The Pitfalls Of The ‘Financialization’ Of American Business by [email protected]

According to Time magazine journalist Rana Foroohar’s new book Makers and Takers: The Rise of Finance and the Fall of American Business, the ‘financialization’ of banking, and of business in general, has hampered real growth and innovation while exacerbating inequality. The result is an “upside-down” economy where finance, instead of serving as a catalyst, has become a headwind. And in the wake of a devastating financial crisis fueled by excessive debt and credit, we are seeing a smoke-and-mirrors recovery driven largely by more of the same.

In the following book review, [email protected] summarizes Foroohar’s argument and shares examples from the book.

There’s a scene in the movie “The Big Short” where a hedge fund manager, played by Steve Carrell, finally begins to grasp the flimsy house of financial cards that would soon collapse and lead to the sub-prime mortgage crisis, and in turn a full-blown banking crisis and global recession. He listens with growing exasperation as a manager of CDOs, collateralized debt obligations, explains how he has packaged and repackaged mortgage debt into increasingly complicated and exotic securities. The tipping point is when he realizes that the market of speculative bets on mortgage bonds is worth 20 times the value of the mortgages themselves.

That outsized relationship of speculation to concrete assets, of abstracted finance to real world business, is at the heart of Rana Foroohar’s urgently argued new book Makers and Takers: The Rise of Finance and the Fall of American Business. Where finance and banking were once the servants of the larger economy, pooling deposits and directing them to productive investment, they have now become the master. The financialization” of banking, and of business in general, has hampered real growth and innovation while exacerbating inequality. The result is an “upside-down” economy where finance, instead of serving as a catalyst, has become a headwind. And in the wake of a devastating financial crisis fueled by excessive debt and credit, we are seeing a smoke-and-mirrors recovery driven largely by more of the same.

Casino Finance

In distinct yet eerily similar ways, the collapses of 1929 and 2008 were both set in motion by speculative finance. The stock market crash of 1929, and the Great Depression that followed, ushered in a wave of reform in finance and banking, including the creation of the FDIC and the SEC. Four provisions of the Banking Act of 1933, collectively known as Glass-Steagall, were designed to erect a wall between commercial and investment banking, between banking and commerce — a separation that became a core principle of banking for the next few decades. But evolution within the industry, and in regulatory oversight, slowly chipped away at that wall, and Citibank was at the center of that history.

The ‘financialization’ of banking, and of business in general, has hampered real growth and innovation while exacerbating inequality.

Citibank was founded in 1812 as City Bank of New York and became National City Bank in 1863, the year the National Banking Act was passed. After World War II, under the stewardship of Walter Wriston, the bank began expanding into new areas, and pushed back against constraints like Regulation Q, a provision of Glass-Steagall limiting the interest rates banks could offer. A key turning point was the introduction of the certificate of deposit (CD) in the early 1960s, an innovation Foroohar describes as an “ingenious way around the Glass-Stegall rules.” With the creation of CDs, and soon after of a secondary market for them, Wriston blurred the line between lending and trading, a game changer for postwar banking. “Banking was no longer a utility. Just as Wriston had hoped, it was increasingly a high-speed, high-stakes business.”

Wriston changed the bank’s name to Citibank in 1976, and it was during this decade that the industry searched in earnest for more and more high-yield products. Banks began experimenting with derivatives, and with packaging mortgages into securities. Meanwhile, regulatory oversight back-pedaled, and was ultimately rewritten. President Jimmy Carter deregulated bank interest rates in 1980, effectively wiping out Regulation Q. John S. Reed took over the bank as CEO in 1984, and “championed a new wave of high-tech finance,” the author writes. In 1998, Reed engineered a merger with Travelers Group, an insurance and investment firm. The newly christened entity, Citigroup, became the world’s largest financial institution, changing the financial services landscape overnight.

Glass-Steagall would be formally repealed in late 1999. But in Foroohar’s view, it was the merger — and Citi’s aggressive expansion into “pretty much every financial service ever invented” — that “dealt the final blow to the dividing wall between commercial and investment banking.” It was also the birth of ‘Too Big To Fail,’ and so it was no surprise, the author says, that Citi was at the “epicenter” of the 2008 crisis. Yet she argues that finance and banking had long since moved off its “moorings” in the real economy, a development Nobel Prize-winning economist James Tobin worried about as early as 1984. He lamented a growing “casino aspect to our financial markets,” and expressed unease that “we are throwing more and more of our resources, including the cream of our youth, into financial activities removed from the production of goods and services.”

Today, finance, while making up only 7% of the economy and creating a mere 4% of all jobs, generates more than a fourth of corporate profits — up from 10% 25 years ago.

‘Whiz Kids’ and Bean Counters

Parallel to the ascendance of finance, Foroohar contends, was a decline in American business as large corporations increasingly came to mimic the banks that were supposed to serve them and to seek profits in ‘financial engineering’ activities divorced from their core services and goods.

An unexpected villain in this story is Robert McNamara, best known for his later tenure as secretary of defense under John F. Kennedy and Lyndon B. Johnson. Critics of his role as one of the architects of the Vietnam War would point to his obsession with systems analysis — a preoccupation he developed in the Air Force’s Office of Statistical Control during World War II, and then brought to bear on American industry.

In the Air Force, McNamara and a group of like-minded peers became known as the ‘Whiz Kids’ for their ability to crunch numbers and find operational efficiencies. Almost immediately after the war, all 10 of them became executives at the Ford Motor Co., recruited and hired by Henry Ford II himself. The company was losing money and market share, and was certainly in need of an overhaul. “Where finance had once been nearly nonexistent within Ford,” the author writes, “it quickly became the control hub of the firm.” The ‘Whiz Kids’ and young MBAs wrested control from the ‘car guys’ in engineering and design.

For a while, McNamara’s “management by numbers” worked. The company was quickly in the black, and in prime position to ride the transportation boom of the 50s. Yet over the long run, argue Foroohar and others, the new mindset had disastrous consequences, and was part of a larger shift in American industry from tradesmen to accountants. “The ‘Whiz Kids’ were the forerunner of the new class in American business,” David Halberstam wrote in his book The Reckoning. “Their knowledge

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