Regulating Markets In An Economy Without Angels

An inaugural lecture

Text
Pope St John Paul II in 1991: His  encyclical “Centesimus Annus” of that year argued that human dignity requires economic freedom (©Grzegorz Galazka/Archivio Grzegorz Galazka/Mondadori Portfolio via Getty Images)

Since the financial crash, many have argued that there is a crisis in economic thinking. Some have called into question the detachment of economics from ethics. Others have criticised the over-formalisation of economics.

It is perhaps worth noting that, whatever problems face the academic discipline of economics, out there in the real world — whether because of or despite economists — things do not look too bad. For example, global poverty has fallen by more than three-quarters since 1980. This is a remarkable achievement; it outstrips any other achievement in world economic history by quite a distance.

Not only that, in the same period the world income distribution has become much more equal. And malnutrition, illiteracy, child labour and infant mortality are not only falling, but have fallen faster than at any other time in human history.

To say that things are “not too bad” is not something that academics and commentators like doing. The philosopher Steven Pinker argues that this tendency is at least partly to do with the “psychology of moralisation” whereby academics compete for moral authority. Critics of the present state of affairs who argue that things should be much better are seen as morally engaged, whereas those who say things are not too bad are seen as apathetic.

However, the virtue of prudence demands that we look at the world as it really is. If we don’t, we will make mistakes. It also demands of political economists that we develop a discipline that has a realistic view of human nature whilst taking account both of the inherent dignity of every human person and of our imperfections.

Catholic social teaching has often been very good at this. The two bookends of Pope Leo XIII’s social encyclical letter Rerum Novarum, published in 1891, and Pope John Paul II’s encyclical Centesimus Annus, published in 1991, are particularly fine examples. Much earlier, St Thomas Aquinas followed exactly the same approach, especially in his justification for private property. Indeed, from what little I know as a non-theologian, it is tempting to say that St Thomas perfected the art of understanding human imperfection and its implications for politics, the law and society.

On the other hand, too much modern economics makes unrealistic assumptions about human nature and human behaviour which are designed to make economic problems tractable and amenable to mathematical analysis. This approach can leave important gaps in our understanding. It is OK to make an unrealistic assumption to make an economic model more tractable.

However, if, in the process, you omit the most important aspects of the problem, then your analysis may subtract from, rather than add to, the sum of human knowledge.

If we are to develop economic principles underpinned by sound reasoning we need to start with a reasonably accurate understanding of the human person. John Paul II highlighted one aspect of this in Centesimus Annus. He argued that the dignity of the human person requires that human persons should be able to use reason and act purposefully and freely in the economic sphere.

Three other characteristics which I think are especially important are:

• No human person is omniscient: that is, there are limits to human knowledge.
• Human persons are capable of good.
• Human persons are capable of evil.

These characteristics of human nature have profound implications for how we might think about economic problems which I shall explore and apply to one area of policy.

However, by way of context, I want to begin by considering the role of self-interest in economic life.

Adam Smith pointed out that taking economic decisions on the basis of self-interest, paradoxically, often promotes the welfare of society as a whole. For example, if businesses are to promote their own interests, they must serve their customers well.

This means that, in a society based on freedom of contract and where corruption, nepotism and the plundering of the property of others are not prevalent, the vast majority of economic transactions involve economic co-operation to the benefit of all parties involved. If you don’t like Adam Smith’s take on this, then let’s try John Paul II’s. In Centesimus Annus, he said: “The social order will be all the more stable, the more it takes this fact into account and does not place in opposition personal interest and the interests of society as a whole, but rather seeks ways to bring them into fruitful harmony.”

And self-interest is not inherently bad. At its best, it is an extension of self-respect. For example, it was in my self-interest to take the train to Twickenham today rather than to walk. If I had walked, I would now be somewhere just north of Gatwick airport. It was, though, in no sense selfish of me to take the train.

But, self-interest can turn into selfishness. Indeed, we can think of selfishness as disordered self-interest. And, without question, this is problematic. Just think of the damage Fred Goodwin caused.

