization is often associated with de-­regulation, it actually results in new forms of regulation that are more appropriately identified as re-­regulation. According to Levi-­Faur and Gilad 2004: 106), Amidst the rise of neoliberalism . . . liberalization and managerial reforms that were supposed to hollow-­out the state were intimately coupled with the rise of multi-­layered regulatory institutions and formalization of codes of behaviour at the corporate, state and international levels.

Conclusions   271 Thus, since the 1980s, as liberal states have increasingly withdrawn from the area of provision (and distribution), they have become involved in the regulation of private sector providers. Recognition of this phenomenon has generated a growing literature that identifies the period of economic liberalization as an era of ‘regulatory capitalism’,1 in which both markets and states have become stronger. Thus, contrary to the neo-­liberal claim that markets should be free from government intervention, Braithwaite (2005), for example, argues that since the 1980s, markets have themselves become regulatory mechanisms; and, because financial market liberalization has produced a new set of regulations and regulatory institutions, Levi-­ Faur (2005) suggests that ‘financial market liberalization ends up being the diffusion of regulatory capitalism’. Despite agreement about the regulatory role of the liberal state, however, how markets should be regulated, how their benefits should be distributed and to what end the regulatory power of the state should be directed remains contested. By prioritizing markets – financial markets, in particular – re-­regulation has skewed the marketplace to favour the interests of finance (and thereby the wealthy, who are both more familiar with and have better access to these tools of commerce). This has been at the expense of the public and non-­financial sectors of the economy – including industrial manufacturing and service provision (and the less wealthy). With globalization and the increased reach of international business (in trade and finance), the state’s ability to effectively intervene has been increasingly compromised. The increased influence of financial and political elites has further leveraged this effect, reinforcing financialization and the instability it has created. Globalization Globalization is not unique to the period of economic liberalization. The architects of Bretton Woods recognized the economic damage caused by protectionism during the interwar years. They had thus sought to establish a system in which the international trade of goods and services was supported by controls on international capital flows that served to stabilize markets for finance. However, as we have already seen, it was not long before financial markets regained the freedom they had enjoyed prior to Bretton Woods, undermining the foundations of the postwar accord and providing the funds to accelerate the process of globalization. Such was the drive – and insatiable hunger – of the British and American financial markets during the postwar period, that most regulations were eventually circumvented. Early on, globalization had created incentives for the relocation of production to ever lower cost regions, both nationally and internationally. This contributed to the onset of deindustrialization and the export of manufacturing jobs, a process that was accelerated by economic liberalization. In countries such as the US and the UK, whose major industrial firms were, for the most part, operating with widely dispersed shareholder ownership structures, the theorization of the

272   S.J. Konzelmann and M. Fovargue-Davies stock market as an ‘efficient market’ for managerial control justified the use of leveraged buyouts and hostile takeovers to reorganize industry. In this context, firms whose share price fell below the value of the underlying productive enterprise’s assets, soon became targets for hostile action. This was often followed by asset stripping and dismemberment, to raise the funds required to repay the debt that had been used to finance the acquisition (Lazonick and O’Sullivan 2000). Whilst this approach had a brief heyday in both Australia and New Zealand, it was largely absent from the corporate landscape of Canada. This was not only a function of the way that financial markets operated; it was in no small part due to the fact that dispersed shareholder ownership structures were much less common. The predominance of concentrated ownership, particularly family-­owned businesses, made these far less vulnerable to takeover and subsequent asset stripping. The unemployment and income stagnation caused by deindustrialization was aggravated by the economic challenges of the 1970s. This made low-­price imports increasingly more attractive than more expensive domestically produced goods and services, adding to the problems associated with lost domestic employment and investment opportunities. The availability of cheap credit, fuelled by the inflow of money from high-­saving countries into the LMEs’ financial markets, made it possible for households to maintain standards of living above what their incomes could afford. This gave the illusion of prosperity whilst contributing to growing trade deficits and lost employment opportunities. The substitution of locally produced goods, or those from other OECD countries, with often cheaper goods from developing countries, appears to have met the needs of the masses in all of the jurisdictions studied here. The globalization of business (in trade and finance), encouraged an increase in the overall scale of enterprise. In some jurisdictions, instead of attracting criticism for being in restraint of trade, this was justified by liberal economists on the grounds that large size was both evidence of – and a reward for – successful competition in markets (Chandler 1977; Kirzner 1997; Schumpeter 1943). This allowed businesses (including financial institutions) to grow to become ‘too big to fail’. At the same time, it undermined the ability of the state (especially in the UK and USA) to effectively regulate; and it created incentives for ‘light touch’ regulation in order to attract highly mobile international business, giving gave rise to regulatory arbitrage and creating a situation that would ultimately lead to a race to the bottom. Financialization Financialization has been a defining feature of economic liberalization. Although it was already underway before the 1970s’ abandonment of Keynesian macro-­ economic management, the return to economic liberalism during the 1980s provided the theoretical justification that would reinforce and accelerate it. A central doctrine of economic liberalism was the ‘efficient markets hypothesis’ – the notion that financial markets can be trusted to accurately price assets (Fama 1970). The price of shares delivered by the stock market, for example, was seen

Conclusions   273 to provide an accurate indication of the value of the underlying productive enterprise; it was therefore viewed as the best guide for decisions about investment and production. Assuming away the dangers of speculative aspects of financial markets, the efficient markets hypothesis served as a justification for the re-­ regulation of financial markets in ways that weakened controls on capital movements and increased the freedom of market actors to innovate in the pursuit of individual economic interests. It also further fuelled financialization. During the 1980s, financialization emerged as a means of bolstering incomes and generating economic growth, especially in the absence of alternative drivers. Confronted with high unemployment, economic stagnation and falling real incomes, the extension of cheap debt was seen to be a way of stimulating demand and growth by funding spending in excess of incomes. Money thus became ‘commoditized’ and society, instead of seeing it as a social evil, became habitualized to debt, as evident in the steadily increasing leverage of households, businesses and government during the period of economic liberalization; this was an outcome that continued right up to the 2008 financial crisis, by which households in all jurisdictions sought to redress weaknesses in their household balance sheets. This was also a period when speculative finance and asset bubbles came to be accepted as legitimate engines for growth. Money serves as both a medium of exchange and a store of value; and can be used for both transactions and speculation. In the more highly financialized countries, the inflation of successive asset bubbles gave the illusion of growth; and it made investors (in houses, stocks and other assets) feel that they were gaining wealth. Asset price inflation also disguised the economic devastation caused by the collapse of previous bubbles, as the next one inflated. This effect was most marked in countries – like the US, UK and, more recently, Ireland – where the financial sector had come to dominate (politically and economically), where there were relatively few alternative drivers for economic growth and where the financial and real sides of the economy had been effectively de-­coupled. The financialization of society, however, significantly broadens and increases vulnerability to changes in the supply and price of credit. The financialization of society also means that voters are likely to vote on financial criteria (i.e. low interest rates and increasing asset prices), providing political incentives for policy-­makers to pursue and support policies that will deliver these short-­term outcomes. This is in spite of the fact that, over the longer term, they are destabilizing to the economy as a whole. Whilst low interest rates make debt-­funded consumption, house and asset purchases more attractive, the flip side of the coin is lower returns from traditional business lending and financial instruments, creating incentives for the financial innovation and risk-­taking that contributed so much to the 2008 financial crisis. Disenfranchization The postwar Keynesian era had been one of ‘enfranchization’ of society. Following the Second World War, governments across the developed world

274   S.J. Konzelmann and M. Fovargue-Davies c­ ommitted themselves to full employment and the welfare state, albeit to varying degrees. In this context, everyone had a right to a healthy standard of living, which for workers meant the right to a job with good terms and conditions of employment and independent trade union representation. The pinnacle of this achievement was New Zealand during the 1950s and 1960s, when employment was less than 0.5 per cent and prosperity prevailed – for a time, anyway. The result, generally, was widespread full employment and rising living standards, healthy business profits, strong economic growth, reduced inequality and a more or less comprehensive welfare state, with the greatest gains going to those at the bottom of the income distribution. From the 1980s, onward, however, this was sharply reversed, starting in the US and spreading, to a greater or lesser degree, across the Anglosphere. In the process, most of society and the economy has been progressively disenfranchized. Especially hard hit have been middle and working class households, the poor, small- and medium-­sized private businesses (that are not too big to be allowed to fail) and the public sector. Since the disenfranchization of one group is the reverse side of the enfranchization of another, under economic liberalism, the enfranchized have, for the most part, been financial elites, wealthy households and large private corporations. This effect too, has varied across the Anglosphere, being most marked in the US and the UK, and the least, in Canada, Australia and New Zealand. This is mainly due to the existence of both more, and more vocal veto possibilities, as well as the existence of alternative drivers of economic growth in these countries. In short, economic liberalization has resulted in increased centralization of power and influence for the enfranchized and a loss of economic and political influence for the disenfranchized. The extent to which the financial sector, the wealthy and large corporations have been privileged has differentially shaped the institutional configuration of the political economy and the veto opportunities within the LMEs, which, in turn, has reinforced the direction of their particular brand of financialized liberal capitalism. The overall shift in influence and voice may help to explain why neoliberalism has yet to be replaced as the ideological and policy norm – despite the evidence of its contradictions and instabilities.

