Financialization and its Discontents

By Francis Lee for the Saker Blog

THE NONAGE

The term financialization is generally used as a reference to that part of the economy indicated by the acronym FIRE (Finance, Insurance and Real Estate) and its growing importance in the economy in both qualitative and quantitative terms. Financialization has been a developmental process whereby financial markets, financial institutions, and financial elites have gained greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems at both the macro and micro levels. Its principal impact has been to elevate the significance of the financial sector relative to the real value producing sector of the economy; that is to say to transfer income from the value-producing sector to the extractive sector and thereby increase income inequality and wage stagnation.

EXPANSION AND GROWTH

Since 1970 this part of the economy has grown from a significant part of the US economy as well as of those overseas. This means that a significant magnitude of market transactions are associated with finance. In terms of corporate profits finance is said to account for approximately 40% of US GDP. This is a significant but disputed figure and, moreover, it does not include those overseas earnings of companies whose profits are repatriated to their countries of origin. Thus, the increasing presence and role of finance in overall economic activity and the increase of profits channelled to the financial sector represent the salient indicators as to what has been termed financialization. However, the level and importance of finance in the US economy is held in some quarters to have been actually deleterious to growth. A 2012 International Monetary Fund study concluded that the U.S. financial sector has grown so large that it is slowing economic growth. New York University economist Thomas Philippon supported those findings, estimating that the U.S. spends $300 billion too much on financial services per year, and that the sector needs to shrink by 20%. Harvard University and University of Chicago economists agreed, calculating in 2014 that workers in research and development add $5 to the GDP for each dollar they earn, but finance industry workers cause the GDP to shrink by $0.60 for every dollar they are paid. A study by the Bank for International Settlements reached similar conclusions, saying the finance industry impedes economic growth and research and development-based industries.

Wall Street – Belly of the Beast

So this 40% figure increasingly looks like an estimate and does not necessarily represent value or productivity since financialisaton is essentially an extractive process which basically moves wealth from one group to another. For example from everyday wage earners and productive enterprises to the banking, insurance, real estate, and other extractive retail and loan industries. In a study in 2016 two finance academics one at the University of Massachusetts, Professor Gerald Epstein one of the best-known authorities on financialization, together with Juan Montecino of Colombia University published a joint document.(1) It was a type of financial curse for the United States, and it sought to use established methods which attempted to measure the overall damage created by a bloated financial sector in the US. It was argued by these eminent scholars that financialization would put the economy at risk of debt deflation and prolonged recession. Crunching the figures the conclusion that they arrived at was ‘that the US financial system will impose an excess cost of between $12.9 trillion and $22.7 trillion on the US economy between 1990 and 2023, thereby ‘making finance in its current form a net drag on the American economy.’

This calculation of the putative benefits of the financial sector to the US economy, minus the costs imposed by this same sector, was equivalent to a net loss of $105,000-$184,000 for the average American family: without this loss, the typical US household would have doubled its wealth at retirement. The US economy would have been stronger today if the US government had simply paid its highest paying financiers their full salaries, then sent them off to live in luxurious gated communities to play golf all day. (2)

Regardless, financialization operates through three different conduits: changes in the structure and operation of financial markets, changes in the behaviour of nonfinancial corporations, and changes in economic policy. Countering financialisaton would call for a multifaceted agenda that; restores policy control over financial markets; challenges the neoliberal economic policy paradigm encouraged by financialization; makes corporations responsive to interests of stakeholders other than just financial markets, and; reforms the political process so as to diminish the influence of corporations and wealthy elites. As policy options go, this seems eminently sensible. But when have sensible ideas ever been given house room by the financial powers-that-be (PTB). Unfortunately, therefore, we seem stuck with this enemy within.

THE DESTRUCTION OF VALUE.

This ongoing transformative process – akin to an economic late-stage carcinoma – represents a regressive structural change in the nature of the late capitalist economy. This is to say the relationship between the value-creating manufacturing sector and the extractive sector, (FIRE) Finance, Insurance and Real Estate. In the earlier phase of capitalism, the financial sector was much smaller and served to grease the wheels of industry by providing investment capital and credit obtained from depositors. That symbiotic relationship has now ended, and finance has increasingly taken on a life form of its own relegating manufacturing industry to the second tier. Financialization is a pattern of accumulation that relies increasingly on profit making through financial channels even for firms which are not financial. As a case in question: General Motors in the US, for example, had a trading and finance sector which was to grow larger than the original auto-vehicle operation itself. And it was precisely this branch of the company which went bust during the 2008 crash, which gave rise to a bail-out from the Federal Government of $50 billion dollars. What’s good for GM is good for America, yes? Unfortunately, the same Federal Government was unable to stump up petty-cash of $13 billion for the home base of GM – Detroit – which also became bankrupt. This I think speaks volumes regarding the US government’s priorities. Interestingly Detroit was largely a population of Afro-American people.

