Foroohar:
How Wall Street is choking our economy and how to fix it
How Wall Street is choking our economy and how to fix it
A
couple of weeks ago, a poll conducted by the Harvard Institute of Politics
found something startling: only 19% of Americans ages 18 to 29 identified themselves
as “capitalists.” In the richest and most market-oriented country in the world,
only 42% of that group said they “supported capitalism.” The numbers were
higher among older people; still, only 26% considered themselves capitalists. A
little over half supported the system as a whole.
This
represents more than just millennials not minding the label “socialist” or
disaffected middle-aged Americans tiring of an anemic recovery. This is a
majority of citizens being uncomfortable with the country’s economic
foundation—a system that over hundreds of years turned a fledgling society of
farmers and prospectors into the most prosperous nation in human history. To be
sure, polls measure feelings, not hard market data. But public sentiment
reflects day-to-day economic reality. And the data (more on that later) shows
Americans have plenty of concrete reasons to question their system.
This
crisis of faith has had no more severe expression than the 2016 presidential
campaign, which has turned on the questions of who, exactly, the system is
working for and against, as well as why eight years and several trillions of
dollars of stimulus on from the financial crisis, the economy is still growing
so slowly. All the candidates have prescriptions: Sanders talks of breaking up
big banks; Trump says hedge funders should pay higher taxes; Clinton wants to
strengthen existing financial regulation. In Congress, Republican House Speaker
Paul Ryan remains committed to less regulation.
All of
them are missing the point. America’s economic problems go far beyond rich
bankers, too-big-to-fail financial institutions, hedge-fund billionaires,
offshore tax avoidance or any particular outrage of the moment. In fact, each
of these is symptomatic of a more nefarious condition that threatens, in equal
measure, the very well-off and the very poor, the red and the blue. The U.S.
system of market capitalism itself is broken. That problem, and what to do
about it, is at the center of my book Makers and Takers: The Rise of Finance and the Fall of American Business, a
three-year research and reporting effort from which this piece is adapted.
To
understand how we got here, you have to understand the relationship between
capital markets—meaning the financial system—and businesses. From the creation
of a unified national bond and banking system in the U.S. in the late 1790s to
the early 1970s, finance took individual and corporate savings and funneled
them into productive enterprises, creating new jobs, new wealth and,
ultimately, economic growth. Of course, there were plenty of blips along the
way (most memorably the speculation leading up to the Great Depression, which
was later curbed by regulation). But for the most part, finance—which today
includes everything from banks and hedge funds to mutual funds, insurance
firms, trading houses and such—essentially served business. It was a vital
organ but not, for the most part, the central one.
Over
the past few decades, finance has turned away from this traditional role.
Academic research shows that only a fraction of all the money washing around
the financial markets these days actually makes it to Main Street businesses.
“The intermediation of household savings for productive investment in the
business sector—the textbook description of the financial sector—constitutes
only a minor share of the business of banking today,” according to academics
Oscar Jorda, Alan Taylor and Moritz Schularick, who’ve studied the issue in
detail. By their estimates and others, around 15% of capital coming from
financial institutions today is used to fund business investments, whereas it
would have been the majority of what banks did earlier in the 20th century.
“The
trend varies slightly country by country, but the broad direction is clear,”
says Adair Turner, a former British banking regulator and now chairman of the
Institute for New Economic Thinking, a think tank backed by George Soros, among
others. “Across all advanced economies, and the United States and the U.K. in
particular, the role of the capital markets and the banking sector in funding
new investment is decreasing.” Most of the money in the system is being used
for lending against existing assets such as housing, stocks and bonds.
To get
a sense of the size of this shift, consider that the financial sector now represents
around 7% of the U.S. economy, up from about 4% in 1980. Despite currently
taking around 25% of all corporate profits, it creates a mere 4% of all jobs.
Trouble is, research by numerous academics as well as institutions like the
Bank for International Settlements and the International Monetary Fund shows
that when finance gets that big, it starts to suck the economic air out of the
room. In fact, finance starts having this adverse effect when it’s only half
the size that it currently is in the U.S. Thanks to these changes, our economy
is gradually becoming “a zero-sum game between financial wealth holders and the
rest of America,” says former Goldman Sachs banker Wallace Turbeville, who runs
a multiyear project on the rise of finance at the New York City—based nonprofit
Demos.
