moral hazard

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Endless Money: The Moral Hazards of Socialism by William Baker, Addison Wiggin

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The sharp difference on expected outcomes crafted by socialists and conservatives is attributable to how each estimates the behavioral aspects of the problem of moral hazard. The former ignore this effect, thus enhancing the chance of systemic destruction; the latter attempt to stave off disaster through strongly incentivizing market participants to be risk-proof. It may well be that the last stone in the foundation of the construction of the modern socialist state will be laid by the financial community, as it thinks nothing of surrendering its dominion to the government in a time of crisis. The call for a comprehensive government solution to the credit crisis is the ultimate temptation of moral hazard, for the certainty that unsuccessful financial ventures will always be healed by the public treasury creates a nation of financial participants who can pursue upside without the fear of financial ruin.

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But most instead took out mortgages on the right hand side and accumulated mutual funds on the left hand side, assuming they would save at all with the complimentary moral hazard of reliance upon state services from Medicare to Social Security. Extremely strong and persistent incentives were codified into law that undermined any attempt by the citizenry to avoid debt, stocks, or real estate. The result is that out of a sense of equity we now find ourselves in the messy predicament of engaging in wholesale printing of money directly and outside the banking sector, which favors statist interests over the private sector, and further erodes any wealth left in the uppermiddle class among those who were prudent in the face of central bank Moral Hazard 155 seduction.

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This group continues to inhabit urban zones that have rapidly deteriorated from the 1960s onward coincident with a rise of single-parent families and toleration of the drug and “gangsta” culture. If one is content not to work and can obtain a large percentage of even a subsistence existence from government programs, then the government may be perpetuating a moral hazard, strangulating the urban poor. There is also a spillover effect as middle-class youth emulate such self-destructive behavior, making this in more ways than one a moral hazard for society at large. Conservative economist Walter Williams advises how not to be poor: “First, graduate from high school. Second, get married before you have children and stay married. Third, work at any kind of job, even one that starts out paying the minimum wage.

When Free Markets Fail: Saving the Market When It Can't Save Itself (Wiley Corporate F&A) by Scott McCleskey

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bear Stearns, Bernie Madoff, break the buck, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, financial engineering, financial innovation, fixed income, Glass-Steagall Act, information asymmetry, invisible hand, Isaac Newton, iterative process, junk bonds, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, place-making, Ponzi scheme, prediction markets, proprietary trading, risk tolerance, Savings and loan crisis, shareholder value, statistical model, The Wealth of Nations by Adam Smith, time value of money, too big to fail, web of trust

Treasury bonds issued by the government, whose safety is more explicitly guaranteed by the people who print the money. The three prevailing interest rates—on C03 06/16/2010 26 11:16:33 & Page 26 Moral Hazard government bonds, on GSEs, and on corporate bonds—reflect the different levels of government backing. As discussed in the following, however, this reflects moral hazard as viewed by a firm’s creditors, not by the firm’s managers. THE REALITY Beyond the theory, the practice of moral hazard is far less straightforward. One way to look at it is to consider those practices that encouraged risk in the years leading up to the financial crisis and ask whether firms had engaged in them because they assumed the government would bail them out if everything went south.

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Just Glide to the Next Boardroom,’’ New York Times, December 26, 2009. C03 06/16/2010 28 11:16:34 & Page 28 Moral Hazard in the future, clawbacks in compensation and civil liability. In conclusion, it is hard to imagine that the presumption of a government bailout encourages greater risk taking in the real world. It just does not happen, and it flies in the face of common sense. But moral hazard does have the potential to encourage risk from another quarter: those who lend to the firm. THE OTHER MORAL HAZARD Other than the failing firm, its employees, and owners (shareholders), those who are most exposed to the failure of a financial firm are its creditors.

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Better to let the failing firm go down; this is the core of the theory of moral hazard. Moral hazard theory holds that when the government steps in to bail out a firm, and particularly a financial services institution, that firm and all other E1BAPP01 06/16/2010 16:33:45 Page 165 Summaries of Regulatory Concepts and Issues & 165 firms absorb a lesson that firms that are deemed too big to fail will always be bailed out. Knowing that they are now working with a safety net, the theory goes, they will take more risks than they normally would, and even inordinate risks. Whereas systemic risk has moved from theory to painful reality, moral hazard is still largely a theory.

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Bernie Sanders, Black Monday: stock market crash in 1987, break the buck, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency risk, David Brooks, Doomsday Book, eurozone crisis, fear index, financial engineering, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, Greenspan put, housing crisis, Hyman Minsky, illegal immigration, implied volatility, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Nate Silver, negative equity, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, proprietary trading, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, Savings and loan crisis, savings glut, selection bias, Sheryl Sandberg, short selling, sovereign wealth fund, stock buybacks, tail risk, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

The prospect of a similar “rescue” was not much comfort to other systemic firms or potential investors; Bear ceased to exist and its shareholders lost a fortune. The moral hazard theorists simply underestimated the mania, the power of Hyman Minsky’s theory, which I first read in 2007, that stability can breed instability. That said, moral hazard was a legitimate problem. Fannie and Freddie exploited their access to cheap capital—a result of the widespread (and ultimately correct) assumption that the government would stand behind their obligations—to take on way too much leverage and risk, a classic example of moral hazard. The large banks also enjoyed lower-cost financing because of their access to a government safety net, which was one reason they got so large.

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The large banks also enjoyed lower-cost financing because of their access to a government safety net, which was one reason they got so large. And there was a real danger that moral hazard created by our actions to resolve this crisis could plant the seeds of a future crisis. I still didn’t think firehouses caused fires—as Stan Fischer put it during the emerging-market crises, condoms don’t cause sex—but resolutions of financial crises always create some moral hazard, and I wanted our reforms to limit moral hazard going forward. It was also tempting, and intuitively satisfying, to blame the crisis on the deceit and fraud and other misbehavior that flourished during the boom—duplicitous brokers luring borrowers into mortgages they couldn’t afford, Bernie Madoff types running wild, securities firms dumping toxic products on unsuspecting clients.

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Old Testament vengeance appeals to the populist fury of the moment, but the truly moral thing to do during a raging financial inferno is to put it out. The goal should be to protect the innocent, even if some of the arsonists escape their full measure of justice. Our approach did create some moral hazard, although the critics I came to call “moral hazard fundamentalists” tended to overstate our generosity to failed risk-takers. Shareholders in the five bombs had already absorbed huge losses; the leaders of Fannie, Freddie, and AIG had been pushed out; Lehman had ceased to exist. But the larger point, as President Obama later said, was that you shouldn’t refuse to deploy fire engines to a burning neighborhood in order to highlight the dangers of smoking in bed.

The Euro and the Battle of Ideas by Markus K. Brunnermeier, Harold James, Jean-Pierre Landau

"there is no alternative" (TINA), Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, battle of ideas, Bear Stearns, Ben Bernanke: helicopter money, Berlin Wall, Bretton Woods, Brexit referendum, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, collective bargaining, credit crunch, Credit Default Swap, cross-border payments, currency peg, currency risk, debt deflation, Deng Xiaoping, different worldview, diversification, Donald Trump, Edward Snowden, en.wikipedia.org, Fall of the Berlin Wall, financial deregulation, financial repression, fixed income, Flash crash, floating exchange rates, full employment, Future Shock, German hyperinflation, global reserve currency, income inequality, inflation targeting, information asymmetry, Irish property bubble, Jean Tirole, Kenneth Rogoff, Les Trente Glorieuses, low interest rates, Martin Wolf, mittelstand, Money creation, money market fund, Mont Pelerin Society, moral hazard, negative equity, Neil Kinnock, new economy, Northern Rock, obamacare, offshore financial centre, open economy, paradox of thrift, pension reform, Phillips curve, Post-Keynesian economics, price stability, principal–agent problem, quantitative easing, race to the bottom, random walk, regulatory arbitrage, rent-seeking, reserve currency, risk free rate, road to serfdom, secular stagnation, short selling, Silicon Valley, South China Sea, special drawing rights, tail risk, the payments system, too big to fail, Tyler Cowen, union organizing, unorthodox policies, Washington Consensus, WikiLeaks, yield curve

The rule-based approach worries a great deal about the destruction of value and insolvency and about avoiding bailouts that will set a bad example and encourage inadequate behavior among other actors (economists call this the moral hazard problem). The discretionary approach sees many economic issues as temporary liquidity problems that can be easily solved with an injection of new lending. Here the provision of liquidity is costless: A bailout incurs no losses; in fact, the knock-on effects make everyone better off. There are, in this vision, multiple possible states of the world—multiple equilibria—and the benign action of governments and monetary authorities can shift the whole polity from a bad situation to a good one. To this, the long-faced adherents of the moral hazard view point out that costs will pile up in the future from the bad example that has just been set.

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Just as central banks have an incentive to inflate economies ex post given inflation expectations (see chapter 5), they also have an incentive to stabilize the economy through redistribution more than was expected beforehand. Overall, then, both the provision of insurance itself and the tendency of central banks to provide excessive amounts of insurance raises thorny moral hazard problems. There are, however, some actions that the central bank can take to limit the fallout from these moral hazard issues. The first thing to note is that redistribution through interest rate cuts is a very blunt tool and may fuel bubbles. Within any given distressed sector, the benefits of the policy intervention should ideally accrue mostly to those firms who behaved (in comparative terms) the least imprudently.

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The rescue of Bear Stearns in March had created moral hazard; there was a need to demonstrate that there was no overall government guarantee for banks and that insolvent institutions should be allowed to fail in a market economy. Hence, when Lehman Brothers encountered a run in September 2008, the government would not help. And, in fact, the press on the Monday after the Lehman collapse almost unanimously welcomed the decision as a victory of market principles. When Lehman set off a global financial crisis, the sentiment was reversed, and the case turned into a powerful demonstration of the dangers of overemphasizing the moral hazard risk.

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, book value, break the buck, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial engineering, financial innovation, fixed income, friendly fire, full employment, Glass-Steagall Act, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, junk bonds, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market clearing, market fundamentalism, McMansion, Minsky moment, money market fund, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, Paul Volcker talking about ATMs, price mechanism, proprietary trading, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, vertical integration, working-age population, yield curve, Yogi Berra

Neither seems imminent. The Ghost of Moral Hazard Past One of the least desirable legacies of the emergency measures of 2008 and 2009 is the creation of moral hazard everywhere. Bailouts, rescues, guarantees, and the like succeeded in saving many investors, companies, and even some executives and traders from oblivion. The moral hazard ayatollahs notwithstanding, doing so was not a mistake. Had we stood firmly on the anti-moral–hazard high ground, our principles would have emerged unscathed but our economy would not have. Necessity mothered pragmatism. But moral hazard is now an undesirable feature of the financial landscape.

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JP Morgan’s board minutes later revealed that they had reduced their $4 bid to $2 “because the government would not permit a higher number . . . because of the ‘moral hazard’ of the federal government using taxpayer money to ‘bail out’ the investment bank’s shareholders.” The purchase price was later raised to $10 a share to ensure that Bear Stearns’ shareholders would not vote the “merger” down. Behind the scenes, and invisible to almost everyone, the details of the shotgun marriage that had been hurriedly arranged that Sunday then took about three months for all to agree on. THE MORAL HAZARD DEBATE “Moral hazard” is one of those awkward phrases that is not self-descriptive. In particular, the term, which is borrowed from the insurance industry, has nothing whatsoever to do with morality.

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No one denies that moral hazard exists: the debate is over magnitudes and tradeoffs. Using Bear Stearns as a concrete example: Would other Wall Street firms line up for the honor of replicating Bear’s experience? Many moral hazard “doves” thought this unlikely. Perhaps more important are the fates of innocent bystanders. Bernanke, Geithner, and others did not save Bear Stearns as an act of charity or forgiveness. They did it because they feared that a messy failure would do extensive damage to third parties—and to the economy itself. That tradeoff encapsulates the essence of the moral hazard debate. A bailout may mitigate serious problems today.

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, behavioural economics, Boeing 747, book value, break the buck, Bretton Woods, business cycle, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, Eyjafjallajökull, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, foreign exchange controls, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, junk bonds, Kenneth Rogoff, lateral thinking, Lewis Mumford, London Whale, Long Term Capital Management, market bubble, Michael Milken, money market fund, moral hazard, Myron Scholes, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, proprietary trading, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, Sam Peltzman, savings glut, scientific management, subprime mortgage crisis, tail risk, technology bubble, TED Talk, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk, William Langewiesche, zero-sum game

Jacques, “Society on the Basis of Mutual Life Insurance,” 16 Hunt’s Merchants’ Magazine (1849): 152, 153, quoted in Tom Baker, “On the Genealogy of Moral Hazard,” Texas Law Review 75, no. 2 (1996): 247, available at https://www.law.upenn.edu/fac/thbaker/Tom-Baker-On-the-Genealogy-of-Moral-Hazard.pdf. 2 Thai Life Insurance: It can be viewed here: https://www.youtube.com/watch?v=IkOGwdxcwaw. 3 which stipulates that a man: David Rowell and Luke B. Connelly, “A Historical View of the Term ‘Moral Hazard,’” Geneva Association Insurance Economics Newsletter, January 2012, available at https://www.genevaassociation.org/media/178212/ga2012-ie65-rowellconnelly.pdf. 4 The term “moral hazard”: Rowell & Connelly, “A Historical View.” 5 Children’s advocates: V.

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Everyone wants to take their money out at once, and everybody can’t take their money out at once. So there is a need to provide confidence.” Confidence is central to Summers’s thinking about crises. We regard confidence as good and moral hazard as bad, but, he likes to note, they are two sides of the same coin. Moral hazard means encouraging us to take risks by protecting us from their consequences. We assume that’s reprehensible, but it’s not. By providing confidence, moral hazard enables society to do things and take risks that it otherwise wouldn’t, many of which make us better off. To take a very basic example: money is central to a market economy because it makes it possible for people who don’t know one another to do business.

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Yet at the time, it is also clear that some officials thought letting it fail would serve a useful purpose: it would purge the financial system of the moral hazard that the rescue of Bear Stearns had created and that had drawn reproof from many quarters. Over the course of the summer, Treasury had tried to make it clear that no similar rescue would await Lehman. Inside the Fed, feelings were more conflicted; Tim Geithner, president of the New York Fed, was adamant that the Fed should keep the bailout option open, but some staffers agreed that bankruptcy was better than a bailout. One staffer said the Fed must not contribute its own money to assist a takeover of Lehman as it had with Bear Stearns because the “moral hazard and reputation cost is too high.”

Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini, Stephen Mihm

Alan Greenspan, Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bond market vigilante , bonus culture, Bretton Woods, BRICs, British Empire, business cycle, call centre, capital controls, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, dark matter, David Ricardo: comparative advantage, debt deflation, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, Glass-Steagall Act, global pandemic, global reserve currency, Gordon Gekko, Greenspan put, Growth in a Time of Debt, housing crisis, Hyman Minsky, information asymmetry, interest rate swap, invisible hand, Joseph Schumpeter, junk bonds, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market bubble, market fundamentalism, Martin Wolf, means of production, Minsky moment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, new economy, Northern Rock, offshore financial centre, oil shock, Paradox of Choice, paradox of thrift, Paul Samuelson, Ponzi scheme, price stability, principal–agent problem, private sector deleveraging, proprietary trading, pushing on a string, quantitative easing, quantitative trading / quantitative finance, race to the bottom, random walk, regulatory arbitrage, reserve currency, risk tolerance, Robert Shiller, Satyajit Das, Savings and loan crisis, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, subprime mortgage crisis, Suez crisis 1956, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, too big to fail, tulip mania, Tyler Cowen, unorthodox policies, value at risk, We are all Keynesians now, Works Progress Administration, yield curve, Yom Kippur War

Lack of transparency, underestimation of risk, and cluelessness about how new financial products might behave when subjected to significant stress are recurrent problems in many crises, past and present. Moral Hazard While the financial engineers who gave us monstrosities like the CDO3 deserve plenty of blame, many other problems were accumulating that went far beyond the obvious flaws in the securitization food chain. The faulty ways in which financial firms governed themselves helped lay the groundwork for the recent crisis as well. The key to understanding this situation is the concept of “moral hazard.” Simply put, moral hazard is someone’s willingness to take risks—particularly excessive risks—that he would normally avoid, simply because he knows someone else will shoulder whatever negative consequences follow if not bail out those who took those risks.

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While recent fiscal policies may weigh many countries down in the coming years, debt burdens are not yet at a breaking point for many of the advanced industrial nations, even if issues of public debt sustainability and risks of refinancing crises—if not outright default—are becoming sources of serious concerns for financial markets. The larger problem of bailouts and moral hazard is a bit more complicated. Bailouts of reckless lenders and borrowers can easily lead to even more reckless behavior in the future. That in turn can lead to more bubbles and more crises. But it’s important to keep things in perspective: holding the line on moral hazard in the midst of a crisis can inflict tremendous collateral damage. Why? Imagine that someone living in a huge apartment building has done something extraordinarily reckless and stupid, like smoking in bed.

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Fabozzi, “Collateralized Debt Obligations and Credit Risk Transfer,” Journal of Financial Transformation 20 (2007): 47-59. 66 an elegant solution: the CDO: Zandi, Financial Shock, 117-19. See also Janet Tavakoli, Collateralized Debt Obligations and Structured Finance: New Developments in Cash and Synthetic Securitization (Hoboken, N.J.: John Wiley and Sons, 2003). 68 Moral hazard played a significant role: See, for example, Kevin Dowd, “Moral Hazard and the Financial Crisis.” Cato Journal 29 (2009): 141-66. 68 the way these firms provided compensation: Much of the discussion in this section is drawn from Gian Luca Clementi, Thomas F. Cooley, Matthew Richardson, and Ingo Walter, “Rethinking Compensation in Financial Firms,” and Viral V.

Firefighting by Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson, Jr.

Asian financial crisis, asset-backed security, bank run, Basel III, Bear Stearns, break the buck, Build a better mousetrap, business cycle, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Doomsday Book, financial deregulation, financial engineering, financial innovation, Glass-Steagall Act, housing crisis, Hyman Minsky, income inequality, invisible hand, Kenneth Rogoff, labor-force participation, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, opioid epidemic / opioid crisis, pets.com, price stability, quantitative easing, regulatory arbitrage, Robert Shiller, Savings and loan crisis, savings glut, short selling, sovereign wealth fund, special drawing rights, tail risk, The Great Moderation, too big to fail

Responding too quickly can encourage risk takers to believe they’ll never face consequences for their bad bets, creating “moral hazard” that can promote even more irresponsible speculation and set the stage for future crises. But once it’s clear that a crisis is truly systemic, underreacting is much more dangerous than overreacting, too late creates more problems than too early, and half measures can just pour gasoline on the flames. The top priority in an epic crisis should always be to end it, even though that will likely create some moral hazard; the downsides of encouraging undisciplined risk taking in the future, while real, pale in comparison to the downsides of allowing a systemic collapse in the present.

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There’s a fuzzy and hard-to-discern line between a healthy adjustment that inflicts pain on the irresponsible and a panic that imposes indiscriminate damage throughout the system. Systemic crises are not the time for free-market absolutism or moral-hazard purism, because of the serious risks they pose to lending, jobs, and incomes, and because systemic crises rarely end without government substituting sovereign credit for private credit, putting some public money at risk, and, as a consequence, creating some moral hazard. It’s messy, it’s distasteful, but it’s preferable to a financial implosion that sends the broader economy into a tailspin. There will always be investor pressure on central banks to do more to boost markets, and there will always be political pressure on central banks to do less, to teach speculators a lesson.

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This kind of haircut makes sense in ordinary times, forcing creditors to suffer the consequences of their unwise loans, but not during panics, when it sends a message that creditors of other financial firms should run. Bair thought our rescues had created too much moral hazard, and saw WaMu’s failure as a teachable moment for the financial system. She was also very protective of the FDIC’s Deposit Insurance Fund, often citing her legal obligation to seek the least-cost option for her agency. But there was a “systemic risk exception” to that obligation when financial stability was at stake, and haircutting WaMu seemed like it would create significant risk of more bank failures, more FDIC losses, more rescues, and more moral hazard. Sure enough, the next morning there was a run on Wachovia, the next domino in line, and the fourth-largest bank in the country by assets.

House of Debt: How They (And You) Caused the Great Recession, and How We Can Prevent It From Happening Again by Atif Mian, Amir Sufi

Andrei Shleifer, asset-backed security, balance sheet recession, bank run, banking crisis, behavioural economics, Ben Bernanke: helicopter money, break the buck, business cycle, Carmen Reinhart, collapse of Lehman Brothers, creative destruction, debt deflation, Edward Glaeser, en.wikipedia.org, financial innovation, full employment, high net worth, Home mortgage interest deduction, housing crisis, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, liquidity trap, Long Term Capital Management, low interest rates, market bubble, Martin Wolf, money market fund, moral hazard, mortgage debt, negative equity, paradox of thrift, quantitative easing, Robert Shiller, Robert Solow, school choice, seminal paper, shareholder value, subprime mortgage crisis, the payments system, the scientific method, tulip mania, young professional, zero-sum game

Just like the trader on the Chicago Board of Trade floor, many believe that government intervention encourages moral hazard—households must be made to suffer so that they never again borrow so aggressively. As we discussed in chapter 6, many home owners during the boom did indeed treat their homes as ATMs and spent more as a result. As economists with a strong background in the optimal design of financing arrangements, we have a deep appreciation for moral-hazard concerns. But in this case, we’re not dealing with moral hazard. Moral hazard refers to a situation in which a sophisticated individual games a flawed system by taking advantage of a naive counterparty.

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Moral hazard refers to a situation in which a sophisticated individual games a flawed system by taking advantage of a naive counterparty. The classic example of moral hazard is someone driving irresponsibly after getting auto insurance because he knows the insurance company will pay for an accident. If the auto insurance company naively provides unlimited insurance at a cheap price, the driver’s moral-hazard problem could become quite severe. This does not explain what happened during the housing boom. Home owners were not sophisticated individuals who took advantage of naive lenders because they understood house prices were artificially inflated. They weren’t counting on a government bailout, and indeed they never received one.

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Yet this responsible home owner, through no fault of his own, experienced the complete loss of his home equity from 2006 to 2009 and was pushed way underwater by the 60 percent decline in house prices. How is the loss of wealth the home owner’s fault? Why should he be punished? Such massive aggregate shocks are not any one individual’s fault and are therefore not well described by the notion of moral hazard. Moral hazard also does not easily apply to the main policies we advocate, because they are not wholesale taxpayer-funded bailouts of home owners. Instead, we advocate a more even distribution of housing losses between debtors and creditors. Is a more even distribution “unfair”? Remember, it is not a wealth transfer to a guilty party from an innocent one.

Austerity: The History of a Dangerous Idea by Mark Blyth

"there is no alternative" (TINA), accounting loophole / creative accounting, Alan Greenspan, balance sheet recession, bank run, banking crisis, Bear Stearns, Black Swan, book value, Bretton Woods, business cycle, buy and hold, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Greenspan put, Growth in a Time of Debt, high-speed rail, Hyman Minsky, income inequality, information asymmetry, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, low interest rates, market bubble, market clearing, Martin Wolf, Minsky moment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, Philip Mirowski, Phillips curve, Post-Keynesian economics, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, Robert Solow, savings glut, short selling, structural adjustment programs, tail risk, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, Two Sigma, unorthodox policies, value at risk, Washington Consensus, zero-sum game

But why did these bond buyers believe that this new and untested institution, the ECB, would in fact guard the value of their bonds, that national governments didn’t matter any more, and that Greece was now Germany? The answer was, they didn’t need to believe anything of the sort because arguably what they were doing was the mother of all moral hazard trades. Figure 3.2 Eurozone Ten-Year Government Bond Yields Source: European Central Bank Statistical Data Warehouse The Mother of All Moral Hazard Trades If you were a European bank back in the late 1990s seeing sovereign bond yields falling, it might have bothered you since a source of risky profits was disappearing. On the other hand, if this new ECB gizmo really did get rid of exchange-rate risk for the sovereigns issuing the debt and take inflation off the table by housing in Frankfurt the only money press in Europe, then it really was a banker’s dream—a free option—safe assets with a positive upside, just like those CDOs we saw in the United States.

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As such, the more risk that you took onto your books, especially in the form of periphery sovereign debt, the more likely it was that your risk would be covered by the ECB, your national government, or both. This would be a moral hazard trade on a continental scale. The euro may have been a political project that provided the economic incentive for this kind of trade to take place. But it was private-sector actors who quite deliberately and voluntarily jumped at the opportunity. Now, either because they really believed that the untested ECB had magically removed all risk from the system or saw the possibilities of a moral hazard trade, or both, major European banks took on as much periphery sovereign debt (and other periphery assets) as they could.

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Public choice theory, like any universal gizmo, has not only helped revolutionize the institutional relationship between voters, politicians, and bankers in democratic societies, it has become, as Daniel Dennett said about evolution in Darwin’s Dangerous Idea, the “universal acid” that eats away everything it touches by turning everything into a principal-agent/rent-seeking problem.74 Think that countries in a currency union might actually come to each other’s aid out of a sense of solidarity? Don’t be so naïve. Moral hazard is ever present. Worried that you can’t tell what the future may hold? Don’t worry. Properly defined rules will make the future conform to your preferred vision. Terrified that profligate governments will not reform their economies when you compensate for their unemployment through transfers? You are right. They will not do so, they will “hide and rent seek” off your taxpayers; so their governments should be replaced with ones that you can trust. Welcome to Europe. The moral hazard logic embedded at the core of public choice arguments covers, and infects, all possible circumstances.

The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, Kevin Coldiron

active measures, Alan Greenspan, Asian financial crisis, asset-backed security, backtesting, bank run, Bear Stearns, Bernie Madoff, Bretton Woods, business cycle, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, currency risk, debt deflation, disinformation, distributed ledger, diversification, financial engineering, financial intermediation, Flash crash, global reserve currency, implied volatility, income inequality, inflation targeting, junk bonds, labor-force participation, Long Term Capital Management, low interest rates, Lyft, margin call, market bubble, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, negative equity, Network effects, Ponzi scheme, proprietary trading, public intellectual, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, rising living standards, risk free rate, risk/return, sharing economy, short selling, short squeeze, sovereign wealth fund, stock buybacks, tail risk, TikTok, Uber and Lyft, uber lyft, yield curve

In Chapter 2, when discussing currency carry trades, we emphasized the involvement of central banks in the process, which creates a form of moral hazard. The intervention of central banks in currency markets along with the knowledge that the central banks will be prepared to intervene in the event of large currency exchange rate movements makes currency carry trades more attractive. The idea that all carry trades are aspects of the same broad phenomenon, and that therefore there must be an equivalence between currency carry trades and stock market volatility-selling trades, would suggest that volatility selling by the central bank must create moral hazard. In other words, it would seem to suggest that quantitative easing and the resulting size of the central bank balance sheet could serve as a quantitative measure of moral hazard.

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It is a small step from those insights to recognize that as the convergence toward the vanishing point takes place, there will be a simultaneous convergence of the carry trade on one carry instrument—the S&P 500 itself. In the background of this convergence under the global carry regime is the globalization of central bank-created moral hazard. We have stressed in this book that the moral hazard created by central bank policies has played a fundamental role in the rise of carry in financial markets. Low or zero inter- 196 THE RISE OF CARRY est rates in the major developed economies, bailouts, central banks’ quantitative easing policies, and their implicit promise to intervene in the event of market “instability” have all encouraged investment or speculative strategies that seek to extract a return from expectations of low market volatility.

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See European Union euro area crisis, 113 euro-funded carry trade, 31 European Central Bank, 31, 104, 113, 136, 198, 216 European Union (EU), 198 evolution, cumulative advantage and, 188–190 exchange rate risk, 12–13 of dollar carry trade, 17 exchange rates carry strategy returns and stability of, 52 currency carry trades and, 9, 10 INDEX exchange-traded funds (ETFs), 111–112 exchange-traded notes (ETNs), 90, 92 Facebook, 185 financial assets loss of moneyness of, 215 US household holdings of, 118, 118f financial crises, volatility spikes in, 52 financial institutions, carry growth and growth of, 69 financial markets, 1 carry and structures of, 7 carry as cumulative advantage mechanism in, 183 central bank stabilization of, 5–6 desires of, 193–195 increasing complexity of, 57 financial volatility, suppression of, 1 Ford, Harrison, 184 foreign exchange markets carry trades on, 2 central banks and, 11, 13, 20 forward exchange rates, interest rates and, 10 funding currencies, 10 melt-up in, 23–24 volatility in, 215 futures VIX, 90–92 volatility bets with, 89 gamma, 149–150 selling, 152–153 for S&P 500, 154, 154f gates, 72 GDP carry regime and, 115–116 growth in, 56 profits as share of, 139 US personal net worth in relation to, 137, 138f global business cycle, carry and, 2 global capitalism, 195 global economy, carry dominance of, 69 global financial crisis of 2007–2009, 1 Asian financial crisis compared with, 30 carry bubble after, 136 credit bubbles and, 36 currency and equity carry trade correlations and, 59 225 dollar carry trade collapse during, 17 experimental monetary policies during and after, 113 government guarantees for funds during, 113 as last chance to lean against carry, 220 short-term interest rate collapse after, 62 yen currency carry trade and, 28, 29 global financial markets carry dominance of, 69 complexity of, 127 transformation of, 83–84 global monetary policy, carry effects on, 3 global volatility, 99, 101 globalization, of moral hazard, 195–200 gold bugs, 113–114 gold prices, 113 government policies, carry trade returns and, 48 Greenspan, Alan, 26 hard money, 113 Heathcote, Gilbert, 179 Hedge Fund Research (HFR), 73 hedge funds as agents of carry, 72–73 carry trading by, 73–75 compensation structure, 73 employee compensation and, 73 growth of industry, 73–74, 83, 194 leverage usage by, 73, 74 liability categories for, 72 HFR (Hedge Fund Research), 73 high-frequency trading firms (HFTs), 84 Hungarian forint, 34 IMF (International Monetary Fund), 14, 16, 198 implied volatility, 57, 90, 164, 167–168 anti-carry regime and, 171–172 realized volatility relationship to, 158 income streams, from carry trades, 2 India, 19 industrial production growth, 56 inflation alternative monies and, 211 anti-carry crashes and, 170 anti-carry regimes and, 211, 212 asset price, 113–114 226 inflation (continued) carry bubbles and, 39 interest rates and, 110–111 information ratio (IR), 49 institutional liabilities, 69–70 insurance, 34–36 interest rates Australia and spreads of, 41–42, 60–61 bailouts and, 198–199 covered interest parity principle and, 21 credit demand and, 110 currency carry returns and differentials in, 60–62 currency carry trades and, 9, 10 forward exchange rates and, 10 global financial crisis of 2007–2009 and, 62 inflation and, 110–111 in Japan, 23 profit share and, 139 spreads in, 60–62, 60f, 81 Turkey, 12–13 UIP and, 47, 48 US Federal Reserve and, 14, 137, 208 International Monetary Fund (IMF), 14, 16, 198 investment banks, proprietary trading by, 77 IR (information ratio), 49 Italian lira, 60 Japan currency carry trades and, 17–18, 27 current account surplus, 27 foreign reserves holdings, 26 interest rates, 23 net short-term foreign assets of banks in, 28–29, 28f Lehman Brothers, 104, 140, 197 collapse of, 29 leverage, 3 carry and importance of, 70–72 carry crashes and, 96–98 carry growth and, 7 in carry trades, 33–35 constant, 93 in currency carry trades, 11 equity and, 93–94 hedge fund usage of, 73, 74 INDEX risk controls and, 65 trade dynamics and, 65 leveraged buyouts, as carry trades, 78–80 liquidity, 3–4 carry crashes and, 128 carry existence and, 190 carry trades providing, 35–36 central banks and, 110–111 currency carry trade and provision of, 88 of emerging currencies, 62 negative pricing of, 166–168 short squeezes on, 165 S&P 500 premiums for providing, 161 volatility curves expressing price of, 164 liquidity backstop, 86 liquidity provision trades, 84 return-to-risk ratio of, 165 liquidity swaps, 104–105, 196–198 lock-ins, 185 Long-Term Capital Management (LTCM), 23, 25, 27, 74 Lucas, George, 184 Madoff, Bernard, “Bernie,” 140–141 market corrections, 79 market discipline, 199, 200 market making, 84, 158–159 market risk, 99 mean reversion, 152, 154f, 155, 164 Microsoft Office, 185 Ministry of Finance of Japan (MOF), 26 mispricing of risk, 21, 35–37, 132, 134–140, 142 MOF (Ministry of Finance of Japan), 26 momentum, selling optionality and, 153 monetary conditions anti-carry regime and, 174 carry bubbles and, 39 monetary equilibrium, carry regime and, 169 monetary growth, carry regime and, 169 monetary policy carry effects on, 3 moral hazard and, 208 money. See also specific currencies alternative, 211 asset bases for, 211 availability of, 4 in carry regime, 108–113 creation of, 109 INDEX defining, 109 Divisia, 111 statistical measures of, 109 US household holdings of, 117, 117f VIX and value of, 100, 122 volatility and value of, 98–101, 122 money market funds, government guarantee for, 113 money supply, 20, 21 business cycle and, 125–126 carry crashes and, 122–123 monopoly power, 176 natural, 186 moral hazard central banks and, 195, 200 globalization of, 195–200 monetary policy and, 208 mortgage bubble, 36 movie stars, 184–186 multiple equilibria, 183 natural monopolies, 186 negative yields, 70 net claims Australia, 40, 40f currency carry trade measurement and, 41 Turkey, 43, 43f net foreign assets, 14, 16, 29 network effects, 185 New Zealand, interest rate spreads and, 60–61 New Zealand dollar, capital flows into, 62 nonbank financial sector, 137 nonmonetary assets carry bubbles and, 169 carry regime and, 112, 114, 122 Norway, sovereign wealth fund, 75 OECD (Organisation for Economic Co-operation and Development), 115 oil carry trade, 128–133, 132f oil prices, 129f, 131 oil producers, debt levels of, 130 “The Optimal Design of Ponzi Schemes in Finite Economies” (Bhattacharya), 142 optionality buying, 146 227 selling, 152, 153 volatility and, 93–95 options delta hedging, 149–151 delta of, 149 gamma of, 149–150 pricing of, 149 unhedged, 150 volatility and, 146–148 volatility bets with, 89 volatility implied by, 57 Organisation for Economic Co-operation and Development (OECD), 115 output gap, 125 Panic of 1907, 218 personal net worth, 137, 138f photosynthesis, 189 pi Economics, 27–29 Piketty, Thomas, 219 poker, 182–183 Polish zloty, 34 Ponzi schemes, 140–143 Pope, Alexander, 179 popularity, 181–182, 184 populist political movements, 1 portfolio insurance, 155 portfolio volatility, 159 power, carry as, 191–192 pricing kernel, 99 private equity leveraged buyouts, as carry trades, 78–80 productivity, 115 profit share, 82, 137, 138f, 139 proprietary trading, compensation incentives and, 77 public intellectuals, 186 put options, 34, 89 selling fully collateralized, 156n4 QE.

