One of the most intriguing concepts of economics is the concept of “moral hazard.” It is a corollary to a more obvious principle that everything has a cost. An understanding of it is critical for those whose world view is a never-ending series of crisis that demand a government solution.
Insurance, for example, encourages the risk it is designed to protect us from. Seat belts may make us more reckless drivers. I may be more inclined to eat the high fat burger with cheese if I think I am protected by Lipitor. Free health care may make us less healthy and more obese.
But nowhere is the cost of moral hazard more significant and more obvious than in our financial system.
We insure bank depositors to bring stability to our financial system, but such insurance means that the depositors are freed from the responsibility of even caring about the bank’s stability. It also increases the bank’s proclivity for risk taking. They get to pocket profits and get bailed out of losses. We privatize the profits and socialize the risk.
FDIC protection started out at $10,000, and soon went to $40,000. Jimmy Carter raised it to $100,000 and some partially faulted this move with creating the savings and loan fiasco about ten years later. In the midst of our recent crisis the limit was raised to $250,000 to avoid another bank run. Given our historical correlation of increasing FDIC protection limits with worsening crisis, I wonder if in our effort to avert the current crisis whether we have simply sown the seeds of the next one.
Those who fault the absence of regulation for our current crisis should look further at the moral hazard created by the very protections embodied in our current regulations.
Regulations written in response to our last crisis do not seem to protect us from the next one. Rules written as a result of the dot.com bubble did not protect us from the ensuing housing bubble. In fact our regulators and our government was more of a willing participant via Fannie Mae and Freddie Mac.
In the absence of FDIC insurance perhaps the consumer and society would be better served by an “independent” rating such as the AM Best rating service is for life insurance companies or an equivalent of Moody’s or S&P for small banks. I do stress the independence which had been seriously compromised in the past.
There will never be enough regulators to counter the number of people who seek loopholes, ply lobbyists, create new products or who otherwise seek to game the system.
Even if we were able to staff enough bureaucracies to squeeze excess risk and abuse out of our financial system, it would likely restrict growth so severely that we may long for the days of a few bubbles and the ensuing market correction.
Facing record deficits this administration needs economics growth desperately. The union card check bill, the budget deficit, the uncertainty of cap and trade, higher taxes on the wealthy and private businesses, and the cost of the health care proposals severely threaten business growth.
But the biggest hindrance may be both an increase in moral hazard that increases the likelihood of the next bubble, and overly restrictive regulations that retard the growth we need to recover from the last one.