Character and Capitalism

Via the indefatigable Mark Thoma, our attention is drawn to an odd piece by Robert Skidelsky. I was left mostly bewildered by the article, but I was intrigued by the author’s discussion of the virtues that are and are not inculcated by market capitalism:

Consider character. It has often been claimed that capitalism rewards the qualities of self-restraint, hard-work, inventiveness, thrift, and prudence. On the other hand, it crowds out virtues that have no economic utility, like heroism, honor, generosity, and pity. (Heroism survives, in part, in the romanticized idea of the “heroic entrepreneur.”)

The problem is not just the moral inadequacy of the economic virtues, but their disappearance. Hard work and inventiveness are still rewarded, but self-restraint, thrift, and prudence surely started to vanish with the first credit card. In the affluent West, everyone borrows to consume as much as possible. America and Britain are drowning in debt.

One thing to remember is that there is no such thing as “capitalism”. In the real world, there are actual practices and institutions, the details of which bear consequentially on both moral and economic outcomes. There are infinity of possible capitalisms, and at any given moment we are living just one. A stylized graph of supply and demand always hides more than it reveals.

The capitalism we are living right now is rather a nightmare, due to a credit, um, event. So it seems a propos to remember that credit analysis traditionally includes an explicitly moral component. Remember the “5 Cs of Credit“? Character, capacity, capital, collateral, and conditions. Character.

Here’s a famous bit of financial history, as recounted by Jean Strouse in the New York Times:

Asked by the lawyer for a congressional investigating committee in 1912 whether bankers issued commercial credit only to people who already had money or property, [J. P. Morgan] said, “No sir; the first thing is character.” The skeptical lawyer repeated his question and Morgan, in Victorian terminology, elaborated on his answer — “because a man I do not trust could not get money from me on all the bonds in Christendom.”

If you think Morgan, the arch plutocrat, was just telling a nice sounding, self-serving lie, think again. Think about a world in which there was no SEC, FDIC, or Federal Reserve; in which there was no technology sufficient to prevent a person from simply disappearing, changing his name, starting over somewhere else. Morgan invested vast sums, and though he was a powerful man, he could always be taken. When parting with a dollar, he could not be so lazy as to presume a courtroom would ensure its repayment. Morgan had to trust.

Since Morgan’s day, in pursuit of efficiency and safety, we’ve built up institutions designed to automate and certify the evaluation of character. When we lend money, we don’t ask to meet the person who promises to repay us. We look for a nod by a regulator, the AAA brand provided by S&P or Moody’s or Fitch, perhaps a FICO score. But those are not markers of character at all. We don’t take them to be. We understand that banks engage in regulatory arbitrage, finding ways to stretch their balance sheet as far as possible for yield despite whatever regulatory regime is in place. We know that credit issuers (and bond insurers) do what they need to and no more for their rating, that perfectly dishonorable individuals attend to their FICO scores to maintain access to credit. Actual character is completely washed out of these proxies. The capitalism we have is one that presumes that all actors are sharks, that business is business, and that it is irrational to take any less than you can get away with unless you will “incur costs” from decertification. I’m not sure that J.P. Morgan would be willing to lend to any of us, and it’s not because we’re worse people. We just live in different times, a different world.

We shouldn’t go back to the world as it was at the turn of the century. When character evaluation was a personal exercise, it necessarily depended upon social connections, whether someone you know and trust can vouch for someone you don’t yet know, whether you can be sure that disgrace and dishonor would be costly. And we definitely should not adopt a moralistic attitude towards debt nonrepayment right now, just when a throng of irresponsible lenders are demanding “responsibility” from borrowers whose calls they would not even take a year ago. (For the record, I think that “jingle mail” is perfectly acceptable under present circumstances, and that the recent “bankruptcy reform” was a cruel mistake.)

But I do think that it’s an interesting technical question, going forward, whether we couldn’t set things up so that the criteria by which investors decide where to put their money map more closely to what we would recognize as trustworthiness or character. “Abolish the SEC and the Fed and the ratings agencies!” is not a sufficient proposal. Crises due to misplaced trust long predate those institutions, and are a large part of why they came to be in the first place. Morgan was successful not because he did what everybody did, but because he did what almost nobody did, despite the lack of ratings by S&P to stand-in for due diligence. Investors have always been hopeful and lazy in good times.

T.S. Eliot once wrote, “It is impossible to design a system so perfect that no one needs to be good.” Perhaps the art is to come up with a system, however imperfect, under which being good is the best way to succeed.


10 Responses to “Character and Capitalism”

  1. Cassandra writes:

    Steve, Nice thought-provoking series of posts! Interestingly, the contrasts between Citi and JP Morgan today should not be lost upon people. The Culture of Credit lives (Chase’s little petro-dollar recycling hiccup notwithstanding). And its even more fascinating that its survived the evolution of the House of Morgan from principal to agent. Heck, even other money center’s sent their new hires for Chase’s credit boot camp. A little dedicated training and adopted-culture goes along way.

