Prudence and ethical hazard

Paul Voss contends that in the current economic meltdown, irrationality replaced the reason required of the free marketplace. In order for markets to work, both honesty and reason must operate fully. In retrospect, it’s easy to blame banks and predatory lending practices. But it should be noted that consumers didn’t have guns to their heads . . .

Paul J. Voss

By definition, ethical hazard — often called moral hazard — occurs when systems or processes actually provide incentives for individuals to engage in illegal, risky or unethical behavior. Ethical hazard often occurs when individuals bear little or no responsibility for their actions.

Ethical hazard continues to flourish in our world today, often with a profound economic dimension. For example, Michael Lewis, author of the best-selling The Big Short: Inside the Doomsday Machine, keenly chronicles how ethical hazard helped contribute to the devastating mortgage crisis and, ultimately, to our current great recession. Lewis, perhaps the most insightful (and certainly the most readable) commentator on the global economic crisis, examines how easy credit and free-flowing money provided perverse incentives in a bubble real estate market—encouraging hundreds of banks to loan money (they didn’t have) to millions of consumers to buy homes (they could not afford).

In a short period of time, irrationality replaced the reason required of the free marketplace. In order for markets to work, both honesty and reason must operate fully. However, the numbers simply would not scan when applied to risky (or sub-prime) loans, losing any semblance of rationality. According to Lewis, “the interest rate on the loans wasn’t high enough to justify the risk of lending to this slice of the American population. It was as if the ordinary rules of finance had been suspended in response to a social problem.” Collectively, bankers and home buyers lost the good of the intellect.

In retrospect, it’s easy to blame banks and the so-called “predatory lending practices” used by mortgage companies. But it should be noted consumers didn’t have guns to their heads. No bank coerced them into taking out the loans. Both sides of the transaction share culpability for acting without prudence. Now that our economy appears on the slow road to recovery, what can we learn from this financial debacle?

The Catechism of the Catholic Church actually says very little about business and the pressing issues facing the world economy. In fact, with all the attention given to questions about stimulus, tax rates, unions, free markets, health care reform, welfare, unemployment, and a host of other economic concerns, the Catechism only provides rather general, even if excellent, guidelines:

“The Church has rejected the totalitarianism and atheistic ideologies associated in modern times with ‘communism’ or ‘socialism.’ She has likewise refused to accept, in the practice of ‘capitalism,’ individualism and absolute primacy of the law of the marketplace over human labor. Regulating the economy solely by centralized planning perverts the basis of social bonds; regulating it solely by the law of the marketplace fails social justice, for there are many human needs which cannot be satisfied by the market. Reasonable regulation of the marketplace and economic initiatives, in keeping with a just hierarchy of values and a view to the common good, is to be commended” (CCC 2425).

The definition of “reasonable regulation” can vary widely from person to person, and we see this tension played out each day in Washington. The emphasis upon prudence, however, remains a hallmark of the teaching. So how should we enhance prudential judgments in our lives — both in the public and private spheres?

Oscar Wilde once quipped, “I can resist anything except temptation.” Unfortunately, the world is full of temptations. Thus, the Act of Contrition reminds us to avoid the near occasion of sin. The Lord’s Prayer famously pleads “lead us not into temptation.” It’s a warning away from the power of temptation and staying clear of the ethical hazard.

The lives of the saints provide us with ample examples of heroic virtue in business. Quick trivia question: Who is the Patron Saint of Business? If you guessed St. Homobonus (Latin for “good man”), congratulations. It puts you in rare company. We know very little about Homobonus and few feel a deep connection to his patronage. We have more information, however, on St. Margaret Clitherow, a martyr from the Elizabethan period and patroness of businesswomen. Margaret was crushed to death by rocks for allowing a Catholic priest to say Mass in her home. She left behind an accounts book from the family farm and thus came about her patronage. But even the communion of saints provides only a modest number of models to emulate.

Yet, at the end of the day, we must use the general framework of the faith and the virtue of prudence (the queen of all the virtues according to St. Thomas Aquinas) in conducting business activity. Prudential judgments play a signal role in the business enterprise — from cash flows, to inventory, to expansion, hiring, product offerings, and nearly every aspect of a company. But more than ever, we need to exercise the virtue of prudence, both to recognize and to resist the lures of ethical hazard.

Paul J. Voss, Ph.D., is president of Ethikos, a professional organization offering ethics training, and an associate professor of literature at Georgia State University.