Financial engineering can have benefits for economies, but it has gotten out of control. As a result, it has created a fresh set of problems for the U.S. economy and others.
Many books that have covered the growth of financial engineering in the U.S. have expanded on so-called financialization.
The financialization of the economy refers to the substitution of financial activity for manufacturing growth and innovation.
The consequences of this substitution have been less business investment in capital expenditures and slower growth in labor productivity and in the overall economy.
Efforts to combat the slower economic growth have primarily been aimed at producing more financial engineering, but this additional financial engineering has exacerbated the situation resulting in even fewer capital expenditures, even slower growth of labor productivity and economic growth.
Changing this situation will require a change in the focus of economists and policymakers, time to implement new approaches to economic policy, and patience to allow the new direction to work.
Financialization in the U.S. began in earnest in the 1960s as Keynesian economic policies were introduced that attempted to fine-tune the American economy.
Through tax cuts and other fiscal policies, it was thought that the government could stimulate aggregate demand and economic downturns could be shortened, maybe even eliminated.
Once this philosophy gained ground within economic circles and the tax cuts during the presidential administration of John F. Kennedy became a reality, this idea of fine-tuning was expanded to apply to the whole economy in the hopes of producing even faster economic growth.
The statistical relationship called the Phillips Curve, a relationship between inflation and unemployment, was used to justify more fiscal stimulus, producing modestly more inflation, so that unemployment could be reduced to an even lower level.
Although in the late 1960s the economist Milton Friedman argued that this statistical relationship was valid for short-term purposes, it couldn't be maintained over time. The use of the Phillips Curve continued to be applied by policy markers even into the 21st century.
But the financial engineering of the economy started in the early 1960s produced the conditions late in that decade for the application of financial engineering to the banking industry. Commercial banks moved from just being asset managers to becoming liability managers to becoming asset-liability managers.
Commercial banks in the United States, historically had been limited in size due to the constraints upon geographic expansion. Their deposit bases were determined by how widely they could branch.
In the late 1960s, the larger banks in the U.S. discovered how the one-bank holding company could be used to expand their sources of funds. To manage their balance sheets, they created new financial innovations, the negotiable certificate of deposit and the Eurodollar deposit, in which funds could be purchased at the going market price.
That is these large banks could buy or sell funds in markets in the United States and Europe, at will, and expand or contract their balance sheets as they saw fit. Commercial banking has never been the same.