Growing asymmetry Across the Anglosphere, economic liberalization – and the processes of re-­ regulation, globalization, financialization and disenfranchization – created significant and growing asymmetries. Variation in the extent of this asymmetry proved to be an important determinant of the nature of the relationship between the state and the private sector and, especially, between regulators and the institutions they oversee. This largely shaped the six countries’ differing experiences of the 2008 financial crisis. Asymmetry is evident in three main areas: (1) the balance between domestic and global economic activities; (2) the balance between the financial sector and the non-­financial side of the economy and the

Conclusions   275 existence (or otherwise) of alternative engines for growth; and (3) the distribution of income and wealth. Domestic and global economic activities During the period of economic liberalization, pressures to internationalize and to financialize contributed to growing asymmetry in the balance between domestic and global trade and finance, especially in the US and the UK, whose industrial bases had been eroded both by increased foreign competition and leveraged buyout fever. Although Canada, Australia and New Zealand were subjected to many of the same macroeconomic challenges as the US and the UK, on the whole they continued to benefit from relatively strong export markets for agricultural products, natural resources and commodities. They were consequently less reliant on the economic performance of their financial sectors and on attracting international finance. Nevertheless, across the Anglosphere in general, there were mounting pressures for financial market liberalization from the 1980s, onward. This observation is not to suggest that the outcome was necessarily deliberate; as observed in both New Zealand and Australia, successive governments sought to shift the balance of economic activity from the primary and extraction sectors to that of finance. Ireland represents perhaps the most extreme example of rapid increase in asymmetry through internationalization and financialization. Initially a largely agricultural economy, from the mid-­1990s, a combination of low-­cost commercial property, a well-­educated but low-­cost workforce and low corporate taxes made Ireland an attractive location for corporate headquarters. This initially powered the ‘Celtic Tiger’; but it also sowed the seeds that produced its devastating property bubble. This was ignited by the sharp reduction in interest rates when Ireland joined the European Monetary Union (EMU) in 2002, prompting a rapid increase in leverage for individuals and institutions alike. In itself, this was not so very different from the asset bubbles in the US and the UK – except for its extreme asymmetry with the rest of the Irish economy. At its peak, the value of Irish property assets represented 20 per cent of gross national product. Whilst this created enormous risk through excessive leverage, the adoption of a neo-­ liberal approach to taxation made things considerably worse. Cuts in corporate and personal taxes were balanced by increases in taxes on consumption (many of them property related), with tax payers dependent on the continued inflation of the property bubble to maintain their customary level of consumption. However, Ireland’s experience of the 2008 financial crisis clearly demonstrated that extreme asymmetry would inflict a level of damage to match. In Australia, the financial sector enjoyed a brief period of liberation, which resulted in widespread financial devastation and a severe recession in 1990. In response, Australian regulators duly reined it in. In New Zealand, the historical distrust between banks (which, for the most part, are now Australian-­owned) and the government meant that foreign-­owned banks tended to harbour assets ­off-­shore rather than aspiring to any level of domestic prowess. The Canadian

276   S.J. Konzelmann and M. Fovargue-Davies financial sector, too, has historically remained firmly under the regulators’ control. During the period of economic liberalization, Canada’s financial regulators remained committed to the 1964 Porter Commission goals of efficiency, competitiveness and independent, prudent regulation. This has been credited with creating a consistent and predictable regulatory environment conducive to a cooperative relationship between Canadian regulators and financial institutions. The Canadian, Australian and New Zealand financial sectors are also largely domestic in orientation and relatively concentrated in structure, making supervision and regulation more straightforward. The concentrated structure of the financial sector, especially in Canada and Australia (and therefore, New Zealand), contributes to stability in capital markets by reducing price competition among banks. With little opportunity for (even the threat of ) regulatory arbitrage, it is much easier to set and enforce the rules of the game. By contrast, the competition between London and New York for global finance has had the opposite effect. The likelihood of either the threat or reality of regulatory arbitrage resulting from the international nature of the financial sector in both countries has enabled it to effectively shape its own regulatory system, rather than the other way round. This has resulted in the effective disenfranchization of the state in this arena and, by extension, the majority of its citizens, who were left to pay the bill for cleaning up after the 2008 financial crisis. Another moderating factor in Canada, Australia and New Zealand has been the more pragmatic and incremental approach to reform, that has largely been evolved in response to emerging developments and threats. This stands in sharp contrast to the ideologically driven reforms under Reagan and Thatcher during the 1980s in the US and UK, that were continued under successive governments, regardless of political party affiliation. It also contrasts sharply with the nature of financial market reforms, which were sudden and abrupt – May Day 1975 in New York and Big Bang 1986 in London. Thus, as well as having other engines for growth, the financial sectors in Canada, Australia and New Zealand have had relatively limited access to global finance. The predominantly domestic structure of their banking systems strengthens the ability of regulators to effectively supervise; and it offers very little opportunity for regulatory arbitrage. Canadian banks in particular, have found the door to international financial activities solidly barred. Not only have they been unable to engage in international financial activities themselves; overseas institutions have found it difficult to find their way in. Financial institutions in Canada, Australia and New Zealand have therefore been unable to grow by merger and acquisition to a point where they were too fragmented to supervise and too large to fail. This has been reinforced by constraints on domestic mergers that might have had the potential to create one-­stop-shop financial institutions. The Canadian approach, in particular, stands in sharp contrast to that of the US, where Citi Bank’s (at the time illegal) takeover of Traveler’s Group – which created CitiGroup – prompted a retrospective change in the law to remove the pre-­existing constraint.

Conclusions   277 Asymmetry in the structure of the economy Asymmetry in the structure of the economy is another significant factor affecting both the nature and structure of the financial sector and its regulation. In this, within the Anglosphere, the divide is especially sharp between the US, the UK and Ireland (especially since its entry into the EMU in 2002), on the one hand, and Canada, Australia and New Zealand, on the other. As discussed above, Canada, Australia and New Zealand have traditionally been (and remain) strong commodities exporters. Canada and Australia have retained some of their manufacturing capacity; and New Zealand’s agricultural and public sectors have traditionally been important employers within the national economy. This resulted in a greater degree of resilience when confronted with the economic challenges of the 1970s; and, in turn, especially in Canada and Australia, it was reinforced by the countervailing influence of strong regional government. Together, these provided greater veto possibilities during the process of economic liberalization and financialization; and it allowed for a wider range of policy alternatives in response to recurring challenges. By contrast, having been among the first to industrialize, the UK and the US had a greater traditional reliance on manufacturing. Following the Second World War, they benefited from the reconstruction of war-­torn Europe and Japan. However, when faced with growing international competition from their newly reconstructed industries during the 1960s and 1970s, the US and UK found it difficult to effectively respond. In the UK, competitive challenges were exacerbated by the sudden loss of imperial export markets after the Second World War; and in both the US and the UK, ageing industrial firms found themselves with growing competitive disadvantages, in the face of which they failed to effectively respond. In the search for an alternative engine for growth, finance was repeatedly given the economic and political advantage. In addition to the immediate results of the rise to dominance of the financial sector in the US and UK, discussed earlier – and in Ireland during the period of financialization since 2002 – two further effects should be noted. First, the ability of the financial sector to grow rapidly (often at twice the rate of the ‘real’ economy) gives the impression that manufacturing and other non-­financial sectors of the economy had withered away to almost nothing. However, this was not wholly the case, especially in the US and the UK. Although traditional large-­ scale manufacturing companies had experienced serious – and very public – decline, small- and medium-­sized companies continued to thrive.2 Indeed, PricewaterhouseCooper’s (2009) report on the state of UK manufacturing cited 2007 as the best year since 1970. The second major effect of economic asymmetry was access to funds and political leverage. This has been influenced by the financial sector’s ability to generate higher profits than industry – and much more quickly through speculation than is possible through industrial development – with a spill-­over effect on short-­term macro-­economic performance measures, such as quarterly gross domestic product (GDP). As a consequence, financial markets increasingly channelled money into making ‘money’ rather

