Not that anyone seems to notice or care, but ethical behavior has taken a big hit since the Financial Crisis of 2008-09. True, ethically suspect behavior was running riot before the crisis and was among its proximate causes. But that was behavior on the part of private citizens behaving greedily (i.e., taking huge risks to enrich themselves and their institutions) in part because they knew they were acting in a world of moral hazard created by their governments and central bankers.

The term “moral hazard” is tossed around a lot, but its essence is this: I can take huge risks in the hope of getting personally rich knowing that if I fail I won’t suffer many consequences because those will be covered by the broader society. Thanks to the “Greenspan put,” it was a simple case of heads I win, tails you lose.

Moral hazard often arises because the risk takers have more information than the risk sufferers. This was certainly the case with subprime debt – the banks owned massive amounts of it while most Americans had never heard of it and the Fed and Treasury were clueless.

The US (and European) financial regulators may have been clueless about subprime debt in particular, but once you create a situation fraught with moral hazard, you can be absolutely certain that lots of people will take advantage of it. You may not know precisely where or how, but those are details.

The world will always be full of scumbags, and the more money there is to be made behaving scummily, and the less risk that is associated with scummy behavior, the more scumbags there will be. But what is different, post-2008, is the institutionalization of morally questionable behavior by governments and, especially, central bankers, based on the simple but morally-suspect grounds that the end justifies the means. I’ve long complained about the I-am-God-hear-me-roar attitude of our central bankers. But today I’m suggesting not just that the bankers are arrogant, but that they are behaving amorally, or even immorally, with very unfortunate consequences for society in general and for free markets in particular.

Back in the days when I was an active attorney, we had a saying that “hard cases make bad law.”(1) In other words, when a court stretches the law to reach a result that justice (or more often mercy) seems to require, that precedent is now on the books and will be exploited by every slippery character who comes along. The same thing can be said of black letter law – legislatures often rush to pass laws in response to some rare abuse, but that poorly-thought-through law is now on the books and will cause endless mischief.

2007 began with HSBC scrambling to contain losses on subprime mortgages. But it wasn’t until that summer that panic began to form, as two obscure hedge funds at Bear Stearns imploded on similar bets. All that seemed remote from everybody’s portfolios, but as the summer morphed into fall and the fall into winter, it turned out that virtually every large financial institution in the world(2) had made huge, levered bets on subprime mortgages and other dicey credits. Banks took massive hits as they had to reserve against looming losses that would eventually total close to $2 trillion.

Matters went from bad to worse and eventually the most over-levered firm – call it the worst-managed, the greediest – Lehman Brothers, actually failed, resulting in the largest bankruptcy in US history ($640 billion) in September of 2008. Bear Stearns had failed earlier in the year. IndyMac had failed in July, and Fannie and Freddie were effectively nationalized a week before the Lehman bankruptcy. Merrill Lynch was forced into the arms of Bank of America, and the Fed loaned $85 billion (!) to AIG to prevent its collapse.

By Thursday, September 18, 2008, the Fed and the Treasury were in full panic mode. Hank Paulsen told the Senate leadership that, “Unless you act, the financial system of this country and the world will melt down in a matter of days.”(3) Not to be outdone, Ben Bernanke opined that if Congress didn’t pass a $700 billion bailout fund over the weekend, “We may not have an economy on Monday.”

As I’ve noted before in these (web) pages, there is very little evidence that matters were so dire, and a lot of evidence that there were more efficient and less disruptive ways to instill confidence: “We’ll do whatever it takes,” for example. But the problem was that the folks in charge were certain that only they stood between the world and disaster, and therefore however distasteful an action might be, it was obviously justified.

Maybe, at the moment of maximum panic, the Fed and Treasury’s actions could be forgiven. Lord knows that most of us wouldn’t have wanted to be sitting in those seats in those days and if we had been, we, too, might have been willing to ignore a lot of niceties. Unfortunately, this mindset – “We are too important to be bothered with ethical fussiness” – once established, became the mode of the day. It wasn’t just that the Fed ignored its own moral compass when it believed it held The Fate of the World in its hands. The Fed simply stopped believing that ethics had anything to do with it as an institution or with themselves as individuals. They were too important to worry about such things.

Ah, you are thinking, Machiavelli would have approved! Well, not so fast. It’s certainly true that Machiavelli introduced – or at least analyzed and massively popularized(4) – the difference between public and private virtue. To put it in simple terms, a statesman who disadvantages his country rather than compromise his private principles should never have decided to become a statesman in the first place.

In the next post, though, we’ll apply Machiavellian principles to the world’s central bankers and see whether the great Florentine would have approved – or might have consigned Bernanke, Draghi et al. to the bottom circle of Hell.

(1) Way back in 1842, in the case of Winterbottom v. Wright, 10 M. & W. 109, 152 Eng. Rep. 402, Judge Rolf wrote, “This is one of those unfortunate cases…in which it is, no doubt, a hardship upon the plaintiff to be without a remedy, but by that consideration we ought not to be influenced. Hard cases, it has frequently been observed, are apt to introduce bad law.” Winterbottom seems to have been rightly decided under existing precedent at the time, but we would consider the result bizarre today. The plaintiff, Winterbottom, was injured when the coach he was driving fell apart, having been defectively maintained by Wright. Since Wright had been engaged to repair the coach not by Winterbottom but by the Postmaster General of England, the court held that poor Winterbottom had no case.

(2) See, for example, Sayuri Shirai, “The Impact of the US Subprime Mortgage Crisis on the World and East Asia through Analyses of Cross-border Capital Movements,” ERIA Discussion Paper Series, October 2009.

(3) I played football at Dartmouth with Paulsen, who seemed like a good guy.

(4) Leo Strauss, for example, argued that Machiavelli was profoundly influenced by Xenophon, one of Socrates’ students. See Strauss’s Thoughts on Machiavelli (The Free Press, 1958).

Next up: The Financial Crisis and Institutional Ethics, Part 2

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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