Traveling The Narrow Road

My recent article, America’s Level of Prosperity is Not Sustainable, dealt mainly with the yet to come lowering of living standards in the U.S. due to having to pay back external debt to our trading partners.

The Financialization of the Economy

But there is a more insidious, pervasive and direct cause of our current economic woes – the financialization of our economy. There are a number of ways to describe financialization. It occurs when the financial sector accounts for a disproportionate share of a nation’s profits at the expense of the real economy. The real economy is that part of the economy that is devoted to actually producing goods and services rather than to buying and selling assets and debt.

This increased diversion of income from labor to capital owners results in inequality as wages of workers stagnate and wealth is transferred to those who use money first, i.e., the financial sector. Financialization is characterized by a penchant to obtain short-term profit at the expense of long-term economic growth. Normal economic common sense becomes increasingly uncommon as the concept of making money from money takes priority over using capital together with labor to produce goods and services.

It’s as if our society has become infatuated with investments that, in fact, are not – at least not in an economic sense. Many of our “investments” are no more than the buying of assets hoping their price will increase. For example, when we buy stock in a company, unless we purchase an IPO, we are simply buying ownership in a company from another owner. This “exchange” of stock puts no money in the company’s coffers to invest in future economic output.¹

The Financial Industry is not Part of the Real Economy

The distinction between the financial industry and the real economy has been lost, along with any notion that the financial industry’s excessive growth actually chokes the life out of the real economy. Financializaton has already caused a lower standard of living for many. Wages have stagnated despite the fact that those producing goods and services have become more efficient in their work. Financialization ensures that the fruit of increased productivity goes mostly to capital owners rather than to workers.

Short-term Thinking, Long-term Pain

When financiers are given free rein, the economy loses its bearings as firms seek quick profits by whatever means allowed. Leveraged buyouts and massive layoffs result as shareholder’s returns on their “investment” trump the earnings of employees who actually produce real wealth. Pension funds go the way of the dodo bird and companies are carved up into pieces so that the most valuable assets can be sold to satisfy the shareholders’ greed.

When financiers are given free rein, research and capital equipment investment (key drivers of economic growth and wealth creation) decrease substantially because they are long-term investments. Corporate CEOs (who are mostly compensated with company stock) who delay satisfying the insatiable desire of capital owners for yield, are quickly punished by a drop in their company’s stock price.

Such economic practices are irresponsible. A farmer would be foolish to eat all of his grain leaving none to plant in the spring. He would be foolish to neglect his equipment, letting it break down while spending his profits on lavish parties and trips to the Caribbean. If he does so and wants to farm the next year, he will have to go into debt. Why should we expect better results when we sacrifice our nation’s economic future on the altar of short-term greed?

What is the proper role of finance?

Finance does play an important role in our economy. When the financial community does its job well they provide a trustworthy bridge between savers with money to invest and businesses that need capital to expand. Expanding business means more and better paying jobs and an increased standard of living.

Unfortunately, because of a lack of transparency and past abuses, financial markets have lost much of the public’s trust. Today, financial institutions only use 15% of their capital to fund business investments in the real economy.²

So, where does all the money go? Much of it is used for lending to buy existing assets.³ When this happens, besides creating a bubble and transferring wealth to the first users of money, less money is used to create new wealth. The financiers profit but the economy stagnates.

What evidence is there that the financial sector has grown too large? The financial sector takes a disproportionate share of corporate profits (25%) while creating few jobs (4%).⁴

It is government’s responsibility to rein in excessive power and influence, but it is instead complicit in the rise of the financial sector. When interest rates are nearly zero and when government hands power to the financial sector with little accountability, should we be surprised when they take the easy path to profits instead of the prudent path to economic stability?

Modern Day Money Changers

While not the only modern-day example, I have long thought that Wall Street and our financial system is a good representation of what the Bible refers to as money changers in Matthew 21 and John 2. The money changers should have been outside the temple serving those who needed to buy animals to sacrifice in the temple. Instead, they were a distraction and a hindrance to them even as they took advantage of them. Jesus drove them out calling them robbers who misused the house of prayer.

I use the term money changers to describe the financial “industry” because they have moved almost entirely from their traditional role to serve the public and business by facilitating the use of savers’ funds for investment in the real economy to a role of traders who, in the pursuit of large short-term profits charge excessive fees for products that add little to economic growth. Like the money changers in the Bible they no longer serve others, but instead, serve themselves.

Why We Will Have to Live On Less

When an economy is skewed toward finance the future is largely ignored. Inequality increases as wages stagnate because gains go to capital owners rather than labor, jobs are lost and debt piles up.

Productive capacity is reduced when capital is wasted on bidding up the price of existing assets. Investment in capital equipment and new business will prove to have been inadequate to meet our future needs. The only way we will be able to sustain our previous standard of living is to go further in debt to our trading partners. But, never-ending trade deficits are unsustainable.

These mistakes can be corrected, but much damage has been done and it will take time to repair our economy, even if we have the will to do so. We won’t escape from our own folly without having to endure a significantly lowered standard of living. We cannot reap from what we have not sown.

 

 

Notes:

1. Stock price does have an effect on the company’s ability to borrow money for business expansion. However, it is the creditors (corporate bondholders) who are investing in the company, not stockholders.
2. Foroohar, Rana, Makers and Takers, New York, Crown Business, 2016
3. Foroohar, Rana, Makers and Takers, New York, Crown Business, 2016
4. Rana Foroohar, Makers and Takers, New York, Crown Business, 2016