Category Archives: The Economy

Financialism: Concluding Thoughts

Few of the developments I‟ve described could have happened without the triumph of neo-classicism and its effects on American law and public policy from the 1980s through the 2008 collapse.

The legal story begins with a variety of measures designed to deregulate the banking industry, starting with savings and loan institutions in the 1980s and culminating in the virtual liberation of commercial banks from New Deal restrictions with the passage of the Gramm-Leach-Bliley Act in 1999.  Banking deregulation began with efforts to permit institutions which had distinctly local or regional business to grow nationally, and increasingly removed restrictions on the businesses in which the regulated institutions could engage. This, along with attractive inducements from states like North Carolina, paved the way for substantial bank consolidation in the 1990s and early 21st century.

Traditional small lending institutions thus became further removed from their clients, and banks sought greater profits in the process of securitization, which brought higher profits than mere lending and allowed banks to evade capital restrictions. Securitization, which of course is represented most publicly by mortgage-backed securities and other forms of consumer-debt backed derivatives, allowed loan officers to pay less attention to the safety of their loans, since they were promptly to be sold off and removed from banks’ balance sheets (although not entirely from the risk assumed by the banks).The Commodities Futures Modernization Act of 2000 ensured that these instruments would not be regulated.Despite their profound effect on the real economy, these instruments mushroomed in growth while providing financing not for production but simply for more finance.

This process paralleled what happened in the stock market under the capital asset pricing model and its progeny, largely separating (on paper and in practice) the responsibility for, and consequent monitoring of, risk from the real economy that nonetheless was exposed to that risk. The story of credit derivatives has been told many times, and I only mention it here in order to show how it fits into the rest of the story of financialism, and how the law consciously adopted the ideology of free markets in order to permit financialism to develop.

I would be remiss in ignoring the regulatory failings of the Securities and Exchange Commission, and especially its fateful decision in 2004 to permit largely unregulated investment banks to dramatically diminish their capital requirements (and its inverse, to increase their leverage),eliminating one of the very few regulatory tools available to the SEC to limit the activities of investment banks.

In addition, bank regulators, misplacing their trust in the prudence of bankers, also significantly diminished capital reserve requirements. This allowed banks to borrow and gamble with enormous sums of money while maintaining little available cash to help them through financial distress. As the U.S. implemented an international agreement to lower banks’ capital requirements in 2007, New York Senator Charles Schumer said: “There need not be a conflict between being the safest and the most competitive, and this fine agreement proves it.” The echoes of economist Irving Fisher‟s famous early October 1929 statement: “Stock prices have reached „what looks like a permanently high plateau,”are all too resounding.

The highlight of deregulation and, I believe, the most foolish piece of economic legislation ever to be passed by Congress and signed by a president, is the Gramm-Leach-Bliley Act of 1999. Its most important consequence was the merging of commercial banking and investment banking functions to permit the growth of enormous financial institutions whose role in protecting the nation’s credit system and money supply was now compromised by the huge profits available from speculation in securities and derivatives. This growth was accompanied by increased incentives of well-compensated bankers to earn fortunes from engaging in the creation of new financial instruments and proprietary trading which, just as in the years preceding the Great Depression, exposed that credit system to the possibility of collapse.

It is unfortunate to note that, despite some recognition of these failings, the course of “reform” points in the direction of continuing to institutionalize financialism, which I believe will eventually succeed in destroying American capitalism. Such reforms will do nothing to shift financialism back to capitalism, but rather maintain financialism on perhaps a slightly safer plane. 

Restoring American capitalism in the face of growing financialism is urgent, both as a function of American economic well-being, and as a matter of national security, as financialism pushes the production of essential goods abroad. Faced with this urgency, it is short-sighted and irresponsible for lawmakers, regulators, financial professionals, lawyers, and even the investing public, to fail to understand our shift to financialism and the long-term destruction it promises for America’s economic well-being.

