Financialization Part I- What Is Financialization?
One of the most important macroeconomic trends of the past several decades is financialization. Financialization is the tendency in developed countries for the finance sector to take up an ever-increasing percentage of GDP. In the United States, this trend has been particularly pronounced: the proportion of finance in value-added GDP increased by 60% between 1980 and 2007. This post and the next one are adapted from a presentation I gave in a finance class; this post will be a more comprehensive explanation of what financialization is and how it has developed in the United States since the 1980s.
(Source: Greenwood and Scharfstein)
The above graph shows the three branches of finance: insurance, credit intermediation, and securities, all of which have grown substantially. Much of the growth in insurance is due to the incredibly complex economics behind American health insurance, and, while fascinating, that topic would take up several theses to even begin to explain. I’ll focus on credit intermediation and securities.
Credit intermediation has grown by about 50% (Figure Two) since 1980, although not evenly across its components. The bottom two categories on the graph represent traditional banking, the conventional business of lending and taking deposits. That sector has actually declined slightly as a revenue share of GDP, from about 2.8% to 2.5% over 30 years. The entirety of the growth in credit intermediation came from a sector broadly called “transactional services”- credit card accounts, deposit accounts, ATMs, and, most importantly, loan origination, particularly for mortgages during the mid-2000s housing bubble. Securitization, a sector that barely registered in the 1980s, grew tremendously to a 1.5% share of GDP due to the rise of
mortgage-backed securities. Much of this is the rise of the infamous mortgage-backed securities, which often collapsed in 2007-2008. In fact, essentially the entire growth of access to credit, much of which went to subprime buyers who later defaulted on their mortgages, grew either as securitization or “shadow banking”- banking not done by a traditional bank and thus performed without insured deposits or ensured access to the Federal Reserve’s lender-of-last-resort capacity. The effect of this supply shift can be seen in Figure Three; household debt increased drastically, going from 60% to almost 100% of nominal GDP during the 2000s. This increasing complexity and leveraging of the financial system came to a crashing halt with the bursting of the housing bubble, these trends began a fast shift back towards historical norms.
The third sector of finance is securities, a diverse array of management services. Trading, underwriting of credit, commissions on advisory services, and pension administration have all remained stable (Figure Four). A category that has grown substantially is “traditional asset management,” mutual funds and ETFs. There are two effects determining fee revenues: magnitude of fees and value of assets under management. According to Greenwood and Scharfstein, due to the decline of mutual funds with up-front fees, overall fees on equity mutual funds did drop from 2% of assets to 1% of assets. However, between 1980 and 2007, US nominal GDP grew from $2.8 trillion to $14.5 trillion (St. Louis Fed) while the percentage of households with professionally managed equity holdings went from 25% to 53%. The effect was a huge influx of funds to asset managers. Also benefitting from the flood was high-fee “alternative asset management”: hedge funds, private equity, and venture capital, all of which became significant starting in the 1990s. These firms use a fee structure known as the ‘2-and-20’ model: a flat fee of around 2%, plus a 20% cut of profits made above a certain benchmark. Also growing substantially is the category marked “other broker-dealer activities,” a category dominated by derivatives trading (basically, trading on bets people made on whether certain events would happen in the world).
This post is long and really mostly from an essay I wrote, but the details are important in seeing how finance has changed through the period of deregulation beginning in the 1980s. I’ll talk on a more conceptual level about the debate over whether this is a positive development next week.
Greenwood, Robin, and David Scharfstein. “The Growth of Finance.” JSTOR. Journal of Economic Perspectives, n.d. Web. 16 Sept. 2014.
“FRED Graph.” Federal Reserve Bank of St. Louis, n.d. Web. 16 Sept. 2014.
March 2, 2015
The Federal Budget and the Long-Term Fiscal Deficit
In recent years, the federal deficit has fallen significantly, from about 10% of GDP in 2009 to only a projected 2.6% this year. (The raw number for the deficit is the number usually quoted in the news, but really, it’s the debt-to-GDP ratio that matters. It’s not difficult to pay back a high raw debt if the government has a high GDP from which it can get tax revenues.) This is good news, and the deficit has declined in news significance. Unfortunately, though the short-term picture for the deficit and debt is rosier than it was a few years ago, the long-term trajectory is, frankly, a disaster in waiting. To see why, first we need to look at how the federal budget is spent.
