Ended: Oct. 1, 2012
Arjun Jayadev and Samuel Bowles have estimated that 19.7% of the U.S. labor force in 2002—supervisors, security personnel, members of the military—was involved in guarding in some form.17 The high percentage of our citizens paid to guard us and our installations and possessions is at its essence surely more troubling than the percentage engaged in the substantially productive activities of finance. Yet relatively few of us seem bothered by this statistic.
Moreover, the growth in high salaries that we have seen in recent decades might in part be explained as the result of improvements in our capitalist system, as the system comes to recognize the importance of qualified leaders and refuses to be bound by arbitrary pay conventions. This is why the Squam Lake Group (a nonpartisan, nonaffiliated group of fifteen academics who offer counsel on financial regulation, of which I am a member) advised in its 2009 report that the government should not regulate the level of CEO compensation. Some CEOs are, and always will be, worth a great deal to their firms. On the other hand, the group did believe that regulation of the structure of CEO compensation is called for.5
Lucian Bebchuk and Jesse Fried, both professors at Harvard Law School, have argued in their 2006 book Pay without Performance that the growth of top executive salaries has largely been the result of a breakdown in the arms-length bargaining process between boards of directors and the top executives they hire. When the “bargaining” is among close friends, it may have only the appearance of being fair: “Directors have had various economic incentives to support, or at least go along with, arrangements favorable to the company’s top executives. Various social and psychological factors—collegiality, team spirit, a natural desire to avoid conflict within the board team, and sometimes friendship and loyalty—have also pulled board members in that direction.”
In the future, we will still hear about some CEOs with extraordinarily high(-sounding) salaries and benefits. That will be part of the story of financial capitalism, but we can hope that there will be more sense to the process of awarding these benefits and so better public acceptance of them. This—and a better public appreciation of the principles underlying the corporation—would better align the interests of the corporation with those of the larger society.
In the words of Andrew Redleaf and Richard Vigilante, who are themselves hedge fund managers, “If the ideology of modern finance had a motto, it might be ‘thinking doesn’t work.’”3
We might instead regard the theory as a reductio ad absurdum for the efficient markets theory. How can markets become efficient if that very result would imply that nobody trades? If markets are going to display prices that efficiently incorporate all information, there has to be some activity. Part of this activity would involve trading, and other parts of it would involve information gathering. All this takes time and effort, and costs money. Who would undertake such activities if all markets were perfectly efficient? This viewpoint is reflected in another classic paper in financial theory, “The Impossibility of Informationally Efficient Markets,” written by financial theorists Sanford Grossman and Joseph Stiglitz.5 They frame their conclusion in terms of the “nonexistence” of an efficient markets “equilibrium.” In other words, it just doesn’t make sense to suppose that markets are really generally completely efficient.
It is hard to find out if smarter people generally can beat the market since it is hard to measure who is smarter. But we can find the names of the colleges investment managers attended, and there are data on average Scholastic Aptitude Test scores for students entering those colleges. Judith Chevalier and Glenn Ellison found evidence that smartness does generate performance for mutual fund managers.7 Haitao Li, Xiaoyan Zhang, and Rui Zhao found similar results for hedge fund managers.8 Mark Grinblatt, Matti Keloharju, and Juhani Linnainmaa found that individuals in Finland with higher IQ scores (measured when they first reported for that country’s mandatory military service) showed evidence of better performance on their choices of investments, after correcting for risk.9
William Goetzmann and some of his colleagues in the Yale finance group have calculated the optimal strategy for a manager of an investment fund who wishes to deceive investors by producing good returns for a number of years, and then to take the investment fees and run in that rare year when the fund does very badly for its investors.16 Such a nefarious strategy generates “tail risk,” risk in the tails of the probability distribution of investment returns, or, in other words, “black swan events” that are so rare that investors may not see them coming, even though they are huge when they do occur. In the meantime, the investment fund can profit from the appearance of good and safe returns. The optimal strategy involves adding options to the portfolio, in such a way as to sell off the benefit of any (rare) unusually high portfolio returns (sell out-of-the-money call options on the portfolio) and also to profit in the short run by redoubling any (rare) unusually bad portfolio returns (sell out-of-the-money put options on the portfolio).
Ultimately, the idea that investment managers as a group are “frauds” because they cannot as a group outperform the market is mistaken. They are providing a multitude of services, including honestly watching over portfolios with sympathy for the needs of their clients—and the better among them apparently are outperforming the market. The intellectual community that they provide also constitutes an externality that benefits society, in directing resources and incorporating information into market prices. In the future, better regulation and better financial advice for general investors can help improve the overall state of the investment management industry.
But the overall process of share issuance and incentivization is far kinder and gentler than armed conflict, and it provides a civilized outlet for human aggression that can ultimately lead to more productive corporations and thus beneficial outcomes for society as a whole. Investment bankers in a sense serve as diplomats negotiating an understanding between contentious powers—an understanding that ultimately allows them to cooperate and get on with their business. In the corporate world, investment bankers are, in the final analysis, keepers of the peace and promoters of progress.
contrary to popular belief, only a very small fraction (0.17%) of the principal of U.S. AAA-rated subprime mortgage–backed security tranches issued between 2004 and 2007 had experienced losses owing to underlying mortgage default as of 2011.1 News accounts of a few AAA subprime securities that suffered major default losses, of the significant default losses in the lower-rated tranches, and of major market price declines have all left people with a faulty impression of the failures of the tranching system.
I myself wondered, in the years just before the financial crisis, why so many people thought home prices could never fall. To me, the extraordinarily rapid ascent of home prices from around 1997 to 2006 suggested there was a housing bubble, which might burst, producing rapid price declines. But practically no one in the mortgage industry seemed to think that was even a remote possibility. I asked some of these people why they thought prices could never fall. They would sometimes reply that home prices had never fallen since the Great Depression. And the Depression was so long ago that it just didn’t seem relevant anymore. Needless to say, they were wrong about that.
