What I propose to
show is that the current economic and financial crisis results not
only from faulty policies, but more importantly, from serious moral
deficiencies. I will also argue that attempts to counter the crisis
should, in addition to tackling major policy issues, call into
question the widespread notion that economics and ethics belong to
entirely separate worlds. 

People are prone to
pointing to a particular villain bearing the main responsibility for
the crisis. Some say it’s the government, others greedy bankers.
But as Richard Parsons, the new board chairman of Citigroup Inc.
wisely noted, “everybody participated in pumping up this balloon
[and] everybody has some part of the blame”. Everybody means
governments, financial institutions, credit-rating agencies and
consumers. To understand how the crisis came about, we must assess
the role played by each group.

First, let us look
at governments.
In a book titled Getting Off Track, Stanford economist John Taylor provides
an analysis of the crisis that is summarized in the subtitle: How
Government Actions and Interventions Caused, Prolonged and Worsened
the Financial Crisis. Taylor, who was
also deputy undersecretary of the US Treasury from 2001 to 2005,
argues that the sudden collapse in the US housing market was caused
by bad government policy – in particular, bad monetary policy. More
specifically, from 2002 to 2004, the Federal Reserve Bank adopted a
policy of easy money by keeping the federal funds rate below 2
percent. This policy led to excessive risk taking and gave rise to a
housing boom followed by a bust.

According to Taylor,
the US government also worsened the crisis by encouraging
“government-sponsored” enterprises such as Fannie Mae and Freddie
Mac to expand and buy mortgage-backed securities, including risky
subprime mortgages. Indeed, these two enterprises were specifically
put outside the supervision of the Securities and Exchange
Commission, which oversees the activities of most financial
institutions, and put by Congress under the supervision of a separate
supervisory body (the Office of Federal Housing Enterprise Oversight)
that actually encouraged Fannie Mae and Freddie Mac to increase its
lending to subprime borrowers.

Financial
institutions also bear a major
responsibility in the present crisis. While much has been said about
he outrageous compensation that their managers have been getting, of
even greater concern is the systemic danger arising out of the
financial derivatives they have developed.

In a book titled Infectious Greed: How Deceit and Risk
Corrupted the Financial Markets, law
professor and former investment banker Frank Partnoy, shows that
while derivatives can be quite useful when used in an appropriate
manner, they have often been used to subvert financial laws and
regulations, both domestically and internationally. He explains how
Wall Street developed the practice of selling derivatives that
carried massive risk to customers who did not understand what they
were buying. He details the specific wrongdoings of companies like
Enron, Global Crossing and WorldCom. He also describes how lobbying
was used to keep regulators at bay and how ineffectual politicians
can be. One example he gives is that of the chairperson of the US
Commodities Futures Trading Commission, who exempted important parts
of Enron’s business and, a few weeks later, was appointed to
Enron’s Board of directors. Partnoy shows how recent financial
scandals are rooted in the culture of greed that pervades Wall
Street.

One should also note
that the expertise of large financial institutions has been much
exaggerated. In 2006, the Chairman of the Federal Reserve, Ben
Bernanke, raved about how market risk and credit risk had become
“increasingly sophisticated” thanks to banks of all sizes having
made “substantial strides over the past two decades in their
ability to measure and manage risks”. We now know that risk
management was almost a joke. For example, the Financial Products
Division of the American Insurance Group (AIG) made $2.5 billion in
pre-tax profits in 2005 mainly by providing insurance on complex but
poorly-understood financial products. As of last fall, AIG had
outstanding insurance on more than $400 billion worth in securities.
To date, the US Government has committed more than $150 billion in
investments and loans to cover losses that AIG’s supposedly
sophisticated risk managers assessed over the past 10 years.

The third group that
has contributed significantly to the economic crisis is made up of credit rating agencies,
such as Moodys, Standard & Poors and Fitch. Their role consists
in rating, inter alia, various financial instruments, such as
Collateralized Debt Obligations (CDOs) – securities backed by a
pool of bonds, loans and other assets. In testimony before Congress,
representatives of these agencies acknowledged that they knew that the CDOs were high risk and that they were paid by the
banks issuing these CDOs rather than by their purchasers. They also
admitted that the sale of the CDOs allowed the issuer banks to make
billions of dollars of profit and that the rating agencies collected
millions of dollars in fees.

