Moral Hazard and Optimization

Lawrence Summers has an editorial in yesterday’s Financial Times arguing against excess concern with moral hazard (“Beware the Moral Hazard Fundamentalists,” 24 September 2007, p. 11). It is a well deserved and long overdue point. Whenever an economic crisis looms, the usual suspects trot out all the laissez faire tut-tuting. It was probably a day or two after the major news stories about the most recent central bank interventions that The Wall Street Journal editorial page started in with the boiler plate about how a few routine government interventions today spelled cataclysm of serfdom down the road. Mr. Summers’s editorial or others like it should be kept at the ready at more responsible economic editorial boards around the country.

I’m going to refrain from reposting Mr. Summers’s analysis because it is long, but it is worth reading at the link. It is worth noting that Mr. Summers doesn’t split hairs about the significance of his argument though.

Moral hazard fundamentalists misunderstand the insurance analogy, fail to recognise the special features of public actions to maintain confidence in the financial sector and conflate what are in fact quite different policy issues. As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability.

Mr. Summers’s three points of contention all argue that moral hazard, as its soothsayers characterize it, does not in fact obtain. I’m not an economist, but I’m going to go further and suggest that even if it did, under sufficiently dire circumstances, we still shouldn’t concern ourselves too much with it.

The economy isn’t a system that admits a state of perfect tune, but instead of optimization. Many factors trade off and the object is a state of affairs where maximum benefit is derived from a given factor without the deleterious effects of said factor overwhelming the positive. The Philips curve or patent protection are good examples, but others abound. It’s part of the power of economic-like thinking. And the economy is dynamic: the advantageousness or deleteriousness of a certain ratio of factors may change with time, or in relation to a third factor. For instance, central banks may have an easier time controlling inflation and may be able to do so at lower rates of interest when governments balance their budgets.

Given a dynamic balance of harms and advantages, moral hazard is a factor like any other. Moral hazard trades off with other objectives. Like the present, the most common example that people point to where it trades off is with capitol liquidity. Mr. Summers compiles a good list of examples of so objected government programs to preserve liquidity.

Moral hazard is indeed something to be minimized when times are good, it’s affordable, and its harms relatively troubling compared to the mix of harms on the horizon. But it is a goal to be relaxed when its attainment becomes extremely costly in the face of our other goals.

Think of it like this. Not spilling hot coffee in out lap is one of our objectives and under most circumstances it’s a pretty affordable one. On the go, you may have to drink from one of those sippy-cups and lean into a swig as an extra precaution, but still pretty easy. When suddenly an oncoming car swerves mid-coffee-sip into your lane, the equation shifts and the time, attention and dexterity to maneuver the coffee cup into your car’s dashboard cup holder becomes unaffordable. In order to achieve some of your other goals, you may forgo the no-hot-coffee-in-lap objective and just drop the damn cup to get the second hand on the steering wheel in a timely fashion.

When faced with a potential economic crisis, a little moral hazard may be an acceptable sacrifice. So long as the government preserves an element of roulette and just deserts in who survives and who perishes in a crisis and cultivates a reputation of preferred laissez faire — or at least an adequate amount of uncertainty about where and when it will intervene — then economic actors will remain sufficiently terrified about the future as to plan accordingly.