The logic of funding European pension restructuring and ... - CiteSeerX

Environment and Planning A 2003, volume 35, pages 1357 ^ 1372

DOI:10.1068/a35307

The logic of funding European pension restructuring and the dangers of financialisation À Ewald Engelen

Department of Geography and Planning, Faculty of Social and Behavioural Sciences, University of Amsterdam, Nieuwe Prinsengracht 130, 1018 VZ Amsterdam, The Netherlands; e-mail: [email protected] Received 9 September 2002; in revised form 6 February 2003

Abstract. During the 1990s, pension funds seemed to dominate the world's capital markets, reaping unprecedented rates of return. This stands in glaring contrast to the budgetary difficulties of most nonfunded European pension arrangements, which are a result of the changing demographic composition of the population. As a result, a growing number of European states is trying to transform the existing pay-as-you-go systems into funded pension arrangements. After a critical examination of these demographic projections, the claim that funded pension systems are not subject to `demographic stress' is critically assessed. Finally, given the logic to which funded pension arrangements are subject, it is argued that the introduction of such institutions could result in a growing financialisation of the economy. It is claimed here that this is not without dangers for the long-term wealth-generating capacity of firms. So, not only are the reasons for pension restructuring less compelling than is generally thought, restructuring could also result in unwanted side-effects.

1 Introduction Even though the gradual build up of pension savings in the USA, the United Kingdom, Canada, Australia, the Netherlands, Switzerland, and a handful of other countries has not resulted in the `socialisation of the economy', as management guru Peter Drucker famously predicted in 1976 (Drucker, 1976), pension funds did come to dominate the world's asset markets, tempting some to speak of a veritable `pension fund revolution' (Clowes, 2001). Just to illustrate: in 1993 worldwide pension fund savings amounted to $10 trillion, of which $6 trillion was owned by US pension funds, $750 billion by British funds, and $400 billion by Dutch pension funds.(1) In 2000 the assets of US pension funds had risen to $7 trillion, those of British pension funds to approximately $1 trillion, and Dutch holdings to $500 billion. The total amount of pension savings exceeded the combined total capitalisation of the stock markets of New York, London, and Tokyo. Daily trading by US and British funds was equivalent to 30% of total trading on an average business day of the New York Stock Exchange and the London Stock Exchange put together, and their reserves amounted to circa 60% of the gross national product (GNP) of the USA and the United Kingdom combined. Dutch pension reservesöthe world's largest after US, British, Canadian, and Japanese (in that order)öhad increased from 80% of GNP in 1980 to more than 160% in the late 1990s. Of course, this has radically changed since 2000. Nevertheless, barring a complete `meltdown' of the financial system, the expectation is that the political and ideological urge to inject the largest welfare regimes of the European continent with a shot of funded old-age provision will continue unabated. For that is what this paper is aboutö the ongoing drive to transform the continental European pay-as-you-go (PAYGo)

(1) Dollar

amounts are in US dollars throughout. À An earlier version of this paper was presented at the 14th Annual Meeting on Socio-Economics, University of Minnesota, Minneapolis, MN, 27 ^ 30 June 2002.

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pension systems, in particular those of France, Germany, and Italy, into a hybrid one by shifting pension responsibilities in part to funded arrangements, to absorb the imminent demographic shift. Of course, the interests involved are massive, and the pressure that is being built up is hugeöas are the consequences if the current pension regimes of Germany, France, and Italy are indeed transformed along AngloAmerican lines. As the rise of pension funds, the growth of capital markets, the increasing sophistication and economic importance of the financial industry, the growing political clout of financial players, and the dominance of shareholder value as a new ideology of wealth creation appear to be reinforcing one another, the decision to shift the burden of pension provision from public to private pension plans and from a PAYGo to a funded regime is sure to set in motion far-reaching changes. In this paper I offer a critical examination of the arguments for pension restructuring. I start in section 2 with a brief description of the parameters of European pension restructuring. In section 3 I critically assess the underlying arguments, arguing that the demographic projections hide important policy alternatives behind ceteris paribus conditions (section 3.1) and that the assumed `superiority' of funded regimes is premised on the assumption that funded arrangements are beyond `demographic stress' (section 3.2). In section 4 I describe the logic of funded pension arrangements and elucidate the ties with financialisation, defined as a discrete regime of accumulation (section 4.1). Finally, as a kind of afterthought, I briefly sketch some of the dangers such a process presents for the wealth-generating capabilities of firms in the long run (section 4.2). Although dealing with topics that cry out for a `grand theory', my aims are rather more modest. By providing a closer analysis of the arguments in favour of pension restructuring I aim to highlight the ìdeological moment' within these discourses in an attempt to widen the room for political manoeuvring. Debunking `false necessities' is, of course, only the first step in the creation of `real utopias' but is indispensable nevertheless. My undertaking is humble in a second sense too. When addressing the subfields of demography and financial economy I do not claim to be the ultimate umpire. I am not equipped for that. Once again, I merely aim to show the contested nature of the projections and assessments to highlight that we all now live under conditions of contingency. 2 The greying of capitalism During the past decade the topic of pensions has risen on the political agenda. This is largely as a result of demographic arguments, projecting a worsening dependency ratio in the long run, ultimately kicking the legs from under existing welfare arrangements. Because in most European countries the number of childbirths has declined rather dramatically over the past fifty years and longevity has gradually increased, a declining number of workers have to provide for a growing number of pensioners and other dependents. As this drives up nonwage labour costs, the competitiveness of firms in export markets comes under pressure, setting in motion a downward spiral of economic decline if policies remain unchanged. According to this argument, the `greying' of the population puts a `time bomb' underneath the `contract between the generations', ultimately leading to à fiscal crisis of the state' (Bolkestein, 2001; Disney, 2000; OECD, 1995; 1996; 1998; World Bank, 1994). The OECD, for instance, has stated that in all member states even the present value of contributions is insufficient to cover expenditure. The deficits, expressed in percentages of gross domestic product (GDP), range from ÿ234.5% in the case of Denmark, via ÿ102.1% in the case of France, to ÿ23% in the case of the USA. Countries such as Italy, Germany, and France, in which public pension payments in

