Welcome to the Seven Pillars Institute for Global Finance and Ethics. The mission of the Institute is to highlight and analyze issues of moral philosophy in finance with a view to enhancing practice and policy.
The Seven Pillars Institute, or SPI, is a unique think tank, indeed, the first of its kind to focus on “Financial Ethics.”
Why We Are
The discipline of “Business Ethics” is a common and established one. But, the complementary yet distinct area of “Financial Ethics” is not yet widely recognized. That is ironic.
A common theme emerging after many financial crises is the inattention paid to their moral causes and consequences. The dearth of recognition of “Financial Ethics” also is puzzling. The financial services sector now accounts for nearly 8 percent of the Gross Domestic Product (GDP) of the United States and 40 percent of American corporate profits – both historically high figures. In this unprecedented era of globalization, scarcely an individual, institution, or market is not affected by the ethical dimensions of finance.
Why is “Financial Ethics” an inchoate field, and what added value does this Institute provide to the field?
The Short Answer
Finance views itself as a positive science, that is, an objective discipline that is value-neutral. It deals solely with facts, and confines itself to drawing empirically testable propositions from them. Neither academic nor practicing financial professionals endeavor to offer normative, i.e., value-based, prescriptions.
This separation of facts from moral values is sometimes called the “Separation Thesis.” Milton Friedman, winner of the 1976 Nobel Prize in Economics, gave the Thesis his intellectual benediction in the context of Economics, when he wrote:
“Positive economics is in principle independent of any particular ethical position or normative judgments. Its task is to provide a system of generalizations that can be used to make correct predictions about the consequences of any change in circumstances.”
Finance is an offspring of Economics, so it is unsurprising that Finance scholars and professionals apply the same Thesis to their subject. They allocate little, if any, space for Ethics in the theory or practice of Finance. They believe the market fully and effectively occupies that space. Using the criterion of efficiency, the market itself is the arbiter of right from wrong.
This view is more than the conventional wisdom. Over the past decades, it has hardened into an implacable ideology that Finance and Ethics are and must be separate. This ideology predominates the financial culture on Wall Street and around much of the world.
The Long Answer
The long answer starts with a short history and description of Modern Finance Theory (MFT). MFT is only about 60 years old. Most scholars agree MFT was born in 1952, with the development of portfolio theory by Harry Markowitz. Essentially, MFT comprises three beliefs:
In contrast, as an intellectual discipline, Moral Philosophy, or Ethics in modern parlance, is over 2,500 years old. The canon of Ethics is magnificently broad and deep.
This canon stretches back to Socrates (469 – 399 B.C.), Plato (428/427 – 348/347), Aristotle (384 – 322), Saint Thomas Aquinas (1225–1274 A.D.), Immanuel Kant (1724 – 1804), David Hume (1711 – 1776), Adam Smith (1723 – 1790), Jeremy Bentham (1748 – 1832), John Stuart Mill (1806 – 1873), and Friedrich Nietzsche (1844 – 1900). It extends through recent contemporary thinkers such as Jean Paul Sartre (1905–1980), an existentialist philosopher and novelist, Peter Singer (1946-), a moral philosopher, and Amartya Sen (1933-), winner of the 1998 Nobel Prize in Economics. Notably, Sen works in Development Economics, but is deeply concerned about moral issues associated with wealth and poverty. In this way, he follows the tradition of the father of capitalism, Adam Smith, who was a moral philosopher. Indeed, he held the Chair of Moral Philosophy at the University of Edinburgh.
With 2,500 years of research, analysis, and scholarship in Ethics, at least one conclusion is inescapable: this discipline is more fully developed than the nascent field of Finance. A second conclusion also is warranted: when issues of right and wrong arise in Finance, this tradition should not be neglected. Rather, with a dose of humility, and candid introspection about the excesses and other failings of contemporary finance, the champions of MFT ought to appreciate their beliefs and practices may be informed and improved by a better understanding and application of the frameworks and precepts developed by Moral Philosophers in the last two millennia.
Assumptions of MFT
MFT makes five major assumptions:
(1) Economic Agents are always rational.
Interestingly, Ethics went through this phase with Kantian theory, which posits human reason as the final arbiter of moral values. Kant sought to refute David Hume, a Scottish philosopher and contemporary of Adam Smith, who proposes human emotions as the final arbiter of moral values. Contrast this situation with the one Finance finds itself in at the moment. MFT assumes economic agents are always rational. Redolent of Hume’s approach, Behavioral Finance Theory now tries to refute this assumption by taking greater account of emotions.
(2) Rational agents are self-interested.
(3) Rational agents only aim to maximize utility.
(4) Utility or preference can be distilled to just one thing, economic utility or profits.
(5) Thus, rational agents aim to maximize profits.
These assumptions are accepted credo in free market capitalist systems. Yet, these assumptions are made to simplify a complex world, and there by help Finance scholars and practitioners to develop predictive models of a small portion of the world they study.
Are they correct assumptions? Yes, in a limited, qualified, view of the world and of humanity. Humans are rational, except when they are not. Have you ever “cut off your nose to spite your face”?
Experiments show people are not motivated solely by profit, but also by values such as fairness. Individuals are willing to punish unfair behavior, even at some cost to their self-interest. Are we always and only economic agents? Or are we also parents, artists, teachers, and friends, and in those roles, agents who do not mechanically act to maximize our own welfare?
