Steve Waldman is on a roll. He has an excellent piece today arguing that despite contemporary notions otherwise, capitalism and character (meaning moral fiber) have not and need not be contradictory.
Although Waldman makes a good case, the barriers to the return of character in commerce are more profound than he lets on.
A colleague of mine, Amar Bhide, a professor at Columbia School, did some field work in the early 1990s on the role of trust in business and was very disheartened with what he found. Power and economic self interest trumped considerations of morality. Business owners were willing to accept being screwed by customers because they felt they needed them. They resented it deeply, they grumbled, but they accepted that they lacked the leverage to demand better treatment (I will need to locate his article, which I think ran in the Harvard Business Review, but the title was something along the lines of “Why Be Honest?” and it concluded, with considerable reluctance, that there wasn’t much upside in behaving well).
What makes it possible to have values is enforcement mechanisms, which usually boil down to prevailing standards. In a small town, if a store owner is unpleasant, tries to short change customers, or kicks his dog, word gets out and business suffers. But many of us mange our affairs in a impersonal way (think of Internet purchases). We have limited interactions with people. We might have a relationship with a firm, yet the account manager changes every couple of years. The standards thus reflect what is considered acceptable for the industry as well as the company. Great conduct in the credit card industry (if there even is such a thing) is not the same as great conduct from a hotel. Where is there opportunity for character to enter into either of these interactions? Even if someone goes the extra mile for you, you might never see that person again. Their effort will probably go unrewarded, or worse, might be against policy.
Now I am digressing a bit; Waldman meant character in a narrower Victorian sense, as being a person of one’s word. But even then, the drive to efficiency that has become pervasive in American businesses has made it well-nigh impossible for that to be operative. The reliance on FICO scores in place of more nuanced credit decisions is merely the logical result of processes that have been in play for many years.
One of my favorite banking industry factoids is that despite the widespread belief that bigger banks are more efficient, every study of commercial banks ever done has found that they have a slightly increasing cost curve once a certain size threshold has been achieved. Where the increasing costs (per dollar of assets) kicks in varies, but the highest point I saw (this was some years ago) was $5 billion in assets. One study found the break point was $100 million.
Now this flies in the face of most logic. Banking is all about automated, repeatable transactions. Moreover, big banks enjoy tremendous cost advantages in funding (big bond issues and other capital markets sources are much cheaper than relying primarily on deposits). Big banks are also more likely to be in pure fee businesses like M&A and loan servicing which require nothing in the way of assets beyond desks and phones.
My pet theory is that old-fashoned lending, the know-your-borrower types, is much more efficient on an all-in basis than the interpersonal, multi-layered credit scoring processes used in every type of loan product in a large bank. Yes, it costs you a lot more to source the loan. But they probably make it up in lower loan losses (a combination of lower default and more success with loss mitigation, since if you know the borrower, he will probably feel a greater obligation to repay. In addition, if he does experience real duress, your knowledge of him and the community will enable you to make a more informed assessment of his ability to repay, again improving the odds of a successful restructuring.
No academic has ever investigated my pet theory, but as of the last time I read the literature, no one had come up with an explanation. But there is anecdotal evidence. My colleague Doug Smith (no relation) in an article in Slate, pointed out that not-for profit lenders had provided subprime loans, yet experienced losses no worse than on prime loans, precisely because they screened borrowers in the traditional manner, in person, and assessed, among other things, their understanding of the loan and their degree of commitment.
So why, when we have had a resounding failure of impersonal methods of assessment, am I pessimistic about the revival of interest in character? Because it appears our society is unwilling to go back on the false economy of preferring anonymous, rule-based approaches. These methods do broaden the market of possible counterparties, which is seen an entirely beneficial, when there are hidden costs in having only superficial proxies about the people you interact with. If anything, I see ample evidence this attitude is becoming more pervasive.
Some examples: it has become common practice to put vendors to large corporations through a formal approval process. I have found them to be inappropriate and often misguided. For instance, one company required its vendors (which included big ticket law firms and consulting firms) to certify that their employees had gone through drug screening recently (the logic apparently was that if they had a drug habit, they might steal Big Corp’s secrets, as if they learned anything that might indeed be that easily traded upon). If you work for a good firm, the idea that you have to get tested to work on XYZ account is a non-starter.
Now a firm like McKinsey can usually escalate matters to a level of management where can get an exemption from this nonsense (a McKinsey partner told me that on a study where it came up, there was absolutely no useful intelligence the firm would be party to, plus, as pointed out, “We pay people well enough for them to afford their own drugs.”). But a smaller vendor would be unable to escape this and other cookie cutter demands that are often both intrusive and irrelevant. I’ve pretty much written off having large corporations as clients (I used to work for them quite frequently). It isn’t worth the indignity of going through that process. In fact, it seems destined (ex the firms that can wriggle their way out of it) to assure negative selection: only firms who really need the business will put up with these demands.
