Rapid Growth In Financial Sector : Fall And Fall Of The Real Economy

By - Saumil Sharma

Rapid Growth in Financial Sector : Fall and Fall of the Real Economy Introduction Financial economy stands today as dominating the role in global economic order. The finance sector, although having a long history, saw a much quicker growth since the early 1970‟s. Within three decades finance has established its mark in he global order today with substantial shift in the perspectives of state and the real economy towards the role of finance. Global financial sector has experienced multiple periods of extreme growth as well as sudden collapse during the short period in which it has gained a significant role in defining the world economy. As it appears, finance leaves no alternatives to capital flows by creating strategic imperatives to be pressed upon the real economy and the industrial establishments in the developed and developing economies. A neo-liberal view point criticizes state intervention as the disruption in the natural working of the Financial Markets. This paper argues against the consideration of a disembedded market operation from the real economy. Finance as assumed to have taken its place in the global economy by relegating the real economy, presenting new opportunities for economic growth based on market fundamentals alone is of a problematic nature. This view is suggestive of the existence of financial markets in a vacuumed space with no relation to the social fabric of the real economy. Literature on financial growth is often of the opinion that the markets are a self-sustaining natural phenomenon which have self-correcting capabilities. Also that the growth in financial sector is achieved through an independent nature of finance and its clear division from the real economy. Such an explanation disregards the historical analysis of a social and political framework in which the finance industry settles itself. This paper is an effort to bring to light the existence of certain social circumstances combined with the deregulation efforts of the states to build a historical relevance of social and political conditions under which the finance sector grew rapidly and has sustained impacts of abrupt change during the three decade long period under study. The literature involved in this analysis has been incorporated in view of tracing the

development in the finance sector since the introduction of new forms of electronic money till the most formidable form of financialization that the global economy is currently experiencing. Impacts of Introduction of Electronic Money During the 1970‟s the global economy saw a new development in the form of electronic money. It evolved into this new form with the IT revolution, creating new dimensions of storage and exchange of money at different levels in the major economies, ranging from individual consumers to large scale financial institutions. Due to this transformation a majority of the opinion in the concerned literature is of a standpoint that new forms of money pose a threat to the existing form of world order and undermine the role of states in both controlling the flow of money and exercising power over monetary matters. Helleiner1, in his critique on this strand of thought, expresses that there is more to understanding the new forms of money and its interaction with the state than to constrain the debate on control of money by states. Money, even in its more confirmative paper forms, has not always been strictly locked under state control. There has been money laundering, illegal trade and exchange, and other forms of state inefficiency to control the flow of money. So, the mobility of money is not significant support to the idea of a transformation of world order and global economy. The more important aspect of electronic money and its ever pervasive nature is an underlining factor of the growth of financial markets around the world. As Helleiner puts in his own words: The IT revolution has, after all, coincided with a period when the most powerful states have liberalized their external capital controls completely. Although, he expresses his decent from completely basing the process of liberalization on the compulsive pressures on the states in the face of what he calls „competitive deregulation‟ pertaining to the extreme mobility of new money forms. So, the eroding state control over money, even if not a result of the technology of new money forms, has a link in the transformation of the economic order during the 1970‟s and the 1980‟s. Therefore, I consider a relationship in the framework of deliberate liberalization policies adopted by

states with the increased mobility of cash flows, transforming the world economy, as a fundamental condition for the growth of finance as a major part of world economy in the following decades. While Joel Kurtzman argues that impact of technology developments is different between finance and the real economy by providing a world view in which he stages that new forms of money have created a separate universe in which it breaks all natural boundaries of state control and regulation over its appearance to the world and its implications on the real industrial growth2. I believe that the author maintains an extreme focus on finance as it exists rather than going into the depth of its rise and growth through relevant state response to the new forms of money and the state domestic policy not being eroded as an irrelevant concept in this new era, but as being a very important mechanism through which the finance industry has grown into what we observe today as the integrated Global Financial Markets. It seems as if the development of new forms of money was an intrinsic demand of the growing world of finance. As the financial paradigm was growing, so was the demand for faster and intangible modes of monetary exchange. If framed on how far did real economy account for such a demand, it looks grim in the face of a severe demand that rose from the finance industry. The free flow of money can be seen as both the result and the premise of the growth in finance and provides a reason for the growth of financial economy overshadowing the role of real economy. At such a pace of transfer of funds and large sums of money proved utterly beneficial for financial growth in the face of rising state concern over foreign capital flows and the efforts of finance industry to break free from the constraints of state domestic policy. Rapid growth of Finance The finance sector in major economies grew rapidly after the 1971 crisis. This sector comprised of a growing deregulated form of flow of capital and banked upon the liberalized state policies. With a qualified monetary system involved in the practices of the growing financial markets around the world, it was clear to be based on an

