Beware the Moral Hazard Trivializers
The current financial crisis is the result of longstanding political interventionism. In what follows we argue that our monetary system creates incentives for irresponsible behavior (moral hazard) and is therefore an important cause of recurrent crises. Then we discuss two recent articles purporting to downplay the significance of this fact.
Moral Hazard and Financial Crises: Two Views
Virtually all economists agree on the proximate cause of the current financial world crisis: institutionalized moral hazard in the financial industries. Banks and other firms operating as financial intermediaries have a tendency to behave irresponsibly. They display an exuberant bias in their investment decisions, often taking risks out of proportion with possible returns on investment. Most notably they have reduced their equity ratios to extremely low levels, typically to less than ten percent. Equity being the economic buffer for losses, it follows that financial firms are more vulnerable the smaller their equity ratio. If such vulnerable firms dominate the market — as is presently the case — then there is an increased likelihood of contagion, as the liabilities of any one firm are more than often the assets of other financial firms. The bankruptcy of just one sufficiently large firm can then trigger a domino effect of subsequent bankruptcies. The entire financial market melts down.
While economists agree on this basic fact, they disagree about its causes and remedies. Some seem to believe that the bias toward irresponsible investment decisions is a fact of nature such as bad weather and death. Financial markets are unstable by their very nature because the agents on these markets profit from superior knowledge as compared to their customers ("information asymmetries") and therefore can enrich themselves at the expense of the latter.
While this theory is very widespread, it lacks any foundation in fact. If financial agents really had a bias to rip off their customers, there would soon be no clientele for them. Common people might be less informed than their bankers about the technicalities of financial instruments and investment strategies, but they can read a bottom line. They can also compare bottom lines and abandon their agent if they feel other people might take better care of their money.
The true cause of moral hazard in the financial sector is to be seen elsewhere, namely, in monetary policy and especially in the current monetary system.
Paper Money and Moral Hazard
Central banks function as lenders of last resort, that is, they lend money to financial firms and others who are unable to find creditors on the market. The salient point is that they can provide this service without any technical or economic limitations. Indeed, the money they lend does not cost them anything at all. Central banks do not have to borrow money; rather they make the money of the nation. Because paper notes ("greenbacks") and electronic accounts ("liquidities") are virtually costless to make, it follows that the amount central banks can lend is basically unlimited. This allows them not only to provide virtually unlimited credit to governments and similar institutions, but also to bail out market participants on the verge of bankruptcy. Thus they can prevent financial contagions and meltdowns.
At first sight, it appears that the activity of central banks is wholly beneficial. However, the exact opposite is the case. The problem is that the financial firms know that the central banks are there to help them out in times of trouble. They know that these institutions can make and lend as much money as they wish, at any price they wish, without being subject to physical or economic constraints. As a consequence, financial agents have the incentive to reckon with this kind of assistance. Rather than making their business plans and investment decisions in a responsible way, relying on other people only through contracts and other voluntary agreements, they now rely on publicly sponsored bailouts.
Who pays for such bailouts? Not the customers of the banks and other financial agents. Rather, these groups belong to the net beneficiaries of this policy. The true paymasters are citizens as a whole, in their capacity as money users. Bailouts through monetary policy always involve increases in the money supply. Money prices then tend to increase beyond the level they would otherwise have reached, and thus the purchasing power per unit of money is diminished below the level it would otherwise have reached. The real cash balances in the pockets of the citizens shrink, as do the real incomes of all people living on nominally fixed revenues. Of course financial agents and their customers share this kind of loss, because they too are money users. But they pay only a part of the total bill. The rest is imposed on the rest of society.
To sum up, bailouts through monetary policy socialize the costs of bad investment decisions. This creates a moral hazard on the side of all the beneficiaries. Financial agents can worry less about risk and concentrate on possible profits. They become exuberant and turn to excessively risky business practices such as reducing the equity ratio. But their customers are prone to moral hazard too. They realize — even if they do not understand the technical reasons — that money invested on the financial markets benefits from central-bank support. Therefore they have a perverse incentive not to look too closely at the risks. They become exuberant as well.
