ISSUES★2016

Over the past four decades, the rules that govern theUnited States’ free-market system have been warped.

That, Rana Foroohar argues in her new book,Makers and Takers, seriously imperils every American’s

economic future. How we got here and how to fix it

28 Time May 23, 2016

creating new jobs, new wealth and, ultimately, eco­nomic growth. Of course, there were plenty ofblips along the way (most memorably the specula­tion leading up to the Great Depression, which waslater curbed by regulation). But for the most part,finance—which today includes everything frombanks and hedge funds to mutual funds, insurancefirms, trading houses and such—essentially servedbusiness. It was a vital organ but not, for the mostpart, the central one.

Over the past few decades, finance has turnedaway from this traditional role. Academic researchshows that only a fraction of all the money wash­ing around the financial markets these days actu­ally makes it to Main Street businesses. “The inter­mediation of household savings for productiveinvestment in the business sector—the textbook de­scription of the financial sector—constitutes only aminor share of the business of banking today,” ac­cording to academics Oscar Jorda, Alan Taylor andMoritz Schularick, who’ve studied the issue in detail.By their estimates and others, around 15% of capi­tal coming from financial institutions today is used

to fund business investments, whereas it wouldhave been the majority of what banks did earlier inthe 20th century.

“The trend varies slightly country by country, butthe broad direction is clear,” says Adair Turner, a for­mer British banking regulator and now chairman ofthe Institute for New Economic Thinking, a thinktank backed by George Soros, among others. “Acrossall advanced economies, and the United States andthe U.K. in particular, the role of the capital marketsand the banking sector in funding new investmentis decreasing.” Most of the money in the system isbeing used for lending against existing assets suchas housing, stocks and bonds.

To get a sense of the size of this shift, consider thatthe financial sector now represents around 7% of theU.S. economy, up from about 4% in 1980. Despite cur­rently taking around 25% of all corporate profits, itcreates a mere 4% of all jobs. Trouble is, research bynumerous academics as well as institutions like theBank for International Settlements and the Interna­tional Monetary Fund shows that when finance getsthat big, it starts to suck the economic air out of theroom. In fact, finance starts having this adverse effectwhen it’s only half the size that it currently is in theU.S. Thanks to these changes, our economy is gradu­ally becoming “a zero­sum game between financialwealth holders and the rest of America,” says formerGoldman Sachs banker Wallace Turbeville, who runsa multiyear project on the rise of finance at the NewYork City–based nonprofit Demos.

It’s not just an American problem, either. Most ofthe world’s leading market economies are grapplingwith aspects of the same disease. Globally, free­market capitalism is coming under fire, as countries

SOURCE: BURE AU OF L ABOR STAT IST ICS

Financialization hasfunneled wealth up,

not down, which is partlywhy middle-class

wages have hardlybudged since the 1960s

STAGNANTINCOME

Average hourly payhas increased just

$1.25 in 50 yearsafter adjusting

for inflation

Wages

1965$19.79

2015$21.04

couple of weeksago, a poll con­ducted by the Har­vard Institute ofPolitics foundsomething startling:only 19% of Ameri­cans ages 18 to 29

identified themselves as “capitalists.” In the rich­est and most market­oriented country in the world,only 42% of that group said they “supported capital­ism.” The numbers were higher among older people;still, only 26% considered themselves capitalists. Alittle over half supported the system as a whole.

This represents more than just millennials notminding the label “socialist” or disaffected middle­aged Americans tiring of an anemic recovery. This isa majority of citizens being uncomfortable with thecountry’s economic foundation—a system that overhundreds of years turned a fledgling society of farm­ers and prospectors into the most prosperous nationin human history. To be sure, polls measure feelings,not hard market data. But public sentiment reflectsday­to­day economic reality. And the data (more onthat later) shows Americans have plenty of concretereasons to question their system.

This crisis of faith has had no more severe expres­sion than the 2016 presidential campaign, which hasturned on the questions of who, exactly, the systemis working for and against, as well as why eight yearsand several trillions of dollars of stimulus on from thefinancial crisis, the economy is still growing so slowly.All the candidates have prescriptions: Sanders talksof breaking up big banks; Trump says hedge fundersshould pay higher taxes; Clinton wants to strengthenexisting financial regulation. In Congress, Republi­can House Speaker Paul Ryan remains committedto less regulation.

