In the May 2009 edition of the Atlantic monthly there was an influential article by the former chief economist of the IMF and Professor of Economics at MIT, Simon Johnson. Titled ‘The Quiet Coup’, it claimed that the financial industry has effectively captured the United States government. At that time, I was fairly persuaded. Evidence of the dominance of the financial sector was everywhere.
Prior to 1980, the financial sector accounted for less than 15% of corporate profits in the United States. This number steadily increased to reach an astounding 41% at the peak in 2006. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99% and 108% of the average for all domestic private industries. From 1983, it shot upward, reaching 181% in 2007. This increasing concentration of wealth gave bankers enormous political heft.
Increasing campaign contributions played a part: in the ten year period of 1998-2008, the sector spend a stunning $5 billion on campaign contributions and lobbying efforts. Even more important that direct contributions, soft money and lobbying was the revolving door between Washington and Wall Street. Financiers routinely moved from investment banking to the US treasury, the Federal Reserve, advisory positions to Senators and even to the White House; the appointment of the JP Morgan banker William Daley as the White House Chief of Staff being a case in point. Top officials also landed lucrative financial sector gigs when they retired: Alan Greenspan works as a consultant for Pimco, the trillion dollar gorilla of the bond market; John Snow became chairman of Cerberus, the giant private equity firm; and President H.W. Bush famously joined the Carlyle group. Most importantly, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Washington insiders have increasingly come to believe that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.
Observe the deregulation of the sector since Reagan, the repeal of the Glass-Steagall Act, the pressure to keep derivatives unregulated and carried interest under-taxed, the unwillingness to regulate the hedge funds, the financial bailout and absurdly ineffectual financial regulatory reform act. It is clear that there is a strong case for the Johnson thesis.
But thinking about it since then, I have come to a more astonishing conclusion. But before I get to stating my thesis, we need to consider some more facts about the structure of the United States economy.
A good place to begin is the golden post-war period. In the period from 1947-73, the US economy grew at a robust 4% per annum. Most of this growth was due to sharply increased labor force participation by women and rising productivity per worker. Incomes grew faster at the bottom and slower at the top of the income ladder. Inequality reduced to its lowest level in US history. This outcome was in part due to the privileged position of the United States which faced no significant international competition and accounted for nearly half of global output. International currencies were traded on a fixed exchange rate system, which made fiscal policy effective and capital controls unavoidable. Equally, if not more, important was the domestic political economy equilibrium: highly protected and regulated oligopolies dominated every industry while powerful industrial unions ensured high and rising wages for the working class. Top marginal tax rates were extremely high and the financial sector was heavily regulated and no more profitable than manufacturing. As Paul Krugman likes to say, banking was boring.
A number of changes then occurred in the 1970s that changed the context completely. Europe and Japan reemerged fairly quickly from the unprecedented destruction of the Second World War and now they were joined by emerging economies in East Asia and elsewhere in challenging US economic domination. The computer, tele-communcations and transportation revolutions that came out from investments that the Pentagon made in the post-war period altered the underlying economics of US corporations. Now it was possible to create global supply chains that created pressure on wages at home, increased profitability and lowered prices for consumers. But first, the rigidity of the international trading system had to go. This occurred with the Oil embargo of 1973, protesting the Israeli attack on Egypt, the Arab oil producers raised the price of crude threefold. This led to an almost immediate collapse of the fixed exchange rate system and a sharply higher inflation rate.
The fixed exchange rate system was replaced by a flexible exchange rate system and capital controls were relaxed globally. It became easier for US corporations to invest capital in other countries and relocate their operations abroad. The old production system of the golden age could now be parcelled out wherever it could be done best and cheapest. This broke the political economy equilibrium at home. The bargaining power of the unions went into permanent decline. Almost all gains in productivity were captured by investors and executives. CEOs salaries starting diverging sharply from median wages. All this led to stagnant real incomes for the bottom 90% of the population and sharply rising inequality, especially at the top.
Beginning in the late 1970s, finance began to change significantly. Trading in currency futures began in 1972, followed quickly by equity futures, T-bill futures, bond futures. Theoretical developments in stochastic finance spurred innovation in financial instruments. Fisher Black and Myron Scholes published their famous formula for options pricing in 1973. But it was the deregulation of banking and interest rates in the 1980s that unleashed speculative and arbitrage opportunities that made finance so much more lucrative. The commodities and bond market bubbles in the 1980s and the tech bubble in the 1990s were followed by the mother of all bubbles in real estate in the 2000s. Bankers and financial speculators made billions of dollars while the party lasted, and were bailed out when the bubbles burst.
All of the above is well understood, but another role of finance has not been emphasized before: the role that investment bankers and capital markets began to play in other industries.
In the golden age, because most industries were protected, regulated and characterized by collective bargaining arrangements there was not much scope of increasing profitability by executive action and capital market pressure. With the advent of new possibilities of improving the bottom line and innovations in investment banking, pressure to make companies more profitable began to build. One by one, investment bankers began to consolidate industries by mergers and acquisitions. Buyout firms emerged, that threatened hostile takeovers of companies that did not increase shareholder value. CEOs started to be awarded ever higher pay checks to outsource processes, cut payroll and increase profitability. Investment bankers and financiers began to sit down corporate executives and tell them what to do.
In effect, the managerial revolution of the golden period came to an end. Capital came back with a vengeance and this time it was the bankers who were in control. Investors, rating analysts and bankers became the primary audience for the corporate executives who came to report their progress every quarter. The fortunes of companies and CEOs are judged solely in the capital markets. And because the bankers were the conduit between CEOs and capital markets they effectively began shaping corporate policy. Perhaps even more importantly, corporate executives in all sectors were financially, culturally and ideologically incorporated into a plutocratic world shaped by Wall Street. Those who created more shareholder value were awarded Wall Street level pay checks, eight figure bonuses and golden parachutes. Those who took the eye off the ball were promptly punished in private equity backed hostile buyouts and management purges.
It seems that I am arguing that the financial sector has power not just over the US government but over the entire economy as well. That is correct. The financial sector firmly consolidates and rationalizes all other sectors in the economy. It runs the show. Its not that the bankers have a choice in what they can tell CEOs to do. They have to follow the logic of the market. In that sense, it is the capital markets where the buck stops.
Now its clear why the financial sector seems to be in control and why they want bankers in Washington. They are needed to navigate the capital markets. They are needed to conduct what has been called ‘stock market diplomacy’. The bankers are the insiders. They know how they system works. You need to keep the markets happy, who better to advise you than a JP Morgan executive?
Similar discipline is imposed on poor countries by the ‘virtual senate’. If you deviate too much from what the global investors demand, the bond market vigilantes will strike, capital flight will ensure that your currency collapses and you will have to come begging to the IMF. This keeps poor world state policy on a tight leash. It also explains why there have been no coups sponsored by the United States in this period. The point is to have pro-Business, pro-Western governments. Violence is a very unwieldy instrument. Much better control is exercised by the international capital markets, ensuring investor friendly policies automatically. Political leaders in emerging markets are quickly learning to placate the markets and behave appropriately with investors.
What has happened is subtly different and even more radical than what Simon Johnson alleges. The financial sector has not just captured the state, it has taken over the reins of the entire system. Real allocative decision making about the economy is basically conducted through the capital markets. The bankers just happen to be the gate keepers and guides. But there has not been a coup, at least if we understand that to mean that there are other sectors that are not in on it. Business has always dominated politics in the United States, it just so happens that legal, technological and ideological factors have combined to concentrate and align the financial and political interests of all business sectors with that of the financial sector. In retrospect, it is just a natural consequence of the financialization of the economy.