Genre: Government Management
Author: Robert J. Shiller
Title: Finance and the Good Society (Buy the Book)
Summary
Finance and the Good Society takes a comprehensive look at the role our financial institutions play in today’s society. Shiller refutes the commonly held notion that finance is nothing more than a tool or expression of greed.
In fact, finance may be the single most important tool in the establishment of a good society. The traditional definition of a
It is easy to blame the “rampant and unconstrained” financial institutions for our most recent economic downturn. Many are calling for further regulation of the profession, but that is precisely the opposite direction in which we should move.
We need to make changes to our financial system and enact them in a way that encourages the innovative power of financial capitalism. If we expand, correct, and realign finance in this manner, we have the opportunity to support the greater goals of a good society.
Humans naturally create and work to achieve goals throughout our lives. Finance is fundamental to goal architecture. Financing an activity is creating the architecture to reach a goal and then providing stewardship to protect and preserve the assets required to achieve and maintain that goal.
Finance is all around us, but not everyone can yet wield its powerful tools. They must become more attainable and comprehensible to all. This would help broaden prosperity across an increasingly wide range of social classes.
Finance and the Good Society is broken into two halves. The first half of the book largely discusses the different roles and responsibilities that people play in the field of finance and why the public holds so much hostility toward a few of these roles.
Part two is the focus of this brief. It looks critically at the financial system and offers ideas as to how it can and will be improved in the future. Our society faces two large barriers that our current financial systems fail to adequately account for the human impulses for conventionality and
These two seemingly opposite impulses often work in conjunction in a way that creates issues that our society has not quite figured out how to handle. One prime example is debt and our tendency to take on too much risk and overleverage ourselves.
On the whole, we simply do not understand well the risks we are taking on with leverage. Because of the impulse for conventionality, we tend to look at age-old credit vehicles as safe and successful simply because they have been around a long time. This isn’t necessarily the case and ultimately leads people to make decisions based on false pretexts.
Part two also addresses the perceived sleaziness of finance and how the misdeeds of a few individuals wrongly implicate the whole profession. Speculation in particular is a bane to society’s perception of finance.
Speculation and speculative bubbles have led contributors to some of our most prolific economic downturns but speculation is an essential part of a productive financial system with efficient markets.
Shiller looks into the inequality created by our current financial system and offers a number of solutions. A change in our tax system, an increase in philanthropic contributions, and the further dispersal of ownership of capital are several ideas that are explored in great depth in Finance and the Good Society. We examine these and other ideas within the context of the brief.
We conclude with a discussion on how past innovations in our financial institutions led to a softer and gentler society. We have not yet achieved the “Good Society,” but we are well on our way, provided financial capitalism continues to flourish.
Introduction
Shiller describes the conservation laws of finance and how the beauty in the symmetry of modern financial theory often captivates academics and professionals alike. More often than not, the underlying assumptions of most modern financial theory hold little applicability to the real world.
But it is the comprehensible nature of symmetry in these theories that
Human desires and possibilities drive finance, facilitating the daily activity of our working lives. In this sense, finance is the backbone in a human society filled with richness and diversity shared by all people—the Good Society.
In Finance and the Good Society, Shiller looks to correct people’s misunderstandings about finance and its role in society. He makes the plea to people of all backgrounds to learn the powerful tools of finance and utilize them in bettering their life and the lives of people all around them.
Contrary to what the general population has come to believe due to the financial mismanagement and speculation associated with the recent “Great Recession”, finance and those that work in the profession are not inherently evil. Finance at its best does not just manage risk but acts as the steward of society’s assets and is the biggest proponent of its goals.
The problem with finance in its current state is that it has not reached the level of democratization that is necessary for it to be at its best. Imagination and skill from the new generation of finance professionals is needed for finance to expand its positive reach to all corners of the globe.
The Contradiction (or lack there of) between Artist and CEO
Traditionally we view the arts and those who perform them as distinctly different than business and those who operate in the finance world. One is either born with the tool set to become an artist or the tool set necessary to become a businessman.
Shiller refutes this commonly held perception in an effort to show that finance and business are all around us, intermingling.