Financial market fragility and moral hazard are therefore only proximate causes of financial crises. The ultimate cause is monetary policy, and in particular, the current paper-money system, which allows the central banks to provide limitless lender-of-last-resort services. Monetary policy creates powerful incentives for market participants to reduce their equity ratios and thus increase the likelihood of contagion. The lower the average equity ratio, the smaller is the critical firm size that might entail contagion effects. Ten years ago, a medium-sized firm called Long Term Capital Management (LTCM) — founded and directed by two Nobel Prize–winning economists — went bankrupt and threatened to pull much of the world financial markets with it. The meltdown was prevented through a monetary bailout, with the result that there is now even less of an incentive to hold equity.
The foregoing considerations are perfectly straightforward. They are a hard pill to swallow, though, for true believers in the benefits of paper money and monetary policy. In the past few months, two of these true believers have taken a hard look at the causal connection between monetary policy, moral hazard, and financial crises. We will discuss their arguments in turn.
Moral Hazard Fundamentalism?
Writing for the Financial Times online, Professor Lawrence Summers warns against "moral hazard fundamentalism." He admits that moral hazard is "central to every policy discussion in response to a financial crisis or the prospect of a crisis." However, he holds that it is not always a problem and that fighting it can do more harm than good.
Summers raises three main points, so let us discuss them in turn.
First, he claims that
if there is "contagion" as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.
Clearly, Professor Summers should get in touch with an insurance agent and inquire how fire contagion is handled in practice. He will find ample empirical confirmation that the free market can handle this problem. The reason is that people will usually be held responsible for fire that spreads from their buildings to others. They therefore do have an incentive to buy sufficient insurance, lest they have to pay the difference out of their own pockets. Things are entirely different in the financial sector. The point of monetary bailouts is precisely to prevent certain firms from paying the full amount of the damage that results from their activities.
Second, Summers holds that monetary interventionism often
does not impose any costs on taxpayers and may actually make them better off. In the much criticized LTCM case no taxpayer money, except perhaps the cost of a lunch, was spent.
This argument is correct only in a narrow technical sense. It is true that central banks usually do not confiscate notes and bank accounts, and neither did they do so in the LTCM case. But it would be a grave error to infer that the LTCM bailout did not occasion any substantial cost for the citizenry. We have already seen who ultimately pays for bailouts: the citizens in their capacity as money users. When central banks bail out firms such as LTCM they increase the money supply and thus reduce the purchasing power per dollar below what it would otherwise have been. Each citizen is therefore somewhat expropriated, just as he would be expropriated through taxation (which is also why economists speak in this context of an "inflation tax"). The amount per person or household might have been just a few cents or dollars in the LTCM case. But the total reached hundreds of millions of dollars, not just the cost of a lunch.
Third, Professor Summers argues that moral hazard is the price to pay for various benefits of monetary policy — benefits that could not otherwise be obtained. He mentions in this context the fight against deflation and stresses in particular the liquidity services that a flexible money supply might convey. This latter point is based on the conventional distinction between insolvency and illiquidity. Summers argues that central banks should let insolvent firms go bankrupt, whereas it might be wise to bail out firms that are "only" illiquid, in order to avert "needless panic and contagion." Such a policy allows financial firms to reduce the "capital" (he probably means equity) they have to hold and thus "encourages investment in productive but illiquid projects."
This very broad argument cannot be fully discussed in the present paper. Let us merely state a few central points in response.
The first thing to notice is that monetary policy is to a very large extent the cause of the very problems it is supposed to solve. Most notably it incites financial firms to minimize equity ratios and liquidity provisions. Because these incentives would not exist on the free market, contagion and liquidity problems would be much fewer in number and (in the case of contagion) possibly absent.
