What is financialization and why does it matter? – part 1

Financialization is one of the most important drivers of changes in the last 50 years in American capitalism, and consequently in our society.

As noted in other posts, and recently by Bernie Sanders, almost all of the income growth in the past 50 years has ended up in the bank accounts of the top 10% of the US population. Really, almost all of it actually ended up in the hands of the top 1%. I have described this as the $47 Trillion Rip Off (on Substack). There are four key drivers of this transfer:

• Market concentration and monopoly power
• Globalization – offshoring jobs to low-wage countries
• Decline in unionization
• Financialization – increased power of the finance sector and changes in the behavior of corporations
• Changes in laws and regulations – enabling the others

All of these resulting from concerted efforts by the rich and corporations to set the rules of the economy to their nearly exclusive benefit.

OK, so what is financialization?

Financialization reduces every business’s focus to how much money can be squeezed out and how quickly. A company’s products or services are completely subordinated to the very short-term goal of maximizing cash, the proverbial quarterly results reported to Wall Street.

“Financialization is a process whereby financial markets, financial institutions, and financial elites gain greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems at both the macro and micro levels.

Its principal impacts are to (1) elevate the significance of the financial sector relative to the real sector, (2) transfer income from the real sector to the financial sector, and (3) increase income inequality and contribute to wage stagnation. Additionally, there are reasons to believe that financialization may put the economy at risk of debt deflation and prolonged recession.

Financialization operates through three different conduits: changes in the structure and operation of financial markets, changes in the behavior of nonfinancial corporations, and changes in economic policy.”¹

Changes in the structure and operation of financial markets

The growth of the finance sector has been enormous. In 1950, the finance sector represented approximately 4.5% of the economy. Today it is over 8.5%. Its share of profits is disproportionately larger at 26% of all corporate profits.² The value added to the real economy³ of this activity is controversial. For example, foreign exchange market activities show speculation on a breathtaking scale. In 2022, international trade in merchandise, services, and digital services was $35.92 trillion. In April 2022, turnover(activity) in global foreign exchange markets reached $7.5 trillion per day. Annualized, this equals $1,620 trillion in foreign exchange trading to support the actual world trade of $35.62 trillion. This produces a total foreign exchange turnover of over 46 times the real-world trade volume.⁴ 45% of that activity was “inter-dealer,” meaning banks betting against each other on the direction of exchange rates and not supporting actual transactions required to settle accounts between buyers and sellers of tangible goods and services. Some will try to explain that some of this activity involves hedging and risk management to ameliorate the risks of the ups and downs of exchange rates. Others speak of this activity as increasing the liquidity of the market. That is making sure that there are enough buyers and sellers available. But, it is stretching credulity to say that this can account for a turnover that is 46 times that required to sustain the genuine transactions between buyers and sellers of tangible goods and services.

Much of the finance sector’s activity involves buying and selling complex financial products. Derivative contracts, for example, involve betting on the future value of another financial instrument. You may recall that during the 2008 global financial crisis, a range of derivative financial instruments were involved: Mortgage-Backed Securities, Collateralized Debt Obligations,  and Credit Default Swaps (CDS) among them. Today, these are the most common derivatives:

1. Futures Contracts –  Definition: Standardized agreements traded on regulated exchanges to buy or sell a specific asset (such as commodities, currencies, or financial instruments) at a predetermined price on a specified future date.

• Usage: Widely used by producers, consumers, and investors to hedge against price fluctuations and by speculators seeking to profit from price movements.

2. Options Contracts – Definition: Contracts that give the buyer the right—but not the obligation—to buy (call option) or sell (put option) an underlying asset at a specified price (the strike price) before or at the contract’s expiration date.

• Usage: Utilized for hedging risk, generating income, and speculative strategies. Options are traded on both exchanges and over-the-counter (OTC).

3. Swaps – Definition: Bilateral agreements where two parties exchange cash flows or other financial instruments over a set period.

• Common Types:

• Interest Rate Swaps: Exchange fixed interest rate payments for floating rate payments, or vice versa, to manage exposure to interest rate fluctuations.

• Currency Swaps: Exchange cash flows in different currencies to hedge against foreign exchange risk.

• Commodity Swaps: Exchange cash flows based on commodity prices, useful for companies involved in commodity trading or production.

