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My Two Cents

Moral hazard

Chris Farrell Sep 23, 2008

I’ve always felt that the problem of moral hazard has been exaggerated. But this time, no.

Here’s Peter Bernstein, dean of finance economists, on moral hazard in his latest newsletter:

For as long as I can remember, every government or Fed bailout has elicited cries of alarm about moral hazard: “If we bail out today the miscreants who overreached in risk-taking, then we can expect a huge increase in overreaching miscreants tomorrow. And an even larger gang next time around.” Why not? Why not make high-risk bets when you are confident the government will restore you to life even if you end up financially dead?

Up to this point, I have always argued that moral hazard is a valid but secondary con-cern, because saving the system must have the highest priority. Our way of life and society itself depends upon it. In today’s world, with the prevailing levels of debt in the system, re-playing the Great Depression would be an even greater catastrophe than it was back then…

… Yet the magnitude of the moral hazard in the current proposal is awesome. We are not talking about just AIG or Long-Term Capital Management. Washington is going to rescue thousands of bad bets, many of which were stupid or reckless, and just about all of which reflected a stubborn disregard of risk. Risk means the range of possible outcomes is in all likelihood wider than you think. At the heart of risk management lies the critical question: “What if we are wrong?” Hence, risk management must include hedging against outcomes worse than what you anticipate. Failure to make such calculations – or failure to act on such calculations, in households as well as in institutions – is now costing society dearly.

The government is now indulging in moral hazard in extreme orders of magnitude. How do we control the consequences? When all bad bets are made good by the government, or at least settled somewhere over zero, how do we prevent a replay of the light-hearted risk-taking of this era next time prosperity takes hold? Jiggling with the fed funds rate is hardly a barrier. The implication is that today’s crisis and tomorrow’s bailout could be just a minor prelude to a more grandiose climax somewhere in the not-too-distant future.

One implication is that to deal with situation, and forestall an even bigger disaster, the regulatory overhaul will have to be dramatic. It can’t be regulatory changes at the margin. And the regulations can’t be written by Wall Street and their well-paid lobbyists.

Another implication is that both Obama and McCain are going to have to rewrite their tax proposals. Any fiscal policy proposal has to take into account that we’ve raised the national debt by $6 trillion in just a few months. The fiscal tab is likelty to get bigger.

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