Robert Shiller, Finance and the Good Society
Princeton University Press, $24.95 (cloth)
Robert Shiller at the Annual Meeting 2012 of the World Economic Forum
In January, the Economist published a cover titled Save the City, portraying bankers in Londonspecifically, the City of London, Britains Wall Streetas latter-day Churchills fending off a blitzkrieg of misguided critics. Its writers praised financiers for performing vital roles in society. One columnist sternly warned against demonizing bankers, lest they decamp to Dubai or Singapore.
What a difference six months makes. In July the same magazine featured the stark cover title Banksters and ran an editorial on The Rotten Heart of Finance.
Scandals had proliferated in the first half of 2012: tax-evasion, money laundering, racial discrimination, illegal foreclosures, bond bid-rigging, and, of course, reckless trading. But what finally pushed the editors over the edge was the manipulation of the London Interbank Offered Rate, or Libora key interest rate for numerous financial transactions. A trove of emails from Barclays employees revealed lies and self-dealing.
Taken individually, each scandal can be explained away as the deviance of a bad apple. Together, they suggest that modern finance itself is rotten. Corruption has become so endemic that the very possibility of ethical bankers has come into question. As former prosecutor Neil Barofsky puts it in Bailout, The incentives are to cheat, and cheating is profitable because there are no consequences.
In his new book Finance and the Good Society, Robert Shiller tries to restore faith in the financial system. Though he chides greedy corporate titans, he earnestly reminds us of the good they can do. He also offers a balanced account of financial regulation, explaining where government intervention is essential and why some aspects of the Dodd-Frank financial-reform law are unlikely to work.
Had Shiller stopped there, Finance and the Good Society would be a worthy, if not terribly notable book: another wise mans reflections on an ailing economy. However, by the end of the volume Shillers scholarly detachment curdles into complacency. He views the financial scandals of the past few years as freakish events, not as the natural consequence of a captured regulatory system. He also suggests that excessive suspicion toward Wall Street is a bigger threat to the economy than the wrongdoing of bankers.
When Shiller emphasizes the importance of trust to economic growth, he speaks with authority. He has eloquently analyzed the role of human psychology in markets, and he predicted both the tech and housing bubbles. He has been a methodological trailblazer, introducing behavioral science to the ossified academic discipline of finance. Times Michael Grunwald has called him a must-read among wonks in the Obama Administration. Shillers past books command respect and repay close reading. Given his sterling career, it is deeply disappointing to see Shiller divert the behavioral turn in economics into the apologetics of Finance and the Good Society.
Shillers book begins with an overview of contemporary finance. He describes the roles and responsibilities of key actors in the financial sector, ranging from CEOs to lawyers and lobbyists. Financial institutions are intermediaries, standing between parties who have money and parties who need money. But as Shiller is quick to explain, the quaint picture of small-town depositors and lenders in Its a Wonderful Life is a far cry from what you see in todays world of securitized lending. Everything from selling a home to investing your savings and retiring has become more complicated. As financial institutions have become more specialized, so too have the instruments they use.
Rather than viewing this growing complexity with skepticism, Shiller marvels at the multiplication of todays financial institutions and instruments the way a biologist might enthuse about rainforest biodiversity. Other analysts might look at the housing bubble and conclude that instruments like credit default swaps should be tightly restricted. For Shiller, the answer is almost always more financial innovation: he even wants to let homeowners buy options that rise in value if their homes price falls.
For Shiller, whether in love or money, quants do it better.
Shiller brims with ideas for redirecting financial ingenuity to real-world problems. For instance, he endorses social policy bonds, which would allow governments to raise money while encouraging entrepreneurs to find creative ways to meet public goals. (The bonds would pay out more than a baseline return if the bond purchaser, say, reduced recidivism among a set of prisoners.) He believes that even the most personal problems can benefit from a financial engineers precision, since finding a match between husband and wife is like finding a trade in a financial market. For Shiller, whether in love or money, quants do it better.
His ambitions soar beyond the pragmatic into the panegyric. Some of our greatest human achievements have their origins in . . . self promotion and the acquisition of wealth, he reminds us. He praises the aesthetics of financethe elegance of its theorems, and the beauty in what it creates. Contemplating how finance facilitates all the day-to-day activities that constitute our working lives, Shiller is so moved that he quotes Whitmans Song for Occupations: In the labor of engines and trades and the labor of fields I find the developments, / And find the eternal meanings. He believes that leading CEOs and bankers share important similarities with poets, artists, and philosophers, whose vision can shape a good society.