Of
even greater concern, however, is the fact that: (a) the rating
agencies gave the CDOs the highest possible rating (AAA) in order to
get the lucrative business from the issuing banks; (b) the AAA
ratings were totally spurious; and (c) the fraud never would have
occurred if Congress had passed a law requiring the rating agencies
to be compensated by the purchaser of the CDOs rather than by the
issuing banks. Since Congress was well aware of the practice, one can
only wonder why it did not act to change the law in question.

The fourth group
bearing some responsibility for the crisis is that of financial
consumers. This is evidenced by an
abundance of cases of small borrowers who lied about their income,
assets and liabilities when they applied for subprime loans. The
counterpart to that, of course, is that many lenders did not exercise
due diligence in the granting of loans. Indeed, there is ample
evidence of millions of mortgage loans made in full knowledge that
the borrower would not be able to repay.

Putting the
pieces together

A thorough
understanding of the crisis requires some grasp of the interactions
between the four groups mentioned. A fascinating analysis of these
interactions has been provided by William K. Black, Executive
Director of the Institute for Fraud Prevention from 2005-2007 and
author of a book titled The Best Way to
Rob a Bank Is to Own One. As Black
describes it in a recent interview with Bill Moyers on PBS, as well
as in The Huffington Post,
the current crisis was driven, not by incompetence, but rather by
organized fraud.

Black’s
allegations are supported by two documents which, he says, “everyone
should read to better understand the crisis”. The first, written by
Standard & Poor, “demonstrates that the investment and
commercial banks that purchased nonprime loans, pooled them to create
financial derivatives, and sold them to others engaged in... willful
blindness. They did not review samples of loan files because doing so
would have exposed the toxic nature of the assets they were buying
and selling. The entire business was premised on massive lie – that
fraudulent, toxic non prime mortgage loans were virtually risk-free.”

The second document
is an analysis done by Fitch, also a rating agency, of a sample of
nonprime loan files after the collapse of the secondary market in nonprime lending. It
concludes that “the result of the analysis was disconcerting at
best, as there was the appearance of fraud or misrepresentation in
almost every file.”

Black refers to the
credit rating agencies as fully complicit to this massive fraud
because they never even attempted to evaluate the creditworthiness of
the securities backed by nonprime loans, before giving them an “AAA”
rating. The other accomplices were all the government regulators,
officials and politicians directly responsible for oversight, who
Black accuses, first, of deliberately ignoring the fraud and, second,
of intentionally covering up losses by refinancing bad loans. On the
basis of this evidence, Black concludes that “many of the big banks
are deeply insolvent due to severe credit losses”. However, “those
banks and Treasury don’t know how insolvent they are because they
didn’t even have the loan files”.

What
are the solutions?

Solutions proposed
to deal with the financial have focused on re-regulation and disposal
of banks’ toxic assets.

A lot has been said
about the need for greater and better
regulation of financial institutions.
And, indeed, there are several factors that militate in favour of
some revamping of financial regulatory systems. First, considering
that the lack of information on financial derivatives is making it
extremely difficult to assess the health of many banking
institutions, it seems some disclosure requirements on such
derivatives are called for. Second, it is now clear that heads of
financial institutions failed miserably in upholding any kind of
“private market discipline” and some rules must be put in place
to prevent other similar failures. Third, there is probably some need
to assess the role of derivatives such as collateralized debt
obligations (CDOs), the object of which is to increase bank leverage
and to take debt off balance sheet, which reduces transparency.
Finally, given the role of greed in the crisis, it may well be that
constraints on the compensation of top executives is in order.

The second remedy to
the current crisis is the disposal of
banks’ toxic assets. Most economists
acknowledge that there can be no return to normal lending practices
until banks dispose of them. The Financial Stability Plan announced
by Treasurer Tim Geithner in February proposes to deal with this
matter through a $500 billion Public-Private Investment Program
designed to provide government capital and financing to leverage
private capital to buy up toxic assets from banks. This would result
in a cleansing of the banks’ balance sheet and allow them to get
back into the business of lending.