Claire Hill, in her article “Securitization: A Low-Cost Sweetener for Lemons,” written before the crisis, argued persuasively that an important reason the securitization and CDO market can function well is that it helps solve the lemons problem.9 Bundling mortgages into securities that are evaluated by independent rating agencies, and dividing up a company’s securities into tranches that allow specialized evaluators to do their job, efficiently lowers the risk to investors of getting stuck with lemons. They should be able to trust the higher-tranche CDOs more than any pool of mortgages or any share in a complex and difficult-to-understand mortgage-lending institution. So there was a valid theory as to why the splitting of securitized mortgage debt into tranches was a good idea. Of course it turns out not to have worked superbly well in practice, but this is largely because of the erroneous assumption noted earlier—that everyone, including the rating agencies, thought home prices just couldn’t fall. That mistake, and not any flaw in the logic of Claire Hill’s theory, was the real problem.
Other financial professionals respect traders; they consider them a breed apart and often consult them for their insights in important decisions. That traders should have such expertise in no way contradicts the notion that markets are basically efficient. There is no respectable theory according to which there is not a normal return to be had in trading. Trading is a necessary activity for a market economy, and so there should be a normal return to expertise in trading.
prices.15 Futures market prices of single-family homes for ten U.S. cities—Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco, and Washington, D.C.—as well as a market for an aggregate index of all ten of them together were launched at the CME on May 22, 2006. Options on futures were also offered at that time.16 We had every reason to think that these markets would be fundamentally important, for real estate was a significant risk for which there were at the time no risk management vehicles. I
They fail to realize that expanding the scope of our financial trading is in its essence a route to democratizing finance—by making financial markets more representative of and responsive to our needs—and thus to advancing the central objective of the Occupy Wall Street movement. As we have seen, markets—and the people who make them and trade in them—are the vital link that allows financial capitalism to respond to developments in the larger society. It is through markets that we appreciate the value of that which is traded and, in many cases, have a sense of larger trends in our world. We need traders and market makers if we are to transform and improve our system of financial capitalism.
Most people simply do not appreciate what insurers offer, for the total value of the services they provide can be hard to grasp. In this respect the news media seem to see tragedy in the wrong places. Take for example the 2010 BP oil spill in the Gulf of Mexico, when the Deepwater Horizon oil rig exploded and spilled oil into the gulf for three months. The news media described this as a greater tragedy than it was, disregarding that much of the loss was insured. In fact the truest tragedy here was the initial loss of life, including the eleven crewmen who died in the explosion. No insurance policy can bring back life. But the other tragedies of the spill could be—and largely were—dealt with by insurance.
If risks are shared appropriately and comprehensively, then, in the BP example, the clearest economic impact on happiness—on what economists refer to as utility—might come from the ultimate effects on the world economy of the loss of oil. A small part of the world’s oil reserves has been wasted, and so the world might run out of oil, say, a few days sooner a century hence. But no—the impact is more abstract than that, as the world will never actually run out of oil. As supplies are depleted, the price of oil will be forced up to encourage economizing and also create an incentive for the development of alternative forms of energy, which will phase in as oil supplies wane. Therefore such an oil spill, in a world with complete insurance, means only incrementally higher prices over the next century—a fact of life that society will certainly learn to tolerate.
The first imperative is to get a far broader segment of the public covered by existing, well-understood policies. For example, the fundamental tragedy of the Haitian earthquake of 2010, even including the loss of life, was that few buildings were insured there. This meant not only that there was no compensation for damage but also that there had been no insurance companies overseeing building codes in years past—a practice that certainly would have reduced damage and loss of life. The Caribbean Catastrophe Risk Insurance Facility had since 2007 tried to establish better property insurance practices in Haiti, as well as other countries in the region, but it had made little headway when the earthquake of 2010 struck.
This magnitude 7.0 earthquake caused at least fifty thousand deaths. In contrast, the magnitude 6.7 earthquake in Northridge, California, in 1994—similarly significant in its proximity to an urban center and in its effects—resulted in only thirty-three deaths. The much better developed insurance industry in California as compared to Haiti is a major part of the explanation for this discrepancy.
A new kind of insurance, long-term catastrophe insurance, which effectively insures against the risk that risks will increase, is an innovation we can expect to see in the future.
There is a clear need for home equity insurance (which insures people against a drop in the market value of their homes) and, as we have seen, livelihood insurance. These seem no closer to reality today.
There was also, in 1940, no exchange anywhere in the world for the trading of options, so there was no way even to know whether the price a broker quoted was indeed a market price. The first options exchange, the Chicago Board Options Exchange, did not open until 1973. The lesson is again that our financial system is not nearly a finished product. If traders in 1940 had no mathematical theory whatsoever for options, but were trading them every day nonetheless, it is indeed unlikely that our financial markets have reached perfection today.
If we move to a world in which people have access to better financial advice, then the options market could move closer to the ideal market initially envisioned by theorists like Kenneth Arrow and Stephen Ross. The market might even expand further in its usefulness, by aligning itself more squarely with the real interests of real people. Options could be created that represent genuine, personally significant risks to individuals, like the risks of a decline in home prices or a decline in career incomes. This would make derivatives such as options, even more clearly than they are today, instances of finance in the service of the good society.
There are enormous differences across countries in the number of lawyers per capita. Among countries for which data are available, the country with the highest number is Israel, with one lawyer per 169 people. Brazil is second with one lawyer per 255 people, and the United States third with one per 273 people. Next in line are various advanced European countries. At the other extreme are various Asian countries, with Japan at one lawyer per 4,197 people, Korea with one per 5,178 people, and the People’s Republic of China with one per 8,082 people.1 There are nearly fifty times as many lawyers per capita in Israel as there are in China!
Government subsidy of financial and legal advice can be justified on the basis of the externality provided by having a society that functions well, without some feeling that they are excluded from the financial world and later finding themselves punished for their mistakes.
Most people can’t afford heart surgeons when they need them either: that is why we have government subsidies of health insurance for low-income people. It is commonplace for governments to subsidize medical advice. We can see—especially in the financial crisis that continues as of this writing, particularly in the United States—that many people have made errors in the purchase of their homes and the selection of their mortgages—errors that could have been prevented had they had proper financial advice as well. Avoidance of a financial crisis such as the one in which we now find ourselves offers a perfect example of the kind of externality that justifies government subsidy of financial, as well as legal, advice for everyone.
