The Rise Of Financialization

Hello and welcome back to Breaking the Dollar. I'm your host Everett Millman and this week's episode is going to discuss the trend of financialization. It sounds like a kind of a long and fancy word, but really it just means that there is a growing tendency for everything to become part of the financial world. Everything is a financial vehicle. And we especially see this in developed economies like the United States. That's probably where this trend is the most pronounced and it has really ramped up since the 1980s.

But that doesn't really tell us what is really going on. What does financialization really mean? And ultimately it is a tendency for capital, in this case money, to be directed less toward productive processes and more toward creating new financial products. That capital is being diverted from, let's say, building new businesses, building factories or perhaps most importantly new innovations. And instead it just flows into the financial sector and into banks in order to create these new types of investment vehicles and financial products. You'll sometimes hear this characterized just as quote unquote pushing paper or moving money around. Of course that is an essential part of what banks and financial institutions do. So the problem with financialization isn't that it happens at all. It's the degree to which it happens. It is becoming a bigger and bigger part of the economy to the point that we start to ignore all of the other normal productive things that our wealth and our money should be doing.

One of the topics that we've discussed on the show before about collateralized loan obligations, CLOs, and other types of risky investment products, these are a byproduct of financialization. If you can package together risky assets or you can take debt and transform it into a financial product that creates opportunities for profit for the banks when they trade. But the point about why too much financialization is a bad thing is that even though there is profit to be had, it's not actually adding any real value to the economy. It's not providing greater value to consumers and customers and other businesses. More or less all it is creating are arbitrage opportunities.

Now as a refresher, arbitrage is essentially being able to make a profit margin by being a middleman. You're buying something and then reselling it for a profit. Once again I want to stress the point that arbitrage itself, the fact that it exists, is not inherently a bad thing. There does have to be some degree of that for markets to run smoothly, for the economy to grow. That really is a fact of life. The problem arises when there is too much of this going on. That's because on some level of analysis arbitrage is also not creating value for anyone. You're not changing the item or the service that you are passing on, you're just getting it from one person and selling it to another.

When you think about how different industries fit together and work in the economy, it's usually that each step of the process is in some way adding value. So a basic example would be a mining company extracts a resource from the earth, then at the next step in the line a refinery will transform that resource into a usable metal or commodity. And then perhaps another factory down the line will then fashion that into a useful part that can go toward the building of something even larger; and on down the line you go. Each step of the process changes or transforms the original input so that it's useful and usable for the next company down the line.

With financialization, that really doesn't happen. Something I want to keep reiterating is that this is not an argument against the existence of banks and the financial sector as a whole. Obviously lending, creating loans, holding people's money, that is a service that is needed. And of course these types of institutions far predate the explosion of financialization that we saw in the 1980s. That decade really was a time where the Wall Street culture that we all associate the idea of finance with really came into being. It really took shape. And the primary issue is simply how widespread this has become and how big of a portion of the economy the financial sector now is.

As I said, the best example where you see this is in the United States, but it's also happening in other parts of the developed world. On some level when it gets to be that big of a part of the economy, it's obviously going to attract a lot of smart people and a lot of people who want to make lots of money. Normally that is not a bad thing in business. However, when you're not adding value, that's basically a waste of that intellectual capital. In other words, it's a waste of people's brain power. Instead of doing something useful or doing something innovative and entrepreneurial, those smart people are just coming up with new ways to move money around. It creates profits for the banks, but it doesn't really add anything to the rest of the world. Ultimately, this leads us to a pretty big philosophical conundrum about free markets and how much should we regulate the financial industry. In almost all cases, more regulation tends to be a bad thing. Under the guise of protecting everyone, it allows the government to pick winners and losers and it does place a burden on new innovative businesses popping up. But there's a pretty good reason that after the Great Depression, we enacted some pretty stringent regulations on banks and financial institutions.

The rise of financialization in the 1980s coincided with a pretty fast deregulation movement. The banking industry was unshackled from a lot of the regulations that were put in place to stop this type of behavior. For the most part, it's never changed ever since. No matter what we may think about how some of the laws passed after our recent financial crisis were supposed to protect us from that ever happening again, it hasn't put much of a damper on the spread of financialization. If anything, the trend has only gotten worse. To me, I think perhaps the biggest problem with addressing this is that not only is it outside of the purview of most people's daily lives, but it seems very complicated and confusing. If the average person doesn't really understand how these complex financial products work, how can we really tell that they aren't creating value or they aren't somehow contributing to the expansion of wealth in society?

But the crisis that we saw in 2007-2008 should have been a wake-up call. When you're just packaging debt and risky assets together and you're creating new financial products, it sort of masks the problem. Everything seems fine until the crisis hits. In my opinion, until we address financialization and until we do somehow rein in these types of practices, we're just going to see that process repeat itself. When it comes down to it, innovation should be used to create new products and services that people can actually use, new technologies and new businesses. Innovation shouldn't just be directed toward finding new ways to hide how risky an investment is and pass it off onto someone, but that is one of the incentives that are created by financialization. For some period of time, until you get caught or until things blow up, that is actually a very profitable enterprise. So although I am personally and philosophically opposed to most types of regulation and certainly against overregulation, the financial sector is one example where I think greater regulation is desperately needed.

And one other related problem that stems from this is what's known as regulatory capture. And that is where there's a revolving door between the high-ranking people who work in the financial industry often end up taking the jobs that are meant to regulate that industry itself. So if you look at a lot of the bureaucratic positions that are tasked with regulating banks and financial institutions, almost all of those people formerly worked at the institutions they are now regulating. Again, this is a pretty thorny problem because you need and want your regulators to know something about the industry they're trying to oversee. But if the people with the power of oversight are still very friendly with the businesses they're supposed to be regulating, the regulator becomes basically powerless.

So in addition to placing more stringent restrictions on the spread of financialization, I think the second order problem that has to be addressed is how do we find impartial regulators? How do you keep a wall between the banks and the regulators of those banks? And at the same time, how do you preserve the integrity of free markets? Because it would be just as bad if it were so overregulated that now even very small community local banks can no longer do their jobs properly if regulation becomes so burdensome. So this is certainly a topic that I don't have an overly optimistic viewpoint on. I can't give you a lot of good news about how it's getting better or even how to solve it, but it is a problem that needs to be talked about and addressed.

And so now is the time in our program where we take questions from the listeners. This week's question comes from David L. doesn't say where he's from. And he asks, I heard recently that China is going to issue its own cryptocurrency. What is your opinion on this? Yeah, that has been kind of a recurring headline. And I even saw that they're trying to ramp up the timeline on this, that the Chinese government wants to develop a cryptocurrency in the next couple of months. My opinion is that that's really a crypto in name only. By definition, cryptocurrencies are supposed to be a decentralized way of exchanging money or exchanging value. If any government entity is issuing it, that defeats the purpose. That is by its nature centralized.

So whether it's China or the United States or any other government -- the Bank of England also kind of made similar arguments along these lines that it wanted to see a government issued cryptocurrency -- I think all of that I think all of that is pretty much a diversion. It is governments trying to get in on the game and maybe get out ahead of the cryptocurrency movement. But ultimately, those will be no different than our existing fiat currencies. They will just be backed by a blockchain ledger, which is perhaps an improvement, but it is by no means an actual cryptocurrency, in my opinion.

That does it for this week's episode. I hope you enjoyed. And as always, we really appreciate everybody tuning in. Join us next week where I will discuss a kind of popular topic that keeps coming up about how to know if a gold dealer is trustworthy. So important stuff. Be sure not to miss it.