How do we fix this? I have some preliminary suggestions, some of which have emerged in the reform debate. It is critical to re-enact laws separating investment banking and commercial banking, pass tax law reform to diminish market volatility, consider financial reform that would require demonstrated economic utility before the offering and sale of new financial instruments, create accounting reform that would require all corporations, including financial institutions, accurately to reflect their debt exposure, ensure full tax parity of capital gains and dividends in order to encourage long-term investment and re-introduce the notion of patient capital into American investment practices, restrict the types of compensation contracts corporations, and especially financial institutions, can award their employees (principally accomplished through tax laws), and create disincentives to proprietary trading and incentives for financial institutions to return to their former financing practices (again, most likely through tax changes). All of these changes could be made without unduly aggressive government restructuring of the basic economy. More aggressive suggestions include the use of antitrust law and perhaps new legislation to encourage the development of smaller and more localized financial institutions that monitor their risk because they remain in relationships with their customers, restrictions on the amount, if any, of a financial institution’s assets it can securitize, and law and policy statements that disavow the acceptance of institutions that are too big to fail, including a reconsideration of the role of the Federal Reserve in financial disasters.

The need to end financialism and restore capitalism is underscored by the special moral role a sound economic system plays in our society. Perhaps the most important benefit of capitalism is its ability to stimulate economic growth, the creation and distribution of wealth, and the sustaining of that wealth over time. Whatever benefits financialism may have, it lacks these essential characteristics. Indeed, as I hope I have at least preliminarily shown, financialism is a system in which the present generation robs future generations of their economic patrimony and national security and thus is intrinsically immoral. We owe to our children, and our children’s children, the benefits of a system that allowed the United States to become the world’s most successful and prosperous democracy from its founding until the present. We must destroy financialism for the sake of capitalism.

Lawrence Mitchell

Financialism: Finance is Where the Money Is

I have thus far shown the development of financialism and its effects upon corporate finance. But financialism also profoundly affects the way that managers of businesses in the real economy define their business goals. In 2006, over 30% of the profits of corporations classified as “industrial” came from financial transactions, not from the production of goods and services, and financial assets constituted almost 48% of the total assets of non-farm, non-financial corporations.Only a relatively small portion of this is composed of accounts receivable. By far the largest class is identified as “miscellaneous.” Industrial corporations, at least pre-crash, had come to rely upon finance rather than their own core businesses to provide profits. This has obvious adverse potential consequences for the future of American economic self-sufficiency.

Why has this occurred? There are several reasons. The first is the capitulation of industry to the demands of finance that I described earlier. The second, which goes along with this, is a shift in the prior careers of industrial CEOs, from marketing and engineering earlier in the century to finance, which came to be the most common background of CEOs between 1997 and 2007.The training and interests of these chief executives, and the greater profits to be made from finance, inevitably incline them in that direction, and suit the demands of financialism better than those of capitalism. American Can Company is a perfect example. Incorporated in 1901, that important manufacturing corporation acquired a modest Midwest insurance company in 1981 and, along with it, Gerald Tsai, Jr., the famous, fallen whiz kid of 1960s speculative mutual funds. As vice-chairman and then chairman of American Can, Tsai abandoned manufacturing and transformed the company into financial conglomerate, Primerica.General Electric, one of the mainstays of American industry since the late 19th century, presents a different type of example. While it continues its manufacturing operations, it now reaps a substantial proportion its profits from its financial subsidiaries.It isn’t difficult to replicate these stories many times over.

A final reason is changes in executive compensation. Executive compensation became largely stock-based beginning in the early 1990s, thus creating incentives for CEOs to engage in

financial manipulation in order to achieve higher stock prices.Even in periods of strong industrial production, the profits of industry often pale in comparison to the profits generated by financial transactions. In order to earn the returns that would justify higher compensation, they turned, as the data above suggests, to finance.

I’ve described the growth of institutional investors, but now would like to address the incentives and behavior of institutions that have contributed to the rise of financialism. Institutional investors are a particularly important

I’ve described the growth of institutional investors, but now would like to address the incentives and behavior of institutions that have contributed to the rise of financialism. Institutional investors are a particularly important cause of financialism, even as a debate continues over giving greater power over corporate affairs to stockholders which, in practical terms, means institutions.Yet institutional investor activism has been one of the principal causes of destructive short-term management in the real economy.

Institutional activism was hailed in the early 1990s as the solution to the longstanding set of problems known as agency costs caused by the separation in the modern corporation of ownership and control.  Agency costs are the losses that result when corporate managers favor their own interests over that of the shareholders together with the expense of preventing this. It was widely thought that institutional investors, through their large blockholdings of stock, could provide the shareholder oversight that disappeared with the creation of the large public corporation at the turn of the 20th century and had been sought since at least the publication of Adolf A. Berle, Jr. and Gardiner Means‟s The Modern Corporation and Private Property in 1932.

