Just financial markets finance in a just society

De Bruin 2015 explores the nexus between epistemology and ethics in financial markets; Emunds 2014 provides a critical account of financial markets from a perspective of global justice.. I

J U S T F I N A N C I A L M A R K E T S ?

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Just Financial

Markets?

Finance in a Just Society

EDITED BY LISA HERZOG

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1 Introduction: Justfinancial markets? Finance in a just society 1Lisa Herzog

PART I NORMATIVE FOUNDATIONS

Rosa M Lastra and Alan H Brener

3 A capability framework forfinancial market regulation 56Rutger Claassen

4 Financial markets and institutional purposes:

Seumas Miller

5 Can incomes infinancial markets be deserved?

Lisa Herzog

PART II LEGAL STRUCTURES

6 Punishment in the executive suite: Moral responsibility,

Mark R Reiff

7 A culture beyond repair? The nexus between ethics

PART III INSTITUTIONS AND PRACTICES

10 Normative dimensions of central banking: How the guardians

Peter Dietsch

11 Information as a condition of justice infinancial markets:

Boudewijn de Bruin

Roseanne Russell and Charlotte Villiers

13 It takes a village to maintain a dangerousfinancial system 293Anat R Admati

List of Contributors

Anat R Admatiis the George G C Parker Professor of Finance andEconomics at the Graduate School of Business, Stanford University She haswritten extensively on information dissemination infinancial markets, tradingmechanisms, portfolio management,financial contracting, and, most recently,

on corporate governance and banking Since 2010, she has been active in thepolicy debate onfinancial regulation, particularly capital regulation, writingresearch and policy papers and commentary She is a co-author, with MartinHellwig, of the book The Bankers’ New Clothes: What’s Wrong with Bankingand What to Do about It (2013) She was also named by Time Magazine as one

of the 100 most influential people in the world and by Foreign Policy Magazine

as one of the 100 global thinkers in 2014

Alan H Breneris currently undertaking a PhD at the Centre for CommercialLaw Studies (CCLS), Queen Mary University of London He is a member ofthe Advisory Board of the Centre for Ethics and Law at University CollegeLondon and a council member of The Chartered Institute of Bankers inScotland He is also a qualified Chartered Accountant and member of theInstitute of Chartered Accountants in England and Wales and has a LLM fromUCL Prior to starting his PhD, he worked for Santander UK and wasresponsible, at different times, for the compliance and retail legal departmentsand regulatory policy Before joining Santander in 2005, from 1996 he headedthe compliance departments for the retail banking divisions of NatWest andRBS banks From 1989 to 1996 he was a senior prudential and conduct ofbusiness regulator for the insurance and collective investments sectors, havingpreviously worked on aspects of public policy at the Department of Tradeand Industry He also helped set up the Banking Standards Board with theobjective of improving standards of conduct and professionalism within thebanking industry

Rutger Claassenis Associate Professor of Ethics and Political Philosophy atthe Department of Philosophy of Utrecht University His research centers onthree main themes: socio-economic justice (especially the capability approach,

on which he is writing a monograph); economic and ethical theories aboutthe concept of the market and the justifications for regulating and limitingmarkets; and conceptions of freedom, autonomy, and paternalism He haspublished in journals such as Economics and Philosophy, Inquiry, Law andPhilosophy, Journal of Social Philosophy and Politics, Philosophy and

Economics He also regularly publishes articles and books in Dutch, to

bring philosophy to a broader audience He is an editor of a public journal(Filosofie & Praktijk) and co-organizer of a monthly Philosophical Café

in Utrecht

Jay Cullenis a lecturer in banking andfinance law at the University ofSheffield His main research and teaching interests are banking regulation,shadow banking, and corporate governance offinancial institutions He hasbeen a visiting scholar at Columbia University (2016) and has receivedresearch grants from the British Academy and European Commission forwork onfinancial regulation His work on bank leverage and corporategovernance has been quoted by the Financial Times and the BBC In addition,

he is an associated expert at the Institute for New Economic Thinking and

a member of the Sustainable Market Actors Network, hosted by the LawFaculty at the University of Oslo His monograph on executive compensation(Executive Compensation in Imperfect Financial Markets) was published in

2014 He has published articles in journals such as The Columbia Journal

of European Law and the Journal of Financial Perspectives His work hasbeen presented at leading academic venues including the Institute for NewEconomic Thinking, Oxford University, Berkeley, and The National Institutefor Economic and Social Research

Boudewijn de Bruinis Professor of Financial Ethics at the University ofGroningen He held visiting positions at Cambridge University, the FondationMaison des sciences de l’homme in Paris, and Harvard Business School, and is

a Life Member of Clare Hall (Cambridge) With Alex Oliver (Cambridge), he

is directing a program on Trusting Banksfinanced by the Dutch ResearchCouncil (NWO) De Bruin’s research interests are financial ethics, moral,and political philosophy, theory of knowledge, philosophy of mathematics,economics andfinance, game theory, and philosophical logic He is the author

of a monograph on Explaining Games: The Epistemic Programme in GameTheory, published in 2010, and co-editor, with Christopher F Zurn, of NewWaves in Political Philosophy (2008) His monograph Ethics and the GlobalFinancial Crisis: Why Incompetence Is Worse than Greed was published

in 2015

Peter Dietschis Associate Professor in the Philosophy Department at theUniversité de Montréal His research interests lie in the domain of economicjustice, with a focus on income inequality as well as on normative issues ineconomic policy, includingfiscal and monetary policy His book CatchingCapital: The Ethics of Tax Competition was published by Oxford UniversityPress in 2015 Among other journals, he has published in The Journal ofPolitical Philosophy, the Journal of Moral Philosophy, the Journal of SocialPhilosophy, and Politics, Philosophy and Economics

Lisa Herzogis Professor of Political Philosophy and Theory at the BavarianSchool of Public Policy at the Technical University Munich She works on theintersection of economic and political questions, with a focus on the history ofeconomic and political thought, the normative status of markets, and, mostrecently, the role of complex organizations in markets and their moral status.She is the author of Inventing the Market Smith, Hegel, and Political Theory(2013) and numerous academic papers in English and German She also writesfor a broader audience, including the monograph Freiheit gehört nicht nur denReichen Plädoyer für einen zeitgemäßen Liberalismus (2014).

Aaron Jamesis Professor of Philosophy at the University of California, Irvine

He is the author of various papers that have appeared in journals includingPhilosophy and Public Affairs and Philosophy and Phenomenological Research,and of Fairness in Practice: A Social Contract for a Global Economy (2012) Hehas been a recipient of ACLS’s Burkhardt Fellowship, a fellow at the Center forAdvanced Study in the Behavioral Sciences, Stanford University, and VisitingProfessor of Philosophy at NYU

Rosa M Lastrais Professor in International Financial and Monetary Law atthe Centre for Commercial Law Studies (CCLS), Queen Mary University ofLondon She is a member of the Monetary Committee of the InternationalLaw Association (MOCOMILA), a founding member of the European ShadowFinancial Regulatory Committee (ESFRC), an associate of the FinancialMarkets Group of the London School of Economics and Political Science,and an affiliated scholar of the Center for the Study of Central Banks atNew York University School of Law From 2008 to 2010 she was a VisitingProfessor of the University of Stockholm She has served as a consultant to theInternational Monetary Fund, the European Central Bank, the World Bank,the Asian Development Bank, and the Federal Reserve Bank of New York.From November 2008 to June 2009 she acted as Specialist Adviser to theEuropean Union Committee [Sub-Committee A] of the House of Lordsregarding its Inquiry into EU Financial Regulation and responses to thefinancial crisis Since 2015 she has been a member of the Monetary ExpertPanel of the European Parliament and since 2016 she has been a member ofthe Banking Union (Resolution) Expert Panel of the European Parliament Shehas written extensively in herfields of expertise (central banking, financialregulation, international monetary law, EU law), with several authored andedited books and numerous articles

Seumas Milleris a professorial research fellow at the Centre for AppliedPhilosophy and Public Ethics (an Australian Research Council SpecialResearch Centre) at Charles Sturt University (Canberra) and the 3TU Centrefor Ethics and Technology at TU Delft (The Hague) (joint position) He is theauthor or co-author of over 200 academic articles andfifteen books, including

Social Action (2001), The Moral Foundations of Social Institutions (2010),Investigative Ethics (co-author Ian Gordon) (2014), Shooting to Kill: The Ethics

of Police and Military Use of Lethal Force (2016), and Institutional Corruption(forthcoming)

Katharina Pistoris the Michael I Sovern Professor of Law at ColumbiaLaw School and the Director of the School’s Center on Global Legal

Transformation She previously taught at the Kennedy School of Government,and worked at the Max Planck Institute for Foreign and InternationalPrivate Law in Hamburg, Germany and the Harvard Institute for InternationalDevelopment Her research interests include the relation of law andfinance, thetransformation of economic systems, comparative corporate governance, andlaw and development She serves as President of the World InterdisciplinaryNetwork for Institutional Research, and on the editorial boards of the Journal

of Institutional Economics, and the Columbia Journal of Transnational Law,among others In 2012 she received the Max Planck Research Award for hercontributions to internationalfinancial regulation Recent publications

include“A Legal Theory of Finance” (Journal of Comparative Economics, 2013);

