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John Judis and the financialization argument

by Robert Teitelman | Published July 22, 2011 at 3:51 PM

In the August New Republic, John Judis has a longish piece that tries to get at the connection -- or lack of connection -- between the rise of Wall Street and the decline of American industry. He actually draws a number of conclusions that come as something of a surprise, since The New Republic has long provided a forum for the financialization crowd, which argues not only that Wall Street is generally evil and greedy, but that its explosive growth has somehow "crowded out" American industry and driven its decline. This is a position most recently articulated by MIT's Simon Johnson (in TNR as well as many other outlets, including a book with James Kwak, "13 Bankers," reviewed here) and was one component of the argument during and after the financial crisis that the banks needed to be broken up. The "financialization" case actually has a number of interrelated themes: first, that Wall Street is too big and speculative, producing too-big-to-fail subsidies, dangerous systemic risk and bailouts to the plutocrats; and second, that the growth of Wall Street and the big banks somehow caused the decline of American industry, not just by allocating capital to nonsocially useful, meaning speculative uses, but by paying the best and the brightest too much money and directing them to activities that provide nothing to the public good. This "financialization" critique thus effectively links to any number of other current concerns: that finance caused increasing inequality and middle-class wage stagnation; that the oligopoly of big banks has effectively captured regulators and the government and is running the economy for its own gain; and that the big banks and the big bankers are harvesting vast sums of money while starving and exploiting Main Street and ordinary Americans.

This is a powerful populist argument, which attracts both far left and right; the fact that it was revived and re-energized by Kevin Phillips, who began his political career on the Nixonian right (he came up with Nixon's Southern strategy), is revealing. In fact, the financialization critique makes a number of quite valid points. Wall Street and the banks were key perpetrators in the financial crisis and are major voices in Washington. There clearly is a kind of market subsidy for TBTF, which government-sponsored enterprises once enjoyed and that, to a lesser extent today, because of the uncertainty over regulation, the big banks share. A lot of talented kids do flock to Wall Street to get rich. And the size of the financial sector and the available compensation does exacerbate inequality. Moreover, the financialization critique taps a traditional American demonology, fed by rural vs. urban, nativist vs. immigrant, farm and factory vs. finance tensions and summed up mostly recently in Wall Street vs. Main Street. As Judis writes, "Picturing bankers and Wall Streeters as a 'parasite class' or as 'vampires' is an old tradition in American politics," going back as far as Andrew Jackson and the Second Bank of the United States and Populist Party polemics against 'a government of Wall Street, by Wall Street and for Wall Street.' "

Judis applies a corrective to that tendency. First, he breaks it down. The financialization crowd often conflate two phenomenon: the market meltdown of 2008, driven by the real estate collapse and leverage on Wall Street, and the longer-term decline of American industry. Judis separates them. For all the debate about accountability, it's easy to see finance's involvement in the meltdown. It's harder to see how the rise of Wall Street determined the long-term decline of Main Street -- as the Manichean financialization critique might put it. Second, Judis understands how long-term these trends really are; how apolitical they appear when you step back; and how complex and ambiguous they are. There are few legitimate villains here; there are, as always, difficult trade-offs that go beyond ideology. Policies that seem sensible over the short and medium term produce unfortunate long-term effects. And while politics looms over every economic decision, the underlying issues here are simply beyond the ambit of ordinary voters. And there is always the temptation politically to kick the can down the road to the next administration.

Judis begins in 1968, though the real genesis of this problem came with the American victory in World War II. The U.S. was the architect of Bretton Woods that established the post-war monetary system based on the dollar fixed to $35 an ounce for gold. "As long as American industry reigned supreme in the world, and dollars were in demand to buy U.S. goods, other countries had no incentive to exchange their dollars for gold," he writes. That industrial hegemony lasted until the late '60s when the U.S. balance of trade went negative. This was partly because of the inflationary effects of the Vietnam War but also because other parts of the world, first Europe and Japan, had finally recovered. The dollar came under pressure, and in 1971 President Nixon detached the dollar from gold, which eventually ushered in the age of floating exchange rates with the dollar as the world's reserve currency.

