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Financialization: From Financial Deregulation to Boom Bust Cycles

Financialization

BY ENGELBERT STOCKHAMMER

The term financialization is used to summarize a broad set of changes in the relation between the ‘financial’ and ‘real’ sector which give greater weight than heretofore to financial actors or motives. The financial sector includes banks and insurance companies, but also institutions like hedge funds or money market funds. While much of economic theory assumes a neat separation between the financial and producing sectors, or the monetary and the ‘real’ sphere, the financialisation debate highlights that the boundaries are not clear-cut and that changes in the financial sector can impact non-financial sectors in numerous ways. The term financialisation has been used to encompass phenomena as diverse as shareholder value orientation, increasing household debt, changes attitudes of individuals, increasing incomes from financial activities, increasing frequency of financial crises, and increasing international capital mobility. The debate on financialization covers contributions from different disciplines ranging from economics to sociology, history, political science and business studies and from different theoretical traditions (see Ertürk et al. 2008 for an insightful collection of seminal contributions). While Arrighi (1994) uses the term financialization to analyse long waves of economic development in global capitalism since around 1500, most authors regard financialization as one of the key components of a broader societal shift in social and economic relations from a Fordist accumulation regime to a new ‘neoliberal’ regime (Harvey, 2005).

Financialization was made possible by a series of measures to deregulate the financial sector and to liberalize international capital flows. Many of these measures were themselves reactions to increasing activities on part of private agents to circumvent financial regulation. These measures include the liberalization of international capital flows and an industry-wide deregulation of the type of transactions that banks are allowed to engage in. As a result new financial institutions like money market funds, private equity and hedge funds became major players. Financialization thus describes an increasing volume of financial transactions (relative to ‘real’ transactions) and the direct and indirect effects these changes have on the non-financial sectors.

A first important area of debate was the financialization of non-financial businesses. A shareholder revolt in the form of activist institutional investors and the emergence of a market for corporate control via hostile takeovers have forced firms to give ‘shareholder value’ a high priority. This means increasing payouts in the form of dividends and share buybacks. Remarkably these developments have come with lower rates of investment by firms and, at the same time, with higher debt ratios of firms. In other words, firms have often taken out loans to buy back shares to increase shareholder value. Lazonick and O’Sullivan (2000) summarise this as a shift from what they call ‘retain and reinvest’ to ‘downsize and distribute’. A growing empirical literature has demonstrated that increasing financial activity of non-financial firms has had a negative effect on (real) investment of these firms (Stockhammer, 2004; Demir, 2009).

Secondly, the effects of financialization on households have been as profound as those on businesses. Individuals and households have become used to relying on credit. This has involved changes in attitudes as well as changes in financial institutions and instruments. Household debt levels have increased sharply since the mid 1970s, mostly driven by mortgage credit. Some authors have argued that consumption expenditures in the Anglo-Saxon countries seems to be determined by changes in asset prices or in credit rather than in income (Guttmann and Plihon, 2010). Mainstream economic institutions, not least central banks, have investigated the extent to which consumption expenditures react to asset prices. A marginal propensity to consume out of wealth of 5 percent is often quoted (Slacalek, 2009), with housing wealth typically found to be associated with stronger effects than financial wealth. A key issue is whether the increase in household debt should be regarded as part of a rational decision process in the face of increasing wealth (which is the mainstream perspective) or as the outcome of increasing consumption norms and of changing lending standards by banks (Cynamon and Fazzari, 2009).

A third key area is the impact of financialization for the financial sector itself. First with the emergence of a shadow banking system, a substantial and growing part of the financial sector does not take the form of (traditional) banking (or insurance), but of other, typically much less regulated, institutions such as investment funds, money market funds, and hedge funds. This shadow banking system has been a motor for financialization. One important result has been an increase in the leverage ratio of these institutions. Second, within banking this development has led to a shift towards fee-generating business rather than traditional banking that generates income as a result of the interest differential between rates on deposits and on loans. Thirdly, within banking there has been a shift to lending to households rather than to firms. In particular mortgages are now by far the largest loan positions (Ertürk and Solari, 2006).

There are several important effects of financialization along the international dimension. First, financialization is part of the globalization of production. International production networks require international financial transactions and, in a setting with market-determined exchange rates, have given rise to various instruments to hedge against exchange rate variations. Foreign direct investment and its associated income flows will show up as financial income (e.g. in the form of dividends paid by a foreign subsidiary, see Milberg and Winkler (2009)). Second, the liberalization of international capital flows has given rise to a substantial rise in the volatility of exchange rates, which are increasingly determined by capital flows rather than by economic fundamentals such as current account positions. Indeed episodes of massive capital inflows followed by sudden and sharp capital flow reversals resulting in exchange rate crises have been a common feature in particular for emerging and developing countries (Epstein, 2005).

