Predatory Financialization. Paul Krugman, Understanding Inequality: Part V

This is Part V of Stone Center Senior Scholar Paul Krugman’s series “Understanding Inequality,” which originally appeared on his Substack newsletter.

By Paul Krugman

My favorite line from the 1987 movie Wall Street comes when Gordon Gekko ridicules the Charlie Sheen character for his limited ambitions: “I’m not talking about some $400,000-a-year working Wall Street stiff, flying first class, and being comfortable.”

Adjusted for inflation, 400K in 1987 would be around $1.1 million now.

What the line tells us is that even in 1987, fairly early in the great post-1980 surge in inequality, many people in finance — working Wall Street stiffs — were already being paid very large sums, and a few people were acquiring extraordinary fortunes.

Last week I noted that the very biggest fortunes in America are now primarily based on technology quasi-monopolies. But go down the Forbes 400 list a bit and you see a number of plutocrats who made tens of billions in finance, especially hedge funds. These include people like Stephen Schwarzman, who compared efforts to close a Wall Street-friendly tax loophole to Hitler’s invasion of Poland, and Ken Griffin, a Republican megadonor.

The fact is that financialization of the U.S. economy has been a major driver of rising inequality. What do I mean by financialization? Actually I mean two different but related things. One aspect is the extraordinary rise in the share of the U.S. economy devoted to financial activities as opposed to production of goods and services. A second is the pervasive way in which financiers and financial institutions like hedge funds and private equity have changed how even nonfinancial business operates. These changes have almost always increased inequality.

I will discuss the following:

1. The growth of the financial sector and what explains it
2. How growth in finance directly increases income and wealth inequality
3. How the increased role of Wall Street has changed the way the rest of the economy operates

The growth of the financial industry

Banking used to be a relatively boring, sleepy industry. People would talk about “bankers’ hours” — strictly speaking a reference to the days when bank branches were open only from 10 to 3, but informally an implication that banking offered cushy jobs with short hours and not much exertion.

Clearly, that’s not how banking is perceived these days. Investment bankers, especially ambitious young men and women, famously work punishing hours. Today, finance is anything but sleepy. During the 1950s it was a minor part of the economy. By the eve of the global financial crisis, finance’s share of GDP had almost tripled from its 1950s level, and it has remained very high:

Source: Bureau of Economic Analysis

The extraordinary growth of the share of U.S. GDP accounted for by the financial industry raises two related questions. First, what are all these overworked but highly paid people doing? Second, is what they’re doing productive for the economy as a whole?

Bankers, of course, don’t directly produce stuff. However, financial institutions like banks, mutual funds and so on can and do play a crucial productive role in the economy. Ideally, they help direct money to its most productive uses — e.g. effectively channeling household savings into the financing of investment in cutting-edge technologies. Financial institutions also manage risk in the economy by helping investors diversify. And they provide liquidity, giving people ready access to their money even as most of that money is being put to work in long-term investments.

The curious thing is that the financial industry of the 1950s and 1960s, which accounted for 3 percent to 4 percent of GDP, served all these functions for the U.S. economy. So why has it expanded to almost 8 percent of GDP? And did this expansion enhance its benefits to the economy?

The outsized growth of the U.S. financial industry can be attributed largely to a change in government policy and, more broadly, the ideological climate that shaped policy. In the 1970s and 1980s, bank regulation was loosened. The Monetary Control Act of 1980 effectively removed limits on the ability of banks to compete with each other by offering higher interest rates on deposits. Even more important, regulators stood aside while the “shadow banking sector” grew. “Shadow banks” are financial institutions like money market funds and overnight lending arrangements that fulfil some traditional banking roles but are neither regulated like conventional banks nor backstopped by deposit insurance. By allowing these shadow banks to displace conventional banking without any major effort to police the new risks these institutions created, policymakers set the stage for eventual catastrophe.