People like Whitman, Thoreau, Charles Ives, Jeff Koons, and Damian Hirst were and are artists, and successful ones at that. But they were and are considered successful because of the exposure and reach they obtained primarily due to business prowess and financial stability.
The point is that these artists, poets, and musicians, whom one would think could not be any further removed from finance, are indeed affected by it on a daily basis and need it just as much as any financial professional.
An Impulse for Risk Taking
Part of the problem with
Wolfram Schultz in his classic experiments involving the dopamine reward system in the
Essentially, humans are more inclined to take risk than financial theory would indicate.
Risk taking in itself is not bad as it has kept human beings from accepting the predictable and
In our current financial system, an inclination for sensation seeking (an inherent genetic trait commonly found in many individuals) closely correlates with risk taking. Risk taking in turn closely correlates with economic uncertainty.
Economic uncertainty leads to inequality. Excessive inequality prohibits the development of the ‘Good Society’. Well-designed financial capitalism should allow outlets for sensation seekers while managing their risk and uncertainty.
An Impulse for Conventionality
Tradition and conventionality permeate through our financial institutions. Conventionality is a major factor in inhibiting the application of financial principles to the design of new financial institutions.
The majority of the population, understanding the need and importance of sound financial strategy, looks to tried-and-true principles and theories. Because these financial concepts and strategies have been around for many years, people tend to view these age-old financial ideas as safe and successful. New ideas are often only adopted by a small fraction of the population, the ones who have a better understanding of financial concepts.
To illustrate this point, one can look at the gap between the development of corporate shares in ancient Rome and when corporations finally started to become prevalent in the 17th century. Similarly, insurance was first developed in the ancient world but only gained traction on a wide scale over the past several hundred years.
For whatever reason innovation and advances in financial technology tend to lag behind advances in other types of technology.
Entitlement is an element and product of conventionality that has failed our society. Entitlements guard the rights and liberties of a certain group of citizens but often come at the expense of other citizen groups. The Universal Doctrine of Human Rights, adopted by the United Nations in 1948, is indicative of entitlement’s absolute nature.
It states that “Everyone has the right to a standard of living adequate for the health and well-being of himself and of his family, including food, clothing, housing, and medical care and necessary social services.” While this is great in principle, it fails to address the concerns of those required to give in order to help guarantee these universal rights.
Shiller argues that we must reshape the meaning of “universal human rights” so that they represent the rights of all people to a fair compromise, rather than the status quo of guaranteeing one group at the expense of another.
Debt and Leverage
The impulses of risk-taking and conventionality can interact to create dangerous situations when involving debt and leverage. The impulse towards risk-taking causes people to run with crowds and bet on bubbles. The impulse towards conventionality may mean that these people take no steps to protect themselves from risks they assume.
People and businesses have trouble living up to the rationality purported by financial economists who model fundamental economic issues like debt.
People tend to blindly accept the credit vehicles put in front of them and then take too much risk through these credit vehicles because they do not understand the problems associated with leverage. Increasing leverage has the effect of magnifying otherwise small issues.
Overreliance on credit cards in the United States has become a big issue with each American holding an average of five credit cards.
To contrast, in
Part of this is attributable to the unchecked promotion of credit vehicles to the average consumer. The 2010 Dodd-Frank act was the first attempt at any type of regulation involving credit card promotion.
While this is just a start in getting our society’s leverage under control, it will hopefully drive further discussion on how to reform our debt institutions so that they may work more effectively for the public interest.
There is a leverage cycle that affects the global economy. In such cycles, overindebtedness may apply to the individual, the corporation, the government, or a combination of all three. Boom periods are typically full of over optimism and complacency.
During these periods, people feel that the government will fix any problem and thus increase their indebtedness. After the boom, a period of sever debt overhang occurs where people continue to hold onto to their debt in the hope that the government will bail them out. This holding pattern leads to economic distress where people, corporations, and governments cannot rid themselves of debt burdens for years.
World governments are much more aware of the potential problems caused by over-indebtedness following the last financial crisis. However, they have not developed reliable ways to solve them.
Regulatory boards like the Financial Stability Oversight Council in the U.S. and the European Systematic Risk Board are popping up all over the place to help study leverage problems around the globe. However, regulatory actions alone cannot solve the debt problem. We must develop better financial procedures and instruments.
