By Mark A. Calabria, Cato Institute
Introduction: Over Throughout human history, economic relationships depended heavily on social status. increased personal freedoms, along with organized banking and finance, have played a crucial role in social progress.
Does finance benefit society? This seemingly simple question was posed by Luigi Zingales, a finance professor at the University of Chicago Booth School of Business and past president of the American Finance Association, during his recent American Finance Association Presidential Address.
Based on news coverage, one might conclude that the financial industry exists solely to exploit the public for the benefit of some shadowy group of oligarchs. But the reality is different. Substantial evidence suggests that countries and communities with vibrant financial sectors display less inequality and more opportunity. If policymakers and the general public really want to see the opportunity for wealth creation and advancement extended, the solutions will be found in reducing barriers to market entry, increasing competition, and expanding access to financial services.
Beyond the economic benefits, evidence exists to suggest that finance plays a critical role in expanding another societal benefit: securing and protecting political freedoms. In the past, financial innovation provided the catalyst for positive political change. Finance has also been instrumental in driving social progress, with economic relations shifting from being status-based to contract-based, freeing individuals from existing social hierarchies. It is this relationship between finance and individual freedoms that will be my focus.
What’s Finance For?
On a basic level, the connection between freedom and finance should be obvious. At its core, finance is about freeing us from the constraints of time. For households, this could include the desire to invest today in human capital – that is, education – despite a lack of resources for doing so, or it could mean starting a new business, even if you have inadequate resources. By building a bridge to our future selves, finance expands our choices. Finance can also do this on a collective level, by connecting current communities to their potential futures – an important consideration in political change, to which I will return.
But finance doesn’t just help connect us to our future selves; it can also reduce the uncertainty over which one of our potential future selves comes into being. Borrowing to invest in human or productive capital can increase the likelihood that our future self is wealthier.
From Status to Contract
Throughout human history, one’s economic relationships depended heavily upon one’s social status. Your family history, race, religion, or gender could well determine your line of work, whether you could open or own a business, or whether you could even work at all (outside of the home). As Henry Sumner Maine described in Ancient Law, societies have progressed, with greater individual freedoms, as economic relationships have depended less on status and more on voluntary contractual relationships.
While there are a number of reasons for the persistence of status-based economies, a primary driver is the problem of asymmetric information between strangers. In a borrower-lender relationship, the most important of these asymmetries is the borrower’s willingness to pay, which can be quite difficult to forecast. This is particularly important in the area of unsecured lending. Societies over time have partially solved asymmetric information problems with reputational effects related to status. A recent fictional example is the repeated line “a Lannister always pays his debts” from the TV series Game of Thrones. That line resonates because a number of families, particularly those prominent in merchant banking such as the Rothschilds, built extensive family-based businesses based upon a reputation of trust and discretion. If one member of such a family did not honor his or her obligations, other members would do so; in addition, significant social pressure would be placed upon the borrower to hold up his end of the bargain. Similar reputational effects have been witnessed across religious and ethnic groups, such as Greeks in the shipping industry.
Most of us, however, are not born into families or networks that have built up considerable reputational capital. One can easily imagine how reputational effects could exhibit returns to scale, resulting in considerable concentrations of market power and increased economic inequality. Reputation, in other words, may solve one set of problems while creating another. Yet despite the public outrage that sometimes accompanies excessive profits, the reality is that large profits always attract competitors. Sometimes these competitors develop innovations that completely disrupt the existing model. Finance has repeatedly been one of those great disruptors.
Even with the advantages of a family reputation, the overwhelming majority of family businesses are not continued by later generations. The ability of children (or grandchildren) to monetize their stake in the business – a financial innovation in itself – reduces the likelihood of entrenched family business dynasties. The offspring may become quite wealthy due to this monetization, but the influence and opportunity that running a business allows can be opened to others. In one study, scholars found that the increased capital market access provided by the U.S.-Canada free trade agreement had a significant negative impact on family-controlled Canadian firms.
Moreover, returning to the issue of asymmetric information and reputation, one avenue for challenging reputational monopolies is to create specialized entities that monitor borrowers, allowing individuals to develop their own reputations and compete with incumbents. Many financial institutions are delegated monitors. What is less recognized is that the emergence of these delegated monitors has expanded access to credit by allowing transactions to be more person-based.
Banks are, of course, not the only monitors in a financial system. The development of consumer credit reporting registries has been critical in allowing individuals more independence from their social and family networks. Scholars have found that countries with credit registries witness greater levels of private credit and a greater willingness of banks to lend. A recent World Bank study found that the existence of credit reporting registries was particularly important in improving the access to credit for female-owned businesses.
