The Financialized Economy

Theoretical Views and Empirical Cases

Alexander Styhre

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000371710
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Social science theorists from various scholarly disciplines have contributed to a recent literature that examines how the finance industry has expanded and now wields increasing influence across a variety of economic fields and industries. In some cases, this tendency towards a more sizeable and influential finance industry has been referred to as "the financialization" of the economy. This book explains how what is referred to as the finance-led economy (arguably a more neutral and less emotionally charged term than financialization) is premised on a number of conditions, institutional relations, and theoretical propositions and assumptions, and indicates what the real economic consequences are for market actors and households.

The book provides a theoretically condensed but empirically grounded account of the contemporary finance-led economy, in many cases too complicated in its design and rich in detail to be understood equally by insiders—empirical research indicates—and lay audiences. It summarizes the relevant literature and points at two empirical cases, the construction industry and life science venturing, to better illustrate how the expansion of the finance industry has contributed to the capital formation process, and how the sovereign state has actively assisted this process. It offers a credible, yet accessible overview of the economic conditions that will arguably shape economic affairs for the foreseeable future.

The book will find an audience amongst a variety of readers, including graduate students, management scholars, policymakers, and management consultants.

1 The financial economy

A review of the literature

Introduction: the business franchise to issue credit

The purpose of the financial system is to provide credit, that is, to ensure the circulation of money in the economic system. While the term credit may be regarded as a technical term, the word money is better aligned with everyday practices and a common-sense outlook, but still the concept of money is fairly complex. Without delving into all the details regarding the various classes of money (e.g. as currency, fiat money, as managed money, e.g. assets holdings), money can be practically defined as the monetary supply in an economy, defined accordingly:

[W]‌e can define the money supply (M) as consisting of currency (C), checkable bank deposits (D), shadow-banking instruments (S), and government obligations (G). Thus, M = C + D + S + G.

(Levitin, 2016: 433)

For most non-expert readers, this definition introduces more questions than it answers, and it includes many technical terms. At this point, it may be simply concluded that money is more than currency, the bills and coins that people carry around in their purses and pockets and that they retrieve from their bank accounts when they need to make a purchase (if paying in cash, that is). Currency, money used in everyday practices is something similar to the tip of the iceberg in the well-known metaphor: it is the money people see and practically deal with in day-to-day transactions. In addition to such money, there are a variety of classes of money in the money supply stock.

By the end of the day, the supply of money, for example, in the form of credit, is a “constitutional project,” Levitin (2016: 446) says: “Control over the monetary system is a fundamental part of the sovereign condition.” That is, it is the sovereign state (say, the state of Denmark or Chile) that is the principal-agent relations of the finance industry being granted the right to issue credit de novo and ex nihilo. To better explain the rationale and the implications of Levitin’s (2016) statement, what Pistor (2013) calls the legal theory of finance is helpful. In this theoretical perspective, Pistor (2013: 315) writes, “finance is legally constructed; it does not stand outside the law.” Consequently, financial assets are issued on the finance market and traded as contracts whose value “depends in large part on their legal vindication” (Pistor, 2013: 315). In this view, finance assets are contracts, which per se are legal devices constituted by legislation monitored by the sovereign state, and it is therefore not fully meaningful to speak of financial assets outside of the context of their legal constitution, ultimately backed by the legislative authority of the sovereign state. Hockett and Omarova (2016) speak explicitly about the credit supply provided by the finance industry as a “franchise arrangement,” a “public-private partnership” initiated to assist credit formation in the economy, and ultimately intended to lower the cost of capital so that market participants, both businesses and households, can access credit in a safe and efficient manner (see also Braun, 2016; Sgambati, 2016). Boy and Gabor (2019: 304) regard this “franchise arrangement” as a form of “social contract” formulated in the nineteenth century:

[T]‌he nineteenth century saw the state enter into a “social contract” with banks, agreeing to support bank money parity to state money and thereby removing convertibility risk from bank money creation. States guaranteed banks’ pledges to their depositors through deposit insurance and access to central bank liquidity during times of crisis as lender of last resort. In exchange for underwriting financial and monetary stability, states demanded control over money creation through regulation and monetary policy. Yet as this systemic insurance comes at a cost, private actors continually seek to circumvent the state’s balance sheet and create pledges that credibly pledge moneyness.

