Can finance be harnessed?

Lane Kenworthy, The Good Society
July 2022

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 adequate funding for useful endeavors but won’t impede economic growth, won’t cause economic crises, and won’t discourage government from doing good things. Is that possible?

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GETTING MONEY TO THOSE WHO CAN USE IT EFFECTIVELY

An effective financial system will direct funds toward any borrower that has a good shot at succeeding. Part of the genius of markets is that they facilitate unplanned but beneficial economic behavior. It’s very 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.

But biases may cause lenders to underinvest in certain types of businesses, communities, and individuals — companies with little potential for good short-run returns, low-income communities, racial or ethnic minorities, entrepreneurs aiming to challenge large monopolistic firms, worker cooperatives, and others.

Two things can help. One is rules that prohibit discrimination, along with active enforcement of those rules. The other is support for local financial institutions and ones dedicated to funding of less advantaged borrowers. Historically, local public, community, and cooperative banks have played an important role in ensuring that businesses don’t get underfunded because of lender biases.1

In addition, society might want to direct investment toward firms or sectors that are likely to achieve a particular social goal, such as climate stability, but that may not yield much in the way of profits. Here a national funding agency can play a useful role.

THE FINANCIAL SECTOR’S HEIGHTENED PROMINENCE

Since the 1970s, globalization, the emergence of large institutional investors, advances in computing and telecommunications, the creation of new financial instruments, and reductions in regulatory constraints have allowed financial companies 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 in the world’s rich democratic countries.2

One element of this development is that the financial sector accounts for a rising share of the economy. In the United States, finance has grown to about 7% of the economy and a whopping 25% of corporate profits.3

According to Rana Foroohar, this causes a shift of resources away from the “real economy” — from investment in research or production of useful goods and services — toward financial speculation4:

“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.”

In the view of some observers, this shift of resources has caused a reduction in lending to small businesses, which has contributed to the decline in business startups in the United States.5 Reliable data on business startups don’t begin until 1978, but as best we can tell from these data, shown in figure 1, the decline in startups began prior to the era of financialization and didn’t accelerate when financialization took hold.6

Figure 1. Business startups
Establishments born during the past year as a share of all firms. Data source: Census Bureau, “Business Dynamics Statistics: Establishment Age, 1978-2019 (BDSEAGE),” 2019 Business Dynamics Statistics Data Tables.

THE FINANCIALIZATION OF NONFINANCIAL FIRMS

A second element of financialization is that nonfinancial firms increasingly engage in financial operations in addition to, or as a substitute for, their core business operations. Most large American firms now issue credit cards and offer loans to consumers who purchase their products. Universities with large endowments are major investors in stocks and bonds.

This, according to some, has weakened nonfinancial firms’ ability to pursue their regular operations effectively. Here again is Rana Foroohar7:

“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.”

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

Figure 2. R&D spending by business
Business expenditures on research and development as a share of GDP. Data source: Mark Boroush and Ledia Guci, “Research and Development: U.S. Trends and International Comparisons,” National Science Board, 2022, figure RD-3, using data from the National Center for Science and Engineering Statistics, National Patterns of R&D Resources.

EQUITY MARKETS AND SHORT-TERMISM

In a decentralized capital market, most 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 is not 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. 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 this overlooks a potentially important problem that stems from an ambiguity in the notion of profit maximization. The hitch is that there is a time component involved. Actions taken to maximize return in the near term may not be conducive to profit maximization over a longer period, and vice versa. For example, firms often face a choice whether or not to make an expensive investment that might yield a handsome payoff, but only after a number of years. A firm seeking to maximize short-run profits would likely elect not to make the investment, whereas one interested in long-term results would be more inclined to do so.

Firms in a decentralized, equity-based financial system may face strong pressures to focus on near-term performance. This stems from the lack of incentive for disengaged investors to commit to any particular firm, the quality of information they must rely on to evaluate company prospects, and their lack of capacity to directly influence managerial behavior.

Disengaged investors have no incentive to hold onto their shares in a company that is not currently performing at a satisfactory standard. Their interest in a firm is confined solely to its ability to yield a high return. There is no other attachment or tie linking the investor to the company. Selling the stock has only a negligible effect on the firm in any case, because each individual investor owns an inconsequential share of the company.

Disengaged investors must rely chiefly on the market for information about firms’ performance and prospects. This, too, encourages a focus on the short run, because the quality of information the market uses to value companies is inadequate.

