(From Chapter IV of “How Financial Capital Conquered the World” (Como o Capital Financeiro Conquistou o Mundo), Jorge Nascimento Rodrigues, Centro Altantico, 2012)
From the mid-nineteenth century we witnessed a new phenomenon, the financialization of economies, a process in which the capitalist economy has become dominated by financial logic and the political system has been captured by that dynamic.
The process of financialization emerged in capitalism in late nineteenth century with a new segment in meteoric rise.
Until the 1820s, the real economy in developed countries lived from family capital and the countries suffered from a real “monetary starvation”, as referred by the French historian Jean Duché em Le Grand Tournant. That lead to the emergence of new financial houses. This dynamism in the world of finance derived from the legislation that allowed the creation of limited liability companies from 1855, first in the UK.
The gallery of honor includes the new European financial houses (Baring Brothers, House of Rothschild) and then Americans (JP Morgan, Kuhn, Loeb & Company, Kidder, Peabody & Company, Lee, Higginson & Company) and the arising of trusts in the U.S. (Standard Oil controlled by John D. Rockefeller, U.S. Steel by JP Morgan).
Stock exchanges have become the levers of this new capitalism. In his “Manuel du Spéculateur à la Bourse”, Pierre-Joseph Proudhon spoke ironically of “exchanges as philosophy, morals, homeland and church.” In over 500 pages, the French political philosopher described, in detail, the financial innovations of the time.
The French writer Marie-Henri Beyle, better known by his pen name, Stendhal, and works such as “The Red and the Black”, dubbed this new layer “the new nobility of the bourgeoisie.”
The world watched the first crises of this global financial capitalism. First in 1825-1826, with the epicenter in the UK, the cradle of the world’s leading financial center, the City. Then in 1890-1893, with the epicenter, again, in the City, and which became known as the crisis of the Baring Brothers Bank (which, incidentally, would deeply affect Portugal). And later, in 1907-1908, with the epicenter on Wall Street, in lower Manhattan, New York.
The downfalls in market capitalization were brutal in all three periods. The “creative destruction” in the financial sector was one of the highest in history. These global crises enabled the shift of leadership and the transfer of economic and financial power to a confined new series of financial groups and business corporations.
There is also the beginning of the “synchronized finance” between various parts of the world, as underlined by the researchers Shimshon Bichler and Jonathan Nitzan.
And the new large organizations of the productive economic world – the “corporations” – became the paradigm of management. James Burnham showed this change in The Managerial Revolution, published in 1941. Peter Drucker, later, described masterfully this new business world in one of his earlier books The Concept of Corporation, published in 1946. The “father” of management wrote the book almost as a report of the study in 1940 of General Motors, the company founded in 1908 and profoundly revolutionized in the 1920s by Alfred P. Sloan Jr., one of the of the most remarkable practical masters of management of all time.
What Drucker did not anticipate when he discovered the virtues of this new type of social organization, which led him to consider it “the most important event in the recent social history of the Western world,” was that in the race between financial institutions and corporations, the former would end to dominate the latter.
The landscape had become clear when the Austrian economist Rudolph Hilferding decided to dissect what was “financial capital” at the time, in a striking work published in Vienna in 1910, with that short title.
According to experts, this process of financialization has transformed the functioning of the overall capitalist system in the developed world both at macro and the micro level, changing the actual behavior of economic players, managers and families by encouraging the “rentier” spirit (obtaining financial rents as a way of life) as the French coined. An ecosystem whose feeding depends on the growth generated by financial investments not through the famous (or infamous) “plus value” dissected by the German philosopher Karl Marx.
One of the first to observe this transformation, in its early stages, even in companies, was the American Thorstein Veblen, who pointed the finger at financiers’ managers. It was back in 1904, when this economist wrote The Theory of Business Enterprise literally accusing the new elite to be “financial predators”. A few decades later, the Englishman John Maynard Keynes would reach even further. He would demand, in chapter 24 of his much-quoted book The General Theory of Employment, Interest and Money, the “euthanasia of the rentier.” However, he believed, in 1936, that the rentier aspect of capitalism “would be transitory.”
But it was not. A little more than half a century after Keynes’ book, the “financialization” returned to the limelight. In the meantime, the idea that after the industrial society would come the victory of “tertiary” was built up. But in fact, “it was a very special part of the services sector – the financial sector – which turned out to have a huge impact on the rest of the economy and the political system,” tells us the American professor Gerald Epstein.
Moritz Schularick, from Free University of Berlin, and Alan Taylor, University of California, have mentioned “two eras in financial capitalism” in an article in the Financial Times in which they refer their research over 140 years in 12 developed countries. One that would have occurred between 1870 and 1939, when the aggregate credit was inextricably linked to monetary aggregates, where “in the long run, maintained a stable relationship between themselves and in relation to the size of the economy measured by GDP.” Following the post-war we would watch a transition period until 1970. With financial innovation and deregulation in the following decades, the credit system “has disconnected” from monetary aggregates. In 2007, the authors say, the aggregate rose to 70% of Gross Domestic Product (GDP), but bank loans exceeded 100% and banks assets went over 200% of GDP. “We have been living in a different world,” they conclude.
