On the social value of finance

Over many years the finance industry has developed a set of powerful tools which could be used to improve well-being and to solve our environmental problems. For example, to avoid dangerous climate change, the required 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 savings surplus where trillions of dollars are sitting in government bonds earning negative returns which 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. Governments have outsourced the management of its assets to the finance industry and set the industry the wrong incentives, we need to re-think 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, who invest our savings (for example 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.

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 are 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.

It is clear that the allocation of capital by the finance system does not work in practice, either. The finance sector has grown rapidly in size without becoming more efficient so that now half of all savings are ultimately eaten up by charges, less than 4% of savings are actually invested at all (the rest spends its life as abstract “financial” assets”), the system is prone to asset bubbles and crashes, returns have been driven down by the system itself to close to zero making a pension unaffordable, the level of debt in the economy has increased unsustainably.

So how would a better system work? The government currently supports, promotes and sets incentives based on flawed economic theories to promote a system that doesn’t work. What needs to happen is as a society we need to decide on what we want finance to do and set incentives to achieve these outcomes.

In return for the continued support of the finance system, the finance industry should have to demonstrate that it is socially useful. Banks that have the right to create money and are guaranteed by governments should preference lending to create jobs and other social benefits (at the moment the proportion of lending to the “real” economy is a rounding error). To benefit from a tax rebate, pensions and savings products would have to be impact investors (show that investments have a positive social benefit) or invest in sustainable infrastructure and research and development. The sustainable finance tools to do this exist 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 maybe a worthy value, but it does not apply to our current non-free financial markets. We need to decide what values we want finance to embody, and then set the rules to achieve this.

Nick Silver is author of Finance, Society and Sustainability which will be published by Palgrave Macmillan in July