The Heart of the Matter: Moral Hazard

Posted: March 29, 2014 in economics, Uncategorized
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Moral Hazard is a very simple concept that has immense and sweeping repercusions. It is at the very root of the decay we see in America today. It causes people, companies, and other entities to behave in a manner they otherwise would not… a manner which is often reckless and destructive. The biggest proliferator of moral hazard in this country is our government along with it’s partner in crime, the federal reserve.

If you don’t know, Moral Hazard is the principle that says if you remove or mitigate the consequences of someone or something’s actions you remove their incentive to guard against risk associated with those actions. In other words, if one is not punished for poor choices, he or she will continue to make those same choices. To boil it down even further: people respond to incentives. Too often our government incentivizes destructive, or at the very least, non productive behavior.

The most obvious example of this are bailouts. The most recent round of bailouts in 2008 is perhaps the most egregious example in US history. Morally there is no question the bailouts were wrong. Banks and other industries engaged in irresponsible behavior, and when the free market system Grim Reaper came calling (I call him Roger) the taxpayer was forced to foot the bill to stave him off. In other words, these companies enjoy privatized profits and socialized losses. Must be nice, huh? So morally it seems obvious bailouts in this case are wrong. The rich get richer and the poor and middle class must pay for their bad decisions. Millions of small businesses would love to have this backstop in place, but needless to say they do not. They must act responsibly, and if they do not they pay the price. They can take some risks if they so choose. They may pay off and they may not, but either way the owner is responsible. Now from the morality to the practicality of moral hazard: imagine if this small business owner, let’s call him Jonathan W. McMichael-Stevens (the W is for Warren which is what I call him), has a guarantee in place. The local government has guaranteed Warren that if he gets in trouble they will bail him out. Well, Warren is likely to engage in behavior he otherwise would not have. He will likely take more risks because hey, if the risks pays off he may get rich, and if the risk fails well he’s none to poorer. This is human nature. It’s tough to blame ole Warren for taking risks. The local government is essentially encouraging the risk taking. This is the same on the federal level. Big banks know there is an implicit bailout in place so they are in essence encouraged to take risks. Risks with your money. You can thank your government for this. All the subprime mortgages and crazy derivatives that led to the housing bubble were the love children of the implicit government guarantees and the federal reserve’s artificially low interest rates. The guarantees have distorted the free market in other ways too. In a true free market, depositors, borrowers, and investors would thoroughly vet banks before entrusting them with their money. As it stands now we don’t really do this because we know there is no real risk.

The Federal Deposit Insurance Corporation, an FDR big government creation, insures deposits up to $250,000. In typical government reactionary fashion, the FDIC was created in response to the bank runs experienced in 1929 and the early years of the depression. As counterintuitive as it may sound, bank runs are actually a good thing. They serve to keep banks in check and make sure they are acting responsibly with your money. The FDIC is yet another backstop that encourages them to act recklessly with depostis. Austrian economists believe the fractional reserve system in itself is immoral and a major cause of the business cycle. Fractional reserve banking means that banks must only keep a small percentage of deposits in reserve. They can loan out the rest. This means that the money you deposit at the bank is not really there. Very little of the money depositors put in the bank is actually kept on hand. This in itself leaves banks susceptible to runs. If banks were made to be honest and keep 100% of reserves on hand, most of the risky practices would be eliminated. The business cycle would be kept at bay if not eradicated. The FDIC is a means to perpetuate and backstop the dishonest fractional reserve banking system.

We also see moral hazard in the welfare and food stamp programs. Many people feel that government should provide for the poor and downtrodden. In reality, government cannot help the poor any better than they can run the Postal service, Amtrak, or anything else. By providing a safety net they actually encourage people to stay impoverished. An old economic adage goes something like this: if you want less of something tax it. If you want more of something subsidize it. By subsidizing the poor, our government is actually creating more poor. The moral hazard in this case is the fact that people will not act in a manner consistent with obtaining and maintaining a job if they have welfare checks and food stamps as an option. Just as we see with bank bailouts, the program in question fails to punish irresponsible behavior and in fact encourages it. Many republicans will say welfare recipients are just lazy, etc. and I’m sure that is the case in some instances, but I say simply that people respond to incentives. I’ve seen estimates that put total government benefits for welfare recipients at around that of a $40,000 job. Here’s a website with some telling statistics: welfare stats People are not lazy as a rule, they are smart. Why put yourself through the drudgery of a 9-5 when you can stay home and get the same benefits? I do not blame people for opting for welfare checks. And for those of you who think that it is insensitive and heartless to say welfare is wrong, I would say that you are the insensitive ones, for private charities could address the problem way, way more efficiently than could the bumbling government. And they would not increase the number of destitute in the process either. If you actually cared about the poor you would want the government to step off (I’m doin’ the Hump).

