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. Â 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. Â “Too Big to Fail” encourages pursuing mergers (to become big) Â and risk taking. Â For a prime example of what I mean see Â James Kwak and Simon Johnson’s 13 Bankers. Â If big firms expect that they will be bailed Â out for bad decisions, then they are flipping one sided coins and we will end up with a weaker macro economy. Â Â Firms would engage in more dueÂ diligence if they believed they would be on the hook for bad choices. Â Â Ex-ante precautions are more likely to be taken if Â you pay ex-post for bad choices. Â Â If anticipated government intervention leads to a mis-allocation of capital, does this actually shrink long term economic growth? Â I believe that the answer is yes. Â China’s State Owned Enterprises will offer a test of this hypothesis in the near future.