Economists then need to consider, given the reality of selfishness, what the best forms of economic and political organisation are. In some senses, selfish business people can, without intending to, do an awful lot of good by providing goods and services which are valuable to others (not always, of course). A free economy can make the best out of the human condition by requiring even selfish people to serve others and do something useful — indeed, it might even force them to develop some virtues such as keeping their word, paying what they owe on time, taking care to produce a good product, treating their workers well (if they want to keep them), co-operating with others, and so on. It would be better if such people were virtuous, but economics policy should not be based on the assumption that they always will be.

On the other hand, if the same people were finance ministers in a corrupt country (or even a low-grade official in a corrupt country) they could do enormous harm. Colonel Gaddafi amassed $200 billion and President Mobutu of the Congo $5 billion — which is actually at the low end for a dictator — at the expense of the people.

Political or government regulation of the economy is certainly no substitute for ethics and, by concentrating power, may well make things much worse by creating what we now call    cronyism. Pope Francis’s home country, Argentina, and its neighbour, Brazil, are very good examples of this.

Thus, government regulation or direction of the economy cannot be assumed to be a corrective for greed and selfishness. That is lesson one. However, economists also need to understand that, whatever policy choices they make, there will be poorer outcomes if people behave selfishly. As Pope Benedict said in his encyclical letter, Caritas in Veritate (and he wrote it in italics), “Without internal forms of solidarity and mutual trust, the market cannot completely fulfil its proper economic function.”

If you prefer to listen to economists, Nobel Prize winner Kenneth Arrow has said more or less the same thing:

Virtually every commercial transaction has within itself an element of trust . . . It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.

And, despite popular misconception, Adam Smith said exactly the same. So, economists should not detach the study of economics from the study of ethics. Ethics are important for economic wellbeing. This is lesson two.

Even if government control of the economy is no panacea when people behave poorly, it is difficult to avoid government action in cases where greed and selfishness cause great harm and clear injustice. At the extreme, we should not be content if business people go around murdering their competitors or bulldozing villages to construct mining operations. Such extreme cases may demand some type of government intervention through a judicial system and the application of the criminal and common law. Human dignity and the common good demand it.

However, I want to dwell more on the question of the extent to which it is the role of government to get involved in more detailed regulation and direction of economic life given the aspects of our human nature I have identified. I will focus mainly on the financial sector in this discussion on which the Vatican has made quite a lot of comment. Indeed, if you Google the term “pope calls for global regulation of finance” there are 15,100,000 results.

To somebody who has read an A-level or first-year undergraduate economics textbook, the role of government in economic life is easily defined. Economists start by making unrealistic assumptions about human nature in their models. When those assumptions do not hold (for example, if there is an absence of perfect information in the perfect competition model) they argue that there has been what they call a “market failure”. They then ascribe a role to government regulation in correcting such “market failures”.

In doing so, economists generally assume that governments act in the general public interest, that government regulatory bureaus have the perfect information lacked by market participants, and so on. In other words, economists make unrealistic assumptions about how people behave in markets. They then relax these assumptions and follow up by making unrealistic assumptions about how people behave in government. This is an intellectual dead end.

So, instead let us consider the implications of making realistic assumptions about human nature when it comes to government regulation of economic life. Let’s start with the limits to our knowledge. F. A. Hayek, in his last book, commented: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

This statement of Hayek’s is based on an understanding of the reality and implications of human ignorance which resonates entirely with a profoundly Christian understanding of the limitations of the human person. We may think that top-down regulation of, for example, the financial sector will improve matters. But perhaps that is just hubris. Indeed, it should be rather sobering for any regulator that there are close on 250,000 academic articles that respond to the search term “unintended consequences regulation” on Google Scholar!

As well as having to deal with the reality of human ignorance, we also have to think about the reality of other aspects of human imperfection when it comes to the development of regulation. To begin with, instead of being developed for the general public interest, regulation can be shaped by private interests — Catholic social teaching (including the work of Pope Francis) has warned about this without really exploring its implications. This is one of the areas of research for which James Buchanan won his Nobel Prize in 1986. One of the authors of the TV series, Yes Minister, the late Sir Anthony Jay, was very much influenced by Buchanan’s work.

