Financialization and the Problem of Mutually Assured Capital Destruction
Science, as well as technology, will in the near and in the farther future increasingly turn from problems of intensity, substance, and energy, to problems of structure, organization, information, and control.
—John von Neumann, 1949
Mathematician John von Neumann foresaw how increasingly sophisticated economic modeling and automated machine intelligence would lead to the primacy of information games. Indeed, von Neumann invented one of the first electronic computers, worked on the Manhattan Project, and developed the field of economic game theory, which he would use in developing the theory of “Mutually Assured Destruction” as an adviser to the United States on its nuclear strategy. In doing so, he saw firsthand how the economic logic of game theory was able to account for behavior involving the most destructive weapons invented by mankind.
A less apocalyptic problem of “structure, organization, information, and control”—yet one that is central to the twenty-first-century sociopolitical order—is faced by capital allocators and firm managers who aim to maximize value for shareholders. The growing share of resources and range of strategies—particularly those that seek to increase share values while relying on no or only incidental changes to the underlying productivity of firms’ operations—employed in asset management and governance exemplifies the secular trend von Neumann predicted.
What are the consequences of the rise of an industry that seeks to maximize the value of asset portfolios more efficiently? At the most superficial level, the financial sector has captured a growing share of GDP, profits, and human capital. The influence of a sophisticated investor base on the nature of corporate capital allocation, however, has been of greater consequence than the rents it extracts. Critics of financialization have compellingly illustrated how an asset governance paradigm designed to maximize shareholder value has driven a wedge between asset value growth and productivity, net investment, and wage growth. Corporate profits have increasingly concentrated within asset-light, high-margin superstar firms, and excess profits that were once invested in physical capital and used to produce broader prosperity have been diverted toward buying up existing assets in public and private markets.
Politicians like Elizabeth Warren may blame simple greed for this extractive approach to capital allocation, but without a structural account of the relationship between financialization and competition, arguments decrying buybacks, leveraged buyouts, asset-stripping, industry concentration, and other forms of financial engineering can be dismissed on the grounds that there is no reason to believe the social efficiency of markets has been impaired. The dislocation between asset values and productivity growth may simply be the result of more dynamic capital allocation that will enhance prosperity in the long term.
An examination of the way that today’s markets and management incentives shape capital allocation, however, reveals that the most powerful economic force financialization has unleashed to benefit shareholders is not greed, but consensus. By creating incentives to maximize overall industry profit pools and minimize competitive investment, a shareholder-centric asset governance model has undermined the competitiveness of markets and encouraged a de facto coordination among firms that benefits asset owners at the expense of broader prosperity.
Shifting the Focus of Competition
Over the past four decades, U.S. markets have effectively pivoted from a capital allocation model based on individual firm values to one based on asset managers’ portfolio values. In the first model, corporate managers drive the economy by seeking to maximize the growth of their respective firms’ values. In the second, the leading role is taken by asset managers rebalancing asset allocations and influencing the behavior of individual firms to maximize aggregate portfolio value. This shift was enabled by two core innovations.
The first is the growth of an asset management complex, composed of mutual funds, alternative asset managers, and passive index funds, that has increased information transparency and the efficiency with which owners’ wealth can be rebalanced across a broader universe of assets to maximize portfolio value. As customers, asset owners drive financialization through their demand for more optimal portfolio allocation across assets. Since the 1980s, the share of institutional investor ownership has grown from 20 percent to 80 percent as the share of direct equity ownership by individuals has decreased. The rise of defined contribution pension plans originally fueled the growth of actively managed mutual funds. Endowment and pension fund allocations have increasingly shifted to alternative asset classes, historically the focus of high-net-worth individuals, in search of higher returns, and this demand has been met by a growing industry of hedge funds, private equity firms, and venture capitalists. Along with an industry of bankers, lawyers, and consultants, these alternative asset managers structure assets, determine their value, and enable concentrated bets on individual firms in public and private markets. More recently, the growth of institutional management has been driven by the rise of passive index and exchange-traded funds, which have grown assets under management from nearly zero to greater than $10 trillion since 1990. The top passive index and mutual fund managers (BlackRock, Vanguard, State Street, Fidelity, and Capital Group) now manage more than $34 trillion in assets. In parallel, the growth and digitization of capital markets, along with an expansion of the investable asset universe, has reduced the costs and increased the opportunity of rebalancing asset portfolios.
