Moral Hazard Revisited

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.

Author: Matthew E. Kahn

Professor of Economics at UCLA.

8 thoughts on “Moral Hazard Revisited”

  1. Moral hazard for thee, profit for me. The Dewan article is not so much about “moral hazard” (or its twin, “adverse selection”), qua terms of art in the economics of insurance, as it is about authoritarianism, and making up myths that blame the victims of elite failure and malfeasance.

    A few thousand banksters make off with millions and billions and trillions, and, suddenly “we” cannot “afford” Social Security. A couple of days ago the Huffington Post had an article about FDIC lawsuits seeking to recover, from bank executives of defunct banks. Its worth reading, for some insight into real “moral hazard”:
    The FDIC ends up settling for pennies on the dollar with insurance companies that had provided banker malpractice insurance; the executives and their gains are rarely touched.

    Economists like to theorize ex ante, but in the real world of genuine uncertainty, we often cannot really manage ex ante rule-making. We wait for situations to manifest in all their concrete detail and we go about making ex post judgments. This is governance in action. Rational expectations are formed observing such ex-post judgements. I wonder what this “government intervention” (or lack thereof) portends for the future misallocation of capital?

    We might want to think seriously about the advisability of raising top marginal income tax rates north of 70%. People would be less likely to think it worthwhile to buy the lottery ticket of corporate control fraud.

  2. The basic question over moral hazard has been answered ever since the abolition of imprisonment and bondage for debt before 1800, and the doubling-down of debtor protection with limited liability before 1850. Socializing the risk of investment through bankruptcy (and on the upside profits taxes) basically pays off. Excesses like the railway and dot-com bubbles were transitory problems, and after all left us with a lot of useful stuff. The problem is that these protections also incite harmful risk-taking, especially complex financial betting. The implication of the limited liability safety-net is the regulatory state.

    “If anticipated government intervention leads to a mis-allocation of capital, does this actually shrink long term economic growth?” No, if the intervention also leads to sufficiently greater (positive-yield) investment. Cf. China.

  3. This assumes that firms still make decisions in the long-run. With firms with high executive turn-over, where is the real incentive for officers to make decisions that are beneficial for the firm five years down the road? The possibility of government intervention only comes into play near a crisis point. Due diligence and precaution must be built into the structure of businesses if they are to survive economic downturns. Yet if a CEO parachutes in and out every five to seven years, they can discount the possibility of a near-term crisis. Executives can leave with high regard and a nice severance package and move on to the next firm.

    I would bet that poor long-term strategizing results more from the career choices than a belief than a belief that government will step in. Culture surrounding top executives has encouraged excessive risk taking and a lack of preparation for cyclical downturns.

    1. Ben,
      What you (and less forgivably Matthew) miss is the bondholders. You’re mostly right about the incentives of executives, but animal spirits don’t cause corporations to behave. Lenders do. The lenders have to be repaid, and they often have long-term debt. So lenders usually put the brakes on excessive corporate exuberances.
      The problem with banks is that all their lenders get 100 cents on the dollar in case of insolvency. Political economy aside, this is the problem of TBTF. Since no risk is internalized on bondholders, they are quite happy to fluff up the size and risk level of the bank–something they would not be willing to do if they were at risk.

      1. “So lenders usually put the brakes on excessive corporate exuberances.”

        What was Greenspan’s phrase? Oh — ‘with certain noticeable exceptions’.

  4. “concerns about moral hazard are over-stated”

    Well there is moral hazard and there is moral hazard. The US (or at least large segments of its politicians and economists) seem willing to believe that people enjoy going to the doctor and would voluntarily guzzle down anti-cancer meds if they didn’t have “skin in the game”. These same people don’t seem much concerned that people will happily create bonfires in their houses because most of us have a free city fire station nearby, and fire insurance.

    I think we’ve reached the point where simply crying “moral hazard” is not helpful.
    (a) People respond differently to incentives in different circumstances.
    (b) People see a whole lot of other issues (which economists are blind to) —the hassle of burning down the house and losing personal possessions, the hassle of going to the doctor for no reason.
    (c) The degree of oversight/regulation required should be commensurate with the amount of damage possible, especially taking into account third parties. The flexibility a CEO has to screw over the rest of the world (especially when bask-stopped by the US treasury) is rather more important than the chance than one Munchausen’s patient might get three free medical treatments before being noticed and sent to the psych ward.

    We’d be vastly better off using empirical evidence for these various cases rather than simply shouting “moral hazard”. But of course that would make economists no better than anthropologists and social scientists and god knows, we can’t have that. Here’s a clue guys — if you’re going to suffer physics envy, you might want to remember that half the physics way of looking at the world is mathematical models AND HALF IS VALIDATING THOSE MODELS AGAINST REALITY, AND CALIBRATING THEM TO THE ACTUAL PARAMETERS OF THE WORLD.

  5. To a large degree ths moral hazard arguement in too big to fail misses the point. People, executives, make decisions not companies. Moral hazard is a concern because the bombers who blew up the financial system got to keep their millions, and in many cases their jobs, with no PERSONAL accountability. If the Masters of the Universe knew they’d be fined into the poorhouse and spend a few years in Allenwood Federal Prison, they would be a bit more careful. There is simply too much money to be made before a collapse, and kept afterward, for their company’s failure alone to be a deterrent.

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