“The financialization of the nonfinancial corporation”

One common narrative attached to the murky term financialization is that nonfinancial corporations have, in effect, turned themselves into banks or hedge funds — they have replaced investment in means of production with ownership of financial assets. Financial profits, in this story, have increasingly substituted for profits from making and selling stuff. I’m not sure where this idea originates — the epidemiology points toward my own homeland of UMass-Amherst — but it’s become almost accepted wisdom in left economics.

I’ve been skeptical of this story for a while, partly because it conflicts with my own vision of financialization as something done to nonfinancial corporations rather than by them — a point I’ll return to at the end of the post — and partly because I’ve never seen good evidence for it. On the cashflow side, it’s true there is a rise in interest income from the 1960s through the 1980s. But, as discussed in the previous post, this is outweighed by a rise in interest payments; it reflects a general rise in interest rates rather than a reorientation of corporate activity; and has subsequently been reversed. On the balance sheet side, there is indeed a secular rise in “financial” assets, but this is all in what the financial accounts call “unidentified” assets, which I’ve always suspected is mostly goodwill and equity in subsidiaries rather than anything we would normally think of as financial assets.

Now courtesy of Nathan Tankus, here is an excellent paper by Joel Rabinovitch that makes this case much more thoroughly than I’d been able to.

The paper starts by distinguishing two broad stories of financialization: shareholder value orientation and acquisition of financial assets. In the first story, financialization means that corporations are increasingly oriented toward the wishes or interests of shareholders and other financial claimants. The second story is the one we are interested in here. Rabinovitch’s paper doesn’t directly engage with the shareholder-value story, but it implicitly strengthens it by criticizing the financial-assets one.

The targets of the paper include some of my smartest friends. So I’ll be interested to see what they say in response to it.

The critical questions are:  Have nonfinancial corporations’ holdings of financial assets really increased, relative to total assets? And, has their financial income risen relative to total income?

The answers in turn depend on two subsidiary issues. On the first question, we need to decide what is represented by the “other unidentified assets” category in the Financial Accounts, which is responsible for essentially all of the apparent rise in financial assets. And on the income side, we need to consistently compare the full set of financial flows to their nonfinancial equivalents. Rabinovitch argues, convincingly in my view, that looking at financial income in isolation is not give a meaningful picture.

On the face of it, the asset and income pictures look quite different. In the official accounts, financial assets of nonfinancial corporations have increased from 40% of nonfinancial assets to 120% between 1946 and 2015. Financial income, on the other hand, is only 2.5% of total income and shows no long-term increase. This should already make us skeptical that the increase in “financial” assets represents income-generating assets in the usual sense.

Rabinovitch then explores this is detail by combining the financial accounts with the IRS statistics of income (SOI) and the Compustat database. Each of these has strengths and weaknesses — Compustat provides firm-level data, but is limited to large, publicly-traded corporations and consolidates domestic and overseas operations; SOI gives detailed breakdowns of income sources for all forms of legal organization broken down by size, but it doesn’t include any balance-sheet variables, so it can’t be used to answer the asset questions.

iI the financial accounts, the majority of the increase in identified financial assets is FDI stock. As Rabinovitch notes, “it’s dubious to directly consider FDI as a financial asset if we take into account that it implies lasting interest with the intention to exercise control over the enterprise.” The largest part of the overall increase in financial assets, however, is in the residual “other unidentified assets” line of the financial accounts. The fact that there is no increase in income associated with these assets is already a reason to doubt that they are financial assets in the usual sense. Compustat data, while not strictly comparable, suggests that the majority of this is intangibles. The most important intangible is goodwill, which is simply the accounting term of the excess of an acquisition price over the book value of the acquired company. Importantly, goodwill is not depreciated but only written off through impairment. Another large portion is equity in unconsolidated subsidiaries; this accounts for a disproportionate share of the increase thanks to a change in accounting rules that required corporations to begin accounting for it explicitly. Other important intangibles include patents, copyrights, licenses, etc. These are not financial assets; rather they are assets or pseudo-assets acquired, like real investment, in order to carry out a company’s productive activities on an extended scale.

These are all aggregate numbers; perhaps the financialization story holds up better for the biggest firms? Rabinovich discusses this too. Both Compustat and SOI allow us to separate firms by size. As it turns out, the largest firms do have a greater proportion of financial income than the smaller ones. But even for the largest 0.05% of corporations, financial income is still only 3.5% or total income, and net financial income is still negative. As he reasonably concludes, “even for the biggest nonfinancial corporations, financialization must not be understood as mimicking financial corporations.”

