Lane Kenworthy, The Good Society
Finance is vital to a good society. People need to be able to borrow money to fund expensive purchases such education, homes, and cars. Entrepreneurs and firms need access to external funds in order to start up or expand a business, invest in research, and adjust to changing conditions.
What we want is a financial sector that will provide funding for useful endeavors without impeding economic growth, causing massive economic crises, and preventing government from doing good things. Is that possible? If not, do we have any alternative?
- Getting money to those who can use it effectively
- Economic crises
- Economic growth
- Loose monetary policy
- Income inequality
- Regulating finance
- Is there an alternative?
GETTING MONEY TO THOSE WHO CAN USE IT EFFECTIVELY
An effective financial system will direct funds toward any borrower that has a decent shot at succeeding. Part of the genius of markets is that they facilitate unplanned but beneficial economic behavior. It’s difficult to anticipate where such firms or sectors will come from, so the best bet is to have multiple sources of financing. Decentralized private market-based financial systems seem to work well in this regard.
Biases may cause lenders to underinvest in certain types of businesses, communities, and individuals — entrepreneurs aiming to challenge big monopolies, companies with little potential for short-run returns, worker cooperatives, low-income communities, racial or ethnic minorities, and others. One solution here is rules that prohibit discrimination. Another is support for financial institutions, such as local public, community, and cooperative banks, that are dedicated to funding less-advantaged borrowers.1
In addition, society may want to direct investment toward firms or sectors that are likely to achieve an important goal, such as climate stability, but that might not yield much in the way of profits. Here a national funding agency can help.2
Since the 1970s, globalization, advances in computing and telecommunications, the emergence of large institutional investors, the creation of new financial instruments, and reductions in regulatory constraints have allowed financial companies in the rich democratic countries to draw on larger pools of funds and to channel those funds into a wider array of investments. This has increased the prominence of financial activity.3 In the United States, finance has grown to about 7% of the economy and 25% of corporate profits.4
According to Rana Foroohar, this shifts resources away from the “real economy” — from investment in research or production of useful goods and services — toward financial speculation5:
“The traditional role of finance within an economy — the one our growth depends on — is to take the savings of households and turn it into investment. But that critical link has been lost. 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…. Rather than funding the new ideas and projects that create jobs and raise wages, finance has shifted its attention to securitizing existing assets (like homes, stocks, bonds, and such), turning them into tradable products that can be spliced and diced and sold as many times as possible…. Only a fraction of all the money washing around the financial markets these days actually makes it to Main Street businesses. As recently as the 1970s, the majority of capital coming from financial institutions would have been used to fund business investments, whereas today’s estimates indicate that figure at around 15 percent. The rest simply stays inside the financial system.”
A second element of financialization is that nonfinancial firms increasingly engage in financial activities in addition to, or as a substitute for, their core business operations. Many large American firms now issue credit cards, make loans to their customers, and borrow money to buy back some of their stock.
This, according to some, has weakened nonfinancial firms’ ability to pursue their regular business effectively. Here again is Rana Foroohar6:
“The fact that Apple, probably the best-known company in the world and surely one of the most admired, 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, tells us how upside down our biggest corporation’s priorities have become…. Apple’s behavior is no aberration…. The business of America isn’t business anymore. It’s finance…. Apple and other tech companies now anchor new corporate bond offerings just as investment banks do…. Airlines often make more money from hedging on oil prices than from selling seats…. GE Capital, a subsidiary of the company launched by America’s original innovator, Thomas Alva Edison, was until quite recently a Too Big to Fail financial institution…. Any number of Fortune 500 firms engage in complicated Whac-A-Mole schemes to keep their cash in a variety of offshore banks to avoid paying taxes not only in the United States but also in many other countries where they operate…. 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.”
Do we see evidence of the hypothesized harmful effects of financialization?
Figure 1 shows that investment has indeed decreased in most of the affluent democratic nations. However, if financialization is the key driver, we would expect this decline to be larger in the United States, where financialization has been most pronounced, than in other countries. That isn’t the case.7
As American companies have focused more attention and resources on financial operations, have they invested less in research and development?8 Actually, no. In fact, as we see in figure 2, business spending on research and development has increased during the era of financialization.9
In the view of some observers, the shift of resources toward the financial sector has reduced lending to small businesses, which has contributed to a decline in business startups in the United States.10 Reliable data on business startups don’t begin until 1978, but as best we can tell from these data, shown in figure 3, the decline in startups actually began prior to the era of financialization and didn’t accelerate when financialization took hold.11
According to a common view, a decentralized, equity-market-based financial system leads firms to focus excessively on the near-term.12
In a decentralized capital market, companies are owned by a diffuse mass of investors, and investors tend to allocate their resources across a number of firms. Because the financial stability of a firm isn’t dependent on the contribution of any single agent and stock shares are a relatively liquid form of investment, owners are free to sell their shares in a firm if the return isn’t satisfactory. Assuming they aim to maximize the return on their assets, investors will buy and sell shares based on companies’ projected profit success. In this way, stockholders act as an effective arbiter of firms’ performance, executing the verdict rendered by the market via the mechanism of exit.13 Management is induced to maximize efficiency in order to keep shareholders happy. Thus, in principle, decentralized ownership and competitive financial markets ought to foster efficient economic activity.
