Economic morals

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“The Economic Bill of Rights”

"It is our duty now to begin to lay the plans and determine the strategy for the winning of a lasting peace and the establishment of an American standard of living higher than ever before known. We cannot be content, no matter how high that general standard of living may be, if some fraction of our people—whether it be one-third or one-fifth or one-tenth—is ill-fed, ill-clothed, ill-housed, and insecure.

This Republic had its beginning, and grew to its present strength, under the protection of certain inalienable political rights—among them the right of free speech, free press, free worship, trial by jury, freedom from unreasonable searches and seizures. They were our rights to life and liberty.

As our nation has grown in size and stature, however—as our industrial economy expanded—these political rights proved inadequate to assure us equality in the pursuit of happiness.

We have come to a clear realization of the fact that true individual freedom cannot exist without economic security and independence. “Necessitous men are not free men.” People who are hungry and out of a job are the stuff of which dictatorships are made.

In our day these economic truths have become accepted as self-evident. We have accepted, so to speak, a second Bill of Rights under which a new basis of security and prosperity can be established for all—regardless of station, race, or creed.

Among these are:

  • The right to a useful and remunerative job in the industries or shops or farms or mines of the nation;
  • The right to earn enough to provide adequate food and clothing and recreation;
  • The right of every farmer to raise and sell his products at a return which will give him and his family a decent living;
  • The right of every businessman, large and small, to trade in an atmosphere of freedom from unfair competition and domination by monopolies at home or abroad;
  • The right of every family to a decent home;
  • The right to adequate medical care and the opportunity to achieve and enjoy good health;
  • The right to adequate protection from the economic fears of old age, sickness, accident, and unemployment;
  • The right to a good education.

All of these rights spell security. And after this war is won we must be prepared to move forward, in the implementation of these rights, to new goals of human happiness and well-being.

America’s own rightful place in the world depends in large part upon how fully these and similar rights have been carried into practice for our citizens."

"Caritas in Veritate"

"...Another important consideration is the common good. To love someone is to desire that person's good and to take effective steps to secure it. Besides the good of the individual, there is a good that is linked to living in society: the common good. It is the good of “all of us”, made up of individuals, families and intermediate groups who together constitute society[4].

It is a good that is sought not for its own sake, but for the people who belong to the social community and who can only really and effectively pursue their good within it.

To desire the common good and strive towards it is a requirement of justice and charity.

To take a stand for the common good is on the one hand to be solicitous for, and on the other hand to avail oneself of, that complex of institutions that give structure to the life of society, juridically, civilly, politically and culturally, making it the pólis, or “city”.

The more we strive to secure a common good corresponding to the real needs of our neighbours, the more effectively we love them.

Every Christian is called to practise this charity, in a manner corresponding to his vocation and according to the degree of influence he wields in the pólis.

This is the institutional path — we might also call it the political path — of charity, no less excellent and effective than the kind of charity which encounters the neighbour directly, outside the institutional mediation of the pólis.

When animated by charity, commitment to the common good has greater worth than a merely secular and political stand would have."

What is "unconscionable conduct"?

The doctrine of unconscionable conduct developed over several hundred years in the courts of equity. It is a mechanism whereby equity may intervene to undo a state of affairs which it would offend against conscience to permit to continue, irrespective of the legality of the situation at common law.

Traditionally, relief on the basis of unconscionable conduct is available where: one party to a transaction is at a special disadvantage in dealing with the other party because illness, ignorance, inexperience, impaired faculties, financial need or other circumstances affect his ability to conserve his own interests, and the other party unconscientiously takes advantage of the opportunity thus placed in his hands.3

The factors leading to the ‘special disadvantage’ need not be restricted to those mentioned by Justice Kitto in the passage above (illness, ignorance and so on). Rather, relief on the basis of unconscionable conduct may be available wherever the ‘special disadvantage’ exists ‘by reason of some condition of circumstance’.4

For this reason, courts have found it difficult to define or circumscribe the concept of unconscionable conduct with any greater degree of specificity. Any consideration of unconscionability will rest, in any particular case, on the idiosyncratic nature of the facts at issue and the subjective nature of their assessment.

A broader understanding of ‘unconscionable conduct’

‘Unconscionable conduct’ as described above has been characterised by some commentators as the narrow doctrine of unconscionability. This may be contrasted with a broader doctrine of unconscionability, which may encompass the doctrines of duress, exploitation of vulnerability, fair dealing, undue influence and equitable estoppel.5

Many of these doctrines allow equity to intervene where conduct may be said to be against ‘good conscience’. For example, in Commonwealth v Verwayen Justice Deane noted that the: doctrine of estoppel by conduct is founded upon good conscience. Its rationale is not that it is right and expedient to save persons from the consequences of their own mistake. It is that it is right and expedient to save them from being victimized by other people.6

Other commentators have suggested that unconscionability is a key component of doctrines such as equitable estoppel. That is, whatever other factors may make estoppel available, it can only be available where there would be some element of unconscionability in the decision of a party to change its position.7

Concepts of ‘fairness’ or ‘harshness’

While conduct that is ‘unfair’, ‘harsh’, ‘unjust’, ‘unreasonable’, or ‘inappropriate’ may be captured by the doctrine of unconscionable conduct, depending on the surrounding circumstances, these concepts are not necessarily equivalent to unconscionable conduct.

Where the law seeks to regulate unfairness, for example, it generally does so through specific legislative frameworks such as the European Union’s Unfair Commercial Practices Directive.8 The Australian Government recently introduced into Parliament a Bill concerning unfair contract terms in standard-form consumer contracts.9

Policy options for regulating unfairness, as distinct from unconscionability, are not within the scope of this Issues Paper or the deliberations of the panel.

A society in which money has replaced honor

LONDON – From next year, on swearing allegiance to the Queen, all members of Britain’s House of Lords – and I am one of them – will be required to sign a written commitment to honesty and integrity. Unexceptionable principles, one might say. But, until recently, it was assumed that persons appointed to advise the sovereign were already of sufficient honesty and integrity to do so. They were assumed to be recruited from groups with internalized codes of honor.

No more. All peers must now publicly promise to be honest. Only one had the guts to stand up and say that he found the new procedure degrading.

