Robert Shiller argues that financial markets are a force for good. But is he blind to their current failings?by Martin Wolf / May 24, 2012 / Leave a comment
Nowadays a book with the title “Finance and the good society” is likely to appear, at best, a contradiction in terms and, at worst, a sick joke. It is a measure of Robert Shiller’s intellectual courage, or perhaps his foolhardiness, that this understandable hostility to finance did not daunt him. He believes strongly that finance makes an essential contribution to the good society.
This latest book from Shiller is a thought-provoking, lucid, wide-ranging and largely convincing explanation of why this is so. Shiller falls into the category of idealistic, yet practical, reformers on whom so much of human progress has depended. This book demonstrates these qualities perfectly.
Shiller has won a deserved reputation as being among the world’s most prescient analysts of financial excesses. When he defends finance, we should pay attention. Yet how, the reader must wonder, can any reasonable person defend finance after the recent epidemic of greed, knavery and folly, which resulted in the biggest financial and economic crisis since the 1930s? A part of the answer is that Shiller defines finance very broadly:
“At its broadest level, finance is the science of goal architecture—of the structuring of the broadest arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement. The goals may be those of households, small businesses, corporations, civic institutions, governments, and of society itself. Once an objective has been specified—such as payment for a college education, a couple’s comfortable retirement, the opening of a restaurant, the addition of a new wing on a hospital, the creation of a social security system or a trip to the moon—the parties involved need the right financial tools, and often expert guidance, to help achieve the goal. In this sense, finance is analogous to engineering.”
The implication of Shiller’s definition is that finance is not just about the financial sector, narrowly defined. It is not even about the market economy. It concerns public finances as well as private and so public purposes as well as private ones. It is a necessary aspect of any complex society in which people seek to plan their activities. It is a vital part of an economy that relies on decentralised decision-making within a market-governed division of labour.
We cannot do without finance. Yet, for Shiller, finance is not just a necessity that has to be tolerated. It is a means of achieving valuable ends via peaceful means. “The key to achieving our goals and enhancing human values,” he argues, “is to maintain and continually improve a democratic financial system that takes account of the diversity of human motives and drives… It must be a system that redirects the inevitable human conflicts into a manageable arena, an arena that is both peaceful and constructive.”
All this may seem high flown. But Shiller is no naïve believer in efficient markets. On the contrary, he has written two celebrated books on financial manias: Irrational Exuberance, on the stock market boom of the 1990s, and The Subprime Solution, on the housing bubble of the 2000s in the US. He is the co-author, with George Akerlof, a winner of the Nobel prize in economics, of Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism. He is an admirer of Keynes and is himself a financial innovator.
This is a man to be taken seriously, even by critics of finance. Shiller is well aware of the “excess volatility” of asset markets and the disruption they can bring with them. How then does Shiller lay out his argument? He does so by dividing the book into two halves.
The first half is about roles. Because finance touches every aspect of the economy, the roles that interest him are wide-ranging: corporate management; asset managers; bankers; investment bankers; mortgage lenders; financial traders; insurers; the designers of markets; the providers of derivatives; lawyers and financial advisors; lobbyists; regulators; accountants; educators; financiers of public goods; policy makers; trustees and managers of non-profit institutions; and even philanthropists.
Because finance is such a broad range of activities, all these different roles must be properly performed if it is to work. On balance, it has, partly because of the activities of governments. The result, he argues, has been a history of innovation and improved standards that have, despite the many problems, helped people live better lives. Even in the crisis, much of this complex system continued to work well.
Think of a world without life insurance or property insurance, without pensions or health insurance, without banks or credit cards, without mortgages, bond markets, equity markets or commodity markets. Yet every one of these was, at some point, a financial innovation, distrusted and, not infrequently, abused. Laws had to be introduced, accounting had to be established and regulation has to be imposed. Yet all these erstwhile innovations have now become essential elements of contemporary life.
Yet think, too, of how much better all this could be if we could improve such contracts further. Shiller argues, for example, that “we need more active trading of derivatives for such things as consumer prices, GDP, longevity, and real estate risks.” He wants mortgage contracts that adjust their terms to the state of the housing market automatically. He wants government bonds that adjust to the state of the economy. He wants better advice, paid for by the state. He wants more finance and better finance.
