A response on financialization

In comments on a recent post on financialization, a number of criticisms were raised that are worth exploring further. Readers have reasonably objected that a graph showing increased financialization of the US economy demonstrated less than first appears. These objections break down into at least four claims:

1. Finance has been a part of modern economies for ages, and a major part at least since the late 19th century, what’s so different now?

2. To the degree there is something new, isn’t it a product of increasing complexity and thus a further refinement of the division of labor?

3. The financial class is really the only group that understands the ins and outs, and thus the stakes, in various regulatory and private decisions regarding this area of economic activity. There are experts, and only experts have the competence to make informed decisions. It’s either the experts or the Tea Party, you decide.

4. If there are other interests at stake, what exactly are those interests, and how are they articulated in the particular case of, say, financial regulations? All that has been said on this blog so far is some vaguely democratic stuff about general interests.

We agree that these are important issues, but cannot respond to all of these objections at once. Question 1 is for separate posts. Suffice to say we think something distinctive has happened since the 1970s in national and global finance (one thing being the more global character of finance). These trends are importantly different from, say, the period from 1870-1914 that gave rise to concepts like ‘finance capital’ and ‘monopoly capital.’

Questions 2 and 3 go together. It is misleading, in our mind, to view the current financial architecture as a kind of natural development of the division of labor and economic complexity. Current markets are the product of a host of conscious political decisions, especially regulatory and de-regulatory choices. One could choose any number of examples, but few recent ones include the Gramm-Leach Bliley Act (1999), which eroded the boundaries between investment banking, commercial banking, and insurance provision; and the 2004 SEC decision to raise debt-to-capital ratios. These decisions significantly altered the structure of financial markets, allowing for certain kinds of financial ‘innovation,’ which it must be said many people even in finance don’t seem to have understood. So the structure of financial (and all economic) markets is the product of the laws the institute them, and the incentives these create.

A further reason we have doubts about the expertise argument is that everything suggests that they have not been using this expert knowledge in the public interest, but rather to their private interest.  As we have noted on this blog before, dramatic rises in incomes at the top over this period have gone hand-in-hand with stagnating real wages and rising consumer debt. It would seem one of the most significant elements of financialization has been its distributional implications, not the improved risk management or allocation of resources. Put another way, there is no reason after this crisis to particularly trust the experts!

Which brings us to our response to question 3: people might not understand everything, but they can understand enough. That is to say, not only is it misleading to view the growth of finance as a natural development of economic complexity (question 2), but it is also wrong simply to say these market are too complex for most people to understand (question 3). True, most people can’t be expected to know about or even understand the ins and outs of Tier 1 capital ratio requirements, or the kinds of collateral required for overnight repo agreements. But that does not mean a) they cannot be given better information, and get better educated than many are now (see, for instance, well-known misperceptions about inequality) and b) that they cannot know their own interests and c) that they cannot be organized on the basis of these interests to put pressure on their government to better serve them. Echoing one of the commentators on this blog, we would say the greater problem is not the people’s incompetence, but rather their relative apathy. The popular response to this crisis – Tea Party aside – has been decidedly tepid. But when representatives and regulators fear they will lose their jobs, or worse, they tend to do at least a better job of keeping the worst at bay. Or put another way, as plenty of post-crisis evidence has suggests, the problem was not the lack of knowledge amongst regulators, but a willingness to look. That is not a problem of incompetence v. expertise, but a political problem. One suspects they look harder when there is more popular pressure on the government. But now we are talking about things like social movements and popular protests, which are too quickly written off as the noise of incompetent mobs.

One final point. Question 4 was about what kinds of regulations and economic structures would be more in the public interest. Not just who are we talking about, but concretely what are their interests? If financialization has been generally bad, what is the proper response? That is a harder question, though it is easy enough to start by saying most people do not have an interest in more tax cuts for the wealthy and more spending cuts in social services. That, however, is only one part of the question and does not directly address how to respond to financialization itself. This is a question we do not ourselves have clear and complete answers to, but we are confident enough to say that we have no confidence in our existing rulers, or current experts, to solve those problems.

Obama and Financial Regulation

Over at Naked Capitalism, Yves Smith reposts an argument that, early in Obama’s administration, there was a “crucial window of opportunity” to seize on popular discontent and regulate the financial industry in a way that could have reduced the systemic risks that brought the economy to its knees. Instead, “Obama failed to act” and, even more problematically, turned to what appears rather disturbingly to be a propaganda campaign to promote his non-reform. The propaganda pivots on what Smith deems the “Theory of Positive Thinking,” or the theory that, so long as everyone’s expectations are optimistic, the market will continue to grow. The real economy doesn’t work that way, but Obama chose this path.

Smith’s indictment is powerful, but it under-estimates the magnitude of the problem involved in re-regulation. We are the last to let Obama off the hook, and he has received too many passes from supporters who think that, deep down, there is some kind of lefty who is simply stymied by the limits of American politics. In that argument, the wish is father to the thought. However, in the case of financial regulation, it is worth recalling some of the reasons why the issue can’t be reduced to the political will of a president willing to seize on the very amorphous and contingent discontent of the public.

