Ethical Reflections on the Financial Crisis 2007/2008

In this introduction I sketch the problem that I will address in the book: the financial crisis 2007–2008 and the subsequent recession. I point to the fact that notwithstanding Adam Smith’s defense of the free market, he also points to a role for the government in promoting a well-functioning economy. I quote Adam Smith’s argument for the necessity of governmental oversight of banking. We contrast this to Greenspan’s naive belief in self-regulation of the banking system. We document Greenspan’s opposition to banking regulation.

In this chapter I show Adam Smith’s great admiration for the new free market economy that is exemplified by his report on the enormous productivity of the pin-factory. Smith attributes this great productivity to the division of labor which allows workers to specialize and which encourages them, out of self-interest, to look for machines to help in their work. On the demand side, the new economy relies on the human tendency to barter where self-interest replaces friendship as the means to get what one wants. This tendency to barter entices the system to produce what people want at the cheapest possible price. This is, according to Smith, the presence of a kind of “invisible hand.” It is not the result of a (government) plan. Next, I show that Smith, provides an argument that the help of the government is needed in the case of the provision of roads thereby prefiguring the modern concept of public goods. I show how Smith anticipates the modern concept of merit good in his discussion of education, monopolies and the need of governmental control of banking. Smith even discusses the danger of lobbying to influence the regulatory power of the state.

In this chapter I expand on Adam Smith’s observation that roads and education cannot be conceptualized satisfactorily by the concept of private goods. The concepts of public and merit goods need to be added. I reduce the eighteen different characteristics of public goods, found in the economic literature, to the two crucial ones of non-rivalness in consumption and non-exclusion possibility of non-payers. I build upon the partial insight of Samuelson to claim that the three concepts of private, public and merit goods are ideal concepts which can be present jointly and in varying degrees in every economic event. Given that both Samuelson and Olson show the need for the government to make, in some cases, a decision without sufficient scientific evidence (Samuelson) or on ethical considerations (Olson), I argue that the concept of public goods demands the ethical concept of merit goods as introduced by Musgrave. I provide the different definitions and justification given by Musgrave. A discussion of the secondary literature allows me to strengthen Musgrave’s own confession that he has only been able to give a partial justification of the concept of merit goods. I announce that in the next chapter I will provide a Kantian inspired justification for merit goods.

In this chapter I add the concept of merit goods to the concepts of public goods and the free rider problem as one more economic concept that can be useful in the vocabulary of business ethics. Musgrave defines merit goods as goods that are so meritorious that the government has the right to interfere with consumer preferences. Thus the government can subsidize education and even make it obligatory. Musgrave (and I agree) stresses the fact that the concept of public goods is quite different in that in the provision of public goods the government intends to respect the wishes of consumers. I then produce a Kantian argument to justify and limit merit goods and I defend eleven categories of merit goods. I provide an example of a failed merit good implementation. The food business was successful in preventing the government’s implementation of the merit good program for breast feeding. Our question is whether, and when, business leaders have the obligation not to try to stop the implementation of a proven merit good. At the end of the chapter I argue that the idea of merit good expands the notion of stakeholder beyond what the concept of public good is doing.

In this chapter I make use of the publications of Reinhart and Rogoff, Reich and Rajan to understand the causes of the financial crisis of 2007–2008 and the ensuing recession. Reich and Rajan go beyond a purely economic analysis and introduce socio-political factors such as the income gap between the very rich and the rest of society in the decade before the crisis, the lack of regulations of the financial sector, the use of easy mortgages to keep the American dream alive, and the fraudulent treatment of some mortgages and the derivatives based on them. These socio-political factors touch upon ethical problems. The ethical dimension in economic thinking has been captured by Musgrave’s concept of merit goods. Reich and Rajan make use of seven of my eleven categories of merit goods to explain both the financial crisis of 2007–2008 and the characteristics of the ensuing recession. I end the chapter by showing that the American political system is currently not capable of delivering the merit good decisions required for dealing in a reasonable way with the challenges that led to the financial crisis and the recession caused by it.

I here survey the content of the book. In Chap.​ 2 I demonstrate that Adam Smith argued for allowing the self-interest of individuals to be the motor of the new efficient free market economy. Adam Smith saw a modest role for the government to deal with roads and education. I argue that this insight leads to the need to develop the concepts of public and merit goods. I develop those concepts in Chap.​ 3. In Chap.​ 4 I develop eleven domains where the government has a regulatory function. I call them the eleven categories of merit goods. In the last chapter I show, on the basis of the writings of Rajan, Reich and Reinhart and Rogoff, that the financial crisis 2007–2008 and the subsequent recession can be explained by deficient governmental actions in seven of the eleven merit good categories.