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Introduction
Finance has moved on to the front page. The collapse of some of Britain’s leading banks in 2007 and 2008 has cost the taxpayer billions. It has brought the City, once seen as Britain’s most successful industry, into disrepute. Many people think the financial sector has been too powerful, imposing free-market dogma on unwilling populations. They resent the way that financiers make millions in bonuses when times go well but expect the taxpayer to bail them out when things go badly, as they did in 2008.
This ambivalent attitude towards financiers dates back over centuries. Roman emperors and medieval monarchs had to flatter financiers when they needed to borrow money; the attitude quickly turned to revulsion when the time came to pay it back. Whole populations have been caught up in frenzies of speculation dating back from Dutch tulip mania through the South Sea Bubble to the Florida land boom of the 1920s. Individual financiers have found it laughably easy to buy popularity when their schemes were prospering (think of Robert Maxwell). But there have been no shortages of commentators saying ‘I told you so’ when their empires subsequently collapsed.
Perhaps the public has tended to treat the subject of finance as a soap opera (complete with heroes and villains) because too few people attempt to understand the workings of the financial system. Although the details of individual financial deals can be very complex, there are basic principles in finance which everyone can understand and which apply as much to the finances of Mr Smith, the grocer, as to Barclays Bank. The more fully people understand these principles, the more they will be able and willing to criticize, and perhaps even participate in, the workings of the financial system. Like all areas of public life, it needs criticism to ensure its efficiency.
Even those who do not own shares should care about how the City performs. It is one of the UK’s biggest industries and a vital overseas earner in areas such as insurance and fund management.
THE CITY
First of all, what is the role of the UK financial system, and in particular of the City of London, which is at its heart?
Its primary function is to put people who want to lend (invest) in touch with people who want to borrow. A simple example of this role is that of the building societies. They collect the small savings of individuals and lend them to house buyers who want mortgages.
Why do the savers not just lend directly to borrowers, without the intervention of financial institutions? The main reason is that their needs are not compatible with those of the end borrowers. People with mortgages, for example, want to borrow for twenty-five years. Savers may want to withdraw their money next week. In addition, the amounts needed are dissimilar. Companies and governments need to borrow amounts far beyond the resources of most individuals. Only by bundling together all the savings of many individuals can the financial institutions provide funds on an appropriate scale.
Who are the borrowers? Businesses are one group. Companies will always need money to pay for raw materials, buildings, machinery and wages before they can generate their own revenues by selling their goods or services. To cover the period before the cash flows in, companies either borrow from the banks or raise capital in the form of shares or bonds. Without this capital it would be impossible for companies to invest and for the economy to expand.
The second major set of borrowers is governments. No matter what their claims to fiscal rectitude, few governments have ever managed to avoid spending more than they receive. The UK government and other nations’ governments come to the City to cover the difference.
Who wants to lend? In general, the only part of the economy which is a net saver (i.e. its savings are greater than its borrowings) is the personal sector – individuals like you and me. Rarely do we lend directly to the government or industry or other individuals: instead we save, either through the medium of banks and building societies or, in a more planned way, through pension and life assurance schemes. Lending, saving and investing are thus different ways of looking at the same activity.
So financial institutions are there to channel the funds of those who want to lend into the hands of those who want to borrow. They take their cut as middlemen. That cut can come in three forms: banks can charge a higher interest rate to the people to whom they lend than they pay to the people from whom they borrow, or they can simply charge a fee for bringing lender and borrower, or issuer and investor, together. Over the last twenty years, they have increasingly added a third activity: trading assets. This contributed to the credit crunch that started in 2007.
There is no doubt that financial institutions perform an immensely valuable service: imagine life without cashpoint cards, credit cards, mortgages and car loans. Even those Britons who do not have a bank account would never be paid if the companies for which they work did not have one. Indeed, the companies might not have been founded without loans from banks.
It is important, when considering some of the practices discussed in this book, to remember that the business of financial institutions is the handling of money. Some of their more esoteric activities, like financial futures, can appear to the observer to be mere speculation. But speculation is an unavoidable part of the world of financial institutions. They must speculate, when they borrow at one rate, that they will be able to lend at a higher rate. They must speculate that the companies to whom they lend will not go bust. To criticize the mechanisms by which they do speculate is to ignore the basic facts of financial life.
Financial institutions are a vital part of the British economy. Whether the rewards they receive are in keeping with the importance of the part they play is another question, which we will examine in the final chapter.
THE INSTITUTIONS
The most prominent financial institutions are the banks, which can be divided roughly into two groups, commercial (retail) and investment, formerly known as merchant, banks. The former rely on the deposits drawn from ordinary individuals, on which they pay little or no interest and which they re-lend at a profit. Commercial banks must ensure that they have enough money to repay their customers, so they need to own some safe assets they can sell quickly. The latter group traditionally relied more on fees earned from arranging deals such as takeovers; nowadays, these banks also get heavily involved in market trading. However, the division between the two groups is not clear-cut since many commercial banks have investment banking arms.
The second group of financial institutions, known as the investment institutions, include the pension funds and life insurance companies. They bundle together the monthly savings of individuals and invest them in a range of assets, including the shares of British and foreign companies and commercial property. This is a vital function, since industry needs long-term funds to expand. Banks lend money to industry, but by tradition they have been less ready to invest for long periods. Pension funds can count on regular contributions and can normally calculate in advance when and how much they will have to pay out to claimants. Life insurance companies have the laws of actuarial probabilities to help them calculate their likely outgoings.
But pension funds and insurance companies are less significant, in stock market terms, than they used to be. Nowadays, the investors who dominate the market tend to be more aggressive and short-term in outlook. Two prominent groups, hedge funds and private equity firms, will be discussed at length.
The third main group is the exchanges, which provide a market for trading in the capital that companies and governments have raised. People and institutions are more willing to invest money in tradeable instruments, since they can easily reclaim their money if the need arises. The best-known exchange in the UK is the Stock Exchange.
Within and outside these groups is a host of institutions which perform specialized functions. The building societies have already been mentioned, but we will also need to look at the Bank of England, insurance brokers and underwriters, to name but a few.
THE INSTRUMENTS
Chapter 2 examines in detail questions about the definition of money and the determination of interest rates. But for the moment the best way to understand the workings of the financial system is to stop thinking of money as a homogeneous commodity and instead to think of notes and coins as constituting one of a range of financial assets. It is the liquidity of those assets that distinguishes them from each other. The liquidity of an asset is judged by the speed with which it can be exchanged for goods without financial loss.
Notes and coins are easily the most liquid because they can be traded immediately for goods. At the opposite extreme is a long-term loan, which may not be repaid for twenty-five years. Between the two extremes are various financial assets which have grown up in response to the needs of the individuals and institutions that take part in the financial markets.
Essentially, financial assets can be divided into four types: loans, bonds, equities and derivatives.
Loans are the simplest to understand. One party agrees to lend another money in return for a payment called interest, normally quoted as an annual rate. It is possible, as in the case of many mortgages or hire-purchase agreements, for the principal sum (that is, the original amount borrowed) to be paid back in instalments with the interest. Alternatively, the principal sum can be paid back in one lump at the end of the agreed term.
Bonds are pieces of paper like IOUs, which borrowers issue in return for a loan and which are bought by investors, who can sell them to other parties as and when they choose. Bonds are normally medium- to long-term (between five and twenty-five years) in duration. The period for which a loan or bond lasts is normally known as its maturity, and the interest rate a bond pays is called the coupon. Shorter-term bonds (lasting three months or so) are generally known as bills.
Equities are issued only by companies and offer a share in the assets and profits of the firm, which has led to their being given the more common name of shares. They differ from other financial instruments in that they confer ownership of something more than just a piece of paper. In the financial sense, shareholders are the company, whereas bondholders are merely outside creditors.