278   S.J. Konzelmann and M. Fovargue-Davies than ‘things’; and much less funding was made available to industry on favourable terms. This disenfranchization of industry relative to finance has been magnified by the far greater political leverage of finance (including the near immediacy of results); and it has resulted in an extended programme of financial re-­ regulation in both the US and the UK (and more recently, Ireland) – but very little in the way of coherent industrial policy. Increasing inequality The skewing of the economy towards finance (and the wealthy) is closely related to another area where growing asymmetry is apparent: increasing inequality. This has been made worse by the shifting balance away from the productive use of finance (which has a positive effect on employment and incomes and on the economic development of the real side of the economy), towards the speculative use of finance (the benefits of which are disproportionately shared by the wealthy whereas, as we have recently seen, the costs are likely to be socialized). The retreat from Keynesianism brought an end to policies aimed at full employment and social welfare provision; and the increased speculative use of finance has diverted resources from their productive use, which in so doing, has undermined industrial development and competitiveness within the Anglosphere. One effect has been a sharp reduction in the number of well-­paid manufacturing and other jobs in the economy, and their replacement (if at all) by low-­paid service sector jobs where employees are largely viewed as a cost to be economized, rather than a source of measurable added value to be retained. Not only have wages been stagnating under economic liberalization, the growth in the number of people seeking jobs relative to domestic employment opportunities has exerted further downward pressure on wages. The main losers – the increasingly disenfranchized – have been working-­class people and those at the bottom of the income distribution. The decline of economic muscle is typically accompanied by the suppression of economic voice, which for a growing segment of the population has been further eroded by the decline in independent trade-­union representation. The result has been widespread and growing disenfranchizement. Since the 1970s, the jobless and poor have been increasingly blamed for their plight, a message that has been amplified by the media. An interesting departure has been the case of New Zealand during the decade leading up to the 2008 crisis. Whilst the 1984–1994 period of liberal economic reforms produced sweeping financial market liberalization that contributed to expansion of non-­bank financial organizations in New Zealand, they remain relatively insignificant within the sector as a whole. However, by the end of the 1990s, since big business was seen to have captured a disproportionate share of the benefits generated by the reforms – at the possible expense of wage-­earning New Zealanders – there was a sharp reversal. This produced the 1999–2008 ‘Third Way’ reforms under Labour which aimed to improve societal egalitarianism for low- and middle-­income New Zealanders. This attempted shift towards redistribution and social spending in New Zealand thus encompassed a

Conclusions   279 significantly different set of policies and objectives than did the UK’s ‘Third Way’ under Blair’s New Labour party and the US’s under Clinton, both of which preserved the policy status quo of previous conservative administrations. Growing inequality within the Anglosphere is nevertheless apparent. A recent OECD (2011) report, Divided We Stand: Why Inequality Keeps Rising, revealed that aside from Ireland (for which the figures are not all available), by the time of the 2008 financial crisis, inequality in the Anglo-­Saxon countries was well above the OECD average; and it had been rising steadily during the period of economic liberalization. By the late 2000s, in terms of inequality, the US ranked fourth (below Chile, Mexico and Turkey), the UK seventh, Canada ninth, Australia tenth and New Zealand twelfth.3 In the US, the average income of the wealthiest 10 per cent of households was 15 times higher than the poorest 10 per cent, up from ten times higher during the mid-­1980s; with the richest 1 per cent accounting for 18 per cent of national income in 2008, compared with 8 per cent in 1980. In the UK, income inequality rose faster than any other OECD country since 1975. In 2008, the average income of the top 10 per cent of households was 12 times higher than the bottom 10 per cent, compared with eight times higher during the mid 1980s; with the wealthiest 1 per cent accounting for 14.3 per cent of national income in 2005, compared with 7.1 per cent in 1970. In Canada, the highest 10 per cent of income earners took home ten times more than the lowest 10 per cent, compared with eight times more in the early 1990s; with the wealthiest 1 per cent accounting for 13.3 per cent of national income in 2007, up from 8.1 per cent in 1980. In Australia, the richest 10 per cent earned ten times more than the poorest, compared with eight times more in the mid-­1990s; with the top 1 per cent accounting for 8.8 per cent of national income in 2008, up from 4.8 per cent in 1980. In New Zealand, inequality increased sharply during the 1990s but has been flat ever since, In 2008, the wealthiest 10 per cent of New Zealanders earned, on average, nine times more than the poorest, compared with 6 per cent in the mid 1990s; with the top 1 per cent accounting for 9 per cent of national income in 2005, up from 6 per cent in 1980. In short, the figures show that whilst inequality rose in all of the LMEs during the decades preceding the 2008 financial crisis, it was higher in the US and UK than in Canada, Australia and New Zealand.4

Economic liberalization – hypotheses and outcomes Across the Anglosphere, the outcomes generated by the parallel processes of economic liberalization and financialization – along with re-­regulation, globalization and disenfranchization – were influenced by institutional dimensions of the political economy and of the financial system; international capital flows and the position of the country within the world economy; and globalization and reliance on international trade and finance. The ways that these are theorized to interact are summarized in the three hypotheses introduced in Chapter 1 and explored further in the light of the comparative case studies in Chapter 10. We

280   S.J. Konzelmann and M. Fovargue-Davies hypothesized that a ‘purer’ form of financialized liberal capitalism would emerge in countries: (1) where the number of veto opportunities is low and concentration of financial interests is high, since in these cases we would expect fewer challenges to the status quo (of economic liberalization and financialization); (2) where the financial system is closely interrelated with those of the other LMEs, since in this context international capital flows can be expected to serve as an enabling force for financialization; and (3) where there is a greater reliance on international trade and finance, privileging and strengthening the private sector relative to the state. In all six countries, the parallel processes of economic liberalization and financialization generated increasing inequalities which privileged financial elites and the wealthy, eroding veto opportunities within the system as a whole and hence opportunities to challenge the emerging status quo. The US and UK surpassed Canada, Australia and New Zealand on all measures of inequality. The concentration of financial interests in the US, UK and Ireland was also high, given their reliance on finance as a driver for economic growth. The resulting political and economic power of their financial elites reinforced their ability to resist challenges to outcomes from neo-­liberalization that served their interests. We thus would have expected – and indeed observed – a purer form of financialized liberal capitalism to emerge in the US, UK and Ireland than in Canada, Australia and New Zealand. Although the Australian and New Zealand financial sectors were closely interrelated, given their geographic proximity and the largely Australian nature of the New Zealand banking system, they were less interrelated with the other four LMEs. By contrast, the financial sectors of the US, UK and Ireland were closely interrelated, much more so than were those of Canada, Australia and New Zealand with the six LMEs. Thus, the progressive liberalization of international capital flows served as an enabling force for financialization, accelerating it in the US, UK and Ireland, which realized significant growth following its entry into the European Monetary Union. The US, UK and Ireland were also heavily dependent on international finance and evolved their regulatory systems to be increasingly attractive to very mobile international capital, giving rise to regulatory arbitrage and progressively more ‘light touch’ regulation in the decades leading up to the 2008 crisis. In short, institutional configurations, the position of a country within the world economy and reliance on international trade and finance produced a more highly financialized form of liberal capitalism in the US, UK and Ireland than can be observed in the other three Anglo-­Saxon countries. This created feedback effects that influenced the degree of asymmetry in the three areas discussed above; and it was an important determinant of the influence that the financial sector might be able to wield in the political economy, in its regulation (in particular, in whose interests regulators, the political economy and the market operate) and in the ability (or otherwise) of financial institutions to grow to become too big to fail. The extent and nature of this asymmetry was significantly influenced by the existence (or otherwise) of effective countervailing influences, the most important of which were provided by regional politics and national

Conclusions   281 government. This leads us to return to the question of how – rather than if – the state should intervene in markets; how markets should be managed; and, perhaps most importantly, in whose interests they should be presumed to operate.

