Financialization and the Shareholder Revolution
The argument in this chapter is that financialization is not a good long-term strategy for the country or the economy. Financialization is about risky trading and the return on net assets that benefits its shareholders but not the parts of the economy that could lead to long-term growth.
Prior to 1980, the financial industry’s role was to fund business and enable investment. But, over the years, a new financial strategy has emerged called 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.” It began with deregulation and slowly grew to create changes in tax, trade, regulatory, corporate governance, and law policies. Financialization is about shareholder value and short-term profits and is based on speculation, risk, and debt to enrich investors. This chapter shows how financialization and the quest for short-term profits have permeated all American corporations.
Figure 7.1 shows that the finance industry grew from 10 percent of GDP in 1950 to 22 percent by 2020. The disproportionate growth of finance diverted income from labor to capital. At its peak in the mid-20th century, manufacturing had 40 percent of all profits and created 29 percent of the nation’s jobs. Today finance has 40 percent of the nations’ profits with 5 percent of the jobs.1 One of the big problems caused by finance rising and manufacturing sinking is that a high-employment industry was replaced by a low-employment industry.
Figure 7.1 Changes in the share of U.S. GDP: 1950 to 2020
Source: Bureau of Economic Analysis—Value added by Industry as a Percentage of Gross Domestic Product [Percent], last revised on September 30, 2021.
This financial growth has led to a tremendous increase in economic and political power. The fact that Wall Street are the bankers of most public corporations has given them power over major sectors of the economy, especially manufacturing. Wall Street used to be the banks that once financed manufacturing and the capital investment and R&D that made America the best economy in the world. But after deregulation, Wall Street became the masters, demanding short-term profits over the strategies that led to long-term growth. Wall Street’s demand for short-term profits forced most corporations to slim down their organizations and eliminate the functions that did not show a quick return on investment (ROI).
Financialism is totally about making money from money and has nothing to do with creating jobs or shared prosperity. In his article “Wall Street’s Police State,” Les Leopold says,
financial corporate raiders swooped in to suck the cash flow out of healthy manufacturing facilities. Wall Street, freed from its New Deal Shackles, loaded companies up with debt, cut R&D, raided pension funds, slashed wages and benefits, and decimated good paying jobs in the United States, while shipping many abroad.
Before getting into the results of the financialization of the economy, it is useful to show how the financial industry was able to remove or reduce most of the laws and regulations created during the New Deal.
The most important laws changed by deregulation were as follows:
1978: A successful legal challenge to state usury laws and the massive promotion of credit cards by the banks led to dramatic growth of credit card debt by consumers.
1978: Pension regulation was loosened which created a new market for speculation and the capital to feed it.
1978: Investors fled conventional interest-bearing accounts to alternatives such as money market, venture capital, and hedge funds which were lightly regulated.
1982: Congress passed the Garn-St. Germaine Depository Institution Act which deregulated the Savings and Loan industry. This led to speculation with other people’s money and a crisis which would cost the taxpayer $201 billion.
1933: The Glass–Steagall Act regulated interest rates, established deposit insurance, and erected a wall between commercial and investment banking by restricting the former from engaging in nonbanking activities like securities and insurance.
1999: Congress, led by Senator Phil Gramm and President Bill Clinton, passed the Financial Services Modernization Act, which killed key parts of the Glass–Steagall law and allowed investment banks, insurance companies, and securities firms to consolidate through financial holding companies and use higher risk tools to gamble with the new money they had access to. This bill was passed as bipartisan legislation.
2000: Only a year later, Gramm inserted the new Commodity Futures Modernization Act into a must-pass budget bill that rocketed through Congress. One part of this bill would prohibit the regulation of derivatives which allowed finance gurus to leverage and speculate with other people’s money. By using derivatives, credit default swaps, and other high-risk financial instruments, the big banks were able to chop up and resell loans and mortgages as repackaged securities or derivatives. The new securitization became globalized and eventually affected much of the world economy.
2007: Speculation and lack of effective regulation led to the crash of 2007 and the Great Recession. The banking sector was bailed out by the tax payers, and the new regulations in the Dodd–Frank bill were not enough to prevent another crash occurring.
