Irrational Exuberance

This article appeared in the Jan/Feb 2009 issue of Islamic Horizons, Page 26.

In December 1996, then Chairman of Federal Reserve, Alan Greenspan said, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…?” Immediately after he said this, the stock market in Tokyo fell sharply and closed down 3%. Hong Kong fell 3%. Then markets in Frankfurt and London fell 4%. The stock market in the US fell 2%. This strong reaction made the term “irrational exuberance” famous and focused global attention on fear and greed being the two most powerful factors that shape market behavior.

A decade later in May of 2007 the Dow Jones Industrial Average (the most popular indicator of the stock market’s health) had nearly doubled from the time Greenspan uttered the famous words. A year and a half after that high-point the markets had dropped 49 percent in value. It took the market nearly a decade to double its value and only 18 months to precipitously drop half that value!

Financial markets impact Main Street. Jobs are being lost at record pace. Unemployment rate, which stood at 4.5 percent in May 2007, now stands at 6.1 percent in September 2008, a whopping 35 percent sharp increase in less than a year and a half. At the core of this malaise stands the collapse of the housing market created by the astronomical foreclosure rates. In August 2008 RealtyTrac reported 303,879 foreclosure filings — default notices, auction sale notices and bank repossessions. This represented a 27 percent increase from just a year ago, showing one in every 416 U.S. households received a foreclosure filing during the month. These foreclosures have led to credit squeeze in the banking sector, which in turn lead to the $700 billon bail-out package passed by the U.S. Congress and signed by President Bush in September, 2008.

Are Investors Really Rational?

How did we get to this point in history? Why were ordinary taxpayers forced to underwrite the gambling practices of the rich and powerful, when the U.S. Congress passed and the President signed into law the $700 billion bailout package? It is indeed bad economics when the federal government socializes risk while keeping profits privatized. It would have been equally foolish to allow the federal government to stand on the sidelines, as a terrible credit squeeze paralyzed the general economy.

Not that the bailout (euphemistically called the rescue package) will solve our current economic problems. For the current woes are the result of decades of a dogmatic belief that the “invisible hand” can in-and-of-itself keep markets efficient and in Pareto optimum (an economic system is Pareto efficient if by changing the allocation of goods some individuals can be made “better off” without any other individual being made worse off).

For over a decade those in charge of the economy (the Fed and the Treasury) both placed an inordinate emphasis of laissez-faire (French for hands-off or let do) ideology, thus favoring systems that tilted the playing field towards efficiency without regards to the equally important societal concerns of fairness. Moreover, they assumed investors to be “rational” disregarding an emerging body of literature in finance and economics that posited investor behavior to be less than rational, influenced by psychological biases like cognitive dissonance that are the result of human beings pursuing heuristic simplifications (shortcuts to decision making) and self deception (people deluding themselves to believing that they are better than they actually are).

Learning From History

Not knowing the past is a sure recipe for being condemned to repeat history. The crisis of 2008 actually has many antecedents. Perhaps none more important than the repeal of the Glass-Steagall Act in 1999. The demise of Glass-Steagall allowed Wall Street and the banking system to become essential enablers of our current crisis.

The Glass-Steagall Act was enacted in the wake of the financial market crash of 1929, which many economists believe was partly responsible for the Great Depression that followed. While the Act itself was in response to the greatest economic catastrophe faced by our nation (among other tell-tale signs one in five banks had failed), its repeal came without much fanfare and perhaps more noteworthy not the result of any structural change in the market or economy. The proponents of the repeal put forward the argument that in a globalized economy the removal of the barrier separating commercial and investment activities will allow U.S. banks to be more competitive in the world market.

The Slippery Slope of Deregulation

By the 70s, banks began to lobby against the Glass-Steagall Act and brokerage firms began encroaching on banking by offering credit or debit cards and interest-bearing money-market accounts that allowed check-writing. A major blow against the Act was leveled in 1987 when the Federal Reserve Board, which regulates banks, voted 3-2 in favor of easing some of the restrictions. The vote came despite dire warnings from the then Fed chairman Paul Volcker (now economic advisor to Presidential candidate Barrack Obama). The result of this vote allowed depository institutions like banks to get involved in the underwriting business. Volcker’s prescient observation that the loosening of the Act will lower credit standards as banks will pursue lucrative securities offerings (often at increased risks to depositors) and market bad loans to the public, rings prophetic today.