The initial capital invested in shares will rarely be repaid unless the company folds. (But shares, like bonds, can be sold to other investors.) The company will generally announce a semi-annual or quarterly dividend (a sum payable to each shareholder as a proportion of the profit), depending on the size of its profits. All ordinary shareholders will receive that dividend. However, it is not compulsory for companies to pay dividends. Some companies choose not to do so because they wish to reinvest all their profits with the aim of expanding the business. Others may omit paying a dividend because they are in financial difficulties.
Equity investors only get paid after the demands of lenders and bond-holders are satisfied. If a company gets into trouble, equity investors may well lose the bulk of their money whereas bondholders have a chance of getting a chunk of their capital back. The good news for equity investors is they get all the upside. Whereas the claims of lenders and bondholders are fixed, equity owners benefit from a company’s growth.
That brings us to one of the most important principles in finance. Greater risk demands greater reward. If a lender is dubious about whether a borrower will be able to repay the loan, he or she will charge a higher rate on that loan. Why lend money at 10 per cent to a bad risk when you can lend money at 10 per cent to a good risk and be sure that your money will be returned with interest? To compensate for the extra risk, you will demand a rate of, say, 12 per cent, for the borrower with a doubtful reputation.
Derivatives are financial assets that are based on other products; their value is derived from elsewhere. Among the best-known derivative instruments are futures, options and swaps.
They perform a number of functions, allowing some people to insure themselves against price moves in other assets and others to speculate on price changes. These functions allow derivative users to get involved in hedging and leverage. Hedging is the process whereby an institution buys or sells a financial instrument in order to offset the risk that the price of another financial instrument or commodity may rise or fall. For example, coffee importers buy coffee futures to lock in the cost of their raw materials and reduce the risk that a rise in commodity prices will cut their profits.
Leverage gives the investor an opportunity for a large profit with a small stake. Options, futures and warrants all provide the chance of leverage because their prices vary more sharply than those of the underlying commodities to which they are linked. These concepts are more fully explained in Chapters 12 and 13.
ALCHEMY
Financial institutions must perform a feat of alchemy. They must transform the cash savings of ordinary depositors, who may want to withdraw their money at any moment, into funds which industry can borrow for twenty-five years or more. This process involves risk – the risk that the funds will be withdrawn before the institutions’ investments mature. They must therefore demand a higher return for tying up their money for long periods, so that they can offset that risk. This brings us to a second important principle of finance. Lesser liquidity demands greater reward. The longer an investor must hold an asset before being sure of achieving a return, the larger he will expect that return to be. However, this is not an iron rule. In Chapter 2 we shall see how, for a variety of reasons, long-term interest rates can be below short-term rates.
The range of financial assets extends from cash to long-term loans. Cash, the most liquid of assets, gives no return at all. A building society account that can be withdrawn without notice might give a return of, say, 5 per cent. In the circumstances, why should lenders make a twenty-five-year loan at less than 5 per cent? They would be incurring an unnecessary risk for no reward. So lenders generally demand a greater return to compensate them for locking up their money for a long period. In the same way some banks and building societies offer higher-interest accounts to those who agree to give ninety days’ notice before withdrawal. The borrowers (in this case, the banks and building societies) are willing to pay more for the certainty of retaining the funds.
Bonds and shares are usually liquid in the sense that they can be sold, but the seller has no guarantee of the price that he or she will receive for them. This differentiates them from savings accounts, which guarantee the return of the capital invested. Thus bond- and shareholders will generally demand a higher return. For both, that extra return may come through an increase in the price of the investment rather than through a high interest rate or dividend. This applies especially to shares. As a consequence, the dividends paid on shares is often, in percentage terms, well below the interest paid on bonds such as gilts (highly reliable investments because they are issued by the UK government).
THE CITY’S INTERNATIONAL ROLE
The City, of course, plays a role that far exceeds the dimensions of the national economy. It is this role that the supporters of the City invoke when they defend its actions and its privileges. And it is to preserve this role that the City has undergone so many changes in recent years.
In the nineteenth century the City’s importance in the world financial markets reflected the way in which Britannia ruled the waves. Britain financed the development of Argentinian and North American railways, for example. By 1914 Britain owned an enormous range of foreign assets, which brought it a steady overseas income. Much of the world’s trade was conducted in sterling because it was a respected and valued currency.
The two world wars ended Britain’s financial predominance. Foreign assets were repatriated to pay for the fighting. As the Empire disintegrated, so too did the world’s use of sterling as a trading instrument. Just as the US emerged as the world’s biggest economic power, so New York challenged London for the market in financial services and the dollar took over from sterling as the major trading currency. It seemed that Britain and the City would become backwaters on the edge of Europe.
One thing saved the City. The US, which had regarded banks with suspicion since the Great Crash of 1929, did not welcome the growth of New York as a financial centre. The US authorities began to place restrictions on the activities of its banks and investors. International business began to flow back to London, where there were fewer restrictions. The Euromarket grew into the most important capital market in the world and made London its base.
The revival of the City in the 1960s brought many foreign banks to London and they have stayed as Britain’s capital has become one of the world’s three great trading centres, together with New York and Tokyo. But the challenge is never-ending. The development of the European single currency caused some to fear that London could lose its place to Paris or Frankfurt; so far, the challenge has been seen off fairly easily.
However, London does face what has been called the ‘Wimbledon’ problem; Britain may be the venue for a great tennis tournament but the best players come from elsewhere. The London Stock Exchange has narrowly fought off takeover bids from the Frankfurt exchange and from the US electronic market, NASDAQ; the ultimate owner of the London futures market is now the New York Stock Exchange. The banks that dominate activity in the London markets are overwhelmingly foreign, particularly the Americans, Swiss, Germans, French and Japanese.
It is best that we look at these changes before we examine in detail the workings of the UK financial system. Discussion of these changes requires an assumption of some knowledge on the part of the reader as to how the system works. However, this book is also designed to be read by those who know little of finance. They may well want to start at Chapter 2 and return to the first chapter after they have read the rest.
The International Financial Revolution
In the past thirty years, the City has changed beyond recognition. It has always been an important part of the UK economy and a key source of overseas earnings, particularly in areas such as banking and insurance.
The City, or at least its financial markets, has always been powerful. Many blame a ‘bankers’ ramp’ for forcing out the Labour government in 1931, and subsequent Labour governments ran into problems over sterling in 1948, 1967 and 1976. But now the financial markets’ influence seems all-pervasive. Governments round the world find themselves constrained in their economic policies for fear of offending the markets. James Carville, one of President Clinton’s key advisers, remarked that he would like to be reincarnated as the bond market so he could ‘intimidate everybody’. When the financial system wobbles as it did in 2007 and 2008, the whole economy is threatened.
In addition, a combination of lower tax rates and liberalized financial markets has widened income differentials. Many City employees earn as much in a year as normal people might hope to earn in a lifetime, helping to force the prices of properties in London beyond the reach of teachers and nurses. All this has created a lot of resentment against ‘greedy’ bankers.
Wider share ownership, encouraged by the government through privatizations and tax breaks, has created much greater interest in financial markets, reflected in greater coverage in newspapers and on TV. And, with governments round the world quailing in the face of the cost of state pension schemes, citizens are realizing that they may depend on the financial markets for their security in old age.
Why has all this happened? In part, it is because of the breakdown of the financial system that prevailed from the end of the Second World War until the early 1970s. That system, generally known as Bretton Woods, combined fixed exchange rates with strict controls on capital flows, so restricting the scope for financial market activity. Under fixed exchange rates, currency speculation was only profitable at occasional times, such as when Britain was forced to devalue sterling in 1967.
Foreign-exchange controls also made it difficult for investors to buy equities outside their home markets. That reduced the scope for share trading and ensured that the UK equity market was a protected haven, dominated by small firms operating in a climate which author Philip Augar has described as ‘gentlemanly capitalism’.
But the system broke down in the early 1970s (for a full description see Chapter 14). The first domino to fall was fixed exchange rates. The system had depended on the US dollar but that currency buckled in the face of the costs of the Vietnam War.
