I am becoming more and more certain that Wall Street, and the
whole enterprise of financial capitalism, is destined to be
massively disrupted.
But probably not until 2024 or so...
![]()
What are we to make of Wall Street? Can
we avoid feeling some admiration for the swashbuckling
titans and their brash handling of unimaginable amounts of
money? Or horror at the greed and sleaze that their
activities lead to? Should we deplore the feeble efforts at
regulators to repair the damage that Wall Street caused to
Main Street in the Great Recession of 2008, or to prevent
another crisis? Or instead attack the dynamic within the
banks that led to the financial meltdown in the first place?
Fortunately help is at hand with Robert Shiller’s book, Finance
and the Good Society (Princeton University
Press, 2012). This is an important book, even with some
serious shortcomings.
The strengths of the book are that it presents us—for
once—with a balanced historical perspective of what the
financial sector has done for society over its five-hundred
year history as well as a brilliant and convincing picture
of what a responsible and morally sound financial sector
should be contributing to the good society.
The book’s main shortcoming is that it gives us an
incomplete analysis of why the last thirty years have been
such a particularly “bad patch” within the broader story of
the centuries-long success of modern banking. As a result,
the book misses five steps that are needed for banking and
finance to help achieve the good society.
Let’s start with the book’s strengths.
“Finance” and “good society” are words that are today
rarely used in the same sentence. Yet Shiller does us a
service by reminding us that finance has in fact made
important contributions over time to achieve a more an
egalitarian society.
Greed and the excesses of the recent crisis have made
finance and banking today the least trusted sectors in the
entire economy—a paradox, given that banking ultimately and
necessarily rests on a foundation of trust. But Shiller
points out that finance is not inherently elitist or an
engine of economic injustice. In fact, finance has been
central to the rise of prosperous market economies in the
modern age— indeed their rise would be unimaginable without
it.
Finance is an essential social institution, necessary for
managing the risks that enable society to transform creative
impulses into vital products and services, from improved
surgical protocols to advanced manufacturing technologies to
sophisticated scientific research enterprises to entire
public welfare systems. The connections between financial
institutions and individual people are fundamental for
society. It is central to activities like the development of
a new laboratory, the funding of a medical research project,
the building of a new university, or the construction of a
new city subway system. Finance provides structure to these
and other enterprises and institutions throughout society.
If finance succeeds for all of us, it helps to build a good
society.
Shiller notes that the very financial system that
facilitates some of our greatest achievements can also
implode and create a disaster. But finance, despite its
flaws and excesses, is a force that potentially can help us
create a better, more prosperous and more equitable society.
Banking’s original role was in serving primarily the
wealthy and the financially sophisticated. Throughout
history there has been a long trend toward the
democratization of finance, the opening of financial
opportunities to an ever wider circle of people and reduce
the risks to which they are subject.
2. Historically, finance helps good society achieve
its goals
Shiller argues that at its broadest level, finance is the
science of goal architecture—of the structuring of the
economic arrangements necessary to achieve a set of goals
and of the stewardship of the assets needed for that
achievement. The goals may be those of households, small
businesses, corporations, civic institutions, governments,
and of society itself. Once an objective has been specified—
such as payment for a college education, a couple’s
comfortable retirement, the opening of a restaurant, the
addition of a new wing on a hospital, the creation of a
social security system, or a trip to the moon— the parties
involved need the right financial tools, and often expert
guidance, to help achieve the goal. In this sense, finance
is analogous to engineering.
Shiller accepts—at times—that finance is not just about
“making money” per se. It is a “functional” science in that
it exists to support other goals: those of the society. The
better aligned a society’s financial institutions are with
its goals and ideals, the stronger and more successful the
society will be. If its mechanisms fail, finance has the
power to subvert such goals, as it did in the subprime
mortgage market of the past decade. But if it is functioning
properly it has a unique potential to promote great levels
of prosperity.
Finance, suitably configured for the future, can be the
strongest force for promoting the well-being and fulfillment
of an expanding global population— for achieving the greater
goals of the good society. The democratization of financial
innovations has often proceeded at a snail’s pace, often
over centuries. The challenge is to accelerate the pace of
positive innovation, while averting the problems that have
arisen.
3. The financial system is still going through a
severe crisis
While politicians wonder why there hasn’t been a more
robust recovery from the crisis of 2008, Shiller points that
the crisis hasn’t yet ended.