Hockett and Omarova (2016: 147) argue that the finance industry acts on the basis of a licence issued by the sovereign state: “Pursuant to this arrangement, the sovereign public, as franchisor, effectively licenses private financial institutions, as franchisees, to dispense a vital and indefinitely extensible public resource: the sovereign’s full faith and credit.”

More specifically, this franchise arrangement stipulates at least three activities that finance institutions actively participate in: (1) “credit-intermediation”; (2) “credit-multiplication”; and (3) “credit generation” (Hockett and Omarova, 2016: 1148; emphasis in the original). In addition, Bai, Philippon, and Savov (2016: 627) identify five key activities that the finance industry and the finance market are held responsible for in the economy: (1) generating information about “investment opportunities and allocation of capital,” (2) handling the “mobilization and pooling of household savings,” (3) monitoring investments and performance, (4) financing trade and consumption, and, finally (5) handling a series of financial services pertaining to the “provision of liquidity, facilitation of secondary market trading, diversification, and risk management.” The implication from the close relation between the state and the finance industry is that the state, acting through its political entities, legislative bodies, and regulatory agencies (e.g. the central bank), “ultimately generates and underwrites capital flows in a modern financial system” (Hockett and Omarova, 2016: 1149). Ricks (2018: 758–759) refers to this view as the “the money paradigm,” wherein banks are not only seen as intermediaries, being in the “business of ‘taking funds’ from depositors and then ‘lending them out’” (Ricks, 2018: 758), but also being “distinctly monetary institutions” inasmuch as the claims on banks are, in a real sense, money. This means that banks “augment the money supply” (Ricks, 2018. 758–759). Rather than seeing bank money creation as “a legitimate private activity,” the money paradigm view regards “money creation as an intrinsically public activity that is then outsourced” (Ricks, 2018: 765–766). For instance, if the finance industry is in distress, for instance on the basis of a too high level of systemic risk that makes it complicated to borrow and lend money on the money market¹ as it is difficult (i.e., costly) to determine which market actors that are at risk to default, the sovereign state needs to serve as the lender of last resort and actively implement resolution system activities so that the faith in the market is restored, and the credit supply activities can be maintained. Critics have argued that such insurances, which result in rescue activities whenever they are needed, generate moral hazard, that is, invite opportunistic behaviour and excessive risk-taking as the finance industry de facto (but not necessarily de jure) is insured against default. Under all conditions, the franchise model for credit supply renders the line of demarcation between the state and market actors fluid and permeable, Pistor (2013: 322) proposes: “Financial systems are not state or market, private or public, but always and necessarily both.” She continues:

[D]‌escribing finance as a system of private/private commitments subject to some (external) constraints that may enhance market efficiency […] misses much of what is unique to contemporary finance: It is based on money as the legal tender, relies on the legal enforceability of private/private commitments and in the last instance depends on backstopping by a sovereign.

(Pistor, 2013: 323)

At the same time as the state and the finance industry are intimately connected through the legislative foundation of the finance industry and the credit formation process, this does not of necessity translate into a harmonious coexistence as finance industry actors are incentivized to extract returns and economic compensation for their work, and whenever the state imposes regulations such as disclosure rules or prohibitions against the trading of certain classes of assets (say, collateralized debt obligations (CDOs), a complex “second-level” derivative instrument that is complicated to price and therefore essentially illiquid; see, e.g., Bluhm and Wagner, 2011), finance industry actors tend to circumvent regulatory rules by creating financial innovations or new investment vehicles (Funk and Hirschman, 2014). “[L]‌aw and finance are locked into a dynamic process in which the rules that establish the game are continuously challenged by new contractual devices, which in turn seek legal vindication,” Pistor (2013: 315) says. In the end, the credit supply is a concern of the sovereign state, but it is practically accomplished by granting business charters to finance institutions such as banks to issue credit as part of their business operations. The complexity that follows from this elementary relation are considerable, and at times even complicated to anticipate or understand for centrally located agents, which makes the finance industry protean and vulnerable to disturbances, not the least from the inside of the industry, wherein, for example, speculation on prices may distort the market pricing of assets.

