Financialization

Share in GDP of US financial sector since 1860.^[1]

Financialization is a term sometimes used in discussions of the financial capitalism that has developed over the decades between 1980 and 2010, in which financial leverage tended to override capital (equity), and financial markets tended to dominate over the traditional industrial economy and agricultural economics.

Financialization describes an economic system or process that attempts to reduce all value that is exchanged (whether tangible or intangible, future or present promises, etc.) into a financial instrument. The intent of financialization is to be able to reduce any work product or service to an exchangeable financial instrument, like currency, and thus make it easier for people to trade these financial instruments.

Workers, through a financial instrument such as a mortgage, may trade their promise of future work or wages for a home. The financialization of risk sharing is what makes possible all insurance. The financialization of a government's promises (e.g., US government bonds) is what makes possible all government deficit spending. Financialization also makes economic rents possible.

Specific academic approaches

Various definitions, focusing on specific aspects and interpretations, have been used:

Greta Krippner of the University of Michigan writes that financialization refers to a "pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production." In the introduction to the 2005 book Financialization and the World Economy, editor Gerald A. Epstein wrote that some scholars have insisted on a much narrower use of the term: the ascendancy of shareholder value as a mode of corporate governance, or the growing dominance of capital market financial systems over bank-based financial systems. Pierre-Yves Gomez and Harry Korine, in their 2008 book Entrepreneurs and Democracy: A Political Theory of Corporate Governance, have identified a long-term trend in the evolution of corporate governance of large corporations and have shown that financialization is one step in this process.
Oleg Komlik asserts that financialization is a state project, stressing that:^[2]

"Financialization is a key feature of neoliberalism. It refers to the capturing impact of financial markets, institutions, actors, instruments and logics on the real economy, households and daily life. Essentially it has significant implications for the broader patterns and functioning of a (inter)national economy, transforming its fabrics and modificating the mutual embeddedness of state-economy-society."

Michael Hudson described financialization as "a lapse back into the pre-industrial usury and rent economy of European feudalism" in a 2003 interview:^[3]

"only debts grew exponentially, year after year, and they do so inexorably, even when–indeed, especially when–the economy slows down and its companies and people fall below break-even levels. As their debts grow, they siphon off the economic surplus for debt service (...) The problem is that the financial sector's receipts are not turned into fixed capital formation to increase output. They build up increasingly on the opposite side of the balance sheet, as new loans, that is, debts and new claims on society’s output and income.

[Companies] are not able to invest in new physical capital equipment or buildings because they are obliged to use their operating revenue to pay their bankers and bondholders, as well as junk-bond holders. This is what I mean when I say that the economy is becoming financialized. Its aim is not to provide tangible capital formation or rising living standards, but to generate interest, financial fees for underwriting mergers and acquisitions, and capital gains that accrue mainly to insiders, headed by upper management and large financial institutions. The upshot is that the traditional business cycle has been overshadowed by a secular increase in debt. Instead of labor earning more, hourly earnings have declined in real terms. There has been a drop in net disposable income after paying taxes and withholding "forced saving" for social Security and medical insurance, pension-fund contributions and–most serious of all–debt service on credit cards, bank loans, mortgage loans, student loans, auto loans, home insurance premiums, life insurance, private medical insurance and other FIRE-sector charges. ... This diverts spending away from goods and services.

