The Politics of Financial Markets and Regulation

The United States, Japan and Germany

S. Konoe

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137277336
• eBook ISBN: 9781137277343
• Topic: Economics
• Subtopic: Finance
• Index: Economics

Sara Konoe looks into the politics of financial regulatory developments in the United States, Japan, and Germany. These case studies highlight systemic interaction between institutions and political contexts, and provide broader implications for global financial governance.

Part I

The Problem under Analysis

1

Domestic Responses to Global Shifts

1.1 Introduction

1.1.1 Background

Many scholars in the field of international political economy (IPE) consider the early 1970s to be a time of regime shift in international finance due to the collapse of the Bretton Woods system, the removal of cross-border capital control, and the growth of unfettered financial flow. These events led to a series of deregulatory initiatives in each country to make its financial sector and market more globally competitive. After the oil shocks and economic fluctuation of the 1970s, a period of benign economic and financial stability, called the Great Moderation, arrived in the 1980s and continued until the early 2000s in most developed countries (Bean 2010; Bernanke 2004). During this relatively benevolent period, global imbalances accumulated, interest rates were kept low, and capital markets expanded with complex financial instruments and the involvement of various new financial actors. Global imbalances and credit expansion created conditions for financial volatility in the lead-up to the 2008 global financial crisis.

Nevertheless, in the same period, a series of financial crises in developing countries – such as the Latin American debt crisis of the 1980s and 1997–8 Asian financial crisis – erupted and overshadowed the world economy. Responses to these crises led to the increased level of financial regulation and supervision through the formation of the Basel Accord and the spread of international financial standards in Asia. These regulations were intended to ensure the minimum level of bank soundness and were a prerequisite for banks to internationally conduct their businesses. Yet such developments did not alter the overall trend of liberalization in financial business and products from the 1980s to the early 2000s in most countries.

As stated by Helleiner (2010), a global financial regime shifted “from the ‘embedded liberal’ ideology” in the Bretton Woods period to “more ‘neo-liberal’ values supporting freer financial markets and a more constrained role for the state” in the post-Bretton Woods era. Such changes occurred without a “single conference or foundational ‘moment’ which ushered in this ‘neo-liberal globalized’ financial regime” (Helleiner 2010, p. 626). Rather, they were due to incremental and accumulative domestic policy changes in many different countries. This book analyzes what happened in the financial regulatory structure of three large economies – the United States, Japan, and Germany – from the late 1970s to the early 2000s, and discusses domestic and regional changes behind such a global shift.

The three countries examined in this book had commonalities in their overall policy directions: fostering capital market expansion, consolidating financial sectors and markets, reducing structural restrictions on financial businesses, and harmonizing or integrating regulatory standards and organizations within a country in accordance with international standards. Despite such striking homogeneity, the speed and scope of policy changes significantly differed across these countries and across time periods even within a single country. Liberalization made progress much faster and more significantly at certain times compared to other times; in a time of crisis, painful and costly restructuring of markets and organizations occurred after reform made no progress for a long period; some countries (such as the United States) liberalized financial markets faster than others (such as Japan) in favor of cross-sectoral market integration, but delayed corresponding regulatory integration to match market developments. What explains the diversity? This book addresses such questions by examining the interrelationship between political contexts and institutional structure, on the one hand, and financial policy changes, on the other hand.

1.1.2 Approach

An analysis of the comparative histories of regulatory policies from the 1970s to the early 2000s contributes to a broad understanding of the international regime shift during this period – the transformation which came to light as the 2008 financial crisis hit the global economy. Moreover, careful attention to political contexts in which policies are discussed, drafted, and approved shows that contextual factors have a critical impact on how institutions actually function. A cross-country comparison demonstrates distinctive policy patterns which are influenced by countries’ institutional characteristics. Nevertheless, static and country-specific institutional analysis cannot explain differences in the speed and scope of reforms across different time periods in a single country. As the discussion in this book shows, even without formal institutional changes, the way in which institutions formulate the policy-making process could still change, thus causing sudden policy shifts at certain times.

The relevant literature to be discussed in this study includes what have been studied in the fields of IPE and finance. First, the book refers to the literature on IPE, economic history, and global governance to discuss the international regime shifts in financial markets during the post-Bretton Woods era. Second, to some degree, the book refers to the literature on comparative financial systems and political institutions in order to understand distinctive characteristics of the three countries. Third, the book discusses the literature on the political processes of financial regulatory changes in domestic, regional, and international dimensions to analyze the impact of political and regulatory institutions and other contextual factors on their policy outcomes. Fourth, in order to assess how these regulatory changes could or did impact financial markets, the book looks at the study of economics related to financial regulation.

