What is Financialization?

Financialization describes the process by which the share of the overall economy represented by the financial economy increases relative to the real economy. We can describe the real economy as any economic activity that involves the production, purchase, or flow of goods and services, and the financial economy as any economic activity that involves the financial markets and the transaction of money and financial assets.  

The rapid expansion of the financial economy is not exclusive to the volume of financial trading, but also the increasing diversity of transactions, security choices, market participants and interactions. In short, financialization can be understood as the rapid takeover of the financial sector.

The History of Financialization

The emergence of the financial economy traces back to the industrial revolution. As agrarian and artisanal economies transformed with the emergence of large scale industry and machine manufacturing, the demand for capital and investments grew. Small and fragmented businesses gave rise to multinational conglomerates which were initially state-backed but later became more privatized and had greater demand for capital to finance their operations. This capital was largely supported by the growth of the banking system and the emergence of financial institutions. 

Investors came to realize that in some instances the use of financial instruments provided quicker and easier returns when compared to traditional brick and mortar businesses. This, along with the rise of neoliberal policies which supported private business and free market capitalism further accelerated the increase in volume of financial transactions.

The Fall of Bretton Woods

The Bretton Woods agreement, signed in 1944, established rules for commercial and financial relations among North America, Western European countries, Australia, and Japan. The agreement anchored international currencies to the US dollar, and fixed the US dollar to gold. The result was a predictability in exchange rates between countries. 

Throughout the mid 20th century the US continued to print more dollars, far exceeding the gold they had in their reserve. In 1971 the US dissolved the Bretton Woods agreement, allowing free-floating currencies. This event was pivotal to the rise of financialization, as it led the way for further deregulation, free movement of capital, and accelerated global liquidity. 

Financial Innovation

Floating exchange rates and unregulated capital flows presented new risks, but also provided an opportunity for new financial innovation. Perhaps the two most novel additions to the financial sector were derivatives and securitization. 

Derivatives

A financial derivative refers to any type of financial contract whose value is dependent upon, or “derived” from an underlying asset, group of assets, or benchmark. The most common derivatives include futures contracts, options, and swaps, all of which trade on a futures exchange.

Created in the mid-19th century, futures exchanges were initially focused on the exchange of agricultural or physical commodities. As government deregulation began to unfold, the rise of financial future contracts - those derived from interest rates, currencies, and equity indexes - was exponential. Beside is a figure which depicts the aforementioned transition of future contract composition since 1970. 

Securitization

Securitization is the process of taking an illiquid asset or group of assets and transforming them into a security. The novelty of this process is the ability to link the real economy and the financial economy by engineering financial assets that derive their value from ownership claims of real sector goods and services. 

A common example of securitization is a mortgage backed security (MBS). An MBS is similar to a bond in that investors receive periodic payments comparable to bond coupon payments. The difference however, is that these payments comes from a pool of underlying home loans (mortgages) bought from the banks that issued them, instead of the bank themselves.

Securitization has greatly improved the financial economy by reducing borrowing costs, increasing the liquidity of otherwise illiquid assets, and improving investors portfolio diversity and risk management. 

Conclusion

“Financialization means the increasing role of financial motives, financial markets, financial actors. and financial institutions in the operation of the domestic and international economies'"

Gerald Epstein, 2005