2010: During the bailout, the government allowed many of the big banks to use the bailout money to merge—Chase and Bear Stearns, Wells Fargo and Wachovia, and Bank of America with Merrill Lynch. So, the result is that they are much bigger today and have become an oligopoly that controls a huge amount of money. The 12 largest banks now control 70 percent of all bank assets. Derivatives are again backed by the FDIC.
2019: Today, the six largest banks in America have $10 trillion in assets underwrite nearly a third of all mortgages, control about 40 percent of all bank deposits, issue two-thirds of all credit cards, and hold 90 percent of all derivatives.2 The industry is not afraid to do it again because they know no one goes to jail, and the government will bail them out.
The big banks and other Wall Street corporations are MNCs with offices all over the world. The problem is that the big banks have enormous lobbying power to buy off Congress and they are still too big to fail.
Growth of Debt
Debt is the lifeblood of financialization. It is where the finance sector makes the most money. Table 7.1 shows that since 1974, debt has had phenomenal growth in both households and businesses and shows that total financial and nonfinancial debt grew from $2.4 trillion in 1974 to $54.3 trillion in 2019. What is emerging is a new kind of speculative bubble based on consumer and corporate credit. In the last four decades, most of the increase in wealth went to the top 10 percent of all earners and the other 90 percent maintain their consumption by borrowing. There is a strong correlation between the rich getting richer and the other 90 percent going deeper in debt.
Table 7.1 Debt outstanding by sector
1974 | 1984 | 1994 | 2004 | 2014 | 2019 | |
Domestic financial | $258 | $1,052 | $3,791 | $11,868 | $15,287 | $16,001 |
Foreign financial | $81 | $233 | $443 | $1,431 | $3,284 | $4,493 |
Total nonfinancial business | $821 | $2,315 | $3,830 | $7,650 | $12,044 | $16,223 |
Total household | $680 | $1,943 | $4,541 | $10,593 | $13,915 | $16,001 |
Federal government | $358 | $1,364 | $3,492 | $4,395 | $14,441 | $19,056 |
State and local government | $208 | $514 | $1,107 | $1,683 | $3,089 | $3,093 |
Total U.S. financial and nonfinancial debt | $2,407 | $7,422 | $17,205 | $37,620 | $43,489 | $54,373 |
Source: Flow of Funds, D3: Debt Outstanding by Sectors, Board of Governors of the Federal Reserve, December 12, 2020.
The debt picture has also changed for corporations. Corporate borrowing was around 4 percent of GDP between 1960 and 1990. Between 1994 and 2019, business debt rose from $3.8 to $16.0 trillion. Because of super low interest rates, debt is accumulating in oil fracking, student debt, BBB-rated corporate bonds, private equity firms, hedge funds, mortgage companies, institutional leveraged loans, and MNCs borrowing to finance stock buybacks. It is all reminiscent of the dot.com bubble in the late 1990s and the toxic mortgage bubble in 2008. Since the lifeblood of financialization is debt, it begs the question of has the financial sector set us up for another bubble or financial collapse?
According to the Federal Reserve Bank of St. Louis, “one of the major causes of the Great Recession was the excessive amount of risky debt in home mortgage markets and the resulting financial crisis.” This has been exacerbated by the growth in recent years of auto loans and student debt with high delinquency rates.
According to the U.S. Bureau of Public Debt, in December 2020, the United States had a debt-to-GDP ratio of 128.1 percent.3 This is a comparison of what a country owes with what it produces and is an indication of the country’s ability to pay back its debt. A study by the World Bank found that countries whose debt-to-GDP ratio exceeds 77 percent for prolonged periods experience significant slowdowns in economic growth. Every percentage point of debt beyond 77 percent costs the country 0.017 percentage point of economic growth. As of 2020, America was 51 percentage points over the safe ratio. To put these figures into perspective, the U.S.’s highest debt-to-GDP ratio was 106 percent at the end of World War II in 1946. The higher the debt to GDP ratio climbs, the higher the risk of default. America is now a debtor nation sinking slowly into deeper debt.