The problem, argues Shiller, is not with the fundamental idea of transferring resources from those who have it, but do not need it, to those who do not have it, but do need it. The problem is more with the often inflexible execution of this idea. Thus, flexibility needs to be built into contracts, to minimise the cost of unnecessary bankruptcies and the resulting distress. The same applies to insurance. It makes an essential contribution to the good life. The problem is that we face too many risks—over the choice of career, for example—that we cannot currently insure at all.
In short, the modern world does not make full use of the potential of finance and suffers from too many of the drawbacks. This is the theme of the second half of the book, in which Shiller examines our many and varied financial discontents.
The list, again, is long: excessive belief in elegant financial theories; a proclivity for incontinent risk-taking matched by equally inordinate conservatism in response to novelty; a willingness to offer, and accept, excessive quantities of debt; the tendency for insiders to exploit the ignorance of outsiders; the willingness of regulators to encourage dangerous practices (the zero risk-weighting afforded to sovereign debt being a powerful recent example); the proclivity towards speculative bubbles; and the recent explosion of inequality.
This does not exhaust the scope of this discussion. Shiller examines the limitations of philanthropy, which he believes is too small: even in the US, only 2.2 per cent of national income was given away in 2010. Much needs to be done to promote greater giving. He considers, too, efforts to distribute ownership more broadly through society. He even evaluates the goals of life and the role of the pursuit of wealth among them.
This, then, is not a book about finance, as we normally conceive that area of economic activity. It is not even a book about financial capitalism, broadly defined. It is about the role of financial arrangements in pursuit of the good life. The range is extraordinary, but, inevitably, it also makes the discussion of many topics brief, even superficial.
Much in this book is admirable: its range, its imagination, and its pragmatic and eclectic approach to reform. The moral vision, too, is impressive. Shiller is right that the rise of commerce is a part of the reason why society has become less violent and war among great powers less acceptable. He reminds us of the stupid and catastrophic view, widely held a century ago, that conquest brought not just glory, but wealth. This was indeed the “great illusion” Norman Angell wrote about in his famous book with that title.
Today, we do understand that the positive-sum game of peaceful exchange is far more rewarding than the negative-sum game of war. We admire the conquests of a Steve Jobs far more than we do those of some bloody-handed warrior. This is genuine moral progress.
Above all, Shiller is right that finance is the handmaiden of a decentralised market economy. We cannot live without it. But it is here, in the core of the contemporary economy, that the discussion is weakest.
By and large, Shiller is optimistic about human motivations. He does not consider the extent to which the impersonal nature of modern financial interaction makes it easy for individuals and organisations to behave destructively, indifferent to the mayhem they cause. The victims, being nameless and faceless, do not really exist. He understates, too, the extent to which insiders—financial professionals and managers—seek to rig the game for their advantage and the great difficulty in changing that situation. Shiller wants to make finance more democratic and humane. But he surely understates the difficulties of so doing.
Yet perhaps the most striking defect of the book is its limited discussion of how to make the system as a whole more robust. It looks so much to the stars that it ignores the rock-strewn ground under our feet.
One of the more striking sections is on the failure of official institutions to foresee the current crisis. That makes efforts at so-called “macroprudential regulation,” with which the Bank of England is to be charged, seem hopeless. The implication is that the financial system needs to be more robust. We may be unable to predict financial earthquakes, but we can make the buildings more quake-proof.
A big part of making the system robust must come from lowering leverage in both financial institutions and society. One part of the solution needs to be elimination of the favourable treatment of debt in our tax codes. Another part must be more equity in financial institutions. This is an important area for the sort of financial innovation that so interests Shiller. But he hardly discusses the requirements. Indeed, the discussion of the fragility of the current financial system is strikingly limited. What I would expect to read is a full discussion of how, in crucial aspects, finance needs fewer “middle men” than at present or, at least, entirely different forms of middle men.
On the big point, however, Shiller is right. Like it or not, we have to live with finance. It is an indispensable aspect of our lives. We will never make it perfect. The challenges are too great for that. But it can be made more useful and less damaging: more democratic and humane, as he himself would put it. That is a huge agenda. This book is certainly not the last word on how to achieve it. But it makes a valuable contribution.