Lutheran bishop Peter Rogness recently decried our national loss of awareness that government is self-government, and warned that political discourse “to rally people against their own government...is like an immune system run amuck that eats the very body in which it resides.” Yet since the electoral success of Ronald Reagan in 1980, more and more Republicans have run for office “against government.” This has been at the center of the political stalemate in Washington, and certainly creates resistance to the quite reasonable proposals of the Pontifical Council for Justice and Peace (“Note on Financial Reform,” October 26) for such things as stronger international oversight of financial markets and better funding for development through a very small tax on financial transactions, small enough not to alter investment decisions other than highly speculative arbitrage.
Yet separate from the many strengths of the Note (for example, its economic analysis is first-rate) and the many problems in the way it’s been received in this country, it must also be said that there remains a significant hole in official Catholic social teaching on the economy. In addition to appropriately encouraging virtuous action, the church’s teaching proposes systemic solutions to our problems without a systemic ethical analysis of the moral dynamics of daily economic life. That is, it intends to condemn some current financial practices and leave others with implicit support, without offering a way for Catholics to think about how to draw the line between them. To understand that, consider the character of the financial fraud that we now know was quite common prior to the crash of 2008.
In October, Citigroup paid a $285 million fine to the Securities and Exchange Commission for defrauding its own clients. Goldman Sachs earlier paid a $550 million penalty to the SEC for the same crime. The list of finance firms similarly caught defrauding their customers is a long one, including J.P. Morgan, Wachovia Capital, American Home Mortgage, Countrywide, Charles Schwab, Morgan Keegan, Evergreen, TD Ameritrade, Bank of America, and Brookstreet. In one way or another, these firms deliberately kept from clients their corporate assessment of the risk of the financial instruments they were peddling. So far, the SEC has charged thirty-nine corporate officers and forty-two firms, resulting in suspending or barring individuals from participation in the board of directors, the senior management, or in some cases any sort of employment in the securities industry, and nearly $2 billion in settlement penalties, which will go to the injured clients in partial repayment for their losses.
There’s plenty here for us and the Wall Street occupiers to be angry about, but we might come to a better understanding of our moral situation by considering the character of the investments involved and how they grew out of helpful but complex financial instruments susceptible to unethical use.
Derivatives are financial instruments created for sale in order to hedge risk, something like insurance. And what’s insurance? You’ve probably taken out fire insurance on your house. With a monthly payment, you provide the security of knowing that should your house burn down, the insurance company will give you the money to rebuild. People in business often have good reason for a similar insurance policy. Consider an inventor who’s just come up with a great new idea in computer technology. He’s quite confident that his idea will work and is willing to borrow the $10 million necessary to get it started, but he has one big worry. If the computer industry tanks while he’s working on this, he’ll lose this investment. So he wants to take out an insurance policy to cover that possible calamity.
The inventor goes to a firm like American International Group (AIG) and works out a deal, typically called a credit default swap. Put simply, he agrees to pay the firm, say, $100,000 per year and in return the firm will pay him $10 million if the computer industry tanks. Of course, they need a clearer definition of what it means to “tank” and they might agree that the trigger for the payment will be the day that a highly respected computer firm—say, Intel—sees it stock price drop to 50 percent of what it is on the day the inventor signs the insurance contract. So in a sense, he is here betting against Intel, but in doing so he is “hedging” his own $10 million bet on his new invention.
One big difference between your fire insurance and the inventor’s credit default swap is that insurance regulation forbids me from also buying fire insurance on your home. The reason our government does this is what economists artfully call “moral hazard.” If I had fire insurance on your home, I might then be tempted to visit your home with a match and some gasoline while you were away on vacation. No such restrictions exist on credit default swaps. Anyone can take out this bet against Intel, or any other firm or business deal, in effect hoping that it will fail. (Of course, the inability of firms like AIG to pay off these insurance policies is what deepened the financial crisis, but that’s another story.)
Once hedge funds got used to making such bets against firms and business deals they projected to fail, some of them learned it would be helpful to watch the finance houses that were creating those instruments in order to learn about the riskiest deals even before they were sold. The finance firms creating these bundles of mortgages gained their usual percentage commission from the sale and garnered more business with the hedge funds by offering them advance notice. Court records now show that the hedge funds planning to bet against a package were at times even part of the discussion as to how to structure the package itself, to increase the likelihood of failure or sweeten the payoff should failure occur. This is the most serious of the SEC charges against the big finance firms: they deliberately kept their own clients in the dark about the risks those clients were about to take on.
