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| These guys don’t look very moral to me. |
Deficits is a wonderfully crazy collection of conference papers edited by Charles Rowley, Robert Tollison and the late “Nobel” Laureate
James M. Buchanan. It has been called “the Rosetta Stone of insane conservatism”, and it contains a chapter on the Ethics of Debt Default.
Matt O’Brien has promised me a piece on it which hasn’t appeared yet—he assures me that he will not default on this obligation because default is immoral—but I have some thoughts in response to what I think he will write that I might forget, so here goes. Besides, it’s easier to formulate a response to something if you haven’t read it.
- During the financial crisis there was a lot of discussion about whether it would be ethical for underwater homeowners to default and walk away from their mortgages, especially in no-recourse states. The legal scholars were generally agnostic on the ethics: from their point of view, a mortgage loan is a contract, breaching a contract is not even illegal (it would simply expose you to damages), and something that is not illegal cannot be wrong. Liberal types tended to favor this sort of strategy because it would alleviate misery.
- Conservative and libertarian types, perhaps because it could be good for poor people, railed against any sort of effort to encourage homeowners to do default. The argument goes something like this: There is a social contract that borrowers will try to stay current on their loans and not default. This social contract cannot be enforced in a court, but if it is broken, it will inevitably lead to higher mortgage interest rates because it would change the behavioral assumptions about default that are used when interest rates are set. If borrowers start defaulting willy-nilly, they will hurt themselves in the long run.
- I basically think that analysis is correct, even if I might disagree with the conclusions. I do, however, worry about the ethics of encouraging one group of borrowers [not] to do something for the benefit of a larger, and possibly different, group. The people we would be encouraging to default probably would not be able to borrow again for a while, no matter what they do.
- Some (subblog!) even tried to argue that strategic default by corporations is perfectly fine. Default is only bad if individuals do it.
- Buchanan makes a moral argument for the US defaulting on its debt, or maybe just half its debt. In my reading, he stops short of actually advocating for default, but the whole theme of the book points in that direction.
- Matt thinks that default is immoral and Buchanan is nuts. (This is a danger of responding to something that hasn’t been written yet: maybe his views aren’t that strong.)
- Is it moral for individual underwater homeowners to default strategically? Yes.
- Is it moral for the United States to default to make a point about the Affordable Care Act? No.
- Is it ever moral for the United States to default? In the present situation, default wouldn’t serve any useful fiscal purpose. Trust-with-a-capital-T is important: we should fulfill the obligations we incur. With the possible exception of the most questionable loans, we should expect borrowers to pay what they owe. But part of the implicit contract was also that they could default if they had to and were willing to suffer the consequences. There’s a reason we call it the default option. Many homeowners were (are?) in a desperate situation where they could clearly benefit from defaulting.
- The implicit contract for US government debt is different. While a subprime or credit card lender knows that the borrower might default, the expectation on both sides of the US Treasury debt contract is that there will never be a default. In a sense, the US government has promised never to default, a promise that regular borrowers—whether they are individuals or corporations—do not and cannot make.
- The US does not actually benefit fiscally from defaulting right now. Would default be more moral or advisable if the United States were in a situation where debt is high, interest rates are high, but deficits are low, so there would be some conceivable benefit from defaulting? I am not sure.
Update: Read this, this and this from Matt Bruenig.
I'm pretty sure no libertarian would ever argue that something needs to be done because of a mythical "social contract."
ReplyDeleteThey probably wouldn’t use that phrase, but that’s how I interpret arguments like this: http://www.theatlantic.com/business/archive/2011/12/why-shouldnt-people-just-default/250059/
Delete"There is a social contract that borrowers will try to stay current on their loans and not default. "
DeleteAnd few, if any, right-wingers have a problem with corporate default.
Conservatives and libertarians who argue that there is a moral obligation on underwater homeowners in non-recourse states are simply hypocrits - what happened to the sanctity of contract?
ReplyDeleteA mortgage in a non-recourse state is simply a call option on a house. If the holder of a call option chooses to not exercise it (in this case the home owner by not paying the mortgage) where is the moral fault? The banks knew what the law was when they offered the interest rate.
So far as morality of default goes: it would be moral for Greece to default; it would have been moral for Ireland and Spain to refuse to guarantee their banks' obligations to German lenders.
Is it totally weird that I think the morality of US default is somewhat different from Greek default or Irish and Spanish implicit (?) default?
