Paul Kedrosky has a guest post from Tom Vanderwell on moral hazard. Moral hazard describes a situation where parties behave differently because they do not expect to bear the full consequences of their actions. For example, when a guy in a bar acts especially belligerent because he’s got his big, tough friend with him, that’s moral hazard at work.
Free market purists argue that moral hazard distorts the free market, and so firms and investors should not be insulated from risk. In other words, the FDIC should not exist, because then the risk of bank default would force customers to be more informed about the loans their banks make. This would cause banks who make risky loans to lose business, and thus strengthen the banking industry.
Of course, there are reasons why we protect people from the consequences of risk, even if it introduces moral hazard to the equation. Only rarely do only the people taking on unwise risks suffer the consequences when their bets don’t pay off, which leads Vanderwell to this question:
But how can we prevent a total meltdown of the housing and mortgage market (what would happen if Fannie and Freddie actually went under) without absolving some of the participants (for this particular discussion, we’ll limit it to Wall St., the Ratings Agencies, the Mortgage Companies, and the Banks who wrote the loans oh, and the mortgage lenders themselves if they did anything criminal or fraudlent) of at least some of their consequences?
He has some suggestions.
Needless to say, moral hazard is a concept that is of great interest to insurers. Malcolm Gladwell wrote an article in 2005 explaining why moral hazard isn’t really a concern when it comes to health insurance.