A second—related and largely simultaneous—structural innovation is the proliferation of mechanisms that enable greater influence on firm governance by sophisticated asset owners and allocators. Or, in other words, mechanisms that ensure a greater alignment of individual firm governance and behavior with shareholder interests, which in practice often means asset manager interests. While shareholder influence over the operations of firms has always been a fundamental mechanism of capitalist markets, the scale of that control has grown rapidly and is larger than it has ever been due to the rise of institutional asset governance. This includes the influence of activist hedge funds in dictating priorities to the management teams of public firms in which they have accumulated concentrated stakes, or the direct influence of private equity partners on the boards of portfolio companies they own outright. Or, in a different way, Vanguard, State Street, and BlackRock’s influence over their index constituents; collectively the top index managers have an average stake of nearly 20 percent across S&P 500 firms and exert influence through private meetings with management teams and proxy votes. Additionally, the proliferation of stock-based compensation and an MBA-instilled consensus to prioritize shareholder value has created incentives and cultures within firms that are aligned with top-down institutional influence.
The combination of these innovations has replaced the competitive forces of a firm-centric economy, in which firms compete against one another to serve customers, with the incentives of a shareholder-centric economy, in which asset allocators compete against one another to better serve asset owners. Whereas in the past, firms may have overinvested in physical assets and R&D at the expense of capital efficiency and financial returns, today they are likely to privilege the latter, knowing that rival firms, also operating under the priorities set by asset managers, are unlikely to compete by increasing investment.
Hence, despite record growth in asset values, the rate at which American firms have grown the capital base that creates broader wealth and social value has stagnated. A focus on maximizing returns for shareholders, as opposed to maximizing the operating profits and productivity of firms, leads managers to apply return thresholds for investment, or hurdle rates, far above their cost of capital and return excess profits instead of investing them.
Capital exodus from established industries alone is not enough to indict markets, however. A “firm value maximization” paradigm, in which companies invest only in the most locally attractive opportunities, would lead to the arbitrary sequestration of capital within industries. But serving the interests of shareholders requires weighing local opportunities against the highest marginal return available across a broader investment universe. If companies have historically been overinvesting in their respective industries in aggregate, it is not surprising that the result of applying a more rigorous approach to capital allocation would adjust hurdle rates upward above the cost of capital to direct resources to more efficient uses elsewhere. But it should be noted that transitioning from a firm-biased toward an “efficient” capital allocation approach will mechanically drive the levels of competitive investment downwards in “mature” industries until returns on competitive investment in these sectors are equal to the highest marginal returns available elsewhere. A turn away from firm value maximization to shareholder value maximization is, therefore, a rebalancing of competition, and it should concern us where competition is being diminished and where it is ramping up.
The evidence suggests that the locus of competition in the U.S. economy today is in the market for levered asset buying, which provides investors the highest marginal (risk-adjusted) returns and continues to attract capital. Private equity assets under management reached $9.8 trillion in July 2021, and capital not yet used (“dry powder”) continues to accumulate. The past four decades have seen the explosive growth of a levered-asset-buying industry, amplified by cheap credit, that bids up the prices of assets with high rents.
A relative lack of information and liquidity among privately held firms has also resulted in discount buying opportunities relative to public markets. In private markets, the existence of underbought assets means that marginal returns remain elevated, and excess profits are reinvested in more buying activity; this shift from building to buying may persist for some time. Asset buying is not a series of instantaneous cash transfers that leaves capital free to be immediately redeployed for productive investment; the upward repricing of assets is a time- and resource-intensive process that pulls financial capital away from building productive assets, which increase demand for physical goods and labor, and directs it toward the activity of creating information.
Moreover, assets with market power that can profit from rents are not just underbought; they are also under-levered. A popular account given by critics of financial engineering is that the leverage investors apply to enhance equity returns negatively impacts other stakeholders by increasing the chances of default. But this phenomenon is not limited to decisions of financial leverage; in the name of shareholder value maximization, firms make analogous tradeoffs between risk-reducing investments (e.g., safety, cybersecurity, product integrity, excess supply chain capacity, infrastructure resilience) and returning cash to shareholders. On a long enough timescale, critical technology providers that do not invest in cybersecurity will be breached; firms that do not invest in engineering resiliency and safety will experience malfunctions (e.g., planes falling out of the sky, power lines failing, dams collapsing); and over-levered firms will fail in cyclical downturns. With 100 percent capital-at-risk, these events can manifest as catastrophic wealth destruction for owners and impair future returns, but not if a critical failure only impacts 5 percent of a financial sponsor’s portfolio.
