The Financial Crisis: Government Intervention and Moral Failure
[29.06.2009, Samuel Gregg, LECTURES]

Introduction 1

‘Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice.’

The great Scottish philosopher and founder of modern economics, Adam Smith, had it basically right when he described the essential pre-conditions for widespread economic prosperity. But if the current financial upheaval teaches us anything, it should be how much market capitalism depends upon most people developing and adhering to some rather uncontroversial moral virtues. Smith himself always understood this, which is why his Wealth of Nations of 1776 should always be read in light of his 1759 treatise, The Theory of Moral Sentiments.

It seems, however, unlikely at this point that this will be one of the lessons learnt when the current financial crisis has been relegated to the pages of history. While we have heard much mention of the impact of greed on Wall St, the City of London, and other financial centers around the world, it is comparatively rare to find any analysis that takes the moral dimension of the credit crisis especially seriously. A predictable by-product of the 2008 financial crisis was a renewed wave of moral condemnation of market capitalism, invariably from those who might be called “the usual suspects”. Germany’s finance minister at the time, for example, proclaimed that “Anglo-Saxon” capitalism was finished. Equally unsurprising was the near-universal insistence of leaders of governments and international organizations around the world that the key to resolving the financial crisis and preventing similar occurrences in the future was to increase the regulation of banks and the financial industry. Unfortunately such comments on the current crisis and proposed solutions tend to reflect an ignorance of how particular financial devices, ranging from interest-rates to short-selling, actually work. Nor, I think, do they reflect a sound understanding of the nature of morality and the vital – indeed indispensible - role that it plays in building and sustaining free market economies. To this extent, such comments have, I fear, actually hindered sound moral analysis insofar as they have focused attention on areas rather marginal to the economic and moral dimensions of the financial crisis.

It is now over 18 months since the credit crunch began wrecking havoc throughout the global economy. Never before, it seems, have we been so aware of how dependent our economies are upon the willingness to lend and borrow. Since August 2007, we have seen numerous banks and financial houses enter bankruptcy. In the United States, the Federal Reserve has assumed an 80% stake in America’s biggest insurance company. The mortgage giants Freddie Mac and Fannie Mae have been taken over by the US government. Financial institutions in America and Europe have written off billions in losses. In Europe and America, governments have taken large stakes in banks unprecedented in history. There is considerable speculation that the British government may have to turn to the IMF for assistance in addressing the British economy’s problems. The Bank of England has more-or-less warned Gordon Brown’s government that its approach of high borrowing, high spending, and high taxing when it comes to addressing Britain’s recession is beginning to border on the irresponsible. Then of course there is the human dimension – the level at which most people have experienced the reality of the recession. The IMF is projecting that Slovakia’s GDP, for example, will contract by 2.1% in 2009. 2 Among other things, this is likely to mean higher unemployment for Slovakia after several years of declining unemployment. Unemployment continues to rise in Europe and the United States and, despite some signs that the rise is slowing, it is likely to continue rising. Across the globe, people’s careers, families, and lives have been shattered. Everyone is asking: ‘Who’s next?’

There has been no shortage of analyses attempting to study the crisis in strictly economic terms. Phrases such as ‘overexposure to high-risk investments,’ ‘suspension of withdrawals from funds invested in illiquid credit securities,’ and ‘margin-calls forcing hedge funds to liquidate good assets’ dominate the discussion. All these and other expressions have real meaning and accurately describe elements at work in the economic storm that has wrecked such havoc. Unfortunately the language of these commentaries sometimes distracts our attention from the human dimension involved. Like other elements of the market, financial businesses do not consist of faceless entities, anonymous group-dynamics, or even ‘the gnomes of Zurich’ (as anti-Semites and conspiracy theorists imagine). Real human beings, actions, and choices are at the heart of the world’s bourses: that is, real people who create wealth, respond to incentives, make honest mistakes, and sometimes behave irresponsibly, even immorally.

This evening, I would like to take some of your time to think through where we might say with some confidence that government intervention and moral lapses, both in choices and character, have contributed to the financial crisis. My comments assume, of course, that there is moral good and moral evil; that it can be known to people through – among other means - their use of right reason; and that human beings and human institutions can make free choices and therefore are indeed masters of their destinies. These assumptions, I might add, may seem uncontroversial to you, but I can assure you that they are vigorously disputed by perhaps even a majority of Western intellectuals, philosophers, and economists today. In part, this flows from the soft and hard relativism that dominates much elite and popular opinion. But it also owes something, I would argue, to the tendency of many post-Keynesian schools of economics to focus on macro-economic aggregates, to reduce economics to applied mathematics, and to downgrade the importance of complex human beings who do not always choose morally and rationally when it comes to making economic choices.

