On Moral Hazard...

Various economists have talked recently about the bail-outs of banks and other “Too Big to Fail” companies in terms of “Moral Hazard”.  The idea of “moral hazard” is that…if such banks or other companies know that they are going to get a bail-out, they will invariably take greater risks and not fear the consequences.  (There’s a good educational video on this topic at the following link:  http://www.youtube.com/watch?v=_SdtoKeFTi0 )  I am, in a way, glad that this issue has arisen, because it forced me to learn about this concept called “moral hazard”.

There is also another aspect of moral hazard called “information asymmetry” in which a “party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.” (source: Wikipedia)

For example, Congress and debt limit increases...!  This is a great example of moral hazard on a Congressional level!  If debt limit increases are virtually automatic (as they have been in the past), then moral hazard comes into play and Congress will just keep spending over any reasonable limit because the consequence of default has been removed…at least, until we get to complete bankruptcy.  Those in Congress know that they are going to bail themselves out of the jam and there will be no immediate consequence.

More to the point, let’s just substitute the debt limit issue into the description of “informational asymmetry” above:  A party (Congress) is insulated from risk (of default and of being voted out of office)…  Moral hazard occurs when the party with more information about its actions or intentions (Congress) has a tendency (like the “buying” of votes) or incentive (like not taking the blame for making the hard but right choices) to behave inappropriately from the perspective of the party with less information (voters).

Didn’t follow…?  Congress has an incentive to not address the spending issue; no Congressman (at least, no Congressman who hopes to be re-elected) wants to be the one to suggest cutting Medicare benefits or Social Security benefits or Education spending or Research funding or any number of other things.  They would be painted as heartless; I believe the phrase “killing old people” was used recently with respect to the Tea Party.  So, Congress has a tendency to not only continue spending on those programs but to add new programs as a way of buying votes from still other constituents.  Voters receiving such benefits are much less likely to vote out the Congressman who made their benefits possible.

Similarly, Congress funds huge projects through various businesses and that benefits those same Congressmen through reciprocation in the form of campaign contributions from those same companies and their employees, campaign contributions that (in turn) insulate the Congressmen from any real danger of being removed from office by voters who must overcome the disinformation about (and character assassination of) the opponents of these sitting Congressmen through the barrage of campaign ads that their “war chest” affords them.

All of these factors add up to a greatly reduced risk to a Congressman of suffering any real consequences at the polls.  The more Congress spends with grateful companies (and the voters that work for those companies) and the more voters that qualify for various benefits, the more all of those voters will be reluctant to remove their benefactor from office.

And what happens when 55-60^% of the voters receive benefits, work for government entities, or work for the companies that hold huge government contracts?  How would we EVER reduce the size of government?  In a very real sense, big government creates its own moral hazard dilemma.

A failure to bail out the banks and other companies would have been exceedingly painful, economically, but such pain is necessary in order to maintain the integrity of any free market system.  Ditto with our government!  Not allowing Congress to raise the debt limit would create exceedingly painful consequences for America, but such pain is necessary in order to regain the integrity of our government and remain a free people.

If the U.S. has to fail in order to set things right again, then it has to fail.  I would greatly prefer that Congress simply do the right thing and stop running up the debt in the first place, but if they are irresponsible and will not listen to the American people, then eventually the world will clue them in to the fact that “Enough is enough!”

Debt Limit increases must no longer be automatic.  In fact, the debt limit should not be raised at all for the foreseeable future…and, no, that does not automatically mean that we would default on our debt.  It means that spending would have to be harshly cut back in order to not default, a situation caused by the overspending.

It’s a little like a husband and wife arguing about her excessive shopping (or his) and charging the credit cards up to and over their max.  If she knows that he is going to get mad but, in the end, he’s going to pay the over-charge fees and raise the credit limits every time, then she will just keep charging.

If, instead, he stops getting the limits raised (and stops paying the bill), the credit card company will do what he apparently couldn’t – force her to stop spending what she doesn’t have.  Painful?  Sure.  Bad credit score, steeper default interest rates, having to finally start paying the cards down plus still try to live…and live, now, not just within their means (which they’re not used to doing) but live on even less than that until the debt is paid.

This is where we are as a nation.  The party is over.  It’s time to act with some self-discipline or we will plunge our nation headlong into economic oblivion…where old people…and young…really will die.