Enforcing Credit Norms of a Different Kind

by: Steve Waldman

Megan McArdle has responded to my earlier piece on strategic default. Before offering a substantive reply, I’d like to emphasize that my piece was not intended as a “slap down”. If there was anything uncivil either in tone or content, I apologize for it. I often disagree with Ms. McArdle, but she is a talented writer whom I’ve enjoyed for years. I’m pleased to be one of her “little chickadees“. I hope she’ll forgive that I chirp and peck.

Moreover, I think I share McArdle’s deep concern, that a collapse in the norms of commerce will leave us with more cumbersome and substantively worse means of regulating ourselves than we’ve had in the past. We disagree, I think, about who is responsible for the putative collapse, how far along it is, and what we ought to do going forward to regain a desirable equilibrium. I think that the collapse is already upon us, and that the proximate cause is a failure by businesses — especially though not uniquely in the FIRE industries — to live up to tacit social bargains. I blame that in part on a corrosive but remunerative ideology that denies those bargains bind at all. I suspect that Ms. McArdle would tell a different story.

Communities regulate themselves via a wide variety of tools, ranging from formal legal arrangements to unspoken social norms. Laws are much more visible than norms, but norms carry most of the burden of helping us get along. In the language of economists, norms make markets more complete, by rendering practical contracts too complicated and pervasive to be written and enforced by courts. If I lend a friend some money on a handshake, there are a thousand circumstances under which I would agree to delay in repayment, circumstances in which we would both agree that repayment has become justifiably impossible, and circumstances in which my friend might accelerate her repayment and overpay on the interest with gratitude. To delineate all of those contingencies in a formal contract would be impossible, and attempts to do so leave us with phonebook-length legal documents that make a mockery of the phrase “meeting of the minds”.

My view is that a “good society”, both in a moral sense and from the perspective of economic growth, depends much more on the depth and stability of its tacit norms than on its laws and formal institutions. But norms and laws are interrelated. If a society is to be stable, the two must reinforce one another. Norms and laws are complements at a macro level precisely because they are micro-level substitutes. Norms directly substitute for legal text. They “fill in the blanks”, permitting contracts and laws to be concise and intelligible, yet equitable under a wide variety of circumstances. Since legal arrangements that are unintelligible to those they bind cannot be legitimate, the capacity of tacit norms to stand in for textual complexity is an essential complement to a system of laws.

I think the fight over “strategic default” is really about a collapse in the normative arrangements surrounding reputable business. Ideas have consequences, as they say, and I do think that the theory of business that Friedman helped popularize was corrosive. I don’t condemn him personally for that. His views were sincere, and I was once enchanted by them. But we are where we are.

McArdle writes:

[W]e treat business behavior as different from personal behavior…. [W]e’ve lived in a world where profit-maximizing corporations operate by different normative rules from individuals for 150 years. It may be that the norms to which we hold corporations aren’t the right ones — indeed, in the case of things like overdraft fees and credit card rate games, I think it’s very clear that they’re not, and the banks have only themselves to blame when we decide to handle the problem legally instead. But that doesn’t mean that we should therefore abrogate the norms by which our personal lives are conducted.

I think that she is almost right, but she misses something. Businesses have operated and should operate under very different norms than individuals in their interactions with one another. We have, and have long had, the expression “it’s just business”. When spoken by one businessman to another in the context of even a tragic transaction, like calling in a loan that will force a firm to fold, we recognize the words as legitimate, a kind of apology. But if a businessman uses the same phrase while creating trouble for an individual in her role as customer, tenant, or borrower, it marks the businessman as, well, a jerk (to use McArdle’s very excellent descriptor). Behavior at the interface between businesses and individuals in those roles is supposed to be governed by interpersonal rather than intercorporate norms. Expectations of reciprocity still apply. There have always been businesses that sought every legal cover to profitably mistreat people. But such businesses used to be disreputable.

As McArdle acknowledges (I think) with respect to revolving debt, over the past few decades the financial industry has increasingly applied the norms of hard-nosed business to its interactions with customers. Certainly, a home mortgage to an unrelated party is too high value and dangerous a transaction to be regulated by social norms alone. Lengthy contracts are necessarily involved. But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. Along a whole variety of dimensions, the financial industry has increasingly violated those expectations.

