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ETHICS MATTER

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By Eileen P. Flynn

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The Montréal Review, January 2013

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"Ethical Lessons of the Financial Crisis" by Eileen P. Flynn (Routledge, 2012)

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"Ethical Lessons of the Financial Crisis" is a lucid and detailed analysis of the economic crisis of 2008 and its ethical dimensions. Eileen Flynn wrote a superb book that we highly recommend to both the general reader and the specialist. Readers will find well-defined answers to hard questions such as: Who and what caused the financial meltdown? Was it a result of corruption and greed or a natural effect of the flawed organization of the modern financial system? What is the role of ethics in resolving the crisis? And is there a hope for sustainable recovery and growth?

--The Montreal Review

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It would be a serious error to think the financial crisis resulted from a glitch in the market for mortgage backed securities, or flaws in computer programs at credit rating agencies, or the failure of government regulators to read between lines of fine print. It's easy to understand why people are tempted to think that the cause of the crisis was something along these lines because many complicated factors combined to bring the economy down and it is hard to grasp how these factors played out. In fact, however, the reason for the financial crisis is rightly attributed to unethical human behavior, not an IT failure or the misreading of reams of prospectuses. The crisis happened because of misconduct and culpable ignorance at all levels of organizations in both the public and private sectors, and beyond.

In the aftermath of the crisis people wondered why Adam Smith's theory of the Free Market held sway for so long. The economic meltdown exposed as fatally flawed the assumption that markets, driven by the desire of individuals and corporations to maximize profits, would self-regulate. Alan Greenspan admitted as much: "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief."  Adam Smith was wrong and, 232 years later, former U.S. Federal Reserve Chairman Greenspan was wrong to count on Smith's economic theory.

The crisis might have been prevented if leaders of government and finance had not embraced a laissez faire attitude based on the belief that the markets take care of themselves. The crisis was not a market failure; it was a human failure. The markets are entities created by humans and people need to direct the markets so that they function properly. Instead individuals acted irresponsibly and triggered worldwide calamity. Since the markets do not take care of themselves, people need to do right by each other and by the markets to achieve economic stability. Ethical behavior is the essential condition for setting things right.

A lack of ethics, combined with people's ignorance about how complex financial markets function, resulted in the crisis of 2008. The financial crisis occurred because individuals behaved badly by committing fraud, lying, finding a way to get around regulations or prudent management practices, and acting greedily to fill their outsized wants. The ethical lesson to be learned is as simple as "Do not do these things." If individuals were to make rational financial decisions and act ethically in carrying out transactions, the economy would function well and humankind would prosper. Five lessons need to be learned so that this goal can be achieved:

First, people need to understand the importance of nurturing their own personal integrity. In the aftermath of the crisis, as the U.S. teetered between the Great Recession and a full-fledged depression, how many individuals searched their souls and regretted applying for liar loans, issuing mortgages to unqualified applicants, rendering inflated real estate appraisals, bundling subprime mortgages into so-called "securities," selling these defective products to unwary buyers, speculating in the derivatives market, issuing deceptive credit ratings, or failing to check out-of-control risk taking? Individuals in multiple occupations, and at all levels of corporate and government management, acted unethically. The house of cards, which was composed of the financial and housing sectors of the economy, imploded simultaneously, causing economic catastrophe. Widespread disillusionment and a generalized sense of demoralization set in. Why didn't the government stop destabilizing practices? Why didn't the media report on what was happening? Why didn't credit rating agencies do their jobs? How could Lehman Brothers, the fourth largest investment bank, go bankrupt?

We will never know how many of the individuals who were responsible for the crisis wrestled with themselves and wished for a do over. Once the harm had been done it was too late to stop the maddening progression of events which resulted in economic shock and awe. The lesson here is that personal integrity needs to be valued and acted upon. When greed and short term advantage dictate the choices we make, we live long term with the consequences. Being satisfied that one has done the right thing and upheld personal values, rejecting profits, or a promotion, or complicity in wrongdoing, has an importance far beyond the short-lived gains of the housing bubble years. The ill gotten status symbols acquired through deceitful manipulation quickly lose their luster. Concern for integrity trumps greed.

Second, life in the twenty first century is complicated and it is characterized by tolerance for diversity. People don't want to judge what others do and they want the rights and freedom of all to be respected. We are sensitive about race, gender, and sexual orientation, and we do not condone discrimination; likewise, we tend to reject interference by government authorities with personal choices. There is much that is positive about society's advance in tolerance. However, we need to revisit an accompanying attitude about ethical behavior that seems to be a corollary to our embrace of diversity.

