Debunking the Great Myth of the Financial Markets

Suggestions to solve the financial crises by basically shutting down most of Wall Street are always shouted down by howls of “How are companies going to raise money?” or “How are people going to invest in companies?”

Well, take a good, long look at this graph, which shows the percentage of capital expenditures by U.S. non-financial companies that was raised in U.S. financial markets from 1952 to 2006.

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Wall Street simply is not doing what most people think it’s doing. Nor what most people think it should be doing. Wall Street is not even doing what it says it is doing. Wall Street is pushing a big myth that its services are essential to the functioning of the rest of the economy. But the truth as, as this graph shows, Wall Street does not -- and has not for a very long time -- serve the function of allocating credit in the economy.

This graph is from page 85 of a book by Roosevelt University economics professor Ozgur Orhangazi, entitled Financialization and the US Economy, published in May 2008.

As Orhangazi notes, “The largest and most important use of funds by the NFCs is the expenditures made to acquire capital goods for productive purposes.” (I disagree; the most important, but certainly not the largest, is spending on research and development. Capital expenditures is the second most important use of funds by NFCs.) Wikipedia has a useful definition of capital goods:

Individuals, organizations and governments use capital goods in the production of other goods or commodities. Capital goods include factories, machinery, tools, equipment, and various buildings which are used to produce other products for consumption. Capital goods, then, are products which are not produced for immediate consumption; rather, they are objects that are used to produce other goods and services. These types of goods are important economic factors because they are key to developing a positive return from manufacturing other products and commodities.

Also interesting is the graph on the next page of Orhangazi’s book, which shows that since 1984, new equity issues have been less</em> than capital expenditures by U.S. non-financial companies, except for the three years of 1991 to 1993. In other words, non-financial companies do NOT use the stock market to raise funds for capital improvement programs.

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In fact, Orhangazi notes,

Figure 5.3 shows net funds raised through equity issuance, this time as a percent of capital expenditures (recall that in Figure 2.14 we saw NFC stock buybacks as a percent of NFC / gross value added). It is evident that the stock market has not historically been a major source of NFC funds. On a quarterly basis, its contribution never exceeds 18 percent of capital expenditures. On average its contribution has been below 10 percent, even in the 1952-1980 period before (the increase in stock buybacks. However, there is a dramatic change in the relationship between the stock market and the NFCs starting in the early 1980s. Except for brief periods, in the post-1980 era the net equity issuance of the NFCs has been negative and often large. The NFCs have indeed been buying back their own stocks. The stock market has turned into an institution through which NFCs channel funds to financial markets, not the other way around.

What about the bond market? According to Orhangazi, from 1952 to 1980, NFCs obtained eight to 25 percent of their capital expenditures from the bond market. After 1980, when the “Reagan Revolution” allowed Wall Street to regain the control over the rest of the economy it had lost in the New Deal, NFCs usually obtained around a quarter to a third of their capital expenditures from the bond market, with the high reached in 2001 of 45 percent. But the largest source of funding for NFC capital expenditures had been far and away internal funds.

But isn’t it a good thing that non-financial companies mostly use their own funds for capital expenditures? First of all, remember that what we’re trying to do here is debunk the myth perpetrated by Wall Street that the financial markets are of crucial importance to the rest of the economy.

Second, the fact that the financial markets contribute so little to the most crucial operations of non-financial companies is just the beginning of the story. The financialization of the economy has had severe effects on the goals and objectives of NFCs, not just their operations and capital expenditures. What has really happened is that while the size of financial markets and types of financial instruments and transactions have increased, non-financial companies have been forced to abandon the long-term planning and goals of industrial capitalism, and instead adopt the short-term perspective and “quick buck” goals of the financial markets. This short paper by Orhangazi, Financialization and Capital Accumulation in the Non-Financial Corporate Sector: A Theoretical and Empirical Investigation of the U.S. Economy: 1973-2003, an October 2007 Workingpaper of the Political Economy Research Institute, University of Massachusetts, Amherst, contains many of the main points of the book. Beginning on page 6, Orhangazi explains how and why real investment, such as capital goods expenditures, have suffered in the “financialization era” from Reagan until today.

