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«Tamara Lothian* Columbia University – Center for Law and Economic Studies Roberto Mangabeira Unger* Harvard University March 1, 2011 * © Tamara ...»

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A second attribute of the institutional setting in which finance operates is to be subject to the effects of technological innovation or revolution on economic life. These effects are never direct and determinate; they are always mediated by institutional arrangements.

The role of institutions in mediating them only increases the uncertainty of their impact.

A third attribute of the institutional context of finance is the variable divergence between two forces that operate upon it: popular support, wielding the suffrage, and economic power, manifest in the granting or the denial of confidence. In all contemporary democracies, these two forces regularly diverge. A force that loses in the course of electoral politics and public policy can hope to strike back through disinvestment and capital flight. A line of action that claims to conform to the dictates of financial confidence can be defied and defeated in politics. The relation between these two sets of outcomes conforms to no higher logic; it is open to the consequences of the next step in economic or political action.

24 A fourth attribute of the institutional framework in which financial activity now takes place has to do with the intractable limits to the extent to which the popularization of credit can replace the progressive redistribution of wealth and income. Within a narrow range of experience, the broadening of access to credit, especially consumer credit, can produce some of the same effects of a progressive redistribution of wealth and income, whether such redistribution occurs through an organized broadening of access to economic and educational opportunity or through the retrospective means of taxation and social spending. That a democratization of credit, however, cannot match the work of redistribution, even in the narrow task of sustaining a market in mass consumption goods and services, the genealogy of the recent crisis has once again shown. The consequences of this failure in the functional equivalence between greater access to credit and greater sharing of wealth and income can at any moment generate destabilizing forces.

A fifth attribute of the institutional context in which finance operates is its susceptibility to the effect of the intellectual fashions influencing the conduct of monetary policy by central banks. What will be the contrasting attitudes to the evils of inflation and deflation? Or the relative weight placed on the goals of monetary stability and full employment? Or the trust placed in policy regimes such as inflation targeting and its rivals? The answers to these questions lack a secure basus in any economic analysis with a rightful claim to the authority of science. Yet they may exert powerful effects, generating another series of destabilizing forces.

A sixth attribute of the institutional ground on which finance operates is international anarchy. There is not now a commonly accepted monetary basis for the world economy. The periods in which such a basis was widely accepted -- the heyday of the gold standard until its collapse in the 1920s and the rule of the original Bretton Woods system 25 from its conception in the aftermath of the Second World War to its collapse in August 1971 -- have been followed by periods of relative national autarchy and international disorder. The precarious and contested role of the dollar as the international reserve currency merely masks this disorder and attenuates its consequences.

An expression of this disorder is that in choosing which two aims marked out by the so-called trilemma of fixed exchange rates, monetary sovereignty, and free capital flows, they are to prefer (given that they cannot have all three of them of them at once), the major national and regional economies of the world have made divergent and contradictory choices. China has chosen the first and the second elements of this trilemma; the United States, the second and the third.

The present anarchy in the monetary arrangements of the world has helped make possible the vast imbalances between countries (beginning with China) that run huge surpluses of trade and saving and countries (the United States first among them) that import and consume much more than they produce and live off borrowed money.

The international anarchy and its expression in these imbalances represents yet another source of tremendous destabilizing mechanisms in the setting of finance, even for the capital that continues to stay at home, as most capital does.

This enumeration of attributes of the context of finance amounts to an open list of forces that, both separately and in conjunction with one another, can at any moment wreak havoc on financial calculation. The

identity of the particular sources and phenomena is constantly changing:

a generation hence it will not be what it is now, and what it is now is not what it was a generation ago.

The forms of destabilization that arise from these sources cannot in 26 principle be avoided by any financial innovation. In fact, even the first source of instability -- the fateful but haphazard, contingent, and therefore revisable character of the institutional setting within which finances operates -- cannot be easily understood, much less controlled, from the vantage point of the financiers. For them, the sole sufficient antidote is a defensiveness so guarded that it contradicts the requirements of risk-taking and entrepreneurship.

From the perspective of government and society, however, there is a possible response to the problem presented by the first trouble with finance. The generic character of the response is what we call -- bending the meaning conventionally given to the term -- financial deepening, by contrast to financial hypertrophy. By the hypertrophy of finance, we understand increase in the size of the financial sector, of its share in profit, talent, and influence, regardless of the service that it renders to the real economy. By financial deepening, we mean the intimacy of the relation between finance and the real economy: not only consumption but also and above all production and innovation. The more broadly based the engagement of finance in the whole cycle of production and exchange, the greater the number of independent sources as well as consumers of finance, the less likely is it that there be a specifically financial crisis that is not simply the expression in finance of a crisis in the real economy. Financial deepening thus understood is the development of which financial hypertrophy represents the perversion.

Regulation as conventionally understood -- the correction of localized market deficiencies, such as inequalities of bargaining power and asymmetries of information -- cannot ensure financial deepening the better to avoid financial hypertrophy. Regulation cannot do so unless it is practiced as the first step toward innovations in the arrangements governing the relation of finance to the real economy that put the former more effectively at the service of the latter.