All of them are missing the point. America’s eco­nomic problems go far beyond rich bankers, too­big­to­fail financial institutions, hedge­fund billionaires,offshore tax avoidance or any particular outrage ofthe moment. In fact, each of these is symptomatic ofa more nefarious condition that threatens, in equalmeasure, the very well­off and the very poor, the redand the blue. The U.S. system of market capitalismitself is broken. That problem, and what to do aboutit, is at the center of my book Makers and Takers: TheRise of Finance and the Fall of American Business, athree­year research and reporting effort from whichthis piece is adapted.

To understand how we got here, you have to un­derstand the relationship between capital markets—meaning the financial system—and businesses. Fromthe creation of a unified national bond and bank­ing system in the U.S. in the late 1790s to the early1970s, finance took individual and corporate sav­ings and funneled them into productive enterprises,

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across Europe question its merits and emergingmarkets like Brazil, China and Singapore run theirown forms of state-directed capitalism. An ideolog-ically broad range of financiers and elite businessmanagers—Warren Buffett, BlackRock’s Larry Fink,Vanguard’s John Bogle, McKinsey’s Dominic Bar-ton, Allianz’s Mohamed El-Erian and others—havestarted to speak out publicly about the need for anew and more inclusive type of capitalism, one thatalso helps businesses make better long-term deci-sions rather than focusing only on the next quar-ter. The Pope has become a vocal critic of mod-ern market capitalism, lambasting the “idolatry ofmoney and the dictatorship of an impersonal econ-omy” in which “man is reduced to one of his needsalone: consumption.”

During my 23 years in business and economicjournalism, I’ve long wondered why our market sys-tem doesn’t serve companies, workers and consum-ers better than it does. For some time now, financehas been thought by most to be at the very top of theeconomic hierarchy, the most aspirational part of anadvanced service economy that graduated from agri-culture and manufacturing. But research shows justhow the unintended consequences of this misguidedbelief have endangered the very system America hasprided itself on exporting around the world.

AmericA’s economic illness has a name: fi-nancialization. It’s an academic term for the trendby which Wall Street and its methods have cometo reign supreme in America, permeating not justthe financial industry but also much of Americanbusiness. It includes everything from the growthin size and scope of finance and financial activityin the economy; to the rise of debt-fueled specu-lation over productive lending; to the ascendancyof shareholder value as the sole model for corpo-rate governance; to the proliferation of risky, self-ish thinking in both the private and public sectors;to the increasing political power of financiers andthe CEOs they enrich; to the way in which a “mar-kets know best” ideology remains the status quo.Financialization is a big, unfriendly word with broad,disconcerting implications.

University of Michigan professor Gerald Davis,one of the pre-eminent scholars of the trend, likens fi-nancialization to a “Copernican revolution” in whichbusiness has reoriented its orbit around the financialsector. This revolution is often blamed on bankers.But it was facilitated by shifts in public policy, fromboth sides of the aisle, and crafted by the governmentleaders, policymakers and regulators entrusted withkeeping markets operating smoothly. Greta Krippner,another University of Michigan scholar, who has writ-ten one of the most comprehensive books on finan-cialization, believes this was the case when financial-ization began its fastest growth, in the decades from

the late 1970s onward. According to Krippner, thatshift encompasses Reagan-era deregulation, the un-leashing of Wall Street and the rise of the so-calledownership society that promoted owning propertyand further tied individual health care and retire-ment to the stock market.

The changes were driven by the fact that in the1970s, the growth that America had enjoyed fol-lowing World War II began to slow. Rather thanmake tough decisions about how to bolster it(which would inevitably mean choosing amongvarious interest groups), politicians decided to passthat responsibility to the financial markets. Littleby little, the Depression-era regulation that hadserved America so well was rolled back, and financegrew to become the dominant force that it is today.The shifts were bipartisan, and to be fair they oftenseemed like good ideas at the time; but they alsocame with unintended consequences. The Carter-era deregulation of interest rates—something thatwas, in an echo of today’s overlapping left- andright-wing populism, supported by an assortmentof odd political bedfellows from Ralph Nader toWalter Wriston, then head of Citibank—openedthe door to a spate of financial “innovations” and ashift in bank function from lending to trading. Rea-ganomics famously led to a number of other eco-nomic policies that favored Wall Street. Clinton-era deregulation, which seemed a path out of theeconomic doldrums of the late 1980s, continuedthe trend. Loose monetary policy from the AlanGreenspan era onward created an environment inwhich easy money papered over underlying prob-lems in the economy, so much so that it is nowchronically dependent on near-zero interest ratesto keep from falling back into recession.

