My Two Cents

Frederick Mishkin, author and Fed governor

Chris Farrell Jun 8, 2007

Financiers may pocket gargantuan paychecks, but they get no respect. There is a widespread sense that financiers don’t create anything of value, at least not enough to justify their incomes. My favorite example of this derisive perspective comes form author Tom Wolfe in his 1980s classic, Bonfire of the Vanities. Judy, the wife of a “master of the universe” is trying to explain to their daughter, Campbell, what her father does.

Daddy doesn’t build roads or hospitals, and he doesn’t help build them, but he does handle the bonds for the people who raise the money…. Just imagine that a bond is a slice of cake, and you didn’t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that… If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake.

Even worse than the crumb theory of finance is the fear in many parts of the world that financiers are a force for chronic instability and occasional catastrophe. With good reason, considering the history of financial calamities, currency crisis, and debt implosions in emerging markets in Latin America and the Far East in recent decades. Thanks to the mysterious mood swings of the global money men (and yes, it’s still mostly men), waves of speculative fevers and chills can upend economies, shutter thousands of companies, and throw millions out of work. For instance, the poverty rate in Indonesia soared by 50% after its 1997 currency crisis.

Even a number of eminent economists that argue vociferously for free trade in goods and services share qualms about the flee flow of capital. “Only an untutored economist will argue that free trade in widgets and life insurance policies is the same as free capital mobility,” Jagdish Bhagwati, professor of economics at Columbia University and a leading free trade advocate, wrote several years ago.

Frederick S. Mishkin is hardly an untutored economist. He’s a former colleague of Bhagwati’s and now a governor at the Federal Reserve Board. He agrees with Bhagwati that unfettered global capital flows are risky and potentially dangerous. Financial assets are inherently volatile since its reasonably easy for investors and banks to quickly change their risk assessment, especially with the time-honored tendency of financiers to follow the herd on the way up and on the way down. But in his new book, The Next Great Globalization, Mishkin argues that the unleashing the wealth-creating promise of globalization now calls for a global financial revolution.

“For emerging economies to reach the next stage of development and get rich, financial globalization must go much further than it already has,” he writes. “In particular, the financial systems in emerging economies must be more tightly integrated with those in the developed countries in order to partake in the benefits of financial investment, the lifeblood of the industrialized world.”

What Mishkin is tapping into is a far different view of the role of the financier in the economy. To him, the banking and capital markets are remarkable social and economic institutions for communicating all kinds of data, information, and knowledge. Financiers are the elixir of creative destruction, channeling money into profitable ideas and organizational innovations while abandoning stale business models and failed management strategies. And the richer the financial system and the more developed its financial institutions, the better the financial system does at efficiently channeling money toward productive investment–a boon to economic growth and everyday living standards. The question, of course, is how mto tap into the power of finance to allocate capital while limiting the downside risk. Mishkin believes it can be done.

History offers some intriguing analogies for his perspective. For instance, Mishkin cites a pioneering study by economists Robert King and Ross Levine (“Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics, 1993). Using a sample of 80 countries, the scholars found that those countries with the largest financial sector in 1960 compared to other countries on the list experienced faster economic growth over the following three decades.

Even more intriguing is the story told about the early U.S. by economists Peter L. Rousseau of Vanderbilt University and Richard Sylla of the Stern School of Business at New York University (“Emerging Financial markets and Early U.S. Growth,” NBER Working paper 7448, 1999). In a remarkable tale, not long after the end of the Revolutionary War, the U.S. had restructured its war debt, introduced the dollar as a convertible currency, formed a banking system, established securities markets, and attracted plenty of European capital. Over the next century, state governments chartered more than 800 new banks and securities markets. America’s innovative and expanding financial system was central to the country’s early growth and modernization. “By implication, the interest today in improving financial systems as a means of fostering sustainable growth is not misplaced,” argue Rousseau and Sylla.

It’s a convincing story. Mishkin’s book is largely a central banker’s manifesto on how to accomplish the goal of developing stronger financial systems in emerging markets. That means it often reads like a textbook with a heavy focus on establishing solid rules of the road to prevent financial skullduggery and meltdowns. Free-market fundamentalists and competition loathing governmentalists will abhor his balanced, nuanced approach toward establishing sensible boundaries between the private sector incentives and the public sector infrastructure.

He goes into detail over what conditions encourage a healthy financial system. They are: Strong property rights, a healthy legal system, anti-corruption initiatives, good financial information, improved corporate governance, and private institutions dominating the allocation of credit. At the same time, he shows a healthy respect for indigenous solutions to financial problems.

Mishkin is convincing in his core argument. The Next Great Globalization should be read alongside another book that makes a terrific case for finance. It’s Saving Capitalism from the Capitalists: Unleashing the Power of Financial markets to Create Wealth and Spread Opportunity by Raghuram G. Rajan and Luigi Zingales (Crown Business, 2003). The thoughtful authors of that book summarize the new view of finance well: “Many of the evils of capitalism–the tyranny of capital over labor, the excessive concentration of industry, the unequal distribution of income in favor of the owners of capital, the relative lack of opportunity for the poor–can be attributed, in some if not substantial measure, to the underdevelopment of finance.”

Perhaps the motto of the next stage of globalization should be “Finance for the People.” If so, Mishkin’s book offers a practical guide toward moving closer to that goal.

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