The next aspect of financialism I’d like to explain is the historical development of its principal institutions, commercial and investment banks, and particularly the shift in the nature of their core businesses that marks the transition from capitalism to financialism.
This part of the story begins with the growth of the investment banking industry from the middle of the century, as the Exchange permitted member incorporation in 1953, which allowed firms to take advantage of limited liability and therefore engage in higher risk activities. The story goes on to a key moment in the development of the financial industry, the public offering of stock in investment bank Donaldson, Lufkin, Jenrette in 1970, and the tectonic shift in the industry created by the existence of publicly held investment banks, a shift which dramatically expanded both the (realized) possibility of high leverage for the banks and the concomitant explosion in profits and compensation.The greater financial resources that public offerings brought to the investment banks also allowed them to automate, first their back offices and then, far more importantly, their trading desks. Eventually the major human contact that traders had with stock was their design of computer programs to trade it.
By the end of the twentieth century, the industry had undergone a dramatic shift in business focus. Where once investment banks made their money underwriting securities, arranging deals, and providing financial advice to clients, they now moved in the direction of proprietary trading, that is, trading for their own profits, and the development of what are generally referred to as “new financial products,” mortgage backed securities, collateralized debt obligations, other exotic derivatives, proprietary hedge funds, and other financial instruments, some of which are aptly described by Warren Buffett as “financial weapons of mass destruction.”The development of computerized trading, and especially the recent development of high frequency trading, increased the separation of finance from the real economy. Computers don’t care about the companies they trade in; computers don’t care about the real economy.
These changes clearly moved the financial industry away from the traditional function of finance as providing funds for productive industry, at the same time that it increased the risk to the nation’s credit supply. The new trading-centered finance employed the beautiful minds of Wall Street to help banks and investment banks sell off risk, while keeping most of the profit. The justification for these practices, echoed by Federal Reserve Board Chairman Ben Bernanke, was that they increased liquidity in the American economy and thus the funds available for financing business. This would have been consistent with capitalism, even if much of the profit of this business shift remained with the banks. But the increased liquidity was more commonly used to continue to finance trading and the sale of new financial products like credit default swaps than for financing real economic production. This behavior is financialism, not capitalism.
Another feature of financialism is the relatively recent acceptance of the existence of financial institutions that are too interconnected to be permitted to fail.While not exclusive to financialism (capitalism has sometimes recognized institutions as too big to fail), financialism embraces the existence of such institutions and at least implicitly pledges the continuing willingness of the American taxpayer to sustain their solvency.
The acceptance of the concept of too big too fail is a consequence of misguided free market ideology. While the term often is acknowledged to have originated in the federal bailout of Continental Illinois Bank and Trust Company in 1984,government bailouts had periodically been a feature of American economic policy, including the Chrysler bailout of 1979 and the rescue of Long Term Capital Management in 1998.But it was not until the substantial deregulation of the financial industry with the passage of the Gramm-Leach-Bliley Act in 1999that financial concentration really exploded, creating the monster banks that characterized the American financial sector at the beginning of the 21st century.This transformation, among other things, helped to fuel the rise of trading as a major profit center, not only in the investment banks I’ve just described, but even in the most traditionally conservative commercial banks.Financial liberation continued with the explicit non-regulation of over-the-counter derivatives by the Commodities Futures Modernization Act of 2000.
American capitalism is not well served by the existence of financial institutions that are too big to fail. A larger amount of somewhat smaller financial institutions that, in a very real economic sense, structurally diversify the risk of economic failure across a broader spectrum of banks and reduce, if not eliminate, the need for continual federal intervention in order to protect the nation’s credit supply, is almost certainly better suited both to stimulate production in the real economy and to keep our credit supply safe without unnecessarily chilling appropriate risk-taking.