Greater access to credit and increased business formation are important ends in themselves, but how do they relate to individual freedom? By equalizing economic power and loosening social constraints. Increased female participation in the economy, which can be facilitated by finance, is often accompanied by greater gender balance in both the family and in the larger society.
A woman with an independent credit rating, who can borrow against her own name, is a woman less dependent on her spouse and also one who will be less accepting of abuse. The same can be said for the laborer. Someone who can borrow to start his or her own business will demand more as an employee. Fundamentally, finance is about connecting us to our possible future selves. In doing so, we loosen the constraints that bind our current selves.
Economic empowerment, via finance, can also lead to greater demands for political empowerment. It’s no coincidence that political revolutions, such as Britain’s Glorious Revolution, are often preceded by financial innovations.
Given the role of finance in expanding opportunity and challenging the status quo, it should not be surprising that entrenched interests have repeatedly fought financial liberalization. As Raghuram Rajan and Zingales (2003) observe, “Arm’s length financial markets do not respect the value of incumbency and instead give birth to competition.” In addition, established incumbents are more likely to rely on retained earnings for their expansion, whereas potential new firms would more heavily rely on external financing. Limitations on the cost and access of credit ultimately benefit established elites. Some scholars have suggested that religious limitations on usury were primarily intended to benefit elites by limiting access to the credit markets by higher-risk borrowers.
Efraim Benmelech, from the Kellogg School of Management at Northwestern University, and Tobias Moskowitz, from The University of Chicago Booth School of Business, provide a fascinating case study in how 19th century state usury laws were used to protect local elites from potential competitors. Potential entrants, who would compete directly with established elites, were more likely to lack collateral and/or reputation, which meant they could only access credit at a higher cost than the elites. By instituting binding ceilings on the cost of credit, elites could limit competition by eliminating the borrowing needed for new market entry. Benmelech and Moskowitz document this effect and provide empirical support for the theory that financial market restrictions were driven by the interests of established elites. Such restrictions only ended when they no longer benefited the elite. Unfortunately, these restrictions not only constrained competition but also retarded financial and economic development, leaving the areas in question poorer and more unequal.
The long road from status- to contract-based relations has often been rocky. Those who enjoy a privileged status, regardless of whether it was earned or inherited, don’t take this challenge lightly, as illustrated by Benmelech and Moskowitz’s study of 19th century America. Yet finance, which played a crucial role in social progress historically, is no longer perceived as being on the side of the challenger, and it’s often is associated with the elite. Our society and our economy would be better served if finance would more fully embrace its role in upending the status quo.
Another important social benefit of arm’s-length financial systems is that they facilitate a more accurate price system. The limitations on competition that arise with family controlled or other relationship-based economic system reduces the accuracy of the price system, reducing the efficiency of the overall economy. A well-functioning price system is vital to economic coordination and may well be the most important “public good” provided by a financial system based upon contract instead of status.
Trust, Growth & Freedom
It’s obvious that finance depends to a high degree on trust. What may be less obvious is that finance can increase levels of trust, ultimately increasing economic growth as well as strengthening social bonds.
Scholars have found that higher levels of trust are, in part, driven by higher levels of income and education, but they’re reduced by feelings of social exclusion. Finance can indirectly impact trust by its influence on other variables. For instance, Levine and Rubinstein find that banking deregulation led to an expansion in college attainment of middle-class households. All else being equal, the resulting increase in those with a college education should increase social trust. To the extent such an increase in educational attainment also increases incomes, there should be a further positive impact on trust.
By connecting present rewards with future behavior – for example, getting a loan now in exchange for paying it off over time – finance can instill trustworthy behavior on the part of borrowers. Every financial literacy course relays the importance of keeping a good credit score, even going as far as estimating how much can be saved on a mortgage or auto loan if you’ve maintained good credit. In one-off transactions with strangers, there is much less incentive to cooperate. Finance offers a way of overcoming the “prisoner’s dilemma,” in which individuals may refuse to cooperate even though it is in their best interests to do so.
Whether trustworthiness in finance translates to such behavior in other settings is an open question. It seems likely that individuals who develop a practice of honoring their obligations in one setting, such as regularly paying their mortgage, will display similar behavior in other settings. Research using the World Values Survey finds that outgroup trust is high “when human empowerment diminishes people’s dependence on ingroups and opens them to cooperation with outgroups.” These are the conditions created when finance works well. The World Values Survey also shows a close correlation between one’s trust in strangers and specifically of strangers of a different religion or nationality. To the extent that finance helps facilitate cooperative interaction among strangers, it is likely to also improve general social levels of trust.