“Regulatory Capabilities” (with Fabrizio Cafaggi) (Journal on Regulation andGovernance, 2015), and a book co-edited with Olivier De Schuttter, GoverningAccess to Essential Resources (2015)

Mark R Reiffis the author of four books: On Unemployment, Volume I:

A Micro-Theory of Economic Justice (2015), On Unemployment, Volume II:Achieving Economic Justice after the Great Recession (2015), Exploitation andEconomic Justice in the Liberal Capitalist State (2013), and Punishment,Compensation, and Law: A Theory of Enforceability (2005) His papers onissues within political, legal, and moral philosophy have appeared in leadingacademic journals in the US, the UK, France, and Canada He has taughtpolitical, legal, and moral philosophy at the University of Manchester, theUniversity of Durham, and most recently at the University of California atDavis, and in 2008–9 was a Faculty Fellow at the Safra Center for Ethics atHarvard University He is also a lawyer, and prior to retuning to academia toobtain his PhD at the University of Cambridge he practiced complex civil trialand appellate litigation in California for many years He is also admitted topractice as a solicitor in England and Wales

Roseanne Russellis a Lecturer in Law at Cardiff University Her research lies

at the intersection of company law, employment law, and feminist legaltheory She is a solicitor and practiced in Edinburgh and London beforemoving to academia

Charlotte Villiersis Professor of Company Law and Corporate Governance atthe University of Bristol Her research focuses on company law, employment

law, and Spanish Law She studied law at the University of Hull and theLondon School of Economics and Political Science, and is a qualifiedsolicitor She has taught at the Universities of Sheffield and Glasgow, and was

a Visiting Lecturer at the University of Oviedo in Spain She was appointedProfessor of Company Law in 2005 Her publications include EuropeanCompany Law—Towards Democracy (1998), and most recently, CorporateReporting and Company Law (2006) She has also written extensively on

UK industrial relations Her current research sponsored by the Arts andHumanities Research Council (AHRC) concerns female participation incompany boards

Finance in a just society

Lisa Herzog

1 1 I N T R O D U C T I O N

Finance has become a serious political affair In a 2000 newspaper article,the speaker of the board of Deutsche Bank, Rolf-E Breuer, called financialmarkets the “fifth power,” which, together with the “fourth power” of themedia, helped to keep in check the executive, legislative, and judicialbranches, the three traditional powers of the state (Breuer 2000) In 2002,Warren Buffet, one of the world’s most successful investors, called derivatives

“financial weapons of mass destruction,” and he has recently confirmed thisview (Financial Review 2015) Weapons of mass destruction, if they shouldexist at all, should certainly not exist in the hands of a small group of privateactors—they are a political issue par excellence Some bankers think of theirwork even more highly: Goldman Sachs’s chief executive Lloyd Blankfeinonce famously told a reporter that bankers are “doing God’s work” (WallStreet Journal 2009)

Rhetoric and self-aggrandizing aside,finance has certainly become an issue

of utmost importance for capitalist societies Since the 1970s, the volume offinancial services has grown with around twice the speed of GDP growth inboth the UK and the US (Turner 2016, 20ff.) The Great Financial Crisis of

2008 has made painfully clear thatfinancial markets are not just markets likeany others Their impact on the lives of numerous individuals is huge: so manyjobs, wages, nest eggs, mortgages, and consumer loans depend, directly orindirectly, on what happens on the tradingfloors of Wall Street, the City ofLondon, and elsewhere, a phenomenon sometimes described as the“financial-ization” of society And yet, financial markets are highly abstract entities, andtherefore difficult to grasp: all we see are charts on computer screens, in green

or red, and maybe some pictures of nervous men (and the occasional woman)

in suits shouting orders at each other from their trading desks The ness offinancial markets may be one of the reasons why it has been moredifficult than with regard to other institutions to address a very simplequestion to them: are they in line with our considered judgments about how

abstract-a just society should be orgabstract-anized? After the Greabstract-at Finabstract-anciabstract-al Crisis, politicabstract-alphilosophers and theorists1have begun to develop an interest in such ques-tions, and a new debate has started.2This volume brings together contribu-tions to this debate not only from political philosophy, but also fromeconomics and law They shed light on a number of interconnected themesthat all have to do with the relation betweenfinancial markets and justice

In the last decades, political philosophers have by and large3relied on theacademic division of labor and mostly left questions about markets to econo-mists, despite the fact that there is a venerable tradition in philosophy—fromAristotle to Montesquieu, Smith, Kant, Marx, and many others—that takeseconomic questions seriously as genuinely philosophical questions Morerecent discussions, in contrast, have started to open up the “black box” ofmarkets (Dietsch 2010) and to look in more detail at the structures of markets:the values they embody, the institutional landscape they are part of, and theimpact they have on the distribution of opportunities and resources (seeHerzog 2013 for an overview) So far, however, the debate about marketshas been limited to considerations about markets in general, and has focusedmostly on their moral limits (see notably Anderson 1992, Satz 2010, andSandel 2012) or on the duties of market participants, which have also beendiscussed in business ethics (see e.g Heath 2014) In this volume, in contrast,the focus is on one particular kind of markets: financial markets As I will

1 I here use these terms interchangeably.

2

Contributions that analyze the Great Financial Crisis include Lomansky (2011), Nielsen (2010), Graa fland and Van de Ven (2011), Nowak and O’Sullivan (2012), Roemer (2012), and the essays collected in Dobos, Barry, and Pogge (2011) There are now some emerging discus- sions about “justice in finance,” e.g James (2012, 249–84) or Wollner (2014) Monographs that discuss normative questions about finance, but mostly from a perspective of ethics rather than political philosophy—i.e with a focus on moral agency rather than institutional structures— include Koslowski (2011), Hendry (2013), Boatright (2014); see also the volume edited by Boatright (2010) De Bruin (2015) explores the nexus between epistemology and ethics in financial markets; Emunds (2014) provides a critical account of financial markets from a perspective of global justice A speci fic branch of the financial services industry, microfinance, raises questions of justice of its own: often motivated to help the poor by providing them with loans, there has also been some debate about abuses and exploitative practices For a discussion from a philosophical perspective see for example Sorrel and Cabrera (2015).

3 There are some exceptions that concern speci fic aspects of markets—for example the role of luck in markets, or the role of self-interested motives and the role of incentives in a just society — that were discussed in debates about luck egalitarianism and about Rawls ’s approach (see e.g Cohen 1997) These debates, however, concerned abstract features of markets rather than markets as concrete institutions.

discuss below, they have specific features that make them particularly esting for those interested in justice, or in obstacles to justice.

inter-There are good reasons not to leave the consideration offinancial markets

to economists alone Much could be said about the way in which economics,with its focus on elegant mathematical models, had smuggled idealizedassumptions about human behavior and about the structure of markets into itsdescriptions offinancial markets (see e.g Krugman 2009a, Shiller 2012, chap 19).While it might be unfair to expect economists to predict the precise timingand evolution of an event like the Great Financial Crisis, the way in which thiscrisis took the discipline by surprise speaks volumes Simplifying models,however, are not the only problem of an exclusively economic perspective.4Another one is the almost exclusive concentration on Pareto-efficiency as theonly normative criterion, that is, efficiency in the sense that it is impossible tomake anyone better off without making someone else worse off For somemarkets, it may be a useful strategy to do so: Pareto-efficient markets can help

to create a large “pie” that can then be redistributed by other institutions.While much can be said about existingfinancial markets from a perspective ofPareto-efficiency, it is questionable whether this strategy is sufficient forunderstanding markets that have become so dominant in our societies asfinancial markets have in recent years While some of the chapters in thisvolume remain tied to a perspective of efficiency, others ask more fundamentalquestions about the institutional structures of financial markets and thenormative values or principles we should draw on when thinking about them

In the remainder of this Introduction, I will first provide an overview ofsome of the mechanics of financial markets and the justifications that havetraditionally been offered for them.5I then present some of the preliminaryevidence that suggests that financial markets should be considered not onlyfrom a perspective of efficiency, but also from a perspective of justice This isfollowed by a more in-depth discussion of howfinancial markets differ fromthe markets for apples and oranges that populate economics textbooks.6Theseconsiderations lead to a strong case for reform I conclude with a preview ofthe chapters of this volume, which discuss not only the principles of justicethat can serve as guidelines for evaluating financial markets, but also moreconcrete aspects that are relevant from a perspective of justice, and that

4 Another problem on which I cannot comment here is the way in which members of the economic profession were coopted by financial institutions and other interest groups The documentary movie Inside Job provides sobering insights into these connections See also Chapter 13 (by Admati) in this volume.

