Reversing Financialization in the Post-COVID-19 World

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The COVID-19 pandemic has revealed the extreme income and wealth inequality that has undermined U.S. economic growth for more than 40 years. The bottom 90% of U.S. households by income have endured stagnant wages, rising debt loads and generalized economic insecurity, all of which became evident as house prices collapsed in 2007-2009. Although many suggest that the inequality is attributable to the impact of globalization and technological advancements on employment and wages, what they miss is the role of speculative finance (financialization) and the complicity of the central bank in driving this process.

The Great Depression is the closest analogue to the extraordinary dislocation currently unfolding in the U.S. economy. Conditions will likely deteriorate further throughout 2020, given the non-linear spread of the virus. The frailty of the U.S. economy is revealed by the staggering levels of income and wealth inequality that pre-dated the arrival of the pandemic. In fact, polarization of income and wealth have been increasing over the past 40 years. A key driver of this phenomenon was the turn toward the “market knows best” framework that began during the 1980s, especially the deregulation and liberalization of financial markets and capital flows.1

The process of financialization reflects the role of unfettered financial markets in fueling the debt-induced asset price cycles and the turn by non-financial corporations toward maximizing shareholder value that began during the 1980s. Prior to 1980, speculative use of debt was constrained under the financial framework adopted during the New Deal. Interest rates were regulated (Regulation Q) and Glass-Steagall separated commercial from investment banking. Those regulations were eliminated during the 1980s and 1990s, as were other regulations that prohibited corporations from buying back their own stock (November 1982), exempting credit default swaps (CDS) from federal regulations (2000) and permitting corporations to grant stock options (early 1990s). The financialization process began during the 1980s and took hold during the 1990s and 2000s, as financial markets decoupled from the underlying real economy in a series of debt-driven boom-bust cycles (see chart below).

The Fed has been complicit in the financialization process though it is not entirely clear whether this was attributable to regulatory capture, ideology or more than likely, a combination of both. Central bankers, policymakers and financial regulators failed to understand the implications of financial deregulation as constraints were lifted from banks and other financial market participants. This shortcoming was underscored in a speech delivered by Ben Bernanke in February 2004, The Great Moderation, which some have referred to as the “great illusion.” Bernanke believed that markets were efficient and rational. His speech illustrated the obliviousness of the mainstream economics profession to the challenges that would confront the U.S. economy several years later. In fact, mainstream neoclassical models (known as dynamic stochastic general equilibrium models) were designed based on a belief that money is a mere “veil” over the real economy. Those models did not incorporate money, credit, banking, or finance.