Why the World of Finance Affects Us All, Now More Than Ever

 

You don't have to be an investor dabbling in the stock market to feel the power of finance. Finance pervades the lives of ordinary people in many ways, from student loans and credit card debt to mortgages and pension plans.

And its size and impact are only getting bigger. Consider a few measures:

• U.S. credit market debt -- all debt of private households, businesses, and government combined -- rose from about 1.6 times the nation's GDP in 1973 to over 3.5 times GDP by 2007.
• The profits of the financial sector represented 14% of total corporate profits in 1981; by 2001-02 this figure had risen to nearly 50%.

These are only a few of the indicators of what many commentators have labeled the "financialization" of the economy -- a process University of Massachusetts economist Gerald Epstein succinctly defines as "the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions."

In recent years, this phenomenon has drawn increasing attention. In a new book, pundit Kevin Phillips wrote last spring about the growing divergence between the real (productive) and financial economies, describing how the explosion of trading in myriad new financial instruments played a role in polarizing the U.S. economy. On the left, political economists Harry Magdoff and Paul Sweezy over many years pointed to the growing role of finance in the operations of capitalism; they viewed the trend as a reflection of the rising economic and political power of "rentiers" -- those whose earnings come from financial activities and from forms of income arising from ownership claims (such as interest, rent, dividends, or capital gains) rather than from actual production.

 

 

From finance to financialization

The financial system is supposed to serve a range of functions in the broader economy. Banks and other financial institutions mop up savings, then allocate that capital, according to mainstream theory, to where it can most productively be used. For households and corporations, the credit markets facilitate greatly increased borrowing, which should foster investment in capital goods like buildings and machinery, in turn leading to expanded production. Finance, in other words, is supposed to facilitate the growth of the "real" economy -- the part that produces useful goods (like bicycles) and services (like medical care).

 

In recent decades, finance has undergone massive changes in both size and shape. The basic mechanism of financialization is the transformation of future streams of income (from profits, dividends, or interest payments) into a tradable asset like a stock or a bond. For example, the future earnings of corporations are transmuted into equity stocks that are bought and sold in the capital market. Likewise, a loan, which involves certain fixed interest payments over its duration, gets a new life when it is converted into marketable bonds. And multiple loans, bundled together then "sliced and diced" into novel kinds of bonds ("collateralized debt obligations"), take on a new existence as investment vehicles that bear an extremely complex and opaque relationship to the original loans.

The process of financialization has not made finance more effective at fulfilling what conventional economic theory views as its core function. Corporations are not turning to the stock market as a source of finance for their investments, and their borrowing in the bond markets is often not for the purpose of productive investment either. Since the 1980s, corporations have actually spent more money buying back their own stock than they have taken in by selling newly issued stock. The granting of stock options to top executives gives them a direct incentive to have the corporation buy back its own shares -- often using borrowed money to do so -- in order to hike up the share price and allow them to turn a profit on the sale of their personal shares. More broadly, instead of fostering investment, financialization reorients managerial incentives toward chasing short-term returns through financial trading and speculation so as to generate ballooning earnings, lest their companies face falling stock prices and the threat of hostile takeover.