Confusions on financialisation

This column was first published on Wednesday in Fund Strategy.

Financialisation is one of the most important trends in the world economy. It is also one of the most misunderstood.

In the mainstream discussion the term generally refers to the ascendancy of finance. This can take many forms but the main thrust of the argument is that finance is growing in importance relative to the rest of society. It is allegedly becoming larger economically and more powerful politically. As a result its practitioners are better paid than almost everyone else.

In the popular discussion the common image of finance is exemplified by the widely lauded description of Goldman Sachs as a “giant vampire squid”. The image comes from Matt Taibbi, a campaigning American journalist, in a 2009 article in Rolling Stone magazine and in a subsequent book he called the Wall Street investment bank “a giant vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”.

This ghastly spectre, which is open to objection on several counts, embodies many of the key themes of the financialisation. It suggests finance is powerful, manipulative and parasitic.

Although the economic discussion is less graphic, and not always so critical, it often embodies similar themes. Often the concept is used by economists who regard themselves as critical of what they see as a free market or “neo-liberal” form of capitalism. For example, Thomas Palley, has defined financialisation as “a process whereby financial markets, financial institutions, and financial elites gain greater influence over economic policy and economic outcomes”. But, as will be shown, figures who can be justly described as pillars of the establishment hold similar views.

That is not to say there is no foundation to their argument. Finance has become a more important component of economic activity over the years by many different measures.

Two professors of finance from Harvard Business School recently published a systematic study of the phenomenon in the US (Robin Greenwood and David Scharfstein “The growth of finance” Journal of Economic Perspectives, Spring 2013). The two authors calculate that the financial services sector grew from 2.8 per cent of GDP in 1950 to 4.9 per cent in 1980 and a peak of 8.3 per cent in 2006. It has dipped since the advent of the financial crisis but the long-term trend is still clearly up.

Another dimension they point to is financial assets. In 1980 the total value of financial assets was about five times GDP; by 2007 this ratio had doubled. In other words financial asset prices rose much faster than economic activity.

A similar trend is apparent across the developed world and is apparent from many other measures. Perhaps the clearest is the rise in the total level of debt – both public and private – over the long-term.

The next step often made in the argument is more contentious. It is widely argued that the trend towards financialisation means that more extensive regulation of the financial sector is needed. Adair Turner, the chairman of the Financial Services Authority until its recent abolition, currently promotes this argument .

Simon Johnson, a former chief economist at the International Monetary Fund, has gone even further. He has argued the financial sector has engineered a “quiet coup” in which the American financial industry has gained substantial power (Simon Johnson “The quiet coup” The Atlantic, May 2009).

In a way the arguments put forward by Turner and Johnson can be seen as self-serving. The thrust of what they are saying is that clever technocrats such as themselves should be given more power to regulate financial institutions.

But their arguments should not be dismissed simply because for this reason. There is instead a fundamental problem with their view of financialisation. Instead of seeing the trend in terms of the ascendancy of finance it would be better as understanding it as the merging of finance with the rest of the economy. It is not just that financial institutions have become a larger part of the economy but other sections of the economy have become more financialised. The boundaries between finance and the rest of the economy have become blurred.

Vendor financing provides perhaps the classic example. For a long time car purchasers have been able to harness loans from the manufacturer. In that respect car companies have themselves also become financial institutions. It has also become common for retailers to provide credit to their customers.

A similar trend is also apparent in the capital markets. Large companies will often tap the markets directly rather than borrowing money from banks. Such securitisation is another form of financialisation.

Indeed the fund management industry itself can be seen as exemplifying this trend. Asset managers – themselves part of the financial sector –have taken small stakes in all sorts of firms in the course of their business. Once again this means that the boundaries between finance and non-finance have become blurred.

In its own way the state is also becoming part of the financialisation process. Measures such as quantitative easing mean that the state becomes directly involved in the financial markets.

Understanding financialisation as simply the ascendancy of the financial sector is too narrow. It would be more accurate to see it as the blurring of the boundaries between finance, non-financial companies and economic policy.