End the Fed by Ron Paul

affirmative action, Alan Greenspan, Bear Stearns, Bernie Madoff, Bernie Sanders, Bretton Woods, business cycle, crony capitalism, currency manipulation / currency intervention, fiat currency, Fractional reserve banking, guns versus butter model, hiring and firing, housing crisis, illegal immigration, invisible hand, Khyber Pass, Long Term Capital Management, low interest rates, market bubble, means of production, military-industrial complex, Money creation, moral hazard, Ponzi scheme, price mechanism, reserve currency, road to serfdom, Robert Gordon, Ronald Reagan, Savings and loan crisis, too big to fail, tulip mania, We are all Keynesians now, Y2K

The apparent prosperity based on the illusion of such wealth and savings led to misdirected and excessive use of capital. The false information generated by the Federal Reserve policy led to a false confidence that all would be well. This illusion is referred to as moral hazard. Anything that is seen as protection against risk causes people to act with less caution. Even if their actions may seem risky, someone else suffers the consequences, and moral hazard will encourage bad economic behavior. Knowing that savings were no longer required to get a loan from a bank, since easy credit came from the Federal Reserve, many a banker and borrower were encouraged to “gamble” on business ventures.

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It is easy to accept this risk, especially in the boom part of the business cycle, with stock, land, and housing assets all going up in nominal value. Beneath the surface, they were buying into a moral hazard, that is, they were being rewarded in the short term for activity that would in the long term prove to be detrimental to everyone. Competitive pressures in the banking industry made it impossible for most to resist the chance for a quick profit. Moral hazard, from whatever source, is detrimental because it removes the sense of responsibility for one’s own actions. The more socialized the society, the less the sense of personal responsibility for one’s own behavior; responsibility becomes collective.

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There are other benefits as well, such as stopping the business cycle, ending inflation, building prosperity for all Americans, and putting an end to the corrupt collaboration between government and banks that virtually defines the operations of public policy in the post-meltdown era. Ending the Fed would put the American banking system on solid financial footing. The industry would thrive without the moral hazard of banks that are “too big to fail.” Its loan operations would take a more realistic account of risks, and the bank’s capital would not be put at risk in the service of politically driven priorities. Customers’ deposits would be safer than they are today, as banks would compete with one another in their most important function of providing a secure means of preserving wealth.

Global Governance and Financial Crises by Meghnad Desai, Yahia Said

Asian financial crisis, bank run, banking crisis, Bretton Woods, business cycle, capital controls, central bank independence, corporate governance, creative destruction, credit crunch, crony capitalism, currency peg, deglobalization, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, floating exchange rates, frictionless, frictionless market, German hyperinflation, information asymmetry, Japanese asset price bubble, knowledge economy, liberal capitalism, liberal world order, Long Term Capital Management, low interest rates, market bubble, Meghnad Desai, Mexican peso crisis / tequila crisis, moral hazard, Nick Leeson, Nixon triggered the end of the Bretton Woods system, oil shock, open economy, Post-Keynesian economics, price mechanism, price stability, Real Time Gross Settlement, rent-seeking, short selling, special drawing rights, structural adjustment programs, Tobin tax, transaction costs, Washington Consensus

However, in the case of Brazil, real interest rates not only start at a much higher level than other Latin American countries, but (for reasons discussed in detail in another paper on Brazil16) they are never allowed to fall anywhere near the values of ‘route 1’ countries (let alone ‘route 2’ countries). The case of Brazil is very important from the point of view of a critique of mainstream ‘moral-hazard-type’ crisis-analysis. For example, according to the McKinnon and Pill approach to financial crisis the main cause of borrowingagents losing their capacity to assess and price their risk properly is that internal and external moral hazards lead to ‘artificially’ low interest rates; these, in turn, gave a false incentive to agents to accumulate excessive amounts of risk.17 However, in Brazil high interest rates did not seem to have been able to avoid a financial crisis either.

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While a financial meltdown is a rare occurrence in developed country markets, the frequency of such events in periphery is worrisome. In the last ten years, we have had crises in Mexico, Indonesia, Thailand, Malaysia, South Korea, Brazil, Argentina and Turkey. There is financial fragility in India and China. The uneasy marriage of moral hazard of lenders lending to sovereign governments in the knowledge of a certain bailout and the inability of sovereign borrowers to follow time-consistent strategies in shaping their debt profile is becoming a major problem. The questions are many but the answers are few. This volume attempts to address some of the questions raised by the string of financial crises over the past ten years.

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In early December, the initiative shifted to the US Treasury that led an international lender of last resort (LOLR) rescue with a private sector involvement. This episode introduced a concept foreign to the Fund’s practice initiated in the Mexican crisis, consisting in bailing out international banks entirely, thus creating maximum moral hazard. The Asian crisis raised doubts on the Fund’s legitimacy in the American Congress and like-minded ultra-liberal economists in the academic community. Without contemplating such an extreme view, a serious debate has been raised on the future of the IMF. Since the time of the C20, it has been the first debate to argue about principles, not only technical matters.

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, Cornelius Vanderbilt, corporate governance, Credit Default Swap, cross-subsidies, currency risk, dematerialisation, disinformation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Greenspan put, Growth in a Time of Debt, Ida Tarbell, income inequality, index fund, inflation targeting, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, it is difficult to get a man to understand something, when his salary depends on his not understanding it, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jim Simons, John Meriwether, junk bonds, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, M-Pesa, market design, Mary Meeker, megaproject, Michael Milken, millennium bug, mittelstand, Money creation, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, Paul Volcker talking about ATMs, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, reality distortion field, regulatory arbitrage, Renaissance Technologies, rent control, risk free rate, risk tolerance, road to serfdom, Robert Shiller, Ronald Reagan, Schrödinger's Cat, seminal paper, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, vertical integration, Washington Consensus, We are the 99%, Yom Kippur War

‘Too big to fail’ takes responsibility for the supervision of credit risks away from market participants and places it more or less exclusively in the hands of regulators: a duty that in this instance (and many others) they were not capable of discharging. The term ‘moral hazard’ is perhaps unfortunate, because moral hazard is about incentives, not about ethics: about deterrence rather than punishment. Timothy Geithner appeared to have missed this point – his memoir makes frequent reference to moral hazard, almost invariably accompanied by a disparaging reference to ‘Old Testament fundamentalists’.32 Presumably this is with the intention of contrasting the retributive ethos of the Old Testament with the forgiveness found in the New.

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Many might feel retribution rather than forgiveness appropriate for those responsible for the global financial crisis. But those who worry about moral hazard are not motivated by revenge. Moral hazard in its application to the banking system is the well-founded concern that, if there is an expectation of government assistance for troubled financial businesses, the people who run and trade with these businesses will behave in ways that make the need for such assistance more likely. In Michel Albert’s Swiss village, community pressures handled the problems of information asymmetry, adverse selection and moral hazard. Information asymmetry was reduced, though not necessarily eliminated, by geographical proximity and personal ties.

…

Still, the sense that Central Banks and Treasuries act as backstop has influence on the behaviour of a firm: Dick Fuld of Lehman was delusional both about the risks in his business and in his belief that Lehman both should and would receive support if it ran into financial difficulties. If Fuld had not made these errors, he would have made greater efforts to sell Lehman’s business before it collapsed. But the more serious problem of moral hazard is its impact on those who deal with banks. If potential creditors know that they will be made whole, then they have little incentive to undertake careful credit assessment. In the sub-prime mortgage fiasco such moral hazard arose at every level. Fannie Mae and Freddie Mac, the failed US mortgage agencies, could not conceivably have built their enormous, and severely under-capitalised, balance sheets had their lenders not believed (correctly, as it turned out) that their liabilities were guaranteed by the US government.

Wealth and Poverty: A New Edition for the Twenty-First Century by George Gilder

accelerated depreciation, affirmative action, Albert Einstein, Bear Stearns, Bernie Madoff, book value, British Empire, business cycle, capital controls, clean tech, cloud computing, collateralized debt obligation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversified portfolio, Donald Trump, equal pay for equal work, floating exchange rates, full employment, gentrification, George Gilder, Gunnar Myrdal, Home mortgage interest deduction, Howard Zinn, income inequality, independent contractor, inverted yield curve, invisible hand, Jane Jacobs, Jeff Bezos, job automation, job-hopping, Joseph Schumpeter, junk bonds, knowledge economy, labor-force participation, longitudinal study, low interest rates, margin call, Mark Zuckerberg, means of production, medical malpractice, Michael Milken, minimum wage unemployment, Money creation, money market fund, money: store of value / unit of account / medium of exchange, Mont Pelerin Society, moral hazard, mortgage debt, non-fiction novel, North Sea oil, paradox of thrift, Paul Samuelson, plutocrats, Ponzi scheme, post-industrial society, power law, price stability, Ralph Nader, rent control, Robert Gordon, Robert Solow, Ronald Reagan, San Francisco homelessness, scientific management, Silicon Valley, Simon Kuznets, Skinner box, skunkworks, Solyndra, Steve Jobs, The Wealth of Nations by Adam Smith, Thomas L Friedman, upwardly mobile, urban renewal, volatility arbitrage, War on Poverty, women in the workforce, working poor, working-age population, yield curve, zero-sum game

The near bankrupt government may even be tempted to consolidate its dangers in war—the one risk that the state can manage far better than business. But the entrepreneurial ventures of a Napoleon ill-behoove the modern ruler. In the delicate balance between the risk and insurance features of capitalism, the boundaries are defined by what insurance companies term moral hazard. Moral hazard is the danger that a policy will encourage the behavior—or promote the disasters—that it insures against. This is the limiting point in insurance schemes and it sets the natural boundary of welfare in a capitalist system. Just as a siege of saving, or hoarding of gold, impelled by a fear of economic trouble, may cause depression by greatly reducing consumer demand, so a siege of insurance can bring about some of the dangers that motivate it.

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It no longer responds so well to the bad news of scarcity and disequilibrium—the high prices that signal new opportunities—and no longer provides so dependably the good news of creativity, invention, and entrepreneurship. This is the overall moral hazard of the welfare state. But all insurance and welfare programs do not present this problem, and some of them compensate for it by creating an atmosphere of safety more hospitable to long-range ventures and investments. The leaders of capitalism must become more discriminating in appraising the claims and demands, dangers and benefits of the eleemosynary state. It is not an alien presence but the now burly offspring of an essentially capitalist idea. The moral hazards of government programs are clear. Unemployment compensation promotes unemployment.5 Aid to Families with Dependent Children (AFDC) made more families dependent and fatherless.

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Excluding measures focused on the elderly, a resourceful welfare family could get benefits from some seventeen programs, among them AFDC, Medicaid, food stamps and supplemental foods, a variety of social, legal, and child-care services, and an array of housing grants and subsidies.7 Even overlooking the very important benefits of leisure time and unreported earnings, welfare subsidies in general pose a very grave danger of moral hazards, such as workforce withdrawal, familial breakdown, and other adjustments to the terms of the grants. Such welfare systems, at levels that heavily influence lower middle-class families as well as the poor, illustrate the famous tendency of “poverty” programs to reach far beyond their mandate. Poor families alone, however, received average benefits that brought them some 30 percent above the official “poverty line,” something that could only be achieved by two full-time workers at the minimum wage.8 Again, the potential for moral hazard emerges clearly. Most of these programs expanded steadily through the entire period of economic and employment growth of the late seventies, creating a sense of dependency in millions of families seemingly capable of self-support.

The Planet Remade: How Geoengineering Could Change the World by Oliver Morton

Albert Einstein, Anthropocene, Apollo 13, Asilomar, Boeing 747, British Empire, Buckminster Fuller, carbon credits, carbon tax, Cesare Marchetti: Marchetti’s constant, colonial rule, Colonization of Mars, Columbian Exchange, decarbonisation, demographic transition, Dr. Strangelove, electricity market, Elon Musk, energy transition, Ernest Rutherford, Garrett Hardin, germ theory of disease, Haber-Bosch Process, Intergovernmental Panel on Climate Change (IPCC), James Watt: steam engine, Jeff Bezos, John Harrison: Longitude, John von Neumann, Kim Stanley Robinson, Kintsugi, late capitalism, Louis Pasteur, megaproject, Michael Shellenberger, military-industrial complex, moral hazard, Naomi Klein, negative emissions, nuclear winter, ocean acidification, oil shale / tar sands, orbital mechanics / astrodynamics, Philip Mirowski, planetary scale, plutocrats, public intellectual, renewable energy transition, rewilding, scientific management, Scramble for Africa, Search for Extraterrestrial Intelligence, Silicon Valley, smart grid, South China Sea, Stewart Brand, systems thinking, tech billionaire, Ted Nordhaus, Thomas Malthus, Virgin Galactic

One spur of particularly well-rehearsed argument is the risk that simply talking about climate geoengineering will lead to less climate mitigation – the same concern that contributed to the marginalization of adaptation efforts in the past. This is often called the ‘moral hazard’ problem. In economics, the moral hazard of an insurance policy is the extent to which it encourages the insured to take more risks. Thus, subsidized flood insurance encourages people heedlessly to build on flood plains; likewise, the knowledge that banks have a very good chance of being bailed out if things go wrong encourages bankers to take self-serving risks. In geoengineering, ‘moral hazard’ has been used to describe the expectation that if cooling technologies seem a real possibility, people will put less effort into reducing carbon-dioxide emissions.

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Germany is also home to the world’s most ambitious strategy for moving away from fossil fuels towards renewable energy, the Energiewende. Even if it does not currently look politically germane, though, the moral-hazard point has to be taken seriously. It does seem likely that, other things being equal, an increased role for climate geoengineering in climate policy would reduce the pressure for emissions reduction. This is not necessarily a negative. For moral hazard to be a problem, you need to show that the behaviour it is encouraging is actually a bad thing. Climate geoengineering research thus raises a real moral hazard only if it reduces action on mitigation without making progress of its own in reducing the risks of climate change.

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This fear is clearly related to the persistent nightmare of a ‘superfreak pivot’ in which the American right moves overnight from a position of not wanting to act on climate at all to wanting to act only through some sort of crash geoengineering programme. But moral hazard is a broader issue than that. The superfreak pivot imagines a new enthusiasm for geoengineering; the moral-hazard worry doesn’t require enthusiasm for geoengineering, merely a slacking off on emissions reduction because geoengineering is thought to be an option. If people believe that there’s a plan B that could work, they will pursue plan A with less vigour.

The End of Wall Street by Roger Lowenstein

"World Economic Forum" Davos, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, benefit corporation, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, break the buck, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, financial engineering, fixed income, geopolitical risk, Glass-Steagall Act, Greenspan put, high net worth, Hyman Minsky, interest rate derivative, invisible hand, junk bonds, Ken Thompson, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Martin Wolf, Michael Milken, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, Rubik’s Cube, Savings and loan crisis, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

Paulson had a surprising response: The price should be lower.17 The secretary was hypersensitive to the charge that Washington was helping Bear’s shareholders, cushioning the impact of failure and thus dulling the perceived incentive of other banks to monitor their risks. (In the language of economists, policies that weaken such incentives and encourage excessive risk-taking create a “moral hazard”; it was a charge that had often been leveled at Greenspan.) Morgan settled on $2 a share, prompting howls of protest from Bear. Critically, Morgan agreed to provide a backstop—to guarantee Bear’s trades—so that Bear could remain in business until the deal closed, and the Fed agreed to finance, and absorb any losses on, $29 billion of Bear’s most problematic assets.v Essentially, the taxpayers would cover Jamie Dimon’s downside.

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These actions did not, as some argued, entice firms to fail, but they did sustain their ability to take the sort of risks that might lead to failure. In particular, they encouraged lenders to keep lending. The press focused on whether the price paid for Bear’s stock imposed a sufficient penalty on shareholders,w but the real moral hazard was that people who had lent to Bear suffered no pain at all. In fact, they were rewarded. Prior to the acquisition, Bear’s credits traded at a discount. (Its IOU was worth much less than face value, or “par.”) Once its debts became the obligation of JPMorgan, they returned to par. Robert Barbera, a prominent Wall Street economist, naturally counseled clients that they could count on the United States to back up Wall Street credits.22 Thanks to the Fed, the lending could go forth; thus was the illusion of solvency sustained.

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In the spring, he even hired two of his former Goldman cronies, guaranteeing them each tens of millions of dollars—evidence anew of the compensation disconnect at a bank losing billions every quarter.30 The regulators that spring were more worried than the bankers. They were torn between their desire for expanded powers and the wish not to seem either overly meddling or insensitive to moral hazard. Geithner insisted in testimony to the Senate that the Fed only lent to “sound institutions,” though that hardly described Bear Stearns.31 But he, like Paulson and Bernanke, were concerned that their scope was too limited. The system should not be so fragile as to depend on ad hoc, extralegal improvisation.

Modernising Money: Why Our Monetary System Is Broken and How It Can Be Fixed by Andrew Jackson (economist), Ben Dyson (economist)

Alan Greenspan, bank run, banking crisis, banks create money, Basel III, Bretton Woods, business cycle, call centre, capital controls, cashless society, central bank independence, credit crunch, David Graeber, debt deflation, double entry bookkeeping, eurozone crisis, financial exclusion, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, Fractional reserve banking, full employment, Greenspan put, Hyman Minsky, inflation targeting, informal economy, information asymmetry, intangible asset, land bank, land reform, London Interbank Offered Rate, low interest rates, market bubble, market clearing, Martin Wolf, means of production, Money creation, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, negative equity, Northern Rock, Post-Keynesian economics, price stability, profit motive, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, risk-adjusted returns, Savings and loan crisis, seigniorage, shareholder value, short selling, South Sea Bubble, technological determinism, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, unorthodox policies

Furthermore, the implicit insurance the government has provided is likely to lead to an increase in the risky behaviour (due to moral hazard) that led to the crisis in the first place, setting the stage for an even bigger crisis in the future. Conversely, under the reformed system, banks would be allowed to fail. The government and central bank would be under no obligation to intervene in the market and in so doing validate risky behaviour. This will lower moral hazard, as banks will now face the full downside of their investment decisions. This should decrease their willingness to participate in asset price bubbles.

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Due to the failure of certain banks in 2008-09, just £171 million of the £19.86 billion (less than 1%) was funded through levies, while the rest was provided by government (Financial Services Compensation Scheme, 2009). There are two main problems with deposit insurance. The first is that by being insured, customers will take little or no interest in the way that the bank lends and takes risks. This is known as ‘moral hazard’.3 In a system without deposit insurance, depositors would have a strong incentive to monitor their bank’s behaviour to ensure the bank does not act in a manner that may endanger its own solvency. For example, a depositor would be concerned with the types of loans their bank was making and the amount of capital their bank had (capital acts as a buffer, protecting depositors from losses when loans go bad).

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In a recent paper, Hart and Zingales (2011) create a simple framework to analyse the effect of bank lending on inflation in the economy, asking the question: “Does a competitive banking sector generate the socially optimal amount of the means of payment? In this paper we show that the answer is no, even if we abstract from any moral hazard and asymmetry of information. In particular, we analyse the general equilibrium effects that the availability of money has on prices and identify two pecuniary externalities: more money increases the equilibrium price of the goods that those with the money buy; but it also increases the wealth of the agents supplying these goods and so the prices of the goods they buy.

Magic Internet Money: A Book About Bitcoin by Jesse Berger

Alan Greenspan, barriers to entry, bitcoin, blockchain, Bretton Woods, Cambridge Analytica, capital controls, carbon footprint, correlation does not imply causation, cryptocurrency, diversification, diversified portfolio, Ethereum, ethereum blockchain, fiat currency, Firefox, forward guidance, Fractional reserve banking, George Gilder, inflation targeting, invisible hand, Johann Wolfgang von Goethe, liquidity trap, litecoin, low interest rates, Marshall McLuhan, Metcalfe’s law, Money creation, money: store of value / unit of account / medium of exchange, moral hazard, Network effects, Nixon shock, Nixon triggered the end of the Bretton Woods system, oil shale / tar sands, planned obsolescence, price mechanism, Ralph Waldo Emerson, rent-seeking, reserve currency, ride hailing / ride sharing, risk tolerance, Robert Metcalfe, Satoshi Nakamoto, the medium is the message, Vitalik Buterin

This ability to exert control over other people’s money is the ability to deny property rights, which only accentuates injustice since it breaks the golden rule. 10.5 Moral Hazard “With great power comes great responsibility.” Stan Lee, Spiderman The residual effects of the Global Financial Crisis have scarred the psyche of a generation by dramatically exposing them to fiat money’s most dangerous fault – moral hazard. In economics, moral hazard is the detachment of cost from risk. When the crisis struck, global central banks used their privileged powers to conjure hundreds of billions of dollars from thin air in order to purchase undesirable assets bound for the scrap yard of financial history.

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3.5 Fiat Functionality 3.6 Bitcoin on Point 3.7 Bitcoin Functionality Chapter 4: Growth 4.1 The Root of All Growth 4.2 The Value of Price 4.3 Time Is Money 4.4 Calculated Risk 4.5 Divestment Advice Chapter 5: Innovation 5.1 Evolution & Revolution 5.2 The Smart Money 5.3 Blockchain 101 Chapter 6: Resilience 6.1 An Unstoppable Force 6.2 Teamwork Makes the Dream Work 6.3 An Immovable Object 6.4 Harder, Better, Faster, Stronger Chapter 7: Scarcity 7.1 Limited Edition 7.2 $€¥£: A Sea of Fiat 7.3 Setting a Precedent 7.4 Pushing Limits 7.5 Making a Statement 7.6 No Second Chance for First Impressions Chapter 8: Competition 8.1 A New Frontier 8.2 Bitcoin Versus Fiat 8.3 Bitcoin Versus Gold 8.4 Bitcoin Versus Crypto 8.5 Bitcoin Versus Forks 8.6 Bitcoin Versus Stablecoins Chapter 9: Governance 9.1 Fair Is Rare 9.2 Tilted 9.3 Balanced 9.4 Ground Rules 9.5 Lead by Example Chapter 10: Freedom 10.1 The Golden Rule 10.2 The Dependency Trap 10.3 Home of the Brave 10.4 Capital Control 10.5 Moral Hazard 10.6 Amoral Safeguard 10.7 Unchained Chapter 11: Drawbacks 11.1 Mind the Gap 11.2 Ease of Use 11.3 Speed & Scale 11.4 Full Custody 11.5 Dark Mode 11.6 Mining 11.7 On Apathy & Atlas 11.8 Upset the Setup Chapter 12: Outlook 12.1 Monopoly Money 12.2 The Debtor’s Dilemma 12.3 From Sapling to Sequoia 12.4 Forward Guidance 12.5 The Bottom Line Resources Endnotes Key Terms Acknowledgments What Is Money?

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This initial instance of Bitcoin is known as the “Genesis block.” Within the Genesis block, Satoshi embedded the following message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” Here, Satoshi commemorated the network’s launch by highlighting a timely concern about the moral hazards inherent in our global monetary and banking systems, which were, and still are, on the brink of fallibility. This message is relevant to Bitcoin because it was specifically developed as a systematic upgrade – to be a principled monetary alternative for the 21st century and beyond. In late 2010, almost 2 years after its launch, Satoshi stopped communicating publicly about Bitcoin in chat forums, and also stopped contributing to ongoing software development.

The Wisdom of Finance: Discovering Humanity in the World of Risk and Return by Mihir Desai

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, AOL-Time Warner, assortative mating, Benoit Mandelbrot, book value, Brownian motion, capital asset pricing model, Carl Icahn, carried interest, Charles Lindbergh, collective bargaining, corporate governance, corporate raider, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, follow your passion, George Akerlof, Gordon Gekko, greed is good, housing crisis, income inequality, information asymmetry, Isaac Newton, Jony Ive, Kenneth Rogoff, longitudinal study, Louis Bachelier, low interest rates, Monty Hall problem, moral hazard, Myron Scholes, new economy, out of africa, Paul Samuelson, Pierre-Simon Laplace, principal–agent problem, Ralph Waldo Emerson, random walk, risk/return, Robert Shiller, Ronald Coase, short squeeze, Silicon Valley, Steve Jobs, Thales and the olive presses, Thales of Miletus, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, tontine, transaction costs, vertical integration, zero-sum game

A selection of the most important fundamental work for the ideas of adverse selection and moral hazard includes Arrow, Kenneth J. “Uncertainty and the Welfare Economics of Medical Care.” American Economic Review 53, no. 5 (June 1963): 941–73; Pauly, Mark V. “The Economics of Moral Hazard: Comment.” American Economic Review, part 1, 58, no. 3 (June 1968): 531–37; Arrow, Kenneth J. “The Economics of Moral Hazard: Further Comment.” American Economic Review, part 1, 58, no. 3 (June 1968): 537–39; Akerlof, George A. “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84, no. 3 (August 1970): 488–500; Holmstrom, Bengt. “Moral Hazard and Observability.”

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That Simpsons plotline provides a great example of how the presence of insurance can create an incentive to alter your behavior, a manifestation of what’s known as moral hazard. The example isn’t perfect, since usually the insured person takes more risk because of the insurance, as opposed to trying to kill people because of insurance—but you get the idea. Insurance and safety nets of all kinds can lead to more risk-taking, and insurers have to think through that behavioral response in pricing insurance. For more on this, just stream that classic film noir Double Indemnity and think about Barbara Stanwyck’s character—that’s serious moral hazard. Given the importance of adverse selection and moral hazard, what are the best mechanisms for dealing with them?

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Ensuring that insurance pools aren’t susceptible to people advantageously selecting into policies is what national mandates to buy insurance and employer-provided insurance are all about. Similarly, deductibles make sure that individuals aren’t overusing healthcare because they’re insured. But what organization is best suited to pool risk and counter the effects of moral hazard and adverse selection? It should be one where membership isn’t a choice, so that adverse selection isn’t operating, and one where you can closely monitor each other’s behavior to make sure moral hazard doesn’t work against you. Well, of course, that’s the family. You don’t get to choose your family, so that takes care of adverse selection. And families provide the intimacy for making sure behavior isn’t changing to take advantage of the insurance.

The Limits of the Market: The Pendulum Between Government and Market by Paul de Grauwe, Anna Asbury

Alan Greenspan, banking crisis, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, conceptual framework, crony capitalism, Easter island, Erik Brynjolfsson, eurozone crisis, Honoré de Balzac, income inequality, income per capita, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kitchen Debate, means of production, Money creation, moral hazard, Paul Samuelson, price discrimination, price mechanism, profit motive, Robert Gordon, Robert Solow, Ronald Coase, Simon Kuznets, The Nature of the Firm, The Rise and Fall of American Growth, too big to fail, transaction costs, trickle-down economics, ultimatum game, very high income

In recent decades social security in many European countries has run into this problem of moral hazard. The perception that many people benefit from the system at the expense of those who work undermines support from society for social security. This allows politicians to paint themselves as the ones who will combat ‘social welfare fraud’.  INTERNAL LIMITS OF GOVERNMENTS It is clear that the problem of moral hazard must be tackled. If it is not, then the system will be rejected by society. Some countries, particularly the Scandinavian countries, have succeeded relatively well in keeping moral hazard under control. They achieve this through a policy of activation of the unemployed, encouraging and helping them to re-enter the job market.

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Large banks profit from it because they are so big that the government cannot allow them to fail as a result of the crisis. That would damage the economy too badly, because many people would be pulled into bankruptcy. Large banks are too big to fail and they know it. In fact governments provide these banks with a guarantee that they will not go bankrupt. This leads to what economists call ‘moral hazard’. A large bank which enjoys implicit government insurance will therefore take  THE L IMI TS OF TH E MAR KET more risks. These high risks lead to large profits when everything is going well, and when things go badly, governments step in and the taxpayer must cover the losses. Perversely enough, the bank’s profits are privatized and its losses are nationalized.

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If people are affected by a calamity and are unable to perform, leaving them excluded, this does not disturb the market equilibrium. The market system continues, as if nothing has happened. That clashes with our sense of fairness. This is the fundamental reason why social security exists. But social security systems can in turn come up against their limits. Social security, like any insurance mechanism, leads to moral hazard,  THE L IMI TS OF TH E MAR KET by which economists mean the following. Whenever we insure ourselves against a particular risk, our vigilance with respect to that risk will be reduced. If we take out insurance against theft, we might neglect to instal the latest security technology in our homes.

Money Free and Unfree by George A. Selgin

Alan Greenspan, asset-backed security, bank run, banking crisis, barriers to entry, Bear Stearns, break the buck, Bretton Woods, business cycle, capital controls, central bank independence, centralized clearinghouse, Charles Lindbergh, credit crunch, Credit Default Swap, crony capitalism, disintermediation, Dutch auction, fear of failure, fiat currency, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, foreign exchange controls, Fractional reserve banking, German hyperinflation, Glass-Steagall Act, Hyman Minsky, incomplete markets, inflation targeting, information asymmetry, invisible hand, Isaac Newton, Joseph Schumpeter, large denomination, liquidity trap, Long Term Capital Management, low interest rates, market microstructure, Money creation, money market fund, moral hazard, Network effects, Northern Rock, oil shock, Paul Samuelson, Phillips curve, plutocrats, price stability, profit maximization, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, Robert Gordon, Robert Solow, Savings and loan crisis, savings glut, seigniorage, special drawing rights, The Great Moderation, the payments system, too big to fail, transaction costs, Tyler Cowen, unorthodox policies, vertical integration, Y2K

But the most important costs that must be set against any possible short-run gains from Fed departures from classical LOLR doctrine consist of the moral hazard problems caused by such departures, including the problem of zombie institutions gambling for recovery. As Kaufman (2000: 237) puts it, “there is little more costly and disruptive to the economy than liquid insolvent banks that are permitted to continue to operate.” It is a common misconception to think that imposing losses on management and shareholders, while shielding counterparties and creditors, is enough to contain moral hazard. So long as bank creditors can expect high returns on the upside, with implicit government guarantees against losses on the downside, they will lend too cheaply to risky, poorly diversified banks, making overly high leverage (thin capital) an attractive strategy.

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To contain this threat, the Federal Reserve provided secured loans to AIG. The trouble with such a mingling of Bagehotian and too-big-to-fail lending criteria is, as we have seen, that it raises a moral hazard. Bernanke himself was fully aware of the danger. “Some particularly thorny issues,” he observed after the Bear rescue, are raised by the existence of financial institutions that may be perceived as “too big to fail” and the moral hazard issues that may arise when governments intervene in a financial crisis. [Bear’s rescue was] necessary and justified under the circumstances that prevailed at that time. However, those events also have consequences that must be addressed.