But where they are relatively free to shift assets from firm to firm, investors seeking to maximize the return on their assets may tend to buy and sell frequently. To please such investors, to keep them loyal, firms will need to maximize short-run profits. If they fail to do so, investors exit. The company’s stock price drops, precipitating further exit, so it now costs the firm a good deal more to raise new funds, because it must sell a greater number of shares than before in order to raise whatever amount it needs. And a low stock price opens the door for corporate raiders to buy the company and replace its management. So firms have an incentive to prioritize short-run profits over long-term investments with uncertain payoff.
What does the evidence suggest? Is an equity-market-based financial system more harmful than helpful? The most thorough examination of the US case, by Mark Roe, concludes that “The evidence does not support the idea that the stock market’s time horizon is damaging the economy in any major way.”14
First, the logic underlying the hypothesis is suspect. As Roe notes, “For stock-market-driven short-termism to deeply afflict the US economy — as opposed to damaging only some firms, here and there, now and then — normal market processes must fail. When one big firm is too short-term and gives up long-term profit, others can jump in to profit from the short-termers’ neglect.”15
Second, do investors shun or flee from firms that don’t have strong current quarterly profit performance? That hasn’t been the case in the United States, as Roe explains: “Consider the following when you think about how plausible it is that the stock market’s time horizon is persistently and perniciously too short: Tech companies that had their initial stock offerings in 2018 and 2019 before the Covid-19 slowdown included Dropbox, Survey Monkey, Cloudflare, and Spotify. Not one was profitable; the stock market bought them on a future-oriented view. Similarly, a slew of money-losing biotech companies made their initial stock offerings in 2018. In 2019 seven of the top ten biotech IPOs had no approved drug — hence, the market valued those companies for their long-term prospects not their immediate marketing capabilities — and still they collectively raised more than $1.95 billion from the stock market. Future possibilities, not current profits, drove investors, who were betting on the firms’ potential successes in drugs that would treat maladies such as autoimmune disorders and cancer. This is not an accidental or one-time event…. When Amazon years ago first sold its stock to the public, it had no earnings but still was accorded a half-billion-dollar value by the stock market, while Apple, Facebook, and Google obtained a stock price about one hundred times their earnings when they first sold their stock — more than five times the stock market’s overall ratio of stock price to earnings. All this indicates the stock market does value the distant future and has been doing so for decades.”16
Third, as we saw earlier in figure 1, while overall investment in the United States has decreased since 1980, that decline hasn’t been larger in the US than in other affluent democratic nations, contrary to what the equity-markets-cause-short-termism hypothesis would predict.17
Fourth, as we saw in figure 2, American firms’ investment in research and development has increased, not declined, during the era of stock market primacy.
Two of the biggest economic crises of the past century were driven by financial bubbles that popped and spilled over to the broader economy, wreaking havoc on the lives of hundreds of millions of people and causing not just temporary agony but also long-term financial and psychological scarring.18 Financial crises have occurred frequently in the rich democratic countries, as we see in figure 4.19
The most recent was the financial crisis that precipitated the 2008-09 Great Recession. Finance played a key role in most of the developments that caused the crisis.
Begin with the housing bubble. After holding roughly constant for a century, home prices in the United States shot up beginning in 1997, nearly doubling in less than a decade, as figure 5 shows. In 2006 the bubble began to pop, and prices crashed, leaving many homeowners with mortgage debt that significantly exceeded the value of their home. That in turn led to numerous defaults on loan payments, threatening the solvency of lenders.
Finance contributed to the housing bubble in several ways. Lenders grew increasingly confident that mortgage loans wouldn’t result in default, so even as home prices skyrocketed and analysts expressed growing worry that a crash was coming, lenders continued to make it easier, rather than harder, for Americans to get such loans. They kept interest rates low. They relaxed lending standards, allowing homeowners to borrow a larger and larger portion of the money needed to purchase a home. They allowed — indeed, encouraged — homeowners to refinance their mortgage or to take out a second mortgage (“home equity loan”) to pay for vacations or cars or other things unrelated to the value of the home. To further expand the customer base, they sought out borrowers who were significant credit risks; “subprime” mortgages jumped from 5% of new mortgages in 1994 to 20% in 2006.20
One reason why lenders kept expanding mortgages was securitization — a new financial innovation created to reduce the risk underlying many of these new mortgages. Alan Blinder explains21:
“Here, in vastly oversimplified form, is how securitization of mortgages worked. Suppose Risky Bank Corporation (RBC) has made one thousand subprime mortgage loans averaging $200,000 each — all, let us say, in the Las Vegas area. RBC’s highly concentrated portfolio of $200 million in mortgage loans is, to say the least, risky. Many of these loans are probably ‘designed to default,’ and the creditworthiness of many of the borrowers is somewhat dubious. Should an economic downturn or natural disaster hit the Las Vegas market, many of these homeowners would likely stop paying, perhaps taking RBC down with them. So the bank would like to find a buyer for these loans while they are still good. Enter Friendly Investment Bank (FIB), a securitizer from Wall Street. FIB offers RBC an attractive deal: ‘Sell us your $200 million in subprime mortgages. We will pay you cash immediately, which you can lend out to other borrowers. We’ll then combine your mortgages with others from around the country, and package them all into well-diversified mortgage-backed securities. The mortgage-backed security will be less risky than the underlying mortgages because of geographical diversification. Then we will spread the risk around by selling pieces of the security to investors all over the world.’ FIB is not proposing an act of altruism, of course. It stands to earn handsome fees for its services. On the surface, this little bit of financial engineering seems to make good sense. RBC is relieved of a substantial risk that could threaten its very existence. If all goes according to plan, FIB’s securitization of all those mortgages really should reduce risk in the two ways claimed. While real estate prices in Las Vegas may fall, it is highly unlikely that real estate prices would drop simultaneously in Los Angeles, Chicago, Orlando, and so on. And with the risks parceled out to hundreds of investors all over the world, no single bank is left holding the bag. Or at least that was the theory. Unfortunately, it turned out not to work so well in practice.”
