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 JUST FINANCIAL MARKETS?

Diese Publikation geht hervor aus dem DFG-geförderten Exzellenzcluster

“Die Herausbildung normativer Ordnungen” an der Goethe-Universität
Frankfurt am Main.
Just Financial
Markets?
Finance in a Just Society

EDITED BY
LISA HERZOG

1
OUP CORRECTED PROOF – FINAL, 23/2/2017, SPi

3
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 Contents

List of Contributors vii

1. Introduction: Just financial markets? Finance in a just society 1

Lisa Herzog

PART I. NORMATIVE FOUNDATIONS

2. Justice, financial markets, and human rights 39
Rosa M. Lastra and Alan H. Brener
3. A capability framework for financial market regulation 56
Rutger Claassen
4. Financial markets and institutional purposes:
The normative issues 78
Seumas Miller
5. Can incomes in financial markets be deserved?
A justice-based critique 103
Lisa Herzog

PART II. LEGAL STRUCTURES

6. Punishment in the executive suite: Moral responsibility,
causal responsibility, and financial crime 125
Mark R. Reiff
7. A culture beyond repair? The nexus between ethics
and sanctions in finance 154
Jay Cullen
8. Moneys’ legal hierarchy 185
Katharina Pistor
9. Investor rights as nonsense—on stilts 205
Aaron James

PART III. INSTITUTIONS AND PRACTICES

10. Normative dimensions of central banking: How the guardians
of financial markets affect justice 231
Peter Dietsch
vi Contents

11. Information as a condition of justice in financial markets:

The regulation of credit-rating agencies 250
Boudewijn de Bruin
12. Gender justice in financial markets 271
Roseanne Russell and Charlotte Villiers
13. It takes a village to maintain a dangerous financial system 293
Anat R. Admati

General Index 323

 List of Contributors

Anat R. Admati is the George G. C. Parker Professor of Finance and

Economics at the Graduate School of Business, Stanford University. She has
written extensively on information dissemination in financial markets, trading
mechanisms, portfolio management, financial contracting, and, most recently,
on corporate governance and banking. Since 2010, she has been active in the
policy debate on financial regulation, particularly capital regulation, writing
research and policy papers and commentary. She is a co-author, with Martin
Hellwig, of the book The Bankers’ New Clothes: What’s Wrong with Banking
and 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. Brener is currently undertaking a PhD at the Centre for Commercial
Law Studies (CCLS), Queen Mary University of London. He is a member of
the Advisory Board of the Centre for Ethics and Law at University College
London and a council member of The Chartered Institute of Bankers in
Scotland. He is also a qualified Chartered Accountant and member of the
Institute of Chartered Accountants in England and Wales and has a LLM from
UCL. Prior to starting his PhD, he worked for Santander UK and was
responsible, at different times, for the compliance and retail legal departments
and regulatory policy. Before joining Santander in 2005, from 1996 he headed
the compliance departments for the retail banking divisions of NatWest and
RBS banks. From 1989 to 1996 he was a senior prudential and conduct of
business regulator for the insurance and collective investments sectors, having
previously worked on aspects of public policy at the Department of Trade
and Industry. He also helped set up the Banking Standards Board with the
objective of improving standards of conduct and professionalism within the
banking industry.
Rutger Claassen is Associate Professor of Ethics and Political Philosophy at
the Department of Philosophy of Utrecht University. His research centers on
three main themes: socio-economic justice (especially the capability approach,
on which he is writing a monograph); economic and ethical theories about
the concept of the market and the justifications for regulating and limiting
markets; and conceptions of freedom, autonomy, and paternalism. He has
published in journals such as Economics and Philosophy, Inquiry, Law and
Philosophy, Journal of Social Philosophy and Politics, Philosophy and
Economics. He also regularly publishes articles and books in Dutch, to
viii List of Contributors