    But the concept of “Trust” in America faces near-insurmountable hurdles. Myth, blatant demogoguery, wishful-thinking and perceptions of reality have merged in so many circles- not simply finance – such that one may wonder whether the culprit is deeply cultural, and not mere parochial greed. Whether in the realm of government, advertising, political correctness in education, or religion (and of course finance), bullshit and reality are juxtaposed forming the most lurid of non-sequitirs for those keen observers keeping account. Yes, there is nothing more dis-piriting than listening to a heartfelt sermon about kindness, respect responsibility, love thy brother, and trust, met with lots of “amens” and warm handshakes after, only for the same parishioners to nearly kill each other cutting one another off in the scrum to exit the church parking lot…

  2. jh writes:

    Character reflects the successful integration of personal responsibility and accountability.

    But differentiation of the same aspects has been the catalytic idea for securitization, derivatives, and the explosion of complexity, which together have become the credit beast.

    Now in the midst of the risk hurricane, we struggle to re-integrate, at first intellectually.

    We’re seeing in the mirror our own inadequacy to integrate the complexity we’ve created.

    From excessive precision has flowed mind numbing opacity. Soros’ reflexivity notion comes to mind.

    After the clean-up, where are we going?

    Does laissez-faire differentiation of risk require some restraint as a system for credit and capital allocation?

    Will the hyperbolic quantification and trading of risk be reigned in under some new paradigm of adult (intellectual/character) supervision?

    Isn’t this question essentially being asked of those institutions that have driven into the ditch?

    (i.e. “What were they thinking”, “Who was in charge?” etc.)

  3. groucho writes:

    “”Abolish the SEC and the Fed and the ratings agencies!” is not a sufficient proposal. ”

    Steve, you’re right it’s not sufficient, but it would be a good start!!!

    The # 1 problem facing us is the PRIMACY of the state over the citizen. Our founding fathers would be outraged if they were alive today and saw that their heroic efforts had been mainly in vain.

    The silver lining to this current state abuse of it’s citizens is that people are quickly getting “FED-UP”….

    as people realize that they are being manipulated over and over again; yet their(on average) standard of living is declining(which is bizarre with technological and efficiency gains)

    With information tech and electronic payment methods there is mathematically no reason to expand money claims. Division and subdivision are the only requirements. When Lemaitre developed the “Big Bang Theory”, he calculated that our Universe is a product of subdivision. I believe ~ 273(?) subdivisions. Which means if you took a penny and subdivided by that number(273(?), you would have as many units as there are planck units in our universe.(I hope my memory of the math is close)

    The finance areas where I would like to see changes are the legal tender laws and the FED’s charter. Opening up the legal tender laws to all would allow a productive competitive environment to evolve the payment/transaction process.

    Changing the FED charted to prohibit currency debasement would be the primary way to increase the citizens standard of living in the near future.

    Think about “price inflation” for a minute. To get an INCREASE in prices the govt has to devalue, on average, the currency enough to wipe out(on average) ALL efficiency that the system is able to generate. On top of that you must further devalue the exchange unit enough to get the govt’s required inflation tax to keep the treadmill in motion and make it hard for most workers to take a break.

    The system at this point has taken in all the domestic workers that it can and has even brought in foreign workers (some legal many not) to keep the treadmill moving forward.

    Any rational analysis of this system can see the inherent unfairness of the current system. Some individuals and groups will be efficient enough to overcome the currency devaluation(think transistor derivative industries and their spread throughout society). Most will not be productive and their gains will be “Free-riders”.

    The current system structure encourages this huge group of non-productive workers because of the refusal by govt to allow the currency to maintain(and increase) in value relative to those who are productive.

    It’s a dirty game, and hopefully, we can put an end to it in the not too distant future.

  4. Data Vs. Character writes:

    I would like to believe that people are better judges of character then a model like a FICO score or a credit rating. I don’t believe it though.

    A quantitative approach stops working when people are gaming the system. I’ll start with the rating agencies. The problems are not and haven’t been with real businesses but with synthetic, pseudo businesses, like CDO’s. No one can design a real business from the ground up to produce an optimal S&P rating. However, synthetic, business like entities like CDO’s were designed by ‘financial engineers’ to optimize ratings for any set of cash flows. They were designed to fail, because any rating model has its weaknesses, and these things were designed ‘backwards’ with full knowledge of the model. Think of sausage (but not too much). No problem when it’s made by the consumer, but rather disgusting when large meat packers decided to sell everything but the oink.