5 This section can be skipped by those already familiar with the basic mechanisms of financial markets.

6 See also Bowles 1991, 15 on the weird fact that textbook examples of markets are often fruit markets, which are very different from more complex markets such as labor markets or financial markets.

provide food for thought about howfinancial markets could be changed such

as to be brought better into line with our considered judgments about whatmakes a society just

1 2 F I N A N C I A L M A R K E T S—A FEW NUTS AND BOLTS

In afirst approximation—and in the view that was, arguably, dominant beforethe Great Financial Crisis—financial markets are a subgroup of markets ingeneral Hence, the descriptions and justifications offered for free markets areassumed to apply to them as well Markets are institutions in which agentsexchange goods and services, usually using money as a medium of exchange.Market prices mediate the interplay between supply and demand: if supply ishigh relative to demand, the price falls, signaling to suppliers that less of theproduct in question is required (or driving some suppliers out of the market);

if supply is low relative to demand, the price rises, signaling to suppliers thatthey should provide more of the product in question (or attracting newsuppliers) Those on the demand side can equally react to changing prices,for example by increasing or reducing their consumption or by switching toother goods or services There is no need for a central planner who wouldcoordinate the behavior of all these agents; rather, the changes of the pricelevel do so automatically To be sure, this does not mean that the state has norole at all to play: it has to create a framework of property rights in thefirstplace, and it has to offer the legal infrastructure needed for enforcing theserights and the contracts that right-holders can enter with one another It mayalso have to regulate certain aspects of markets, for example in order toprevent market participants from causing“external effects” on third parties,such as environmental pollution But within this framework, individuals arefree to decide according to their own preferences: to buy or to sell at whateverprice theyfind appropriate Or so the textbook story goes

Free markets are“competitive” in the sense that on both sides of the market,participants have to compete with one another in order to be successful: those

on the supply side have to compete for customers, and those on the demandside have to compete for access to the goods or services in question Depending

on the structures of a market, competition on either side can be stronger than

on the other, creating advantages for those on the other side: if there is strongcompetition among suppliers, customers benefit by receiving lower prices and/

or better quality; if there is strong competition on the demand side, supplierscan demand higher prices and/or offer lower quality In the“perfectly competi-tive markets” presented in many textbooks, there are large numbers of marketparticipants on either side This means that all mutually beneficial opportunitiesfor trade will be used, which means that the result is“Pareto-optimal.” In more

colloquial terms: there is no“waste” from unused opportunities to gain fromtrade For this result to apply in practice, however, markets have to come close

to the idealized markets of textbooks For example, all market participants must

be fully informed about the products that are traded, they have to be fullyrational, and they have to be able to buy and sell whenever they like There is anextensive literature on“market failures,” that is, cases in which these assump-tions do not hold and this fact causes inefficiencies

Financial markets can be understood as markets in whichfinancial productsare traded Sometimes this trade takes place physically, in trading places such

as the New York Stock Exchange; increasing amounts offinancial products,however, are traded electronically, either on regulated electronic tradingplatforms or in other trading networks This holds both for business-to-business trade, in which financial institutions trade with one another, andfor business-to-consumer trade, in which private or institutional clients buy orsellfinancial products from brokers The products traded in financial marketsinclude various forms of equity and debt contracts Equity means that investorshold property rights that often come with certain control rights—for examplethe right to vote at a shareholder meeting—and that involve the full transfer ofrisk, upwards (gains), and downwards (losses) to the owner.“Capital,” in thetraditional sense of shares in traded companies that pay a dividend if thecompany makes a profit, is the prototypical case of equity The owners of debtcontracts, in contrast, do not receive control rights or the right to a dividend;instead, they receive the right tofixed payments This categorization, however,

is only a rough one, as there can be various intermediate forms Many equityand debt contracts are traded very frequently; what matters to investors isthus not only the profile of payments and risks that they receive, but also theprice levels of these assets and in particular the expected future development oftheir prices

In addition to company shares and government bonds, a huge number ofother products are traded infinancial markets In a first approximation, they canall be understood as bundles of contractual rights that describe payment sched-ules for different future scenarios They vary with regard to their risk (how likely

is it that their owner will experience gains or losses?), their profitability (howmuch money can the owner earn in different future scenarios?), and theirliquidity (how easy or difficult is it to exchange them for other products,typically, money, in the short term?) Other goods that are traded infinancialmarkets include, for example, insurance contracts or foreign currencies

It would be impossible to understand modernfinancial markets, however, ifone assumed that the goods traded in them were only the goods listed so far,all of which are relatively closely tied to phenomena in the“real economy”—companies issue shares in order to raise capital, governments issue bonds

in order tofinance public investment, individuals or companies insure selves against untoward events such as a natural disaster, companies buy

foreign currency in order to trade with business partners in other countries.

In addition to these bread-and-butter products, financial markets includelarge numbers of“derivative” products that are related, in one way or another,

to other, underlyingfinancial products The existence of such products is notnew; especially in times offinancial manias, derivative products tend to spring

up like mushrooms The amount and the complexity of such derivativeproducts in the last decades, however, beat everything that had happenedearlier The possibility of using computers and IT networks for creatingproducts and keeping track of them allowed for an explosion in derivativesthat would have been hard to imagine in a world of paper-based trading.Derivative products can be relatively simple or they can be very complex,and they all relate, in one way or another, to thefluctuation of prices of otherproducts Relatively simple products include, for example, options, which givethe owner the right to buy or sell afinancial product or commodity at a certainprice at a certain future date For example, a wheat farmer might want to buy

an option for selling the annual harvest at a certain price; if the demand forwheat at the time of delivery is higher than expected, driving up the price, thefarmer does not have to use the option, but if the demand, and hence the price,

is lower, he or she can use the option to avoid selling at a lower price In thatway, the option serves as an insurance against losses from pricefluctuations.Similarly, forwards and futures are contracts about the obligation (rather thanthe right) to buy or sell somefinancial product at a fixed price in the future.Swaps are contracts in which two market participants exchange the future cashflows of different underlying financial products In addition to these stillrelatively simple derivatives, there can be combinations or derivatives-of-derivatives of almost unlimited complexity Often, they are tailor-made be-tween parties and traded“over the counter,” that is, in one-on-one transactionoutside of regulated exchanges such as the New York Stock Exchange or theChicago Mercantile Exchange

Such derivatives can be bought by investors who want to“hedge” risks towhich they are exposed in their economic operations For example, a companyheavily trading with companies in other currency areas might want to hedgethe risks of currency fluctuations But they can also be used for speculativepurposes Derivatives are themselves heavily traded, which means that theirprices can fluctuate considerably If a trader expects the price of a certainderivative to rise, he or she might buy a bunch of it in the hope of selling it at abetter price in the future—or he or she may buy a derivative that builds on thisvery price development, for example an option contract that gives him or herthe right to buy these derivatives at the current price in the future.7If the price

7 A related practice, which can be described as a “bet” on falling prices, is “short-selling,” which means selling financial products one does not currently own (but which one can borrow), and then repurchasing them later.

has by then risen, he or she can make a profit Sophisticated mathematicalmodels have been developed for calculating the expected profits, and hencethe current prices, of options and other derivatives.8In the years before theGreat Financial Crisis, it seemed that these models were doing a good job atdescribing the underlying reality In fact, the very existence of these models—and hence the impression that one could remain in control of all the risksone was exposed to when trading in complex derivatives—contributed to theboom in derivatives trading The total amount of outstanding derivativecontracts, that is, legal claims to certain payments under certain scenarios,had reached a sum of 400 trillion US dollars by 2008 (Turner 2016, 1).What is the point of all these derivative contracts?, you might ask Did theyall fulfil a useful function in the economy? Why were the markets for deriva-tives not closely watched and regulated in order to make sure that they wouldnot cause additional risks? To understand why they were seen as harmless, andeven beneficial, by many commentators, including academic economistsand regulators, it is important to understand the ideological landscape beforethe Great Financial Crisis Free markets in general were seen as fundamentallybeneficial: the free play of supply and demand enables a process of “pricediscovery” that supports the efficient allocation of scarce goods Financialmarkets were seen as similar to other markets in this respect In fact, in manymacroeconomic models, finance was not even included: it was considered a

“veil” that did not change the underlying structures of the real economy, nomatter how large it was and what kinds of products were traded in it Centralbank policy did not pay attention to financial markets either, as it focusedmostly, and largely successfully, on keeping inflation in check The possibilitythatfinancial markets might create instability from within was simply not onthe radar (see also Turner 2016, 38)

This narrowness of vision, however, was no pure dogmatism, but ratherbased on microeconomic considerations that formed a coherent narrative.According to this narrative, financial markets were basically markets forstreams of payments under different future scenarios Market participantswho differed in their estimations about the likelihood of these scenarios, intheir demand for liquidity, or in their appetite for risk, could reap gainsfrom trade in those markets The morefine-grained the products they couldbuy, the better they couldfine-tune their investment strategies, choosing port-folios that exactly matched their preferences Thus, risks would be carried bythose who were able and willing to carry them, and scarce capital would beoptimally allocated Relatedly, it was thought that more efficient financialmarkets would be able to serve as control mechanisms for those who heldcontrol over productive assets—typically the executive managers of companies

8 For example, the “Black-Scholes” or “Black-Scholes-Merton” model for option pricing (Black and Scholes 1973).

Share prices provided them with a real-time feedback mechanism on how wellthey were doing, and the threat of a hostile takeover, by an investor whothought that the stock of capital could be used more efficiently, was seen as adisciplinary mechanism on management not to squander resources (see e.g.Emunds 2014, 70ff.).

