There are many important questions about what the financial sector is up to—it's disturbing that finance has faced so little scrutiny.
“There’s doubtless lots of waste—and lots of predatory behavior—in the financial sector. The task is to sort out which criticisms of finance make sense and which ones don’t. And then the task is to take on—and ultimately defeat—the illegitimate entrenched interests.”
“Baker says that ‘reining in CEO pay is very important because of the distorting effect it has on pay structures throughout the economy’—a ‘world where CEOs get paid $2M (like in the good old days) is very different than today’s world where they get paid $20M’.”
“We should all combat the effort to atomize the population—there’s no reason to acquiesce to the neoliberal situation that works amazingly well for the wealthy and their institutions while the rest of us somehow try to survive.”
My 16 August 2022 piece raises questions about (1) what the American financial sector is up to and (2) economists’ silence about finance.
Rana Foroohar’s 2017 book Makers and Takers adds more questions on these fronts, so I want to use this short piece to summarize the book’s key points—I’ll also lay out some issues that I need to investigate.
There’s doubtless lots of waste—and lots of predatory behavior—in the financial sector. The task is to sort out which criticisms of finance make sense and which ones don’t. And then the task is to take on—and ultimately defeat—the illegitimate entrenched interests.
Foroohar’s 2017 Book
Foroohar writes about Apple that Steve Jobs had a relentless focus on products, whereas Tim Cook “pays close attention to the money and to increasingly sophisticated manipulations of money”. Apple “now spends a large amount of its time and effort thinking about how to make more money via financial engineering rather than by the old-fashioned kind”—this fact “tells us how upside down our biggest corporation’s priorities have become, not to mention the politics behind a tax system that encourages it all”.
There’s “a chicken-and-egg cycle” where the “more a company focuses on financial engineering rather than the real kind, the more it ensures it will need to continue to do so”. And for David Einhorn and “many others in corporate America today”, financial creativity is just as good as the creativity that has to do with actual real products.
The “tail is wagging the dog”—wealth “creation within the financial markets has become an end in itself, rather than a means to the end of shared economic prosperity”. Financiers “dictate terms to American business, rather than the other way around”.
An even worse phenomenon is that “financial thinking has become so ingrained in American business that even our biggest and brightest companies have started to act like banks”—“American firms today make more money than ever before by simply moving money around, getting about five times the revenue from purely financial activities, such as trading, hedging, tax optimizing, and selling financial services, than they did in the immediate post–World War II period”.
Tech companies like Apple are essentially acting like banks without being regulated like banks; airlines “often make more money from hedging on oil prices than on selling seats”; and GE Capital “was until quite recently a Too Big to Fail financial institution like AIG”.
The American “financial system has stopped serving the real economy and now serves mainly itself”.
The American “system of market capitalism is sick”. The illness has resulted in symptoms—“slower-than-average growth, higher income inequality, stagnant wages, greater market fragility, the inability of many people to afford middle-class basics like a home, retirement, and education”—that are felt throughout the entire economy and society.
The sickness is called financialization—“Wall Street and its way of thinking have come to reign supreme in America, permeating not just the financial industry but all American business”.
Financialization “includes everything from the growth in size and scope of finance and financial activity in our economy to the rise of debt-fueled speculation over productive lending, to the ascendancy of shareholder value as a model for corporate governance, to the proliferation of risky, selfish thinking in both our private and public sectors, to the increasing political power of financiers and the CEOs they enrich, to the way in which a ‘markets know best’ ideology remains the status quo, even after it caused the worst financial crisis in seventy-five years”.
And financialization “has even affected our language, our civic life, and our way of relating to one another”.
America’s “upside-down economy” is “one in which Makers—the term I use in this book to describe the people, companies, and ideas that create real economic growth—have come to be servants to Takers, those that use our dysfunctional market system mainly to enrich themselves rather than society at large”.