DeleteNo, it is not weird at all because fundamentally you know that: (1) the United States can afford to pay its debt; (2) Greece cannot pay its debt and (3) Ireland and Spain should never have allowed themselves to be strong armed into assuming their banks' obligations to German and French banks. On the other hand, Italian default, like American default, would be immoral because, as a nation, they have the means to pay but would prefer not to.
DeleteI think the more interesting question is: Can our economic system survive in the long run if businesses (or consumers) treat default as just another business decision?
ReplyDeleteArguably the whole subprime crisis was driven by firms that intended to default (i.e. the subprime mortgage originators like New Century).
Wrote a blog post on this a while ago: http://syntheticassets.wordpress.com/2010/01/09/should-default-be-a-business-decision/
It’s only a question question as applied to consumers, right? Businesses already treat it as just another business decision.
DeleteThe question is what happens "in the long run"? I don't think the economy has fully adjusted yet to the fact that businesses believe they have contracts, not obligations.
DeleteArguably, that's why the pension crisis is unrolling so slowly (i.e. workers still think they have pensions, not obligations that their companies will offload to the PBGC in the future).
I think there's a genuine question whether the bond market can survive this change in attitude over a long horizon. In the end (i.e. a few more crises down the road) the investors may flee. The institutionalization of investment (where many individuals have little or no control over where money is invested "for their benefit") is probably slowing the economy's reaction time to such phenomena.
cssisoko - you are confusing the ex ante fraud in the mortgage industry with ex post decisions to default. We have had limited corporate liability and personal bankruptcy for a long time.
DeleteAnon: I am well aware that we have had limited liability and personal bankruptcy for a long time. But, for that very reason, in the developmental stages of financial markets in bonds the underwriters made sure there was a commitment (beyond mere legalities) to pay. The Rothschilds in fact used to buy up the bonds that were heading towards default that they had underwritten in order to demonstrate their good faith to the investors to whom they had marketed the bonds -- although they had no legal obligation to do so.
DeleteThe question is whether markets that were built on one set of principles and approach to debt can survive a transition to an aggressively legalistic approach to debt.
Re the mortgage industry. It's pretty clear that a lot of corporate structures are being designed these days with the ex ante anticipation that bankruptcy is a real possibility. Bankruptcy is far from a simple "ex post" decision to default in the modern era.
Unless of course you want to argue that someone who borrows $100 to buy a lottery ticket with the intention of paying only if he wins the lottery never has an "ex ante" intent to default. An argument which I would say is clearly silly.
csissoko - Libertarians advocate an aggressively legalistic approach to everything so they should applaud home owners in non-recourse states walking away from their mortgages.
DeleteI think you are dreaming of a golden age that never existed. Forcing debtors to wear a hair shirt and sacrifice their health and their children's futures so that mortgage holders can collect a few extra thousand dollars on a mortgage that should never have been granted and can never be paid makes no sense from society's social point of view.
The possibility of default is always acknowledged at the time of borrowing and the odds taken into account in setting the interest rate. There is nothing wrong with that as long as there is full and honest disclosure at the time. The financial crisis was caused by widespread deceit and no one has gone to prison for it.
If you want a focus for your moral outrage focus on the mortgage originators who mislead unsophisticated borrowers and mislead mortgage investors rather than some poor schmuck who now has to chose between paying his mortgage and feeding his children. You can talk about the morality of consumer default after we have sent ten thousand bankers to prison for the rest of their lives.
Anon: Moral outrage? You aren't hearing any of that from me, as is clear if you read my comments.
DeleteI'm simply stating that a "moral" approach to bankruptcy (which I actually would frame as a matter of a principle-based foundation to a debt based economy) is as -- if not more -- relevant to business bankruptcy than to consumer bankruptcy.
Given the treatment that businesses offer to consumers/employees, I don't think there is any choice for consumers but to join them in their "amoral" approach to obligations. My question is whether our financial system can in fact survive this evolution in the long run.
In short, given the world we live in, I have no problem with strategic default by borrowers. But I think we need to ask a first question: whether strategic default by business is undermining our financial system.
Re: "golden age that never existed": If you spend time with the classic works of European literature or European history books, you will probably see that attitudes towards debt have evolved dramatically.
Strategic ex post default by business to avoid re-paying loans does not really work (or make sense from the corporate point of view). Artificially engineered defaults as a way to break collective agreements and drain pension funds to benefit bond holders should be a crime.