Behind these ideas stood the“efficient market hypothesis” (see especiallyFama 1970), which holds that in efficient markets, asset prices reflect allavailable information on a given asset This hypothesis is based on theassumption that all market participants behave rationally, or if they do not,irrational behavior occurs in a random fashion, and rational arbitrageurs haveincentives to correct irrational behavior by betting against it.9 From thisperspective, it cannot be the case that a market as a whole deviates from thefundamentals on which it is based; once a deviating movement starts, thisimmediately creates profit opportunities for rational investors who will bringmarket prices back to normal, hence there can be no price bubbles Whether

or not the efficient market hypothesis possesses any plausibility is hotlydebated among economists; Eugene Fama, one of its most prominent defend-ers, continued to argue against the possibility of bubbles—or at least againstthe usefulness of the concept—even after the Great Financial Crisis (Cassidy2010) Among his most prominent critics are behavioral economists, forexample Robert Shiller, who not only takes into account a more empiricallyrobust picture of human nature, but who was also one of thefirst to warn thatthe US real estate market might be subject to overheating (Shiller 2007).Another problem with the efficient-market hypothesis is that, if true, itparadoxically destroys the incentive to acquire information, because marketparticipants must assume that all available information is already reflected inprices (Grossman and Stiglitz 1980) Lomansky (2011, 150ff.) describes thisparadox nicely:

A rational agent will, then, choose to free-ride on the cognitive undertakings ofothers The greater the confidence in the overall efficiency of the market, thegreater the incentive to take a free ride At the extreme, everyone is free-riding oneveryone else, and no one is actually monitoring the condition of the underlyingassets Well before that stage is reached, however, serious informational distor-tions will have been introduced [ ] The proposition that markets are efficient

9 It is worth noting that in this case the assumption of human rationality became more than

a mere modeling assumption or “heuristic.” Many economists, when faced with criticism of

“economic man,” defend it in this way, admitting that men of flesh and blood often behave differently But in the case of financial markets, such models were used not only as a basis for regulation (or rather, non-regulation), but were also drawn upon by market participants to describe the behavior of other market participants and to adapt their behavior accordingly in order to make most pro fit For a discussion of how economic models, especially models of option pricing, helped to shape the reality they were supposed to describe (their “performativity”) see MacKenzie 2006, with the telling title An Engine, Not a Camera: How Financial Models Shape Markets.

tends to be self-refuting The more it is believed, the less accurate it becomes Themore skeptical market players are of its truth, the more effort they will invest inmonitoring their potential investments, the overall effect of which is to enhanceefficiency That will then create conditions under which those who subscribe tothe efficient-markets proposition will do better than the skeptics And the merry-go-round takes another spin.

Nonetheless, the narrative of efficient markets is the narrative that the stream of economics had told At the time, many scholars and practitionersfound it sufficiently plausible to base their behavior on it Some economistsfocusing onfinancial markets certainly held more sophisticated pictures thatincluded questions about market failure, stability, or the relation betweenfinancial markets and the real economy, but especially in the curricula ofundergraduate economics courses, these more nuanced accounts had played amarginal role In a macroeconomic environment that seemed fairly stable, thenarrative of efficient markets seemed accurately to grasp the economic reality.But if one puts together the various idealizations and generalizing assumptions

main-it contains, one arrives at an all-too-rosy picture of whatfinancial markets areand how one should see their role in society Adair Turner, former head of theUK’s Financial Services Authority, provides a good summary of the conclu-sions that market participants, regulators, and politicians had drawn on thebasis of these assumptions:

A strongly positive assessment dominated amongfinance academics and at leastimplicitly among regulators It reflected the assumption that free competition wasbound to result in useful rather than harmful activity, and that increasedfinancialactivity, by making more markets complete and efficient, must be improvingcapital allocation across the economy (2016, 28)

Important institutions such as the International Monetary Fund shared theseviews It was assumed that more efficient financial markets would, in the finalanalysis, lead to economic growth, which would benefit everyone in society.10

Almost everyone trusted that the recent “innovations” in risk managementhad really made the whole system safer and more stable Critics of this broadconsensus seemed outlandish Cassandras

But then, the Great Financial Crisis happened It arose around a specific type

offinancial products: securitized loans Securitization is a financial practice thathad started with Fannie Mae and Freddie Mac, two government-sponsoredentities in the US that handled large amounts of mortgages for home purchases.The basic mechanism is to bundle together a certain amount of mortgages into

10 Empirical studies seemed to con firm that “financial deepening” was related to GDP growth (e.g Levine 2005, quoted in Turner 2016, 32) and this relation from the past was assumed to also hold in the present and future, despite the fact that the kind of financial products through which the “deepening” had happened were not necessarily the same as were now used.

a portfolio and then to divide it up into different“tranches” with different riskand return structures The top tranches, whose claims would be given priority

in the case of defaults on loans, were considered extremely safe—they received

“triple A” ratings from rating agencies, the same investment grade as UStreasury bonds Investors trusted these ratings, because rating agencies hadbeen perceived as doing a good job in the past when evaluating bonds andshares and had thereby acquired a reputation as trustworthy, competentevaluators (Akerlof and Shiller 2015, chap 2; see also de Bruin 2015, chap 7)

It was also assumed that any remaining risks could be hedged by diversification,because the market as a whole could not go wrong Credit securities andcredit derivatives were often traded many times, between multiple institutions;they seemed to offer what had previously been taken to be an impossiblecombination: high returns and safe investments

As long as there was general optimism—not to say enthusiasm—andeveryone believed in the prevailing narrative, the trade with these productssoared Once market participants started to realize, however, that they hadbecome entangled in a huge speculative bubble, and once it became clear thatthe US government would not bail out all endangered institutions—asevidenced by the fall of Lehman Brothers in September 2008—trust andoptimism evaporated overnight (for a summary of the events see e.g Shiller

2012, chap 5) It was especially the role of credit default swaps (CDSs)—whichmagnified the losses from small rises in defaults rates, because numeroustraders could insure against each default, and which had been vastlyunderpriced—that brought the financial system to a halt, because marketsfor CDSs were extremely complex and lacked transparency, and no oneunderstood any more who had which exposure (see e.g Reiff 2013, 240ff.).The Great Financial Crisis showed that the models on which investors hadbased their decisions, and banks and regulators their risk assessment, hadbeen fundamentally flawed They had assumed that future events could bedescribed in terms of quantifiable risks, excluding the possibility of nonquan-tifiable uncertainty (Knight 2006 [1921], III.VII.3), which created a sense ofsecurity because quantifiable risks could be “managed” by using other finan-cial instruments Many models also included an assumption that differentevents, for example the development of asset prices in different marketsegments, would be independent from one another This is a crucial assump-tion for the strategy of managing risks through diversification: if risks occurjointly, spreading one’s investments across a large number of assets is of nohelp More generally speaking, the likelihood of non-normal events, in thesense of large deviations from the general trend, was underestimated becauseinvestors often used normal approximations, rather than functions thatallowed for greater“tail risks.” Also, the past data on which many calculationswere based did not go back very far in time—and many asset prices hadbeen relatively stable within this time window, which also contributed to

underestimating volatility In other words: the techniques used for reducingrisks were unable to capture precisely those cases in which risk managementwould be most needed, that is, a downswing of whole markets This possibilitywas conceptually excluded, creating the impression that one had finallymastered the art of risk management.11

In hindsight, it seems hard to deny that much of what had taken place infinancial markets before the Great Financial Crisis was anything but product-ive: trading in financial products as such cannot, after all, increase theeconomic pie; in the best case, it helps to allocate capital and risks efficiently,which can in turn benefit the economy But this does not mean that thesebenefits continue to be created if trading is blindly expanded—at the very least,one has to ask whether there might also be a price one has to pay for theseexpanded activities in financial markets, for example in terms of increasinginstability And, as some commentators have pointed out (e.g Mullainathan

2015, Turner 2016, 27), there is also another price one has to consider from asocial perspective: the opportunity costs of resources, and especially the skills

of well-educated and highly motivated young people being employed infinance rather than in, say, cancer research, engineering, technology, teaching,

or public service Considerations of counter factual scenarios are, of course,always to some degree speculative, and it is hardly possible to quantify thesecosts—but this does not mean that they do not exist

on these shared assumptions, however, different theorists of justice have drawndifferent conclusions with regard to other features of a just society, andespecially with regard to the degree of inequality that is compatible with justice

It is worth noting, however, that the degree of inequality currently prevailing in

11 Trust in “scientific” expertise seems to have played a role as well, as can be seen from a remark by a former hedge fund employee: “a lot of the Ph.D.-like jobs you can get out there, in finance especially, are window-dressing jobs It’s basically a company where they open their door

to the client and then they point to a back room filled with Ph.D.s working furiously; they say:

Oh, don ’t worry about our product; you can have faith; we have Ph.D.s” (Econtalk 2013).

