Financialization: When Money Took Over

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Bankers walking into the City of London, one of the symbols of financialization. Image: Chris Brown/flickr

Money was invented to facilitate economic transactions and thus serve the real economy. Over the past 30 years or so, this relationship has been reversed: the real economy now appears to serve financial markets with financial crises bringing down economies. “Financialization” is the term experts use to describe this phenomenon.

As part of our Editorial Plan’s focus on international economics and finance, yesterday we described the history of the international monetary system.  On Monday the ISN speculated that the growing importance of foreign direct investment and global  financial markets makes the most recent wave of globalization the most impressive. What follows is a critical analysis of the evolution of financialization, which has pernicious side-effects that remain difficult to resolve.

Financialization is defined by Gerald A Epstein as “the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (p 3). The process of financialization is said to have started in the late 1970s or early 1980s, progressively shifting the gravity of economic activity from production to finance.

According to Epstein and the other contributors to Financialization and the World Economy, financialization makes financial markets prone to speculation, herding and instability. It leads to speculative and excessively liquid financial flows that create debt-laden balance sheets, overly short-term perspectives, volatility and mispricing of important assets, including foreign currencies. Ultimately, financialization leads to the misallocation of resources and unstable economic growth. As a result, financial markets have become increasingly fragile, as demonstrated by the recent wave of economic crises.

In “Financialization: What it is and Why it Matters” Crottey and Pally also note that financialization has had effects on the real economy, which has experienced increasing income inequality, falling employment, stagnating wages, weakening consumption and investment, and decreasing production and profits in the manufacturing industry.

As hinted at above, financial speculation can further cause a misalignment of exchange rates, prompting trade deficits and inefficient allocation of resources. It is even said to have transformed the functioning of the economic system and invalidate the theory of comparative advantage that lies at the core of ‘the free trade is the “best” trade’ mantra.

However, arguably the greatest problem financialization presents is that economists and policy makers are seeminlgy unwilling to confront the challenges it poses. According to Epstein, unwillingness among resource-dependent developing countries can be attributed to an over-reliance on theories that support “financialization, neoliberalism and globalization”. In such countries reform may also be obstructed by powerful financial elites.

Luiz Carlos Bresser-Pereira recently argued in “The Global Financial Crisis and a New Capitalism?” that the economic crises of the 1920s and 1930s helped develop theories – mainly Keynesianism – and build institutions and regulations that led to the “30 glorious years of capitalism” (1948–77). According to Bresser-Pereira these took the instability out of a laissez-faire economic system and may have helped avoid the most recent financial crisis.

Yet, these institutions and principles were largely discarded by the early 1980s by a coalition of rentiers and “financists”. They achieved almost hegemonic influence over financial markets and pressed for further deregulation of existing financial operations. They now continue to reap the benefits of the financialized system while pushing its costs onto the bulk of the global population.

With regard to the current crisis, politicians seem not only unwilling but also unable to push through the structural reforms needed to prevent future crises. Jonah D Lévy‘s analysis of French economic policy under Sarkozy demonstrates that the return to a Keynesian model, which the president would have preferred, was hard to push through partly due to neoliberal reforms introduced under the socialist government of François Mitterrand (1981-1995).

During the 1980s, key agencies and instruments of French industrial policy had been dismantled. Those reforms were accompanied by an expansion of social welfare to pacify and demobilize the victims of economic restructuring. The expansive schemes greatly reduced the financial capacity of the French state and globalization had further limited France’s regulatory capacity. As a result, the government did not have the institutional, regulatory, nor fiscal capacity to launch the industrial policy programs that could have helped re-launch its economy.

So financialization not only appears to have created the current economic, it also seems to make reform efforts extremely hard to implement. If future crises are to be prevented a re-examination of the current capitalist system proposed by Ha-Joong Chan and others may be in order. Structural changes seem to be the most salient way to face the current crisis, stem social unrest and prevent future crises.

After all, the capitalist system has been changed and improved before and many things that seemed impossible a few decades back such as the abolishment of child labor, are now generally accepted. As Chan argues, there is no reason not to think about ways to change and improve the current capitalist system because, “capitalism is the worst system, except for all the others.”

Tomorrow in ISN Podcasts, Heiner Flassbeck, Director at UNCTAD, will discuss problems of the current international financial system and share with us his pessimistic outlook to the future.

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