Financial globalization and crony capitalism.

Many economic transactions are characterized by asymmetric information; that is, one of the parties is more aware of or has more control over the circumstances and performance of the transaction than the other party has. This is particularly true when money is lent. The borrower typically has a better idea of and more control over what the money will be used for, and the risks involved in that use, than the lender does. Any transaction that involves the extension of credit or the expectation of future performance by one party may have similar characteristics. Asymmetric information can inhibit transactions if lenders believe that borrowers will typically behave in opportunistic fashion and exploit their informational advantage. At worst, the financial system could be dysfunctional and economic development could be retarded.

This problem is handled in different ways in different cultures. A traditional, closed society with a high degree of cultural homogeneity might develop a widely shared sense of solidarity and "fair play" that would inhibit opportunistic behavior. A more pluralistic society might develop a system where networks of people who are related by ethnicity, family, religion, class, school ties, or some other bond would deal preferentially within the network, excluding those outside the network. We might call this "crony capitalism." Large, modern pluralistic societies might develop elaborate means for reducing the incentives for opportunism, requiring borrowers to make large down payments, put up collateral or performance bonds, hold compensating deposits, and so on. Such contracts can become very complicated, and elaborate legal process is usually available to enforce their terms. We could call this the "litigious society."

Which of these approaches a society adopts will depend a great deal on its size and degree of heterogeneity in culture, religion, and race. It will also depend on the widely shared ideological and religious values within that society.

Crony Capitalism

Opportunistically taking advantage of people, especially in a business relationship, is something that usually will work only once. "Fool me once, shame on you; fool me twice, shame on me." Having an ongoing relationship between business partners is a deterrent to the abuse of asymmetric information, because sacrificing the relationship forecloses too many future opportunities for profitable deals. When a relationship is multi-dimensional, there are many avenues open for retaliation against a business partner who behaves badly. This is the most obvious when family relationships are involved. Families have non-economic ways of punishing opportunistic behavior. Favoring family means you tend to be dealing with people whose character you understand, whom you will deal with repeatedly in economic and non-economic contexts, and who have a moral loyalty to you because of the family connection. So in the family context, opportunism is less likely than it would be with strangers. The elaborate means we in the West use to thwart opportunism are less necessary where the loyalty of family can be assumed. However, a family orientation may inhibit the formation and institutionalization of large-scale industrial enterprises, as Fukuyama suggests (1995, ch. 7). But even when large corporations are involved, the Asian practice of preferential dealing within "families" of companies affords this kind of protection. The traditional practice of "relationship banking" in the Western world indicates that the advantages of "crony" relationships are not lost on lenders in the West, either.

The "crony capitalism" approach to asymmetric information is consistent with, and reinforced by, some aspects of Asian and Islamic cultures. Of course, all of these cultures have traditions that call for hospitality toward strangers and guests, but there is a firm line drawn between insiders and outsiders.

In the Islamic world, outsiders were traditionally labeled "infidels"; to the Chinese they were "barbarians." Bernard Lewis's book (2002) about the encounters between the Islamic world and the West make it clear that there was enough hostility and suspicion on both sides to make the relationship difficult from the start, but it is tempting to conclude that "What went wrong" in the Islamic world was the failure to embrace the non-discriminatory principle that Westerners value so highly. Many Western observers tend to think that the economic development of those countries is inhibited by the tendency not to deal with outsiders. Other analysts would point to the history of Western hostility towards Islam as providing plenty of justification for Muslims to be wary in dealing with the West.

Chinese economic culture represents another example. The Chinese are famous for favoring those with family connections in their economic dealings. Many observers have credited this aspect of their culture for the great commercial success of Chinese communities around the world (Lodge 1995, Fukuyama 1995, chs. 8 and 9). This "family values" approach to commerce has also led to tremendous resentment of the expatriate Chinese, because of the way it closes off economic opportunity to non-Chinese, even natives in their own country. This approach may play a role in both the recent success of the economy of China, as well as the difficulty in incorporating China into the WTO. National treatment of exporters of financial services has been particularly difficult to achieve with China (and other Asian economies), perhaps because this is exactly where asymmetric information is most problematical, and therefore favoritism is likely to play the largest role.

Most of the literature about the relationship of crony capitalism to the Asian financial crisis is not about this kind of asymmetric information issue. Rather, it suggests that the problem was straightforward corruption. Government officials were willing to use public funds to guarantee bank loans to private borrowers with family or political connections to the government (Krugman 1999, pp. 88-9). In this form of moral hazard, taxpayer funds were misappropriated by unaccountable politicians. In the financial collapse and subsequent macroeconomic crisis caused by the overvaluation of many of the Asian currencies, many of these loans went bad. Drawing on the economics of loan guarantees, some of the literature suggests that this increased the vulnerability of the Asian economies to financial crisis (e.g., Heslag and Pecchenino 2005). Krugman is more inclined to think that it merely touched off a garden-variety bank run, and he points out differences between more developed economies, particularly South Korea, and some of the others (1999, pp. 98-101). If government corruption is really the issue, banking system reforms will not solve the problem. Rather, the corruption problem needs to be addressed at its root.

