Wall Street and the Financialization of The Economy.

A new word has emerged in the lexicon of the new economy – financialization- defined as the “growing scale and profitability of the finance sector at the expense of the rest of the economy and the shrinking regulation of its rules and returns.” The success or failure of the financial sector has had serious effect on the rest of the economy and most of its returns have gone to the wealthy driving inequality.

As the New Deal regulations were slowly dismantled, the financial sector growth accelerated along with risks and speculation. The employment and total sales of the finance industry grew from 10% of GDP in 1970 to 20% by 2010. The emphasis was no longer on making things – it was making money from money.

At the same time the manufacturing industry fell from 30% of GDP in 1950 to 10% in 2010. The finance industry swelled as the rest of the economy weakened. The disproportionate growth of finance diverted income from labor to capital. Wall Street profits rose from less than 10% in 1982 to 40% of all corporate profits by 2003.

Since the 1980s, the financial industry has pursued short term financial returns over long term goals such as technology and product development investments. The financial industry, consequently, has played a major role in the decline of manufacturing in the U.S. for a variety of reasons.

Wall Street followed their capitalist instincts and saw that there was more profit in making money from money rather than in engineered products. They wanted quick returns of financial instruments and software rather than investing in the brick and mortar of expensive factories. They were also supportive of products that could be sold at Wal-Mart and manufactured overseas.

In an article in Industry Week, Susan Berger a professor at MIT makes the assertion that, “Since the 1980s, financial market pressures have driven companies to hive off activities that sustained manufacturing.” She gives the example of The Timken Company that was forced to split into two companies by the board of directors. The Chairman argued that the company should stay together because that is how it has been able to offer high quality products with good service support. The board overruled him based on the potential of better short term profits.

This stripping down the company to their core competencies has been forced on most of the large publicly held corporations to some degree. But in stripping them down, many critical functions are lost. For instance, apprentice type training has been lost in many American corporations because it is long term training and doesn’t have a good enough ROI. Basic research, funding to bring innovation to scale, and diffusion of new technologies to suppliers, have also been dropped or reduced because they are seen by the shareholders as being peripheral to the core competencies.

The growth of financialization also begs another important question. If innovation is the key strategy that will keep America in the race and its position as global leader, how can it happen without financial support? I can see where basic research and R&D are nebulous terms for shareholders that are hard to forecast as a financial return. But if these functions are not properly funded, how will we be able to compete with the rest of the world like we did in the twentieth century?

Why Financialisation has run amok.

My article last Friday, “Why IBM Is In Decline”, described how a cabal of senior IBM executives and the managers of some big investment firms got together and devised a five-year scheme—IBM’s Roadmap 2015—for increasing IBM’s earnings per share—and their own compensation—through measures that are not only increasing earnings per share but also steadily crippling IBM’s ability to innovate and compete in a rapidly changing marketplace. As revenues decline, while earnings per share increase through relentless cost-cutting and clever “financial engineering,” the rot within IBM continues.

The case is not an isolated one, as the excellent article by Gautam Mukunda makes clear in “The Price of Wall Street Power” in the June 2014 issue of Harvard Business Review. The IBM case is simply another instance of “excessive financialization” of the economy and the “unbalanced power” of the financial sector over management mindsets.

The insidious power of excessive financialization

“Real power,” Mukunda says, “comes not from forcing people to do what you want but from changing the way people think, so that they want to do what you want.”

Take for instance Sam Palmisano’s stint as the CEO of IBM from 2002 to 2011 and his account of it in his June HBR interview. Palmisano wasn’t “forced” to commit to doubling IBM’s earnings per share by 2015 and in the process steadily undermine IBM’s ability to innovate and compete. Instead, he welcomed it as a good idea and now, in the HBR interview, he even celebrates it as an example of excellent management. Not only that: he has launched a Center for Global Enterprise to disseminate this kind of “excellence” in management to other companies.

Palmisano’s HBR interview reveals no interest in “clients”, “innovation” or “trust”, the very IBM values that he had espoused, following his famous 2003 ValuesJam. Instead the interview describes the CEO’s role as one of “allocating capital” in ways that are “friendly” to the big investment firms. Instead of being obsessed with the real economy and producing ever better goods and services for clients, the focus is on “making money out of money.”

