Tuesday, October 07, 2008

The Financial Crisis & Moral Hazard

GARY BECKER DISCUSSES short term and long term financial policies. With respect to the short term policies Becker emphasizes doing the best at coping, and when he turns to the long-term he emphasizes reducing the likelihood of future crises. A key aspect of his discussion is moral hazard:
"The moral-hazard consequences for banks receiving a bailout now is worrisome since they may expect to get rescued again by the government if their future investments turn sour. Yet while I find helping these banks highly distasteful, moral-hazard concerns should be temporarily relaxed when the whole short-term credit system is close to collapse. Still, the bank bill with its huge bailout does suggest that the $29 billion bailout of the bondholders of Bear Stearns in March was a mistake. It seemed to have a moral-hazard effect by encouraging Lehman Brothers and other investment banks to delay in raising more capital because they too might have expected the government to come to their rescue if times got much worse. Although the government was apparently concerned that foreign central banks were major holders of the bonds, it was unwise to give them and other bondholders such full protection."
The idea of moral hazard is that a person may choose to take more risk when he is insured. It seems to me that moral hazard is a big part of the explanation for the present situation. Government policies have encouraged moral hazard with respect to mortgage loans. It may well be the case that in the short term government actions that increase incentives with respect to moral hazard are useful in coping with the present situation. On the other hand, Becker's analysis just above also suggests that this may not be the case because it may also increase the short term negative impacts.

Even if in the short term increasing incentives toward moral hazard are helpful, why should we think that sufficient numbers of people in Congress will learn good lessons from this crisis? It seems members of Congress were advised in the past by their own colleagues, and by others with knowledge of our capital markets, about the results of the moral hazard incentives that had been created by Congress. But, Congress did not act. It seems that a dominant story line in political discussion today is not about moral hazard, but about the evils of "capitalist greed." If increasing moral hazard in the short term policy responses to this crisis is perceived as useful in coping with the present situation, then how will the politicians telling the greed story come to understand the needed changes in policies in the long term? Further, it seems this economic crisis is increasing the likelihood that the politicians with a political philosophy that tells the "capitalist greed" story will be in the majority in Washington come January. While main street may be unhappy about bailing out those who made mistakes in giving out too many bad loans, it seems unlikely that main street will also largely come to understand the role of moral hazard in all of this. After all if enough of main street, explicitly or implicity, understood this, then it seems to me the candidacy of Senator Obama would not be benefiting from this crisis as appears to be the case.

Again, I recall BRYAN CAPLAN'S "RATIONAL IRRATIONALITY," and I'm not very optimistic that the voters and the politicians will emerge for this crisis and from this election cycle with the understanding and the motivation to reduce the moral hazard created by public policy in the future.

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