Finance Contributing to the Good Society

Finance Contributing to the Good Society

Shiller, Robert J
Business Economics
02-01-2013

The title for this NABE Annual Meeting, "The Path to Prosperity: Bridging the Gap between Finance and the Real Economy," resembles the title to my latest book Finance and the Good Society (2012), which I will talk about today. There is only a difference in emphasis, perhaps. Although the title of the meeting perhaps suggests that prosperity might be measured by conventional national income accounting variables, like GDP, I would like to take a broader view: I think we should emphasize that human goals are diverse and that finance is an enabler of a wide spectrum of human goals, whose outcome may not be well measured by income and product accounts.

My idea here is to understand how finance functions well in our society. To me, understanding that requires understanding the diversity of goals of people, and that requires that we consider what are peoples' best-considered goals. When people are thoughtful about their goals in life, it becomes clear that these goals are a mixture of self-interest and public interest.

As a result, designing a better financial capitalism requires thinking about how the system helps people to focus on achieving their real goals. As such, it includes considering the role of philanthropy in our society and, in fact, thinking about how we can redesign philanthropy for the future.

The session just before this talk was entitled "Financial Stability and Complexity." It focused on problems of our financial system that arise when financial vehicles are so complex that few people understand them well enough to steer clear of their pitfalls. These problems became much more prominent after our recent financial crisis and have led to public dissatisfaction. The emphasis in this session was on threats, rather than opportunities for a stronger financial system, mirroring much public discussion these days.

Finance and the Good Society takes a more positive direction. It is more about what the financial system does for us--and can do for us--in the future. We are in a new century, with a level of information technology that could hardly have been imagined 30 years ago. My book makes the case that finance has been a pillar of our civilization, and that improvements in the future will take us to even more breathtaking achievements.

The malfunctioning of our financial system since 2007 is troublesome, to be sure; but it is important to note that by the second quarter of 2011 U.S. real GDP surpassed the level it had on the eve of the crisis, in the fourth quarter of 2007. Thus, from one perspective, all we have lost in this crisis is some opportunities for rapid growth. Moreover, the crisis notwithstanding, since the peak in 2007, some remarkable achievements have been made. Take, for example, smartphones that now offer thousands of apps, even have their own sensory devices, and seem almost extensions of our bodies. These devices were hardly imaginable 20 years ago. So why, after all, are these phones available just now, at this time in history? One thought is that their appearance now reflects some exogenous leaps in technology, as a process that happens within scientists' minds, and has nothing to do with the financial world. But, in fact, although our minds have not changed appreciably over the centuries, our economic system has evolved to support people working together in ever more effective teams, to find others who share the right talents and interests, and to encourage people to focus their real creativity on the goals of the enterprise. Thus, the smartphone is an idea whose time has come.

I argued in Finance and the Good Society that the very word finance needs rethinking to fit the essence of the field better. What does that word seem to convey? Cigar smoking financiers pushing incomprehensible papers before us to sign? What ought rethinking convey?

The dictionary tells us that finance comes from the Latin word finis , meaning end . One dictionary speculated that finis led to finance because people used to write finis on expired or completed contracts. Whatever the reason, I proposed in my book taking the origins of the word finance to refer to a second meaning, which finis shares with end : that meaning is goal . That second meaning for finis goes back to ancient times: finance is the science of achieving human ends or goals.

Think of the active form: to finance an enterprise. This means to provide the resources, both human and physical, to achieve a goal. So, to do this efficiently, we need market prices of resources, we need to represent the price of time (interest rates), and we need the price of human services that can be applied directly to the achievement of goals. We also need an enduring business structure for the achievement of that goal, because human lives and attention spans are shorter than most of our important goals.

Very few human goals can be attained by one individual in isolation. One brain is not enough. Perhaps poets can achieve in isolation, without financing, but even that is doubtful if they want to be read or heard. They need to be brought into contact with a substantial number of people: they need transportation and communication equipment, and they need recital halls and publicity agents and newspapers and magazines to spread the word, and book publishers and bookstores and libraries. All of these people, however, have many different personal goals, all in total disarray. In order to focus activities whose actors have different personal goals into a positive plan for a large, enduring, group of people and replacing the personal goals with a group goal, we need a financially defined organization. That is the essence of finance.