The ongoing rise of financialization has been attributed to the decline in the rate of profit of manufacturing industry over the period of the post-war boom, the Trente Glorieuses 1950-1970, as the French called it. (3) The reasons for this long-term decline are another article, but the decline was palpable, nonetheless. Suffice it to say that the fall in the level of profitability occasioned a basic reconfiguration, both political and economic, in the nature of the global political economy. During this period of economic and political turbulence firms had to look for other ways of making profits other than through boom-style brick- and -mortar investment.

Fattening up the bottom line through reductions in corporation tax, tax avoidance scams such as transfer pricing, company share buy-backs, some very dubious mergers and acquisitions, the creation of ‘flexible’ labour markets, all generally involved finance and banking services which expanded their services to meet this increased demand; a demand that this sector created in the first place.

The financial leech on the productive economy may be best understood by a reference to biology.

There is a particular type of parasite which preys on humans – dracunculus – which can reach a metre in length. Care must be taken extracting these creatures since when one simply pulls off the protruding head of the worm, the worm will break and leak high levels of foreign antigen which can lead to anaphylactic shock and fast death of the host. Professor Michael Hudson compares this sort of biological parasitism with the financial parasitism, which is now sucking dry the world economy, the host. He writes:

‘’Furthermore, the rise of the Finance, Insurance and Real Estate sector – banks, credit agencies, investment companies, brokers and dealers of commodities and securities, security and commodity exchanges, insurance agents, buyers, sellers, lessors, lessees and so forth – has now reached such a level that it has become larger, more ubiquitous, and profitable than productive industry. Prior to the ascent of financialised capital and the deregulation and privatisation mania, the role of finance was usually restricted to greasing the wheels of the productive (value-creating) economy. Commercial banks took the publics’ deposits and funnelled it as credit into manufacturing and commercial enterprises. In this regulated environment commercial banks and other financial institutions were legally circumscribed in the level of credit they could extend.’’ (4)

FINANCE GOES GLOBAL

The seemingly unstoppable financial Runaway Train rolled on with the ‘Big Bang’ – that is to say the deregulation of finance carried out initially by the Thatcher government in the UK in 1986. The phenomenon was to spread around the world now that finance was off the leash. Instead of producing real value as embodied in goods and services, the selling of ownership titles – fictitious capital, which effectively represents accumulated claims, legal titles, to future production and more specifically claims to the income generated by that production – were simply paper claims to wealth rather than wealth itself. Banks for example were loath to lend to start-up manufacturing companies but fell over themselves to lend mortgage loans to anyone who had a pulse. This was to become the chosen field of investment. It was the essence of extractive capitalism. (5)

Unfortunately, as a result of financial deregulation the situation actually got worse. The Bank of England had, in its infinite wisdom, decided to host but not regulate a new market for homeless dollars in London. Yet this new business was not regulated or taxed by the United States either, so who was regulating or taxing it? The answer was nobody. Amid high anxiety about the loss of empire the City of London establishment had quietly turned Britain into an offshore tax and financial haven. Currency and financial traders immediately took note. The Americans gave this business an appropriate name. Eurodollar markets or Euromarkets. (6)

Thenceforth a Eurodollar, a dollar which was simply a dollar which had escaped Bretton Woods controls and was being traded in these new libertarian markets which were mostly located in Europe. Eurodollars were a new form of stateless monies and, as a London banker put it ‘completely isolated from the monetary mass of the rest of the UK .’… So Eurodollars were in one sense dollars like any other, but in another sense, they were different because they had escaped into a market outside of US government control, where they could behave freely.

According to A Bank of England memo in those early days this move explained the Euromarkets attractions: to wit, freedom from local supervisory controls such as Banking regulations to stop excessive risk taking – with OTO – ‘other peoples’ money’. Freedom from macroeconomic controls such as foreign exchange restrictions; low or zero taxes for the customers and players; secrecy and very liberal company legislation.