As you know, there is no one single cause that explains the financial meltdown. Some of the candidates include loose monetary policy by the Federal Reserve, massive bank overleveraging, and the American subprime-mortgage implosion, not to mention the social-engineering interventionist programs pursued by Fannie Mae and Freddie Mac. This evening, however, I am going to focus on two aspects of the problem that underline some of the moral causes driving the crisis: first, monetary policy and mortgages; and second, failures in the securities-ratings industry. I will then show how some responses to the recession on the part of policy-makers raise profound questions concerning whether they have learnt anything from past errors. Finally, I will conclude with some remarks about how the credit crunch may teach us, whether we like it or not, that the very practice of lending and accepting credit is highly dependent on some very basic, uncontroversial moral habits.


Before looking at these matters, however, I want to specify the primary ethical lens that I will be using to explore these issues. One of my working assumptions is that whether it was borrowers lying in their loan applications, or lenders neglecting to do the most basic due diligence, or political pressures being bought to encourage financial institutions to lend money to people manifestly unable to make their payments, or securities ratings agencies becoming mired in conflicts of interests, many of these sins constitute failures in prudence. 3 The ancient Greeks as well as Christian medieval philosophers, especially Thomas Aquinas, viewed prudence as the cause and measure of all virtues. They understood prudence to be the auriga virtutum: the charioteer of the virtues. Prudence is the cause in the sense that the virtues, understood as the ‘perfected ability’ of individuals as persons (i.e., creatures with intelligence and free will), can only be realized when they are founded upon prudence; that is to say, upon the perfected ability to make right decisions. An individual, for example, can only live the virtue of temperance when he has acquired the habit of deciding correctly the actions to take in order to master his instinctual cravings.

Prudence is considered the measure of moral virtues insofar it provides a model of ethically good actions. A market trader, for example, draws upon his experience and all the data available to him at a given moment and decides that it is beneficial to sell stock A at 5pm tomorrow and buy stock B today. The content of the decision (e.g., the stock, amount, time and means) is the product of an act of prudence. The actual carrying out of the decision may involve other virtues like fortitude (doing it in spite of the risk) and justice (doing his job properly because it is what he owes in justice to his company and his family).

Like all the virtues, prudence has its own integral parts, all of which must be present if an act is to be a complete or perfect act of the virtue. The following characteristics constitute the integral parts of prudence:

  • Intelligentia: an understanding of first principles, such as ‘don’t steal’.
  • Docilitas: this is a kind of open-mindedness which recognizes the true variety of situations to be experienced, which does not limit itself to accepted or popular wisdom, and which involves a willingness to make use of the experience of others to make prudent decisions. This might also be understood as humility.
  • Caution: the willingness to take risks while mitigating the same risks as far as possible.
  • Discursive reasoning: the willingness to research and compare alternative possibilities.
  • Foresight: the ability to estimate whether a particular action will lead to the realization of our goal.
  • Memoria: An accurate memory in the sense of memory that is true to reality.
  • Shrewdness: the capacity to judge a situation by oneself and quickly.
  • Circumspection: the ability to take all relevant circumstances into account without becoming paralyzed by indecision.
When we think about these parts of the virtue of prudence, I think that you may begin to see its relevance to our subject this evening. Without gradually acquiring most or all of these qualities, it is arguable that someone working in the world of finance will either not last very long or will continue to make some very bad decisions. The very same qualities are surely essential if one is going to be a successful central banker, precisely because monetary policy is surely one of the most inexact sciences in the world.

Monetary Policy and Mortgages

Most people know that the credit crisis is directly related to the collapse of the housing bubble in the United States. Most also know that the collapse owed a great deal to the massive growth in the subprime mortgage industry which began unraveling as early as mid-2006. Some people, however, have not made the connection to monetary policy. There is little doubt that the Federal Reserve contributed to the bubble in house prices by lowering interest rates earlier in the decade and keeping them low. This lowering occurred primarily to diminish the impact of the collapse of the dot-com bubble in late 1999. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. It believed that interest rates could be lowered safely because the inflation rate was low. The problem, however, was that the Federal Reserve’s inflation figures were flawed. It is often said that good central bankers know to be skeptical of data and to keep questioning it, if only to force economists to keep verifying it. But because they failed to do so, the Federal Reserve kept interest-rates low for far too long, thereby allowing a flood of cheap money to enter the market, much of which went into the housing boom. This was not simply policy-misjudgment in the sense that much monetary policy seems dominated today by the imperative of avoiding recessions at all costs, regardless of the fact that recessions are sometimes necessary to correct imbalances of equilibrium and to allow resources to be invested more efficiently. It also represents, I submit, profound failures of foresight, caution, humility, and discursive reasoning on the Federal Reserve’s part.