The 2008 crisis began with subprime mortgages but it didn’t
stop there. That was only the initial shock in a vast
catastrophe. The consequence was a drop in real estate
prices and the collapse of financial institutions, not only
in the United States but also in Europe and elsewhere. By
the spring of 2009 the crisis was so severe that it was
described as the biggest financial calamity since the Great
Depression of the 1930s—bigger than the Asian financial
crisis of the 1990s and bigger than the oil-price-induced
crises of 1974–75 and 1981–82. Beginning in 2010 it was
complicated by a European sovereign debt and banking crisis,
which by 2012 resulted in many downgrades of governments’
debt, and even of the Eurozone’s bailout fund, the European
Financial Stability Facility. This crisis continues to have
repercussions around the world.
So the reason why the recovery is so weak is that the
financial crisis of 2008 is not finished. Shiller writes:
”As I write in 2012, we certainly do not believe that it is
over yet, and the worst may be yet to come. Efforts by
governments to solve the underlying problems responsible for
the crisis have still not gotten very far, and the ‘stress
tests’ that governments have used to encourage optimism
about our financial institutions were of questionable
thoroughness.”
Shller contends that “the financial crisis was ultimately
due to fundamental structural shortcomings in our financial
institutions. Yet such shortcomings as a failure to manage
real estate risk or a failure to regulate leverage are still
not really being addressed; the response to the crisis has
not been to innovate confidently to address areas where our
institutions failed.”
4. Continuing innovation in finance is needed
Hostility among the general public generated by the crisis
has, according to Shiller, had the unfortunate effect of
inhibiting progress in banking and finance. There is a high
level of public anger about the perceived unfairness of the
amounts of money people in finance have been earning, and
this anger inhibits innovation: anything new is viewed with
suspicion. The political climate stifles innovation and
prevents financial capitalism from progressing in ways that
could benefit all citizens. Ironically, better financial
instruments, not less activity in finance, is what we need
to reduce the probability of financial crises in the future.
Shiller is sympathetic to the goals of the Occupy Wall
Street movement, if not its means: “While the arguments and
rhetoric are not always coherent, the protests represent, in
substantial measure, a welcome assertion of democratic
values and citizen responsibility.”
Financial capitalism is an invention, he says, and the
process of inventing it is hardly over. The system has to be
thoughtfully guided into the future. Most importantly, it
has to be further expanded and democratized and humanized.
Financial innovation is still percolating, at a slow and
conservative level, but major new financial inventions
cannot be launched now because of fear. The main focus of
financial reform has not been on fixing structural issues.
Initiatives have been shaped by what the public perceives as
the problem, not the real problems.
Those are the strengths of this important book which
presents a brilliant picture of what the financial sector
should be contributing to the good society. The book also
has serious shortcomings in showing how we might get to the
future that it depicts. Five steps should have figured more
prominently.
1. Shed the romantic view of financial capitalism as
a goal in itself
Shiller has a romantic view of financial capitalism. “The
past several decades,” he writes, ”have witnessed the rise
of financial capitalism: a system in which finance, once the
handmaiden of industry, has taken the lead as the engine
driving capitalism. The triumph of financial capitalism or
its analogues since the 1970s, even in formerly Marxian
communist countries, is one of the most significant
revolutions in history, and a radical departure from the
past.”
Here Shiller’s romance with finance causes him to lose
sight of his recognition elsewhere that making money and
finance are not goals in themselves: they are means to
achieve the goals of society—a college education, a
comfortable retirement, the opening of a restaurant, the
addition of a new wing on a hospital, the creation of a
social security system, or a trip to the moon or whatever.
Finance is the means, not the end.
2. Recognize why the last 30 years have been booms
and busts
The book fails to recognize that the financial booms and
busts of the last thirty years are directly related to the
adoption of the theory that the purpose of a firm is to
maximize shareholder value, i.e. to make money.
This idea took hold in the early 1980s and became pervasive
throughout the economy, ostensibly because firms, including
banks, had been pursuing multiple goals: they had lost focus
and so had allegedly poor performance. The idea was that a
firm with a single goal would do better; the goal chosen was
to make money for the shareholders. It has however led to
some noxious consequences across the economy, particularly
in the financial sector.