To translate this into our fire-insurance example: not only were people taking out fire insurance on others’ homes, they were also working with the builder to design a home likely to catch fire due to bad wiring. The builder then sold the home without mentioning the fire hazard to the buyers. Of course, we have building codes to prevent such dangers, but there were no such rules for financial derivatives. The investment houses typically say that all their clients are big investors that bear the usual risks of market uncertainty. Gone completely is the trust that clients once presumed they would have in their investment broker.
Beyond the problem of fraud, the systemic threat caused by the very size of the finance industry calls for the kind of oversight recommended in the Vatican’s Note. The Financial Times estimated that, prior to the crisis, there were between $3 trillion and $5 trillion of loans in the world with hard assets behind them (assets like land, buildings, etc., that would be lost if the lender defaulted).* They estimated that the derivatives markets (where there’s nothing behind the instrument besides another firm’s pledge to pay as required) was more than ten times that large. Industry groups have since estimated that figure to be $75 trillion. (Recall the total GDP of the United States was about $14 trillion at the time; the world’s about $55 trillion.) The potential for instability was great and has not been much reduced since. Yet the finance industry continues to resist regulation.
When the pontifical council calls for stronger international oversight of the financial system, it speaks from common sense. Still, while the council can identify fraud as immoral, it hasn’t tried to say anything about where one should draw the line between immoral excess and moral profit-seeking in the finance industry. And it can’t. For it has no analysis of the moral exercise of self-interest in markets. Nor do the social encyclicals from Leo XIII’s Rerum novarum in 1891 to Benedict XVI’s Caritas in veritate in 2009.
The problem is clear: The founder of Christianity preached love of neighbor and told us that the greatest love was to lay down one’s life for another; self-interest wasn’t among the virtues Jesus encouraged. Thomas Aquinas was suspicious of the merchant, whose work so often led to greed (and of course he relied on both Aristotle and Jesus here).
But the moral defense of the market is based on the systemic effect of self-interest, which within the proper institutional and cultural conditions can conduce to the well-being of even the poor. This is the more adequate depiction of Adam Smith’s argument about markets, and a far cry from that preached by the pseudo-Smithians who assert that his “invisible hand” means that just about any form of self-interest in any situation will generate good for all.
A systemic moral defense of markets dates from Bernard Mandeville’s 1705 “Fable of the Bees” and has been proposed in more subtle and theologically more careful ways by neoconservative Catholics since Michael Novak’s 1982 The Spirit of Democratic Capitalism. But Novak does little better than the Vatican in providing an adequate moral account of the exercise of self-interest in markets; his argument is driven by a determination to endorse markets, cherry-picking the Catholic tradition for theological support.
Interestingly, the same problem that keeps the pontifical council from drawing a line at what we might call “the top end” of the market between moral and immoral financial transactions explains why Pope Benedict’s Caritas in veritate endorses “hybrid” firms (that give a sizeable portion of their profits to public purposes) and yet is eerily quiet about the 99.9 percent of firms that don’t. He, too, lacked the ethical resources to draw a line at “the bottom end” of the market between endorsable exercise of self-interest and the morally objectionable sort.
But let us not forget how difficult this line-drawing task is. Ask yourself where, on the spectrum from fire insurance for your home to derivatives designed to fail, you would draw the line of acceptable and unacceptable behavior. And before you answer too quickly, recall that, historically, fire insurance has its own dark side. It replaced local mutuality that led members of a community to pitch in and help rebuild a neighbor’s burned-out home. Fire insurance meant you didn’t have to depend on your neighbors, and was both a cause and an effect of the slow withering of neighborly cooperation (dare we say “love of neighbor”) that has characterized so much of U.S. history.
In 1902, economist Thorsten Veblen presciently warned that, even in his day, the production of goods and services was “carried on for the sake of business, and not conversely.... The pecuniary interests of the business men...may come to them from a given disturbance of the system, whether it makes for heightened facility or for widespread hardship.”
Today, the church has publicly responded to the problem of the dangerous power of finance, and has done a creditable job of policy analysis. Three centuries after Mandeville, it’s high time that the church develop an ethical analysis that will integrate proposals for systemic change for financial markets with an ethical analysis of daily economic life. Conservative Catholic columnist and commentator George Weigel is certainly wrong in calling the pontifical council’s note “rubbish, rubbish, rubbish”—and in his confidence that Pope Benedict disagrees with its contents—but the rift between left and right in Catholic social thought on the economy won’t be closed without Rome’s careful attention to the criteria for a moral assertion of self-interest.
* This sentence has been corrected. The original version erroneously reported that there were $30 to $50 trillion of loans backed by collateral.
Related: Justice & Economics, by the Editors