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.
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.
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.
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.