It’s
not just an American problem, either. Most of the world’s leading market
economies are grappling with aspects of the same disease. Globally, free-market
capitalism is coming under fire, as countries across Europe question its merits
and emerging markets like Brazil, China and Singapore run their own forms of
state-directed capitalism. An ideologically broad range of financiers and elite
business managers—Warren Buffett, BlackRock’s Larry Fink, Vanguard’s John
Bogle, McKinsey’s Dominic Barton, Allianz’s Mohamed El-Erian and others—have
started to speak out publicly about the need for a new and more inclusive type
of capitalism, one that also helps businesses make better long-term decisions
rather than focusing only on the next quarter. The Pope has become a vocal
critic of modern market capitalism, lambasting the “idolatry of money and the
dictatorship of an impersonal economy” in which “man is reduced to one of his
needs alone: consumption.”
During
my 23 years in business and economic journalism, I’ve long wondered why our
market system doesn’t serve companies, workers and consumers better than it
does. For some time now, finance has been thought by most to be at the very top
of the economic hierarchy, the most aspirational part of an advanced service
economy that graduated from agriculture and manufacturing. But research shows
just how the unintended consequences of this misguided belief have endangered
the very system America has prided itself on exporting around the world.
America’s
economic illness has a name: financialization. It’s an academic term for the
trend by which Wall Street and its methods have come to reign supreme in
America, permeating not just the financial industry but also much of American
business. It includes everything from the growth in size and scope of finance
and financial activity in the economy; to the rise of debt-fueled speculation
over productive lending; to the ascendancy of shareholder value as the sole
model for corporate governance; to the proliferation of risky, selfish thinking
in both the private and public sectors; to the increasing political power of
financiers and the CEOs they enrich; to the way in which a “markets know best”
ideology remains the status quo. Financialization is a big, unfriendly word
with broad, disconcerting implications.
University
of Michigan professor Gerald Davis, one of the pre-eminent scholars of the
trend, likens financialization to a “Copernican revolution” in which business
has reoriented its orbit around the financial sector. This revolution is often
blamed on bankers. But it was facilitated by shifts in public policy, from both
sides of the aisle, and crafted by the government leaders, policymakers and
regulators entrusted with keeping markets operating smoothly. Greta Krippner,
another University of Michigan scholar, who has written one of the most
comprehensive books on financialization, believes this was the case when
financialization began its fastest growth, in the decades from the late 1970s
onward. According to Krippner, that shift encompasses Reagan-era deregulation,
the unleashing of Wall Street and the rise of the so-called ownership society
that promoted owning property and further tied individual health care and
retirement to the stock market.
The
changes were driven by the fact that in the 1970s, the growth that America had
enjoyed following World War II began to slow. Rather than make tough decisions
about how to bolster it (which would inevitably mean choosing among various
interest groups), politicians decided to pass that responsibility to the
financial markets. Little by little, the Depression-era regulation that had
served America so well was rolled back, and finance grew to become the dominant
force that it is today. The shifts were bipartisan, and to be fair they often
seemed like good ideas at the time; but they also came with unintended
consequences. The Carter-era deregulation of interest rates—something that was,
in an echo of today’s overlapping left-and right-wing populism, supported by an
assortment of odd political bedfellows from Ralph Nader to Walter Wriston, then
head of Citibank—opened the door to a spate of financial “innovations” and a
shift in bank function from lending to trading. Reaganomics famously led to a
number of other economic policies that favored Wall Street. Clinton-era
deregulation, which seemed a path out of the economic doldrums of the late
1980s, continued the trend. Loose monetary policy from the Alan Greenspan era
onward created an environment in which easy money papered over underlying
problems in the economy, so much so that it is now chronically dependent on
near-zero interest rates to keep from falling back into recession.
