A Note About Moral Hazard   3 comments

You hear about “moral hazard” a lot when people are talking about finance.  It’s an interesting topic, currently being (somewhat contentiously) edited on Wikipedia.

The less contentious part of the article consists of the opening paragraphs:

Moral hazard is a special case of information asymmetry, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.

Okay, here’s the interesting bit, to me.  Fiscal conservatives often cite moral hazard as a reason against government intervention in the economy.  On the face of it, it’s certainly a plausible theory, although I’ve never seen convincing evidence that moral hazard itself is actually a pervasive cause of risk taking.  Standard disclaimer, I’m not an economist, so I can hardly claim to be well read in the literature.

However, something I’ve never heard a fiscal conservative mention is that the entire concept of a corporation is fraught with moral hazard.  There’s a reason a corporation is a distinct entity from a partnership, it enables the investors to absolve themselves of some of the liability involved with doing business.

If you’re really all a-fired convinced that moral hazard is such a horrible concept, why aren’t you for the dissolution of the corporation and the limited liability company as legal entities, and a change to partnerships or sole proprietorship businesses as the only legal business entities?

Sure, it would murder our GDP, destroy the entire mechanism of the 401k and 403b as retirement vehicles, result in a complete destruction of Wall Street (hm, that could be argued as a plus, there), put a severe damper on liquidity… all of those things are pretty bad outcomes for economic growth.  So I suppose that one can make the case that moral hazard has some place in our economy, right?  Sometimes, amortizing risk across a population increases risk taking, but innovation is a risky thing and we like and benefit from real innovation, so maybe subsidizing this can sometimes be justified?

So if that’s the case, can we at least come up with some other substantive objection to government intervention in the economy as a main talking point? Allow me to digress into non-finance related current affairs.  Indulge me, for a moment.

Taxpayers are likely going to be paying for a substantial portion of the cleanup of the Deepwater Horizon.  That’s a GAO PDF link in the middle, there. See, when the Exxon Valdez spill occurred (ostensibly to prevent oil companies from being sued into oblivion and/or remove the economic externality of an oil spill depending upon the degree of your pro- or anti-business stance), the government passed the Oil Pollution Act of 1990.  A tax was imposed on each barrel of oil, and the funds were deposited in a cleanup account.  Then liability limits were set on each type of vessel that might spring a leak, and if a spill occurred, the oil company owning the vessel only had to pay up to the limit of liability, the rest was covered by the fund.

Hm, doesn’t that create a moral hazard scenario?  We limit liability for each individual corporation, and if the amount of a spill exceeds what we have available in the cleanup fund, well, who is going to pay for that, I wonder?  Certainly not the corporation, it’s been absolved.

Hey, who was President in 1990, again?  Well, that’s not entirely fair, those pesky Democrats were in charge of Congress.  I’m sure that the Republicans fought tooth and nail to prevent such a horrid piece of government intervention in the marketplace.  I didn’t know Congress was so lopsided in 1990, only 5 Republicans in the House and none in the Senate?  Amazing.  One would have thought the numbers were more balanced!

From that GAO report:

A catastrophic spill could strain the Fund’s resources: Since the 1989 Exxon Valdez spill, which was the impetus for authorizing the Fund’s usage, no oil spill has come close to matching its costs.42 Cleanup costs for the Exxon Valdez alone totaled about $2.2 billion, according to the vessel’s owner. By comparison, the 51 major oil spills since 1990 cost, in total, between $860 million and $1.1 billion. The Fund is currently authorized to pay out a maximum of $1 billion on a single spill. Although the Fund has been successful thus far in covering costs that responsible parties did not pay, it may not be sufficient to pay such costs for a spill that has catastrophic consequences

One of the reasons that the Fund might not be sufficient to pay such costs?  From 1994 to 2005, our delightful Congressional representatives did not collect the tax that put money into the fund.  Say, who held majorities in Congress from 1994 to 2005?

If this spill, or any other spill in the near future, exceeds the ability of the fund to clean it up, would you care to make a small wager as to what will be said on Meet the Press or Face the Nation by the Republican representative the next week?  Undoubtedly something about the government being incompetent and being incapable of handling this sort of thing.

Now there is a moral hazard for you, ladies and gentlemen of the taxpaying public.  You don’t hold your elected officials responsible for the votes they cast.  You don’t stand up for your principles, and write your congressperson and tell them when they’re blatantly going back on funding the services that you asked them to create.

To be fair, I’m pounding a lot on Republicans in this post, and I do believe that the idea of moral hazard has some weight and ought to be considered.  However, it seems obvious to me that moral hazard is a rhetorical weapon used only when it is convenient, and I for one am really tired of hearing it trotted out right now…

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Posted April 28, 2010 by padraic2112 in politics, rants, Uncategorized

3 responses to “A Note About Moral Hazard

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  1. Anyone who wants a good picture of moral hazard as applied to corporations only needs to watch the Goldman Sachs execs responding to the Senate panel’s questions in the hearings conducted this week.

  2. Hi Pat,

    I like this, as well as your exception scenarios post. I think, however, they could be more explicitly linked. Information asymmetry is at the heart of both issues, I believe. “Moral hazard” is fine as a term and concept so long as it is applied wherever it is relevant and not merely used as a club to beat those who don’t by the market myth currently embraced by the right. It can, in fact, be a useful petard to hoist those same people with.

    Best,
    Rob

  3. Pingback: There’s A Flaw In Your Logic, Good Sir « Pat’s Daily Grind

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