Bold economic thinkers warn that it's time to tame the financialization monster.
Author's note: This post is based on papers presented and remarks made during a *conference panel I moderated featuring William Lazonick of U Mass-Lowell, Jan Kregel of the Levy Institute and Damon Silvers of the AFL-CIO.
Whatever happened to innovation in America? President Obama told us that our future depends on it. Across the political spectrum, everyone pretty much agrees that innovation is vital to prosperity.
So why aren’t we getting the job done? Clearly, we’re in desperate need of clean technology that won’t poison us. Our information and communications systems are not up to snuff. Our infrastructure is outdated and crumbling before our eyes. We’re not investing enough in these areas, and it shows. Yet they’re necessary not only for America’s economic health, but for stability and prosperity around the globe.
The U.S. used to be the envy of the world when it came to innovation, making things that dazzled the world and enhanced the lives of millions. But the Information Technology & Innovation Foundation, a bipartisan think-tank that ranks 36 countries according to innovation-based competitiveness, tells us we’re getting pushed aside on the global innovation stage. In 2009, to the surprise of those conducting the study, the U.S. ranked #4 in innovation, behind Finland, Sweden and Singapore. In 2011, the U.S. ranking was unchanged. Worse, the U.S. ranked second to last in terms of progress over the last decade.
Research by the Organization for Economic Cooperation and Development (OECD) also shows that the U.S. is not making as many cutting-edge products as it used to, and that other countries with strong investment in the foundations of innovation, like education and research and development, and fewer of the things that hinder it, like income inequality, are making greater strides than we are.
What went wrong?
William Lazonick, an expert on the history of the American business corporation, points out that the U.S has enjoyed, over its history, an extremely productive economy. We still have important productive assets, but we’re now taking money out of our productive economy instead of investing in it. The shift has happened over time, but the mechanisms of extraction have become dangerously efficient. A giant financial sector and wealthy class are sucking money, vampire-like, out of the productive sector, where the goods, technologies and services that we want are created.
Financiers may appear to be simply “making money out of money,” but if you look closely, you can see that they are really getting rich on the backs of people producing useful things, like consumer electronics, and capital goods like factories and equipment. Good jobs, the health of the overall economy and society, growing incomes for the poor and middle class—all of these things have been put aside in the quest for more financial profits. The game is unsustainable. And it’s turning out badly.
To get the economy humming, argues Lazonick, you want to fuel the kind of growth that allows people to enjoy higher living standards. You want an economy that is stable and allows everyone to share in prosperity. But nowadays, the executives who are running large industrial corporations like GE, Dupont, Cisco and Microsoft are focused on making as much money as they can in the short-term for shareholders, and more importantly, themselves.
Unsurprisingly, they support the policies that allow them to do this: things like low taxes, risky speculation, sky-high executive pay, and pulling investment out of education and infrastructure. What happens to our economy in the long-term is not really their concern. There’s a motto on Wall Street: “I.B.G.-Y.B.G.” or “I’ll Be Gone, You’ll Be Gone.” As long as you’re making money right now, what happens tomorrow is not your problem.
It’s everyone else’s problem. Witness the decline in the number and quality of jobs, the middle class evaporating, and the financial instability that brought about the Great Recession.
A look back
It wasn’t always like this, as Lazonick and Damon Silvers have pointed out. It used to be that Wall Street made its money issuing long-term bonds that governments and corporations could then use to invest in America’s productive assets. Sure, there was trading in stocks and bonds, but you didn’t get huge increases in wealth funneled to Wall Street as a result. There was some speculation involved, but it was expensive for individuals to trade and such trading wasn’t designed to get huge amounts of volume.
The commercial banking system was well regulated, and household savings could be channeled to businesses at fairly good rates of return. Financial institutions were relatively stable and they could help industry to produce technological advances and economic development. Up until the 1960s, most Americans understood and accepted the importance of the federal government in helping to jumpstart innovation through things like defense and aerospace spending. Some of that money got channeled through universities, and some of it was directed to large corporations, which, like GE, could “bring good things to life.”
But in recent decades, several monkey wrenches got thrown into this system, starting in the 1960s with the trend of conglomeration, in which corporate titans built empires that gobbled up scores and even hundreds of companies. In the 1970s, as inflation grew and the Japanese economy took off, Wall Street shifted from investing to trading, and later, in the 1980s, executives came to adopt a harmful ideology known as “shareholder value,” which held that shareholders are the only people who deserve returns from corporations — forget about the taxpayers and the employees without whose support, sweat and risk such companies would not exist. Corporations started focusing on manipulating stock prices to realize short-term gains, and conducting stock buybacks to enrich executives at the expense of research and development or investing in the skills of workers.
Wall Street banks started moving into higher margin businesses. They were no longer regulated utilities, but high-risk, high-return institutions. This destabilized their basic credit intermediation function. Up to the 1970s the productive system dominated the financial system. But from the 1980s on, the balance of power was reversed.
The financialization monster
Think about it: what GE product did you recently purchase that enhanced your life? In the era of financialization, big companies like GE have turned their attention to making quick Wall Street profits instead of fabulous products. In the 1980s, for example, GE’s Jack Welch rapidly expanded the company’s business into issuing credit cards, mortgage lending and other financial activities. It wouldn’t be long before financial operations accounted for almost half of the company's profit.
