Global Agenda: How's your moral hazard?

The general public may not be familiar with the term "moral hazard," but they know very well what it is and how it works.

By PINCHAS LANDAU
August 30, 2007 20:24
3 minute read.
Global Agenda: How's your moral hazard?

global agenda 88. (photo credit: )

 
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The general public may not be familiar with the term "moral hazard," but they know very well what it is and how it works. When John Smith owes the bank ten grand, or the mortgage company a hundred grand, and he doesn't meet his repayment schedule, they send in the bailiffs or foreclose on his house. He and his family can end up on the street because they took on more debt than they could handle. However, when John Smith's employer, the well-known multi-national XYZ Inc. can't meet its debts, the company's banks meet to reschedule them. In the worst case, a corporate raider buys control of XYZ, fires the managers - who float off on multi-million dollar golden parachutes - then fires John Smith and his parachute-less colleagues, and then renegotiates the debts with the banks. In short, every intelligent person knows that if you owe the bank ten or hundred grand, you have a problem, but if you owe the bank ten or a hundred million, the bank has a problem. That is Moral Hazard writ small. Serious moral hazard is when the bank itself can't meet its obligations. This usually happens because the bank managers lent lotsa money to their mates (the heads of XYZ and similar outfits) who then did stupid or criminal things with it, or to hedge funds who borrowed heavily and used black box investment strategies (as per last week's column) that then blew up. Here, too, size is critical. If your bank is the Fourth Local Bank of Hicksville, nobody will bat an eyelid and you will be left to die. But if your bank is Citicorp (in 1991, for example) or Bank Hapoalim (in 1985) or any bank that is a major player in its local economy, then the government and central bank will come to your rescue. If you are really lucky, you will notify them discreetly that you have problems, and the bailout will be arranged before the mess becomes public. If not, they'll save you anyway although you personally will probably be forced to jump and open that golden parachute. That is Moral Hazard writ large. Or very large - if the rescue encompasses an entire sector, like the Savings and Loan mess in the US or the kibbutzim in Israel. These situations involve "systemic risk" in which the screw-up is so big that the entire banking sector of the country could go down the tubes. In such a case, any price is deemed worthwhile paying to prevent so disastrous an outcome. The people who pay "any price" are John Smith and his fellow taxpayers; the people who are saved are John D. Rockefeller and his fellow fat-cats. But since Rockefeller & Co. know that they will be saved if and when they screw up, they have an incentive to take risks that they might well avoid if they had some doubt regarding the certainty of their rescue. That is the very essence of Moral Hazard. This is the background to the intense moral hazard debate now raging in academic, regulatory, professional and business circles in all the developed economies. If the Fed and other central banks continue the policy of former Fed chairman Alan Greenspan, by rescuing the financial market players via a sharp reduction in interest rates and a resulting flood of liquidity, they are effectively rewarding their irresponsible behavior while leaving John Smith and millions like him buried under mortgages they can't afford. It is possible that the Fed's interest rate cuts might also save Smith, but if they do that's a desirable side-effect, not the object of the exercise. The real goal is to make sure that the mess made by rapacious bankers, greedy hedge fund managers and the rest of the fat cats doesn't drag the whole economy under water. The Wall Street lobby pretends that the Fed "must act" to save John Smith on Main Street, but the reality is that the Greenspan solution it seeks will save Wall Street. Many alternative ideas, using a variety of policy initiatives and tools, are being put forward to try and save Smith while leaving Rockefeller to sink or swim as best he can. The arena is currently blogs, op-ed articles and academic forums. But this burning topic will soon enter the political debate and may well be a big factor in next year's elections. Stay tuned. landaup@netvision.net.il

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