Ordoliberalism – a solution to the problem of market operation? As discussed in Chapter 11, ordoliberalism is an early variant of neo-­liberalism that views national economies as complex, market-­based systems, embedded in society. Effective competition and economic performance were seen to depend upon a strong state, charged with responsibility for establishing and upholding the liberal economic order. Because ordoliberals recognized the potential for market actors to consolidate economic power – and in so doing, to undermine the requirements of market competition – they assigned a regulatory role to the state, in addition to its role in supporting a stable society. During the early postwar years, however, liberal economists for the most part departed from this perspective. Instead, they embraced a more optimistic view of markets and were increasingly distrustful of state intervention to correct market failures. Over time, this evolved into the mainstream view that even the most basic state intervention in the economy and society is economically damaging. Markets were theorized as being ‘natural orders’ rather than man-­made constructs; therefore state intervention represented a corruption of the market’s natural order and a constraint on individual liberty. This conceptualization of the appropriate relationship between the state and the market (and society) was most pronounced in the experience of the US and the UK, under the Reagan and Thatcher governments. It took a more moderate form in Canada, Australia and New Zealand, countries with a greater social democratic influence and tradition of collectivism. Nevertheless, across the Anglosphere, the emphasis on market-­based solutions was predominant, to varying degrees and with varying effect. During the early postwar years, liberal economists also abandoned the early ordoliberal view that the decentralization of production in relatively small units was economically beneficial – because it avoided the challenge to competition posed by economic concentration. Instead, as the scale of enterprise increased, they justified large size as evidence of – and the reward for – successful competition in markets. Thus, whereas the early ordoliberals sought to avoid the possibility that private firms would grow to become ‘too big to fail’, neo-­liberals did not consider this to be a problem. However, the early ordoliberals did not go beyond the idea that decentralized production in small enterprises was a requirement for effective competition in markets. Their focus remained steadfastly on the operation of the market; and the ‘black box’ within which the relations of production (technical and social) are conducted remained firmly shut. This is where the productive systems framework5 offers an alternative analytical approach that takes us further than the early ordoliberal framework can in analysing the functioning and requirements of effective economic system

282   S.J. Konzelmann and M. Fovargue-Davies p­ erformance. It does not deny the central importance of markets. Rather, it considers what is required for effective productive system performance within them.

Productive systems – re-­enfranchizing production, markets and people As we have seen, the fundamental premise upon which the most prevalent incarnation of liberalized capitalism is based – that markets are a force of nature – is fundamentally flawed. Markets are a political construct; and free markets in which individuals and organizations are able to effectively compete do not result from the withdrawal of state intervention. The asymmetry resulting from the processes of economic liberalization and financialization – and the associated disenfranchization of certain groups within the political economy – provides evidence that neo-­liberal markets are neither ‘free’ nor ‘competitive’ in the sense that liberal economists theorize them to be. But liberal economic theory does not engage with questions about the social and human dimensions of the economy and the role that this might play in the arenas of both production (supply) and effective demand. In this respect, New Zealand plays a vital role because not once, but twice, was the process of economic liberalization suspended. As Keynesians – and the early ordoliberals – recognized, the political economy is embedded in a complex social structure; and there is continuous interaction between the economic system and society as a whole. For the economy to flourish, society must be healthy and stable. There is therefore a role for the state in the provision of those things required by society (and the economy) which the market is unlikely to deliver effectively. These include such ‘public goods’ as education, health and social welfare, all of which contribute to a stable society and produce human resources with the skills, physical attributes and values required in production – and upon which the longer term effective functioning of the broader political and economic system depends. Not only do these public goods contribute to the ability of productive agents to fully participate in their productive role within the system; they also affect their willingness and ability to continue doing so over time. An important insight of the productive systems approach is that production is an essentially cooperative activity; and cooperation is centrally important both within productive systems – whether they be at the level of the household, workplace, firm, industrial sector or inter-­firm network, nation state, or transnational trading bloc – and between them. This approach also recognizes the inevitability of conflicting interests, particularly with respect to the distribution of jointly produced value (since what one receives, the others cannot have). Dissatisfaction with distributional shares has the potential to undermine the willingness to cooperate; thus, the system’s long term success depends upon the existence of effective mechanisms for securing agreement with respect to distribution. The productive systems approach is not a simplistic model, nor does it ignore inconvenient problems. Instead, it acknowledges the reality of economics and of relationships within it – including the inevitable (and legitimate) conflicts of

Conclusions   283 interest and the differences in relative power. Only by accepting these realties can the conditions for securing effective cooperation be created and the requirements for successful long-­term economic performance be established. In this, as we have seen, the relationship between the state and the private sector – both productive and financial – is centrally important. For the system to succeed, it is also important that it generates sufficient effective demand to absorb what is produced. This was achieved during the early postwar period through Keynesian-­style macro-­economic management and relatively widespread commitment to full employment and social welfare provision. Whilst this system generated significant macro-­economic benefits and unprecedented improvements in standards of living and equality across the developed world, as we have seen, these achievements were reversed in the LMEs (to varying degrees) during the decades of liberal economic reforms that preceded the 2008 financial crisis. Despite the apparent socio-­economic effects of economic liberalization within the Anglosphere – explored in the chapters above – it is important to recognize that this is not ‘the end of history’. We can identify the factors that contributed to variation in the six Anglo-­Saxon countries’ experience of the 2008 financial crisis; and we can speculate about how these economies, in particular, and liberal capitalism, in general, might evolve in the future. But what is certain is that they will, indeed, continue to evolve. The processes of economic liberalization – re-­ regulation, globalization, financialization and disenfranchization – are not yet fully played out. The productive systems approach may yet provide further insight into the dynamically interrelated processes that produced the institutional configurations which shaped the varying paths of the LMEs though the period of economic liberalization. It may also provide a roadmap for progressing beyond the current crisis of contemporary capitalism. But that is another story.

Notes 1 See, for example, Levi-­Faur 2005; Braithwaite 2005. 2 However, in the wake of the financial crisis, they have faced difficulties associated with the unwillingness of financial institutions to lend. 3 Inequality rankings are based on the Gini coefficient, which measures the share of income earned by the share of households in a country, from lowest to highest. A zero coefficient implies that all households in a country have exactly the same amount of wealth, while a coefficient of 1.0 means a single household has all the country’s income. The OECD average for the late 2000s (between 2006 and 2009) was 0.3041. The GINI for the six Anglo-­Saxon countries was: US (0.3701); UK (0.3446); Canada (0.3283): Australia (0.3236): New Zealand (0.3230) and Ireland (0.2892). 4 Aside from the late 2000s Gini coefficient, comparable OECD figures are not available for Ireland. 5 See Wilkinson (1983 and 2003), for seminal articles on the productive systems framework for analysis. See, also, Burchell et al. (2003) for empirical applications of this framework.

284   S.J. Konzelmann and M. Fovargue-Davies

References Braithwaite, J. (2005) ‘Neoliberalism or Regulatory Capitalism’. RegNet Occasional Paper No. 5, October, online, available at: http://papers.ssrn.com/sol3/ papers. cfm?abstract_id=875789. Burchell, B., S. Deakin, J. Michie and J. Rubery (2003) Systems of Production: Markets, Organizations and Performance, London: Routledge. Chandler, A.D. (1977) The Visible Hand: The Managerial Revolution in American Business, Cambridge, MA: Harvard University Press. Fama, E. (1970) ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, 25(2): 383–417. Fligstein, N. (1996) ‘Markets as Politics: A Political Cultural Approach to Market Institutions’, American Sociological Review, 61(4): 656–673. Kirzner, I. (1997) How Markets Work: Disquilibrium, Entrepreneurship and Discovery, IEA, Paper No. 133, London: Institute of Economic Affairs. Lazonick, W. and M. O’Sullivan (2000) ‘Maximizing Shareholder Value: A New Ideology for Corporate Governance’, Economy and Society, 29(1): 13–35. Levi-­Faur, D. (2005) ‘The global diffusion of regulatory capitalism’, Annals of the American Academy of Political and Social Science, 598(1): 12–32. Levi-­Faur, D. and S. Gilad (2004) ‘Review: The Rise of the British Regulatory State: Transcending the Privatization Debate’, Comparative Politics, 37(1): 105–124. OECD (2011) Divided We Stand: Why Inequality Keeps Rising, online, available at: www.oecd-­i library.org/social-­i ssues-migration-­h ealth/the-­c auses-of-­g rowinginequalities-­in-oecd-­countries_9789264119536-en. PricewaterhouseCooper (2009) The Future of UK Manufacturing: Reports of its Death are Greatly Exaggerated. Observations, Analysis and Recommendations, online, available at: www.pwc.co.uk/assets/pdf/ukmanufacturing-­300309.pdf. Shumpeter, J. (1943) Capitalism, Socialism and Democracy, London: George Allen and Unwin Ltd. Wilkinson, F. (2003) ‘Productive Systems and the structuring role of economic and social theories’, in B. Burchell, S. Deakin, J. Michie and J. Rubery (eds) Systems of Production: Markets, Organizations and Performance. London: Routledge, pp. 10–39. Wilkinson, F. (1983) ‘Productive systems’, Cambridge Journal of Economics, 7(3/4): 413–429.