The trigger for imposing this code of conduct was a scandal over MPs’ expenses, which rocked Britain’s political class for much of 2009.

It was a scandal with deep historical roots. Until 1910, British legislators were unpaid. Payments were then started, but kept below the professional level, on the ground that members of parliament ought to be willing to make some personal sacrifice in the service of their country.

During the inflationary 1970’s, a byzantine system of “allowances” was instituted to supplement lagging parliamentary salaries. Parliamentarians were allowed to claim expenses for the upkeep of properties connected with their official duties. Supervision was lax, and, human nature being what it is, all sorts of minor abuses crept in.

In May of this year, London’s Daily Telegraph began publishing details of MPs’ expenses claims. In an aggressive campaign of “naming and shaming,” the paper showed how MPs had been exploiting loose regulation to their advantage.

Most offenses were trivial, and only a few were illegal. Upwardly mobile MPs from the ruling Labour Party claimed the trappings of their newly-acquired middle-class status: second homes, mock-tudor beams, and plasma screen televisions.

By contrast, the rich grandees of the Conservative Party claimed reimbursement for such things as repairs to swimming pool boilers, moat cleaning, and hanging chandeliers. Revelations about such behavior has already forced over 100 legislators out of public life. Personal honor can no longer be relied upon to keep legislators straight.

The expenses scandal is a symptom of a society in which money has replaced honor. The new assumption is that individuals will act not honorably, but gainfully: they will never miss an opportunity to turn a profit. In a money-obsessed society, the only way to restrain this proclivity is by externally imposed sanctions. The older language of trust has been replaced by a new language of “accountability” and “transparency.” People must be regulated into good behavior.

The market has been insidiously creeping into many spheres of society traditionally governed by non-market norms. Duties of government, like fighting wars, educating children, or punishing criminals, are being outsourced to private companies. The United States employs over 100,000 private “military contractors” in Iraq. The ethic of public service is being replaced by contracts and financial incentives.

The market logic of individual choice has been busy destroying the social logic of community. Formerly, leaders of the people were leaders of their communities, often personally known to those whom they served, and jealous of their reputations for probity and fair dealing. Trust was based on local knowledge fortified by continuous contact. The erosion of these powerful constraints on bad behavior was bound to produce a growing demand for public “accountability.”

The quest for market efficiency has also led to a frightening rise in complexity. Today, the systems by which most services are provided have become almost completely opaque to their users. People who call for greater “transparency” do not understand that complexity is the enemy of transparency, just as simplicity is the hallmark of trust. Complexity, by leading to moral ambiguities, forces relationships onto a contractual footing.

Parliamentarians are by no means the only, or chief, victims of the cold blast of public mistrust. Some of the most respected banks have been exposed as perpetrators of moral fraud: hence the demand for a new regulatory framework. But pervasive mistrust of politicians is more dangerous, because it undermines the basis of a free society.

A low-trust society is the enemy of freedom. It will produce a juggernaut of escalating regulation and surveillance, which will reduce trust further and encourage cheating. After all, human nature is not only inherently gainful, but also takes satisfaction in gain cunningly achieved – for example, by finding ways round regulations. A free society requires a high degree of trust to reduce the burden of monitoring and control, and trust requires internalized standards of honor, truthfulness, and fairness.

Systems in which people are trusted to behave well are more likely to produce good behavior than systems in which they are compelled to do so by regulation or fear of legal sanctions. Liberal societies must tolerate some degree of crime and corruption. But there will be less of it than in societies run by bureaucrats, courts, and policeman. In the former communist countries, private crime was virtually non-existent, but state crime was rampant.

There is nothing inevitable about the disappearance of trust. We have a choice. Societies can decide to protect trust-based ways of life by limiting the scope of developments that undermine it. The law, for example, could be used to favor institutions (like the family) that incubate commitment, and to decentralize decision-making to the maximum practicable extent. Politicians should stop treating religious belief as a “problem” rather than as a powerful social resource for good behavior.

The role of a free press should be to put pressure on public officials to behave better. But it is counterproductive to whip up such popular resentment at “abuses” as to produce precipitate changes in law or regulation, as has happened in Britain. After any such media-stoked scandal, there should be a pause to allow better norms to take root. Legislation or regulation aimed at restoring faith in the political class should be a last, not a first, resort.

Financial accounting and decency

As health care reform has become a cliffhanger, it may be therapeutic to take a little vacation elsewhere — in this case financial accounting, also known as fiduciary accounting.

That destination is suggested by the unseemly accounting that Lehman Brothers is reported to have rendered its owners and the rest of the world, just before its collapse and years after it was hoped that the strict Sarbanes-Oxley Act of 2002 had put such gimmicks to rest.

As the term implies, the central idea of fiduciary accounting is that individuals to whom resources have been entrusted — in this case corporate managers — report to their owners on how those resources were used, and with what results.

Because managers make mistakes and the firms they manage can be buffeted by negative forces outside of their control, there will be many occasions when bad news have to be delivered. On those occasions there arises the temptation to lie.

The Generally Accepted Accounting Principles (GAAP) promulgated by the accounting profession and sanctioned by the government are intended to fence in the degree of lying that would otherwise take place among adults in the business world. But those principles can never stop the lying altogether. In the end, we must rely on plain decency among corporate executives.

It so happens that for several decades I had taught financial accounting to legions of Princeton undergraduates, until I tired of it. In that course, I structured the lectures around each distinct topic — income measurement, inventory accounting, asset valuation, debt refunding, and so on — as an answer to the following questions:

  1. . If we wanted to report honestly, what does economic theory tell us to measure and report?
  2. . What measures would be practically feasible?
  3. . What are the current rules under the GAAP for this measurement?
  4. . Finally, how will seasoned adults abuse the GAAP rules for their own gain?

For the last segment, I found ample ammunition in the annual financial reports of corporations, in the financial press — notably Forbes magazines’ marvelous columns “The Numbers Game” — and eventually in Howard M. Schilit’s classic “Financial Shenanigans.”