How has financialization overall affected macroeconomic dynamics? Supporters of financial deregulation have argued that financialization provides a superior way of dealing with risk: securitization, for example, was supposed to slice risk into different parts and allocate it to those who were best equipped to hold it. Securitization is the process of turning illiquid assets, or certain aspect of that asset like their volatility, into financial assets that can be traded on markets. In particular thousands of mortgages were bundled into mortgage-backed securities, which were then tranched into so-called collateralized debt obligations (CDO) according to their default risk. This would allow those with higher risk appetites to hold riskier assets. Famously, the IMF (2006, p.61) argued that the financial system would be more stable and society better off. By contrast, critics have highlighted conflicts of interest and the dangers entailed by the belief that risk could be easily sliced by means of looking at past correlations (Aglietta and Rebérioux, 2005; Crotty, 2009).

In our view financialization has contributed to a sluggish overall economic performance with rising debt levels over the period 1980-2008. Many countries have experienced a credit-driven consumption boom. Hein (2014) and Stockhammer (2015) argue that financialization has led to bifurcation of growth models. On the one hand, financialization has given rise to two different growth models: a consumption-driven growth model and an export-driven growth model, both of which are explained as the results of the interaction of trends in the polarization of income distribution and of financialization. Both of them rely on increasing debt-to-income ratios and are therefore prone to instability. In the debt-driven model, domestic debt (and usually property prices) is driving demand; financial deregulation has given rise to increased credit growth, which fuelled property prices, which in turn gave the illusion of rising household wealth. As real estate is the most important form of collateral, the housing boom fuelled further credit growth. The precise mechanism differs across countries. In the US securitization of mortgages (which was tolerated by financial authorities) played a key role; in southern European countries credit growth proceeded along more traditional lines, but relied heavily on capital inflows. In contrast the export-driven model did not rely on domestic credit growth, but rather on growing trade surpluses.

At first sight, this looks like a more industrial or ‘real’ growth model. However, it is also relying on increasing debt, namely on the growing foreign debt of trade partners. For each country with a current account surplus there needs to be another one with a current account deficit. That country needs to accumulate foreign debt. Thus, but the debt-driven and the export-driven growth model rely on growing debt and are unstable in the long run. Obviously, in the event of a crisis it makes a big difference whether the debt burden is household debt within the country (as in the US or Ireland) or whether it is the debt of the trade partner. The latter is the situation of Germany, which has seen its position strengthened.

Financialization has also had effects on income distribution: The high salaries in the financial sector contribute to national inequality, but Jayadev (2007) and Stockhammer (2013) also provide econometric evidence that international financial globalization has led to a decline in wage shares. There are several channels by which financialization impacts on distribution. It increases the exit options for capital. First, firms can invest at home or abroad, but they can also invest in machinery or in financial assets. Second, shareholders and financial investors have put pressure on firms to increase dividend payments and push up share prices via share buybacks. That constitutes a drag on the means available for investment and puts a downward pressure on wages. Third, the increasing financialisation of households undermines working class identities, which were the basis for the trade union movement.

The central concern, however, is the rise of financial instability, particularly after the financial crisis that began in 2007. On the more mainstream side Drehman et al. (2012) and Schularick and Taylor (2012) document the close link between economic fluctuations and financial variables.  They argue that credit growth is a powerful predictor of financial crises. Stockhammer and Wildauer (2015) find that in the decade before the crisis (1998-2008) for Anglo-Saxon and southern European countries, about half of GDP growth was driven by property prices and debt. This has led to revival in the interest of the work of Hyman Minsky, a post-Keynesian economist, who had long put financial instability at the very heart of the functioning of capitalism (Minsky, 1995; Charles, 2008; Ryoo, 2013). In this view, financial deregulation is destabilizing economic growth and a de-financialisation paired with active fiscal policy is necessary in the aftermath of financial crises.

References

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ENGELBERT STOCKHAMMER

is Professor of Economics at Kingston University. He is presently research associate at the Political Economy Research Institute at the University of Massachusetts at Amherst and member of the coordination committee of the Research Network Macroeconomics and Macroeconomic Policy.

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