That utopia was not to be realized. Some critics, including me,  predicted that the natural incentives of institutional money managers would lead them to use their power to push corporate managers to focus on short-term stock prices rather than long-term corporate health and patient profits from production. That prediction has been amply borne out both by observation and in rigorous empirical studies, and many of those who had celebrated institutional activism have since retreated from those views.

Two other kinds of institutional investor flourished in the years before the 2008 market collapse and are likely to remain active after recovery; private equity funds and activist hedge funds. Although very different in their business models and functions, these investors have also contributed to financialism by exacerbating the short-term climate that led to industrial overleveraging, the disappearance of retained earnings, and the practice of subordinating the ends of production for the gains of finance.

Lawrence Mitchell

Financialism: It’s All About the Capital Gains

Financialism has diverted economic resources from capitalist production in the real economy to satisfy the demand of financial claimants, primarily stockholders.  To recap, data I’ve collected over several years show the disappearance of corporate equity capital and its replacement by massive amounts of debt, largely done to satisfy the demands of finance.The argument here is that American public stockholders have withdrawn more equity from corporations than they contributed, leaving debt as the real risk capital of American industry. Yet the legal power to control American corporations rests with the stockholders. The result is a disconnect between responsibility and risk, and has destabilized the capital structures of American industrial corporations while leaving stockholders with the power to pressure managers to gamble with industrial credit and economic well-being. While stockholders do continue to take risks, the logic of the capital asset pricing model tells us that the risks they take are casino risks created by themselves, not real financial risks which have been left to creditors. What is true of stockholders is even more true of derivatives traders and the financial institutions that trade for their own accounts.

Here are some facts: From the turn of the 20th century until the 1960s, American industrial corporations practiced a policy of retaining substantial portions of their earnings for reinvestment in their businesses while paying a reasonable dividend to shareholders and relying upon trade credit and some long-term debt for the balance of their needs. Retained earnings averaged in the range of 50% to 60% as recently as the early 1960s. By 2007, that average was down to 11%, rising from a low in 2002 of just over 3%. Almost all of the rest of the money needed to finance production came from debt, increasingly shoved off-balance sheet to conceal corporations‟ true reliance on borrowing.

How and why did this happen? As more Americans entered the market, which grew at its fastest pace during the great bull market that lasted from 1952 until 1970, investors’ desires shifted from steady dividends to making quick capital gains from trading.Approximately 90%  of listed corporations were paying dividends, and there was a general belief that dividends were what individual investors sought. There was good reason for this. Although dividend payouts were low compared to the 1920s, in 1952, 52% of corporate earnings (a post-war high) were paid out as dividends. But dividends did not appear to be the answer. A two day study of market transactions by the NYSE in 1952 revealed that 46% of individually-purchased shares were bought for long-term capital gains, followed by 25.5% for income, 13% for capital gains within 30 to 120 days (which the Exchange classified as long-term, although the federal long-term capital gains tax break occurred only after six months), and 6.5% for capital gains in under 30 days. Putting together transactions by members and institutions, the Exchange concluded that 75% of all transactions had been for investment purposes rather than speculation. But particularly notable is the fact that the vast majority of individual stock purchases were in pursuit of capital gains rather than income.

Prior to the 1960s, those capital gains largely came from the increase in share value caused in large part by the retaining earnings I just mentioned. The investment technology derived from the capital asset pricing model taught investors to see capital gains as coming from the future anticipated cash flows of the corporation, discounted to present value. Thus, instead of selling their stock for money already earned, investors began to sell their stock for money that was to be earned but which may never be earned, and thus, in a sense, shorted future dividends or, to put it differently, stripped the profits of the future for the benefit of the present.  This process was exacerbated by the increasing impatience of investors for capital returns, especially the rapidly growing class of institutional investors whose money managers were compensated based on the amount of assets they had under management, and who were beginning to acquire the ability to put pressure on managers to increase stock prices.  Even without this, the increased volatility of trading for capital gains that had started to soar in the 1980s gave managers strong incentives to maintain high stock prices in order to maintain the independence of their companies, and later to increase their own compensation as stock option compensation came to dominate due to tax reform in 1993. The result was to put pressure on mangers to manage for stock price, not for long-term sustainability. Perhaps the most trenchant piece of evidence for this is the fact that in a three year period ending in 2007, the S&P 500 spent more money on stock buybacks (which increases stock prices) than on investment in capital production.