Thomas Marois, looking at the big emerging markets, defines "emerging finance capitalism" as the current phase of accumulation, characterized by "the fusion of the interests of domestic and foreign financial capital in the state apparatus as the institutionalized priorities and overarching social logic guiding the actions of state managers and government elites, often to the detriment of labor."^[4]
According to Gerald A. Epstein" "Financialization refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international levels."^[5]
Financialization may be defined as "the increasing dominance of the finance industry in the sum total of economic activity, of financial controllers in the management of corporations, of financial assets among total assets, of marketised securities and particularly equities among financial assets, of the stock market as a market for corporate control in determining corporate strategies, and of fluctuations in the stock market as a determinant of business cycles" (Dore 2002).
More popularly, however, financialization is understood to mean the vastly expanded role of financial motives, financial markets, financial actors, and financial institutions in the operation of domestic and international economies.
Sociological and political interpretations have also been made. In his 2006 book, American Theocracy: The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century, American writer and commentator Kevin Phillips presents financialization as "a process whereby financial services, broadly construed, take over the dominant economic, cultural, and political role in a national economy" (268). Phillips considers that the financialization of the US economy follows the same pattern that marked the beginning of the decline of Habsburg Spain in the 16th century, the Dutch trading empire in the 18th century, and the British Empire in the 19th century (it is also worth pointing out that the true final step in each of these historical economies was collapse):

... the leading economic powers have followed an evolutionary progression: first, agriculture, fishing, and the like, next commerce and industry, and finally finance. Several historians have elaborated this point. Brooks Adams contended that "as societies consolidate, they pass through a profound intellectual change. Energy ceases to vent through the imagination and takes the form of capital."

Nassim Taleb discusses the role that mis-estimated financialization methods and processes can play in causing disaster. In his book The Black Swan, Taleb points out how financialization can misrepresent reality and lead to large errors. With regard to the 2007-2009 financial crisis, it became clear that many mortgages did not accurately represent the risk to the lender or the promise of future income from the borrower. Credit default swap transactions initially overwhelmed the marketplace as many rushed to correct the error caused by the mis-financialization of borrowers' promises—that is, mortgages. In a 2001 work titled "Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets", Taleb foretold many of the errors in financialization that were being made at the time; those errors ultimately proved to be the major cause of the 2007–9 crisis. Taleb suggests that mis-financializations are the root causes of most systemic economic problems in modern economies.

Jean Cushen explores how the workplace outcomes associated with financialization render employees insecure and angry.^[6]

Roots

In the American experience, some have argued that the roots of financialization can be traced to the rise of neoliberalism and the free-market doctrines of Milton Friedman and the Chicago School of Economics, which provided the ideological and theoretical basis for the increasing deregulation of financial systems and banking beginning in the 1970s. Notre Dame heterodox economist David Ruccio has summarized the politico-economic philosophy of Friedman and the Chicago School as one in which "markets, private property and minimal government will achieve maximum welfare." Others see a greater role arising from the issuance of fiat currency untethered to gold or other commodities.

In a 1998 article, Michael Hudson discussed previous economists who saw the problems that result from financialization.^[7] Problems were identified by John A. Hobson (financialization enabled Britain's imperialism), Thorstein Veblen (it acts in opposition to rational engineers), Herbert Somerton Foxwell (Britain was not using finance for industry as well as Europe), and Rudolf Hilferding (Germany was surpassing Britain and the United States in banking that supports industry).

At the same 1998 conference in Oslo, Erik S. Reinert and Arno Mong Daastøl in "Production Capitalism vs. Financial Capitalism" provided an extensive bibliography on past writings, and prophetically asked^[8]

In the United States, probably more money has been made through the appreciation of real estate than in any other way. What are the long-term consequences if an increasing percentage of savings and wealth, as it now seems, is used to inflate the prices of already existing assets - real estate and stocks - instead of to create new production and innovation?

Financial turnover compared to gross domestic product

Other financial markets exhibited similarly explosive growth. Trading in US equity (stock) markets grew from $136.0 billion (or 13.1% of US GDP) in 1970 to $1.671 trillion (or 28.8% of U.S. GDP) in 1990. In 2000, trading in US equity markets was $14.222 trillion (144.9% of GDP). Most of the growth in stock trading has been directly attributed to the introduction and spread of program trading.

According to the March 2007 Quarterly Report from the Bank for International Settlements (see page 24.):

Trading on the international derivatives exchanges slowed in the fourth quarter of 2006. Combined turnover of interest rate, currency and stock index derivatives fell by 7% to $431 trillion between October and December 2006.