Similar failures are also apparent among other players in the mortgage fiasco, most notably those selling and buying mortgages, as well as politicians determined to defend the indefensible lending policies of Fannie Mae and Freddie Mac. There is a common assumption that the housing market’s collapse flowed from sub-prime lending to people who simply could not afford to pay back the high-interest loans. There is some truth to this. But it does not account for the fact that a good amount of sub-prime lending went to relatively well-off people hoping to make a killing in the American housing boom that, to their misfortune, began imploding last year. Not only did some of these individuals unreasonably assume that house-prices could only continue to rise at an unsustainable annual rate of almost 11%. A good number of them also violated some basic elements of prudence. An early 2008 BasePoint Analytics report states, for example, that almost 70% of mortgage early-payment defaulters made fraudulent misrepresentations on their original loan applications – that is, they lied about factors such as their income, assets, and liabilities. In other words, a good number of commercial arrangements, many of which were used as the foundation for an increasing number of securities and equities, were based on untruths about assets and untruths about persons. Such actions are already illegal, so extra regulation is unlikely to deter future misrepresentation. Indeed, the only sure way to address this situation is for people to stop lying. Knowing and choosing the truth, it seems, is not as dispensable for harmonious human existence and economic relations as some imagine.

Unfortunately, many banks and other lenders neglected to do even the most rudimentary checks on some lenders’ applications, thus violating a basic duty of justice that they owed to their shareholders. Sometimes this resulted from their interest in creating as many mortgages as possible in order to consolidate them into mortgage-based securities and then sell them off to investment banks and hedge funds. On other occasions, however, it was a direct result of legislation – such as the now infamous 1995 Community Reinvestment Act, which compelled banks to make credit available to low-to-moderate-income consumers. CRA-influenced loans do not in themselves seem to have resulted in a high rate of defaults, perhaps because they only constituted about a quarter of all subprime loans. They did, however, contribute to a weakening of lending standards throughout the American economy – a weakening encouraged and abetted by activist groups, not to mention American congressmen and senators determined to increase home-ownership, regardless of people’s financial situations, and over and against market-rates of interest.

The problem was compounded when Fannie Mae and Freddie Mac begin easing the credit requirements on loans that it purchases from banks and other lenders. In 1999, Fannie Mae began a pilot program involving 24 banks in 15 markets - including the New York metropolitan region – to encourage these banks to extend home mortgages to individuals whose credit was generally not good enough to qualify for conventional loans. Fannie Mae, America’s biggest underwriter of home mortgages, did not lend money directly to consumers. Instead, it purchased loans that banks make on what is called the secondary market. By expanding the type of loans that it bought, Fannie Mae hoped to spur banks to make more loans to people with less-than-stellar credit ratings. While Fannie Mae executives stressed that the new mortgages would be extended to all potential borrowers who could qualify, they added that the move was intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings.

The irony, of course, was that home ownership had already grown significantly among minorities during the 1990s economic boom. The number of mortgages extended to Hispanic applicants jumped by 87.2% between 1993 and 1998. During that same period, the number of African Americans who secured mortgages to buy homes increased by 71.9% and the number of Asian Americans by 46.3%. Increasing home ownership among these groups, it seemed, needed only economic prosperity rather than the easy-credit policies associated with the CRA or Fannie and Freddie.

But further complicating the problem was the fact that the Community Reinvestment Act provided Fannie Mae and Freddie Mac executives with the legislative leverage they needed to raise their own subprime lending quotas, the mortgages of which they then used as a basis for their own securities marketed through Fannie and Freddie’s own hedge fund. This gave Fannie and Freddie a vested interest in preventing the many attempts at controlling their lending policies made by successive treasury secretaries from 2000 onwards. By the end of 2000, subprime loans accounted for almost half of Fannies and Freddie’s total business. This may also explain the millions of campaign donations made by Fannie and Freddie executives to those politicians on the House and Senate banking committees willing to protect Fannie and Freddie – which were, after all, government-sponsored enterprises – from those determined to rein in lending policies that were, as we know now, out of control.

So what moral failures are involved in the overall subprime fiasco? Once again, it would appear that several elements of prudence were violated. First principles such as ‘don’t lie’ were systematically violated by thousands of subprime lenders. Caution was also thrown overboard in the name of easy profit and the desire to subordinate long-established lending precautions and the workings of market exchange to the demands of politically-driven mortgage-lending. A certain detachment from economic reality also featured, most notably in false and in some instances arrogant expectations about the on-going profitability of investments in property. It is also clear that shrewdness, in the sense of being able to accurately judge economic realities for themselves, was absent from the calculations of many borrowers, lenders, and Congressional politicians.

