Does Finance Benefit Society?

For a finance academic, the answer to the question raised in the title seems obvious. After all, there are plenty of theories that explain the crucial role finance plays: theories about managing risk, providing valuable price signals, curbing agency problems, and alleviating informational asymmetries, among others. Furthermore, there is plenty of evidence that finance fosters growth, promotes entrepreneurship, favors education, alleviates poverty, and reduces inequality.

Yet this feeling is not shared by society at large. Fifty-seven percent of readers of the Economist (not a particularly unsympathetic crowd), when polled in 2010, disagreed with the statement that “financial innovation boosts economic growth.” When a representative sample of adult Americans were asked, “Overall, how much, if at all, do you think the US financial system benefits or hurts the US economy?” 48 percent responded that it hurts the economy and only 34 percent said that it benefits it, according to a Chicago Booth/Kellogg School Financial Trust Index survey that Paola Sapienza and I conducted in December 2014.

This sentiment is not just the result of the 2007–10 financial crisis: throughout history (prohibitions against finance date as far back as the Old Testament), finance has been perceived as a rent-seeking activity. The aftermath of the crisis has only worsened this view. Americans’ trust toward bankers dropped tremendously and has not yet fully recovered. Fresh financial scandals—from Libor-fixing to exchange-rate manipulation, from gold-price-rigging to outright financial fraud in subprime mortgages—hit the news every day.

It is tempting for those of us who are academics to dismiss all these feelings as the expression of ignorant populism. After all, we are the priests of an esoteric religion: only we understand the academic scriptures and can appreciate the truths therein revealed. For this reason, we almost wallow in public disdain and refuse to engage, rather than considering whether there is good reason for the public’s feelings.

This is a huge mistake. As finance academics, we should care deeply about the way the financial industry is perceived by society. Not so much because this affects our own reputation, but because there might be some truth in all these criticisms, truths we cannot see because we are too embedded in our own world. And even if we thought there was no truth, we should care about the effects that this reputation has in shaping regulation and government intervention in the industry. Last but not least, we should care because the positive role finance can play in society is very much dependent on the public perception of our industry.

When the antifinance sentiment becomes the rage, it is difficult to maintain a prompt and unbiased enforcement of contracts, the necessary condition for competitive, arm’s-length financing. Without public support, financiers need political protection to operate, but only those financiers who enjoy rents can afford to pay for the heavy lobbying. Thus, in the face of public resentment, only the noncompetitive and clubby finance can survive. The more prevalent this bad type of finance is, the stronger the antifinance sentiment will become. Hence, a deterioration of the public perception of finance risks triggering a vicious circle, all too common around the world. The United States experienced it after the 1929 stock-market crash and faces it again today.

What can we do as a profession? First of all, we should acknowledge that our view of the benefits of finance is inflated. Although there is no doubt that a developed economy needs a sophisticated financial sector, there is also no theoretical reason or empirical evidence to support the notion that all the growth in the financial sector in the last 40 years has been beneficial to society. In fact, we have both theoretical reasons and empirical evidence to claim that a component has been pure rent-seeking. By defending all forms of finance, by being unwilling to separate the wheat from the chaff, we have lost credibility in defending the real contributions of finance.

Our second task is to use our research and our teaching to curb the rent-seeking dimension of finance. We should use our research to challenge the existing practices in finance and blow the whistle on what does not work. We should be the watchdogs of the financial industry, not its lapdogs. Although there are several encouraging examples in this direction, we can do more.

We should get more involved in policy (although not in politics). Policy work enjoys a lower status in our circles, because too often it becomes the ex post rationalization of proposals advanced by various interest groups. By contrast, the benefit of a theory-based analysis is that it imposes some discipline, making capture by industry more difficult.

Finally, we can do more from an educational point of view. Borrowing from other sciences, we have taken an agnostic approach to teaching. Physicists do not teach to atoms and atoms do not have free will. But if they did, physicists would be concerned with how the atoms being instructed could change their behavior and affect the universe. Experimental evidence seems to suggest that finance academics inadvertently do teach people how to behave, and not in a good way.

