Financialization

Financialization -- the growing role of financial markets, financial institutions, and financial motives in the operation of the economy -- is one of the most significant structural changes in American capitalism since 1980. The financial sector's share of corporate profits rose from approximately 16% in the early 1970s to over 40% by the mid-2000s. Financial assets grew relative to physical capital. The logic of financial markets -- short time horizons, extractive rather than productive orientation, return maximization over stakeholder welfare -- increasingly colonized the governance of non-financial corporations.

The proximate causes of financialization include: the deregulation of financial services beginning in the late 1970s, which expanded the range of profitable activities available to financial firms; the Reagan-era reduction in top marginal tax rates, which increased the after-tax returns to financial strategies that convert ordinary income to capital gains; the growth of institutional investors (pension funds, mutual funds, insurance companies) as major market participants, which increased the proportion of corporate equity held by investors with short holding periods and performance incentives linked to quarterly returns; and the development of financial derivatives that allowed risks to be bundled, tranched, and sold to remote investors.

The consequences for the real economy have been documented across multiple research programs. Increasing financial activity by corporations -- share repurchases, special dividends, financial market investments -- is associated with reduced investment in physical capital, research and development, and workforce training (Lazonick, 2014). The shift in corporate time horizons that financialization produced has contributed to the erosion of US manufacturing capability, the underfunding of basic research, and the substitution of financial engineering for productive innovation.

Share buybacks, which were effectively prohibited as market manipulation before 1982, have become the primary vehicle for distributing corporate cash to shareholders -- at the expense of investment, wages, and long-term productive capacity.William Lazonick, Profits Without Prosperity, Harvard Business Review (2014)

The financial crisis of 2008 illustrated the systemic risks of a financialized economy. The mortgage-backed securities and collateralized debt obligations at the center of the crisis were products of financial innovation -- the slicing and distribution of mortgage risk across the global financial system -- that the financial sector's regulators and risk models had certified as safe. When housing prices fell, the distributed risk became distributed catastrophe, propagating through financial networks in ways that destroyed value far exceeding the original losses on the underlying mortgages.

The post-crisis response -- the bank bailouts, quantitative easing, and regulatory reforms of Dodd-Frank -- preserved the financial system and partially constrained its most dangerous behaviors without reversing the underlying dynamics of financialization. Share buybacks, which S&P 500 companies repurchased at a rate exceeding $1 trillion annually before the COVID-19 crisis, continue to dominate the deployment of corporate cash flow. The financial sector remains the most profitable sector of the American economy and the largest source of campaign contributions to both political parties. The structural conditions that produced the crisis have been moderated, not resolved.