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 Cullen is a lecturer in banking and finance law at the University of
Sheffield. His main research and teaching interests are banking regulation,
shadow banking, and corporate governance of financial institutions. He has
been a visiting scholar at Columbia University (2016) and has received
research grants from the British Academy and European Commission for
work on financial regulation. His work on bank leverage and corporate
governance 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 Law
Faculty 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 has
been presented at leading academic venues including the Institute for New
Economic Thinking, Oxford University, Berkeley, and The National Institute
for Economic and Social Research.
Boudewijn de Bruin is Professor of Financial Ethics at the University of
Groningen. He held visiting positions at Cambridge University, the Fondation
Maison 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 Banks financed by the Dutch Research
Council (NWO). De Bruin’s research interests are financial ethics, moral,
and political philosophy, theory of knowledge, philosophy of mathematics,
economics and finance, game theory, and philosophical logic. He is the author
of a monograph on Explaining Games: The Epistemic Programme in Game
Theory, published in 2010, and co-editor, with Christopher F. Zurn, of New
Waves in Political Philosophy (2008). His monograph Ethics and the Global
Financial Crisis: Why Incompetence Is Worse than Greed was published
in 2015.
Peter Dietsch is Associate Professor in the Philosophy Department at the
Université de Montréal. His research interests lie in the domain of economic
justice, with a focus on income inequality as well as on normative issues in
economic policy, including fiscal and monetary policy. His book Catching
Capital: The Ethics of Tax Competition was published by Oxford University
Press in 2015. Among other journals, he has published in The Journal of
Political Philosophy, the Journal of Moral Philosophy, the Journal of Social
Philosophy, and Politics, Philosophy and Economics.
 List of Contributors ix

Lisa Herzog is Professor of Political Philosophy and Theory at the Bavarian

School of Public Policy at the Technical University Munich. She works on the
intersection of economic and political questions, with a focus on the history of
economic and political thought, the normative status of markets, and, most
recently, 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 writes
for a broader audience, including the monograph Freiheit gehört nicht nur den
Reichen. Plädoyer für einen zeitgemäßen Liberalismus (2014).
Aaron James is Professor of Philosophy at the University of California, Irvine.
He is the author of various papers that have appeared in journals including
Philosophy and Public Affairs and Philosophy and Phenomenological Research,
and of Fairness in Practice: A Social Contract for a Global Economy (2012). He
has been a recipient of ACLS’s Burkhardt Fellowship, a fellow at the Center for
Advanced Study in the Behavioral Sciences, Stanford University, and Visiting
Professor of Philosophy at NYU.
Rosa M. Lastra is Professor in International Financial and Monetary Law at
the Centre for Commercial Law Studies (CCLS), Queen Mary University of
London. She is a member of the Monetary Committee of the International
Law Association (MOCOMILA), a founding member of the European Shadow
Financial Regulatory Committee (ESFRC), an associate of the Financial
Markets Group of the London School of Economics and Political Science,
and an affiliated scholar of the Center for the Study of Central Banks at
New York University School of Law. From 2008 to 2010 she was a Visiting
Professor of the University of Stockholm. She has served as a consultant to the
International 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 the
European Union Committee [Sub-Committee A] of the House of Lords
regarding its Inquiry into EU Financial Regulation and responses to the
financial crisis. Since 2015 she has been a member of the Monetary Expert
Panel of the European Parliament and since 2016 she has been a member of
the Banking Union (Resolution) Expert Panel of the European Parliament. She
has written extensively in her fields of expertise (central banking, financial
regulation, international monetary law, EU law), with several authored and
edited books and numerous articles.
Seumas Miller is a professorial research fellow at the Centre for Applied
Philosophy and Public Ethics (an Australian Research Council Special
Research Centre) at Charles Sturt University (Canberra) and the 3TU Centre
for Ethics and Technology at TU Delft (The Hague) (joint position). He is the
author or co-author of over 200 academic articles and fifteen books, including
x List of Contributors