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1995 amounted to 13.3%, 11.1%, and 10.6% of GDP, respectively, will in 2030 have to face percentages of 20.3%, 16.5%, and 13.5%, respectively, requiring an increase in the tax/GDP ratio of 7.1%, 9.6%, and 9.7%, respectively, to keep net debt constant (OECD, 1996; 1998). In principle, this fiscal time bomb can be defused in several ways. The first `solution' would be a policy of open borders to extend the pool of future earners. Indeed, a growing number of European governments is currently exploring the possibilities of introducing labour migration regimes to lessen the tensions within specific labour-market segments and to diminish the prospective pressure on existing welfare arrangements (Engelen, 2003). However, it is fairly obvious that the degree of openness required to diminish the dependency ratio in any substantial way will exceed the democratic mandate of most governments. The number of migrants required to keep even the EU population level at its 2000 peak of 372 million amounts to 949 thousand annually, without considering what is needed to maintain the working population and the potential support ratio (1.4 million and 12.7 million, respectively)önumbers that clearly exceed the politically feasible (UN, 2000, pages 85ff ).(2) The second option is a radical overhaul of the available pension arrangements. Where funding predominates öas is the case in the USA, the United Kingdom, Canada, the Netherlands, Japan, and Switzerland öthe level of redistribution between generations tends to be lower than in PAYGo systems, because funded systems have two sources of income whereas PAYGo systems have only one. Hence, the more that pensions are paid for by capitalised funds, the less is their long-term viability subject to demographic changes, or so it is claimed. For this reason a growing number of European policymakers have shown considerable interest in a reconstruction of public pension systems along Anglo-American lines (Minns, 2001). Adapting, rather than radically overhauling, current PAYGo systems is the third option. By raising the threshold for eligibility and the retirement age, by lowering benefits, by changing the indexation, and by extending the tax base, governments try to prolong the financial viability of public pension systems, the gradual, incremental introduction of these measures being intended to deflect political obstruction (Disney, 2000). Regime change is hard to conduct anyway, but in the case of pension systems this is especially so. For turning PAYGo systems into capitalised systems forces current contributors to pay twice, once for their predecessors under the PAYGo systems and once for themselves under the newly established funded system (Brooks, 2002; Miles, 1999, pages 30 ^ 33; Myles and Pierson, 2001; Pierson, 2000, page 811). Moreover, pension restructuring is perceived by voters to infringe upon vested rights, as was demonstrated by the 1995 mass uproar in France and the ousting of the Berlusconi coalition in Italy in 1994 (Schludi, 2001). So, regime changes, however radical in the middle to long term, can be implemented incrementally only, but radical changes are increasingly perceived to be unavoidableöpartly because of European pressures deriving from worries about the `health' of government budgets as defined by the Maastricht treaty, and partly because of internal political pressures. These are the parameters within which the current European discussion of pension restructuring takes place. (2) The net average annual migration to the EU amounted to 857 000 during the 1990s. Hence, current levels of migration suffice to keep the total population of the EU steady. To keep the working-age population level, however, requires a doubling of current migration levels. However, to keep the potential support ratio at its 1995 value of 4.3 persons for every pensioner would require a flow of migrants 15 times larger than current flows. Raising the retirement age to 76 years would have the same effect (UN, 2000, page 87).

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3 Underlying arguments 3.1 Demographic projections

Given the significance of pension restructuring it is pertinent to scrutinise the underlying projections. In a general sense it is, of course, true that each and every long-term prediction is vulnerable to prognostic errors as a result of problems of multicausality and overdetermined effects (Bader, 1997; Mayntz, 2002, pages 21 ^ 24). Predictions strictu sensu presuppose closed systems and deterministic laws and are based on a radical reduction of complexity. Social predictions, moreover, are unable to account for agency as well as the reflexivity of self-fulfilling or self-destructing prophecies (Bader, 1997, pages 156 ^ 157). Obviously, higher-level projections, for instance global demographic ones, are less vulnerable to these objections than are lower level ones, such as macroeconomic projections. However, for both types of projections it is true that they must be based on ceteris paribus conditions because the number of relevant variables is simply too large. In reality, however, conditions never stay the same. Small variations in the starting premises rapidly `fan out' when projected further into the future, largely explaining the differences between OECD and International Monetary Fund (IMF) predictions, for instance, as well as the attractions of scenario studies (Disney, 2000, page 6). The 2001 UN report on Population, Environment, and Development is a case in point. It presented new data on worldwide fertility, necessitating a radical revision of earlier demographic projections. Wisely, the report began with a sobering overview of the UN's own prognostic failures, noting that the apocalyptic projections of a demographically induced environmental disaster of the late 1960s and early 1970s have, from 1997 onward, suddenly given way to expectations of an early stabilisation of population growth around the middle of the 21st century. Thus the UN ``future population size is sensitive to small but sustained deviations in fertility levels'' (2001a, page 5). A fertility rate of 2.1 children per woman results in a projected population of 9.3 billion in 2050, whereas a rate of 1.6 will lead to a population decline to 7.9 billion. A fertility rate of 2.6 children per woman, however, will result in a total population of 10.9 billion in 2050. Currently, worldwide fertility is ``believed to have traversed over four-fifths of the journey from a total fertility rate of 5.0 in 1950 to 2.1 in 2050'' (Caldwell, 2002, page 72). However, as Caldwell notes, ``projections are far from certain'' and ``projections are necessarily based on past experience öincluding past policy experienceöand, if this changes, then the projections must do so too'' (page 72). This state of affairs is implicitly acknowledged by the demographers of the UN, for they have produced in their World Population Prospects no fewer than four scenarios: constant, high, medium, and low growthöresulting in a spread of 3 billionö of which, incidentally, the medium-growth scenario has so far proven to be the most reliable (UN, 2001b).(3) More important, however, is what is hidden behind the ceteris paribus clause of most long-term demographic projections, for these projections are highly dependent on background assumptions about employment, productivity, wage growth, and inequality. As most studies fail to address these and start unblinkingly from depressed levels, the dire scenarios are already contained within the premises (Jacot, 2000, page 126; Weller, 2001, pages 9 ^ 16). This is not to deny that demographic changes are taking place, nor that these changes do bear upon existing pension regimes, but merely to point out that (3)

