Saturday, January 31, 2009

Moral hazard for dummies

The collapse of Lehman is universally recognized as the start of the total meltdown of the financial system last autumn. The Bush administration decided to let Lehman fail, at least in part because of the 'moral hazard' implicit in saving banks from the consequences of their recklessness.

The moral hazard idea is quite simple - if you guarantee to someone that you will help them out if they get into a mess, they have less incentive not to get into a mess. So, if I buy my daughter another ice cream after she has carelessly dropped the first one, more ice creams may hit the deck in the future (yes, I have and they did).

Since banks getting into a mess is bad news for all of us, moral hazard in the financial system is particularly important. If they think we'll bail them out whatever they do, then they will do, ehm, whatever. Well, whatever will make them a pile of money until their luck runs out.

So there was a rationale for the Lehman decision. But, guess what. Now, moral hazard is far more severe than before, because of the demonstration effect of the Lehman collapse. The authorities' bluff has been called: they let Lehman slide, and in the chaos that followed, bailed everyone else out (in the case of AIG, about a week later). $700 billion, no questions asked.

This is much worse than if Lehman had been bailed out in the first place. The government attempted to show the banks that they can fail, and was so scared at the consequences that it immediately dropped the whole moral hazard agenda. A bit like my daughter kicking up such a fuss when I refuse to buy another ice cream that I end up buying here another one anyway, along with a couple of Disney DVDs and a new doll.

Who is going to believe, after all that trauma, that a big financial institution in trouble will ever again be allowed to fail? Unless regulators act very smartly, moral hazard will be an even greater problem in the future than it was in the disastrous decade just passed.