Moral hazard and market failure

Much of the talk last year about how to address the developing financial crisis focused on the concept of “moral hazard”. The concern about moral hazard led folks with no particular aversion to government spending to delay taking action at the earliest stages until the situation had snowballed beyond Lehman Brothers. Now people are starting to use the phrase again. As long as we’re waxing philosophical – and let’s face it, moral hazard is a philosophical, not an efficiency argument – we ought to take a look at another philosophical concept in this context: market failure.

The entire moral hazard argument is based on a simple, but fundamentally flawed, premise:

Markets always value risk taking efficiently.

Now, I’m a big fan of markets. Given the option, I’d always take the market failures in favor of bureaucratic control and the more common bureaucratic failures. Still, an intelligent discussion of moral hazard and risk taking requires acknowledging that the only way that moral hazard can even come into play is if markets failed to properly value risk taking at some point. Either risk taking was overvalued two years ago or it’s undervalued today, perhaps both. I think that it’s actually more of the latter.

Risk taking behavior doesn’t just mean making subprime loans, loans which are not actually losing that much money and would still be making money if not for job losses and media doom and gloom encouraging “jingle mail”. It even includes more than packaging those loans into securities, some of which are losing money by the boatload.

Risk taking includes a whole range of behaviors like:

  • Investing in a startup company like McDonald’s (1965), Wal-Mart (October 1970), Microsoft (1986), Ford (1903) or Google (2004).
  • Sailing three little ships west to get to the East Indies.
  • Signing an agreement to trade stocks under a buttonwood tree in an untested nation on a new continent.
  • Putting a man on the moon.
  • Committing the entire industrial might, technological expertise and human capital of a nation to defeat totalitarianism on two fronts.

One of the reasons market capitalism is so productive is that it encourages risk taking behavior, while socialism and all its variants discourage it. If risk taking is undervalued today, and I think it’s pretty clear that it is, then the efficient response would be to ignore moral hazard arguments and take actions that incentivize risk taking. Those actions could be the simplest things like tax credits for investments by business and durable goods purchases for consumers or they could involve government more actively subsidizing risk as with Treasury buying up mortgage backed securities or the Fed discounting commercial paper. In any case, while the philosophical argument that the market should prevail has some appeal it’s worth remembering that the same government took an active role in forcing risk to be undervalued in the first place. The best place to deal with economic moral hazard is the same place we deal with every other moral hazard – the courtroom. Those who broke laws should be punished and those who played fast and loose with other people’s money and then came feeding at the public trough should be banned from the banking, securities or insurance industries. But public policy towards protecting shareholders, creditors and taxpayers and ultimately ensuring that markets do function efficiently shouldn’t be held hostage to false concerns that undervalue entrepreneurship.

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The Banker's Depression

It’s funny that today Lawrence Kudlow wrote a blog post (Tough GOPers Stand Up to Geithner; All GOPers Should Counter Keynesian Stimulus ) on the need to oppose Keynesian stimulus just as more news came out showing that bankers are playing a game of chicken with the the pro-Keynesians. The new housing starts report today showed that builders are doing exactly what they should – cutting new production 50% year-to-year in the face of falling prices, an inventory glut and bankers refusing to roll over construction loans to solid builders. Consumers are doing exactly what’s been asked of them – new applications for home purchase mortgages rose again despite the continuing chorus of doomsayers.

Meanwhile, bankers are just sitting on a pile of new money – the Federal Reserve has printed and put in bank reserves $238 billion new dollars in the last 12 months. That’s a massive 15% increase in the monetary base (M1 for the technically minded). But bankers aren’t lending it. Ditech reports:

Fall out for refinance applications are estimated at 50% to 65%, because of low appraisals and qualifying issues. The new Fannie Mae and Freddie Mac appraisal code may contribute to more fall out, as well as FHA’s 2 appraisal requirement for cash out refinancing over 85%.

The neoclassical and supply side arguments against Keynesian stimulus hinge largely on the idea that saving isn’t actually removed from the economy as Keynes posited, but is actually invested – in stocks, bonds or bank accounts. And that money deposited in bank accounts isn’t a leakage, because banks will lend it. Except they aren’t.

Monetarists contend that Keynesian fiscal stimulus just isn’t as effective as monetary stimulus. They generally lean toward the conservative, free market view when it comes to what fiscal stimulus might be acceptable that, to paraphrase Milton Friedman, any tax cut is a good tax cut. But we’ve had some $600 billion of monetary stimulus between the Fed action and the TARP and it’s not being lent, putting the lie to monetarism as well.

To all outward appearances, money invested in bank accounts in this environment, whether by a newly positive personal savings rate or by a massive monetary stimulus, is a classical Keynesian leakage.

I agree with Kudlow that what we really need are supply side incentives to bring back real investment; unfortunately the actions of the big bankers are putting more ammunition behind the Keynesian argument and making sensible folks sound like the lunatic fringe as evidence mounts against us.

The small consolation is that the bankers will pay for this as much as anyone, as a slower economy with massively increased money supply means more of the loans they hold will go bad AND those paid back will be paid back with depreciated dollars. This economic event may deserve the title The Banker’s Depression – created by bankers, compounded by bankers and abetted by the bankers’ political cronyism even as the parts of the American economy that produce more than bookkeeping entries are more productive than ever.

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Rantlets: Gaza, Burris, Richardson

  • Message to Hamas: This day will the Lord deliver thee into mine hand; and I will smite thee, and take thine head from thee; and I will give the carcasses of the host of the Philistines this day unto the fowls of the air, and to the wild beasts of the earth; that all the Earth may know that there is a God in Israel.
  • If the party of Jefferson Davis won’t seat Roland Burris, the Party of Lincoln should stand up for the guy. He was legally appointed by the sitting Governor of his state. Last I heard, Blagojevich hadn’t even been indicted. Are all the actions of Dick Cheney and Alberto Gonzalez somehow called into question because they were? Are all President Bush’s appointments null and void because Dennis Kucinich filed impeachment articles against him? This is part and parcel of what a government of laws is all about – the law can function through an imperfect vessel. What is most important is protecting the system, not punishing one man.
  • It’s a shame to see Bill Richardson withdraw as Commerce Secretary designate. He’s not perfect – no one is. But he was the most qualified of any of the Democratic Presidential candidates and has a lifelong history of public service. “Pay-to-play” has become a convenient catchphrase politicians doing what politicians have always done – wheeling and dealing on behalf of their various voting and fund raising constituencies. It’s just the newest chapter in the politics of personal destruction, the era of politics by prosecution.