Act as whistleblowers

“Publicity,” wrote Louis Brandeis in 1914, two years before he would become a US Supreme Court justice, “is justly commended as a remedy for social and industrial diseases.” Thus, our primary contribution as researchers is to expose these distortions, to act as whistle blowers. We’ve succeeded at times, in part because of the competitive nature of research academics. Our drive to write interesting papers in order to advance our academic careers has contributed to the uncovering of scandals, from collusive quotes on NASDAQ to postdated stock options, overinflated house transaction prices to disappearing analysts’ recommendations. In pure Adam Smith fashion, competition ensures that the pursuit of self-interest delivers the common good.

Yet this mechanism does not always work well. Other scandals have passed our scrutiny, and have included the recent mortgage fraud. I fear we are only successful in exposing distortions when the data necessary to conduct the research are broadly accessible.

Unfortunately, this is increasingly not the case. In spite of their quasi-government status, Fannie Mae and Freddie Mac kept their data closely guarded, preventing any academic inquiry into their activities. In other cases, companies and regulators use access to their data to indirectly influence research. Access to proprietary data provides a unique advantage in a highly competitive academic market. To obtain those data, academics generally have to maintain a reputation for treating their sources favorably. Therefore there are incentives to cater to the industry or the political authority that controls the data.

The problem is potentially even more severe with regulators, who have captive research departments. Even when regulators are not captured by the industry, they tend to be risk averse: they do not want a scandal under their watch. This is why they tend to refuse to grant data access to independent researchers: they fear the researchers will uncover something inconvenient. They do not appreciate that independent researchers are their allies, not their enemies.

Do a cost-benefit analysis

“Publicity” does not work only against fraud; it can also work to favor evidence-based regulation. To understand this mechanism, let us consider a concrete example of a controversial financial innovation: payday loans. Payday loans are a form of regulatory arbitrage around anti-usury laws. Payday lenders, instead of charging high rates, charge fees ($15 to $20 per $100 principal balance) for unsecured loans with short, two-to four-week time horizons, with rates above 400 percent per year.

Not surprisingly, this practice is controversial and has been banned in several US states. Yet it could be defended as a unique financing opportunity for low-income people who have no other option. Both arguments have some validity; thus only empirical work can tell us which argument is true.

In 2010, the state of Colorado tried to eliminate a feature of payday lending by mandating that the loans be offered in installments. A legitimate question is why this contractual form should be mandated. The simple reason is that unsophisticated borrowers cannot appreciate the convenience of installment loans. Lenders prefer conventional payday loans because they make customers borrow repeatedly, maximizing the fees they can charge.

The experience in Colorado is positive. Three years after the reform, borrowers spent 44 percent less in interest than they had in 2009 under the conventional payday-loan model, saving $41.9 million.

Given such a drastic reduction in fees paid to lenders, it is entirely relevant to consider what happened to the payday lending supply. In fact, supply of loans increased. The explanation relies upon the elimination of two inefficiencies. First, fewer bankruptcies. Second, the reduction of excessive entry in the sector. Half of Colorado’s stores closed in the three years following the reform, but every remaining store served 80 percent more customers, with no evidence of reduced access to funds.

While some seminal work in this area has been done by academics (a fuller assessment of the Colorado initiative was undertaken by the Pew Foundation), I wonder to what extent there are not enough incentives, from an academic point of view, to produce this type of research. If profitable trading strategies are considered publishable research, why shouldn’t well-done policy program evaluations be as well?

Be rigorous, not policy relevant

When we engage in policy work, we try to be relevant. Theoretical work needs to be, first and foremost, rigorous. If our main goal is to be policy relevant, we can do empirical work. The reason rigor is so important is that our set of tools is so powerful that we run the risk of our models becoming simply an elegant formalization of the consensus. Good theoretical work, by contrast, makes us see the world differently.

Unfortunately, all too often we succumb to the temptation of policy-relevant theory for fear of becoming irrelevant. Suppose, for example, that there are two methods to curb the too-big-to-fail problem. One solves the problem completely, but is costly for banks. The other one provides only a partial solution, but costs banks far less. Which approach would an economist who wants to be relevant advocate? Obviously, the second one. By advocating the first one, he would be considered unrealistic. He would not be invited to major conferences (often sponsored by banks or by regulators who are captured by banks) and his papers would probably be rejected from the major economic journals in which editors will prefer to publish “more realistic” schemes.

Separate policy from politics

Many policy-oriented economists think that “to take public positions on important policy issues without knowledge of the political process is a big mistake,” according to the spring 2009 Brookings Papers on Economic Activity, where “knowledge of the political process” should be read as “the political constraints imposed by lobbying.”