The first to use the term “financialization” to describe this “different world” was an American political scientist, Kevin Price Phillips, in the book Boiling Point published in 1993. Phillips, an angry Republican about what was happening with the decline of the middle class and the umbilical cord between Wall Street and Washington DC, dedicated in the following year, an entire chapter to “the financialization of America” in Arrogant Capital. The motto was given.
Gerald Epstein tells us: “the word financialization wants to describe the growing importance of financial markets, financial motivations and financial elites in the economy and in the institutions that govern it, both nationally and internationally.” In short, stresses the professor at the University of Massachusetts, it is a new ecosystem where growth is fueled by rentier-led growth – which has led to an inexorable decline in the average annual growth rate in developed economies. Which, in turn, generated a surprising fact: a dual reality, and paradoxical, in rich economies, in which the annual growth is increasingly lower and the financial exuberance amazingly higher and higher.
The astonishing financial innovation of the last thirty years responded to this “demand” from the side of capital holders and took advantage of the revolution in information and communication technologies.
This second wave of financialization had two allies. On the one hand, the increasing dematerialization and digitalization of processes and economic activities, referred by the physicist Tessaleno Devezas in his latest research on the increased efficiency on the use of natural resources over the past fifty years, and by the economist William Brian Arthur, the “father” of the “Invisible” Economy. On the other hand, there is the growth of the virtualization of money and financial flows in recent decades; the anthropologist David Graeber draw attention to this trend.
Over the past twenty-five years, we have watched the birth of new financial products – like the famous subprime invented in the United States, “incriminated” as public enemy number one in 2007 – and also the emergence of new services hitherto unthinkable – first with the massification of ATM machines and debit cards, then with the pre-paid cards, internet banking, and electronic money. New processes emerged, from automated clearing houses to high-frequency trading in markets dominated by algorithms, or risk management – and new forms of financial organization – as banks exclusively on the Web. Some of these were created by traditional banks, or absorbed by them, or eventually open physical presence. Or have just disappeared from Planet Earth.
The real economy was caught
Costas Lapavitsas, from the University of London, says that this process led to a “systemic transformation” of developed economies and Greta R. Krippner, from UCLA (University of California, Los Angeles), explained that the very traditional divisions between finance and “real economy” are getting blurred. Much of the business fabric is impregnated by the financier logic, and in many cases the financial activities of these companies started to generate more income than the core activities of the business.
“It’s easier to make money financially than through [productive] direct investment,” says Michael Hudson, professor at the University of Missouri. It became “boring” to grow companies by expanding the production or trade quips Jan Toporowski, University of London, author of the controversial Why the World Economy Needs a Financial Crash.
The use of financial markets is more attractive. “Companies have moved from productive activities to financial ones and become rentier entities” states Toporowski, adding that in large extent, they have become “financial intermediaries”.
The great theorists of this shift, which surprised even the indoctrinated masters of management, were two U.S. academics. Michael Jensen, Harvard University, and William Meckling, University of Rochester, advocated, in 1976, in the article “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” that corporate management must be guided by the maximization of value for shareholders. The new doctrine subordinates the strategic direction of the companies to the release of quarterly results.
The logic of financialization begins to dominate the entrepreneurial activity discarding the historical role of firms that was to “find” markets (including inventing or reinventing them), retain and expand customer base and generate profit from products and services, with a major concern on reinvestment and the long term.
The “corporate governance” changed its azimuth radically. The revolution and the modern doctrine of management, that were the reason for the life of Peter Drucker, would give rise to “shareholder revolution” that would legitimize the movement of hostile takeovers by financial famous raiders and completely subvert the mission of the corporation. Result: we started to see a growing transfer of funds generated by companies in the real economy to financial activities and people.
The logic of portfolio and short-termism has prevailed. The investment has resented. In the case of the U.S., according to the study by Thomas I. Palley, from the Levy Economics Institute, the non-real estate investment (a component of fixed capital) declined from 11.1% of GDP in 1973 to 10.2% in 2005. That is, in three decades its weight has decreased.
The process of capital accumulation became fed by financial activities, rather than by production or non-financial services, including international trade.
A study of Urban Jermann and Vincenzo Quadrini for a conference organized by the Federal Reserve Bank of San Francisco, on the impact of financial innovations, reached the following paradox: “although the sector of the real economy has become less volatile in recent decades, the volatility of the financial structure of the companies has increased.” Financial innovation that started in the 1980s undoubtedly allowed great financial flexibility to business management, creating greater capacity to borrow for business expansion or replacing the reinforcement of capital with access to debt, but the business cycles experienced by companies have become more “sensitive” to the financial cycles, its volatility and its impact. Jermann and Quadrini spoke in 2006 before the outbreak of the current crisis.
Financialization is not a temporary “deviation” of the logic of capitalism, or a “defect” or “failure” of the markets where there is a lack of “transparency” or lack of “ethics”, but a model of capitalism. It was a reversal of the previous model after centuries of a strategic intent for hegemony on the part of one of the most dynamic sectors, the financial capital, that knew how to explore opportunities.
