The Washington PostDemocracy Dies in Darkness

How Wall Street became a big chunk of the U.S. economy — and when the Democrats signed on

A Wall Street sign outside the New York Stock Exchange. (Mark Lennihan/AP)

Modern economies depend on a thriving financial sector, and the U.S. finance, insurance and real estate (FIRE) sector now accounts for 20 percent of GDP — compared with only 10 percent in 1947.

But many observers believe that this expansion of the financial sector comes at a high cost. Scholars and politicians alike point to the “financialization” of the economy — and an increased reliance on the financial sector to create growth — as the root cause of many of our economic problems. The list includes income inequality, growing household debt, slow growth and the instability manifested in the 2008 global economic crisis.

In “The Politics of Financialization in the United States, 1949-2005,” an article in the British Journal of Political Science, I demonstrate that politics and policy contributed just as much to the FIRE sector’s growth as hedge fund managers and bank officials trying to get rich.

Some win — and some lose — from the shift to a financialized economy

Here’s how this works. Major economic changes, such as the shift from an agricultural to industrial economy or from an industrial to a post-industrial economy, create winners and losers. The winners turn to the government to make policies that accelerate these changes, while the losers ask the government to enact policies to slow harmful economic changes, as when unions pursue laws that would make it harder to shift jobs overseas.

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There are some obvious winners in the age of financialization: Financial industry managers and shareholders see their incomes grow much more rapidly than other skilled professionals. But corporate managers and wealthy investors also profit as stock prices rise.

Who loses? The poor and the working class don’t have the capital or expertise to take advantage of new investment opportunities. These people suffer disproportionately from layoffs or reductions in salary and benefits — the choices firms make to keep profit margins and stock prices high. Working folks also carry most of the growing debt that is needed to maintain living standards when wages and benefits are stagnant as financialization takes hold.

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Influence pays

Both winners and losers try to influence policy through the organized interest and party systems. Wall Street and America’s banks have traditionally invested in lobbying and funding campaigns, especially for candidates from the Republican Party. In contrast, working-class and lower-income groups in the United States historically relied on labor unions and the Democratic Party to stand up for their interests.

I investigated whether financialization slows when labor unions are stronger and the Democratic Party is in power, and whether the financial sector grows more quickly when the banks are stronger and the Republican Party is in power. The full details can be found in the article.

From 1949 to 2005, the percentage of GDP created in the financial sector grew more rapidly when the Republicans controlled more institutions of government, when the banking industry was more heavily mobilized into politics and when labor unions were weaker.

This reflects that unions and the Democratic Party historically focused on growing manufacturing and construction industries, which provided the jobs their constituents needed. The Democratic Party also tended to be tougher on financial regulation because of a greater willingness to intervene in the economy and protect consumers, which kept the financial sector from expanding rapidly.

When did the Democrats switch sides?

But the political climate shifted after 1980. The GOP started winning more elections. And banks and their allies took advantage of slow growth to argue that deregulation was stifling economic growth. Meanwhile, the power of organized labor declined, making unions less of a force in establishing national economic policy.

As contemporary observers from Sen. Bernie Sanders (I-Vt.) to the scholars Jacob Hacker and Paul Pierson have argued, since the 1980s the Democrats have started siding with the banks and the Republicans in pursuing financial deregulation. This was most evident in the Clinton administration’s support for the Financial Services Modernization Act of 1999, which repealed a number of Depression-era financial regulations.

Why the change? As organized labor weakened and the working class shrank because of economic changes, the Democratic Party courted a new group of voters: white-collar professionals and managers (including bankers in the financial sector). The Democratic Party started supporting deregulation and other policies that their new voters and campaign funders preferred, helping the financial sector grow — while beginning to ignore policies that would help manufacturing, construction and the like.

In the figure below, you can see how the relationship between Democratic control of one additional branch of the federal government influences the pace of FIRE-sector GDP growth depending on the strength of unions and the class gap in support for the Democratic presidential nominee (based on American National Election Study data). The bottom axes show the proportion of workers represented by labor unions, and the difference in support for the Democratic presidential nominee between working-class voters (i.e. non-managerial, non-professional employees) and professionals and managers.

Here’s what you find. When unions are strong and working-class voters are pulling the lever for Democrats while professionals and managers support the Republican candidate, having Democrats in power means the financial sector grows more slowly. But when unions are smaller and the class gap in voting is smaller, having Democrats in charge is not statistically distinguishable from having Republicans in charge.

In other words, the results were just what the theory predicted. As organized labor declined and the Democratic Party became more heterogeneous, the Democrats no longer put a “brake” on the financial industry’s growth. At the same time, Democrats stopped helping such economic sectors as construction and manufacturing.

What does this mean in 2016?

After the 2008 financial crisis, Republicans — more or less uniformly — tried to block tighter regulation of the financial industry. Democrats created the Consumer Financial Protection Bureau.

But Democrats and Wall Street retain close links. In fact, President Obama’s first Treasury Secretary, Tim Geithner, is seen as so close to Wall Street that many people make the mistake of believing he’s a former Goldman Sachs executive.

For now, neither party seems committed to boosting sectors such as construction and manufacturing, in which lesser-skilled workers once earned good wages. In the short term, in other words, the financial sector will probably keep growing.

But here’s the twist: Both Bernie Sanders and Donald Trump have campaigned on populist economic principles, arguing that our financialized economy has left many Americans behind. Trump claims that Wall Street bankers are “getting away with murder.” Sanders attacks Hillary Clinton for being too close to Wall Street. Both candidates claim foreign trade agreements have cost too many U.S. jobs, particularly in manufacturing.

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Even if neither candidate ends up in the White House, many voters have these arguments clearly on their radar. The bottom line? Voters and politicians will almost certainly keep arguing about — and objecting to — how financialization has changed the U.S. economy.

The article from which this post is drawn has been ungated for the next six months as part of our continuing collaboration with the British Journal of Political Science.

Christopher Witko is an associate professor of political science and the director of the Masters of Public Administration program at the University of South Carolina. Find him on Twitter @cmwitko.