Global Finance: How globalization hit the high street

Thanks to the democratization of finance, we have individuals, through pension funds and mutual funds, holding the sovereign debts of many countries. Part two of an excerpt from The Lexus and the Olive Tree, the Pulitzer prize winning columnist's new book, published by Farrar,

Straus & Giroux.

When Mexico got in trouble again for excessive spending in 1995, all sorts of big and little guys started selling their Mexican bonds, driving down their value, and Jose Angel Gurria (former director general of public credit in Mexico's Ministry of Finance) could not just call up 20 bankers and ask them to roll over the debt and cut him some slack. Mexico's debt had been democratized into too many hands. So this time Mexico had to call up the US Treasury and ask for help, and Uncle Sam would only give Mexico the money on very strict terms and Mexico had to put up its oil reserves as collateral. The only way the US government was going to bail out Mexico was on the condition that it ran its economy as well as New Mexico. Soon, lots of emerging economies started selling bonds the Brady way, often denominated in dollars. Today there are 16 countries issuing Brady bonds worth roughly $150 billion.There is nothing new about governments issuing bonds to foreign holders. That has been around for many years. What is new is the degree to which these bonds are now widely dispersed to individuals, pension funds and mutual funds. In the early part of this century it was mostly the wealthy who took part in international bond deals. Now the retirement fund of Orange County, the school janitor, not to mention you and me and my aunt Bev, can all play.

This is because the democratization of lending coincided, in America, with the democratization of investing, thanks primarily to pension reform and the creation of personal 401(k) pension accounts. America is moving from a country in which companies guaranteed an employee's pension through a defined "set of benefits" to a country in which many companies now just guarantee a defined "contribution," and the individual manages his or her own money and shifts it around, according to where he or she can get the best return. And with people now living longer, and wondering whether social security will be there when they want to retire, they are not only turning to these mutual funds and pension funds in an aggressive manner but also managing them very aggressively for high returns.Your parents probably had very little idea where or how their pension funds were invested. Now many workers are offered a menu of funds, with different kinds of returns and risks, and they move their money around like chips on a roulette table, rewarding the successful mutual funds and punishing the less successful.

This democratization of investing was also enhanced internationally when the system of fixed exchange rates and strict controls on international flows of capital, which was set up after World War II at Bretton Woods, came apart in the early 1970s. We forget now, but before 1970, it was very difficult for a Japanese, Mexican or European investor to buy stocks or bonds in America, and it was very difficult for an American to do so in their countries. But when the system of fixed exchange rates and capital controls came unstuck, developed countries gradually democratized their capital markets, opening them to any foreign traders who wanted to play, and then the developing countries followed suit.

Soon all sorts of products were available: Mexican bonds, Lebanese bonds, Turkish bonds, Russian bonds, German bonds, French bonds. You could take your choice, and people did.The more individual investors could move their money in and out of these highly competitive global mutual funds, the more these fund managers would move their money between companies and countries, constantly demanding higher, more sustained returns. Each fund wanted to beat out the other funds to attract more money. According to market economist Henry Kaufman, in 1985 the combined total of equity and bond funds in the United States was just over $100 billion, less than 2% of the total financial net worth of households. Today these stock and bond mutual funds represent over $3 trillion, with $2 trillion of that held by households, representing roughly 10% of their net worth and rising.

It is important to note that a lot of the junk bond money was also used to trigger a boom in company takeovers in America. Here again, the little guy, who could never participate in such potentially lucrative deals, could suddenly do so indirectly through his pension and mutual fund. This process of takeovers, though, put company managers under greater scrutiny, particularly if they underperformed.The process also helped to drive the streamlining of the American economy in the 1980s and prepare America for the era of globalization better and sooner than any other major country in the world. Many companies saw their efficiency improve as a result, although some had the life squeezed right out of them.

One of the main reasons Japan has so many lagging domestic companies is that finance there, until the late 1990s, was not at all democratized. Japan's big banks dominated finance, so unknown upstarts had a much harder time raising cash, and capital for hostile takeovers was not easily available. Even if it were, such takeovers were frowned upon for cultural reasons and because so many bank boards and corporate boards were in bed with each other. Moreover, Japanese workers had little choice in or control over their pensions.They could not just shuffle their money around, so the pressure on local Japanese companies, mutual funds and pension funds to perform to ever higher global standards was diminished. That is why Japan has a more genteel economy, but one that is much less efficient at Schumpeter's creative destruction.

Thanks to this democratization of finance, we have gone from a world in which a few bankers held the sovereign debts of a few countries to a world in which a lot of bankers held the sovereign debts of a lot of countries, to a world in which some wealthy individuals and bankers held the sovereign debts of a lot of countries, and finally to a world today in which many individuals, through pension funds and mutual funds, hold the sovereign debts of many countries.