Foundation Damage

Friday, June 27, 2008
Subprime-mortgage meltdown by Becker

Hardly a day goes by that the news media do not report on families in foreclosure proceedings or in arrears in repaying mortgages that had close to zero down-payment requirements and low teaser interest rates. Among the many excuses offered by some home owners for their plight, eagerly echoed by the writers of these human-interest stories, is that the borrowers did not understand that these introductory interest rates might rise a lot after a few years or that the occupants would have negative equity in their homes if housing prices stopped rising and began to fall. Another obvious way to explain their behavior is that they gambled that the good times would continue indefinitely.

This response to failed decisions is not unique to the housing crisis but belongs to the trend of shifting responsibility onto others. Women who sign a prenuptial agreement specifying the amount of their husbands’ premarital wealth that would be theirs in the event of divorce often try, when the marriage fails, to have the agreements overthrown. They claim that they did not understand what the agreements meant or that their husbands took advantage of them in other ways to get them to sign. Usually they signed simply because that was the only way they could marry the men they very much wanted to marry, perhaps in part because the men were wealthy.

Many criminals who confess to or are convicted of serious crimes try to have the courts excuse or mitigate their behavior. They allege that they had uncaring or abusive parents or that fathers, stepfathers, or other relatives or adults molested them as children. Abusive treatment is awful, but the vast majority of abused children manage to grow into law-abiding and responsible adults.

People who succeed in shifting the responsibility for bad decisions onto others, and to society more generally, create a “moral hazard” in behavior. If they are not held accountable for decisions and actions that harm themselves or others, they have less incentive to act responsibly in the first place because they will escape some or all of the unwanted consequences of their actions. It does not matter greatly whether this moral hazard results from shifting blame onto a contract and its “fine print,” an abused childhood, or a mental state.

Subprime-mortgage meltdown by Becker

A foundation of the philosophy behind the arguments for private enterprise, free economies, and free societies more generally is that these societies rely on and require individual decision making and responsibility. This philosophy emphasizes not only the moral hazard but also the principle one might call “use it or lose it”—that those who are accustomed to having other people or institutions make decisions for them lose the ability to make good decisions for themselves. Free societies lead to better decision making partly because men and women accumulate more experience at making decisions that affect their well-being and that of others.

Of course, I recognize that people are not equally capable of making decisions in their own interests. Clearly, the mentally impaired have trouble understanding complicated decisions. Ordinary people sometimes are fooled by how contracts and transactions are presented to them, perhaps because of cognitive quirks. College-educated people generally manage their financial assets better, and respond more successfully to many types of economic, health, and other stresses, than people with less schooling. For example, the anarchy in Russia after the collapse of communism greatly lowered the life expectancy of all Russian men except those with a college education. Those men continued to improve their life expectancy throughout the economic crisis that engulfed Russia.

People who succeed in shifting the responsibility for bad decisions onto others, and to society more generally, create a “moral hazard” in behavior.

Still, greater practice in making decisions, and greater responsibility for the consequences of one ’s decisions, usually significantly improves decision making by the majority of adults, regardless of limitations in education and cognition. The subprime-mortgage mess that continues to devastate financial institutions cannot be blamed on limited information given to borrowers because the crisis has also financially ruined many highly educated and sophisticated bankers, hedge fund managers, and others with years of experience in complicated financial assets. Borrower and lender alike, regardless of financial experience, were caught up in the atmosphere of a bubble that seemed to promise perpetual good times in financial markets.

What, if anything, should governments do to help out in this crisis, staying aware of the many kinds of moral hazards that lurk but also noting that the financial structure is delicately balanced? Despite the moral hazard risks, interventionist policies might be justified—not because some borrowers or lenders were taken advantage of but to help the economy recover more quickly and ensure that the recession is neither prolonged nor deep.