institutional setup of the existing framework of world economy. The literature criticizing finance as an entity which grew almost independently regardless of the fact that most economies during the early years of major growth in finance sector were facing a conflicting position of decreasing profit margins and increasing high wage demand dismisses the position and role of state policies in nurturing the growth of finance. Most of these economies had accumulated massive reserves of US dollars following which the world experienced the collapse of Bretton Wood system and a re-introduction of free floating exchange rates3. There were many attempts by the states of the major manufacturing economies to recover from this condition of downward spiral of decreasing profitability4. In the words of Martin Konings, who criticizes the neo-liberal viewpoint of the growth of world financial system as a self-sustained self-regulating entity, the financial setup of the world should be looked at as: “It is widely understood that markets are not a natural phenomenon and that it is not only economic logic but rather the configuration of economic and political interests and the institutions that determine the precise relations between the state and economy at any given time“5. Robert Brenner‟s analyses the end of a long boom post-WWII which ended into a long cycle of economic downturn encompassing all major developed economies. Developing economies were also engulfed later as a consequences of the developments in finance and increased flow of foreign capital into these economies. Brenner posts an argument against the most embracing explanations for decreasing rate of returns and incapability of states to regulate for a revival of increase in profitability. He rejects productivity, technological exhaustion, and real wages as the basis of this decreasing profitability during the 70‟s and the 80‟s, but instead suggests that the underlying problem was international competition among major manufacturing economies. The competition created a condition of reduced rates of return due to extreme pressures of losing international export market share in the face of long sustained problem of over-capacity over-production6. The factors which governed growth were paradoxical in nature as each competing economy in the manufacturing sector was dependent on the simultaneous growth of other economies for

maintaining prices in their international markets. Where at the same time this simultaneous growth was a major reason for falling average rate of returns which did not allow the creation of any surplus reserves to create new investment for maintaining the increase in supply in response to the state subsidy towards creating a demand. The state borrowing was high during the decades of 70‟s and the 80‟s with an exception of the short lived strict monetarist policy experiment in the early 80‟s. The state deficits were increasing due to increased borrowing, especially in the US which created the grounds of revaluation of many major currencies against the dollar, making exports to US market more difficult on the top of US domestic market protectionist policies. But this also created a situation of an ease in the prices of US assets for foreign buyers in the international market. During these two decades there was a cyclic problem of high inflation due to an enormous increase in state borrowing thereby creating large deficits. In efforts to curb high prices and inflation the states adopted protectionist policies which resulted in very high interest rates and thus had to be revived by the older model of heavy borrowing to create sufficient liquidity in the domestic markets. For example the Latin American debt crisis of 1982 was a direct result of high interest rates creating a scarcity of opportunities to obtain debt thereby creating a condition of recession in developing economies of Latin America, mounting international pressures of an economic slowdown due to decreased liquidity in international markets7. As US economy was universally accepted as the driver of growth in the global economy, and also as the one player in the world order which had the capability to pull the global economy out of multiple periods of recession, for example sustaining the pressures during the oil embargo of 1973 even with a substantial devaluation of the dollar8. The role of the US in the world economy has much to do with the role of Federal Reserve(Fed) policies which regulate the US domestic market and also the interaction of US Banks and other financial entities in the international market9. Changing role of Fed during the growth of finance As argued by Konings the role of Fed during its early years of formation was to ensure

that the banking system of the US remained buoyant with liquidity in times of economic upturns and downturns. It was exercising procyclical policies in effect to meet the increased demand during the economic upturns, and restricting credit expansion during monetary tightening in the economic downturns. Later due to the New Deal legislation and the federal deposit insurance made Fed‟s role as the lender of the last resort fade away and it became a more focused and centralized institution with sufficient power towards maintaining a monetary policy for the economy as a whole. During late 1950‟s and early 1960‟s the US banks found it extremely difficult to maintain the process of corporate lending due to a crunch of liquidity in the banks. The banks were restricted to capped rates of interest which instigated the rise of financial markets an alternative for corporate borrowing. In response to this disintermediation trend of the direct borrowing-lending for money supply in the real economy, the banks shifted their focus from the traditional asset management policies to liability management policies. Therefore, the banks recreated the method of subscribing to sources of funding by creating growth targets of its assets and finding funds in the money markets for matching these growth commitments. This constituted the process of aggravating securitization of traditional bank assets by transforming them into liabilities for generating funds10. With a negative response of the Fed towards this process of liability management persued by the bank for generating funds created the need for bypassing the Fed‟s control, as banks needed to sustain their new funding mechanism. This is commonly understood as the creation of Euromarket, a market which was based on dollar holdings in foreign countries. The Euromarket provided the US Banks an opportunity to continue their effective securitization process to fund their domestic funds requirements. The increasing free flow of capital in the US domestic market which was not under control of the Fed‟s regulation was a result of the undergoing a process of further complicated financial innovations to create new financial products. The Fed was no more fully capable of maintaining the control over domestic monetary policy to influence interest rates and other money market indicators by committing to open market operations11.