• Credit Default Swaps (CDS) are insurance contracts that transfer the credit exposure of fixed-income products, allowing one party to hedge or speculate on the credit risk of an entity or instrument.

4. Forward Contracts – Definition: Customized, non-standardized agreements (typically traded over-the-counter) between two parties to buy or sell an asset at a specified price on a future date.

• Usage: Commonly used by businesses to lock in prices or exchange rates, thus reducing the uncertainty associated with future price movements.

5. Credit Derivatives (including CDS) – Definition: Contracts designed to transfer credit risk between parties without necessarily transferring the underlying asset.

• Usage: Credit derivatives like credit default swaps (CDS) are particularly prominent in managing credit exposure and have been closely watched following their significant role in the 2008 financial crisis.

Lynn Stout sums it all up:

“Financial derivatives, in particular, are bets between parties that one will pay the other a sum determined by what happens in the future to some underlying financial phenomenon, such as an asset price, interest rate, currency exchange ratio, or credit rating. This is exactly why derivatives are called derivatives. The value of a derivative agreement is “derived” from the performance of the underlying financial phenomenon, just as the value of a betting ticket at the racetrack is “derived” from the performance of a horse in a race.”⁵

The scale of the derivatives market is hard to measure. The notional value⁶ of derivatives in the global financial markets was $632 trillion (6,320 billion) in June 2022. This is in a world with roughly $97 trillion global GDP.

Private Equity is the ultimate expression of financialization in the finance sector

Private equity firms, such as Blackstone, KKR & Co. (Kohlberg Kravis Roberts), The Carlyle Group, Apollo Global Management, TPG Capital, and many others, employ entirely extractive business strategies.

Brendan Ballou lists the strategies employed by PE firms:⁷

• Acquire a company and take it private⁸

• Debt –  load up the acquired company with debt that it must pay back out of its operating funds.
• Leasebacks involve selling assets and leasing them back to the acquired company. PE firms gain the value of the assets, while the acquired firm is further burdened with lease payments.
• Dividend Recaps: Use part of the borrowed money to pay a dividend to the owner, the PE  For example, using borrowed money, Blackstone extracted $200 million from Apria Health in 2020.
• Operational changes – Layoffs, Price Hikes, and Quality Cuts
• Strategic Bankruptcies
• Tax Avoidance
• Legal structures are designed to shield PE from liabilities and responsibilities.
• Perverse incentives for managers of acquired companies

To explore the impact of PE on the country, you can readily find media and academic reports on their activities in retail, restaurants, nursing homes, hospitals, medical clinics, housing, and many other markets.

A Side Effect – Socializing Private Risk

As demonstrated during the 2008 global financial crisis, the financial system is too big to fail. Governments step in to convert the private risk-taking failures of the industry into public obligations. Several $trillion was flushed into financial institutions by governments around the world following the 2008 collapse. Thus, the risky behavior of private corporations and individuals became the responsibility of society at large –  us.

Next – in Part 2 –Changes in the behavior of nonfinancial corporations – the real economy

1. (bold emphasis added)From summary of Thomas Palley, “Financialization: What It Is and Why It Matters,” Working Paper Levy Economics Institute at Bard College. No. 25 (December 2007).
2. See https://www.bea.gov/tools for data sources.
3. The real economy produces products and services
4. Triennial Survey shows global foreign exchange trading averaged $7.5 trillion a day in April 2022, OTC interest rate derivatives $5.2 trillion “– https://www.bis.org/press/p221027.htm
5. Lynn A. Stout, “Derivatives and the Legal Origin of the 2008 Credit Crisis,” Harvard Business Law Review 1 (June 29, 2011): 38, https://papers.ssrn.com/abstract=1874806.
6. Notional value is used to describe the value of derivatives, options, and currency exchanges, amongst other financial products. This is not a market price. Experts claim that the market value of these derivatives is significantly lower. The mathematics of calculating notional values are complex and filled with assumptions. Very murky.
7. Brendan Ballou, Plunder: Private Equity’s Plan to Pillage America(New York: PublicAffairs, 2023). Chapter 1 Part 1.
8. Going “private” means that the company is not traded publicly and thus is not subject to public disclosure of its performance.