Robert Shiller is wrong

The American academic Robert Shiller has taken another contrarian tack with his latest book  Finance and the good society. His claim is that Western finance has lost the sense of virtue that it once had. It is interesting to trace where Shiller is wrong, or at least looking in the wrong direction.  Because it tells us much about where finance has become post-capitalist and ever more dangerous.

Much of what Shiller says is right. For instance his observation that “financial institutions and financial variables are as much a source of direction and an ordering principle in our lives as the rising and setting sun, the seasons and the tides.” This is undoubtedly true. Indeed, finance IS rules, so it sets the rules of money, and therefore the rules of commerce.

He then goes on to argue that most bankers and financiers aren’t especially bad people, that greed is something of an aberration. He cites the virtuous stalwarts of the past from Goldman Sachs and ratings agencies to show that recklessness has not always characterised the sector. A return to that sense of virtuous service of commerce, he argues, will re-invigorate the strength of capitalism, surely the best economic and political system. Shiller cites Montesquieu’s argument that healthy commerce tends to produce societies less inclined to war and vicious politics (the Frenchman was obviously not writing at a time when some society’s commerce heavily depended on the production of instruments of war, as is the case now).

It is all fine stuff, and there is certainly considerable historical precedent to support what he is saying. Trouble is, it has very little to do with the problems that have emerged over the last decade or two. Here are some objections:

1. It is true that many bankers and financiers are not unusually bad people. They are probably like any other group of people; some good, some bad. And that is the point. It is a systemic problem. The financial behaviour that emerged is just what most would do, given the chance. Blaming individuals is not the way to solve it, deeply satisfying though that often is. Changes have to be made to the system.

2. Shiller makes an error that I think is almost ubiquitous. He assumes that regulation is somehow external to finance, acting on it as an outside constraint. That is not true, as we can see implied in his own quote. Money IS rules and governments set those rules. What has changed in the last two decades is that governments gave up that role, until they could no longer avoid it after the GFC, and traders instead established their own rules, derivatives mostly. We now have a system in which the financial players make up their own rules. Little wonder that the systemic problems are massive (see point 1).

3. Allowing traders to make up their own rules means that the subordinate role of finance, its function of serving commerce, has been altered, very much for the worse. Shiller argues that finance should support business, it should be humble. That is what will not happen in the current system, or at least not happen often enough. It has become a world unto itself, an exercise in gaming a system of rules in a potentially endless regress of making money out of the money made out of money.

4. We are now in that world of “meta-money”. Its most extreme iteration is high frequency trading, which, especially in stock markets, is a travesty of capitalism. The purpose of stock markets is to raise capital to fund public companies. The trading in nano seconds has nothing to do with that; the algorithms make no distinction between companies. It is just an exercise in gaming the rules of share trading. Same with currencies, which is also dominated by high frequency trading.

We would all love to go back to the world Shiller describes.Such virtuous men and women could grace the hallowed corridors of Yale, no doubt, making the odd financial donation. The problem is that it is not going to return. The computer driven monster of meta money has been unleashed. That is the world as it is, not as it once was.

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  1. Charles Ponzi

    Yes, we now have a system in which the financial players make up their own rules. I would add that financial players have also been making their own laws. Many financial players should be facing criminal charges. It seems thieves are not put in jail if they steal billions.

  2. Thanks for the interesting post H&H.
    I agree finance professionals should not be labelled as bad people. Not at all. Individuals with a craving for power often get to positions of power and if greed takes over, the common good gets trampled, in politics, finance and elsewhere. There are bully types in a lot of work places, and they often do a lot of harm.

    Your point 2 goes to the heart of the problem. Well, all the points do really.

    A lot of us are still in denial, not even noticing that we seek to be friends with the bully and foolishly believe we are among the beneficiaries of the system even though we are not, if the system is en route to general destruction.

    In general, industries that are self-regulated are probably as functional as a self-regulated prison.

  3. I agree with the points, and people might enter the profession with the best of intent, but the vast sums of money these guys make drives them further, and of course not all are bad, or maybe embrace risk more than others.

    If you go through the vesting records of many big US companies you’ll see say a CFO e.g. picking up USD 70M in three months (look over a five/ten year period, and you’ll see the scale of benefits these guys get), and this is on top of the USD 5-10M in base salary.

    I chose a link to make my point…look down the filings:

    I worked in a company like this, and I’d say these people are totally driven; are they are like bankers, I don’t know, but probably.?

    The bankers have a system that favours them, and with the knowledge if they get into trouble we’ll bail them out. They move from bank to regulator and back to bank jobs how is that right?

    Look at this:
    Click on [Next] until 1ms comes up, and you can see how these guys are going to kill you on a trade. Guys like me program this stuff, but from a specification from a banker.

    • Individuals may not be good or bad, but it is a fact that the finance industry now attracts people with only one desire, to make a lot of money regardless of the means of achieving it. What sort of self-regulation is possible with that type of mentality? None.