DeleteAnon: "Strategic ex post default by business to avoid re-paying loans does not really work"
DeleteWhat about New Century and the other subprime mortgage originators? The companies were set up with significant liabilities the existence of which would only show up when housing started to fall in price. They were able to use current income to pay comfortable salaries, and declare bankruptcy when the liabilities started to come due.
More generally making sure that liabilities get placed with less capitalized subsidiaries, that go bankrupt separate from the better capitalized parent, is I believe a fundamental corporate structuring strategy.
So I don't understand your claim about the absence of strategic default by businesses (whether ex ante or ex post). Strategic default seems more like standard business practice these days.
There is a difference between (1) setting up subsidiary with low capital knowing it might fail and making full disclosure of its circumstances to all prospective creditors; and (2) setting up a subsidiary with low capital expecting that it will probably fail and using misleading accounting treatments to hide the risks from prospective creditors. The first is ok, the second is a fraud (really no better than a "dine and dash").
DeleteOff balance sheet (undisclosed or incorrectly valued) liabilities are a huge problem. The financial crisis should have triggered a major existential crisis for the accounting profession.
The regulators have demonstrated that they are only capable of getting a conviction when the perpetrator comes in and makes a complete confession a la Madoff. Other than that, the regulators don't find the frauds in a timely fashion and can't prosecute them effectively when things blow up publicly. (how many people have gone to prison for the billion dollar shortfall in customer accounts at MF Global?)
In a theoretic model perhaps everything can be divided into "full disclosure" or "fraud." In practice:
DeleteWhat is "full disclosure"? GAAP accounting (where contingent liabilities don't always need to be reported)? There are lots of smart people who are very good at finding the grey area that lies between "full disclosure" and "misleading accounting." And, in practice, these issues are far too complicated to capture all undesirable activity under the rubric "fraud" even with the best quality accounting standards. Whatever rules are written can be gamed, if there are people looking for a way to game them.
That's why I believe that social norms matter. When people consider being associated with a bankruptcy a stigma, it's easier for a debt-based economy to function. When people are more willing to take aggressive positions that risk bankruptcy, it may over time undermine the whole financial system.
I fully understand that there is a continuum between full disclosure and fraud. I pointed to the two alternate extremes for rhetorical purposes. I think prison for false financial reporting would be a better solution than attaching more stigma to bankruptcy. Stigma of bankruptcy will not improve corporate conduct.
DeleteMost personal bankruptcies in the United States are caused by medical bills. Add in bankruptcies caused by bad luck, addiction, mental illness or divorce and you will probably cover the overwhelming majority of bankruptcies. More stigma will make society worse, not better.
Anon: I'm saying that our financial structures may be built on the foundation that a stigma exists for any accounting firm, underwriter or parent firm that is associated with a business bankruptcy. (This stigma used to mean that it was hard or impossible to get new business -- unless there was a very good explanation for the bankruptcy.)
DeleteBusiness bankruptcies are not caused by medical bills. I'm not really addressing the issue of consumer or personal bankruptcy. My whole point is that we need to address the issue of a principle based approach to business debt, before we even address the issue of consumer debt.
The problem with prison as a solution is that it is simply not possible to write rules that both allow valid business transactions to take place and cannot be gamed.
csissko - This comment is limited to business debt.
DeleteWe want people to take risks and that means that sometimes there will be failure and creditors will not be paid. Failure is feature not a bug in a capitalist economy. In a free market we want business people and investors to be able to negotiate who will bear what risk. Lenders and creditors are just particular types of investors.
Attaching stigma to all business failure is counter-productive. We actually have a shortage of entrepreneurs and punishing those who try and fail is not a good idea. What does deserve punishment is falsehood which leads investors to misprice risk. While the boundaries between behavior which is acceptable, which attracts civil liability and which attracts criminal liability may be difficult it is not impossible.
Five per cent to 10% of Wall Street bankers are sociopaths. The threat of stigma will not make them honest. The threat of a lifetime in prison might make them careful.
We also want people to be able to live lives. That means personal bankruptcy cannot be considered a moral fault. In fact, we should have a mechanism so that ALL individuals have a shell operating company that can be folded at bankruptcy and immediately replaced with a clean corporation so they can have access to credit promptly, just as if they were a state chartered collective.
DeleteAnon: I agree that the ability to declare bankruptcy and to get a new start are very important to our economy.