The housing bubble has received the lion’s share of the blame for the 2008-09 economic crisis. But it almost certainly wasn’t the only cause. Housing prices in the United States fell just as sharply in the second half of 2022 as they did in 2006-07, yet the American economy didn’t go into recession, much less a full-blown crisis.22
An equally important — perhaps more important — cause of the Great Recession was a bubble in the bond market. Here again is Alan Blinder23:
“The U.S. economy limped, rather than leaped, out of the minirecession of 2001. GDP grew slowly at first, and employment continued to decline for nearly two years of so-called job-loss recovery. Inflation was low and falling. In fact, by 2003 the Fed was getting worried that the United States might actually slip into deflation. In an effort to stimulate the sluggish economy, it pushed its overnight interest rate (called the federal funds rate) all the way down to 1 percent — the lowest since 1954. The aggressive monetary policy worked, and the economy perked up. But it also meant that investors in safe assets like Treasuries were earning very little. That, in turn, led investors to ‘reach for yield.’ If a Treasury bond would pay you only 4.5 percent interest, but a mortgage-backed security with (allegedly) negligible default risk would pay you 6 percent interest instead, why not sell the Treasury bond and buy the mortgage-backed security, picking up an extra 150 basis points in the process? Seems like a no-brainer, right? And if default risk really is negligible, it is. But, of course, the risk wasn’t negligible. Investors should never have extrapolated the amazingly favorable default experience of 2004–2006 into the indefinite future. But they did. It was the kind of thinking that led to the bond-market bubble. As investors shifted out of Treasuries into riskier fixed-income securities — whether Columbian government bonds or mortgage-backed securities backed by subprime mortgages — those riskier securities were bid up in price, and hence down in yield. You had to pay more to buy the same stream of interest payments. So what was once, say, a 150-basis-point reward for bearing more risk became a 100-basis-point reward, or maybe just a 50-basis-point reward. Investors’ response to dwindling yields on fixed-income securities was to try to magnify their yields by going for more leverage [funding their purchases of bonds with borrowed money rather than with their own assets]. If bearing a little additional risk would bring you only, say, 50 basis points in additional return, you could magnify that reward to 500 basis points by making the investment with 10-to-1 leverage.”
Financial crises may be endemic to capitalism, for three reasons.24 First, private financial actors have a strong tendency to periodically overreach in search of new financial instruments and new customers, making too many risky investments and loans that eventually go bad. Alan Blinder, who has offered perhaps the most detailed and careful analyses of the 2008-09 financial crisis, puts it this way: “Can we prevent asset-price bubbles in the future? Here, unfortunately, the answer is mostly no. Speculative markets have succumbed to occasional bubbles for as long as there have been speculative markets. Indeed, one of the first common stocks ever issued, in the South Sea Company in England, was hyped into the first stock-market bubble — the famed South Sea Bubble of 1720 — which devastated, among others, a pretty smart fellow named Isaac Newton. And the Dutch had managed to grow a gigantic bubble in — of all things — tulip bulbs almost a century earlier. No, while we may be lucky enough to nip a few bubbles in the bud, we will never stamp them out. The herding behavior that produces them may well be programmed into our DNA. Our best hope is to minimize the consequences when bubbles go splat — as they inevitably will.”25
Second, regulating finance is more difficult than regulating, say, food or traffic. Regulators restrict particular activities, but people and financial companies can potentially make a great deal of money if they can find a way around the restrictions. They will look very hard, and there’s a good chance they eventually will find something.
Third, the financial system is more interconnected and complex than most regulated systems. Our measures of risk will therefore tend to be limited. And it can be difficult to spot a problem that poses a threat to the entire system until it’s too late.
Our best hope, then, may be to minimize the consequences of financial crises. Is that a realistic goal? Looking across the rich democratic countries during the era of financialization offers grounds for hope. Figure 6 shows the share of years each of these nations has spent in a banking crisis since 1979. While the share is quite high in the United States, in many countries it is fairly low.
Also encouraging is that in the two most recent major economic crises — the 2008-09 Great Recession and the 2020-21 Covid downturn — governments and central banks responded aggressively enough that the crises ended up milder than their historical predecessors.26
While finance is critical for economic growth, there are a number of ways in which it might obstruct growth. One is by increasing the frequency and/or depth of economic crises.
Financial crises in the rich democratic nations were less common during the three decades or so following World War II than they have been since the late 1970s, in the era of mobile and deregulated finance (figure 6 above). And economic growth was faster in the former period than in the latter. On the surface this seems consistent with the hypothesis. However, the strong growth during the mid-twentieth-century “golden age” almost certainly was in part a catch-up process coming on the heels of the Great Depression. Economic growth in recent decades has been roughly on track with the historical average for the past century and a half.27
Moreover, in this recent era countries with more frequent financial crises haven’t suffered slower economic growth, as we see in figure 7.
Other observers point to financialization as a cause of slower economic growth, mainly because it directs resources toward speculative activity that doesn’t contribute to genuine economic progress.28
As with the previous hypothesis, here too the slowdown in economic growth since the 1970s might be supportive but also might tell us nothing about the causal impact of financialization.
