When the financial crisis hit us hard in 2008, CNBC and Bloomberg pundits trotted out the term “Moral Hazard” on an all too frequent basis. Just what is Moral Hazard? During the Great Recession it was the first time that I had heard it since an Economic History class in 1971.
Simply put, Moral Hazard is when you have an economic set-up that does not penalize reckless market behavior. Some even say that it encourages it. Today, you often hear the term that some major banks are too big to fail. Smaller firms and financial houses are not so lucky. The big guys are often bailed out with taxpayer money and do not get punished for their mistakes.
So, in 2008, Lehman Brothers, was allowed to go bust but insurance giant AIG which had insured the majority of the infamous credit default swaps got bailed out. The banks who had foolishly gotten way over their heads on the swaps got funds and there were few consequences for their huge mistakes. More damningly, there seemed to be little effort or incentive for them to avoid such financial gaffes in the future.
So, if risky behavior works, the organization gets the profit. If highly speculative ventures blow up, the taxpayer is there to bail out the gamblers masquerading as financial titans. British financial writer John Lanchester described it as “the bad guys getting away with it.”
Why bring it up now? I am getting a bit edgy about some governmental action or possible future action that seems to reek of Moral Hazard.
Please do not misunderstand me. The Covid-19 epidemic is something that I hope is a once in a hundred-year event. And, so, I am not trashing Congress. They had to act quickly to avert disaster. Years from now, Monday morning quarterbacks and financial historians will write about what should have been done in 2020-21.
I do think that the future can be fraught with moral hazard. What will happen when the next recession comes along? Let us assume that it is a mild or vanilla recession compared to the terrible blows of the Covid-19 downturn.
My guess is that millions of
people will be clamoring for extended unemployment benefits, lengthy rent
relief and debt accommodation that was built in to our 2020-21 national
emergency. They will look for a bailout even though the difficulty is much
milder than the current situation. Beyond individuals, watch for some large companies with their hands out, too.
Here is another one. Some progressive politicians are calling for a cancellation of all educational debt. When I first heard a few people discuss it, I was amazed. What about the millions of parents who took on a second job or a second mortgage to put their sons and daughters through college or graduate school and then paid it off? How about the students who worked throughout their college years and took six years to finish so they would not take on onerous debt? Is that fair to them?
A very erudite woman whom I know and is a self-proclaimed progressive hit me with a different angle. She has no problem with a proposal floating around to cancel the first $10,000 of student debt. She is strongly opposed to a total bailout, however. Cancelling all debt, she stated, would subsidize the soon to be rich. A graduate of Yale Medical or Wharton Business School might have $200,000 in debt but could pay it off fairly swiftly once their careers took hold. Total debt forgiveness would be unfair in many ways.
My favorite example of someone who saw moral hazard and refused to play the game was John M. Nichols, a depression era banker. Nichols was president of the First National Bank but not of New York but rather Englewood, Illinois. Nichols was a rare bird and somewhat eccentric, I suppose. He did not believe in fractional reserve banking and was known as John M. (One Hundred Percent) Nichols. When the Federal Deposit Insurance Corporation (FDIC) was formed in 1934, Nichols refused to pay dues to the insurance fund. His attitude was that he was essentially being forced to subsidize his competition who were often unsound. Amazingly, Nichols was 100% solvent—he could meet all depositor claims at any time with cash or readily marketable securities. He left the banking business in Roosevelt’s 3rd term and tore his bank building down. He called the FDIC “a damnable piece of political trickery.”
So moral hazard is not new but I fear it may raise its head again big time in the not too distant future. Will leaders have the courage to say NO at that time?
If you would like to contact Don Cole directly, you may reach him at doncolemedia@gmail.com