DeleteThe question I am asking is whether the bankruptcy system is best supported by an accompanying social obligation that business debtors, their accountants, and their underwriters all support the creation of debt contracts only when they reasonably believe that they can be paid. Or whether it is the creditors' obligation to ensure that debt contracts can be paid.
In the absence of such a social norm, the asymmetric information problems inherent in debt contracts are aggravated. And we shall see where this increasing problem of asymmetric information will lead us.
Just one more thought: the first 4 items are about two questions. One is a moral one about whether it’s okay to default. Another is a meta question about whether it’s moral to encourage people to default or educate them about the possibility and the consequences.
ReplyDeleteProfessor Lars Pålsson Syll : "Do a Eugene Fama — help create a financial crisis and get a Nobel prize"
ReplyDeletehttp://larspsyll.wordpress.com/2013/11/02/do-a-eugene-fama-help-create-a-financial-crisis-and-get-a-nobel-prize/
Great point about it not being illegal to break a contract.
ReplyDeleteThe moral question is obviously a silly side show. I think your attempting to address it seriously highlights that once again.
I strongly doubt that your point number 2 is anything but a ridiculous strawman. The point is utterly irrelevant as no one ever is recommending defaulting willy-nilly.
There is an empirical question however, do interest rates get set permanently higher as a residual penalty once a person/entity has defaulted. My best guess is that the evidence will show that does not happen. Lets just use one timely example. Everyone knew Greece defaulted every few years yet lenders fell on top of themselves to shovel money at them right until the next default.
Lenders do get paid for credit risk, but like most investments, the credit risk is prospective not historical. Credit risk usually declines post default. (and of course it is also often miss-priced, but that you don't know till later)
Dan
Default is an ethical approach to a debt with a commercial lender. Selling that debt to further investors I think has a much broader scope for unethical decisions to be made. It is unethical to discontinue required insurance and property tax payments while in default but prior to losing the property to foreclosure. These last two steps are routinely done, but not by people who have integrity. I do think the insurance part of it can be somewhat foolhardy as well as a loan might be non-recourse with respect to paying the priniciple and interest, but the value of the secured property in the event of an uninsured loss is frequently not non-recourse. It could be a real kick in the teeth to discover that a court decides that once you rebuild the house that got destroyed, you can at that time walk away from the loan on it.
ReplyDeleteI have been giving insolvent consumers legal advice for thirty years. Discontinuing property tax and insurance payments is not unethical but it may not be good strategy.
DeleteWhen the bubble burst, several people I knew who worked in the financial industry simply stopped making mortgage payments and were surprised at how long it seemed for their mortgage servicing companies to notice. They had bought in near the top. It was time to re-balance their portfolios. Why shouldn't everyone do that if it would be to their advantage? Surely there is no moral basis for insisting that people act as if they were stupid to their own detriment.
ReplyDeleteIf we were concerned about the morality of our business relationships, we would have stopped subsidizing our bloated financial sector and put tens of thousands of perjurers, bucket shop operators, con game operators and the like in jail. We didn't.
Since, for ideological reasons, we had to fly in the face of laissez faire economics and bail out the failed financial sector, we could have done it morally by simply paying down underwater mortgages, perhaps by means of a tax credit and mandatory note revaluation. This would have improved everyone's books and prevented a lot of foreclosures and economic problems. Unfortunately, as in the Soviet Union, ideology trumped common sense.
"something that is not illegal cannot be wrong"
ReplyDeleteSomebody actually makes that argument? it is ridiculous: it is wrong to be rude to people unnecessarily, but not illegal! And anyone can easily come up with thousands of similar examples.
yeah,, come confusion"What is "full disclosure"?"
ReplyDeleteIvory tower nonsense to suggest there should be some moral impetus to continue to pay the mortgage on an underwater asset. Do homeowners borrow at the risk free rate? No? Then STFU
ReplyDeleteIs charging interest beyond the risk free rate moral? Certainly not if debtors are obliged to pay no matter what. Or is it not a symmetric moral obligation?
ReplyDeleteHow is it my comment didn't make it through moderation but, MTR Gaming Launches Innovative Online, sachin Dubey, and Jan (all obviously spam) did?
ReplyDeleteMTR Gaming Launches Innovative Online6:43 AM
yeah,, come confusion"What is "full disclosure"?"
I take it back about Jan being spam. No need to publish my moderator approval rants.
ReplyDeleteCheers