If financialization reduces economic growth, we would expect growth in recent decades to have been slower in the United States than in other rich democratic nations where financialization has been less advanced. This the prediction isn’t borne out, as growth hasn’t been slower in the US than elsewhere.29
A third hypothesis says globalized and deregulated finance reduces economic growth by discouraging governments from sufficiently stimulating the economy during and shortly after economic downturns. The standard Keynesian remedy in a recession is for government to increase public spending or lower taxes in order to boost demand. But if lenders don’t cooperate — if they increase borrowing costs by raising interest rates — the benefit of the fiscal stimulus will be negated, or the government may feel compelled to pull back on its stimulus efforts. As a result, the downturn will tend to be deeper and longer and the ensuing recovery will be weaker and slower.
The mostly commonly-cited instance of this is during and shortly after the 2008-09 Great Recession, when the meek fiscal responses by a number of European governments deepened and prolonged the period downturn. Yet the chief cause of this, at least in some accounts, wasn’t pressure from global finance but rather European Union rules and decisions by EU officials.30 The much more aggressive fiscal response to the Covid-19 recession in 2020-21 by these countries’ and by the EU itself further suggests that finance isn’t automatically an impediment.
LOOSE MONETARY POLICY
Following the 2008-09 financial crisis, the Federal Reserve reduced interest rates to zero in order to help pull the US economy back into growth. In the ensuing years it kept interest rates very low, as we see in figure 8. The goal was to help the economy continue to grow and to allow the unemployment rate to fall to and remain at a low level, which tends to force employers to bid up wages, allowing the gains of economic growth to be shared by all.
On one view, this loose monetary policy instead boosted asset prices and thereby generated rising wealth inequality rather than shared prosperity. Very low interest rates encouraged firms and affluent individuals to borrow more money. Lacking an attractive alternative use for that money, they used it to purchase financial assets. The result was soaring stock market values. Because stock ownership is highly concentrated, this was of benefit to only the wealthiest Americans — those in the top 20%, and particularly the top 5% — rather than the population as a whole.31
However, the pattern in the US stock market isn’t consistent with this view. Figure 9 shows the inflation-adjusted value of the S&P 500 — the 500 largest publicly-owned US-based firms — over time. The straight line represents what the value would look like if it had grown at a constant rate since 1945 (the end of World War 2). The actual values aren’t far from this line, suggesting that stock prices have stayed more or less on track with the historical trend.
Moreover, the Fed’s loose money approach in the 2010s succeeded in its aim of coupling low unemployment with low inflation. The US unemployment rate was below 4% from 2017 through early 2020 (when the Covid-19 pandemic hit), and this led to an increase in wages for Americans in the middle and lower parts of the distribution.32
Finance has contributed to America’s top-heavy increase in income inequality.33 Over the past century, the financial sector’s share of America’s GDP has correlated fairly strongly with the top 1%’s share of income; it was high in the 1920s, then lower for about 50 years, then high again since the late 1970s.
However, several pieces of evidence tell us that finance is only one among many causes of rising income inequality.34 First, in the United States financial professionals account for about one-quarter of the rise in the income share of the top 1%, according to the best available estimate.35 Second, the top 1%’s income share began to increase around 1980 in the US, yet the financial sector’s share of income has been rising since the 1950s. Third, if we look across countries, we see that the Netherlands and Japan look similar to the United States in over-time trends in financial regulation, in finance’s share of income or value-added, and in financial-sector wages relative to wages in nonfinancial sectors, yet they are among the rich countries in which the top 1%’s share of income has risen the least over the past generation.36
An influential adage, often attributed to Karl Marx, holds that the government in a capitalist society is structurally dependent on capital.37 Policy makers need the economy to perform well, in part because this is good for people and in part because it boosts politicians’ likelihood of getting reelected. This dependence enables businesses to exert significant influence on policy choices by withholding investment or threatening to move to another country. Providers of finance are especially powerful, because money is more mobile than factories and offices and because finance feeds every sector of the economy. In modern economies, international finance also can influence policy makers by increasing a government’s cost of borrowing in the bond market.38 James Carville, an advisor to President Bill Clinton, once said “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”39
That there is some degree of structural dependence is not in dispute. There are plenty of examples, from France’s Mitterrand government feeling compelled to retreat from its nationalization and government spending plans in the early 1980s to pressure on the governments of all rich democracies to reduce tax rates to particular policies that have been blocked or abandoned due to worry about capital flight or a negative reaction from the bond market.40
Countries can reduce the threat of capital flight by adopting capital controls, and governments in most of the rich democratic nations did so in the 1950s, 1960s, and 1970s.41 Since then, they have tended to judge that the benefits of access to international financial markets outweigh the damage incurred from capital flight.
How big a problem is the threat of capital flight in the typical affluent democratic nation? Some analysts contend that it is much smaller than the conventional image holds. Domestic providers of finance can in principle move their money wherever they like. But most of the time they don’t leave, because they can make money by lending to firms and individuals in these nations, and most of those firms stay put because they, in turn, can make money by utilizing the employee skills, network ties, and high-quality infrastructure in these countries. Torben Iversen and David Soskice put the point as follows: “Advanced capital is geographically embedded in the advanced nation-state rather than footloose…. The value added of advanced companies is geographically embedded in their skilled workforces, via skill clusters, social networks, the need for colocation of workforces, and skills cospecific across workers and the implicit nature of a large proportion of skills. The nature and pattern of industrial organization has changed substantially through the century but the insight of economic geographers that competences are geographically embedded has not. Thus, while advanced companies may be powerful in the marketplace, advanced capitalism has little structural power.”42
We want a financial system that is innovative and flexible but that supports the rest of the economy rather than distorting or wrecking it. Government regulation is vital, perhaps more than for any other sector of the economy. As Martin Wolf writes, “Treating the financial system in the same way as, say, retailing does not make sense. No other industry has the capacity to create such widespread economic and social damage.”43
As with most areas of policy, regulation of the financial industry should proceed in a trial-and-error fashion, using incremental learning to try to move steadily toward a “just right” — not too light, not too heavy — regulatory approach. Between the mid-1970s and the mid-2000s the trend in the rich democracies was toward significantly less regulation of finance.44 That was reversed following the financial crisis of 2008-09.45 But there may be a need to go farther.