Shortly thereafter President Regan appointed, Wall Street’s own, Alan Greenspan to become the Chairman of the Federal Reserve. But the death nail to the coffin was struck during the Clinton era. Sandy Weil of Travelers insurance hooked up with John Reed of Citicorp to announce the formation Citicorp that brought under one roof Travelers Insurance, Salomon Smith Barney and Citibank, thus creating the world’s largest financial services company. The audacity of the merger was not in the fact that it was at the time the biggest corporate merger in history but the fact that the merger went against the letter and spirit of Glass-Steagall. Weil had successfully lobbied then Treasury Secretary Robert Rubin and the Fed Chair Greenspan to allow him “temporary” approval, allowing Weil time to lobby the Congress to repeal Glass-Steagall. After furious lobbying efforts and without much public discussion in 1999 the U.S. Congress repealed Glass-Steagall.

The Inherent Moral Hazard of the System

Banks are originating loans thereby expecting to participate in the profits from those loans. However, they are passing those loans to agencies like Fannie and Freddie who then securitizes those loans into mortgage backed derivative securities (being sold on unregulated market due to the passage of another law favoring deregulation – the Commodity Futures Modernization Act in 2000). These derivatives are being marketed by the brokerage houses owned by the same bank that originated the loan. This creates a vested self-interest on the part of Wall Street to hype the value of real estate. At one level the entire thing becomes a giant ponzi-scheme enabled by the moral hazard of housing brokerage, investment and banking under common ownership.

Ironically countries like China maintain a separation between commercial banking and the securities industries. The World Bank reports that China has continued use a form of the Glass-Steagall Act to regulate their system.

Unregulated Derivatives

Undoubtedly derivative markets serve an important societal function by allowing appropriate management of risk for both farmers and factories. Derivatives are form of insurance that allows the transfer of risk from parties that cannot bear them to those who can or want to bear them. The derivative markets in-and-of-themselves are not the problem. It is the unmitigated greed of speculators and the herd mentality of the rest that lays the seed for the formation price bubbles (like we saw recently with the increases in oil prices).

Derivative securities are high risk-high reward assets. In light of the psychological biases of individuals thus, these markets are more susceptible to being swayed by fear and greed. Thus, when the Commodity Futures Modernization Act of 2000 left open the so-called “Enron loophole”, which exempts energy derivative trading on electronic commodity markets, it laid the foundations of for today’s excessive speculation.

The “loophole” was drafted by lobbyists for Enron working with Senator Phil Gramm (former advisor to Presidential candidate John McCain). In September 2007, Senator Carl Levin (D-MI) introduced a bill to specifically close the “Enron Loophole”. On June 18th, 2008 the bill was enacted into law. In her book “The Tyranny of Oil” author Antonia Juhasz illustrates the connection between the CFMA and devastating run-up on the oil prices that we observed earlier this summer. Even though the “Enron Loophole” has been closed the CFMA still keeps credit derivatives from being regulated.

Where Do We Go From Here?

Adam Smith in his “The Theory of Moral Sentiment” wrote, “All members of human society stand in need of each other’s assistance, and are likewise exposed to mutual injuries. Where the necessary assistance is reciprocally afforded from lover, from gratitude, from friendship and esteem, the society flourishes and is happy. All the different members of it are bound together by the agreeable bonds of love, affection and are, as it were, drawn to one common center of mutual good offices.”

Thus the underpinning of an economic system has to be geared towards the idea of common good. The ethical ideal is to pursue the internal good, which Adam Smith defines as being “perfectly virtuous” i.e. “the man who acts according to the rules of perfect prudence, of strict justice, and of proper benevolence.” This does not imply that we need to discard the traditional financial economic goal of wealth maximization. Attaining “internal good” is necessary not just for altruistic reasons but also for profit making purposes. Providing profit by harming society perverts the purpose of business. To enable this pursuit of internal good by societal norms and internal business culture must be made intrinsic to both personal and professional goals.

Ethics must become an internal motivation for individuals to pursue moral excellence as a goal in-and-of-itself. This approach is based is based on the philosophical foundation of what is called “virtue ethics.” A virtue is an internal good that the characteristic of which is the achievement of good for the whole community and not just the individual. Thus, virtue ethics views professional development as a moral process, arguing that one cannot be practically rational without being just. Virtue ethics secondly emphasizes the existence a community that nurtures these virtues. The third aspect of virtue ethics is the role of moral judgment. This implies that virtue ethics is not so much about rules as it is about exercising sound judgment.

