What is Philosophy of Finance? For many who work in or close to finance, it is how they go about achieving their objectives. These include investing successfully; managing risk prudently, and acting ethically. But to academic philosophers, it’s an under-explored corner of the philosophy of economics.

1. The Metaphysics of Finance: what is there?

Finance consists in, amongst other things: its people or ‘actors’; its institutions, for example, banks, insurance companies, pension funds, corporates, and non-profit organisations; financial instruments and transactions, contracts, markets and marketplaces; but also language, culture, norms, laws, rules & regulations, and data. It can also be argued that finance also includes theories, ideas, and beliefs about financial assets, which in turn arise from its participants, using systems, tools, and operations within and between institutions.

Finance has some interesting characteristics, arguably more akin to art than to natural sciences, in that the complexity of its contracts and agreements is created and managed by the beliefs and norms of people, institutions and laws, rather than arising from any natural, physical laws. This leads to interesting challenges as to what we can say uncontroversially about financial objects regarding concepts of value or risk. These questions are often epistemic in nature: to what extent can we know anything about uncertain future outcomes?

2. The Goals, Merits and Challenges of Finance

Finance is typically viewed as an enabler of exchange in goods and services for mutual benefit, solving the problems of non-coincidence of wants and timing. Neoclassical economics has built the theoretical case for profit maximation and the pursuit of self-interest leading to maximised total utility, which finance facilitates. More recently, finance itself has become a source of significant profit and wealth creation for financiers, something which reached a peak in 2008 before the GFC and again potentially in the early 2020s. with this has come increasing inequality of all kinds, which raises moral and political questions that challenge the role of finance. These questions are addressed in more detail below.

3.  Epistemic challenges: in finance, what constitutes knowledge?

Given that knowledge is classically defined as justified true belief, what counts as knowledge poses a problem for finance. Much of finance concerns claims on uncertain future outcomes, such as those represented by shares, loans, and bonds. The key parameters are expected return, and financial risk. As De Bruin et al. note: [The treatment of] “financial risk is especially interesting from a philosophical viewpoint since it represents the financial industry’s response to epistemic uncertainty” (SEP PMF, Sec 2).

Much of the financial services industry is devoted to the management of this risk. A key problem for finance is the extent to which inductive reasoning is used to predict or estimate future returns and risk. Epistemic failings are often uncovered during or after a crisis in finance, whereby previously accepted beliefs about prospects, risk and return are retrospectively judged as false, unrealistic, or even fraudulent. Ex post financial explanations often seem ad hoc and quite different to ex ante predictions, rendering finance ‘unscientific’. The concept of exhibiting epistemic virtue, for example behaviours that include honesty, transparency, rigour, open-mindedness and best-practice appears especially important to individuals and collective organisations in finance (SEP PMF, Sec 2).

4.  The existence and validity of underlying theories: e.g. rational choice, utility maximisation and efficient markets.

Modern finance is constructed on the foundations of theories, models and laws mostly proposed and implemented by business schools and financial institutions in the second half of the twentieth century. Such theories include Markowitz’s Modern Portfolio Theory (1952), Modigliani and Miller’s capital structure irrelevance theorem (1958), Treynor and Sharpe’s Capital Asset Pricing Model (1962) & (1964), Fama’s Efficient Markets Hypothesis (1965), the Black-Scholes Options pricing model (1973), and many derivative theories of the above.

Economists have debated the various merits of these theories, but despite strong criticism and evidence to the contrary, these theories generally persist as reference points and indeed standard education and dogma for all financial activity today. These laws, theories and models are undoubtedly instrumentally useful as they provide a common measurement framework, language and set of cultural norms that facilitate many financial transactions. However often the predictions of laws, theories and especially models are often found to break down spectacularly, with little or no warning, leading to crises and shocks, and their explanations are found wanting. This phenomenon will be familiar philosophers of science who are understand ‘paradigm shifts’ that occur in science (Kuhn, SSR, 1962).

Some philosophers of economics challenge the validity of rational choice theory. They also question whether utility maximisation theory is consistent with actual behaviour. They also ask: how useful are models as idealisations or descriptions of the real world? Or do they in fact shape, create or ‘perform’ the economy? These topics are of great significance to financial markets but are generally under-explored in finance.

5.  Finance and ethics

Following de Bruin et al., an analysis of ethics in finance should be divided into at least four areas. First, moral suspicion; second, issues of fairness; third, that individuals have certain basic rights in finance; and fourth, that financial agents have broader social responsibilities (ibid).  Each of these is explored briefly below.

