It is hard to decide which is more shocking. Not one of the central bankers or market regulators who presided over the greatest financial boom and bust in history has lost his or her job as a result. Nor has any seen any just cause to alter his or her view of the world as a result of it. Indeed, in their reaction to the alleged excesses in investment banking, the public authorities could scarcely have adopted a more conventional response if they were playing villains in a play by George Bernard Shaw. They appear to subscribe to a one-dimensional view of human nature, in which good behavior can be encouraged and bad behavior deterred by adjustments to the blend of incentives and punishments that bankers face. This is why they and their political friends have attacked guaranteed bonuses, applauded government proposals to cap and tax performance bonuses, and set out measures they claim will restore a degree of balance to the propensity of bankers to take outrageous risks with the money of their shareholders (though not, tellingly, of their depositors). Perhaps they are merely cynical, knowing that such measures are irrelevant, but accepting that politics demands them. It is more likely that they are mistaken. Regulators of all kinds are still trapped by the conventional forms of thinking that caused them to mistake a credit-induced asset price bubble for a new economic paradigm. It is the world of Homo economicus, populated by rational and well-informed men and women pursuing their self-interest in markets that are efficient because they are competitive, and that always return to an optimal state of equilibrium. Ironically, this less-than-convincing description of the realities of financial markets is proving as useful to the regulators as it did to the Friedmanites who colonized investment banks and hedge funds during the last 20 years. The regulators now argue that the events of 2007-09 tested free market theory to destruction, and regulation is required to correct its failures. That the flaw in this approach is obviousif the regulators are wiser than the market participants, why did they not anticipate the crisis either?is no obstacle to its success. After all, votes, budgets and careers are at stake.
But there is a more profound objection than its nauseating political utility to the Rasputin-like refusal of Homo economicus to die. This is its unashamedly circumscribed conception of human nature. That there even is such a thing as human nature, and certainly that it needs to be taken into account in schemes of reform, such as the proposed changes to the regulation of financial markets, remains a surprisingly controversial idea. All discussions of the role played by genetics in human behavior are tainted by association with the cod eugenics of the Nazis and apartheid South Africa. Despite the many advances it has made in recent years, evolutionary psychology has yet to shed completely its association with illiberal brands of politics. It does not help, of course, that ascribing an important role to something as unalterable as the genetic inheritance of individuals appears to be antithetical to government intervention. If the innate differences between individual human beings are ineradicable, it is hopeless to believe that they can be mitigated by education or taxation or regulation. This is one reason why financial regulators, like mainstream economists, have resisted outright discussion of the idea that human nature may conspire in some fashion with the market environment to determine outcomes. It was thought extremely daring when the chief executive of the principal regulatory authority in the United Kingdom recently delivered a speech that addressed the question of whether regulators had any role to play in setting or policing the ethics and culture of regulated firms.
Culture and ethics are safe substitutes for a discussion about human nature. It is not that culture is unimportant. There are situations, such as certain neurological disorders, where heredity is a complete explanation. But an understanding of most human predicaments entails a grasp of complex interactions between the inherited traits of the individuals concerned and the environment in which they operate. In devising methods of reducing the amplitude of the financial cycle, the mistake is not to underestimate the importance of culture. It is to believe that it is the culture of financial firms that is the primary influence over the actions and decisions of individuals toward colleagues and clients. Culture matters, but the conception and transmission of that culture depends on the character and personality of those who create, sustain and disseminate itand character and personality are the product of various combinations of nature and nurture. The biological sciences are transforming our understanding of this process. Indeed, they are transforming our understanding of human nature all together, the working of the human mind, its genetic inheritance and its evolution through time. In doing so, they are transforming our conception of ourselves. For a regulator to discuss corporate culture and ethics without taking account of these findings is an understandable omission. For the less constrained, it is a dereliction of duty. But to attempt a reform of the financial markets without even a rudimentary understanding of the role of evolved human nature in decision-makingby bankers, as by othersis not simply to ignore the growing volume of evidence on the genetic origins of the intellect and the emotions. It is to encourage the most counterproductive forms of regulation, by freeing reformers to continue to believe that individual and organizational behavior can be reshaped by mere alterations in the patterns of punishment and reward. This is applied behavioral science at the level of its animal equivalent three generations ago: putting rats in a box and studying how they respond to either electric shocks or food pellets.
Oddly, accepting that human nature must play a role in decision-making by financial market participants is not a revolutionary idea at all. After all, nobody believes that there are no differences between men and women. Virtually nobody believes that differences in intelligence or athletic ability are entirely environmental. And anybody who reads a novel or watches a film will know that their purpose is to reveal the inner lives of a wide variety of human stereotypes (the psychopath is a staple of crime fiction). Yet there is one realm of human endeavor even better acquainted with the role of human nature in organizational behavior than novelists and screenwriters. It is called working in an office at a large financial institution. Anybody who has worked at an investment bank, for example, would have come across at least one person, and probably several, whose behavior conforms to the seven characteristics listed by the American Psychiatric Association as distinctive of the sociopath, or conscience-less individual: anti-social, manipulative, impulsive, aggressive, reckless, irresponsible and, above all, lacking remorse after hurting, mistreating or exploiting others. Only the most unreconstructed psychiatrist would dispute that behavior of this kind is somewhere between one-third and one-half genetic, and one-half and two-thirds environmental. Yet regulators have chosen to confine their interest in who runs investment banks to the measurement of technical competence, placing quantitative limits on short-term incentives, inviting firms to send senior executives on awareness courses, and fining firms or taking them to court after their employees have done something outrageous. Yet every time an investment bank is forced to disclose internal correspondence as part of an investigation or court proceedings, it serves only to reinforce the impression that, for investment bankers, clients exist not for mutually profitable business, but for exploitation. The information asymmetries between investment banks and their clients make the financial markets unusually susceptible to exploitative behavior of this kind. So, of course, does the commonplace belief within the investment banking industry in the veracity of the efficient markets hypothesis. Improving market efficiency is exactly how investment bankers choose to justify their behavior.
