Structural Changes and Dominance of Finance in Contemporary Capitalism Sunanda Sen

There has taken place , over the last three decades,  a considerable structural change  in economies in terms of the sector-wise contribution to aggregate output as well as employment in majority of economies which today include the advanced as well as the developing economies. The structural changes include a rising share for the services sector, providing more than one-half of the GDP in the majority of countries.  The changes get reflected in the proportionate declines in the shares relating to the remaining sectors – with the drop being particularly steep for industry.

As for the services sector, which covers activities ranging from finance to transport, hospitality and other miscellaneous activities, those include the  high value financial activities, the weights of which are disproportionately large. As a result the rising share of services to the GDP indicates simultaneous increases in the share of financial activities to the GDP.

That structural changes  as above, discussed in the literature, have major implications for the functioning of economies , is an aspect which would be discussed further in the present paper. The processes of  these structural change rely on the politico-economic and social realities in  economies. There has been  earlier attempts in the literature to explain above changes  as a sequential path for  the three major sectors  of agriculture, industry and services , which necessarily remain incomplete.

Analysis   as available in the  literature has  explained the structural changes  by using the  role of the relative profitability of  different activities , which work  as the prime mover to explain the actions of agents across different  activities in the market. (Pasinetti, L 1965) . The path indicates an  unilineal  move  guided by the profit motive, which operates  as a prime mover of change.

One can also relate the process to financialisation of economies , which, as pointed out  in 2005,  works  as   “the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies.” (Epstein 2005)

In analysis as  above we  further identify   a circuitous link,  prevailing  between the socio- political and economic-forces  on the one hand, and   the  changing weight (   tantamount to power relations)   of different  sectors in the economy on the other –  continuing to shape  the dynamics of the structural changes. (Sen,S 2023)

Changes as above, mostly reinforced by  pressures from domestic as well as international   financial institutions ,  oblige  the state in the developing countries  to ensure financial de-regulation. Above can be held responsible for the growth of financial activities at a  faster rate as compared to activities  in the  industrial sector. The path that emerge reflects   the respective changes in the real and financial activities –  often moving in opposite directions . With   financial institutions achieving a superior status in the economy , especially with their  effective persuasion  (to the ruling state in alliance)  to keep open the flows of capital  –  finance gains ground in the economy as the most powerful sector. The fast growth of the finance-related activities  also renders financial activities  a major role in  the services sector of those  economies.

As pointed out ( Scazzieri 2011) ,the path taken by  finance  in achieving its current state of dominance  by relying on  relative profitability as the prime mover of structural changes ,  can proceed   beyond  the unilineal  explanations   as provided by Pasinetti (1965).  Scazzieri  here   brings in  Fernand ,Braudel’s position that capitalism entails  a multi-layered structure.  In this one  can find a variety of trajectories in  the path of structural changes   by considering   the specifics of the dynamic impulses as remain open in a profit-driven economy. As  pointed out,   the alternate trajectories  relate  to  “… the ‘horizontal’ reshuffling of activities in the real economy ( as well as)  the ‘vertical’  shifting of liquid funds between real and financial activities.” (Scazzieri 2023) . As Braudel pointed out,  with economic success there has been  a switch from  horizontal layers of specialisation (or de-specialisation ) to  the vertical layer of diversification between real and financial activities. (Braudel, 1977, Chap. II)   Braudel  also pointed out that shifts of activity to  banking and finance reflects  “..shift of business from low to high levels of activity”. (Scazzieri 2023)

Structural changes in an economy where finance  rises to dominance entails an expansionary path   for the financial sector itself which rests on an  access to larger volumes of liquidity.  This  usually comes up , first  by moving out liquidity from the relatively low profit activities in the  real sector to the high- risk high-return  short -term  financial assets . This amounts to a shift   away from the real  sphere of activities to the financial, generating  an economic environment in which the profit motive induces short-term capital flows through the purchase and sale of financial assets ,  under volatile price movements.   In addition , there remain a  second route to the expansionary  path  of finance     which   can generate additional liquidity    by  using financial engineering (or innovations)  to  initiate different forms of   derivatives  in the market .

Derivatives  in the market are designed to protect  the value of financial assets  by hedging   against risks under rising uncertainty which come up in de-regulated financial markets. The additional flow of liquidity to  meet the   demands  for hedging under uncertainty   amounts to   further expansions of the financial sector;  thus adding  to its share of finance to the  GDP as well as in the services sector. It is worth  noticing that most of those derivatives are usually backed by credit margins provided by  banks, which implies an accommodative  expansion of liquidity by the financial institutions.

The dual routes  as above  bring in the  additional liquidity as are needed to    continue   the expansionary path of the financial sector.

The quantitative significance of finance  which is contributed by additional liquidity   as above is supported by  the qualitative support   lent by the   power of finance which originates from the socio-economic and political set-up  (including those of the state in alliance) ;  ever-ready to support the expanding pace of the financial activities under contemporary capitalism.

