Commercial Banks, River Banks, and Moral Hazard, Jeff Frankel: Quite a few economists are worried about moral hazard in financial markets. ...
Of course moral hazard is a serious problem that lies close to the heart of the financial market crises. But I am not sure that I completely share the priority at this point on drawing a tougher line with the ex post bailouts. It may be futile advice. Fixing the hole in the roof when it is raining is, after all, rather difficult.
Consider two other areas where moral hazard is an issue: commercial banks and river banks. Some economists would prefer that the government refrain from helping the victims of banking panics and river floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future.
But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates mandatory federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for a wider range of financial institutions. ...
Beyond helping flooded out homeowners, as with Bear Stearns, if there was ever a natural disaster costly enough to threaten the health of the insurance industry and the financial system more generally, I suspect the government would step in with a bailout for insurance companies. We can argue that the insurance companies never should have written such risky policies, but having a dysfunctional insurance industry would be stifling.
Some risks are too large for the private sector to carry on its own, when very large shocks hit the private sector may not be able to fully absorb them, and we rely upon and expect government to step in when shocks are so large that they endanger the overall economy. The government can and should act as insurer of last resort when the health of the economy is threatened, it really has no choice, and because of that regulation will be needed to, as much as possible, limit the the chance that the impact from a shock will require the government to intervene.