This book mainly intends to highlight domestic aspects which have fueled or impeded globalization, as well as the domestic factors behind institutional and regulatory harmonization or divergence, through a comparison of regulatory developments in the three countries. An increasing number of works on financial governance has been published in response to the 2008 financial crisis, and these studies have discussed how financial markets and banking businesses evolved from the 1970s to the early 2000s in a way that undermined financial stability. However, the political and institutional elements of such developments have not been fully analyzed from a comparative perspective. In fact, comparative approaches to financial politics provide a basic understanding of which political and institutional factors could serve or impede the effective functioning of financial governance, and offer useful insights on the analysis of global financial governance.

1.1.3 Structure of the book

The book consists of three parts. Part I (Chapter 1) discusses the beginning of structural shifts in the global financial regime and markets in the 1970s and subsequent countries’ policy responses and market consequences in the following decades. In response to the advancement of financial technologies and intensified global competition in those decades, banks expanded their business across borders and beyond traditional lending into fee-based investment services, which included transactions on complicated financial instruments and contributed to interconnectedness in the financial markets and financial risk – a global trend supported by many governments in advanced industrial economies. Moreover, this chapter introduces a comparative perspective on the three countries and discusses the country-specific characteristics of financial systems and political institutions, which broadly influenced the countries’ policy responses in a changing global environment and their specific regulatory settings and contexts.

Part II (Chapters 2–4) analyzes the case studies of financial liberalization and restructuring financial sectors and regulators in the United States, Japan, and Germany from the 1970s to the early 2000s. It first focuses on regulatory and political structures and their degrees of fragmentation impacting the scope and speed of financial liberalization across three countries under a common pressure from global market forces. The impact of regulatory and political structures on the restructuring of financial sectors and regulators is then discussed, with particular attention being paid to the context of financial crises or broader political change. The analysis shows how economic and political contexts mediated the way in which political institutions functioned and coordinated the actors’ preferences.

Part III (Chapter 5) analyzes global financial governance at both the regional and global levels, which has been shaped by the policies and political needs of each country and which, in turn, sets the contours of financial regulation in each country during the period under examination. Domestic liberalization necessitated more global regulation through cross-national regulatory harmonization and placed an increasing emphasis on prudential regulation that provided principles and standards for financial supervisory practices. However, a “global” structure inherently favored financial liberalization rather than costly re-regulation, due to regulatory fragmentation and power segmentation embedded in a system of independent sovereign states. A sense of crisis shared among states during periods of financial crisis could help them to overcome fragmentation to a certain degree, but the entity to be blamed for the financial turmoil is unclear at the international level, so that driving forces and incentives for re-regulation can only be limited.

1.2 International regime change and its impact

1.2.1 Domestic aspects of regime change

Regime change originates not only from global shifts such as the collapse of the Bretton Woods system but also from incremental and accumulative domestic policy shifts, especially where changes in a country progress in parallel with changes in other countries. Domestic financial policies are embedded in the regime structure of international finance and in turn could have a long-lasting impact on an international finance regime.

A radical shift in global finance began with the collapse of the Bretton Woods system from 1971 to 1973 and the emergence of the Eurocurrency market outside of nationally regulated areas. After the United States abandoned dollar–gold convertibility, which ended the Bretton Woods system and marked the onset of a dramatic regime change, states regained their power of discretion over currency and financial policies. In parallel, capital control began to be lifted in most countries and subsequent cross-border financial market integration led to converging interest rates, occasional cross-country coordinated interventions in foreign exchange markets to stabilize the markets, and financial regulatory harmonization.

Moreover, the global shift toward a floating exchange rate system prompted a surge of hedging strategies, including currency futures and options, thus leading to the development of derivatives markets in general. Additionally, developments of financial technologies contributed to the decreasing cost of securities market transactions and expanded investment opportunities in capital markets. The expansion of capital markets worked to the advantage of certain economic actors, such as securities industries and nonbank financial entities, and to the disadvantage of others, such as the banking sector in a traditional sense.¹ Such distributional effect impacted the incentives and behavior of these actors in each country. For example, the banking sector began expanding the scope of its businesses into capital market– based businesses by pressuring the government to remove cross-sectoral business-entry restrictions or by utilizing new financial instruments such as securitization.²

The global shifts above also had an impact on political actors and induced policy changes. States could be either political or economic actors which vie with one another for economic gains in global markets. In response to global financial integration and increasing cross-border and cross-exchange financial transactions (see Section 1.3.2 for more details), each state began changing its legal framework to make its stock exchange markets attractive to companies and investors at home and abroad and to strengthen the competitiveness of its financial sectors in a global market. The policies introduced included interest rate liberalization, foreign exchange market liberalization, the opening up of capital markets to new financial technology and financial instruments, and the removal of cross-sectoral business-entry restrictions across different financial sectors (banking, securities, and insurance).

