Tuesday, April 23, 2013

Moral Hazards and Capitalism

A common critique of the TARP bank bailout by conservatives was that the bailouts created a moral hazard - the situation where people take excessive risks because others will shoulder some of the burden if they fail. The American Conservative magazine even went so far as to entitle an article "Moral Hazard, Everywhere", which is rather ironic because they only place they seemed to find moral hazard was in places where the government was involved. These self-same conservatives then go on to blame the economic collapse of 2008 on the moral hazard created by potential bailouts of banks during a crash, which allowed banks to take undue risks prior to the collapse. In essence, they are arguing that a hypothetical second-order chance of a bailout in an extreme situation was enough to cause the global economy to wilt like a daisy in the desert sun as soon as punch-bowl was removed. They are also implicitely arguing that only the government can cause moral hazard, as they are completely blind to moral hazard that exists in its absence.

This is far from the case. In fact, there are very large moral hazards at the very heart of every corporation - limited corporate liability, the principal-agent problem between management and ownership, and externalities such as pollution, for example. Any form of insurance, public or private, creates moral hazard. Any situation where one purchases from someone with more knowledge than oneself (a doctor, an auto mechanic, a home contractor, etc) also creates moral hazard. Even things like the rampant mis-labelling of fish arises from information asymmetry-driven moral hazard. In fact, it is pretty hard to think of a market that ISN'T riddled with moral hazard.

There are non-market moral hazards as well. Personal bankrupcty laws create moral hazard, as does any potential "bailouts" by family and friends. Very fundamentally, there is also a zero-lower-bound moral hazard as well - no matter how badly you screw up, the most you can potentially pay back is the sum of your future earnings less whatever it takes you to survive.

For a corporate executive, there are at least SEVEN layers of moral hazard affecting his or her decision: corporate limited liability limits the corporate risk, corporate malfeasance laws that shift consequences of bad corporate behavior to shareholders, principal-agent problems regarding corporate pay, opportunities to externalize costs, and in the case that the executive is actually held liable for something personally, personal bankrupcty, bailouts by friends and family, and the zero bound.

In other words, the corporate structure is literally riddled with moral hazards that have nothing to do with government beyond the very existence of the corporation itself, which of course cannot exist without government, as you can't create limited liability with a private contract. Non-corporate portions of markets have only slightly fewer moral hazards, lacking the limited liability issue and some of the principal-agent problems, but markets with few moral hazards are rare beasts indeed.

If the moral hazard created by potential bank bailouts was enough to collapse the economy, then the very idea of capitalism is a failure, as it is hopelessly wrought with moral hazards built into its very heart.