Simultaneously, there was widespread financial “innovation,” largely involving creation of new financial instruments like junk bonds (which had long existed but suddenly became a major force), asset-backed securities, credit default swaps and subprime loans. Again, there was little effort to manage the risks this innovation created.

The proliferation of new financial institutions and instruments, together with the increased role of finance in directing and managing non-financial institutions (more about that later) was a major source of the growth of finance relative to the rest of the economy.

But the important question is whether the huge growth in the financial sector and the financial products it offered was good for the economy. Paul Volcker, the legendary Federal Reserve chairman, famously quipped: “The most important financial innovation that I have seen the past 20 years is the automatic teller machine.”

My guess is that today he would include payment apps like Venmo, Apple Pay, and Zelle. Yet Volcker’s main point was correct: the U.S. economy did a better job of delivering rising living standards when the financial sector was relatively small and boring than it did after all that innovation came along (I use the log of real income so that the slope of the line shows the rate of growth):

Of course, many factors affect economic growth, so the failure of a larger financial sector to deliver faster growth isn’t proof that it was useless. However, the 2008 financial crisis provided a more pointed rebuttal to claims that financial innovation was an economic boon. Far from helping direct savings to highly productive investments, the deregulated financial system funneled large sums into inflating a disastrous housing bubble. Far from helping to manage risk, financial innovation encouraged both borrowers and investors to take on risks they didn’t understand. And it certainly increased income inequality as subprime mortgages were disproportionately marketed to low and middle income home buyers.

So, in hindsight, the explosive growth in finance after the deregulation of the 1980s looks more predatory than productive.

Is it plausible to claim that the economy plowed large resources into activities with little or no real economic value, maybe even negative value? Yes — and for proof we have a contemporary example: crypto. Sixteen years after Bitcoin was created there are still no clear use cases for cryptocurrency that don’t involve illegal activity. Yet at the time of writing the value of crypto assets was approximately $3.3 trillion.

So it is, in fact, quite plausible to argue that financialization did little to benefit the American economy. It did, however, make a significant contribution to rising U.S. income inequality.

The financial elite

It’s hard to believe now, but in the 1970s the financial sector didn’t offer especially high pay. Average wages in finance were about the same as average wages in U.S. business as a whole. Top earners in finance similarly resembled top earners in other industries.

After 1980, however, earnings for employees in finance began soaring, more or less in tandem with the rising share of finance in GDP. This surge mainly took place in the more exotic parts of finance — that is, earnings in insurance or ordinary lending didn’t take off, but earnings in the activities we usually mean by “Wall Street” did. Philippon and Reshef have a nice chart making this point. The left axis shows the ratio of compensation in financial sectors to compensation in the nonfarm private sector as a whole:

Source: Philippon and Reshef

And all indications are that the gains were extremely large for top earners within the financial industry. As a result, high earners within the financial industry came to make up a large fraction of very high earners in the United States as a whole. As with wealth inequality, looking at the “one percent” understates how radical the change was: Gordon Gekko’s working Wall Street stiff was well into the top 1 percent of earners, as were quite a few owners of relatively small businesses.

Interpreting the data on very high earnings is tricky and controversial, in part because people with very high earned incomes often find ways to make that income appear to come from businesses they own. So I’m going to steer clear of that morass and go back to wealth data, which in this case are actually clearer. Last week I cited Freund and Oliver on the origins of the superrich. Here’s another table from their paper, showing where billionaires came from as the U.S. financial sector was metastasizing:

Source: Freund and Oliver

According to their numbers, more than 40 percent of new U.S. billionaires created between 1996 and 2014 came from the financial sector.

So I would summarize it this way: After 1980 the U.S. financial sector expanded rapidly, but there is little evidence that this expansion yielded any benefits to the economy as a whole. It did, however, offer very high earnings — in some cases almost surreally high earnings — to a financial elite, playing a significant role in the overall rise in income inequality.

And that’s just the direct effect of high earnings within the financial industry.

