economic strategy. In September 2009, Turkey announced that it will implement a series of policies that will turn itself into (yet another) financial hub of the Middle East. Even the government of Korea, a traditional manufacturing powerhouse, is implementing policies aimed at turning itself into the financial hub of Northeast Asia, although its enthusiasm has been dented since the collapse of Ireland and Dubai, after which it was hoping to model the country.
Now, the real trouble is that what countries like Iceland and Ireland were implementing were only more extreme forms of the economic strategy being pursued by many countries – a growth strategy based on financial deregulation, first adopted by the US and the UK in the early 1980s. The UK put its financial deregulation programme into a higher gear in the late 1980s, with the so-called ‘Big Bang’ deregulation and since then has prided itself on ‘light-touch’ regulation. The US matched it by abolishing the 1933 Glass-Steagall Act in 1999, thereby tearing down the wall between investment banking and commercial banking, which had defined the US financial industry since the Great Depression. Many other countries followed suit.
What was encouraging more and more countries to adopt a growth strategy based on deregulated finance was the fact that in such a system it is easier to make money in financial activities than through other economic activities – or so it seemed until the 2008 crisis. A study by two French economists, Gerard Dumenil and Dominique Levy – one of the few studies separately estimating the profit rate of the financial sector and that of the non- financial sector – shows that the former has been much higher than the latter in the US and in France during the last two or three decades.[2] According to this study, in the US the rate of profit for financial firms was lower than that of the non-financial firms between the mid 1960s and the late 1970s. But, following financial deregulation in the early 1980s, the profit rate of financial firms has been on a rising trend, and ranged between 4 per cent and 12 per cent. Since the 1980s, it has always been significantly higher than that of non-financial firms, which ranged between 2 per cent and 5 per cent. In France, the profit rate of financial corporations was
In the US, the financial sector became so attractive that even many manufacturing companies have turned themselves essentially into finance companies. Jim Crotty, the distinguished American economist, has calculated that the ratio of financial assets to non-financial assets owned by non-financial corporations in the US rose from around 0.4 in the 1970s to nearly 1 in the early 2000s.[3] Even companies such as GE, GM and Ford – once the symbols of American manufacturing prowess – have been ‘financialized’ through a continuous expansion of their financial arms, coupled with the decline of their core manufacturing activities. By the early twenty-first century, these manufacturing firms were making most of their profits through financial activities, rather than their core manufacturing businesses (
The result of all this was an extraordinary growth in the financial sector across the world, especially in the rich countries. The growth was not simply in absolute terms. The more significant point is that the financial sector has grown much faster – no, much, much faster – than the underlying economy.
According to a calculation based on IMF data by Gabriel Palma, my colleague at Cambridge and a leading authority on financial crises, the ratio of the stock of financial assets to world output rose from 1.2 to 4.4 between 1980 and 2007.[5] The relative size of the financial sector was even greater in many rich countries. According to his calculation, the ratio of financial assets to GDP in the UK reached 700 per cent in 2007. France, which often styles itself as a counterpoint to Anglo-American finance capitalism, has not lagged far behind the UK in this respect – the ratio of its financial assets to GDP is only marginally lower than that of the UK. In the study cited above, Crotty, using American government data, calculates that the ratio of financial assets to GDP in the US fluctuated between 400 and 500 per cent between the 1950s and the 1970s, but started shooting up from the early 1980s with financial deregulation, to break through the 900 per cent mark by the early 2000s.
This meant that more and more financial claims were being created for each underlying real asset and economic activity. The creation of financial derivatives in the housing market, which was one of the main causes of the 2008 crisis, illustrates this point very well.
In the old days, when someone borrowed money from a bank and bought a house, the lending bank used to own the resulting financial product (mortgage) and that was that. However, financial innovations created mortgage-backed securities (MBSs), which bundle together up to several thousand mortgages. In turn, these MBSs, sometimes as many as 150 of them, were packed into a collateralized debt obligation (CDO). Then CDOs-squared were created by using other CDOs as collateral. And then CDOs-cubed were created by combining CDOs and CDOs-squared. Even higher-powered CDOs were created. Credit default swaps (CDSs) were created to protect you from default on the CDOs. And there are many more financial derivatives that make up the alphabet soup that is modern finance.
By now even I am getting confused (and, as it turns out, so were the people dealing with them), but the point is that the same underlying assets (that is, the houses that were in the original mortgages) and economic activities (the income-earning activities of those mortgage-holders) were being used again and again to ‘derive’ new assets. But, whatever you do in terms of financial alchemy, whether these assets deliver the expected returns depends ultimately on whether those hundreds of thousands of workers and small-scale business-owners who hold the original mortgages fall behind their mortgage payments or not.
The result was an increasingly tall structure of financial assets teetering on the same foundation of real assets (of course, the base itself was growing, in part fuelled by this activity, but let us abstract from that for the moment, since what matters here is that the size of the superstructure relative to the base was growing). If you make an existing building taller without widening the base, you increase the chance of it toppling over. It is actually a lot worse than that. As the degree of ‘derivation’ – or the distance from the underlying assets – increases, it becomes harder and harder to price the asset accurately. So, you are not only adding floors to an existing building without broadening its base, but you are using materials of increasingly uncertain quality for the higher floors. No wonder Warren Buffet, the American financier known for his down-to-earth approach to investment, called financial derivatives ‘weapons of financial mass destruction’ – well before the 2008 crisis proved their destructiveness.
All my criticisms so far about the overdevelopment of the financial sector in the last two or three decades are
However, the fact that financial development has been crucial in developing capitalism does not mean that all forms of financial development are good.
What makes financial capital necessary for economic development but potentially counterproductive or even destructive is the fact that it is much more liquid than industrial capital. Suppose that you are a factory owner who suddenly needs money to buy raw materials or machines to fulfil unexpected extra orders. Suppose also that you have already invested everything you have in building the factory and buying the machines and the inputs needed, for the initial orders. You will be grateful that there are banks that are willing to lend you the money (using your factory as collateral) in the knowledge that you will be able to generate extra income with those new inputs. Or suppose that you want to sell half of your factory (say, to start another line of business), but that no one will buy half a building and half a production line. In this case, you will be relieved to know that you can issue shares and sell half your shares. In other words, the financial sector helps companies to expand and diversify through its ability to turn illiquid assets such as buildings and machines into liquid assets such as loans and shares.
However, the very liquidity of financial assets makes them potentially negative for the rest of the economy. Building a factory takes at least months, if not years, while accumulating the technological and organizational know-how needed to build a world-class company takes decades. In contrast, financial assets can be moved around
