In this article, Mark Esposito (co-editor with O’Sullivan and Allington of the book From Hubris to Disgrace) and Terence Tse, take a closer look at the economic and philosophical domain of finance in order to understand the circumstances in which market corruption unfolds and explore what appears to be ingrained attitude of disregard for rules and regulations in the financial sectors.
Following the September 2008 financial crisis, in which the players of the financial industry caused the near collapse of the U.S. economy, a proverbial narrative has emerged. The rich, who controlled America’s investment banks and financial institutions, had schemed, lied, and cheated Americans and the American system. In the aftermath, a disgrace shadowed over banks and financial institutions, but the consequences of greed and deception were already set in motion. Small companies and businesses could not get the credit they needed to stay open and unemployment soared for most of the world, while financiers took home big checks. Although now history generally assigns the blame on an abstract, faceless entity colloquially known as “the greedy rich,” we seek a closer examination of the economic and philosophical domain of finance in order to understand the circumstances in which market corruption unfolds, and ask what can be done to prevent future economic debacles.
Although the U.S. economy has managed to put itself on the road to recovery, future crises may not be very far off. As government officials and the public continue to discover, lessons of morality still have yet to be learned globally across the financial sector. Even as the economic crisis unfolded in 2008, banks did not stop manipulating LIBOR and EURIBOR rates but instead chose to continue manipulating rates to hide their financial positions rather than to face the music. In another case in the much more recent past, proceedings began on yet another rate-fixing scandal in 2013, this time involving a cartel in Yen interest rate derivatives (YIRD) between 2007-2010.
As history appears to be repeating itself even in the wake of financial crisis and disgrace, it would appear that the regulators who failed to protect the people from past crises are still not doing enough to stop what seems to be an ingrained attitude of disregard for rules and regulations in our financial sectors. Images of the last recession are still painful: the government ferociously pumping out newly printed currency or taxpayer money into the banking system, Bernie Madoff and the likes of him preying on unsuspecting clients, institutions dictating economic policy to governments, and powerful investors systematically setting speculative runs in motion against an array of Eurozone member states’ bonds.
The scale of how intertwined the financial world and our societies are is often underestimated. Consider, for instance, how the power of the press is also a force when it comes to finance: newspapers and publications too can influence public opinion and hinder economic recovery. In Germany, tabloids spread distortive stereotypes of Greeks at a time when Germans were angry and resentful over a possible default in Greece and fearful for the stability of the Eurozone. The tabloid press affected investor opinion of European financial markets, and Southern European markets, in particular. Since the time of Keynes, it has been reluctantly but clearly recognised by most economists that financial markets and public opinion are based to a large extent on herd mentality and animal spirits rather than on rationality. Whether the future is uncertain, this is to a degree inevitable. But once we admit that emotion and herd mentality have a preponderant influence on financial market decision-making, we are more able to recognise when herd mentality leads to adverse economic consequences and stereotyping as an outcome of emotion and prejudice.
It is these types of influence and interrelationships with the financial system that make reform mandatory for the entire system, not just one or two particular parts. The propositions set forth here and in the book, From Hubris to Disgrace, aim to discuss the multifarious contemporary problems of finance. The research delves into the economics of finance to explain the supposed ultimate function of finance and the financial system in the wider real economy; to look at the power relationships that underpin finance, its regulation, and its manipulation by key actors; and to probe such fundamental questions such as how money, initially designed to be a medium of exchange and so an instrument to serve mankind, has somehow evolved into an end-in-itself which transcends every other sort of value in its path. In the book, the contributing authors and editors dissect the issue into four parts: 1) The Mechanics of Money, Banking, and Finance, 2) The Economics of Finance, 3) The Politics of Finance, and 4) The Philosophy of Finance.
