Not So Fast on the Moral Hazard

Last week American International Group requested assistance in the amount of $40 billion from the Federal Reserve. This was rejected only to have A.I.G. come back with a second request, this time for $75 billion. Over the weekend the Federal Reserve and the Treasury decided to let Lehman Brothers fail. On Monday and today the editorial pages were full of adulation about the reinstantiation of the rule of moral hazard. “If Lehman is able to liquidate without a panic … the benefits would include the reassertion of ‘moral hazard’ on Wall Street.” (“Wall Street Reckoning,” The Wall Street Journal, 15 September 2008, p. A22) “It was a brave decision. By abandoning Lehman Brothers, a 158-year-old piece of Wall Street furniture, and refusing to remove their hands from their pockets when Merrill Lynch came calling, Hank Paulson, US Treasury secretary, and Tim Geithner, governor of the Federal Reserve Bank of New York, had one of the busiest weekends of dispassion on record.” (Persaud, Avinash, “Lehman Had to Fall to Save the Financial System,” Financial Times, 16 September 2008, p. 13).

But then on midday Monday, New York state started waiving insurance regulations to allow A.I.G. to make a complex set of financial transfers to try to gather up enough collateral to cover it’s debts at a downgraded credit rating. At midday today when it started to look like a private bailout package being negotiated between J.P. Morgan and Goldman Sachs was faltering, the Federal Reserve stepped in to assist in the negotiations. Then it appeared that the Federal Reserve would be playing a key role in the package, but Fed spokesman was declining comment. Now, late this evening the Federal Reserve is announcing that it’s not going to be facilitating a private loan to, but outright buying a controlling interest in A.I.G. (de la Merced, Michael J. and Eric Dash, “Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake,” The New York Times, 16 September 2008):

In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said.

The Fed’s action was disclosed after Treasury Secretary Henry M. Paulson and Ben S. Bernanke, president of the Federal Reserve, went to Capitol Hill on Tuesday evening to meet with House and Senate leaders. Mr. Paulson called the Senate majority leader, Harry Reid, Democrat of Nevada, about 5 p.m. and asked for a meeting in the Senate leader’s office, which began about 6:30 p.m.

The Federal Reserve and Goldman Sachs and JPMorgan Chase had been trying to arrange a $75 billion loan for A.I.G. to stave off the financial crisis caused by complex debt securities and credit default swaps. The Federal Reserve stepped in after it became clear Tuesday afternoon that the banking consortium would not be able to complete the deal.

Extraordinary indeed! It would seem that the Federal Reserve and the Treasury aren’t so bullish on moral hazard after all.

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.

Public Financial Institutions

Thomas Barnett is conservative leaning and — ironically enough — is one of those intellectuals who is stupid in exactly the way that conservatives predict intellectuals to be: he tends to trip over his own intelligence. A perfect example is his completely incoherent take on the recent, sudden burst of the housing bubble (“Nice analysis of the sub-prime ‘crisis’,” 13 August 2007):

The only crisis I see coming out of the subprime shenanigans (such new tricks to fleece people will always be with us) would involve governments assuming they should bail out all those hedge funds that long dabbled in this stuff. O’Driscoll makes a great comparison to the S&L crisis of years ago: so long as financial institutions assumed the FDIC bailout was coming, they’d pawn off the risk to the government instead of effectively discounting it themselves.

Really? The only crisis he sees is moral hazard? So we’re courting moral hazard toward no specific end?

Government intervention isn’t bailing out “all those hedge funds”: it is protecting the rest of us — not necessary culpable in the “shenanigans,” but still subject to the consequences thereof — from spreading economic misery. To suggest that this same old moral hazard argument that economic conservatives have been making since 1913 is somehow penetrating analysis of our present day woes is completely retrograde. Moral hazard is real, but people with less pronounced agendas have a lot more interesting things to say about the subject than that in the face of it we should do nothing.

The FDIC, the Federal Reserve, the SEC, punitive, but stabilizing taxes, transparency laws, etc. were created specifically because “foolish” investors engaging in “shenanigans” could be found well before any of these public sector economic institutions ever existed; and further, to protect non-privileged investors who did everything by the book from said “shenanigans” — in other words, to prevent the spread of irrationality. Once a critical mass of people begin to act irrationally — e.g. in a financial panic — rationality flips and the irrational becomes the rational thing to do.

And as if this wasn’t disconnected enough, then there’s this parenthetical aside:

(since finance is–to a large part–a young man’s game, the bulk of the front-line players tends to age out every dozen years or so, which pretty much guarantees you new forms of shenanigans with the same regular frequency)

It’s all fine and good to use pejoratives such as “shenanigans” and “foolish” — as Mr. Barnett does — to describe less than perfectly rational market actors who continue to fall for plaid-out investment schemes such as the housing bubble long after their true nature has become more than apparent, but if less than perfectly rational behavior is in fact systematic, as Mr. Barnette suggests with this theory, then what’s the point of moralizing about it? Systematic problems should be dealt with through systematic solutions — and not systematic solutions that entail mass suffering for all of society.