‘Moral hazard’

This phrase always makes me chuckle, but I can see the intuitive logic of the concept. If we continually rescue people from the consequences of their bad behavior, we set them up to repeat it. It’s actually a good principle to keep in mind when dealing with irresponsibility in the personal as well as the financial realm.

In finance ‘moral hazard’ refers to the unintended consequences of bailing out institutions or individuals who have made mess of things, and the frequent linkage of the two phrases is no accident. Conservatives love to argue that they aren’t heartless, they just don’t want to create ‘moral hazard’ through things like extending unemployment benefits or rescuing destitute mortgage-holders.

Average folks have a sense of ‘moral hazard’ too. They (we) are mad as wet hens over all the government cash pouring into the pockets of the banker screw-ups, not just because they don’t deserve it, but also because it encourages those responsible to go right back to business-as-usual as soon as the threat of cataclysm fades.

I hope that’s not the meaning of today’s stampede into banking stocks as Geithner and Summers seem to have got their way. If they are rescuing the big debtholders of the giant vampire banks despite their catastrophic performances, the same speculators and sharpies who did this to us will be encouraged to go do it again, and all the talk of ‘tighter regulation’ will turn into pious bromides. The moneychangers have a million ways to get around that stuff especially if there’s no real risk involved in blowing open the system once again.

On the other hand, if these guys are wiped out as they so richly deserve, fancy regs from Uncle Sam will be welcome reminders but with much larger teeth. It might keep these institutions cut down to a less threatening size, too, as big-bigger-biggest will be no longer a guarantee of eternal life.

This isn’t the same as letting B of A or Citigroup collapse a la Lehman Brothers. A coherent nationalization process would separate good from bad bank assets as in the Swedish model everyone is talking about, manage the latter and return the former to a re-privatized institution somewhere down the road. As I imperfectly understand it, the fact that the government would be holding the bag of bad debt eliminates the stampede threat that occurred with Lehman and other big entities that then cascades throughout the financial system, carrying the threat of a total meltdown. It costs money, but the system is cleansed quickly to avoid the Japanese error of dragging out the process forever (which everyone is also talking about), which results in higher eventual costs and can also fail entirely.

A bold stroke of this sort would also dispose of the need to price the mystery assets accurately. You read everywhere that uncertainly about who really is holding what is clogging up lending of all sorts as people simply don’t trust each other. (The crafty financiers outsmarted themselves and took us along with them.) We need the state to repair the damage, but there has got to be some real pain attached to the strategy so that we’re not back in the soup ten or twenty years from now.