This is a review of three books that warn about the danger of growing financialization of developed economies: The Finance Curse by Nicholas Shaxson (2018) from where the title for this review is borrowed; Other People’s Money by John Kay (2016) and The Value of Everything by Mariana Mazzucato (2018). The ⅓ in the title of this review refers to the latter book, which deals with a broader topic of value creation in modern economies, what counts as value and how it is reported in national accounts and other relevant statistics. But one third of Mazzucato’s book (which I reviewed somewhere else: https://deveconhub.com/mariana-mazzucato-the-value-of-everything-part-1/) focuses on the value extracting trends in the modern financial sector expressed in continued financialization. So, the problem is there, it is well recognized but each author approaches it from a somewhat different perspective.
I will move forth and back between the three books to discuss various aspects of financialization, and so it would be fair to shortly characterize each of them. Mariana Mazzucato and John Kay are academics and there books present an academic perspective on the fascinating subject of financialization although, as already noted, Mazzucato considers it from a broader perspective of value and value creation (for her financialization is a method for value extraction and value destruction par excellence) whereas Kay’s analysis is based on a discussion of the key functions of the financial system in the market context and how financialization impedes efficient delivery of these functions. Shaxson is an investigative journalist and his book analyzes financialization through a combination of examples and case studies of different (negative) manifestations of financialization, be they geographic (there is an interesting chapter on how Ireland came to be an international financial center and crumbled under the weight of financialization); regulatory (offshore tax havens); or sectoral (private equity firms). Of the three, Kay’s book is my favorite – because he offers a very comprehensive, systematic and theoretically convincing analysis of financialization. But Shaxson’s book also makes a good reading highlighting amusing and salacious anecdotes about excesses of financialization (as befits an investigative journalist). I’m saving a final summary reading recommendation until the end of this review to keep you going.
Although all three books discuss financialization in developed economies focusing on the US, UK and to a lesser extent on Europe (Germany and France), I believe this discussion is also relevant in the context of developing and emerging economies. As globalization (particularly free movement of capital – not so much free movement of labor as we can see) involves more countries, financialization is fraught with three negative consequences. As capital from the developed countries invests in developed economies in pursuit of higher returns, capital flight remains a high risk due to relative instability of developing economies and may significantly exacerbate economic shocks in those countries bringing them to their knees (as the Asian financial crisis of 1998 vividly demonstrated). Second, arbitrage opportunities in developed economies in combination with high security of investment attract financial outflows from developing countries sucking out resources that could be used for national development (I don’t mention here the illicit financial flows which cost Africa $50 billion annually and some of which end up in the financial sector of developed countries). Last but not least, technology transfer, which is usually considered a benefit of globalization may be used to transfer to developing countries practices and experiences that may significantly harm their economies by undermining their financial stability, reducing resources for the real economy and, in the worst case scenario, financial distress through bailing the banks ‘too big to fail’. As I argued somewhere else, there are signs of progressive financialization in East Africa: the growth of the financial sector outpaces GDP growth whereas domestic credit growth is lagging behind the financial sector growth and GDP growth (for Uganda, the average growth of the financial sector in 2015-2018 was about 10% against 5% GDP growth and 0.9% domestic credit growth). This is a clear indication that the financial sector in East Africa (the figures for Kenya are even more dismal, with a negative trend since 2015 despite a healthy 5% GDP growth) is failing in one of its key functions, capital allocation for real economy.
What is financialization, anyway? All three authors agree that financialization essentially means too much of finance. But how much is too much? Whereas the size of the financial sector (measured as a percentage of GDP) is an indicator, it may vary greatly: it is 6.8% in the UK, 7.4% in the US, 9% in Kenya and 20%(!) in South Africa. A more meaningful quantitative indicator is the sector growth in comparison to the real sector growth. Kay argues that a key function of the financial sector is provision of credit to the real economy. If the financial sector grows faster (let alone much faster) than the rest of the economy (as was the case in the period prior to the financial crisis of 2007-2008), it may be a clear indication that the financial sector does not perform that important function properly. Fast financial sector growth, particularly in developing economies with large unbanked populations and helped by the latest technological innovations, may be a sign of financial deepening and imply both a wider choice of financial services and better access for different socioeconomic groups. However, a long-term outperforming trend may be a warning signal. In Kenya, for example, the FIRE (Financial and Insurance Services and Real Estate) was contributing to GDP growth as much as manufacturing in 2015-2016 and in 2017-2018 outperformed manufacturing. According to Mazzucato, business investment in the US (less than 2%) is now around its lowest level for more than sixty years, an amazing and disturbing phenomenon.
The other alarming indicator of the size of the financial sector is credit to private sector/GDP. All three authors highlight excessive borrowing (in combination with highly leveraged financing structures) as a typical feature of financialization that played the decisive role in the global financial crisis of 2007-2008. Although none of the authors address it directly, there is a solid body of research that links credit to GDP with economic growth (Easterly, Islam, Stiglitz, 2000; Arcand, Berkes, Panizza, 2012; Law and Singh, 2014; Ductor and Grechyna, 2014, etc.). In particular, Easterly, Islam, and Stiglitz (2000) empirically show that there is a convex and non-monotone relationship between financial depth and the volatility of output growth. Their point estimates suggest that output volatility starts increasing when credit to the private sector reaches 100% of GDP. Essentially, if the x-axis shows the size of the financial sector as credit/GDP and the y-axis shows output growth volatility, the resulting function has an inverted U-shape, first increasing with the financial sector growth and then decreasing, with the inflection point around 100% of GDP. This is very close to the findings of Arcand, Berkess and Panizza (2012) showing that in countries with very large financial sectors there is no positive correlation between financial depth and economic growth. In particular, their data show that there is a threshold (estimated to be at around 80-100% of GDP) above which finance starts having a negative effect on economic growth. Law and Singh (2014) based on their analysis of private sector growth rate rates rather than the total size of the financial sector argue that when private credit growth exceeds the growth in real output by 3.28%, the effect of financial development on growth becomes negative. Easterly, Islam, and Stiglitz (2000) explain the negative impact of ‘too much finance’ by an increased likelihood of funding risky investments and leading to lower economic growth rates and bank runs or financial crises when the expansion of credit (due to financial innovations or deregulations) is not followed by the expansion of the demand for funds by the productive sector of the economy.