Economists have long argued that trust is an important contributor to economic growth, with Douglass North arguing that a lack of trust, in the form of low-cost contract enforcement, is the most important source of underdevelopment and stagnation among emerging economies. There is empirical support for this claim with trust being found to be an important determinate in economic growth. Interestingly, the same study found the level and cost of investment services are both correlated with the level of trust in a society.
Finance & Political Freedom
Given the association of finance with capitalism, it should not be surprising that the wealthiest countries tend to be those with the most extensive financial systems. The wealthiest countries also tend to have the freest financial systems. Poor countries, contrary to popular myth, do not suffer any lack of financial regulation. On the contrary, they tend to have extensive regulatory structures consisting of numerous restrictions, particularly on credit terms. One of the reasons for the relative poverty of these societies is that the regulatory schemes often limit competition and reduce the supply of credit available to the private sector. At one extreme, public ownership of the financial sector, which one might associate with conducting finance in the “public interest,” actually results in “slower subsequent development of the financial system, lower economic growth, and, in particular, lower growth of productivity.” The latter is especially important, since productivity growth is ultimately what drives wage and income growth.
While the economics might seem obvious, what might be surprising is the positive association between freer financial markets and both democracy and personal freedoms. An index of financial freedom, constructed by the Heritage Foundation, shows a strong positive correlation (0.63) with that of democracy. Financial freedom is also shown to be strongly correlated (0.65) with personal freedom, as measured by the Cato Institute’s Human Freedom Index. Alternative measures of finance, such as the Cato Institute’s index of financial regulation, or broad measures, such as private credit as percentage of GDP, also show a strong positive correlation with measures of democracy and individual freedom. This should not be surprising, as governments that attempt to control the political and individual freedoms of their citizens also tend to control their economic freedoms as well.
Financial Innovation & Politics
Over 30 years ago, leading development economist Richard Easterlin asked, “Why isn’t the whole world developed?” His research led him to the conclusion that political and ideological differences relating to mass schooling were the main causes. Decades of increased access to education have challenged this conclusion, with some scholars suggesting political rigidities intended to protect “rents” have become important obstacles to reform. For instance, we know that liberalizing market access can help spur economic growth. We also know that protected incumbent producers – for instance, monopolies – would suffer from such liberalization, despite the greater gains to society. If entrenched incumbents can defeat reform, they may be able to preserve their rents at the cost of persistent underdevelopment and stagnation. Essentially, those societies that have managed to overcome this resistance are those that have developed.
In a series of papers, Stanford University professor Saumitra Jha has documented cases in which financial innovation fostered the formation of political coalitions advocating growth-enhancing policy change. If such reforms are beneficial, they will result in a much wealthier future economy. This, in turn, creates a vital development opportunity. Recall that finance can allow us to bridge the present and the future: One manifestation of this is that parties hostile to reform can be given a stake in future gains via the creation of claims on that future in the form of financial instruments. In one case, Jha examines how samurai in the Meiji period were essentially converted into bankers, shifting them from being dangerous opponents to modernization to being advocates for reform. Or as Jha puts it, “Financial innovators in the Japanese government took swords and made them into bank shares.” Without this shift, Japan would likely have drifted into civil war and certainly would not have managed its first national elections in 1890. By offering entrenched, but threatened, incumbents – in this case, skilled warriors – a financial stake in the future, Japan was able to lay the foundation of its impressive 20th century growth.
One of the more fascinating case studies is the influence of financial asset holdings by members of the U.K. Parliament on their support or opposition to monarchist control during the Glorious Revolution in 1688. Jha finds a direct link between the ownership of overseas shares and support for parliamentary supremacy. In addition to laying the foundation for Britain’s later financial revolution, the reforms of the Long Parliament represented a major historic shift away from dictatorship toward popular sovereignty. Jha argues that without the financial innovations that allowed established elites a stake in the future benefits, these reforms would not have occurred.
More recently in field work in Israel, Jha and Moses Shayo find in “Voting for Peace in A Conflict Zone: The Effects of Exposure to Financial Markets World” (2015) that “exposure to the stock market raises support for a peace deal,” suggesting that giving conflicting parties a greater stake in future economic growth, via financial instruments, can help overcome entrenched opposition to positive-sum political change. A study found that the lack of financial connectedness between countries was a powerful predictor of war.
One of the most important human freedoms is the freedom from state violence, whether from war, ethnic conflict, or oppression from autocrats. Finance has, in a number of instances, provided an important avenue for reducing state violence. It’s no coincidence that the historical peaks of private market financial capitalism have also been moments of relative peace.
