Fifty years ago, only 3% of MBA students at Harvard studied finance. The introductory course, nicknamed "Darkness at Noon" did not draw the brightest students; marketing and operations, the making of selling of things were the focus of aspiring corporate leaders. That has changed. The making of things has been subcontracted to China, the selling of things underpaid compared to the massive incomes even the moderately talented can earn on Wall Street. Finance used to serve the needs of the real economy. Today, the financial tail is wagging the real economy dog.
Although humans have been lending money at interest since ancient Babylon, modern finance can be said to have begun in early 17th century Amsterdam, when a secondary market developed for shares in the Dutch East India corporation. Before, if you, as say, a Venetian merchant, financed a share in Marco Polo’s trading expedition to Xanadu, you probably owned that share until Mr. Polo returned. If you needed cash, unloading your right to 1/128th of Marco’s profits, would be a tricky enterprise, requiring bespoke arrangements, finding that unique individual who wanted your share just as you wanted to get rid of it.
This could be tricky, and anyone knowing your desire to sell could offer you much less than the financial instrument was worth. Before the innovation of the Amsterdam secondary market, financial assets were illiquid (hard to turn into cash) and difficult to price. How much is 1/128th share of Marco’s profits worth? The only way to tell was to sell them; no one knew what that number was ex ante.
The Dutch East Asia Corporation needed large sums of money to finance their two year journeys to the Spice Islands. Unlike previous financing arrangements, say to purchase herring and furs from Baltic entrepots, owners of capital did not get their money back in a matter of months, rather it was a matter of years. So naturally, more and more financiers needed to unload their shares, and because of the innovation of printing, these prices were published in newspapers. Now, for the first time, owners of shares in merchant voyages could tell what their shares were worth even before their ship came in. Now, for the first time, owners of shares wishing to turn them into cash needn’t go to the effort of finding that specific person wanting their asset but could rather deal them into an established market where they could be confident of finding a buyer at a fair price.
Increased liquidity is a valuable thing as are lower transaction costs (those expenses necessary to enable two parties to make a deal) and so interest rates (the cost of borrowing money) declined, allowing more and more voyages from Holland to Indonesia. Finance in the 17th century was an adjunct to commerce, to trade, and we can term the era the age of merchant capitalism.
Historians who don’t want to go so far back can date the beginning of modern finance to the mid 19th century, to the establishment of railroads. At the beginning of the industrial era, if a Quaker from Manchester wanted to establish a textile mill, he would seek the necessary funds from friends, relatives, co-religionists and these men would become his partners, authorized to receive a proportional share of the profits, liable to a proportional share of the debts. Further expansion would generally be financed from retained profits.
The amount of capital required for building railroads was too huge and the amount of time between the expense of buying land and building track and the revenue of hauling freight too long for such personal financial arrangements. The corporate structure of limited liability emerged from the needs of railroads, which also stimulated the growth of stock and bond markets. These innovations allowed the savings of individuals and businesses to be pooled and so allowed the creation of the great factories that exemplify late 19th and much of 20th century capitalism. Mass production, economies of scale, and indeed the growing prosperity of much of humanity would have been impossible without these financial innovations that permitted the development of Industrial Capitalism.
According to finance textbooks, the societal purpose of their discipline is to most efficiently link savers and investors so that capital will flow to the most advantageous investments. My favorite example is the late 19th century London bond market, raising capital to build railroads in Argentina that allowed the transport of meat from the Pampa at greatly reduced price to the dining tables of Europe. The British bondholders were paid their interest from the increased railroad revenues which Argentine landowners were happy to pay because of increased exports to Britain. The railroad made money, the landowners made money, the bondholders made money, and ate better too.
