Wednesday, June 15, 2011

Do bailouts create moral hazard?

In my “Sudden Financial Arrest” paper, I draw an analogy between panics and sudden cardiac arrest. We all understand that it’s very important to have a good diet and good exercise in order to prevent cardiac arrest. But once you’re in a seizure, that’s a totally secondary issue. You’re not going to solve the crisis by improving the diet of the patient. You don’t have time for that. You need a financial defibrillator, not a lecture. ...

There are many incentive problems within the financial system, and hence there is a strong need for regulation. However, it’s ludicrous to suggest that anticipation of support (a “bailout”) in an extreme systemic event is one of the most significant sources of moral hazard.

With very few exceptions—perhaps Fannie Mae and Freddie Mac?—financial institutions and investors (when in bullish mode) make portfolio decisions that are driven by dreams of exorbitant returns, not by distant marginal subsidies built into financial defibrillators. Nothing is further from these investors’ minds than the possibility of (financial) death, and hence they could not ascribe meaningful value to an aid that, in their mind, is meant for someone else.

Logical coherence dictates that if one believes in the undervaluation of the possibility of a future crisis that characterizes the booms that precede crises, then one must also believe in the near-irrelevance of anticipated subsidies during distress for private actions during the boom. ...

People indeed consume more cheeseburgers than they should, but this is more or less independent of whether or not defibrillators are visible. Surely there is a need for advocating healthy habits, but no one in their right mind would propose doing so by making all available defibrillators inaccessible. Such a policy would be both ineffective as an incentive mechanism and a human tragedy when an episode of sudden cardiac arrest occurs.

I think this is one of the many instances when economists and politicians choose to solve a second-order problem they understand rather than focusing on what actually happens in real life.
--Ricardo Caballero, The Region, on the disconnect between irrational exuberance and bailout-induced moral hazard