We are achieving these goals better and better through time, despite the setbacks of the financial crisis. Mathematical finance has developed to allow us to manage risk better. Behavioral finance has helped us to design financial contracts that motivate people more effectively.

Neuroeconomics is developing to help refine the behavioral finance principles even more. The new insights from these fields allow us to democratize and humanize finance so that people are enabled to reach new and undreamed of goals.

This is all about financial innovation, something that we ought to see develop rapidly in the rest of the twenty-first century. As information technology gets closer and closer to providing artificial intelligence, we will see the veritable linking of human brains to achieve larger goals.

There is a lot of skepticism about financial innovation these days. Recent events have turned attention to innovations that did not work, like subprime mortgage securities and complex derivatives. I want to discuss some innovations that have worked, and worked in just the last couple of years. These illustrations of ongoing progress, despite a historic financial crisis, offer reasons to be optimistic about the future.

1. Social Impact Bonds

In 2010, the U.K. nonprofit, Social Finance, developed a proposal to deal with recidivism rates at the Peterborough prison that had defied solution. After prisoners who had committed minor crimes were released from there, they often committed another crime and landed right back in the same position. For various bureaucratic reasons, the U.K. penal system seemed unable to offer ex-prisoners the kind of help they needed to rejoin constructive activities in society and was unable to deal with high re-incarceration rates at that prison. There was no government bureau specifically responsible for this problem, which seemed intractable.

Social Finance acted like a good investment banker. It approached the U.K. Ministry of Finance, with an idea: Social Finance would put together a group of organizations to solve the problem, if paid to do so, for nothing more than a commitment from the U.K. government to pay them in six years according to a formula if the re-incarceration rates actually fell. Thus the government would issue a "social impact bond." The U.K. government was persuaded to agree because the lower re-incarceration rates would save it money in the future, resulting in no net cost to the government.

Social Finance then persuaded 17 investors--15 in the United Kingdom and 2 in the United States--to contribute 5 million pounds at risk. This group consists of other foundations with a philanthropic bent but also happy to make a return on their investment. If they succeed, Social Finance will develop a reputation not unlike that of a venture capital firm and may be able to put through many more such investments. For-profit investors as well as ethical investors may be attracted to this. There is now a U.S. branch in Boston, Social Finance U.S., which is on track to solve similar problems in the United States.

2. Crowdfunding

Another financial innovation is part of the U.S. Jumpstart Our Business Startups (JOBS) Act of 2012, introduced by Republicans. The act received bipartisan support and was signed by President Obama. The act creates a legal structure that encourages the creation of Internet sites that facilitate thousands of small investors contributing--each in small amounts, but collectively providing a large amount--to entrepreneurial businesses.

The idea is inspired by things that have already been happening on the Internet. Wikipedia, an encyclopedia written by a vast Internet crowd, may have seemed like a preposterous idea when first proposed. How could an encyclopedia that anyone can contribute to be reliable? But, it has turned out to be fairly reliable and magnificently broad in its offerings. Crowdfunding is an attempt to take that experiment to another dimension.

Crowdfunding might sound like a fantasy, if it weren't for the fact that it has been slowly developing on the Internet for 10 years, even though it is severely hampered by the absence of a supportive legal framework and has to limit itself to possibilities created by a few exemptions in securities law. Securities law exists substantially to prevent investors from suffering abuses, and so the law needs to be developed further to protect investors. The JOBS Act attempts to do that, by, for example, putting a limit of $2000 or 5 percent of the investors' income, if under $100,000, whichever is higher, for all of a given investor's investments in a given year.

3. Benefit Corporations

The benefit corporation is a new corporate form that is half-way between for-profit and nonprofit. Laws enabling benefit corporations have been enacted in twelve U.S. states, starting with Maryland in 2010. A benefit corporation has a goal of making money for its shareholders, and there is no cap or limit on how much they can make: they may hope it will make them rich. But the benefit corporation also specifies, in its charter, some social or environmental purpose, benefiting a wider society. The corporation is then required to pursue both goals. The corporate charter then imposes a hard restriction that lets the world know of its identity, which can be expected to survive changes in management and vicissitudes of the market place.