The Litigious Society

Economic culture and economic science in the West have stressed treating each transaction as a separate, independent event, for which the best deal must be negotiated. The competitive forces that guarantee marginal cost prices and efficiency in the allocation of resources can only work if every transaction must be won by hard competition. Furthermore, if there is to be equal opportunity for all comers, including small, unknown businesses, new start-ups, and people from traditionally excluded groups; then cronyism is out. Crony capitalism and ongoing relationships are frowned on, so other methods must be found to deal with imperfect information. Arm's-length negotiations are normative. The exceptions we observe only prove the rule.

Then how does Western capitalism deal with the problem of asymmetric information? Transactions have to be structured in such a way that there are incentives for the parties not to act opportunistically. These include provisions like large down payments, collateral, disclosure of financial statements and credit ratings, insurance, restrictive financial conditions, call provisions, and the like. The transaction has to be formalized in a way that is enforceable at law. Contracts are complicated and long, they have to be written by legal specialists, and very often they must be litigated. As we have learned to our sorrow, this is very costly.

At the source of the principle of non-discrimination is the Judeo-Christian moral tradition. Hans Kung points out that one of the principles basic to most religions and moral systems is the Golden Rule: Do unto others as you would have them do unto you (1998, p. 98). He proposes this principle as the foundation for a global economic ethic. A familiar, nearly equivalent formulation is: Love your neighbor as you love yourself. But the ancient question comes: who is my neighbor? The rules and regulations of the Hebrew Bible call for hospitality to be shown toward foreigners, but there are some distinctions made in the treatment of Israelites and others. For example, the usury regulation prohibited charging interest on loans to Israelites, but not to foreigners.

While the New Testament still teaches that there are special charitable obligations toward those of the "household of faith," most moral distinctions between insiders and outsiders are erased. Jesus answers the "Who is my neighbor?" question with the story of the Good Samaritan (Luke 10: 25-37), and Paul says there is neither Jew nor Greek in Christ (Colossians 3:11).

Still, the usury rule was a troublesome issue for the Christian church down to the time of the Reformation in the sixteenth century. Then the reformer John Calvin made the case that the rule should no longer apply among Christians. The argument had two prongs. Calvin read the usury rule of the Hebrew Bible as meaning to protect the poor, and therefore it should not apply to loans made for commercial purposes. But he also made an argument that built on a kind of universalism in the New Testament. Calvin noted that the usury rule made a distinction between Israelites and foreigners, and therefore must be something less than an absolute moral standard, since such standards must apply to everyone. Since Christians did not recognize any moral distinction between insiders and outsiders, only the universal moral law should apply to Christians' dealings with everyone. Therefore charging interest on loans was morally acceptable, even among Christians (Nelson 1949).

This is how Calvin earned his propers as the founder of Western-style capitalism. It is not so much that he opened the way for a market in fixed-interest loans. Modern Muslims have demonstrated that you can run a modern market economy without interest-bearing financial instruments (though some financial devices they use can resemble fixed interest very closely). The more important contribution he made is the argument that in economic life, everyone should be treated equally. When it comes to economic transactions, there is no ethical reason for treating people differently based on family, religious, national, or ethnic connections. Calvin's main principle was that economic transactions should offer substantial benefits not only to both parties involved, but also to the community at large (Calvin 1999, p. 222). Intellectuals in the Western tradition came to think of the idea of non-discrimination as the foundation of economic theory and a source of the efficiency of market economies. Extended to political, civil, and even intellectual life, it also becomes a basic principle of Western democracy, and the American ideology of equal opportunity.

Not that the West has completely stifled its discriminatory impulses over the last 500 years. Protectionist impulses in the U.S. still seem more likely to be directed most vigorously against those most different from us--those of different civilizations (in Samuel Huntington's (1996) scheme), like the Mexicans or the Japanese. Indeed, support for NAFTA seemed as much based on hope for reducing Mexican immigration to the U.S. as on hope for U.S. economic gains. But the principle of non-discrimination is still there, and it establishes the presumption that we will favor free trade and national treatment unless it is not reciprocated.

Litigious societies are also subject to corruption. The collapse of Enron and other recent scandals have exposed lending practices in the banking industry based on maximizing fee income for bankers and deceptively pumping up securities prices to enrich executives, rather than being based on sound banking principles. These practices not been sufficiently common to result in major bank failures or systemic problems, but consensus partially attributes the 1990's stock-market bubble and 2000-01 collapse, and the resulting recession, to corruption in corporate America, including major money-center banks. Only adroit action by the Federal Reserve prevented a full-blown crisis.

The Rules of Globalization 

Economic globalization now extends to a global market for financial instruments and services. Banks and brokerage houses are now global businesses, bringing together borrowers and lenders across national, cultural, and religious boundaries. Under these new circumstances, how should we handle the problem of asymmetric information?