Once exchange rates began to float, two things started to happen. First, companies faced foreign-exchange risk when selling goods. For example, Mercedes’ costs were in Deutschmarks; when it sold a car in the US, it received dollars. If the dollar fell against the Deutschmark, that would be bad news. So companies looked for ways to protect themselves from these risks.
Secondly, floating exchange rates created the potential for continuous speculation. The 1970s saw the creation of the financial futures market in Chicago, which allowed traders to bet on the likely movement of exchange rates.
Both developments were opportunities for financial companies. They could make money speculating on the markets and they could make money helping companies protect themselves from foreign-exchange risk. Both opportunities were taken.
Floating exchange rates also had significant implications for governments. Think of three key elements of monetary policy: exchange rates, interest rates and capital controls. Under the Bretton Woods system, countries controlled their exchange rates and capital flows. However, if countries ran a substantial trade deficit, capital would still flow out of the country.
Take the UK, a country which habitually runs a trade deficit. When a foreign company sells goods to the UK, it receives sterling in return. (Even if it asks for dollars, the UK buyer of the goods must sell sterling and buy dollars in order to make the payment. Sterling will still flow out of the country.) Eventually, those companies will become less and less willing to hold sterling at the prevailing exchange rate. The Bank of England may be willing to buy that sterling off the overseas companies but it needs foreign-exchange reserves to do so. After a while the money will run out.
To avoid this problem, governments tried to cut the trade deficit. The easiest way of doing so was to raise interest rates; this had the effect of cutting consumer demand for foreign goods. But the result was a stop– go kind of economy, in which periods of rapid expansion were suddenly cut short as governments raised interest rates to protect sterling.
In a world of floating exchange rates, there is no requirement for governments to ratchet up interest rates every time the currency falls. Voters naturally don’t like high interest rates. The problem was exacerbated by governments’ desire to keep unemployment low; at the slightest sign of economic weakness, they acted to boost the economy.
So in the 1970s, governments let their currencies sag, and kept interest rates lower than they might have been. The result (higher import prices, too much money chasing too few goods) was inflation. By the end of the 1970s, there was a general feeling that the old system of economic policy had failed. Governments had tried to micromanage the economy but in their attempts to keep down unemployment, they had merely achieved stagflation: high inflation and unemployment. Right-wing politicians such as Ronald Reagan and Margaret Thatcher argued that state intervention in industry had stifled the economy, concentrating resources in sunset industries such as coal and steel, and starving the growth sectors of the economy such as technology.
Inflation was eventually brought to heel with the help of very high interest rates, which also prompted massive job losses in those sunset industries. This process caused much distress and protest at the time and would have been politically impossible without the economic chaos of the 1970s.
At the same time (and to rather less fanfare), governments in the US and the UK relaxed the regulations on the financial sector and abolished capital controls. The idea was that the economy would function best when the markets, rather than bureaucrats, decided where to allocate capital.
Suddenly, investors were free to invest anywhere in the globe. Instead of concentrating on old UK stalwarts such as Imperial Chemical Industries or Marks & Spencer, they were free to invest in the likes of Bayer of Germany or Wal-Mart of the US.
These changes had enormous consequences for those who traded shares in the City. The old system had been like a gentlemen’s club. A group of people called jobbers did all the trading in shares. They were not allowed to deal directly with investors. Instead, a group of intermediaries called brokers linked investors and jobbers, finding the best prices for the former in return for a fixed commission.
In theory, this system protected the interests of investors. Because brokers did not trade in shares, they could give independent advice to investors. And because brokers could shop around, jobbers had to offer competitive prices.
But there were two problems with this system. The first was that it was clearly not a free market: jobbers and brokers were restricted in the roles they could play and commissions were fixed. Brokers could not compete on price.
The second was that the broking and jobbing firms were all small. This was fine in a world where equity trading was limited to the home market. But when investment became international, the domestic firms were just too small to cope; they did not have the capital to deal with the risks involved.
BIG BANG
The solution was Big Bang: a set of sweeping changes that were implemented in 1986. The old distinction between brokers and jobbers was abolished –firms could both act for investors and trade in shares. Outside capital was brought in, with UK, European and US banks buying up existing broking and jobbing firms.
A whole generation of senior brokers and jobbers retired on the proceeds of the sales and famous names such as de Zoete & Bevan, or Akroyd & Smithers, either disappeared or were subsumed within larger groups. (The process is well described in The Death of Gentlemanly Capitalism by Philip Augar, published by Penguin.) The old Stock Exchange floor, where brokers and jobbers met face to face, became a museum piece. Now the bulk of the trading was done by telephone, with investors kept constantly updated on share prices by brightly coloured Topic computer screens – with red signalling a falling price and blue, a rising one.
The whole process brought benefits to institutional investors, since the abolition of fixed commissions substantially cut their trading costs. But it had its downsides as well. One substantial problem was that the integration of broking and trading created an automatic conflict of interest within the financial sector. When a broker recommended a stock, was that because of a genuine opinion or because the trading arm of his firm had a large position in the shares? In recent years, a more significant conflict of interest has arisen. The abolition of fixed commissions has gradually ensured that commissions are only a small part of any bank’s revenues. But, in theory, institutional investors are supposed to reward analysts for their advice by placing trades with the firms concerned. The sums do not add up.
Instead, banks have concentrated on increasing their revenues from transaction fees – acting for corporations in issuing new shares or bonds and making takeovers. This has led to analysts becoming ‘cheerleaders’ for such companies, talking up their prospects so that the deals will be successful. The idea of thoughtful, unbiased research has been severely compromised.
The second problem that followed Big Bang was that control of equity trading moved out of the hands of UK institutions. It was inevitable that control of part of the City would move overseas: the US, European and Japanese banks all had a lot of capital. But it seemed for a while as if the UK could develop domestic champions. One such was Barclays, which bought the broker de Zoete & Bevan, and the jobber Wedd Durlacher, and created BZW. Another was S. G. Warburg, a successful merchant bank that bought brokers Rowe & Pitman, Mullens, and the jobber Akroyd & Smithers.
Alas, most of the UK champions eventually dropped out of the race. This development was prompted by the next stage of the international financial revolution, which occurred during the 1990s.
THE END OF THE COLD WAR
Free-market philosophy may have swept the board in the US and the UK during the 1980s but it was not so successful elsewhere. Many observers believed that this so-called Anglo-Saxon model was inferior to those developed elsewhere, particularly in Germany and Japan.
Both countries decided against giving the markets free rein. In Germany, hostile corporate takeovers were virtually unknown: companies had close relationships with their banks, which had seats on the boards. Maximizing returns to shareholders was not the priority it was in the Anglo-Saxon system; instead the interests of customers, suppliers and employees were taken into account.
In Japan, takeovers were also unheard of. Companies were protected against them by elaborate cross-shareholding with friendly groups. Maximizing profits was seen as less important to Japanese managers than maximizing sales and market share.
To their admirers, the German and Japanese systems seemed to offer many advantages. The absence of takeovers allowed companies to plan for the future, regardless of short-term profit performance. The result was higher investment. And the focus on employees seemed far less socially divisive than the Anglo-Saxon model.
Under the German–Japanese models, the freedom of financial markets played second fiddle to other factors. That did not stop the Japanese stock market soaring to unprecedented heights in the late 1980s.
Of course, until the end of the Cold War, a large part of the world followed a communist or socialist-style model, in which the financial markets played virtually no role at all.
All this changed during the course of the 1990s. The collapse of communism was clearly an epochal event and appeared to underline the fact that there was no alternative to capitalism as an economic model. Suddenly a whole raft of countries moved into the Western economic system, adopting stock markets and allowing US companies like McDonald’s to open for business.
The collapse of communism also led to the reunification of Germany. The immense costs involved in taking on the old East Germany led to the imposition of high interest rates by the Bundesbank, the German central bank, in an attempt to control inflationary pressures. (This also eventually led to the break up of the Exchange Rate Mechanism.) By the mid-1990s, the German model no longer looked so attractive. German unemployment was far higher than that prevailing in the US. German social costs were also far higher, prompting some German companies to site facilities overseas. German politicians began to feel that high taxes were deterring entrepreneurship and causing sluggish economic growth. An ageing German population suggested that, in the long run, pension costs could become a massive burden on the German state.
