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government. In most countries, the government guarantees bank deposits either explicitly or
implicitly. If the banks get into trouble, the government steps in and society as a whole bears
the burden. This is what happened in the crisis of 2007–2009.^27
Some people argue that firms are free to “invest for the long run” in bank-based systems
where financial institutions absorb business risks and few individuals invest directly in the
stock market. The close ties of Japanese and German companies to banks are supposed to
prevent the dreaded disease of short-termism. Firms in the United States and United Kingdom
are supposedly held captive by shareholders’ demands for quick payoffs and therefore have to
deliver quick earnings growth at the expense of long-term competitive advantage. Many found
this argument persuasive in the late 1980s when the Japanese and German economies were
especially robust.^28 When market-based economies surged ahead in the 1990s, views changed
accordingly. If short-termism is a problem in market-based economies, why not provide
incentives for shareholders to hold on to their shares? France, for example, already has adopted
a rule that gives extra voting rights to long-term shareholders. The danger is that disenfran-
chising new investors may serve to entrench incompetent managers.
Growth Industries and Declining Industries
Market-based systems seem to be particularly successful in developing brand-new industries.
For example, railways were first developed in the United Kingdom in the nineteenth century,
financed largely through the London Stock Exchange. In the twentieth century, the United
States led development of mass production in the automobile industry, even though the auto-
mobile was invented in Germany. The commercial aircraft industry was also mainly devel-
oped in the United States, as was the computer industry after World War II, and more recently
the biotechnology and Internet industries.^29 On the other hand, Germany and Japan, two
countries with bank-based financial systems, have sustained their competitive advantages in
established industries, such as automobiles.
Why are financial markets better at fostering innovative industries?^30 When new products
or processes are discovered, there is a wide diversity of opinion about the prospects for a new
industry and the best way to develop it. Financial markets accommodate this diversity, allow-
ing young, ambitious companies to search out like-minded investors to fund their growth.
This is less likely when financing has to come through a few major banks.
Market-based systems also seem to be more effective at forcing companies in declining
industries to shrink and release capital.^31 When a company cannot earn its cost of capital and
further growth would destroy value, stock price drops, and the drop sends a clear negative
signal. But in bank-based financial systems, uneconomic firms are often bailed out. When
Mazda faltered in the 1970s, Sumitomo Bank guaranteed Mazda’s debts and orchestrated a
rescue, in part by exhorting employees within its keiretsu to purchase Mazda cars. Sumitomo
Bank had an incentive to undertake the rescue, because it knew that it would keep Mazda’s
business when it recovered. In the 1990s, Japanese banks continued to lend to “zombie” firms
(^27) Another possibility is that banks that take a long-run view and are not subject to intense competition can smooth risk across different
generations by building up reserves when returns are high and running them down when returns are low. Competition from financial
markets prevents this type of intergenerational risk sharing. Generations with high returns want to receive their full returns and will
not be willing to have reserves built up. See F. Allen and D. Gale, “Financial Markets, Intermediaries, and Intertemporal Smoothing,”
Journal of Political Economy 105 (June 1997), pp. 523–546.
(^28) See M. Porter, “Capital Disadvantage: America’s Failing Capital Investment System,” Harvard Business Review, September/
October 1992, pp. 65–82.
(^29) There are counterexamples, such as the development of the chemical industry on a large scale in nineteenth-century Germany.
(^30) See F. Allen and D. Gale, “Diversity of Opinion and the Financing of New Technologies,” Journal of Financial Intermediation 8
(April 1999), pp. 68–89.
(^31) See R. Rajan and L. Zingales, “Banks and Markets: The Changing Character of European Finance,” in V. Gaspar, P. Hartmann,
O. Sleijpen (eds.), The Transformation of the European Financial System, Second ECB Central Banking Conference, October 2002,
Frankfurt, Germany (Frankfurt: European Central Bank, 2003), pp. 123–167.