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Deposit insurance and central bank loans have increasingly had these effects in recent years, particularly in the thrift industry where hundreds of bankrupt “zombie institutions” have been kept afloat at taxpayers’ expense instead of being allowed to succumb to the Darwinian forces of the market. (Thrifts received their first direct Federal Reserve support on February 23, 1989.) The ill effects of government deposit insurance are, as is well known, due to its lack of risk-adjusted premiums. This leads to moral hazard whereby the insured firms pursue risks that they would not pursue in an uninsured state.7 Depositors, in turn, no longer feel any need to be concerned about the safety of particular depository institutions, and are tempted to supply funds to wherever rates are highest. According to J. Huston McCulloch (1986: 82), thanks to federal deposit insurance, banks and thrifts have engaged with impunity in all manner of excessive risks—foreign exchange speculation (Franklin National), speculative energy loans (Penn Square), inadequately investigated loans (Continental Illinois), insider loans (the Butcher banks), uncollectable Third World loans (almost every top ten bank) and so forth.

Finance and the Good Society by Robert J. Shiller

Alan Greenspan, Alvin Roth, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, benefit corporation, Bernie Madoff, buy and hold, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, cognitive dissonance, collateralized debt obligation, collective bargaining, computer age, corporate governance, Daniel Kahneman / Amos Tversky, democratizing finance, Deng Xiaoping, diversification, diversified portfolio, Donald Trump, Edward Glaeser, eurozone crisis, experimental economics, financial engineering, financial innovation, financial thriller, fixed income, full employment, fundamental attribution error, George Akerlof, Great Leap Forward, Ida Tarbell, income inequality, information asymmetry, invisible hand, John Bogle, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, land reform, loss aversion, Louis Bachelier, Mahatma Gandhi, Mark Zuckerberg, market bubble, market design, means of production, microcredit, moral hazard, mortgage debt, Myron Scholes, Nelson Mandela, Occupy movement, passive investing, Ponzi scheme, prediction markets, profit maximization, quantitative easing, random walk, regulatory arbitrage, Richard Thaler, Right to Buy, road to serfdom, Robert Shiller, Ronald Reagan, selection bias, self-driving car, shareholder value, Sharpe ratio, short selling, Simon Kuznets, Skype, social contagion, Steven Pinker, tail risk, telemarketer, Thales and the olive presses, Thales of Miletus, The Market for Lemons, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, Vanguard fund, young professional, zero-sum game, Zipcar

Some CEOs are, and always will be, worth a great deal to their rms. On the other hand, the group did believe that regulation of the structure of CEO compensation is called for.5 Moral Hazard and Deferred Compensation There is a reason for the government to intervene in the process of determining executive salaries: to mitigate a speci c moral hazard that seems to have played a substantial role in causing the nancial crisis that began in 2007—at least for big and so-called systemically important rms. This moral hazard arises because the CEOs and other top o cers of such key rms have incentives to take extraordinary risks. They believe that their companies are too big to be allowed to fail.

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This distinction must in part have to do with the fact that bankers typically stay out of the most volatile, headline-grabbing markets. But perhaps too it is because bankers, in contrast to hedge fund managers and the like, are following a long and time-honored tradition, extending back hundreds of years, which has evolved to solve certain problems—including liquidity, moral hazard and selection bias, and transaction service problems—to the satisfaction of most people most of the time. The anger toward bankers takes a very di erent form. It seems to be anger at their power and presumption, at their single-minded pursuit of money. And the anger ares up whenever there is a banking crisis and the governments of the world come to the rescue of these wealthy interests.

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In the United States, explicit reserve requirements date back to the early days of the Federal Reserve, in 1917.2 Capital requirements for banks began to be enforced by the United States in 1982.3 International capital agreements began with the Basel Accord in 1988, and they were reformed by the Basel Committee in response to the nancial crisis that began in 2007, to avoid more government bailouts in future crises. Bank regulation becomes more and more complex as the years go by, as does the banking business itself. In addition to providing liquidity, banks address another problem that individuals seeking a return on their investments face if they try to invest directly—a moral hazard problem. If individuals invest directly in companies, by lending money to them or buying their securities, they may in e ect be robbed by the people with whom they invest. There are numerous ways for the managers of a business to funnel money out of the company and into the hands of friends, thereby in e ect stealing money from their investors.

Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State by Paul Tucker

"Friedman doctrine" OR "shareholder theory", Alan Greenspan, Andrei Shleifer, bank run, banking crisis, barriers to entry, Basel III, battle of ideas, Bear Stearns, Ben Bernanke: helicopter money, Berlin Wall, Bretton Woods, Brexit referendum, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, centre right, conceptual framework, corporate governance, diversified portfolio, electricity market, Fall of the Berlin Wall, financial innovation, financial intermediation, financial repression, first-past-the-post, floating exchange rates, forensic accounting, forward guidance, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, George Akerlof, Greenspan put, incomplete markets, inflation targeting, information asymmetry, invisible hand, iterative process, Jean Tirole, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, liberal capitalism, light touch regulation, Long Term Capital Management, low interest rates, means of production, Money creation, money market fund, Mont Pelerin Society, moral hazard, Northern Rock, operational security, Pareto efficiency, Paul Samuelson, price mechanism, price stability, principal–agent problem, profit maximization, public intellectual, quantitative easing, regulatory arbitrage, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, road to serfdom, Robert Bork, Ronald Coase, seigniorage, short selling, Social Responsibility of Business Is to Increase Its Profits, stochastic process, subprime mortgage crisis, tail risk, The Chicago School, The Great Moderation, The Market for Lemons, the payments system, too big to fail, transaction costs, Vilfredo Pareto, Washington Consensus, yield curve, zero-coupon bond, zero-sum game

The argument against such a role rests on the possibility of conflicts of interest. Moral Hazard from Insuring Liquidity and Macrostability People, businesses, and financial intermediaries plausibly take more risk than otherwise, including taking on too much debt, due to central banks’ role as the LOLR to the financial system and as the authority that seeks to smooth the economy’s ups and downs.24 While this has attracted attention since talk of the “Greenspan put” during the 1990s, it is not obvious that it should knock central banks out of contention for formal regulatory and supervisory responsibilities. After all, these various moral hazard risks are no smaller when a separate body is the regulator.

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In fact, however, the Fed has pretty much the same political insulation in supervision and regulation as it does in monetary policy, and a lot closer to that than to, say, the EPA or SEC: job security, budgetary autonomy, instrument autonomy (chapter 4). 22 Tucker, “Resolution of Financial Institutions.” 23 In the UK, confidence that information would flow smoothly was strongly, but naively and damagingly, asserted (Roll et al., Independent and Accountable, pp. 44 and 68). 24 Miller, Weller, and Zhang, “Moral Hazard,” and Farhi and Tirole, “Collective Moral Hazard.” 25 Cecchetti, “Financial Supervisors.” Also, Copelovitch and Singer, “Financial Regulation,” which appeals to a structural explanation from Dewatripont, Jewitt, and Tirole, “Economics of Career Concerns.” The central difference with this book is that, under the Multiple-Mission Constraints, each mission is delegated to a distinct committee, whereas Dewatripont et al. have a unitary policy maker. 26 Hood, “Public Management.” 27 Bagehot, Lombard Street. 28 On a broad point of substance, the constraints on banking would take the following general shape: X percent of the face value of short-term liabilities (S) to be “covered” by holdings of liquid assets, discounted to the value attributed to them by the central bank (d.LA); residual assets ((1-d).LA plus assets ineligible at the central bank) to be funded in prescribed minimum proportions by common equity (K) and debt that can be converted into equity without disruption (known as bail in-able debt, B), plus any “uncovered” short-term liabilities ((1-x).S).

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It should be to avoid or mitigate the social costs that flow from illiquid but fundamentally sound intermediaries failing in a disorderly way or rationing credit and other services (in order to serve the intermediaries’ private interest in staying alive). Once under such an obligation, as a general matter central banks would lose their discretion as to whether to activate their LOLR powers depending on their particular view of moral hazard costs. Instead, they would stand accountable for their assessment of the facts they confronted and the terms set on any assistance (Design Precept 4). They would also be incentivized to combat moral hazard through the ex ante terms and conditions of their lending facilities and through the regulatory regime. (As sketched in chapter 20’s discussion of the Money-Credit Constitution, those could be linked if runnable liabilities had to be covered by assets eligible for discount at the central bank.)

How Markets Fail: The Logic of Economic Calamities by John Cassidy

Abraham Wald, Alan Greenspan, Albert Einstein, An Inconvenient Truth, Andrei Shleifer, anti-communist, AOL-Time Warner, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Bear Stearns, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, Black-Scholes formula, Blythe Masters, book value, Bretton Woods, British Empire, business cycle, capital asset pricing model, carbon tax, Carl Icahn, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, corporate raider, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, different worldview, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, Garrett Hardin, George Akerlof, Glass-Steagall Act, global supply chain, Gunnar Myrdal, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kickstarter, laissez-faire capitalism, Landlord’s Game, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, low interest rates, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, military-industrial complex, Minsky moment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, Naomi Klein, negative equity, Network effects, Nick Leeson, Nixon triggered the end of the Bretton Woods system, Northern Rock, paradox of thrift, Pareto efficiency, Paul Samuelson, Phillips curve, Ponzi scheme, precautionary principle, price discrimination, price stability, principal–agent problem, profit maximization, proprietary trading, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, subprime mortgage crisis, tail risk, Tax Reform Act of 1986, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, Tragedy of the Commons, transaction costs, Two Sigma, unorthodox policies, value at risk, Vanguard fund, Vilfredo Pareto, wealth creators, zero-sum game

“Insurance removes the incentive on the part of individuals, patients, and physicians to shop around for better prices for hospitalization and surgical care,” Arrow noted. Following Arrow’s example, economists now refer to the phenomenon of insurance changing people’s behavior as “moral hazard.” Ultimately, this is another problem of hidden information: insurers can’t fully monitor the behavior of their policyholders, so they try to influence it in other ways. In the cases of hurricane and earthquake insurance, moral hazard is a minor concern, because the policyholders can’t affect the probability of a payout. In other areas, they can. Motorists with car insurance tend to drive less carefully and leave their vehicles unattended, which means they are more likely to crash and have their vehicle stolen; drivers with seat belts tend to drive faster; and property owners with fire insurance are less apt to install fire alarms and fire extinguishers.

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Even before the development of alphabet soup finance, the presence of deposit insurance and implicit government guarantees meant that banks, especially the biggest ones, were apt to take too many risks—this is the issue of moral hazard. But the combination of securitization, credit insurance, and reforms to the regulatory structure greatly accentuated this problem. “[T]here is an immutable law of insurance that says that, while hedging can reduce the risk to an individual party taking out the insurance, it increases the risk for the system as a whole because of moral hazard,” John Plender, a veteran commentator for the Financial Times, noted in October 2006. “That is, the mere existence of insurance means people become less risk averse.

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They also insist on precertification for visits to specialists, limit the choice of doctors whom patients can see, and investigate suspect claims. But such measures add to the insurers’ already substantial administrative costs, and they haven’t proved sufficient to keep down costs. One way to banish moral hazard would be to do away with health insurance, but that would also eliminate the benefits of risk sharing, which are substantial. Alternatively, insurers could refuse to pay for superfluous tests and treatments that don’t offer much prospect of curing the patient. In a competitive environment, however, holding the line is difficult.

Culture and Prosperity: The Truth About Markets - Why Some Nations Are Rich but Most Remain Poor by John Kay

Alan Greenspan, Albert Einstein, Asian financial crisis, Barry Marshall: ulcers, behavioural economics, Berlin Wall, Big bang: deregulation of the City of London, Bletchley Park, business cycle, California gold rush, Charles Babbage, complexity theory, computer age, constrained optimization, corporate governance, corporate social responsibility, correlation does not imply causation, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, Donald Trump, double entry bookkeeping, double helix, Dr. Strangelove, Dutch auction, Edward Lloyd's coffeehouse, electricity market, equity premium, equity risk premium, Ernest Rutherford, European colonialism, experimental economics, Exxon Valdez, failed state, Fairchild Semiconductor, financial innovation, flying shuttle, Ford Model T, Francis Fukuyama: the end of history, George Akerlof, George Gilder, Goodhart's law, Great Leap Forward, greed is good, Gunnar Myrdal, haute couture, Helicobacter pylori, illegal immigration, income inequality, industrial cluster, information asymmetry, intangible asset, invention of the telephone, invention of the wheel, invisible hand, John Meriwether, John Nash: game theory, John von Neumann, junk bonds, Kenneth Arrow, Kevin Kelly, knowledge economy, Larry Ellison, light touch regulation, Long Term Capital Management, loss aversion, Mahatma Gandhi, market bubble, market clearing, market fundamentalism, means of production, Menlo Park, Michael Milken, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, Naomi Klein, Nash equilibrium, new economy, oil shale / tar sands, oil shock, Pareto efficiency, Paul Samuelson, pets.com, Phillips curve, popular electronics, price discrimination, price mechanism, prisoner's dilemma, profit maximization, proprietary trading, purchasing power parity, QWERTY keyboard, Ralph Nader, RAND corporation, random walk, rent-seeking, Right to Buy, risk tolerance, road to serfdom, Robert Solow, Ronald Coase, Ronald Reagan, Savings and loan crisis, second-price auction, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, Steve Jobs, Stuart Kauffman, telemarketer, The Chicago School, The Market for Lemons, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, total factor productivity, transaction costs, tulip mania, urban decay, Vilfredo Pareto, Washington Consensus, women in the workforce, work culture , yield curve, yield management

The only solution to the potential information asymmetry is to stop such information being collected at all-which would be impossible even if it were desirable. In fifty years, private medical and life insurance may { 240} John Kay be as difficult to obtain as divorce and unemployment insurance today, and for the same reasons. Moral Hazard Most risks in our environment depend on the actions we take. If we have financial protection against risk, we will expose ourselves to more risks. This is the problem of moral hazard. 12 People do not allow their houses to burn down because they have fire insurance. Young women do not set out to become pregnant because there are social benefits for single mothers. But their behavior is adaptive.

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When those you insure can influence the risks you cover, you must supervise them. Social Insurance of Personal Risks ••••••••••••••••••••••••••••••••••••• When people can opt out, adverse selection is a problem. If you can't easily watch what they're doing, moral hazard is a problem. The combination of adverse selection and moral hazard means that risks are best managed by groups that have other common bonds: typically families, communities, workplaces, and nations. The management of everyday risk is best and principally undertaken through social institutions. Purely economic agencies such as insurance companies and securities markets play only a minor role.

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The term social insurance originated in Germany in the late nineteenth century, 18 as government came to take over the insurance functions of voluntary organizations such as mutual societies and trade unions and to extend more generally the kinds ofbenefit they had provided to employees. This organized mutual sharing of risks is today part of the economic structure of most West European states. Government is well-placed to reduce adverse selection, because it can compel participation, but is less effective at reducing moral hazard than the social pressures of a local community. Formal social insurance schemes address the moral hazard problem by limiting the generosity of the benefits they provide, the time period for which the benefits are paid, and attaching conditions-such as tests of genuineness of the search for work-to their benefits. Business Risk Some economic risks are inescapable.

Doctored: The Disillusionment of an American Physician by Sandeep Jauhar

Affordable Care Act / Obamacare, delayed gratification, illegal immigration, income inequality, independent contractor, Induced demand, medical malpractice, moral hazard, obamacare, PalmPilot, profit motive, randomized controlled trial, source of truth, stem cell, The Wealth of Nations by Adam Smith, Yogi Berra

When people complain that their rising insurance premiums are funding others’ irresponsible behavior, they are complaining about moral hazard. When patients with low-deductibility insurance go to the emergency room for a hangnail, they are succumbing to moral hazard. When a nurse in the ICU criticizes a family for refusing to authorize a DNR order (“They would never do this if they had to pay for it”), she is talking about moral hazard. The moral hazard hypothesis was put to the test in the 1970s with the RAND Health Insurance Experiment. For a decade it followed eight thousand people who had been randomly assigned to one of five types of health insurance plan: an HMO-style group cooperative or a traditional plan that covered 100 percent, 95 percent, 50 percent, or 25 percent of costs.

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Of course, many forces, including new and expensive technology, the aging of the population, and the rise of chronic diseases, are behind increasing imaging costs. But moral hazard undoubtedly plays a role. Managed care, with its reliance on high deductibles and capitation, in which physicians are paid a set amount per assigned patient, whether or not that patient seeks care, came of age with the idea of controlling moral hazard. In the 1970s many insurers adopted co-payments to increase the price of medical care to consumers in an effort to reduce inefficient spending. In the 1980s and 1990s, economists promoted fixed payments and utilization review, in which payers approve or deny requests for medical services, to further reduce moral hazard. The managed care system that we know today is largely a product of this theory.

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In 1867 the Aetna Guide to Fire Insurance introduced the concept of moral hazard into actuarial science. The publication warned that generous insurance policies could make some people careless about preventing fires. Protected in part from the consequences of their actions, those people were more likely to engage in risky behavior, like not clearing their yards of brush or leaving their houses without adequate ventilation. The guide made a revolutionary and counterintuitive point: insurance in some cases can increase risk. Moral hazard undoubtedly plays a role in health care, too. When people complain that their rising insurance premiums are funding others’ irresponsible behavior, they are complaining about moral hazard.

Money: The Unauthorized Biography by Felix Martin

Alan Greenspan, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business cycle, call centre, capital asset pricing model, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, creative destruction, credit crunch, David Graeber, en.wikipedia.org, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, fixed income, Fractional reserve banking, full employment, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Hyman Minsky, inflation targeting, invention of writing, invisible hand, Irish bank strikes, joint-stock company, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kenneth Rogoff, land bank, Michael Milken, mobile money, moral hazard, mortgage debt, new economy, Northern Rock, Occupy movement, Paul Volcker talking about ATMs, plutocrats, private military company, proprietary trading, public intellectual, Republic of Letters, Richard Feynman, Robert Shiller, Savings and loan crisis, Scientific racism, scientific worldview, seigniorage, Silicon Valley, smart transportation, South Sea Bubble, supply-chain management, The Wealth of Nations by Adam Smith, too big to fail

It seemed inconceivable that the regulators would let it go: everyone knew that it was “too big to fail.” Yet the sanctimonious talk of the dangers of moral hazard emanating from the central bank was far from reassuring. And then, taking everyone by surprise, it happened. There was a full-blown run, and the central bank let it fail. All hell broke loose: a panic the like of which hadn’t been seen for decades. As financial markets tanked, credit seized up, and the economy capsized, moral hazard was suddenly the last thing the central bankers were worrying about. The policy-makers realised that the time had come to run the printing press at full tilt and bail out the financial sector before it disintegrated completely.

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“Financial stability,” warned Daniel Tarullo—the leading authority on bank regulation on the Board of Governors of the Federal Reserve—in June 2012, “is, in important ways, endogenous to the financial system, or at least the kind of financial system that has developed in recent decades.”10 Moral hazard is hard-wired into the system. This is why attempting to mitigate it by tinkering with capital ratios or liquidity requirements would be a Sisyphean task. So long as the nature of banking is to lend long-term by borrowing short-term, and take credit risk whilst promising none, the boulder of moral hazard would forever be tumbling back to the bottom of the hill just as the regulators think they have it fixed. What is needed is reform targeted at the fundamental structure of the banking system, rather than at the behaviour of the bankers within it.

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It opened with a chilling warning: “[c]harity is the national error of Englishmen.”9 There was no question that the impending Irish famine was an economic disaster and a human tragedy. But simply sending aid was absolutely the wrong way to help. It would violate two central principles of economic theory. The first was the need to avoid moral hazard. Send aid, and one might alleviate the immediate problem—but at the cost of reducing the Irish to a state of permanent dependency. The second was the hallowed principle of non-intervention in the operation of the market. Adam Smith had proved that it was allowing private self-interest to operate as freely as possible that most efficiently achieves the social good.

How the Other Half Banks: Exclusion, Exploitation, and the Threat to Democracy by Mehrsa Baradaran

access to a mobile phone, affirmative action, Alan Greenspan, asset-backed security, bank run, banking crisis, banks create money, barriers to entry, Bear Stearns, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, cashless society, credit crunch, David Graeber, disintermediation, disruptive innovation, diversification, failed state, fiat currency, financial innovation, financial intermediation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, housing crisis, income inequality, Internet Archive, invisible hand, junk bonds, Kickstarter, low interest rates, M-Pesa, McMansion, Michael Milken, microcredit, mobile money, Money creation, moral hazard, mortgage debt, new economy, Own Your Own Home, Paul Volcker talking about ATMs, payday loans, peer-to-peer lending, price discrimination, profit maximization, profit motive, quantitative easing, race to the bottom, rent-seeking, Ronald Reagan, Ronald Reagan: Tear down this wall, Savings and loan crisis, savings glut, subprime mortgage crisis, the built environment, the payments system, too big to fail, trade route, transaction costs, unbanked and underbanked, underbanked, union organizing, W. E. B. Du Bois, white flight, working poor

The argument was that banks would not be incentivized to take risks because if they did, the market would punish them, and the FDIC would facilitate their failure, thus eliminating any concerns about moral hazard. Obviously, this was not the case twenty years later when government bailouts abruptly cut off market discipline. In fact, market discipline for banks, if it exists at all, is not robust because of the moral hazard introduced by deposit insurance. And what of the fears of concentrated power that so consumed Jefferson, Brandeis, and Roosevelt? The FDIC was not too worried: “There will [not] be fewer banks or less competition in any given market.… While concentrations of political power may be undesirable, it is not clear that large organizations or highly concentrated industries are able to wield too much influence over government.

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And so, postal banking’s popularity increased. Many saw it as a way to respond to the constant banking crises of the time and further, viewed it to be a better alternative than federal deposit insurance because there was less moral hazard involved (insurance protection tends to make banks take more risks). The government would fund and oversee postal banks to minimize the chance of moral hazard. And interestingly, it was the Republicans who supported a broad federal banking system rather than a private bank-funded insurance scheme. During the 1908 presidential election, postal banking became a major issue.

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Insurance removes the incentive for customers to police a bank. It can also remove the incentive for banks to police themselves because they do not bear the full or even the most serious consequences of their actions. Removing the natural tendencies of the market to notice and punish bad choices creates a moral hazard that may result in well-funded cats and other undetected market risks. In the United States, only federal deposit insurance has been effective at stabilizing banks. State and private insurance funds have been attempted and have failed because to be effective at deterring runs, an insurance system must be basically unlimited.

The Undercover Economist: Exposing Why the Rich Are Rich, the Poor Are Poor, and Why You Can Never Buy a Decent Used Car by Tim Harford

Alan Greenspan, Albert Einstein, barriers to entry, Berlin Wall, business cycle, collective bargaining, congestion charging, Corn Laws, David Ricardo: comparative advantage, decarbonisation, Deng Xiaoping, Fall of the Berlin Wall, George Akerlof, Great Leap Forward, household responsibility system, information asymmetry, invention of movable type, John Nash: game theory, John von Neumann, Kenneth Arrow, Kickstarter, market design, Martin Wolf, moral hazard, new economy, Pearl River Delta, price discrimination, Productivity paradox, race to the bottom, random walk, rent-seeking, Robert Gordon, Robert Shiller, Ronald Reagan, sealed-bid auction, second-price auction, second-price sealed-bid, Shenzhen special economic zone , Shenzhen was a fishing village, special economic zone, spectrum auction, The Market for Lemons, Thomas Malthus, trade liberalization, Vickrey auction

If I lose my job and the government pays unemployment benefit, I may not hurry to find a new job quite as quickly as I would if I had no income whatso-ever. If the money in my checking account is insured against a bank failure, why bother to check that the bank is financially sound? Moral hazard is an inevitable problem in the real economy. While it is impossible for insurance companies (or anyone else) • 123 • T H E U N D E R C O V E R E C O N O M I S T to avoid moral hazard altogether, they can take steps to reduce it. For example, they do not offer insurance against being fired or becoming pregnant, which is a shame, because it would be great to have that kind of insurance.

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There are many people who would like to leave their jobs and many others who would like to have children, and such people would be particularly eager to buy an insurance policy that would pay them handsomely for putting their plans into action. As a result, moral hazard destroys the market for private unemployment insurance. On the other hand, public unemployment insurance still exists, in spite of moral hazard. It is not polite to say so, but it is obvious that paying people to be unemployed encourages unemployment. Yet if a government scrapped unemployment benefit, there would still be jobless people, and supporting the jobless is something that every civilized society should do.

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The truth is that we have a trade-off: it is bad to encourage unemployment but good to support those without incomes. Both governments and private insurers will try to protect themselves against moral hazard. One of the most common ways insurance companies do this is by modifying the insurance policy to provide incomplete insurance, in the form of a deductible. If my car insurance deductible is $200, the fear of losing that money probably won’t persuade me to take extravagant safety precautions, but it should be enough to make me check that my car is locked. Another way insurance companies can fight moral hazard is by gaining access to the inside information. Health insurers will want to know whether I am a smoker before they set my premiums.

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, barriers to entry, Basel III, Bear Stearns, Bernie Sanders, Black Monday: stock market crash in 1987, break the buck, Bretton Woods, business cycle, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial engineering, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, Glass-Steagall Act, greed is good, Greenspan put, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, junk bonds, liquidity trap, London Whale, Long Term Capital Management, low interest rates, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, Navinder Sarao, negative equity, new economy, Northern Rock, obamacare, Phillips curve, price stability, proprietary trading, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, stock buybacks, tail risk, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

He had proven his mettle as a “big swinging dick” by insisting that the Fed sweeten the pot by providing JPMC with downside protection to cover the risk of the unknown. The rescue’s fallout for the Fed was swift and unflattering. Congress and the press blasted Bernanke, Geithner, and Paulson for inflaming “moral hazard.” The term “moral hazard” refers to the problem created when one party (an investment bank) engages in risky behavior, knowing that it will be rescued by a second party (the Federal Reserve or the taxpayers), which will incur the cost. Paulson fully grasped what was at stake. During the negotiations over Bear’s salvage, he insisted that the rescue had to hurt.

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Bernanke would trim the sails to right the foundering ship. I disagreed. The demise of the Bear was a flashing red light that shouted “DANGER.” My colleagues rolled their eyes. Rosenblum treated me with a new respect. The chain of events was playing out as I had predicted. He and I began collaborating on a paper on moral hazard. It would make Rosenblum no fans at the Board of Governors. The bailout both relieved and alarmed the financial press. The Economist wrote that the Fed was “taking the unprecedented (and, some say, disturbing) step of financing up to $30 billion of Bear’s weakest assets. This could cost the central bank several billion dollars if those assets fall in value.”

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There he would have seen the arrogant “Master of the Universe” so reckless with other people’s money that he ignored reality. As Lehman’s stock tanked, Fuld began peppering Paulson with phone calls, trying to find an exit route. The treasury secretary wasn’t helpful. Bail out the Gorilla? Paulson recognized he was dealing with moral hazard in spades. It again seemed as if Dimon would come to the rescue. On September 9, at the Fed’s urging, JPMC agreed to loan Lehman operating funds; without the deal, Lehman would have had to close its doors the next day. But Lehman had to come up with $5 billion in extra collateral. It couldn’t.

The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry by William K. Black

accounting loophole / creative accounting, affirmative action, Alan Greenspan, Andrei Shleifer, Black Monday: stock market crash in 1987, book value, business climate, cognitive dissonance, corporate governance, corporate raider, Donald Trump, fear of failure, financial deregulation, friendly fire, George Akerlof, hiring and firing, junk bonds, margin call, market bubble, Michael Milken, money market fund, moral hazard, offshore financial centre, Ponzi scheme, race to the bottom, Ronald Reagan, Savings and loan crisis, short selling, The Market for Lemons, transaction costs

They also concentrate in investments best suited for accounting fraud. That triple concentration means that waves of control fraud will create, inflate, and extend bubbles. MORAL HAZARD Moral hazard is the temptation to seek gain by engaging in abusive, destructive behavior, either fraud or excessive risk taking. Failing firms expose their owners to moral hazard. This is not unique to S&Ls; it is in the nature of corporations. Moral hazard arises when gains and losses are asymmetrical. A company with $100 million in assets and $101 million in liabilities is insolvent. If it is liquidated (sells its assets), the stockholders will get nothing because they are paid only after all the creditors are paid in full.

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If the corporation makes an extremely risky investment and it fails, the loss is borne entirely by the creditors. If the investment is a spectacular success, the gain goes overwhelmingly to the shareholders. The shareholders have a perverse incentive to take unduly large risks rather than to make the most productive investments. The examples of moral hazard I have used involve unduly risky behavior. The theory, however, is not limited to honest risk taking. Moral hazard theory also explains why failing firms have an incentive to engage in reactive control fraud (White 1991, 41). Indeed, since S&L control fraud was a sure thing (it was certain to produce, for a time, record profits), reactive control fraud was a better option than an ultra-high-risk gamble.

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Instead, it endorsed absurd accounting abuses like “loan loss deferral” (which meant not recognizing losses currently) as purportedly superior accounting treatments under economic and accounting theory.6 The task force also encouraged fast growth and interest-rate risk in a get-rich-quick scheme called “risk-controlled arbitrage” (RCA).7 Second, the design and implementation of the cover-up guaranteed a disaster. Moral hazard theory unambiguously predicts that if you greatly weaken restraints on abuse at a time of mass, intense moral hazard, you will suffer severe abuses. Had you asked Richard Pratt, when he was still a graduate student, to write a paper on the effect of removing restraints at a time of mass insolvency, I am confident that you would have received a sound analysis predicting disaster.

The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality by Brink Lindsey

Airbnb, Asian financial crisis, bank run, barriers to entry, Bernie Sanders, Build a better mousetrap, Capital in the Twenty-First Century by Thomas Piketty, carbon tax, Carmen Reinhart, Cass Sunstein, collective bargaining, creative destruction, Credit Default Swap, crony capitalism, Daniel Kahneman / Amos Tversky, David Brooks, diversified portfolio, Donald Trump, Edward Glaeser, endogenous growth, experimental economics, experimental subject, facts on the ground, financial engineering, financial innovation, financial intermediation, financial repression, hiring and firing, Home mortgage interest deduction, housing crisis, income inequality, informal economy, information asymmetry, intangible asset, inventory management, invisible hand, Jones Act, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, knowledge worker, labor-force participation, Long Term Capital Management, low skilled workers, Lyft, Mark Zuckerberg, market fundamentalism, mass immigration, mass incarceration, medical malpractice, Menlo Park, moral hazard, mortgage debt, Network effects, patent troll, plutocrats, principal–agent problem, regulatory arbitrage, rent control, rent-seeking, ride hailing / ride sharing, Robert Metcalfe, Robert Solow, Ronald Reagan, Savings and loan crisis, Silicon Valley, Silicon Valley ideology, smart cities, software patent, subscription business, tail risk, tech bro, too big to fail, total factor productivity, trade liberalization, tragedy of the anticommons, Tragedy of the Commons, transaction costs, tulip mania, Tyler Cowen, Uber and Lyft, uber lyft, Washington Consensus, white picket fence, winner-take-all economy, women in the workforce

Given the expectation that bailouts will again be forthcoming the next time a crisis hits, the riskiness of lending to highly leveraged institutions is much lower than it otherwise would be; thus, the interest rates that those institutions pay to their nominally uninsured creditors are kept artificially low. The perverse incentives created by these leverage subsidies are known as “moral hazard,” an expression that comes from the insurance industry to describe the reduced motivation to guard against risks that have been insured against. How moral hazard operates in the financial sector is widely misunderstood. The common picture is that if moral hazard is present, it must mean that financial sector executives are consciously making business decisions with an attitude of “heads I win, tails you lose.” In other words, they deliberately make investments they know are risky because they understand that they will make big profits if the investments pay off, and if they don’t, well that’s the government’s problem.

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Far from seeing themselves as reckless, the unwitting architects of the financial crisis were highly confident that they were managing risks expertly and were shocked when the facts proved otherwise. Accordingly, it would seem that moral hazard wasn’t a major factor in explaining what went wrong. But in fact moral hazard was absolutely central to the story, and it is at the heart of why the financial sector remains a disaster waiting to happen. The main effect of moral hazard isn’t on the incentives facing the executives of financial institutions. Rather, the main effect is on depositors and other creditors. Because their risk of loss has been artificially reduced by the formal and informal safety net created by government, they do not respond as normal market actors would to the heightened risk of insolvency created by extreme leverage.

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Upjohn Institute for Employment Research Policy Paper no. 2011-009, July 2011, http://research.upjohn.org/up_policypapers/9/. 2.Department of the Treasury Office of Economic Policy, Council of Economic Advisers, and Department of Labor, “Occupational Licensing: A Framework for Policymakers,” July 2015, pp. 19–20, https://www.whitehouse.gov/sites/default/files/docs/licensing_report_final_nonembargo.pdf. 3.Department of the Treasury Office of Economic Policy, Council of Economic Advisers, and Department of Labor, “Occupational Licensing: A Framework for Policymakers,” p. 7. 4.See Dick M. Carpenter II, Lisa Knepper, Angela C. Erickson, and John K. Ross, “License to Work: A National Study of Burdens from Occupational Licensing,” Institute for Justice, May 2012, https://www.ij.org/licensetowork. 5.See Carl Shapiro, “Investment, Moral Hazard, and Occupational Licensing,” Review of Economic Studies 53, no. 5 (1986): 843–62, http://www.jstor.org/stable/2297722. 6.See Adam B. Summers, “Occupational Licensing: Ranking the States and Exploring Alternatives,” Reason Foundation Policy Study no. 361, July 2007, http://reason.org/news/show/occupational-licensing-ranking. 7.See Carpenter et al., “License to Work.” 8.See Carpenter et al., “License to Work.” 9.See Morris M.

Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition by Kindleberger, Charles P., Robert Z., Aliber

active measures, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, Boeing 747, Bonfire of the Vanities, break the buck, Bretton Woods, British Empire, business cycle, buy and hold, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, Corn Laws, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cross-border payments, currency peg, currency risk, death of newspapers, debt deflation, Deng Xiaoping, disintermediation, diversification, diversified portfolio, edge city, financial deregulation, financial innovation, Financial Instability Hypothesis, financial repression, fixed income, floating exchange rates, George Akerlof, German hyperinflation, Glass-Steagall Act, Herman Kahn, Honoré de Balzac, Hyman Minsky, index fund, inflation targeting, information asymmetry, invisible hand, Isaac Newton, Japanese asset price bubble, joint-stock company, junk bonds, large denomination, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Mary Meeker, Michael Milken, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, price stability, railway mania, Richard Thaler, riskless arbitrage, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, special drawing rights, Suez canal 1869, telemarketer, The Chicago School, the market place, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, very high income, Washington Consensus, Y2K, Yogi Berra, Yom Kippur War

He added: ‘If speculators could find unlimited credit, one can’t tell what crises would ensue.’8 The moral hazard dilemma is that policy measures undertaken to provide stability to the system during this crisis may encourage speculation during the next expansion by those who seek exceptionally high returns and who have become somewhat convinced that there is a strong likelihood that the government will adopt measures to prevent the economy from imploding – and so their losses on the downside will be limited. A ‘free lunch’ for the speculators today means that they are likely to be less prudent in the future. Hence the next several financial crises could be more severe. The moral hazard problem is a strong argument for non-intervention as a financial crisis develops, to reduce the likelihood and severity of future crises.

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The traditional debate is between those who believe that the government should not intervene to save firms that are financially challenged; those who advance this view believe that if asset prices decline sufficiently sharply, the markets eventually will stabilize and investors who had been waiting on the sidelines will then buy the institutions that had lost most of their capital. Those who support this view subscribe to the moral hazard position that the next financial crisis will be more severe because the lenders would believe that they will be bailed out. The challenge to this view is that each of these crises is different, and that the economic costs of not stabilizing the system are severe. Moreover, the moral hazard view fails to distinguish between government intervention to stabilize a single failing firm, and intervention to stabilize a group of firms as a real estate bubble implodes.

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The Italian literature calls the process the ‘salvage’ of banks and companies; the British in 1974–75 referred to saving the fringe banks as a ‘lifeboat’ operation. Issues related to a domestic lender of last resort are the focus of Chapter 11 – primarily whether there should be such a lender, who this lender should be and how it should operate. A key topic is ‘moral hazard’ – if investors are confident that they will be ‘bailed out’ by a lender of last resort, their self-reliance may be weakened. But on the other hand, the priority may be to stop the panic, to ‘save the system today’ despite the adverse effects on the incentives of investors. If there is a lender of last resort, however, whom should it save?

The Price of Time: The Real Story of Interest by Edward Chancellor

"World Economic Forum" Davos, 3D printing, activist fund / activist shareholder / activist investor, Airbnb, Alan Greenspan, asset allocation, asset-backed security, assortative mating, autonomous vehicles, balance sheet recession, bank run, banking crisis, barriers to entry, Basel III, Bear Stearns, Ben Bernanke: helicopter money, Bernie Sanders, Big Tech, bitcoin, blockchain, bond market vigilante , bonus culture, book value, Bretton Woods, BRICs, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, cashless society, cloud computing, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, commodity super cycle, computer age, coronavirus, corporate governance, COVID-19, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cryptocurrency, currency peg, currency risk, David Graeber, debt deflation, deglobalization, delayed gratification, Deng Xiaoping, Detroit bankruptcy, distributed ledger, diversified portfolio, Dogecoin, Donald Trump, double entry bookkeeping, Elon Musk, equity risk premium, Ethereum, ethereum blockchain, eurozone crisis, everywhere but in the productivity statistics, Extinction Rebellion, fiat currency, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, Flash crash, forward guidance, full employment, gig economy, Gini coefficient, Glass-Steagall Act, global reserve currency, global supply chain, Goodhart's law, Great Leap Forward, green new deal, Greenspan put, high net worth, high-speed rail, housing crisis, Hyman Minsky, implied volatility, income inequality, income per capita, inflation targeting, initial coin offering, intangible asset, Internet of things, inventory management, invisible hand, Japanese asset price bubble, Jean Tirole, Jeff Bezos, joint-stock company, Joseph Schumpeter, junk bonds, Kenneth Rogoff, land bank, large denomination, Les Trente Glorieuses, liquidity trap, lockdown, Long Term Capital Management, low interest rates, Lyft, manufacturing employment, margin call, Mark Spitznagel, market bubble, market clearing, market fundamentalism, Martin Wolf, mega-rich, megaproject, meme stock, Michael Milken, Minsky moment, Modern Monetary Theory, Mohammed Bouazizi, Money creation, money market fund, moral hazard, mortgage debt, negative equity, new economy, Northern Rock, offshore financial centre, operational security, Panopticon Jeremy Bentham, Paul Samuelson, payday loans, peer-to-peer lending, pensions crisis, Peter Thiel, Philip Mirowski, plutocrats, Ponzi scheme, price mechanism, price stability, quantitative easing, railway mania, reality distortion field, regulatory arbitrage, rent-seeking, reserve currency, ride hailing / ride sharing, risk free rate, risk tolerance, risk/return, road to serfdom, Robert Gordon, Robinhood: mobile stock trading app, Satoshi Nakamoto, Satyajit Das, Savings and loan crisis, savings glut, Second Machine Age, secular stagnation, self-driving car, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, Stanford marshmallow experiment, Steve Jobs, stock buybacks, subprime mortgage crisis, Suez canal 1869, tech billionaire, The Great Moderation, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, Thorstein Veblen, Tim Haywood, time value of money, too big to fail, total factor productivity, trickle-down economics, tulip mania, Tyler Cowen, Uber and Lyft, Uber for X, uber lyft, Walter Mischel, WeWork, When a measure becomes a target, yield curve

For instance, if car insurance is priced too cheaply, more bad drivers take to the roads leading to a rise in the number of car accidents. Subsidized home insurance encourages people to build on flood plains or move into hurricane-prone areas. In extremis, moral hazard might induce a policyholder to burn down his house so he can claim on the insurance. Moral hazard also occurs when the interest rate – Galiani’s price of insurance – is set too low. Credit booms occur at times of easy money, when financial risks are mispriced and market participants believe that the authorities will protect them from loss. On the eve of the financial crisis, insurance giant Marsh ran an advertising campaign with the slogan, ‘I risk therefore I am.’

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‘We did not flinch from our post … throughout the succeeding week we made advances which would hardly be credited.’59 Bagehot’s argument that the Bank should serve as lender of last resort was not universally accepted by contemporaries. There was a widespread feeling that such a policy would encourage financial recklessness (moral hazard). During the Black Friday panic, The Times castigated failing banks for operating on insufficient capital: ‘if Private and Joint-stock Banks keep cash balances amounting to little more than five per cent. of their liabilities, they have no right to expect that they can escape the consequences of their recklessness and improvidence by resorting to the Bank of England,’ the Thunderer thundered.60 This controversy heated up after the publication of Lombard Street.

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Until such a doctrine is repudiated by the banking interest, the difficulty of pursuing any sound principle of banking in London will be always very great.61 A sympathetic reviewer of Hankey’s Principles of Banking in The Times warned against suspending the Bank Act: ‘whenever it [suspension] has taken place houses which were insolvent and ought to have fallen beneath the attacks of their distrustful creditors have been enabled to weather the storm only to fall at length into greater ruin.’62 The reviewer didn’t say as much, but had the Bank Charter Act not been suspended during the earlier banking crisis of 1857, Overend Gurney would probably have failed at that date, thus sparing the City from the ‘reign of terror’ nearly a decade later.63 It is no coincidence that the chief proselytizers for central bank accommodation came from banking families. The family fortunes of both Baring and Bagehot were endangered by uncontrolled panics. To be fair, it should be noted that the Bagehot rule, in its original form, sought to mitigate moral hazard. The scion of Stuckey’s recommended that during panics the Bank of England should only lend for a short period, against high-quality collateral and should charge a high rate of interest for its money.fn7 The Bagehot rule is much cited by monetary policymakers in the twenty-first century. After the 2008 global financial crisis, US Treasury Secretary Tim Geithner, a former President of the New York Federal Reserve, referred to Lombard Street as the ‘bible of central banking’.

Capitalism: Money, Morals and Markets by John Plender

activist fund / activist shareholder / activist investor, Alan Greenspan, Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, Black Swan, bond market vigilante , bonus culture, Bretton Woods, business climate, business cycle, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, Cornelius Vanderbilt, corporate governance, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial engineering, financial innovation, financial intermediation, Fractional reserve banking, full employment, Glass-Steagall Act, God and Mammon, Golden arches theory, Gordon Gekko, greed is good, Hyman Minsky, income inequality, industrial research laboratory, inflation targeting, information asymmetry, invention of the wheel, invisible hand, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, joint-stock company, Joseph Schumpeter, labour market flexibility, liberal capitalism, light touch regulation, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, mass immigration, means of production, Menlo Park, money market fund, moral hazard, moveable type in China, Myron Scholes, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Paul Samuelson, plutocrats, price stability, principal–agent problem, profit motive, proprietary trading, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, Veblen good, We are the 99%, Wolfgang Streeck, zero-sum game

Long before they acquired their monetary policy role – tightening and relaxing monetary conditions by, for example, raising or reducing interest rates – they acted as lenders of last resort to solvent banks that might otherwise have failed as a result of a contagious financial panic. Given the moral hazard arising from the reduction of market discipline implicit in last-resort lending and the similar moral hazard arising from the introduction of deposit insurance from the 1930s onwards, the central banks also acquired a role in regulating and supervising banks. Yet when Alan Greenspan was chairman of the Federal Reserve as the housing bubble inflated, he conspicuously failed to fulfil the Fed’s mandate to supervise the subprime mortgage market.

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If a bank failed, creditors had recourse to all the personal assets of the individual partners. Once partnerships turned themselves into joint stock companies, the shareholders still enjoyed unlimited potential for gain but could never lose more than the amount they spent buying shares in the bank. This asymmetry was morally hazardous in that it encouraged greater risk taking. And in the nineteenth and twentieth centuries, commercial banks took more risks by extending their traditional deposit-taking and lending operations into investment banking and securities trading. Investment banking, which consists of issuing and distributing shares on behalf of corporate clients and making markets in shares, has a buccaneering culture wholly different from that of commercial banking.

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There is always some jurisdiction, after all, in which the rules are looser than in most of the countries where a given bank is domiciled. As risk accumulates in areas that watchdogs find hard to monitor, the seeds of another crisis are sown. Come the crash, another round of imperfect re-regulatory measures is imposed. And so on, indefinitely. This vicious circle, when combined with morally hazardous bailouts when banks go bust, helps explain why there have been more than 100 major banking crises worldwide over the past three decades.49 This process of regulatory escalation can be clearly seen in the Basel capital accords, the international agreements referred to earlier governing the amount of capital banks must maintain.

The Price of Inequality: How Today's Divided Society Endangers Our Future by Joseph E. Stiglitz

affirmative action, Affordable Care Act / Obamacare, airline deregulation, Alan Greenspan, Andrei Shleifer, banking crisis, barriers to entry, Basel III, battle of ideas, Bear Stearns, behavioural economics, Berlin Wall, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collapse of Lehman Brothers, collective bargaining, colonial rule, corporate governance, Credit Default Swap, Daniel Kahneman / Amos Tversky, Dava Sobel, declining real wages, deskilling, electricity market, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, framing effect, full employment, George Akerlof, Gini coefficient, Glass-Steagall Act, Great Leap Forward, income inequality, income per capita, indoor plumbing, inflation targeting, information asymmetry, invisible hand, jobless men, John Bogle, John Harrison: Longitude, John Markoff, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Arrow, Kenneth Rogoff, London Interbank Offered Rate, lone genius, low interest rates, low skilled workers, Marc Andreessen, Mark Zuckerberg, market bubble, market fundamentalism, mass incarceration, medical bankruptcy, microcredit, moral hazard, mortgage tax deduction, negative equity, obamacare, offshore financial centre, paper trading, Pareto efficiency, patent troll, Paul Samuelson, Paul Volcker talking about ATMs, payday loans, Phillips curve, price stability, profit maximization, profit motive, public intellectual, purchasing power parity, race to the bottom, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Savings and loan crisis, search costs, shareholder value, short selling, Silicon Valley, Simon Kuznets, spectrum auction, Steve Jobs, stock buybacks, subprime mortgage crisis, technology bubble, The Chicago School, The Fortune at the Bottom of the Pyramid, The Myth of the Rational Market, The Spirit Level, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, Tragedy of the Commons, transaction costs, trickle-down economics, ultimatum game, uranium enrichment, very high income, We are the 99%, wealth creators, women in the workforce, zero-sum game

They did set aside about $50 billion from the Toxic Asset Relief Program for mortgage restructuring, but interestingly, the Obama administration has spent only about $3.4 billion of this amount—suggesting that it was the resistance of the banks, more than the money itself, that has been the real impediment to restructuring. 48. Even the use of the term “moral hazard” (as opposed the more neutral term “incentive effects”) has emotive overtones, suggesting that there is something immoral about these particular incentive responses. As the University of Pennsylvania law professor Tom Baker put it, the term “helps deny that refusing to share [the burdens of life] is mean-spirited or self-interested.” (Quoted in Shaila Dewan, “Moral Hazard: A Tempest-tossed Idea,” New York Times, February 26, 2012, p. BU1.) In fact, there is little evidence that there would be serious “moral hazard consequences” even of a generous program to help homeowners.

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Shaun Donovan, secretary of the Department of Housing and Urban Development, argues that “only about 10 or 15 percent of Americans who can still pay their mortgages try to walk away from their debt.” Ibid. The general theory of moral hazard was developed in the midsixties and seventies by Arrow, Mirrlees, Ross, and Stiglitz. See, e.g., Kenneth Arrow, Aspects of the Theory of Risk Bearing (Helsinki, Finland: Yrjö Jahnssonin Säätiö, 1965); James Mirrlees, “The Theory of Moral Hazard and Unobservable Behaviour I,” Review of Economic Studies 66, no. 1 (1999): 3–21; S. Ross, “The Economic Theory of Agency: The Principal’s Problem,” American Economic Review 63, no. 2 (1973): 134–39; and J.

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It would be “unfair” to help those who were struggling with their mortgages when there were so many good and responsible citizens who had worked hard and paid off their mortgage, or were able to make their current payments. Furthermore, offering relief to homeowners would exacerbate the problem of moral hazard: if individuals were left off the hook, it would undermine incentives to repay.48 What was curious about these arguments was that they could have applied just as easily, and with greater force, to the banks. The banks had repeatedly been bailed out. The Mexican bailout of 1995, the Indonesian, Thai, and Korean bailouts of 1997–98, the Russian bailout of 1998, the Argentinean bailout of 2000, these and others were all really bank bailouts, though they carried the name of the country where banks had lent excessively.

A Theory of the Drone by Gregoire Chamayou

drone strike, failed state, Francis Fukuyama: the end of history, Jeff Hawkins, junk bonds, military-industrial complex, moral hazard, Necker cube, operational security, Panopticon Jeremy Bentham, private military company, RAND corporation, Seymour Hersh, telepresence, Yom Kippur War

What this argument postulates is that those other means really would have been used—in other words, that the military action would have taken place anyway, and it’s just a question of which weapon is used. But that is precisely what the moral hazard associated with drones renders doubtful. The sophistry becomes clear when one reflects that those other means might never have been employed because of the prohibitively high reputational costs associated with them. Another way of putting that is to say that in a situation of moral hazard, military action is very likely to be deemed “necessary” simply because it is possible, and possible at a lower cost.10 In such cases, it is necessarily false to say that the drone has inflicted less collateral damage: as Jeremy Hammond sums up, the number of civilian victims “of course isn’t lower than it would be if there weren’t drone strikes, in which case precisely zero civilians would be killed in them.”11 The second objection concerns the cumulativeness of lesser evils.

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As John Kaag and Sarah Kreps write, given that “remote-controlled machines cannot suffer the consequences [of their actions] and the humans who operate them do so at a great distance, the myth of Gyges is more a parable of modern counterterrorism than it is about terrorism.”1 Freed from the constraints imposed by reciprocal relations, will the drone masters be able to continue to demonstrate virtue and to resist the temptation to commit injustice with virtually no sanction imposed? That question, to which we shall return, raises the matter of moral hazard. But there is another way of posing the problem. If it remains true that “the strongest is never strong enough to be always the master, unless he transforms his strength” into virtue,2 we may ask ourselves the following question: what kind of right or virtue is needed by these modern Gyges? Let us put that question another way: not whether the invisible man can be virtuous, but what redefinition of virtue will he need if he wishes to persist in calling himself virtuous and considering himself to be so even in his own eyes.

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Assuming that the democratic commander in chief is a rational agent, how will the “low cost” of this weapon affect his decisions? The main effect is to introduce a massive bias into his decision. Any agent who can take action with fewer risks to himself or his camp is likely to adopt a riskier pattern of behavior—that is to say, riskier for others. Similarly, the drone is a classic “moral hazard”—a situation in which being able to act without bearing the costs of the consequences relieves agents of responsibility for their decisions.8 More precisely, we are told that drones introduce a threefold reduction in the costs traditionally attached to the use of armed force: a reduction of the political costs associated with the loss of national lives, a reduction of the economic costs associated with armament, and a reduction of the ethical or reputational costs associated with the perceived effects of the violence that is committed.9 That last point is very important.

The Corruption of Capitalism: Why Rentiers Thrive and Work Does Not Pay by Guy Standing

"World Economic Forum" Davos, 3D printing, Airbnb, Alan Greenspan, Albert Einstein, Amazon Mechanical Turk, anti-fragile, Asian financial crisis, asset-backed security, bank run, banking crisis, basic income, Ben Bernanke: helicopter money, Bernie Sanders, Big bang: deregulation of the City of London, Big Tech, bilateral investment treaty, Bonfire of the Vanities, Boris Johnson, Bretton Woods, business cycle, Capital in the Twenty-First Century by Thomas Piketty, carried interest, cashless society, central bank independence, centre right, Clayton Christensen, collapse of Lehman Brothers, collective bargaining, commons-based peer production, credit crunch, crony capitalism, cross-border payments, crowdsourcing, debt deflation, declining real wages, deindustrialization, disruptive innovation, Doha Development Round, Donald Trump, Double Irish / Dutch Sandwich, ending welfare as we know it, eurozone crisis, Evgeny Morozov, falling living standards, financial deregulation, financial innovation, Firefox, first-past-the-post, future of work, Garrett Hardin, gentrification, gig economy, Goldman Sachs: Vampire Squid, Greenspan put, Growth in a Time of Debt, housing crisis, income inequality, independent contractor, information retrieval, intangible asset, invention of the steam engine, investor state dispute settlement, it's over 9,000, James Watt: steam engine, Jeremy Corbyn, job automation, John Maynard Keynes: technological unemployment, labour market flexibility, light touch regulation, Long Term Capital Management, low interest rates, lump of labour, Lyft, manufacturing employment, Mark Zuckerberg, market clearing, Martin Wolf, means of production, megaproject, mini-job, Money creation, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, Neil Kinnock, non-tariff barriers, North Sea oil, Northern Rock, nudge unit, Occupy movement, offshore financial centre, oil shale / tar sands, open economy, openstreetmap, patent troll, payday loans, peer-to-peer lending, Phillips curve, plutocrats, Ponzi scheme, precariat, quantitative easing, remote working, rent control, rent-seeking, ride hailing / ride sharing, Right to Buy, Robert Gordon, Ronald Coase, Ronald Reagan, Sam Altman, savings glut, Second Machine Age, secular stagnation, sharing economy, Silicon Valley, Silicon Valley startup, Simon Kuznets, SoftBank, sovereign wealth fund, Stephen Hawking, Steve Ballmer, structural adjustment programs, TaskRabbit, The Chicago School, The Future of Employment, the payments system, The Rise and Fall of American Growth, Thomas Malthus, Thorstein Veblen, too big to fail, Tragedy of the Commons, Travis Kalanick, Uber and Lyft, Uber for X, uber lyft, Y Combinator, zero-sum game, Zipcar

Some subsidies might be acceptable from an economic viewpoint if they were designed to compensate for ‘externalities’ (public benefits not reflected in the market price) and thus promote desired behaviour, such as investment in renewable energy or land conservation. However, most are not designed for this purpose and have nothing to do with creating or sustaining free markets. Subsidies involve moral hazards, inducing people or firms to behave in unethical ways just to qualify to receive them. Employment subsidy schemes exemplify one type of moral hazard known as the ‘deadweight effect’. Widely practised in industrialised countries, these costly schemes pay firms that increase employment. Evaluations have found that as many as nine out of every ten jobs for which the subsidy was paid would have been created anyway, without the subsidy.1 Politicians deceive in claiming that all those subsidised jobs result from the subsidy scheme, yet journalists report such claims as gospel.

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Evaluations have found that as many as nine out of every ten jobs for which the subsidy was paid would have been created anyway, without the subsidy.1 Politicians deceive in claiming that all those subsidised jobs result from the subsidy scheme, yet journalists report such claims as gospel. Another moral hazard is associated with subsidies that pay firms to take on particular types of worker, such as youth or the long-term unemployed. This is ‘substitution’ – firing existing workers in order to take on others for whom the firm can claim a subsidy.2 In reality, moral hazards arise with most subsidies. Politically, one advantage of subsidies is their relative invisibility. Most who do not receive them are unaware of how much they are worth for those who do, or even that they exist.

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The assurance of intervention amounts to a regressive subsidy to the affluent, who own shares. There is no macroeconomic justification for propping up stock markets. Research shows that declines in equities have little long-term adverse effect on the economy, since they affect only the wealthy. Central bank intervention also creates a moral hazard, since the message is passed that investors can take risks with impunity. It thus encourages rent-seeking speculation, making money from money, not from producing anything. This is one way by which independent central banks have pursued regressive policies, storing up problems for the future. Monetary policy has been recalibrated as central banks have become more secure from democratic accountability.

The Corona Crash: How the Pandemic Will Change Capitalism by Grace Blakeley

Anthropocene, asset-backed security, basic income, Big Tech, bond market vigilante , Bretton Woods, business cycle, capital controls, carbon tax, central bank independence, coronavirus, corporate governance, COVID-19, creative destruction, credit crunch, crony capitalism, debt deflation, decarbonisation, degrowth, deindustrialization, don't be evil, financial deregulation, Francis Fukuyama: the end of history, full employment, gig economy, global pandemic, global value chain, green new deal, Greenspan put, income inequality, informal economy, inverted yield curve, invisible hand, Jeff Bezos, liberal capitalism, light touch regulation, lockdown, low interest rates, Martin Wolf, Modern Monetary Theory, moral hazard, move fast and break things, Network effects, North Sea oil, Northern Rock, offshore financial centre, pensions crisis, Philip Mirowski, post-war consensus, price mechanism, quantitative easing, regulatory arbitrage, rent control, reshoring, Rishi Sunak, savings glut, secular stagnation, shareholder value, social distancing, structural adjustment programs, too big to fail, universal basic income, unorthodox policies, Washington Consensus, yield curve

Regardless of their productivity, the sustainability of their business models or their environmental impact, the world’s largest firms will exit the current crisis with even more market power than they currently have. But the level of support being provided suggests that central banks are creating a problem of moral hazard – shielding investors, banks and businesses from the risks they took during the upswing of the economic cycle as soon as the downturn begins.20 Many though certainly not all corporations may also be rescued by outright nationalisation, to tide them over this sticky patch. The airline industry is a case in point.

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And with airlines like British Airways, Singapore Airlines and Cathay Pacific all having been forced to ground more than 90 per cent of their fleets, more nationalisations are likely to follow, even allowing for a destabilising Lehman Brothers-type exception to the rule, possibly involving the likes of Virgin Atlantic. The present combination of state-provided liquidity and full-on bailouts mirrors the extraordinary interventions undertaken by states in the Global North to save their finance sectors in 2008 – only this time, the money is being directed towards the entire corporate sector. Moral hazard is a genuine issue – irresponsible lenders and uncreditworthy businesses are being protected by the state – but no one is seriously suggesting that the global economy be allowed to implode. States and central banks are now being forced to engage in the active planning of their entire economies under the imperial coordination of the Federal Reserve.

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Ongoing centralisation during the pandemic will strengthen links between business and the state on the one hand – states will become more dependent upon these businesses for tax revenues and political funding, while the businesses will become more interested in regulation and tax policy – and businesses and the banks that manage their cash on the other. In other words, we will increasingly see private planning of the economy. Free market, competitive capitalism – if it ever actually existed – is dead. Many economic libertarians would recognise this critique. They frequently complain about moral hazard and loose monetary policy, blaming the overactivity of the state for the emergence of a form of ‘crony capitalism’ characterised by market centralisation, complex regulation and low productivity, and arguing for a return to a purer, more competitive, freer version of capitalism. These arguments are generally pitted against those of social democrats, who respond that state intervention is necessary to mitigate the ups and downs of the business cycle – to protect workers from the caprices of capitalist accumulation.

War and Gold: A Five-Hundred-Year History of Empires, Adventures, and Debt by Kwasi Kwarteng

accounting loophole / creative accounting, Alan Greenspan, anti-communist, Asian financial crisis, asset-backed security, Atahualpa, balance sheet recession, bank run, banking crisis, Bear Stearns, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business cycle, California gold rush, capital controls, Carmen Reinhart, central bank independence, centre right, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, currency manipulation / currency intervention, Deng Xiaoping, discovery of the americas, Etonian, eurozone crisis, fiat currency, financial engineering, financial innovation, fixed income, floating exchange rates, foreign exchange controls, Francisco Pizarro, full employment, German hyperinflation, Glass-Steagall Act, guns versus butter model, hiring and firing, income inequality, invisible hand, Isaac Newton, it's over 9,000, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, land bank, liberal capitalism, low interest rates, market bubble, money: store of value / unit of account / medium of exchange, moral hazard, new economy, Nixon triggered the end of the Bretton Woods system, oil shock, plutocrats, Ponzi scheme, price mechanism, quantitative easing, rolodex, Ronald Reagan, South Sea Bubble, subprime mortgage crisis, Suez canal 1869, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the market place, The Wealth of Nations by Adam Smith, too big to fail, War on Poverty, Yom Kippur War

In his later work on the euro, Issing summarized the problem of ‘moral hazard’ which the euro created. ‘Moral hazard’ is a term in economics which has been defined as the ‘presence of incentives for individuals or institutions to act in ways that incur costs they do not have to bear’.39 One common instance of moral hazard exists in the case of insurance. Economists have observed that possessions which are insured are less well looked after than those without insurance. In 2008, just before the Greek sovereign-debt crisis, Issing wrote that the nations of the eurozone were conducting their fiscal policy under the condition of moral hazard. He wrote: ‘In a single currency area, the political benefit from deficit spending (gaining votes) is enjoyed by national [italics in original] players, while the potential negative effects in the form of higher interest rates (due to increased government borrowing) are felt by all [italics in original] member states.’

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Lehman’s demise had wider repercussions, the reverberations of which were felt, and argued about, for years. Lehman’s problems raised the issue of moral hazard, which has already been referred to in connection with problems associated with the creation of the euro. It was decided, as Lehman tottered and eventually fell, not to ‘bail out’ the bank in order not to create moral hazard. ‘The idea that borrowers should be allowed to escape is one example of “moral hazard”,’ wrote Philip Coggan. ‘Let the borrowers believe they will be rescued from their folly . . . and they will never meet their responsibilities.’

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He wrote: ‘In a single currency area, the political benefit from deficit spending (gaining votes) is enjoyed by national [italics in original] players, while the potential negative effects in the form of higher interest rates (due to increased government borrowing) are felt by all [italics in original] member states.’ This state of affairs ensured that ‘the resistance to deficit spending is reduced, and the propensity to pursue an (inappropriate) expansionary fiscal policy increases – a typical case of what is known as moral hazard [italics in original]’.40 Observations similar to those made by Issing in 2008 were made by Germans sceptical about the single-currency euro project at the very beginning of the 1990s. Indeed the scale of initial German distrust of the single currency is something which is often overlooked as the German economy came to be regarded as the anchor of the eurozone, and the German political elite began to see themselves as guardians and guarantors of the euro.

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

accounting loophole / creative accounting, Alan Greenspan, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, business cycle, capital controls, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, Greenspan put, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, low interest rates, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, money market fund, moral hazard, mortgage tax deduction, Naomi Klein, National Debt Clock, new economy, Northern Rock, Own Your Own Home, precautionary principle, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

When the United States got a central bank (the Fed) in 1914, its bank supervisor, the Office of the Comptroller of the Currency, happily declared that "financial and commercial crises or panics ... seem to be mathematically impossible."4 That, unfortunately, was wrong, because another effect was that banks and investors no longer stayed clear of big risks once they knew that they would be bailed out if there was a crisis. In fact, they were all of a sudden given an incentive to act irresponsibly, as they could privatize any gains but socialize any losses. This is usually referred to as "moral hazard." In his classic history of financial crises, Charles Kindleberger explains it thus: "The dilemma is that if investors knew in advance that government support would be forthcoming under generous dispensation when asset prices fall sharply, markets might break down somewhat more frequently because investors will be less cautious in their purchases of assets and of securities."5 What's more, in 1933 the United States introduced deposit insurance, meaning that savers would get their money back even if their bank went out of business.

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That may not be a solution that he himself advocates, but he still thinks it would be better than today's system: "Given the frequency of banking crises, this might be a big improvement."' To limit the risk taking that government protection has encouraged, governments may demand to know more about what banks are up to, and if banks get into trouble, they may bail out depositors but let stockholders and senior executives lose their money and jobs. Another way to deal with moral hazard is to require banks not to lend too much relative to their capital. Under Basel I, capital requirements were calculated on the basis of a five-way breakdown of banks' assets. The assets that were deemed not to be in the least dangerous, such as cash or lending to Organization for Economic Cooperation and Development governments, did not count as risks at all, whereas the most precarious assets, such as lending to most corporations, counted at a rate of 100 percent.

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Morgenson, "Debt Watchdogs." 12. Tett and Davies, "Out of the Shadows." 13. Berkshire Hathaway Inc., 2002 Annual Report, p. 13ff. 14. Krugrnan, "After the Money's Gone." 15. Fortune, "101 Dumbest Moments in Business." 16. The Economist, "On Credit Watch." 17. Stafford, "Traders Blind to Mounting Worries." 18. Dowd, "Moral Hazard and the Financial Crisis." 19. Reuters, "`US Homes Market Will Shed Investor Glut."' 20. Hilzenrath, "Fannie's Perilous Pursuit of Subprime Loans." 21. The Economist, "Fannie and Freddie Ride Again"; Duhigg, "Doubts Raised on Big Backers of Mortgages." 22. Duhigg, "At Freddie Mac, Chief Discarded Warning Signs." 23.

The Enigma of Capital: And the Crises of Capitalism by David Harvey

accounting loophole / creative accounting, Alan Greenspan, anti-communist, Asian financial crisis, bank run, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, cotton gin, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, equal pay for equal work, European colonialism, failed state, financial innovation, Frank Gehry, full employment, gentrification, Glass-Steagall Act, global reserve currency, Google Earth, Great Leap Forward, Guggenheim Bilbao, Gunnar Myrdal, guns versus butter model, Herbert Marcuse, illegal immigration, indoor plumbing, interest rate swap, invention of the steam engine, Jane Jacobs, joint-stock company, Joseph Schumpeter, Just-in-time delivery, land reform, liquidity trap, Long Term Capital Management, market bubble, means of production, megacity, microcredit, military-industrial complex, Money creation, moral hazard, mortgage debt, Myron Scholes, new economy, New Urbanism, Northern Rock, oil shale / tar sands, peak oil, Pearl River Delta, place-making, Ponzi scheme, precariat, reserve currency, Ronald Reagan, Savings and loan crisis, sharing economy, Shenzhen special economic zone , Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, subprime mortgage crisis, technological determinism, the built environment, the market place, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, Timothy McVeigh, too big to fail, trickle-down economics, urban renewal, urban sprawl, vertical integration, white flight, women in the workforce

Current chair of the White House’s National Economic Council Larry Summers, in a telling analysis of the effects of government bail-outs on financial behaviour in the wake of the stock market crash of 1987, clearly saw where the problems of moral hazard might lead, but concluded that the effects of government not standing behind financial institutions would be far worse than the effects of always bailing them out. The policy problem was not to avoid but to constrain moral hazard. Unfortunately, when Treasury Secretary in the late 1990s he forgot his own analysis and promoted exactly the kind of unconstrained moral hazard that he had earlier shown might wreck the economy (a clear case of denial in action). Paul Volcker, past chair of the Federal Reserve, warned of a financial crash within five years back in 2004.

