Economic Notes by Banca Monte dei Paschi di Siena SpA,

vol. 35, no. 2-2006, pp. 219–225

Essay Review on Raghuram G. Rajan and

Luigi Zingales (2003), Saving Capitalism from
the Capitalists, Random House, New York
GIOVANNI FERRI∗

This book by Raghuram G. Rajan and Luigi Zingales (RR–LZ) is a major

undertaking by the two authors who provide an interesting case of MIT
offsprings transplanted at the University of Chicago. To use the economic
jargon of the 1960s, referring to the heated debate between the Keynesian-
oriented Boston economists and the Chicago monetarists, we might say
that Rajan and Zingales have made an intriguing cocktail of sweet and
salty water. In today’s words, we could say that sweet water economists
were stressing public sector failures (the ineffectiveness/undesirability of
interventionist economic policies) while salty water economists emphasized
market failures (thus requiring government intervention).
RR–LZ try to escape the perils of rebuking exclusively public failures
(while neglecting the eventuality of market inefficiencies) as well as the
opposite danger of highlighting public policies too much (while disregard-
ing the virtues of the invisible hand). As we will see in some detail, the
book tailors a pro-free-market programme but this does not translate into
laissez-faire-type prescriptions. To the contrary, the two Boston–Chicago
boys advocate interventionist public policies to sustain free markets. They
do this referring mostly to financial markets and condensing several years
of their premier research in the economics of finance. Their refrain hinges
on the following political economy argument. In the absence of strong and
persistent pro-market policies, the capitalists may provoke the euthanasia of
capitalism: unless they are constantly stimulated to innovate, capitalists will
tend to indulge in rent-seeking behaviour and free markets may thus give
way to the dominion of the incumbent economic establishment. To be sure,
according to RR–LZ, the incumbent establishment will be most effective
at jeopardizing free markets when it can coalesce with the army of the
distressed, that is, segments of society suffering unemployment and/or per-
ceived economic marginalization. Suppression of free financial markets –
or, to that extent, retarding their development – is the first price to be paid
under this scenario. Thus, policies supporting financial market development
∗ Department of Economics, University of Bari, Via Camillo Rosalba 53, 70124 Bari, Italy.
Email: g.ferri@dse.uniba.it

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220 Economic Notes 7-2006: Review of Banking, Finance and Monetary Economics

are called for to protect free markets more generally. This brings in the need
for pro-free-market activist economic policies.
The big question is whether this sweet and salty water cocktail works.
We will return to this after reviewing the main contents of the book.
The book consists of four parts. 1 The first part (‘the benefits of free
financial markets’) describes the benefits of free financial markets. This is
not only the longest part of the essay but also the most rooted in economics
research at the frontier. RR–LZ question the belief that developed financial
markets benefit only the rich and the affluent. To the contrary, the authors
argue that when finance evolves harmoniously – that is, also the institutional
and regulatory infrastructure appropriate to sustain financial development
is adequately upgraded – it bestows new opportunities to everybody.
Namely, RR–LZ argue that, coupled with increasing competition and fast
technological progress, the impressive revolution of financial markets of the
recent decades has been the key to improving the allocation of economic
resources and, thus, has improved the growth potential. In their view,
this financial revolution has dramatically increased the chances for new
deserving capitalists to get rich. RR–LZ admit that financial markets may
temporarily deviate from fundamental values but judge that the benefits of
unfettered financial markets by far outweigh the costs of such short-lived
misalignments. RR–LZ ground this assessment on a masterful synopsis –
based on the most significant recent literature – of the evidence on the
finance–growth nexus.
This first part is the most persuasive component of the book but it is
not the major intent of the authors. Rather, RR–LZ want to use it as the
basis on which to ground their appeal for free markets. The second and
third parts of the book are strongly inter-related and found the argument
on an innovative reading of the economic and political history. As this
falls outside of RR–LZ’s usual domain, interpretations appear somewhat
looser. In the second part (‘when do financial markets emerge?’), noting
that the evolution of financial markets requires well-enforced property
rights, the authors recount how the respect of property rights developed
in England thanks to the growth of the bourgeoisie and the parliamentary
representation of its interests. RR–LZ argue that the build-up of the ade-
quate infrastructure to support financial market development is sometimes
checked or slowed by the influential establishment which would otherwise
stand to lose. At the same time, they remark that, however, the opposition
of the establishment against financial market development – or its ability
to hold it in check against the emergence of new productive groups –
is lessened in the presence of market expansions and/or of technological
breakthroughs.

