Moral Hazard is a media buzzword that became very popular in 2008 thanks to the financial crisis. It was used to refer to the situation where banks knew they were too big to fail and thus took on more risk than normal, but more on that in a second.
Moral hazard is a legitimate economic term used to describe certain events in the market. But the media has really taken off with the word. I’ve seen headlines like “Tiger Woods’ Moral Hazard” or “No Moral Hazard In Obama Housing Plan” and even a connection of moral hazard to the iPad. And I can’t tell you how many times it’s come up in conversation with colleagues lately. The Wall Street Journal seems to be the primary culprit, but no one is immune (even me now). Everyone wants to use the word but few really understand what it is, or that it might be misused in today’s uses.
So what is the moral hazard? It exists whenever someone lacks a sufficient incentive to do what they’re supposed to do. If there are speed limits, but no tickets, then there is moral hazard. If you work in sales but aren’t paid a commission, then the moral hazard is you don’t have incentive to sell as much as possible. Moral hazard exists in my apartment, because the office doesn’t enforce the parking policy by towing unregistered vehicles. We encounter moral hazard all the time. But the word has become popular thanks to Wall Street. It is believed that a moral hazard existed with the banks taking on risk. See, they knew that their roles in the economy were vital, so if things got bad then the government would help them out. So they took on more risk than a prudent firm would, knowing the government would help them out. At best, I’d say a select few might have guessed it was possible, but I’m more inclined to call this a conspiracy theory than anything else.
Many of the CEOs and CFOs of the largest banks and investment firms have been shamed, fired, and grilled by Washington as a result. Their careers are mostly ruined and they’ve been replaced. Even the business schools that graduated these people have dissociated themselves from their most famous alums. There’s no way these guys would take on so much risk and assume their company would survive with only their career’s to sacrifice. Too much altruism there. And for another matter, half of these firms are gone. But none of this even compares with a different issue: these people weren’t smart enough to notice a moral hazard.
For it to be a moral hazard, one party has to take on more risk than expected with the assumption that someone would help them out if need be. That assumes these firms knew how much risk they’d taken on. There is very little evidence that says executives on Wall Street even knew how much risk they were exposed to. None of these people are dumb enough to risk their entire firms for a certain kind of investment, but they sure were dumb enough to think they weren’t overexposed. Moral hazard this is not. Ignorance it is.
But nevertheless, moral hazard lives on. It will be used in countless talking points on Capitol Hill, get printed thousands of more times by the media, and whenever another buzz word pops up die a quick death. I’d like to hurry along this process by giving the media and Congress a new word to play with: externality. Have fun.
I realize not everyone may know who the guy in the picture is. He’s Dick Fuld (no jokes), the disgraced CEO of Lehman Brothers, the firm that the government refused to save from disaster. Just days before Lehman failed he did an interview on CNBC from Florida trying to save his firm from collapse. He didn’t know answers to softball questions and it was clear he had no idea what was going on. Perhaps at this point he would have thought he’d get a bailout, but he didn’t when he allowed his firm to get so exposed to the subprime market.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
