With apologies for this digression (which I thought to be important for a more nuanced and informed discussion), let me now return to the three books under review.
Hence, it is not so much the size or growth rates of the financial sector per se as the direction of this growth with respect to nonfinancial sectors, specifically the extent to which it replaces nonfinancial activities and impairs delivery of its four key functions. Kay again: ‘The growth of the financial sector has not been matched by corresponding improvements in the provision of services in the non-financial economy – payment systems, capital allocation, risk mitigation and long-term financial security for individuals and household’. Shaxson gives a very grim picture of how the takeover by private equity firms destroyed the elderly care service in the UK while forcing the carers to make around 50 visits a day and substantively reducing the interaction time with the beneficiaries. Mazzucato emphasizes the reduction of patient capital and short-termism that is negatively affecting the capital allocation function of the financial sector. Mazuccato remarks in this respect: ‘…the average holding time for equity investment, whether by individuals or institutions, has relentlessly fallen: from four years in 1945 to eight months in 2000, two months in 2008 and (with the rise of high-frequency trading) twenty-two seconds by 2011 in the US’. Yet another quantitative indicator of financialization on which all three authors agree is the draining money from company investment budgets through share buy-backs. Between 2003 and 2012, the ten biggest re-purchasers in the US shelled out a staggering $859 billion on share buy-backs, equivalent to 68 per cent of their combined net income. Seven of those companies committed more than 100 per cent of their net income to buy-backs and dividends.
In sum, financialization operates as a drag on national economies. Shaxson quotes a study produced by two US academic called Overcharged: The High Cost of High Finance. The study sought to use established methods to create an estimate of the overall damage created by an outsized financial sector in the US. It concludes that the US financial system will impose an excess cost of between $12.9 trillion and $22.7 trillion on the US economy. The same academic estimated the costs of the damage to the UK economy from having an oversized finance sector at £4.5 trillion plus (http://speri.dept.shef.ac.uk/2018/10/05/uk-finance-curse-report/).
However, the authors see the major danger of financialization in less quantifiable but even more impactful societal influences with much longer-term consequences than financial crises that come and go (Kay has no doubts that they will come because of the current incentive structure of the financial sector). One is disproportionate influence of the financial sector on politics and policy decisions. Shaxson quotes the American offshore and financial crime expert Henry: ‘Overall, the US government has become the world’s most recent example of “bank capture”… The United States has become a one-party state, presided over by the Bankster Party and its revolving doormen.’ Mazzucato and Kay share this concern with respect to the UK government.
They also flag the dangerous conceptual influence of financialization on public attitudes and beliefs, kind of ‘moral corruption’ engendered by financialization. Kay says: ‘The belief that the profitability of an activity is a measure of its social legitimacy has not only taken root in the financial sector but has spread its poison throughout the business world.’ He doesn’t spare the financial sector some very strong language: ‘Read dispassionately, there is little to distinguish the cri de coeur of “We are Wall Street” from the manifesto of a criminal gang.’ Shaxson and Kay talk about an ‘intellectual capture’ of the financial sector that extends into academia and, by supplying the veneer of academic robustness, influences managerial practices in both the public and private sectors. This is another powerful reminder that we, in the development community, need to apply a critical ‘do no harm’ lens to our programmatic designs and interventions to make sure that we do not inadvertently contribute to the excess of financialization. This is particularly relevant for us in UNCDF. So much of our work is related to financial sector development and facilitating access to finance for different population groups and types of projects in developing countries. As we design and suggest various financial solutions to the development challenges faced by our partner countries, it is important to ‘proof’ those solutions to make sure that they contribute to the real economy sector and not solely for the benefit of the financial sector. I can’t help quoting one of my favorite Keynesianisms here as a might warning: ‘Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.’
There is one technical point on which I disagree with Kay: securitization. Securitization and financial engineering were particularly prominent in the period leading to the last financial crisis when subprime residential mortgages were repackaged into, guess what?, triple A securities. He argues that ‘there is no alchemy through which a collection of loans on weak security to unreliable borrowers could be anything other than just that’. Kay refers to Modigliani-Miller theorem, which postulates no relationship between the total value of the firm and its capital structure (no matter what combination of debt and equity you use, the value of your firm will not change). Firstly, the original M&M theorem (no, it’s not about those yummy small colorful chocolates) assumes absence of taxes (which is not a realistic assumption). But more importantly, Kay’s statement about no alchemy possible would be true if the underlying assets were considered of the same quality and the same risk level. However, the Modern Portfolio Theory (MPT) argues that it is possible to construct a portfolio to maximize returns and minimize risk by combining securities that have a low degree of covariance (in other words, their risks are unrelated because of the underlying characteristics). The challenge is of course to identify such securities in a real world. What didn’t work in the period leading to the global financial crisis was the analysis of covariance, which assumed that mortgage-backed securities were uncorrelated whereas in reality they were highly correlated (at the same time the risk of the underlying assets was highly underestimated based on an assumption of the ever rising real estate prices). This doesn’t mean however that MPT is wrong and structuring does not make sense in principle. I think this is particularly relevant in the context of our International Municipal Investment Fund planning where a properly constructed portfolio will be critical for ensuring the financial viability and long-term sustainability of the facility.