Sleaziness in Finance
The public widely believes that there is something inherently sleazy about the finance profession. Part of that perception stems from the fact that so many young people are entering finance fields when they could alternatively be doing something more high-minded in other fields.
It also partially stems from a culture in finance where people are incentivized to cut corners on the law or the intent of the law to get ahead and meet performance expectations.
And finally, it partially stems from the fact that finance is so reliant on the dissipation of information and there remains large information asymmetry within the profession. There are many opportunities to withhold information or even provide false information resulting in an unlawful advantage.
However, the financial system seems to reward people with a certain kind of moral purpose. It’s hard to see on a day-to-day basis the moral purpose in helping one’s clients. But the fact is most people need a moral purpose, or spiritual direction, in order to carry out all the activities that define a job. Human nature instinctively leads us to help and do good for others, so it is inaccurate to state that the finance profession as a whole is “sleazy.”
The rich are often powerful wielders of financial tools and are consequently scrutinized for the money and power they accumulate.
Thus, the financial tools and institutions used by the rich in turn come under scrutiny themselves as the general population grows suspicious of them.
What our society must accept is that some less-than-high-minded behavior might result from an economic system that is good overall (albeit imperfect). A few individuals should not set the bar for the profession as a whole.
A large number of the actors that have given finance a negative public reputation have been involved in speculative behavior. Speculation tends to create an environment that attracts the selfish and manipulative. Speculation is explored more in-depth in the next section.
Financial Speculation
There have long been two opposing sides to the argument for the merits of speculation with renowned early 20th century financial expert Charles Conant arguing for, and the likes of Karl Marx and John Maynard Keynes arguing against.
Speculation, Shiller argues, is an expression of the base human animal spirit. When we subdue the animal spirit and focus solely on mathematical expectations as means for which to derive our decisions, we kill our spontaneous optimism and enterprise fades and dies.
The financial markets were created in way that would limit the average investor’s liability and thus encourage a gambling spirit.
The result of the aggregate investor gambling spirit is what contributes to our efficient markets. More investors are willing to take a risk and bet that a stock price is either under or over valued. Theoretically, the more investors willing to take on this risk, the closer to the stock price moves to its intrinsic value. While sometimes unsuccessful, these speculative investments can, on occasion, result in great advances in society.
Where speculation becomes an issue is in other areas of finance. Traditionally, investment bankers, consultants, lawyers, and accountants have been formed under partnership structures. They lack limited liability, as the partners themselves are the owners.
Recently, there has been concern as the partnership structure dies out. There is worry that some of the factors that contribute to the financial integrity of our system are slowly going to fade away.
Some believe that the decline of the partnership structure on Wall Street is directly correlated with the financial crisis in 2007. The thought is that the corporate structure that has become prevalent has reduced the incentives to manage long-term reputations and long-term risks in favor of a structure that allows and encourages rapid speculation and growth in firms.
Speculative Bubbles
Speculative bubbles, both positive and negative, can come in financial and non-financial form. Both are barriers for the creation of the ‘Good Society.’ Financial bubbles like the housing market in the early to mid 2000s and the technology bubble of the late 1990s are a little more easily definable.
A speculative bubble in this sense is a situation where a “price increase spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a large and larger class of investors, who despite doubts about the real value of an investment, are drawn to it partly through envy of others successes and partly through a gambler’s excitement.”
Social epidemics such as the soviet collectivization and the Chinese Great Leap Forward also hold the characteristics of a bubble.
With these two cases, there was no particular financial instrument in which one could invest but there was a baseless build up in enthusiasm for both plans by their respective populations, providing a kind of faux initial success for both. Ultimately, enthusiasm could only sustain the plans for so long and their true value (or lack there of) eventually came into fruition.
We are taking steps to create the good society with organizations like the United Nations and Group of Twenty (G20). The G20 is the first international body to have had any success in coordinating global economic policy. They are committed to “policies designed to avoid both the re-creation of asset bubbles and the re-emergence of unsustainable global financial flows.”
Shiller asks why there is a need for prices in financial markets at all if they only lead to bubbles and crashes? The answer is that although the fluctuating level of aggregate stock market prices over the past century has generally discovered little more than changing market psychology, stock prices still mean something. More specifically, individual stock prices carry extremely useful information.
