Time to drop the baggage that comes with moral hazard

4th October, 2008

During the bail-out of AIG, Fannie Mae and Freddie Mac – and, at the time of writing, the still unresolved debate over the bail-out of the entire US financial system – the phrase “moral hazard” has become popular, typically in conjunction with the phrase “privatising profits and socialising losses”. It’s easy to sympathise: the erstwhile masters of the universe seem to have forgotten the meaning of both “moral” and “hazard”. Why should they be helped now?

Still, we might usefully remember what the antiquated jargon “moral hazard” means. The term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

Moral hazard can sometimes take extreme forms. According to the Florida newspaper The St Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicentre, “Nub City” – the tiny town of Vernon, Florida – almost 10 per cent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot; fortunately he had been carrying a tourniquet at the time of the accident. He pocketed a million dollars. Another man shot his foot off – “while aiming at a squirrel” – just 12 hours after buying insurance. Now that’s careless – and that’s moral hazard in spades.

Sometimes moral hazard is so severe that it makes insurance impossible. Footballers would like to insure against losing football matches, and students would like to be compensated if their exams go poorly. Tough: moral hazard makes such insurance contracts absurd. But all these examples exaggerate the problem. So does the archaic use of the word “moral”. It used to carry no ethical connotation, referring merely to a risk arising from human action rather than natural forces.

Forget the baggage that comes with the word “moral”. While moral hazard makes insurance more expensive and less efficient, many insurance markets work well enough to be useful. Moral hazard need not destroy them, and it need not destroy financial markets either. If AIG had shot off its own metaphorical foot to claim a government bail-out, the argument against the bail-out would be compelling. But it didn’t, and it isn’t.

This perspective can suggest lessons for today’s bail-outs. The government will not help you replace your possessions if you smoke in bed and your house burns down, but government-funded fire engines will put out the blaze, moral hazard or not. That is partly because fire can spread, and your neighbours should not suffer for your carelessness. The same motive lies behind the current spate of rescues. It is also because a civilised society tries to save people from accidentally burning themselves to death. If the consequence is a little more carelessness, so be it.

A second lesson is that remedies for moral hazard will always be imperfect. Insurance companies could fight moral hazard by checking that your behaviour is consistently safety-conscious. Because that’s impractical, deductibles have to serve as imperfect proxies. The current bail-outs are a strong argument for tighter regulation, but regulators cannot be everywhere, any more than a claims adjuster can ride around in your car all day.

Bail-outs can save the innocent as well as the culpable, but even when they don’t, it is fantasy to expect governments to refrain from them. It is useless to pretend otherwise: bail-outs are inevitable and sometimes they are even desirable. The moral hazard they provoke is also inevitable. The final lesson: insurers get paid for the insurance they provide; it would be nice if the taxpayer were shown the same courtesy.

Also published at ft.com.

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