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The journey from 1971 to 2020 - the consolidation of financialization

Hector McNeill1

The current discussions surrounding the failures in performance of local authorities and more obviosly the National Health Service are generally characterised as a problem with public services and the need to involve private enterprise in resolving the situation.

The reality is that the private sector in the form of banks and other financial intrermediaries having been involved for some years now under PFIs, that is, Private Finance Initiatives, used as a vehicle to activate so called "public–private partnerships" (PPP). It is the performance of these schemes which have high interest rates that have greatly debilitated these public services through uncontrollable debt. As a result the government decisions have defaulted to an unacceptable trade-off between maintaining the level of service, employment of highly trained medical practitioners and support staff, on the one hand, and insisting that such debts be paid, on the other.

Don't touch finance

The recent request by the House of Lords to ask the government to reconsider their plans for removing tax credits is considered by the government leadership to be "unconstitutional". But there are already two unconstitutional elements to this. One is that the government gained its power as a result of the support of less than 25% of the electorate and under such circumstances it is unreasonable to make "finance acts" something that cannot be changed even when the elected government has only a weak democractic legitimacy. Under such circumstances any rational government should act with some decorum to seek a more broadly based consensus on any decisions. Under the current circumstances private "finance" has become an activity that has become a totem pole ring fenced by governments and surrounded by taboos against changing the basis of its operations, even when its impacts are so detrimental to the social constituency. At the extreme we can observed the case of Greece, Cyprus and currently in Portugal where the expression of the majorities of the populations concerned was ignored by their own governments. The reason for the increasing prejudice created by poor, and often fraudulent financinal dealing, is that most "regulation" of the financial sector is extra-constitutional where the main influence on regulation remains the financial sector itself. Clearly, this in itself, is unconstitutional. The Maastritch Treaty (1992) limited public borrowing but governments and local authorities got round this as a result of accepting offers to run "off balance sheet" private loans being offered by private banks involved in PFIs but paying very high interest rates; by borrowing directly from the government would have been half the cost. Both that banks and governemnt agencies were in breach of European Law. It is notable that in several PFI cases the private banks concerend opened offshore operations to "manage" their PFI accounts.

The rise of financialization

Today, there is a general notion that financialization of the economy is a relatively recent phenomenon. Financial intermediation and banking are ancient practices, well over 3,000 years old. In terms of modern economic management it has become a complement to lending using funds built up as corporate equity or from savings built up from earned income by households. It complemented already existing investment assets.

However the activities, processes and products have become increasingly complex process to the degree that oversight for risk has sometimes been deficient for extremely large amounts of funds. The main contributory steps and phases initiated in the 1970s in the form of changes in mechanisms, techniques and policy are listed below in roughly chronological order:
  • The movement off the Gold standard in 1971 (Nixon, USA)

  • The accelerating development of financial derivative products beyond commodity futures

  • The development of the 1973 Black-Scholes hedging model for derivatives

  • The Reagan administration’s generation of one of the largest government debts in history under a monetarist agenda aiming to “reduce the size of government”

  • The rupture of the Glass-Steagall Act (1933) in 1991 when the Commodity Futures Trading Commission provided Goldman Sachs with a “Bona Fide Hedging” exemption to be followed by similar exemptions for other banks

  • Under President Bill Clinton bank deregulation was formalized through the repeal of the Glass-Steagall Act (1933) in 1999 by the Gramm-Leach-Bliley Act. This effectively removed the barrier between retail and investment/trading activities in banks

  • In the UK the Thatcher government deregulated deposit takers, such as mutuals, to become banks on the plc model

  • The dominance of macroeconomic policy by monetarism since the 1980s

  • Monetary policy has maintained a tolerance of low but positive inflation rates that have devalued the pound by over 97% since 1945

  • A refusal of policy-makers to target zero or negative inflation but maintenance of low positive interest rates creating a real income depreciation treadmill

  • The organization of the Euro Zone in 1999 precipitating and crystallizing economic regional differentials and in some cases national marginalization

  • A rate of enlargement of the European Union since 2004 exceeded the economic resources to bring all countries into a comparable economic status on the basis of the monetarist model applied within the Euro Zone as well as in member states not members of the Euro Zone

  • The increasing participation of banks in derivative and commodity futures trading

  • Bank and company regulation came under extra-constitutional regimes that effectively were managed by the main players in the financial and corporate sector

  • With deregulation and the advance in shaping of many new financial derivative products private banking activities shifted from their prime policy role as mainstream lenders in support of the social and economic constituency to trading activities carried out largely for the benefit of bank shareholders and executives

  • Monetary policy control over national finance has become increasingly ineffective as a result of unrecorded derivative trading being variously reported to be 4-6 times the size of the national income

  • The growth in use of performance “ratings” sector based almost exclusively on financial measures and issued by agencies close to the parties who derive a direct benefit from the sale of rated products

  • In November 2007 the Federal Reserve in the USA increased interest rates causing many low income mortgage payers to be unable to meet payments causing many mortgage based derivatives to lose their value

  • Many banks failed not only because of the falling value of their derivative portfolios but because it became impossible to recoup full equity in collateral because of falling house prices and facing falling dollar exchange rate, exacerbating value of derivatives held by UK banks

  • Governments (2008-2012) decided to bail out banks to such a degree that issues of risk to sovereign debt became a major issue for the social constituencies in terms of future tax liabilities

  • The enforced Euro Zone monetary policy begins to fail in the periphery of Europe where major bank failures and sovereign debt becomes a major issue (Greece, Spain, Portugal, Italy, Cyprus and others) requiring bail outs.

