Financialization at Heart of Economic Malaise

Yves here. The statement in this article’s headline about the dangers of financialization needs to be repeated loudly and often. Financial services should be boring and low cost, and where they get government subsidies via explicit or de facto guarantees (often!) they should be regulated as utilities. Otherwise, they become vehicles for rentierism and wasteful allocation of resources. For instance, as Michael Hudson pointed out, classical economist backed usury ceilings; otherwise, one of the most lucrative borrower groups were rich gamblers, who hardly deserved to have their habits supported at the expense of productive industry.

As we wrote in ECONNED:

It is easy to be overwhelmed by the vast panorama of financial instruments and strategies that have grown up (and blown up), in recent years. But the complexity of these transactions and securities is all part of a relentless trend: toward greater and greater leverage, and greater opacity.

The dirty secret of the credit crisis is that the relentless pursuit of “innovation” meant there was virtually no equity, no cushion for losses anywhere behind the massive creation of risky debt. Arcane, illiquid securities were rated superduper AAA and, with their true risks misunderstood and masked, required only minuscule reserves. Their illiquidity and complexity also meant their accounting value could be finessed. The same instruments, their intricacies overlooked, would soon become raw material for more leverage as they became accepted as collateral for further borrowing, whether via commercial paper or repos.

But even then, the bankers still needed real assets, real borrowers. Investment bankers screamed at mortgage lenders to find them more product, and still, it was not enough.

But credit default swaps solved this problem. Once a CDS on low-grade subprime was sufficiently liquid, synthetic borrowers could stand in the place of subprime borrowers, paying when the borrowers paid and winning a reward when real borrowers could pay no longer…..

Institution after institution was bled dry. Yet economists and central bankers
applauded the wondrous innovations, seeing increased liquidity and more efficient
loan intermedation, ignoring the unhealthy condition of the industry.

The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.

The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Not enough has changed since then, even with the IMF warning in 2015 that too much financialization was a drag on growth and that Poland represented the optimal level of financialization. Other studies during that time frame also suggested that excessive levels of financial activity, particularly almost entirely unproductive secondary market trading and asset management, were significant drivers of secular stagnation. This post provides more current data and arguments supporting these views.

By Anis Chowdhury, Adjunct Professor at Western Sydney University and University of New South Wales (Australia), who held senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, a former economics professor, who was United Nations Assistant Secretary-General for Economic Development, and received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought. Originally published at Jomo Kwame Sundaram’s website

COVID-19 has exposed major long-term economic vulnerabilities. This malaise – including declining productivity growth – can be traced to the greater influence of finance in the real economy.

The deep-seated causes of the current resurgence of inflation, inequalities and contractionary tendencies have not been addressed. Meanwhile, reform proposals after the 2008-2009 global financial crisis (GFC) have been largely forgotten.

Declining Productivity

Productivity growth has been declining in major economies since the early 1970s. As the World Bank noted, well “before the … pandemic, the global economy featured a broad-based decline in productivity growth”.

World labour productivity growth slowed from its 2007 peak of 2.8% to a post-GFC nadir of 1.4% in 2016, remaining under 2.0% in 2017-2018. This slowdown has hurt over two-thirds of advanced, emerging market and developing economies.

Except for a brief productivity spike in some countries around the turn of the century, labour productivity growth in developed Organization for Economic Cooperation and Development (OECD) countries was declining, with trends low, but stable after the GFC.

Why the Slowdown?

For Robert Gordon, this was mainly due to declining total factor productivity growth (TFP) – or slower technical innovation, organizational improvements and labour skill growth – in recent decades, particularly in industrial nations.

For the World Bank, reduced investment and TFP growth deceleration have been roughly equally responsible for the productivity slowdown. Slowing working age population growth and limited education progress have also contributed.

The United Nations noted, “as firms around the globe have become more reluctant to invest, productivity growth has continued to decelerate”. It blamed the slowdown on reduced investments in machinery, technology, etc.

Slower transitions to more diverse and complex production have also delayed progress. Some supply shocks due to ‘natural causes’ – of which 70% were climate change related – have also hurt productivity growth.