But even so, legal and financial advisers who sat down with their clients and patiently talked through the issues would most likely have reduced the extent of the errors that so many made just before the crisis erupted, such as thinking that they should buy the biggest possible house, or even two houses. When one borrows a large sum of money to make an investment, one leverages the risks, as only a small drop in the value of the investment can wipe out the investor—and any competent adviser should know this. Advisers are trained to see the full array of possible investments and to have better knowledge of the risks inherent in leverage. The further development of legal and financial advisers, including government support of their services to clients with lower incomes, will also create a different culture in our society. It will foster an expanded public discourse that might in turn help change the conventional wisdom, and better connect the knowledge base with the real problems people face, as well as make it more timely and relevant. The more people have access to those with useful knowledge, the more intelligent will be our approach, as a society, to financial capitalism.
Just as in sports, people in business want referees who will enforce the rules. Everyone has an interest in the game being fair. The fact that players try to push the limits of the rules or argue with referees doesn’t mean they don’t want them. In the same way, businesspeople very much want regulators, for regulations imposed on all players do not generally work to their individual disadvantage—quite to the contrary, they typically work to the advantage of all. Without effective rules one is forced to do things that one finds personally questionable to stay in business. That is why businesses set up their own self-regulatory organizations, which impose rules that are usually (though, to be sure, not always) in the public interest.
Milton Friedman, following his 1954 study with Simon Kuznets of occupational incomes and regulation, made a strongly worded argument against regulation, particularly occupational licensing, in his 1962 book Capitalism and Freedom.1 He thought regulation was little more than a cynical ploy to limit the supply of services so as to keep their prices high. Friedman’s book turned out to be very influential, creating a measure of public distaste for regulation. His University of Chicago colleague George Stigler carried the theme forward, writing in 1971 that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.”2 Stigler believed that the principal goal of regulation, whether government regulation of an industry or self-regulation by the industry itself, is to deny entry to competitors.
The Friedman complaint was taken up again by other University of Chicago economists, Raghuram Rajan and Luigi Zingales, in their 2003 book Saving Capitalism from the Capitalists. But now the argument is more nuanced. Rajan and Zingales recognize the need for appropriate regulation in many places and also believe that society can exert oversight over regulators to help prevent their capture by private interests. It isn’t that we need “more” or “less” regulation, but that regulation must not be commandeered by selfish special interests, and that it needs to be done right.
Accountants have to determine what is important to remember, to document, to publish. The term bookkeeper—with its suggestion of dusting off old documents in a basement archive—gives a misleading impression of what they do. Their responsibilities are far more central, for they are essential to the stewardship that should be the central mission of our financial institutions. Responsible for storing essential information, accountants are upholders of consistent moral standards, since consistency of standards is a prerequisite for remembering commitments and details. They must have a strong sense of their own standards. They tend to be hired by those who want or need to prove to others that they are honest—but who sometimes behave as dishonestly as possible within that constraint. This fact creates a moral challenge for accountants, a major theme in their everyday lives. But the best, and over time the most successful, in the accounting profession are those who embrace this moral challenge.
There is necessarily a degree of conflict of interest between the CEO and the accountant—a conflict that is built into the very model of the modern organization. The CEO is supposed to be a visionary, looking to the future. The accountant remembers commitments and resource limits, with an eye to the promises of the past and the realities of the present.
Accountants are responsible for ensuring that financial appearance matches reality, and it is ultimately through their efforts that we trust our businesses enough to find it motivating and even inspiring to work for them or invest in them.
Errors by educators in recent decades seem to have played an important role in the severe financial crisis that began in 2007. In particular, the efficient markets theory was oversold to students, and this helped contribute to the formation of speculative bubbles. Many teachers seemed to inculcate the extreme view that markets are perfectly efficient. From this view many of their students drew the conclusion that it hardly matters ethically what one does in business, since nothing one could do would ever disturb this magnificent equilibrium.
The first such school was founded at the University of Pennsylvania in 1881, and the first graduate school of business (offering a master of science in commerce, essentially today’s masters of business administration or MBA) at Dartmouth College in 1900. No other country followed suit until Canada’s University of Western Ontario did so in 1951, half a century later.
It was at first called the Wharton School of Finance and Economy, a name that has since been shortened to the Wharton School. It was dedicated to teaching business as a noble calling. According to an 1881 summary of its prospectus, its purpose was “to inculcate, among other things, the immorality of acquiring wealth by winning it from others rather than by earning it through service to others.”2 Here Wharton was on to a fundamental truth about finance: it is not, and should not be, merely a zero-sum game, but rather an adjunct to, and a means toward, a productive life.
It is in school—starting with the education of children and teenagers, and leading next to undergraduate programs and MBA, JD, and PhD programs—that young people have their only real, unhurried opportunity to examine the underpinnings of their future professions, to talk to others unhampered by nondisclosure requirements and professional loyalties. This is where the moral decisions that will guide later life are really made, and educators have a responsibility to see that they are made well. There is unfortunately a so-called agency problem, particularly in our colleges and graduate schools, where academic faculty often see themselves as having no purpose other than to train scholars like themselves. Their teaching may become too focused on the frontiers of research and on research methods, rather than on preparing their students to be participants in the real-world practice of financial capitalism.
Public finance, the financing of public goods and causes, is curiously considered a very different profession from “straight” finance. Courses in public finance at the university level are generally offered in the economics department, not the business school, and it appears that the professors in the two fields rarely talk to one another. Communications between the fields seem to be improving, and recognition is growing that they are, or at least ought to be, closely related. They deal with essentially similar problems, differentiated by the fact that public finance confronts a special “public goods” problem.
The fundamental problem for public finance is that public goods are not naturally provided in a free-market system. A public good is an economic activity that automatically benefits the public, including all those who choose not to pay for the activity. Roads and scientific knowledge are public goods, as are clean air and cities free from crime. If one thinks the air is not clean enough, or that the streets are still too dangerous, one cannot go to a store and buy these things for oneself. The provision of these goods has to be public, the result of a collective decision to embark on certain costly activities.
A problem with public goods provision is that information about what can be done is neither visible nor comprehensible to most voters. A candidate for public office extolling some new plan to clean the air or reduce crime will be met with incomprehension by most individuals. They might know how much cleaner they would like the air to be and how much they would pay for that, but such awareness does not translate for them into specific knowledge of how they should vote on the issues.
Most individuals do not have the imagination to conceive of what might possibly be done. They tend to have some understanding of public goods already provided, for they observe their benefits. But they are unlikely to have any sense of what to do next.
