Friday, November 30, 2012

Moral Hazard: Bail outs, Debt relief, and Immigration

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.

13 comments:

Jim Baerg said...

Another example of policies with a moral hazard, I've seen pointed out is when electric companies are allowed to pass on to the customers increases in costs due to fuel price rises. This removes any incentive for the companies to avoid generators with low capital costs that use fuels with highly variable prices, & amounts to a penalty for generators that have a high capital cost but low & steady fuel costs or no fuel cost.

SS400 said...

I feel like there's a dilemma here. On the one hand, we want to set up institutions that reward responsibility and not irresponsibility, but in a system like that, as you note, good, responsible people will fall through the cracks through no real fault of their own.

On the other hand, if you try and create a method to help those good people in their time of need, you at the same time reward immoral individuals who will abuse the system to get benefit with no cost to themselves at the detriment of other good people.

So, either we allow good people to suffer, or evil people to prosper. I hope there's a third option I'm missing here, because I don't like either alternative; however, it seems like the way to go would be with the first option, set up a system that rewards good and not bad even if you can't necessarily help good people who need it.

It's probably better to look at these things on a case by case basis, though.

Steven said...

@Jim Baeg

Not unnecessary.

Increasing price lessens demand. If there is a monopoly, they would already be at the point where they get the most profit. Raising the price any more and they would lose money.

Also, if they are not a monopoly, and they are Operating at prices higher than they need to (and passing it on to consumers), then someone else can enter the market and offer the same service (energy) for a lower price, and steal most of the market away from them.

With competition, these companies still have a need to operate at the lowest cost possible, even if they are allowed to pass on the costs to consumers.

Steven said...

Not necessarily*

For whatever reason, I can not seem to type with proper grammar on this site...

mojo.rhythm said...

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.

That's actually not true. Taxpayer money does not finance government spending. Government creates money as it spends it simply by entering a few strokes on a keyboard.

mojo.rhythm said...

Alonzo,
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.

Mojo,
There is a very easy, concise way to ameliorate this problem. You reward the savers with a commensurate cash injection. That way, the reckless agents will have an incentive to save and be frugal, as they will want the future pile of money that comes with it if there is another financial meltdown.

The same logic applies to the illegal immigration issue. The question becomes: how can you reward the immigrants, who pursued all the proper channels, in a way that provides all future potential immigrants with an incentive to do it the proper way?

Steven said...

@mojo

First of all, I have to wonder why you are responding to yourself.

Second of all, the fact that most money is strokes on a keyboard is irrelevant.

Me paying the restaurant $5 (let's say via Debit card), and you wire $5 to my bank account, then it is virtually the same thing as if you had paid the restaurant $5.

If the government doesn't take in money, and prints it, we get inflation. The fact that money is mostly virtual is absolutely positively irrelevant when talking about the consequences of inflation.

So yes, taxpayer money and debt (and inflation, which can be viewed as a debt that everyone pays) does finance all government spending.

In your next post, you say that we should just give monetary incentives to those who are frugal.

Well... that's the problem.

Why would we give them money, just to tax it away from them? You give them money, to take it away from them?

Your solution is equivalent to not taxing them to help those who are not frugal. Then the not frugal people suffer because we don't have the money to help them. The money needs to come from somewhere.

mojo.rhythm said...

Steven,
First of all, I have to wonder why you are responding to yourself.

Mojo,
What do you mean?

Steven,
Second of all, the fact that most money is strokes on a keyboard is irrelevant.

Mojo,
No it isn’t. It means a lot, as you will see.

Steven,
Me paying the restaurant $5 (let's say via Debit card), and you wire $5 to my bank account, then it is virtually the same thing as if you had paid the restaurant $5.

Mojo,
You have pushed a false analogy between a household and a government (a mainstream misconception that needs to be dismantled). The analogy is wrong. For one thing, private agents have solvency constraints and are at risk of default or bankruptcy. The United States government does not have this problem. When the United States issues bonds at a Primary Auction, those bonds will always be bought by the banks; the NY Fed has set up the auctions not to fail.

Furthermore, interest rates on short-term T-bonds are not decided by the market and bond vigilantes. In America they are at the discretion of the Federal Reserve.

So bottom line, Treasury can spend as much as it wants. If it defaults on its debts, that will be a voluntary (and utterly retarded) political decision by Congress.

