Does Government Intervention in Financial Markets Slow Economic Growth?
As we saw with the Dodd-Frank legislation and the Consumer Financial Protection Bureau, the question underlying the debate over financial regulation is whether it stifles economic growth. Leo F. Goodstadt’s book, Reluctant Regulators, provides useful insights from the experiences of Hong Kong and China. It also causes us to ponder whether our measurement of economic growth is fundamentally flawed.
Americans are astonishingly provincial. They know little about the world outside the US and Europe. Stories about the financial crisis and its aftermath center on New York, London and other European capitals. Dozens of books about what Australians call the GFC – the 2007-2009 Global Financial Crisis – focus on events in offices and boardrooms in New York, Washington and Europe to some extent. How many are about why Canada’s crisis was so mild? How many are about what happened in Hong Kong?
Yet as Goodstadt demonstrates, Hong Kong’s story is a very important one. It played, and continues to play, a central and crucial role in China’s economic miracle and therefore in the world’s economy.
Goodstadt’s book bears the intriguing subtitle “How the West Created and How China Survived the Global Financial Crisis.” Goodstadt – formerly head of the Hong Kong Government’s Central Policy Unit – first criticizes Western financial regulatory culture for its ideology-driven mythology and laxity in the face of foreseeable structural problems. Then, he critiques Chinese regional governments’ endemic practice of forcing banks to make bad loans for policy or relationship reasons. Finally, one place comes out smelling like a rose by stark comparison: Hong Kong.
Hong Kong’s experience gives the lie to the conventional wisdom that ongoing government intervention in financial markets slows economic growth. And as I’ll opine at the end of this article, the experience of the financial crisis should cause us to question whether we even have a coherent definition of economic growth.
The laissez-faire Western financial regulatory culture
In the first part of his book, Goodstadt claims the structural problems in finance that ultimately created the financial crisis were well known and frequently commented on by regulatory officials. He writes that their eventual upshot was foreseeable and preventable, but the prevailing regulatory philosophy and culture precluded action. He backs up this claim with direct quotes from financial officials. This may or may not prove anything, of course, since many observations were made publicly by many people, and it is possible to find every sort of concern voiced. It does, however, show that most officials believed that though there may have been problems, the market would sort things out, while regulation would only worsen the situation.
Goodstadt says this regulatory philosophy had become so deeply entrenched that it is not necessary to invoke the doctrine of regulatory capture to explain why regulators in the US and the UK regulated so lightly. It was not that they were doing a favor for the companies they regulated, in anticipation of eventual payback, as that doctrine indicates — it was that they actually believed regulation was bad.
One of the truisms frequently trotted out to reinforce this view was a common assertion after the market crashed, a version of which Goodstadt attributes to Alan Greenspan: “Officials could not be expected to have sufficient comprehension of financial markets to oversee them effectively.”
In other words, financial industry practitioners know their business better than regulators ever could, so they are in a better position to control it than regulators could ever be.
But issues of conflict of interest aside, whatever happened to the good old saying about “seeing the forest for the trees”? In her insightful book, Fool's Gold, Financial Times writer Gillian Tett makes much of the “silo mentality” of financial industry participants – most of whom hardly ever looked beyond their own areas of responsibility to consider how much risk exposure the whole chain, on which they were only one link, was causing investors and the financial system.
For that kind of overview, the system needs those for whom such perspective is in their job descriptions — regulators.
Moral hazard and too-big-to-fail
Surprisingly, Goodstadt also criticizes the ongoing Western concerns about moral hazards and the protection of too-big-to-fail banks as overwrought. He writes that according to studies, breaking up big banks into a larger number of smaller ones will not create a more stable financial system.
Though he doesn’t express it clearly enough, his point seems to be that if you have hands-on, interventionist regulators, you don’t need to worry about moral hazard. Moral hazard means that if you’ve bailed out banks before, they will take more risk because they know they will be bailed out again. But if they are subjected to tight regulation, Goodstadt argues, regulators will prevent them from taking that risk.
