Finance And Democracy: Towards A Sustainable Financial System

310 Pages·2019·2.831 MB·English

by  Alessandro Vercelli

Finance
and Democracy
Towards a Sustainable Financial System
Alessandro Vercelli
Finance and Democracy
Alessandro Vercelli
Finance and
Democracy
Towards a Sustainable Financial System
Alessandro Vercelli
University of Siena
Siena, Italy
ISBN 978-3-030-27911-0 ISBN 978-3-030-27912-7 (eBook)
https://doi.org/10.1007/978-3-030-27912-7
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P
reface
The main purpose of this book is to shed light on the co-evolution of the
financial system and its regulation after the Great Financial Crisis of the
2007–2009 and the ensuing Great Recession. The need of more light is in
this case a particularly appropriate metaphor. In fact, despite the amazing
growth of power and importance acquired in the recent decades by the
financial system, the latter managed to conceal many crucial aspects of its
strategic behaviour in a thick fog that is very difficult to penetrate. This
clever survival and thriving strategy is by no means restricted to the so-
called shadow banking. Not by chance, financial experts and authorities
have recently rechristened shadow banking as non-bank sector (industry)
or market-based finance, namely, finance fully adapted to the ruling
market- based economy without being encumbered by the regulation of
the banking sector. Notwithstanding the misgivings expressed just after
the crisis, after a few years most mainstream financiers, economists, politi-
cians and regulators do not seem to see shadow banking as a dangerous
deviation from the virtuous model of good finance. They present it now
rather as the harbinger of the ongoing metamorphosis of the financial
system from the chrysalis of boring and heavily repressed banking to the
full-fledged butterfly of unfettered market-based finance. In fact, after the
crisis, investment banking and speculative trading continued to migrate
into the shadows, namely, where regulators and stakeholders cannot easily
monitor financial decisions and cannot thus exert an effective pressure on
decision-makers. In such a situation, the democratic control of financial
behaviour is becoming increasingly problematic. As soon as a financial
institution or practice succeeds to conceal itself within market shadows it
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viii PREFACE
may decide to make visible to customers, stakeholders and regulators only
what is in its interest to show. This shields the financial institutions from
damaging censure by regulators and stakeholders, let alone public opin-
ion, while their active participation in the powerful financial lobbying on
policy makers and regulators becomes more likely to be successful.
To rebuild a badly needed democratic control on finance, we have to
first direct the spotlight of scientific analysis, moral awareness and sheer
good sense on the financial system to understand the inner determinants
of its evolution as well as its consequences. Second, we have to consider
the impact of regulation on the evolution of the financial system. To this
end, this book discusses the regulation philosophy adopted since the late
1970s, focusing on its implementation after the Great Financial Crisis of
2007–2009. Since the early 1970s, mainstream regulation abandoned the
philosophy underlying the “directive regulation” introduced in the United
States by the Glass-Steagall Act (approved in 1933) and then agreed in the
Peace Conference of Bretton Woods (1944). The new approach of policy
makers and regulators towards the financial system embraced the justifica-
tion, which was then becoming mainstream, that in absence of intrusive
interventions of public authorities, markets are able to self-regulate them-
selves and obtain optimal results. The trouble is that market-based finance
progressively empowered by systematic deregulation and swelling shadow
banking has been a crucial source of serious financial distress culminating
in runs that characterised the trough of the 2007–2009 financial crisis.
The ensuing panic forced massive public bailouts of deeply stressed finan-
cial institutions despite the mainstream conviction of their counter-
productive effects, because of the encouragement of moral hazard and the
violation of market discipline. This disturbing contradiction between
actions and beliefs is visible in the efforts of regulating finance after the
Great Recession. Moreover, it provides a clue to explain why these efforts
did not succeed to make the financial system more robust than before the
crisis. The disquieting empirical evidence that has continued to accumu-
late on the persisting fragility of the financial system produces a pragmatic
puzzle for policy makers, lawmakers and regulators. Should we deregulate
further the financial system to implement a more consistent model of self-
regulation? Alternatively, should we fix the failures of absent or weak regu-
lation by re-regulating the financial system in a more systematic and
coherent manner?
The recent crisis and its aftermath confirmed that a financial system
could not operate without a minimal set of directives, constraints, and
PREFACE ix
regulatory institutions that guarantee the rule of law and other crucial
conditions for its viability. What has actually happened in developed coun-
tries has been quite different from what pure theory prescribed and policy
makers and regulators declared to pursue. The actual result was not the
alleged self-regulation of financial markets but a different form of regula-
tion that proved to be inefficient and misleading. In the meantime, an
ideological smokescreen has blurred the understanding of its contradic-
tory nature and dire implications. A process of systematic deregulation has
really started since the 1970s deepening and broadening its reach in the