  • Countries enter phase of low interest rates and quantitative easing hurting savers

  • Austerity regimes initiated to pay off government debts and account deficits exacerbating ability to generate growth

  • Quantitative easing causes a major inflation in the asset markets including land, real estate, precious metals, objects of rare art, selected commodities and shares whose prices are driven upwards by companies using cheap finance to buy back shares)

  • 2020: Flaws in financial/monetary theory exposed

    RIO-Real Income Objective research demonstrates that the Quantity Theory of Money QTM is flawed because it does not allow for non-ciculating money assigned to savings and asset purchases. As a result the QTM could not explain the outcome of quantitative easing. RIO replaced this with the Real Money Theory (RMT) which includes savings and assets.

    RIO-Real Incomes Objective research separate loans into "exogenous money" and supply side money stock (circulating) as "endogenous money". This helps trace the transfer of inflation (inflationary leakage) from asset markets into the supply side goods and services markets as a result of rising prices and rents for land, houses, farm land, office and industrial premises. This reduces real incomes.
  • The share inflation caused by exogenous money flowing into assets is used to create a parallel source of bonuses and income for executives; shareholders supor this trend

deficits exacerbating ability to generate growth This changing framework within which derivatives and other financial products evolved undermined the ability of policy makers to predict, monitor and avoid the recent financial crisis. However, the basic approach to monetary policy was already undermining the real economy, but in a less obvious fashion, before they came into being.

Real income depreciation treadmill

The theoretical monetary model has been based on a notion that funds, in the form of savings, provide the base capital for banks to hypothecate these holdings to generate loans that are nominally many times the value of the holdings (between 20:1 and 30:1). The role of banks as organizations that can manage people’s savings arose in the past when communications networks were poor and expensive so the options open to savers were restricted. There are, however, a series of subtle details in monetary policy (money volume and interest rate setting) that play into the hands of banks as the main recipients of personal and corporate savings. Monetary policy is normally geared towards a positive and low inflation rate, of around 2%, which imposes a constant devaluation of the currency of around 18% each decade, because the purchasing power of a given quantity of money declines due to the steady increase in unit prices. This establishes a real income depreciation treadmill that encourages people with cash in excess of their immediate requirements to save these funds in interest-bearing accounts at banks. Banks then lend this money on at a profit supported by lender collateral and other guarantees. Collateral is often many times the value of the loan. The central monetary authorities, now in the form of the Bank of England, establish base interest rates above which all bank business is conducted. Monetarist policy parallels the Keynesian model in conducting decisions in the context of an aggregate demand model. So the theory is that by raising interest rates savings are encouraged and investment discouraged creating an investment deficit, whereas, by lowering interest rates savers are discouraged and investment encouraged creating a capital deficit. Monetary policy is operated through an agency, the Bank of England, through a monopoly coercive intervention in markets, an imposition that distorts the free determination of the price of money in the form of interest rates and creates an income depreciation treadmill to force people towards specific decisions. What is notable is that this is an entirely arbitrary system that does not relate the return on saver funds to a free investment market where the value of savings would be related to the return on capital investment in the economy. Therefore the price of money expressed as an interest rate is not related to a market generated price which would be the opportunity cost of cash. Savers are essentially kept at a distance from the large range of portfolios of existing investment opportunities within which they could gain a higher return on their savings. Under QE banks have ben able to invest themselves using cheap money to bolster their own profits and "shareholder value" which marginalizing small savers. Indeed QE has in effect removed the need for savers.

There has therefore been a slow realization on the part of fixed income investors such as savers and pensioners that financialization has undermined any compensation for investors. However, today, the current cost of entry for savers to invetment vehicles is lower because of the extent and accessibility of online networks geared towards group funding and investment and sophisticated software-based risk assessment models supporting this evolution, are appearing. This provides a feasible basis for enjoying a range of investment opportunities and dispensing with the need for banking intermediation whose objectives increasingly prioritize their shareholder returns over saver and customer returns. Recently it was estimated that 50% of larger companies were enjoying firm stock values, not as a result of sound investment and increases in productivity or even market prospects but rather as a result of companies buying their own shares so as to push up their price making use of cas reserves, issuing their own bonds of raising bank loans. This trend contributes to the declining levels of productivity,

In constitutional terms conventional monetary policies are perverse because interest rate policy, for example in the United Kingdom in the 1980s resulted in around 2 million people losing their houses through the repossession of around £180 billion in assets, companies failed and there was a spike in unemployment. In the 2000’s failures in financial dealing and increased debt resulted in the same number of mortgage payers in the UK losing their houses and loss of a further £200 billion in assets and unemployment has risen. Deflationary schemes coordinating low interest rates with quantitative easing have punished savers imposing a loss of around £160 billion in the UK alone and those on investment incomes and the export led boom resulting from devaluation has not materialized because all major countries apply similar devaluation policies. There are therefore associated with conventional policy moves, different arbitrary distributions of imposed prejudice. This inequitable treatment of the social and economic constituencies of the United Kingdom is unacceptable and it is notable that many policy-makers consider such prejudice arising from policy inadequacy as being part of the necessary “medicine” or “collateral damage” associated with effective economic policy; indeed austerity is the inevitable result of such ill-advised policies.