Commentary

The Economy’s Greatest Illness: The Rise of Unproductive Finance

How financial markets no longer support business, and thus, economic growth

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By Rana Foroohar

Markets typically react more to economic fundamentals than politics. But these are not typical times, and our economic future is deeply entangled with the political economy.

Donald Trump’s presidential victory fundamentally challenges the future of globalization and status quo capitalism. Indeed, the fact that Trump grabbed an unexpected share of minority vote, as well as some college educated women, speaks to the fact that economic anxiety is about more than just income levels. It’s about the fact that a large percentage of the population feels that we have a rigged economic system that disproportionately benefits the US and global elite. Nevermind that Trump is one of those elites. He ran as a challenger to Hillary Clinton, the ultimate establishment political figure and sold the electorate on the idea that he was the face of change.

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How did we get here? Despite the economic progress made since 2008, our current recovery has been the longest, slowest one of the post World War II era, and the level of inequality is as high as it has been since the Gilded Era. The key reason is something that neither candidate in the 2016 cycle addressed fully – the fact that the financial markets themselves are no longer supporting business, and thus, economic growth.

Why is this? Because the financial industry has, according to a large body of data, grown too large and too far removed from its original mission of investing in new, productive ventures. This illness has a name: academics call it financialization. It’s a term for the trend by which Wall Street and its way of thinking have come to reign supreme in America, permeating not just Wall Street but all American business.

It includes the growth in size and scope of finance and financial activity in our economy (which has doubled since the 1970s), to the rise of debt-fueled speculation over productive lending, to the ascendancy of shareholder value as the sole model for corporate governance (and the short term pressure that puts on companies), to the enormous political power of the financial lobby. It’s a shift that has even affected our language, our civic life, and our way of relating to one another. We speak about human or social “capital” and securitize everything from education to critical infrastructure to prison terms, a mark of our burgeoning “portfolio society.”

This isn’t the way it was supposed to be. Market capitalism, as envisioned by Adam Smith, was supposed to funnel our collective savings into productive investment, via the banking system. But today, deep academic research shows that only around 15% of the money flowing from financial institutions actually makes its way into business investment. The rest gets moved around a closed financial loop, via the buying and selling of existing assets, like real estate, stocks, and bonds.

It’s a cycle that increases inequality, since the top quarter of the population owns the vast majority of those assets (witness the disconnect between the markets and Main Street, which has fueled much of the populist sentiment in the election cycle).

The financial sector — including everything from banks, to hedge funds to mutual funds to insurance to trading houses — represents around 7% of the economy. Yet it creates only 4% of all US jobs, and takes 25% of all private sector profits. While a healthy financial system is crucial for growth, research by numerous academics as well as institutions like the Bank of International Settlements and the International Monetary Fund shows that when finance gets that big, it starts to suck the economic air out of the room – and in fact, the slower growth effect starts happening when the sector is half the size it is today in the US.

It’s crucial that we tackle this issue to ensure not only more sustainable growth, but more stable politics. A recent Harvard survey found that only 19 % of millenials, now the largest voting bloc in the country, consider themselves “capitalists.” Ironically, our next president—an investor known for highly leveraged real estate deals — has been one of the biggest beneficiaries of our financialized system.

Yet if the next administration doesn’t take serious steps to reconnect the markets to Main Street, we will find ourselves in the same slow growth economy in four years. Only this time, the politics will be even more extreme—and there may be new outsiders to challenge the status quo.

Originally published here.

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2016 November 15


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  • DaveHolden

    The elites are in a panic. Not over Trump but because of what the Trump victory symbolizes and the support behind it. In the 90’s the elites tried to plug in their globalism and were met with resistance from the militia. Most of this was kept out of the media and then they retreated and bided their time while never relenting on smearing normal Americans that they view as the enemy. They thought they had another shot at it and nearly won but normal Americans rallied again. Since last time we were able to fight back using many of the tools that used to be restricted to the media only. It really *is* an info war…

  • rolf5

    thank you for article. but i do not follow the paragraph:
    “The financial sector — including everything from banks, to hedge funds to mutual funds to insurance to trading houses — represents around 7% of the economy. Yet it creates only 4% of all US jobs, and takes 25% of all private sector profits. While a healthy financial system is crucial for growth, research by numerous academics as well as institutions like the Bank of International Settlements and the International Monetary Fund shows that when finance gets that big, it starts to suck the economic air out of the room – and in fact, the slower growth effect starts happening when the sector is half the size it is today in the US.”

    please clarify:
    1. so, our securitize Financialized “portfolio society” is due to Financial sector (FS), but FS is only 7% of our economy?
    2. FS creates only 4% of US jobs, so does not give jobs really & still sucks 25% of profits.
    3. healthy FS = growth. yet if too big, sucks at sharing profits. so why, if it is better not to grow too much, and one should want 1/2 its size, is it equally slow for growth market as when it is too big?

    thanks

    • Moslerfan

      See comment above on finance as an overhead expense to the productive part of the economy (finance produces no real goods and services). In this case, overhead is eating too much of the profits.

