Free market madness and human nature presented at Harvard University


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Free market madness and human nature presented at Harvard University. The presentation is about 2008 financial crisis and human nature.

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Free market madness and human nature presented at Harvard University

  1. 1. Free Market Madness & Human Nature: Can Islamic Finance Help? Necati Aydin, Ph.D. Director of Neuroeconomics and Well-being Program Florida State University, Tallahassee, FL Email: [email_address] or [email_address] Ninth Harvard University Forum on Islamic Finance Building Bridges Across Financial Communities March 27-28, 2010 Harvard Law School Cambridge, Massachusetts
  2. 2. <ul><li>Recognize and act on certain elements of human nature (three pillars of capitalism) </li></ul><ul><ul><li>Self (ego) </li></ul></ul><ul><ul><li>Interest (nefs) </li></ul></ul><ul><ul><li>Mind (rationality ) </li></ul></ul><ul><li>Effectively use the market mechanism based on s elf-interest (ego-centered human nature) </li></ul><ul><ul><li>Profit driven capitalists </li></ul></ul><ul><ul><li>Pleasure (utility) driven consumers </li></ul></ul><ul><li>Unprecedented success in production and consumption </li></ul>
  3. 3. Source: The Industrial Workers of the World (IWW)
  4. 4. <ul><li>Ignore or deny some aspects of human nature (Adam Smith’s “moral sentiments” and Weber’s “spirit of capitalism”) </li></ul><ul><li>Create perfect conditions for economic and financial tsunami (ignite economically suicidal behaviors due to unrestrained interests of animal soul & ego) </li></ul><ul><li>Fail to bring happiness (or maximize cumulative utility) despite increase in consumption (“American Paradox”, “Progress Paradox”, or “Capitalist Paradox”) </li></ul>
  5. 5. “ Free Market Madness” <ul><li>The root cause of all possible causes is the animal soul with a greedy and selfish nature. </li></ul><ul><ul><li>Politicians who acted upon the greed for vote </li></ul></ul><ul><ul><li>Capitalists who acted upon the greed for profit maximization, and </li></ul></ul><ul><ul><li>Consumers who acted upon the greed for pleasure made the crisis inevitable. </li></ul></ul>Most economists did not foresee the 2008 crisis mainly due to “the profession’s blindness to the very possibility of catastrophic failures in a market economy…. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets – especially financial markets-….” (Krugman, 2009)
  6. 6. <ul><li>Perfectly rational </li></ul><ul><li>Predictably irrational </li></ul><ul><li>The boom in the housing market </li></ul><ul><li>The boom in consumer spending </li></ul><ul><li>The free market madness drivers </li></ul><ul><ul><li>Utility maximizing populist politicians </li></ul></ul><ul><ul><ul><li>De-regulation in the financial market </li></ul></ul></ul><ul><ul><li>Short-term profit driven capitalists (creditors) </li></ul></ul><ul><ul><ul><li>Availability of cheap an excessive credits </li></ul></ul></ul><ul><ul><li>Short-term pleasure (utility) driven conspicuous consumers </li></ul></ul><ul><ul><ul><li>Unsustainable consumption </li></ul></ul></ul>In 2007, Eugene Fama, the intellectual father of the efficient market theory, stated that “the word “bubble” drives me nuts,” and defended his theory even for the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It is typically the biggest investment they are going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
  7. 7. <ul><li>The “dream” turned to a “nightmare” </li></ul><ul><li>Death of trust in the financial market </li></ul><ul><li>The cost to the federal government </li></ul><ul><ul><li>$700 billion for TARP </li></ul></ul><ul><ul><li>$787 billion for AER P </li></ul></ul><ul><li>The cost of shoring up U.S. banks might reach $4 trillion </li></ul><ul><li>World-wide losses of U.S. originated loans might reach $2.7 trillion (GFSR) </li></ul><ul><li>The full cost to the U.S. economy might be $15 trillion (Jeffrey Sachs) </li></ul><ul><li>The global damage is much greater </li></ul><ul><ul><li>Developing countries are being affected disproportionately </li></ul></ul>In its editorial, the voice of capitalism for over 165 years, expressed concern that “economic liberty is under attack and capitalism, the system which embodies it, is at bay.”