These private interests might be regulators themselves. They might be politicians. Or the private interests might be the regulated industries which may try to capture the regulatory process for their own benefit. It is difficult to argue that private interests did not strongly influence the regulatory interventions immediately after the financial crash — especially in the US and Ireland.

In addition, politicians and regulators may simply have cognitive biases that lead them to overestimate the efficacy of government regulation. They are not neutral arbiters.

These are all manifestations of the reality of human imperfection which it is foolish to ignore. To put it simply, one imperfect human institution — government — cannot be expected to perfect another imperfect human institution — the market. It might not even improve it.

You don’t have to go very far to find interventions by government institutions that demonstrate human imperfection, just as you don’t have to go very far to find corporate behaviours that demonstrate human imperfection.

For example, in the run-up to the financial crash, the extensive international framework for bank regulation (the Basel Accords) explicitly encouraged securitisation and the development of the complex instruments (described very effectively in the book by Michael Lewis, later made into a film, The Big Short) that were at the seat of the crash. The US financial regulatory system also very much encouraged and gave government guarantees to the very same complex mortgage-backed securities, especially where those securities related to loans taken out by low-income households.

In addition to this, US interventions by the central banks over the 40 years before the crash stoked up moral hazard by using lender of last resort facilities to support banks that should have been allowed to fail. This was not the only error made by US central banks.

US regulators also required banks to discriminate in favour of borrowers who had a low capacity to repay their loans (and such loans were often granted without any proper documentation of ability to repay).

This list of regulatory interventions that encouraged the behaviours that led to the financial crisis is almost endless.

It is not that there was a lack of government regulation of the financial sector. To put the regulation of finance into some kind of context in the UK, from 1979 to 2010 there was an increase from one government regulator for every 11,000 people employed in finance to one regulator for every 300 people employed in finance. And this excludes the growth of compliance officers working within banks themselves. At that rate of growth, by the time today’s students retire, there will be more financial regulators than people working in finance — again excluding compliance officers.

There was no shortage of financial regulation: it just did not seem to have the effects hoped for — indeed, much of it had the opposite of the effects hoped for.
In addition, one of the characteristics of the regulatory interventions of the past 40 years was that the taxpayer came to underwrite the reckless behaviour of financial institutions. Given a Christian understanding of human nature, nothing can be more foolish than underwriting imprudent and risky behaviour in a situation where those indulging in the behaviour take the profits and society as a whole bears the losses. It is certainly not how to help people “choose the good”.

My point is not in any way to excuse those responsible who worked within banks in the 2000s. The point is that nearly all actions taken by regulatory authorities or central banks made the financial crash either no less likely or more likely. Those who regulated banks were carved out of the same block as the rest of humanity and share the same imperfections as the rest of us.

So, where do we go from here? Pope Francis often says that we don’t want unfettered markets. He is right and his intentions in commenting on these issues are certainly good. But, a free economy no more equates to unfettered markets than freedom from government interference in sexual relationships equates to unfettered promiscuity. The issue is not “fettered versus unfettered”, the question is, “Who should do the fettering?”

Fortunately, the rich tradition of Catholic social teaching does have something to tell us about how to approach these issues, though it has to be said that discussion of such things has been less apparent in recent years. The particular aspect that I want to focus on is the way in which non-governmental institutions can regulate economic and civil life.

Centesimus Annus, for example, pointed out: “Another task of the state is that of overseeing and directing the exercise of human rights in the economic sector. However, primary responsibility in this area belongs not to the state but to individuals and to the various groups and associations which make up society.” These would include professions, trades unions, and so on.

Rerum Novarum
made similar points back in 1891. The important principle in Catholic social teaching is the principle of subsidiarity which was defined in a Papal encyclical letter of 1931, Quadragesimo Anno, in which it was stated: “It is an injustice and at the same time a grave evil and disturbance of right order to assign to a greater and higher association what lesser and subordinate organisations can do.” In other words, in this field of regulating the economy perhaps civil society and other institutions should be the main players.