Introduction: Justfinancial markets? 11

Western12societies (see e.g Piketty 2014) is problematic from the perspective

of almost all theories of justice that are discussed in the literature

There is strong prima facie evidence that much that happened infinancialmarkets in recent years was unjust, no matter how exactly one defines

“justice.” One could start with the cases of spectacular fraud such as Madoff ’sPonzi scheme or the manipulation of the LIBOR On the one hand, one mightsay that these cases are theoretically easy to grasp because they violatedexisting laws On the other hand, they raise questions that are anything buttrivial about the possibility of law enforcement in systems that are as complex

as today’s financial markets, and in which the likelihood of discovery offraudulent behavior is therefore lower than in other areas of life A secondfact aboutfinancial markets that should catch the attention of those interested

in justice is the sheer size of the profits that were made in them, including thesize of bonuses for individual traders or managers Standard economic theorypredicts that when high profits are being made in a market, this attractscompetitors and profits are driven down again This did not happen, nor doall those who made a fortune before the Great Financial Crisis seem to havesuffered the ensuing losses Moreover, the group of“winners” did not repre-sent a cross-cutting section of society; for one thing, they were predominantlywhite and male While a full analysis of the effects of financial marketliberalization and the ensuing Great Financial Crisis on distributive justicewould have to take into account numerous complex factors—general econom-

ic developments, differential impacts of interest rates and asset prices, effects

on unemployment and inflation, etc.—and although claims that make parisons to counterfactual scenarios face methodological difficulties, it seemsfair to say that these effects deserve close scrutiny

com-The Great Financial Crisis was, after all, not a natural disaster Turner puts itstarkly:“This catastrophe was entirely self-inflicted and avoidable” (2016, 2).The greatest loss, in his view, was the slowing down of economic growth in theyears since the crisis—a view that is probably based on the assumption thathigher growth could have benefited everyone in society The relationshipbetween inequality andfinancial expansions is a complex one, because inequal-ity arguably also drove some of the financial excesses and hindered theeconomic recovery (Turner 2016, chap 7) What is especially interesting,from a perspective of justice, is the structural impact offinancial markets onwider societies and their distributive outcomes Financial markets do not exist

in a void, after all If they were what they have often been compared to—that is,casinos—they would probably be far less harmful: they would be contained,individuals would—hopefully—know what they are doing when entering them,

12 I here focus on Western societies because these are the ones that have fully developed financial markets of the kind described earlier This does not mean, of course, that the effects of financial markets could be limited to these societies.

they would play with their own money and, at worst, go bankrupt, which mightimpose unjust costs on others, but which is still a somewhat limited problem.But today, we are in a situation in which what happens infinancial markets has

a much broader impact—not only on the distribution of resources, but also onthe distribution of opportunities and the distribution of power in society.Almost everyone in society relies on using financial services, after all Evenbread-and-butterfinancial products are connected to the rest of the financialsystem;financial markets have become closely interwoven with the fabric of oursocieties So it does seem worth asking: dofinancial markets, in the way in whichthey are currently organized, make our societies more or less just?13

A further point deserves emphasis There is a broad scholarly consensusthat the Great Financial Crisis was not caused exclusively by individual orcorporate misbehavior, but also by structural features, for example incentives

to take excessive risks because the gains were privatized while losses could besocialized Otherwise one might think that normative issues in financialmarkets raise only questions of individual morality or of the morality offinancial companies—questions that are addressed mostly in the discipline

of business ethics The perspective taken in this volume does by no meansdeny the importance of individual behavior Nonetheless, the focus ismostly on institutions and the ways in which they coordinate and regulatebehavior Normative perspectives on institutions are the domain of politicalphilosophy—and more specifically theories of justice—rather than ethics Inrecent years, there have been some calls to bring political philosophy andbusiness ethics closer together (e.g Heath, Moriarty, and Wayne 2010) Whilethere already exist some accounts of business ethics in financial markets,this volume brings the other side, that is, perspectives of justice, to the table.Before sketching some of the proposals for reforms offinancial markets andproviding an overview of the chapters of this volume, however, we shouldsubject to scrutiny one of the premises that underlie the very notion of

“financial markets”—namely that the financial system as we know it can bedescribed as a subgroup of the institution we call“market.”

1 4 A R E F I N A N C I A L M A R K E T S—MARKETS?

This question, to be sure, is a polemical one But it is nonetheless worth asking,given the degree to whichfinancial markets—in contrast to, say, markets in

13 There is also an international dimension to this question The high volatility of capital flows

in and out of developing countries makes their economic development highly unstable; it is probably not the best way of supporting a form of sustainable economic growth that would bene fit the global poor (for a discussion see Emunds 2014).

Introduction: Justfinancial markets? 13

health care, education, or surrogate motherhood—were seen by many as theprototype of well-functioning, competitive markets Financial markets havespecificities of their own These can be roughly grouped into three categories:concerning products, concerning participants, and concerning equilibria(or the lack of equilibria, i.e bubbles).

As already described, many of the products traded infinancial markets arehighly artificial legal constructs, many of which are several layers away fromwhat happens in the real economy.14As such, they obviously do not directlysatisfy the preferences of consumers; as Turner puts it: “No one gets up inthe morning and says ‘I feel like enjoying some financial services today’”(2016, 20) In some markets, such products are traded with a speed that isfar beyond anything we can imagine for markets with physical products Intextbook markets, it is usually assumed that participants intend to hold theproperty rights of products for a certain amount of time; even if they buyfor speculative purposes, they have to wait a bit until the price has moved into

a certain direction In many financial markets, participants siphon profitsfrom tiny movements in prices, sometimes—in computerized trading—on amillisecond scale Computerized or “algorithmic” trading is taking place inmanyfinancial markets, despite the fact that it is still rather badly understood

It is unclear, for example, how exactly the numerous “subsecond extremeevents” that take place in these markets are related to the stability of thefinancial system as a whole (see e.g Johnson et al 2013)

Another specific feature of the products traded in financial markets—although arguably less specific than the character of these products—is thesheer volume that is traded in financial markets With these amounts ofmoney being moved around by relatively small groups of traders andfinancialinstitutions, we should not be surprised that the temptation to enrich oneself isgreater than in many other markets—especially in upswings As Kindlebergerand Aliber drily note: “The supply of corruption increases in a pro-cyclicalway much like the supply of credit” (2005, 143) Corruption can mean thatmarket participants use illegal, fraudulent methods for making money, but itcan also mean that they increase their efforts to exploit other people’s vulner-abilities, for example their ignorance, their fears, or their time-inconsistentpreferences As Akerlof and Shiller argue in their latest book, Phishing forPhools, the tendency to exploit such vulnerabilities is not a rare“externality,”but rather“inherent in the workings of competitive markets” (2015, 166) It iscertainly not exclusive tofinancial markets, but the high sums at stake in them,and the abstractness and complexity of the products traded in them, maymake them a particularly attractive pond for“phishers.”

14 Much more could be said here about the nature of money, money creation, and its role in society, but as this volume focuses on financial markets, this is not the place to go into these details For discussions see e.g Douglas 2016 or Amato and Fantacci 2012.

A second specificity of financial markets has to do with the agents whoparticipate in them In standard models of markets, it is assumed thateconomic agents carry both the upward and the downward risks of theirdecisions; this is what creates incentives for them to choose carefully betweendifferent options, depending on their appetite for risks and/or profits Infinancial markets, however, liability is limited in numerous ways, which areoften not reflected in prices For one thing—but which is not too specific tofinancial markets—many participants in them are corporations, which meansthat their shareholders enjoy limited liability by definition, because they areonly liable with the capital they have invested, not with their private capital(see e.g Ciepley 2013 on the nature of corporations) The limitations ofliability in the financial system, however, go much further Deposits inbanks are often insured by government-run insurance systems that are sup-posed to prevent“bank runs.” A country’s central bank serves as “lender of lastresort” for banks that run out of liquidity (see e.g Minsky 1986, chap 3;Kindleberger and Aliber 2005, chap 11) And as the Great Financial Crisis hasshown,financial markets are marred by the issue of “too big to fail,” or “toocomplex to fail”: if financial institutions are so central for the financial system

as a whole that their failure would engulf the whole system in the abyss,governments will take steps to prevent such failures This means thatfinancialinstitutions benefit from an implicit insurance by the government, whichcreates problems of “moral hazard”: why not choose a somewhat riskierstrategy if it promises high profits, and the downward risk is covered bytaxpayers’ money?

Less attention has been paid to another way in which liability was mined, or at least reduced, infinancial markets: this is the problem of internalcontrol in financial institutions Within large, complex institutions such aslarge banks there exist numerous possibilities of covering up wrongdoings ordiluting responsibilities In banks, many tasks are highly specialized andrequire technical skills that few individuals possess, which means that it isdifficult for others to monitor their behavior It also seems that the complianceculture of many banks was not working very well Evidence for this is the factthat many cases of wrongdoing by individual employees, for example theunauthorized trading by Jérôme Kerviel at Société Générale, were discoveredvery late in the day, when huge damage had already been done.15The smalllikelihood of discovery of wrong or questionable behavior, combined withhigh bonuses tied to short-term profits, created a situation in which thetemptation to behave recklessly was presumably far greater than it would

under-15 Kerviel was a derivatives trader who was convicted for unauthorized trades that caused losses estimated at €4.9 billion In the ensuing process, Société Générale claimed that he had traded without authorization, whereas Kerviel claimed that his trading activities had been known and that such practices were widespread in the company.

Introduction: Justfinancial markets? 15

have been had employees acted in a more transparent context with morepossibilities of control, let alone if they had traded with their own money.