A key idea underlying effective public goods finance is that it does not have to be the government that comes up with ideas for public goods through a political process, and it does not have to be candidates for national office who dream up such ideas. The Reconstruction Finance Corporation listened to ideas from the private sector and actively sought private-sector advice. And the strategy worked: even in the midst of the Great Depression, almost all of the loans it made to private businesses were repaid.
Another key idea is that the government can finance organizations of individuals rather than hire single individuals as employees of the government. In that way, expenditure on public goods is entirely analogous to expenditure on private goods, except that the customer is the government.
Bush had clear ideas about how government should facilitate the advancement of science. Grants should be made to organizations outside the federal government, which should never operate its own laboratories. Decisions to award funds would be made not by bureaucrats but by real scientists, outside the government, who would volunteer to evaluate research proposals.2 The National Science Foundation would thus operate more like an investor in a venture capital firm, specializing in science, than a typical agency of the government. The foundation would provide the funds that would enable risk management and incentivization, but beyond that, market forces would be allowed to operate. Bush’s model has been a spectacular success, and it has been copied by virtually every developed country in the world.
Financial capitalism is far from a perfect system, and one of its fundamental problems is that it is vulnerable to booms and busts, recessions and depressions. These events have happened so many times in the past that one can predict with certainty they will happen again. So it is widely appreciated that we need policy makers whose duty is to counteract such instabilities and reduce their impact. But preventing these episodes presents a difficult problem: the reasons for them have never been well understood. The causes of economic booms or busts are multifaceted, and understanding them requires human judgment—judgment of people’s motives, of their patterns of thinking, and of the changing political climate.
There has long been hope that forecasting and stabilization of the economy can be reduced to a science. To a significant extent this hope has been fulfilled: there is a science of economic forecasting. My own research with Ray Fair, the author of FairModel, an econometric model of the world economy, confirms that his and other prominent models of the economy do have some ability to forecast. The model makers have learned how to extrapolate economic data, and moreover their models do more than just extrapolate plots of data: their underlying economic theory appears to be sound as well.
As Walter Bagehot, then the editor of The Economist, put it in the 1896 edition of his book Lombard Street: A Description of the Money Market: “Credit—the disposition of one man to trust another—is singularly varying. In England, after a great calamity, everybody is suspicious of everybody; as soon as that calamity is forgotten, everybody again confides in everybody. . . . The Bank of England is bound, according to our system, not only to keep a good reserve against a time of panic, but to use that reserve effectually when that time of panic comes.”4 The job of trying to manage such things as suspicions and panics is inherently difficult for anyone—more akin to the work of a psychotherapist than a scientist or an engineer. It is a fundamentally human task—so much so that it is very difficult to conclude in hindsight whether the task has been done well or to draw really useful lessons for future interventions.
This total failure of central bankers to anticipate the crisis is related to the politically involved nature of their jobs, the importance of political judgment to their jobs, and the difficulty political forecasters have always faced. The bankers, being professionals, no doubt wanted to avoid sounding any alarms until they had objective evidence—but what evidence there was of a coming crisis required personal intuition to judge, and there was no politically correct consensus that would have encouraged them to use such intuition publicly. Forecasting the crisis would have required making judgments about such things as the wishful-thinking bias that led to the housing bubble, the moral lapses that many leaders showed in failing to criticize the bubble, the political reasons for the failure of regulatory authorities or securities raters to confront the bubble, and the convenient opportunity the bubble gave to politicians to make use of the “let them eat credit” strategy (to use a term coined by Raghuram Rajan after the collapse of the economy) to deal with worldwide rumblings of discontent resulting from increasing social inequality.
Starting with the Great Depression in the 1930s, the idea took hold that government policy makers need to stimulate the economy from time to time, when central bank policy has proven inadequate, by means of appropriate fiscal policies, that is, by cutting taxes, raising government expenditures, or both. Such policies were called “pump priming” during the Great Depression, the analogy expressing a wish that a little fiscal stimulus might make a big difference to the economy. The problem with this notion—discovered during the Great Depression and again in the economic crisis of the 2000s—has been that while it seems easy to cut taxes, cutting taxes without cutting expenditures increases the national debt. If the depression continues for a number of years, the burgeoning national debt becomes a concern, and the public is likely to call for a period of fiscal austerity—a possibly premature reversal of the stimulus.
In theory the economy may be boosted by a balanced-budget stimulus, increasing both taxes and expenditures by the same amount, so as not to increase the national debt. Economists in the 1940s asserted that the “balanced budget multiplier” was equal to one, at least when interest rates were stuck at rock bottom, as they were in the Great Depression and are in the United States today. That means that GDP goes up dollar-for-dollar with the increase in government expenditures. But the problem here is that the tax increases weaken the impact of the fiscal stimulus, so that the policy effect is not so much “pump priming” as it is “commandeering.” If one wants to boost the economy with balanced-budget expenditures, one has to use a lot of such expenditures. Then there comes the problem of finding suitable causes on which to spend the government money. It is very difficult to come up on short notice with quality government expenditure projects on a large scale—projects that can also be fairly quickly shut down if the economy improves.
In 1941 the U.S. government formed the Public Work Reserve, which was to create a “shelf” of high-quality, turnkey public works projects that could be started any time the economy faltered. According to a 1943 analysis of its operations by Benjamin Higgins, the control of that organization was divided between several agencies, and “a struggle for control developed in which the agency that established jurisdictional rights turned out to be the agency which had no funds to continue the project.”13 The operations of that agency were also inhibited by the distractions of the war itself, and it was disbanded in 1942, its responsibilities distributed among other agencies, and soon forgotten. The short life of the Public Work Reserve does not necessarily prove that such a program could not be a success. We need agencies that are more forward looking, as the National Science Foundation has been. Martin Shubik has proposed re-creating something like the Public Work Reserve in a new form that he calls the Federal Employment Reserve Authority.
We ultimately cannot completely prevent major economic fluctuations with monetary or fiscal policy, but we can still lessen the impact of those fluctuations on individuals by setting up appropriate financial institutions. These are known as automatic stabilizers—institutions that relieve the policy makers of the burden of making politically difficult stabilization moves.
