American capitalism is sick. Not just “I think I might stay in bed today” sick. More like “call an ambulance” sick.
The sickness has a name. It’s called financialisation. It’s not a bug that’s appeared overnight. It’s crept up on us over decades like a degenerative disease. Or, perhaps more accurately, like a parasite.
This, in a nutshell, is the message of Rana Foroohar’s excellent – and profoundly troubling – book, Makers and Takers: The Rise of Finance and the Fall of American Business. It tells the story of how, in recent decades, the financial industry has ballooned in size – and at what cost to the economy and society.
Today, Foroohar writes, finance represents 7% of the US economy, 4% of US jobs and a whopping 25% of corporate profits (down from nearer a third pre-crisis). It has gone from being the servant of business to being its master – and not a very benign master at that. It’s extractive. It cares for nobody but itself. And it will stop at nothing to serve its own self-interest.
But financialisation isn’t just about the growth of finance – it’s also about the way financial thinking has infected mainstream business, as well as academia (or business schools, at least) and government.
Foroohar traces the story of how financial thinking came to rule American business back to the 1940s. Not long after America entered World War II, a senior officer in the US Army visited Harvard to recruit a group of ‘the best and the brightest’, who would form a new statistics analysis group at the War Department. The group became known as ‘the Whiz Kids’ and their quantitative analysis had a big influence on US military strategy.
After the war, the Whiz Kids’ stock was high enough that they were hired by Ford Motor Company to overhaul its structure, strategy and management practices. The result was a culture of ‘management by numbers’, which, because it was pioneered at Ford, the most revered American company of the age, was soon widely replicated.
The most famous of the Whiz Kids, Robert McNamara, would go on to serve in the Kennedy and Johnson administrations, where his obsession with paying attention only to things that were quantifiable was a major contributing factor to the failure of US strategy in Vietnam. But that’s another story.
In the corporate context, the trouble with McNamara’s ‘management by numbers’ was that it almost always led to a focus on cost reduction and short-term profit maximisation for shareholders and not on the drivers of long-term value. “Downsize-and-distribute” rather than “retain-and-reinvest” became the corporate strategy of choice.
But the damage caused was fairly contained until deregulation in the 1980s transformed the relationship between Wall Street and Main Street. The most significant regulatory change of that decade was the legalisation in 1982 of unlimited share buybacks – effectively allowing companies to manipulate their own stock price to keep investors happy. Almost immediately, a new breed of financier was born: the ‘corporate raider’ to his critics; ‘activist investor’ to his friends. Carl Icahn was perhaps the most famous of this new breed. Today, he’s a special adviser on financial regulation to President Trump.
Icahn and his ilk have spent the last three decades effectively extorting money from America’s biggest companies. Since 2004, Foroohar reports, American firms have spent $7 trillion buying back their own stock – equivalent to half their total profits.
Add dividends into the picture too and the numbers get even more mind-boggling. Between 2005 and 2015, S&P 500 companies spent $4 trillion on buybacks and another $2.5 trillion on dividends – which represents 90% of their net earnings over the period. And still the raiders go on raiding and corporations go on meekly handing over cash. ‘In 2014, buybacks and dividends represented 105% of net earnings of publicly traded American companies; in 2015, they reached above 115%.’
No publicly listed company, it seems, is able to buck this trend for long. Not even Apple. Foroohar begins her book with the rather puzzling story of how, in 2013, a company with more than $145 billion in its bank account came to borrow $17 billion in order to buy back its own shares, thereby artificially inflating its share price. But within weeks, the sharks were circling again. Icahn was back buying up Apple stock, ‘all the while tweeting demands that [Tim] Cook spend billions and billions more on buybacks.’ In May 2015, Apple pledged to spend a further $200 billion on dividends and buybacks by March 2017. ‘Meanwhile, the company’s R&D as a percentage of sales, which has been falling since 2001, is creeping ever lower.’ Cook’s Apple, Foroohar concludes, is more in the business of financial engineering than real engineering.
The perverse outcome of all this is that public markets, which were originally set up to provide companies with the means to raise capital in order to fund their own growth, today do precisely the opposite. An IPO has become a way for entrepreneurs to cash out, not a way to access capital for growth.