These “takers include many (though certainly not all) financiers and financial institutions, as well as misguided leaders in both the private and the public sector, including numerous CEOs, politicians, and regulators who don’t seem to understand how financialization is undermining our economic growth, our social stability, and even our democracy”.
Financialization is an “immensely complex and broad-based phenomenon”.
Today “finance engages mostly in alchemy, issuing massive amounts of debt and funneling money to different parts of the financial system itself, rather than investing in Main Street”—Adair Turner’s 2015 book Between Debt and the Devil explains in detail how (A) capital markets and the banking sector are decreasingly involved in funding new investment and (B) most of the system’s money is instead being used to lend against existing assets.
Turner’s argument is that finance’s focus has shifted away from (1) “funding the new ideas and projects that create jobs and raise wages” to (2) “securitizing existing assets (like homes, stocks, bonds, and such)” and “turning them into tradable products that can be spliced and diced and sold as many times as possible”.
And Turner is correct—there’s research showing that only 15% of “all the money washing around the financial markets these days actually makes it to Main Street businesses”, whereas in the 1970s most of the capital “coming from financial institutions would have been used to fund business investments”.
85% of the money “stays inside the financial system, enriching financiers, corporate titans, and the wealthiest fraction of the population, which hold the vast majority of financial assets in the United States and, indeed, the world”.
The simple key question is how finance went from generating some 10% of all corporate profits “twenty-five years ago” to generating “almost a third of all corporate profits in America at the height of the housing boom”—the simple key question is how finance went from merely facilitating business to having such a stranglehold over business.
Chapter 1 explains finance’s rise—how did an industry representing 4% of jobs come to account for 25% of all corporate profits? The story is told through the lens of Citigroup.
Chapter 2 examines financial thinking’s rise—how did financialized thinking come to dominate US corporate life? The topic is examined through telling the story of General Motors and the story of Robert McNamara and the Whiz Kids.
Chapter 3 delves deeply into the history of US business education and examines how and why US business education “came to focus on balance sheet manipulation to the exclusion of real managerial skills”.
Chapter 4 deconstructs the conventional wisdom regarding shareholder value through looking at how Carl Icahn and other activist investors “now call the shots at the country’s largest and most successful firms—such as Apple—at the expense of innovation and job creation”.
Chapter 5 tracks General Electric’s history and shows that “much of corporate America has come to emulate banking”.
Chapter 6 focuses on one of the financial sector’s most dangerous areas, namely derivatives. And tells the story of how Goldman Sachs has manipulated the commodities market—this story shows how banks now control natural resources in a way that affects the prices of goods.
Chapter 7 tells the story of how private equity has come to dominate the housing sector in a way that’s made “the American Dream of owning a home an elusive fantasy for so many middle-class American families”.
Chapter 8 looks at how privatizing the retirement system let asset management “grow rich on unnecessary fees, and how the mutual fund business is essentially gambling away our nest eggs”.
Chapter 9 lays out “how and why we came to have a tax system that privileges corporations over individuals, encourages debt over equity, and allows firms like Pfizer to engage in financial engineering as a business strategy”.
Chapter 10 analyzes “how the money culture and the revolving door between Wall Street and Washington have made it so hard to turn back the tide of financialization, and why so many of the reforms promised after the 2008 meltdown have yet to come to pass”.
Chapter 11 lays out policy solutions regarding “how finance might be put back into the service of the real economy”.
Foroohar proposes—in Chapter 11—“five big ideas for how we might move toward a financial system that is a help, rather than a hindrance, to business and society”.
The first big idea is to end complexity and cut leverage—we “need to make our financial system a lot simpler and a lot more transparent”. Most financial institutions “are just Too Complex to Manage”—you can’t “fully police the millions of transactions happening daily in a US financial system worth $81.7 trillion”.
The second big idea is to reduce debt and increase equity. Research shows that too much credit—and too big a financial sector—causes financial crises and slows growth and destabilizes the economy.
