Financialization is the logical conclusion of the fact that for capitalists, money is not everything. It has become the only thing. Financialization reduces the entire focus of every business to how much money can be squeezed out how quickly. The products or services a company produces are completely subordinated to the very short-term goal of maximizing cash, the proverbial quarterly results reported to Wall St.
“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.”[fn]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).[/fn](bold emphasis added)
The following discussion of financialization will be structured around the three elements cited in Palley’s definition above:
- changes in the structure and operation of financial markets
- changes in the behavior of nonfinancial corporations
- changes in economic policy and regulation
Changes in the structure and operation of financial markets
Since the 1970s there has been a significant increase in the number and types of financial instruments and their associated institutions.
Commercial banks (including community banks, retail banks, credit unions, savings and loans, and Internet banks) are part of the transaction system. Our paychecks are increasingly directly deposited to our checking accounts. We use the bank to pay our bills. These banks also loan money to people for home mortgages, cars, and other high-value items. Banks also loan to businesses, real estate developers, and others. Real estate loans of all types are the largest category of loan activity for commercial banks. The largest commercial banks include JP Morgan Chase, Bank of America, Citibank, Wells Fargo, and USBC. Commercial banks are issuers of the myriad credit and debit cards that are now how we conduct our transactions almost to the exclusion of actual currency.
Investment banking is quite different. They typically only deal with corporations and wealthy individuals with liquid assets > $1 million. Their activities include initial public offerings and underwriting, mergers and acquisitions, securitization, and trade in financial assets. Lending to the real economy, the economy of products and services, Main Street in the lingo of the US press, represents only 15-20% of investment banking activities. The rest is lending within the financial sector for the purchase of existing financial assets in search of profits.[fn]Adair Turner, BETWEEN DEBT AND THE DEVIL (Princeton University 2016).[/fn] The largest investment banks include JP Morgan Chase, Bank of America, Morgan Stanley, Wells Fargo, and Goldman Sachs.
Private banks serve the needs of the rich. These include wealth management, tax planning, estate planning, investment advisory, and more traditional banking services like savings accounts and loans. The largest private banks include Morgan Stanley, Bank of America Merrill Lynch, JP Morgan Private Bank, Citigroup, and Goldman Sachs.
Hedge Funds serve the needs of the rich and other institutional investors (e.g. pension funds, university endowments, etc.). A hedge fund pools investor money and uses lots of borrowed money to apply high-risk strategies in the financial markets to achieve returns. Hedge funds use the same 2 + 20 fee structure found in PE firms. The largest hedge funds include Bridgewater Associates (Ray Dalio), Man Group, Renaissance Technologies, Millenium Management, and Citadel. Hedge Funds globally have over $5.03 trillion under management in 2023.[fn]https://www.statista.com/statistics/273133/assets-under-management-of-the-largest-hedge-fund-firms/[/fn]
Hedge funds invest in a wide range of financial instruments. Individual hedge funds vary in the types of investments they engage with. Some invest stocks, bonds, and real estate. Many engage with speculative instruments like options, futures, swaps, and collateralized debt obligations (CDOs)[fn]. These were some of the drivers of the financial meltdown of 2008-9[/fn] and a myriad of derivatives.
Venture Capital firms gather an investment pool from rich individuals, pension funds, institutional funds, and others. They then make early investments in startup firms. The returns to the investors come when the startup company matures sufficiently to be bought or go public on a stock market. Sequoia Capital, Accel Partners, Andreessen Horowitz (a16z), Benchmark, Kleiner Perkins, Sequoia Capital China, Lightspeed Venture Partners, Greylock Partners, and Index Ventures are prominent venture capital firms.
Private Equity (PE) funds are, at the moment, the pinnacle of financialization. PE firms work on an entirely extractive business model. They are only interested in extracting as much money as possible in the shortest time. And they do this with other people’s money, borrowed money. “These facts of short-term, high-risk, and low-consequence ownership explain why private equity firms’ efforts to make companies profitable so often prove disastrous for everyone except the private equity firms themselves.”[fn]Brendan Ballou, Plunder: Private Equity’s Plan to Pillage America (New York: PublicAffairs, 2023). Chapter 1 Part 1.[/fn]
Brendan Ballou lists the strategies employed by PE firms:
- Debt – load up the acquired company with lots of debt that it must pay back out of operating funds.
- Leasebacks – sell off assets and lease them back to the acquired company. PE firms gains 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 firm. For example, Blackstone extracted $200 million in 2020 from Apria Health using borrowed money.
