The hazard of moral hazard

Excerpts from James Glassman's piece of the same title.

The most dangerous kind of moral hazard is produced not from explicit insurance policies (on which, after all, the insurer can raise premiums) but from implicit ones. If your teenager thinks you will bail him out of jail or fix it with the judge if he gets arrested, then he will be more apt to drive drunk. More broadly, in the jargon of Alcoholics Anonymous, your behavior would be called “enabling.” By rescuing an alcoholic from the consequences of his actions, you are encouraging him to drink because he figures you will rescue him the next time. . .

Over the past three decades, the world has been awash in just this kind of moral hazard, as governments have become more adept at economic rescue and as practitioners of the art have won praise for seeming to pull the world back from the abyss. . .

The financial historian Charles Kindleberger, in his classic Manias, Panics, and Crashes, had it right more than 30 years ago when he described “the moral hazard that the more interventionist the authorities are with respect to the current crisis, the more intense the next bubble will be, because many of the market participants will believe that their possible losses will be limited by government measures.”. .

the dirty little secret is that regulation can enhance moral hazard, not dampen it. When people expect regulations to protect them, they lose the incentive to protect themselves. . .

Kevin Dowd, an economist who specializes in risk management, wrote recently about the banking crisis in the Cato Journal, “The root problem is limited liability, which allows investors and executives the full upside benefit of their risk-taking, while limiting their downside exposure.” Dowd quoted Adam Smith’s warning about corporations in The Wealth of Nations:

The directors of such companies . . . being the managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance. . . . Negligence . . . must always prevail, more or less, in the management of such a company.

Another example of the organic approach would be to reduce, rather than increase, government’s role in protecting consumers. Consider federal deposit insurance, which was instituted in 1934 to prevent runs on banks. Originally, deposits were insured up to $10,000; today the limit is $250,000. In practice, as Kindleberger points out, the federal government protects all depositors in insured banks. The effect, he writes, is that insurance “encouraged banks to make riskier loans since they were confident that they were protected against runs—if these loans proved profitable, the owners of the banks would benefit.” If the government cut the limit on insurance to, say, $20,000, that single act would send a strong signal to consumers (put your money in a strong bank rather than a weak one) and to bankers (shore up your balance sheet or you won’t get deposits). That this is not likely to happen, to put it mildly, has nothing to do with whether it should happen.