So, slowly but surely, Germany and the rest of Europe started to edge towards the Anglo-Saxon model. Businesses began to talk of ‘shareholder value’; they divested themselves of non-core operations, simplified their shareholding structures and focused on improving profits. Perhaps the ultimate signal of the change in culture came in early 2000 when Mannesmann of Germany was taken over by Vodafone of the UK; this in a culture where hostile takeovers were extremely rare, let alone a hostile takeover by a foreign company.
As Germany moved in an Anglo-Saxon direction, the attractions of the Japanese model also faded. In the late 1980s, Japan’s economy developed all the symptoms of a speculative bubble: share prices rose to record levels in terms of profits or dividends while land prices also soared.
The bubble popped in 1990 and some of Japan’s apparent virtues began to be revealed as vices. Companies did not worry about short-term profits, but this led them to invest in unsuitable projects. The absence of takeovers meant there was no market discipline on poor companies to perform well. The soaring stock market also led companies to indulge in speculation which proved ill-timed once the market turned. The friendly relationship between banks and the corporate sector meant that the banks were saddled with bad loans, a problem that took more than a decade to sort.
Japan spent much of the 1990s stuck in a deflationary trap. Despite a host of government spending packages and interest rates that eventually fell to zero, the Japanese authorities found no way of reviving their economy.
The problems of Japan caused an almost 180-degree turn in the commentaries of those writing about economics and management. In the late 1980s, bestselling books were written about how the US should copy the Japanese; by the late 1990s, there was almost unanimous agreement on the need for all countries to copy the US.
THE US ECONOMIC MIRACLE
The retreat from the German and Japanese models was not just about their perceived failures; it was also about the perceived success of the US.
By the late 1990s, the US seemed by far the most dynamic of the world’s economies. Growth averaged more than 4 per cent a year, and that growth was achieved with barely a trace of inflation. At the same time, European economies struggled to grow at 2–3 per cent a year; the Japanese economy struggled to grow at all. Unemployment fell to 4–5 per cent, around half the level prevailing in Europe. There was, apparently, a productivity miracle (the figures were subsequently revised down but still showed a substantial improvement over the 1980s).
In almost every growth industry – software, hardware, the internet, biotechnology, media – the US appeared to lead the world. The US accordingly attracted floods of capital from overseas; both the dollar and the US stock market rose substantially.
Economists attributed the US success to the openness of its economy, the lack of regulations, the use of share options to motivate executives and employees, and a host of other ‘free-market’ factors. Understandably, countries trying to emulate the US example tended to adopt some of those measures.
Free-market enthusiasts also pointed to the success of those Asian countries that had followed a broadly free-market view, such as Singapore, Hong Kong and Taiwan, and the failure of those countries, notably in Africa, that had followed a statist or socialist model.
A so-called ‘Washington consensus’ argued that any economy which wanted to prosper should follow the free-market model: lower taxes, reduced government deficits and open capital markets. These policies were often made a condition for countries requiring aid from the International Monetary Fund, the Washington-based organization that underpins the global financial system.
The period since 2000 has seen the Washington consensus come under attack. First, the US model looks not quite as attractive as it did in the late 1990s. The dotcom bubble burst in 2000 and then a housing boom ended in a credit crunch in 2007 and 2008. Critics argue that the American financial free-for-all leads to recurrent crises. Meanwhile, emerging countries like China and Russia showed it was possible to achieve rapid economic growth while still retaining a fair degree of government control. Having seen what the IMF could do to debtor countries, many developing nations focused on building up trade surpluses, so they would not be dependent on foreign money. Now it is the US which is dependent on the Asians and the oil producers to finance its deficit. Some argue that this imbalance created the conditions for the credit crunch. Americans used cheap money from abroad to speculate on their property market.
GLOBALIZATION
What is globalization? It is one of those terms that is often used, but more rarely defined. Broadly speaking, it is a trend whereby trade, investment and culture have become ever more international.
What we have defined we can attempt to measure. Is globalization new? Not in terms of trade. In the UK, exports formed 29.8 per cent of GDP back in 1913: in 2000, they were just 20.7 per cent. Other countries are more open to trade than they were before the First World War but arguably, in this respect, the modern economy is not that much different from the one familiar to the Edwardians. It was the opening up of the US prairie states, and the consequent arrival of cheap wheat, that devastated British agriculture in the late nineteenth century.
In terms of trade and population movements, the world was pretty ‘globalized’ before the First World War; the subsequent battles with fascism and communism sent that process into reverse for sixty years.
In two respects, however, globalization has surpassed the First World War system. In terms of investment, ownership of foreign assets peaked as a proportion of world GDP in 1900, at 18.6 per cent. By 1945, the proportion had dropped to 4.9 per cent. Pre-First World War levels were finally reached by 1980, at 17.7 per cent. But since then there has been a massive acceleration; around a third of the UK stock market is owned by foreign investors, for example. The big change has come with the integration of the ex-communist world into the financial system. Instead of being bit players, the likes of China, Russia and India are the key drivers of global economic growth. They are blamed for everything from driving up the prices of commodities to driving down the wages of workers in the West. Arguably, they were the main reason why inflation was so low in the 1990s and early 2000s as they brought downward pressure on the prices of manufactured goods.
In cultural terms, also, globalization is more powerful than ever before. Clearly, before 1914, educated people in Europe and the US had a common culture based on the classics, orchestral music, opera and so on. But the cinema, television and popular music mean that people from almost every country in the world will be able to recognize Tom Cruise, Bono or Madonna. This is one factor that can cause great resentment, with some people feeling their culture is being swamped by American imports.
THE UK’S ROLE IN THE FINANCIAL SYSTEM
What is the effect of globalization in the UK? The UK economy may have had its problems but the UK’s financial system has traditionally punched above its weight in global terms. The leading operators may well be US or European but they still choose London as their base. Even though the UK is not part of the Eurozone, European banks have not left en masse for Frankfurt, the financial centre of the Eurozone and home of the European Central Bank.
Some of this success as a financial centre is due to luck: the UK speaks the same language as the US, the world’s leading economy and financial powerhouse. US bankers feel more comfortable in an English-speaking country; in addition, London seems a more attractive place to live than Frankfurt.
Some of the success is due to the UK regulatory regime, which has consistently been fairly welcoming to financial institutions. The financial reforms of the Conservative administration of 1979–97, and the higher-rate tax cuts it introduced, have played their part. The Labour government, which has been in office since 1997, has done little to reverse the trend.
It is now generally accepted that the UK needs to offer an economy that is appealing to foreign investors and foreign companies. The UK has been quite successful in attracting what is known as ‘direct investment’ from overseas companies: the building of factories, often in areas of high unemployment in Wales, Scotland or the North East. Politicians have argued that the UK has been successful in this quest because the government has cut taxes on corporate profits and because of more flexible labour markets (a euphemism for saying that companies face fewer problems in firing workers). Wider share ownership has also served the UK government’s purpose. The cost of providing state pensions is a great burden on European countries, with their ageing populations. The Conservative government of 1979–97 cut this cost substantially, by linking future pension payments to prices rather than earnings. But the effect after twenty years is that the state pension now provides a pretty measly income.
UK citizens have therefore come to realize that they will depend on their own savings for a decent retirement income. Since shares have historically provided better returns than other assets, investors have welcomed government schemes such as personal equity plans and individual savings accounts which give tax breaks to savers. They have also opted for personal pension schemes, which offer tax advantages for long-term savers.
All this has fuelled the growth of the institutional investors mentioned in the Introduction and has meant that the majority of Britons have some kind of interest in the stock market.
But we have got ahead of ourselves. Before we discuss these issues in more detail, it is time to go back to first principles.