- Operational Efficiencies – Layoffs, Price Hikes, and Quality Cuts
- Strategic Bankruptcies
- Tax Avoidance
- Legal structures designed to shield PE from liabilities and responsibilities.
- Perverse incentives for managers of acquired companies
PE serves the needs of the rich and other institutional investors (e.g. pension funds, university endowments, etc.). PE is a rebranding of the 1980s’ Leveraged Buy Out (LBOs) operations.
A fund of money is raised from private investors, pension funds, endowments, wealthy individuals, sovereign wealth funds, etc. Companies are targeted for acquisition most often with large amounts of borrowed money to meet the acquisition price. Once acquired, additional debt can be added with a rigorous regime of cost cutting to drive down operating costs. Reductions in staffing and benefits (including pensions) are typical. This supports the greatly increased costs of paying back the debt. Not uncommonly fixed assets of the acquired company are sold off. This is a favorite strategy for retail companies. In these cases, the PE firm retains the money from the sale of the retail store’s real estate while further burdening the retail operation with the costs of leasing the space back from the new owner. The acquired companies are typically sold off within 5 years. PE funds also earn money through what is usually referred to as the 2 + 20 fee structure. Each year the PE firm charges the investors 2% of their invested capital and also receives 20% of the gains in the transactions. The PE firm managers also receive very favorable Federal income tax breaks through the carried interest deduction. A study of 484 companies acquired by PE firms showed that they suffered a 20% bankruptcy rate compared to a 2% rate for a control sample.[fn]Ayash, Brian, and Mahdi Rastad. “Leveraged Buyouts and Financial Distress.” SSRN Scholarly Paper. Rochester, NY, July 20, 2019. https://doi.org/10.2139/ssrn.3423290.[/fn] The PE strategy is entirely focused on immediate, short-term financial results for the PE firm not for the acquired company, its employees, and customers.
Beyond these financial strategies are the use of the legal system to shield private equity firms from legal responsibility or even visibility. Unlike public corporations, privately held companies are exempt from most of the regulations and requirements for public disclosure. PE then adds a further layer of obfuscation by breaking firms up into small pieces that are then held by innumerable shell corporations that make it difficult if not impossible to determine who is doing what. This also facilitates the shifting of legal responsibility back to the acquired companies.
In summary PE operates on a calendar of rapid actions. First, acquire companies with a lot of borrowed money. Second force the acquired companies to pay for this debt through suspension of investing in the business, overhead cuts, labor cuts, sale of fixed assets with lease backs that further burden the acquired company, third, break up the company into multiple shell corporations. Fourth,
A Brief Private Equity Case Study from Healthcare
“Steward Healthcare System:[fn]Matt Sedlar, “Private Equity in Healthcare: Profits before Patients and Workers,” Center for Economic and Policy Research (blog), February 1, 2022, https://www.cepr.net/private-equity-in-healthcare-profits-before-patients-and-workers/.[/fn]
Selling off Property to pay Investor Dividends at Patients’ Expense
“PE firm Cerberus Capital bought out a small Catholic hospital system in the Boston area, Caritas Christi Health Care in 2010. It was required to comply with the Attorney General’s rules to invest in the hospital in exchange for converting it to a for-profit system. But when the rules expired after 5 years, Cerberus immediately sold off most of its hospitals’ property for $1.25 billion — leaving the hospitals saddled with long-term inflated leases. It used the sale proceeds to pay itself almost $500 million in dividends, and then used the Steward system as a platform for a massive debt driven acquisition strategy – buying out 27 hospitals in 9 states in 3 years between 2016 and 2019. The rapid, scattershot M&A strategy was designed to create a large corporation that could be sold off in five years for financial gain — not for regional healthcare integration. Its debt load exploded, and by 2019, its financials were deeply in the red. Its Massachusetts hospitals were the worst financial performers of any system in the state and had higher than average rates of patient falls, hospital acquired infections, and patient readmissions, according to Massachusetts state data. Cerberus exited Steward in 2020 in a deal that left its physicians, the new owners, holding the massive debt.”