Goodstadt invokes former Obama adviser Lawrence Summers to support his argument:
Financial institutions can fail because they become insolvent. … But solvent institutions can also fail because of illiquidity, simply because creditors rush to withdraw their funds, and assets cannot be liquidated fast enough. In this latter case, the availability of external support averts needless panic and contagion.
This quote, interestingly, indicates a straightforward acceptance of the persistent possibility of market failure. In a perfect market, a solvent institution’s assets – its sound long-term loans – could be sold immediately for their fair values in the marketplace and the proceeds used to pay creditors. Summers’ statement admits that in crash conditions, the market cannot be relied on to recognize asset values and pay a fair price for them. This situation did, in fact, occur in 2008.
China’s on-again off-again financial reforms
China has had its own serious financial management issues, as a widely read book, Red Capitalism (which I reviewed for the Hong Kong Economic Journal), by Carl Walter and Fraser Howie, makes clear. Walter and Howie provide a more detailed and intricate analysis of China’s financial problems than does Goodstadt, but Goodstadt’s book minces its words less – perhaps because Walter and Howie are still doing business in China.
Until 1997, China used its banks as instruments for Communist Party policy, directing the banks to make loans for Party projects, such as infrastructure projects and state-owned industries, many of them provincial-level or local. Not surprisingly, since the loans were not subject to careful financial due diligence, a large proportion turned out to be non-performing. When the non-performing loans accumulated, undermining bank solvency, the central government recapitalized the banks and placed the non-performing loans in special-purpose entities (as Walter and Howie observe, not unlike those used by Enron), sweeping them under the rug.
Goodstadt calls those lending practices “policy lending” and “relationship lending.” Policy lending is lending to carry out Party industrial policy. Relationship lending is extending credit to powerful officials — frequently, Party bureaucrats. “As a result,” Goodstadt writes, “they profited handsomely from access to loans from state-owned banks which could be rolled over indefinitely and to public land which they occupied with impunity. The state’s assets were the foundations of the future fortunes of these officials, who were to make up the bulk of the most successful, new entrepreneurs.”
The Asian financial crisis of 1997-98 brought about a serious effort toward financial reform in China, which included efforts to end the practices of policy lending and relationship lending. But Goodstadt points out that “the global financial crisis gave a new lease of life to both ‘policy’ and ‘relationship’ lending.” This was because China’s response in 2008 to the crisis was a $586-billion economic stimulus package, which “led unavoidably to an expansion of the state’s direct involvement in the economy.” The responsibility for dispensing these funds was given to local government officials, who reverted to old lending and borrowing practices to fulfill their mandates.
Hong Kong’s regulation
Unlike the West – and contrary to common perceptions – Hong Kong’s regulatory arrangements since 1986 “are among the strictest of any financial centre and have been tightened steadily over the last decade” according to Goodstadt, “Yet, its financial system has flourished, its business volumes have grown, and it has continued to attract the world’s leading banks.” He further notes that “In the process, Hong Kong discovered that strict regulation of financial markets and their players did not stifle either growth or innovation, nor did it diminish its attractions as an international financial centre.”
Goodstadt makes it clear that Hong Kong’s interventionist regulatory practices are not so much the result of a different regulatory philosophy as the result of past experiences with repeated financial crises, a need to protect its franchise as an international financial center by protecting against instability and a need to keep on the good side of mainland China. “In the last resort, financial stability is not negotiable for Hong Kong. If its credibility as an international financial centre were endangered, its value to the Mainland would suffer immediately, and its unique role in the nation’s financial affairs would be in jeopardy. … This is the ultimate political pressure which dictates the priority of financial stability for Hong Kong.”