And where did this leave national governments? Well, the Euromarkets provided anonymity to tax avoiders, scammers and criminals of every stripe which included flight capital, terrorist and illicit drug cartels so they were the natural bases and hideaways for both elements of both the haute bourgeois and the criminal cartels. An illustration of the amount of monies secreted away in these tax havens can be gleaned from the figures: The Shadow Banking Sector of the Cayman Islands, stood at assets worth $5.8 trillion – equivalent of 170,000 percent of Cayman’s GDP and over twice the size of the UK’s GDP. Worth adding that the Cayman Islands in the Caribbean is only one tax-avoidance venue in Britain’s hidden empire.

The Cayman Islands.

Other dubious income stream recipients include, Anguilla, Bermuda, British Virgin Islands, Gibraltar, Montserrat, and the Turks and Caicos Islands. Nearer to home in the English Channel, there lie the tax havens of Jersey, Guernsey and the Isle of Man in the Irish Sea. These are now known as Crown Dependencies who did not cut all their ties after the Empire expired. (7)

But although in this respect the UK, that is to say the City of London and Canary Wharf, could arguably be regarded as being market leaders, it is only one of many well-heeled investor outposts in an archipelago of a global no-tax, no-questions asked, venues including Delaware – does Delaware ring any bells? It should. This is a multinational operation organized by multinational institutions, offering its services to an opulent global multinational clientele.

CLASS, POWER AND POLITICS

Reading the material for this article I became increasingly reminded as to the manner of which the present political/ideological developments and present conjuncture came into being along with its past manifestations. Back in the 18/19^th centuries there was a battle royal taking place between the old aristocratic landed classes and the newly emerging bourgeoisie based in the manufacturing towns of both Europe and the United States (8). The United Kingdom was very much at the centre of this political confrontation and the challenge to the established order of the King and the divine right to rule which had already been shaken by the English Civil War 1642-49 and had visibly weakened – particularly when Charles 1 had his head chopped off in 1649; this was followed by the French Revolution when Louis XVI also lost his head in January 1793. After which the French seemed to have developed a penchant for revolutions! (See 1848 and 1871.) But the new order was beginning to make its presence felt. Thus the 18^th and 19^th centuries were in essence class struggles which carried on into the 20^th century with the rise of socialism and nationalism.

But the interesting aspect has been the late 20^th century counter-revolutionary movement predicated on the development of a new bourgeois class which has effectively established itself inside the financial sector of the economy and has effectively become a new ruling class ably assisted by a vast political bureaucracy, the entertainment industry, Big Tech/Pharma and the media which now plays the role of an organized religious pillar of support to the existing order. History seems to be repeating itself, but not in quite the same fashion. So as Marx once said: “Hegel remarks somewhere that all great, world-historical facts and personages occur, as it were, twice. He has forgotten to add: the first time as tragedy, the second as farce.” (The Eighteenth Brumaire of Louis Bonaparte).

Key Historical Figures:

ADAM SMITH 1723-1790

Adam Smith was born in the Scottish town of Kirkcaldy 1723 son of a customs officer. Attended the university of Glasgow where he studied moral philosophy (1759) and was to publish The Theory of Moral Sentiments. And in 1776 The Wealth of Nations.

1. This was the age of Industrial capitalism.
2. He was a friend of the great conservative Scottish philosopher David Hume.
3. In 1776 his magnum opus ‘’An Inquiry into the Nature and Causes of The Wealth of Nations. A work which became the foundation for the new ‘science’ of Political Economy.
4. Smith saw the economy as being subject to a set of invariant scientific laws. Economic processes were driven above all by ‘’the natural effort that every man is continually making to better his own condition … within the complex and changing web of economic phenomena we will find one constantly acting force; the uniform, constant and uninterrupted effort of every man to better his condition, the principle from which public and national as well as private opulence is originally derived.’’
5. This is human nature, according to Smith. Moreover, this invariable human nature manifests itself most forcefully under social conditions, namely those of the bourgeois order of private property and unrestricted competition.
6. So far as economic contacts are concerned everyone enters intercourse with others only insofar as this is dictated by his own personal interests and promises some form of gain. The form of this intercourse is exchange conducted in markets.
7. Famous quote: ‘’It is not from the benevolence of the brewer, the butcher or the baker that we expect our dinner but from their regard to their own interests.’’
8. Smith deduces the basic socio-economic institutions that characterise a commodity-capitalist economy from the nature of man; what he takes as human nature, however, is the determinate nature of man under the influence of the commodity-capitalist economy.
9. A philosophy of rational and radical individualism.
10. Society and the individual will prosper with freedom of individual economic initiative and the elimination of state interference. ‘’Thus, every man as long as he does not violate the laws of justice, is left perfectly free to pursue his own interests in his own way, and to bring both his industry and his capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty performed ….
11. Smith was the founder of the doctrine of economic liberalism – maximum freedom for the individual and freedom from coercive state interference.
12. Smith therefore considered the economic phenomena of bourgeois society to be ‘natural’ in the sense that they had been arranged in the best possible fashion and required no conscious intervention by any agencies of state or of society.
13. Smith was vehemently opposed to the creation of monopoly, which he viewed as simply criminal organizations.

