Several articles in recent years have focused on the so-called “financialization” of business and commerce. I’ll highlight a couple of them here. I think they explain very clearly why our economy is out of balance. Basically:
- This is how you get a company like Bain Capital, asset-stripping the companies it buys, maximizing “shareholder value”, and then selling off the stripped shell, leaving employees without jobs or pensions. Its primary focus is on finance, not production.
- This is how you get product pricing that has nothing whatsoever to do with the intrinsic value of the product, or the amount of work or materials that went into it, but is predicated solely on what the market will bear – thus leading, for example, to prices for established medicines increasing by hundreds or even thousands of percent, purely to subsidize owner or shareholder “value”.
- This is why profits go, not to the workers who made the product, or the people who invented or developed it, but to professional managers and financiers who manipulated the market, rather than producing any part of that underlying value.
- This is why major companies in reality derive a very large proportion of their profits, not from their products, but from financializing those products (for example, the securitization of mortgages and other financial instruments). This often produces more income for the companies than the sale of the original product.
This is also why President Trump’s economic measures are focused, not on Wall Street – the heart of financialization – but on Main Street, where business and commerce are actually conducted. As a result, we have a Wall Street financial elite who are adamantly opposed to many of this Administration’s policies, because it will mean less money for financiers and their cronies. On the other hand, the ordinary working man and woman is delighted to be earning higher (and more steady) wages, and wants more of the same. It’s as much of a divide in society as the famous rift between the “haves” and the “have-nots”. In this case, it’s the financiers who “have”, and the rest of us who are left out in the cold with the crumbs they decide to toss us from time to time.
Click on the headline for each article to read it in full.
Today, finance, while making up only 7% of the economy and creating a mere 4% of all jobs, generates more than a fourth of corporate profits — up from 10% 25 years ago.
Parallel to the ascendance of finance … was a decline in American business as large corporations increasingly came to mimic the banks that were supposed to serve them and to seek profits in ‘financial engineering’ activities divorced from their core services and goods.
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A famous Harvard Business Review article from 1980, “Managing Our Way to Economic Decline,” dates falling investment in research and development back to the mid-1960s. Increasingly, the authors found, U.S. companies focused on “sophisticated and exotic” management of their growing cash reserves, grew preoccupied with cost-cutting measures, and treated “technological matters simply as if they were adjuncts to finance or marketing decisions.”
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The purpose of the corporation, Milton Friedman and others asserted, was to maximize financial value … Accordingly, maximizing stock prices was increasingly elevated as a cardinal virtue. In 1990, the Business Roundtable (a group of CEOs from America’s largest companies) defined management’s responsibility as that of serving a broad range of stakeholders, including but not limited to stockholders. Just seven years later, the wording had changed. Management’s “paramount duty” was to stockholders — the interests of other stakeholders relevant only “as a derivative” to that primary loyalty.
Armed with this ideology, powerful shareholders like Carl Icahn pressured companies to pass on more and more of their earnings to those who owned stock in the company — in the form of higher dividends, and increasingly, stock buybacks. In 1982, the SEC loosened regulations limiting a company’s ability to repurchase its own stock, despite protests by some dissenters that this would essentially legalize market manipulation. And this, Foroohar and others argue, is exactly what happened.
Reducing the number of outstanding shares on the market artificially inflates a key measure of a company’s value: its earnings-per-share, or EPS. Buybacks are often followed by an immediate surge in stock price, at least in the short term. The concern is that prominent owners of a stock will lobby for buybacks and then sell off that same stock, reaping a healthy profit even though there has been no change in a company’s underlying value. Icahn was recently charged with such a “pump and dump” strategy when, after successfully lobbying Apple to engage in a series of costly repurchases, he sold his entire stake in the company.
The buyback boom began in the 1980s, and has only accelerated since. In the last decade, the author writes, “American firms have spent a stunning $7 trillion buying back their own stock — the equivalent of half their profits.”
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Complicating matters further, Foroohar and others point out, is the fact that stock options account for a huge chunk of executive compensation — creating a built-in incentive to engage in financial maneuvering that lifts stock prices but doesn’t create real value. This has eroded American competitiveness, a Brookings Institute paper worries, by replacing a “retain-and-reinvest” corporate model with a “downsize-and-distribute” one. The end result, the author of the paper writes, is “profits without prosperity” as business focuses on “value extraction” instead of “value creation.”
Financialization isn’t bad in itself. Its initial role is the healthy one of translating work-products and services into exchangeable financial instruments to facilitate trade in the real economy. Through mortgages, workers can trade their promise of future wages for a home. Through insurance, homeowners are able to share financial risks and avoid financial catastrophe. The problems begin when financialization becomes excessive.
Throughout history, periods of excessive financialization have often coincided with periods of national economic setbacks … The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. “In a financialized economy, the financial tail is wagging the economic dog.”
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Quite apart from the tendency of a super-sized financial sector to cause increasingly bad global financial crashes, excessive financialization leads to resources being misallocated. “As far back as 1984 the Nobel Prize–winning economist James Tobin observed that ‘very little of the work done by the securities industry…has to do with the financing of real investment.’ He was troubled that ‘we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services…that generate high private rewards disproportionate to their social productivity.’”
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… we need more fundamental change in the way we think about management—a radical transformation in the whole notion of how companies, both financial and non-financial, should be run.
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Obsolete ideas like maximizing shareholder value need to be discarded … Instead, we need to get back to Peter Drucker’s 1973 insight: the only valid purpose of a firm is to create a customer.
Most worrying of all, financialization also creates a pathway to socialism. If socialists see an imbalance of wealth between the financializers and the rest of society, it gives them an opportunity to peddle their unworkable, historically catastrophic policies by claiming that they’ll “nationalize” the wealth and spread it around. They never do, of course: they end up becoming wealthy themselves, a new “ruling class” to replace those they displaced. Nevertheless, they can (and do) use the imbalance as a lever to pry their way into power. Right now, in these United States, that’s a very real threat.