Honesty and the Financial Crisis

Honesty is part of the moral foundation of capitalism. Buyers and sellers must trust each other in order to trade with each other. Without honesty, the free market fails. If customers think a business is deceiving them, they will walk away. If a business thinks customers are shoplifting or using bad checks, they will prosecute them. If a business does not honor its contract with an employee, the employee may quit and sue the business. If an employee tries to steal from his employer, the business may fire and prosecute the employee.

FINANCIAL CHAIN REACTION

The recent financial crisis of 2008 is a good example of how honesty impacts our economy as a whole. In that year, housing prices started to drop. This led to a chain reaction where:

1) borrowers defaulted on their mortgages in unexpectedly large numbers

2) banks and mortgage lenders lost lots of money due to bad mortgages

3) AIG, a company that insured against defaults, couldn’t cover all the losses

4) Investors pulled their money out of banks and mortgage lenders

5) banks and mortgage lenders failed as they couldn’t cover their bad loans

6) remaining banks made it harder to borrow money

7) consumers borrowed less money and reduced their purchases

8) businesses sold fewer products and reduced their production

9) employees lost their jobs and defaulted on more mortgages

WEAKENED MORAL FOUNDATION

Before the crisis, only 1.5% of borrowers would usually default on their mortgages. Government started to encourage lenders to make more loans to home buyers. Home prices started to rise. Looking for a higher rate of return, with little additional risk, investors began to buy packages of mortgages. Demand for these packages grew to the point that lenders started to recruit even riskier borrowers. Borrowers became less honest in describing their ability to pay back the loans. Lenders became less honest about the quality of the mortgage packages they were selling to investors. As long as housing prices went up, however, the lies could be covered with profits.

This weakening of the moral foundation was toxic to our financial system which is based on trust. Banks only keep about 10% of our deposits in reserve. The rest are lent out to consumers and businesses. If depositors have trust in their bank, they believe their money is safe and can be accessed whenever they need it. They have no reason to withdraw all their money at the same time other depositors withdraw all of theirs.  To strengthen this trust, the government even guaranteed the first $100,000 dollars of deposits for each customer of the rare bank that might fail. Under normal financial conditions, if customers believe their money is safe, it is.

2008, however, was not a normal year. Housing prices dropped, the default rate tripled. AIG had made bets it couldn’t cover, investors with much more than $100,000 withdrew their money, several of the largest banks failed, and the U.S. government allocated hundreds of billions of dollars to bailout and restore trust in the financial system. Temporarily, the U.S. government had to offer unlimited deposit protection, and later raised the level of permanent protection to $250,000.

A significant decrease in the honesty of individuals had a costly effect. Whether those individuals were borrowers or lenders, their decisions affected not just themselves, their businesses, and their families, but the whole world economy as well. How, then, can we prevent another financial crisis in the future?

TEACHING HONESTY

Dan Ariely has studied human behavior for many years (see article) and believes that all of us are dishonest and need to “create very strict rules and regulations to protect ourselves.” Ayn Rand reflected on the ideals of capitalism in her work Atlas Shrugged and believed, “A person should be honest because his happiness depends on it.” Certainly, we cannot guarantee that everyone will be honest whether we create an infinite number of laws or perfectly teach the way to happiness. Wisdom probably dictates an intermediate path: simple, clear laws and rules consistently enforced to define the consequences of dishonesty as well as simple, clear principles consistently modeled to explain the benefits of honesty. In every classroom, both should exist to help students establish a pattern of behavior that will continue throughout their lives. As students progress through different grade levels, they can experience honesty in different contexts such as budding entrepreneurs (see lesson plan PDF) or future taxpayers (see article). The eventual result, whether seller, buyer, employer, employee, borrower, or lender is a more honest, stable, and productive economy.

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3 thoughts on “Honesty and the Financial Crisis

  1. After reading the posting, articles, lesson plan, interview with Dan A., and seeing the video I’m left with the following impression: 1. Learn from past mistakes 2. Surround yourself with honest, hard-working, dedicated individuals 3. Teach young people the benefits of honest,hard work 4. Be a role-model for young people in all the areas mentioned above.

  2. Dan Ariely’s article, “The Truth about Honesty and Dishonesty” was intriguing. I am excited to share this with my students and to help guide their moral compass. I would love to see one of my students build off of the research with the5min. math tests and create a science fair project out of it. It might be fun to give the tests to honors students vs. regular; parents vs. students; teachers vs. students; etc.

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