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 Pistor is the Michael I. Sovern Professor of Law at Columbia
Law 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 International
Private Law in Hamburg, Germany and the Harvard Institute for International
Development. Her research interests include the relation of law and finance, the
transformation of economic systems, comparative corporate governance, and
law and development. She serves as President of the World Interdisciplinary
Network 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 her
contributions to international financial regulation. Recent publications
include “A Legal Theory of Finance” (Journal of Comparative Economics, 2013);
“Regulatory Capabilities” (with Fabrizio Cafaggi) (Journal on Regulation and
Governance, 2015), and a book co-edited with Olivier De Schuttter, Governing
Access to Essential Resources (2015).
Mark R. Reiff is 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 and
Economic Justice in the Liberal Capitalist State (2013), and Punishment,
Compensation, and Law: A Theory of Enforceability (2005). His papers on
issues within political, legal, and moral philosophy have appeared in leading
academic journals in the US, the UK, France, and Canada. He has taught
political, legal, and moral philosophy at the University of Manchester, the
University of Durham, and most recently at the University of California at
Davis, and in 2008–9 was a Faculty Fellow at the Safra Center for Ethics at
Harvard University. He is also a lawyer, and prior to retuning to academia to
obtain his PhD at the University of Cambridge he practiced complex civil trial
and appellate litigation in California for many years. He is also admitted to
practice as a solicitor in England and Wales.
Roseanne Russell is a Lecturer in Law at Cardiff University. Her research lies
at the intersection of company law, employment law, and feminist legal
theory. She is a solicitor and practiced in Edinburgh and London before
moving to academia.
Charlotte Villiers is Professor of Company Law and Corporate Governance at
the University of Bristol. Her research focuses on company law, employment
 List of Contributors xi

law, and Spanish Law. She studied law at the University of Hull and the
London School of Economics and Political Science, and is a qualified
solicitor. She has taught at the Universities of Sheffield and Glasgow, and was
a Visiting Lecturer at the University of Oviedo in Spain. She was appointed
Professor of Company Law in 2005. Her publications include European
Company Law—Towards Democracy (1998), and most recently, Corporate
Reporting and Company Law (2006). She has also written extensively on
UK industrial relations. Her current research sponsored by the Arts and
Humanities Research Council (AHRC) concerns female participation in
company boards.
 1

Introduction: Just financial markets?

Finance in a just society
Lisa Herzog

1.1 I NTRODUCTION

Finance has become a serious political affair. In a 2000 newspaper article,

the speaker of the board of Deutsche Bank, Rolf-E. Breuer, called financial
markets the “fifth power,” which, together with the “fourth power” of the
media, helped to keep in check the executive, legislative, and judicial
branches, 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 this
view (Financial Review 2015). Weapons of mass destruction, if they should
exist at all, should certainly not exist in the hands of a small group of private
actors—they are a political issue par excellence. Some bankers think of their
work even more highly: Goldman Sachs’s chief executive Lloyd Blankfein
once famously told a reporter that bankers are “doing God’s work” (Wall
Street Journal 2009).
Rhetoric and self-aggrandizing aside, finance has certainly become an issue
of utmost importance for capitalist societies. Since the 1970s, the volume of
financial services has grown with around twice the speed of GDP growth in
both the UK and the US (Turner 2016, 20ff.). The Great Financial Crisis of
2008 has made painfully clear that financial markets are not just markets like
any others. Their impact on the lives of numerous individuals is huge: so many
jobs, wages, nest eggs, mortgages, and consumer loans depend, directly or
indirectly, on what happens on the trading floors of Wall Street, the City of
London, and elsewhere, a phenomenon sometimes described as the “financial-
ization” of society. And yet, financial markets are highly abstract entities, and
therefore 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)
2 Lisa Herzog

in suits shouting orders at each other from their trading desks. The abstract-
ness of financial markets may be one of the reasons why it has been more
difficult than with regard to other institutions to address a very simple
question to them: are they in line with our considered judgments about how
a just society should be organized? After the Great Financial Crisis, political
philosophers and theorists1 have begun to develop an interest in such ques-
tions, and a new debate has started.2 This volume brings together contribu-
tions to this debate not only from political philosophy, but also from
economics and law. They shed light on a number of interconnected themes
that all have to do with the relation between financial markets and justice.
In the last decades, political philosophers have by and large3 relied on the
academic division of labor and mostly left questions about markets to econo-
mists, despite the fact that there is a venerable tradition in philosophy—from
Aristotle to Montesquieu, Smith, Kant, Marx, and many others—that takes
economic questions seriously as genuinely philosophical questions. More
recent discussions, in contrast, have started to open up the “black box” of
markets (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 the
impact they have on the distribution of opportunities and resources (see
Herzog 2013 for an overview). So far, however, the debate about markets
has been limited to considerations about markets in general, and has focused
mostly on their moral limits (see notably Anderson 1992, Satz 2010, and
Sandel 2012) or on the duties of market participants, which have also been
discussed 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), Graafland 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 specific 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 specific 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.
 Introduction: Just financial markets? 3