One can observe from above a  close relationship between de-regulation of finance, uncertainty and related volatility in markets, which encourages  speculation and flows of  short-term capital.  As  we pointed out earlier, ‘speculation by nature is rife  in markets only when these are fluid’ -. The co-evolution of rising uncertainty and increasingly liquid short term investment goes hand-in-hand with financial innovation ( mentioned above) , which may have ‘a  contractionary effect on the real economy’ – all due to the fact that rising uncertainty in the financial markets draws away finance from the real economy. (Sen, 2014, p. 116; Sen,S 2023).

To explain the shifting structure in an economy with changing weight and power of individual sectors vis à vis the rest, we deviate  here briefly from the main argument  by providing an exposition of the role as well as  the   pattern of uncertainty in the process.  An economy can encounter a crisis when faced with  what has been  identified in the literature as ‘fundamental uncertainty’ ,  which  relates to “the un-knowability of the future, to creative human agency and the unique nature of unfolding time”(Dunn 2008, 96),                    As further mentioned, it reflects the future as “transmutable or creative in the sense that future economic outcomes may be perman,ently changed by the actions today of individuals, groups and/or governments, often in ways that are not even perceived by the creators of change.” (Davidson,P 2003, pp 234). Thus   with “creativity” of actions by investors, new realities come up as “potential surprises”. (Rosser 2001, pp 547; Sen,S, 2018 )

We mention here the elucidations by Crotty which brings up Keynes’s characterisation of the effect of  fundamental or radical uncertainty on the capital investment decision of the firm, in chapter 12 of the General Theory. As Crotty mentions,“..fundamental  uncertainty  means that probability distribution that describes future states of the economy are not knowable in the present because these states have yet to be determined in the present and will be influenced by decisions taken today and tomorrow by agents ignorant of the future” (Crotty 2019 p240, italics added) Crotty views this notion as a“crucial underpinning” of Keynesian revolution in macro theory, apart from providing a construction of agent choice in micro theory.   Fundamental uncertainty can also be viewed as a typical ponzi finance  situation where  the financial assets   held by an investor fail  to perform   while the  financial liabilities as become due  can not be met by incurring further liabilities (borrowings). The situation leads to   steep declines in the profitability of financial assets held by the investor. With finance   privileged by higher profitability  as compared to those in the real activities, investments in financial assets will continue to grow along  with rising uncertainty , but only  until  the stage  of fundamental uncertainty. With growth in real assets having already taken a downhill path, those in financial assets now will  too turn negative. The economy, as a consequence, will now move along a decelerating growth path.

Thus the triumph of the financial sector and its superior weight in the economy, while pushing the system along a finance-led path led by high-risk high-return investments, may not continue beyond the  critical stage of ‘fundamental uncertainty’ when speculation consistently fails to add to further profitability of financial investments. Situations such as above can be identified in the episodes of crisis as are observed in recent times.

Analysis as provided above remains incomplete unless the implications of fundamental uncertainty on  ‘agent choice’  to  determine the path of investments are worked out.  Crotty highlights  the answer provided by Keynes in his post-GT writings and lectures,    an early formulation of which can be traced back to the GT.  A clarification of the above matter is provided by Jim Crotty  (Crotty: 2019  p240 ) ,   mentioning  Keynes in the General Theory (chapter 12) on   “… the effect of radical or fundamental uncertainty on capital investment decisions of the firm. “  As we have already mentioned above,  Crotty further goes to provide an explicit definition of fundamental   uncertainty  which,   may be worth repeating here , It “…  means that the probability distributions that describe the future states of the economy are not knowable in the present because these states have yet to be determined in the present and will be influenced by decisions  taken today or tomorrow by agents ignorant of the future.”   (Crotty 2019, p240 italics added)  As held by Crotty, this observation is a ‘revolutionary  transformation of macro theory ‘  while it simultaneously provides   a theory of ‘agent choice ‘ in micro theory. He also points out that the argument, while   demolishing the  claim in neo-classical economics  based on rational choice,  has  remained  largely unrecognized. ( Crotty 2019, p240)

Here comes Jim Crotty’s pointer to the decision making process of agents faced with the fundamental  uncertainties which relate  to future as identified by Keynes in his post-GT writings   which include the 1937 Galton lecture . ( Crotty 2019:p242)

Above brings us back  to an  important question  which  relates to the way agents choose their  investment policies  when the future remains completely unknown. Since they would like to avoid  a chaos  as can come with the radical/fundamental uncertainty , how do they justify  their own   decisions taken by pinning it down to some  criteria?  However, to overcome the lacunae of the unknowns on basis of which the agents choose their actions in the market,  Crotty  cites   the Galton lecture by Keynes published by the Eugenics Review . April 1937  which   goes as follows:

