Here’s the conclusion, which is very much in line with my post from Monday: “the U.S. financial sector no longer serves the productive sector—in fact, it may be killing it.” Here’s Lynn’s summary of one of the main papers presented at the Rio conference:
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.
Yes, the rent-seeking Vampires are pulling out income that could have gone to financing innovations. Worse than that, Wall Street directs economic activity to rent extraction rather than production–so we do not even use the productive capacity and innovations that we already have. Instead, Wall Street buys up and dismantles the productive capacity. Or, like Goldman Sachs, they hoard scarce resources and shuffle them between warehouses. They layer households and firms under mountains of debt so that they cannot afford to buy the output that does get produced.
As you might remember, the last time that Wall Street ran the whole show was in the 1920s. That didn’t work out so well—financial institutions like Goldman Sachs buried the economy under mountains of debt and created financial scams that sucked away life savings in the Great Crash of 1929. Sound familiar? Yes, déjà vu all over again—read John Kenneth Galbraith’s The Great Crash and all of the financial shenanigans sound eerily familiar because those of the 2000s perfectly mirror the earlier episode. Indeed, you do not even need to change the names of the guilty—Galbraith titled one of the chapters after Goldman Sachs, as the investment bank had played a pivotal role in destroying the economy. And Goldman is doing it again, and will keep doing it until we euthanize the firm.
However, what is different this time around is the policy response. Last time, the New Deal drove a stake through the heart of Wall Street as financial reform completely separated commercial banking from investment banking, downsized finance, and prohibited financial institutions from direct ownership of our nation’s real productive capacity. Effectively, the real sector was “de-financialized” for the next two generations. And it worked. The economy grew rapidly, debt remained low, and the financial sector was repressed.
Here’s the deal. The natural tendency in modern capitalism is for finance to dominate. For a variety of reasons, financial markets are easy to manipulate. They sell ephemeral products that are hard to value. Judicious use of favorable accounting makes it easy to manufacture short-term profits and big rewards to management. Rapid growth is relatively easy to attain—unlike in, say, manufacturing where plant must be built and products produced and sold. In the financial sphere marginal costs are low, and lower still with the spread of powerful desktop computing. Inside information is easy to exploit and hard to uncover.
Successful financial practices spread quickly. They cannot be resisted because those who refuse to mimic the most profitable financial firms get trounced in equities markets. Finance’s tentacles spread to “industrial” firms through two avenues. First through financing take-overs, with Michael Milken’s leveraged buy-outs of “cash cows” a prime example. This encourages defensive leveraging-up debt ratios. Second through “diversification” of an industrial firm’s portfolio to include financial assets, and as well to use of the firm’s cash as a profit center. Soon, there is no real difference between a financial firm like Citigroup and an industrial firm like General Electric—both are highly levered firms that rely on net interest, fees, and capital gains for much of their revenues.
As Lynn put it:
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.
The only effective barrier is government regulation and supervision to constrain finance’s reach. The problem is that the regulatory agencies have gradually but inexorably removed all restraints. In the 1930s the argument was that we need to keep finance out of the “real” economy because direct ownership of productive firms is too risky—when the economy turns down, those firms fail and bring down the banks. Over the past 30 years, as regulators evaluated finance’s proposals to increase its penetration into the “real” sector, the main consideration was over risk to the financial sector itself. In case after case, finance won the argument that by getting more heavily involved in the “real” sector, it gained information that made its financial activities lessrisky.
On face value, that is often true. If I’m going to trade financial futures in, say, commodities, the more information I can obtain about real commodities markets, the better. If I know, for example, that inventories of copper are growing, I am better placed to project near-term price movements. More importantly, I use the inside information to manipulate the market, to take advantage of my customers, and even to defraud them. Since fraud is always the most profitable game in town, Gresham’s Law dynamics ensure that “fraud pays” and that fraudsters dominate.
Is there a solution? Well, I like the stake through the heart, or Keynes’s euthanasia. Here’s Bill Lazonick’s recommendation:
- 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.
I recommend that you take a look at Lynn’s piece and also follow the research that was presented at the Rio conference: “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), where 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.