What exactly do the creative geniuses of finance contribute? Shiller takes for granted that most financiers play a constructive role in the economy. For example, consider his discussion of finances share of GDP. He reports the gross value added by financial corporate business was 9.1 percent of U.S. GDP in 2010. But why not say that some firms extracted value, rather than added it? Think back to the last time you were charged a late fee on a credit card by a bank that already takes a cut of every purchase you make. Or the endless series of fees involved in a mortgage transaction, or the oft-mysterious charges that eat away at 401(k) accounts. How much value are the professionals pocketing these fees really creating, and how much of their role is explained by arcane law or custom, by their leverage over their debtors, or by their bosses power over networks of financial transfers?
Shiller endorses mild consumer-protection remedies for some of these practices. But he never seriously examines how much of bankers pay comes from skimming exorbitant fees off of normal economic activity, front-running, accounting shenanigans, and the like. He is untroubled by the fact that financiers as a class are so much better compensated than, say, scientists, let alone poets and philosophers. A Ph.D. cancer researcher with ten years of experience tends to make about $110,000 to $160,000 annually; a banker specializing in mergers and acquisitions, about $2 million. Top hedge fund managers make billions of dollars annually. The disparity fails to rankle Shiller, since the scientists are mostly living comfortably doing what they really want to do.
Unless, of course, theyre among the thousands of drug developers laid off by pharmaceutical firms, which have been pressured by Wall Street to focus on core competencies and cut R&D. Last year, investment managers punished Merck for investing in research, while rewarding Pfizer for cutting it dramatically. Investors and analysts also questioned R&D levels at Lilly and Amgen. The constant pressure for quarterly earnings makes each cut to scientific investment seem rational when it occurs, but its consequences are devastating in the long run.
Shiller is eager to praise financiers for funding innovation, but barely mentions the asset-stripping and short-term thinking that have devastated many industries over the past two decades. A study from the New Economics Foundation recently estimated that leading London bankers destroy £7 of social value for every pound in value they generate. In the United States, the Kauffman Foundation concluded that an expanding financial sector is depleting [the] pool of potential high growth company founders. Why go to the trouble of developing a new product or service when you can take on much less risk (and probably net a far bigger return) as a financier deciding which company merits investment? Whatever one thinks of their methods, at least the NEF and Kauffman are asking tough questions about finances role vis-à-vis the real economy of goods and services. Shiller does not even try to assess what part of financiers outsized returns are attributable to their outsized power, and what reflects productive contributions to the economy.
Shiller occasionally acknowledges that there are deceptive derivatives traders and dishonest investment bankers. But these are always waved away as deviants who betrayed institutional values. They shouldnt turn us off to modern finance generally. Moreover, in Shillers view, too much negativity is not only unjustified by the facts but can also hurt the markets.
For example, he disapprovingly notes:
People widely assume that Countrywide Financial deliberately issued and securitized mortgages that they believed would ultimately default. . . . There may well have been some moral lapses behind these events, but it is not correct to claim that [Countrywide] acted deliberately in full knowledge of the actual outcome. To the extent they misbehaved, it was not really in their ex ante interest to do so.
The argument is murkywho among us can act deliberately in full knowledge of the actual outcome of what we do? Countrywide had no time machine that could transport its CEO and Board from 2005 to 2010, but the managers had plenty of warning about the likely consequences of declining underwriting standards.
The same psychological approach that allowed Shiller to discern bubble dynamics years ago works against him here.
Countrywide was a massive mortgage lender with a good reputation until the rise of subprime loans. To compete in that growing market, its CEO, Angelo Mozilo, adopted many of the tactics of subprime pioneers like Ameriquest, even though Mozilo had reported Ameriquest to Eliot Spitzer after he learned of its business practices from former employees. Mozilo himself wrote, In all my years in the business I have never seen a more toxic prduct [sic] than the zero-down loans his company sold.
Eileen Foster, Countrywides former senior vice president for fraud risk management, has stated on 60 Minutes that the fraud at Countrywide appeared to her systemic and intentional. After she complained to the mortgage lenders Employee Relations Department, it investigated her for allegedly unprofessional conduct. Things got even worse after Countrywide was purchased by Bank of America:
[In 2007,] I found various levels of management working to circumvent fraud detection and disguise document doctoring by high-producing loan officers. . . . Since then, Ive found there were scores of whistleblowers inside Countrywide and then BofA. Trumped-up investigations were widely used to discredit us. The inner circle at both corporations operated like the mob: company staff, including attorneys, often worked to silence employees, using weapons like blacklisting, hush money and confidentiality agreements. The upper echelons at BofA attempted to buy my silence with more than $200,000; I refused.
