Moral Hazards

One term that keeps popping up in discussions of the finance bailout (e.g., John Stossel a couple of weeks ago and in the WaPo this morning) is "moral hazard". The term has also been referred to in debates about health insurance. But you probably haven't heard a good definition of what the words actually mean.


The term dates back to the 1600s and was widely used in the British insurance industry by the 1800s. Wikipedia defines it as a special case of information asymmetry -- the advantage that goes to a party who has more information than the counterparty being negotiated with. In this sense, the moral hazard arises in that if one has special or inside information he will be tempted to use that information to "game" the transaction. At bottom is probably the idea that he would be a fool not to do so, and so the hazard or asymmetry must be identified and mitigated before the transaction is final.


In the current debate, commentators on the right, like Stossel, are appealing to another sense of "moral," in the sense that it is immoral not to properly punish a bad decision or mismanagement. Just like we make sure a house fire is an accident before putting it out, and lifeguards make sure the swimmer didn't just decide to venture too far out, and ER doctors first decide who's wrong or right before treating a gunshot. Oh, right. That's not the way life works in this modern, western, judeo-christian culture. Correction and improvement is one thing;  punishment is something else entirely.


This is not just abstract, soft-headed charity, agape or eros. We have learned, through many hard lessons, that a neighbor's fire can burn our house, no matter who started it. It used to be that if you hadn't bought insurance from the fire fighters, your house was going to burn, no matter who started it. As a society we decided the price was too high -- to everybody.


In the last few years, there are some individuals, mostly but not entirely on the right, who have argued there is a moral hazard inherent in robust health care insurance -- people will use too much of it. If health care is too cheap, they'll just go running to the doctor for any frivolous reason at all. It doesn't matter that real life doesn't support this psychological tale; it was a textbook example of moral hazard, as defined by health insurers. And it was their argument for making the system difficult and mean: "We are removing the moral hazard for their own moral good. (And our profits.)"


So let us return to the failure and bailout of the financial sector of the economy. It is ironic to me that the system, again largely defined and sold by the right but support by key characters on the left, actually installed moral hazard in the system more than 30 years by assuring information asymmetry in the system itself. The key reason for removing oversight of banks and brokerages was that they -- the finance pros -- knew best, only they had the info to make the best choices and make the market work at its optimal efficiency. Left to these wise men, the market would just take care of itself. And I'm not even talking about quants! (Some other time, perhaps.)


This gospel was largely preached by the so-called Chicago School economists. The neoclassical offspring of von Hayek and Friedman, they believed they understood how to insure efficient markets. They leveraged a uniquely adolescent understanding of the world (Rand-ian objectivism/libertarianism) into an economic theory that valued concise measurements and simple predictive models, predicated on (universal) rational self-interest. They have stood astride the global economy of the last three or four decades convinced of the perfectibility of their models, and look how well it's worked! 


Former Fed chief Paul Greenspan (a youthful acolyte of Ayn Rand's) rode his absolute conviction about the ultimate aim of economy's arrow right to the ground and only expressed mild chagrin that he hadn't -- that the industry hadn't -- foreseen the role of inefficient greed and self-destructive ambition. He still doesn't have his head around that. Who is John Galt, indeed.


When they talk to themselves, the right seems to be pretty comfortable trotting out "moral" issues. But what can be said about the morality of letting others suffer -- in terms of under- and un-employment, inadequate and uneven health care, a growing disparity between wealthy elites and not-quite-making-it proles -- while preaching moral hazard? Even if you don't actually say "Let them eat brioche?"