Improving market efficiency, by correcting market failure, is of course exactly what the regulators believe themselves to be doing too. It is a tribute to the protean nature of macroeconomic theory that it can subsume such contradictions in a common belief that market participants will always respond rationally to new information and incentives. It was the same conceit which led the public authorities in the United States and the United Kingdom to flood the markets with cheap money in the years ahead of the crisis of 2007-09, confident that a combination of new technology plus diligent Chinese savers and cheap Chinese workers would keep prices under control. Using the same methodology that caused the crisis to extricate ourselves from it might seem counterintuitive. But the conventional approach is the default mode of most public policymaking, most of the time, even in the wake of such an enormous financial catastrophe. Perhaps only those whose philosophy obliges them to believe that economic agents are always and everywhere in possession of the most complete and objective information could be so unaware of the extent of their own ignorance. For it is hard to think of a time in which there is a greater need for a new approach to the entire question of money, bank credit and financial cycles, or a better opportunity to discuss and even adopt it. After all, the last decade tested to destruction the fractional reserve banking system invented in the 19th Century, which has proved such a powerful source of wealth for bankers and votes for politicians, but also such a potent source of volatility in the real economy. It is time to abandon the idea that prosperity can be designed and disaster averted by feeding aggregates into algorithms, and to enrich our understanding of how economies work with the insights of modern biology. However dreary its reputation, economics is not just about money and goods and statistics. It is also about individual men and women, what they value and what they want, how those values and desires were formed, and how they are pursued.
Take bankers. They are of course only the operators of a system sustained by the central bank (and, ultimately, the taxpayer). But they are operating a powerful system capable of practically unlimited credit creation. They also enjoy the extraordinary privilege of using their customers’ assets to create that credit. It is convenient for them to believe that financial markets are always efficient and tend to equilibrium; that clients and colleagues are motivated chiefly by the prospect of financial gain; and that the securities markets are merely part of a price-signaling system that ensures resources are always put to their optimum use. Evolutionary theory and psychology offers a competing, but far more compelling, description of how markets and individuals really behave. It suggests that markets are not operated by rational utility-maximizers at all, but by a species of intrinsically violent animal named Homo sapiens, apt to organize into coalitions that compete for resources with similar coalitions, prone to predation, vitiated only by forms of altruism based on reciprocity. Evolution also suggests that markets are rarely stable, but are instead spontaneous, extended and continuously adapting and evolving orders with a natural tendency not to equilibrium but to disequilibrium. On this view, the price and state of the markets at any time is not a correct summation of all that is known at that point, as conventional theory has it. Rather, they are merely snapshots in time of the continuously evolving product of long and complicated chains of changes and modifications and errors by individuals and firms, in which successful adaptations are reinforced, and unsuccessful ones jettisoned. In effect, firms and individuals within markets are engaged in an unending process of discovery by trial and error, in an environment in which resources are scarce, information is limited and technology and techniques are changing constantlyand in which errors and redundancy are bound to occur. It also suggests, through the action of the positive feedback mechanism in nature, that conducting monetary policy to avoid periods of scarcity, as central banks did during the era of the Greenspan put, is bound to encourage excessive expenditure and consumption.
For regulators, the implications of this richer and more human understanding of how individuals, firms and markets work in practice are profound. The most obvious is that it is fallacious to believe that a less volatile financial system can be designed or planned, since the system develops spontaneously in relation to challenges, and proceeds in large part by error. It follows that the modern central bank, far from being part of the solution to recurrent financial crises, is a large part of the problem. This is because, if money is cheap, much of it will be wasted. Inevitably, money is borrowed for investment in marginally profitable assets, like subprime mortgage loans. The borrowing drives up the cost of the assets, obliging borrowers to take on even more debt to avoid losing the whole of their investments. Modern central banking is really no more than an elaborate political con trick to avoid the reality that stalks this sequence of events. Even in a fractional reserve banking system that at its height in the early years of this century was content to place an inverted pyramid of credit on reserves worth a few percent of total assets, credit creation cannot continue indefinitely. Once it starts to be withdrawn, the original investments are revealed for what they always were: unprofitable mistakes made temporarily appealing by cheap money. Even now, rather than allowing bad investments to be written off, the central banks are pursuing a policy deliberately designed to inflate the value of the bad assets still sitting on the balance sheets of the banks. Perhaps this reluctance to take the infamous advice of Andrew Mellon (“liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate … it will purge the rottenness out of the system”) is another aspect of our human nature: our tendency to worry more about what we will lose than what we might gain. Yet empowering the central banks to inflate our past mistakes away cannot avoid the reckoning with reality, even if it postpones it. In the end, it redistributes the credit-induced mistakes, from borrowers to savers, and from old to young. That is something else which evolutionary psychology teaches us. We care a lot less about strangers than we do about members of our own family, clan, village or tribe. It is not a nice thing, human nature. But, as the great man said, it is hard to see how we can become better until we know what we are really like. GC