The economist Paul Samuelson opined that stocks were “micro efficient” and “macro inefficient,” and Shiller found evidence that tends to confirm Samuelson’s view. He noted that excessive volatility (volatility above and beyond what one would expect as a mere result of the incorporation of new relevant information into a stock price) is most apparent for the aggregate market.
Not all of the fluctuations in an individual stock price are explainable by things that make good economic sense. But enough is explainable by rational economics to make the market an important source of information for directing resources.
Inequality and Injustice
If financial markets are so useful, then why has our financial infrastructure not yet brought us a harmonious egalitarian society where we have all learned to care for and respect one another?
Wealth itself does not seem to inspire anger or dissatisfaction among those who lack it.
However, those that become wealthy through financial dealings, or with very high executive compensation packages, are often met with skepticism. However, it is not just these wealthy “financial” executives that use financial tools to amass their fortune.
Only a quarter of the Forbes 400 list of richest Americans
Financial executives have salaries that seem inordinately high compared to equally bright and capable people in the scientific community. Part of this may be attributable to a possible speculative bubble relating to financial salaries as the compensation has increased drastically for these individuals over the past decade. But part of it may very well be attributable to the level of risk taken on by each respective party in their daily jobs.
Society has two important weapons that it uses to guard against economic inequality: the estate tax and the progressive income tax system.
The school of thought behind the estate tax is that a person has a duty to his country, to help bridge economic inequality. Upon a person’s passing, a certain percentage of his/her financial estate passes back to the government. This contrasts directly with the natural human inclination of wanting to provide for one’s children.
While many view the wealthy that oppose the estate tax as selfish, and the children of the deceased as undeserving of the inheritance, it is a natural human instinct to want to preserve as much for one’s children as possible.
The progressive tax system is a system in which taxes are raised disproportionately on high-income people, and much of the benefits of the proceeds are directed to the poor. The problem is that the system was not expressly designed to manage income inequality. Tax law was not written in a way to allow it flexibility in responding to income inequality.
Shiller proposes that nations index their tax systems.
Under inequality indexation, the government would not create fixed income tax rates for each income bracket but would create a formula to tie tax rates to some statistical measure of pretax inequality. If income inequality were to worsen, the tax system would automatically become more progressive.
With this formula, society would create an insurance plan in advance in the case of deepening inequality. It would protect against a situation in which the rich slowly began to accumulate a greater proportion of the nation’s wealth and have an
Inequality in itself is not a bad thing. There should be some that are richly rewarded for their business success, but society must systematically impose limits on this inequality. The impulse of conventionality and familiarity increasingly hamper our tax system, but with increases in technology, we are slowly reaching a point where we can introduce more responsiveness and nuances into the system to help create a better society.
Problems with Philanthropy
In 2010, individuals and organizations in the United States donated only 2.2 percent of total income. The concept of diminishing marginal utility would imply that there is only so much wealth that we can consume. So, with so many people in need, and seemingly providing little additional utility to those that have great amounts of it, why is wealth not more widely given away?
One issue is that it is often a challenge to motivate people to donate without external pressure or rewards.
One may not be as apt to donate if they do not feel that they will receive direct gratitude from the person they benefit. Donation solicitation
With the telethons and preapproved scripts, gift giving has become less personal and consequently quelled the satisfaction that one may have received from unsolicited donations. Essentially, people feel that they are giving into some form of manipulation when gift giving in this form, chilling the personal aspect of the whole process.
Improving the experience and the process through which charitable giving is managed might remedy the low contribution levels.
Studies have shown that the success rate in the solicitation of donations is greatly improved when there is a promise that the donor will be identified by name to his or her peers. Organizations that give back in some form or fashion, such as Save the Children where the child who benefits actually corresponds with the donor, show higher success rates at acquiring contributions. Gift giving must become more meaningful in order to have a widespread effect on our society.
An issue with our current tax system in regard to contributions is that it gives no incentive to donate for the overwhelming majority of people. The standard deduction enacted by Congress in 1944 allows people to take a tax deduction regardless of whether they made any contributions or not.
