The dissonance between academics’ and public perception of the benefits of finance is cause for concern. The author gives several reasons why finance academics should be more concerned about this apparent divergence of opinion and outlines an agenda for reorienting research and teaching in the academic field of finance.
The author states that academics’ view of the significant benefits of finance generally is not shared by society. He argues that finance academics should be concerned about the dissonance and points out that in the absence of proper rules, finance can easily degenerate into a rent-seeking activity, an aspect that has not received the necessary attention in academic work. The author outlines what finance academics should do in research and teaching to promote sound finance.
How Is This Research Useful to Practitioners?
The reputation of the financial industry has suffered significantly over the past decade. The two main reasons are the financial crisis, which involved massive transfers of public money to the private sector, and the large number of financial scandals that have recently come to light. These events must be considered against a backdrop of fundamental distrust of the financial industry, an industry that is poorly understood by the public and characterized by activities that have been perceived as pure rent seeking throughout history.
The author argues that negative public sentiment, even if it is completely unfounded—which it probably is not—should not be ignored by academic researchers. The main reason is the strong link between public opinion and regulatory action. The author warns of a vicious cycle of increased regulation countered by lobbying, which is financed by rents and followed by a further strengthening of anti-finance sentiments. According to the author, the United States witnessed such a scenario after the 1929 stock market crash and currently faces the same risk again.
He proposes several possible countermeasures that finance academics could take. First, he suggests that the profession needs to reassess the commonly held position that financial activities are always welfare enhancing. Although there is no doubt that a developed economy needs a sophisticated financial sector, the author finds little evidence to support the view that all growth in the financial sector over the past 40 years has benefited society. Research in finance should thus be more discriminating and more careful in identifying areas in which true value creation takes place.
Second, finance academics should take a much stronger role as watchdogs and try to expose the rent-seeking aspects of finance. Third, finance academics should get more involved in policy research. This policy research needs to be rigorous and not influenced by political considerations. Finally, finance academics need to be more aware of the fact that the way they teach the subject shapes student behavior. The author argues that teaching social norms should have a more prominent role in the curriculum.
How Did the Author Conduct This Research?
The author prepared this paper for the 2015 presidential address to the American Finance Association. To put the issue of public distrust in perspective, he initially provides evidence about the extent of misbehavior in the financial industry by compiling a long list of fines paid to US enforcement agencies from 2012 to 2014.
To develop his arguments for reorienting research and teaching in the academic field of finance, the author draws on a vast body of theoretical and empirical literature as well as on personal experience. He starts with the insight that public dislike of finance is unsurprising, even in the absence of fraud. This negative public opinion is related to the fact that the private return of financial activities frequently exceeds the social return and that on occasion, this difference can become extreme. Such an imbalance tends to create public envy, especially because the reasons for high private returns are poorly understood. If fraud is added to the picture, dislike easily turns into rage.
Regarding the large number of financial scandals, the author argues that they are not completely surprising from a theoretical perspective. In his view, agency problems, which facilitate the exploitation of customers, are particularly severe in finance: Innovation happens very fast, financial engineering can be used to benefit from agency problems, and such principals as shareholders or taxpayers are extremely dispersed.
The author also points out that government regulation, if poorly designed, can easily create additional inefficiencies. Two prominent examples are the implicit put option provided by central banks to the financial sector during the financial crisis and the guarantees given to Fannie Mae and Freddie Mac.
The author considers financial activities from a wider societal point of view. The most important message is that finance academics should broaden their perspective on the subject and consider much more than merely its technical aspects. Although finance has an important role to play in supporting real economic activities, finance academics need to do a better job of concretely identifying these contributions and of separating socially useful activities from wasteful activities.