      Think also about the point made in the article about 15% of the profits (interest) from financialization going back into investment. If the interest paid to finance was either invested or spent on consumption, no problem. But it’s not, most of it (85%?) is plowed back into creating new debt. This creates exponential growth of debt. Exponential at a slow rate, but exponential nonetheless, and exponential growth is never sustainable long term. So we get a crashes, where asset values collapse but debt remains, as what happened in 2008 when people found themselves owning $200,000 house and a $400,000 mortgage. Finance picks up the assets in foreclosure, and consumption suffers while consumers try to work out from under debt. Then we rinse and repeat, and debt ratchets ever upward.

      • rolf5

        wow. thanks so much for your patience, time & explanation. this is how we grow, through learning, understanding, spreading truth & clarity and not just to the few but laymen. appreciate your help! ; ) what is your work background?

  • GaryReber

    The core problem preventing strong economic growth is the reliance on the slavery of savings. The false reality is that past savings are required to finance growth – thus, those who have savings (in the form of assets) can directly invest their savings or use their savings as collateral (something pledged as security for repayment a loan, to be forfeited in the event of a default) to secure capital credit to invest in new capital asset formation. The so-called 1 percent wealthy ownership class are the ONLY ones, in the present monetary system, that can qualify to invest in our economic future. The wealthy ownership class have benefited from (1) earning high incomes well beyond what they need to satisfy their family’s needs or (2) inheritance, in which their parents left them valuable assets, such as a home or business, or stocks, etc, the value of which they could use to invest in future capital asset growth of the economy or to gamble in the securities markets hoping the value of secondary stocks (previously owned) will increase.

    But the real key to growing the economy and creating new owners of new income-producing wealth is the democratization of access to productive capital credit. The Capital Homestead Act would employ the Fed’s existing powers under Section 13 of the Federal Reserve Act and make the Fed’s money power accessible directly to every American.

    By reorganizing the Federal Reserve System and its twelve regional banks into a “fourth branch of government,” every citizen can become a shareholder of this basic institution of money creation. Why “End the Fed,” as some are calling for, when we as citizens should “Own the Fed”?

    No longer should the Federal Reserve and our tax system merely serve the special interests of a financial elite or become the tool of the Federal government for financing war and deficit spending. “We the People” must be empowered to hold the Fed accountable and to return it to its true social purpose. With changes in our tax and monetary policies, as embodied in the comprehensive economic plan called “the Capital Homestead Act,” we could create sound, asset-backed money for sustainable private sector growth, and liberate every child, woman and man as a direct owner of new productive wealth.

    Below is a scenario that will accomplish broadened ownership of productive capital simultaneously with the growth of the economy.

    The common belief is that you can’t get money for investment––to buy capital (productive assets)––except by saving it yourself or borrowing it or just taking it away from somebody who has managed to save, is true. But this belief has a critical error, it assumes that the only way to save is to cut consumption and accumulate cash. And this therefore is what Louis Kelso and Mortimer Adler called “the slavery of past savings,” which was written about in the book “The New Capitalist.”

    Beyond conventional thinking there is another way: Let the capital pay for itself out of its “own” future earnings. Anybody can “create money” by promising to pay for something he or she receives now or in the future and having the promise accepted. It’s called “credit.” When it’s used to purchase food, clothing and shelter (consumer goods) now and pay later, it’s called “consumer credit,” and it’s pretty much the worst form of credit possible. When it’s used to purchase productive capital that pays for itself out of future earnings, it’s called “capital credit,” and can be the very best form of credit––and of creating money and help finance future growth, which this economy sorely needs.

    This is called “future savings.” Instead of reducing consumption in the past or now to finance new capital, increase future production from new capital that you’ve promised to pay for, out of future profits. You don’t save to save now, produce later. You can produce now, and save later. In other words, get “capital credit” now. Credit is nothing more than a promise to repay a loan out of future profits. You can use the promise itself as money to buy capital, then use what the capital produces to repay the loan. It’s a lot easier and faster than saving now and then producing later, and is much broader and larger in scale. It is the same basic architectural model of financing used by every 100 percent leveraged Employee Stock Ownership Plan (ESOP).

    Here is how, it could work. You would get a notice in the mail from the federal government that the Congress passed the Capital Homestead Act of 201_. A government survey of the capital growth needs of the economy has been determined that in the coming year, new and existing small and large “for-profit” companies want to sell $2.31 trillion (with a capital ‘T’) worth of newly-issued, full dividend payout, full voting shares to meet their growth and modernization needs in response to the demands of their U.S. and global customers. The Act gives all financially sound companies a way to invest in new capital and create new jobs to meet new customer demand for new and better products and services and even begin to construct and modernize new infrastructure through citizen-owned for-profit corporations. The obvious keywords, is new and citizen owned.