The ability of asset owners to diversify means that savings from cutting back on risk-reducing investments across an entire portfolio can compensate for the relatively rare but catastrophic failures experienced by individual companies. This incentive is further exaggerated if increased risk is not immediately observable on a three-to-five-year private equity investment horizon and has limited impact on share price. This is a fundamental driver of private equity returns: investors incentivize management of individual firms to take levels of risk that maximize aggregate portfolio returns but would be suboptimal or even catastrophic for a fully invested owner-operator, or even a corporate manager tied to one company. Fundamentally, the ability to diversify is an advantage unique to asset owners. The result of increasing risk levels throughout the economy to a level that fully exploits the benefits of diversification enhances shareholder returns at the expense of stakeholders who cannot diversify themselves.
When investors or established firms do make physical investments, the exception proves the rule: investments must have high asset efficiency (revenue per dollar of physical assets) and market power (ability to charge more than marginal costs). While at some level it seems natural to scoff at criticism of sound investment principles, the impact of a mass rebalancing of assets toward financially optimal modes of production is a problem for stakeholders who are not asset owners and for the economy as a whole. Each dollar of capital subsequently invested builds back the American capital base at a reduced rate and in a form that benefits fewer people (asset-light) and extracts greater rents (higher margins).
The Anticompetitive Consensus
But even an aggregate shift from building to buying is not proof that markets are broken; despite being portrayed as pure speculation, asset buying has economic value. As financial capital flows between asset owners, it leaves behind updated price information instead of physical assets. Bidding up asset prices in a given industry should enable greater competition by signaling the existence of excess profits and decreasing the cost of capital for competitive entrants.
A lack of information that causes higher capital costs is the barrier to entry in most investment scenarios, not the fixed up-front cost in and of itself. Consider that Tesla’s competitors have been able to raise massive amounts of capital on the back of Tesla’s capital markets success. In this sense, competitive investments in building productive capacity are downstream of price transparency for incumbents. In theory, capital will eventually flow back toward physical investment after assets have been bid up to the extent that building new ones becomes relatively more attractive. In other words, the tether between asset value and underlying productivity growth and labor prosperity may have been stretched, but it is not necessarily severed. Critics who emphasize the current stagnation in productivity growth amid runaway asset price growth face the inherent unfalsifiability of long-term market efficiency. Who can prove that a lack of investment resulting in forgone innovation and the erosion of the U.S. industrial base will not be compensated for by future productivity growth unlocked by more efficient capital allocation?
Nevertheless, the fact that valuations are at cyclical highs and profit margins are healthy would suggest that competitive investment should be highly attractive. And yet, the high-rent, asset-light firms that have seen meteoric increases in valuations are not, in general, seeing an influx of competitors and investment to compete away high profits.
In private markets, private equity firms rarely make competitive investments in capacity and innovation even in the markets where they find assets with attractive market power, despite record levels of dry powder. In the same way that higher beef prices despite lower cattle prices can signal a lack of competition in meat processing, a persistent gap between the cost of capital and hurdle rates signals an anticompetitive approach to investment.
Neoclassical economics argues that oligopolistic collusion is unstable despite being more advantageous than competition, but it has not accounted for the rise of a sophisticated asset management industry dedicated to maximizing asset values. Any substantive critique or defense of financialization must therefore be concerned with whether it has created conditions that incentivize a lack of competition or enable anticompetitive behavior. And indeed, more efficient and transparent markets can make competition less attractive.
The notion that efficient markets make competition less financially attractive is not an esoteric concept. In fact, it is the thesis of popular texts on strategic management. In Michael Porter’s “What Is Strategy?” and Peter Thiel’s Zero to One, the authors argue that outsize returns are driven by creating competitive advantage through step-change innovations instead of incremental competition in existing industries. A competitive regime in which firms can match each other’s innovations makes investments equivalent to a tax. Innovations or operating strategies that can be easily copied are therefore unlikely to be financed because they do not provide a durable competitive advantage, and informationally efficient markets make it easier to ascertain and copy competitive behavior. Diffusion of the information reflected in asset prices makes it more difficult to retain profits derived from investments in incremental production efficiencies and product innovations.
The most concerning prospect is that we have shifted toward a market structure in which competition between firms of any kind is not only less advantageous, but outright detrimental to asset owners. Consider a market in which asset owners have uniform stakes across all investable assets and firm managers are perfectly incentivized to operate in shareholders’ best interests. What does maximizing shareholder value mean in this context? In what cases would competitive investment be beneficial to asset owners?