This was enacted in an effort to simplify tax preparation. However, with today’s computers and technology, Shiller argues that there really is no need for simplification in this regard as it disincentives charitable contributions.
A better thought-out system of contribution deductions and credits would help as well. Currently, a contribution either qualifies for a deduction or it does not. The government could give special tax incentives for contributions that fill a particular national need.
For example in a time of recession, issuing tax breaks for donations made to organizations creating jobs for the unemployed. This is particularly favorable to the rich as they would have a personal connection to the distribution of their wealth. Under the traditional method, the rich pay higher taxes into the government coffers and ultimately have little idea or control over how those funds will be used.
Tax incentives for interpersonal gift giving need consideration as well.
According to one study, 40.8 percent of U.S. household made substantial gifts to relatives not living in their own home, and 26.2 percent made direct gifts to friends. These gifts often directly impact income inequality. However, there is nothing in the tax law that encourages or supports this form of giving.
Shiller’s most inventive way to increase philanthropy is the creation of participation non-profits in which people could buy shares of the non-profit. Buying these shares would be a charitable contribution for tax purposes.
The organization could even distribute profits to shareholders with the stipulation that the profits must be used for charitable giving. With this method of gift giving, the donor would continue to have a psychological stake in the non-profit, akin to ownership, and could watch their stake in the organization grow.
Altruistic acts increase happiness. There is a positive externality for all of us in seeing a society where altruistic acts are common. Accordingly, governments should encourage such acts. A tax law that encourages people to accumulate wealth in order to gain recognition for giving it away should have the effect of promoting the general sense of a good society.
The Dispersal of Ownership of Capital
Financial capitalism is to an extent, a history of deliberate government policies to disperse financial interests that have resulted in the increased democratization of finance.
The modern capitalist system acts to liberate the populations in such systems from a serfdom mindset.
Capitalist systems best demonstrate creativity in a form bounded by a set of rules and assumptions that allow for orderly business. The dispersal of information is key in this regard. What we need to improve upon in our current system is the dispersal of control.
Broader public participation in shareholding in corporations and tax preferences to small firms are two of many ways to disperse control. The accumulation of capital, land and other resources in giant corporations and a few individuals is indicative of a society in which serfdom proliferates. Creativity is lost and innovation slows down.
The status quo does not ever change and the population is at the mercy of those that hold the capital. The good society is an ownership society in which citizenship and responsibility are encouraged by the widespread ownership of and control over individual properties.
Land reform has been key in the democratization of finance in places ranging from South Korea to the U.S. The Chicago Press and Tribune in a pre civil war editorial made the case for individual land ownership, “The history of the world proves that the larger proportion of land owners in any given country, the greater the degree of personal liberty, the greater the progress in civilization, and the greater the security of the nation from external attack.”
Government policies that encouraged personal home ownership have also contributed to the democratization of finance.
These policies discouraged the development of huge rental property corporations. Home ownership helps in the creation of a market-oriented psychology that encourages other kinds of property ownership and a feeling of participation and equality in society. Governments must continue to implement policies targeted at low-income individuals that support individual homeownership.
Policies that promote employee ownership of business are important because it then encourages the labor force to feel loyalty towards their employers. Membership in a group becomes a source of identity, and George Akerlof and Rachel Kranton, in the book Identity Economics, stress that this identity is fundamental to economic behavior.
We must make changes to our financial institutions that improve our sense of loyalty to our business colleagues and lead to a better form of financial capitalism. Concepts like Employer Stock Compensation Plans increase employee motivation and effectiveness.
Additionally, we must put an emphasis on subsidizing the most innovative small business ideas to encourage
Concentration limits, with the effect of limiting monopolies, are crucial to a financially democratic society. Concentration of economic power hinders economic equality and the United States has not done nearly enough to curtail this.
In 2010, Dodd-Frank introduced a concentration limit for financial firms to help address the “Too big to fail” problem. This has had the positive side effect of making our markets more democratic in a period where we face high levels of resentment towards the concentration of wealth and power.
While we typically believe that the current ownership structure of our society happened naturally, that is far from the truth. Past policies made to disperse ownership of farms, homes, and companies are largely the reason we have any sense of equality and participation in our society today.