A third way in whichfinancial markets are different from other kinds ofmarkets is the question of whether they self-stabilize or whether they can alsogenerate destabilizing dynamics—bubbles instead of a market equilibrium.The dominant pre-Crisis picture assumed the former, holding, as noted above,that movements away from the market equilibrium would attract rationalarbitrageurs that would return markets to the equilibrium But not all econo-mists sawfinancial markets in this way John Maynard Keynes had alreadyused the term“animal spirits”—which George A Akerlof and Robert J Shillerthen picked up in the title of a 2009 book—for describing “a spontaneous urge

to action rather than inaction, and not as the outcome of a weighted average ofquantitative benefits multiplied by quantitative probabilities” (1936, 161–2)

If market participants follow their“animal spirits,” markets may not equilibrate,but rather create irrational upswings or downswings These can lead to massivefinancial crises like the one we saw in 2008

Based on earlier work by Hyman P Minsky (1986), Kindleberger and Aliberprovide a good account offinancial crises; as their historical work illustrates,these can be based on underlying assets of very different kinds, ranging fromtulip bulbs—in the famous “tulipmania” of the 1630s (see also Dash 2001)—tocompany shares and real estate (see Kindleberger and Aliber’s Appendix(2005, 256ff.) for an overview of historical bubbles) Shiller defines bubbles

as situations “in which news of price increases spurs investor enthusiasm,which spreads by psychological contagion from person to person, in theprocess amplifying stories that might justify the price increases and bringing

in a larger and larger class of investors, who, despite doubts about the realvalue of an investment, are drawn to it partly through envy of others’ successesand partly through a gambler’s excitement” (2000, 2) This definition empha-sizes the psychological elements of the phenomenon, which is also present inKindleberger and Aliber’s analysis

In an upswing—which Kindleberger and Aliber also call a “mania”—anincreasing percentage of trade is motivated not by a desire to invest money inthe long term or to hedge risks in the real economy, but rather by the hope togain from short-term increases in price-levels Attracted by the opportunity tomake easy money, many investors buy assets, often financed by credit, inorder tofind a “greater fool” to whom they can sell them before everyonerealizes that the assets have been hugely overpriced (Kindleberger and Aliber

2005, 12) Once an upward movement is on its way, optimism spreads, and it

is almost impossible for investors to resist it Even sophisticated investors maydecide to go with the herd, especially if their employers or clients evaluatethem in comparison to the trend (see also Turner 2016, 40ff.) This canfuel the movement even more As Citigroup’s CEO Charles Prince famouslysaid: “As long as the music is playing, you’ve got to get up and dance”

(quoted in Lomansky 2011, 151) The question is: what happens when themusic stops?

As Kindleberger and Aliber note, in such a mania“asset prices will declineimmediately after they stop increasing—there is no plateau, no ‘middleground’” (2005, 10) Once prices have started to fall, everyone realizes thatthey have to get out as quickly as they can—and the same mechanism thatdrove prices upwards in the upswing now drives them downwards For whenthere is a surplus of sellers in a market, prices fall, which means that otherholders of assets also want to sell them before their prices fall even more Thisholds in particular when many investors have bought assets with borrowedmoney They can quickly get overwhelmed by debt—which they have a fixed,legal obligation to repay—while they see the value of their assets meltingdown Some of them will be forced into“fire sales,” others will go bankrupt,further driving down prices In a general climate of panic and disillusionment,lenders have little incentive to hand out further loans This role of credit forthe cyclical instability offinancial markets had been emphasized in particular

by Minsky; mainstream economics, in contrast, had hardly paid any attention

to the role of credit and its expansion

Some commentators argue that seemingly technical details in the regulation

of banks reinforced the pro-cyclicality even more For each loan they handout, banks are required to hold a certain amount of capital in their balancesheets But the value of this capital was calculated in terms of the current value

of these assets on the market, rather than historical costs This meant that

in an upswing, the values of the assets in the banks’ balance sheets rose,which implied that they had more capital available to fulfil the regulatoryrequirements for making new loans Thus, they could provide credit to moreinvestors, who would use it to buy more assets, driving prices up even further

—whereas in a crisis, falling asset prices would be directly reflected in thebalance sheets, even if banks had no intention of selling an asset Thus, the use

of “value at risk” models functioned as a pro-cyclical amplifier of theprice movements (see e.g Turner 2016, 102ff.) Other factors that fueled theincreases of financial crises in the decades since 1980s—documented, forexample, by Reinhart and Rogoff (2009)—were the use of credit securitizationand of structured financial products, while the free flow of capital in aglobalized economy meant that crises in one country or region could lead tointernational contagion (Kindleberger and Aliber 2005, chaps 7 and 8).Thus,financial markets have quite specific features, which is why it is worthasking whether we should describe them as“markets” at all But why does thismatter?, you might ask—isn’t this just a verbal question, and aren’t othermarkets quite different from the idealized, perfectly competitive markets onefinds in textbook models as well? This is true But if we call the arenas in whichfinancial products are traded “markets,” our attention is directed to certainfeatures and distracted from others Our views about what a just regulation of

Introduction: Justfinancial markets? 17

these arenas would be is also likely to be influenced A widespread view of howmarkets should be regulated with regard to justice runs, roughly, as follows:markets should have fair rules that create a level playingfield, and they alsorequire regulation—and maybe some voluntary ethical commitment on thepart of market participants (Heath 2014)—to prevent market failures thatarise from unequal access to information, externalities, or other deviationsfrom perfectly competitive markets Apart from that minimal, proceduralaccount of justice, markets should be left free This not only makes themmaximally efficient, but also maximizes human freedom Regulation withregard to the justice of distribution kicks in afterwards, usually in the form

of redistributive taxation, but it can come at the cost of efficiency (see e.g.Okun 1975; for a critical discussion see Le Grand 1990)

Much could be said about the strengths and weaknesses of this picture, butthis is not the place to do so For it should be clear that iffinancial markets lackcentral features that other markets have, we may have to ask much morefundamental questions about them and their relation to justice—questionsthat are obscured if financial markets are seen as the prototypical case ofmarkets that come quite close to textbook markets, as they were often seenbefore the Great Financial Crisis We cannot take for granted that there can beideal“free” financial markets that are such that all deviations from the model

of a perfectly competitive market are corrected by regulation; at least it seemsquestionable whether such an ideal would be compatible with the monetarysystems we currently have, in which money is created by private banks thatare backed up by a central bank.16 In other words, it may be futile to lookfor regulation that would “repair” financial “markets,” so that they becomemore similar to markets for apples and oranges We cannot assume that“freer”financial markets also contribute to increasing the freedoms of humanindividuals; they might, in fact, create threats to these freedoms, e.g the freedom

to plan one’s life in a reasonably stable macroeconomic environment Andlastly, we do not have to take for granted that when we regulate financialmarkets for justice, there is necessarily a price to be paid in terms of efficiency

16 This is why some more radical critics have questioned the current monetary system, for example by proposing to abolish fractional banking and private money creation altogether (e.g Felber 2014) or by taking up Keynes ’s proposal of introducing an international monetary unit (the “Bancor”) instead of using the dollar or the Euro as lead currencies (Amato and Fantacci 2012) Such proposals seem even more utopian than others that have been brought forward in the debate; they might seem preferable as blueprints for building monetary systems from scratch, but it is unclear how we could get there from where we currently are It is also unclear whether it is required, from a perspective of justice, to adopt such proposals, or whether our current monetary system, suitably amended, could be suf ficiently just One of the functions

of such proposals, however, is to remind ourselves that the current system is not without alternatives, and to see its strengths and weaknesses in comparison to the strengths and weaknesses of other, theoretically possible, systems.

or the size of the economic pie; this might make regulation for justice easier than

it would otherwise be

Thus, we need to ask questions of justice about the institutional structures

of financial markets afresh, without having in mind assumptions about therelation between justice and markets that may not hold in this case To be sure,for some aspects of somefinancial markets it may make perfect sense to try toapproximate them as far as possible to textbook markets, and there mayalso be areas in which there are trade-offs between efficiency and equality.The main lesson to be drawn from these considerations—whether financialmarkets are markets—maybe is to take seriously the diversity of what financialmarkets are or can be: the diversity of their products, their participants andtheir respective liabilities, and their tendency to form bubbles This means that

an evaluation from a perspective of justice also needs to be sufficientlynuanced Not all dimensions of financial markets are equally problematicfrom a perspective of justice Some markets function reasonably well andmanage efficiently to allocate capital and risk without doing harm to thirdparties or the society as a whole In fact, some parts offinancial markets havecontinued to function largely uninhibited during the Great Financial Crisis.17Financial markets are many different things, and their character cancrucially depend on seemingly small technical details that vary from country

to country In theory, one could maybe separate out thefinancial markets thatfunction reasonably well, from a perspective of efficiency and justice,18 andone could suggest to simply keep those and shut down the others In practice,differentfinancial markets are highly interconnected—and the advantages anddisadvantages of these various connections would in turn have to be evaluatedfrom the perspectives of justice and efficiency This is part of what makes theissue so complex It means that different proposals for reform apply indifferent degrees to different kinds offinancial markets.19But if we tried tosimplify these complexities further, we would risk ending up with theories thatare not sufficiently complex to describe the complex social phenomena we are

17 E.g so called “ethical,” locally operating banks, see Herzog, Hirschmann, and Lenz 2015.

18 Depending on one ’s theory of justice, efficiency might be integrated into one’s conception

or might be a separate consideration, which might then either pull in the same direction or stand

in a con flictual relationship with justice I assume that for many concrete regulatory questions, considerations of justice (according to different understandings) and considerations of ef ficiency can travel together a long way, at least if efficiency is defined in a way that includes effects on third parties (e.g considerations of overall stability).

19 This also holds for the chapters of this book: while some take on a “global” perspective that looks at the financial system as a whole, others make more specific proposals that apply more or less to different parts of the financial system For reasons of space, most discussions cannot spell out these more detailed considerations To get to the level of concrete policy proposals, one would also have to take into account speci ficities of national legislation and the economic situation of different countries.