5.1     Moral criticism

First, the criticism of the pursuit of money ‘for its own sake’ can be traced at least to Aristotle (Politics, 1252a), to the Bible, and to a wide range of traditional ethical commentators (SEP PMF, Sec. 4). Aristotle held that objects should be valued in ways that reflected their fundamental nature. Money, being merely a means to achieve other ends, is therefore not a ‘good’ in itself. Second, it has been argued that that seeking profit, especially excess profit, is not consistent with virtue ethics, although this is contested, for example by Adam Smith (1776), and later by the neoclassical economists. Modern societies have wholeheartedly backed the benefits of finance to economic growth and welfare. Third, a Kantian approach demands that our actions are guided by fairness or duty, not by profit, and that it is not enough that a profitable act is right, it must be done because it is right (Kant, 1785) (SEP PMF, Sec. 4).

De Bruin et al. note that from the above it follows that the idea that making money from money (interest, usury, etc) must be even more morally suspect. This view has been contested and largely dismissed in global finance, aside from in certain religious financial activities such as Sharia banking, although some political viewpoints see debt, especially when taken on from a position of weakness, as unfair, unjust, or “odious” (Graeber, 2011). A further criticism equates financial investment with speculation and thus gambling, an activity often seen as morally unwelcome (SEP PMF, Sec. 4).

5.2   Fairness

At least four areas can be discussed that bring into question fairness in finance. These are broadly: asymmetric of information and power, conflicts of interest, extreme inequality, and fraud.

First, participants in finance often encounter asymmetric information. The nature of trade is that the seller of a good or service may know more than the buyer. How much information should be disclosed is a matter for negotiation and convention, but often the larger or more powerful parties in finance can take advantage of smaller, weaker parties. Furthermore, such asymmetric information can be used to engage in ‘insider trading’ whereby a privileged agent can illegally act ahead of others to their own advantage. The area of insider trading sheds a difficult light on how to view ‘legitimate’ knowledge asymmetry, as many forms of profit in finance are derived from acting before others gain knowledge or understanding of an asset’s value, due to superior data, better interpretation, or faster technology.

Second, parties are often faced with conflicts of interest, whereby an action by an agent may affect the fortunes of more than one stakeholder. This is particularly the case in finance where intermediaries are used, as specialisation in intermediation, such as brokerage services, brings significance advantages of scale and expertise (SEP PMF, Sec. 4).

Third, some have noted that common structures of finance, especially debt and equity financing, lead to large shares of profits in ventures accreting to a very small group, often the founders and majority ‘equity’ holders, resulting in extreme inequality between owners and management on the one hand, and employees and customers on the other. This challenge has been defended: that founders and equity holders are rewarded for the greater risks they take. However, the outsized fortunes of modern billionaire CEOs and entrepreneurs brings this issue into sharp relief.

Fourth, outright deception and fraud are possible in finance due to the extensive role of agents as intermediaries, coupled with asymmetric information and power. Taking advantage of weaker, less informed customers seems an outright wrong which is not limited to finance but nevertheless seems to arise regularly in finance. This may be due to the arcane and intangible nature of many financial products (SEP PMF, Sec. 4).

5.3     Rights

Financial economics is strongly committed to the idea that markets comprise agents seeking to maximise utility, even in the face of significant evidence to the contrary (SEP PMF, Sec. 3). One consequence is that philosophers of finance often tacitly assume utility maximisation behaviour governs all market participants without considering rights. Some have argued that the following rights exist:

• Access to basic banking, loans, and microfinance at reasonable cost
• The right to reasonable debt rescheduling or forgiveness
• To make one’s own financial decisions (even bad ones)

Access to rudimentary finance and banking can be seen as a basic right as well as a social good in developed economies, as has been de facto provided free or subsidised in many societies. Whilst such rights do not have the same status as the right to life, security and liberty, there seems societal agreement that such rights are reasonable. Lending, when priced as risk-based, is often prohibitively expensive (consider credit card APRs, payday lending and other forms of unsecured finance) so some have also argued for cost-capping as a regulatory policy.  Others have argued further: that financial consumers should also be protected in case of missed debt payments in the form of rescheduling or forgiveness, rather than incurring punitive fees. One problem for defining this within rights is the moral hazard involved, as well as the fairness argument from those who do repay their debts.

Libertarians believe that individuals should be free to make their own decisions regarding finance, just as in other spheres of life. This seems defensible but runs into the problem of incomplete information and understanding, unrealistic expectations, and predatory sales of fraudulent investment ideas. As most financial returns are uncertain, a challenge for defenders of these rights is where to draw the line between freedoms and protection. Empirical studies, especially from behavioural finance, have shown that individuals can be unreasonably optimistic, biased or blind to risk when making investment decisions, and so granting ‘the right to make poor decisions’ is contestable. Against this, libertarians argue against paternalistic policy and regulations if individuals are fully informed and act freely.

