Caution, Morals Ahead

I have a piece in Crikey today about the global financial crisis and change in government direction. It is over the fold.

Wall St bail out means capitalism never really existed

Crikey, 19th September, 2008.

Joshua Gans writes:

Many years ago I was grading an exam that asked students to define “moral hazard.” Sure, there is a correct answer but the one that sticks in my memory is that of a simple sketch of a triangular road sign with the words “Morals Ahead.” It got marks for making me laugh but let’s face it, it wasn’t the intended answer.

But in the last 10 days, that sign has come back to me. We have seen an unprecedented amount of government intervention — especially within the US. Each one is distinct in its mechanism but each one shares a commonality, the government is stepping in to ensure they have enough liquidity to continue to do whatever it was they were doing. Usually what they were doing was backing some security that was in danger of default. For instance, for AIG it was insurance claims that rested on the now greatly devalued subprime generated real estate investments. Let those go and the whole operation would be at risk as default would trigger claims from others who had backed AIG’s operations. And it was the same story for most of these cases. Let it go and more will follow. There were morals ahead.

The intervention is to keep what is happening in the financial markets away from the real economy as much as possible. Once it gets there, real costs might emerge that cause more investments to be at risk. This is exactly what happened to Fannie and Freddie. The subprime drive had fuelled house prices across the US. When those loans went bad, house prices went with them and so regardless of whether you had engaged in subprime lending or not (Fannie and Freddie pretty much had not), you faced a problem. If insurance markets were undermined, we could easily have the same deal.

What is interesting is that the US government has had no better instrument than to literally take over failing financial enterprises. What is more, the case for doing so is not that far from the case to take over a failing non-financial enterprise. It is hard not to look on this as anything but a form of nationalisation.

But why is this a good idea now? Lots of bits of this, especially the seeming reactive nature of it all give us pause for concern. What the US government brings to the table that the private sector cannot is a AAA-rating. This restores confidence but only to a point. After all, the reason for that rating is that the US government can raise taxes (something private firms can’t do). That means that if the intervention cannot restore normal operations and debts are called in, the US economy is still bearing risk here. The bills might soon be due.

There is, of course, another thing the US government brings: it has an eye to more than just the money. There will be no CEOs walking away with big bonuses (whether they deserve it or not). There will be no bureaucrats accumulating private assets. However, these companies are managed for the foreseeable future, it will not be based on the hope of profits.

The definition of “moral hazard” regards the situation that arises when someone gets to make decisions while taking the upside and not bearing the downside. We have now switched to a situation where the downside implications (mostly moral) are real for the new managers of these trillions of dollars in assets but there is no upside. Some claim that this is a strike against capitalism. Perhaps it is, but the capitalism that is supposed to happen is where managers are exposed to both up and downside risks. Here, we had a problem where that capitalism effectively never existed (well, except for shareholders) and now we have switched from one single-handed model to another.

But my final question is: what model do we have here in Australia? Are the morals behind or ahead?

Joshua Gans is an economics professor at Melbourne Business School. He recently argued for a transparent form of government intervention in Australian lending markets. You can read more about that here. He is also the author of Parentonomics: An Economist Dad’s Parenting Experiences.

5 thoughts on “Caution, Morals Ahead”

  1. As I sadly watched Paulsons speech, I thought about moral hazard as a member of a family. Lets call them the Hazards. Each Hazard shares something in common, they are all an outside force on markets that change prices away from where they would be if no outside forces existed.
    This changes the signals and incentives these prices provide. Moving away from efficiency towards inefficiency. Moral is just one of these Hazards.

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  2. It is not just a hazard it is a certainty.

    If you build a system where people can profit from taking a particular action with little retribution from taking that action and it is in the world of commerce then people will take it. Worse many “smart business people” will seek out these opportunities and be admired as after all it is “just business”.

    In the world of social relationships they would not take these actions because it would not be moral but those social constraints go away when it becomes a matter of business. This is described well in Dan Ariely’s book on “Predictably Irrational”.

    Trying to build too many regulations to stop this type of thing is unlikely to work as it only gives more opportunities for “work arounds”. One way that may work is that if it can be shown that people are twisting the rules then they simply be not allowed to play in the game. Give them a yellow card, then a red one.

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  3. Invig,

    If you have a problem with short selling, you must also have a problem with fractional reserve banking.

    Banks lend out money that is not their own to other people devaluing the $$$, and then later on people pay back the bank.

    I don’t have a problem with short selling… I do have a problem with Naked Short Selling — which is selling shares you don’t own and haven’t borrowed. Basically counterfeiting shares.

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