Plutonomy and caste structure
Some economists even believe that the economics are now dependent on the decisions of a financial plutocracy, leading them to dub the current economic model as “Plutonomy” – a term coined by analysts at Citigroup in two exclusive memos for their clients in 2005 and 2006.
The academic Robert Shiller, from Yale University, in Finance and Good Society, refers to a “caste structure” that emerged in capitalist societies as a result of financialization, an ecosystem in which bankers are just part of it, as various professional groups and political circles are involved. However, the Yale scholar wrote, and mention in an interview to “Le Journal du Net”, in defense of financial capitalism: “Financial capitalism allows the organization of modern civilization. Nothing can be accomplished without at least a modicum financial support. I feel that most people do not realize that and they are angry and against our banking institutions. I would like that this anger could be constructive and lead to financial innovation to address those criticisms.”
Professor Shiller believes it is possible to “democratize” the system and change behavior through different incentives. Unlike Charles H. Ferguson, author of Predator Nation, a book that goes in line with his shocking movie “Inside Job,” which won an Oscar and mobilized millions of viewers worldwide. Ferguson accuses the “hiperfinancialization” and draws attention to the birth of a “financial elite” who captured
the political power and the academy itself.
One of the views of the impressive evolution of the weight of that elite in the U.S. national income is given by Shimshon Bichler studies, a professor in Israel, and Jonathan Nitzan, from York University, Toronto, Canada.
Between 1930 and 2010, the share of capital income in U.S. national income rose 48%; and the share of profit after tax on the top segment (0.01% of the created and publicly traded companies in the U.S.) in national income soared 134%. By “capital” defined as companies (financial and non-financial) and not the wealthy segment of individual taxpayers, which will be discussed below. The top, in the U.S., was around 600 companies in 2010, the cream of the crop, not only financial capital but also from the universe of what Americans call “corporations”, whose business history is linked to several non-financial activities.
Moreover, Emmanuel Saez, director of the Center for Equitable Growth at the University of California, Berkeley, studied the evolution of the weight of the top segment of 10% of the U.S. population since 1917.
The results can be found in the “The World Top Incomes Database” and are surprising. In the case of the U.S., between 1917 and 1928, the weight of the top segment increased from 40.29% to 46.09% in national income, under the first wave of financialization. And then broke the systemic crisis known as the Great Depression. But that weight continued to rise even during the hardest years of the recession, reaching a maximum of 46.3% in 1932. That is, the rich continued to increase its share in income (in relative terms), while the remaining 90% of the population suffered a brutal contraction.
Thereafter, the weight of the top 10% declined slightly until 1940, when it dropped to 44.43% of the national income. A sharp drop occurs in the following decade, reaching a record low of 31.38% in 1953. The measures of Franklin D. Roosevelt (president between 1933 and 1945) against the power of finance and after the World War, certainly contributed to this significant decline. From that until 1979, the weight remained relatively stagnant around 32%.
With the second wave of financialization, that weight soared again, reaching a peak of 45.67% in 2007, before the outbreak of the financial crisis that would lead to the current so-called “Great Recession.” It declined slightly, standing at 45.47% in 2009, but soon rebounded in 2010 to reach a historical high of 46.26%, based on available data. In short, for now, a repetition of the pattern from 1928 to 1932. The question is whether this upward trend will continue, or if a break will occur, as happened in 1933.
In the case of the United Kingdom, the abrupt fall of the weight of the top segment occurs in 1937 and continues to fall until 1978. It fell from 38.37% to 27.78% of the British national income in those forty years. The series for this case begins in 1908, with a maximum of 38.73% in 1919, during the first wave of financialization. From 1978 there is a “jump” with the emergence of the second wave of financialization. It reached a historical high of 42.66% in 2007, falling to 40.43% in 2009, the most recent data available in “The World Top Incomes Database”.
In the Portuguese case, the available data shows a trend from 1976. In a period of four years until 1980 there was a sharp drop in the weight on the top 10% segment of the Portuguese population in national income – it fell from 31.7% to 18.77% during the first five constitutional governments. Then resumed an upward process reaching 38.25% in 2005, the latest data available on “The World Top Incomes Database”. It recovered, not just from the contraction in late 1970, but also added more than six percentage points to the level it had in 1976.
The behavior of the weight of the crème de la crème, the super-rich – forming 0.1% of the population – is, however, interestingly different from the pattern observed on the 10%. In the U.S., after a peak of 9.87% of national income in 1916, the weight fell to 1.89% in 1976. Then, there was a recovery, reaching 8.16% in 2007. In the UK, the drop was even more brutal, from a maximum of 11.24% in 1913 to 1.24% in 1978. There was, then, a recovery, reaching 6.05% in 2007.
This means that there was a continued increase until 1978 of the base of the rich segment of 10%. There is a set of social transformations in capitalism that explain it. First: the revolution of management since the 1940s, with the creation of a wide layer of managers (not company founders); the CEOs paid their weight in gold have become the media expression of that revolution. Second: the expansion of the financial sector with new professional layers of “knowledge workers” highly paid and with new financial entities operating in the market. Third: the explosion of entrepreneurship and of the new entrepreneurs based on waves of technological innovation since the 1940s. All these social phenomena have radically changed the landscape of business and financial community in developed countries. The top 10% of the pyramid expanded.