There needs to be acknowledgement of objective standards of morality. We need to deal ethically in carrying out financial transactions, by telling the truth, rendering fair value for payments received, not looking the other way when subordinates or colleagues are defrauding customers, maintaining an appropriate distance between the regulator and the regulated, rejecting bribes, and acting to insure the solvency of the corporation rather than maximizing its profits in the current quarter to the detriment of its viability in the long term. Relativistic thinking would question whether ethical standards such as these should be asserted as always in force; the relativist would say that it all depends on the person, or the transaction, or the circumstances. Relativists are in error when they carryover tolerance for diversity in social and personal spheres to tolerance of diversity in regard to moral standards. There are objective standards; the legal system prosecutes individuals who violate them. It would be worth people's time to consider this fact and acknowledge that these standards are reasonable and that we need to adhere to them.

Third, we live at a time in human history when individualism is paramount. Individual rights are emphasized to the detriment of social responsibility. People act on the beliefs that they have to support themselves, make their own way, pay their own bills, accumulate their own possessions, look out for their own interests, and provide for their own families. There is concern for others and acknowledgement of the golden rule, but the emphasis is on Number One. Regrettably, the philosophy of individualism has migrated from the personal sphere of conduct so that it is also apparent in the marketplace. We came to understand this when the story behind the financial crisis was told. The rights of the counterparty in numerous kinds of transactions were short circuited because the interests of the borrower, lender, securitizer, regulator, trader, senior manager, investment banker, or credit default swap salesperson took precedence. The playing field was skewed and the game went the way of the individuals who were directing the moves until, all at once, it ended in a horrible loss for everyone involved. Yes, we need to take care of ourselves but we also need to respect the rights of those on the other side of transactions and assure that those rights are being upheld.

Fourth, there needs to be concern for others in general, in other words, commitment to the common good. The common good is achieved when individuals and groups act to bring about the well being of everyone. In order to bring about the common good financial institutions need to broaden the perspective from which they evaluate transactions. In addition to how transactions and policies affect the firm, its employees, shareholders and clients, financial institutions need to take into account the effects on other businesses and the public. When directors of financial institutions acknowledge that the economy is composed of interconnected enterprises and that shared prosperity is better for everyone, the climate in which business is conducted will improve significantly. If a commitment to the common good were to be part of a firm's strategy, some money-making prospects likely would be rejected in the interests of the stability of the financial system. During the heyday of the housing boom, the strategy of pursuing profits without regard to consequences backfired, causing economic hardship for everyone, including financiers and mortgage brokers who lost their jobs and countless others who saw a precipitous drop in income and investments. People from the financial and housing sectors wound up standing in unemployment lines alongside unemployed waiters and retail clerks and government workers and IT personnel and millions of others whose jobs disappeared during the Great Recession.

Fifth, the four points made above are rational and would no doubt be evident in an ideal world. The reality is that this is not an ideal world. Human conduct often falls short of conforming to what is in the best of interest of the individual or the collectivity. This is why there is need for the government to regulate business and finance. There is an obvious tension between business and government. Executives do not want their enterprises hampered by regulations that outlaw profitable activities that benefit the corporation and its shareholders. They question the analysis that leads to government regulations and claim that the government is misinformed and should not be regulating one practice or another. Government officials push back by defending their policies as well thought out and unbiased and argue that they do their job when they act in behalf of the common good. Stalemates arise and nothing happens to change the way business is done.

What needs to be done to move things along and put sensible regulations in place? For starters, citizens need to realize that financial corporations contribute to political candidates and hire lobbyists in order to prevent laws and regulations from being passed. Business does not want to be constricted by regulations, but some regulations are needed. The influence of corporate money on the political system is ethically problematic because it results in regulations that favor financial institutions instead of the common good. The public is not served and questionable practices that could undermine the stability of the economy are allowed. The simple solution to this problem is to get money out of politics or do not elect candidates who accept political donations. To this simple solution the pessimist would reply that it will never happen; the optimist with "Let's get it done;" the realist with it will take a monumental effort at consciousness raising but it may be possible. It is up to all people of good will to embrace the cause.

Phil Angelides, the Chairperson of the Financial Crisis Inquiry Commission, was correct when he said that the financial crisis was not an immaculate calamity. Angelides blamed the crisis on human misconduct. Over-leveraging, imprudent risk-taking, poor balance sheet management, and over-exposure to scratch-and-dent subprime mortgages were causes of the chaos. Mr. Angelides said that poor business decisions, many of which emanated from poor ethics, brought incalculable human hardship. The biggest lesson the crisis taught us is that failures of ethics undermined the economy and adopting sound ethical standards is essential to recovery.

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Eileen P. Flynn is a Professor in the Department of Theology at Saint Peter's University, Jersey City, NJ. The author of sixteen books and numerous articles, Dr. Flynn's latest work is Ethical Lessons of the Financial Crisis, Routledge, 2012.

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