The new capitalism

Two further long-term developments help explain what has happened. The first is the revolution in financial economics, notably the discovery of options pricing by Myron Scholes and Fischer Black in the early 1970s, which provided the technical underpinning of today's vast options markets. The second is the success of central banks in creating a stable monetary background for the world economy and so also for the global financial system. "Fiat" (or government-created) money has now worked well for a quarter of a century, providing the monetary stability on which complex financial systems have always depended.

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today's global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fuelled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.

What then have been the consequences of this vast expansion in financial activity, much of it across international borders?

Among the results are that households can hold a wider array of assets and also borrow more easily, so smoothing out their consumption over lifetimes. Between 1994 and 2005, for example, the liabilities of UK households jumped from 108 per cent of GDP to 159 per cent. In the US, they soared from 92 per cent to 135 per cent. Even in conservative Italy, liabilities rose from 32 per cent to 59 per cent of GDP.

Similarly, it is ever easier for companies to be taken over by, or merge with, other companies. The total value of global mergers and acquisitions in 2006 was $3,861bn, the highest figure on record, with 33,141 individual transactions. As recently as 1995, in contrast, the value of mergers and acquisitions was a mere $850bn, with just9, 251 deals.

With the vast size of the new private equity funds and the scale of the bond financing arranged by the big banks, even the largest and most established companies are potentially for sale and break-up, unless they enjoy special protection. The market in control of companies, to which private equity is an active contributor, has greatly increased the power of owners (shareholders) over that of incumbent management.

The new financial capitalism represents the triumph of the trader in assets over the long-term producer. Hedge funds are perfect examples of the speculative trader and arbitrageur. Private equity funds are conglomerates that trade in companies, with a view to financial gain.

In the same way, the new banking system is dominated by institutions that trade in assets rather than hold them for long periods on their own books.

With the orientation towards trading come explicit, rather than implicit, contracts and arms-length dealing rather than long-term relationships. So-called” relational contracts" are no longer worth the paper they are not written on. They are subject to the solvent of new opportunities for profit. It is no surprise, therefore, that the cross-holdings of postwar capitalism in Japan and the bank-dominated equity ownership of postwar Germany have both evaporated.

Moreover, the presence on share registers of large numbers of foreigners, who are fully prepared to exercise their rights of ownership and are unconstrained by national social and political bonds, has transformed the way companies operate: the successful shareholder revolt against the plans of Deutsche Borse's management for a takeover of the London Stock Exchange is an excellent example. Thus is global financial capital eroding the autonomy of national capital.

Another consequence has been the emergence of two dominant international financial centers: London and New York. It is no accident that these are located in English-speaking countries with a long history of financial capitalism. It is no accident either that Hong Kong, not Tokyo, is generally viewed as the leading international financial centre in Asia, even though Japan is the world's biggest creditor country. Hong Kong's legacy is British. The legal tradition and attitudes of English-speaking countries appear to be big assets in the development of financial centers.