Similarly, it’s become increasingly common to use credit reports as part of the new hire screening process, even for very low level jobs. Again, I’m not sure what that proves, I can think of plenty of reasons why an otherwise conscientious person might have a bad credit record (say needing to support an ailing parent and becoming overextended). In close calls where there was a particular reason to think it might be helpful, I could see resorting to it, but to use it as a proxy for character is silly.
From Waldman:
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.
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Excellent post, can’t be repeated enough.
Yves, Thanks for the link to my Slate piece about the superior performance of nonprofits. Readers who would like my take on the entire issue of character and capitalism might read my book, “On Value and Values: Thinking Differently About We In An Age Of Me”
Good stuff, other than the fact that moral behavior would preclude one from practicing theft by deception – the underpinning of our economy. Inflation, bail outs, securitization of fraudulent assets (while shorting them as they are created), fiat money, insane compensation for the players, and Ponzi schemes are all parts of the “system”.
Capitalism works when well regulated (self-regulation being the rare anomaly). Remove the regulations, and it becomes little more than a breeding ground for criminality.
Yves:
I highly recommend reading “The Origins of Virtue” by Matt Ridley……
Being good is the best way to succeed….
No ifs ands of buts about it….
Best regards,
Econolicious
There is a debate right now in the academic economics literature about whether people are purely rational and self interested or whether they exhibit “social preferences” which is a catch all phrase for whether people are willing to behave in some sort of a non-selfish way, and how markets are affected by this. Check out some of the papers by Ernst Fehr. John List and Steven Levitt wrote an article about this in a recent issue of the Journal of Economics Perspectives, although I will warn you that List tends to lean toward the “social preferences don’t exist” camp.
the opinions of various high ranking business school professors, feldstein, bernanke, et al, are constantly aired. while a lot of the fraud and financial machinations currently causing the chaos in the markets is created and perpetuated by their former students. what did they teach them? when the little monsters win the nobel prize, all the academies trip trying to take credit, so why not give it to them when their alumni cause bankruptcy, recession and worse?
We live in an age of litigation. As a defensive measure, companies must turn primarily to blindly quantifiable and objectively impartial measures, however silly or irrelevant. If you turn down one applicant and accept another, and on paper they both look equally qualified, good luck defending the lawsuit by arguing intangible issues of “character”. Don’t blame corporations for adapting as they must to the society they exist within.
rexl,
You are a perfect example of the point of the post. When things are anonymous and your reputation doesn’t matter, you can make asanine comments.
You mean to tell me that bankruptcies, recessions, bubbles and busts didn’t occur prior to the advent of business school professors and their alumni? Let’s see, economics was born with Adam Smith in 1700s. Modern economics was born in the 20th century. So who “caused” the Tulip bubble in Holland in the 1600s? Who caused the South seas bubble in 1711?
A wonderful post – I’ll do my part to ensure a wider audience.
On an anecdotal and personal note this struck me:
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Where is there opportunity for character to enter into either of these interactions? Even if someone goes the extra mile for you, you might never see that person again. Their effort will probably go unrewarded, or worse, might be against policy.
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I completely relate to that – Someone at a peanut processing plant in a not-so-Southern state really went out of the way to ensure that I made the contacts so that I got “green peanuts” – a particular delicacy for me since I live in arid, cold Colorado.
I’d have LOVED to have written to the CEO telling them of the wonderful customer service I got when it struck me – she was, while still carefully obeying the rules of database privacy and of USDA regs still definitely going to the edge – for all I knew the CEO might get pissed, not pleased ! It would have the height of stupidity if my best wishes for her turned out to be a nightmare. So I just quietly ensured some money went her way.
Sad state of affairs…
-K
This is the best post Yves! Wall Street seems to think they can screw everybody all of the time.
What reason is there for character and morality when you can make as much money as you can now, and have the government bail you out later. Character and morality lead you to the poorhouse, while deceit and leverage lead you to the Hamptons. The fish rots from the head down!
Posts like these are the reason why I make sure that your blog is part of my daily reading.
Truly outstanding…and sorely needed.
Memo to Wall Street and Corporate America: doing the right thing brings the best long-term profits. It is also the best way to stave off the urge for more and more regulations, while far more economical than paying lobbyists.
How about this for slogan?
“Our behavior is our best lobbysit.”
“Character and morality lead you to the poorhouse, while deceit and leverage lead you to the Hamptons.”
njdoc,
There comes a time where the trip to the Hamptons can be diverted to a jail cell.
One of the best posts ever – can’t say thank you enough for this.
On a related point, as the owner of a small business I’ve found the same intrusive garbage in negotiating contracts with big investment companies. I refuse on principal to agree to that level of intrusion into my employees’ lives, and eventually the client backs down on some kind of technicality, such as the condition that we not be onsite for more than two consecutive days (not an issue for us). Silly, but it does seem to work, FWIW.