David Ricardo (1772-1823)

Born in London, England, Ricardo was the third to be born to a Sephardic Jewish family of Portuguese origin who had recently relocated from the Dutch Republic. His father, Abraham Ricardo, was a successful stockbroker. Ricardo junior began working with his father at the age of 14. At age 21, Ricardo eloped with a Quaker woman, Priscilla Anne Wilkinson, and, against his father’s wishes, converted to the Unitarian faith. This religious difference – Judaism and Christianity – resulted in estrangement from his family, and he was led to adopt a position of independence. His father disowned him, and his mother apparently never spoke to him again.

Ricardo was part of the radical intelligentsia who believed that history was cyclical rather than linear. His was a high-Tory view rather than the Whiggish notion that history was advancing in the direction of progress and reason. This is clearly reflected in Ricardo’s views (see below) as well as others such as Thomas Malthus. What Ricardo foresaw was rather different than the Whiggish view of progress. This latter view postulated a world in which everyone moved together up the escalator of progress. Unlike Smith, however, Ricardo saw that the escalator worked with different effects on different classes. Some rose triumphantly to the top, whilst others, who managed to move up a few rungs of the ladder could be kicked down to the bottom; whilst those who got the full benefit of the ride – the landed aristocracy – did nothing at all to earn their reward – i.e., the power of the soil and the rent on land.

To Adam Smith society was one great family; to Ricardo it was an internally divided camp. ‘’The interest of the landlord is also opposed to the interest of every other class in society – namely, capitalists and workers. Ricardo’s animus toward to the land-owning classes was in part based upon this theory of economic rent as outlined in his definitive work, The Principles of Political Economy and Taxation first published in 1817.

THE THEORY OF RENT

Suppose, says Ricardo, there are two neighbouring land-lords. On one landlord’s fields the soil is fertile, and with the labour of a hundred men and a given amount of equipment he can raise 15 hundred bushels of wheat. On the second landlord’s field the soil is less fecund; the same men and their equipment can only raise one thousand bushels. This is merely a fact of nature, but it has an economic consequence; the grain will be cheaper per bushel on the fortunate landlord’s estate. Obviously since both landlords must pay the same wages and capital expenses, there will be an advantage in cost to the man who secures 500 more bushels than his competitor.

It is this difference in costs that rent springs. For if the demand is high enough to warrant tilling the soil on the less productive farm it will certainly be a very profitable operation to raise grain on the more productive farm. Indeed, the greater difference between the two farms, the greater will be the differential rent. If for example it is just barely profitable to raise grain at a cost of £2 a bushel on very infertile land, then certainly a fortunate landowner whose rich soil produces grain at only 50 pence a bushel will gain a large rent indeed. For both farms will sell their grain on the market at the same price say £2.10 – the owner of the better ground will therefore be able to pocket the difference of £1.50 in their respective costs of production.

No-rent on Marginal Land:

In the diagram below the most productive land (A) has the highest yield 35 quintiles. The marginal land (D) which just covers its expenses and no more. This land is called ‘no-rent land’. All rents are measured from it upwards.

‘D’ quality and land which produces 20 quintals per plot is the marginal land. Here the return and cost are equal. It is just worthwhile cultivating this land since it just covers expenses of cultivation and yields no surplus to the cultivator. Thus, the concept of economic rent, more broadly applied, means a rent (surplus) income over and above the normal/average income which normally accrues to factors of production. This particularly applies to monopolistic and oligopolistic market conditions. Present day monopolists/oligopolists pay a premium for their costs of output over and above average profit – this premium is ‘economic rent’.