In the ensuing single-minded search for profits for
shareholders, banks slid into pursuing what Fred Reichheld
has called “bad profits”. These practices were not illegal,
but they were not in the best interests of customers or
society. In their search for profits, banks got involved in
price gouging, seeking unusual ways to levy
hidden charges on customers, particularly customers who were
vulnerable. Banks and others began practices that appeared
to be gaming the system, such as betting
against securities that they themselves had created. Banks
and others began practices that seemed to resemble toll
collecting, such as high speed trading, using
their position to extract charges and profits, simply
because of their position in the system. Banks and others
began to spend a large part of their energies in zero-sum
proprietary trading in derivatives, with dubious
social benefit and great risk to society. Banks and others
awarded themselves extraordinary increases in
compensation, that were inversely related to the
firms’ long-term financial performance or their contribution
to society.
![]()
At first, these “bad profits” were achieved through
practices that were shady but not strictly illegal. But in
due course, the temptations became too great and the “bad
profits” turned into practices that were illegal. They
include price fixing of LIBOR, abuses in foreclosure, money
laundering of drug dealers and terrorists, assisting tax
evasion and misleading clients with worthless securities,
that led to settlements entailing tens of billions of
dollars in settlements.
Shiller cites the old saying that “while the problem with
socialism is socialism, the problem with capitalism is
capitalists.” The implication is that there might be a few
rotten apples in the barrel, but basically the barrel is ok.
This is not correct. The scale of the abuses was widespread
at all levels and across all the large banks. What Shiller
misses is that the problem with current capitalism is not a
few bad capitalists, but shareholder capitalism itself.
Shareholder value leads directly to “bad profits”, which in
turn inevitably leads to “illegal profits”. It is the system
that is to blame, as well as the individuals.
3. Recognize the alternative to financial capitalism
Shiller asserts there is no alternative to the current
version of financial capitalism.
“Indeed there appears to be no viable alternative. We never
hear talk of nonfinancial capitalism as a model… — although
one could use such a term to refer to a market economy with
poorly developed financial institutions, as we still see
today in some poorer regions of the world. As much as we
might like to criticize finance, no one seems to view these
alternatives as suitable models for anyone’s future. Our
task, both in the financial sector and in civil society, is
to help people find meaning and a larger social purpose in
the economic system.”
There is however an alternative to financial capitalism.
It’s called customer capitalism, as described by Roger
Martin in his classic HBR article in January 2010: “The Age
of Customer Capitalism”. An increasing number of firms like
Apple [AAPL], Amazon [AMZN], Salesforce [CRM] and Whole
Foods Markets [WFM]are now pursuing, with great financial
success.
By contrast, financial capitalism, aka shareholder
capitalism, is struggling. It is based on a conceptual
error. As Peter Drucker pointed out in 1973, “the only valid
purpose of a firm is to create a customer.” Shareholder
value, or making money, is the result of a
firm’s activities not the goal. If
shareholder value ever becomes the goal, it leads the firm
into shady or illegal activities that eventually detract
from shareholder value. Even the most famous exponent of
shareholder value, Jack Welch the former CEO of GE, came to
see in 2009 that maximizing shareholder value is “the
dumbest idea in the world.”
In banking, shareholder value has not only led the banks
into activities of dubious social benefit, of great risk to
society, loss of trust and eventually illegality. Pursuit of
shareholder value has also had high opportunity cost for the
banks. Pursuing profits has distracted banks from their true
social purpose of reducing risk and increasing opportunities
for an ever wider circle of citizens and enterprises.
Innovation has been taking place in banking, but not in a
way that provides sustained benefits for either the banks or
society.
4. Support the paradigm shift in banking
Shiller notes that many countries around the world are
still struggling to deal with the aftermath of the financial
crisis that began in 2007. He argues that we “must smooth
the rough edges off our financial system— those aspects that
can cause trouble when people make mistakes.”
The leadership challenge for bankers requires more than
“smoothing the rough edges”. What is needed is a paradigm
shift in management towards customer capitalism. In banking,
this means:
- a banking sector whose very goal is to continuously add
value to its customers, not just making money or
shareholder value.