Lawrence Mitchell

Financialism: The Banks

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.

Lawrence Mitchell

Financialism: Own Your Share of American Business

Please do yourself a favor, follow this link, and watch the stock market cartoon produced by the New York Stock Exchange in 1952, at the beginning of its Own Your Share of American Business campaign. It is hilarious.  If only it were true.  Those of you who, like me, are of the 1960s cartoon generation, will also appreciate the wonderful nostalgia.

No single factor can describe the development of a complex economic system, but I’d like to provide a brief historical account of the creation of financialism from the early 1950s to the present in an attempt to tie together a number of different trends. These trends include a sharp growth in the number of individual investors, the eventual dominance of institutional investors and the rise in institutional activism, changes in investment goals from dividends to capital gains, dramatic increases in market volatility, changes in executive compensation, and the deregulation of financial institutions in a manner that stimulated speculation by commercial banks and led to the creation of financial instruments that bore little relationship to the real economy. These trends had combined by the turn of the 20th century to create financialism. I will discuss the most important elements arising from this history in a little more detail as I go along, focusing more on the early stages of the growth of the stock market because that story is perhaps less well-known than more recent developments.

I begin in 1952. Stockbrokers were languishing in a long, desultory market. Turnover, the rate at which share ownership changed hands, was even lower than it had been during the years of the Great Depression. Turnover averaged almost 32% from 1931 to 1939.During the following ten years, it averaged half of that. The Depression decade high was 50% in 1933, and ranged beyond that from 44% to 21%. During the 1940s, the high was 24% during the short bull market of 1945-46, but otherwise ranged between 19% and 12%.

Turnover is an imperfect proxy for market activity, and daily trading volume did increase in the late 1940s. But stock brokers made their money from commissions on trades. With such desultory trading, the commissions were increasingly few. In fact one historian describes that era as one in which brokers played baseball on the Exchange floor using rolled-up and crumpled quotation sheets as bats and balls.But that was also the year the New York Stock Exchange commissioned a study by the Brookings Institution to determine the number of Americans who owned stock.The surprising result was 4.2% of the population.In response, the Exchange instituted a program, “Own Your Share of American Business,” a program of advertising, marketing, public relations, and educational outreach, which was designed to bring greater numbers of individual investors into the market.But increasing the number of American stockholders was not the NYSE‟s only goal. In order for brokers to make money, people not only had to buy stock but to trade it as well. In its 1955 Annual Report, the Exchange complained of low turnover, explaining that this was a consequence of an “investment” market in which investors paid cash for their shares. The Report explicitly discussed the NYSE‟s continuing efforts to persuade the Federal Reserve to lower margin requirements to stimulate borrowing for investment, making more money available for individual shareholders to invest and with a consequent expected increase in turnover and volatility (and thus commissions), even as its “Own Your Share” campaign for individual investors preached prudence and caution.

While it took several decades for turnover and volatility to explode, the results of the NYSE campaign were almost immediate.By 1958, individual share ownership had grown from the 6.5 million of 1952 to 12.5 million, almost doubling in four years. This number continued to grow dramatically through the 1960s, so that by 1965, 20 million people, more than 10% of the population, owned stock.The trend continued through the end of the century, as, by 2001, more than half of American families, directly or indirectly, owned corporate stock.

At the same time appeared a new type of investor, who would have a profound impact on American capitalism. These were the institutional investors. From almost a standing start at the beginning of the decade, by 1957 Business Week was predicting that institutions would become “the most powerful investment group in the world.”Twenty-two states had adopted the “prudent man rule” by 1950, allowing fiduciary institutions like pension funds to invest substantial chunks of their assets in common and preferred stocks.The pension funds grew rapidly, increasing in value from $11 billion to almost $40 billion between 1950 and 1957 alone.29 The book value of the common stock they owned increased from $812 million in 1951 to $2.9 billion in 1955. And, growing almost as quickly, were the mutual funds, which had almost disappeared after the 1929 Crash and had started to make a very slow comeback in the 1940s. From 1940, when mutual funds barely existed, to 1959, between $7 and $8 billion of new money was invested in mutual funds.By 1959, they were adding $4.5 billion in a single year.  By 2000, institutional investors owned 61.4% of the equities of the 1,000 largest American corporations, growing to an astonishing 76.4% at the end of 2007.And with this growth has come worrying concentrations of institutional capital and the financial muscle that goes with it; seventeen of the largest American corporations had 60% or more of their stock owned by institutions in 2007, including six that had at least 70% institutional ownership.

