Fixing Finance

A few years ago, while looking at the Journal of Economic Literature, the weighty compendium that tracks economic research, the economist James Galbraith spotted a curious omission. Although the journal monitors work on income inequality and on financial stability, he explains in his new book, before the recent financial crisis, "there was (and is) no category for work relating inequality to the financial system."

Part of the problem is academic tribalism: the type of economists who study inequality tend to be interested in micro-level issues of poverty rather than macroeconomic issues, such as the global supply of credit. But the gap also reflects an intellectual illusion that prevailed during the decade before 2007. Back then, most Western economists believed that the world had entered an era in which the business cycle had flattened out and financial instability no longer mattered -- "the great moderation," it was called. In particular, many hoped that markets were self-healing; bouts of financial excess were unlikely to last because they would quickly self-correct. Before 2007, Galbraith writes in Inequality and Instability, "there was practically no study of credit and therefore no study of financial instability at all. In a discipline that many might suppose would concern itself with the problems of managing an advanced financial economy, the leading line of argument was that no such problems could exist."

How times change. These days, the gurus who compile the Journal of Economic Literature need only turn on the television or open a newspaper to see why inequality and financial stability matter deeply, not just as separate issues for their own sake but also in connection with each other. Never mind all the handwringing about the failures of financial policy before 2007 or the scramble by regulators to devise new rules to make the financial system safe again. These days, there are equally furious rows about inequality: in Congress between Democrats and Republicans over the "millionaires' tax" and, of course, in the Occupy Wall Street movement, whose adherents complain about both the excesses of finance and the privileges enjoyed by the top one percent.

Galbraith's timely and provocative book adds some economic and statistical ballast to the vague rhetorical slogans of the Occupy protesters. Drawing on meticulous academic research, it argues that the main source of the growing inequality across the world in recent years has been not industrial change, educational reform, or geopolitical shift but the financialization of the modern world. In other words, the American middle class cannot blame its woes on China alone; Wall Street is responsible, too. The sector has come to dominate, not serve, the economy, thus "financializing" society at large with its loans, derivatives, and other financial instruments. According to Galbraith's analysis of global historical trends, "the difference between the financial sector and other sources of income is -- wherever we can isolate it -- a large (and even the prime) source of changing inequalities."

As Galbraith explains, the dramatic growth of the financial sector in recent decades, amid a supply of excess credit from central banks and other sources, has allowed a tiny elite to become far wealthier than everyone else, particularly in the United States. In part, the rich have gotten richer because excess credit pumps up the value of tradable securities, thus raising the paper value of their wealth. But the growing clout of finance has also strengthened their position by enabling banks to skim off more profits from the economy -- "rents," in economic jargon. 

Moreover, he adds, it is a mistake to think that these changing patterns have affected the population as a whole; growing inequality in the United States during the 1980s and 1990s was a reflection of "the concentration of income and wealth among the richest of the rich, and the corresponding financial fragility affecting everyone else." Instead of watching the top one percent, in other words, Occupy protesters and economists should be looking at the behavior of the top 0.01 percent, since it is the hyper-rich who have been skewing the data across the world.

Galbraith does not always present this provocative argument in a particularly user-friendly way. On the contrary, Inequality and Instability will probably be somewhat intimidating for the layperson. Galbraith has developed his thesis after years of academic research into inequality statistics, conducted with fellow researchers at the University of Texas at Austin, and as a result, the text is replete with equations and charts. The first few chapters of the book, for example, are devoted to a fascinating but technical discussion of the quality of the existing data on inequality. (Galbraith considers traditional measures flawed because they rely on out-of-date conceptions of the modern economy, focusing too heavily, for example, on trends in manufacturing salaries.)

This academic grounding lends his thesis credibility. But at times, it makes for a dry argument, even when Galbraith is handling potentially incendiary issues, such as the link between voting patterns and inequality in various regions in the United States or the degree to which the George W. Bush administration deliberately created a housing bubble as part of its "ownership agenda." Another frustration is Galbraith's refusal to offer policy solutions to the problems he outlines. Instead, he ruefully concludes that "the ability or willingness of political systems to affect the movement of inequality is very limited in the world today." The ability of some countries to have a more equal income distribution and lower unemployment reflects differences in "economic institutions rather than the political structure per se." Policymakers and protesters searching for ideas about how to cure, not measure, inequality and financial instability will find no neat answers here.

