Katharina Pistor on financial risk, wealth creation, digital currencies, and more

Project Syndicate: You have lamented the excessive financialisation of the economy, noting that “finance is both dumb and dangerous,” not least because it relies almost entirely on the price mechanism. How should we go about changing what you call a “bloated, fragile financial system that is in constant need of stewardship by central banks”?

Katharina Pistor: The price mechanism assumes that everything that matters can be reliably expressed in prices, and when it comes to corporate shares, for example, that the price reflects all relevant information about the company. Yet investors are interested only in the price at which they will be able to resell the shares in the future. They pay little attention to costs – social, environmental, or otherwise – that firms can shift to others. In fact, thanks to “limited liability,” investors are protected from incurring these costs directly.

The price mechanism is also used for assessing debt, but rarely the risk that debt poses to the financial system. Credit-based financial systems are inherently fragile, because they under-estimate the probability that future events will interfere with debt repayment. And yet, we actively encourage the use of debt, both by making interest tax-deductible and by offering implicit guarantees for the financial system as a whole.

Leverage artists know that central banks will do “whatever it takes” – as then-European Central Bank Governor Mario Draghi famously put it in 2012 – to protect the financial system from its endogenous demise. This message has drowned out the “never again” promise politicians made after they bailed out banks following the 2008 global financial crisis, and for good reason: central banks have continued to offer liquidity accommodations whenever they see signs of distress, and they have not shied away from bailing out relatively small banks, like Silicon Valley Bank in 2023.

By offering tax incentives and guarantees, governments subsidise a system that is incredibly lucrative for the few, but exposes the many to serious risks. If you are interested in reform, this is where you must start.

PS: While our obsession with prices, you argue, prevents us from “developing effective strategies that avoid imposing the greatest costs on people whose lives are not ‘priced in,” the “good-governance agenda” emphasises “technocratic goal-setting and box-ticking.” What does this approach leave out?

KP: The focus on putting a price tag on everything has led to a highly technocratic mode of governance. This is often presented as a positive: if prices reflect the true value and relevance of everything, from widgets to regulatory policies, then they can underpin a logical, unbiased approach to governance. The problem is that most of these prices do not emerge from “objective” mechanisms, such as trade, but rather are artificially constructed, and account for only what can be easily measured.

But key aspects of individual and societal well-being are supported by unpaid work – such as caring for children, the sick, or the elderly – or work that is consistently underpriced, because it cannot be sold on markets for pecuniary gain. How does one price a good teacher or a nurse that supports one’s recovery from severe illness? What about a work of art that cannot find a buyer today, but might touch people for generations to come?

The price mechanism works for the exchange of simple goods and services, but it is useless, if not outright harmful, when applied in other areas. But people follow the money, just as rats follow the pied piper, so the price mechanism is now heralded as our savior from climate change. This is a recipe for disaster.

PS: Back in 2022, you noted that “whether and when it is appropriate for former politicians to pursue lucrative business opportunities is a question of fundamental importance for democracies.” In the United States, politicians’ ability to trade stocks while in office has been the subject of much criticism, but efforts to combat insider trading and conflicts of interest in Congress have fallen short. How should such behavior be reined in?

KP: Elected officials are subject the same laws that apply to all citizens and face similar disclosure requirements as appointed officials. But as we well know, laws mean little if they are not properly enforced. The lower the probability of enforcement, and the gentler the expected punishment, the weaker the deterrence effect. So far, enforcement has tended to be woefully slack for politicians, much more so than for appointed officials.

Yes, enforcement powers can easily be abused. For evidence of that, look no further than Chinese leaders’ use of “anti-corruption” campaigns to weaken or silence political rivals. Nonetheless, more resources could be channeled toward enforcing laws against white-collar crimes, and punishments could be made harsher. Politicians should know that, if they break the law, they can be suspended from office.

There is also room to address the revolving door between politics and business. By tolerating – and even encouraging – the pursuit of lucrative employment by former chancellors, prime ministers, or presidents the minute they step down from public office, governments effectively perpetuate this behavior. This corrupts the political process, as the promise of future income affects political decision-making much earlier.

By the Way…

PS: Discussing your 2019 book The Code of Capital: How the Law Creates Wealth and Inequality, you recently explained that you’re “all for” redistribution, but “unless we think about the creation of wealth and how inequality is being created…we will never get ahead of the game.” What must policymakers understand about how wealth is created if they are to address inequality “at the front end”?

KP: It is widely assumed that wealth is the much-deserved reward for hard work and in-demand skills. But this explanation cannot possibly account for the amount of wealth in the hands of the 1% or the 10%. Without the law – a social, not private, resource – enabling the coding of capital, the gains of the wealthiest people could be diminished by liability and would be more vulnerable to economic downturns.

Private wealth benefits mightily from a handful of legal devices. For example, property law can turn simple objects, promises, or ideas into wealth-generating assets. Asset-holders can use the law to claim stronger rights and to limit access to their assets by creditors. Meanwhile, the state protects these legal empowerments against the world.

Crucially, the law is not fixed, but malleable. That means that skilled lawyers can shape it to fit their clients’ needs and interests. The key questions that policymakers should be asking is: How far should this legal outsourcing to private attorneys go, and which of these claims should (and should not) enjoy full legal protection?

PS: Testifying before Congress in 2019, you noted that recent advances in digital and crypto technologies “put the dream of an inclusive and efficient financial system within our reach,” but realising this dream would require “great care.” What do digital currencies demand of legal systems? Can monetary sovereignty exist without territorial sovereignty?

KP: We have become accustomed to profit-driven money creation by private banks. But the creation of the US dollar and other public moneys was driven by purpose, not profit. Prior to the information-technology revolution, private intermediaries might have been needed to ensure the diffusion of money, but even this is not clear. In any case, we now have technology that makes it possible to place money-creation in the hands of a single actor, yet assure broad access.

This can be done by way of central-bank (or better yet, treasury) digital currencies, which cut out the middlemen (banks). Or, as Mark Zuckerberg tried (but failed) to do with Libra, it can be done by a single economic actor who cuts out the government. This is more difficult, because without the government’s power to tax, it is much harder to ensure the money’s credibility and widespread use. Still, controlling people by controlling their data might be just as powerful as controlling people by controlling the territory they occupy. This may be sufficient to achieve monetary sovereignty.

PS: If you were to release a new edition of The Code of Capital now – five years after its publication – which ideas, events, or topics would you add?

KP: In the book, I show how different objects, promises, and ideas have been coded as capital by using essentially the same legal devices. The key assets I focused on were land, firms, debt, and scientific knowledge. What is missing are the new asset classes of data and the environment, though these follow the exact same pattern that land and debt established.

Data did not belong to anybody until we developed technologies that made it easy to capture and sell. Just as with the early enclosure of land, first-movers exploited ambiguities about data ownership. These actors were then able to claim superior rights to it – claims that were subsequently vindicated by courts and legislatures.

Similarly, nature has been established as one of the biggest asset classes ever. By creating standardised measures for, say, carbon-capture capacity, natural assets are turned into financial assets, which can be bought and sold just like any other derivative. But trading nature derivatives is not the same as protecting nature. Moreover, much like credit-default swaps, which failed to protect asset holders from major losses, nature derivatives are likely to be rendered toxic by climate change.

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Katharina Pistor, professor of comparative law at Columbia Law School, is the author of The Code of Capital: How the Law Creates Wealth and Inequality (Princeton University Press, 2019).

Copyright: Project Syndicate, 2024.

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