Dark Side of Finance
Returning to Zingales’s question – “Does finance benefit society?” – we must recognize that the general public often sees finance as a detriment to society. On one level, this is a question of marginal benefit. Sure, finance is necessary, but can you have too much of a good thing?
Both American households and government are highly indebted. The IMF estimates gross government debt as a percent of GDP is over 105% for the United States, up from around 65% just a decade ago. Yes households have deleveraged since the crisis and debt burdens as a percent of income are at manageable levels, but such is also an artifact of historically low interest rates. Owners’ aggregate equity in their homes has almost doubled since the crisis to over $12 trillion. Yet such masks the fact that over 4 million homeowners are still in a negative equity position. Most American families and businesses are in reasonable financial health, but sizeable minorities are not. It should also be of concern that for most families the bulk of their wealth is their home – an asset that is hard to diversify and whose returns are closely correlated with a family’s labor income. Fortunately this a problem that financial innovation may be able to solve. As importantly the long term fiscal situation of our federal government is unsustainable in the absence of significant reform to our entitlement programs.
While it might be hard to conclude what the optimal amount of debt is, for either a household or government, there is certainly reason to believe that America may well have passed that point on both accounts. For instance, the marginal benefit of moving from 90% loan-to-value mortgages to 97% is far less than the marginal benefit of creating a mortgage market. There is clearly a strain of thought that worries about excessive consumerism and debt-fueled spending.
Another concern is that while finance is providing a necessary service, its costs for doing so may have become excessive or predatory. At a basic level, if consumers feel a good or service is priced “excessively,” they would likely purchase less, reducing demand and ultimately reducing the price. Despite the financial crisis, there is little evidence that American households have decided to consume less finance. As Thomas Philippon (2015) has documented, the growth in total income (revenue minus costs) going to finance has largely tracked the growth in total assets intermediated as a percentage of GDP. This measure of income is measured before compensation paid to employees, so does capture any trend in bonuses or other compensation. Interestingly, it has been estimated that the unit cost of financial intermediation has been relatively stable since the late 1800s, at around 1.9% of outstanding assets.
Although such stability suggests finance has not become significantly more efficient, it does prove that it also has not become more expensive as a whole.
As stated earlier, finance can also disrupt established social patterns. I believe such has largely been a benefit, but needless to say, such disruption produces losers. Sometimes potential losers can be co-opted, sometimes they can’t. Most great social advances have produced a backlash. How to balance the forces of reaction and progress is never easy, yet it is a balance that those involved in finance must weigh.
Finance has at times been co-opted for the benefit of established elites. This control has almost always taken the form of restrictions upon entry, access, and the terms of finance. The solution is to reduce these barriers. Special privileges, available to only a few, should be discarded. The best way to continue to bring finance into the light is to continue to open it up to competition.
There is a tendency in both politics and economics to conclude that if any activity offers positive social benefits, then it also merits subsidy or protection. We’ve repeatedly seen this in finance, such as guarantees for mortgages, student loans, small-business loans, deposits, etc., not to mention broad-based rescues. Rather than resulting in more and better, these guarantees have resulted in more and worse, as the moral hazard created has undermined and, in some cases, offset the public benefits provided by contractual finance. Of course, if we are to embrace greater competition, the probability of calling upon such guarantees increases. A more socially useful finance would be one with fewer subsidies, guarantees, and rescues.
Conclusions
“We have the potential to support the greater goals of good societies – prosperous and free societies in the industrial as well as the developing world – if we expand, correct, and realign finance." — Robert Shiller, Nobel Prize winner in Economic Sciences
A healthy and free financial system is found everywhere one also finds a free, democratic people. Generally, the reverse also holds. Countries that lack relatively free financial markets are also those that are both the poorest and most lacking in basic human freedoms. If one wants to escape the reach of private financial markets, it’s easy enough. Just try Zimbabwe, Angola, Venezuela, Iran, or Sierra Leone. These countries lack anything resembling Wall Street. They also lack basic economic and political rights. That isn’t a coincidence.
The financial crisis that began in 2007-’08 tarnished the reputation of finance and reduced public trust in the financial services industry. As Yale professor and Nobel Prize winner Robert Shiller has observed, the answer is not less finance, but better finance – luckily, better can also mean more.25 What angers the public most is a sense that the game is rigged, protecting a small elite. History has repeatedly shown that more and better finance comes from reducing barriers to entry and increasing competition. The solution is not to build new walls, but to tear down old ones.