How Financialization Is Starving Manufacturing

Sept. 21, 2018
The shift in the economy that began during the Reagan era is all about short-term strategies to make fast profits.

The news seems to be full of praise for our strong economy. Columnists continuously cite the low 3.9% unemployment rate and GDP growth as the best in many years. Citizens know that there has been a huge redistribution of income to the 1% and the shareholders of corporations and that their wages have been stagnant or declining for many decades. They also remember the economic meltdown in 2007 caused by the big banks and are distrustful of corporations and what they might do to the economy.

Economic analyst Rana Foroohar makes the case that the U.S. system of market capitalism itself is broken. She says that the finance sector of the economy, which includes banking, insurance, real estate, hedge funds and mutual funds, used to be the servant of business, in which they took individual and corporate savings and funneled the money into productive enterprises.

Foroohar thinks that has changed, and finance is now the master who is dictating to corporations and to the economy.

This change in free-market capitalism is also called financialization. Financialization is a way to make money from money rather than from goods and services. Financialization emphasizes short-term profits and cost reduction rather than long-term investment.

The big change in capitalism that led to financialization actually began during the Reagan administration—and with the influence of the economist Milton Friedman, who argued that a corporation’s only responsibility was to increase profits to shareholders.

The free-market capitalists saw the New Deal laws and regulations as restricting growth particularly for the wealthy and preventing business shareholders from earning more money. Their answer was to get the government out of business by eliminating or modifying New Deal laws and regulations

One of their primary objectives was to eliminate the Glass-Steagall Banking Act. Four years after the 1929 stock market crash, Congress passed Glass-Steagall to separate investment banking from people’s savings and checking account money. This was an eminently practical approach to try and protect the average citizen’s “small money” from the big-time gamblers in the investment banking business.

In 1999, Congress, led by Sen. Phil Gramm and President Bill Clinton, passed the Financial Services Modernization Act, which killed key parts of the Glass-Steagall law and allowed investment banks, insurance companies and securities firms to consolidate through financial holding companies and use higher-risk tools to gamble with the new money they had access to. This bill was passed as bipartisan legislation.  

Supporters of financialization make the case that financialization is the final or perfect form of free-market capitalism where profits are realized the quickest, costs are minimized, and the government is not allowed to interfere in the process.

But financialization is all about short-term strategies to make fast profits. The short-term strategy effort has been so successful that the financial sector grew as manufacturing and other sectors have declined.

What does financialization mean for manufacturing? 

Financialization is about making short-term profits and cutting costs to satisfy high-risk investors looking for quick returns. This has caused a lot of problems for American manufacturing and threatens its growth over the long-term. Some of its effects include:

1. A decline in startup companies. “The rate of company formation is half of what it was four decades ago,” says a February 2018 New York Times article. The innovation that startups bring is particularly important to manufacturing and high-tech, which rely on new ideas, technologies, and increased productivity for long-term growth. In her article, Foroohar links this decline with the U.S. financial industry’s change in focus from lending to speculation. Many start-ups must now go overseas to get the second round of funding to expand.

2. Controlling public company boards. Financialization and big banks have a growing influence on corporate strategies. Players in the financial industry, particularly hedge funds, have amassed enough stock to gain spots on corporate boards and force short-term strategies. A good example is Dupont Chemical. A hedge fund called Trian Fund Management purchased enough Dupont stock to become its fifth-largest shareholder. Trian said publicly it wanted Dupont to double its share prices and cut $4 billion [PL1] from its business. Dupont submitted, cutting 5,000 people from their workforce, including 1,700 from their R&D lab. Dupont’s share price climbed 210% between 2009 and 2015.

Carl Icahn did the same thing to both Apple and Xerox because he wanted them to return more cash to shareholders. Activity by these hedge funds and other short-term activists have skyrocketed in public corporations. John Coffee, a professor from Columbia University, found 1,115 activist campaigns in the United States between 2010 and 2015.

3. Long-term training. Financialization has also reduced the investment in long-term programs like apprentice training. I define long-term training as journeyman training that takes thousands (not hundreds) of hours. Even though manufacturing suffers from a critical shortage of high-skilled workers, corporations do not want to invest in long-term training because the ROI is too low.

4. Infrastructure. The American Society of Civil Engineers (ASCE) published a study (in 2009) that says it is going to take at least $220 billion per year for 30 years to repair and upgrade America’s highway and bridge systems. Infrastructure includes water, sewer, ports, railroads, bridges, and the electrical grid systems. Making an investment in infrastructure could provide millions of manufacturing and construction jobs, but an investment in infrastructure using federal funds is simply not supported by financialization. The Trump administration and the Republican Congress are against federal funding because of the federal deficit we are carrying after the corporate tax cuts. It is worth noting that net government investing—government spending on infrastructure minus the depreciation of old infrastructure, was at .5% of GDP in 2015—much lower than the 1% to 2% range from 1970 to 2010, according to the Hutchins Center of the Brookings Institute.

The worst of the short-term profit strategies? 

The most popular strategy used today for quick profits is called stock buybacks. Before 1982, this technique was illegal because of New Deal laws, because it was thought to be a form of stock market manipulation. But in 1982, stock buybacks were essentially legalized by the SEC.

Stock buybacks have become the most popular financial engineering tool in use today. When companies buy back their stock, they must pay above current market prices, or no one will sell. This drives the company’s stock price up, no matter how good or bad the company is doing.

Stock buybacks became the fastest way increase wealth, and now companies borrow money to do it. According to Robert Reich in 2017, public corporations spent $780 billion on stock buybacks and dividends.

A recent example was in 2016, when United Technologies (UTC) announced it was closing the Carrier air conditioner plant in Indiana. UTC said publicly that the reason was that the labor costs in Mexico would save a lot of money. However, the Carrier plant was one of the most profitable plants in United Technologies. At the same time, UTC announced to share-holders a $6 billion stock buyback, after from pressure from 50 hedge funds and private equity investor firms. Many people believe that closing the Carrier plants was a way to help finance the stock buyback and drive up the stock price.

The innovation strategy 

If we are going to use the strategy of innovation to be competitive in the world, then we must promote the manufacturing sector to continue to invest in the research and manufacturing of the new technologies and products that will allow the U.S. to compete. This means investing in capital equipment, research and development, basic science research and start-up companies for the long term. This won’t happen as long as the financial sector is in charge.

Financialization is really hurting American manufacturers. If we keep on this course for the long-term, inequality will get worse, aggregate demand will not grow and manufacturers will be starved for investment.

However, financialization is very vulnerable because of its ongoing thirst for more profits. Here are some specific suggestions:

1. We need a financial transaction tax that would tax high-risk strategies and tools used to make big profits this includes taxing derivatives, hedge funds, and other bank speculation that leads to windfall profits.

2. We need to make stock buybacks illegal and to reimpose the Glass Steagall law that separates bank lending from speculation.

3. We also need to pass a law that insures that taxpayers do not have to bail out banks after they fail from speculation. Dodd-Frank is not strong enough, and the big banks are again too big to fail.

4. A suggested tax law change called bonus depreciation would allow 50% of a capital investment to be deducted immediately

5. We can also offer lower taxes on assets that are kept for the long term and raise taxes on assets sold in the short term.

6. We need to provide tax and other incentives to help manufacturers invest in long-term training.

7. And we need to publicly fund our infrastructure because the return in terms of jobs and reducing infrastructure failures is a real opportunity for the country and manufacturing.

 Michael Collins is the author of The Rise of Inequality and the Decline of the Middle Class. He was a vice president at Columbia Machine in Vancouver, Washington.

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