Financialization and its emphasis on shareholder value and short-term profits are not benefitting the parts of the economy that could lead to long-term growth. Here are some examples.
Stripping Corporations: In an article in the Boston Review, 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.
Capital Investment: Research from the Roosevelt Institute shows that productive corporate investment disappeared in the last 30 years and has been replaced by shareholder payouts. They say, “Whereas firms once borrowed to invest and improve their long-term performance, they now borrow to enrich their investors in the short-run.” The research showed that “In the 1960s and 1970s, an additional dollar of earnings or borrowing was associated with about a 40-cent increase in investment. Since the 1980s, less than 10 cents of each borrowed dollar is invested.”4
If we are going to be competitive in the world, then we must promote the manufacturing sector and continue to invest in the research and manufacturing of the new technologies and products that will allow the United States to compete. This means investing in capital equipment, research and development, basic science research, and start-up companies for the long term. This won’t happen as long as the financial sector is in charge.
Innovation and R&D: Most politicians today agree that innovation is the key strategy that will keep America in the race and its position as global leader. Innovation comes from research and development, and more than 70 percent of all private sectors’ R&D comes from manufacturing. So, this is the same problem as capital investments mentioned earlier and begs the same question—how can innovation and new technologies happen without long-term financial support? And as the Roosevelt Institute found, how will there be enough money for R&D investment if most of the money is flowing out to shareholders in the form of dividends and stock buybacks. At this point, Wall Street has the upper hand and continues to focus on short-term profits rather than investing in manufacturing and the R&D that leads to innovation.
If we are going to have a chance at reversing the decline of manufacturing or developing a strategy of innovation that will keep us competitive, the current direction of the financial industry must be changed. In their pursuit of short-term profits, they are jeopardizing the long-term health of the economy and the manufacturing sector.
A decline in start-up companies: “The rate of company formation is half of what it was four decades ago,” says a February 2018 New York Times article.5 The innovation that start-ups bring is particularly important to manufacturing and high tech, which rely on new ideas, technologies, and increased productivity for long-term growth. The article said, “Researchers found that the decline in companies entering the market since 1980 has trimmed productivity growth by about 3.1 percent.” I think this decline has happened because of the U.S. financial industry’s change in focus from lending to speculation. Many start-ups must now go overseas to get the second round of funding to expand.
Financialization has hurt the American economy, and the symptoms are as follows:
1. Rising inequality
2. Stagnant wages
3. Falling productivity
4. The decline of GDP growth
5. Lack of regulation
6. The decline of innovation
7. Decline of capital investment
8. Short-term planning over long-term planning
Supporters of financialization make the case that financialization is the final or perfect form of Free-Market Capitalism (FMC) where profits are realized the quickest, costs are minimized, and the government is not allowed to interfere in the process. Financialization is about making short-term profits and cutting costs to satisfy high-risk investors looking for quick returns.
The argument in this chapter is that financialization is not a good long-term strategy for the country or the economy. There is no coincidence that the rise of financialization has happened during the decline of manufacturing, middle-class income, and capital investment or during the rise of inequality. It is also no coincidence that during the same period, there was an enormous shift in wealth to the top 20 percent earners at the expense of the bottom 80 percent.
The choice is clear, either we push for more regulation of the financial industry like we did during the New Deal or they will eventually destroy both themselves and the economy. William Banzai put the big bank problem in perspective when he said, “If we don’t get rid of the incentive to loot, then the only question is what form the next round of looting will take.”
1 K. Phillips. 2008, Bad Money; Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism (NY: The Penguin Group).
2 Senator B. Sanders, May 23, 2019. Senator Sanders Speech on Taxing Wall Street Speculation.
3 The White House, Office of Management and Budget. December 2020. United States Recorded Government Debt of 128.10 percent of GDP in 2020.
4 J.W. Mason. May 2015. Disgorge the Cash, The Disconnect Between Corporate Borrowing and Investment (The Roosevelt Institute).
5 E. Porter. February 06, 2018. Where Are the Start-Ups? Loss of Dynamism Is Impeding Growth (New York Times).