More regulations needed to survive financialization in the West
In comparing economic performance of the last three decades (1980-2015) with that of the prior three decades (1943-1973), we notice a number of startling facts: on average, we have higher unemployment, slower growth, and higher income inequality today.
What can we draw from this? Does this amount, as some suggest, to a new form of capitalism? If so, what are the consequences?
Many economists seem to think that we are living in a new globalized economy, which operates under very different rules. They argue that this financialized version of capitalism, aptly labelled "financialization," has transformed our economies into casinos, and in the process has rendered them riskier, unstable, more fragile and more prone to financial crises.
These questions are now slowly seeping into the mainstream of the profession as evidence is mounting in support of this view.
Financialization is the process by which profits of non-financial firms are generated increasingly through financial channels. The old economy, in which unemployment was lower on average, was based on the physical production of actual goods — in other words, manufacturing industries.
Firms were net borrowers and invested in machinery that fuelled job creation and higher growth. In the process, they made satisfactory profits.
But all this has now changed. The production or manufacturing of goods is no longer the relevant generator of value and profit in our economy. Rather, companies are increasingly turning to financial markets, and financial companies (what we call the FIRE industries: finance, insurance and real estate) account for an increasing share of total employment and output.
The road to great prosperity should be obvious to any student of economic history: we need more regulations and we need to encourage more investment in productive activities.- Louis-Philippe Rochon, Laurentian University associate professor, Review of Keynesian Economics co-editor
All this carries important consequences. First, the growth of the FIRE or financial sector harms the productive side of the economy. In an important paper for the Bank for International Settlement, Stephen G. Cecchetti and Enisse Kharroubi show that “the growth of a country's financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth.”
As a result, there is “a pressing need to reassess the relationship of finance and real growth.”
Second, even among industrial or manufacturing firms, short-term profits have now become the overall objective of firms, rather than the growth of the firm — a change that has been called "short-termism."
The primary reason behind this change is the shift in power from managers to shareholders, who are more interested in profits now than growth tomorrow. Hence, there has been a realignment of the goals of the firms in such a way that they are now identified with those of the shareholders.
Why is this important? There is evidence that this new focus is done at the expense of investment in physical assets, resulting in what can only be called an "under-investment crisis" in Canada.
When firms are investing in physical assets, it is often accompanied with an increase in productivity, and hence growth. Investment is what drives our system to higher rates of growth, so it is little wonder that under financialization, we have witnessed a slow down of growth rates since 1980.
So what do firms do with all their profits? Some will be distributed to shareholders, and the rest, so the story should go, will be reinvested into the company to help it grow. However, an ever increasing part is now going to shareholders either as increased dividends or toward buying back the shares of their own companies in order to push up earnings per share (which is called "buybacks"). When this occurs, investment goes down.
Buybacks have become increasingly important in the last 30 years, having increased in the US from $5 billion in 1980 to close to $400 billion and rising today.
Readers will recall the warnings from the former governor of the Bank of Canada-cum Governor of the Bank of England Mark Carney, as well as from the former minister of finance Jim Flaherty. They called on Canadian companies not to sit on idle piles of money and to start re-investing.
How did we get here?
Of course, the most important question is how did we get here and can we get out of it?
The story of how we got here is the result of the continuing crisis in economics: the increasing belief in the wisdom of unfettered markets and the refusal to consider any other alternatives.
In the spirit of this, and under the influence of financial markets, governments rushed to eliminate regulations and turned to the privatization of a number of state-owned companies, all in the name of pleasing financial interests. Prior to this, before 1975, a number of regulations existed aimed at preventing erratic and greedy behaviour, as in the explosion in the U.S. of subprime loans and their role in triggering the worst financial crisis since 1929.
The road to great prosperity should be obvious to any student of economic history: we need more regulations and we need to encourage more investment in productive activities.
We need to reduce the growth of the FIRE industries and we need to regulate specifically the financial industry, the banks and shadow banks. If we don’t, our system will grow increasingly fragile and unstable, and the next crisis will do even more, irreparable harm.
Louis-Philippe Rochon is an associate professor at Laurentian University and co-editor of the Review of Keynesian Economics.