During the 1970‟s this process of massive credit creation, especially by the liability management policies of the US Banks, coupled with the crisis and collapse of Bretton Woods System and a free floating exchange rates with contagion of low profitability created an enormous opportunity for the huge amount of credit created to be channeled to the continuously growing financial markets. All through the 1970‟s major financial growth in terms of credit creation and industry spending on the speculative markets was maintained on a rise. With the monetarist tightening of credit and restrictive policies in 1979 created a change in the approach of Fed‟s view of regulating economic growth. The restrictions of obtaining additional reserves by depository intuitions was lifted and the deregulated model of control led to an extremely high interest rate. Even in when facing lack of liquidity the banks and other institutions found overwhelming credit generation from the Euromarket and there was a concurrent flow of this capital into the developments in financial products offered by the gradual integration of the Financial Markets. Therefore, the long held problem of high inflation was not solved by the tightening of credit and liquidity crisis, as there was sufficient credit generation, but due to declining profit margins in the manufacturing industries of all major economies huge amounts of liquidity was channeled into the financial sector. This was an era of extreme stimulation of financial activity and the position of finance compared to real economy was far better in terms of rates of return when compared to the same in the real economy. The real economy still worked as was expected on low liquidity and thus gave rise to high rates of interest. These high interest rates created a further involvement of banks in securitization and large capital flows into the financial markets. In the words of Konings the condition that prevailed in the real economy and in the financial sector was: “These processes of financialization essentially represented a massive inflation of asset prices - not, however, an inflation that represented a dysfunctional aberration incompatible with the structure and institutions in place to organize economic activity, but precisely a kind of inflation that was embedded in institutions and policies bestowing

on financial strategies a degree of systemic viability and coherence“.12 Konings argues that after the 1987 shock of stock market crash in the US, the Fed gained more control over the policy making and regulation mechanism of capital flows in the financial sector and therefore made a commendable position for itself. The global integration of the Financial Markets and its continued growth during the 1990‟s leads to a paradoxical condition of Fed‟s improved position in controlling the financial activity and also maintain the desired directions of capital flow movements. Fed reorganized its policy into a clear position based on interest rates and its influence on the real economy by performing open market operations. The deregulation of markets was supported by the Fed policies and also a deregulation pattern was imposed on developing economies so as to create new venues for foreign capital ventures. The dependence of financial markets on real economy operations can be attributed to the market size and liquidity growth to enormous levels which gave the regulative bodies a position of leverage to maintain their command on factors which reflected direct consequences on financial markets and thus create conditions that have been argued by Konings in his explanation of the role of Fed in the 1990„s. This approach also emphasizes on the institutional framework of the real economy in which the financial sector prevails and provides a standpoint against the popular arguments of finance growing out of the social fabric of the real economy. Role of Finance and practices in Financial Markets As put by Jim Stanford - “Financial Markets are a medium to match savers with investors and thereby fuelling the process of economic growth”13. Financial industry works as the intermediary to manage the flow of capital between different economic agents to stimulate greater investment in the real economy for economic growth. The stock market, theoretically, is an institutional setup to generate new financial capital that can be used in the by industry in the real economy as new investments. Breaking from the theoretical framework and cutting into the reality the financial markets