So, how have such societal, non-governmental regulatory institutions emerged to regulate economic behaviour in the past? Let me first give some examples to demonstrate how pervasive such mechanisms have been before I settle on one example that I will explain in a little more detail.

Uber is essentially a system of commercial private regulation of taxis which has overcome the huge problem of rent-seeking by incumbents within the existing generally municipal regulatory system for taxis.

The system of examining boards that existed before their emasculation by successive secretaries of state for education neatly balanced the interests of students, schools and universities and thus maintained standards and prevented the race to the bottom that many believe that the Ofqual-regulated system is creating now. City and Guilds, the Royal Society of Arts and Trinity Guildhall were also three regulators among many of professional, vocational and artistic qualification standards, in some cases two whole centuries before Ofqual was created.

The development of towns and the constraints on the development of buildings was often regulated entirely by private institutions in the 19th century. Some of you may not be so sure, but there are many people who prefer Bath, Bourneville, Eastbourne, Edinburgh Newtown and Southport, which were all privately planned, to later alternatives such as Skelmersdale and Crawley which were not.

Even the adoption of countrywide standard time was  introduced entirely by an industry standard-setting body, the Railway Clearing House. But, perhaps the area where these forms of regulatory mechanism were most prominent was in the field of finance. One of the extraordinary things about the financial sector in the UK up to 1986 was the way in which it developed its own regulatory institutions. One such example was the stock exchanges that developed in the late 17th century.

From their earliest days, stock exchanges developed their own forms of regulation for members who were trading and then for companies the shares of which were quoted on the exchange. To take what is probably the earliest example of such rules, those members who did not fulfil their financial obligations were chalked on a blackboard under the heading “lame duck” so that members would know who was trustworthy and who was not. Not very sophisticated, but this was the 1690s — and it worked.

Formal rulebooks both for members and companies quoted on the exchange then developed. The first was introduced as early as 1812. In 1909 the exchange famously banned members from simultaneously trading on their own book and giving advice in order to prevent conflicts of interest.

So successful was the London exchange, and so demanding was it, that its motto became “my word is my bond” in 1923. A Royal Commission reported on the stock exchange in 1878, saying that its rules “had been salutary to the interests of the public” and that the exchange had acted “uprightly, honestly, and with a desire to do justice”. It further commented that the exchange’s rules were “capable of affording relief and exercising restraint far more prompt and often satisfactory than any within the read of the courts of law”.

There were, of course, many other forms of institution in the world of finance — friendly societies, mutual societies, trustee savings banks and so on — that developed from within the community itself in the 19th century. In each and every case they had their own special forms of corporate governance designed to address specific problems that arise within financial markets. Just to give one example, in the days before central bank- backed deposit insurance, introduced in the UK in 1979, the Trustee Savings Banks offered deposits that were 100 per cent backed by government treasury bills. Deposit insurance for commercial banks completely removed their comparative advantage and they disappeared.

These are all examples of the principle of subsidiarity at work. These were forms of very effective regulation that had nothing to do with government. And there are many more examples, such as the way in which, until 1986, an industry body of insurance companies limited commission payments to prevent financial advisers mis-selling products; or the way in which defined benefit pension funds operated before the 1986 Social Security Act.

These institutions were successful in regulating behaviour in financial markets. So, what happened?

With regard to the stock exchange (and also as it happens, the agreement to limit commission payments to which I have just referred), the government used competition law to effectively abolish and make illegal many of the regulatory powers the stock exchange had. This was the process known as “big bang” in 1986. Indeed, the fact that these private systems of regulation were so much more comprehensive than government systems is indicated by the fact that big bang is often described as “deregulation”. In fact, big bang was the government prohibition of the use of powers by a private regulatory body.

In many of these cases where the state acted to prohibit civil society and market-based forms of regulation in the 1980s, the problems that have been left behind remain still unsolved by the Financial Services Authority and its successor three decades on.

