The Dukes of Hazard,
financialsense.com
by George J. Paulos
Editor, www.freebuck.com
May 14, 2003
Although it is considered a social science, the discipline of economics seems far removed from greater society. Buried in incomprehensible mathematics and impenetrable jargon, economists occupy the pinnacle of the ivory tower, isolated from the brutal realities of everyday commerce. Between the charts and the formulas lies a concept that seems strangely out of place in the economic vocabulary: Moral Hazard. This is a curious choice of words coming from the secular world of partial differential equations and seasonally adjusted data series. Even though it is an academic concept, moral hazard is a fundamental aspect of economic life. Moral hazard is always present in any attempt to transfer or mitigate risk. The widespread use of risk avoidance and risk transfer strategies by individuals, firms, and governments makes the obscure concept of moral hazard one of today’s most pertinent economic issues.
There are many ways to define moral hazard. Essentially, moral hazard results when individuals or firms are insulated from the economic consequences of their actions. Examples of moral hazard abound in society. A common example is insurance. People buy insurance to remove the financial risk from various activities such as owning property. Should a disaster befall the property, the insurance company will restore the value lost in the disaster. The moral hazard in this example is when the property owner takes on far more risk than would otherwise be taken. The property owner may decide to build on a beautiful river that just happens to flood every few decades. If it does flood, insurance will pay to rebuild and the owner is saved from financial ruin. Without insurance the property owner may not be willing to take the risk of loss in a flood and locate on higher ground, but insurance makes building on a flood plain a reasonable risk. In extreme examples of moral hazard the owner may intentionally cause damage to the property in order to get an insurance payout. The economic result from moral hazard in insurance is chronically rising premiums as more and more risk is assumed by policyholders. In the end all people pay for the risky behavior of a few because the consequences for that risky behavior has been assumed by others. In simple terms, “Heads I win, tails you lose.”
Large portions of the economy are involved in the business of risk transfer. The insurance industry is the largest and most obvious example, but the investment and banking industries are also major players in the risk transfer business. Big money is being made in credit insurance and interest rate risk control. For example, homebuyers are often forced to buy credit insurance in the form of PMI (Private Mortgage Insurance) on a new mortgage. This insurance does nothing for the homebuyer but protects the lender from a mortgage default. A loan that would otherwise be deemed too risky for investment grade debt is now “sanitized” by the use of credit insurance and may be resold into the financial markets as high-quality debt securities. Insurance paid by the borrower makes the loan a no-lose proposition for the lender. The risk that was once borne by the lender is now transferred to a third party insurer, allowing the lender to be far more aggressive. Many more people have become eligible for home ownership because of credit insurance, but many people are also far more extended in debt than what used to be considered prudent. The net result of this activity over the long-term has been a general reduction in the credit quality of mortgage borrowers and an increase in the mortgage default rate. The moral hazard incurred by credit insurance has actually increased the risk level in the entire system.
Governments are expert at creating moral hazard conditions. Much legislation contains some component of moral hazard. This is particularly true of social legislation. Most social programs are designed to shield citizens from some kind of misfortune. In essence, they are a form of insurance or “social safety net.” Welfare, Medicare, FEMA, and FDIC deposit insurance all incur some form of moral hazard. In all of these cases, the long-term consequences are chronically rising costs and an increase in the types of behavior that ultimately causes additional misfortune. This can be seen in exploding healthcare costs, reckless banking activities, and endlessly expanding social services.
Governments are also massive borrowers. In fact the largest borrower around is the US federal government. These loans are in the form of government or treasury bonds, notes, and bills. The federal government has a unique advantage as a borrower. The government will not default on its loans. This is because the government has the power to create the money necessary to pay the interest and principal even if there is insufficient tax revenue to do so. This is essentially the same as having credit insurance. It is easy to perceive the moral hazard resulting from government borrowing. There is no incentive for governments to limit spending and the lenders do not care since they are guaranteed to receive their payments. The long-run result of this activity is ever increasing government debt levels and chronic inflation.
Moral hazard creeps into our monetary system in subtle but profound ways. It is well-known that currencies, specifically the US Dollar, lose value over time in a process called inflation. This is partially due to the constant creation of new money required to pay for the increasing government debt. This new money competes for a limited supply of goods and services in the economy and causes prices to rise. This price inflation is highly destructive to savers who are also typically investors in government bonds. These investors will not purchase government bonds that have a yield below the inflation rate, unless they have no choice. If investors refuse to purchase bonds at the prevailing interest rate, then market forces will discount the bonds until they yield a high enough interest rate to reimburse bondholders for their loss of purchasing power. Bond investors (also known as “Bond Vigilantes”) therefore have a powerful influence on the spending activities of the government by limiting the ability to create new money and inflation through bond issuance.