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Put crudely, the policy was: privatise profits and socialise risks; save the banks and put the screws on the people (in Mexico, for example, the standard of living of the population dropped by about a quarter in four years after the financial bail-out of 1982). The result was what is known as systemic ‘moral hazard’. Banks behave badly because they do not have to be responsible for the negative consequences of high-risk behaviour. The current bank bail-out is this same old story, only bigger and this time centred in the United States. In the same way that neoliberalism emerged as a response to the crisis of the 1970s, so the path being chosen today will define the character of capitalism’s further evolution.

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The United States promptly reinvigorated the international Monetary Fund (IMF) (which the reagan administration had sought to de-fund in 1981 in accordance with strict neoliberal principle) as the global disciplinarian that would ensure that the banks would get their money back and that the people would be forced to pay up. IMF ‘structural adjustment programs’, which mandated austerity in order to pay back the banks, thereafter proliferated around the world. The result was a rising tide of ‘moral hazard’ in international bank lending practices. For a while, this practice was hugely successful. On the twentieth anniversary of the Mexican bail-out the chief economists from Morgan Stanley hailed it as ‘a factor that set the stage of increasing investor confidence worldwide and helped to ignite the growth market of the late 1990s, along with a strong US economic expansion’.

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

Alan Greenspan, American ideology, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Bonfire of the Vanities, bonus culture, book value, break the buck, business cycle, business logic, buy and hold, capital controls, Carmen Reinhart, central bank independence, Charles Lindbergh, collapse of Lehman Brothers, collateralized debt obligation, commoditize, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency risk, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Glass-Steagall Act, Gordon Gekko, greed is good, Greenspan put, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, junk bonds, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, Martin Wolf, Michael Milken, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, proprietary trading, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, Savings and loan crisis, sovereign wealth fund, Tax Reform Act of 1986, The Myth of the Rational Market, too big to fail, transaction costs, Tyler Cowen, value at risk, yield curve

Figure 6-1 shows the perceived likelihood that major banks would go bankrupt, as measured by the price of credit default swap protection on their debt; each time the government intervened, the market’s fears ebbed, until finally the stress tests broke the year-long fever. That was what Wall Street needed to hear: they could go back to doing business as usual, and Washington would be there if things went wrong. A panic that began with an attempt to reduce moral hazard by letting Lehman fail only ended when everyone was convinced that the government would not let another major bank fail—magnifying moral hazard to an unprecedented degree. And as the real economy began to bottom out over the summer, it became easier and easier to make money again. But this was only true for the major banks; in the real economy, it became harder and harder to get a loan.

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Support by the Federal Reserve can take two broad forms: liquidity loans, where the Fed gives a bank a short-term loan that can be rolled over repeatedly; and lower interest rates, which help banks by promoting economic growth and increasing the chances that bank loans will be paid back.* These steps can mitigate individual disasters. However, the existence of government insurance against a worst-case scenario creates “moral hazard”—the incentive for banks to take on more risk in order to maximize shareholder returns—thereby laying the groundwork for the next system-wide crisis. Each emergency rescue only increases banks’ confidence that they will be rescued in the future, creating a cycle of repeated booms, busts, and bailouts.72 In principle, in exchange for providing this insurance, the Federal Reserve would supervise the banks it was protecting, preventing them from taking too much risk.

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As Figure 1-1 demonstrates, the half-century following the Glass-Steagall Act saw by far the fewest bank failures in American history.103 But once financial deregulation began in the 1970s, these low equity levels became increasingly dangerous.104 Figure 1-1: Bank Suspensions and Failures Per Year, 1864—Present * Actual values for 1930-33 are 1,352, 2,294, 1,456, and 4,004. Source: David Moss, “An Ounce of Prevention: Financial Regulation, Moral Hazard, and the End of ‘Too Big to Fail,’” Harvard Magazine, September–October 2009. Used with the permission of Mr. Moss. Updated with data from FDIC, “Failures and Assistance Transactions.” Some of the regulations in place during this period may have been excessive. For example, it’s not clear that limiting banks to a single state—a long-standing rule in the United States that was reaffirmed in the 1930s—makes them safer (other than by restricting competition, which increases their profits).

Big Debt Crises by Ray Dalio

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, basic income, Bear Stearns, Ben Bernanke: helicopter money, break the buck, Bretton Woods, British Empire, business cycle, buy the rumour, sell the news, capital controls, central bank independence, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, currency risk, declining real wages, equity risk premium, European colonialism, fiat currency, financial engineering, financial innovation, foreign exchange controls, German hyperinflation, global macro, housing crisis, implied volatility, intangible asset, it's over 9,000, junk bonds, Kickstarter, land bank, large denomination, low interest rates, manufacturing employment, margin call, market bubble, market fundamentalism, military-industrial complex, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Northern Rock, Ponzi scheme, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, refrigerator car, reserve currency, risk free rate, Savings and loan crisis, short selling, short squeeze, sovereign wealth fund, subprime mortgage crisis, too big to fail, transaction costs, universal basic income, uptick rule, value at risk, yield curve

Unlike in the Great Depression, when the Fed allowed banks to fail en masse, the Fed took the view that although it would be good to minimize moral hazard when possible, its top priority had to be saving the economy. Tim Geithner, who was the president of the New York Fed at the time, shared my thinking. He believed the moral hazard framework was the wrong way to think about policy during a financial crisis because policy needs to be very aggressive in taking out catastrophic risk, and one can’t move slowly or precisely.13 That has proven true time and time again. Providing plenty of liquidity during a liquidity crisis leaves the government open to less risk and leaves the system healthier. In contrast, the moral hazard framework leads people to believe that if you let things burn, the government will assume less risk.

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–New York Times September 21, 2007 Economic Indicators Drop the Most in 6 Months as Confidence Ebbs –Bloomberg September 22, 2007 Fed Governor Warns Against Shielding Investors From Their Losses –Bloomberg September 24, 2007 Beware Moral Hazard Fundamentalists “The term ‘moral hazard’ originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precautions with respect to avoiding fire or when holders of health insurance use more healthcare than they would if they were not insured. In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions.

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The other consideration was that the problems all stemmed from wrongheaded speculation, and anything that the Fed did to ameliorate the problems of those speculators would only encourage them to take excessive risks again in the future. This notion of “moral hazard” was one that the Fed (and Treasury) would have to wrestle with many times throughout the crisis. How the “moral hazard” question is dealt with during big debt crises is one of the biggest determinants of how these crises turn out. Because undisciplined lending and borrowing was the cause of crisis, it is natural to want to let those who were responsible experience the consequences of their actions, and to impose lots of discipline by tightening lending and borrowing.

Portfolios of the poor: how the world's poor live on $2 a day by Daryl Collins, Jonathan Morduch, Stuart Rutherford

behavioural economics, Cass Sunstein, clean water, failed state, financial innovation, financial intermediation, income per capita, informal economy, job automation, M-Pesa, mental accounting, microcredit, moral hazard, profit motive, purchasing power parity, RAND corporation, randomized controlled trial, seminal paper, The Fortune at the Bottom of the Pyramid, transaction costs

Dinesh’s illness led to a sell-off of land, and forced his wife to take on added burdens. Only insurance arrangements (or tax-funded public safety nets) can aggregate these kinds of risks, provide urgently needed resources at the right time, and do so without creating additional obligations. Two Sides of Moral Hazard One of the concerns that economists have about insurance is the problem of moral hazard: that being insured for one’s health may also change one’s behavior. The problem arises if the insured start neglecting themselves, knowing they have insurance to cover health problems in the future, which increases the likelihood that they will need insurance.

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Providing insurance profitably also entails high-quality actuarial analysis, careful pricing policies, and wise investments: these are complex skills not widely available outside the formal insurance industry, a fact that makes it hard for informal and semiformal providers to compete with formal providers in the way that they have so spectacularly succeeded in doing for microcredit. On the other hand, insurers like those entering the funeral insurance market in South Africa must not only be confident that moral hazard and fraud are kept to a minimum, but, in order to compete successfully with informal schemes, they must bring down the costs and increase the speed of verifying claims and making payouts. They also need better marketing strategies and better ways of spreading risk through market-based tools. 91 CHAPTER THREE Insurers need help reaching the poorer and more remote groups.

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This efficiency may apply as much to informal as to formal insurance, helping to explain why community-based funeral coverage has thrived in South 92 DEALING WITH RISK Africa, whereas we found no equivalent in the field of health. Other risks that are insurable in principle, such as crop or livestock loss, are harder to implement in practice because of moral hazard, outright fraud, and documentation difficulties—it is notoriously difficult to know exactly whose cow it was that died, or indeed whether it died of natural causes. Because of these limitations, the poor will continue to face many risks that are not easily insurable. The list of common emergencies in table 3.1 includes, for example, violent crime and the failure to receive a payment.

The Middleman Economy: How Brokers, Agents, Dealers, and Everyday Matchmakers Create Value and Profit by Marina Krakovsky

Affordable Care Act / Obamacare, Airbnb, Al Roth, Ben Horowitz, Benchmark Capital, Black Swan, buy low sell high, Chuck Templeton: OpenTable:, Credit Default Swap, cross-subsidies, crowdsourcing, deal flow, disintermediation, diversified portfolio, experimental economics, George Akerlof, Goldman Sachs: Vampire Squid, income inequality, index fund, information asymmetry, Jean Tirole, Joan Didion, John Zimmer (Lyft cofounder), Kenneth Arrow, Lean Startup, Lyft, Marc Andreessen, Mark Zuckerberg, market microstructure, Martin Wolf, McMansion, Menlo Park, Metcalfe’s law, moral hazard, multi-sided market, Network effects, patent troll, Paul Graham, Peter Thiel, pez dispenser, power law, real-name policy, ride hailing / ride sharing, Robert Metcalfe, Sand Hill Road, search costs, seminal paper, sharing economy, Silicon Valley, social graph, supply-chain management, TaskRabbit, the long tail, The Market for Lemons, the strength of weak ties, too big to fail, trade route, transaction costs, two-sided market, Uber for X, uber lyft, ultimatum game, Y Combinator

And yet, as the chapters on Certifiers and Enforcers showed, middlemen must be discriminating to avoid adverse selection and moral hazard. Therefore, to profit from risk, middlemen, like successful insurers, must be astute at teasing apart these two types of risk: •Internal risk. This is my term for what finance scholars call counterparty risk, or risk due to the characteristics or actions of a trading partner. In other words, internal risks are risks caused by asymmetric information (adverse selection and moral hazard). Risk-bearing middlemen should avoid internal risk because it can only harm them and their partners on the other side.

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Not so with services: regardless of service providers’ underlying ability, they can decide how much effort to put in and how honestly to conduct business. Sussing out hidden information about sellers, as Certifiers do, won’t protect buyers from shirking and cheating, problems that can come up after buyers sign on the dotted line. These problems of shirking and cheating, variously called moral hazard, postcontractual opportunism, or hidden action1—are especially acute when a player’s actions are hidden and when buyers and sellers don’t have an ongoing relationship. An ongoing relationship can protect against such problems, as long as the future value of the relationship is higher than the gains from cheating or shirking today.

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The middleman who is able to bear risk can profit from doing so by charging a risk premium, while the more risk-averse party doesn’t mind paying the risk premium to reduce risk. So why don’t we see middlemen bearing most of the risk? The answer to this risk-sharing question goes back to the old problems of adverse selection and moral hazard. Most economic outcomes in the world are some combination of effort and chance (or skill and luck). How many widgets a sales rep sells, for example, depends on how hard the rep works, how good the rep is at sales to begin with, and factors completely outside the rep’s control, from the quality of the widget to the state of the economy.

The Making of Global Capitalism by Leo Panitch, Sam Gindin

accounting loophole / creative accounting, active measures, airline deregulation, Alan Greenspan, anti-communist, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Basel III, Bear Stearns, Big bang: deregulation of the City of London, bilateral investment treaty, book value, Branko Milanovic, Bretton Woods, BRICs, British Empire, business cycle, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, carbon credits, Carmen Reinhart, central bank independence, classic study, collective bargaining, continuous integration, corporate governance, creative destruction, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, dark matter, democratizing finance, Deng Xiaoping, disintermediation, ending welfare as we know it, eurozone crisis, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, foreign exchange controls, full employment, Gini coefficient, Glass-Steagall Act, global value chain, guest worker program, Hyman Minsky, imperial preference, income inequality, inflation targeting, interchangeable parts, interest rate swap, Kenneth Rogoff, Kickstarter, land reform, late capitalism, liberal capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, manufacturing employment, market bubble, market fundamentalism, Martin Wolf, means of production, military-industrial complex, money market fund, money: store of value / unit of account / medium of exchange, Monroe Doctrine, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, new economy, Nixon triggered the end of the Bretton Woods system, non-tariff barriers, Northern Rock, oil shock, precariat, price stability, proprietary trading, quantitative easing, Ralph Nader, RAND corporation, regulatory arbitrage, reserve currency, risk tolerance, Ronald Reagan, Savings and loan crisis, scientific management, seigniorage, shareholder value, short selling, Silicon Valley, sovereign wealth fund, special drawing rights, special economic zone, stock buybacks, structural adjustment programs, subprime mortgage crisis, Tax Reform Act of 1986, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, vertical integration, very high income, Washington Consensus, We are all Keynesians now, Works Progress Administration, zero-coupon bond, zero-sum game

Japan displayed its usual “follow-the-leader mentality” in a case where “neither transnational institutional linkages nor interest in the Mexican rescue were strong.”27 On the other hand, the IMF directors from Germany, the UK, the Netherlands, Belgium, Switzerland, and Norway registered their discomfort with the Treasury’s ultimatum (the Executive Board was given only twenty-four hours to look at the plan) by abstaining on the vote. But this was “as strong a diplomatic sign of disapproval as they felt they could send without undermining the rescue”; they recognized that more than their aversion to “moral hazard” would be at stake if “one of the shining stars of market-oriented reform in the developing world . . . became an international financial pariah.”28 In response to Germany’s continued harping about moral hazard, the IMF’s chief economist, Michael Mussa, commented tersely: “And if we hadn’t rescued 800 people from the Titanic, we would have taught everyone an even more valuable lesson about the dangers of ocean travel.”29 If this crisis was indeed the harbinger of a new level of global financial instability, what was just as significant was that the Mexican crisis was, to a remarkable degree, effectively contained.

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The UK’s 1973 “secondary banking” crisis, which was also due to the collapse of a real-estate bubble, “threatened some of the biggest financial institutions with the real risk of collapse.”86 Moreover, a broad range of European banks were revealing major losses amid the volatility in short-term capital flows that were initially triggered by both floating currencies and the recycling of petrodollars. This came to a head in June 1974, when the Bundesbank allowed Bankhaus I.D. Herstatt of Cologne, one of Germany’s largest private banks, to collapse. Apart from the Bundesbank’s traditional obsession with a tight monetary policy, this was justified in terms of avoiding “moral hazard’—that is, “to teach speculators, as well as banks dealing with speculators, a lesson.”87 But in contrast to the carefully managed Franklin crisis that the Fed and OCC were engaged in, the consequence of the Bundesbank’s action was that the Herstatt crisis immediately spilled over to the international interbank lending markets, including nearly collapsing the New York clearing house, CHIPS, which connects the dozen or so largest US banks with major banks around the world in processing payments among them primarily related to foreign exchange transactions.

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The pattern of letting banks that were too small to matter go under, while acting as lender of last resort to save the ones that were “too big to fail” was set in 1982, when Volcker bluntly told the Federal Open Market Committee (FOMC): “If it gets bad enough, we can’t stay on the side or we’ll have a major liquidity crisis. It’s a matter of judgment as to when and how strongly to react. We are not here to see the economy destroyed in the interest of not bailing somebody out.”78 The “moral hazard” tightrope that the state had to walk in this respect was nothing compared with the practical hazard involved in figuring out whether allowing even a small bank to collapse might have systemic effects. This was vividly demonstrated in the summer of 1982, when the decision to close a small Oklahoma bank, Penn Square, immediately endangered Continental Illinois, the sixth-largest commercial bank in the US, which then immediately turned to the international interbank market for its funding.

The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope by John A. Allison

Affordable Care Act / Obamacare, Alan Greenspan, American ideology, bank run, banking crisis, Bear Stearns, Bernie Madoff, business cycle, clean water, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, fiat currency, financial innovation, Fractional reserve banking, full employment, Greenspan put, high net worth, housing crisis, inverted yield curve, invisible hand, life extension, low skilled workers, market bubble, market clearing, minimum wage unemployment, money market fund, moral hazard, negative equity, obamacare, open immigration, Paul Samuelson, price mechanism, price stability, profit maximization, quantitative easing, race to the bottom, reserve currency, risk/return, Robert Shiller, subprime mortgage crisis, The Bell Curve by Richard Herrnstein and Charles Murray, too big to fail, transaction costs, Tyler Cowen, yield curve, zero-sum game

In October 2010, as an ex-CEO, Mozilo settled out of court on civil fraud charges for misleading investors on risky mortgages, but Countrywide’s buyer (Bank of America) ended up paying most of the $67 million to the SEC. Bank of America also paid $600 million to settle a class-action lawsuit filed by Countrywide’s robbed shareholders. 6. See Bert Ely, “Financial Innovation and Deposit Insurance: The 100% Cross-Guarantee Concept,” Cato Journal (Winter 1994), pp. 413–445, and Bert Ely, “Regulatory Moral Hazard: The Real Moral Hazard in Federal Deposit Insurance,” Independent Review (Fall 1999), pp. 241–254. 7. See Michael Keeley, “Deposit Insurance, Risk, and Market Power in Banking,” American Economic Review (1980), pp. 1183–1200, and Gary Gorton and Richard Rosen, “Corporate Control, Portfolio Choice and the Decline of Banking,” Journal of Finance (1995), pp. 1377–1420. 8.

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However, there are all types of good and bad stories and unintended secondary consequences that make the plans of the social policy “do-gooders” destructive, both economically and in terms of the effect on real human beings. Visit a mortgage collection center some time and listen to the stories. In fact, let me tell you a story to help you grasp the moral hazard risk. In the fall of 2008, I was visiting BB&T’s mortgage collection center to try to boost the morale of our employees. One of our collectors whom I had known for a long time handed me a phone call from a client. This client had moved from the Northeast to Florida about 18 months before. He had purchased a $1,000,000 house, and BB&T had made him a $600,000 loan.

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According to this individual, the house was now worth $500,000. He wanted us to reduce his interest rate from 5½ percent to 3 percent and forgive $100,000 of his debt. Interestingly, he had $800,000 on deposit with the bank. I asked him whether, if the house had appreciated to $2,000,000, he would have given us the $1,000,000 gain. I don’t think so. Moral hazard is a real risk. There is also a significant job-destroying effect of not letting the housing market correct. Individuals who do want to buy a house will not do so until they believe the market has bottomed. As long as there is a massive inventory of unsold homes in the foreclosure process, new homes will not be built because potential buyers are concerned about future home-price declines.

Unhappy Union: How the Euro Crisis - and Europe - Can Be Fixed by John Peet, Anton La Guardia, The Economist

"World Economic Forum" Davos, bank run, banking crisis, Berlin Wall, Bretton Woods, business cycle, capital controls, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, debt deflation, Doha Development Round, electricity market, eurozone crisis, Fall of the Berlin Wall, financial engineering, fixed income, Flash crash, illegal immigration, labour market flexibility, labour mobility, light touch regulation, low interest rates, market fundamentalism, Money creation, moral hazard, Northern Rock, oil shock, open economy, pension reform, price stability, quantitative easing, special drawing rights, supply-chain management, The Great Moderation, too big to fail, transaction costs, éminence grise

To borrow Schäuble’s phrase about banking union, there could first be a “wooden” structure, followed by a steel one. But if debtors are to agree to more discipline, they need confidence that a system of greater solidarity will follow. Germany has every reason to worry about moral hazard. Weak countries might fail to reform once market pressure is lifted. But moral hazard applies to the strong too: no sooner had fear of the euro’s break-up subsided than Germany started to water down banking union. A plan for greater sharing of liabilities matched by the restoration of a credible no-bail-out rule could prove an attractive bargain.

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Spain mattered not only because it was larger than the other bailed-out states, but also because it was the the last link in the chain of contagion before Italy. The size of the euro zone’s firewall was inadequate because it could not protect Italy. Eurobonds were unacceptable because they would mean Germany having to guarantee Italy’s gargantuan debt. And the fear of moral hazard was acute, in part because nobody trusted Italian politicians to reform. Italy at least had the foresight not to engage in fiscal stimulus, and its primary budget (that is, before interest payments) was in surplus. Moreover, its banks seemed in reasonable shape, and domestic savings were high.

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She had already lost her “chancellor’s majority” in votes to approve bail-out programmes, meaning that she now had to rely on votes from the opposition Social Democrats. In some ways Draghi’s threat of unlimited intervention worked too well. As pressure from markets eased, so did the pressure to fix the euro zone. The danger of moral hazard did not apply just to debtors; it applied to creditor countries too. Leaders may have pledged to do “whatever it takes”, but more often it was a matter of doing “as little as we can get away with”. Ugliness on Aphrodite’s island The new doctrines of banking union would be tested sooner than expected, in the case of Cyprus.

Too big to fail: the inside story of how Wall Street and Washington fought to save the financial system from crisis--and themselves by Andrew Ross Sorkin

"World Economic Forum" Davos, affirmative action, Alan Greenspan, Andy Kessler, Asian financial crisis, Bear Stearns, Berlin Wall, book value, break the buck, BRICs, business cycle, Carl Icahn, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Dr. Strangelove, Emanuel Derman, Fall of the Berlin Wall, fear of failure, financial engineering, fixed income, Glass-Steagall Act, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, junk bonds, Ken Thompson, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Michael Milken, Mikhail Gorbachev, money market fund, moral hazard, naked short selling, NetJets, Northern Rock, oil shock, paper trading, proprietary trading, risk tolerance, Robert Shiller, rolodex, Ronald Reagan, Savings and loan crisis, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, uptick rule, value at risk, éminence grise

As Bernanke, looking exhausted, sat slumped at a long table in the lodge’s wood-paneled conference room, speaker after speaker stood up to criticize the Fed’s approach to the financial crisis as essentially ad hoc and ineffective, and as promoting moral hazard. Only Alan Blinder, once a Fed vice chairman and a former Princeton colleague of Bernanke’s, defended the Fed. Blinder told this tale: One day a little Dutch boy was walking home when he noticed a small leak in the dike that protected the people in the surrounding town. He started to stick his finger in the hole. But then he remembered the moral hazard lesson he had learned in school…. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout, and doing so would just encourage more shoddy construction.

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The previous day, Bernanke, in his address to the symposium, had made a plea to move beyond a finger-in-the-dike strategy by urging Congress to create a “statutory resolution regime for nonbanks.” “A stronger infrastructure would help to reduce systemic risk,” Bernanke noted. It would also mitigate moral hazard and the problem of “too big to fail” by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention. A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.

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In other words, they’re saying, is this now the wave of the future, Mr. Secretary? That financial institutions that get in trouble in the future turn to the government to get bailed out?” It was a particularly poignant question; only nights before Paulson had railed on a conference call with all the Wall Street CEOs about “moral hazard”—that woolly economic term that describes what happens when risk takers are shielded from the consequences of failure; they might take ever-greater risks. “Well, again, as I said, I don’t believe the Bear Stearns shareholders feel they’ve been bailed out right now,” Paulson repeated. “The focus is clearly, all of our focus is on what’s best for the American people and how to minimize the impact of the disruption in the capital markets.”

Battling Eight Giants: Basic Income Now by Guy Standing

basic income, Bernie Sanders, carbon tax, centre right, collective bargaining, decarbonisation, degrowth, diversified portfolio, Donald Trump, Elon Musk, Extinction Rebellion, full employment, future of work, Gini coefficient, income inequality, Intergovernmental Panel on Climate Change (IPCC), job automation, labour market flexibility, Lao Tzu, longitudinal study, low skilled workers, Martin Wolf, Mont Pelerin Society, moral hazard, North Sea oil, offshore financial centre, open economy, pension reform, precariat, quantitative easing, rent control, Ronald Reagan, selection bias, universal basic income, Y Combinator

As with all targeted schemes, many of those eligible would not be reached, while those receiving the free food would, as a result, face an even greater poverty trap and accompanying precarity trap than exist in the British welfare state today.6 The proposal would also generate a new moral hazard. Someone deemed food insecure, and thus entitled to free meals, would have a disincentive to become food secure, unless the free food on offer were lousy (which could hardly be a policy objective, even though it is likely to be a policy outcome). That moral hazard would be accompanied by an equally perverse ‘immoral’ hazard, since some people would have an incentive to become food insecure deliberately in order to claim free meals.7 Providing ‘the poor’ with free food would extend the charity state and institutionalize the obnoxious system of food banks, which have mushroomed in the austerity era.

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But in a flexible modern, service-oriented labour market, that is not the case. The sort of wages and jobs that someone on benefit could expect to obtain are low and uncertain. As successive governments have admitted, someone going from benefits into a low-paid job faces in effect a marginal tax rate of over 80%. The poverty trap creates a moral hazard, because it acts as a disincentive to doing what someone would otherwise wish to do, in this case taking a job; it also creates an ‘immoral’ hazard: because people gain so little and lose so much, they may be tempted to enter the ‘black economy’, not declaring work they are doing, and thus risk losing entitlement to certain benefits and even prosecution.