Lenders drafted contracts with fees and other “revenue enhancers” that borrowers are unlikely to fully understand, and profited when borrowers managed them poorly. They enthusiastically marketed loans to individuals whom they were perfectly able to foresee could not easily bear the debt, against collateral whose valuation they knew to be dodgy, then sold those loans via circuitous paths to investors who literally could not know what they were buying. Mortgage lenders suborned appraisers to soothe both buyers and funders with overoptimistic valuations. The normative breakdown went both ways: individuals preyed on businesses too. The gentleman receiving large commissions selling usuitable loans, perhaps prodding the borrower to overstate his income, may have been betraying his employer (or not, depending on who was ultimately going to bear the risk of the loan). Certainly the ruthless flipper was violating interpersonal norms when she took a mortgage she knew she could not afford, gambling that a huge upside if prices rose was worth a downside that was limited by non-recourse or bankruptcy. But she was hardly alone, and she could be forgiven for believing that those norms no longer applied at the interface between banks and customers. They did not.

One group of people who did not violate traditional norms during the course of the credit bubble is the ordinary homebuyer who bought at the top of the market without forming an opinion on valuation, trusting market prices and professional advisors. Most homebuyers are not market timers: they purchase when the circumstances of their own lives make homeownership attractive, and take regional prices as given. Certainly the momentum of home prices affected Joe Sixpack’s (or G.I. Joe’s) buy vs. rent decision. Nevertheless, this group had the least culpability for the malfunctions of the credit market yet they are bearing a disproportionate share of the costs. McArdle thinks it would be desirable, from a social perspective, to reinforce norms under which borrowers have a moral obligation to pay. I would rather lenders ensure that loans, where it would not be mutually advantageous for the borrower to pay, are rare. To uphold McArdle’s norms on the backs of people who were drawn into a speculative bubble not of their making, whose “banking relationship” consists of a note that has been sold and resold multiple times, and whose risks are legally shared with other parties that have not hewn to any standard of good behavior, is simply unjust. Even if they could bear the cost. Even if they buy new furniture with the savings.

I’ll end on an irony. I think that underwater homeowners ought to walk away from their loans for the very same reason McArdle want us to consider them jerks for doing so. We both want to see norms we consider valuable enforced. I think that banks violated a great many norms of prudence and fair dealing in their practices during the credit bubble, and that they violate the fundamental norm of reciprocity by fully exploiting their own legal rights while insisting that borrowers have a moral obligation not to exercise a contractual option. In order to strengthen norms I consider crucial, I hope transgressors face legal and social consequences (strategic default and reduced shame attached to default) that will alter their behavior going forward. McArdle values a norm that I think most of us share in interpersonal settings, that a person should make every possible effort to pay back money he has borrowed. She also wants to create consequences for transgressors, social costs via a consensus that those who walk away by choice be considered jerks. We have different preferences regarding the kind of world we want our normative frameworks to support: McArdle favors a world with both easy credit and easy bankruptcy. I favor the easy bankruptcy, but not the easy credit. I think that debt arrangements are hazardous and should be entered into only with great care. I don’t consider increasingly leveraged homeownership and aggressively accessible consumer credit to have been positive developments. As a practical matter, I think we must rely on creditors rather than potential debtors to differentiate between wise and unwise loans. So I consider it a feature rather than a bug that holding creditors accountable will encourage them to think twice before sending out convenience checks. Norms, like laws, are always contested. McArdle and I have very different worldviews, and that is reflected in the different norms we are each trying to reinforce.

Afterthoughts: McArdle suggests that in my previous piece, I misread or misrepresented Milton Friedman. I don’t think I have. Interested readers might review Friedman’s essay and decide for themselves. The piece is powerfully argued. Friedman does try to carve out exceptions for “ethical custom” and “deception”, but I don’t think those caveats withstand the force of his argument when there is even a hint of a shade of grey. I’ve written a bit more on this in a comment. (If you are new to Interfluidity, you may not know that the commenters here are far more insightful than the host. The comment sections on the two previous pieces on “strategic default” — here and here — have been excellent.) Also, a while back, The Compulsive Theorist had a couple of good posts on norms and the financial crisis, here and here. Several of the links above are to pieces by Tanta, whom I miss.