There are three possibilities. One is to impose one model, the litigious society model, on the whole world. This appears to be the direction in which the world is being led by the International Monetary Fund and the other global organizations that the United States dominates. This approach addresses the asymmetric-information problem, it elevates the non-discrimination idea to a universal principle, and it makes the global system consistent by extending to finance an analog of the "national treatment" principle that has been so effective in promoting free trade in goods. However, it means serious, disruptive cultural change in societies outside the West. Even here in the U.S., we have begun to question the high costs that extensive litigation imposes on us.

But this approach is not necessary. Another possibility is to allow different countries to maintain their different systems, and require each financial institution to pick a home country whose rules will govern its approach to lending. Financial companies could still operate around the globe, but foreigners then would be aware of what rules would govern their relationships with each institution, and could choose based on their own cultural preferences or financial advantage.

The third possibility is to give up financial globalization as a goal and an ideal. There are some economists and commentators who believe that this sacrifices too much of the gains in development and efficiency that come with globalization. Some would even say that it is inconsistent with globalization in goods markets. But others have argued that globalization of financial markets is not an inevitable consequence of globalization in goods markets, and that globalized financial markets pose too many risks for financial crises, like the Asian crisis of the mid-1990's (e.g. Bhagwati 2000).

A Pluralistic Approach

Hans Kung to the contrary notwithstanding, the moral quality of non-discrimination is not universally appealing. Even in the West, while we deplore racism, sexism, and chauvinism, we still admire genuine patriotism, family values, and loyalty to church and community. In economic life, even after the last twenty years of celebrating our flexible labor, financial, and other markets, we still find to it be useful, if not admirable, to have some degree of loyalty between employer and employee, and between vendor and customer. The model of human behavior governed almost exclusively by economic incentives is not very appealing, because it seems to suggest that people should behave opportunistically when they can get away with it (behavior that the Christian Reformers would have strongly condemned). This model also misleads us when it suggests that economic transactions always can be made "incentive-compatible," so that there are no incentives to cheat or behave opportunistically, making trust is unnecessary. The "moral capital" of trust is necessary for a market economy to function efficiently, as Fred Hirsch pointed out long ago (1976), and has been reiterated by Fukuyama (1995).

The rules of the global economy rightly suggest that when national governments decide to open their borders to trade and investment, national treatment (i.e., imports treated the same as goods of domestic origin) is the appropriate policy. But this does not say anything about the behavior of private economic agents. Private economic favoritism may be frustrating to foreigners, and it may have an illegitimate racial dimension. But eliminating favoritism of all kinds is not necessary to the proper functioning of a market economy in the global context. Indeed, for the global market economy to function properly, people have to be able to choose to deal with those whom they can trust. In the West we have elaborate rules excluding discriminatory criteria. But when it comes to international law, instituting rules to eliminate favoritism and crony capitalism unnecessarily invites conflict between countries with different religious and cultural foundations.

It is hard for us as Westerners to give up the principle of non-discrimination. We should continue to hold it as an ideal in our own societies. The principle of the moral equality of all humans is one of the glorious and unique characteristics of Western civilization. It is also a necessary thing in our own societies. Our U.S. society is deliberately a pluralistic one, where immigrants of different races and creeds can come and continue to develop their own cultures, while contributing to the common culture. We Americans have also taught ourselves that in economic life, it is acceptable, even good, to look out for our own individual interests and not worry about the interests of others. We have adapted our institutions to make this principle work reasonably well in our economies, but it doesn't always fit other societies. We must be wary about imposing this idea on others, and we must be very careful about assuming that people of other cultures and religions will accept the superiority of non-discrimination and will practice it rigorously.

References

Bhagwati, Jagdish, 2000, The Wind of the Hundred Days, Cambridge: MIT Press.

Calvin, John, 1999, "Letter on Usury," in Denis R. Janz, ed., A Reformation Reader, Minneapolis: Fortress, pp. 219-22.

Fukuyama, Francis, 1995, Trust: The Social Virtues and the Creation of Prosperity, New York: Free Press.

Heslag, Joseph H., and Rowena Pecchenino, 2005, "Crony Capitalism and Financial System Stability," Economic Inquiry 43(1), January, pp. 24-38.

Hirsch, Fred, 1976, The Social Limits to Growth, Cambridge: Harvard University Press.

Huntington, Samuel P., 1996, The Clash of Civilizations and the Remaking of World Order, New York: Touchstone.

Krugman, Paul, 1999, The Return of Depression Economics, New York: Norton.

Kung, Hans, 1998, A Global Ethic for Global Politics and Economics, New York: Oxford University Press.

Lewis, Bernard, 2002, What Went Wrong? Western Impact and Middle Eastern Response, New York: Oxford University Press.

Lodge, George, 1995, "The Asian Systems," in Stackhouse, et. al., 1995, pp. 754-57.

Nelson, Benjamin N., 1949, The Idea of Usury: From Tribal Brotherhood to Universal Otherhood, Princeton, NJ: Princeton University Press. Excerpted in Stackhouse, et. al., 1995, pp. 265-71.

Stackhouse, Max L., Dennis P. McCann, and Shirley J. Roels, eds., 1995, On Moral Business: Classical and Contemporary Resources for Ethics in Economic Life, Grand Rapids: Eerdmans.