This sickness, not so much the product of venalinterests as of a complex and long-term web ofchanges in government and private industry, nowmanifests itself in myriad ways: a housing marketthat is bifurcated and dependent on governmentlife support, a retirement system that has left mil-lions insecure in their old age, a tax code that favorsdebt over equity. Debt is the lifeblood of finance;with the rise of the securities-and-trading portion ofthe industry came a rise in debt of all kinds, publicand private. That’s bad news, since a wide range ofacademic research shows that rising debt and creditlevels stoke financial instability. And yet, as financehas captured a greater and greater piece of the na-tional pie, it has, perversely, all but ensured thatdebt is indispensable to maintaining any growthat all in an advanced economy like the U.S., where70% of output is consumer spending. Debt-fueledfinance has become a saccharine substitute for thereal thing, an addiction that just gets worse. (Theamount of credit offered to American consumers

SOURCE: FEDERAL RESERVE

SMALL BUSINESS CREDIT SURVEY

This article wasadapted from

Foroohar’s Makersand Takers

(Crown), outthis month

In 2015, 50% ofsmall businesseshad a financing

shortfall, securingless than the full

amount requested

Commercial banks’interest in small-business

lending has wanedbecause it tends to be

less profitable than othertypes of financial activity

MAIN STREETCREDIT

CRUNCH

Small-businessloans

and 21% turned topersonal funds to

finance their business

As a result, 32%of growing firms

reported thatthey had to delay

expansion

30 Time May 23, 2016

has doubled in real dollars since the 1980s, as havethe fees they pay to their banks.)

As the economist Raghuram Rajan, one of themost prescient seers of the 2008 financial crisis, ar-gues, credit has become a palliative to address thedeeper anxieties of downward mobility in the middleclass. In his words, “let them eat credit” could wellsummarize the mantra of the go-go years before theeconomic meltdown. And things have only deterio-rated since, with global debt levels $57 trillion higherthan they were in 2007.

The rise of finance has also distorted local econo-mies. It’s the reason rents are rising in some commu-nities where unemployment is still high. America’shousing market now favors cash buyers, since banksare still more interested in making profits by tradingthan by the traditional role of lending out our sav-ings to people and businesses looking to make long-term investments (like buying a house), ensuring thatyounger people can’t get on the housing ladder. Oneperverse result: Blackstone, a private-equity firm, iscurrently the largest single-family-home landlord inAmerica, since it had the money to buy propertiesup cheap in bulk following the financial crisis. It’sat the heart of retirement insecurity, since fees fromactively managed mutual funds “are likely to con-fiscate as much as 65% or more of the wealth that . . .investors could otherwise easily earn,” as Vanguardfounder Bogle testified to Congress in 2014.

It’s even the reason companies in industries fromautos to airlines are trying to move into the businessof finance themselves. American companies acrossevery sector today earn five times the revenue fromfinancial activities—investing, hedging, tax optimiz-ing and offering financial services, for example—thatthey did before 1980. Traditional hedging by energyand transport firms, for example, has been over-taken by profit-boosting speculation in oil futures,a shift that actually undermines their core business

by creating more price volatility. Big tech compa-nies have begun underwriting corporate bonds theway Goldman Sachs does. And top M.B.A. programswould likely encourage them to do just that; financehas become the center of all business education.

Washington, too, is so deeply tied to the ambas-sadors of the capital markets—six of the 10 biggestindividual political donors this year are hedge-fund barons—that even well-meaning politiciansand regulators don’t see how deep the problemsare. When I asked one former high-level ObamaAdministration Treasury official back in 2013 whymore stakeholders aside from bankers hadn’t beenconsulted about crafting the particulars of Dodd-Frank financial reform (93% of consultation on theVolcker Rule, for example, was taken with the fi-nancial industry itself), he said, “Who else shouldwe have talked to?” The answer—to anybody notprofoundly influenced by the way finance thinks—might have been the people banks are supposed tolend to, or the scholars who study the capital mar-kets, or the civic leaders in communities decimatedby the financial crisis.