It is noted, however, that, from late 1970s, with the second wave of financialization, there was an attempt by the super-rich segment to regain some of the glory of the nineteenth and early twentieth century, when Stendhal spoke of the “nobility of the bourgeoisie.” Thomas Piketty, professor at the Paris School of Economics and founder of the project “The World Top Incomes Database,” explains that, “the fact that much of the action [after the 1970s] was focused at the level of 1% – and even more in the top 0.1% – derives from a combination of two factors – an undoubtedly increasing concentration of wealth, and also the explosion of income at the CEO and executive level, in both financial and non-financial sectors.”
In the Portuguese case of the wealthiest of the wealthy, 0.1% of the population, the project “The World Top Incomes Database” shows a larger evolution than what is available for the 10%. The series for the Portuguese super-rich begins in 1936, three years after the formal establishment of the dictatorship of “Estado Novo Corporativo”, and shows a trajectory similar to the British case. Starting from a maximum of 5.24% of national income in 1936, the weight of this minority fell to 3.12% in 1946. That value hold until 1969, and then felt to 2.45% in 1973 and reached the minimum 0.73% in 1981. From this point, it started to rise and reached 2.48% in 2005, roughly the same level as in 1973.
Although limited to the U.S. case, the research of Nitzan and Bichler, to which we refer, points to a trend that illustrates a brutal shift of power – in the literal sense of the term – in the economy and in the society, in developed countries. The authors mention “capital as power” and a process of structuring a “hierarchy of organized power”. They opt to refer to “modes of power” in the history of capitalism instead of “modes of production”.
There is, however, a new phenomenon shuffling the structure of the prevailing capital in the U.S. – the increasing share of foreign companies listed on U.S. stock exchanges. In 1950, only 4% of the 500 largest companies in the U.S. were foreigners. But that number raise to 15% in 1980 and 26% in 1990. The second wave of globalization changed the correlation of forces – the share of foreign companies in the top 500 rose to 41% in 2000 and 48% in 2010. The foreign segment has gradually “eaten” a share of profits after tax in the U.S. – the share increased from 5% in 1990 to 20% today. Which means that the U.S. “caste structure” is increasingly a part of global capital. “This is a foundational change,” conclude Nitzan and Bichler.
In short, after a first wave that began in the mid-nineteenth century which ended in a succession of global crises, for over a hundred years, between 1825 and 1929, the “financialization” returned to the stage in force in the 1970s.
The first systemic crisis – as the Spanish academic Santiago Niño Becerra calls it in “Más Allá del Crash” – of this second wave broke in 2007 and still remains.
Christopher Kobrak and Mira Wilkins, in the article “The 2008 crisis in an economic history perspective” stress that before 2008, there was no lack of global crises, although without the “calamity” dimension of this one that began in 2007.
A succession of crises that could have served as a warning from history not for the fact that most politicians and economists were under the influence of the dominant myth that financial markets in its “natural efficiency” would solve disturbances making the idea of bubbles and cyclic major crashes like something obsolete from a distant past.
The successive “warnings” almost left no time to breathe since 1970: The Savings and Loan Crisis in the 1980s (in the U.S.); the Latin American debt bomb crisis that started in 1982 and covered emerging markets that would remain until 1989; the burst of the Japanese bubble in 1990 (the beginning of a prolonged crisis of deflation in the Japanese economy) and the extension of the 1991-1992 crisis to Europe’s Nordic countries; the Mexican “tequila crisis” in 1994-1995 extending to other emerging markets; the 1997-1998 Asian crisis that would spread to Brazil and Russia; the 1998 financial crisis (collapse of Long Term Capital Management in the U.S., the first seismic shock to the hedge funds sector); the burst of the dot-com bubble in 2000 (in the U.S.); light international trade crisis in 2001 (0.5% drop).
The last two decades of the twentieth century were not an easy ride in the international financial system. According to Jan Toporowski, “each of these crises cost twice to refinance than the preceding.”
The secondarization of those “warnings” was due, largely, to the dormancy caused by the idea that some “great moderation” had taken hold of the economy of developed countries since the mid-1980s. It went to a substantial reduction in business cycle fluctuations, mainly due to the monetary policy developed by independent central banks in developed countries.
The image of “great moderation” was revealed in 2002 in a paper by James Stock and Mark Watson, suggestively titled “Has the Business Cycle Changed and Why?”, published in the National Bureau of Economic Research. The Nobel laureate Robert Lucas would say, a year later, before a restricted audience at the American Economic Association, that “the central problem of depression-prevention has been solved, at least from a practical standpoint.” And Ben Bernanke, then just a member of the board of governors of the U.S. Federal Reserve, magnified that image in a famous speech in 2004 at a meeting of the Eastern Economic Association. In short, we could sleep peacefully.