In the future, such automatic stabilizers should, and probably will, take many new forms. There could be insurance policies against declines in home prices or home equity, which would protect homeowners against declines in the value of their homes, or there could be risk-managing forms of mortgages like the continuous-workout mortgages that I have proposed.15
Governments should issue shares in the nation’s GDP or other similar measures of its economic success.16 This would be like issuing equity—shares in the nation’s economy—rather than debt. Thus debts would be made more flexible, and the repayment of debts would become more contingent on economic outcomes. For example, the GDP-linked bonds would automatically become less onerous to the government in an economic crisis. Countries could issue shares in their GDPs to investors around the world. If one share was equal to one-trillionth of total GDP, these might be called “trills.”17
Our ability to insulate people from the vagaries of booms and depressions still seems to be one of the most imperfect aspects of our financial system. A good part of the reason why we have found it so difficult to manage such instabilities is that they arise from a higher-order system, a complex system that involves people and their emotions. People must be incentivized to do good work, but such incentivization, by reason of its emotional component, becomes hard to design to perfection. One cannot do controlled experiments with national economies to learn their dynamics. But we must do the best we can, developing a better understanding of the instabilities in a modern financial economy and being as creative as possible in our application of this understanding.
In contrast, in Europe (where share ownership has traditionally been less dispersed), corporate boards have less to fear if they interpret their duties more broadly than making money for shareholders.3 Institutional structures encourage less focus on shareholder value. In Germany, for example, the supervisory board (Aufsichtsrat) of a corporation must by law, in most kinds of companies, have members representing labor, and boards often include representatives of labor unions.4 Surely such boards will be less focused on maximizing shareholder value.
There is of late a movement under way in the United States to persuade state governments to create what is envisioned as a “fourth sector,” comprising a new kind of corporation—called a benefit corporation—that includes in its charter acknowledgment of some broader cause, beyond simply making a profit. A benefit corporation is not legally obligated to maximize return to shareholders and so does not need to worry about lawsuits from those shareholders if it does not single-mindedly pursue profits. The articles of a benefit corporation may stipulate a specific public purpose, which would make these corporations more clearly publicly oriented than are European corporations. A benefit corporation does not enjoy the tax advantages of a nonprofit. To date seven U.S. states have passed legislation to make possible these corporations. Maryland was the first, in April 2010, followed by Vermont, New Jersey, Virginia, Hawaii, California, and New York. Still more states have legislation pending to enable them.5 This seems a healthy development, for many investors in private companies really do not want them to pursue profits single-mindedly.
This is not to say that a nonprofit does not make profits. It simply does not distribute them; it keeps them in its endowment for the furtherance of its causes. Many nonprofits find themselves really trying to make a profit as they compete alongside often similar for-profit organizations. They may even start to look very much like the for-profits. But they are fundamentally different because they exist to serve an institutional cause rather than the individual causes of their owners, and so their organizational identity can have a stronger element of corporate idealism.
Universities sometimes amass huge endowments from their activities. To what purpose do they put them if they never spend them down? One argument is that the endowment is a buffer, to be used in emergency situations. But, as economist Henry Hansmann has stressed, most universities typically have not drawn down their endowments—not in any historically known contingency.10 The severe financial crisis that began in 2007 did not cause universities to spend any substantial amounts of capital from their endowments; instead they tended to curtail activities. This accumulation of endowments for no apparent purpose is the institutional counterpart of individuals accumulating wealth far beyond their ability to benefit from it. Indeed it seems at least in part driven by some sense of immortality. By maintaining a large endowment in perpetuity, a university is able to appeal to alumni donors, who see their own mortality and look to the university as a means of transcending it.
Seeing the futility of amassing large fortunes, most people choose not even to try. Many choose another kind of benevolent behavior that is akin to philanthropy: they enter occupations that are relatively low paying but that give them the satisfaction of helping people and seeing the results directly. Teachers and nurses are obvious examples, but one might argue that most people’s jobs are philanthropic in this sense.
People who amass large fortunes have to plan to give it away, whether to their children, to friends or relatives, or to philanthropic causes. There is no other sensible end to their story. But that ultimate disposal of the fortune should not be just an afterthought for them. There is a natural mission for a person who amasses great wealth. The kind of person who is able to earn a fortune in business is also most likely well suited for managing philanthropic endeavors.
It is not that those successful in business are necessarily smarter than other people. In fact they may be relatively insensitive to the real needs of the poor and, because of their specialization in business, to many intellectual pursuits as well. It is rather that they are specialized in a particular kind of intelligence: the ability to put human talents and business opportunities together. This same talent can and should be used for human benefit.
Carnegie’s article was a theory of capitalism as an arena for competition: the business world is a stage for “survival of the fittest.”5 Those who are most fit in practical managerial skills will tend to rise to the top and become wealthy. But for Carnegie it is not simply a vicious Darwinian competition, for a moral duty stands over it. The moral duty of the winners in the economic struggle is to retire from their business careers when they are still young enough to retain the skills that got them where they are, and to begin managing the disposal of their wealth for the public good.
Philanthropy often seems to be egotistical—but of course much of it is. There is a generous side to human nature, but it is not the only side. Yet it is still philanthropy even if the donors insist on putting their names on it and enjoying the rewards of earning a reputation for generosity. One comes to the realization that the satisfaction great wealth might bring lies almost entirely in enhancing one’s own self-respect, and hardly at all in either the consumption of wealth or the gratitude or admiration of others. A newly wealthy person has most likely already received praise for his or her many achievements, from a distance, from relatives and associates, and the actual making of the money is only the last in the long string of those achievements. These same relatives and associates are unlikely to know much about, let alone praise, the individual’s philanthropic contributions. After the initial thrill, wealth provides at best a lonely pleasure, and each discovers for him-or herself that it brings neither fame nor friendship. Contemplating one’s wealth may in fact lead to an empty feeling.
In the end, for all of us who strive to achieve, whether in business or in other walks of life, the end of life is a disappointment. The personal pleasure over a lifetime was mostly in the striving and in one’s friendships and interactions. The pinnacle of achievement does not bring happiness, but at best the reflection that the striving achieved some benefit for others, unappreciative and unrelated though those others may be.
The discovery of a mathematical law to describe the price of a stock option in terms of the price of the underlying stock (as exemplified by the famous mathematical formula derived by Fischer Black and Myron Scholes) is an example of a conservation law in finance.4 The option price is driven by exactly the same shocks as affect the price of the underlying stock, but with a nonlinear transformation of effect, a transformation that is at first challenging to comprehend but that, upon sufficient reflection, seems almost obvious. The same kind of conservation laws can be found throughout the field of financial derivatives pricing.