Introduction: Justfinancial markets? 19

faced with—and we have already seen enough of the problems of overlysimplistic theories to want to avoid that trap.

1 5 T H E C A S E F O R R E F O R M

The picture that thefinancial system presents us with is not black and white,but rather complex, both from a descriptive and from a normative perspective.This explains why some forms of criticisms seem to go into different direc-tions For example, we may at the same time argue for more equal—forexample gender-equal—access to certain markets, while also criticizing theirfunction from a broader perspective and demand changes in their overallstructure

What seems clear is that leaving thefinancial system simply as it is would be

a bad idea; in fact, there have been numerous proposals for reform, some ofwhich have also been realized in new laws or regulation For example, highercapital ratios for banks have been proposed (see especially Admati andHellwig 2013), and reforms in bonus structures have been suggested and

in some places implemented Other new regulation concerns transparencyrequirements, as well as the various safety mechanisms put in place in theEurozone in order to stabilize its banking system Usually, these reforms havebeen proposed from an economic perspective; political philosophy can endorsesome of them, but would want to go further in many cases, based on consid-erations not only of efficiency and stability, but also of justice And politicalphilosophy can add reflections on what kind of changes are required from aperspective of justice

After the Great Financial Crisis, the focus of such reform efforts has been onlegal regulation: changes in the rules and regulations that govern thefinancialsystem While doubtlessly important, however, one wonders whether suchchanges in the legal regulation are sufficient, or whether they need to beaccompanied by changes in the ethos and the culture of financial markets

In a system as complex as today’s financial system, governance by rulesrequires getting the incentives right, which is no easy task.20 Rules are, bydefinition, rather rigid and may not be ideal as the only tool for regulating awide variety of cases; if circumstances change quickly, rules may becomeoutdated and those setting them may have trouble catching up Rules need

to be applied to concrete cases, which can require some degree of judgment

20 Some therefore argue that this very complexity should be reduced as far as possible, for example by using simple heuristics instead of complex indicators that can easily be manipulated (e.g Haldane 2012) Rules that are simple and easy to understand and apply might avoid many of the disadvantages of existing rules.

and a joint understanding of the practices they are supposed to regulate Andlast but not least: the control of whether rules are obeyed is time-consumingand costly.

These various factors imply that it is highly desirable that complex systems

be regulated not exclusively by rules but also by a joint ethos of those whoparticipate in the systems In an idealfinancial system, one would want marketparticipants to cooperate with regulators on how to best set rules, voluntarily

to forgo opportunities of making profit by using loopholes, and to build aculture of co-responsibility for the functioning of the system as a whole Onewould want them to develop a professional ethos that embodies an orientationtowards the standards implicit in the practices they are active in, whether theyare allocating capital, hedging risks, or advising customers (see also van deVen 2011) One would want them to organize themselves in professionalbodies in which they can discuss, and reinforce, ethical norms; such profes-sional bodies might also take on legal liability for certain kinds of risks orharms One would want them jointly to build and maintain an ethos that isappropriate to the responsibility of an industry that plays a crucial role inmodern capitalist societies

But such an ethos is an elusive affair, and it is anything but clear how itcould be implemented in a social sphere that, arguably, had a very differentethos Awrey et al (2013) have discussed how the idea of“process-orientedregulation” might help to design concrete steps that would improve ethicalstandards in the financial industry Based on the UK’s “Treat CustomersFairly” initiative they suggest that similar models—which focus on dialogue,

“tone from the top,” board-level ethics committees, internal controls, andchanges in behavioral norms—could also help to improve the behaviorvis-à-vis counterparties and to reduce “socially excessive risk-taking.” Thiswould mean thatfinancial companies would be expected to internalize some

of the tasks of regulation, and would not be allowed to externalize the negativeeffects of their actions any more

Concerning the aims of regulation, one can distinguish between specific andintegrated approaches.21 Specific approaches suggest specific measures foraddressing specific issues; often, the assumption behind them is that it isuseful to have a division of labor between different institutions that areresponsible for different tasks When it comes to markets, this often corres-ponds to the line mentioned on pp 4–5, which holds that markets should bemade efficient, and regulation concerning justice should take place through

21 The following considerations concern a more concrete level than that typically considered

in “theories of justice.” Thus, different theories of justice can have different positions on how, for example, to integrate considerations of ef ficiency into an account of justice, or how to make trade-offs between different values or principles more generally speaking They might then also differ —or in fact agree—on whether to realize the resulting account of justice in a way that assigns speci fic tasks to specific institutions or in an integrated way.

Introduction: Justfinancial markets? 21

other institutions, whether taxation or the welfare state Such approachesmight suggest new institutions in order to address social issues that currentinstitutions do not address A case in point is Baradaran’s proposal to revivepostal banking in the US (2015) It is based on an analysis of how currentfinancial markets exclude poorer parts of the population, and on skepticismconcerning the possibility of forcing profit-oriented banks to serve the needs

of poor clients Hence, it does not focus on the structures of existingfinancialmarkets—although it is quite clear from Baradaran’s text that she wouldwelcome changes there as well—but suggests a new solution to a problemthat current institutions fail to solve

Integrated approaches to regulation focus on the interconnectedness ofinstitutions and try to inscribe broader objectives into existing institutions.For example, they might propose regulation for markets that aims not only atmaximum efficiency but tries to incorporate considerations of distributivejustice as well This might involve the prevention of certain kinds of markettransactions that tend to reinforce inequality (even if they might be Pareto-efficient), or the redesign of existing institutions in ways that better realizenormative goals such as the prevention of poverty and the reduction ofinequality For example, Mian and Sufi (2014) argue that the way in whichmortgages currently work means that too much risk—notably, the risk of largeprice swings in real estate markets—ends up on the shoulders of those who areleast able to carry it, namely private households This, they argue, means thatwhen prices in real estate markets fall, these households will cut back theirconsumption, leading to a slump in overall demand that reinforces therecession To address this problem, they discuss the possibility of “shared-risk mortgages,” in which debtors are somewhat shielded from this riskbecause payment plans are tied to the local house price index, in exchangefor sharing some of the future capital gains with creditors (Mian and Sufi 2015,chap 12) This proposal is very ambitious, in the sense that it suggests achange at the heart of the legal infrastructure on which certain financialmarkets are based

There is no a priori reason for favoring specific or integrated approaches; alldepends on which problems one tries to address—and, to be sure, creatingadditional, specific institutions can also have implications for how existinginstitutions work, for example because customers now have alternatives andcan opt out of existing institutions, which means that the boundary betweenthe two categories can be blurred Creating specific institutions may seemless risky in the sense that it does not involve quite as many “unknowns”concerning the reaction of a complex system to changes in its core, but it mayalso appear as a rather helpless second-best that tries to put band aids onwounds that require surgery Integrated proposals have the potential to bemore far-reaching, but might also be more difficult to push through becausethey impact the vested interests of those benefitting from the current system

If there is one thing to be learned from the Great Financial Crisis and theregulation (or lack thereof) that preceded it, it is the importance that seem-ingly technical details, whether in the design of regulation or the use ofindicators, can have for the working of the system as a whole No wonderthat such details are the target of intense lobbying by banks and otherfinancialinstitutions that have to gain or lose from changes.

Although there are certainly many important theoretical questions to beasked about how to regulate betterfinancial markets, the elephant in the room

is the question of whether politicians and regulators are actually willing tomake the changes that would be required to really improve the situation—orwhether thefinancial industry is successful in resisting real change and can getaway with what are, in thefinal analysis, only cosmetic changes This is, in theend, a question of power Much has been written about the problem oflobbyism and the influence of money in politics (e.g Hacker and Pearson

2010, Gilens 2013, Reich 2015) This issue is, of course, much broader andmore fundamental than its implications for the regulation of financial mar-kets But the latter is a place where the implications of this problem becomeparticularly visible Another problem is the international dimension offinan-cial markets, which would, ideally, call for an internationally coordinatedeffort at regulation Indeed, financial stability has been conceptualized as aglobal public good (Kaul et al 1999; see also Emunds 2014, 272ff for adiscussion), with incentives for individual countries to free-ride on the regu-latory efforts of others The problems of the international dimension also raiseadditional questions of justice—concerning global justice, which theorists ofjustice have just started to explore; these concern not only the structure ofinternational taxation and the legitimacy of internationalfinancial flows, butalso the governance of institutions such as the International Monetary Fund orthe World Bank (see e.g Wollner 2014, Emunds 2014, Krishnamurthy 2014).These questions are not discussed explicitly in this volume, but some of thechapters have implications for them as well

1 6 S U M M A R Y O F C H A P T E R S

As an edited volume, this book reflects the views of its different authors whooften, but not always, agree about the problems of justice raised by today’sfinancial markets The three parts cover different deficits and failuresconcerning the justice offinancial markets The first part discusses what onemight call“conceptual failures”: failures to use sufficiently broad and nuancednormative frameworks for thinking about justice andfinancial markets Whatunites the chapters in this part—and, in fact, also many of the other chapters—

is the rejection of a simplistic free market approach to finance, and a

Introduction: Justfinancial markets? 23

broadening of the perspective from a purely economic to a economic one From such a perspective, we can ask questions aboutfinancialmarkets that go beyond the perspective taken by—even very sophisticated—economists: How do they relate to human rights? Do they support individuals

philosophical-cum-in exercisphilosophical-cum-ing their capabilities? What is their function philosophical-cum-in society? Can weassume that incomes in them are deserved, as some economists have claimed?The second set of chapters looks at the legal framework within whichfinancial markets take place, and analyzes various ways in which this frame-work is unjustly biased Such biases can be found both in the legal infrastruc-tures that hold individuals and companies accountable for wrongdoing andexcessive risk-taking, and in the underlying system of rights that makesfinancial markets as we know them possible in the first place

