How Big a Problem is Moral Hazard?

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Scott Sumner writes:  "I am increasingly of the view that moral hazard is the central problem with our financial system."

This is a very popular view with substantial segments of the left and the right.  To the left, it verifies the sense that banks are playing fast and loose with money that is rightfully ours.  To the right, it absolves the market of most of the responsibility for financial crises, which can now be pinned on the FDIC or some other government institution.

Scott Sumner is a very smart guy, and I quail to disagree with him, especially on macroeconomic topics.  But I've been mulling over this argument a lot, and I'm just not convinced.  I go to a lot of pro-market think tank events where one speaker or another blames the financial crisis and the current recession on moral hazard, as well as basically everything else that has gone wrong in the last sixty years.  I'm afraid I don't see it.

The sticking point for me is twofold.  The first is that we had crises before there was moral hazard--really, really dreadful crises, crises far worse than the one we're having now.  I just don't see how you can look at the 1930s and name the FDIC as the decade's biggest financial problem.  Or this decade's biggest financial problem.  The closest our era came to a really devastating financial crash along the lines of the 1929-1933 period was in the total unguaranteed institutional money market funds.

Nor do I find the central story of how the FDIC induced this moral hazard very compelling.  Supposedly, ordinary depositors don't bother to check the soundness of their banks because they don't actually have skin in the game. 

Anyone making this argument cannot have met many ordinary depositors.  If you stripped away my mother's FDIC protection, she wouldn't do any better of a job at evaluating Citigroup's finances.  Moreover, this theory simply cannot explain the waves of bank failures that happened before 1934--failures in which the depositors neither expected, nor received, bailouts.  Bankers still got overconfident, lent too much, and then went out of business.  If you read contemporary accounts like the Benjamin Roth diary I recommended the other day, it's very clear that even when the shareholders and depositors were prominent local businesspeople with a lot of skin in the game and a pretty intimate knowledge of the bank's circumstances, they were still unable to foresee the trouble the banks got into.

The other reason that I don't find it all that compelling is that I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong.  The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout.  Maybe this had some effect on the margin.  Maybe it even subtly percolated into prices, and thereby, everyone's consciousness.  But that is not a big enough effect to explain the whole thing.

Do I think that we have a moral hazard problem in our system? Indisputably.  The continued existance of Citibank defies belief, unless you factor in implied guarantees.  And everything I hear about the credit terms available to the biggest banks indicates that they are getting very good rates because it's as safe as buying t-bills.

Is this a big problem?  I think so, though I'm not sure I can prove it.  It's certainly immensely corrosive to civic trust, and the political system, which is itself an enormous problem.  My basically free-market instinct is to assume that very bad things happen when people believe that a government will never allow a company to fail.  So I'm pretty sure that this is a very large problem.

But the moral hazard seems to have gotten much bigger recently.  And while Freddie/Fannie/Etc. are huge problems, they are not the only problems we have.  I do not buy the libertarian argument that the CRA and the GSEs bear the lion's share of the responsibility for this mess.

The central problem(s) we're dealing with right now seem to me to be, first, that asset/credit markets are sometimes subject to bad feedback loops which cause bubbles and crashes, and that the regulators cannot entirely forestall these, because the regulators are getting the same bad information from the feedback loop.  And second, that to figure out what is going on in the banking system, we have to ask the bankers, who are going to tell us things that work to the advantage of the bankers.  And third, that when new financial assets emerge, we don't fully understand the risks, and we tend to thereby get ourselves in trouble.  Moral hazard seems like a distant fourth.

Of course, it may be that Scott Sumner and I are talking about something else.  When I think of a central problem, I think about the problem we're facing now.  But the problems we're facing now are the kinds of problems that are going to plague us once every fifty years or so.  The moral hazard, we will always have with us.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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