Fosters treatment was not an isolated case. Internal auditors routinely faced obstruction and sabotage. Fuck the compliance areaprocedures, schmecedures, stated the former president of Merrill Lynch Professional Clearing Corporation in a memorable email. A Merrill trader who refused to go along with dubious deals at that firm was sidelined and then unceremoniously fired. Richard Bowen, a would-be whistleblower at Citigroup, went from supervising 220 employees to supervising two after he expressed concerns. Risk managers were also swept aside at Lehman Brothers. As Satyajit Das memorably put it in his book Traders, Guns, and Money (well before the financial crisis), No trader making $1 million + a year is going to take questions from an auditor making $50,000 a year.
These power dynamics largely escape Shillers notice. When he finally addresses some unfortunate incentives to sleaziness inherent in finance in chapter 24, he offers no concrete discussion of actual financial scandals of the last decade. Instead we are treated to a perfunctory tour of casinos, bucket shops, tricky brokers, the neuroscience of hypocrisy, polygamy, and conspicuous consumption.
When Shiller does discuss leading firms, his treatments tend toward superficial affirmations disguised as contrarianism. Its unfortunate that some people loathe firms such as Goldman Sachs, he says, because we would not have securities markets without investment bankers. This breezy, look on the bright side bonhomie would work fine as an after-dinner speech at the Kiwanis Club. But its embarrassing in comparison with recent rethinkings of the role of finance, ranging from the LSEs Future of Finance Report, to the Kay Review, to Amar Bhides insightful A Call for Judgment: Sensible Finance in a Dynamic Economy. And it is a shame to consider that Shillers work is probably getting more attention in the United States than those three works combined.
Unlike those volumes, Shillers book often shrinks from dealing with complicated factual situations. Consider, for instance, Goldmans role in selling toxic mortgage-backed securities. In the Abacus case, a hedge fund betting against a Goldman Sachs derivative was, unbeknownst to investors, allowed by Goldman Sachs to play a major, but hidden, role in selecting assets on which the derivative was based. The hedge fund unsurprisingly chose assets that were likely to fail, thereby triggering a credit event that would pay off handsomely once that happened, at the expense of investors. Goldman personnel appeared to be under no illusions about the arrangement; one vice president bragged to his girlfriend, [I] managed to sell a few abacus bonds to widows and orphans that I ran into at the airport.
Reviewing the firms dealings, the bipartisan Levin-Coburn Report concluded, Goldman recommended [securities] to its clients without fully disclosing key information about those products, Goldmans own market views, or its adverse economic interests. Senator Carl Levin accused the firm of not only deceiving its clients, but also misleading Congress. Everyone knows the excremental litany from the Goldman emails that Levin read in a congressional hearing regarding a similar deal: Boy that Timberwolf was one shitty deal, How much of that shitty deal did you sell? Despite all that, when he discusses the infamous Abacus case, Shiller says only that Goldman was allegedly involved in deliberately double-deal[ing] its clients. Moreover, he insists that reputational concerns and regulation can significantly deter such behavior in the future.
The same psychological approach that allowed Shiller to discern bubble dynamics years ago works against him here. Shillers reputational argument appears weaker by the day. Wall Street is unchastened by reports like Levins. Regulation, as currently constituted, is a hollow hope as well. In the Abacus case, the Securities and Exchange Commission ultimately filed civil charges against Goldman for failing to disclose the hedge funds role. The case settled for about $550 million, the SECs largest penalty ever. This may seem like a huge concession, but it was less than 5 percent of the $15.3 billion in compensation Goldman paid out in 2010. Dozens of lesser examples of financial legerdemain, described in detail in government reports and newspapers, have barely been punished, if at all. Critics ranging from former bank regulator and academic criminologist William K. Black to technology entrepreneur Charles H. Ferguson have articulated the case for extensive prosecutions, but they have been ignored.
Had Shiller taken the critics of bankers seriously, he could have restored some faith in finance.
Slaps on the wrist have become the rule, not the exception, when it comes to the largest banks. Even the most egregious behavior, however much it hurts the firm responsible or the world at large, almost never results in jail time, direct financial losses, or even serious reputational damage for the individuals involved. Instead the talent for grabbing quick gains for oneself and ones supervisors remains in high demand. Power in these firms is held by those who can realize outsized gains that by year-end can be passed through to top managers as bonuses. As The New York Times has reported, in 2006, Merrill gave $5 billion to $6 billion in bonuses, but in the following two years, the firm lost over $20 billion. As a senior research associate at the Corporate Library, a shareholder activist group, observed of traders in 2008, What happened to [the banks] investments was of no interest to them, because they would already be paid. Clawback provisions, which allow firms to recover some pay when it is based on illusory performance, are still weak and inadequate, years after the crisis began. When former CEOs such as Mozilo and Dick Fuld of Lehman Brothers still enjoy fortunes of hundreds of millions of dollars, its difficult to accept that reputational concerns will suffice to hinder similar wrongdoing in the future.