The major disappointment of Goodstadt’s book is that he does not flesh out the details of this strict regulation. I would have liked many examples, not just one, of how Hong Kong’s regulators acted differently from those in other jurisdictions. Yet not only does he not give specific examples, he does not even describe the organizational structure of Hong Kong’s financial oversight bodies or their history or top management. This is a very serious failure in the book, and one that I fear will limit its readership and impact, perhaps only to those who already know the financial regulatory bodies of Hong Kong (or perhaps, have read Goodstadt’s previous books).
Nevertheless, it must be recognized that Hong Kong has had a uniquely important role in the financial history of China and its relationship with the West. When I visited Hong Kong in the early 2000s – not long after the handover that marked the transition of the UK’s former colony to a Special Administrative Region of mainland China – there was much pessimistic talk about the expectation that Hong Kong would soon be eclipsed as a financial center by Shanghai. Goodstadt, in a talk on May 5, 2011, to the Foreign Correspondents Club of Hong Kong, said he lost his hair while waiting for these frequent forecasts to come true. Hong Kong is still the most important financial center in East Asia and one of the few most important in the world.
The cult of growth
Goodstadt’s finding that government intervention in Hong Kong’s financial markets did not hamper economic growth should, among other things, give rise to questions about the conventional definition of economic growth. In this exploration, I’m hoping a reader can help me with the answer to a question.
Goodstadt cites a post-crisis IMF study, Redesigning the Contours of the Future Financial System, as warning that “a more stable and more regulated system would be associated with slower growth for the entire economy.” Indications suggest that Goodstadt doubts this conclusion, but let us examine it.
Growth has become a shibboleth, so much so that anyone who merely questions what it really means is immediately categorized as a Malthusian or back-to-the-Earther.
But in the case of growth in the financial industry, we need to question how we evaluate it. Recently some have argued that the growth of the financial industry of the last 30 years was nothing but an increase in transfer payments from users of financial services to those with exponentially increasing wealth in the financial services sector, a result of the bamboozling of the public by the confusing “innovations” that sector has introduced. (For anyone who is not sure what that means, look no further than Gretchen Morgenson’s article on bank charges for interest rate swaps in the Sunday New York Times.)
In short, the growth of the financial sector has been widely denounced as a zero-sum game, a growth in one sector at the expense of the others.
I think this claim needs to be examined seriously in the context of what is really measured by GDP and growth in the GDP – or really, gross world product (GWP).
The GDP is supposed to measure total payments for final goods. Its calculation cancels out payments for intermediate goods – those that are paid for by one business to another on the way to producing a final product for the consumer.
Aren’t all financial products intermediate goods? Finance is a tool for the efficient allocation of capital toward production – it does not produce anything itself. Why should it count in the GDP at all, let alone in growth of the GDP?
I’ll zero in on the problem with a specific example. I invite anyone with greater expertise than my own to enlighten me on this subject.
As is well known, the service of providing for the retirements of corporate employees has largely shifted from pension funds to 401(k) plans. When the service is provided by pension funds, corporate pension fund sponsors pay for investment management services. Therefore, I assume investment management services count as payments for intermediate goods and services and thus are not included in the GDP.
When the service is provided by 401(k) plans however, plan participants — the final consumers — pay for investment management. Do they therefore now count as payments for final goods and services and are they therefore included in the calculation of the GDP? Has the shift from pension funds to 401(k) plans thus caused an increase in the calculated GDP? If so, that increase is spurious.
Continuing in this hypothetical vein – and hoping to be checked, perhaps corrected, by an informed reader – how many other financial innovations, whether or not they are in some sense beneficial, may have brought about a spurious increase in the GDP?
It’s often regarded in the modern world as namby-pamby to question economic growth, but we should at least question whether we even know what that term means. We know that China and especially Hong Kong have experienced strong, mostly stable growth in the last 25 years – we don’t need a statistical measure to tell us that; and a measure that calls transfers to a runaway industry “growth,” implying the industry must be allowed to run rampant for growth to continue, is worse than no statistical measure at all.
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment, and sustainable development fields. He is a Visiting Fellow at the Hong Kong Advanced Institute for Cross-Disciplinary Studies, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.