The Wall Street Journal
Why have Asia and Europe not been as prosperous as the U.S. in recent years? A good part of the answer lies in the dynamics of "social capital," an issue I made the subject of my first Wall Street talk, titled "The Best Investor Is a Social Scientist," 30 years ago. Social capital includes universal education and health care, police and fire protection, religious freedom, a sense of neighborhood bonds and widely available cultural resources. But it also includes the incentives for risk taking inherent in established property rights, protection of creditors, regulatory continuity, transparent markets and rigorous financial reporting standards. These incentives are strong in the U.S., improving rapidly in Europe, and highly variable throughout Asia and elsewhere.
Social capital is important both for investors and policy makers trying to address the problems of poverty and unemployment. But as Japan has shown us in this decade, social capital alone doesn't create dynamic growth. The future prosperity of any country depends on the sum of "financial technology" - the kinds of financial instruments and methods developed in the U.S. over the past generation - multiplied by the combined social capital, human capital and "real" assets of the nation. A look at the U.S. experience in changing its capital markets, and the capital structures of its job-producing companies, illustrates the multiplier effect of financial technology. Back in the 1960s, a small number of money-center banks and large insurance companies pretty much determined who got access to U.S. financial capital. Their customers were large, established corporations - companies with history - and capital was allocated to these 800 or so "investment grade" firms based on a look in the rear-view mirror. Tens of thousands of smaller enterprises - companies with prospects - scrambled for crumbs at the tables of the capital club. Wall Street seemed more interested in financing the past than the future.
Tagged as 'Junk'
Over the last third of the 20th century, control of capital in America has shifted away from private institutions and toward public markets, making the process of financing growth more forward-looking and democratic. Entrepreneurs are no longer limited to the few institutions that used to control the money spigot. The turning point was 1974, when interest rates spiked, the stock market fell 45 percent, and large financial institutions, faced with their own problems, stopped lending to all but the highest-rated borrowers. Thousands of below-investment-grade debt instruments - including those of municipal governments and utilities - were then tagged as "junk" because their issuers were supposedly on the verge of bankruptcy. When the issuers survived, investors in these high-yield instruments received a stunning 100 percent return in the next two years.
By 1977, dozens of Wall Street firms were issuing high-yield securities for a broad range of below-investment-grade companies. Although considered "high risk," these securities turned out to carry less portfolio risk than higher-rated instruments because yield premiums more than compensated for defaults. Leaders of small and medium-sized firms with good prospects, who had been dependent on relationships with individual banks and insurance companies, could now turn to a market-based system with thousands of institutional buyers, including mutual funds, which, as the chart nearby shows, would eventually grow larger than the banks.
When interest rates skyrocketed in 1980, the yield spread on high-yield bonds (compared with investment-grade debt) narrowed as investors came to understand modern credit analysis. Aiding this understanding was a parallel phenomenon in the labor market. Smaller, entrepreneurial companies had always been engines of job creation while larger investment-grade corporations often grew by investing capital to replace jobs. But now the job-creation trend accelerated as greater access to capital allowed MCI, McCaw Cellular, TCI, Turner Broadcasting and hundreds of other newcomers in the telecommunications, cable and emerging technology industries to challenge established companies. In a 1980s speech, the late chairman of MCI, Bill McGowan, looked back at his company's early days: "Our biggest obstacle was not the opposition of the government or the monopoly position of AT&T. It was the availability of capital. Those days are over now." By the end of the '80s, MCI had generated more than 50,000 jobs, part of a net 54 million jobs created in the U.S. since 1970. That's the sum of minus three million jobs eliminated by "blue chip" companies plus some 57 million new jobs created primarily by below-investment-grade firms. In the same 29-year period, Europe created very few new jobs, at least in part because it clung to the old relationship-based system of capital access. Significantly, only 17 percent of Europe's fixed-income issues last year were below investment grade, compared with 60 percent in the U.S.