have become self-indulgent entities of exploding financial capital growth which is then reinvested in the same financial setup further aggravating the process of capital growth. The creation of new financial products as a conscious process of financial innovation is a method to contain the flow of capital with in the financial industry to create a vicious circle of reinvestment of capital raised from finance into new financial assets. In practice the relation between the industry in real economy and its investment made are arguably not generated in the theoretical framework of capital generation in finance, but instead are funded by the internal capital flows of the firm itself. It becomes evident that the industrial exposure to financial markets is limited to the speculative behaviour of stock markets and not a determinant of the corporate investments. The financial industry runs on speculation of asset prices. Volatility of currency, bonds, stocks, futures market, etc. is crucial towards the process of increasing rate of returns on investments made into such financial assets. Fluctuations in asset prices are a natural phenomenon of the speculative trade in financial markets. The uncertainty of prices is reflected as volatility of the parameters governing the growth in real economy. As the financial markets and the real economy converge at factors like Interest Rates, Currency Exchange Rates, Securitization of Real Assets (like mortgage backed securities), Commodity Futures, etc. there is a clear interdependence of the two. These factors define the capacity to which the real economy can expand, borrow, and invest to maintain a methodical advance towards growth. Kurtzman suggest: “This tug of between the real economy and the speculative economy, while adding costs to the real, garner profits for the speculative. The two are in a way, in conflict with each other; not always, but usually. And they interact in ways we do not fully understand“.14 Financial Markets have a tendency to overshoot in either direction, positive or negative, depending upon the inclination of the economic agents, whether government or investors, towards economic stability, growth credibility and other indicators of soundness of an economy. As Harmes puts in his argument that overshooting is a consequence of the false signals provided by the ill-representation of the „true‟ value of assets when markets do not operate efficiently causing poor economic synthesis and decisions. Overshooting of a

currency, as in the case of the 1994 Mexican Crisis, is based on the high value of the currency relative to its true value in the international exchange market which creates a fundamental flaw in terms of overpriced currency. On due correction this flaw creates a heavy devaluation of the currency leaving it into a negative overshoot which leads to a crisis situation.15 Almost all major crisis since the 1982 debt crisis have a fundamental similarity while at the same time each has an acute difference from the rest. The 1982 debt crisis of Latin America was a result of the foreign deficit accounts of all major economies involved had surpassed their debt-repaying power. The situation of lack of credit availability lead to a condition of extreme debt in the face of which the economies had to adjust budget spending to create surplus for debt repayment. As Barry Eichengreen and Albert Fishlow state in their analysis that the during the 1982 crisis: “Fiscal correction became the principle vehicle for external adjustment”16. They also suggest that the between the crisis of 1982 was different in nature of financial exposure than the 1987 US stock market crash, the 1994 Mexican Crisis and the 1997 Asian Crisis. In these later crises the adjustments had to be made with fiscal as well as monetary instruments due to the massive growth of financial industry, especially during the 1997 Asian Crisis. During the 1990‟s the international diversification of the financial markets and increasing complexity of the financial products created ever higher risk involved investments in the developing economies of Asia. The governments were in support of foreign capital inflow for which they adopted liberal policies and maintained a position of economic credibility by fixing their currency exchange rates. Stephan Haggard and Andrew MacIntyre suggest, by providing economic fundamentals which partially constituted the basis of the Asian Crisis, that there was a dramatic increase in foreign inflows including bank lending, foreign direct investment and portfolio investment. They argue that problems of overvalued currency along with speculative attacks of devaluation combined with a contagion leading to crisis of confidence led to the pull out of foreign inflow from these economies, ultimately leading to a major currency devaluation in the affected economies17. In the context of developing economies, Robert Shiller‟s comment provides

an explanation to the economic condition of the affected economies in Asian at the time of crisis: “If we exaggerate the present value of the stock market, then as a society we may invest too much in business start-ups and expansions, and too little in infrastructure, education, and other forms of human capital“.18 Conclusion In essence the finance industry has always remained embedded in the social and political system. Even today, when economies have been massively deregulated, the role of finance cannot be seen without reference to the real economy. The appearance of finance industry is far more impressive in terms of the amount of capital flow that exchanges hands every day through the stock exchange but it has to be understood that this money has no form or tangible existence. Rather it is of a recycled nature, being constantly regenerated in the form on new exchange with new economic agents. As for the case, the Banks today have far more money in circulation than compared to the commercial banking deposits made by the retail investors. This is possible by methods of securitization and re-securitization in continuous cycles which creates enormous amounts of intangible credit which circulates in the financial industry. The real economy has been affected very closely by the fall of financial setup of a particular economy than compared to the rise of the same financial setup. The underlying reason exists in the recirculation of credit generated by financial products by re-investment into new financial models, thus refraining to let any gains spill over in the real economy. The huge amount of credit creation leads to an inflation of asset prices but does not affect the consumer prices. Whereas during the collapse of the financial markets, the direct impact is on the factors of the real economy affecting the financial markets like interest rates, exchange rates, etc. Also there is a sudden demand for huge amounts of liquidity due to the failure of credit generation through financial endeavors. The short-term behaviour of the many financial institutions like the mutual funds19 and the risk-covering hedge funds create conditions of unnecessary response by investors in the financial markets. Such practices strongly prevailing in the financial markets today further aggravate the condition of speculation and volatility. This creates uncertainty in prediction of economic indicators in the real economy. Therefore, they are often

considered responsible for creating imbalances by over-inflating the financial assets, at times resulting in a crisis of confidence. As Jim Stanford summarizes the Minsky‟s most important conclusion about ‟financial fragility‟: “The Financial Instability carries important real economic consequences. Financial markets are not quarantined casinos. Both their manias and their crises have powerful consequences for the real economy, where people work to produce real goods and services of real value”.