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See also individual entries definition 1, 4–8 reasons for need 8–9 security 98, 113, 114 system 1, 20, 23, 26, 32, 37, 52, 70, 84, 90–1, 122 n.7 Basic Income Earth Network (BIEN) 94 behavioural conditionality 70, 73, 77, 114 behaviour-testing 4, 39, 70, 84 benefits 5, 7, 27 conditional schemes 41 social assistance 23 BET365 11 Beveridge, William 8–9, 38 Beveridge model 21 Big Bang liberalization 18 BJP 92 black economy 40, 60 B-Mincome 99–100 Booker, Cory 101 brain development 98–9 132 Branson, Richard 54 Brexit 53 Britain 6, 8–10, 12–18, 20, 23–4, 26–7, 30–1, 33–4, 37–8, 40–2, 55, 57, 59, 90, 101, 104, 112 British Columbia 95 British Constitution 1 Buck, Karen 57 bureaucracy 40, 49, 100, 102 Bureau of Economic Analysis 16 Business Property Relief 58 California 69, 96–7 Canada 35 capacity-to-work tests 6, 104 cap-and-trade approach 34 Capita 50 capital dividend 59 capital fund 89–90 capital grants 59, 75, 76, 92 carbon dividends 37 carbon emissions 33–4 carbon tax 34–5, 37 care deficit 53 care work 36, 53, 67, 74, 84 cash payments 111 cash transfers 99 ‘casino dividend’ schemes 88 charities 48 The Charter of the Forest (1217) 1 Chicago 99 Child Benefit 57, 58, 72, 123 n.4 childcare 99, 110–11 child development 88 Child Tax Credits 81 chronic psychological stress 26 Citizens Advice 46–8 Citizen’s Basic Income Trust 7, 122 n.7, 123 n.4 citizenship rights 1, 29 civil society organizations 79 Index climate change 34 Clinton, Hillary 126 n.4 Clinton, Bill 105 Coalition government 41, 50 cognitive performance 33 collateral damage 53 common dividends 7, 20, 21, 59–60, 69, 73, 75, 83, 84, 85 Commons Fund 8, 35, 57, 59, 89 community cohesion 3 resilience 23 work 84 ‘community payback’ schemes 102 Compass 59 compensation 2, 7, 16, 104 ‘concealed debt’ 24–5 conditional cash transfer schemes 90 Conservative government 9, 85 Conservatives 23 consumer credit 24 consumption 23 contractual obligations 46 Coote, Anna 113 cost of living 25, 49, 52, 83 council house sales 76 council tax 25 Crocker, Geoff 122 n.15 cross-party plans 80 crowd-funded schemes 100 deadweight effects 102 ‘deaths of despair’ 27 Deaton, Angus 10 debt 23–6, 67, 85 debt collection practices 24–5 decarbonization 34 dementia 33 democratic values 69 Democrats 37 demographic changes 15 Index 133 Department for Work and Pensions (DWP) 11–12, 42–8, 50–2, 73, 81, 92, 129 n.6 depression 28, 94 direct taxes 56, 58 disability benefits 6, 49–52, 83 Disability Living Allowance (DLA) 49–51 Disabled People Against Cuts 52 Dividend Allowance 58 ‘dividend capitalism’ 8 domestic violence 29, 87 Dragonfly 92 due process 46, 49 ecological crisis 33, 37, 39, 114 ecological developments 21 ecological disaster 35 ecological taxes and levies 37 economy benefits 20, 60 crisis 106 damage 34 growth 20, 36, 106 industrialized 20 insecurity 21, 35, 39, 89 security 75, 80, 84, 88 system 15, 27, 38 tax-paying 60 uncertainty 8, 22–3, 31 ‘eco-socialism’ 8 ecosystems 33 Edinburgh 80 education 88, 108 Elliott, Larry 122 n.15 employment 16, 22, 39, 60–1, 81, 89, 93–4, 102, 106, 107, 110, 114 Employment Support Allowance (ESA) 27, 41, 49–51 England 28, 63, 110–11 Enlightenment 85 Entrepreneurs’ Relief 18 equality 31, 85 Europe 37 European Foundation for the Improvement of Living and Working Conditions (Eurofound) 120 n.1 European Heart Journal 33 European Union 6, 17, 41 euthanasia 113 extinction 33–7 ‘Extinction Rebellion’ 33 Fabian Society 57–8 Facebook 97 family allowances 56 family benefits 56 family insecurity 23 federal welfare programs 106 Fife 24, 80 financial crash (2007–8) 23, 26, 34 financialization 116 n.22 financial markets 18 Financial Services Authority 123 n.15 Financial Times 19, 123 n.15 financial wealth 18 Finland 28, 61, 93–5 food banks 10, 29–30, 43, 109 food donations 29 food insecurity 108–9 fossil fuels 33–4 France 12, 17, 18, 32, 38, 57 free bus services 112 freedom 8, 30, 84, 85, 101, 114 ‘free food’ 108–9, 129 n.6 ‘free’ labour market 106 free trade 13 Friends Provident Foundation 75 fuel tax 35 fund and dividend model 89 funding 29, 59, 62, 69, 71–2, 112 134 G20 (Group of 20 large economies) 15 Gaffney, Declan 57 Gallup 105 GDP 14, 17–18, 23–4, 34, 36, 59, 89, 108 General Election 91–2, 94 ‘genuine progress indicator’ 36 Germany 17–18, 38, 100 Gillibrand, Kirsten 101 Gini coefficient 9, 12 GiveDirectly 91 Glasgow City 80 globalization 14 Global Wage Report 2016/17 14 global warming 33, 37 Good Society 75, 106 The Great British Benefits Handout (TV series) 92 Great Depression 9 Great Recession 23 greenhouse gas emissions 34, 36 gross cost 110 The Guardian 101, 103, 122–3 n.15 Hansard Society 37 Harris, Kamala 101 Harrop, Andrew 57 Hartz IV 100 HartzPlus 100 health 67, 87, 100 human 33 insurance premiums 35 services 60 healthcare costs 28 hegemony 14 help-to-buy loan scheme 76 Her Majesty’s Revenue and Customs (HMRC) 64, 73, 81 Hirschmann, Albert 56 household debt 24 Index household earnings 16 household survey 12 House of Commons 110–11 housing allowance 95 Housing Benefit 24, 41, 53, 71 housing policy 53 hub-and-spoke model 112 Hughes, Chris 97 humanity 33 human relations 3 ‘immoral’ hazard 109 ‘impact’ effects 78 incentive 62 income 81 assistance 88 average 83 components 11 distribution system 4, 13–14, 38, 67, 84, 107, 114 gap 9 growth 16 insecurity 27 men vs. women 15–16 national 14, 36 pensioners’ 16 rental 13–15, 20 social 14, 16–17 support payments 110 tax 1, 7, 57, 89, 111 transfer 85 volatility 22 India 68, 80, 90–2 Indian Congress Party 91 inequality 2, 4, 9–13, 21, 29, 31, 33, 35, 37, 38, 39, 54, 80, 85, 114 growth 17 income 9–10, 15–17, 19 living standard 20 wealth 18–19, 76 informal care 111 Index 135 inheritance tax 58 in-kind services 111 insecurity 21–3, 29, 38, 39, 47, 67, 85, 106 Institute for Fiscal Studies (IFS) 10 Institute for Public Policy Research 125 n.17 Institute for Public Policy Research (IPPR) 75, 111 Institute of New Economic Thinking 123 n.15 Institute of Public Policy Research 59 insurance schemes 8 intellectual property 14–15 Intergovernmental Panel on Climate Change (IPCC) 34 International Labour Organization (ILO) 14, 122 n.4 International Monetary Fund (IMF) 31, 34 international tax evasion 18 interpersonal income inequality 83 inter-regional income inequalities 83 intra-family relationships 3 involuntary debt 26 in-work benefits 22 Ireland 35 Italy 18 labour 31, 107 inefficiency 106 law 101 markets 8, 14, 32, 39, 40, 60, 62–3, 96, 100, 106 regulations 13 supply 67, 95 Labour governments 85 labourism 106 Lansley, Stewart 59 Latin America 90 Left Alliance 94 Lenin, Vladimir Ilyich 113 Liberal government 35 life-changing errors 51 life-threatening illness 33 Liverpool 80 living standards 20, 23, 33, 36, 53, 59, 92 Local Housing Allowances 24 London Homelessness Project 92–3 low-income communities 33 low-income families 21 low-income households 17 low-income individuals 86 Low Pay Commission 63 low-wage jobs 60, 107 Luddite reaction 32 lump-sum payments 35, 59, 76 Jackson, Mississippi 99 JobCentrePlus 47 job guarantee policy 101–7 job-matching programs 106 Jobseeker’s Allowance (JSA) 41, 46 Joseph Rowntree Foundation 21 McDonnell, John 129 n.13 McKinsey Global Institute 31 Macron, Emmanuel 35 Magna Carta 1 ‘Making Ends Meet’ 97 ‘mandatory reconsideration’ stage 51 Manitoba 87–8 Manitoba Basic Annual Income Experiment (Mincome) 87 market economy 105, 114 master-servant model 101 Kaletsky, Anatole 123 n.15 Kenya 90–2 Khanna, Ro 103 Kibasi, Tom 113 136 Index Maximus 50 means-testing 4, 39, 42, 48, 58, 61–2, 70, 84, 88, 90, 109–10, 114 benefits 5, 7, 27, 40, 46, 56, 71–3, 81, 129 n.6 social assistance 23, 41, 95, 122 n.7 system 6 medical services 28 Mein Grundeinkommen (‘My Basic Income’) 100 mental health 26, 28, 94 disorders 88 trusts 28 mental illness 33, 68 migrants 7, 113 ‘minimum income floor’ 45 Ministry of Justice 51 modern insecurity 22 modern life 31 monetary policy 59 Mont Pelerin Society 13 moral commitment 75 moral hazard 109 mortality 27, 76 multinational investment funds 34 Musk, Elon 31, 54 Namibia 90–2 National Audit Office (NAO) 24, 43–4, 46, 76 National Health Service (NHS) 8, 24, 27–8, 44, 68, 80, 108, 111 National Insurance 18, 22, 124 n.4 nationalism 37 National Living Wage 63 National Minimum Wage 63–4 national solidarity 3 Native American community 88 negative income tax (NIT) 23, 87, 95, 100 neo-fascism 37–8 neoliberalism 13, 84 Netherlands 96 New Economics Foundation (NEF) 57, 113, 122 n.15 non-resident citizens 113 non-wage benefits 16 non-wage work 74 North America 67 North Ayrshire 80 North Carolina 88 North Sea oil 89–90 Nyman, Rickard 23 Oakland 96–7 Office for National Statistics (ONS) 14–15, 17, 36 Ontario, Canada 95–6 open economy 84 open ‘free’ markets 13, 15 opportunity dividend 59 Organization for Economic Co-operation and Development (OECD) 18, 23, 27, 31 Ormerod, Paul 23 Osborne, George 19 Paine, Thomas 2, 75 Painian Principle 2 panopticon state 55 Paris Agreement (2015) 34 participation income 74–5 paternalism 42, 55 pauperization 63 Pawar, Alderman Ameya 99 pay contributions 21 pension contributions 18, 58 Pension Credit 41 Pericles Condition 75 permanent capital fund 71 personal care services 110–11 Index 137 personal income tax 35 Personal Independence Payment (PIP) 49–51 personal insecurity 23 Personal Savings Allowance 58 personal tax allowances 17, 58, 59 perverse incentives 50 physical health 26, 94 piloting in Britain 67–81 applying 80–1 rules in designing 70–80 policy development 3, 69 political decision 78 political discourse 92 political instability 35 political system 38 populism 37–8, 75 populist parties 37 populist politics 39 Populus survey 55 post-war system 8 poverty 2, 4, 10–12, 22, 27, 29, 36, 38, 40, 60–1, 89, 100, 108–9, 114, 125 n.17, 129 n.6 precarity 29–30, 38, 39, 60–1, 85, 103, 129 n.6 Primary Earnings Threshold 124 n.4 private debt 23–4, 39 private inheritance 2 private insurance 85 private property rights 13 private wealth 18 privatization 13, 17, 112 property prices 76 prostitution 43 Public Accounts Committee (PAC) 51 public costs 28 public debt 23 public inheritance 61 public libraries 47 public policy 97 public sector managers 103 public services 4, 17, 62, 108, 112, 114 public spending 89 public wealth 18 ‘quantitative easing’ policy 59 quasi-basic income 89, 98 quasi-universal basic services 30 quasi-universal dividends 35 quasi-universal system 61, 70, 90 Randomised Control Trial (RCT) 124–5 n.14 rape 44 Ratcliffe, Jim 12 Reagan, Ronald 13 Reed, Howard 59 refugees 7 regressive universalism 57 regular cash payment 7 rent arrears 24 controls 53 rentier capitalism 13–21, 107, 116 n.22 republican freedom 2–3, 30, 84 Republicans 37 Resolution Foundation 10, 15, 19, 25, 76 ‘revenue neutral’ constraint 7 right-wing populism 37–8 robot advance 31–3 Royal College of Physicians 33 Royal Society of Arts 55, 59, 124 n.12 RSA Scotland 125 n.17 Rudd, Amber 9 Russia 113 138 Sanders, Bernie 101 scepticism 31 schooling 67, 89 Scotland 69, 80, 111 Second World War 19, 21 security 8, 38, 55, 68, 84 economic 3, 4, 49, 56 income 73–4 social 8, 22, 49 Self-Employed Women’s Association (SEWA) 68 self-employment 45 Shadow Chancellor of the Exchequer 3, 115 n.3 Smith, Iain Duncan 42 ‘snake oil’ 113 social assistance 3, 28 social benefit 20 social care 102, 104, 110–11 social crisis 106 social dividend scheme 92 Social Fund 29 social inheritance 2 social insecurity 21 social insurance 22, 85 social integration 44 social justice 2, 8, 20, 69, 84, 101, 114 social policy 8, 23, 26, 30, 42, 53, 84–5, 96 social protection system 32 social relation 100 social security 10, 70–1, 95 social solidarity 3, 8, 39, 61, 84–5, 91 social spending 17 social status 104 social strife 35 social value 29 ‘something-for-nothing’ economy 19–20, 61 Index Speenhamland system 63 State of the Global Workplace surveys 105 statutory minimum wages 106 stigma 47, 55 stigmatization 41, 109 Stockton 97–9 Stockton Economic Empowerment Demonstration (SEED) 97 stress 26–9, 39, 51, 67, 68, 85, 93 student loans 24 substitution effects 102–3 suicides 26–7 Summers, Larry 105–6 Sweden 113 Swiss bank Credit Suisse 12 Switzerland 35 tax advantages 49 and benefit systems 17, 18, 69, 110 credits 3, 17, 24, 63, 105, 106 policies 16 rates 72 reliefs 17–18, 57–8, 61 tax-free inheritance 19 technological change 105 technological revolution 14, 31, 114 ‘teething problems’ 42 Thatcher, Margaret 13 Thatcher government 9, 18 The Times 92 Torry, Malcolm 122 n.7 Trades Union Congress 24 tribal casino schemes 76 ‘triple-lock’ policy 16 Trump, Donald 37 Trussell Trust 29, 43 Tubbs, Michael 97–8 Index 139 Turner, Adair 123 n.15 two-child limit 44 UK.

Twilight of the Elites: America After Meritocracy by Chris Hayes

"Hurricane Katrina" Superdome, "World Economic Forum" Davos, affirmative action, Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, barriers to entry, Bear Stearns, Berlin Wall, Bernie Madoff, carried interest, circulation of elites, Climategate, Climatic Research Unit, collapse of Lehman Brothers, collective bargaining, creative destruction, Credit Default Swap, dark matter, David Brooks, David Graeber, deindustrialization, Fall of the Berlin Wall, financial deregulation, fixed income, full employment, George Akerlof, Gunnar Myrdal, hiring and firing, income inequality, Jane Jacobs, jimmy wales, Julian Assange, Kenneth Arrow, Mark Zuckerberg, mass affluent, mass incarceration, means of production, meritocracy, meta-analysis, military-industrial complex, money market fund, moral hazard, Naomi Klein, Nate Silver, peak oil, plutocrats, Ponzi scheme, post-truth, radical decentralization, Ralph Waldo Emerson, rolodex, Savings and loan crisis, The Spirit Level, too big to fail, University of East Anglia, Vilfredo Pareto, We are the 99%, WikiLeaks, women in the workforce

Stack came to believe this to be true not just in tax law, but in every single part of American life: the rich and powerful blatantly flouted the law without sanction, bending the law to their own benefit or simply writing the law themselves, while guys like him couldn’t catch a break. A society in which cheaters, shirkers, and incompetents face no sanction, where bad behavior meets reward, is a morally hazardous one. In economics, the term “moral hazard” refers to the perverse incentives that can arise when agents are insulated from the cost of their actions: A hypochondriac with a health insurance plan that covers the full cost of doctor’s visits will make more appointments than one who has a sizable co-pay; a banker who knows at some level that the cost of catastrophically bad bets will ultimately be picked up by the government has far less incentive to avoid blowing everything up while in the zealous pursuit of the highest yield possible.

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HN90.E4H39 2012 305.5’20973—dc23 2012002435 eISBN: 978-0-307-72047-4 Jacket design by Ben Wiseman Jacket photography © Ryan McVay/Getty Images v3.1 To my mom and dad, who taught me how to see the world. Contents Cover Title Page Copyright Dedication Chapter One THE NAKED EMPERORS Chapter Two MERITOCRACY AND ITS DISCONTENTS Chapter Three MORAL HAZARDS Chapter Four WHO KNOWS? Chapter Five WINNERS Chapter Six OUT OF TOUCH Chapter Seven REFORMATION Acknowledgments Notes Selected Bibliography About the Author Chapter 1 THE NAKED EMPERORS Now see the sad fruits your faults produced, Feel the blows you have yourselves induced

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It would reflexively protect its worst members, it would operate with a wide gulf between performance and reward, and would be shot through with corruption, rule-breaking, and self-dealing as those on top pursued the outsize rewards promised for superstars. In the way the bailouts combined the worst aspects of capitalism and socialism, such a social order would fuse the worst aspects of meritocracy and bureaucracy. It would, in other words, look a lot like the American elite circa 2012. Chapter 3 MORAL HAZARDS The bargain has been breached.… The American people do not think the system is fair, or on the level. —JOE BIDEN ON THE MORNING OF FEBRUARY 18, 2010, ANDREW Joseph Stack woke in his home in the quiet, leafy neighborhood of North Austin, Texas. A self-employed software consultant and a part-time bassist in a local band, Joe, as his friends called him, started the day by setting fire to his house.

Who Owns the Future? by Jaron Lanier

3D printing, 4chan, Abraham Maslow, Affordable Care Act / Obamacare, Airbnb, augmented reality, automated trading system, barriers to entry, bitcoin, Black Monday: stock market crash in 1987, book scanning, book value, Burning Man, call centre, carbon credits, carbon footprint, cloud computing, commoditize, company town, computer age, Computer Lib, crowdsourcing, data science, David Brooks, David Graeber, delayed gratification, digital capitalism, digital Maoism, digital rights, Douglas Engelbart, en.wikipedia.org, Everything should be made as simple as possible, facts on the ground, Filter Bubble, financial deregulation, Fractional reserve banking, Francis Fukuyama: the end of history, Garrett Hardin, George Akerlof, global supply chain, global village, Haight Ashbury, hive mind, if you build it, they will come, income inequality, informal economy, information asymmetry, invisible hand, Ivan Sutherland, Jaron Lanier, Jeff Bezos, job automation, John Markoff, John Perry Barlow, Kevin Kelly, Khan Academy, Kickstarter, Kodak vs Instagram, life extension, Long Term Capital Management, machine translation, Marc Andreessen, Mark Zuckerberg, meta-analysis, Metcalfe’s law, moral hazard, mutually assured destruction, Neal Stephenson, Network effects, new economy, Norbert Wiener, obamacare, off-the-grid, packet switching, Panopticon Jeremy Bentham, Peter Thiel, place-making, plutocrats, Ponzi scheme, post-oil, pre–internet, Project Xanadu, race to the bottom, Ray Kurzweil, rent-seeking, reversible computing, Richard Feynman, Ronald Reagan, scientific worldview, self-driving car, side project, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, Skype, smart meter, stem cell, Steve Jobs, Steve Wozniak, Stewart Brand, synthetic biology, tech billionaire, technological determinism, Ted Nelson, The Market for Lemons, Thomas Malthus, too big to fail, Tragedy of the Commons, trickle-down economics, Turing test, Vannevar Bush, WikiLeaks, zero-sum game

Consider the expansion of the financial sector prior to the Great Recession. It’s not as if that sector was accomplishing any more than it ever had. If its product is to manage risk, it clearly did a terrible job. It expanded purely because of its top positions on networks. Moral hazard has never met a more efficient amplifier than a digital network. The more influential digital networks become, the more potential moral hazard we’ll see, unless we change the architecture. A First Pass at a Definition A Siren Server, as I will refer to such a thing, is an elite computer, or coordinated collection of computers, on a network. It is characterized by narcissism, hyperamplified risk aversion, and extreme information asymmetry.

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Upon hearing that I propose that people be able to earn their livings in part just for doing what they do while being watched by cloud algorithms, the parent voice can be expected to say: “Doing what you want shouldn’t be a way of earning a living. Allowing even a hint of that is the very core of moral hazard. The moment kids get a whiff of the notion, they’ll never learn to take on the sheer pain of growing up—or the self-sacrifice of doing a job or paying a mortgage—and civilization will fall apart.” The child voice doesn’t listen to any of this, naturally, but instead demands exactly the same thing using a different argument: “Why bring money into it?

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Living languages ought to require continued examples from living people in order for automated translation services to stay up to date. If the cloud has learned all it will ever need to learn to translate between English and Chinese, it means those languages have become fixed. People ought to be in the driver’s seat and not allow the network to define and capture a language for all time. A humanistic economy would remove moral hazards that might incentivize artificial language stasis, and other similar traps. If a language translation service becomes so refined that it requires only one one-hundredth of the data gathering it did in its early years, just to keep up to date with new expressions, then that service should not be surprised to pay a hundred times more for a given amount of the latest data it requires.

Super Thinking: The Big Book of Mental Models by Gabriel Weinberg, Lauren McCann

Abraham Maslow, Abraham Wald, affirmative action, Affordable Care Act / Obamacare, Airbnb, Albert Einstein, anti-pattern, Anton Chekhov, Apollo 13, Apple Newton, autonomous vehicles, bank run, barriers to entry, Bayesian statistics, Bernie Madoff, Bernie Sanders, Black Swan, Broken windows theory, business process, butterfly effect, Cal Newport, Clayton Christensen, cognitive dissonance, commoditize, correlation does not imply causation, crowdsourcing, Daniel Kahneman / Amos Tversky, dark pattern, David Attenborough, delayed gratification, deliberate practice, discounted cash flows, disruptive innovation, Donald Trump, Douglas Hofstadter, Dunning–Kruger effect, Edward Lorenz: Chaos theory, Edward Snowden, effective altruism, Elon Musk, en.wikipedia.org, experimental subject, fake news, fear of failure, feminist movement, Filter Bubble, framing effect, friendly fire, fundamental attribution error, Goodhart's law, Gödel, Escher, Bach, heat death of the universe, hindsight bias, housing crisis, if you see hoof prints, think horses—not zebras, Ignaz Semmelweis: hand washing, illegal immigration, imposter syndrome, incognito mode, income inequality, information asymmetry, Isaac Newton, Jeff Bezos, John Nash: game theory, karōshi / gwarosa / guolaosi, lateral thinking, loss aversion, Louis Pasteur, LuLaRoe, Lyft, mail merge, Mark Zuckerberg, meta-analysis, Metcalfe’s law, Milgram experiment, minimum viable product, moral hazard, mutually assured destruction, Nash equilibrium, Network effects, nocebo, nuclear winter, offshore financial centre, p-value, Paradox of Choice, Parkinson's law, Paul Graham, peak oil, Peter Thiel, phenotype, Pierre-Simon Laplace, placebo effect, Potemkin village, power law, precautionary principle, prediction markets, premature optimization, price anchoring, principal–agent problem, publication bias, recommendation engine, remote working, replication crisis, Richard Feynman, Richard Feynman: Challenger O-ring, Richard Thaler, ride hailing / ride sharing, Robert Metcalfe, Ronald Coase, Ronald Reagan, Salesforce, school choice, Schrödinger's Cat, selection bias, Shai Danziger, side project, Silicon Valley, Silicon Valley startup, speech recognition, statistical model, Steve Jobs, Steve Wozniak, Steven Pinker, Streisand effect, sunk-cost fallacy, survivorship bias, systems thinking, The future is already here, The last Blockbuster video rental store is in Bend, Oregon, The Present Situation in Quantum Mechanics, the scientific method, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Tragedy of the Commons, transaction costs, uber lyft, ultimatum game, uranium enrichment, urban planning, vertical integration, Vilfredo Pareto, warehouse robotics, WarGames: Global Thermonuclear War, When a measure becomes a target, wikimedia commons

For example, will you drive more recklessly in a rental car after you purchase extra rental insurance, simply because you’re more protected financially from a crash? On average, people do. This phenomenon, known as moral hazard, is where you take on more risk, or hazard, once you have information that encourages you to believe you are more protected. It has been a concern of the insurance industry since the seventeenth century! Sometimes moral hazard may involve only one person: wearing a bike helmet may give you a false sense of security, leading you to bike more recklessly, but you are the one who bears all the costs of a bike crash. Moral hazards can also occur when a person or company serves as an agent for another person or company, making decisions on behalf of this entity, known as the principal.

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When she sells her own house, an agent holds out for the best offer; when she sells yours, she encourages you to take the first decent offer that comes along. Like a stockbroker churning commissions, she wants to make deals and make them fast. Why not? Her share of a better offer—$150—is too puny an incentive to encourage her to do otherwise. Moral hazard and principal-agent problems can occur because of asymmetric information, where one side of a transaction has different information than the other side; that is, the available information is not symmetrically distributed. Real estate agents have more information about the real estate market than sellers, so it is hard to question their recommendations.

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The only way this system works, though, is if healthy, lower-risk people continue paying into the system, allowing insurers to spread out the cost of higher-risk individuals. This helps keep premiums from rising too high, making care more affordable for everyone. That’s why the ACA mandate was so important to the viability of the overall system. The mental models from the last section (tragedy of the commons, externalities, etc.) and those from this section (moral hazard, information asymmetry, etc.) are signs of market failure, where open markets without intervention can create suboptimal results, or fail. To correct a market failure, an outside party must intervene in some way. Unfortunately, these interventions themselves can also fail, a result called government failure or political failure.

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

"World Economic Forum" Davos, AI winter, Alan Greenspan, algorithmic trading, AOL-Time Warner, Apollo 11, asset allocation, banking crisis, barriers to entry, Bear Stearns, Big bang: deregulation of the City of London, Bob Litterman, book value, business cycle, butter production in bangladesh, butterfly effect, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, Charles Babbage, citizen journalism, collateralized debt obligation, Cornelius Vanderbilt, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, electricity market, Emanuel Derman, en.wikipedia.org, experimental economics, fake news, financial engineering, financial innovation, fixed income, Ford Model T, Gordon Gekko, Hans Moravec, Herman Kahn, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, Ivan Sutherland, Jim Simons, John Bogle, John Nash: game theory, Kenneth Arrow, load shedding, Long Term Capital Management, machine readable, machine translation, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, military-industrial complex, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, proprietary trading, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Reminiscences of a Stock Operator, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, Savings and loan crisis, semantic web, Sharpe ratio, short selling, short squeeze, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, stock buybacks, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, tontine, too big to fail, transaction costs, Turing machine, two and twenty, Upton Sinclair, value at risk, value engineering, Vernor Vinge, Wayback Machine, yield curve, Yogi Berra, your tax dollars at work

Shooting the Moon 299 Wildly Complex Derivatives Traded on Analyzed with Utterly Opaque Markets Even More Complex Pricing Models Lack of Market Prices Create Need for Driven by Carelessly Inappropriate Data Figure 12.10 An interconnected structure for disaster: uses and abuses of technology in bringing on the Great Mess of ’08. There are many other causes, over-leverage, moral hazard (“heads, I win, tails, you lose”), and heads in the sand. These are the ones that involve wires. Figure 12.10 shows the vicious circle of financial technology errors that contributed to our sorry situation today—the design of monstrously complex incomprehensible derivatives, which then required monstrously complex valuation models, since there was no transparent market to provide this information.

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New structural flaws in the government’s rescue plans are revealed on an almost daily basis. The incentives for these plans to work to the 312 Nerds on Wall Str eet benefit of the country, and not the failed firms, are poorly aligned. The new American bank initiative (NABI) would involve no moral hazard,* no hoarding banks, no government ownership, and no throwing good money after bad. Most important, it will immediately provide $7 trillion or more in unencumbered lending capacity to real projects—green energy, infrastructure, and auto and other manufacturing. It is also the best plan for preserving the operational and human assets of failed banks and saving existing solvent institutions by making everyone confident in the availability of funds again.

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Unfortunately, these solutions ignore the fact that every relevant institution is in survival mode and will only use any liquidity or capital injections as a cushion in case their sources of funding dry up or their assets have to be further written down (very likely considering where we are in the economic cycle). Even worse, they all involve some type of moral hazard by cushioning the losses for equity and unsecured debt holders (who are to varying degrees responsible for the crisis). The recent reports of capital injections effectively being used for dividends and deferred compensation are perhaps the most heinous examples of taxpayer funds being used to directly pay existing equity holders and management.

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

Alan Greenspan, asset-backed security, bank run, banking crisis, Bernie Madoff, bond market vigilante , bonus culture, Bretton Woods, business cycle, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, deal flow, disintermediation, diversification, fiat currency, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, foreign exchange controls, Francis Fukuyama: the end of history, George Santayana, global reserve currency, Greenspan put, Home mortgage interest deduction, inverted yield curve, Isaac Newton, joint-stock company, junk bonds, Kickstarter, liquidity trap, London Interbank Offered Rate, long peace, low interest rates, margin call, market clearing, mass immigration, Money creation, money market fund, moral hazard, mortgage tax deduction, Nixon triggered the end of the Bretton Woods system, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Phillips curve, plutocrats, Ponzi scheme, profit maximization, proprietary trading, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, Suez canal 1869, systems thinking, tail risk, The Great Moderation, the long tail, the new new thing, the payments system, too big to fail, value at risk, very high income, War on Poverty, We are all Keynesians now, Y2K, yield curve

Both the banks and regulators end up going through the motions. It is hard to name a single banking crack-up that was ever spotted and prevented by formal regulatory procedures in any jurisdiction. MORAL HAZARD Meanwhile, the fact that deposits are insured by the government motivates everyone from depositors to bankers to politicians to act like spoiled children instead of grown-ups. Economists call this The Limits of Financial Regulation infantilization of conduct ‘‘moral hazard.’’ Basically, moral hazard is what happens when you remove consequences for risky behavior. If you know in advance that the judge will let you off if you are stopped for a DWI, you might be inclined to drive with a few drinks in you.

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Fairness requires that government work to reverse the most troubling aspect of the free market: There are always a few winners and many losers, and many of the winners start life on third base. Conveniently, the few cannot defend their property in a system of universal elective franchise where majorities rule, a point that the great Victorian legal scholar A.V. Dicey made in arguing that letting people who got more out of the state than they paid in tax constituted a moral hazard. Politicians would always grab more and more from the few and spend it to buy political power through providing financial security to the many. Representation without taxation leads as certainly to tyranny as taxation without representation. ILLIBERALISM The New Deal and FDR’s four presidential victories prove that Dicey was on to something, as does the perennial power of socialist parties 181 182 Conclusion in European electoral politics.

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See also Credit money, Coinage, Commodity money, Deposit money, Paper money money market, 4, 6, 13, 23, 41–42, 84, 86–87, 90, 102, 106, 108, 110, 130, 150, 167 monoline credit insurers, 66 monopoly, 65, 81, 84–85, 95–96, 124; clearing and settlement, 13; deposit taking, 12, 15, 19, 90 Monte dei Paschi di Siena, bank, 79 ‘‘moral hazard,’’ 128–129, 181 Morgan Bank, 87, 108, 142–143 Morgan, J.P., 103, 105, 121, 164 Mortgages, 7, 18, 25, 35, 41, 55–58, 61–64, 66, 71–73, 110, 113, 121, 130–134, 142, 165, 176, 185, 187 NASDAQ, 165 National Accounts (US), 6, 113 National Bank Act of 1864 (US), 38 negotiable instrument, 10, 33, 35, 38–39, 130, 145 New Deal, 56, 114, 117, 126, 128, 130, 141–143, 154, 158–159, 162–163, 166, 176, 181–182, 184, 187, 189 Newton, Sir Isaac, 137 Nikkei, stock index, 168, 171 Nixon, Richard M., 154–155 Northern Rock, 86 NOW (Negotiable Order of Withdrawal) account, 130 off-shore banking centers, 150 open market operations, 107–108, 145 OPM or ‘‘Other People’s Money,’’ 15–19, 22, 26–27, 39, 46, 61, 71, 87–88, 92–93, 104, 129, 144–145, 150, 165, 167 Index ‘‘options,’’ 54–55, 75, 77 overdraft, 37–38, 61, 78, 89–90 Pac-Man banking, 157, 159 panics, xix–xx, 2, 5, 19, 45, 48, 98, 102, 109–10, 121, 136, 140–141, 150, 164, 183; of 1873, 5, 103; of 1907, 103; of 2008, 52; use of, 139 ‘‘paper money,’’ xiv–xvi, 14, 29, 33, 35, 83, 97.

Broken Markets: A User's Guide to the Post-Finance Economy by Kevin Mellyn

Alan Greenspan, banking crisis, banks create money, Basel III, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, bond market vigilante , Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, business cycle, buy and hold, call centre, Carmen Reinhart, central bank independence, centre right, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, compensation consultant, corporate governance, corporate raider, creative destruction, credit crunch, crony capitalism, currency manipulation / currency intervention, currency risk, disintermediation, eurozone crisis, fiat currency, financial innovation, financial repression, floating exchange rates, Fractional reserve banking, Glass-Steagall Act, global reserve currency, global supply chain, Home mortgage interest deduction, index fund, information asymmetry, joint-stock company, Joseph Schumpeter, junk bonds, labor-force participation, light touch regulation, liquidity trap, London Interbank Offered Rate, low interest rates, market bubble, market clearing, Martin Wolf, means of production, Michael Milken, mobile money, Money creation, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nixon triggered the end of the Bretton Woods system, Paul Volcker talking about ATMs, Ponzi scheme, profit motive, proprietary trading, prudent man rule, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, rising living standards, Ronald Coase, Savings and loan crisis, seigniorage, shareholder value, Silicon Valley, SoftBank, Solyndra, statistical model, Steve Jobs, The Great Moderation, the payments system, Tobin tax, too big to fail, transaction costs, underbanked, Works Progress Administration, yield curve, Yogi Berra, zero-sum game

Of course, the US government did let Lehman fail, partially because the Federal Reserve did not have the authority it needed to bail out an investment bank. But the authorities also feared that doing so—and in effect reinforcing the idea that no major firm would be allowed to fail under any circumstances—would give rise to an extremely dangerous level of moral hazard in the financial markets. Moral hazard is an economic term for how people behave when their actions have no downside. Successful and often repeated rescues of the financial economy during the Greenspan years had led to a situation of “Heads, I win; tails, the government pays.” Sometimes this is referred to as private profits and socialized losses, and even deposit insurance is tainted with the same problem.

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Certainly Lehman’s management must have made this assumption. After all, Bear Stearns, a far less important house with more to answer for in the mortgage securities bubble, had been rescued. Surely, the authorities could see the domino effect that would occur if they let Lehman go down? Economists use the term moral hazard to describe what happens when the consequences of bad decisions are eliminated. For example, deposit insurance means you don’t have to evaluate the soundness of your bank. Uncle Sam will always make you whole if it goes bust.What would happen if deposit insurance was abolished overnight during a market panic?

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This lender-of-last-resort function is fundamental to central banking, but creates great risks to the taxpayer, so it logically requires that the central bank have an ability to supervise the behavior of private-sector banks. Otherwise, the very fact that someone is willing and able to bail them out of the consequences of risky behavior in fact provides incentives to the private-sector banks for that behavior—a concept knows as a moral hazard, as mentioned previously. The second key reason why some degree of financial regulation is legitimate is that deposit money in banks forms the basis of the payments system. Payments system is an arcane term for all the institutions and mechanisms that allow one person or organization to transfer monetary claims to another.

Kicking Awaythe Ladder by Ha-Joon Chang

Asian financial crisis, business cycle, central bank independence, classic study, clean water, colonial rule, Corn Laws, corporate governance, creative destruction, David Ricardo: comparative advantage, fear of failure, income inequality, income per capita, joint-stock company, joint-stock limited liability company, land bank, land reform, liberal world order, moral hazard, open economy, purchasing power parity, rent-seeking, scientific management, short selling, Simon Kuznets, tacit knowledge, The Wealth of Nations by Adam Smith, trade liberalization, Washington Consensus

However, for a few centuries after its invention in the sixteenth century for highly risky large-scale commercial projects (the British East India Company being the best-known early example), it tended to be regarded with great suspicion. Many people believed that it led to excessive risk-taking (or what today we call 'moral hazard') on the part of both owners and managers. They regarded it as an institution that undermined what was then regarded - along with greed - as one of the key disciplinary mechanisms of capitalism, namely, fear of failure and destitution, especially given the harshness of bankruptcy laws at the time (see section 3.2.4.C).

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Britain banned the formation of new limited liability companies on these grounds with the Bubble Act in 1720, although with the repeal of the act in 1825 it was again allowed.63 However, as has been proven repeatedly over the last few centuries, limited liability provides one of the most powerful mechanisms to 'socialize risk', which has made possible investments of unprecedented scale. That is why, despite its potential to create 'moral hazard', all societies have come to accept limited liability as a cornerstone of modern corporate governance.64 In many European countries, limited liability companies - or joint stock companies as they were known in those days - had existed under ad hoc royal charters since the sixteenth century.6S However, it was not until the mid-nineteenth century that it began to be granted as a matter of course, rather than as a privilege.

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Generalized limited liability was first introduced in Sweden in 1844. England followed this closely with the 1856 Joint Stock Company Act, although limited liabilities for banks and insurance companies were introduced somewhat later (1857 and 1862 respectively), reflecting the then widespread concern that they could pose serious 'moral hazard'. Rosenberg and Birdzell document how, even a few decades after the introduction of generalized limited liability (the late nineteenth century), small businessmen 'who, being actively in charge of a business as well as its owner, sought to limit responsibility for its debts by the device of incorporation' were frowned upon.66 In Belgium, the first limited liability company was founded in 1822, and the 1830s saw the formation of a large number of such companies.