DIMINISHING RETURNS

However, Ricardo was astute enough to point out the capitalism was (still is) a dynamic system, constantly mutating and expanding. This had the effect of an increasing demand for factor inputs, including labour. This led to rising wages; but only temporarily, since this increased income produced more children, future labourers, who would flood the market with still more labourers. And this is where Ricardo parted company with the sunny, prosperous world predicted by Smith. Ricardo postulated that as population expanded it would become necessary to push the margin of cultivation out further. More mouths would demand more grain and more grain would need more fields. Naturally, the newly cultivated fields would not be so productive as those already in use, for it would be a foolish farmer who had not already used the best soil available to him.

Therefore, as the growing population caused more and more land to be put into use, the cost of producing grain would rise. Thus, the selling price would also rise and so would the incomes of the well-situated landlords. Moreover, wages would need to rise pari passu also, since as grain became more expensive the labourer would have to be paid more, simply to enable him to buy his sustenance to stay alive.

This is the ‘law’ of diminishing returns. And it benefits nobody except the landlords. The capitalist-the man responsible for the progress of society in the first place-has been caught in two jaws of a vice. 1. He must pay higher wages which increase costs, since bread is become more expensive. 2. The landlords are much better off, since the rents they have been rising on good land, as worse and worse land has been planted. And as the landlord’s share in society’s bounty increases, there is only one class that gets elbowed aside to make room for him – the capitalist. What a different conclusion from Adam Smith’s great pageant of progress. Suffice it to say Ricardo was the voice of the rising industrial bourgeois class against what both he and they considered a parasitic, rentier landowning gentry. It was in this spirit that he campaigned against the high tariff on imported corn.

FREE TRADE & COMPARTIVE ADVANTAGE: The condition in which the free flow of goods, services and finance in international exchange is neither restricted nor encouraged by government intervention. This line of reasoning was originally given a theoretical elaboration by David Ricardo (1772-1823) and his theory of comparative advantage. This was a hypothetical construct where two nations – England and Portugal – both produced wine and cloth. Portugal had an absolute advantage in both. But a comparative advantage in wine. It would therefore benefit all if England were to specialise in cloth and Portugal in wine. This theory rested upon a number of questionable assumptions. These are as follows:

a) Factors of production are perfectly mobile within each country and they can be instantly switched between industries without any adjustment problems. However the same factors are immobile between countries, though final goods and services can be traded.

b) There are constant returns to scale and constant average costs of production in both industries and both countries

c) Both commodities, wine and cloth, are in demand in both countries.

d) The limited resources and factors of production in each country are fully employed.

e) Transportation and adjustment costs involved in trade are discounted

In the real world, however, none of the above assumptions hold. All governments are heavily involved in regulating overseas trade. They either seek entry into other markets or attempt to restrict entry into their own. Essentially all governments are in one way or another mercantilist (see below) and in this sense free-trade is just another policy option to be placed alongside protectionism: they are not antipodes but twins. International trade, like war, is a continuation of politics by other means.

NOTES

The development of political economy did not of course stop at this point, but quite simply I did not have any inclination to go further and summarise the significant impact of Karl Marx, John Stuart Mill in the 19^th century and J.M.Keynes and J.A.Schumpeter in the 20^th. The process is of course open ended.

(1) Overcharged: The High Costs of High Finance. 2016

(2) The Finance Curse – Nicholas Shaxson. – 2018 – p.11

(3) K.Marx – The Long Run Tendency for the Rate of Profit to Fall – Capital Volume 3, Chapter 25. And/or J.A.Schumpeter, ‘Business Cycles ‘- Schumpeter believes in the existence of the long wave of upswings (or boom) and downswings (or depression). Once the upswing ends, the long wave of downswing begins and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” starts.

(4) M.Hudson – Terminal Infection – Killing The Host 2015

(5) The Big Bang – 1986 – finance goes global. See also, Fictious capital, Marx, chapter25 Volume 3 of Capital.

(6) What is a Eurodollar? The term Eurodollar refers to U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. Because they are held outside the United States, eurodollars are not subject to regulation by the Federal Reserve Board, including reserve requirements. Dollar-denominated deposits not subject to U.S. banking regulations were originally held almost exclusively in Europe (hence, the name Eurodollar). Now, they are also widely held in branches located in the Bahamas and the Cayman Islands. What is a euromarket? The euromarket extends beyond the Eurozone countries that use the euro currency to all countries signed on to that free trade agreement.

(7) Nicholas Shaxson – The Finance Curse – 2018 passim.

(8) Although there was no Aristocratic class in the US – perhaps in the South. There was King George of course but he was on the other side of the Atlantic.