Saturday, June 9, 2012

The myth of moral hazard, or why punishing debtors is futile

This crisis, and its Eurozone variant in particular, is teaching us an awful lot about the political economy. Sadly, most of what we are learning is entirely at odds with the conventional wisdom which still informs policy. And a good part of the wrongheadedness that we are subject to revolves around the concept of moral hazard.

The plausible expectation of bailouts creates moral hazard, we are told. Yes, it does. There is plenty of evidence that big financial institutions take risks because they expect governments to pick up the pieces if everything goes pear-shaped. Certainly, if top bankers are anywhere near as smart as their paypackets suggest, they should lever up and max on risk, confident that governments will plug the gap if their bets go bad.

Trouble is, we also know that finance is also prone to bouts of irrational exuberance and panic. Moral hazard may exacerbate the exuberant parts of the cycle, but it also mitigates the panic when things turn bad. Part of (maybe most of) the reason that the Eurozone periphery is in such a self-fulfilling debt trap is that there isn't enough moral hazard around - investors are terrified that if their paper goes bad, they will lose everything. And so the downward spiral accelerates, making bailout infinitely more expensive as panic sets in.

What about governments? Well here the virtuous Northern economies in the Eurozone are afraid that bailouts now will encourage Southern sovereigns to ignore their fiscal problems in the future, leaving Germany and the others on the hook forever. Moral hazard here gives politicians an incentive to run deficits and buy popularity, whilst others pick up the tab.

The trouble with this one is that the politicians that are punished are not usually the ones who exploited moral hazard. Mariano Rajoy took over when Spain's fiscal situation was already out of control, yet he is the politician being exposed to popular anger now. For the anti-bailout policy to work, voters would have to be sophisticated enough to gauge how likely it is that a party's fiscal proposal at time t will result in another party having to impose brutal austerity at time t + 1. Very often, as in Greece, successive alternating governments are responsible for the fiscal mess. How can voters cast a partisan vote that sends the correct signal to politicians, so that the risk of irresponsible policy is averted? Do we really think that if this crisis ever ends Greek voters will become eager observers of fiscal rigour on the part of their politicians, anxious to avoid this all happening again? For this to happen some Greek politicians would have to offer voters fiscal prudence whilst others stuck to deficit-fuelled patronage politics, making elections a clear choice between happiness and hazard. That's rarely the way politics works.

In short, moral hazard is a red herring, and theorizations of its role in the crisis are crude, confused and make no historical sense. In the real world of politics and markets, when you get to the point where bailouts are necessary, it's far too late to worry about moral hazard. This is what we should be worrying about.