Free Market or Regulated Financial Systems - Article Example

Is it free market or regulated financial systems that underpin long-term economic success and effective corporate governance? : Tutor: Date: A - Explaining different types of Economic Systems Economic Systems An economic system can be explained as a coordinated way in which a government allocates its economic resources or distributes goods and services throughout the national community. It involves coordination of various institutions and agencies as well as consumers in a given nation (Carson and Traynor, 1996). It is a free market economic system with minimal regulation that underpins the long-term economic success and effective corporate governance. To successfully study economic systems, of an essence is an understanding of how various agencies and institutions are connected to one another. As well, of interest is the way information is shared between these agencies, the social association within a particular system, and this affects corporate governance. There are various economic system as discussed below. 1. The free market system In a free market system, decision about what is produced is an outcome of separate individual decisions that are made by consumers, producers and owners of factors of production. The decisions reflect private preferences and interests. In other word, it is a market based on forces of demand and supply with no government interventions. Organisation is free to come up with their governance policies. Mises (1998) asserts that, in a free market system individual, works for themselves while at the same time working for social interests. Through market forces, the decisions about what, how, and for whom to produce are taken. The US finance industry has thrived in a free market system, it has been strong and generally well regulated. The market demands dictate the levels of interest rates. Financial institutions use the framework provided by the Federal Reserve Board to price their credit facilities, this way, the market gives rise to the concept of Consumer Sovereignty. Consumer sovereignty, as discussed by Nazemzadeh (1998) is a situation in which consumers are the ultimate dictators. Subject to the level of technology, variety and quantity of goods and services to be produced in an economy. Consumers will exercise this power by bidding up the prices of the products of their preference. Supplier motivated by the lure of higher profits, produce more of the goods. Below is a curve that shows how an equilibrium point is set up by the forces of demand and supply in free enterprise system. Demand Curve Price Equilibrium Point Supply curve Quantity (Nevile, 1993) Characteristic of a free-market 1. There is a free ownership of factors of production. In USA, Bank of America shares are traded on the New York Security Exchange. Willing member of the public can own these shares. 2. Freedom of Choice and Enterprise. Entrepreneurs are free to invest in business of their source. Likewise, workers are free to sell their labour and occupations to the industries of their choices. Consumers are free to buy products of their choosing. 3. Self-Interest as the Dominating Motive. Bank of America Corp. aims at maximising their profits, its workers aim at maximising their wages. In a free market system, owners of factors of production aim at maximising their returns. Consumers objective is to maximise their satisfaction. Majority of the companies in the nations in context aim at maximising profit by captivating a huge market share. 4. Competition. Economic is the order of the market, in the market for each. The system has an incentive. People are encouraged to work hard since opportunities exist for individuals to accumulate more wealth. In a free market, people can spend their resources how they want; they can either decide to set up their firm or decide for whom they wish to work for. Additionally, competition weeds out fewer efficient producers while more active producers supply their products at lower prices for the consumers and by using factors of production more efficiently. Competition also stimulates new ideas and processes, which again leads to efficient use of resources (Scherer and Ross, 1990). There exist disadvantages of a free market economy. The system gives rise to market failures, where the market system fails to provide an optimal allocation of resources. The well-off members of the society tend to accumulate economic and political power while, at the same time, the poorer members have much less influence. Portney (2003) argues that, market system has lead to the production of numerous luxury vehicle being produced in the USA economy. 2. Planned economy In this type of a system, all the main economic decisions are made by a government through its agencies or planning department. The government determines all allocation of resources. The government of China used to plan its economy centrally economy before it liberalised the market in 1978 (Park and David, 2006). In a planned economy, businesses are owned by the government; corporate governance policies are decided by the state. Characteristics All economic commands are exclusively from the state. The government decide what is manufactured, how it is made, how much is made and how distribution takes place. Factors of production belong to the government and are managed by the same government on behalf of the citizens. The levels of prices are not determined by the forces of supply and demand but are fixed by the government. Although there exist division of labour and specialisation, planned economies tend to be more self-sufficient. Their sufficiency can be attributed to their minimal involvement in the international trade as compared to free market economies. Certain advantages can be attributed to a planned economy. Central planning may encourage full usage of the available factors of production thereby reducing unemployment. It encourages large scale production that makes economies of scale possible as a result of mass production taking place. Additionally the system ensures there is less concentration on making luxuries but put an emphasis on the responsibility of giving goods and services to the general public (Nelson,1987). Planned economies have limitations, and that include: Consumers have little or no influence on what is produced. In planned markets, there lacks incentives to improve the existing production systems. Labourer has no real incentives to work harder; this