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September 10 - October 28, 2018
corporations use their profits to boost share prices in the short term instead of reinvesting them in production for the long term.
Prior to the 2007 financial crisis, the income share of the top 1 per cent in the US expanded from 9.4 per cent in 1980 to a staggering 22.6 per cent in 2007. And things are only getting worse. Since 2009 inequality has been increasing even more rapidly than before the 2008 financial crash. In 2015 the combined wealth of the planet’s sixty-two richest individuals was estimated to be about the same as that of the bottom half of the world’s population–3.5 billion people.
A common critique of contemporary capitalism is that it rewards ‘rent seekers’ over true ‘wealth creators’.
Value can be defined in different ways, but at its heart it is the production of new goods and services.
By ‘value creation’ I mean the ways in which different types of resources (human, physical and intangible) are established and interact to produce new goods and services. By ‘value extraction’ I mean activities focused on moving around existing resources and outputs, and gaining disproportionately from the ensuing trade.
the disappearance of the concept of value, this book argues, has paradoxically made it much easier for this crucial term ‘value’–a concept that lies at the heart of economic thought–to be used and abused in whatever way one might find useful.
In practice, markets are what economists call imperfect, so prices and wages are often set by the powerful and paid by the weak.
We cannot limit progressive politics to taxing wealth, but require a new understanding of and debate about wealth creation so that it is more fiercely and openly contested.
If labour produced value, why was labour continuing to live in poverty and misery? If financiers did not create value, how did they become so rich?
The development of natural sciences and mathematics encouraged attempts to place economics on a similar ‘scientific’ footing, as opposed to what was becoming seen as the more ‘literary’ endeavours of the political economists. Above all, perhaps, the rising power of capitalists in a society long dominated by aristocratic landowners and local gentry meant that a new analysis of capitalism was required to justify their standing.
The inclusion of concepts like equilibria in the neoclassical model had the effect of portraying capitalism as a peaceful system driven by self-equilibrating competitive mechanisms–a stark contrast to the ways in which the system was depicted by Marx, as a battle between classes, full of disequilibria and far from optimal, whose resulting revolutions would have been better described by Erwin Schrödinger’s concept of quantum leaps and wave mechanics.
The emergence of marginalism was a pivotal moment in the history of economic thought, one that laid the foundations for today’s dominant economic theory.
The consequences of marginal thinking for the production boundary are dramatic. As we have seen, classical thinkers differed in their definition of who was and was not productive. For Quesnay only farmers were productive; Smith put services in the ‘unproductive’ bracket; and even Marx defined productive workers as those who were working in capitalist production. In marginal thinking, however, such classification was swept aside. What replaced it was the notion that it is only whatever fetches a price in the market (legally) that can be termed productive activity. Moreover, productivity will
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When students learn about microeconomics in the classroom (e.g. how prices are determined, including wages), they are not told that this is only one of many different approaches to thinking about value. It is, as far as they are concerned, the only one–and, as a result, there is no need to refer to the word ‘value’. The term essentially disappears from the discourse. It is simply Microeconomics 101.
If value derives from price, as neoclassical theory holds, income from rent must be productive. Today, the concept of unearned income has therefore disappeared.
As long as products and services fetch a price on the market, they are worthy of being included in GDP; whether they contribute to value or extract it is ignored. The result is that the distinction between profits and rents is confused and value extraction (rent) can masquerade as value creation.
It is crucial to remember that all types of accounting methods are evolving social conventions, defined not by physical laws and definite ‘realities’ but reflecting the ideas, theories and ideologies of the age in which they are devised.
By focusing on government only in terms of the spending, it is by definition assumed to be ‘unproductive’–outside the production boundary.
If the non-market prices of the output are lower than the total costs of intermediate inputs, value added would even show up as negative–indeed, government activities would ‘subtract’ value. However, it makes no sense to say that teachers, nurses, policewomen, firefighters and so on destroy value in the economy.
In essence, we behave as economic actors according to the vision of the world of those who devise the accounting conventions. The marginalist theory of value underlying contemporary national accounting systems leads to an indiscriminate attribution of productivity to anyone grabbing a large income, and downplays the productivity of the less fortunate. In so doing, it justifies excessive inequalities of income and wealth and turns value extraction into value creation.
Until the 1970s, the financial sector was perceived as a distributor, not a creator, of wealth, engaging in activities that were sterile and unproductive. At that point, through a combination of economic reappraisal of the sector and political pressure applied by it, finance was moved from outside to inside the production boundary–and in the process wreaked havoc.
today, if we use the value-added formula (wages plus profits), we find that the financial sector, far from contributing 7.2 per cent of GDP to the UK economy and 7.3 per cent to the US (as the 2016 national accounts showed), in fact makes a contribution to output that is zero, or even negative. By this yardstick it is profoundly, fundamentally unproductive to society.
Short-selling (or ‘shorting’), which involves borrowing an asset and selling it in the expectation of buying it back after its price has fallen,11 is another speculative activity whose growth contributes to GDP under the new form of measurement. If money is made by shorting property-related investments before a slump, as investors such as the hedge fund manager John Paulson famously did before the 2008 crash, the profit increases GDP.
Society at large then bears the costs of the speculative mania: unemployment rises and wages are held down, especially for those left behind during the previous economic expansion. In other words, value is extracted from labour’s share of earnings in order to restore corporate profits.
Banks are not only empowered to create money as well as channel it from one part of the economy to another; they also do remarkably little to turn households’ savings into business investment. In fact, in the US case, when the flow of funds is analysed in detail, households ‘invest’ their savings entirely in the consumption of durable goods while large businesses finance their investment through their own retained profits.
