Larry Summers: Beware Moral Hazard Fundamentalists

Larry Summers says the moralists have it wrong:

Beware moral hazard fundamentalists, by Larry Summers, Commentary, Financial Times (free): Central to every policy discussion in response to a financial crisis ... is the concept of moral hazard. Unfortunately, there is great confusion ... about ... when moral hazard is, and is not, a problem. ...

The term “moral hazard” originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire...

In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future “bail-outs”. ...

Moral hazard fundamentalists misunderstand the insurance analogy... As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability. They are wrong in three crucial respects.

First, ... the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.

Second, the insurance analogy fails to take account of ... a key aspect of the financial context – moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent... But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.

More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

Third, in the insurance template used in thinking about moral hazard, the insurer pays more out because of the behavioural changes induced by insurance... Something parallel happens when the government guarantees a financial institution’s liabilities.

But much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money ... was spent. A competent lender of last resort ... actually turns a profit, as the IMF did in its response to the financial crises of the 1990s. Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Where does all of this leave policy? ...[T]hese considerations suggest that prudent central banks will make judgments during financial crises not on the basis of “avoiding moral hazard” but rather by asking themselves three questions.

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.