Financialism: a Lecture Delivered at Creighton University School of Law

• Publication year: 2022

43 Creighton L. Rev. 323. FINANCIALISM: A LECTURE DELIVERED AT CREIGHTON UNIVERSITY SCHOOL OF LAW

FINANCIALISM: A LECTURE DELIVERED AT CREIGHTON UNIVERSITY SCHOOL OF LAW

September 25, 2009

LAWRENCE E. MITCHELL(fn*)

The United States no longer is a capitalist country. It has created a new economic system that appears to be capitalist but no longer performs the functions of capitalism. Capitalism is a system in which wealth is created and sustained by the production of goods and services determined through market supply and demand. A variety of related structures support capitalism, including the institutions of finance, which provide the funds necessary for the production and trade of goods and services.

While capitalism still characterizes a portion of the American economy, it has become subordinated to a new economic order. This economic system is one in which the financial markets exist primarily to serve themselves. In this system, capital is raised for the purpose of creating, selling, and trading securities and derivative securities that do not finance industry but rather trade within markets that exist as an economy unto themselves. At the same time, those markets have profound and adverse effects on the real economy. This new economic system is Financialism.

Much has been written and said on the American-initiated global financial crisis that began in 2007 and continues today. Little of that conversation recognizes the fundamental change in the function and groundwork of American capitalism that caused the crisis. None of the Obama Administration's efforts to reform the American economy acknowledge this fundamental transformation. All of the proposals currently circulating seem to seek only to reform the regulation of existing markets and financial institutions in a manner that institutionalizes financialism and imposes little if any social or economic responsibility on them. Few question whether financialism is a sound model for the sustainable future of American economic health. Yet financialism threatens to rob the patrimony of future generations for the profit of the present, and damages our national security by forcing us to outsource the production of our most essential goods and services.

I would like to explain financialism and how it grew in slightly more detail. I know that by trying to cover so much ground, I will almost certainly frustrate you by overgeneralizing and, perhaps, leave you with more questions than answers. I will use data where I have it, but apologize that this work is in its relatively early stages and I have much to do.

Financialism is grounded principally in two dangerous ideas, ideas not dangerous in themselves but dangerous in practice. These ideas have helped to provide intellectual support for the shift from capitalism to financialism and lie at its foundation. The first idea grew out of the work of Adam Smith. Smith's theory of the invisible hand was designed to show how economic growth could better be stimulated by free market activity than by the dominant practice of mercantilism, while at the same time pursuing the Enlightenment goal of freeing people from oppressive economic and social policies and providing the opportunity for them to improve their own economic conditions. Smith's theory was as much sociological as political and economic, and was grounded in the behavior of self-interested, but nonetheless morally sensitive, economic man that he had earlier developed in his A Theory of Moral Sentiments. Through the nineteenth century, this central idea was transformed by neo-classical economists into a justification for the individual pursuit of maximum utility, and in the twentieth century into the individual pursuit of maximum wealth, all stripped of, and abstracted from, Smith's highly contextualized and social ideas and having all but abandoned Smith's emphasis on real economic growth. The abstraction was complete by the last third of the twentieth century, and free market ideology resulted in the substantial deregulation of the American economy. This cleared the way for the growth of financialism.

The second idea, which depended on the notion of free markets, was the capital asset pricing model. Developed over the course of a decade by economists principally associated with the University of Chicago and the Massachusetts Institute of Technology ("MIT"), the capital asset pricing model reduced stock selection to a single number, beta, which was derived from a regression analysis of a stock price's historical movement in relationship to the market. While the goal of this model was to permit investors rationally to make decisions balancing risk and return, its unintentional consequence was to separate the investment decision from any need to be interested in, or concerned with, the underlying corporation issuing the stock, leading to a separation of stock ownership from the underlying business and laying the groundwork for an irresponsible and detached investor class.

Building upon the capital asset pricing model, option pricing theory developed as a way to bring certainty to the derivatives market, the market for trading in instruments that in part track the behavior of stocks and bonds without requiring a trader to own the underlying security - as Paul Krugman describes them, "claims on claims." The result was an explosion in over-the-counter derivatives trading and the creation of a bewildering variety of new securities, all of which were further removed from the real economy than even the deracinated portfolios assembled by investors using beta.

The complex economic modeling that produced these theories, combined with new technologies, also led to the possibility and proliferation of computer-based trading and its contemporary realization in high frequency trading, further detaching any human element of concern for the real economy while at the same time profoundly affecting real economic behavior by affecting the underlying stock prices that drive managerial incentives. The combination of these practices with free market ideas and policies that equated responsibility with selfishness laid the groundwork for a capitalism centered on a financial industry and capital markets that had largely lost touch with the fundamental purpose of capitalism as a system for the production of goods and services and wealth creation and distribution. It laid the groundwork for financialism.

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No single factor can describe the development of a complex economic system, but I would like to provide a brief historical account of the creation of financialism from the early 1950s to the present in an attempt to tie together a number of different trends. These trends include a sharp growth in the number of individual investors, the eventual dominance of institutional investors and the rise in...