Another failure of prudence in the subprime meltdown was been an unwillingness to accept that what economists call “moral hazard” – a term derived from the insurance industry of the eighteenth century – can be encouraged by many of the policies I have just described. Moral hazard is a term commonly used to describe those situations when a person or institution is effectively insulated from the possible negative consequences of their choices. This makes them more likely to take risks that they would not otherwise take, most notably with assets and capital entrusted to them by others. The higher the extent of the guarantee, the greater is the risk of moral hazard.

Fannie Mae and Freddie Mac are prominent contemporary examples of this problem. Implicit to their lending policies was the assumption that, as government-sponsored enterprises with lower capital-requirements than private institutions, they could always look to the Federal government for assistance if an unusually high number of their clients defaulted. In a 2007 Wall St Journal article, the Nobel Prize-winning economist Vernon Smith noted that both Fannie Mae and Freddie Mac were always understood as “implicitly taxpayer-backed agencies.” Hence they continued what are now recognized as their politically-driven lending policies until both suffered the ignominy of being placed in Federal conservatorship on 7 September 2008.

Outside the immediate realm of prudence, grave violations of justice – in the sense of what banks and financial institutions owe to their owners and investors – also occurred, most notably in their failure to do due diligence on potential and established borrowers. The virtue of temperance was also largely forgotten. The thrifty, even parsimonious Adam Smith would have been appalled by the ‘I-want-it-all-now’ mentality that has helped the personal savings-rate in America to hover around 0 percent since 2005 - the lowest rate since the Depression years of 1932 and 1933. It is arguable that the same mindset encouraged many on ‘Wall Street’, anxious to enhance their bonus prospects, to sell securities they knew were based on collapsing subprime foundations to ‘Main Street’ buyers who themselves were blinded by the prospects of quick profits. Of course such actions are not illegal. I am also skeptical about trying to prevent them through regulation. As Johan Norberg observes, ‘regulation . . . is always a response to the last crisis. Generals fight the last war and always try to avoid the mistakes made then. So we get new rules that target the mistakes that everybody already knows they must avoid. The next possible crisis and its causes are so far unknown, and our regulations may have no effect or even make them worse.’ 4 Norberg’s claim is, I believe, substantially correct. No-one, however, seems anxious to defend the morality of some of the choices made on Wall St, Main St, and in Washington DC that contributed to the subprime mortgage meltdown that contributed to the credit crisis.

Ratings Agencies and Conflicts of Interest

As mentioned, the first signs of a meltdown in the subprime mortgage market occurred in late 2006. It was not, however, until late August 2007 – that is, eight months later – that greater awareness of the subprime problem became more widely known in the world’s financial centers. This is curious, because one of the services of securities ratings agencies – firms such as Moodys, Standard & Poors, and Fitch Ratings – is to provide investors with early warning when there are significant problems with a security or equity package. But here too, it seems, imprudent behavior contributed to the failure of some rating agencies to provide timely and accurate insight into what was going on. Many of these agencies, it seems, apparently acquiesced in conflict-of-interest situations.

As is well-known, rating agencies derive their income from rating bonds and other securities issued by financial institutions. They do so by assigning an investment with a score, such as an AA or - even better - Moody’s highest score of AAA, thereby providing actual and potential investors with some sense of an investment’s creditworthiness – be it good or bad. A bad rating usually indicates that there is a high risk of default. Given that rating agencies are paid by the issuers of bonds and securities they rate, it has often been suggested that this leads to conflicts of interests. Rating agencies deny this. They point out that they are open about the fact that they are paid by the financial institutions issuing the bonds and securities they rate. They also argue that their ratings are not compromised by that relationship, precisely because to do so would undermine their reputation as honest and accurate assessors. Lastly, they point out that the analysts working at rating agencies are not compensated on the basis of the level of ratings that they assign to different bonds and securities.

The subprime fiasco, however, raises significant questions about the accuracy of this picture. Since 1995, increasing numbers of asset-based securities that used American subprime mortgages as collateral were purchased in unprecedented numbers by individuals and institutional investors. These securities were in turn consolidated into collateralized-debt obligations (CDOs) and collateralized-loan obligations (CLOs). The risks associated with different CDOs and CLOs are assessed by securities-ratings agencies. It is one of their most profitable activities. The problem, however, is that many financial institutions - knowing that ratings help determine the value of CDOs and CLOs - began approaching rating agencies some years ago to ask their advice on how to structure CDOs and CLOs in order to maximize their value.

But when the subprime mortgage market on which many CDOs/CLOs were built began imploding, some ratings agencies were slow to concede something was wrong. Some ratings agencies did start putting out warning signs as early as mid-2006. Yet they did not significantly downgrade their ratings of the very same investments. A common claim by some ratings agencies is that they were afraid that significant downgradings would further undermine already weakening capital markets. There is no reason not to take this claim at face-value. But it may also be true that many ratings agencies, fully aware that many investors know how deeply such agencies had been involved in structuring these securities, may have themselves become conscious that their objectivity – i.e., their primary asset - would be called into question.

