Moral Hazard — Cancer to the Economic System

Moral Hazard:  lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.

Moral hazard is a growing problem in our economic system. The recession is often attributed to faults in the “free market” or “lack” of regulations on corporations, which allows these greedy, unrestrained businesses to gain too much power and end up in trouble which only good ol’ Daddy Washington can fix.

First of all, that isn’t the fault of free markets. Actually, it’s the fault of the lack of free markets. The system we currently have is what Ron Paul calls, “corporatism” or “crony capitalism” — a partnership of government and big corporations in which the printing policies of the Federal Reserve are a major player.

Corporatism breeds moral hazard. These big corporations make these unrealistically risky investments that lead to default only because their money comes with a guarantee by the federal government, a guarantee only possible because of the government’s possession of an unlimited credit card, the Federal Reserve. Imagine if the government could only acquire its funds through direct taxation? The taxes would be enormous.

A prime example of the dangers of moral hazard can be found in the case of the semi-private mortgage giants, Fannie Mae and Freddie Mac.  Fannie and Freddie are so linked to this guarantee from 300 million taxpayers that if you take away the government’s connection they have zero credibility, because those who do business with them do so in the knowledge that their money is always safe — in a worst case scenario, the taxpayers will foot the bill. You take away that back up, no one is going to want to deal with these businesses that make such risky malinvestments. These “big businesses” have no incentive to conduct good business practices.

Corporations like Fannie and Freddie make malinvestments because it’s a no-brainer. They get to reap the profits of these risky investments while not having to worry about the potential for loss. If they are not successful, instead of crashing and burning (as they would in a free market), they get to distribute those losses on to the millions of taxpayers. That’s what occurs when the Federal Reserve bails out these big corporations because they’re “too big to fail.”

In a free market, these banks would not be making such investments because they would be fully aware of the risk potential. They would be completely susceptible to the risk of bankruptcy and would therefore take the necessary steps to mitigate those risks (i.e., not making loans that have a huge potential of default). If a bank doesn’t mitigate those risks and made those malinvestments anyways, then they fail and go under as they deserve, freeing assets and capital for more efficient areas of the industry.

When you provide guaranteed protection against the potential of loss, you directly encourage the risky actions that lead to the very loss you’re protecting against.

Published in

Post a comment