In this scenario, the only incentive to compete would come from the threat of new entrants seeking to capture their own share of the profit pool. But why should firms burn cash in efforts to preemptively disrupt themselves if their shareholders can simply gain exposure to disruptors through allocations to venture capital? In this hypothetical, we would expect to see a cessation of competitive activity in favor of asset buying, and for innovation to be increasingly externalized from mature firms. Of course, no market is entirely defined by these characteristics, but these effects are increasingly present today. Industries in which asset managers hold large stakes across multiple firms exhibit lower investment and more anticompetitive behavior despite the persistence of high asset valuations and profit margins that should make further investment attractive, as shown by Germán Gutiérrez and Thomas Philippon:
Industries with more concentration and more common ownership invest less, even after controlling for current market conditions and intangibles. Within each industry, the investment gap is driven by firms owned by quasi-indexers and located in industries with more concentration and more common ownership. These firms return a disproportionate amount of free cash flows to shareholders.
But even this line of argument underplays the scope of anticompetitive incentives by neglecting the power of markets to establish common knowledge and coordinate behavior without the direct influence of large shareholders. The stock market is not only a means of transmitting price information, but also of coordinating behavior by creating an immediate feedback loop between asset owners and managers. In the same article in which he predicted a turn toward “problems of structure, organization, information, and control,” von Neumann provides a definition for feedback mechanisms:
[Feedback] observes the relationship of some mechanism to its surroundings, continuously senses the direction in which the controls of the mechanism have to be adjusted in order to bring it nearer to a certain desired relationship with those surrounds, makes the adjustment of these controls in the indicated direction, and thereby causes the mechanism gradually to find the desired position by this automatic procedure.
In this sense, the economic forces that have shaped the American economy over the past four decades are similar to those that dictated the trajectory of the twentieth century’s nuclear arms race. Just as nation-states will only initiate a first strike if retaliation will be ineffective, asset owners only pursue investments where they can create a durable competitive advantage. For nation-states, the development of large and more sophisticated nuclear arsenals neutralized any potential first-strike advantage, and this mutually assured destruction established the conditions for a sort of peaceful equilibrium. So too have more efficient markets undermined the ability of firms to retain competitive advantage in mature markets. But firms’ response is not to maximize investment, like weapons stockpiles, but rather, subject to asset manager feedback, to minimize competitive investment as much as possible.
Compared to the ability of distributed asset owners to collectively punish firm behavior that diminishes overall industry profits, Adam Smith’s concern that meetings between competitors would result in a “conspiracy against the public, or in some contrivance to raise prices” seems quaint. Consensus in modern markets operates according to the principles of John von Neumann, not Adam Smith, and it is more threatening than short-term greed to the social efficiency of capitalism. Firms know that they and their competitors have received the same mandate to hit successive earnings targets and apply elevated hurdle rates in evaluating investments. Common consensus to avoid competitive behavior is established by the mutual knowledge of managers that they and their peers are compensated via stock that will fall in value if the market perceives a risk of competition which would diminish overall industry profits. In this sense, steadily rising S&P operating margins, rather than increasingly complex derivatives, are the more sinister face of a financialized economy.
Decisions of whether to invest or return capital should ideally be made by managers on a case-by-case basis. But with immediate market feedback and stock-based compensation, managers must also convince the market that capital allocation decisions are sound. Only a minority of managers have the market’s mandate to pursue significant investments, usually CEO-founders (like Elon Musk and Jeff Bezos) operating in fast-growing markets in which large swaths of market share are still up for grabs. This anticompetitive consensus enabled by shareholder incentive alignment and the immediate feedback loop of capital markets provides a fundamental explanation for how S&P 500 companies can avoid competitive investment and mechanically expand margins each year. But this structural issue is often mischaracterized by critics as market-induced “short-termism,” when both the motivations and the effects are more profound and complex.
Some apologists for the status quo have interpreted the fact that public firms invest more than private firms as evidence that stock-based compensation and buybacks are not the underlying cause of underinvestment because private firms’ lower investment cannot be explained by market-induced “short termism.” But this reasoning confuses a market-induced anticompetitive consensus with behavioral “short-termism” among individual executives. An absence of public disclosure requirements does not mean that private firms are less subject to investor pressure to pursue anticompetitive behavior.