In the past, such a corporate form might well have been seen as ill-suited to fulfillment of either of the goals, making profits or creating a benefit to society, because it introduces a sort of vagueness to the purpose of the corporation. However, a more penetrating look at what it is that motivates people suggests that the vagueness may be just the recipe for success. The binary goal of the corporation may mirror the very same dichotomy of goals that motivate its employees, its customers, and its community. All these people may be more loyal to the enterprise if it is set up as a benefit corporation. As our information society develops further, such corporations may attract employees and customers who share certain goals and ideals. Such individuals may be rare as a percent of society but large enough in absolute number to enable a significant corporation.

4. Toward a Dramatically Better Financial Capitalism

The benefit corporation, like the social impact bond and like crowdfunding, is an experiment and too new to judge yet. For each of them there is the possibility of failure in its present form. But, still, the experiments we are seeing today will set the stage for further, future, experiments. In Finance and the Good Society I entertain a number of possibilities for the forms that such experiments might take, but it is impossible to be concrete about future innovations.

The above examples share a number of features that give us reason to believe that these will be followed in the future by yet more improvements along similar lines that will lead to a society that permits better achievement of all our diverse goals.

The practicality of any invention, whether financial or not, depends on the state of our knowledge in diverse areas. We may now have a general idea for an invention, but it may take years, centuries even, for all its practical problems to be solved. The basic concept of the computer was invented in the nineteenth century by Charles Babbage, but computers could not be built until about a century later when the vacuum tube, and then the transistor, was invented. The same gradual progress, involving long lags between basic concepts and real application, are a reality with basic financial concepts, just as they are with engineering concepts.

The examples of recent financial innovations will continue to evolve and develop, drawing on future improvements in information technology. Already notable for this is crowdfunding, which has used the Internet to assemble groups of otherwise diverse investors and is modeled after websites that allow the kind of search and assembly of information that can bring up crowds of investors with similar focuses. Also, the benefit corporation and the social impact bonds will find it easier to succeed with the kind of communication and search that information technology provides.

These examples all draw on modern behavioral economics. Our understanding of the potential of all three of them are tied to the state of knowledge of psychology, for all three of them are based on concepts of motivating drives in people, on their ability to respond to incentives, and the diversity of types of people that may be brought together creatively in enterprises.

And, of course, they all make use of modern mathematical finance, which sets a framework for individual goal pursuit in a general equilibrium, implies that diversification should embrace the broadest set of risks, accommodates varying tastes for risk, and helps us understand how complex financial instruments transform risks.

With our understanding of all these fields, we ought to be able to address the kinds of mishaps that constituted the recent financial crisis and at the same time make the financial system serve pursuits of our diverse goals better and better.
REFERENCE
Shiller, Robert J. 2012. Finance and the Good Society . Princeton University Press.

Based on a presentation at the NABE 54th Annual Meeting, New York City October 15, 2012, "The Path to Prosperity: Bridging the Gap between Finance and the Real Economy."Finance Contributing to the Good Society

 

Dude, I need a "Economics for Idiots" version of that post. I know that I need to understand finance better, but it just isn't my forte. A little help?

 

Actually, from what I can tell, what he's saying is that the goal of finance, using his new definition and the psychology of finance (not that I agree with either, just trying to distill it down as best I can based on my understanding of what I read) is that modern (mathematical) finance:

• should drive and reward individual goal achievement, and do so in an environment that "level's the playing field;
• assumes that if you diversify, you should also by trying to mitigate across the largest set of risks by embracing the largest set of risks...but by diversifying you are offsetting the increased potential for risk;
• accommodates for different people having both different tastes and tolerances for risk (most likely based on their stage of life), and;
• helps the lay person understand how complex financial instruments, such as the following can transform, mitigate and offset risk
  • derivatives
  • futures
  • options
  • arbitrage

He's being an egg-head and trying to sell his book though. There's absolutely NO REASON to be as convoluted as the OP was. Like @ghrit said, it was a case in point of why most of us just stay the hell away from finance and put our money, our real money, under the mattress and in coffee cans in the back forty. He'll sell his book to his finance-nerd buddies and any regular people that buy it thinking "look at me, I'm so astute!" will get lost after page thirteen and wonder why they are still losing money in the market and upside down on their mortgage...

 

I think it is important to take a moment to think about the societal impact of the field of finance regardless of whether or not you agree with Shiller's approaches in the article.

I tend think that some of the ideas in the article are not practical, but certainly this type of creative thinking will led to some plausible ideas that are beneficial to society. However, I certainly agree that the ability to allocate capital relatively efficiently is a key societal benefit of finance.