The third big idea is to rethink who companies are for—we should reexamine whether companies should be run only for shareholders’ benefit. There’s an issue about who should benefit from American corporations’ riches—there’s also an issue about shareholder activists shaping the markets in a way that harms firms’ long-term viability and inflates dangerous financial bubbles.
The fourth big idea is to build a new growth model. Financialization causes slower growth and vice versa too—countries “try to use debt and financial markets as a way to artificially buoy growth, in lieu of a strong economic growth model that would bolster the real economy”. The US “needs a new moonshot goal for economic growth, something that will galvanize the country and create the kinds of productivity gains and innovations that the short-term high of finance never will”; Europe “needs to become a true union” with “a shared fiscal policy and wealth transfers from rich to poor countries”; and China “may be the toughest part of the economic mix in terms of reform”.
The fifth big idea is to change the narrative and empower the makers—we “need to develop a new and more accurate story about the role finance plays in our economy”. We should debate what finance has done wrong, ask what finance can do right, ask how bankers can help business and society, and ask how the markets can start working for all of us. We must understand what happens when finance grows at business’s expense—we should “try to imagine what might happen if it could be put back in service to the economy”.
Foroohar puts forward some eye-catching assertions in the book.
For example, she cites a 15 June 2015 Politifact piece that rates as “True” the claim that America’s top 25 hedge fund managers were making more money than all of America’s kindergarten teachers combined.
For another example, she cites Shai Bernstein’s 13 April 2015 article that finds—Foroohar writes—that “innovation tails off by 40 percent at tech companies after they go public, often because of Wall Street pressure to keep jacking up the stock price, even if it means curbing the entrepreneurial verve that made the company hot in the first place”. Everyone should take look at the Bernstein article, since it’s interesting:
The paper says that “quality of internal innovation declines following the IPO and firms experience both an exodus of skilled inventors and a decline in productivity of remaining inventors”, but the paper also says that “public firms attract new human capital and acquire external innovations”.
Issues to Investigate
My 16 August 2022 piece cites Dean Baker’s work on the extent to which the financial sector collects economics rents. And cites Benjamin M. Friedman’s 2010 article that asks: (A) how successfully the financial sector performs its most basic function; (B) how cost-effectively the financial sector performs its most basic function; and (C) how we might evaluate the financial sector’s performance—regarding its most basic function—when there’s no clear counterfactual against which to compare the financial sector’s performance.
I hope to get to the bottom of the issues that Baker and Friedman raise.
And I hope to look into Foroohar’s criticisms—maybe all of them make sense, but maybe at least one of them misses the mark.
Foroohar refers—in her book—to “the ascendancy of shareholder value as a model for corporate governance”. That’s one issue to sort out—are companies are being run in shareholders’ interests? Baker has an 8 December 2019 piece that points out that recent decades have been disappointing for shareholders—by historical standards—and have been fantastic for CEO pay, so the data doesn’t necessarily support the idea that shareholders’ interests are in the center of things.
Baker points out in the piece that you’d need to do serious research in order to find out whether share buybacks raise the price-to-earnings ratio (PE). And that “if share buybacks do raise PEs there would be a clear story whereby CEOs could drive up their own pay, which typically is largely in stock options, to the detriment of future shareholders, which would explain both soaring CEO pay and declining returns to shareholders”.
Baker also has a 28 January 2021 piece that responds to the notions that share buybacks (1) “allow companies to inflate share prices”, (2) allow “top management to manipulate share prices” in order to maximize the value of stock options, (3) divert money away from long-term investment, and (4) allow for tax avoidance.
Regarding (4), Baker says that there is a gift to rich people, since share buybacks—as opposed to dividends—“do allow shareholders to avoid paying taxes as long as they hold their stock”. But Baker says that “shares typically turn over very quickly”, so people shouldn’t exaggerate how big this gift is.