Keilman, assessing the accuracy of UN projections for the 1970s and 1980s, found that inaccurate data on the base populations accounted for most of the inaccuracy, especially inaccuracies concerning population growth in Asia, Eastern Europe, and Africa. However, as a result of the use of better statistical techniques, UN projections tend to improve over time (Keilman, 1998).


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pension restructuring per se, whether in its radical or its adaptive variant, is not the òne best way' to solve the demographic issue. Lifting the ceteris paribus constraint allows one to recognise that the scope of possible solutions is in fact much larger and is highly interwoven with labour-market, family, and migration policies (that is, increasing the participation rate and shifting the fertility equilibrium)öas well as economic and educational policiesö(that is, enhancing labour productivity, either through more spending on research and development or through increased investment in competencies and capabilities) (Weller, 2001, pages 33 ^ 34). For it has to be kept in mind that the distributive shift between capital and labour that was initiated in the mid-1970s was very much politically induced (Korpi, 2002; Marglin and Schor, 1990), creating conditions under which the `generational contract' could be upheld only by `betting' on increasing capital returns. As such, there was nothing necessary about this shift, implying that a reverse shift could once again create the circumstances under which the obligations flowing from the `generational contract' could be honoured by labour returns. To initiate such a shift, more attention ought to be paid to policies aimed at increasing labour returns. However, the contemporary political climate in Europe in which monetarism rules supreme and in which government deficits are being ruled out under the arbitrary Maastricht criteria of the European monetary union is not particularly conducive for such a shift (Weller, 2001, page 33). Nevertheless, the overall implication is that the pension crisis is more a `willingness-to-pay crisis' than an àbility-to-pay crisis' (Weller, 2001, page 4). 3.2 Equity premium

The second assumption underlying the presumed superiority of funded pension regimes over PAYGo systems is the notion of a substantial and enduring èquity premium'. As fully funded arrangements are legally required to maximise returns, pension funds have every reason to invest in those assets that provide the highest rewards. And, as the folklore of the financial trade wants to have it, such assets are publicly traded corporate equities, generating a structural `premium' of 5.5% over `safe' government bonds. Hence, the question of whether capital returns do indeed structurally exceed those of labour and, if so, if they will do so in the future, is crucial. The èquity premium puzzle' is the stock-in-trade of financial economists. In a seminal paper published in 1985 the financial economists Mehra and Prescott argued that the net èquity premium', or the rate by which risky equities are alleged to outperform safe assets such as government bonds, was too high to explain with standard microeconomic assumptions about the risk aversion of rational agents (Mehra and Prescott, 1985). In particular, Mehra and Prescottöusing data from the Ibbotson Associates' annual US-portfolio reviews, generally accepted as the best proxies for asset returnsöcalculated a historical equity premium of 6%, but, according to microeconomic assumptions, an equity premium of less than 0.25 percentage points should have sufficed. How to account for this gap? Most attempts to solve this `puzzle' have focused on refining the theoretical assumptions underlying microeconomic behavioural modelling (for an overview, see Siegel and Thaler, 1997). Recently, however, a growing number of financial economists have taken up the other horn, and have critically analysed the dataset used by Mehra and Prescott to see if the puzzle might not be caused by overestimated returns on equity and underestimated returns on bonds. These studies have indeed borne that out, albeit only partially (Claus and Thomas, 2001). More specifically, the Ibbotson estimates betray an upward bias because of `data picking'ötaking the undervalued stock exchange of 1926 as their benchmark instead of the much more overvalued one of 1900öas well as a `survivorship bias', for the indices they used to determine long-term returns covered price rises and declines only and

