I have argued previously that the moral hazard explanation of the crisis fits the basic facts i.e. bank balance sheets were highly levered and invested in assets with severely negatively skewed payoffs. But this still leaves another objection to the moral hazard story unanswered – It was not only the banks with access to cheap leverage that were heavily invested in “safe” assets, but also asset managers, money market mutual funds and even ordinary investors. Why was this the case?
A partial explanation which I have discussed many times before relies on the preference of agents (in the principal-agent sense) for such bets. But this is an incomplete explanation. Apart from not being applicable to investors who are not agents, it neglects the principal’s option to walk away. A much better explanation that I mentioned here and here is the role of extended periods of stability in creating “moral hazard-like” outcomes. This is an altogether more profound and pervasive form of the moral hazard problem and lies at the heart of the Minsky-Holling thesis that stability breeds loss of resilience.
It is important to note that such an outcome can arise endogenously without any government intervention. Minsky argued that such an endogenous loss of resilience was inevitable but this is not obvious. As I noted here: “The assertion that an economy can move outside the corridor due to endogenous factors is difficult to reject. All it takes is a chance prolonged period of stability. However, this does not imply that the economy must move outside the corridor, which requires us to prove that prolonged periods of stability are the norm rather than the exception in a capitalist economy.”
But it can also arise as a result of macro-stabilising fiscal and monetary policies. Whether the current crisis was endogenous or not is essentially an empirical question. I have argued in previous posts that it was not and that the “Greenspan Put” monetary policy did as much damage as all the explicit bailouts did. The evidence behind such a view has been put forth well by David Merkel here and by Barry Ritholz in his book or in this excellent episode of Econtalk.