First, it’s worth recalling that loosening the reins on finance and promoting the expansion of credit (especially mortgages), through low interest rates, Clinton’s decision to allow Fannie Mae/Freddie Mac to finance sub-prime mortgages (1995), de-regulations like the Gramm-Leach-Bliley Act (1999), Commodity Futures Modernisation Act (2000), and the 2004 SEC decision to raise debt-to-capital ratios, were all part of a particular kind of social compact. Various observers have noted that financialization of the American economy begins to pick up just as real wages begin to stagnate in the mid-1970s. Here is a graphic on stagnating wages:

Compare with various figures showing starting in the late 1970s. The Economist, for instance, observes that consumer debt went from 100% of household income in 1980 to 173% in 2009. Basically, the post-1970s downturn social model was to keep consumption levels high through the expansion of credit, rather than by maintaining the ability of workers to compete for their share of the actual social product. (It’s no accident that unionization and strikes – key methods for keeping wages and benefits high – have declined). For this kind of expansion of credit, especially in key areas like home loans and credit cards, de-regulation was required, not to mention lax oversight and a general social willingness to allow bankers to play.

To be clear, this is not a point about fairness, social justice or any other kind of moral judgement about whether this was a good way of dealing with the crises of the 1960s and 70s. It’s just a point about the way the actually existing accord appears to have worked. The upshot is that re-regulation implies a kind of transformation of American society not just the economy. It would require making a decision to go for a different kind of accord between the various interests in society, and that is not something that Obama can manage single-handedly. It’s evident he doesn’t have the stomach for even the first baby steps. The Employee Free Choice Act is tabled, Obama wants to talk about stock markets not job markets, and nobody wants to talk about real wages.

On top of everything, even if someone decided to tackle the problem of coming up with a different kind of social model, there are the global imbalances that would also have to be managed. An excellent paper by Anush Kapadia and Arjun Jayadev reminds us that the difficulty in dealing with the financial meltdown comes from the overlapping layers of financialization and risk. Over the past decade, what has made possible low interest rates, cheap consumer goods, and thus debt-financed consumption are ‘global imbalances,’ or the way the Chinese have suppressed their own financial markets, instead cycling their profits into US T-bills. This keeps the dollar strong relative to the renminbi, and allows the US to run trade deficits (alongside Chinese trade surpluses). Here again, balancing out this dynamic would involve some development of Chinese financial markets, alongside higher domestic consumption in China, and meanwhile higher American savings and investment, but lower consumption. It’s hard to imagine a move like that, especially a globally coordinated one, especially given the implications that would have for the already struggling majority of Americans.

So, in sum, Smith is certainly right to point to the abject failure of leadership by Obama and the Democrats, especially in the early post-election days when there was indeed some kind of critical juncture, or at least minimal opportunity. Even in the small window available to them, the Democrats took conservative options. And the major strategy seems simply to be to kick the can down the road. But it’s also important to note the magnitude of the social and political problem, because it means the fight to craft a new order will involve some major major losers and winners. In that battle, it’s going to take more than amorphous public opinion to overcome well-organized interests.

The Problem of a Financial Class

Gillian Tett commented today on the growth of the ‘shadow banking‘ sector in relation to regulated banks. Tett’s anecdotal evidence suggests that shadow banking – basically those unregulated banking-like activities by hedge funds, investment vehicles, and other bodies – is not just growing but colonizing areas that regulated banks used to dominate. The reason is that Dodd-Frank only regulates the already regulated banks, like Citibank, which means it has become harder, more expensive, or just impossible to engage in certain financial transactions. While these shadow banks claim that this is all ok because they are responsive to investors, that is not particularly comforting by any stretch.

Tett seems worried but, somewhat oddly, her conclusion is that, if these shadow banks turn out to be just as bad the second time around, we might end up seeing this period as “(yet another) lesson in the unintended consequences of regulatory reform.” This is hardly the obvious conclusion. This sounds like the classic ‘perversity’ thesis – all attempts at regulation (or any political action) will produce the opposite or worse unintended results than the intended ones. Plenty of people noticed, during the debates over the Dodd-Frank bill, that if shadow-banking activities were not also brought into the light and regulated, then the regulations would be woefully inadequate. There is nothing unexpected about this emerging problem.

However, it does highlight an underlying problem with the political assumptions of the liberal model of regulation. Many liberal arguments during the debate over financial regulation were about how ‘if we just get the regulations right’ – or even, ‘if we just go back to the Glass-Steagal acts’ – then we can solve the problem. But the idea that we just had to figure out the right regulations fails to grasp the kind of struggle that would have been involved in a full scale regulation of the financial industry. Compared with the New Deal, and even the post-war boom period, the financial class today is much more powerful and influential. And serious regulation of finance would undoubtedly have imposed a dramatic constraint on the activities that have allowed the financial class to grow. It may very well have meant the shedding of far more financial jobs than have been shed, and permanently restructuring the activities of those who remained.

In other words, serious regulation would have required a full on assault on the financial class. I don’t think just a little bit of public reasoning about the ‘right regulations’ would have won financiers over. This would have required a kind of class war, at least in the sense of one well-organized, politically powerful set of interests would have had to defend and put its political muscle behind these regulations.

It is precisely those conditions that are absent. No amount of clever policy-wonkery can address those background problems. Worse yet, thinking about the problem as merely one for a bit of wonkery misses out on the political economy of something as seemingly remote and boring as financial regulation. Regulators and elected officials did not just ‘make a mistake,’ they played the only game in town.