This
sickness, not so much the product of venal interests as of a complex and
long-term web of changes in government and private industry, now manifests
itself in myriad ways: a housing market that is bifurcated and dependent on
government life support, a retirement system that has left millions insecure in
their old age, a tax code that favors debt over equity. Debt is the lifeblood
of finance; with the rise of the securities-and-trading portion of the industry
came a rise in debt of all kinds, public and private. That’s bad news, since a
wide range of academic research shows that rising debt and credit levels stoke
financial instability. And yet, as finance has captured a greater and greater
piece of the national pie, it has, perversely, all but ensured that debt is
indispensable to maintaining any growth at all in an advanced economy like the
U.S., where 70% of output is consumer spending. Debt-fueled finance has become
a saccharine substitute for the real thing, an addiction that just gets worse.
(The amount of credit offered to American consumers has doubled in real dollars
since the 1980s, as have the fees they pay to their banks.)
As the
economist Raghuram Rajan, one of the most prescient seers of the 2008 financial
crisis, argues, credit has become a palliative to address the deeper anxieties
of downward mobility in the middle class. In his words, “let them eat credit”
could well summarize the mantra of the go-go years before the economic
meltdown. And things have only deteriorated since, with global debt levels $57
trillion higher than they were in 2007.
The
rise of finance has also distorted local economies. It’s the reason rents are
rising in some communities where unemployment is still high. America’s housing
market now favors cash buyers, since banks are still more interested in making
profits by trading than by the traditional role of lending out our savings to
people and businesses looking to make longterm investments (like buying a
house), ensuring that younger people can’t get on the housing ladder. One
perverse result: Blackstone, a private-equity firm, is currently the largest
single-family-home landlord in America, since it had the money to buy
properties up cheap in bulk following the financial crisis. It’s at the heart
of retirement insecurity, since fees from actively managed mutual funds “are
likely to confiscate as much as 65% or more of the wealth that … investors
could otherwise easily earn,” as Vanguard founder Bogle testified to Congress
in 2014.
It’s
even the reason companies in industries from autos to airlines are trying to
move into the business of finance themselves. American companies across every
sector today earn five times the revenue from financial activities—investing,
hedging, tax optimizing and offering financial services, for example—that they
did before 1980. Traditional hedging by energy and transport firms, for
example, has been overtaken by profit-boosting speculation in oil futures, a
shift that actually undermines their core business by creating more price
volatility. Big tech companies have begun underwriting corporate bonds the way
Goldman Sachs does. And top M.B.A. programs would likely encourage them to do
just that; finance has become the center of all business education.
Washington,
too, is so deeply tied to the ambassadors of the capital markets—six of the 10
biggest individual political donors this year are hedge-fund barons—that even
well-meaning politicians and regulators don’t see how deep the problems are.
When I asked one former high-level Obama Administration Treasury official back
in 2013 why more stakeholders aside from bankers hadn’t been consulted about
crafting the particulars of Dodd-Frank financial reform (93% of consultation on
the Volcker Rule, for example, was taken with the financial industry itself),
he said, “Who else should we have talked to?” The answer—to anybody not
profoundly influenced by the way finance thinks—might have been the people
banks are supposed to lend to, or the scholars who study the capital markets,
or the civic leaders in communities decimated by the financial crisis.
Of
course, there are other elements to the story of America’s slow-growth economy,
including familiar trends from globalization to technology-related job
destruction. These are clearly massive challenges in their own right. But the
single biggest unexplored reason for long-term slower growth is that the
financial system has stopped serving the real economy and now serves mainly
itself. A lack of real fiscal action on the part of politicians forced the Fed
to pump $4.5 trillion in monetary stimulus into the economy after 2008. This
shows just how broken the model is, since the central bank’s best efforts have
resulted in record stock prices (which enrich mainly the wealthiest 10% of the
population that owns more than 80% of all stocks) but also a lackluster 2%
economy with almost no income growth.
Now, as
many top economists and investors predict an era of much lower asset-price
returns over the next 30 years, America’s ability to offer up even the
appearance of growth—via financially oriented strategies like low interest
rates, more and more consumer credit, tax-deferred debt financing for
businesses, and asset bubbles that make people feel richer than we really are,
until they burst—is at an end.
