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Moral Hazard Redux

March 21, 2008

Robert Reich

In light of all the blather about “moral hazard” in recent days, several of [my readers] have suggested I re-publish my blog from last September 07, on the issue of moral hazard. Herewith:

One day while sitting on a beach last summer I overheard a father tussle with his young son about whether the child was old enough to take out a small sailboat. The father finally relented. “Go ahead, but I’m not gonna save you,” he said, picking up his newspaper. A while later, the sailboat tipped over and the child began yelling for help, but father didn’t budge. When the kid sounded desperate I put down my book, walked over to the man, and delicately told him his son was in trouble. “That’s okay,” he said. “That boy’s gonna learn a lesson he’ll never forget.” I walked down the beach to notify a lifeguard, who promptly went into action.

Letting children bear the consequences of their risky behavior — what some parents call “tough love” — is equally applicable adults, and conservatives have made something of a fetish out of it.

Letting children bear the consequences of their risky behavior — what some parents call “tough love” — is equally applicable adults, and conservatives have made something of a fetish out of it. A few weeks ago, as George W. announced a paltry plan to help out a few of the millions of homeowners who got caught in the sub-prime loan mess, he reiterated the credo: “It’s not government’s job to bail out … those who made the decision to buy a home they knew they could not afford.”

It’s true that people tend to be less cautious when they know they’ll be bailed out. Economists call this “moral hazard.” But even when they’re being reasonably careful, people cannot always assess risks accurately. Many of the mostly poor home buyers who got into trouble did NOT in fact know they couldn’t afford the mortgage payments they were signing on to. The banks and mortgage lenders that pulled out all the stops to persuade them to the contrary were in a far better position to know; after all, they had lots of experience at this game. So did the credit-rating agencies that gave these loans solid credit ratings, as did the financiers who bundled them with less-risky loans and sold them to other financial institutions, and the hedge fund managers who quietly tucked them into their portfolios.

The real moral hazard in this saga started when Fed Chair Ben Bernanke cut the Fed’s discount rate (charged on direct federal loans to banks) and announced that the Fed would take whatever action was needed to “promote the orderly financing of markets.” Translated, this means that lenders, credit-rating agencies, financial intermediaries, and hedge funds will be bailed out, one way or another, because they’re simply too big to fail. Note that behind every one of these institutions lie thousands of well-paid executives who would have lost big if the Fed didn’t come to their rescue. Even though they had more information and experience at risk-taking than the suckers who borrowed their money, and even though executives at the top of these instutions typically earn more in a day than the borrowers do in a year, moral hazard somehow doesn’t apply to them.

the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations.

When it comes to risky behavior in the market, America has a double standard. We’re told that economic risk-taking is the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it’s amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. Some are well known, such as the Chrylser bailout of 1979, the savings and loan bailout of 1989, and the airline bailout of 2001. Most occur in the relative dark, such as the 1998 bailout of giant hedge fund Long-Term Capital Management (courtesy of former Fed chair Alan Greenspan), the not infrequent bailouts of under-funded corporate pension plans by the government’s Pension Benefit Guarantee Corporation, price supports for big agribusinesses facing market downturns, or the current bailout of Wall Street being engineered by Ben Bernanke’s Fed. Behind every one of these bailouts are CEOs or financial executives who were rescued from their bad bets.

Conservatives tell us that unemployment insurance reduces…incentive to find a new job quickly.

CEOs get away with stupid mistakes all the time. Some, like Robert Nardelli, the former CEO of Home Depot, drive their company’s stock so low that their boards eventually oust them. But they leave with eye-popping going-away presents nonetheless. (Nardelli got several hundrd million dollars on his departure.) If you’re an average American who gets canned from his job, even through no fault of your own, you probably won’t even get unemployment insurance (only 40 percent of job-losers qualify these days). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard.

Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have “known they could not afford” when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald (“you’re fired!”) Trump’s casino empire has gone into bankruptcy twice — most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets — with no apparent diminution of the Donald’s passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you’re an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued — you guessed it — moral hazard.

Bush’s “ownership society” has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.

Robert B. Reich is Professor of Public Policy at the Goldman School of Public Policy at the University of California at Berkeley. He has served in three national administrations, most recently as secretary of labor under President Bill Clinton. He has written eleven books (including his most recent, Supercapitalism). Mr. Reich is co-founding editor of The American Prospect magazine. His weekly commentaries on public radio’s “Marketplace” are heard by nearly five million people. This entry originally appeared on his blog.

Copyright 2008 Robert B. Reich

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