As we have seen, however, Professor Summers thinks that reduced equity and liquidity provisions convey an aggregate benefit, because they allow financial firms to invest more than they otherwise could. It is true that banks and other financial firms with central bank support can invest more than they otherwise could. But it is a fallacy to infer that this necessarily translates into higher overall growth rates. Real economic growth is always determined by real factors of production — human beings and their competences, the ingenuity of entrepreneurs and technicians, quantities and qualities of tools, hardware, materials, and so on. Financial firms are only intermediaries in channeling these real resources into certain uses. This can be beneficial, but financial intermediation is not an absolutely indispensable element of the market economy. Real resources can be used one way or another, even when no financial intermediation takes place. What central banks do is to prop up artificially the amount of investment mediated through the financial sector, and to artificially diminish investment that is not so mediated. Central banks confer an artificial advantage to debt-based financial strategies and a corresponding disadvantage to strategies based on equity. In the best of all cases, this makes for a zero-sum game.
The benefits that Summers sees in monetary policy evaporate under closer scrutiny. Austrian economists have argued in some detail that the same holds true for just about any alleged benefit of paper money and central banking. It would lead us too far afield to reiterate the arguments contained in this literature; we just state for the record that this literature exists.
Finally, we need to notice that Professor Summers shows no awareness of the dynamics of institutionalized moral hazard. Even if we assume for the sake of argument that central-bank policy can convey the benefits he mentions, the fact is that these benefits come at an ever-increasing cost. The presence of monetary-policy-induced moral hazard means that the market participants have a permanent and powerful incentive to explore ever-new ways to socialize the risks of their investments. Financial regulation does not eliminate this incentive. It merely channels it into forms of behavior that are not yet regulated.
It follows that, from just about any point of view, our present monetary system is a foolish institutional setup. Summers thinks that the present benefits outweigh the (moral hazard) costs of monetary policy. Fine. Others might share this value judgment, and still others might accept even higher levels of moral hazard as the price to pay for those benefits. But the benefits are doubtful and do not grow, whereas the costs are manifest and do grow the longer the system is in operation. The longer we wait, therefore, the more people will come to the personal conclusion that the costs are just too high as compared to the benefits. In the long run only the most starry-eyed doctrinaire monetary statists will brush this consideration aside. All others are well advised to act in time, consider the dynamics of moral hazard, and acquaint themselves with the Austrian literature on monetary policy.
In Search of Actual Moral Hazard
In a carefully crafted statement, St. Louis Fed President William Poole has recently stressed the difference between the moral hazard that might potentially result from monetary policy, and the one that actually has resulted from it so far. While the potential is "clearly enormous," he believes that in actual fact moral hazard has been a minor issue, with the sole exception of government-sponsored enterprise.
In a similar vein as Lawrence Summers, Poole admits that financial firms have reduced their equity ratios because of monetary policy and are therefore more vulnerable in the face of shocks; but he holds that shocks have become less frequent thanks to a monetary policy of price-level stabilization.
The main objection to this argument is that it is not necessarily beneficial to suppress monetary shocks — just as in medicine it is not beneficial to prevent fever under any and all circumstances. Economic shocks and crises can have the very useful and important function of purging the economy of bad investments and other wasteful practices. When central banks fight recessions through the printing press, they ultimately prevent this cleansing of the economy. As a consequence, growth rates are lower than they otherwise could have been and the average living standard of the population is correspondingly curtailed.
Next, Poole argues that the Fed has protected a meltdown of the market as a whole, yet "without protecting any particular firm." This is certainly in line with what most citizens think their central bank should do. It is not in line, however, with the facts. And indeed, Poole then goes on to admit that some firms may simply be too big to fail. In more technical jargon, in such cases "the adverse consequences for stability are so great that intervention is unavoidable."