  4. Of cause the individual people are not to blame, because they can’t be so bad as to make the whole world suffering. That is very much true.

    Once upon a time there was a very good capitalist, Robert Owen. He didn’t play according to the rules of capitalism, he was too good and he got bankrupted. He established in his own factory 8 hours working day and day childcare for the workers. He was too good to be a capitalist and he was playing against the capitalist rules and he was bankrupted.

    So,H&H, if the system is to blame,for which you are right, what kind of system we want to live in and who has to change the system? If a society looks and dreams to go back for a change, not forward for better future, this society is doomed, because is already sclerotic. The old model of 20th century capitalism is in the past and can’t be revived.

  5. Great post.

    Point 2 is key. When financiers rule “money” (or government, or any one does, for that matter), greed and corruption inevitably follow, sooner or later.

    IMO the solution is decentralisation of “money” issuance. Alternate/complementary currencies, in other words. Looking across the post-2008 world, especially in some of those nations hit hardest, there are evidently more and more of these arising. So I assume that I am not the only one thinking along these lines.

  6. Sorry SoN, some of your assertions seem way off-beam to me. Point 4 for example asserts that meta-money, as represented in high frequency trading does no good. In fact, high frequency traders do no harm to any “normal” market participant because they operate in an entirely different timeframe and do most of their volume with each other. They represent the electronic equivalent of the essential liquidity providers like jobbers and locals in the old style open outcry markets. We could go back to those days, but it seems to me that electronic trading with all of its own peculiarities is a much cleaner and open system than the old boys club I first had to deal with 35 years ago.

    High frequency trading is an easy target for broad swipes when looking for baddies, because it is telegenic. The only people they may do harm to is themselves, and they are big boys who can stand any negative consequences of playing with themselves.

    Contrary to popular perception, the markets would be far less effecient (for the raising of capital) without them.

    Their behaviour may seem silly, but there is no proper evidence that they hurt the markets. Just like a lot of other parts of the system who are dumped on because they are now an easy and popular target. The last little bit of market history has no more sillyness or inherently bad guys than any other times in history.

  7. IMHO, it’s the meta-money economy that is creating the most problems in that it leaks its way through the system to impact on the financialisation of social assets like infrastructure and housing, and allows the debt-funded trend towards duopoly/oligopoly in core service service providers and the resulting corporate pricing and political power.

    If it wasn’t for this then mostly people going about their lives could tend to ignore what goes on at the mezzanine level where trillions and beyond are becoming the norm.

    It is true, we are all becoming embedded and lost in a game where money is the rules – and human behaviour is corrupted to these rules.

  8. “The purpose of stock markets is to raise capital to fund public companies”

    Yes, indeed, they are used to raise capital, but they are also secondary markets and this is an equally important part of the process of capital formation.

    Having a secondary market means investors can get into and out of an equity postion independently of the timetable of a Company’s capital raising requirements. It therefore reduces risk for the investor. Eg, it not easy to get or sell shares in a private company and the secondary market, ie the Stock market, is the reason that Public companies have a different risk profile.

    Having a secondary market as it stands means traders, brokers, investment banks and many other institutions, all providing liquidity in the market, HFT amongst them.

    Also to suggest that there’s bankers, financiers and ratings agents who do it solely for the love of it, or out of some underlying concern for humanity is poppy cock. They are incentivised to work in their industry, just as in any other industry, with the possible exceptions of charity and academia, but this does not make them greedy or bad.

    Yes, there are bad apples, but no, not everyone is one.

  9. I completely agree with you and I am surprised Shiller would cop out like that. The problem is endemic and systemic, it has been caused by governments who bought some stupid economic theories. It can be stopped by governments.

    “Never tear down a wall until you know what it is for”
    Robert Frost

  10. Bryan Kavanagh

    I’ve not read his book, but Robert Shiller’s interview with Geraldine Doogue on the Radio National’s “Saturday Extra” yesterday was one of the most wimpish cop-outs I’ve ever heard. No great structural flaw in our system, we’ve just got to become nicer: this, from a man, who with Karl Case (whom I’ve met), who developed the mighty Case-Shiller Index relating to US residential real estate!

    Robert, don’t you see real estate bubbles are getting worse every 18 years, because we’re drawing less and less taxes from real estate as a percentage of all revenues? This surely leaves more and more publicly-created rent to be capitalised in private hands into bigger and bigger bubbles?

    It’s sad you’ve missed your very own point: the US (and the world) would curb residential bubbles, and free up labour and capital, if we were to reform tax systems along the lines recommended by the Henry Tax Review – i.e. capture more of our land and resource rents, and abolish many inefficient other taxes.

  11. George Locust

    There IS something wrong with a system which massively rewards twenty somethings coke heads for speculating other peoples money, creating nothing tangible, while nurses, police, teachers etc make only a fraction of the income for performing more socially beneficial duties. But when Wall Street owns Capitol Hill, what should one expect.

