Conversation with Rana Foroohar, Assistant Managing Editor in Charge of Economics and Business, Time Magazine and Author of The Makers and the Takers: The Rise of Finance and the Fall of American Business.
The sub-title of your book is The Rise of Finance and the Fall of America Business. But your book is about more than the rise of the financial industry; it is about what you call the rise of financialization. What do you mean by financialization?
Financialization is an academic term for the trend by which Wall Street and its methods have come to reign supreme in America, permeating not just the financial industrial but also much of American business. It includes everything from the growth in size and scope of finance and financial activity in the economy, to the rise of debt-fueled speculation over productive lending, to the ascendancy of shareholder value as the sole model for corporate governance, to the proliferation of risky, selfish thinking in both the private and public sectors; to the increasingly political power of financiers and CEOs they enrich, to the way in which a “markets know best” ideology remains the status quo, University of Michigan professor Gerald Davis, one of the pre-eminent scholars of the trend, likes financialization to a “Copernican revolution” in which business has reoriented its orbit around the financial sector.
At the heart of your argument lies a change in the relationship between the financial system—the capital markets—and businesses.
Yes, the role of finance in the American economy has changed dramatically over the years—going from serving business to largely serving itself. From the creation of a unified national bond and banking system in the late 1790s to the early 1970s, finance took individual and corporate savings and funneled them into productive enterprises, creating new jobs, new wealth and, ultimately, economic growth. Of course, there were plenty of blips along the way (most memorably the speculation leading to the Great Depression, which was later curbed by regulation). But for the most part, finance—which today includes everything from banks and hedge funds to mutual funds, insurance firms, trading houses and such—essentially served business. It was a vital organ but not, for the most part, the central one.
Over the past few decades, finance has turned away from this traditional role. Academic research shows that only a fraction of all the money washing around the financial markets these days actually makes it to Main Street businesses. As Oscar Jorda, Alan Taylor and Moritz Shularick have pointed out in one of their studies, “the intermediation of household savings for productive investment in the business sector—the textbook description of the financial sector—constitutes only a minor share of the business of banking today.” By their estimates, around 15 percent of the capital coming from financial institutions today is used to fund business investments, whereas it would have been the majority of what banks did earlier in the 20th century.
In a conversation with the Private Debt Project, Lord Adair Turner, Chairman on the Institute for New Economic Thinking, pointed out that the much of the money today is being used not for new business investment but for lending against existing assets such as housing, stocks, and bonds. You make a similar argument in your book and add some interesting data about the change in the lending patterns of commercial banks to prove the point.
Back in the early 1980s, when financialization began to gain steam, commercial banks in the United States provided almost as much in loans to industrial and commercial enterprises as they did in real estate and consumer loans; that ratio stood at 80 percent. By the end of the 1990s, the ratio fell to 52 percent, and by 2005 it was only 28 percent. Lending to small business has fallen particularly sharply as has the number of start-up firms themselves in the early 1980s, new companies made up half of all U.S. businesses. By 2011, they were just a third, a trend that numerous academics and even many investors and business people have linked to the financial industry’s change in focus from lending to speculation. The wane in entrepreneurship means less economic vibrancy, given that new businesses are the nation’s foremost source of job creation and GDP growth.
Financialization has gone hand in hand with the expansion of debt in the economy and the economy’s dependence on debt. In your view, how are financialization and debt connected?
With the rise of securities and trading portion of the industry came a rise in debt of all kinds, public and private. Debt is the life-blood of finance; it is where the financial industry makes its money. But with the increase in debt comes new problems as those in the Private Debt Project know well. For one thing, rising debt and credit levels can stoke financial instability. They also signal that the economy is becoming more dependent on debt for growth. As I point out in the book, as finance has captured a greater and greater piece of the national pie, it has perversely ensured that debt is indispensable to maintaining any growth at all in advanced economy like the United States, where 70 percent of output is consumer spending. Stagnating wages and historically low economic growth can’t do the trick, so debt-fueled finance becomes a saccharine substitute for the real thing, an addition that just gets worse and worse. The amount of credit offered to American consumers has doubled in real dollars since the 1980s, as have the fees they pay to their banks. (The latter is proof that as finance has gotten bigger, it hasn’t got more efficient, just more ingenuous in growing profits by charging more fees.)
As the economic economists Raghuram Rajan, one of the most prescient seers of the 2008 financial crisis, argued in his book, Fault Lines, credit has become a palliative to address the deeper anxieties of downward mobility in the middle class. As he puts it sharply, “let them eat credit” could well summarize the mantra of the go-go years before the economic downturn. And this balloon of debt and credit has not gone away since the crisis. Private debt, as most of us know, increased dramatically in the run-up to the 2008 crisis. But now public debt too is at record levels, as tax revenues fell and as government bail-out and stimulus programs were undertaken to save the system.
One of the more insidious aspects of financialization is the extent to which it has worked its way into the business models of many large American companies.
One aspect of financialization is the growth of the finance industry itself, which has roughly doubled in size as a percentage of GDP over the past 40 years. As finance grew, so did its profits—the industry creates only 4 percent of US jobs yet takes around 25 percent of the corporate profit share.