    The same with FICO. Once Suze Orman started pitching FICO 24/7, everyone knew exactly what lenders looked at, and were able to game the system to optimize their FICO.

    It’s not that judgment is superior to a number or rating, but that a number or rating in absence of any judgment, and with the rating formula or model well known, is bound to deteriorate over time.

  5. DownSouth writes:

    “The human mind cannot grasp the causes of phenomena in the aggregate. But the need to find these causes is inherent in man’s soul. And the human intellect, without investigating the multiplicity and complexity of the conditions of phenomena, any one of which taken separately may seem to be the cause, snatches at the first, the most intelligible approximation to a cause, and says: ‘This is the cause!”

    “The soldiers of the French army went to kill the Russian soldiers at Borodino not because of Napleons’s orders, but by their own volition. At the sight of an army barring their road to Moscow, the whole army–the French, Italians, Germans, Poles–hungry, ragged, and exhausted by the campaign, felt that the wine was drawn and must be drunk. Had Napoleon then forbidden them to fight the Russians, they would have killed him and would have proceeded to fight the Russians because it was inevitable.”–Leo Tolstoy, “War and Peace”


    “In recent years, America has put consumption ahead of production, spending ahead of saving, immediate gratification ahead of working for the future, the welfare of old people ahead of the interests of the young, greed ahead of sacrifice, self-interest ahead of loyalty, stockholders ahead of employees, short-term profits ahead of long-term growth, expediency ahead of quality, and the needs of the individual ahead of the needs of the society.”

    “…for the experts the key factors are the ‘hard’ technical variables (exchange rates, capital formation, production, and the technical skills of the labor force). For the public, the key factors are qualitative, especially the fear that America’s moral fiber is deteriorating….

    “I have grown even more convinced the solution to the …problem lies in the political will of the many rather than the technical cleverness of the few: Unless the American people have the stomach for the competition that lies ahead and are prepared to exert the necessary energy and commitment, there is little the experts can do. Our economic competition…is not going to be won or lost by the decision of a few economists, government leaders, and corporate executives. It will ultimately depend on whether average Americans are truly willing to overcome their reluctance to make the sacrifices and the commitment–as workers, as savers, as taxpayers, and as voters–that are necessary for America to compete better. If the energy and committment are not there, experts cannot compensate for their absense by technical agreements on currency rates, trade practices, or tax policy.

    “…I have grown even more convinced that the public’s frame of reference must be taken into account: if the value issues are resolved correctly,the technical solutions will follow. The alternative–to ignore the moral fiber questions and to focus exclusively on the correct technical policies of exchange rates, trade negotiations, investment in technology, curriculum reform, and so on–is a formula for failure.”–Daniel Yankelovich, “Coming to Public Judgment: Making Democracy Work in a Complex World”

  6. Cassandra writes:

    Groucho – while “The People” may indeed be getting Fed-up, I would argue they are no closer to either understanding or articulating precisely how or why their interests are being subverted. In fact, there remains a reasonable chance that they will yet again be seduced by popular demagoguery and empty platitudes promising more for less, come election time, while sadly “public Interest” remains negatively charged.

    DownSouth – Yankelovich hits the target, yet the realization, awakening, awareness of the Polity, the one that could vote in an admin as this – twice! – remains lacking, and is unlikely to to have an epiphany moment en masse until they (again en masse) hit bottom (recall the Vomit Scene in “Team America”), …rock bottom. Of course I wish this weren’t so, yet even tempering my own rather cynical view has proven too generous to predicting the path America has chosen for itself – politically, socially, and financially.

  7. Doug writes:

    The best way to foster character and enforce morality is to maintain the natural law of the markets. We are experiencing the failure of the markets to be allowed to correct and punish wild speculation. Who is preventing this? It is none other than the Fed and congress. With every well-intentioned bailout comes the unaviodable and worse moral hazard that promotes and sustains bad behavior. Recessions and market corrections are natural mechanisms that reinforce sound behavior and punish bad behavior. When we subvert the natural cleansing processes through manipulation, lying, and covert hiding of material facts that would otherwise be acted upon by the market to correct, we do ourselves a great inservice in the long run. Bernanke is trashing our currency while attempting to prevent the correction that end the end will take place anyway (just more dramatically). People need not fear recessions. The danger we have here is no different than forest management, where every forest fire was attempted to be put out immediately. Eventually, we inherited really huge fires that did much more damage. When will folks learn that cleansing is good, and that recessions are natural mechanisms to foster good behavior and punish bad behavior? The sooner we get rid of Bernanke’s unnatural attempt to manipulate the markets, hide losses, and protect bad actors, the better we will all be. If we don’t get rid of Bernakne soon, we’ll have that monster fire in the markets and a failed currency. People…wake up!