I also want to discuss the role of civil society in the regulation of environmental resources because I think that this was a huge omission from Pope Francis’s recent encyclical on environmental issues, Laudato Si’, which was full of much theological and practical wisdom. Elinor Ostrom won her Nobel Prize in economics in 2009 for her work in this field. She is the only female winner of that Nobel Prize and her work is widely admired on all sides of the political spectrum. Ostrom’s thesis is simple. Communities from the bottom up — and her work was mainly with poor communities — are extraordinarily effective in developing forms of regulation to control the use of environmental resources such as fish and forests. They develop their own systems of enforcement and governance to ensure conservation and sustainability. Ostrom’s study of these mechanisms involved examining how people in the real world actually solve their own problems, given the realities of human nature and the imperfections inherent in political institutions. They are potentially very important not just in political economy, but also for developing Catholic social teaching.

Why are such regulatory institutions important? Let’s bring this to a conclusion in two stages. The problem with much debate in political economy is that it is often assumed, and sometimes explicitly stated, that a market that is not controlled by government regulatory bodies is unfettered. We should instead to ask the question, “What are the most appropriate institutional arrangements for regulating economic activity given what we know about human nature?” Economics is about human action in the economic sphere and it needs to be built on realistic assumptions about human nature. Economists such as Ostrom, Coase, Buchanan, North and Hayek addressed economics this way. They all won Nobel Prizes, but they tend to be bit-part players in the economics syllabus. Elegant abstractions are much preferred.

The mechanisms I have described allow individuals, those involved in commerce, civil society institutions and the community more generally, to use their reason and initiative to resolve problems. Essentially this is the principle of subsidiarity at work. And the principle of subsidiarity cannot be decoupled from that of human dignity.

These institutions have been very successful in promoting a sense of civic responsibility and they nurture important virtues such as “trust”. Such characteristics were absolutely at the core of the institutions of financial regulation that we used to have, and Ostrom shows that they are at the core of the institutions developed in poor countries to regulate environmental resources. These kinds of institutions also fit well with realistic assumptions about human nature. To begin with, they recognise the limits to human knowledge and the consequent impossibility of trying to perfect (or even to improve) the economic system from outside using highly complex systems of bureaucratic regulation (the US Act designed to regulate the banking system after the financial crisis, for example, runs to 22,000 pages including associated regulations).

Instead, these systems I have described allow experimentation, adaptation to local circumstances and the use of on-the-ground, local knowledge.

These institutions also lead to errors happening on a smaller scale when they do inevitably happen. Indeed, it is difficult to think of anything more monumentally irresponsible than the creation of a global system for regulating finance unless the objective is deliberately to create systemic risk by ensuring that the effects of mistakes within that system have global ramifications. Only God could successfully design such a system successfully!

These approaches also recognise the reality of human imperfection in the political sphere. Government regulations of financial and other systems are not produced by a uniquely disinterested group of people and are, indeed, strongly influenced by the corporate interests that the regulation is often supposed to restrain. By contrast, the regulatory institutions I have described are formed because participants in economic life come together knowing that their interests — and those of wider society — will be better served if they mutually agree to restrain their behaviour according to a set of rules. They are contestable in the economic sense that, if they do not serve their purpose, they will eventually disintegrate.

However, there are problems with the forms of regulation I have discussed. They can give rise to market power. That is why both trades unions and the private regulatory bodies I have described had their wings clipped by the Thatcher governments. However, we may have thrown the baby out with the bathwater; or, perhaps the crash showed that we threw out the baby and kept the bathwater.

And this leads to my final conclusion. However we regulate economic activity, there is no substitute for resourceful ethical people in all sectors of the economy. Catholics believe that the virtues are discernible by all people of good will. As a Catholic university, I hope that we will help students discern the right values because those values, more than anything else, are responsible for making the business world a better place.

So, perhaps I can give the final words to our Chancellor, Cardinal Vincent Nichols,  who said in his 2010 pre-general-election paper: “In place of virtue we have seen an expansion of regulation. A society that is held together just by compliance to rules is inherently fragile, open to further abuses which will be met by a further expansion of regulation. This cannot be enough. The virtues are not about what one is allowed to do but who one is formed to be. They strengthen us to become moral agents, the source of our own actions.”

So, let us base our economics on a sound understanding of the human person; but let us also re-enrich Catholic social teaching with a renewed understanding of the respective roles of government and society.