I once had the chance to study mortgage applications in Chicago from the early 70’s. The only thing that mattered on the application was the racial profile of the neighborhood of the house. Not income, not net worth, only race. (This was part of my stats M.S. program).
I believe reliance on objective measures such as FICO scores has been a tremendous advancement in removing racism and discrimination from the “know and be friends with the person you are lending to (and have the same skin color as)” system.
Let me chime in with the compliments as well. It’s rare to find a financial blog talk about something so quaint as character.
I do think that such notions of character and ethics can return to the field of business. But it has to be inculcated and taught from the very beginning. To look at another field, people entering medicine aren’t all angels. But students in medical school are taught from the first day about the need to put their patients’ interests first. Whether explicitly through courses and discussions or implicitly through subtle social pressures and being surrounded by good rode models, students gradually internalize the ethos of medicine. And it works. While there is plenty of abuse within the medical field, there’s still plenty of that character still around (how many MBAs would rush to the hospital in the middle of the night to operate on a blood-soaked HIV+ patient with no insurance?)
I think business schools need to look at themselves and realize that character matters, and that it can and should be a part of their educational goals. It can be taught. Perhaps that would start the process of rebuilding a profession that is uniformly reviled by the public right now (I’m hearing far more Wall St. jokes than lawyer jokes right now :-)
“I highly recommend reading “The Origins of Virtue” by Matt Ridley” – he’s a good writer, is Dr Ridley. He was less successful as Chairman of a bank – Northern Rock. What conclusion to draw from that is entirely unclear to me.
What does it profit a man, if he gain the world but loose his soul?
Sometimes financial considerations should not be the only ones when we make financial decisions.
Thanks for all the great comments and pointers.
Anon of 10:23,
I’d love to get to the papers (which all these financial implosions, the news du jour has become overwhelming). I get quite annoyed when I read the “rational economics” crowd. Yes, incentives matter, but the literature on cognitive biases is so deep that their premise bothers me.
As for “social preferences don’t exist” I suggest they visit Japan, or even much of Europe and Australia, where people like a high lever of social services and accept the corresponding higher tax rates.
Values in industries also shift over time; is this not a social preference?
Indeed, one of the things that makes me so disturbed about the current state of affairs is the contrast between Wall Street now and in the 1980s. Yes, people were greedy then too, they had an idea of where the lines were and they’d go to the edge often. But the industry operated on the philosophy that Goldman called “long term greedy.” You didn’t screw customers or investors (or if you did, only in teeny ways around the margin) because they were your meal ticket. You understood this was a symbiotic relationship.
Deregulation helped undo this (I think Rule 415, shelf registration, had more to do with this than anyone realizes. It shifted the relationship away from underwriters to deal counsel). The LBO wave was another big nail in the coffin, since some blue chip IBs supported raiders (suddenly companies couldn’t trust their banker). So customer interactions became more transactional, and the bankers became less interested in the client’s well being and more fixed on how each deal worked for them in isolation.
Lune,
The last time business schools became worried about ethics (I think this was circa 2002, in the wake of Enron and numerous accounting scandals), Harvard Business School concluded (based on some research as I recall) that ethics couldn’t be taught, you had to select for it. They allegedly changed their admissions policies.
I’m not certain business schools exhorting ethics in the absence of a bigger cultural shift in attitudes will work. Unfortunately, people judge actions more than words, and when you see the head of a criminal enterprise like Angelo Mozilo get cash and prizes, it’s hard not to discern how the game really works.
But if we were to see more miscreants going to jail, more excessive comp clawed back (I’m not holding my breath) then the B-schools could play a very useful reinforcement role.
Yves,
Then you would really enjoy the work of Ernst Fehr. Do a Google search and you’ll get to his website(s) which have a wealth of information on fairness, cooperation and social norms. He is widely published in main stream economics journals so he is a “serious” economist. He also collaborates with cultural anthropologist to look at the evolution of fairness and norms across cultures. One of his basic points is that you only need a few good apples to keep certain markets alive and create trust. Then even the selfish bastards will conform because they want to appear trustworthy as well. So having a few good apples can actually create a self-enforcing mechanism in the marketplace. Of course, this research is still somewhat in its infancy so a lot more needs to be done to understand the interaction between institutions, formal enforcement and self enforcement, but it’s a start.
Countrywide Financial (CFC) is trying to block a federal inquiry into the way it treats bankrupt borrowers, according to the Wall Street Journal on Friday. Reportedly, the Justice Department is leading the inquiry. The Office of the U.S. Trustee is also suing the troubled mortgage lender on similar issues in Florida, Georgia and Ohio.
The investigation is looking to allegations against Countrywide Financial about possible securities fraud and checking whether the company made misrepresentations about its financial state as well as the condition of its mortgages in its filings.
