Our last conversation brought up the subject of moral hazard.
This is a term largely used in economics. There, it is typically used to refer to policies that remove the costs of failure - thus giving people an incentive to take risks they would not otherwise take. These risks end up costing society a great deal, because they have to cover the cost of failure.
As an illustrative example, imagine a game of poker. One of the players receives a promise from an observer, "If you win, you keep all of your winnings. But if you lose, I will cover all of your losses."
This creates a situation where the player now a huge and perverse incentive to take all sorts of risks he would not otherwise take. He has an incentive to try for "long shots" - plays that pay off big if they succeed, but almost never succeed.
How many lottery tickets would you buy if somebody said, "You can buy as many as you want. I will cover the cost of every ticket that does not win?"
Now, the person making the promise is the government. The people they make this promise to are investors - your standard "Wall Street Bankers". Propagandists tell us that the government spends too much money helping the poor and middle class. Yet, huge amounts of government money go to helping the wealthy avoid major losses - helping the very people who refuse to any taxes to cover these guarantees.
"Moral Hazard" is tightly linked to "To Big To Fail". The reason the government covers the losses of these risk takers is because of the costs of failure to the economy as a whole. By knowing that the government cannot possibly allow these costs to stand, the government does not even need to explicity cover these costs. Thus those companies take huge risks, they fail, and the bailout begins (bailouts that those who are bailed out are refusing to pay for).
I have described this with respect to multi-billion dollar government bailouts. It applies to regular borrowers as well.
Imagine two households. Household 1 purchases a $100,000 house, refrains from buying expensive gadgets or vacations, saves for retirement, and keeps their debt manageable. The value of their house goes up over the next several years, but they allow the equity to build and maintain their current life style. After 10 years, the value of their house collapses back down to $100,000. However, they now owe $50,000, which they can easily continue to cover.
Household 2 buys a $200,000 house. As housing prices rise they refinance and spend the equity on cruises or other forms of entertainment and gadgets. At the end of 10 years, the value of their house collapses back down to $200,000. However, they have $300,000 worth of mortgages from refinancing. At this point, the government steps in to give them assistance with their loan. This household ends up after 10 years with a $200,000 house, a house full of gadgets, and memories of the places they have seen and the things they have done.
Now, to add injury to insult, the government needs money to cover these costs. It can only get the money from those who managed their finances responsibility and, consequently, have money to spare. The person who gave up all sorts of luxuries and who kept his finances in order finds himself with an additional tax burden precisely because he has to give some of his money to the household that spent wildly.
The moral hazard comes from the fact that such a policy rewards (in the biological sense) those who are financially irresponsible and punishes those who are financially responsible. It teaches a lesson that those who spend wildly and accumulate massive debts enjoy a greater quality of life over the long run than those who manage their finances responsibly. This, in turn, sets the stage for yet another round of fiscal irresponsibility - one in which people have been taught to sense the rewards of being one of those who act irresponsibility and sense the costs of being responsible.
I should add that it is not the case that all people who end up in financial distress have mismanaged their money. They might end up in this situation due to a severe illness (though illnesses brought about by poor life-style choices such as drinking, smoking, and obesity will not count in this regard). Criminals might take a person's ability to pay their debts, or some (unforeseeable) natural disaster (against which proper precautious could not have been taken) might have caused them great harm. However, there are people who end up in financial distress due to their own actions.
In that previous discussion I mentioned at the start of this article, moral hazard came into play regarding immigration reform.
Let us again take a situation that involves two people in another country in identical circumstances. The one difference between these two people is that one has a disregard for the law or the rules. He does as he pleases and tries to get away with what he can. He crosses into the country illegally and gets a job. The other person has a respect for the rules. He learns and tries to follow all of the proper procedures. However, this involves a lot of red tape and waiting with no guarantee of acceptance, so he remains out of the country legally.
Now, an amnesty is declared. In doing so, the person with low respect for the law and regard for the rules ends up getting a significant advantage - he ends up being accepted into this country. On the other hand, the one who respected and followed the rules is kept out. In fact, his chances of getting into the country may be reduced because the "quotas" are taken up by those who came into the country illegally.
Here, we have created a situation where we have rewarded (in the biological sense) disregard for the law and a willingness to do what one wishes, and punished (in the biological sense) those who are inclined to follow the rules and accomplish their ends legitimately. This, in turn, sets the stage for yet another round of illegal immigration - one in which more people see the advantages of breaking the law and hoping for the next amnesty, and fewer people see any reason to respect the rules and procedures that have been put into place regarding immigration.
All of these elements of moral hazard are legitimate.
In practice, we tend to see Republicans who ignore the moral hazard of "too big to fail" government bailouts - or even benefit from the government's implicit promise of future bailouts - by paying any additional taxes and fees to the government. Those practitioners are permitted to keep everything that they get when they win, while having others cover their debts when they lose. While debates go on about funding the massive deficit that, to a substantial degree, was created to bail out these people, we hear them demanding that they should pay nothing. They should only obtain government benefits - and never pay the costs.
At the same time we see Democrats that ignore the moral hazard of rewarding fiscal irresponsibility and a disregard for the rules on the part of the middle class and poor.
In fact, moral hazard is a legitimate concern - a legitimate reason for action - at all levels. What we should be doing is creating institutions that reward responsibility and respect for the rules, while at least forcing people to accept the costs of their own failures and preventing them from obtaining benefits through criminal activity.
Friday, November 30, 2012
Our last conversation brought up the subject of moral hazard.
Posted by Alonzo Fyfe at 8:07 AM