A near-term focus is further encouraged by the difficulty small shareholders face in implementing desired changes in management strategy. Stockholder meetings are typically held only once each year, and in order to influence managerial decision making, small shareholders must form coalitions, the collective action costs of which are, understandably, often viewed as prohibitive. For these reasons, the tendency of dissatisfied minor shareholders is to simply sell their stock. As Albert Hirschman noted in his classic treatise on exit and voice, difficulty in exercising voice as a response to ineffective managerial performance encourages resort to exit.10

So where they are relatively free to shift assets from firm to firm, investors seeking to maximize the return on their assets tend to buy and sell frequently. To please such investors, to keep them loyal, corporate executives must strive to maximize the short-run profits of the firm. 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.11

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.”12

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.”13

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.”14

Third, as we saw in the previous section, American firms’ investment in research and development has increased, not declined, during the era of stock market primacy.

Fourth, overall investment in the US economy has decreased since 1980. But that decline has been small, and it has been smaller than the average among the affluent democratic nations, which is not what the equity-markets-cause-short-termism hypothesis would predict.15

FINANCIAL CRISES

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.16 Financial crises have occurred frequently in the rich democratic countries, as we see in figure 3.17

Figure 3. Share of rich democratic nations in banking crisis
The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Korea (South), Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States. Data source: Carmen M. Reinhart and Kenneth Rogoff, “Dates for Banking Crises, Currency Crashes, Sovereign Domestic or External Default (or Restructuring), Inflation Crises, and Stock Market Crashes (Varieties),” carmenreinhart.com/data.

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 4 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.

Figure 4. Home prices
Home prices, adjusted for inflation. Index: 1890=1. Data source: Robert Shiller, “US Home Prices 1890-Present,” econ.yale.edu/~shiller/data.htm.

Finance contributed to the housing bubble in several ways. Mortgage 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 share 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 2006.18

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 explains19:

.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 financial crisis, but just as more important — perhaps more important — was a bubble in the bond market. Here again is Alan Blinder20:

“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.”

This might be endemic to capitalism. It may be inevitable that a largely private financial sector will periodically overreach in search of new financial instruments and new customers, making too many risky investments and loans that eventually go bad, resulting in an economic downturn. Alan Blinder, who has offered perhaps the most detailed and careful analyses of the 2008-09 financial crisis, concludes similarly: “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.”21

Can we minimize the consequences? Looking across the rich democratic countries over the past half century offers grounds for hope. Figure 5 has a measure of social democratic capitalism on the horizontal axis and the number of years the country spent in a banking crisis since 1973 on the vertical axis. Nations with more of a social democratic capitalist orientation have tended to spend fewer years mired in financial crisis.

Figure 5. Social democratic capitalism and banking crises
Years in banking crisis: share of years, 1973-2010. Data source: Carmen M. Reinhart and Kenneth Rogoff, “Dates for Banking Crises, Currency Crashes, Sovereign Domestic or External Default (or Restructuring), Inflation Crises, and Stock Market Crashes (Varieties),” carmenreinhart.com/data. Social democratic capitalism: average standard deviation score on four indicators: public expenditures on social programs as a share of GDP, replacement rates for major public transfer programs, public expenditures on employment-oriented services, and modest regulation of product and labor markets. The data cover the period 1980-2015. Data source: Lane Kenworthy, Social Democratic Capitalism, Oxford University Press, 2020, pp. 39-40. The line is a linear regression line. “Asl” is Australia; “Aus” is Austria.

FINANCIALIZATION AND ECONOMIC GROWTH

The chief consequence of financialization, according to some observers, has been slower economic growth.22 What does the evidence suggest?

America’s growth rate has indeed been slower in the period since 1980 than it was during three decades or so following World War II. But the strong growth during that mid-twentieth-century “golden age” almost certainly was in part a catch-up process coming on the heels of the Great Depression. Economic growth since 1980 has been roughly on track with the historical average for the past century and a half.23

If financialization has reduced economic growth, we also 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 pronounced. Here too, however, the prediction isn’t borne out. Growth hasn’t been slower in the US than elsewhere.24

What about financial crises in particular? Because we have good data on financial crises across countries, we can look to see whether the frequency of such crises is associated with slower economic growth. The horizontal axis in figure 6 shows the share of years since 1979 that national economies have been in banking crisis. This ranges from a low of 6% in Switzerland to a high of 38% in the United States. Countries with greater financial instability haven’t tended to suffer slower long-run economic growth.