Of course the very moment that ratings agencies were asked to become involved in the structuring of the assets they were supposed to be assessing, their moral antennae should have begun quivering. It is very difficult to provide objective assessment of risks associated with particular securities when you have helped structure the very same securities. This, however, did not deter some ratings agencies from involving themselves in structuring CDOs and CLOs based on subprime-based securities.

This is not to suggest that rating agencies were somehow engaged in sordid financial swindles. The point is that when ratings agencies were asked by banks to become involved in structuring CDOs and CLOs, they should have said: ‘No. That would compromise our capacity to objectively assess the risks associated with your securities. Our objectivity is our greatest asset. It can lend value to your assets. But only if our assessments remain objective and detached.’ The fact that some ratings agencies did otherwise suggests, I submit, significant failures of judgment and character on their part. In terms of the virtue of prudence, it reflects a major absence of the quality of foresight, in the sense that it was reasonable that any relatively clear thinking person, especially those with enormous experience of the securities-ratings business, should have recognized what was likely to eventuate from this type of activity.

To address these problems with securities-ratings agencies, it does appear that the legislatures around the world will introduce legislation to try and prevent such conflicts of interests from happening again. Once again, however, I am skeptical that this will achieve very much. In fact, it is likely to be counterproductive. What, however, has not been highlighted is the fact that markets have already disciplined securities-ratings agencies – sometimes severely. The value of stock in many such agencies has plunged by more than 40% in some cases. This indicates that, whatever might be the agencies’ protests to the contrary, they are going to have to work hard to regain the markets’ confidence in their basic prudence and trustworthiness.

Proposed solutions and Learning-Failures

One might think that the combination of failed interventionist policies and some rather significant moral problems that have contributed to the current crisis would have shaped the response of policy-makers in ways that underscored a new skepticism about the worth of government intervention and a new emphasis on avoiding the moral hazard problem. I am afraid, however, that this is not likely to be the case. To take one example, let us examine the approach of President Obama’s new Administration when it comes to the subject of addressing one of the underlying causes of the current recession, but which is now contributing to the current climate of uncertainty: the turbulent American housing and mortgage market. The context is America, but the lessons are universally applicable.

By now, most people understand that many of the toxic financial assets held by American and European banks were premised to varying degrees on a grossly inflated housing market in America and parts of Europe. Hence, the harsh reality is that until the housing market bottoms out, it is going to be very difficult to price the real market value of these financial assets. This in turn creates uncertainty about the real value of many assets held by banks, thereby leaving many banks stranded in their present state of financial limbo, unwilling to lend and unable to attract private investors and capital. As a consequence, economic growth is stalled and will remain so until the housing market regains a state of equilibrium.

It follows that one of the fastest ways to allow the market price of the assets in question to be realized is to permit the housing market to stabilize under its own volition. There is, however, a considerable human price to be paid for this necessary process of adjustment. In some cases, it takes the form of families losing their homes through foreclosures on their mortgages. While the vast majority move quickly into rented accommodations and are in fact very likely to own a house again in the future, the social cost and psychological distress associated with home-loss should not be trivialized. Yet others face the daunting prospect of being stuck with mortgages worth considerably more than the property’s actual current value.

Naturally enough, there are plenty of people who want to see governments try to alleviate the pain, if not attempt to render the adjustment unnecessary. Thus no one was surprised when President Obama announced the federal government’s mortgage relief plan this past February 18th. It includes using $75 billion of taxpayers’ money to help approximately 4 to 5 million homeowners avoid foreclosure. The same plan also allows the Treasury Department to purchase $200 billion worth of preferred stock in the technically insolvent Fannie Mae and Freddie Mac, thus allowing the two lenders to re-negotiate mortgages with some of their clients facing difficulties. These measures follow in the wake of other smaller-scale mortgage relief strategies implemented by the Bush Administration—none of which, incidentally, slowed down the foreclosure rate across the United States.

Unfortunately, there is little reason to be optimistic about the probable effects of the Obama Administration’s interventionist approach to mortgage relief. In fact, it is most likely to be counterproductive. For one thing, it will encourage many people to stay locked—potentially for years—into mortgages that, financially speaking, they would be better off exiting. For some people, selling their home at a loss or even foreclosure would actually be a better alternative. Either scenario would enable many mortgage holders to extract themselves from an economically burdensome situation and begin the process of rebuilding their financial lives. Certainly, foreclosure will have some negative impact upon a person’s credit record, but so too will the fact of requesting and receiving government assistance in order to keep one’s otherwise untenable mortgage afloat.

