The Failure of Finance

In 1944, the nations of the world assembled at the Bretton Woods Conference to create a new, global financial system. The resulting institutions tied up financial markets, allowing states to pursue productive and widespread economic growth. The conference’s president declared that the goal was to remove “usurious money lenders from the temple of international finance,” and delegate John Maynard Keynes predicted the system would lead to the “euthanasia of the rentier.” Bretton Woods toppled finance’s lordship over the economy and gave control to states. Although the system helped spark a decades-long economic boom, it was dismantled in the '70s and '80s. First, Nixon abandoned the gold standard vital to the agreement. Then, the Reagan and Thatcher administrations unleashed neoliberalism to hack away at regulations and create unfettered financial institutions. Governments the world over ended the separation of commercial and investment banking (a hallmark of Glass-Steagall in the U.S.), relaxed rules, and curbed oversight. Given the green light by neoliberals, this finance system’s takeover of the global economy was inevitable. Our economic system has become over-financialized—with devastating consequences for the world.

Financialization, the “increasing importance of finance, financial markets, and financial institutions to the workings of the economy,” has steadily infiltrated the U.S. and the world. The financial industry’s share of American G.D.P. grew from 15% in 1960 to 23% in 2001 (excluding government and self-employment). Raking in around 40% of all corporate profits, it is one of the most profitable sectors of the economy. Banks’ turn towards speculation and securitization fueled finance’s rise. The removal of regulation allowed banks to practice “originate-to-distribute" lending. Instead of making a loan to collect payment and interest, banks lend money just to sell the loan in financial markets. They also package many loans into one sale in a process called securitization; securitized sales are supposedly safer because it is less likely for many loans to fail compared to just one. Now unregulated, banks move to securitize any financial assets they have on hand, so they can sell them into markets and make huge profits. The so-called “shadow banking” arms of major institutions then take securities or assets and repackage, collateralize, insure, and bet on them (these spin-off assets are called “derivatives”). Thus, more and more items are created and sold not because they have value but because they are theoretically connected to something valuable. The cycle of packaging, repackaging, and selling continues infinitely: an endless chain of more and more sales and clients. Derivatives are made out of other derivatives, drawing assets farther away from anything real. The financial industry did more than just spin straw into gold—it turned empty space into infinite cash. Intangible, imaginary derivatives became more profitable than producing goods and services or even financing those products. Financialization created billions in wealth for financial institutions, but it was at the expense of the broader economy.

When finance takes over the economy and its imaginary markets blow up, things eventually crash. The U.N. Conference on Trade and Development (U.N.C.T.A.D.) concludes that banks’ reckless speculation “increased volatility and aggravated contagion effects.” The vast shadow banking system, which comprises around one third of all finance, is one big bubble that is always ready to pop. Assets built on nothing are perpetually at risk of losing value. When a single asset market crashes, it can spread to the entire system because of the complex web of assets that are all spun off from each other. This precarious, byzantine house of cards led to the Global Financial Crisis of 2007. Subprime mortgages started to default, which made mortgage securities fail. When securitized mortgages failed, derivatives based on repackaged securitized mortgages failed. Then derivatives betting on the success of securitized mortgages failed. Then the derivatives built on those assets failed. And so on, and so on. Financialization also helped crash the economy in the preceding recession of 2001. The spark of this downturn was the dot-com bubble of the late '90s. The market for technology stocks over-inflated during the expansion of financial investment, and the inevitable crash dragged the entire country into recession for months. In a future dictated by a financialized economy, these scenarios are the only future. Dramatic boom-bust cycles within an ever-unstable system are the necessary outcomes of financialization.

Even during the periods of insecure expansion, financialization paralyzes productive growth. As the U.N.C.T.A.D. graph shows below, current corporate investment focuses on acquiring financial assets—not physical investment that could produce more goods and services. For every $1 spent on physical investment, $2.11 is spent on financial assets. More interested in making money than anything useful, businesses have abandoned productive growth. Investment by non-corporate sectors follows the same trend. Financialization has increasingly sucked up all the money in the room, using it solely to boost asset prices. The black hole of financialization is why today’s stock and debt markets reach huge highs while the real economy stays sluggish and teters on recession. It no longer matters how well businesses do, so long as financial markets expand. Drawing money away from physical investment also means long-term growth falls and actual products that regular people benefit from are underfunded.