The Mechanics of Money, Banking, and Finance
We first set the stage for how markets work and how markets are regulated by introducing the mechanics of finance. There are many interrelated functions, including the role of central banks and seigneuriage, the role of financial intermediaries, the basics of portfolio choice theory, liquidity preference and attitudes to risk and uncertainty, the creation of new and ever more complex derivative assets since the early 1990s, and the role which they were expected to play. There are also the mechanics of financial regulation through a Central Bank or other authority, the trend of deregulation starting in the mid-1980s in the Western financial world, the hidden increase in financial risk and uncertainty for many actors in the system as more and more complex derivative assets were being created, and finally, the role of the rating agencies, both historically and in the contemporary context of extreme uncertainty. With these mechanics in place, some of the questions that arise include how some financial transactions were ever allowed to take place. For example, some of the derivative assets that were based on collections of American subprime mortgages were sold to financial institutions and brokers outside of the U.S. with a take it or leave it clause, whereby the buyer of the derivative asset agreed not to inquire into the detailed composition of the asset being bought, or, at the very least, not to hold the seller liable if afterwards the derivative turned out to be a dud. The as-is arrangement has more in common with a used car dealership than it should. Under the span of implications mentioned before, understanding the mechanics of the various types of financial assets and the regulations that rule them is crucial to be able to properly examine the forces that shape the financial sector and its actors in the wider economy.
The Economics of Finance
Current discussions of the financial and debt crises have often been characterised by a reflection on the contrast take it or leave it between the financial sector and the real economy. The financial sector is seen as somehow increasingly unreal and out of touch with the economic reality of everyday trade, commerce and exchange; after all, despite the headlines of financial crisis, people are still buying food and clothing, traveling, and taking holidays. So while the financial chaos has indeed wrought havoc with some aspects of the real economy — most notably through unemployment — there is also a clear sense that the chaos seems unreal. There has been no war or great natural catastrophe that would have fundamentally undermined everyday commerce and supply chains, and in that sense, the pain and suffering seems somewhat artificial and self-inflicted in nature. This leads us into that great debate of classical macroeconomics: the veil of money. Has the financial sector evolved to serve only a monetary economy and disconnected itself from the real economy of concrete production and consumption of commodities, services, and activities? If so, it begs the question whether the financial sector is a smoke screen that distorts the real economy, in which case, macroeconomic policy should seek to dispel the smoke screen in order to reveal the true workings of the real economy.
Another perspective to evaluate is whether or not we might consider the financial sector as an integral part of the real economy, producing real products and services to facilitate trade, and therefore just one sector among many others. One of the most striking features to any neutral observer of finance and money is the regularity with which financial crises have been reproduced repeatedly in modern times. Since the essential causal mechanisms of these crises rarely differ from one to the other, one must be led to ask why the cause of financial crises always stems from this particular sector, and what is it about our financial systems that leaves us seemingly incapable of permanently rooting out the source of the problem.
With this debate in mind, From Hubris to Disgrace considers the relevance of the basic economic role and function of money as well as the typical mechanisms of money creation. It also considers how the old gold standard — which some see as a panacea to all of our current ills — and the Hayekian project to replace state-backed money with an array of private sector-competing currencies might offer a solution to preventing future crises.
The Politics of Finance
As sensationalist as it may sound at first, there is a real political question about who rules the world today: an ill-defined coterie of financiers and financial institutions, or elected (and non-elected) officials? From one point of view, our financial system can be described as a case of modern Darwinism. There seems to be an inevitable tendency of financial firms and institutions to outwit or “run ahead” of any type of imposed regulation by workarounds and the invention of ever-newer types of financial instruments, leading to an uncanny semblance between Charles Darwin’s theory on survival of the fittest and those who walked away from the financial crisis with full pockets. To that end, we must ask which ‘species’ truly dictates the macroeconomic policies of states: financiers, rating agencies, politicians, or yet another actor.
Events since 2010 in the Eurozone suggest that the demonisation of finance has gone from being a hypothetical question to becoming an authentic public concern. In his 2012 presidential election campaign in France, François Hollande declared that the real enemy of the state was “finance.” This amorphous ‘enemy’ struck a very respondent chord with much of the French electorate and with the electorates of many other Eurozone states. If divisive macroeconomic policy and regulatory malfeasance is an obvious area of conflict between financial interests and the interests of the common good, it should also be possible to identify the reasons behind the conflict.
The most obvious reason is the short-term bias in the microeconomic investment appraisal of both public and private sector projects. In these appraisals, there is a concentration on narrow financial return, without taking into account the potential costs or benefits to wider groups of stakeholders or future unborn generations. To many nowadays, it seems as though the concerns of financiers, be they either at the micro or macro level, trump or drown out the political consideration of any other types of interest. That which was supposed to be a set of economic instruments of intermediation to serve the public has instead become an all dominating political end-in-itself. In that respect, the political dominance of the financial sector may be a manifestation of a wider delusion in materialistic societies, whereby the acquisition of ever-more material wealth becomes an end in itself rather than at most a useful means to securing a degree of happiness.
