J Bus Ethics (2012) 106:58

DOI 10.1007/s10551-011-1054-z

Three Ethical Roots of the Economic Crisis

Thomas Donaldson

Published online: 18 October 2011

Springer Science+Business Media B.V. 2011

On Sept 15, 2008, Dark Monday, the world witnessed a

radical reshaping of Wall Street. Lehman Brothers fell
toward bankruptcy; Merrill Lynch was sold to its rival,
Bank of America; and AIG pleaded for $40 billion in
government relief. Those calamities marched in step with a
dismal parade including the US government takeover of
Fannie Mae and Freddie Mac, the bailout of Bear Stearns,
and the entire subprime debacle.
We rightly blame Wall Street leaders for bungling
business decisions, for misestimating risk and overloading
banks with single-strategy investments. We now are living
with the aftermath of these business mistakes. But how
about ethical mistakes? Were they, too, part of the crisis?
Of course we need and certainly will get more robust
regulation. We have been reminded that banks are like
utilities. We must keep the lights on; we must heat our
homes. The biggest banks cannot fail; and thats why at
least the utility-like portion of banking will have to be
regulated, and regulated more firmly. Thats an important
story, and one to tell on another day. But the ethics story is
at least as important as the regulatory one.
Recall that regulation always lags behind novel events,
so that often it is only our ethics that can save us. And
consider: The existing scheme of regulation, or even an
intensified version of it, would not have stopped the crisis.
The new regulation we put in place will not stop the next
crisis, because it will have been designed to stop the previous one. SarbanesOxley was designed to stop firms from
hiding losses in off-balance sheet entities and misaccounting sums on balance sheets and income statements.
T. Donaldson (&)
Wharton School, University of Pennsylvania,
Philadelphia, PA, USA
e-mail: donaldst@wharton.upenn.edu

But that was yesterdays mess. SarbanesOxley didnt even

slow down the torrent of disaster emerging in our current
economic mess. The law regulating asbestos in the mid
twentieth century lagged behind the knowledge held by
scientists in the industry about the cancerous products
danger; just as laws regulating banking lagged behind
bankers knowledge of the dangers of the leverage they
employed.
So how about ethics? Just how is bad ethics also a part
of the Dark Monday story? I submit that among the causes
of the economic crisis can also be found three ethical roots.
Unfortunately, most ethical commentary on the current
crisis has been obvious or misleading. Critics have
lamented irresponsible home mortgage borrowing, selfserving judgments by ratings agencies, and demand-driven
loans made to unworthy borrowers. Others slam the greed
is good mentality of Wall Street. But these ethical criticisms are strikingly unhelpful. The former, i.e., irresponsible home mortgage borrowing, self-serving judgments
by ratings agencies, and demand-driven loans made to
unworthy borrowers are obvious. The deeper questions are
about why borrowers were allowed to take out stupid loans,
how the ratings agencies were lulled into complacency, and
why the banks and lenders decided to make stupid loans.
Still more important, the mortgage mess, as were learning,
was only the trigger for the explosion of much deeper
financial munitions including credit default swaps and
securitized credit card debt. Even today we have no clear
idea what the toxic assets on banks books amounted to
(or even in some instances amount to today); some will no
doubt turn out to be bad loans to hedge funds; some to
private equity funds.
Then there is the greed claim about Wall Street. This,
too, is unhelpful. I want to acknowledge the role of greed
too, but no serious study has shown that greed is higher on

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Wall Street than in other industries, or for that matter

higher in any one industry than in another, or in any time
period than in another. Greed no doubt varies by time and
place, but it is notoriously hard to measure, and is a persistent feature of the human condition.
Greed, rather, depends on opportunity and rationalization, and that is where the more subtle and important part
of the Dark Monday ethics story begins. Three patterns
emerge: 1. Paying for peril; 2. The normalization of
questionable behavior; and 3. Tech-shock.

