In his 2015 book, The Age of Stagnation – Why Perpetual Growth is Unattainable and the Global Economy is in Peril, internationally respected consultant and financial commentator, Satyajit Das, attributed the causes of the 2008 global financial crisis to four main factors: high debt levels, excessive financialization, large global imbalances, and a buildup of future entitlements that had not been properly provided for. The following is the highlight of his analysis on the damage of high debt and financialization.
========HIGH DEBT LEVELS:============
A increasing reliance of global economy on borrowings to create economic activity. A 2015 study covering twenty-two developed economics and twenty-five developing economies found that between 2000 and 2007 total global debt grew from US$87 trillion to US$142 trillion, an increase of 7.3% percent per annum, double the growth in economic activity. Global financial assets in the form of shares and debt securities grew form US$51 trillion in 1990 to US$294 trillion (some 3.8 times global GDP) by 2014, an annual growth rate of about 8 percent, again well above real economic growth. Debt now drove economic growth, allowing immediate consumption or investment against the promise of paying back the borrowing in the future. Spending that would normally have taken place over a period of years was accelerated because of the availability of debt.
Household borrowed because real wage levels, especially in the US had not kept pace with living costs. The availability of finance and low interest rates allowed businesses to expand. Corporations substituted debt for equity, as it was cheaper and interest was tax-deductible. They borrowed to buy back their own shares. Governments borrowed to build essential infrastructure and to provide additional services for their citizens – it was electorally more palatable than increasing taxes. Financial institutions borrowed to meet the rising demand for loans. As money was their stock-in-trade, lending more increased profits and dividends. Banks became adept at speeding up the circulation of money, further increasing the supply of credit. Central to this was the shadow banking system, estimated to be between US$25 trillion and US$100 trillion in size (40-160 percent of global GDP).
American business journalist Henry Hazlitt argued in 1946, that other than things that were available for free in nature, everything has to be paid for. In effect, you cannot get something for nothing. You cannot increase borrowing without limit. He dismissed the idea that debt can be ignored, because as a society we own the money to ourselves. Debt can be beneficial where the economic activity generated is sufficient to repay the borrowing, but the buildup of debt since the late 1980s was excessive, beyond repayment capacity. Only around 12-20 percent of the borrowed money went into investment projects, the remaining 80-85 percent financed existing corporate assets, real estate, or unsecured personal finance to “facilitate life cycle consumption smoothing.” Debt also must be repaid on a fixed date. Deteriorating asset values or creditworthiness can reduce the ability to re-borrow in order to repay the original borrowing, triggering financial crises, as illustrated by European sovereign debt problems. Fractional banking, as well as the shadow banking system and derivatives, can amplify the risk within an economy. Ultimately, excessive debt resembles a Ponzi scheme.
====LARGE FINANCIAL SECTOR, FINANCIAL ENGINEERING:=====
As debt levels rose, banks increased in size, especially relative to the size of economies. By 2007, bank assets in many developed countries were in excess of 100 percent of GDP. In the US, at its peak (before financial crisis of 2008), the finance industry generated 40 percent of corporate profits and represented 30 percent of the market value of stocks. With debt and savings being two sides of the same coin, when the liabilities cannot be repaid, the phantom assets become worthless. The system collapses.
A large banking system does create problems when its role expands beyond support for the real economy – facilitating payments, providing a safe place for savings, financing real activity, and managing risk. The drive for growth and higher profitability leads banks to take greater risks. It encourages a higher volume of loans by lowering the lending standards, as exemplified by the US subprime loans, so that credit is extended against inadequate collateral or without acceptable legal protection. The focus shifts to channeling funds into speculative activities and trading for profit unrelated to client needs. These are frequently zero-sum games, entailing transfers of wealth between the parities to a transaction and adding little to overall economic activity. One problem is the global financial system’s intricate linkages, which in 2008 became a conduit for transmitting contagion. This led to sharp falls in cross-border capital flows, which today remain well below the pre-crisis levels.
Financial innovations create new risks, both for individuals, institutions and systemically. Financiers profit from and exploit the asymmetry of information between sellers and buyers of complex products. Capital ratios and liquidity reserves of banks have fallen sharply. Leverage increasingly drove higher and more volatile returns on equity. The risk associated with the increase in size and complexity of the banking system is implicitly underwritten by the state, a fact recognized by rating agencies. Business increasingly relied on financial engineering not linked to the provision of goods and services to improve earnings or increase their share price. Companies increased the use of lower-cost debt financing. Share buybacks and capital returns supported share prices. In January 2008, US companies were using almost 40 percent of their cash flow to repurchase their own shares. Complex securities frequently exploit discrepancies in ratings and tax rules to lower the cost of capital. Merges and acquisitions, as well as various types of corporate restructurings (spin-off, carve-outs, etc), were used to create value. Given the indifferent results of such transactions, the major benefits accrued to insiders, bankers, and consultants.
In a Dilbert cartoon, Scott Adams depicted a company that abandons making good products in favor of a strategy of random reorganizations – mergers, acquisitions, spin-offs of parts of the business, partnerships, joint ventures, and a program of paying the good employees to leave. The stock price goes up. Companies traded in financial instruments for profit. Oil companies could make money irrespective of whether the oil business was good or bad the price high or low, profiting from uncertainty and volatility. It was not necessary to actually produce, refine, or consume oil to benefit from price fluctuations. Legendary investor Warren Buffett’s Berkshire Hathaway used financial engineering extensively, including leverage and derivative contracts. The company received the insurance premiums in cash, which could then be used to finance investments. It sold long-dated options (a form of insurance) on international stock indices and corporate default risks. The option fees received augmented its investment capital. In both strategies employed by Berkshire Hathaway, the leverage derived from the receipt of cash up-front against a promise to make a contingent payment in the future. The risk is back-ended and the company only has to make payments when the contracts are unwound or expire, allowing them the use of the cash received.
Financialization interferes ultimately with market mechanisms, creating an artificial economy with manipulated and unsustainable values. Stock markets are designed to facilitate capital raisings of investment projects. They allow savers to invest, and provide existing investors with the ability to liquidate their investments when circumstances require. Financialization undermines these functions. Stock markets have increasingly decoupled form the real economy despite the fact that shares represent claims on the real economy. Equity prices now do not correlate to fundamental economic factors, such as GDP growth, or, sometimes, earnings. High-frequency trading (HFT), which entails super-fast computers rapid trading stocks, usually with other computers, constitutes up to 70 percent of the trading volume in some markets. The average holding period of HFT is around ten seconds. The portfolio investor’s average investment period was seven years in 1940. By 2014, it was around seven months. Momentum trading, rather than investing for the long run, now dominates. The nature of stock markets has been changed by alternative sources of risk capital; and a shift to different forms of business ownership, such as private equity. New capital raisings are used by private investors or insiders to realize accreted gains, subtly changing the function of the market.
Longer term, these developments threaten the market’s viability as a source of capital for businesses and also as an investment, damaging the real economy. Alfred E. Neuman captured the surreal world of modern finance: “We are living in a world today where lemonade is made from artificial flavors and furniture polish is made from real lemons.”