However, The Program
has come under substantial criticism because it carries the risk of
large hidden subsidies to banks’ shareholders and creditors, and
also because it leaves the financial oligarchs responsible for the
crisis unscathed. As Simon Johnson, former chief economist of the
IMF, noted in the latest issue of The
Atlantic, much of the public funds
appropriated to deal with the crisis “was used to recapitalize
banks, buying shares in them on terms that were grossly favourable to
the banks themselves. As the crisis has deepened... the government
has gotten more and more creative in figuring out ways to provide
banks with subsidies that are too complex for the general public to
understand.”

Johnson also
considers the US government’s approach grossly “inadequate to
change the behaviour of a financial sector accustomed to doing
business on its own terms, at a time when that behaviour must change” (his emphasis). He characterizes this approach as a “policy
by deal” whereby the Treasury “is trying to negotiate bailouts
bank by bank, and behaving as if the banks hold all the cards...
Under these conditions, cleaning up bank balance sheets is
impossible.” As an alternative, Johnson proposes a nationalization
of weaker banks, but one that would not imply permanent state
ownership. More specifically, he envisages a “government-managed
bankruptcy process” which would “allow the government to wipe out
bank shareholders, replace failed management, clean up the balance
sheets, and then sell the banks back to the private sector”.
William Black advocates similar measures, emphasizing the need to
“get rid of the people who caused the problems” and of closing
failed institutions.

A
moral crisis

As the foregoing
makes clear, there are several economic and financial policy issues
that must be addressed to resolve the current crisis. But assuming
that we find all the right solutions to all these problems, can we
assume that we will then have eliminated or significantly reduced the
risk of economic and financial instability?

The response given
by many is that all that is required for the efficient functioning of
a free market economy is the establishment and enforcement of proper
rules by the State. Free markets and greed, they say, produce optimal
outcomes for society through the operation of the “invisible hand”.
The current crisis makes this view laughable.

The first lesson to
be drawn from the current crisis is that the behaviour of lenders,
borrowers, financial managers and rating agencies is not always
consistent with established rules. People easily abuse those rules,
especially when there is a prospect of making large sums of money.

The second lesson to
be drawn is that full compliance with established rules does not
guarantee stability and the absence of abuse. The reason for this is
that the economic and financial world evolves constantly and quickly,
so that rules meant to deal with today’s problems soon become
obsolete.

Edmund Burke, the
great conservative thinker of the late 18th century, reminds us that
“History consists, for the greater part, of the miseries brought
upon the world by pride, ambition, avarice, revenge, lust, sedition,
hypocrisy, ungoverned zeal, and all the train of disorderly
appetites...” Genuine reform, he adds, requires that we distinguish
between, on the one hand, “the causes of evil which are permanent”,
i.e. the vices just enumerated, and on the other, “the occasional
organs by which they act, and the transitory modes in which they
appear”. Burke explains as follows why State-set rules cannot
guarantee virtuous behaviour on the part of business people:

Seldom
have two ages the same fashion in their pretexts and the same modes
of mischief. Wickedness is a little more inventive. Whilst you are
discussing fashion, the fashion is gone by. The very same vice
assumes a new body. The spirit transmigrates; and, far from losing
its principle of life by the change of its appearance it is renovated
in its new organs with the fresh vigour of a juvenile activity. It
walks abroad; it continues its ravages; whilst you are gibbeting the
carcass, or demolishing the tomb. You are terrifying yourself with
ghosts and apparitions, whilst your house is the haunt of robbers. It
is thus with all those, who attending only to the shell and husk of
history, think they are waging war with intolerance, pride, and
cruelty, whilst, under colour of abhorring the ill principles of
antiquated parties, they are authorizing and feeding the same odious
vices in different factions, and perhaps worse.

Those who think that
all that is required to remedy the current situation is some
tinkering with existing rules assume we can dispense with the need
for moral agents. In the words of T.S. Eliot, they seek “systems so
perfect that no one will need to be good.” In effect, they are
“discussing fashion” and “attending only to the shell and husk
of history” because they fail to recognize that men can be as
creative in wickedness as in goodness.

What this implies is
that there can be no stable and reliable economic system without a
moral culture. An ethics of utility, which reduces the moral worth of
an action to its overall utility – often interpreted as its dollar
value – simply will not do. We need an ethics of virtue that
emphasizes character formation.

Richard Bastien
worked 31 years as an economist in the Canadian Ministry of Finance
and is a founding member and regular contributor to Égards
(www.egards.qc.ca),
a French-language conservative quarterly.