Index

Page numbers in italics denote tables, those in bold denote figures. 1920s 33–4, 36, 52, 126, 140, 251 1930s 33–4, 52, 83, 126, 250; mid 57, 135 1940s 28n31, 259; mid 75; late 41, 76, 257–8 1950s 37, 60, 69, 82, 84–5, 87, 91, 134, 137, 161–2, 187, 233, 234, 247, 253, 255–6, 259, 274; early 83, 257–8; late 80, 162 1960s 37–8, 60, 85, 87–8, 182, 187, 233, 247, 250, 255, 274, 277; early 162, 260; mid 42, 75, 83; late 39–40, 52, 61, 139 1970s 10–11, 13, 15, 18, 20, 25, 27n30, 36–7, 39–40, 42–6, 48, 52, 59, 61, 69, 72, 74, 80, 83, 87–8, 90–1, 96, 99–100, 102n4, 127, 137–8, 156, 166, 168, 172, 186–7, 190, 223–5, 230–1, 233, 236, 241, 248n1, 272, 277–8 1980s 13, 15, 27n14, 47, 49–51, 62–3, 65, 68, 74–5, 80, 93, 95, 97, 99, 109, 111, 134, 164, 172, 179, 187, 224–5, 233, 235–7, 239–40, 255, 257, 263, 264n3, 271–6; early 10, 43, 46, 72, 88, 92, 137, 156, 166, 171, 224, mid-1980s 60, 93, 134, 165, 216, 224, 245, 279; late 110, 159, 224; end 96 1990s 10, 13, 15, 20–1, 27n14, 47, 50–1, 64, 68, 91, 94, 96, 99, 122, 147, 224–5, 228, 232–4, 235, 239; early 7, 9, 44, 46–7, 75, 93, 110, 159, 188, 204, 214, 279; mid 66, 111, 244, 275; late 63, 118, 177, 240, 245, 278 2000s 10, 21, 63–4, 68, 111, 114, 118, 121, 128–9, 188, 228, 234, 236, 239–40; early 8–9, 125; mid 46, 69, 245; late 134, 279, 283n3, 283n4 Adam Smith 41; Institute 102n7, 102n8

Agency Theory 38, 53n7 Ahern, B. 125–6, 128 Amable, B. 1, 14, 20–1, 23, 27n12 American see United States Anglo-Saxon 4, 13; banking systems 1, 5, 25, 193, 223–4; capitalism 27; countries 1–2, 7, 10, 14, 21, 26, 52, 236–7, 242, 270, 279–80, 283, 283n3; economies 7, 10–11, 48, 224, 237–8, 247; world 5, 25, 35–6 Anglosphere 2–3, 5–7, 10–11, 15, 18, 21, 36, 48, 135, 224–5, 235–8, 240, 242, 245–7, 269–70, 274–5, 277–9, 281, 283 Arndt, H.W. 34 Asia 4; Asian economies 219; Asian savings 5 asset-backed commercial paper 179–81, 232; crisis 156–8, 164–5, 182 asset price inflation 7–8, 47, 273 Association of Concerned Taxpayers 151n5; ACT Party 146, 148 asymmetry 95, 280, 282; increasing 270, 274–5, 278; informational 163; structural 277 austerity 51, 90; programmes 13, 46, 49, 100, 135 Australia 1–4, 8, 10, 14, 16, 26n7, 27n12, 137, 187–91, 193, 195, 204, 214, 215, 218–19, 220n1, 224–5, 235, 237–8, 240, 242, 244, 246–8, 270, 272, 274–7, 279–81; financial sector 22, 187, 190–1, 214, 275–6, 280 Australia, New Zealand, United States Security Treaty 137, 146 Australian banks 1–2, 26n2, 149, 187, 190, 213, 226, 241; Australia and New Zealand Banking Group (ANZ) 189, 230;

286   Index Australian banks continued Commonwealth (CSA) 189; National (NAB) 147, 189, 227, 230; Reserve (RBA) 187, 189, 213, 220n1, 220n3, 226, 230 Australian Consumer and Competition Committee 189 Australian Mutual and Provident Society 189 Australian Prudential Regulatory Authority 189–90, 213, 226 Australian Securities 189; Commission (ASC) 187; Exchange (ASX) 209, 232; and Investment Commission (ASIC) 213, 226 bailout 2, 26n3, 74, 89, 147, 155, 170 balance of power 19, 25, 51, 235, 248 bank holding companies 58; Act 58; Douglas Amendment 62 Banking Act 58; 1979 89, 94, 225, 227 Bankruptcy Code 68, 233 bank 94; Bank of England 53n12, 73, 80, 83–4, 86, 89, 94, 98–9, 135, 225, 227; Bank of International Settlements (BIS) 33, 111, 246; Basel Committee on Bank Supervision (BCBS) 68–9; European System of Central Banks (ESCB) 119; HSBC 159; Johnson Matthey Bankers (JMB) 101n2, 236; Midland 84–5, 94; operational independence 98, 225; Post Office Savings 139; Royal Bank of Scotland (RBS) 94, 177, 227; struggling 2, 108 Bear Sterns 69, 172 Blyth, M. 15, 18, 20, 27n24, 238–9, 250 boom and bust 8, 52 Born, B. 71, 73 Boyer, R. 10, 14–16, 20 Brash, D.T. 136–7, 140, 142, 149, 150n3 Brazil 26n3, 60 Bretton Woods Agreement 36, 39, 60, 82; Bretton Woods System 13, 34–7, 53n5, 53n8, 61, 83–4, 160, 271 British see United Kingdom Broome, L.L. and Markham, J.W. 58–9, 61–2, 65, 67, 71 bubble 5, 38, 47, 100, 125; asset 8, 28n31, 36, 47, 69, 200, 237, 242, 245, 273, 275; burst 6, 51, 101, 187, 239; dot-com 9; financial market 33; housing 8, 47; Irish property 127; property 1, 5, 93, 109, 113, 125, 235, 275; technological 46 Callaghan, J. 80, 90

Campbell, J.L. 16–17 Canada 1–5, 8, 13–14, 16, 27n12, 94, 137, 155–6, 159–61, 163, 171–4, 179, 193, 224–5, 235, 238–9, 241–2, 247–8, 270, 274–7, 279–81; Toronto Dominion 158, 175 Canadian Deposit Insurance Corporation 158, 169–70, 172, 175 Canadian Mortgage and Housing Corporation 158, 160 Canadian banks 1–2, 155–6, 159, 164, 166, 167–9, 171–4, 176–82, 226, 228, 230, 232, 234, 235, 238, 241, 276; Big-Five 155, 161, 166, 168, 170, 172–6, 178, 181–2; Commercial (CCB) 168–72; Imperial Bank of Commerce (CIBC) 158, 174–5; of Montreal (BMO) 158, 175; Canadian financial sector 155–7, 159, 162, 165–6, 179, 181–2, 275–6; Financial Consumer Agency (FCAC) 158, 177 capital flow 39, 245; cross-border 244; international 24, 35, 82, 223, 247, 271, 279–80 capitalism 14, 25–6, 27n12, 33, 259, 261; comparative 14–17, 20–2; financialized liberal 223, 274, 280; liberal 1, 22, 25–6, 36, 47–8, 50, 193, 210, 216, 219, 270, 283; market-based 2, 27; varieties of 16–17, 21–2 capital: Long-Term Capital Management 66; fixed capital formation 3 Carter, J. 72 Celtic Tiger phase 111, 113, 275 Central Bank 44, 107–8, 116, 119, 124, 225, 227, 231, 251 Chant, J. 165–6, 180–1 Chicago School of Economics 72, 75–6, 83, 140, 142, 250, 254–9, 263–4 China 28n31, 46, 54n14, 197, 218–19 civil rights 157; Movement 60 coalition 100, 118, 147, 240; building 20–1; government 107, 147, 150 collateralized debt obligations (CDOs) 45, 63–4 Commission of Investigation (Banking Sector) 109, 129n2 Commodity Futures 67, 71; Modernization Act (CFMA) 68, 233; Trading Commission (CFTC) 66, 73 competitive markets 1, 21, 25, 41, 112, 114, 253, 259, 269; Competition and Credit Control 89, 102n5 Conservative 20, 98; Chancellor 94, 101n2; government 80, 84–6, 88–9;

