On Moral Hazard

Editor’s note: all premium level pieces, whether investment, economics, news or opinion pieces, will now always be clearly marked as this one is.

This is a silver level post. The last piece I wrote on Ireland got an interesting response from a reader over at Seeking Alpha that I agree with. He commented:

I think a great part of the equation of not bailing out the institution has to do with making those people who were at fault responsible.

The reality is that never happens. Bob Nardelli, walks away from every business he nearly destroys with his pockets stuffed with millions.

They may be incompetent, they may be responsible, but they aren’t stupid and they build themselves walls to protect them selves. We all saw the executives at Border’s award themselves bonuses for skilfully guiding the company into Chapter 11. A job well done deserves rewards.

When you let that bank fail you’re holding the bank teller and janitors responsible.

You could argue that’s not a reason to bailout the bank, but you’re not holding those responsible by not bailing them out either. You’re setting a torch to a stack of paper that’s called a corporation.

The problem with bailouts is moral hazard as I said in the piece. What that means is that a bailout of specific parties encourages those parties to engage in the same behavior in the future for which they received the bailout unless those parties most responsible feel the consequences of their action. I think a bailout of a too big to fail bank to save the banking system from collapse is akin to saving a reckless penthouse owner’s apartment to keep the whole building from bursting into flames. What happens after you have put the fire out? Do you make the tenant pay for the damage due to negligence. Does doing so penalise others dependent on her?

The biggest problem most people have with the bailouts is not that the banks were bailed out but additionally that there seem to have been no consequences for individual actors, the executives that brought the global system to the brink of collapse. And as the reader says, "[w]hen you let that bank fail you’re holding the bank teller and janitors responsible."

I don’t know how you fix this. The system still seems pretty broken.