Thus, derivatives trading—mostly futures contracts on interest rates, foreign currencies, Treasury bonds, and the like—had reached a level of $1,200 trillion, or $1.2 quadrillion, a year. By comparison, US GDP in 2006 was $12.456 trillion.

Futures markets

The data for turnover in the futures markets in 1970, 1980, and 1990 is based on the number of contracts traded, which is reported by the organized exchanges, such as the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Commodity Exchange, and compiled in data appendices of the Annual Reports of the U.S. Commodity Futures Trading Commission. The pie charts below show the dramatic shift in the types of futures contracts traded from 1970 to 2004.

For a century after organized futures exchanges were founded in the mid-19th century, all futures trading was solely based on agricultural commodities. But after the end of the gold-backed fixed-exchange rate system in 1971, contracts based on foreign currencies began to be traded. After the deregulation of interest rates by the Bank of England and then the US Federal Reserve in the late 1970s, futures contracts based on various bonds and interest rates began to be traded. The result was that financial futures contracts—based on such things as interest rates, currencies, or equity indices—came to dominate the futures markets.

The dollar value of turnover in the futures markets is found by multiplying the number of contracts traded by the average value per contract for 1978 to 1980, which was calculated by ACLI Research in 1981. The figures for earlier years were estimated on computer-generated exponential fit of data from 1960 to 1970, with 1960 set at $165 billion, half the 1970 figure, on the basis of a graph accompanying the ACLI data, which showed that the number of futures contracts traded in 1961 and earlier years was about half the number traded in 1970.

According to the ALCI data, the average value of interest-rate contracts is around ten times that of agricultural and other commodities, while the average value of currency contracts is twice that of agricultural and other commodities. (Beginning in mid-1993, the Chicago Mercantile Exchange itself began to release figures of the nominal value of contracts traded at the CME each month. In November 1993, the CME boasted that it had set a new monthly record of 13.466 million contracts traded, representing a dollar value of $8.8 trillion. By late 1994, this monthly value had doubled. On January 3, 1995, the CME boasted that its total volume for 1994 had jumped by 54%, to 226.3 million contracts traded, worth nearly $200 trillion. Soon thereafter, the CME ceased to provide a figure for the dollar value of contracts traded.)

Futures contracts are a "contract to buy or sell a very common homogenous item at a future date for a specific price". The nominal value of a futures contract is wildly different from the risk involved in engaging in that contract. Consider two parties who engage in a contract to exchange 5,000 bushels of wheat at $8.89 per bushel on December 17, 2012. The nominal value of the contract would be $44,450 (5,000 bushels x $8.89). But what is the risk? For the buyer. the risk is that the seller will not be able to deliver the wheat on the stated date. This means the buyer must purchase the wheat from someone else; this is known as the "spot market". Assume that the spot price for wheat on December 17, 2012, is $10 per bushel. This means the cost of purchasing the wheat is $50,000 (5,000 bushels x $10). So the buyer would have lost $5,550 ($50,000 less $44,450), or the difference in the cost between the contract price and the spot price. Furthermore, futures are traded via exchanges, which guarantee that if one party reneges on its end of the bargain, (1) that party is blacklisted from entering into such contracts in the future and (2) the injured party is insured against the loss by the exchange. If the loss is so large that the exchange cannot cover it, then the members of the exchange make up the loss. Another mitigating factor to consider is that a commonly traded liquid asset, such as gold, wheat, or the S&P 500 stock index, is extremely unlikely to have a future value of $0; thus the counter-party risk is limited to something substantially less than the nominal value.