Of cOurse, there are other elements to the story ofAmerica’s slow-growth economy, including familiartrends from globalization to technology-related jobdestruction. These are clearly massive challenges intheir own right. But the single biggest unexploredreason for long-term slower growth is that the finan-cial system has stopped serving the real economyand now serves mainly itself. A lack of real fiscalaction on the part of politicians forced the Fed topump $4.5 trillion in monetary stimulus into theeconomy after 2008. This shows just how brokenthe model is, since the central bank’s best effortshave resulted in record stock prices (which enrichmainly the wealthiest 10% of the population that

Shareholder value isa narrow definitionof corporate value.Companies should berun for shareholdersbut also for workers,customers and, to acertain extent, societyat large. Capitalmarkets must servethe long-term growthof companies, notpressure them intoshort-term alchemy.

America needs taxreform that ensurespeople and companiesalike aren’t rewardinghollow spending:buying McMansions,for instance, or usingdebt just to appeaseshareholders. Savingand investing—public and private,individual andcorporate—should beincentivized by thenational tax code.

“Too big to fail” is aproblem, but so is“too big to manage.”Financial institutionssimply cannot becomeso complex that eventheir leaders can’ttrack risk, as wasthe case leading upto 2008. That mightnecessitate breakingup some banks. Butit also means more-transparent trading ofderivatives and swaps,many of which are stilltoo hard to track.

Rethinkwhocompaniesare run for

Stoprewardingdebt overequity

Makefinancemoretransparent

SOURCE: EMPLOYEE BENEF IT RESE ARCH INST ITUTE

How torewritethe rules

The rules ofcapitalism areman-made.Here are fiveways to beginrighting thesystem

ILLUSTR ATIONS BY MATT CHASE FOR TIME

Americans are finding itharder to save enough

money to retire; highasset-management

fees can eat upretirement-fund gains

FEWERGOLDENYEARS

Today, workers25 to 35 years old are

planning to retirelater than their

counterparts twodecades ago

Retirement

1996 2016

65 or younger

84% 57%

Older than 65

8% 34%

Never retire

3% 2%

REMAINING PERCENTAGES DO NOT

KNOW WHEN THEY WILL RETIRE

31

on share buybacks and the fall in corporate spend-ing on productive investments like R&D, the twolines make a perfect X. The former has been goingup since the 1980s, with S&P 500 firms now spend-ing $1 trillion a year on buybacks and dividends—equal to about 95% of their net earnings—ratherthan investing that money back into research, prod-uct development or anything that could contributeto long-term company growth. No sector has beenimmune, not even the ones we think of as the mostinnovative. Many tech firms, for example, spendfar more on share-price boosting than on R&D as awhole. The markets penalize them when they don’t.One case in point: back in March 2006, Microsoftannounced major new technology investments, andits stock fell for two months. But in July of that sameyear, it embarked on $20 billion worth of stock buy-ing, and the share price promptly rose by 7%. Thiskind of twisted incentive for CEOs and corporate of-ficers has only grown since.

As a result, business dynamism, which is at theroot of economic growth, has suffered. The numberof new initial public offerings (IPOs) is about a thirdof what it was 20 years ago. True, the dollar valueof IPOs in 2014 was $74.4 billion, up from $47.1 bil-lion in 1996. (The median IPO rose to $96 millionfrom $30 million during the same period.) This mayshow investors want to make only the surest of bets,which is not necessarily the sign of a vibrant market.But there’s another, more disturbing reason: firmssimply don’t want to go public, lest their work be-come dominated by playing by Wall Street’s rulesrather than creating real value.

An IPO—a mechanism that once meant raisingcapital to fund new investment—is likely today tomark not the beginning of a new company’s great-ness, but the end of it. According to a Stanford Uni-versity study, innovation tails off by 40% at tech com-panies after they go public, often because of WallStreet pressure to keep jacking up the stock price,even if it means curbing the entrepreneurial vervethat made the company hot in the first place.