A cousin of welfare is unemployment insurance. Again, by subsidizing the jobless you create more jobless. I see it all the time at my job. People will try to get fired so that they can collect unemployment. They collect the checks for awhile, go out partying, sleep in late, occasionally peruse the internet for a job… all courtesy of you, the taxpayer. Without the promise of a government check, these folks would behave in a much different manner. They would work as long as they could at one job until they found another, instead of trying to get fired. Of course once they are getting monthly or bi-weekly checks their incentive to look for a job is diminished. Another thing unemployment insurance brings about is allowing the unemployed to take their sweet time and find the perfect job. I hear plenty of anecdotal stories of people who could very easily get a bridge type job, something to get them by till they find a job they really want, but instead take those government checks and bide their time… and Obama keeps extending the amount of time one can get these checks. We are literally paying people not to work. The moral hazard in these cases create unemployment. Want to reduce the unemployment rate? Get rid of the moral hazard. There are plenty of free market solutions to deal with the unemployed for those of you who would say this is an insensitive stance… solutions that would be much more effective than the current program. Forcing taxpayers to pay for this is immoral.

A lot of these programs we have come to believe are necessary create moral hazard. Social Security is just another example. It discourages saving and planning for retirement. It discourages responsible behavior. It’s a bailout. Most of these programs are well-intentioned but horribly misguided. They often create more of the very problem they are trying to solve. So, not only do they presume to know how to plan for your retirement better than you do, but they distort normal savings patterns of workers and disrupt a healthy system. These workers will have a rude awakening one day in the future when this unsustainable program goes bust. It’s nothing but a vote-getting Ponzi scheme.

Here’s a great video of Peter Schiff, economic badass, testifying before congress and schooling them on the moral hazard of government backed flood insurance. The entire video is great but to see the moral hazard part, fast forward to the 25:20 mark: Mr. Schiff Returns to Washington

Perhaps the biggest and most dangerous example of moral hazard today is the implicit backstop given our federal government by the federal reserve. Here’s a quick lesson on how government policy and finance works. The politicians pass expensive legislation in order to secure votes. Whoever promises the most stuff wins the election (I remember in 3rd grade, Billy Stevens won class president by promising cookie dispensers in all the classrooms. Same principle). Where does the government get the money to pay for all these expensive promises? First, they tax you the maximum amount they can get away with and still get your vote: first your income, then your property, then the things you buy, then your investments, and finally your estate. They tax every small business and every corporation. Sadly, this is not even close to enough money to fulfill all their expensive promises. So how do they get more money? They borrow it. Yes, we go into debt so that they can fund these massive vote buying programs. They do this by selling bonds. Who buys these bonds? China, Japan, European countries, American investors, etc. Is this now enough to fund the government? Nope. They still need more money so the federal reserve comes in and buys up more bonds until the treasury is finally fully funded. They do this by printing the money out of thin air. The moral hazard here is that the federal government, knowing the federal reserve will essentially monetize their overcommitments, has no incentive to curtail their spending. The politicians have every incentive to promise more stuff so the spending explodes. We are well over $17 trillion in debt and these is zero hope of ever coming out of that hole. That number is exploding at an absolutely stunning rate. Once our creditors realize we must either default or pay them back with worthless money fresh off the fed printing press, interest rates will skyrocket… which means the interest on our debt will also skyrocket. Then the donkey and elephant feces will hit the fiscal fan, forming a flaming, fed induced fascist fiasco… f#ck!!! This is moral hazard on a macro scale and it sets a precedent for all government activities and programs on the micro level.

Moral Hazard has spread all over our country like an aggressive cancer. My fear is that it will eventually kill the patient. To contain it would take a President and Congress devoted to its eradication. But the odds of voters actually electing someone who would take away their safety nets and bailouts are very low. In regards to the Fed, it would take a Volcker-like chairman who would return us to sound monetary policy and end the money printing. The odds of a President nominating a Fed chair that would deny a printing press backstop for government overspending are also very low. The more likely scenario is an economic crisis. My hope is that we will then see the error of our ways and return to the principals that made us prosperous in the first place.

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