discuss below, they have specific features that make them particularly inter-
esting for those interested in justice, or in obstacles to justice.
There are good reasons not to leave the consideration of financial markets
to economists alone. Much could be said about the way in which economics,
with its focus on elegant mathematical models, had smuggled idealized
assumptions about human behavior and about the structure of markets into its
descriptions of financial markets (see e.g. Krugman 2009a, Shiller 2012, chap. 19).
While it might be unfair to expect economists to predict the precise timing
and evolution of an event like the Great Financial Crisis, the way in which this
crisis took the discipline by surprise speaks volumes. Simplifying models,
however, are not the only problem of an exclusively economic perspective.4
Another one is the almost exclusive concentration on Pareto-efficiency as the
only normative criterion, that is, efficiency in the sense that it is impossible to
make anyone better off without making someone else worse off. For some
markets, 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 existing financial markets from a perspective of
Pareto-efficiency, it is questionable whether this strategy is sufficient for
understanding markets that have become so dominant in our societies as
financial markets have in recent years. While some of the chapters in this
volume remain tied to a perspective of efficiency, others ask more fundamental
questions about the institutional structures of financial markets and the
normative values or principles we should draw on when thinking about them.
In the remainder of this Introduction, I will first provide an overview of
some of the mechanics of financial markets and the justifications that have
traditionally been offered for them.5 I then present some of the preliminary
evidence that suggests that financial markets should be considered not only
from a perspective of efficiency, but also from a perspective of justice. This is
followed by a more in-depth discussion of how financial markets differ from
the markets for apples and oranges that populate economics textbooks.6 These
considerations lead to a strong case for reform. I conclude with a preview of
the chapters of this volume, which discuss not only the principles of justice
that can serve as guidelines for evaluating financial markets, but also more
concrete 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.
4 Lisa Herzog

provide food for thought about how financial markets could be changed such
as to be brought better into line with our considered judgments about what
makes a society just.

1.2 F INANCIAL MARKETS —A FEW NUTS AND BOLTS

In a first approximation—and in the view that was, arguably, dominant before

the Great Financial Crisis—financial markets are a subgroup of markets in
general. Hence, the descriptions and justifications offered for free markets are
assumed to apply to them as well. Markets are institutions in which agents
exchange goods and services, usually using money as a medium of exchange.
Market prices mediate the interplay between supply and demand: if supply is
high relative to demand, the price falls, signaling to suppliers that less of the
product 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 that
they should provide more of the product in question (or attracting new
suppliers). Those on the demand side can equally react to changing prices,
for example by increasing or reducing their consumption or by switching to
other goods or services. There is no need for a central planner who would
coordinate the behavior of all these agents; rather, the changes of the price
level do so automatically. To be sure, this does not mean that the state has no
role at all to play: it has to create a framework of property rights in the first
place, and it has to offer the legal infrastructure needed for enforcing these
rights and the contracts that right-holders can enter with one another. It may
also have to regulate certain aspects of markets, for example in order to
prevent market participants from causing “external effects” on third parties,
such as environmental pollution. But within this framework, individuals are
free to decide according to their own preferences: to buy or to sell at whatever
price they find 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 demand
side 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 strong
competition among suppliers, customers benefit by receiving lower prices and/
or better quality; if there is strong competition on the demand side, suppliers
can demand higher prices and/or offer lower quality. In the “perfectly competi-
tive markets” presented in many textbooks, there are large numbers of market
participants on either side. This means that all mutually beneficial opportunities
for trade will be used, which means that the result is “Pareto-optimal.” In more
 Introduction: Just financial markets? 5