As a matter of fact, only about 3 per cent of the money in the UK economy is cash (or what is sometimes called fiat money, i.e. any legal tender backed by government). Banks create all the rest. It wasn’t until after the 2008 crisis that the Bank of England admitted that ‘loans create deposits’, and not vice versa.
Trade in financial instruments had vastly outgrown trade in real products and was stimulating the very price fluctuations from which profits are made–by creating opportunities to buy low and sell high.
Financial bubbles can be seen as the result of value being extracted; during financial crises value is actually destroyed. The fallout can be measured not only in output and job losses but also by the amount of money that governments had to pour into private banks because they were ‘too big to fail’: the quantitative easing (QE) schemes that followed the crisis might have been used to help sustain the economy, but ended up further propping up the banks.
The massive and disproportionate growth of the financial sector (and with it the origins of the global financial crisis) can be traced back to the early 2000s, when banks began increasingly to lend to other financial institutions via wholesale markets, making loans not matched by deposits.
The growth of finance has also fed the growth of inequality, not least by adding to the influence and lobbying power of financiers who tend to favour reduction of taxes and social expenditures, and promoting the financial-market volatility that boosts the fortunes of those who serially buy low and sell high.
Legislators allowed financial intermediaries to regulate themselves, or imposed only minimal regulation because their operations were too complex to be understood.
The rise in private debt in the US and UK has resulted in household savings falling as a percentage of disposable income–income minus taxes–especially in periods of sustained economic growth (during the 1980s, the late 1990s and the beginning of the 2000s).
The wealth of the sixty-two very richest individuals increased by 45 per cent in the five years to 2015, a jump of more than half a trillion dollars in total. Over the same period, the wealth of the bottom half fell by just over a trillion dollars–a drop of 38 per cent.46
in the end, the real challenge is not to label finance as value-creating or value-extracting, but to fundamentally transform it so that it is genuinely value-creating.
Impatient finance–the quest for short-term returns–can hurt the productive capacity of the economy and its potential for innovation.
The financial sector now accounts for a significant and growing share of the economy’s value added and profits. But only 15 per cent of the funds generated go to businesses in non-financial industries.
the investment industry and investment banks, despite seeming to be highly competitive, often behave more like monopolies protected from competition. They extract rent for the benefit of managers and shareholders while the ultimate clients–ordinary customers and investors in shares, pensions and insurance policies–frequently pay fees for mediocre returns that do not pass on the benefits of fund management’s expansion and profitability.
when–as is usually the case by the time the revaluation occurs–shares have passed beyond the original inventors and become owned by private equity or quoted on financial markets, it is passive rather than active investors who capture most of the revaluation gains. Financialization enables investment bankers and fund managers who picked the right stock–often by chance–to make profits that would previously have gone to those who built the right product, by painstaking design. And, having captured this value, they invariably race to extract it–channelling the gain into real estate or other
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VC usually enters the fray after others, notably taxpayer-funded basic research, have taken the biggest risks and the technology is already proven.
alpha is indeed zero-sum–and turns into a negative-sum game once active managers deduct the extra fees they must charge for selecting stocks rather than just buying them in proportion to the relevant index.
Financial markets merely distribute income generated by activity elsewhere and do not add to that income. Chasing alpha–selecting and over- or under-weighting stocks so as to outperform an index–is essentially a game that will produce as many losers as winners. This is why actively managed funds frequently fail to beat the performance of passive funds.
In the 2000s, for example, the US arm of Ford made more money by selling loans for cars than by selling the cars themselves. Ford sped up the car’s transition from physical product to financial commodity by pioneering the Personal Contract Plan (PCP), which allowed a ‘buyer’ to pay monthly instalments that only covered the predicted depreciation, and trade up to a new model after two or three years rather than pay off the balance (thus resulting in a higher loan amount than the new car’s price).
Adopted by most other auto-makers, and with the additional merit of being bundled into securitizations and resold on financial markets, PCPs drove sales to record levels, alarming only the regulators, who wondered what would happen if (as with houses in 2008) cash-strapped contractees walked away from their vehicles and handed back the keys.
Between 2003 and 2012, 449 companies listed in the S&P 500 index deployed $2.4 trillion in buying back their own shares, mostly through open-market purchases. That sum constituted 54 per cent of their collective earnings. Add in dividends, which took out a further 37 per cent, and only 9 per cent of profits were available for capital investment.
However, far from being a lodestar for corporate management, maximizing shareholder value turned into a catalyst for a set of mutually reinforcing trends, which played up short-termism while downplaying the long-term view and a broader interpretation of whom the corporation should benefit. In the name of MSV, managers sought profits anywhere they could, directly fuelling globalization and outsourcing production to locations from China to Mexico. Jobs were lost and communities wrecked.
the average holding time for equity investment, whether by individuals or institutions, has relentlessly fallen: from four years in 1945 to eight months in 2000, two months in 2008 and (with the rise of high-frequency trading) twenty-two seconds by 2011 in the US.
In 2013 the management consultants McKinsey and Company and the Canadian Pension Plan Investment Board surveyed 1,000 board members and senior company executives around the world to assess how they ran their businesses.22 The majority of respondents said that the pressure to generate strong short-term results had increased during the past five years to a point where managers felt obliged to demonstrate strong financial performance. But while roughly half of the respondents claimed to be using a time horizon of less than three years in setting strategy, almost all of them said that taking a
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When one considers that CEO pay is heavily weighted towards share price performance, the need for companies to perform in the short term can be viewed not as pressure from an external gatekeeper gone rogue but as a mutually advantageous set-up that has served the interests of an elite few at the expense of the many.
business investment in the US is now around its lowest level for more than sixty years, an amazing and disturbing phenomenon.
William Lazonick, the chronicler of share buy-backs, has characterized these two trends, when taken together, as a shift from a model of ‘Retain and Invest’ to ‘Downsize and Distribute’.