What are the reasons for the rising prominence of the financial sector and where can it lead us? Unless the situation changes, the authors argue, it will lead us to another financial crisis. It’s not a matter of if, argues Kay, but a matter of when. It is easy to blame the existing arbitrage opportunities (accounting, fiscal, jurisdictional and regulatory that the financial sector exploits and actively promotes. This is what Shaxson’s book is mostly about. There is a long chapter on how the jurisdictional arbitrage works with a juicy description of offshore tax havens from Anguilla and Bahamas to Luxembourg and Switzerland and another chapter on regulatory arbitrage focusing on PE funds (isn’t it a financial market segment with which UNCDF has been trying to engage recently?). Kay offers a more systematic treatment of the underlying problem. He believes that ‘the origins of the problem are to be found in the structure of the industry and in the organization, incentive and culture of financial firms’. Hence, going forward he rejects the idea of more regulation and insists on measures that would address those fundamental issues.
What are the fundamental issues in the financial sector? One is the low ethical standards that characterize the industry. These standards undermine the obligations of loyalty and prudence that go with the management of the other people’s money. The second one is the incentives focusing on profit maximization without due regard to their relevance for, and impact on, the real economy sector. The specialized expertise of particular real economy sectors that characterized the banks in the past has been replaced with purely financial expertise. Related to this is the culture of short-termism and regularly updated financial ratios (ROI, ROE and others) that reduce the availability of patient and long-term capital. There is a basic inconsistency between the cultures of retail banking – hierarchical, bureaucratic, dependent on processing millions of transactions with a high degree of accuracy – and investment banking – buccaneering, entrepreneurial, and reliant on the talents of small numbers of egotistical individuals. This is a conflict in which the investment bankers have mostly come out on top, to the inevitable detriment of retail banking. The next one is the industry structure. The assembly of financial conglomerates has markedly increased the fragility of the system. Contagion from small parts of the overall activities of the business may lead (and has led in the past) to the collapse of the entire corporate structure. The rise of the trading culture has contributed to financial instability and has enhanced the ‘bias to action’ that increases the cost of financial intermediation while being totally unrelated to the needs of the real economy sector. Lastly, it is the use of the financial sector as an instrument of economic policy, and the disproportionate influence of the industry on economic decisions.
There is an evergreen question of what is to be done that comes next. ‘Reform is difficult, the City’s power is immense, and recent events aren’t encouraging,’ laments Shaxson. His proposal is a global crusade against tax havens, which should deny financial institutions and businesses low (or zero) tax regimes and return money to national economies. His other proposal is ‘smart capital controls’, not in the sense of preventing money outflows but controlling financial inflows, particularly those coming from Russia and China. In my opinion, the first proposal is inadequate on its own as it addresses only one type of arbitrage (jurisdictional) while leaving opportunities for other types of arbitrage. The second proposal is almost paranoid (‘The Russians are coming’ as the US Secretary of Defense Forrestal famously muttered before throwing himself out of the window), and its impact on curbing financialization is not apparent. Kay’s reform proposals are more comprehensive and systematically address the key problems discussed above (return to specialist, focused financial institutions; reduction in trading volumes; improving the industry’s ethical standards and behavior, etc.). What is not clear is how this can be achieved (there are little specifics except for introduction of a tax on the value of all financial transactions). Mazzucato places her proposals in the broader context of value creation and concerns about not only about the rate of growth but also its direction. Her recipes for serious reforms of the present ‘dysfunctional’ system closely resemble those by Kay and include making the financial sector more focused on long-run investments; changing the governance structures of corporations so they are less focussed on their share prices and quarterly returns; taxing quick speculative trades more heavily; and legally curbing the excesses of executive pay.
These proposals make sense, but they miss the bigger picture in my opinion. The tacit assumption behind these proposals (and probably no one has expressed this sentiment better than Paul Collier in his recent The Future of Capitalism, which I’m also planning to review) is that the system overall is inherently sound and its current state is an aberration from the normative ‘normal’ state, which existed in the 60s and 70s. Capitalism has proved its resilience in competition with other economic systems but whether its current state is an aberration (almost an abomination of that wonderful liberal capitalism where, as Marx reminded us, ‘alone rule Freedom, Equality, Property and Bentham’) or a logical development of the system is the critical question. The reforms that the three authors suggest require changes in the behavior and attitudes of the industry and the people closely associated with it (politicians, academics and others). Is it realistic to expect this change and the incentive structure and logic of modern capitalism? As one of my favorite modern philosophers Slavoj Žižek says, ‘The true courage is not to imagine an alternative, but to accept the consequences of the fact that there is no clearly discernible alternative: the dream of an alternative is a sign of theoretical cowardice, functioning as a fetish that prevents us from thinking through to the end the deadlock of our predicament. In short, the true courage is to admit that the light at the end of the tunnel is probably the headlight of another train approaching us from the opposite direction.’
To end it on a lighter note, here’s the promised reading recommendation (yes, I remember about it). What do you do if you were to read only one book? If you want to have a deep dive into the world of finance and develop a comprehensive understanding of financialization and its consequences, my recommendation is Kay’s Other People’s Money. If you want to focus on the phenomenon of financialization in a broader development context and particularly through the lens of the current debates about value creation and value extraction, I recommend Mazzucato’s The Value of Everything. If you are into a lighter reading and investigative journalism I recommend Shaxson’s The Finance Curse for a kaleidoscopic mishmash of anecdotes, salacious facts, interviews about how financialization robs us all, what the ‘masters of the universe’ do for it and how they misuse the spoils.