There is much more to the PE story, but this brief review gives you an idea of how they work. The largest PE firms include KKR & Co., Blackstone, EQT, CVC Capital, and Carlyle Group . PE firms in the US had $4.4 trillion of assets under management in 2022.[fn]“Three Ways CFOs Are Adapting to Emerging Private Equity Trends.” Accessed September 12, 2023. https://www.ey.com/en_us/private-equity/global-private-equity-survey.[/fn]
Changes in Behavior of Nonfinancial Corporations – the real economy
So, that describes some of the institutional features of the financial services sector. As Palley noted, financialization also acts to change the behavior of “nonfinancial corporations”. Traditional pre-1980s corporate management practice focused on long-term strategy, developing and retaining people, executing tasks with a focus on creating value for customers, suppliers, and employees. Developing new products and services were a core corporate activity. It was seen as a key part of the people equation that management succeeded when they created conditions in which people could be effective, learn new skills, and grow in the work environment. The general mantra was that if you did these well, sales and profits would follow.[fn]See Peter F. Drucker, The Effective Executive (HarperCollins Publishers, 1966); Peter F. Drucker, “Managing Oneself.,” Harvard Business Review 77, no. 2 (March 1999) 64–74; Alfred D. Chandler, The Visible Hand: The Managerial Revolution in American Business (Belknap Press, 1993); Alfred D. Chandler, Scale and Scope: The Dynamics of Industrial Capitalism (Belknap Press, 1994).[/fn]
Beginning in the early 1980s with the neoliberal movement there was an enormous shift in how management success was defined. Gone were long term profits, happy customers, innovations in products and services, and a stable workforce. The only purpose of a corporation became to return profits to shareholders.
Shareholder Value Theory
In a 1970 piece in the New York Times, Milton Friedman declared, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”[fn]Milton Friedman, “A Friedman Doctrine‐- The Social Responsibility Of Business Is to Increase Its Profits,” The New York Times, September 13, 1970, sec. Archives, https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html.[/fn] The phrase beginning with “so long as it stays within the rules” of course must be greeted with an appropriate sense of irony. Who sets the “rules of the game”? The rich and corporations of course. Do we see any of the huge monopolist corporations that dominate most market segments demanding a return to competitive markets?
Shareholder value came to be the management and Wall St. mantra. Really more than a mantra, it became a management operating principle that fundamentally changed the way in which corporations worked and a significant change of corporate purposes. It ended any sense that corporations should be good citizens, pay their employees reasonable wages, look after improving the skills and contributions of employees, and create new and better products and services. The purpose of a corporation became extractive. Extracting the maximum financial returns in the shortest period possible became the primary objective. Every other management task was subordinated or put into play to maximize next quarter’s profits.
With stock buybacks, employee stock options, and executive compensation policies linking pay to stock performance, managers lived in a world of extremely perverse incentives. These led them to act for their individual gain over the needs of the corporation and its other stakeholders. It has resulted in the extreme ratios of CEO pay to average worker pay that is now commonplace.
Professor Bill Lazonick critiqued Shareholder Value Theory as follows:
“The truth is that a corporation’s profits are not the shareholders’ profits. They’re the people’s profits. The people who do the work, like the employees. The people who fund the infrastructure and the education of the employees, like us, the taxpayers.
Shareholders don’t do any of those things. They don’t even really take on much risk; they can sell their shares in an instant. An employee takes on a lot of risk, investing time and know-how to help the company succeed.”[fn]In Lynn Parramore, “After Over Three Decades, Rebel Economist Breaks Through to Washington. Here’s How He Did It.,” Institute for New Economic Thinking, accessed November 26, 2023, https://www.ineteconomics.org/perspectives/blog/after-over-three-decades-rebel-economist-breaks-through-to-washington-heres-how-he-did-it.[/fn]
Some have argued that corporate law requires management to pursue this profit maximization rule. But, as Professor Lynn Stout argues in her book:
“As far as the law is concerned, maximizing shareholder value is not a requirement; it is just one possible corporate objective out of many. Directors and executives can run corporations to maximize shareholder value, but unless the corporate charter provides otherwise, they are free to pursue any other lawful purpose as well. Maximizing shareholder value is not a managerial obligation, it is a managerial choice.”[fn]Lynn Stout, The Shareholder Value Myth. (Oakland: Berret Kohler Publishers, 2012).[/fn]