At the macro-level, there is no guarantee that the envisaged intervention will stabilize the housing market. Data provided by the Office of the Comptroller of the Currency suggests that, at present, approximately 55% of those people who renegotiate their mortgages are re-defaulting within six months. This indicates that government-sponsored mortgage relief will merely delay the final reckoning for millions of people. It will also impede foreclosures from shifting properties from those unable to pay their debts, to those who can afford to buy. This transfer, along with the normal process of people buying and houses at market prices, is crucial for stabilizing the housing market, thus helping to facilitate an accurate market pricing of all those financial products built upon mortgage assets. This is critical if the banking sector’s current difficulties are to be resolved in any lasting way.

Leaving aside the economic difficulties with the Administration’s plan, there are also serious moral problems associated with such government mortgage relief efforts. Primary among these is the problem of moral hazard. Government officials, including the President, have insisted that the mortgage relief plan will not assist those who have behaved irresponsibly. But this claim is hard to reconcile with the details of the plan, released on March 4th. It makes, for instance, eligibility for what is called “mortgage modification” dependent on how much borrowers owe above their house’s current value (which is presently a rapidly-moving downward target). Eligibility also depends upon borrowers providing, among other things, an “affidavit of financial hardship.” This is a sure recipe for arbitrariness on the part of those deciding who gets relief and who does not. Defining what counts as “financial hardship” is usually a very subjective matter. It depends on factors as variant as one’s income, responsibilities, family-size, stage of life, cost-of-living differences, etc.

Even more problematic, however, is the fact that the plan avoids the issue of why some people are facing financial hardship. There is a considerable difference between, for example, a married couple with a good credit history and who are only experiencing mortgage payment difficulties because the main wage-earner has been made redundant though no fault of his own, and those individuals who freely—and, in many instances, recklessly—played the house-flipping game in order to make rapid financial gains. The willingness to take high risks is rightly associated with the prospect of large gains. But the corollary in justice is that those who take high risks must also be willing to accept the possibility of heavy losses.

As presently configured, the government mortgage relief plan actively undermines this reasonable expectation. Whether we like it or not, it will send the message to many people that they need not face up to the consequences of being financially irresponsible. Quite rightly, those home owners who have behaved prudently and continue to meet their mortgage payments, often at considerable sacrifice, will wonder why a portion of their taxes is being used to shield large numbers of people who have behaved rashly from the effects of their own actions. The end result is likely to be a community-wide increase in disavowal of personal responsibility for one’s actions in a society that increasingly struggles to accept these concepts as indispensible foundations for a free political order. Over the long term, this is likely to contribute to future economic recklessness on Wall Street and Main Street, not to mention reinforce an already complacent attitude among government officials to the moral hazard problem.

Credit and Trust: Corrupting Intangible Assets

Much more could be said about the moral problems contributing to the financial crisis, and which are still being ignored by most policy-makers. I would, however, like to turn our attention to some reflections on the institution and practice of credit itself. In the current financial environment, considerable anger has been directed against those who specialize in the credit business, especially subprime-lending, be it of mortgages or credit-cards. No doubt, some predatory lending has occurred. We need only pick up the nearest newspaper to read about elderly couples on the brink of bankruptcy because they signed mortgage agreements that they either did not understand or were never adequately explained to them by their financial advisors.

But why, some argue, should subprime-lending businesses exist in the first place? Are they not financial traps for the poor and vulnerable? Don’t they discourage prudent saving? There have even been calls for official caps on interest-rates offered by private lenders. The difficulty with some of these critiques is that they often reflect fundamental misunderstandings of the nature of credit and its underlying moral apparatus.

A revealing feature of the analyses of the borrowing and lending habits contributing to aspects of the 2008 financial crisis is that they indirectly underline the extent to which many moral philosophers and economists have forgotten that the extension and seeking of credit was a subject of considerable and often heated discussion for centuries. The very morality of charging interest on loans has been intensely debated by religious and secular thinkers for over two thousand years. Many contemporary practitioners of finance may be surprised to know that Adam Smith actually favoured usury laws. As John T. Noonan illustrates in his classic study of the Roman Catholic Church’s teaching on usury, Christianity’s internal debate about this subject lead to major clarifications of the nature of money, the development of the first “embryonic theory of economics”, and “the first attempt at a science of economics known to the West”. 5 It helped, for example, to establish in theoretical terms when money transcended its character as a means of exchange and assumed the qualities of what we today call “capital”.

Credit is about lending others the financial means - the capital - that most of us need at some point of our lives. Whether it is starting a business or buying a house, most people need capital. This means someone else such as a bank or a private lender has to be willing to take a risk. They do stand to profit if the mortgage is paid off or the business succeeds. But they also lose if a house is foreclosed or a business goes bankrupt.

