HAZARDOUS MATERIALS?

by James Surowiecki
New Yorker
FEBRUARY 9, 2009

In the course of the ongoing financial crisis, we’ve been ceaselessly reminded of the dangers of moral hazard—the idea that if people are insulated from the negative effects of their gambles they are more likely to act rashly. When Bear Stearns was bailed out, last spring, the move was attacked for exacerbating the threat of moral hazard. When Lehman Brothers was allowed to go bankrupt, in mid-September, the decision was praised by some for reducing the risk of moral hazard. These days, moral-hazard concerns are making policymakers cautious about stemming the rise in foreclosures, and about dealing with ailing banks: if we bail out banks or homeowners, we’re told, it will only encourage more recklessness.

The concept of moral hazard seems commonsensical. A frequently cited example is fire insurance: people who know they’ll be reimbursed if their house burns down supposedly won’t worry as much about preventing fires, and so will have more fires than people who don’t have insurance. By extension, the argument goes, if banks think that the government will bail them out in a pinch, they’re more likely to make risky bets. That’s why moral-hazard fundamentalists advocated letting Lehman Brothers fail, and making it clear that bad decisions have consequences.

Of course, not acting also has costs, and sometimes—as in the case of Lehman’s failure—those costs are immense. So, if the threat of moral hazard is going to encourage inaction in a crisis, we should be sure that threat is real. And there certainly are situations where moral hazard does seem to have an effect on people’s choices. Deposit insurance can make depositors less vigilant about the quality of banks, increasing the likelihood that bankers will make bad gambles with depositors’ money, as they did during the savings-and-loan crisis of the eighties. In other circumstances, though, moral hazard seems to have a much smaller impact. And, in the case of public-sector intervention during financial crises, evidence for its dangers is surprisingly flimsy.

(More here.)