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Here’s what the rise of finance has wrought

In June, the U.S. economy started its seventh year of recovery from the Great Recession with a bang: A whopping 287,000 jobs were added, a much higher number than anyone expected.

Yet despite the recovery’s staying power—it ranks among the longest expansions in the last half-century—and the fact private employers have added nearly 15 million jobs over the last 76 months, the rebound from the worst downturn since the Great Depression has been a big disappointment to many people. Blame the GDP growth rate, which still lags the pre-recession norm.

Experts have struggled to explain the economy’s persistent slow growth since June 2009. In a recent New York Times piece, Harvard University economics professor Gregory Mankiw outlined five current theories. They range from secular stagnation and stalled innovation to policy missteps and the prolonged impact of financial crises. In addition, there’s the contrarian view—the problem, some say, is not in the economy but in the data used to explain it.

“I have no idea which one is right,” Mankiw concluded. “The truth may well involve a bit of each.”

I’d bet on multiple causes too. But one of the biggest culprits might be missing from his list.

In her new book, “Makers and Takers,” Rana Foroohar points her finger elsewhere. The Time business columnist and CNN global economic analyst argues that the “financialization of America” is the root cause of the U.S. economy’s problems.

“Wealth creation within the financial markets,” she writes, “has become an end in itself, rather than a means to the end of shared economic prosperity. The tail is wagging the dog.”

By some estimates, she notes, “a mere 15 percent of all financial flows now go into projects in the real economy.” The rest stays in the financial system, where the rich get richer. Today, finance contributes 4 percent of all jobs but grabs nearly one-third of total corporate profits.

“Moreover,” she writes, “financialization has bred a business culture built around MBAs rather than engineers and entrepreneurs.” The result: “Innovation is falling to cash management, long-term plans to short-term tricks. Risk in the financial system continues to rise, even as risk capital to real businesses declines. These trends are choking off our growth.”

Financialization did not materialize out of thin air. Foroohar explores a number of causal factors, from innovations such as securitized mortgages and derivatives to policy changes like deregulated interest rates. She also shows how the “false gospel of efficient markets” gave rise to the notion that stock prices are the truest measure of corporate value.

The efficient market hypothesis is most often viewed as a product of the University of Chicago, but the Simon Business School at the University of Rochester also played a notable role. Former Simon School professor Michael Jensen’s thinking shaped the hypothesis’s application in the business world.

Public companies that tied executive compensation to shareholder value may have thought they were driving superior performance, but instead they often were simply encouraging management to play games with numbers. To make matters worse, generous equity incentives often don’t deliver higher shareholder returns, let alone stronger long-term profitability. (Research firm MSCI Inc. this week issued a report on nearly 430 large-cap U.S. companies that found fatter equity incentives for CEOs produced below-median returns.)

Without financialization, it’s hard to imagine a company like Bausch & Lomb parent Valeant Pharmaceuticals International Inc., whose business model under its former CEO centered on slashing staff and R&D at acquired firms and then jacking up prices. But as Foroohar notes, even a corporate icon like Apple Inc. now spends more and more time on financial engineering rather than product innovation. Hence its decision a few years ago to borrow $17 billion for stock buybacks and bigger dividends—even though it already was sitting on nearly $150 billion in cash.

If you think the financial system’s recent near-death experience taught us a hard lesson, think again. “The world is more awash in debt now than ever before in history,” Foroohar writes. “And who benefits from all this? The financial industry, of course.”

Thankfully, many private firms have not fallen for the nearsighted financial maneuvers so common among their publicly traded brethren. They are an important economic counterweight.

Nevertheless, the message of “Makers and Takers”—that the economy is best served by companies and government policies focused on sustainable, broadly shared growth—is one meant for all of us.

7/29/2016 (c) 2016 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email rbj@rbj.net.


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