Nobel Prize winning economist Paul Krugman defined moral hazard as:
Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.
Companies exploiting moral hazard privatise the reward (they keep the profit) but socialise the risk (government bails them out if everything goes wrong)
Moral Hazard and the GFC During the Great Depression more than 6000 American banks went bankrupt between 1930-33 and caused significant levels of unemployment. Learning from this event authorities believe that in future banks should be bailed out and this eventuated after the GFC in 2008. The main cause of the GFC was the sub-prime mortgage market where lenders faced a situation of moral hazard. Because the banks were taking on the risk the mortgage brokers, who sold the mortgages to the banks, didn’t really check whether the person taking on the mortgage could actually pay it back. Brokers were encourages to lie on the mortgage contracts about the income etc of their clients.
Moral Hazard and Covid-19 With corporate stimulus packages rolling out in most countries one wonders if there have been thorough enough checks on corporate behaviour. Issues like firing employees and bonuses to the top executives of companies have been prevalent in the past especially during the GFC. Then large businesses were favoured over small businesses. Today some of the wealthiest people made their money by borrowing from the banks to buy their own company shares in order to inflate its price. Following this they then sold their shares for a profit on the market. Now some of them are asking for bailouts as their company starts to struggle to survive. As well as government bailouts the central banks around the world have also engaged in the purchase of bonds and risky high-yielding debt. This is to ensure liquidity in the market but this intervention could shape how people perceive risk in the future and reward those institutions that behaved recklessly before the pandemic. Also more generous unemployment by the government might encourage people to be laid off and not seek work. However the time taken to minimise the moral hazard could have meant greater economic harm to the economy as a whole.
Here is another clip from Seinfeld which is an example of moral hazard and imperfect information.
Jerry’s car is stolen, so he rents a car. The rental company doesn’t give him the car he reserved; he gets a small economy car. They ask if he wants insurance, and he replies, “Yes, because I’m going to beat the hell out of this car.” Source: Seinfeld Economics
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.
Below is a graph showing the frequency of the term “Moral Hazard” between 1960-2000 using the Google ngram.