Finance has moved on to the front page. The collapse of some of Britain’s leading banks in 2007 and 2008 has cost the taxpayer billions. It has brought the City, once seen as Britain’s most successful industry, into disrepute. Many people think the financial sector has been too powerful, imposing free-market dogma on unwilling populations. They resent the way that financiers make millions in bonuses when times go well but expect the taxpayer to bail them out when things go badly, as they did in 2008.
This ambivalent attitude towards financiers dates back over centuries. Roman emperors and medieval monarchs had to flatter financiers when they needed to borrow money; the attitude quickly turned to revulsion when the time came to pay it back. Whole populations have been caught up in frenzies of speculation dating back from Dutch tulip mania through the South Sea Bubble to the Florida land boom of the 1920s. Individual financiers have found it laughably easy to buy popularity when their schemes were prospering (think of Robert Maxwell). But there have been no shortages of commentators saying ‘I told you so’ when their empires subsequently collapsed.
Perhaps the public has tended to treat the subject of finance as a soap opera (complete with heroes and villains) because too few people attempt to understand the workings of the financial system. Although the details of individual financial deals can be very complex, there are basic principles in finance which everyone can understand and which apply as much to the finances of Mr Smith, the grocer, as to Barclays Bank. The more fully people understand these principles, the more they will be able and willing to criticize, and perhaps even participate in, the workings of the financial system. Like all areas of public life, it needs criticism to ensure its efficiency.
Even those who do not own shares should care about how the City performs. It is one of the UK’s biggest industries and a vital overseas earner in areas such as insurance and fund management.
THE CITY
First of all, what is the role of the UK financial system, and in particular of the City of London, which is at its heart?
Its primary function is to put people who want to lend (invest) in touch with people who want to borrow. A simple example of this role is that of the building societies. They collect the small savings of individuals and lend them to house buyers who want mortgages.
Why do the savers not just lend directly to borrowers, without the intervention of financial institutions? The main reason is that their needs are not compatible with those of the end borrowers. People with mortgages, for example, want to borrow for twenty-five years. Savers may want to withdraw their money next week. In addition, the amounts needed are dissimilar. Companies and governments need to borrow amounts far beyond the resources of most individuals. Only by bundling together all the savings of many individuals can the financial institutions provide funds on an appropriate scale.
Who are the borrowers? Businesses are one group. Companies will always need money to pay for raw materials, buildings, machinery and wages before they can generate their own revenues by selling their goods or services. To cover the period before the cash flows in, companies either borrow from the banks or raise capital in the form of shares or bonds. Without this capital it would be impossible for companies to invest and for the economy to expand.
The second major set of borrowers is governments. No matter what their claims to fiscal rectitude, few governments have ever managed to avoid spending more than they receive. The UK government and other nations’ governments come to the City to cover the difference.
Who wants to lend? In general, the only part of the economy which is a net saver (i.e. its savings are greater than its borrowings) is the personal sector – individuals like you and me. Rarely do we lend directly to the government or industry or other individuals: instead we save, either through the medium of banks and building societies or, in a more planned way, through pension and life assurance schemes. Lending, saving and investing are thus different ways of looking at the same activity.
So financial institutions are there to channel the funds of those who want to lend into the hands of those who want to borrow. They take their cut as middlemen. That cut can come in three forms: banks can charge a higher interest rate to the people to whom they lend than they pay to the people from whom they borrow, or they can simply charge a fee for bringing lender and borrower, or issuer and investor, together. Over the last twenty years, they have increasingly added a third activity: trading assets. This contributed to the credit crunch that started in 2007.
There is no doubt that financial institutions perform an immensely valuable service: imagine life without cashpoint cards, credit cards, mortgages and car loans. Even those Britons who do not have a bank account would never be paid if the companies for which they work did not have one. Indeed, the companies might not have been founded without loans from banks.
It is important, when considering some of the practices discussed in this book, to remember that the business of financial institutions is the handling of money. Some of their more esoteric activities, like financial futures, can appear to the observer to be mere speculation. But speculation is an unavoidable part of the world of financial institutions. They must speculate, when they borrow at one rate, that they will be able to lend at a higher rate. They must speculate that the companies to whom they lend will not go bust. To criticize the mechanisms by which they do speculate is to ignore the basic facts of financial life.
Financial institutions are a vital part of the British economy. Whether the rewards they receive are in keeping with the importance of the part they play is another question, which we will examine in the final chapter.
THE INSTITUTIONS
The most prominent financial institutions are the banks, which can be divided roughly into two groups, commercial (retail) and investment, formerly known as merchant, banks. The former rely on the deposits drawn from ordinary individuals, on which they pay little or no interest and which they re-lend at a profit. Commercial banks must ensure that they have enough money to repay their customers, so they need to own some safe assets they can sell quickly. The latter group traditionally relied more on fees earned from arranging deals such as takeovers; nowadays, these banks also get heavily involved in market trading. However, the division between the two groups is not clear-cut since many commercial banks have investment banking arms.
The second group of financial institutions, known as the investment institutions, include the pension funds and life insurance companies. They bundle together the monthly savings of individuals and invest them in a range of assets, including the shares of British and foreign companies and commercial property. This is a vital function, since industry needs long-term funds to expand. Banks lend money to industry, but by tradition they have been less ready to invest for long periods. Pension funds can count on regular contributions and can normally calculate in advance when and how much they will have to pay out to claimants. Life insurance companies have the laws of actuarial probabilities to help them calculate their likely outgoings.
But pension funds and insurance companies are less significant, in stock market terms, than they used to be. Nowadays, the investors who dominate the market tend to be more aggressive and short-term in outlook. Two prominent groups, hedge funds and private equity firms, will be discussed at length.
The third main group is the exchanges, which provide a market for trading in the capital that companies and governments have raised. People and institutions are more willing to invest money in tradeable instruments, since they can easily reclaim their money if the need arises. The best-known exchange in the UK is the Stock Exchange.
Within and outside these groups is a host of institutions which perform specialized functions. The building societies have already been mentioned, but we will also need to look at the Bank of England, insurance brokers and underwriters, to name but a few.
THE INSTRUMENTS
Chapter 2 examines in detail questions about the definition of money and the determination of interest rates. But for the moment the best way to understand the workings of the financial system is to stop thinking of money as a homogeneous commodity and instead to think of notes and coins as constituting one of a range of financial assets. It is the liquidity of those assets that distinguishes them from each other. The liquidity of an asset is judged by the speed with which it can be exchanged for goods without financial loss.
Notes and coins are easily the most liquid because they can be traded immediately for goods. At the opposite extreme is a long-term loan, which may not be repaid for twenty-five years. Between the two extremes are various financial assets which have grown up in response to the needs of the individuals and institutions that take part in the financial markets.
Essentially, financial assets can be divided into four types: loans, bonds, equities and derivatives.
Loans are the simplest to understand. One party agrees to lend another money in return for a payment called interest, normally quoted as an annual rate. It is possible, as in the case of many mortgages or hire-purchase agreements, for the principal sum (that is, the original amount borrowed) to be paid back in instalments with the interest. Alternatively, the principal sum can be paid back in one lump at the end of the agreed term.
Bonds are pieces of paper like IOUs, which borrowers issue in return for a loan and which are bought by investors, who can sell them to other parties as and when they choose. Bonds are normally medium- to long-term (between five and twenty-five years) in duration. The period for which a loan or bond lasts is normally known as its maturity, and the interest rate a bond pays is called the coupon. Shorter-term bonds (lasting three months or so) are generally known as bills.
Equities are issued only by companies and offer a share in the assets and profits of the firm, which has led to their being given the more common name of shares. They differ from other financial instruments in that they confer ownership of something more than just a piece of paper. In the financial sense, shareholders are the company, whereas bondholders are merely outside creditors.