The Great Divide: Unequal Societies and What We Can Do About Them by Joseph E. Stiglitz

"World Economic Forum" Davos, accelerated depreciation, accounting loophole / creative accounting, affirmative action, Affordable Care Act / Obamacare, agricultural Revolution, Alan Greenspan, Asian financial crisis, banking crisis, Bear Stearns, Berlin Wall, Bernie Madoff, Branko Milanovic, Bretton Woods, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, carbon tax, Carmen Reinhart, carried interest, classic study, clean water, collapse of Lehman Brothers, collective bargaining, company town, computer age, corporate governance, credit crunch, Credit Default Swap, deindustrialization, Detroit bankruptcy, discovery of DNA, Doha Development Round, everywhere but in the productivity statistics, Fall of the Berlin Wall, financial deregulation, financial innovation, full employment, gentrification, George Akerlof, ghettoisation, Gini coefficient, glass ceiling, Glass-Steagall Act, global macro, global supply chain, Home mortgage interest deduction, housing crisis, income inequality, income per capita, information asymmetry, job automation, Kenneth Rogoff, Kickstarter, labor-force participation, light touch regulation, Long Term Capital Management, low interest rates, manufacturing employment, market fundamentalism, mass incarceration, moral hazard, mortgage debt, mortgage tax deduction, new economy, obamacare, offshore financial centre, oil shale / tar sands, Paul Samuelson, plutocrats, purchasing power parity, quantitative easing, race to the bottom, rent-seeking, rising living standards, Robert Solow, Ronald Reagan, Savings and loan crisis, school vouchers, secular stagnation, Silicon Valley, Simon Kuznets, subprime mortgage crisis, The Chicago School, the payments system, Tim Cook: Apple, too big to fail, trade liberalization, transaction costs, transfer pricing, trickle-down economics, Turing machine, unpaid internship, upwardly mobile, urban renewal, urban sprawl, very high income, War on Poverty, Washington Consensus, We are the 99%, white flight, winner-take-all economy, working poor, working-age population

Wasting money on banks might be necessary to save the economy, and any fine-tuning of the bank rescue programs apparently was viewed as a luxury we could not afford. But exactly the opposite attitude was taken in regard to homeowners and ordinary citizens: we had to proceed carefully, so as not to make any mistakes. Terms like “moral hazard” were thrown around glibly—the risk that a bailout to homeowners would encourage reckless borrowing—even though the real moral hazard issue was that of the banks, which had been rescued time after time. Standard economics—taught in virtually every textbook—calls for a fiscal stimulus when the economy is weak. But we had learned from the Bush 2008 tax cut for the rich that a poorly designed stimulus would be relatively ineffective.

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Going forward, it would discourage prudence on the part of homeowners—the “moral hazard problem” well-known to economists. I never understood how he (like so many in the banking community) could embrace such a double standard. Bailing out bad banks was, in these terms, not only unfair to other banks; it was unfair to the millions of Americans who were suffering because of the misdeeds of the banks. It was going to the assistance of the victimizer, and leaving the victims to take care of themselves. If there was ever need for proof of the relevance of moral hazard, the bankers had provided it: the savings-and-loan bailout, and the Mexican, Korean, Thai, and Indonesian bailouts, which were all really bailouts of Western financial institutions.

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The president’s former Treasury secretary, Timothy Geithner, in his recent book, Stress Test, made a valiant but unsuccessful attempt to defend the administration’s actions, suggesting that there were no alternatives. But Geithner clearly worried excessively about the “moral hazard” of helping underwater homeowners—in other words, encouraging lax borrowing habits—while seeming to care far less about the moral hazard of helping banks, or the culpability of the banks in encouraging excessive indebtedness and in marketing mortgages that put unbearable risks on the poor and middle classes. In fact, Geithner’s attempts to justify what the administration did only reinforce my belief that the system is rigged.

A Pelican Introduction: Basic Income by Guy Standing

"World Economic Forum" Davos, anti-fragile, bank run, basic income, behavioural economics, Bernie Sanders, Bertrand Russell: In Praise of Idleness, Black Lives Matter, Black Swan, Boris Johnson, British Empire, carbon tax, centre right, collective bargaining, cryptocurrency, David Graeber, declining real wages, degrowth, deindustrialization, Donald Trump, Elon Musk, Fellow of the Royal Society, financial intermediation, full employment, future of work, gig economy, Gunnar Myrdal, housing crisis, hydraulic fracturing, income inequality, independent contractor, intangible asset, Jeremy Corbyn, job automation, job satisfaction, Joi Ito, labour market flexibility, land value tax, libertarian paternalism, low skilled workers, lump of labour, Marc Benioff, Mark Zuckerberg, Martin Wolf, mass immigration, mass incarceration, moral hazard, Nelson Mandela, nudge theory, offshore financial centre, open economy, Panopticon Jeremy Bentham, Paul Samuelson, plutocrats, precariat, quantitative easing, randomized controlled trial, rent control, rent-seeking, Salesforce, Sam Altman, self-driving car, shareholder value, sharing economy, Silicon Valley, sovereign wealth fund, Stephen Hawking, The Future of Employment, universal basic income, Wolfgang Streeck, women in the workforce, working poor, Y Combinator, Zipcar

The advice of an expert (or perhaps a ‘nudge’ by a government-appointed adviser) may have poor results for one person and good ones for another at a different time. In effect, the capital grant leaves too much to chance. It would be difficult to refuse help for people if, for whatever reason, they subsequently fell upon hard times. But this would also create a moral hazard, since expectation of further financial support if the money was lost could tempt some recipients into more reckless decisions. By contrast, a modest amount paid as a regular basic income would not encourage excessive risk-taking, and would have the added advantage of allowing people to learn over time how to handle money if they had not been able to do so previously.

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As it happened, I did manage to work for a short while, only to have to push myself far too hard to replace the benefit lost, leading to a relapse from which I have never recovered.6 A basic income paid as a right would remove the worst poverty trap and this precarity trap. It would reduce the moral hazard entailed by existing social assistance schemes, that people do not do what they would otherwise wish to do (for example, taking a job). It would also reduce the immoral hazard of entering the shadow or black economy instead, because the disincentives to entering the legal tax-paying economy are excessive.

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Dynamic and Feedback Effects A fundamental drawback of both back-of-the-envelope exercises and simulation models is their essentially static approach, ignoring the potential dynamic effects of basic income on economic activity. For instance, as noted earlier, a basic income would remove the disincentive posed by poverty and precarity traps to take low-wage jobs, increase hours of paid labour or push for higher pay. This ‘moral hazard’ (discouraging people from doing what they would otherwise wish to do) has a treble cost: the continuation of dependence on low state benefits, the economic output foregone, and the loss of tax and national (social) insurance contributions that would flow into national coffers. The current means-tested system also creates a huge immoral hazard, tempting people in and around the precariat to enter the black economy, thereby avoiding tax and national insurance contributions altogether.

How to Speak Money: What the Money People Say--And What It Really Means by John Lanchester

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, asset allocation, Basel III, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, blood diamond, Bretton Woods, BRICs, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collective bargaining, commoditize, creative destruction, credit crunch, Credit Default Swap, crony capitalism, Dava Sobel, David Graeber, disintermediation, double entry bookkeeping, en.wikipedia.org, estate planning, fear index, financial engineering, financial innovation, Flash crash, forward guidance, Garrett Hardin, Gini coefficient, Glass-Steagall Act, global reserve currency, high net worth, High speed trading, hindsight bias, hype cycle, income inequality, inflation targeting, interest rate swap, inverted yield curve, Isaac Newton, Jaron Lanier, John Perry Barlow, joint-stock company, joint-stock limited liability company, junk bonds, Kodak vs Instagram, Kondratiev cycle, Large Hadron Collider, liquidity trap, London Interbank Offered Rate, London Whale, loss aversion, low interest rates, margin call, McJob, means of production, microcredit, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, negative equity, neoliberal agenda, New Urbanism, Nick Leeson, Nikolai Kondratiev, Nixon shock, Nixon triggered the end of the Bretton Woods system, Northern Rock, offshore financial centre, oil shock, open economy, paradox of thrift, plutocrats, Ponzi scheme, precautionary principle, proprietary trading, purchasing power parity, pushing on a string, quantitative easing, random walk, rent-seeking, reserve currency, Richard Feynman, Right to Buy, road to serfdom, Ronald Reagan, Satoshi Nakamoto, security theater, shareholder value, Silicon Valley, six sigma, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, sovereign wealth fund, Steve Jobs, survivorship bias, The Chicago School, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tragedy of the Commons, trickle-down economics, two and twenty, Two Sigma, Tyler Cowen, Washington Consensus, wealth creators, working poor, yield curve

We know that for sure because of the Herfindahl-Hirschman index, a rather groovy way of putting a numerical value on the concentration of monopoly power. moral hazard A term most people had never heard before the financial crisis of 2008, but it was used so often during the crisis that we all got sick of it. There is moral hazard when there is an economic structure that does not penalize, and at worst actively encourages, reckless behavior. Bailing out the banks, for instance, creates a classic form of moral hazard, because it exempts those banks from the consequences of their mistakes. Perhaps the most spectacular example during the credit crunch was the bailout/nationalization of AIG, the company that had insured most of the world’s credit default swaps, and as a result was on the brink of going broke.

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Banks had taken out insurance with AIG, and there was a case to be made for punishing them for being so stupid. Instead AIG got its bailout, which mainly involved direct transfers of cash to the banks that were its counterparties. The banks suffered no consequences for their mistakes, and so had no incentives to avoid such mistakes in the future—a textbook example of moral hazard. It was worry about moral hazard that made the Bank of England slow to act when the first signs of the credit crunch appeared with the collapse of the bank Northern Rock in autumn 2007. The term is close to being an example of reversification, but perhaps it’s more like a simple obfuscation: what we’re really talking about is the bad guys getting away with it.

Birth of the Euro by Otmar Issing

accounting loophole / creative accounting, behavioural economics, Bretton Woods, business climate, business cycle, capital controls, central bank independence, currency peg, currency risk, financial innovation, floating exchange rates, full employment, inflation targeting, information asymmetry, labour market flexibility, labour mobility, low interest rates, market fundamentalism, money market fund, moral hazard, oil shock, open economy, price anchoring, price stability, purchasing power parity, reserve currency, Robert Solow, Y2K, yield curve

In a single currency area, the political benefit from deficit spending (gaining votes) is enjoyed by national players, while the potential negative effects in the form of higher interest rates (due to increased government borrowing) are felt by all member states. Thus the resistance to deficit spending is reduced, and the propensity to pursue an (inappropriate) expansionary fiscal policy increases – a typical case of what is known as moral hazard. In the consultations on the constitution for the future monetary union, this problem could not be disregarded. On the one hand, a ‘European government’ with corresponding powers was not an option. The national governments (and parliaments) would basically retain their fiscal policy sovereignty.

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This in turn supports expectations of macroeconomic stability and makes the task of the single monetary policy oriented towards maintaining price stability easier. 14 See ECB, ‘Fiscal policies and financial markets’, Monthly Bulletin, February 2006. 196 • The central bank and monetary policy in EMU 2. The rules must lead to sustainable budget policies in the member states and offer protection against moral hazard. As the sanction imposed by the market (interest rates) is insufficient, precautions must be taken so that the case of sovereign insolvency due to over-indebtedness never arises and the no-bail-out principle is never put to the test. 3. While committing governments to a sound budget policy, the rules must also strengthen the incentives for structural reforms to promote employment and growth. 4.

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This risk would always arise, for example, if the central bank, counting on a restrictive fiscal policy stance, committed itself to an expansionary monetary policy. Even if some governments kept their ‘promises’, it would be most unlikely that all governments (and parliaments) would do so. There would, at any rate, be a high risk of moral hazard. To judge from the experience with the Stability and Growth Pact, it would most certainly be unwise to subject the ECB’s monetary policy to such ‘tests’. In the end, monetary policy would be blamed for having sacrificed its own objective of price stability to the interests of the other stakeholders.

The Irrational Economist: Making Decisions in a Dangerous World by Erwann Michel-Kerjan, Paul Slovic

"World Economic Forum" Davos, Alan Greenspan, An Inconvenient Truth, Andrei Shleifer, availability heuristic, bank run, behavioural economics, Black Swan, business cycle, Cass Sunstein, classic study, clean water, cognitive dissonance, collateralized debt obligation, complexity theory, conceptual framework, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, Daniel Kahneman / Amos Tversky, endowment effect, experimental economics, financial innovation, Fractional reserve banking, George Akerlof, hindsight bias, incomplete markets, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Isaac Newton, iterative process, Kenneth Arrow, Loma Prieta earthquake, London Interbank Offered Rate, market bubble, market clearing, money market fund, moral hazard, mortgage debt, Oklahoma City bombing, Pareto efficiency, Paul Samuelson, placebo effect, precautionary principle, price discrimination, price stability, RAND corporation, Richard Thaler, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, social discount rate, source of truth, statistical model, stochastic process, subprime mortgage crisis, The Wealth of Nations by Adam Smith, Thomas Bayes, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, ultimatum game, University of East Anglia, urban planning, Vilfredo Pareto

Another challenge is that badly designed insurance contracts can discourage investments in loss prevention or even encourage negligent behavior (“If I know I’m protected anyway, I can take more risk”), commonly referred to in economics as moral hazard or in the climate community as maladaptation. As a remedy, index-based contracts, by decoupling losses and claims, avoid moral hazard and can provide strong incentives for risk-reducing interventions and lifestyle changes. Two of my earlier examples illustrate this: In Mongolia, insured herders will face increasing premiums as climate change worsens weather conditions, giving them an added incentive to change their livelihood if animal husbandry becomes unproductive; and in Mexico, government officials will face higher interest on their catastrophe bonds by not taking measures to reduce risks to public infrastructure.

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CONCLUSION: REFRAMING THE DISCUSSION AS A PREREQUISITE FOR REFORM It is no secret that the current (and long-standing) federal approach to financing disaster losses is far from perfect. Since disaster risk is spread unevenly across the country, financing federal relief out of general revenues involves large cross-subsidies, from low-risk to high-risk areas. Many critics claim, moreover, that generous federal relief creates a large “moral hazard” problem, ensuring greater losses over the long term by encouraging building in hazard-prone areas and generally reducing incentives for investment in preventive measures. Nor is there any lack of good policy alternatives. One reasonable option would be to make private disaster insurance mandatory and to create a federal reinsurance program, allowing private insurers to transfer some portion of the risk to the government reinsurance agency, in return for an appropriate premium.

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It is clear and reasonable that different individuals have access to different information; they have varying life experiences and varying opportunities to make observations. A number of economists came to stress this concept from varying points of view; I myself came to it by considering the economics of medical care (Arrow, 1963).4 Insurance companies had long understood the consequences of asymmetry of information under such headings as moral hazard and adverse selection. It is not always recognized that the most neoclassical approaches in economics also assume asymmetry of information. It is a standard claim for the usefulness of a system of markets that it requires an individual to know only his or her own utility function and production possibilities.

Paper Promises by Philip Coggan

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, Alan Greenspan, balance sheet recession, bank run, banking crisis, barriers to entry, Bear Stearns, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, bond market vigilante , Bretton Woods, British Empire, business cycle, call centre, capital controls, Carmen Reinhart, carried interest, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, currency risk, debt deflation, delayed gratification, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, falling living standards, fear of failure, financial innovation, financial repression, fixed income, floating exchange rates, full employment, German hyperinflation, global reserve currency, Goodhart's law, Greenspan put, hiring and firing, Hyman Minsky, income inequality, inflation targeting, Isaac Newton, John Meriwether, joint-stock company, junk bonds, Kenneth Rogoff, Kickstarter, labour market flexibility, Les Trente Glorieuses, light touch regulation, Long Term Capital Management, low interest rates, manufacturing employment, market bubble, market clearing, Martin Wolf, Minsky moment, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Myron Scholes, negative equity, Nick Leeson, Northern Rock, oil shale / tar sands, paradox of thrift, peak oil, pension reform, plutocrats, Ponzi scheme, price stability, principal–agent problem, purchasing power parity, quantitative easing, QWERTY keyboard, railway mania, regulatory arbitrage, reserve currency, Robert Gordon, Robert Shiller, Ronald Reagan, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, Suez crisis 1956, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, time value of money, too big to fail, trade route, tulip mania, value at risk, Washington Consensus, women in the workforce, zero-sum game

Creditors tend to believe that a borrower should honour his debts as a matter of principle; ‘they hired the money, didn’t they?’ as 1920s US President Calvin Coolidge remarked when faced with his allies’ requests to reschedule First World War debts. The idea that borrowers should be allowed to escape is one example of ‘moral hazard’ in economics. Let the borrowers believe they will be rescued from their folly, the tone implies, and they will never meet their responsibilities. The concept of moral hazard persuaded the US authorities not to rescue the investment bank Lehman Brothers in September 2008, a decision that almost brought the global financial system to a halt. The debtors also appeal to morality. They argue that creditors demand too high a price for lending money.

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Indeed, even if White had been sympathetic to Keynes’s ambitions, he had to deal with congressional opposition to a large US commitment. One newspaper feared that ‘Uncle Sam would be treated as an Uncle Sap for the rest of the world’.3 The concept of a domestic lender of last resort had always been dogged by moral hazard. What was to stop a bank from taking excessive risks if it believed the central bank stood behind it? The same was true at the international level. Would the IMF act as a sugar daddy to deficit nations and prevent them from making the required policy changes to address their own problems? The initial proposal of Keynes was for a ‘clearing union’ in which international trade balances would be settled.

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The relationship between central banks, markets and debt levels has already been mentioned; when markets falter central banks cut interest rates, thus encouraging investors to take more risk. There is also another spiral at work involving banks and governments. Governments support banks, so banks get bigger, requiring more government support. One study found that deposit insurance schemes increased fourfold, relative to GDP, in the wake of a financial crisis.16 This leads to a ‘moral hazard’ problem. Depositors have no incentive to monitor the health of their banks since governments stand behind them and will guarantee their deposits. That was how British savers became exposed to an Icelandic bank. Banks ceased to compete on safety. Instead they competed to attract shareholders by the size of their profits, creating the incentive to take more risk.

Trillion Dollar Triage: How Jay Powell and the Fed Battled a President and a Pandemic---And Prevented Economic Disaster by Nick Timiraos

"World Economic Forum" Davos, Alan Greenspan, asset-backed security, banking crisis, Bear Stearns, Bernie Sanders, bitcoin, Black Monday: stock market crash in 1987, Bonfire of the Vanities, break the buck, central bank independence, collapse of Lehman Brothers, collective bargaining, coronavirus, corporate raider, COVID-19, credit crunch, cryptocurrency, Donald Trump, fear index, financial innovation, financial intermediation, full employment, George Akerlof, George Floyd, global pandemic, global supply chain, Greta Thunberg, implied volatility, income inequality, inflation targeting, inverted yield curve, junk bonds, lockdown, Long Term Capital Management, low interest rates, managed futures, margin call, meme stock, money market fund, moral hazard, non-fungible token, oil shock, Phillips curve, price stability, pushing on a string, quantitative easing, Rishi Sunak, risk tolerance, rolodex, Ronald Reagan, Savings and loan crisis, secular stagnation, Skype, social distancing, subprime mortgage crisis, Tesla Model S, too big to fail, unorthodox policies, Y2K, yield curve

But the Fed will in fact be better off if the public recognizes that its leaders are regular people who will err—and that society cannot count on them to correct politicians’ mistakes or broader social ills.6 The Fed’s actions almost certainly exacerbated a moral hazard that could lead investors to take more risks in the future, particularly if glaring fragilities in financial markets are not addressed. If moral hazard does indeed inculcate riskier behavior, it may not be evident for a long time. The 2020 panic exposed semi-predictable deficiencies in the shadow banking system—a catchall term that describes asset managers, hedge funds, and other institutions that provide bank-like services.

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Robert Glauber, a Harvard academic whom Powell reported to, came down firmly on one side: he hated bailouts. Powell huddled with Fed governor John LaWare at a Treasury Department conference room where Glauber pounded the table and insisted the depositors take a haircut and pay for the sins of the bank. If we always run to the rescue, he said, it creates a “moral hazard”—a term the insurance industry uses to refer to people who take risks knowing they’re protected against larger losses. After Glauber got off his soapbox, LaWare calmly laid out the Fed’s line: “You’re the government, and you can do whatever you want, but here’s what we think will happen if we haircut uninsured depositors.

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Central banks, cautious by nature, don’t attract risk-takers; central bankers prefer to take time to see if one, two, or three days of wild market swings might fade. What’s more, taking bold steps sometimes risked bailing out sophisticated investors who had knowingly made highly leveraged, risky bets. It was the same “moral hazard” rationale used to argue against the bailout of the Bank of New England in 1991. It’s not the Fed’s job to keep them from losing money, one Fed staff director warned. Are we really going to go bail out hedge funds that knew they were taking on more risk when they invested in off-the-run Treasury securities?

The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King

Alan Greenspan, Andrei Shleifer, Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, behavioural economics, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Boeing 747, Bretton Woods, British Empire, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, centre right, classic study, collapse of Lehman Brothers, creative destruction, Credit Default Swap, crowdsourcing, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, distributed generation, Doha Development Round, Edmond Halley, Fall of the Berlin Wall, falling living standards, fiat currency, financial engineering, financial innovation, financial intermediation, floating exchange rates, foreign exchange controls, forward guidance, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, German hyperinflation, Glass-Steagall Act, Great Leap Forward, Hyman Minsky, inflation targeting, invisible hand, Japanese asset price bubble, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, labour market flexibility, large denomination, lateral thinking, liquidity trap, Long Term Capital Management, low interest rates, manufacturing employment, market clearing, Martin Wolf, Mexican peso crisis / tequila crisis, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, Nick Leeson, no-fly zone, North Sea oil, Northern Rock, oil shale / tar sands, oil shock, open economy, paradox of thrift, Paul Samuelson, Ponzi scheme, price mechanism, price stability, proprietary trading, purchasing power parity, quantitative easing, rent-seeking, reserve currency, Richard Thaler, rising living standards, Robert Shiller, Robert Solow, Satoshi Nakamoto, savings glut, secular stagnation, seigniorage, stem cell, Steve Jobs, The Great Moderation, the payments system, The Rise and Fall of American Growth, Thomas Malthus, too big to fail, transaction costs, Tyler Cowen: Great Stagnation, yield curve, Yom Kippur War, zero-sum game

The provision of insurance without a proper charge is an incentive to take excessive risks – in modern jargon, it creates ‘moral hazard’. Both Bagehot and Hankey were right, in their own way. Once a panic has started, the provision of liquidity to others can prevent widespread contagion. But the design of the LOLR mechanism must be thought through carefully beforehand in order to avoid incentives to excessive risk-taking. As time passed, it became easier to flood the system with liquidity when problems arose than to design a framework that would counter moral hazard. If Bagehot’s ideas grew out of his study of earlier financial crises, can we too learn from financial episodes after 1866?

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The system in place before the crisis provided many incentives for banks to structure themselves in a way that made a crisis more likely – and that is exactly what concern about ‘moral hazard’ means. Standing ready to do whatever it takes to keep the financial system functioning is not enough. The system itself has to be designed carefully in order to reduce the frequency and severity of crises. There is a case for the provision of catastrophic insurance – but not unconditionally and not in the way that was forced on policy-makers in the circumstances of 2008. Some commentators have taken issue with concerns about moral hazard, arguing, by analogy, that fire departments put out fires started by people who smoke in bed.

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It allows banks and other financial intermediaries to choose for themselves the structure of their balance sheet and how to relate particular types of assets to the structure of their liabilities. In so doing, it offers a way of promoting competition in the financial sector while restricting the degree of alchemy. Compared with the Chicago Plan, it lowers the cost of eliminating bank runs. Fourth, it solves the moral hazard problem associated with the conventional lender of last resort. Banks will be required to take out insurance in the form of pre-positioned collateral with the central bank, so that, when required, liquidity can be provided quickly and cheaply on demand. There will be no need to apply a penalty rate on lending during a crisis because the disincentive to rely on the provision of central bank liquidity is provided by the haircuts on collateral.

Money and Government: The Past and Future of Economics by Robert Skidelsky

"Friedman doctrine" OR "shareholder theory", Alan Greenspan, anti-globalists, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, barriers to entry, Basel III, basic income, Bear Stearns, behavioural economics, Ben Bernanke: helicopter money, Big bang: deregulation of the City of London, book value, Bretton Woods, British Empire, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, constrained optimization, Corn Laws, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Graeber, David Ricardo: comparative advantage, debt deflation, Deng Xiaoping, Donald Trump, Eugene Fama: efficient market hypothesis, eurozone crisis, fake news, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, forward guidance, Fractional reserve banking, full employment, Gini coefficient, Glass-Steagall Act, Goodhart's law, Growth in a Time of Debt, guns versus butter model, Hyman Minsky, income inequality, incomplete markets, inflation targeting, invisible hand, Isaac Newton, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Joseph Schumpeter, Kenneth Rogoff, Kondratiev cycle, labour market flexibility, labour mobility, land bank, law of one price, liberal capitalism, light touch regulation, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, long and variable lags, low interest rates, market clearing, market friction, Martin Wolf, means of production, Meghnad Desai, Mexican peso crisis / tequila crisis, mobile money, Modern Monetary Theory, Money creation, Mont Pelerin Society, moral hazard, mortgage debt, new economy, Nick Leeson, North Sea oil, Northern Rock, nudge theory, offshore financial centre, oil shock, open economy, paradox of thrift, Pareto efficiency, Paul Samuelson, Phillips curve, placebo effect, post-war consensus, price stability, profit maximization, proprietary trading, public intellectual, quantitative easing, random walk, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, rising living standards, risk/return, road to serfdom, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, shareholder value, short selling, Simon Kuznets, structural adjustment programs, technological determinism, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, tontine, too big to fail, trade liberalization, value at risk, Washington Consensus, yield curve, zero-sum game

The attempt in the 1970s to control inflation by wage and price controls led directly to a ‘crisis of governability’, as trade unions, particularly in Britain, refused to accept them. Large state subsidies to producer groups, both public and private, fed the typical corruptions of behaviour identified by the New Right: rent-seeking, moral hazard and free-riding. Palpable evidence of government failure obliterated earlier memories of market failure. The new generation of economists abandoned Keynes and, with the help of sophisticated mathematics, reinvented the classical economics of the self-correcting market. Battered by the crises of the 1970s, governments caved in to the ‘inevitability’ of free market forces.

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To ensure the necessary trust, creditors have always created as many obstacles to default as government or convention allow. They have kept interest rates as high as possible against risk of default. They have imprisoned or enslaved defaulting debtors, or taken their property. They have invaded, or refused loans to, states that repudiate their debts. Economists talk of the ‘moral hazard’ of making life too easy for debtors. The more cynical see loans to impecunious debtors as a kind of asset-stripping, a substitute for armies to obtain land and resources. However, the debtor position is not without moral support. All religions have supported ‘debt forgiveness’ and abhorred ‘debt-bondage’.

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Moreover, it was in the second half of the nineteenth century that the Bank of England started to develop its modern function as ‘lender of last resort’ to the banking system, a duty codified in Walter Bagehot’s 1873 classic, Lombard Street. Bagehot argued that it was the Bank’s duty to keep large-enough reserves to be able, in a crisis, to lend freely to all solvent banks at a very high rate of interest. Widely resisted at the time on the high ground of ‘moral hazard’, it led to the Bank organizing the rescue of Barings in 1890. This was the doctrine that the US Federal Reserve signally failed to apply in the Lehman Brothers crisis of September 2008, and which the European Central Bank was debarred by law from applying in the European banking crisis that followed.

Big Data and the Welfare State: How the Information Revolution Threatens Social Solidarity by Torben Iversen, Philipp Rehm

23andMe, Affordable Care Act / Obamacare, algorithmic bias, barriers to entry, Big Tech, business cycle, centre right, collective bargaining, COVID-19, crony capitalism, data science, DeepMind, deindustrialization, full employment, George Akerlof, income inequality, information asymmetry, invisible hand, knowledge economy, land reform, lockdown, loss aversion, low interest rates, low skilled workers, microbiome, moral hazard, mortgage debt, Network effects, new economy, obamacare, personalized medicine, Ponzi scheme, price discrimination, principal–agent problem, profit maximization, Robert Gordon, speech recognition, subprime mortgage crisis, tail risk, The Market for Lemons, The Rise and Fall of American Growth, union organizing, vertical integration, working-age population

Every worker faced the risk of falling ill and thus forgoing wages that were essential to their families’ welfare, so this was an important matter for all workers (Andersson and Eriksson 2017). As a result, there was widespread willingness to pay into sickness funds, and many were successfully set up. Moral hazard, which is an otherwise serious problem when it comes to illness, could usually be dealt with through community monitoring and peer pressure (checking on colleagues failing to show up at work, requiring doctors’ notes, etc.). Gottlieb notes that “intrusive monitoring and social pressure may have been an effective way of mitigating moral hazard” (2007, 278), and such monitoring can be seen as an extension of MASs “fraternizing” function (which sometimes turned abusive).

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In addition, some risks are correlated across individuals, which violate actuarially sound insurance principles. Unemployment, which is subject to macroeconomic shocks, is an example. This does not rule out private providers, but it does require the state to be an “insurer of last resort,” which itself leads to problems of moral hazard. For these reasons, the transition to a private system is by no means a foregone conclusion in a high-information environment. Yet privatization and public sector marketization enter the political debate in a way not seen in a low-information environment. methods and evidence A study of the consequences of more and better information about individual risks faces the obvious problem that most of such information is private and protected by privacy policies.

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In addition, the fund was built up gradually and resembled fully funded retirement schemes in the sense that most collected benefits only after a life of contributions. The fund was designed for future, not current, widows and orphans. This gradualism, and the fact that life expectancy did not vary very much among ministers, prevented what we referred to in the previous chapter as the timeinconsistency problem. Moral hazard was also not a problem: most ministers led ascetic lives and had no reason or proclivity to put their own lives at risk. 1 The foundations of actuarial science were being established simultaneously in England and were explained for the first time by James Dodson in his “First Lecture on Insurances” in 1756 (Brackenridge and Brown 2006).

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

Alan Greenspan, asset-backed security, Bear Stearns, book value, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Glass-Steagall Act, Hyman Minsky, Irwin Jacobs, Jim Simons, John Meriwether, junk bonds, Long Term Capital Management, low interest rates, margin call, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, proprietary trading, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, Savings and loan crisis, savings glut, shareholder value, sovereign wealth fund, stock buybacks, too big to fail, traveling salesman, uptick rule, vertical integration, Y2K, yield curve

—Brutus to Julius Caesar, Act I, Julius Caesar, William Shakespeare, circa 1600 CONTENTS PART I / HOW IT HAPPENED: TEN DAYS IN MARCH CHAPTER 1 / The Ultimate Roach Motel CHAPTER 2 / The Confidence Game CHAPTER 3 / “Bear Stearns Is Not in Trouble!” CHAPTER 4 / The Run on the Bank CHAPTER 5 / The Armies of the Night CHAPTER 6 / Feeding Frenzy CHAPTER 7 / Total Panic CHAPTER 8 / The Price of Moral Hazard? $2 CHAPTER 9 / The Fed Comes to the Rescue (After the Battle Is Over) CHAPTER 10 / Mooning at the Wake CHAPTER 11 / “New Developments from Hell” CHAPTER 12 / “We're the Bad Guys” PART II / WHY IT HAPPENED: EIGHTY-FIVE YEARS CHAPTER 13 / Cy CHAPTER 14 / Ace CHAPTER 15 / Jimmy CHAPTER 16 / May Day CHAPTER 17 / Haimchinkel Malintz Anaynikal CHAPTER 18 / The Joy of Mortgage-Backed Securities CHAPTER 19 / “Bullies Always Cave” CHAPTER 20 / The Math Whiz and the Baseball Star CHAPTER 21 / “We're All Going to a Picnic and the Tickets Are $250 Million Each” CHAPTER 22 / The Fish Rots from the Head PART III / THE END OF THE SECOND GILDED AGE CHAPTER 23 / The 10-in-10 Strategy CHAPTER 24 / Cayne CAPs Spector CHAPTER 25 / Cioffi's Bubble CHAPTER 26 / “The Entire Subprime Market Is Toast” CHAPTER 27 / “If There's Fraud, We're Gonna Pay” CHAPTER 28 / A Very Stupid Decision CHAPTER 29 / Nashville CHAPTER 30 / The Cayne Mutiny CHAPTER 31 / Desperate Times Call for Hare-Brained Schemes Epilogue: The Deluge Notes Acknowledgments HOW IT HAPPENED: TEN DAYS IN MARCH THE ULTIMATE ROACH MOTEL he first murmurings of impending doom for the financial world originated 2,500 miles from Wall Street in an unassuming office suite just north of Orlando, Florida.

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He said that while everyone was “taken aback” by the $10 deal, there was also a feeling of resignation: “It is what it is. Let's go get this done. Let's go do what we have to do to get done here.” People started trickling home after midnight on Saturday, somewhat confident that a deal with JPMorgan would coalesce the next day before the deadline. THE PRICE OF MORAL HAZARD? $2 n Sunday morning at around eight-thirty, Bear's team of fifty professionals reassembled in the thirteenth-floor conference center. Schwartz kicked off the day by telling everyone how it “was going to unfold,” explained one participant, “but people were not in a good mood.” Bear's lawyers had received a draft of a proposed merger agreement from Wachtell, Lipton, JPMorgan's lawyers, as well as a draft of an option agreement that would allow JPMorgan to buy a large chunk of Bear Stearns's stock.

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But on Sunday morning, when Paulson appeared on ABC's This Week, he gave no indication how high the stakes had been increased since the Fed stepped in on Friday morning. He dutifully defended that decision when asked about it by George Stephanopoulos. “The right decision here, I am convinced, was the decision the Fed made, which was to do things, work with market participants, to minimize the disruptions.” He said he was “very aware of moral hazard. But our primary concern right now—my primary concern—is the stability of our financial system.” When Stephanopoulos asked Paulson if the Fed's back-to-back loan to Bear Stearns had solved the problem, Paulson used evasive tactics, even though he knew full well that the situation was then at its most flammable.