The other worrying aspect of financialization is the extent to which companies in other sectors, from autos to airlines, have moved into the business of finance themselves. Given the outsized profits of the financial sector, it is not surprisingly that non-financial businesses wanted a piece of that action. American companies across every sector, today, earn five times the revenue from financial activities—investing, hedging, tax optimizing and offering financial activities—than they did before 1980. Airlines, for instance, often make more from hedging on oil prices than on selling seats; even though it undermines their core business by increasing their exposure to commodities volatility ands bad bets can leave them with millions of dollars in sudden losses. GE, America’s original innovator, only recently stopped being a “too big to fail” bank.
The pharmaceuticals industry, perhaps the most financialized of all, has cut nearly 150,000 jobs since 2008, most in R & D, as companies focus instead on outsourcing, tax optimization, inversions and “creative” accounting. So much so that they look suspiciously like portfolio management companies—a group of disparate firms operating separately and trying to make as much money as quickly as possible with little thought to the long-term impact of their decisions.
Even Silicon Valley is not immune from this phenomenon. Apple and other tech behemoths have vast corporate bond holdings—which is not surprising considering how much cash they hold. If Big Tech decided at any point to dump those bonds, it could become a market moving event, an issue that is already raising concern among experts at the US Treasury Department’s Office of Financial Research.
Another aspect of financialization you take up is how the emphasis on finance has led to an increasingly resort to financial engineering on the part of many companies at the expense of productive investment.
Exactly. Take share buybacks, in which a company—usually with some fanfare—goes to the market, and often as a way of artificially bolstering share prices in order to enrich investors and executives paid largely in stock options. Indeed, if you were to chart the rise in money spent on share buybacks and the fall in corporate spending on productive investments like R & D, the two lines make a perfect X. The former has been going up since the 1980s, with S & P 500 firms now spending $1 trillion a year on buybacks and dividends—equal to more than 95 percent of their net earnings—rather than investing that money back in research, product development, or anything that could contribute to long-term company growth.
No sector has been immune, not even the ones we think as the most innovative. Many tech firms, for example, spend far more on share-pricing boosting than on R & D as a whole. The markets penalize them when they don’t. One case in point: back in March 2006, Microsoft announced major new technology investments, and its stock fell for two months. But in July of that same year, it embarked on $20 billion worth of stock buying, and the share price promptly rose by 7 percent. This kind of twisted incentive for CEOs and corporate officers has only grown since.
Interestingly, you suggest we may be seeing a new debt bubble in the corporate space linked in part to this practice of financial engineering.
Many of these same companies have developed s a pattern of using debt to buy-back stock at a number of well-known companies. Take Apple, one of the most successful American companies over the past 50 years. Apple has around $200 billion sitting in the bank, yet it has borrowed billions of dollars cheaply over the past several years to pay back investors in order to bolster its share price. Why borrow? In part, because it’s cheaper than repatriating cash and paying U.S. taxes. All this financial engineering helped boost Apple’s share price for a while. Yet it didn’t stop activist investor, Carl Icahn, who had advocated for borrowing and buybacks, from dumping the stock the minute revenue growth took a turn for the worse in late April.
It is perhaps the ultimate irony that large, rich companies like Apple are not involved with financial markets at times when they don’t need any financing. Top-tier U.S. businesses have never enjoyed greater financial resources. They have a record $2 trillion in cash on their balance sheets—enough money combined to make them the 10th largest economy in the world. Yet in the bizarre order that finance has created, they are also taking on record amounts of debt to buy back their own stock, creating what may be the next debt bubble to burst, particularly if the economy and profits turn sour.
In your book you suggest that we may be approaching the end of financially engineered growth.
None of the financial engineering now going on in corporate America is good for the real economy: a wealth of academic research show that not only has finance become an obstacle to growth, but also that financial engineering is destroying long-term value within companies. Buyback booms of the sort we have seen in the past couple of years tend to happen at the top of the market, when financially manufactured growth is tapped out. With corporate profits under pressure, US business that have not been investing in real, underlying growth and innovation may be in for a fall. The result will be more economic stagnation—and more political populism.
Despite this depressing state of affairs, you conclude your book on a somewhat optimistic note. What do you think can and needs to be done at this time?
In my view, America faces an opportunity right now: a rare second chance to do the work of refocusing and right-sizing the financial sector that should have been done in the years immediately following the 2008 crisis. And there are bright spots on the horizon.
Despite the lobbying power of the financial industry and the vested interests both in Washington and Wall Street, there’s a growing push to put the financial system back in its rightful place, as a servant of business rather than its master. This is a big but critical agenda.
Re-mooring finance in the real economy isn’t as simple as splitting up the biggest banks (although that would be a good start). It’s about dismantling the hold of financial-oriented thinking in every corner of corporate America. It’s about reforming business education, which is still permeated with academics who resist challenges to the gospel of efficient markets in the same way that medieval clergy dismissed scientific evidence that might challenge the existence of God. It’s about changing a tax system that treats one-year investment gains the same as longer-term ones and induces financial institutions to push overconsumption and speculation rather than healthy lending to small businesses and job creators. It’s about rethinking retirement, crafting smarter housing policy and restraining a money culture filled with lobbyists who violate America’s essential economic principles.
Above all, it’s about starting a bigger conversation about all this with a broader group of stakeholders. And that is what I have tried to do with my book.