Starting with the understanding that there was significant change in international monetary regime in the 1970s, this book investigates what followed after that, and how accumulative and incremental domestic policy changes and responses to this global change in effect contributed to the formation of another regime. As Keohane and Nye (2012, p. 273) emphasize, “The nature of international regimes can be expected to affect domestic structures as well as vice versa.” A study on the impact of international regime and that of regime change on state behavior is much needed, as the former affects political and economic bargaining at domestic levels. After a series of domestic struggles, the world in which states operate could become one very different from what it used to be, and the question of how this systemic change occurred would not be fully addressed without an investigation into the domestic processes that occurred during this period of transition.

1.2.2 International finance and states: The end of the Bretton Woods system

Before significant changes in international monetary regime in the early 1970s,³ the early post–World War II period from the 1950s to the 1960s was characterized by economic growth and stability. This period is often called the “Golden Age,” where industrial economies, including those of Europe and Japan, recovered from war disaster and started to grow rapidly (Glyn 2007, pp. 1, 8–9; Capie 2010, p. 3).⁴ These buoyant economies were supported by a post–war international monetary regime, called the Bretton Woods system, which adopted the basic ideas proposed by two economists, John Maynard Keynes and Harry Dexter White. The major feature of this system was a fixed exchange rate system with some flexibility for countries to devalue or revalue their currencies to a limited degree (called the “adjustable peg system”), except for the United States, whose dollar was pegged to the price of gold.

Under this system, governments had flexibility to exercise monetary policy, to either lower or increase interest rates depending on their economic situation, and were permitted (or even required) to restrict cross-national short-term capital flows. In order to avoid fluctuations due to short-term speculative financial flows in search of higher yields (higher interest rates), it was necessary to put in place restrictions on short-term international investment (Frieden 2007, p. 291). As the Mundell–Fleming model suggests, if countries did not impose capital control, they could not pursue autonomous macroeconomic policy under a fixed exchange rate system. If they raised interest rates to cool down the boom, financial inflows would result and would push interest rates back down to the global level. If they lowered interest rates to boost their economies, capital would flow out of their countries, which would push interest rates up to the global level. Thus, capital control was a necessary tool for countries to control aggregate demands under a fixed exchange rate system (Goodman and Pauly 1993, pp. 55–6).

The period of affluence under international economic stability came to an end with accelerating inflation in the late 1960s, in part due to the United States’ financing of the Vietnam War and a social welfare program, called the “War on Poverty,” which resulted in the deterioration of investors’ confidence in the dollar. Investors suspected that existing currency parities would be unsustainable and rushed to convert their dollar holdings into gold, thus leading to the breakdown of the Bretton Woods system in the early 1970s (Capie 2010, p. 5; Frieden 2007, p. 344).

Moreover, Frieden (2007) points out two other underlying factors – “results of the success of the Bretton Woods order” – which undermined the system and led to its breakdown. The one is “growing economic importance of Western Europe and Japan.” The ability of the United States to meet gold–dollar convertibility at the pre-fixed parity was called into question, as the US relative economic share shrank. This led to depreciation pressures on the dollar with the aid of restored international finance – the other element of “success.” Despite the fact that the Bretton Woods system assumed governments’ control over short-term capital movement across borders, international finance had become too abundant and dynamic, so that countervailing forces had been at work and ended up inducing the collapse of the system. Frieden (2007, p. 343) notes:

[In the 1950s and 1960s] short-term money flows were practically nonexistent, in part because of the trauma of the 1930s, in part because of booming opportunities at home, in part because of capital controls … World financial markets revived over the course of the 1960s. By the early 1970s the global financial system was holding abo...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Figures and Tables
• Acknowledgments
• List of Acronyms
• Part I: The Problem under Analysis
• Part II: The Impact of Regulatory and Political Fragmentation
• Part III: Implications for Global Financial Governance
• Notes
• References
• Index