Index   287 Party conference 91; prime minister 13, 87; voters 92, 140 Consolidated Supervised Entities program 69, 71 consumers 4–7, 19, 38, 53n13, 89, 93, 101, 112, 162, 166–8, 170–3, 198, 223; American 88; Canadian 159, 176–7; consumer goods 38, 54n14, 87; debt 5, 8, 89, 100 consumption 5–6, 25, 38, 45–6, 47, 51, 100–1, 145, 198 convergence 15, 20–1, 61, 255 corporate raiders 85–7, 144 Council of Financial Regulators 189, 213 cross-country differences 15, 18 Crouch, C. 16–17, 24, 27n11, 27n18 currency 81, 92, 99, 111; Canadian 234; crisis 187; devalued 53n8, 144; exchange rates 35, 39, 60–1; European 96; international 84–5; national 97; New Zealand 136; Office of the Comptroller of the Currency OCC 58, 68, 70–1, 229; reserves 161; speculation 82; supply 158; support 247 debt 4–5; cheap debt 6, 25, 273; funding 7; rate of growth 2, 200, 202, 217 deindustrialization 36, 37–8, 51, 88, 271, 272 Department of Trade and Industry 84, 95 depository institutions 45, 57–9, 61–2, 65–7, 71, 157, 159, 167, 225, 226, 228–9, 233 deregulation 10, 27n30, 50–1, 65–7, 70–2, 74–6, 93–4, 110, 134, 140–1, 145, 148, 150n2, 156, 175, 182, 186, 214, 216, 224–5, 229, 269 disenfranchization 51, 270, 273–4, 276, 278–9, 282–3 Douglas, R. 140–6, 148–9, 150n2 Douglas, R. and Callen, L. 143–4 Dumenil, G. and Levy, D. 20, 53 East Asia 112; financial crisis 66, 147 economic agents 16, 21, 33 economic growth 9–10, 160–1, 201, 273; accelerated 46; drivers 14, 23, 47, 100, 274, 280; higher 49, 83, 111, 125; national 34; slow 137; slowdown 7–8, 26n3; strong 149, 274; sustained 135, 149 economic liberalism 13, 18, 25, 33, 37, 41, 48–9, 52, 57, 80, 91, 102n7, 186, 248, 272, 274; Australian 190–1; new 42–3

economic liberalization 2, 7, 10, 13–16, 18–23, 25, 36, 48–52, 80, 186, 190, 239, 241–2, 247, 269–80, 282–3 Educational Building Society 110 employment 1, 10–11, 19, 33–5, 39, 42–4, 47, 49, 52–3, 73, 82–4, 88, 92, 101n3, 113, 122, 125, 135, 139, 142, 147, 160, 186, 205, 210, 212–13, 218, 219, 224, 272, 2754, 283; Act 60; domestic 25, 272, 278 Engelen, E. and Konings, M. 14, 27n29 Epstein, G. 14, 53n6 Eurodollar markets 37, 80, 84–5, 233, 234 European Economic Community 88, 255; membership 96 European Monetary Union 27n12, 231, 275, 277, 280 exchange rate 39, 61, 92, 162; controls 82, 84, 88, 92, 145; currency 35; European Exchange Rate Mechanism 96–7, 234; fixed 97, 135, 234; interventions 137; policies 143 Fannie Mae and Freddie Mac 63 Federal Reserve 58, 61, 67–8, 71–3, 129n11, 199, 220n1, 225, 229; Board 53n5, 66, 227, 231 Fianna Fáil party 110, 118, 125–6, 240; coalition 107 financial crisis 2, 7–9, 11, 13, 46–9, 68, 70–2, 74, 89, 100, 107–8, 123, 155–6, 173, 178, 181, 193, 195; 1931 crisis 33, 37, 263; 1987 crisis 214; 2007–2008 crisis 14, 22, 25, 36, 179, 223–5, 234, 236, 238–9, 244, 259, 264, 269–70, 273–6, 279, 283, 283n1; Asian 66; Brazil 60; Irish 128 financial holding company 67, 71 financial innovation 6, 59, 61, 64, 69, 73–4, 236, 273 financial instability 7, 11, 16, 36 financial institutions 5, 7, 13, 17, 22–3, 35, 37, 47, 49, 57–8, 61, 63, 67–8, 70, 94–5, 235–6, 241, 247, 264, 272, 280, 283n2; American 180; Australian 190, 214, 225; British 229, 239; Irish 111, 117; Canadian 155–8, 160–4, 166–70, 173–8, 181–2, 276; distressed 108; domestic 107, 110; international 60, 111, 190, 248–9, 255; New Zealand 145; Office of the Superintendent of Financial Institutions OSFI 158–9, 169–72, 177–9, 181–2, 226; private 248; Reform, Recovery, and Enforcement Act (FIRREA) 65, 70

288   Index financial integration 24, 25 financial intermediaries 63–4, 94, 163 financialization 2, 10, 13–23, 24, 25–6, 27n30, 27n31, 36, 38, 47–8, 50–1, 53n6, 57, 69, 223–5, 236–42, 246–8, 270–5, 277, 279–80, 282–3 financial services sector 11, 12, 38, 63, 72–3, 101, 109, 118, 167, 175: Canadian 176, 178; Financial Services Authority (FSA) 4, 10, 69, 73–4, 98, 101, 108, 114, 117, 119, 124; regulation 57, 59, 66, 74, 157; special purpose vehicles (SPV) 45 financial stability 36, 119–20, 173, 190 Financial Times 1, 26n2, 73, 122 Fitzpatrick, S. 118, 123 Fligstein, N. 52n1, 269 Foundation for Economic Education 75–6 Free Market Studies 257–8 Friedman, M. 41–2, 53n8, 72, 75–6, 91, 257–9, 264n6 Gamble, A. 41, 253, 256, 263 Ganghof, S. 27n28 Garn–St Germain Act 65, 229 Germany 1, 33, 81, 111, 248n1, 250, 252, 256–7 Germany Treaty of Versailles 33–4 Gini coefficient 283n3 Glass–Steagall Act 35, 58–60, 67, 70, 72, 95, 172, 229 global financial crisis 1–2, 14, 33, 57, 73, 80, 100–1, 116, 134, 140, 259, 264 global financial markets 32, 35–6, 39 globalization 13, 15, 20, 25, 34, 36–8, 40, 48–51, 74, 88, 156, 235, 242, 246–7, 270–2, 274, 279, 283 golden age 35–6, 82–3, 134 Goldman Sachs 69 Goldsmith, J. 85–7 Gold Standard 83, 135, 161 Goldthorpe, J. 15 Goodhart, C. 89, 98 government debt 2–3, 3, 97 government deficit 140, 145, 149 government intervention 1, 72, 135, 160, 186, 238, 253, 269, 271; Australian 220n15 government policy 42–3, 138–9, 216 government-sponsored enterprises 63 Gramm–Leach–Bliley Act 59, 67–8, 70–1, 225, 227, 229 Great Depression 1, 32–7, 53n11, 58, 65, 84, 135, 160, 172, 195, 220n1