I regularly peppered my students with my “Memos From the World of Seasoned Adults” explaining to them how particular accounting gimmicks work, and I shared with them “The Art of Siffing Among Seasoned Adults,” my general treatise on the way seasoned adults — including economists — “structure information felicitously” (i.e., sif) to mislead others.

My course spawned a good number of short sellers — that is, financial analysts who search for garbage in corporate reports and, if they find it, borrow the firm’s stock from a broker to sell it at a high price, hoping they can buy it at a much lower price and return it to the lender when the truth comes out. The hedge-fund manager David Einhorn (not my student) is one such short seller who had smelled a rat in Lehman’s financial reports, only to be vilified by Lehman executives and others.

Lehman wanted to report to investors that its debt-to-asset ratio — a measure of the riskiness of the bank’s financial position — was lower than it actually was.

Therefore, just before the date on which financial reports were due, Lehman reportedly “sold” billions of dollars of assets to other banks, albeit with the contractual commitment that Lehman would shortly thereafter buy them back at a profit to the other banks.

Lehman used the cash proceeds from that “repo” (repurchase agreement), as it is called, to buy back some of its own debt. The transaction could be structured so as to temporarily reduce the firm’s debt-to-asset ratio enough to make a difference to the investment community.

After the financial reports had showed the lowered debt-to-asset ratio, Lehman then raised new debt whose proceeds were used to repurchase the assets from the other banks under the repo agreement. Thereafter its debt-to-asset ratio rose again to its true and riskier level.

To make this trick work under the GAAP, the repo had to be styled as a genuine sale of assets, not a fake sale. To their credit, no American law firm apparently was willing to render a legal opinion that such a repo was indeed a genuine sale. A law firm in Britain, however, was willing to do so — for a fee, of course. And with that legal opinion in hand, Lehman’s external auditor was willing to treat it as a genuine sale under the hallowed GAAP.

One must wonder what went on at the audit committee of Lehman Brothers’ board. They had a duty to meet in private with the firm’s external auditors, absent management, to query them on any untoward behavior on the part of management.

The sheer size of Lehman’s repos would have compelled management to apprise the audit committee and the entire board of them. Even if assured by Lehman’s auditors that the firm’s accounting for these repos conformed to the GAAP, did none of the directors ever wonder whether these transactions were decent?

In the closing lecture of the last time I taught my accounting course I projected on the screen a picture of their classmate who had joined the Marines. “I have taught you in this course how seasoned adults will use the tools of accounting to enrich themselves at their country’s expense,” I said. “So what then will you do with that knowledge, as your fellow classmate risks his life for our country?”

The recent 2,200-page report on Lehman Brothers from a bankruptcy examiner, Anton R. Valukas, tells us what those executives did as our warriors stood tall for their country. I hope none of my former students was among them.

The Ethical Dimension of the Market Crisis

A Q&A from the Practitioners’ Perspective: A Resource for Financial Professionals

By CFA Institute Standards of Practice Council member volunteers and the CFA Institute Centre for Financial Market Integrity

Q. Is the current crisis in global capital markets the result of a systemic failure of market institutions, or of widespread misconduct by market participants?

A. The historic meltdown of the global capital markets is the result of a number of factors, including the actions, and inactions, of a variety of market participants. In many ways, the current collapse echoes the mistakes made in past crises: ignorance of risk coupled with widespread use of leverage.

When such wide-reaching events occur, there is a temptation to discount the role of the individuals’ actions, concluding instead that there were systemic failings compounded by a series of extraordinary circumstances that no individual or entity could have reasonably foreseen. Managers did not deliberately make bad investments; most probably believed they were doing the right thing with the information given to them. Behavior biases are likely at play in this crisis, and perhaps a herding instinct led investment professionals to make certain investment decisions because they believed that “if everyone is doing this, it must be okay.”

Q. What role does the CFA Institute Code and Standards play?

A. The economic impacts of the crisis have been discussed a great deal, but considerably less attention has been paid to the ethical dimension. An examination of the root causes of the crisis highlights a number of ethical concerns about which the CFA Institute Code of Ethics and Standards of Professional Conduct (Code and Standards) can provide guidance. Among the fundamental tenets of the CFA Institute Code of Ethics that may have been ignored are those that state (in part):

  • “Act with integrity, competence, diligence, respect, and in an ethical manner”;
  • “Use reasonable care and exercise independent professional judgment”; and,
  • “Practice and encourage others to practice in a professional and ethical manner.”

While there are many players and regulatory flaws that contributed to the turmoil, only CFA charterholders and CFA Program candidates are obligated to abide by the Code and Standards. We believe that the industry could have benefited, and the severity of the crisis been mitigated, had these concepts and the CFA Institute standards of professional conduct been observed more broadly.

CFA Institute's Financial Market Integrity Index

The Financial Market Integrity Index was developed by the CFA Institute Centre for Financial Market Integrity to gauge the perceptions investment professionals have about the state of ethics and integrity in six major financial services markets and to track changes in these perceptions over time. Specifically, the index measures the level of integrity that investment practitioners experience in their respective markets and the practitioners’ beliefs in the effectiveness of regulation and investor protections to promote such integrity. This pragmatic input from working investment professionals will help raise awareness of leading issues in the capital markets and will inform the work of the Centre in conducting regulatory outreach and developing enhanced professional standards.

Fit and proper

Based on the Report on Consultation and Exchange of Information under Fit and Proper Assessments prepared by the International Organization of Securities Commissions’ (IOSCO) Emerging Markets Committee (EMC) Working Group on Enforcement and the Exchange of Information (WG4),, the decision was made to prepare a guide to Best Practices as a continuation of the WG4 mandate. The guide's main aim is to reduce the risk that responsible persons of the regulated institutions are not fit and proper for their roles.

The EMC believes that the maintenance of fit and proper standards is essential to ensuring that business activities in financial sector are conducted with high standards of market practice and integrity.

The Best Practices are intended to support the members of IOSCO in ensuring that financial institutions are subject to adequate regulations and supervision and that competent authorities take necessary legal or regulatory measures in this matter.

The fit and proper assessment is both an initial test undertaken during consideration of an application for licensing or authorization, and also a continuing and cumulative test which takes into account the ongoing conduct of business and the history of compliance with all applicable laws, regulation and codes.