Growing inequality has weakened demand, slowing economic and productivity growth. As workers’ spending declined with labour’s income share, demand has been sustained by more public and private borrowing.

The International Monetary Fund (IMF)’s April 2017 World Economic Outlook confirmed this trend. Productivity growth declines have lowered real incomes, reducing consumer spending, demand and growth.

joint report of the Bank of International Settlements (BIS), OECD and IMF also blamed unconventional monetary policies – very low, even negative real interest rates, and corporate bond purchases. Thus, corporate financial fragilities have weakened investment and productivity growth, especially since the GFC.

Deeper Malaise

More sustainable and inclusive growth policies can help increase productivity. But blind faith in ‘market solutions’ since the 1980s has worsened resource misallocations, sectoral imbalances and job-skill mismatches.

One-sided demand stimuli – through more deficit spending or monetary expansion, without complementary supply-side measures – have only made limited impact. Also, supply-side measures to enhance growth need appropriate regulatory reforms – not wholesale deregulation.

Deregulation has often strengthened product market oligopolies while labour’s bargaining strength has generally declined. Growing corporate power has reduced labour income shares as executive salaries have risen since the 1980s.

Paranoia viz deficits and debt has cut public spending. Public investment remained flat during the early 2000s, rising slightly after the GFC, before declining until the pandemic. Worse, public spending cuts have not been offset by more private investment.

Slower capital stock increases cut potential growth in advanced economies from the 1980s. Debt and deficit paranoia has cut public services, social protection, public education and healthcare – hurting the vulnerable most.

Negative Externalities

Markets have also failed the environment, undermining sustainability. Inadequate investments in renewable energy and sustainable agriculture have resulted in food and energy shortages – now exacerbating inflationary pressures.

Financialization, tax cuts and deregulation have also encouraged speculative activities, share buybacks and other portfolio purchases. Unconventional monetary policies have also enabled unviable ‘zombie’ firms to survive.

Thus, there has been rising protectionism and harmful beggar-thy- neighbour policies – such as competing corporate income tax rate cuts while weakening environmental protection and labour rights.

Meanwhile, much needed productive investments, especially in infrastructure, technology and innovation, remain underfunded. National problems have been worsened by failure to improve multilateral economic governance.


Declining productivity growth was due to finance’s creeping dominance over the real economy from the 1970s. With banking more internationalized and concentrated, traditional financial intermediation by commercial banks has been undermined by market allocation and ‘universal banking’, combining both commercial and investment banking services.

Financialization has thus subverted economic motives, markets and institutions, adversely affecting progress, balanced development and long-term productivity growth in various ways:

• Corporate decision-making and firm behaviour are increasingly influenced by short-term financial market indicators, e.g., share market prices, rather than medium- and long-term prospects;
• Non-financial corporations increasingly profit from financial, rather than productive activities;
• ‘Non-traditional’ financial activities (e.g., stock market investments) of commercial banks have increased their exposure to systemic, including external risks;
• The distinction between short-term speculation and patient long-term investment has become blurred;
• Executive and even managerial remuneration has been increasingly linked to short-term profitability, as measured by share prices, not longer-term considerations.

Such features have adversely affected real investments and innovation, due to finance pursuing short-term returns. Thus, financialization has negatively affected investment, technology adoption and skill upgrading, with adverse consequences for productivity and decent jobs.


The financial system has also undermined the real economy by syphoning talent from it, with attractive inducements. Thus, talent has gone to finance at the expense of the real economy, especially harming technological progress.

James Tobin challenged “throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to the social productivity.”

Then American Finance Association president Luigi Zingales showed financial growth in the last four decades has basically been rent seeking, i.e., securing profits without adding any value.

Finance has captured rents “through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities… By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers”.

Banking abuses have been innovative, ranging from collusion, abusive practices, market manipulation, rigging interest, exchange and other rates, passing risk to unsuspecting customers, aiding and abetting tax evasion and money laundering.