References 1. Helleiner, Eric (1998) “Electronic Money: A Challenge to the Sovereign State?”, Journal of International Affairs, Vol. 51 No. 2, Spring, pp. 387-409 2. Kurtzman, Joel (1993), “The Death of Money”, London: Little, Brown and Company (chap 1,2,5,6) pp. 15-40, 62-84 3. Eichengreen Barry (1995), “Hegemonic Stability: Theories of International Monetary System”, in J Friden and D. Lake (eds.), International Political Economy: Perspectives on Global Pwer and Wealth, London: Routledge: 240-254 4. Brenner, Robert (2002), “The Boom and the Bubble: The US in the World Economy”, London, Verso(Chap 1): pp. 7-41 5. Konings, Martijn (2007), “Monetarism in the US: The Development of New Forms of Institutional Control Over Banks and Financial Markets” in L. Assassi, A. Nesvetailova and D. Wigan (eds.) Global Finance in the New Century: Beyond Deregulation, London: Palgrave: pp. 151-165 6. Brenner, Robert (2002), “The Boom and the Bubble: The US in the World Economy”, London, Verso(Chap 1): pp. 7-41 7. Eichengreen, Barry and Fishlow, Albert (1998), “Contending with Capital Flow. What is Different about the 1990‟s?” in M. Kahler (ed.), Capital Flows and Financial Crises: pp. 23-68 8. Brenner, Robert (2002), “The Boom and the Bubble: The US in the World Economy”, London, Verso(Chap 1): pp. 7-41 9. Konings, Martijn (2007), “Monetarism in the US: The Development of New Forms of

Institutional Control Over Banks and Financial Markets” in L. Assassi, A. Nesvetailova and D. Wigan (eds.) Global Finance in the New Century: Beyond Deregulation, London: Palgrave: pp. 151-165 10. Konings, Martijn (2007), “Monetarism in the US: The Development of New Forms of Institutional Control Over Banks and Financial Markets” in L. Assassi, A. Nesvetailova and D. Wigan (eds.) Global Finance in the New Century: Beyond Deregulation, London: Palgrave: pp. 151-165 11. Konings, Martijn (2007), “Monetarism in the US: The Development of New Forms of Institutional Control Over Banks and Financial Markets” in L. Assassi, A. Nesvetailova and D. Wigan (eds.) Global Finance in the New Century: Beyond Deregulation, London: Palgrave: pp. 151-165 12. Konings, Martijn (2007), “Monetarism in the US: The Development of New Forms of Institutional Control Over Banks and Financial Markets” in L. Assassi, A. Nesvetailova and D. Wigan (eds.) Global Finance in the New Century: Beyond Deregulation, London: Palgrave: pp. 151-165 13. Stanford, Jim (1999), “Paper Boom: Why the Real Prosperity Requires a New Approach to Canada‟s Economy”, (Chap 3 and 13), pp. 41-71, 283-303 14. Kurtzman, Joel (1993), “The Death of Money”, London: Little, Brown and Company (chap 1,2,5,6) pp. 15-40, 62-84 15. Harmes, Adam (2001), “Unseen Power: How Mutual Funds Threaten the Political and Economic Welfare of Nations”, Toronto: Stoddart; pp. 18-82 16. Eichengreen, Barry and Fishlow, Albert (1998), “Contending with Capital Flow. What is Different about the 1990‟s?” in M. Kahler (ed.), Capital Flows and Financial Crises: pp. 23-68 17. Haggard, Stephen and MacIntyre, Andrew (1998), “The Political Economy of the Asian Economic Crisis”, Review of the International Political Economy, 5 (3): pp. 381-392 18. Harmes, Adam (2001), “Unseen Power: How Mutual Funds Threaten the Political and Economic Welfare of Nations”, Toronto: Stoddart; pp. 18-82 19. Harmes, Adam (2001), “Unseen Power: How Mutual Funds Threaten the Political and Economic Welfare of Nations”, Toronto: Stoddart; pp. 18-82

20. Stanford, Jim (1999), “Paper Boom: Why the Real Prosperity Requires a New Approach to Canada‟s Economy”, (Chap 3 and 13), pp. 41-71, 283-303