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December 28, 2008

The Dukes of Moral Hazard

Decisions and actions generally have consequences- good decisions and good actions generally yield good consequences, bad decisions and bad actions generally yield bad consequences. That's what we try to teach our kids.

But Sometimes, decisions and actions become insulated from consequences. Sometimes that's a retroactive implication, and sometimes there's a future implication.

Here's an exaggerated example: the North Carolina realtor tells a client: Sure you can build a beach house right on the dunes, the federal government will reimburse you when it gets washed away every three years. Or another: when a social program tells the welfare queen that she'll get increased benefits and a bigger place if she has another kid. Either case, when risk is subsidized, risky behavior is more likely to occur.


The lack of connection between decisions/actions and consequences is called Moral Hazard. The phrase comes out of economics and the insurance industry, and the memo goes like this: if you protect somebody too well from likely outcomes, then they will act differently, probably in a manner that would be ordinarily considered irresponsible.

Although it sounds like something a preacher would say, there's no moral critique or condemnation of behavior; the term moral hazard strictly refers to behavior in the face of artificially relieved or subsidized risk.


Generally, we're talking about government guarantees. Some government programs are good things: we want recently unemployed people to have a safety net. If there were no risk involved in not returning to work, we'd have moral hazard. Often, moral hazard occurs when a well-intentioned, altruistic goverment program extends beyond the initial scope to become a counter-productive anti-pattern.

There are interesting social and economic responses to moral hazard, summed up in those three little words: "I want mine". When I find out that my neighbor is immune from consequences, I think I'd also like to be immunized. If he can have some, I want some. This certainly skews the notion of government of the people and turns Uncle Sam into Big Daddy with Special Dispensations.

So General Motors is in trouble. Ford is in trouble. Some people want to bail them out, because there's a lot of jobs at stake, there's politics involved, and anyway - they're too big to be permitted to fail, the spokesmen tell us. And somehow the Government is going to take $2000 from you and your kids (which you've made, presumably, with good decisions and actions) and give it to those Corporations and businessmen who made bad decisions.

This of course, increases competitive pressure on the carmakers who were making good decisions all along, and who aren't angling for your $2000. Toyota calls "foul!", but we don't know what to do about that.

Wall Street is in trouble, too. They just got $700B of your money because they made bad decisions. I don't remember getting any of theirs when they made good decisions.

Thomas Friedman says "the only question will be, is it being done for you or to you?" Will this transfer of funds change Detroit/Wall Street's future behavior, or just delay the inevitable reckoning (with your money?) Friedman also suggests these CEOs shouldn't be looking for a bailout, they should be looking for bail.

Where's the bailout for the 250 Fore/Marconi/Ericcson employees?
Where was the bailout for the USAirways retirees and employees?
Where was the bailout for the steel mills?
Have you ever seen a corporation bail out a town?
Have you ever seen a casino bail out a loser?

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