Tech firms scale back innovation by 40% after an IPO. Private companies – that is those not listed on any stock exchange – invest about twice as much in things like R&D, technology upgrades and worker education than comparable public companies do. And for a sense of historical perspective, consider this: in the early 1970s, the amount of money American companies ploughed back into the business was fifteen times the amount they dished out to shareholders; in recent years the ratio has plummeted to below two.
This is both completely mad and, today, completely normal.
Not all corporate bosses come out of the book quite as badly as Tim Cook. Former IBM CEO, Sam Palmisano, earns an honourable mention for standing up to activist investors in 2004, when he announced the company’s move out of the PC business and into services. Even though IBM was in the midst of returning $70 billion to shareholders, investors weren’t satisfied and called for Palmisano’s head. In the end, he decided to stop issuing quarterly earnings guidance and effectively told investors who weren’t happy with his strategy to shove it. The result: ‘one of the most successful turnarounds in corporate history.’ IBM’s share price doubled in the process.
Even so, the resistance to the pull of financialisation was short-lived. Soon the pressure on IBM from the markets to “disgorge” its cash began to mount again. Over the entire period from 2000 to 2014, the company spent more than twice as much on buybacks and dividends as it did on its own capital expenditures. The moral of the story: individuals can stand up to the system, but the system always wins in the end.
Jeff Immelt of GE is another of the CEOs whom Foroohar praises. In the decades leading up to 2008, GE’s financial arm, GE Capital, had grown to become America’s largest nonbank financial firm. GE had become, in effect, a ‘finance company that made a few things.’ Then, in 2015, Immelt announced that GE would sell off GE Capital as quickly as possible and go back to its industrial roots.
Foroohar pins a lot of hope on GE’s “back to basics” turn, describing it as ‘a canary in the coal mine of corporate America.’ She argues that ‘much of the future of corporate financialisation will depend on whether the company’s efforts to put its business model back in service to the real economy will succeed.’
But why should GE be different to Apple or IBM? The most likely scenario is that, even if Immelt succeeds in reinventing GE as a great industrial “maker”, he will eventually go and the next CEO of GE will play Tim Cook to Immelt’s Steve Jobs – unless the whole system fundamentally changes, which is hard to imagine happening without political intervention. And we all know how likely that is given who’s in the White House.
Not that previous administrations were much better. As already discussed, the rot set in during the Reagan era – and it only got worse under Clinton.
In 1993, the administration made a fateful decision to push through legislation on corporate pay. Sensibly enough, they wanted to cap corporate tax reductions for regular salaried income at $1 million. But, crucially, the legislation exempted ‘performance-related’ pay above and beyond that. It was a loophole large enough to drive a tank through. Unfortunately, nobody ever seems to have come up with a clear definition of ‘performance-related’, which is why bankers continued to receive absurd bonuses even after they’d crashed the whole system.
Worse still, the resultant growth of bonuses paid in stock options added another layer of perverse incentives: it was no longer just the corporate raiders who were focused solely on boosting stock prices; it was now in the direct financial interest of most company executives to do whatever it took to boost their firm’s share price – including, in many cases, “creative accounting” (a rather generous term: remember Enron?).
Then, in 1999, the Glass-Steagall Act – the Depression-era legislation that prevented banks from getting into non-financial lines of business – was repealed. As a result, Goldman Sachs and others began manipulating commodities markets by buying up the actual physical commodities and hoarding them. Once again, financial institutions were effectively able to extort money from companies that relied on a particular commodity – like Coca-Cola needing aluminium for its cans.
Why does all this matter? Isn’t it just the rough and tumble of the free market? Coca-Cola and Apple are big boys: can’t they look after themselves?
Unfortunately, financialisation doesn’t just impact blue-chip firms. It hurts the whole economic, social and political life of the nation (and the damage doesn’t stop at the border, either). Financialisation has three inter-linked consequences that should worry us all.