Charging interest is how lenders maintain their loan’s value and make a profit (the margins of which are much narrower than most people realize), thereby increasing the sum-total of capital available in a society. But it is also their way of calibrating risk: the higher the risk, the higher the interest-rate in order to compensate for the greater possibility of loss. It follows that if interest-rate ceilings were imposed by government fiat, lenders would effectively be prohibited from charging interest-rates commensurate to the risks involved. Hence, they would be unlikely to lend capital to entrepreneurs and businesses pursuing high-risk endeavors. Many risky but wealth-creating and employment-generating activities would thus simply never occur. Legislated interest-rate ceilings would also mean that some poor people would never have the chance to acquire the capital they might need, for example, to go to university, let alone begin developing a credit-record. Entire categories of people - recent immigrants, the urban poor - could be condemned to life on the margins.

But at a deeper level, we also forget that while credit is about capital, it is ultimately about something more intangible but nonetheless real. The word ‘credit’ is derived from credere - the Latin verb for ‘to believe’ but also ‘to trust. Thus, whether it is a matter of giving someone a credit-card for the first time, or extending a small business the capital that it needs to grow into a great enterprise, providing people with credit means that you trust and believe in them enough to take a risk on their insight, reliability, honesty, prudence, thrift, courage and enterprise: in short, the moral habits without which wealth-creation cannot occur.

A moment’s thought about credit thus reminds us how much market capitalism, so often viewed as materialistic, relies deeply upon a web of moral qualities and non-material relationships. As the credit crunch has taught us, once these are corrupted, whether by basic dishonesty, excessive regulation, or political manipulation, the wheels of wealth-creation splutter and eventually grind to a halt. Businesses die; people lose their jobs; and families suffer.


And so to conclude. We should have no illusions: the modern case for the free market - so painstakingly developed against interventionists of all stripes since Adam Smith’s time - has been set back years by the current disarray on financial markets. The very same calamity, however, should remind everyone – including those who favor free markets – that loosening the political bonds imposed on economic liberty requires society’s moral bonds to be constantly renewed and strengthened. In short, we are learning the hard way that virtues like prudence, temperance, thrift, promise-keeping, honesty, and humility - not to mention a willingness not to do to others what we wouldn’t want them to do to us – cannot be optional-extras in communities that value economic freedom. If markets are going to work and appropriate limits on government power maintained, then society requires substantial reserves of moral capital. With so many people’s economic well-being now partly determined by decisions of those working in financial industries, sound moral character in their employees and directors should be a premium asset sought by any bank or financial house. Virtue is, of course, good in itself, and ought to be pursued for the sake of human flourishing rather than as simply a question of economic efficiency. But this does not mean we should close our eyes to the very real economic benefits that can flow from large numbers of people embracing the virtues. It would be a culture-changing exercise.

In this regard, it is arguable that a concern for, and attention to the virtues would mark a return to the type of political economy that was pursued during the eighteenth century by the modern thinkers who made such a substantial contribution to understanding how markets work as well as the character of the commercial society that began to spread across the globe in the last quarter of the eighteenth century. I speak of course of the Scottish Enlightenment. While Scots such as Adam Ferguson, Gershom Carmichael, Francis Hutcheson, and, of course, Adam Smith were committed to, and in many ways founded, the modern empirical approach to issues of political economy, the contemporary insistence on separating empirical analysis from normative inquiry and judgment is based on a distinction that the Scots would have found unintelligible. A similar contrast can be made with the modern tendency to judge institutions and habits solely in terms of efficiency. While the Scots certainly believed that efficiency is preferable to inefficiency, the Scots regarded utility-maximization as only one of three ends that are promoted by well-functioning institutions and processes. Scottish social science also spoke of virtue and liberty whereas ours tends to speak only of utility. They did so, in part because they believed virtue and liberty were just as real and discernible through reason as utility. But they also did so because the Scots believed that neither market economies nor commercially orientated societies will last if virtue and liberty – not just one but both - are either ignored or deemed not to exist because of the rationalist refusal to regard anything as real that cannot be quantified.

To provide a brief example of how this Scottish attention to morality might be seamlessly blended into economic analysis, let us briefly consider the issue of moral hazard. Today there is a great deal of literature on the economics of moral hazard. The same material, however, contains curiously little reflection on why the adjective “moral” is attached to the word “hazard.” Indeed, when economists started studying the subject of moral hazard in the 1960s, their analysis rarely included an explicitly ethical dimension. For the most part, this remains true today. So why do we not simply describe these situations as instances of “risk hazard”? It may be that the word “moral” reflects some innate, albeit largely unexpressed awareness that there is something morally questionable about creating situations in which people are severely tempted to make imprudent choices. To employ a loose analogy from the realm of moral theology, the one who creates “an occasion of sin” bears some indirect responsibility for the choices of the person tempted by this situation to do something very imprudent or just plain wrong. If governments and businesses took moral hazard seriously, they would make an effort to identify those state and non-state structures, policies, and practices that tempt for people to take excessive risks with their own and other peoples’ assets. They would then do what they could to minimize these instances of moral hazard. The economic price might be fewer booms. But economic growth over time would likely be steadier. The chances of mild or severe recessions would also be reduced.

