NEW YORK (Thomson Reuters Regulatory Intelligence) - Popes these days generally don’t get as deeply involved in high finance as they did when the Medicis ran the Vatican and made a killing selling indulgences (the original market in spiritual futures). But last month the Vatican issued a document that not only addressed the role of markets in helping the poor, but even weighed in on the debate over the role of regulation. Perhaps the timing was driven by an “invisible hand,” since the document comes out just as a retrenchment of post-crisis market regulation in the United States is taking hold.
A battle has been underway for the past decade between those who believe regulation is necessary to curb abuse and prevent market crises, and those who believe that the only hands that should be regulating markets are the invisible kind, as Adam Smith described the work of free markets in “The Wealth of Nations.”
The election of Donald Trump and a Republican majority in Congress gave the pendulum a mighty shove in the direction of deregulation. Within weeks of taking office, Trump directed his administration to kill two existing regulations for every new one issued, and to reduce the total number of regulations by 75 percent. The policy stems from a dogmatic and simplistic antagonism to regulations, and so the fewer of them around the better markets will operate.
Fast forward a year, and we see this deregulatory push taking hold in U.S. financial markets, with the release of the Fed’s proposal to pare back the Volcker rule banning proprietary trading by banks, and recent legislation to similarly rein in other parts of Dodd-Frank. So far the approach seems more temperate than the sweeping purge proclaimed from the White House and prevailing in other agencies, most notably the Consumer Financial Protection Bureau. Have cooler heads prevailed, or is this just the beginning of the purge?
Now is the time to address how far deregulation of the markets should go. That’s why the Vatican document is so timely – it shines a light on the assumptions beneath the opposing views: is regulation a necessary part of the market, or is it inherently harmful? Are markets meant to help society, or should they be seen as neutral mechanisms for price discovery and resource allocation, letting the chips fall where they may? That’s where the Pope comes in.
REGULATORS OF THE WORLD UNITE
The May document, entitled "Considerations for an Ethical Discernment Regarding Some Aspects of the Present Economic-Financial System,”(here) was jointly prepared by the Vatican’s doctrinal office and its department on human development, and it is considered official teaching of the Catholic Church.
The document clearly reflects Pope Francis’ well-known focus on a universally shared duty to care for the poor. Although the document acknowledges the important role of markets and their capacity to bring prosperity, it zeroes in on their potential to do harm in the form of financial crises, greed, and misguided incentives resulting from an emphasis on short-term performance. It calls for the financial world to develop a new approach in which markets are understood to have a moral purpose of redistributing wealth to alleviate poverty and suffering.
Holy cow, you’re thinking, has the Vatican just gone Marxist? Actually, no. Marx and his fellow travelers were against capitalism and free markets, period. Their idea was to use the government to direct economies and redistribute wealth. The Vatican document is not against markets or capitalism. Rather, it is critical of what it sees as their failure to achieve an outcome that would otherwise, through market forces, provide a more equitable distribution of resources so that a rising tide does in fact lift all boats.
To achieve this, the document supports a more active approach to regulation, particularly with respect to curbing speculative activity, the creation of complex instruments with no real economic purpose, and the abuse of offshore financial systems. It calls out a number of instruments and practices as being especially pernicious, such as credit default swaps, and calls for national regulatory authorities to consolidate their standards to prevent market players from working around them. Importantly, though, the document also calls for financial institutions to take up the cause as well by investing more in internal compliance and risk functions and making ethics the mainspring of corporate governance.
LIGHTEN UP FRANCIS
The Vatican document makes valid points and adds a needed element of “mission” to the regulatory debate.
But the message could easily be lost in its delivery. It’s a pretty dense read before it gets to the good stuff. It could also use a bit less finger-wagging and a bit more positive reinforcement. Most of all, it should go easy on the “redistribution of wealth” rhetoric if it aims to persuade free-market enthusiasts to address market failures.
When you take a step back, though, the document is still pro-market. It just starts from the point of view that markets have a moral purpose which they are failing to achieve. In this sense the document is closer to Adam Smith than to Karl Marx.
IN THE BEGINNING THERE WAS ADAM
Before he even wrote “The Wealth of Nations,” Adam Smith was famous in his time as a moral philosopher. He made his mark and his fortune with a book on “moral sentiments”, and he saw economics as one aspect of the larger moral question of how society should progress. This is fundamental to understanding his views in “The Wealth of Nations,” where he sees free markets as the best means to achieve a moral goal. Smith judged market systems by how well they looked after the poor: “No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable.” Like the Vatican, Smith saw markets as having a responsibility to alleviate poverty.
Smith made the case clearly and strongly that the way to achieve this distribution of wealth was through free markets with as little government interference as possible. But it’s important to note that his objection was really to the distortion of markets, and government regulation was undesirable to the extent that it distorts the market.
In some cases such as monopolistic behavior, Smith pointed out, markets are distorted by other factors and regulation can be useful in preventing or correcting them. Human behavior made these natural distortions, and therefore the regulation to address them, inevitable: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices…. (the law) ought to do nothing to facilitate such assemblies.” Would he endorse the Vatican’s call for regulatory oversight at a global level? Probably not. But neither would he endorse a market with no regulation at all.
AND NOW THERE IS DONALD
This warts-and-all understanding of markets is the starting point for those who believe that regulation is part of free markets. Smith wrote in simpler times but recognized the inevitability of regulation to address the equally inevitable existence of market distortions. The Vatican document extends this thinking to modern markets, recognizing that their larger scale, automation and complexity create more distortions and magnify their impact on society. The Pope believes this requires stronger regulation on a global scale. Smith would probably object to the scale and powers of such a regime, but the disagreement would be on the scale of the project, not its goal.
In contrast, the Trumpist assertion that markets simply need fewer rules may be good politics but it’s bad economics. This is inevitably the case when dogma replaces critical thinking. The good news is that cooler heads seem to be prevailing, and the steps thus far to address Dodd-Frank are reasonable. Let’s hope that they continue in that direction.
(Scott McCleskey is a Senior Vice President at Eukleia, a Compliance training consultancy with over 25 years of experience in the United States and Europe. His commentary for Regulatory Intelligence has been recognized with a national award from the Society of American Business Editors and Writers. His publications include “When Free Markets Fail: Saving the Market When It Can’t Save Itself.” The views he expresses are his own.)