First, it fuels massive inequality. Today in America, the top 25 hedge fund managers earn more than all the country’s kindergarten teachers combined. You don’t have to be a bleeding heart liberal to think there’s something fundamentally unjust about such disparities – especially when one considers how little social value hedge fund managers create compared to kindergarten teachers. But even if you’re unmoved by the social justice argument, there are pragmatic reasons to be concerned. Inequality on this scale leads to worse health and wellbeing outcomes for everyone – not just the poor (see Richard Wilkinson and Kate Pickett’s 2009 book, The Spirit Level); it destabilises democracies (as the French economist Thomas Piketty points out, currently levels of inequality in the US are not far off where they were in France on the eve of the bloodbath that was the French Revolution); and it undermines consumer demand (the poor spend a higher proportion of their money than the rich, so as more money gets funnelled to the top end of society, demand for consumer goods – an absolutely critical component of US GDP – dries up).
Which leads us onto the second negative consequence of financialisation: it stifles growth, leading to what some economists call ‘secular stagnation’ (the secular part isn’t to do with the decline of religious belief; it means the stagnation isn’t just part of the usual cycle of boom and bust). As we’ve seen, financialisation has undercut both firms’ investment in their own productive capacity and consumer demand (the latter is partly a result of inequality and partly a result of the burden of debt). ‘The economic “recovery” that we have now isn’t a real one,’ writes Foroohar, ‘it has been genetically modified by the Fed and enjoyed mainly by the investor class.’ For most Americans, the end of growth happened a generation ago: real median wages have flat-lined since the 1970s.
But worse is almost certainly to come. There is more debt in the world today than there was on the eve of the 2008 crash – much of it carried by governments. Between 2007 and the second quarter of 2015, global debt and leverage grew by a whopping $57 trillion. In other words, though the 2008 crisis caused plenty of real suffering, that was not the bubble bursting. That was the bubble threatening to burst and being put on life support so that it deflated gently rather than bursting. But pretty quickly it started re-inflating again. Worse, we haven’t switched off the life support machine – we’ve been running down its battery and it’s the only one we have.
This is the third worrying consequence of financialisation: it’s leading us headlong towards the next crisis, which will almost certainly be much worse than the last one. It’s debatable whether governments were right to bail out financial institutions in 2008. Next time round, it may be a moot point: even if the political will is there to bail the banks out again, governments may be so weighed down by debt of their own that they’re not able to.
As the writer Michael Lewis (of The Big Short fame) puts it, ‘we have too much debt and much of the debt isn’t going to be repaid, but we’re pretending that it is.’ The final act of this drama is ‘the elimination of pretence,’ leading to ‘a more violent financial event… banks going out of business, countries having to restructure their debt, investors taking lots and lots of losses.’
There are those who think such an event will be salutary. We need to hit the reset button and start again, they argue. They’re probably right. Foroohar’s book, which came out before last year’s presidential election, is full of worthy policy recommendations – like reforming the tax system so that debt isn’t cheaper than equity – which she hopes ‘the next President’ might champion. But in the context of everything she tells us about the scale of financial industry lobbying, about the revolving door between Wall Street and Washington and about the consequent ‘cognitive capture’ of regulators and politicians, this seems like a vain hope indeed. And now we have President Trump, ably assisted by Carl Icahn and ex-Goldman COO Gary Cohn.
Salutary though it may be in the long run, we should have no illusions about what the next crisis will be like. We won’t be watching with glee as Wall Street gets its come-uppance. Ordinary people will lose their jobs and homes. Law and order may begin to break down. We’ll be looking on in horror as our life’s savings disappear down the plughole, for, as Foroohar puts it, ‘we have made a Faustian bargain, in which we depend on the markets for wealth and thus don’t look too closely at how the sausage gets made.’ Anyone with savings, a pension, property or assets of any kind – in short, everyone but the already completely destitute – stands to lose when the bubble really does burst.
For a glimpse of just how grim life after the next crash promises to be, I recommend another recent book: The Mandibles, by Lionel Shriver, is a dystopian novel set in a near-future America, in which the government defaults on its debts and allows hyperinflation to wipe out all private wealth. It’s not a happy story, but it may yet prove to be a handy survival guide for what comes next.