The morality of the free market system

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: Do you think it's morally fair for a bank or mortgage company to make profits from the interest on a home mortgage when all people are trying do is provide a home for themselves and their family? --Herbert K., Anchorage, Alaska

Answer: Essentially, you're asking whether the economic and financial system we have in the United States is equitable. It's a fair question, excuse the pun, and one that many people are asking today.

Given what's happened over the past year or so, there's a widespread perception among many people, justified or not, that the system is rigged or at least inherently flawed. How else, they say, could so many members of the financial community exploit the financial markets for their own gain by peddling toxic mortgage securities and derivatives that ultimately damaged the economy while leaving taxpayers (most of whom never bought derivatives or defaulted on their home loans) with the tab for the bailouts?

There are enough experts barking back and forth at each other on these matters, each claiming the moral high ground. I don't want to simply add to the cacophony.

Rather, I'd like to suggest a few ways you might think about our financial system and how it works, so that you can come to your own conclusion about how fair or unfair it is, recognizing at the same time that no system is perfect.

Let's start with your question. You ask whether it's moral for a bank to profit from mortgage interest when all someone is trying to do is put a roof over his or her family's head.

Well, let me put a question to you: Would it be fair for a bank not to pay its employees?

I think you'd agree the answer is no. We expect to be paid for our work. But if a bank doesn't charge interest on the loans it makes, then how can it generate the revenue it needs to pay the people who work there? At the most fundamental level, that's what banks do. They lend money to make money.

I guess you could say, okay, banks should be able to pay their expenses and even make a profit. But couldn't they also be more empathetic when evaluating borrowers and setting loan rates, and perhaps cut some slack for people who need loans but can't afford to pay the going rate? In other words, why can't they lower the rate in cases where people deserve some help?

But would that be fair? Who would decide who deserves lower rates? What criteria would be used? If a bank charges some customers less, it will have less money to pay to the people who earn their living working at the bank (which, by the way, isn't just hot-shot executives, but tellers, administrative people and lots of others who aren't pulling down huge bucks).

And there's another party to consider in this decision: savers. To get money to lend, banks must attract it from depositors. If you're a retiree living off interest from CDs, would you be okay with earning less on your CDs because the bank wants to give a break to more deserving borrowers, whoever they may be? Or would you be more inclined to get your CDs from a less compassionate bank that can afford to pay you more interest because it insists on getting the highest rate it can on its loans?

Obviously I'm skipping over lots of details here. But the point is that interest rates, whether those paid to depositors or charged on loans, are not figures that banks dream up or set arbitrarily. Interest rates represent an interaction between savers and borrowers, with savers wanting the highest rate they can get and borrowers the lowest. While it may seem from the outside that the bank sets the rate, it's really the pull and tug between borrowers and savers -- as well as other forces in the economy -- that do so.

Interest rates are the price people pay for the use of money -- i.e., what banks pay depositors and borrowers pay banks. And it's that price that ultimately determines where savings or capital goes -- i.e., which banks attract it and which borrowers get it -- just as the price of cars or electronic gadgets determines who buys them and how many are produced each year.

That, in a grossly oversimplified way, is how our system, a market-based system, works.

Is it perfect? Hardly. We've seen the effect of some of its weaknesses over the past year. One problem was that many lenders apparently felt free to make dubious mortgages because they knew the loans would be bundled into securities and sold to other people. The lenders didn't have to worry whether the loans would default.

But there are ways to address these weaknesses. Tighter and more comprehensive regulation is certainly one prescription that the Obama administration is already considering.

Higher capital standards for financial institutions might also help. We've got to remember, though, that regulation and capital requirements also have costs. Regulate too heavily or impose onerous capital requirements and you may raise the cost of borrowing, making it even harder for people to get loans they can afford. I'd note that other forms of government intervention that are popular in some circles today, like setting compensation levels for executives, also have at least as much potential to do harm as good.

Clearly, there are lots of other issues -- job creation, health care, tax burdens, etc. -- to consider in determining the fairness of our economic system. But my feeling is that, when you tote up its plusses and minuses, our system is pretty fair, although there's plenty of room for improvement. I can understand, though, that others may feel a lot differently.

So when you're considering whether our system is equitable, don't restrict your gaze to a single group of people. You've got to consider the ripple effects actions may have on other groups. An attempt to give an advantage to one party (in your case, deserving homeowners) could very well disadvantage another (retirees living on interest payments) that would then feel aggrieved.

Do this often enough and the system devolves into myriad splinter groups clamoring for special treatment and feeling aggrieved and resentful if they don't get it.

All these issues, both in the financial arena and beyond, have huge implications for our economy and our society overall. They deserve a public airing and spirited debate as we work through the detritus of this recession. I, for one, look forward to it.

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