    The notice informs you that, as a new right of citizenship under the Act, like the political ballot, you have the right, if you choose, to receive a free government-issued Capital Credit Card that for the coming year will entitle you to receive free of charge capital credit to purchase $7,000 worth of the newly-issued shares of “qualified” companies with interest-free “new money.” The Capital Credit Card isn’t money, but it allows you to get productive credit, another form of money, to buy capital (productive assets) that can pay for itself.

    You will not be at risk if the loan cannot be paid off, because the loan will be insured by one of several “qualified” private capital credit insurance companies and/or reinsured by a for-profit Capital Credit Reinsurance Company established by many capital credit insurers, and not government insurance. Your loan is to be entirely backed by the anticipated profits in the form of dividends on each of the “qualified” shares that you, with your advisors, decide you wish to buy, with added backup from the capital insurance pool if the shares fail to earn a dividend. After the Capital Credit loan on each of the shares is repaid, you will receive outright all future dividends directly as “supplemental income” over and above income received from your work (job) and all other sources.

    The notice would also inform you (and your family members) that you should go down to your local commercial bank that is a member of the Federal Reserve System to set up in your own name a “Capital Homestead Account” (CHA). Like an Individual Retirement Account or “Super-IRA,” a CHA would be a “tax-shelter” for you to build up a growing accumulation of income-producing investments to meet your future consumption needs. Your CHA is designed to distribute dividend incomes during your working career as well as when you retire or become disabled.

    Your Capital Credit Card would authorize your CHA “tax shelter” to be the legal vehicle for receiving each year’s loan to purchase “qualified” shares that you want to buy from the market––and would allow you to defer taxes on the income used to purchase the shares until you take the assets out of the CHA or die––at which point the assets become income to your heirs, not to the estate. The heirs, not the estate, pays taxes, unless the heirs put the assets into their own CHAs, in which case taxes are again deferred.

    Each annual loan for buying additional shares would take the form of a promissory note backed with a “bill of exchange” that you “draw” or “issue.” Your bill (which, like any bill, has to be paid) is backed in turn by the full stream of future profits paid out to your CHA. These anticipated (but obviously uncertain) future profits would in turn be backed by the “future savings.” These future savings take the form of the future capital products and future consumer products and services that the company issuing the new shares expects to produce with the money the companies receive from the sale of shares to your CHA.

    The local commercial bank “discounts” your bill of exchange (gives you less than the face value of the bill), issuing a promissory note in return. The discount covers the cost of the bank’s own services and the risk premiums to be paid out of future dividends expected on the shares purchased by your CHA. Each bank’s promissory note is thus a form of asset-backed (non-fractional) “money” over and above money issued by the government in the form of coins and official currency. Bills of exchange discounted by member banks of the Fed can be rediscounted in the financial markets or directly at the (re)discount window of the regional Federal Reserve Bank to be backed by the Fed’s promissory notes: newly-issued currency or Fed demand deposit accounts under Section 13, paragraph 2 of the Federal Reserve Act. In other words, “money” is anything that can be used in settlement of a debt, and new capital credit can be created in ways that it can be repaid entirely with “future savings,” making it possible for today’s propertyless to own future productive capital. Maybe your entire family could open their Capital Homestead Accounts at the same time.

    And that is how we will finance the future and help pay down the national debt.

    Help Pass Capital Homesteading Now! Support the Capital Homestead Act (aka Economic Democracy Act) at http://www.cesj.org/learn/capital-homesteading/, http://www.cesj.org/…/capital-homestead-act-a-plan-for…/,http://www.cesj.org/…/capital-homestead-act-summary/ andhttp://www.cesj.org/learn/capital-homesteading/ch-vehicles/.

    • progrock

      This is what we need. A green back. Take credit creation away from the banks.

      I’d also like to see land value tax to discourage speculation on a finite resource.

  • Moslerfan

    Finance is properly seen as an overhead expense to the real economy (that is, the economy that produces real goods and services). As any businessman knows, overhead is necessary but must be minimized because it cuts into profit. Profit in this case being the goods and services produced by the real economy.

    One of the greatest tricks the financial industry has played on us is to convince people, perhaps Congress in particular, that it is part of the real economy. It isn’t. Of course, it did that the old fashioned way – campaign contribution bribery.

    • progrock

      Exactly, if finance is so efficient why is it so big? Banks own the largest buildings, the lobbies are like church cathedrals, banking is the new religion.

  • progrock

    Good article, but with one big problem.

    > Despite the economic progress made since 2008, our current recovery has been the longest, slowest one of the post World War II era

    Here you talk about the “recovery” which I think you mean “GDP”. We need to change how we talk about “growth”. The deflator doesn’t reflect land prices. Banks create money via loans on land, primarily. Therefore any reference to inflation adjusted GDP is overstating growth.

    You are using the banker lexicon and you will not win the debate until you redefine the axioms.