A graph representing the federal budget can be found at the link to National Priorities. For the 2015 fiscal year, the President proposed a budget fairly similar to that of past years: Social Security, Unemployment, and Labor would be 33%, Medicare and Health would be 27%, the military would be 16%, interest payments on already existing debt would be 6%, and energy, environment, science funding, education, housing, veteran’s health, foreign aid, agriculture, transportation and infrastructure, and domestic and international government agencies combined would total the remaining 18% of federal spending. Public perceptions about these proportions are completely, disastrously wrong. One particularly egregious example: for decades, polls have consistently found that Americans believe that foreign aid constitutes somewhere between 25 and 30% of the federal budget, and they support foreign aid cuts to about 10% of the budget. The actual percentage of the budget spent on aid is about 1%, so really, to accommodate public opinion the foreign aid budget should be increased by 1000%. (When told of the actual number, people tend to say 1% of the budget is appropriate).
In terms of the long-term US fiscal trajectory, what the reality of the federal budget demonstrates is that the only sectors that really matter are the military and health care. Small changes to either sector would overwhelm even drastic cuts or massive increases in funding to any other individual budget area. And in the area of health care, which consumes more than half of the federal budget, the trend is alarming. The Baby Boomer generation, born in the years following World War II, is entering retirement, and so less workers are going to have to contribute more money to fund more retirees’ Social Security and Medicare. The Congressional Budget Office estimates that the Social Security trust fund will run out of money, at current pace, in 2033. At that point, stabilizing Social Security would require either massive tax increases or correspondingly massive cuts and benefits.
Unbelievable, this scenario is a huge improvement over scenarios envisioned a decade ago, mostly due to the sequester and the slowing of the rise in projected health care costs. Research on why health care costs are slowing is being done, and it is probable that the Affordable Care Act is a significant reason. However, the Center on Budget and Policy Priorities still expects debt-to-GDP ratio to rise from around 70% today to over 100% by 2040, and the major entitlement programs are the primary reason. If the United States has another war on the scale of Iraq or Afghanistan, which is not improbable, those numbers could shift quite significantly.
Overall, the United States’ short-term fiscal health is under control. However, public misconceptions about how the federal government spends money are hindering effective public dialogue on our long-term debt problem, which, if left unattended, poses a serious threat to American prosperity.
February 23, 2015
Author: Andrew Granato
February 23, 2015
Recently, the headline economic news has been, once again, the economic situation inGreece, whose resolution was kicked down the road (once again) by a four-month extension of the Eurogroup bailout. A brief recap of the situation: of all the countries to become trapped in the Eurozone crisis, Greece was the hardest-hit. Some statistics from The Economist provide some context. Since 2008, while the GDP of the rest of the Eurozone has weakly recovered andis within reach (about 2% less) of pre-crisis levels, Greece’s GDP has dropped by 25%, an absolutely jaw-dropping number on par with the nadir of the Great Depression. Every economic indicator has moved accordingly: unemployment (currently at 26%), particularly young unemployment (currently at 50%), has skyrocketed along with poverty. As more and more people stopped contributing to government funding through the income tax and instead started requiring social welfare assistance, Greece’s deficit exploded at the exact time a bailout was required.
The now-despised ‘troika’ (The International Monetary Fund, European Central Bank, and European Commission) bailed out the country, averting financial disaster. It is the conditions attached to that bailout that lead to the recent election of Syriza, a far-left party whose finance minister, Yanis Varoufakis, describes himself as an ‘erratic Marxist’. Syriza, while it maintains that it wants to keep the Euro as its currency and not move back to the previous Greek currency, the drachma, has taken an extremely hard line against the austerity conditions that the previous Greek government was forced to accept. Greek government debt is currently at about 170% of GDP (for comparison, the average of the Eurozone is around 100% of GDP, as is the United States, which is regularly attacked for excessive indebtedness by domestic politicians). Bailout conditions, among other things, required Greece to cut thousands of government jobs, drastically reduce labor protections, lower the minimum wage, all while maintaining a budget surplus of 4.5% of GDP. Syriza, though it was recently forced to essentially abandon its promises to repudiate the conditions to get its bailout extension, vows to continue fighting.
