The moral hazard of governemnt actions

Moral hazard is a term that come from the insurance literature where it meant the change in behaviour that occurred because the a person had insurance. A person with insurance is more likely to act carelessly than a person without insurance. For example, a person who insures their car against theft is more likely not to worry if the car is locked when they leave it than someone without theft insurance. This is simply because the insured person does not bear the full costs of their actions. The insurance company compensates them for some of the loss. While the idea of moral hazard may have originated with insurance it soon became clear that the idea applied in many other settings, including financial markets.

In a recent posting at the Becker-Posner Blog, Gary Becker discusses, among other things, some of the moral hazard problems that arise from the recent actions taken by the US Treasury and the Fed in an effort to deal with the current financial problems. Becker writes

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

The whole Becker piece, The Crisis of Global Capitalism?, is worth reading.