The new landscape of capitalism

Recent changes in the landscape of capitalism have received many labels such as neo-liberalism, post-industrialism, globalization and financialization. Since the 1950’s, the role of the finance sector in the economy has become increasingly dominant as reflected by the fivefold increase in the ratio of portfolio income relative to cash flow from operations of firms by the 1990’s, in the United States. The cause of such development is largely attributed to financialization. The purpose of this essay will be to provide a better understanding of the concept and to review the main implications of financialization for large firms in terms of structure, operations, corporate behavior and the economy as a whole. We will begin by presenting a brief historical overview of some of the events we consider that led to the development of such phenomenon.

Historical Overview

In the first half of the twentieth century, the wide diffusion of stock-ownership gave managers of large firms considerable discretion in defining the goals of the firm, limiting the influence of shareholders (Berle & Means, 1932). ‘This lack of control over management was reflected in the pursuit of market share and growth at the expense of profitability via vertical and horizontal integration, the diversification into unrelated products translated into the rise of complex conglomerates and the rapid growth of compensation of top corporate executives, even when the performance of the company was mediocre’ (OECD, 1998). Management allocated resources according to a corporate governance principle of ‘retain and reinvest’: corporations reinvested retained earnings in physical capital and complementary human resources that provided the financial foundations for corporate growth (Lazonick and O'Sullivan, 2000).

However, in the 1960s and 1970s, important developments started shifting the balance of power and resource allocation within the firm. The oil-induced inflation of the 1970s made key US financial institutions unable to compete against the higher yields offered by mutual funds and money market funds. The outcome was the financial deregulation of the American economy, which enabled regulated banks, pension funds and insurance companies to invest substantial portions of their portfolios in corporate equities with higher yields and other risky securities rather than just in high-grade corporate and government securities. The latter was of particular significance for the quest of shareholder value in the US economy because it translated into the support of a very important player: the institutional investor (Lazonick and O'Sullivan, 2000).

Another important event came with the development of agency theory by Jensen & Meckling (1976), who construed the firm not as an organization, but as a nexus of contracts among owners and managers. This theory suggests that the central problem was that managers did not always act in the best interests of the shareholders. In essence, they proposed that information asymmetries and the difficulty of monitoring agents, gave way for autonomous management to be guided by their own utility maximization rather than by that of the shareholders.

With this in mind, advancements in the field of Finance, in the form of new financial instruments, provided novel tools for management compensation and transformed the field of Mergers & Acquisitions. These developments ‘proved fairly effective in making management adopt shareholders' priorities and have profoundly altered patterns of managerial power and behavior’ (Baker & Smith, 1998). Simply put, they served to align managers’ and shareholders’ interests in a more accurate manner.

Since then, deregulation and shareholder value movement led firms in all sectors to primarily think in financial terms. Consequently, shareholders have increased their influence on management behavior substantially, leading shareholder value maximization to become an aim that firms have to pursue (Shin, 2013). The ascendancy of shareholder value as a mode of corporate governance is identified by many as financialization (Froud et al., 2000; Lazonick and O'Sullivan, 2000; Williams, 2000).

Implications for the operations and managerial structure of large firms

The implications of such phenomenon in terms of the structure of large firms are complex. According to Lazonick & O'Sullivan (2000), it entails a managerial shift in the strategic allocation of the firms’ resources away from ‘retain and reinvest’ towards ‘downsize and distribute’ back to shareholders. Similarly, Williams (2000) suggests that financialization transformed the hierarchy of management objectives and added complexity into management work as managers not only have to organize processes and please consumers in the product market, but also must satisfy professional fund managers and meet the expectations of the capital market. The result is a new form of competition where every firm must compete as an investment to meet the same standard of financial performance (Williams, 2000). By the same token, Froud et al. (2000) analyze the evolution of competition from productionism to financialization. The shift represents a change from competition in the product market to the capital market based on financial results. The main contrast being that the capital market, via investment institutions and professional fund managers, are generally much more dynamic than the old forces of the product market via retailers and consumers (Froud et al., 2000).