Paying for Peril

Paying for peril refers to the phenomenon of rewarding
short and suffering long. During the savings and loan crisis of
the 1980s, a key flaw was borrowing short and lending
long. S&LS borrowed short-term at fluctuating rates, but
lent long to customers for 30 year mortgages. The formula
was disaster. Contemporary financial services firms acquired
a still worse habit: rewarding short and suffering (or succeeding) long. It has been called a doctrine of Pay for Peril.
Firms pay huge salaries and bonuses to managers for actions
today, even though the firms rewards or penalties for those
actions happen tomorrow. Such systems encourage bad ethics
and rationalization. High performance can be faked short
term. Part of the phenomenon even has a formal name: the
Taleb distribution. This is a distribution with a high chance
in any period of a handsome gain with a low chance of a
massive loss. A Taleb pattern can easily tempt a manager to
gamble on a ten percent annual risk of disaster in order to reap
a big bonus. He knows that it is not his money he is gambling
and probably that his action is wrong. He also knows that if
the one-in-ten chance occurs, then he must find a new job, but
the day-to-day odds are in his favor. Finally, he knows that if
the one-in-ten chance occurs, his firm will suffer massive
losses. Did the masters of Wall Street have no idea of what
they were doing? Of course they did. Traders and others even
had a name for it: the free option. Traders have the free
option on their performance: As Nassim Taleb remarked,
they get the profits, not the losses. It is a vicious asymmetry. (Taleb 2009) And did the heads of the banks have no
idea of the big risks their institutions were taking by making
so many Taleb gambles? Of course some did. As Alan
Greenspan, long a friend of the banking industry remarked
recently, they knew the risk, they just thought they could get
out in time.

The Normalization of Questionable Behavior

Psychologists speak of the normalization of danger in
instances where groups of people live with danger long

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enough that it becomes the norm, and hence accepted. In

business ethics it is one of the most powerful forces I have
studied and takes the form of what might be called the
normalization of questionable behavior. Where, we might
ask, were the bosses who should have stopped such Taleb
gambles? Some were blindsided themselves. The complexity of highly leveraged financial transactions escaped
the scrutiny of even seasoned leaders. But often bad
practices can become institutionalized, and initial queasiness gives way to industry-wide acceptance. For any given
firm to have abandoned the rewards promised by securitized, subprime mortgages might have placed it at a large,
short-term disadvantage in the industry. As Chuck Prince
remarked, As long as the music is playing, youve got to
get up and dance.
Creeping industry precedent is common. When, in the
late 1990s, accounting firms discovered novel, legally
suspicious tax shelters for clients, most of the big
accounting firms eventually embraced themat heavy
long-term cost. And when, in the early 1990s investment
banks first saw the research showing that investment bank
analysts tended to give higher ratings to client companies
stocks, they continued to reward analysts partly with an eye
on client involvementuntil the government finally blew
the whistle. Industries often permit and finally accept a
practice that enriches the short term only to impoverish the
long term.

Tech-Shock
When a transition of the ethical interpretation of economic
events by market participants occurs over time, it can be
understood as a transition from the opaqueness of general
ethical principles, or what Tom Dunfee and I have called in
our writing about social contracts in business, hypernorms, to the relative clarity of specific rules, procedures,
and generally understood practices. These we have called
microsocial contracts (Donaldson and Dunfee 1999).
Clues to this phenomenon can be discovered in noneconomic contexts. Modern medicine stands out as an
example. It is worth reflecting on the way in which modern
medicine exhibits a recurring pattern over time: new
medical technologies create ethical confusion, only later
for the confusion to be abated as society develops new
ethical precepts and practices. Consider: during the twentieth century, medical science became increasingly adept at
extending human life beyond traditional limits. The
invention of feeding tubes, respirators, bottled oxygen, and
kidney dialysis extended the lives of patients who before
would have died quickly. This new technology meant not
only that patients lived longer, but sometimes did so with
many normal abilities impaired or destroyed. Old practices

