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Department of Economics

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Responsible Actions-

Establishing Order

Opening Keynote at Finanzethik Congress 2012

"Vertrauen und Verantwortung im Finanzsystem"

Zürich, 25./26.October 2012

Prof. Josef Falkinger

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1 Outline of talk

1. Introductory remarks

2. Responsibility in an economic system

3. Responsible economics, responsible finance

4. Responsibility and thrust in the financial system

5. Responsible regulation and credible policy

“Responsible Actions - Establishing Order”, Josef Falkinger, Department of Economics, University of Zürich.

2 Responsibility in an economic system

2.1 Individual agents, roles and systems

Interaction of agents in system.

Agents act in roles (e.g. worker, consumer, financial investor, real investor,

manager, firm owner, expert, financial intermediary, politician).

Hierarchy of influence: Active agents, passive agents (Kalecki).


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2.2 "Holy" orders, authoritarian systems and ideal markets

Delegation of responsibility to

Authority (God, benevolent monarch, omniscient planer).

Ideal market solution (minimal "moral" requirements).

Behavioral requirement: Be "rational" by perusing your interests in

consistent and optimal way.

System requirement: Organize all interactions in free markets.


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2.3 Responsibility in realistic (market) economy

i. Markets do not solve distribution conflicts.

ii. Behavior not always rational in the sense of axiomatic decision theory. In

particular, no complete preference order, incomplete knowledge of states

of world.

iii. Markets often imperfect (concentration of ownership, asymmetry of

information, systemic power of key players like big banks) and always

incomplete, in particular financial markets (not all economic relevant

interactions are organized in markets, not all states of the world are known).

iv. So-called economic fundamentals (distribution of endowments,

technological restrictions, uncertainty structure)

- not given by "nature"

- but "men-made".

In particular, the economic and financial system, including its crises, are

men-made and not the consequence of "fate" or eternal statistical laws.


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2.4 Normative goals: Wealth, stability and fairness

Wealth

Mercantilistic view: Appropriation of wealth by elite.

Modern economy: Production and consumption; participation of mass of

people.

Revival of mercantilistic view promoted by financial wealth management

perspective.

Robust development and fair distribution

Gains for minority at cost of majority are not sustainable.

Exploiting any advantage at any risk and at cost of others or of the system

fires back.

Avoiding "catastrophes" (wars, mass unemployment, deep depressions,

decades of instability and stagnation) more important than optimal

outcomes under smooth conditions.


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„No society can surely be flourishing and happy, of which the far greater part of

the members are poor and miserable”

(Smith,1776, Vol.1, p.48).

„No man of spirit will consent to remain poor if he believes his betters to have

gained their goods by lucky gambling”

(Keynes, 1923, p.24).


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3 Experts and scientific communities

3.1 Responsible economics


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Appropriate economic modeling must address essential features of

economic reality:

efficiency, fairness and robustness of system,

heterogeneity of agents, in particular hierarchy of roles and unequal

distribution of endowments,

imperfect competition and incomplete markets,

shocks and disequilibria,

and track key indicators of long-term system performance …

Key indicators

Looking only at P-level disarmed policy from dealing with emerging financial instability.

Traditional "Magic Polygon"

employment,

growth,

price level,

external balance,

income and wealth distribution,

enlarged by

debt- and leverage ratios (in private as well as public sector),

inflation of financial sector (relative to real sector),

can serve as early detector of structural breaks in system.


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3.2 Responsibility in finance

Framework

M financial products for intertemporal exchange across S uncertain states of

future world.

If M < S, markets incomplete and financial innovations desirable.

Basic problems

No solid theoretical ground for correct pricing and general equilibrium

effects of financial products in incomplete markets.

Financial innovations may create new uncertain states of the world (e.g. by

inducing careless actions or trades conditioned on artificial states).

Failures spread (through price system) over whole system and do harm to

efficiency, fairness and stability of the economy.


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Maxims of responsible finance

Do not rely on techniques which are only sound in complete markets.

Be aware that non-price information is relevant as well, since prices in

incomplete markets or under imperfect competition do not reveal the whole

information.

Reflect about macro consequences of financial intermediation activities and

products.

Ask what they contribute to the productivity of the real economy. (Example:

What is impact on real economic growth or world GDP if speed of financial

trades increases by some milliseconds?)

Ask about performance of intermediation service and product in financial

system crisis?

Account for hierarchy of wants and give priority to stable banking and

finance for standard needs of mass of ordinary people and firms.


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4 Responsibility and trust in the financial

system

4.1 The role of the financial system for the real economy

Financial system deals with future and uncertainty. Therefore thrust in financial

system is basis of financial business.

Responsible banking should avoid distortive banking activities and focus on

productive banking rather than on appropriative (redistributive) financial

activities.

"Productive Banking":

Transform savings to most productive real investment projects in firms.

Help households and firms to bring the stream of earnings and the stream

of required or desired expenditures in line over time and across

fundamental states (Smoothening and insurance).


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4.2 Fundamental disorder built up over last three decades

Two indicators:

Inflation of financial products (including confusion- and risk-generating

financial innovations).

Inflation of volume of financial transactions (in particular by highly

leveraged instruments).

Like inflation of price level, the inflation of financial products and financial

transaction volumes distort information-processing capacity of price

mechanism.

Required:

Control of rate of growth of financial products and transaction volumes

(analogous to monetary rules).


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4.3 Responsible banking

Nihil nocere! Avoid distortive banking (that is profit making by generating transaction costs, confusion, systemic risks).

