Shaila Dewan has written an excellent piece for the NY Times arguing that concerns about moral hazard are over stated. Dewan argues that there is only a “nugget of truth” to the claim that well meaning government intervention often has nasty unintended consequences of encouraging excess risk taking. The piece focuses on “small ball” choices made by individuals such as buying a house or bad luck of becoming sick.
The piece sidesteps trickier issues related to large firms’ expectations that government will “bail out” them out when bad things happen to them. “Too Big to Fail” encourages pursuing mergers (to become big) and risk taking. For a prime example of what I mean see James Kwak and Simon Johnson’s 13 Bankers. If big firms expect that they will be bailed out for bad decisions, then they are flipping one sided coins and we will end up with a weaker macro economy. Firms would engage in more due diligence if they believed they would be on the hook for bad choices. Ex-ante precautions are more likely to be taken if you pay ex-post for bad choices. If anticipated government intervention leads to a mis-allocation of capital, does this actually shrink long term economic growth? I believe that the answer is yes. China’s State Owned Enterprises will offer a test of this hypothesis in the near future.