Saturday, September 20, 2008

Moral hazard

Watching the business news over the last couple weeks has given me a feeling I have rarely felt before in my life. The news is bad, but more than that, it is so vast and unimaginable that it is hard to comprehend its impact. It's like missing the newspapers for a couple days, and the next time you sit down to read them, you find out that the Germans have occupied France.

It is hard to comprehend that the entire profession that many people I know went into, may soon cease to exist.

The main argument against the government protecting banks like AIG from failure is the existence of "moral hazard", that investors will know that the government will save them in the event of a crisis, so they will not have to bear the full extent of their risks. With this implicit guarantee, they will be willing to make unjustifiably risky investments which they shouldn't make. I am not an economist, but I'm not sure the "moral hazard" argument is applicable to the current crisis.

The people buying complex derivatives, who would be on the hook for most of the losses, did not understand what they were buying. For that matter, the people who made them in the first place didn't always understand them! And home-buyers who took out unreasonable mortgages certainly had no way of knowing that the lenders were irresponsible.

People did not make bad decisions assuming that the government would bail them out. People made bad decisions because they mistakenly thought a bailout situation would never arise.

The "moral hazard" theory presumes that people will rationally decided that investments which are bad for society are nevertheless worthwhile for themselves. In the current crisis, we had no such rational thinking, only irrational thinking based on misunderstandings. Moral hazard did not create this crisis, and will not create a future crisis of the same nature (though it could contribute somewhat to a preexisting crisis, including this one).

I know of at least one financial services person who reads this blog, any comments?

1 comment:

ari said...

Even if moral hazard didn't cause this crisis, it can cause others. And don't forget it's definitely moral hazard that allowed Fannie and Freddy to fail - they borrowed at government rates because of implicit backing, and invested in risky high-yielding securities.