Figure 6. Financial crises and economic growth
Catchup-adjusted economic growth: residuals from a regression of 1979-2016 growth rates on 1979 level of GDP per capita. Data source: OECD. Years in banking crisis: share of years, 1979-2010. Data source: Carmen M. Reinhart and Kenneth Rogoff, “Dates for Banking Crises, Currency Crashes, Sovereign Domestic or External Default ( or Restructuring), Inflation Crises, and Stock Market Crashes (Varieties),” carmenreinhart.com/data. “Asl” is Australia; “Aus” is Austria. The line is a linear regression line. The correlation is +.20.

DOES FINANCIALIZATION UNDERMINE LOOSE MONETARY POLICY?

In the United States, the Federal Reserve cut interest rates to zero during the 2008-09 financial crisis in order to help pull the economy back into growth. In the ensuing years it has kept interest rates very low, as we see in figure 7. The goal was to help the economy continue to grow and to allow the unemployment rate to fall to and remain at a very low level, which tends to force employers to bid up wages, ensuring that the gains of economic growth are shared by all.

Figure 7. Real long-term interest rates
Interest rate on 10-year government bond minus the average rate of inflation (excluding food and energy) in the three previous years. Data source: Paul Krugman, “Is the Era of Cheap Money Over?,” New York Times, Newsletter, June 21, 2022, using data from the Federal Reserve Bank of St. Louis (FRED).

On one view, this has instead had the effect of boosting asset prices and thereby increasing wealth inequality rather than producing shared prosperity. It has encouraged firms and affluent individuals to borrow more money than they otherwise would have. Without a good use for that extra money, they’ve used it to purchase financial assets. The result has been soaring stock market values. Because stock ownership is highly concentrated, this has been of benefit to only the wealthiest Americans — those in the top 20%, and particularly the top 5%, of the distribution — rather than the population as a whole.25

But the pattern in the US stock market isn’t consistent with this view. Figure 8 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.

Figure 8. US stock values (log)
Natural log of inflation-adjusted S&P 500. A log scale is used to focus on the rate of change. The vertical axis doesn’t begin at zero. The line is a linear regression line; it represents a constant rate of growth from 1945 to 2022. Data source: multpl.com/inflation-adjusted-s-p-500, using data from Standard & Poor’s and Robert Shiller.

Moreover, the Fed’s loose money approach in the 2010s appears to have succeeded in its core aim of coupling low unemployment with low inflation. The US unemployment rate was below 4 percent 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.26

FINANCE AND INCOME INEQUALITY

Finance has contributed to America’s top-heavy increase in income inequality.27 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. Financial professionals get one-seventh of the top 1%’s income, and they account for about one-quarter of the rise in its income share.28

However, finance is only one among many causes of rising income inequality.29 In the United States, the financial sector’s share of income has been rising since the 1950s, whereas the top 1%’s income share only began to increase around 1980. And if we look across countries, we find a number of anomalies. For instance, 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.

FINANCE AND STATE CAPTURE

An influential adage, often attributed to Karl Marx, holds that the government in a capitalist society is structurally dependent on capital.30 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.31 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.”32

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.33

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.34 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 follows35:

“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.”

Rather than capital flight, it is conservative political parties that have tended to be the chief obstacle to enactment of progressive policies. The Republican Party in the United States, for instance, favors low taxes, limited regulation, and a weak welfare state not just because of pressure from the financial sector or other business interests, but because this has become a core element of its political ideology.36

REGULATING FINANCE

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 the key to discouraging excess.

As with many 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. In the past half century the trend has been toward significantly less regulation of finance, as we see in figure 9. (The appendix has a separate graph for each country.) This may need to change.

