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March 27, 2008
The Moral Hazard with the Moral Hazard Problem
You can't read a story, watch CNBC, or even hang out at Metafilter these without hearing endlessly about moral hazard. The idea, in essence, is that by preventing people from feeling the painful consequences of their errors you prevent them from learning, and thus they make the same mistake again, to their and (often) our cost.
The current context is subprime, the credit crisis, Bear Stearns, etc. Lots of people are alleging that by assisting in saving Bear Stearns, and by the Fed's and the government's aggressive actions in favor of mortgage holders, we are creating moral hazard. It's a useful discussion, but it's also important to put it in context: Pulling members of a Monopoly club off a train-track just before a train whizzes through creates moral hazard -- and it feels particularly bad if the someone now gets to put his hotel on Park Place after all -- but leaving them there to be sliced and diced, or causing the train to be derailed, is almost certainly worse.
I keep wondering, with that in mind, about the consequences of all this chatter about "moral hazard". Because the trouble is, moral hazard exists many times we do anything to prevent someone from suffering, but that doesn't mean we shouldn't do it, nor does it mean we should moralize about moral hazard every darn time. You could easily imagine a reverse situation taking hold, one where we're so afraid of taking action, because of "moral hazard", that we're frozen into inaction when we should just be getting the f**k on with things. In a sense, moral hazard ends up creating a moral hazard problem.
Idle musings, but there is some interesting data on the subject available via Google Trends. Here is the upswing on searches for "moral hazard" on Google in the last four years. It's a moonshot.
In case you're wondering, most of the moral hazard searching at Google is coming from Singapore, Switzerland, Austria, Taiwan, and Germany. Damn moralizers. The U.S. is only 8th on the list.
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2. Comment by
Paul K.
--
March 27, 2008 @ 1:25 PM
I don't disagree. Blithely bailing out banks is disastrous policy, both for the banks and for the country/economy.
On the other hand, we are too easy with our usage of the word "moral hazard", of late, with inadequate thought given to the broader consequences of our high-minded tough love. I'm essentially for arguing for a realistic worldview, as opposed to tough orthodoxy in either direction.
Who has the gall to claim the private sector has superior performance and simultaneously claim they have "no idea" what the value of their "mortage backed securities" is?
There are 10 year old books on Amazon about how to rate "mortage backed securities".
If I'm not mistaken, one of the reasons "moral hazard" has come into currency so much in the past couple of years is that the present administration has been using it as a way of arguing against nationalized health care, or indeed any significant changes to the way health care & insurance work in the U.S. That's the idea behind private spending accounts: By making people spend their own money on health care, you'll ensure that they make wise decisions about whether they really do need that MRI, or that open heart surgery, or that appendectomy. At least, that's how I understand the argument.
If you are against regulation, then, in order to keep a "consistent" (vs. "realistic") worldview, you must view this Bear Sterns (B.S.) bailout as a moral hazard.
In other words, the person playing Monopoly on the railroad track may return tomorrow, but, eventually, you will realize that you have better things to do than save him from the train everyday. Instead, you will pass a law (regulation!) against playing on the tracks and you will jail him (restrict his freedom!) in order to prevent the problem from reoccurring.
So, which is it? More regulation of investment banks in exchange for passing risk on to taxpayers or no regulation and no bailout? There is no middle ground here unless you are pro-theft, which is hazardous to one's morals.
It's great to come up with phrases that conceal the real issue. Why is any private entity allowed to be supported by the government in a capitalistic society? For the "good of the masses" argument can be made by any number of entities, for any number of reasons.
Like a forest fire, stronger and more stable companies will arise from the ashes of old ones. The wider effect? Yes, there will be pain. Caveat emptor on a wide scale. Will lead to better practices, and more stringent regulations.
Allowing the pendulum to swing the other way is but natural.
The entire enterprise, i.e. markets, appears work best in some band of risk. Too hot and everybody goes home, hides under their bed, game over. So we have engineered the game with all these schemes to temper the risk. Standards, quality regulation, bankrupcy laws, etc. You get this odd calculus: Moral Hazard == Limited Liablity == Limited Warrenty. Note that anything that increases your chances of externalizing costs creates moral hazard; so tort reform does. Idle muzings indeed.
This takes the cake:
http://www.msnbc.msn.com/id/23835791/
Reward for failure without taxpayer bailout: $0
Reward for failure with taxpayer bailout: $61M
That is right, $61 million. The Paypal founders got less for creating something useful from scratch and this guy (Chairman James Cayne) gets the same payout for destroying something! If that is not socialism, I do not know what is!
OK, last post on this topic, but I am morally outraged at this point. Marc Andreessen picked up on this story and has a lot of great links:
http://blog.pmarca.com/2008/03/congratulations.html
Some good quotes from the following source:
http://online.wsj.com/article/SB119387369474078336.html?mod=hps_us_whats_news
"On July 12, chatting with visitors over lunch, Mr. Cayne seemed less interested in discussing the markets than in talking about a breakfast-cereal allergy and his stash of unlabeled Cuban cigars. On another occasion, he told a visitor he pays $140 apiece for the cigars, keeping them in a humidor under his desk.
Five days later managers of both funds informed investors their holdings were virtually worthless.
The next day, July 18, Mr. Cayne left for Nashville to play in the bridge tournament, accompanied by his wife, Patricia, who is a neuropsychologist and another avid bridge player. Mr. Cayne took part in a prestigious event called Spingold KO. He was in Nashville all or parts of 10 days, according to bridge and hotel records."
AND
"Attendees say Mr. Cayne has sometimes smoked marijuana at the end of the day during bridge tournaments. He also has used pot in more private settings, according to people who say they witnessed him doing so or participated with him.
After a day of bridge at a Doubletree hotel in Memphis, in 2004, Mr. Cayne invited a fellow player and a woman to smoke pot with him, according to someone who was there, and led the two to a lobby men's room where he intended to light up. The other player declined, says the person who was there, but the woman followed Mr. Cayne inside and shared a joint, to the amusement of a passerby."
That's not what "moral hazard" means.
It has nothing to do with "teaching a lesson". It has everything to do with leaving someone else holding the bag.
"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."
http://en.wikipedia.org/wiki/Moral_hazard
It is a mistake to allow those at the top of the financial pyramid to pay little or no price for being wrong. Such heads-I-win-tails-you-lose incentives led to the S&L bailout. This is a huge agency problem. I simply argue for more honesty from those running the show. If we are to have socialism when things don't work out, why not just nationalize the banks and direct the profits of the good times into government coffers instead of allowing Blankfein, et al, to skim profits in the good years with the taxpayer holding the bag when their gambles don't pay off?
Be honest. The current system is not capitalism. Despite Larry Kudlow's protestations to the contrary, Schumpeter must be rolling in his grave. Either we have creative destruction or not. At the very least equity holders must be zeroed out before any bailouts and forfeit their gains from the good years.