The Best Practices are a framework of minimum voluntary standards for sound supervisory practices and are considered universally applicable. National authorities are free to adopt supplementary measures that they deem necessary to achieve effective supervision in their jurisdiction.

The Best Practices may be read in conjunction with relevant international agreements and national regulations.

Greed isn't good– it's dangerous

"Capitalism always throws up problems and failings. This is neither surprising nor a fatal criticism. Society has to find a way of either living with them or correcting them. However, as capitalism evolves, so the nature of its failings and problems changes. So too must be the way in which society copes with them.

The Great Implosion has laid bare several different sorts of failing. First, it has revealed just how fragile the financial system is. Second, it has demonstrated the markets' excessive risk-taking. Third, it has shown how bloated the financial sector has become. Fourth, it has exhibited a failure of the market with regard to the setting of executive remuneration in general, and pay in the financial sector in particular. Fifth, it has uncovered a deep-seated failure of the corporate system, arising from the separation between owners and managers and the weakness of institutional shareholders in influencing corporate policy.

It is no wonder that these problems have emerged only recently, since it is only since the early 1970s that the financial markets have grown to such size and importance in the economy, that markets have been given free rein, and that large-scale institutional shareholders have become dominant. Moreover, the serious problems for society that would be unleashed by blatant self-interest only burst forth once the combination of deregulation and the doctrine of "greed is good" released them in the 1980s.

But now we know. Greed is dangerous, and the encouragement of it is stupid. In order for society to work efficiently, never mind fairly and cohesively, there has to be a balance between the competitive and co-operative parts of the system. This balance goes right to the heart of human nature.

In many areas, such as health care, education, pollution control and road usage, we need more of the market, not less. But in finance, although we need the market, it must be restricted. Moreover, financial markets do not offer a blueprint for the whole of society.

Society cannot live by greed alone. Even if it can cope perfectly well if some of its members are motivated in this way, it needs millions of people to be motivated by duty, responsibility, and a sense of public purpose. These are feelings that the triumph of unbridled greed in the financial markets threatens to overwhelm. The market was made for man, not man for the market.

Hard to earn a "legal" living on Wall Street

A group of university students I spoke to recently asked if it was possible to make a living on Wall Street without compromising your values. I had to tell them no.

Wall Street has many decent, honorable people, but they work in a system that fundamentally compromises people’s ethics. The high pay is like an anesthetic that numbs you from feeling how you are being corrupted. Not only that, many honest people who work there would agree with an even more extreme statement: It’s hard to make a living legally on Wall Street.

The goal of investing is to get an edge, whereas the securities laws presume all investors should have the same information at once. If ever there was a recipe for a system rife with abuse, this is it. The harder that money managers, traders and analysts must work to get information that gives them that edge, the more likely some are to cross a legal line.

This week, Manhattan federal court dealt with a case of insider trading when Michael Koulouroudis pleaded guilty to charges that he traded on secret tips from UBS AG investment banker Nicos Stephanou, who previously took a guilty plea. Joseph Contorinis, a former money manager for Jefferies Group Inc.’s Paragon Fund, was indicted by a federal grand jury last week for his role in the scheme.

People who are looking from the outside at the Galleon hedge fund insider-trading case may also be thinking, “How could they have been so stupid?” Admittedly, naming the ringmaster “Octopussy” wasn’t the brightest move, yet the reason insider traders create networks to exchange illegal information isn’t because they are dumb. It is because so few money managers outperform market averages over time.

Not Enough Alpha

There is only so much alpha -- that excess return above a baseline average -- to be had in an efficient market. The incentive to create some artificial alpha one way or another is very high. Those who bend the rules successfully post good numbers, which adds to pressure on other Wall Streeters to push the gray boundaries of legal information flow.

One had to wonder if that’s what happened when the volume of 3Com Corp. call options surged to the highest level since September 2007 before Hewlett Packard Co. said it would buy the computer-networking equipment maker for $2.7 billion this week.

Investors also form an “us against them” mentality of sleuthing by whatever means is necessary to counter the stonewalling and obfuscation of company executives. A lot of inappropriate blabbing on Wall Street takes place by people who are outraged at some atrocity that is being committed by a company whose stock is overvalued.

Lying Managers

The tippees feel self-righteous about using the information, no matter how it was obtained. They see themselves as leveling a playing field skewed by lying company managers who are aided and abetted by cynical investment bankers and invertebrate analysts who (still) do bankers’ bidding out of concern for their careers.

Beyond that, big money managers feel entitled to even more information by virtue of clout: the first phone call from analysts; a heads-up that a salesperson thinks a downgrade on a stock may be coming; preference in a hot banking deal. This is simple economics. It goes without saying (because it can’t be publicly acknowledged) that the millions of dollars of business that an institutional client is doing with an investment bank means they will be treated much better than a small retail client who is paying a 1 percent wrap fee on a $50,000 account.

The better class of financial advisers tries to make up for this crooked system with creativity and pride in the way they serve their clients. They resist pressure from their employers to sell products only because they are profitable.

Over Legal Line

They have another, bigger problem, the same one faced by the large institutions. There is only so much alpha to be had in the market, and they are chasing it along with everybody else.

The aggregate number of people trying to carve fees out of investor returns simply overwhelms the potential gains for stockholders. It is this oversupply of overhead that creates so much pressure to cross the legal line.

Victims of their own success, the banks have severely aggravated this situation by going public, then taking on too many masters to “diversify” earnings: institutional money managers, retail investors, investment-banking clients, prime brokerage clients, “financial sponsors” (private-equity and buyout funds), their own asset-management arms, and proprietary traders. It is all but impossible for people at investment banks to serve all these clients -- whose interests conflict -- while doing their real job: to satisfy the quarterly earnings expectations of the banks’ investors.

Incentives to Cheat

Breaking up the banks into their constituent parts and forcing them to return to privately funded partnerships might reduce the apparatus that provides all parties with the incentives to cheat.

Even in the very unlikely case that this happened, it would still leave a shortage of alpha. As long as working on Wall Street is the most prestigious and financially rewarding job in the U.S., too many mouths will show up every morning to be fed.