Great Moderation 46, 50 Greece 13, 112 Greenspan, A. 46–7, 73 gross domestic product 2, 3–4, 5, 8, 9, 10, 26n3, 26n7, 46, 91, 97, 100, 107–8, 110, 137, 140, 149, 194, 195–6, 201, 202, 203–4, 205, 207, 208–13, 218, 220n2, 244, 245, 246, 277; European 110; fall in 52n2, 91, 195, 201, 202–3, 204, 205, 207, 244, 245, 246, 277; Australia 218, 220n2; growth 10, 46; New Zealand 137, 140, 149; UK 195 gross national product 108, 113, 129n1, 275 Hacker, J.S. and Pierson, P. 20, 23, 74, 76, 236 Hall, P. and Soskice, D. 1, 14–16, 22, 38 Harris, S.L. 14, 173, 175, 177 Hawke, G. 135–6, 139–40 Heath, E. 87, 91; government 80, 86, 89 hedge funds 64, 66, 73, 107, 114, 128 Helleiner, E. 33, 35, 37, 39, 83–4, 187 heterogeneity 17, 20, 23, 24, 223 homeowners 99–100; Australian 188; First Home Owner Scheme 217, 217 homeownership 5, 50, 63, 110, 237 Honohan, P. 107–9, 111, 115–16, 119–23, 125 Hopner, M.A. et al. 10, 26n5 hostile takeover 17, 38, 85, 115, 272 household debt 4, 195, 196; levels 5; unsecured 45, 100 house prices 5, 8, 9, 45, 89, 96, 100, 108, 111, 113, 125, 207–9, 210, 216, 217, 217, 218 income distribution 25, 46, 51, 274, 278 India 54n14, 80–1 Industrial Reorganisation Corporation 86 inequality 36, 46, 280, 283n3; economic 74; income 100, 236–7; increasing 51, 278–9; reduced 35, 274 Institute for Economic Affairs 91, 102n7, 238 institutional 16–17, 19, 223, 247; complementarities 25, 239; configuration 15, 24, 274, 280, 283; layering 18, 223, 236, 240; reproduction 18, 23 institutional change 21–2; incremental 18–19, 238; macro 14–15, 20, 23, 25, 223, 236, 241 insurance companies 57, 59, 63, 65, 189;

Index   289 FDIC 58, 66, 69; FDICIA 65–6, 70; New York State Insurance Department 68 Insurance and Superannuation Commission 187, 189 internal rating-based approach 177–8 International Monetary Fund 13, 60, 80, 90, 108, 120, 155, 160, 190 International Swaps and Derivatives Association 68, 70 international trade 35–6, 53n8, 271, 279–80 interventionist 40; states 35, 134; policies 40; 140, 160, 257 investment banks 35, 58–63, 66–7, 69, 71, 159–60, 189; Canada 172–3, 241; United States 229, 233 investment dealers 156, 172–3; Canada 228, 232 investment 44, 59, 171; foreign direct 92, 111, 244, 245, 246; funds 57, 64, 224; houses 159, 172–3; Intermediaries Act 233; private 2, 64, 173; products 61, 63, 171, 235–6 investors 6–7, 38, 59, 61, 63–4, 66, 114, 116, 127, 145, 165, 170–1, 174–5, 181, 198, 273; Canadian 156, 159, 163, 180, 228; foreign 164 Irish Association of Investment Managers 117 Irish Financial Services 122–3; CBFSAI 120; CBIFSA 119–22; Centre (IFSC) 110–11; Regulatory Authority (IFSRA) 115–16, 119, 121 Irish Life and Permanent 110 Irish banks 1–2, 111–13, 122, 124–5, 227, 242; Allied (AIB) 107, 110, 112, 118, 227; Nationwide Building Society (INBS) 107, 110, 121; Resolution Corporation Ltd (IBRC) 107 Irish financial sector 107, 225, 273, 277, 280 Irish Stock Exchange 115, 117, 229 Italy 13, 111, 248n1 Jackson, G. and Deeg, R. 15–16, 27n14 Japan 2, 39, 46, 277 Johnson.L.B. 39 Kaldor, N. 44, 53n11, 89, 102n5 Karmel, R.S. 60, 65 Keynes, J.M. 8, 33, 35, 41, 52, 53n5, 83; Keynesianism 39–40, 52, 83, 91, 135, 263, 278; New Keynesians 42–3

Keynesian policies 13, 18, 33–4, 36–7, 40, 42, 44, 52, 60–1, 72, 136–8, 161, 186, 238, 272; capitalism 25, 27n31 Kirzner, I. 50, 272 Konzelmann, S. et al. 13, 26n4, 102n4, 142 Krippner, G.R. 14, 20, 27n30, 53n6 Krugman, P. 196–8, 200–1, 205 Labour 86, 141, 143, 146, 149, 278; government 85, 88, 90, 95, 102n8, 136, 138–40, 144, 148, 186–7, 191, 216, 240; Manifesto 83; Party 80, 90–1, 96–9, 137, 142, 279 labour markets 1, 26n6, 42, 44, 51, 146; reforms 147; regulation 15 labour standards 44, 98 Laidler, D. and Sandilands, R. 34, 53n5 Lazonick, W. and O’Sullivan, M. 38, 53n6, 272 left wing 21, 236, 252 legal system 1–2, 251, 261 legitimacy 19, 92, 163, 236, 252, 254, 256–8 Lehman Brothers 69, 107, 124, 172 Levy, J. et al. 61, 75, 89–90 Lewis, M. 107, 113, 122, 124–5 liberal capitalism 1–2, 22, 25–6, 47–8, 50, 98193, 210, 216, 219, 270, 283; financialized 223, 274, 280 liberal market 98, 270; economies 1, 3, 8, 10, 13–15, 17, 22, 24–5, 27n12, 38–9, 49, 51–2, 223–5, 235, 239, 242, 243, 244, 247–8, 272, 274, 279–80, 283 Listed Property Trusts 188 lobbying 18, 66–7, 70, 74, 143–4; lobby groups 240 Long Depression 32–3, 36 McDowell, M. 118–19 Macmillan, H. 13, 84 macro-economic 1–2, 13, 22, 40, 46, 49, 171, 186; benefit 283;imbalances 4, 7; management 37, 40, 283; outcomes 15, 38, 88; performance 16, 277; policy 37, 44, 98, 157; stability 34, 47 Mahoney, J. and Thelen, K. 18–20, 23 Maiden, M. 14, 190 Major, J. 96–7, 99 Marglin, S. and Schor, J. 35, 39 market-based economies 14, 21 market capitalization 2, 94 market for corporate control 17, 38, 86, 114–15, 188, 241–2

290   Index Marshall Plan 37, 84 mass production 11, 34–5, 82, 87–8 Meade, J. 42–3 media 18, 75, 122 Merrill Lynch Bank 62–3, 69 microeconomics 72, 186 Mirowski, P. and Plehwe, D. 41, 255 Mixed Member Proportional representation 147, 150, 151n4 monetarist policy 42, 72, 80, 89, 91, 134, 137, 141, 146–7, 149, 199 money markets 5, 44–5, 61, 64, 80, 84–5, 89, 93, 139, 187; US 233 Mont Pelerin Society 41, 75–6, 102n7, 238, 255–6, 258, 260 Morgan Stanley 69, 220n3 mortgage 5, 8, 45, 63, 98, 100, 110, 112–13, 155, 158–9, 161, 171; lenders 6, 8, 63, 139, 236; LMI 188 mortgage-backed security 188–9, 191n2 mortgage debt 5, 26n4, 188, 207, 216, 218; acceleration 208–9; growth 215 National Asset Management Agency 108 National Economic Development Council 88 National Health Service 82 National Mutual 189 national political economy 15, 20, 23 National Union of Mineworkers 90, 92 Neary, P. 116, 123–4 negative equity 6, 8 neo-liberalism 14, 18, 21, 25, 41, 96, 148, 224, 226, 240, 281; neo-liberal capitalism 36; neo-liberal markets 282 New Deal 34, 57, 75, 82, 258 new institutional economics NIE 261–2 New Zealand 1–4, 11, 16, 22, 137, 147, 151, 193, 224–5, 227, 229, 231, 233, 234, 235, 238, 242, 246–7, 270, 272, 274–7, 279–81; Business Roundtable 143; financial sector 22, 150n1, 275–6, 280; Stock Exchange NZSE/NZX 140 New Zealand banks 1, 135; BNZ 136, 139, 144, 146–7; RBNZ 136–7, 139–40, 145, 227; Act 135 Nixon, R. 39, 53n8, 61 Northcott, C.A. 156, 171 Nyberg, P. 109–10, 112–13, 115, 120, 124; Nyberg Commission 114, 116, 119, 121–2, 127 oil 39, 68; North Sea 92; OPEC 40; prices 40, 46, 54n14; shocks 13, 61, 137

