Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

Raghuram R. Rajan and Luigi Zingales

Saving Capitalism from the Capitalists:
Unleashing the power of financial markets to create wealth and spread opportunity

Introduction Capitalism, or more precisely, the free market system, is the most effective way to organize production and distribution that human beings have found. While free markets, particularly free financial markets, fatten peoples’ wallets, they have made surprisingly little inroads into their hearts and minds. Financial markets are among the most highly criticized and least understood parts of the capitalist system. The behavior of those involved in recent scandals like the collapse of Enron only solidifies the public conviction that these markets are simply tools for the rich to get richer at the expense of the general public. Yet, as we argue, healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting poverty. Because of their role in financing new ideas, financial markets keep alive the process of “creative destruction” – whereby old ideas and organizations are constantly challenged and replaced by new, better, ones. Without vibrant, innovative financial markets, economies would invariably ossify and decline. In the United States, constant financial innovation creates devices to channel risk capital to people with daring ideas. While commonplace here, such financing vehicles are still treated as radical, even in developed countries like Germany. And the situation in third-world countries borders on the hopeless: People find it difficult to get access to even

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

a few dollars of financing, which would give them the freedom to earn an independent, fulfilling, living. If financial markets bring prosperity, why are they so underdeveloped around the world and why were they repressed, until recently, even in the United States? Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from two groups of opponents. The first are incumbents, those who already have an established position in the marketplace and would prefer to see it remain exclusive. The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organized labor. The second group of opponents, the distressed, tends to surface in times of economic downturn. Those who have lost out in the process of “creative destruction” unleashed by markets – unemployed workers, penniless investors, and bankrupt firms -see no legitimacy in a system where they have been proven losers. They want relief, and since the markets offer them none, they will try the route of politics. The unlikely alliance of the incumbent industrialist – the capitalist in the title -and the distressed unemployed worker is especially powerful amidst the debris of corporate bankruptcies and layoffs. In an economic downturn, the capitalist is more likely to focus on costs of the competition emanating from free markets than on the opportunities they create. And the unemployed worker will find many others in a similar condition and with similar anxieties to his, which will make it easy for them to organize

Saving Capitalism from the Capitalists

© Rajan and Zingales, 2003

together. Using the cover and the political organization provided by the distressed, the capitalist captures the political agenda. For at such times it requires an extremely courageous (or foolhardy) politician to extol the virtues of free markets. Instead of viewing destruction as the inevitable counterpart of creation,