Finance industry expansion

A sizeable scholarly literature indicates that the finance industry turnover has expanded considerably over the last four decades since the early 1980s. In 2003, Rajan and Zingales (2003: 17) reported that “the average ratio of deposits to GDP increased by 35%, [while] the average ratio of stock market capitalization to GDP increased four times,” which are indicators of how the finance market both deepened (i.e., included a larger variety of asset classes) and thickened (i.e., increased its turnover). Stockhammer (2013: 513) reports that this tendency has continued more or less unabatedly since 2003:

From 1997 stock-market capitalization exceeds GDP [in the United States], rising from 58 percent of GDP in 1988 to 163 percent in 1999 (and flattering out thereafter). The rise of stock-market turnover is even more spectacular in the period from 33 percent in 1988 to 383 percent in 2008.

The perhaps most remarkable change in the industry is the expansion of the securities trade, wherein the estimated value of total derivatives in 2007 (just prior to the 2008 finance industry collapse) was “600 trillion according to United Nations—964 percent of world GDP” (Levitt, 2013: 166). This figure indicates that the total output of securities is today valued at more than 9.5 times the global gross domestic product (GDP), a mind-boggling figure to consider and apprehend.

Another indication of the consolidation of the finance industry and its more central role in the global economy is the concentration of economic power in the finance industry. In the United States, the total asset share of the ten largest banks grew from approximately 28 per cent in 1990 to 68 per cent in 2010 (Strahan, 2013: 53, figure 2). Expressed differently, the ten largest US banks increased their relative share of total assets holding by 2.5 times in two decades. In the United Kingdom and in the measure of asset holdings as a share of GDP, a similar tendency has been reported: by the beginning of the twentieth century, the largest three banks had asset holdings that corresponded to 7 per cent of GDP, and by the mid-century the figure had reached 27 per cent. In 2007, this figure stood at 2,000 per cent of the GDP. That is, three banks alone held assets worth 20 times the United Kingdom GDP (Dodd, 2014: 114). Statistics that indicate a growing finance industry have prompted increased scholarly interest, also among non-finance theory-oriented disciplines (e.g. economic sociology and management studies) regarding finance industry business practices and their role in the contemporary economy (see e.g. Lépinay, 2011; Mackenzie, 2006; Jacobides, 2005). Critical scholars use the term financialization to denote how the finance industry not only serves an intermediary function in the globalized economy but actively shapes how non-financial industries act and make business decisions (e.g. Carruthers, 2015; Davis and Kim, 2015; Dore, 2008; Epstein, 2005).

The concept of financialization

“Many analysts see financialization as the defining characteristic of the world economy of the last twenty-five years,” Milberg (2008: 423) argues, and thereby underlines the centrality of the finance economy in the contemporary period of time (say, after the turn of the millennium). To define financialization is no trivial issue as there are a variety of perspectives and underlying disciplinary frameworks that are deemed to shape economic conditions. Dore (2008: 1097–1098) provides a definition of the term and says it denotes “[t]‌he increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of domestic and operational economies.” Onaran, Stockhammer, and Grant (2011: 637) recognize a variety of implications of the finance-led economy:

The notion of financialization covers a wide range of phenomenon: the deregulation of the financial sector and the proliferation of new financial instruments, the increase in household debt, the development of the originate-and-distribute model of banking, the emergence of institutional investors as major player on financial markets, the boom (and bust) in asset markets, shareholder value orientation and changes in corporate governance (of non-financial business), and a spectacular rise of income in the financial sector and of financial investments.

In this account, financialization may cover most things under the sun, which by default may render it inoperable as a scholarly term, critics may contend. To examine the consequences of finance-led economic activities on a more manageable scale, Van der Zwan (2014: 118) introduces what she refers to as a “varieties of financialization” view (inspired by the “varieties of capitalism” literature; Hall and Thelen, 2009). Furthermore, in addition to the examination of finance-led economic activities in local and regional settings, the term can be discriminated along theoretical categories. Wansleben (2018: 775) associates financialization with institutional conditions and changes thereof, and defines the term as “[a]‌ structural process and institutional transformation in capitalist democratic states.” One such example is the management studies view that the finance industry-led growth has been assisted or even made possible on the basis of changes in corporate governance practices, and more specifically with what is referred to as shareholder value governance, the policy of transferring the residual cash generated by a corporation—the money that remains when all other costs are covered—to the owners of the stock (Tomaskovic-Devey, Lin, and Meyers, 2015; Lazonick and O’Sullivan, 2000). “Financialization is understood here as a finance-led regime of accumulation and as a process based on a strategy of shareholder value maximization,” Darcillon (2015: 499) writes.

