Logic of Finance Can Banish Corruption (Part 4): Robert Shiller

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The economic power that some in the financial community attain bothers many people deeply. It offends our ideal of a society that aspires to respect, appreciate and support everyone. The pursuit of power that often drives financial capitalism seems contrary to the concept that finance should be about the stewardship of society’s assets.

Yet successful societies develop elites partly because they need leaders with the power to get things done. We have to make it possible for a relatively small number of people to use their personal judgment to direct our major activities. A system of financial capitalism will eventually imbue those in possession of such faculties with wealth and power.

Still, there is a reason that the level of resentment of the wealthy and powerful is so high: A free capitalist system can support an equilibrium in which some kinds of social conspiracy pay off. George Akerlof, in his 1976 article, “The Economics of Caste and of the Rat Race and Other Woeful Tales,” explains the tendency of certain social groups to form a sort of business conspiracy against outsiders. He uses the caste system, most notorious in traditional India, to examine the phenomenon of power elites in business and finance.

Castes in Finance

Those in the world of finance who belong to a higher caste -- because they are graduates of an elite college or are connected to a specific business culture -- realize an immense economic advantage. Fearful of compromising that advantage, they adhere to the caste’s social norms. They favor their own caste in business and reject those who don’t belong -- or who don’t respect the social norms. This promotes stability of the caste.

The financial tools themselves don’t create the caste structure, though their mechanisms are part of the equilibrium. The same financial tools can also, if suitably designed and democratized, become a means to break free from the grip of caste equilibrium. Truly democratic finance can enable citizens to escape outcast status.

Financial capitalism is a work in progress, not yet perfected but gradually improving. It is defined by a long list of practices and, within them, specific roles and responsibilities for people. Watching these people in operation day to day, one can easily observe that, in our society, caste- like behavior has been on the decline.

India’s caste system has never been accepted by the Buddhist, Christian and Muslim religions, and it was deplored by Mahatma Gandhi and other spiritual leaders. Vladimir Lenin in Russia, Kemal Ataturk in Turkey, Yukichi Fukuzawa in Japan, Sun Yat-sen and Mao Zedong in China, Eva Peron in Argentina and Nelson Mandela in South Africa had the same distaste for castes or their analogues. Just as their beliefs represent a worldwide 20th-century trend toward greater social enlightenment, a parallel trend exists in the business world.

The concept of an aristocracy or “high society,” so strong in the 19th century, is fading around the world. No longer is a listing in the Social Register a coveted status symbol for prominent U.S. families. Burke’s Peerage has likewise fallen from importance in the U.K. In China, the national records of degree-holding literati and the local gazetteers died out before the end of the Qing dynasty in 1912. A more egalitarian spirit is abroad in the world, and it is supported by democratized finance.

Regarding the Rich

President Franklin D. Roosevelt once said, “I am delighted to show any courtesy to Pierpont Morgan or Andrew Carnegie or James Hill, but as for regarding any of them as, for instance, I regard … Peary, the Arctic explorer or Rhodes the historian -- why I could not force myself to do it even if I wanted it, which I don’t.”

Most of us might think Roosevelt himself was rich. After all, in the 1940s his family was the most prominent of all in the Social Register, with no less than a page and a half of entries. But he was not among the extremely rich, and he seems to have considered himself at the same distance from them that most of us do. This mindset must have been a factor in his New Deal policies, which helped democratize U.S. financial markets.

Further democratization of finance entails relying more on effective institutions of risk management that prevent random redistributions of power and wealth. We have to further develop the financial system’s inherent logic, its own ways of making deals among independent and free people -- deals that leave them all better off.

We also have to improve the nature and extent of participation in the financial system, including by distributing to everyone fundamental information about its workings. When people get reliable information, they come to feel less dominated by a power elite. At present, most people have little or no such information. Instead they are routinely confronted by salespeople for financial products who have inadequate incentive to tell them what they really need to know.

An enlightened system of financial capitalism requires some government interventions, including a progressive income tax. There also needs to be a social safety net, and it has to be continually improved and reworked.

Make Finance Humane

The democratization of finance works hand in hand with the humanization of finance. To that end, it is important that finance be humane, and that its models incorporate our increasingly sophisticated understanding of the human mind. The rise of behavioral economics and neuroeconomics in recent decades provides a foundation for such an approach, for understanding how people really think and act. People aren’t inherently and uniformly loving to their neighbors, but our institutions can be changed to reward the better side of human nature.

One of these better sides is the charitable impulse, and the tendency, at least in the right social environment, for wealthy people to give much of their wealth away constructively. Such a tendency ought to be considered central to financial capitalism.

One other singularly important human impulse was emphasized by Adam Smith in his 1759 book, “The Theory of Moral Sentiments.” This is the desire for praise. We see this plainly in the behavior of the youngest children and the oldest and weakest people, those with no hope of attaining power over others.

An enormous literature in modern psychology confirms the importance of self-esteem. But Smith put a different slant on the desire for praise. In mature people, he wrote, it is transformed into a desire for praiseworthiness. Further, he believed that our desire for praise can be truly satisfied only if we deserve it. No one is satisfied merely to look praiseworthy; one wants to be praiseworthy.

This aspect of human nature is essential to the success of our economic system. Economic development is, in substantial measure, the development of a social milieu in which few people find corrupt behavior worthy of praise.

Achieving such a system requires innovations to humanize finance. Regulations are like rules of war; they work to lessen the unnecessary damage of human aggression and encourage the expression of other, more charitable, impulses.

Many of our hopes for the future should be pinned on further development of the institutions representing financial capitalism. We are easily dazzled today by advances in information technology, and these advances can certainly interact positively with financial innovations. But advances in our economic institutions may ultimately be more important than those in our hardware and software. The financial system is itself an information-processing system -- one built with human, rather than electronic, units.

We need a system that allows people to make constructive deals to further their goals, and one that allows an outlet for our aggressions and lust for power. It must redirect inevitable human conflicts into a manageable arena, one that makes room for those who are happy to commit themselves to a life of stewardship and the protection of others.

(Robert Shiller is a professor of economics and finance at Yale University, where he teaches financial markets in the Open Yale Courses program. He is the author of “Irrational Exuberance” and “The Subprime Solution.” This is the last in a series of four excerpts from his new book, “Finance and the Good Society,” to be published April 4 by Princeton University Press. The opinions expressed are his own. Read Part 1, Part 2 and Part 3.)

Read more opinion online from Bloomberg View.

To contact the writer of this article: Robert Shiller at Robert.Shiller@yale.edu

To contact the editor responsible for this article: Mary Duenwald at mduenwald@bloomberg.net

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