In my next post, I’ll address banking.

Lawrence Mitchell

The Intellectual Underpinnings of Financialism

Financialism is grounded principally in two dangerous ideas, ideas not dangerous in themselves but dangerous in practice. These ideas have helped to provide intellectual support for the shift from capitalism to financialism and lie at financialism’s foundation. The first idea grew out of the work of Adam Smith. Smith’s theory of the invisible hand was designed to show how economic growth could be better stimulated by free market activity than by the dominant practice of mercantilism, while at the same time pursuing the Enlightenment goal of freeing people from oppressive economic and social policies and providing the opportunity for them to improve their own economic conditions. Smith’s theory was as much sociological as political and economic, and was grounded in the behavior of the self-interested, but nonetheless morally sensitive, economic man that he had earlier developed in his A Theory of Moral Sentiments.  Through the 19th century, this central idea was transformed by neo-classical economists into a justification for the individual pursuit of maximum utility, and in the 20th century into the individual pursuit of maximum wealth, stripped of, and abstracted from, Smith’s highly contextualized and social ideas and having all but abandoned Smith’s emphasis on real economic growth. The abstraction was complete by the last third of the 20th century, and free market ideology resulted in the substantial deregulation of the American economy. This cleared the way for the growth of financialism.

The second idea, which depended on the notion of free markets, was the capital asset pricing model. Developed over the course of a decade by economists principally associated with the University of Chicago and MIT, the capital asset pricing model reduced stock selection to a single number, beta, which was derived from a regression analysis of a stock price‟s historical movement in relationship to the market. While the goal of this model was to permit investors to make rational decisions balancing risk and return, its unintentional consequence was to separate the investment decision from any need to be interested in, or concerned with, the underlying corporation issuing the stock, leading to a separation of stock ownership from the underlying business and laying the groundwork for an irresponsible and detached investor class.

Building upon the capital asset pricing model, option pricing theory developed as a way to bring greater certainty to the derivatives market, the market for trading in instruments that in part track the behavior of stocks and bonds without requiring a trader to own the underlying security – as Paul Krugman describes them, “claims on claims.” The result was an explosion in over-the-counter derivatives trading and the creation of a bewildering variety of new securities, all of which were further removed from the real economy than even the deracinated portfolios assembled by investors using beta.

The complex economic modeling that produced these theories, combined with new technologies, also led to the possibility and proliferation of computer-based trading and its contemporary realization in high frequency trading, further detaching any human element of concern for the real economy while at the same time profoundly affecting real economic behavior by affecting the underlying stock prices that drive managerial incentives. The combination of these practices with free market ideas and policies that equated responsibility with selfishness laid the groundwork for a capitalism centered on a financial industry and capital markets that had largely lost touch with the fundamental purpose of capitalism as a system for the production of goods and services and wealth creation and distribution. It laid the groundwork for financialism.

Lawrence Mitchell

Financialism and the Disappearance of Corporate Savings

One of the most important developments in our descent into financialism has been the disappearance of corporate savings.  it is a trend that took place gradually, from the late 1960s until just before the financial crisis of 2008.  This trend is significant for several reasons. First, it deprived American corporations of the means with which to finance their own production, leaving them to rely more heavily than perhaps is prudent on outside sources of funding.  Second, it led to a shift in financing from equity to debt.  As a result, it put these corporations in a position where high rates of return were necessary to pay their debt service.  This led to a substantial shift from production to investment.  On average now, more than 50% of the balance sheets of S&P 500 corporations consist of financial assets rather than productive assets.

American industrialization occurred without much of a public stock market.  Although we were largely industrialized by the turn of the twentieth century, only a handful of industrial stocks were listed on exchanges. Rather, giants like Standard Oil, Carnegie Steel, American Sugar, Swift, John Deere, and the like, were financed internally.  That is to say, they saved most of the money they earned, and reinvested it in their businesses.  They didn’t have to look outside for investors. And what they did need, they took in debt, which is cheaper than issuing stock.