The Countrywide probe was first reported by the Wall Street Journal on Saturday, identifying it as one of the fourteen companies under investigation by the FBI as part of a larger investigation into the mortgage crisis. In late January, the FBI announced that it was probing 14 loan agencies for accounting fraud, insider trading, and various other violations in relation to subprime mortgage loans.
Is this the paper of Bhide that was mentioned:
With Howard Stevenson, “Why Be Honest if Honesty Doesn’t Pay,” Harvard Business Review, V 68, N 5: pp. 121-129, September-October 1990.
Oh, fantastic, that’s the article.
yves, try this:
The July 2005 Report of the Counterparty Risk Management Policy Group II draws a distinction between financial disturbances and systemic or potentially systemic “financial shocks.” An excerpt from the report follows:
“Financial disturbances arise with some frequency and can have their origins in a number of factors ranging from a geopolitical event such as September 11 to a failure of a specific financial or nonfinancial corporation. However, financial disturbances do not exhibit the very rapid contagion effects present in financial shocks. The absence of rapid and far reaching contagion effects may be due to any number of factors including: (1) the event was widely discounted in the first place, (2) public or private policy responses are swift and decisive, and/or (3) the event does not raise broad-based concerns about potential or actual credit losses that could compromise the ability of financial counterparties to perform in a manner consistent with their obligations. Credit-related problems, as discussed below, are of special concern because — as we have seen on many occasions — financial markets have a remarkable capacity to cope with financial disturbances so long as widespread credit problems are not seen as an imminent threat. Experience also shows that the fact or the fear of large credit losses is often the key variable through which financial disturbances become financial shocks.”
Refer to
Max Weber:
Protestant Ethic and Capitalism
anonymous 3/15;12:04pm
i don’t need anonymity for what i wrote. yes, there have been other ‘bubbles’. but not so expertly ‘engineered’. and if the building and bridges begin collapsing then the engineers who designed them and those who trained them should be interrogated. not merely asked for solutions to the current problem.
this current situation was created by people with very good educations and pedigrees. not mother nature or the carpenter’s union.
but at least class is still in session and some real lessons are on the way. there will be a test.
the assinine is in your mirror.
Trult fine post, thank you!
It is interesting how discussion about morality nowadays always involves rationality. Rationality seems to say one should always be selfish. And being moral means you sometimes do something that’s not selfish. And, horror of horrors, that’s not rational! What if the deal is that being moral means being irrational? Contributing something without expecting anything in return certainly is irrational, but without that, what would life be like?
But it is indeed an interesting drama to watch the profit-seeking crowd sing the hymns to morality – as they perceive that strange and beautiful creature.
Excellent thinking. One aspect that might be worth discussing further is the fact that the Fair Credit Reporting Act, which regulates to some degree the use and sharing of FICO scores (among other credit bureau info), uses language that explicitly identifies the character concern.
It defines a “credit report” as being “any written, oral, or other communication of any information…bearing on a consumer’s credit worthiness, credit standing, credit capacity, CHARACTER, general reputation, personal characteristics, or mode of living…” (emphasis mine).
Is it possible that this has misled lenders into believing that FICO is a stand-in for character?
E
Good post .
increasingly common to use credit reports as part of the new hire screening process…
When I first heard of this practice , I thought that for most jobs , it’s downright silly . Does it ever occur to anyone that a bad credit rating might be tied to being UNEMPLOYED?. In other words, it’s a Catch-22 situation , that this practice can further perpetuate.
… it has become common practice to put vendors to large corporations through a formal approval process..
I can attest to the folly of that . I worked for a landscaping/garden center/sod farm business. We recieved a request from Lowe’s to sell them sod . They sought us out, not the other way around . Most of our larger sod sales were based on a handshake deal, or even more commonly, just a phone call . If somebody wasn’t a good customer , they got no more sod . The next closet grower was > 100 miles away , and had the wrong soil , which caused problems . Suffice it to say , there was a substantial penalty for bad behavior . For our part , any poor performance (not that we would) could hurt other aspects of the business , through word-of-mouth criticism.
Along comes the BigBoxMarts. They were offering sod that was grown far away, on a different soil than our area , of poorer quality ( less care and younger age) that cost more to ship, that spent more time in transit . Even though he was skeptical of the long trem effect on our business, my boss, the owner agreed to become a vendor . That is , until the vendor agreement arrived . It was a twenty-page booklet . Even so he started to fill it out . Then, as he got further into it ,my boss got more and more irritated , until he threw it across the room , into the garbage .
The deal was one-sided, intrusive, insulting and we wouldn’t get paid for 90 days . Also if they mishandled it, and killed it , they wouldn’t have to pay. Lowe’s could have had a better product, at less expense, with a same-day (3-4hrs) response time for more , but process trumped everything else .