This
pinch is particularly evident in the tumult many American businesses face.
Lending to small business has fallen particularly sharply, as has the number of
startup firms. In the early 1980s, new companies made up half of all U.S.
businesses. For all the talk of Silicon Valley startups, the number of new
firms as a share of all businesses has actually shrunk. From 1978 to 2012 it
declined by 44%, a trend that numerous researchers and even many investors and
businesspeople link to the financial industry’s change in focus from lending to
speculation. The wane in entrepreneurship means less economic vibrancy, given
that new businesses are the nation’s foremost source of job creation and GDP
growth. Buffett summed it up in his folksy way: “You’ve now got a body of
people who’ve decided they’d rather go to the casino than the restaurant” of
capitalism.
In
lobbying for short-term share-boosting management, finance is also largely
responsible for the drastic cutback in research-and-development outlays in
corporate America, investments that are seed corn for future prosperity. Take
share buybacks, in which a company—usually with some fanfare—goes to the stock
market to purchase its own shares, usually at the top of the market, and often
as a way of artificially bolstering share prices in order to enrich investors
and executives paid largely in stock options. Indeed, if you were to chart the
rise in money spent on share buybacks and the fall in corporate spending on
productive investments like R&D, the two lines make a perfect X. The former
has been going up since the 1980s, with S&P 500 firms now spending $1
trillion a year on buybacks and dividends—equal to about 95% of their net
earnings—rather than investing that money back into research, product
development or anything that could contribute to long-term company growth. No
sector has been immune, not even the ones we think of as the most innovative.
Many tech firms, for example, spend far more on share-price boosting than on
R&D as a whole. The markets penalize them when they don’t. One case in
point: back in March 2006, Microsoft announced major new technology
investments, and its stock fell for two months. But in July of that same year,
it embarked on $20 billion worth of stock buying, and the share price promptly
rose by 7%. This kind of twisted incentive for CEOs and corporate officers has
only grown since.
As a
result, business dynamism, which is at the root of economic growth, has
suffered. The number of new initial public offerings (IPOs) is about a third of
what it was 20 years ago. True, the dollar value of IPOs in 2014 was $74.4
billion, up from $47.1 billion in 1996. (The median IPO rose to $96 million
from $30 million during the same period.) This may show investors want to make
only the surest of bets, which is not necessarily the sign of a vibrant market.
But there’s another, more disturbing reason: firms simply don’t want to go
public, lest their work become dominated by playing by Wall Street’s rules
rather than creating real value.
An
IPO—a mechanism that once meant raising capital to fund new investment—is
likely today to mark not the beginning of a new company’s greatness, but the
end of it. According to a Stanford University study, innovation tails off by
40% at tech companies after they go public, often because of Wall Street
pressure to keep jacking up the stock price, even if it means curbing the
entrepreneurial verve that made the company hot in the first place.
A flat
stock price can spell doom. It can get CEOs canned and turn companies into
acquisition fodder, which often saps once innovative firms. Little wonder,
then, that business optimism, as well as business creation, is lower than it
was 30 years ago, or that wages are flat and inequality growing. Executives who
receive as much as 82% of their compensation in stock naturally make
shorter-term business decisions that might undermine growth in their companies
even as they raise the value of their own options.
It’s no
accident that corporate stock buybacks, corporate pay and the wealth gap have
risen concurrently over the past four decades. There are any number of studies
that illustrate this type of intersection between financialization and
inequality. One of the most striking was by economists James Galbraith and
Travis Hale, who showed how during the late 1990s, changing income inequality
tracked the go-go Nasdaq stock index to a remarkable degree.
Recently,
this pattern has become evident at a number of well-known U.S. companies. Take
Apple, one of the most successful over the past 50 years. Apple has around $200
billion sitting in the bank, yet it has borrowed billions of dollars cheaply
over the past several years, thanks to superlow interest rates (themselves a
response to the financial crisis) to pay back investors in order to bolster its
share price. Why borrow? In part because it’s cheaper than repatriating cash
and paying U.S. taxes. All the financial engineering helped boost the
California firm’s share price for a while. But it didn’t stop activist investor
Carl Icahn, who had manically advocated for borrowing and buybacks, from
dumping the stock the minute revenue growth took a turn for the worse in late
April.
