Nick Silver examines the environmental and social impact of the finance markets, and asks how would a better system work?
Over many years, the finance industry has developed a set of powerful tools that could be used to improve wellbeing and to solve our environmental problems. For example, to avoid dangerous climate change, the essential rapid shift away from fossil fuels requires enormous levels of investment into low-carbon infrastructure. We mostly know how to do this technically, and the funds are available; there is a global savings surplus resulting in trillions of dollars sitting in government bonds earning negative returns; surely, this could be mobilised into the low carbon economy? Why is this investment not happening at the scale required?
These powerful financial tools have been co-opted by the same finance industry for the main purpose of growing its own revenue and importance, with resultant collateral damage to society and the environment. Figure 1 shows the increase in size of the US financial sector compared with the economy, from about 2% of GDP to about 8%. The French economist Thomas Philippon has calculated that the efficiency of financial services has not changed over the past 130 years; remarkable in a period where we have gone from steam and the telegraph to the internet. There might be more need for finance in an increasingly globalised and complex world, but the quadrupling in size of the finance sector relative to the economy with zero increase in efficiency implies a great deal of rent extraction taking place.
Flawed belief system
The reason this has occurred is that governments have outsourced the management of assets to the finance industry and set the industry the wrong incentives. The finance industry uses this privileged position to enrich itself with no care for the needs of society, the economy or the environment. It is not doing this because it is bad, greedy or evil, but because of a flawed philosophical belief system that forms the modus operandi of the finance system. We need to rethink how we want our assets managed and reset the incentives to achieve this.
The tools of finance are so powerful because they are used to allocate society’s capital, and this determines the future direction of the economy. So, for example, China has decided to direct finance, in co-ordination with other government support, towards manufacturing-export industries, and these sectors have rapidly grown.
In our economy, this decision is made by the finance sector, which invests our savings via pension funds and bank accounts. The justification is that free markets will make the best decision on where to allocate resources, because the most efficient users of capital will be able to pay the best return, so everyone will be better off. The finance industry therefore aims to make money for itself, and this is in the best interests of society.
However, we don’t have free financial markets. People mostly save via capital markets, because they are induced to do so by the government. The most important financial variable is the interest rate, which is set by a government agency. The largest asset class is government bonds. Only a restricted group of government-mandated banks can accept deposits, and government regulation shapes the way markets work – for example, there are over 100,000 pages of pension regulations. Oh, and the whole system owes its existence to the 2008 bail-out.
So as financial markets are not free, the theory that free markets are efficient and reflect people’s social preferences is not applicable.
The efficient allocation of capital by the finance system does not occur in practice, either. If we take pensions as an example – if you save for a pension, between the time you start saving and the time you die almost half of your savings will be taken as fees by the finance system. Your pension is supposed to be invested “efficiently” so that the economy recycles your savings into useful investment. Actually, almost none of your savings are invested at all; less than 4% is invested in real assets; the rest circulates in a financial merry-go-round, buying and selling financial assets, with an intermediary taking a fee at each transaction. The economy is managed by institutional investors, such as pension funds, who ensure that the companies they invest in are well run.
However, the system motivates these investors to chase short-term returns, so they get the companies they control to engage in short-term behaviours. For example, before the financial crisis, the banks were owned by the same institutional investors, who did not raise any concerns about management taking on more and more risk, which resulted in the financial crisis. Less dramatically, but maybe with greater long-term consequences, finance encourages companies to take action to boost their short-term share price – for example, Figure 2 shows that companies are reducing investment while increasing the cash they give back to shareholders. This reduction in investment means that the economy is less able to generate jobs and develop.
A better way
So how would a better system work? The government currently supports, promotes and sets incentives for the finance system based on flawed economic theories. What needs to happen is that as a society we decide what we want finance to do and set incentives to achieve these outcomes.
The logical conclusion from this article might be for governments to withdraw support for the financial system entirely. However, the resultant collapse of the finance system would lead to a great deal of damage to the economy. I feel a better option might be to move to a system that uses the tools of finance for social benefit.
In return for continued support for the finance system, the finance industry should have to demonstrate that it is socially useful. Banks have a privileged position given to them by governments in that they have the right to create money when lending and also benefit from an explicit or implicit guarantee because of their crucial place in the economy.
In return for this they should have to use preference lending to create jobs and other social benefits; the proportion of lending to the ‘real’ economy is so small it’s practically a rounding error compared with their main business of lending against property.
Pensions and savings are privileged from the government encouraging savings via a tax incentive. To qualify for this tax rebate, one option would be that pensions should have to be impact investors; that is to demonstrate that investments have a positive social benefit.
Another would be that investments would have to be in socially useful sustainable infrastructure, such as care homes or renewable energy. Alternatively, they could invest in listed equity, but those companies would have to show improvements in triple-bottom-line accounting – that is, produce accounts which consider social and environmental performance as well as financial performance. These sustainable finance tools have existed for a while and have been tried and tested over an extended period.
Defining what is socially useful is problematic, but it is not a problem that we can duck. Currently the government support for finance is justified ethically – theoretically efficient free markets ensure that the economy runs at maximum potential. This may be a worthy value, but it does not apply to our current financial markets, from the very fact that they are not free markets but largely owe their existence to governments.
We need to decide what values we want finance to embody, and then set the rules to achieve this. In a democratic society, this will be a difficult decision because people have different values. But, with the increasingly urgent need to address global environmental crises, and societal discontent leading to the rise of populism, we need to make these decisions soon.
Nick Silver is managing director of Callund Consulting, and founder and director of Climate Bonds Initiative (CBI) and Radix, the think tank of the radical centre. He is a visiting fellow at Anglia Ruskin University and Cass Business School, and recently won the Institute and Faculty of Actuaries’ President’s Award for outstanding contribution to the actuarial profession. His book, Finance, Society and Sustainability, will be published by Palgrave Macmillan in July.