Here, I sense a breath of change in the air. Kids who left college to import crafts made by women war refugees in Sudan are beginning to be envied by junior bankers who toil 80 hours a week creating spreadsheets. That’s a trend to be encouraged.

Aspiring young bankers and hedge-fund managers, be assured of this: The more of you who choose to import crafts from Sudan, the easier the rest of you will find it to make a living legally on Wall Street.

Capitalism has slipped its moral moorings

"Capitalism has slipped its moral moorings. Since the financial crisis erupted, remedies have focused on capital, equity and structure. These are certainly necessary. But it is even more important that we address the deficiency in moral and human spirit which was the real root of the crisis. We are doomed to repeat our mistakes if we do not restore sound ethics to economic behaviour.

In recent years finance has forgotten or ignored that it is a servant and not a master. Letting the market decide was the morality of our time. We became identified with the market and lost sight of its real purpose: to enable us to fulfil a duty owed by virtue of a shared humanity to the wider community. Financiers created credit out of nothing but eschewed the responsibility of the creator.

Yet I passionately believe that capitalism is the best way we know of improving people’s living standards. Precisely for that reason, wealth creation is a duty and, as George Osborne, Britain’s shadow chancellor, has emphasised, enterprise must be supported. Society as a whole benefits – provided that individual enterprise is grounded in broadly acceptable and agreed values.

Adam Smith understood this. Far from being the prophet of competition red in tooth and claw – as often depicted – he believed the economy could not function properly without ethical foundations. He did not believe that people should act with complete disregard for each other.

Why do we seem to think otherwise? Why do we seem to have lost the grammar of ethical discourse, at least in business? The fundamental reason is that the short-term gains from globalisation have dazzled us, blinding us to the longer-term responsibilities and benefits of interconnectedness. Markets consist of people and the global market is no exception.

These people – society at large – are the ever-present invisible partners in business, not least finance. Their presence is a rebuke to the atomised view of what it is to be human that has prevailed in recent years.

The task we face is to recover that discourse, to rediscover the moral spirit of capitalism so that it best serves all people. Regulation, though necessary, is not enough. A box ticked is not a duty done. It does not address the complexity of human beings. We have spiritual desires (longing for happiness) and a moral spirit (an instinct that doing well comes from doing right), as well as financial imperatives.

That moral spirit is distilled in the simple principle: “Do unto others as you would have them do unto you.” The wording is biblical but the precept is echoed across religions, cultures and time. Its practical power is evident: if the purveyors of sometimes dishonest sub-prime mortgages had followed this golden rule a lot of misery would have been avoided.

Unfortunately they did not follow the golden rule. We are suffering the consequences, even though everyone in financial markets knew the rule and few would dispute it. The failure to act on a universally-recognised principle is not just down to the strong attraction of short-term gains, seductive as they are. A more profound reason is that we lack a way of embedding the rule in everyday actions.

Turning the principle into practice requires a world view. In essence, a world view has two elements: a set of assumptions about our world, and application of those assumptions to life. A world view incorporates a narrative which describes the journey’s end – what kind of society we want. I think the story should be that markets are servants of people. We can then begin to act in the moral spirit of capitalism, informing markets with our moral and spiritual dimensions.

It cannot be done overnight. We need to take three practical steps: example, education and engagement. Example means leaders must set the tone. Education means engendering a robust business culture in tomorrow’s leaders and establishing ethics committees in companies on a par with, say, the remuneration committee. Engagement means forging links with all the other social partners who make business possible, increasing charitable giving and tackling environmental degradation and poverty. In these ways we can begin to reattach capitalism to its moral moorings."

The author is chairman of Lazard International and Gresham Professor of Commerce. This article is based on a lecture he is giving tonight at Gresham College, London

Skewed incentives distort economy and society

” …But Borlaug’s death at 95 also is a reminder of how skewed our system of values has become. When Borlaug received news of the [Nobel] award, at four in the morning, he was already toiling in the Mexican fields, in his never-ending quest to improve agricultural productivity. He did it not for some huge financial compensation, but out of conviction and a passion for his work.

What a contrast between Borlaug and the Wall Street financial wizards that brought the world to the brink of ruin. They argued that they had to be richly compensated in order to be motivated. Without any other compass, the incentive structures they adopted did motivate them – not to introduce new products to improve ordinary people’ lives or to help them manage the risks they faced, but to put the global economy at risk by engaging in short-sighted and greedy behavior. Their innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

There is also a deeper point in this contrast: our societies tolerate inequalities because they are viewed to be socially useful; it is the price we pay for having incentives that motivate people to act in ways that promote societal well-being. Neoclassical economic theory, which has dominated in the West for a century, holds that each individual’s compensation reflects his marginal social contribution – what he adds to society. By doing well, it is argued, people do good.

But Borlaug and our bankers refute that theory. If neoclassical theory were correct, Borlaug would have been among the wealthiest men in the world, while our bankers would have been lining up at soup kitchens.

Of course, there is a grain of truth in neoclassical theory; if there weren’t, it probably wouldn’t have survived as long as it has (though bad ideas often survive in economics remarkably well). Nevertheless, the simplistic economics of the eighteenth and nineteenth centuries, when neoclassical theories arose, are wholly unsuited to twenty-first-century economies. In large corporations, it is often difficult to ascertain the contribution of any individual. Such corporations are rife with “agency” problems: while decision-makers (CEO’s) are supposed to act on behalf of their shareholders, they have enormous discretion to advance their own interests – and they often do.

Bank officers may have walked away with hundreds of millions of dollars, but everyone else in our society – shareholders, bondholders, taxpayers, homeowners, workers – suffered. Their investors are too often pension funds, which also face an agency problem, because their executives make decisions on behalf of others. In such a world, private and social interests often diverge, as we have seen so dramatically in this crisis.

Does anyone really believe that America’s bank officers suddenly became so much more productive, relative to everyone else in society, that they deserve the huge compensation increases they have received in recent years? Does anyone really believe that America’s CEO’s are that much more productive than those in other countries, where compensation is more modest?

Worse, in America stock options became a preferred form of compensation – often worth more than an executive’s base pay. Stock options reward executives generously even when shares rise because of a price bubble – and even when comparable firms’ shares are performing better. Not surprisingly, stock options create strong incentives for short-sighted and excessively risky behavior, as well as for “creative accounting,” which executives throughout the economy perfected with off-balance-sheet shenanigans.