27 The first trouble with finance, then, is its perennial vulnerability to the destabilizing forces that arise from an institutional setting beyond its control or even beyond its field of vision. The second trouble with finance is that, regardless of the interests and intentions of individual bankers, entrepreneurs, and consumers, it may not be able to perform its supposed goal of channeling the saving of society into productive investment. Its ability to serve this goal is hostage to the institutional arrangements governing the relation of finance to the real economy.

Those institutions may either tighten or loosen the relation of finance to the real economy and to the possibilities of production.

The standard identity of aggregate saving with aggregate investment makes it difficult even to formulate the problem. It becomes even harder to do so because the categorical language of national accounts, established after the Second World War under the influence of Keynes and his followers, turns this identity into a terminological tautology.

In this way, it reinforces the tilt of dominant thinking about the economy and the role of finance within it. The market will route saving into its most efficient uses, the available language of national accounts as well as the predominant doctrines in economics prompt us to believe.

To the extent that it fails to do so, the failure must be due to a localized market failure -- imperfect competition, unequal power, asymmetrical information -- that it is the proper aim of regulatory rule and policy to redress or to counterbalance. Such is the approach that has, despite all, continued to shape almost all contemporary thinking about the regulation of finance.

Finance: turning the bad master into a good servant

The familiar categories and the prevailing ideas may make it difficult to study how different institutional arrangements may either tighten or 28 loosen the link between finance and the real economy. They may make the very statement of such a problem seem nonsensical. It is nevertheless a real problem in a real world. It will not vanish simply because our preferred ways of talking and thinking fail to accommodate it.

That institutional arrangements, expressed in law, decisively modify the extent to which saving is channeled into production and productive investment can be shown by homely examples. All agents of finance, including all manner of banks, are themselves legal constructions, subject to a long, variable, and often surprising institutional evolution. The pension regimes of the present -- a major way in which saving has come to be held and deployed -- are relatively recent creations. The ways in which pension saving becomes available for productive investment is entirely determined by the rules under which they operate. A particular form of financial activity such as venture capital that seems very directly to exemplify the putative major role of finance is an innovation with an uncertain future: what, for example, can and should be the respective roles of private and public venture capital?

Under the institutional arrangements of present-day market economies, we earlier remarked, production is largely self-financed on the basis of the retained and reinvested earnings of private firms. The extent to which it is self-financed, although always overwhelming, is nevertheless variable. We have reason to suppose that the existing variations are only a subset of a much broader range of possible variation.

We have only to consider historical experience to appreciate how in the past institutional innovations have succeeded in making finance more useful to production. If they have made it more useful in the past, they can again make it more useful in the future. The early nineteenth century United States, for example, witnessed a struggle over the 29 national banks. This struggle culminated, during the presidency of Andrew Jackson, in the disbanding of the national banks and in the subsequent development of the most decentralized system of credit that had ever existed in a major country: a network of local banks the potential of which remains to this day far from being exhausted. This banking network placed finance more effectively at the service of the local producer as well as of the local consumer than it had previously been, in the United States or elsewhere.

An advance of this kind can be achieved again, not by repeating the institutional formulas of an earlier epoch but by institutional innovations suited to the present circumstance. Such innovations would give practical content to the idea of financial deepening. Their working assumption must be that it is not enough to cut finance down to size, by requiring for example more stringent capital-leverage ratios or even by imposing absolute limits on the size of financial firms, if we fail to establish arrangements that make finance more useful to production and innovation. We do not serve the deepening of finance -- in the sense in which we have defined it -- merely by combating its hypertrophy.

The relation between the two troubles with finance becomes clear in the course of the effort to deal with these troubles. In the spirit of a pragmatist experimentalism, the answer to the speculative question comes in practice.

To the susceptibility of finance to destabilizing forces that arise from the institutional setting in which it operates -- forces beyond its reach and even beyond its view -- there is no effective response other than financial deepening: the broadest possible grounding of finance in the whole work of the real economy: in every step of the cycle of production and exchange. Such a grounding does not advance spontaneously or automatically as a result of the sheer quantitative expansion of financial activity; it depends on the institutional 30 arrangements governing finance and its relation to the real economy.

Such arrangements may so disfavor the connection that they help generate financial hypertrophy without financial deepening. This is a recurrent phenomenon in world economic history. We have seen an example of it in the events leading up to the recent worldwide financial and economic crisis.

This reasoning shows that the only way in which we can effectively deal with the first trouble is also the generic character of the response to the second trouble. The idea of financial deepening marks out the conceptual space in which to address, through institutional innovation detailed in law, the relation of finance to the real economy in general and to production in particular. Just as economic institutions can organize a market economy in different ways, with different consequences of the trajectory of growth as well as for the distribution of advantage, so the part of this institutional order that deals with the role of finance can either tighten or loosen its link to production and to the real economy as a whole.

It is this simple but vital fact that our established ideas and nomenclature prevent us from fully acknowledging or even describing.

A discourse about regulation that identifies as its guiding task the redress of localized market failures further entrenches this way of thinking and talking. In every real dispute about regulation, the subtext has to do with alternative pathways for the reorganization of the area of social and economic practice in question. Regulation, properly understood, is the first step toward institutional reconstruction.

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