Moralism and Monetary Policy

Last week I mentioned in the comments to this post that I think most political and financial problems are fundamentally technical rather than moral and cultural in nature. Several people took exception to this idea, so I figured I should probably try to elaborate a bit on what I meant.

Start with a historical example. During the 14th century, European society was rent asunder by the Black Death. Between a third and half of people died, and the resulting turmoil caused serious political, economic, and social upheavals. As Wikipedia notes, many governments “instituted measures that prohibited exports of foodstuffs, condemned black market speculators, set price controls on grain and outlawed large-scale fishing,” none of which stopped the spread of the disease. Given the vast amount of suffering, it’s only natural that many people concluded that the causes of the Black Death were fundamentally moral or cultural in nature. Many people argued that human sinfulness, greed, pride, etc., had caused God to turn his back on Western society, whereas others sought to blame the outbreak on a specific group, such as the Jews. Today, of course, most people recognize that the cause of the plague was less a matter of morality than of hygiene. But if you were to tell an average 14th century European that the plague was being caused by fleas from rats, he would likely think you were naively trivializing the issue.

The Great Depression, though on a much smaller scale, also represents a time of political and economic turmoil, with unemployment reaching as high as one third in some areas. With disturbing parallelism, governments responded by restricting foreign trade, instituting price controls, and attacking Jews.

As with the plague, many people concluded that the Great Depression indicated some deep flaw in the capitalist system. Yet as with the plague, the root problem was not moral but technical. John Maynard Keynes and Milton Friedman did not agree on much, but they both saw monetary policy, and in particular the contraction of the money supply, as being the primary cause of the Depression (Austrians, of course, take a different view, but their explanation of the Depression is also technical in nature). If the Federal Reserve or other government entities had adopted a more expansionary policy during 1929-32, it is likely that most of the suffering caused by the Depression (and the rise of Nazism) could have been avoided. But because of its simple technical nature, many at the time and since have viewed the monetary idea as frivolous (it is said that when someone proposed to FDR that the government end the Depression via monetary expansion, he dismissed the idea as “too easy.”)

Today, of course, we are in the midst of another period of economic turmoil which is to some extent reminiscent of the Great Depression, though on a lesser scale. And again some have suggested that the crisis has exposed a serious moral flaw at the heart of Western civilization and/or liberal capitalism. Given the large amount of suffering caused by the current crisis, the idea that the crisis could have had a technical cause (such as, say, the decision of the Federal Reserve to start paying interest on bank reserves in October of 2008) may seem unlikely. My belief, however, is that if one wants to discover both the causes of and cure for the current crisis, one is best off looking in the realm of technique rather than moralism.

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  1. Ironically, F.D. Roosevelt’s changes in monetary policy and in financial regulation were very effective.

    The difficulty with your argument is that it is dead wrong with regard to this particular problem. The current crisis has had sources and motors which derive from aspects of the moral and ethical life. Those of you schooled in law and philosophy can parse it out, but this layman will call it a deficit of conscientiousness on the part of both households and institutions and a deficit of public spirit on the part of politicians and some commentators.

    1. The decay in the capacity for deferral of gratification, manifest in the secular increase in per capita debt loads by households.

    2. The decline in underwriting standards by those originating mortgages (I’ve a friend in the banking business in Rochester; his disgust over the phenomenon of subprime lending, which his bank eschewed, was in part a moral judgment about the practice).

    3. Lack of due diligence. The characters in the AIG Financial Products group had, up to 2005, no clue about the composition of the mortgage pools on which they were writing credit default swaps.

    4. Inertia. Asked to explain some of his odd behavior in 2008 and 2009, Henry Paulson: Congress does flat nothing about anything unless their is a crisis (and yet the institution is consumed by busyness as they play parliamentary games with each other).

    5. Absence of historical sense: Charles Calomiris has made this point. Banking and financial crises are not all that unusual and there are established protocols for addressing them. His complaint was that Paulson and Geithner (and Bernanke?) threw this out the window and commenced madly improvising.

    6. Cronyism. The eschewal of certain policy tools (e.g. debt for equity swaps) and the character of the eventual piece of financial regulation does not have too many plausible explanations bar the reflexive subordination of public interest to private interest by Barney Frank and others. Ditto the very existence of Fannie Mae and Freddie Mac.

    7. Artifice. The Democratic Party given the chance made use of circumstances to push pork projects and enact a contextually gratuitous piece of legislation on medical insurance in lieu of a serious amendment to financial architecture.

    8. Sheer carelessness. So, just who owns that promissory note?

  2. Excellent, AD.

    Many factors contributed. The proportion of home ownership rose from 64% to 69% in 2005. HUD, under new NY Gov Cuomo, ordered FNMA/FHLMC to do 50% of their mortgage purchases in “low-to-moderate” income citizens.

    The amount of money that FNM/FHLMC ran unto the housing market caused a price bubble.

    Banks saw comparable sale prices rising and bought into the maxim RE prices never decline.

    Loans were made solely on nonstabilized comp sales appraisals. The other four factors in credit underwriting were ignored.

    Many other factors were invoilved. But, the players all beleived that a new paradygm was at play and things had changed forever. NOT!

    That hapens over and over and they never learn.

  3. I suppose any crisis can ultimately be blamed on greed and ignorance. In that case, human nature, i.e., self-interest and information asymmetry, is part of the technical equation and may be remedied with technical solutions.

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