For reasons I won’t explain here (but do in The Speculation Economy:  How Finance Triumphed Over Industry), the American market for industrial stocks developed almost overnight — in just over five years, between 1897 and 1903.   But, again for reasons I’ll skip here, the $25 billion (in 1903 dollars) of capitalization created wasn’t used for financing.  Corporations still financed internally.

And so it remained, up until the early 1970s.  More than half of American corporate balance sheets were in the form of retained earnings.  But matters began to change.  Over the next forty years, retained earnings disappeared, to the point where in 2003, only 3% of balance sheets were retained earnings.  Where did the money go?  Mostly back to stockholders. What replaced it?  Debt.  And, for the most part, off-balance sheet debt.  Not only was the cash gone, but you couldn’t even really see what was going on financially within corporations unless you read the balance sheet footnotes very carefully.

Now, look at this.  It’s like you spent all of your savings and borrowed all the money needed to replace them. One of the consequences of this behavior is that you have to make sure you’re earning enough to pay your debt service.  So it was with American public corporations.  And those kinds of earnings — as well as some extra to keep the stockholders happy, which allows managers to keep their jobs — are hard to earn from the homely process of making things and providing services.  Financial assets had higher returns.  Some manufacturing companies — GE is a prime example — essentially became financing companies with a manufacturing arm.

There’s another consequence worth noting, one that is not essential to financialism but is important to note and does create problems I’ll discuss.  Corporate risk capital is debt.  But, under American corporate law, stockholders control the corporation’s direction through a combination of their voting power and their ability to sell stock (which can drive down stock price and adversely affect management).

So this sets the financial stage.  Tomorrow I will begin to develop the historical story of financialism.

Lawrence Mitchell

Financialism and the Stock Market: Introduction


In my last post on the subject, I defined financialism as “an economic system characterized by the private ownership of property and relatively free markets designed for the diversion of surplus wealth from labor to capital.”  Today, I’d like to spend some time showing how this works in practice before discussing how financialism developed and the principal actors in the system.  You might also want to check out Thomas Piketty’s new bookwhich I haven’t yet read, but which apparently sets out a theory of capitalism that looks an awful lot like financialism.

Central to financialism is the stock market.  Other capital markets matter, too — the debt market, the commodities markets, etc.  These are the trading locii  of financial participations in productive enterprise.  These markets, functioning on their own, ideally move money to its highest uses, and widely spread risk.  Built on top of these markets are derivatives markets, about which I’ll have something to say in the future. I will, tomorrow, demonstrate that the stock market doesn’t perform the functions we expect it to, and almost never has. But for today I’d like to focus on really one point about the stock market, a point necessary to my definition of financialism as a redistributive system.  For the stock market is one of the principal devices financialism uses to divert money from labor to capital.

Don’t take my word for it.  A recent paper by three economists writing for the National Bureau of Economic Research found that, since 1980, more than 100% of the real gains in the US public equities market came from labor, not from increased profits. (Leaving aside the economic definition of this 100%, the diverted amount was 65% of stock market appreciation.)  I’d like to say that this is surprising, but it’s not.  Nor does the distorting effect of the stock market depend on these capital transfers. Writing in the early 1970s, economist Raymond Goldsmith imagined the economy of that time in the absence of a public stock market.  He concluded that the economy would look pretty much that way it then did, but for one fact:  Income inequality would have been significantly less.  And it is widely known that the public stock markets have, since the early 1990s, provided the impetus for significantly increased income inequality.

Do these facts condemn the stock market?  Not at all.  In fact, they suggest that one solution to the problems of financialism and income inequality is to find ways to bring more Americans into the market, something the New York Stock Exchange tried to do with a vengeance in the early 1950s.  They also suggests directions for market reform.  My only point today, is that the means of finance have in fact been used to divert wealth from one segment of the population — labor — to another — capital.

Lawrence Mitchell

Capitalism and Financialism: Some Definitions


One of the concerns I’ve had over the past decade, and to which I have devoted a great deal of my scholarly time, is the disappearance of American capitalism and its replacement with what I call financialism.  It’s a long story, with its roots at the turn of the twentieth century, as I show in my book, The Speculation Economy.  Preliminary to my engaging in a discussion of the economy over the next few posts, I thought I’d lay the groundwork by beginning with some definitions.  Too many people misunderstand capitalism, and believe that our current system is capitalism, or at least the best form of it.  As I will show, this is a very dangerous situation for all of us.

