Creating Moral Hazard

Has Fed Risked Creating Moral Hazard?
By David Wessel, 9/20/07, WSJ

Federal Reserve Chairman Ben Bernanke and his colleagues clearly explained why they cut interest rates this week by one-half percentage point: "To help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets."

But a vocal chorus is complaining that Bernanke & Co., instead, just bailed out a bunch of greedy speculators, imprudent lenders and short-sighted homebuyers who got too-good-to-be-true mortgages."This is like adding Jack Daniels to the AA-meeting punch bowl," emailed Rob Brantley, a Washington consultant. "The market's reaction provides proof."

"I plan to now sell my house and upgrade to a $4 million or $5 million home in Highland Park. If I find I can't meet my mortgage payments, will Mr. Bernanke bail me out?" Cheryl Kawalsky emailed from Dallas. "Or, is that type of American socialism reserved for hedge-fund managers, investment bankers, and private-equity moguls? The truth is, in America today, I feel like I'm living in a huge house overrun by children. All the adults have left town."

Some of this skepticism is implicit criticism of the Fed's reading of the economy. If one is convinced the economy will muddle through recession or painfully slow growth, then cutting rates is somewhere between unnecessary and unwise because it risks stoking inflationary embers.

That appears to be a risk Mr. Bernanke was willing to take. The more provocative attacks -- which come both from left and right --accuse the Fed of encouraging people to take foolish risks by cutting rates now to protect them from harm. This is known as creating moral hazard, a notion that dates back more than a century and holds that offering insurance encourages people to take risks they otherwise would avoid.

"With automobile-collision insurance, one is more likely to venture forth on an icy night," Harvard's Richard Zeckhauser puts it in the Concise Encyclopedia of Economics. "Federal deposit insurance made savings and loans more willing to take on risky loans. Federally subsidized flood insurance encourages citizens to build homes on flood plains. ... Products covered under optional warranties tend to get abused, as do autos that are leased with service contracts.

The worries are, in part, practical. "Providing [after-the-fact] insurance for risk behavior ... encourages excessive risk-taking and sows the seeds of a future financial crisis," the governor of the Bank of England, Mervyn King, said with conviction Sept. 12, a few days before he and the British government had to move from the sidelines to fight a bank run.

But there also is an ethical dimension to the criticism, a righteous indignation at speculative excess. "There's a definite feeling, when the crisis comes along, that these un-Christian people are getting their comeuppance," says Brad Delong, an economic historian at the University of California, Berkeley. He cites British thinker Edmund Burke in 1790, bemoaning the ascendance of financiers following the French Revolution, who said, "The age of chivalry is gone; that of sophisters, economists, and calculators has succeeded, and the glory of Europe is extinguished forever."

Lower short-term interest rates do help banks that borrow in the short term and lend for the long term. They help anyone who holds debt securities, since their value increases when interest rates come down. No doubt some speculators, greedy investors and imprudent borrowers profited by the Fed's rate cut. But there are moments -- and this may be one -- where one can worry too much about moral hazard. As Fed officials have quipped: We want to discourage people from smoking in bed, but do we want to prevent the fire department from putting out fires caused by such carelessness?

Or, to paraphrase Charles Kindleberger, the late Massachusetts Institute of Technology economic historian: In a speculative boom, one wants to stir doubt as to whether the lender of last resort will step in. But when the bust comes, one certainly wants him to show up.

At times like these, it is the Fed's job to make sure the financial system functions. The Fed shouldn't cut rates just to protect investors or lenders who made stupid bets they didn't fully understand that only made sense when credit was cheap and rising home prices were thought to be inevitable. But neither should the Fed hesitate to cut rates or otherwise intervene when financial panic imperils otherwise sound investments and businesses; otherwise, people will be reluctant to make such sound investments in the future and the overall economy will suffer.

At times like these, there is a danger that a principled stand to punish the profligate could inflict severe economic pain on millions of innocent bystanders. As Mr. King put it in his Sept. 12 statement: "There must be strong grounds for believing that 'central-bank inaction' would lead to economic costs on a scale sufficient to ignore the moral hazard. When there are such strong grounds, failure to act is wrong, no matter what the critics say."