- a banking sector that sees making money as the result,
not the goal of its activities…
- a banking sector that deploys its very best talent in a
continuous search to find new ways to secure the financial
future of average citizens and make their lives better …
- a banking sector that cares profoundly about the
well-being of its customers, seeing them as
flesh-and-blood human beings, not as wallets to extract
money from…
- a banking sector with products and services which are
fewer in number, but which fit exactly the needs of its
customers, even needs customers had never themselves
imagined…
- a banking sector whose credit cards help customers pay
down their balances and warn them of any late fees they
may be about to incur…
- a banking sector whose managers and staff function as
teams that are passionately committed to these goals …
- a banking sector that is totally transparent about all
its activities, and proud to reveal how it conducts every
aspect of its business…
- a banking sector that exists in a virtuous cycle of
value creation, while also delivering superior financial
results year after year, decade after decade…
Banks must have one goal: adding value for customers.
Shareholder value must be seen as a result, not the goal.
Everyone in the bank must have a clear line of sight as to
how their work is adding value to customers on a daily
basis. Any jobs that are not adding value to customer should
be eliminated.
Wall Street is already signaling the case for change: the
book value of most of the large banks is greater than their
valuation in the stock market. It’s time that the banks
themselves recognized the problem and pressed ahead with
paradigm shift in management.
5. Resolve the #1 regulatory problem: lack of
transparency
Meanwhile with so many banks are on the wrong track, it’s
not enough to expect them to reform themselves on their own.
Regulation is needed.
Shiller’s book recognizes that the current approach to
regulation has failed. His book is aligned with the
conclusion in the The Atlantic in December 2012:
“Banks today are bigger and more opaque than ever, and they
continue to trade in derivatives in many of the same ways
they did before the crash, but on a larger scale and with
precisely the same unknown risks.”
The failure of regulation is not due to lack of effort. The
effort has been massive:
- Draft Basel III regulations total 616 pages.
- Quarterly reporting to the US Federal Reserve requires a
spreadsheet with 2,271 columns.
- The 2010 Dodd-Frank law is 848 pages
- The regulations may amount to 30,000 pages
of legal minutiae
This effort has increased costs for the banking industry
without making the financial system safe. The brute fact is
that this regulation doesn’t get to the root cause of the
2008 meltdown: lack of transparency. After Lehman’s
collapse, no one could understand any particular bank’s
risks from derivative trading and so no bank would deal with
any other bank or shadow-bank. In retrospect, with the
wisdom of hindsight, we can see that some “troubled assets”
were not as toxic as people worried at the time. But at the
time, the opaqueness created uncertainty and the uncertainty
was enough to cause the meltdown.
The numbers involved in the market in secret trading
derivatives are now truly mind-boggling. The notional value
of the entire derivatives market is some $700 trillion, or
ten times the size of the entire world economy. We have
little information on what this activity comprises. It’s not
an exaggeration to say that the $700 trillion market in
derivatives is a ticking financial time bomb that is large
in scale and dangerous. If only a tiny sliver of this market
were to explode, it could bring down the entire world
economy.
Thus the ongoing secret trading in derivatives is too large
and too complex to manage. It’s too opaque to be safe. It is
zero-sum in nature, i.e. it has little value to society. It
doesn’t expand the real economy: it merely redistributes
assets in the financial sector. It would have huge social
costs in a financial meltdown. It would be too costly for
today’s governments to bail out yet again. And it has
massive opportunity costs. It distracts banks from their
true purpose of expanding financial opportunities and
reducing risk for an ever wider circle of citizens and
enterprises.
The conclusion is inescapable: trading in derivatives must
be conducted in public so that the risks can be assessed and
safety measures can be put in place.
Shiller was among the few who were prescient in predicting
the housing crisis in 2007. His book is once again
concluding that the current approach to regulation hasn’t
solved the structural problems of banking and predicts that
“the worst may be yet to come”.
The book however is less than clear about what should be to
done to avert a global crisis that will be worse than 2007.
For esteemed financial experts like Shiller, there is a
special responsibility to press for the obvious top-priority
change: transparency in derivatives trading.
And read also:
How
bankers can recover our trust
The
dumbest idea in the world: maximizing shareholder value
Big
Banks & Derivatives: Why Another Financial Crisis Is
Inevitable
Does
Wells Fargo practice radical management?
Don’t
diss the paradigm shift: it’s happening
_________
Steve Denning’s most recent book is: The
Leader’s Guide to Radical Management (Jossey-Bass,
2010).
Follow Steve Denning on Twitter @stevedenning
