Can Market Integration and Community Size Explain Criticism of Strategic Defaults?

-- By BrookSutton - 06 Apr 2010

Introduction

A recent paper entitled “Markets, Religion, Community Size, and the Evolution of Fairness and Punishment” may help explain the opprobrium directed at U.S. homeowners who have walked away from their underwater mortgages.

The authors of “Markets” seek to understand the evolutionary mechanisms underlying the dramatic expansion of human communities from small kin-based foraging bands into complex, intensively cooperative societies comprised of large, unrelated groups. They propose that this transformation depended on the development of new norms and institutions that promoted trust and fairness in commercial interactions between strangers. By lowering transaction costs associated with distrust, societies were able to achieve more productive distributions of knowledge, skills and resources and could better sustain large-scale cooperative enterprises. This essay will argue that the same mechanisms are at work in the debate over strategic defaults.

The Researchers' Findings

The authors of “Markets” support their conclusions with data collected from experiments conducted among 2148 subjects representing fifteen diverse sample populations. To test their theories, they placed participants in one of three variations of an anonymous, one-time interaction in which one subject received a sum of money and had the option of offering a share of it to a second participant. The first variation, called the Dictator Game, measured the level of offers where the party controlling them was immune from sanction. The Ultimatum Game and the Third-Party Punishment Game allowed a second or third party, respectively, to surrender all or some of a share of the stake in order to punish the controlling player for making an unfair offer. In the Dictator Game the researchers found that more equitable allotments correlated with greater market integration of the sample population. Individuals who obtained a greater percentage of their daily sustenance through commerce generally shared more of the money, even though a decision to keep the entire amount served their best economic interest. Data from the Ultimatum and Third-Party Punishment games showed that subjects from larger communities were more willing than those from smaller communities to forego all or some of a potential payoff in order to penalize an unequal apportionment of the stake.

Three themes emerge. First, individuals in market-based societies are conditioned to act equitably in transactions, even where such action defeats their self-interest. Second, members of large populations are willing to disadvantage themselves in order to penalize actors who profit disproportionately from an exchange. Finally, the expectation of fairness and the willingness to punish unfairness are the result of evolutionary processes that reward the reduction of distrust in commercial interactions. These themes support an inference that large, market-based societies will reject transactions that create disparity. However, a concern arises that the assumption of fairness essential to the development of large societies may subvert the application of punishment in transactions that are relatively opaque.

An Alternative to Caveat Emptor

The moral ambivalence characteristic of the public debate over strategic defaults may reflect the above concern. On first glance, criticism of homeowners who walk out on their underwater mortgages tends to invoke principles of caveat emptor and resists the authors’ conclusion that members of large, market-based societies are conditioned to seek and enforce equitable outcomes in commercial transactions. Critics of strategic default frequently argue that a homeowner has an obligation to continue payments on a mortgage regardless of the financial burdens that doing so would impose. While moral objections often exculpate homebuyers who were victims of facially abusive industry practices, critics otherwise affirm the disparity of wealth that would result where homeowners who bought or refinanced near the market peak continue to make payments. This judgment holds even though many homebuyers paid considerably more for their homes than they were worth; analysts predict properties in states like California and Florida may not reach their 2006 peaks for another twenty years. By implication, moral arguments against strategic default validate the substantial profits that the mortgage industry reaped by encouraging borrowers to overextend themselves in an overheated market. Additionally, they reject the premise that both parties to a mortgage assume the risk of declining home values, thereby diminishing the sense that a home purchase is a cooperative enterprise. As a result, critics of strategic default advocate asymmetrical outcomes that appear to contradict predictions based on the themes discussed above.

However, the researchers’ work in “Markets” points to an alternative framework for understanding objections to strategic default. In order to warrant punishment it follows that a transaction must appear unfair to observers. In their experiments the researchers facilitated moral judgments by abstracting from real-world exchanges, which typically introduce variable relational coefficients into the fairness equation--information involving, for instance, the motives of contracting parties or the type of transaction. Relational information has the potential to cloud assessments of fairness by operating on an observer’s perception of the terms of an exchange. This effect seems particularly likely where interactions involve complex or ambiguous relational factors. For example, an underwater homeowner might be a speculator seeking a quick profit or a young family looking to buy into the American dream. Likewise, a voluntary default will often punish a relatively innocent third-party investor, such as a pension fund, not the party that got the better of the deal. Where ambiguity persists regarding a family of commercial interactions, the underlying presumption of fairness may lead to a general moral judgment that the exchanges are fair, even if the resulting disparity is substantial. Under this analysis, inequity is the product of imperfect supervision rather than a commitment to principles of freedom of contract.

Conclusion

Accordingly, in transactions involving especially complex relational factors, the confusion created could systematically negate the moral instinct to penalize unfairness. This proposition leads to the ironic conclusion that large, market-based societies will tolerate grossly inequitable outcomes, at least in relatively complicated interactions, precisely because they value fairness. On the other hand, the research reported in “Markets” suggests that the moral impulse to favor fairness over self-interest is deeply rooted in those societies and can serve as a powerful force for justice when capably marshaled.

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