Why the World of Finance Affects Us All, Now More Than Ever
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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.
What is more, the workings of these markets tend to act like an upper during booms, when euphoric investors chase the promise of quick bucks. During downturns these same mechanisms work like downers, turning euphoria into panic as investors flee. Financial innovations like collateralized debt obligations were supposed to "lubricate" the economy by spreading risk, but instead they tend to heighten volatility, leading to amplified cycles of boom and bust. In the current crisis, the innovation of mortgage-backed securities fueled the housing bubble and encouraged enormous risk-taking, creating the conditions for the chain reaction of bank (and other financial institution) failures that may be far from over.
Financialization and power
The arena of finance can at times appear to be merely a casino -- albeit a huge one -- where everyone gets to place her bets and ride her luck. But the financial system carries a far deeper significance for people's lives. Financial assets and liabilities represent claims on ownership and property; they embody the social relations of an economy at a particular time in history. In this sense, the recent process of financialization implies the increasing political and economic power of a particular segment of the capitalist class: rentiers. Accelerating financial transactions and the profusion of financial techniques have fuelled an extraordinary enrichment of this elite.
This enrichment arises in different ways. Financial transactions facilitate the reallocation of capital to high-return ventures. In the ensuing shake-up, some sectors of capital profit at the expense of other sectors. More important, the capitalist class as a whole is able to force a persistent redistribution in its favor, deploying its newly expanded wealth to bring about changes in the political-economy that channel even more wealth its way.
The structural changes that paved the way for financialization involved the squashing of working-class aspirations during the Reagan-Thatcher years; the defeats of the miners' strike in England and of the air traffic controllers' (PATCO) strike in the United States were perhaps the most symbolic instances of this process. At the same time, these and other governments increasingly embraced the twin policy mantras of fighting inflation and deregulating markets in place of creating full employment and raising wages. Corporations pushed through legislation to dismantle the financial regulations that inhibited their profitmaking strategies.
Financialization has gathered momentum amid greater inequality. In the United States, the top 1% of the population received 14.0% of the national after-tax income in 2004, nearly double its 7.5% share in 1979. In the same period the share of the bottom fifth fell from 6.8% to 4.9%.
And yet U.S. consumption demand has been sustained despite rising inequality and a squeeze on real wages for the majority of households. Here is the other side of the financialization coin: a massive expansion of consumer credit has played an important role in easing the constraints on consumer spending by filling the gap created by stagnant or declining real wages. The credit card debt of the average U.S. family increased by 53% through the 1990s. About 67% of low-income families with incomes less than $10,000 faced credit card debt, and the debt of this group saw the largest increase -- a 184% rise, compared to a 28% increase for families with incomes above $100,000. Offered more and more credit as an individualistic means of addressing wage stagnation, then, eventually, burdened by debt and on the edge of insolvency, the working poor and the middle class are less likely to organize as a political force to challenge the dominance of finance. In this sense, financialization becomes a means of social coercion that erodes working-class solidarity.
As the structures created by financial engineering unravel, the current economic crisis is revealing the cracks in this edifice. But even as a growing number of U.S. families are losing their homes and jobs in the wake of the subprime meltdown, the financial companies at the heart of the crisis have been handed massive bailouts and their top executives have pocketed huge pay-outs despite their role in abetting the meltdown -- a stark sign of the power structures and interests at stake in this era of financialization.
Sources: Robin Blackburn, "Finance and the Fourth Dimension," New Left Review 39 May-June 2006; Robert Brenner, "New Boom or Bubble," New Left Review 25 Jan-Feb 2004; Tamara Draut and Javier Silva, "Borrowing to make ends meet," Demos, Sept 2003; Gerald Epstein, "Introduction" in G. Epstein, ed., Financialization and the World Economy , 2006; John Bellamy Foster, "The Financialization of Capitalism," Monthly Review , April 2007; Gretta Krippner, "The financialization of the US economy," Socio-Economic Review 3, Feb. 2005; Thomas Palley, "Financialization : What it is and why it matters," Political Economy Research Institute Working Paper #153, November 2007; A. Sherman and Arin Dine, "New CBO data shows inequality continues to widen," Center for Budget Priorities, Jan. 23, 2007; Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism , 2008.