colloquial terms: there is no “waste” from unused opportunities to gain from

trade. 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 fully
rational, and they have to be able to buy and sell whenever they like. There is an
extensive 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 which financial products
are traded. Sometimes this trade takes place physically, in trading places such
as the New York Stock Exchange; increasing amounts of financial products,
however, are traded electronically, either on regulated electronic trading
platforms or in other trading networks. This holds both for business-to-
business trade, in which financial institutions trade with one another, and
for business-to-consumer trade, in which private or institutional clients buy or
sell financial products from brokers. The products traded in financial markets
include various forms of equity and debt contracts. Equity means that investors
hold property rights that often come with certain control rights—for example
the right to vote at a shareholder meeting—and that involve the full transfer of
risk, upwards (gains), and downwards (losses) to the owner. “Capital,” in the
traditional sense of shares in traded companies that pay a dividend if the
company makes a profit, is the prototypical case of equity. The owners of debt
contracts, in contrast, do not receive control rights or the right to a dividend;
instead, they receive the right to fixed payments. This categorization, however,
is only a rough one, as there can be various intermediate forms. Many equity
and debt contracts are traded very frequently; what matters to investors is
thus not only the profile of payments and risks that they receive, but also the
price levels of these assets and in particular the expected future development of
their prices.
In addition to company shares and government bonds, a huge number of
other products are traded in financial markets. In a first approximation, they can
all 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 (how
much money can the owner earn in different future scenarios?), and their
liquidity (how easy or difficult is it to exchange them for other products,
typically, money, in the short term?). Other goods that are traded in financial
markets include, for example, insurance contracts or foreign currencies.
It would be impossible to understand modern financial markets, however, if
one 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 to finance public investment, individuals or companies insure them-
selves against untoward events such as a natural disaster, companies buy
6 Lisa Herzog

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

In addition to these bread-and-butter products, financial markets include
large numbers of “derivative” products that are related, in one way or another,
to other, underlying financial products. The existence of such products is not
new; especially in times of financial manias, derivative products tend to spring
up like mushrooms. The amount and the complexity of such derivative
products in the last decades, however, beat everything that had happened
earlier. The possibility of using computers and IT networks for creating
products and keeping track of them allowed for an explosion in derivatives
that 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 the fluctuation of prices of other
products. Relatively simple products include, for example, options, which give
the owner the right to buy or sell a financial product or commodity at a certain
price 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 for
wheat at the time of delivery is higher than expected, driving up the price, the
farmer 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 that
way, the option serves as an insurance against losses from price fluctuations.
Similarly, forwards and futures are contracts about the obligation (rather than
the right) to buy or sell some financial product at a fixed price in the future.
Swaps are contracts in which two market participants exchange the future cash
flows of different underlying financial products. In addition to these still
relatively 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 transaction
outside of regulated exchanges such as the New York Stock Exchange or the
Chicago Mercantile Exchange.
Such derivatives can be bought by investors who want to “hedge” risks to
which they are exposed in their economic operations. For example, a company
heavily trading with companies in other currency areas might want to hedge
the risks of currency fluctuations. But they can also be used for speculative
purposes. Derivatives are themselves heavily traded, which means that their
prices can fluctuate considerably. If a trader expects the price of a certain
derivative to rise, he or she might buy a bunch of it in the hope of selling it at a
better price in the future—or he or she may buy a derivative that builds on this
very price development, for example an option contract that gives him or her
the right to buy these derivatives at the current price in the future.7 If 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.
 Introduction: Just financial markets? 7