The skewed incentives distorted our economy and our society. We confused means with ends. Our bloated financial sector grew to the point that in the United States it accounted for more than 40% of corporate profits.

But the worst effects were on our human capital, our most precious resource. Absurdly generous compensation in the financial sector induced some of our best minds to go into banking. Who knows how many Borlaugs there might have been among those enticed by the riches of Wall Street and the City of London? If we lost even one, our world was made immeasurably poorer.”

Collective immoral action and a "greater good"

"...Naked self-interest is just another term for greed, as Freidman recognized, leading him to conclude that, "greed is good." According to Freidman, the one and only worthy economic objective of corporations or individuals trading, not just in financial markets but in the economy as a whole was "to make as much money as possible," to "maximize profits," i.e. be as greedy as possible. In this way, the economic system would supposedly realize economic efficiency and maximize the economic welfare of society as a whole.

Freidman’s views on capitalism and greed epitomize the current state of an extremely prominent economic philosophy in the U.S.: the laissez-faire, unregulated free market school of political economy. From an economic policy perspective, free market fundamentalist views amount to endorsing a form of economic organization (market capitalism, so called "free enterprise") based on acknowledged immoral motives and promoting or acquiescing in immoral activities in economic decisions and policy making. Supposedly, for policy reasons, society as a whole is better off with the free enterprise system than it otherwise would be, because – - not in spite – - of its reliance on the unrestrained exercise of self-interest (i.e. greed) in the market place. The reasoning is that the greatest good for the greatest number will result from the adoption of naked self-interest as the basic driver of the economic system.

Alas, while there is substantial social scientific evidence supporting the general functioning of markets in accordance with a rough approximation of the tenants of neoclassical economic theory, there is no empirical validity to the broad, sweeping assumptions of free market fundamentalism and laissez-faire capitalism. The competitive free enterprise system (as a system) is neither self-correcting of market mistakes or changed circumstances, nor self-regulating against abuses and excesses. In fact, the apparent near instant replay of 1929 et. seq. with which we are currently contending demonstrates just the opposite.

Nor is the efficient market hypothesis empirically true. Similarly, self-interest, or even competitive forces which it may generate, are not always engines of social good. Indeed, greed (or unrestrained self-interest) is usually just that – - and in need of restraint in economic decision- making, as in life generally..."

"Deal honestly and fairly!"

“In the great ancient religious and ethical traditions of humankind we find the directive: You shall not steal! Or in positive terms: Deal honestly and fairly! Let us reflect anew on the consequences of this ancient directive: No one has the right to rob or dispossess in any way whatsoever any other person or the commonweal. Further, no one has the right to use her or his possessions without concern for the needs of society and Earth.

To be authentically human in the spirit of our great religious and ethical traditions means the following:

  • We must utilize economic and political power for service to humanity instead of misusing it in ruthless battles for domination. We must develop a spirit of compassion with those who suffer, with special care for the children, the aged, the poor, the disabled, the refugees, and the lonely;
  • We must cultivate mutual respect and consideration, so as to reach a reasonable balance of interests, instead of thinking only of unlimited power and unavoidable competitive struggles;
  • We must value a sense of moderation and modesty instead of an unquenchable greed for money, prestige, and consumption. In greed humans lose their ‘souls’, their freedom, their composure, their inner peace, and thus that which makes them human.”

Brown - "How do we restore trust in banks?"

"There has always been an implicit economic and social contract between our financial institutions and the society they serve.

Over centuries the guarantee of responsible stewardship of people’s money has been the foundation of the most precious asset a financial institution can ever have – trust.

Two years into the financial crisis, it is clear that the old contract has to be rethought and now made explicit for new times.

In recent years, our global financial system has achieved extraordinary successes; creating jobs, funding businesses, driving down costs and lifting people out of poverty.

But the scale of the failings in recent months cannot be disguised.

The new contract must recognise the two new characteristics of modern financial institutions – their global scope and their interconnectedness.

As we now know, a failure in one large bank anywhere can affect all banks, large and small, everywhere.

Since the potential damage to the wider economy was so great, taxpayers have had no choice but to keep the system afloat.

So while our regulatory changes are designed to reduce moral hazard, any new contract between our financial institutions and our society now needs to reflect the wider costs to the economy and society of potential failure.

At its heart, the contract must answer another issue raised by the crisis: that the distribution of risks and rewards between the banks, citizens and taxpayers is balanced fairly.

Our first response has been to reduce risks by agreeing reforms to the national and global supervisory system – in capital requirements, liquidity, leverage, governance and transparency.

When fully implemented, I believe these will represent a transformation of the sector.

But, as the discussions of the Group of 20 nations this weekend reflected, these changes alone may not be sufficient to protect against future risk and to compensate for wider costs to the general public.

The world has moved on since some of the earlier ideas to address the responsibilities of the financial sector to the economy and society. There are now broader areas that have been the subject of the recent debate amongst policy makers, commentators, economists and bankers. These include insurance fees to reflect systemic risk; collective or individual resolution funds; contingent capital arrangements; and global financial levies.

In Pittsburgh and at St Andrews, leaders and finance ministers asked the International Monetary Fund to look afresh at this issue and at the range of options available.

I believe any measures we consider should be assessed against four core principles.

First, in a global economy and with a global financial sector, any such measures could work only if applied globally.

Second, any measures must not create distortions or incentivise avoidance.

Third, any measures must complement regulatory measures already being adopted or discussed.

And fourth, any costs to the financial sector must be fair and measured to enable institutions to do their job for our economy.

A new contract requires a wide public debate, one in which banks themselves should be leading participants. It will not always be a comfortable discussion, but it is in my view an essential one.

Banks cannot assume that trust will return without significant change. So it is in the interests of all banks and financial institutions to participate in this debate and I am happy to play my part in bringing banks and governments together. As this crisis has also shown, some financial institutions have managed their risks and maintained trust. And one of our tasks now is to ensure that all rise to the standards of the best

While I do not doubt there are practical and technical issues that will need to be overcome, the gravity of the recent crisis makes this discussion urgent. The restoration of trust depends on a resolution of these issues. Failure to do so will put at risk the confidence of millions of people in globalisation, setting back economic and social progress. We must all rise to the challenge."

