Moral Hazard refers to the presence of incentives for individuals to act in ways that incur costs that they don’t have to bear. An example would be the incentive to find a job given the existence of social welfare benefits for the unemployed. Moral Hazard is a market distortion based on imperfect information and fails to distinguish between those that are honest and those that take advantage of the incentive.
Recently there have been numerous examples of moral hazard especially in the US. Shaila Dewan in the New York Times wonders why ordinary American taxpayers should rescue the banks when they caused the downturn that the economy is going through. The specter of moral hazard haunts a basic tension in American life: to what extent are people responsible for their own problems? The more trouble you’re in, moral hazard suggests, the less we should help. With the debacle of the sub-prime housing bubble bankers have indicated that assisting mortgage holders would encourage those who can pay to act as if they are unable to. Furthermore it would also make those that have a financial commitment rather irresponsible. Last month the Department of Housing and Urban Development negotiated a $26 billion deal with the banks regarding foreclosure abuses. But homeowners who have prudently paid their mortgage payments might wonder why their neighbour, who has been unable to honour their financial commitment, should be getting help.
In 1996 Tom Baker, a law professor at University of Pennsylvania, wrote in “On the Genealogy of Moral Hazard” that:
“Moral hazard signifies the perverse consequences of well-intentioned efforts to share the burdens of life, and it also helps deny that refusing to share those burdens is mean-spirited or self-interested.”
However policies in the US have been trying to reduce the moral hazard issue. Countrywide have offered support to people that have defaulted on their mortgages instead of those who have just taken on dodgy loans. But wouldn’t that just encourage the latter to default? What is needed is more regulation of the banking sector – eg the Dodd–Frank Wall Street Reform and Consumer Protection Act passed in 2010.