Other commentators, who do not necessarily reject this view but may regard it as being more of several implications of a finance-led economy, point at financialization as an explicitly “techno-political project, which both professional, political and economic actors promote” (Livne and Yonay, 2016: 340). In this view, the finance industry is merely one of many devices in the hands of activists and policy entrepreneurs who actively seek to downplay the role of the welfare state and its legislative entities and regulatory agencies. Finally, financialization has been understood as a new set of rules of the game that have equally behavioural roots and create a demand for behavioural changes. This may sound tendentious, but Tori and Onaran (2018: 1394–1395) propose that “‘financialization’ is a self-reinforcing socio-economic process, which manifests itself in the growing prominence of behaviours derived from the functioning of the financial sector.” For instance, to substantiate the point made, in a society wherein the access to credit at reasonable costs (to enable, e.g., home mortgage borrowing as part of a house purchase), individuals need to pay attention to their creditworthiness, being a most complicated term, in the United States operationalized as a so-called FICO score, which is a standardized method to estimate the parametric risk regarding a presumptive client would default within a two years’ time horizon. In this view, the finance-led economy may be a legal creation at the level of the constitutional rights of the sovereign state, but the consequences of this legal-political system inevitably trickle down to behavioural practices and regulations, and not least the social norms, such as the valuing of prudence and calculated risk-taking, derived therefrom. The “substantial meaning of financialization,” Bryan and Raffery (2014: 891) write, is “not (or not just) that the finance sector is getting bigger but that financial ways of calculating are becoming more pervasive socially.” In this view, all subjects are incentivized and encouraged to consider themselves and the assets and resources they hold as a form of finance asset portfolio on which they can yield rents or returns, per se a form of reification of human skills, competencies, and relations, but is nevertheless one of the foremost consequences of the finance-led economy, critics repeatedly remark (Rona-Tas, 2017; Baradaran, 2015; Fourcade and Healy, 2013; Karger, 2005).

A more critical view of financialization, regardless of the underlying theoretical interests of analytical models, is to consider it as what is unambiguously related to forms of policy failure. Hockett and Omarova (2016: 1213–1214) speak explicitly about financialization as “a dysfunctional mode of interaction between the financial system and the real (i.e., non-financial) economy, in which a disproportionate share of the flow of the monetized full faith and credit of the sovereign is continuously re-absorbed by the former rather than flowing to the latter.” More explicitly, Hockett and Omarova (2016: 1214) argue, financialization denotes the situation wherein rentier interests overshadow and are prioritized over the entrepreneurial need for credit to finance the development that would be supportive of a new generation of businesses and corporations:

[A]‌t its most fundamental, systemic level, financialization is a manifestation of the failure of the finance franchise arrangement to deliver its intended result: effective modulation and allocation of credit that ensures full utilization of the economy’s productive capacity.

In this situation, the finance industry no longer serves an intermediary role at all, that is, to transfer credit from mature industries and risk-tolerant investors to emerging industries and start-up ventures. This is thus a situation wherein the finance-led economy becomes dysfunctional as it eats its own tail, investing considerable resources in illiquid high-risk/high-return assets such as hedge funds or in second-level securities such as CDOs or credit default swaps (CDSs). In that situation, Müller (2014: 548) says, “financialization does not entail close institutional interconnections between banks and industry, b...

Table of contents

• Cover
• Half Title
• Series Information
• Title Page
• Copyright Page
• Contents
• Preface
• Acknowledgements
• Introduction
• 1 The financial economy: A review of the literature
• 2 The institutional framework: The capital formation process in finance-led economies
• 3 Thickly capitalized ventures: Housing production, illiquid assets, and social welfare
• 4 Thinly capitalized ventures: Financing science-based innovation in entrepreneurial firms
• 5 The institutional logic of the finance-led economy
• Bibliography
• Index