Many years ago I was grading an exam that asked students to define “moral hazard.” Sure, there is a correct answer but the one that sticks in my memory is that of a simple sketch of a triangular road sign with the words “Morals Ahead.” It got marks for making me laugh but let’s face it, it wasn’t the intended answer.
But in the last 10 days, that sign has come back to me. We have seen an unprecedented amount of government intervention — especially within the US. Each one is distinct in its mechanism but each one shares a commonality, the government is stepping in to ensure they have enough liquidity to continue to do whatever it was they were doing. Usually what they were doing was backing some security that was in danger of default. For instance, for AIG it was insurance claims that rested on the now greatly devalued subprime generated real estate investments. Let those go and the whole operation would be at risk as default would trigger claims from others who had backed AIG’s operations. And it was the same story for most of these cases. Let it go and more will follow. There were morals ahead.
The intervention is to keep what is happening in the financial markets away from the real economy as much as possible. Once it gets there, real costs might emerge that cause more investments to be at risk. This is exactly what happened to Fannie and Freddie. The subprime drive had fuelled house prices across the US. When those loans went bad, house prices went with them and so regardless of whether you had engaged in subprime lending or not (Fannie and Freddie pretty much had not), you faced a problem. If insurance markets were undermined, we could easily have the same deal.
What is interesting is that the US government has had no better instrument than to literally take over failing financial enterprises. What is more, the case for doing so is not that far from the case to take over a failing non-financial enterprise. It is hard not to look on this as anything but a form of nationalisation.
But why is this a good idea now? Lots of bits of this, especially the seeming reactive nature of it all give us pause for concern. What the US government brings to the table that the private sector cannot is a AAA-rating. This restores confidence but only to a point. After all, the reason for that rating is that the US government can raise taxes (something private firms can’t do). That means that if the intervention cannot restore normal operations and debts are called in, the US economy is still bearing risk here. The bills might soon be due.
There is, of course, another thing the US government brings: it has an eye to more than just the money. There will be no CEOs walking away with big bonuses (whether they deserve it or not). There will be no bureaucrats accumulating private assets. However, these companies are managed for the foreseeable future, it will not be based on the hope of profits.
The definition of “moral hazard” regards the situation that arises when someone gets to make decisions while taking the upside and not bearing the downside. We have now switched to a situation where the downside implications (mostly moral) are real for the new managers of these trillions of dollars in assets but there is no upside. Some claim that this is a strike against capitalism. Perhaps it is, but the capitalism that is supposed to happen is where managers are exposed to both up and downside risks. Here, we had a problem where that capitalism effectively never existed (well, except for shareholders) and now we have switched from one single-handed model to another.
But my final question is: what model do we have here in Australia? Are the morals behind or ahead?
Joshua Gans is an economics professor at Melbourne Business School. He recently argued for a transparent form of government intervention in Australian lending markets. You can read more about that here. He is also the author of Parentonomics: An Economist Dad’s Parenting Experiences.
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Am in agreement with Tim, to the extent that blaming short sellers (and I have only just learned what short selling actually is!) seems much like blaming real estate agents for the cost of housing. Neither the short seller nor the agent determines the market price. And as to the rest, well yes – privatising the profits and socialising the losses (not my words but I don’t know where to attribute the quote) is something the bastards continue to get away with. It seems to happen under any system of political/social/economic organisation and will continue to occur while ever there are people who are bastards.
This US Fed bailout which is reverberating around our world is all about giving time for bankers (esp. investment ones) to bail out before the everyone truly understands the real downside of their greed over the past decades. It (new US policy) is a reckless one because now a world recession is virtually guaranteed and the “saved bankers” will get to keep their flashy cars and houses and be able to claim “it is all about timing” accompanied with a weak smile. Don’t blame the short sellers – they are the ones that understood how bad the problems in the financial markets really were. Banning them is just buying the bankers more time – don’t be fooled. No I don’t short sell, I can’t stomach the logic of common sense versus emotion.
Excellent article, Joshua. One line is very telling: ‘The intervention is to keep what is happening in the financial markets away from the real economy as much as possible.’ The real economy makes and/or provides services that people need or want. The financial markets have grown into a shadow house of cards with outrageous gambling allowed to occur on all governments’ watch via short selling and hedging.
What’s galling about the US Govt bail out of the investment banks and insurers is that the likes of Lehman Bros CEO Dick Fuld will never be personally held accountable for any of this. And what really irritates is the fact that the financial media have repeatedly worshipped these ultimately irresponsible high rollers with fawning profiles over the years. Here’s a perfect example from CNN’s Fortune Magazine in 2006, http://money.cnn.com/2006/04/10/news/companies/lehmanintro_f500_fortune_041706/index.htm:
‘In many ways Fuld is precisely what you’d expect at a firm that was once defined by its internecine warfare: aggressive, confrontational, blunt. Yet despite this no-holds-barred demeanor—or perhaps because of it—Fuld has incongruously turned Lehman into one of Wall Street’s most harmonious firms. Fuld’s modus operandi has been to bind his employees’ fates together—to turn the culture from one of sibling rivalry to cooperation and teamwork. His tool: money.’
It’s doubtful whether Fuld’s fate is now binded to his employees’ fate. His massive bonuses paid over the years will make his ‘retirement’ very comfortable.
Joshua,
This is a great article. Moral hazard unerpins a lot of what is going on at the moment – the too big to fail issue. Is there not a way for government to bail these institutions out and exact proper penalties at the same time. e.g. make the bailout conditional on a percentage of future profits being paid back.
Another thing that puzzles me is the role of auditors and the moral hazard they face in giving clear and fair reports in the face of having to keep clients happy in order to keep the business. Arthur Andersen was broken up for this very reason. Why weren’t they reporting on the onward selling of dodgy mortgage lending practice.
As an aside if i was one of the people who was sold a mortgage I had no hope of paying I would be investigating whether I had a claim, in law, against the lender.
Why aren’t businesses above a certain size , or in certain sectors forced to accept allocated auditors that would change every 3-5 years from a licensed pool.
The last problem is the role of institutional investors and their lack of due diligence as shareholders. They are often in the same club as the failing businesses and face failure themselves if dodgy practice is exposed. In other words the shareholders who control big companies do not have a clear interest in good governance.
I know I am an amateur in this but would really appreciate your views on whether my point make sense and, if so, what could be done.
Regards,
Ian
This is such a big pile of moral hazard that it deserves a special name, how about ‘a uriah heap’ of moral hazard?
Its certainly as nasty and ugly as Dickens invented character was,,do you think that this time the real owners will ever get out of jail ?