These high-yield securities have an extensive history. The first U.S. Treasury secretary, Alexander Hamilton, used junk bonds to finance the young country. But such instruments are appropriate only in certain circumstances, because risk in capital structure should vary inversely with business risk. For some companies, even a dollar of debt is too much, a lesson many airlines, aerospace and technology companies learned in the 1960s. Effective balance-sheet management uses varying amounts of equity, debt, hybrids and other instruments to match corporate capital-structure needs and adapt seamlessly to changing markets. There are times, such as 1976-78, when many companies are best advised to sell debt because the market welcomes it and interest rates are relatively low. By the late '80s and into the '90s, it made sense for some of these firms to deleverage by selling equity.
Another factor that has accelerated the shift toward public markets is the digital revolution, which has driven down expenses. Over the past 20 years, as computers combined with America's bench strength in capital market skills, Wall Street produced such new financial technologies as securitized debt, mortgage and credit-card obligations, and a variety of equity-based derivatives. Will overseas markets enjoy a U.S.-style boom as they increasingly import American financial technologies and adopt market-oriented economic management theory? The short-term outlook is better for Western Europe than for Asia. Western Europe generally has an educated workforce, political and religious freedom, strong cultural resources, available investment capital, established and well-regulated financial markets and enforceable property rights. Traditional inhibitors to growth, such as excessive social welfare programs, are beginning to yield to a renewed entrepreneurial spirit as monetary union opens markets and stimulates competition.
Some would argue that Asia presents even brighter prospects given its strong work ethic and high savings rates. Asia does have enormous long-term potential, but a lot must change for that potential to be realized. In much of the region, political power, industrial control and financial capital are concentrated in too few hands. In Indonesia, for example, 61.7 percent of the stock market is held by the nation's 15 richest families. The comparable figures for the Philippines and Thailand are 55.1 percent and 53.3 percent, respectively.
Asian brokerages are weak, mutual funds are small, and there isn't a public corporate bond market as we know it. Thus Asia has a way to go in developing the kinds of secondary markets that financed growing U.S. companies. Entrepreneurs must turn to commercial banks, which are often state-owned or -directed and historically not accountable to shareholders.
It won't be easy to overcome tradition and reform Asian economies. When a few powerful families control a developing nation's media outlets, how fast will change occur? If a politically connected holding company can shift most of its liabilities to a few subsidiaries and then give those units to the government, will investment grow? Will a farmer plant fruit trees that take eight years to produce if he's not sure he will own his fruit in eight years? While much of Asia is beginning to address these issues, the kind of revolution in capital markets that set the stage for the U.S. boom can take root only in the soil of comprehensive social capital. Throughout the developing world today, inadequate social capital - especially the incentive to put investment capital at risk - is the weak link that limits the multiplier effect of financial technology in creating broad-based and lasting prosperity.
Creative New Approaches
Even in the U.S., many of our two million minority-owned businesses struggle in "domestic emerging markets" because they don't have access to financial technology. We need creative new approaches, such as securitizing packages of loans to establish a secondary market for their debt, much as mortgage-backed securities strengthened the housing market by separating borrowers and lenders. One of the greatest returns on investment in social capital would be produced by funding expanded medical research. How much would it cost to cure cancer? No one knows for sure, but I believe that a tenfold increase in the research investment - to $20 billion a year from about $2 billion - would advance a series of cures by as much as a decade. The main benefit would be an incalculable, but magnificent, reduction in human suffering; and the economic benefit of lives saved would be in the tens of trillions of dollars -- all for an annual investment that is the equivalent of what Americans spend on beauty products. Increased cancer research in the U.S. and financial reform in developing nations may seem unrelated. But each is a measure of national commitment to increasing the stock of social capital and enhancing the quality of life; each requires the political will to change the status quo; and the benefits of each will flow through the global economy, enhancing prosperity for us all.
Michael Milken, a financier and philanthropist, is chairman of the Milken Institute, an economic think tank in Santa Monica, Calif.