What do we make of all this?

First, the view of financialization as nonfinancial businesses acquiring financial assets for income in placer of real investment, is widely held on the left. After my Jacobin interview came out, for example, several people promptly informed me that I was missing this important fact. So if the evidence does not in fact support it, that is worth knowing. Or at least, future statements of the hypothesis will be stronger if they respond to the points made here.

Second, the fact that “financial” assets in fact mostly consist of goodwill, interest in unconsolidated subsidiaries, and foreign investment is interesting in its own right, not just as negative criticism of the  financialization story. It a sign of the importance of ownership claims as a means of control over production— both as the substantive content of balance sheet positions and as a core part of corporate activity.

Third, the larger importance of the story is to the question of whether nonfinancial corporations and their managers should be seen mainly as participants in, or victims of, financialization. Conversely, is finance itself a distinct social actor? In a world in which the largest nonfinancial corporations have effectively turned themselves into hedge funds, it would not make much sense to talk about a conflict between productive capital and financial capital, or to imagine them as two distinct sets of people. But in a world like the one described here, or in my previous post, where the main nexus between nonfinancial corporations and finance is payments from the former to the latter, it may indeed make sense to think of them as distinct actors, of conflicts between them, and of intervening politically  on one side or the other.

Finally, to me, this paper is a model of  how to do empirical work in economics. Through some historical process I’d like to understand better, economists have become obsessed with regression, to the point that in academic economics it’s become synonymous with empirics. Regression analysis starts from the idea that the data we observe is a random draw from some underlying data generating process in which a variable of interest is a function of one or more other variables. The goal of the regression is to recover the parameters of that function by observing independent or exogenous variation in the variables. But for most macroeconomic questions, we are dealing with historical processes where our goal is to understand what actually happened, and where the hypothesis of some underlying data-generating process from which historical data is drawn randomly, is neither realistic nor useful. On the other hand, the economy is not a black box; we always have some idea of the mechanism linking macroeconomic variables. So we don’t need to evaluate our hypotheses by asking how probable the it would be to draw the distribution we observe from some hypothetical random process; we can, and generally should, ask instead whether the historical pattern is consistent with the mechanism. Furthermore, regression analysis is generally focused on the qualitative question of whether variation in one variable can be said to cause variation in a second one; but in historical macroeconomics we are generally interested in how much of the variation in some outcome is due to various causes. So a regression approach, it seems to me, is basically unsuited to the questions addressed here. This paper, it seems to me, is a model of what one should do instead.

13 thoughts on ““The financialization of the nonfinancial corporation””

  1. Good post. Helped me process quickly what was in the Rabinovich paper.

    Two quick notes:

    (i) seems clear that “cash and current assets” have increased dramatically in larger firms, e.g. Figure 13. This can be part of a financialization story in the sense that derivative-based “investments” will typically be off-balance sheet, but firms need cash collateral to manage the positions. So the cash positions may be part of a financialization process.

    (ii) It seems to me that the income data is almost entirely from the IRS. (I saw cash-flow charts from Compustat, but that’s not really income is it?) Is there any reason to believe that the IRS data accurately reflects the firm’s operations? Most large firms have tax accounting that is distinct from their financial accounting, and the tax management of the former could be driving the results. Non-tax based income data would be more persuasive.

    1. (i) seems clear that “cash and current assets” have increased dramatically in larger firms

      They have, reversing an earlier decrease. There are lots of reasons for firms to hold cash, mostly relating to liquidity in one form or another – the ability to quickly make acquisitions, to buffer changes in cashflow or credit conditions, etc. None of this reasons are to generate income as such. Keep in mind that almost all of these firms also have large outstanding debt, which almost always carries a higher interest rate than their cash holdings. Given that, cash holdings are a cost center, not a profit center.

      This can be part of a financialization story in the sense that derivative-based “investments” will typically be off-balance sheet, but firms need cash collateral to manage the positions.

      This sounds plausible for a bank, but we’re not talking about banks here. Is there any evidence that nonfinancial corporations have significant derivative positions?

      Re ii, first, Compustat includes both income statements and cashflow statements. Rabinovich emphasizes the latter because cashflow-basis data is not available from the other sources, but he uses both. (As have I.) The story is not different between the two.

      In general, I think we should resist the impulse to respond to data that contradicts our priors, by speculating about hypothetical alternative data sources that would say what we want.

