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The Ethical and Socio-Political Dimensions of the Financial Crisis of 2007–2008 and the Subsequent Recession

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Ethical Reflections on the Financial Crisis 2007/2008

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Abstract

In this chapter I make use of the publications of Reinhart and Rogoff, Reich and Rajan to understand the causes of the financial crisis of 2007–2008 and the ensuing recession. Reich and Rajan go beyond a purely economic analysis and introduce socio-political factors such as the income gap between the very rich and the rest of society in the decade before the crisis, the lack of regulations of the financial sector, the use of easy mortgages to keep the American dream alive, and the fraudulent treatment of some mortgages and the derivatives based on them. These socio-political factors touch upon ethical problems. The ethical dimension in economic thinking has been captured by Musgrave’s concept of merit goods. Reich and Rajan make use of seven of my eleven categories of merit goods to explain both the financial crisis of 2007–2008 and the characteristics of the ensuing recession. I end the chapter by showing that the American political system is currently not capable of delivering the merit good decisions required for dealing in a reasonable way with the challenges that led to the financial crisis and the recession caused by it.

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Notes

  1. 1.

    Keynes attributed the lack of demand to the degree and the slowness of the adjustment of prices and wages in a downturn of the economy.

  2. 2.

    On the tax side there are also automatic stabilizers. First, progressive taxation means that lower economic activity in depression means that lower tax rates apply. Second, the total tax bill for the country is tied to the level of GDP.

  3. 3.

    Some authors include universal health insurance in the idea of a safety net. I make a separate category of universal health insurance.

  4. 4.

    The list of domains in which I argue the government has to make merit good kind of decisions is the following: (1) Defining and protecting property rights including granting limited liability. (2) Institutional arrangements to promote economic efficiency including banking regulations. (3) Dealing with business cycles. (4) Education. (5) Safety net. (6) Public health measures. (7) A well-functioning social contract. (8) Transparency and prevention of corruption. (9) Strategic planning and investment decisions or industrial policy. (10) Environmental protection. (11) Protection of cultural heritage (Chap. 3).

  5. 5.

    “it is clear that Ver Eecke regards the merit goods concept as having much wider application than Musgrave himself has ever suggested. He argues this very persuasively on a case-by-case basis in summarising the contributions from a wider literature in Part III of the volume (Ver Eecke 2007). With this view, I would emphatically concur” (Head 2008).

  6. 6.

    The categories used by different authors are: breakdown of a well-functioning social contract (gap in income distribution threatened American dream); a weak safety net; absence of universal health insurance; failing education system; lack of transparency; lack of banking regulations and responsibility for turning around a recession (responsibility for avoiding the pains of the business cycle).

  7. 7.

    For a recent publication on the negative consequences of inequality see: Stiglitz. The Price of Inequality.

  8. 8.

    See also their paper (2008), 53.

  9. 9.

    . 90th percentile earner means a person earning more than 90 % of the population.

  10. 10.

    The above facts are also documented in Kumhoff and Rancière 6–8.

  11. 11.

    “the earnings of corporate employees in the financial sector relative to employees in other sectors started climbing around 1980, as the sector was deregulated” (Rajan 142).

  12. 12.

    Rajan seems to be following what he considers the majority opinion in the US, which is not opposed to income inequality, but insists on equality of access and opportunity for all, and especially access to quality education. The absence of this equality is seen as a violation of economic freedom. As actions to restore equal opportunity would take time and in the absence of a consensus on redistribution policies, including through taxation, the route chosen and agreed upon by politicians was easier credit, in particular to make housing more affordable.

  13. 13.

    For Singapore see Ghesquiere. For the other Asian Tigers see Campos and Root and World Bank 1997. Reich makes the same argument for the American period of Great Prosperity from 1947–1975 writing that “the basic bargain had ensured that the pay of American workers coincided with their output. In fact, the vast middle class received an increasing share of the benefits of economic growth” (Reich 51).

  14. 14.

    Bush made an enthusiastic connection between the American dream and home owning (Rajan 37).

  15. 15.

    “As of 2007, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3 % drop in asset values could wipe out a firm” (Conclusions of The Financial Crisis Inquiry Report, XIX). “At the end of 2007 Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing between $50 and $70 billion in the overnight market (Conclusions of The Financial Crisis Inquiry Report, XIX–XX).

  16. 16.

    Rajan points out that the financial actors knew about the so-called tail risk and created expressions for it, like: “the Acapulco Play, IBG (I’ll be gone if it does not work), and, in Chicago, the O’Hare Option (buy a ticket departing from O’Hare International Airport: if the strategy fails, use it; if the strategy succeeds, tear up the ticket and return to the office)” (Rajan 139).

  17. 17.

    Benchmark return is the average return of similar securities.

  18. 18.

    The area of merit and demerit goods can give rise to a fundamental misconception: i.e., the idea that the government may intervene with everything in the economy and that such intervention has no limits. It is my view, however, that there are areas in the economy where the government unavoidably has to play a role such as in property specification and regulation of competition, credit creation and quality of many products. It is also my view that the role of the government can be wise or unwise. Hence, merit and demerit good actions must have solid reasons. These reasons limit the right for government intervention. Finally, it is also my view that the idea of merit and demerit goods is the way in which we see the conflict between capitalism and democracy work itself out (Rajan 18). This conflict can lead to felicitous and efficient outcomes or it can lead to deplorable outcomes. But the categories of merit/demerit goods provide a conceptual tool to reflect on dramatic aspects of capitalism like the events of 1929 and 2007–2008. In my view, Rajan makes deftly use of several categories of merit goods in his analysis of the 2007–2008 crisis and its aftermath.

  19. 19.

    Still it is worth noting that despite various weaknesses in the stimulus program, indications are that its impact on output and employment was positive (Blinder and Zandi 2010, 17; IMF 2010b April, 44; IMF 2011, 1).

  20. 20.

    For a libertarian analysis of the financial crisis which does not look for solutions by government actions, see: Lomasky, 2011.

  21. 21.

    The eleven categories are enumerated in footnote 4.

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  1. Georgetown University, 37th and O Street NW, Washington, 20057, DC, USA

    Wilfried Ver Eecke

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  1. Wilfried Ver Eecke
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Eecke, W.V. (2013). The Ethical and Socio-Political Dimensions of the Financial Crisis of 2007–2008 and the Subsequent Recession. In: Ethical Reflections on the Financial Crisis 2007/2008. SpringerBriefs in Economics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-35091-7_5

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  • DOI: https://doi.org/10.1007/978-3-642-35091-7_5

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  • Print ISBN: 978-3-642-35090-0

  • Online ISBN: 978-3-642-35091-7

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