makes levels of production remain small. As well, central planning encourages a form bureaucracy that leads to inefficient planning and communication breakdown. Governance in business is left at the digression of the government issues policies. The management of state-owned business in China have to rely on government orders and procedures to run this companies (Fan et. al., 2007) 3. The Mixed Economy A mixed economy has the features of both a planned and a free enterprise system. Practically the economies of the USA, the UK, Germany Japan and China are all mixed economies. The level of mix in any given economy is influenced by cultural, historical, political factors. For instance, currently in the Chinese the government still plans and control particular sectors of the economy. For example defence and education while providing the very basic healthcare services for those who cannot afford (Wiston et. al.,1994). Government policies and regulations which is an aspect a mixed economic system directly affects the interest rates in the respective nations financial industry. The table below compares Real Interest Rates in China, Germany, Japan, US and UK as of 2013. Real interest rate being the prevailing lending interest rate that is adjusted for inflation as measured by the GDP deflator. Country 2010 (%) 2011 (%) 2012 (%) 2013 (%) China - 0.8 - 1.2 3.9 4.2 Japan 3.8 3.4 24 1.9 Germany 1.6 1.5 0.75 0.5 USA 2.0 1.2 1.4 1.7 UK - 2.6 - 1.6 -1.1 1.2 (World bank, 2015). 4. Transition Economies These are economies undergoing change from a centrally planned economic structure to a free market. Economies in transition liberalise their market, where market forces are left to determine prices in contrast to a centrally planned system. There is the removal of trade barriers with massive privatisation of state-owned corporations and resources. There is an establishment of a financial sector to facilitate circulation of capital. When economies are in transition, transfer of ownership from the government to the private entrepreneurs is not enough to create powerful incentives for management to engage in the enterprise economies in line with objectives stockholders (Meyer, 2003). B - How do differences in Economic Systems explain differences in Corporate Governance of firms in these countries The concept of corporate governance evolved from developed nations where the competitiveness of business was determined by how a company was owned and governed. In the economies of Germany and the USA, political influence has facilitated the emergence of a new type of "shareholder capitalism" in the finance industry. It has come up as a result of the fact that, the two economies have an increased reliance on stock markets, enormous institutional investors, and equity financing. This type of capitalism comes up with more pressure, strategic and structural reform as well as a convergence on the Germanys economy. Nonetheless, policymakers in both economies have had time to deal with conflicting interests of stockholders, the management, and workers in corporate. These conflicts have served to shape the politics and policy surrounding corporate governance reform (Cioffi, 2002). Different economic system presented different corporate governance problem. In a free market system characterised by concentrated ownership, the key problem is between the shareholder who owns large amounts of share and minority investors. External financing can only be availed by outside or minority investors in case where the management or the large shareholder decide not to exploit their benefits of control. These benefits are private in nature and range from outright embezzlements to insisting on staying on the job even they are incompetent (Shleifer and Vishny, 1997). Shleifer and Vishny have proposed that a functional system of corporate governance is possible at a time when the ownership of companies is be seeking to enforce profit-seeking behaviours. It can be easy in a system that has the large shareholder, whereas it only likely occur through the mechanism of hostile takeovers in the case of a system with no controlling shareholder. To ensure efficiency, the legal rights of all the external fund suppliers needs to be taken into consideration and protected. There are issues that affect agency approach to corporate governance. Investment financing patterns in the free market economies like the USA and UK and the procedures through which the management is disciplined in firms that are not doing well in the market. As well, there is usage of equity though minimal, as a source of financing even in the USA and the UK (Corbett and Jenkinson, 1997). Corbett and Jenkinson have compared usage of money between 1970 - 1994 in USA, UK, Germany and Japan. They found out that the UK, Germany and the US utilise internal sources of funding for external sources, that is, market sources are playing a minimal role. In a free market system, there is a relationship between management turnover and poor performance. Kaplan (1994a, b) found out that salary cuts as measure of disciplining managers and dismissals when companys performance fall below established point is common and similar to organisations in Germany, the USA and Japan. Ownership differences coupled with control structures across these economies could not be perceived create variations in this aspect of executing corporate governance. Elsewhere, Mayer (2003) emphasises that concentration of ownership, takeovers and changes in shareholding and share stakes in the financial industry could have another effect rather than ex-post monitoring. If Ex-post monitoring is in place, and then the major difference between a financial system and concentrated ownership by companies not commercial in nature would be that, each entity is able of maintaining different sets of activities. Corporate governance system in Germany financial services industry is different from other nations. This is because it foresees the possibility to integrate lenders, borrowers and the employees in the process of governing these corporate entities. In German, the system of corporate governance has been depicted as the standard illustration of a system controlled from inside and a much stakeholder-oriented system (Schmidt, 2004). China was the first centrally planned economy to try to transition to a free market economy. The reform that began in 1979 saw privately owned enterprises compete with state-owned companies. The results of the changes were