By Jomo Kwame Sundaram and Michael Lim Mah Hui
KUALA LUMPUR and PENANG, Jul 2 2019 – The relationship between finance and the real economy is arguably at the root of the contemporary economic malaise. Unlike earlier acceptance of simple linear causation, recent recognition of a curvilinear relationship between finance and economic growth, implying ‘diminishing returns’, has important implications.
Undermining the real economy
Financialization undermines the real economy in the following ways. While finance may promote growth of the real economy ‘in the early stages’, ‘too much finance’ is bad for growth. The rise of market finance promises higher returns, i.e., more financial rents.
With finance increasingly used for speculation, debt-financed share buybacks, as well as both ‘brownfield’ direct and ‘portfolio’ investments, purchasing existing assets means not creating new economic capacities. Financialization has thus accelerated the ‘slow retreat’ from providing credit for productive investments to fund speculation for short term gain from unproductive investments. Meanwhile, smaller enterprises face higher interest rates and more difficult access to finance.
Second, ‘impatient’ capital increases asset prices and financial volatility. Surging capital inflows – driven by banks or asset managers seeking quick yields – raise the prices of securities, derivatives and other assets, to the delight of their owners.
Reversals of capital inflows trigger sharp drops in asset prices, typically triggering systemic problems, sometimes destabilizing the real economy via violent price fluctuations, or worse, cataclysmic financial crises that may take years to recover from.
Third, the overblown financial sector sucks financial resources and human talent away from the real economy. Nobel laureate James Tobin lamented that the US was drawing its best human resources into finance with remuneration unrelated to social productivity. On the eve of the 2008 financial crisis, almost 70% of Harvard seniors chose to work on Wall Street upon graduation.
Banking before financialization
Before financialization, finance was dominated by banks engaged in both short-term and long-term lending. The former mainly funded working capital and trade while the latter financed capital investments and projects – what Hyman Minsky called ‘hedged financing’.
Hedged financing, mainly by banks, funded productive investments, with borrowers servicing both interest and principal repayment. Cross-border financial activity was constrained by the Bretton Woods system of fixed exchange rates and effective capital controls.
Besides bank-based financing, capital markets – mainly for securities, primarily equities and bonds – financed the long-term capital needs of corporations. Corporations issued securities to finance long-term capital investments, typically purchased by patient investors, such as insurance companies and pension funds.
Development banking needed
Investment banks, or ‘merchant banks’ in the erstwhile British empire, were the main financial intermediaries in capital markets. But commercial banks were often averse to financing the risky innovations necessary to accelerate economic and technological progress.
In response, governments in many countries stepped in to provide development banking. Most countries which have successfully industrialized – US, France, Japan, Korea, China, India, Brazil – have relied on public development banking as a critical tool.
Development banking has enabled states to provide subsidized long-term loans to ‘strategic’ industrial sectors to promote the international competitiveness of local firms, in turn enhancing what is termed national economic competitiveness.
With financial liberalization, international financial institutions have encouraged the development of market finance in many countries to reduce reliance on bank financing.
Capital markets key
Financial systems based on capital markets are more prone to financialization. It is easier, faster and more lucrative for speculative investors to ‘chase yield’ in such market-based financial systems.
The key is ensuring liquid secondary markets, especially with poorly regulated ‘repo’ arrangements generating profits from movements in the prices of securities, either by owning them, or by taking derivative positions on market price movements.
Market-making financial intermediaries quote prices at which they are prepared to buy – or sell – a security, securing profits from the buy-ask spread. Market makers meet demand for securities in secondary markets by either buying or borrowing them, using deregulated wholesale repo funding and derivative markets.
Central banks reluctantly foster liquidity illusion
The sine qua non of securities market-making is liquidity – the ability to buy and sell, in order to profit. For Keynes, the liquidity fetish is the most anti-social maxim of orthodox finance; as he warned, liquidity is only relevant to individual investors, not to the financial system as a whole.
This illusion of liquidity in securities-based financial systems became clear during the 2008 Global Financial Crisis when the money market – the most liquid of markets – froze when no party was willing to take on credit and counterparty risks.
The bond markets of many emerging market economies rely on foreign investors to move the prices of securities. They prefer liquid securities markets offering easy entry and exit, and demand market infrastructures conducive to short-term positions. These typically include liberalized ‘repo’ and derivative markets, to more easily finance and ‘short’ securities.
Despite central bank concerns about the illusory nature of securities market liquidity as such liquidity can easily disappear when the foreign investors pull out, most authorities in these countries have nonetheless catered to their demands by creating the desired market infrastructures.
When large highly leveraged financial institutions in these markets collapse, e.g., Lehman Brothers in September 2008, central banks are forced to step in to salvage the financial system. Thus, many central banks have little choice but to become securities market makers of last resort, providing safety nets for financialized universal banks and shadow banks.