The initial capital invested in shares will rarely be repaid unless the company folds. (But shares, like bonds, can be sold to other investors.) The company will generally announce a semi-annual or quarterly dividend (a sum payable to each shareholder as a proportion of the profit), depending on the size of its profits. All ordinary shareholders will receive that dividend. However, it is not compulsory for companies to pay dividends. Some companies choose not to do so because they wish to reinvest all their profits with the aim of expanding the business. Others may omit paying a dividend because they are in financial difficulties.
Equity investors only get paid after the demands of lenders and bond-holders are satisfied. If a company gets into trouble, equity investors may well lose the bulk of their money whereas bondholders have a chance of getting a chunk of their capital back. The good news for equity investors is they get all the upside. Whereas the claims of lenders and bondholders are fixed, equity owners benefit from a company’s growth.
That brings us to one of the most important principles in finance. Greater risk demands greater reward. If a lender is dubious about whether a borrower will be able to repay the loan, he or she will charge a higher rate on that loan. Why lend money at 10 per cent to a bad risk when you can lend money at 10 per cent to a good risk and be sure that your money will be returned with interest? To compensate for the extra risk, you will demand a rate of, say, 12 per cent, for the borrower with a doubtful reputation.
Derivatives are financial assets that are based on other products; their value is derived from elsewhere. Among the best-known derivative instruments are futures, options and swaps.
They perform a number of functions, allowing some people to insure themselves against price moves in other assets and others to speculate on price changes. These functions allow derivative users to get involved in hedging and leverage. Hedging is the process whereby an institution buys or sells a financial instrument in order to offset the risk that the price of another financial instrument or commodity may rise or fall. For example, coffee importers buy coffee futures to lock in the cost of their raw materials and reduce the risk that a rise in commodity prices will cut their profits.
Leverage gives the investor an opportunity for a large profit with a small stake. Options, futures and warrants all provide the chance of leverage because their prices vary more sharply than those of the underlying commodities to which they are linked. These concepts are more fully explained in Chapters 12 and 13.
ALCHEMY
Financial institutions must perform a feat of alchemy. They must transform the cash savings of ordinary depositors, who may want to withdraw their money at any moment, into funds which industry can borrow for twenty-five years or more. This process involves risk – the risk that the funds will be withdrawn before the institutions’ investments mature. They must therefore demand a higher return for tying up their money for long periods, so that they can offset that risk. This brings us to a second important principle of finance. Lesser liquidity demands greater reward. The longer an investor must hold an asset before being sure of achieving a return, the larger he will expect that return to be. However, this is not an iron rule. In Chapter 2 we shall see how, for a variety of reasons, long-term interest rates can be below short-term rates.
The range of financial assets extends from cash to long-term loans. Cash, the most liquid of assets, gives no return at all. A building society account that can be withdrawn without notice might give a return of, say, 5 per cent. In the circumstances, why should lenders make a twenty-five-year loan at less than 5 per cent? They would be incurring an unnecessary risk for no reward. So lenders generally demand a greater return to compensate them for locking up their money for a long period. In the same way some banks and building societies offer higher-interest accounts to those who agree to give ninety days’ notice before withdrawal. The borrowers (in this case, the banks and building societies) are willing to pay more for the certainty of retaining the funds.
Bonds and shares are usually liquid in the sense that they can be sold, but the seller has no guarantee of the price that he or she will receive for them. This differentiates them from savings accounts, which guarantee the return of the capital invested. Thus bond- and shareholders will generally demand a higher return. For both, that extra return may come through an increase in the price of the investment rather than through a high interest rate or dividend. This applies especially to shares. As a consequence, the dividends paid on shares is often, in percentage terms, well below the interest paid on bonds such as gilts (highly reliable investments because they are issued by the UK government).
THE CITY’S INTERNATIONAL ROLE
The City, of course, plays a role that far exceeds the dimensions of the national economy. It is this role that the supporters of the City invoke when they defend its actions and its privileges. And it is to preserve this role that the City has undergone so many changes in recent years.
In the nineteenth century the City’s importance in the world financial markets reflected the way in which Britannia ruled the waves. Britain financed the development of Argentinian and North American railways, for example. By 1914 Britain owned an enormous range of foreign assets, which brought it a steady overseas income. Much of the world’s trade was conducted in sterling because it was a respected and valued currency.
The two world wars ended Britain’s financial predominance. Foreign assets were repatriated to pay for the fighting. As the Empire disintegrated, so too did the world’s use of sterling as a trading instrument. Just as the US emerged as the world’s biggest economic power, so New York challenged London for the market in financial services and the dollar took over from sterling as the major trading currency. It seemed that Britain and the City would become backwaters on the edge of Europe.
One thing saved the City. The US, which had regarded banks with suspicion since the Great Crash of 1929, did not welcome the growth of New York as a financial centre. The US authorities began to place restrictions on the activities of its banks and investors. International business began to flow back to London, where there were fewer restrictions. The Euromarket grew into the most important capital market in the world and made London its base.
The revival of the City in the 1960s brought many foreign banks to London and they have stayed as Britain’s capital has become one of the world’s three great trading centres, together with New York and Tokyo. But the challenge is never-ending. The development of the European single currency caused some to fear that London could lose its place to Paris or Frankfurt; so far, the challenge has been seen off fairly easily.
However, London does face what has been called the ‘Wimbledon’ problem; Britain may be the venue for a great tennis tournament but the best players come from elsewhere. The London Stock Exchange has narrowly fought off takeover bids from the Frankfurt exchange and from the US electronic market, NASDAQ; the ultimate owner of the London futures market is now the New York Stock Exchange. The banks that dominate activity in the London markets are overwhelmingly foreign, particularly the Americans, Swiss, Germans, French and Japanese.
It is best that we look at these changes before we examine in detail the workings of the UK financial system. Discussion of these changes requires an assumption of some knowledge on the part of the reader as to how the system works. However, this book is also designed to be read by those who know little of finance. They may well want to start at Chapter 2 and return to the first chapter after they have read the rest.
The International Financial Revolution
In the past thirty years, the City has changed beyond recognition. It has always been an important part of the UK economy and a key source of overseas earnings, particularly in areas such as banking and insurance.
The City, or at least its financial markets, has always been powerful. Many blame a ‘bankers’ ramp’ for forcing out the Labour government in 1931, and subsequent Labour governments ran into problems over sterling in 1948, 1967 and 1976. But now the financial markets’ influence seems all-pervasive. Governments round the world find themselves constrained in their economic policies for fear of offending the markets. James Carville, one of President Clinton’s key advisers, remarked that he would like to be reincarnated as the bond market so he could ‘intimidate everybody’. When the financial system wobbles as it did in 2007 and 2008, the whole economy is threatened.
In addition, a combination of lower tax rates and liberalized financial markets has widened income differentials. Many City employees earn as much in a year as normal people might hope to earn in a lifetime, helping to force the prices of properties in London beyond the reach of teachers and nurses. All this has created a lot of resentment against ‘greedy’ bankers.
Wider share ownership, encouraged by the government through privatizations and tax breaks, has created much greater interest in financial markets, reflected in greater coverage in newspapers and on TV. And, with governments round the world quailing in the face of the cost of state pension schemes, citizens are realizing that they may depend on the financial markets for their security in old age.
Why has all this happened? In part, it is because of the breakdown of the financial system that prevailed from the end of the Second World War until the early 1970s. That system, generally known as Bretton Woods, combined fixed exchange rates with strict controls on capital flows, so restricting the scope for financial market activity. Under fixed exchange rates, currency speculation was only profitable at occasional times, such as when Britain was forced to devalue sterling in 1967.
Foreign-exchange controls also made it difficult for investors to buy equities outside their home markets. That reduced the scope for share trading and ensured that the UK equity market was a protected haven, dominated by small firms operating in a climate which author Philip Augar has described as ‘gentlemanly capitalism’.
But the system broke down in the early 1970s (for a full description see Chapter 14). The first domino to fall was fixed exchange rates. The system had depended on the US dollar but that currency buckled in the face of the costs of the Vietnam War.