Yes, Congress does require Treasury’s account at the Fed to be positive before it can be debited, but that is a self-imposed voluntary constraint. It is a vestige from the gold-standard era which politicians have simply neglected to get rid of. I’m personally for removing it and no longer issuing bonds (T-bonds are mostly just corporate welfare in a fiat money system). But despite it being there, Treasury will still never face a solvency problem, unless the US goes back on a gold standard or pegs their currency.

Steven,
If the government doesn't take in money, and prints it, we get inflation. The fact that money is mostly virtual is absolutely positively irrelevant when talking about the consequences of inflation.

Dispelling the idea that government prints money to pay for stuff is important. When you replace the visual of a printing press with a government keyboard, people get a more intuitive feel of what money actually is.

Money is like points in a game. The Fed+Treasury are the scorekeepers and the dollar is a spreadsheet. The government doesn’t “have money” and it doesn’t not “have money” either.

It is like asking if a referee “has” any points to award. She doesn’t “have” points and she doesn’t not “have” points. The ref just awards and deducts points as required. This is how the Federal Reserve + Treasury works in a nutshell.

Steven,
So yes, taxpayer money and debt (and inflation, which can be viewed as a debt that everyone pays) does finance all government spending.

Mojo,
Then let me ask you: where do you think those people got the fiat money to lend to the government if the government did not first spend the dollars into existence?

Steven,
Why would we give them money, just to tax it away from them? You give them money, to take it away from them?Mojo,
That is a loaded question. I don’t propose giving frugal folks money just to destroy that money through taxation again. I propose giving frugal folks a cash bonus and letting them spend it as they see fit. The government can afford to do this. The government can afford to buy anything for sale in US dollars and it can afford to give out however much money it wants to give out in US dollars. That is the fundamental and essential difference between a sovereign government that issues its own currency (like the US, Australia, and so on) and a household.

Steven,
Your solution is equivalent to not taxing them to help those who are not frugal. Then the not frugal people suffer because we don't have the money to help them. The money needs to come from somewhere.

Mojo,

That’s right. The money comes from the government which spends it into existence.

Steven said...

@mojo

I now realize that you head your posts with "Mojo" to signal that you are speaking, and not that you are responding to that person.

I'm still confused as to how this will help the non-frugal people.

Yes, the government can create the money into existence. I understand this. That still causes inflation (most of the time).

So how does giving the frugal people money help the non-frugal people?

In fact, wouldn't it hurt them by inflating their money?

mojo.rhythm said...

Steve,
[Government money creation] still causes inflation (most of the time).

Mojo,
It really does depend on the circumstances. Only monetarism posits a linear relationship between money supply growth and price inflation. It all depends on the state of the economy. Unlike Communist, state-controlled economies, private enterprise systems usually have an effective demand shortfall, unused resources, far from full capacity utilisation, etc. Under those conditions, government spending doesn’t directly translate into “too much money chasing too few goods.” The relationship between money supply and inflation is a bloody complicated one that very few economists really understand properly, especially the neoclassicals (the New Keynesians and New Classicals) and the Austrians.

Steve,
So how does giving the frugal people money help the non-frugal people?

Mojo,
I advocate giving both classes (the frugals and prodigals) money. The cash injection would have one very important string attached: you must first use it to pay debts down, even if that uses up the whole sum of it.

Assuming that there is some left over, that money can be saved, spent, invested, or whatever you wish.

Steve,
In fact, wouldn't it hurt them by inflating their money?

Mojo,
If it happened right now, big-time inflation would not occur. Since such a large portion of the money would be allocated to paying debts down—and not bidding up the cost of goods, services, and/or assets—it would roughly cancel out. After that, the vast majority of the left over money would be in the hands of the frugal people, who already have a higher marginal propensity to save anyway.

Furthermore, even after this debt jubilee has taken place, unemployment will still be high, and there will still be vastly underutilized capacity.

But if the government, after writing off the debt, putting everybody back to work and providing the means for the private sector to get to near full capacity again, continued to run massive deficits, then you would probably see some excessive inflation. That would be the time for the government to start going in the direction of budget surplus to cool the overheating economy (note: I didn’t say it had to achieve a literal surplus, just move in that direction with just enough acceleration).

It is all about balances; getting just the right amount of deficit spending to (a) compensate for the US current account deficit, and (b) minimize unemployment without crazy inflation.

Steven said...

@mojo

Yes, it does depend on the economy, and how you distribute the money. What you just described is a distribution that would most definitely cause inflation.