has by then risen, he or she can make a profit. Sophisticated mathematical

models have been developed for calculating the expected profits, and hence
the current prices, of options and other derivatives.8 In the years before the
Great Financial Crisis, it seemed that these models were doing a good job at
describing the underlying reality. In fact, the very existence of these models—
and hence the impression that one could remain in control of all the risks
one was exposed to when trading in complex derivatives—contributed to the
boom in derivatives trading. The total amount of outstanding derivative
contracts, 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 they
all 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 would
not cause additional risks? To understand why they were seen as harmless, and
even beneficial, by many commentators, including academic economists
and regulators, it is important to understand the ideological landscape before
the Great Financial Crisis. Free markets in general were seen as fundamentally
beneficial: the free play of supply and demand enables a process of “price
discovery” that supports the efficient allocation of scarce goods. Financial
markets were seen as similar to other markets in this respect. In fact, in many
macroeconomic models, finance was not even included: it was considered a
“veil” that did not change the underlying structures of the real economy, no
matter how large it was and what kinds of products were traded in it. Central
bank policy did not pay attention to financial markets either, as it focused
mostly, and largely successfully, on keeping inflation in check. The possibility
that financial markets might create instability from within was simply not on
the radar (see also Turner 2016, 38).
This narrowness of vision, however, was no pure dogmatism, but rather
based on microeconomic considerations that formed a coherent narrative.
According to this narrative, financial markets were basically markets for
streams of payments under different future scenarios. Market participants
who differed in their estimations about the likelihood of these scenarios, in
their demand for liquidity, or in their appetite for risk, could reap gains
from trade in those markets. The more fine-grained the products they could
buy, the better they could fine-tune their investment strategies, choosing port-
folios that exactly matched their preferences. Thus, risks would be carried by
those who were able and willing to carry them, and scarce capital would be
optimally allocated. Relatedly, it was thought that more efficient financial
markets would be able to serve as control mechanisms for those who held
control 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).
8 Lisa Herzog

Share prices provided them with a real-time feedback mechanism on how well
they were doing, and the threat of a hostile takeover, by an investor who
thought that the stock of capital could be used more efficiently, was seen as a
disciplinary mechanism on management not to squander resources (see e.g.
Emunds 2014, 70ff.).
Behind these ideas stood the “efficient market hypothesis” (see especially
Fama 1970), which holds that in efficient markets, asset prices reflect all
available information on a given asset. This hypothesis is based on the
assumption that all market participants behave rationally, or if they do not,
irrational behavior occurs in a random fashion, and rational arbitrageurs have
incentives to correct irrational behavior by betting against it.9 From this
perspective, it cannot be the case that a market as a whole deviates from the
fundamentals on which it is based; once a deviating movement starts, this
immediately creates profit opportunities for rational investors who will bring
market prices back to normal, hence there can be no price bubbles. Whether
or not the efficient market hypothesis possesses any plausibility is hotly
debated among economists; Eugene Fama, one of its most prominent defend-
ers, continued to argue against the possibility of bubbles—or at least against
the usefulness of the concept—even after the Great Financial Crisis (Cassidy
2010). Among his most prominent critics are behavioral economists, for
example Robert Shiller, who not only takes into account a more empirically
robust picture of human nature, but who was also one of the first to warn that
the US real estate market might be subject to overheating (Shiller 2007).
Another problem with the efficient-market hypothesis is that, if true, it
paradoxically destroys the incentive to acquire information, because market
participants must assume that all available information is already reflected in
prices (Grossman and Stiglitz 1980). Lomansky (2011, 150ff.) describes this
paradox nicely:
A rational agent will, then, choose to free-ride on the cognitive undertakings of
others. The greater the confidence in the overall efficiency of the market, the
greater the incentive to take a free ride. At the extreme, everyone is free-riding on
everyone else, and no one is actually monitoring the condition of the underlying
assets. 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 profit. 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.
 Introduction: Just financial markets? 9
tends to be self-refuting. The more it is believed, the less accurate it becomes. The
more skeptical market players are of its truth, the more effort they will invest in
monitoring their potential investments, the overall effect of which is to enhance
efficiency. That will then create conditions under which those who subscribe to
the 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 main-
stream of economics had told. At the time, many scholars and practitioners
found it sufficiently plausible to base their behavior on it. Some economists
focusing on financial markets certainly held more sophisticated pictures that
included questions about market failure, stability, or the relation between
financial markets and the real economy, but especially in the curricula of
undergraduate economics courses, these more nuanced accounts had played a
marginal role. In a macroeconomic environment that seemed fairly stable, the
narrative of efficient markets seemed accurately to grasp the economic reality.
But if one puts together the various idealizations and generalizing assumptions
it contains, one arrives at an all-too-rosy picture of what financial markets are
and how one should see their role in society. Adair Turner, former head of the
UK’s Financial Services Authority, provides a good summary of the conclu-
sions that market participants, regulators, and politicians had drawn on the
basis of these assumptions:
A strongly positive assessment dominated among finance academics and at least
implicitly among regulators. It reflected the assumption that free competition was
bound to result in useful rather than harmful activity, and that increased financial
activity, by making more markets complete and efficient, must be improving
capital allocation across the economy. (2016, 28)
Important institutions such as the International Monetary Fund shared these
views. It was assumed that more efficient financial markets would, in the final
analysis, lead to economic growth, which would benefit everyone in society.10
Almost everyone trusted that the recent “innovations” in risk management
had really made the whole system safer and more stable. Critics of this broad
consensus seemed outlandish Cassandras.
But then, the Great Financial Crisis happened. It arose around a specific type
of financial products: securitized loans. Securitization is a financial practice that
had started with Fannie Mae and Freddie Mac, two government-sponsored
entities 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 confirm 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.
10 Lisa Herzog