  8. Steve,

    I like the sentiment of the your piece and, in fact, I live in, and am able avail myself of, an environment in which trust, reputation, family ties and the like go a long way in one’s relationship with a bank.

    But aside from that, there are certain legal constraints, especially in the U.S., to making lending decisions on the basis of anything but a numerical arbiter – and this would likely apply to foreclosures as well. My take would be that this is one of the costs of the proper and correct, in my opinion, evolution of the basis for legal decisions away from the ‘spirit’ and towards the ‘letter’ of the law that took place starting forty years ago.

    The foregoing is, of course, irrelevant to the point of being imbecilic in an environment in which the only credit check made was a thumb placed on the inside of any applicant’s wrist. The ugliness of the situation is only superceded by the stupidity that led up to it.

  9. You're not sceptical enough writes:

    I’m sorry, but reading all this talk about the purity of the law of the market and how the FED has to get out of the way brings up all my bile. You all talk as if what was in question was the weather. “Fires burn forests and renew the land.” But hey, even Adam Smith understood the limits of natural law philosophy, and it seems like the libertarian ultra-capitalists can’t seem to acknowledge the fact that all the business they do happens not in the rough-and-tumble of the jungle, but in the cozy confines of a sovereign nation, where the police and the firemen and the teachers and all the other “service” people make it possible for them to sit and calculate the effects of the “natural” forces in the market.

    Why is it that all the gurus of pure capitalism always seem to exclude from their calculations of profit and loss all of the hidden costs. What does a barrel of oil cost if you establish an algorithm that accounts for environmental damage? Reproductive? What does it cost to replace the educated, democratic workforce capable of not only making consumer-oriented choices but having “character”?

    Stop selling this snake-oil!

  10. DownSouth writes:

    Cassandra, my thoughts exactly. Here’s a short account of America’s last ephiphany and the events required to trigger it:

    “Intermittently throughout the year 1933 the Senate Committee on Banking and Currency, with the aid of its inexorable counsel, Ferdinand Pecora, had been putting on one of the most extaordinary shows ever produced in a Washington committee room: a sort of protracted coroner’s inquest upon American finance. One by one, a long line of financial overlords–commercial bankers, investment bankers, railroad and public-utility holding-company promoters, stockbrokers, and big speculators–had filed up to the witness table; and from these unwilling gentlemen, and from their office files, had been extracted a sorry story of public irresponsibility and private greed. Day by day this story had been spread upon the front pages of the newspapers….

    “Naturally the composite picture blocked out by these revelations was not fair to the financiers generally. The worst scandals got the biggest headlines. Yet the amount of black in the picutre was shocking even to the most judicial observer, and the way in which the severity of the Depression had been intensified by greedy and shortsighted financial practices seemed blindingly plain. So high did the public anger mount that the New Deal was sure of strong support as it drove on to new measures of reform….

    “…the Depression had wrecked so many of the assumptions uon which the American people had depended that millions of them were inwardly shaken.

    “Let us look for a moment at the pile of wreckage. In it we find the assumption that well-favored young men and women, coming out of school or college, could presently get jobs as a matter of course; the assumption that ambition, hard work, loyalty to the firm, and the knack of salesmanship would bring personal success; the assumption that poverty (outside of the farm belt and a few distressed communities) was pretty surely the result of incompetence, ignorance, or very special misfortune, and should be attended to chiefly by local charities; the assumption that one could invest one’s savings in ‘good bonds’ and be assured of a stable income thereafter, or invest them in the ‘blue-chip’ stocks of ‘our leading American corporations’ with dizzying chance of appreciation; the assumption that the big men of Wall Street were economic seers, business forecasters could forecast, and business cycles followed nice orderly rhythms; and the assumption that the American economic system was sure of a great and inspiring growth.”

    “Not everybody, of course, had believed all of these things. Yet so many people had based upon one or more of them their personal conceptions of their status and function in society that the shock of seeing them go to smash was terrific. Consider what happened to the pride of the business executive who had instinctively valued himself, as a person, by his salary and position–only to see both of them go; to the banker who found that the advice he had been giving for years was made ridiculous by the turn of events, and that the code of conduct he had lived by was now under attack as crooked; to the clerk or laborer who had given his deepest loyalty to ‘the company’–only to be thrown out on the street; to the family who had saved their pennies, decade after decade, against a ‘rainy day’–only to see a torrent of rain sweep every penny away; to the housewife whose ideal picutre of herself had been of a person who ‘had nice things’ and was giving her children ‘advantages,’ economic and social–and who now saw this picture smashed beyond recognition; and to the men and women of all stations in life who had believed that if you were virtuous and industrious you would of course be rewarded with plenty–and who now were driven to the wall. On what could they now rely? In what could they now believe?”–Frederick Lewis Allen, “Since Yesterday: The 1930’s in America”