Although its value has been poo-poohed over the years, the concept of morality has not been so easily disposed of. Noted historian Paul Johnson declares that morals are at the heart of the current financial crisis in a philosophical sense. Writing in Forbes Magazine, Johnson says:
The financial crisis, detonated by greed and recklessness on Wall Street and in the City of London, is for the West a deep, self-inflicted wound. The beneficiary won’t be Russia, which, with its fragile, energy-based economy, is likely to suffer more than we shall; it will be India and China. They will move into any power vacuum left by the collapse of Western self-confidence. If we seriously wish to repair the damage, we need to accept that this is fundamentally a moral crisis, not a financial one. It is the product of the self-indulgence and complacency born of our ultraliberal societies, which have substituted such pseudo-religions as political correctness and saving the planet for genuine distinctions between right and wrong and the cultivation of real virtues.
But the importance of morality goes beyond being a figure of speech or a nod to piety, Karl Okamoto, at the Drexel School of Law, believes that we need to incentivize morality in transactions by making changes to regulation, otherwise our financial system will continue to be subverted. Okamoto writes we are in this mess because we have failed to control “moral hazard”.
The assertion of this Article is that the root cause of the current financial crisis is systemic moral hazard. Systemic moral hazard poses a unique challenge in crafting a regulatory response. The challenge lies in that the best response to systemic moral hazard is “preventive prediction.” It is inherently difficult to reward individuals for producing preventive prediction. Therefore markets fail to produce it at optimal levels, and thus prevent systemic moral hazard and the kind of crisis we are facing.
The difficulty in valuing preventive prediction is seen when we model how risk managers make decisions regarding the prevention of excessive risk. The model reveals that the balance is easily tipped in favor of risk-taking that leads to systemic failure and broad social harm. The model also reveals how regulation might work to reset the balance to one that is superior for society. We achieve this by imposing two requirements on all asset managers in the market: we require them to put their own money at risk in their trading decisions, and we require them to use “best practices” in managing risk. These prescriptions arise out of a regulatory strategy that accepts the need to balance the benefits of risk-taking in financial markets (and the consequent inevitability of some financial failure) with the desire to avoid excessive risk-taking and the costs of systemic collapse. It is a strategy that focuses on those instances where we cannot trust ourselves to be prudent.
In the both the Johnson and Okamoto senses the practical problem is how to ensure people act under incentives which are aligned with the desired outcomes. It is easy for people in actual positions of power or influence to pursue a separate agenda and serve those goals instead of the stated ones. In the case of financial transactions, the natural temptation is to put your pocket-book ahead of those of the investors. Hence, Okamoto recommends that all asset managers be required to “put their own money at risk in their trading decisions”. This concept is familiar to everyone, even Joe the Plumber, in the expression “put your money where your mouth is.”
In the Western morality that Paul Johnson criticizes, “a farcical coalition of fashionably liberal academics on the make, assorted eco-crackpots and media wiseacres” pursue their fantasies with other people’s money and other people’s futures. It’s Okamoto’s moral hazard situation in another setting where well-to-do social activists instead of asset managers take risks with things that have merely been entrusted to them, presumably because they are the Great and the Good. Johnson tells the following story: “I had to laugh when a Chinese visitor recently said to me: ‘I see you’re going back to the windmill in Britain. We Chinese cannot afford that.’” Al Gore can afford a windmill. The question is whether the average working stiff can.
ABC News describes how Hugo Chavez is making friends with Hollywood’s “A List”. He’s invited a number of well known entertainment figures to view his revolution. “Venezuelan President Hugo Chavez’s list of Hollywood buddies is getting larger. The latest A-list acquaintance is an intriguing friendship that’s sprung up with Oscar-winning actor Sean Penn — in a trend critics say is aimed at improving the left-wing leader’s international reputation. … Other high-profile visits have been made by actors Kevin Spacey, Danny Glover and Tim Robbins, all of whom have been vocal critics of President Bush, Chavez’s so-called nemesis. Last year, supermodel Naomi Campbell got a one-on-one with the man for a magazine interview, during which she called him a “rebel angel” and he playfully invited her to touch his muscles. “ A poor Venezuelan might not be able to afford the luxury of a Hugo Chavez, but Hollywood can. And guess who wins?
This is the reason for the underlying unease with the “redistributive” financial system proposed by Barack Obama, which was highlighted by a comparison in tax plans between the two financial candidates by Harvard economist Greg Mankiw. At one level, the problem is not the numbers, it’s the principle of putting someone else, besides yourself, in control of who gets what. Why? The moral hazard problem of course.
Some people of course, have no problems leaving their fates to others. Recently a 52 year old man in El Paso jumped to his death from a highway overpass leaving a note “asking for Barack Obama to help his family”. Tigerhawk asks whether the man from El Paso should expect help before or after any assistance to Obama’s uncle and aunt who are living in a run down dump not far from Harvard. Nobody is under any obligation to his help his relatives — except a moral one — but how certain are we that asset managers and politicians will do what they promised? Many sectors we had counted on to lead society are now marching to a drummer of their own. If so, maybe the right watchword for the times isn’t ‘Hope’ or ‘Change’ but ‘remember who your’re working for’. That would be the government, right?