Indeed, the image of “great moderation” would come late, ironically just five years before the outbreak of a global systemic crisis. Turbulence has been a shocking reality in the last thirty years. From 1970 to 2011, covering the second wave of financialization, Luc Laeven and Fabian Valencia, experts from the International Monetary Fund, identified 147 banking crises, 218 currency crises and 66 sovereign debt crises in the world, in their recent work to update the database of banking crises.
Banking crises were concentrated in waves since the 1980s, hardly giving rest, both in developed countries and in emerging and developing economies, underline the two researchers. Escaped this frequency only three geographic spaces; Canada, Australia and Saudi Arabia managed to avoid this frequency. The rest of the world map, if seen from a space station or the Moon, would be spotted by a diverse frequency of banking crises.
Overall, the statistical median of the cumulative negative impact on the product, caused by banking crisis until 2011, was 23% of GDP. The contribution to the rise of sovereign debt was at a median of 12.1 percentage points of GDP in four years, from the beginning of a crisis. If we look just to the case of developed economies, the medians are higher: 32.9% to the loss of GDP and 21.4% increase in the ratio of sovereign debt to GDP. That is, since 1970 the impact was quite high within developed economies. Adding to that, there was a monetary expansion of 8.3% of GDP in these countries. Anything but a quiet walk in the wonderful world of Lucas and Bernanke.
Despite periods of euphoria, that financialization always generates, its fragility is high, and that was pointed in the 1970s by an almost ignored economist, Hyman P. Minsky. Minsky has mentioned a “financial instability hypothesis” and that the system has been transformed into a “money manager capitalism”. One of the titles of one of his works from 1982 reads: “Can “It” Happen Again? – Essays on instability and finance.” In fact, a crisis of major proportions, “it” happened again, a quarter century after that book, when Minsky had already died. Gerald Epstein refers to this reality as a “pro-cyclical system in its internal dynamics.”
The first “it” was a systemic crisis from 1929 to 1938. But despite having had its original epicenter in the financial downfalls on Wall Street in October 1929, in a second stage, the crisis saw its epicenter moving to Europe with the banking crisis that followed the bailout of the Austrian bank Creditanstalt, from Rothschild family.
It can’t be overstressed, that this second phase of the crisis would lead to the advance of totalitarianism in Europe and the outbreak of the Second World War. The historian Niall Ferguson and the economist Nouriel Roubini, recently mentioned that in Der Spiegel, while writing on the dangers of ignoring history.
Paul Krugman, in the book “End This Depression Now!” regrets that several economists – including himself – “have come relatively late to Minsky’s work that we should have read long before.”
The Shadow System
One of the leading actors of the second wave of financialization is the so-called shadow system – not even the official documents of the G20 summits put the expression in quotation marks anymore.
Some segments of financial capital accuse the shadow system as a de facto power, freewheel running, without control. The name comes from the English expression shadow banking system, which collects all entities, infrastructures and practices that occur outside the scope of regulation and supervision by public authorities. The shadow system include hedge funds (a concept invented in 1949 by a Fortune contributor), money market funds (the first was created in Brazil in 1968) and structured investment vehicles (SIVs, that emerged from the imagination of Citigroup bankers in London, in 1988 and 1989).
According to a 2011 Financial Stability Board (FSB) survey, cited by Brooke Masters in the Financial Times, the world’s largest economies would have a shadow sector in operation that would add to 60 trillion U.S. Dollars – matching 87% of world GDP that year. That accounted for over 25% of the entire global financial system, and half the size of traditional banks. In 2011, the U.S. had 46% of this “shadow”, while in 2007, it represented 54%. More recently Bloomberg published an article by Ben Moshinsky and Jim Brunsden, stating that the shadow system has grown to about 67 trillion USD. Only between 2002 and 2011, that system grew by 41 trillion. The amount given does not take into account the shadow system in China, which is not reflected in official statistics. In short, the shadow system has gone global. Bloomberg says in China alone, the value of shadow banking loans is estimated at roughly 1.3 trillion USD, according to research firm IHS Global Insight. The FSB was established by the G20 in April 2009, from the expansion of the previous Financial Stability Forum, founded by the G7.
And what is amazing is that today, after a fall in the height of the crisis, the volume of its operation is already higher than in 2007, during the height of the financial “bubble”, before the crash.
The FSB believes this shadow system represents a “systemic risk”, not just because of its own direct action, but as a result of the interconnections with the regulated financial system.
The rise of financial speculation in the middle of the crisis
One of the aspects of the amazing agility of financial capital is the rise of speculation amid a phase considered of Great Recession, as the one we live in.
Gerald Epstein and Pierre Habbard refer three vectors of this euphoria after the shock of the 2008 financial crisis, in a study on “speculation and sovereign debt – an insidious interaction.”
Despite the global economic slowdown, along the Great Depression on these past four years, several financial segments grew.
Transactions in the currency markets in April 2010 were 20% higher than in April 2007. This rate is lower than what was observed during the stage of euphoria between 2004 and 2007, which was close to 72%, but remained significant. “The post-crisis growth can not be explained by the behavior of international trade during this crisis period [2007-2010],” refer the authors. According to data from the World Economic Forum, world trade grew by 7.3% in 2007, the pace dropped to 2.8% in 2008, significantly broke in 2009, around 10.7%, and resumed in 2010, with 12.7% growth.