These constraints should be considered by politicians. “Politics,” the German chancellor and master strategist Otto von Bismarck said, “is the art of the possible, the attainable—the art of the next best.” These constraints should also be studied by political economists. But they should not be at the forefront of our economic analysis, for though they are relevant, they inevitably embed the lobbying pressure of the powerful incumbents. By incorporating them in our analysis, we run the risk of becoming (inadvertently) the mouthpiece of those interests.

Eliminating the tax advantage of debt, for example, does not strike me as a politically feasible proposal. But it is certainly the right proposal to eliminate many financing distortions. Ignoring it and marketing alternative proposals only contributes to making it less likely that the tax distortion will be eventually eliminated. For this reason it is important to separate policy from politics and advocacy. We need more of the first in our academic literature, less of the second.

Keep it simple, stupid

When we economists try to derive policy implications, we tend to prefer elaborate solutions: they show our cleverness and demonstrate the importance of our technical expertise. In so doing, however, we ignore some important considerations.

First, when the possibility of arbitrage and manipulation is considered, the best (most robust) solutions tend to be the simplest ones. Second, simple rules also facilitate accountability. Complicated rules are difficult to enforce even under the best circumstances, and it is impossible to do so when their enforcement is the domain of captured agencies. In the context of regulation, there is one added benefit of simplicity. Not only does simple regulation reduce lobbying costs and distortions, it also makes it easier for the public to monitor enforcement, reducing the level of regulatory capture.

Finally, when we factor in the enforcement and lobbying costs, simpler choices, which might have looked inefficient at first, often turn out to be optimal in a broader sense. Thus, we should make an effort to propose simple solutions, which are easier to explain to people and easier to enforce and monitor.

Change what we teach

Many things seem to suggest that moral standards in the financial industry are low. One possible reason is self-selection. After all, as Raghuram G. Rajan, distinguished service professor of finance at Chicago Booth, and governor of the Reserve Bank of India, argues, money is the only metric in the financial world. Thus, people motivated by other goals prefer to enter different businesses.

Yet indoctrination seems to be playing a role. Work by Alain Cohn, a postdoctoral fellow at Chicago Booth’s Center for Decision Research, and the University of Zurich’s Ernst Fehr and Michel André Maréchal, shows that employees of a large international bank behave more dishonestly when their professional identity as bank employees is rendered salient. This effect is unique to bank employees. The researchers suggest that the prevailing business culture in the banking industry undermines honesty. Are we as instructors training people to be dishonest?

Our standard defense is that we are scientists, not moral philosophers: just as physicists teach not how atoms should behave but how they do behave, so do we teach financial norms with little regard for social norms. But shouldn’t we be concerned about the effect of our “scientific” teaching?

A former student of the late Gary S. Becker once admitted to me that many of his classmates were remarkably amoral. He attributed this to the fact that—in spite of Becker’s intentions—the students took his 1968 descriptive model of crime as prescriptive. We label as “irrational” not committing a crime when the expected benefit exceeds the expected punishment. Most people call this behavior moral. Is being agnostic subtly teaching students the most amoral behavior, without us taking any responsibility?

I fear so. We should not relegate our prescriptive analysis to separate, poorly attended courses, validating the implicit assumption that social norms are a matter of interest only for the less bright students. There are several social norms that are crucial to the flourishing of a market economy. We should teach them in our regular classes, at the very least emphasizing how violating these norms has negative effects on reputation.

We should also be much more transparent about the negative aspects of the financial industry, including rent-seeking behavior, captured regulation, inefficient boards, and outright fraud. Unfortunately, business cases do not help us in this dimension. Most of them are field-based and rely on private information provided by the company. The explicit quid pro quo is that the author will request the company’s approval before release. The implicit one is a positive spin in exchange for access to interesting information. Some companies actively manage their information release to shape the cases. Although there is more to be learned from failures, cases tend to celebrate successes and be fairly acritical of business. For example, to find problems with venture capitalists, one has to read marketing cases, not finance ones. Some of these biases might be inevitable, but the more aware we become, the more we can correct them.

Luigi Zingales is Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth.

A form of this essay originally appeared in the Journal of Finance as Zingales, Luigi. 2015, Presidential Address: Does Finance Benefit Society?, Journal of Finance 70:4, 1327–1363.