The money and debt don't just cancel out. The money now just goes to the debt holder, who then does bid on goods/services, or lends it out to someone, who then bids on goods/services. With more money for everyone, that causes inflation.

Also, frugal people do not necessarily have a higher MP to save. They could just be good at investing. They might spend 95& of their income, but know how to invest the 5% to make them frugal.

Furthermore, the entire point of government spending to stimulate the economy is to target spend, not to give everyone money.

If you give everyone money, despite the economy, there will always be inflation, AND it will increase inequality.

That's why the stimulus plan didn't just hand out money, it went to pay certain industries.

mojo.rhythm said...

Steven,

The money and debt don't just cancel out.

The money now just goes to the debt holder, who then does bid on goods/services, or lends it out to someone, who then bids on goods/services.

Mojo,

Oh contraire Steve! By definition, the loan and the principle cancel out; they are on opposite sides of the ledger in the spreadsheet (the loan is the bank asset and the liability is the deposit). This is bog-standard double-entry bookkeeping, which you learn in your first year in an accounting course.

Interest is left over, which the banker collects. But remember: even if there was no debt jubilee, interest would still be paid on a regular basis to the banker, year after year. The Jubilee stops this debt peonage in its tracks, ensuring that banks get no more interest money (which is rent; not income earned by productive means, like entrepreneurial activity or labor).

Even if paying back debts gave banks a massive injection of new reserves, it does not follow that they will lend more money. The standard Money Multiplier model is flat-out false. Banks’s don’t have to sit on their hands, waiting for reserves, before extending loans; they lend solely on the basis of creditworthiness and expected return. In short, the money supply is endogenous.

en.wikipedia.org/Endogenous_Money

Endogenous money explains why quantitative easing has been so inconsequential.

Steven,

Also, frugal people do not necessarily have a higher MP to save.

They could just be good at investing.

Mojo,
If they are, then great! They have more cash to allocate towards capital goods. This will mobilize unused capacity, create jobs, and raise people’s standards of living. As I mentioned before, the US has very under-utilized capacity right now. Perfect.

Of course we are assuming that their investments weathered the recession and were able to generate sufficient income for the frugal folks to hold the fort and not get ensnared in a debt trap. Implausible, perhaps? Unfortunately, it is.

Steven,
Furthermore, the entire point of government spending to stimulate the economy is to target spend, not to give everyone money.

Mojo,
It actually is targeted spending. While not aimed at specific industries, firms or people, it is targeted for a very specific purpose: to eliminate the debt overhang. That is why I said the one condition of accepting the money will be you must first use it to pay down your debts, even if that uses all the money up.

mojo.rhythm said...

Steven,
They might spend 95& of their income, but know how to invest the 5% to make them frugal.

Mojo,
Like I mentioned, we have to assume that the Great Recession did not sour their investments and plunge them into debt hell. In fact, the very existence of this Depression is concrete evidence that those kinds of fantastically lucky people are either extremely rare or do not exist. The crisis was caused by an unsustainable acceleration of aggregate private debt, and the Depression is the subsequent outcome of everybody trying to pay down those unsustainable debts at the same time and not buying stuff in the real economy. If the economy was instead populated with prodigals who made most of their income from investing in Depression-proof capital goods, it would be a very different world.

Steven,
If you give everyone money, despite the economy, there will always be inflation, AND it will increase inequality.

Mojo,
It will decrease inequality. Why? Because, overall, the only parties who stand to lose big time from a Jubilee would be the bankers themselves. The banking sector makes money by creating debt. The more private debt there is in a society, and the quicker it is rising, the richer they become from interest payments. Financialization of the economy has been a huge catalyst for the insane inequality observed today. That financialization can be reversed if the bankers power can be taken away, which a debt Jubilee could play a big part in doing. The Golden Age of Capitalism occured during low levels of private debt and a largely industrial economy based on producing real goods and services.

I’ve already addressed your concerns about potential inflation here and in previous posts.

A Jubilee might seem like a far-out radical idea in this day and age, but for the vast majority of human history in which we have had markets and money, Jubilees were boringly regular occurences.

In fact, during the Roman Empire, the first thing the King of Rome would do, once crowned, would be to cancel all the outstanding debts. Why? Because if the majority of the population was too mired in debt, they would simply leave and seek residence elsewhere. And the Roman Empire could not abide that; they needed citizens for labor and soldiers for the army.