Journal of Financial Economics

REF 137 40 Years of Financial Liberalization

How did France switch to a policy of monetarist inspiration only two years after the election of President Mitterrand in 1981, elected on a left-wing program? Two main types of reasons led her to make this switch. The first is common to all OECD countries from 1973, the second is specific to France.

In addition to a very serious deterioration in the economic situation throughout the OECD, there has been the observation of the growing ineffectiveness of Keynesian policies and the idea that monetarist policies would be more effective. For its part, France had, more than others, sacrificed to a debt economy with ever more inflation and unemployment.

Furthermore, in 1981, France economic policy was at the opposite of the international economic situation and the monetarist policies developed in the Anglo-Saxon countries. This, plus the commitment to sharply lowering inflation, very quickly led her to choose a policy of monetarist inspiration.

This article examines the main stages of the liberalisation of the financial sector in the United Kingdom (UK) over the past forty years. Perhaps counterintuitively, this period is also characterised by the increasing formalisation of financial regulation in the UK. Until the 1980s, the London financial marketplace was indeed composed of diverse but fragmented players governed by a light and largely informal framework. By opening up the London Stock Exchange to new actors such as foreign and domestic banks in 1986, Margaret Thatcher's Big Bang led to the emergence of large financial conglomerates and transformed the City. Yet, despite the introduction of a more formal regulatory regime under Thatcher, the UK financial sector was ridden by crises and scandals during the 1990. The 2000s saw the City undergo another period of intense growth and development – partly driven by the liberal tendencies of its new regulator – before crashing down during the global financial crisis of 2008. To a certain extent, the process of financial liberalisation that began under Thatcher came to a halt after the crisis with the recent introduction of ring-fencing, a set of rules requiring UK banks to separate their retail and investment activities. The parallel trend towards the increasing formalisation of the financial regulatory framework, however, endures to this day.

The deregulation of the financial system that began in the United States in the late 1970s and then spread across the world profoundly transformed financial markets, financial institutions and institutional investors. Financial services markets became increasingly integrated, leading to competition among financial institutions and producing a profusion of new products and processes, including securitization. The 2007 crisis was the product of financial deregulation and liberalization policies practiced since the 1980s. Its fierceness justified the adoption of new regulations in the form of the Dodd-Frank Act of 21 July 2010. The economic history of regulation in the United States teaches us that in times of prosperity, financial euphoria is born at the same time as risk aversion declines in markets. Techniques for circumventing regulation emerge, spread and gradually lead to the unraveling of existing regulations. The euphoria-deregulation-crisis-regulation chain appears. Financial regulation, the rules that are imposed on the actors of the financial system, and the supervisory measures that verify the application of these rules, is not an option but a necessity if we appreciate that financial stability is a common good that must be preserved.

The article analyses the evolution of banking business models in developed countries over the last 40 years and shows that after the rapid growth of banking activities induced by the deregulation starting in the 80s, the 2008-9 crisis has triggered significant changes in favour of more traditional and less market-oriented models. At the same time, after the increase in cross border exposures before the 2008-9 crisis, internationally oriented business models have been adversely affected by the crisis and the regulatory response has increased convergence. But some differences remain among banks, with some systemic institutions (GSIB or Global Systemically Important Institutions) that have continued their internationalisation. Overall, the relative profitability of universal or more specialised models has varied over time: the performance of retail and universal banking models has improved in the aftermath of the crisis, but they still face some challenges.

Narratives of liberalization focus on the "commodification" of the Welfare State, but the phenomenon has mainly led to the resolution of market failures. Insurers were thus able to underwrite risks that were not previously covered. In the life insurance sector, the variation of inflows seems to have been determined by instantaneous rates of return, which were driven to zero by quantitative easing policies. Competition has led to concentration, which may appear quite high at the national level, but is still hampered by the nature of certain operators and, more generally, by the importance of local characteristics, even though regional and international regulatory harmonization made significant progress.

In the early 1980s, various reports and analyses promoted the emergence of investment funds. The objective was to attract savings to the financial markets, in order to compete with bank financing, thus reducing the cost of financing and encouraging investment. On the one hand, the size of the asset management industry today illustrates the success of this ambition. Both household and institutional investors' savings are more diversified than they were forty years ago. On the other hand, new market risks and an ambivalent impact on financing and investment are dampening this success and currently worrying regulators.

Public debt management was deeply reformed from 1985 under the impetus of Pierre Bérégovoy, Minister of the Economy and Finance from July 1984 to April 1986. The reforms were continued under his successor Édouard Balladur, then again under Pierre Bérégovoy. These reforms aimed at a double objective, on the one hand the control of the load of the public debt, in strong growth since 1981, and on the other hand, the inclusion of public debt management in a great reform of money and financial markets to improve the financing of the French economy. Thirty years later, most of these reforms undertaken from 1985 continue to exist and French public debt still continues to attract investors, especially foreign ones. This legacy confirms their success.

In terms of financial behaviour of households in advanced countries, the financial liberalization initiated in the 1980s brought less changes than one would have thought. Admittedly, it has favored the use of credit, encouraged the holding of equity securities and helped to reduce the share of liquidity. But, because of some excesses and of the crises of 2001 and 2008, the supervisory authorities strengthened their surveillance from the end of the last century. At the end of the period, household behaviours got a little closer, especially with regard to debt, but important specificities remain, among which pensions management is the main one. Capitalization management, in countries where it is significant, indeed is an important contributor to the amount of financial assets.