As another example, our faith in efficient markets seems to have given rise to the notion of Ricardian equivalence, as expounded most notably by Harvard economist Robert Barro, refining the work of nineteenth-century economist David Ricardo, who had suggested the concept over a century earlier.6 The principle is that government deficit spending to stimulate the economy is in a sense a trick, for savvy taxpayers will know that any such expenditure needs to be followed by increased taxes to pay back the debt. A simple mathematical expression called the present value relation equates the future tax increases to the present stimulus. Here again there is a conservation law at work, and one of some value—though of considerably less practical value than many economists perceive. There is a very human tendency to be a bit too attracted—perhaps distracted—by the symmetrical and the beautiful. The conservation laws of finance are only as valid as their underlying assumptions, and their applicability to real-world phenomena has been overrated. And yet the sense of beauty pervading the theory, tempered with reality, remains part of the satisfaction for practitioners of this or any other science.
People naturally categorize other people, and we place them into groupings that take on exaggerated significance in our imaginations. We tend to think that those in careers other than our own are fundamentally different kinds of people. Personality and character differences are indeed somewhat associated with occupations. But this overly strong tendency to categorize people is related to what psychologists have dubbed “the fundamental attribution error.”1 It is a known fact that we tend to attribute the behavior of others to personality differences far more often than is warranted.
Rather it is that the very same person could be either on the picket line or on Wall Street, depending on personal proclivity or historical circumstance. This may not be the world about which young artists, philosophers, and poets fantasize, but it is reality—and a reality we must learn to accept. Self-promotion and the acquisition of wealth, whether by financial or other means, is no crime. In fact, some of our greatest human achievements have their origins in just such behavior.
Apparently there has been some evolutionary advantage to such deliberate risk taking. Schultz and his colleagues speculate that the dopamine signals in a time of uncertainty trigger attention and learning responses in the brain that are appropriate to the situation. But there is a side effect of these signals. The mere presence of uncertainty in a positive direction creates a pleasurable sensation, and so the reward system creates an incentive to take on risky positive bets. Maybe that side effect is also advantageous from an evolutionary point of view. It helps people not just to focus on the predictable and the known but to be visionaries. This human tendency helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.
But sensation seeking is not directly a desire to make one’s lifetime well-being uncertain, though it can have that consequence. A well-designed financial capitalism should allow outlets for sensation seekers, in the form of stimulating opportunities, while at the same time making it possible for people to avoid meaningless uncertainty. Risk management needs to be a fundamental principle in our financial system, even though many people will ignore or try to circumvent it.
Standing in opposition to the impulse for risk taking described in the preceding chapter is a nearly opposite impulse for conventionality and familiarity. This impulse can take many forms, but for our broad purposes here it is important to consider how it can push people toward reliance on old-fashioned financial institutions and outdated economic structures.
The invention of insurance, in its simplest forms, likewise goes far back into ancient times, but the first modern forms of insurance did not recur until the seventeenth century. Even so, well into the twentieth century most people in developed countries still did not have either life insurance or fire insurance. Most people in less-developed countries are still not adequately insured.
The amortizing mortgage—in which the borrower pays the same amount each month, and, after a specified number of months, is done paying and has no more principal to repay—sounds like a very simple, commonsense concept. Such mortgages have an advantage in that the borrower does not have to have the foresight and self-discipline to accumulate the money to pay off the principal when it comes due. But amortizing mortgages did not become well established in the United States until the government stepped in to encourage them, well into the twentieth century.1 Inflation-indexed bonds were invented in the eighteenth century, but there were virtually no issues of them until the second half of the twentieth century.2 Even today most people do not appear interested in replacing their fixed-income investments with inflation-indexed ones, let alone in adopting some more complex investment vehicle that is tailored to their particular risks and designed to share these risks effectively.3 The first mutual fund—an investment vehicle that treats all participants equally and that is transparent about its methods of investing—was set up in the 1920s. But mutual funds did not become a significant part of the market until the late twentieth century. Progress is certainly made, but fundamental progress in finance seems to be measured in lifetimes rather than years.
This slowness to innovate has to do with our difficulties in handling basic financial concepts, which are unfamiliar abstractions, and our reliance instead on the familiar concepts that are already built into our thinking.
The philosopher John Locke, in his 1690 work An Essay Concerning Human Understanding, discerned a human tendency to err in “taking words for things.” He noticed that we tend to imbue concepts that are associated with words in our language with an objective reality that causes us to exaggerate their importance. When concepts are dignified by a word, they start to seem “so suited to the nature of things that they perfectly correspond with their real existence.”4 Opinions, once given names, seem more than opinions; they seem to take on an objective and tangible reality, so much so that they make our thinking more rigid. This human tendency, Locke believed, encourages schools of thought, which in turn encourage an obstinacy in thinking that is related to the language of the particular schools of thought.