Key regulatory considerations in the American context include the following46:
Aim for regulatory simplicity and transparency. Complexity mostly has the effect of making it easier for firms to hide what they’re doing.
Require financial companies to maintain fairly large capital cushions. Having enough money on hand as a share of total loans reduces the likelihood a firm will end up insolvent in the event that a large number of its loans go bad in a short period of time. Since the passage of Dodd-Frank in 2010, the Federal Reserve has conducted periodic “stress tests” on the largest banks and other financial institutions, including verification that they have adequate capital on hand. In addition, the Basel III accord (reached in 2010) boosted capital requirements beginning in 2019.
Should we prohibit commercial banks from engaging in investment banking? America’s Glass-Steagall law did so from 1933 to 1999. The “Volcker Rule” in the Dodd-Frank Act goes part of the way: it prohibits banks from engaging in speculative trading activities — buying or selling securities, derivatives, commodity futures, or options. The jury is still out on the merits of this kind of restriction on banks. Alan Blinder, for one, has expressed skepticism: “Think about the travails of Bank of America, Wachovia, Washington Mutual, and even Citi…. They did not come — or did not mostly come — from investment banking activities. Rather, they came from the dangerous mix of high leverage with disgraceful lending practices, precisely what has been getting banks into trouble for centuries. Or consider the five giant investment banks prior to the crisis: Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. They were not creatures of Gramm-Leach-Bliley [GLB, the 1999 reform that did away with Glass-Steagall]. Merrill did own a large savings bank. But Merrill Lynch Bank predated GLB by many years, was explicitly allowed under Glass-Steagall, and had virtually nothing to do with Merrill’s problems. Nor would Glass-Steagall strictures have prevented any of the shenanigans at Bear Stearns, AIG, Countrywide, and the rest.”47
What to do about financial firms that are too big, or too interconnected, to fail. If a bank or investment firm or insurance company or other type of financial entity knows that policy makers will be forced to bail it out in the event it becomes insolvent, it has little incentive to refrain from overly aggressive investing, lending, or borrowing. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act provides for a new “orderly liquidation authority,” the Financial Stability Oversight Council (FSOC), that makes it easier for the government to break up a large financial firm — or if the firm fails, to put it out of business while avoiding big ripple effects. How effective this will prove depends on how it is used in practice.
Regulate the shadow banking sector. The shadow banking system is “a complex latticework of financial institutions and capital markets that are heavily involved in various aspects of borrowing and lending. There is no agreed-upon definition of the shadow banking system, but the institutions involved on the eve of the 2008-09 crisis included nonbank loan originators; the two government-sponsored housing agencies, Fannie Mae and Freddie Mac; other so-called private-label securitizers; the giant investment banks (who were often securitizers, too); structured investment vehicles; a variety of finance companies (some of which specialized in housing finance); hedge funds, private equity funds, and other asset managers; and thousands of mutual, pension, and other sorts of investment funds. The markets involved included those for mortgage-backed securities (MBS), other asset-backed securities (ABS), commercial paper (CP), repurchase agreements (‘repos’), and a bewildering variety of derivatives, including the notorious collateralized debt obligations (CDOs) and the ill-fated credit default swaps (CDS).”48 The Dodd-Frank Act authorizes the Securities and Exchange Commission (SEC) to regulate derivative trading. The aim is to identify risks in these trades and take action to prevent them from triggering severe financial instability. The Act also requires hedge funds to register with the SEC and to provide the agency with information about their assets and trades so the SEC can assess their risk.
Require financial companies to account for activities that aren’t on their balance sheets. A key contributor to the 2008-09 financial crisis was banks’ and other financial firms’ practice of hiding leverage, and hence risk, by keeping it separate from their reported balance sheets. That allowed them to take on much more risk than regulations permitted.49 The Dodd-Frank financial reform specifies that “the computation of capital for purposes of meeting capital requirements shall take into account any off-balance-sheet activities of the company.” This should help, provided it’s enforced.
A financial transactions tax? A “Tobin tax” might dampen speculation and volatility in markets for stocks, bonds, and currencies. Its effectiveness has been questioned. Mark Roe, for instance, points out that a financial transactions tax “is hard to implement. When tried, it has been easy to avoid. The trading parties, or their broker, need only move the locus of the trade to a jurisdiction without the tax…. Several European nations enacted Tobin taxes, but gathered little revenue, because trading went abroad.”50 Still, it might help.