One of the new players, are the high frequency trading (HFT) platforms – which, in addition to the stock markets, after the financial crisis, started to operate in commodities markets.
Between 2007 and 2010, the average daily trading volume in the spot market by HFT players, almost doubled, surpassing in 2010 the dynamic between classic dealers, according to a study by Samual Nightingaile, Crystal Ossolinski and Andrew Zurewski, published in the quarterly newsletter of the Reserve Bank of Australia, in December 2010.
Most HFT firms are located in London.
The same divergence between real and speculative can be watched between assets and derivatives supposedly related to those assets. The total notional value of derivatives in the unregulated OTC markets (over-the-counter) went from 2.6 times the world GDP in 1998, to 9 times in 2008. In comparison, financial assets in equities, debt securities and bank assets, remained at a level of 1.5 times the world GDP, throughout the period from 1998 to 2010, covering the phase of the financial “bubble” prior to 2007.
According to data from the World Federation of Exchanges, which annually conducts a review, between 2006 and 2011, the number of derivatives contracts traded, more than doubled. More than 24 billion derivatives contracts were traded in 2011, up from 22 billion in 2010. Annual growth has slowed, but it remains significant (11%).
High frequency trading, mentioned above, became a leading player on speculation in all financial markets after the height of the crisis – the numbers speak volumes.
It was estimated that in 2010 HFT had 25% of the foreign exchange spot market, according to a study by Michael King and Dagfinn Rime, published by the Bank for International Settlements (BIS) in its quarterly magazine, in December 2010.
In equity markets, it is estimated that in 2012, HFT represents 70% of the trading in the U.S. (versus 3% in 2003, 21% in 2005 and 25% in 2009) and 39% in Europe (it was 21% in 2008 and 37% in 2011), according to TABB group.
The yoyo economy
The combination of global “financialization” with the decline of annual growth rate in developed countries and the sovereign over-indebtedness could generate a prolonged period of high volatility and the operation of rich economies as a yoyo.
The era of rapid growth in the developed world has ended long ago and the ideas that financing through sovereign debt or financial “bubbles” could bring back a golden age begin to be discredited, as the economist Raghuram Rajan points in his essay “The real lessons of the recession.”
Economic “expansions”, politically encouraged by financial speculation or by private or sovereign debt, have their days numbered. The economic model of developed countries is experiencing a stage of violent maladjustment.
And that would eventually have a devastating effect in the emerging and developing economies that depend on exports to rich countries and foreign direct investment, as Lakshman Achuthan, founder of the Economic Cycle Research Institute, has stressed. The contagion will be global, he warns.
In short, inadequacies that we were not used to.
Academic research also showed that a negative correlation between investment and financialization started to occur.
Dynamics of attaining financial rents progressively “dried” the willingness of banks and even companies for investment. There was a new crowding out – from the real economy to finance. An econometric study by Ozgur Orhangazi, from the Department of Economics at the Roosevelt University in Chicago, revealed this trend in the U.S. between 1973 and 2003. The rate of capital accumulation become lower, and the compensation was made by the rise of corporate indebtedness.
The race to the over-indebtedness by the financial system, companies and states didn’t generate positive effects. Studies by Thomas I. Palley, from the Levy Economics Institute, show that since 1979 there was an acceleration of indebtedness of the financial sector (an increase from 9.7% of GDP to 31.5% in the U.S. between 1979 and 2005). Moreover, since 1980, the stock market instead of being a net source of funding has become a financial drain.
One of the consequences of financialization, is that “the traditional business cycle was obscured by a secular growth of debt”, says Michael Hudson, professor at the University of Missouri and president of The Institute for the Study of Long-Term Economic Trends (ISLET). Debt became a snowball, prisoner of what the systems analysts call “positive feedback.” Fred Magdoff wrote on the U.S. magazine Monthly Review that the multiplier effect of public debt has fallen dramatically: for every dollar of additional debt the effect on GDP was 60 cents in 1970 and 20 cents in the early 2000s.
Over-indebtedness also increasingly causes negative effects on the cost of long-term credit.
A one percentage point increase in the ratio of public debt to GDP, on a developed country, when over the 50% threshold, has the multiplier effect of raising yields of long-term sovereign debt between 2.5 and 7 basis points, raising the cost of credit, according to a study of C. Emre Alper and Lorenzo Forni, from the International Monetary Fund, published in the June 2012 edition of the IMF Research Bulletin. That is, it has a detrimental domestic effect.
When sovereign debt is over the level of 70 to 80% of GDP, the rise of one percentage point in major economies (and in particular, in the U.S. case), adding to the domestic negative impact, it also affects emerging countries. The effect estimated by the IMF researchers on yields of long-term sovereign debt of emerging countries is an increase by 10 basis points. That is, there is a negative externality even higher than the negative domestic effect.
Since the 1930s, that “any finance book teaches that debt increases the risk,” reminds Kobrak and Wilkins. “However, finance texts also teach that there are different forms of debt, each with its specific and different risks, which can be evaluated in the context of “how” and “why”. And so, ink will continue to flow on academic writings on the subject.
