Finance and competition in the U.S. economy

Critiques of the U.S. financial system over the past seven years largely zero in on how it was able to spark a massive recession. But increasingly, some economists, policy makers, and analysts are concerned about the ways in which the financial system might negatively influence business decisions by companies. Finance, if it works well, should efficiently transform individual savings into investments in companies, who use those funds to expand their businesses. But there’s evidence that finance isn’t doing what it’s supposed to, perhaps in a number of ways.

Economist J.W. Mason of John Jay College argues that the financial system, in the form of the public stock market, has become a vehicle for disgorging cash from firms. Instead of channeling savings into firms, the financial system seems to be focused on getting firms to push their money out and into the hands of investors in the form of stock buybacks. Money that would have otherwise gone toward investment in the firm goes to shareholders instead.

One criticism of Mason’s work is that the investors receiving this cash often reinvest that money into new, dynamic firms in the tech sector. The disgorging is simply a part of the regular process of channeling savings to its best uses. Activist hedge fund managers, to use an example, are taking money out of a bloated company and putting it into firms where there is (or there is the promise of) a higher return.

In a new blog post, Mason shows that’s not what’s happening. Investment in the tech sector hasn’t been increasing as you’d expect if share buybacks were part of the efficiency-enhancing process of a healthy financial system. In fact, it’s been on the decline since 2000. Investment has increased, however, in the energy sector. As much as fracking might be an innovation, fossil fuel extraction is far from anyone’s idea of the bleeding edge future of the U.S. economy. To simplify Mason’s critique: The financial system is committing a sin of commission—pressuring companies to increased payouts—which is causing underinvestment in the broader economy.

Another critique would have it the other way: that sins of omission are causing problems for companies operating in the U.S. economy. Economists José Azar and Isabel Tecu of Charles Rivers Associates, and Martin C. Schmalz of the University of Michigan argue that index mutual funds, by concentrating the ownership of firms in the hands of a few, passive funds, has led to a decrease in competition among firms. Firms realize they do not have to compete as much if they are all owned by the same index fund that wont’ interfere much. The result is higher prices for goods and services..

Matt Levine of Bloomberg View says that this critique is so interesting because of its audaciousness. In his view, the economists and those who find their critique persuasive are saying that when the practices of modern portfolio theory are put into practice, the result is an uncompetitive and ossified economy. “Everything about the system is working perfectly. And it’s still bad,” he quips.

Levine also points out that the debate is really about who has the final say on investment decision at firms. In his telling, the modern way of thinking about who owns companies results in shareholders becoming the final decision makers who orient the running of firms in a way that’s best for shareholders as a whole—but not individual firms.

Both Mason’s work and the analysis from Azar, Tecu, and Schmalz implicitly agree with this assertion. But what the financial system is doing to the U.S. economy in these two interpretations of its activities and priorities seem wildly at odds. How can the financial system be both too active and too passive at the same time? The contrast is particularly jarring considering that both interpretations focus on the public stock market as the main vehicle for these financial activities.

Could it be that more activist-style investors set the expectations for investment decisions, while the passive investors sit back and reap the rewards of increased profits paid out to shareholders? The lack of competition spurred by passive investments results in excess profits at firms that are then prime candidates for activist investors to demand payouts from. Of course, this assumes the two critiques are both correct.

Whatever the case, these potentially competing interpretations about the U.S. financial system are good reminders that it’s not a monolith. Understanding how the financial system and its constituent parts—be it corporate finance and portfolio investment, housing finance and consumer credit—interact with the broader economy is, to say the least, quite important.