Now is this not a moral-hazard issue with potentially major consequences? If so, does actual moral hazard not come dangerously close to potential moral hazard? Poole tackles this problem by shifting the ground from positive to normative analysis. Rather than analyzing actual moral hazard as it has been in the recent past, he presents a recommendation for how firms that are too big to fail should be dealt with:
In that situation, any intervention ought to take a form such that the costs to shareholders and management are so large that no firm in the future will want to allow itself to fall into such a situation. Lest I be regarded as a soft touch when I say that a situation could arise that could make intervention "inevitable," I would set a very high bar to any intervention. [Emphasis added]
Are we to infer from this that the Fed has not, in actual practice, imposed sufficiently heavy costs on the firms it has bailed out? If not, why does Dr. Poole state what it ought to do, and what he would do, rather than what the Fed actually did? These are vexing questions. In lieu of an answer, Poole embroils himself in contradictions. On the one hand, he stresses that "some boards of directors have forced out their CEOs and companies have raised new capital, diluting the ownership position of existing shareholders." On the other hand, and virtually in the same breath, he reports that "we are fortunate that in the current episode, so far anyway, no large financial firms have been so weakened by large losses that they were unable to raise new capital."
Thus there was some pain inflicted on the companies that are too big to fail, but not too much after all? His colleagues at the Federal Open Market Committee have been heeding his advice, but without overdoing it? And the result was all in all "fortunate," even though the Fed did not do what should have done? Clearly, Poole's statements leave quite a few black holes in the analysis of actual moral hazard
Let us therefore turn to considering Poole's proposition itself. Would there be no significant moral hazard if the Fed were to follow his recommendation and bail out firms that are too big to fail only at a punitive cost?
Notice first of all that this is a very old approach that can be traced back at least to the originator of the "lender of last resort" phrase, British economist Walter Bagehot, who proposed in 1873 that the Bank of England bail out other banks in times of financial turmoil — but only at a very high interest rate. This policy was undoubtedly applied in the years to come. But did it prevent moral hazard in the financial industries? Did it stem the tide toward an ever-further reduction of equity ratios? To ask these questions is to answer them.
The basic problem with Bagehot and Poole's approach is that a bailout, even if very costly, is never quite as costly as bankruptcy. It is still a bailout. As a consequence, firms that are too big to fail still do have a very strong incentive to behave irresponsibly. In the worst of all cases, a few heads will roll (well, not quite — a few managers will leave with compensation packages), and there will be heavy write-downs. But the show will go on, always, as long as the firm in question remains too big to fail; and there is no reason why it should ever grow smaller as long as it has the support of the Fed.
Longstanding political meddling with money has ushered into the present a worldwide system of paper money and central banking. These two institutions create incentives for irresponsible behavior on a mass scale. The result is recurrent financial and economic crises such as the present one. Central banks can "fight" a crisis only by bailing out financial firms and similar market participants with the help of the printing press. Thus, they make the overall community of money users pay for the mistakes of those firms. The beneficiaries of a bailout have no incentive to behave more responsibly in the future. On the contrary, their incentives to take risks out of proportion with the possible returns on investment are even stronger. To avoid such economic crises and such unjustifiable redistribution of income from the many to the few, one has to end the legal interference that has created the present system. There is no other way to achieve these objectives.
These are the plain facts about our present monetary system. Beware those who trivialize them.
 In recent months, the Fed has applied a new bailout technique, which consists in swapping defaulting assets from the balance sheets of banks and other financial agents against sound assets held by the Fed. This policy too is ultimately premised on an increase of the money supply, because the Fed comes to hold any asset only by first making new money and then buying the asset.
 The theory of moral hazard is therefore an integral part of modern Austrian business cycle theory. See J.G. Hülsmann, "Toward a General Theory of Error Cycles," QJAE, vol. 1, no. 4 (1998); idem, "The Political Economy of Moral Hazard," Politická ekonomie (February 2006).
 I have explained this in more detail in "The Cultural and Spiritual Consequences of Fiat Inflation," which is chapter 13 of my book Die Ethik der Geldproduktion (Leipzig: Manuscriptum, 2007). An English version of this book is forthcoming from the Mises Institute.