The Value of Everything: Making and Taking in the Global Economy

by Mariana Mazzucato

2016, total cumulative household borrowing in the UK had reached £1.5 trillion–about 83 per cent of national output, and equivalent to nearly £30,000 for each adult in the land–well above average earnings.

Another fundamental danger is the tendency of the system to overexpand: for credit to become too readily available, as the Bank for International Settlements has recently recognized.41 The system is stable when the growth in debt is matched by the growth in the value of assets whose purchase is financed by that debt. As soon as people begin to have doubts about the assets’ value, however, the cracks appear. That is what happened when US property prices collapsed after the crash of 2008.

Simultaneously, household consumption expenditure has been buoyant. It has outpaced any rise in disposable income, and its contribution to GDP has grown.

First, real wages have fallen or stagnated for many low- and middle-income households. For instance, OECD data on the US economy indicate that the annual real minimum wage (in 2015 US dollars) fell from $19,237 in 1975 to $13,000 in 2005 (in 2016 it was $14,892).

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.

The upshot of growing inequality of income and wealth was that, to maintain the living standards they had enjoyed from the Second World War to the 1980s, workers had to shoulder an increasing debt burden from the 1980s onwards.

Figure 11 below shows that total household debt as a percentage of net disposable income grew by 42 per cent in the US and by 53 per cent in the UK from 1995 to 2005.

The rise in US real-estate prices translated into higher rates of mortgage-equity withdrawal and ultimately boosted consumer spending.51 The Survey of Consumer Finances produced by the US Federal Reserve shows that the poorer a family is, the more heavily indebted it is likely to be.

Sustaining economic growth through household borrowing has been aptly defined as ‘privatized Keynesianism’,54 because ‘instead of governments taking on debt to stimulate the economy, individuals did

There are two key aspects to the long-term growth of the financial sector and its effect on the real economy.

The first, covered in this chapter, is its expansion in absolute terms and as a share of total economic activity.

But only 15 per cent of the funds generated go to businesses in non-financial industries.3 The rest is traded between financial institutions, making money simply from money changing hands, a phenomenon that has developed hugely, giving rise to what Hyman Minsky called ‘money manager capitalism’.

The second aspect, covered in the next chapter, is the effect of financial motives on non-financial sectors, e.g. industries such as energy, pharmaceuticals and IT. Such financialization can include the provision of financial instruments for customers–for example, car manufacturers offering finance to their customers–and, more importantly, the use of profits to boost share prices rather than reinvest in actual production.

The key issue is: what role does finance, in all its complexity, play in the economy? Does it justify its size and pervasiveness? Are the sometimes huge rewards that can be earned from financial activities such as hedge funds (an investment fund that speculates using borrowed capital or credit) or private equity proportional to the actual risks taken?

Such questions are not new. Back in 1925, Winston Churchill, then Chancellor of the Exchequer, had begun to get itchy about the way in which finance was changing. He famously claimed that he would ‘rather see finance less proud and industry more content’.

By reclassifying them from collectors of rent to creators of financial ‘value added’, the newly ignited bundle of finance, insurance and real estate (FIRE) was transformed into a productive sector at which economists of the eighteenth, nineteenth and even the first half of the twentieth century would have marvelled.

Until 1980, finance’s share of employment and income was almost identical (the ratio is 1). After that, the ratio spiked: by 2009 it had almost doubled to 1.7 (Figure 16).

Brown solemnly declared (not for the first time): ‘We will not return to the old boom and bust.’ How could Brown–and so many others–have got it so horribly wrong? The key to this catastrophic misjudgement lies in their losing sight of one crucial factor: the distinction between ‘price’ and ‘value’, which over the previous decades had been lost from sight.

In modern capitalism, the financial sector has greatly diversified as well as grown in overall size. Asset management in particular is a sector which has risen rapidly and secured influence and prominence; it comprises the banks which have traditionally been at the centre of the value debate but also, now, a broad range of actors. Hyman Minsky argued it was reshaping the economy into what he called ‘money manager capitalism’. But how much value does it actually create?

Here, I look at how 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.

But in the 1970s, the relaxation of the ‘prudent man’ investment rule allowed pension funds to invest in less conventional ways, such as private equity (PE) and venture capital (VC), while the Employee Retirement Security Act of 1974 permitted pension funds and insurance companies to invest in a greater variety of funds, such as equities, high-yield debt, PE and VC.

Public and private pension funds contribute about a third of the value of the total funds PE firms invest.

PE firms have become particularly adept at borrowing to acquire a firm and then arranging a ‘special dividend’, often for a similar sum, which ensures a rapid profit from the deal even if the borrowings, transferred to the acquired firm, depress its resale price or even doom its existence.

How does finance extract value? There are broadly three related answers: by inserting a wedge, in the form of transaction costs, between providers and receivers of finance; through monopoly power, especially in the case of banks; and with high charges relative to risks run, notably in fund management.

Maximum efficiency, friction-free capitalism, would in theory be reached when the interest differential disappears. Yet the ‘indirect’ measure of financial intermediation services adopted by national accounts (FISIM, explained in Chapter 4) assumes that a rise in added value will be reflected in a wider wedge (or, if the wedge narrows, by increased fees and charges through which intermediaries can obtain payment directly).

