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Tuesday, August 28, 2007

Fed Intervention and Moral Hazard

Imagine living a world with no insurance, there's no health insurance, fire insurance, auto insurance, unemployment insurance, Social Security, nothing of this sort at all. As we know from countries such as China, when insurance is not widely available households tend to increase their savings, i.e. to increase their precautionary saving balances.

But in a world with insurance, consumers are able to reduce these precautionary savings considerably. In doing so, they can be more exposed to risk from large shocks. If you are relying upon your insurance company to pay for the loss if your house burns down, your car is wrecked, or you have a costly health problem, etc., and hence have not left sufficient available liquidity to cover these contingencies yourself, and if the insurance company does not pay off as expected, things could be pretty tough. With insurance, people do not leave as much margin for error along a lot of fronts, they reduce their precautionary balances, and failure of an insurance company to payoff as expected could cause severe financial distress, distress that might not have occurred without the dependence on insurance.

This is different than another way of increasing risk, moral hazard. If I get fire insurance, I can reduce my precautionary balances as described above, and this leaves me more exposed than before if the insurance company fails. But if I then start to use real candles on my Christmas tree, don't bother to get the fireplace cleaned, don't bother to clear the dry brush around the house, etc., then that is moral hazard.

Moral hazard is a form of market failure and, as such, we need to avoid it. One way is not to provide insurance at all. No insurance, no moral hazard, simple. But there are other ways of dealing with the problem that can reduce its negative effects without causing us to give up on providing insurance. For example, co-payments and deductibles are both ways of reducing moral hazard. The idea is to make the insured pay part of the cost when there is a payout so that they will reduce the incidence of avoidable risks.

Turning to mortgage and financial markets, I see nothing at all wrong with participants in those markets expecting the Fed to stabilize the macroeconomy. In essence, the Fed is providing insurance against volatility in the overall economy and of course traders are going to anticipate that if the economy turns downward, the Fed will adjust rates. They should expect that and take it into account in their decisions.

But just as with regular insurance, this can induce moral hazard and that seems to be what most of the discussion surrounding whether the Fed should intervene is about - by providing the insurance to the macroeconomy does the Fed also provide the motivation for moral hazard behavior (excessive risk taking)?

There is that chance, and likely that reality, but just as with regular insurance the solution is not to withhold coverage, i.e. for the Fed to do nothing in the face of an apparently weakening economy to avoid creating poor incentives going forward. We know a lot about how to solve moral hazard problems and there's no reason at all those cannot be applied to these markets to reduce this problem.

When necessary, the Fed needs to intervene to stabilize the macroeconomy, moral hazard or not. Just as you would anticipate your insurance company paying off if there was a fire, and just as you might face bankruptcy if it did not pay, participants in financial markets anticipate the Fed will provide insurance to the macroeconomy (as it always does), and they may face financial difficulties if it does not.

There's nothing wrong with financial market participants expecting a stable environment, and reducing their precautionary balances (e.g. their cash positions) in response just as you would reduce your precautionary saving. It's the moral hazard part we want to avoid and, as I noted above, there are many, many ways to intervene into these markets to reduce market failure from moral hazard in the future, and those can and should be applied whether the Fed intervenes now or not.

There is an exception to when insurance should pay off, of course, and that is if (for example) you willfully burn down your own house. I want to be careful here. If I have insurance, and a behavior is not ruled out and it causes a payoff, I have not crossed any moral lines, I have simply acted according to the economic constraints that are in place. If there's no deductible on my auto insurance and no co-pay, if everything is 100% covered, then I won't be so careful about how I park or about getting small dents, etc., they're covered. If the insurance company's customers then take excessive risks, and payouts are so high that the insurance company crashes, that is not the customers fault. The incentives need to be fixed to make the insurance viable.

Did participants in mortgage markets do the equivalent of burning down their own houses, or were they simply acting according to the constraints the insurance company (i.e. the Fed) had in place? I'm sure there were some who set the place afire themselves, but I believe the preponderance were simply behaving according to the rules of the game.

Payoff now, as promised, i.e. stabilize the economy if needed and don't worry about who gets bailed out in the process (but prosecute the arsonists). It may look like a big bailout, the Fed may have to intervene before signs of problems in the overall economy are evident due to lags in monetary policy, but there should be no hesitation about intervening to stabilize economic conditions.

We need to fix the markets so that the incentive to engage in moral hazard type behavior in the future is substantially reduced, no doubt about it. But what we shouldn't do is withhold insurance altogether just because we are worried about creating moral hazard problems in the future. That's not the best way to fix the problem.

Update: In comments, knzn adds:

We don't just want to prevent people from taking excessive risks; we also want to encourage people to take appropriate risks. In fact, the latter is what we mostly want to do: Because risk often cannot be sufficiently diversified, the risk-takers experience personal costs of failure that are not matched by the social costs.

Update: Martin Wolf and Robert Reich discuss the same issue. Martin Wolf first:

Central banks should not rescue fools, by Martin Wolf, Commentary, Financial Times: ...Ben Bernanke ... said ... he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.

Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents. What then would be the right response to this latest scrape that supposedly sophisticated financial markets have fallen into?

Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. ...

Everybody knows that the Fed’s job is to stabilise the economy and prevent deflation. Everybody knows, too, that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates. ...

This brings one to the second objective: ensuring the functioning of the financial system. The question is how to help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone... I think of the underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two. ...

So what should the authorities do...? My answer is “nothing”. They should, of course, stand ready to provide liquidity to the market, at a penal rate (since insurance should never be free), and also to adjust interest rates to overall macroeconomic conditions. ...

Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them... It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.

Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.

My point is about protecting the macroeconomy, and about getting the microeconomic incentives correct, so in that sense I think we agree.

Next, Robert Reich, and again, I think we are in substantive agreement:

Stop the Hedge Fund Casinos, by Robert B. Reich, American Prospect: ...Ordinarily, central banks shouldn't bail out speculators. It's bad policy to make money cheaper -- and investments less risky -- after investors have been hoisted with the petard of their own foolishness. That only invites more foolishness next time.

Yet..., ordinary rules don't apply in extraordinary circumstances. That the inability of several thousand lower-income Americans to meet their mortgage payments set off a chain reaction leading to a worldwide credit crunch is ...[an] extraordinary circumstance. This one may require even more intervention by the Fed and other central banks around the world than we've witnessed already. ...

Americans are understandably nervous. Most American households have invested their savings in stocks and bonds. Most have also relied on the rising values of their homes as "nest eggs" when they retire. The fact that the housing bubble has burst while stocks and bonds have lost ground is likely to cause American consumers to cut their spending. Given that consumers comprise 70 percent of the economy, this could push America into a recession. ...

The ... Fed has to bail out the speculators, because we'll all suffer if it doesn't.

That doesn't mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten.

Hedge funds have been operating huge financial casinos without having to disclose what they're betting on, or why. Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need. They've been too eager to make money off underwriting the new loans and other financial gimmicks on which they're supposed to be objective judges. Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

For the financial market to work well -- to ensure fair dealing and to prevent speculative excess -- government must oversee it. This mess occurred because nobody was watching. The Fed and other central banks now have to clean it up. But regulators in America, Europe and Asia have to make sure it stays clean. Hedge funds have to be more transparent. Credit-rating agencies must not have any relationship with underwriters. Banks and mortgage lenders should be better supervised. Finance is too important to be left to the speculators.

    Posted by on Tuesday, August 28, 2007 at 01:08 PM in Economics, Market Failure, Monetary Policy | Permalink  TrackBack (1)  Comments (83)


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