The Philosophy of Finance
A final theme here is the legal framework of finance and the degree to which the legal framework of contracts may or may not harbor the potential for some challengeable features from both the point of view of business ethics (extortion of various kinds) and of natural justice. Politicians of many stripes today like to trumpet about the “rule of law,” but in light of the many financial scandals that keep coming to pass, one must ask if the law is, in some cases, nothing more than just a convenient device for the domination of certain interests. For instance, are contracts too loaded in favor of creditors? If so, then perhaps we should be more concerned about the rule of justice rather than the rule of law. As any serious student of business ethics learns in one of their very first classes, law and morals do not coincide and there can indeed be bad laws.
The themes that emerged in the Politics of Finance inevitably lead on to a deeper level of reflection on the entire role, purpose and power of finance in contemporary society. We might reasonably label these broader themes and reflections as the Philosophy of Finance. It is true that finance and philosophy are strange bedfellows, but over the centuries they have occasionally encountered each other. “Wealth,” Aristotle once wrote, “is evidently not the good we are seeking; for it is merely useful and for the sake of something else.” Given some of the financial excesses of recent years, it is time that philosophy and finance encounter each other again in a critical reflection of the role that the financial sector ought ideally to be playing in advanced contemporary societies. It is just such an encounter that this final section of the work attempts to create.
The predominance of financial interests has permeated many areas of society and science. The world of sports is a prime example of the overemphasis on wealth and monetary reward. The most successful football clubs buy the world’s most talented players, so in effect, the club with the greatest financial means is most likely to win. In the pharmaceutical industry, many beneficial yet experimental drugs are never taken to full development because drug companies don’t want to pay for the costs of trials. Such is also the case in the field of education, where students with a more financially advantageous life have a competitive edge over others. Ultimately, with a better college education, they will lead more financially prosperous lives. It is sobering to remember that what will maximise profits for private, for-profit healthcare institutions (but not for private health insurance companies) is to have more sick people. Venture capitalists are another example of this fixation on financial returns. Though venture capitalists can and should play a useful financial intermediary role in the development of new businesses or the transformation of older stagnant ones, they too often approach a business with only an eye toward seeing the financial bottom line, while being blind to such factors as climate change, humanitarian needs, capacity building, or other basic but important products and services that have minimal returns on investment.
In all of the instances above, interests are driven by money and identified with the pursuit of maximum profits. While one might quibble about the exact definition of profits or about long-term vs. short-term perspectives in calculating profits, there is no doubt that when a financier looks at any business, it is inevitably in terms of profit and loss and in terms of a “financial bottom line” to be expected at some future date.
As the world continues to become more intertwined and complicated, we seek answers in new places. By stepping away from the notion of ‘business as usual,’ we hope to shed light on the sophisticated relationships between the financial world and everyone else. Between this article and From Hubris to Disgrace, we illuminate some of the shortcomings the world faces today in light of the current domination of finance along with all of its drawbacks. We also seek to suggest solutions. The revamping of the entire financial world and its motivations may not be possible, but recalibrating our systems of checks and balances, instilling a new code of ethics and a sense of responsibility in the people who run our financial institutions, and ensuring severe repercussions for those involved in immoral turpitude and negligent risk may offer plausible results.
Special Thanks to Stella Tran, Research Aide at Harvard University, for the research conducted.
About the Authors
Dr. Mark Esposito is an Associate Professor of Business & Economics at Grenoble Graduate School of Business in France and Instructor at the Harvard Extension School in the USA. He serves as Senior Associate for the University of Cambridge Institute for Sustainability Leadership in the UK. He is the founder of the Lab-Center for Competitiveness and has worked with governments, the UN, and the NATO over the past 10 years on economic development and sustainability issues. He holds a PhD from the International School of Management in Paris/New York.
Dr. Terence Tse is an Associate Professor in Finance at the London campus of ESCP Europe Business School. He is also the Head of Competitive Studies at i7 Institute for Innovation and Competitiveness academic think-tank at ESCP Europe. He began his career in investment banking at Schroders and Lazard Brothers, and later as an independent consultant to a University of Cambridge-based biotech start-up and various major corporations. He worked as a consultant at Ernst & Young in London. He holds a PhD from the Judge Business School, University of Cambridge, UK.