  8. 8. “ Free Market Madness” and Animal Spirits &quot;Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.&quot; (John Keynes, 1936, pp. 161-162) “ The cause of our economic despair, however, is human nature ’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship .” Alan Greenspan, 2008 “ I made a mistake ,&quot; Greenspan said to the House Committee on Oversight and Government Reform, &quot;in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms&quot; (The Washington Post, 2008)
  9. 10. <ul><li>Who am I? </li></ul><ul><li>Who are YOU? </li></ul><ul><li>Who are THEY? </li></ul><ul><li>Who are WE? </li></ul><ul><li>“ Outer universe” </li></ul><ul><li>vs. </li></ul><ul><li>“ Inner universe” </li></ul>
  10. 11. <ul><li>“ He that knows himself knows others.” Colton </li></ul><ul><li>“ Knowing yourself is the beginning of all wisdom.”      Aristotle </li></ul><ul><li>“ Knowing others is intelligence; knowing yourself is true wisdom. Mastering others is strength, mastering yourself is true power.”      Lao-Tzu </li></ul><ul><li>“ Knowledge is to know something Knowledge is to know yourself If you do not know yourself What is the point of your knowledge?” Yunus Emre </li></ul>
  11. 14. <ul><li>Self-interest and free market </li></ul><ul><ul><li>Free Market Success </li></ul></ul><ul><ul><li>Free Market Failure </li></ul></ul><ul><li>Subjective well-being and free market </li></ul><ul><ul><li>Happiness paradox </li></ul></ul><ul><li>Invisible hand(s) and free market </li></ul>
  12. 15. <ul><li>Key Residents of Human Palace </li></ul><ul><li>The spiritual heart/qalb (the king) </li></ul><ul><li>The conscience/vijdan (the judge) </li></ul><ul><li>The mind/aql (the advisor) </li></ul><ul><li>The animal soul/nafs (the elephant) </li></ul><ul><li>The self/ana (the guard) </li></ul>An Islamic Theory of Human Nature Bediuzzaman Said Nursi (1878-1960)
  13. 16. Self Empowered Transformed Humangod Master and owner Shirk (partnership with God) Capitalism Self Weakened Trained Servant to God Servant and trustee Shukr (giving thanks to God) Islam
  14. 18. Sensual pleasures Self-acceptance pleasures Social pleasures Emotional pleasures Intellectual pleasures Aesthetical pleasures Conscience pleasures Altruistic pleasures Spiritual pleasures Egoistic pleasures
  15. 19. Materialism/ capitalism serves The elephant The guard Sensual and egoistic pleasures Unsustainable consumption and Destructive technology Islam serves The king The judge The advisor Spiritual and intellectual pleasure Sustainable consumption and constructive technology
  16. 20. <ul><li>Growing interest in Islamic finance (Vatican) </li></ul><ul><li>Moral failure and Islamic finance </li></ul><ul><ul><li>Assumption about human nature </li></ul></ul><ul><ul><ul><li>predict and prevent irresponsible and irrational behaviors </li></ul></ul></ul><ul><ul><li>Moral constraints (moral/religious intervention) </li></ul></ul><ul><li>Market failure and Islamic finance </li></ul><ul><ul><li>Market discipline </li></ul></ul><ul><ul><li>No riba and gambling (qimar) </li></ul></ul><ul><ul><li>Restrictions on the sale of debt, short sales </li></ul></ul><ul><ul><li>Sales- and lease-based modes of financing (murabaha, ijara, salam, istisna and sukuk) </li></ul></ul>
  17. 21. <ul><li>Yes, if it sticks with its main principles: </li></ul><ul><li>Real asset based financial instruments </li></ul><ul><li>Risk sharing through ownership (no pain, no gain!) </li></ul><ul><li>Genuine transaction with full intention of giving and taking delivery (No muta’ financing) </li></ul><ul><li>No second hand market for debt </li></ul><ul><li>Moral education and training </li></ul><ul><li>Developing new instruments without compromising </li></ul><ul><li>Educating public about the merits of its instruments </li></ul><ul><li>No credit for personal consumption </li></ul>