Academic journal article The Cato Journal

Moral Hazard and the Financial Crisis

Academic journal article The Cato Journal

Moral Hazard and the Financial Crisis

Article excerpt

There is no denying that the current financial crisis has delivered a major seismic shock to the policy landscape. In country after country, we see governments panicked into knee-jerk responses and throwing their policy manuals overboard: bailouts and nationalizations on an unprecedented scale, fiscal prudence thrown to the winds, and the return of no-holds-barred Keynesianism. Lurid stories of the excesses of "free" competition--of greedy bankers walking away with hundreds of millions whilst taxpayers bail their institutions out, of competitive pressure to pay stratospheric bonuses and the like--are grist to the mill of those who tell us that "free markets have failed" and that what we need now is bigger government. To quote just one writer out of many others saying much the same, "the pendulum will swing--and should swing--towards an enhanced role for government in saving the market system from its excesses and inadequacies" (Summers 2008). Free markets have been tried and failed, so the argument goes, now we need more regulation and more active macroeconomic management. (1)

Associated with such arguments is the claim that the problem of moral hazard is overrated. A prominent case in point is Lawrence H. Summers himself. In a widely cited column, he exhorted his readers to beware of a "moral hazard fundamentalism" which, he argued, was "as dangerous as moral hazard itself" (Summers 2007). His use of the disparaging term "fundamentalism" suggests that he did not intend it as a compliment. But whatever his intent, the issue identified by Summers--the role of moral hazard--is central to the controversy over the causes of the present crisis and the lessons that should be drawn from it. Unlike him, however, I believe that moral hazard is a (much) underrated problem: moral hazard played a central role in the events leading up to the crisis, and we need to appreciate this role if future reforms are to be well designed and prevent further disasters down the line. Understanding moral hazard is fundamental to understanding how the economy works--and if this is "moral hazard fundamentalism," so be it.

The Nature of Moral Hazard

A moral hazard is where one party is responsible for the interests of another, but has an incentive to put his or her own interests first: the standard example is a worker with an incentive to shirk on the job. Financial examples include the following:

* I might sell you a financial product (e.g., a mortgage) knowing that it is not in your interests to buy it.

* I might pay myself excessive bonuses out of funds that I am managing on your behalf; or

* I might take risks that you then have to bear.

Moral hazards such as these are a pervasive and inevitable feature of the financial system and of the economy more generally. Dealing with them--by which I mean, keeping them under reasonable control--is one of the principal tasks of institutional design. In fact, it is no exaggeration to say that the fundamental institutional structure of the economy--the types of contracts we use, and the ways that firms and markets are organized--has developed to be the way it is in no small part in response to these pervasive moral hazards.

Subsidized Risk-Taking: Heads I Win, Tails You Lose

Many of these moral hazards involve increased risk-taking: if I can take risks that you have to bear, then I 'nay as well take them; but if I have to bear the consequences of my own risky actions, I will act more responsibly. Thus, inadequate control of moral hazards often leads to socially excessive risk-taking--and excessive risk-taking is certainly a recurring theme in the current financial crisis.

A topical example is the subprime scandal. In the old days, a bank would grant a mortgage with a view to holding it to maturity. If the mortgage holder defaulted, then the bank would usually make a loss. It therefore had an incentive to be careful who it lent to and prospective borrowers would be screened carefully: a subprime would-be borrower didn't have much chance of getting a mortgage. …

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