So let’s start with a simple definition. Capitalism is an economic system characterized by relatively free markets and the private ownership of property.  It’s not entirely clear to me that the second condition is necessary.  China’s system looks a lot like capitalism even with substantial government ownership of property. (Another interesting question is whether capitalism requires democracy.  On both counts, China is the question, and the jury remains out.)  “Relatively free markets” also raises a question — how free must markets be?  I would argue that entirely free and unconstrained markets — if such a thing could exist — would malfunction terribly.  Some ground rules constraining perverse incentives –like fraud and theft — need to be established, even if only by social norms.  But that is a topic for another day.

Once we have markets and private property, pretty much everything definitional is up for grabs.  We clearly have private property and relatively free markets in the US.  So how can I argue that we no longer have a system of capitalism?

I’d like to suggest that we ground the discussion in the purpose of capitalism.  It is one thing to identify a system.  It is another to understand why we have it.  Now, it would be pure fiction to claim that anybody sat down and drew up a blueprint for capitalism, attempting to attain a specific goal.  (Adam Smith comes as close as anybody, but he was describing a system already in existence.  His advocacy of the system is a different matter — for that, he had a very clear purpose, and that was to break the limitations of mercantilism, both for the sake of social and economic mobility and for the improved functioning of the economy.)

Why capitalism?  Why any economic system?  Well, the first condition of any economic system is the creation of wealth.  In the absence of that simple result, society itself would cease to function, let alone the economic system.  In order for an economic system to survive, it must be sustainable.  That is to say, wealth creation must be regular and continuous.  The glory of capitalism, which Smith saw so clearly, is that it is the best available system for sustainable wealth creation.  The exchange of private property in market transactions creates wealth both for the direct participants and surplus wealth for others. It is the surplus that moves us beyond subsistence to wealth.

Notice that I have said nothing of the distribution of that wealth, nor will I.  Economists of a neo-classical bent believe that the distribution resulting from market transactions is ideal. Now there is a lot behind that conclusion, but all that we need for now is to note it. I’m not at all sure that you have to accept this conclusion as a necessary one for capitalism, but that, too, is another issue.

Capitalism is heavily dependent on the incentives of the participants in the system.  I very much doubt that you could have a subsistence economy based upon capitalism.  If we assume that humans want to maximize their welfare in some manner (and broadly put — perhaps too broadly to be terribly useful — I think they do), then a system of private property characterized by market transactions will lead at least some participants to attempt to capture more than their share, even in the absence of surplus, and the system would likely break down, leading to necessary central control to restrain human nature — natural incentives, if you will.  (This might break down too, as centralized economies have demonstrated.  But the simple point is that capitalism fails if the goal is subsistence.)

So I would add to our definition of capitalism one more dimension:  creation of surplus.  Thus, capitalism is an economic system characterized by the private ownership of property and relatively free markets designed for the creation of surplus wealth that permits sustainability even in times of relative scarcity.

I want to stress the word “creation” here.  Capitalism is, definitionally, creative.  (As Schumpeter observed, it is also destructive, but it is destructive in the service of creation.)  This is a critically important point in distinguishing financialism from capitalism.  As I will argue, financialism is, at least in practice, largely redistributive.  It is in this critical respect that it differs from capitalism.

So what is financialism?  I define financialism as an economic system characterized by the private ownership of property and relatively free markets designed for the diversion of surplus wealth from labor to capital.

Now, I know that is quite a definition, and rather politically loaded.  That doesn’t change the fact that financialism is a real and observable system, and it is the system we largely have developed over the last forty years, as I will show in the next few posts.  The problem with financialism, as the definition suggests, is that it is parasitic on capitalism.  As I have defined it, financialism diverts surplus wealth.  In order for that wealth to be diverted, it has to be created.  It is capitalism that creates that wealth.  So I guess we can’t call financialism a “system” in the same way we can with capitalism, since, unlike financialism, capitalism can exist on its own.  Nonetheless, I think the conceit of calling it a system is useful, at least for purposes of discussion.