BLAME GAME

But for that they can turn to two more readable, but less pioneering, books: Robert Shiller's Finance and the Good Society and Charles Ferguson's Predator Nation. As their titles indicate, these two works approach the issue of inequality and instability from different ideological viewpoints. Shiller, an economist at Yale University, is instinctively well disposed toward finance; although he acknowledges the excesses of the pre-crisis years, he is convinced that financial innovation can be valuable, if only it can be married with a better set of ethics and a more "democratic spirit." Thus, rather than demonizing bankers, society should celebrate them as potentially valuable craftsmen who should be encouraged to tap into their better natures. Ferguson, by contrast, seems to be outraged by most modern bankers; in his eyes, the twenty-first-century financial elite has raped the United States' political and economic system and the rapists need to be punished. Indeed, he argues that the sins of finance not only created the last boom-to-bust cycle but also are fueling the broader decline of the United States.

Leaving aside the difference in tone, both books share Galbraith's interest in financial instability and wealth, and that leaves them grappling with the question that Galbraith ducks: Should governments rein in finance to crush the elite, or should they simply accept income differentials and financial swings as the inevitable price of dynamic societies?

Shiller leans toward the second camp. In presenting his defense of finance, he first describes how the modern financial system works, detailing the species of professionals in this ecosystem (in which bankers are only one small subcategory). The more interesting part of his book is a loosely linked set of essays on the nature of finance, covering topics such as philanthropy, speculative bubbles, and the dispersal of the ownership of capital.

In some respects, Finance and the Good Society is a slightly odd pastiche, having arisen from a lecture series that Shiller devised for his students. But the common thread running throughout is Shiller's belief that finance is about far more than numbers; it involves people, too. Shiller helped make behavioral economics popular in the last decade, and his discussion of finance draws not only on insights from economics but also on those from psychology, sociology, and even anthropology.

That approach gives his work a relativistic tinge, as he tries to explore the incentives that drive humans. Thus, he argues that although some financial players may have engaged in egregious behavior before the crisis, it is a mistake to view them all as greedy, immoral, or dumb. "We tend to think of the philosopher, artist, or poet as the polar opposite of the CEO, banker, or businessperson," he writes. "But it is not really so." Both groups of professions attract intelligent and well-meaning people.

Instead of lambasting bankers, then, politicians should be trying to build incentives that reward sensible, morally upright behavior. And rather than banning innovation or trying to even out compensation, Shiller argues, society should embrace financial creativity and wealth. Finance can be extremely beneficial for everyone when it helps push capital around the economy and enables consumers and companies to manage risk. "Yet our wonderful financial infrastructure has not yet brought us the harmonious society that we might envision," he admits.

Shiller therefore concludes that finance needs to become more "democratic," with more people participating more freely in markets and taking advantage of financial instruments; indeed, in recent years, he himself has tried to develop housing-linked derivatives and securities so that ordinary households can insure themselves against risk. At the same time, he adds, those in the industry need to drop the "great illusion" that it is just about money and salaries. "We need a system that allows people to make complex and incentivizing deals to further their goals," he writes, "and one that allows an outlet for our aggressions and lust for power."

Ferguson is far more pessimistic. In his eyes, when bankers start talking about philanthropy, innovation, and free-market competition, this is simply a cloak concealing the fact that modern banking is a rapacious beast -- a system that, having distorted the global economy in the credit boom, then sparked a terrible bust. Ferguson is particularly angry that bankers have emerged from this debacle without suffering any serious financial penalties (that "the bad guys got away with it") and that they are continuing to peddle their dangerous financial wares. "As of early 2012 there has still not been a single criminal prosecution of a senior financial executive related to the financial crisis," he writes. "Nor has there been any serious attempt by the federal government to use civil suits, asset seizures, or restraining orders to extract fines or restitution from the people responsible for plunging the world economy into recession."

Such statements will not surprise anyone who watched Ferguson's clever and droll Oscar-winning documentary Inside Job (for which I was interviewed). Indeed, parts of Predator Nation are essentially a written version of that film, although the print version contains less well-timed wit. Ferguson contends that the "uncontrolled hyperfinancialization" of the U.S. economy fed growing income inequality and empowered the financial elite, which then used its influence to control Congress and achieve the cognitive capture, as it were, of the academic world. 