“.. Neverheless, as living and moving things we are forced to act.  Peace and comfort of mind require that we should hide from ourselves how little  we foresee. We tend therefore, to substitute for the knowledge that is unattainable, certain conventions  the chief of which is to assume, contrary to all likelihood,that the future will resemble the past” (Collected Works   of Keynes Vol XIV p124 cited in Crotty 2019: p202)

Moving further   , Crotty  notices that ‘conventions’ help agents   the calming of   nerves, and (as Keynes argued), those  collectively develop a “conventional process of expectation formation.” Above, as held by Crotty, is one of most important theoretical innovations” of Keynes which  brings in  expectation formation and decision making by agents based on custom , habit, tradition,  instinct etc as   relevant in a model of human agency faced with fundamental uncertainty. ( Crotty 2019:p243)

Crotty had  raised  earlier in a paper ( Crotty 1994)   two further questions   on   how decisions are made by agents  under fundamental uncertainty.   The first relates to agents encountering the ‘ dilemma ‘ of unknowability. Crotty  in this paper mentions  the answer from  Keynes  as , “..  Given that “..agents are socially and endogenously-constituted human beings…., a theory of agent choice.. must reflect both the social constitution of the agent  which is contingent on  institutions, values, and practices specific to time and place as well as the psychological complexity of the human-being-in-society.”

The second point,  on  a behaviorial issue,  seeks answers to the actual decision-making process . Here Keynes reverts to human behaviour as   a psychological trait leaning on continuity even when it turns out as un-realistic. Keynes’s proximity to democratic socialism is reflected here by a mention of institutions as good support to agent choice as above.

There remain, however further issues  . in particular, relating to decisions based on conventions  which , as Keynes  had held, “ ….Knowing that our own individual judgement is worthless,  we endeavour to fall back on the judgement on the rest of the world which is perhaps better informed.” (Keynes 1937 p214)

Now, does above remind the reader of   Keynes’ ‘beauty contest’ analogy  on reaching a decision in stock markets , or even of ‘animal sprits’ or ‘herd behaviour’ in similar situations?

This, however is strongly denied by Keynes, a point  Crotty makes clear ( Crotty 2019)    with a citation which  goes as follows :   “ In the end ,it is the it is the propensity of agents to believe in the solidity and validity of the conventional forecast  and not just “animal spirits” – some innate or genetically transmitted urge to “spontaneous action” rather than inaction”.

We draw our conclusions here, on the pattern of structural changes in economies,  with finance gaining ground as the major activity  with power moving along  an unstable path . Much of the rise and dominance of finance  goes through the uncertain terrain of the future in de-regulated markets, however conditioned by conventional decision making by agents, with uncertainty of a radical or uncertain nature often bringing in a crisis  , led by finance and spread to the real sector.

References

Fernand Braudel, Afterthoughts on material civilization and capitalism Johns Hopkins 1977

James Crotty , Keynes Against Capitalism Routledge 2019

James  Crotty,”Are Keynesian Uncertainty and Macro-theory Compatible?Conventional Decision making,Institutional Structures and ConditionalStability in Keynesian Macro models” 2014

Davidson ,Paul Financial Markets, Money and the Real World  Elgar 2003

Dunn, S., 2008. Uncertain Foundations of Post-Keynesian Economics: Essays in Explorations. Routledge, Oxfordshire, UK.

Gerald Epstein,Financialisation and the World Economy Edward Elgar 2005

John Maynard Keynes,  Collected Works   of Keynes Vol XIV (edited) Moggeridge E and Johnson E Davidson,P 2003,

Rosser, J.B Junior“Alternative Keynesian and Post Keynesian Perspective on Uncertainty and Expectations” Journal of Post Keynesian Economics Volume 23, 2001 – Issue 4

Scazzieri, Roberto “ A Theory of Similarity and Uncertainty”  in Marzetti Dall, Brandolini,S and Scazzieri, Roberto (ed),Resources,Production and Structural Dynamics Cambridge University Press 2011

Scazzieri, Roberto “Instability and Structural Dynamics in the Macro-economy: A Policy Perspective” in Arie Arnon, Maria Cristina Marcuzzo, and Annalisa Rosselli (ed) Financial Markets in Perspective   Springer 2023

Sen,S  Globalisation and Development National Book Trust Delhi 2007

Sen, S., & Marcuzzo, M. C. (2018).o (Eds.), The changing face of imperialism. Colonialism to contemporary capitalism (pp. 1–11). Routledge  2018

Sen,S “Patterns of Structural Dynamics at different stages of capitalism:USA and India “ Structural Change and Economic Dynamics 65 (2023) pp468-473

(This Paper was presented in the Memorial Conference for Prof Jim Crotty held on 22^nd and 23^rd September at Amherst PERI and is posted as Working Paper of PERI, University of Massachusetts.)