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

Abraham Wald, Albert Einstein, Bayesian statistics, Bear Stearns, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk free rate, risk tolerance, risk/return, Robert Solow, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, Thales and the olive presses, Thales of Miletus, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

To prevent the bankruptcy of one of the largest companies in the country, the US government supplied $182.5 billion in credit to the company in what constituted, at the time, the largest corporate bailout in history.1 Of course, the danger of privatized profits but socialized losses in insurable activities is the moral hazard problem. The Black-Scholes equation assumes that the random walk of log-normal values follows a log-normal distribution. This is a symmetric distribution, and assumes that upside and downside risk are equally likely consequences of external forces. When the insured entity can affect the risk profile and hence increase its probability of crossing the exercise threshold, the Black-Scholes estimate of efficient options pricing is biased. In essence, the insured can purchase the option too cheaply, or, in the case of moral hazard, exhibit insufficient prudence because of the protection of insurance.

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In an era of investment banks too big to be allowed to fail, if a market suddenly seizes and prevents investors from unwinding, they may find themselves owing hundreds of billions of dollars, as AIG had discovered. In such a case, in which companies keep their profits in good times but must be bailed out to prevent even greater financial catastrophe in bad times, the financial system creates the moral hazard problem of privatized gains and socialized losses. Scholes agreed that the reality in which finance found itself by 2007 was problematic. Scholes proposed that the financial system should be deleveraged. However, he acknowledged the difficulty of such a proposal. If investors must establish a safer balance between assets controlled and the capital invested, then a large portion of their securities assets would have to be sold.

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During the unwinding of Long Term Capital Management, the New York Fed was involved in its first huge financial company bailout of a financial company deemed too big to fail. It would not be its last. At the time, as in the aftermath of even larger bailouts in 2008 and 2009, some expressed grave concern that to bail out firms deemed too big to fail encouraged similarly positioned firms to take inordinate risks. Suddenly, the insurance concept of moral hazard had entered the finance lexicon. In the aftermath, executives of related companies were forced to resign by their boards. Goldman Sachs CEO Jon Corzine was ousted in a board-level effort organized by future Treasury Secretary Henry Paulson. Corzine went into politics and represented New Jersey in the US Senate, then led the large investment bank MF Global to its dramatic demise as it illegally comingled its customer’s funds with its proprietary investment fund and lost hundreds of millions of dollars.

Ethics in Investment Banking by John N. Reynolds, Edmund Newell

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, banking crisis, Bear Stearns, collapse of Lehman Brothers, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, financial independence, Glass-Steagall Act, index fund, invisible hand, junk bonds, light touch regulation, margin call, Michael Milken, moral hazard, Nick Leeson, Northern Rock, proprietary trading, quantitative easing, shareholder value, short selling, South Sea Bubble, stem cell, the market place, The Wealth of Nations by Adam Smith, too big to fail, two and twenty, zero-sum game

Calculated as the discount rate that makes the net present value of all future cash flows zero Investment banking: providing specialist investment banking services, including capital markets activities and M&A advice, to large clients (corporations and institutional investors) Glossary xi Investment banking adviser: see Adviser Islamic banking: banking structured to comply with Shariah (Islamic) law Junior debt: debt that is subordinated or has a lower priority than other debt Junk bond: see High yield bond Lenders: providers of debt finance Leverage: debt Leveraged acquisition: acquisition of a company using high levels of debt to finance the acquisition LIBOR: London Inter-Bank Offered Rate, the rate at which banks borrow from other banks Liquidity: capital required to enable trading in capital markets M&A: mergers and acquisitions; typically the major advisory department in an investment bank Market abuse: activities that undermine efficient markets and are proscribed under legislation Market capitalism: a system of free trade in which prices are set by supply and demand (and not by the Government) Market maker: a market participant who offers prices at which it will buy and sell securities Mis-selling: inaccurately describing securities (or other products) that are being sold Moral hazard: the risk that an action will result in another party behaving recklessly Moral relativism: the concept that morals and ethics are not absolute, and can vary between individuals Multi-notch downgrade: a significant downgrade in rating or recommendation (by a rating agency) Natural law: the concept that there is a universal moral code Net assets: calculated as total assets minus total liabilities Net present value (NPV): sum of a series of cash inflows and outflows discounted by the return that could have been earned on them had they been invested today NYSE: New York Stock Exchange Operating profit: calculated as revenue from operations minus costs from operations P:E: ratio used to value a company where P (Price) is share price and E (Earnings) is earnings per share Price tension: an increase in sales price of an asset, securities or a business resulting from a competitive situation in an auction xii Glossary Principal: equity investor in a transaction Principal investment: proprietary investment Private equity: equity investment in a private company Private equity fund: investment funds that invest in private companies Proprietary investment: an investment bank’s investment of its own capital in a transaction or in securities Qualifying instruments: securities covered by legislation Qualifying markets: capital markets covered by legislation Quantitative easing: Government putting money into the banking system to increase reserves Regulation: legal governance framework imposed by legislation Restructuring: investment banking advice on the financial restructuring of a company unable to meet its (financial) liabilities Returns: profits Rights-based ethics: ethical values based on the rights of an individual, or an organisation SEC: the Securities and Exchange Commission, a US regulatory authority Sarbanes–Oxley: the US “Company Accounting Reform and Investor Protection Act” Senior debt: debt that takes priority over all other debt and that must be paid back first in the event of a bankruptcy Shariah finance: financing structured in accordance with Shariah or Islamic law Sovereign debt: debt issued by a Government Speculation: investment that resembles gambling; alternatively, very short-term investment without seeking to gain management control Socially responsible investing (SRI): an approach to investment that aims to reflect and/or promote ethical principles Spread: the difference between the purchase (bid) and selling (offer) price of a security Subordinated debt: see Junior debt Syndicate: group of banks or investment banks participating in a securities issue Syndication: the process of a group of banks or investment banks selling a securities issue Takeover Panel: UK authority overseeing acquisitions of UK public companies Too big to fail: the concept that some companies or sectors are too large for the Government to allow them to become insolvent Glossary xiii Unauthorised trading: trading on behalf of an investment bank or other investor without proper authorisation Universal bank: an integrated bank Utilitarian: ethical values based on the end result of actions, also referred to as consequentialist Volcker Rule: part of the Dodd–Frank Act, restricting the proprietary investment activities of deposit-taking institutions Write-off: reduction in the value of an investment or loan Zakat: charitable giving, one of the five pillars of Islam This page intentionally left blank 1 Introduction: Learning from Failure There has been significant criticism of the ethics of the investment banking sector following the financial crisis.

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The UK’s Independent Commission on Banking stated that too big to fail “constitutes a perceived acceptance of risk by the state . . . . with the potential for the related rewards to be enjoyed by the private sector”. This is described, in their Call for Evidence, as “inequitable” and “creating moral hazard incentives for poor decision making”.6 Ethical duties and the implicit Government guarantee The duty that investment banks owe to their Governments is affected by the implicit guarantee from Governments to support the financial markets. Investment banks have benefitted from this during the financial crisis – the liquidity crisis in the markets would have brought markets to some form of collapse without Government intervention.

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Consequently, while markets can be “efficient” and it is understood that all participants are seeking to profit, there can also be unequal economic outcomes to market activity (one counterparty may profit and another lose from a trade). Preventing outcomes where some participants incur losses may be an attractive ideal, but it is not practical and not ethically required. It also gives rise to moral hazards. If an investment bank is by its nature a market counterparty, and is expected by its customers and the market operators to take risks, it is difficult to expect the investment bank to behave towards all market counterparties as if they are clients, and to act so as to always protect its counterparties’ interests.

End This Depression Now! by Paul Krugman

airline deregulation, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, bond market vigilante , Bretton Woods, business cycle, capital asset pricing model, Carmen Reinhart, centre right, correlation does not imply causation, credit crunch, Credit Default Swap, currency manipulation / currency intervention, debt deflation, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, full employment, German hyperinflation, Glass-Steagall Act, Gordon Gekko, high-speed rail, Hyman Minsky, income inequality, inflation targeting, invisible hand, it is difficult to get a man to understand something, when his salary depends on his not understanding it, It's morning again in America, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Joseph Schumpeter, junk bonds, Kenneth Rogoff, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, low interest rates, low skilled workers, Mark Zuckerberg, Minsky moment, Money creation, money market fund, moral hazard, mortgage debt, negative equity, paradox of thrift, Paul Samuelson, price stability, quantitative easing, rent-seeking, Robert Gordon, Ronald Reagan, Savings and loan crisis, Upton Sinclair, We are all Keynesians now, We are the 99%, working poor, Works Progress Administration

If you’ve ever seen the movie It’s a Wonderful Life, which features a run on Jimmy Stewart’s bank, you might be interested to know that the scene is completely anachronistic: by the time the supposed bank run takes place, that is, just after World War II, deposits were already insured, and old-fashioned bank runs were things of the past. On the other side, Glass-Steagall limited the amount of risk banks could take. This was especially necessary given the establishment of deposit insurance, which could have created enormous “moral hazard.” That is, it could have created a situation in which bankers could raise lots of money, no questions asked—hey, it’s all government-insured—then put that money into high-risk, high-stakes investments, figuring that it was heads they win, tails taxpayers lose. One of the first of many deregulatory disasters came in the 1980s, when savings and loan institutions demonstrated, with a vengeance, that this kind of taxpayer-subsidized gambling was more than a theoretical possibility.

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It reduces their exposure to changes in the housing market and in interest rate levels. This in turn will make the thrift industry a stronger, more effective force in financing housing for millions of Americans in the years to come. But it didn’t work out that way. What happened instead was that deregulation created a classic case of moral hazard, in which the owners of thrifts had every incentive to engage in highly risky behavior. After all, depositors didn’t care what their bank did; they were insured against losses. So the smart move for a banker was to make high-interest-rate loans to dubious borrowers, typically real estate developers.

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academic sociology, 92, 96, 103 AIG, 55 airlines, deregulation of, 61 Alesina, Alberto, 196–99 American Airlines, 127 American Recovery and Reinvestment Act (ARRA): cost of, 121 inadequacy of, 108, 109–10, 116–19, 122–26, 130–31, 212, 213 Angle, Sharron, 6 anti-Keynesians, 26, 93–96, 102–3, 106–8, 110–11, 192 Ardagna, Silvia, 197–99 Argentina, 171 Arizona, housing bubble in, 111 Asian financial crisis of 1997–98, 91 asset-backed securities, 54, 55 auction rate securities, 63 Austerians, 188–207 creditors’ interests favored by, 206–7 supposed empirical evidence of, 196–99 austerity programs: alarmists and, 191–95, 224 arguments for, 191–99 economic contraction and, 237–38 in European debt crisis, 46, 144, 185, 186, 188 as ineffective in depressions, xi, 213 state and local governments and, 213–14, 220 unemployment and, xi, 189, 203–4, 207, 237–38 Austrian economics, 150 automobile sales, 47 babysitting co-op, 26–28, 29–30, 32–33, 34 Bakija, Jon, 78 balance of trade, 28 Ball, Laurence, 218 Bank for International Settlements (BIS), 190, 191 Bank of England, 59 Bank of Japan, 216, 218 bankruptcies, personal, 84 bankruptcy, 126–27 Chapter 11, 127 banks, banking industry: capital ratios in, 58–59 complacency in, 55 definition of, 62 deregulation of, see deregulation, financial European, bailouts of, 176 government debt and, 45 “haircuts” in, 114–15 incomes in, 79–80 lending by, 30 money supply and, 32 moral hazard in, 60, 68 1930s failures in, 56 origins of, 56–57 panics in, 4, 59 political influence of, 63 receivership in, 116 regulation of, 55–56, 59–60, 100 repo in, 62 reserves in, 151, 155, 156 revolving door in, 86, 87–88 risk taking in, see risk taking runs on, 57–58, 59, 60, 114–15, 155 separation of commercial and investment banks in, 60, 62, 63 shadow, 63, 111, 114–15 unregulated innovations in, 54–55, 62–63, 83 Barro, Robert, 106–7 Bebchuck, Lucian, 81 Being There (film), 3 Bernanke, Ben, 5, 10–11, 32, 76, 104, 106, 151, 157, 159–60, 210 recovery and, 216–19 on 2008–09 crisis, 3–4 “Bernanke Must End Era of Ultra-low Rates” (Rajan), 203–4 Black, Duncan, 190 Blanchard, Olivier, 161–63 Bloomberg, Michael, 64 BNP Paribas, 113 Boehner, John, 28 bond markets: interest rates in, 132–41, 133 investor confidence and, 132, 213 bonds, high-yield (junk bonds), 115, 115 bond vigilantes, 125, 132–34, 138, 139, 140 Bowles, Erskine, 192–93 Brazil, 171 breach of trust, 80 Bretton Woods, N.H., 41 Broder, David, 201 Brüning, Heinrich, 19 Buckley, William F., 93 Bureau of Labor Statistics, U.S.

Profiting Without Producing: How Finance Exploits Us All by Costas Lapavitsas

Alan Greenspan, Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, borderless world, Branko Milanovic, Bretton Woods, business cycle, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, computer age, conceptual framework, corporate governance, credit crunch, Credit Default Swap, David Graeber, David Ricardo: comparative advantage, disintermediation, diversified portfolio, Erik Brynjolfsson, eurozone crisis, everywhere but in the productivity statistics, false flag, financial deregulation, financial independence, financial innovation, financial intermediation, financial repression, Flash crash, full employment, general purpose technology, Glass-Steagall Act, global value chain, global village, High speed trading, Hyman Minsky, income inequality, inflation targeting, informal economy, information asymmetry, intangible asset, job satisfaction, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, liberal capitalism, London Interbank Offered Rate, low interest rates, low skilled workers, M-Pesa, market bubble, means of production, Minsky moment, Modern Monetary Theory, Money creation, money market fund, moral hazard, mortgage debt, Network effects, new economy, oil shock, open economy, pensions crisis, post-Fordism, Post-Keynesian economics, price stability, Productivity paradox, profit maximization, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, race to the bottom, regulatory arbitrage, reserve currency, Robert Shiller, Robert Solow, savings glut, Scramble for Africa, secular stagnation, shareholder value, Simon Kuznets, special drawing rights, Thales of Miletus, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, total factor productivity, trade liberalization, transaction costs, union organizing, value at risk, Washington Consensus, zero-sum game

Consequently the relationship between borrower and lender takes the contractual form of the lender advancing money to the borrower for a given period of time in exchange for a proportionately fixed share of the proceeds from the project (interest).8 The lender must also practise information collection and monitoring of the borrower in order, first, to minimize the chances of the borrower undertaking fraudulent or careless action (moral hazard) and, second, to avoid attracting disproportionate numbers of poor quality borrowers (adverse selection). The outcome of moral hazard and adverse selection could be the rationing of credit actually provided by lenders, and hence the failure of credit markets to clear.9 In this light, banks and other financial institutions are providers of services that presumably improve the efficiency of the interaction between borrowers and lenders.

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Participants in capitalist markets presumably have to bear the consequences of their own decisions. If it is necessary for financial markets occasionally to receive wholesale provision of liquidity from the state, it follows that markets produce suboptimal results, while participants are protected from their own actions by publicly backed liquidity. Consequently, moral hazard is an inherent outcome of the function of lender of last resort. The second component of generic market-negating regulation is deposit insurance guarantees. The practice emerged already in the late nineteenth century, and can take a variety of legal forms – private and public as well as explicit and implicit.

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If deposit holders converged on a bank demanding cash, the bank would go bankrupt irrespective of its profitability, of the quality of its assets, and so on. Public guarantees prevent or ameliorate bank runs by re-establishing trust in banks among the public. It is apparent that public deposit insurance guarantees represent market-negating regulation since they effectively lower the cost of liabilities for banks. But they also create moral hazard since, on the one hand, some of the liabilities of banks are publicly protected and, on the other, deposit holders need not ultimately monitor the performance of banks. By this token, deposit insurance guarantees raise the profitability of banks, other things equal. The third and most striking aspect of market-negating regulation in the course of financialization, however, has been the gradual prevalence of the principle of ‘too big to fail’ among financial institutions.

Termites of the State: Why Complexity Leads to Inequality by Vito Tanzi

accounting loophole / creative accounting, Affordable Care Act / Obamacare, Alan Greenspan, Andrei Shleifer, Andrew Keen, Asian financial crisis, asset allocation, barriers to entry, basic income, behavioural economics, bitcoin, Black Swan, Bretton Woods, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Cass Sunstein, central bank independence, centre right, clean water, crony capitalism, David Graeber, David Ricardo: comparative advantage, deindustrialization, Donald Trump, Double Irish / Dutch Sandwich, experimental economics, financial engineering, financial repression, full employment, George Akerlof, Gini coefficient, Gunnar Myrdal, high net worth, hiring and firing, illegal immigration, income inequality, indoor plumbing, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Jean Tirole, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labor-force participation, libertarian paternalism, Long Term Capital Management, low interest rates, market fundamentalism, means of production, military-industrial complex, moral hazard, Naomi Klein, New Urbanism, obamacare, offshore financial centre, open economy, Pareto efficiency, Paul Samuelson, Phillips curve, price stability, principal–agent problem, profit maximization, pushing on a string, quantitative easing, rent control, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Second Machine Age, secular stagnation, self-driving car, Silicon Valley, Simon Kuznets, synthetic biology, The Chicago School, The Great Moderation, The Market for Lemons, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, transfer pricing, Tyler Cowen: Great Stagnation, universal basic income, unorthodox policies, urban planning, very high income, Vilfredo Pareto, War on Poverty, Washington Consensus, women in the workforce

The expectation that the government will intervene in the future may be influenced by its past behavior and may create what economists call “moral hazard,” which may make some institutions take greater risks than they would have otherwise. The danger created by “too big to fail” financial institutions is based on these expectations. Some institutions, and especially some banks, may become so big that the expectation that the government would not allow them to fail, because it would put a country’s economy at high risk, comes to be widely shared. This also allows some banks to get credit more cheaply, thus distorting competition. Inventory of Government Tools 139 Contingent liabilities and moral hazards may become particularly important in catastrophic events.

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The socialization of the losses incurred by some very large financial enterprises has, in fact, been justified (by those who made the decisions to help them) on the grounds that, without the government rescue, the economy would risk falling into a depression similar to or worse than the one in the 1930s. As the justifiers might put it, when a house is on fire, firefighters cannot worry about the moral hazard consequences of putting out the fire! Of course, these interpretations of what might have happened might be right or wrong, and we shall never know. The same argument will be offered in probable future crises, as long as the banks and the other financial institutions remain “too big to fail.” See Bernanke (2015) and Geithner (2014) for a defense of the rescue operations in 2008–2009.

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The problem is that, while governmental interventions may prevent potential, but not certain, current disasters from occurring, they also create expectations of interventions in future crises. The previous interventions, tend to create problems for future governments and for society, putting future governments at greater risk, and creating more reasons to keep the fiscal accounts in good order (see Tanzi, 2013b). The expectation of governmental intervention creates a “moral hazard” and tends to distort the operation of the free market, creating (unfair) advantages for institutions that have become “too big to be allowed to fail” and that, because of their size, have come to expect being rescued in future crises. These institutions’ lower risks allow them to borrow more cheaply than smaller enterprises can, thus distorting the market and Modernity and Growing Termites in Market 157 increasing the likelihood of future crises and of future government interventions during crises.

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", "there is no alternative" (TINA), "World Economic Forum" Davos, affirmative action, Alan Greenspan, Albert Einstein, algorithmic trading, Andy Kessler, AOL-Time Warner, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Bear Stearns, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, BRICs, British Empire, business cycle, buy the rumour, sell the news, capital asset pricing model, carbon credits, Carl Icahn, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, Daniel Kahneman / Amos Tversky, deal flow, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Dr. Strangelove, Dutch auction, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Fall of the Berlin Wall, financial engineering, financial independence, financial innovation, financial thriller, fixed income, foreign exchange controls, full employment, Glass-Steagall Act, global reserve currency, Goldman Sachs: Vampire Squid, Goodhart's law, Gordon Gekko, greed is good, Greenspan put, happiness index / gross national happiness, haute cuisine, Herman Kahn, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", job automation, Johann Wolfgang von Goethe, John Bogle, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Michael Milken, Mikhail Gorbachev, Milgram experiment, military-industrial complex, Minsky moment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, National Debt Clock, negative equity, NetJets, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, Phillips curve, planned obsolescence, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, proprietary trading, public intellectual, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, Reminiscences of a Stock Operator, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Thaler, Right to Buy, risk free rate, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, short squeeze, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, stock buybacks, survivorship bias, tail risk, Teledyne, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, two and twenty, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

No doctor or surgeon expects to or receives a tip for doing their job properly. The bonus culture encouraged moral hazard—a focus on narrowly quantifiable outcomes while ignoring wider risks and costs. Elite bankers and traders took risks with other people’s money, aware that if they won the bet they would get a significant share of profits, while suffering no permanent damage if they lost. In a comedy sketch featuring British comedians John Bird and John Fortune, the interviewer asks: “Can we talk about moral hazard?” The banker responds: “About what?” The interviewer reiterates the question: “Moral hazard?” The banker says: “I know what ‘hazard’ means, but what’s the other word?”

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Banks estimate the worst-case daily change in the value of positions to cover the risk. Event risk, where the value of the position changes a lot quickly, is difficult to measure. Competition reduces the haircuts. LTCM was special, not requiring any haircut. As one observer asked: “Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?”22 At their peak, hedge funds accounted for 30–40 percent of total investment bank earnings. Citadel paid $5.5 billion in trading costs to investment banks,23 the largest portion being interest on borrowings. Citadel’s total and net assets were $166 billion and $13 billion respectively.

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Rising debt drives up asset prices leading to even more debt that cannot be supported by values or income produced. The system is underpinned by faith in the competence of legislators, regulators and the chattering classes—commentators, gurus and financial journalists. Faux theories, such as Alan Greenspan and Ben Bernanke’s Great Moderation, reassure investors that old problems have been overcome. Moral hazard increases as excessive risk taking and speculation become commonplace. There are increases in beezle42—fraud or embezzlement—as sharp people take advantage of the favorable conditions and abundance of money. As Dr. Pangloss, professor of “metaphysico-theologo-cosmolo-nigology” in Voltaire’s Candide, knew: “All is for the best in the best of all possible worlds.”

MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them by Nouriel Roubini

"World Economic Forum" Davos, 2021 United States Capitol attack, 3D printing, 9 dash line, AI winter, AlphaGo, artificial general intelligence, asset allocation, assortative mating, autonomous vehicles, bank run, banking crisis, basic income, Bear Stearns, Big Tech, bitcoin, Bletchley Park, blockchain, Boston Dynamics, Bretton Woods, British Empire, business cycle, business process, call centre, carbon tax, Carmen Reinhart, cashless society, central bank independence, collateralized debt obligation, Computing Machinery and Intelligence, coronavirus, COVID-19, creative destruction, credit crunch, crony capitalism, cryptocurrency, currency manipulation / currency intervention, currency peg, data is the new oil, David Ricardo: comparative advantage, debt deflation, decarbonisation, deep learning, DeepMind, deglobalization, Demis Hassabis, democratizing finance, Deng Xiaoping, disintermediation, Dogecoin, Donald Trump, Elon Musk, en.wikipedia.org, energy security, energy transition, Erik Brynjolfsson, Ethereum, ethereum blockchain, eurozone crisis, failed state, fake news, family office, fiat currency, financial deregulation, financial innovation, financial repression, fixed income, floating exchange rates, forward guidance, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, future of work, game design, geopolitical risk, George Santayana, Gini coefficient, global pandemic, global reserve currency, global supply chain, GPS: selective availability, green transition, Greensill Capital, Greenspan put, Herbert Marcuse, high-speed rail, Hyman Minsky, income inequality, inflation targeting, initial coin offering, Intergovernmental Panel on Climate Change (IPCC), Internet of things, invention of movable type, Isaac Newton, job automation, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, junk bonds, Kenneth Rogoff, knowledge worker, Long Term Capital Management, low interest rates, low skilled workers, low-wage service sector, M-Pesa, margin call, market bubble, Martin Wolf, mass immigration, means of production, meme stock, Michael Milken, middle-income trap, Mikhail Gorbachev, Minsky moment, Modern Monetary Theory, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Mustafa Suleyman, Nash equilibrium, natural language processing, negative equity, Nick Bostrom, non-fungible token, non-tariff barriers, ocean acidification, oil shale / tar sands, oil shock, paradox of thrift, pets.com, Phillips curve, planetary scale, Ponzi scheme, precariat, price mechanism, price stability, public intellectual, purchasing power parity, quantitative easing, race to the bottom, Ralph Waldo Emerson, ransomware, Ray Kurzweil, regulatory arbitrage, reserve currency, reshoring, Robert Shiller, Ronald Reagan, Salesforce, Satoshi Nakamoto, Savings and loan crisis, Second Machine Age, short selling, Silicon Valley, smart contracts, South China Sea, sovereign wealth fund, Stephen Hawking, TED Talk, The Great Moderation, the payments system, Thomas L Friedman, TikTok, too big to fail, Turing test, universal basic income, War on Poverty, warehouse robotics, Washington Consensus, Watson beat the top human players on Jeopardy!, working-age population, Yogi Berra, Yom Kippur War, zero-sum game, zoonotic diseases

When borrowers take risks with the confidence that someone will come to their rescue, there is what economists like to call “moral hazard.” If you feel confident the government will bail you out if a risky bet fails, why not go for it? The higher the risk, the higher the potential return, and there may be no downside. If you win your bet, you get to keep all the chips; if you lose it, someone else picks up the tab and you live to bet another day. When taxpayers are on the hook, moral hazard privatizes gains and socializes losses. Ironically, there is one controversial but popular solution to high debt problems: take on yet more debt, to stimulate growth.

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Emerging markets often get in trouble when the Fed hikes interest rates rapidly, or the price of exported commodities falls sharply—or both. In international courtrooms I testified for a decade to help Argentina fend off aggressive lawsuits by vulture investors after the default in 2001. When they mobilize to fix problems, government policy makers often lay the groundwork for future crises. Economists single out “moral hazard”—shorthand for economic bailouts that induce borrowers and investors to throw caution to the wind. Why worry about risk if someone else will shoulder your losses? Policy decisions have many unintended consequences, not least the subprime mortgage imbroglio that turned into the Global Financial Crisis of 2008.

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If authorities tax accumulated wealth or impose lofty tax rates on super-high incomes, tax avoidance may increase and proceeds still won’t approach amounts needed to ease the global debt load. And taxing labor to reduce debt levels is often politically impossible when many workers are income strapped and already facing high tax rates. Every single remedy to high debt levels brings its own costs: the paradox of thrift, the chaos of defaults, the moral hazard of bailout, the wealth taxation that hurts the wealthy and may lead to less private capital investment, the labor taxation that hurts the most vulnerable, unexpected inflation that wipes out the wealth of creditors. That is why we have arrived at the new “consensus” of MMT, as if it were a free lunch.

The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse by Mohamed A. El-Erian

"World Economic Forum" Davos, activist fund / activist shareholder / activist investor, Airbnb, Alan Greenspan, balance sheet recession, bank run, barriers to entry, Bear Stearns, behavioural economics, Black Monday: stock market crash in 1987, break the buck, Bretton Woods, British Empire, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, collapse of Lehman Brothers, corporate governance, currency peg, disruptive innovation, driverless car, Erik Brynjolfsson, eurozone crisis, fear index, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, fixed income, Flash crash, forward guidance, friendly fire, full employment, future of work, geopolitical risk, Hyman Minsky, If something cannot go on forever, it will stop - Herbert Stein's Law, income inequality, inflation targeting, Jeff Bezos, Kenneth Rogoff, Khan Academy, liquidity trap, low interest rates, Martin Wolf, megacity, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Norman Mailer, oil shale / tar sands, price stability, principal–agent problem, quantitative easing, risk tolerance, risk-adjusted returns, risk/return, Second Machine Age, secular stagnation, sharing economy, Sheryl Sandberg, sovereign wealth fund, The Great Moderation, The Wisdom of Crowds, too big to fail, University of East Anglia, yield curve, zero-sum game

Importantly, it provided financial (loss-protected) backing for a shotgun wedding between failing Bear Stearns and solid-standing JPMorgan Chase. Central banks’ hope was that these two very sudden and disturbing shocks, together with the exceptional nature of the policy response, would entice banks to de-risk in an orderly manner. Instead, banks seemed beholden to what economists call “moral hazard”—that is, the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism. There is perhaps no better example of this phenomenon than what Chuck Prince, the then CEO of Citigroup, one of the biggest and most closely followed banks in the world, told the Financial Times in a front-page interview.

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To some, the behavior of financial markets once again showed insufficient heed paid to the important insights of Hyman Minsky, the American economist. Known for his “financial instability hypothesis,”7 Minsky argued that, in capitalist economies, periods of financial stability give rise to subsequent periods of great financial instability. The extent of underlying moral hazard became more and more notable. I remember being bemused in October 2014 by the extent to which the return of some modest market volatility caused some respected market participants to call for the Fed to come up with “QE4”—that is, yet another program of large-scale asset purchases in order to repress market volatility and artificially boost asset prices again.

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But it’s a complicated argument to make and I don’t think we always made it as well as we could have.”2 Former secretary Geithner went further. Recognizing the difficulty of selling to the public the case for bailouts, he reacted quite sharply to those who suggested that such assistance to banks would encourage renewed irresponsible behavior down the road. He saw little merit for the claims of those he labeled in his book “moral hazard fundamentalists.”3 Recognizing the continued anger in the country, an active group of politicians is interested not only in de-risking the banks further but also in gaining greater insights into how their de facto main supervisor, the Federal Reserve, operates—so much so as to push an inherently nonconfrontational Chair Yellen to warn in July 2014 congressional testimony that greater Fed oversight could be a “grave mistake.”4 Yet this phenomenon will not dissipate anytime soon, especially as it unites lawmakers on both sides of the political aisle, albeit for different reasons.

Poor Economics: A Radical Rethinking of the Way to Fight Global Poverty by Abhijit Banerjee, Esther Duflo

"World Economic Forum" Davos, Albert Einstein, Andrei Shleifer, business process, business process outsourcing, call centre, Cass Sunstein, charter city, clean water, collapse of Lehman Brothers, congestion charging, demographic transition, diversified portfolio, experimental subject, hiring and firing, Kickstarter, land tenure, low interest rates, low skilled workers, M-Pesa, microcredit, moral hazard, purchasing power parity, randomized controlled trial, Richard Thaler, school vouchers, Silicon Valley, The Fortune at the Bottom of the Pyramid, Thomas Malthus, tontine, urban planning

What stops people from doing more to help one another? Why are some forms of risk not covered, or not covered well? There are good reasons we may be unwilling to offer unconditional help to our friends and neighbors. For one thing, we may worry that the guarantee of help might create a temptation to slack off—this is what insurers call moral hazard. Or that people may claim that they are in need even when they are not. Or simply that the promise of mutual help may not be carried through: I help you, but when your turn comes around, you are too busy. These are all explanations for why we may want to hold back our help a little, but it is not clear whether this could explain not offering help to those who just became very sick, because falling ill is presumably not a choice.

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There are of course a number of obvious difficulties with providing insurance. These problems are not specific to the poor. They are fundamental problems, but they are amplified in poor countries, where it is more difficult to regulate insurers and monitor the insured. We have already mentioned “moral hazard”: People may change their behavior (farm less carefully, spend more money on health care, and so forth) once they know that they will not bear the full consequences. Consider some of the problems of providing health insurance, for example. We have seen that even without health insurance, the poor visit some forms of health providers all the time.

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A farmer should value a policy that pays him a fixed amount (based on the premium he paid) when the rainfall measured at the nearby weather station falls below a certain critical level. Because no one controls the weather and there is no judgment to be made about what should be done (unlike in medical care, where someone must decide which tests or treatment is needed), there is no scope for moral hazard or fraud. Within health care, insuring catastrophic health events—major illnesses, accidents—seems much easier than covering outpatient care. Nobody wants to have surgery or chemotherapy just for the heck of it, and the treatment is easily verified. The danger of overtreatment remains, but the insurer can cap what it will pay for each treatment.

In FED We Trust: Ben Bernanke's War on the Great Panic by David Wessel

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, Berlin Wall, Black Swan, break the buck, business cycle, central bank independence, credit crunch, Credit Default Swap, crony capitalism, debt deflation, Fall of the Berlin Wall, financial engineering, financial innovation, financial intermediation, fixed income, full employment, George Akerlof, Glass-Steagall Act, Greenspan put, housing crisis, inflation targeting, information asymmetry, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, Michael Milken, money market fund, moral hazard, mortgage debt, new economy, Northern Rock, price stability, quantitative easing, Robert Shiller, Ronald Reagan, Saturday Night Live, Savings and loan crisis, savings glut, Socratic dialogue, too big to fail