Much of Judis' piece then marches through the post-war history of the dollar, American trade deficits and the rise of one global competitor after another. His essential argument: that one administration and then the next accepted a kind of "bargain" to retain the supremacy of the dollar and to finance deficits and keep interest rates low in exchange for putting American industry at a cost disadvantage with overseas competitors. There's a lot to be said here about this bargain that is still rarely debated: how it not only hollowed out U.S. industry but produced the fantastically baroque American culture of consumption, which, let's face it, was a winning political strategy over the decades. But the very forces that were shrinking American industry (and sapping the unions and squeezing the middle class) were feeding a larger, more global, more innovative, more competitive and more speculative financial sector, particularly as other nations took their surpluses and began to reinvest them into the U.S. We know the end of that story.

For all the detail, much of it convincing, Judis provides a sweeping, reductionist history of the last 60 years that's pretty schematic and occasionally thin. For instance, after initially trying to manage trade with surplus countries, the Clinton administration, "fearing recession in Japan would halt America's recovery," reduced the pressure on Japan to lower trade barriers (Judis blames Robert Rubin for urging a go-easy policy; the guy can't catch a break). Toward the end of the '90s, Judis argues, "Fed chair Alan Greenspan and Clinton officials [meaning presumably Rubin and Larry Summers] believed the new economy would sustain the boom, but, by the end of Clinton's second term, the global market in computer electronics became saturated, leading to the bursting of the dot.com bubble." Well, the dot-com bubble burst not because of a saturated market, but because equity markets had gotten ahead of the commercial potential of the Internet, bringing down ramshackle dot-coms and high-flying telecoms as well. Once the bubble burst, consumer markets might have seemed saturated. The bust was followed by recession and some stagnation, but it's still open to debates whether this was because of the hollowing out of American industry or the vagaries of technology -- the kind of long cycles Tyler Cowen focuses on (to the similar disregard of other factors) in "The Great Stagnation," reviewed here. What seems clear in retrospect certainly wasn't clear at the time.

Judis' retrospective view is sometimes a little harsh. He argues that administrations going back to Nixon should have recognized what was happening and done more to save U.S. industry and middle-class jobs, both through support and subsidies and through tougher treatment of overseas rivals. That's not as easy as it sounds, particularly given how strong the economy often appeared. American service industries, including finance, were long considered a post-industrial solution to the deindustrialization problem. And even he admits that truly fixing the problem would mean the end of the dollar as the reserve currency and create all kinds of restraints on American power. Maybe that's good, maybe that's bad. What's clear is that even today, with foreign misadventures all over the place, there's little appetite in either Republican or Democratic circles to reduce American reach.

Judis is certainly correct that the financialization process was hardly a conspiracy of the banks and Wall Street ("old" Wall Street fought reforms in the '70s) and did not "starve" either Main Street or American industry. Glass-Steagall banking undoubtedly restricted credit, particularly to the middle market and consumers, more than the go-go deregulated system. In fact, while a reformed Wall Street clearly made life tougher on CEOs and boards through the rise of M&A, it also generated liquidity for companies large and small, new financial products (some good, some bad, some good and bad) and strategies, like private equity, that offered a greater variety of financial options, and, of course, that double-edged sword, credit in abundance, including mortgages, for just about everyone but the family dog. But financializaton did have some detrimental effects that Judis does not examine. Tufts' Amar Bhidé argues compellingly in "A Call for Judgment" (reviewed here) that tough investor protection rules of the '30s eventually produced highly liquid markets (helped along, it is true, by low-interest rates and overseas dollars) and encouraged what he calls "arms-length stockholding," which, in turn, spawned serious corporate governance problems. As institutional investors grew larger, portfolios grew more complex, and oversight declined. Stakeholder governance was supplanted by the shareholder model. Highly liquid markets encouraged trading, easy exits for shareholders and drove the rapid turnover of shares that encouraged a short-term, quarter-by-quarter mentality (and also fueled rising CEO pay, pegged to the share price). How detrimental was that short-term mentality? It's hard to quantify. But once again, we see the unforeseen -- perhaps unforeseeable -- consequences of much-lauded reforms.

For all the caveats, Judis is convincing that financialization was a consequence, not a cause, of the deindustrialization of America. That neither takes Wall Street off the hook nor makes a compelling case for allowing the banks to remain so large and so speculative. But it does provide some refreshing realism on an issue that too often has consisted of little more than hot air. - Robert Teitelman

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