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failed to correct for equity retirement, either through mergers and acquisitions or through bankruptcy (Dickson et al, 2002). In addition, they used Wall Street data only, and the performance of Wall Street can hardly be taken as exemplary for stock exchanges in general (Jorion and Goetzmann, 1999). Moreover, the estimated returns of 0.8% on fixed-income assets such as bonds have been seen to be an artefact of the time period examined and appear to have been caused mainly by the high levels of inflation after the replacement of the gold standard by a paper monetary standard from the 1930s and 1970s onward (Siegel, 1999; 2001). Corrections result in much lower estimates than the 6% of the Ibbotson reviews. According to Siegel, the annual net return on bonds has to be revised upward to 3.5%. Combined with a stable return of approximately 7% annually over a 196-year period for equities, this results in an average equity premium of 3.5% (Siegel, 1999; 2001). Claus and Thomas, using data from 1985 onward on the six largest equity markets, estimate the equity premium to hover around the level of 3% (Claus and Thomas, 2001), whereas Dickson et al, using historical indices from 16 stock exchanges, downscale the equity premium to 4.3%, of which 1.7% is attributable to contingencies such as the one mentioned by Siegel, leaving an effective premium of only 2.6% (Dickson et al, 2002). Much more important, of course, especially in light of the current stock-market crash, is the question of whether these revised returns can be maintained. Here, the need for explanations of the 1990s stock-market boom looms large. In his 2000 bestseller, Irrational Exuberance, Shiller lists a total of twelve `precipitating factors', ranging from the Internet bubble to capital gains tax cuts, to account for the stock-market boom, before focusing on the self-fulfilling, irrational nature of such a boom, while wisely abstaining from making claims about the weights that should be attached to them. However, given the self-fulfilling nature of the most recent boom and the growing discrepancy between real market valuations and share prices, Shiller, using insights from `feedback theory', does not refrain from predicting a short-term fall of 50% from the height of mid-2000 as the equity bubble implodes and a subsequent steady decline of equity returns as some of the precipitating factors slowly `lose steam' (Shiller, 2000, page 209). Others have been less modest and have maintained that the stock-market bubble of the 1990s was mainly a `scarcity effect'. Enticed by the double-digit market gains of the mid-1990s, institutional investors have invested ever larger amounts in domestic and, increasingly, foreign equities, in the process driving up the prices of the very equities they bought, setting in motion a `virtuous cycle' of asset inflation and turning their buyand-sell decisions, because of sheer scale, into a veritable `Ponzi-scheme' (Toporowski, 2000, pages 49 ^ 63). Add the enormous amounts of equity retirements, either through buybacks or mergers and acquisitions (Brenner, 2002, pages 146 ^ 153), and the short supply of government bonds resulting from the new policy fad of balanced budgets (Ferguson, 2001, page 318), and it is not hard to see why equity prices reached historical levels (Brenner, 2002; Lazonick and O'Sullivan, 2000; O'Sullivan, 2000; Shiller, 2000). Interestingly, a number of financial economists have recently started to investigate the link between demographic changes and the demand for capital assets, analysing the claim that the life cycle of the baby-boom generation, especially through the accumulation and subsequent decumulation of pension funds, can explain the long-term boom and bust of the equity market (one of Shiller's twelve `precipitating factors'; see Shiller, 2000, page 25). According to this claim, pension funds are affected by changes in the ratio between contributors and beneficiaries, which will gradually transform their investment behaviour. Within the life cycle of a pension fund a so-called èxpansion phase' is followed by a period of relative


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equilibrium that is best called the `maturation phase', and, finally, depending on demographic and/or economic developments, by the ultimate `retirement phase' or the `winding up' of the fund (Toporowski, 2000, pages 69 ^ 90). During the first phase, the fund is a net buyer of assets, has only limited need for liquidity, and is hence able to act as a `committed blockholder', reflecting an ìntegrative' or èntrepreneurial investor orientation' (Engelen, 2002). This changes when the `maturation phase' approaches. If the amount of actual liabilities reaches a certain threshold, the fund is forced to push the envelope of prudential investment in order to maximise returns, and is gradually turned into a net seller of assets because of a growing need for liquidity, implying a much more `speculative orientation' and a preference for more liquid and more sophisticated asset categories at the same time. As a result, mature funds tend to shift their focus towards those financial centres that are on top of the global market hierarchy and away from the local centres where most of their contributors live or away from the small and medium-sized enterprises where most contributors work, leaving these areas and segments relatively cash poor (Martin and Minns, 1995). As many large corporate and multiemployer pension funds `came of age' in the 1970s and are hence now reaching maturity, the very forces of accumulation that drove the spectacular stock-market gains of the 1990s, following the retirement of the baby boom generation, can be expected to turn into their exact opposite in the coming decades, resulting in stagnant or even falling asset values (Dent, 1998; Siegel, 1998; Sterling and Waite, 1998; Toporowski, 2000). The relevance of this thesis is obvious. For part and parcel of the argument for fully funded pension regimes is the presupposition that funded arrangements do not suffer from demographic `stress', at least not to the same degree as PAYGo systems. However, the empirical evidence appears to be mixed. Poterba, using data from the USA, the United Kingdom, and Canada for the past 75 years, claims that there is no robust empirical evidence linking demographic structure and asset returns. In particular, the decumulation claim is found to be spurious, as decumulation takes place over a much longer period and is much less pronounced than accumulation (Poterba, 1998; 2001). It is unclear if Poterba's study does indeed disqualify the demographic explanation of the equity boom and bust. As Poterba himself notes, his ``projected asset demand variable'' includes only defined contribution plans and leaves out demography-driven shifts in the assets of defined benefit plans (Poterba, 2001, page 583). As these plans still make up nearly half of total pension assets in the USA (USGAO, 2001, tables E5 and E11), and a much higher percentage in the Netherlands, Canada, Australia, and Switzerland, and as they are particularly prone to demographic `stress', their inclusion might cause Poterba to change his assessment. In fact, Miles reports about calculations that lead him to conclude that if private and public supplementary pension funds are included there is indeed evidence of an àge effect', at least on savings; ``While there is only a small decline in the average financial assets directly held by households as they move through retirement, there is a very marked fall in total net assets including pension wealth. Saving rates would be sharply lower on a wide definition of wealth than on a narrow one'' (Miles, 1999, page 8). A second qualification has to do with ÙS exceptionalism'. Recent studies stress the diverging demographic developments of continental Europe and the USA. Owing to a continuing influx of immigrants, and a structurally higher fertility rate, the US population is much younger than is the continental European population (Toporowski, 2000, page 145; UN, 2001b; USBC, 2000). Subsequently, the demographic effects on aggregate savings and hence on asset demands should be much less pronounced in the USA than in Europe.