There are two main channels through which financialization could hamper real investment. First, increased investment in financial assets can have a ‘crowding out’ effect on real investment. Total funds available to a firm can either be invested in real assets or used to acquire financial assets. When profit opportunities in financial markets are better than those in product markets, this creates an incentive to invest more in financial assets and less in real assets. There are two cases to consider. First, if we assume that external funds are limited because of quantitative constraints, because additional funds are only available at a higher cost, or because internal funds are ‘safer’ than external financing for the firm, then investing more in financial assets crowds out investment in real capital. Second, the pressure on firm management to increase returns in the short-run can force them to choose financial investments, which provide more rapid returns, as opposed to real investments, which provide returns in the medium to long-run. . . .

A second channel through which financialization could undermine real investment is by means of pressure on NFCs to increase payments to financial markets in the form of dividends and stock buybacks by the firm.8 Of course, if the evolution of financial markets and practices in the era of financialization leads to greater debt burdens on NFCs, interest payments will rise as well. The increase in the percent of managerial compensation based on stock options has increased NFC managers’ incentive to keep stock prices high in the short-run by paying high dividends and undertaking large stock buybacks. Simultaneously, the rise of institutional investors, who demand constantly rising stock prices, as well as the aftermath of the hostile takeover movement have pressured NFC managers to raise the payout ratio. NFC managers are thus motivated by both personal interest and financial market pressure to meet stockholders’ expectations of higher payouts via dividends and stock buybacks (a shift in incentives) in the short-run. Both the NFC objective function and its constraint set have changed. As a result, the percent of internal funds paid to financial markets each year has risen dramatically. This creates three distinct restraints on real investment. First, if internal funds are cheaper or safer than external financing, rising financial payments would decrease the funds available to finance real investment by reducing internal funds. Second, the time-horizon of NFC management has dramatically shortened, hampering the funding of long-run investment projects, including research and development. Third, since the firm management does not know how much it will cost to re-acquire the financial capital it pays back to financial markets each year (i.e. it has no idea what the cost of financing for ongoing long-term projects will be next year), uncertainty rises, making some projects with attractive expected gross long-term returns too risky to undertake.

And there is no mistaking what the results have been. This graph is an artifact of the de-industrialization of the United States.

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The fundamental problem is the big players on Wall Street have misused the credit mechanism of the economy for their own private gains through the bloating of debt and speculation, at the expense of actually allocating and supplying capital to the real economy. The dollar volume of financial trading has increased nearly forty-fold since the 1960s, but almost none of that trading is of any use to the real economy. Even now, after the collapse of September 2008, big Wall Street firms like are still making most of their money by trading for their own account. Last month, Time.com reported that Goldman Sachs made nearly $2 billion in the first three months of this year alone. But some analysts say Goldman, which received $10 billion from the government through the Troubled Asset Relief Program, is generating most of those profits by making risky bets on interest rates and other fluctuations in the financial markets with money it has received from the government.

Anyone who believes that saving the financial system is the way to save the economy, just does not know what the financial system is really all about.

But what about those people who want to save the financial system, because they do know what the financial system is really all about? They’re the ones winning the political fight, so far.

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In all the charts you post, except perhaps the last, 1972 (or so) seems to be some kind of turning point in the overall trend, (not a bounce but a turn). Do you think this might have something to do with the introduction of floating exchange rates?

You are proposing a far more extreme proposal than FDR et al. if you are suggesting that businesses should be restricted to working with their own capital. It seems to me that properly regulated by the government the extension of credit is an important means to creating a viable economy.


I note that a reconstruction finance bank is being set up, which will be used to support the stimulus package and infrastructure investment. Certainly we need a much larger stimulus package but the kind of remedy that you seem to be suggesting, to me looks like throwing out the baby with the bath water.

carol

the baby drowned in the bath water ... just sayin'.

I am NOT advocating a system of self-financing using only internal funds. What I'm trying to do is show that Wall Street is NOT performing the function it is supposed to be performing, and says it performs, namely, allocating capital within the economy. The fact that Wall Street is not performing this function - and has not been for quite some period of time - goes directly to the heart of the Obama / Summers / Geither rescue of the financial system. Even before the 2007-2008 crisis, the financial system was NOT performing its duties towards non-financial companies. So, trying to get the financial system "working again" is not going to do anything to help non-financial companies, even if the rescue succeeds.