old institutional economics 261, 264n7, 265n8 Olympia and York 156; bankruptcy 172, 174, 178 Omarova, S. 58, 67–8 ordoliberal 141, 149, 248, 250–8, 260–4, 264n2, 264n7; ordoliberalism 25, 251–7, 259–64, 264n1, 264n2, 264n3, 264n6 Organisation for Economic Co-operation and Development OECD 3, 4, 6–7, 9, 10, 11, 12, 113, 139, 145, 149, 272, 279, 283n3, 283n4 Orhangazi, O. 14, 69 O’Toole, F. 122, 126–7 over-the-counter OTC 62–3, 65–71, 73, 229 Pay As You Earn 138 Peck, J. 41, 251–2, 254–7, 260, 262 pegged rates 35, 97 Persson, T.G. et al. 21 political economy 14–16, 20, 23, 223, 237, 262, 264n4, 274, 279–80, 282 political power 20, 73–4, 76 Porter Commission 155–6, 159–68, 175, 181–2, 224, 230, 247, 276 PricewaterhouseCoopers 99, 155, 158 prime minister 13, 87, 90–1, 96, 99, 110, 147, 150, 157; deputy 151n3 profitability 43, 64, 155, 181, 213 Programme for International Student Assessment 149 property developers 112–13, 122, 126, 129, 240 Public Accounts Committee 115, 118 Reagan, R. 41, 61, 66, 74–5, 142, 156, 239–40, 257, 276, 281; administration 72; Reaganomics 238 real estate 7, 10, 12, 69, 218, 237; firm 156, 174; loans 215; markets 169; mortgages 161; sub-prime 1, 9 recession 7, 9, 33, 52, 52n2, 72, 90, 97, 111, 125, 159, 169, 171, 181–2, 188, 201, 202, 204, 214, 216; deep 43, 46, 218; severe 52n3, 187, 275 redistribution 21, 46, 148, 278 Regling, K. and Watson, M. 108–9, 111–13, 116–17, 119–21, 127 regulation 1, 17, 24, 32–3, 35, 37, 48, 52, 53n13, 59–61, 64, 73, 84, 91, 95, 101, 114, 116, 118–24, 128–9, 139, 148, 155, 156–8, 160–1, 163–5, 168–70, 172–3, 176–9, 181–2, 186–7, 189–90, 213–15, 230, 232–3, 235–40, 247, 262, 264,

Index   291 269–72, 277, 280; banking 58, 89, 156, 214, 226; financial 22–3, 60, 63, 73, 95, 117–19, 158, 162, 165–8, 182, 189, 227, 237–8, 247; financial market 37, 39, 248; government 34, 160–1, 165; light touch 23, 37, 74, 94, 120, 124, 239, 272, 280; prudential 57, 59, 119, 163, 169–70, 181–2, 189–90, 213, 215, 226 regulatory arbitrage 25, 45, 69, 189–90, 235, 248, 272, 276, 280 regulatory fragmentation 23, 70–1, 240 Reinhart, C. and Rogoff, K. 7, 9–11, 112 re-regulation 48, 51, 236, 238, 256, 262, 269–71, 279 Richardson, R. 147 Riegle–Neal Act 62, 231 right wing 240; think tanks 41, 91, 238 risk assessment 112, 115, 117, 121, 174 role of the state 19, 98, 149, 190, 251, 259–60, 262–3 Roosevelt, F. 34, 53n5, 258 Rowley, A. 81, 85 Roy, R.K. and Denzau, A.T. 21 rule of law 2, 75, 251 Sarbanes–Oxley Act 66, 74 savings rates 5, 6 Scandinavia 1; Norway 46; Sweden 27n18 Schenk, C. 37, 84–5 Schumpeter, J.A. 21, 50, 198–200, 205, 210, 257, 259 Securities and Exchange Commission 57, 59, 64, 66–7, 69, 71–2, 74 Securities and Investment Board 95, 189, 213 securities regulation 60, 98; American 155; Canadian 157, 164–5, 232 self-regulating 167, 177, 242, 269; markets 41, 72; organization 64, 94 service sector employment 11, 12, 46, 278 shareholder 19, 38, 50, 53n6, 81, 100, 114–15, 117; dispersed 17, 53n7, 87, 188, 271–2; minority 144; oriented 1, 15 share ownership 93, 114, 162, 176, 188 Shearer, R.A. 161–2 shock 178, 247; exogenous 17–18; financial 174, 179; market 189; oil 13, 137; oil-price 40, 61 Slater Walker 85–7 small and medium-sized enterprises 257, 274, 277 social welfare 35, 190, 262, 283; benefits 186; costs 38, 88; provision 237, 278, 283; reforms 136; system 144

Soviet Union 37, 84, 258; Soviet Bloc 134, 144, 150 stagflation 27n13, 40, 46, 61, 88, 90; stagflationary crisis 15, 36, 52 state intervention 32, 34–5, 39, 41, 47–8, 135, 251–3, 256–7, 269, 281–2 state-owned enterprises 145, 150 State Supervisory Authorities 187 Stiglitz, J.E. 72, 76 stock market 8, 16, 19, 50, 69, 81, 86, 94, 100, 165, 172, 188, 209, 225, 232, 272; 1929 crash 33–5, 37, 58, 83–4; 1987 crash 54n15, 93, 226; boom 52; liquid 38; operators 85; values 50 Streek, W. and Thelen, K. 18 Taoiseach 110, 121, 124–6 tariffs 32, 35, 175; General Agreement on Tariffs and Trade 35–7, 175 taxation 1, 80, 102n7, 115, 252, 275 terrorist attack 9, 147 Thatcher, M. 13, 80, 82, 91–3, 96–9, 102n7, 142, 239–40, 250, 255, 276; government 91, 93, 97, 156, 281; Thatcherism 80, 91, 238 Thelen, K. 15, 17–18 Third Way 97–8, 102n8, 143, 148–9, 252, 278–9 trade union 42–4, 88–91, 96–8, 236; power 92, 99; representation 274, 278; trade unionist 141 Turner, A. 73, 114; Turner Report 242 unemployment 37, 40, 42–4, 46, 49, 51, 53n9, 53n11, 60–1, 72, 85, 88, 90–2, 95, 98, 100, 102n4, 139, 146–7, 193, 194, 205, 205–6, 272–3 United Kingdom 2–11, 12, 13, 16, 22, 26n3, 27n7, 27n12, 35, 37–9, 46, 85, 93–5, 99, 101, 112, 120, 136, 143, 177, 193, 194, 195, 196, 203, 206–7, 209, 210, 211, 214, 216, 219, 224–5, 229, 234, 235–42, 243–4, 246, 247–8, 264n3, 270–81, 283n3; banks 1–2, 26n2, 94, 227, 235; Combined Code 117–18, 129n7; debt 204, 220n1; economy 14, 92, 100; financial sector 9, 11, 22, 37, 81, 83, 93, 220n3, 225, 273, 277, 280; industry 80–1, 85–8, 92–3; unemployment 53n11, 101n3, 213; non-accelerating inflation rate 43–4 United Nations Conference on Trade and Development 245, 246

292   Index United States 2–4, 5–6, 7–8, 9, 10–11, 12, 16, 20, 26n3, 27n12, 38, 46, 83, 86, 107, 112, 142–3, 193, 195, 197, 203, 204, 206, 208, 210, 211–12, 214–15, 215, 216, 219, 220n1, 220n3, 220n14, 224–5, 235–42, 243–4, 245, 246–8, 250–1, 253–4, 270–81, 283n3; banks 1–2, 95, 178, 220n14, 227; Congress 58, 62, 65–7, 70; dollar 35, 37, 40, 53n8, 62, 84–5; economy 33; financial sector 11, 22, 37, 58, 220n3, 225, 273, 277, 280; government 264n3; market 81, 94; neoliberalism 255–9, 263; presidents 39, 72–3; president’s working group 66; sub-prime mortages 45, 109; sub-prime real estate 1, 9 Van Horn, R. and Mirowski, P. 72, 75–6 Varieties of Capitalism 15 varieties of Liberalism 250 veto players 20–1, 23–4, 27n28, 240; veto possibilities 223, 241, 247, 274, 277 von Hayek, F. 41, 82–3, 91, 253, 255–7, 260, 263

Walker, D. 100; Walker Report 101 Wall Street 62, 72, 83 welfare 1, 50, 76, 148, 252; economic 41, 49, 135, 144; state 35, 47, 51, 87, 186, 190, 252, 258, 263, 274; system 136, 144 Western Europe 40; governments 39 White, D. 35, 53n5, 83 Whitley, R. 1, 22, 26 Wilkinson, F. 45, 47, 54n14, 82, 87, 93, 99, 283n5 Wilmarth, Jr., A.E. 59, 62–3, 66, 69, 71 Wilson, H. 86, 90 World Trade Organization 13 World Wars 34; First 39; interwar period 25, 35, 83, 250, 260, 271; Second 34–5, 40, 52, 81–3, 135–7, 155, 159, 264n2, 273, 277; post-Second 60, 75, 160, 162, 181, 220n1, 253, 257, 260 Y2K Year 2000 147 Zysman, J. 14–15, 82