When future economic (and regular) historians will look back over the past century of financial crashes and panics, one wonders what they will conclude. They may argue that we sowed the seeds of our own fiscal and financial destruction. If so, they will certainly be correct. We must ask ourselves why this keeps happening. Supposedly, humanity figured out a long time ago how economies work and run. Yet financial bubbles, panics, manias, and crises have become more common, not less. One factor that figures prominently in mainstream and academic discussions of manias and panics is financialisation. This amounts to the “crowding out” of the productive economy by the financial sector, to the point where actual productive investment no longer takes place. In this article, I explore why financialisation damages markets and destroys value. And I come to a perhaps unusual conclusion about the roots of financialisation.

Defining Terms

In order to understand why financialisation is so destructive, we must first understand what it is. Unfortunately this is not straightforward because nobody can really define it strictly. Even so, we must look for a reasonable approximation that might get us somewhere.

Paul Wilmott‘s definition of it will suffice:

A widely commended definition of financialization is offered by Epstein (2005: 3): ‘… financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of domestic and international economies’. The present analysis is consistent with this formulation as it gives as much attention to ‘financial motives’ and ‘financial markets’ as it does to financial institutions. A rather narrower conception of financialization focuses upon the growing dominance of financial institutions in the global economy; and a wider definition extends beyond ‘economies’ to everyday life (Martin, 2002). Of course, financialization is not new and, arguably, is a potential inherent to capitalist accumulation (see Kindleberger and Aliber, 2005). In the post-1970s era of neo-liberal deregulation, financialization—in the sense advancing a ‘pattern of accumulation in which profit-making occurs increasingly through financial channels rather than through trade and commodity production’ (Krippner 2004: 14)— became an increasingly important driver of growth. [Emphasis mine]

— Wilmott 2010: 519

(For those outside of the finance industry who don’t know who Paul Wilmott is, he wrote what most quants consider to be THE Bible of derivatives pricing – in 3 volumes.)

For my purposes, I will stick to the second, simplified definition. Basically, financialisation means that the bit of the economy that “trades stuff” crowds out the bit that “makes stuff”.

Bearing in mind that this is literally below Macroeconomics 101… what does that look like?

Signs of a Financialised Economy

The following graphs are very good indicators of an economy that grows based on pushing around pieces of paper instead of making things.

The first graph is from Deloitte Insights and breaks down the contribution by sector to US GDP within the economy:

The second graph is from the ever-useful FRED, the St. Louis Fed’s Federal Reserve Economic Database. It charts the historical contributions of all private- and public-sector industries to economic growth and output, as measured by GDP:

It’s a little hard to see. But there is no mistaking the fact that, since 2015, the single biggest contributor to US GDP has unquestionably been the financial sector.

Even more tellingly – look at the output levels of construction, manufacturing, and utilities. They simply cannot compare with the contribution of the US financial sector.

Here is employment by sector within the US economy in 2019, taken from Statista:

Well now, ain’t that interesting… According to the US Bureau of Labour Statistics – yes, my American friends, that is the CORRECT spelling – the total US labour force in 2019 was about 163.54 million people. Therefore, based on the above data, the financial sector employed 6.6% of the total US labour force.

Yet, in 2019, the financial sector accounted for about 21% of GDP.

We now have a fairly decent broad idea of what a financialised economy looks like:

• Disproportionate share of GDP generated by the financial sector;
• Significant and sustained decreases in output of other industries, especially those producing “real things”, compared to financial sector;
• Excessive influence of one particular sector upon employment and output of the entire economy;

But these are nothing more than symptoms. What are the actual real-world consequences of financialisation?

Differential Diagnostics

The literature on financialisation is fairly wide-ranging. This problem has been under examination for decades and the issue has come under increased scrutiny ever since the Great Crash of 2008. If I may grossly oversimplify things, here is a BY NO MEANS exhaustive or rigourous list of negative consequences of financialisation:

1. Vastly increased power wielded by financial firms

This is pretty self-explanatory; when 6.6% of employees generate 21% of GDP in ANY country, that sector wields ENORMOUS power. And these days, financial firms, whether they be investment banks, hedge funds, institutional investors, or whatever, use that power for their own ends. This is inevitable. That in turn leads to…

2. Tremendous pressure on public companies to meet market expectations

That power in turn influences other industries. In an era of cheap money – keep that in mind, it’s important – and significant deregulation, financial firms can raise funds quickly and easily in public markets. They can then deploy those funds to buy out companies that they believe are not returning value to shareholders. This results in…

3. Explosive growth of LBOs

Like so many things, the leveraged buy-out (probably) started out as a more-or-less good idea. The basic theory came down to private equity firms raising capital to buy out an underperforming firm and unlocking that firm’s capital on the balance sheet. This would then be returned to shareholders, either directly through dividends or indirectly by stripping the firm of productive assets and turning it around with new management.

Did it work? Well… at best, the jury is still out on that one. But they also tend to push firms to…

4. Prioritise share price growth over everything else

A firm that does not meet market expectations can easily fall prey to the attentions of private equity firms looking to unlock value. This pushes managers to seek out short-term growth strategies to boost share prices. I do not argue that the stick of an LBO is the sole motivator, though, because market pressures to push the share price up also result in…

5. Outsize rewards for mediocre performance

It is no secret that CEO compensation has grown at fairly astonishing levels in many industries, especially when compared with the wages of the average worker. The typical justification offered by industry analysts is that this is necessary to attract top talent. I take no position on this argument, other than to point out that the growth of CEO pay has not led to commensurate performance. As a result of this focus on paying top executives, though, managers often use techniques such as…

6. Heavy use of debt issuance to cover share buybacks and boost RoE

A standard technique to boost a company’s share price is as follows. The company takes advantage of extremely low benchmark yields to issue cheap debt. It then uses that debt to buy back its own shares. This boosts its share price and significantly boosts its Return on Equity (RoE). Managers look good in front of shareholders as a result. This has become commonplace over the past 20 years. Apple, for instance, has spent an estimated $284 BILLION buying back its own shares over the past 10 years. Yet Apple’s cash pile sits at close to $90 billion.

