Comments on: Moral Hazard: A Wide Definition

By: Implications of Moral Hazard in Banking at Macroeconomic Resilience

Implications of Moral Hazard in Banking at Macroeconomic Resilience — Tue, 21 Sep 2010 14:18:41 +0000

[...] my previous post, I explained how a moral hazard outcome can come out even in the absence of explicit agent [...]

By: Amar Bhide on “Robotic Finance”: An Adaptive Explanation at Macroeconomic Resilience

Mon, 23 Aug 2010 10:34:53 +0000

[...] and rigid solutions rather than adaptable and flexible solutions. This may be a consequence of moral hazard or principal-agent problems as I have analysed many times on this blog but it does not depend on [...]

By: Blog Profile: Macroresilience, Common Sense Economic Thought « Financialfreezeframe's Blog

Sun, 06 Jun 2010 08:32:05 +0000

[...] addition he frequently points out the problems of moral hazard and fundamental problems with our financial systems causes obtuse payouts for finance sectors and [...]

By: Does Majoritarian Democracy Systematically Result in Moral Hazard and Financial Industry Irresponsibility? « Let A Thousand Nations Bloom

Thu, 20 May 2010 15:31:00 +0000

[...] If our best economists knew in 1993, in a widely published article that bankruptcy for profit could occur when government guarantees a firm’s debt obligations, why is it that the U.S. government continue to guarantee debt obligations? Indeed, not only it continued the guarantees, but it expanded them – by means of numerous actions supported by both Democratic and Republican Congressmen expanded the scale of its debt obligations through the deliberate growth of Fannie Mae and Freddie Mac. And note that bankruptcy for profit is merely the most extreme case of moral hazard due to government guarantees; there are plenty of deep moral hazard issues due to government guarantees that could lead to similarly catastrophic outcomes well before we get to the case of outright looters. (See both Roberts and Macroeconomic Resilience, a brilliant anonymous blogger he cites; see the analysis here,here, and here). [...]

By: admin

admin — Fri, 19 Feb 2010 17:33:53 +0000

That’s an interesting paper – Thanks!

As you’ve argued, we have enough problems as it is. My frustrations are directed at how many of our current problems, especially those pertaining to the current crisis, are entirely avoidable institutional errors that make things a lot worse than they otherwise would be.

By: Alex Golubev

Alex Golubev — Fri, 19 Feb 2010 16:57:34 +0000

I agree, too big to fail is a huge problem. The best we can hope for is that JPM’s and BOA’s get broken up into smaller failable pieces. But something tells me that our banks don’t exist in a vacuum, so while this would be a giant first step, we would still have a lot more to make our systems more fair.

First of all, too big to fail doesn’t apply to the actual agents, so natural selection still guarantees that certain executives will cash out on a 1-year frequency (through bonuses and some of their equity), while the population of retail investors will continously get replenished and end up holding the bag when the long term risk finally bears fruit. Wolves and sheep. Wolves aren’t evil for eating the sheep, but there is an element of unfairness if the rules of the game aren’t explained or explainable to the entire population. or maybe they are, but i would still argue that information asymmetry creates a fundamental unfairness problem. you may enjoy this paper showing that dishonesty/bluffing is the best evolutionary policy:
http://emergentfool.com/2009/09/24/dishonesty-is-the-best-policy/

(i’m not trying to argue against any of your points. i just think the conclusions reach way beyond big banks)

By: admin

admin — Fri, 19 Feb 2010 16:29:10 +0000

Alex – Leveraged strategies outcompete other strategies if the environment is “stable”. This is essentially Minsky’s theory that stability breeds instability. I would rephrase this as “stability breeds loss of resilience” which is a core concept in ecology, especially in the research of C.S. Holling which I have referred to in earlier posts.

If the stability and increased leverage arise endogenously, then the course of action is tricky. But much of our stability in the Great Moderation is a result of explicitly stabilising strategies followed by the Fed in particular. It sounds counterintuitive but small and frequent disturbances are the antidote against potential economic depressions. My earlier post on Knightian uncertainty touches on this briefly and I will be writing a lot more on this topic.

By: Alex Golubev

Alex Golubev — Fri, 19 Feb 2010 16:12:25 +0000

but it’s not just the taxpayer. there are generations of less-levered failed banking business models which allocated resources much more fairly. and thus generations of un-underwritten loans and businesses that lost out to “high-leverage bet the house” businesses. Just carry out the implications of natural selection with leverage vs without. ultimately economics is about best resource allocation and it is doomed to fail if there’s high leverage in the system. I think one can only justify debt for educational purposes and even then with demand pricing, ivy leagues, medical schools, and law schools can burden people with crippling amounts of debt. The sad truth is that information asymmetry creates this problem. Most people don’t run the #’s to see if some types of education even make sense financially. That’s just simply not how things should be.

By: admin

admin — Fri, 19 Feb 2010 08:14:34 +0000

Alex – the key assertion I am making is that the increased leverage is a product of the moral hazard problem. Increased leverage increased the moral hazard subsidy that a bank can extract from the taxpayer.

By: Alex Golubev

Alex Golubev — Fri, 19 Feb 2010 00:11:41 +0000

Sounds like it all comes down to leverage. if the system has enough leverage that is a SUFFICIENT condition for moral hazard. Leverage can take the form of debt and options, which exist on more than one level in our economy – executive/money manager incentives and financing.

In fact our political process has some elements of this where politicians can through out random economically neutral initiatives to see if they generate public support, while at the same time rewriting laws to benefit special interests who sponsor both sides (illusion of choice).

all in all, we pretty much have to start over, which is not feasible. However i’m optimistic that technological progress isn’t subject to the evils of this society, so the most important thing we can do is make sure that the internet remains free, particularly if it means greater transparency. Privacy is something we have to give up to fix information asymmetry.

what do you think?