Finance and the Good Society, by Robert J. Shiller, Princeton University Press, RRP$24.95
Robert Shiller worries about troubled souls such as Greg Smith, the Goldman Sachs salesman who called the culture of his former employer “toxic and destructive” in a two-fingered resignation letter published last week in the New York Times. According to Mr Smith, Goldman staff describe their clients as “muppets”, and four years after the worst economic crisis since the Great Depression that is how much of the world feels: that financial capitalism has made muppets of us all.
Finance is in need of a little redemption. In his priestly new book, Finance and the Good Society, Mr Shiller – a Yale economist famous for calling both the internet bubble in 2000 and the US housing bubble in 2005 – sets out to provide it. He argues convincingly that finance can, should and usually does make the world a better place. It helps us to buy a home, ward off catastrophic risks, and invest small sums in enterprises that would otherwise be too risky.
Mr Shiller tends to assume that innovations in finance automatically make society better. But if collateralised debt obligations and subprime mortgages prove anything, it is surely the reverse: the natural tendency of financial innovation is towards complexity, exploitation and crisis. Finance can serve the “good society”, but Mr Shiller is curiously reluctant to demand that governments, regulators and financiers make it do so.
As an advocate for the financial system, however, he is wonderfully persuasive because he never plays down the problems. Instead, he shows how they reflect the flaws of human nature. Yes, chief executives can inflate their own pay, but managers in communist countries did the same. Yes, fund managers get paid a lot and do not beat the market on average, but they serve us by directing investment into worthy companies.
A constant battle must be fought, however, to limit that pay inflation, fee extraction and all the other abuses for which finance has become known. Innovation often makes that harder.
Consider the stock market. It is one of the most transparent and democratic of financial arenas, and now that electronic trading has lowered costs and squeezed out the privileged role of floor traders, it should have become even more so.
But what happens when you buy shares today is not democratic at all. Your broker may send the order to a particular market maker who pays them for that privilege. If you are an investor who wants to buy a lot of shares you must now sneak past an army of algorithms, which have paid to lurk next to the computers of the exchange itself, and want to sniff out your intentions and get in on the deal.
It is not at all clear that this high frequency trading has helped society but Mr Shiller dismisses it with an airy wave: these are “growing pains”, he says; investors complained about the telegraph back in 1847. He is more interested in innovations that create new markets – for longevity risk, GDP derivatives or earthquake insurance.
The trouble, though, is that there are far greater incentives to create innovations that will cream off even a fraction of a percentage point of the multi-trillion dollar global equity markets than there are to invent something new. A new market may take years to build up liquidity and when it does competitors can barge in.
One of the touching things about Finance and the Good Society is its underlying faith in financiers; its belief that all those Yale graduates Mr Shiller sends off to Wall Street are rather nice people. He says we are in danger of a “great illusion”: of letting ourselves think that ripping off the muppets is in the best interests of Goldman Sachs, when in fact it is not.
But as Mr Smith’s letter suggests, it is hard to be a nice person in a bank, and banks do not always act in their own long-term interests. Managers demand revenues and morals, but the first are easy to measure and the pressure for them can be cruel, while the latter are more easily compromised.
We should not, therefore, sit and wait for finance to evolve in ways that make us happy. All financial markets have rules; we should demand the fairest and most transparent possible. There may be a role for governments to jump start new financial markets: the idea of issuing bonds linked to longevity, to help pension funds hedge their liabilities, is a case in point.
Regulators should be suspicious of financial activities that deliver persistently high returns. They should look for barriers to competition they can take down, informational advantages they can erode, or malpractices they can halt. Mr Shiller reminds us of the profound importance of finance to making our society work. But a good society rests always on the good people who struggle to make it so.