Reduce abundance of noisy “financial price news“. Gather information on real economy; do not watch at financial markets prices only.

Stick to role as intermediary for real economy with households which want reliable financing of life-time consumption and firms which invest in productive and productivity increasing projects.

Security for financing of basic needs and a convenient life over the life-cycle of mass of people comes first. Wealth management for thin rich elite comes second.

Focus on “productive banking“ rather than on “appropriative banking“ (which increases wealth of some agents at the cost of others. Possible by exploiting asymmetric information, power and incompleteness of financial markets).


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5 Responsible regulation and credible policy 5.1 The relationship between citizens and financial

gamblers: An aggregate view

Conventional wisdom: Higher rates of return, , imply higher risk level

(), 𝜎′ > 0.

Inflation of financial products modifies the risk-return structure in two ways:

i. Besides private risk, 𝜎, also a systemic (social) risk, , emerges when

high is created by complex financial innovations. See for instance the

derivative and leveraging business.

ii. Illusionary risk perception, 𝜎 < 𝜎, is produced among private investors.

See for instance the CDO/CDS business.


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Figure 1: Risk-return structure with external effects.

Source: Falkinger (2011)

Citizens pay for the true external risk (including the ignored gap from

illusion)

+(𝜎 − 𝜎 )

and thus deliver a high 𝜌 to the market.

The level of these costs depends on volume of high risk-return segment of the

financial system.

Policy actions required. Responsible political and economic leaders will find

support for these actions.

“Responsible Actions - Establishing Order”, Josef Falkinger, Department of Economics, University of Zürich. 17

5.2 Possible policy instruments

Recapitalization of banks (with issuance of shares to the state to the

extent that capital comes from government) may help us as far as region

𝑟1, 𝑟2 is concerned.

Alternatively (and beyond 𝑟2 in my view preferable):

Rate of return regulation or progressive tax on return or

Admission procedure for financial innovations (with burden of the proof

of systemic innocence at the side of the issuer).

And more generally:

Control of inflation of financial sector (analogous to monetary rules)


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6 Conclusion

Focus on clear goal

"Bring financial system in order as top priority" (of responsible management,

research and policy).

Clear message to the market

"Inflation of financial sector will be controlled and high-return banking at social

costs will not be tolerated."

Clear message to citizens and business:

"Maybe there will be no financial instruments for all kind of

wishes of wealthy agents, but we will guarantee a stable

financial system for all needs of ordinary households and

firms."


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Supplementary slides


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Belief

Responsible political and economic leaders will find support for these actions.

"Experience shows with great certainty that the active part of the community will

not submit in the long-run to pay too much to vested interests, and, if the

necessary adjustment is not made in one way, it will be made in another ... "

(Keynes, 1923).

Premises for successful political action are obviously fulfilled, namely "that

activism and interventionism are possible and useful when conditions are

regarded as unjust or undesirable, particularly in regard to basic needs and

extreme inequalities“ (K.W. Rothschild, 1999).

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Individual responsibility

Strengthen virtues of enlightened age.

Be reasonable

Acquire knowledge and competence.

Reflect your goals and actions.

Use your intellectual capacity (Sapere aude!, Mündigkeit).

Be aware of others

Fairness,

Empathy ("sympathy"),

"Sense of duty" as social being.

Try to improve ("love of improvement")


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Principles of responsible role and system

design

Design roles consistent with virtues of responsible individual behavior. Do

not assign "dirty jobs«!

Sanction foul players, including free-riders who opportunistically exploit

system failures.

Assign transparent responsibilities to roles so that decision rights and the

bearing of the costs of wrong decisions are clearly aligned.

Align responsibility and power in congruent way: Cut back functionless

power; endow responsible roles with sufficient power.

Design systems which are controlled by robust rules. Account for

imperfections.


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Responsibility of experts

Scientific competence (fachliches Können)

Intellectual honesty

Be aware of limited knowledge. (Only ideologies claim to be always true.

Scientific results are subject to falsification.)

Disclosure of undesired outcomes.


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Stylized structure of appropriate modeling of

economy with financial sector

Real economy (Resources, production capacity)

Total output 𝑌, usable for real investments or consumption.

Distribution of real endowments 𝑒1, … , 𝑒𝑁, 𝑒𝑛𝑛 = 𝐸.

Relative goods prices 𝑝, relative factor prices ω.

Fundamental uncertainty structure (𝑆, 𝜋).

Financial sector (Money + Assignments and exchange of property rights)

Aggregate price level, P.

Relative asset prices 𝑞, rates of returns and risks 𝜌, .

Financial uncertainty structure (𝑆 , 𝜋 ).

Welfare

Efficiency (allocation of resources + productivity).

Equity (distribution of 𝑌).


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Market economy

Real sector

Allocation, productivity and distribution governed by prices 𝑝, 𝜔. Imperfect or

incomplete goods and factor markets lead to distortions.

Financial sector

Prices of 𝑝, 𝜔 depend on financial sector. If 𝑞, 𝜌,, (𝑆 , 𝜋 ) are distorted, then 𝑝, 𝜔

and thus real allocation, productivity and distribution are distorted.


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Responsibility in media sector

Stop expansion of price-information at cost of non-price information about

markets and economies.

Do not sell the “banker’s view“ as financial and economic expertise.

Display and discuss long-term development of indicators reflecting system

performance (Extended “magic polygon" as early warning system).

Information is more than news.

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