Real Economy Drag

Finance has thus retarded development of the real economy in various ways. First, financial development has not been conducive to intermediating between savings and real investments. Markets allocate funds by criteria other than promoting investment in the real economy.

Second, financial markets and speculation do not generate or otherwise add real value. Third, financialization and regulatory failure have generated more frequent and damaging financial crises.

Seeking to maximize returns, fund managers and their ilk mainly invest in response to short-term financial trends. Presumed to be best left to markets, actual capital formation – increasing economic output – and productivity growth have slowed, to the detriment of most.

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  1. rick shapiro

    Financialization is only one aspect of a broader issue that increasingly pervades the economy: concealment of risks by agents. This is not merely the classic agency problem (viz. managers who never need to disgorge
    bonuses after a panic reveal the risks inherent in their bets), but also similar risk concealment by money managers who pretend to be fiduciaries for their clients. The supply chain crisis reveals another aspect of risk concealment, as managers, who achieved personal success by using just-in-time to squeeze out higher profits enabled by reduced inventory, are mostly untouched as the concomitant risks are realized.

    1. Colonel Smithers

      Thank you, RS.

      I would add the UK energy market to that with the new providers / intermediaries behaving like many banks pre-GFC and their mismatch between borrowing short and lending long.

  2. sadie the cat

    Can anyone help clarify this paragraph?

    “But credit default swaps solved this problem. Once a CDS on low-grade subprime was sufficiently liquid, synthetic borrowers could stand in the place of subprime borrowers, paying when the borrowers paid and winning a reward when real borrowers could pay no longer……”

    There is much about the GFC that I still do not understand and would like to. If anyone can recommend a striaghtforward Financial Crisis 101 book, written for non-economists and non-bankers, I woud be grateful.

    Thank you.

    1. JEHR

      Naked Capitalism is the place where you can learn about CDS, subprime mortgages and the GFC. You can also read Econned by Yves Smith. It will take a long time to learn everything, believe me!

      1. michaelismoe

        The reason that he won’t forgive student debt is not entirely because he has to pay back the principle but the unknown ramifications of the derivatives that have been issued around them. They’d bet on a cockroach race if it made them money

        Private student loans can be packaged together to form derivatives called SLABS, which (in theory) allow investors to receive regular coupon payments on the underlying loans. These SLABS bear significant similarities to the Collateralized Debt Obligation (CDO) derivatives that were a substantial factor in the 2008 financial crisi

      2. sadie the cat

        Thanks. I’m coming late to the NC posts and missed early analyses / discussions when we were undergoing the GFC. Smart crowd. High level of basic understanding of HOW things work. I appreciate your tip(s) and honesty about the learning process.

    2. tindrum

      Basically you get aroud needing ever more real people who take out a mortgage and buy a real house by allowing many people to bet on whether the actual borrowers will default or not. This adds leverage-fairy-dust and Robert is indeed your father’s brother.

      1. sadie the cat

        Oh…after the 3rd read, i just realize you answered what the phrase meant. It took awhile! Thank you!
        (Actually Robert was my father)

    3. Roger

      CDS is really an insurance product, you are insuring against a significant credit event (downgrade to junk, default etc.) to the underlying bonds. Unlike normal insurance you are allowed to buy insurance against another’s assets, just like buying house insurance against your neighbour’s house. There is a reason that you cannot do the latter. In the 1990s the regulators tried to get CDS regulated as insurance but the “powers that be” blocked them.

      “The Big Short” involved Goldman Sachs creating crappy mortgage-backed-securities by basing them on crappy mortgage pools intentionally, then selling them to unsuspecting investors while selling CDS to a certain hedge fund manager. They were set up to fail and the hedge fund manager collected the insurance while the MBS holders took the losses – just like burning down your neighbour’s house.

      CDS’s allow a huge amount of manipulation and outright fraud, as well as removing the need for investors to do the proper diligence on what they are buying – one of the basic problems that created the 2008 GFC. They should be regulated like insurance, but that would impact big bank’s earnings and force investors to carry out basic debt credit analysis – most probably increasing credit spreads on shitty borrowers.