Eventually we ended up with a situation in which, as my colleague Joshua Holland has noted, a corporate executive will starve the company of needed resources and hinder its ability to be productive in the interest of short-term gains. In his book The Speculation Economy, Lawrence Mitchell of George Washington University points out that a recent survey of CEOs of major American corporations revealed that nearly 80 percent would have "at least moderately mutilated their businesses in order to meet [financial] analysts’ quarterly profit estimates."
Silvers notes that as financialization fever took over, the U.S. developed a dangerous imbalance between private and public finance, and we promoted public policy founded on the strange idea that there really is no such thing as a public good. We embraced the idea that capital markets are more efficient if regulators step aside, and we subscribed to the faulty notion that deregulation of financial institutions would help the economy prosper.
Without regulation and strong unions to ensure that the U.S. kept steadily and thoughtfully channeling money into productive investments like training workers and creating stable jobs with reasonable incomes, the economy essentially became a casino and the gap between the rich and the rest grew wider. We became known less for innovation that enriched people’s lives than for creating complicated financial instruments that are designed to rip people off. From 2004-2008, for example, when other advanced economies were pouring money into clean technology, the U.S. financial markets were rapidly innovating new financial products that served to extract yet more wealth from the productive parts of our economy.
The wrong kind of innovation
Paul Volcker once famously quipped that the ATM is the only useful financial innovation he’s seen in the last 20 years. It seems that while we haven’t gotten around to things like clean technology, we’ve created lots of innovative ways for ordinary people to lose money—things like lines of credits on homes that tend to thrust people into debt more quickly and force them to bear the burden of Wall Street’s obsession with making bigger returns at any cost.
Jan Kregel and Leonardo Burlamaqui have examined how as the financial sector has grown larger, the U.S. has ceased to be a center for developing new knowledge. Finance is no longer playing the role of the “handmaiden of creative destruction” that allows industry to produce technological advance and economic development.
Kregel and Burlamaqui also observe that the financial services industry has special features which create economic instability in a variety of ways, for example, using things like derivatives packages to shift risk from financial firms onto those less able to bear that risk. Bubbles followed by catastrophic crashes become inevitable: eventually, the weight of financial speculation becomes so great that it overwhelms the system, as we saw in the late 1920s, and in the 2007-08 financial crisis. When these crises occur, speculation decreases for a time, but as we can see now, the financial sector is hell-bent on restoring profits— not for the sake of the economy and jobs, but for the sake of their incomes.
Damon Silvers has also pointed out that the costs of financial bubbles include the effects of the failure to productively invest capital, including the decline of government investment in research and development. Income inequality keeps growing, and Wall Street types push the false idea that any money they make is made fairly and that the government should never intervene. Wages are pressed down and yet wealth keeps on building— but only for the very few.
What to do?
Bottom line: the U.S. financial sector no longer serves the productive sector—in fact, it may be killing it. But can it be stopped?
Taming the financialization monster won’t happen through volunteerism. Through our increasingly corrupt political system, the titans of the financial sector pull more of the strings in Washington, and they’re not likely to speak out against things like skyrocketing executive pay, one of the forces driving income inequality, vaporizing jobs, and diverting money from more productive channels. According to a report by the Economic Policy Institute, American CEOs now earn 273 times the average worker’s salary. Thirty years ago, the average chief executive of a large public company took in less than 30 times the pay of the typical worker. Have CEOs really become that much more valuable?
As Lazonick points out, social norms have to change. In Japan, stratospheric executive pay is considered unacceptable because there’s an understanding that making a company work is a collective endeavor. That’s an important social value. In Europe, there’s a movement to curb executive pay at bailed-out banks. Senior staff at banks that enjoy state funding would only be able to earn 15 times the national average salary or 10 times the wages of the average worker at the bank. Bonuses would be capped at twice fixed salary.
That’s a good idea, and something we need to be discussing in the U.S., where executive pay is not only extremely high compared to the rest of the world, but often arbitrary and shockingly detached from performance.
Lazonick thinks what we really need is a whole new mindset about the economy. He recommends several things that would help get us back on track:
Understand that markets don’t create value, but that organizations investing in productive capabilities, like business, governments, and households do.
Ban stock repurchases by U.S. corporations so corporate financial resources can be channeled to innovation and job creation instead of wasted for the purpose of jacking up companies’ stock prices.
Realize that the shareholder value ideology is destructive and will cause us to lag behind other countries that don’t subscribe to it.
Regulate employment contracts to ensure that workers who contribute to the innovation process get to share in the gains from innovation.
Create work programs that make use of and enhance the productive capabilities of educated and experienced workers whose human capital would otherwise deteriorate through lack of other relevant employment.
Move toward a tax system that channels some of the money made on the gains from innovation toward government agencies that can invest in the public knowledge base needed for the next round of innovation.
We’ve still got plenty of innovation left in us, but we have to change our priorities and make the financial economy subordinate to the productive economy. That would go a long way toward getting Wall Street off our backs and allowing America to once again be a place where energetic people thrive and work together to produce great things.
**At a recent conference in Rio de Janeiro, “Financial Institutions for Innovation and Development,” sponsored by the Ford Foundation Initiative on Reforming Global Finance, the Multidisciplinary Institute for Development and Strategies (MINDS) and the Brazilian Development Bank (BNDES), economists discussed innovation and how financial markets, business enterprises and the state interact with and invest in the process of creating and producing useful things.
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