1
Part of the assessment contained in this section draws on my previous review of this book
(Ferri 2005).

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 G. Ferri: Essay Review 221

The third part (‘the great reversal’) intends to explain why, according
to the proposed paradigm, financial market development regressed in the
1930s and did not resume until the 1980s. RR–LZ study in various depth
the cases of the US, Japan and Italy, certifying that financial markets
evaporated with the Great Depression. They argue that markets were
suppressed because, during the Great Depression, a dominating coalition
formed against free finance between the incumbent establishment against
financial evolution and large parts of the distressed middle to low classes.
As a result of the suppression of free markets, the system became a
‘relationship capitalism’, which subsided only beginning with the 1980s,
after some big shocks upset the economic and financial international order
which began at the end of the Second World War.
The fourth and final part of the book (‘how can markets be made more
viable politically?’) encapsulates the assessment of the current situation and
perspectives together with policy prescriptions. RR–LZ judge that today
four factors – globalization, technological change, aging and inadequate
global governance – bring with themselves the danger of creating large
segments of distress in rich societies, which might coalesce with the incum-
bent establishment against free markets. The authors propose a detailed list
of measures to support the free market and its acceptance. These pertain to
(i) measures to lower the establishment’s incentives against free markets,
(ii) creating a safety net to protect the losers, (iii) measures to trim the
influence by the establishment and (iv) educate and keep the public opinion
well informed of the benefits from free markets.
We are now ready to judge the virtues and the shortcomings of
the book. It is useful to distinguish form from substance. On a formal
level, it oscillates between the subtle first part and the less sophisticated
second and third parts. It is in the first part that RR–LZ are in fact most
successful at moulding together their expertise and their wit. The result
is a compelling and tight synthesis of the relevant literature tailored with
perspicuous fabric. Unsurprisingly, the book becomes less erudite when the
two eminent scholars venture outside the area of the economics of finance,
the field where they know very well what to seed and when to harvest.
This is suggested also by the extent of the referenced material, which is
proportionally much larger in the first part of the essay: whereas the first
part counts for 32.2 per cent of text pages, its share is 44.2 per cent in terms
of references and 44.4 per cent in terms of endnotes. Also the quality of
the references seems lower in the second and third parts – devoted to the
analysis of institutions and economic history – where some citations are
indirect.
Beside this asymmetry, the authors make a valuable effort to strengthen
the book. One way they do this is by taking a truly international perspective,
trying to avoid relying exclusively on the Anglo-American case as the
paradigm of financial market evolution. In this, the authors benefit from

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222 Economic Notes 7-2006: Review of Banking, Finance and Monetary Economics

their origins, coming, respectively, from India and Italy. To be sure, Zingales
does a good job here, as several pages are devoted to the Italian case,
drawing also on original materials, especially relating to the market reversal
of the 1930s. 2 Also Japan receives fair attention, while other potentially
relevant country experiences are touched on by and large only in the first
part of the book.
Whatever our judgment on the form of the book, is the substance of
this sweet-salty water cocktail tasty enough? In my view, the book has
many strengths but it also shows some weaknesses. Three stand out among
the former.
First, as said, avoiding to lean on either the market-failure or the
institution-failure ideologies, RR–LZ take a fruitful pragmatic method.
Their view that institutions and markets constantly interact and that the
incumbent establishment together with other interest groups play a key
role in this, as well as their conclusion that public intervention is needed
to make the market viable, are substantive achievements. All too often the
recent literature on cross-country comparisons of the degree of financial
development has taken an excessively naı̈ve approach to the interplay be-
tween institutions and markets. In their various papers devoted to this issue,
La Porta et al. (1997, 1998) ascribe the different financial development to
the type of legal tradition. Though these contributions have the merit of
drawing the attention to the impact of (a particular type of) institutions,
they appear unsatisfactory in that they fail to explain why the legal tradition
was chosen in the first place or why it was not changed if it turned out
to be inadequate. RR–LZ escape from the trap of assigning legal tradition
a predetermined and immutable role. For them, the institutions – the legal
and regulatory setup – interacting with financial markets are chosen, not
inherited, by society. That is why RR–LZ assign so much importance
to building and maintaining political support for the free market in the
public opinion at large. In this sense, the two Boston–Chicago boys reject
a naı̈ve evolutionary view of the free market. To the contrary, in their view,
unchecked capitalists – by pursuing rents – could short-circuit markets and
cause the euthanasia of capitalism. This brings the need for countries to
engage in activist pro-market policies.
The second merit of this book is making available to the informed
public opinion the recent advances in the literature. The tone used by RR–
LZ makes it readable to non-specialists. Indeed, the authors make a diligent
effort to represent difficult analytical findings of the literature in a plain
language. The result is a neat report. There is much value added in this.
Third, RR–LZ convincingly choose a multi-disciplinary approach. Top
journal economics is not the only angle to understand how markets evolve
and/or subside. Their use of case studies to support the proposed view gives