    • Well what can be said, and said in much of the Anglo-speaking countries, is that the mantra of ‘you can be anything you want to be’ does in effect put in
      place a faustian pact with ‘the corporation’. They will pay more than the value we offer the utility of nurses, police and teachers.

      Everyone is ‘brilliant, a genius in waiting, if only they work harder’ (despite the fact someone in the economy has to be the lowest paid). Creating virtue in the endless pursuit of work, or even ‘make-work’.

      The end game is we see that 50 hours becoems normalised, so much so that 40 hours becomes insufficient that you’re priced out of consumer items in the market. Noble pursuits such as teaching become less and less affordable.

      Then the recalibration will head towards 60 hours per week.

      What Shiller says is correct, there’s no real structural problem and that people have to be nicer, or more accurately, more value has to be given to noble pursuits, even though this value can’t be exchanged for material items (much like motherhood). Overall, the rewards are wrong.

      A banker is to the flow of money is what a plumber is to the flow of sewerage. The demands are roughly equal, the intelligence required is roughly equal. But as I said when the stakes are so high, that a 0.01% commission seems reasonable because the nominal fraction sounds small. But the end result is a huge number, so it will attract the sociopath.

      Once in power, with such large sums of money, the sociopath will obviously seek to capture the regulatory system,as we see in the U.S.

      It is game theory once again.

      The only way to overcome the worst aspects of game theory is death to the participants when they lose the game.

  12. It’s interesting that most commentators look at the supply side of the equation rather than the demand side. After all, it has been possible for people to write crazy derivatives for the past 25 years, but they’ve only recently started being able to sell them in bulk. An old Wall Street joke is that it’s really unfortunate the 99% of really crappy derivative-based financial instruments cast such a pall over the 1% of good ones.

    It’s a complex subject, and one that’s really too long to put in a comment. I think what has made the market for crazy derivatives is an ongoing financialization process which started in the 1980s. It accelerated from 2002 onwards, driven by the inability of traditional enterprises to compete with information-based enterprises (so they sought returns elsewhere than in their own businesses) and the natural investments of information-based businesses which had nowhere else to sink their profits (no plant and equipment, and few employees, no desire to expand beyond the capacity of the founders to manage).

    The only sure-fire way to regulate the market is to setup a conservative government run ratings agency to replicate the work of Moody’s etc, and require that agency to certify all AAA investments that can be entered into by government agencies and pension funds.

    That will never happen, precisely because it would be too effective.

    It’s so obvious, that arguing about other measures is pointless. Basically, the market thinks it needs to be rigged to be effective. That’s the bottom-line.

  13. Read this earlier in the day and to be honest thought ‘nothing new here’. That is not a criticism per se, rather an observation that this is a much discussed and debated topic, unfortunately solution remains (and probably will remain) out of reach.

    The JP Morgan Chase London Whale news serves to remind.

    ““Jamie Dimon and JP Morgan Chase just proved what anyone not getting a paycheck from a Wall Street bank already knows: gigantic too-big-to-fail banks are too-big-to-manage.””

    And I for one think this true. The revolving door of Wall Street/Whitehouse/US Treasury/Financial Services Supervision both embeds practices preferred by the big finance houses and ensures their continuation and protection. Short extreme dislocation in global finance, which as we are told will threaten the fabric of the global economy, it is unlikely anything will change in any significant manner.

    Truth is there has always been an element of finance that is NOT virtuous and frankly does not even (in the company of like-minds) pretend to be. Money begetteth money. Profit. At any cost.

    Such is life.

  14. “His claim is that Western finance has lost the sense of virtue that it once had.”

    It seems that things were always better in the good old days! Since when has finance been imbued with virtue?

    If the starting premise of Shiller’s work is nostalgic longing for an imaginary past, then it can be no surprise when he continues to romanticize finance by likening it to the processes of the natural world. This is really too much. Finance is about time and money; and finding ways to derive a profit by arbitraging these factors in the context of risks – such misfortunes as we know are common in human affairs – ineptitude, complacency, tragedy, incompetence, fraud, disaster, theft, war, plague, epidemic, civil violence, greed, gross mismanagement, manipulation, speculation, dishonesty and plain stupidity.

    Finance is conducted in spite of these things. This was the case in the heyday of the Medici caste, the South Sea Bubble and the Tulip Mania and continues to be so, Basel III and Volcker notwithstanding.

  15. Let me strip this piece of the usual scholarly pretence and see if I have the argument correct: The fact that finance is largely conducted electronically today means that there is no point even attempting to regulate it? Do I have that right? Jesus Herbert Christ, it just gets better each week. Although, the time you advocated the eradication of economic statistics was certainly a high water mark in absurdity. I’ve never read anything like it on an economics blog. Oh, but what about the time you accused the economist of getting its facts wrong whilst in the same paragraph getting your facts wrong! There’s just too much…