  2. I think that one of the two “not”s is a typo in “foreign investment is interesting not in its own right, not just as negative criticism of the financialization story.” Which one?

  3. JW: I’ve not been following this debate. It reminds me of the “Finance Capital” (Hilferding) concept. I’ve always thought that a fallacy of composition. For every borrower there’s a lender. The Junker Fallacy (“Prussia had low investment because the rich invested in land rather than machines”) is related, though is less of a fallacy because in an OLG model land can substitute for capital as an intergenerational savings vehicle.

    1. Yes, this is something I thought about bringing up in the post. Who is all this financial income supposed to be coming from?

      Hilferding and his critics did anticipate a lot of this debate, I think. Nothing new under the sun.

  4. For many years now we have been reading in media, books, academic papers, etc., that many corporations are engaging in stock buybacks instead of investing. This has not been just the “left” saying this. I have read moderate/center authors mentioning this as well. Maybe the authors point is its not ALL the NFC’s do it, but many of the large corporations are engaging in financialization such as Apple, etc. Even in this post you mention,

    ” In a world in which the largest nonfinancial corporations have effectively turned themselves into hedge funds, it would not make much sense to talk about a conflict between productive capital and financial capital, or to imagine them as two distinct sets of people”.

    Isn’t turning into a hedge fund essentially financialization or am I missing something?

    1. Jerry- I don’t think you understand what actually is the ‘conventional wisdom’ Mason is attacking. It’s not the idea that corporations have been more focused on paying down debt and buying back their own stocks. You can tell this simply from the fact of how much of Mason’s public writing is devoted to stock buybacks and their potential economic effects. You can also tell that from the fact that… that’s not what the post is about at all. If he were attacking stock buybacks he would mention it. What he’s attacking is the idea that non-financial firms have transitioned to seeking financial profits i.e. attempting to gain a net income by purchasing financial assets or getting into direct lending.

      There is no way you can describe buying back one’s own stock as becoming a “hedge fund”. It just doesn’t make any sense.

      1. Thanks Nathan. My career and academic background is in engineering and psychology. I have read my share of economics books and papers but this blog can take me into the realms of the unknown. That is why I stated at the end if I was missing something. I wanted someone to clarify my lack of understanding. So thanks for the clarification!

  5. An equity investment in an unrelated firm counts as a “cash or cash equivalent”, so if a firm turned into a giant hedge fund, you would see the “cash” on its balance sheet to grow, which we have seen.

    1. That a implies b doesn’t mean that b implies a. If “cash and equivalents” were mainly held to generate income, there should in fact be income to see.

  6. “I’ve been skeptical of this story for a while, partly because it conflicts with my own vision of financialization as something done to nonfinancial corporations rather than by them”

    If I understand correctly your post, your idea is that nonfinancial corporation are net givers to “finance”, as opposed to nonfinancial corporations owning a lot of financial assets and therefore being net takers.

    This makes sense to me.

    So we have a situation where at the top there is finance, that makes money A) from direct lending to consumers (or government) and B) from direct lending to nonfinancial business.
    In turn, nonfinancial business makes money through the good old profit share, so part of the profit share goes to finance.

    But I don’t see why you speak of it as a “conflict” between financial and nonfinancial business.

    Conflict implies that there are different and opposite ends, for example there might be conflict between exporters and importers on monetary policy; but I don’t think that nonfinancial business has opposite ends than finance, since the purpose of nonfinancial business is still that of making money, either directly for the owners or indirectly for that sort of indirect owners that are the lenders.

    In some historical periods, there were social classes, like small farmers, who often got into debt to buy land (their form of capital) and in many situations went bankrupt, and they often really really hated bankers.
    But in those times the borrowers were very small “capitalists”, really in the gray zone between proletarian (or peasants) and owners (or landlords). Furthermore, these people sociologically could not really change job if they tought the price of land was too high.

    Today, we have generalist managesr who could hop from banana production to IT to finance, without seeing a difference, so I don’t see this conflict; there might be conflict between finance/high management and small business owners (with varying degrees of “small”), but in my opinion not of big corporations; and even there only on a limited set of monetary policies, not on things like tax policy or labour rights etc.

  7. Always like your posts. Genuinely thought provoking. Your last paragraph really caught my eye and reasonates very much. I am on the lookout for models of empirical work in economics (particularly macro) that do not embody the standard approach (define toy model, ignore the bizarre assumptions, calibrate to data, declare scientific advance). So feel free to return to that theme whenever you like. You will have one happy taker at least.

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