2
More on this aspect in Ferri (2005).

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 G. Ferri: Essay Review 223

the same dignity as economics to economic history as well as to political,

societal analyses and assigns a role also to market practitioners’ reports.
This is also a valuable trait, which is not so common among specialized
economists.
But the book has also a few shortcomings. I will discuss three of
these. In the first place, the two Boston–Chicago boys do not account
adequately for how the evolution of free financial markets tends to happen
in the country at the centre of the international economic and monetary
order. Using economic history, RR–LZ should have noticed that during
both eras of economic and financial globalization – at the turn of the 1900
and after the 1980s – the greatest financial development happened in the
country dominating the international economic affairs. While de Cecco
(1974) reminds us that this was the case in England during the first spell
of globalization, it is evident that the most pronounced financial evolution
materialized in the US during the globalization bout of the late twentieth
century. Thus, it appears that having the vehicle currency and setting the
international tone of monetary policy together with holding the exclusive
privilege in terms of lending of last resort 3 are all ingredients which may
have something to do with financial development. Following Kennedy
(1987), the argument could perhaps be taken to the point of considering
the evolution of finance as one of the ways to stretch the influence of
the country at the centre of the international economic order. Naturally,
this does not erase the benefits of financial development altogether but it
requires specifying that one country – the global economic power – may
be more equal than the others, i.e. those at the periphery. In other words,
the benefits from the evolution of finance could be significantly smaller for
peripheral countries and this might help to explain why they are usually
lagging in this respect. As it disregards this issue, the paradigm proposed
by RR–LZ seems less convincing than it could be.
Second, over their own academic careers, the authors shift from re-
counting the virtues to pointing out the fallacies of relationship finance. It
is not clear how they can offer a consistent reading of some of their earlier
results – for example, Rajan (1992), Petersen and Rajan (1994) – with
the paradigm of financial evolution they propose in this book. Academic
readers would like to receive a more thorough explanation of the seeming
contradiction.
Finally, connected to the previous remark, are we sure that, in
line with the interpretation proposed by RR–LZ, the financial evolution
à la Goldsmith (1969) – from bilateral intermediation to the multilateral
relationships of financial markets – is the best way to root capitalism?

3
It is perhaps worth recalling that the Fed appeared more forthcoming with its lending of
last resort when a large domestic hedge fund (LTCM) came under distress than when some emerging
countries were hit by systemic crises.

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In several cases – including that of Italy, cited by RR–LZ – it has been

observed that promoting the formation of the bourgeoisie was based on a
mix of land reforms (redistributing land ownership) and policies favouring
small business. At this juncture, it is worth remarking that the most
appropriate means to provide external finance to the small business –
see, for example, Petersen and Rajan (1994) – is relationship banking and
not financial markets. Furthermore, some scholars – for example, Verdier
(2001, 2003) – hold that, from the perspective of the political system,
centralized financial systems may negatively interfere with the functioning
of the democratic mechanisms, especially those relating to neighbourhood
associations. This should be discussed by somebody who writes a manifesto
to provide democratic support to the free market.

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 G. Ferri: Essay Review 225

REFERENCES

M. DE CECCO (1974), Money and Empire: The International Gold Standard, 1890–
1914, Totowa, NJ: Rowman and Littlefield.
G. FERRI (2005), Rassegna bibliografica di: in R. G. RAJAN and L. ZINGALES
(2003), Saving capitalism from the capitalists. Unleashing the power of
financial markets to create wealth and spread opportunity, in Rivista di
Politica Economica, luglio/agosto, Rome, pp. 315–26.
R. W. GOLDSMITH (1969), Financial Structure and Development, New Haven, CO:
Yale University Press.
P. KENNEDY (1987), The Rise and Fall of the Great Powers, New York: Random
House.
R. LA PORTA – F. LÓPEZ-DE-SILANES – A. SHLEIFER – R. VISHNY (1997), “The Legal
Determinants of External Finance”, Journal of Finance, 52 (3), pp. 1131–50.
R. LA PORTA – F. LÓPEZ-DE-SILANES – A. SHLEIFER – R. VISHNY (1998), “Law and
Finance”, Journal of Political Economy, 106, pp. 1113–55.
M. PETERSEN – R. G. RAJAN (1994), “The Benefits of Lending Relationships:
Evidence from Small Business Data”, Journal of Finance, 49, pp. 3–37.
R. G. RAJAN (1992), “Insiders and Outsiders. The Choice between Informed and
Arm’s Length Debt”, Journal of Finance, 47, pp. 1367–1400.
D. VERDIER (2001), “Social against mobile capital: Explaining cross-national
variations in stock market size in the OECD”, European University Institute
Working Paper SPS, No. 2.
D. VERDIER (2003), Moving Money: Banking and Finance in the Industrialized
World, Cambridge, UK: Cambridge University Press.

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