A flat stock price can spell doom. It can get CEOscanned and turn companies into acquisition fodder,which often saps once innovative firms. Little won-der, then, that business optimism, as well as busi-ness creation, is lower than it was 30 years ago, orthat wages are flat and inequality growing. Executiveswho receive as much as 82% of their compensationin stock naturally make shorter-term business deci-sions that might undermine growth in their compa-nies even as they raise the value of their own options.

It’s no accident that corporate stock buybacks,corporate pay and the wealth gap have risen concur-rently over the past four decades. There are any num-ber of studies that illustrate this type of intersectionbetween financialization and inequality. One of themost striking was by economists James Galbraith

Finance is supposedto be a helpmeet tobusiness, not themain event. The storyof finance itself—asat the center of theAmerican economy—must be altered to putbusinesses back inthe driver’s seat. Thecorrect role for financeis to support jobcreators. Only that willensure more robustnational economicgrowth.

Politicians have beenpassing the buck forslow growth to themarkets since the1970s. Relying on WallStreet and centralbankers to createartificial growth mustbe curtailed. This taskfalls to Congress andthe next President.They must come upwith sensible realfiscal policy and agrowth plan to makethe U.S. competitiveon the global stage.

Redefinewho’s

‘makingand taking’

Build anationalgrowthstrategy

SOURCE: NAT IONAL BURE AU OF ECONOMIC RESE ARCH

Firms withmore than10,000employeesaccountedfor 73% ofnon-federally-funded R&Din 1985

Researchanddevelopment

That sharedropped to54% by 1998

and to51%by2008

Large companies aremore preoccupied withboosting share prices

than funding R&D, whichcontributes to long-term

company growth

STIFLINGINNOVATION

owns more than 80% of all stocks) but also a lack-luster 2% economy with almost no income growth.

Now, as many top economists and investorspredict an era of much lower asset-price returns overthe next 30 years, America’s ability to offer up eventhe appearance of growth—via financially orientedstrategies like low interest rates, more and more con-sumer credit, tax-deferred debt financing for busi-nesses, and asset bubbles that make people feel richerthan we really are, until they burst—is at an end.

This pinch is particularly evident in the tumultmany American businesses face. Lending to smallbusiness has fallen particularly sharply, as has thenumber of startup firms. In the early 1980s, new com-panies made up half of all U.S. businesses. For all thetalk of Silicon Valley startups, the number of newfirms as a share of all businesses has actually shrunk.From 1978 to 2012 it declined by 44%, a trend thatnumerous researchers and even many investors andbusinesspeople link to the financial industry’s changein focus from lending to speculation. The wane in en-trepreneurship means less economic vibrancy, giventhat new businesses are the nation’s foremost sourceof job creation and GDP growth. Buffett summed itup in his folksy way: “You’ve now got a body of peo-ple who’ve decided they’d rather go to the casino thanthe restaurant” of capitalism.

In lobbying for short-term share-boosting man-agement, finance is also largely responsible for thedrastic cutback in research-and-development out-lays in corporate America, investments that are seedcorn for future prosperity. Take share buybacks, inwhich a company—usually with some fanfare—goesto the stock market to purchase its own shares, usu-ally at the top of the market, and often as a way of ar-tificially bolstering share prices in order to enrich in-vestors and executives paid largely in stock options.Indeed, if you were to chart the rise in money spent

32 Time May 23, 2016

and Travis Hale, who showed how during the late1990s, changing income inequality tracked the go-goNasdaq stock index to a remarkable degree.

Recently, this pattern has become evident at anumber of well-known U.S. companies. Take Apple,one of the most successful over the past 50 years.Apple has around $200 billion sitting in the bank,yet it has borrowed billions of dollars cheaply overthe past several years, thanks to superlow interestrates (themselves a response to the financial crisis)to pay back investors in order to bolster its shareprice. Why borrow? In part because it’s cheaperthan repatriating cash and paying U.S. taxes. Allthe financial engineering helped boost the Califor-nia firm’s share price for a while. But it didn’t stopactivist investor Carl Icahn, who had manically ad-vocated for borrowing and buybacks, from dumpingthe stock the minute revenue growth took a turn forthe worse in late April.

