RALEIGH – In this moment of public panic, political posturing, and grave threat to economic freedom and prosperity, it’s important for everyone to grasp the meaning behind the term “moral hazard.”
No, it is not the punchline of a joke about Larry Craig’s proposed potty-parity law or the internship program at the William J. Clinton Foundation. Moral hazard is a concept borrowed from the insurance business. It involves how being protected from the consequences of risky behavior affects the likelihood of such behavior.
Simply put: if you enjoy speeding down the highway in your sports car, but your dad pays your insurance premiums and would be on the hook to replace your car in the event of an accident, you are at least somewhat more likely to speed. The concept applies to insurance coverage that is not fully rated for risk as well as to other kinds of precautions, such as installing “childproof” caps on medicines (they make it less likely parents will stow the meds where children can’t reach them).
The great debate in Washington this week features lots of warnings that a big federal bailout of Wall Street will increase moral hazard in the financial sector, which seems inevitable, though many hand-wringing politicians and commentators support the bailout plan, anyway. Any form of capitalism that allows firms to keep their profits when they decide rightly but has taxpayers bail them out when they decide wrongly is hardly deserving of the name, and fraught with moral hazard. There are other reasons to suspect that Congress and the Bush administration are about to do something colossally foolish – there’s their past history, of course, plus the basic rule of thumb that any vast increase in federal power ought to be suspect if dreamed up over the course of a week – but the risk of encouraging risky investment behavior in the future ought to be pretty high up on the list.
Here in North Carolina, there’s a similar mismatch between risk and reward when it comes to insuring beachfront, riverfront, and lakefront property, particularly in the eastern part of the state. If developers or purchasers of such property could only purchase risk-adjusted insurance against storm damage, the price would be so significant as to require major changes in their development plans, if not outright cancellation. But because these parties know who they are, have means, and know whom they need to lobby to get their risk transferred to the general population, they don’t face such high prices. Instead, they have access to a government-mandated plan in which they pay premiums that are subsidized by current and expected transfers of wealth from all other property owners in the state.
The resulting moral hazard creates plenty of incentives to develop flood-prone property. If you own it, build on it, or spent lots of time recreating on it, you gain. Once the inevitable flood damage arrives, everyone else loses. It’s not fair, it’s not efficient, and it’s not environmentally beneficial. But it’s the law.
Even if there were full agreement today that allowing Freddie Mae and Freddie Mac to grow to gargantuan size, thanks to favorable tax treatment and implicit – now explicit – government guarantees, was a horrendous idea that put the entire American financial system at great risk, that wouldn’t necessarily answer the question of what to do immediately, in response to the crisis. Similarly, even if there were full agreement that it was a mistake to artificially inflate the demand for waterfront property, by subsidizing its insurance against storm risk, that wouldn’t necessarily argue for an immediate abolition of subsidized insurance. In both instances, many people have predicated decisions involving huge amounts of money on the promise of governmental guarantees. Suddenly yanking the rug out from under them is neither politically feasible nor fiscally prudent.
Yet any rescue plan must include a clear, convincing, and irrevocable plan to reduce moral hazard in the future by curtailing guarantees and allowing prices to adjust to risk without government putting its heavy thumb on the scales. In Washington, I have yet to see any such conditions materialize in the bailout debate, and believe that Treasury Secretary Henry Paulson’s plan to force taxpayers to buy banks’ underperforming assets is dangerous in the extreme. As for Raleigh, state lawmakers and regulators should start raising rates and reducing the cross-state subsidies over the next few years, phased in to allow property owners and developers to adjust to the new realities.
Or, more properly, to the old realities from which they will no longer be insulated.
Hood is president of the John Locke Foundation.