He goes further still, naming and shaming those he holds responsible for the crisis. It is a long list, which includes the former Countrywide Financial CEO Angelo Mozilo, who oversaw an organization that pumped out subprime mortgages to borrowers who could never hope to repay them; the former Merrill Lynch CEO Stan O'Neal, whose banks repackaged those risky mortgages into rotten securities, without properly recognizing the risk; the former Citigroup CEO Chuck Prince, who failed to understand how his vast bank was exposed to risk; and many other Wall Street and Washington names. Ferguson even calls for certain bankers to be prosecuted. For example, he charges Lloyd Blankfein, the CEO of Goldman Sachs, with perjury, pointing out that Blankfein testified before Congress that he was unaware of the importance credit ratings played in institutional investors' purchasing decisions -- even though he had spent his entire career at Goldman Sachs. "The idea that he was unaware of the importance that ratings played in institutional purchases of [collateralized debt obligations] is, to put it bluntly, beyond absurd," Ferguson writes. "When Mr. Blankfein so testified, he was, in my opinion, perjuring himself. . . . I'm willing to bet that if you go through his e-mail carefully and depose everyone around him, there would be plenty of evidence that he knew perfectly well how important ratings are."

Ferguson is equally brutal toward academics, even former friends of his, such as the Berkeley economist Laura Tyson; he argues that before the crisis, she did not ring the alarm about the impending financial woes, even though she was (and is) sitting on Morgan Stanley's board of directors. Some of the most powerful scenes in Inside Job are the interviews Ferguson conducted with academics such as Glenn Hubbard and Martin Feldstein, in which he confronts them with the (largely unreported) payments they received from financial firms. In Predator Nation, Ferguson provides more details about what he considers conflicts of interest for such economists as Larry Summers (who has worked for the hedge fund D. E. Shaw), Frederic Mishkin (who was paid to write a report on Iceland), Richard Portes (who also received money for writing about Iceland), and Hal Scott (who is on the board of the investment bank Lazard). "The gradual subversion of academic independence by finance and other large industries is just one of many symptoms of a wider change in the United States," he argues, noting that pharmaceutical money has also corrupted universities. "It is a change that is more general, and even more disturbing, than the financial sector's rising power."

Such allegations will certainly not win Ferguson many friends in American universities; indeed, the angry tone would probably make Galbraith and Shiller wince. But love it or hate it, Ferguson's anger taps into a popular vein. And if there is one thread that links all three books together, it is what Shiller calls the problem of "caste." All three authors recognize that as the financial industry has swelled, it has created an elite that not only wields wealth and power but also passes that privilege onto the next generation, thanks to educational stratification and social exclusion.

To Ferguson, the behavior of this caste looks quasi-criminal, whereas Galbraith prefers to describe it in terms of dry global economic trends. Shiller, meanwhile, sees this caste system as tarnishing higher-minded ideals: he admits that the business community is often too clubby, but he contends that there is nothing inherent about finance that makes that so. "It is not the financial tools themselves that create the caste structure," he writes. "The same financial tools can also, if suitably designed and democratized, become a means to break free from the grip of any caste equilibrium."

REASON TO REFORM

Either way, what one can be sure of is that debate over the rise of this financial elite will not die away soon, least of all in an election year. Not everyone will agree with Ferguson's conclusion that the United States has become a country that "allows predatory, value-destroying behavior to become systematically more profitable than honest, productive work"; even fewer will accept his claim that "the worst people rise to the top . . . behave appallingly, and . . . wreak havoc." But although his language might sometimes seem extreme, the fundamental arguments are correct and should be heeded -- and Ferguson is right to argue that the key policy question today is how governments will respond.

Pushing for more accountability in finance would be one good place to start. As Ferguson notes, the fact that so few people have suffered penalties for the financial crisis of 2008 has robbed the United States of any sense of political closure. Whether prosecutors could make more criminal cases stick is unclear. But looking forward, it is essential that regulators are given more resources to clamp down on future financial misdemeanors. Although Shiller correctly argues that finance needs to become more "moral," preaching ethics will never change behavior as much as the threat of prison. 

More important still, U.S. policymakers need to recognize that if they are going to pay homage to free markets in their political rhetoric, they must ensure that markets are truly free in the sense of being open and competitive. That means making finance dramatically more transparent and simple and ensuring that financial institutions are small and self-contained enough to fail without bringing the entire system down. Without such market discipline, it is impossible to have a proper market at all. But above all else, policymakers must prevent powerful cliques of bankers and banks from dominating the system for their own ends, skimming off outsized margins because nobody else can work out what they are doing or because the barriers to entry are too high for anybody else to compete. And last but not least, governments should make sure the banks pay for the risks they pose to the system, or recognize the costs they could potentially pose, by imposing taxes or fees. 

Such reforms would no doubt make bankers squeal; after all, a more transparent and competitive financial system would probably be a less profitable one. But a world where finance was far more modest would also be more inclusive and equitable. And that outcome would be good for bankers and nonbankers alike.