The Real Enemies of Free Markets

By Peter Coy


Unleashing the Power of Financial Markets

to Create Wealth and Spread Opportunity

By Raghuram G. Rajan and Luigi Zingales

Crown Business -- 369pp -- $29.95

Free markets are easy to admire but hard to love. Creative destruction, survival of the fittest, the warring impulses of greed and fear--all these dire forces raise living standards in the long run by forcing businesses to improve quality and cut costs. But when a stock market crashes, a big employer goes bankrupt, or a small country suffers a flight of foreign capital, free markets usually get the blame. The losers they produce are obvious; the winners, less so.

Raghuram G. Rajan and Luigi Zingales argue that because free markets are underappreciated by the general public, they're vulnerable to attacks from both the disenfranchised left and the entrenched right. And it's the right--Big Business--that they're most worried about. The two economists at the University of Chicago Graduate School of Business say big companies use the political system to insulate themselves from true competition. Echoing Adam Smith, they write: "Capitalism's biggest enemies are not the firebrand trade unionists spewing vitriol against the system, but the executives in pinstriped suits extolling the virtues of competitive markets with every breath while attempting to extinguish them with every action."

Saving Capitalism from the Capitalists will dismay both titans of industry and their foes across the barricades, the antiglobalization left that sees little in capitalism worth saving. It's written for the rest of us--all those who simply want a fair chance to prosper.

The Indian-born Rajan and the Italian-born Zingales appreciate the potential of unfettered markets all the more for having come from countries in which elites are even more entrenched than in the U.S. They say the world is stuck with "grim parodies" of capitalism, in which the spoils go to insiders. Outsiders such as the poor who could benefit from free markets don't fight for them because they "see no legitimacy in a system in which they have been proved losers."

The most unloved market of all is the international capital market, in which money sloshes in and out of the U.S., Thailand, Brazil, and points in between. Critics say speculative "hot money" creates bubbles when it flows into unprepared countries, then pops the bubbles when it rushes out, leaving the local citizenry worse off than before. Even many economists, generally a free-trade bunch, have some sympathy for capital controls in developing countries.

Rajan and Zingales won't hear of it. They argue that free flows of money across international borders keep a nation's capitalists and politicians honest. One example: In the early 1980s, Japan's banks effectively forced Japanese companies to borrow from them at high rates by controlling a body that could deny the companies permission to issue bonds. Once Japanese companies gained the ability to raise funds abroad, the bank-controlled "bond committee" lost its clout and was forced to disband. Germany, they say, still suffers from a closed financial system in which "misleading investors is not an aberration but a tenet of policy."

Because insider capitalism is naturally conservative, its flaws are clearest in times of rapid change, Rajan and Zingales argue. In allocating capital to growing industries, a closed financial system simply can't compete with U.S.-style venture capitalists, who are willing to take chances on dozens of projects in hopes that one or two will pay off on a grand scale. Controls on the international flow of capital, even those imposed with the best of intentions, will inevitably choke off such dynamism, they contend.

How can capitalism be saved from the capitalists? For Rajan and Zingales, the dilemma is that markets need governments to set and enforce the rules--but once government gets involved, well-organized private interests can tilt the rules in their favor. "The nightmare scenario, which has played out before, is that under cover of obtaining security for the distressed, the incumbents also obtain security for themselves by repressing the market," they write.

Their nine-point reform proposal aims to strengthen the political foundation of free markets by decreasing the power of vested interests, providing insurance for potential losers, and keeping borders open to undermine the power of national elites. It's an intriguing blend of ideas:

-- Break up companies whose economic power gives them undue political influence.

-- Tax property, not income. This will penalize businesses that use property inefficiently and let the efficient ones keep the fruits of their labors.

-- Make corporate management more answerable to shareholders.

-- Use inheritance taxes to break up family dynasties.

-- Create a safety net for workers, not their employers.

-- Protect people through insurance, not politicized disaster relief. (They say it's a "travesty" that American children aren't guaranteed health insurance.)

-- Enable workers to cope with change by promoting lifelong education.

-- Allow for free flows of international capital.

-- Promote free trade in goods and services.

Rajan and Zingales fear that the pendulum of political support is swinging away from free markets and toward re-regulation, closed borders, and the triumph of entrenched elites. They're offering their book in an attempt to slow or reverse the pendulum. Let's hope that they succeed.

Coy is Economics Editor.

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