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Doesn't Anyone Care About Moral Hazard Anymore?

Libertarian economist Dan Mitchell says he would like for those who take big risks — and rewards — to accept their losses. Cato Institute hide caption

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Cato Institute

A few months ago, "moral hazard" was the favorite phrase of politicians and policy wonks.

Just six months ago Federal Reserve Chairman Ben Bernanke gave a big speech discussing the need to avoid unwise risk by limiting moral hazard.

But have you noticed that now "moral hazard" has all but disappeared from conversations about the economy?

The answer tells us a lot about the Wall Street bailout. But before we get to that, let's take a moment to give a precise definition of moral hazard.

Simply stated, moral hazard exists when people have an incentive to do the wrong thing. If you buy an old junker for $2,000 and insure it for $100,000, you might be tempted to leave it in a bad neighborhood with the keys in the ignition. In other words, you have a perverse incentive to do the wrong thing.

Or let's use a real-world example from a previous glitch in the banking system — one that galls me as a free-market libertarian. About 20 years ago, many savings and loan institutions became insolvent, meaning that shareholders had been wiped out. But the S&Ls kept their doors open because customers were protected by deposit insurance. It didn't seem to matter whether the S&L was poorly managed and insolvent. This created a moral hazard. The owners of the S&Ls took big risks with their depositors' money. They figured that if their very risky investments paid off, they could turn their worthless shares into real assets. And if their risk gambles didn't pay off, they had nothing to lose since taxpayers picked up the tab.

If this sounds like a crazy system to you, that's because it is.

Unfortunately, the recent government bailout makes a bad situation worse. Uncle Sam is giving insolvent institutions — and all those 29-year-olds with the BMWs who made the mistakes — a new lease on life. There's an old saying that "capitalism without bankruptcy is like religion without hell." But now that taxpayers are picking up the tab, the lesson that's being learned is that imprudent risk is OK.

When government nationalizes moral hazard, it undermines personal responsibility. I'm all in favor of people making big piles of money if they make the right choices, but I sure as heck don't want to cushion their fall if they make the wrong ones. That's not a safety net; it's a hammock.

It's time for government to reduce moral hazard, not subsidize it.

Dan Mitchell is an economist at the Cato Institute.