The Moral Hazard

By now, we've all heard about the Fed/Treasury Resolution Trust Corp. reprise. Among other things, various parties are tut-tutting over the "moral hazard," ie, the idea that having an external party bail our protagonists out of trouble greatly increases the probability they will get into trouble in the first place. In this case, this is usually meant to mean that the lenders and investors are leaning against the gov't bailout, thereby propping up institutions which should have either failed or taken a more conservative business plan some time ago.

That is not something to dismiss out of hand. But on balance it's difficult to say this outweighs the possibility that our banking system was an hour or three away from collapse, a story which nobody has really tried to refute. About the creditors and the equityholders, they might catch a break from the government, but then again they might not. It'll depend on the details, and those might not be in their favor.

However, now that it's clear that some kind of bailout will occur, there is a significant risk of moral hazard that we should be aware of, and take measures against. We should be more afraid of recklessness from the political class than the financial class. Various politicians and bureaucrats will have control over assets, de facto and de jure, on a scale they had only dreamed of beforehand. This might be necessary to resolve an emergency liquidity crisis, so it's important for us to insist that the government intervention be taken for that end, and nothing else. That certainly won't happen by force of bureaucratic intertia, so it will require vigilance from those of us not in government. The flip side is, once we agree that this intervention is something we doing because we have to, not because we want to, the consequences are probably not so bad.