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This argument is partially covered by Poterba by his inclusion, next to Canada, of the United Kingdom in his analysis. Even though, according to Poterba, there is not much difference in terms of àge effects' in these countries, the èxceptionalism' qualification can be laid to rest only if Poterba replaces his `narrow definition of wealth' for Miles's `wide' definition. However, the qualification itself requires a rapid inclusion of immigrant workers in defined contribution and defined benefit pension plans to be valid. As of now, there still appears to be a steady growth of participants in both types of schemes in the USA, suggesting that immigrants and other newcomers on the labour market do indeed have access to employment-related pension arrangements, implying that demographic stress will indeed be less pronounced in the USA. A final qualification has to do with increasing market integration. As Poterba notes, the decumulation thesis presupposes a closed financial system (2001, page 583). As there is increasing evidence of a gradual integration of capital markets as well as of an increasing internationalisation of investment strategiesöpartly because of maturation effects, partly because of the global drive towards capital market liberalisation (Lu«tz, 2002)ödeep and liquid capital markets such as Wall Street and the London Stock Exchange can expect to keep receiving global pension savings, resulting in a spatial distribution of saving and investment, masking the downward effects on equity prices of the gradual maturation of US pension funds and turning Europe into a reserve of rentiers. Although these qualifications cannot all be true at the same time, they do point to the fact that more sophisticated research is needed before the decumulation-thesis can be laid to rest. In particular, the price effects on US assets of international pension saving inflows have to be studied in more detail, as is the case with the asset effects of the shift from defined benefit to defined contribution plans that is currently occurring in the USA. Finally, more information is needed on the incorporation of immigrants within pension arrangements before a policy of open borders can indeed be seen as a partial solution to the predicaments of a `greying' society. 4 Financialisation and the logic of funding That the contentiousness of the promises of funded pension regimes has not been perceived more widely has not only to do with the equity boom of the late 1990s, blinding policymakers and investors alike with double-digit returns, but also with the opacity of the logic of funding and the financial industry as a whole. For it is not widely recognised that there are causal linkages between funded pension arrangements, equity market booms and the asset inflation connected with it, and wider changes in the productive sphere. In the remainder of the paper I will elucidate these linkages. 4.1 The objectives of pension funds

In general, pension funds have four objectives, that is, (1) the minimisation of risks, (2) the maximisation of returns, (3) ensuring liquidity, and (4) the minimisation of costs. As pension savings are deferred wages there are good moral and prudential reasons for risk diversification. As such, it makes sense for trustees to distribute assets over a large number of asset categories with complementary risk and return profiles. The same holds for the maximisation of returns. As surpluses, generated by market gains, are translated into lower contributions in the case of public and multiemployer pension funds, and in substantial paybacks and/or lower contributions in the case of corporate funds, `principals'öthe sponsoring corporation(s) öhave an evident interest in creating an incentive structure to incite àgents'öthe trusteesöto maximise returns. The third objective is closely related to the life cycle of pension funds during which the ratio of contributors and beneficiaries changes gradually, transforming their


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risk profile and hence their investment strategies, turning committed blockholders gradually into speculative investors. Driving this process is an increasing need for liquidity, forcing pension funds to invest in the most liquid markets, and within these markets, in those stocks that have the largest daily `free float'. As decisions to sell can influence share prices negatively, pension funds seek to avoid becoming prisoners of their own investmentsöhence the decision to invest in those asset categories that can be traded easily, explaining the preference for well-developed asset markets and liquid investments, which is reinforced by legal investment restrictions rather than caused by them. Finally, there are strong economies of scale involved. Although it is extremely hard to come by reliable data, because funds do not have legal obligations to disclose costs and fees, it is obvious that investment management is costly, falling within the range of 0.2% and 0.4% for a portfolio worth between 22.5 million and 45 million, and being negotiable above that amount. Bond management costs are approximately half this amount. On top of management fees come commission fees, membership levies, exchange taxes, turnover fees, advertisement costs, computer investments, etc. Moreover, there are substantial search and assessment costs involved in picking new managers and setting up new mandates; information needs to be gathered and processed; and reputations need to be assessed, which is not only costly but is also surrounded with uncertainty. To understand how these objectives represent a binding `logic of funding', we have to analyse the investment decisions of pension funds in more detail and relate the changes these decisions undergo over time to the changing risk profiles of pension funds during maturation. In general, pension funds face two important management decisions. First, they have to decide whether to manage their assets ìnternally' or èxternally', and, in the second case, whether to do so ìntensively' or èxtensively'. Ìntensive management' relates to management by a small number of external managers, whose relation to the fund is long term, trust based, and is best described as `relational', and who manage a limited number of asset categories. Èxtensive management', in contrast, refers to management by a large number of competing outside managers, whose relation with the fund is short term, opportunistic, and best captured as `competitive', and who manage a large number of highly specific asset categories (Clark, 2000, pages 81 ^ 85). A large but immature multiemployer pension fund established in, say, the early 1950s would have opted for internal management, for there would have been only a weakly developed external market for management services. Moreover, employment costs could be kept in check rather easily, for there was hardly any danger of competitive `poaching' by external service providers. Last, such funds would have tended to follow conservative investment strategies, based on simple standardised financial data and consisting of a limited number of traditional asset categories önot merely for reasons of supply, but also for intrinsic reasons. As contributors would clearly outnumber beneficiaries, and would do so for a long time, the risk profile of the fund would be such that the requirements of risk minimisation trumped those of profit maximisation. Hence, their liability structure would induce these funds to follow a long-term investment strategy, investing in `blue-chip' stocks and government bondsöin fact becoming the committed blockholders so much eulogised in the progressive literature (Blackburn, 2002; Hutton, 1995; Roe, 1994). This changed gradually from the late 1970s onward, when, as a result of the aggregate maturation of pension funds, the balance between risk minimisation and profit maximisation shifted, with the growing need for liquidity only aggravating the