Financialization outside finance

So far I’ve been focusing on incomes generated within the financial industry, and especially the part of that industry we normally think of when we say “Wall Street.” But as I said, financialization is a broader story than the rising income and wealth of Wall Street itself.

First, there was an extended period during which companies outside the finance sector in effect tried to get in on the action, shifting their focus away from their traditional businesses toward financial activities. The poster child for this evolution was General Electric, an iconic manufacturer that, as James Surowiecki put it, effectively transformed itself from an industrial company into a huge bank. G.E. Capital, the company’s financial arm:

became a key source of profits, growing almost twice as fast as the company as a whole and expanding into every conceivable market: consumer lending, credit cards, equipment leasing, commercial real estate, auto loans, leveraged buyouts, even subprime mortgages.

This worked for a while, until it didn’t. General Electric eventually sold off G.E. Capital and has tried to return to its industrial roots. But the loss of focus left it much diminished.

The G.E. experience was representative of a much wider trend. Many nonfinancial firms, especially although not only in manufacturing, tried to reinvent themselves as financial players. In addition to probably damaging their core businesses, empirical studies indicate that the financial focus led to lower wages for ordinary workers and higher executive compensation.

I could go on about this phenomenon, but this primer is already getting long, so let me turn to the probably bigger indirect impact of financialization on inequality: the effects of hostile takeovers and the threat of such takeovers on how corporations treated workers.

Last week I cited the argument by Andrei Shleifer and Larry Summers that hostile takeovers “worked” largely through “breach of trust”: breaking implicit contracts with stakeholders in corporations, especially ordinary workers.

Financialization was both a cause and a consequence of such breaches of trust. A deregulated financial industry provided the financial backing for hostile takeovers; the profits made in hostile takeover helped fuel the surge in financial profits and compensation. Ordinary workers suffered slashed benefits, layoffs, and often outright terminations.

At this point you might wonder how much trust is left to be breached. But the financial industry keeps finding new frontiers to exploit. In recent years health care has become a major focus of private equity investments, with private equity firms purchasing a number of hospitals.

What they do next, according to a study published last year in the Journal of the American Medical Association, is sell off land and buildings, then charge the hospitals rent for use of facilities they previously owned. The result, the study claims, is a reduced quality of care for patients, resulting in more falls and higher mortality.

Of course, the financial industry disputes these claims. But the private-equity/hospital story is consistent with the results of decades’ worth of takeovers in other industries. And one has to bear in mind that these financial firms aren’t buying hospitals for their, er, health. They’re doing it because they believe they can make profits on the deals, even though there’s no reason to believe that they have any special expertise in hospital management. And it’s hard to come up with a better example of people historically viewed as stakeholders even though they aren’t shareholders than hospital patients.

OK, I obviously could go on at length about every topic touched on in this primer. But I hope I’ve provided enough evidence and analysis to support four points:

• After 1980 the U.S. economy experienced a surge in financialization — defined both by the fact that it was devoting much more of GDP to finance and by an increased role of the financial industry in business decisions more generally
• There is little evidence that this financialization was good for overall economic performance. It looks more predatory than productive
• Financialization directly contributed to rising inequality via the very high incomes earned by the financial elite
• Financialization also contributed indirectly to inequality by inducing the widespread breach of implicit contracts that had previously softened corporations’ focus on profits and only profits. In addition it directly increased inequality through the financial crisis of 2008-2009, in which subprime mortgages were marketed to low and middle income home buyers.

All of this sounds pretty damning. So why hasn’t there been more of a public backlash?

That will be part of the ground covered in the next installment in this series of primers on inequality, about the ways big money exerts political power.

Read More:

• Oligarchs and the Rise of Mega-Fortunes. Paul Krugman, Understanding Inequality: Part IV
• A Trumpian Diversion. Paul Krugman, Understanding Inequality: Part III
• The Importance of Worker Power. Paul Krugman, Understanding Inequality: Part II
• Why Did the Rich Pull Away from the Rest? Paul Krugman, Understanding Inequality: Part I
• Paul Krugman’s Substack newsletter