This power enabled banks to secure 40 per cent of total US corporate profits in 2002 (up from 13 per cent in 1985).

The high degree of monopoly in wholesale and retail banking is closely linked to its continuing ability to extract rents from the private and public sectors, even when these were shrinking in the aftermath of the 2008 crash.

This steep rise in average income per employee–scarcely interrupted by the crash of 2008–was, according to its supporters, a sign of the financial sector’s rising productivity and a justification for channelling more resources into finance. But the productivity gain was, as seen in Chapter 4, highly dependent on a redefinition that boosts banks’ and other lenders’ ‘value added’. An alternative explanation for the rising income-to-employment ratio is that finance was reinforcing its power to extract value, and gain monopoly rents from other private-sector activities.

Another way to grasp this simple fact is to measure the amount of fees charged by institutional investors and compare them with the performance of the funds they manage. The ratio between the two can be interpreted as a sort of degree of value extraction: the higher the fee, the lower is the gain for the investor and the greater the profit for the manager.

According to Bogle, portfolio turnover rose from 30 per cent in the 1950s and 1960s to 140 per cent in the last decades.

Just as turnover has risen, so the volatility of funds has increased significantly from 0.84 to 1.11 over the same period.

But we should remember that in the end it is a game that balances winners and losers and has little social value: the gains or above-average returns that some investors enjoy will be offset by losses or below-average returns others suffer.

This same ‘2 and 20’ model is also used in venture capital. Like hedge funds, VC claims special skill in picking profitable opportunities in young businesses and technologies. In practice, VC usually enters the fray after others, notably taxpayer-funded basic research, have taken the biggest risks and the technology is already proven.

an influential article,46 Joanne Hill, a Goldman Sachs partner, identifies conditions in which trying to achieve alpha need not be a zero-sum game–conveniently showing that investment banks’ proprietary trading might have some social and economic value.

Asset management has grown into one of modern capitalism’s defining characteristics. If nothing else, its sheer scale and central importance to the financial security of many millions of men and women have given financial management its influence. But at least as significant is that many of its activities extract value rather than create it. Financial markets merely distribute income generated by activity elsewhere and do not add to that income.

Furthermore, the fees being earned by asset managers should reflect real value creation, not the ‘buy, strip and flip’ strategy common in PE, or the ‘2 and 20’ fee model common to PE, VC and hedge funds.

But rent-seeking is not limited to the financial sector. It has pervaded non-financial industries as well–through the pressures that financial-sector profitability, exaggerated by monopoly power and implicit public guarantees, place on the corporate governance of non-financial firms.

Non-financial companies that cannot beat the financial investors’ return are forced to join them, by ‘financializing’ their production and distribution activities.

The financialization of the real economy is in some respects a more extraordinary phenomenon than the expansion of the financial sector itself and is a central social, political and economic development of modern times.

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).

A switch from dividends to buy-backs can, however, make a big difference to executive pay, because (unlike dividends) they reduce the number of shares. This automatically boosts earnings per share (EPS), which is one of the key measures of corporate success.

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.

Some investors are finally waking up. In March 2014, Larry Fink, the CEO of Blackrock, one of the largest institutional investors in the world, wrote to the CEOs of the S&P 500 companies about excessive profit distributions. Observing that too many companies ‘have cut capital expenditure and even increased debt to boost dividends and increase share buy-backs’,

Financial techniques, it is argued, are a legitimate way for managers to improve productivity and therefore benefit workers and customers as well as shareholders. If a company can earn a higher return at any given time from putting capital to work financially rather than directly selling cars or software, it is behaving rationally and in the best interests of the business. Having a choice between a financial or a productive use for capital helps to keep the (supposedly) core business of cars or software on its toes because it has to produce returns which compete with financial alternatives.

By extension, it is argued that making it easier for customers to obtain credit, especially to buy your own products, is a service to ordinary people. There is something to this–but not much. Where did these ideas come from? And do they have validity?

In 1970, Milton Friedman published in the New York Times Magazine an article which became the founding text of the shareholder value movement and, in many ways, of corporate management in general. Titled ‘The Social Responsibility of Business Is to Increase its Profits’,

Friedman’s idea was developed further by the University of Chicago-trained Michael Jensen, who was steeped in its ‘free market’ ideas.

The result was a body of theory that argued that the only way for companies to be well run was if they maximized their ‘shareholder value’. In this way, investors would indirectly keep company managers accountable.

Meanwhile, the added external pressures on corporate management did little to enhance its quality. Rather than become properly trained managers with sectoral expertise, who could make decisions on what to produce and how to produce it, top graduates in business schools preferred to go to Wall Street. While in 1965 only 11 per cent of Harvard Business School MBAs went into the financial sector, by 1985 the figure had reached 41 per cent and has risen since then.

PE is MSV turbo-charged. Many of the companies in which PE firms invest are not financial ones; often, indeed, they can be found on the productive side of the production boundary. But whereas traditional institutional investors were often satisfied to ‘buy and hold’, and to await share price gains via profit being reinvested rather than paid out, PE seeks to buy and resell at a higher price within a few years.