To succeed, Syriza needs to grow up, though it does deserve some credit. Greece has a huge, overbearing bureaucracy that stifles economic growth, and various regulations, such as tenure-like protections that make it almost impossible to cut wages or fire government employees, are almost comical. Syriza also does not seem to recognize that, ultimately, it is Greece and only Greece that is responsible for its current state; Syriza shortsightedly wants to rehire many public workers to inefficient positions and regularly levies all of its criticism at Germany without looking at Greece’s own responsibility. But despite its flaws, Syriza’s point about Greek fiscal sustainability is essentially correct. Greek society is halfway to collapse (which is how Syriza got elected in the first place). Golden Dawn, an openly Neo-Nazi party, has seats in Parliament. To expected Greece to adhere to punishingly austere policies while restricting its ability to provide stimulus to an economy where 1 in 4 people is out of work is overly moralistic and punitive, and self-defeating. Greek tax revenues will not grow back to the state needed to repay its debt if trapped in permanent recession. Germany’s brinksmanship in negotiations means that there is a nonzero change that Greece will actually throw up its hands and leave the Euro, setting off a contagion effect. Podemos, a far-left party in Spain which leads in polls, may be next up.
Syriza has shown elements of pragmatism: it is pushing for a crackdown on rich tax evaders and alienated its own left wing by capitulating to a four-month bailout extension with more conditions. Its basic argument about austerity is right, and it deserves to be taken seriously. Forcing Greece to buckle may appeal to tightfisted morality, but it is not a long-term soluition.
February 19, 2015
Author: Avner Kreps
Divestment and the Global Economy
This past Tuesday, the ASSU decided to pass a controversial resolution to recommend to the board of trustees to divest from a select group of companies. These companies, maintains the Stanford Out of Occupied Palestine (SOOP)-initiated resolution, “caus[e] substantial social injury by violating international humanitarian law in the Occupied Palestinian Territories.” Most of the companies listed by name in the resolution are multinational corporations, including Caterpillar, Lockheed Martin, and Raytheon. The nature of these companies’ places within the global economy is why divestment of this sort will not prove effective.
As a hypothetical, let us assume that divestment of this sort is effective on a macro level, and that it puts pressure on these companies to stop selling to Israeli settlers. While these companies might be the largest multinational firms in their respective fields, they are by no means the only ones. The existence of global substitutes gives any human rights violators in the area choices in deciding which companies to buy from. While removing one firm from the equation might cause people in the area to buy from different companies, it will not stop people in the area from buying at all.
For example, take Caterpillar, the world’s largest manufacturer of construction equipment. SOOP wants Stanford to divest from Caterpillar because they “manufactur[e] bulldozers … that are used to demolish Palestinian homes.” Say that divestment works and Caterpillar stops selling its products to Israel or the Palestinian Territories. Caterpillar is not the only bulldozer supplier in the world; Israeli settlers can simply start buying from companies such as Komatsu, Volvo, or John Deere. The same goes for Lockheed Martin and Raytheon, both of which have substitutes like Boeing and Northrop Grumman. The fact that there are worldwide competitors available makes divestment of one company in the industry ineffectual.
SOOP brings up the South African divestment of the 1980s as evidence that divestment works. However, there is a fundamental difference between South African divestment and this instance: the state of the global economy. Since the late 1970s and early 1980s, when the bulk of South African divestment across college campuses took place, the global economy has expanded in size and scope due to the liberalization of international trade and increases in quality of technology. The entry cost of starting a global company is lower than ever right now, and certainly a significant amount lower than it was in the late ‘70s and early ‘80s. The lower entry costs means that if there is unfulfilled demand in an area, it is much easier for a company to fulfill that need no matter where that company is located worldwide. As an example that globalization is not limited to the largest companies in the world anymore, look at Palo Alto’s own gourmet burger joint, The Counter. The Counter, hardly one of the top businesses in the world, has locations in Ireland, Saudi Arabia, the UAE, and is coming soon to Malaysia. Divestment now not only has to deal with the largest companies in the world, but the plethora of medium-sized companies that couldn’t have gone global in the 1980s and can now. The globalization of smaller businesses means that fully divesting from any and every company that might deal in Israel will certainly take a lot longer than the eight years it took for Stanford to fully adopt South African divestment (source). The actual rate of change of divestment, if it moves at all, would move at a glacial pace.
The ethical tenants of divestment as a symbolic gesture are debatable, with both sides having valid arguments. However, because of the nature of the global economy, it is extremely unlikely that divestment would cause any actual economic change in the region. While SOOP may have won a political victory, their mission of putting economic pressure on Israel to end the occupation will remain unfulfilled.