      1. sadie the cat

        Dear Roger, thanks for your comprehensive reply. I’ve read it several times and have made a dent in my understanding. I never knew the CDS were sold and that the buyer (hedge fund) collected when “the house burned down”. I thought the big banks kept them as a hedge, knowing the mortgages were garbage. When you write “They should be regulated like insurance, but that would impact big bank’s earnings and force investors to carry out basic debt credit analysis – most probably increasing credit spreads on shitty borrowers.” …I’m still working on that one. I thought they WERE insurnace. Asset collapses, insurance (CDS) pays out. But, maybe you’re saying the crappy asset was over-valued in the 1st place, so even CDS insurance does not cover full loss? If I’m way off the mark, don’t feel the need to explain. It’s a long haul.

        Also you wrote “Unlike normal insurance you are allowed to buy insurance against another’s assets, just like buying house insurance against your neighbour’s house. There is a reason that you cannot do the latter. In the 1990s the regulators tried to get CDS regulated as insurance but the “powers that be” blocked them.” The reason you cannot do that is because: it is unseemly to buy insurance on neighbor’s house? or because CDS valuations are all wrong (undervalued? the collateral is over-valed in 1st place?)?? Or some other reason. Lost here.
        You obviously “Get” something essential that I don’t.
        Sometimes I wish I’d been a bank auditor, an insider, just to be able to understand our economy and financial system which rules everything now.

        Many thanks, Roger. Very kind of you to reply in depth.

        Anyway, Thank you! We’ve made a dent.

    4. Beyond the rubicoN

      Not a book, however Paul Jay’s 9 part interview with Bill Black on The Analysis site was very informative helped with some of this stuff.

      1. eg

        Endorsed. While light on the technical side it is the most thorough explanation of the outright fraud and predatory lending at the root of the GFC going all the way back to the Savings and Loan crisis in the 80s. It’s also explains the serial and scandalous malfeasance on the governance and enforcement side in the US over 20 years or more.

  3. Matthew G. Saroff

    I just want to comment on Yves’ introduction to note that a Credit Default Swap (CDS) is clearly insurance, even though regulators have (IMHO maliciously) misclassified it as not-insurance, and the way that those instruments have behaved has been illegal for 276 years:

    In 1746, Parliament passed the Marine Insurance Act, requiring anyone seeking to collect on an insurance contract to have an interest in the continued existence of the insured property. Thus was born the insured-interest doctrine. The indemnity doctrine, which precludes a buyer from insuring property for more than it’s worth, soon followed. The point of these rules is to limit insurance contracts to trading existing risks and not to create new risks by giving buyers of insurance incentive to destroy property. The doctrines have been part of insurance law in both England and the United States (which in 1746 were colonies under English common law) ever since.

    The short version of what happened is that during one of the many wars between England and France, people started taking out insurance on ships for which they had no interest, and on cargos for which they had no interest, and then communicated the schedules of these ships to a co-conspirator in France.

    The French would seize the ships and cargos and said co-conspirators would split the proceeds.

    This was the OG version of, “Taking out insurance on your neighbor’s house, and then burning it down,” and the CDS provides exactly the same perverse incentives.

  4. flora

    per Yves: Financial services should be boring and low cost, and where they get government subsidies via explicit or de facto guarantees (often!) they should be regulated as utilities.

    Great idea.

  5. Susan the other

    Reading this I almost thought the title got it backwards. That, looking back, it appears more to be Economic Malaise at the Heart of Financialization. 6s? They each supported the other. Deregulation was a crazy choice. But in an economy based on the rights of private property, government is restrained. I’ve never seen a politician ever advocate for much regulation of anything. Except Bernie. So like a Greek Tragedy, when the law of diminishing returns hit the US economy in the 70s, value had already been extracted by the boatloads. Always called “profits”, regardless of how they were procured. I’m just sayin’. Yes financialization was a hopeless and immoral tactic, but in order to make things actually function we needed lots of regulation and government stimulus. I think the US economy was already dead in the 70s. We had no time to lose but nobody had the know-how or the courage to do it. Regulate. Allocate. Plan. We haven’t seen anything resembling industrial planning and generous social benefits since FDR – and even he could have done more. So now financialization is killing the economy. But we can’t do without it out of a fear that the whole thing will collapse. It’s crazy. The only choice we have is to spend our way out. And in the process re-regulate in some serious manner that everyone will accept. What else?