Regarding (3), Baker questions the logic of thinking that “companies would invest more if they paid out money to shareholders as dividends” instead of paying out money to shareholders through share buybacks. Baker says that it’s almost a matter of definition that companies will invest less if they pay out more money to shareholders through dividends and share buybacks, but Baker is “strongly inclined to believe” that the reason that companies are paying out money to shareholders is that companies “don’t see good investment opportunities”—Baker doesn’t think that companies see good investment opportunities and then choose to pay money out to shareholders instead.
Regarding (1), Baker says that share buybacks aren’t problematic if the PE is “exactly the same after the buyback as before”. And that buybacks might actually increase the PE, which would mean that “buybacks are effectively a tool used by top management to gain at the expense of future shareholders, with current shareholders being indifferent”.
Regarding (2), Baker says that it strikes him as “a very plausible story”. The implication is that top management is taking money that the shareholders—or the board of directors—didn’t want them to have, which means that “the shareholders should be allies in efforts to rein in CEO pay”. And the other implication is that “the claim that the company is being run to maximize returns to shareholders is not true”.
Baker says that “reining in CEO pay is very important because of the distorting effect it has on pay structures throughout the economy”—a “world where CEOs get paid $2M (like in the good old days) is very different than today’s world where they get paid $20M”.
This “leaves the moral of the evil buyback story as being that we need to crack down on CEOs ripping off their companies and bring their pay down to earth”.
I talked to someone who made some interesting comments to me regarding the financial sector. They said that: (A) financialization has caused issues, but has also significantly increased risk-management possibilities and liquidity; (B) generally speaking, a bigger issue than financializaton is corporations’ massive size, which allows huge companies to choke out competition and get favorable policy treatment; (C) this issue—with corporations being so big—contributes to financialization and allows companies to focus on balance-sheet manipulation instead of innovation; (D) these huge firms are behaving in a predictable fashion that aligns with what the Econ 101 playbook says to do when you’re in an oligopolistic position; (E) securitization has many attractive characteristics when it comes to minimizing the risk to the lender and limiting the costs to the borrower; (F) there’s lots of money out there for people who have amazing—or terrible!—ideas that might create a ton of jobs, so one shouldn’t adopt a zero-sum framing where financial activity necessarily comes at the expense of productive lending; (G) some of the things that are called “financialized thinking” are smart and innocuous things that make sense from the company’s perspective, whereas other things that are called “financialized thinking” are games and stock promotion and BS; and (H) finance’s expansion has allowed people to hedge all kinds of exposures that you couldn’t hedge before.
They also said that Apple’s share buybacks have—in many ways—reflected prudent balance-sheet management given the company’s competitive position and the low-interest-rate environment. And that it’s quite possible that Steve Jobs would’ve done—for example—what Apple did in April 2013.
Everyone should definitely read Arthur MacEwan’s excellent 2022 piece about financialization—MacEwan writes that “financialization has been an important part of the story of inequality, but it is also part of a bundle of changes that have shaped the U.S. economy over several decades”. And he writes that we should look at “financialization as part of a complex of interconnected developments in the United States and the world economies”—these developments “together have generated rising inequality”.
A friend pointed out to me that traditional pensions have been replaced with market instruments. And that this has: (1) decreased people’s security, subjected people to the market’s whims, and made people prey to market forces; (2) increased people’s stress and increased people’s anxiety; and (3) forced people to be constantly glued to the stock market in order to figure out whether they’ll live too long and will be destitute and unable to leave anything to their family.
They also said that this shift away from traditional pensions has had the severe—and intentional—ideological impact of atomizing people, keeping people glued to market values, and preventing people from focusing on working together for the common good. And that the predatory financial institutions have greatly benefited from this ideological impact. And that this shift’s human and ideological consequences fit right into the general neoliberal assault on rights and human values.
We should all combat the effort to atomize the population—there’s no reason to acquiesce to the neoliberal situation that works amazingly well for the wealthy and their institutions while the rest of us somehow try to survive.