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Tuesday, September 16, 2008

"Moral Hazard for Corporations"

Yesterday, in his "Third Rant of the Day", knzn argued:

[W]hen the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

Today, he argues that moral hazard is misunderstood, and that "the financial system as a whole should be insured":

Moral Hazard for Corporations, by knzn: With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. ... Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

    Posted by on Tuesday, September 16, 2008 at 11:16 AM in Economics, Market Failure, Monetary Policy | Permalink  TrackBack (0)  Comments (21)

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