The government implemented these policies but the ideas stemmed from the people and their response to popular concerns. The democratization of finance in its finest form.
The Great Illusion
In the early 20th century, there was a widespread perception that military conquest would bring about economic prosperity. Because of this, it became widely and uncritically accepted that human nature is inherently warlike. Society believed military victories expressed human excellence. The more conquests a nation had, the more prosperous their society became.
While we no longer share this view, we still suffer from an analogous illusion that those in the business world will stand to benefit from business conquest. Consequently, people believe that the wealthy in our society have a genuine incentive to economically attack and subjugate the majority of the population. This assumption, left unchecked, will inhibit business and threaten to slow the world’s prosperity.
Most of the real satisfaction one derives from business is not closely related to the level of profit.
Pleasure is often derived from the crafting of a fine product or helping a customer or providing jobs for employees. There is nothing in financial theory that says people should value making money to the exclusion of all other rewards. In fact, theory holds that it is perfectly normal for people to sacrifice income for substitutes like quality of life.
Nobel Peace Prize winner Norman Angell wrote in the early 20th century about the futility of conquest in war. He noted that it is impossible to extract much wealth from conquered nations. Likewise, it is impossible to extract much happiness from wealth earned by anti-social financial means.
Meaning that it is not in the human nature of financial professionals to alienate themselves from society in the pursuit of wealth. Yet there is a common presumption that business is relentlessly selfish.
Modern society is a result of centuries of modifications to the management of the human tendency towards aggression. Because of these modifications, we maintain a financial capitalism in which we have a tax system and a system of public goods provision that work to curtail severe inequality.
Economic interconnectedness has been proven over the past several decades in an era of globalization to help prevent wars. Economic trade creates an interest in maintaining peace as trade effectively raises the cost of conflict and the benefits of maintaining peace. In conclusion, economic interconnectedness leads to a kinder and gentler society.
In Conclusion: Finance, Power, and Human Values
The pursuit of power that seems to often drive financial capitalism contrasts deeply with the concept that finance is all about stewardship of society’s assets. Despite advancements in technology and communication, society is still in need of individuals with management skills that allow them to accomplish tasks and meet goals in an efficient manner.
Those with superior judgment and coordination skills are aptly rewarded with wealth and power. We realize that an economic system that allows most of us to prosper and pursue our own individuality will also inherently produce some unusually successful, and potentially arrogant, people. We must accept this and prevent it from deterring the overall goal of further democratization.
We must develop more effective institutions of risk management that reduce the random redistributions of wealth and power to further democratize finance. Finance is supposed to reduce randomness in our lives, not increase it.
There must be an improvement in the nature and extent of participation in the financial system, including an understanding of the fundamentals of the system. The public must have access to comprehensible information. When they feel that they can benefit from that information and inform themselves, they may consequently begin to feel less strongly that the powerful elite run the economy.
Government interventions are needed in the form of redistributions through an efficiently progressive tax code. However, the government must act merely as a facilitator and take cues from private financial arrangements and institutions. Too much government intervention works against the ideals of the good society.
The democratization of finance goes hand in hand with the humanization of finance. There must be a personal level to it as we further incorporate our understanding of the human mind into its systems, models, and predictions. Behavioral economics must take a leading role in our development of, and alterations to, current financial institutions.
Philanthropic impulse is one such aspect of the humanization of finance that needs further cultivation in the effort to democratize finance.
There is a tendency for wealthy people to give much of their wealth away constructively and this tendency needs to become a central part of financial capitalism.
Human beings are genetically wired to have aggressive impulses. In past centuries, these aggressive impulses were released in the form of war and violence. Well-constituted financial capitalism creates a safe venue for power struggles without violence.
Financial institutions and regulations are similar to the rules of war. They cut down on the unnecessary damage caused by human aggression and work to encourage the expression of more charitable human impulses.
Shiller writes that “The key to achieving our goals and enhancing human values is to maintain and continually improve a democratic financial system that takes account of the diversity of human motives and drives.” Our future and the further democratization of society depend largely on the advances and innovations we make in our financial institutions.
We need to develop a system that allows people to make complex and profitable deals in an effort to further their goals. And at the same time provide an avenue for people to channel their aggressions and lust for power.
Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.
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