The question of how far can sovereign debt go (in developed countries) was answered in general terms, by academics Carmen Reinhart and Kenneth Rogoff in their book This Time is Different, from a historical research on the relationship between debt and growth. The threshold of 90% of GDP was pointed and has been accepted as the red line from which sovereign debt creates negative impact.
However, assigning the cause of financial crisis to sovereign indebtedness is not seeing the forest for the trees. The process of sovereign over-indebtedness (and of other sectors of the economy) is a link of the ecosystem that consolidated with the second wave of financialization.
Another angle of the problem is even more critical – the relationship between the “financial depth”, the muscle of an economy in assets or access to credit that allows the creation of wealth and economic growth.
A study by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza, published by the IMF, for the period 1960 to 2010, showed that “too much” finance hampers growth. These researchers found that, above the ratio of 80 to 100% of private sector credit to GDP, the marginal effect of “too much” finance on growth is negative. The authors admit, however, that the negative effect results from speculative investments and mortgage loans, and not from credit for productive business activities.
In 2006, curiously, Portugal was in the batch of 17 countries that had a level of “too much finance” higher than 110% of GDP. Ten countries had a level above 150%. Showing the growing evolution of this aspect of financialization, the three authors report that in 1985 only three countries had a level of private sector credit higher than 100% of GDP – Singapore, Switzerland and Japan, in 1995 there were already 14, and in 2006 the number rose to 24 countries. Iceland was at the top of the list (over 250%), followed by the U.S. (almost 200%) and Canada (over 150%).
The authors use as an indicator of “financial depth” the private sector credit granted by all types of financial institutions. And underline the importance of assessing all generated credit and not just from banks. As noted above, from the 1990s, realities as the “shadow banking system” changed the game – in the U.S. case, for example, total credit to the private sector is five times higher than what is provided by traditional banks.
The disturbing thing that the Great Recession that began in 2007 revealed was the “unsustainability of the growth model that prevailed until then,” concludes Gerald Epstein.
And a return to Keynesianism and the “multiplier effect” of public spending, demonstrated by Richard Ferdinand Khan, through indebtedness, even if limited to times of emergency, seems to no longer produce the results of the past, in developed countries. Although, in reverse, one of the mistakes by IMF and forecasters seems to have been during this Great Recession the underestimation of the “fiscal multipliers” (the size of output loss owing to fiscal austerity), as Olivier Blanchard and Daniel Leigh referred in a “technical note” in the World Economic Outlook of october 2012. A major mistake pointed out by Ashoka Mody, a visiting professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs, Princeton University, and former ex-IMF and World Bank.
Khan, the favorite pupil of Keynes, published the proof in an article entitled suggestively “The Relation of Home Investment to Unemployment” in the Economic Journal (Vol. 41, No. 162). We were in 1931. Much water has flowed under the bridges, eventually under the Mathematical Bridge, the popular name of a wooden footbridge in the southwest of central Cambridge, England. But the reading of the article remains mandatory. Just 25 pages.
Translated and adapted by João Proença de Oliveira, LisWires.
Based on Chapter IV of “How the Financial Capital Conquered the World” by Jorge Nascimento Rodrigues.
The chapter may not be copied, reproduced or distributed other than for private purposes, without the written prior authorization of the author, at firstname.lastname@example.org
© JNR, 2012
PREVIEW OF THE BOOK
The capture of political power by financial capital
Behind the progressive decline of economic growth in developed countries, the reduction of the multiplier effect of sovereign debt, the fall in productive investment, and the transformation of the financial “shadow system” into a de facto power, lies a “rentier” economic model, in systematic rent-seeking.
This is the axis of the new book of Jorge Nascimento Rodrigues, “How financial capital conquered the World” | “Como o capital financeiro conquistou o Mundo”, here, in preview.
The new operating logic of economies in which financial capital has become hegemonic, starting in the nineteenth century, has made the capitalist system more unstable and led to several cyclical crises: the Great Depressions of 1890-93 and 1929-1938 and the current Great Recession, erupted in 2007, and that is still ongoing. These three global crises, associated to key moments in which the economic model struggled or is still struggling with tectonic imbalances that required or require economic players and policy makers to change strategy, were dubbed by some economists as “systemic”.
But, the capture of political power by financial capital and the fact that the “real” economy was caught by this financier logic in its management, especially from the late 1970s, makes the needed structural changes, to get out of this “systemic” crisis, more difficult to implement.
Behind the progressive decline of economic growth in developed countries, the reduction of the multiplier effect of sovereign debt (nullifying the kindness of Keynesianism), the fall in productive investment, the euphoria with what can generate financial rents, and the transformation of the financial “shadow system” into a de facto power, are not just “market failures” or “lack of transparency.” Underpinning these “imperfections”, as shocking as they are today, there is the “visible hand” of a “rentier” economic model, in systematic rent-seeking (from the French word rentier). A model characterized by a cyclical pattern that causes large-scale crises, as Hyman Minsky and Charles Kindleberger began to explain in the 1970s.