The names of political parties or approaches to philosophy seem to reflect an objective, not just a transient human, reality. But the names and slogans of political parties in other countries seem baffling to us. So too do the names of financial instruments. Innovative financial instruments often seem to be tied to the culture of one country; thus we have securitized mortgages in the United States and, in a somewhat different form, covered bonds in Europe. From the U.S. perspective, covered bonds seem inscrutable—in the same way securitized mortgages do to those in Europe. Psychologist Paul Bloom refers to such a tendency as “bad essentialism.”5 The brain categorizes things by their presumed essentials, and concepts are filed away with these essentials as filenames—making it very difficult for the mind to avoid taking these presumed filing categories as essentials in every respect. The dominance of word and metaphor in our thinking has been an important object of inquiry for the field of linguistics.6
The scientist Simon Newcomb noted the confusions related to the word (or metaphor) money in 1879. Remarking that people tend to measure wealth in terms of currency units, such as dollars, even when the buying power of the currency unit in terms of commodities swings wildly, he noted that “Even when the facts are understood, the idea that the change is in the value of the commodities measured, and not in that of the dollar itself, is so natural that a long and severe course of mental discipline is necessary to get rid of it.”10 As a result, people seem to strongly prefer contracts denominated in currency, and thus lay themselves open to financial disaster should the value of the currency swing widely. They show relatively little interest in inflation-indexed bonds, wherever they are offered, substantially because of the “taking words for things” phenomenon and the resulting belief in currency as a standard of value.11 Throughout history hyperinflations have repeatedly wiped out the value of bonds into which people put their life savings, and yet most of them never learn, at least not for more than a generation. The 1923 hyperinflation in Germany—which virtually wiped out the real value of all bonds and contributed to the social unrest that brought Hitler to power—left a generation or so of Germans strongly opposed to inflation, but by now that resistance is fading among younger Germans.12
example, the rent on one’s apartment is likely to be quoted in UFs, and so there are no fluctuations in its real value. Every month one pays a different amount in pesos. It makes sense to do this, but in most countries of the world apartment rents are quoted in currency units, and so the real value of rents declines steadily with inflation for a while until the landlord takes the painful step of announcing a rent increase in currency units. Thus, in most countries, the real value of apartment rents describes a sawtooth pattern through time, an absurdity that reflects problems with our language. I have argued that something like the UF should be adopted all over the world, and with a simpler name.14 I would call consumer price index units of account baskets to refer to the market basket of consumer goods and services that statisticians price each month to produce the consumer price index that is used to measure inflation. People would then understand that, for example, when their rent is quoted in baskets, they are in essence paying with a fixed number of real baskets of goods and services that matter to them, and not in terms of some arbitrary and unstable unit. With modern electronic technology, it ought to be possible to make payments directly in baskets without even bothering to look up the exchange rate. There could also be other kinds of units of economic measurement, representing consumer prices for subgroups of the population (such as the elderly), or representing income flows, or for the special purpose of wage setting.
One would think that debts should be tied to a variety of economic outcomes, not just the inflation rate, from the start. Debt should be flexible, should respond to economic circumstances. For example, mortgage borrowers should have, in the initial debt contract, a preplanned workout. The continuous-workout mortgage that I have proposed would specify changes in the terms of the mortgage in the event of an economic contraction or a fall in home prices.15 We would probably not have experienced the financial crisis of 2007 if such mortgages had been the norm. But few attempts have been made to implement anything like them. One reason is that people have a strong cultural tie to the simple notion that one should promise to repay another in the simplest possible terms when viewed from the perspective of our existing language.
Yet all of these biases can be reduced if we introduce new words, and new units of measurement, to help shift patterns of thinking. Such seemingly inconsequential matters as changes in wording must actually be part of how effective financial innovation proceeds.
The declaration is well intentioned. But it neglects to consider how these activities will be financed: who will pay for them and what should be the economic situation of those who pay. The declaration does not build in any flexibility or compromise. The rights that people have ought instead to be defined in terms that respect the well-being of all people, in terms more carefully crafted to represent the concerns of all segments of the population. Social security systems around the world defend the rights of the elderly—usually without regard to the situation of the working people who must pay for those entitlements. The right to a standard of living in old age is framed in an absolute manner, and so the provision of pension benefits becomes stuck in an ancient system. Government pensions should instead be indexed to some indicator of taxpayer ability to pay, such as GDP, but this is rarely done. This and similar policies would promote intergenerational risk sharing, allowing people of all ages to share the major risks to our society, without piling those risks onto any one generation.17 But reliance on conventional entitlements works against such risk sharing.
First of all, as discussed in the previous chapter, people—individuals and to a significant extent those in corporations and governments as well—seem to blandly accept the kinds of credit vehicles that are put before them by salespeople, and that have been sanctified by conventional wisdom or popular opinion. As discussed in Chapter 10 on lawyers and financial advisers, most individuals do not usually have experts available to help them with such decisions. Financial engineers—who might help reduce the problems associated with leverage—are by and large not listened to in public policy discussions. So people often find themselves faced with serious leverage problems.
To behave rationally, in accordance with theory, those involved in financial decision making must keep in mind the long-term wealth management problem: initially borrowing, then eventually tapering off their borrowing and saving enough wealth, given interest rates, to provide a good long-term outcome.
Yet individuals, as well as businesses and governments, often have difficulty in fully understanding—at least before a crisis develops—that when they borrow heavily they become leveraged, so that any otherwise small problem becomes magnified by the debt. If debt becomes too large relative to resources, there is a “debt overhang,” which inhibits any form of positive action. People, and firms and governments as well, feel pinned down by their debt. Few of the individuals presented with this problem have the quantitative skills to understand and resolve the underlying issues without the help of financial advisers.
In Europe the problem of excessive government debt in some countries was compounded by European bank regulators, who imposed zero capital requirements on banks’ holdings of euro-denominated government debt. This regulatory decision meant that government defaults could also bring down banks. Why did the regulators decide that government debt was riskless? Probably they did not really believe that, but they did not want to disturb confidence by signaling their concerns through capital requirements. It was a case of burning the bridges behind us to force ourselves to keep marching ahead: a sense that they did not want to destroy confidence by calling attention to risks. Moreover, almost no one was paying attention to the problem, and, given the social basis for human attention, it was natural that most people would simply not think about debt overhang. These are powerful psychological motivations not to fix the fundamental problem, and as of this writing European banks still have zero capital requirements against euro-denominated government debt, although a new temporary capital buffer has been imposed, and a European Banking Authority was created in 2010 to impose new procedures to evaluate banks.
The outcome of the crisis is still not apparent as of this writing, but it is clear that it has had the potential for major repercussions. The crisis may result in the fragmentation or loss of the euro, the very name of which had come to symbolize European unity. The loss of that symbol may indeed be disastrous in the long run, given the human tendency to take words for things.
The same pattern is seen when one compares countries. In a study of sixteen countries, those that saw larger increases in leverage from 1997 to 2007 tended also to show larger increases in home prices. Moreover, the countries with larger increases in leverage during the interval 1997–2007 tended to show larger drops in consumption expenditure in the depths of the crisis, the years 2008–9.4 Clearly a leverage cycle was at work on a global scale in producing this financial crisis.
The economist Irving Fisher wrote in 1933 that a cycle involving leverage was the major factor leading to the Great Depression of the 1930s.5 When prices fell after 1929, the real values of all debts were magnified. This change benefited creditors at the expense of debtors, but the net effect was negative. The augmented debt overhang led to cutbacks in expenditure that persisted as long as did the overhang problem.
