Market Exchange, Self-Interest, and the Common Good: Financial Crisis and Moral Economy

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The central Lesson for Political Economy

The central problem of the financial crisis--as viewed from my philosopher's perspective, at least--is the failure of self-regulation by self-interest to moderate externalized risk in the financial system. Self-interested market actors--mortgage lenders, securities traders, investment bankers, and bond insurers--made risky investments on the assumption that the risk could be moderated by dispersal throughout the financial system. That assumption failed.

Risk-Management in Financial Markets

Mortgage lenders issuing sub-prime mortgages diverted the risk from their balance sheets by selling the loans on the secondary market. Investment banks buying sub-prime mortgages moderated the risk by securitizing them--bundling loans and dividing the bundles into a series of bonds. Securitizing sub-prime mortgages diluted the risk by spreading it among many investors. Investors leveraged their positions to purchase mortgage-backed securities and then hedged the risk by purchasing derivatives as insurance on their investments. These derivatives, which guaranteed the value of the securities in case the underlying loans went into default, transferred the risk from the security-holder to the derivative-issuer ("credit-default swaps"). This complex system of risk-dispersal by securitization provided the rationale for credit rating agencies to give the highest rating to securities backed by high-risk, sub-prime mortgages. In turn, the AAA rating provided the rationale for investment banks to sell those securities as safe investments, for investors to increase leverage to purchase those securities, for commercial banks to lend money to investors, and for insurance companies to swap the risk of default on those securities with investors.

In the older paradigm of finance and investment, from the Great Depression until the Greenspan era, tightly regulated, highly transparent institutions--commercial banks, savings banks, and insurance companies, backed and monitored by government guarantees and regulators--served as the "risk sink" in the financial system. This public system of financial regulation complemented the professional ethics of private actors: bankers, insurers, and lawyers did their work with a shared sense of public trust.(1) In the new paradigm of the Greenspan era, regulating agencies and self-regulating professions were replaced by self-interested investors and self-regulating markets. Loosely regulated securities markets were to moderate risk by dispersing it among private investors throughout the financial system. Unregulated derivative markets were to be the ultimate sink that would absorb the excess risk of increasing investment in sub-prime mortgages. Thus, Alan Greenspan could say to the Senate Banking Committee in (2003) : "What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so." Furthermore, Greenspan was confident at a Congressional hearing in (2000) that because excess risk had been "sunk" into the derivative markets, the financial markets were sufficiently buffered from systemic crisis: "I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically--I should say, fully--hedged." (2) Banking on a fundamental faith in financial markets, Greenspan consistently resisted government regulation of derivatives during his tenure at the Federal Reserve. (3)

Self-Regulation by Self-Interest

The operative theory of this complex system of risk management in financial markets was to be neither bureaucratic oversight nor professional ethics but self-regulation by self-interest: investors and institutions, acting on rational self-interest would not expose themselves or their shareholders to excessive risk. …