Economic effects

Financial services (banking, insurance, investment, etc.) have become a key industry in developed economies, in which it represents a sizeable share of the GDP and an important source of employment. Those activities have also played a key role in facilitating economic globalization. In the wake of the 2007-2010 financial crisis, a number of economists and others began to argue that financial services had become too large a sector of the US economy, with no real benefit to society accruing from the activities of increased financialization. Some, such as former International Monetary Fund chief economist Simon Johnson, went so far as to argue that the increased power and influence of the financial services sector had fundamentally transformed the American polity, endangering representative democracy itself.^[9]

In February 2009, white-collar criminologist and former senior financial regulator William K. Black listed the ways in which the financial sector harms the real economy. Black wrote, "The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation."^[10]

In testimony before the US Congress in March 2009, former Federal Reserve Chairman

“

Alan Greenspan has proclaimed himself "shocked" that "the self-interest of lending institutions to protect shareholders' equity" proved to be an illusion.... The Reagan-Thatcher model, which favored finance over domestic manufacturing, has collapsed. ... The mutually reinforcing rise of financialization and globalization broke the bond between American capitalism and America's interests... we should take a cue from Scandinavia's social capitalism, which is less manufacturing-centered than the German model. The Scandinavians have upgraded the skills and wages of their workers in the retail and service sectors -- the sectors that employ the majority of our own workforce. In consequence, fully employed impoverished workers, of which there are millions in the United States, do not exist in Scandinavia.^[11]

”

Emerging countries have also tried to develop their financial sector, as an engine of economic development. A typical aspect is the growth of microfinance or microcredit.

On 15 February 2010, Adair Turner, the head of Britain’s Financial Services Authority, directly named financialization as a primary cause of the 2007–2010 financial crisis. In a speech before the Reserve Bank of India, Turner said that the Asian financial crisis of 1997–98 was similar to the 2008–9 crisis in that "both were rooted in, or at least followed after, sustained increases in the relative importance of financial activity relative to real non-financial economic activity, an increasing 'financialisation' of the economy."^[12]

Bruce Bartlett summarized several studies in a 2013 article indicating that financialization has adversely affected economic growth and contributes to income inequality and wage stagnation for the middle class.^[13]

The development of leverage and financial derivatives

One of the most notable features of financialization has been the development of overleverage (more borrowed capital and less own capital) and, as a related tool, financial derivatives: financial instruments, the price or value of which is derived from the price or value of another, underlying financial instrument. Those instruments, whose initial purpose was hedging and risk management, have become widely traded financial assets in their own right. The most common types of derivatives are futures contracts, swaps, and options. In the early 1990s, a number of central banks around the world began to survey the amount of derivative market activity and report the results to the Bank for International Settlements.

In the past few years, the number and types of financial derivatives have grown enormously. In November 2007, commenting on the financial crisis sparked by the subprime mortgage collapse in the United States, Doug Noland's Credit Bubble Bulletin, on Asia Times Online, noted,

The scale of the Credit "insurance" problem is astounding. According to the Bank of International Settlements, the OTC market for Credit default swaps (CDS) jumped from $4.7 TN at the end of 2004 to $22.6 TN to end 2006. From the International Swaps and Derivatives Association we know that the total notional volume of credit derivatives jumped about 30% during the first half to $45.5 TN. And from the Comptroller of the Currency, total U.S. commercial bank Credit derivative positions ballooned from $492bn to begin 2003 to $11.8 TN as of this past June....

A major unknown regarding derivatives is the actual amount of cash behind a transaction. A derivatives contract with a notional value of millions of dollars may actually only cost a few thousand dollars. For example, an interest rate swap might be based on exchanging the interest payments on $100 million in US Treasury bonds at a fixed interest of 4.5%, for the floating interest rate of $100 million in credit card receivables. This contract would involve at least $4.5 million in interest payments, though the notional value may be reported as $100 million. However, the actual "cost" of the swap contract would be some small fraction of the minimal $4.5 million in interest payments. The difficulty of determining exactly how much this swap contract is worth, when accounted for on a financial institution's books, is typical of the worries of many experts and regulators over the explosive growth of these types of instruments.

Contrary to common belief in the United States, the largest financial center for derivatives (and for foreign exchange) is London. According to MarketWatch on December 7, 2006,

The global foreign exchange market, easily the largest financial market, is dominated by London. More than half of the trades in the derivatives market are handled in London, which straddles the time zones between Asia and the U.S. And the trading rooms in the Square Mile, as the City of London financial district is known, are responsible for almost three-quarters of the trades in the secondary fixed-income markets.