Three Ethical Roots of the Economic Crisis

thus confronted new realities. Family members, patients

and doctors found themselves facing the implications of
new technology de novo; as they first groped their way
through these new challenges, they understandably resorted
to broad, normative principles about managing medical
care such as found in the Hippocratic Oath (Hippocrates
2009). They cited hypernorms such as the benefit and do
no harm precept from the Hippocratic Oath.
By the close of the Twentieth Century, however, more
specific principles and practices eclipsed generic ones.
Debates still raged, but they did so over narrower and
narrower matters. It is worth asking what precisely happened in this evolution of moral understanding about death
and dying. The answer is that detailed processes and
agreements came to be substituted for generic hypernorms.
Chief among them was the right of people to adopt ex ante
living wills, documents that specified more precisely
what an individual wanted at the end of his life. What is
more, the institutionalization of hospital ethics committees,
new, agreed-upon definitions of death that depended
more on brain activity and less on physical respiration, and
finally systems of code designations for critically ill
patients played important roles.
This ethical evolution spawned by the advent of new
technology has occurred frequently in medicine and biology.
Inventions such as in vitro fertilization, animal cloning, and
most recently the use of stem cells in research, all provoked
moral confusion at the outset, only later to give way to the
development of specific principles and practices. We confront novelty at first with the only conceptual tools that we
possess, ones that are shaped to fit almost any dilemma.
Using the language of Integrative Social Contracts Theory
(ISCT) these are hypernorms. Later, we reach agreements
about specifics. These are microsocial contracts.
Interpreting ISCT dynamically in this manner is a
reflection of how specific problems require specific
approaches, and that until we discover them we use general
approaches. Consider the analogy of flying. Sometimes a
pilot can know by GPS or visual memory his exact location
and where he must guide his plane. Other times he must
proceed by compass and dead reckoning, i.e., the process
of estimating ones current position by utilizing a previously
known position and then advancing that position based on
known speed, elapsed time, and course. When new economic technology, whether highly leveraged derivatives,
SIVs (special investment vehicles), off-book entities such
as the infamous raptors used by Enron, credit default
swaps, or CDOs (Collateralized Debt Obligations), is
introduced we first resort in the only way possible: to our
moral compass and a process of dead reckoning. Later, we
develop more precise means of guidance.
Lets now turn to the example of securitization in the
economic crisis. It bears all the earmarks of earlier clashes

of new technology with general norms. This time the new

technology involves among other things the so-called
securitization of debt, a novel, ingenious financial technique to allow routine financial obligations such as mortgages, credit card debt, and auto debt, to be repackaged
into bulk units that are then sold as securities in a broader
market. It also involves the use of risk models in banking
that, while simple to use, obscure the treachery of what we
have called Taleb distributions.
In the Twenty-First Century a new form of financial
alchemy took pools of mortgages or credit-card loans and
bundled them for sale to investors around the world. The
bundle was sliced into different tranches, each of which
carried a different level of creditworthiness. The top tranches were the first to be paid, and thus they held higher
ratings than the lower ones. But the bundled products were
notoriously hard to value, and this was true even before the
limited markets for the products nearly vanished in 2008.
Methods of valuation for these highly sophisticated securities varied depending on the firm; there was no uniformity
and hence no agreed-upon price. To make matters worse,
these securitized products sold only rarely, making their
market value opaque (Nocera 2009).
To illustrate the complexity and opaqueness of the
financial technology of securitization, consider a single
example discussed by Bajaj and Labaton: a security that in
2009 was trading at 38 cents on the dollar. The bond was
backed by 9,000 mortgages from borrowers who put down
little or no money to buy their homes. Nearly a quarter of
the loans were delinquent, and losses on the defaulted
mortgages were averaging 40%. But, remarkably, this same
security once had a top rating, i.e., triple-A. (Bajaj and
Labaton 2009) Of course we all know now that Moodys
and Standard & Poors botched their analyses of such
securitized mortgages, but few if anyone could have
anticipated that the price of a security backed by home
mortgages could fall sixty percent within a year or two
(Lewis and Einhorn 2009).
As economies around the world reeled in reaction to the
financial explosions set off by the securitization whirlwind,
moral criticism followed traditional, hypernorm-guided
patterns. Simple greed caused the problem, pundits and
editorialists shouted. And simple lack of self-control by
home buyers who stretched beyond their means to commit
to mortgages aggravated the bankers greed.
No one can reliably predict the long-term outcome of
the 2008 economic crisis, but the manner in which societys ethical attitudes toward securitized loans evolve is
likely to be similar to the way its attitudes toward ethical
issues sparked by other novel technology evolved. In short,
we will over time substitute more tailored norms and
practices in place of simple moral dictums such as avoid
greed and dont take out loans you cant pay off.

