Perhaps we need to be more careful in the way we talk about the financial crisis. After all, why call it a “crisis,” when a more apt description is “scandal”? The tendency to label our current situation a crisis likely flows from an ingrained habit of viewing the world of business in general, and financial markets in particular as if they operate like a chemical reaction in a laboratory with determined and repeatable behavior. For those disposed to explaining market phenomena with a positivist mindset, who see the “business of business as business,” both the symptoms of and cure for today’s credit malaise are diagnosed in squarely scientific, even medical terms, as evidenced by the quick $700 billion and $2.3 trillion prescriptions written by government leaders in the U.S. and Europe respectively. In line with such a viewpoint, we’ve heard a lot of talk of how the economic erosion was precipitated by a falling real estate market, the product of recurring bubbles that appear every 10 or 20 years.

The doctors who seek to heal our financial markets believe that fundamental dynamics in housing and property markets lead to speculative bubbles that inevitably bring financial systems down with them (no matter what kinds of systems they are, not just those having substantial securitization and dominated by private banks) because financial systems are heavily involved in mortgage lending. But relying upon reductive scientific explanations to account for the present business fallout is as serious a delusion as the false belief that government bailouts, coupled with the geyser of regulations set to come gushing from congressional committees, can fix everything.

Professor Harold James’ “Thinking About Greed” offers a salutary reminder that beneath this all-too-real monetary crisis there is a moral malaise that calls for a sober reckoning with enlightened philosophical concepts. Our thinking must be guided with ideas like trust, honor and virtue, wrought from an ancient if somewhat neglected heritage. Yet, equally important, we need to see clearly the demands that moral wisdom anchored in the past imposes upon us today. Consider, for a moment, the fact that the subprime business scandal is intimately bound up with a host of moral malfeasances (naming but a few) such as:

- duping of homebuyers with unsuitable mortgage arrangements ( it should be pointed out that approximately 70% of homebuyers falsified the data submitted with their mortgage applications)
- creating nontransparent financial products (securitized mortgages) with risks either not disclosed or obscured in vague (at best) or utterly indecipherable (at worst) legal terminology
- biased valuations of companies’ financial posture given by rating agencies immersed in massive conflicts of interest
- intentional circulation of false information by hedge funds in order to “short” the shares of companies’ stock (”predatory short selling”)

Regulation No Substitute for Virtue

In light of the widespread malfeasance, the current economic scandal provides a special opportunity to recalibrate moral standards for market participants. However, stepping up government regulation in an attempt to enforce moral conduct in business will provide neither a satisfactory nor a lasting solution. Not only is it the case that a great deal of business activity cannot be effectively regulated (because it is normally too difficult or costly to do so and because it typically triggers elaborate loophole-hunting avoidance schemes), creating excessive laws threatens to dilute entrepreneurial initiative if not completely annihilate it.

The problem with government regulation can be understood through a musical analogy. The idea of, say, “cooking the books” in delivering a live violin performance is inconceivable. Without authentic technical and artistic mastery of the instrument, genuine musicianship is absent; no decent music gets created. Nonetheless there are not, nor could there be, government regulatory agencies charged with the mission of fostering musical artistry. Imagine the absurdity of a law specifying how to properly deliver a trill, complete with a list of penalties for violators. Music is, in its essence, a self-regulating enterprise. A technical execution of all of the notes of a piece of music – call it “minimal compliance” if you will – is understood by all reputable musicians to be merely the barest of requirements. Outstanding musicianship is all about the artistry that is added to the “minimal” accurate rendering of the notes. It is worth noting that we refer to one who has fully mastered the art of music as a “virtuoso.” All of this is to say that just as integrity in music cannot be externally imposed, neither can integrity in business be legislated. In both music and business, the exercise of virtue is fundamental, unavoidable and part of the very lifeblood of the endeavor.

No Bailout for Reputational Losses

The preservation of market efficiency requires much more than just market freedom and government regulation – it requires trust, transparency and truth. Of course, in principle governments possess the authority to enforce business agreements. Yet official efforts to provide legal insulation from all contractual breaches would be utterly futile were it not for a thick blanket woven with shared moral standards of promise-keeping and honor around which market transactions are enfolded. Moral standards are essential for facilitating efficient economic activity. In a free market, these moral standards are properly “enforced” against individuals and firms alike, not primarily or exclusively with government regulation but rather with reputational standards established by members of a free society. Recent studies show that most people believe businesses share the same moral and ethical standards as individuals. And a sizable percentage think we ought to hold companies to even more stringent standards that we hold people to, because businesses’ size, resources, knowledge, and impact greatly exceed those of individuals.