following decades; however, deregulation was restricted to the directive
regulation of the Bretton Woods era that exerted a strict control and
supervision of the financial system in the conviction that its deep structural
shortcomings would necessarily impair an effective self-regulation.
However, this was only a part of the story, the most visible one because of
being fully compatible with the ruling neoliberal paradigm. The other part
of the same narrative is a parallel process of re-regulation following rules
completely different from those of directive regulation and believed to be
fully consistent with the neoliberal paradigm. In what follows, I will call
“vicarious regulation” this approach to the regulation of the financial sys-
tem because it does not aim to substitute the invisible hand or to influence
its action, but only to surrogate or support it wherever it proves to be
inadequate to guide the right choices. Unfortunately, this intrinsically
contradictory compromise between the belief in the superiority of self-
regulation and the necessity of regulation does not work in practice
because it ignores or eludes a series of insurmountable obstacles. First, the
superiority of self-regulation is arguable only in a perfect competition mar-
ket. Second, in a real market self-regulation cannot exist because it requires
a host of necessary institutional conditions often summarised with the
expression “rule of law”. Finally, it is extremely difficult to specify all the
relevant externalities and to find the way to internalise them. That is why,
as we are going to argue in this book, the recent history of financial regu-
lation is characterised by far-reaching shortcomings and actual blunders.
In the absence of a radical redirection of financial regulation, we should
expect that a worse financial crisis, possibly the “big one”, would soon
materialise.
Hayek famously accused Socialism of “fatal conceit” for its belief in the
superior efficiency of a centralised deliberate arrangement of the economic
order. The same fundamental criticism was addressed by him and other
pro-market economists to the interventionist policies of Keynesian
x PREFACE
ascendance. This is perhaps arguable for a particular variety of mainstream
Keynesianism of the 1960s that built large econometric models to fine-
tuning the economy. However, the Keynesian economists who under-
stood the crucial role played by radical uncertainty in the works of the
Master have always been fully aware of the deep ignorance to which the
economists themselves are condemned. Moreover, the accusation of fatal
conceit may be retorted against pro-market economists who are convinced
to know perfectly well the properties of real markets, or at least enough to
be sure that unfettered markets always obtain the best possible results. In
this view, no one can beat the market. This mantra inspired not only main-
stream finance and macroeconomics but also the action of most policy
makers, regulators, and practitioners, especially after the 1970s. In this
view, governments and regulatory authorities should abstain from any
interference into financial markets. The point of view adopted in this book
will avoid any form of conceit. I think that the economists know very little
about the actual economies. This is particularly true of the financial sys-
tem. A possible source of the widespread economic conceit is that the
economists know a lot about the properties of abstract model economies
that are quite different from the actual economies. Economists, mass
media, policy makers and regulators often prefer to ignore or play down
the gap between reality and models applying the latter directly to the
empirical evidence without the necessary caution. What prompted me to
write this book is not the conviction of knowing more about the financial
system than the other researchers who investigate the same field, but the
keen awareness of our ignorance and the conviction that what is at stake is
grossly undervalued by the public opinion. It is time to engage all sections
of society in a great debate on the evolution of the financial system and its
implications for the wellbeing of all citizens to make it fully consistent with
sustainable development. This book aims to be a contribution in this
direction, playing the role of a disturbing, but hopefully construc-
tive, gadfly.
London, UK Alessandro Vercelli
10 July 2019
a b
bout the ook
This book is an outgrowth of the book I published in 2017 with Palgrave
Macmillan aiming at updating and extending the analysis there worked
out. It is an updating, because the 2017 book focused on the long-run
evolution of market economies that led to the 2007–2009 crisis, while this
book focuses mainly on what happened in the subsequent period. In addi-
tion, it is an extension of the part on the financial system contained in my
previous book (mainly Chap. 6 and the Appendixes) as it goes deeper into
the methodological, theoretical, and normative foundations of finance and
develops in a more systematic way the policy and regulation issues.
This book has three main purposes:
1. information on the most important financial issues discussed in
recent years, also those considered by most readers as obscure if not
esoteric, to make them accessible to a broad readership;
2. interpretation of the evolution of the financial system and of the co-
evolution of its regulation after the crisis; and
3. suggestion of a direction of reform of the financial system different
from that pursued after the crisis (“new directive regulation”).
I hope that this book may appeal to:
1. Academics, because it provides a suggested interpretation of the
post crisis co-evolution of the financial system and its regulation. I
hope that the contents of this book may stimulate a debate not only
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