Notes

↑ Thomas Philippon (Finance Department of the New York University Stern School of Business at New York University). The future of the financial industry. Stern on Finance, November 6, 2008.
↑ Oleg Komlik. 2015. Financialization as a state project.
↑ Standard Schaefer. Who Benefited from the Tech Bubble? an Interview with Michael Hudson CounterPunch, August 29, 2003.
↑ Marois, Thomas (2012). States, Banks and Crisis: Emerging Finance Capitalism in Mexico and Turkey. Edward Elgar Publishing.
↑ Gerald Epstein Financialization, Rentier Interests, and Central Bank Policy. December, 2001 (this version, June, 2002 )
↑ Cushen, J. (2013). Financialization in the workplace: Hegemonic narratives, performative interventions and the angry knowledge worker. Accounting, Organizations and Society, Volume 38, Issue 4, May 2013, pp 314–331.
↑ Michael Hudson (1998)March 12, 2009megan . Financial Capitalism v. Industrial Capitalism.
↑ Reinert, Erik S. & Daastøl, Arno Mong (2011). Production Capitalism vs.Financial Capitalism - Symbiosis and Parasitism. An Evolutionary Perspective and Bibliography. . Working Papers in Technology Governance and Economic Dynamics no. 36. The Other Canon Foundation, Norway. Tallinn University of Technology, Tallinn.
↑ Megan McCardle. The Quiet Coup. The Atlantic Monthly, May 2009
↑ William K. Black. How the Servant Became a Predator: Finance's Five Fatal Flaws. The Huffington Post, February 19, 2010.
↑ Harold Meyerson, "Building a Better Capitalism", The Washington Post, March 12, 2009.
↑ Reserve Bank of India. "After the Crises: Assessing the Costs and Benefits of Financial Liberalisation". Speech delivered by Lord Adair Turner, Chairman, Financial Services Authority, United Kingdom, at the Fourteenth C. D. Deshmukh Memorial Lecture on February 15, 2010 at Mumbai.
↑ Bruce Bartlett. Financialization as a Cause of Economic Malaise. NY Times, June 11, 2013.

External links

What is financialization? Marxism, Post-Keynesianism and Economic Sociology’s complementary theorizing
F.Thomson and S.Dutta: Financialisation: A Primer. Transnational Institute. January 2016.
Özgür Orhangazi. Financialization and the US Economy. Edward Elgar Publishing, 2008
John Bogle, founder and retired CEO of The Vanguard Group of mutual funds, discusses how the financial system has overwhelmed the productive system, on Bill Moyers Journal
World Financial Crisis and Civil Society: Implications for Global Democracy, Lecture by Prof. Jan Aart Scholte, June 5, 2013, DRadio Wissen Hörsaal (introduction in German, lecture in English)
Gerald A. Epstein’s Introduction to Financialization and the World Economy
Thomas I. Palley's November 2007 paper, Financialization: What it is and Why it Matters
Greta R. Krippner: The financialization of the American economy. Socio-Economic Review 2005 3(2):173-208.
The Financialization of Capital and the Crisis, Monthly Review, April 2008
Cushen, J. (2013). "Financialization in the workplace: Hegemonic narratives, performative interventions and the angry knowledge worker". Accounting, Organizations and Society, 38(4), 314-331.
The Financialization of Capitalism, Monthly Review, April 2007
Monopoly-Finance Capital, Monthly Review, December 2006
"Financialization and Capital Accumulation", peri.umass.edu
Blackburn - Subprime Crisis. New Left Review, Mar April 2008
Financialization: A Primer by economist Ramaa Vasudevan in Dollars & Sense magazine, Nov/Dec 2008
Luiz Carlos Bresser-Pereira: The Global Financial Crisis and a New Capitalism? Levy Economics Institute Working Paper No. 592. Mai 2010.
Tori D., Onaran O. (2015): The effects of financialization on investment: evidence from firm-level data for the UK Greenwich Papers in Political Economy, November 2015.

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