One important lesson that must be drawn from the scandal is that a deep connection exists between economic value and moral virtue. The hard physical and financial assets that market participants work so hard to establish (or shall we say create the illusion of having established) on their books are fundamentally linked to the way they deploy, or as is increasingly the case, destroy, intangible reputational assets such as credibility and transparency. Such intangible assets, which represent the most powerful force behind a firm’s long-term performance, are vanishing virtually unnoticed from our financial system.

All of the effort spent on tallying up the staggering financial losses from the collapse of Lehman et al over the past weeks has ignored a much greater and more significant loss of wealth from the raft of financial scandals: a catastrophic exodus of reputational capital, not only from financial institutions and corporate leaders but from political establishments as well, as the public begins to perceive the bailout as tainted with complicity, and conflicts of interest.

Ecology of Market Efficiency

Professor James’ suggestion of a reconsideration of Aristotelian, natural law, and enlightenment thinking about the role of ethics in business life is prescient. Yet some may wonder exactly what the conceptual link is between phronesis and synthetic collateralized debt obligations. While spelling out all the details exceeds the scope of this reflection, let me offer a glimpse as to the sort of path this promising inquiry could take us down. Since Aquinas, the natural law tradition has sought to use human reason to derive moral principles in such a way as to promote human well-being. The moral urgency engendered by the present economic crisis ought to prompt a return to reasoned moral discernment. There should be an effort to identify moral principles that impose civic obligations on market participants – all the way from corporate CEOs, CFOs, CAOs, to behind-the-scenes “gatekeepers” such as accounting and law firms. Without such principles there is the risk of systemic damage to, indeed outright subversion of, the overall market system.

Market participants share a goal of overall economic welfare as a necessary, albeit not sufficient, condition for achieving human well-being. Maintaining a market economy demands moral coordination. We might think of this as a call to arms to help sustain the “ecology” of market efficiency. The challenge of preserving the ecology of efficiency is particularly relevant to the present problem of business scandals, because it requires that market participants (among other things) not distort and withhold information that ought to be available to other market participants – that is, information upon which market efficiency itself depends.

It is reasonable to suppose that our human nature leads us to build up what Nobel Laureate Amartya Sen calls aggregative resources. Such resources are more health care, more education, more wealth, and so on. We take an increase in these things to be good even before moving on to consider how the “more” is going to be passed around to everyone in society.

All things being equal, achieving more efficiency means having greater aggregative resources. Yet because regulatory regimes are unable to legislate and enforce all of the moral conduct necessary for optimal efficiency, market participants have civic responsibilities to support cooperative business practices that enhance efficiency. What does all of this mean in the context of the current debacle? For starters, it would suggest that market participants ought to:

- promote transparency of relevant information (e.g. disclose the value of mortgage-related securities and other investment vehicles)
- refrain from promoting opprobrious business-government relationships (e.g. creating a dependency on and expectation of, government bailouts)
- honor contracts, promises and other business commitments
- eschew crony capitalism
- resist fraud
- avoid insider trading

Business leaders will find it in their long-term interest to develop virtues of cooperative action that will foster market efficiency, not burn it down. It is clear that cultivating such economic virtues penetrate way beyond the reach of regulation. Moral coordination as a response to the rash of scandals promises to circumvent the drawbacks of overt regulation, and will be a step in the direction of building trust and restoring confidence in the markets.

Kevin T. Jackson, Ph.D., J.D., is Professor of Legal and Ethical Studies at Fordham University in New York City, and a Senior Fellow of the Witherspoon Institute. Dr. Jackson has taught at Princeton University, Georgetown University and Peking University. He has published numerous journal articles as well as Building Reputational Capital, and Charting Global Responsibilities: Legal Philosophy and Human Rights. He sits on the Editorial Board of Public Discourse.

Copyright 2008 The Witherspoon Institute. All rights reserved.