5.4      Social Responsibility

The discussion about social responsibility of business and therefore finance which enables it often builds on the argument between Friedman (1970), who states that the primary goal of shareholders in a firm is to maximise profits; and his critics, such as Freeman (2010), who argue that a firm has additional stakeholders and social responsibilities. Since finance underpins the initiation and growth of all industries, issues and problems with finance typically concern the whole global economy. Whilst Friedman defends the domain of companies as limited to the resources that they control within the rule of law, critics emphasise the effect on the background conditions of environment, labour availability and conditions, and social structures & fairness. Modern business and finance has become sensitive to these issues especially since the financial crisis of 2008, often under the umbrella of “Environment, Social, and Governance” (‘ESG’) issues. From this has arisen the concept of “Socially Responsible Investing” (‘SRI’), whereby actors in finance may actively consider the non-financial implications of their actions. This has led to drivers of investment decision-making moving beyond the traditional parameters of return and risk, with the increasing complexity that this brings (SEP PMF, Sec 4.3).

5.5     Finance and Politics

The relationship between finance and politics is often a question of the balance between private (e.g., banks, insurance companies, private capital) and public elements (e.g., governments, central banks, regulators) (SEP PMF, Sec. 5).  Different political systems, both traditional democracies sand autocracies incorporate varying levels of market freedom and state intervention. All modern political systems exhibit a mixture of these, and the interconnectedness of private capital to public institutions such as money-issuing central banks and government borrowing and lending creates a problem of moral hazard: that private institutions may take more risk that their capital supports, since public institutions will backstop their activities the save the wider economy. This often leads to a cyclical nature of first, modest governmental involvement in markets; then significant state intervention after crises, and eventually demands for that intervention to be rolled back.

Politics also has a role to play in mediating the levels of inequality that arise from the financial system. A market-based system may charge weaker parties such as marginalised individuals a greater fee to account for greater risk, and conversely offer better terms to already wealthy individuals. Similar biases may exist resulting from gender, race, or class. Financial discrimination for risk or other factors exacerbates inequality and so political intervention may be desired to counteract it.  Because finance enables large transactions such as mortgages for houses or loans for small businesses, etc., the impact is often significant and magnified.

The question of who gets to create money and finance is also a political issue. Traditionally this has been controlled by agencies such as central banks, who in turn regulate private banks and credit creation through a variety of mechanisms. Different political ideas prefer control of the money supply using different mechanisms, and these have implications for who benefits. Most recently, the emergence of cryptocurrencies such as Bitcoin offer a significant challenge to traditional monetary systems and political thinking.

Financial systems also have consequences for global fairness and fairness. The existence of a hierarchy of currencies, with the US dollar acting is the de-facto global reserve currency, results in power imbalances between richer creditor, and poorer debtor nations.  Often political differences are played out in financial markets in terms of pricing or access to capital. As multi-national corporations such as Google and Amazon have increased in systemic importance and wealth, this brings an additional power dimension alongside national politics.

 

Bibliography, General

SEP PMF             Stanford Encyclopaedia of Philosophy

Philosophy of Money and Finance: de Bruin, Boudewijn, Lisa Herzog, Martin O’Neill, and Joakim Sandberg, “Philosophy of Money and Finance”, The Stanford Encyclopedia of Philosophy (Winter 2020 Edition), Edward N. Zalta (ed.)
https://plato.stanford.edu/entries/money-finance/

SEP P of E           Stanford Encyclopaedia of Philosophy

Hausman, Daniel M., “Philosophy of Economics”, The Stanford Encyclopedia of Philosophy (Winter 2021 Edition), Edward N. Zalta (ed.)
https://plato.stanford.edu/entries/economics/

Aristotle                 Politics, in The Complete Works of Aristotle, J. Barnes (ed.), Princeton: Princeton University Press, 1984

Graeber, David        Debt: The First 5000 Years, New York: Melville House (2011)

Kant, Immanuel     Groundwork (1785)

Smith, Adam          An Inquiry into the Nature and Causes of the Wealth of  Nations, London: W. Strahan and T. Cadell. (1776)

 

Philosophy of Science

Kuhn, T               The Structure of Scientific Revolutions, Chicago: University of Chicago Press (1962)

 

Financial Theories and Models

Markowitz, H                                Modern Portfolio Theory (1952)

Modigliani, F & Miller, M          Capital structure irrelevance theorem (1958)

Treynor, J & Sharpe, W             Capital Asset Pricing Model (1962) & (1964)

Fama, E                                          Efficient Markets Hypothesis (1965)

Black. F and Scholes, M             Options pricing (1973)