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tension between these objectives. For as soon as pension funds mature, their need to push the envelope of existing investment norms and practices grows, resulting in increasingly speculative behaviour and a frantic search for financial innovations. Subsequently, ever more specialised and sophisticated asset categories are demanded and constructed, setting in motion a gradual externalisation of investment management, ultimately resulting in an elaborate and complex division of managerial labour. The immediate forces driving this process are: (a) information asymmetries, where, under conditions of growing complexity, trustees face an increasing inability to follow and comprehend industry developments and assess different asset categories and products adequately, and, (b) the increasing difficulties to hire and retain internal managers, as the market for management advice starts to look more and more like a `winner-takes-all market', with sky-rocketing remunerations, highly publicised transfers, and true `stars' or `masters of the universe'. Owing to the complexity of investment management, the scope of decisionmaking by the fund's trustees is increasingly restricted to parametric decisions öthat is, decisions related to the distribution of total assets among different asset categories and the accompanying choice of consultants, who, in turn, serve as intermediaries between trustees and external managers and are paid to select different managers for different asset categories by using detailed performance and reputation assessments. The crucial point is that the aggregate maturation of pension funds serves as a powerful incentive for the financial industry as a whole to consolidate as well as specialise and hence to grow. The incentive to consolidate has to do with the minimisation of management costs and the economies of scale involved and affects both the supply side and the demand side of financial markets. One way to reap economies of scale is through pension-fund mergers, a route that is currently being pursued by an increasing number of funds. A second way is by means of splitting up management and administration and assigning these tasks to distinct commercial providers. A third is the joint establishment of specialised funds. For suppliers, costs can be kept in check by increasing the amount of capital, not only because many taxes and commissions are regressive, but also because scale gives intermediaries more market power and hence a greater leverage over other agents during price negotiations. This has resulted in a highly consolidated market of investment management and consultancy. The world's top-ten money managers currently hold $6.3 trillion of a worldwide total of $15 trillion of pension savings, whereas the next forty largest managers manage $7.6 trillion. The market for consultancy, where the ten largest firms represent asset values of $5.8 trillion, is almost as oligopolistic (P&I, 2003). Equally powerful is the push towards specialisation. As maturation forces pension funds to strike a balance between risk and return, and as the need for liquidity disallows large-scale investment in nontradable assets, the solution to this trilemma is increasingly sought in a further differentiation of asset categories, and, within these categories, of investment products, meanwhile creating highly specialised market niches populated by highly specialised (or not so specialised, but simply cheap and not so reputable) craft producers, the so-called `boutiques'. As such, the increasingly sophisticated investment products demanded by investment managers in the service of their pension fund clients is one of the main driving forces behind investment innovation and the proliferation of derivative markets. This results in a highly fragmented market for financial services, consisting of a low-risk, low-yield market populated by a handful of reputable firms on the one hand and a large number of high-risk, high-yield markets composed of a large number of highly specialised financial services providers on the other. Although the bulk is still


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invested in the low-risk, low-yield market and managed by long-term service providers whose reputations guarantee high quality and who are paid to trail the index, with a well-developed business press and highly institutionalised rating agencies taking care of assessment, the fund's trustees divert a growing amount of capital to more risky asset categories, despite the opaqueness of these markets and despite the absence of well-established reputations. Moreover, it has transformed the finance industry from a facilitator of other firms' economic growth into a growth industry in its own right. The total value of the US financial industry increased from $1 trillion in 1990 to almost $1.8 trillion in 1999. Expressed as a percentage of US GDP this represents an increase from 17.4% to nearly 20%. Total employment in the financial service sector more than doubled between 1970 and 1998, from 3.6 million to 7.7 million. Total revenues of the US securities industries rose from $19 billion in 1980 to $266 billion in 1999, and net pretax income increased from $3 billion to $29 billion over the same period. And to disaggregate even further, the volume of trading on the New York Stock Exchange increased twenty-fold in numbers of shares tradedöfrom 11 billion in 1980, to 265 billion in 2000öand their value rose from $382 billion in 1980, to $11 trillion in 2000.(4) Add to these figures the increasing weight of portfolio incomes in total nonfinancial corporate cash flowö reaching levels as high as 45% in the early 1990s, before dropping back to 35% in the late 1990s (Krippner, 2002)ö and it will be obvious that the weight of financial activities within the US economy has indeed become hard to overlook. 4.2 The dangers of financialisation

