A crisis of morals, not just of finance

The meltdown in the world economy calls into question the idea that economics and ethics belong in two different pigeonholes. 
Richard Bastien | Apr 23 2009 | comment  

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.

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