Prevent bank runs. When financial sector problems become a financial crisis, typically a big part of the reason is panic. People worry that they won’t be able to get their money from their bank or other financial institution, so they rush to withdraw it, which puts some financial institutions in a precarious condition, which then ripples harmfully throughout the financial system and the broader economy.51 The federal government could reduce the likelihood of widespread bank runs by guaranteeing all bank deposits. A banking reform in the mid-1930s created government deposit insurance, and although there was a cap on the amount guaranteed, in practice a large share of deposits were under the cap and thus covered. The United States had no major financial crises in the ensuing decades. The cap currently is $250,000, and more than 40% of bank deposits in the US are above this amount. The main argument in favor of the cap is that depositors who have more than $250,000 in a bank will monitor the bank carefully to be sure it remains solvent, but in practice depositors can’t, or don’t, do that. And when large or midsize banks occasionally do become insolvent, the government frequently decides to refund all deposits, even those exceeding the cap. Uncertainty about whether the government will do that can, however, turn quickly into widespread panic. So the best approach may be to simply guarantee all deposits.52
None of these regulatory steps, alone or in combination, will bring us a perfect financial system — one that manages to be maximally innovative and flexible and also safe and stable. But they will help, and that might be good enough.
IS THERE AN ALTERNATIVE?
If regulation isn’t good enough, what alternative do we have?
There are sectors in most rich democratic capitalist nations that are heavily socialized — government-funded and mainly government-run. The chief examples are education and healthcare. A number of these countries have public early education (childcare and preschool), all have public K-12 schooling, and all have an array of public colleges. Quite a few have single-payer healthcare, in which government pays for most healthcare services. In some, such as the United Kingdom and the Nordic nations, government also employs most medical providers. Perhaps something along these lines could work for finance too.
What might that look like? A minimal version would consist of public banks, with the rest of the financial system similar to its current form.
Another version might couple public banks with a prohibition on equity ownership, so that borrowing from the public banks would be the only, or at least far and away the main, source of financing for firms wishing to start up or expand.53
Another possibility is John Roemer’s “coupon socialism” proposal.54 Mid-sized and large companies would issue stock shares, just as they do today in capitalist economies. At age 18, each person is given a certain number of coupons, equal to a per capita share of the total value of the economy’s stock shares, which she can use to purchase shares in particular firms (or in a mutual fund or index fund). Coupons can be used for this purpose only; they can’t be sold for cash. Firms pay dividends, yielding an income flow to their owners. And ownership confers the right to vote as a shareholder in electing a firm’s board of directors. If a person sells some or all of his shares in a particular company, he receives coupons, which can be used only to purchase shares in other firms. Share ownership can’t be inherited or gifted; at death, a person’s coupons go back to the common pool, to be redistributed among living citizens.
Because stock shares can be traded, the price (in coupons) of successful firms will increase. Thus, over the course of a lifetime, people who invest in more successful companies will end up with a larger ownership share than others. This may also yield them more income via the dividend payments of the companies (or mutual funds) whose shares they own. But this type of income inequality will be minor relative to what exists in contemporary capitalist economies, where a small share of the population own lots of stock shares and most people own few or none.
Firms in the Roemer plan can raise money by issuing new shares and selling them on the stock market for coupons. The government (central bank) determines the value of new stock shares, which gives it some influence over the direction of economic activity. If the government wants to encourage investment in, say, clean energy, it can increase the value of new shares of firms in that line of business. But in other respects a Roemer “coupon socialism” economy would operate similarly to existing affluent capitalist economies.
How well would something like this work in practice? Would it yield innovation and economic growth similar to a capitalist financial system but with fewer crises and less income inequality? How would it function in the context of a global economy in which firms can, presumably, receive financing from private lenders and investors abroad? Because it has never been tried, we have no way of knowing.
Finance is necessary for a good society, and a decentralized mostly-private financial sector tends to be effective at allocating resources to productive uses. The question is whether its drawbacks outweigh its benefits. Quite a few contemporary observers appear to believe they do.
Yet the evidence in the era of financialization gives some reason for optimism. Financialization has contributed to rising income inequality, but it is only one of a number of causes. It hasn’t reduced business investment in research and development, and it likely hasn’t reduced overall investment. It doesn’t appear to have impeded entrepreneurship. It doesn’t seem to have fostered harmful short-termism among American companies. It has caused economic crises, but economies have recovered and regulation has proven effective at reducing the incidence of crises. Financialization doesn’t seem to have reduced economic growth. And the financial sector doesn’t dominate policymaking.
There is much we don’t fully understand, and we are by no means safe from the possibility of a future finance-induced catastrophe. But we probably don’t need to scrap the current organization of finance and build an entirely different system. Continued reform may well suffice.
The appendix has additional data.