The Bond Vigilantes may now be neutralized if the Federal Reserve has its way. Recent speeches by US Federal Reserve governors Greenspan and Bernanke plainly state that the monetary authorities plan to use all the resources available to keep interest rates low. They have committed the Federal Reserve to purchase government bonds without limit to prevent market forces from causing a rise in interest rates. This is part of a new policy that the Federal Reserve has announced to prevent price deflation, a fall in the general price level of goods and services. They have the power to do this because the Federal Reserve can create money without limit. This cap on interest rates is equivalent to an insurance policy issued by the government that will prevent bondholders from suffering the capital loss incurred by rising interest rates. Bondholders will, however, be allowed to capture capital gains if interest rates fall further. Sound familiar? It is the same old moral hazard again. If the risk is removed from an investment, then more people will be motivated to participate and do so recklessly.
The core component of the Federal Reserve anti-deflation policy is an accelerated expansion of the money supply. More money in circulation will presumably chase goods and services to support prices. The Fed is worried about deflation because of a global production overcapacity and excessive debt levels. The world is creating more stuff than people can consume. This is putting severe pressure on prices and pushing many businesses into bankruptcy. Lenders to bankrupt borrowers usually lose part or all of their principal. This is the equivalent to a reduction in the money supply (deflation). Widespread debt default could result in a debt collapse with severe economic damage. The Fed authorities figure that if they expand the money supply enough to support prices that the deflationary effects of overcapacity and bankruptcy can be avoided.
Nobody wants a debt collapse. A debt collapse would damage large sections of the productive economy. The voting public would probably hold governmental authorities responsible for such an event so they are doing everything they can to prevent it. But all of the proposed remedial actions incur massive moral hazard. The economy is in this situation because of the debts built up from decades of accumulated malinvestments. The massive monetary intervention in the economy to rescue failing (risky) investments is essentially equivalent to investment insurance which will only increase the appeal of risky investments and create the need for additional intervention in the future.
The Fed and most mainstream economists believe that very low interest rates and lots of new money are the best cure for the current situation. But this same therapy was tried in Japan under similar circumstances and utterly failed. Furthermore, the Fed’s activities in the bond market to hold down interest rates may create a bond bubble. Economist Dr. Antal E. Fekete envisions a nightmare scenario where government bonds become a giant black hole that sucks up all of the new money and exacerbates the deflation problem. Remember, the Fed has all but guaranteed that long-term interest rates will remain stable or go lower, so what is the risk of investing in long bonds? If interest rates remain stable, the investor receives a relatively small, but risk-free interest payment. If interest rates fall, the investor can receive a handsome capital gain in addition to interest. What is to stop big institutions from borrowing short term at extremely low interest rates and investing those proceeds into long government bonds? Normally such a strategy would have unacceptable risk due to a possible interest rate hike, but the Fed has effectively removed the risk by guaranteeing stable or lower rates. A possible unintended consequence of the Fed policy on government bonds is that much of the newly created money will chase bonds instead of going into general circulation, making Dr. Fekete’s deflationary bond bubble scenario into a reality.
Economic intervention by the US Federal Reserve has become so pervasive that it has become known as the “Greenspan Put”. This is referring to a “put option” which is a form of insurance that investors can buy to protect an investment from losses. The Greenspan Put was established early in the Federal Reserve Chairman’s career when he orchestrated an effective intervention in the stock market after the 1987 crash. Since then, each time that the financial system has experienced distress, Mr. Greenspan and his colleagues have intervened to support the markets with infusions of fresh money and unlimited credit. Over time, investors and traders have learned to rely on the monetary authorities to bail out the markets. As a result, they take on excessive risk in an attempt to boost returns by relying on the Greenspan Put. The moral hazard resulting from these policies may have contributed greatly to the stock market bubble.
Market participants make a grave error by assuming that the Greenspan Put or any additional actions by government authorities will prevail over the markets. All of the interest rate cuts and money creation to date have been unable to prevent a severe market decline. More extreme measures will only further distort the economy and make future adjustments even more painful. Market interventions may have some short term positive effects but only at the cost of pushing risk out into the future and threatening long-term stability. In the long run, real-world economics always trumps policy.
A popular 1970s television sitcom depicts the heroes engaging in unbelievably risky behavior but always miraculously escaping injury. The New Dukes of Hazard who run our government and monetary system blithely assume that they can impose massive market interventions without injury to the economy. Yet each intervention has resulted in unintended consequences by rewarding risky behavior. As the authorities delve deeper into their policies, these moral hazards will only increase further. Because they are encouraging undesirable behavior, these policies will over time weaken the both the economy and the ethical fabric of society. Bubbles and corruption are the inevitable result of this erosion of economic judgment. Generations are being raised without a realistic sense of risk and reward who believe that wealth is created by speculation rather than productive effort. How are these people to be re-educated into a more reasoned sense of value? Systemic moral hazard within a society tends to dull judgment and corrupt the spirit.
Ultimately, all of society will be forced to confront the consequences of pervasive moral hazard. Risk never just disappears, it is simply redirected to other parties or off into the future. Ultimately everybody pays for the mistakes of the reckless if the reckless are not allowed to lose. Continuing the policies of extreme economic intervention is functionally equivalent to socialism and will inevitably end with an equivalent outcome: stagnation and impoverishment. If we believe in free markets and capitalism, then individuals and firms must be allowed to fail and suffer the consequences of failure. Investors who put their capital at risk must face the potential loss of that capital. In a truly free society there will always be opportunities to try again and succeed. |