In general, financialization entails a variety of changes in the structure and operations of the firm that go from competition to resource allocation. Nonetheless, these are not the only changes. We will now examine how it influences corporate behavior and the economy as a whole.

Implications for corporate behavior in large firms and the economy as a whole

Arrighi (1994) and Krippner (2005) go beyond the idea of financialization as the ascendancy of ‘shareholder value’, and described it as ‘a pattern of accumulation in which profits accrue primarily through financial channels (activities related to the provision or transfer of liquid capital in expectations of future dividends, interests or capital gains) rather than through trade and commodity production’. In other words, it is phenomenon that reflects how financial investment is replacing physical investment (Stockhammer, 2013).

Krippner (2005) depicts a picture of the structural change in corporate behavior and the economy by comparing two views: activity centered and accumulation centered. The former revolves around changes in employment and the contribution of different sectors, whereas the latter focuses on where profits are generated. The comparison characterizes what is happening in the economy: accumulation is now occurring increasingly through financial channels. In essence, financialization is not a label, a permanent trend or a novel phase of capitalism; but, a perspective on economic change that is justified by its usefulness in terms of approaching key theoretical issues such as how does it affect corporate behavior? And, the relationship between the state and the economy? In regards to the first question, financialization provides a different perspective to better understand corporate governance and behavior by analyzing the convergence between financial and non-financial firms (Krippner, 2005). Essentially, non-financial corporations are beginning to resemble financial corporations. Orhangazi (2008) goes into more detail and reflects on two negative effects on real capital accumulation. First, higher financial profits can change the incentives of the firm management regarding investment decisions and crowd out real capital accumulation by directing funds away from real investment into financial investment, leading to the increasing size of the financial sector. Second, increased financial payments can decrease the funds for real capital accumulation, shortening the planning horizon of its management and increasing uncertainty, which leads to lower levels of investment in the real economy. In the same line of thinking, Bollier (2011) points out that financialization pushes firms to disregard the dynamic, long-term value of technological and manufacturing knowledge, which could potentially translate into a valuable source of profits.

Regarding the second question, the deregulation and financialization of the economy have reduced the participation of the state in molding the structure of the economy and increased the influence of large private firms. Financialization can provide new insight on the spatial restructuring of economic activity by making reference to the divesting pattern of growing accumulation through financial channels in non-financial firms (Krippner, 2005). The question that arises is whether this new allocation is healthy for the economy as a whole? Some scholars believe that financially driven resource allocation can undermine the sustainability of the economy by affecting the amount and allocation of resources in the real economy (Lazonick, 2010). Others go even further and contend that a growing body of analysis suggests that an oversized financial industry is hurting the broader economy by polarizing income distribution. More precisely, it has affected both the micro and macro economy and transformed how economic actors (households, workers, firms, financial institutions) perceive themselves, what goals they pursue and what constraints they face (Stockhammer, 2013).

The latter becomes particularly troubling when finance becomes primarily a speculation activity. To illustrate, John Maynard Keynes (1936) made an important distinction between enterprise and speculation. There is enterprise, which is comprised of different industries, part of the real economy; and, there is speculation, which is incurred by the financial sector. When enterprise is dominant, speculation is a tiny part of the real economy. In other words, it is just a bubble. As a result, the economy as a whole still grows. On the other hand, ‘when the capital development of a country becomes a by-product of the activities of speculation, the job is likely to be ill done…’ (Keynes, 1936).

Recapitulating, financialization denotes several implications for the structure of the firm, including the increasing relevance of the financial sector over the real sector. The latter entails the transfer of resources from the real sector to the financial sector potentially changing the power structure and generating income inequality.

To conclude, it is important to keep in mind that financialization is a recent term and still ill-defined. In this essay we have examined some of the most relevant views on the concept, but there are many others; for example, some use financialization to identify the growing dominance of capital markets over systems of bank-based finance, others use it to describe the explosion of trading due to the proliferation of new financial instruments, and so on. However, in broad terms, we believe that it mainly tries to capture the growing weight of finance in the economy. The implications for the structure of large firms are seminal for understanding key issues in corporate governance, resource allocation and where the global economy is headed.

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