To Break ‘Em Up, or Not to Break ‘Em Up, That Is the (Wrong) Question



Image Courtesy of Flickr (DonkeyHotey)


Over the coming months, I will be finalizing a white paper whose working title is “Fixing Finance: System Design in Service of the Regenerative Economy.” I will be drawing on the eight principles of Regenerative Economics[1] to explore an aspirational framework for the redesign of global finance. This is the first in a series of articles, previewing ideas from the paper. I will be grateful for all constructive input from our readers.

Bernie says the banks are too powerful so we need to break them up and reinstitute Glass-Steagall, the depression era legislation that separates high-risk investment banking from staid commercial banking. Hillary says we need to strengthen Dodd-Frank, the comprehensive banking reform passed in the wake of the 2008 financial crisis, and extend financial reform to the shadow-banking sector, which includes hedge funds and private equity. Trump just sent chocolates to Wall Street (self-funding is so “Primaries”) by announcing he would largely “dismantle Dodd-Frank.”

All three have a point.

Bernie’s right. The big banks remain too powerful and are more concentrated than before the crisis (although they are individually much less risky). Hillary is justified in saying that Dodd-Frank needs more work if it is to do the job it was designed to do. (Trouble is Dodd-Frank, at 2,300 pages—plus an incomprehensible 22,000 pages of regulatory content written by the numerous agencies charged with implementing the rules—is impossibly cumbersome already, and hard, if not impossible, to enforce. Glass-Steagall was an elegant 37 pages by comparison.) And we agree with what Trump might be suggesting – but who really knows what that is- that Dodd-Frank has created numerous unintended consequences beyond the cumulative brain damage of reading and understanding the legislation. Importantly, Dodd-Frank has harmed the sound community banks doing the kind of banking we need, and together with new capital and liquidity rules, discourages big banks from doing the long-term project-finance lending needed to finance the transition to alternative energy systems. But none of the remaining presidential candidates appear to be even contemplating the financial reform we truly need in service of a Regenerative Economy.

Comprehensive financial reform must not only rein in Wall Street recklessness and predatory behavior, essentially what Dodd-Frank was designed to do, but it must also promote the kind of finance we need. It is a design challenge, not just a police action. And like any intelligent and practical redesign, it must be driven by a clear purpose—it must be a means to a particular end—and, it must reflect the current particular context (from banking culture to climate change) rather than abstract, ideological beliefs.

Let us begin with the current context. Given space limitations here, I will simply assert seemingly self-evident facts.

Wall Street (broadly defined) is too powerful and undermines trust throughout society. It has too much influence on a political system whose job it is to legislate for its prudent and pro-social behavior. Repeatedly, powerful actors’ reckless and fraudulent behavior is rarely, if ever, held to account. And, what is most cruel and unfair, the catastrophic costs of this behavior get socialized across innocent and vulnerable citizens and, more generally, the public sector. While a majority of those working in finance are honest, the business as it is conducted today seems to enable and even elevate sociopathic behavior. Wall Street, with a long history of at times anti-social behavior, is simply not a trusted institution. And trust is the foundation of a functional financial system and society at large.

Second, while private sector banking is run as a profit-maximizing enterprise, it is not “just” a business, like selling software or soap. Banking, and in particular the function of credit (money) creation and allocation, has a distinct public purpose—to serve and support the real economy. Even in free-enterprise-dominated economies like we have in the U.S., this reality is reflected in the unique regulatory framework, central banking architecture as lender of last resort, and federal government backstop programs such as deposit insurance that make finance distinct from other private sector industries.

Third, the financial system is currently designed to finance what is most profitable to investors in the short-term, not what is needed in the real economy over the medium- and long-term. Misguided incentives and pervasive conflicts of interest further distort what gets financed. In other words, the “invisible hand” needs an upgrade, reflecting the urgent priorities of mitigating inequality and financing the energy transition off fossil fuels, and more generally, the desired end finance is designed to achieve. Finance, a subsystem of the broader economy, is not the end itself. A proper design must sort out means from ends.

Finally, the financial system is a complex system. Our growing understanding of complexity teaches us that we cannot fully manage it, but we can influence how it unfolds. But this requires a plan and a decision-making framework, not merely a set of ideological belief systems that favor, on the one hand, free markets or, on the other, heavy-handed government intervention to limit risk and fraudulent behavior.

To imagine the financial system we want, we first need a clear idea of what end we are trying to achieve and then we must design a system to achieve that end. This design approach is quite different than the rules and regulation approach that describes much (but not all) of the modern financial regulatory framework.   To effect this redesign, we must first challenge the assumption that underlies how advocates of both more and less government regulation view finance: that its purpose is to promote efficiency and thereby economic growth. The left and right may differ on the appeal of unfettered financial markets, and on how the spoils that arise from economic growth should be divvied up. But both sides agree that sustained economic growth is the “be all and end all” of a high-functioning financial system.

Regenerative Economics on the other hand, defines economic health and therefore the purpose of finance in a more nuanced way. To quote urban economist and systems thinker Jane Jacobs, “It’s not how big you grow, it’s how you grow big” that matters.

To answer this critical “how to grow” question, we must take a fresh approach rooted in hard science, which is also remarkably aligned with common sense and our many humanistic wisdom traditions.   The science is called energy flow network science, an integrated understanding drawn from modern physics, thermodynamics, biology, ecology, and complexity science.[2]

While it is new to many, this science represents our latest understanding of how the universe actually works. Our premise is simple and logical, built on the assertion that human economies are in fact clear examples of these same energy flow networks. (Einstein taught us that everything is energy.) We must therefore look to real-world living systems that have sustained themselves for long periods of time to discern the proven patterns and design principles of how to grow a sustainable economy, rather than be guided by demonstrably flawed and ideologically driven beliefs and theories, and models based on simplifying but wrong assumptions. Modern Portfolio Theory, Shareholder Value, Value-at-Risk, Efficient Market Hypothesis all come to mind.

Since finance properly understood is embedded in, and in service of, the economic system, the same science can help us design a framework for a financial system, and along with it, a banking system that supports the right kind of economic growth. And because it has nothing to do with the ideologies of the left or the right, it has the potential to transcend the tired political fight pitting free market champions against government interventionists.

I will talk more about what integral science can teach us about financial and banking system redesign in the next edition of this new series on Regenerative Finance.