- Richard Deeg, Finance Capital Unveiled, University of Michigan Press, 1999; Marc Schneiberg, “Toward an Organizationally Diverse American Capitalism? Cooperative, Mutual, and Local, State-Owned Enterprise,” Seattle University Law Review, 2011. ↩
- Mariana Mazzucato, The Entrepreneurial State, PublicAffairs, 2015. ↩
- Gerald F. Davis, Managed by the Markets: How Finance Reshaped America, Oxford University Press, 2009; Greta Krippner, Capitalizing on Crisis: The Political Origins of the Rise of Finance, Harvard University Press, 2011; Mike Konczal and Nell Abernathy, “Defining Financialization,” Roosevelt Institute, 2015; J.W. Mason, “Disgorge the Cash: The Disconnect Between Corporate Borrowing and Investment,” Roosevelt Institute, 2015; Adair Turner, Between Debt and the Devil: Money, Credit, and Fixing Global Finance, Princeton University Press, 2015; Wallace Turbeville, “Financialization and Equal Opportunity,” Demos, 2015; Rana Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, Crown Business, 2016. ↩
- Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, p. x ↩
- Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, p. 6. This draws from Moritz Schularick and Alan M. Taylor, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008,” Working Paper 15512, National Bureau of Economic Research, 2009. ↩
- Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, pp. 2-4. The “five times the revenue” figure is from Krippner, Capitalizing on Crisis: The Political Origins of the Rise of Finance, p. 35. ↩
- See also Mark J. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, Oxford University Press, 2022. ↩
- Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, pp. 10-11. ↩
- See also Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem. ↩
- According to Rana Foroohar, the decline in business startups is “a trend that numerous academics and even many investors and businesspeople have linked to the financial industry’s change in focus from lending to speculation…. They include Nobel laureates Joseph Stiglitz and Edmund Phelps, economist James Galbraith, sociologists Gerald Davis and Greta Krippner, investors Warren Buffett and John Bogle, and numerous other academics and businesspeople.” Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, pp. 10, 333. ↩
- See also Ben Casselman, “A Start-Up Slump Is a Drag on the Economy. Big Business May Be to Blame,” New York Times, 2017; Ewing Marion Kauffman Foundation, “Startup Density (1977-2016),” 2017 Kauffman Index of Startup Activity, p. 24. ↩
- Richard R. Ellsworth, “Capital Markets and Competitive Decline,” Harvard Business Review, 1985; Michael E. Porter, Capital Choices: Changing the Way America Invests in Industry, Council on Competitiveness, 1992; Lane Kenworthy, In Search of National Economic Success, Sage, 1995; Robert H. Hayes and William J. Abernathy, “Managing Our Way to Economic Decline,” Harvard Business Review, 2007; Aspen Institute, “Overcoming Short-Termism: A Call for A More Responsible Approach to Investment and Business Management,” 2009; Alfred Rappaport, Saving Capitalism from Short-Termism, McGraw-Hill, 2011; Dominic Barton and Mark Wiseman, “Focusing Capital on the Long Term,” Harvard Business Review, 2014; Richard Davies, Andrew G. Haldane, Mette Nielsen, and Silvia Pezzini, “Measuring the Costs of Short-Termism,” Journal of Financial Stability, 2014; William Lazonick, “Profits Without Prosperity,” Harvard Business Review, 2014; The Conference Board, “Is Short-Term Behavior Jeopardizing the Future Prosperity of Business?,” 2015; William A. Galston and Elaine Kamarck, “More Builders and Fewer Traders: A Growth Strategy for the American Economy,” Brookings Institution, 2015; Roger L. Martin, “Yes, Short-Termism Really Is a Problem,” Harvard Business Review, 2015; Joe Biden, “How Short-Termism Saps the Economy,” Wall Street Journal, 2016; Jamie Dimon and Warren E. Buffett, “Short-Termism Is Harming the Economy,” Wall Street Journal, 2018. ↩
- Albert O. Hirschman, Exit, Voice, and Loyalty, Harvard University Press, 1970. ↩
- Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, p. 4. ↩
- Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, p. 9. ↩
- Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, pp. 8-9. ↩
- Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, figure 2.3. ↩
- Lisa Kahn, “The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy,” Labour Economics, 2010; P. Oreopoulos, T. von Wachter, and A. Heisz, “The Short- and Long-Term Career Effects of Graduating in a Recession: Hysteresis and Heterogeneity in the Market for College Graduates,” American Economic Journal: Applied Economics, 2012; Paola Giuliano and Antonio Spilimbergo, “Growing Up in a Recession,” Review of Economic Studies, 2014. ↩
- See also Anthony B. Atkinson and Salvatore Morelli, “Inequality and Banking Crises: A First Look,” Report for the International Labour Organization (ILO), 2010; Anthony B. Atkinson and Salvatore Morelli, “Chartbook of Economic Inequality,” 2014. ↩
- Alan S. Blinder, After the Music Stopped, Penguin, 2013, pp. 31-40, 68-72. ↩
- Blinder, After the Music Stopped, pp. 72-73. ↩
- Noah Smith, “Unlearning the Macroeconomic Lessons of the 2010s,” Noahpinion, 2022. ↩
- Blinder, After the Music Stopped, pp. 45-46. ↩
- Jon Danielsson, The Illusion of Control: Why Financial Crises Happen, and What We Can (and Can’t) Do About It, Yale University Press, 2022. ↩
- Blinder, After the Music Stopped, pp. 46-47. ↩
- Blinder, After the Music Stopped; Danielsson, The Illusion of Control. ↩
- Lane Kenworthy, “Economic Growth,” The Good Society. ↩
- Stephen G. Cecchetti and Enisse Kharroubi, “Reassessing the Impact of Finance on Growth,” Working Paper 381, Bank for International Settlements, 2012; Boris Cournède and Oliver Denk, “Finance and Economic Growth in OECD and G20 Countries,” Working Paper 1223, OECD Economics Department, 2015; Lawrence R. Jacobs and Desmond King, Fed Power: How Finance Wins, Oxford University Press, 2016; Foroohar, Makers and Takers: How Wall Street Destroyed Main Street. ↩