It is
perhaps the ultimate irony that large, rich companies like Apple are most
involved with financial markets at times when they don’t need any financing.
Top-tier U.S. businesses have never enjoyed greater financial resources. They
have a record $2 trillion in cash on their balance sheets—enough money combined
to make them the 10th largest economy in the world. Yet in the bizarre order
that finance has created, they are also taking on record amounts of debt to buy
back their own stock, creating what may be the next debt bubble to burst.
You and
I, whether we recognize it or not, are also part of a dysfunctional ecosystem
that fuels short-term thinking in business. The people who manage our
retirement money—fund managers working for asset-management firms—are typically
compensated for delivering returns over a year or less. That means they use their
financial clout (which is really our financial clout in aggregate) to push
companies to produce quick-hit results rather than execute long-term
strategies. Sometimes pension funds even invest with the activists who are
buying up the companies we might work for—and those same activists look for
quick cost cuts and potentially demand layoffs.
It’s a
depressing state of affairs, no doubt. Yet America faces an opportunity right
now: a rare second chance to do the work of refocusing and right-sizing the
financial sector that should have been done in the years immediately following
the 2008 crisis. And there are bright spots on the horizon.
Despite
the lobbying power of the financial industry and the vested interests both in
Washington and on Wall Street, there’s a growing push to put the financial
system back in its rightful place, as a servant of business rather than its
master. Surveys show that the majority of Americans would like to see the tax
system reformed and the government take more direct action on job creation and
poverty reduction, and address inequality in a meaningful way. Each candidate
is crafting a message around this, which will keep the issue front and center
through November.
The
American public understands just how deeply and profoundly the economic order
isn’t working for the majority of people. The key to reforming the U.S. system
is comprehending why it isn’t working.
Remooring
finance in the real economy isn’t as simple as splitting up the biggest banks
(although that would be a good start). It’s about dismantling the hold of
financial-oriented thinking in every corner of corporate America. It’s about
reforming business education, which is still permeated with academics who
resist challenges to the gospel of efficient markets in the same way that
medieval clergy dismissed scientific evidence that might challenge the
existence of God. It’s about changing a tax system that treats one-year
investment gains the same as longer-term ones, and induces financial
institutions to push overconsumption and speculation rather than healthy
lending to small businesses and job creators. It’s about rethinking retirement,
crafting smarter housing policy and restraining a money culture filled with
lobbyists who violate America’s essential economic principles.
It’s
also about starting a bigger conversation about all this, with a broader group
of stakeholders. The structure of American capital markets and whether or not
they are serving business is a topic that has traditionally been the sole
domain of “experts”—the financiers and policymakers who often have a
self-interested perspective to push, and who do so in complicated language that
keeps outsiders out of the debate. When it comes to finance, as with so many
issues in a democratic society, complexity breeds exclusion.
Finding
solutions won’t be easy. There are no silver bullets, and nobody really knows
the perfect model for a high-functioning, advanced market system in the 21st
century. But capitalism’s legacy is too long, and the well-being of too many
people is at stake, to do nothing in the face of our broken status quo. Neatly
packaged technocratic tweaks cannot fix it. What is required now is lifesaving
intervention.
Crises
of faith like the one American capitalism is currently suffering can be a good
thing if they lead to re-examination and reaffirmation of first principles. The
right question here is in fact the simplest one: Are financial institutions
doing things that provide a clear, measurable benefit to the real economy?
Sadly, the answer at the moment is mostly no. But we can change things. Our
system of market capitalism wasn’t handed down, in perfect form, on stone tablets.
We wrote the rules. We broke them. And we can fix them.
Rana Foroohar is an assistant managing
editor at TIME and the magazine’s economics columnist. She’s the author of Makers and Takers: The Rise of Finance and the Fall of American Business.
This appears in the May 23, 2016 issue of
TIME.