overwhelming, with the economy picking up and displaying substantial growth rate over the decades that followed. According to Nolan (1994) the success can be attributed to the fact that, Chinese reforms were gradual and incremental although this not supported by any economic theory. Sachs and Woo (1994, 1997) argued that the vast agricultural sector, minimal number of industries, lack of financial subsidies in addition to the huge diaspora population gave China a competitive edge during the transition period. During the transitioning period, challenges in corporate governance were experienced mainly in the industrial and financial system. Lin (2001) asserts that, ways of enhancing enterprise efficiency by establishing a balance between the State and the enterprise system have been at the heart of the Chinese Authorities for long. Development of reliable financial systems and how to govern them free of state involvement was a challenge the Chinese face. C- How do differences in Economic Systems explain differences in Economic Success of these countries? Campbell (2004) held that, in a majority of advanced countries, Germany, USA, UK and Japan, a skilled workforce was undeniably one of the keys to industrialisation and economic prosperity. Germany economy is operated as a social market economy, it reflects the principles of a free market system where all members of the society benefit. It is centrally structured but not dictated by the government. The government of Germany liberated the rights to train the workforce and accredit their skills during the early 19th century. As a result, skill formation did not at any time become an issue between workers union and employers. Apprenticeship became an attractive option for young graduates. This enabled the system to succeed and provided the banking and finance industry with skilled labour during the 20th century. Yoder (1998) asserts that when East and West were merging, there were concerns revolving around the uncertainties of the political and economic transition. Issues concerning job insecurity, economic restructuring, and the unfamiliarity with new social and political dispensation had to be dealt with adequately. After that, Germanys economy with its cautious blend of market capitalism, organised social welfare, and high protection of workers has continued to serve the citizens well over the years. The UK operates a mixed economy. Campell (2004) argues, through liberalisation, the UK government destroyed artisanal organisation in UK, and this allowed craft union to control training of the workforce. Firms management tried to fight back, and this gave rise to labour-management conflicts over training programmes that never reached the resolution. The conflicts served to ensure that training of labour was not as standardised as was the case in Germany. Lack of state control in the job market left employers to use apprenticeships since they were cheap compared to the skilled workforce. Apprenticeship was never attractive to young graduates. This in effect had an adverse influence on the rate of industrialisation. The Japanese economy has grown to a highly industrialised free-market economy due to the government policies. The government depended on independent artisans for the training and certification of labour skill. To organise the labour subsector, the government disbanded all artisanal organisations. With the assistance emerging trade unions coupled with governments help, the automobile subsector was able to develop and manage strong in-house training programmes. This attracted young Japanese graduates to invest in career development and advancement within the high-quality programmes run by the employing companies. Success of the labour sector in the Japanese economy can be attributed to the intensity of investment place on in the private sector training (Odagiri,1994). The government also encouraged westerner to relocate to Japan to teach science, technology and mathematics to the local population. The Japanese economy has elevated education as an important tool for economic success. The government of the US did not take measures to organise the artisans. As a result, craft unions were relatively weaker. Automobile companies in the USA were free to devise their labour objectives and strategies; they aimed at implementing mass production techniques that required minimal input from skilled workers. The unregulated job market experienced conflict between a labour union and the employer. Skilled labour was absorbed and trained foremen who supervised semi-skilled labourers. Apprenticeship suffered a great deal when firms abandoned a broad based in-house training programmes. Instead, firm concentrated on training supervisors and hiring college graduates to take over these roles. After the Great Depression, the federal government continued to regulate certain sectors like banking strictly in a bid to ensure equitable gains for all (Mitchener, 2005). Nations that have transitioned from a purely planned economy to free market enterprise system have reaped big in terms of economic growth. China economy is a blend of planned market and free market system. Most business and more so manufacturing firm are run by the government. An example is SAIC Motor, a corporation run by the Chinese government. Government involvement has enabled the economy to become the world number one manufacturing centre. From the year 1978, Chinese economy has sustained a growth rate never experienced before. Over the last three decade, the national GDP has grown by over ten percent annually. Competition brought about by liberalisation of labour market ensured that high-quality skill are developed. Availability of cheap labour is now attracting manufacturer to relocate to China (Park and David, 2006). The graph below shows how Chinese economy has grown over the last three decades GDP Year (Zhu, 2012) Conclusion The diversity of the economic systems in this nations allowed for incremental economic growth and development under different environments. Progressive changes in states economy took place as a result of changes in corporate governance and state interventions. Additionally, it is evident from this analysis that, a free market system with minimal regulation underpins the long-term economic success and effective corporate governance. References BLANCHARD, O., 1997. The Economics of Post-Communist Transition Oxford: OUP CAMPBELL, J.L., 2005. 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