    1. flora

      an aside: when the US economy stalled with stagflation in the late 70’s, the Milton Friedman school of neoclassical economics insisted the fault was in the New Deal’s adoption of Keynesian-style economics and that model had failed. A *new* economic was needed, they said, and they had just the plan ready to go for Reagan. The neoclassicals had been working and writing on their plan since the 1950s. Enter stagflation, enter Friedman’s neoclassical “freedom to choose” plan on the public stage. Planning meets opportunity…for them, not for us. (Hope that history is at least directionally right.) My 2 cents.

      (Where has a new school of economic thought been building in the US over the past 20 years? There are scattered economists doing great work, but I don’t know of a university economic department, outside of UMKC, that departs from the reigning paradigm. )

      1. Susan the other

        And the MMTers at UMKC aren’t terribly radical. They are making corrections to the imbalance caused by libertarian capitalism/neoliberalism. That’s a moderate way to change things without rocking the boat too much. I do think it is working because MMT advocates have been listened to by just about every government in the Western sphere. Germany, Italy, the UK; and China and probably Russia. Kelton has also advised democrats in Congress – and Republicans seem to be good at picking up her points. The one thing that MMT doesn’t do is infringe on personal property rights (beyond taxing them). Which is probably a good thing because if personal property rights come with obligations then they can be justified. I’ve been wondering if we shouldn’t propose an amendment to the dear old Constitution which effectuates and emphasizes the “obligations” half of the bargain. (Kind of like Russia saying one sovereign cannot create its own security at the expense of another’s.) That could even be done in the same context as using MMT to balance the inequalities of our system. And you’d think it would also serve to stabilize finance. But that would take some serious governance.

  6. hemeantwell

    I’d appreciate it if someone would use the above to address the work of people like Michael Roberts, who place great emphasis on the tendency of the profit rate to fall, thereby leading capitalists to avoid fixed, long-term investment in favor of the grab bag of alternatives the article describes.

    As I read the above, it sounds like there’s much chicken and egging going on, leading into a bog of correlations. Roberts’ work tries to bring some order, but at times the RoP sounds like an indicator that’s relatively discernible, instead of being an aggregate measure that most capitalists would have trouble determining, and likely wouldn’t bother since they are oriented relatively narrowly to their industry.

    That said, the sources cited by the article at least occasionally sound superficial and uninquisitive, as in the problem with productivity is due to lack of investment, full stop, instead of asking why that lack exists. Because the RoP seems absent from their considerations, one wants to use that to improve the explanation, but is that getting us anywhere?

    Any takers?

    1. deplorado

      Think of economists as the priests of the middle ages legitimizing power with their formulations – previously based on the scripture and now on the economic textbooks. The priests obviously have the role to ask a whole lot of questions within the cannon and to studiously avoid questions that go beyond. That’s why, as you said, the sources sound “superficial and uninquisitive” – their purpose is to place the debate within the cannon while creating the appearance of critical thinking.

      One of the giveaways is the phrase “intermediating between savings and real investment” – which has been demonstrated to be a false concept, in all its parts.

  7. Godfree Roberts

    Productivity growth has been declining in major economies since the early 1970s???

    In the world’s largest economy, productivity has been doubling every ten years for decades and shows no sign of slowing.

    Sadly, that economy belongs to The Country Whose Name Must Not Be Spoken, but savvy readers can figure it out.

    Perhaps they can also figure out why its name may not be spoken…

    1. Yves Smith Post author

      I am pretty sure his statement is accurate.

      All of the G-7 countries except the United States had their largest increases in manufacturing output during the 1950–73 period. As was the case in other countries, U.S. output growth slowed after 1973, but then it grew faster after 1990, regaining and even surpassing its pre-1973 growth rate.

