Less than a pound of flesh

Justice, Moral Hazard and Deterrence in the Global Financial Crisis:

Saving the World but Getting Something Less than Your Pound of Flesh

The forgiveness and punishment matrix

	Strategy for fixing  the global financial crisis
	Tried and failed	Not tried yet
	(1) BAILOUT OF CREDITORS	(2) BAILOUT OF DEBTORS
moral hazard – who is not deterred from behavior that harms society? Or, who goes unpunished for past irresponsible behavior?	creditors	debtors
who is deterred from future behavior that harms society?	debtors	creditors

This post may not appear to be connected with the theme of this blog, but the relevance is explained toward the end.

There are two possible approaches to fixing the global financial crisis. Governments could (1)pass laws and adopt policies that help creditors – banks that made bad decisions to lend money, or (2) they could pass laws and adopt policies that help debtors – people who made bad decisions about borrowing money.

It would be better if neither strategy were necessary because they both involve not making people suffer for  behavior that caused harm to society. It was bad of the banks to have knowingly loaned too much money to people who couldn’t pay it back, and bad of millions of people to have borrowed money that they couldn’t repay.

With Strategy 1, many creditors who were careful will be angry that their competitors didn’t have to suffer for their mistakes and go out of business. Furthermore, debtors will be angry that the banks get paid back by governments, but the debtors still have to pay back their loans or lose their homes.

With Strategy 2, people who were cautious and never borrowed too much money will be angry that people will have their debts erased or reduced.

Whatever is done, there will be unjust results for some people. Every possible solution is imperfect. Some people are going to be unjust losers, and others will be unjust winners. However, something must be done to restore the global financial system. The goal is not to find justice for all but to find the solution that brings the least overall injustice to society.

Some economists, such as Steve Keen (for a lively description of his work, see here), are saying that because Strategy 1 failed in the years 2008-2012, we should now try Strategy 2. They think that common people (debtors) should take less responsibility than the professional bankers who loaned too much money to their customers. It is more important to deter banks from lending too much in the future. If we control the behavior of financial professionals, we won’t have to worry about stopping consumers from borrowing more than they can pay back because bankers will be much more careful about lending to them. The greatest responsibility should be on the creditors because they failed in their professional duties. The debtors were mostly amateurs who were enabled by professionals who knowingly misguided them in order to reap short-term profits.

Who is angry that someone is getting bailed out and not being forced to take responsibility for past mistakes?

Strategy 1

Bank A behaved responsibly and is in good financial condition. The shareholders, executives and employees are annoyed that their competitor, Bank B, is being rescued.

Strategy 2

Mr. and Mrs. Smith have lived in their house for 25 years and they just made their last loan payment. Their neighbors, Mr. and Mrs. Jones, bought their house five years ago and still have $400,000 left to repay on their loan. But according to Strategy 2, this debt is erased and they can keep their house. Mr. and Mrs. Smith are obviously angry about this!

It is all so very unjust, but there is too much at stake to worry about making things fair for everyone. Children are going hungry and homeless because of their parents' mistakes. As Paul Krugman has written many times, economics is not a morality play. You might be outraged that millions of people are getting off the hook while the costs of their follies are carried by those who did no wrong. But what future social disorder would you be willing to suffer to pursue your justice? In The Merchant of Venice, the moneylender Shylock didn’t get the pound of flesh owed to him because it became apparent that getting it required the spilling of blood. There is a metaphor in this for the present global predicament.

PORTIA:

A pound of that same merchant's flesh is thine;

The court awards it, and the law doth give it.

SHYLOCK:

Most rightful judge!

PORTIA:

And you must cut this flesh from off his breast;

The law allows it, and the court awards it.

SHYLOCK:

Most learned judge! A sentence! come, prepare!

PORTIA:

Tarry a little; there is something else.

This bond doth give thee here no jot of blood;

The words expressly are, a pound of flesh:

Take then thy bond, take thou thy pound of flesh;

But, in the cutting it, if thou dost shed

One drop of Christian blood, thy lands and goods

Are, by the laws of Venice, confiscate

Unto the state of Venice.

-William Shakespeare, The Merchant Of Venice, Act 4, scene 1

Everything said above applies to the real economy which we call the ecosystem. The past and present generations have left a debt of damage they cannot repay, and, strangely, when it’s not strictly perceived as a matter of money, we realize it is senseless to worry about making the criminals pay. They can’t possibly compensate for the damage. We know that mining companies declare bankruptcy and leave behind cleanup costs that often exceed what these companies were ever worth. The true cost of compensating every loss caused by the Fukushima Daiichi disaster would bankrupt both TEPCO and the Japanese government. Chernobyl finished off the Soviet Union.

People worry more about their neighbors being forgiven for a debt than they do about the radionuclides in their food, but most of us come to the sensible conclusion that, pragmatically, there is little to gain in hunting down the individuals responsible for wrecking the environment. The pursuit of justice would divert our energies and may do as much harm as the crimes it seeks to right. The younger generation of innocents is stuck with the mess, and the best thing to do is start over with a fresh approach. Why shouldn’t this also be the attitude we have toward the global financial system?

Footnote:

A few hours after I posted this, Andrew Leonard wrote at Salon.com about the battle within various branches of the U.S. government over the issue of mortgage principal reductions, also known as "cramdowns." These would rescue any mortgage holder who was underwater by reducing principal until the balance owed on the mortgage was equal to the market value of the property.