Moral Hazard

30 09 2008

The tower at nightI lost my faith in my early twenties. I used to be a believer in the left and government intervention but I came to realise that, much like the devil having all the good tunes, the free-market right had the best arguments even if I did (and still do) despise many of their values. I reluctantly went about defending and explaining the actions of free markets and how, in the medium term, they were overall better at alleviating poverty and providing choice and freedom. I was willing to stand in front of 80 or so wishy-washy liberal volunteer types and explain that free markets could and should have a role in developing economies. I even worked in an investment bank for several years.

But now the high priests of the market are trying to commit sacrilege. They are trying to protect the edifice of the market by attacking one of its fundamental foundations. Now I’m no economist but I do understand the principle of moral hazard which says that if an individual or institution will gain the benefits of any risk but be able to pass those risks on to others they will behave in increasingly reckless ways. My understanding is that classic free market economics says that that is the problem with government intervention – the individuals who make the decisions and reap many of the benefits (e.g. managers of state industries) aren’t the ones who bear the cost (the poor tax payers). Just as the soviet system told managers that it didn’t matter whether the cars they produced were any good the US treasury is in the process of telling fund managers, traders and other professionals that it doesn’t matter whether the products they sell are any good either. In each case the government will pour money in to protect them. And many similar arguments are being wheeled out – that they’re too big and important to the economy to let them fail.

Just like a minister who has preached against divorce changes his beliefs when his marriage fails the US and UK governments, whom have had a much louder and destructive pulpit for the last 30 years, now appear to be experiencing a theological shift. What was good for car workers in Coventry and Detroit isn’t good for Wall St bankers. What was good for rice growers in Ghana and copper miners in Zambia and Bolivia isn’t good for wealthy European shareholders. What was good for the governments of Argentina and Mexico isn’t good the government of America. Three decades of IMF and World Bank structural adjustment plans and austerity packages are being ignored by the governments who control the majority control of those two organisations. Why should any government in the future listen to even their good advice?

I do understand the risks involved in creating problems in the banking system, but if free market theory works then the market will find its own solution; introducing moral hazard simply delays a bigger failure. If they it doesn’t apply to the financial sector then massive intervention should be applied to prevent a few individuals from exploiting it. Either nationalise the lot or let some fail.

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4 responses

1 10 2008
MAtt

Perhaps neither answer is right? Neither free market theory or state intervention? If that is the case then why let the ‘free market’ teach those that are exposed how they should have behaved? or penalize those were prudent for others excess? Is there not some common sense that can prevail? Perhaps some were too overcome with greed and borrowed more than they should? Perhaps some were too eager to please with others money and lent where it was not prudent? Does this mean that all is bad?

From what I can see this situation enables those who were prudent to benefit from imprudence whether that is the developing world or the developed world.

Yet instability benefits no man – you live in Africa and should know that better than most.

A suggest a course be plotted that promotes stability while penalizing only those who acted imprudently. For it is always the poor who pay the highest price when resources are scarce.

2 10 2008
Verity Lewis

cracking post stuart little!

following the US bailout rejection, one of our brokers commented: “A man eats hamburgers every day for 10yrs. He has a heart attack & collapses. If you were a doctor would you a) put him on a diet, or b) treat the heart attack?”

I was inclined to ask why he wasn’t on a diet in the first place.

2 10 2008
Tim Little

Matt –
You’re right; my last sentence is extremely simplistic. My fear is that unless the people with overall responsibility for running the financial system (that is the directors, senior executives and major shareholders) don’t feel some pain all that will happen is that governments will find clever people to draft regulations and the banks will find cleverer people to find ways around those regulations.

Verity –
I guess a better analogy than the burger eater would be the current milk crisis in China. Of course action should be taken to remove the toxic products from the market, but the action shouldn’t stop there. The people responsible for introducing the poison should be punished in order to deter future irresponsible behaviour. (Thanks btw for the praise)

23 01 2011
Bankers’ Bonuses « The Fat Worm

[…] obvious danger from the way that bankers are rewarded is moral hazard, the idea that person taking risks benefits if the gamble works but someone else pays if it goes […]

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