The Pope Analyzes the Market Crash

And he has a point. I have not often agreed with previous Popes' concerns with the lack of morality of free markets, but Pope Benedict, in a 1985 presentation titled "Money, Markets and Ethics" authored when he was Cardinal Ratzinger had the following to say:

But the damage caused by the lack of morality of market players could end up being fatal for the system itself. "The decline of such discipline" – the moral discipline which is the product of "strong religious convictions" – "can actually cause the laws of the market to collapse."

How prescient. All market economies are built on trust. We trust that competition causes prices for similar goods to be similar when we shop. Investors trust that published financial information of companies is more or less accurate. Lenders trust that borrowers accurately describe their ability to repay loans. Sometimes trust is aided by regulation. More often it is the product of the free market, where untrustworthy actors suffer through loss of reputation and therefor loss of business.

However, the market discipline tends to break down when transactions are one-off, i.e. not likely to be repeated. This is why garage sales have to deeply discount used goods compared to Ebay. You are probably never returning to that garage sale, but the Ebay seller has a reputation to maintain. Standard game theory tells us that there is far less incentive to be honest in transactions where there is no likelihood of repeat business. This is where a culture of honesty allows commerce to proceed with low transaction costs, because it is likely that both sides are getting fair value. Ethics and honesty have a positive network effect on the economy.

We can look at how failing ethics works in the housing market, filled with many one-off transactions. Many borrowers succumbed to greed and failed to disclose risks in their ability to repay, betting that a rising market would bail them out. Mortgage dealers set up loans without due diligence, knowing they could sell the loans to banks. Banks gave up on due diligence, knowing they could pass the loans to Fannie Mae. Fannie Mae's executives were earning fat bonuses cooking the books, and hiding loan risk while selling securitized loans to Wall Street. Wall Street was just looking at all the fat profits being made with an ever rising housing market. Greed and dishonesty work their way through this entire chain of transactions. Not by everyone, but by enough that eventually the system collapses, just as the Pope predicts.

Morality has consequences for society and nations. Many on the left decry moral judgement as judgemental, but clearly it is necessary for the good outcome of sustainable economic growth. Most Americans don't have to be told and wouldn't even be persuaded that honesty is the best policy just because of a little economics lesson. But the left seems to need object lessons like this, because they instinctively reject tradition. There is a reason for traditional morality, whether you believe it is due to God's will or natural selection, it works for both individuals and society.