      As Paul Krugman explained in the 2000s, it turned out the supposed productivity growth in the US in the 1990s relied on increases in efficiency in check processing being overstated in terms of their significance to financial players. Correcting for that produced more meager results.

  8. Altandmain

    It is a shell game to enrich the already rich further. That what all of this financialization is all about.

    For all its failings, industries like the energy industry, manufacturing, Silicon Valley, etc sometimes produce things that are valuable to society. Often they too are unethical and try to claim credit for publicly funded innovation too. It’s a far from perfect system.

    Sure, we need some degree of finance, but not to the size it’s become. It is a rent seeking parasite.

  9. drumlin woodchuckles

    A real estate agent showing a house to a client in the Raleigh area for under $300,000 saw Eleventeen Hundred people coming in to see about that house. She made a video of it. I am not sure exactly how financialization at the heights of the economy causes effects like this down in the valleys of society, but I suspect it is all linked.

    Here is the video.

  10. Sound of the Suburbs

    Before the new liberal order there was an old liberal order.

    We stepped onto an old path that still leads to the same place.
    1920s/2000s – neoclassical economics, high inequality, high banker pay, low regulation, low taxes for the wealthy, robber barons (CEOs), reckless bankers, globalisation phase
    1929/2008 – Wall Street crash
    1930s/2010s – Global recession, currency wars, trade wars, austerity, rising nationalism and extremism
    1940s – World war.
    We forgot we had been down that path before.

    Everything is progressing nicely and we are approaching the final destination.
    This is what it’s supposed to be like.
    Right wing populist leaders are what we should be expecting at this stage and it keeps on getting worse.

    Things do tend to fall apart at the seams when using neoclassical economics.

    I remember now, it was Keynesian capitalism that won the battle of ideas against Russian Communism.
    These liberal phases never end well.

    What’s wrong with neoclassical economics anyway?
    Any serious attempt to study the capitalist system always reveals the same inconvenient truth.
    Many at the top don’t create any wealth.
    That’s the problem.
    Confusing making money and creating wealth is the solution.
    Some pseudo economics was developed to perform this task, neoclassical economics.

    Rentiers make money, they don’t create wealth.
    Rentier activity in the economy has been hidden by confusing making money with creating wealth.

    Knowing what real wealth creation is has always been a big problem.
    The classical economists identified the constructive “earned” income and the parasitic “unearned” income.
    Most of the people at the top lived off the parasitic “unearned” income and they now had a big problem.
    They needed some new economics, and fast.
    Neoclassical economics.

    The neoclassical economist doesn’t know what wealth creation is for a very good reason.
    To protect the interests of those at the top of society.

    What could possibly go wrong?
    Neoclassical economists have always excelled in creating wealth of the evaporating kind.

    At the end of the 1920s, the US was a ponzi scheme of inflated asset prices.
    The use of neoclassical economics, and the belief in free markets, made them think that inflated asset prices represented real wealth.
    1929 – Wakey, wakey

    The wealth evaporation event of 1929 finally brought them to their senses.
    They needed to find out what real wealth was.

    It took them a long time to disentangle the hopelessly confused thinking of neoclassical economics in the 1930s.
    This is when they invented GDP.
    The real wealth creation in the economy is measured by GDP.
    Real wealth creation involves real work, producing new goods and services in the economy.
    That’s where the real wealth in the economy lies.

    The belief that rising asset prices creates wealth is great for bankers.
    On a BBC documentary, comparing 1929 to 2008, it said the last time US bankers made as much money as they did before 2008 was in the 1920s.

  11. TomDority

    Since all this financial innovation has only benefited a small segment of the population and has been a clear contributor to war, famine, global warming and detriment to most of the worlds population, environment, civilization, society and governance – – I would be looking for a way that this financial innovation (created by humans) can be harnessed for the good of man and the planet and all of it’s creatures.
    Maybe it requires the highest taxation. Instead of billionaires and plutocrats donating a small bit to their charities to get recognition as a good fellow – maybe it should be taken back from these FIRE sector barons and baseball card traders as restitution for the thefts from the public purse that they are

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