The financialization waves
# The first wave of financialization, that began in the nineteenth century eventually ended to reduce the importance of the role of the captains of the Industrial Revolution and the geniuses of the nascent revolution in business management catapulting into the spotlight the barons of high finance, which Stendhal called “nobility of the bourgeoisie.” The balance of this wave of financialization is tainted by the first global crises of capitalism, between 1825 and 1938, in over a hundred years.
# The second wave of financialization, started in the last decades of the twentieth century, eventually “engulfed” the rise of the “knowledge workers” and the revolution of entrepreneurship, and subdued the “knowledge society” of Peter Drucker. This wave became marked, since the 1980s, by several sovereign debt crises, in various parts of the world, the crash of the technology-based companies’ “bubble” in 2000, and finally the current great crisis, that we are living since 2007. A Great Recession, to the annals of history, triggered by the subprime.
The problem is not lack of theoretical knowledge of the mechanisms that generates the financial crises of capitalism, or even lack of historical memory.
Financial innovation, the ancient resilience of financial capital, its Darwinian adaptation ability, its enormous agility to exploit windows of opportunity, even amid the financial crises and among the Achilles’ heels of politics, are all part of the rent-seeking model. It is not an “imperfection” of the market that could be reshaped by ethics talk, nor lessons of history or economic theory. It is a model of capitalism and power.
It is therefore a problem of the political sphere, as it was well understood by the U.S. president Franklin Roosevelt, once he took office, in March 1933. Roosevelt rapidly adopted the conclusions of the Commission led by the fearful Ferdinand Pecora and produced a wave of legislation that would delimit the role of finance for nearly half a century. Prophetically, Pecora, in his memoirs, “Wall Street under Oath”, wrote: “It cannot be doubted that, given a suitable opportunity, they would spring back into pernicious activity”.
Investigating history, allows to sharpen the memory, without being a warranty seal not to fall into the traps of the present. As stated by Christopher Kobrak and Mira Wilkins, in “The 2008 Crisis in an Economic history perspective,” published in the magazine Business History, “one of the most enduring lessons, is that despair or euphoria, based on historical analogies, are as common as dangerous”.
But it is better to have memory, than to ignore history. There is always repetition of patterns. But there is also, originality and innovation in every age. These are traits present in the whole picture of financial revolutions, seen as a long process, more than ancient. The patterns are the search for financial rents, and the cycles. The originality is the multitude of innovations over the centuries and how and when crises break out.
“How financial capital conquered the World” | The book
“How financial capital conquered the World” has two goals.
On the one hand, to project a short picture on the ancient history of the birth and expansion of finance capital, through the revolutions that led, from the late eighth century, a story filled with surprising innovations. The financial capital is one of the most extraordinary human inventions, and a vector of the economy and society with remarkable adaptability, agility, innovation, change, transformation and mobility.
This book is not a brief history of money, or banks, or sovereign monetary policy. It is the history of the main chapters of the strategic projection of this segment of capitalism.
On the other hand, to highlight that financialization is the biggest structural change in capitalism over the past two centuries. Understanding this phenomenon is now crucial.
In this book we opted to break with the three variants of ‘traditional’ historical narrative on the evolution of finance capital.
The first narrative ignores the role of China and medieval Islam, erasing five centuries of history, finding finance only in thirteenth century, in the Italian Republics or in the German financial houses.
The second narrative, obliterates the fundamental role of the globalization initiated by the Portuguese and their contribution to satisfy the “hunger for gold” in Europe.
The third narrative, ignores that financialization is an almost bicentennial phenomenon, based on financial innovation and the progressive capture of the political power by the finance capital. The common idea, is that financialization is a recent phenomenon, which resulted from neoliberalism.
The book covers five financial revolutions since the ninth century:
# the first centered on Islam and China of the Sung dynasty;
#the second in the Italian Republics and Flanders, and with crucial contribution of the Portuguese Discoveries;
# the third in Holland and England;
# the fourth covering the first wave of financialization since the nineteenth century;
# and the fifth since 1971, covering the second wave of financialization still ongoing.
As background, this book is based on the historical evolution of globalization drawn in the work of “Portugal, Pioneer of Globalization”:
# a proto-globalization phase with the external projection of the Chinese from the Ming dynasty and with the Italian Maritime Republics;
# a first wave of globalization, which extends from the Portuguese network empire, that came out of the Discoveries of the fifteenth and sixteenth centuries, to the modern imperialism started in the nineteenth century;
# and a second wave of globalization, recent, in which great powers are emerging with new strategies for global projection, after the capitalist revolution in China, the implosion of the Soviet Union and the radical transformation of the former Third World.
This second wave of globalization is beginning to make its own mark in the second wave of financialization and the outcome is still unclear.
Despite the umbilical relationship between financialization and globalization, between the modern financial capital and the projection of the great powers, since the nineteenth century, this book does not include the evolution of modern hegemony. That is another story, which begins with modern imperialism, then passes through “imperialism based on debt” and deals today with the rising phenomenon of external projections and the new financial capital connected to the large emerging economies.
Jorge Nascimento Rodrigues
Translated and adapted by João Proença Oliveira