Consider the approach that private equity firms take in evaluating prospective investments. Typically, private equity funds only entertain buying market-leading firms or else pursue “platform plays,” using aggressive mergers and acquisitions to roll up smaller firms in unconsolidated industries. While the logic of cost synergies and other scale efficiencies make roll-ups incrementally attractive, investors are primarily concerned with the target’s relative market share, market size, and market growth, and the ability to increase prices consistently year over year.
Moreover, large privately held firms that compete against one another are often owned by rival private equity firms, and an anticompetitive consensus is far more easily established in industries that are dominated by investment firms competing to deliver a minimum threshold investment return to their clients. When all participants in the game know that their return targets incorporate yearly price increases and reduced capital expenditures, price wars and competitive innovation are effectively ruled out as plausible strategies. This approach is exemplified by the fact that private equity firms, during diligence, typically focus on determining the extent to which players in the target industry are “rational,” i.e., whether they will collectively avoid engaging in price competition. Anecdotally, MBAs report that the knowledge from their educational program most relevant to their role as investors is best summarized as “invest in businesses with a high degree of market power.”
Thus, the expansion of more direct investor influence over individual firms via stock-based compensation and the consolidation of private ownership has incentivized an investment ceasefire that allows firms to avoid mutually assured capital destruction, securing a more profitable peace for shareholders. Not only has financialization redirected capital toward buying up assets, it has shifted the game theory equilibrium of markets in aggregate from competition to consensus, enabling firms to better serve the narrow interests of asset owners.
Monetary Stimulus in a Financialized World
A structural account of the mechanisms that produce consensus between firms also provides insight into how looser monetary and fiscal policies impact firm behavior and transfer wealth to asset owners. Analysts who laugh off the notion that corporate greed is fueling inflation in consumer prices neglect that while monetary inflation is not the product of anticompetitive behavior, the latter contributes to a consensus that allows firms to coordinate price increases more effectively. Of course, firms have not become uniquely greedy; instead, an inflationary regime has solidified a cooperative equilibrium of price increases.
In a financialized economy, loose monetary policy not only further cements an anticompetitive consensus but also constitutes a direct wealth transfer to asset owners. Lower interest rates influence real economic activity by reducing borrowing costs on the premise that this lower cost of capital will be transmitted throughout the economy in the form of increased capital expenditures, and thereby initiate a positive feedback loop of supply and demand. Accommodative monetary policy, however, also constitutes an economic transfer to owners of assets or anyone looking to buy assets with leverage. Hence the Fed’s policy has contributed to a boom in asset-buying activity, and the valuation of companies has adjusted upward to reflect central bank support. Critically, though, in a regime of monetary inflation, whoever is closest to the spigot of monetary creation will receive outsize benefits. Consider a scenario in which the Federal Reserve provides you personally with one trillion dollars to stimulate the overall economy. As you spend your stimulus, prices will gradually adjust upwards, but at the end of your buying spree you and those to whom you allocated capital first (either through consumption or investment) will have received the most benefit. This heterogeneous property of monetary transmission is known as the Cantillon effect, and Matt Stoller has described how it undermines both trickle-down economics and accommodative monetary policy.
Furthermore, in a financialized economy, the Cantillon effect is magnified. High hurdle rates above the cost of capital and higher profit margins enable asset managers to capture a greater return for every dollar invested. A consensus to return capital instead of investing it means that more of the monetary stimulus remains sequestered in asset buying for a longer period of time and away from productive investment; value will not trickle down until asset prices have been homogeneously bid up to reflect monetary inflation. At its core, a financialized world is a world of asset inflation, in which excess profits from the expanded margins and reduced investment enabled by a lack of competition are continuously rebalanced across existing assets, and the wealth transfer of monetary stimulus is more efficiently captured by asset owners.
Updating Models of Firm Competition
Over the last several decades, the innovations of financialized markets have incentivized an anticompetitive consensus within the corporate sector. A trend toward reduced competition explains the persistence of the gap between the cost of capital and investment hurdle rates, which has resulted in an aggregate reduction in overall investment, along with consolidation in many industries and margin expansion. Issues around competition in markets and what factors enable a consensus among firms and asset owners introduce a more serious line of critique than making accusations of “corporate greed” or “short-termism,” and provide a framework for understanding the impact of firm behavior and macroeconomic policies.
Many contemporary economic debates remain grounded in older models of firm competition. But today’s economy is largely characterized by market-feedback-induced consensus among firms that reflects the priorities of asset managers and the interests of asset owners. Recognition of this fact is the first step toward a better understanding of today’s capitalism and toward policies that address its key weaknesses, particularly incentives against competitive investment in many industries.