Once exchange rates began to float, two things started to happen. First, companies faced foreign-exchange risk when selling goods. For example, Mercedes’ costs were in Deutschmarks; when it sold a car in the US, it received dollars. If the dollar fell against the Deutschmark, that would be bad news. So companies looked for ways to protect themselves from these risks.
Secondly, floating exchange rates created the potential for continuous speculation. The 1970s saw the creation of the financial futures market in Chicago, which allowed traders to bet on the likely movement of exchange rates.
Both developments were opportunities for financial companies. They could make money speculating on the markets and they could make money helping companies protect themselves from foreign-exchange risk. Both opportunities were taken.
Floating exchange rates also had significant implications for governments. Think of three key elements of monetary policy: exchange rates, interest rates and capital controls. Under the Bretton Woods system, countries controlled their exchange rates and capital flows. However, if countries ran a substantial trade deficit, capital would still flow out of the country.
Take the UK, a country which habitually runs a trade deficit. When a foreign company sells goods to the UK, it receives sterling in return. (Even if it asks for dollars, the UK buyer of the goods must sell sterling and buy dollars in order to make the payment. Sterling will still flow out of the country.) Eventually, those companies will become less and less willing to hold sterling at the prevailing exchange rate. The Bank of England may be willing to buy that sterling off the overseas companies but it needs foreign-exchange reserves to do so. After a while the money will run out.
To avoid this problem, governments tried to cut the trade deficit. The easiest way of doing so was to raise interest rates; this had the effect of cutting consumer demand for foreign goods. But the result was a stop– go kind of economy, in which periods of rapid expansion were suddenly cut short as governments raised interest rates to protect sterling.
In a world of floating exchange rates, there is no requirement for governments to ratchet up interest rates every time the currency falls. Voters naturally don’t like high interest rates. The problem was exacerbated by governments’ desire to keep unemployment low; at the slightest sign of economic weakness, they acted to boost the economy.
So in the 1970s, governments let their currencies sag, and kept interest rates lower than they might have been. The result (higher import prices, too much money chasing too few goods) was inflation. By the end of the 1970s, there was a general feeling that the old system of economic policy had failed. Governments had tried to micromanage the economy but in their attempts to keep down unemployment, they had merely achieved stagflation: high inflation and unemployment. Right-wing politicians such as Ronald Reagan and Margaret Thatcher argued that state intervention in industry had stifled the economy, concentrating resources in sunset industries such as coal and steel, and starving the growth sectors of the economy such as technology.
Inflation was eventually brought to heel with the help of very high interest rates, which also prompted massive job losses in those sunset industries. This process caused much distress and protest at the time and would have been politically impossible without the economic chaos of the 1970s.
At the same time (and to rather less fanfare), governments in the US and the UK relaxed the regulations on the financial sector and abolished capital controls. The idea was that the economy would function best when the markets, rather than bureaucrats, decided where to allocate capital.
Suddenly, investors were free to invest anywhere in the globe. Instead of concentrating on old UK stalwarts such as Imperial Chemical Industries or Marks & Spencer, they were free to invest in the likes of Bayer of Germany or Wal-Mart of the US.
These changes had enormous consequences for those who traded shares in the City. The old system had been like a gentlemen’s club. A group of people called jobbers did all the trading in shares. They were not allowed to deal directly with investors. Instead, a group of intermediaries called brokers linked investors and jobbers, finding the best prices for the former in return for a fixed commission.
In theory, this system protected the interests of investors. Because brokers did not trade in shares, they could give independent advice to investors. And because brokers could shop around, jobbers had to offer competitive prices.
But there were two problems with this system. The first was that it was clearly not a free market: jobbers and brokers were restricted in the roles they could play and commissions were fixed. Brokers could not compete on price.
The second was that the broking and jobbing firms were all small. This was fine in a world where equity trading was limited to the home market. But when investment became international, the domestic firms were just too small to cope; they did not have the capital to deal with the risks involved.
BIG BANG
The solution was Big Bang: a set of sweeping changes that were implemented in 1986. The old distinction between brokers and jobbers was abolished –firms could both act for investors and trade in shares. Outside capital was brought in, with UK, European and US banks buying up existing broking and jobbing firms.
A whole generation of senior brokers and jobbers retired on the proceeds of the sales and famous names such as de Zoete & Bevan, or Akroyd & Smithers, either disappeared or were subsumed within larger groups. (The process is well described in The Death of Gentlemanly Capitalism by Philip Augar, published by Penguin.) The old Stock Exchange floor, where brokers and jobbers met face to face, became a museum piece. Now the bulk of the trading was done by telephone, with investors kept constantly updated on share prices by brightly coloured Topic computer screens – with red signalling a falling price and blue, a rising one.
The whole process brought benefits to institutional investors, since the abolition of fixed commissions substantially cut their trading costs. But it had its downsides as well. One substantial problem was that the integration of broking and trading created an automatic conflict of interest within the financial sector. When a broker recommended a stock, was that because of a genuine opinion or because the trading arm of his firm had a large position in the shares? In recent years, a more significant conflict of interest has arisen. The abolition of fixed commissions has gradually ensured that commissions are only a small part of any bank’s revenues. But, in theory, institutional investors are supposed to reward analysts for their advice by placing trades with the firms concerned. The sums do not add up.
Instead, banks have concentrated on increasing their revenues from transaction fees – acting for corporations in issuing new shares or bonds and making takeovers. This has led to analysts becoming ‘cheerleaders’ for such companies, talking up their prospects so that the deals will be successful. The idea of thoughtful, unbiased research has been severely compromised.
The second problem that followed Big Bang was that control of equity trading moved out of the hands of UK institutions. It was inevitable that control of part of the City would move overseas: the US, European and Japanese banks all had a lot of capital. But it seemed for a while as if the UK could develop domestic champions. One such was Barclays, which bought the broker de Zoete & Bevan, and the jobber Wedd Durlacher, and created BZW. Another was S. G. Warburg, a successful merchant bank that bought brokers Rowe & Pitman, Mullens, and the jobber Akroyd & Smithers.
Alas, most of the UK champions eventually dropped out of the race. This development was prompted by the next stage of the international financial revolution, which occurred during the 1990s.
THE END OF THE COLD WAR
Free-market philosophy may have swept the board in the US and the UK during the 1980s but it was not so successful elsewhere. Many observers believed that this so-called Anglo-Saxon model was inferior to those developed elsewhere, particularly in Germany and Japan.
Both countries decided against giving the markets free rein. In Germany, hostile corporate takeovers were virtually unknown: companies had close relationships with their banks, which had seats on the boards. Maximizing returns to shareholders was not the priority it was in the Anglo-Saxon system; instead the interests of customers, suppliers and employees were taken into account.
In Japan, takeovers were also unheard of. Companies were protected against them by elaborate cross-shareholding with friendly groups. Maximizing profits was seen as less important to Japanese managers than maximizing sales and market share.
To their admirers, the German and Japanese systems seemed to offer many advantages. The absence of takeovers allowed companies to plan for the future, regardless of short-term profit performance. The result was higher investment. And the focus on employees seemed far less socially divisive than the Anglo-Saxon model.
Under the German–Japanese models, the freedom of financial markets played second fiddle to other factors. That did not stop the Japanese stock market soaring to unprecedented heights in the late 1980s.
Of course, until the end of the Cold War, a large part of the world followed a communist or socialist-style model, in which the financial markets played virtually no role at all.
All this changed during the course of the 1990s. The collapse of communism was clearly an epochal event and appeared to underline the fact that there was no alternative to capitalism as an economic model. Suddenly a whole raft of countries moved into the Western economic system, adopting stock markets and allowing US companies like McDonald’s to open for business.
The collapse of communism also led to the reunification of Germany. The immense costs involved in taking on the old East Germany led to the imposition of high interest rates by the Bundesbank, the German central bank, in an attempt to control inflationary pressures. (This also eventually led to the break up of the Exchange Rate Mechanism.) By the mid-1990s, the German model no longer looked so attractive. German unemployment was far higher than that prevailing in the US. German social costs were also far higher, prompting some German companies to site facilities overseas. German politicians began to feel that high taxes were deterring entrepreneurship and causing sluggish economic growth. An ageing German population suggested that, in the long run, pension costs could become a massive burden on the German state.
