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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