After the Great Depression and through the 1980s, the financial sector was regulated to serve the rest of the economy. Today, it serves mostly itself. It’s time that changed.
When even Larry Fink is talking about too much short-termism in our economic lives, you know something important is going on—perhaps an inflection point in the making. A lot of what ails us economically, many smart people say, can be sourced directly to the unwinding of rules that kept the financial sector more or less contained. Later this month, I’m going to be commenting on the financialization of the economy, building on the work of famed economist Edith Penrose, noting how her work could have anticipated many of the issues we are grappling with today.
How we got here: An end to boring banking and the growth of the financial sector
From the New Deal era right through the Reagan era, banking was boring. Banks were prohibited from many of today’s creative financial engineering practices. Bankers, of course, hated that. Aided by a deregulatory ideology and abetted by their political clout, they succeeded in persuading policymakers on both sides of the aisle to lift many of the limits the sector operated under, including the repeal of limitations on using government-backed savings to engage in speculative investment, such as Glass-Steagall.
The financial sector made up 3-4% of Gross Domestic Product from the 1940s to the 1970s. It’s above 7% today, with some arguing it’s as high as 9%. Moreover, relative to the rest of the economy, the financial sector is far more profitable and its denizens are paid much better. In the era of boring banking, a researcher found that in 1978 the average salary of a worker in the financial sector was $48,300, compared to the average full-time worker salary of $48,100.
Stunningly, a recent report found that the average salary of a worker on Wall Street was $422,500 (yes, that’s over four hundred thousand dollars). Median household income in the US? $61,372. Nouriel Roubini (of “Dr. Doom” fame) and Stephen Mihm went so far in their book Crisis Economics to call the growth of the financial services sector “cancerous.” Other scholars have pointed out that unintentionally, too large a finance sector funnels investment into existing assets, such as housing, and starves productive investment in innovation.
One counterintuitive outcome: even as efficiency in virtually every other sector has increased, the cost of financial intermediation has ballooned over the decades, from 5% in 1980 to 9% in 2010. What that means, economist Thomas Philippon argues, is that there is a simple answer to that left-behind feeling many Americans have. It’s that the benefits of economic growth have flowed disproportionately to the financial sector and to the investing class, which has creatively found new ways to make money by moving money around.
More frequent and more expensive crashes—this time is not different
Charles Kindleberger in his book Manias, Panics and Crashes found that historically, a major crash occurred somewhere in the world about every seven years. And yet, economists Carmen Reinhart and Kenneth Rogoff in their book This Time is Different: Eight Centuries of Financial Folly, found that in the first 35 years or so after the Second World War, there was virtually no financial crisis anywhere in the world. Why was this the case? They attribute this to finance playing a smaller role in the economy, as financial regulations were stringent (banking was boring, remember). Because so much of finance depends on trading of investments with uncertain futures, a hiccup anywhere in the chain of trades can act like a collapsing house of cards, as one trade washes over others.
So here we are in 2019, a decade after the financial crash and the great recession and two decades after Long Term Capital’s implosion. Unfortunately, the patterns of those two great traumas taught people that it was possible to play a game in finance in which gains are privatized and losses are socialized.
If you’re going to be bailed out, why not take outsize risks? We’re literally seeing the same headlines about lucrative but risky trading that we’ve seen before. As Damian Paletta of the Washington Post writes, we need to once again be prepared for “How regulators, Republicans and big banks fought for a big increase in lucrative but risky corporate loans.”
Strangling growth and other unintended consequences: Why financialization matters
While entire books have been written on this topic, it is worth highlighting a few other consequences. The first is that the bulk of activity in the banking sector isn’t funding productive growth. According to research done by academics Oscar Jorda, Alan Taylor, and Moritz Schularick, only 15% of the money sloshing around the financial industry is funding new investment in productive assets. Most of the funds are being spent on existing assets, such as housing, stocks, and bonds, leaving relatively little to invest in new assets, as is important for innovation.
