Every financial panic is unique in its details but they all have the same root cause. Too many people are looking for a free lunch in a futile zero-sum game. Basically the various actors – bankers, investors, borrowers, civil servants, politicians and the public – are enticed by moral hazard in different disguises. They are fooled by shortsighted greed in the unsustainable chase for ever higher returns on overabundant capital. Responsible, value-creating plus-sum players are engulfed in the frantic zero-sum play but should come out stronger after the dust has settled. More control is no panacea but increasing and enforcing transparency can never be wrong. Honesty and openness are after all the preconditions for value-creating plus-sum games.
Over a long time span we have amassed a significant amount of moral capital as reflected in successful spiritual and material plus-sum play. Still morality remains a relatively weak force and our personal interest usually overshadows the common good. Therefore we need constitutions, laws and regulations – the written rules of the game – to support the broad-based-trust capital which is indispensable for democratic societies and a dynamic market economy.
But constitutions must be followed, laws must be enforced and regulations supervised by sufficiently dependable politicians, judges, police officers and civil servants. Corruption is an ever-present temptation at all levels of an extended formal organization. Supervision, auditing etc. is only a partial solution. Even if we dismiss outright fraud, written rules cannot cover all loopholes. In this grey area, actions are not strictly illegal but may be morally dubious.
In on open market economy the grey area is particularly prominent. Business behavior enjoys wide latitude and there is ample room for deceptive zero-sum play. To preserve trustful plus-sum play we rely on a set of shared values, a sense of fair play – the unwritten rules of the game. Thus in the last instance we have to rely on the moral rectitude and good will of the relevant actors.
The demand for moral capital increases with the size and complexity of the interactive network. The financial system is particularly dependant on trust. Thus we must try to minimize temptation while leaving room for innovation and freedom of action. Rules and regulations certainly need upgrading but above all we must find ways to leverage our scarce moral capital.
A moral hazard appears when there is a temptation to betray the trust of a counterparty in the context of legality. All decision-makers are facing moral hazards and the quality of a leader is dependant on his or her capability to steer clear of these traps. Customers and employees, pensioners and taxpayers are all potentially exposed to insidious machinations. By definition the agent – be it economic, legal, medical or political – is the consummate insider. He or she is always tempted to take advantage of this position to the detriment of a trusting counterparty. The agent may not be breaking the law but he or she is breaking trust.
In finance the conflict between agent and principal looms large. Owners, creditors and investors are more or less at the mercy of agents which are subject to the temptation to preferentially advance their own interests. The classic case is risk-taking with other people’s money. For the reckless agent there is often a huge upside with a non-existent or very limited downside risk. Speculation as such is not the culprit. It self-evidently serves a useful purpose as market maker and harbinger of price fluctuations. But the conception that speculation can be both profitable and safe – that there is a free lunch – is pernicious to say the least.
In the world of finance, competition in corner-cutting can be particularly devastating. Increasing the debt leverage by circumventing the rules becomes the name of the game; greed overcomes fear by a large margin. When a few aggressive players go out on a limb, there is little cause for concern. But unfortunately they offer an irresistible pointer towards superior profitability. Everybody wants to have a share of the free lunch and caution is thrown to the winds. The ensuing stampede then puts the whole system at risk.
Bad policies have played their part in the financial debacle. Politicians are no less susceptible to moral hazard than bankers and businessmen; power and prestige can be more tempting than mere money. The housing boom in the United States (and elsewhere) was underwritten by government guarantees, tax deductions for interest payments and limited liabilities for housing loans. Double taxation of equity income is another reason for increasing indebtedness.
Wherever we turn, moral hazard is at work in tempting financial managers to corrupt the unwritten charter of behavior, which keeps the wheels of finance moving with a minimum of friction. The sense of fiduciary responsibility wears thinner and thinner in the face of the rising tide of profits and the apparent absence of risk. But fear suddenly overcomes greed when, for any reason, the thin crust of mutual trust is punctured. The outcome is a full-blown financial panic as the abundant supply of capital dries up and everyone runs for the exit.
What can be done?
In the long term we can (and should) hope to acquire more moral capital. In the meantime we must try to reduce moral hazard all around. An overhaul of the relevant rules and regulations is certainly called for. The problem is that the creativity of competitive markets might get lost in a thicket of bureaucratic red tape. We need indirect means to support our week morality.
Transparency is a fundamental condition for plus-sum play and the most powerful way to keep people honest. The relevant records of major financial institutions should, for example, be accessible to all comers. Secrecy is an advantage in zero-sum play but it should not be granted to organizations which depend on public trust, serve an important public interest and enjoy implicit or explicit public guarantees. Openness serves all parties except those who are looking for an unfair advantage.
Well-informed media reporting is more efficient than any official system of supervision. Corporations could watch out for any improper move by competitors and act as whistleblowers. Moreover, responsible trade organizations could take preventive action by exerting peer pressure, for example by ostracizing misbehaving members. Dubious innovations should be exposed and condemned, not copied. In general, increasing transparency on the company level would be a boon to all parties, provided that illicit cooperation is avoided.
Governments are the lenders of last resort. They have lately been forced to intervene in the market for securities and become the buyer of last resort. This necessity should be turned into a virtue. The state could take a proactive role in preventing excessive bubbles and busts by well-advised moves in the financial markets. With an unlimited access to capital, well-heeled sovereign actors will inevitably make money in market operations against disruptive instabilities. State intervention presents its own set of moral hazards but it is high time that the taxpayers are compensated for the implicit guarantees they provide through their representatives.
Progress in macroeconomic understanding can ameliorate the ill effects of economic downturns. But a dynamic market economy is inherently unstable and its complexity will defeat any attempts to create a recession-free economy. Moreover, the rationality of the economic actors is not a given. Besides our moral infirmity, we suffer from emotional swings or plain stupidity which undermine good judgment and contribute to financial instability. Our very human shortcomings ensure that there will be bumps and occasional potholes on the road towards increased prosperity.
To minimize moral hazard, the rules of the economic game should aim at aligning the self-interest of economic actors to the interests of society at large. This will diminish futile zero-sum games and encourage plus-sum oriented company strategies. Ideally the profit of a business should be proportionate to its contribution to the common weal.
The root cause of financial foul-ups is the illusion that a profitable business be sustained solely by playing astute zero-sum games. In 2006, 33 % of the corporate profit in the United States was made in the financial sector. The illusory rise in values and the attached easy profits create an invisible, collective debt which must invariably be paid back when the bubble bursts. Unfortunately many winners escape unscathed while a substantial part of the losses falls on the taxpayer.
The proximate cause of the financial meltdown is the erosion of trust between financial institutions. The ultimate cause is the moral deficit of the relevant actors, including the public. If the household savings rate falls close to zero (as it did in the United States), economic responsibility has been deserted, not only by a few greedy bankers but by the majority of the population. Sound capitalism is after all about accumulating capital.
A moral deficit always hits home albeit with some delay. That is the way we learn good behavior, not least in matters of economy. Eventually the moral lesson is forgotten as new ways are invented to eat your cake and retain it. A shortcut to wealth is opened for a few clever or lucky free-riders. But a whole nation can only build on adding value by honest plus-sum play. Our prosperity grows in direct proportion to the available moral capital.