There is one last dimension of financialism I’ll mention before signing off until tomorrow.  If you have followed me so far, you realize that financialism is, unlike capitalism, unsustainable.  Eventually, financialism kills the incentives of those who produce wealth just as surely as does state control of markets. (Eventually, I’m afraid, it foments revolution.)  Financialism is killing capitalism.  This is a reality about which all of us should worry.

Lawrence Mitchell


Why Does Income Inequality Persist?: The Argument from Choice

So I was diverted a bit over the past few days, but have not forgotten my promise to complete my series on income inequality.  Obviously, the answer to the title question comprises a series of causes, and I have spent the past few weeks explicating only one.

I noted that some readers might legitimately argue that people make bad choices which result in their status at the lower end of the income spectrum, and that they should be held to the consequences of the choices they made. After all, they reaped whatever rewards they perceived to be available as a result of those choices.  This objection to my argument probably is the most common argument against any sort of significant redistributive policies, and frequently features the TV watching welfare mother who has kids so she can be supported by the state and not have to work.

I don’t think anybody denies that there are abuses in our system of social welfare.  But study after study shows us that this is anything but the rule.  Most people want to support themselves.  If you have any doubt, look at the statistics on the number of working poor.  Many of these people would be no worse off quitting their jobs and living on state assistance.  But they don’t.  As I have been at pains to point out, most people are like you and me.  They have pride, and that means self-support from self-respect.

So, if not choice, why do people wind up at the bottom?  Well, we’ve seen that circumstances of birth are powerfully determinative.  Other forms of bad luck play their roles as well; personal or family illness, disability, and the like.  But it is also true that a lot of people make bad choices.  The argument from choice doesn’t go away.

I agree with the argument from choice.  Pace Hume, Kant’s notion that as autonomous beings we should –indeed, we must – experience the consequences of our decisions strikes not only a chord with me but, I think, with most of us. (The problem with Kant – and I think Hume got it right, here – is that once you start to unravel the theory in real life and see it play through human nature, it doesn’t work.)  So if I agree with the choice argument (and many people who make the choice argument will make exceptions for certain kinds of bad luck), what have I been talking about?

Try this. Compare two nine-year old children.  Jimmy lives in Compton, California, and Susie, in Scarsdale, New York.  Jimmy’s father abandoned the family, and his mother dropped out of high school.  She works hard.  Too hard for Jimmy’s welfare. She’s out of the house before dawn, waking Jimmy and his three siblings for school, but leaving them otherwise to fend for themselves, and home well after a healthy nine year old should be in bed. While Jimmy’s dad is gone, Jimmy does have an uncle.  But his uncle went to prison when Jimmy was six. As much as his mom tells him to go straight home from school, Jimmy likes to hang around a bit with the older boys, some of whom have had problems with the law and almost all of whom spend as little time in school or doing homework as possible.  Many of these boys also have missing fathers, and none have parents who got past high school.  Like Jimmy, some have family members in prison.  They do know of one girl from the neighborhood who went to USC on a scholarship a few years back, and of a few kids who started community college, but that’s about it.

Susie lives in Scarsdale. Susie’s dad is an investment banker.  Mom worked at a big New York law firm before having kids, and now largely is home but also does some volunteer work for several civic organizations.  Susie has a younger brother, and while the schools in Scarsdale are good, they both attend private school.  Summers are spent in camp in the Adirondacks, and at the family’s home on Martha’s Vineyard.  I don’t think I need to say much more.

Do we mean the same thing when we talk about choice for Jimmy and for Susie?  Should we?  I don’t think so.  You see, we have permitted the perpetuation of a society in which Jimmy doesn’t have a lot of good choices and what good choices he has are obscured by his environment.  Who is there to help Jimmy sort the good from the bad?  Where are the examples for him of those who made good choices and reaped their rewards?  Susie, on the other hand, has good choices all around her. While it certainly is possible for her to make bad choices, her life circumstances are such that she will likely make good choices even if she were blindfolded.  And, should she make bad choices, she has a very substantial net to catch her and redirect her. (Does Jimmy deserve his circumstances?  Does Susie?)

The point is simple.  Before we hold people to the consequences of their choices we have, I think, a social obligation to ensure that they have enough good choices that are reasonably visible to them to justify doing so.  Simply setting out an array of bad choices, and holding people responsible because bad choices are what they make, seems to me wrong, immoral, and unfair.

Lawrence Mitchell