Battle Lines Drawn: Hands-on or Hands-off?

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Battle Lines Drawn: Hands-on or Hands-off?

Was last year the first time you heard the term “sub-prime”? In 2008, the term of the year could be moral hazard. Moral hazard, a term used by economists for many years, arises when individuals or institutions act less carefully because they are protected from paying the full consequences of their actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his car because the costs of theft are partially borne by the insurance company.

Many Cincinnatians remember the 1985 S&L crisis during which some S&L associations were on the ropes. They needed cash and aggressively courted depositors by offering very high interest rates. Potential depositors had little reason to assess the risks of depositing their funds with these S&Ls because their accounts were insured by the government. The S&Ls, on the other hand, were investing these funds in risky ventures in order to stave off potential bankruptcy. The moral hazard occurred when depositors acted less carefully because of the government provided insured safety net.

Today moral hazard is evident among investors who, when they believe the Federal Reserve System or the government will rescue them from their mistakes, take greater risks in their effort to gain higher returns. Moral hazard devotees argue that when individuals don’t have to bear the full consequences of their actions they are likely to repeat their undesirable behavior. Thus, the specter of moral hazard is invoked to oppose policies that offset 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.

Others argue that when there is contagion, or the likelihood that the bad decisions of one may infect many others, government or Fed action is appropriate. Intervention is appropriate, they maintain, if the failure of a large institution would lead to a recession or a breakdown of the financial system. Think about this commonly used analogy: If your neighbor smokes in bed, you may hope he burns his hand and learns a lesson. But if, because of his careless smoking, his house is burning down and threatening the rest of the neighborhood, you probably would prefer that the fire department come to extinguish the fire.

To help or not to help -- this is the choice the Fed's policy makers face today. Earlier in his term as Fed chairman, Ben Bernanke was seen by many investors as too inclined to bail people out. The other side worried that his refusal to aggressively cut rates and promote liquidity in financial markets was hurting growth and enable the credit crisis to fester. The Fed has sought out the middle ground. Instead of cutting rates even more aggressively, the Fed offered additional loans to banks to ensure liquidity and it has offered to buy bonds from banks that feel they are holding too many bonds in the midst of a bond crisis.

The trade-offs remain. By acting aggressively now, the Fed risks incurring negative long-term effects of moral hazard. On the other hand, taking a less aggressive approach heightens the possibility of damage to the economy as a whole, but it may curb risky behavior and serve as an important lesson for the future.