Given Shillers treatment of recent scandals, it is hard to imagine a scenario that could shake his faith in finance. In fact, far from worrying about what these stories say about the practice of banking, Shiller anguishes instead over the damage that perceptions of fraud can do to economic confidence generally. Left unchecked, resentment toward business will slow the advance of the worlds prosperity in coming years. However powerful Shillers insights on market psychology are, this is an extraordinarily cynical application of them. Like Platos noble lie, which explained why men of gold must rule, Shillers approach comes across as more of a rationalization than an explanation or justification for the power of finance in our society.
As a Yale professor, Shiller is anxious to establish not only finances value in the real world but also its place in the academy. He sees the discipline as worthy of becoming part of a true liberal education, thanks to its mathematical and empirical aspects. I want people in all the majors at the university to take my course, Shiller said in an interview about the book, because youre condemning yourself to a kind of childlike existence if you dont know how things get done in our society. However, Finance and the Good Society itself is frequently jejune, cobbling together arguments from cherry-picked anecdotes. Many of the books 30 chapters follow the same simple narrative arc: Shiller explains some aspect of finance, briefly entertains a few critical voices, and then parries their attacks and offers a happily-ever-after ending for financiers. Chapter 9, on derivatives, is typical: we get a potted history of options contracts, a discussion of disreputable sales practices in the industry, and reassurance that such practices have a limited, and declining, audience. We hear virtually nothing about how they contributed to the crisis of 2008. Shillers great lesson for his readers is to accept that some less-than-high-minded behavior may be the product of an economic system that is essentially good overall. Such casual assessments, tossed off with the bland, genial tone of a cleric explaining away the problem of evil, are one of Shillers favorite rhetorical moves.
Sometimes Finance and the Good Society borders on Sunday school theodicy, explaining how benevolent finance redeems even the most disastrous aspects of capitalism. For example, Shiller looks at the bright side of the BP oil spill: to the extent that all risks were insured properly. . . . then there was no real and lasting suffering, except of course for the initial loss of life caused by the platforms explosion. Compromised ecosystems, disrupted lives, countless hours of cleanupall smoothed away by the mellifluous flow of properly allocated money.
In a recent interview, economist Daron Acemoglu cast doubt on the trend toward empirical studies in development economics. Leaders already know the difference between good and bad policies, Acemoglu says. Nations fail to grow and equitably distribute resources by design, not by mistake. Extractive institutions, such as corrupt oil companies or mercenary banks, continually stifle growth. But a research-industrial complex continues searching for the right policy when the real task is to diminish the power of those who sap resources and rig economies.
Its hard not to think of Shillers work in this light. He sees the banking systems innovations as a source of security and wealth, if only we could discover how to democratize finance. One can imagine a decade of Shillerite graduate students studying whether 25, 30, or 50-year mortgages are best for homeowners, or how to market options to renters. Meanwhile, median wages and wealth decline, and more of the economy shifts into paper pushing and skimming off transactions rather than producing actual goods and services. Highly financialized economies like the United States and United Kingdom stagnate, while the Chinese and German emphasis on manufacturing and research is paying rich dividends.
Had Shiller taken the critics of bankers seriously, he could have restored some faith in finance. Instead, the book comes off as a long-winded paean to financiers leavened by pleas that they behave slightly better. Its inadvertent lesson is that even the most methodologically sophisticated economists can end up rationalizing a corrupt status quo if they fail to grapple with the actual power dynamics within Wall Street firms and the captured regulatory system that allows those dynamics to persist. However devoutly Shiller may believe in the nobler instincts and constructive possibilities of bankers, he does himself no favors by ignoring the most penetrating critiques of finance. The book often sounds more like an apologia for an industry Shiller is in, rather than a dispassionate analysis of phenomena he objectively writes about.
At the beginning of Finance and the Good Society, Shiller acknowledges that he is currently engaged in the joint analysis and development of exchange-traded notes with Barclays Capital in London. He is also represented by a speakers bureau for for-fee talks, a position shared by some who write about Wall Street, and shunned by others. I do not know what fees he earns from this role, or from other outside activities listed at his Yale University Web site. Nevertheless, one cant help but wonder if Shillers forgiving attitude toward a Wall Street rife with conflicts of interest reflects a partiality of his own. As Whitman put it: Objects gross and the unseen soul are one.
Frank Pasquale is Schering-Plough Professor in Health Care Regulation and Enforcement at Seton Hall Law School and an Affiliate Fellow at the Yale Information Society Project.