This type of analysis, one which the Scots would have recognized as similar to their own, is surely even more essential today if we are to avoid the fatal intersection of government intervention and moral failure that, I submit, has contributed so much to the present financial crisis and which, I fear, failure on the part of policy-makers to acknowledge will create similar problems in the future. Because in the end, no amount of regulation — heavy or light — can substitute for the type of character formation that is supposed to occur in families, schools, churches, and synagogues. These are the institutions (rather than ethics-auditors, business-ethics courses, or commitments to corporate social responsibility) which Adam Smith identified as primarily responsible for helping people develop what he and other Scots called the ‘moral sense’ that causes us to know when particular courses of action are imprudent or simply wrong — regardless of whether we are Wall St bankers or humble actuaries working at securities-rating agencies. At the end of his life, Adam Smith added an entirely new section entitled, ‘Of the Character of Virtue’, to the sixth and final edition of his Theory of Moral Sentiments. His reasons for doing so are much debated. But perhaps Smith decided that as he glimpsed a world in which the spread of free markets was already beginning to diminish poverty, he needed to re-emphasize the importance of sound moral habits for societies that aspired to be both commercial and civilized. This surely is advice worth heeding today.

About the author

Dr. Samuel Gregg has written and spoken extensively on questions of political economy, economic history, ethics in finance, and natural law theory. He has an MA from the University of Melbourne, and a Doctor of Philosophy degree from the University of Oxford, which he attended as a Commonwealth Scholar and worked under the supervision of Professor John Finnis. He is the author of several books, including Morality, Law, and Public Policy (2000), On Ordered Liberty (2003), and his prize-winning The Commercial Society (2007), as well as monographs such as Ethics and Economics: The Quarrel and the Dialogue (1999), A Theory of Corruption (2004), and Banking, Justice, and the Common Good (2005). Several of these works have been translated into a variety of languages. He also publishes in journals such as the Journal of Markets & Morality, Law and Investment Management, Journal des Economistes et des Etudes Humaines, Economic Affairs, Evidence, Oxford Analytica, and Policy. He is a regular writer of opinion-pieces which appear in newspapers such as The Wall Street Journal Europe, the Washington Times, the Australian Financial Review, and Business Review Weekly. His op-eds are also widely published in newspapers throughout Europe and Latin America. Dr. Gregg is also an editorial consultant for the Italian journal, La Societa, as well as American correspondent for the German newspaper Die Tagespost.

Dr. Gregg is Director of Research at the Acton Institute and a consultant for Oxford Analytica Ltd. In 2001, he was elected a Fellow of the Royal Historical Society, and a Member of the Mont Pèlerin Society in 2004. In 2008, he was elected a member of the Philadelphia Society, and a member of the Royal Economic Society. In 2007, Dr. Gregg’s book The Commercial Society was awarded a Templeton Enterprise Award. These awards are given annually to the best books and articles published in the previous year on the culture of enterprise. The awards are designed to encourage young scholars to explore and illuminate the process by which economics and culture are related throughout the world.

The lecture was presented at the Conservative Economic Quarterly Lecture Series (CEQLS) held by the Conservative Institute of M. R. ©tefánik in Bratislava on May 14, 2009.

The lecture is available also as a video here.


[1] © Samuel Gregg 2009. Not to be copied or distributed without the author’s permission.


[3] The subject of prudence is an entirely separate area for discussion. For the non-philosopher/lay-reader’s ease of reference, this account is drawn from


[5] John T. Noonan, The Scholastic Analysis of Usury, Harvard: Harvard University Press. 1957, p. 2. Perhaps the twentieth-century’s foremost modern expert on the subject, Noonan famously concluded – contra the Archbishop of Canterbury’s 2008 assertion that Christianity simply changed its position on money-lending in the sixteenth-century - that the Catholic teaching on usury “remains unchanged” (ibid., p. 399). The sin of usury, Noonan states, was always and remains understood as “the act of taking profit on a loan without just title” (ibid., p. 399). Noonan then adds: “What is just title, what is technically to be treated as a loan, are matter of debate, positive law, and changing evaluation. The development on these points is great. But the pure and narrow dogma is the same today as in 1200” (ibid., p. 400).

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Conservative Economic Quarterly Lecture Series /CEQLS/

Templeton Freedom Award 2009




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