Recently economic theorist John Geanakoplos has expanded on Fisher’s theory; he argues that although there has not been significant deflation during the severe financial crisis that began in 2007, the crisis is indeed well thought of as a debt overhang problem.6 When people’s debts exceed their assets, many problems are created for the economy: Geanakoplos lists nine troubling “externalities” caused by the debt overhang. These include troubles in the construction industry, setbacks for small business, rising inequality, loss of productivity, and damage to collateral.7 Thus there is a clear role for government regulation of leverage.
There is a legal concept according to which not all debt is evil, only so-called odious debt: debt that does not originate in free and informed contracting between the parties, or debt that is not managed in a humane way. For example, in the United States in the years leading up to the crisis that began in 2007, excessive mortgage debt was cynically issued to low-income, ill-informed families, who were not told of its consequences. This debt may be considered odious, and it may therefore give the debtors some later moral claim to help with their predicament. If a country with a dictatorial government borrows money without any implied consent by its public, and does not use the money to benefit the public, then a subsequent government can disavow that debt as fraudulent and not binding on the new government. Unfortunately there is as of now no international body that defines in an orderly manner which debt is to be considered odious.
Economists Seema Jayachandran and Michael Kremer have argued that an international authority like the United Nations should declare the future debt of certain governments—governments that it might wish to punish for unacceptable behavior—as odious. These measures would make it harder for them to borrow, even from lenders who themselves had no scruples, since the lenders would have no moral authority to demand repayment from a successor government. Such sanctions will be less easily evaded, Jayachandran and Kremer argue, than the conventional trade sanctions typically used today to influence rogue governments.8
In ensuring that more debt is salubrious rather than odious, and that debt is used to solve basic human problems, financial regulators face a long road ahead. Achieving this state of affairs will mean encouraging financial innovation that allows debts to be defined more flexibly, as in the continuous-workout mortgage or the GDP-indexed national debt described earlier, or other indexation schemes that really work in the interest of the borrower. Achieving better management of debt and leverage—more enlightened debt—will require a change not only in the lending institutions themselves, but also in the way they hedge, securitize, and bundle debt.
Part of the answer has to relate to the impulse for risk taking described earlier, which is context specific. The casino context is expressly designed to deflect attention from the reality of the actual gamble and to place that gamble in a context that encourages risk taking. Casino operators are usually not psychologists, but they experiment with different settings, and they replicate anything that works for them. They tinker with many seemingly minor details of the gambling environment—things that one might not even consciously notice, but that affect the willingness to gamble. Survival of the fittest among casinos has resulted in casino environments that are exquisitely designed to overtake risk aversion. Casinos arrange their environments in certain particular ways, some of them very obvious, to lower inhibitions. They freely serve alcohol. They also cultivate the notion that those who frequent the casinos are rich and successful. This confuses some people, who lose sight of the reality of their repeated losses at the tables.
Psychologists Joseph Simmons and Nathan Novemsky have noted that casino gambling differs from the psychological laboratory settings of Kahneman and Tversky in a number of subtle ways.2 In casinos people see others making large gambles, which makes their own potential losses less salient. When there are maximum wager amounts, the amounts are set at a high level, which makes the bet actually placed seem small. People are asked to generate their own wager amounts while subject to a minimum allowable wager. Simmons and Novemsky replicated some of these features in their psychological laboratory setting, and they found that such factors indeed encourage risk taking.
Cognitive dissonance, a term coined by social psychologist Leon Festinger, is a negative emotional response, a feeling of psychological pain, when something conflicts with one’s stated beliefs—an emotional response that may lead to something other than a rational updating of the beliefs.5 In particular, when a person’s own actions are revealed to be inconsistent with certain beliefs, he or she often just conveniently changes those beliefs. Hypocrisy is one particular manifestation of cognitive dissonance, in which a person espouses opinions out of convenience and to justify certain actions, while often at some level actually believing them. The evidence that Festinger and his successors presented is solid: cognitive dissonance is a genuine phenomenon and leads with some regularity to human error—or at times to what we would label sleaziness. And yet there remains skepticism about cognitive dissonance in many quarters, particularly among people who feel committed to the fully rational model of human behavior.
Neuroscientist Vincent van Veen and his colleagues put human subjects in an experimental situation in which they were paid or otherwise incentivized to lie about their true beliefs as they were observed by functional magnetic resonance imaging. The researchers found that certain regions of the brain, the dorsal anterior cingulate cortex and the anterior insula, were stimulated during this experience. These are regions of the brain that are known to be stimulated when people lie. When van Veen and his co-workers measured the extent of stimulation in these regions, they found that some subjects showed more stimulation in these regions than did others. Importantly, those subjects with more activity in these regions showed a stronger tendency to change their actual beliefs to be consonant with the beliefs they were made to espouse.6 We thus have evidence of a physical structure in the brain whose actions are correlated with the outcome of cognitive dissonance, and that thus appears to be part of a brain mechanism that produces the phenomenon Festinger described based solely on his observations of human behavior.
If hypocrisy is built into the brain, then there is a potential for human error that can be of great economic significance. A whole economic system can take as given certain assumptions, such as, for example, the belief in the years before the current financial crisis that “home prices can never fall.” That theory was adopted by millions of people who would have experienced cognitive dissonance had they not done so, either because they were involved one way or another in a system that was overselling real estate or because they themselves had invested in real estate. For another example, there may even have been an element of cognitive dissonance behind the decision of European bank regulators years ago to put zero capital requirements on euro-denominated government debt. The decision had already been made, and widely affirmed, that an end to the euro was unthinkable; hence any later decisions that recognized the risk of…
But the finance professions also attract people who are relatively invulnerable to hypocrisy. It attracts those who become traders or investment managers, who delight in the truth that is ultimately revealed in those markets. They are often people who are troubled by hypocrisy. They seek vindication by being proven right, not by sounding right. A financial system that lets them take a stab at doing just that will generate some economic inequality. But they do collectively offer a benefit to society in leaning against conventional and politically correct thinking. The presence of people who will respond in this way to financial opportunities is part of the success story—poorly understood by most of the public—of modern financial institutions. For financial theorists, it is often difficult to comprehend the real reasons we have the financial institutions that we do and the reasons that they contribute so well to a good society. Many…