HowTo: Moral Hazard

I don’t recall whether or not I mentioned this specifically, but economists everywhere will have considered the moral hazard of central banks bailing out financial markets.

Moral Hazard on Wall Street

Moral Hazard is usually considered within the context of insurance (health insurance, more specifically). It basically says that, if you have health insurance, the consequences of you taking risks (not making effort to prevent ill-health, participating in “extreme sports”, and so forth) are much less – you won’t have to pay the entire cost of that 6 weeks in traction, so you worry about it less (okay, bad example). This means people take more risk than they would if made to be personally liable, and more health care ends up needing to be consumed as a result.

So where do central banks fit in? Just like the Wall Street Journal (and any other economist) says:

If investors believe the Fed will rescue them from their excesses, people will take greater risks and, ultimately, suffer greater consequences. Some grumble that the Fed created problems this way in 1998, 1999 and 2003.

If the Fed were to cut rates now, it certainly could help with the current market crisis. The cheaper money would reduce pressure on stock and bond markets by making it easier to buy beaten-down stocks, bonds and other securities world-wide. Wall Street is a powerful lobby in Washington, and its bleating for help can be hard to resist for politicians, whose campaigns often depend on financial contributions from Wall Street figures.

But if the Fed were to ride to the rescue, the skeptics worry, it would encourage people to speculate even more, creating an even bigger bubble later.

The stock market cannot be made into a one-way street. We can’t have the likes of Jim Cramer insisting job losses are a boon when they’re elsewhere, and then going crazy as a bloody March hare, screaming for Wall Street Welfare, when it’s his turn. Financial markets are in this mess because they made it. They thought they were making hay while the Sun shone, not noticing it was actually a bonfire.

The same is true, sadly, of sub-prime and Adjustable-Rate mortgages. Having central banks bail out households who cannot afford their mortgages is temporary – it only encourages re-financing and the false belief that these households can in fact afford their mortgages after all.

So: Moral Hazard. The more that Bernanke earns his nickname of Helicopter Ben, the more risks Wall Street (and bond makers, traders, hedge funds and private equity the world over) will take – with your pension fund – and the more they’ll lose when shit like this happens. Which it will. Again, and again, and again (with apologies to the Highwaymen).

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