Does this imply financialisation? First, a financialised economy is more than an economy with a large and deep equity market, for the New York Stock Exchange has always been deep and liquid, at least since ìncorporation' started, but has only during the past two decades turned into the `master of the economic universe' it is today (Krier, 2001). Rather, financialisation refers to a gradual process in which financial values (shareholder value, capital market gains), backed by a professional business press and other well-organised interest groups (Harmes, 1998; 1999), become leading institutional and organisational design criteria (Froud et al, 2000, pages 103 ^ 104), with the financial sector as a whole, because of sheer scale, starting to dominate cities, regions, and even national economies (Martin and Minns, 1995; Minns, 1980). This is not only in terms of employees, firms, and share of financial flows, profits, and investments, as authors such as Castells (1996), Sassen (2001), and Bell (1999) maintainöwho each in his or her own way, has tried to describe and explain the structural shift from manufacturing to servicesöbut rather in the sense of installing a new regime of accumulation, as a number of authors have suggested. Using either Post-Marxian (Aglietta and Breton, 2001; Boyer, 2000) or Post-Keynesian perspectives (Minsky, 1992; Toporowksi, 2000; Whalen, 1999), or a combination of both (Pineault, 2001), these authors have stressed the derivative nature of public equity markets and have identified the asset demands of pension funds and other institutional investors as the main drivers behind the reversal of the causal link between the real and the financial economy that is characteristic of a ``finance-led accumulation regime'' as Boyer has dubbed it (2000, page 116). Toporowski, in particular, has argued that the large influx of pension savings since the mid-1970s has transformed the èntrepreneurial capitalism' of yesterday into the `rentier capitalism' of today. Because of the volatility and uncertainty of the returns on fixed capital investments, equity markets are inappropriate sources for (4)

See US statistical abstracts, at http://www.census.gov/prod/2002pubs/01statab/banking.pdf.

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real investment capital. Instead, they merely serve a `refinancing function', giving òwners' the opportunity to replace illiquid assets for liquid assets. In other words, no new `productive capital' is added to the total stock by equity emissions and initial public offerings (Toporowski, 2000, pages 22 ^ 23). However, despite equity markets being marginal to the productive process, the excess inflow of pension savingsöitself an effect of the aggregate maturation of pension funds (Toporowski, 2000, pages 65f ) and an increasing preference for liquid assets that, unlike bonds, have no maturation limits öhas resulted in `capital market inflation', turning corporations into corporate rentiers who increasingly face an incentive structure that rewards equity investmentsöfor portfolio-building reasons, for reasons of mergers and acquisitions, or as equity buybacksöand punishes, relatively, productive investment. As rising share prices provide an outlet for corporate gains that is more liquid, more rewarding, and less uncertain than fixed capital investment, conventional notions of prudence require firms to become ever more oriented towards the financial sphere and its short-term emphasis on capital gains (Toporowski, 2000, pages 29f ). According to Toporowski (2000, page 53): ``The contribution of funded pension schemes to the corporate economy of the UK and the USA has been to inflate capital markets in which unproductive takeover and corporate restructuring activity flourishes, while industrial production and employment activity stagnate.'' This process is further enhanced by a ubiquitous finance and business press that serves as a ceaseless, hands-on òpinion board' and by a complex network of institutions and organisations that produce a constant `buzz' of `statsbabble' to arouse speculative desires among financial and nonfinancial traders alike (Toporowski, 2000, pages 41, 148). In a recent paper, Froud et al listed three conditions for economies outside the United Kingdom and the USAönotably, those on the European continent and Japanöto undergo a similar process of financialisation. These are: (1) the presence of shareholder-value oriented investors, (2) a sufficient amount of mobile capital, and (3) an adequate level of managerial discretion to increase factor mobility (read: labour) more generally (Froud et al, 2000, page 105). Taking Germany as the epitome of a nonliberal, nonfinancialised economy, it is obvious that some of these conditions are currently in the process of being met. As Beyer and Hassel (2002, page 327), on the changing corporate governance practices of German firms, state: ``the increasing orientation of firms towards international financial markets and the increasing importance of a market of corporate control'' has indeed resulted in ``changes in the distribution of net value added ... between different stakeholders'', notably from employees to òwners'. Moreover, given the fact that most legal changes that have been instrumental in the market of corporate control coming into being in the first place are fairly recent, whereas others, notably the harmonisation of accountancy rules, are pending (Clark, 2003), it is reasonable to expect these developments to become even more salient in the near future. It hardly needs to be stressed that the gradual introduction of a funded pension regime, providing both a `sufficient amount of mobile capital' [condition (2)] and, given the logic of funding sketched above, `shareholder-value-oriented investors' [condition (1)] will only strengthen them. What will the long-term effects of these changes be? Bearing in mind the earlier caveats concerning the reliability of extrapolations of multicausal processes, the outline of such a story would go something like this. If one accepts that the welfare of people depends on the ability of firms, sectors, and economies to innovate, and that innovation is more a matter of having the right organisation than of having enough `dough' or