The third part combines chapters that look at specific institutions andpractices and their impact on various dimensions of justice—whether dis-tributive justice, epistemic dimensions of justice, or gender justice Theseanalyses are what economists would call“partial analyses,” in the sense thatthey look at specific institutions or practices from specific perspectives Even if

we could change the general conceptual take onfinancial markets, and correctthe fundamental biases in their legal infrastructure, the questions raised bythese chapters would remain open One important question in this context,addressed by the last chapter, is how the current set of institutions andpractices—including mental habits and vested interests—stands in the way

of change

1.6.1 Part I: Normative foundations

Rosa M Lastra and Alan H Brener, in Chapter 2,“Justice, financial markets,and human rights,” focus on the necessity for social institutions to gain andmaintain legitimacy One source of legitimacy, on a national and internationallevel, is compliance with the human rights frameworks that have been devel-oped after World War II Lastra and Brener trace some aspects of the history

of human rights thinking, notably in the“School of Salamanca,” emphasizingthe parallels with the development of both conceptions and practices of markets

To gain legitimacy, markets need to remain within a framework of justice, andthis can require careful trade-offs and compromises, as the authors show bybriefly discussing some of the complexities of payday lending regulation On aninternational scale, the United Nations’ “Guiding principles on foreign debt andhuman rights” can be seen as an example of how the gap that has openedbetween market thinking and market practice and human rights could beclosed Lastra and Brener conclude that only if the compatibility of financialmarkets with human rights will be secured,financial markets can regain legit-imacy and social trust

Rutger Claassen suggests a unified approach for evaluating and regulatingmarkets, includingfinancial markets, in Chapter 3, “A capability frameworkfor financial market regulation.” Reviewing the mainstream approaches tomarket regulation, he concludes that they separate economic considerationsthat aim at Pareto-efficiency from social considerations that aim at paternalistprotection and distributive justice This means that no guidance can beprovided when these different aims are in conflict Claassen suggests shifting

to a different paradigm: the capability approach developed by Amartya Senand Martha Nussbaum Applying this approach to questions of market regu-lation, Claassen distinguishes participatory capabilities, consumer capabilities,and third-party capabilities He closes by showing how this approach throwslight on three issues discussed by other contributors to this volume: de Bruin’ssuggestions for how to think about the role of rating agencies, Russell andVilliers’s discussion of gender justice in financial markets, and Admati’sanalysis of failures of reform

Seumas Miller, in Chapter 4,“Financial markets and institutional purposes:The normative issues,” provides a different, but arguably not incompatible,normative account of financial markets: a “teleological” account Rejectingapproaches such as Shareholder Theory and Corporate Social Responsibilitytheories, Miller argues for taking the purpose of institutions seriously whenthinking about their proper regulation Institutions are supposed to providecollective goods for a society This teleological perspective leads to a number ofquestions: about the institutional purpose of specific institutions, the formaland informal institutional means for achieving them, and the wider macro-institutional context within which they operate Miller applies this account tothree segments of thefinancial system: the banking sector, retirements savingschemes, and capital markets The resulting arguments and calls for reform areintuitively plausible—so much so that one wonders whether some commen-tators have instinctively been guided by an account similar to Miller’s teleo-logical account Another possibility is that this account converges with otheraccounts when it comes to practical recommendations Miller’s perspectivechallenges us to revise traditional notions of how to think about institutions ingeneral, andfinancial markets in particular

In Chapter 5, “Can incomes in financial markets be deserved? A based critique,” I take up a notion frequently heard in public criticisms offinancial markets: that the high incomes generated in them cannot possibly bedeserved In contrast, some economists have used the notion of desert in order

justice-to defend high incomes Drawing on the philosophical debate about desert,

I defend a modest, institutional notion of desert and apply it to financialmarkets Doing so directs our attention to the institutional rules within whichmarkets take place, and which determines whether they are“Mandevillian”—

in the sense of rewarding vicious behavior—or “Smithian”—in the sense

of rewarding socially useful, if somewhat mundane, forms of behavior

Introduction: Justfinancial markets? 25

Modernfinancial markets, especially in their pre-Crisis form, failed to live up

to the idea that the rules of markets should be designed such that they fulfiltheir role in society and that rewards should go to those who play by the rules.Instead, they were, and arguably still are, marred by problems of marketfailure and externalities; they are neither efficient nor do they reward desert

on any defensible notion of the term Hence, economists and philosophers canagree on many of theflaws of the financial system that generated undeservedhigh incomes, and jointly push for reform

1.6.2 Part II: Legal structuresThe next two chapters deal with legal questions that concern the enforcement

of law and their impact on the justice offinancial markets Mark R Reiff, inChapter 6, “Punishment in the executive suite: Moral responsibility, causalresponsibility, and financial crime,” argues for a thorough rethinking of theway in which criminal justice infinancial markets works Many debates aboutjustice do not discuss criminal justice, but simply presuppose that once certainrules have been determined and agreed upon, it will be possible to enforcethem through law The Great Financial Crisis throws some doubt upon thisassumption: despite some outrageous forms of wrongdoing—at least some ofwhich were also illegal by existing standards—very few individuals went toprison Enormousfines have been imposed on financial companies, but it isdoubtful whether they can serve as a sufficient deterrent that would elicit moreresponsible business practices in the future Reiff argues that our traditionalways of thinking about knowledge and intent as a precondition for a criminalconviction is too limited Instead, he suggests a morally loaded conception ofcausal responsibility, which needs to be established on a case-by-case basis,depending on the concrete responsibilities of corporate officers Reiff ’s dis-cussion suggests that the imposition of terms of imprisonment can be legallyand morally justified in a far greater number of cases than the prosecutioncurrently seems to assume

Jay Cullen takes on questions of legal accountability from a different angle.The central question of Chapter 7, “A culture beyond repair? The nexusbetween ethics and sanctions infinance,” is how sanctions could be designedsuch that they create a culture in which socially excessive risk-taking isreduced Cullen argues that banks are special in certain ways: they receiveimplicit public subsidies and insurance because of their “too big to fail”characteristics, and there are also numerous asymmetries of knowledge andconflicts of interest in banking that are hard to regulate This limits theeffectiveness of self-regulation, which is why questions of culture and ethics

as alternative ways of regulating behavior come to the fore But the character

of modernfinancial markets with anonymous, IT-based interaction makes it

difficult to find an anchor for an ethics of responsibility Cullen thereforesuggests taking a closer look at the relation between ethics and sanctions,emphasizing the role of the latter for creating accountability, a key component

of the former He describes the UK’s new “Senior Managers’ Regime” as apromising approach that could help to bring about a change in the funda-mental assumptions that drive the culture offinancial markets

In contrast to Reiff, Cullen prefers an approach to legal justice infinancialmarkets that relies mostly on civil law, quoting both systematic and pragmaticreasons for doing so He is more optimistic than Reiff that monetary sanctionscould be effective, and less optimistic about how criminal law could be used inthe context offinancial markets Both agree, however, that individual liabilityneeds to be strengthened Both also emphasize the importance of sanctioningnot only actions, but also omissions, specifically failures by managers tounderstand and properly supervise the behavior of their team members.This points to the problem of epistemic responsibility in financial markets,which de Bruin also discusses in Chapter 11

Katharina Pistor opens up a road rarely traveled by political philosophers,but therefore all the more interesting for them: questions of justice that lie atthe very core of the social ontology offinance, namely the legal construction ofmoney In her “legal theory of finance” (2013), Pistor has developed anintriguing account of how finance is legally constructed In Chapter 8,

“Moneys’ legal hierarchy,” Pistor pursues this line further and explores theunequal treatment that these legal structures imply for market participants atthe “apex” and at the “periphery” of financial markets As the historicaldevelopment of means of payments shows,financial markets, despite a rhet-oric to the contrary, are anything but a“level playing field,” because the legalclaims on which they are built are of different strengths Pistor thus challengesthe view that whereas firms are hierarchical, markets consist of horizontalrelationships The legal claims on which they are built include not only thestructures of payment systems, but also trust law and corporate law, which canserve to insulate assets from legal claims Pistor ends by pointing out one of themain obstacles to creating a more impartial system: government finance,which makes governments dependent on private money creation This theor-etical approach helps us to understand the legal and hence structural injustices

of the currentfinancial system at a fundamental level The questions raised bythose structures are no legal technicalities, but political questions that concernboth the control of hierarchies and their distributional consequences.Aaron James, in Chapter 9,“Investor rights as nonsense—on stilts,” chal-lenges a legal practice that has become widespread in recent years: the use ofbilateral or multilateral investment treatises that provide special protection tointernational investors Today’s financial markets are perhaps the mostglobalized institution (maybe in a tie with organized crime) Hence, the legalapparatus that undergirds them is of utmost importance for questions of

Introduction: Justfinancial markets? 27