Creative vs distributive activities

“The British economist Roger Bootle, argues that all economic activity can be classified as either ‘creative’ or ‘distributive’,” Mukunda tells us. “Creative work increases a society’s wealth. Distributive work just moves wealth from one hand to another. Every industry contains both. But activity in the financial sector is primarily distributive.”

IBM’s Roadmap 2015 is an example of distributive economic activity: it moves cash being generated from within IBM into the hands of shareholders and IBM’s top management. Rather than recognizing this as a capitulation to Wall Street and a sacrifice of the very values which he himself declared were needed make IBM great, he presents it as a “success.” Rather than fight the idea of “making money out of money,” he has embraced it, as his estimated $225 million compensation at IBM indicates.

Note too that issues raised by IBM’s Roadmap 2015 aren’t those of “short-termism,” as defenders of the shareholder-value doctrine sometimes contend. IBM’s Roadmap 2015, following Roadmap 2010, involve relentless cost-cutting and share buybacks over a ten year period, and a public commitment to big investors to keep on doing so, making the impact all that more inflexible and devastating.

Maximizing shareholder value is bad enough when it is done quarter by quarter and confined within the organization. When it is pursued over such an extended period and combined with a firm public commitment to big investors that cannot be easily reversed, it becomes a metastasizing cancer.

Undue influence, not corruption

“So why do managers make choices they know are wrong?” asks Mukunda. His answer comes in two words: “unbalanced power.” Finance is “so powerful that it dominates how an entire society thinks about itself.” In effect, the managers no longer know what’s wrong.

For instance, Palmisano’s HBR interview reveals no sign of knowing that what he was doing was wrong. Wall Street led the way IBM’s top management thought about itself.

And of course, it’s not just IBM. “A recent survey of chief financial officers,” says Mukunda, “showed that 78 percent would ‘give up economic value’ and 55 percent would cancel a project with a positive net present value—that is, willingly harm their companies—to meet Wall Street’s targets and fulfill its desire for ‘smooth’ earnings.”

“The ability of a powerful group to reward those who agree with it and punish those who don’t,” says Mukunda, “distorts the marketplace of ideas. This isn’t about corruption—beliefs naturally shift in accord with interests… The result can be an entire society twisted to serve the interests of its most powerful group, further increasing that group’s power in a vicious cycle.”

Financialization run amok

Let’s be clear. Financialization isn’t bad in itself. Its initial role is the healthy one of translating work-products and services into exchangeable financial instruments to facilitate trade in the real economy. Through mortgages, workers can trade their promise of future wages for a home. Through insurance, homeowners are able to share financial risks and avoid financial catastrophe. The problems begin when financialization becomes excessive.

Throughout history, periods of excessive financialization have often coincided with periods of national economic setbacks, such as Spain in the 14th century, the Netherlands in the late 18th century, and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. “In a financialized economy, the financial tail is wagging the economic dog.”

Financialization becomes a problem when it gets too big.

How big is too big?

Mukunda cites an IMF study which showed “that “once the [financial] sector becomes too large—when private-sector credit reaches 80 percent to 100 percent of GDP— it actually inhibits growth and increases volatility. In the United States in 2012, private-sector credit was 183.8 percent of GDP.”

Undue size also brings with it undue influence. “The jump in size and profits has also increased finance’s influence on government. From 1998 through 2013 the finance, insurance, and real estate industries spent almost $6 billion on lobbying; the only sector to spend more was health care.”

“The issue, as former Federal Deposit Insurance Corporation chairwoman Sheila Bair explained, is ‘cognitive capture. It’s not so much about corruption. It’s just about listening too much to large financial institutions and the people who represent them and not enough to the people out on Main Street.’”

The result? Recent impacts have included a slowed implementation of the Volcker Rule, a curtailing of efforts by the Commodity Futures Trading Commission (CFTC) to regulate derivatives, and an attitude that the big banks are “too big to jail,” no matter how much illegality or mismanagement they are involved in.

Resource misallocation to zero-sum activities

Quite apart from the tendency of a super-sized financial sector to cause increasingly bad global financial crashes, excessive financialization leads to resources being misallocated. “As far back as 1984 the Nobel Prize–winning economist James Tobin observed that ‘very little of the work done by the securities industry…has to do with the financing of real investment.’ He was troubled that ‘we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services…that generate high private rewards disproportionate to their social productivity.’”