Financial engineering harms both productivity and economic growth


Financial engineering can have benefits for economies, but it has gotten out of control. As a result, this has created a new set of problems for the US economy and others.

Many books that have covered the growth of financial engineering in the United States have expanded on so-called financialization.

The financialization of the economy refers to the substitution of financial activity for manufacturing growth and innovation.

The consequences of this substitution have been lower business investment in capital expenditures and slower growth in labor productivity and the economy in general.

Efforts to combat slowing economic growth have focused primarily on producing more financial engineering, but this additional financial engineering has exacerbated the situation, leading to even less capital spending, even slower labor productivity growth and economic growth.

Changing this will require a shift in focus from economists and policymakers, time to implement new approaches to economic policy, and patience to allow the new direction to work.

Financialization in the United States began in earnest in the 1960s when Keynesian economic policies were introduced in an attempt to fine-tune the American economy.

Through tax cuts and other fiscal policies, it was believed that the government could stimulate aggregate demand and that economic downturns could be shortened or even eliminated.

Once this philosophy gained traction in economic circles and the tax cuts under the John F. Kennedy presidential administration became a reality, this idea of ​​fine-tuning was extended to apply to the economy as a whole in hopes of producing even faster economic growth.

The statistical relationship called the Phillips curve, a relationship between inflation and unemployment, has been used to justify more fiscal stimulus, producing slightly more inflation, so that unemployment can be reduced to an even lower level .

Although in the late 1960s economist Milton Friedman argued that this statistical relationship was valid in the short term, it could not be sustained over time. The use of the Phillips curve has continued to be applied by political markers even into the 21st century.

But the financial engineering of the economy begun in the early 1960s produced the conditions at the end of that decade for the application of financial engineering to the banking sector. Commercial banks have evolved from simple asset managers to liability managers and then to asset-liability managers.

Commercial banks in the United States were historically limited in size due to geographic expansion constraints. Their bases of deposits were determined by the extent of their ramifications.

In the late 1960s, major US banks discovered how the one-bank holding company could be used to expand their funding sources. To manage their balance sheets, they created new financial innovations, the negotiable certificate of deposit and the Eurodollar deposit, in which funds could be purchased at market prices.

That is, these big banks could buy or sell funds in the markets of the United States and Europe, at will, and expand or shrink their balance sheets as they pleased. Commercial banking has never been the same again.

From the late 1960s through the 1970s, the government led financial engineering in the mortgage market by helping to create the mortgage-backed security, an instrument that bundled mortgages into one large collection and then sold the others various cash flows that were generated by the pool of mortgage loans.

The objective of this new innovation was to remove mortgages from the balance sheets of commercial banks, mutual savings banks and savings and loan associations so that they could grant even more mortgages and sell the new backed bonds to mortgages to pension funds and insurance companies that needed more longer-term assets for their balance sheets.

The doors were open. As the amount of credit was inflated in the economy and price inflation became an economy-wide problem in the 1970s and 1980s, more financial innovations emerged. The junk bond was one such innovation. Another was financial derivatives.

Advances in information technology have contributed to this expansion of financialization because, at their most basic level, money and credit are nothing more than information, zeros and ones.

And, politicians, Republicans and Democrats alike, continuing to seek re-election, have produced more opportunities for more financial innovation.

An increasing number of financial institutions grew to support this expansion, and we secured the growth of asset management companies, private companies and hedge funds to take advantage of the opportunities that were available.

Even manufacturing companies have entered the scene. Companies like General Electricbefore the financial upheaval of the Great Recession, were so into financial engineering that more than 50% of their profits came from their financial divisions.

The government has only made the situation worse. my post, Bernanke underwrites the rich, discussed how corporations and others with existing wealth were taking advantage of government economic policies and using the results of those policies to make big bucks.

Remember that John Maynard Keynes, the creator of Keynesian economics, was a wealthy trader who profited from government economic policies and was even referred to by some as one of the first hedge fund traders.

More resources have been directed to the financial industry and to the financial wings of corporate America. The CFO’s office has become one of the most productive profit centers in a business organization.

But, as the importance of the CFO increased, the importance of the other engineers in the company decreased. In addition, innovation and business investment have declined, as has labor productivity growth.

For the future health of the American economy and workforce, and the peace of those who feel excluded from participating in the economic system, perhaps economists and government should refocus their efforts, more on the supply side of the economy and on the impacts that advances in information technology are having on increasingly less educated workers. maybe there is a part of this change already in the air.

This article is the commentary of an independent contributor.


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