These concepts are rooted in the theology and hermeneutics of every religious system, including Islam. The comparable word for ethics in Islam is Akhlaq or khuluq. Goodness in Islam is conveyed through a whole range of words – khayr (goodness), birr (righteousness), qist (equity), ‘adl (equilibrium and justice), haqq (truth and right), ma‘ruf (known and approved), and taqwa (God consciousness or piety).

The goals of Islam are based on Islamic concepts internal good, which is expressed as preservation of mind, body and spirit. Thus the Islamic system stress brotherhood/sisterhood and socioeconomic justice and require a balanced satisfaction of both the material and spiritual needs of all humans.

Islam considers that the fundamental purpose of human beings is to worship their Creator (God). “I have created the spirits and humankind only for My worship,” Quran, Chapter 51, Verse 56. The word worship (ubudiyah) in Islam is a not limited to ritual prayers but encompasses each and every human act that leads to internal good. In Quran, Chapter 6, Verse 162 reads: “Say: ‘Surely my prayer, my sacrifice, my living and my dying are for God, the Lord of all the worlds.’” The Quran also gives the purpose of human life on earth as “[It is He] who created death and life to test which of you is best in conduct; and He is the Mighty, the Forgiving” Quran, Chapter 67, Verse 2.

Taqwa is the Islamic concept of “God-consciousness.” Having taqwa allows a person to be constantly aware of both God’s omnipresence and attributes and a reminder of their relationship and responsibility to God as his creation and servant. Ihsan is an Arabic term meaning “perfection” or “excellence.” Ihsan is the Muslim responsibility to obtain perfection, or excellence, in worship, morals, manners, attitudes and social interactions.

Another Islamic concept that relates well to the issue of internal good is the concept of unity (tawhid). Unity is a coin with two faces: one implies that God is the sole creator of the universe and the other implies that people are equal partners or that each person is a brother or sister to the other.

The issue of “moral judgment” is best exemplified by two Islamic concepts of justice (adl) and trusteeship (khilafa). In pursuing wealth maximization, people should not lie or cheat; they must uphold promises and fulfill contracts. Usurious dealings are prohibited. Islam teaches that all wealth should be productive and hoarding of wealth is shunned.

The intense commitment of Islam to justice and brotherhood demands that Muslim society take care of the basic needs of the poor. But while helping the needy is encouraged, Islam also obliges individuals to earn a living. The hand that gives is considered better than the hand that accepts. The Islamic institution of zakah is form of a wealth tax comprising compulsory charitable-giving for specially designated groups in society, facilitates the care of all members of society. In the Islamic hermeneutics, the rich are not the real owners of their wealth; they are only trustees. They must spend it in accordance with the terms of the trust, one of the most important of which is fulfilling the needs of the poor.

The word “zakah” means purification and as such, income redistribution is not only an economic necessity but also a means to spiritual salvation (“. . . of their wealth take alms so that you might purify and sanctify.” Qur’an 9:103).Thus, economics is effectively integrated with ethics.

In Islam, human beings are viewed as God’s vicegerent or trustee (khalifa) on earth. This does not negate private ownership of property but does have some important implications. It implies that there is no conflict between the moral and socio-economic requirements of life. Resources are for the benefit of all and not just a few and everyone must acquire resources rightfully. Given the right motivation, all economic activity assumes the character of worship. Indulgence in luxurious living and the desire to show-off is condemned. Islam does not tolerate conspicuous consumption.

One important consideration in virtue ethics is the role of an exemplar. For Muslims the best exemplar is Prophet Muhammad who advised Muslims to be moderate in all their affairs; he described Islam as the “middle way.” A balance in human endeavors is necessary to ensure social well-being and continued development of human potential.

Prophet Muhammad said, “work for your worldly life as if you were going to live forever, but work for the life to come as if you were going to die tomorrow.” Islam, like some other religions, places a greater emphasis on duties than on rights. The wisdom behind this is that if duties (relating to justice and trusteeship, for example) are fulfilled by everyone, then self-interest is automatically held within bounds and the rights of all are undoubtedly safeguarded. Society is the primary institution in Islam, not the state. This point also illustrates the centrality of the concept of “community” in Islam, which is the fourth and final pillar of virtue ethics.

Wall Street and Main Street are joined at the hip. The task before the next President will be to create sensible regulation that promotes greater transparency, curbs excessive speculation and fosters efficiency. Furthering this goal requires support from ordinary Americans. Muslims should be at the forefront demanding such reforms. Their faith demands it. Their country needs it.