The ideology of “maximizing shareholder value” (M.S.V.) drives the financialization of corporations. After the unleashing of finance, businesses decided they existed solely to enrich their stockholders. The late 90s saw mission statements such as Coca Cola’s—“We exist to create value for our share owners”—and Sara Lee’s—“Our primary purpose is to create long-term stockholder value.” Corporations enforced this ideology by awarding C.E.O.'s stock options and tying their compensation to stock price. Now, C.E.O.'s did not need to trouble themselves with long-term stability, physical investment, or even offering a quality product (and definitely not that useless notion of treating workers well). Cross-industry conglomerates broke up, firms became lean and specific, and corporations turned to contractors, temporary laborers, and rented capital. Companies like Apple or Nike now produce almost nothing: they pay outside companies to assemble their products. Amazon relies on temporary, gig, and contract workers to runs its business. This focus on stock price undermined growth and made corporations beholden to Wall Street, but the business model largely succeeded for those at the top. Stock prices are at all-time highs and shareholders are very happy. However, those on the other side of corporations suffered immensely.

The M.S.V. mindset has been terrible for workers. Corporations, in the effort to shrink their companies, sought to remove any obligation to employ workers long-term or at decent wages. Financialization brought layoffs, labor-replacing technology, and non-permanent labor. In the past, workers could get stable jobs at successful companies. Now, businesses increasingly offer gig work, temporary positions, part-time jobs, or contracts. These workers face low pay, have little labor rights, and have no job security. Thousands of other jobs are being destroyed by automation or corporate restructuring. Unionized labor has seen particularly high job loss. The C-suite and Wall Street took profits for themselves and locked them off from those lower on the ladder.

Income inequality has grown and standards of living have fallen in the era of financialization. Wages stagnated as money was not reinvested in productive industries; instead, it all went to financial markets. M.S.V.’s decades-long assault on workers suppressed wages further and reduced pension and retiree health benefits. With stagnating income, people were forced to take on debt, which further reduced their economic standing. At the same time, a small number of people enriched themselves immensely. C.E.O.'s, with their stock options and stock-linked compensation package, saw their salaries explode with the rise of the stock market. Financialization gave Wall Street bankers extremely high salaries, as well. The inflation of financial markets brought huge wealth to those who own financial assets, but the owner class is incredibly small. Around 90 percent of all stocks are owned by the top 10 percent, so the benefits of these financial markets accrue to only a select few. The working class has been chained up by debt and low pay while the richest in our society ride the money train of financial machinations.

Financialization has also made the economy less democratic. The waves of bank mergers and centralizations have stolen local banks from their cities. The heads of banks used to live in the same communities they lent to, and residents might even know them. Now, economic power is centralized in Wall Street; small or mid-sized communities have no way to access the elites that govern their lives. Even firms lose autonomy. Sara Lee’s C.E.O. famously said, “Wall Street can wipe you out. They are the rule-setters.” Corporations traded their decision-making power for more money. Municipalities were also swept up in financialization, and the increased use of financial instruments and securitization in local government has constrained public budgets to the whims of the market—not voters. The rise of Wall Street created too-big-to-fail banks, and their crash in the late 2000s forced the Federal government to bail them out. Rather than democratically debate the best ideas, taxpayers were forced to pay for the mistakes of the big banks. Of course, more money for financial institutions gave them more funds for lobbying; maybe these funds are the reason the administration is filled with Goldman Sachs alumni. Financialization has facilitated our society’s long slide long into oligarchy; more of people’s lives are controlled by a smaller amount of elites.

What the international community accomplished over 75 years ago was a complete restructuring of our economic system. No more would profits retained by a centralized group of bankers and their cronies dictate our world. Finance would be shackled, states would be empowered. It was a deliberate attempt to democratize the macroeconomy. Now, the aims of production would be full employment, higher income, and strengthened democracy. Unfortunately, finance soon fought back and moved “from servant to master,” as U.N.C.T.A.D. states. Workers have fallen behind while the richest among us grasp at more and more wealth. Workers, corporations, and even governments have been sucked into the disastrous world of unregulated finance—all to their peril. If we continue on this path, inequality, sluggish growth, and human misery are the only outcomes. After almost fifty years of this disaster, we are on the brink of collapse yet again. Is crawling back from recession every few years really the best policy? Is slowing see our wealth sapped into financial markets really the best allocation of resources? Or is it time for the era of financialization to end, permanently? The tools exist. The model has already been implemented. In the modern day, we can build a better Bretton Woods system: one that is long-lasting, fairer for marginalized communities and nations, and solves the issues of climate change. To save the economy, democracy, and the world, the choice is clear—we need only to make the decision.

Katharine Sciackitano is a first-year C.L.E.G. major in the School of Public Affairs. She is Deputy Editor for Economics at the Agora.

Wall Street image courtesy Andrés Nieto Porras, under license CC BY-SA 2.0. Image has been modified from its original form.