a portfolio and then to divide it up into different “tranches” with different risk
and 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 US
treasury bonds. Investors trusted these ratings, because rating agencies had
been perceived as doing a good job in the past when evaluating bonds and
shares and had thereby acquired a reputation as trustworthy, competent
evaluators (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 and
credit derivatives were often traded many times, between multiple institutions;
they seemed to offer what had previously been taken to be an impossible
combination: high returns and safe investments.
As long as there was general optimism—not to say enthusiasm—and
everyone believed in the prevailing narrative, the trade with these products
soared. Once market participants started to realize, however, that they had
become entangled in a huge speculative bubble, and once it became clear that
the US government would not bail out all endangered institutions—as
evidenced by the fall of Lehman Brothers in September 2008—trust and
optimism 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)—which
magnified the losses from small rises in defaults rates, because numerous
traders could insure against each default, and which had been vastly
underpriced—that brought the financial system to a halt, because markets
for CDSs were extremely complex and lacked transparency, and no one
understood any more who had which exposure (see e.g. Reiff 2013, 240ff.).
The Great Financial Crisis showed that the models on which investors had
based their decisions, and banks and regulators their risk assessment, had
been fundamentally flawed. They had assumed that future events could be
described in terms of quantifiable risks, excluding the possibility of nonquan-
tifiable uncertainty (Knight 2006 [1921], III.VII.3), which created a sense of
security because quantifiable risks could be “managed” by using other finan-
cial instruments. Many models also included an assumption that different
events, for example the development of asset prices in different market
segments, would be independent from one another. This is a crucial assump-
tion for the strategy of managing risks through diversification: if risks occur
jointly, spreading one’s investments across a large number of assets is of no
help. More generally speaking, the likelihood of non-normal events, in the
sense of large deviations from the general trend, was underestimated because
investors often used normal approximations, rather than functions that
allowed for greater “tail risks.” Also, the past data on which many calculations
were based did not go back very far in time—and many asset prices had
been relatively stable within this time window, which also contributed to
 Introduction: Just financial markets? 11

underestimating volatility. In other words: the techniques used for reducing

risks were unable to capture precisely those cases in which risk management
would be most needed, that is, a downswing of whole markets. This possibility
was conceptually excluded, creating the impression that one had finally
mastered the art of risk management.11
In hindsight, it seems hard to deny that much of what had taken place in
financial markets before the Great Financial Crisis was anything but product-
ive: trading in financial products as such cannot, after all, increase the
economic 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 these
benefits 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 these
expanded activities in financial markets, for example in terms of increasing
instability. And, as some commentators have pointed out (e.g. Mullainathan
2015, Turner 2016, 27), there is also another price one has to consider from a
social perspective: the opportunity costs of resources, and especially the skills
of well-educated and highly motivated young people being employed in
finance 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 these
costs—but this does not mean that they do not exist.

