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.
Here’s what Charlie Munger had to say at the Daily Journal meeting
Charlie Munger spoke at the Daily Journal Corporation's Annual Meeting of Shareholders today. Although Warren Buffett is the more well-known Berkshire Hathaway chief, Munger has been at his side through much of his investing career. Q4 2020 hedge fund letters, conferences and more Charlie Munger's speech at the Daily Journal meeting was live-streamed on Yahoo Read More
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.
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 was not concrete, about a product, but abstract, about systems.”
Eventually, this disconnect from core product and value came back to haunt Ford and other companies driven by finance. A famous Harvard Business Review article from 1980, “Managing Our Way to Economic Decline,” dates falling investment in research and development back to the mid-1960s. Increasingly, the authors found, U.S. companies focused on “sophisticated and exotic” management of their growing cash reserves, grew preoccupied with cost-cutting measures, and treated “technological matters simply as if they were adjuncts to finance or marketing decisions.”
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.
McNamara became president of Ford in 1960, and some of the ‘Whiz Kids’ stayed at the company into the 1980s. Others moved on to high positions at other companies, where the bottom-line approach began to take its toll. After two Ford alumni took over Xerox in the late 1960s, tightening budgets and cutting back on R&D, the once innovative and dominant company “went into permanent decline, losing more than half its market share and selling off assets piece by piece.” The author cites Hewlett-Packard as a more recent example of a “culture of innovation destroyed by bean counters.”
The Ford approach has at times blown up in its face, quite literally. Its low-cost subcompact car the Pinto, introduced in 1970, soon became a nightmare when it was found to burst into flames during rear-end collisions — costing the company millions in payouts and lost market share. According to Foroohar and writer Andrea Gabor, that disaster “could be traced directly back to the cost-benefit analyses established by the ‘Whiz Kids.’”
Ford’s competitor General Motors recently went through its own safety disaster when a faulty ignition switch in two models resulted in at least 124 deaths and cost the company well over a billion dollars in penalties and lawsuits. An exhaustive inquiry into the problem didn’t blame cost-cutting per se. But it did point to the prevalence of corporate silos at GM: departments and divisions that become isolated and protective, undermining communication and accountability. And in the view of the Foroohar and former GM vice chairman Bob Lutz, author of Car Guys vs. Bean Counters, putting finance in charge “leads inexorably to corporate silos.” Accountants love silo structures that allow them to micro-manage expenses. “It’s all part of the financial control mentality,” says Lutz.
MBAs: Studying Markets, Not Companies
Two related developments have fed into the financialization of American business. One is the growing influence of MBAs, and the changing nature of the education they receive. The ‘Whiz Kids’’ love of systems analysis had its academic correlate in the University of Chicago. Perhaps not coincidentally, Foroohar notes, Milton Friedman, a star proponent of the “markets know best” argument, was exposed to McNamara-style systems analysis at Columbia’s Navy-sponsored Statistical Research Group during the war. With help from the Ford Foundation (which had a huge hand in shaping postwar business education), Chicago attracted Friedman and a cadre of star economists.
The “Chicago school,” as it came to be known, placed great value on highly theoretical models. It was enormously influential in political circles, helping to spur the movement to deregulate in the 70s and 80s; and it also helped inform business education more broadly. The result, Foroohar writes, “was a very finance-driven approach to business education, in which the central questions were no longer about companies, but markets.”
Large corporations increasingly came to mimic the banks that were supposed to serve them and to seek profits in ‘financial engineering.’
Critics of this approach contend it was guilty of falsely emulating the physical sciences, and aren’t surprised that in recent years these models seem to have fallen flat in real-world situations. Emanuel Derman is a mathematician and physicist at Columbia who believes mathematics holds too much sway in both economics and business. “Models of all kinds,” he says, “have been behaving very badly. To confuse a model with the world of humans is a form of idolatry — and dangerous.”
Yet MBAs continue to dominate the business world; and as executive and Wall Street compensation has soared, finance commands a disproportionate hold on the best young minds at the best universities. “A full quarter of American graduate students earn a master’s degree in business, more than the combined share … in the legal, health, and computer science fields,” the author writes. This misallocation of talent, she says, has real consequences for our ability to generate real growth and innovation.
In spite of that dominance, industries with fewer MBAs and less finance tend to be more successful. Silicon Valley, for example, is “light on MBAs and heavy on engineers.” And a 2015 comparative international study found out that productivity “declines in markets with rapidly expanding financial sectors.”
The Cannibalized Company
The Chicago school helped establish the ideological basis for a wave of “shareholder activism” that would further push American business toward an obsession with the short-term bottom line, at the expense of long-term investment in growth and innovation. The purpose of the corporation, Milton Friedman and others asserted, was to maximize financial value. And the Efficient Market Hypothesis (credited to Friedman disciple Eugene Fama) holds that stock prices are the best measure of a company’s value.
Accordingly, maximizing stock prices was increasingly elevated as a cardinal virtue. In 1990, the Business Roundtable (a group of CEOs from America’s largest companies) defined management’s responsibility as that of serving a broad range of stakeholders, including but not limited to stockholders. Just seven years later, the wording had changed. Management’s “paramount duty” was to stockholders — the interests of other stakeholders relevant only “as a derivative” to that primary loyalty.
Armed with this ideology, powerful shareholders like Carl Icahn pressured companies to pass on more and more of their earnings to those who owned stock in the company — in the form of higher dividends, and increasingly, stock buybacks. In 1982, the SEC loosened regulations limiting a company’s ability to repurchase its own stock, despite protests by some dissenters that this would essentially legalize market manipulation. And this, Foroohar and others argue, is exactly what happened.
This disconnect from core product and value came back to haunt Ford and other companies driven by finance.