On the eve of the 1980s, French companies were financed by significant debt through banks and numerous specialized, segmented and compartmentalized financial institutions. During the following decade, reforms were undertaken to get out of this "economy of administered funding".

After presenting the reform proposals of the early 1980s, this article analyzes the evolution of the financing and governance of non-financial companies that rely more on financial markets. However, it appears that the changes in funding structures were more modest than considered.

This article examines changes in corporate governance, in Europe and in the U.S.A, from the late 1970s to the present. The financial liberalisation and globalisation movements have been associated with a rise of investment funds in the equity capital of large listed companies, in the 1980s and 1990s. At the same time, legal reforms have enhanced the rights of these minority shareholders. As a result, significant changes in corporate governance practices have taken place (composition of company boards, executive compensation, profit distribution, etc.). In the 2000s, we observe a shift towards a governance less focused on the return on investment for minority shareholders. A number of rules and practices have developed, aimed at limiting the short-term effects of market finance and at fostering the ecological and social transition.

Financial crises have multiplied since the beginning of the process of financial globalisation four decades ago. These successive crises have affected very diverse financial systems, located in developing and emerging countries, as well as in the most developed countries. Recent financial crises have taken different forms: stock market crises, real estate crises, banking crises, currency crises, sovereign debt crises. Beyond their diversity, financial crises obey a small number of fundamental mechanisms. Most economists have put forward financial liberalisation since the 1970s as the main factor explaining the acceleration of financial crises, increasing the vulnerability of banks, contributing to greater interdependence of financial markets, amplification of financial cycles, contagion processes and the formation of financial bubbles.

Over time, the shaping of financial regulations and coordinated supervision of internationally active banks has appeared as a regulatory response to financial and economic shocks that have followed episodes of financial liberalisation. While the definition of regulatory capital has remained stable since the initial Basel I agreement, the measurement of risk has undergone radical changes. In particular, the key concept in international solvency regulations – the risk sensitivity – has been profoundly revised under the Basel II framework. By providing the financial institutions with the ability to assess the risks internally, by themselves, the regulator has unintendedly introduced adverse incentives and paved the way for regulatory arbitrage. This, in turn, has challenged the effectiveness of the solvency standards.

This article aims to briefly retrace the history of monetary policies since the post-war period in order to put into perspective and highlight the impact of the financial liberalization process on these policies. We observe that from the 1980s onwards most advanced countries adopted the same model of “Central Banking” focusing the action of the monetary authorities on the objective of price stability and reducing their scope and instruments of intervention. . It is shown that the neglect of the objective of financial stability called into question, after the crisis of 2007, this model and perhaps also the process of liberalization.

At a time when the question of the management of capital flows and the usefulness of controls is once again on the agenda, this article revisits the key drivers of capital account policy since 1970. The structural push towards liberalisation in the 1980's and 90's and the different timing across countries cannot be solely explained by a clear-cut scientific consensus on the benefits of free capital movements, nor by structural transformations in the global financial system. This article points notably to the crucial role of multilateral frameworks on capital flow management such as those of the EU, the OECD and the IMF in influencing countries' courses. It also emphasizes the cyclicality of debates about the costs and benefits of liberalisation over time and argues that a long-run historical perspective provides a useful critical background to on-going debates.

After the collapse of the Bretton-Woods system, almost all advanced economies had, by the end of 80s implemented the floating exchange rate regime combined with capital flows liberalization. In emerging market economies, this mutation is still ongoing. Major financial disruptions due to both volatility and persistent procyclicality of flows have fueled the fear of floating and the reluctance to pursue the liberalization process. In addition, the two last global crises, namely 2008/09 and 2020, showed that sudden stops are related more to the global financial cycle than to country-specific fundamentals. International organizations, in particular the IMF, have adapted their recommendations: keeping financial account liberalization as the long-term objective but allowing for reversibility and integrating capital flows management measures in the economic policy toolbox.

Should we still be concerned with current account imbalances, known as global imbalances, in the context of international financial liberalization? Because financial liberalization transforms the external constraints that weigh on policy makers, and this is the purpose of this article. In section 1, we examine the theoretical and empirical characterization of good and bad current imbalances. In section 2, some stylized facts allow us to assess the magnitude of global imbalances and external financial positions. Section 3 analyzes the impact of financial liberalization on the financial component of global imbalances and the dynamics of external financial positions. Finally, in section 4, we examine the thesis of the decoupling between current imbalances and international transfers of savings and liquidity.

By adopting an expansionary fiscal policy at the end of 2017, the United States returned to twin deficits (fiscal and current). In 2019, the federal budget deficit is projected to reach 5% of GDP, while the current account deficit is projected to be close to 3% of GDP. Having established the existence of a positive long-term relationship between the budget deficit and the current account deficit in the United States, this article highlights the specificities of the current twin deficits. These deficits differ from past deficits, first of all in the context of the emergence of deficits and then in their financing. While previous twin deficits appeared in an underemployment economy, the current episode of double deficit occurred in a context of full employment. On the other hand, the sources of financing of the twin deficits now come mainly from non-resident private investors, whereas until 2014 it was the non-US central banks that, by placing their foreign exchange reserves in Treasuries, ensured the bulk of the financing of these deficits. In the absence of serious rivals of the dollar as international reserve currency, the twin US deficits are now financed without difficulty. However, this situation may not last. The increase in US external debt could eventually lead to an increase in US long-term interest rates and/or a depreciation of the dollar.