The Other Moral Hazard

The Other Moral Hazard September 26, 2008

One of the arguments against having the government bailout failing businesses is that it will create a moral hazard. That is to say, businessmen, bankers, and so forth will engage in more risky behavior than they otherwise would if they know the government will step in to help them should they get into trouble.

No doubt there is something to this, as the stories about AIG turning down offers for a private financing days before being bought out by the Fed illustrate. At the same time, the peril of moral hazard isn’t limited to government bailouts of business. The fact that the government provides flood and other forms of disaster relief leads people to build more houses in areas with a high risk of flooding than would otherwise do so. Mountain climbers may take more risks knowing that massive rescue operations will be undertaken on their behalf (and at no cost to themselves) than they would if they knew they would be on their own should they get into trouble. And on a more pedestrian level the fact that people who accumulate too much debt can file for bankruptcy undoubtedly leads some people to rack up more debt than they would if there was no legal means of their ever getting out from under it. People support such things as bankruptcies, rescuing stranded mountain climbers, and flood relief not because they don’t think there is a risk of moral hazard involved in them, but because they think this moral hazard is outweighed by other considerations. And truth be told, while I don’t doubt that the knowledge of a possible bailout may induce more risk taking by lenders than would otherwise occur, I can’t imagine that the prospect of being bailed out by the government is all that pleasant.

To my mind, as troubling as the moral hazard for business created by the proposed bailouts is the moral hazard created for politicians. The fact that people are lining up behind a bailout of Wall Street (not most people’s favorite people) makes it that much more difficult to say no to, say, giving $25 billion to the auto industry. And then there is the gloomy prospect, mentioned by some, that the Treasury might actually make a profit off the Paulson plan. The last think I want to see (okay, not the *last* thing, but it’s pretty far down on the list) is politicians coming to see business bailouts as a new revenue source.

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