The writer is the UK prime minister

Where there is no common power, there is no law

"In a provocative comment to an essay I wrote, Kevin de Bruxelles argues that the government has broken the social contract with the American people, and discusses the ultimate meaning of such a breach of contract:

One only needs to consult Hobbes to see where the answer lies.

In Leviathan, Hobbes contrasts two states for human society. The first being a state of nature which is described as perpetual war between individuals. The moral logic of the state of nature is that there is no right or wrong: “To this war of every man against every man, this is also consequent, that nothing can be unjust. The notion of right or wrong, justice and injustice have no place. Where there is no common power, there is no law: where there is no law, no injustices. Force and fraud, are in war the two cardinal virtues.” (13.13) And then Hobbes goes on to describe the moral logic of the state of nature: “And because the condition of man is a condition of war of every one against every one; in which case every one is governed by his own reason; and there is nothing he can make use of, that may not be a help unto him, in preserving his life against his enemies, it followeth, that in such a condition, every man has a right to every thing, even to another’s body. (14.4)

In order to transcend the state of nature, men accede to a social contract with each other to submit to a sovereign and in the process establish a civil society. To Hobbes (later diminished by Locke) the sovereign is almost all powerful. His job is to keep the peace, to install laws and justice, and to coerce the population to live within the limits he sets. But the one of the few limiting factors on his subject's duty to submit to the sovereign is “The obligation of subjects to the sovereign, is understood to last as long, and no longer, that the power lasteth, by which he is able to protect them. For the right men have by nature to protect themselves, when none else can protect them, can by no covenant be relinquished.” (21.21)

What is clear is that in the United States, where the sovereign is the elected government, an elite segment of society, namely bankers and other extremely wealthy individuals, are playing by the old rules, the rules of the state of nature, and they are grabbing as much of the pie as they can. All this while the sovereign has at best lost the ability to resist this crime, or at worst, is actively complicit. But the vast majority of citizens are sitting by idly still thinking they live in a commonwealth with laws and justice.

There are two ways out of this mess. Either the sovereign must start playing his role and start enforcing the law and justice for all, or alternatively the citizens must stop submitting to this sovereign, overthrow this system government, and start all over again to find a sovereign since living in a state of nature is not an option."

Blame global crisis on corporate greed - Rudd

RAMPANT corporate greed caused the global financial crisis, Prime Minister Kevin Rudd says.

Speaking at a function for the Brotherhood of St Laurence in Melbourne, exactly a year after he announced the first emergency measures to combat the local effects of the global meltdown, Mr Rudd blamed corporate executives for creating the worst economic downturn in 75 years.

"Tonight, around the world there are tens of millions of families who have lost their jobs, lost their businesses, lost their homes and lost hope because of a crisis which was not of their making," he said.

"Millions of working people around the world who, because of unrestrained and unregulated greed in financial markets, have been thrown out onto the streets.

"If you want a definition of social injustice, this was it in living, brutal colour - millions of innocent workers losing their jobs because a few thousand financial executives around the world surrendered any pretence of social responsibility in their blind pursuit of absolute greed."

Decisive action on the part of his government and those in other countries, including stimulus strategies, pulled the world economy back from the brink of collapse, Mr Rudd said.

"We were looking into the abyss of the total failure of the global financial system, the collapse of the global economy and the real possibility of a global depression of indefinite severity and duration," Mr Rudd said.

"One year later, as a result of the direct and decisive interventions by government, we have pulled back from the brink."

But despite those efforts, Mr Rudd warned that as many as 60 million people would lose their jobs in the developed world this year.

Investment banking and the good of society

In the latest extract from his new book, Roger Bootle examines the principles behind bankers' pay.

"The whole of economic life is a mixture of creative and distributive activities. Some of what we "earn" derives from what is created out of nothing and adds to the total available for all to enjoy; but some of it merely takes what would otherwise be available to others and therefore comes at their expense. Successful societies maximise the creative and minimise the distributive. Societies where everyone can only achieve gains at the expense of others are by definition impoverished. They are also usually intensely violent.

This distinction between creative and distributive activities applies in today's society. Consider the doctor tending to a patient or the midwife helping to deliver a baby. Everything they do is creative rather than distributive. Interestingly, the same is not true of teachers. They are further along the spectrum toward distributive gains. Some of what they do is about advancing the interests and life chances of their charges against those of other teachers.

Or consider the marketing executive for a washing powder manufacturer. Her job is pretty much purely distributive. It is to do her best to ensure that her company sells more washing powder than its rivals. If she succeeds, the rewards will be greater for her and her company. But her success will be mirrored by other companies doing badly. Her contribution is purely distributive. Most jobs are a mixture of the creative and distributive. And society needs a mixture. But do the financial markets do too much of the distributive?

A leading British journalist recently decried the widespread condemnation of bankers' and hedge fund executives' high remuneration on the grounds that these people, it said, were "the wealth creators". The article argued that we should be praising, and even aping, such people rather than criticising them, and thereby concentrating on the distribution rather than the creation of wealth.

This completely misses the point. We shouldn't be mesmerised by the millions of pounds squirreled into some private corner or other. The question is, what has the process that generated this money contributed to the common weal?

Much of what goes on in financial markets belongs right at the purely distributive end. The gains to one party reflect the losses to another, and the vast fees and charges racked up in the process end up being paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through the costs and charges that he pays for goods and services.

Even what the great investors do belongs at the distributive end of the spectrum. The genius of the great speculative investors is to see what others do not, or to see it earlier. That's all. This is a skill; of that I have no doubt. But so also is the ability to stand on tip-toe, balancing on one leg, while holding a pot of Earl Grey tea above your head, and pouring the contents into a cup on the ground, without spillage. I am not convinced, though, of the social worth of such a skill, still less of the wisdom of encouraging society's brightest and the best to try to perfect it.