- Kenworthy, “Economic Growth,” The Good Society. ↩
- Paul Krugman, End This Depression Now, W.W. Norton, 2012, ch. 10; Robert Kuttner, Can Democracy Survive Global Capitalism?, W.W. Norton, 2018, ch. 6. ↩
- Rana Foroohar, “The Stock Market Is Plummeting. Welcome to the End of the ‘Everything Bubble’,” The Ezra Klein Show, 2022; Sheila Bair, “Higher Rates for Longer Are a Good Thing,” Financial Times, 2023. ↩
- Jared Bernstein, “Recent Wage Trends Are Impressive. Their Levels … Not So Much,” Washington Post: Post Everything, 2019. ↩
- Thomas Philippon and Ariell Reshef, “An International Look at the Growth of Modern Finance,” Journal of Economic Perspectives, 2013; Donald Tomaskovic-Devey and Ken-Hou Lin, “Financialization: Causes, Inequality Consequences, and Policy Implications,” North Carolina Banking Institute Journal, 2013; Eoin Flaherty, “Top Incomes Under Finance-Driven Capitalism, 1990–2010: Power Resources and Regulatory Orders,” Socio-Economic Review, 2015. ↩
- Lane Kenworthy, “Income Distribution,” The Good Society. ↩
- Jon Bakija, Adam Cole, and Bradley T. Heim, “Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data,” 2012. ↩
- Kenworthy, “Income Distribution.” ↩
- Fred Block, “The Ruling Class Does Not Rule: Notes on the Marxist Theory of the State,” Socialist Revolution, 1977; Charles E. Lindblom, “The Privileged Position of Business,” in Politics and Markets, Basic Books, 1977; Goran Therborn, What Does the Ruling Class Do When It Rules?, Verso, 1978; Adam Przeworski and Michael Wallerstein, “Structural Dependence of the State on Capital,” American Political Science Review, 1988; Leo Panitch, “Europe’s Left Has Seen How Capitalism Can Bite Back,” The Guardian, 2014; Leo Panitch, “The Long Shot of Democratic Socialism Is Our Only Shot,” Interview with Bhaskar Sunkara, Jacobin, 2020. ↩
- Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton, 2009; Paul Krugman, End This Depression Now!, W.W. Norton, 2012; Mark Blyth, Austerity: The History of a Dangerous Idea, Oxford University Press, 2013. ↩
- James Carville, “The Bond Vigilantes,” Wall Street Journal, 1993. Fred Block suggests a different causal pathway: “In tracing out the linkages between financial interests and establishment politicians, the most useful idea is that of ‘cognitive capture.’ It is not just personal connections and campaign contributions that make political leaders beholden to financial interests. The core problem is that most politicians … have adopted the same beliefs about how the economy works as the financial community. It is as though they all went to school together and read the same books, so they share the same belief system.” Block, Capitalism: The Future of an Illusion, University of California Press, 2018, pp. 7-8. ↩
- Peter A. Hall, Governing the Economy, Oxford University Press, 1986; Philipp Genschel, “Globalization, Tax Competition, and the Welfare State,” Politics and Society, 2002; Dani Rodrik, The Globalization Paradox, W.W. Norton, 2010; Kuttner, Can Democracy Survive Global Capitalism?; Kevin A. Young, Tarun Banerjee, and Michael Schwartz, “Capital Strikes as a Corporate Political Strategy: The Structural Power of Business in the Obama Era,” Politics and Society, 2018. ↩
- Fred Block, “Capitalism Without Class Power,” Politics and Society, 1992; Tom Malleson, After Occupy: Economic Democracy for the 21st Century, Oxford University Press, 2014, ch. 7; Kuttner, Can Democracy Survive Global Capitalism?. ↩
- Torben Iversen and David Soskice, Democracy and Prosperity, Princeton University Press, 2019, Preface. See also Joel Rogers and Satya Rhodes-Conway, Cities at Work: Progressive Local Policies to Rebuild the Middle Class, Center for American Progress Action Fund, 2014; Torben M. Andersen et al, Nordic Economic Policy Review: Whither the Nordic Welfare Model?, Norden, 2015, ch. 5. ↩
- Martin Wolf, The Shifts and the Shocks: What We’ve Learned — and Have Still to Learn — from the Financial Crisis, Penguin, 2015, p. 137. ↩
- Lane Kenworthy, “Finance: Additional Data,” The Good Society. ↩
- Blinder, After the Music Stopped; Deniz Anginer, Ata Can Bertay, Robert Cull, Asli Demirgüç-Kunt, Davide S. Mare, “Bank Regulation and Supervision Ten Years After the Global Financial Crisis,” Policy Research Working Paper 9044, Development Research Group, World Bank, 2019. ↩
- Dani Rodrik, “The Tobin Tax Lives Again,” Project Syndicate, 2009; Paul Krugman, “Six Doctrines in Search of a Policy Regime,” New York Times: The Conscience of a Liberal, 2010; Alan Blinder, “Financial Collapse: A Twelve-Step Recovery Plan,” New York Times, 2013; Simon Johnson, “Resurrecting Glass-Steagall,” Project Syndicate, 2015; Mike Konczal, “Structural Reform Beyond Glass-Steagall,” Next New Deal, 2015; Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, ch. 11; Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World, Penguin, 2018. ↩
- Blinder, After the Music Stopped, pp. 266-67. ↩
- Blinder, After the Music Stopped, pp. 59-60. ↩
- Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe, Free Press, 2009; Blinder, After the Music Stopped. ↩
- Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, p. 138. See also Steven M. Davidoff, “Tax on Trades Is a Simple Idea With Unintended Outcomes,” New York Times, 2013; The Economist, “Do Tobin Taxes Actually Work?,” 2013. ↩
- Morgan Ricks, The Money Problem: Rethinking Financial Regulation, University of Chicago Press, 2016. ↩
- Lev Menand and Morgan Ricks, “Scrap the Bank Deposit Insurance Limit,” Washington Post, 2023. ↩
- Malleson, After Occupy: Economic Democracy for the 21st Century. ↩
- John E. Roemer, A Future for Socialism, Harvard University Press, 1994; John E. Roemer et al, Equal Shares: Making Market Socialism Work, Verso, 1996. ↩