In both the era of merchant capitalisms and in the era of industrial capitalism, finance was the handmaiden of the real economy, allowing more trade in the first, more production in the latter. The link between the financial and real economy today is not nearly as straightforward. Finance is no longer focused on mobilizing capital so as to increase productive capacity; real corporate investment (the purchase of machinery, factories etc.) is almost entirely funded by retained profits, and as the profitability of finance has skyrocketed post 1973, the creation of real capital goods as a share of GDP has actually declined. Indeed, the buyback of shares by US corporations has caused the stock market to mobilize capital in the opposite direction: from corporations to individuals. For the past generation the equity market has been a net drain on corporate coffers.
In the 80s the archetypal financial deal was the leveraged buy-out in which management, using borrowed capital purchased their firm, saddling it with enormous debt. To repay the debt, they would have to cut expenses, eliminate research and development, fire workers, sell divisions. Leveraged buyouts were enormously profitable for management and investment bankers but by reducing investment in capital goods, they damaged the corporation’s future prospects.
Today the focus of finance is arbitrage, that is to say the buying and selling of almost identical financial assets seeking to exploit miniscule price anomalies. The mathematization of finance, the use of quants or "rocket scientists" to discern these price differences means that financial traders focus more on the relative value between say an option and its underlying stock than on the growth prospects of that given company. A hedge fund generally does not take a position assuming the value of a stock will rise, but instead seeks to find profitable opportunities in that stock whether it goes up or down.
When a Venetian merchant lent Marco Polo money, he allowed real profitable trade to occur. When an Amsterdam investor bought a share of Dutch East India Company stock on the emerging secondary market, that money, of course, did not fund any more journeys for the East India Corporation, but by making the market for its shares more liquid, did indeed make it able to raise funds more cheaply. When British capital, mobilized by JP Morgan, bought railroad bonds in America, they lowered the cost of transport throughout the continent, allowing the exploitation of previously worthless land, which before had been too far from markets to be of any economic value. These uses of capital may well have made huge profits for their owners but they even more fundamentally made the entire society richer.
Today, an archetypical speculator might be short selling the 30 year Treasury bond while buying the 29 year or simultaneously buying an out of the money put (the right to buy a stock at a price well below its current price) and call (the right to sell a stock at a price well above its current price) on a stock (a strategy called "buying volatility") or borrowing in one currency while lending in another (the "carry" trade). He may well make a profit but it is hard to discern how we as a society benefit from his speculations. Indeed, speculative profits in this self-referential, postmodern finance have to come from somewhere and that somewhere can be nowhere else than the real economy, the economy of buying and selling of goods and services, the economy in which most of us make our livings.
The revenues of a corporation are divided into shares appropriated by labor and by capital. As capital’s share increases, it is naturally tempted into increasing investment, allowing the firm to grow. As labors share increases it will consume more, increased demand allowing the economy as a whole to grow. But speculation does not increase the size of the economic pie, it does not stimulate real investment, it is in effect a parasite on real productive capital, which may be a partial explanation for why real investment, the creation of real fixed assets, of factories and machinery, has declined even as financial manipulations have exploded.
Apologists for postmodern finance will say that the growth of derivatives have allowed companies to hedge risks, to sell risk to those more willing to accept it, and thus made markets more efficient. More sociological investigations into the nitty gritty of financial transactions suggest that actually risk is being sold from those who understand it to those who don’t. Meanwhile, the repeated bailouts of failed investments by governments and the IMF have allowed the profits of speculation to remain in private hands while their catastrophic failures (the savings and loan crisis, the Latin American debt crisis, the East Asia crisis, the Tequila crisis) are funded by the public.
In the 1960s the most highly remunerated executive on Wall Street made $500,000. Last year more than a few hedge fund managers made $1 billion. In the 1960s, median American wages had more than doubled in a generation. Today, the median American makes little more in real terms than he did in 1973. The financialization of our economy has made a few of us very very rich, has lowered real investment, and has contributed to the stagnation in wages. Why, in a democracy, do we let this go on?
A miniscule tax on financial transactions would make most highly leveraged arbitrage unprofitable with almost no effect on real investment. Investors seeking high yield could no longer make fortunes playing mathematical games. Finance could return to its traditional role of mobilizing capital to make real investments that will make our society as a whole more productive and thus richer.