So, slowly but surely, Germany and the rest of Europe started to edge towards the Anglo-Saxon model. Businesses began to talk of ‘shareholder value’; they divested themselves of non-core operations, simplified their shareholding structures and focused on improving profits. Perhaps the ultimate signal of the change in culture came in early 2000 when Mannesmann of Germany was taken over by Vodafone of the UK; this in a culture where hostile takeovers were extremely rare, let alone a hostile takeover by a foreign company.
As Germany moved in an Anglo-Saxon direction, the attractions of the Japanese model also faded. In the late 1980s, Japan’s economy developed all the symptoms of a speculative bubble: share prices rose to record levels in terms of profits or dividends while land prices also soared.
The bubble popped in 1990 and some of Japan’s apparent virtues began to be revealed as vices. Companies did not worry about short-term profits, but this led them to invest in unsuitable projects. The absence of takeovers meant there was no market discipline on poor companies to perform well. The soaring stock market also led companies to indulge in speculation which proved ill-timed once the market turned. The friendly relationship between banks and the corporate sector meant that the banks were saddled with bad loans, a problem that took more than a decade to sort.
Japan spent much of the 1990s stuck in a deflationary trap. Despite a host of government spending packages and interest rates that eventually fell to zero, the Japanese authorities found no way of reviving their economy.
The problems of Japan caused an almost 180-degree turn in the commentaries of those writing about economics and management. In the late 1980s, bestselling books were written about how the US should copy the Japanese; by the late 1990s, there was almost unanimous agreement on the need for all countries to copy the US.
THE US ECONOMIC MIRACLE
The retreat from the German and Japanese models was not just about their perceived failures; it was also about the perceived success of the US.
By the late 1990s, the US seemed by far the most dynamic of the world’s economies. Growth averaged more than 4 per cent a year, and that growth was achieved with barely a trace of inflation. At the same time, European economies struggled to grow at 2–3 per cent a year; the Japanese economy struggled to grow at all. Unemployment fell to 4–5 per cent, around half the level prevailing in Europe. There was, apparently, a productivity miracle (the figures were subsequently revised down but still showed a substantial improvement over the 1980s).
In almost every growth industry – software, hardware, the internet, biotechnology, media – the US appeared to lead the world. The US accordingly attracted floods of capital from overseas; both the dollar and the US stock market rose substantially.
Economists attributed the US success to the openness of its economy, the lack of regulations, the use of share options to motivate executives and employees, and a host of other ‘free-market’ factors. Understandably, countries trying to emulate the US example tended to adopt some of those measures.
Free-market enthusiasts also pointed to the success of those Asian countries that had followed a broadly free-market view, such as Singapore, Hong Kong and Taiwan, and the failure of those countries, notably in Africa, that had followed a statist or socialist model.
A so-called ‘Washington consensus’ argued that any economy which wanted to prosper should follow the free-market model: lower taxes, reduced government deficits and open capital markets. These policies were often made a condition for countries requiring aid from the International Monetary Fund, the Washington-based organization that underpins the global financial system.
The period since 2000 has seen the Washington consensus come under attack. First, the US model looks not quite as attractive as it did in the late 1990s. The dotcom bubble burst in 2000 and then a housing boom ended in a credit crunch in 2007 and 2008. Critics argue that the American financial free-for-all leads to recurrent crises. Meanwhile, emerging countries like China and Russia showed it was possible to achieve rapid economic growth while still retaining a fair degree of government control. Having seen what the IMF could do to debtor countries, many developing nations focused on building up trade surpluses, so they would not be dependent on foreign money. Now it is the US which is dependent on the Asians and the oil producers to finance its deficit. Some argue that this imbalance created the conditions for the credit crunch. Americans used cheap money from abroad to speculate on their property market.
GLOBALIZATION
What is globalization? It is one of those terms that is often used, but more rarely defined. Broadly speaking, it is a trend whereby trade, investment and culture have become ever more international.
What we have defined we can attempt to measure. Is globalization new? Not in terms of trade. In the UK, exports formed 29.8 per cent of GDP back in 1913: in 2000, they were just 20.7 per cent. Other countries are more open to trade than they were before the First World War but arguably, in this respect, the modern economy is not that much different from the one familiar to the Edwardians. It was the opening up of the US prairie states, and the consequent arrival of cheap wheat, that devastated British agriculture in the late nineteenth century.
In terms of trade and population movements, the world was pretty ‘globalized’ before the First World War; the subsequent battles with fascism and communism sent that process into reverse for sixty years.
In two respects, however, globalization has surpassed the First World War system. In terms of investment, ownership of foreign assets peaked as a proportion of world GDP in 1900, at 18.6 per cent. By 1945, the proportion had dropped to 4.9 per cent. Pre-First World War levels were finally reached by 1980, at 17.7 per cent. But since then there has been a massive acceleration; around a third of the UK stock market is owned by foreign investors, for example. The big change has come with the integration of the ex-communist world into the financial system. Instead of being bit players, the likes of China, Russia and India are the key drivers of global economic growth. They are blamed for everything from driving up the prices of commodities to driving down the wages of workers in the West. Arguably, they were the main reason why inflation was so low in the 1990s and early 2000s as they brought downward pressure on the prices of manufactured goods.
In cultural terms, also, globalization is more powerful than ever before. Clearly, before 1914, educated people in Europe and the US had a common culture based on the classics, orchestral music, opera and so on. But the cinema, television and popular music mean that people from almost every country in the world will be able to recognize Tom Cruise, Bono or Madonna. This is one factor that can cause great resentment, with some people feeling their culture is being swamped by American imports.
THE UK’S ROLE IN THE FINANCIAL SYSTEM
What is the effect of globalization in the UK? The UK economy may have had its problems but the UK’s financial system has traditionally punched above its weight in global terms. The leading operators may well be US or European but they still choose London as their base. Even though the UK is not part of the Eurozone, European banks have not left en masse for Frankfurt, the financial centre of the Eurozone and home of the European Central Bank.
Some of this success as a financial centre is due to luck: the UK speaks the same language as the US, the world’s leading economy and financial powerhouse. US bankers feel more comfortable in an English-speaking country; in addition, London seems a more attractive place to live than Frankfurt.
Some of the success is due to the UK regulatory regime, which has consistently been fairly welcoming to financial institutions. The financial reforms of the Conservative administration of 1979–97, and the higher-rate tax cuts it introduced, have played their part. The Labour government, which has been in office since 1997, has done little to reverse the trend.
It is now generally accepted that the UK needs to offer an economy that is appealing to foreign investors and foreign companies. The UK has been quite successful in attracting what is known as ‘direct investment’ from overseas companies: the building of factories, often in areas of high unemployment in Wales, Scotland or the North East. Politicians have argued that the UK has been successful in this quest because the government has cut taxes on corporate profits and because of more flexible labour markets (a euphemism for saying that companies face fewer problems in firing workers). Wider share ownership has also served the UK government’s purpose. The cost of providing state pensions is a great burden on European countries, with their ageing populations. The Conservative government of 1979–97 cut this cost substantially, by linking future pension payments to prices rather than earnings. But the effect after twenty years is that the state pension now provides a pretty measly income.
UK citizens have therefore come to realize that they will depend on their own savings for a decent retirement income. Since shares have historically provided better returns than other assets, investors have welcomed government schemes such as personal equity plans and individual savings accounts which give tax breaks to savers. They have also opted for personal pension schemes, which offer tax advantages for long-term savers.
All this has fuelled the growth of the institutional investors mentioned in the Introduction and has meant that the majority of Britons have some kind of interest in the stock market.
But we have got ahead of ourselves. Before we discuss these issues in more detail, it is time to go back to first principles.
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