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Already in 2009 a series of suggestions for new norms and

practices had been made inside and outside the banking
industry. In addition to higher capital requirements for
banks and more direct regulation, they included industry
norms requiring that issuing banks maintain a significant
position, say, twenty percent, of the securitized products
they market to others. Still more, Treasury Secretary Bernanke and others pushed for new measures to be taken by
banking executives about the quality of loans and the due
diligence that preceded loans, including those made to
hedge funds (Bernanke 2006). One can predict that once
more hypernorms will give way over time to microsocial
contracts tailored to the precise ethical challenges of
securitized loans.

What Can We Learn?

What can we learn from examining the three ethical roots
of the current economic crisis, i.e., paying for peril, the
normalization of questionable behavior, and technology
shock? The obvious, backward looking question of blame
is obvious but unhelpful. Were business leaders, and, yes,
let us be honest, business educators, ethically responsible
for much of this mess? The answer must be yes. They knew
or at a minimum should have known of the tragic and
social dangers implicit in the three forces we have
examined.
But the more important and forward looking question is
whether industry leaders and business educators have a
responsibility to understand and deal with the three ethical
forces we have examined. Yes they do. Consider just one
example, i.e., paying for peril. Investors, educators, and
business leaders must now push for new reward schemes
that reflect long-term firm risk by paying over a longer
term. And dont count on the government to do it. Over the
past two decades government attempts to rein in executive

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pay have been unblemished by success. The government

probably has a better shot of doing this in partially
nationalized banks, but almost none in the broader business
sector, including financial services such as hedge funds,
securities dealers, and private equity firms. In the end
collective action is the only antidote to excessive government regulation. We must teach it in business schools and
practice it in business. When Treasury Secretary Paulson
gathered the heads of Wall Street firms together in the
Federal Reserve Building in Manhattan in the fall of 2008
to push them to craft a collective solution to the Lehman
Brothers meltdown, he appealed to this very sense of collective responsibility. Perhaps his particular solution was
flawed. But his underlying concept was right: industry
participants have both a stake and a responsibility for the
health of their industry and the health of society. Anything
less amounts to ethical and financial failure.

References
Bajaj, V., & Labaton S., (2009, February 2). Big Risks for U.S. In
Trying to Value Bad Bank Assets. New York Times.
Bernanke, B. S. (2006). Hedge Funds and Systemic Risk. In Federal
Reserve Board, Proceedings of Federal Reserve Bank of
Atlantas 2006 Financial Markets Conference. Kansas City:
Federal Reserve Board.
Donaldson, T., & Dunfee, T. (1999). Ties That Bind: A Social
Contracts Approach to Business Ethics. Cambridge, MA:
Harvard Business School Press.
Hippocrates. Hippocratic Oath. (2009). M.D. Survivor. http://www.pbs.
org/wgbh/nova/doctors/oath_classical.html. Retrieved 1 June
2009.
Lewis, M., & Einhorn, D., (2009, January 4). The End of the
Financial World as We Know It. New York Times (2009 sec.
OpEd, p. WK9).
Nocera, J., (2009, January 4). Risk Mismanagement. New York Times.
Taleb, N., (2009, February 25). How Bank Bonuses Let Us All Down.
Financial Times.