This distinction between creative and distributive goes some way to explaining why the financial sector has become so large in relation to GDP – and why those working in it get paid so much. Even when a certain sort of financial activity is purely distributive, the returns to the winning parties are so enormous that the activity is immensely seductive – and the professionals who appear to be responsible for securing these gains are highly sought after and highly rewarded. Meanwhile, the professionals who are "responsible" for the corresponding losses do not suffer commensurately. The worst they can suffer is not to be paid at all, which would scarcely offset the winners' rewards. In practice, even those working for "the losers" usually get a fair bit more than nothing.

And we need to consider the identity of the investors who are making a lower return to make it possible for hedge funds and their like to make a higher return. They are the investors in slow-moving and restricted institutions such as pension funds and insurance companies, or central banks whose market activities are dictated by some objective of public policy, rather than private gain.

Yet there are reasons why we should want such institutions to be this way. Pensioners do not want their pension funds to be run like hedge funds – or their insurance companies, or their central banks. So we have allowed, and even encouraged, a system to develop in which clever people make huge amounts of money out of institutions that, for reasons of public policy, we constrain in a way that allows scope for such profits to be made. Is that clever or what?

Perhaps the greatest problems are caused by the interaction between financial markets and the real economy. There, time horizons are longer, price adjustments are more sluggish, and motivations less single-mindedly selfish. And so much the better – for them and for us. But how are they able to withstand the onrush of supercharged greed that floods out at them from the financial markets? If we think that it is right and proper – and economically advantageous – that some parts of the economic system should not be organised like investment banks, then we should make sure that they are protected from those parts of the system that are organised like investment banks."

New approaches for businesses

"The business environment of the next decade will be significantly different to what might have been expected just two years ago. The financial crisis and the recession that has followed have altered operating conditions by imposing new challenges and exacerbating existing ones.

Businesses will respond across the organisation, moving to a more flexible, collaborative and leaner model. Over the next five to ten years, businesses will face major changes to finance and capital conditions.

Finance will be more expensive and its availability will be constrained by regulation and changes to the banking market. From an era in which finance was cheap and readily available, these changes will be a significant driver of adjustments to corporate finance models and investment behaviour. Businesses will also need to adjust to a less benign economic backdrop.

The next decade will almost certainly be characterised by a higher level of economic volatility and increased risk – clouding the certainty required for long-term planning.

The financial crisis has accelerated three other existing drivers of change or has changed their character. Public trust in business and markets, already in decline, is now at a low ebb. The profit motive is distrusted, and the onus is now on businesses to demonstrate their ethical credentials.

There is greater scepticism about the Anglo-Saxon model of capitalism and its ability to deliver desirable and efficient outcomes; greater political activism, government intervention and supervision can be expected. Businesses’ approach to social and demographic change will also alter as a result of the recession.

Retirement will still accentuate existing shortages of critical skills, but plugging these gaps will have to be the responsibility of business rather than government, whose spending will be constrained. In addition, pension problems will force some to work longer, requiring businesses to manage staff with wider age ranges, expectations and motivations than before.

Lastly, the recession has altered the economic climate in which business needs to move to a low-carbon economy and improve resource use. The ability and preferences of government and some consumers to pay for this movement have been compromised, raising new questions about the role of business.

At the same time, trends in technology change are set to continue, and as over the last decade, will have a significant impact on business models and ways of working.

Foundation to support educational initiatives

"...Of course, Goldman has the money for all this corporate largesse. Yesterday it announced a fourfold rise in quarterly profits, to £1.96bn in the three months just gone. Those investment banks still standing are beneficiaries of the consolidation that swept through high finance last year, leaving them with much less competition and a licence to print money. Only this time around, the masters of the universe are even more aware of how this might look to the little people; that is why Goldman's management (not the most communicative bunch) have spent the past few weeks on a PR offensive – and why the bank is putting £122m into a charitable foundation to support educational initiatives. Think of it as tip money, for all our hard work in rescuing the banking system (Goldman held out its hand for $10bn from the US taxpayer), wrecking the public finances – and bearing up through the worst recession in decades."

Strauss-Kahn-Economic stability and war

"...Let me stress that the crisis is by no means over, and many risks remain. Economic activity is still dependent on policy support, and a premature withdrawal of this support could kill the recovery. And even as growth recovers, it will take some time for jobs to follow suit. This economic instability will continue to threaten social stability.

The stakes are particularly high in the low-income countries. Our colleagues at the United Nations and World Bank think that up to 90 million people might be pushed into extreme poverty as a result of this crisis. In many areas of the world, what is at stake is not only higher unemployment or lower purchasing power, but life and death itself. Economic marginalization and destitution could lead to social unrest, political instability, a breakdown of democracy, or war. In a sense, our collective efforts to fight the crisis cannot be separated from our efforts guard social stability and to secure peace. This is particularly important in low-income countries.

War might justifiably be called “development in reverse”. War leads to death, disability, disease, and displacement of population. War increases poverty. War reduces growth potential by destroying infrastructure as well as financial and human capital. War diverts resources toward violence, rent-seeking, and corruption. War weakens institutions. War in one country harms neighboring countries, including through an influx of refugees.

Most wars since the 1970s have been wars within states. It is hard to estimate the true cost of a civil war. Recent research suggests that one year of conflict can knock 2-2½ percentage points off a country’s growth rate. And since the average civil war lasts 7 years, that means an economy that is 15 percent smaller than it would have been with peace. Of course, no cost can be put on the loss of life or the great human suffering that always accompanies war.

The causality also runs the other way. Just as wars devastate the economy, a weak economy makes a country more prone to war. The evidence is quite clear on this point—low income or slow economic growth increases the risk of a country falling into civil conflict. Poverty and economic stagnation lead people to become marginalized, without a stake in the productive economy. With little hope of employment or a decent standard of living, they might turn instead to violent activities. Dependence on natural resources is also a risk factor—competition for control over these resources can trigger conflict and income from natural resources can finance war.

And so we can see a vicious circle—war makes economic conditions and prospects worse, and weakens institutions, and this in turn increases the likelihood of war. Once a war has started, it’s hard to stop. And even if it stops, it’s easy to slip back into conflict. During the first decade after a war, there is a 50 percent chance of returning to violence, partly because of weakened institutions..."


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