To be sure, applying MFT and its assumptions has resulted in much good for the global economy. But like any paradigm in science, or philosophy, shifts must be explored. Theories must change when confronted with evidence highlighting their flaws and inadequacies. That is all the more true when the paradigm and its theories are ideologically driven.
Consequences of MFT
What have been the consequences of the assumptions underpinning MFT? With the passage of time and constant use, the assumptions have evolved from “is” to “ought:”
(1) Assume we are rational agents.
(2) As rational agents, assume we maximize profits.
(3) Based on (2) it is a short intellectual leap from the proposition that “We do maximize profits …
(4) … to the proposition that “We should maximize profits.
The upshot is another irony: the assumption has become the ethic. In other words, the assumptions of what “is” have become the ethic of what “ought to be.”
Indeed, the assumptions of profit maximization behavior and an all-knowing, providential market have replaced any need for recourse to Moral Philosophy to resolve ethical questions in Finance. Hence, the conventional wisdom, ideology, and culture: with the market in place, Ethics is inconsequential to Finance.
There are remarkable parallels between the Deity of the three major monotheistic religions and the free market Finance deity:
The Mosaic God:
Omniscient – all knowing
Providential – all good
Omnipotent – all powerful
The Free Market:
All information is already in the market (i.e., the EMH) – all knowing
The consequences of allowing the free market to work are maximization of efficiency and profits – all good
There is no way to outperform the market, either by active management or by government planning – all powerful
In other words, just as God revealed to humanity a moral code, the Market give us its moral code, which is:
We are rational optimizers and profit maximization is and should be the good and the goal.
From Homo Sapiens we have been reduced to Homo Economicus, a shadow of what we are, a thin slice of what it means to be fully human.
Empirical Evidence Against MFT
While CAPM originated first, and OPT is a key tool to pricing risk, arguably EMH is the cornerstone of MFT. Yet, the past decade has shown the weakness of the EMH and, by extension, MFT.
Consider Intel. Its stock probably was not worth $146 per share in July 2000, during the dot-com bubble. Likewise, Intel stock was not worth only $13.22 in October 2002, at the bottom of the tech bear market.
Consider the housing bubble of the last decade. It was not rational for house prices to triple in 10 years. Bubbles, as well as the crashes that follow them, do not reflect rational economic agency, because they do not reflect correct prices that have taken in all available information. Bubbles are a reflection of irrational expectations that arise when investors herd into the same investments at the same time. Prices are driven by greed, not rational calculations.
More generally, every bubble or crash disproves EMH, a fundamental concept of MFT. Consider all the crashes that occurred in the past 20 years:
Savings and Loans Crisis – 1984
Junk Bond Crisis – 1989
Japanese Bubble Bursts – 1992
Mexico Currency Devaluation – 1994
Barings Securities Collapse – 1995
Asian Currency Crisis – 1997
Russian Currency Devaluation and Default – 1998
Long Term Capital Management Bailout – 1998
Dot-Com Bubble Bursts – 2000
Bear Stearns Bails Out Funds – 2007
Lehman Goes Bankrupt – 15 September 2008
To reiterate, people are not always rational, point made by Robert Shiller and Arthur M. Okun, both Professor of Economics at Yale University:
“The problem with economics is that psychology isn’t in our department.”
Bubbles and crashes are proof of the non-rationality of markets says Jeremy Siegel, author of Stocks for the Long Run (2007):
“The case [for EMH] was weakened significantly by such extreme price movements. It’s hard to believe that the 1,000 point swing in the Dow Jones Industrial average on May 6  was the result of a rational market.”
What We Do
The Institute does not advocate either a complete overhaul or a disposal of MFT. MFT has served economies around the world well, increasing wealth and contributing to the well-being of hundreds of millions of people. Rather, the Institute suggests MFT has become too entrenched, too unquestioned as an ideology among academics and practitioners. Consequently, it now is used – or abused – to justify an array of behaviors, financial instruments, and financial transactions that are socially useless, ethically suspect, or both.
MFT needs to be probed and challenged. Critically, the infusion of Finance with Ethics needs exploration. Should the Separation Thesis still be accepted? Or, do Finance and Ethics need integration? Can MFT be used, and how, while simultaneously applying Ethics?
The Institute asks and seeks answers to questions of this nature.
SPI is the thinking space for new theories and practices that might synthesize Ethics with Finance.
The Institute welcomes donations from the public – individuals, groups, and institutions interested in the mission of SPI and the issues it probes. As the Institute raises more funds, it increases capacity, research capabilities, and online offerings.
The Institute publishes an online journal, Moral Cents: The Journal of Finance and Ethics on a biannual (Fall and Spring) basis. It has an open submission policy, welcoming contributions from academics, practitioners, and informed readers of all backgrounds.
The Institute also welcomes readers to contribute to its online library of Finance and Ethics Case Studies (FECS). The cases should be financial in scope and contain ethical issues. These issues should then be discussed and analyzed using one or more rigorous frameworks of Moral Philosophy. Remedies or policy recommendations are encouraged.
 Milton Friedman, “The Methodology of Positive Economics,” in Essays in Positive Economics, Chicago, University of Chicago Press (1966).
 Robert Kolb, “Ethical Implications of Finance,” in Finance Ethics by John R. Boatright (ed.), John Wiley & Sons, Hoboken, New Jersey (2010).
 Kolb (2010).
 John Waggoner, USA Today, 15 February 2011.