Financialization has been linked to a decline in new business formation, as a financial sector more interested in short-term speculation doesn’t provide conventional access to capital for small businesses. It’s been linked to “profits without prosperity” as mechanisms such as stock buybacks allow profits to be distributed to executives and investors, without increasing the share of those profits that go to workers.
William Lazonick, an economist who has been studying the effects of financialization in general, and stock buybacks in particular, points out that companies are not investing in innovation. Rather, they are rewarding executives and shareholders, extracting value from previous investments in building capabilities in ways that do not benefit the other stakeholders of a firm.This will be core to my Penrose talks. As he says:
“…companies that have over decades accumulated productive capabilities typically have enormous organizational and financial advantages, known as ‘dynamic capabilities,’ for entering related product markets, either by setting up new divisions or spinning off new firms. The strategic function of top executives is to discover new opportunities for the productive use of these dynamic capabilities.When instead they opt to do large-scale open-market repurchases, these executives are in effect not doing their jobs.”
Lazonick’s research points to some staggering numbers. As he recently reported: “We found that from 1981 to 1983, … companies spent 4.3 percent of profits on buybacks. In comparison, from 2014 to 2016, these same companies spent 59 percent of their profits buying back their own stock.” The rule change that made buybacks essentially legal occurred in 1982.
Ironically, the buybacks that are often cheered by investors seem to weigh down the long-term potential of the firms that use them the most, according to research covered by CNBC. Indeed, rather than an IPO representing the start of a company’s journey to stable, long-term growth, research suggests that innovation declines by as much as 40% post-IPO.
Increased income inequality and globalization have all been linked to financialization, as have a decline in so-called good jobs. Boeing, for instance, began to outsource its production to keep capital expenditures and R&D costs down.
As Penrose herself anticipated:
“…The role of financial institutions as shareholders can now be seen to require much careful analysis, as does the role of directors in their financial managerial functions who, as Lazonick (1992) has so clearly shown, may well be more interested in their own financial rake-offs through high salaries, stock options, golden handcuffs, bonuses, etc. than in the growth of their firms.”
Huge profits to some, slow growth for the rest. It doesn’t sound like a very bright future.
What is to be done?
William Baumol, the famed economist, pointed out that if we want to understand where entrepreneurial energy in an economy is directed, we need to understand the structure of payoffs created in that society. In other words, if you want to change the outcome, you need to change what is rewarded. If incentives (as they once did) offer better rewards to productive entrepreneurship, you’re likely to get that. If incentives reward non-productive “rent-seeking” or extraction, you’re likely to get that in contrast. The design of the structure of incentives is at its heart a problem for policymakers.
The financial sector as it stands isn’t likely to voluntarily put the genie of a large, lucrative financial services sector back in the bottle. There are, however, increasingly loud voices arguing for some kind of pushback against the size and influence of the sector and short-termism in general. In addition to Larry Fink voicing concern, there are a number of wealthy and influential people adding to the call for an inflection point that would change how economic short-termism and the functions of markets work.
Peter Georgescu, a refugee-turned-CEO, feels that the American economy no longer works for most citizens. “For the past four decades,” Georgescu has written, “capitalism has been slowly committing suicide.” Even Warren Buffett is talking about class warfare.
We didn’t get here overnight, and we won’t see a quick fix any time soon. That much being said, if we want to bring back a historically appropriate balance between the financial economy and the “real” economy, there are a few straightforward policy changes that could be a start. We could change the way buybacks are regulated, and Congress has started to show some interest. We could see a requirement that companies put workers’ representatives on their boards, as is quite common in European countries. We could use some of the funds currently going into buybacks to increase worker pay. We could take a page out of Costco’s book and recognize that providing good jobs can actually help everybody in the long run.
I’m not at all opposed to people making gobs of money. But if we are to believe Penrose, there should be a balance between returning enough to shareholders via dividends or other mechanisms and investing in the growth of firms, and thereby, our economy.