This is common practice nowadays – “all the cool kids are doing it“. But the results are often unhealthy in the long run, because it results in…

7. Ruthlessness with respect to employees

Can anyone remember an era of real job security anymore? No? That’s because it doesn’t really exist. These days, layoffs and “restructurings” are common news. (I know. I’ve been through three of them.). Outsourcing is a common tactic used by firms to boost the bottom line, but it causes endless headaches and morale problems for the employees left standing. Firms cut back on R&D spending and critical long-term capital expenditures in favour of short-term measures to boost share prices. The result damages America’s (and any financialised economy’s) long-term growth potential.

To Know the Cause of Things

All in all, that is a laundry list of terrible, horrible, no good, very bad, dreadful, awful, nasty, brutish outcomes.

But we still have no clue what causes it all.

And, in all honesty, neither do most academics or practitioners, either. We still don’t know why financialisation really happened.

Left-leaning economists blame deregulation under Presidents Reagan and both Bushes – but this is insufficient. President Reagan’s deregulation drive actually started under President Carter. Deregulation of the financial industry continued under President Clinton too.

Right-leaning economists blame outsourcing and the cannibalisation of American industry by management. Perhaps that is true. But this begs the question – what caused those things?

The answer lies outside the realm of orthodox economic theory, within the Austrian Business Cycle Theory.

It is beyond my capabilities to explain this in detail – entire books have been written on the subject. The original idea came from The Theory of Money and Credit by Ludwig von Mises – and he developed it from ideas derived from Carl Menger and Eugen von Bohm-Bawerk.

Here is a simple explanation of the theory in two videos:

So essentially, the theory argues that everything we see today can be explained by derangement, in the medical sense of the term, of money.

Money to Burn

Once you see things through this lens, suddenly everything makes far more sense. Systemic panics and crises have a clear cause in this framework. And the incentives of managers and directors that cause financialisation suddenly make perfect sense too.

Consider: if vast amounts of money are being pumped into the markets, this causes asset prices to rise artificially. But Austrian economic theory, alongside Gresham’s Law, teaches very clearly that these gains are NEVER equally distributed. They always go first to the biggest and most influential players – the ones closest to the money spigots.

That in turn sends signals to other market players as to whom to emulate. This creates an artificial aura of success around firms, and managers, whose outperformance is not necessarily attributable to skill or talent. It is instead attributable to the piles of money flushing their balance sheets, injected exogeneously by the monetary system.

Do we have any evidence that these injections happen?

Well… here is a graph showing the year-on-year change in the market value of the S&P 500, compared with the aggregate money supply in the USA:

The correlation isn’t perfect, but if you click on the link to the original article, you will see a very good explanation for how endless money printing is driving nosebleed stock market valuations. And the same phenomenon also pushes financialisation throughout the economy.

We Have Seen the Enemy, and it is Us

Much of the argument against financialisation focuses on the actions of managers. Those actions are pretty clear. Companies and managers deprecate long-term strategic investments in favour of short-term measures that boost stock returns. Employee morale suffers and quality of output declines.

But “blaming” managers is irresponsible and incorrect. The fact is, we are ALL to blame.

All of us who own shares in corporations are guilty of promoting financialisation in some way or another. I certainly am guilty of this myself. I own shares in a number of companies. As a shareholder, I want my investments to perform well – that is why I gave those companies my money.

That principle also drives the decisions of large institutional investors, who can buy up significant stakes in given companies. Imagine a single investor’s desire to see an investment perform well. Now multiply his few hundred or thousand shares up to MILLIONS or even BILLIONS of shares. And then you will see that this sentiment produces a push from institutional investors on corporate managers to get results.

Market discipline is, in most cases, a very Good Thing. But paying too much attention on what the market wants in the short term is a very Bad Thing.

Conclusions

Financialisation is a huge topic of study these days and it is not possible to summarise the entire argument quickly or easy. But the academic and practical consensus is clear. Financialisation causes cannibalisation of the productive parts of the economy.

The causes of financialisation are hotly debated within academia and practical circles. But most of those debates don’t really have a clear root cause behind all of the problems of financialisation. Some theories focus on regulatory solutions. Others focus on executive compensation. Still others focus on globalisation and its negative consequences.

But none of them really strike at the heart of the matter. The clearest and most intuitive root cause is the derangement of the money supply by central banks and monetary authorities.

The chaos caused by excessive money printing simply cannot be overstated. Most financial panics and crashes can be traced right back to, basically, too much money chasing too little stuff. This misalignment of incentives and time preferences causes people to chase ever-higher returns for their money. This in turn puts pressure on regulators, managers, and institutional actors in an economy to chase yield and return.

This can only end in one way:

Collapse.

As to when that collapse will happen… I have no clue. My Palantir has been rather clouded for the last few years. But the fissures in the global economy are widening and the stress fractures are driving political and economic change in ways that the most highly credentialed economists and analysts in the world consistently fail to predict.

In summary, the consequences of financialisation are becoming too severe to ignore. But we stubbornly refuse to address the cause of financialisation. That cause is clear – the endless printing of money at rates that would astound the architects of some of the worst hyperinflationary crises in history.