Debates about capitalism and the good society, from Karl Marx's incendiary criticisms in the nineteenth century through Milton Friedman's spirited defenses of free markets in the twentieth, have tended to center on industrial capitalism: the system of production, banking, and trade that shaped modern society up through the end of World War II. But the past several decades have witnessed the rise of financial capitalism: a system in which finance, once the handmaiden of industry, has taken the lead as the engine driving capitalism. The current severe financial crisis has called forth questions not only about the system's parts but also about financial capitalism as a whole.
This crisis — dubbed by Carmen Reinhart and Kenneth Rogoff as the "Second Great Contraction," a period of weakened economies around the world starting in 2007 but continuing for years after, mirroring the Great Contraction that followed the financial crisis of 1929 — has led to angry rejections of the value of financial capitalism.
Given this experience, many wonder, What is the role of finance in the good society? How can finance, as a science, a practice, and a source of economic innovation, be used to advance the goals of the good society? How can finance promote freedom, prosperity, equality, and economic security? How can we democratize finance, so as to make it work better for all of us?
At its broadest level, finance is the science of goal architecture — of the structuring of the economic arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement. The goals may be those of households, small businesses, corporations, civic institutions, governments, and of society itself. Once an objective has been specified — such as payment for a college education, a couple's comfortable retirement, the opening of a restaurant, the addition of a new wing on a hospital, the creation of a social security system, or a trip to the moon — the parties involved need the right financial tools, and often expert guidance, to help achieve the goal. In this sense, finance is analogous to engineering.
It is a curious and generally overlooked fact that the very word finance actually derives from a classical Latin term for "goal." The dictionary tells us that the word derives from the classical Latin word finis, which is usually translated as end or completion. One dictionary notes that finis developed into the word finance since one aspect of finance is the completion, or repayment, of debts. But it is convenient for our purposes to recall that finis, even in ancient times, was also used to mean "goal," as with the modern English word end.
Most people define finance more narrowly. Yet financing an activity really is creating the architecture for reaching a goal — and providing stewardship to protect and preserve the assets needed for the achievement and maintenance of that goal.
The goals served by finance originate within us. They reflect our interests in careers, hopes for our families, ambitions for our businesses, aspirations for our culture, and ideals for our society; finance in and of itself does not tell us what the goals should be. Finance does not embody a goal.
Finance is not about "making money" per se. It is a "functional" science in that it exists to support other goals — those of the society. The better aligned a society's financial institutions are with its goals and ideals, the stronger and more successful the society will be. If its mechanisms fail, finance has the power to subvert such goals, as it did in the subprime mortgage market of the past decade. But if it is functioning properly it has a unique potential to promote great levels of prosperity.
The attainment of significant goals and the stewardship of the assets needed for their achievement almost always require the cooperation of many people. Those people have to pool their information appropriately. They must ensure that everyone's incentives are aligned. Imagine the development of a new laboratory, the funding of a medical research project, the building of a new university, or the construction of a new city subway system.
Finance provides structure to these and other enterprises and institutions throughout society. If finance succeeds for all of us, it helps to build a good society. The better we understand this point, the better we will grasp the need for ongoing financial innovation.
Excerpt from: Finance and the Good Society (Princeton University Press, 2012).
The author is Arthur M. Okun Professor of Economics, Department of Economics and Cowles Foundation for Research in Economics at Yale University; Professor of Finance and Fellow at the International Center for Finance at the Yale School of Management; and the fall 2012 Allianz Distinguished Visitor at the American Academy in Berlin