Reducing the number of outstanding shares on the market artificially inflates a key measure of a company’s value: its earnings-per-share, or EPS. Buybacks are often followed by an immediate surge in stock price, at least in the short term. The concern is that prominent owners of a stock will lobby for buybacks and then sell off that same stock, reaping a healthy profit even though there has been no change in a company’s underlying value. Icahn was recently charged with such a “pump and dump” strategy when, after successfully lobbying Apple to engage in a series of costly repurchases, he sold his entire stake in the company.
The buyback boom began in the 1980s, and has only accelerated since. In the last decade, the author writes, “American firms have spent a stunning $7 trillion buying back their own stock — the equivalent of half their profits.” In the last two years, buybacks and dividends have actually exceeded the net earnings of publicly traded American companies. Adding insult to injury, companies like Apple often fund these buybacks, not by dipping into their substantial cash reserves, but by borrowing. In 2013, despite having $145 billion in the bank, Apple borrowed $17 billion. It was able to do so at favorable rates, and to save on taxes it would have owed if it had tapped into its many tax-sheltered offshore accounts. Meanwhile, the company’s R&D as a percentage of sales, in decline since 2001, dipped even lower.
Complicating matters further, Foroohar and others point out, is the fact that stock options account for a huge chunk of executive compensation — creating a built-in incentive to engage in financial maneuvering that lifts stock prices but doesn’t create real value. This has eroded American competitiveness, a Brookings Institute paper worries, by replacing a “retain-and-reinvest” corporate model with a “downsize-and-distribute” one. The end result, the author of the paper writes, is “profits without prosperity” as business focuses on “value extraction” instead of “value creation.”
“We’re All Bankers Now”
In a key chapter on how financial maneuvering and an obsession with short-term profits have undermined innovation and the building of long-term value, Foroohar uses the evolution (or devolution) of General Electric as a striking case in point. There is good reason to do so: As the only U.S. company that has remained in the Dow Jones Industrial Average for the index’s entire 120-year history, GE is both a mainstay and a “bellwether” for American business. Yet during much-heralded CEO Jack Welch’s watch, she says, the company went from a focus on “making things” to “moving money around.”
Known for innovation in a wide array of products — from jet turbines to X-ray machines — GE’s earnings had tripled over the 1970s, but the growth of its stock price was less impressive. When Welch took over the company in 1981, he quickly set about changing that. He engaged in an aggressive campaign of acquisitions and cost-cutting, both of which boosted its share price. Finance moved front and center. Divisions focused on consumer credit and lending doubled in size, while manufacturing stagnated. Yet even while slashing jobs (earning him the nickname “Neutron Jack”) and investment in R&D, he funded his acquisitions and financial operations with unprecedented levels of corporate debt.
At the center of all this “financial wizardry” was GE Capital, the company’s financial services firm. At its peak, it accounted for over half of GE’s profits, and its total assets swelled from $371 billion in 2001 to nearly $700 billion in 2008 when the financial crisis hit. By that time, GE had become a kind of closet bank, and as such had become part of ‘Too Big To Fail.’ When it too was caught up in the collapse of the real estate market, it received a bail-out in the form of $139 billion in guaranteed loans from the FDIC.
The story of GE Capital, Foroohar says, is representative of a larger trend in American business. At countless other classic companies such as Sears and Ford, stand-alone lending units originally established to help individual consumers finance purchases of a company’s core products became “financial behemoths that overshadowed the manufacturing or retailing activities of the parent firm,” writes Greta Krippner in Capitalizing on Crisis: The Political Origins of the Rise of Finance. Automakers generate a substantial portion of revenue from consumer loans, and airlines sometimes make more money hedging on oil prices than by selling seats.
“My gut told me that compared to the industrial operations,” Welch wrote in his autobiography, the financial operations of GE Capital “seemed an easy way to make money. You didn’t have to invest heavily in R&D, build factories, and bend metal day after day.” Although the decline in America’s manufacturing base is sometimes seen as inevitable, Foroohar says the country neglects that sector at its peril. Manufacturing may account for only 9% of employment, yet it represents 69% of private-sector R&D and contributes 30% of the nation’s productivity growth.
“Re-Mooring” Finance in the Real Economy
Later chapters of Makers and Takers detail other corrosive effects of the financialization of American business. Even as financial operations have swallowed up traditional manufacturing, deregulation has allowed financial giants like Goldman Sachs and Morgan Stanley to expand into nonfinancial sectors of the economy. The two firms now have significant infrastructure holdings in agriculture and industrial metals — all while trading commodities futures in those same markets. In recent years, both have been charged with hoarding and fined millions of dollars for market manipulation. Critics contend that this latest blurring of the lines between banking and commerce has introduced dangerous volatility into commodities prices.
The economic recovery, the author says, is uneven and two-tiered as a growing share of the housing market is gobbled up by private investment firms. Our retirement system has been “hijacked” by finance, creating a patchwork of plans with high fees and high, if hidden, risks. Overseas tax shelters and other loopholes undermine the tax base and create incentives for unproductive investment. Meanwhile, a revolving door between Washington and Wall Street threatens to undercut and roll back Dodd-Frank and other reforms.
In a closing chapter, Foroohar puts forth broad principles for “How to Put Finance Back in Service to Business and Society.” Along the way, she finds some hopeful signs that the pendulum of financialization may be ready to swing back. Last year, for example, General Electric announced it was spinning off GE Capital and getting out of the business of banking. It has launched a “growth board” (a sort of internal venture capital firm) and upped its spending on R&D. And in a return to its roots, the company’s Schenectady campus is, after decades of downsizing, the focus of new investments in renewable energy and a high-tech battery plant, and “is once again a growing R&D hub for the company.”