It is perhaps the ultimate irony that large, richcompanies like Apple are most involved with finan-cial markets at times when they don’t need any fi-nancing. Top-tier U.S. businesses have never en-joyed greater financial resources. They have a record$2 trillion in cash on their balance sheets—enoughmoney combined to make them the 10th largesteconomy in the world. Yet in the bizarre order thatfinance has created, they are also taking on recordamounts of debt to buy back their own stock, creat-ing what may be the next debt bubble to burst.

You and I, whether we recognize it or not, are alsopart of a dysfunctional ecosystem that fuels short-term thinking in business. The people who manageour retirement money—fund managers working forasset-management firms—are typically compensatedfor delivering returns over a year or less. That meansthey use their financial clout (which is really our fi-nancial clout in aggregate) to push companies to pro-duce quick-hit results rather than execute long-termstrategies. Sometimes pension funds even invest withthe activists who are buying up the companies wemight work for—and those same activists look forquick cost cuts and potentially demand layoffs.

It’s a depressIng state of affaIrs, no doubt.Yet America faces an opportunity right now: a raresecond chance to do the work of refocusing and right-sizing the financial sector that should have been donein the years immediately following the 2008 crisis.And there are bright spots on the horizon.

Despite the lobbying power of the financial in-dustry and the vested interests both in Washingtonand on Wall Street, there’s a growing push to putthe financial system back in its rightful place, as aservant of business rather than its master. Surveysshow that the majority of Americans would like to

see the tax system reformed and the governmenttake more direct action on job creation and povertyreduction, and address inequality in a meaningfulway. Each candidate is crafting a message aroundthis, which will keep the issue front and centerthrough November.

The American public understands just how deeplyand profoundly the economic order isn’t working forthe majority of people. The key to reforming the U.S.system is comprehending why it isn’t working.

Remooring finance in the real economy isn’t assimple as splitting up the biggest banks (althoughthat would be a good start). It’s about dismantlingthe hold of financial-oriented thinking in everycorner of corporate America. It’s about reformingbusiness education, which is still permeated withacademics who resist challenges to the gospel of ef-ficient markets in the same way that medieval clergydismissed scientific evidence that might challengethe existence of God. It’s about changing a tax sys-tem that treats one-year investment gains the sameas longer-term ones, and induces financial insti-tutions to push overconsumption and speculationrather than healthy lending to small businesses andjob creators. It’s about rethinking retirement, craft-ing smarter housing policy and restraining a moneyculture filled with lobbyists who violate America’sessential economic principles.

It’s also about starting a bigger conversation aboutall this, with a broader group of stakeholders. Thestructure of American capital markets and whetheror not they are serving business is a topic that hastraditionally been the sole domain of “experts”—the financiers and policymakers who often have aself-interested perspective to push, and who do soin complicated language that keeps outsiders outof the debate. When it comes to finance, as withso many issues in a democratic society, complexitybreeds exclusion.

Finding solutions won’t be easy. There are nosilver bullets, and nobody really knows the perfectmodel for a high-functioning, advanced market sys-tem in the 21st century. But capitalism’s legacy is toolong, and the well-being of too many people is atstake, to do nothing in the face of our broken statusquo. Neatly packaged technocratic tweaks cannot fixit. What is required now is lifesaving intervention.

Crises of faith like the one American capitalism iscurrently suffering can be a good thing if they leadto re-examination and reaffirmation of first princi-ples. The right question here is in fact the simplestone: Are financial institutions doing things that pro-vide a clear, measurable benefit to the real economy?Sadly, the answer at the moment is mostly no. Butwe can change things. Our system of market capital-ism wasn’t handed down, in perfect form, on stonetablets. We wrote the rules. We broke them. Andwe can fix them. □

The per-capita rateof new business

creation has not madesubstantial gains—and

has been decreasingoverall—since the 1980s

STARTUPSLUMP

Startups(per 100,000 people)

Entrepreneurshipfosters job creation

and economicdevelopment

SOURCE: CALCUL AT IONS BASED ON DATA FROM THE EWING MARION K AUFFMAN FOUNDAT ION

1977257

1992181

1983185

2001165

2013129