Nevertheless, the Friedman doctrine of shareholder value maximization remains a core element of the transformation of the corporation from producing better products and services to extracting money. When you observe how fabulously rich this dictum has made corporate managers, it is easy to see why, without a countervailing force, this remains so. When you combine this new definition of management with changes in compensation practice and permitted uses of corporate profits, the direction of corporate development changed significantly.[fn]Beware of this book: David Gelles, The Man Who Broke Capitalism: How Jack Welch Gutted the Heartland and Crushed the Soul of Corporate America―and How to Undo His Legacy (New York: Simon & Schuster, 2022). Jack Welch may be the epitome of the financializing executive but his strategies simply refine and intensify the overall thrust of neoliberal ideology in the management of corporations.[/fn] Further, this new management environment created perverse incentives for top management. In the 1980s and ongoing top managers came to be compensated with significant stock options. This happened under the banner of giving managers skin in the game of maximizing shareholder value. Clearly, this created a situation in which short-term extremely large piles of cash in the accounts of managers led them to take actions that favored this short-term game versus paying attention to the long-term interests of shareholders, employees, and customers.[fn]See Lynn Stout, The Shareholder Value Myth. (Oakland: Berret Kohler Publishers, 2012). for a full discussion.[/fn]
In some sort of piling-on game, executive compensation from the 1980s spiraled out of sight without much proof that all of this money actually produced even short-term gains in corporate results.[fn]There are many studies of the relationship between CEO compensation and company performance. None display a consistent positive correlation, and none show any proportional relationship (e.g. bigger CEO pay leads to proportionally larger returns to the company). See for example, “CEO Pay Levels and Pay Structure – Predictors of Company Performance?,” BDO, accessed March 24, 2022, https://www.www.bdo.com/insights/tax/global-employer-services/ceo-pay-levels-and-pay-structure-predictors-of-c.; Raghu Rau, Michael Cooper, and Huseyin Gulen, “Performance for Pay? The Relationship between CEO Incentive Compensation and Future Stock Price Performance,” December 2009.; “Out of Whack: U.S. CEO Pay and Long-Term Investment Returns,” accessed March 24, 2022, https://www.msci.com/ceo-pay.[/fn]
Changes in Economic Policy
The third component of financialization are the changes in economic policy, regulation, and laws. The financial sector plays an outsized role in the control of government policy by capitalist enterprises and the rich. This is crudely yet robustly illustrated by the parade of finance chieftains who have occupied leading roles in the Federal government through many administrations of both parties. Goldman Sachs
Examples of laws and regulations changed since 1980:
- Securities and Exchange Commission (SEC) Rule 10b-18 in 1982 made stock buybacks[fn]A stock buyback occurs when a company uses company financial resources to buy its own shares on the market. The reduction in the number of shares outstanding in the market produces a rise in the price of the remaining shares.by corporations legal. This opened the door for a tsunami of stock buybacks that have become a regular use of corporate profits instead of investment. Before this change stock buybacks were considered stock price manipulation (which of course it is).[/fn]
- Anti-trust policy: In the 1980s, there was a shift in antitrust enforcement influenced by the Chicago School of Economics. This puts much greater weight on the effect of market concentration on consumer prices and shifts away from concerns over other effects monopolization in the economy. More about this will be discussed in Chapter
- Financial Services Modernization Act (1999) (aka Gramm-Leach-Bliley Act (1999): this law repealed the Glass-Steagal Act of the Great Depression era and lifted the barriers between commercial banking, investment banking, and insurance companies.
- Commodity Futures Modernization Act (2000) – exempted many derivatives, commodities, hybrid financial instruments and many others from regulation by the Commodity Futures Trading Commission.
- Sarbanes-Oxley Act (2002) increased stricter accounting and reporting requirements for public companies following the Enron and Worldcom scandals of the 1990s.
- Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) – established new regulations and oversight for banks and other financial institutions, created the Consumer Financial Protection Bureau (CFPB)
- Jumpstart Our Business Startups (JOBS) Act (2012) – facilitate capital formation for small businesses and startups. It relaxed certain securities regulations, allowing for crowdfunding, eased IPO requirements, and provided exemptions for certain securities offerings.
- Biden administration signals new interest in returning to more vigorous enforcement of anti-trust laws. Results to date are thin.
The most significant changes in law and regulation by far are:
- the Rule 10b-18 allowing stock buybacks
- the decline in anti-trust enforcement beginning in the 1980s
- Repeal of Glass-Steagal in 1999 ending the separation between commercial and investment banks
- Commodity Futures Modernization Act (2000) that opened the flood gates to speculation in various financial instruments – derivatives, etc.
- Significant weakening of protection for labor unions from corporate harassment
The Great Recession of 2008-2009, during which the global financial system teetered on total collapse, demonstrates the results in the finance sector of the banking and commodities deregulation.