15 October 2008

The role of "moral hazard" in the current crisis

I've previously blogged re the definition of moral hazard:
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...
I've just encountered a well-written essay re the relevance of moral hazard to the current economic collapse.
Who is to blame for this extraordinary crisis? … Congress and the American people are looking for a "villain" or "villains" … Wall Street's investment bankers rank high on that list… Government, and central banks, come in a close second. Regulators failed to do their jobs and the central banks simply fed the credit bubble without regard to the consequences. Others tag individuals like Alan Greenspan, Ben Bernanke and George Bush…

The fact of the matter is none of this really hits the mark. The real culprit is an idea … The words which encompass that idea most closely are "moral hazard." When we hear those words we immediately think of the Wall Street financial houses and funds in their relationship with the government. What we do not generally compute is that moral hazard applies to the rest of us as well.

Moral hazard is the state of mind created by a belief that the government is going to bail us out if something goes wrong -- in our lives, in our economy. How many of us assessed the spreading damage of the credit crisis and said to ourselves, "the government will step in and take care of it"?..

But you see, this whole idea of personal and public bailouts is what is behind the problem in the first place. As long as institutional man believes that the government stands behind him no matter what level of risk is taken, the level of risk will rise to the point failure is imminent. Why not swing for the fences? Win and you take home the prize. Lose and the government covers the losses… It is what led millions to take on mortgages they couldn't afford; it is what drove Wall Street to take risks it couldn't possibly cover...
The person who wrote that is trying to sell gold, but whatever his motivation, the comments are incisive.

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