1.3 FINANCIAL MARKETS AND JUSTICE —THE

PRIMA F ACIE E VIDENCE

Why, then, should one subject financial markets to an inquiry from a perspec-
tive of justice? And what is the relevant notion of justice anyway? The chapters
of this volume all share a liberal egalitarian perspective, which is based on the
assumption of the equal moral value of all individuals. This implies that all
members of a society have certain basic rights, and that certain forms of
discrimination, e.g. along the lines of gender or race, must be excluded. Based
on these shared assumptions, however, different theorists of justice have drawn
different conclusions with regard to other features of a just society, and
especially 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).
12 Lisa Herzog

Western12 societies (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 in financial
markets in recent years was unjust, no matter how exactly one defines
“justice.” One could start with the cases of spectacular fraud such as Madoff ’s
Ponzi scheme or the manipulation of the LIBOR. On the one hand, one might
say that these cases are theoretically easy to grasp because they violated
existing laws. On the other hand, they raise questions that are anything but
trivial about the possibility of law enforcement in systems that are as complex
as today’s financial markets, and in which the likelihood of discovery of
fraudulent behavior is therefore lower than in other areas of life. A second
fact about financial markets that should catch the attention of those interested
in justice is the sheer size of the profits that were made in them, including the
size of bonuses for individual traders or managers. Standard economic theory
predicts that when high profits are being made in a market, this attracts
competitors and profits are driven down again. This did not happen, nor do
all those who made a fortune before the Great Financial Crisis seem to have
suffered the ensuing losses. Moreover, the group of “winners” did not repre-
sent a cross-cutting section of society; for one thing, they were predominantly
white and male. While a full analysis of the effects of financial market
liberalization and the ensuing Great Financial Crisis on distributive justice
would 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 com-
parisons to counterfactual scenarios face methodological difficulties, it seems
fair to say that these effects deserve close scrutiny.
The Great Financial Crisis was, after all, not a natural disaster. Turner puts it
starkly: “This catastrophe was entirely self-inflicted and avoidable” (2016, 2).
The greatest loss, in his view, was the slowing down of economic growth in the
years since the crisis—a view that is probably based on the assumption that
higher growth could have benefited everyone in society. The relationship
between inequality and financial expansions is a complex one, because inequal-
ity arguably also drove some of the financial excesses and hindered the
economic recovery (Turner 2016, chap. 7). What is especially interesting,
from a perspective of justice, is the structural impact of financial markets on
wider 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.
 Introduction: Just financial markets? 13

they would play with their own money and, at worst, go bankrupt, which might
impose unjust costs on others, but which is still a somewhat limited problem.
But today, we are in a situation in which what happens in financial markets has
a much broader impact—not only on the distribution of resources, but also on
the distribution of opportunities and the distribution of power in society.
Almost everyone in society relies on using financial services, after all. Even
bread-and-butter financial products are connected to the rest of the financial
system; financial markets have become closely interwoven with the fabric of our
societies. So it does seem worth asking: do financial markets, in the way in which
they are currently organized, make our societies more or less just?13
A further point deserves emphasis. There is a broad scholarly consensus
that the Great Financial Crisis was not caused exclusively by individual or
corporate misbehavior, but also by structural features, for example incentives
to take excessive risks because the gains were privatized while losses could be
socialized. Otherwise one might think that normative issues in financial
markets raise only questions of individual morality or of the morality of
financial companies—questions that are addressed mostly in the discipline
of business ethics. The perspective taken in this volume does by no means
deny the importance of individual behavior. Nonetheless, the focus is
mostly on institutions and the ways in which they coordinate and regulate
behavior. Normative perspectives on institutions are the domain of political
philosophy—and more specifically theories of justice—rather than ethics. In
recent years, there have been some calls to bring political philosophy and
business ethics closer together (e.g. Heath, Moriarty, and Wayne 2010). While
there 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 of financial markets and
providing an overview of the chapters of this volume, however, we should
subject to scrutiny one of the premises that underlie the very notion of
“financial markets”—namely that the financial system as we know it can be
described as a subgroup of the institution we call “market.”

1.4 ARE FINANCIAL MARKETS—M A R K E T S?

This question, to be sure, is a polemical one. But it is nonetheless worth asking,

given the degree to which financial 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
benefit the global poor (for a discussion see Emunds 2014).
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