BEWARE THE BIGGEST MORAL HAZARD OF THEM ALL / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Beware the biggest moral hazard of them all


By Marc Lackritz

Published: Last updated: June 10 2010 00:05

Moral hazard has become the swine flu of 2010. Bankers, some politicians and a few vocal pundits warn us incessantly of the impending epidemic in our financial markets if Wall Street reform is enacted.

Political conservatives find moral hazard lurking in every nook and cranny of government involvement – from ill-considered bail-outs of financial institutions, which allegedly encourage even riskier behaviour by chief executives, to aid for defaulting homeowners, which rewards them for bad financial decisions and encourages others to do the same. Conservatives see “pragmatic” regulation as a pretext for rewarding the undeserving. Any rules should be at least uniform or even mindlessly consistent in their application – just as Captain Vere executed Billy Budd – to bring certainty and accountability.

Political liberals, on the other hand, are untroubled by any moral hazard created by government, including the spectacularly conflicted government-sponsored entities Fannie Mae and Freddie Mac. But they become apoplectic at “moral hazard” in the marketplace, where playing with Other People’s Money (in other words, that of shareholders) encourages excessive risk-taking by bankers and traders, and the reward of stock options induces recklessness and myopia.

Moral hazard, the misalignment of incentives away from rational, competitive and optimal outcomes, has always spooked the economics profession. Ever since Adam Smith, economists have seen the social optimality of the market as the product of decisions by countless anonymous individuals operating with no incentives other than to respond to price signals.

But is the pristine objectivity this model requires possible? In reality, conflicts of interest abound – between buyers and sellers, short and long terms, equity and debt, taxpayers and shareholders. Context is all-important – the idiosyncrasies of age, financial circumstances and geography. How do we provide a “neutral” framework for such crooked timber?

The short answer is that we cannot – and the elegance of the smooth, mathematical models should not blind us to the reality that the exceptions to perfect competition are, in fact, the rule. As investment blogger Nicholas Vardy put it, mathematical models are like bikinis: “What they reveal is suggestive; but what they conceal is vital.” So when considering moral hazard in the context of financial reform, what is to be done?

First, we need a clear understanding of how we got into this mess. An evolving consensus holds that flawed government policies and wrong incentives resulted in too much lending, too much leverage, too much opacity and too little oversight. This admixture led to the housing bubble that has burst so ignominiously on us all.

What flawed government policies? First, leaving interest rates too low for too long; second, tilting public policy too heavily in favour of home ownership; and third, placing excessive reliance on deregulation.

In the ensuing public debate, the harshest voices now warning of disaster from Wall Street reform and moral hazard are the very same voices that, a few years ago, claimed that pure, free markets did a far better job than any regulatory agency could or would. Before mounting their soapboxes, these avatars of ideology might look in the mirror. They might think about apologising for the numerous errors in their theories that helped cause this crisis. And they might adopt a cloak of humility, as at least the housing advocates seem to have done.

The debate should not be about moral hazard, it should be about the entirety of financial reform. The conservatives are right that regulation sometimes creates flawed incentives. But their opponents – a group that now includes pragmatists who once resided in the conservative camp – are right that such moral hazard is to be anticipated and designed around.

Just as we do not want to undermine optimal economic outcomes, neither should we reward the free-market zealots with any additional attention. As Ben Bernanke, a convert to pragmatism, famously observed in the midst of the meltdown: “There are no ideologues in financial crises.” Nor should there be in Wall Street reform.

The writer is an adjunct professor at Georgetown’s McDonough School of Business and a lecturer at the Washington Campus. He was president and chief executive of the Securities Industry Association and its successor the Securities Industry and Financial Markets Association from 1992 to 2008

Copyright The Financial Times Limited 2010.