I think it pays to be cautious about blanket condeminations of the Obama administration. I think it is still possible for things to take a much better turn.


I am impressed about the continuity of government that exists which is difficult to defeat. Things are likely much more difficult for Obama than they were for FDR for many reasons aside from issue of their respective personal qualifications etc.

carol

Well, 1972 is the year an Undersecretary of the Treasury named Paul Volcker convinced Nixon to end fixed exchange rates, right? A complete violation of Article 1, Section 8 of the Constitution regarding regulating the value of money. Also, about the same time the Bank of England stopped trying to manage interest rates, wasn't it? A year ago or so, Bill Engdahl posted a 3 or 4 part series entitled "Financial Tusnami" that went through the details of elites' mismanagement of the U.S. and world economies.

By the way. Engdahl has a powerful interview with Russia Times now online (hat tip to Melo on EuroTrib for the link): 

"Not even Jesus could reverse the decline in the US"

 

RT: So how long do you think it is going to take before we see the end of this recession?

W.E.: The point is we are at an epochal change. This is something that happens perhaps every four or five hundred years. This is not a once a decade recession we are living through. And I call it in my new book the ‘Decline of the American century’. This is a terminal decline as you had with the British Empire after WWI. It would not matter if Jesus Christ was the President of the US today. There would be nothing he could do to reverse that decline process. We would almost have to reorganize and start from scratch, because the cancer of this financial system has embedded so deeply that they’ve destroyed the industrial technology in the US.

They outsourced manufacturing over the past 25-30 years to Asia, to Eastern Europe, all over the world. The American elite have rotted itself from the inside out over the past 30-40 years since the early 1970s.

Bill's free to write and say what ever he wants, I'd wonder if he might not be on safer ground if his formulations were a bit more understated. I'd personally feel more comfortable with something that was less definitive, and not in the present indicative. Verb forms  perhaps which said "I think" coupled with more contingent forms like "might" or "maybe", subjunctive constructions, or even outright contingent hypotheticals, like "if we assume that... or if this is so then..." After all he's writing about the future isn't he?

I do believe that the unsalvageable will not be salvaged, that the more that is put into the banks, the worse things will be.When the government puts its faith and credit into bailing out these things, there will come a time when the government is on the line for what it has done. Obama told C-Span yesterday that we're out of money. Here's the link to the transcript. Here's the snippity snip

"SCULLY: Yet, it all takes money. You know the numbers, $1.7 trillion debt, a national deficit of $11 trillion. At what point do we run out of money?
OBAMA: Well, we are out of money now. We are operating in deep deficits, not caused by any decisions we've made on health care so far. This is a consequence of the crisis that we've seen and in fact our failure to make some good decisions on health care over the last several decades." (Find it near the bottom of page four of the transcript). And Standard and Poors is warning the Brits about downgrading their government debt. Humiliating details here.

And on page 6 near the top Obama also said

"And you know the economy is going to bounce back..."

But it isn't is it? And those green shoots are turning out to be real weeds -- one of the reasons being, as long as they defend financial securitization they can't provide mortgage relief for homeowners on the scale needed to outrun the growth in unemployment.

But who is to say whether that is epochal or not, what kind of support would make the phrase about the last four or five hundred years meaningful? The Dutch Truce with Spain began in 1609. A hundred years before Pope Julius della Rovere was at war against the rest of  Italy, I think. I'd stick with Ecclesiates, and leave it all to the Byrds. ! hope you haven't taken to reading Norman Cohn in your spare moments,  :) If we are coming to an end though, remember the rule, last one out, turn off the lights, please.

As, uhm, interesting as it looks, I simply don't have time for it right now. My top priority right now is to figure out a way to prevent a determined young squirrel from eating the birds' suet block I have hanging outside my window - without killing the little bugger, I hope.

I just drove over one coming back from Harper's Ferry (I was driving back, I don't know where the squirrel was coming from, or why it chose to cross the road). Sic Transit...