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`brainpower' (Whitley, 2000), it follows that the focus of policymakers ought to be not so much on factor mobility as on the conditions for collective learning. As can be deduced from the rapidly growing literature on corporate learning (Lazonick, 2000; O'Sullivan, 2000), `patient capital', or firm commitments from capital providers that long-term objectives will not be trumped by short-term financial demands, is one of the most important enabling conditions for innovation to take place. It is obvious that a growing financialisation of the economy, driven by the logic of funding and pushing the case of `shareholderism', will reverse this order and will hence endanger the long-term wealth-generating capabilities of firms. The second condition, with reference to Beyer and Hassel (2002), has to do with the extent to which the distribution of corporate net value added is internally controlled. As it is highly uncertain which future activities will bring most rewards, the decision to invest retained earnings ought to be based on the type of tacit or situated knowledge only insiders possess. As shareholders have only crude and standardised financial data at their disposal, granting them a say over internal distributive issues will be paramount to eroding the future capabilities of the firm. Once again, it is obvious that the presence of a liquid equity market, a sufficient amount of mobile capital, and a sophisticated and large financial industry boils down to the creation of a corporate environment in which portfolio investments generate higher returns than do fixed capital investments, leading to a situation where equity buybacks, for instance, are perceived as more profitable than investments in research and development or training. The third, and final, condition, has to do with the degree of òrganisational integration'. This refers to the degree of hierarchical control within firms. In general, organisations consisting of complex structures of control and coordination and simple tasks have a low level of organisational integration, whereas organisations with a simple coordinating structure and complex tasks have a high level of organisational integration. As innovation is equal to collective learning, organisations that allow for a continuous exchange of knowledge are superior to organisations that have erected impenetrable walls between workstations, between business units, and between divisions. Of course, financialisation and `shareholderism' do not directly impact the organisation of production processes within firms. However, as the US case demonstrates, capital market inflation has effected a shift in focus of corporate USA, inciting US managers to spend increasing amounts of time and money on investor relations, with changes in the composition of the board of directors ö away from directors who made their career within the corporation and who possessed a thorough knowledge of the nitty-gritty details of product, process, and markets, towards directors with primarily financial backgroundsö clearly reflecting this shift. As the management of speculation has more and more replaced the management of production, the rift between top floor and work floor has deepened considerably, not only in terms of the in between organisational layers but also in financial, social, and cultural terms. A corporate culture that results in huge lay-offs, meagre growth in real wages, and an increasing precariousness of employment contracts on the one hand and exorbitant and increasingly fraudulent self-enrichment among the managerial cadres on the other is sure to breed antagonism and alienation. This is hardly the breeding ground for the reciprocal trust that is required for a free and easy exchange of insights, information, and knowledge (Capelli et al, 1997; O'Sullivan, 2000; Schor, 1992; Sennett, 1998). As Beyer and Hassel note, the spillover effects of the increasing financialisation of German firms on surrounding institutions such as labour relations, codetermination, and vocational training are still rather limited, enticing them to conclude that

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the `functional fit' between discrete institutions is apparently less solid than is assumed by dichotomous conceptions of models of capitalism. Instead, they argue that: `èconomic institutions in different spheres of the political economy are much more loosely coupled than is assumed in theory and that the specific national clusters of institutions are due more to historic coincidences than to systematic microeconomic linkages ... If this is the case, less patient capital might happily coexist with strong labour rights'' (Beyer and Hassel, 2002, pages 328 ^ 329). It remains to be seen, however, whether this claim (or, indeed, the German model itself ) will be able to withstand the corrosive effects of financialisation that will be unleashed by the flow of pension savings which, if the financial industry has its way, will before long flood the equity markets. Acknowledgements. I want to thank Andrew Pendleton, Gregory Jackson, Veit Bader, Julie Lawson, Gordon Clark, Greta Krippner, and two anonymous referees for their comments. The research for this paper was made possible by the Amsterdam Study Centre for the Metropolitan Environment. References Aglietta M, Breton R, 2001, ``Financial systems, corporate control and capital accumulation'' Economy and Society 30 433 ^ 466 Bader V M, 1997, ``The arts of forecasting and policy making'', in Citizenship and Exclusion Ed.V M Bader (Macmillan, Basingstoke, Hants) pp 155 ^ 174 Bell D, 1999 The Coming of Post-industrial Society (Basic Books, New York) Beyer J, Hassel A, 2002, ``The effects of convergence: internationalization and the changing distribution of net value added in large German firms'' Economy and Society 31 309 ^ 332 Blackburn R, 2002 Banking on Death, or, Investing in Life: The History and Future of Pensions (Verso, London) Bolkestein F, 2001, ``Defusing Europe's timebomb'', speech given in Brussels, 6 February, http://www.efrp.org/downloads/eu publications/Defusing Europe Pensions.pdf Boyer R, 2000, `Ìs a finance-led growth regime a viable alternative to Fordism? A preliminary analysis'' Economy and Society 29 111 ^ 145 Brenner R, 2002 The Boom and the Bubble: The US in the World Economy (Verso, London) Brooks S M, 2002, ``Social protection and economic integration: the politics of pension reform in an era of capital mobility'' Comparative Political Studies 35 491 ^ 523 Caldwell J C, 2002,``The contemporary population challenge'', in Completing the Fertility Transition (United Nations, New York) pp 72 ^ 79 Capelli P, Bassi L, Katz H, Knoke D, Osterman P, Useem M, 1997 Change at Work (Oxford University Press, New York) Castells M, 1996 The Information Age. Economy, Society, and Culture. Volume 1: The Rise of the Network Society (Blackwell, Oxford) Clark G L, 2000 Pension Fund Capitalism (Oxford University Press, Oxford) Clark G L, 2003 European Pensions and Global Capitalism (Oxford University Press, Oxford) Claus J, Thomas J, 2001, `Èquity premia as low as three percent? Evidence from analysts' earnings forecasts for domestic and international stock markets'' Journal of Finance 56 1629 ^ 1666 Clowes M J, 2001 The Money Flood: How Pension Funds Revolutionized Investing (John Wiley, New York) Dent H, 1998 The Roaring 2000s (Simon and Schuster, New York) Dickson E, Marsh P, Staunton M, 2002 Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, Princeton, NJ) Disney R, 2000, ``Crises in public pension programmes in OECD: what are the reform options?'' The Economic Journal 110 (February) 1 ^ 23 Drucker P, 1976 The Unseen Revolution: HowPension Fund Socialism came to America (Oxford University Press, Oxford) Engelen E, 2002, ``Corporate governance, property, and democracy: a conceptual critique of shareholder ideology'' Economy and Society 31 391 ^ 413 Engelen E, 2003, ``How to combine openness and protection? Citizenship, migration and welfare regimes'' Politics and Society 31(4) forthcoming


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