Figure 9. Financial regulation
Higher values indicate more regulation. The index is constructed by combining seven dimensions of financial regulation: (1) Credit controls: restrictions on the amounts of bank lending to specific sectors or ceiling on overall credit extended by banks. (2) Interest rate controls: the degree to which banks are restricted in setting rates (whether floor or ceiling interest rates exist and/or bind). (3) Entry barriers: barriers to entry into the financial system which may take the form of restrictions on the participation of foreign banks; restrictions on the scope of banks’ activities; restrictions on the geographic area where banks can operate; or excessively restrictive licensing requirements. (4) Privatization: the degree to which the government is not involved directly in financial services (using thresholds of 50%, 25%, and 10% of state ownership to differentiate between full state control and full liberalization, respectively). (5) Capital account restrictions: having multiple exchange rates for various transactions, as well as transactions taxes or outright restrictions on inflows and/or outflows. (6) Securities market development: policies that governments use to encourage development of securities markets; these include auctioning of government securities, establishment of debt and equity markets and policies to encourage development of these markets (such as tax incentives or development of depository and settlement systems), and policies to promote the openness of securities markets to foreign investors. (7) Prudential regulation and supervision: whether a country adopted risk‐based capital adequacy ratios based on the Basle I capital accord, and whether the banking supervisory agency is independent from the executive’s influence and has sufficient legal power. Each index originally ranges from 0 to 3, where 3 indicates the most restrictive regulations, except in 7, where 0 indicates the most restrictive regulation. The deregulation index is the sum of indices 1 to 6 minus index 7. Data source: Thomas Philippon and Ariell Reshef, “An International Look at the Growth of Modern Finance,” Journal of Economic Perspectives, 2013, online appendix, figure A4, using data from Abiad, Detragiache, and Tressel, “A New Database of Financial Reforms,” International Monetary Fund Working Paper 08/266, 2008.

Helpful regulatory changes in the American context might include37:

Aim for regulatory simplicity and transparency rather than complexity. Complexity isn’t much of an obstacle for large firms that can hire hundreds of intelligent, hard-working accountants and lawyers. It mostly has the effect of making it easier for firms to hide what they’re doing.

Break up financial firms that are “too big to fail.” If a bank or investment firm 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.

Require financial companies to maintain fairly large capital cushions. Having enough money on hand as a share of total loans reduces the likelihood that a firm will end up in default in the event that a large number of loans going bad in a short period of time.

Require a sharp separation between commercial banks and investment banks. America’s Glass-Steagall law did so from 1933 to 1999. The jury is still out on this, however.

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).”38

Financial transactions tax. A “Tobin tax” might dampen speculation and volatility in markets for stocks, bonds, and currencies. But their effectiveness has been questioned. Mark Roe 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.”39 Still, it might help.

None of these, 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’s probably good enough.

SUMMARY

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 doesn’t appear to have impeded entrepreneurship. It hasn’t reduced business investment in research and development. 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. On the whole, financialization hasn’t 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 future finance-induced catastrophe. But the evidence doesn’t suggest that we need to scrap the current organization of finance and build an entirely different system.

APPENDIX

The appendix has additional data.


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  2. 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. 
  3. Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, p. x 
  4. 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. 
  5. 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. 
  6. 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. 
  7. 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. 
  8. Foroohar, Makers and Takers: How Wall Street Destroyed Main Street, pp. 10-11. 
  9. See also Mark J. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, Oxford University Press, 2022. 
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  12. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, p. 4. 
  13. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, p. 9. 
  14. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, pp. 8-9. 
  15. Roe, Missing the Target: Why Stock Market Short-Termism Is Not the Problem, figure 2.3. 
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  18. Alan S. Blinder, After the Music Stopped, Penguin, 2013, pp. 31-40, 68-72. 
  19. Blinder, After the Music Stopped, pp. 72-73. 
  20. Blinder, After the Music Stopped, pp. 45-46. 
  21. Blinder, After the Music Stopped, pp. 46-47. 
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  24. Kenworthy, “Economic Growth,” The Good Society. 
  25. Rana Foorohar, “The Stock Market Is Plummeting. Welcome to the End of the ‘Everything Bubble’,” The Ezra Klein Show, 2022. 
  26. Jared Bernstein, “Recent Wage Trends Are Impressive. Their Levels … Not So Much,” Washington Post: Post Everything, 2019.  
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  28. 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. 
  29. Lane Kenworthy, “Income Distribution,” The Good Society. 
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  31. 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. 
  32. James Carville, “The Bond Vigilantes,” Wall Street Journal, 1993. 
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  34. Fred Block, “Capitalism Without Class Power,” Politics and Society, 1992; Tom Malleson, After Occupy: Economic Democracy for the 21st Century, Oxford University Press, 2014. 
  35. 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. 
  36. Thomas E. Mann and Norman J. Ornstein, It’s Even Worse Than It Looks, Basic Books, 2012; Monica Prasad, Starving the Beast: Ronald Reagan and the Tax Cut Revolution, Russell Sage Foundation, 2018. In a recent book, Fred Block offers a different take: “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. 
  37. 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. 
  38. Blinder, After the Music Stopped, pp. 59-60. 
  39. Roe, Missing the Target, 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.